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∑TY–nTY
b=
∑T2–nT2
a = Y – bT
The parameters are calculated below:
Calculation in the Least Squares Method
T Y TY T2
1 2,000 2,000 1
2 2,200 4,400 4
3 2,100 6,300 9
4 2,300 9,200 16
5 2,500 12,500 25
6 3,200 19,200 36
7 3,600 25,200 49
8 4,000 32,000 64
9 3,900 35,100 81
10 4,000 40,000 100
11 4,200 46,200 121
12 4,300 51,600 144
13 4,900 63,700 169
14 5,300 74,200 196
∑ T = 105 ∑ Y = 48,500 ∑ TY = 421,600 ∑ T 2 = 1,015
T = 7.5 Y = 3,464
57,880
= = 254
227.5
a = Y – bT
= 3,464 – 254 (7.5)
= 1,559
Thus linear regression is
Y = 1,559 + 254 T
2. In general, in exponential smoothing the forecast for t + 1 is
Ft + 1 = Ft + α et
1 2,000
2 2,200
3 2,100 F4 = (2000 + 2200 + 2100)/3 = 2100
4 2,300 2100 F5 =(2200 + 2100 + 2300)/3= 2200
5 2,500 2200 F6 = (2100 + 2300 + 2500)/3 = 2300
6 3,200 2300 F7 = (2300 + 2500 + 3200)/3= 2667
7 3,600 2667 F8 = (2500 + 3200 + 3600)/3 = 3100
8 4,000 3100 F9 = (3200 + 3600 + 4000)/3 = 3600
9 3,900 3600 F10 = (3600 + 4000 + 3900)/3 = 3833
10 4,000 3833 F11 = (4000 + 3900 + 4000)/3 =3967
11 4,200 3967 F12 =(3900 + 4000 + 4200)/3 = 4033
12 4,300 4033 F13 = (4000 + 4200 + 4300)/3 = 4167
13 4,900 4167 F14 = (4200 + 4300 + 4900) = 4467
14 5,300 4467
4.
Q1 = 60
Q2 = 70
I1 = 1000
I2 = 1200
Q2 – Q1 I1 + I2
Income Elasticity of Demand E1 = x
I2 - I1 Q2 + Q1
E1 = Income Elasticity of Demand
Q1 = Quantity demanded in the base year
Q2 = Quantity demanded in the following year
I1 = Income level in base year
I2 = Income level in the following year
70 – 60 1000 + 1200
E1 = x
1200 – 1000 70 + 60
22000
E1 = = 0.846
26000
5.
P1 = Rs.40
P2 = Rs.50
Q1 = 1,00,000
Q2 = 95,000
Q2 – Q1 P1 + P2
Price Elasticity of Demand = Ep = x
P2 –P1 Q2 + Q1
P1 , Q1 = Price per unit and quantity demanded in the base year
P2, Q2 = Price per unit and quantity demanded in the following year
Ep = Price Elasticity of Demand
95000 - 100000 40 + 50
Ep = x
50 - 40 95000 + 100000
- 45
Ep = = - 0.231
1950
Chapter 6
1.
Projected Cash Flow Statement (Rs. in million)
Sources of Funds
Profit before interest and tax 4.5
Depreciation provision for the year 1.5
Secured term loan 1.0
Total (A) 7.0
Disposition of Funds
Capital expenditure 1.50
Increase in working capital 0.35
Repayment of term loan 0.50
Interest 1.20
Tax 1.80
Dividends 1.00
Total (B) 6.35
(Rs. in million)
Liabilities Assets
Share capital 5.00 Fixed assets 11.00
Reserves & surplus 4.50 Investments 0 .50
Secured loans 4.50 Current assets 12.85
Unsecured loans 3.00 * Cash 1.65
Current liabilities 6.30 * Receivables 4.20
Provisions 1.05 * Inventories 7.00
24.35 24.35
MINICASE
Projected Income Statements
I Operating II Operating
Year Year
--------------
Projected Cash Flow Statement ---------------
Sales 42,000 60,000
Cost of sales 28,000 40,000
Depreciation 3,643 3,643
Interest 4,838 4,722
Write-off of preliminary expenses 86 86
Net profit 5,433 11,549
Share capital 16,300 16,300 16,300 Fixed assets 41,280 37,637 33,994
(net)
Reserves & Nil 5,433 16,982
surplus
Secured loans Current assets
Term loans 29,000 32,535 28,635 Cash 3,160 10,153 21,031
Short-term Nil 17,100 19,100 Other current Nil 22,804 25,304
bank borrowing assets
Notes:
Allocation of Preoperative expenses
Cost before allocation Allocation Cost after
allocation
--------------------------- -------------
------------------------
Land 1,220 160 1,380
Building 6,100 803 6,903
Plant and machinery 24,440 3,216 27,656
Miscellaneous fixed assets 4,720 621 5,341
Total 36,480 4,800 41,280
Depreciation schedule:
4. Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is
equivalent to saving Rs.2000 a year for 15 years and Rs.1000 a year for the
years 6 through 15.
(10.000 – 9.930)
r = 20 + -------------------- x 4% = 20.3%
(10.980 – 9.930)
(5.000 – 4.411) x 2%
r = 16% + = 17.4%
(5.234 – 4.411)
8. The present value of Rs.10,000 receivable after 8 years for various discount
rates (r ) are:
r = 10% PV = 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670
10. The present value of an annual pension of Rs.10,000 for 15 years when r = 15%
is:
Obviously, Mr. Jingo will be better off with the annual pension amount of
Rs.10,000.
14. To earn an annual income of Rs.5,000 beginning from the end of 15 years from
now, if the deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000
is required at the end of 14 years. The amount that must be deposited to get this
sum is:
Rs.50,000 / FVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,168
5.019 – 5.00
r = 15% + ---------------- x 3%
5.019 – 4.494
= 15.1%
= Rs.2590.9
Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs.2,825.5
19. A B C
20. Investment required at the end of 8 th year to yield an income of Rs.12,000 per
year from the end of 9th year (beginning of 10th year) for ever:
Rs.12,000 x PVIFA(12%, ∞ )
= Rs.12,000 / 0.12 = Rs.100,000
Rs.100,000 Rs.100,000
= = Rs.40,388
PVIF(12%, 8 years) 2.476
21. The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of
Rs.5,000 now is:
Rs.20,000
FVIF (r,10 years) = = 4.000
Rs.5,000
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should
be
Rs.50,000
A = FVIFA(12%, 10 years) x (1.12)
Rs.50,000
= = Rs.2544
17.549 x 1.12
24. The discounted value of Rs.20,000 receivable at the beginning of each year from
2005 to 2009, evaluated as at the beginning of 2004 (or end of 2003) is:
If A is the amount deposited at the end of each year from 1995 to 2000 then
A x FVIFA (12%, 6 years) = Rs.51,335
A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115 = Rs.6326
25. The discounted value of the annuity of Rs.2000 receivable for 30 years,
evaluated as at the end of 9th year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854
The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)
= Rs.18,854 x 0.424
= Rs.7,994
26. 30 percent of the pension amount is
0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate
of 12% is 1%, the discounted value of an annuity of Rs.180 receivable at the end of
each month for 180 months (15 years) is:
Rs.180 x PVIFA (1%, 180)
(1.01)180 - 1
Rs.180 x ---------------- = Rs.14,998
.01 (1.01)180
If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%
P x (1.01)60 = Rs.14,998
P x 1.817 = Rs.14,998
Rs.14,998
P = ------------ = Rs.8254
1.817
27. Rs.300 x PVIFA(r, 24 months) = Rs.6,000
1 – [1/(1+r)n]
Using the formula PVIFA = ------------------
r
we find that:
PVIFA(1%,24) = 21.244
PVIFA (2%, 24) = 18.914
21.244 – 20.000
r = 1% + ---------------------- x 1%
21.244 – 18 .914
= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)12 – 1 ] x 100 = 20%
29. Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn
annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (10 %, n) = Rs.100,000 / Rs.20,000 = 5.000
From the tables we find that
PVIFA (10%, 7 years) = 4.868
PVIFA (10%, 8 years) = 5.335
Thus n is between 7 and 8. Using a linear interpolation we get
5.000 – 4.868
n=7+ ----------------- x 1 = 7.3 years
5.335 – 4.868
31. Define n as the maturity period of the loan. The value of n can be obtained
from the equation.
200,000 x PVIFA(13%, n) = 1,500,000
PVIFA (13%, n) = 7.500
From the tables or otherwise it can be verified that PVIFA(13%,30) = 7.500
Hence the maturity period of the loan is 30 years.
32. Expected value of iron ore mined during year 1 = Rs.300 million
Expected present value of the iron ore that can be mined over the next 15 years
assuming a price escalation of 6% per annum in the price per tonne of iron
1 – (1 + g)n / (1 + r)n
= Rs.300 million x (1+g) x ------------------------
r-g
MINICASE
2. How much money should Ramesh save each year for the next 15 years to be
able to meet his investment objective?
This means that his savings in the next 15 years must grow to :
3. How much money would Ramesh need when he reaches the age of 60 to meet
his donation objective?
15
1.12
1–
1.08
= 400,000
0.08 – 0.12
= Rs.7,254,962
Chapter 8
INVESTMENT CRITERIA
= - 44837
= - 1,000,000
100,000
+
(1.12)
200,000
+
(1.12) (1.13)
300,000
+
(1.12) (1.13) (1.14)
600,000
+
(1.12) (1.13) (1.14) (1.15)
300,000
+
(1.12) (1.13) (1.14)(1.15)(1.16)
2. Investment A
r = 15 + 1 x (0.019 / 0.136)
= 15.14%
Investment B
d) BCR = PVB / I
= 194,661 / 300,000 = 0.65
Investment C
a) Payback period lies between the 2nd and 3rd years as the cumulative
cash flow at the end of the second year is - 70,000 and at the end of the third
year is 10,000. Linear interpolation in this range provides an approximate
payback period = 2 + 70,000/ ( 70,000+10,000) = 2.88 years.
Trying r = 28 %, LHS =
80,000 x 0.781 + 60,000 x 0.610 + 80,000 x 0.477
+ 60,000 x 0.373 + 80,000 x 0.291 + 60,000 x 0.227
+ 40000 x 2.241 x 0.227
= 62,480 + 36,600+38,160+22,380+23,280+13,620+20,348= 216,868
Trying r = 32 %, LHS =
80,000 x 0.758 + 60,000 x 0.574+ 80,000 x 0.435
+ 60,000 x 0.329 + 80,000 x 0.250 + 60,000 x 0.189
+ 40000 x 2.096 x 0.189
= 60,640 + 34,440 + 34,800 + 19,740 + 20,000 + 11,340 + 15,846
= 196,806
By linear interpolation in the range , we get
. r = 28 + [4 x ( 216,868-210,000) / ( 216,868 –196,806)] = 29.36 %
Payback period lies between the 8th and 9th years as the cumulative cash flow
at the end of the eighth year is - 100,000 and at the end of the ninth year is
100,000. So ,by linear interpolation , it becomes nil half way through, i.e. in 8.5
years, which is the payback period
Investment A B C D
a) Payback period
(in years) 5 9 2.88 8.5
3. IRR (r) can be calculated by solving the following equations for the value of r.
60000 x PVIFA (r,7) = 300,000
i.e., PVIFA (r,7) = 5.000
Trying r= 9%, LHS = 60,000 x 5.033 = 301,980
Trying r=10%, LHS = 60,000 x 4.868 = 292,080
(301,980 – 300,000)
By linear interpolation , r = 9 + 1 x ------------------------- = 9.20%
(301,980 – 292,080)
4. The IRR (r) for the given cashflow stream can be obtained by solving the
following equation for the value of r.
-3000 + 9000 / (1+r) – 3000 / (1+r)2 = 0
Simplifying the above equation we get
r = 1.61, -0.61; (or) 161%, (-)61%
Note : Given two changes in the signs of cashflow, we get two values for the
IRR of the cashflow stream. In such cases, the IRR rule breaks down.
5. Define NCF as the minimum constant annual net cashflow that justifies the
purchase of the given equipment. The value of NCF can be obtained from the
equation
NCF x PVIFA (10%,8) = 500000
NCF = 500000 / 5.335
= 93271
6. Define I as the initial investment that is justified in relation to a net annual cash
inflow of 25000 for 10 years at a discount rate of 12% per annum. The value
of I can be obtained from the following equation
25000 x PVIFA (12%,10) = I
i.e., I = 141250
Project
P Q R
Discount rate
0% 400 500 600
5% 223 251 312
10% 69 40 70
15% - 66 - 142 - 135
25% - 291 - 435 - 461
30% - 386 - 555 - 591
9.
(a) NPV profiles for Projects P and Q for selected discount rates are as follows:
Project
P Q
Discount rate (%)
0 2950 500
5 1876 208
10 1075 - 28
15 471 - 222
20 11 - 382
-1000 -1200 x PVIF (r,1) – 600 x PVIF (r,2) – 250 x PVIF (r,3)
+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5) = 0
Trying r=20%,
LHS= -1000 -(1200 x 0.833) – (600 x 0.694) – (250 x 0.579)
+( 2000 x 0.482) +( 4000 x 0.402)
= -1000-999.6-416.4-144.75+964 +1608 = 11.25
Trying r=24%,
LHS = -1000 -(1200 x 0.806) –( 600 x 0.0.650) –( 250 x 0.524)
+( 2000 x0.423) +( 4000 x 0.341)
= -1000-967.2- 390 – 131 +846 + 1364 = - 278.2
By linear interpolation, we get
11.25
. r = 20 + 4 x ----------------------- = 20 + 0.16 = 20.16%
( 11.25 + 278.2)
(ii) The IRR (r') of project Q can be obtained by solving the following
equation for r'
-1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5) = 0
d) Project P
PV of investment-related costs
= 1000 x PVIF (12%,0)
+ 1200 x PVIF (12%,1) + 600 x PVIF (12%,2)
+ 250 x PVIF (12%,3)
= 1000 + (1200x 0.893) + (600x0.797) +(250x0.712)
= 1000+ 1071.6+478.2+178 = 2728
TV of cash inflows = 2000 x (1.12) + 4000 = 6240
The MIRR of the project P is given by the equation:
6240
------------ = 2728
(1 + MIRR)5
(1 + MIRR)5 = 2.2874 . MIRR = 18%
Project Q
10.
(a) Project A
NPV at a cost of capital of 12%
= - 100 + 25 x PVIFA (12%,6)
= Rs.2.78 million
Project B
NPV at a cost of capital of 12%
= - 50 + 13 x PVIFA (12%,6)
= Rs.3.45 million
IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6) = 50 i.e. PVIFA (r'', 6) = 4.167
By trial and error we can find the value of r’’ as follows.
Trying r’’ = 11% we get LHS = 4.231
. Trying r’’ = 12% we get LHS = 4.111 . By linear interpolation we get
( 4.231– 4.167)
’’
r = 11 + 1 x --------------------- = 11 + 0.53 =11.53 %
( 4.231- 4.111)
11.
(a) Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period
20
= 2 + 1 x ----- = 2.63 years
3
Project N
The pay back period lies between 1 and 2 years. Interpolating in this range we
get an approximate pay back period
12
= 1 + 1 x -------- = 1.55 years
22
(c) Project M
( Rs. in millions)
-------------------------------------------------------------------------------------------------
Year Cash Flow Discounting Present Value Cumulative Net Cash
Factor @12% Flow after Discounting
-------------------------------------------------------------------------------------------------
0 - 50 1.000 - 50 - 50
1 11 0.893 9.823 - 40.177
2 19 0.797 15.143 - 25.034
3 32 0.712 22.784 - 2.250
4 37 0.636 23.532 21.282
Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in
2.250
this range we get an approximate DPB = 3 + 1 x ------------------- = 3.1 years
( 2.250 + 21.282)
Project N
( Rs. in millions)
-------------------------------------------------------------------------------------------------
Year Cash Flow Discounting Present Value Cumulative Net Cash
Factor @12% Flow after Discounting
-------------------------------------------------------------------------------------------------
0 - 50 1.000 - 50 - 50
1 38 0.893 33.934 - 16.066
2 22 0.797 17.534 1.468
Discounted pay back period (DPB) lies between 1 and 2 years. Interpolating in
16.066
this range we get an approximate DPB = 1 + 1 x ------------------- = 1.92 years
( 16.066 + 1.468 )
.
(c) Project M
Cost of capital = 12% per annum
NPV = - 50 + 11 x PVIFA (12%,1)+ 19 x PVIF (12%,2)
+ 32 x PVIF (12%,3)+ 37 x PVIF (12%,4)
= -50 + (11 x0.893)+ (19 x 0.797)+ ( 32 x 0.712)+( 37 x0.636)
= - 50 + 9.823 + 15.143 + 22.784 + 23.532 = Rs.21.282 million
Project N
Cost of capital = 12% per annum
NPV = - 50 + 38 x PVIFA (12%,1)+ 22 x PVIF (12%,2)
+ 18 x PVIF (12%,3)+ 10 x PVIF (12%,4)
= - 50 + (38 x0.893)+ (22 x 0.797)+ ( 18 x 0.712)+( 10 x0.636)
= - 50 + 33.934 + 17.534 + 12.816+ 6.360 = Rs.20.644 million
Since the two projects are independent and the NPV of each project is (+) ve,
both the projects can be accepted. This assumes that there is no capital
constraint.
(d) Project M
Cost of capital = 10% per annum
Project N
Cost of capital = 10% per annum
NPV = - 50 + 38 x PVIFA (10%,1)+ 22 x PVIF (10%,2)
+ 18 x PVIF (10%,3)+ 10 x PVIF (10%,4)
= -50 + (38 x0.909)+ (22 x 0.826)+ ( 18 x 0.751)+( 10 x0.683)
= - 50 + 34.542 + 18.172 + 13.518+ 6.830 = Rs.23.062 million
Since the two projects are mutually exclusive, we need to choose the project
with the higher NPV i.e., choose project M.
Note : The MIRR can also be used as a criterion of merit for choosing between
the two projects because their initial outlays are equal.
(e) Project M
Cost of capital = 15% per annum
NPV = - 50 + 11 x PVIFA (15%,1)+ 19 x PVIF (15%,2)
+ 32 x PVIF (15%,3)+ 37 x PVIF (15%,4)
= -50 + (11 x0.870)+ (19 x 0.756)+ ( 32 x 0.658)+( 37 x0.572)
= - 50 + 9.570 + 14.364+ 21.056 + 21.164 = Rs.16.154 million
Project N
Cost of capital: 15% per annum
(f) Project M
Terminal value of the cash inflows:
= 11x(1.14)3 + 19 x (1.14)2 + 32x(1.14) + 37 = 16.297 + 24.692 + 36.48 +37
= 114.469
MIRR of the project is given by the equation
50 (1 + MIRR)4 = 114.469 i.e. (1 + MIRR)4 = 2.289
i.e., MIRR = 23.00 %
Project N
Terminal value of the cash inflows:
= 38 x(1.14)3 + 22 x (1.14)2 + 18x(1.14) +10 = 56.299+ 28.591+20.52 +10
= 115.41
MIRR of the project is given by the equation
50 (1 + MIRR)4 = 115.41 i.e. (1 + MIRR)4 = 2.308
i.e., MIRR = 23.26%
MINICASE
The theory part of the solution may be obtained from the relevant part of the
text. The solution for the calculation part is as under.
a) Project A.
Year Cash flow Unrecovered investment balance By linear interpolation
----- ---------- -------------------------------- the payback period
0 ( 5000) ( 5000) 1500
1 3500 ( 1500) = 1 + -- --------- = 1.6 years
2 2500 1000 1500 + 1000
Project B
Year Cash flow Unrecovered investment
balance
----- ---------- ----------------------------- By linear interpolation the payback
0 ( 5000) ( 5000) 1000
1 1000 ( 4000) period= 2 + ------------- = 2.25years
2 3000 (1000) 1000 + 3000
3 4000 3000
Calculation of discounted payback period
--------------------------------------------
Year Cash flow Discounting factor Present Cumulative net cash
at 12 percent Value flow after discounting
------ ----------- ------------------- ------- ---------------------
0 ( 5000) 1.000 ( 5000) ( 5000)
1 1000 0.893 893 ( 4107)
2 3000 0.797 2391 1716
3 4000 0.712 2848 1132
1716
By linear interpolation, the discounted payback period is = 2 + ----------- = 2.60 years
1716 + 1132
b)
NPV of project A = -5000 + 3500 PVIF( 12%, 1yr) + 2500 PVIF (12%, 2yrs) +
1500 PVIF( 12%, 3yrs)
= -5000+ 3500 x 0.893 + 2500 x 0. 797 + 1500 x 0.712
= - 5000 + 3126 + 1992 + 1068 = 1186
NPV of project B = -5000 + 1000 PVIF( 12%, 1yr) + 3000 PVIF( 12%, 2yrs) +
4000 PVIF( 12%, 3yrs)
= -5000 + 1000x 0. 893 + 3000 x 0. 797 + 4000 x 0.712
= -5000 + 893 + 2391 + 2848 = 1132
NPV of project C = -5000 + 15000 PVIF( 12%, 1yr) - 10000 PVIF( 12%, 2yrs)
= -5000 + 15000x 0. 893 - 10000 x 0. 797
= -5000 + 13395 - 7970 = 425
c)
Project A
Project B
Let the IRR be r . We then have
1000 PVIF( r, 1yr) + 3000 PVIF ( r, 2yrs) + 4000 PVIF ( r, 3yrs) = 5000
Trying r=20 %, LHS = 1000 x 0. 833 + 3000 x 0.694 + 4000 x 0.579
= 833 + 2082 + 2316 = 5231
As the RHS is slightly higher than 5000, we try a higher value for r
Trying r=24 %, LHS = 1000 x 0. 806+ 3000 x 0.650 + 4000 x 0.524
= 806 + 1950 + 2096 = 4852
5231 - 5000
By linear interpolation in the range of 20% and 24%, r = 20 + ( 24-20)x --------------
5231 – 4852
= = 20 + 2.44 = 22.44%
Project C
d)
Project A
Project B
Project C
Chapter 9
Year 0 1 2 3 4 5 6 7
6. Profit before tax 112.5 121.87 128.91 134.18 138.13 141.1 143.33
14. NCF (200) 116.25 113.44 111.33 109.75 108.56 107.67 205
(d) IRR (r) of the project can be obtained by solving the following equation for r
Year 0 1 2 3 4 5 6 7
21. Net cash flow (140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00
(17+18-19+20)
(b) NPV of the net cash flow stream @ 15% per discount rate
3. Note: In the problem where it is stated that the ‘working capital associated with
ths machine is Rs.500,000’ the same should be read as ‘ incremental working capital
associated with the new machine is Rs. 500,000’. Also in the sentence ‘ The net
working capital required for the new machine is expected to bring a saving of
Rs.650,000 annually in manufacturing costs…..’ delete the words ‘ The net working
capital required for’.
(a) A. Initial outlay (Time 0)
Year 1 2 3 4 5
i. Post-tax savings in
manufacturing costs 455,000 455,000 455,000 455,000 455,000
ii. Incremental
depreciation 550,000 412,500 309,375 232,031 174,023
D. Net cash flows associated with the replacement project (in Rs)
Year 0 1 2 3 4 5
i. Depreciation
of old machine 18000 14400 11520 9216 7373
ii. Depreciation
of new machine 100000 75000 56250 42188 31641
Year 0 1 2 3 4 5
MINICASE
Cash Flows from the Point of all Investors
Item 0 1 2 3 4 5 6
9. Recovery of net
working capital 100
13. Net cash flow (200) (300) 187.5 180 174.4 170.2 367
17. Net cash flow (200) - 159.5 103.2 102.5 103.2 204.9
Item 0 1 2 3 4 5 6
1. Plant and equipment (200) (200)
6. Interest on working
capital 12 12 12 12 12
15. Net cash flow (200) (300) 199.5 191.5 183.9 177.5 192.2
(11 + 12 + 13)
Chapter 10
THE COST OF CAPITAL
1(a) Define rD as the pre-tax cost of debt. Using the approximate yield formula, rD
can be calculated as follows:
14 + (100 – 108)/10
rD = ------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108
2. Define rp as the cost of preference capital. Using the approximate yield formula
rp can be calculated as follows:
9 + (100 – 92)/6
rp = --------------------
0.4 x100 + 0.6x92
5. Given
0.5 x 14% x (1 – 0.35) + 0.5 x rE = 12%
(b) The cost of equity has been taken as D1/P0 ( = 6/100) whereas the cost of equity
is (D1/P0) + g where g represents the expected constant growth rate in dividend
per share.
7. The book value and market values of the different sources of finance are
provided in the following table. The book value weights and the market value
weights are provided within parenthesis in the table.
(Rs. in million)
Source Book value Market value
Equity 800 (0.54) 2400 (0.78)
Debentures – first series 300 (0.20) 270 (0.09)
Debentures – second series 200 (0.13) 204 (0.06)
Bank loan 200 (0.13) 200 (0.07)
Total 1500 (1.00) 3074 (1.00)
8.
(a) Given
rD x (1 – 0.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pre-tax cost of debt.
(b) Given
13% x (1 – 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.
The average cost of capital using book value proportions is calculated below :
The average cost of capital using market value proportions is calculated below :
Equity capital
and retained earnings 14.5% 200 0.62 8.99
Preference capital 15.9% 7.5 0.02 0.32
Debentures 9.6% 40 0.12 1.15
Term loans 6.0% 80 0.24 1.44
(b)
The Rs.100 million to be raised will consist of the following:
Retained earnings Rs.15 million
Additional equity Rs. 35 million
Debt Rs. 50 million
The first batch will consist of Rs. 15 million each of retained earnings
and debt costing 14.5 percent and 14(1-0.5)= 7 percent respectively. The
second batch will consist of Rs. 10 million each of additional equity and
debt at 14.5 percent and 7percent respectively. The third chunk will
consist of Rs.25 million each of additional equity and debt costing 14.5
percent and 15(1-0.5) = 7.5 percent respectively.
The marginal cost of capital in the chunks will be as under
First batch: (0.5x14.5 ) + (0.5 x 7) = 10.75 %
Second batch: (0.5x14.5 ) + (0.5 x 7) = 10.75 %
Third batch : (0.5x14.5 ) + (0.5 x 7.5) = 11 %
The marginal cost of capital schedule for the firm will be as under.
0 - 50 10.75
50-100 11.00
11.
(a) WACC = 1/3 x 13% x (1 – 0.3)
+ 2/3 x 20%
= 16.37%
(b) Weighted average floatation cost
= 1/3 x 3% + 2/3 x 12%
= 9%
(c) NPV of the proposal after taking into account the floatation costs
= 130 x PVIFA (16.37%, 8) – 500 / (1 - 0.09)
= [1- 1/(1.1637)8]
130 x --------------------- - 549.45
0.1637
= 130 x 4.292 – 549.45 = 8.51 million
MINICASE
rd (1 – 0.3) = 5.55
2.80 (1.10)
+ 0.10 = 0.385 + 0.10
80
= 0.1385 = 13.85%
f. WACC
0.50 x 14.70 + 0.10 x 7.53 + 0.40 x 5.55
= 7.35 + 0.75 + 2.22
= 10.32%
Chapter 11
Assumptions: (1) The useful life is assumed to be 10 years under all three
scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.
(3) The tax rate has been calculated from the given table i.e.
10 / 35 x 100 = 28.57%.
2.
(a) Sensitivity of NPV with respect to quantity manufactured and sold:
(in Rs)
Pessimistic Expected Optimistic
(c) Sensitivity of NPV with respect to variations in unit variable cost. [ Please note
that the variable cost per unit under the pessimistic and optimistic scenarios are
Rs.40 and Rs.15 respectively( In the problem these figures have inadvertantly
been interchanged)]
4 Expected NPV
4 At
= - 25,000
t
t=1 (1.08)
0 – 3044
= Prob Z<
1296
The required probability is given by the shaded area in the following normal
curve.
6 Given values of variables other than Q, P and V, the net present value model of
Bidhan Corporation can be expressed as:
5
[Q(P – V) – 3,000 – 2,000] (0.5)+ 2,000 0
t=1
NPV = ---------------------------------------------------------- + ------- - 30,000
(1.1)t (1.1)5
5
0.5 Q (P – V) – 500
t=1
= ------------------------------------ - 30,000
(1.1)t
Exhibit 1
Correspondence between values of exogenous variables and
two digit random numbers
Exhibit 2
Simulation Results
50
Variance of NPV = 1/50 NPVi – NPV)2
i=1
7 To carry out a sensitivity analysis, we have to define the range and the most
likely values of the variables in the NPV Model. These values are defined
below
The relationship between Q and NPV given the most likely values of other
variables is given by
5 5Q - 500
= - 30,000 = (5Q-500)PVIFA(10%,5yrs)-30,000
t
t=1 (1.1)
= (5Q-500) x 3.791 - 30,000
The net present values for various values of Q are given in the following table:
The relationship between P and NPV, given the most likely values of other
variables is defined as follows:
5 700 P – 14,500
= - 30,000 = (700P – 14,500)PVIFA(10%,5yrs)-30,000
t
t=1 (1.1)
= (700P – 14,500) x 3.791-30,000
The net present values for various values of P are given below :
P (Rs) 20 30 40 50
NPV(Rs) -31,896 -5,359 21,179 47,716
8. NPV -5 0 5 10 15 20
(Rs.in lakhs)
PI 0.9 1.00 1.10 1.20 1.30 1.40
6
Expected PI = PI = (PI)j P j
j=1
= 1.24
6
Standard deviation = (PIj - PI) 2 P j
o f P1 j=1
Since the risk associated with the investment is much less than the maximum
risk acceptable to the company for the given level of expected PI, the company
should accept the investment.
9. Investment A
Outlay : Rs.10,000
Net cash flow : Rs.3,000 for 6 years
Required rate of return : 12%
Investment B
Outlay : Rs.30,000
Net cash flow : Rs.11,000 for 5 years
Required rate of return : 14%
NPV(B) = 11,000 x PVIFA (14%, 5 years) – 30,000
= 11,000 x 3.433 – 30,000 = Rs.7763
(30195 – 30000)
By linear interpolation, r’= 24 + ------------------- = 24.08 %
(30195 – 27852)
Project A B
PI 1.23 1.26
IRR 19.91% 24.08 %
B is superior to A in terms of NPV, PI, and IRR. Hence the company must
choose B.
10 The certainty equivalent for the various years using the given formula is as
follows
----------------------------------------------------------------------------------------------
Year(t) 1 2 3 4 5
---------------------------------------------------------------------------------------------
Certainty equivalent
t = 1 – 0.06t 0.94 0.88 0.82 0.76 0.70
-------------------------------------------------------------------------------------------------
NPV of the project
0.94 x 7000 0.88 x 8000 0.82 x 9000 0.76 x 10000 0.70x 8000
= ------------- + -------------- + --------------- + ---------------- + -------------
( 1.08) ( 1.08)2 ( 1.08)3 ( 1.08)4 ( 1.08)5
- 30,000
= 6,092 .59+ 6,035.67+ 5,858.48+ 5,586.23 + 3,811.27 – 30,000
= - Rs. 2615.76
MINICASE
0.65 [0.8 (17500) + 0.2 (3000)] + 0.35 [0.4 (17500) + 0.6 (3000)]
+
(1.12)2
= 2369
2. If Southern Airways buys the piston engine aircraft and the demand in year 1
turns out to be high, a further decision has to be made with respect to capacity
expansion. To evaluate the piston engine aircraft, proceed as follows:
First, calculate the NPV of the two options viz., ‘expand’ and ‘do not expand’ at
decision point D2:
= 6600
Second, truncate the ‘do not expand’ option as it is inferior to the ‘expand’
option. This means that the NPV at decision point D2 will be 6600
Third, calculate the NPV of the piston engine aircraft option.
3. The value of the option to expand in the case of piston engine aircraft
If Southern Airways does not have the option of expanding capacity at the end of
year 1, the NPV of the piston engine aircraft would be:
4. Value of the option to abandon if the turboprop aircraft can be sold for 8000 at the
end of year 1
If the demand in year 1 turns out to be low, the payoffs for the ‘continuation’ and
‘abandonment’ options as of year 1 are as follows.
Abandonment : 8000
Thus it makes sense to sell off the aircraft after year 1, if the demand in year 1
turns out to be low.
0.65 [5500 +{0.8 (17500) + 0.2 (3000)}/ (1.12)] + 0.35 (500 +8000)
NPV = - 11,000 +
(1.12)
12048 + 2975
= - 11,000 + = 2413
1.12
Since the turboprop aircraft without the abandonment option has a value
of 2369, the value of the abandonment option is : 2413 – 2369 = 44
5. The value of the option to abandon if the piston engine aircraft can be sold for
4400 at the end of year 1:
If the demand in year 1 turns out to be low, the payoffs for the ‘continuation’
and ‘abandonment’ options as of year 1 are as follows:
Abandonment : 4400
Thus, it makes sense to sell off the aircraft after year 1, if the demand in year 1
turns out to be low.
The NPV of the piston engine aircraft with abandonment possibility is:
5915 + 1820
= - 5500 + = 1406
1.12
For the piston engine aircraft the possibility of abandonment increases the NPV
from 929 to 1406. Hence the value of the abandonment option is 477.
Chapter 12
2. (i) Since there are 3 securities, there are 3 variance terms and 3 covariance
terms. Note that if there are n securities the number of covariance terms are: 1 +
2 +…+ (n + 1) = n (n –1)/2. In this problem all the variance terms are the same
(2A) all the covariance terms are the same (AB) and all the securities are equally
weighted (wA)
So,
2p = [3 w2A 2A + 2 x 3 AB]
2p = [3 w2A 2A + 6 wA wBAB]
1 2 1 1
=3x x 2A + 6 x x x AB
3 3 3
1 2
= 2A + AB
3 3
(ii) Since there are 9 securities, there are 9 variance terms and 36 covariance
terms. Note that if the number of securities is n, the number of covariance
terms is n(n – 1)/2.
In this case all the variance terms are the same (2A), all the covariance terms are
1
the same (AB) and all the securities are equally weighted wA
9
So,
n(n-1)
p= 9 w A A + 2 x
2 2 2
wA wBAB
2
2
1 1 1
= 9 x x 2A + 9(8) x x AB
9 9 9
1 8
= 2A + AB
9 9
3. (Note: In the given problem the returns on the stock and the market portfolio for
the 19th period were intended to be 22 and 37 and not 6 and 12 as printed in the
problem.)
The beta for stock B is calculated below:
Period Return of Return on Deviation of Deviation Product of Square of
stock B, market return on of return the the
RB (%) portfolio, stock B on market deviations deviation
RM (%) from its portfolio (RB – RB) of return
mean from its (RM – RM) on market
(RB - RB) mean portfolio,
(RM – RM) from its
mean
(RM – RM)2
1 15 9 6 -1 -6 1
2 16 12 7 2 14 4
3 10 6 1 -4 -4 16
4 -15 4 -24 -6 144 36
5 -5 16 -14 6 -84 36
6 14 11 5 1 5 1
7 10 10 1 0 0 0
8 15 12 6 2 12 4
9 12 9 3 -1 -3 1
10 -4 8 -13 -2 26 4
11 -2 12 -11 2 -22 4
12 12 14 3 4 12 16
13 15 -6 6 -16 -96 256
14 12 2 3 -8 -24 64
15 10 8 1 -2 -2 4
16 9 7 0 -3 0 9
17 12 9 3 -1 -3 1
18 9 10 0 0 0 0
19 22 37 13 27 351 729
20 13 10 4 0 0 0
180 200 Σ(RB – RB) Σ(RB – RB)2
Σ RB = 180 ΣRM = 200 (RM – RM) = 1186
RB = 9% RM = 10% = 320
2M
Σ (RB - RB) (RM – RM) 320
Cov (RB, RM) = = = 16.84
n –1 19
Given a risk-free rate (Rf ) of 11 percent and the expected market risk premium
{E(RM – Rf )} of 6 percent we get the following:
Project Beta Required rate(%) Expected rate (%)
A 0.5 11 + 0.5 x 6 = 14 15
B 0.8 11 + 0.8 x 6 = 15.8 16
C 1.2 11 + 1.2 x 6 = 18.2 21
D 1.6 11 + 1.6 x 6 = 20.6 22
E 1.7 11 + 1.7 x 6 = 21.2 23
a. The expected return of all the 5 projects exceeds the required rate as per the CAPM.
So all of them should be accepted.
b. If the cost of capital of firm which is 16 percent is used as the hurdle rate, project A
will be rejected incorrectly.
5. The asset beta is linked to equity beta, debt-equity ratio, and tax rate as follows:
E
A =
[1 + D/E (1 –T)]
1.15
B = 0.48
[1 + (2.00) x 0.7]
1.10
C = 0.45
[1 + (2.1) x 0.7]
0.49 + 0.48 + 0.45
Average of the asset betas of sample firms = = 0.47
3
The equity beta of the cement project is
E = A [ 1 + D/E (1 – T)]
= 0.47 [1 + 2 (1-0.3)] = 1.128
As per the CAPM model, the cost of equity of the proposed project is:
12% + (17% - 12%) x 1.128 = 17.64%
The required rate of return for the project given a debt-equity ratio of 2:1 is:
1/3 x 17.64% + 2/3 x 11.2% = 13.35%
6. E
A =
[1 + D/E (1 –T)]
E = 1.25 D/E = 1.6 T = 0.3
E 1.30
A = =
[1 + D/E ( 1 –T)] [1 + 1.5 (1 –0.4)]
= 0.68
The equity beta (systematic risk) for the petrochemicals project of Growmore,
when D/E = 1.25 and T = 0.4, is
0.68 [1 + 1.25 (1 – .4)] = 1.19
MINICASE
a) Metals division
--------------- E 1.1
Asset beta of Amtex Metals : A = --------------- = ---------------------- = 0.95
D 300
1 + --- ( 1-T) 1 + ------ ( 1-0.3)
E 1300
By proxy this is the asset beta of the metals division also.
D
Equity beta of the metals division : E = A[ 1 + ---- ( 1-T) ]
E
The total asset value of the metals division is 1150 out of which the debt component
is 400. So the equity component is 1150 –400 = 750
400
Therefore E = 0.95 [ 1 + ----- ( 1- 0.3) ] =1.30
750
Cost of equity = Rf + E x Risk premium =7 + 1.30 x 7 = 16.10 %
b)
Metals division
---------------
200 200
Post-tax weighted average cost of debt = [ ------ x 8 + ------x 10 ] ( 1-0.3) =6.3%
400 400
750 400
Weighted average cost of capital = ----- x 16.10 + ------ x 6.3 = 12.69 %
1150 1150
Real Estate division
------------------
500 100
Post-tax weighted average cost of debt = [----- x 8 + ----x 10 ] ( 1-0.3) = 5.84 %
600 600
450 600
Weighted average cost of capital = ----- x 15.89 + ------ x 5.84 = 10.15 %
1050 1050
Finance division
---------------
300 200
Post-tax weighted average cost of debt = [ ------ x 8 + ---- x 10 ] ( 1-0.3) = 6.16 %
500 500
300 500
Weighted average cost of capital = ----- x 17.01 + ------ x 6.16 = 10.23 %
800 800
Chapter 13
1. PV Cost
UAE =
PVIFAr,n
Cost of plastic emulsion painting = Rs.3,00,000 Life = 7 years
Cost of distemper painting = Rs. 1,80,000 Life = 3 years
Discount rate = 10%
UAE of plastic emulsion painting = Rs.3,00,000 / 4.868 = Rs.61,627
UAE of distemper painting = Rs.1,80,000 / 2.487 = Rs.72,376
Since the less costly overhaul has a lower UAE, it is the preferred alternative
9.
a. Base case NPV = -12,000,000 + 3,000,000 x PVIFA (20%, b)
= -12,000,000 + 3,000,000 x 3,326
= - Rs.2,022,000
b. Adjusted NPV if the adjustment is made only for the issue cost of external equity
= Base case NPV – Issue cost
Term loan = Rs.8 million Equity finance = Rs.4 million
Issue cost of equity = 12%
Rs.4,000,000
Equity to be issued = = Rs.4,545,455
0.88
Cost of equity issue = Rs.545,455
(c)
Computation of Tax Shield Associated with Debt Finance
Year (t) Debt outstanding Interest Tax shield Present value of
at the beginning tax shield
Rs. Rs. Rs. Rs.
1 8,000,000 1,440,000 432,000 366,102
2 8,000,000 1,440,000 432,000 310,256
3 7,000,000 1,260,000 378,000 230,062
4 6,000,000 1,080,000 324,000 167,116
5 5,000,000 900,000 270,000 118,019
6 4,000,000 720,000 216,000 80,013
1,271,568
Present Value of tax shield on debt finance = Rs.1,271,568
10.
a. Base Case NPV = - 8,000,000 + 2,000,000 x PVIFA (18%, 6)
= - 8,000,000 + 2,000,000 x 3.498
= - Rs.1,004,000
b. . Adjusted NPV if the adjustment is made only for the issue cost of external
equity = Base case NPV – Issue cost
Term loan = Rs.5 million
Equity finance = Rs.3 million
Issue cost of equity = 10%
Rs.3,000,000
Hence, Equity to be issued = = Rs.3,333,333
0.90
Cost of equity issue = Rs.333,333
Adjusted NPV if the adjustment is made only for the issue cost of external
equity = - 1,004,000 – 333,333 = - 1,337,333
c.
Computation of Tax Shield Associated with Debt Finance
Year Debt outstanding at the Interest Tax shield Present value of tax
beginning shield
5807.6 4633.6
+ +
(1.18)4 (1.18)5
= -9200 + 2041.10 + 2535.77 + 2893.31 + 2995.5 + 2025.39
= Rs. 3291.07 million
Chapter 14
The IRR of the stream of social costs and benefits is the value of r in the
equation
Benefits
1. Resale value of the diesel train (one time) Rs.240,000
2. Avoidance of annual cash loss Rs.400,000
Fare collection = 1000 x 250 x Rs.4
= Rs.1,000,000
Cash operating expenses = Rs.1,420,000
3. The social costs and benefits of the project are estimated below :
Rs. in
million
Nature Economic Explanation
value
Costs
1. Construction cost One-shot 24
2. Land development cost One-shot 150
3. Maintenance cost Annual 1
4. Labour cost One-shot 40 This includes the cost of
transport and rehabilitation
5. Labour cost Annual 12 The shadow price of
labour equals what others
are willing to pay.
6. Decrease in the value of the Annual from 4
timber output year 2
Benefits
7. Savings in the cost of shipping Annual 0.5
the agriculture produce
8. Income from cash crops Annual for the 10
first 5 years
9. Income from the main crop Annual from 50
year 6
10. Increase in the value of timber One-shot (at 20
output the end of
year 1)
Assuming that the life of the road is 40 years, the NPV of the stream of
social costs and benefits at a discount rate of 10 percent is :
40 1 + 12 40 4
NPV = - 24 - 150 - 40 - -
t=1 (1.1)t t=2 (1.1)t
40 0.5 5 10 40 50 20
+
t=1 (1.1)t t=1 (1.1)t t=6 (1.1)t (1.1)1
= - Rs.9.93 million
4.
Table 1
Social Costs Associated with the Initial Outlay
Rs. in
million
Item Financia Basis of Tradeable value T L R
l cost conversion ab initio
Land 0.30 SCF = 1/1.5 0.20
Buildings 12.0 T=0.50, L=0.25 6.0 3.0 3.0
R=0.25
Imported equipment 15.0 CIF value 9.0
Indigeneous equipment 80.0 CIF value 60.0
Transport 2.0 T=0.65, L=0.25 1.3 0.5 0.2
R=0.10
Engineering and know-how 6.0 SCF=1.5 9.0
fees
Pre-operative expenses 6.0 SCF=1.0 6.0
Bank charges 3.7 SCF=0.02 0.074
Working capital 25.0 SCF=0.8 20.0
requirement
150.0 104.274 7.3 3.5 3.2
Table 2
Conversion of Financial Costs into Social Costs
Rs. in
million
Item Financia Basis of Tradeable value T L R
l cost conversion ab initio
Indigeneous raw material 85 SCF=0.8 68
and stores
Labour 7 SCF=0.5 3.5
Salaries 5 SCF=0.8 4.0
Repairs and maintenance 1.2 SCF=1/1.5 0.8
Water, fuel, etc 6 T=0.5, L=0.25 3 1.5 1.5
R=0.25
Electricity (Rate portion) 5 T=0.71, L=0.13 3.55 0.65 0.8
R=0.16
Other overheads 10 SCF=1/1.5 6.667
119.2 82.967 6.55 2.15 2.3
As per table 1, the social cost of initial outlay is worked out as follows :
Rs. in million
Tradeable value ab initio 104.274
Social cost of the tradeable component 4.867
(7.3 / 1.5)
Social cost of labour component 1.75
(3.5 x 0.5)
Social cost of residual component 1.60
(3.2 x 0.5)
Total 112.491
As per Table 2, the annual social cost of operation is worked out as follows :
The annual CIF value of the output is Rs.110 million. Hence the annual social
net benefit will be : 110 – 89.559 = Rs.20.441 million
Working capital recovery will be Rs.20 million at the end of the 20th year.
Putting the above figures together the social flows associated with the project
would be as follows :
Chapter 15
MULTIPLE PROJECTS AND CONSTRAINTS
1. The ranking of the projects on the dimensions of NPV, IRR, and BCR is given below
Project NPV (Rs.) Rank IRR (%) Rank BCR Rank
M 60,610 3 34.1 2 2.21 1
N 58,500 4 34.9 1 1.59 3
O 40,050 5 18.6 4 1.33 5
P 162,960 1 26.2 3 2.09 2
Q 72,310 2 14.5 5 1.36 4
A B
Initial outlay 10000 1000
Cash inflows
Year 1 5000 600
Year 2 5000 600
Year 3 5000 600
3. The two hypothetical 4-year projects for which BCR and IRR criteria give different
rankings are given below
Project A B
Investment outlay 20000 20000
Cash inflow
Year 1 2000 8000
Year 2 2000 8000
Year 3 2000 8000
Year 4 31500 8000
Project BCR Rank IRR Rank
A 1.24 1 19% 2
B 1.21 2 about 22% 1
Since B and E have negative NPV, they are rejected. So we consider only A, C,
and D. Further C and D are mutually exclusive. The feasible combinations, their
outlays, and their NPVs are given below.
5 The linear programming formulation of the capital budgeting problem under various
constraints is as follows:
Maximise 10 X1 + 15 X2 + 25 X3 + 40 X4 + 60 X5 + 100 X6
Subject to
15 X1 + 12 X2 + 8 X3 + 35 X4 + 100 X5
+ 50 X6 + SF1 = 150 Funds constraint for year 1
5 X1 + 13 X2 + 40 X3 + 25 X4 + 10 X5
+ 110 X6 ≤ 200 + 1.08 SF1 Funds constraint for year 2
5 X1 + 6 X2 + 5 X3 + 10 X4 + 12 X5
+ 40 X6 ≤ 60 Power constraint
15 X1 + 20 X2 + 30 X3 + 35 X4 + 40 X5
+ 60 X6 ≤ 120 Managerial constraint
6 Given the nature of the problem, in addition to the decision variables X1 through X10
for the original 10 projects, two more decision variables are required as follows:
X11 is the decision variable to represent the delay of projects 8 by one year
X12 is the decision variable for the composite project which represents the
combination of projects 4 and 5.
The integer linear programming formulation is as follows:
X3 + X7 ≥1
X5 + X8 + X9 + X10 ≥2
X2 ≤ X6
X8 ≤ X9
X4 + X5 + X12 ≤1
X8 + X11 ≤1
Xj = {0,1} j = 1, 2….12
SFi ≥ 0 i = 1, 2
It has been assumed that surplus funds can be shifted from one period to the next
and they will earn a post-tax return of r percent.
– – – – – – – +
7 Minimise [P1(3d1+ 2 d 2 + d 3) + P 2 (4 d 4 + 2 d 5 + d 6) + P 3 (d 7 – d 7 )]
Subject to:
Economic Constraints
12 X1 + 14 X2 + 15 X3 + 16 X4 + 11 X5 + 23 X6 + 20 X7 ≤ 65
Goal Constraints
4 X1 + 5 X2 + 6 X3 + 8 X4 + 4 X5
– +
+ 9 X6 + 7 X7 + d 7 – d 7 = 50 NPV
– +
Xj 0 d i, d i 0
8. The BCRs of the projects are converted into NPVs as of now as follows
Subject to
800,000 X1 + 200,000 X2 + 400,000 X3 + 300,000 X4 + SF1 = 20,00,000
500,000 X6 + 400,000 X7 + 600,000 X8 + 300,000 X9 ≤ 500,000 + SF1 (1.032)
Xj = {0,1} j = 1, 2, 3, 4, 6, 7, 8, 9
Chapter 16
1. S = 100 , uS = 150, dS = 90
u = 1.5 , d = 0.9, r = 0.15 R = 1.15
E = 100
Cu – Cd 50
= = = 0.833
(u-d)S 0.6 x 100
u Cd – d Cu 0 – 0.9 x 50
B = = = - 65.22
(u-d)R 0.6 x 1.15
2. S = 60 , dS = 45, d = 0.75, C = 5
r = 0.16, R = 1.16, E = 60
Cu – Cd 60u – 60 u–1
= = =
(u-d)S (u – 0.75)60 u – 0.75
C = S+B
(u – 1) 60 45 (1 – u)
5 = +
u – 0.75 1.16 (u – 0.75)
Multiplying both the sides by u – 0.75 we get
45
5(u – 0.75) = (u – 1) 60 + (1 – u)
1.16
3. E
C0 = S0 N(d1) - N (d2)
ert
S0 = 70, E = 72, r = 0.12, 0.3, t = 0.50
S0 1
ln + r+ 2 t
E 2
d1 =
t
70
ln + (0.12 + 0.5 x .09) x 0.50
72
=
0.30 0.50
- 0.0282 + 0.0825
= = 0.2560
0.2121
N (d1) = 0.6010
N (d2) = 0.5175
E 72
= = 67.81
ert e0.12x 0.50
C0 = S0 x 0.6010 – 67.81 x 0.5175
= 70 x 0.6010 – 67.81 x 0.5175 = Rs.6.98
4. E
C0 = S0 N(d1) - N (d2)
ert
E = 50, t = 0.25, S0 = 40, 0.40, r = 0.14
S0 1
ln + r+ 2 t
E 2
d1 =
t
40
ln + (0.14 + 0.5 x 0.40) 0.25
50
d1 =
( 0.40 x 0.25)1/2
- 0.2231 + 0.085
= = - 0.4367
0.3162
N (d1) = 0.3312
N (d2) = 0.2256
E 50
= = 48.28
rt 0.14 x 0.25
e e
C0 = 40 x 0.3312 – 48.28 x 0.2256
= 2.36
5.
a. The NPV of the proposal to make Comp-I is:
20 50 50 20 + 10
-100 + + + +
1.20 (1.20)2 (1.20)3 (1.20)4
Step 4 : Plug the numbers obtained in the previous steps in the Black-Scholes formula:
C0 = 85.17 x 0.3733 – 123.76 x 0.1780
= Rs.9.76
6. Presently a 9 unit building yields a profit of Rs.1.8 million (9 x 1.2 – 9) and a 15 unit
building yields a profit of Rs.1.0 million (15 x 1.2 – 17). Hence a 9 unit building is
the best alternative if the builder has to construct now.
However, if the builder waits for a year, his payoffs will be as follows:
Market Condition
Alternative Buoyant (Apartment price: Sluggish (Apartment price:
Rs.1.5 million) Rs.1.1million)
9 – unit building 1.5 x 9 – 9 = 4.5 1.1 x 9 – 9 = 0.9
15 – unit building 1.5 x 15 – 17 = 5.5 1.1 x 15 – 17 = -0.5
Thus, if the market turns out to be buoyant the best alternative is the 15 – unit
building (payoff: Rs.5.5 million) and if the market turns out to be sluggish the best
alternative is the 9 – unit building (payoff: Rs.0.9 million).
Given the above information, we can apply the binomial method for valuing the
vacant land:
Given a risk free rate of 10 percent, the risk-neutral probabilities must satisfy the
following conditions:
p x 1.6 + (1 – p) x 1.20
1.2 million =
1.10
Solving this we get p = 0.3
Since Rs.2.07 million is greater than Rs.1.80 million, the profit from
constructing a 9 unit building now, it is advisable to keep the vacant land. The value of
the vacant land is Rs.2.07 million.
7.
S0 = current value of the asset = value of the developed reserve discounted for
3 years (the development lag) at the dividend yield of 5% = $22 x 100/
(1.05)3 = $ 1900.4 million.
E = exercise price = development cost = $600 million
= standard deviation of ln (oil price) = 0.25
t = life of the option = 20 years
r = risk-free rate = 8%
y = dividend yield = net production revenue/ value of reserve = 5%
Calculate d1 and d2
S 2
ln + r–y+ t
E 2
d1 =
t
ln (1900.4/ 600) + [.08 - .05 + (.0625/ 2)] 20
= =
0.25 20
1.1529 + 1.225
= ------------------------- = 2.1269
1.1180
Step 4 : Plug the numbers obtained in the previous steps in the Black-Scholes formula:
C = $1900.4 million x 0.9832 - $121.14 million x 0.8434
= $1766.30 million
MINICASE
Working :
Working :
b. To value the option to invest in Harmonica – II we have to cast the information
given in the case in terms of the inputs required by the Black – Scholes
formula.
So = present value of the asset = 507.8 x e- 0.18 x 4 = 247.2
E = exercise price = 1100
σ = standard deviation of the continuously compounded
annual returns = 0.3
t = years of maturity = 4
r = interest rate per annum = 12 percent
Given the above inputs, the value of the option to invest in Harmonica – II
may
be calculated as follows:
So σ2 0.09 4
ln + r + t - 1.492 + 0.12 +
d1 = E 2 = 2
σ√t σ√4
= - 1.3867
1.40 - 1.3867
N( - 1.3867) = 0.808 + x ( 0.0885 - 0.0808 )
0.05
= 0.0828
2.00 - 1.9867
N(- 1.9867) = 0.0228 + ( 0.0256 - 0.0228)
0.05
= 0.0235
Step 3 Estimate the present value of the exercise price.
Step 4 Plug the numbers obtained in the previous steps in the Black –
Scholes formula
MINICASE
A. VNR Informatics Private Limited may seek finance from friends and
relatives or from a venture capital fund. The instrument of finance should be
equity or quasi-equity because of the uncertainty characterizing the
investment in the development of a software product.
B. Apparently, Manas Textiles require additional finance mainly for supporting
receivables. The most appropriate source of financing for Manas Textiles
seems to be factoring.
D. Given the riskiness of movie industry, ADCL will have to rely primarily on
external equity financing. ADCL’s recent success, particularly in a highly
visible industry (movie industry), will enable it to raise equity from the
general investing public. So, ADCL can go for an IPO to raises the required
money.
E. With all of its assets already encumbered, Tasty Foods Private Limited may
go in for an equipment lease of Rs.2 crore for its shipping department. As
the business is profitable it should not have a problem in paying the lease
rentals. Since the firm is growing rapidly it may go for a longer lease
period. This will reduce the periodic lease rental so that financial resources
may be available to support growth..
Chapter 21
PROJECT MANAGEMENT
1.
i. Cost variance: BCWP – ACWP = 5,500,000 – 5,800,000
= – Rs.300,000
5,500,000
iii. Cost performance index: BCWP/ ACWP = = 0.948
5,800,000
5,500,000
iv. Schedule performance index: BCWP/ BCWS = = 0.916
6,000,000
BCTW 10,000,000
v. Estimated cost performance index: =
(ACWP + ACC) 5,800,000 + 5,000,000
= 0.926
Chapter 22
2. The network diagram with the earliest and latest occurrence times for each event is
shown in Exhibit 1.
Exhibit 1
Network for the Project
2 1 5
4 4 11 11
4 5
2 3
1 3 4 5 7
0 0 9 9 14 14
2 6
3
2 3
There are two critical paths: 1-2-4-5-7 and 1-2-4-7. The minimum time required
for completing the project is 14 weeks.
Exhibit 1
Time Estimates
(a) The network diagram with average time estimates is shown in Exhibit 2.
Exhibit 3
2
6⅓ 6⅓ EOT LOT
11 4⅓ 9⅓
6⅓
3⅚ 3⅙
4 5 6
17 ⅓ 17⅓ 21 1/6 211/6 24 ⅓ 24 ⅓
7⅙
6⅓
3
7⅙ 10 ⅙ 2½
7⅙
1 4 7
0 0 26 ⅚ 26 ⅚
Exhibit 3
Event slacks
Event LOT EOT Slack = LOT – EOT
1 0 0 0
2 6 1/3 6 1/3 0
3 10 1/6 7 1/6 3
4 17 1/3 17 1/3 0
5 21 1/6 21 1/6 0
6 24 1/3 24 1/3 0
7 26 5/6 26 5/6 0
Exhibit 4
Activity Floats
Activity Duration Total Float Free Float Independent Float
(i –j) dij LOT(j) – EOT(i) – dij EOT(j) – EOT(i) – dij EOT(j) – LOT (i) – dij
1-2 6 1/3 0 0 0
1-3 7 1/6 3 0 0
1-4 6 1/3 11 11 11
1-7 4 22 5/6 22 5/6 22 5/6
2-4 11 0 0 0
2-6 4 1/3 13 2/3 13 2/3 13 2/3
2-7 9 1/3 11 1/6 11 1/6 11 1/6
3-4 7 1/6 3 3 0
3-7 5 14 2/3 14 2/3 11 2/3
4-5 3 5/6 0 0 0
5-6 3 1/6 0 0 0
6-7 2 1/2 0 0 0
(d) Standard deviation of the critical path duration = [Sum of the variances of activity
durations on the critical path]1/2
The variances of the activity durations on the critical path are shown in Exhibit 5.
Exhibit 5
Variances of Activity Durations on critical path
Activity tp to tp – to 2
=
6
1-2 10 4 1.00 1.00
2-4 20 6 2.33 5.43
4-5 5 2 0.50 0.25
5-6 6 1 0.83 0.69
6-7 6 1 0.83 0.69
The standard deviation of the duration of critical path is:
= (1.00 + 5.43 + 0.25 + 0.69 + 0.69)1/2
= (8.06)1/2
= 2.84 weeks.
D–T 30 – 26.83
Prob (D< 30) = Prob < = Prob [ Z < 1.116]
c 2.84
= 0.87
Exhibit 6
Network Diagram
10 7
2 6 4 9 7
5 7 6
1 4 3 12 5 12 9
(b) The all-normal critical paths are 1-2-4-6-7-9 and 1-3-4-6-7-9. For all-normal
network, the project duration is 34 weeks and the total direct cost is
Rs.66,000.
(c) The time-cost slope of the activities constituting the project is given in
Exhibit 7.
Exhibit 7
Time-Cost Slope of Activities
Time Cost (Rs.) Cost to expedite per
in weeks week (Rs.)
(1) (2) (3) (4) (5) (6)
Activity Normal Crash Normal Crash [(5)-(4) (2)-(3)]
(1-2) 5 2 6,000 9,000 1,000
(2-4) 6 3 7,000 10,000 1,000
(1-3) 4 2 1,000 2,000 500
(3-4) 7 4 4,000 8,000 1333.35
(4-7) 9 5 6,000 9,200 800
(3-5) 12 3 16,000 19,600 400
(4-6) 10 6 15,000 18,000 750
(6-7) 7 4 4,000 4,900 300
(7-9) 6 4 3,000 4,200 600
(5-9) 12 7 4,000 8,500 900
Examining the time-cost slope of activities on the critical path, we find that
activity (6-7) has the lowest slope on both the critical paths. The project network after
crashing this activity is shown below in Exhibit 8.
Exhibit 8
6
10 4
2 6 4 9 7
5 7 6
1 4 3 12 5 12 9
As per Exhibit 8, the critical paths are (1-3-4-6-7-9) and (1-2-4-6-7-9) with a
length of 31 weeks and the total cost is Rs.66,900.
Looking at the time-cost slope of the activities on the critical paths (1-3-4-6-7-9)
and (1-2-4-6-7-9), we find that activities (1-3) and (7-9) have the least time-cost slopes
on the two critical paths respectively. The project net work after crashing these
activities is shown in Exhibit 9.
Exhibit 9
6
10 4
2 6 4 9 7
5 7 4
1 2 3 12 5 12 9
As per Exhibit 9, the critical path is (1-2-4-6-7-9) with a length of 29 weeks and
the total direct cost is Rs.(66,900 + 2,200) = Rs.69,100. Activity (4-6) has the least
time-cost slope on the critical path. Hence this is crashed the net work after crashing
(4-6) is shown in Exhibit 10.
Exhibit 10
6
6 4
2 6 4 9 7
5 7 4
1 2 3 12 5 12 9
As per Exhibit 10, the critical path is (1-3-5-9), with a length of 26 weeks, and
total direct costs of Rs.72,100. Looking at the time-cost slope of the non-crashed
activities on this path we find that activity (3-5) has the lowest slope. Hence it is
crashed. The project net work after such crashing is shown in Exhibit 11.
Exhibit 11
6 4
2 6 4 9 7
5 7
1 2 3 3 5 12 9
As per Exhibit 11, the critical path is (1-2-4-6-7-9), with a length of 25 weeks
and a total direct cost of Rs.75,700.
Looking at the time cost slope of the activities on this critical path, we find both
activities (1-2) and (2-4) have the same slope. We crash activity (2-4). The resulting
project network net work is given in Exhibit 12.
Exhibit 12
6 4
2 3 4 9 7
5 7
1 2 3 3 5 12 9
As per Exhibit 12, the critical path is (1-3-4-6-7-9), with a length of 23 weeks
and a total direct cost of Rs.78,700. Crashing activity (3-4), the only uncrashed activity
on this critical path, we get the net work shown in Exhibit 13.
Exhibit 13
6
6 4
2 3 4 9 7
5 4 4
1 2 3 3 5 12 9
As per Exhibit 13, the critical path is (1-2-4-6-7-9), with a length of 22 weeks
and a total direct cost of Rs.82,700. The only uncrashed activity on this critical path is
(1-2). Crashing this we get Exhibit 14.
Exhibit 14
6 4
2 3 4 9 7
2 4 4
1 2 3 3 5 12 9
As per Exhibit 14, the critical path is (1-3-4-6-7-9) with a duration of 20 weeks,
and a total direct cost of Rs.85,700. Since all activities on this path are crashed, there is
no possibility of further time reduction.
Exhibit 15 shows the time-cost relationship.
Exhibit 15
Project Duration and Total Cost
Exhibit Activities Crashed Project Total Total Total
duration direct indirect cost (Rs.)
(in weeks) cost cost
(Rs.) (Rs.)
6 none 34 66,000 34,000 1,00,000
8 (6-7) 31 66,900 31,000 97,900
9 (6-7), (1-3) and (7-9) 29 69,100 29,000 98,100
10 (6-7), (1-3), (7-9) and (4-6) 26 72,100 26,000 98,100
11 (6-7), (1-3), (7-9), (4-6) and (3-5) 25 75,700 25,000 1,00,700
12 (6-7), (1-3), (7-9), (4-6), (3-5) and (2-4) 23 78,900 23,000 1,01,700
13 (6-7), (1-3), (7-9), (4-6), (3-5), (2-4) and (3-4) 22 80,500 22,000 1,02,500
14 (6-7), (1-3), (7-9), (4-6), (3-5), (2-4), (3-4) and 20 83,500 20,000 1,03,500
(1-2)
If the objective is to minimise the total cost of the project, the pattern to crashing
suggested by Exhibit 8 may appear as the best. However, it is possible to reduce the
cost further without increasing the project duration beyond 26 weeks by decrashing
some activities on the non-critical paths. To do so, begin with the activity which has the
highest time-cost slope and proceed in the order of decreasing time-cost slope.
Chapter 23
2.
SV = Rs.120 million DV = Rs.175 million
30 35 45 50
PVCF = + + +
(1.12) (1.12)2 (1.12)3 (1.12)4
30 25
= = Rs.148.21 million
5 6
(1.12) (1.12)
Since DV > PVCF > SV
it is advisable to sell it to the third party at Rs.175 million