CHAPTER 2 1.

As a rule of thumb, real rates of interest are calculated by subtracting the inflation rate from the nominal rate. What is the error from using this rule of thumb for calculating real rates of return in the following cases? Nominal rate (%) "nflation rate (%) Solution:
Nominal rate(%)(N&) "nflation rate(%) ( "&) &eal rate by the rule of thumb(%) 'orrect rate(%)((1)N&)*(1)"&)+1 /rror from using the rule of thumb(%) 7 # , .!! %.1 1 $ $ -.$$ %.,# 1! ! 1% .. $ %.7# 1% 1 1%..1 1.%.

7 #

1 $

1! !

1%

As a rule of thumb, real rates of interest are calculated by subtracting the inflation rate from the nominal rate. What is the error from using this rule of thumb for calculating real rates of return in the following cases? Nominal rate (%) "nflation rate (%) # 1 ! , 11 1. #

Solution:
Nominal rate(%)(N&) "nflation rate(%) ( "&) &eal rate by the rule of thumb(%) 'orrect rate(%)((1)N&)*(1)"&)+1 /rror from using the rule of thumb(%) # 1 , ..7 %.%, ! , #.!%.1. !.! %.1! 11 1. # 11#.# %.-!

CHAPTER 3 1. At the end of 0arch, %1$ the balances in the 2arious accounts of 3honi 4 'om5any are as follows6 Rs. in million Accounts Balance /7uity ca5ital 8reference ca5ital 9i:ed assets (net) &eser2es and sur5lus 'ash and ban; 3ebentures (secured) 0ar;etable securities <erm loans (secured) &ecei2ables =hort+term ban; borrowing (unsecured) "n2entories <rade creditors 8ro2isions 8re+5aid e:5enses 1 % ,% 17 %% ,1%% 1! .% %% 7% 1% $% % 1%

&e7uired6 8re5are the balance sheet of 3honi 4 'om5any as 5er the format s5ecified by the 'om5anies Act. Solution: Balance Sheet of Dhoni & Company As on March 31, 20 Liabilities =hare ca5ital /7uity 8reference &eser2e 4 sur5lus Assets 9i:ed assets 1 % Net fi:ed assets ,% %% "n2estments 0ar;etable securities 'urrent assets, loans 4 ad2ances 1%% .% Pre-paid expenses "n2entories 7% &ecei2ables 'ash 4 ?an; $% % 17 !

18

=ecured loans 3ebentures <erm loans >nsecured loans =hort term ban; borrowing 'urrent liabilities 4 5ro2isions <rade creditors 8ro2isions

10 1% %% 35

$.% $.% At the end of 0arch, %17 the balances in the 2arious accounts of =ania @imited are as follows6 Rs. in million Accounts Balance /7uity ca5ital 8reference ca5ital 9i:ed assets (net) &eser2es and sur5lus 'ash and ban; 3ebentures (secured) 0ar;etable securities <erm loans (secured) &ecei2ables =hort+term ban; borrowing (unsecured) "n2entories <rade creditors 8ro2isions 8re+5aid e:5enses -% !% ,!% ,-% 1%% 1.% ,% 1 % # % 11% ,1% .% 7% %

&e7uired6 8re5are the balance sheet of =ania @imited as 5er the format s5ecified by the 'om5anies Act. Solution: Balance Sheet of Sania "imite# as on March 31, 20 Liabilities =hare ca5ital /7uity 8reference &eser2e 4 sur5lus 9i:ed assets -% Net fi:ed assets !% ,-% "n2estments 0ar;etable securities 'urrent assets, loans 4 ad2ances 1.% 1 % 8re+5aid e:5enses "n2entories 11% &ecei2ables 'ash 4 ?an; .% ,!% Assets $

30

=ecured loans 3ebentures <erm loans >nsecured loans =hort term ban; borrowing 'urrent liabilities 4 5ro2isions <rade creditors

20 ,1% # % 100

,.

7% 1 $% <he com5arati2e balance sheets of /2ergreen 'om5any are gi2en below6 '(ners) *+uity an# "ia,ilities =hare ca5ital &eser2es and sur5lus @ong+term debt =hort+term ban; borrowings <rade creditors 8ro2isions <otal Assets 9i:ed assets (net) "n2entories 3ebtors 'ash Ather assets <otal As on 31.3.20 ! 7% #% !% !% #% 1% , % 1 % .% $% , %

8ro2isions

1 $%

%Rs. in million& As on 31.3.20 $ 7% !% .% !7% % #11% .$,% 1#1-

<he 5rofit and loss account of /2ergreen 'om5any for the year ending ,1st 0arch %%7 is gi2en below6 %Rs. in million& -rofit & "oss Account for the -erio# 1...20 ! to 31.3.20 $ Net sales 'ost of goods sold =toc;s Wages and salaries Ather manufacturing e:5enses Bross 5rofit A5erating e:5enses =elling, administration and general 3e5reciation A5erating 5rofit Non+o5erating sur5lus or deficit /?"< "nterest 8rofit before ta: <a: 8rofit after ta: 7-% -%.% 1%11% #1,1 % 111% ( %) .% $1-%

3i2idends &etained earnings &e7uired6

1% #%

(a) 8re5are the classified cash flow statement for the 5eriod 1.#. %1$ to ,1.,. %17 (b) 3e2elo5 the cash flow identity for the 5eriod 1.#. %1$ to ,1.,. %17

Solution: A. Cash flow from operating acti ities + Net 5rofit before ta: and e:traordinary items + AdCustments for "nterest 5aid 3e5reciation + A5erating 5rofit before wor;ing ca5ital changes - AdCustments for "n2entories 3ebtors <rade creditors 8ro2isions "ncrease in other assets + 'ash generated from o5erations "ncome ta: 5aid + 'ash flow before e:traordinary items /:traordinary item + Net cash flow from o5erating acti2ities Cash flow from in esting acti ities + 8urchase of fi:ed assets + Net cash flow from in2esting acti2ities Cash flow from financing acti ities + "ncrease in loans + 3i2idends 5aid + "nterest 5aid Net cash flow from financing acti2ities !et increase in cash an" cash e#ui alents + 'ash and cash e7ui2alents as on ,1.%,. %1$ + 'ash and cash e7ui2alents as on ,1.%,. %:7 "t has been assumed that Dother assetsE re5resent Dother current assetsE.

!11 (-) (-) ,% 1% 1% 1$(1-) 1-% ( %) 1,% (1%-) (1%-)

?.

'.

1(1%) ( -) ( %) ,%

3.

Note

(b) A$ Cash flow from assets + A5erating cash flow + Net ca5ital s5ending + 3ecrease in net wor;ing ca5ital + 'ash flow from assets ?. Cash flow to cre"itors + "nterest 5aid + &e5ayment of long term debt + 'ash flow to creditors Cash flow to sharehol"ers + 3i2idends 5aid + Net new e7uity raised + 'ash flow to shareholders (A) i.e., 'ash flow from assets #. ( ( (?) ) ( ') 'ash flow to creditors ) 'ash flow to shareholders 1% % 1% .% (1%-) ,% (1-) 1%

'.

We find that

<he com5arati2e balance sheets of 1a2ier @imited are gi2en below6 '(ners) *+uity an# "ia,ilities =hare ca5ital &eser2es and sur5lus @ong+term debt =hort+term ban; borrowings <rade creditors 8ro2isions <otal Assets 9i:ed assets (net) "n2entories 3ebtors 'ash Ather assets <otal As on 31.3.20 ! % 1% ,% 11% .% 1$ ## % .% %Rs. in million& As on 31.3.20 $ ,% 1! 11! 111 % -1 ! 7 111

<he 5rofit and loss account of 1a2ier @imited for the year %%7 is gi2en below6 %Rs. in million& -rofit & "oss Account for the -erio# 1...20 ! to 31.3.20 $ Net sales % 'ost of goods sold =toc;s Wages and salaries Ather manufacturing e:5enses Bross 5rofit A5erating e:5enses =elling, administration and general 3e5reciation A5erating 5rofit Non+o5erating sur5lus or deficit /?"< "nterest 8rofit before ta: <a: 8rofit after ta: 3i2idends &etained earnings &e7uired6 1#% .% ,1!% #% % 11 1$ # 1 1% !

(a) 8re5are the classified cash flow statement for the 5eriod 1.#. %1$ to ,1.,. %17 (b) 3e2elo5 the cash flow identity for the 5eriod 1.#. %1$ to ,1.,. %17

Solution : A. Cash flow from operating acti ities + Net 5rofit before ta: and e:traordinary items + AdCustments for "nterest 5aid 3e5reciation + A5erating 5rofit before wor;ing ca5ital changes AdCustments for "n2entories 3ebtors <rade creditors

11 # %

(11) (1) -

?.

8ro2isions "ncrease in other assets + 'ash generated from o5erations "ncome ta: 5aid + 'ash flow before e:traordinary items /:traordinary item + Net cash flow from o5erating acti2ities Cash flow from in esting acti ities + 8urchase of fi:ed assets + Net cash flow from in2esting acti2ities Cash flow from financing acti ities % "ncrease in e7uity + &e5ayment of term loans +3i2idend 5aid + "nterest 5aid Net cash flow from financing acti2ities !et increase in cash an" cash e#ui alents + 'ash and cash e7ui2alents as on ,1.%,. %1$ + 'ash and cash e7ui2alents as on ,1.%,. %:7

, ( ) 1# ( ) 1 1 1, (.) (.) 10 (-) ( ) (#) (1) , !

'.

3.

Note (b) A

"t has been assumed that Dother assetsE re5resent Dother current assetsE. Cash flow from assets + A5erating cash flow + Net ca5ital s5ending + 3ecrease in net wor;ing ca5ital + 'ash flow from assets Cash flow to cre"itors + "nterest 5aid + &e5ayment of long term debt + 'ash flow to creditors Cash flow to sharehol"ers + 3i2idends 5aid + Net new e7uity raised + 'ash flow to shareholders (A) ( ( (?) ) ( ') 'ash flow to creditors ) 'ash flow to shareholders

1. (.) (.) 1 # . (1%) (!)

?.

'.

We find that i.e., 'ash flow from assets

CHAPTER & 1. 8remier 'om5anyFs net 5rofit margin is ! 5ercent, total assets turno2er ratio is .times, debt to total assets ratio is %.$. What is the return on e7uity for 8remier? Net 5rofit &eturn on e7uity ( /7uity ( Net 5rofit : Net sales ( 3ebt Note 6 <otal assets ( %.$ =o <otal assets %.%! : <otal assets 1 .: ( %.- or -% 5er cent %.# ( 1+ %.$ ( %.# Net sales : /7uity <otal assets

Solution:

/7uity

Gence <otal assets*/7uity ( 1*%.# . <he following information is gi2en for Al5ha 'or5oration =ales ,-%% 'urrent ratio 1.Acid test ratio 1. 'urrent liabilities 1%%% What is the in2entory turno2er ratio? Solution: "n2entory ( -%%%*'urrent assets ( ( 1%%% 'urrent liabilities : 1.( 1%%% : 1.- ( 1-%% 'urrent assets Huic; assets ( 'urrent liabilities 'urrent ratio ( ( 1.# : 1. ( 1%%% : 1. 'urrent liabilities ( 1 %% "n2entories ( ,%% ,-%% 'urrent assets I "n2entories "n2entory turno2er ratio ( ( 11.7 Acid test ratio ( ( 1.% ,%% 'urrent @iabilities ,. <he following information is gi2en for ?eta 'or5oration. '.A + 1%%% =ales -%%% ( 1.% 'urrent 1.# '@ratio "n2entory turno2er ratio 'A 1%%% Acid test ratio+ 1.% ( 1.% '@ of current '@ liabilities? What is the le2el 1%%% Solution: 1.# + ( 1.% '@ 1%%% %.# ( '@ ( -%% '@

#.

=afari "nc. has 5rofit before ta: of &s..% million. "f the com5anyFs times interest co2ered ratio is #, what is the total interest charge?

Solution: 8?< ( &s..% million -B/0 <imes interest co2ered ( =o -B/0 ( # : "nterest 8?< ( 8?"< I interest ( #: interest+ interest ( , : interest ( .% million <herefore interest ( .%*, ( &s.,% million -. A has 5rofit before ta: of &s.#% million. "f its times interest co2ered ratio is $, what is the total interest charge? ( # "nterest

Solution: 8?< ( &s. #% million -B/0 <imes interest co2ered ( "nterest =o -B/0 ( $ : "nterest -B/0 I "nterest ( -B0 ( &s.#% million $ : "nterest I "nterest ( &s. #% million - : "nterest ( &s.#% million ( $

Gence "nterest ( &s.! million $. 0cBill "nc. has 5rofit before ta: of &s.$, million. "f the com5anyFs times interest co2ered ratio is !, what is the total interest charge?

Solution: 8?< ( &s.$, million -B/0 <imes interest co2ered ( "nterest =o -B/0 ( ! : "nterest -B/0 I "nterest ( -B0 ( &s.$, million ! : "nterest I "nterest ( 7 : "nterest ( &s.$, million Gence "nterest ( &s.. million 7. <he following data a55lies to a firm 6 "nterest charges &s. %%,%%% =ales &s.$,%%%,%%% <a: rate #% 5ercent Net 5rofit margin - 5ercent What is the firmFs times interest co2ered ratio? ( !

=olution6 =ales ( &s.$,%%%,%%% Net 5rofit margin ( - 5er cent Net 5rofit ( &s.$,%%%,%%% : %.%- ( ,%%,%%%

( #% 5er cent ,%%,%%% =o, 8rofit before ta: ( (1+.#) "nterest charge ( &s. %%,%%%

<a: rate

( &s.-%%,%%%

=o 8rofit before interest and ta:es ( &s.7%%,%%% Gence <imes interest co2ered ratio ( !. 7%%,%%% ( ,.%%,%%% <he following data a55lies to a firm6 "nterest charges =ales <a: rate Net 5rofit margin &s.-%,%%% &s.,%%,%%% - 5ercent , 5ercent

What is the firmFs times interest co2ered ratio? Solution: =ales ( &s.,%%,%%% Net 5rofit margin ( , 5er cent Net 5rofit ( &s.,%%,%%% : %.%, ( .,%%% <a: rate ( - 5er cent .,%%% =o, 8rofit before ta: ( (1+. -) "nterest charge ( &s.-%,%%% $ ,%%% ( 1. # -%,%%% =o 8rofit before interest and ta:es ( &s.$ ,%%% Gence <imes interest co2ered ratio ( .. ( &s.1 ,%%%

<he following data a55lies to a firm 6 "nterest charges =ales <a: rate Net 5rofit margin &s.1%,%%%,%%% &s.!%,%%%,%%% -% 5ercent 1% 5ercent

What is the firmFs times interest co2ered ratio?

Solution: =ales ( &s.!%,%%%,%%% Net 5rofit margin ( 1% 5er cent Net 5rofit ( &s.!%,%%%,%%% : %.1 ( !,%%%,%%% <a: rate ( -% 5er cent !,%%%,%%% =o, 8rofit before ta: ( ( &s.1$,%%%,%%% (1+.-) "nterest charge ( &s.1%,%%%,%%% =o 8rofit before interest and ta:es ( &s. $,%%%,%%% Gence $,%%%,%%% <imes interest co2ered ratio ( ( .$ 1%,%%%,%%% 1%. A firmFs current assets and current liabilities are -,%%% and 1!,%%% res5ecti2ely. Gow much additional funds can it borrow from ban;s for short term, without reducing the current ratio below 1.,-?

Solution: 'A ( -,%%% '@ ( 1!,%%% @et ?? stand for ban; borrowing 'A1?? ( 1.,'@1?? -,%%%)?? ( 1!,%%%)?? 1.,-: 1!,%%% ) 1.,- ?? ( -,%%% ) ?? %.,-?? ( -,%%%+ #,,%% ( 7%% ?? ( 7%%*%.,- ( ,%%% 11. @NBJs current assets and current liabilities are %%,%%% and 1#%,%%% res5ecti2ely. Gow much additional funds can it borrow from ban;s for short term, without reducing the current ratio below 1.,,? 1.,-

Solution: 'A ( %%,%%% '@ ( 1#%,%%%

@et ?? stand for ban; borrowing 'A1?? ( 1.,, '@1?? %%,%%%)?? ( 1#%,%%%)?? 1.,,

1.,, : 1#%,%%% ) 1.,,?? ( %%,%%% ) ?? %.,, ?? ( %%,%%%+ 1!$, %% ( 1,,!%% ?? (1,,!%%*%.,, ( #1,!1! 1 . Na2neetJs current assets and current liabilities are 1%,%%%,%%% and 7,%%%,%%% res5ecti2ely. Gow much additional funds can it borrow from ban;s for short term, without reducing the current ratio below 1.#?

Solution: 'A ( 1%,%%%,%%% 'A1?? ( 1.# '@1?? 1%,%%%,%%%)?? ( 7,%%%,%%%)?? 1.# : 7,%%%,%%% ) 1.#?? ( 1%,%%%,%%% ) ?? %.# ?? ( 1%,%%%,%%%+ .,!%%,%%% ( %%,%%% ?? ( %%,%%%*%.#% ( -%%,%%% 1,. A firm has total annual sales (all credit) of -,%%%,%%% and accounts recei2able of !,%%%,%%%. Gow ra5idly (in how many days) must accounts recei2able be collected if management wants to reduce the accounts recei2able to $,%%%,%%%? -,%%%,%%% A2erage daily credit sales ( ( $!,#., ,$"f the accounts recei2able has to be reduced to $,%%%,%%% the A'8 must be6 $,%%%,%%% ( !7.$ days $!,#., 1.# '@ ( 7,%%%,,%%%

@et ?? stand for ban; borrowing

Solution:

1#.

A firm has total annual sales (all credit) of 1, %%,%%% and accounts recei2able of -%%,%%%. Gow ra5idly (in how many days) must accounts recei2able be collected if management wants to reduce the accounts recei2able to ,%%,%%%?

Solution: 1, %%,%%% A2erage daily credit sales ( ,$"f the accounts recei2able has to be reduced to ,%%,%%% the A'8 must be6 ,%%,%%% ( .1., days , !7.$7 1-. A firm has total annual sales (all credit) of 1%%,%%%,%%% and accounts recei2able of %,%%%,%%%. Gow ra5idly (in how many days) must accounts recei2able be collected if management wants to reduce the accounts recei2able to 1-,%%%,%%%? 1%%,%%%,%%% A2erage daily credit sales ( ,$"f the accounts recei2able has to be reduced to 1-,%%%,%%% the A'8 must be6 1-,%%%,%%% ( -#.! days 7,,.7 .$ 1$. <he financial ratios of a firm are as follows. 'urrent ratio Acid+test ratio 'urrent liabilities "n2entory turno2er ratio What is the sales of the firm? ( ( ( ( 1. 1.1% %%% 1% ( 7,,.7 .$ ( , !7.$7

=olution6

Solution: 'urrent assets ( 'urrent liabilities : 'urrent ratio ( %%% : 1. (

-%%

'urrent assets + "n2entories ( 'urrent liabilities : Acid test ratio ( %%% : 1.1% ( %% "n2entories ( ,%% =ales ( "n2entories : "n2entory turno2er ratio

,%%

1%

,%%%

17.

<he financial ratios of a firm are as follows. 'urrent ratio ( Acid+test ratio ( 'urrent liabilities ( "n2entory turno2er ratio ( What is the sales of the firm?

1.,, %.!% #%,%%% $

Solution: 'urrent assets ( 'urrent liabilities : 'urrent ratio ( #%,%%% : 1.,, ( -,, %% 'urrent assets + "n2entories ( 'urrent liabilities : Acid test ratio ( #%,%%% : %.!% ( , ,%%% "n2entories =ales 1!. ( ( ( 1, %% "n2entories : "n2entory turno2er ratio 1, %% : $ ( 1 7, %%

<he financial ratios of a firm are as follows. 'urrent ratio Acid+test ratio 'urrent liabilities "n2entory turno2er ratio What is the sales of the firm? ( ( ( ( 1.$ 1. ,%%%,%%% -

Solution: 'urrent assets ( 'urrent liabilities : 'urrent ratio ( ,%%%,%%% : 1.$ ( ,, %%,%%% 'urrent assets + "n2entories ( 'urrent liabilities : Acid test ratio ( ,%%%,%%% : 1. ( ,#%%,%%% "n2entories =ales ( ( ( !%%,%%% "n2entories : "n2entory turno2er ratio !%%,%%% : ( #,%%%,%%%

1..

'om5lete the balance sheet and sales financial data6 3ebt*e7uity ratio Acid+test ratio <otal assets turno2er ratio 3aysF sales outstanding in Accounts recei2able Bross 5rofit margin "n2entory turno2er ratio

data (fill in the blan;s) using the following ( ( ( ( ( ( %.!% 1.1 ,% days ,% 5ercent $

Balance sheet /7uity ca5ital !%,%%% &etained earnings -%,%%% =hort+term ban; borrowings . . . . =ales 'ost of goods sold Solution: 3ebt*e7uity ( %.!% /7uity ( !%,%%% ) -%,%%% ( 1,%,%%% =o 3ebt ( =hort+term ban; borrowings ( %.! : 1,%,%%% ( 1%#,%%% Gence <otal assets ( 1,%,%%%)1%#,%%% ( ,#,%%% <otal assets turno2er ratio ( =o =ales ( : ,#,%%% ( #$!,%%% Bross 5rofit margin ( ,% 5er cent =o 'ost of goods sold ( %.7 : #$!,%%% ( , 7,$%% 3ayJs sales outstanding in accounts recei2able ( ,% days =ales =o Accounts recei2able ( ,$% #$!,%%% ( ,$% 'ost of goods sold "n2entory turno2er ratio ( "n2entory ( "n2entory , 7,$%% ( $ : ,% ( ,.,%%% : ,% .... .... KK.. 8lant and e7ui5ment "n2entories Accounts recei2able 'ash .... .... .... .... ....

=o "n2entory ( -#,$%% As short+term ban; borrowing is a current liability, 'ash ) Accounts recei2able Acid+test ratio ( 'urrent liabilities 'ash ) ,.,%%% ( 1%# ,%%% =o 'ash ( 7-,#%% 8lant and e7ui5ment ( <otal assets + "n2entories I Accounts recei2able I 'ash ( ,#,%%% + -#,$%% + ,.,%%% I 7-,#%% ( $-,%%% 8utting together e2erything we get 'alance Sheet /7uity ca5ital !%,%%% &etained earnings -%,%%% =hort+term ban; borrowings 1%#,%%% 8lant 4 e7ui5ment "n2entories Accounts recei2able 'ash ,#,%%% ,#,%%% =ales 'ost of goods sold %. #$!,%%% , 7,$%% $-,%%% -#,$%% ,.,%%% 7-,#%% ( 1.1

'om5lete the balance sheet and sales data (fill in the blan;s) using the following financial data6 3ebt*e7uity ratio ( %.#% Acid+test ratio ( %.. <otal assets turno2er ratio ( .3aysF sales outstanding in Accounts recei2able ( - days Bross 5rofit margin ( - 5ercent "n2entory turno2er ratio ( ! 'alance sheet /7uity ca5ital 1$%,%%%,%%% &etained earnings ,%,%%%,%%% =hort+term ban; borrowings . . . KK =ales 'ost of goods sold .... ....K. KK. 8lant and e7ui5ment++++++++ "n2entories KKK Accounts recei2able K.. . . . 'ash .... ....

Solution: 3ebt*e7uity ( %.#% /7uity ( 1$%,%%%,%%% ) ,%,%%%,%%% ( 1.%,%%%,%%% =o 3ebt ( =hort+term ban; borrowings ( %.# : 1.%,%%%,%%% ( 7$,%%%,%%% Gence <otal assets ( 1.%,%%%,%%%) 7$,%%%,%%% ( $$,%%%,%%% <otal assets turno2er ratio ( .=o =ales ( .- : $$,%%%,%%% ( $$-,%%%,%%% Bross 5rofit margin ( - 5er cent =o 'ost of goods sold ( %.7- : $$-,%%%,%%% ( #.!,7-%,%%% 3ayJs sales outstanding in accounts recei2able ( - days =ales =o Accounts recei2able ( ( ,$% 'ost of goods sold "n2entory turno2er ratio ( "n2entory =o "n2entory ( $ ,,#,,7-% As short+term ban; borrowings is a current liability, 'ash ) Accounts recei2able Acid+test ratio ( 'urrent liability 'ash ) #$,1!%,--$ ( 7$,%%% ,%%% =o 'ash ( , 1.,### 8lant and e7ui5ment ( <otal assets + "n2entories I Accounts recei2able I 'ash ( $$,%%%,%%% + $ ,,#,,7-% + #$,1!%,--$ I , 1.,### ( 1,-, -$, -% 8utting together e2erything we get 'alance Sheet /7uity ca5ital &etained earnings =hort+term ban; borrowings =ales 1$%,%%%,%%% 8lant 4 e7ui5ment 1,-, -$, -% ,%,%%%,%%% "n2entories $ ,,#,,7-% 7$,%%%,%%%Accounts recei2able #$,1!%,--$ 'ash , 1.,### $$,%%%,%%% $$,%%%,%%% $$-,%%%,%%% ( %.. ( "n2entory #.!,7-%,%%% ( ! : ,$% $$-,%%%,%%% : ( #$,1!%,--$

1.

'ost of goods sold #.!,7-%,%%% 'om5lete the balance sheet and sales data (fill in the blan;s) using the following financial data6 3ebt*e7uity ratio Acid+test ratio <otal assets turno2er ratio 3aysF sales outstanding in Accounts recei2able Bross 5rofit margin "n2entory turno2er ratio ( 1.( %., ( 1.. ( - days ( ! 5ercent ( 7 'alance sheet /7uity ca5ital $%%,%%% &etained earnings 1%%,%%% =hort+term ban; borrowings . . . =ales 'ost of goods sold .... . . . K.. KKK 8lant and e7ui5ment "n2entories Accounts recei2able 'ash .... .... .... .... ....

Solution: 3ebt*e7uity ( 1./7uity ( $%%,%%% ) 1%%,%%% ( 7%%,%%% =o 3ebt ( =hort+term ban; borrowings (1.- : 7%%,%%% ( 1%-%,%%% Gence <otal assets ( 7%%,%%%)1%-%,%%% ( 1,7-%,%%% <otal assets turno2er ratio ( 1.. =o =ales ( 1.. : 1,7-%,%%% ( ,,, -,%%% Bross 5rofit margin ( ! 5er cent =o 'ost of goods sold ( %.7 : ,,, -,%%% ( ,,.#,%%% 3ayJs sales outstanding in accounts recei2able ( - days =ales =o Accounts recei2able ( ,$% ( "n2entory turno2er ratio ( ,,, -,%%% : - ( ,%,.%, ,$% 'ost of goods sold ,,.#,%%% ( ( 7 "n2entory "n2entory : -

=o "n2entory ( ,# ,%%% As short+term ban; borrowings is a current liability , 'ash ) Accounts recei2able Acid+test ratio ( 'urrent liabilities 'ash ) ,%,.%, ( 1%-% ,%%% =o 'ash ( !#,%.7 8lant and e7ui5ment ( <otal assets + "n2entories I Accounts recei2able I 'ash ( 1,7-%,%%% I ,# ,%%% I ,%,.%, I !#,%.7 ( 1,%.,,%%% 8utting together e2erything we get 'alance Sheet /7uity ca5ital $%%,%%% &etained earnings 1%%,%%% =hort+term ban; borrowings 1%-%,%%% 1,7-%,%%% =ales 'ost of goods sold . ,,, -,%%% ,,.#,%%% 8lant 4e7ui5ment 1,%.,,%%% "n2entories ,# ,%%% Accounts recei2able ,%,.%, 'ash !#,%.7 1,7-%,%%% ( %.,

'om5ute the financial ratios for Acme @td. /2aluate AcmeFs 5erformance with reference to the standards. Acme "imite# Balance Sheet, March 31, 20 $ "ia,ilities an# *+uity /7uity ca5ital &eser2es and sur5lus @ong+term debt =hort+term ban; borrowing <rade creditors 8ro2isions <otal Assets 9i:ed assets (net) 'urrent assets &s.11%,%%%,%%% &s.$%,%%%,%%% #-,%%%,%%% 7 ,%%%,%%% #%,%%%,%%% ,%,%%%,%%% 1-,%%%,%%% $ ,%%%,%%%

'ash and ban; &ecei2ables "n2entories 8re+5aid e:5enses Athers <otal

,%,%%%,%%% #-,%%%,%%% $1,%%%,%%% 1%,%%%,%%% $,%%%,%%% $ ,%%%,%%%

Acme "imite# -rofit an# "oss Account for the 2ear *n#e# March 31, 20 $ Net sales 'ost of goods sold Bross 5rofit A5erating e:5enses A5erating 5rofit Non+o5erating sur5lus 8rofit before interest and ta: "nterest 8rofit before ta: <a: 8rofit after ta: 3i2idends &etained earnings Acme 'urrent ratio Acid+test ratio 3ebt+e7uity ratio <imes interest co2ered ratio "n2entory turno2er ratio A2erage collection 5eriod <otal assets turno2er ratio Net 5rofit margin ratio /arning 5ower &eturn on e7uity Solution: 9or 5ur5oses of ratio analysis, we may recast the balance sheet as under. @et assume that LAthersJ in the balance sheet re5resents other current assets. "ia,ilities an# *+uity /7uity ca5ital &eser2es and sur5lus @ong+term debt =hort+term ban; borrowing .$%,%%%,%%% #-,%%%,%%% 7 ,%%%,%%% #%,%%%,%%% &s., %,%%%,%%% %#,%%%,%%% 11$,%%%,%%% -%,%%%,%%% $$,%%%,%%% #,%%%,%%% 7%,%%%,%%% 1 ,%%%,%%% -!,%%%,%%% %,%%%,%%% ,!,%%%,%%% #,%%%,%%% ,#,%%%,%%% Stan#ar# 1., %.7% .% #.-.% #- days 1.!% %% 1! %

Assets <otal 9i:ed assets (net) 'urrent assets 'ash and ban; ,%,%%%,%%% &ecei2ables #-,%%%,%%% "n2entories $1,%%%,%%% 8re+5aid e:5enses 1%,%%%,%%% Athers $,%%%,%%% @ess6 'urrent liabilities <rade creditors ,%,%%%,%%% 8ro2isions 1-,%%%,%%% Net current assets <otal 'urrent assets (i) 'urrent ratio ( 'urrent liabilities 1- ,%%%,%%% ( 1.! !-,%%%,%%% ('urrent liabilities here includes short+term ban; borrowing also) (ii) Acid+test ratio ( .1,%%%,%%% ( 'urrent liabilities !-,%%%,%%% ('urrent liabilities here includes short+term ban; borrowing also) @ong+term debt ) =hort+term ban; borrowing (iii) 3ebt+e7uity ratio ( /7uity ca5ital ) &eser2es 4 sur5lus 7 ,%%%,%%% ) #%,%%%,%%% ( $%,%%%,%%% ) #-,%%%,%%% 8rofit before interest and ta: (i2) <imes interest co2erage ratio ( "nterest 7%,%%%,%%% ( 1 ,%%%,%%% ( -.!, ( 1.1 'urrent assets I "n2entories ( 1.1 ( 17,%%%,%%% 11%,%%%,%%%

1- ,%%%,%%%

#-,%%%,%%% 1%7,%%%,%%% 17,%%%,%%%

'ost of goods sold (2) "n2entory turno2er 5eriod (2i) A2erage collection 5eriod ( ( "n2entory ,$(

%#,%%%,%%% ( ,.,# $1,%%%,%%%

Net sales * Accounts recei2able ,$( ( -1., days , %,%%%,%%%*#-,%%%,%%% (2ii) <otal assets (/7uity ) <otal debt (( $%,%%%,%%% ) #-,%%%,%%% ) )(7 ,%%%,%%%)#%,%%%,%%%) ( 17,%%%,%%% Net sales , %,%%%,%%% <otal assets turno2er ratio ( ( <otal assets 17,%%%,%%% 8rofit after ta: (i:) Net 5rofit margin -B/0 (:) /arning 5ower ( <otal assets (:i) &eturn on e7uity ( ( 17,%%%,%%% ( Net sales 7%,%%%,%%% ( , ., % ( , %,%%%,%%% ,!,%%%,%%% ( 11..%

( 1.-

/7uity earning ,!,%%%,%%% ( ( ,$. % Net worth 1%-,%%%,%%%

<he com5arison of the AcmeJs ratios with the standard is gi2en below Acme 1.! 1.1 1.1 -.! ,., -1., days 1.11.. % , ., % ,$. % Stan#ar# 1., %.7 .% #.-.% #- days 1.!% %% 1! %

'urrent ratio Acid+test ratio 3ebt+e7uity ratio <imes interest co2ered ratio "n2entory turno2er ratio A2erage collection 5eriod <otal assets turno2er ratio Net 5rofit margin ratio /arning 5ower &eturn on e7uity

,.

'om5ute the financial ratios for Nainar @td. /2aluate NainarFs 5erformance with reference to the standards.

3ainar "imite# Balance Sheet, March 31, 20 $ "ia,ilities an# *+uity /7uity ca5ital &eser2es and sur5lus @ong+term debt =hort+term ban; borrowing <rade creditors 8ro2isions <otal Assets 9i:ed assets (net) 'urrent assets 'ash and ban; &ecei2ables "n2entories 8re+5aid e:5enses Athers <otal &s.1%%,%%%,%%% $-,%%%,%%% 1#%,%%%,%%% 7%,%%%,%%% #,%%%,%%% 1.,%%%,%%% #1!,%%%,%%% &s. %$,%%%,%%% -,%%%,%%% 7%,%%%,%%% !-,%%%,%%% %,%%%,%%% 1 ,%%%,%%% #1!,%%%,%%%

3ainar "imite# -rofit an# "oss Account for the 2ear *n#e# March 31, 20 $ Net sales 'ost of goods sold Bross 5rofit A5erating e:5enses A5erating 5rofit Non+o5erating sur5lus 8rofit before interest and ta: "nterest 8rofit before ta: <a: 8rofit after ta: 3i2idends &etained earnings 3ainar 'urrent ratio Acid+test ratio 3ebt+e7uity ratio <imes interest co2ered ratio "n2entory turno2er ratio A2erage collection 5eriod <otal assets turno2er ratio Net 5rofit margin ratio /arning 5ower &eturn on e7uity &s.7#%,%%%,%%% - %,%%%,%%% %,%%%,%%% 1% ,%%%,%%% 11!,%%%,%%% 1 ,%%%,%%% 1,%,%%%,%%% ,%%%,%%% 1%!,%%%,%%% #$,%%%,%%% $ ,%%%,%%% %,%%%,%%% # ,%%%,%%% Stan#ar# 1.7 1.% 1.# -.$.% #% days .% !% ,% % ,- %

Solution: 9or 5ur5oses of ratio analysis, we may recast the balance sheet as under. @et assume that LAthersJ in the balance sheet re5resents other current assets. "ia,ilities an# *+uity /7uity ca5ital &eser2es and sur5lus @ong+term debt =hort+term ban; borrowing <otal Assets 9i:ed assets (net) 'urrent assets 'ash and ban; &ecei2ables "n2entories 8re+5aid e:5enses Athers @ess6 'urrent liabilities <rade creditors 8ro2isions Net current assets 1%%,%%%,%%% $-,%%%,%%% 1#%,%%%,%%% 7%,%%%,%%% ,7-,%%%,%%% %$,%%%,%%% -,%%%,%%% 7%,%%%,%%% !-,%%%,%%% %,%%%,%%% 1 ,%%%,%%% #,%%%,%%% 1.,%%%,%%% <otal 'urrent assets (i) 'urrent ratio ( 'urrent liabilities 1 ,%%%,%%% ( ( 1.. 11,,%%%,%%% ( 'urrent liabilities here includes short+term ban; borrowing also) 1 7,%%%,%%% ( 'urrent liabilities 11,,%%%,%%% ( 'urrent liabilities here includes short+term ban; borrowing also) (ii) Acid+test ratio ( @ong+term debt ) =hort+term ban; borrowing (iii) 3ebt+e7uity ratio ( /7uity ca5ital ) &eser2es 4 sur5lus 'urrent assets I "n2entories ( 1.1

1 ,%%%,%%%

#,,%%%,%%% 1$.,%%%,%%% ,7-,%%%,%%%

1#%,%%%,%%% ) 7%,%%%,%%% ( ( 1., 1%%,%%%,%%% ) $-,%%%,%%% 8rofit before interest and ta: (i2) <imes interest co2erage ratio ( "nterest 1,%,%%%,%%% ( ,%%%,%%% 'ost of goods sold (2) "n2entory turno2er 5eriod (2i) A2erage collection 5eriod ( Net sales * Accounts recei2able ,$( ( ,#.- days 7#%,%%%,%%%*7%,%%%,%%% (2ii) <otal assets ( /7uity ) <otal debt ((1%%,%%%,%%% ) $-,%%%,%%% ) )(1#%,%%%,%%%)7%,%%%,%%%) ( ,7-,%%%,%%% Net sales <otal assets turno2er ratio ( <otal assets 8rofit after ta: (i:) Net 5rofit margin -B/0 (:) /arning 5ower ( <otal assets (:i) &eturn on e7uity ( ( ,7-,%%%,%%% ( Net sales 1,%,%%%,%%% ( ,#.7 % ( 7#%,%%%,%%% ( ,7-,%%%,%%% $ ,%%%,%%% ( !.# % 7#%,%%%,%%% ( .% ( "n2entory ,$( !-,%%%,%%% - %,%%%,%%% ( $.1 ( -..

/7uity earning $ ,%%%,%%% ( ( ,7.$ % Net worth 1$-,%%%,%%%

<he com5arison of the NainarJs ratios with the standard is gi2en below

3ainar 'urrent ratio Acid+test ratio 3ebt+e7uity ratio <imes interest co2ered ratio "n2entory turno2er ratio A2erage collection 5eriod <otal assets turno2er ratio Net 5rofit margin ratio /arning 5ower &eturn on e7uity #. 1.. 1.1 1., -.. $.1 ,#.- days .% !.# % ,#.7 % ,7.$ %

Stan#ar# 1.7 1.% 1.# -.$.% #% days .% !% ,% % ,- %

<he com5arati2e balance sheets and com5arati2e 8rofit and @oss accounts for Nal2ar @imited, are gi2en below6 Comparati4e Balance Sheets, 3al4ar "imite# %Rs. in million& 20X3 1.$ 1.% 1.# 1., 1.1 $.# 1. 0.3 1.8 1.8 1.3 $.# 20X4 1.$ 1.$ 1.1.1., 7.1.# 0.3 2.1 2.2 1.5 7.0.2 2.5 2.8 1.7 .. 20X5 1.! .# 1.! 1.7 1... 20X6 1.! ., 1.$ 1.1.$ !.! 1.7 0.4 2.4 2.4 1.9 !.! %., ..! 1.! ..# 20X7 , 1.# 1. 1.! ..#

=hare ca5ital &eser2es and sur5lus @ong+term debt =hort+term ban; borrowing 'urrent liabilities Total Assets Net fi:ed assets 'urrent assets 'ash and ban; &ecei2ables "n2entories Ather assets Total

Comparati4e -rofit an# "oss Accounts, 3al4ar "imite# %Rs. in million&

Net sales 'ost of goods sold Bross 5rofit A5erating e:5enses A5erating 5rofit Non+o5erating sur5lus deficit 8rofit before interest and ta: "nterest 8rofit before ta: <a: 8rofit after ta:

20X3 3.8 2.6 1.2 0.3 0.9 0.1 1 0.1 0.9 0.05 0.85

20X4 4.2 3.1 1.1 0.3 0.8 %. 1 0.1 0.9 0.08 0.82

20X5 5.3 3.9 1.4 0.4 1 %.1 1.1 0.2 0.9 1 -0.1

20X6 6.5 4 2.5 0.6 1.9 %., 2.2 0.1 2.1 1.2 0.9

20X7 7.8 #.! 3 %.$ 2.4 %., 2.7 %.1 2.6 1.2 1.4

&e7uired6 'om5ute the im5ortant ratios for Nal2ar @imited for the years %1,+ %17. Mou may assume that other assets in the balance sheet re5resent other current assets. N 'urrent ratio N 3ebt+e7uity ratio N <otal assets turno2er ratio N Net 5rofit margin N /arning 5ower N &eturn on e7uity Solution: We will rearrange the balance sheets as under for LAther assetsJ are other current assets "ia,ilities an# *+uity 2()3 2()& =hare ca5ital 1.$ 1.$ &eser2es and sur5lus 1 1.$ @ong+term debt 1.# 1.=hort+term ban; borrowing 1., 1.<otal -., $. Assets Net fi:ed assets 1. 1.# 'urrent assets 'ash and ban; 0.3 0.3 &ecei2ables 1.8 2.1 "n2entories 1.8 2.2 ratio analysis. "t is assumed that

2()* 1.! .# 1.! 1.7 7.7

2()+ 1.! ., 1.$ 1.7. 1.7

2(), , 1.# 1. 7.$

0.2 2.5 2.8

0.4 2.4 2.4

%., ..!

Ather current assets @ess6 'urrent liabilities Ather current liabilities Net current assets <otal

1.3 1.1

-. 1.1 4.1 5.3

1.5 1.,

$.1

1.7

7. 1.5.7 7.7

1.9 1.$

7.1 1.$ 5.5 7.2

1.! 1.!

7.# 1.! 5.6 7.6

1., 1.4.8 6.2

<he re7uired ratios are as under6 N 'urrent ratio N 3ebt+e7uity ratio <otal assets turno2er ratio N Net 5rofit margin(%) N /arning 5ower (%) N &eturn on e7uity (%) 20 3 20 . 20 5 20 ! 20 $ 2.2 2.2 2.3 2.3 2.5 1.0 0.9 0.8 0.8 0.5 0.7 22.4 18.9 32.7 0.7 19.5 16.1 25.6 0.7 -1.9 14.3 -2.4 0.9 13.8 30.6 22.0 1.0 17.9 35.5 28.0

$. <he com5arati2e balance sheets and com5arati2e 8rofit and @oss accounts for =omani @imited, a machine tool manufacturer, are gi2en below6 Comparati4e Balance Sheets, Somani "imite# %Rs. in million& 20X 3 =hare ca5ital &eser2es and sur5lus @ong+term debt =hort+term ban; borrowing 'urrent liabilities Total Assets Net fi:ed assets 'urrent assets 'ash and ban; &ecei2ables "n2entories Ather Assets Total #1 1$ ! ,# 1## 7 ! # ,1## 20X 20 20 4 X5 X6 -% -% -% ,$ 7 11! ,% . ,% ,$ ,! ! ,% ,% 1$. 1! $!% . ,% # ! 1$. 71-. -1# 1! 1% 1 $ 71# $-

20X7 -1-% ,! .% 1%, 11 !7. 1 .%

Comparati4e -rofit & "oss Account of Somani "t# (&s. in million) 20X 20X 20X3 4 5 20X6 20X7 Net sales !, % ,$% ,-% ,-'ost of goods sold 1$# 1-% 17% 1717# Bross 5rofit 1 1 17% 1.% 171!1 A5erating e:5enses $# $$ $! $! $# A5erating 5rofit -7 1%# 1 1%7 117 Non+o5erating sur5lus deficit , # # , , 8rofit before interest and ta: $% 1%! 1 $ 11% 1 % "nterest ! $ 1% 1 1 8rofit before ta: 1% 11$ .! 1%! <a: 1$ ,% $ . 8rofit after ta: ,7 7$ !$ 7 7. 'om5ute the following ratios for years %1,+ %176 N 'urrent ratio N 3ebt+e7uity ratio N <otal assets turno2er ratio N Net 5rofit margin N /arning 5ower N &eturn on e7uity 9or ratio analysis 5ur5ose, we will rearrange the balance sheet assumed that LAther assetsJ are other current assets %1, %1# %1%1$ =hare ca5ital #1 -% -% -% &eser2es and sur5lus 1$ ,$ 7 11! @ong+term debt ! ,% . =hort+term ban; borrowing ,,% ,$ ,! Total 1 % 1#1 1!! ,Assets Net fi:ed assets 7 !% 71% 'urrent assets 'ash and ban; ! . 11 &ecei2ables # ,% -. $ "n2entories ,# -7Ather assets 7 ! !. 1# 1#, 1# 1$, @ess 6 'urrent liabilities # # ! ! ,% ,% ,% ,% Net current assets #! $1 11, 1,, Total 1 % 1#1 1!! ,as under. "t is %17 -1-% ,! $1%, 11 !7. 1 -

1!7 1$ $-

<he ratios wor;ed out are as under6 N N N N N N 'urrent ratio 3ebt+e7uity ratio <otal assets turno2er ratio Net 5rofit margin (%) /arning 5ower (%) &eturn on e7uity (%) %1, 1. 1.1 .# 1,.% -%.% $#.. %1# 1.%.$ ., ,.! 7$.$ !!.# %1. %.1.. ,.. $7.% 7%.%1$ .# %.# 1.%.$ #$.! # .. %17 ,.% %., 1., ., #-., ,!.-

$. <he ?alance sheets and 8rofit and @oss accounts of @OB 'or5oration are gi2en below. 8re5are the common siPe and common base financial statements ?alance =heets =hareholdersJ funds @oan funds <otal 9i:ed assets "n2estments Net current assets <otal (&s. in million) %:$ %:7 -$ $ 1-$ 1 #1 #7# , ,,% 1171 . #1 #7#

8rofit 4 @oss Accounts Net sales 'ost of goods sold Bross 5rofit 8?"< "nterest 8?< <a: 8A< %:$ $ , #71#! 1%(&s. in million) %:7 7%1 -1#. !. 1 !, $! #1 ,# # ,#

Solution: 'ommon =iPe statements6 8rofit and @oss Account &egular ( in &s. million) %:$ %:7 $ , 7%1 #7-1#! 1#. 1%!. 1 !, $! #1 ,# # ,# ?alance =heet &egular ( in million) %:$ %:7 =hareholdersF funds @oan funds <otal 9i:ed assets "n2estments Net current assets <otal 7. -$ 1-$ #1 , 17#1 $ 1 #7# ,,% 11 . #7# 'ommon =iPe(%) %:$ %:7 1%% 1%% 7$ 7. # 1 17 1, # , 1, 1% 7 7 -

Net sales 'ost of goods sold Bross 5rofit 8?"< "nterest 8?< <a: 8A<

'ommon =iPe(%) %:$ %:7 $ ,! 1%% 7! # 1! 1%% -#1%% 7% , 7 1%%

<he ?alance sheets and 8rofit and @oss accounts of Brand @imited are gi2en below. 8re5are the common siPe and common base financial statements ?alance =heet =hareholdersJ fund @oan funds <otal 9i:ed assets "n2estments Net current assets <otal %:$ !1 1% 1 7 ! 71% %:7 !1!% $17% 1% !$-

8rofit 4 @oss Account %:$ Net sales #-% 'ost of goods sold , % Bross 5rofit 1,% 8?"< !"nterest 1 8?< 7, <a: 8A< -1 Solution: ?alance =heet =hareholdersF funds @oan funds <otal 9i:ed assets "n2estments Net current assets <otal 8rofit 4 @oss Account Net sales 'ost of goods sold Bross 5rofit 8?"< "nterest 8?< <a: 8A< &egular (&s. in million) %:$ %:7 !!1 1!% 1% $1 7 17% ! 1% 7!1% $&egular (&s. in million) %:$ %:7 #-% -$% , % #1% 1,% 1-% !.! 1 17 7, !1 ,! -1 #,

%:7 -$% #1% 1-% .! 17 !1 ,! #,

'ommon =iPe(%) %:$ %:7 #% , $% $! 1%% 1%% $% $# # # ,$ , 1%% 1%% 'ommon =iPe(%) %:$ %:7 1%% 1%% 71 7, . 7 1. 1! , , 1$ 1# 7 11 !

'ommon base year statements &egular (&s. in 'ommon base year ?alance =heet million) (%) %:$ %:7 %:$ %:7 =hareholdersF funds !!1%% 1%% @oan funds 1 1!% 1%% 1## <otal 1% $1%% 1 $ 9i:ed assets 1 7 17% 1%% 1,# "n2estments ! 1% 1%% 1 Net current assets 7!1%% 11, <otal 1% $1%% 1 $ 8rofit 4 @oss Account Net sales 'ost of goods sold Bross 5rofit 8?"< "nterest 8?< <a: 8A< CHAPTER * 1. <he 5rofit and loss account of =asi "ndustires @imited for years 1 and is gi2en below6 >sing the 5ercent of sales method, 5re5are the pro forma 5rofit and loss account for year ,. Assume that the sales will be ,-%% in year ,. "f di2idends are raised to #%, what amount of retained earnings can be e:5ected for year ,? 2ear Net sales 'ost of goods sold Bross 5rofit =elling e:5enses Beneral and administration e:5enses 3e5reciation A5erating 5rofit Non+o5erating sur5lus deficit 1 2300 17$% -#% 1-% 1 % .# 17$ 1 2 2700 2000 7%% 180 124 84 ,1 10 &egular (&s. in million) %:$ %:7 #-% -$% , % #1% 1,% 1-% !.! 1 17 7, !1 ,! -1 #, 'ommon base year (%) %:$ %:7 1%% 1 # 1%% 1 ! 1%% 111%% 111%% 1# 1%% 111 1%% 17, 1%% !#

/arnings before interest and ta: "nterest /arnings before ta: <a: /arnings after ta: 3i2idends &etained earnings Solution: 2ear

1!! ,% 1-! -$ 1% ,$7

, 38 !# 96 1!! 35 1-,

A2erage 5ercent of sales

8roforma 8rofit 4 @oss account for year , assuming sales of ,-%% ,-%% $,-.#, !$#.-7 ,%.!% 171.$7 1 -..7 ,,$.1# 1-.$1 ,-1.7#7.#$ ,%#. . 1%#.!, 1...#$ #% 1-..#$

Net sales 'ost of goods sold Bross 5rofit =elling e:5enses Beneral and administration e:5enses 3e5reciation A5erating 5rofit Non+o5erating sur5lus deficit /arnings before interest and ta: "nterest /arnings before ta: <a: /arnings after ta: 3i2idends(gi2en) &etained earnings

,%% 17$% -#% 1-% 1 % .# 17$ 1 1!! ,% 1-! -$ 1% ,$7

7%% %%% 7%% 1!% 1 # !# ,1 1% , ,! !# .$ 1!! ,1-,

1%% 7-.,% #.7% $.-. #..% ,.$% ..$% %.#1%.%1.,$ !.$. ,.%% -.7%

2.

<he 5rofit and loss account of OB /lectronics @imited for years 1 and is gi2en below6 >sing the 5ercent of sales method, 5re5are the pro forma 5rofit and loss account for year ,. Assume that the sales will be $,%%% in year ,. "f di2idends are raised to -%%, what amount of retained earnings can be e:5ected for year, . 2ear Net sales 'ost of goods sold Bross 5rofit =elling e:5enses Beneral and administration e:5enses 3e5reciation A5erating 5rofit Non+o5erating sur5lus deficit /arnings before interest and ta: "nterest /arnings before ta: <a: /arnings after ta: 3i2idends(gi2en) &etained earnings 1 1!, ,% 1,, 1% -% % ! % 1 %% ,! $1! 1, 7-% $! %$! 7!% 1 !! , % .$! ,#$% 1$1%% $,$% !.% 1 1% ,$# ,!.$ ! ,.7! !.% ,%!! .!% 1%! #-% 1$-!

Solution: 2ear 8roforma 8rofit 4 @oss account for year , assuming sales of $,%%% $%%% 1!7,!..! 7 $1.% 1%...!. 1--$.%. #!,.%. #1 1..1#1.-.

Net sales 'ost of goods sold Bross 5rofit =elling e:5enses Beneral and administration e:5enses 3e5reciation A5erating 5rofit Non+o5erating

1 1!, ,% 1,, 1% -% % ! % 1 %% ,! $1! 1,

,#$% 1$1%% $,$% !.% 1 1% ,$# ,!.$ !

A2erage 5ercent of sales 1%% 7 .%7 7.., #. , -..! 1.!$ 1-.!%.-#

sur5lus deficit /arnings before interest and ta: "nterest /arnings before ta: <a: /arnings after ta: 3i2idends(gi2en) &etained earnings ,.

7-% $! %$! 7!% 1 !! , % .$!

,.7! !.% ,%!! .!% 1%! #-% 1$-!

1$.#% ,.!1 .-#., !. ,

# $,.-1%%1.#! , $ .%7 11 ,.#$ 1,!.$1 -%% 1$,!.$1

&e+wor; 5roblem 1 assuming the following budgeted amounts6 Beneral and administration e:5enses 1,=elling e:5enses %% "nterest # 3i2idends #%

Solution: 2ear 1 ,%% 17$% -#% 1-% 1 % .# 17$ 1 1!! ,% 1-! -$ 1% ,$7 A2erage 5ercent of sales 1%% 7-.,% #.7% ?udgeted ?udgeted ,.$% ..$% %.#1%.%?udgeted !.$. ,.%% -.7% ?udgeted 8roforma 8rofit 4 @oss account for year , assuming sales of ,,-%% ,-%% $,-.#, !$#.-7 %%.%% 1,-.%% 1 -..7 ,,$.1# 1-.$1 ,-1.7# .%% ,%#. . 1%#.!, 1...#$ #% 1-..#$

Net sales 'ost of goods sold Bross 5rofit =elling e:5enses Beneral and administration e:5enses 3e5reciation A5erating 5rofit Non+o5erating sur5lus deficit /arnings before interest and ta: "nterest /arnings before ta: <a: /arnings after ta: 3i2idends(gi2en) &etained earnings

,7%% %%% 7%% 1!% 1 # !# ,1 1% , ,! !# .$ 1!! ,1-,

#.

&e+wor; 5roblem assuming the following budgeted amounts6 Beneral and administration e:5enses 1$ % 3e5reciation - % "nterest 1 % 3i2idends -$%

Solution: 2ear A2erage 5ercent of sales 1%% 7 .%7 7.., #. , ?udgeted ?udgeted 1-.!%.-# 1$.#% ?udgeted 1 .-#., !. , ?udgeted 8roforma 8rofit 4 @oss account for year , assuming sales of $,%%% $%%% 1!7,!..! 7 $1.% 1%...!. 1$ %.%% - %.%% #1 1..1#1.-. # $,.-1 %.%% , $ .%7 11 ,.#$ 1,!.$1 -$% 1-7!.$1

Net sales 'ost of goods sold Bross 5rofit =elling e:5enses Beneral and administration e:5enses 3e5reciation A5erating 5rofit Non+o5erating sur5lus deficit /arnings before interest and ta: "nterest /arnings before ta: <a: /arnings after ta: 3i2idends(gi2en) &etained earnings -.

1 1!, ,% 1,, 1% -% % ! % 1 %% ,! $1! 1, 7-% $! %$! 7!% 1 !! , % .$!

,#$% 1$1%% $,$% !.% 1 1% ,$# ,!.$ ! ,.7! !.% ,%!! .!% 1%! #-% 1$-!

<he 5rofit and loss account and balance sheet for the years %%$ and %%7 of &adiant 'or5oration are as under. 9or the year %%! , the following are the budgeted figures. =ales ,%%% Beneral and Administration e:5enses 1-% 3e5reciation 1%% Non o5erating sur5lus !% 3i2idend -% "n2estments 11% 8re+5aid e:5enses !%

>nsecured ban; borrowings 1%% <here will be no change in the le2els of share ca5ital, secured ban; borrowings and miscellaneous e:5enditure and losses. All other figures both in the 5roforma 5rofit and loss account as well as balance sheet, will change in 5ro5ortion to the a2erage its 5ro5ortion to sales of that year for the 5ast two years. "t is also assumed that any e:tra funds needed to achie2e the desired financial 5osition for %%! will be raised by way of debentures. 8re5are the 5roforma financial statements for the year %%! using the e:cel model gi2en in the te:t. 2ear Net sales 'ost of goods sold Bross 5rofit =elling e:5enses Beneral and administration e:5enses 3e5reciation A5erating 5rofit Non+o5erating sur5lus deficit /arnings before interest and ta: "nterest /arnings before ta: <a: /arnings after ta: 3i2idends(gi2en) &etained earnings %%$ ,%% 17$% -#% 1-% 1 % .# 17$ 1 1!! ,% 1-! -$ 1% ,$7 %%7 ,7%% %%% 7%% 1!% 1 # !# ,1 1% , ,! !# .$ 1!! ,1-,

?alance =heets 9i:ed assets (net "n2estments 'urrent assets, loans and ad2ances Q 'ash and ban; Q &ecei2ables Q "n2entories Q 8re+5aid e:5enses 0iscellaneous e:5enditures 4 losses <otal

Mear %%$ %%7 1#$% 1- % 7.%

$1 #,! $ % 7! ,! 77%

-! -1% 71% !# # ,%1#

"ia,ilities =hare ca5ital /7uity 8reference &eser2es and sur5lus =ecured loans 3ebentures ?an; borrowings >nsecured loans ?an; borrowings 'urrent liabilities and 5ro2ision <rade creditors 8ro2isions <otal Solution:

-#% !% #$% $.% -!% 1 %

-#% !% - 7 $# $ %%

%% 1%% 77%

, % !% ,%1#

2ear A2erage 5ercent of %%7 sales 8roCected ,7%% 1%%.%?udgeted %%% 7-. 7%% #.! 1!% $.$ 1 # ?udgeted !# ?udgeted ,1 R 7% ?udgeted ,! R ! .,. 7.7 R .$ ,.% 7 R ,?udgeted 1#1 .R %%7 %.1

Net sales 'ost of goods sold Bross 5rofit =elling e:5enses Beneral and administration e:5enses 3e5reciation A5erating 5rofit Non+o5erating sur5lus deficit /arnings before interest and ta: "nterest on ban; borrowings "nterest on debentures /arnings before ta: <a: /arnings after ta: 3i2idends(gi2en) &etained earnings ?alance =heets

%%$ ,%% 17$% -#% 1-% 1 % .# 17$ -% $ 77 ,% 11. -$ 11. ,! %%$

?efore After iteration iteration 8roforma 8roforma 5rofit 5rofit and and loss loss account account for %%! for %%! ,%%%.% ,%%%.% -$.% -$.% 7##.% 7##.% 1.!.% 1.!.% 1-%.% 1-%.% 1%%.% 1%%.% .$.% .$.% !%.% !%.% ,7$.% ,7$.% .-.7 .-.7 7.!%.$ - .! 1...7 .1. .1. - .! 1...7 -%.% -%.% 111.$ -!.-

9i:ed assets (net "n2estments 'urrent assets, loans and ad2ances Q 'ash and ban; Q &ecei2ables Q "n2entories Q 8re+5aid e:5enses 0iscellaneous e:5enditures 4 losses <otal "ia,ilities =hare ca5ital /7uity 8reference &eser2es and sur5lus =ecured loans 3ebentures ?an; borrowings >nsecured loans ?an; borrowings 'urrent liabilities and 5ro2isions <rade creditors 8ro2isions <otal $.

1#$% 7-

1- % .%

-..$ .?udgeted

17!!.% 11%.%

17!!.% 11%.%

$1 #,! $ % 7! ,! 77%

-! $1 71% !# # ,11$

.# 1.% $.$ .?udgeted No change

71.# $,%.% 7.!.% !%.% # .% ,-1..#

71.# $,%.% 7.!.% !%.% # .% ,-1..#

-#% !% .1% #% -!% 1 % %% 1%% 77%

-#% !% 1%-1 % $ %% , % !% ,11$

No change No change R

-#%.% !%.% 11$ .$ -.1.! $ -.% 1%%.% ,1 .% 1%!.% ,-1..#

-#%.% !%.% 11%..$##.. $ -.% 1%%.% ,1 .% 1%!.% ,-1..#

No change ?udgeted 1%.# ,.$

<he following information is a2ailable for A?' @imited 6 A*S ( %.$, S ( &s.,%% million, "*S ( %.,%, m ( %.%!, S1 ( &s.,-% million, and # ( %.-. What is the e:ternal funds re7uirement for the forthcoming year?

Solution: <he e:ternal funds re7uirement of Alym5us is6 *6R ( A7*S% (S) I "7*S (S) I mS1 (r) ( %.$ : -% I %., : -% + .%! : ,-% : %.( &s.1 million

7.

<he following information is a2ailable for 1MS @imited 6 A*S ( %.-, S ( &s.,million, "*S ( %. %, m ( %.%#, S1 ( &s.-- million, and # ( %.$. What is the e:ternal funds re7uirement for the forthcoming year?

Solution: <he e:ternal funds re7uirement of Alym5us is6 *6R ( A7*S% (S) I "7*S (S) I mS1 (r) ( %.- : % I %. : % + .%# : -- : %.# ( &s.-.1 million !. <he balance sheet of Tasundhara 'or5oration as at 0arch ,1, %%7 is shown below6 =hare ca5ital -%% 9i:ed assets 7-% &etained /arnings 1 % "n2entories #%% <erm @oans ,$% &ecei2ables ,,% =hort+term ?an; ?orrowings ,%% 'ash .% Accounts 8ayable 1% 8ro2isions !% 1-7% 1-7% <he sales of the firm for the year ending on 0arch ,1, %%7 were ,!%%. "ts 5rofit margin on sales was ! 5ercent and its di2idend 5ayout ratio was ,% 5ercent. <he ta: rate was #% 5ercent. Tasundhara 'or5oration e:5ects its sales to increase by #% 5ercent in the year ending 0arch ,1, %%!. <he ratio of assets to sales and s5ontaneous current liabilities to sales would remain unchanged. @i;ewise the 5rofit margin ratio, the ta: rate, and the di2idend 5ayout ratio would remain unchanged. &e7uired6 a. /stimate the e:ternal funds re7uirement for the year %%!. b. 8re5are the following statements, assuming that the e:ternal funds re7uirement would be raised e7ually from term loans and short+term ban; borrowings6 (i) 5roCected balance sheet and (ii) 5roCected 5rofit and loss account.

Solution: a A *6R 8 S 1-7% ( !%% b. (i) -ro;ecte# /ncome Statement for 2ear *n#in< 31st March , 200= =ales 8rofits before ta: <a:es 8rofit after ta: (!% on sales) 3i2idends &etained earnings (ii) -ro;ecte# Balance Sheet as at 31.12 2001 "ia,ilities =hare ca5ital &etained earnings <erm loans (,$%)1#$) -%$ =hort+term ban; borrowings (,%% ) 1#$) Accounts 5ayable 8ro2isions Assets -%% ,#% ##$ .# 11 1.! 1.! 9i:ed assets "n2entories &ecei2ables 'ash 1%-% -$% #$ 1 $ ,,. % - , %. ,1# .# % + !%% ( &s. . + S .% 11 % I %.%! : ,. % (1+%.,) "

S 9 m S1 %1:#&

..

<he balance sheet of 0B0 @imited as at 0arch ,1, %%7 is shown below6 =hare ca5ital #, %% 9i:ed assets !,!7% &etained /arnings ,#!% "n2entories ,,#!% <erm @oans ,,. % &ecei2ables ,-!% =hort+term ?an; ?orrowings ,#.% 'ash 1!% Accounts 8ayable 1, #% 8ro2isions 7!% 1-,11% 1-,11% <he sales of the firm for the year ending on 0arch ,1, %%7 were ,1,#1%. "ts 5rofit margin on sales was 7 5ercent and its di2idend 5ayout ratio was -% 5ercent. <he ta: rate was ,# 5ercent. 0B0 @imited e:5ects its sales to increase by ,% 5ercent(i.e by .,# ,) in the year %1!. <he ratio of assets to sales and s5ontaneous current liabilities to sales would remain unchanged. @i;ewise the 5rofit margin ratio, the ta: rate, and the di2idend 5ayout ratio would remain unchanged. &e7uired6 a. /stimate the e:ternal funds re7uirement for the year %%!. b. 8re5are the following statements, assuming that the e:ternal funds re7uirement would be raised from term loans and short+term ban; borrowings in the ratio 16 (i) 5roCected balance sheet and (ii) 5roCected 5rofit and loss account.

Solution: a. *6R 8 A " :::: : :::: S S 1-,11% ( ,1,#1% ( #.! b.(i) -ro;ecte# /ncome Statement for 2ear *n#in< 31st March , 200= =ales 8rofits before ta: <a:es 8rofit after ta: (7% on sales) 3i2idends &etained earnings #%,!,, #,,,% 1,#7 ,!-! 1,# . 1,# . + ,1,#1%

S 9 m S1 %1:#&

% % .,# , I %.%7 : #%,!,, (1+%.-)

(ii) -ro;ecte# Balance Sheet as at 31.3 200= "ia,ilities =hare ca5ital #, %% 9i:ed assets &etained earnings ,,.%. "n2entories <erm loans (,. %) #.!:1*,) #,7-, &ecei2ables =hort+term ban; borrowings #,1-'ash ( #.% ) #.!: *,) Accounts 5ayable 1,$1 8ro2isions 1,%1# 1.,$#, Assets 11,-,1 #,- # ,,,-# ,#

1.,$#,

1%.

<he balance sheet of Banesh Associates as at 0arch ,1, %:7 is shown below6 =hare ca5ital $, -! 9i:ed assets 1-,7 1 &etained /arnings $,7!% "n2entories -,.!# <erm @oans -,, % &ecei2ables ,,-!$ =hort+term ?an; ?orrowings #,,7! 'ash -# Accounts 8ayable 1,!7, 8ro2isions .,$ -,-#-,-#<he sales of the firm for the year ending on 0arch ,1, %:7 were -!,#,$. "ts 5rofit margin on sales was 1% 5ercent and its di2idend 5ayout ratio was #- 5ercent. <he ta: rate was ,, 5ercent. Banesh Associates e:5ects its sales to increase by -% 5ercent in the year %1!. <he ratio of assets to sales and s5ontaneous current liabilities to sales would remain unchanged. @i;ewise the 5rofit margin ratio, the ta: rate, and the di2idend 5ayout ratio would remain unchanged. &e7uired6 a. /stimate the e:ternal funds re7uirement for the year %:!. b. 8re5are the following statements, assuming that the e:ternal funds re7uirement would be raised entirely from short+term ban; borrowings 6 (i) 5roCected balance sheet and (ii) 5roCected 5rofit and loss account.

Solution: *6R 8 A " ::::: : :::::: S 9 m S1 %1:#& S S -,-#( -!,#,$ + -!,#,$ ( &s.$,-#7 -ro;ecte# /ncome Statement for 2ear *n#in< 31st March , 200= =ales 8rofits before ta: <a:es 8rofit after ta: (1%% on sales) 3i2idends &etained earnings !7,$-# 1,,%! #,,17 !,7$,,.## #,! 1 ,!%. ., 1!I %.1% : !7,$-# (1+%.#-)

-ro;ecte# Balance Sheet as at 31.3 200= "ia,ilities =hare ca5ital &etained earnings <erm loans =hort+term ban; borrowings (#,7! ) $-#7) Accounts 5ayable 8ro2isions 11. Assets $, -! 9i:ed assets 11,$%1 "n2entories -,, % &ecei2ables 1%,. 'ash ,!%. 1,#%# ,!,,17 ,,-!1 !,.7$ -,,7. ,!1

,!,,17

<he following information is gi2en for A?' 'om5any6 Assets to sales ratio ( %.!% =5ontaneous liabilities to sales ratio ( %.#% 8rofit margin ( ! 5er cent 3i2idend 5ayout ratio ( %.8re2ious yearJs sales ( #,%%% What is the ma:imum sales growth rate that can be financed without raising e:ternal funds?

Solution: *6R ( A + " + m %1)<& (1+#&

S S S < Bi2en A>S( %.! , ">S( %.# , m( %.%! , #( %.- and *6R ( % we ha2e, (%.%!)(1)<)(%.-) (%.!+%.#) + < %.%#(1)g) ( %.#g (%.# +%.%#)g ( %.%# or g ( %.%#*%.,$ ( %.1111 i.e. 11.11% 1 . <he following information is gi2en for &ahul Associates.6 Assets to sales ratio ( %..% =5ontaneous liabilities to sales ratio ( %.-% 8rofit margin ( 11 5er cent 3i2idend 5ayout ratio ( %.7 8re2ious yearJs sales ( #-,,$% What is the ma:imum sales growth rate that can be financed without raising e:ternal funds? (%

Solution: *6R ( A + " + m %1)<& (1+#&

S S S < Bi2en A>S( %.. , ">S( %.- , m( %.11 , #( %.7 and *6R ( % we ha2e, (%.11)(1)<)(%.,) (%..+%.-) + < %.%,,(1)g) ( %.#g (%.# +%.%,,)g ( %.%,, or g ( %.%,,*%.,$7 ( %.%!.. i.e. !...% 1,. <he following information is gi2en for AhuCa /nter5rises. Assets to sales ratio ( %.-% =5ontaneous liabilities to sales ratio ( %. % 8rofit margin ( $ 5er cent 3i2idend 5ayout ratio ( %.1 8re2ious yearJs sales ( 1 ,%%% (%

What is the ma:imum sales growth rate that can be financed without raising e:ternal funds? Solution: *6R ( A + " + m %1)<& (1+#&

S S S < Bi2en A>S( %.- , ">S( %. , m( %.%$ , #( %.1 and *6R ( % we ha2e, (%.%$)(1)<)(%..) (%.-+%. ) + < %.%-#(1)g) ( %.,g (%., +%.%-#)g ( %.%-# or g ( %.%-#*%. #$ ( %. 1.- i.e. 1..-% 1#. <he balance sheet of Ar2ind 'om5any at the end of year % : 7, which is Cust o2er, is gi2en below6 =hare ca5ital %% 9i:ed assets !% &etained earnings 1 % "n2entories ,% @ong+term borrowings 1% &ecei2ables 1% =hort+term borrowings 1-% 'ash $% <rade creditors 7% 8ro2isions ,% 7!% 7!% <he sales for the year Cust ended were 1#!%. <he e:5ected sales for the year %:! are 17% . <he 5rofit margin is ! 5ercent and the di2idend 5ayout ratio is ,% 5ercent. &e7uired6 (a) 3etermine the e:ternal funds re7uirement for Ar2ind for the year %:!. (b) Gow should the com5any raise its e:ternal funds re7uirement, if the following restrictions a55ly? (i) 'urrent ratio should not be less than 1.,. (ii) <he ratio of fi:ed assets to long+term loans should be greater than 1.,. Assume that the com5any wants to ta5 e:ternal funds in the following order6 short+term ban; borrowing, long+term loans, and additional e7uity issue. (%

Solution: A (a& *6R ( S 7!% + S 1%% " S 9 mS1 (1+#)

( 1#!% ( $1 (b)

+ 1#!%

I (%.%!) (17% ) (%.,)

i.

@et CA ( denote 'urrent assets C" ( 'urrent liabilities SC" ( =5ontaneous current liabilities S0" ( =hort+term ban; borrowings 6A ( 9i:ed assets and "0" ( @ong+term loans 'urrent ratio 1.3 CA i.e C" CA 1.3 S0" 1SC" As at the end of %1!, CA ( -%% : 1.1- ( -7SC" ( 1%% : 1.1- ( 11=ubstituting these 2alues, we get 1., (S0" ) 11-) -7or 1., S0" 575 (115 : 1.3) 4 25.5 # -.greater than or e7ual to 1., or

or S0"

1., i.e S0" = , 7., &atio of fi:ed assets to long term loans 1., -A 1.3 "0" At the end of %1!, 6A ( !% : 1.1- ( , , "0" or "0" ( #7.7 1., "f S0" and "0" denote the ma:imum increase in S0 borrowings 4 "0 borrowings, we ha2e 6 S0" 8 S0" ( %1!) I S0" ( %17) ( , 7., I 1-% ( 177.,

ii.

 "0" 8 "0" ( %1!)+ "0" ( %17) ( #7.7 I 1% ( ,7.7 Gence, the suggested mi: for raising e:ternal funds will be 6 =hort+term borrowings $1 @ong+term loans +++++ Additional e7uity issue ++ $1 1-. <he balance sheet of Oamath /nter5rises at the end of year % : 7, which is Cust o2er, is gi2en below6 =hare ca5ital ,-.%%% 9i:ed assets ,7.!!% &etained earnings 1,1$% "n2entories -,# % @ong+term borrowings !,,$% &ecei2ables 1!,-#% =hort+term borrowings 1$,- % 'ash -$% <rade creditors ,!% 8ro2isions .!% ! ,#%% ! ,#%% <he sales for the year Cust ended were 1$ ,!%%. <he e:5ected sales for the year %:! are 7,. %. <he 5rofit margin is 1% 5ercent and the di2idend 5ayout ratio is #% 5ercent. &e7uired6 a 3etermine the e:ternal funds re7uirement for Oamath /nter5rises for the year %:!. b Gow should the com5any raise its e:ternal funds re7uirement, if the following restrictions a55ly? (i) 'urrent ratio should remain unchanged. (ii) <he ratio of fi:ed assets to long+term loans should be greater than 1.-. Assume that the com5any wants to ta5 e:ternal funds in the following order6 short+term ban; borrowing, long+term loans, and additional e7uity issue.

Solution: A (a& *6R ( S ! ,#%% ( 1$ ,!%% ( ,, .. + 1$ ,!%% + S " S 9 mS1 (1+#)

1,,$% : $-,1 %I (%.1%) ( 7,. %) (%.#)

b (i) <he current ratio will remain unchanged when the assets and liabilities rise in the same 5ro5ortion. <he =hort term borrowing as on 0arch ,1, %%! should therefore be ( 1$,- % : 1.# ( ,,1 ! (ii) @et 6A ( 9i:ed assets =<@ ( =hort+term loans and "0" ( @ong+term loans &atio of fi:ed assets to long term loans 1.-A "0" At the end of %1!, 6A ( ,7,!!% : 1.# ( -,,%, -,,%, "0" or "0" ( ,-,,-1."f S0" and "0" denote the ma:imum increase in S0 borrowings 4 "0 borrowings , we ha2e 6 S0" 8 S0" ( %:!) I S0" ( %17) ( ,,1 ! I 1$,- % ( $, $%! "0" 8 "0" ( %1!)+ "0" ( %17) ( ,-,,-- I !,,$% ( $,..Gence, the suggested mi: for raising e:ternal funds will be6 =hort+term borrowings $, $%! @ong+term loans $,..Additional e7uity issue .,$.$ ,, .. 1$. <he following information is a2ailable about Geadstrong @imited6 =ales of this year ( #!, #% 8roCected sales increase for ne:t year ( - 5ercent 8rofit after ta: this year ( #,! # 3i2idend 5ayout ratio ( #% 5ercent 8roCected sur5lus funds a2ailable ne:t year ( ,%%% 8resent le2el of s5ontaneous current liabilities ( 1 ,,!% What is the le2el of total assets for Geadstrong now? 1.5

Solution: A *6R ( S + S " S 9 m S1 (1+#) A <herefore, mS1(1:#) I + " S re5resents sur5lus funds

S S Bi2en m( %.1%, S1 ( $%,,%%, #( %.# , "( 1 ,,!% S( #!, #% and sur5lus funds ( ,%%% we ha2e A 1 ,,!% (%.1%) : $%,,%%: (1+%.#) + + : 1 ,%$% ( ,%%% #!, #% #!, #% A I 1 ,,!% ( ,$1!+ %%% ( 1$1! # or A ( # : 1$1!) 1 ,,!% ( 1!,! <he total assets of Geadstrong must be 1!,!17.

<he following information is a2ailable about 0eridian 'or5oration6 =ales of this year ( 1%%,7!% 8roCected sales increase for ne:t year ( ,% 5ercent 8rofit after ta: this year ( 1-,117 3i2idend 5ayout ratio ( -% 5ercent 8roCected sur5lus funds a2ailable ne:t year ( 7,%%% 8resent le2el of s5ontaneous current liabilities ( 1#,,%% What is the le2el of total assets for 0eridian now?

Solution: A *6R ( S + S " S 9 m S1 (1+#) A <herefore, mS1(1:#) I "

+ S re5resents sur5lus funds S S Bi2en m( %.1- , S1 ( 1,1,%1#, #( %.- , "( 1#,,%% , S( 1%%,7!% and sur5lus funds ( 7,%%% we ha2e A 1#,,%% (%.1-) : 1,1,%1#: (1+%.-) + + : ,%, ,# ( 7,%%% 1%%,7!% 1%%,7!% (A I 1#,,%%): ,%, ,# ( .! $+ 7%%% ( ,! $ 1%%,7!% or A ( ,! $ : 1%%,7!%*,%, ,# ) 1#,,%% ( ,,7 %

 <he total assets of 0eridian must be ,,7 %

1!.

0aharaCa @imited has the following financial ratios6 Net 5rofit margin ratio ( ! 5ercent <arget di2idend 5ayout ratio ( #% 5ercent Assets+to+e7uity ratio ( ,.% Assets+to+sales ratio ( 1.! (a) What is the rate of growth that can be sustained with internal e7uity? (b) "f 0aharaCa @imited wants to achie2e a ! 5ercent growth rate with internal e7uity, what change must be made in the di2idend 5ayout ratio, other ratios remaining unchanged? (c) "f 0aharaCa @imited wants to achie2e a ! 5ercent growth rate with internal e7uity, what change must be made in the assets+to+e7uity ratio, other ratios remaining unchanged? (d) "f 0aharaCa @imited wants to achie2e a 7 5ercent growth rate with internal e7uity, what should be the im5ro2ement in the 5rofit margin, other ratios remaining unchanged? (e) "f 0aharaCa @imited wants to achie2e a 7 5ercent growth rate with internal e7uity, what change must occur in the assets+to+sales ratio, other ratios remaining unchanged?

Solution: m( .%! , # ( %.# , A** ( ,.% , A*S ( 1.! m (1+#)A>* (a) <( A>S 9m(1+#)A>* .%! (1+d) : 3.0 (b) %.%! ( 1.! + .%! (1+ d ) ,.% %.1## I %.%1. ) %.%1. d ( %. # I %. # d d( %. # ) %.%1. ) ( %. # ) %.%1. I %.1## ( %.11d ( %.#### or ##.## % <he di2idend 5ayout ratio must be raised by #.# 5ercent. %.%! (1+%.#) : A>* %.%! ( 1.! +.%! (1+%.#) A>* %.1## I %.%%,!# A*/ ( %.%#! A*/ , A*/ ( %.1##*%.%-1!# ( .7! Assets to e7uity ratio should be reduced by %. m (1+%.#) , (d) .%7 ( 1.! I m (1+%.#) : , ( 1.! +.%! (1+%.#) ,.% .%! (1+%.#) ,.% ( !.7 5er cent

(c)

%.1 $ +%.1 $m ( 1.!m , m (%.1 $*1.. $ ( $.-# % <he net 5rofit margin must be reduced from ! 5er cent to $.-# 5er cent .%! (1+%.#) , (e) .%7 ( A>S + .%! (1+%.#) , %.%7 A*= I %.%1 ( %.1## , A>S 8 0.15.>0.0$ 8 2.2 <he asset to sales ratio must increase from 1.! to . 1.. 0aCestic 'or5oration has the following financial ratios6 Net 5rofit margin ratio ( 7 5ercent <arget di2idend 5ayout ratio ( ,- 5ercent Assets+to+e7uity ratio ( 1.! Assets+to+sales ratio ( 1.% (a) What is the rate of growth that can be sustained with internal e7uity? (b) "f 0aCestic 'or5oration wants to achie2e a 1% 5ercent growth rate with internal e7uity, what change must be made in the di2idend 5ayout ratio, other ratios remaining unchanged? (c) "f 0aCestic 'or5oration wants to achie2e a 11 5ercent growth rate with internal e7uity, what change must be made in the assets+to+e7uity ratio, other ratios remaining unchanged? (d) "f 0aCestic 'or5oration wants to achie2e a 1 5ercent growth rate with internal e7uity, what should be the im5ro2ement in the 5rofit margin, other ratios remaining unchanged? (e) "f 0aCestic 'or5oration wants to achie2e a $ 5ercent growth rate with internal e7uity, what change must occur in the assets+to+sales ratio, other ratios remaining unchanged?

Solution: m( .%7 , # ( %.,- , A** ( 1.! , A*S ( 1.% m (1+#)A>* (a) <( A>S 9m(1+#)A>* ( 1.% +.%7 (1+%.,-) 1.! .%7 (1+d) 1.! (b) ( %.1% 1.% +.%7 (1+d) 1.! %.1% +%.%1 $ ) %.%1 $ d ( 1. $ I 1. $ d d ( ( 1. $ ) %.%1 $ I %.1%)*(1. $ ) %.%1 $) ( %.. 1 or . .1% <he di2idend 5ayout ratio must be raised from ,- % to . .1%. <( .%7 (1+%.%.,-) 1.! ( !.. 5er cent

(c) .%7 (1+%.%.,-) A*/ ( %.11 1.% +.%7 (1+%.,-) A*/ %.11 I %.%%-%%- A*/ ( %.%#-- A*/ A*/ ( %.11*(%.%#--)%.%%-%%-) ( . Assets to e7uity ratio should be raised from 1.! to . . . (d) m (1+%.%.,-) 1.! %.1 ( 1.% +m (1+%.,-) 1.! %.1 I %.1#%# m ( 1.17 m , m ( %.%. or . % <he net 5rofit margin should be changed from 7 5ercent to . 5ercent. (e) .%7 (1+%.%.,-) 1.! %.%$ ( A*= +.%7 (1+%.,-) 1.! %.%$ A*= I %.%%#. ( %.%!1., A*= ( 1.,! <he assets to sales ratio should be raised from 1.% to 1.,! CHAPTER + 1. 'alculate the 2alue 1% years hence of a de5osit of &s. %,%%% made today if the interest rate is (a) # 5ercent, (b) $ 5ercent, (c) ! 5ercent, and (d) . 5ercent.

Solution: Talue 1% years hence of a de5osit of &s. %,%%% at 2arious interest rates is as follows6 r r r r ( ( ( ( #% $% !% .% 9T9T9T9T( ( ( ( ( ( ( ( %,%%% : 9T"9 (#%, 1% years) %,%%% :1.#!% ( &s. .,$%% %,%%% : 9T"9 ($ %, 1% years) %,%%% : 1.7.1 (&s.,-,! % %,%%% : 9T"9 (! %, 1% years) %,%%% : .1-. (&s.#,,1!% %,%%% : 9T"9 (. %, 1% years) %,%%% : .,$7 (&s. #7,,#%

'alculate the 2alue , years hence of a de5osit of &s.-,!%% made today if the interest rate is (a) 1 5ercent, (b)1# 5ercent, (c) 1- 5ercent, and (d) 1$ 5ercent.

Solution: Talue , years hence of a de5osit of &s. -,!%% at 2arious interest rates is as follows6 r r r r ,. ( ( ( ( 1 % 9T1# % 9T1- % 9T1$ % 9T( ( ( ( ( ( ( ( -,!%% : 9T"9 (1 %, , years) -,!%% : 1.#%- (&s.!,1#. -,!%% : 9T"9 (1#%, , years) -,!%% : 1.#! (&s.!,-.$ -,!%% : 9T"9 (1-%, , years) -,!%% : 1.- 1 (&s.!,! -,!%% : 9T"9 (1$%, , years) -,!%% : 1.-$1 (&s. .,%-#

"f you de5osit &s. ,%%% today at $ 5ercent rate of interest in how many years (roughly) will this amount grow to &s., ,%%% ? Wor; this 5roblem using the rule of $2Ido not use tables.

Solution: &s., ,%%% * &s. ,%%% ( 1$ (

#

According to the &ule of 7 at $ 5ercent interest rate doubling ta;es 5lace a55ro:imately in 7 * $ ( 1 years =o &s. ,%%% will grow to &s., ,%%% in a55ro:imately # : 1 years #. ( #! years

"f you de5osit &s.,,%%% today at ! 5ercent rate of interest in how many years (roughly) will this amount grow to &s.1,. ,%%% ? Wor; this 5roblem using the rule of $2Ido not use tables.

Solution: &s.1. ,%%% * &s. ,,%%% ( $# (

$

According to the &ule of 7 at ! 5ercent interest rate doubling ta;es 5lace a55ro:imately in 7 * ! ( . years =o &s.,%%% will grow to &s.1. ,%%% in a55ro:imately $ : . years ( -# years

-.

A finance com5any offers to gi2e &s. %,%%% after 1# years in return for &s.-,%%% de5osited today. >sing the rule of !?, figure out the a55ro:imate interest rate offered.

Solution: "n 1# years &s.-,%%% grows to &s. %,%%% or # times. <his is de5osit. Gence doubling ta;es 5lace in 1# * ( 7 years. times the initial

According to the &ule of $., the doubling 5eriod is %.,- ) $. * "nterest rate We therefore ha2e %.,- ) $. * "nterest rate ( 7 "nterest rate ( $.*(7+%.,-) ( 1%.,! % $. =omeone offers to gi2e &s.!%,%%% to you after 1! years in return for &s.1%,%%% de5osited today. >sing the rule of !?, figure out the a55ro:imate interest rate offered.

Solution: "n 1! years &s.1%,%%% grows to &s.!%,%%% or ! times. <his is de5osit. Gence doubling ta;es 5lace in 1! * , ( $ years.
,

times the initial

According to the &ule of $., the doubling 5eriod is %.,- ) $. * "nterest rate. We therefore ha2e %.,- ) $. * "nterest rate ( $ "nterest rate ( $.*($+%.,-) ( 1 . 1 % 7. Mou can sa2e &s.-,%%% a year for , years, and &s.7,%%% a year for 7 years thereafter. What will these sa2ings cumulate to at the end of 1% years, if the rate of interest is ! 5ercent?

Solution: =a2ing &s.-%%% a year for , years and &s.$%%% a year for 7 years thereafter is e7ui2alent to sa2ing &s.-%%% a year for 1% years and &s. %%% a year for the years # through 1%. Gence the sa2ings will cumulate to6 -%%% : 9T"9A (!%, 1% years) ) %%% : 9T"9A (!%, 7 years) ( -%%% : 1#.#!7 ) %%% : !.. , ( &s..% !1

!.

Orishna sa2es &s. #,%%% a year for - years, and &s.,%,%%% a year for 1- years thereafter. "f the rate of interest is . 5ercent com5ounded annually, what will be the 2alue of his sa2ings at the end of % years?

Solution: =a2ing &s. #,%%% a year for - years and &s.,%,%%% a year for 1- years thereafter is e7ui2alent to sa2ing &s. #,%%% a year for % years and &s.$,%%% a year for the years $ through %. Gence the sa2ings will cumulate to6 #,%%% : 9T"9A (.%, % years) ) $,%%% : 9T"9A (. %, 1- years) ( #,%%% : -1.1$% ) $, %%% : ..,$1 (&s. 1,#%#,%%$ .. Mou 5lan to go abroad for higher studies after wor;ing for the ne:t fi2e years and understand that an amount of &s. ,%%%,%%% will be needed for this 5ur5ose at that time. Mou ha2e decided to accumulate this amount by in2esting a fi:ed amount at the end of each year in a safe scheme offering a rate of interest at 1% 5ercent. What amount should you in2est e2ery year to achie2e the target amount?

Solution: @et A be the annual sa2ings. A : 9T"9A (1%%, -years) A : $.1%=o, A ( ,%%%,%%% * $.1%1%. ( ( ( ,%%%,%%% ,%%%,%%% &s. , 7,$%%

Gow much should TiCay sa2e each year, if he wishes to 5urchase a flat e:5ected to cost &s.!% lacs after ! years, if the in2estment o5tion a2ailable to him offers a rate of interest at . 5ercent? Assume that the in2estment is to be made in e7ual amounts at the end of each year.

Solution: @et A be the annual sa2ings. A : 9T"9A (. %, ! years) A : 11.% ! ( ( !%,%%,%%% !%,%%,%%% &s. 7, -,# $

=o, A ( !%,%%,%%% * 11.% ! (

11.

A finance com5any ad2ertises that it will 5ay a lum5 sum of &s.1%%,%%% at the end of - years to in2estors who de5osit annually &s.1 ,%%%. What interest rate is im5licit in this offer?

Solution: 1 ,%%% : 9T"9A (r, - years) ( 9T"9A (r, - years) 9rom the tables we find that 9T"9A ( #%, - years) 9T"9A ( !%, - years) ( ( !.%#! !.7%% ( 1%%,%%% 1%%,%%% * 1 ,%%% ( !.,,,

>sing linear inter5olation in the inter2al, we get6 (!.,,,I !.%#!) r ( #% ) (!.7%% I !.%#!) 1 . =omeone 5romises to gi2e you &s.-,%%%,%%% after $ years in e:change for &s. ,%%%,%%% today. What interest rate is im5licit in this offer? : #% ( -.7-%

Solution: ,%%%,%%% : 9T"9 (r, $ years) ( -,%%%,%%% 9T"9 (r, $ years) ( -,%%%,%%% * ,%%%,%%% ( .9rom the tables we find that 9T"9 (1$%, $ years) ( 9T"9 (17%, $ years) ( .#,$ .-$-

>sing linear inter5olation in the inter2al, we get6 ( .- I .#,$. : 1 % r ( 1$% ) ( .-$- I .#,$) 1,. At the time of his retirement, &ahul is gi2en a choice between two alternati2es6 (a) an annual 5ension of &s1 %,%%% as long as he li2es, and (b) a lum5 sum amount of &s.1,%%%,%%%. "f &ahul e:5ects to li2e for % years and the interest rate is e:5ected to be 1% 5ercent throughout , which o5tion a55ears more attracti2e ( 1$.- %

Solution: <he 5resent 2alue of an annual 5ension of &s.1 %,%%% for % years when r ( 1%% is6 1 %,%%% : 8T"9A (1%%, % years) ( 1 %,%%% : !.-1# ( &s.1,% 1,$!% <he alternati2e is to recei2e a lum5sum of &s 1,%%%,%%% &ahul will be better off with the annual 5ension amount of 1#. &s.1 %,%%%.

A leading ban; has chosen you as the winner of its 7uiP com5etition and as;ed you to choose from one of the following alternati2es for the 5riPe6 (a) &s. $%,%%% in cash immediately or (b) an annual 5ayment of &s. 1%,%%% for the ne:t 1% years. "f the interest rate you can loo; forward to for a safe in2estment is . 5ercent, which o5tion would you choose?

Solution: <he 5resent 2alue of an annual 5ayment of &s.1%,%%% for 1% years when r ( .% is6 1%,%%% : 8T"9A ( . %, 1% years) ( 1%,%%% : $.#1! ( &s.$#,1!% <he annual 5ayment o5tion would be the better alternati2e 1-. What is the 5resent 2alue of an income stream which 5ro2ides &s.,%,%%% at the end of year one, &s.-%,%%% at the end of year three , and &s.1%%,%%% during each of the years # through 1%, if the discount rate is . 5ercent ?

Solution: <he 5resent 2alue of the income stream is6 ,%,%%% : 8T"9 (.%, 1 year) ) -%,%%% : 8T"9 (.%, , years) ) 1%%,%%% : 8T"9A (. %, 7 years) : 8T"9(.%, , years) ( ,%,%%% : %..17 ) -%,%%% : %.77 ) 1%%,%%% : -.%,, : %.%.77 ( &s.#-#,$-!. 1$. What is the 5resent 2alue of an income stream which 5ro2ides &s. -,%%% at the end of year one, &s.,%,%%% at the end of years two and three , and &s.#%,%%% during each of the years # through ! if the discount rate is 1- 5ercent ?

Solution: <he 5resent 2alue of the income stream is6 -,%%% : 8T"9 (1-%, 1 year) ) ,%,%%% : 8T"9 (1-%, years)

) ,%,%%% : 8T"9 (1-%, , years) ) #%,%%% : 8T"9A (1- %, - years) : 8T"9 (1-%, , years) ( -,%%% : %.!7% ) ,%,%%% : %.7-$ ) ,%,%%% : %.$-! ) #%,%%% : ,.,- : %.$-! ( &s.1- ,,.-. 17. What is the 5resent 2alue of an income stream which 5ro2ides &s.1,%%% a year for the first three years and &s.-,%%% a year fore2er thereafter, if the discount rate is 1 5ercent?

Solution: <he 5resent 2alue of the income stream is6 1,%%% : 8T"9A (1 %, , years) ) (-,%%%* %.1 ) : 8T"9 (1 %, , years) ( 1,%%% : .#% ) (-%%%*%.1 ) : %.71 ( &s., ,%$. 1!. What is the 5resent 2alue of an income stream which 5ro2ides &s. %,%%% a year for the first 1% years and &s.,%,%%% a year fore2er thereafter, if the discount rate is 1# 5ercent ?

Solution: <he 5resent 2alue of the income stream is6 %,%%% : 8T"9A (1#%, 1% years) ) (,%,%%%* %.1#) : 8T"9 (1#%, 1% years) ( %,%%% : -. 1$ ) (,%,%%%*%.1#) : %. 7% ( &s.1$ ,177 1.. 0r. Bana5athi will retire from ser2ice in fi2e years .Gow much should he de5osit now to earn an annual income of &s. #%,%%% fore2er beginning from the end of $ years from now ? <he de5osit earns 1 5ercent 5er year.

Solution: <o earn an annual income of &s. #%,%%% fore2er , beginning from the end of $ years from now, if the de5osit earns 1 % 5er year a sum of &s. #%,%%% * %.1 ( &s. ,%%%,%%% is re7uired at the end of - years. <he amount that must be de5osited to get this sum is6 &s. ,%%%,%%% 8T"9 (1 %, - years) ( &s. ,%%%,%%% : %.-$7 ( &s. 1,1,#,%%% %. =u55ose someone offers you the following financial contract. "f you de5osit &s.1%%,%%% with him he 5romises to 5ay &s.-%,%%% annually for , years. What interest rate would you earn on this de5osit?

Solution: &s.1%%,%%% (+ &s.-%,%%% : 8T"9A (r, , years) 8T"9A (r,, years) ( .%% 9rom the tables we find that6 8T"9A ( % %, , years) 8T"9A ( # %, , years) >sing linear inter5olation we get6 .1%$ I .%% r ( % % ) ++++++++++++++++ .1%$ I 1..!1 ( ,.,. % 1. "f you in2est &s.$%%,%%% with a com5any they offer to 5ay you &s.1%%,%%% annually for 1% years. What interest rate would you earn on this in2estment? ( .1%$ ( 1..!1

: #%

Solution: &s.$%%,%%% (+ &s.1%%,%%% : 8T"9A (r, 1% years) 8T"9A (r,1% years) ( $.%% 9rom the tables we find that6 8T"9A (1% %, 1% years) 8T"9A (11 %, 1% years) >sing linear inter5olation we get6 $.1#- I $.%% r ( 1% % ) ++++++++++++++++ $.1#- I -.!!. ( 1%.-7 % What is the 5resent 2alue of the following cash flow streams? /nd of year 1 =tream 1 =tream M =tream S -%% 7-% $%% --% 7%% $%% , $%% $-% $%% # $-% $%% $%% 7%% --% $%% $ 7-% -%% $%% +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ <he discount rate is 1! 5ercent. ( $.1#( -.!!.

: 1%

Solution: 8T( =tream 1) ( -%% 8T( 1!%, 1yr) )--% 8T( 1!%, yrs) ) $%% 8T( 1!%, ,yrs) ) $-% 8T( 1!%, #yrs) ) 7%% 8T( 1!%, -yrs) ) 7-% 8T( 1!%, $yrs) ( -%% : %.!#7 )--% : %.71! ) $%% : %.$%. ) $-% : %.-1$ ) 7%% : %.#,7 ) 7-% : %.,7% ( 1% .$ 8T( =tream 1) ( 7-% 8T( 1!%, 1yr) )7%% 8T( 1!%, yrs) ) $-% 8T( 1!%, ,yrs) ) $%% 8T( 1!%, #yrs) ) --% 8T( 1!%, -yrs) ) -%% 8T( 1!%, $yrs) (( 7-% : %.!#7 )7%% : %.71! ) $-% : %.$%. ) $%% : %.-1$ ) --% : %.#,7 ) -%% : %.,7% ( $!.$8T (=tream 1) ( $%% 8T"9A (1!%, $yrs) ( $%% : ,.#.! ( %.!.! ,. =u55ose you de5osit &s. %%,%%% with an in2estment com5any which 5ays 1 5ercent interest with com5ounding done once in e2ery two months, how much will this de5osit grow to in 1% years?

Solution: 9T1% ( ( ( ( &s. %%,%%% U1 ) (%.1 * $)V1%:$ &s. %%,%%% (1.% )$% &s. %%,%%% : ,. !1 &s.$-$, %%

#.

A ban; 5ays interest at - 5ercent on >= dollar de5osits, com5ounded once in e2ery si: months. What will be the maturity 2alue of a de5osit of >= dollars 1-,%%% for three years?

Solution: 0aturity 2alue ( >=3 1- ,%%% U1 ) (%.%- * )V,: ( 1-,%%% (1.% -)$ ( 1-,%%% : 1.1-.7 ( 17,,.-.-% -. What is the difference between the effecti2e rate of interest and stated rate of interest in the following cases6 Case A6 =tated rate of interest is ! 5ercent and the fre7uency of com5ounding is si: times a year. Case B6 =tated rate of interest is 1% 5ercent and the fre7uency of com5ounding is four times a year. Case C6 =tated rate of interest is 1 5ercent and the fre7uency of com5ounding is twel2e times a year.

Solution: A =tated rate (%) 9re7uency of com5ounding /ffecti2e rate (%) ! $ times B 1% # times (1)%.1%*#)# I1 ( 1%.,! C 1 1 times (1 ) %.1 *1 )1 +1 ( 1 .$!

(1 ) %.%!*$)$+ 1 ( !. 7

3ifference between the effecti2e rate and stated rate (%) $.

%. 7

%.,!

%.$!

Mou ha2e a choice between &s. %%,%%% now and &s.$%%,%%% after ! years. Which would you choose? What does your 5reference indicate?

Solution: <he interest rate im5licit in the offer of &s.$%%,%%% after ! years in lieu of &s. %%,%%% now is6 &s. %%,%%% : 9T"9 (r,! years) ( &s.$%%,%%% &s.$%%,%%% 9T"9 (r,! years) ( ( ,.%%% &s. %%,%%% 9rom the tables we find that 9T"9 (1-%, !years) ( ,.%-. <his means that the im5lied interest rate is nearly 1-%. " would choose &s.$%%,%%% after ! years from now because " find a return of 1-% 7uite attracti2e. 7. &a2i;iran de5osits &s.-%%,%%% in a ban; now. <he interest rate is . 5ercent and com5ounding is done 7uarterly. What will the de5osit grow to after - years? "f the inflation rate is , 5ercent 5er year, what will be the 2alue of the de5osit after - years in terms of the current ru5ee?

Solution: 9T( &s.-%%,%%% U1 ) (%.%. * #)V-:# ( &s.-%%,%%% (1.% -) % ( &s.-%%,%%% : .$-, ( &s.7!%, --

"f the inflation rate is , % 5er year, the 2alue of &s.7!%, -- - years from now, in terms of the current ru5ees is6 &s.7!%, -- : 8T"9 (,%, - years) ( &s.7!%, -- : %. !$, ( &s.$7,,,$% !. A 5erson re7uires &s.1%%,%%% at the beginning of each year from %1- to %1.. <owards this, how much should he de5osit ( in e7ual amounts) at the end of each year from %%7 to %11, if the interest rate is 1% 5ercent.

Solution: <he discounted 2alue of &s.1%%,%%% recei2able at the beginning of each year from %1- to %1., e2aluated as at the beginning of %1# (or end of %1,) is6 &s.1%%,%%% : 8T"9A (1%%, - years) ( &s.1%%,%%% : ,.7.1( &s.,7.,1%% <he discounted 2alue of &s.,7.,1%% e2aluated at the end of %11 is &s.,7.,1%% : 8T"9 (1% %, years) ( &s.,7.,1%% : %.! $( &s.,1,,1,7 "f A is the amount de5osited at the end of each year from %%7 to %11 then A : 9T"9A (1%%, - years) ( &s.,1,,1,7 A : $.1%- ( &s.,1,,1,7 A ( &s.,1,,1,7* $.1%( &s.-1, . .. Mou re7uire &s. -% ,%%% at the beginning of each year from %1% to %1 . Gow much should you de5osit( in e7ual amounts) at the beginning of each year in %%7 and %%! ? <he interest rate is ! 5ercent.

Solution: <he discounted 2alue of &s. -%,%%% recei2able at the beginning of each year from %1% to %1 , e2aluated as at the beginning of %%. (or end of %%!) is6 &s. -%,%%% : 8T"9A (! %, , years) ( &s. -%,%%% : .-77( &s.$##, -% <o ha2e &s. $##, -% at the end of %%!, let A be the amount that needs to be de5osited at the beginning of %%7 and %%!.We then ha2e A: (1)%.%!) : 9T"9A ( !%, years) ( $##, -% A : 1.%! : .%!% ( $##, -% or A ( !$,7.

,%.

What is the 5resent 2alue of &s.1 %,%%% recei2able annually for % years if the first recei5t occurs after ! years and the discount rate is 1 5ercent.

Solution: <he discounted 2alue of the annuity of &s.1 %,%%% recei2able for % years, e2aluated as at the end of 7th year is6 &s.1 %,%%% : 8T"9A (1 %, % years) ( &s.1 %,%%% : 7.#$. ( &s.!.$, .% <he 5resent 2alue of &s. !.$, .% is6 &s. !.$, .% : 8T"9 (1 %, 7 years) ( &s. !.$, .% : %.#( &s.#%-,11. ,1. What is the 5resent 2alue of &s.!.,7$% recei2able annually for 1% years if the first recei5t occurs after - years and the discount rate is . 5ercent.

Solution: <he discounted 2alue of the annuity of &s.!.,7$% recei2able for 1% years, e2aluated as at the end of #th year is6 &s. !.,7$% : 8T"9A (.%, 1% years) ( &s. !.,7$% : $.#1! ( &s.-7$,%!% <he 5resent 2alue of &s. -7$,%!%is6 &s. -7$,%!%: 8T"9 (.%, # years) ( &s. -7$,%!%: %.7%! ( &s.#%7,!$, . After eight years 0r.<iwari will recei2e a 5ension of &s.1%,%%% 5er month for % years. Gow much can 0r. <iwari borrow now at 1 5ercent interest so that the borrowed amount can be 5aid with #% 5ercent of the 5ension amount? <he interest will be accumulated till the first 5ension amount becomes recei2able.

Solution: #% 5er cent of the 5ension amount is %.#% : &s.1%,%%% ( &s.#,%%% Assuming that the monthly interest rate corres5onding to an annual interest rate of 1 % is 1%, the discounted 2alue of an annuity of &s.#,%%% recei2able at the end of each month for #% months ( % years) is6 &s.#,%%% : 8T"9A (1%, #%) &s.#,%%% : (1.%1) #% + 1 ++++++++++++++++ ( &s.,$,, 7! .%1 (1.%1) #%

"f 0r. <iwari borrows &s.- today on which the monthly interest rate is 1% - : (1.%1).$ ( - : .$% ( ,,. ( &s. ,$,, 7! &s. ,$,, 7! &s. ,$,, 7! ++++++++++++ ( &s.1,.,7 .$%

After one year 0r. Ohanna will recei2e a 5ension of &s.1-,%%% 5er month for ,% years. Gow much can 0r. Ohanna borrow now at 1 5ercent interest so that the borrowed amount can be 5aid with - 5ercent of the 5ension amount? <he interest will be accumulated till the first 5ension amount becomes recei2able.

Solution: - 5er cent of the 5ension amount is %. - : &s.1-,%%% ( &s.,,7-% Assuming that the monthly interest rate corres5onding to an annual interest rate of 1 % is 1%, the discounted 2alue of an annuity of &s.,,7-% recei2able at the end of each month for ,$% months (,% years) is6 &s.,,7-% : 8T"9A (1%, ,$%) (1.%1),$% + 1 &s.,,7-% : ++++++++++++++++ ( &s.,$#,-$. .%1 (1.%1),$% "f 0r. Ohanna borrows &s.- today on which the monthly interest rate is 1% - : (1.%1)1 - : 1.1 7 ,#. ( ( ( &s. ,$#,-$. &s. ,$#,-$. &s. ,$#,-$. ++++++++++++ ( &s., ,,#!$ 1.1 7

Mou buy a car with a ban; loan of &s.- -,%%%. An instalment of &s. -,%%% is 5ayable to the ban; for each of ,% months towards the re5ayment of loan with interest. What interest rate does the ban; charge?

Solution: &s. -,%%% : 8T"9A(r, ,% months) ( &s.- -,%%% 8T"9A (r, ,% months) ( &s.- -,%%% * &s. -,%%%( 1 9rom the tables we find that6

8T"9A(,%, ,%) 8T"9A ( %, ,%)

( (

1..$%% .,.7

>sing a linear inter5olation .,.7 I 1.%%% r ( %) ++++++++++++++++++++++ .,.7 I 1..$%% ( .-%%

: 1%

<hus, the ban; charges an interest rate of .-% % 5er month. <he corres5onding effecti2e rate of interest 5er annum is U (1.% -%)1 I 1 V : 1%% ( ,#.#. % ,-. Mou ta;e a ban; loan of &s.17#,%%% re5ayable with interest in 1! monthly instalments of &s.1 ,%%% What is the effecti2e annual interest rate charged by the ban; ?

Solution: &s.1 ,%%% : 8T"9A(r, 1! months) ( &s.17#,%%% 8T"9A (r, 1! months) ( &s.17#,%%% * &s.1 ,%%%( 1#.9rom the tables we find that6 8T"9A( %, 1!) ( 8T"9A (,%, 1!) ( 1#... 1,.7-#

>sing a linear inter5olation 1#... I 1#.-%% r ( %) ++++++++++++++++++++++ 1#... I 1,.7-# ( .,.7%

: 1%

<hus, the ban; charges an interest rate of .,.7 % 5er month. <he corres5onding effecti2e rate of interest 5er annum is U (1.% ,.7)1 I 1 V : 1%% ( , .!! %

,$.

0etro 'or5oration has to retire &s. % million of debentures each at the end of $, 7, and ! years from now. Gow much should the firm de5osit in a sin;ing fund account annually for - years, in order to meet the debenture retirement need? <he net interest rate earned is 1% 5ercent.

Solution: <he discounted 2alue of the debentures to be redeemed between $ to ! years e2aluated at the end of the -th year is6 &s. % million : 8T"9A (1%%, , years) ( &s.#..7#million ( &s. % million : .#!7

"f A is the annual de5osit to be made in the sin;ing fund for the years 1 to -, then A : 9T"9A (1%%, - years) ( &s.#..7# million A : $.1%- ( &s.#..7# million A ( &s.!,1#7,# % ,7. An;it @imited has to retire &s.,% million of debentures each at the end of 7, !, . and 1% years from now. Gow much should the firm de5osit in a sin;ing fund account annually for - years, in order to meet the debenture retirement need? <he net interest rate earned is 1 5ercent.

Solution: <he discounted 2alue of the debentures to be redeemed between 7 to 1% years e2aluated at the end of the $th year is6 &s.,% million : 8T"9A (1 %, # years) ( &s.,% million : ,.%,7 ( &s..1.11 million "f A is the annual de5osit to be made in the sin;ing fund for the years 1 to $, then A : 9T"9A (1 %, $ years) ( &s..1.11 million A : !.11- ( &s. .1.11 million A ( &s.11, 7,,-7 ,!. 0r.0ehta recei2es a 5ro2ident fund amount or &s.!%%,%%%. Ge de5osits it in a ban; which 5ays . 5ercent interest. "f he 5lans to withdraw &s.1%%,%%% at the end of each year, how long can he do so ?

Solution: @et WnJ be the number of years for which a sum of &s.1%%,%%% can be withdrawn annually.

&s.1%%,%%% : 8T"9A (.%, n) ( &s.!%%,%%% 8T"9A (.%, n) ( &s.!%%,%%% * &s.1%%,%%% ( ! .%%% 9rom the tables we find that 8T"9A (.%, 1# years) ( 7.7!$ 8T"9A (.%, 1- years) ( !.%$% >sing a linear inter5olation we get !.%%% I 7.7!$ n ( 1# ) +++++++++++++++++ : 1 ( 1#.7! years !.%$% I 7.7!$ ,.. 0r. Naresh wants to in2est an amount of &s. #%%,%%%, in a finance com5any at an interest rate of 1 5ercent, with instructions to the com5any that the amount with interest be re5aid to his son in e7ual instalments of &s.1%%,%%%, for his education e:5enses . Gow long will his son get the amount ?

Solution: @et WnJ be the number of years for which a sum of &s.1%%,%%% can be withdrawn annually. &s.1%%,%%% : 8T"9A (1 %, n) ( &s.#%%,%%% 8T"9A (1 %, n) ( &s.#%%,%%% * &s.1%%,%%% ( # 9rom the tables we find that 8T"9A (1 %, - years) ( 8T"9A (1 %, $ years) ( >sing a linear inter5olation we get #.%%% I ,.$%n ( - ) +++++++++++++++++ : 1 ( -.7! years #.111 I ,.$%#%. Mour com5any is ta;ing a loan of 1,%%%,%%%, carrying an interest rate of 1- 5ercent. <he loan will be amortised in fi2e e7ual instalments. What fraction of the instalment at the end of second year will re5resent 5rinci5al re5ayment ? ,.$%#.111

Solution: 1,%%%,%%% Annual instalment ( ,.,( .!,, .

Loan Amortisation Sche"ule 2ear 1 Be<. 1,%%%,%%% !-1,$71 /nstalment .!,, . .!,, . -rincipalBalance repayment 1-%,%%% 1#!,, . !-1,$71 1 7,7-1 17%,-7! $!1,%., 17%,-7! * .!,, . ( %.-7 or -7. % /nterest

#1.

Anurag @imited borrows &s. ,%%%,%%% at an interest rate of 1 5ercent. <he loan is to be re5aid in - e7ual annual instalments 5ayable at the end of each of the ne:t - years. 8re5are the loan amortisation schedule

Solution: /7uated annual installment ( ,%%%,%%% * 8T"9A(1 %,-) ( ,%%%,%%% * ,.$%( &s.--#,7!-

"oan Amortisation Sche#ule Be<innin< Annual 2ear amountinstallment /nterestrepai# :::::: ::::::::::::: ::::::::::::::: ::::::::::: 1 ,%%%,%%% --#,7!#%,%%% 1,$!-, 1--#,7!% , $ , 1,,, ,$-$ --#,7!1-...1. # .,7,7.% --#,7!11 ,-,#.-,-#% --#,7!-.,#$(X) rounding off error # . -rincipal ,alance ::::::::::::: ,1#,7!,- ,--. ,.#,!$$ ## , -% #.-, % Remainin< ::::::::::::: 1,$!-, 11,,, ,$-$ .,7,7.% #.-,-#% %X

Mou want to borrow &s.,,%%%,%%% to buy a flat. Mou a55roach a housing com5any which charges 1% 5ercent interest. Mou can 5ay &s.#%%,%%% 5er year toward loan amortisation. What should be the maturity 5eriod of the loan?

Solution: @et n be the maturity 5eriod of the loan. <he 2alue of n can be obtained from the e7uation. #%%,%%% : 8T"9A(1%%, n) 8T"9A (1%%, n) 9rom the tables we find that 8T"9A (1%%,1# years) 8T"9A (1% %, 1- years) ( ( ( ( ,,%%%,%%% 7.7.,$7 7.$%$

>sing a linear inter5olation we get 7.-%% I 7.,$7 n ( 1# ) +++++++++++++++++ : 1 ( 1#.-$ years 7.$%$ I 7.,$7 #,. Mou want to borrow &s.-,%%%,%%% to buy a flat. Mou a55roach a housing com5any which charges 11 5ercent interest. Mou can 5ay &s.$%%,%%% 5er year toward loan amortisation. What should be the maturity 5eriod of the loan?

Solution: @et n be the maturity 5eriod of the loan. <he 2alue of n can be obtained from the e7uation. $%%,%%% : 8T"9A(11%, n) 8T"9A (11%, n) 9rom the tables we find that 8T"9A (11%, % years) 8T"9A (11 %, - years) >sing linear inter5olation we get ( ( ( ( -,%%%,%%% !.,,, 7..$, !.#

!.,,, I 7..$, n ( % ) +++++++++++++++++ : - ( #.%, years !.# I 7..$, ##. Mou are negotiating with the go2ernment the right to mine 1$%,%%% tons of iron ore 5er year for % years. <he current 5rice 5er ton of iron ore is &s.,-%% and it is e:5ected to increase at the rate of ! 5ercent 5er year. What is the 5resent 2alue of the iron ore that you can mine if the discount rate is 1- 5ercent

Solution: /:5ected 2alue of iron ore mined during year 1( 1$%,%%%:,-%% ( &s.-$% million /:5ected 5resent 2alue of the iron ore that can be mined o2er the ne:t % years assuming a 5rice escalation of !% 5er annum in the 5rice 5er ton of iron ( &s.-$% million : 1 I (1 ) <)n * (1 ) i)n ++++++++++++++++++++++++ i+<

( &s.-$% million :

1 I (1.%!) % * (1.1-) % %.1- I %.%!

( &s.-$% million : 1%. 17, ( &s.-,7 1,$!!,%%% #-. Mou are negotiating with the go2ernment the right to mine ,%%,%%% tons of iron ore 5er year for - years. <he current 5rice 5er ton of iron ore is &s., %% and it is e:5ected to increase at the rate of 7 5ercent 5er year. What is the 5resent 2alue of the iron ore that you can mine if the discount rate is 1! 5ercent

Solution: /:5ected 2alue of iron ore mined during year 1( ,%%,%%%:, %% ( &s..$% million /:5ected 5resent 2alue of the iron ore that can be mined o2er the ne:t - years assuming a 5rice escalation of 7% 5er annum in the 5rice 5er ton of iron ( &s..$% million : 1 I (1 ) <)n * (1 ) i)n ++++++++++++++++++++++++ i+< 1 I (1.%7) - * (1.1!) %.1! I %.%7

( &s..$% million :

( &s..$% million : !.,%,$ ( &s.7,.71,#-$,%%% #$. As a winner of a com5etition, you can choose one of the following 5riPes6 a. &s. !%%,%%% now b. &s. ,%%%,%%% at the end of ! years c. &s. 1%%,%%% a year fore2er d. &s. 1,%,%%% 5er year for 1 years e. &s. , ,%%% ne:t year and rising thereafter by ! 5ercent 5er year fore2er. "f the interest rate is 1 5ercent, which 5riPe has the highest 5resent 2alue? (a) (b) (c ) (d) (e) 8T ( &s.!%%,%%% 8T ( ,%%%,%%%8T"91 %,!yrs ( ,%%%,%%% : %.%.#%# ( &s.!%!,%%% 8T ( 1%%,%%%*r ( 1%%,%%%*%.1 ( &s. !,,,,,, 8T ( 1,%,%%% 8T"9A1 %,1 yrs ( 1,%,%%% : $.1.# ( &s.!%-, % 8T ( '*(r+g) ( , ,%%%*(%.1 +%.%!) ( &s.!%%,%%%

Solution:

A5tion c has the highest 5resent 2alue 2iP. &s.!,,,,,, #7. Ail "ndia owns an oil 5i5eline which will generate &s. % million of cash income in the coming year. "t has a 2ery long life with 2irtually negligible o5erating costs. <he 2olume of oil shi55ed, howe2er, will decline o2er time and, hence, cash flows will decrease by # 5ercent 5er year. <he discount rate is 1- 5ercent. a. "f the 5i5eline is used fore2er, what is the 5resent 2alue of its cash flows? b. "f the 5i5eline is scra55ed after ,% years, what is the 5resent 2alue of its cash flows? Solution: (a) 8T ( c*(r I g) ( %*U%.1- I (+%.%#)V ( &s.1%-. $ million 1)g n 1 + +++++++ 1)r 8T ( A(1)g) +++++++++++++++++ ( % : %..$ : -. ,.! ( &s.1%%.$%# million r+ g

(b)

#!.

8etrolite owns an oil 5i5eline which will generate &s. 1- million of cash income in the coming year. "t has a 2ery long life with 2irtually negligible o5erating costs. <he 2olume of oil shi55ed, howe2er, will decline o2er time and, hence, cash flows will decrease by $ 5ercent 5er year. <he discount rate is 1! 5ercent. a."f the 5i5eline is used fore2er, what is the 5resent 2alue of its cash flows? b."f the 5i5eline is scra55ed after 1% years, what is the 5resent 2alue of its cash flows? Solution: (a) 8T ( c*(r I g) ( 1-*U%.1! I (+%.%$)V ( &s.$ .- million 1)g n 1 + +++++++ 1)r 8T ( A(1)g) +++++++++++++++++ ( 1- : %..# : ,.7,7. ( &s.- .7%# million r+ g

(b)

#..

An oil well 5resently 5roduces !%,%%% barrels 5er year. "t will last for % years more, but the 5roduction will fall by $ 5ercent 5er year. Ail 5rices are e:5ected to increase by - 5ercent 5er year. 8resently the 5rice of oil is Y!% 5er barrel. What is the 5resent 2alue of the wellFs 5roduction if the discount rate is 1- 5ercent?

Solution: <he growth rate in the 2alue of oil 5roduced, g ( (1+ %.%$)(1 )%.%-) + 1 ( + %.%1, 8resent 2alue of the wellJs 5roduction ( 1)g n 1 + +++++++ 1)r 8T ( A(1)g) +++++++++++++++++ r+ g ( (!%,%%% : !%) : ( 1+%.%1,): 1 I (%..!7 * 1.1-) % %.1- ) %.%1, ( Y ,$,.,%,7-$ /0!0CASE 1 1. As an in2estment ad2isor, you ha2e been a55roached by a client called Ti;as for your ad2ice on in2estment 5lan. Ge is currently #% years old and has &s.$%%,%%% in the ban;. Ge 5lans to wor; for % years more and retire at the age of $%. Gis 5resent salary is &s.-%%,%%% 5er year. Ge e:5ects his salary to increase at the rate of 1 5ercent 5er year until his retirement. Ti;as has decided to in2est his ban; balance and future sa2ings in a balanced mutual fund scheme that he belie2es will 5ro2ide a return of . 5ercent 5er year. Mou agree with his assessment. Ti;as see;s your hel5 in answering se2eral 7uestions gi2en below. "n answering these 7uestions, ignore the ta: factor. (i) Ance he retires at the age of $%, he would li;e to withdraw &s.!%%,%%% 5er year for his consum5tion needs from his in2estments for the following 1- years (Ge e:5ects to li2e u5to the age of 7- years). /ach annual withdrawal will be made at the beginning of the year. Gow much should be the 2alue of his in2estments when Ti;as turns $%, to meet this retirement need? (ii) Gow much should Ti;as sa2e each year for the ne:t % years to be able to withdraw &s.!%%,%%% 5er year from the beginning of the 1st year ? Assume that the sa2ings will occur at the end of each year. (iii) =u55ose Ti;as wants to donate &s.-%%,%%% 5er year in the last - years of his life to a charitable cause. /ach donation would be made at the beginning of the year. 9urther, he wants to be7ueath &s.1,%%%,%%% to his son at the end of his life. Gow much should he ha2e in his in2estment account when he reaches the age of $% to meet this need for donation and be7ueathing?

(i2) Ti;as is curious to find out the 5resent 2alue of his lifetime salary income. 9or the sa;e of sim5licity, assume that his current salary of &s.-%%,%%% will be 5aid e:actly one year from now, and his salary is 5aid annually. What is the 5resent 2alue of his life time salary income, if the discount rate a55licable to the same is 7 5ercent? &emember that Ti;as e:5ects his salary to increase at the rate of 1 5ercent 5er year until retirement. Solution: (i) <his is an annuity due Talue of annuity due ( Talue of ordinary annuity (1 ) r) <he 2alue of in2estments when 2i;as turns $% must be6 !%%,%%% : 8T"9A (.%, 1- years) : 1.%. ( !%%,%%% : !.%$% : 1.%. ( &s.7,% !,, % (ii) Ge must ha2e &s.7,%. ,!%% at the end of the %th year. Gis current ca5ital of &s.$%%,%%% will grow to6 &s.$%%,%%% : 9T"9 (.%, %yrs) ( $%%,%%% : -.$%# ( &s.,,,$ ,#%% =o, what he sa2es in the ne:t 1- years must cumulate to6 7,% !,, % I ,,,$ ,#%% ( &s.,,$$-,. % A : 9T"9A (.%, % yrs) ( &s.,,$$-,. % A : -1.1$% ( ,,$$-,. % A ( ,,$$-,. %*-1.1$% ( &s.71,$-$ (iii) $% $. 7% 71 7 A A A 7, A 7# A 7-

1,%%%,%%% <o meet his donation obCecti2e, Ti;as will need an amount e7ual to6 -%%,%%% : 8T"9A (.%, -years) when he turns $.. <his means he will need -%%,%%% : 8T"9A (.%, -yrs) : 8T"9 (.%, .yrs) when he turns $%. <his wor;s out to6 -%%,%%% : ,.!.% : %.#$% ( &s.!.#,7%% <o meet his be7ueathing obCecti2e he will need 1,%%%,%%% : 8T"9 (1-%, .yrs) when he turns $% <his wor;s out to6 1,%%%,%%% : %. 7- ( &s. 7-,%%% =o, his need for donation and be7ueathing is6 !.#,7%% ) 7-,%%% ( &s.1,1$.,7%%

(i2)

1+

(1)g)n (1)r)n rIg

8TBA ( A (1)g) Where A(1)g) is the cash flow a year from now. "n this case A (1)g) ( &s.-%%,%%%, g ( 1 %, r ( 7%, and n ( % =o, (1.1 ) % 1+ (1.%7) % 8TBA ( -%%,%%% %.%7 I %.1 ( &s.1#,. -,%$-

/0!0CASE 2 . As an in2estment ad2isor, you ha2e been a55roached by a client called &a2i for ad2ice on his in2estment 5lan. Ge is ,- years and has &s. %%, %%% in the ban;. Ge 5lans to wor; for - years more and retire at the age of $%. Gis 5resent salary is -%%,%%% 5er year. Ge e:5ects his salary to increase at the rate of 1 5ercent 5er year until his retirement. &a2i has decided to in2est his ban; balance and future sa2ings in a balanced mutual fund scheme that he belie2es will 5ro2ide a return of . 5ercent 5er year. Mou concur with his assessment. &a2i see;s your hel5 in answering se2eral 7uestions gi2en below. "n answering these 7uestions, ignore the ta: factor. Ance he retires at the age of $%, he would li;e to withdraw &s. .%%,%%% 5er year for his consum5tion needs for the following % years (Gis life e:5ectancy is !%years)./ach annual withdrawal will be made at the beginning of the year. Gow much should be the 2alue of his in2estments when he turns $%, to meet his retirement need? (ii) Gow much should &a2i sa2e each year for the ne:t - years to be able to withdraw &s..%%, %%% 5er year from the beginning of the $th year for a 5eriod of % years? Assume that the sa2ings will occur at the end of each year. &emember that he already has some ban; balance. (iii) =u55ose &a2i wants to donate &s.$%%, %%% 5er year in the last # years of his life to a charitable cause. /ach donation would be made at the beginning of the year. 9urther he wants to be7ueath &s. ,%%%,%%% to his daughter at the end of his life. (i)

Gow much should he ha2e in his in2estment account when he reaches the age of $% to meet this need for donation and be7ueathing? (i2) &a2i wants to find out the 5resent 2alue of his lifetime salary income. 9or the sa;e of sim5licity, assume that his current salary of &s -%%,%%% will be 5aid e:actly one year from now, and his salary is 5aid annually. What is the 5resent 2alue of his lifetime salary income, if the discount rate a55licable to the same is ! 5ercent? &emember that &a2i e:5ects his salary to increase at the rate of 1 5ercent 5er year until retirement. Solution: (i) .%%,%%% : 8T"9A ( . %, % ) : 1.%. .%%,%%% : ..1 ! : 1.%. ( &s. !,.-#,-$! (ii) &a2i needs &s. !,.-#,-$! when he reaches the age of $%. Gis ban; balance of &s. %%,%%% will grow to 6 %%,%%% ( 1.%. ) ( %%,%%% ( !.$ , ) ( &s. 1,7 #,$%% <his means that his 5eriodic sa2ings must grow to 6 &s. !,.-#,-$! + &s. 1,7 #,$%% ( &s. 7, .,.$! Gis annual sa2ings must be6 7, .,.$! A ( 9T"9A ( -, .% ) ( &s. !-,,-. (iii) 77$ ( !#.7%1 7, .,.$!

$%% $%% $%% $%% %%% Amount re7uired for the charitable cause6 $%%,%%% : 8T"9A ( .% , #yrs ) : 8T"9 ( .%, 1-yrs ) ( $%%,%%% : ,. #% : %. 7&s. -,#,$%% Amount re7uired for be7ueathing ,%%%,%%% : 8T"9 ( .%, %yrs ) ( ,%%%,%%% : %.17! ( &s.,-$,%%%

(i2) A(1)g) % 8TBA ( A(1) g) 1 ( 1 ) g )n 1 + ( 1 ) r )n r + g ( 1.1 ) ( -%%,%%% 1 + ( 1.%! ) %.%! + %.1 ( &s. 1!,- !,. A ( 1 ) g )n n

CHAPTER , 1. <he 5rice of a &s.1,%%% 5ar bond carrying a cou5on rate of ! 5ercent and maturing after - years is &s.1% %. (i) What is the a55ro:imate M<0? (ii) What will be the realised M<0 if the rein2estment rate is 7 5ercent?

Solution: (i) !% ) (1%%% I 1% %) * M<0 Z %.$ : 1% % ) %.# : 1%%% (ii) <he terminal 2alue will be !% : 9T"9A (7%, -yrs) ) 1%%% !% : -.7-1 ) 1%%% ( 1#$%.%! <he realised M<0 will be6 1#$%.%! 1% %
1*-

7.-1%

I 1 ( 7.##%

<he 5rice of a &s.1,%%% 5ar bond carrying a cou5on rate of 7 5ercent and maturing after - years is &s.1%#%. (i) What is the a55ro:imate M<0? (ii) What will be the realised M<0 if the rein2estment rate is $ 5ercent?

Solution: (i) <he a55ro:imate M<0 is6 7% ) (1%%% I 1%#%)*( %.%$%- or $.%- 5ercent %.$ : 1%#% ) %.# : 1%%% (ii) % +1%#% 1 7% 7% , 7% # 7% 7% 1%%%

<he terminal 2alue at $ 5ercent rein2estment rate is6 7% : 9T"9A ($%, -yrs) ) 1%%% 7% : -.$,7 ) 1%%% ( &s.1,.#.-. 1,.#.-. 1*&ealised yield to maturity ( I 1 ( $.%#% 1%#% ,. A &s.1%%% 5ar 2alue bond, bearing a cou5on rate of 1 5ercent will mature after $ years. What is the 2alue of the bond, if the discount rate is 1$ 5ercent? $ t(1 1 % ) (1.1$)t (1.1$)$ 1%%%

Solution: - (

( &s.1 % : 8T"9A(1$%, $ years) ) &s.1%%% : 8T"9 (1$%, $ years) ( &s.1 % : ,.$!- ) &s.1%%% : %.#1% ( &s. !- . %

#.

A &s.1%% 5ar 2alue bond, bearing a cou5on rate of . 5ercent will mature after # years. What is the 2alue of the bond, if the discount rate is 1, 5ercent?

Solution: - ( # t(1 . ) (1.1,)t (1.1,)# 1%%

( &s.. : 8T"9A(1,%, # years) ) &s.1%% : 8T"9 (1,%, # years) ( &s.. : ..7# ) &s.1%% : %.$1, ( &s. !!.%7 -. <he mar;et 2alue of a &s.1,%%% 5ar 2alue bond, carrying a cou5on rate of 1% 5ercent and maturing after - years, is &s.!-%. What is the yield to maturity on this bond?

Solution: <he yield to maturity is the 2alue of r that satisfies the following e7uality. - 1%% 1,%%% &s.!-% ( ) t(1 (1)r) t (1)r)<ry r ( 1#%. <he right hand side (&G=) of the abo2e e7uation is6 &s.1%% : 8T"9A (1#%, - years) ) &s.1,%%% : 8T"9 (1#%, - years) ( &s.1%% : ,.#,, ) &s.1,%%% : %.-1. ( &s.!$ .,% <ry r ( 1-%. <he right hand side (&G=) of the abo2e e7uation is6 &s.1%% : 8T"9A (1-%, - years) ) &s.1,%%% : 8T"9 (1-%, -years) ( &s.1%% : ,.,- ) &s.1,%%% : %.#.7 ( &s.!, . % <hus the 2alue of r at which the &G= becomes e7ual to &s.!-% lies between 1#% and 1-%. >sing linear inter5olation in this range, we get Mield to maturity ( 1#% ) !$ .,% I !-%.%% !$ .,% I !, . % : 1%

( 1#.#1%

$.

<he mar;et 2alue of a &s.1%% 5ar 2alue bond, carrying a cou5on rate of !.- 5ercent and maturing after ! years, is &s..-. What is the yield to maturity on this bond?

Solution: <he yield to maturity is the 2alue of r that satisfies the following e7uality. .- ( ! !.1%% ) t t(1 (1)r) (1)r)!

<ry r ( 1%%. <he right hand side (&G=) of the abo2e e7uation is6 !.- : 8T"9A (1%%, ! years) ) &s.1%% : 8T"9 (1%%, ! years) ( &s.!.- : -.,,- ) &s.1%% : %.#$7 ( &s.. .%<ry r ( .%. <he right hand side (&G=) of the abo2e e7uation is6 !.- : 8T"9A (. %, ! years) ) &s.1%% : 8T"9 (.%, !years) ( !.- : -.-,- ) &s.1%% : %.-% ( #7.%# ) -%. % ( .7. # <hus the 2alue of r at which the &G= becomes e7ual to &s..- lies between .% and 1%%. >sing linear inter5olation in this range, we get Mield to maturity ( . % ) ( ..#, % 7. A &s.1%%% 5ar 2alue bond bears a cou5on rate of 1% 5ercent and matures after years. "nterest is 5ayable semi+annually. 'om5ute the 2alue of the bond if the re7uired rate of return is 1! 5ercent. .7. # I .-.%% .7. # I . .%: 1%

Solution: - ( 1% t(1 -% ) (1.%.) t (1.%.)1% 1%%%

( -% : 8T"9A (.%, 1% years) ) 1%%% : 8T"9 (.%, 1% years) ( -% : $.#1! ) &s.1%%% : %.# ( &s. 7# ..%

!.

A &s.1%% 5ar 2alue bond bears a cou5on rate of ! 5ercent and matures after 1% years. "nterest is 5ayable semi+annually. 'om5ute the 2alue of the bond if the re7uired rate of return is 1 5ercent.

Solution: - ( % t(1 # ) (1.%$) t (1.%$) % 1%%

( # : 8T"9A ($%, % years) ) &s.1%% : 8T"9 ($%, % years) ( $ : 11.#7% ) &s.1%% : %.,1 ( &s.1%%.% .. Mou are considering in2esting in one of the following bonds6 Coupon rate Maturity -rice>Rs.100 par 4alue ?ond A 11% ! yrs &s.!% ?ond ? .% . yrs &s.7% Mour income ta: rate is ,# 5ercent and your ca5ital gains ta: is effecti2ely 1% 5ercent. 'a5ital gains ta:es are 5aid at the time of maturity on the difference between the 5urchase 5rice and 5ar 2alue. What is your 5ost+ta: yield to maturity from these bonds? Solution: <he 5ost+ta: interest and maturity 2alue are calculated below6 Bon# A Bon# B X X 8ost+ta: interest (' ) 8ost+ta: maturity 2alue (0) 11(1 I %.,#) (&s.7. $ 1%% + U (1%%+!%): %.1V (&s..! 7. $ ) (.!+!%)*! ++++++++++++++++++++ %.$ : !% ) %.# : .! 1%..1% -..# ) (.7 I 7%)*. ++++++++++++++++++++++ %.$: 7% ) %.# : .7 11.%$ % . (1 I %.,#) (&s.-..# 1%% + U (1%% I 7%): %.1V (&s..7

<he 5ost+ta: M<0, using the a55ro:imate M<0 formula is calculated below ?ond A 6 8ost+ta: M<0 ( ( ?ond ? 6 8ost+ta: M<0 ( (

1%.

Mou are considering in2esting in one of the following bonds6 Coupon rate ?ond A 1 % ?ond ? !% Maturity -rice>Rs.1000 par 4alue 7 yrs &s. .,% - yrs &s. !$%

Mour income ta: rate is ,, 5ercent and your ca5ital gains ta: is effecti2ely 1% 5ercent. 'a5ital gains ta:es are 5aid at the time of maturity on the difference between the 5urchase 5rice and 5ar 2alue. What is your 5ost+ta: yield to maturity from these bonds? Solution: <he 5ost+ta: interest and maturity 2alue are calculated below6 Bon# A X X 8ost+ta: interest (') 8ost+ta: maturity 2alue (0) 1 %(1 I %.,,) (&s.!%.#% 1%%% + U(1%%%+.,%) : %.1V (&s. .., Bon# B !% (1 I %.,,) (&s.-,.$ 1%%% + U (1%%% I !$%): %.1V (&s..!$

<he 5ost+ta: M<0, using the a55ro:imate M<0 formula is calculated below ?ond A 6 8ost+ta: M<0 ( ( ?ond ? 6 8ost+ta: M<0 ( ( !%.#% ) (..,+.,%)*7 ++++++++++++++++++++ %.$ : .,% ) %.# : .., ..,$ % -,.$ ) (.!$ I !$%)*++++++++++++++++++++++ %.$: !$% ) %.# : .!$ !.$$ %

11.

A com5anyFs bonds ha2e a 5ar 2alue of &s.1%%, mature in - years, and carry a cou5on rate of 1% 5ercent 5ayable semi+annually. "f the a55ro5riate discount rate is 1# 5ercent, what 5rice should the bond command in the mar;et 5lace? 1% t(1 ) (1.%7) t (1.%7)1% 1%%

Solution: - (

( &s.- : 8T"9A(7%, 1%) ) &s.1%% : 8T"9 (7%, 1%) ( &s.- : 7.% # ) &s.1%% : %.-%! ( &s. !-.. 1 . A com5anyFs bonds ha2e a 5ar 2alue of &s.1%%%, mature in ! years, and carry a cou5on rate of 1# 5ercent 5ayable semi+annually. "f the a55ro5riate discount rate is 1 5ercent, what 5rice should the bond command in the mar;et 5lace? 1$ t(1 7% ) (1.%$) t (1.%$)1$ 1%%%

Solution: - (

( &s.7% : 8T"9A($%, 1$) ) &s.1%%% : 8T"9 ($%, 1$) ( &s.7% : 1%.1%$ ) &s.1%%% : %.,.# ( &s. 11%1.# 1,. <he share of a certain stoc; 5aid a di2idend of &s.,.%% last year. <he di2idend is e:5ected to grow at a constant rate of ! 5ercent in the future. <he re7uired rate of return on this stoc; is considered to be 1- 5ercent. Gow much should this stoc; sell for now? Assuming that the e:5ected growth rate and re7uired rate of return remain the same, at what 5rice should the stoc; sell , years hence?

Solution: Do ( &s.,.%%, < ( %.%!, r ( %.1-o ( D1 * (r I <) ( ( ( Do (1 ) <) * (r I <)

&s.,.%% (1.%!) * (%.1- + %.%!) &s.#$. .

Assuming that the growth rate of !% a55lies to mar;et 5rice as well, the mar;et 5rice at the end of the ,rd year will be6 ( ( -o : (1 ) <), ( &s.#$. . (1.%!), &s. -!.,1

1#.

<he share of a certain stoc; 5aid a di2idend of &s.1%.%% last year. <he di2idend is e:5ected to grow at a constant rate of 1- 5ercent in the future. <he re7uired rate of return on this stoc; is considered to be 1! 5ercent. Gow much should this stoc; sell for now? Assuming that the e:5ected growth rate and re7uired rate of return remain the same, at what 5rice should the stoc; sell # years hence?

Solution: Do ( &s.1%.%%, < ( %.1-, r ( %.1! -o ( D1 * (r I <) ( ( ( Do (1 ) <) * (r I <)

&s.1%.%% (1.1-) * (%.1! + %.1-) &s.,!,.,,

Assuming that the growth rate of 1-% a55lies to mar;et 5rice as well, the mar;et 5rice at the end of the #th year will be6 1-. ( ( -o : (1 ) <)# ( &s.,!,.,, (1.1-)# &s. $$..!7

<he e7uity stoc; of Gansa @imited is currently selling for &s. !% 5er share. <he di2idend e:5ected ne:t is &s.1%.%%. <he in2estorsF re7uired rate of return on this stoc; is 1# 5ercent. Assume that the constant growth model a55lies to Gansa @imited. What is the e:5ected growth rate of Gansa @imited?

Solution: -o ( D1 * (r I <)

&s. !% ( &s.1% * (%.1# I <) %.1# Ig ( 1%* !% ( %.%,-7 g ( %.1#+%.%,-7 ( %.1%#,or 1%.#, % 1$. <he e7uity stoc; of Amulya 'or5oration is currently selling for &s.1 %% 5er share. <he di2idend e:5ected ne:t is &s. -.%%. <he in2estorsF re7uired rate of return on this stoc; is 1 5ercent. Assume that the constant growth model a55lies to Amulya 'or5oration. What is the e:5ected growth rate of Amulya 'or5oration?

Solution: -o ( D1 * (r I <) &s.1 %% ( &s. - * (%.1 I <) %.1 Ig ( -*1 %% ( %.% %! g ( %.1 +%.% %! ( %.%.. or ... %

17.

=lo55y @imited is facing gloomy 5ros5ects. <he earnings and di2idends are e:5ected to decline at the rate of - 5ercent. <he 5re2ious di2idend was &s. .%%. "f the current mar;et 5rice is &s.1%.%%, what rate of return do in2estors e:5ect from the stoc; of =lo55y @imited?

Solution: -o ( D1* (r I <) ( Do(1)<) * (r I <) Do ( &s. .%%, < ( +%.%-, -o ( &s.1% =o 1% ( .%% (1+ .%-) * (r+(+.%-)) ( 1..% * (r ) .%-) r )%.%- (1..%*1% ( %.1. r ( %.1. I %.%- ( %.1# 1!. 0ammoth 'or5oration is facing gloomy 5ros5ects. <he earnings and di2idends are e:5ected to decline at the rate of 1% 5ercent. <he 5re2ious di2idend was &s.,.%%. "f the current mar;et 5rice is &s. -.%%, what rate of return do in2estors e:5ect from the stoc; of 0ammoth @imited?

Solution: -o ( D1* (r I <) ( Do(1)<) * (r I <) Do ( &s.,.%%, < ( +%.1%, -o ( &s. =o ( ,.%% (1+ .1%) * (r+(+.1%)) ( .7 * (r ) .1%) r )%.1% ( .7* - ( %.1%! r ( %.1%! I %.1% ( %.%%! or %.! 5ercent 1.. <he current di2idend on an e7uity share of Amega @imited is &s.!.%% on an earnings 5er share of &s. ,%.%%. (i) Assume that the di2idend 5er share will grow at the rate of % 5ercent 5er year for the ne:t - years. <hereafter, the growth rate is e:5ected to fall and stabilise at 1 5ercent. "n2estors re7uire a return of 1- 5ercent from AmegaJs e7uity shares. What is the intrinsic 2alue of AmegaJs e7uity share? Solution:

g1 ( % %, g ( 1 %, n ( - yrs , r ( 1-% 31 ( ! (1. %) ( &s. ..$% 1) g1 1+ 8o ( 31 1) r ) r + g1 1. % 1 + ( ..$% 1.1) %.1- + %. % %.1- + %.1 ..$% ( 1. %)# (1.1 ) : ( 1.1-)1
n

31 (1 ) g1)n + 1 (1 ) g ) : r + g

1 ( 1 ) r )n

( #-.-, ) ,$..#. ( &s. #1-.%

(ii)

Assume that the growth rate of % 5ercent will decline linearly o2er a fi2e year 5eriod and then stabilise at 1 5ercent. What is the intrinsic 2alue of AmegaJs share if the in2estorsJ re7uired rate of return is 1- 5ercent?

Solution:

3% U ( 1 ) gn) ) G ( ga + gn)V 8% ( r + gn ! U (1.1 ) ) .- ( %. % + %.1 )V ( %.1- + %.1 ( %. &s. ,-

<he current di2idend on an e7uity share of 0agnum @imited is &s.#.%%. (i) Assume that 0agnumJs di2idend will grow at the rate of 1! 5ercent 5er year for the ne:t - years. <hereafter, the growth rate is e:5ected to fall and stabilise at 1% 5ercent. /7uity in2estors re7uire a return of 1- 5ercent from 0agnumJs e7uity shares. What is the intrinsic 2alue of 0agnumJs e7uity share?

Solution:

g1 ( 1!%, g ( 1%%, n ( - yrs, r ( 1-% 31 ( # (1.1!) ( &s.#.7 1 ) g1 1I 1)r 8% ( 31 r I g1 1.1! 1+ ( #.7 #.7 (1.1!)# (1.1%) ) %.1- I %.1! %.1- I %.1% 1.11 : (1.1-)n

31 (1 ) g1) n I 1 (1 ) g ) ) rIg :

1 (1 ) r)n

( 1.$ ) 1%%.1 ( 1 1.7# (ii) Assume now that the growth rate of 1! 5ercent will decline linearly o2er a 5eriod of #years and then stabilise at 1% 5ercent . What is the intrinsic 2alue 5er share of 0agnum, if in2estors re7uire a return of 1- 5ercent ?

Solution:

(1 ) gn) ) G (ga I gn) 8% ( 3% r I gn (1.1%) ) (%.1! I %.1%) ( #.%% %.1- I %.1% ( &s.1%%.!

1. (i)

<he current di2idend on an e7uity share of Ame: @imited is &s. -.%% on an earnings 5er share of &s. %.%%. Assume that the di2idend will grow at a rate of 1! 5ercent for the ne:t # years. <hereafter, the growth rate is e:5ected to fall and stabiliPe at 1 5ercent. /7uity in2estors re7uire a return of 1- 5ercent from Ame:Js e7uity share. What is the intrinsic 2alue of Ame:Js e7uity share?

Solution: g1 ( 1! %, g ( 1 %, n ( #yrs , r ( 1-% 31 ( - (1.1!) ( &s. -..% 1) g1 1+ 8o ( 31 1) r ) r + g1 1.1! 1 + ( -..% 1.1) %.1- + %.1! ( . 1.,# ) %$.. %.1- + %.1 ( &s. !.,-..% ( 1.1! ), ( 1.1 ) : ( 1.1-)# 1
# n

31 (1 ) g1)n + 1 (1 ) g ) : r + g

1 ( 1 ) r )n

Mou can buy a &s.1%%% 5ar 2alue bond carrying an interest rate of 1% 5ercent (5ayable annually) and maturing after - years for &s..7%. "f the re+in2estment rate a55licable to the interest recei5ts from this bond is 1- 5ercent, what will be your yield to maturity?

Solution: <erminal 2alue of the interest 5roceeds ( 1%% : 9T"9A (1-%,-) ( 1%% : $.7# ( $7#. % &edem5tion 2alue ( 1,%%% <erminal 2alue of the 5roceeds from the bond ( 1,$7#. %

let r be the yield to maturity. <he 2alue of r can be obtained from the e7uation .7% (1 ) r)r ,. ( 1,$7#. % ( (1,$7#. %*.7%)1*- +1 ( %.11-, or 11.-, %

Mou can buy a &s.1%% 5ar 2alue bond carrying an interest rate of ! 5ercent (5ayable annually) and maturing after ! years for &s..%. "f the re+in2estment rate a55licable to the interest recei5ts from this bond is 1% 5ercent, what will be your yield to maturity?

Solution: <erminal 2alue of the interest 5roceeds ( ! : 9T"9A (1%%,!) ( ! : 11.#,$ ( .1.#. &edem5tion 2alue ( 1%% <erminal 2alue of the 5roceeds from the bond ( 1.1.#. let r be the yield to maturity. <he 2alue of r can be obtained from the e7uation .% (1 ) r)! r #. ( 1.1.#. ( (1.1.#.*.%)1*! +1 ( %.%.. or ... %

Oeerthi @imited is e:5ected to gi2e a di2idend of &s.- ne:t year and the same would grow by 1 5ercent 5er year fore2er. Oeerthi 5ays out $% 5ercent of its earnings. <he re7uired rate of return on OeerthiJs stoc; is 1- 5ercent. What is the 8TBA?

Solution: -o ( D1 rI< -o ( ( &s. 1$$.$7 %.1-+%.1 -o ( *1 ) 8TBA r -o ( !.,, ) 8TBA %.11$$.$7 ( --.-, ) 8TBA

=o, 8TBA ( 111.1#

-.

Adinath @imited is e:5ected to gi2e a di2idend of &s., ne:t year and the same would grow by 1- 5ercent 5er year fore2er. Adinath 5ays out ,% 5ercent of its earnings. <he re7uired rate of return on AdinathJs stoc; is 1$ 5ercent. What is the 8TBA?

Solution: -o ( D1 rI< -o ( , ( &s. ,%% %.1$+%.1-o ( *1 ) 8TBA r -o ( 1% ) 8TBA %.1$ ,%% ( $ .- ) 8TBA =o, 8TBA ( ,7.CHAPTER 2 1. Mou are considering 5urchasing the e7uity stoc; of /lectra @imited. <he current 5rice 5er share is &s. %. Mou e:5ect the di2idend a year hence to be &e. .%%. Mou e:5ect the 5rice 5er share of /lectra stoc; a year hence to ha2e the following 5robability distribution. 8rice a year hence 8robability &s.1. %.% %., %.

(a) What is the e:5ected 5rice 5er share a year hence? (b) What is the 5robability distribution of the rate of return on /lectra Fs e7uity stoc;? Solution: (a) (b) /:5ected 5rice 5er share a year hence will be6 ( %.- : &s.1. ) %., : &s. % ) %. : &s. &ate of return (Ri) 8robability (pi)%.-% %., ( &s. 1...% %% %. 8robability distribution of the rate of return is 1% %

Note that the rate of return is defined as6 3i2idend ) <erminal 5rice ++++++++++++++++++++++++++++++++ + 1 "nitial 5rice

Mou are considering 5urchasing the e7uity stoc; of /m5ire 'or5oration. <he current 5rice 5er share is &s.1!%. Mou e:5ect the di2idend a year hence to be &e.!.%%. Mou e:5ect the 5rice 5er share of /m5ire 'or5oration stoc; a year hence to ha2e the following 5robability distribution. 8rice a year hence 8robability &s.17%. 1!% %., %% %.-

(a) What is the e:5ected 5rice 5er share a year hence? (b) What is the 5robability distribution of the rate of return on /m5ire 'or5oration Fs e7uity stoc;? Solution: (a) /:5ected 5rice 5er share a year hence will be6 ( %. : &s.17- ) %., : &s.1!% ) %.- : &s. %% ( &s. 1!. (c) 8robability distribution of the rate of return is &ate of return (Ri) 8robability (pi)%. ,. 1.7 % %., #.# % %.1-.$ %

<he stoc; of =outh "ndia 'or5oration (="') 5erforms well relati2e to other stoc;s during recessionary 5eriods. <he stoc; of North "ndia 'or5oration ( N"'), on the other hand, does well during growth 5eriods. ?oth the stoc;s are currently selling for &s.1%% 5er share. <he ru5ee return (di2idend 5lus 5rice change) of these stoc;s for the ne:t year would be as follows6 @i<h <ro(th %.# #% $*conomic con#ition "o( <ro(th Sta<nation %., %.1 $% 7% $% -% Recession %. !% ,-

8robability &eturn on ="' stoc; &eturn on N"' stoc;

'alculate the e:5ected return and standard de2iation of6 (a) &s.-,%%% in the e7uity stoc; of ="'[ (b) &s.-,%%% in the e7uity stoc; of N"'[ (c) &s. ,-%% in the e7uity stoc; of ="' and &s. ,-%% in the e7uity stoc; of N"'[ (d) &s.,,%%% in the e7uity stoc; of ="' and &s. ,%%% in the e7uity of N"'. Which of the abo2e four o5tions would you choose? Why?

Solution: (a) 9or &s.-,%%%, -% shares of ="'Js stoc; can be ac7uired. <he 5robability distribution of the return on -% shares is *conomic Con#ition Gigh Browth @ow Browth =tagnation &ecession /:5ected return ( ( Return (&s) -% : #% ( ,%%% -%: $% ( ,,%%%%., -%: 7% ( ,,-%%%.1 -%: !% ( #,%%%%. -ro,a,ility %.#

( ,%%% : %.#) ) (,,%%% : %.,) ) (,,-%% : %.1) ) (#,%%% : %. ) &s. ,!-%

=tandard de2iation of the return ( U( ,%%% I ,!-%) : %.# ) (,,%%% I ,!-%) : %., ) (,,-%% I ,!-%) : %.1) (#,%%% I ,!-%) : %. V1* ( &s. 77$. 1 (b) 9or &s.-,%%%, -% shares of N"'Js stoc; can be ac7uired. <he 5robability distribution of the return on -% shares is6 *conomic con#ition Gigh growth @ow growth =tagnation &ecession /:5ected return ( Return %Rs& -% : $- ( ,, -% -% : $% ( ,,%%% -% : -% ( ,-%% -% : ,- ( 1,7-% -ro,a,ility %.# %., %.1 %.

(,, -% : %.#) ) (,,%%% : %.,) ) ( ,-%% : %.1) ) (1,7-% : %. ) ( &s. ,!%%

=tandard de2iation of the return ( U(,, -%I ,!%%) : .# ) (,,%%%I ,!%%) : ., ) ( ,-%%I ,!%%) : .1 ) (1,7-%I ,!%%) : . V1* ( &s. -$7.!. (c) 9or &s. ,-%%, - shares of ="'Js stoc; can be ac7uired[ li;ewise for &s. ,-%%, shares of N"'Js stoc; can be ac7uired. <he 5robability distribution of this o5tion is6 Return %Rs& -ro,a,ility ( - : #%) ) ( - : $-) ( ,$ %.# ( -: $%) ) ( -: $%) ( ,,%%% %., ( - : 7%) ) ( -: -%) ( ,,%%% %.1 ( -: !%) ) ( - : ,-) ( ,!7%. /:5ected return ( ( ,$ - : %.#) ) (,,%%% : %.,) ) (,,%%%: %.1) ) ( ,!7- : %. )

=tandard de2iation

( ( (

&s. ! U( ,$ - I ! -) : %.# ) (,,%%%I ! -) : %., ) (,,%%%I ! -) : %.1 ) ( ,!7-I ! -) : %. V1* &s.1$..-$

d.

9or &s.,%%%, ,% shares of ="'Js stoc; can be ac7uired[ li;ewise for &s. %%%, % shares of N"'Js stoc; can be ac7uired. <he 5robability distribution of this o5tion is6 Return %Rs& (,%: #%) ) ( %: $-) (,% : $%) ) ( %: $%) (,%: 7%) ) ( %: -%) (,%: !%) ) ( %: ,-) /:5ected return ( ( ( ( ( ( =tandard de2iation ( ( ,-%% ,,%%% ,,1%% ,,1%% -ro,a,ility %.# %., %.1 %.

( ,-%%: %.#) ) (,,%%%: %.,) ) (,,1%%: %.1) ) (,,1%%: %. ) &s. ,!,% U( ,-%%I ,!,%) : %.# ) (,,%%%I ,!,%) : %., ) (,,1%%I ,!,%) : %.1 ) (,,1%%I ,!,%) : &s. 7 . 1

%. V1* <he e:5ected return to standard de2iation of 2arious o5tions are as follows 6 *Apecte# return %Rs& Stan#ar# #e4iation *Apecte# > Stan#ar# 'ption %Rs) return #e4iation a ,!-% 77$. 1 ,.$7 b ,!%% -$7.!. #.., c ,! 1$..-$ 1$.$$ d ,!,% 7 . 1 1%.#% A5tion WcJ is the most 5referred o5tion because it has the highest return to ris; ratio. #. <he following table, gi2es the rate of return on stoc; of A55le 'om5uters and on the mar;et 5ortfolio for fi2e years

2ear 1 , # -

Return on the stocB Apple Computers (%) +1, 17 1%

Return MarBet -ortfolio (%) +, ! 1 7

(i) What is the beta of the stoc; of A55le 'om5uters? (ii) /stablish the characteristic line for the stoc; of A55le 'om5uters. Solution: 2ear 1 , # =um 0ean M ( RA +1, 17 1% ## !.! 1,#.! ( ,,.7 -+1 !,.-A ( (ii) ( ,,.7 Al5ha ( ( RA I \A RM !.! I ( .#! : -. ) ( + #.1 .#! Co4 A,M ( -+1 RM +, ! 1 7 $ -. RA + RA + 1.! +,.! $. 1!. 1. RM + RM +!. +,. .! $.! 1.! (RA + RA) (RM + RM) 17!.7$ 1 .1$ 17.,$ 1 ,.7$ .1$ ,,#. ,,#. ( !,.-(RM + RM) $7. # 1%. # 7.!# #$. # ,. # 1,#.!

/7uation of the characteristic line is RA ( + #.1 ) .#! RM -. <he rate of return on the stoc; of =igma <echnologies and on the mar;et 5ortfolio for $ 5eriods has been as follows6

-erio# 1 , # $

Return on the stocB of Si<ma 0echnolo<ies (%) 1$ 1 +. , 11!

Return on the marBet portfolio (%) 1# 1% $ 1! 1 1-

(i) What is the beta of the stoc; of =igma <echnologies.? (ii) /stablish the characteristic line for the stoc; of =igma <echnologies Solution: (i)

Mear

&A (%)

&0 (%)

&A+&A

&0+&0

(&A+&A) :(&0+&0) 1.1 17.. 1-!-.. #.$., ,7.1

(&0+&0)

1 , # -

,$ # + % #$ -%

! % +! ,$

!.! +,. +#7. 1!.! .!

.# +-.$ +,,.$ $.# 1%.#

-.7$ ,1.,$ 11 !..$ $.$..$ 1%!.1$ ,-!.#

&A ( 1,$ &A ( 7.

&0 ( 1 ! &0 ( -.$

'o2 A,0 ( -+1

0 ( 1.71. -I1 A ( (ii) Al5ha ( ,-!.# * (-+1) +++++++++++++++++++ 1.71. * (-+1) ( 1.1.$

RA I \A RM ( 7. I (1.1.$ : -.$) ( +,.# /7uation of the characteristic line is RA ( + ,.# ) 1.1.$ RM

$.

<he rate of return on the stoc; of Amega /lectronics and on the mar;et 5ortfolio for $ 5eriods has been as follows 6 -erio# Return on the stocB of 'me<a *lectronics (%) 1!% 1%% +-% %% .% 1!% Return on the marBet portfolio (%) 1-% 1 % -% 1#% + % 1$%

1 , # $

(i)What is the beta of the stoc; of Amega /lectronics? (ii) /stablish the characteristic line for the stoc; of Amega /lectronics. Solution:

8eriod 1 , # $

&% (%) 1! 1% +% . 1!

&0 (%) 11 1# + 1$

(&% I &%) $.,, +1.$7 +1$.$7 !.,, + .$7 $.,,

(&0 I &0) +# +1 $

(&% I&%) (&0 I &0) ,1.$+ ,.,# !,.,,,., , .%# ,7..!

(&0 + &0) # 1$ 1## ,$ -%

&% ( 7% &0 ( $% &% (11.$7 -% 0 ( % ( ( -% #,.% ( %.!$ -%.% Al5ha ( ( R' I \A RM 11.$7 I (%.!$ : 1%) &0 ( 1%

(&%+&%) (&0+&0) ( 11'o2A,0 ( ( #,.%

(ii)

( ,.%7

/7uation of the characteristic line is RA ( ,.%7 ) %.!$ RM

7.

<he ris;+free return is ! 5ercent and the return on mar;et 5ortfolio is 1$ 5ercent. =toc; 1Fs beta is 1. [ its di2idends and earnings are e:5ected to grow at the constant rate of 1% 5ercent. "f the 5re2ious di2idend 5er share of stoc; 1 was &s.,.%%, what should be the intrinsic 2alue 5er share of stoc; 1 ?

Solution: <he re7uired rate of return on stoc; A is6 R ( ( ( R6 ) \ (RM I R6) %.%! ) 1. (%.1$ I %.%!) %. 17$

"ntrinsic 2alue of share ( D1 * (r+ <) ( Do (1)<) * ( r I <) Bi2en Do ( &s.,.%%, < ( %.1%, r ( %.17$ ,.%% (1.1%) "ntrinsic 2alue 5er share of stoc; 1 ( %.17$ I %.1% ( !. &s. #,.#

<he ris;+free return is 7 5ercent and the return on mar;et 5ortfolio is 1, 5ercent. =toc; 8Fs beta is %.! [ its di2idends and earnings are e:5ected to grow at the constant rate of - 5ercent. "f the 5re2ious di2idend 5er share of stoc; 8 was &s.1.%%, what should be the intrinsic 2alue 5er share of stoc; 8 ?

Solution: <he re7uired rate of return on stoc; 8 is6 R( ( ( R6 ) \- (RM I R6) %.%7 ) %.! (%.1, I %.%7) %. 11!

"ntrinsic 2alue of share ( D1 * (r+ <) ( Do (1)<) * ( r I <) Bi2en Do ( &s.1.%%, < ( %.%-, r ( %.11! 1.%% (1.%-) "ntrinsic 2alue 5er share of stoc; 8 ( %.11! I %.%( &s. 1-.##

..

<he ris;+free return is $ 5ercent and the e:5ected return on a mar;et 5ortfolio is 15ercent. "f the re7uired return on a stoc; is 1! 5ercent, what is its beta?

Solution: <he =0@ e7uation is RA ( R6 ) \A (RM I R6) Bi2en RA ( 1!%. R6 ( $%, RM ( 1-%, we ha2e

%.1! ( .%$ ) \A (%.1- I %.%$) %.1 i.e.\A ( %.%. ?eta of stoc; ( 1.,, 1%. <he ris;+free return is . 5ercent and the e:5ected return on a mar;et 5ortfolio is 1 5ercent. "f the re7uired return on a stoc; is 1# 5ercent, what is its beta? ( 1.,,

Solution: <he =0@ e7uation is RA ( R6 ) \A (RM I R6) Bi2en RA ( 1#%. R6 ( .%, RM ( 1 %, we ha2e

%.1# ( .%. ) \A (%.1 I %.%.) %.%i.e.\A ( %.%, ?eta of stoc; ( 1.$7 11. <he ris;+free return is - 5ercent. <he re7uired return on a stoc; whose beta is 1.1 is 1! 5ercent. What is the e:5ected return on the mar;et 5ortfolio? ( 1.$7

Solution: <he =0@ e7uation is6 R ( R6 ) \ (RM I R6) We are gi2en %.1! ( %.%- ) 1.1 (RM I %.%-) i.e., 1.1 RM ( %.1!or RM ( %.1$!1 <herefore return on mar;et 5ortfolio ( 1$.!1 %

1 .

<he ris;+free return is 1% 5ercent. <he re7uired return on a stoc; whose beta is %.-% is 1# 5ercent. What is the e:5ected return on the mar;et 5ortfolio?

Solution: <he =0@ e7uation is6 R ( R6 ) \ (RM I R6) We are gi2en %.1# ( %.1% ) %.-% (RM I %.1%) i.e., %.- RM ( %.%. or RM ( %.1! <herefore return on mar;et 5ortfolio ( 1! % 1,. <he re7uired return on the mar;et 5ortfolio is 1- 5ercent. <he beta of stoc; A is 1.-. <he re7uired return on the stoc; is % 5ercent. <he e:5ected di2idend growth on stoc; A is $ 5ercent. <he 5rice 5er share of stoc; A is &s.!$. What is the e:5ected di2idend 5er share of stoc; A ne:t year? What will be the combined effect of the following on the 5rice 5er share of stoc; ? (a) <he inflation 5remium increases by , 5ercent. (b) <he decrease in the degree of ris;+a2ersion reduces the differential between the return on mar;et 5ortfolio and the ris;+free return by one+fourth. (c) <he e:5ected growth rate of di2idend on stoc; A decrease to , 5ercent. (d) <he beta of stoc; A falls to1.

Solution: RM ( 1-% -o ( D1 * (r + <) &s.!$ ( D1 * (%. % + .%$) =o D1 ( &s.1 .%# and Do ( D1 * (1)<) ( 1 .%# *(1.%$) ( &s.11.,$ RA ( Rf ) \A (RM I Rf) \A ( 1.RA ( % % < ( $ % -o ( &s.!$

%. % ( Rf ) 1.- (%.1- I Rf) %.-Rf ( %.% =o Rf ( %.%- or -%. 'ri<inal Rf RM I Rf < \A -% 1%% $% 1.Re4ise# !% 7.-% ,% 1.

&e2ised RA ( ! % ) 1. (7.-%) ( 17 % 8rice 5er share of stoc; A, gi2en the abo2e changes is 11.,$ (1.%,) ( &s. !,.-! %.17 I %.%, 1#. <he re7uired return on the mar;et 5ortfolio is 1$ 5ercent. <he beta of stoc; A is 1.$. <he re7uired return on the stoc; is 5ercent. <he e:5ected di2idend growth on stoc; A is 1 5ercent. <he 5rice 5er share of stoc; A is &s. $%. What is the e:5ected di2idend 5er share of stoc; A ne:t year? What will be the combined effect of the following on the 5rice 5er share of stoc; ? (a) <he inflation 5remium increases by - 5ercent. (b) <he decrease in the degree of ris;+a2ersion reduces the differential between the return on mar;et 5ortfolio and the ris;+free return by one+half. (c) <he e:5ected growth rate of di2idend on stoc; A decrease to 1% 5ercent. (d) <he beta of stoc; A falls to 1.1

Solution: RM ( 1$% -o ( D1 * (r + <) &s. $% ( D1 * (%. + .1 ) \A ( 1.$ RA ( % < ( 1 % -o ( &s. $%

=o D1 ( &s. $ and Do ( D1 * (1)<) ( $ *(1.1 ) ( &s. ,. 1 RA ( Rf ) \A (RM I Rf)

%. ( Rf ) 1.$ (%.1$ I Rf) %.$Rf ( %.%,$ =o Rf ( %.%$ or $%. 'ri<inal Rf RM I Rf < \A $% 1%% 1 % 1.$ Re4ise# 11% -% 1% % 1.1

&e2ised RA ( 11% ) 1.1 (-%) ( 1$.- % 8rice 5er share of stoc; A, gi2en the abo2e changes is

,. 1 (1.1%) ( &s. ,. .7! %.1$- I %.1% CHAPTER 3 1. <he returns of two assets under four 5ossible states of nature are gi2en below 6 State of nature 1 , # -ro,a,ility %.#% %.1% %. % %.,% Return on asset 1 +$% 1!% %% -% Return on asset 2 1 % 1#% 1$% %%

a. What is the standard de2iation of the return on asset 1 and on asset ? b. What is the co2ariance between the returns on assets 1 and ? c. What is the coefficient of correlation between the returns on assets 1 and ? Solution: (a) * (R1) ( %.#(+$%) ) %.1(1!%) ) %. ( %%) ) %.,( -%) ( 1%.. % * (R ) ( %.#(1 %) ) %.1(1#%) ) %. (1$%) ) %.,( %%) ( 1-.# % ](R1) ( U.#(+$ I1%..) ) %.1 (1! I1%..) ) %. ( % I1%..) ) %., ( - I1%..) V = 1,..!% ](R ) ( U.#(1 I1-.#) ) %.1(1# I1-.#) ) %. (1$ I 1-.#) ) %., ( % I1-.#) V ( ,.,- % (b) <he co2ariance between the returns on assets 1 and is calculated below -ro,a,ility Return on asset 1 De4iation of return on asset 1 from its mean (#) +1$..% 7.1% ..1% 1#.1% Return on asset 2 De4iation of the return on asset 2 from its mean ($) +,.#% +1.#% %.$% #.$% =um ( -ro#uct of #e4iation times pro,a,ility ( ):(#):($) ..! +%... 1.%. 1..## .-,

State of nature

(1) 1 , #

( ) %.# %.1 %. %.,

(,) +$% 1!% %% -%

(-) 1 % 1#% 1$% %%

<hus the co2ariance between the returns of the two assets is # .-,. (c) <he coefficient of correlation between the returns on assets 1 and is6 'o2ariance1 # .-, ( ( %..1 ]1 : ] 1,..! : ,.,. <he returns of # stoc;s, A, B, C, and D o2er a 5eriod of - years ha2e been as follows6 A B C D 1 !% 1%% .% 1%% 1%% $% $% !% , +$% +.% ,% 1,% # +1% #% -% 7% .% 11% !% 1 %

'alculate the return on6 a. b. c. d. 5ortfolio of one stoc; at a time 5ortfolios of two stoc;s at a time 5ortfolios of three stoc;s at a time. a 5ortfolio of all the four stoc;s.

Assume e7ui5ro5ortional in2estment. Solution: /:5ected rates of returns on e7uity stoc; A, ?, ' and 3 can be com5uted as follows6 A6 ?6 '6 36 (a) (b) ! ) 1% I $ +1) . 1%) $+ .)# ) 11 . ) $ ) , ) -) ! 1% ) ! ) 1, ) 7 ) 1 ( #% ( #.#% ( $. % ( 1%.%% ( #%

&eturn on 5ortfolio consisting of stoc; A

&eturn on 5ortfolio consisting of stoc; A and ? in e7ual 5ro5ortions ( %.- (#) ) %.- (#.#) ( #. %

(c )

&eturn on 5ortfolio consisting of stoc;s A, ? and ' in e7ual 5ro5ortions ( 1*,(# ) ) 1*,(#.#) ) 1*, ($. ) ( #.!7% &eturn on 5ortfolio consisting of stoc;s A, ?, ' and 3 in e7ual 5ro5ortions ( %. -(#) ) %. -(#.#) ) %. -($. ) )%. -(1%) ( $.1-%

(d)

,.

A 5ortfolio consists of # securities, 1, , ,, and #. <he 5ro5ortions of these securities are6 (1(%.,, ( (%. , (,(%. , and (#(%.,. <he standard de2iations of returns on these securities (in 5ercentage terms) are 6 ]1(-, ] ($, ],(1 , and ]#(!. <he correlation coefficients among security returns are6 ^1 (%. , ^1,(%.$, ^1#(%.,, ^ ,(%.#, ^ #(%.$, and ^,#(%.-. What is the standard de2iation of 5ortfolio return?

Solution: <he standard de2iation of 5ortfolio return is6 p ( U(1 1 ) ( ) (, , ) # # ) (1 ( 1 1 ) (1 (, 1, 1 , ) (1 (# 1# 1# ) ( (, , , ) ( (# # # ) (, (# ,# , # V1* ( U%., : - ) %. : $ ) %. : 1 ) %., : ! ) : %., : %. : %. : - : $ ) : %., : %. : %.$ : - : 1 ) : %., : %., : %., : - : ! ) : %. : %. : %.# : $ : 1 ) : %. : %., : %.$ : $ : ! ) : %. : %., : %.- : 1 : !V1* ( -.! % #. Assume that a grou5 of securities has the following characteristics 6 (a) the standard de2iation of each security is e7ual to A [ (b) co2ariance of returns AB is e7ual for each 5air of securities in the grou5. What is the 2ariance of a 5ortfolio containing si: securities which are e7ually weighted ?

Solution: When there are $ securities, you ha2e $ 2ariance terms and $ : - ( ,% co2ariance terms. As all 2ariance terms are the same, all co2ariance terms are the same, and all securities are e7ually weighted, the 5ortfolio 2ariance is6 $(A A ) ,% (A AB

-.

<he following information is gi2en6 /:5ected return for the mar;et ( 1-% =tandard de2iation of the mar;et return ( -% &is;+free rate ( !% 'orrelation coefficient between stoc; A and the mar;et ( %.! 'orrelation coefficient between stoc; B and the mar;et ( %.$ =tandard de2iation for stoc; A ( ,%% =tandard de2iation for stoc; B ( #% (i) What is the beta for stoc; A?

Solution: Co4 (A,M) [ %.! ( A M - ( $ Co4 (A,M) 4 M $%% 4 %..$ $ Co4 (A,M) ,% : -

AM ( M A ( 4

Co4 (A,M) ( $%%

(ii) What is the e:5ected return for stoc; A ? Solution: *(RA) ( Rf ) A (* (RM) + Rf) ( !% ) %..$ (7%) ( 1#.7 %

$.

<he following table gi2es an analystJs e:5ected return on two stoc;s for 5articular mar;et returns. MarBet Return A<<ressi4e StocB Defensi4e StocB -% + -% 1%% -% #-% 1$% (i) What is the ratio of the beta of the aggressi2e stoc; to the beta of the defensi2e stoc;?

Solution:

#- I (+-) ?eta of aggressi2e stoc; ( -I1$ + 1% ?eta of defensi2e stoc; ( -I&atio ( .-*%.,% ( !.,, (ii) "f the ris;+free rate is 7% and the mar;et return is e7ually li;ely to be -% and -% what is the mar;et ris; 5remium? ( %.,% ( .-

Solution: / (&0) ( %.- : - ) %.- : - ( 1-% 0ar;et ris; 5remium ( 1-% + 7% ( !% (iii) What is the al5ha of the aggressi2e stoc;? Solution: /:5ected return ( %.- : I- ) %.- : #- ( %% &e7uired return as 5er 'A80 ( 7% ) .- (!%) ( 7% Al5ha ( + 7% 7. <he following table gi2es an analystJs e:5ected return on two stoc;s for 5articular mar;et returns. MarBet Return !% %% A<<ressi4e StocB % , % Defensi4e StocB 1%% 1$%

(i) What is the beta of the aggressi2e stoc;? Solution: , %+ % ?eta ( %% + !% ( .-

(ii)

"f the ris;+free rate is $% and the mar;et return is e7ually li;ely to be !% and %%, what is the mar;et ris; 5remium?

Solution: <he e:5ected return on the mar;et 5ortfolio is6 %.- : !% ) %.- : %% ( 1#% =ince the ris;+free rate is $%, the mar;et ris; 5remium is !% (iii) What is the al5ha of the aggressi2e stoc;? Solution: /:5ected return on the aggressi2e stoc; ( %.- : % ) %.- : , % ( 17% &e7uired return ( $% ) ! : .- ( $% Al5ha ( 17 I $% ( I .%

/0!0CASE51. 0r. Nitin Bu5ta had in2ested &s.! million each in Asho; /:5orts and ?iswas "ndustries and &s. # million in 'inderella 9ashions, only a wee; before his untimely demise . As 5er his will this 5ortfolio of stoc;s were to be inherited by his wife alone . As the 5artition among the family members had to wait for one year as 5er the terms of the will, the 5ortfolio of shares had to be maintained as they were for the time being. <he will had sti5ulated that the Cob of administering the estate for the benefit of the beneficiaries and 5artitioning it in due course was to be done by the re5uted firm of 'hartered Accountants, <alwar ?rothers. 0eanwhile the widow of the deceased was 2ery eager to ;now certain details of the securities and had as;ed the senior 5artner of <alwar ?rothers to brief her in this regard. 9or this 5ur5ose the senior 5artner has as;ed you to 5re5are a detailed note to him with calculations using 'A80, to answer the following 5ossible doubts. 1. What is the e:5ected return and ris; (standard de2iation) of the 5ortfolio? . What is the sco5e for a55reciation in mar;et 5rice of the three stoc;s+are they o2er2alued or under2alued? Mou find that out the three stoc;s, your firm has already been trac;ing two 2iP. Asho; /:5orts (A) and ?iswas "ndustries (?)+their betas being 1.7 and %.! res5ecti2ely.

9urther, you ha2e obtained the following historical data on the returns of 'inderella 9ashions(')6 8eriod 0ar;et return (%) &eturn on 'inderella 9ashions (%) ++++++++ +++++++++++++ +++++++++++++++++++++++++++++++ 1 1% 1# ! , ( ) ($) # (1) # 1% $ ! 11 7 1% 1An the future returns of the three stoc;s, you are able to obtain the following forecast from a re5uted firm of 5ortfolio managers. +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ =tate of the 8robability &eturns ( in 5ercentage ) /conomy <reasury Asho; ?iswas 'inderella =ense: ?ills /:5orts "ndustries 9ashions +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ &ecession %., 7 1(1%) ( ) Normal%.# 7 1! ! 1$ 17 ?oom %., 7 ,% 1 # $ &e7uired6 8re5are your detailed note to the senior 5artner.

Solution: (1) 'alculation of beta of 'inderella 9ashions stoc; from the historical data 8eriod 1 , # $ 7 &eturn &eturn &c+&c &m+&m (&m+&m) &c ( % ) &m ( %) 1# 1% $ ! % % % ($) ( ) (1#) (7) #. # (1) (#) ($) ,$ 1% % % 11 ! , , . 11% 7 (&c+&c) : (&m+&m) ,% % .! # % . ,-

_&c(-$ _&m(,_ (&m+&m) ( 1## _ (&c+&c)(&m+&m)( 1.$ &c( ! &m( - ]m ( 1##*$ ( # 'o2(c,m) ( 1.$*$( , .7 ?eta of 'inderella 9ashions \c ( , .7* #( 1.,$ ( ) 'alculation of e:5ected returns, standard de2iations and co2ariances /(A) (U %.,:-V ) U%.#:1!V )U %.,:,%V ( 17.7 /(?)( U%.,:1-V ) U%.#:!V ) U%.,:1 V ( 11., /(')( U%.,:(+)1%V ) U%.#:1$V )U%.,: #V ( 1%.$ /(0)( U%.,:(+) V) U%.#:17V ) U%.,: $V ( 1# ]A ( U %.,(-+17.7) )%.#(1!+17.7) )%.,(,%+17.7) V1* ( U#!.# ) %.1)#-.#V1* ( ..7 ]? ( U%.,(1-+11.,) ) %.#(!+11.,) )%.,(1 +11.,) V1* ( U #.11 )#.,$) %.1-V1* ( ..# ]c ( U%.,(+1%+1%.$) )%.#(1$+1%.$) ) %.,( #+1%.$) V1* ( U 1 7.,1 )11.$$)-,.!7V1* ( 1,.!. ]0 ( U%.,(+ +1#) )%.#(17+1#) )%.,( $+1#) V1* ( U 7$.! ),.$ )#,. V1* ( 11.1 'alculation of co2ariances between the stoc;s =tate of the 8rob+ &A+&A &?+&? &'+&' ( ):(,) ( ):(#):(-) ( ):(,):(-) /conomy ability (#) (-) : (#) (1) ( ) (,) &ecession %., +1 .7 ,.7 + %.$ +1#.1 + .. 7!.Normal %.# %., +,., -.# +%.1 +7.1 %.$ ?oom %., 1 ., %.7 1,.# .$ .! #..# ]A,? ( +11.$ ]?,'( + 7. ]A,'( 1 !.-

/:5ected return and standard de2iation of the 5ortfolio /(8) ( (%.#:17.7) ) (%.#:11.,) )(%. :1%.$)( 1,.7 ]5 ( U wA ]A ) w? ]? ) w' ]' ) wAw? ]A,? ) w?w' ]?,' ) wAw' ]A,'V1* ( U 1-.1) 1.# )7.7+,.7+#.#) %.$V1* ( $.1 ( ,) 3etermining o2er5ricing and under5ricing using 'A80 \A (1.7 \? (%.! \' ( 1.,$ /(&0) ( 1# &f (7%

=0@ ( 7 ) (1# +7):?eta ( 7 ) 7 : ?eta &e7uired return on Asho; /:5orts ( 7 ) (7 : 1.7) ( 1!.. % &e7uired return on ?iswas "ndustries ( 7 ) (7 : %.! ) ( 1 .$ % &e7uired return on 'inderella 9ashions ( 7 ) (7 : 1.,$ ) (1$.- % As the e:5ected return of 17.7 % on Asho; /:5orts is slightly less than the re7uired return of 1!.. %, its e:5ected return can be e:5ected to go u5 to the fair return indicated by 'A80 and for this to ha55en its mar;et 5rice should come down. =o it is slightly o2er2alued. "n the case of ?iswas "ndustries stoc;, as the e:5ected return of 11.,% is again slightly less than the re7uired return of 1 .$ %, its e:5ected return can be e:5ected to go u5 and for this to ha55en its mar;et 5rice should come down. =o it is also slightly o2er2alued. "n the case of 'inderella 9ashions the e:5ected return is 1%.$ % against the re7uired return of 1$.- %. =o it is considerably o2er2alued.

/0!0CASE52. =eth &atanlal, who was widower and issueless, had left his substantial wealth as legacy to his ne5hew and niece through a will. 3etailed instructions had been left on how the estate should be shared between the two , once both of them attained the age of maCority. A wee; before his demise he had ta;en a fancy to the ca5ital mar;et and had in2ested a siPeable amount in e7uity shares, s5ecifically, &s.$ million in Arihant 8harma, &s.#.! million in ?est "ndustries and &s. 1. million in 'entury @imited. As the 5artition among the siblings had to wait for at least one more year as the girl was still a minor, the 5ortfolio of shares had to be maintained as they were for the time being. <he will had entrusted the Cob of administering the estate for the benefit of the beneficiaries and 5artitioning in due course to the re5uted firm of 'hartered Accountants, Oaraniwala and Oaraniwala. 0eanwhile the young beneficiaries were 2ery eager to ;now certain details of the securities and had as;ed the senior 5artner of the firm to brief them in this regard. 9or this 5ur5ose the senior 5artner has as;ed you to 5re5are a detailed note to him with calculations using 'A80, to answer the following 5ossible doubts. 1. What is the e:5ected return and ris; (standard de2iation) of the 5ortfolio? . What is the sco5e for a55reciation in mar;et 5rice of the three stoc;s+are they o2er2alued or under2alued? Mou find that out the three stoc;s, your firm has already been trac;ing two 2iP. Arihant 8harma (A) and ?est "ndustries (?)+their betas being 1. and %.! res5ecti2ely. 9urther, you ha2e obtained the following historical data on the returns of 'entury @imited(')6 8eriod 0ar;et return (%) &eturn on 'entury @imited (%) ++++++++ +++++++++++++ +++++++++++++++++++++++++++++++ 1 ! 1% ($) ! , 1 # 1% (!) . 1# $ . 11 An the future returns of the three stoc;s, you are able to obtain the following forecast from a re5uted firm of 5ortfolio managers. +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ =tate of the 8robability &eturns ( in 5ercentage ) on /conomy <reasury Arihant ?est 'entury Nifty ?ills 8harma "ndustries @imited +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ &ecession %. $ (1%) (!) 1(!) Normal%.# $ 1! 1 $ 1?oom %.# $ ,% % (1%) -

8re5are your re5ort. Solution: (,) 'alculation of beta of 'entury @imited stoc; from the historical data 8eriod 1 , # $ &eturn &eturn &c+&c &m+&m (&m+&m) &c ( % ) &m ( %) 1% ! % 1 1 ! ($) ( ) (1,) 1$. 1 1(!) 1% (1!) , . 1# . # # 11 . 1 # (&c+&c) : (&m+&m) % $ 7(-#) !

_&c($% _&m(# _ (&m+&m) ( 1 _ (&c+&c)(&m+&m)(-7 &c(1% &m(7 ]m ( 1 *- (# .# 'o2(c,m) ( -7*-(11.# ?eta of 'entury @imited \c ( 11.#*# .# ( %., (#) 'alculation of e:5ected returns, standard de2iations and co2ariances /(A) (U %. :(+)1%V ) U%.#:1!V )U %.#:,%V ( + )7. )1 (17. /(?)( U%. :(+)!V ) U%.#:1 V ) U%.#: %V ( +1.$ )#.!)! ( 11. /(')( U%. :1-V ) U%.#:$V )U%.#:(+) 1%V ( ,) .#+ # ( 1.# /(0)( U%. :(+)!V) U%.#:1-V ) U%.#: -V ( +1.$)$.% )1%(1#.# ]A ( U %. (+1%+17. ) )%.#(1!+17. ) )%.#(,%+17. ) V1* ( U1#! ) %.,)$-.-V1* ( 1#.$ ]? ( U%. (+!+11. ) ) %.#(1 +11. ) )%.#( %+11. ) V1* ( U 7,.7 )%.,),1.%V1* (1%. ]c ( U%. (1-+1.#) )%.#($+1.#) ) %.#(+1%+1.#) V1* ( U ,7 )!.-)- V1* ( ... ]0 ( U%. (+!+1#.#) )%.#(1-+1#.#) )%.#( -+1#.#) V1* ( U 1%%.# )%.1 )##..V1* ( 1 .1 'alculation of co2ariances between the stoc;s =tate of the 8rob+ &A+&A &?+&? &'+&' ( ):(,):(#) ( ):(#):(-) ( ):(,):(-) /conomy ability (#) (-) (1) ( ) (,) &ecession %. ( 7. ) (1.. ) 1,.$ 1%#.# (- . ) (7#.%) Normal %.# %.! %.! #.$ %., 1.1.?oom %.# 1 .! !.! (11.#) #-.1 (#%.1) (-!.#) ]A,? (1#..! ]?,'((.%.!) ]A,'( (1,%..)

/:5ected return and standard de2iations of the 5ortfolio /(8) ( (%.-:17. ) ) (%.#:11. ) )(%.1:1.#)(!.$)#.-)%.1(1,. % ]5 ( U wA ]A ) w? ]? ) w' ]' ) wAw? ]A,? ) w?w' ]?,' ) wAw' ]A,'V1* ( U -,., ) 1$.$ )1.% ) -...+7.,+1,.1V1* ( 1%.( ,) 3etermining o2er5ricing and under5ricing using 'A80 \A (1. \? (%.! \' ( %., /(&0) ( 1#.# &f ($%

=0@ ( $ ) (1#.# +$):?eta ( $ ) !.# : ?eta &e7uired return on Arihant 8harma ( $ ) (!.## : 1. ) ( 1$.1% &e7uired return on ?est "ndustries ( $ ) (!.## : %.! ) ( 1 .7% &e7uired return on 'entury @imited( $ ) (!.## : %., ) ( !.-% As the e:5ected return of 17. % on Arihant 8harma is slightly more than the re7uired return of 1$.1 %, its e:5ected return can be e:5ected to come down to the fair return indicated by 'A80 and for this to ha55en its mar;et 5rice should go u5. =o it is slightly under2alued. "n the case of ?est "ndustries stoc;, as the e:5ected return is slightly less than the re7uired return of 1 .7%, its e:5ected return can be e:5ected to go u5 and for this to ha55en its mar;et 5rice should go down. =o it is slightly under2alued. 'entury @imited can be considered as o2er2alued as its re7uired return is far in e:cess of the e:5ected return which is li;ely to dri2e the mar;et

CHAPTER 1( 1. A stoc; is currently selling for &s.!%. "n a yearJs time it can rise by -% 5ercent or fall by % 5ercent. <he e:ercise 5rice of a call o5tion is &s..%. (i) What is the 2alue of the call o5tion if the ris;+free rate is 1% 5ercent? >se the o5tion+e7ui2alent method.

Solution:

=% ( &s.!% / ( &s..% 'u I 'd `( (u I d) = u 'd I d 'u ?( (u I d) & ( ( %.7 : !% ,% I %

u ( 1.r ( %.1% ,% ( -$

d ( %.! & ( 1.1%

1.- : % I %.! : ,% ( + ,1.17 %.7 : 1.1%

' ( `= ) ? ,% ( : !% I ,1.17 -$ ( 11.$.

(ii) What is the 2alue of the call o5tion if the ris;+free rate is $ 5ercent? >se the ris;+ neutral method. Solution:

U8 : -%%V ) U(1 I 8) : I %%V ( $% -% 8 ) % 8 ( $ 8 ( %.,7 /:5ected future 2alue of a call %.,7 : ,% ) %.$, : % ( &s.11.1% &s.11.1% 'urrent 2alue ( 1.%$ ( &s.1%.#7

An e7uity share is currently selling for &s 1%%. "n a yearJs time it can rise by ,% 5ercent or fall by 1% 5ercent. <he e:ercise 5rice of call o5tion on this share is &s.11%. (i) What is the 2alue of the call o5tion if the ris; I free rate is 7 5ercent ? >se the o5tion I e7ui2alent method.

Solution:

=% ( 1%%, ( ? ' ( ( 'u I 'd ( u I d) =% u'd I d'u ( u I d) & =)?

/ ( 11%, ( ( (

u ( 1.,, (

d ( %.., % #% ( %.( (

& ( 1.%7

%I% %.# : 1%%

1., : % I %.. : % %.# : 1.%7 %.- : 1%% + # .%$

+ # .%$

7..#

(ii) What is the 2alue of the call o5tion if the ris;+free rate is $ 5ercent? >se the ris; I neutral method. Solution:

8 : ,%% ) (1+8) : +1%% ( $% ,%8 ) 1%8 + 1% ( $ (( 8 ( %.#

/:5ected future 2alue of call %.# : % ) %.$ : % ( &s. !.%% 'urrent 2alue ( ! ( 1.%$ &s. 7.--

,.

An e7uity share is currently selling for &s.$%. "n a yearJs time, it can rise by -% 5ercent or fall by 1% 5ercent. <he e:ercise 5rice of a call o5tion on this share is &s.7%. a. What is the 2alue of the call o5tion if the ris;+free rate is ! 5ercent? >se the o5tion+e7ui2alent method.

Solution:

=% ( &s. $%, / ( &s. 7%, u ( 1.-, d ( %.., & ( 1.%! 'u + 'd a ( (u + d ) =o u 'd + d 'u ? ' ( (u + d) & ( ( %.$ : 1.%! ( &s. -.-a = ) ? ( % * ,$ : $% + 7.7! ( (%.$) $% % + % ( ,$ ( + 7.7! 1.- : % + %.. : % %

b.What is the 2alue of the call o5tion, if the ris;+free rate is $ 5ercent? >se the ris;+ neutral method. Solution: 8 : -% % ) ( 1 I 8 ) : +1%% ( $ % -% 8 ) 1%8 + 1% ( $ 8 ( %. 7

/:5ected future 2alue of call %. 7 : % ) %.7, : % ( -.# -.# 'urrent 2alue ( 1.%$ #. <he following information is a2ailable for a call o5tion6 <ime to e:5iration (months) &is; free rate /:ercise 5rice =toc; 5rice 'all 5rice , !% &s.$% &s.7% &s.1# &s. -.%.

What is the 2alue of a 5ut o5tion if the time to e:5iration is , months, ris; free rate is !%, e:ercise 5rice is &s.$% and the stoc; 5rice is &s.7% ? @int C >se 5ut+call 5arity theorem

Solution: According to 5ut+call 5arity theorem -% ( C% ) ( 1# ) * + S% ert $% e .%! : . + + 7%

( 1# ) $% 1.% % -.

7% ( &s. .!1

'onsider the following data for a certain share6 8rice of the stoc; now ( =% ( &s.!% /:ercise 5rice ( / ( &s..% =tandard de2iation of continuously com5ounded annual return ( ( %., /:5iration 5eriod of the call o5tion ( , months &is;+free interest rate 5er annum ( ! 5ercent (i) What is the 2alue of the call o5tion? >se the normal distribution table and resort to linear inter5olation.

Solution: =% ( &s. !%, / ( &s. .%, r ( %.%!, ] ( %., , t ( %. / 'o ( =o N (d1) + e =o ln / d1 ( ]bt ) r )
rt

N (d ) ] t

%.%. + %.117! ) ( %.%! ) ( %., b %. d ( d1 + ] b t ( + %.-77 + %., b %. - ( + %.7 7 N ( + %.$%%) ( %. 7#, N (+ %.--% ) ( %. .1 N ( +%.-77) ( %. 7#, )( %.% , * %.%-%) U%. .1 I %. 7#,V ( %. ! 1 ) %. ( + %.-77

N (d1) ( N (+ %.-77)

N(d ) ( N ( + %.7 7)

'o

N (+ %.7-%) ( %. $# N (+ %.7%%) ( %. # % N (+ %.7 7) ( %. $# )(% .% , *.%-%) U. # % + . $#V ( %. ,,$ .% ( !% : %. ! 1 + : %. ,,$ e %.%! : %. ( .- 7 + %.$1 ( &s. 1..$

(ii) What is the 2alue of a 5ut o5tion Solution: / 8o ( 'o + =o ) e rt .% ( 1..$ + !% ) e

%.%! : %. -

( &s. 1%.1!

$.

'onsider the following data for a certain share. 'urrent 8rice ( =% ( &s. !% /:ercise 8rice ( / ( &s. .% =tandard de2iation of continuously com5ounded annual return ( ( %./:5iration 5eriod of the call o5tion ( , months &is; I free interest rate 5er annum ( $ 5ercent (i) What is the 2alue of the call o5tion? >se the normal distribution table gi2en at the end of this boo;let and resort to linear inter5olation. Solution:

=% ( &s. !% r ( %.%$, ] ( %.-, '% d1 ( =%N(d1) + / N (d ) ert ( ln =% r)] t / ) ( ] t ( d ( d1 I ] t ( %.+ %. !$ + %. !$ + %.- %. - ( + %.-,$ %. +%.117! ) %.%$ ) %. - %. -

/ ( &s. .% t ( %. -

N(d1) ( N ( + %. !$ ) N (+%. !$ ) N(d ) ( N( + %.-,$ ) N( + %.-,$ ) '% ( !% : %.,!7# ( ,%... + $. ( &s. #.7-

N (+%.,%) ( %.,! 1 N (+%. -) ( %.#%1, ( %.,! 1 ) %.%1,! U %.#%1, I %.,! 1V %.%( %.,!7# N (+%.--) ( %. .1 N (+%.-%) ( %.,%!( %. .1 ) %.%1,! U %.,%!- I %. .1 V %.%( %. .$% + .% : .$% .%$ : %. #

(ii) What is the 2alue of a 5ut o5tion? Solution: 8% ( '% I =% ) / ert ( #.7- + !% ) e ( &s. 1,.#1 ,$ 'onsider the following data for a certain stoc;6 8rice of the stoc; now ( =% ( &s.1-% /:ercise 5rice ( / ( &s.1#% =tandard de2iation of continuously com5ounded annual return ( ( %.,% /:5iration 5eriod of the call o5tion ( , months &is;+free interest rate 5er annum ( $ 5ercent (i) What is the 2alue of the call o5tion? >se normal distribution table and resort to linear inter5olation? Solution: '% ( =% N(d1) I
ln (=%*/) ) (r ) * ) t

.%
.%$ : %. -

/ N(d ) ert

=% ( &s.1-%, / ( &s.1#%, r ( %.%$,

( %.,, t ( %. -

d1 ( t %.%$. ) (%.%$ ) %.%.* ) %. ( %.,%. d ( d1 + t ( %.#!N (d1) ( N (%.$,-) ( %.7,7, N (d ) ( N (%.#!-) ( %.$!$1 N (%.$%) ( 1 I %. 7#, ( %.7 -7 N (%.$-) ( 1 I %. -7! ( %.7# .%,N (%.$,-) ( %.7 -7 ) (.7# I.7 -7) .%( %.7,7, 1#% N (%.#-) ( 1 I %., $# ( %.$7,$ '% ( 1-% : %.7,7, I : %.$!$1 N (%.-%) ( 1 I %.,%!- ( %.$.1.%$ : %. e .%,N (%.#!-) ( %.$7,$ ) (.$.1- I %.$7,$) .%(11%.$% I .#.$ ( &s.1-..! ( %.$!$1 ( %.$,-

(ii) What is the 2alue of the 5ut o5tion? Solution: / 8% ( '% I =% ) ert 1#% ( 1-..! I 1-% ) e.%$ : . ( &s.,..%
-

!.

@a;shmi @imited has a current 2alue of !%%%. <he face 2alue of its outstanding bonds is $%%%. <hese are 1 year discount bonds with an obligation of $%%% in year 1. <he ris;+free interest rate is ! 5ercent and the 2ariance of the continuously com5ounded rate of return on the firmJs assets is 1$ 5ercent. What is the 5resent 2alue of @a;shmi @imitedJs e7uity, S%, and debt, B%?

Solution: So ( ( #1 ( Do 3(#1) I B1 e Irt 3 (# ) !%%% 3 (#1) I $%%% e I %.%! 3(# ) ln (!%%% * $%%%) ) (%.%! : 1) ) (%.1$* ) ++++++++++++++++++++++++++++++++++++++++++++++ %.1$ : 1 ln (1.,,,) ) %.1$ ( %.# ( (%. !7#)%.1$)*%.# ( 1.11!-

3(#1) ( 3 (1.11!-) 9rom the tables N(1.1%) ( 1+%.1,-7 ( %.!$#, N(1.1-) ( 1+ %.1 -1( %.!7#. ?y linear e:tra5olation N(1.11!-) ( %.!$#, )(1.11!-+1.1%)(%.!7#.+%.!$#,)*%.%( %.!$#, ) %.%%,. ( %.!$!

( (

1.11!- + %.71!3 (%.71!-)

%.#

3 (# ) ( 9rom the tables

N(%.7%) ( 1+%. # %( %.7-!% N(%.7-) ( 1 I %. $# ( %.77,$ ?y linear inter5olation N(%.71!-) ( %.7-!%) (%.71!-+%.7%)(%.77,$+%.7-!%)*%.%( %.7-!%)%.%%-77 ( %.7$,! =o B% ( ( ( ( !%%% : %.!$! I ($%%% : %.. ,1 : %.7$,!) 71D% I S% !%%% I 71- ( - !/0!0CASE An maCoring in finance you ha2e got selected as the finance manager in Na2in /:5orts, a firm owned by Na2in =harma a dynamic young technocrat. <he firm has been registering s5ectacular growth in recent years. With a 2iew to broad base its in2estments, the firm had a55lied for the shares of >ni2ersal "ndustries a month bac; during its "8A and got allotment of -%%% shares thereof. . &ecently 0r. =harma had attended a seminar on ca5ital mar;ets organised by a leading ban; and had decided to try his hand in the deri2ati2es mar;et . =o, the 2ery ne:t day you Coined the firm, he has called you for a meeting to get a better understanding of the o5tions mar;et and to ;now the im5lications of some of the strategies he has heard about. 9or this he has 5laced before you the following chart of the o5tion 7uotes of >ni2ersal "ndustries and re7uested you to ad2ise him on his following doubts, based on the figures in the chart. >ni2ersal "ndustries A5tion Huotes. (All amounts are in ru5ees) =toc; 8rice 6,-% 'alls 8uts =tri;e 8rice can 9eb 0arch can 9eb ,%% -% -+ X + + , % ,$ #% #, , ,#% 1! % 1 ! 11 ,$% $ . 1$ 1! 1 ,!% # $ + #, X A blan; means no 7uotation is a2ailable

0arch + 7 + , +

1. @ist out the o5tions which are out+of+the+money. . What are the relati2e 5ros and cons (i.e. ris; and reward) of selling a call against the -%%% shares held, using (i)9eb*,!% calls 2ersus (ii) 0arch , %* calls ? ,. =how how to calculate the ma:imum 5rofit, ma:imum loss and brea;+e2en associated with the strategy of simultaneously buying say 0arch*,#% call while selling 0arch* ,$% call? #. What are the im5lications for the firm, if for instance, it simultaneously writes 0arch ,$% call and buys 0arch , %*5ut? -. What should be 2alue of the 0arch*,$% call as 5er the ?lac;+=choles 0odel? Assume that t(, months, ris;+free rate is ! 5ercent and the standard de2iation is %.#% $. What should be the 2alue of the 0arch*,$% 5ut if the 5ut+call 5arity is wor;ing? Solution: 1) ) 'alls with stri;e 5rices ,$% and ,!% are out Iof Ithe+ money. (i) "f the firm sells 9eb*,!% call on -%%% shares, it will earn a call 5remium of &s. -,%%% now. <he ris; howe2er is that the firm will forfeit the gains that it would ha2e enCoyed if the share 5rice rises abo2e &s. ,!%. (ii) "f the firm sells 0arch , % calls on -%%% shares, it will earn a call 5remium of &s. 1-,%%% now. "t should howe2er be 5re5ared to forfeit the gains if the share 5rice remains abo2e &s., %. @et s be the stoc; 5rice, 51 and 5 the call 5remia for 0arch* ,#% and 0arch* ,$% calls res5ecti2ely. When s is greater than ,$%, both the calls will be e:ercised and the 5rofit will be d s+,#%+51e I d s+,$%+ 5 e ( &s. 1<he ma:imum loss will be the initial in2estment , i.e. 51+5 ( &s.<he brea; e2en will occur when the gain on 5urchased call e7uals the net 5remium 5aid i.e. s+,#% ( 51 I 5 (- <herefore s( &s. ,#"f the stoc; 5rice goes below &s., %, the firm can e:ecute the 5ut o5tion and ensure that its 5ortfolio 2alue does not go below &s. , % 5er share. Gowe2er, if stoc; 5rice goes abo2e &s. ,!%, the call will be e:ercised and the stoc;s in the 5ortfolio will ha2e to be deli2ered* sold to meet the obligation, thus limiting the u55er 2alue of the 5ortfolio to &s. ,!% 5er share. =o long as the share 5rice ho2ers between &. , % and &s. ,!%, the firm will lose &s. 1 (net 5remium recei2ed) 5er 5air of call and 5ut.

,)

#)

-) =% ( ,-% ln ,$% d1 ( %.#% : %. ( ( +%.% ! ) %.%,7-) * %. ( %. %#$d ( %.%#$- +%.#% bf%. -ff ( +%.1-,>sing normal distribution table N (%.%%) ( 1+ %.-%%% ( %.-%%% N (%.%-) ( 1 I %.#!%1 ( %.-1.. <herefore N( %.%#$-) ( %.-%%% ) (%.%#$-*%.%-%%) : (%.-1.. I %.-%%%) ( %.-1!N ( + %. %) ( %.# %7 N ( +%.1-) ( %.##%# <herefore N ( +%.1-,-) ( %.# %7 ) ( %.%#$-*%.%-%%) :(%.##%# I %.# %7) ( %.#,.% / * ert ( ,$% * e%.%7 : %. - ( ,$% * 1. %17$- ( ,-,.7'% ( ,-% : %.-1!- I ,-,.7- : %.#,.% ( 1!1.#!% I 1--.,% ( &s. $.1! $) "f 5ut+ call 5arity is wor;ing, we ha2e 8% ( '% I =% ) /*ert Talue of the 0arch*,$% 5ut ( $.1! +,-% ) ,-,.7( &s. ..., / (,$% t (%. - r ( %.%7 ] (%.#% ,-% ) %.%7 ) (%.#%) : %. -

CHAPTER 11 1. 0atri: Associates is e2aluating a 5roCect whose e:5ected cash flows are as follows6 2ear Cash flo( (&s. in million) % ( ,) $ ! . 7

<he cost of ca5ital for 0atri: Associates is 1# 5ercent. (i) What is the N8T of the 5roCect?

Solution: $ ! . N8T ( + , ) ++++++++ ) +++++++++ ) ++++++++ (1.1#) ( 1.1#) ( 1.1#), ( + , ) -. $, ) $.1-$ ) $.%7- ) #.1#( +1.,$1 (ii) What is the "&& of the 5roCect? Solution: When the discount rate is 1# %, the N8T is +1.,$1 <rying a lower rate of 1 % $ ! . 7 N8T ( + , ) ++++++++ ) ++++++++ ) ++++++++ ) +++++++++ (1.1 ) (1.1 ) (1.1 ), (1.1 )# ( + , ) -.,-7 ) $.,7! ) $.#%$ ) #.##. ( +%.#1 <rying a still lower rate of 11% $ ! . 7 N8T ( + , ) ++++++++ ) ++++++++ ) ++++++++ ) +++++++ (1.11) (1.11) (1.11), (1.11)# ( + , ) -.#%- ) $.#., ) $.-!1) #.$11 ( %.%. ?y linear inter5olation we get %.%. "&& ( 11 ) ++++++++++++++++++ ( 11.1!% (%.#1 ) %.%.) (iii) What is the N8TX of the 5roCect if the rein2estment rate is 1! 5ercent? Solution: <erminal 2alue ( $(1.1!), ) !(1.1!) ) .(1.1!) ) 7 ( ,!.$17 N8TX ( ,!.$17 * (1.1#)#+ , ( +%.1,$ (i2) What is the 0"&& of the 5roCect if the rein2estment rate is 1! 5ercent? 7 ) +++++++++ ( 1.1#)#

Solution: , (1)0"&&)# ( ,!.$17 (1)0"&&)# ( ,!.$17 * , ( 1.$7. 0"&& ( (1.$7.)1*# I 1 ( 1,.!,% . =igma 'or5oration is e2aluating a 5roCect whose e:5ected cash flows are as follows6 2ear % 1 , # Cash flo( (&s.in million) + 1$.% ,. #.7.% !.#

<he cost of ca5ital for =igma 'or5oration is 1 5ercent . (i) What is the N8T of the 5roCect? Solution: N8T ( +1$.% ) ,. (1.1 ) ) #.(1.1 ) ) 7.% (1.1 ), ) !.# (1.1 )#

.!-7$ ) ,.-!$( %.77%-

) #..!#

) -.,# #

(ii) What is the "&& of the 5roCect? Solution: At 1 % discount rate N8T is %.77%<ry 1,% ( +1$ ) ,. (%.!!-) ) #.- (%.7!,) ( +1$ ) .!, ) ,.- ,( %.,--7

N8T

) 7 (%.$.,) ) #.!-1

) !.# (%.$1,) ) -.1#.

<ry 1#% ( +1$ ) ,. (%.!77) ) #.- (%.7$.) ) 7 (%.$7-) ( +1$ ) .!%$# ) ,.#$%) #.7 ( +%.%,-, As this is 2ery nearly Pero, the "&& of the 5roCect is 1# % N8T

) !.# (%.-. ) ) #..7 !

(iii) What is the N8T X of the 5roCect if the rein2estment rate is 1$%? Solution:

<erminal Talue ( ( ( ( ( ,. (1.1$), ) #.- (1.1$) ,. (1.-$1) ) #.- (1.,#$) #...) $.%-7 7.-7 7.-7 + 1$ ( 1.-,-. # (1.1 ) ) 7 (1.1$)1 ) 7 (1.1$) ) !.1 ) ) !.# ) !.# !.#

N8TX

(i2) What is the "&&X if the rein2estment rate is 1$%? Solution: 1$ ( 1 ) 1&&X)# ( 1 ) 1&&X)# 1&&X ( 7.-7 7.-7 ( ( 1.7 ,, 1$ ( (1.7 ,,) 1*# +1 ( 1.1#-7 + 1 ( 1#.-7 %

,.

3umas 'om5any is e2aluating a 5roCect whose e:5ected cash flows are as follows6 Cash flo( + &s.7%%,%%% &s.1-%,%%% &s. %%,%%% , &s.,%%,%%% # &s.,-%,%%% <he cost of ca5ital for 3umas 'om5any is 1 5ercent (i) What is the N8T of the 5roCect? 2ear % 1

Solution: + 7%%,%%% 1-%,%%% %%,%%% ,%%,%%% ,-%,%%% 1.%%% %.!., %.7.7 %.71 %.$,$ +7%%,%%% 1,,,.-% 1-.,#%% 1,,$%% ,$%% .,--%

(ii) Solution:

1-%,%%% %%,%%% ,%%,%%% ,-%,%%%

1,% 8T"9 %.!!%.7!, %.$., %.$1,

1#% 8T 1, ,7-% 1-$,$%% %7,.%% 1#,--% 711,!%% 8T"9 %.!77 %.7$. %.$7%.-. 8T 1,1,--% 1-,,!%% % ,-%% %7, %% $.-,%-% ( 1,.7%%

711,!%% + 7%%,%%% "&& ( 1, % ) 711,!%% + $.-,%-% : 1%

(iii) What is the N8T X of the 5roCect if the rein2estment rate is 1-% ? Solution: <erminal 2alue ( 1-%,%%% (1.1-), ) ) ,-%,%%% ( 1-%,%%% (1.- 1) ) ) ,-%,%%% %%,%%% (1.1-) ) ,%%,%%% ( 1.1-)1 %%,%%% (1., ) ) ,%%,%%% (1.1-%)

( !,1-% ) $#,#%% ) ,#-,%%% ) ,-%,%%% ( 1,1!7,--% 1,1!7,--% N8T X ( (1.1 )# ( -#,7%. + 7%%,%%%

(i2)

What is the "&&X if the rein2estment rate is 1-%?

Solution: 7%%,%%% ( 1 ) "&&X)# (1 ) "&&X)# "&&X ( ( ( ( 1,1!7,--% 1,1!7,--% * 7%%,%%% ( 1.$.$(1.$.$-)g + 1 1.1#1, + 1 ( 1#.1,%

#.

Mou are e2aluating a 5roCect whose e:5ected cash flows are as follows6 2ear % 1 , # Cash flo( +1,%%%,%%% %%,%%% ,%%,%%% #%%,%%% -%%,%%%

What is the N8T of the 5roCect (in F%%%s) if the discount rate is 1% 5ercent for year 1 and rises thereafter by 5ercent e2ery year? Solution: %% 8T? ( (1.1%) ) (1.1%) (1.1 ) (1.1#) (1.1$) ( 1!1.! ) #,.-1 ) !#.!% ) ,%$..% ( 1%17.%, [ N8T ( 1,%17,%,% I 1,%%%,%%% ( 17,%,% -. <he cash flows associated with an in2estment are gi2en below6 2ear Cash flo( % &s.(!-%,%%%) 1 1 %,%%% #-%,%%% , ,$%,%%% # 1%,%%% 1,%,%%% ) (1.1%) (1.1 ) -%% ,%% ) (1.1%) (1.1 ) (1.1#) #%%

'alculate the benefit cost ratio of this in2estment, if the discount rate is 1 5ercent. Solution: 8T of benefits (8T?) (1 %,%%%: 8T"9 (1 ,1))#-%,%%%: 8T"9 (1 , ) ),$%,%%%: 8T"9 (1 ,,)) 1%,%%%: 8T"9 (1 ,#) )1,%,%%%: 8T"9 (1 ,-) (1%7,1$%),-!,$-%) -$,, %)1,,,-$%)7,,71% ( &s. . .,#%%(A) "n2estment ( !-%,%%% ( . .,#%%*!-%,%%% ( 1.%. (?)

?enefit cost ratio (A*?) $.

<he cash flows associated with an in2estment are gi2en below6 2ear % 1 , # Cash flo( &s.( $%,%%%) !-,# % 1%,, #% 1 !,#,% . ,#!% 7!,,-%

'alculate the benefit cost ratio of this in2estment, if the discount rate is 1! 5ercent. Solution: 8T of benefits (8T?) (!-,# %:8T"9 (1!,1)) 1%,, #%: 8T"9 (1!, ) )1 !,#,%:8T"9 (1!,,)) . ,#!%: 8T"9 (1!,#) )7!,,-%:8T"9 (1!,-) (7 ,,-1)7#,1 $)7!, 1#)#7,7 %),#, ,. ( &s. ,%$,$-%(A) "n2estment ( $%,%%% ( ,%$,$-%* $%,%%% ( 1.1! (?)

?enefit cost ratio(A*?)

7.

Mour com5any is considering two mutually e:clusi2e 5roCects, A and B. 8roCect A in2ol2es an outlay of &s. -% million which will generate an e:5ected cash inflow of &s.$% million 5er year for ! years. 8roCect B calls for an outlay of &s.1%% million which will 5roduce an e:5ected cash inflow of &s. - million 5er year for ! years. <he com5anyFs cost of ca5ital is 1# 5ercent. a. 'alculate the N8T and "&& of each 5roCect b. What is the N8T and "&& of the differential 5roCect (the 5roCect that reflects the difference between 8roCect B and 8roCect A) Solution: (a) 8roCect A N8T at a cost of ca5ital of 1#% ( + -% ) $% : 8T"9A (1#,!) ( &s.+ -%) $%: #.$,. ( &s. !.,# million "&& (r ) can be obtained by sol2ing the following e7uation for r. $% : 8T"9A (r,!) ( -% 8T"9A (r,!) (#.17 9rom tables we see that when6 r (17 %, r ( 1!%, &G= ( #. %7 &G= ( #.%7!

?y e:tra5olation, r (17 ) (#. %7+#.17)*(#. %7+#.%7!) ( 17. . % 8roCect ? N8T at a cost of ca5ital of 1#% 4 % 1%% ) - : 8T"9A (1#,!) ( &s.1-..! million "&& (r') can be obtained by sol2ing the e7uation - : 8T"9A (r',!) ( 1%% 8T"9A (rE,!) (# 9rom tables we see that when6 rJ (1! %, &G= ( #.%7! rJ ( 1.%, &G= ( ,..-# ?y e:tra5olation, rJ (1! ) (#.%7!+#)*(#.%7!+ ,..-#) ( 1!.$, %

(b)

3ifference in ca5ital outlays between 5roCects A and ? is &s.1-% million 3ifference in net annual cash flow between 5roCects A and ? is &s.,- million. N8T of the differential 5roCect at 1#% ( +1-% ) ,- : 8T"9A (1#,!) ( &s.1 .,7 million "&& (r') can be obtained by sol2ing the e7uation ,- : 8T"9A (r',!) ( 1-% 8T"9A (rEE,!) ( #. !$ 9rom tables we see that when6 rJJ (1$ %, &G= ( #.,## rJJ ( 17%, &G= ( #. %7 ?y e:tra5olation, rJJ (1$ ) (#.,##+#. !$)*(#.,##+ #. %7) ( 1$.# %

!.

Mour com5any is considering two 5roCects, M and 3. /ach of which re7uires an initial outlay of &s. #% million. <he e:5ected cash inflows from these 5roCects are6 2ear 1 , # -ro;ect M !1 % 1!% 1%% -ro;ect 3 1%% 11% 1 % .%

a. What is the 5aybac; 5eriod for each of the 5roCects? b. What is the discounted 5aybac; 5eriod for each of the 5roCects if the cost of ca5ital is 1- 5ercent? c. "f the two 5roCects are inde5endent and the cost of ca5ital is 1- 5ercent, which 5roCect(s) should the firm in2est in? d. "f the two 5roCects are mutually e:clusi2e and the cost of ca5ital is 1 5ercent, which 5roCect should the firm in2est in? e. "f the two 5roCects are mutually e:clusi2e and the cost of ca5ital is % 5ercent, which 5roCect should the firm in2est in? f. "f the cost of ca5ital is 1, 5ercent, what is the modified "&& of each 5roCect? Solution: 8roCect 0 <he 5ay bac; 5eriod of the 5roCect lies between and , years. "nter5olating in this range we get an a55ro:imate 5ay bac; 5eriod of .1. years. 8roCect N <he 5ay bac; 5eriod lies between and , years. "nter5olating in this range we get an a55ro:imate 5ay bac; 5eriod of . - years. (b)

'ost of ca5ital

8roCect 0 ( 1- % 5.a 'umulati2e 8T of cash flow 7,..1 1$#.$!,

Mear 'ash flow 8T of cash flow 1 , # !1 % 1!% 1%% 7,..1 .%.7# 11!.,-

3iscounted 5ay bac; 5eriod (38?) lies between and , years. "nter5olating in this range we get an a55ro:imate 38? of .$# years. 8roCect N 'ost of ca5ital ( 1- % 5.a 'umulati2e 8T of cash flow !$..$ 17%.1# #..%#

Mear 'ash flow 8T of cash flow 1 , # 1%% 11% 1 % .% !$..$ !,.1! 7!..%

3iscounted 5ay bac; 5eriod (38?) lies between and , years. "nter5olating in this range we get an a55ro:imate 38? of .!. years. (c ) 8roCect 0 'ost of ca5ital N8T ( ( ( ( 8roCect N 'ost of ca5ital N8T 1-% 5er annum + #% ) !- : 8T"9 (1-,1) ) 1 % : 8T"9 (1-, ) ) 1!% : 8T"9 (1-,,) ) 1%% : 8T"9 (1-,#) + #% ) !- : %.!7%)1 % : %.7-$ ) 1!% :%.$-! ) 1%% : %.-7 &s. 1%%.,1million

( 1 % 5er annum ( + #% ) 1%% : 8T"9 (1-,1) ) 11% : 8T"9 (1-, ) ) 1 % : 8T"9 (1-,,) ) .% : 8T"9 (1-,#) (+ #% ) 1%% :%.!7%) 11% : %.7-$ ) 1 % : %.$-! ) .% : %.-7 ( &s. $%.$ million

=ince the two 5roCects are inde5endent and the N8T of each 5roCect is 5ositi2e,

both the 5roCects can be acce5ted. <his assumes that there is no ca5ital constraint. (d) 8roCect 0 'ost of ca5ital N8T 8roCect N 'ost of ca5ital N8T ( 1 % 5er annum ( &s.1 ,. , million ( 1%% 5er annum ( &s.7..-. million

=ince the two 5roCects are mutually e:clusi2e, we need to choose the 5roCect with the higher N8T i.e., choose 5roCect 0. 3'0*6 <he 0"&& can also be used as a criterion of merit for choosing between the two 5roCects because their initial outlays are e7ual. (e) 'ost of ca5ital ( N8T ( 8roCect 0 1-% 5er annum $$.-$ million

8roCect N 'ost of ca5ital61-% 5er annum N8T ( &s., .-7 million Again the two 5roCects are mutually e:clusi2e. =o we choose the 5roCect with the higher N8T, i.e., choose 5roCect 0.

(f)

8roCect 0 <erminal 2alue of the cash inflows6 -7.. 7 0"&& of the 5roCect is gi2en by the e7uation #% (1 ) 0"&&)# ( -7.. 7 i.e., 0"&& ( #.$# % 8roCect N <erminal 2alue of the cash inflows6 -1%.,0"&& of the 5roCect is gi2en by the e7uation #% ( 1) 0"&&)# ( -1%.,i.e., 0"&& ( %.7$ %

..

"f an e7ui5ment costs &s.,-%,%%% and lasts $ years, what should be the minimum annual cash inflow before it is worthwhile to 5urchase the e7ui5ment ? Assume that the cost of ca5ital is 1 5ercent

Solution: @et N'9 be the minimum constant annual net cash flow that Custifies the 5urchase of the gi2en e7ui5ment. <he 2alue of N'9 can be obtained from the e7uation N'9 : 8T"9A (1 ,$) ( N'9 1%. ,-%,%%% ( ,-%,%%% * #.111 ( !-,1,7

"f an e7ui5ment costs &s. .%%%,%%% and lasts ! years, what should be the minimum annual cash inflow before it is worthwhile to 5urchase the e7ui5ment ? Assume that the cost of ca5ital is 1# 5ercent

=olution6 @et N'9 be the minimum constant annual net cash flow that Custifies the 5urchase of the gi2en e7ui5ment. <he 2alue of N'9 can be obtained from the e7uation N'9 : 8T"9A (1#,!) ( N'9 11. ,%%%,%%% ( ,%%%,%%% * #.$,. ( #,1,1 7

Gow much can be 5aid for a machine which brings in an annual cash inflow of &s.-%,%%% for ! years ? Assume that the discount rate is 1- 5ercent.

Solution: 3efine / as the initial in2estment that is Custified in relation to a net annual cash inflow of &s.-%,%%% for ! years at a discount rate of 1-% 5er annum. <he 2alue of / can be obtained from the following e7uation -%,%%% : 8T"9A (1-,!) i.e., / 1 . ( / ( -%,%%% : #.#!7 ( &s. #,,-%

Gow much can be 5aid for a machine which brings in an annual cash inflow of &s.$%%,%%% for 1 years ? Assume that the discount rate is 1$ 5ercent.

Solution: 3efine / as the initial in2estment that is Custified in relation to a net annual cash inflow of &s.$%%,%%% for 1 years at a discount rate of 1$% 5er annum. <he 2alue of / can be obtained from the following e7uation $%%,%%% : 8T"9A (1$ ,1 ) i.e., / ( / ( $%%,%%% : -.1.7 ( &s. ,,11!, %%

CHAPTER 12 /0!0CASE 1 0etaland is a maCor manufacturer of light commercial 2ehicles. "t has a 2ery strong &43 centre which has de2elo5ed 2ery successful models in the last fifteen years. Gowe2er, two models de2elo5ed by it in the last few years ha2e not done well and were 5rematurely withdrawn from the mar;et. <he engineers at its &43 centre ha2e recently de2elo5ed a 5rototy5e for a new light commercial 2ehicle that would ha2e a ca5acity of # tons. After a lengthy discussion, the board of directors of 0etaland decided to carefully e2aluate the financial worthwhileness of manufacturing this model which they ha2e labeled 0eta #. Mou ha2e been recently hired as the e:ecuti2e assistant to TiCay 0athur, 0anaging 3irector of 0etaland. TiCay 0athur has entrusted you with the tas; of e2aluating the 5roCect. 0eta # would be 5roduced in the e:isting factory which has enough s5ace for one more 5roduct. 0eta # will re7uire 5lant and machinery that will cost &s.#%% million. Mou can assume that the outlay on 5lant and machinery will be incurred o2er a 5eriod of one year. 9or the sa;e of sim5licity assume that -% 5ercent will be incurred right in the beginning and the balance -% 5ercent will be incurred after 1 year. <he 5lant will commence o5eration after one year. 0eta # 5roCect will re7uire &s. %% million toward gross wor;ing ca5ital. Mou can assume that gross wor;ing ca5ital in2estment will occur after 1 year. <he 5ro5osed scheme of financing is as follows 6 &s. %% million of e7uity, &s. %% million of term loan, &s.1%% million of wor;ing ca5ital ad2ance, and &s.1%% million of trade credit. /7uity will come right in the beginning by way of retained earnings. <erm loan and wor;ing ca5ital ad2ance will be raised at the end of year 1. <he term loan is re5ayable in ! e7ual semi+annual instalments of &s. - million each$ <he first instalment will be due after 1! months of raising the term loan. <he interest rate on the term loan will be 1# 5ercent. <he le2els of wor;ing ca5ital ad2ance and trade credit will remain at &s.1%% million each, till they are 5aid bac; or retired at the end of - years, after the 5roCect commences, which is the e:5ected life of the 5roCect. Wor;ing ca5ital ad2ance will carry an interest rate of 1 5ercent.

0eta # 5roCect is e:5ected to generate a re2enue of &s.7-% million 5er year. <he o5erating costs (e:cluding de5reciation and ta:es) are e:5ected to be &s.- - million 5er year. 9or ta: 5ur5oses, the de5reciation rate on fi:ed assets will be - 5ercent as 5er the written down 2alue method. Assume that there is no other ta: benefit. <he net sal2age 2alue of 5lant and machinery is e:5ected to be &s.1%% million at the end of the 5roCect life. &eco2ery of wor;ing ca5ital will be at boo; 2alue. <he income ta: rate is e:5ected to be ,% 5ercent. TiCay 0athur wants you to estimate the cash flows from three different 5oints of 2iew6 a. 'ash flows from the 5oint of all in2estors (which is also called the e:5licit cost funds 5oint of 2iew). b. 'ash flows from the 5oint of e7uity in2estors. Solution: Cash Flows from the Point of all Investors /tem % 1 , # - $

1. 8lant and e7ui5ment ( %%) ( %%) . Net wor;ing ca5ital (1%%) ,. &e2enue #. A5erating costs -. 3e5reciation $. 8rofit before ta: 7. 8rofit after ta: (%.7 : $) !. Net sal2age 2alue of 5lant and e7ui5ment .. &eco2ery of net wor;ing ca5ital 1%. "nitial in2estment ( %%) (,%%) 11. A5erating cash flow (7 ) -) 1 . <erminal cash inflow 1,. Net cash flow ( %%) (,%%)

7-% - 1%% 1 !7.-

7-% - 71-% 1%-

7-% - -$., 1$!.7 11!.1

7-% - # . 1! .! 1 !.%

7-% - ,1.$ 1.,.# 1,-.# 1%%

1%% 1!7.1!% 17#.# 17%. 1$7 %% 1!7.1!% 17#.# 17%. ,$7

Cash Flows from the Point of Equit Investors /tem % 1 , # - $

1. /7uity funds ( %%) . &e2enues ,. A5erating costs #. 3e5reciation -. "nterest on wor;ing ca5ital $. "nterest on term loan 7. 8rofit before ta: !. 8rofit after ta: .. Net sal2age 2alue of 5lant 4 e7ui5ment 1%. &eco2ery of wor;ing ca5ital 11. &e5ayment of term loans 1 . &e5ayment of wor;ing ca5ital ad2ance 1,. &etirement of trade credit 1#. "nitial in2estment (1) 1-. A5erating cash inflows (! ) #) 1$. @i7uidation 4 retirement cash flows (. ) 1% I 1, I 1# I 1-) 17. Net cash flow ( %%)

7-% - 1%% 1 ! !-..-

7-% - 71 $., 111.7 7!.

7-% - -$., 1 1.., 1,7.# .$.

7-% - # . 1 1 ., 1-!.111

7-% - ,1.$ 1 -., 17$.1 1 ,., 1%% %%

-%

-%

-%

-% 1%% 1%%

1-..-

1-,. (-%)

1- .(-%) 1% .-

1-,. (-%) 1%,.

1-#.. -% %#..

( %%)

1-..-

1%,.

/0!0CASE 2 0a: 3rugs @imited is a leader in the bul; drug industry. "t manufactures a range of bul; drugs, technically called A8"s (acti2e 5harmaceutical ingredients). 0a: is considering a new bul; drug called 0?3+.. Mou ha2e recently Coined 0a: as a finance officer and you re5ort to 8ra;ash =ingh, Tice 8resident (9inance), who coordinates the ca5ital budgeting acti2ity. Mou ha2e been as;ed to de2elo5 the financials for 0?3+.. After discussing with mar;eting, technical, and other 5ersonnel, you ha2e gathered the following information. <he 0?3+. 5roCect has an economic life of - years. "t would generate a re2enue of &s.-% million in year1 which will rise by &s.1% million 5er year for the following two years. <hereafter, re2enues will decline by &s.1% million 5er year for the remaining two years. A5erating costs (costs before de5reciation, interest, and ta:es) will be $% 5ercent of re2enues. 0?3+. is e:5ected to erode the re2enues of an e:isting bul; drug. 3ue to this erosion there will be a loss of &s.# million 5er year by way of contribution margin for - years. While there may be some other im5acts as well, they may be ignored in the 5resent analysis. 0?3+. will re7uire an outlay of &s.#% million in 5lant and machinery right in the beginning. <he same will be financed by e7uity and term loan in e7ual 5ro5ortions. <he term loan will carry an interest of ! 5ercent 5er annum and will be re5ayable in # e7ual annual instalments, the first instalment falling due at the end of year 1. 9or ta: 5ur5oses, the de5reciation rate will be 1- 5ercent as 5er the written down 2alue method. <he net sal2age 2alue of 5lant and machinery after - years is e:5ected to be &s. % million. <he net wor;ing ca5ital re7uirement will be % 5ercent of re2enues. Assume that the in2estment in net wor;ing ca5ital will be made right in the beginning of each year and the same will be fully financed by wor;ing ca5ital ad2ance carrying an interest rate of 1% 5ercent 5er annum. At the end of - years the wor;ing ca5ital is e:5ected to be li7uidated at 5ar. <he effecti2e ta: rate is ,%% &e7uired 1. /stimate the net cash flows relating to e:5licit cost funds (in2estor claims) o2er the -+year 5eriod. . /stimate the net cash flows relating to e7uity o2er the -+year 5eriod.

Solution:

3et Cash 6lo(s Relatin< to *Aplicit Cost 6un#s 1. 9i:ed assets . Net wor;ing ca5ital ,. &e2enues #. A5erating costs -. @oss of contribution margin $. 3e5reciation 7. 8rofit before ta: !. <a: .. 8rofit after ta: 1%. Net sal2age 2alue of fi:ed assets 11. &eco2ery of wor;ing ca5ital 1 . "nitial outlay 4 wor;ing ca5ital 1,. A5erating cash flow (. ) $) 1#. <erminal cash inflow (1% ) 11) 1-. Net cash flow 6 % (#%.%) (1%.%) 1 ( .%) -%.% ,%.% #.% $.% 1%.% ,.% 7.% ( .%) $%.% ,$.% #.% -.1 1#.. #.#7 1%.#, , .% 7%.% # .% #.% #.,# 1..$$ -..% 1,.7$ (Rs.in million) # .% $%.% ,$.% #.% ,.$! 1$., #..% 11.# -%.% ,%.% #.% ,.1, 1 .!7 ,.!$ ..%1 %.% 1%.% (-%.%) ( .%) 1,.% ( .%) 1-.-, .% 1!.1% .% 1-.1 1 .1# ,%.%% (-%.%) 11.% 1,.-, %.1% 17.1 # .1#

1. /7uity funds . &e2enues

3et Cash 6lo(s Relatin< to *+uity%Rs.in million& % 1 , ( %.%) + + + -%.% $%.% 7%.% ,%.% #.% $.% 1.% 1.$ 7.# . -.1! ,$.% #.% -.1 1. 1. 1 .,.7!.7# .% #.% #.,# 1.#% %.! 17.#$ -. # 1 .

# + $%.% ,$.% #.% ,.$! 1. % %.# 1#.7 #.# 1%.,%

+ -%.% ,%.% #.% ,.1, 1.%% + 11.!7 ,.-$ !.,1 %.% 1%.%

,. A5erating costs #. @oss of contribution margin -. 3e5reciation $. "nterest on wor;ing ca5ital ad2ance 7. "nterest on term loan !. 8rofit before ta: .. <a: 1%. 8rofit after ta: 11. Net sal2age 2alue of fi:ed assets 1 . Net sal2age 2alue of current assets 1,. &e5ayment of term loan 1#. &e5ayment of wor;ing ca5ital ad2ance 1-. "nitial in2estment (1) 1$. A5erating cash flows (1% ) -) 17. @i7uidation 4 retirement cash flows (11 ) 1 I 1, I 1#) 1!. Net cash flow (1-)1$)17)

-.%

-.%

-.%

-.%

+ 1%.%

( %.%)

+ 11.1! (-.%)

+ 1,.!(-.%) !.!-

+ 1$.-$ (-.%) 11.-$

+ 1,..! (-.%) !..!

+ 11.## %.% ,1.##

( %.%)

$.1!

/0!0CASE 3 0edi5harm, a 5harmaceutical com5any, is considering the manufacture of a new antibiotic 5re5aration, 0+cin, for which the following information has been gathered. 0+cin is e:5ected to ha2e a 5roduct life cycle of fi2e years and thereafter it would be withdrawn from the mar;et. <he sales from this 5re5aration are e:5ected to be as follows6

2ear 1 , #

Sales % Rs in million& -% 1%% 1-% 1%% -%

<he ca5ital e7ui5ment re7uired for manufacturing 0+cin will cost &s.!% million and it will be de5reciated at the rate of - 5ercent 5er year as 5er the W3T method for ta: 5ur5oses. <he e:5ected net sal2age 2alue of the ca5ital e7ui5ment after years is &s. % million. <he net wor;ing ca5ital re7uirement for the 5roCect is e:5ected to be - 5ercent of sales. <he net wor;ing ca5ital will be adCusted at the beginning of the year in relation to the e:5ected sales for the year. 9or e:am5le, the net wor;ing ca5ital at the beginning of year 1 (i.e at the end year %) will be &s.1 .- million, that is 5ercent of the e:5ected re2enue of &s.-%.% million for year 1. <he accountant of the firm has 5ro2ided the following cost estimates for 0+cin 6 &aw material cost 6 #% 5ercent of sales Tariable labour cost 6 1% 5ercent of sales 9i:ed annual o5erating6 &s.# million and maintenance cost A2erhead allocation 6 1% 5ercent of sales (e:cluding de5reciation maintenance, and interest) While the 5roCect is charged an o2erhead allocation , it is not li;ely to ha2e any effect on o2erhead e:5enses as such$ <he manufacture of 0+cin would use some of the common facilities of the firm. <he use of these facilities will necessitate reducing the 5roduction of other 5harmaceutical 5re5arations of the firm. <his will mean a reduction of &s.1% million of contribution margin from those 5re5arations. <he ta: rate a55licable for this 5roCect is ,% 5ercent. (a) /stimate the 5ost+ta: incremental cash flows of the 5roCect 2iewed from the 5oint of all in2estors(which is also called the e:5licit cost funds 5oint of 2iew). (b) <o calculate the cash flows from the 5oint of e7uity in2estors, what additional

information would you need ? Solution: Cash 6lo(s from the -oint of All /n4estors % 1 (!%) 1 .(1 .-) -.% (1 .-) -%.%% %.%% -.%% #.%% %.%% 1%.%% ( ..%%) ($.,%) ,7.(1 .-) 1%%.%% #%.%% 1%.%% #.%% 1-.%% 1%.%% 1.%% 1#.7% -.% 1 .1-%.%% $%.%% 1-.%% #.%% 11. 1%.%% #..7,#.!, 1 .1 .1%%.%% #%.%% 1%.%% #.%% !.## 1%.%% 7.-$ 1.. . I I -%.%% %.%% -.%% #.%% $.,, 1%.%% #.$7 ,. 7 %.%% 1 .(!%) (1 .-)

"tem 1. 9i:ed assets . Net wor;ing ca5it+ al le2el ,. "n2estment in net wor;ing ca5ital #. =ales -. &aw material cost $. Tariable labour cost 7. 9i:ed annual o5er+ ating cost !. 3e5reciation .. @oss of contribu+ tion margin 1%. 8rofit before ta: 11. 8rofit after ta: 1 . N=T of fi:ed assets 1,. &eco2ery of NW' at the end 1#. "nitial in2estment in fi:ed assets 1-. "n2. "n NW' 1$. 'ash flow from o5eration (11)!) 17. <erminal cash flow (1 )1,) Net 'ash 9low

(1 .-) 1,.7

(1 .-) ..7%

1 .#$.%!

1 .7.7, ..$% , .-

(. .-)

1. %

17. %

-!.-!

#%. ,

# .1%

b. <he additional information needed for calculating the cash flow from the 5oint of 2iew of e7uity in2estors are6 /7uity funds committed to the 5roCect "nterest cost on all borrowings &e5ayment *retirement schedule of all borrowings and trade creditors Net sal2age 2alue of all current assets 8reference di2idend and redem5tion of 5reference ca5ital

/0!0CASE & Sesna Auto @td is considering the manufacture of a new bi;e, Bale, for which the following information has been gathered. Bale is e:5ected to ha2e a 5roduct life cycle of fi2e years after which it will be withdrawn from the mar;et. <he sales from this 5roduct is e:5ected to be as follows6 Mear 1 =ales (&s. in million) 7%% N N , !-% 11%% # 1%%% !%%

<he ca5ital e7ui5ment re7uired for manufacturing Bale costs &s.$%% million and it will be de5reciated at the rate of - 5ercent 5er year as 5er the W3T method for ta: 5ur5oses. <he e:5ected net sal2age 2alue after - years is &s.1%% million. <he wor;ing ca5ital re7uirement for the 5roCect is e:5ected to be 1%% of sales. Wor;ing ca5ital le2el will be adCusted at the beginning of the year in relation to the sales for the year. At the end of fi2e years, wor;ing ca5ital is e:5ected to be li7uidated at 5ar, barring an estimated loss of &s.- million on account of bad debt, which of course, will be ta:+deductible e:5ense. <he accountant of the firm has 5ro2ided the following estimates for the cost of Bale. &aw material cost 6 #% 5ercent of sales Tariable manufacturing cost 6 % 5ercent of sales 9i:ed annual o5erating and 6 &s. .- million maintenance costs Tariable selling e:5enses 6 1- 5ercent of sales <he ta: rate for the firm is ,% 5ercent.

&e7uired6 (a) /stimate the 5ost+ta: incremental cash flows for the 5roCect to manufacture Bale. (b) What is the N8T of the 5roCect if the cost of ca5ital is 1! 5ercent?

Solution:

Cash flo(s for the Fale -ro;ect Mear 1. 'a5ital e7ui5ment . @e2el of wor;ing ca5ital ,. &e2enues #. &aw material cost -. Tariable manufacturing cost $. A5erating and maintenance cost 7. Tariable selling e:5enses !. 3e5reciation .. ?ad debt loss 1%.8rofit before ta: 11.<a: 1 .8rofit after ta: 1,.Net =al2age Talue of 'a5ital /7ui5ment 1#.&eco2ery of Wor;ing 'a5ital 1-."nitial "n2estment 1$.A5erating cash flow (1 )!).) 17. <erminal cash flow (1, ) 1#) 1!. Wor;ing 'a5ital in2estment 1.. Net cash flow (1- ) 1$ ) 17 ) 1!) 1-%.7% (b) N8T ( + $7% ) (1.1!) ( ) (1.1!) % $%% 7% 1 !7%% !% 1#% .1%1-% .$.! 1-.7 11% !-% ,#% 17% .1 7.11 ..7... $!. , 1%% 11%% ##% % .1$!#.# 1!!.1 -$.# 1,1.7 (&s. in million) # !% 1%%% #%% %% .1-% $,., 1!#. --., 1 !.. + !%% , % 1$% .1 % #7.1#-.% #,.1%1.1%% 7($%%) 1$-.7% (7%) ($7%) 1--.7) (1.1!), (1-) 1-%.7 1!%.7( -) 1--.7$.1 ) (1.1!)# 1$.1 1% $.1 1 . ) (1.1!)1. . % 1 . , . , . 1-#.% 17-

+ $7% ) 1 7.71 ) 111.!$ ) 1,7.$1 ) 1%..#- ) 1#,.!1

( +,..-$

/0!0CASE * 8hoeni: 8harma is considering the manufacture of a new drug, <orre:in, for which the following information has been gathered <orre:in is e:5ected to ha2e a 5roduct life cycle of fi2e years after which it will be withdrawn from the mar;et. <he sales from this drug are e:5ected to be as follows6

Mear 1 =ales ( &s in million) 1%%

1-%

, %%

# 1-%

1%%

<he ca5ital e7ui5ment re7uired for manufacturing <orre:in is 1 % million and it will be de5reciated at the rate of - 5ercent 5er year as 5er the W3T method for ta: 5ur5oses. <he e:5ected net sal2age 2alue after - years is &s.,% million <he wor;ing ca5ital re7uirement for the 5roCect is e:5ected to be % 5ercent of sales. Wor;ing ca5ital le2el will be adCusted at the beginning of the year in relation to the sales for the year. At the end of fi2e years, wor;ing ca5ital is e:5ected to be li7uidated at 5ar, barring an estimated loss of &s.- million on account of bad debt which, of course, will be ta:+deductible e:5ense <he accountant of the firm has 5ro2ided the following estimates for the cost of <orre:in &aw material cost 6 #% 5ercent of sales Tariable manufacturing 6 1% 5ercent of sales cost 9i:ed annual o5erating and 6 &s.! million maintenance costs Tariable selling e:5enses 6 1% 5ercent of sales

<he ta: rate for the firm is ,% 5ercent

&e7uired 6

(a) /stimate the 5ost+ta: incremental cash flows for the 5roCect to manufacture <orre:in (b) What is the N8T of the 5roCect if the cost of ca5ital is 1- 5ercent?

Solution: (a) % 1. 'a5ital e7ui5ment . @e2el of wor;ing ca5ital (ending) ,. &e2enues #. &aw material cost -. Tariable mfrg cost $. 9i:ed annual o5erating and maintenance costs 7. Tariable selling e:5enses !. ?ad debt loss .. 3e5reciation 1%. 8rofit before ta: 11. <a: 1 . 8rofit after ta: 1,. Net sal2age 2alue of ca5ital e7ui5ment 1#. &eco2ery of wor;ing ca5ital 1-. "nitial in2estment 1$. A5erating cash flow (1 ) ! ) .) 17. ` Wor;ing ca5ital 1!. <erminal cash flow (1,)1#) 1.. Net cash flow (1- ) 1$ ) 17 ) 1!) 1.# (b) N8T ( + 1#% ) (1.1-) ) (1.1-) ,,.1 ) (1.1-), $-.) (1.1-)# (1#%) 1.# ,,.1 $-.-%. (1 %) ,1.# % 1% #,.1 1% --.(1%) #%. (1%) #-.% 71.7 $.7 %.$ 1.# (1 %) % ,% 1%% #% 1% ! 1% + ,% #% 1-% $% 1! 1+ ...!.. %.$ ,% %% !% % ! % + 1$.. --.1 1$.,!.$ % 1-% $% 1! 1+ 1 .7 ,.., 11.! 7.1%% #% 1% ! 1% ..17.-., 1 . ,%.% 1-.% 1 , # -

-%. )

71.7 (1.1-)-

( + 1#% ) 1!.$ ) -.% ) #,.1 ) !.7 ) ,-.$ ( &s 11.% million

/0!0CASE + 0alabar 'or5oration is determining the cash flow for a 5roCect in2ol2ing re5lacement of an old machine by a new machine. <he old machine bought a few years ago has a boo; 2alue of &s.1, %%,%%% and it can be sold to realise a 5ost ta: sal2age 2alue of &s.!%%,%%%. "t has a remaining life of four years after which its net sal2age 2alue is e:5ected to be &s.-%%,%%%. "t is being de5reciated annually at a rate of % 5ercent the W3T method. <he wor;ing ca5ital associated with this machine is &s.7%%,%%%. <he new machine costs &s.-,%%%,%%%. "t is e:5ected to fetch a net sal2age 2alue of &s. ,-%%,%%% after four years. <he de5reciation rate a55licable to it is % 5ercent under the W3T method. <he new machine is e:5ected to bring a sa2ing of &s.!%%,%%% annually in manufacturing costs (other than de5reciation).<he incremental wor;ing ca5ital associated with the new machine is &s. %%,%%%. <he ta: rate a55licable to the firm is ,# 5ercent. (a) /stimate the cash flow associated with the re5lacement 5roCect. (b) What is the N8T of the re5lacement 5roCect if the cost of ca5ital is 15ercent? Solution: (a) A. i. ii. iii i2. ?. "nitial outlay (<ime %) 'ost of new machine =al2age 2alue of old machine "ncremental wor;ing ca5ital re7uirement <otal net in2estment ((i I ii ) iii) &s. -,%%%,%%% !%%,%%% %%,%%% #,.%%,%%%

A5erating cash flow (years 1 through #) 2ear 1 2 - !,%%% $%!,%%% %$,7 % 7,#,7 % 3 - !,%%% #!$,#%% 1$-,,7$ $.,,,7$ . - !,%%% ,!.,1 % 1, ,,%1 $$%,,%1

i. 8ost+ta: sa2ings in manufacturing costs - !,%%% ii. "ncremental de5reciation iii. <a: shield on incremental de5. i2. A5erating cash flow ( i ) iii) 7$%,%%% -!,#%% 7!$,#%%

'.

<erminal cash flow (year #) i. ii. iii. i2. =al2age 2alue of new machine =al2age 2alue of old machine &eco2ery of incremental wor;ing ca5ital <erminal cash flow ( i I ii ) iii) &s. ,-%%,%%% -%%,%%% %%,%%% , %%,%%%

3. 2ear N'9 (b)

Net cash flows associated with the re5lacement 5roCect (in &s) 0 (#,.%%,%%%) 1 7!$,#%% 2 7,#,7 % 3 $.,,,7$ . ,!$%,,%1

N8T of the re5lacement 5roCect ( + #,.%%,%%% ) 7!$,#%% : 8T"9 (1-,1) ) 7,#,7 % : 8T"9 (1-, ) ) $.,,,7$ : 8T"9 (1-,,) ) ,!$%,,%1 : 8T"9 (1-,#) ( + &s.1,-$!,%-%

/0!0CASE , =angeeta /nter5rises is determining the cash flow for a 5roCect in2ol2ing re5lacement of an old machine by a new machine. <he old machine bought a few years ago has a boo; 2alue of &s. ,!%%,%%% and it can be sold to realise a 5ost ta: sal2age 2alue of &s. , %%,%%%. "t has a remaining life of fi2e years after which its net sal2age 2alue is e:5ected to be &s..%%,%%%. "t is being de5reciated annually at a rate of ,% 5ercent the W3T method. <he wor;ing ca5ital associated with this machine is &s.1.%%%,%%%. <he new machine costs &s.!,%%%,%%%. "t is e:5ected to fetch a net sal2age 2alue of &s.,,-%%,%%% after fi2e years. <he de5reciation rate a55licable to it is - 5ercent under the W3T method. <he new machine is e:5ected to bring a sa2ing of &s.1,%%%,%%% annually in manufacturing costs (other than de5reciation).<he incremental wor;ing ca5ital associated with the new machine is &s.$%%,%%%. <he ta: rate a55licable to the firm is ,, 5ercent. (a) /stimate the cash flow associated with the re5lacement 5roCect. (b) What is the N8T of the re5lacement 5roCect if the cost of ca5ital is 1# 5ercent? Solution: (a) A. i. ii. iii i2. /. 2ear "nitial outlay (<ime %) 'ost of new machine =al2age 2alue of old machine "ncremental wor;ing ca5ital re7uirement <otal net in2estment ((i I ii ) iii) &s. !,%%%,%%% , %%,%%% $%%,%%% $,#%%,%%%

A5erating cash flow (years 1 through #) 1 2 1,%%%,%%% 1,-%%,%%% -!!,%%% .1 ,%%% ,%%,.$% 1,,%%,.$% 3 1,%%%,%%% 1,1 -,%%% #11,$%% 71,,#%% ,-,# 1, ,-,# . 5 1,%%%,%%% 1,%%%,%%% !#,,7-% !!,1 % ---,$,% 1!,,,-! $, ,!1, %1,$!# #,1,1 . 1# , 7,

i. 8ost+ta: sa2ings in manufacturing costs 1,%%%,%%% ii. 3e5reciation on new machine ,%%%,%%% iii. 3e5reciation on old machine !#%,%%% i2."ncremental dereciation 1,1$%,%%% 2.<a: shield on incremental de5. ,! ,!%% i2. A5erating cash flow( i )2) 1,,! ,!%%

1,1!,,,-! 1,1# , 7,

9.

<erminal cash flow (year -) i. ii. iii. i2. =al2age 2alue of new machine =al2age 2alue of old machine &eco2ery of incremental wor;ing ca5ital <erminal cash flow ( i I ii ) iii) &s. ,,-%%,%%% .%%,%%% $%%,%%% ,, %%,%%%

B. 2ear N'9 (c)

Net cash flows associated with the re5lacement 5roCect (in &s) 0 ($,#%%,%%%) 1 1,,! ,!%% 2 3 . 1,1!,,,-! 5 #,,# , 7,

1,,%%,.$% 1, ,-,#

N8T of the re5lacement 5roCect ($,#%%,%%%)) 1,,! ,!%%: 8T"9 (1#,1)) 1,,%%,.$%: 8T"9 (1#, ) ) 1, ,-,# : 8T"9 (1#,,)) 1,1!,,,-!: 8T"9 (1#,#) )#,,# , 7,: 8T"9 (1#,-) ( + &s.,.!,7#.

!.

A machine costs &s. -%,%%% and is subCect to a de5reciation rate of # 5ercent under the W3T method. What is the 5resent 2alue of the ta: sa2ings on account of de5reciation for a 5eriod of - years if the ta: rate is ,# 5ercent and the discount rate is 1$ 5ercent?

Solution: <a: shield (sa2ings) on de5reciation (in &s) Depreciation 0aA shiel# 2ear char<e %DC& 80.3. A DC 1 $%,%%% #-,$%% , # ,#,$-$ $,,,. %,%17 %,#%% 1-,-%# 11,7!, !,.-$,!%$ 11,7,-#. #,.#$ ,, #% ++++++++++ ##,!#, ++++++++++ -D of taA shiel# G 1!H p.a. 17,-!$

8resent 2alue of the ta: sa2ings on account of de5reciation ( &s.##,!#,

..

A machine costs &s.$!%,%%% and is subCect to a de5reciation rate of 7 5ercent under the W3T method. What is the 5resent 2alue of the ta: sa2ings on account of de5reciation for a 5eriod of # years if the ta: rate is ,$ 5ercent and the discount rate is 1! 5ercent?

Solution: <a: shield (sa2ings) on de5reciation (in &s) Depreciation 0aA shiel# 2ear char<e %DC& 80.3! A DC 1 , # 1!,,$%% 1,#,% ! .7,!#% 71,# , $$,%.$ #!, -% ,-, -,71 1,#,7 -D of taA shiel# G 1=H p.a. -$,%1# ,#,$-

1,, $ ++++++++++ 1 -,,$++++++++++ 8resent 2alue of the ta: sa2ings on account of de5reciation ( &s.1 -,,$CHAPTER 13 1. A 5roCect re7uires an in2estment of -%%,%%%. <he unit selling 5rice is 7% and the unit 2ariable cost is ,-. 9i:ed costs other than de5reciation will be !%,%%% 5er year. 3e5reciation will be !%,%%% 5er year for ta: 5ur5oses. <he life of the 5roCect is - years. <he effecti2e ta: rate is ,, 5ercent. <he cost of ca5ital is 1# 5ercent. What is the financial brea;+e2en 5oint?

Solution: ( %.- of sales (=) ( %.- of sales (=) ( !%,%%% ( !%,%%% ( %.- = I !%,%%% I !%,%%% ( %.- = I ,$%,%%% ( (%.- = I ,$%,%%%) (1+%.,,) ) !%,%%% ( %.,,- = + 1$1, %% 8T of cash flow ( (%.,,- = +1$1, %%) 8T"9A (1#%, -) ( (%.,,- = +1$1, %%) : ,.#,, /7uating this with the initial in2estment, we get (%.,,- = +1$1, %%) : ,.#,, ( -%%,%%% (%.,,- = +1$1, %%) ( 1#-,$#-. 1 = ( .1-,.--.!Tariable cost 'ontribution 9i:ed cost 3e5reciation 8re+ta: 5rofit 'ash flow

A 5roCect re7uires an in2estment of !%%,%%%. <he unit selling 5rice is -% and the unit 2ariable cost is -. 9i:ed costs other than de5reciation will be -%,%%% 5er year. 3e5reciation will be !-,%%% 5er year for ta: 5ur5oses. <he life of the 5roCect is $ years. <he effecti2e ta: rate is % 5ercent. <he cost of ca5ital is 1 5ercent. What is the financial brea;+e2en 8oint?

Solution: Tariable cost 'ontribution margin 9i:ed costs 3e5reciation 8re+ta: 5rofit 'ash flow ( -% 5ercent of sales (=) ( -% 5ercent of sales (=) ( -%,%%% ( !-,%%% ( (%.-= I -%,%%% I !-,%%%) ( (%.-= I ,,-,%%%) %.! ) !-,%%% ( %.#= + 1!,,%%% 8resent 2alue of cash flows is (%.#= I 1!,,%%%) : #.111 /7uating this with the initial in2estment of !%%,%%% we get 1.$### = I 7- ,1, ( !%%,%%% = ( .#,....$ ,. A 5roCect re7uires an in2estment of -%%,%%%. <he unit selling 5rice is 7% and the unit 2ariable cost is ,-. 9i:ed costs other than de5reciation will be !%,%%% 5er year. 3e5reciation will be !%,%%% 5er year for ta: 5ur5oses. <he life of the 5roCect is - years. <he effecti2e ta: rate is ,, 5ercent. <he cost of ca5ital is 1# 5ercent. What is the financial brea;+e2en 5oint?

Solution: ( %.- of sales (=) ( %.- of sales (=) ( !%,%%% ( !%,%%% ( %.- = I !%,%%% I !%,%%% ( %.- = I ,$%,%%% ( (%.- = I ,$%,%%%) (1+%.,,) ) !%,%%% ( %.,,- = + 1$1, %% 8T of cash flow ( (%.,,- = +1$1, %%) 8T"9A (1#%, -) ( (%.,,- = +1$1, %%) : ,.#,, /7uating this with the initial in2estment, we get (%.,,- = +1$1, %%) : ,.#,, ( -%%,%%% (%.,,- = +1$1, %%) ( 1#-,$#-. 1 = ( .1-,.--.!Tariable cost 'ontribution 9i:ed cost 3e5reciation 8re+ta: 5rofit 'ash flow

#.

Mou are the financial manager of Na2neet @imited. Na2neet is 5lanning to set u5 a factory at Aurangabad. Mour 5roCect staff has de2elo5ed the following cash flow forecast for the factory. Cash 6lo( 6orecast for 3a4neetEs factory 2ear 0 "n2estment (-%%) =ales Tariable costs ($%% of sales) 9i:ed costs 3e5reciation (assumed at 1%% of in2estment 5er annum) 8re+ta: 5rofit <a: ( at a rate assumed at ,% % of 5re+ta: 5rofit) 8rofit after ta: 'ash flow from o5erations Net cash flow Rs. in million 2ears 1 : 10 #%% #% $% -% -% 1,!!-

What is the N8T of the 5roCect? Assume that the cost of ca5ital is 1- 5ercent. <he range of 2alues that the underlying 2ariables can ta;e is shown below6 >nderlying Tariable 8essimistic /:5ected A5timistic "n2estment #%% -%% 7%% (&s. in million) =ales (&s. in million) -% #%% $-% Tariable cost as a 5ercent 7% $% -of sales 9i:ed costs (&s. in million) $$% -% 'ost of ca5ital (%) 1! 11 a. 'alculate the effect of 2ariations in the 2alues of the underlying 2ariables on N8T. b. 'alculate the accounting brea;+e2en 5oint. Solution: /:5ected =cenario -%% #%% $% #% $% -% A5timistic =cenario #%% $-% -,-7.-% #% 8essimistic =cenario 7%% -% 7% 17$7%

1. "n2estment . =ales Tariable costs as a 5ecentage of sales ,. Tariable costs #. 9i:ed costs -. 3e5reciation(assumed at 1%% of in2estment 5er annum)

$. 8re+ta: 5rofit 7. <a:( at a rate assumed at ,% % of 5re+ta: 5rofit) !. 8rofit after ta: .. Annual cash flow from o5erations 1%. Net 5resent 2alue

-% 1,!+7,.#%

% .$%.71#1.71!1.7$ $..,

+$% +1! +# ! +-7#.17

Assum5tions6 (1) ( ) (,)

<he useful life is assumed to be 1% years under all three scenarios. "t is also assumed that the sal2age 2alue of the in2estment after ten years is Pero. <he in2estment is assumed to be de5reciated at 1%% 5er annum[ and it is also assumed that this method and rate of de5reciation are acce5table to the "< (income ta:) authorities. "t is assumed that only loss on this 5roCect can be offset against the ta:able 5rofit on other 5roCects of the com5any[ and thus the com5any can claim a ta: shield on the loss in the same year.

%,&

Accountin< ,reaB e4en point %un#er IeApecte#E scenario& 9i:ed costs ) de5reciation ( &s. 11% million 'ontribution margin ratio ( 1$% * #%% ( %.# ?rea; e2en le2el of sales ( 11% * %.# ( &s. 7- million Mou are the financial manager of 0agnum 'or5oration. 0agnum is 5lanning to set u5 a 0achine <ools 5lant at 'hennai. Mour 5roCect staff has de2elo5ed the following cash flow forecast for the 5roCect. Cash 6lo( 6orecast for 3a4neetEs factory 2ear 0 "n2estment (1%%%) =ales Tariable costs (7%% of sales) 9i:ed costs 3e5reciation (assumed at 1%% of in2estment 5er annum) 8re+ta: 5rofit <a: (at a rate assumed at ,, % of 5re+ta: 5rofit) 8rofit after ta: 'ash flow from o5erations Net cash flow Rs. in million 2ears 1 : = !%% -$% .% 1%% -% 1$.,,.1,,.1,,.-

-.

What is the N8T of the 5roCect ? Assume that the cost of ca5ital is 1# 5ercent. <he range of 2alues that the underlying 2ariables can ta;e is shown below6 6n"erl7ing 8ariable Pessimistic E9pecte" :ptimistic "n2estment 1,%% 1%%% !%% (&s. in million) =ales (&s. in million) $-% !%% 1%%% Tariable cost as a 5ercent 77% $% of sales 9i:ed costs (&s. in million) ..% !% 'ost of ca5ital (%) 1$ 1# 1, (a) 'alculate the effect of 2ariations in the 2alues of the underlying 2ariables on N8T. (b) 'alculate the accounting brea;+e2en 5oint. Solution: /:5ected =cenario 1. "n2estment . =ales Tariable costs as a 5ercentage of sales ,. Tariable costs #. 9i:ed costs -. 3e5reciation(assumed at 1%% of in2estment 5er annum) $. 8re+ta: 5rofit 7. <a:( at a rate assumed at ,, % of 5re+ta: 5rofit) !. 8rofit after ta: .. Annual cash flow from o5erations 1%. Net 5resent 2alue Assum5tions6 (1) ( ) (,) 1%%% !%% 7% -$% .% 1%% -% 1$.,,.1,,.+,!%.71 A5timistic =cenario !%% 1%%% $% $%% !% !% #% 7.. 1$%.! #%.! ,--.-# 8essimistic =cenario 1,%% $-% 7#!7..1,% +$ .+ %.$ +#1.!7!!.1 +.17.

<he useful life is assumed to be ! years under all three scenarios. "t is also assumed that the sal2age 2alue of the in2estment after eight years is Pero. <he in2estment is assumed to be de5reciated at 1%% 5er annum[ and it is also assumed that this method and rate of de5reciation are acce5table to the "< (income ta:) authorities. "t is assumed that only loss on this 5roCect can be offset against the ta:able 5rofit on other 5roCects of the com5any[ and thus the com5any can claim a ta: shield on the loss in the same year.

%,&

Accountin< ,reaB e4en point %un#er IeApecte#E scenario& 9i:ed costs ) de5reciation 'ontribution margin ratio ?rea; e2en le2el of sales ( &s. 1.% million ( %., ( 1.% * %., ( &s.$,,.,, million

$.

&a;esh @imited is considering the ris; characteristics of a certain 5roCect. <he firm has identified that the following factors, with their res5ecti2e e:5ected 2alues, ha2e a bearing on the N8T of this 5roCect. "nitial in2estment &s.-%,%%% 'ost of ca5ital 1 % Huantity manufactured and sold annually ,!%% 8rice 5er unit &s.-% Tariable cost 5er unit &s. ! 9i:ed costs &s.!,%%% 3e5reciation &s.-,%%% <a: rate ,-% @ife of the 5roCect $ years Net sal2age 2alue Nil Assume that the following underlying 2ariables can ta;e the 2alues as shown below6 6n"erl7ing ariable Huantity manufactured and sold 8rice 5er unit Tariable cost 5er unit a. Pessimistic ,%%% &s.,&s.,:ptimistic ,,-%% &s.$% &s. %

'alculate the sensiti2ity of net 5resent 2alue to 2ariations in (a) 7uantity manufactured and sold, (b) 5rice 5er unit, and (c) 2ariable cost 5er unit.

Solution: =ensiti2ity of net 5resent 2alue to 7uantity manufactured and sold Pessimisti c 2000 50!000 100!000 56!000 8!000 5!000 31!000 10!850 20!150 25!150 53!402

Expected Quantity manufactured and so d annua y "nitial in2estment =ales re2enue Tariable costs 9i:ed costs 3e5reciation 8rofit before ta: <a: 8rofit after ta: Net cash flow N8T at a cost of ca5ital of 1 % and useful life of $ years ,!%% 50!000 140!000 78!400 8!000 5!000 48!600 17!010 31!590 36!590 100!436

Optimistic 3500 50!000 175!000 98!000 8!000 5!000 64!000 22!400 41!600 46!600 141!592

=ensiti2ity of net 5resent 2alue to 5rice 5er unit

8rice 5er unit "nitial in2estment =ales re2enue Tariable costs 9i:ed costs 3e5reciation 8rofit before ta: <a: 8rofit after ta: Net cash flow N8T at a cost of ca5ital of 1 % and useful life of $ years

Expected -% 50!000 140!000 78!400 8!000 5!000 48!600 17!010 31!590 36!590 100!436

Pessimisti c 35 50!000 98!000 78!400 8!000 5!000 6!600 2!310 4!290 9!290 -11!805

Optimistic 60 50!000 168!000 78!400 8!000 5!000 76!600 26!810 49!790 54!790 175!264

=ensiti2ity of net 5resent 2alue to 2ariable cost 5er unit. Expected ! 50!000 140!000 78!400 8!000 5!000 48!600 17!010 31!590 36!590 100!436 Pessimisti c 35 50!000 140!000 98!000 8!000 5!000 29!000 10!150 18!850 23!850 48!057 Optimistic 20 50!000 140!000 56!000 8!000 5!000 71!000 24!850 46!150 51!150 160!298

Tariable cost 5er unit "nitial in2estment =ales re2enue Tariable costs 9i:ed costs 3e5reciation 8rofit before ta: <a: 8rofit after ta: Net cash flow N8T at a cost of ca5ital of 1 % and useful life of $ years 7.

A 5roCect in2ol2ing an outlay of &s.1- million has the following benefits associated with it. 2ear 1 Cash 6lo( %Rs. in mln& 7 ! . 2ear 2 -ro,. Cash 6lo( %Rs. in mln& %., $ %.! %. 1% 2ear 3 -ro,. Cash 6lo( %Rs. in mln& %.%. 7 %., . -ro,. %.# %., %.,

Assume that the cash flows are inde5endent. 'alculate the e:5ected net 5resent 2alue and the standard de2iation of net 5resent 2alue assuming that i ( 1 5ercent. Solution: 3efine At as the random 2ariable denoting net cash flow in year t. A1 A A, N8T ( ( ( ( ( ( ( ( 7 : %., ) ! : %.- ) . : %. 7.. $ : %.- ) ! : %. ) 1% : %., 7.$ - : %.# ) 7 : %., ) . : %., $.! 7.. * 1.1 )7.$ * (1.1 ) ) $.! * (1.1 ), I 1&s. ..- million

1 ,

( %.,:( 7+7..) ) %.-(!+7..) ) %. (.+7..) ( %.#. ( %.-($+7.$) )%. (!+7.$) )%.,(1%+7.$) ( ,.%# ( %.#(-+$.!) )%.,(7+$.!) )%.,(.+$.!) ( .7$ 1 ) (1.1 ) ,

N8T (

) (1.1 )# (1.1 )$

( %.#.*(1.1 ) ) ,.%#*(1.1 )# ) .7$*(1.1 )$ ( ,.7 (N8T) ( &s.1.., million !. A 5roCect in2ol2ing an outlay of &s. - million has the following benefits associated with it. 2ear 1 Cash 6lo( %Rs. in mln& 1% 1 1, 2ear 2 -ro,. Cash 6lo( %Rs. in mln& %. . %.11 %., 1 2ear 3 -ro,. Cash 6lo( %Rs. in mln& %.$ 1 %. 1, %. 1# -ro,. %.%.# %.1

Assume that the cash flows are inde5endent. 'alculate the e:5ected net 5resent 2alue and the standard de2iation of net 5resent 2alue assuming that i ( 1- 5ercent. Solution: 3efine At as the random 2ariable denoting net cash flow in year t. A1 A A, N8T 1 , ( ( ( ( 1% : %. ) 1 : %.- ) 1, : %.,( 11.. . : %.$ ) 11 : %. ) 1 : %. ( 1% 1 : %.- ) 1, : %.# ) 1# : %.1( 1 .$ 11.. * 1.1- )1% * (1.1-) ) 1 .$ * (1.1-), I - ( &s.1.1. million

( %. :( 1%+11..) ) %.-(1 +11..) ) %.,(1,+11..) ( 1.%. ( %.$(.+1%) )%. (11+1%) )%. (1 +1%) ( 1.$ ( %.-(1 +1 .$) )%.#(1,+1 .$) )%.1(1#+1 .$) ( %.## 1 , N8T ( ) ) (1.1 ) (1.1 )# (1.1 )$

( 1.%.*(1.1-) ) 1.$*(1.1-)# ) %.##*(1.1-)$ ( 1.., (N8T) ( &s.1.,.million .. 0ohan is considering an in2estment which re7uires a current outlay of &s. -,%%%. <he e:5ected 2alue and standard de2iation of cash flows are6 2ear 1 , # *Apecte# Dalue &s. -,%%% 1-,%%% 1#,%%% 1%,%%% Stan#ar# De4iation &s.,,%%% #,%%% #,%%% ,%%%

<he cash flows are 5erfectly correlated. 'alculate the e:5ected net 5resent 2alue and standard de2iation of net 5resent 2alue of this in2estment, if the ris;+free interest rate is 7 5ercent. Solution: /:5ected N8T # At ( + -,%%% t t(1 (1.%7) ( -,%%%*(1.%7) ) 1-,%%% * (1.%7) ) 1#,%%% * (1.%7), ) 1%,%%% * (1.%7)# I -,%%% ( ,%,- , # t(1 (1.%7)t ( ( 1%. =tandard de2iation of N8T t

,,%%% * (1.%7) ) #,%%% * (1.%7) ) #,%%% * (1.%7), ) ,%%% * (1.%7)# 11,%!!.#!

?oldman is considering an in2estment which re7uires a current outlay of &s.1%%,%%%. <he e:5ected 2alue and standard de2iation of cash flows are6 2ear 1 , # *Apecte# Dalue &s.#%,%%% --,%%% ,#,%%% %,%%% Stan#ar# De4iation &s.!,%%% 1%,%%% 7,%%% .,%%%

<he cash flows are 5erfectly correlated. 'alculate the e:5ected net 5resent 2alue and standard de2iation of net 5resent 2alue of this in2estment, if the ris;+free interest rate is 1% 5ercent.

Solution: /:5ected N8T # At ( + 1%%,%%% t(1 (1.1)t ( #%,%%%*(1.1) ) --,%%% * (1.1) ) ,#,%%% * (1.1), ) %,%%% * (1.1)# I 1%%,%%% ( 1,% , =tandard de2iation of N8T # t t(1 (1.1)t ( ( 11. !,%%% * (1.1) ) 1%,%%% * (1.1) ) 7,%%% * (1.1), ) .,%%% * (1.1)# $,.##

3inesh Associates is considering an in2estment 5roCect which has an estimated life of four years. <he cost of 5roCect is #%%,%%% and the 5ossible cash flows are gi2en below6 2ear 2 Cash 6lo( -ro,. 1 %,%%% 1,%,%%% 1#%,%%% %.%., %. 2ear 3 Cash 6lo( -ro,. 1,%,%%% 1#%,%%% 1-%,%%% %. %., %.2ear . Cash 6lo( -ro,. 11%,%%% 1 %,%%% 1,%,%%% %.# %.# %.

2ear 1 Cash 6lo( -ro,. 11%,%%% 1 %,%%% 1,%,%%% %., %.# %.,

<he cash flows of 2arious years are inde5endent and the ris;+free discount rate (5ost+ta:) is ! 5ercent. (a) (b) (c) Solution: (a) What is the e:5ected N8T ? "f the N8T is a55ro:imately normally distributed, what is the 5robability that the N8T will be Pero or less ? What is the 5robability that the 5rofitability inde: will be greater than 1.1 ?

/:5ected N8T # At ( + #%%,%%% K. (1) t(1 (1.%!)t A1 ( 11%,%%% : %., ) 1 %,%%% : %.# ) 1,%,%%% : %., ( 1 %,%%% A ( 1 %,%%% : %.- ) 1,%,%%% : %., ) 1#%,%%% : %. ( 1 7,%%% A, ( 1,%,%%% : %. ) 1#%,%%% : %., ) 1-%,%%% : %.- ( 1#,,%%% A# ( 11%,%%% : %.# ) 1 %,%%% : %.# ) 1,%,%%% : %. ( 11!,%%%

=ubstituting these 2alues in (1) we get /:5ected N8T ( N8T (1 %,%%% * (1.%!)) 1 7,%%% * (1.%!) ) 1#,,%%% * (1.%!), ) 11!,%%% * (1.%!)# + #%%,%%% ( %, #(b) <he 2ariance of N8T is gi2en by the e:5ression # t (N8T) ( KK.. ( ) t t(1 (1.%!) 1 ( U(11%,%%%I1 %,%%%) :%.,)(1 %,%%%I1 %,%%%) :%.# ( )(1,%,%%% I1 %,%%%) : %.,V ( $%,%%%,%%% ( U(1 %,%%% I1 7,%%%) : %.- ) (1,%,%%% I1 7,%%%) : %., ) (1#%,%%% I1 7,%%%) : %. V( $1,%%%,%%% , ( U(1,%,%%% I1#,,%%%) : %. ) (1#%,%%% I1#,,%%%) : %., ) (1-%,%%% I1#,,%%%) : %.-V ( $1,%%%,%%% # ( U(11%,%%% I11!,%%%) : %.# ) (1 %,%%% I11!,%%%) : %.# ) (1,%,%%% I11!,%%%) : %. V( -$,%%%,%%% =ubstituting these 2alues in ( ) we get (N8T) ($%,%%%,%%%* (1.%!) ) $1,%%%,%%%* (1.%!)# ) $1,%%%,%%%* (1.%!)$ ) -$,%%%,%%%* (1.%!)! ( 1$#,.7 ,-- N8T ( 1$#,.7 ,---( &s.1 ,!## NPV NPV 8rob (N8T h %) ( 8rob. h N8T % I %, #( 8rob S h 1 ,!## ( 8rob (S h + 1.-!) 9rom the normal distribution tables, we ha2e, when S ( +1.$%, the 5robability ( %.%-#! when S ( +1.--, the 5robability (%.%$%$ /:tra5olating, we get 8rob (S h + 1.-!) ( %.%-#! )(1.$%+1.-!)(%.%$%$ I %.%-#!)*%.%( %.%-#! ) %.%% , ( %.%-71 =o the 5robability of N8T being negati2e is -.71 % (c) 8rob (-1 i 1.1) 8rob (8T * / i 1.1) 8rob (N8T * / i %.1) 0 - NPV N8T

8rob. (N8T i %.1 : #%%,%%%) 8rob (N8T i #%,%%%) 8rob (N8T i #%,%%%)( 8rob (J i (#%,%%%+ %, #- )* 1 ,!##) ( 8rob (J i + 1.-#) 9rom the normal distribution tables, we ha2e, when S (1.--, the 5robability ( 1 I %.%$%$ (%..,.# when S ( 1.-%, the 5robability ( 1 I %.%$$! ( %..,, /:tra5olating, we get 8rob (S i + 1.-#) ( %..,, )(1.-#+1.-%)(%..,.# I %..,, )*%.%( %..,, ) %.%%#.$ ( %..,! =o the 5robability of -1 i 1.1 is .,.! % 1 . <he e:5ected cash flows of a 5roCect are gi2en below6 Cash 6lo( &s. (-%,%%%) 1%,%%% ,%,%%% , %,%%% # %,%%% 1% ,%%% <he certainty e7ui2alent factor beha2es as 5er the following e7uation 6 t ( 1 I %.%!t 'alculate the net 5resent 2alue of the 5roCect if the ris;+free rate of return is ! 5ercent Solution:
#ertainty '(ui)a ent %actor* +t ,1 - 0.08t #ertainty '(ui)a ent )a ue -iscount %actor at 8. Present /a ue

2ear % 1

"ear

#as$ % o&

0 1 2 3 4 5

+-%%%% 1%%%% ,%%%% %%%% %%%% 1%%%%

1 0.92 0.84 0.76 0.68 0.6

-50000 9200 25200 15200 13600 6000

1 0.925926 0.857339 0.793832 0.73503 0.680583 0P/ ,

-50000 8519 21605 12066 9996 4083 6270

CHAPTER 1& 1 <he latest balance sheet of A&N @imited is gi2en below "ia,ilities /7uity ca5ital 8reference ca5ital &eser2es 4 =ur5lus 3ebentures Wor;ing ca5ital loan 'urrent liabilities 4 8ro2isions ,-%% %% - %% $%% -%% 1-%% 1--%% Assets 9i:ed assets "n2estments 'urrent assets, loans 4 ad2ances 11%%% !%% ,7%%

1--%%

<he target ca5ital structure of A&N has $% 5ercent e7uity, - 5ercent 5reference, and ,5ercent debt. A&NJs 5reference ca5ital has a 5ost+ta: cost of 7 5ercent. A&NJs debentures consist of &s.1%% 5ar, ! 5ercent cou5on 5ayable annually, with a residual maturity of , years. <he mar;et 5rice of these debentures is &s.1%,. Wor;ing ca5ital loan carries an interest rate of 11 5ercent. A&NJs e7uity stoc; is currently selling for &s.1% 5er share. "ts last di2idend was &s.,.%% 5er share and the di2idend 5er share is e:5ected to grow at a rate of 1# 5ercent 5er year in future. A&NJs e7uity beta is 1.-, the ris;+free rate is $ 5ercent, and the mar;et ris; 5remium is ! 5ercent. A&NJs ta: rate is ,, 5ercent (i) What is A&NJs a2erage 5re+ta: cost of debt? (>se the a55ro:imate yield formula) Solution:

! ) (1%%+1%,) * , 7 8re+ta: cost of debenture ( ++++++++++++++++++++++++++++ ( ++++++++ ( $.!!% (%.# : 1%%) ) (%.$ : 1%,) 1%1.! 8re+ta: cost of wor;ing ca5ital loan ( 11% $%% -%% A2erage 5re+ta: cost of debt ( ++++++++ : $.!! ) ++++++++ : 11 ( !..% % -1%% -1%% (ii) What is A&NJs cost of e7uity using the constant growth di2idend discount model?

Solution:

3% ( 1)g) ,.# r/ ( +++++++++++++ ) g ( +++++++ ) %.1# ( 17.,- % 8% 1% (iii) What is A&NJs 5ost ta: weighted a2erage cost of ca5ital? >se the 'A80 to estimate the cost of e7uity and em5loy the weights in the target ca5ital structure. Solution: r/ ( $ ) 1.- : ! ( 1!% rA ( %.$% : 1! ) %.%- : 7 ) %.,- : !..% (1+%.,,) ( 1,. #% ! <he latest balance sheet of 00 @imited is gi2en below "ia,ilities /7uity ca5ital 8reference ca5ital &eser2es 4 =ur5lus 3ebentures Wor;ing ca5ital loan 'urrent liabilities 4 8ro2isions , %% ,%% $!%% 1%% %%% 17%% 1$1%% Assets 9i:ed assets "n2estments 'urrent assets, loans 4 ad2ances 1%-%% 11%% #-%%

1$1%%

<he target ca5ital structure of 00 has $- 5ercent e7uity, - 5ercent 5reference, and ,% 5ercent debt. 00Js 5reference ca5ital has a 5ost+ta: cost of ! 5ercent. 00Js debentures consist of &s.1%% 5ar, . 5ercent cou5on 5ayable annually, with a residual maturity of # years. <he mar;et 5rice of these debentures is &s.1%-. Wor;ing ca5ital loan carries an interest rate of 1% 5ercent. 00Js e7uity stoc; is currently selling for &s..% 5er share. "ts last di2idend was &s. .%% 5er share and the di2idend 5er share is e:5ected to grow at a rate of 1 5ercent 5er year in future. 00Js e7uity beta is 1.%-, the ris;+free rate is 7 5ercent, and the mar;et ris; 5remium is $ 5ercent. 00Js ta: rate is ,% 5ercent (i) What is 00Js a2erage 5re+ta: cost of debt? (>se the a55ro:imate yield formula)

Solution:

8re+ta: cost of debenture . ) (1%% I 1%-) * # %.$ : 1%- ) %.# : 1%% 8re+ta: cost of wor;ing ca5ital loan ( 1%% A2erage 5re+ta: cost of debt 7.- % 1%% #1%% ) 1%% %%% #1%% ( 7.- %

( ,.!- ) #.!! ( !.7, %

(ii) What is 00Js cost of e7uity using the constant growth di2idend discount model ? Solution:

r/

( (

3% (1)g) 8% 1#.#. %

)g

(1.1 ) .%

%.1

(iii) What is 00Js 5ost ta: weighted a2erage cost of ca5ital? >se the 'A80 to estimate the cost of e7uity and em5loy the weights in the target ca5ital structure. Solution: r/ rA ( ( ( ( 7 ) 1.%- ($) %.$- : 1,., !.$#11.$$# ( ) ) 1,.,%% %.%- : ! %.#

) )

%., : !.7, .$1.

,.

<he latest balance sheet of 8hoeni: @imited is gi2en below "ia,ilities /7uity ca5ital 8reference ca5ital &eser2es 4 =ur5lus 3ebentures 'urrent liabilities 4 8ro2isions 1-%% %% %%% 1!%% 1%%% $-%% Assets 9i:ed assets "n2estments 'urrent assets, loans 4 ad2ances #%%% 1%%% 1-%% $-%%

<he target ca5ital structure of 8hoeni: has 7% 5ercent e7uity, - 5ercent 5reference, and 5ercent debt. 8hoeni:Js 5reference ca5ital has a 5ost+ta: cost of . 5ercent. 8hoeni:Js debentures consist of &s.1%% 5ar, ! 5ercent cou5on 5ayable annually, with a residual maturity of - years. <he mar;et 5rice of these debentures is &s.1%-. 8hoeni:Js e7uity stoc; is currently selling at &s.1 - 5er share. "ts last di2idend was &s.,.%% 5er share and the di2idend 5er share is e:5ected to grow at a rate of 1 5ercent 5er year in future. 8hoeni:Js e7uity beta is %.., the ris;+free rate is 7 5ercent, and the mar;et ris; 5remium is 7 5ercent. 8hoeni:Js ta: rate is ,% 5ercent (i) What is 8hoeni:Js 5re+ta: cost of debt? (>se the a55ro:imate yield formula)

Solution: ! ) (1%% I 1%-) * ( $.!%% %.$ : 1%- ) %.# : 1%% (ii) What is 8hoeni:J cost of e7uity using the constant growth di2idend discount model?

Solution: 3% (1 ) g ) r/ ( 8% ) g ( 1 , ( 1.1 ) ) %.1 ( 1#.$.%

(iii) What is 8hoeni:Js 5ost ta: weighted a2erage cost of ca5ital? >se the 'A80 to estimate the cost of e7uity and em5loy the weights in the target ca5ital structure. Solution:

rA #.

r/ ( 7 ) %.. ( 7 ) ( 1,.,% ( %.7% : 1,., ) %.%- : . ) %. - : $.!% ( 1 + %., ) ( ..,1 ) %.#- ) 1.1. ( 1%..- %

Nishant @imitedJs WA'' is 1# 5ercent and its ta: rate is ,, 5ercent. NishantJs 5re+ ta: cost of debt is 1 5ercent and its debt+e7uity ratio is 61. <he ris;+free rate is ! 5ercent and the mar;et ris; 5remium is $ 5ercent. What is the beta of NishantJs e7uity?

Solution: Bi2en6 *, : 1 % : (1 I %.,,) ) 1*, : r ( 1#% where r is the cost of e7uity ca5ital. <herefore r8 (1#+-.,$): , ( -.. % >sing the =0@ e7uation we get6 !% ) $% : ( -.. % =ol2ing this e7uation we get \ ( ... -. Astute 'or5orationJs WA'' is 11 5ercent and its ta: rate is ,$ 5ercent. AstuteJs 5re+ta: cost of debt is 1% 5ercent and its debt+e7uity ratio is 1.-61. <he ris;+free rate is 7 5ercent and the mar;et ris; 5remium is ! 5ercent. What is the beta of AstuteJs e7uity?

Solution: Bi2en6 (1.-* .-) : 1%% : (1 I %.,$) ) (1* .-) : r ( 11 % where r is the cost of e7uity ca5ital. <herefore r8 (11+,.!#) : .- ( 17.. % >sing the =0@ e7uation we get6 7% ) !% : ( 17..% =ol2ing this e7uation we get \ ( 1.,$ $. North =tar @imited has ,% million e7uity shares outstanding. <he boo; 2alue 5er share is &s.$% and the mar;et 5rice 5er share is &s.1!%. North =tar has two debenture issues outstanding. <he first issue has a face 2alue of &s.#%% million, 1, 5ercent cou5on, and sells for .- 5ercent of its face 2alue. "t will mature in $ years. <he second issue has a face 2alue of &s.,%% million, 1 5ercent cou5on, and sells for 1%! 5ercent of its face 2alue. "t will mature in 7 years. North =tar also has a ban; loan of &s.,%% million on which the interest rate is 1# 5ercent. What are North =tarJs ca5ital structure weights on a boo; 2alue basis and on a mar;et 2alue basis? Solution: <he boo; 2alue and mar;et 2alues of the different sources of finance are 5ro2ided in the following table. <he boo; 2alue weights and the mar;et 2alue weights are 5ro2ided within 5arenthesis in the table.

%Rs. in million& Source /7uity 3ebentures I first series 3ebentures I second series ?an; loan <otal 7. 'oo; alue 1!%% (%.$#) #%% (%.1#) ,%% (%.11) ,%% (%.11) !%% (1.%%) /ar;et alue -#%% (%.!#) ,!% (%.%$) , # (%.%-) ,%% (%.%-) $#%# (1.%%)

caihind 'or5oration has 1%% million e7uity shares outstanding. <he boo; 2alue 5er share is &s.1%% and the mar;et 5rice 5er share is &s.$!%. caihind has a debenture issue outstanding with a face 2alue of &s.!%% million. <he cou5on rate for a debenture is 1, 5ercent cou5on, and it sells for !- 5ercent of its face 2alue. "t will mature in # years. caihind also has a ban; loan of &s.$%% million on which the interest rate is 11 5ercent. What are caihindJs ca5ital structure weights on a boo; 2alue basis and on a mar;et 2alue basis?

Solution: <he boo; 2alue and mar;et 2alues of the different sources of finance are 5ro2ided in the following table. <he boo; 2alue weights and the mar;et 2alue weights are 5ro2ided within 5arenthesis in the table. %Rs. in million& Source /7uity 3ebentures ?an; loan <otal !. 'oo; alue 1%,%%% (%.!!) !%% (%.%7) $%% (%.%-) 11,#%% (1.%%) /ar;et alue $!,%%% (%..!) $!%(%.%1) $%% (%.%1) $., !% (1.%%)

9riends Associates manufactures industrial sol2ents. "ts debt+e7uity ratio is -6, "ts WA'' is 1, 5ercent and its ta: rate is ,# 5ercent. a. "f 9riends AssociateJs cost of e7uity is 5ercent, what is its 5re+ta: cost of debt? b. "f 9riends Associates can issue debt at an interest rate of 1% 5ercent, what is its cost of e7uity?

Solution: (a) Bi2en6 rD : (1 I %.,#) : (-*!) ) % : (,*!) ( 1, % rD ( (1, +!. -)*%.#1 - ( 11.-% where rD re5resents the 5re+ta: cost of debt.

..

8ioneer @imitedJs ca5ital structure in terms of mar;et 2alue is6 3ebt &s.,% million /7uity &s..% million <he com5any 5lans to maintain this mar;et+2alue ca5ital structure. <he com5any has a 5lan to in2est &s.1$ million ne:t year. <his will be financed as follows6 &etained earnings Additional e7uity 3ebt &s.$ million &s.$ million &s.# million

<he com5anyJs e7uity stoc; 5resently sells for &s.#% 5er share. <he ne:t di2idend e:5ected is &s.$.%%. <he e:5ected rate of di2idend growth is $ 5ercent. Additional e7uity can be issued at &s.,- 5er share (net). <he interest rate a55licable to additional debt would be as follows6 9irst &s., million Ne:t &s.1 million &e7uired6 (a) At what amounts of new ca5ital will there be brea;s in the marginal cost of ca5ital schedule? (b) What will be the marginal cost of ca5ital in the inter2al between each of the brea;s? Solution: 'ost of e7uity ( D1*-% ) < ( $.%% * #% ) %.%$ ( 1% (a) <he first chun; of financing will com5rise of &s.$ million of retained earnings and , millions of fresh e7uity costing 1 5ercent and &s., million of debt costing 1 (1+.,,) ( !.%# 5er cent <he second chun; of financing will com5rise of &s., million of additional e7uity costing 1 5er cent and &s.1million of debt costing 1#(1+.,,) ( ..,! 5er cent <he marginal cost of ca5ital in the first chun; will be 6 .*1 : 1% ) ,*1 : !.%# % ( 17.7$ % <he marginal cost of ca5ital in the second chun; will be 6 ,*# : 1% ) 1*# : ..,! % ( 1!.1 % Note 6 We ha2e assumed that (i) <he net realisation 5er share will be &s.,-, after floatation costs, and (ii) <he 5lanned in2estment of &s.1$ million is inclusi2e of floatation costs 1 5ercent 1# 5ercent

<he ta: rate for the firm is ,, 5ercent.

1%.

0aha2eer 'ots5inJs ca5ital structure in terms of mar;et 2alue is6 3ebt /7uity &s.-% million &s.7- million

<he com5any 5lans to maintain this mar;et+2alue ca5ital structure. <he com5any has a 5lan to in2est &s.1- million ne:t year. <his will be financed as follows6 &etained earnings Additional e7uity 3ebt &s.#.- million &s.#.- million &s.$ million

<he com5anyJs e7uity stoc; 5resently sells for &s. % 5er share. <he ne:t di2idend e:5ected is &s.#.%%. <he e:5ected rate of di2idend growth is 1% 5ercent. Additional e7uity can be issued at &s.1! 5er share (net). <he interest rate a55licable to additional debt would be as follows6 9irst &s.# million Ne:t &s. million &e7uired6 (a) (b) Solution: 'ost of e7uity ( ( ( D1*-% ) < #.%% * % ) %.1% ,% % At what amounts of new ca5ital will there be brea;s in the marginal cost of ca5ital schedule? What will be the marginal cost of ca5ital in the inter2al between each of the brea;s? 1# 5ercent 1- 5ercent

<he ta: rate for the firm is ,# 5ercent.

(b) <he first chun; of financing will com5rise of &s.#.- million of retained earnings and 1.- millions of fresh e7uity costing ,% 5ercent and &s.# million of debt costing 1# (1+.,#) ( .. # 5er cent <he second chun; of financing will com5rise of &s., million of additional e7uity costing ,% 5er cent and &s. million of debt costing 1-(1+.,#) ( ...% 5er cent <he marginal cost of ca5ital in the first chun; will be 6 $*1% : ,%% ) #*1% : .. # % ( 1.7 % <he marginal cost of ca5ital in the second chun; will be 6 $*1% : ,%% ) #*1% : ...% % ( 1..$ % Note 6 We ha2e assumed that (i) <he net realisation 5er share will be &s.1!, after floatation costs, and (ii) <he 5lanned in2estment of &s.1- million is inclusi2e of floatation costs

11.

0odern @imited has the following boo; 2alue ca5ital structure6 /7uity ca5ital ( - million shares, &s.1% 5ar) 8reference ca5ital, 1% 5ercent (!%%,%%% shares, &s.1%% 5ar) &etained earnings 3ebentures 1# 5ercent ( ,%%%,%%% debentures, &s.1%% 5ar) <erm loans, 1# 5ercent &s. -% million &s. !% million &s. -% million &s. %% million &s. % million &s.!%% million

<he ne:t e:5ected di2idend 5er share is &s.,.%%. <he di2idend 5er share is e:5ected to grow at the rate of 1% 5ercent. <he mar;et 5rice 5er share is &s. $%. 8reference stoc;, redeemable after ! years, is currently selling for &s..% 5er share. 3ebentures, redeemable after - years, are selling for &s.1%- 5er debenture. <he ta: rate for the com5any is ,# 5ercent. (a) 'alculate the a2erage cost of ca5ital using (i) boo; 2alue 5ro5ortions, and (ii) mar;et 2alue 5ro5ortions (b) 3efine the marginal cost of ca5ital schedule for the firm if it raises &s. !% million ne:t year, gi2en the following information6 (i) (ii) (iii) the amount will be raised from e7uity and term loans in e7ual 5ro5ortions the firm e:5ects to retain &s.#% million earnings ne:t year[ the additional issue of e7uity stoc; will fetch a net 5rice 5er share of &s. -%. (i2) the debt ca5ital raised by way of term loans will cost 1 5ercent for the first &s.1%% million and 1, 5ercent for the ne:t &s.#% million. Solution: (a) (i) <he cost of e7uity and retained earnings r* ( D1*-A ) < ( ,.% * $% ) %.1% ( 11.1- % <he cost of 5reference ca5ital, using the a55ro:imate formula, is6 1% ) (1%%+.%)*! r( %.$ : .% ) %.# : 1%% <he 5re+ta: cost of debentures, using the a55ro:imate formula, is 6 1# ) (1%%+1%-)*rD ( ( 1 .$ % ( 11..7 %

%.$:1%- ) %.#:1%% <he 5ost+ta: cost of debentures is 1 .$ (1+ta: rate) ( 1 .$ (1 I %.,#) ( !.,,% <he 5ost+ta: cost of term loans is 1# (1+ta: rate) ( 1# (1 I %.,#) ( .. # % <he a2erage cost of ca5ital using boo; 2alue 5ro5ortions is calculated below 6 Source of capital /7uity ca5ital 8reference ca5ital &etained earnings 3ebentures <erm loans Component Cost (1) 11.1-% 11..7% 11.1-% !.,, % .. # % BooB 4alue Rs. in million ( ) -% !% -% %% % !%% BooB 4alue proportion (,) %.,1 %.1% %.%$ %. %. ! -ro#uct of (1) 4 (,) ,.#$ 1. % %.$7 .%! .-. 1%.% %

A2erage cost of ca5ital

(ii)

<he a2erage cost of ca5ital using mar;et 2alue 5ro5ortions is calculated below6 Source of capital Component cost (1) /7uity ca5ital and retained earnings 8reference ca5ital 3ebentures <erm loans 11.1-% 11..7% !.,,% .. #% MarBet 4alue MarBet 4alue -ro#uct of proportion Rs. in million ( ) (,) (1) 4 (,) $,-%% 7 %.%1 1%%.%, %%.%, 7,%% %.., %.1 %. %. ! A2erage cost of ca5ital 11.% % 1%.,7

(b) <he &s. !% million to be raised will consist of the following6 &etained earnings &s.#% million Additional e7uity &s. 1%% million 3ebt &s. 1#% million <he first batch will consist of &s. #% million each of retained earnings and debt costing 11.1- 5ercent and 1 (1+%.,#)( 7.. 5ercent res5ecti2ely. <he second batch will consist of &s. $% million each of additional e7uity and debt at 11.1- 5ercent and 7.. 5ercent res5ecti2ely. <he third chun; will consist of &s.#% million each of additional e7uity and debt costing 11.1- 5ercent and 1,(1+%.,#) ( !.-! 5ercent res5ecti2ely. <he marginal cost of ca5ital in the chun;s will be as under 9irst batch 6 (%.-:11.1- ) ) (%.- : 7.. ) =econd batch 6 (%.-:11.1- ) ) (%.- : 7.. ) <hird batch 6 (%.-:11.1- ) ) (%.- : !.-!) ( ( ( ..-# % ..-# % ..!7%

<he marginal cost of ca5ital schedule for the firm will be as under. &ange of total financing (&s. in million) % + %% %1+ !% Weighted marginal cost of ca5ital (%) ..-# ..!7

Gere it is assumed that the &s. !% million to be raised is inclusi2e of floatation costs. 1 . 0adhu 'or5oration has the following boo; 2alue ca5ital structure6 /7uity ca5ital (,% million shares, &s.1% 5ar) 8reference ca5ital, 1- 5ercent (1,%%%,%%% shares, &s.1%% 5ar) &etained earnings 3ebentures 11 5ercent ( ,-%%,%%% debentures, &s.1%% 5ar) <erm loans, 1, 5ercent &s.,%% million &s. 1%% million &s. 1%% million &s . -% million &s. ,%% million &s.1%-% million <he ne:t e:5ected di2idend 5er share is &s.#.%%. <he di2idend 5er share is e:5ected to grow at the rate of 1- 5ercent. <he mar;et 5rice 5er share is &s.!%. 8reference stoc;, redeemable after $ years, is currently selling for &s.11% 5er share. 3ebentures, redeemable after $ years, are selling for &s.1% 5er debenture. <he ta: rate for the com5any is ,- 5ercent. (a) 'alculate the a2erage cost of ca5ital using (i) boo; 2alue 5ro5ortions, and

(ii) mar;et 2alue 5ro5ortions (b) 3efine the marginal cost of ca5ital schedule for the firm if it raises &s.#-% million ne:t year, gi2en the following information6 (i) the amount will be raised from e7uity and term loans in the 5ro5ortion 61. (ii) the firm e:5ects to retain &s.!% million earnings ne:t year[ (iii) the additional issue of e7uity stoc; will fetch a net 5rice 5er share of &s.7-. (i2) the debt ca5ital raised by way of term loans will cost 115ercent for the first (2) &s.1%% million and 1 5ercent for amounts thereafter. Solution: (a) (i) <he cost of e7uity and retained earnings r* ( D1*-A ) < ( #.% * !% ) %.1- ( % %

<he cost of 5reference ca5ital, using the a55ro:imate formula, is 6 1- ) (1%%+11%)*$ r( %.$ : 11% ) %.# : 1%% <he 5re+ta: cost of debentures, using the a55ro:imate formula, is 6 11 ) (1%%+1% )*$ rD ( %.$:1% ) %.#:1%% <he 5ost+ta: cost of debentures is 1%.-# (1+ta: rate) ( 1%.-# (1 I %.,-) ( $.!- % <he 5ost+ta: cost of term loans is 1, (1+ta: rate) ( 1, (1 I %.,-) ( !.#- % ( 1%.-# % ( 1 .-! %

<he a2erage cost of ca5ital using boo; 2alue 5ro5ortions is calculated below6 Source of capital Component Cost (1) %.%%% 1 .-! % %.%%% $.!- % !.#-% BooB 4alue BooB 4alue Rs. in million proportion ( ) (,) ,%% 1%% 1%% -% ,%% %. . %.%. %.%. %. # %. . -ro#uct of (1) 4 (,) -.! 1.1, 1.!% 1.$# .#-

/7uity ca5ital 8reference ca5ital &etained earnings 3ebentures <erm loans

1%-%A2erage cost 1 .! % of ca5ital (ii) <he a2erage cost of ca5ital using mar;et 2alue 5ro5ortions is calculated below 6 Source of capital Component cost (1) /7uity ca5ital and retained earnings %.%%% 8reference ca5ital 1 .-!% 3ebentures $.!-% <erm loans !.#-% MarBet 4alue MarBet 4alue -ro#uct of proportion Rs. in million ( ) (,) (1) 4 (,) #%%%.7! 11%%.%# --%.%! ,%%%.1% ,%$1-.$% %. -% %. -%. !A2erage cost of ca5ital 17.-% %

(b)

<he &s.#-% million to be raised will consist of the following6 &etained earnings &s.!% million Additional e7uity &s. % million 3ebt &s. 1-% million <he first batch will consist of &s. !% million of retained earnings and &s.#% million of debt costing % 5ercent and 11(1+%.,-) ( 7.1- 5ercent res5ecti2ely. <he second batch will consist of &s. 1 % million of additional e7uity and &s. $% million of debt at % 5ercent 7.1- 5ercent res5ecti2ely. <he third chun; will consist of &s.1%% million of additional e7uity and &s.-% million of debt costing % 5ercent and 1 (1+ %.,-) ( 7.! 5ercent res5ecti2ely.

<he marginal cost of ca5ital in the chun;s will be as under 9irst batch 6 ( *,): % ) (1*,) : 7.1- ( 1-.7 % =econd batch 6 ( *,): % ) (1*,) : 7.1- ( 1-.7 % <hird batch 6 ( *,): % ) (1*,) :7.! ( 1-..,% <he marginal cost of ca5ital schedule for the firm will be as under. &ange of total financing (&s. in million) % + ,%% ,%1+#-% Weighted marginal cost of ca5ital (%) 1-.7 1-..,

Gere it is assumed that the &s.#-% million to be raised is inclusi2e of floatation costs. 1,. "m5erial "ndustries is currently at its target debt+e7uity ratio of %.! 6 1. "t is considering a 5ro5osal to e:5and ca5acity which is e:5ected to cost &s.$%% million and generate after+ta: cash flows of &s.1-% million 5er year for the ne:t 1% years. <he ta: rate for the firm is ,- 5ercent. Banesh, the '9A of the com5any, has considered two financing o5tions 6 (i) "ssue of e7uity stoc;. <he re7uired return on the com5anyJs new e7uity is - 5ercent and the issuance cost will be 1% 5ercent. (ii) "ssue of debentures at a yield of 1# 5ercent. <he issuance cost will be 5ercent. a. What is the WA'' for "m5erial "ndustries? b. What is "m5erial "ndustriesJs weighted a2erage floatation cost? c. What is the N8T of the 5ro5osal after ta;ing into account the floatation costs? Solution: (a) WA''( #*. : 1#% : (1 I %.,-) ) -*. : -% ( 17..,% ( #*. : % ) -*. : 1%% ( $.## % (c) N8T of the 5ro5osal after ta;ing into account the floatation costs ( ( 1-% : 8T"9A (17..,%, 1%) I $%% * (1 + %.%$##) $7-.7. I $#1.,% ( &s. ,#.#.million

(b)

Weighted a2erage floatation cost

1#.

8an "ndia @imited is currently at its target debt+e7uity ratio of 1.- 6 1. "t is considering a 5ro5osal to e:5and ca5acity which is e:5ected to cost &s.1%%% million and generate after+ta: cash flows of &s. %% million 5er year for the ne:t 1 years. <he ta: rate for the firm is ,, 5ercent. &a2i;iran, the '9A of the com5any, has considered two financing o5tions 6 (i) "ssue of e7uity stoc;. <he re7uired return on the com5anyJs new e7uity is 1. 5ercent and the issuance cost will be 11 5ercent. (ii) "ssue of debentures at a yield of 1 5ercent. <he issuance cost will be 1.5ercent. a. What is the WA'' for 8an "ndia? b. What is 8an "ndiaJs weighted a2erage floatation cost? c. What is the N8T of the 5ro5osal after ta;ing into account the floatation costs?

Solution: (a) (b) WA''( (,*-) : 1 % : (1 I %.,,) ) ( *-) : 1.% ( 1 .# %

Weighted a2erage floatation cost ( ,*- : 1.- % ) *- : 11% ( -., %

(c)

N8T of the 5ro5osal after ta;ing into account the floatation costs ( ( %% : 8T"9A (1 .# %, 1 ) I 1%%% * (1 + %.%-,,) 1 1-.1, I 1%-$.,%( &s. 1-!.!,million

1-.

cawahar Associates, an all+e7uity firm, is e2aluating the following 5roCects6 -ro;ect A ? ' 3 Beta %.# %.! 1., 1.! *Apecte#Return %H& 1 1# 1! #

<he ris;+fee rate is ! 5ercent and the e:5ected mar;et 5remium is 7 5ercent. cawaharJs cost of ca5ital is 1$ 5ercent. Which 5roCects would be acce5ted or reCected incorrectly on the basis of the firmJs cost of ca5ital as a hurdle rate?

Solution: Re+uire# return ,ase# on SM" e+uation %H& 1%.! 1,.$ 17.1 %.$

-ro;ect A ? ' 3

Beta %.# %.! 1., 1.!

*Apecte# return %H& 1 1# 1! #

Bi2en a hurdle rate of 1$% (the firmJs cost of ca5ital), 5roCects A and ? would ha2e been reCected because the e:5ected returns on these 5roCects are below 1$%. 8roCects ' and 3 would be acce5ted because the e:5ected returns on these 5roCects e:ceed 1$%. An a55ro5riate basis for acce5ting or reCecting the 5roCects would be to com5are the e:5ected rate of return and the re7uired rate of return for each 5roCect. ?ased on this com5arison, we find that all the four 5roCects need to be reCected. 1$. Aryan @imited, an all+e7uity firm, is e2aluating the following 5roCects6 -ro;ect 3o. 1 , # Beta %.. 1.1 1. 1.7 *Apecte#Return %H& 1# 1$ 1! -

<he ris;+fee rate is 7 5ercent and the e:5ected mar;et 5remium is . 5ercent. AryanJs cost of ca5ital is 1- 5ercent. Which 5roCects would be acce5ted or reCected incorrectly on the basis of the firmJs cost of ca5ital as a hurdle rate? Solution: &e7uired return ,ase# on SM" e+uation %H& 1-.1 1$.. 17.! ., *Apecte# return %H& 1# 1$ 1! -

-ro;ect 1 , #

Beta %.. 1.1 1. 1.7

Bi2en a hurdle rate of 1-% (the firmJs cost of ca5ital), 5roCect 1 would ha2e been reCected because the e:5ected returns on this 5roCect is below 1-%. 8roCects , ,

and # would be acce5ted because the e:5ected returns on these 5roCects e:ceed 1-%. An a55ro5riate basis for acce5ting or reCecting the 5roCects would be to com5are the e:5ected rate of return and the re7uired rate of return for each 5roCect. ?ased on this com5arison, we find that all the four 5roCects need to be reCected.

CHAPTER 1* 1. 8lastic emulsion for a building costs &s.$%%,%%% and has a life of ! years. 3istem5er 5ainting costs &s. -%,%%% and has a life of # years. Gow does the >A/ of 5lastic emulsion 5ainting com5are with that of distem5er 5ainting if the cost of ca5ital is 1- 5ercent? Solution: /A' (8lastic /mulsion) ( ( ( $%%%%% * 8T"9A (1-%,!) $%%%%% * #.#!7 &s.1,,,7 % -%%%% * 8T"9A (1-%,#) -%%%% * .!-&s.!7,-$$

/A' (3istem5er 8ainting) ( ( (

=ince /A' of distem5er 5ainting is less than that of 5lastic emulsion, it is the 5referred alternati2e. . <he initial outlay on a security system would be &s. ,%%%,%%%. <he o5erating costs are e:5ected to be as follows6 2ear 1 , # 'peratin< Costs %in Rs.& -%%,%%% 7 %,%%% !$%,%%% -,%,%%% #%%,%%%

<he estimated sal2age 2alue at the end of fi2e years is &s.$%%,%%%. What is the >A/ if the cost of ca5ital is 1 5ercent?

Solution: 8T of the net costs associated with the security system ( ( %%% %%% ) -%% %%% : 8T"9 (1 %,1) ) 7 % %%% : 8T"9 (1 %, ) ) !$% %%% : 8T"9 (1 %,,) ) -,% %%% : 8T"9 (1 %,#) ) #%% %%% : 8T"9 (1 %,-) + $%% %%% : 8T"9 (1 %,-) %%% %%% ) -%% %%% : %.!., ) 7 % %%% :%.7.7 ) !$% %%% : %.71 ) -,% %%% : %.$,$ ) #%% %%% : %.-$7 + $%% %%% : %.-$7 ( ,,!-$,,#%

/A' of the security system ( ( ,. ,!-$,#% * 8T"9A (1 %, -) ,!-$,#%* ,.$%- ( 1,%$.,7 %

<he initial outlay for an internal trans5ortation system would be &s..%%,%%%. <he o5erating costs are e:5ected to be as follows6 'peratin< Costs %in Rs.& 1%%,%%% 1! ,%%% , .%,%%% # #%,%%% 1#%,%%% <he estimated sal2age 2alue at the end of fi2e years is &s.1%%,%%%. What is the >A/ if the cost of ca5ital is 1$ 5ercent? 2ear 1

Solution: 8T of the net costs associated with the internal trans5ortation system ( ( .%% %%% ) 1%% %%% : 8T"9 (1$%,1) ) 1! %%% : 8T"9 (1$%, ) ) .% %%% : 8T"9 (1$%,,) ) #% %%% : 8T"9 (1$%,#) ) 1#% %%% : 8T"9 (1$%,-) + 1%% %%% : 8T"9 (1$%,-) .%% %%% ) 1%% %%% : %.!$ ) 1! %%% :%.7#, ) .% %%% : %.$#1 ) #% %%% : %.-) 1#% %%% : %.#7$ + 1%% %%% : %.#7$ ( 1,#-!,!,$

/A' of the internal trans5ortation system ( ( 1,#-!,!,$* 8T"9A (1$%,-) 1,#-!,!,$* ,. 7# ( ##-,-!

#.

Gansen /lectricals is e2aluating a ca5ital 5roCect re7uiring an outlay of &s.1.%% million. "t is e:5ected to generate a net cash inflow of &s.$%% million 5er year for years. <he o55ortunity cost of ca5ital is 1! 5ercent. Gansen /lectricals can raise a term loan of &s.!%% million for the 5roCect, carrying an interest rate of ! 5ercent 5er year 5ayable annually. <he 5rinci5al amount will be re5ayable in # e7ual annual instalments, the first instalment falling due at the end of the second year. <he balance amount re7uired for the 5roCect can be raised by issuing e:ternal e7uity. <he issue cost is e:5ected to be 1% 5ercent. <he effecti2e ta: rate for the com5any is ,% 5ercent (i) What is the ,ase case N8T?

Solution: <he base case NAT ( +1.%% ( +1.%% ( + ,.! (ii) Solution: 11%% ( 1 . 1 I %.1% "ssue cost ( &s. 1 . million AdCusted N8T considering only the issue cost ( + ,.! + 1 . ( + 1#$.% million (iii) Solution: Mear 1 , # 3ebt outstanding at beginning !%% !%% $%% #%% %% "nterest $# $# #! , 1$ <a: shield 1.. 1.. 1#.# ..$ #.! 8T R !% discount rate %.. $ %.!-7 %.7.# %.7,%.$!1 8T 17.7! 1$.#11.#, 7.%$ ,. 7 --... What is the 5resent 2alue of the ta: shield? ) $%% : 8T"9A ) $%% : ,.1 7 (1!%, - yrs)

What is the a#;uste# N8T if the adCustment is made only for the issue cost of e:ternal e7uity?

-.

Alo; A55liances is e2aluating a ca5ital 5roCect re7uiring an outlay of &s.1-%% million. "t is e:5ected to generate a net cash inflow of &s.#%% million 5er year for $ years. <he o55ortunity cost of ca5ital is 1$ 5ercent. Alo; A55liances can raise a term loan of &s..%% million for the 5roCect, carrying an interest rate of 1% 5ercent 5er year 5ayable annually. <he 5rinci5al amount will be re5ayable in - e7ual annual instalments, the first instalment falling due at the end of the first year. <he balance amount re7uired for the 5roCect can be raised by issuing e:ternal e7uity. <he issue cost is e:5ected to be . 5ercent. <he effecti2e ta: rate for Alo; A55liances is ,, 5ercent. (i) What is the ,ase case N8T?

Solution: ?ase case N8T ( +1-%% ) #%% 8T"9A (1$%, $) ( +1-%% ) #%% : ,.$!- ( + $ (ii) Solution: What is the a#;uste# N8T if the adCustment is made only for the issue cost of e:ternal e7uity?

$%% * (1+%.%.) ( $-..,# Additional e7uity to be raised ( -..,# AdCusted N8T for issue cost ( + $ +-..,# ( +!-.,#

(iii) Solution:

What is the 5resent 2alue of the ta: shield?

Mear

3ebt outstanding "nterest <a: shield 8T"9R 1%% 8T of ta: shield at the beginning +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ 1 .%% .% ..7% %..%. 7.%% 7 % 7 ,.7$ %.! $ 1..$, , -#% -# 17.! %.7-1 1,.,! # ,$% ,$ 11.!! %.$!, !.11 1!% 1! -..# %.$ 1 ,.$. ++++++++ 71.!1

$.

0itra 'hemicals is e2aluating a ca5ital 5roCect re7uiring an outlay of &s.1!%% million. "t is e:5ected to generate a net cash inflow of &s.-%% million 5er year for $ years. <he o55ortunity cost of ca5ital is 1- 5ercent. 0itra 'hemicals can raise a term loan of &s.!%% million for the 5roCect. <he term loan will carry an interest of . 5ercent 5er year 5ayable annually. <he 5rinci5al amount will be re5ayable in # e7ual annual instalments, the first instalment falling due at the end of the second year. <he balance amount re7uired for the 5roCect can be raised by issuing e:ternal e7uity. <he issue cost is e:5ected to be 7 5ercent. <he effecti2e ta: rate for the com5any is ,% 5ercent (i) Solution: +1!%% ) -%% : 8T"9A ( 1- %, $ yrs) ( + 1!%% ) -%% : ,.7!# ( + . (ii) What is the a#;uste# N8T if the adCustment is made only for the issue cost of e:ternal e7uity? 1,%%% ( 1%7- ., 1 I %.%7 "ssue cost ( &s.7-., million AdCusted N8T considering only the issue cost ( + . I 7-., ( + 1$7., million (iii) What is the 5resent 2alue of the ta: shield? What is the ,ase case N8T?

Solution:

Solution: Mea r 1 , # 3ebt outstanding at beginning !%% !%% $%% #%% %% "nterest 7 7 -# ,$ 1! <a: shield 1.$ 1.$ 1$. 1%.! -.# 8T R . % discount rate %..17 %.!# %.77 %.7%! %.$-% 8T 1..!1 1!.1. 1 .-1 7.$,.-1 $1.$7

CHAPTER 12 1. ?earings @imited recei2ed a subscri5tion for ,.%,%%% shares as against -%%,%%% shares that were offered and fully underwritten. <he underwritten commitments of - underwriters 8, K, R, S, and < are as under6 Ln#er(ritin< commitment .%,%%% P K !%,%%% R 1%%,%%% S 1,%,%%% 0 1%%,%%% 3etermine the liability of each underwriter. Solution: Ln#er(ritin< commitment K R S < . .%,%%% !%,%%% 1%%,%%% 1,%,%%% 1%%,%%% Shares procure# 7%,%%% 7%,%%% !-,%%% 11-,%%% 1 %,%%% *Acess> shortfall ( %,%%%) (1%,%%%) (1-,%%%) (1-,%%%) %,%%% Cre#it #-%% #%%% -%%% $-%% 3et shortfall (1-,-%%) ($,%%%) (1%,%%%) ( !,-%%) Shares procure# 7%,%%% 7%,%%% !-,%%% 11-,%%% 1 %,%%%

Welcome "ndustries recei2ed a subscri5tion for !-%,%%% shares as against 1,%%%,%%% shares that were offered and fully underwritten. <he underwritten commitments of # underwriters 0, N , A and 8 are as under6 Ln#er(ritin< commitment %%,%%% 1 3 ,%%,%%% ' #%%,%%% 1%%,%%% 3etermine the liability of each underwriter. Shares procure# 1$%,%%% %,%%% ,#-,%%% 1 -,%%%

Solution: Ln#er(ritin< commitment M 3 ' ,. %%,%%% ,%%,%%% #%%,%%% 1%%,%%% Shares procure# 1$%,%%% %,%%% ,#-,%%% 1 -,%%% *Acess> shortfall (#%,%%%) (!%,%%%) (--,%%%) -,%%% Cre#it ---$ !,,, 11111 3et shortfall (,#,###) (71,$$7) (#,,!!.)

<he e7uity stoc; of 8aramount 'or5oration is selling for &s. #% 5er share. <he firm is 5lanning to issue rights shares in the ratio of one right share for e2ery e:isting four shares6 (a) (b) (c) What is the theoretical 2alue of a right if the subscri5tion 5rice is &s. %? What is the e:+rights 2alue 5er share if the subscri5tion 5rice is &s. 1%? What is the theoretical 2alue 5er share when the stoc; goes e:+rights, if the subscri5tion 5rice is &s. #%? &s. %%? -o ( &s. #% a. -o 9 S ( 311 3-o 1 S ( 3)1 c. #)1 # : #% ) #% ( &s. #% #)1 # : #% ) 1%% ( &s. 1 #)1 #)1 # : #% ) 1% ( &s. ,# #% I 3(# % ( &s.#

Solution: <he theoretical 2alue of a right if the subscri5tion 5rice is &s. %

b. <he e:+rights 2alue 5er share if the subscri5tion 5rice is &s. 1%

<he theoretical 2alue 5er share, e:+rights, if the subscri5tion 5rice is &s. #%? 1%%?

#.

<he e7uity stoc; of 8ara;ram @imited is selling for &s.!$% 5er share. <he firm is 5lanning to issue rights shares in the ratio of one right share for e2ery e:isting three shares6 (a) (b) (c) What is the theoretical 2alue of a right if the subscri5tion 5rice is &s.!%% ? What is the e:+rights 2alue 5er share if the subscri5tion 5rice is &s.! % ? What is the theoretical 2alue 5er share when the stoc; goes e:+rights, if the subscri5tion 5rice is &s.!$%? &s.7%%? -o ( &s.!$% a. 3(,

Solution:

<he theoretical 2alue of a right if the subscri5tion 5rice is &s.!%% -o 9 S ( 311 ,)1 , : !$% ) ! % ( 3)1 ,)1 , : !$% ) !$% ( &s.!$% ,)1 ,: !$% ) 7%% ( &s.! % ,)1 ( &s.!-% !$% I !%% ( &s.1-

b.

<he e:+rights 2alue 5er share if the subscri5tion 5rice is &s.! % 3-o 1 S

c. <he theoretical 2alue 5er share, e:+rights, if the subscri5tion 5rice is &s.!$%? 7%%?

CHAPTER 13 1. Ad2aith 'or5oration has a net o5erating income of &s.-% million. Ad2aith em5loys &s. %% million of debt ca5ital carrying 1 5ercent interest charge. <he e7uity ca5italisation rate a55licable to Ad2aith is 1# 5ercent. What is the mar;et 2alue of Ad2aith under the net income method? Assume there is no ta:.

Solution: Net o5erating income %'& "nterest on debt (/& /7uity earnings (-& 'ost of e7uity (r*& 'ost of debt (rD) 0ar;et 2alue of e7uity (*) 0ar;et 2alue of debt (D& 0ar;et 2alue of the firm %D) 6 6 6 6 6 6 6 6 &s.-% million &s. # million &s. $ million 1# % 1 % &s. $ million*%.1# (&s.1!-.7 million &s. # million*%.1 (&s. %% million &s.,!-.7 million

Oanish; @imited has a net o5erating income of &s.1%% million. Oanish; em5loys &s.!%% million of debt ca5ital carrying 1% 5ercent interest charge. <he e7uity ca5italisation rate a55licable to Oanish; is 1, 5ercent. What is the mar;et 2alue of Oanish; under the net income method? Assume there is no ta:.

Solution: Net o5erating income %'& "nterest on debt (/& /7uity earnings (-& 'ost of e7uity (r*& 'ost of debt (rD) 0ar;et 2alue of e7uity (*) 0ar;et 2alue of debt (D& 0ar;et 2alue of the firm %D) ,. 6 6 6 6 6 6 6 6 &s.1%% million &s.!% million &s. % million 1, % 1% % &s. % million*%.1, (&s.1-,.! million &s.!% million*%.1% (&s.!%% million &s..-,.! million

<he following information is a2ailable for two firms, Anil 'or5oration and =unil 'or5oration. Anil =unil Net o5erating income "nterest on debt 'ost of e7uity 'ost of debt &s.,, %%,%%%&s.,, %%,%%% Nil 1$ % 1 % #!%,%%% 1$% 1 %

'alculate the mar;et 2alue of e7uity, mar;et 2alue of debt, and mar;et 2alue of the firm for Anil 'or5oration and =unil 'or5oration. (a) (b) (c) What is the a2erage cost of ca5ital for each of the firms? What ha55ens to the a2erage cost of ca5ital of Anil 'or5oration if it em5loys &s.-% million of debt to finance a 5roCect that yields an o5erating income of &s.- million? What ha55ens to the a2erage cost of ca5ital of =unil 'or5oration if it sells &s.# million of additional e7uity (at 5ar) to retire &s.# million of outstanding debt?

"n answering the abo2e 7uestions assume that the net income a55roach a55lies and there are no ta:es. Solution: Anil =unil 0ar;et 2alue of e7uity,, %%,%%%*%.1$,, %%,%%%*%.1$ ( &s. % million ( &s. % million 0ar;et 2alue of debt % #!%,%%%*%.1 (&s.# million 0ar;et 2alue of the firm &s. %million # million

(a)

A2erage cost of ca5ital for Anil 'or5oration % : 1$% ) % % % :1 % ( 1$ %

A2erage cost of ca5ital for =unil 'or5oration % : 1$% ) # (b) # # : 1 % ( 1-.,, %

"f Anil 'or5oration em5loys &s.-% million of debt to finance a 5roCect that yields &s.- million net o5erating income, its financials will be as follows. Net o5erating income "nterest on debt /7uity earnings 'ost of e7uity 'ost of debt 0ar;et 2alue of e7uity 0ar;et 2alue of debt 0ar;et 2alue of the firm A2erage cost of ca5ital 1,.71$% -% : $,.7$,.7) 1 % : ( 1 .!$ % &s.!, %%,%%% &s.$,%%%,%%% &s. , %%,%%% 1$% 1 % &s.1,.7-million &s.-% million &s.$,.7- million

(c)

"f =unil 'or5oration sells &s.# million of additional e7uity to retire &s.# million of debt , it will become an all+e7uity com5any. =o its a2erage cost of ca5ital will sim5ly be e7ual to its cost of e7uity, which is 1$%.

#.

<he management of canata 'om5any, subscribing to the net o5erating income a55roach, belie2es that its cost of debt and o2erall cost of ca5ital will remain at 7 5ercent and 1# 5ercent, res5ecti2ely. "f the e7uity shareholders of the firm demand a return of - 5ercent, what should be the 5ro5ortion of debt and e7uity in the firmJs ca5ital structure? Assume that there are no ta:es.

Solution: r* ( rA ) (rA:rD&D>* ( 1# ) (1#+7) D>* =o, D>* ( 1.-7

-.

<he management of @a2anya 'or5oration, subscribing to the net o5erating income a55roach, belie2es that its cost of debt and o2erall cost of ca5ital will remain at 1% 5ercent and 1$ 5ercent, res5ecti2ely. "f the e7uity shareholders of the firm demand a return of 5ercent, what should be the 5ro5ortion of debt and e7uity in the firmJs ca5ital structure? Assume that there are no ta:es.

Solution: ( rA ) (rA:rD&D>* ( 1$ ) (1$+1%) D>* =o D>* ( 1.% $. <he management of a firm belie2es that the cost of e7uity and debt for different 5ro5ortions of e7uity and debt in the ca5ital structure are as follows -roportion of *+uity 1.%% %..% %.!% %.7% %.$% %.-% %.#% %.,% %. % %.1% -roportion of De,t %.%% %.1% %. % %.,% %.#% %.-% %.$% %.7% %.!% %..% Cost of *+uity, r*H 1-.% 1$.% 1$.17.% 17.1!.% 1!.1..% 1..%.% Cost of De,t, rDH 7.% 7.!.% !...% ..1%.% 11.% 1 .% 1#.% r*

What is the o5timal ca5ital structure of the firm? Solution: * D1* D D1* r* (%) rD (%) rA ( * r* ) D)* D rD D)*

1.%% %..% %.!% %.7% %.$% %.-% %.#% %.,%

%.%% %.1% %. % %.,% %.#% %.-% %.$% %.7%

1-.% 1$.% 1$.17.% 17.1!.% 1!.1..%

7.% 7.!.% !...% ..1%.% 11.%

1-.%

%.1% %..% 1-.1- %.% 1#.% 1#.! 1#.#1#.1% 1,.71,.#% 1,.#%

1#.$% <he debt ratios %.$% or %.7%

%. % %.!% 1..1 .% 1,.-% minimises the WA'' . <he o5timal ratio is %.$% as the firmJs financial fle:ibility in that case is more. 7. <he following information is a2ailable on Tidyut 'or5oration. Net o5erating income <a: rate 3ebt ca5ital "nterest rate on debt ca5ital 'a5italisation rate a55licable to debt+free 9irm in the ris; class to which Tidyut 'or5oration belongs ( 1# 5ercent What should be the 2alue of Tidyut 'or5oration .according to 0odigliani and 0iller? Solution: <he 2alue of Tidyut 'or5oration.according to 0odigliani and 0iller hy5othesis is /:5ected o5erating income ( 3iscount rate a55licable to the ris; class to which Tidyut 'or5oration.belongs %.1# 1%% ( &s.71# million ( &s.1%% million ( ,- 5ercent ( &s. -% million ( &s.1 5ercent

!.

<he following information is a2ailable on 0agnificent 'or5oration. Net o5erating income <a: rate 3ebt ca5ital "nterest rate on debt ca5ital 'a5italisation rate a55licable to debt+free 9irm in the ris; class to which 0agnificent 'or5oration. belongs ( 1- 5ercent What should be the 2alue of 0agnificent 'or5oration, according to 0odigliani and 0iller? ( &s.!% million ( ,, 5ercent ( &s.1-% million ( &s.1# 5ercent

Solution: <he 2alue of 0agnificent 'or5oration, according to 0odigliani and 0iller hy5othesis is /:5ected o5erating income !% ( ( &s.-,, million 3iscount rate a55licable to the %.1ris; class to which 0agnificent 'or5oration..belongs .. "f tc ( ,%%, tpe ( 1%%, and tp# ( %%, what is the ta: ad2antage of a ru5ee of debt?

Solution: (1+tc) (1 I tpc) 1+ (1 + tp#) ( 1+ (1 I %. %) ( %. 1 or 1 5aise (1+%.,) (1+%.1%)

1%.

"f tc ( ,-%, tpe ( 1%%, and tp# ( - %, what is the ta: ad2antage of a ru5ee of debt?

Solution: (1+tc) (1 I tpc) 1+ (1 + tp#) ( %. CHAPTER 2( 1. <he 5rofit and loss account for the year 1 (the year that has Cust ended) and the balance sheet at the end of year 1 for &ed &oc; @imited are as follows. -rofit an# "oss Account =ales 8?"< "nterest 8?< <a: (tc ( ,%%) 8A< 3i2idends (&s. , 5er share) &etained /arnings (i) Solution: U &A" ) ( &A" + r) 3 * / V ( 1 + tc ) U &A" ) ( &A" + ! ) * , V ( 1 + %.,) &A" ( ( ( %% %% % .,#%. &s.in crore - % !$ 1$ 7% 1 #. 1! ,1 Balance Sheet =ources of 9unds &s. in crore =hareholdersJ 9unds ,%% 8aid u5 ca5ital 6 $% (/7uity shares of 5ar 2alue &s.1%) &eser2es and =ur5lus6 #% @oan 9unds A55lication of 9unds Net fi:ed assets Net current assets %% -%% ,-% 1-% or ( 1+ (1 I %. -) 5aise (1+%.,-) (1+%.1%)

What should ha2e been the &A" of &ed &oc; @imited for it to meet its target &A/ of % 5ercent? Note that the 5re+ta: cost of debt is ! 5ercent.

(ii)

&ed &oc; @imited re7uires &s. %% crore of e:ternal financing for which it is considering two alternati2es6 Alternati2e A 6 "ssue of 1.$ crore e7uity shares of &s 1% 5ar at &s. 1 - each$ Alternati2e ? 6 "ssue of &s. %% crore of debentures carrying ! 5ercent interest rate. What is the /8=+/?"< indifference 5oint?

Solution:

( /?"< I 1$) ( 1 I %., ) /8=A ( 7.$ ( /?"< + , ) ( 1 + %., ) /8=? ( $ /7uating /8=A and /8=? gi2es /?"< ( &s. . crore. . <he 5rofit and loss account for year 1 (the year which has Cust ended) and the balance sheet at the end of year 1 for Blendale are as follows6 Balance Sheet Sources of 6un#s N =hareholdersJ 9unds -rofit an# "oss Account Rs in crore =ales -%% 8?"< !% "nterest 1% 8?< <a: (tc(,%%) 8A< 3i2idends (&s., 5er share) &etained earnings 7% 1 #. 1! ,1

Rs. in crore $%

8aid u5 ca5ital 6 $% (/7uity shares of &s.1% 5ar) &eser2es 4 sur5lus 6 %% N @oan 9unds Application of 6un#s N Net 9i:ed Assets N Net 'urrent Assets 1%% ,$% -% 11% ,$%

(i)

What should ha2e been the &A" of Blendale 'om5any to meet a target &A/ of - 5ercent? Note that the 5re+ta: cost of debt is 1% 5ercent

Solution: U&A" ) (&A" I r) 3*/V (1 I tc) ( -% U&A" ) (&A" I .1%) %.,!-V (1 I %.,) ( -% &A" ( !.-7% (ii) Blendale 'om5any re7uires &s.-% crore of e:ternal financing for which it is considering two alternati2es6 Alternati2e A 6 "ssue of %.# crore shares at &s.1 - each$ Alternati2e ? 6 "ssue of &s.-% crore of debentures carrying 1% 5ercent interest rate.

What is the /8=+/?"< indifference 5oint? Solution:

(/?"< I 1%) (1 I %.,) /8=A ( $.# (/?"< I 1-) (1 I %.,) /8=? ( $ /7uating /8=A and /8=? gi2es %.7 /?"< I 7 ( $.# /?"< ( &s..% crore ,. A com5anyJs 5resent ca5ital structure contains #,%%%,%%% e7uity shares and 1%%,%%% 5reference shares. <he firmJs current /?"< is &s. - million. 8reference shares carry a di2idend of &s., 5er share. <he earnings 5er share is &s.#. <he firm is 5lanning to raise &s.#% million of e:ternal financing. <wo financing alternati2es are being considered6 (i) issuing #,%%%,%%% e7uity shares for &s.1% each, (ii) issuing debentures for &s.#% million carrying 1 5ercent interest. &e7uired (a) 'om5ute the /8=+/?"< indifference 5oint. (b) 3efine the alternati2e which ma:imises /8= for 2arious le2els of /?"<. $.% %.7 /?"< I 1%.-

Solution: 'urrently No. of shares *B/0 "nterest 8reference di2idend *-S *-S 8 No. of shares ( -,%%%,%%% I % ) (1+t& I ,%%,%%% # ( #,%%%,%%% Gence t ( %.,#! or ,#.! 5er cent <he *-S under the two financing 5lans is 6 -inancing Plan A 6 "ssue of #,%%%,%%% shares (*B/0 + % ) ( 1 I %.,#!) + ,%%,%%% *-SA ( !,%%%,%%% -inancing Plan ' 6 "ssue of &s.1% million debentures carrying 1- 5er cent interest (*B/0 I #,!%%,%%%) (1+%.,#!) I ,%%,%%% *-SB ( #,%%%,%%% <he *-S 9 *B/0 indifference 5oint can be obtained by e7uating *-SA and *-SB (*B/0 I % ) (1 I %.,#!) I ,%%,%%% ( !,%%%,%%% (*B/0 I #,!%%,%%%) (1 I %.,#!) I ,%%,%%% #,%%%,%%% (a) ( #,%%%,%%% ( &s - million ( % ( &s., : 1%%,%%% ( &s.%., million ( &s.#

%*B/0 I "nterest) (1:t& I 8reference di2idend

%.$- /?"< +,%%,%%% ( (%.$- /?"<+,,1 .,$%% +,%%,%%%) %.$- /?"< ( $,--., %% or /?"< ( 1%,%$%,1 , (b) As long as *B/0 is less than &s.1%,%$%,1 , e7uity financing ma:imises *-S. When *B/0 e:ceeds &s. 1%,%$%,1 , debt financing ma:imises *-S.

#.

?B0 @imitedJs 5resent ca5ital structure consists of % million e7uity shares of &s.1% each. "t re7uires &s.$% million of e:ternal financing. "t is considering two alternati2es6 Alternati2e 1 6 "ssue of , million e7uity shares of &s.1% 5ar at &s.1- each and 1.- million 5reference shares of &s.1% 5ar, carrying a di2idend rate of 1% 5ercent. Alternati2e 6 "ssue of million e7uity shares of &s.1% 5ar at &s.1- each and debentures for &s.,% million carrying an interest rate of 11 5ercent

<he com5anyJs ta: rate is ,- 5ercent? What is the /8=+8?"< indifference 5oint? Solution: Alternati2e 1 /8= ( ( 8?"< I %) (1 I %.,-) I 1.,

Alternati2e /8= ( ( 8?"< I ,.,) (1 I %.,-) ( %.$- 8?"< I .1#-

%.$- 8?"< I 1., 1#., 8?"< I ,, %.$- 8?"< 8?"< -.

( 1#..- 8?"< I #..,,( 1$.,,( -.1,

Oeerthinath 'or5oration 5resently has two million outstanding e7uity shares (&s.1% 5ar) selling at &s.11 5er share and no outstanding debt . "t needs &s.! million of additional funds which can be raised in two ways6 (a) (b) issue of %.! million e7uity shares at &s.1% 5er share, issue of debt ca5ital carrying 1# 5ercent interest.

<he e:5ected earnings before interest and ta:es after the new funds are raised will be &s.$ million 5er year with a standard de2iation of &s. million. Oeerthinath 'or5orationJs ta: rate is ,- 5ercent. What is the 5robability that the debt alternati2e is better than the e7uity alternati2e with res5ect to earnings 5er share

Solution: 8lan A 6 "ssue %.! million e7uity shares at &s. 1% 5er share. 8lan ? 6 "ssue &s.! million of debt carrying interest rate of 1# 5er cent. (*B/0 I % ) (1 I %.,-) *-SA *-SB ( ,!%%,%%% (/?"< I 1,1 %,%%%) (1 I %.,-) ( ,%%%,%%% /7uating *-SA and *-SB, we get (*B/0 I % ) (1 I %.,-) ( ,!%%,%%% ,%%%,%%% 1.! *B/0 : .%,!# ( 1., *B/0 or *B/0 8 ,.. million <hus the debt alternati2e is better than the e7uity alternati2e when *B/0 i ,.. million *B/0 9 *B/0 ,.. I $.%%% 8rob(*B/0i,,. %,%%%) ( 8rob i *B/0 .%%% ( 8rob UM i + 1.%#V 9rom the tables we ha2e when P ( +1.%%, the 5robability is ( 1+%.1-!7 ( %.!#1, when P ( +1.%-, the 5robability is ( 1+%.1#$. ( %.!-,1 ?y e:tra5olation we ha2e 8rob UM i + .%!V ( %.!#1, ) (1.%# +1)(%.!-,1 +%.!#1,)*%.%( %.!-%7 or !-.%7 5ercent. $. "nno2ation @imited 5resently has 1% million outstanding e7uity shares (&s.1% 5ar) selling at &s.11 5er share and no outstanding debt. "t needs &s.$% million of additional funds which can be raised in two ways6 (a) (b) issue of $ million e7uity shares at &s.1% 5er share, issue of debt ca5ital carrying 11 5ercent interest. (*B/0 I 1,1 %,%%%) (1 I %.,-)

<he e:5ected earnings before interest and ta:es after the new funds are raised will be &s.1$ million 5er year with a standard de2iation of &s.! million. "nno2ation @imited ta: rate is ,, 5ercent. What is the 5robability that the debt alternati2e is better than the e7uity alternati2e with res5ect to earnings 5er share. Solution: 8lan A 6 "ssue $ million e7uity shares at &s. 1% 5er share. 8lan ? 6 "ssue &s.$% million of debt carrying interest rate of 11 5er cent. (*B/0 I % ) (1 I %.,,) *-SA *-SB ( 1$,%%%,%%% (/?"< I $,$%%,%%%) (1 I %.,,) ( 1%,%%%,%%% /7uating *-SA and *-SB , we get (*B/0 I % ) (1 I %.,,) ( 1$,%%%,%%% 1%,%%%,%%% 1%.7 *B/0 :7%.7- ( $.7 *B/0 or *B/0 8 17.$ million <hus the debt alternati2e is better than the e7uity alternati2e when *B/0 i 17.$ million *B/0 9 *B/0 17.$ I 1$.% 8rob(*B/0i17,$%%,%%%) ( 8rob i *B/0 ! ( 8rob UM i %. V ( %.# %7 or # .%7 % 7. Gurricane <rans5ort has an a2erage cost of 1% 5ercent for debt financing. <he financial le2erage ratio is %.! and the &A" is 1- 5ercent. What is the &A/ for the com5any, if its ta: rate is #% 5ercent? (*B/0 I $,$%%,%%%) (1 I %.,,)

Solution: R'* ( U1- ) (1- I 1% ) %.! V (1 I %.#) ( 11.# %

!.

Nanda /nter5rises has a target &A/ of % 5ercent. <he financial le2erage ratio for the firm is %.$ and its ta: rate is ,, 5ercent. What &A" should the com5any 5lan to earn? <he cost of debt is 1# 5ercent.

Solution: % ( N R'/ 1 % R'/ I 1# ) %.$ V ( 1 I %.,,) ( %.$7 &A" )%.#% &A" I -.$ ! 1.%7 &A" ( -.$ ! &A" ( ,..1 % .. <he following information is a2ailable about /:calibur @imited. 3e5reciation /?"< "nterest on debt <a: rate @oan re5ayment instalment &s.- million &s.,- million &s.7 million ,- 5ercent &s.#.% million

&e7uired6 (a) 'alculate the interest co2erage ratio. (b) 'alculate the cash flow co2erage ratio. Solution: /?"< a. "nterest co2erage ratio ( "nterest on debt ,( 7 ( -.% *B/0 ) 3e5reciation b. 'ash flow co2erage ratio ( @oan re5ayment instalment "nt.on debt ) (1 I <a: rate) ( ,- ) ( ,.%# 7 ) #*%.$-

1%.

<he following information is a2ailable about Notting Gill 'or5oration. 3e5reciation /?"< "nterest on debt &s.,% million &s.1 - million &s.- million

<a: rate @oan re5ayment instalment

,, 5ercent &s. %.% million

&e7uired6 (a) 'alculate the interest co2erage ratio. (b) 'alculate the cash flow co2erage ratio. Solution: /?"< a. "nterest co2erage ratio ( "nterest on debt 1 ( ( b. 'ash flow co2erage ratio ( @oan re5ayment instalment "nt.on debt ) (1 I <a: rate) ( 1 - ) ,% ( 1.!. - ) %*%.$7 11. <he following 5roCections are a2ailable for Aristocrats @imited6 Rs. in million 2ear 1 2ear 2 2ear 3 2ear . 2ear 5 8rofit after ta: +,.% 1,.% #.%% !.%% -.%% 3e5reciation 1-.% 11. !.#, $.,, #.7"nterest on term loan 1#.%% 1#.%% 1#.% 11. % !.# <erm loan re5ayment + + %.%% %.%% %.%% instalment &e7uired6 'alculate the debt ser2ice co2erage ratio. Solution: <he debt ser2ice co2erage ratio for Aristocrats @imited is gi2en by6 ( -A0 i 1 Depi 1 /nti) i(1 DSCR ( ( /nti 1 "R/i& i(1 .#% *B/0 ) 3e5reciation

( ( ( 1 .

!7.%% ) #-.7$ ) $1.$ $1.$ ) $% 1.#.,$ 1 1.$ 1.$%

<he following 5roCections are a2ailable for Ascar 'or5oration. Rs. in million 2ear 1 2ear 2 2ear 3 2ear . 2ear 5 8rofit after ta: +#.% +1.% ,-.%% !%.%% 1%%.%% 3e5reciation %% 1$% 1 ! 1% .# !1.. "nterest on term loan .1.%% .1.%% 7!.% $-.% - .% <erm loan re5ayment + 1%%.%% 1%%.%% 1%%.%% 1%%.%% instalment &e7uired6 'alculate the debt ser2ice co2erage ratio.

Solution: <he debt ser2ice co2erage ratio for Ascar 'or5oration is gi2en by 6 ( -A0 i 1 Depi 1 /nti) i(1 DSCR ( ( /nti 1 "R/i& i(1 ( 1% ) $7 ., ) ,77 ,77 ) #%% ( ( 1,. 1 -.., 777 1.$

caisurya Associates is embar;ing on an e:5ansion 5lan re7uiring an outlay of &s.!%% million. <he management of the firm is con2inced that debt is a chea5er source of finance and is confident that it can raise the entire amount by debt finance (5er5etual) at a rate of 1 5ercent. Gowe2er, there is some a55rehension about the firmJs ability to meet interest burden during a recessionary year. <he management feels that in a recessionary year, the net cash flows of the com5any, not ta;ing into account the interest burden on the new debt, would ha2e an e:5ected 2alue of &s. %% million with a standard de2iation of &s.!% million. &e7uired6 (a) What is the 5robability of cash inade7uacy during a recessionary year , if the entire &s.!%% million are raised as debt finance?

(b) "f the management is 5re5ared to acce5t only a # 5ercent chance of cash inade7uacy, what 5ro5ortion of &s.!%% million re7uirement should be raised as debt finance? Solution: (a) "f the entire outlay of &s. !%% million is raised by way of debt carrying 1 5er cent interest, the interest burden will be &s. .$ million.

'onsidering the interest burden the net cash flows of the firm during a recessionary year will ha2e an e:5ected 2alue of &s. 1%# million (&s. %% million + &s. .$ million ) and a standard de2iation of &s. !% million . =ince the net cash flow ( ) is distributed normally I 1%# !% has a standard normal de2iation 'ash flow inade7uacy means that 8rob( h%) ( 8rob (Mh+ 1.,) ( %.%.$! (b) =ince ( &s. %% million, ( &s.!% million , and the J 2alue corres5onding to the ris; tolerance limit of # 5er cent is I1.7- , the cash a2ailable from the o5erations to ser2ice the debt is e7ual to which is defined as 6 I %% ( + 1.7!% ( &s.$% million Bi2en 1- 5er cent interest rate, the debt that be ser2iced is $% ( &s. -%% million %.1 1#. 0edicon @imited is embar;ing on an e:5ansion 5lan re7uiring an outlay of &s.$%% million. <he management of the firm is con2inced that debt is a chea5er source of finance and is confident that it can raise the entire amount by debt finance (5er5etual) at a rate of 1% 5ercent. Gowe2er, there is some a55rehension about the firmJs ability to meet interest burden during a recessionary year. <he management feels that in a recessionary year, the net cash flows of the com5any, not ta;ing into account the interest burden on the new debt, would ha2e an e:5ected 2alue of &s.1-% million with a standard de2iation of &s.#- million. is less than %.

&e7uired6 (a) What is the 5robability of cash inade7uacy during a recessionary year, if the entire &s.$%% million are raised as debt finance? (b) "f the management is 5re5ared to acce5t only a 1 5ercent chance of cash inade7uacy, what 5ro5ortion of &s.$%% million re7uirement should be raised as debt finance ? Solution: (a) "f the entire outlay of &s. $%% million is raised by way of debt carrying 1% 5er cent interest, the interest burden will be &s. $% million. 'onsidering the interest burden, the net cash flows of the firm during a recessionary year will ha2e an e:5ected 2alue of &s. .% million (&s.1-% million + &s. $% million ) and a standard de2iation of &s. #- million . =ince the net cash flow ( ) is distributed normally I .% #has a standard normal de2iation 'ash flow inade7uacy means that 8rob( h%) ( 8rob (Mh+ .%) ( %.% ! (c) =ince ( &s.1-% million, ( &s.#- million , and the J 2alue corres5onding to the ris; tolerance limit of 1 5er cent is I .,% (a55ro:imately) , the cash a2ailable from the o5erations to ser2ice the debt is e7ual to which is defined as 6 I 1-% ( + .,% #( &s.#$.- million Bi2en 1% 5er cent interest rate, the debt than be ser2iced is #$.( &s. #$- million %.1% CHAPTER 21 1. <he following data is a2ailable for Newton @imited6 /arnings 5er share ( &s.$.%% &ate of return ( 1! 5ercent is less than %.

'ost of ca5ital ( 1- 5ercent (a) "f WalterJs 2aluation formula holds, what will be the 5rice 5er share when the di2idend 5ayout ratio is ,% 5ercent? #% 5ercent? (b) "f BordonFs basic 2aluation formula holds, what will be the 5rice 5er share when the di2idend 5ayout is ,% 5ercent, #% 5ercent? Solution: (a) -ayout ratio %., %.1( &s. #-.$% %.1$(%.#%))$(%.$) %.#% %.1(b) 3i2idend 5ayout ratio ,% % #%% . 8rice as 5er Bordon model 8% (/1(1+b)*(;+br) ( $ : %.7%*(%.1- + %.7%: %.1!) ( $ : %.$%*(%.1- + %.$%: %.1!) (&s. 17(&s.!-.7 %.1! %.1( &s. ##.!% -rice per share $(%.,))$(%.7) : %.1!

<he stoc;s of firms A and B are considered to be e7ually ris;y. "n2estors e:5ect the share of firm A I the firm which does not 5lan to 5ay di2idend ++ to be worth &s 1%% ne:t year. 9rom the share of firm B, too, in2estors e:5ect a 5ay off of &s 1%% I &s 1% by way of di2idend and &s .% by way of share 5rice a year from now. 3i2idends are ta:ed at - 5ercent and ca5ital gains at 1 5ercent. What will be the current 5rice of the shares of A and B, if each of them offers an e:5ected 5ost+ta: rate of 1! 5ercent? Assume that the radical 5osition a55lies

Solution: A 1%% % A (1%%+A) %.!!(1%%+A) % %.!! (1%%+A) A ( 1!% A ( &s.!,.% ? .% 1% ? (.%+?) %.!! (.%+?) %.7- : 1% %.!! (.%+?) ) 7.? (1!% ? ( &s.!1.7.

Ne:t yearJs 5rice 3i2idend 'urrent 5rice 'a5ital a55reciation 8ost+ta: ca5ital a55reciation 8ost+ta: di2idend income <otal return

'urrent 5rice (obtained by sol2ing the 5receding e7uation) ,.

<he stoc;s of firms M and 3 are considered to be e7ually ris;y. "n2estors e:5ect the share of firm M I the firm which does not 5lan to 5ay di2idend ++ to be worth &s 1!% ne:t year. 9rom the share of firm 3, too, in2estors e:5ect a 5ay off of &s 1!% I &s % by way of di2idend and &s 1$% by way of share 5rice a year from now. 3i2idends are ta:ed at % 5ercent and ca5ital gains at 1% 5ercent. What will be the current 5rice of the shares of M and 3, if each of them offers an e:5ected 5ost+ta: rate of % 5ercent? Assume that the radical 5osition a55lies

Solution: 0 1!% % 0 (1!%+0) %..(1!%+0) % %.. (1!%+0) 0 ( %% 0( &s.1#7. 7 N 1$% % N (1$%+N) %.. (1$%+N) %.! : % %.. (1$%+N) ) 1$ N ( %% N( &s.1#-.#-

Ne:t yearJs 5rice 3i2idend 'urrent 5rice 'a5ital a55reciation 8ost+ta: ca5ital a55reciation 8ost+ta: di2idend income <otal return

'urrent 5rice (obtained by sol2ing the 5receding e7uation) #.

Assume that in2estors e:5ect a 5ayoff of &s.,%-. a year from now from one share of =uman 'om5any6 &s. -. by way of di2idend and &s. ,%% by way of share 5rice. "f di2idend is ta:ed at 1% 5ercent and ca5ital a55reciation is ta:ed at % 5ercent, what will be the current 5rice of =uman 'om5anyJs share if in2estors e:5ect a 5ost+ta: return of 1# 5ercent?

Solution: @et the current 5rice of the share be 8rice one year hence 'a5ital a55reciation 3i2idend 8ost ta: ca5ital a55reciation 8ost ta: di2idend income <otal return ( ( 8 ( ( ( ( ( ,%% (,%% I 8) -. %.. (,%% I 8) %.! (-. ) %.1#

%.. (,%% I 8) ) #.1$ (

8 7% I %..8 ) #.1$ ( %.1#8 1.%#8 ( 7#.1$ 8 CHAPTER 22 1. Gandsome A55arels e:5ects that its net income and ca5ital e:5enditures o2er the ne:t four years will be as follows6 2ear 1 , # 3et /ncome %Rs.& #%,%%% $%,%%% -,%%% ,#,%%% Capital *Apen#itures %Rs.& 1 ,%%% 1%,%%% $,%%% 7,%%% ( &s. $,.$

<he com5any has 1%,%%% outstanding shares currently on which it 5ays a di2idend of two ru5ees 5er share. <he debt+ e7uity target of the firm is 161 &e7uired6 (a) What will be the di2idend 5er share if the com5any follows a 5ure residual 5olicy? (b) What e:ternal financing is re7uired if the com5any 5lans to raise di2idends by 1- 5ercent e2ery years? (c) What will be the di2idend 5er share and e:ternal financing re7uirement if the com5any follows a 5olicy of a constant -% 5ercent 5ayout ratio? Solution: a. >nder a 5ure residual di2idend 5olicy, the di2idend 5er share o2er the # year 5eriod will be as follows6

38= >nder 8ure &esidual 3i2idend 8olicy %in Rs.& 2ear /arnings 'a5ital e:5enditure /7uity in2estment 8ure residual di2idends 3i2idends 5er share 1 #%,%%% 1 ,%%% $,%%% ,#,%%% ,.# 2 $%,%%% 1%,%%% -,%%% --,%%% -.3 -,%%% $,%%% ,,%%% ,%%% . . ,#,%%% 7,%%% ,,-%% ,%,-%% ,.%-

b. <he e:ternal financing re7uired o2er the # year 5eriod (under the assum5tion that the com5any 5lans to raise di2idends by 1- 5ercents e2ery two years) is gi2en below 6 &e7uired @e2el of /:ternal 9inancing %in Rs.& 2ear A. ?. '. 3. /. 9. Net income <argeted D-S <otal di2idends &etained earnings(A:C) 'a5ital e:5enditure 1 #%,%%% .%% %,%%% %,%%% 1 ,%%% 2 $%,%%% .,% ,,%%% ,7,%%% 1%,%%% % 3 -,%%% .,% ,,%%% ,%%% $,%%% #,%%% . ,#,%%% .$$,-%% 7,-%% 7,%%% %

/:ternal financing re7uirement % (*:D)if * O D or % otherwise

c. Bi2en that the com5any follows a constant -% 5er cent 5ayout ratio, the di2idend 5er share and e:ternal financing re7uirement o2er the # year 5eriod are gi2en below

"ivi#en# Per $hare an# E%ternal Finan&in' (equirement %in Rs.& 2ear A. Net income ?. 3i2idends '. &etained earnings 3. 'a5ital e:5enditure /. /:ternal financing (D:C)if DOC, or % otherwise 9. 3i2idends 5er share . 1 #%,%%% %,%%% %,%%% 1 ,%%% 2 $%,%%% ,%,%%% ,%,%%% 1%,%%% 3 -,%%% 1 ,-%% 1 ,-%% $,%%% . ,#,%%% 17,%%% 17,%%% 7,%%%

% .%%

% ,.%%

% 1. -

% 1.7%

Moung <ur; Associates e:5ects that its net income and ca5ital e:5enditures o2er the ne:t fi2e years will be as follows6 2ear 1 , # 3et /ncome %Rs.& 7%,%%% #%,%%% !-,%%% ,!,%%% 1%-,%%% Capital *Apen#itures %Rs.& -,%%% -%,%%% #,%%% -7,%%% 1#,%%%

<he com5any has %,%%% outstanding shares currently on which it 5ays a di2idend of two ru5ees 5er share. <he debt+ e7uity target of the firm is ,6 &e7uired6 a. What will be the di2idend 5er share if the com5any follows a 5ure residual 5olicy? b. What e:ternal financing is re7uired if the com5any 5lans to raise di2idends by % 5ercent e2ery , years? c. What will be the di2idend 5er share and e:ternal financing re7uirement if the com5any follows a 5olicy of a constant $% 5ercent 5ayout ratio?

Solution: a. >nder a 5ure residual di2idend 5olicy, the di2idend 5er share o2er the # year 5eriod will be as follows6 <PS 6n"er Pure Resi"ual <i i"en" Polic7 % in Rs.& 2ear /arnings 'a5ital e:5enditure /7uity in2estment 8ure residual di2idends 3i2idends 5er share 1 , # 7%,%%% #%,%%% !-,%%% ,!,%%% 1%-,%%% -,%%% -%,%%% #,%%% -7,%%% 1#,%%% 1%,%%% $%,%%% ,.% %,%%% %,%%% 1.% 1,$%% !,,#%% #.17 ,!%% -,$%% 1-, %% ..,#%% %.7$ #..7

b. <he e:ternal financing re7uired o2er the - year 5eriod (under the assum5tion that the com5any 5lans to raise di2idends by % 5ercents e2ery three years) is gi2en below6 &e7uired @e2el of /:ternal 9inancing %in Rs.& 2ear A. ?. '. 3. /. 9. Net income <argeted D-S <otal di2idends &etained earnings(A:C) 'a5ital e:5enditure 1 2 3 . 5 1%-,%%% .#%

7%,%%% #%,%%% .%% #%,%%% ,%,%%% -,%%% .%% % -%,%%% -%,%%%

!-,%%% ,!,%%% .#% .#%

#%,%%% #!,%%% #!,%%% #!,%%% ,7,%%% +1%,%%% -7,%%% #,%%% -7,%%% 1#,%%% % $7,%%% %

/:ternal financing re7uirement % (*:D)if * O D or % otherwise

c.Bi2en that the com5any follows a constant $% 5er cent 5ayout ratio, the di2idend 5er share and e:ternal financing re7uirement o2er the - year 5eriod are gi2en below

3i2idend 8er =hare and /:ternal 9inancing &e7uirement %in Rs.& 2ear A. Net income ?. 3i2idends '. &etained earnings 3. 'a5ital e:5enditure 9. /:ternal financing (D:C)if DOC, or % otherwise 9. 3i2idends 5er share ,. 1 7%,%%% # ,%%% !,%%% -,%%% % .1 2 3 .

#%,%%% !-,%%% ,!,%%% 1%-,%%% #,%%% -1,%%% ,!%% $,,%%% 1$,%%% ,#,%%% 1-, %% # ,%%% -%,%%% #,%%% -7,%%% 1#,%%% ,#,%%% 1. % .-#1,!%% 1.1# % ,.1-

<he di2idend 5er share of a firm for the current year is &s.#. What will be the e:5ected di2idend 5er share of a firm for ne:t year, if the e:5ected /8= for that year is &s. % and the target 5ayout ratio is ,%% and adCustment rate is %.$? Assume that the @intner model a55lies.

Solution: 3t ( c. r. /8=1 ) (1 I c) 3t I 1 ( (%.$ : %., : %) ) (%.#) : # ( &s.-. 3t ( c.r./8=1 ) ( 1 I c ) 3t I 1 ( ( %.! : %.,- : ! ) ) ( 1 I %.! ) : .( CHAPTER 23 1. 8rimtech @imited has a &s. ,%%% million 11 5ercent (cou5on rate) bond issue outstanding which has # years of residual maturity. <he bonds were issued four years ago at 5ar for &s. ,%%% million and 8rimtech incurred floatation costs of &s.#! million which are being amortised for ta: 5ur5oses at the rate of &s.$ million 5er year. "f the bonds are called, the amortised 5ortion of the floatation costs (&s. #.% million) can be deducted for ta: 5ur5oses. 8rimtechJs ta: rate is ,% 5ercent. 8rimtech can call the bonds for &s. 1%% million. Assume that the call 5remium of &s.1%% million can be treated as a ta:+deductible e:5ense. . # ) %.-% ( .7#

8rimetech has been ad2ised by its merchant ban;ers that the firm can issue &s. ,%%% million of new bonds at an interest rate of . 5ercent and use the 5roceeds for refunding the old bonds. <he new issue will ha2e a maturity of # years and in2ol2e a floatation cost of &s.#% million, which can be amortised in # e7ual instalments for ta: 5ur5oses. (i) Solution: (a) 'ost of calling the old bonds 9ace 2alue 'all 5remium (b) Net 5roceeds of the new issue Bross 5roceeds + "ssue cost (c) <a: sa2ings on ta:+deductible e:5enses What will be the initial outlay?

&s. %%% million 1%% million 1%% million &s. %%% million #% million 1.$% million &s. ,7. million

<a: rate U'all 5remium ) >namortised issue costs on old bondsV %.,% U1%% ) #V (d) "nitial outlay6 (a) I (b) I (c) &s.1% .! million

(ii) Solution: (a)

What will be the annual net cash sa2ings?

Annual net cash outflow on old bonds "nterest e:5ense + <a: sa2ings on interest e:5ense and amortisation of issue e:5enses %., ( % ) $) Annual net cash outflow on new bonds "nterest e:5ense + <a: sa2ing on interest e:5ense and amortisation of issue e:5enses 6 %., (1!% ) 1% ) Annual net cash sa2ings6 (a) I (b)

% $7.! 1- .

(b)

1!% -7 1 ,.% ..

(c)

(iii) What is the N8T of refunding the bond? Solution: 8resent 2alue of annual net cash sa2ings6 .. : 8T"9A (%.%$,, # yrs) ( .. : ,.##1 ( 1%%.#! + "nitial outlay ( 1% .!% + ., %.%. (1+ %.,) ( %.%$, 8T"9A (%.%$,, # yrs) 1 I U1*(1.%$,)V# ( ( ,.##1 %.%$,

=anofi @imited has a &s.1 %% million, 11 5ercent (cou5on rate) bond issue outstanding which has # years residual maturity. <he bonds were issued # years ago at 5ar for &s.1 %% million and =anofi incurred floatation costs of &s.,% million which are being amortised for ta: 5ur5oses at the rate of &s.,.7- million 5er year. "f the bonds are called, the unamortised 5ortion of the floatation costs (&s.1-.% million) can be deducted for ta: 5ur5oses. =anofiJs ta: rate is ,% 5ercent. =anofi can call the bonds for &s.1 $$ million. Assume that the call 5remium of &s.$$ million can be treated as a ta:+deductible e:5ense. =anofi has been ad2ised by its merchant ban;ers that due to fall in interest rates, the firm can issue &s.1 %% million of new bonds at an interest rate of ! 5ercent and use the 5roceeds for refunding of old bonds. <he new issue will ha2e a maturity of # years and in2ol2e a floatation cost of &s. # million, which can be amortised in # e7ual annual instalments for ta: 5ur5oses. (i) What will be the initial outlay?

Solution: (a) 'ost of calling the old bonds 9ace Talue 'all 5remium (b) Net 5roceeds of the new issue Bross 8roceeds + "ssue costs (c) <a: sa2ings on ta:+deductible e:5enses <a: rate U'all 5remium ) >namortised issue costs on old bondsV %.,% U $$ ) 1- V (d) "nitial outlay6 ( a ) I ( b ) I ( c )

&s. 1 %% million $$ million 1 $$ million &s. 1 %% million # million &s. 117$ million #., million

( &s. $-.7 million

(ii) Solution:

What will be the annual net cash sa2ings?

( a ) Annual net cash outflow on old bonds "nterest e:5ense + <a: sa2ings on interest e:5ense and amortisation of issue e:5enses %.,% ( 1, ) ,.7-) ( ( b ) Annual net cash outflow on new bonds "nterest e:5ense + <a: sa2ing on interest e:5ense and amortisation of issue e:5enses %.,% (.$ ) $) ( c ) Annual net cash sa2ings ( a ) I ( b ) million (iii) Solution: 8resent 2alue of annual net cash sa2ings6 ( -.!7- : ,.#.71 ( .%.#!7 million + "nitial outlay ( +$-.7 million ( #.7!7 million 8T"9A #.--% $ yrs What is the N8T of refunding the bond?

1, .%%% #%.7 .1. 7.$.%%% ,%.$%% $-.#%% -.!7-

rd ( 1 I t ) ( .%! ( 1 + .,%) ( .%-$

# 1 1 + ++++++++++++ ( 1.%-$ ) ( ++++++++++++++++++++++++++ .%-$ ( ,.#.71

,.

=yne: @imited has a &s.1%%% million, 1% 5ercent (cou5on rate) bond issue outstanding which has - years residual maturity. <he bonds were issued , years ago at 5ar for &s.1%%% million and =yne: incurred floatation costs of &s. # million which are being amortised for ta: 5ur5oses at the rate of &s.,.% million 5er year. "f the bonds are called, the unamortised 5ortion of the floatation costs (&s.1-.% million) can be deducted for ta: 5ur5oses. =yne:Js ta: rate is ,- 5ercent. =yne: can call the bonds for &s.1%$% million. Assume that the call 5remium of &s.$% million can be treated as a ta:+deductible e:5ense.

=yne: has been ad2ised by its merchant ban;ers that due to fall in interest rates the firm can issue &s.1%%% million of new debt at an interest rate of 7 5ercent and use the 5roceeds for refunding of old bonds. <he new issue will ha2e a maturity of years and in2ol2e a floatation cost of &s. % million, which can be amortised in e7ual annual installments for ta: 5ur5oses. (i) Solution: What will be the initial outlay?

(a) 'ost of calling the old bonds 9ace 2alue 'all 5remium (b) Net 5roceeds of the new issue Bross 5roceeds + "ssue cost (c) <a: sa2ings on ta:+deductible e:5enses

&s.1%%% million $% million 1%$% million &s.1%%% million % million .!% million &s. $. - million

<a: rate U'all 5remium ) >namortised issue costs on old bondsV %.,- U$% ) 1-V (d) "nitial outlay6 (a) I (b) I (c) (ii) Solution: (a) Annual net cash outflow on old bonds "nterest e:5ense + <a: sa2ings on interest e:5ense and amortisation of issue e:5enses %.,- ( 1%% ) ,) (b) Annual net cash outflow on new bonds "nterest e:5ense + <a: sa2ing on interest e:5ense and amortisation of issue e:5enses 6 %.,- ( 7% ) # ) (c) Annual net cash sa2ings 6 (a) I (b) 1%% ,$.%$,..7% -.. ##.1 1..!What will be the annual net cash sa2ings? &s.-,.7- million

8resent 2alue of annual net cash sa2ings6 %.%7 ( 1+ %.,-) ( %.%#-1..!- : 8T"9A (%.%#--, - yrs) 1 1.%#-8T"9A ( %.%#--

( #.,!#

(iii) What is the N8T of refunding the bond? Solution: ( 1..!- : #.,!# + "nitial outlay &s.,,. 7 million. #. 'onsider the following data for go2ernment securities6 6ace 4alue &s. 1%%,%%% &s. 1%%,%%% &s. 1%%,%%% /nterest rate % 7% 7% Maturity %years& 1 , Current price .-,%%% ..,-%% .., %% ( ( !7.% -,.7,,. 7

What is the forward rate for year ,(r,)? Solution: 1%%,%%% ( .-,%%% (1 ) r1) 7,%%% ..,-%% ( (1.%- $) 7,%%% .., %% ( (1.%- $) r, ( 7.,7 % ) (1.%- $) (1.%.#!) ) (1.%- $) (1 ) r ) 7,%%% ) (1.%- $) (1.%.#!) (1)r,) 1%7,%%% 1%7,%%% r ( ..#! % r1 ( -. $ %

-.

'onsider the following data for go2ernment securities6 6ace 4alue 1%%,%%% 1%%,%%% 1%%,%%% /nterest rate %H& % $% 7% Maturity %years& Current price 1 .#, -% ..,-%% , 1%%,-%%

What is the forward rate for year ,(r,)? Solution: 1%%,%%% (1)r1) ..,-%% 1%%,-%% ( (

( .#, -% ) ) (

i r1

$.1%% i ) r ( $.#$%

$%%% (1.%$1%) 7,%%% (1.%$1) r,

1%$%%% (1.%$1) (1)r ) 7,%%% (1.%$1) (1.%$#$) !.%1%

1%7,%%% (1.%$1) (1.%$#$) (1)r,)

$.

'onsider the following data for go2ernment securities6 6ace 4alue 1%%,%%% 1%%,%%% 1%%,%%% /nterest rate + $% 7% Maturity %years& 1 , Current price .#,!%% ..,-%% 1%%,-%%

What is the forward rate for year ,(r,)? Solution: 1%%,%%% ( (1 ) r1) $,%%% ..-%% ( (1.%-#.) 7%%% 1%%-%% ( (1.%-#.) r ( !.%1% ) (1.%-#.) (1.%711) ) (1.%-#.) (1 ) r ) 7%%% ) (1.%-#.) (1.%711) (1 ) r,) 1%$,%%% r ( 7.11% 1%7%%% .#,!%% r1 ( -.#.%

7.

'onsider three bonds, A, ? and ' Bon# A 9ace 2alue 'ou5on (interest rate) 5ayable annually Mears to maturity &edem5tion 2alue 'urrent mar;et 5rice 1 5ercent 1,%%% &s..%% 1,%%%

Bon# B 1,%%% 1, 5ercent $ 1,%%% &s.!-%

Bon# C 1%% 1# 5ercent 7 1%% .

What are the (a) yields to maturity (use the a55ro:imate formula) (b) durations, and (c) 2olatilities of these bonds? Solution: a) Mield to maturity of bond A, using the a55ro:imate formula, is 1 % ) (1%%% I .%%)*( +++++++++++++++++++++++++ ( 1#.!. % %.#:1%%% ) %.$:.%% Mield to maturity of bond B, using the a55ro:imate formula, is 1,% ) (1%%% I !-%)*$ ( +++++++++++++++++++++++++++++ ( 17.%, % %.#:1%%% ) %.$:!-% Mield to maturity of bond C, using the a55ro:imate formula, is 1# ) (1%% I . )*7 ( ++++++++++++++++++++++++++ ( 1-..1 % %.#:1%% ) %.$:. (b) Solution: 3uration of bond A is calculated as under6

Mear 'ash flow 1 1 % 1 % , 1 % # 1 % 11 % =um (

8resent 2alue at 8ro5ortion of the 8ro5ortion of the 1#.!. 5ercent bondFs 2alue bondFs 2alue : time 1%#.#%.11$ %.11$ .%..1 %.1%1 %. %1 7..1, %.%!! %. $, $!.!7 %.%7$ %.,%--..-1 %.$ % ,.%.. .% .!7 3uration ( ,..! years

3uration of bond ? is calculated as under6 Mear 1 , # $ 'ash flow 1,% 1,% 1,% 1,% 1,% 11,% =um ( 8resent 2alue at 8ro5ortion of the 8ro5ortion of the bondFs 17.%, 5ercent bondFs 2alue 2alue : time 111.%! %.1,% %.1,% .#.. %.111 %. !1.11 %.%.%. !# $..,% %.%!1 %., # -.. %.%$. %.,#$ #,..!# %.-1# ,.%!!--.#7 3uration( #.,. years

3uration of bond ' is calculated as under6 8resent 2alue at 8ro5ortion of the 8ro5ortion of the bondFs 'ash flow 1-..1 5ercent bondFs 2alue 2alue : time 1# 1 .%! %.1,1 %.1,1 1# 1%.# %.11, %. $ 1# !... %.%.7 %. . 1# 7.7$ %.%!# %.,,$ 1# $.$. %.%7, %.,$, 1# -.77 %.%$, %.,711# #%.-$ %.##% ,.%77 =um ( . . 7 3uration( #.! years Dolatility of ,on# B #.,.1 ( ,.71.17%, Dolatility of ,on# C #.! ( #.1# 1.1-.1

Mear 1 , # $ 7 c)

Dolatility of ,on# A 3.984 ( ,.#7 1.1#!. CHAPTER 2& 1.

A5te: @imited has decided to go for an e7ui5ment costing &s. $% million. A5te: is considering two alternati2es6 (i) leasing the e7ui5ment, and (ii) borrowing and 5urchasing the e7ui5ment. B< ca5ital is willing to lease the e7ui5ment to A5te: for an annual lease rental of &s.1$ million for - years, the lease rental being 5ayable in arrears. <here is a management fees of &s.1 million 5ayable on signing the lease contract. <he ta: rele2ant de5reciation rate on the e7ui5ment is - 5ercent as 5er the W3T method. <he net sal2age 2alue of the e7ui5ment after fi2e years is e:5ected to be &s.1# million. A5te: has an effecti2e ta: rate of ,% 5ercent and its 5ost+ ta: cost of debt is 7 5ercent. What is the net ad2antage of leasing (NA@) for A5te:?

Solution:

1. . ,.

'ost of 5lant 0anagement fee <a: shield on 0anagement fee #. 3e5reciation -. @oss of de5reciation ta: shield $. @ease 5ayment 7. <a: shield on lease 5ayment !. @oss of sal2age 2alue .. 'ash flow of lease (1) ) ( ) ) (,) ) (-) ) ($) ) (7) ) (!) 1%. 8resent 2alue factors 11. 8resent 2alue Af (.) NA@ of leasing

% )$%.%% +1.%% %.,%

&s. in million -

1-.%%% +#.-%% +1$.%%% #.!%%

11. -% +,.,7+1$.%%% #.!%%

!.#,! + .-,1 +1$.%%% #.!%%

$., ! +1.!.! +1$.%%% #.!%%

#.7#$ +1.# # +1$.%%% #.!%% +1#.%%%

)-.., 1.%%% )-.., -..,

+1-.7%% %..,+1#.$!% +1#.$!%

+1#.-7%.!7, +1 .7 #

+1,.7,1 %.!1$ +11. %#

+1,.%.! %.7$, +....# +....#

+ $.$ # %.71, +1!..!, +1!..!,

+1 .7 # +11. %# ( +!. !-

8raCay @imited has decided to go for a 5ollution control e7ui5ment costing &s. -% million. 8raCay is considering two alternati2es6 (i) leasing the e7ui5ment, and (ii) borrowing and 5urchasing the e7ui5ment. B/ ca5ital is willing to lease the e7ui5ment to 8raCay for an annual lease rental of &s.1,. million for - years, the lease rental being 5ayable in arrears. <here is a management fees of &s. 1 million 5ayable on signing the lease contract. <he ta: rele2ant de5reciation rate on the e7ui5ment is - 5ercent as 5er the W3T method. <he net sal2age 2alue of the e7ui5ment after fi2e years is e:5ected to be &s.1%.- million. 8raCay has an effecti2e ta: rate of ,- 5ercent and its 5ost+ ta: cost of debt is $ 5ercent. What is the net ad2antage of leasing (NA@) for 8raCay?

Solution:

'ost of 5lant 0anagement fee ,. <a: shield on 0anagement fee #. 3e5reciation -. @oss of de5reciation ta: shield $. @ease 5ayment 7. <a: shield on lease 5ayment !. @oss of sal2age 2alue .. 'ash flow of lease (1) ) ( ) ) (,) ) (-) ) ($) ) (7) ) (!) 1%. 8resent 2alue of factor 11. 8resent 2alue of (.) NA@ of leasing ( +$. #1 ,.

1. .

% )-%.%%% +1.%%% %.,-%

1 .-%% +#.,7+1,. %% #.$ %

..,7+,. !1 +1,. %% #.$ %

7.%,1 + .#$1 +1,. %% #.$ %

-. 7, +1.!#$ +1,. %% #.$ %

,..-+1.,!# +1,. %% #.$ % +1%.-%%

)#..,-%

+1 ..--

+11.!$1

+11.%#1

+1%.# $

+ %.#$#

1.%%% )#..,-% #..,-%

%..#, +1 . 17 +1 . 17

%.!.% +1%.--$ +1%.--$

%.!#% +.. 7# +.. 7#

%.7. +!. -7 +!. -7

%.7#7 +1-. !7 +1-. !7

=anCee2 @imited has decided to go for an air conditioning 5lant costing &s. #% million. =anCee2 @imited is considering two alternati2es6 (i) leasing the 5lant, and (ii) borrowing and 5urchasing the 5lant. B0 ca5ital is willing to lease the 5lant to =anCee2 @imited for an annual lease rental of &s.1%.! million for - years, the lease rental being 5ayable in arrears. <he ta: rele2ant de5reciation rate on the 5lant is - 5ercent as 5er the W3T method. <he net sal2age 2alue of the 5lant after fi2e years is e:5ected to be &s.!.million. =anCee2 @imited has an effecti2e ta: rate of ,- 5ercent and its 5ost+ ta: cost of debt is 7 5ercent. What is the net ad2antage of leasing (NA@) for =anCee2 @imited?

Solution: % )#%%%% 1 1%.%%% +,.-%% +1%.!%% ,.7!% 7.-%% + .$ +1%.!%% ,.7!% , -.$ +1..$. +1%.!%% ,.7!% # #. 1. +1.#77 +1%.!%% ,.7!% ,.1$# +1.1%7 +1%.!%% ,.7!% +!.-%% )#%.%%% 1.%%% #%.%%% #%.%%% +1%.- % %..,+..!,$ +..!,$ ( +,.. . +..$#%.!7, +!.# % +!.# % +!..!. %.!1$ +7.,,+7.,,+!.#.7 %.7$, +$.#!, +$.#!, +1$.$ 7 %.71, +11.!-+11.!--

1.'ost of 5lant .3e5reciation ,.@oss of de5reciation ta: shield #.@ease 5ayment -.<a: shield on lease 5ayment $.@oss of sal2age 2alue 7.'ash flow of lease (1) )(,) ) (#) ) (-) ) ($) !. 8resent 2alue factor ..8resent 2alue of (7) NA@ of @easing

#.

=hi2a "ndustries re7uires an asset costing &s., million. Benuine 9inance offers a hire+5urchase 5ro5osal for a 5eriod of , years at a flat interest of 1# 5er cent. Benuine also gi2es a lease 5ro5osal wherein the lease rental would be &s., % 5er &s.1,%%% 5er year for the first - years (5rimary 5eriod) and &s.,%,%%% 5er year for the ne:t - years (secondary 5eriod). <hereafter, the asset would re2ert to Benuine. <he de5reciation rate on the asset is - 5er cent (W3T) and its net sal2age 2alue after 1% years would be &s.,-%,%%%. =hi2a has a ta: rate of ,- 5ercent and its 5ost+ ta: cost of debt is . 5ercent. =hould =hi2a choose the hire+5urchase or the leasing o5tion?

Solution: >nder the hire 5urchase 5ro5osal the total interest 5ayment is ,,%%%,%%% : %.1# : , ( &s. 1, $%,%%% <he interest 5ayment of &s. . 1, $%,%%% is allocated o2er the , years 5eriod using the sum of the years digits method as follows6

2ear 1

/nterest allocation ,$$ : &s. . 1, $%,%%% ( &s.$. ,#, $$$ : &s. . 1, $%,%%% ( &s.# %,%%% $$$ 7!

, $$$

: &s. . 1, $%,%%% ( &s.1#7,-$!

<he annual hire 5urchase installments will be6 &s.,,%%%,%%% ) &s. . 1, $%,%%% ( &s.1,# %,%%% , <he annual hire 5urchase installments would be s5lit as follows 2ear 1 , @ire purchase installment /nterest &s. 1,# %,%%% &s. $. ,#, &s. 1,# %,%%% &s. # %,%%% &s. 1,# %,%%% &s. 1#7,-$! -rincipal repayment &s.7 7,-$! &s. 1,%%%,%%% &s. 1, 7 ,#,

<he lease rental will be as follows6 &s. .$%,%%% 5er year for the first - years &s. ,%,%%% 5er year for the ne:t - years <he cash flows of the leasing and hire 5urchase o5tions are shown below 2ear "easin< : "Rt %1:tc& @ire -urchase :/t%1:tc& :-Rt Dt%tc& 3SDt +/t%1:tc&:-Rt1 Dt%tc&13SDt

1 +.$%,%%%(1+.,-)(+$ #,%%% +$. ,#, (1+.,-) +7 7,-$! 7-%,%%%(%.,-) +.1-,1#. +.$%,%%%(1+.,-)(+$ #,%%% +# %,%%% (1+.,-) +1,%%%,%%% -$ ,-%%(%.,-) +1,%7$,1 , +.$%,%%%(1+.,-)(+$ #,%%% +1#7,-$! (1+.,-) +1, 7 ,#, # 1,!7-(%.,-) +1, %,$.# +.$%,%%%(1+.,-)(+$ #,%%% ,1$,#%$(%.,-) 11%,7# - +.$%,%%%(1+.,-)(+$ #,%%% ,7,,%-(%.,-) !,,%-7 $ + ,%,%%%(1+.,-)( + 1.,-%% 177,.7.(%.,-) $ , ., 7 + ,%,%%%(1+.,-)( + 1.,-%% 1,,,#!#(%.,-) #$,71. ! + ,%,%%%(1+.,-)( + 1.,-%% 1%%,11,(%.,-) ,-,%#% . + ,%,%%%(1+.,-)( + 1.,-%% 7-,%!-(%.,-) $, !% 1% + ,%,%%%(1+.,-)( + 1.,-%% -$,,1#(%.,-) ,-%,%%% ,$.,71%

8resent 2alue of the leasing o5tion - $ #,%%% ( + t81 (1.%.)t 1% t($ 1.,-%% (1.%.)t

( +$ #,%%% 8T"9A(.%,-yrs) + 1.,-%% 8T"9A(.%,-yrs) 8T"9(.%,-yrs) ( +$ #,%%% : ,.!.% + 1.,-%% : ,.!.% : %.$-% ( + ,# 7,,$% I #.,,%$ ( + ,#7$,$$$ 8resent 2alue of the hire 5urchase o5tion ( +.1-,1#.*(1.%.) I 1,%7$,1 -*(1.%.) +1, %,$.-*(1.%.),)11%,7# *(1.%.)# )!,,%-7*(1.%.)) $ , .,*(1.%.)$ ) #$,71.*(1.%.)7 ) ,-,%#%*(1.%.)! ) $, !%*(1.%.).) ,$.,71%*(1.%.)1% ( + ,,%$,.-1 =ince the hire 5urchase o5tion costs less than the leasing o5tion, =hi2a should choose the hire 5urchase o5tion . CHAPTER 2* 1. 'onsider the following data6 Number of shares outstanding 6 !% million 'urrent stoc; 5rice 6 &s $% &atio of warrants issued to the number of outstanding shares 6 %.% /:ercise 5rice 6 &s ,% <ime to e:5iration of warrant 6 , years Annual standard de2iation of stoc; 5rice changes 6 %.#% "nterest rate 6 1 5ercent What is the 2alue of a warrant? "gnore the com5lication arising from di2idends and*or dilution.

Solution: l (S**) ) (r ) ] * ) t #1 ( ( ( ( # ( ( ( 3(#1) ( t ln ($% * ,%) ) U%.1 ) (%.#) * V, %.#(,)1* %.$.,1 ) %.$ %.$. ! 1.!$$#1 + t 1.!$$- I %.$. ! 1.17,7 3 (1.!$$-).

9rom the tables we ha2e N(1.!-)( 1+ %.%, ( %..$7! and N(1..%)( 1+ %.% !7( %..71, ?y linear e:tra5olation, we get N(1.!$$-) ( %..$7! ) (1.!$$- I 1.!-%%)(%..71,+%..$7!)*%.%( %..$7! ) %.%%11-- ( %..$.% N(# ) ( N(1.17,7) 9rom the tables we ha2e N(1.1-) ( 1+ %.1 -1 ( %.!7#. N(1. %) ( 1+ %.11-1 ( %.!!#. ?y linear e:tra5olation, we get N(1.17,7) ( %.!7#. ) (1.17,7 I 1.1-%%)(%.!!#. I %.!7#.)*%.%( %.!7#. ) %.%%#7# ( %.!7.$ rt /*e ( ,%*1.#,,, ( %.., ' ( =o 3(#1) I *. e+rt. 3(# ) ( $% : %..$.% I %.., : %.!7.$( ,..7, Talue of the warrant is &s. ,..7,. . Tishal /nter5rises has Cust issued warrants. <he following data is a2ailable6 Number of shares outstanding ( $% million 'urrent stoc; 5rice ( &s 7% &atio of warrants issued to the number of outstanding shares ( ! 5ercent /:ercise 5rice ( &s #% <ime to e:5iration of warrants ( # years Annual standard de2iation of stoc; 5rice changes ( ,% 5ercent "nterest rate ( 1% 5ercent What is the 2alue of a warrant?

Solution: l (S**) ) (r ) ] * ) t #1 ( ( ( # ( ( ( ( t ln (7% * #%) ) U%.1% ) (%.,) * V# %.,(#)1* %.--.$ ) %.-!%% %.$ 1.!.., #1 + t 1.!.., I %.$ 1. ..,

3(#1) (

3 (1.!..,) , which is 2ery nearly e7ual to N(1..%)

9rom the tables we ha2e N(1..%)( 1+ %.% !7( %..71, N(# ) ( N(1. ..,), which is 2ery nearly e7ual to N(1.,%) 9rom the tables we ha2e N(1.,%) ( 1+ %.%.$! ( %..%, /*ert ( #%*1.#.1! ( $.!1 ' ( =o 3(#1) I *. e+rt. 3(# ) ( 7% : %..71, I $.!1 : %..%, ( #,.7! Talue of the warrant is &s. #,.7!. ,. =hi2ali; 'ombines issues a 5artly con2ertible debenture for &s .%%, carrying an interest rate of 1 5ercent. &s ,%% will get com5ulsorily con2erted into two e7uity shares of =hi2ali; 'ombines a year from now. <he e:5ected 5rice 5er share of =hi2ali; 'ombinesJs e7uity a year from now would be &s %%. <he non+ con2ertible 5ortion will be redeemed in three e7ual installments of &s %% each at the end of years #, - and $ res5ecti2ely. <he ta: rate for =hi2ali; is ,- 5ercent and the net 5rice 5er share =hi2ali; would realise for the e7uity after a year would be &s 1!%. (a) What is the 2alue of con2ertible debenture? Assume that the in2estorsJ re7uired rate of return on the debt com5onent and the e7uity com5onent are 1 5ercent and 1$ 5ercent res5ecti2ely. (b) What is the 5ost+ta: cost of the con2ertible debenture to =hi2ali; ? Solution: (a) No. of shares after con2ersion in one year ( Talue of the shares at the 5rice of &s. %% ( : %% ( &s.#%% 8T of the con2ertible 5ortion at the re7uired rate of 1$% ( #%%*1.1$ ( &s.,##.!

8ayments that would be recei2ed from the debenture 5ortion6 8ayments 8T"91 %,t 8T 1 1%! %.!., .$.## Talue of the 7 %.7.7 -7.,! con2ertible , 7 %.71 -1. $ debenture ( ,##.! # 7 %.$,$ 17 ... ) $, . $ ( &s. #! %.-$7 1#%.$ .77.%! $ # %.-%7 11,.-7 (b) <otal( $, . $ <he cash flow for =hi2ali; is wor;ed out as under6 Mear

Mear % 1 , # $

'ash flow (+,$%+1%!X(1+%.,-) (+7 X(1+%.,-) (+7 X(1+%.,-) (+ %%+7 X(1+%.,-) (+ %%+#!X(1+%.,-) (+ %%+ #X(1+%.,-) .%% +#,% +#7 +#7 + #7 + , + 1$

<he 5ost+ta: cost of the con2ertible debenture to =hi2ali; is the "&& of the abo2e cash flow stream. @et us try a discount rate of 1% %. <he 8T of the cash flow will then be ( .%% I #,%*(1.1) +#7*(1.1) + #7*(1.1), + #7*(1.1)#+ , *(1.1)-+ 1$*(1.1)$ ( %. - which is 2ery near to Pero. =o the 5ost Ita: cost of the con2ertible debenture to =hi2ali; is 1%% #. ?rilliant @imited issues a 5artly con2ertible debenture for 1%%%, carrying an interest rate of 1% 5ercent. ,$% will get com5ulsorily con2erted into two e7uity shares of ?rilliant @imited a year from now. <he e:5ected 5rice 5er share of ?rilliant @imitedJs e7uity a year from now would be &s ,%%. <he non+con2ertible 5ortion will be redeemed in four e7ual installments of &s 1$% each at the end of years ,, #, - and $ res5ecti2ely. <he ta: rate for ?rilliant is ,, 5ercent and the net 5rice 5er share ?rilliant would realise for the e7uity after a year would be &s %. (a) What is the 2alue of con2ertible debenture? Assume that the in2estorsJ re7uired rate of return on the debt com5onent and the e7uity com5onent are 1, 5ercent and 1! 5ercent res5ecti2ely. (b) What is the 5ost+ta: cost of the con2ertible debenture to ?rilliant? Solution: (a) No. of shares after con2ersion in one year ( Talue of the shares at the 5rice of &s.,%% ( : ,%% ( &s.$%% 8T of the con2ertible 5ortion at the re7uired rate of 1!% ( $%%*1.1! ( &s.-%!.#7 8ayments that would be recei2ed from the debenture 5ortion6

Mear Talue of the con2ertible debenture ( -%!.#7 ) $1%.%! ( &s. 111!.-(b) 1 , # $

8ayments 8T"91,%,t 8T 1%% %.!!!!.$# %.7!, -%.11 # %.$., 1--. , %! %.$1, 1 7.-% 1. %.-#, 1%#. $ 17$ %.#!% !#.#! <otal( $1%.%!

<he cash flow for ?rilliant is wor;ed out as under6 Mear % 1 , # $ 'ash flow (+##%+1%%X(1+%.,,) (+$#X(1+%.,,) (+1$%+$#X(1+%.,,) (+1$%+#!X(1+%.,,) (+1$%+, X(1+%.,,) (+1$%+1$X(1+%.,,) 1%%% +,$1.!% +# .!! + % .!! +1. .1$ +1!1.# +17%.7

<he 5ost+ta: cost of the con2ertible debenture to ?rilliant is the "&& of the abo2e cash flow stream. @et us try a discount rate of # %. <he 8T of the cash flow will then be ( 1%%% I ,$1.!*(1.%#) +# .!!*(1.%#) I % .!!*(1.%#), +1. .1$*(1.%#)#+1!1.#* (1.%#)-+17%.7 *(1.%#)$ ( +1$.17 <rying a discount rate of - %. <he 8T of the cash flow will then be ( 1%%% I ,$1.!* (1.%-) +# .!!*(1.%-) I % .!!*(1.%-), +1. .1$*(1.%-)#+1!1.#* (1.%-)-+17%.7 *(1.%-)$ ( 1,.$$ ?y e:tra5olation, we ha2e the "&& ( # ) 1$.17*(1$.17 ) 1,.$$) ( #.-# % =o the 5ost Ita: cost of the con2ertible debenture to ?rilliant is #.-# %

CHAPTER 2+ 1. <he following information is a2ailable for N'/8 @imited. Profit an" Loss Account <ata 'alance Sheet <ata Be<innin< of =ales 'ost of goods sold $%%% #%%% "n2entory Accounts recei2able Accounts 5ayable %1$ !%% -%% .% *n# of %1$ ! % #.% %-

What is the duration of the cash cycle? Solution: (!%% ) ! %) * "n2entory 8eriod ( #%%% * ,$(-%% ) #.%) * Accounts recei2able ( 5eriod Accounts 5ayable 'ash cycle . ( #%%% * ,$( !1.## days ( ,%.11 $%%% * ,$( .% ) %-) * ( .-! ( 7,..1

<he following information is a2ailable for A?' @imited. Profit an" Loss Account <ata 'alance Sheet <ata Be<innin< of =ales 'ost of goods sold ,%%% 1!%% "n2entory Accounts recei2able Accounts 5ayable %1,%% 1!% !*n# of %1,1% 17% .-

What is the duration of the cash cycle?

Solution: "n2entory 8eriod Accounts recei2able 5eriod Accounts 5ayable 'ash 'ycle ,. ( ( ( ( (,%%),1%) * 1!%%*,$(1!% ) 17%)* ,%%%*,$(!- ) .-) * 1!%%*,$$#.. days ( ( ( $1.!7 1.,% 1!. -

<he following annual figures relate to =ugarcolt @imited. =ales (at two monthsF credit) 0aterials consumed (su55liers e:tend two months credit) Wages 5aid (monthly in arrear) 0anufacturing e:5enses outstanding at the end of the year ('ash e:5enses are 5aid one month in arrear) <otal administrati2e e:5enses, 5aid as incurred =ales 5romotion e:5enses, 5aid 7uarterly in ad2ance Rs. $,%%%,%%% 1,$%%,%%% 1,,%%,%%% 1#%,%%% ##%,%%% %%,%%%

<he com5any sells its 5roducts on gross 5rofit of % 5ercent counting de5reciation as 5art of the cost of 5roduction. "t ;ee5s one monthFs stoc; each of raw materials and finished goods, and a cash balance of &s. %%,%%%. Assuming a - % safety margin, wor; out the wor;ing ca5ital re7uirements of the com5any on cash cost basis. "gnore wor;+in+5rocess. Solution: 1. =ales @ess 6 Bross 5rofit ( % 5er cent) <otal manufacturing cost @ess 6 0aterials 1,$%%,%%% Wages 1,,%%,%%% 0anufacturing e:5enses . 'ash manufacturing e:5enses (1#%,%%% : 1 ) ,. 3e5reciation 6 (1) I ( ) #. <otal cash cost <otal manufacturing cost @ess6 3e5reciation 'ash manufacturing cost Add6 Administration and sales 5romotion e:5enses &s. $,%%%,%%% 1, %%,%%% #,!%%,%%% ,.%%,%%% 1,.%%,%%% 1,$!%,%%% %,%%% #,!%%,%%% %,%%% #,-!%,%%% $#%,%%% -, %,%%%

A C Current Assets <otal cash cost 3ebtors 1 0aterial cost &aw material stoc; 9inished goods stoc; 8re5aid sales 5romotion e:5enses 'ash balance : 1 1 'ash manufacturing cost :1( 1 =ales 5romotion e:5enses :,( 1 A 5redetermined amount A 6 'urrent Assets B C Current "ia,ilities 0aterial cost =undry creditors 1 0anufacturing e:5enses outstanding Wages outstanding : ( 1 Ane monthJs cash manufacturing e:5enses Ane monthJs wages ? 6 'urrent liabilities Wor;ing ca5ital (A I B) Add - % safety margin Wor;ing ca5ital re7uired #. <he following annual figures relate to >ni2ersal @imited. =ales (at three monthsF credit) 0aterials consumed (su55liers e:tend one months credit) Wages 5aid (monthly in arrear) 0anufacturing e:5enses outstanding at the end of the year ( ( 1,$%%,%%% : ( 1 ( ( 1 #,-!%,%%% : 1( 1 %%,%%% : ,( : ( 1 1,$%%,%%% : 1( -, %,%%% : (

Rs. !7%,%%%

1,,,,,,

,!1,$$7

-%,%%% %%,%%%

( 1,$,-,%%% Rs. $$,$$7

1#%,%%% 1%!,,,, -1-,%%% 1,1 %,%%% !%,%%% 1,#%%,%%%

Rs. !,%%%,%%% ,%%%,%%% 1,$%%,%%% 1%%,%%%

('ash e:5enses are 5aid one month in arrear) <otal administrati2e e:5enses, 5aid as incurred =ales 5romotion e:5enses, 5aid 7uarterly in arrears

-%%,%%% #%%,%%%

<he com5any sells its 5roducts on gross 5rofit of ,% 5ercent counting de5reciation as 5art of the cost of 5roduction. "t ;ee5s two monthsJ stoc; each of raw materials and finished goods, and a cash balance of &s.,%%,%%%. Assuming a % % safety margin, wor; out the wor;ing ca5ital re7uirements of the com5any on cash cost basis. "gnore wor;+in+5rocess. Solution: 1. =ales @ess 6 Bross 5rofit (,% 5er cent) <otal manufacturing cost @ess 6 0aterials ,%%%,%%% Wages 1,$%%,%%% 0anufacturing e:5enses . 'ash manufacturing e:5enses (1%%,%%% : 1 ) ,. 3e5reciation 6 (1) I ( ) -. <otal cash cost <otal manufacturing cost @ess6 3e5reciation 'ash manufacturing cost Add6 Administration e:5enses &s. !,%%%,%%% ,#%%,%%% -,$%%,%%% ,,$%%,%%% ,%%%,%%% 1, %%,%%% !%%,%%% -,$%%,%%% !%%,%%% #,!%%,%%% -%%,%%% -,,%%,%%% A C Current Assets <otal cash cost 3ebtors 1 0aterial cost &aw material stoc; 9inished goods stoc; : 1 'ash manufacturing cost : ( 1 ( 1 #,!%%,%%% : ( 1 !%%,%%% : , ( 1 ,%%%,%%% : ( ,,,,,,, -,,%%,%%% : ,( 1,, -,%%% Rs.

'ash balance

A 5redetermined amount A 6 'urrent Assets B C Current "ia,ilities 0aterial cost ,%%%,%%% : 1( 1 1 Ane monthJs cash manufacturing e:5enses Ane monthJs wages <hree monthsJ e:5enses : 1

( (

,%%,%%% ,7-!,,,, Rs.

=undry creditors 0anufacturing e:5enses outstanding Wages outstanding =ales 8romotion e:5enses

1$$,$$7

( ( (

1%%,%%% 1,,,,,, 1%%,%%% +++++++++++++ -%%,%%% , -!,,,, #-1,$$7 ,71%,%%%

? 6 'urrent liabilities Wor;ing ca5ital (A I B) Add % % safety margin Wor;ing ca5ital re7uired CHAPTER 2, 1.

Mou ha2e been as;ed to 5re5are a cash budget for the ne:t 7uarter, canuary through 0arch, for =harmilee /:5orts. <hey ha2e 5ro2ided you with the following information6 a. =ales are e:5ected to be6 &s.,%%,%%% in canuary, &s. $%,%%% in 9ebruary, and &s.,-%,%%% in 0arch. All sales will be in cash. b. <he estimated 5urchases are6 &s. #%,%%% in canuary, &s. %,%%% in 9ebruary, and &s. -%,%%% in 0arch. 8ayments for 5urchases will be made after a lag of one month. Autstanding on account of 5urchases in 3ecember last are &s. 1%,%%%. c. <he rent 5er month is &s.!,%%% and the 5artnersJ 5ersonal withdrawal 5er month is &s.1 ,%%%. d. =alaries and other e:5enses, 5ayable in cash, are e:5ected to be6 &s.1-,%%% in canuary, &s.1-,%%% in 9ebruary, and &s.1$,%%% in 0arch. e. <hey 5lan to buy two com5uters worth &s.-%,%%% on cash 5ayment in 0arch. f. <he cash balance at 5resent is &s.1 ,%%%. <heir target cash balance, howe2er, is &s. %,%%%. What will be sur5lus* deficit of cash in relation to their target cash balance?

Solution:

<he 5roCected cash inflows and outflows for the 7uarter, canuary through 0arch, is shown below . Month "nflows 6 =ales collection Autflows 6 8urchases 8ayment to sundry creditors &ent 3rawings =alaries 4 other e:5enses 8urchase of com5uters <otal outflows( to$) 1%,%%% Decem,er %Rs.& Panuary %Rs.& ,%%,%%% #%,%%% 1%,%%% !,%%% 1 ,%%% 1-,%%% #-,%%% 6e,ruary %Rs.& $%,%%% %,%%% #%,%%% !,%%% 1 ,%%% 1-,%%% 7-,%%% March %Rs.& ,-%,%%% -%,%%% %,%%% !,%%% 1 ,%%% 1$,%%% -%,%%% ,%$,%%%

Bi2en an o5ening cash balance of &s.1 ,%%% and a target cash balance of &s. %,%%%, the sur5lus*deficit in relation to the target cash balance is wor;ed out below 6 Panuary %Rs.& 1. A5ening balance . "nflows ,. Autflows #. Net cash flow ( + ,) -. 'umulati2e net cash flow $. A5ening balance ) 'umulati2e net cash flow 7. 0inimum cash balance re7uired !. =ur5lus*(3eficit) . 6e,ruary %Rs.& March %Rs.&

1 ,%%% ,%%,%%% $%,%%% ,-%,%%% #-,%%% 7-,%%% ,%$,%%% --,%%% ( 1-,%%%) ##,%%% --,%%% #%,%%% !#,%%% $7,%%% %,%%% #7,%%% - ,%%% .$,%%% %,%%% %,%%% , ,%%% 7$,%%%

Mou ha2e been as;ed to 5re5are a cash budget for the ne:t 7uarter, canuary through 0arch, for cahanara 9ashions. <hey ha2e 5ro2ided you with the following information6 a. =ales are e:5ected to be6 &s.#%%,%%% in canuary, &s.#%%,%%% in 9ebruary, and &s.$%%,%%% in 0arch. All sales will be in cash. b. <he estimated 5urchases are6 &s.,!%,%%% in canuary, &s,$%,%%% in 9ebruary, and &s.#-%,%%% in 0arch. 8ayments for 5urchases will be made after a lag of one month. Autstanding on account of 5urchases in 3ecember last are &s.,-%,%%%.

c. d. e. f.

<he rent 5er month is &s.1%,%%% and the 5artnersJ 5ersonal withdrawal 5er month is &s. -,%%%. =alaries and other e:5enses, 5ayable in cash, are e:5ected to be6 &s. -,%%% in canuary, &s. %,%%% in 9ebruary, and &s.,%,%%% in 0arch. <hey 5lan to buy furniture worth &s.#%,%%% on cash 5ayment in canuary.. <he cash balance at 5resent is &s.$,%%%. <heir target cash balance, howe2er, is &s.1-,%%%. What will be sur5lus* deficit of cash in relation to their target cash balance?

Solution: <he 5roCected cash inflows and outflows for the 7uarter, canuary through 0arch, is shown below . Month "nflows 6 =ales collection Autflows 6 8urchases 8ayment to sundry creditors &ent 3rawings =alaries 4 other e:5enses 8urchase of furniture <otal outflows ( to$) ,-%,%%% Decem,er %Rs.& Panuary %Rs.& #%%,%%% ,!%,%%% ,-%,%%% 1%,%%% -,%%% -,%%% #%,%%% #-%,%%% 6e,ruary %Rs.& #%%,%%% ,$%,%%% ,!%,%%% 1%,%%% -,%%% %,%%% #,-,%%% March %Rs.& $%%,%%% #-%,%%% ,$%,%%% 1%,%%% -,%%% ,%,%%% # -,%%%

Bi2en an o5ening cash balance of &s.$,%%% and a target cash balance of &s.1-,%%%, the sur5lus*deficit in relation to the target cash balance is wor;ed out below 6 Panuary 6e,ruary March %Rs.& %Rs.& %Rs.& 1. A5ening balance . "nflows ,. Autflows #. Net cash flow ( + ,) -. 'umulati2e net cash flow $. A5ening balance ) 'umulati2e net cash flow 7. 0inimum cash balance re7uired !. =ur5lus*(3eficit) $,%%% #%%,%%% #-%,%%% (-%,%%%) (-%,%%%) (##,%%%) 1-,%%% ( -.,%%%) #%%,%%% #,-,%%% (,-,%%%) ( !-,%%%) (7.,%%%) 1-,%%% (.#,%%%) $%%,%%% # -,%%% 17-,%%% .%,%%% .$,%%% 1-,%%% !1,%%%

,.

=martlin; 'or5oration issues che7ues of &s.1%,%%% daily and it ta;es $ days for its che7ues to be cleared. =martlin; 'or5oration recei2es che7ues of &s.,%,%%% daily and it ta;es # days for these che7ues to be realised. Assume that there is a balance of &s.!%,%%% to begin with[ show the balance in the boo; of the firm and the boo;s of the ban;. What will be the balance in the steady state situation? =olution6 <he balances in the boo;s of =martlin; 'or5oration and the boo;s of the ban; are shown below6 %Rs&
1 2 3 . 5 ! $ =

'oo;s of =martlin; 'or5oration : A5ening ?alance A##C 'he7ue recei2ed "essC 'he7ue issued 'losing ?alance 'oo;s of the 'an;: A5ening ?alance A##C 'he7ues realised "essC 'he7ues debited 'losing ?alance !%,%%% !%,%%% !%,%%% !%,%%% 11%,%%% 1#%,%%% !%,%%% !%,%%% !%,%%% !%,%%% !%,%%% ,%,%%% 11%,%%% ,%,%%% 1#%,%%% ,%,%%% 1%,%%% 1$%,%%% 1$%,%%% ,%,%%% 1%,%%% 1!%,%%% !%,%%% ,%,%%% 1%,%%% 1%%,%%% 1%%,%%% ,%,%%% 1%,%%% 1 %,%%% 1 %,%%% ,%,%%% 1%,%%% 1#%,%%% 1#%,%%% ,%,%%% 1%%%% 1$%,%%% 1$%,%%% ,%,%%% 1%,%%% 1!%,%%% 1!%,%%% ,%,%%% 1%,%%% %%,%%% %%,%%% ,%,%%% 1%,%%% %,%%% %,%%% ,%,%%% 1%,%%% #%,%%%

9rom day 7 we find that the balance as 5er the ban;Js boo;s is less than the balance as 5er =martlin; 'or5orationJs boo;s by a constant sum of &s.$%,%%%. Gence in the steady situation =martlin; 'or5oration has a negati2e net float of &s.$%,%%%. #. =hahanshah @imited issues che7ues of &s.-%,%%% daily and it ta;es - days for its che7ues to be cleared. =hahanshah @imited recei2es che7ues of &s.!%,%%% daily and it ta;es , days for these che7ues to be realised. Assume that there is a balance of &s.1%%,%%% to begin with[ show the balance in the boo; of the firm and the boo;s of the ban;. What will be the balance in the steady state situation?

Solution: <he balances in the boo;s of =hahanshah @imited and the boo;s of the ban; are shown below6 %Rs& 'oo;s of Shahanshah Limite"

A5ening ?alance A##C 'he7ue recei2ed "essC 'he7ue issued 'losing ?alance

1%%,%%% 1,%,%%% 1$%,%%% 1.%,%%% !%,%%% !%,%%% !%,%%% !%,%%% -%,%%% -%,%%% -%,%%% -%,%%% 1,%,%%% 1$%,%%% 1.%,%%% %,%%% 'oo;s of the 'an;:

%,%%% !%,%%% -%,%%% -%,%%%

-%,%%% !%,%%% -%,%%% !%,%%%

!%,%%% !%,%%% -%,%%% ,1%,%%%

A5ening ?alance A##C 'he7ues realised "essC 'he7ues debited 'losing ?alance

1%%,%%% 1%%,%%% 1%%,%%% 1%%,%%% 1!%,%%% !%,%%% !%,%%% 1%%,%%% 1%%,%%% 1%%,%%% 1!%,%%% $%,%%%

$%,%%% !%,%%% -%,%%% .%,%%%

.%,%%% !%,%%% -%,%%% , %,%%%

9rom day $ we find that the balance as 5er the ban;Js boo;s is more than the balance as 5er =hahanshah @imitedJs boo;s by a constant sum of &s.1%,%%%. Gence in the steady situation =hahanshah @imited has a 5ositi2e net float of &s.1%,%%%. -. =oura2 "nternational re7uires &s. 1-% million in cash for meeting its transaction needs o2er the ne:t two months, its 5lanning horiPon for li7uidity decisions. "t currently has the amount in the form of mar;etable securities that earn . 5ercent annual yield. <he cash 5ayments will be made e2enly o2er the two months 5lanning 5eriod. <he con2ersion of mar;etable securities into cash entails a fi:ed cost of &s. $,%%% 5er transaction. What is the o5timal con2ersion siPe as 5er ?aumol model?

Solution: <( 1-%,%%%,%%% " ( %.%.*$ ( %.%1According to the ?aumol model6 bt ' ( +++++ " $. ( b ( $,%%%

: $,%%% : 1-%,%%%,%%% +++++++++++++++++++++++++++++++++ ( &s. 1%,.-#,#-1 %.%1-

Tishal /:5orts re7uires &s..% million in cash for meeting its transaction needs o2er the ne:t three months, its 5lanning horiPon for li7uidity decisions. Tishal /:5orts currently has the amount in the form of mar;etable securities. <he cash 5ayments will be made e2enly o2er the three months 5lanning 5eriod. Tishal /:5orts earns ! 5ercent annual yield on its mar;etable securities. <he con2ersion of mar;etable securities into cash entails a fi:ed cost of &s.#,-%% 5er transaction. What is the o5timal con2ersion siPe as 5er the ?aumol model ? Solution: < ( .%,%%%,%%% " ( %.%!*# ( %.% b ( #,-%%

According to the ?aumol model6 c ( b< +++++++++ " : #-%% : .%,%%%,%%% ( ++++++++++++++++++++++++++++++++ %.% ( &s. $,$,.$1.%,

7.

<o5notch 'or5oration re7uires &s.#- million in cash for meeting its transaction needs o2er the ne:t si: months, its 5lanning horiPon for li7uidity decisions. <o5notch currently has the amount in the form of mar;etable securities. <he cash 5ayments will be made e2enly o2er the si: month 5lanning 5eriod. <o5notch earns $ 5ercent annual yield on its mar;etable securities. <he con2ersion of mar;etable securities into cash entails a fi:ed cost of &s.1,-%% 5er transaction. What is the o5timal con2ersion siPe as 5er the ?aumol model ?

Solution: < ( #-,%%%,%%% "( According to the ?aumol model6 b< ' ( " ( %.%, : 1-%% : #-,%%%,%%% %.%$ ( %.%, b ( 1,-%%

( &s. ,1 1,, %

!. ACit Associates e:5ects its cash flows to beha2e in a random manner, as assumed by the 0iller and Arr model .<he following information has been gathered. Annual yield on mar;etable securities ( . 5ercent <he fi:ed cost of effecting a mar;etable securities transaction ( &s. ,!%% <he standard de2iation of the change in daily cash balance ( &s.1.,%%% 0inimum cash balance re7uired to be maintained as 5er management 5olicy ( &s. ,-%%,%%% What are the Lreturn 5ointJ and Lu55er control 5ointJ? Solution: " ( %.%.*,$% ( %.%%% ,b] , : ,!%% : 1.,%%% : 1.,%%%

&8 ( , +++++++ ) @@ ( , +++++++++++++++++++++++++++++++++++ ) ,-%%,%%% #" # : %.%%% ( &s. ,$##,7# >@ ( , &8 + @@ ( , : ,$##,7# I : ,-%%,%%% ( &s. ,.,#, $ .. Ganson 'or5oration e:5ects its cash flows to beha2e in a random manner, as assumed by the 0iller and Arr model. <he following information has been gathered. Annual yield on mar;etable securities ( ! 5ercent <he fi:ed cost of effecting a mar;etable securities transaction ( &s. 17%% <he standard de2iation of the change in daily cash balance ( &s. 7,%%% <he management wants to maintain a minimum cash balance of &s.,,-%%,%%% What are the Lreturn 5ointJ and Lu55er control 5ointJ? Solution: " ( %.%! * ,$% &8 ( ( %.%%%
2

,b] , ++++++++ >"

) @@

, : 17%% : 7,%%% : 7,%%% ( , ++++++++++++++++++++++++++++++++++ ) ,,-%%,%%% # : %.%%% ( ,,$$1,17#

>@ (

,&8 I @@ ( , : ,,$$1,17# +

: ,,-%%,%%% ( &s. ,,.!,,-

1%.

8remier @imited e:5ects its cash flows to beha2e in a random manner, as assumed by the 0iller and Arr model. <he following information has been gathered. Annual yield on mar;etable securities ( - 5ercent <he fi:ed cost of effecting a mar;etable securities transaction ( &s. !%% <he standard de2iation of the change in daily cash balance ( &s.1 ,%%% <he management wants to maintain a minimum cash balance of &s.1,-%%,%%% What are the Lreturn 5ointJ and Lu55er control 5ointJ?

Solution: " ( %.%-*,$% ( %.%%%1,. &8 ( , ,b #" , : !%% : 1 ,%%% : 1 ,%%% ( , # : %.%%%1,. >@ ( , &8 I @@ ( 1,7-$,% . CHAPTER 2, 1. &a;esh /nter5rises currently 5ro2ides ,% days credit to its customers. "ts 5resent sales are &s. %% million ."ts cost of ca5ital is 1 5ercent and the ratio of 2ariable costs to sales is %.!% &a;esh /nter5rises are considering e:tending the credit 5eriod to #- days which is li;ely to 5ush sales u5 by &s.$% million. <he bad debt 5ro5ortion on additional sales would be 1- 5ercent. <he ta: rate is ,, 5ercent. What will be the effect of lengthening the credit 5eriod on the residual income of the firm? ) 1,-%%,%%% ( 1,-!-,,#, ) @@

Solution: a&" ( U a=(1+T) Ia=bnV(1+t) I ;a" a" ( (A'8N I A'8%)d =%*,$%e ) T(A'8N) a=*,$% ( (#-+,%) : ( %%,%%%,%%%*,$%) ) %.!% : #- : ( $%,%%%,%%%*,$%) ( 1#,,,,,,,, a&" ( ($%,%%%,%%% : %. % + $%,%%%,%%% : %.1-)(%.$7) +%.1 : 1#,,,,,,,, ( .%,%%% . 8hoeni: @imited currently 5ro2ides ,% days of credit to its customers. "ts 5resent le2el of sales is &s.1-% million. <he firmJs cost of ca5ital is 1# 5ercent and the ratio of 2ariable costs to sales is %.7%. 8hoeni: is considering e:tending its credit 5eriod to $% days. =uch an e:tension is li;ely to 5ush sales u5 by &s.1 million. <he bad debt 5ro5ortion on the additional sales would be $ 5ercent. <he ta: rate for 8hoeni: is ,% 5ercent. What will be the effect of lengthening the credit 5eriod on the residual income of 8hoeni: @imited? Assume ,$% days to a year.

Solution:

U1 ,%%%,%%% : %.,% I 1 ,%%%,%%% : %.%$V (1 I %.,) 1-%,%%%,%%% + %.1# ($% I ,%) : ,$% ( ,%1$,%%% I 1,.#$,%%% ( 7%,%%% ,. Acme @imited 5ro2ides ,% days of credit to its customers. "ts 5resent le2el of sales is &s.,%% million. <he firmJs cost of ca5ital is 1 5ercent and the ratio of 2ariable costs to sales is %.7-. Acme is considering e:tending its credit 5eriod to #- days. =uch an e:tension is li;ely to 5ush sales u5 by &s. - million. <he bad debt 5ro5ortion on the additional sales would be ! 5ercent. <he ta: rate for Acme is ,% 5ercent. What will be the effect of lengthening the credit 5eriod on the residual income of Acme? Assume ,$% days to a year. ) %.7% : $% : ,$% 1 ,%%%,%%%

Solution: `&" ( U`= (1+T) + `=bnV (1It) I ; (A'8n I A'8%) ) : A'8n : T

( U -,%%%,%%% : %. - I -,%%%,%%% : .%!V (1 I %.,) ,%%,%%%,%%% I %.1 ,$% ( ,.7-,%%% I 1,7!1, -% ( 1,1.,,7-% #. <he 5resent credit terms of "ndus "ndustries are ,*1-, net ,%. "ts sales are &s.#7% million, its a2erage collection 5eriod is #- days, its 2ariable costs to sales ratio, T, is %.!-, and its cost of ca5ital is 1 5ercent. <he 5ro5ortion of sales on which customers currently ta;e discount, is %.#. "ndus is considering rela:ing its credit terms to -*1-, net ,%. =uch a rela:ation is e:5ected to increase sales by &s. % million, increase the 5ro5ortion of discount sales to %.$, and reduce the A'8 to #% days. "ndusJs ta: rate is ,% 5ercent. What will be the effect of liberalising the cash discount on residual income? (#-+,%) ) ,$% -,%%%,%%% : #- : %.7-

Solution: &" 3"= ( U =("IT)+ 3"= V (1 + t ) ) & " ( 5n (=% ) =) dn + 5%=%do ( %.$ U#7%,%%%,%%% ) %,%%%,%%% V : %.%- + %.# : #7%,%%%,%%% : %.%, ( .,%$%,%%% ( #7%,%%%,%%%
+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

"

%,%%%,%%% (#- I #%) + %.!- :

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

: #%

&"

,$% ,$% ( #,$,!,!!. ( U %,%%%,%%% : %.1- + .,%$%,%%%V %.7% ) %.1 : #,$,!,!!. ( + ,,$!-,,,,

-.

<he 5resent credit terms of Blobus 'or5oration are *1%, net #%. "t sales are &s.$-% million, its a2erage collection 5eriod is ,% days, its 2ariable costs to sales ratio, T, is %.7-, and its cost of ca5ital is 1% 5ercent. <he 5ro5ortion of sales on which customers currently ta;e discount, is %.,. Blobus is considering rela:ing its credit terms to ,*1%, net #%. =uch a rela:ation is e:5ected to increase sales by &s.,% million, increase the 5ro5ortion of discount sales to %.-, and reduce the A'8 to % days. BlobusJs ta: rate is ,- 5ercent. What will be the effect of liberalising the cash discount on residual income?

Solution: ` &" ( U`= (1 I T) I `3"=V (1 I t) ) & ` " ` 3"= ( 5n (=o ) `=)dn I 5oso do ( %.- U$-%,%%%,%%% ) ,%,%%%,%%%V .%, I %.,% U$-%,%%%,%%%V .% ( 1%, %%,%%% I ,,.%%,%%% ( $,,%%,%%% $-%,%%%,%%% ,%,%%%,%%% `" ( (,% I %) I %.7- : : % ,$% ,$% ( 1!,%--,--$ I 1, -%,%%% ( 1$,!%-,--$ ` & " ( U,%,%%%,%%% (%. -) I $,,%%,%%%V (%.$-) ) %.1% : 1$,!%-,--$ ( 7!%,%%% ) 1,$!%,--$ ( ,#$%,--$ $. <he 5resent credit terms of Gitesh @imited are 1*1%, net ,%. "t sales are &s.!%% million, its a2erage collection 5eriod, A'8, is days, its 2ariable costs to sales ratio, T, is %.!%, and its cost of ca5ital, B, is 1- 5ercent. <he 5ro5ortion of sales on which customers currently ta;e discount, 5o, is %.#. Gitesh is considering rela:ing its credit terms to *1%, net ,%. =uch a rela:ation is e:5ected to increase sales by &s.-% million,

increase the 5ro5ortion of discount sales to %.$, and reduce the A'8 to 1! days. GiteshJs ta: rate is ,% 5ercent. What will be the effect of liberalising the cash discount on residual income? Solution: ` &" ( U`= (1 I T) I `3"=V (1 I t) ) & ` " ` 3"= ( 5n (=o ) `=)dn I 5oso do ( %.$ U!%%,%%%,%%% ) -%,%%%,%%%V .% I %.#% U!%%,%%%,%%%V .%1 ( 1%, %%,%%% I ,, %%,%%% ( 7,%%%,%%% !%%,%%%,%%% -%,%%%,%%% `" ( ( I 1!) I %.! : : 1! ,$% ,$% ( !,!!!,!!. I ,%%%,%%% ( $,!!!,!!. ` & " ( U-%,%%%,%%%, (%. ) I 7,%%%,%%%V (%.7) ) %.1- : $,!!!,!!. ( ,1%%,%%% ) 1,%,,,,,, ( ,,1,,,,,,, 7. <he 5resent sales of Nachi;et "ndustries are &s.1%% million. <he firm classifies its customers into , credit categories6 A, ?, and '. <he firm e:tends unlimited credit to customers in category A, limited credit to customers in category ?, and no credit to customers in category '. As a result of this credit 5olicy, the firm is foregoing sales to the e:tent of &s.1% million to customers in category ? and &s. % million to customers in category '. <he firm is considering the ado5tion of a more liberal credit 5olicy under which customers in category ? would be e:tended unlimited credit 5olicy and customers in category ' would be 5ro2ided limited credit. =uch rela:ation would increase the sales by &s.,% million on which bad debt losses would be 1% 5ercent. <he contribution margin ratio for the firm is % 5ercent, the a2erage collection 5eriod is #- days, and the cost of ca5ital is 1$ 5ercent. <he ta: rate for the firm is ,- 5ercent.

What will be the effect of rela:ing the credit 5olicy on the residual income of the firm? Solution: a R/ ( UaS(1+D)+ aS,nV(1+t)+ B a/ aS a/ ( : AC- : D ,$% a S ( &s.,% million, D(%.!%, ,n (%.1%, AC-( #- days, B(%.1$, t ( %.,Gence, aR/ ( U ,%,%%%,%%%(1+%.!%)+ ,%,%%%,%%% : %.1% V (1+%.,-) +%.1$ : ,%,%%%,%%% : #- : %.!% ,$% ( &s. 1,#7%,%%% !. <he 5resent sales of 8ur2anchal @imited are &s.!% million. <he firm is considering the ado5tion of a more liberal credit 5olicy under which customers with annual

income in e:cess of &s.1million would be e:tended unlimited credit and other customers limited credit. =uch rela:ation would increase the sales by &s. % million on which bad debt losses would be ! 5ercent. <he contribution margin ratio for the firm is - 5ercent, the a2erage collection 5eriod is ,% days, and the cost of ca5ital is 1! 5ercent. <he ta: rate for the firm is ,# 5ercent. What will be the effect of rela:ing the credit 5olicy on the residual income of the firm? Solution: a R/ ( UaS(1+D)+ aS,nV(1+t)+ B a/ aS a/ ( : AC- : D ,$% a S ( &s. % million, D(%.7-, ,n (%.%!, AC-( ,% days, B(%.1!, t ( %.,# Gence, aR/ ( U %,%%%,%%%(1+%.7-)+ %,%%%,%%% : %.%! V (1+%.,#) +%.1! : %,%%%,%%% : ,% : %.7,$% ( &s. ,%1.,%%% .. Baribdas @imited is considering rela:ing its collection efforts. 8resently its sales are &s.7% million, its a2erage collection 5eriod % days, its 2ariable costs to sales ratio %.$%, its cost of ca5ital 1$ 5ercent, and its bad debt ratio %.%-. <he rela:ation in collection efforts is e:5ected to 5ush sales u5 by &s.1% million, increase the a2erage collection 5eriod to ,% days, and raise the bad debts ratio to %.%!. <he ta: rate of the firm is ,- 5ercent. What will be the effect of rela:ing the collection effort on the residual income of the firm? Solution: a R/ ( UaS(1+D)+ aBDV(1+t) IBa / aBD(,n(So)aS) I,oSo So a/ ( ,$% (AC-3 IAC-o) ) ,$% aS : AC-3 : D

So(&s.7% million, AC-o( %, D(%.$%, B(%.1$, ,o(%.%-, aS(&s.1% million, AC-3(,% , ,n( %.%! , t ( %.,aR/ ( U &s.1%,%%%,%%%(1+.$%) Id.%!(&s.!%,%%%,%%%)+.%-(&s.7%,%%%,%%%)V(1+%.,-)

2s.70!000!000 + %.1$ ,$% ( &s., ,,!!. 1%.

2s.10!000!000 : (,%+ %) ) ,$%

:,% : %.$

=onar 'or5oration is considering rela:ing its collection efforts. 8resently its sales are &s. %% million, its a2erage collection 5eriod ,% days, its 2ariable costs to sales ratio %.7%, its cost of ca5ital 1! 5ercent, and its bad debt ratio %.%-. <he rela:ation in collection efforts is e:5ected to 5ush sales u5 by &s. % million, increase the a2erage collection 5eriod to #% days, and raise the bad debts ratio to %.%$. <he ta: rate of the firm is ,, 5ercent. What will be the effect of rela:ing the collection effort on the residual income of the firm?

Solution: a R/ ( UaS(1+D)+ aBDV(1+t) IBa / aBD(,n(So)aS) I,oSo So aS a/ ( (AC-3 IAC-o) ) : AC-3 : D ,$% ,$% So(&s. %% million, AC-o(,%, D(%.7%, B(%.1!, ,o(%.%-, aS(&s. % million, AC-3(#% , ,n( %.%$ , t ( %.,, aR/ ( U &s. %,%%%,%%%(1+.7%) Id.%$(&s. %,%%%,%%%)+.%-(&s. %%,%%%,%%%)V(1+%.,,) 2s.200!000!000 + %.1! ,$% ( &s.-.$,%%% 11. <he financial manager of a firm is wondering whether credit should be granted to a new customer who is e:5ected to ma;e a re5eat 5urchase. An the basis of credit e2aluation, the financial manager feels that the 5robability that the customer will 5ay is %.7% and the 5robability that the customer will default is %.,%. Ance the customer 5ays for the first 5urchase, the 5robability that he will 5ay for the re5eat 5urchase will be %..%. <he re2enue from the sale will be &s. %%,%%% and the cost of the sale will be &s.1$%,%%% I these figures a55ly to both the initial and the re5eat 5urchases. What is the e:5ected 5ayoff if the credit is granted? Solution: 2s.20!000!000 : (#%+,%) ) ,$% :#% : %.7%

1 .

<he financial manager of a firm is wondering whether credit should be granted to a new customer who is e:5ected to ma;e a re5eat 5urchase. An the basis of credit e2aluation, the financial manager feels that the 5robability that the customer will 5ay is %.!% and the 5robability that the customer will default is %. %. Ance the customer 5ays for the first 5urchase, the 5robability that he will 5ay for the re5eat 5urchase increases to %..-. <he re2enue from the sale will be &s. -%,%%% and the cost of the sale would be &s.1!%,%%% I these figures a55ly to both the initial and the re5eat 5urchase. What is the e:5ected 5ayoff if the credit is granted?

Solution: /:5ected 5ay off ( ( 1,. (%.!% : 7%,%%%) + (%. : 1!%,%%%) ) %.!% U%..- (7%,%%%) I %.%- : 1!%,%%%V $$,%%%

<he financial manager of a firm is wondering whether credit should be granted to a new customer who is e:5ected to ma;e a re5eat 5urchase. An the basis of credit e2aluation, the financial manager feels that the 5robability that the customer will 5ay is %.7% and the 5robability that the customer will default is %.,%. Ance the customer 5ays for the first 5urchase, the 5robability that he will 5ay for the re5eat 5urchase will be %..%. <he re2enue from the sale will be &s. %%,%%% and the cost of the sale will be &s.1$%,%%% I these figures a55ly to both the initial and the re5eat 5urchases. What is the e:5ected 5ayoff if the credit is granted?

Solution:

1#.

Senith /nter5rises sells on terms, *1%, net ,%. Annual sales are &s. %% million. #% 5ercent of its customers 5ay on the 1%th day and ta;e the discount. "f accounts recei2able a2erage is &s.1- million, what is the a2erage collection 5eriod (A'8) on non+discount sales?

Solution: 3iscount sales Accounts recei2able ( UA'8 on discount salesV ,$% Non I discount sales ) UA'8 on non+discount salesV !%,%%%,%%% 1-,%%%,%%% ( U1%V ,$% =% A'8 ( ,!., days 1-. A<8 @td. sells on terms #*#-, net $% .Annual sales are &s. %% million, #% 5ercent of its customers 5ay on the #-th day and ta;e the discount. "f the accounts recei2able a2erage &s. - million, what is the a2erage collection 5eriod (A'8) on non discount sales? ) A'8 ,$% ,$% 1 %,%%%,%%%

Solution: Accounts receivable Discount sales = [ ACP on discount sales][ --------------------] 360 Non-discount sales +[ACP on non-discount sales][ --------------------------] 360 0. ! "00 0.6 ! "00 # ! ------------------- + ACPND ! ----------------360 360

"# =

i.e. "#! 360 = 3600 + ACPND ! $"0 ACPND = # 1$. Senith /nter5rises sells on terms, *1%, net ,%. Annual sales are &s. %% million. #% 5ercent of its customers 5ay on the 1%th day and ta;e the discount. "f accounts recei2able a2erage is &s.1- million, what is the a2erage collection 5eriod (A'8) on non+discount sales ?

Solution: 3iscount sales Accounts recei2able ( UA'8 on discount salesV ,$% Non I discount sales ) UA'8 on non+discount salesV !%,%%%,%%% 1-,%%%,%%% ( U1%V ) A'8 ,$% 1 %,%%%,%%%

,$% ,$% =ol2ing the abo2e we get A'8 ( ,!., days 17. 0alwa "ndustries sells on terms ,*1%, net ,%. <otal sales for the year are &s.$% million. 9orty 5ercent of the sales amount is 5aid on the tenth day (a2ailing the discount) and the remaining $% 5ercent 5ay, on a2erage, #% days after their 5urchases. 'alculate the a2erage collection 5eriod and the a2erage in2estment in recei2ables.

Solution: #%% of sales will be collected on the 1%th day $%% of sales will be collected on the #%th day AC- ( %.# : 1% ) %.$ : #% ( ! days &s.$%,%%%,%%% Talue of recei2ables ( ,$% ( &s.#,$$$,$$7 Assuming that D is the 5ro5ortion of 2ariable costs to sales, the in2estment in recei2ables is 6 &s. #,$$$,$$7 : D 1!. ?heema /nter5rises sells on terms #*1-, net #%. <otal sales for the year are &s.1%% million. <wenty 5ercent of the sales amount is 5aid on the fifteenth day (getting the benefit of discount) and the remaining !% 5ercent 5ay, on a2erage, $% days after their 5urchases. : !

'alculate the a2erage collection 5eriod and the a2erage in2estment in recei2ables. Solution: %% of sales will be collected on the 1-th day !%% of sales will be collected on the $%th day AC- ( %. : 1- ) %.! : $% ( -1 days &s.1%%,%%%,%%% Talue of recei2ables ( ,$% ( &s.1#,1$$,$$7 Assuming that D is the 5ro5ortion of 2ariable costs to sales, the in2estment in recei2ables is 6 &s. 1#,1$$,$$7: D 1.. A firm is wondering whether to sell goods to a customer on credit or not. <he re2enues from sale will be &s.-%,%%% and the cost of sale will be &s.,$,%%%. What should be the minimum 5robability that the customer will 5ay, in order to sell 5rofitably? : -1

Solution: 8rofit when the customer 5ays ( &s.-%,%%% + &s.,$,%%% ( &s.1#,%%% @oss when the customer does not 5ay ( &s.,$,%%% /:5ected 5rofit ( p1 : 1#,%%% I(1+p1),$,%%%

=etting e:5ected 5rofit e7ual to Pero and sol2ing for p1 gi2es6 p1 : 1#,%%% I (1+ p1),$,%%% ( % p1 ( %.7 Gence the minimum 5robability that the customer must 5ay is %.7 %. A firm is wondering whether to sell goods to a customer on credit or not. <he re2enues from sale will be &s.1%%,%%% and the cost of sale will be &s.!%,%%%. What should be the minimum 5robability that the customer will 5ay, in order to sell 5rofitably? 8rofit when the customer 5ays ( &s.1%%,%%% + &s.!%,%%% ( &s. %,%%% @oss when the customer does not 5ay ( &s.!%,%%% /:5ected 5rofit ( p1 : %,%%% I(1+p1)!%,%%% =etting e:5ected 5rofit e7ual to Pero and sol2ing for p1 gi2es 6 p1 : %,%%% I (1+ p1)!%,%%% ( % p1 ( %.! Gence the minimum 5robability that the customer must 5ay is %.! CHAPTER 23 1. 8ioneer =tores is trying to determine the economic order 7uantity for a certain ty5e of machine tool. <he firm sells $%,%%% numbers of this machine tool annually at a 5rice of &s.!% 5er 5iece. <he 5urchase 5rice 5er machine tool to the firm is, howe2er, &s.$-. <he cost of carrying a machine tool is &s.1% 5er year and the cost of 5lacing an order is &s.!%. (a) What is the total cost associated with 5lacing one, two, fi2e, and ten orders 5er year? (b) What is the economic order 7uantity?

Solution:

Solution: a. 3o. of 'r#er 'r#ers -er Kuantity 2ear %K& %L>K& Lnits 1 1% $%,%%% ,%,%%% 1 ,%%% $,%%% 'r#erin< Cost %L>K A 6& Rs. !% 1$% #%% !%% Carryin< Cost 0otal Cost K>2A-AC of 'r#erin< %(here an# Carryin< -AC8Rs.10& Rs. Rs. ,%%,%%% 1-%,%%% $%,%%% ,%,%%% ,%%,%!% 1-%,1$% $%,#%% ,%,!%% :$%,%%%: !% 1%

b. /conomic Arder Huantity (*'K) (

L6 ( -C ( .!% units (a55ro:)

National =tores is trying to determine the economic order 7uantity for certain ty5e of transformers. <he firm sells #%% numbers of this transformers annually at a 5rice of &s.,%% 5er 5iece. <he 5urchase 5rice 5er machine tool to the firm is, howe2er, &s. ,%. <he cost of carrying a transformer is &s.#% 5er year and the cost of 5lacing an order is &s.1!%. (a) What is the total cost associated with 5lacing one, four, eight , and ten orders 5er year? (b) What is the economic order 7uantity?

Solution: a. 3o. of 'r#er 'r#ers -er Kuantity 2ear %K& %L>K& Lnits 1 # ! 1% #%% 1%% -% #% 'r#erin< Cost %L>K A 6& Rs. 1!% 7 % 1##% 1!%% Carryin< Cost 0otal Cost K>2A-AC of 'r#erin< %(here an# Carryin< -AC8Rs..0& Rs. Rs. !,%%% ,%%% 1,%%% !%% L6 ( -C !,1!% ,7 % ,##% ,$%% : #%%: 1!% #%

b. /conomic Arder Huantity (*'K) ( ( $% units ,.

Garilal 'om5any re7uires -,%%% units of a certain item 5er year. <he 5urchase 5rice 5er unit is &s.$%[ the carrying cost 5er year is ,% 5ercent of the in2entory 2alue[ and the fi:ed cost 5er order is &s.#%%. (a) 3etermine the economic order 7uantity. (b) Gow many times 5er year will in2entory be ordered, if the siPe is e7ual to the /AH? (c) What will be the total cost of carrying and ordering in2entories when 1% orders are 5laced 5er year?

Solution: 2L6 a *'K 8 -C L( -,%%% , 6(&s.#%%, -C( &s.$% : %.,% (&s.1!

: -,%%% : #%% *'K ( 1! -,%%% b. Number of orders that will be 5laced is ( ,.7 1,%-# Note that though fractional orders cannot be 5laced, the number of orders rele2ant for the year will be ,.7 . "n 5ractice # orders will be 5laced during the year. Gowe2er, the # th order will ser2e 5artly(to the e:tent of 7 5ercent) the 5resent year and 5artly(to the e:tent of ! 5er cent) the following year. =o only 7 5er cent of the ordering cost of the #th order relates to the 5resent year. Gence the ordering cost for the 5resent year will be ,.7 : &s.#%% ( &s..,#!! c. <otal cost of carrying and ordering in2entories 1%-# ( U ,.7 : #%% ) : 1! V ( &s.1!,.7# #. Oamal and 'om5any re7uires -%,%%% units of a certain item 5er year. <he 5urchase 5rice 5er unit is &s. %[ the carrying cost 5er year is 1- 5ercent of the in2entory 2alue[ and the fi:ed cost 5er order is &s.1%%. (a) 3etermine the economic order 7uantity. (b) Gow many times 5er year will in2entory be ordered, if the siPe is e7ual to the /AH? (c) What will be the total cost of carrying and ordering in2entories when 1% orders are 5laced 5er year? Solution: 2L6 a *'K 8 -C L(-%,%%% , 6(&s.1%%, -C( &s. % : %.1- (&s., : -%,%%% : 1%% *'K ( , -%,%%% b. Number of orders that will be 5laced is ( 7.,! 1,! $ Note that though fractional orders cannot be 5laced, the number of orders rele2ant for the year will be 7.,! . "n 5ractice ! orders will be 5laced during the year. Gowe2er, the !th order will ser2e 5artly(to the e:tent of ,! 5ercent) the 5resent year and 5artly(to the e:tent of $ 5er cent) the following year. =o only ,! 5er cent of the ordering cost of the !th order relates to the 5resent year. Gence the ordering cost for the 5resent year will be 7.,! : &s.1%% ( &s. ,7,! c. <otal cost of carrying and ordering in2entories ( 1! $ units.(a55ro:imately) ( 1%-# units.

1! $ ( U 7.,! : 1%% ) -. : , V ( &s.-#77

'onsider the following data for a certain item 5urchased by caibharat =tores.. Annual usage ( 1%,%%% units 9i:ed cost 5er order ( &s. %% 8urchase 5rice 5er unit ( &s.1$% 'arrying cost ( - 5ercent of in2entory 2alue What is the economic order 7uantity? Now, assume that a discount of &s.$ 5er unit is offered if the order siPe is ,%%% units. =hould caibharat see; the 7uantity discount?

Solution: L(1%,%%%, 6(&s. %% , -C (&s.1$% : %. - (&s.#% : 1%,%%% : %% *'K 8 #% L 34 = LD 5 K* KE 1%,%%% + ,1$ 1%,%%% : %% ,%%% ,1$ : 1$% : %. + L %KE%-:D&C K7 -C ( ,1$ units (a55ro:imately)

( 1%,%%% : $ )

,%%% (1-#)%. -

( $%,%%% ) -, . I , ,1!% ( &s.,,,1#. $. 'onsider the following data for a certain item 5urchased by @iberty =tores. Annual usage ( -,%%% units 9i:ed cost 5er order ( &s.#%% 8urchase 5rice 5er unit ( &s.,$% 'arrying cost ( ,- 5ercent of in2entory 2alue What is the economic order 7uantity? Now, assume that a discount of &s.1% 5er unit is offered if the order siPe is ,,%%% units. =hould @iberty see; the 7uantity discount?

Solution: L( -,%%%, 6(&s.#%% , -C (&s.,$% : %.,- (&s.1 $ : -,%%% : #%% *'K 8 1 $ L 34 = LD 5 K* KE -,%%% ( -,%%% : 1% ) ,.. ,,%%% (,-%)%.,( 7. + -%,%%% ) 1,7 . I 1-!,$1, ( &s.11,,11$ + ,,%%% ,.. : ,$% : %.,-,%%% : #%% L %KE%-:D&C K7 -C ( ,.. units (a55ro:imately)

=haheed 'or5oration re7uires 1%,%%% units of a certain item annually. <he cost 5er unit is &s.-%, the fi:ed cost 5er order is &s. %%, and the in2entory carrying cost is &s.! 5er unit 5er year. <he su55lier offers 7uantity discount as follows6 'r#er Kuantity ,%%% ,,%%% What should =haheed 'or5oration do? Discount -ercenta<e $ !

Solution: L(1%,%%% , 6( &s. %% , -C( &s.-% : %.1$ ( &s.! : 1%,%%% : %% ( 7%7 units ! "f %%% units are ordered the discount is 6 .%$ : &s.-% ( &s., 'hange in 5rofit when ,%%% units are ordered is 6 *'K (

1%,%%% 34 , 1%,%%% : , ) 7%7 %%% : #7 : %.1$ + + +

1%,%%% : ,%%% 7%7 : -% : %.1$ ( ,%,%%% ) 1! .+ #$. (&s. 7,1,7 %%

"f ,%%% units are ordered the discount is 6 .%! : &s.-% ( &s.# 'hange in 5rofit when ,,%%% units are ordered is 6 34 ( 1%,%%% : #.% ) 1%,%%% 1%,%%% + : %%+ 7%7 ,%%% ( &s. ,,,.-% ,%%%:#$:%.1$ + 7%7:-%:%.1$

( #%,%%% ) 1$ I !, 1

As the change in 5rofit is more when the discount on ,%%% units is a2ailed of, that o5tion is the 5referred one. !. 0erit "nternational re7uires 1-,%%% units of a certain item annually. <he cost 5er unit is &s.!%, the fi:ed cost 5er order is &s.,-%, and the in2entory carrying cost is &s.1% 5er unit 5er year. <he su55lier offers 7uantity discount as follows6 'r#er Kuantity ,,%%% -,%%% What should 0erit "nternational do? Solution: L(1-,%%% , 6( &s.,-% , -C( &s.!% : %.1 - ( &s.1% : 1-,%%% : ,-% ( 1% - units 1% "f ,%%% units are ordered the discount is 6 .%# : &s.!% ( &s.,. % 'hange in 5rofit when ,,%%% units are ordered is 6 1-,%%% 34 , 1-,%%% : ,. ) + 1-,%%% : ,-% *'K ( Discount -ercenta<e # 7

1% ,,%%% ,%%% : 7$.! : %.1 - 1% - : !% : %.1 + ( #!,%%% ) ,,7 + ., 7- (&s.# .%.7

"f -%%% units are ordered the discount is 6 .%7 : &s.!% ( &s.-.$ 'hange in 5rofit when -,%%% units are ordered is 6 1-,%%% 1-,%%% 34 ( 1-,%%% : -.$ ) + : ,-%+ 1% -%%% ( !#,%%% )#%7 I 1!,1 - ( &s. $.,.#7 As the change in 5rofit is more when the discount on -%%% units is a2ailed of, that o5tion is the 5referred one. .. Bulfstar 'or5oration re7uires steel for its fabrication wor;. <he 5robability distributions of the daily usage rate and the lead time for 5rocurement are gi2en below. <hese distributions are inde5endent. Daily usa<e rate in tonnes . 7 .. ., -ro,a,ility # $ 1% "ea# time in #ays .., . -ro,a,ility -%%%: 7#.# :%.1 - 1% -:!%:%.1 +

<he stoc;out cost is estimated to be &s.-,%%% 5er ton. <he carrying cost is &s. ,%%% 5er ton 5er year. &e7uired6 (a) What is the o5timal le2el of safety stoc;? (b) What is the 5robability of stoc;out? Solution: <he 7uantities re7uired for different combinations of daily usage rate(3>&) and lead times(@<) along with their 5robabilities are gi2en in the following table @< (3ays) 3>& (>nits) -(%. ) 7(%.-) #(%.-) $(%.,) 1%(%. )

%X(%.1%) ! (%. -)

,%(%.%$) # (%.1-)

-%(%.%#) 7%(%.1%)

.(%.,) ,$ (%.1-) -#(%.%.) .%(%.%$) <he normal (e:5ected) consum5tion during the lead time is 6 %:%.1% ) ,%:%. %$ ) -%:%.%#) !:%. - ) # :%.1- ) 7%:%.1% ) ,$:%.1- ) -#:%.%. ) .%:%.%$ ( #1.7$ tonnes a. 'osts associated with 2arious le2els of safety stoc; are gi2en below 6 Safety StocB7 1 <onnes #!. # !. # 1 . # StocB outs%in tonnes& 2 StocB out Cost 3 -ro,a,ility *Apecte# Carryin< StocB out Cost 5 U,:#V &s. .$,#!% $,%%% !,%%% 1%,!%% 1!,!%% 1,!%% 1%,%%% 1 ,%%% ,,!%% 1,$%% -,#%% 1#,%%% 1#,#%% ,-,#%% 1!% 1,$#! %.%. %.1% %.%$ -,-%! 1#,1 % 1#,#7 ,-.. ! % ,-,. ! #!% ,-,!!% % %. # !. # 1 . # !. # #!. # 1, %% #1, %% %.%# $1, %% 1#1, %% #1, %% %.1! U(1): ,%%%V &s. .$,#!% -$,#!% 0otal Cost

$ U-)$V &s. $ ,#!%

% % 1$ ,$ # % #%

% 1%%,%%%

% %.%$ %.1% %.%$ %.%. %.1% %.%$

!%,%%% 1!%,%%% %,%%% 1%%,%%% %%,%%%

#,#!%

#,, !%

!. #

1$,#!%

#%, !%

%. #

! 1 ! #!

#%,%%% %.%# $%,%%% %.%. 1#%,%%% %.1% #%,%%% %.%$

=o the o5timal safety stoc;( %. # tonnes &eorder le2el ( Normal consum5tion during lead time ) safety stoc; O( #1.7$ ) %. # ( # tonnes

b. 8robability of stoc; out at the o5timal le2el of safety stoc; ( 8robability (consum5tion being -%, -#, 7% or .% tonnes) 8robability (consum5tion ( -% tonnes) ) 8robability (consum5tion ( -# tonnes) ) 8robability (consum5tion ( 7% tonnes) ) 8robability (consum5tion ( .% tonnes) ( %.%# )%.%.)%.1% ) %.%$ ( %. . 1%. 9i2e =tar @imited re7uires steel for its fabrication wor;. <he 5robability distributions of the daily usage rate and the lead time for 5rocurement are gi2en below. <hese distributions are inde5endent. Daily usa<e rate in tonnes .# , .# # . -ro,a,ility ! 1% "ea# time in #ays .1 .$ ., -ro,a,ility

<he stoc;out cost is estimated to be &s.7,%%% 5er ton. <he carrying cost is &s.1,-%% 5er ton 5er year. &e7uired6 (a) What is the o5timal le2el of safety stoc;? (b) What is the 5robability of stoc;out? Solution: <he 7uantities re7uired for different combinations of daily usage rate(3>&) and lead times(@<) along with their 5robabilities are gi2en in the following table @< (3ays) 3>& (>nits) (%.#) ,(%.#) #(%. ) -(%.1) !(%.$) 1%(%.,)

1%(%.%#) 1- (%.%#) %(%.% )

1$(%. #) #(%. #) , (%.1 )

%(%.1 ) ,%(%.1 ) #%(%.%$)

<he normal (e:5ected) consum5tion during the lead time is 6 1%:%.%# ) 1$:%. # ) %:%.%1 ) 1-:%.%# ) #:%. # ) ,%:%.1 ) %:%.% ) , :%.1 ) #%:%.%$ ( ,. # tonnes

c.

'osts associated with 2arious le2els of safety stoc; are gi2en below 6 StocB outs%in tonnes& 2 StocB out Cost 3 -ro,a,ility *Apecte# Carryin< StocB out Cost 5 U,:#V &s. %% ! % -$,%%% 1#,%%% -$,%%% # ,%%% -$,%%% 1,1 ,%%% %.%$ %.1 %.%$ %.1 %.1 %.%$ % ,,,$% 1,$!% ,,,$% -,%#% -,%#% $,7 % $,7 % 1!,#!% -,1#% 1,,1#% ! U(1):1,-%%V &s. -,1#% 1$,-%% 0otal Cost

Safety StocB7 1 <onnes 1$.7$ !.7$ $.7$

$ U-)$V &s.

! %.7$ $ ! 1$

1%,1#%

1-,1!%

1,1#%

1.,$ %

%.7$ $.7$ !.7$ 1$.7$

-,, % #7,, % %.1 $1,, % 117,, %

%. # -,$7! %.1 %.%$

1, 77 7,,-! 7,%,. % 1,,1,,-

=o the o5timal safety stoc;( $.7$ tonnes &eorder le2el ( Normal consum5tion during lead time ) safety stoc; O( ,. # ) $.7$ ( ,% tonnes d. 8robability of stoc; out at the o5timal le2el of safety stoc; ( 8robability (consum5tion being ,%, , , or #% tonnes) 8robability (consum5tion ( ,% tonnes) ) 8robability (consum5tion ( , tonnes) ) 8robability (consum5tion ( #% tonnes) ( %.1 )%.1 ) %.%$ ( %.,%

11.

<he information about annual usage and 5rice for 1 items used by a firm is as gi2en here. /tem Annual Lsa<e %3um,er of Lnits& $%% ,% #,%%% ,%%% #%% $,%%% ,, %% 1,$%% -rice per Lnit %Rs& ,%.%% %%.%% -.%% 1 .%% 1%%.%% 7-.%% #!.%% 1%.%% 0tem Annual Lsa<e %3um,er of Lnits& 1$,-%% 7%% ,,!%% 1,%%% 1 ,%%% #%% %% -rice per Lnit %Rs& ,.%% #%.%% %%.%% $7.%% 1$.%% 1 %.%% !%%.%%

1 , # $ 7 !

. 1% 11 1 1, 1# 1-

&e7uired6 (a) ran; the items of in2entory on the basis of annual usage 2alue[ (b) record the cumulati2e usage in 2alue[ (c) show the cumulati2e 5ercentages of usage of items[ (d) classify the items into three classes, A, B an# C Solution: Annual Lsa<e%in Lnits& $%% ,% #,%%% ,%%% #%% $,%%% ,, %% 1,$%% 1$,-%% 7%% ,,!%% 1,%%% 1 ,%%% #%% %% -rice per Lnit Rs. ,%.%% %%.%% -.%% 1 .%% 1%%.%% 7-.%% #!.%% 1%.%% ,.%% #%.%% %%.%% $7.%% 1$.%% 1 %.%% !%%.%% Annual Lsa<e %in Lnits& Rs. 1!,%%% $,%%% %,%%% #,%%% #%,%%% #-%,%%% 1-,,$%% 1$,%%% #.,-%% !,%%% 7$%,%%% $7,%%% 1. ,%%% #!,%%% 1$%,%%% RanBin< 1, 11 11 . 1# 7 1% 1 $ , ! #

/tem 1 , # $ 7 ! . 1% 11 1 1, 1# 1-

Cumulati4e Dalue of /tems & Lsa<e /tem no. 11 $ 1, 17 1 . 1# 1% # , 1 ! Annual Lsa<e Dalue %Rs.& 7$%,%%% #-%,%%% 1. ,%%% 1$%,%%% 1-,,$%% $7,%%% #.,-%% #!,%%% #%,%%% !,%%% #,%%% %,%%% 1!,%%% 1$,%%% $,%%% Cumulati4e Annual Lsa<e Dalue%Rs.& 7$%,%%% 1, 1%,%%% 1,#% ,%%% 1,-$ ,%%% 1,71-,$%% 1,7! ,$%% 1,!, ,1%% 1,!!%,1%% 1,. %,1%% 1,.#!,1%% 1,.7 ,1%% 1,.. ,1%% ,%1%,1%% ,% $,1%% ,%, ,1%% Cumulati4e H of Lsa<e Dalue ,7.#% -..-# $!... 7$.!7 !#.# !7.7 .%.1$ . ..#.#. .-.!7 .7.%.!.%, .!.. ...7% 1%%.%% Cumulati4e H of /tems $.$7 1,.,, %.%% $.$7 ,,.,, #%.%% #$.$7 -,.,, $%.%% $$.$7 7,.,, !%.%% !$.$7 .,.,, 1%%

RanB 1 , # $ 7 ! . 1% 11 1 1, 1# 1-

CHAPTER 3( 1. What is the annual 5ercentage interest cost associated with the following credit terms? (a) *1- net ,% (b) ,*1% net ,% (c) *1% net #(d) 1*- net 1-

Assume that the firm does not a2ail of the cash discount but 5ays on the last day of the net 5eriod. Solution: Annual interest cost is gi2en by , ,$% : 1+ 3iscount % 'redit 5eriod I 3iscount 5eriod <herefore, the annual 5er cent interest cost for the gi2en credit terms will be as follows6 a. %.% : %..! 1,$% ( %.#!.! ( #!..! % 3iscount %

b.

%.%, : %..7

,$% ( %.--$7 % ,$% : ( %. %.. ,,$% : ( %.,$,$ 1% ( ,$.,$ % ( %... % ( --.$7 %

c.

%.% %..!

d.

%.%1 %...

'alculate the annual 5ercentage interest cost of 2arious terms in 5roblem 1 abo2e, assuming that it is 5ossible to stretch 5ayment % days beyond the net 5eriod.

Solution: a. %.% : %..! b. %.%, : %..7 c. %.% : %..! d. %.%1 : %... ,. ,% -,$% ( %.1 1 ( 1 .1 % #% ,$% ( %.1,,$ ( 1,.,$ % ,,$% ( %. 7!# ( 7.!# % ,$% ( %. %.. ( %... %

'onsider the data for Oanish;a @imited. 'urrent assets &s (in million) &aw material #% Wor;+in+5rocess ! 9inished goods Ather current assets , 7$ 'urrent liabilities <rade creditors ,% ?an; borrowing (including ?ills 3iscounted) 1%

Ather current liabilities

# ##

What is the ma:imum 5ermissible ban; finance for Oanish;a @imited under the three methods suggested by the <andon 'ommittee? Assume that the core current assets for Oanish;a @imited are &s.1- million. Solution: <he ma:imum 5ermissible ban; finance under the three methods suggested by <he <andon 'ommittee are 6 0ethod 1 6 %.7-(CA:C") ( %.7-(7$+##) ( &s. # million 0ethod 6 %.7-(CA):C" ( %.7-(7$)+## ( &s. 1, million 0ethod , 6 %.7-(CA:CCA):C" ( %.7-(7$+1-)+## ( &s.1.7- million #. 'onsider the data for =martlin; 'or5oration. 'urrent assets &aw material Wor;+in+5rocess 9inished goods Ather current assets &s (in million) !% -! #% $! $#$ 'urrent liabilities <rade creditors 1$% ?an; borrowing (including ?ills 3iscounted) Ather current liabilities %% # #% What is the ma:imum 5ermissible ban; finance for =martlin; 'or5oration under the three methods suggested by the <andon 'ommittee? Assume that the core current assets for =martlin; 'or5oration are &s.1%% million.

Solution: <he ma:imum 5ermissible ban; finance under the three methods suggested by <he <andon 'ommittee are6 0ethod 1 6 %.7-(CA:C") ( %.7-($#$ +#% ) ( &s.1!, million 0ethod 6 %.7-(CA):C" ( %.7-($#$) + #% ( &s.! .- million. 0ethod , 6 %.7-(CA:CCA):C" ( %.7-($#$ +1%%)+ #% ( &s.7.- million CHAPTER 31 /0!0CASE 1 Ti;ram <ha5ar, '9A of Aman cor5oration, recently attended a seminar conducted by an internationally renowned e:5ert on credit analysis. Among 2arious ideas and techni7ues 5resented in that seminar, the techni7ue of discriminant analysis im5ressed him. Ge felt that it could be a55lied for classifying the credit a55licants of Aman 'or5oration into LgoodJ and LbadJ categories. Ge as;ed =udarshan, a finance e:ecuti2e in his de5artment who recently graduated from a leading business school, to e:5lore the 5ossibility to using discriminant analysis for credit e2aluation in Aman 'or5oration. =udarshan suggested that the two ratios that are li;ely to be most hel5ful in discriminating between the LgoodJ and LbadJ accounts are 6 (i) current ratio ('urrent assets * 'urrent liabilities), and (ii) the earning 5ower (8?"<*'a5ital em5loyed) Ti;ram <ha5ar concurred with =udarshanJs suggestion. =udarshan gathered information on 1! accounts, 1% LgoodJ and ! LbadJ, which is gi2en below. A LgoodJ account is an account which 5ays within the sti5ulated credit 5eriod and a LbadJ account is an account which does not 5ay within the sti5ulated credit 5eriod. Foo# Accounts Account num,er 1 , # $ 7 !
i

Ba# Accounts Account num,er 11 1 1, 1# 11$ 17 1!

i

Current ratio 1. % 1.,% 1.#% 1.%% 1.-% 1.$% 1.!% 1.$%

2i *arnin< po(er (%) 1$ 17 1# % 1, 1 11%

Current ratio 1.1% 1.%% 1. % %..% 1.1% 1. % %..% 1.1%

2i *arnin< po(er (%) . I $ $ ! # 1% 7

. 1%

1. % 1.#%

1!

1. %

%.!% %.7%

$ #

Re+uire#6 /stimate the discriminant function which best discriminates between the LgoodJ and LbadJ a55licants. Solution:

Account Number 1 , # $ 7 ! . 1% 11 1 1, 1# 11$ 17 1! 1. % 1(1. 1#.% 11 ( 1% 1%% 1 ( 1% d: 8 %.#

1i 1. 1., 1.# 1.% 1.1.$ 1.! 1.$ 1. 1.# 1.1 1.% 1. %.. 1.1 1. %.. 1.1 %.! %.7

Mi 1$ 17 1# % 1, 1 11% 1! . +$ $ ! # 1% 7 $ # M ( ..-

1i + 1 % %.1 %. +%. %., %.# %.$ %.# %.% %. +%.1 +%. %.% +%., +%.1 % +%., +%.1 +%.# +%.-

Mi I M $.7.#.1%.,..-.%.-.+1.+%.+1-.+,.+1.+-.)%.+ .+7.+,.+-.-

(1i I 1) % .%1 %.%# %.%# %.%. %.1$ %.,$ %.1$ %.% %.%# %.%1 %.%# % %.%. %.%1 % %.%. %.%1 %.1$ %. -

(Mi I M) # . -$. %. 11%. 1 . $. ,%. %. ,%. . %. #%. 1 . . ,%. %. $. -$. 1 . ,%. -

(1i I 1) (Mi IM) % %.7%..% + .1% 1.%1.%% ,., %. % +%., .%,.1 % %.#%.-% %.7%.71.# .7(1i I 1) (Mi+M ) ( 1#.$ 7%1

1i ( #.% Mi ( 1.% (1i I1) ( 1.-$

(Mi IM) (7%1

1#% (1.# M1 ( 1% -% ( 1.% M ( 1% dy ( .% ( -% (1#% : (

1.-$ ( .%! 1. y (

(,$.!. 1. 1#.$ ( %.7$! 1.

:y (

a(

,$.!. : %.# I %.7$! : . 1#.7-$ I $..1 ( ( : .y + :y.:y %.%! : ,$.!. I %.7$! : %.7$! ,. % -I %.-.% 7.!## ( ,. 1 .#,: .dy + :y.d: : .y + :y.:y %.#,1 %.%! : ..% I %.7$! : %.# ( %.%! : ,$.!. I %.7$! : %.7$!

y .d: + :y.dy

b(

( .#,-

( %.177

<he discriminant function is6 Si ( ,. 11i ) %.177 Mi 00!0CASE 2 =omnath, 9inance 3irector of A5e: /lectronics, was loo;ing at ways and means of im5ro2ing credit e2aluation of the 5otential customers of A5e:. Ge called &a2i, a 5roduct of a 5remier business school from Australia, who Coined the finance de5artment of A5e: recently, for a discussion. &a2i showed =omnath a 5roCect on discriminant analysis that he had done as 5art of his graduate studies in business. "n that 5roCect &a2i had considered four inde5endent 2ariables. =omnath thought that A5e: could also use discriminant analysis. Gowe2er, to begin with he felt that a discriminant model with two inde5endent 2ariables may be used. &a2i concurred with this 2iew. =omnath and &a2i discussed this issue with the finance team of A5e:. <he consensus 2iew that emerged during the discussion was that the most a55ro5riate ratios would be (i) &A/ (8A<*Net worth) and (ii) 'urrent &atio ('urrent Assets * 'urrent @iabilities). <he grou5 felt that a linear discriminant function of these two ratios would be hel5ful in discriminating between the LgoodJ and LbadJ accounts. &a2i gathered information on % accounts, 1% LgoodJ and 1% LbadJ which is gi2en below. A LgoodJ account is an account which 5ays within the sti5ulated credit 5eriod and a LbadJ account is an account which does not 5ay within the sti5ulated 5eriod.

Account 3um,er 1 , # $ 7 ! . 1%

Foo# Accounts 2i i Current R'* ratio 1!% 1.-% 1-% 1.!% 1,% 1. % %% 1.,% 1 % 1.#% .% 1.1% 1$% 1.$% 1#% 1. % $% 1.-% -% 1.1%

Ba# Accounts Account 3um,er 11 1 1, 1# 11$ 17 1! 1. %

i

R'* +-% !% .% $% 11% -% 1%% 7% + $% #%

2i Current ratio 1.1% 1. % %..% 1.1% 1.%% 1.#% 1.1% 1. % 1.1% 1. %

Re+uire#6 /stimate the discriminant function that best discriminates between the LgoodJ and LbadJ accounts. Solution: Account Number 1 , # $ 7 ! . 1% 11 1 1, 1# 11$ 17 1! 1. % 1i 1! 11, % 1 . 1$ 1# $ +! . $ 11 1% 7 +$ # Mi 1.1.! 1. 1., 1.# 1.1 1.$ 1. 1.1.1 1.1 1. %.. 1.1 1.% 1.# 1.1 1. 1.1 1. 1i + 1 !.1-.1,.11%.1.1+%.!$.1#.1+,.!1-.1+1#.!+1.!+%.!+,.!1.1+#.!%.1+ .!+1-.!+-.!Mi I M %. %.-+%.%%.%%.1+%.1%.,+%.%%. +%.1+%.1+%.%+%.,+%.1+%. %.1+%.1+%.%+%.1+%.%(1i I 1) $$.# $.... 1%,.% #.$ %.7 ,7.! 17. 1#.! ..%.,.# %.7 1#.! 1., ,.%.% !.1 -1. ,#. (Mi I M) %.%$ %.,% %.%% %.%% %.%% %.% %.1 %.%% %.%$ %.% %.% %.%% %.1 %.% %.%$ %.% %.% %.%% %.% %.%% %.., (1i I 1) (Mi +M) .%,7.!, +%.1-7%.-%7%., %., .1- +%. %7+%..$ + . 7 . 7%.%. %. .7%.-77+%. !7+%.7 7+%.% %.1# .,77%. . ..,-

1.7 M( -

(1i+1) (1%$!.--

1 ( 1.7 1.7 1( ( ..!% 11 ( 1#! 1#! 11 ( 1#.!

M ( M( ( 1. % M1 ( 1,.7 1,.7 M1 ( 1.,7 1% M ( 11., 11., M ( ( 1.1, 1%

(11 I 1) ( 1,%$!.-: ( (11 I 1) 1In ( 1%$!.-1. ( -$. ,.(M1 I M) ( %.., y ( %.., 1. ( %.%#!.

1% 1 ( #. #. 1 ( ( #.. 1%

d: ( 11 I 1 dy ( M1 I M ( 1#.! I #.. ( 1.,7 I 1.1, ( ... ( %. # ..,(11 I 1) (M1IM) ( ..,:y ( ( %.#. 1 1. y .d: + :y.dy %.%#!. : ... I %.#. 1 : %. # a( ( : .y + :y.:y -$. ,.- : %.#!. I %.#. 1 : %.#. 1 %.,$$% ( .-%7. b( : .dy + :y.d: : y + :y:y !.$ -$. ( .-%7. 3iscriminant function S ( %.1#-.1i ) ,.#,.#Mi ( ,.#,.# -$. ,.- : %. # I %.#. 1 : ... ( -$. ,.- : %.%#!. I %.#. 1 : %.#. 1 ( %.1#-.

/0!0CASE 3 &am Oumar, the '9A of "m5e: @imited, was discussing with =reedhar, a senior financial analyst in the com5any, the 5roblem of Cudging the creditworthiness of the 2arious customers of "m5e: @imited. =reedhar suggested that discriminant analysis may be used for credit e2aluation 5ur5oses. &am Oumar concurred with this suggestion. &am Oumar and =reedhar felt that the two ratios that are li;ely to be most hel5ful in discriminating between the LgoodJ and LbadJ accounts are (i) earning 5ower (8?"<*'a5ital em5loyed) and (ii) 7uic; ratio (Huic; assets * 'urrent liabilities). =reedhar gathered information on 1! accounts, 1% LgoodJ and ! LbadJ which is gi2en below. A LgoodJ account is an account which 5ays within the sti5ulated credit 5eriod and a LbadJ account is an account which does not 5ay within the sti5ulated credit 5eriod. Account 3um,er 1 , # $ 7 ! . 1% Foo# Accounts *arnin< KuicB po(er ratio 2i i 1$% %.7% % %.!% 17 1.%% 1 %..% 1# %.7% 1, 1.%% 7 %..% 11.1% 1% %..% 1%.!% Account 3um,er 11 1 1, 1# 11$ 17 1! Ba# Accounts *arnin< KuicB po(er ratio $% . # +1% ! 7 %.7% %.!% %.$% %.!% %.$% %.7% %.-% %..%

Re+uire#6 /stimate the discriminant function which best discriminates between the LgoodJ and the LbadJ a55licants. Solution:

Number 1 , # $ 7 ! . 1% 11 1 1, 1# 11$ 17 1!

1i 1$% % 17 1 1# 1, 7 11% 1$ . # I1% ! 7

Mi %.7% %.!% 1.%% %..% %.7% 1.%% %..% 1.1% %..% %.!% %.7% %.!% %.$% %.!% %.$% %.7% %.-% %..%

1i I 1 $ 1% 7 # , I, % I# I1 I$ I1I! % I I,

Mi I M I%.1% % %. % %.1 I%.1 %. %.1 %., %.1 % I%.1 % I%. % I%. I%.1 I%., %.1

(1i I 1) ,$ 1%% #. # 1$ . . % 1$ 1 ,$ $# % # . j(1i+1) ($ ! $ ! : ( 17 ( ,$..#

(Mi I M) %.%1 % %.%# %.%1 %.%1 %.%# %.%1 %.%. %.%1 % %.%1 % %.%# % %.%# %.%1 %.%. %.%1 j(M+M) ( %.#

j(1i+1) (Mi+M) I%.$ % 1.# %. I%.# %.$ I%., 1.% % %.# % 1. % 1.$ % %.$ I%., j(1i+1) (Mi+M) ( -.. 1 :y ( : -.. 17 ( %.,#7 %.# y ( 17 ( %.% -

j1i(1!% jMi(1#.# 1i( 1% Mi( %.! 1,. 1i ( Mi ( 1% ( 1,..% #1 1 ( ! ( -.1% d: ( !.! a( M ( ! ( %.7% dy ( %.1! 1% ( %.!! -.$ !.!

y .d: I :y.dy : . y I :y. :y %.% - : !.! I %.,#7 : %.1!

( ,$..# : %.% - I %.,#7 : %.,#7 'ontd.

%. a(

I %.%$ #$

%.. ,- I %.1 %# %.1-7-# ( %.!%,1 ( %.1.$ : .dy I :y.d: : .y I :y.:y ,$..# : %.1! I %.,#7 : !.! ( ,$..# : %.% - I %.,#7 : %.,#7 $.$#.# I ,.%-,$ ( %.!%,1 ( #.#77# S ( a1i ) bMi ( %.1.$1i ) #.#77#Mi CHAPTER 32 1. <he 5rofit and loss account and balance sheet of a com5any for two years (1 and ) are gi2en below. Assume a ta: rate of ,% 5ercent for year . 8rofit and @oss Account Net sales "ncome from mar;etable securities Non+o5erating income <otal income 'ost of goods sold =elling and administrati2e e:5enses 3e5reciation "nterest e:5enses <otal costs and e:5enses 8?< 1 #%,%%% !%% $%% #1,#%% -,%%% $,%%% ,#%% ,-%% ,-,.%% -,-%%

b(

-%,%%% 1,%%% 1,%%% - ,%%% ,%,%%% 7, %% ,,%%% ,$%% # ,!%% ., %%

<a: 5ro2ision 8A< 3i2idends &etained earnings ?alance =heet /7uity ca5ital &eser2es and sur5lus 3ebt 9i:ed assets "n2estments (mar;etable securities)X Net current assets All of this re5resents e:cess mar;etable securities (i) What is the /?"< for year ?

1,-%% #,%%% 1,#%% ,$%% $,%%% 1%,%%% 1$,%%% , ,%%% %,%%% 7,%%% -,%%% , ,%%%

,7%% $,-%% 1,!%% #,7%% $,%%% 1#,7%% 1.,,%% #%,%%% #,-%% !,-%% 7,%%% #%,%%%

Solution: 8rofit before ta: ) "nterest e:5ense + + "nterest income Non I o5erating income . %% ) $%% + 1%%% + 1%%% .,!%% (ii) Solution: <a: 5ro2ision from 5rofit and loss account ) + + <a: shield on interest e:5ense <a: on interest income <a: on non + o5erating income <a: on /?"< 7%% 7!% + ,%% + ,%% !!% What is the ta: on /?"< for year ?

(iii) What is the 9'99 for year ? Solution: /?"< + <a: on /?"< + Net in2estment ) Non I o5erating cash flow (1%%% : %.7) .,!%% + ,!!% + $,-%% 7%% 11 % (i2) =how the brea;+u5 of the financing flow Solution:

&s. in million After ta: interest e:5ense ) 'ash di2idend ) "ncrease in borrowing ) /:cess mar;etable securities + After ta: income on e:cess mar;etable securities

1! % ) 1!%% + ,,%% ) 1-%% + 7%%

<he 5rofit and loss account and balance sheet of a com5any for two years (1 and ) are gi2en below. Assume a ta: rate of ,% 5ercent for year . 8rofit and @oss Account Net sales "ncome from mar;etable securities Non+o5erating income <otal income 'ost of goods sold =elling and administrati2e e:5enses 3e5reciation 1 ,%,%%% $%% #%% ,1,%%% 1!,%%% ,,!%% 1,.%%

,-,%%% 1,%%% !%% ,$,!%% 1,%%% #,$%% , %%

"nterest e:5enses <otal costs and e:5enses 8?< <a: 5ro2ision 8A< 3i2idends &etained earnings ?alance =heet /7uity ca5ital &eser2es and sur5lus 3ebt 9i:ed assets "n2estments (mar;etable securities)X Net current assets All of this re5resents e:cess mar;etable securities (i) What is the /?"< for year ?

1,7%% -,#%% -,$%% 1,#%% #, %% 1, %% ,,%%% -,%%% -,%%% 1-,%%% -,%%% 1-,%%% -,%%% -,%%% -,%%%

1,$%% .,#%% 7,#%% 1,.%% -,-%% 1,#%% #,1%% -,%%% .,1%% 1#,.%% .,%%% 1!,-%% $,-%% #,%%% .,%%%

Solution: 8rofit before ta: ) "nterest e:5ense + + "nterest income Non I o5erating income 7#%% ) 1$%% + 1%%% + !%% 7 %% (ii) Solution: <a: 5ro2ision from income statement ) <a: shield on interest e:5ense + + <a: on interest income <a: on non + o5erating income <a: on /?"< 1.%% #!% + ,%% + #% 1!#% What is the ta: on /?"< for year ?

(iii) What is the 9'99 for year ? Solution: /?"< + <a: on /?"< + Net in2estment ) Non I o5erating cash flow 7 %% + 1!#% + -%% ) -$% ,# % (i2) =how the brea;+u5 of the financing flow Solution: &s. in million After ta: interest e:5ense ) 'ash di2idend ) &eduction in borrowing 11 % ) 1#%% ) 1%% ) 1-%% + 7%% ,# % ,. <he 5rofit and loss account and the balance sheet for 0agna 'or5oration for two years (year 1 and year ) are gi2en below 6 Profit an" Loss Account

) a /:cess mar;etable securities + After ta: income on e:cess mar;etable securities

1 1$!%% # % 1% 17#,% .$$%

2 1., % $,% # % %,7% 11,#%

Net sales "ncome from mar;etable securities Non+o5erating income <otal income 'ost of goods sold

=elling and administrati2e e:5enses 3e5reciation "nterest e:5enses <otal costs and e:5enses 8?< <a: 5ro2ision 8A< 3i2idend &etained earnings 'alance Sheet /7uity ca5ital &eser2es and sur5lus 3ebt 9i:ed assets "n2estments Net current assets

1%% 1%-% 1%%! 1,!1! ,$1 1%. - % 1 $% 1 $% 1 $,%% -%#% 7-$% 1!.%% 1 $%% ,7!% - % 1!.%%

,1% 1 $% 117$ 1$%!$ # !# 1,## .#% 1$!% 1 $% 2 $,%% $,%% !! % 1# % 1,$-% # %% ,-7% 1# %

Assume that the ta: rate is #% 5ercent. (i) What is the /?"< (also called 8?"<) for year ?

Solution: 8?< ) "nterest e:5ense + "nterest income + Non+o5erating income # !# )117$ + $,% +# % ##1%

(ii)

What is the ta: on /?"< for year ?

Solution: <a: 5ro2ision from 5rofit and loss account ) <a: shield on interest e:5ense + <a: on interest income + <a: on non+o5erating income <a: on /?"< 1,## ) #7%.# + -

+ 1$! 1,.#.#

(iii) What is the NA8@A< for year ? Solution: /?"< + <a: on /?"< ##1% + 1,.#.# ,%1-.$

(i2) What is the 9'99 for year ? Solution: NA8@A< + Net in2estment ) Non+o5erating cash flow ,%1-.$ + 1%%.% - .% 11$7.$

#.

?oldman =achs, an in2estment ban;ing firm, is engaged in 2aluing 0@9 &ealty, a firm which s5ecialises in the construction of housing and commercial com5le:es. 0@9 is currently riding a construction boom and is e:5ected to grow at a healthy

rate for the ne:t four years at least. <hereafter the growth rate is e:5ected to decline rather gradually for a few years before it stabilises at a modest le2el Mou ha2e recently mo2ed to ?oldman =achs after a few years of e:5erience in another financial ser2ices firm. Mour first assignment at ?oldman =achs is to 2alue 0@9. ?ased on e:tensi2e discussion with management and industry e:5erts you ha2e gathered the following information. ?ase Mear (Mear %) "nformation ++++++++++++++++++++++++++++++++++++++++++++++++ &e2enues &s. 1#%% crore /?"< ( % % of re2enues) &s. !% crore 'a5ital e:5enditure &s. ,-% crore 3e5reciation and amortisation &s. $$ crore Wor;ing ca5ital as a 5ercentage of re2enues % 5ercent <a: rate ,% 5ercent (for all time to come) "n5uts for the Gigh Browth 8eriod +++++++++++++++++++++++++++++++++++++++++++++ @ength of the growth 5eriod ( Browth rate in re2enues, de5reciation, /?"< and ca5ital e:5enditure ( Wor;ing ca5ital as a 5ercentage of re2enues ( 'ost of debt( 5re+ta:) ( 3ebt I e7uity ratio ( &is;+ free rate ( 0ar;et ris; 5remium ( /7uity beta ( "n5uts for the <ransition 8eriod +++++++++++++++++++++++++++++++++++++++++ N N @ength of the transition 5eriod ( , years Browth rate in re2enues, de5reciation, /?"< and 'a5ital e:5enditures will decline from - 5ercent in year # to 1% 5ercent in year 7 in linear increments of - 5ercent 5er year. Wor;ing ca5ital as a 5ercentage of re2enues ( % 5ercent <he cost of debt, debt+e7uity ratio, ris; Ifree rate, mar;et ris; 5remium and e7uity beta will be the same as in the high growth 5eriod. "n5uts for the =table Browth 8eriod ++++++++++++++++++++++++++++++++++++++++++++++ Browth rate in re2enues, /?"<, ca5ital e:5enditure and de5reciation ( Wor;ing ca5ital as a 5ercentage of re2enues ( <he cost of debt, ris; Ifree rate and mar;et

N N N N N N

N N N N N N N N

# years - 5ercent % 5ercent 1% 5ercent 1.% 7.# 5ercent $ 5ercent 1. $$7

N N

N N N

1% 5ercent % 5ercent

N N

ris; 5remium will be the same as in the 5re2ious stages. 3ebt+e7uity ratio /7uity beta a.

( (

6, 1.,

What is the cost of ca5ital in the three 5eriods( high growth, transition, and stable)? What 2alue would you im5ute to 0@9 &ealty using the 3'9 method?

Solution: a. WA'' during the high growth and transit 5eriods6 ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ re ( 7.# ) $ : 1. $$7 ( 1- % WA'' ( %.- : 1% : ( 1 I%.,% ) ) %.- : 1- ( 11 % WA'' during the stable 5eriod6 +++++++++++++++++++++++++++++++++++++++ re ( 7.# ) $ : 1., ( 1-.,, % WA'' ( *- : 1% : ( 1 I %.,% ) ) ,*- : 1-.,, ( 1 % b.
-erio# Fro(th Rate H *B/0 *B/0 %1:t& CA-*

Dep 332.50 .15.!3 51?.53 !.?..1 $$?.2? =?!.1? ?=5.=1

CA-* : D*-

)C
350 .3$.50 5.!.== !=3.!0 =20.31 ?.3.3! 103$.$0

a QC

6C66

QACC %H&

-D

1 2 3 . 5 ! $

25 25 25 25 20 15 10

350 .3$.50 5.!.== !=3.5? =20.31 ?.3.3! 103$.$0

2.5 30!.25 3=2.=2 .$=.51 5$..22 !!0.35 $2!.3?

.3$.50 5.!.== !=3.5? =5...? 1025.3? 11$?.1? 12?$.11

105 131.25 1!..0! 205.0= 2.!.10 2=3.00 311.30

$0 =$.5 10?.3$ 13!.$3 13!.$2 123.05 ?..3.

$0 =$.5 10?.3$ 13!.$ 1?1.. 25..3 320.$5

11 11 11 11 11 11 11

!3.0! $1.02 $?.?= ?0.05 113.5= 135.?! 15...? $0=.1.

9'99! ( 9'997 (1.1%) ( , %.7- : (1.1%) ( ,- .!, <erminal Talue ( 9'99! ,- .!, +++++++++++++++ ( ++++++++++++ WA'' I g %.1 I %.1% ( 17$#1.-%

8resent 2alue of terminal 2alue ( 17$#1.-% * (1.11 )7 ( 8resent 2alue of 9'99 in the high growth and transit 5eriods ( Talue of the firm

!#.7.%1 7%!.1# +++++++++++++++ ( &s. . %-.1- crores

-.

0ultisoft @imited was set u5 about twel2e years ago by a 5roduct+minded technocrat. "n the first fi2e years, the com5any did e:ce5tionally well, than;s to the e:cellent res5onse recei2ed by three of its initial 5roducts. <he com5any recorded a com5ound annual growth rate of !% 5ercent during this 5eriod. =ubse7uently, howe2er, the com5any floundered, as its 5roduct offerings were su5erceded by the offerings of com5etitiors. "n res5onse, the management of 0ultisoft em5hasised software ser2ices. <his strategy has wor;ed well and the com5anyJs 5erformance im5ro2ed significantly in the last few years. <he management is 7uite o5timistic about future and belie2es that its growth is more 5redictable now. &ecently, Bautam 8rabhu, the '/A of 0ultisoft @imited had a 2ery fruitful discussion with the '/A of 0atri: =oftware wherein they e:5lored the 5ossibility of a merger. Bautam 8rabhu belie2es that the com5ensation for the merger, if consummated, will be in the form of the stoc; of 0ultisoft @imited. Ge has re7uested you to 2alue the e7uity of 0ultisoft and as;ed his '9A, &anCan Oaul, to 5ro2ide you with the information about the current and 5roCected financials of 0ultisoft. <he following information has been 5ro2ided to you. Base 2ear %2ear 0& /nformation &e2enues /?"< 'a5ital e:5enditure 3e5reciation Wor;ing ca5ital as a 5ercentage of re2enues 'or5orate ta: rate 8aid u5 ca5ital (&s.1% 5ar) 0ar;et 2alue of debt %%% million 7-% million -%% million 1#% million ,% 5ercent 1- 5ercent &s. $%% million &s. ,%% million &s. &s. &s. &s.

/nputs for the @i<h Fro(th -erio# @ength of the high growth 5eriod Browth rate in re2enues, de5reciation, /?"< and ca5ital e:5enditure Wor;ing ca5ital as a 5ercentage of re2enues 'ost of debt (5re+ta:) <he ta: rate will increase to ,% 5ercent in linear increments of - 5ercent 5er year 3ebt+e7uity ratio &is;+free rate 0ar;et ris; 5remium /7uity beta ( ( ( ( , years #% 5ercent ,% 5ercent 1% 5ercent

( ( ( (

%.- 6 1 7 5ercent $ 5ercent 1.,

/nputs for the 0ransition -erio# @ength of the transition 5eriod Browth rate in re2enues, de5reciation, /?"<, and ca5ital e:5enditures will decline from #% 5ercent in year , to 1% 5ercent in year ! in linear increments of $ 5ercent each year Wor;ing ca5ital as a 5ercentage of re2enues 3ebt+e7uity ratio 'ost of debt (5re+ta:) &is;+free rate 0ar;et ris; 5remium /7uity beta <a: rate /nputs for the Sta,le Fro(th -erio# &e7uired a. b. c. d. e. What will be the WA'' (u5to one decimal 5oint) year+wise? What is the 5resent 2alue of the 9'9 in the high growth 5eriod? What is the 5resent 2alue of the 9'9 in the transition 5eriod? What is the 5resent 2alue of the terminal 2alue? (Answers to (b), (c), and (d) must be in ru5ees in million u5to one decimal 5oint) What is the intrinsic 2alue 5er share? Browth rate in re2enues, /?"<, ca5ital e:5enditure, and de5reciation Wor;ing ca5ital as a 5ercentage of re2enues 3ebt+e7uity ratio 'ost of debt (5re+ta: terms) &is;+free rate 0ar;et ris; 5remium /7uity beta <a: rate ( 1% 5ercent ( ,% 5ercent ( %. !# 6 1 ( 1% 5ercent ( 7 5ercent ( 7 5ercent ( 1.1 ( ,% 5ercent ( - years

( ,% 5ercent ( %.- 6 1 ( 1% 5ercent ( $ 5ercent ( 7 5ercent ( 1. ( ,% 5ercent

Solution: (a) WA'' Gigh growth 5eriod Mear 1 , 'ost of e7uity 7 ) 1., ($) (1#.!% 7 ) 1., ($) ( 1#.!% 7 ) 1., ($) ( 1#.!% 'ost of debt 1% (1 I %. %) ( !% 1% (1 I %. -) ( 7.-% 1% (1 I %.,%) ( 7 .%% <ransition 5eriod 'ost of e7uity $ ) 1. (7) ( 1#.#% 1*, : 7 ( 11.. 'ost of e7uity WA'' 7 ) 1.1 (7) ( 1#.7% WA'' 1% (1 I %.,) ( 7% =table 5eriod 'ost of debt 1% (1 I %.,) ( 7% 'a5e:
-%% !#% 11% .1##%.$ 1.,%.# #7%.. ,%1#.,#.$.! ,!#$.# ,1. 7%% .!% 1,7 1!,!.,-,., !71.% ,,,%., ,$$,.# #% ..7

WA'' *, : 1#.! ) 1*, : ! ( 1 .*, : 1#.! ) 1*, : 7.- ( 1 .# *, : 1#.! ) 1*, : 7.% ( 1 .

'ost of debt *, : 1#.# )

1*1. !# : 1#.7 ) %. !# *1. !# : 7 ( 1,.%%

Mear % 1

Browth rate %

/?"< 7-%

<a: rate (%) 1% ,% ,% ,% ,% ,% ,% ,%

/?"< (1 I<)

3e5rn 1#% 1.$ 7#.# ,!#. -1#.! $-!.. !%,.. ., .1% -.7 11 !.,

W' $%% !#% 117$ 1$#$.# %$. ! ,.. ,##-. ,..$.# #,.$.% #!,-.$

a W'

9'9

WA'' %

8T 9actor

8T

#% #%

1%-% 1#7% %-! 7-7.7 ,- ... #,%$.-

#% ,,$ #7%.# --..! $17.7 $ 1., --1. ,...$ #,..$

.$ $%.. (17.$) #$.. 1-!.! , $.1 -#7.! !%.. !.%.

1 .1 .# 1 . 11.. 11.. 11.. 11.. 11.. 1,.%

%.!!. %.7.1 %.7%%.$,% %.-$, %.-%, %.#-% %.#% %.,-$

!-., #!. (1 .#) ..!..# 1$#.% #$., -., ,1$..

, # $ 7 ! .

#% ,# !

1$ 1% 1%

#..-.-#.-.% $%##.-

(b)

8resent 2alue of 9'9 in the high growth 5eriod ( !-., ) #!. I 1 .# ( &s.1 1.1 million

(c)

8T of 9'9 in the transition 5eriod ( ..- ) !..# ) 1$# .% ) #$.- ) , -., ( &s.!-#.7 million

(d) 8T of terminal 2alue !.%. ( : %.#% ( &s.11. !.7 million %.1, I %.1% (e) "ntrinsic 2alue 5er share Talue of firm I Talue of debt Number of shares 1 1.1 ) !-#.7 ) 11. !.7 + ,%% ( $% ( &s. 1%.1 $. <elesoft "nternational was set u5 se2en years ago to de2elo5 telecommunication software. <hough the com5any started with a bang, it entered a turbulent 5hase because of the shrin;age in the global telecom mar;et in the initial years of this decade. <han;s to reco2ery in the last 1! months or so and a firm indication of strong growth in the ne:t few years, the management of <elesoft "nternational is 7uite u5beat about the future. &ecently, 8an;aC ?ehl, the '/A of <elesoft "nternational had a 5reliminary dialogue with the '/A of a another com5any engaged in de2elo5ing telecommunication software to e:5lore a 5ossible merger. ?oth the '/As felt enthusiastic about this. 8an;aC ?ehl belie2es that the com5ensation for the merger, if consummated, will be in the form of the stoc; of <elesoft "nternational. Ge has re7uested you to 2alue the e7uity of <elesoft and as;ed TiCay &ao, 9inance 3irector, <elesoft "nternational to 5ro2ide you with information about the current and 5roCected financials of <elesoft "nternational. <he following information has been 5ro2ided to you. Base 2ear %2ear 0& /nformation &e2enues /?"< 'a5ital e:5enditure 3e5reciation Wor;ing ca5ital as a 5ercentage of re2enues 'or5orate ta: rate 8aid u5 e7uity ca5ital (&s.1% 5ar) 0ar;et 2alue of debt ( &s. 1 %% million ( &s. ,-% million ( &s. !% million ( &s. 1#% million ( ,% 5ercent ( 1% 5ercent ( &s. ,%% million ( &s. ,%% million

/nputs for the @i<h Fro(th -erio# @ength of the high growth 5eriod Browth rate in re2enues, de5reciation, /?"< and ca5ital e:5enditure Wor;ing ca5ital as a 5ercentage of re2enues 'ost of debt <a: rate will increase to ,% 5ercent in linear increment of - 5ercent 3ebt+e7uity ratio &is;+free rate 0ar;et ris; 5remium /7uity beta /nputs for the 0ransition -erio# @ength of the transition 5eriod Browth rate in re2enues, de5reciation, /?"<, and ca5ital e:5enditures will decline from ,% 5ercent in year # to 1% 5ercent in year ! in linear increments of - 5ercent each year Wor;ing ca5ital as a 5ercentage of re2enues 3ebt+e7uity ratio 'ost of debt &is;+free rate 0ar;et ris; 5remium /7uity beta <a: rate ( # years ( # years ( ,% 5ercent ( ,% 5ercent ( 1% 5ercent (5re+ta:) ( %.!61 ( 7 5ercent ( 7 5ercent ( 1.#

( ,% 5ercent ( %.!61 8 1% 5ercent (5re+ta:) ( ! 5ercent ( $ 5ercent ( 1.1 ( ,% 5ercent

/nputs for the Sta,le Fro(th -erio# Browth rate in re2enues, /?"<, ca5ital e:5enditure and ( 1% 5ercent de5reciation Wor;ing ca5ital as a 5ercentage of re2enues ( ,% 5ercent 3ebt+e7uity ratio ( %.-61.% 'ost of debt ( 1% 5ercent (5re+ta:) &is;+free rate ( ! 5ercent 0ar;et ris; 5remium ( 7 5ercent /7uity beta ( 1.% <a: rate ( ,% 5ercent a. b. c. d. What will be the WA'', year+wise? What is the 5resent 2alue of the 9'9 in the high growth 5eriod? What is the 5resent 2alue of the 9'9 in the transition 5eriod? What is the 5resent 2alue of the terminal 2alue?

e. Solution: (a) WA''

What is the intrinsic 2alue 2alue 5er share?

@i<h <ro(th perio# Mear 1 'ost of e7uity 7 ) 1.# : (7) ( 1$.!% 7 ) 1.# : (7) ( 1$.!% , # 7 ) 1.# : (7) ( 1$.!% 7 ) 1.# : (7) ( 1$.!% 'ost of debt 1% (1 I %.1-) ( !.-% 1% (1 I %. %) ( !.%% 1% (1 I %. -) ( 7.-% 1% (1 I %.,%) ( 7.%% WA'' (-*.):1$.! ) (#*.):!.- ( 1,.1% (-*.):1$.! ) (#*.):!.% ( 1 ..% (-*.):1$.! ) (#*.):7.- ( 1 .7% (-*.):1$.! ) (#*.):7.% ( 1 .#% QACC (-*.) : 1#.$ ) (#*.) : 7 ( 11. % QACC ( *,) 7-.% ) (1*,) : 7.% ( 1 .,%
`W' 9'9 WA'' 8T 8T of % 9actor 9'9 1%! 1#% 1!, ,7 -7 -7 , 177 1..7 .! !7 $, 11! 1. !$ ,., #, 1,.1% 1 ..% 1 .7% 1 .#% 11. % 11. % 11. % 11. % 1 .,% %.!!# %.7!, %.$.%.$1! %.--$ %.-%% %.#-% %.#%# !-.7 7$.7 $%.,!.. $-.$ .$.% 1 !.7 1-!.!

Cost of e+uity ! ) 1.1($) ( 1#.$% Cost of e+uity ! ) 1.% (7) ( 1-.%% (b)

<ransition 5eriod Cost of #e,t 1%(1+%.,) ( 7.%% Sta,le perio# Cost of #e,t 1% (1+%.,) ( 7%
W' ,$ % #$ ! $% ! 7. 1 1% ! 1 !1-# 177 # 1.1 1# $

<a: Mear Browth /?"< rate /?"< 'a5 3e5J rate% % (1+<) /:5 n % ,-% 1% !% 1#% 1 ,% ,% , # $ 7 ! . ,% ,% % 11% 1% #--. 7$. 1%%% 1 -% 1#.. 17 # 1!.7 %!7 1% ,% ,% ,% ,% ,% ,% ,!7 #7# -77 7%% !71%#. 1 %7 1, ! 1#$1 ,$# #7 , $1 !% % 1%% % 1 %% 1,7 . 1-1 7 1$$ . 1! ,7 ,%! #%% -%% $%% $.% 7-. !,-

(c) 8T of 9'9 in the transition 5eriod $-.$ ) .$.% ) 1 !.7 ) 1-!.! ( &s.##..1 million (d) 8T of the terminal 2alue #, : %.#%# ( &s.7-!!. million %.1 , I %.1% (e) "ntrinsic 2alue 5er share Talue of firm I Talue of debt No. of shares ( $1.! ) ##..1 ) 7-!!. ) I ,%% ( ,% ( &s. $$.$ 7. Mou are loo;ing at the 2aluation of a stable firm, =olidaire @imited, done by an in2estment analyst. ?ased on an e:5ected free cash flow of &s.7% million for the following year and an e:5ected growth rate of 1% 5er cent, the analyst has estimated the 2alue of the firm to be &s.,%%% million. Gowe2er, he committed a mista;e of using the boo; 2alues of debt and e7uity. Mou do not ;now the boo; 2alue weights em5loyed by him but you ;now that the firm has a cost of e7uity of 5er cent and a 5ost+ta: cost of debt of . 5er cent. <he mar;et 2alue of e7uity is twice its boo; 2alue, whereas the mar;et 2alue of its debt is eight +tenths of its boo; 2alue. What is the correct 2alue of the firm? 7% ,%%% ( r I %.1% r ( %.1 ,, or 1 .,, %

Solution:

%.1 ,, ( A : %. ) (1+A) : %.%. A ( %. $ <he weight assigned to e7uity is %. $ =o D** ( %.7# * %. $ ( .!=ince the mar;et 2alue of e7uity is twice its boo; 2alue and the mar;et 2alue of debt is eight+tenths of its boo; 2alue, the mar;et 2alue weights of e7uity and debt are in the 5ro5ortion6 %. $ : and %.7# : %.! <hat is %. - and %.-.

Gence the WA'' is %.: %. 1.11 ) %.-. : %.%. ( %.1-%. or 1-.%. % 1.11

Gence the 2alue of the firm is 6 7% ( &s. 11#..#, million .1-%. + .%. CHAPTER 33 1. <he income statement for year % (the year which has Cust ended) and the balance sheet at the end of year % for "nfote: @imited are as follows. /ncome statement =ales Bross margin ( %%) Net current =elling 4 general admin+ =tration (!%) 8rofit before ta: -%,%%% /7uity Balance Sheet ,%,%%% 9i:ed assets -,%%% 1%,%%% -,%%%

assets #,%%% $,%%%

"nfote: @imited is debating whether it should maintain the status 7uo or ado5t a new strategy. "f it maintains the status 7uo6 <he sales will remain at -%,%%% <he gross margin will remain at %% and the selling, general, and administrati2e e:5enses will be !% of sales 3e5reciation charges will be e7ual to new in2estments <he asset turno2er ratios will remain constant <he discount rate will be 1# 5ercent <he income ta: rate will be ,% 5ercent "f "nfote: @imited ado5ts a new strategy, its sales will grow at the rate of ,% 5ercent 5er year for three years. <hereafter, sales will remain constant. <he margins, the turno2er ratios, the ca5ital structure, the income ta: rate, and the discount rate, howe2er, will remain unchanged. 3e5reciation charges will be e7ual to 1% 5ercent of the net fi:ed assets at the beginning of the year. After three years, ca5ital e:5enditure will be e7ual to de5reciation. What 2alue will the new strategy create?

Solution: "ncome =tatement 8roCections 'urrent Talues (Mear %) -%,%%% 1%,%%% #,%%% $,%%% 1,!%% #, %% -,%%% -,%%% ,%,%%% ,%,%%% 1 $-,%%% 1,,%%% -, %% 7,!%% ,,#% -,#$% , ,-%% $,-%% ,.,%%% ,.,%%% !#,-%% 1$,.%% $,7$% 1%,1#% ,,%# 7,%.! , 1%.,!-% 1,.7% !,7!! 1,,1! ,,.-., 7 &esidual 2alue ,) 1%.,!-% 1,.7% !,7!! 1,,1! ,,.-., 7 -#,. 1%,.!$-,.1% $-,.1%

N =ales N Bross margin ( %%) N =elling and general administration (!%) N 8rofit before ta: N <a: N 8rofit after ta: N 9i:ed assets N Net current assets N <otal assets N /7uity

?alance =heet 8roCections # , -% -#,. !,#-% 1%,.!-%,7%% $-,.1% -%,7%% $-,.1% ., 7 -,#., -,#., I ., 7

8rofit after ta: ) 3e5reciation + 'a5ital e:5enditure + "ncrease in net current assets ( A5erating cash flow 8resent 2alue factor 8resent 2alue N N N N

-,#$% ,-%% 1%,%%% 1,-%% (,-#%) %.!77 (,1%-)

'ash 9low 8roCections 7,%.! ., 7 ,, -% #, 1,,%%% 1$,.%% 1,.-% ,-,(#$% ) (-.!,) %.7$. %.$7(,-,.) (#%,!)

8resent 2alue of the o5erating cash flow stream ( (1%$! ) &esidual 2alue ( . 7 * %.# ( $-,.%7 8resent 2alue of residual 2alue ( $-.%7 : %.$7- ( ##,#!7 <otal shareholder 2alue ( ##,#!7 I 1%$! ( ,,,!%# %% N 8re+strategy 2alue ( ( ,%,%%% %.1# N Talue of the strategy ( ,,,!%- I ,%,%%% ( ,,!%. <he income statement for year % (the year which has Cust ended) and the balance sheet at the end of year % for 0egastar @imited are as follows.

/ncome statement =ales Bross margin ( -%) =elling 4 general admin+ =tration (1%%) 8rofit before ta: <a: 8rofit after ta: %%,%%% -%,%%% %,%%% #,,%%% 1#,1.% !,!1% /7uity

Balance Sheet -%,%%% 9i:ed assets 1-%,%%% Net current assets 1%%,%%%

-%,%%%

-%,%%%

0egastar @imited is debating whether it should maintain the status 7uo or ado5t a new strategy. "f it maintains the status 7uo6 <he sales will remain at %%,%%% <he gross margin will remain at -% and the selling, general, and administrati2e e:5enses will be 1% % of sales 3e5reciation charges will be e7ual to new in2estments <he asset turno2er ratios will remain constant <he discount rate will be 1- 5ercent <he income ta: rate will be ,, 5ercent "f 0egastar @imited ado5ts a new strategy, its sales will grow at the rate of ,% 5ercent 5er year for three years. <hereafter, sales will remain constant. <he margins, the turno2er ratios, the ca5ital structure, the income ta: rate, and the discount rate, howe2er, will remain unchanged. 3e5reciation charges will be e7ual to % 5ercent of the net fi:ed assets at the beginning of the year. After three years, ca5ital e:5enditure will be e7ual to de5reciation. What 2alue will the new strategy create? Solution:
'urrent 2alues Mear =ales Bross margin =elling and general administration 8rofit before ta: <a: 8rofit after ta: % %%,%%% -%,%%% %,%%% #,,%%% 1#,1.% !,!1% "ncome statement 5roCections 1 , # $%,%%% ,,!,%%% #,.,#%% #,.,#%% $-,%%% !#,-%% 1%.,!-% 1%.,!-% $,%%% ,,,!%% #,,.#% #,,.#% --,.%% 7 ,$7% .#,#71 .#,#71 1!,##7 ,,.!1 ,1,17,1,17,7,#-, #!,$!. $,, .$ $,, .$ ?alance sheet 5roCections

9i:ed assets Net current assets <otal assets /7uity 8rofit after ta: 3e5reciation 'a5ital e:5enditure "ncrease in net current assets A5erating cash flow 8resent 2alue of the o5erating cash flow stream &esidual 2alue ( $,, .$*%.18resent 2alue of the residual 2alue ( # 1,.7%*(1.1-), <otal shareholder 2alue((111, !%) ) 77#8re+strategy 2alue ( !!1%*%.1Talue of the strategy (1. ,%$7 I 1$$,17

1-%,%%% 1%%,%%% -%,%%% -%,%%%

1.-,%%% 1,%,%%% , -,%%% , -,%%%

-,,-%% , .,--% 1$.,%%% 1.,7%% # ,-%% -#., -% # ,-%% -#., -% 'ash 9low 5roCections ,7,#-, #!,$!. $,, .$ ,%,%%% ,.,%%% -%,7%% 7-,%%% .7,-%% 1 $,7-% ,%,%%% ,.,%%% -%,7%% (,7,-#7) (#!,!11) ($,,#-#)

, .,--% 1.,7%% -#., -% -#., -% $,, .$ $-,.1% $-,.1% % $,, .$

(111, !%) # 1,.7% 77,#1$$,17 1. ,%$7 ( -,!.-)

,.

A new 5lant entails an in2estment of &s.$,% million (&s.#!% million in fi:ed assets and &s.1-% million in net wor;ing ca5ital). <he 5lant has an economic life of ! years and is e:5ected to 5roduce a NA8A< of &s.!% million e2ery year. After ! years, the net wor;ing ca5ital will be realised at 5ar but fi:ed assets will fetch nothing. <he cost of ca5ital for the 5roCect is 1 5ercent. Assume that the straight+ line method of de5reciation is used for ta: as well as shareholder re5orting 5ur5oses. (i) What will be the &A'/ for year , ? Assume that the ca5ital em5loyed is measured at the beginning of the year. (ii) What will be the /TA (&s.in million) for year , ? (iii) What will be the &AB" for year , ? (i2) What will be the 'TA (&s.in million) for year , ? (2) What will be the '9&A" for year ,? (&s.in million) , ,$% 1-% -1% !% $% ,..% $,% 1 %

Solution: 1 #!% 1-% $,% !% $% ,..% $,% 1 %

N N N N N N N N

Net fi:ed assets (beginning) Net wor;ing ca5ital (beginning) 'a5ital em5loyed (beginning) NA8A< 3e5reciation (Accounting) /conomic de5reciation 'ash in2estment 'ost of ca5ital

# % 1-% -7% !% $% ,..% $,% 1 %

N 'a5ital charge #!% /conomic de5reciation ( 9T"9A1 %, !yr &A'/, ( NA8A<,*'/ ( !%*-1% ( 1-.$.% /TA, ( NA8A< I 'A' : '/ ( !% I %.1 : -1% ( 1!.! NA8A< ) 3/8 &AB", ( 'A=G "NT/=<0/N< ( $,% !% ) $% ( ( 1 .,% #!%

7-.$ ( ,..%

$!.#

$1.

. %

'TA, ( A5erating cash flow I /co.de5reciation I 'a5ital charge on full ca5ital in2ested ( (!% ) $%) I ,..% I %.1 : $,% ( -.,! A5erating cash flow I /conomic de5reciation '9&A" ( 'ash in2estment ,. 1#% I,..% ( $,% ( 1$.%,%

A new 5lant entails an in2estment of &s.!%% (&s.$%% million in fi:ed assets and &s. %% million in net wor;ing ca5ital). <he 5lant has an economic life of 1% years and is e:5ected to 5roduce a NA8A< of &s..% million e2ery year. After 1% years, the net wor;ing ca5ital will be realised at 5ar whereas fi:ed assets will fetch nothing. <he cost of ca5ital for the 5roCect is 1% 5ercent. Assume that the straight line method of de5reciation is used for ta: as well as re5orting 5ur5oses. (i) What will be the &A'/ for year , ? Assume that the ca5ital em5loyed is measured at the beginning of the year. (ii) What will be the /TA for year , ? (iii) What will be the &AB" for year , ? (i2) What will be the 'TA for year , ? (2) What will be the '9&A" for year ,?

Solution: N N N N N N N N N Net 2alue of fi:ed assets (beginning) "n2estment in net wor;ing ca5ital 'a5ital em5loyed (beginning) NA8A< 3e5reciation (Accounting 4 ta:) /conomic de5reciation 'ash in2estment 'ost of ca5ital 'a5ital charge 1 $%% %% !%% .% $% ,7.$!%% 1%% !% -#% %% 7#% .% $% ,7.$!%% 1%% 7# , #!% %% $!% .% $% ,7.$!%% 1%% $!

$%% /conomic de5reciation ( 9T"9A1%%, 1%yr &A'/ ( NA8A<,*'/ ( .%*$!% ( 1,. #% /TA, ( NA8A< I 'A' : '/ ( .% I %.1% : $!% ( NA8A< ) 3/8 &AB", ( 'ash "n2est ( !%% .% ) $% (

$%% ( ,7.$1-..,7

( 1!.7-%

'TA, ( A5erating cash flow I /co.de5rn I 'a5ital charge on full ca5.in2ested ( 1-% I ,7.$- I !% ( , .,A5erating cash flow I /conomic de5rn '9&A" ( 'ash in2estment ( 1#.%#%

#.

A new 5lant entails an in2estment of &s.1%%% million (&s. !%% million in fi:ed assets and &s. %% million in net wor;ing ca5ital).<he net wor;ing ca5ital will be maintained at that le2el throughout the 5roCect life. <he 5lant has an economic life of 1% years and it is e:5ected to 5roduce a NA8A< of &s.1#% million e2ery year. After 1% years, the net wor;ing ca5ital will be realised at 5ar whereas fi:ed assets will fetch nothing. <he cost of ca5ital for the 5roCect is 1- 5ercent. Assume that the straight line method of de5reciation is used for ta: as well as re5orting 5ur5oses. (i) (ii) (iii) (i2) What will be the /TA for year ,? What will be the &AB" for year ,? What will be the 'TA for year ,? What will be the '9&A" for year ,?

Solution: 1 Net 2alue of fi:ed assets (beginning) "n2estment in current assets 'a5ital em5loyed (beginning) NA8A< 3e5reciation (Accounting and ta:) /conomic de5reciation 'ash in2estment 'ost of ca5ital !%% %% 1%%% 1#% !% ,..#% 1%%% 1-% 7 % %% . % 1#% !% ,..#% 1%%% 1-% , $#% %% !#% 1#% !% ,..#% 1%%% 1-%

!%% /conomic de5reciation ( 9T"9A1-%, 1% /TA, ( ( &AB", 'TA, ( 'ash "n2estment NA8A<, I 'A' : '/ 1#% I %.1- : !#% ( 1# NA8A< ) 3/8 ( 1%%% (

!%% ( ,..#% %.,%#

1#% ) !% ( %

( A8/&A<"NB 'A=G 9@AW I /'ANA0"' 3/8&/'"A<"AN I 'A8"<A@ 'GA&B/ AN 9>@@ 'A8"<A@ "NT/=<0/N<. ( % I ,..#% I %.1- (1%%%) ( ,%.$% A8/&A<"NB 'A=G 9@AW I /'ANA0"' 3/8&/'"A<"AN

'9&A",

( 'A=G "NT/=<0/N< % I ,..#% ( 1%%% ( 1!.%$%

-.

?iotech "nternational earns a return on e7uity of % 5ercent. <he di2idend 5ayout ratio is %. -. /7uity shareholders of ?iotech re7uire a return of 1$ 5ercent. <he boo; 2alue 5er share is &s.$%. (i) What is the mar;et 5rice 5er share, according to the 0ara;on model ?

Solution: < ( (1+,)r ( %.7- : %. % ( %.1M ( B BI< B ( &s. $% rI< ( %.1$ I %.1M ( - B ( &s.,%% %. % I %.1( -

(ii) Solution:

"f the return on e7uity falls to 1. 5ercent, what should be the 5ayout ratio be to ensure that the mar;et 5rice 5er share remains unchanged.

%.1. I < ( %.1$ I < < ( (1+,) r %.1- - ( (1+,) : %.1. , ( %.1.7# or 1..7# % $. 0iocon @imited is considering a ca5ital 5roCect for which the following information is a2ailable. "nitial outlay 6 8roCect life 6 =al2age 2alue 6 Annual re2enues 6 Annual costs 6 (e:cluding de5reciation, interest, and ta:es) -%%%% 3e5reciation method - years (for ta: 5ur5oses) % <a: rate $%%%% 3ebt+e7uity ratio ,%%%% 'ost of e7uity 'ost of debt 6 (5ost+ta:) 6 6 6 6 $% =in;ing fund ,% % 161 1#% g ( %.1- -

'alculate the /TA of the 5roCect o2er its life. Solution: =in;ing 9und 3e5reciation A : 8T"9A (1%%, -years) ( -%,%%% A : ,.7.1 ( -%,%%% A ( 1,,1!. 3e5reciation =chedule N "n2estment (beginning) N 3e5reciation N 1%% ca5ital charge N Annuity 1. &e2enues . 'osts ,. 8?3"< #. 3e5reciation -. 8?"< 1 -%,%%% !,1!. -,%%% 1,,1!. $%,%%% ,%,%%% ,%,%%% !,1!. 1,!11 #1,!11 .,%%! #,1!1 1,,1!. $%,%%% ,%,%%% ,%,%%% .,%%! %,.. , , ,!%, .,.%. ,, !% 1,,1!. $%,%%% ,%,%%% ,%,%%% .,.%. %,%.1 # ,!.# 1%,.%% , !. 1,,1!. $%,%%% ,%,%%% ,%,%%% 1%,.%% 1.,1%% 11,..# 11,..# 1,1.. 1,,1!. $%,%%% ,%,%%% ,%,%%% 11,..# 1!,%%$

$. NA8A< (-) : %.7 7. 'a5ital at charge !. 'a5ital charge (7 : %.1%) .. /TA 7.

1-, $! -%,%%% -,%%% 1%, $!

1#,$.# #1,!11 #,1!1 1%,-1,

1#,%$# , ,!%, ,, !% 1%,7!#

1,,,7% ,!.# , !. 11,%!1

1 ,$%# 11,..# 1,1.. 11,#%-

canbaP @imited is considering a ca5ital 5roCect for which the following information is a2ailable. "nitial outlay 8roCect life =al2age 2alue Annual re2enues Annual costs 3e5reciation method (for ta: 5ur5oses) <a: rate 3ebt+e7uity ratio 'ost of e7uity 'ost of debt (5ost ta:) <he initial outlay is entirely for ac7uiring fi:ed assets. 'alculate the /TA of the 5roCect o2er its life. 6 %%,%%% 6 # years 6 % 6 -%,%%% 6 1$%,%%% 6 =in;ing fund 6 ,%% 6 161 6 1-% 6 7%

Solution:
Sin;ing -un" <epreciation

A : 8T"9A ( 11 %, #yrs ) ( %%,%%% A : ,.1% ( %%,%%%

A ( $##7-

"n2estment (beginning) 3e5reciation 11% 'a5ital charge Annuity 1. . ,. #. -. $. 7. !. .. &e2enues 'osts 8?3"< 3e5reciation 8?"< NA8A< (-) : (%.7) 'a5ital at charge 'a5ital charge (7 : %.11) /TA

1 %%,%%% # ,#7,%%% $#,#71 -%,%%% 1$%,%%% .%,%%% # ,#7#7,- ,,, $! %%,%%% ,%%% 11, $!

3e5reciation =chedule , # 1-7,- - 11%,,7! -!,%##7,1#7 17,, ! $#,#7-%,%%% 1$%,%%% .%,%%% #7,1#7 # ,!-, .,..7 1-7,- 17,, ! 1 ,$$. - ,,,, 1 ,1# $#,#7, -%,%%% 1$%,%%% .%,%%% - ,,,, ,7,$$7 $,,$7 11%,,7! 1 ,1# 1#, -!,%.% $,,!$#,#7# -%,%%% 1$%,%%% .%,%%% -!.%.% ,1,.1% ,,,7 -!,%#$,,!1-,.-

!.

8olyte: @imited is considering a ca5ital 5roCect for which the following information is a2ailable . "n2estment outlay 6 8roCect life 6 =al2age 2alue 6 Annual re2enues 6 Annual costs 6 (e:cluding de5reciation interest, and ta:es) 1%%%% - years % 1#%%% .%%% 3e5reciation method (for ta: 5ur5oses) <a: rate 3ebt+e7uity ratio 'ost of e7uity 'ost of debt (5ost+ta:) 6 6 6 6 6 =in;ing fund ,% % 1 61 1$% !%

'alculate the /TA of the 5roCect o2er its life and the N8T. Solution: =in;ing 9und 3e5reciation A : 8T"9A (1 %,-yrs) ( 1%,%%% A : ,.$%- ( 1%,%%% A ( 77# 3e5reciation =chedule 1 , 1%,%%% !# $ $$$, 1-7# 17$, 1.7# 1 %% 1%11 !%% 77# 77# 77# # #$!. 11 -$, 77# #7! #7! .7 77#

"n2estment(beginning) 3e5reciation 1 % 'a5ital charge Annuity

1. &e2enues . 'osts ,. 8?3"< #. 3e5reciation -. 8?"< $. NA8A< (-) : (%.7) 7. 'a5ital at charge !. 'a5ital charge (7: %.1 ) .. /TA /TAt N8T ( (1.1 )t ( 11.!*1.1 ) 1 --*(1.1 ) ( #7 #.-,

1 1#%%% .%%% -%%% 1-7# ,# $ ,.! 1%%%% 1 %% 11.!

1#%%% .%%% -%%% 17$, , ,7 $$ !# $ 1%11 1 --

, 1#%%% .%%% -%%% 1.7# ,% $ 11! $$$, !%% 1,1!

# 1#%%% .%%% -%%% 11 7!. 1.#$!. -$, 1,!.

1#%%% .%%% -%%% #77 - , 17$$ #7! .7 1#$.

)1,1!*(1.1 ), ) 1,!.*(1.1 )# )1#$.* (1.1 )-

..

=imte; @imited is considering a ca5ital 5roCect for which the following information is a2ailable. "n2estment outlay 6 8roCect life 6 =al2age 2alue 6 Annual re2enues 6 Annual costs 6 (e:cluding de5reciation interest, and ta:es) (i) !%%% - years % 1%%%% $#%% 3e5reciation method (for ta: 5ur5oses) <a: rate 3ebt+e7uity ratio 'ost of e7uity 'ost of debt (5ost+ta:) 6 6 6 6 6 =in;ing fund ,% % %.$ 61 1-% 7%

What will be the de5reciation charge for year ,? $ 1% :7) 1$ 1$ : 1-

Solution: 8ost+ta: cost of ca5ital6

.$, ) ..,7 (1 .%% 5ercent =in;ing 9und 3e5reciation A : 8T"9A (1 %, -yrs) ( !%%% A : ,.$%- ( !%%% A ( 1. Depreciation Sche#ule 1 !%%% "n2estment (beginning) 1 -. 3e5reciation .$% 1 5ercent charge 1. (ii) Solution:
1. . ,. #. -. $. 7. !. .. &e2enues 'osts 8?3"< 3e5reciation 8?"< NA8A< 'a5ital at charge 'a5ital charge /TA 1%%%% $#%% ,$%% 1-7. % 1 1#1-,,1 $#% 77-

$7#1 1#1% !%. 1.

, -,,1 1-7. $#% 1.

What will be the /TA for year ,?

(iii) A2er time will the /TA of this 5roCect, increase, decrease or remains unchanged? Solution: <he boo; ca5ital decreases o2er time, than;s to de5reciation. Gence the ca5ital charge decreases. <his leads to an increase in /TA o2er time. 1%. Oarishma @imited e:5ects to earn a su5ernormal rate of return of -% 5ercent on new in2estments to be made o2er the ne:t $ years. <he 5roCected new in2estment 5er year is &s.#%% million. "f the weighted a2erage cost of ca5ital for Oarishma @imited is , 5ercent, what is the 2alue of the forward 5lan?

Solution: " r cX 0 8 ( ( ( &s.#%% million %.-% %. , $ years #%% (%.-% I %. ,) $ Talue of forward 5lan ( %. , (1. ,) ( &s. .%.-$ million 11. 8innacle 'or5oration e:5ects to earn a su5ernormal rate of return of $% 5ercent on new in2estments to be made o2er the ne:t # years. <he 5roCected new in2estment 5er year is &s. %% million. "f the weighted a2erage cost of ca5ital for 8innacle 'or5oration is 1! 5ercent, what is the 2alue of the forward 5lan?

Solution: " r cX 0 8 ( ( ( &s. %% million %.$% %.1! # years %% (%.$% I %.1!) # Talue of forward 5lan ( %.1! (1.1!) ( &s. 1-!1.. million

CHAPTER 3& 1. Anil 'om5any (the transferor com5any) and =unil 'om5any (the transferee com5any) amalgamate in an e:change of stoc; to form Anil and =unil 'om5any. <he 5re+amalgamation balance sheets of =unil 'om5any and Anil 'om5any are as follows6 Sunil Company %Rs. in million& 9i:ed assets 'urrent assets <otal assets =hare ca5ital (&s.1% face 2alue) &eser2es and sur5lus 3ebt ##% !,% % ,!Anil Company %Rs. in million& 1#% 1% % 1% #%

<he share swa5 ratio fi:ed is 6-. <he fair mar;et 2alue of the fi:ed assets and current assets of Anil 'om5any was assessed at &s.-% million and &s. % million res5ecti2ely. 8re5are the 5ost+amalgamation balance sheet of =unil 4 Anil 'om5any under the F5oolingF and F5urchaseF methods. Solution: <he 5re+amalgamation balance sheets of =unil 'om5any and Anil 'om5any and the 5ost+amalgamation balance sheet of the combined entity, =unil and Anil 'om5any, under the L5oolingJ method as well as the L5urchaseJ method are shown below6 6efore 7ma 8amation =unil 9i:ed assets 'urrent assets <otal assets =hare ca5ital (face 2alue R &s.1%) 'a5ital reser2e &eser2es 4 sur5lus 3ebt <otal liabilities ##% !,% % ,!Anil 1#% 1% $ % 1% #% #% #1 7fter 7ma 8amation =unil 4 Anil 'om5any 8ooling method 8urchase method 7% .-$% 1 ,# 1-,# -$ % #1--

Man 'om5any (the transferor com5any) and Min 'om5any (the transferee com5any) amalgamate in an e:change of stoc; to form Min Man 'om5any. <he 5re+ amalgamation balance sheets of Min 'om5any and Man 'om5any are as follows6 2in Company %Rs. in million& 9i:ed assets 'urrent assets <otal assets =hare ca5ital (&s.1% face 2alue) &eser2es and sur5lus 3ebt 1 % #% ,$% 1-% 1-% $% ,$% 2an Company %Rs. in million& -% !% 1,% #% 1% !% 1,%

<he e:change ratio fi:ed is one share for e2ery two shares of transferor com5any. <he fair mar;et 2alue of the fi:ed assets, current assets and debt of Man 'om5any was assessed at &s.#% million , &s.$% million and &s..% million res5ecti2ely. 8re5are the 5ost+amalgamation balance sheet of Min Man 'om5any under the F5oolingF and F5urchaseF methods. Solution: Min 4 Man 'om5any 8ooling method 8urchase method 17% , % 1$% ,%% 1% #7% 17%

Min 9i:ed assets 'urrent assets Boodwill <otal assets =hare ca5ital (face 2alue R &s.1%) 'a5ital reser2e &eser2es 4 sur5lus 3ebt <otal liabilities ,. 1 % #%

Man -% !%

,$% 1-%

1,% #%

#.% 17% % 1$% 1#% #.%

1-% $% ,$%

1% !% 1,%

1-% 1-% #7%

?harat 'om5any (the transferor com5any) and cai 'om5any (the transferee com5any) amalgamate in an e:change of stoc; to form cai ?harat 'om5any. <he 5re+amalgamation balance sheets of cai 'om5any and ?harat 'om5any are as follows6

Pai Company %Rs. in million& 9i:ed assets 'urrent assets <otal assets =hare ca5ital (&s.1% face 2alue) &eser2es and sur5lus 3ebt !% 1%% 1!% 7% -% $% 1!%

Bharat Company %Rs. in million& #% #% !% ,% % ,% !%

<he e:change ratio fi:ed is two shares for e2ery fi2e shares of the transferor com5any. <he fair mar;et 2alue of the fi:ed assets, current assets and debt of ?harat 'om5any was assessed at &s.,% million, &s. % million and &s.#% million res5ecti2ely . 8re5are the 5ost+amalgamation balance sheet of cai ?harat 'om5any under the F5oolingF and F5urchaseF methods. Solution: ?efore Amalgamation cai !% 1%% ?harat #% #% After Amalgamation cai ?harat 'om5any 8ooling method 8urchase method 1 % 11% 1#% 1 %

9i:ed assets 'urrent assets Boodwill <otal assets =hare ca5ital (face 2alue R &s.1%) 'a5ital reser2e &eser2es 4 sur5lus 3ebt <otal liabilities #.

1!% 7%

!% ,%

$% ! 1! 7% .% $%

, !

-% $% 1!%

% ,% !%

-% 1%% ,

TiCay 'om5any 5lans to ac7uire ACay 'om5any. <he following are the rele2ant financials of the two com5anies. <otal earnings, / Number of outstanding shares 0ar;et 5rice 5er share Di;ay Company &s. %% million % million &s. %% A;ay Company &s.1%% million 1% million &s.1 %

(i)

What is the ma:imum e:change ratio acce5table to the shareholders of TiCay 'om5any if the 8/ ratio of the combined com5any is 1! and there is no synergy gain?

Solution:

+ =1 /&1 ( = % ( + 1% ) )

8/1 (/1 ) 81 = 1! (,%%) ( %.7 %% : 1%

(ii) Solution:

What is the minimum e:change ratio acce5table to the shareholders of ACay 'om5any if the 8/ ratio of the combined com5any is 1! and there is a synergy gain of $ 5ercent?

8 =1 /& ( (8/1 ) (/1 ) / ) (1)=) I 8 = 1 %: % ( (1!) ( %% ) 1%%) (1.%$) +1 % : 1% ( %.-,

(iii) "f there is no synergy gain, at what le2el of 8/ multi5le will the lines /& 1 and /& intersect? Solution: <he lines /&1 and /& will intersect at a 5oint corres5onding to the weighted a2erage of the two 8/ multi5les wherein the weights corres5ond to the res5ecti2e earnings of the two firms. %% 8/1 ( ,%% ( : % ) ,%% 1%% :1

1,.,,, ) # ( 17.,,

(i2) "f the e:5ected synergy gain is ! 5ercent, what e:change ratio will result in a 5ost+merger earnings 5er share of &s.11? Solution: (/1 ) / ) (1 ) =) ( N1 ) N : /& /& ( %..#% ) 1% : /& ( %% ) 1%%) (1.%!) ( 11

(2)

Assume that the merger is e:5ected to generate gains which ha2e a 5resent 2alue of &s. #%% million and the e:change ratio agreed to is %.$. What is the true cost of the merger from the 5oint of 2iew of TiCay 'om5any?

Solution: 'ost ( 8T (TiCay and ACay) I 8T ( ACay) %.$% : 1% ( ( %. ,1 % ) %.$ : 1%

8T (TiCay 4 ACay) ( #%%% ) 1 %% ) #%% ( -$%% million 'ost ( %. ,1 : -$%% + 1 %% ( &s..,.$ million -. ceet 'om5any 5lans to ac7uire ACeet 'om5any. <he following are the rele2ant financials of the two com5anies. <otal earnings, / Number of outstanding shares 0ar;et 5rice 5er share (i) Peet Company &s.1$%% million #% million &s ..%% A;eet Company &s.$%% million ,% million &s.,$%

What is the ma:imum e:change ratio acce5table to the shareholders of ceet 'om5any if the 8/ ratio of the combined com5any is 1 and there is no synergy gain?

Solution:

/&1 (

+ =1 ) 8/1 (/1 ) +++++++ ++++++++++++++++ += 81= + #% ) 1 : %% +++++++ ++++++++++++++++ ,% .%% 1 ,% %.,7! What is the minimum e:change ratio acce5table to the shareholders of ACeet 'om5any if the 8/ ratio of the combined com5any is % and there is a synergy benefit of ! 5ercent?

( ( (ii)

Solution: 8 =1 ++++++++++++++++++++++++++++++++++++++++++++ (8/1 ) (/1 ) / ) ( 1 ) =) I 8 = ,$% : #% ++++++++++++++++++++++++++++++++++++++++++++ % : ( %%) (1.%!) + ,$% : ,% %.,.

/& (

( (

(iii) "f there is no synergy gain, at what le2el of 8/ multi5le will the lines /& 1 and /& intersect? Solution: <he lines /&1 and /& will intersect at a 5oint corres5onding to the weighted a2erage of the two 8/ multi5les wherein the weights corres5ond to the res5ecti2e earnings of the two firms. 8/1 ( ( ( 1$%% ++++++++++ : %% 1$.,$ ) #..1 1. 7 .- ) $%% ++++++++++ 1 1! %%

(i2) "f the e:5ected synergy gain is 1% 5ercent, what e:change ratio will result in a 5ost+merger earnings 5er share of &s.,% ? Solution: (/1 ) / ) ( 1 ) = ) ( 1$%% ) $%% ) ( 1.1% ) +++++++++++++++++++++++ ( +++++++++++++++++++++++++++ N1 ) N : /& #% ) ,% : /& # % +++++++++++++++++++ #% ) ,%/& /& ( 1.,-(2) Assume that the merger is e:5ected to generate gains which ha2e a 5resent 2alue of &s. -%%% million and the e:change ratio agreed to is %.#-. What is the true cost of the merger from the 5oint of 2iew of ceet 'om5any? ( ,% ( ,%

Solution: 'ost ( = 8T (ceet 4 ACeet) + 8T (ACeet) %.#- : ,% = 0.252 40 + 0.45 : ,%

8T ( ceet 4 ACeet ) ( ,$%%% ) 1%!%% ) -%%% ( -1!%% 8T ( ACeet ) ( 1%!%% 'ost ( %. - ( -1!%% ) I 1%!%% ( $. -,.$

=haan 'om5any 5lans to ac7uire Aan 'om5any. <he following are the rele2ant financials of the two com5anies. Shaan Company Aan Company <otal earnings, / &s.7-% million &s. #% million Number of outstanding shares -% million % million 0ar;et 5rice 5er share &s. -% &s.1-% (i) What is the ma:imum e:change ratio acce5table to the shareholders of =haan 'om5any if the 8/ ratio of the combined com5any is 1- and there is no synergy gain?

Solution: + =1 /&1 ( = -% ( + % (ii) ) -% : % ) 81 = 1- : ..% ( %.#7 8/1 ( / 1 )

What is the minimum e:change ratio acce5table to the shareholders of Aan 'om5any if the 8/ ratio of the combined entity is 1- and there is a synergy benefit of $ 5ercent?

Solution: 8 =1 /& ( (8/1 ) (/1 ) / ) (1)=) I 8 = 1-% : -% ( 1- : ..% : 1.%$ I 1-% : % (iii) "f there is no synergy gain, at what le2el of 8/ multi5le will the lines /& 1 and /& intersect? Solution: <he lines /&1 and /& will intersect at a 5oint corres5onding to the weighted a2erage of the two 8/ multi5les wherein the weights corres5ond to the res5ecti2e earnings of the two firms. 7-% 8/1 ( ..% ( 1-.$$ : 1$.$7 ) ..% #% : 1 .( %.-!.

(i2) "f the e:5ected synergy gain is $ 5ercent, what e:change ratio will result in a 5ost+merger earnings 5er share of &s.1$? Solution:

(/1 ) / ) (1 ) =) ( N1 ) N : /&

( 7-% ) #%) (1.%$) ( 1$ -% ) /& ( %.77. % : /&

(2)

Assume that the merger is e:5ected to generate gains which ha2e a 5resent 2alue of &s. $%% million and the e:change ratio agreed to is %.$%. What is the true cost of the merger from the 5oint of 2iew of =haan 'om5any?

Solution: 'ost ( 8T (=haan 4 Aan) I 8T ( Aan) %.$% : % ( ( -% ) % : %.$% $ ( 1$1%% 1 ( %.1.#

8T (=haan 4 Aan) ( 1 -%% ) ,%%% ) $%% 8T (Aan) ( ,%%%

'ost ( %.1.# : 1$1%% I ,%%% ( &s.1 ,.# million. 7. Arun 'om5any has a 2alue of &s.#% million and Tarun 'om5any has a 2alue of &s. % million. "f the two com5anies merge, cost sa2ings with a 5resent 2alue of &s.- million would occur. Arun 5ro5oses to offer &s. million cash com5ensation to ac7uire Tarun. What is the net 5resent 2alue of the merger to the two firms?

Solution: 8TA ( &s.#% million, 8TD ( &s. % million ?enefit ( &s.- million, 'ash com5ensation ( &s. million 'ost ( 'ash com5ensation I 8TD ( &s. million N8T to Arun ( ?enefit I 'ost ( &s., million N8T to Tarun ( 'ash 'om5ensation I 8TD ( &s. million

!.

Oamal 'om5any has a 2alue of &s.!% million and camal 'om5any has a 2alue of &s.,% million. "f the two com5anies merge, cost sa2ings with a 5resent 2alue of &s.1% million would occur. Oamal 5ro5oses to offer &s.,- million cash com5ensation to ac7uire camal. What is the net 5resent 2alue of the merger to the two firms?

Solution: 8TR ( &s.!% million, 8TP ( &s.,% million ?enefit ( &s.1% million, 'ash com5ensation ( &s ,- million 'ost ( 'ash com5ensation I 8TP ( &s.- million N8T to Al5ha ( ?enefit I 'ost ( &s.- million N8T to ?eta ( 'ash 'om5ensation I 8TP ( &s.- million .. America @imited 5lans to ac7uire ca5an @imited. <he rele2ant financial details of the two firms, 5rior to merger announcement, are gi2en below6 0ar;et 5rice 5er share Number of shares America "imite# &s. 1%% !%%,%%% Papan "imite# &s.#% ,%%,%%%

<he merger is e:5ected to bring gains which ha2e a 5resent 2alue of &s.1 million. America @imited offers two share in e:change for e2ery three shares of ca5an @imited. &e7uired 6 (a) What is the true cost of America @imited for ac7uiring ca5an @imited ? (b) What is the net 5resent 2alue of the merger to America @imited ? (c) What is the net 5resent 2alue of the merger to ca5an @imited ? Solution: @et A stand for America @imited and P for ca5an @imited and AP for the combined entity. 8TA ( &s.1%% : !%%,%%% ( &s.!% million 8TP ( &s.#% : ,%%,%%% ( &s.1 million ?enefit ( &s.1 million 8TAP ( !% ) 1 ) 1 ( &s.1%# million /:change ratio ( 6, <he share of ca5an @imited in the combined entity will be 6 %%,%%% ( !%%,%%% ) %%,%%% ( %.

a) <rue cost to America @imited for ac7uiring ca5an @imited 'ost ( 8TAP + 8TP ( %. : 1%# + 1 ( &s.!.! million b) N8T to America @imited ( ?enefit + 'ost ( 1 + !.! ( &s.,. million c) N8T to ca5an @imited ( 'ost 1%. ( &s.!.! million

Amir @imited 5lans to ac7uire camir @imited. <he rele2ant financial details of the two firms, 5rior to merger announcement, are gi2en below6 Amir "imite# 0ar;et 5rice 5er share &s. -%% Number of shares $%%,%%% Pamir "imite# &s.1%% %%,%%%

<he merger is e:5ected to bring gains which ha2e a 5resent 2alue of &s. % million. Amir @imited offers one share in e:change for e2ery four shares of camir @imited. &e7uired6 (a) What is the true cost of Amir @imited for ac7uiring camir @imited? (b) What is the net 5resent 2alue of the merger to Amir @imited ? (c) What is the net 5resent 2alue of the merger to camir @imited ? Solution: @et A stand for Amir @imited and P for camir @imited and AP for the combined entity. 8TA ( &s.-%% : $%%,%%% ( &s.,%% million 8TP ( &s.1%% : %%,%%% ( &s. % million ?enefit ( &s. % million 8TAP ( ,%% ) % ) % ( &s.,#% million /:change ratio ( 16# <he share of camir @imited in the combined entity will be6 -%,%%% ( ( %.%7$. $%%,%%% ) -%,%%% a) <rue cost to Amir @imited for ac7uiring camir @imited 'ost ( 8TAP + 8TP ( %.%7$. : ,#% + % ( &s.$.1#$ million

b) N8T to Amir @imited ( ?enefit + 'ost ( % + $.1#$ ( &s.1,.!-# million c) N8T to camir @imited ( 'ost 11. ( &s.$.1#$ million

As the financial manager of National 'om5any you are in2estigating the ac7uisition of &egional 'om5any. <he following facts are gi2en6 /arning 5er share 3i2idend 5er share 8rice 5er share Number of shares 3ational Company &s.!.%% &s.-.%% &s.!$.%% !,%%%,%%% Re<ional Company &s.,.%% &s. .-% &s. #.%% ,,%%%,%%%

"n2estors currently e:5ect the di2idends and earnings of &egional to grow at a steady rate of $ 5ercent. After ac7uisition this growth rate would increase to 1 5ercent without any additional in2estment. &e7uired 6 (a) What is the benefit of this ac7uisition ? (b) What is the cost of this ac7uisition to National 'om5any if it (i) 5ays &s.,% 5er share cash com5ensation to &egional 'om5any and (ii) offers two shares for e2ery fi2e shares of &egional 'om5any? Solution: @et the suffi:es A stand for National 'om5any, B for &egional 'om5any and AB for the combined com5any. a) 8TB ( &s. # : ,,%%%,%%% ( &s.7 million <he re7uired return on the e7uity of &egional 'om5any is the 2alue of B in the e7uation. &s. .-% (1.%$) &s. # ( B + .%$ B ( %.17%# or 17.%# 5er cent. "f the growth rate of &egional rises to 1 5er cent as a se7uel to merger, the intrinsic 2alue 5er share would become6 .-% (1.1 ) ( %.17%# + .1 &s.--.-$

<hus the 2alue 5er share increases by &s.,1.-$ Gence the benefit of the ac7uisition is6 , million : &s.,1.-$ ( (b) (ii) (i) &s..#.$! million

"f National 5ays &s.,% 5er share cash com5ensation, the cost of the merger is , million : (&s.,% I &s. #) ( &s.1! million.

"f National offers shares for e2ery - shares it has to issue 1. million shares to shareholders of &egional. =o shareholders of &egional will end u5 with 1. = ( %.1,%# or 1,.%# 5er cent !) 1.

shareholding of the combined entity, <he 5resent 2alue of the combined entity will be 8TAB ( 8TA ) 8TB ) ?enefit ( &s.!$:! million ) &s. #:, million ) &s..#.$! million ( &s.!-#.$! million =o the cost of the merger is 6 'ost ( 8TAB + 8TB ( .1,%# : !-#.$! + 7 1 .

( &s.,..#- million

As the financial manager of =atya @imited you are in2estigating the ac7uisition of 3e2araC @imited. <he following facts are gi2en6 /arning 5er share 3i2idend 5er share 8rice 5er share Number of shares Satya "imite# &s.1 .%% &s.1%.%% &s.11%.%% -,!%%,%%% De4ara; "imite# &s.#.%% &s.,.%% &s.,! .%% 1,#%%,%%%

"n2estors currently e:5ect the di2idends and earnings of 3e2araC to grow at a steady rate of # 5ercent. After ac7uisition this growth rate would increase to 1% 5ercent without any additional in2estment. &e7uired6 (a) What is the benefit of this ac7uisition ? (b) What is the cost of this ac7uisition to =atya @imited if it (i) 5ays &s.1%% 5er share cash com5ensation to 3e2araC @imited and (ii) offers three shares for e2ery se2en shares of 3e2araC @imited ?

Solution: @et the suffi:es A stand for =atya @imited, B for 3e2araC @imited and AB for the combined com5any a) 8TB ( &s.,! : 1,#%%,%%% ( &s.-,. million <he re7uired return on the e7uity of 3e2araC @imited is the 2alue of B in the e7uation. &s., (1.%#) &s.,! ( B + .%# B ( %.1 1 or 1 . 1 5er cent. "f the growth rate of 3e2araC @imited rises to 1% 5er cent as a se7uel to merger, the intrinsic 2alue 5er share would become 6 ,(1.1%) ( %.1 1+ .1% <hus the 2alue 5er share increases by &s.111., is 1.#million : &s.111., ( (b) (i) Gence the benefit of the ac7uisition &s.1#..,

&s.1--.!- million

"f =atya @imited 5ays &s.1%% 5er share cash com5ensation, the cost of the merger is 1.# million : (&s.1%% I &s.,!) ( &s.!$.! million.

(iii) "f =atya @imited offers , shares for e2ery 7 shares it has to issue% .$ million shares to shareholders of 3e2araC @imited. =o shareholders of 3e2araC @imited will end u5 with %.$ = ( %.%.,7- or ..,7- 5er cent -.! ) %.$

shareholding of the combined entity, <he 5resent 2alue of the combined entity will be 8TAB ( 8TA ) 8TB ) ?enefit ( &s.11%:-.! million ) &s.,!:1.# million ) &s.1--.!- million ( &s.!#7.%- million =o the cost of the merger is 6

'ost 1,.

( 8TAB + 8TB ( .%.,7- : !#7.%- + -,.

( &s. $. 1 million K &s.#.%% &s. !.%% 1,%%%

'om5anies - and K are 2alued as follows6 /arnings 5er share &s. 1 .%% 8rice 5er share &s.11%.%% Number of shares $%,%%%

- ac7uires H by offering one shares of 8 for e2ery three shares of H. "f there is no economic gain from the merger, what is the 5rice+earnings ratio of 8Fs stoc; after the merger? Solution: <he e:5ected 5rofile of the combined entity after the merger is shown in the last column below. $%,%%% &s.7 %,%%% &s.$,$%%,%%% ..17 K 1,%%% &s.!#,%%% &s.-!!,%%% 7.% Com,ine# entity !1,%%% &s.!%#,%%% &s. 7,1!!,%%% !..#

Number of shares Aggregate earnings 0ar;et 2alue 8*/ 1#.

'om5anies 0 and 3 are 2alued as follows6 M /arnings 5er share &s.#-.%% 8rice 5er share &s.,$%.%% Number of shares 1%%,%%%

3 &s.1 .%% &s.-,.%% , ,%%%

M ac7uires N by offering one shares of 0 for e2ery three shares of N. "f there is no economic gain from the merger, what is the 5rice+earnings ratio of 0Fs stoc; after the merger? Solution: <he e:5ected 5rofile of the combined entity after the merger is shown in the last column below. M 3 Com,ine# entity 1%%,%%% , ,%%% 1, ,%%% &s.#,-%%,%%% &s.,!#,%%% &s.#,!!#,%%% &s.,$,%%%,%%% &s.1,$.$,%%% &s. ,7,$.$,%%% ! #.# 7.7

Number of shares Aggregate earnings 0ar;et 2alue 8*/

1-.

1 @imited is 5lanning to ac7uire M @imited. <he management of 1 @imited estimates its e7uity+related 5ost ta: cash flows, without the merger, to be as follows6 Mear 1 , # 'ash flow (&s. in million) $% !% 1%% 1-% 1 % ?eyond year -, the cash flow is e:5ected to grow at a com5ound rate of ! 5ercent 5er year for e2er. "f M @imited is ac7uired, the e7uity+related cash flows of the combined firm are e:5ected to be as follows6 Mear 1 , # 'ash flow (&s. in million) 1%% 1 % 1-% -% %% ?eyond year -, the cash flow is e:5ected to grow at a com5ound rate of 1% 5ercent 5er year. <he number of outstanding shares of 1 @imited and M @imited 5rior to the merger are % million and 1 million res5ecti2ely. "f the management wants to ensure that the net 5resent 2alue of e7uity+related cash flows increase by at least -% 5ercent, as a se7uel to the merger, what is the u55er limit on the e:change ratio acce5table to it ? Assume cost of ca5ital to be 1- 5ercent.

Solution: Talue of 1 @imitedJs e7uity as a stand+alone com5any. $% ) (1.1-) (1.1-) !% ) 1%% 1-% 1 %1 % : 1.%! 1 ) ) ) : , # (1.1-) (1.1-) (1.1-) %.1- I %.%!

(1.1-)-

( &s. 1 ##.,, million Talue of the e7uity of the combined com5any 1%% 1 % 1-% -% %% %% (1.1%) ) ) ) ) ) : (1.1-) (1.1-) (1.1-), (1.1-)# (1.1-)%.1- I %.1% ( &s. 7%$. 7million @et abe the ma:imum e:change ratio acce5table to the shareholders of 1 @imited. =ince the management of 1 @imited wants to ensure that the net 5resent 2alue of e7uity+related cash flows increases by at least -% 5ercent, the 2alue of a is obtained as follows. % : 7%$. 7( 1.-% : 1 ##.,, % )a1 =ol2ing this for a we get a 8 %.71 (1.1-)-

1$.

8 @imited is 5lanning to ac7uire H @imited. <he management of 8 @imited estimates its e7uity+related 5ost ta: cash flows, without the merger, to be as follows6 Mear 1 , # 'ash flow (&s. in million) % ,% #% #% ,% ?eyond year -, the cash flow is e:5ected to grow at a com5ound rate of # 5ercent 5er year for e2er. "f H @imited is ac7uired, the e7uity+related cash flows of the combined firm are e:5ected to be as follows 6 Mear 1 , # 'ash flow (&s. in million) ,% -% $% -% #% ?eyond year -, the cash flow is e:5ected to grow at a com5ound rate of ! 5ercent 5er year. <he number of outstanding shares of 8 @imited and H @imited 5rior to the merger are 1% million and ! million res5ecti2ely. "f the management wants to ensure that the net 5resent 2alue of e7uity+related cash flows increase by at least % 5ercent, as a se7uel to the merger, what is the u55er limit on the e:change ratio acce5table to it ? Assume cost of ca5ital to be 1, 5ercent.

Solution: Talue of 8 @imitedJs e7uity as a stand+alone com5any. % ,% #% #% ,% ,% : 1.%# ) ) ) ) ) : (1.1,) (1.1,) (1.1,), (1.1,)# (1.1,)%.1, I %.%# ( &s. .7.!. million Talue of the e7uity of the combined com5any ,% -% $% -% #% #% (1.%!) ) ) ) ) ) : , # (1.1,) (1.1,) (1.1,) (1.1,) (1.1,) %.1, I %.%! ( &s. $ !.$1 million @et a be the ma:imum e:change ratio acce5table to the shareholders of 8 @imited. =ince the management of 8 @imited wants to ensure that the net 5resent 2alue of e7uity+related cash flows increases by at least % 5ercent, the 2alue of a is obtained as follows. 1% : $ !.$1 ( 1. % : .7.!. 1% ) a ! =ol2ing this for a we get a 8 %..1 (1.1,)1 (1.1,)-

17.

&aCagiri 0ills @imited is interested in ac7uiring the te:tile di2ision of 8ricom "ndustries @imited. <he 5lanning grou5 of &aCagiri 0ills @imited has de2elo5ed the following forecast for the te:tile di2ision of 8ricom "ndustries @imited. &s.in millions 2ear Asset 2alue (at the beginning) NA8A< Net in2estment Browth rate (%) 1 1%% % ,% % 1 % , , .1, 1,! 7.$ , .1% # 1-1.! ,%.# ,%.# ! 1$,.. , .! , .! ! $ 177.1 ,-.# -., $

<he growth rate from year 7 onward will be $ 5ercent. <he discount rate to be used for this ac7uisition is % 5ercent. What is the 2alue of this ac7uisition? Solution:
1 9'9 8T"9 8T (1%) %.!,, (!.,,) (!.-) %.$.# , (#..) %.-7. # % %.#! % % %.#% % $ 1%.1 %.,,,.,!, 7 1%.7

(-..%) ( .!,7)

8T (9'9) during the e:5licit forecast 5eriod ( + 1,.$! TG ( 9'97 r+g ( 7$.#71 (1. %)$ 1%.7%$ %. % I %.%$ ( -.$% ( 7$.#71

8T(TG) (

T% ( + 1,.$! ) -.$% ( &s. 11.. million.

1!.

'01 @imited is interested in ac7uiring the cement di2ision of ?4< @imited. <he 5lanning grou5 of '01 @imited has de2elo5ed the following forecast for the cement di2ision of ? 4 < @imited.

&s.in millions 2ear Asset 2alue (at the beginning) NA8A< Net in2estment Browth rate (%) 1 1%% % ,#% 1#% ,$., 17,% ,7 % # 1% ,#.,7.# 1#1.,..7 #,.% 1$ 77.7 #,.7 # .% 1%

<he growth rate from year 7 onward will be 1% 5ercent. <he discount rate to be used for ac7uisition is 1 5ercent. What is the 2alue of this ac7uisition? Solution:

9'9 8T"9 8T 8T (9'9) TG 8T (TG) T% 1..

1 , # $ (1-) (11.-) (7) ( ..) (,.,) 1.7 %.!., %.7.7 %.71 %.$,$ %.-$7 %.-%7 (1,.#%) (..17) (#..!) (1.!#) (1.!7) (%.!$) during the e:5licit forecast 5eriod ( +,.# 9'97 1.!7 ( ( ( .,.rIg %.1 I %.1% ( .,.- * (1.1 )$ ( #7.,7 ( + ,%.#% ) #7.,7 ( &s. 1$..7 million

&e: @imited is interested in ac7uiring the cement di2ision of 9le: @imited. <he 5lanning grou5 of &e: @imited has de2elo5ed the following forecast for the cement di2ision of 9le: @imited 2ear Asset 2alue NA8A< Net in2estment Browth rate(%) 1 1%% 1# % , # $ 1 .-% ..!% -., !

1 1-% 17 .- 1.,. 17.1 #. 7.1 ..#. #.1 % 11 1%

<he growth rate from year 7 onward will be ! 5ercent. <he discount rate to be used for this ac7uisition is 1- 5ercent. What is the 2alue of this ac7uisition?

Solution: 9'9 8T 1 ($) (-) , (1.-) # % I , %.#.7 1.-% $ #.%.#, 1..# 7 #..

%.!7% %.7-$ %.$-! (-. ) (,.7!) (%...)

8T (9'9) during the im5licit forecast 5eriod 9'97 #.. TG ( ( ( 7% r+g %.1- I %.%! 1 8T(TG) ( 7% : (1.1-)
$

( ,%. $

T% ( I $.-- ) ,%. $ ( &s. ,.71

/0!0 CASE Astra 8harma is a fairly di2ersified 5harmaceutical com5any that has 5resence of most of the thera5eutic segments. "t has grown at a healthy rate o2er the 5ast fifteen years, than;s to a balanced 5rogramme of internal growth and ac7uisitions. "n a recent strategy session, the management of Astra 8harma identified the cardio2ascular segment as a thrust area for the ne:t few years. <hough Astra 8harma has a reasonable 5resence in this segment, the management is ;een on 5ursuing aggressi2e growth o55ortunities in this segment, es5ecially through ac7uisitions. An the ad2ice of the management, the business de2elo5ment grou5 at the head office e:amined se2eral inde5endent 5harmaceutical com5anies with a 5rimary focus on the cardio2ascular segment. <his grou5 loo;ed at things li;e re2enues, growth rate, 5rofit margin, mar;et ca5italisation, attitude of incumbent management, and so on. ?ased on such analysis, it Peroed in on 0a: 3rugs as a 5otentially suitable candidate for ac7uisition by Astra 8harma. 0a: 3rug is a two decade old com5any with a turno2er of &s.,%#% million last year. 0a: has had a che7uered history, with a general u5ward trend. <he financial statements of Astra 8harma and 0a: 3rugs for last year are gi2en below6

Astra Pharma 'alance Sheet =hareholderFs 9unds (#% million shares, &s 1% 5ar) @oan funds

#$%% $%% - %%

9i:ed assets (net) "n2estments Net current assets

,,%% -%% 1#%% - %%

Astra Pharma Profit an" Loss Account =ales 8rofit before de5reciation, interest, and ta:es 3e5reciation 8rofit before interest and ta:es "nterest 8rofit before ta: <a: 8rofit after ta: /a9 <rugs 'alance Sheet =hareholderFs 9unds (1% million shares, &s 1% 5ar) @oan funds 1,%% -%% 1!%% /a9 <rugs Profit an" Loss Account =ales 8rofit before de5reciation, interest, and ta:es 3e5reciation 8rofit before interest and ta:es "nterest 8rofit before ta: <a: 8rofit after ta: 1- % ,% 7% 1$% ,% 1,% ,.9i:ed assets (net) "n2estments Net current assets .#% -% $1% 1!%% .$!% 1. % -%% 1# % !% 1,#% ##% .%%

<he mar;et 5rice 5er share of Astra 8harma is &s.,$% and the mar;et 5rice 5er share for 0agnum 3rugs is &s. 11%. (a) 'alculate the e:change ratio that gi2es e7ual weightage to boo; 2alue 5er share, earnings 5er share, and mar;et 5rice 5er share.

(b) (c) (d) (e) (f) (g)

"f the merger is e:5ected to generate a synergy gain of - 5ercent, what is the ma:imum e:change ratio Astra 8harma should acce5t to a2oid initial dilution of earnings 5er share? What will be the 5ost+merger /8= of Astra 8harma if the e:change ratio is 16,? Assume that there is no synergy gain. What is the ma:imum e:change ratio acce5table to the shareholders of Astra 8harma if the 8/ ratio of the combined entity is 1- and there is no synergy gain? What is the minimum e:change ratio acce5table to the shareholders of 0a: 3rugs if the 8/ ratio of the combined entity is 1# and there is a synergy benefit of 5ercent? Assuming that there is no synergy gain, at what le2el of the 8/ ratio will the lines /&1 and /&2 intersect? Assume that the merger is e:5ected to generate gains which ha2e a 5resent 2alue of &s. 1%%% million and the e:change ratio agreed to is 16,. What is the true cost of the merger from the 5oint of 2iew of Astra 8harma? What are the limitations of earnings 5er share as the basis for determining the e:change ratio? @ist the fi2e sins that 5lague ac7uisitions? Solution: Astra /arnings / No.Autstanding shares = =hareholdersJ funds 0ar;et 5rice 5er share 8 /8= ?oo; 2alue 8/ ratio (a) .%% million #% million #$%% million &s.,$% &s .&s ..&s 111$ 0a: .- million 1% million 1,%% million &s.11% &s 1,% 11.-!

(h) (i)

/:change ratio that gi2es e7ual weightage to boo; 2alue 5er share, earnings 5er share and mar;et 5rice 5er share ( (1,%*11- ) ..-* .- ) 11%*,$% )*, ( %.$ "f there should not be initial dilution of /8=, the /8= of the merged com5any should be at least &s. .-. =o, U(.%% ) .-) (1.%-)V * U#% ) /& : 1%V ( <herefore ma:imum e:change ratio /& ( %.$# .- /& 1%##.7- ( .%% )

(b)

UAlternati2ely6 As the /8= of Astra if remains unchanged, the 8/ of the merged com5any has to be 1$ and therefore ma:imum e:change ratio Astra 8harma should acce5t is ( + =1 * = (c) ) 8/1 (/1 )*81= ( +#%*1% ) U1$: ..-(1.%-)V * (,$% : 1%) ( %.$#V

8ost+merger /8= of Astra 8harma ( ..-,%%%,%%% * U#%,%%%,%%% ) 1%,%%%,%%%*,V ( &s.

..$

(d)

0a:imum e:change ratio acce5table to the shareholders of Astra 8harma ( +=1 * = ) 8/1 (/1 )*81= ( +#%*1% ) (1- : ..-)*(,$% : 1%) ( %.10inimum e:change ratio acce5table to the shareholders of 0a: 3rugs ( 8 =1 * ( 81 /1 I 8 = ) ( (11% : #%) * U 1# : (..-:1.% ) I 11% : 1%V ( %.,# <o get the le2el of the 8/ ratio where the lines /&1 and /&2 will intersect we ha2e to sol2e the following for 8/1 + =1 ) = 81= (/1 ) / ) 8/1 ( 8/1 (/1 ) / ) I 8 = 8 =1

(e)

(f)

+ #%*1% ) ..- 8/1 * ,$% : 1% ( (11% : #%)* U 8/1 : ..- +11% : 1%V ..-8/1 I 1#,#%% ( ,,$%% ..- 8/1 + 11%% #,#%%

..%,% -8/ 1 +1#,, !,%%% 8/1 +1,%.#,-%%8/1 ) 1-,!#%,%%% ( 1-,!#%,%%% ..%,% - 8/ 1 ( 1-,# ,-%% 8/1 8/1 ( 1-.-! (g) At the e:change ratio of 16,, shareholders of 0a: drugs will get 1%*,million shares of Astra 8harma. =o they will get k ( (1%*,) * ( #% ) 1%*,) ( 7.$.% share of Astra 8harma. <he 5resent 2alue of Astra 8harma after the merger will be ( #% : ,$% ) 1% : 11% ) 1%%% ( &s.1$-%% million

<herefore the true cost of the merger from the 5oint of 2iew of Astra 8harma ( %.%7$. : 1$-%% I (1% : 11%) ( &s.1$!.!- million

(h)

An e:change ratio based on earnings 5er share fails to ta;e into account the following6

(i) <he difference in the growth rate of earnings of the two com5anies. (ii) <he gains in earnings arising out of merger. (iii) <he differential ris; associated with the earnings of the two com5anies. (i) <he fi2e sins that 5lague ac7uisitions are the following6 a) b) c) d) e) =traying too far afield. =tri2ing for bigness. @ea5ing before loo;ing. A2er5aying. 9ailing to integrate well.

CHAPTER 3, 1. "f the s5ot rate of the >= dollar is &s.#%.%% and the three month forward rate is &s.#%. -, what is the annualised forward 5remium on the dollar?

Solution: <he annualised 5remium is6 9orward rate I =5ot rate : =5ot rate #%. - I #%.%% ( #%.%% . : , 1 ( %.% - or .- % 9orward contract length in months 1

"f the s5ot rate of the >= dollar against ca5anese yen 11#.%% and the si: month forward rate is &s.11%, what is the annualised forward 5remium on the yen ?

Solution: <he annualised 5remium is 6 11# I 11% ( 11# : $ 1 ( %.%7% or 7.% %

,.

Mou ha2e Y,%% million to in2est. Mou are considering de5osits in the >= or >.O. <he >= interest rate on 1 Iyear de5osit of this siPe is -. - 5ercent. <he current s5ot rate is .%,#1 dollars 5er sterling 5ound. <he rate of interest on a 1+year de5osit of this siPe in >.O. is -.7- 5ercent. What forward e:change rate will ma;e you indifferent between in2esting in the >= and de5ositing in the >.O. ?

Solution: ,%% ,%% (1.%- -) ( .%,#1 6 ( .% #A forward e:change rate of .% #- dollars 5er sterling 5ound will mean indifference between in2esting in the >.= and in the >.O. #. Mou ha2e &s.1%%,%%% to in2est. Mou are considering de5osit in "ndia or the >=. <he >= interest rate on 1 Iyear de5osit of this siPe is -. - 5ercent while the rate for a one year de5osit in "ndia is ! 5ercent .<he current s5ot rate is &s.,..-% 5er dollar What forward e:change rate will ma;e you indifferent between in2esting in "ndia and the the >= . 1%%,%%% 1%%,%%%(1.%!) ( ,..-% 6 ( #%.-, A forward e:change rate of &s.#%.-, 5er dollar will mean indifference between in2esting in "ndia and the >.=. -. <he e:change rate between >= dollar and yen is as follows6 =5ot 11#.-# yen 5er dollar ,%+day forwards 11#.11 yen 5er dollar .%+day forwards 11,.,#yen 5er dollar 1!%+day forwards 11 .,% yen 5er dollar &e7uired6 (a) What is the annual 5ercentage 5remium of the yen on the dollar ? (b) What is the most li;ely s5ot rate $ months hence? (c) "f the interest on $+month de5osit in the >= is .#! 5ercent (for $ months), what is it li;ely to be in ca5an? Solution: (a) <he annual 5ercentage 5remium of the yen on the dollar may be calculated with reference to ,%+days forwards : 1.%- - : 6 : 1.%-7- : 6

Solution:

11#.-# I 11#.11 : 11#.-# (b) (c)

1 ( #.-% % 1

<he most li;ely s5ot rate $ months hence will be 6 11 .,% yen * dollar 9orwards rate ( =5ot rate 11 ., ( 11#.-# 1.% #! 3omestic interest rate in ca5an ( %.%%#7$ ( %.#! 5er cent for $ months. $. <he e:change rate between euro and Australian dollar (A>3) is as follows6 1 ) foreign interest rate 1 ) domestic interest rate in ca5an 1 ) domestic interest rate

=5ot 1.-.1- A>3 5er />& ,%+day forwards 1.-.-% A>3 5er />& .%+day forwards 1.$%%! A>3 5er />& &e7uired6 (a) What is the annual 5ercentage 5remium of the euro on the A>3 ? (b) What is the most li;ely s5ot rate , months hence? (c) "f the interest on ,+month de5osit in /uro land is . ! 5ercent (for , months), what is it li;ely to be in Australia ? Solution: <he annual 5ercentage 5remium of the euro may be calculated with reference to ,%+ days forwards 1.-.-% I 1.-.1: 1.-.1(b) (c) 1 1 ( .$# %

<he most li;ely s5ot rate , months hence will be 6 1.$%%! A>3 5er euro 9orwards rate ( =5ot rate 1.$%%! ( 1.-.11.% ! 3omestic interest rate in ca5an ( %.% !! ( .!! 5er cent( for , months) 1 ) foreign interest rate 1 ) domestic interest rate in ca5an 1 ) domestic interest rate

7.

Na2abharat 'or5oration, an "ndian com5any, is considering a 5roCect to be set u5 in >=. <he 5roCect will entail an initial outlay of >=3 -%% million and is e:5ected to generate the following cash flow o2er its fi2e year life6 Mear 1 'ash flow 1%% (in >=3 millions) -% , #%% # #%% ,%%

<he current s5ot e:change rate is &s.,..#% 5er >= dollar, the ris;+free rate in "ndia is ! 5ercent and the ris;+free rate in the >= is -.- 5ercent. Na2abharat 'or5orationJs re7uired ru5ee return on a 5roCect of this ;ind is 17 5ercent. 'alculate the N8T of the 5roCect using the home currency a55roach. Solution: S% ( &s.,..#% , rh ( ! 5er cent , rf ( -.- 5er cent Gence the forecasted s5ot rates are 6 2ear 1 , # 6orecaste# spot eAchan<e rate &s.,..#% (1.%! * 1.%--)1 ( &s. ,..#% (1.%! * 1.%--) ( &s. ,..#% (1.%! * 1.%--), ( &s. ,..#% (1.%! * 1.%--)# ( &s. ,..#% (1.%! * 1.%--)- ( &s.#%.,, &s.#1. . &s.# . 7 &s.#,. 7 &s.##. .

<he e:5ected ru5ee cash flows for the 5roCect 2ear % 1 , # Cash flo( in #ollars %million& + %% 1%% -% #%% #%% ,%% *Apecte# eAchan<e rate ,..#% #%.,, #1. # . 7 #,. 7 ##. . Cash flo( in rupees %million& +7,!!% #,%,, 1%,,%% 1$,.%! 17,,%! 1,, !7

Bi2en a ru5ee discount rate of 17 5er cent, the N8T in ru5ees is6 #,%,, N8T ( +7,!!% ) (1.17)1 ) (1.17) 1%,,%% ) (1.17), 1$,.%!

17,,%! ) (1.17)# )

1,, !7 (1.17)-

( &s. !,.##.. million <he dollar N8T is 6 !,.##.. * ,..#% ( 7,#.$# million dollars !. Asho;a @imited , an "ndian com5any, is considering a 5roCect to be set u5 in >=. <he 5roCect will entail an initial outlay of >=3 !%% million and is e:5ected to generate the following cash flow o2er its si: year life6 Mear 1 , # $ 'ash flow %% ,-% -%% !%% 7%% -%% (in >=3 millions) <he current s5ot e:change rate is &s.,..%% 5er >= dollar, the ris;+free rate in "ndia is 7 5ercent and the ris;+free rate in the >= is - 5ercent. Asho;a @imitedJs re7uired ru5ee return on a 5roCect of this ;ind is 'alculate the N8T of the 5roCect using the home currency a55roach. Solution: S% ( &s.,. , rh ( 7 5er cent , rf ( - 5er cent Gence the forecasted s5ot rates are6 2ear 1 , # $ 6orecaste# spot eAchan<e rate &s.,. (1.%7 * 1.%-)1 ( &s.,..7# &s. ,. (1.%7 * 1.%-) ( &s.#%.-% &s. ,. (1.%7 * 1.%-), ( &s.#1. 7 &s. ,. (1.%7 * 1.%-)# ( &s.# .%$ &s. ,. (1.%7 * 1.%-)- ( &s.# .!$ &s. ,. (1.%7 * 1.%-)$ ( &s.#,.$7 5ercent.

<he e:5ected ru5ee cash flows for the 5roCect

2ear % 1 , # $

Cash flo( in #ollars %million& +!%% %% ,-% -%% !%% 7%% -%%

*Apecte# eAchan<e Cash flo( in rupees rate %million& ,..%% + ,1, %% ,..7# 7,.#! #%.-% 1#,17#1. 7 %,$,# .%$ ,,,$#! # .!$ ,%,%% #,.$7 1,!,5er cent, the N8T in ru5ees is 6 7,.#! 1#,17%,$,) ) (1. )1 (1. ) (1. ), ,%,%% ) (1. )1,!,+++++++ (1. )$

Bi2en a ru5ee discount rate of N8T ( +,1, %% ) ,,,$#! ) (1. )# ( &s. .,11# million <he dollar N8T is6 )

.,11# * ,. ( 7#$.-1 million dollars .. <he .%+day interest rate is 1. - 5ercent in the > = and 1.-% 5ercent in > O and the current s5ot e:change rate is Y .% *. What will be the .%+day forward rate?

Solution: 9orward rate ( =5ot rate 9 ( .% 1 ) .%1-% 9 ( Y .%1- * 1%. <he .%+day interest rate is 1. 7 5ercent in the > = and 1.%7 5ercent in /uro land and the current s5ot e:change rate is Y 1.# %,*euro. What will be the .%+day forward rate? 1 ) foreign interest rate 1 ) .%1 1 ) domestic interest rate

Solution: 9orward rate ( =5ot rate 9 ( 1.# %, 1 ) .%1%7 9 ( Y 1.# ,1* euro 11. <he current s5ot rate for the ?ritish 5ound is &s.!1 <he e:5ected inflation rate is # 5ercent in "ndia and .7 5ercent in > O. What is the e:5ected s5ot rate of ?ritish 5ound a year hence? 1 ) foreign interest rate 1 ) .%1 7 1 ) domestic interest rate

Solution: /:5ected s5ot rate a year from now ( 'urrent s5ot rate /:5ected s5ot rate a year from now ( &s.!1 1.% 7 =o, the e:5ected s5ot rate a year from now is 6 !1 : (1.%# * 1.% 7) ( &s.! .%, 1 . <he current s5ot rate for the euro is &s.-$.#% <he e:5ected inflation rate is - 5ercent in "ndia and , 5ercent in /uro land. What is the e:5ected s5ot rate of euro a year hence? 1 ) e:5ected inflation in foreign country 1.%# 1 ) e:5ected inflation in home country

Solution: /:5ected s5ot rate a year from now ( 'urrent s5ot rate /:5ected s5ot rate a year from now ( -$.#% 1.%, =o, the e:5ected s5ot rate a year from now is 6 -$.#% : (1.%- * 1.%,) ( &s.-7.-% 1 ) e:5ected inflation in foreign country 1.%1 ) e:5ected inflation in home country

1,.

=u55ose "ndia and >O 5roduce only one good, co55er. =u55ose the 5rice of co55er in "ndia is &s. !%%% and in the >O it is Y#%%. a.According to the law of one 5rice, what should the ?ritish 8ound 6 &u5ee s5ot e:change rate be? b.=u55ose the 5rice of co55er o2er the ne:t year is e:5ected to rise is &s.,%,%%% in "ndia and Y#$% in the >O. What should the one year ?ritish 8ound6 &u5ee forward rate be?

Solution: (a) <he s5ot e:change rate of one ?ritish 8ound should be 6 !%%% ( &s.7% #%% Ane year forward rate of one ?ritish 8ound should be 6 ,%%%% ( &s. $-. #$%

(b)

1#.

=u55ose "ndia and =inga5ore 5roduce only one good, tin. =u55ose the 5rice of tin in "ndia is &s.!%%% and in =inga5ore it is =inga5ore dollar ,%%. (a) According to the law of one 5rice, what should the =inga5ore dollar6 &u5ee s5ot e:change rate be? (b) =u55ose the 5rice of tin o2er the ne:t year is e:5ected to rise to &s.1%,%%% in "ndia and Y,,% in =inga5ore. What should the one year =inga5ore dollar6 &u5ee forward rate be? Solution: (a) <he s5ot e:change rate of one =inga5ore dollar should be 6 !%%% ( &s. $.$7 ,%% Ane year forward rate of one =inga5ore dollar should be 6 1%%%% ( &s. ,%.,% ,,%

(b)

1-.

<he inflation rate in >= is e:5ected to be .7 5ercent 5er year, and the inflation rate in ca5an is e:5ected to be %.# 5ercent 5er year. "f the current s5ot rate is 11# yen*$ what will be the e:5ected s5ot rate in , years? (1 ) e:5ected inflation in ca5an), /:5ected s5ot rate ( 'urrent s5ot rate : , years from now (1 ) e:5ected inflation in >O),

Solution:

(1.%%#), ( 11# : (1.% 7), 1$. <he inflation rate in euro currency area is e:5ected to be 1.7 5ercent 5er year, and the inflation rate in "ndia is e:5ected to be ,.- 5ercent 5er year. "f the current s5ot rate is &s. -$.# 5er euro what will be the e:5ected s5ot rate in years? ( 1%$.-1 yen * $

Solution: (1 ) e:5ected inflation in "ndia) /:5ected s5ot rate ( 'urrent s5ot rate : years from now (1.%,-) ( -$.# 17. : (1.%17) =u55ose the s5ot rate between A>3 and >=3 is %.!-%% >=3 5er A>3. <his is denoted as A>3*>=3. <he .%+day forward is %.!-,%. >.= dollars can be lent or borrowed at a rate of -% 5.a, while the rates for A>3 de5osits or loans is #.- % 5.a. Gow much ris;+less 5rofit can you ma;e on a borrowing of 1%% >=3. ( &s.-!.#15er euro (1 ) e:5ected inflation in euro currency area)

Solution: Spot .%+day forward A>3* >=3 %.!-%% %.!-,% ?orrow 1%% >=3 and con2ert it into A>3 117.$"n2est A>3 117.$- R #.-% 5.a. for .% days and get 117.$- U 1 ) %.%#- (.%*,$%)V ( A>3 11!..7,$ 'on2ert A>3 into >=3 at the forward rate and recei2e dollars ( A>3 11!..7,$ : %.!-,% ( Y 1%1.#!#&e5ay >=3 by 5aying 1%% U 1 ) %.%- (.%*,$%)V ( Y 1%1. &is;less 5rofit ( Y 1%1.#!#- + Y 1%1. -%% ( %. ,#1!. =u55ose the s5ot rate between >=3 and "N& is #$.-% "N& 5er >=3. <his is denoted as >=3*"N&. <he .%+day forward is #7. %. "ndian ru5ee can be lent or borrowed at a rate ! % 5.a. while the rate for >=3 de5osits or loans is $.-% 5.a. Gow much ris;+less 5rofit can you ma;e on a borrowing of &s. 1%,%%%?

Solution: >=3*"N& =5ot #$.-% .% I day forward #7. %

?orrow 1%,%%% "N& and con2ert it into >=3 1-.%"n2est >=3 1-.%- R $.- % 5.a for .% days and get 1-.%- U1 ) %.%$- (.%*,$%)V ( >=3 1!.-# 'on2ert >=3 into "N& at the forward rate and recei2e "N& >=3 1!.-# 1 #7. % ( "N& 1%,1-.%!! &e5ay "N& loan by 5aying 1%,%%% U 1 ) %.%! ( .%*,$%) V ( 1%, %% &is;less 5rofit ( 1%,1-.%!! + 1% %% ( "N& 11-.%!! ( "Nc& 11-.%.

1..

An "ndian firm has a liability of -%%,%%% on account of 5urchases from a ?ritish su55lier, which is 5ayable after 1!% days. <he 1!%+day money mar;et rate for de5osits in >O is .- 5ercent. What ste5s should the "ndian firm ta;e to do a money mar;et hedge?

Solution: (i) 3etermine the 5resent 2alue of the foreign currency liability (-%%,%%%) by using 1!%+day money mar;et de5osit rate a55licable to the foreign country. <his wor;s out to 6 -%%,%%% ( #!7,!%(1.% -) (ii) Abtain #!7,!%- on todayJs s5ot mar;et

(iii) "n2est #!7,!%- in the >O money mar;et. <his in2estment will grow to -%%,%%% after 1!% days

%.

An "ndian firm has a recei2able of #%%,%%% on account of e:5orts to a ?ritish firm, which is 5ayable after .% days. <he .%+day money mar;et borrowing rate in >O is .% 5ercent. What ste5s should the "ndian firm ta;e to do a money mar;et hedge?

Solution: (i) 3etermine the 5resent 2alue of the foreign currency asset (#%%,%%%) by using the .%+day money mar;et borrowing rate of 5er cent. #%%,%%% (1.% ) (ii) ?orrow ,. ,1-7 in the >O money mar;et and con2ert them to ru5ees in the s5ot mar;et. ( ,. ,1-7

(iii) &e5ay the borrowing of ,. ,1-7 which will com5ound to #%%%%% after .% days with the collection of the recei2able. 1. =agar @td has a short+term fund sur5lus of &s.1%% million. <he funds can be 5ar;ed for a si:+month 5eriod. <he com5any obser2es the following rates in the mar;et. /urodollar $ month @"?A& 6 - % 5.a. ( <his is the interest rate for a >=3 de5osit) >=3* "N& s5ot 6 #$.7%*#$.!% >=3* "N& $months forward 6 #$..%* #7.%% "f =agar @td. 5ar;s its funds in the >= dollar, what ru5ee rate of return will it finally get o2er the $ month 5eriod, if co2ered forward? Solution: 1%%,%%%,%%% Amount de5osited in >=3 0aturity 2alue of the >=3 ( #$.!% ( ,1,$,7- .1# U1 ) %.%- (1!%*,$%)V ( Y ,1.%,17%..# ( Y ,1,$,7- .1#

&u5ee e7ui2alent at the forward rate of #$..% 5er >=3 ( ( &u5ee rate of return ( Y ,1.%,17%..# : #$..% &s.1% ,71..%17.1% .71. %

/astern "ndustries @td has a short+ term fund sur5lus of &s.1 % million. <he funds can be 5ar;ed for a si: month 5eriod. <he com5any obser2es the following rates in the mar;et. /urodollar $ month @"?A& 6 -% 5.a ( <his is the interest rate for a >=3 de5osit) >=3*"N& s5ot 6 #,.-%*#,.$% >=3*"N& $ month forward 6 #,.!%*#,..% "f /astern "ndustries 5ar;s its funds in the >.= dollar, What return will it finally get o2er the $+month 5eriod, if co2ered forward?

Solution: Amount de5osited in >=3 0aturity 2alue of the >=3 de5osit ( ( 1 %,%%%,%%% ( Y ,7- , .,.-! #,.$% ,7- , .,.-! U1 ) %.%- (1!%*,$%)V

( Y ,! 1,1%%.. &u5ee e7ui2alent at the forward rate of #,.!% 5er >=3 ( 1 ,,-$#, %.,% &ate of return ( ,,-$#, %.,%*1 %,%%%,%%% ( %.% .7 or ..7 %

,.

A foreign e:change dealer in @ondon normally 7uotes s5ot, one+month, and three+ month forward. When you as; o2er the tele5hone for current 7uotations for the ca5anese yen against the >.=. dollar, you hear6 11%.-% * --, (i) -%* --, 7% * 7-

What would you recei2e in dollars if you sold Men %,%%%,%%% s5ot?

Solution: %,%%%,%%% ( 11%.-Y 1!%,.1,.$1,7

(ii) Solution:

What would it cost you to 5urchase c8M ,%,%%%,%%% forward three+months with dollars?

<hree months outright ( ( 11%.-% ) %.7% ) * ( 11%.-- ) %.7- ) ( 111. % * 111.,% ,%,%%%,%%% ( 111. % #. A foreign e:change dealer in @ondon normally 7uotes s5ot, one+month and three+ month forward. When you as; o2er the tele5hone for current 7uotations for the ca5anese Men against the >= dollar, you hear 11-.!%*.%, #%*#-, $%*$(i) Solution: ,%,%%%,%%% ( 11-..% (ii) Solution: <hree months outright ( (11-.!% ) %.$% ) ( 11-..% ) %.$-) ( 11$.#% 11$.-( #%,%%%,%%% ( Y,#,,$# .$1 11$.#% -. =u55ose an "ndian firm has a ,+month 5ayable of c8M !% million. <he mar;et rates are as follows6 0umbai >=3*"N& =5ot 6 #,.-%*$% ,+months 6 ##.-%*$% =inga5ore >=3*c8M =5ot 6 11-. %*,% ,+months 6 11-.1%* % What would it cost you to 5urchase c8M #%,%%%,%%% forward three+months with dollars ? Y -!,!#,.!, What would you recei2e in dollars if you sold Men ,%,%%%,%%% s5ot? ( Y $.,7!#.17 7

"f the firm buys c8M forward against "N&, how much will it ha2e to 5ay? Solution: >=3 re7uired ( !%,%%%,%%% ( >=3 $.-,%#7.7! 11-.1% >=3 $.-,%#7.7! : ##.$% &s. ,%,...,1,%...

&u5ees re7uired ( ( $.

=u55ose an "ndian firm has a ,+month 5ayable of c8M !% million. <he mar;et rates are as follows6 0umbai6 =inga5ore6 a. ha2e to 5ay? >=3* "N& s5ot , months >=3* c8M s5ot , months 6 6 6 6 #$. %* ,% #-.!%* .% 11!.-%* $% 11!.#%* -%

"f the firm buys c8M forward against "N&, how much will it

Solution: !%,%%%,%%% >=3 re7uired ( 11!.#% &u5ees re7uired ( ( CHAPTER &( 1. 8rice changes of two 5harmaceutical stoc;s, - and K, are 5ositi2ely correlated. <he historical relationshi5 is as follows6 >=3 $7-,$7-.$! 1 #-..% &s. ,1,%1,,-1,.71 ( >=3 $7-,$7-.$!

A2erage 5ercentage change in - ( %.%1 ) %.-% (8ercentage change in K) 'hanges in K account for -% 5er cent of the 2ariation of changes in - (R ( %.-). (a) "f an in2estor owns &s. million of 8, how much of H should he sell to minimise his ris;? (b) What is his hedge ratio? (c) Gow should he create a Pero 2alue hedge? Solution:

(a) (b) (c) .

<he in2estor must short sell &s.# million (&s. million * %.-%) of K Gis hedge ratio is %.-% <o create a Pero 2alue hedge he must de5osit &s. million in a ban;.

<he stoc; inde: is currently at -,%%% and the si: month stoc; inde: futures is trading at -,1%%. <he ris;+free annual rate is ! 5er cent. What is the a2erage annual di2idend yield on the stoc;s in the inde:?

Solution: 9utures 5rice ( =5ot 5rice + (1)&is;+free rate)%.-1%% ( -%%% + (1.%!) %.(1.%!) %.<he di2idend yield on a si: months basis is 1.. 5er cent. An an annual basis it is a55ro:imately ,.!# 5er cent. ,. <he stoc; inde: is currently at 1!,%%% and the three month stoc; inde: futures is trading at 1!, %%. <he ris;+free annual rate is . 5er cent. What is the a2erage annual di2idend yield on the stoc;s in the inde:? (1)&is;+free rate)%.-%%% : 3i2idend yield =5ot 5rice : 3i2idend yield

Solution: 9utures 5rice ( =5ot 5rice + (1)&is;+free rate)%. 1! %% ( 1!%%% + (1.%.) %. (1.%.) %. <he di2idend yield on a three months basis is 1.%$7 5er cent. An an annual basis it is a55ro:imately #. $! 5er cent. (1)&is;+free rate)%. 1!%%% : 3i2idend yield =5ot 5rice : 3i2idend yield

#.

<he following information about co55er scra5 is gi2en6 =5ot 5rice 9utures 5rice contract "nterest rate 8T (storage costs) 6 &s.1%,%%% 5er ton 6 &s.1%,!%% for a one year 6 1 5er cent 6 &s.-%% 5er year

What is the 8T (con2enience yield) of co55er scra5? Solution: 9utures 5rice (1)&is;+free rate)1 1%,!%% ( 1%,%%% ) -%% I 8resent 2alue of con2enience yield (1.1 )1 Gence the 5resent 2alue of con2enience yield is &s.!-7.1# 5er ton. -. <he following information about gunmetal scra5 is gi2en6 =5ot 5rice 9utures 5rice contract "nterest rate 8T (storage costs) 6 &s.1-%,%%% 5er ton 6 &s.1$%,%%% for a one year 6 1, 5er cent 6 &s.!%% 5er year ( =5ot 5rice ) 8resent 2alue of I 8resent 2alue storage costs of con2enience yield

What is the 8T (con2enience yield) of gunmetal scra5? Solution: 9utures 5rice (1)&is;+free rate) 1$%,%%% ( 1-%,%%% ) !%% I 8resent 2alue of con2enience yield (1.1,)
1 1

( =5ot 5rice ) 8resent 2alue of I 8resent 2alue storage costs of con2enience yield

Gence the 5resent 2alue of con2enience yield is &s.., %7 5er ton.

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'onsider the following data Amit 'or5n. 3esired 9unding 9i:ed &ate - years -% million 7.% % $+month @"?A& )-% b5 =umit 'or5n. 9loating &ate - years -% million -.% % $ month @"?A&

'ost of 9i:ed &ate 9unding 'ost of 9loating &ate 9unding

=how how both the 5arties can sa2e on funding cost by entering into a cou5on swa5 with the hel5 of a swa5 ban;. Assume that the ban; wishes to earn %.- % and the balance of sa2ings is shared e7ually between the two firms. Solution:

@"?A&+ -% b5 -.-% Amit @td. @"?A& ) -%b5 7. 'onsider the following data 6irm A 3esired 9unding 9i:ed &ate Y - years #% million 7% =wa5 ?an;

@"?A&+-%b5 -% =umit @td. -% 9i:ed &ate

6irm B 9loating &ate Y - years #% million -.-% %

'ost of 9i:ed &ate 9unding 'ost of 9loating &ate 9unding

$+month @"?A& ) 1%% b5

$ month @"?A&) - b5

=how by way of a diagram how the 5arties can sa2e on funding cost by entering into a cou5on swa5 with the hel5 of a swa5 ban;. Assume that the cost sa2ed is shared e7ually by the two firms and the ban;. Solution: <he total sa2ings that will be effected will be U(7% + -.-%) I (@"?A& ) 1.%%% + @"?A& + %. -%V ( %.7-%. <he share of each in the sa2ings is therefore %. -%. <o realise this, a swa5 can be arranged as shown in the following diagram.

!.

'onsider the following data6 3esired 9unding *Acel Corpn. 9i:ed &ate Y - years %% million $. -% $month @"?A&)-%b5 Apple "t# 9loating &ate Y - years %% million -% $ month @"?A&

'ost of 9i:ed &ate 9unding6 'ost of 9loating &ate 9unding6

?oth the com5anies ha2e a55roached you, a swa5 ban;er, for arranging a swa5 in such a way that the sa2ings is s5lit e7ually among all the three. =how diagrammatically how you will arrange such a swa5. Solution:

..

As a swa5 ban;er, you are a55roached by client A who has to fund itself in fi:ed rate />& though it 5refers floating rate >=3 funding. "ts funding cost in />& is -. -% while it is willing to 5ay floating at si:+month @"?A& 5lus -% b5. Mou ha2e another client ? which has easy access to floating >=3 mar;et at =ub+@"?A& cost of @"?A&+-% b5. "t would li;e />& funding at no more than -% to ac7uire some />& fi:ed rate assets. =how how the swa5 can be e:ecuted. Assume that swa5 ban; incurs sa2ings in one currency and an additional 5ayment obligation in other currency.

Solution: