LEGEND ACADEMY FOR CA
Strategic Financial Management
- CA. Alok Agarwal
____________________________________________________________
LEGEND ACADEMY FOR CA
Bandari Arcade, 5
thFloor, Above IDBI Bank
Opposite: SR Nagar Bus Stop, Hyderabad.
Ph: 90004 64672, 90000 13135,
DIVIDEND POLICY
Problem No 1A company has a book value per share of Rs.137.80 its return on equity is 15% and it follows a policy of retaining 60% of its earnings. If the Opportunity Cost of Capital is 18%, what is the price of the share today under:
a. Walter’s Dividend Model b. Gordon’s Model
Problem No 2
A firm pays 18% dividend on its equity having a face value of Rs.100. Find out the price of one equity share if the expectation of shareholder is 12% with consistent dividend forever.
Problem No 3
A Co., pays the first dividend by Y4 at 18% on its face value of Rs.100/-. It expects to maintain the same rate of dividend thereafter. What is the price of the share if the cost of equity if 12%?
Problem No 4
A company wants to declare 3 years holiday for dividends with lots of capital investments program in the offing. It is also decided to declare consistently 14% dividend for the face value of each equity share of Rs.10, thereafter. Find the present value per share of the company if the required rate of return of equity share is 9%.
Problem No 5
The chairman of a company wanted to know the opinion of his policy of not declaring dividend. He feels money with the company is more productive than with the shareholders. However agrees to declare dividend consistency after 20 years @ Rs.40 forever. He also suggests another policy of declaring only Rs.6 consistently forever. In either of the policies consider only a cost of capital of 11%. Which of the policies would be attractive for the shareholders? Suggest.
Problem No 6
A company had just paid a dividend pf Rs.6. Earnings and dividends are expected to grow @ 15%. Find out the price per share of the company if the required rate of return is 18%.
Problem No 7
Dolphin Products Corporation currently pays a dividend of Rs.2 per share and this dividend is expected to grow at a 15% annual rate for 3 years, then at a 10% rate for the next 3 years, after which it is expected to grow at a 5% rate for ever.
Problem No 8
Sigma Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The growth rate is likely to fall to 10% for the third year and fourth year. After that the growth rate is expected to stabilize at 8% per annum. If the last dividend paid was Rs.2.50 per share and the investor’s required rate of return is 15%, find out the intrinsic value per share of Z Ltd as of date.
Determine the price at which an investor may be ready to buy the shares of the company at the end of period Po (i.e., now) and P1, P2, P3, P4, and P5.
Problem No 9
Sai Chemicals has a current cash dividend of Rs.2 per share. You estimate that cash dividend grow at a rate of 12% for each of the three years and then at 6% per year for each of two more years. After you expect them to grow at 2 percent per year infinity.
a. What is the current market value of Sai Chemical’s share if the required rate of return is 14 percent?
b. What is the market price if everything is the same as in (a) except that after year 5 three is no expected growth in cash dividend?
Problem No 10
This risk free return is 10% and the risk premium is 5% with beta of a company is 1.6 the company had declared the latest dividend at Rs.3 (2007) whereas it had declared a dividend of Rs.2.115 in the year 2001. The company’s earnings and the dividend experienced constant growth. Find out the intrinsic value of the shares. Take into account the following PV table value if useful.
% of Cost of Capital PV at the end of 6 years 5% 0.746
6% 0.705 7% 0.666
Problem No 11
A company’s share is quoted in market at Rs.60 currently. A company currently paid a dividend of Rs.5 per share and investors expect a growth rate of 12 percent per year.
Compute:
a. The company’s cost of capital
b. If anticipated growth rate is 13 percent pa. Calculate the indicated market price per share. c. If the company’s cost of capital is 18 percent and anticipated growth rate is 15 percent pa,
Problem No 12
Sheetal has invested in Manali Chemicals Ltd. The capitalization rate of the company is 15 percent and the current dividend is Rs.3.00
a. Calculate the value of the company’s equity share if the company is slowly sinking with an annual decline rate 5% in the dividend
b. Calculate the value of the equity share of Manali Chemicals Ltd, if the company shows no growth but is able to maintain its dividend.
Problem No 13
A company wants to declare 2 years holiday for dividends with lots of capital investments program in the offing. It is also decided to declare dividend of Rs.14, with a growth rate of 9% for ever on account of investments taken up now. Find the present value per share of the company if the required rate of return of equity share is 19%. In case the investment program is not taken up, there will be no holiday for dividend. The company just paid Rs.16 per share. Growth rate would be 6% forever without investment program. Find out the advantage / disadvantage of taking up investment program on the value per share of the company. Make suitable assumptions if required.
Problem No 14
Most Corporation had a net income of Rs. 8, 00,000 in 19X1. Earnings have grown at an 8% annual rate. Dividends in 19X1 were Rs. 3, 00.000. In 19X2, the net income was Rs. 11, 00,000. This, of course was much higher than the typical 8 percent annual growth rate. It is anticipated that earnings will go back to the 8% rate in future. The investment in 19X2 was Rs. 7,00,000 How much dividend should be paid in 19X2 assuming a) stable dividend payout ratio of 25 % b) stable rupee dividend policy is maintained c) residual dividend policy is maintained and 40 % of the 19X2 investment is financed with debt d) the investment for 19X2 is to be financed with 80% debt and 20% retained earnings. Any net income not invested is paid out in dividends.
Problem No 15
Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3.00 dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain constant for the next several years. The company’s target capital structure is 60 percent equity and 40 percent debt; it has 1,000,000 shares of common equity outstanding; and its net income is $8 million. The company forecasts that it would require $10 million to fund all of its profitable (i.e., positive NPV) projects for the upcoming year.
a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget?
b. If Buena Terra follows the residual dividend model, what will be the company’s dividend per share and payout ratio for the upcoming year?
c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be available for the firm’s capital budget?
d. Can the company maintain its current capital structure, maintain the $3.00 DPS, and maintain a $10 million capital budget without having to raise new common stock?
e. Suppose that Buena Terra’s management is firmly opposed to cutting the dividend, that is, it wishes to maintain the $3.00 dividend for the next year. Also, assume that the company was committed to funding all profitable projects and was willing to issue more debt (along with the available retained earnings) to help finance the company’s capital budget. Assume that the resulting change in capital structure has a minimal impact on the company’s composite cost of capital, so that the capital budget remains at $10 million. What portion of this year’s capital budget would have to be financed with debt?
f. Suppose once again that Buena Terra’s management wants to maintain the $3.00 DPS. In addition, the company wants to maintain its target capital structure (60 percent equity, 40 percent debt) and maintain its $10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue in order to meet each of its objectives?
g. Now consider the case where Buena Terra’s management wants to maintain the $3.00 DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming that the company’s projects are divisible, what will be the company’s capital budget for the next year?
h. What actions can a firm that follows the residual dividend policy take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?
Problem No 16
The earnings per share of a company are Rs.8 and the rate of capitalization applicable to the company is 10%. The company has before it an option of adopting a payout ratio of 25% or 50% or 75%. Using Walter’s formula of dividend payout compute the market value of the company’s share if the productivity of retained earnings is (i) 15% (ii) 10% and (iii) 5%.
Explain fully what inferences can be drawn from the above exercise?
Problem No 17
The following information is available in respect of the rate of return on investments (r), the capitalization rate (k) and earnings per share (E) of Hypothetical Ltd.
R= (i) 12% (ii) 10% (iii) 8%; k=10% E=Rs.20 Determine the value of its shares, assuming the following:
Situation 1 2 3 4 5 6 7
Rentention Ratio (b) 10 20 30 40 50 60 70 D/P ratio (1-b) 90 80 70 60 50 40 30
Problem No 18
From the following information supplied to you, determine the theoretical market value of equity shares of a company as per Walter’s Model:
Earning of the company Rs.500, 000 Dividends paid Rs.300, 000
Number of shares outstanding 100, 000
Price earning ratio 8
Rate of return on investment 15%
---Are you satisfied with the current dividend policy of the firm? If not, what should be the optimal dividend payout ratio in this case? Problem No 19 Orix telecommunications has a target capital structure which consists of 70% debt and 30% equity. The company anticipates that its capital budget for the upcoming year will be Rs.30, 00,000. If Orix reports net income of Rs.20, 00,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio? Problem No 20 A Ltd has made a profit of Rs.1, 20,000. Its gearing ratio is 0.4 which is to be maintained. It cost of capital is: debt 10%, equity 22%, retained earnings 20%. Four projects are under consideration. Investment Required Rate of Return on Investment A Rs.60, 000 19%
B Rs.50, 000 18%
C Rs.80, 000 17%
D Rs.20, 000 16% What amount should be paid as dividend?
Problem No 21
What will be the dividend per share of Manik Industries for the year 2003 given the following information about the company?
EPS of 2007 =Rs.5 DPS for 2006 = Rs.2 Target payout ratio = 0.6 Adjustment rate = 0.7 Apply the Lintner Model.
---Problem No 22
ABC Ltd has a capital of Rs.10 lakhs in equity shares of Rs.100 each. The shares currently quoted at par. The company proposes declaration of a dividend of Rs.10 per share at the end of the current financial year. The Capitalization rate for the risk class to which the company belongs is 12%.
What will be the market price of the share at the end of the year, if (i) A dividend is not declared?
(ii) A dividend is declared?
(iii) Assuming that the company pays the dividend and has net profits of 5, 00,000 and makes new investments of Rs.10 lakhs during the period, how many new shares must be issued? Use the M.M. model.
Problem No 23
Jasper Ltd had issued 30 Lacs ordinary shares of Re.1 each that are at present selling for Rs.4 per share. The company plans to issue rights to purchase one new equity share at a price of Rs.3.2 per share for every three shares held. A share holder who owns 900 shares thinks that he will suffer a loss in his personal wealth because new shares are being offered at a price lower than market value. On the assumption that the actual market value of the shares will be equal to the Ex-rights price. What could be the effect on the share holders’ wealth if A) He sells all the rights; B) he exercises half of the rights and sells other half C) He does nothing at all.
Problem No 24
A Ltd is an all equity financed company. The current market price of shares is Rs.180 it has just paid a dividend of Rs.15 per share and expected future growth in dividend is 12 percent. Currently, it is evaluating a proposal requiring funds of Rs.20 lacs, with annual inflows of Rs.10 lacs for 3 years. Find out the Net Present Value of the proposal, if
(i) It is financed from retained earnings and
(ii) It is financed by issuing fresh equity at market price with a floatation cost 5 percent of issue price
Problem No 25
XYZ Ltd has just paid a dividend of Rs.2 per share. The market expects this dividend to grow constantly in each future year at the rate of 6% p.a. The cost of capital is currently 8%. As soon as the dividend was paid, a new project has come up for the consideration of the company. This project requires retaining all the earnings for a period of 3 years. First dividend shall be paid @ Rs.2.50 per share at the end of 4th year and dividend will grow @ 7% thereafter.
An investor holds 1000 shares in that company and has a personal commitment to meet every year for a sum of Rs.2000.
a. What is the price of the company’s share?
b. How would you advise the investor to meet the personal commitment when there is no dividend for 3 years period?
c. Determine the wealth of the investor at the end of year 3.
Problem No 26
The company has flush cash position to carry out buy back operations. Advice the minimum buy back price to be offered
back
Shares to be bought back 1L MPS prior to buy back Rs.378
Problem No 27
Following are the details regarding 3 companies A, B and C Ltd.
Details A B C
Internal Rate of Return 15% 5% 10% Cost of Equity Capital 10% 10% 10% Earnings per Share Rs. 8 Rs. 8 Rs. 8
Calculate the value of an equity share of each of three companies applying Walter’s Formulae when dividend payout ratio (D/P) is
i. 50 % ii. 75 % iii. 25 % What conclusions do you draw?
Problem No 28
Components Manufacturing Corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of $2 par value common stock outstanding. When CMC’s founder, who was also its research director and most successful inventor, retired unexpectedly to the South Pacific in late 2001, CMC was left suddenly and permanently with materially lower growth expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way to replace the founder’s contributions to the firm. Previously, CMC found it necessary to plow back most of its earnings to finance growth, which averaged 12 percent per year. Future growth at a 5 percent rate is considered realistic, but that level would call for an increase in the dividend payout. Further, it now appears that new investment projects with at least the 14 percent rate of return required by CMC’s stockholders (ks _ 14%) would amount to only $800,000 for 2002 in comparison to a projected $2,000,000 of net income. If the existing 20 percent dividend payout were continued, retained earnings would be $1.6 million in 2002, but, as noted, investments that yield the 14 percent cost of capital would amount to only $800,000. The one encouraging point is that the high earnings from existing assets are expected to continue, and net income of $2 million is still expected for 2002. Given the dramatically changed circumstances, CMC’s management is reviewing the firm’s dividend policy.
a. Assuming that the acceptable 2002 investment projects would be financed entirely by earnings retained during the year, calculate DPS in 2002, assuming that CMC uses
the residual dividend model.
b. What payout ratio does your answer to part a imply for 2002?
c. If a 60 percent payout ratio is maintained for the foreseeable future, what is your estimate of the present market price of the common stock? How does this compare with the market price that should have prevailed under the assumptions existing just before the news about the founder’s retirement? If the two values of P0 are different, comment on why.
d. What would happen to the price of the stock if the old 20 percent payout were continued? Assume that if this payout is maintained, the average rate of return on the retained
g = (1.0 - Payout ratio) (ROE)
= (1.0 - 0.2) (7.5%) = (0.8) (7.5%) = 6.0%.
Merger, acquisitions and Restructuring
Problem No 1Find out the NPV of merger with respect to A Ltd and B Ltd.
A Ltd. B Ltd. Merged Company Value of the Company Rs.40 Lacs Rs.10 Lacs 60 Lacs
Compensation paid to B Ltd for takeover is Rs. 12Lacs
Problem No 2
X Ltd is considering the proposal to acquire Y Ltd. and their financial information is given below:
X Ltd Y Ltd
No of Equity Shares 10,00,000 6,00,000
Market Price per Share Rs. 30 18
Market Capitalization Rs. 3,00,00,000 1,08,00,000
X Ltd intend to pay Rs. 1,40,00,000 in cash for Y Ltd’s market price reflects only its value as a separate entity.
Calculate the Cost of merger:
(i) When Merger is financed by cash
(ii) When Merger is financed by 500,000 shares (in the merged entity)
Problem No 3
X Ltd wants to take over Y Ltd and the financial details of both are follows: X Ltd Y Ltd Rs. Rs. Preference share capital
Equity share capital of Rs 10 each Share premium
Profit and loss A/c. 10% Debentures Fixed assets Current assets
Profit after tax and Preference divided
20,000 -1,00,000 50,000 - 2000 38,000 4000 15000 5000 1,73,000 61,000 1,22,000 35,000 51,000 26,000 1,73,000 61,000 24,000 15,000
Market price 24 27
What should be share exchange ratio should be offered to the shareholders of Y Ltd. if based on (i) net asset value, (ii) ESP, and (iii) market price. Which should be preferred from the point of view of X Ltd?
Problem No 4
B Co. is being acquired by A Co. on a share exchange basis. Their selected data are as follows: Determine (a) pre-merger, market value per share, and (b) the maximum exchange ratio A Co. should offer without the dilution of (i) EPS (ii) market value per share.
A B Profit after tax (Rs.lac) 56 21 Number of shares (lac) 10 8.4 Earnings per share (Rs) 5.6 2.5 Price-earnings ratio 2.5 7.5
Problem No 5
If the cost of merger is computed as Rs 277.5 lacs after acquiring S Ltd, what is the exchange ratio worked out by the acquiring company B Ltd. from the following information?
MPS of B Ltd (Before Acquisition) Rs.192.50 MPS of S Ltd(Before Acquisition) Rs.88 No. of shares of B Ltd. (Before Acquisition) 20Lacs No of shares of S Ltd. (Before Acquisition) 15Lacs
It is also estimates that the synergy value is measured at present value of Rs.687.5 Lacs
Problem No 6
Telco Plans to acquire Proton. The following information is provided as following: Telco Proton MPS Rs.300 Rs.200 EPS Rs.25 Rs.20 No of ES 20Lacs 10Lacs PE ratio 12 10
(a) What is the maximum exchange ratio acceptable to the shareholders of Telco if the PE Ratio after on a acquisition is 11 with no synergy gain?
(b) What is the minimum exchange ratio acceptable to shareholders of Proton if the PE ratio after acquisition is 11.5 times with 5% synergy gain?
Big Ltd is determined to report earnings per share of Rs. 2.67; it therefore acquires the Small Ltd. You are given the following facts:
Big Ltd Small Ltd Merged Firm Earning Per Share 2 2.50 2.67 Price per Share 40 25 ? Price-earnings ratio 20 10 ? Number of Shares 100,000 200,000 ? Total earnings 200,000 500,000 ? Total Market value 40,00,000 50,00,000 ?
Once again there are no gains from merging In exchange for Small Ltd shares, Big Ltd issues just enough of its own shares to ensure its Rs.2.67 earnings per share objective.
(a) Complete the above table for the merged firm.
(b) How many shares of Big Ltd are exchanged for each share of Small Ltd? (c) What is the cost of the merger to Big Ltd?
(d) What is the change in the total market value of the Big Ltd. shares that were outstanding before the merger?
Problem No 8
Post Merger Analysis
You have been provided the following financial data of two companies: Krishna Ltd Rama Ltd
Earning after taxes Rs.7,00,000 Rs.10,00,000 Equity shares outstanding 2,00,000 4,00,000 Earning per share 3.5 2.5 Price-earning ratio 10 times 14 times Market Price per Share Rs.35 Rs.35
Company Rama Ltd is acquiring the company Krishna Ltd exchanging its shares on a one-to-one basis for company Krishna Ltd.’s shares, The exchange ratio is based on the market prices of the shares of the two companies.
You are required to calculate-(i) The EPS subsequent to merger,
(ii) Change in EPS for the share holders of Rama Ltd and Krishna Ltd., (iii) The market value of the post-merger firm,
(iv) The profits accruing to share holders of both the Companies.
Problem No 9
X Ltd. made an attempt to acquire Y Ltd. Following information is available for both the Companies:
X Ltd. Y Ltd.
P/E ratio 5 4 No. of Shares (lakhs) (FV of Rs 10) 3.0 2.0 Reserve & Surplus (Rs lakhs) 30 20 Promoters’ holding (lakh shares) 1.2 0.75
Directors of both the Companies have decided that a workable swap ratio is to be based on weights of 30%, 30% and 40% respectively for Earning, Book Value and Market Price of share of each company.
Find out the following: (i) Swap ratio
(ii) After merger, Promoter’s holding % (iii) Post merger EPS
(iv) Gain in Capital market Value of merged company, assuming Price Earnings ratio will remain same
Problem No 10
The following information is provided related to the acquiring Firm Mark Limited and the target Firm Mask Limited:
: 93Jain
Firm Mark Limited Firm Mask Limited
Earnings after tax (Rs.) 2,000 lakhs 400 lakhs Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5
Required:
(i) What is the Swap Ratio based on current market prices? (ii) What is the EPS of Mark Limited after acquisition?
(iii) What is the expected market price per share of Mark Limited after acquisition, assuming P/E ratio of Mark Limited remains unchanged?
(iv) Determine the market value of the merged firm
(v) Calculate gain/ loss for shareholders of the two independent companies after acquisition.
Problem No 11
Blue Dart is analyzing the possible acquisition of Pioneer Couriers. Neither firm has debt. The forecasts of Blue Dart show that the purchase would increase its annual after –tax cash flow by Rs.600,000 indefinitely. The current market value of Pioneer is Rs. 20 million. The current market value of Blue Dart is Rs.35 million. The appropriate discount rate for the incremental cash flow is 8%.
a. What is the synergy from the merger? b. What is the value of Pioneer to Blue Dart?
Blue Dart is trying to decide whether it should offer 25% of its share or Rs.15 Million in cash to Pioneer.
c. What is the cost to Blue Dart of each alternative? d. What is the NPV to Blue Dart of each alternative?
e. Which alternative should Blue Dart use?
Problem No 12
Dividend Growth Model
Chennai Limited and Kolkata Limited have agreed that Chennai Limited will take over the business of Kolkata Limited with effect from 31st December, 2001. It is agreed that.
1. Shareholders of 10,00,000 shares of Kolkata Limited will receive shares of Chennai limited The swap ratio is determined on the basis of 26 weeks average market prices of shares of both the companies. Average prices have been worked out at Rs. 50 and Rs 25 for the shares of Chennai Limited and Kolkata Limited respectively.
2. In addition to (i) above shareholder of Kolkata Limited will be paid cash based on the projected synergy that will arise on the absorption of the business of Kolkata Limited by Chennai Limited. 50% of the projected benefits will be paid to the share holder of Kolkata Limited.
The following projection has been agreed upon by the management of both the companies.
Year 2002 2003 2004 2005 2006 Benefit (in Rs.Lacs) 50 75 90 100 105
The benefit is estimated to grow at the rate of 2% from 2007 onwards. It has been further agreed that a discount rate of 20% should be used to calculate the cash that the holder of each share of Kolkata Limited will receive.
1. Calculate the cash that holder of each share of Kolkata Limited will receive. 2. Calculate the total purchase consideration.
Problem No 13
Nivea Ltd is investigating the possible acquisition FLP Ltd. Following is the data: ___________________________________________________
Nivea Ltd FLP
____________________________________________________ Earnings per share 5 1.50
Dividend per share 3 0.80 Number of shares 1,000,000 600,000 Share price 90 20
____________________________________________________
You estimate that investors currently expect a steady growth of about 6% in FLP earnings and dividends. Under new management this growth rate would be increased to 8% per year, without any additional capital investment required.
(b) What is the cost of the acquisition if Nivea Ltd pays Rs. 25 in cash for each share of FLP?
(c) What is the cost of the acquisition if Nivea Ltd offers one share of Nivea Ltd for every three shares of FLP?
(d) How would the cost of the cash offer and the share offer alter if the expected growth rate of FLP were not changed by the merger?
Problem No 14 Going Private
Alpha Limited a chain of restaurants is considering going private limited. The President Bidhu Das believes that with the elimination of Share holder servicing costs and other costs associated with public ownership the company could save Rs. 800,000 per annum before taxes. In addition the company believes management incentives and hence performance will be higher as a private company. As a result, annual profits are expected to be 10% greater than present after-tax profits of Rs.9 million The effective tax rate is 30 %, the price / earnings ratio of the Share is 12, and there are 10 million shares outstanding. What is the present market price per share? What is the maximum Rupees premium above this price that the company could pay in order to take the company into private Limited?
Problem No 15
Timex products has estimated the following anticipated incremental benefits and investments for a potential target:
Year ΔPBT (in Rs) Δ Dep*(in Rs.) (Investment (in Rs.)
1 80000 20000 150000 2 80000 50000 100000 3 135000 50000 50000 4 190000 50000 0 5 195000 50000 0 6-10 200000 20000 0
*Δ depreciation is for the investment in the column immediately to the right.
a) If Timex’s tax rate is 0.40, Calculate the incremental after-tax cash flows, Δ CF, from the target.
b) The Value of Timex before the merger is Rs 2.4 million, while the target’s market value is Rs.1 million. The market price per share of Timex’s share is Rs. 50, and the required rate of return is 15 percent. Calculate the NPV for both a cash-financed and a Share-financed acquisition if Timex anticipates paying a 15% premium above the current market value of the target.
Problem No 16
Master Corporation wants to buy certain fixed assets of Smith Corporation. However, Smith Corporation wants to dispose of its entire business. The balance sheet of Smith
follows-ASSETS Rs.
Cash 2,000
Inventories 20,000 Equipment 1 10,000 Equipment2 20,000 Equipment3 35,000 Buildings 90,000 Total assets 185,000
LIABILITES AND EQUITY
Total liabilities 80,000
Total stockholders equity 105,000
Total liabilities and stock holders’ equity 185,000
Master needs only equipment 1 and 2 and the building. The other assets excluding cash can be sold for Rs. 35000 .Smith wants Rs. 48,000 for the entire business. It is anticipated that the after-tax cash inflows from the new equipments will be Rs. 30,000 a year for the next 8 years. The cost of capital is 12 percent.
(a) What is the initial net cash outlay? (b) Should the acquisition be made?
Problem No 17 Demerger Analysis
The following information relates to Fortune India Limited having two divisions viz. Pharma Division and Fast Moving Consuming Goods Division (FMCG). Paid up share capital of Fortune India Ltd is consisting of 3000 lacs equity shares of Re.1 each. Fortune India Ltd decided to de-merge Pharma division as Fortune Pharma Ltd with effect from 1.4.2005. Details of Fortune India Ltd as on 31.03.2005 and of Fortune Pharma Ltd as on 1.4.2005 are as below:
Rs in lacs Particular Fortune Pharma Ltd Fortune India Ltd
Outside Liabilities
Secured Loan 400 3000
Unsecured Loan 2400 800
Current Liabilities & Provisions 1300 21200
Assets Fixed Assets 7740 20400
Investments 7600 12300
Current Assets 8800 30200
Loans & Advances 900 7300
Deferred Tax/ Miscellaneous exp 60 (200)
Boards of directors of the company have decided to issue necessary equity shares of Fortune Pharma Ltd of Re.1 each, without any consideration to the shareholders of Fortune Ltd. For that purposes following points are to be considered:
1. Transfer of Liabilities and asset at book values
2. Estimated Profit for the year 2005-06 is Rs 11400 Lacs for Fortune India Ltd and Rs.1470 Lacs for Fortune Pharma Ltd.
4. Average P/E Ration of FMCG sector is 42 & Pharma sector is 25, which is to be expected for both the companies.
Calculate:
1. The ratio in which shares of Fortune Pharma are to be issued to the shareholders of Fortune India Ltd.
2. Book value per share of both the Companies immediately after Demerger.
Problem No 18
The following is the balance sheet of A Ltd.
Liabilities Amount Assets Amount Rs.
13% Preference Share Capital 1, 00,000 Fixed Assets 19, 00,000 Equity Shares (Rs.10 each) 20, 00,000 Investments 1, 00,000 Retained earnings 4, 00,000 Stock 5, 00,000 12% Debentures 3, 00,000 Debtors 4, 00,000 Current liabilities 2, 00,000 Bank 1, 00,000 30,00,000 30,00,000
X Ltd. agreed to take over A Ltd. for which the purchase consideration was agreed as follows: 1. Rs. 3,30,000 in 13% Debentures of X Ltd. for redeeming 12 % Debentures of A Ltd. 2. Rs. 1,00,000 in 12 % Convertible Preference shares for the Preference shares of A Ltd. 3. 1, 50,000 Equity Shares of X Ltd. at the market price of Rs.15 each.
4. X Ltd. to meet acquisition cost of Rs. 30,000
5. The break- up figure of eventual disposition by X Ltd. of the un-required current assets and current liabilities of A Ltd. Is as follows: Investment Rs. 125000; Debtors Rs. 350000; Inventories 425000; and Current Liabilities Rs. 190000.
A Ltd is expected to generate yearly operating cash flows (after tax) of Rs. 700000 per annum for 6 years and that the fixed assets of A Ltd. are expected to expected to fetch Rs.3,00,000 at the end of 6 years. Evaluate the proposals given that the cost of capital of X Ltd’s 15%
Problem No 19
Following are the financial statement for A Ltd. and B Ltd. for the current financial year. Both firms operate in the same industry.
Balance Sheet
A Ltd. B Ltd. Total current assets 14, 00,000 10, 00.000 Total fixed assets (net) 10, 00,000 5, 00,000 Total Assets 24, 00,000 15, 00,000
Retained earnings 2, 00,000 14% Loan term debt 5, 00,000 3, 00,000 Total current liabilities 7, 00,000 4, 00,000 24, 00,000 15, 00,000 Income Statements _______________________________________________________ A Ltd. B Ltd. Rs. Rs. _____________________________________________________ Net sales 34, 50,000 17, 00,000 Cost of goods sold 27, 60,000 13, 60,000 Gross profit 6, 90,000 3, 40,000 Opening expenses 2, 00,000 1, 00,000 Interest 70,000 42,000 Earnings Before taxes 4, 20,000 1, 98,000 Taxes (50%) 2,10,000 99,000 Earning after taxes (EAT) 2,10,000 99,000
Additional Information:
Number of equity shares 1,00,000 80,000 Dividend payment ratio 40% 60% Market prices per share (MPS) Rs.40 Rs.15 ________________________________________________________
Assume that the two firms are in the process of negotiating a merger through an exchange of equity shares. You have been asked to assist in establishing equitable exchange terms, and are required
to:-i. Decompose the share prices of both the firms into ERS and PE components, and also segregate their EPS figures into return on equity (ROE) and book value /intrinsic value per shares (BVPS) components
ii. Estimate future ERS growth rates for each firm
iii. Calculate the post- merger EPS based on an exchange ratio of 0.4:1 being offered by A ltd. Indicate the immediate EPS accretion or dilution, if any, that will occur for each group of shareholders.
iv. Based on a 0.4:1 exchange ratios, and assuming that A’s pre-merger PE ratio will continue after the merger, estimate the post-merger market price. Show the resulting accretion or dilution in pre-merger market prices.
Problem No 20
A ltd. is considering the purchasing of T Ltd. The cash inflows after taxes for T Ltd. are estimated to be Rs. 15 lacs per year in the future. This forecast by A ltd. includes expected merger synergic gains. T Ltd. currently has total assets of Rs.50 lacs with 20% of the total assets being financed with debts funds. A Ltd’s pre-merger weighted average cost of capital is 15%
i. Based on A Ltd. pre-merger cost of capital, what is the maximum purchase price that A Ltd. would be willing to pay to acquire T Ltd.?
ii. Assume that by acquiring T Ltd. A Ltd. will move toward an optimal capital structure such that its weighted average cost of capital will be 12% after the acquisition. Under these conditions, what would be the maximum price A Ltd. should be willing to pay?
iii. Assume that cash flows for T Ltd. estimated at Rs. 15 lacs for the coming year, will grow at a rate of 20% per year for the following two years, and will be on level thereafter. Each rupee increase in cash flows will require Re. 0.7 incremental investment in assets. Estimate the maximum purchase price for T Ltd. based on a 12% cost of capital.
Problem No 21
In 2007, Vishnu Ltd. acquired Ravana Ltd. after a hotly contested takeover for approximately Rs. 110 per share. The free cash flows of the two firms-before and after merger-were projected as follows:
Free Cash Flow (Rs. million)
Year/Firm 1 2 3 4 5 Terminal value* Vishnu 4684 4918 5164 5422 5693 82756
Ravana 471 509 550 594 641 8102 Combined 5195 5558 5948 6364 6809 96672 (Post-merger)
*Terminal value as at the end of the 5th year.
Cost of equity and debt of the individual firms and the combined firm (after merger) were estimated as given under:
Vishnu Ravana Combined Cost of equity 14.23% 15.33% 14.34% Cost of debt 5.40% 6.00% 5.42% Debt/ (Debt + equity) 21% 9% 20%
At the time of merger deal Ravana had 70.6 million outstanding shares and Rs. 537 million worth of outstanding debt:
(a) What is the minimum price per share Vishnu could have offered to Ravana? (b) Do you think the price paid by Vishnu was justifiable? Give reasons
Problem No 22
The chief executive of a Amazon Inc. thinks that shareholders always look for the earnings per share. Therefore, he considers maximization of the earnings per share (EPS) as his Company’s objective. His Company’s current net profits are Rs. 80 Lakh and EPS is Rs.4. The current market price is Rs. 42. He wants to buy another to buy another firm which has current income of Rs. 15.75 Lakh, EPS of 10.50 and the market price per share of Rs. 85.
(i) What is the maximum exchange ratio which the chief executive should offer so that he could Keep EPS at the current level?
(ii) If the chief executive borrows funds at 15 per cent rate of interest and buys out the other company by paying cash, how much should he offer to maintain his EPS? Assume a tax rate of 52%
Problem No 23
OCTL is considering the cash acquisition of R Ltd for Rs.750,000 The acquisition is expected to result in incremental cash flows of Rs 125,000 in the first year, and this amount is expected to grow at a 6 per cent compound rate. In the absence of the acquisition OCTL expects net cash flows of Rs 600,000 this coming year (after capital expenditures), and these are expected to grow at a 6 per cent compouned rate forever. At present, investors and creditors require a 14 percent overall rate of return for OCTL, R Ltd is much more risky, and the acquisition of its will raise the company’s overall return to 15 per cent.
(a) Should OCTL acquire R Ltd?
(b) Would you answer be the same if the overall required rate of return stayed the same?
Business Valuation
Goodwill Valuation Problem No 24
Laxmi Private Limited is negotiating to sell their business to a public limited company. The following is a summarized extract from the Balance Sheet as on 31st March, 2006 of Laxmi
Private Limited.
Rs Capital 1,000 shares of Rs. 1000 each Free
Reserve
Fixed Assets at depreciated cost Current Assets (-) Current Liabilities Rs 7,20,000 1,60,000 10,00,000 2,00,000 12,00,000 6,40,000 5,60,000 12,00,000
The profits of Laxmi Private Limited for the last five years it has been in existence, after eliminating any extraneous or non-recurring debits and credits, were Rs. 90,000; Rs. 1,30,000; Rs.1,15,000; Rs 2,40,000 and Rs 2,75,000. A return of 10% on the capital employed is considered to be reasonable in this particular business and it is expected that future requirements as to capital will not vary materially from the capital employed as on 31st March.
Ignoring any extraneous factors that may affect the position, suggest the amount that should reasonably be paid to the private company for good will for acquiring the company.
Mr. Dinesh a successful entrepreneur has gathered the latest financial information pertaining to an unlisted company. Mr. Dinesh intention is to buy this company.
Liabilities Rs.000 Assets Rs.000 Equity (FV Rs.1) Reserves Term loans Trade credits Overdraft Tax payable 300 730 350 430 320 110
Land and Building Plant and Machinery Stock Debtors Cash 450 720 435 600 35 2240 2240 Amount/Rs. Pre tax Profits Present year
Pre tax profits Last year Post tax profits Present year Dividends declared Present year A year ago 640,000 341,000 384,000 300,000 200,000 Additional Information:
Profits are expected to grow annually at a rate of 8% Average earnings per share of comparable listed companies is Re.0.15 Earnings yield for companies in the same risk class 10% Market value of land and buildings has fallen by 20%
Cost of equity 16%
Replacement cost of plant 900
Realizable value 648
Obsolete element in the stock valuation 75 This obsolete element cab be sold for 3
Debtors can be realized In full
Average pre tax return on net realizable assets 12%
Tax Rate 40%
Required: Compute the price that can pay for this business, using:
1) Net realizable value of assets method 2) Earnings capitalization model
3) Fair value model (Berliner method) 4) Dividend valuation model
5) Price earnings model
6) An average price that you would recommend of models 3 to 5 are used. For this computation assume the following:
• Last two year average pre-tax earnings will be capitalized (15%)
• PE multiple will be on earnings after reckoning growth for only one year
• PE multiple of unlisted companies is normally 90% of Listed companies
• Dividends will grow at the same rate as earnings
Problem No 26
Given below is the balance sheet of S Ltd. as on 31.3.2008 –
Liabilities Rs. Lakhs Assets Rs. Lakhs
Share Capital 100 Land and Buildings 40 Reserves and Surplus 40 Plant and Machinary 80
Creditors 30 Investments 10
Stock 20
Debtors 15
Cash and Bank 5
170 170
You are required to work out the value of the company shares on the basis of Net Asset Method and Profit Earning Capacity Method (Capitalization) Method and arrive at the fair price of the shares, by considering the following information –
(i) Profit for the current year Rs. 64 lakhs includes Rs. 4 lakhs extraordinary income and Rs. 1 lakh income from investments of surplus funds unlikely to recur
(ii) In subsequent years, additional advertisement expenses of Rs. 5 lakhs are expected to be incurred each year
(iii) Market value of Land and Buildings and P&M have been ascertained at Rs. 96 lakhs and Rs. 100 Lakhs respectively. This will entail additional depreciation of Rs. 6 lakhs each year
(iv) The capitalization rate applicable to similar business is 15%
The total value both equity and debt of two companies, Sun Ltd and Moon Ltd, are expected to fluctuate according to the state of the economy.
Economic State
Recession Slow Growth Rapid growth Probability 0.15 0.65 0.20
Total Value:
Sun Ltd (Rs In lakh) 126 165 225
Moon Ltd (Rs.In lakh) 189 240 360
Currently Sun Ltd has Rs 135 lakh of debt and Moon Ltd’s 30 lakh of debt.
If the two companies were to merge and assuming that no operational synergy occurs as a result of the merger, calculate the expected value of debt and equity of the merged company.
Explain the reasons for any difference that exists form the expected values of debt and equity if they do not merge.
Economic Value Added Problem No 28
The following data relates to Morning Glory Limited. Profit and Loss A/c 20 × 1
Rs. In lakh 20 × 2 Rs. in lakh
Turnover 1990 2360
Pre-tax accounting profit 420 530
Taxation 125 160
Profit after tax 294 370
Dividends 100 120 Retained Earnings 194 250 20 × 1 Rs. In lakh 20 × 2 Rs. In lakh Fixed assets 740 960
Net current Assets 800 1000
1540 1960
Financed by Shareholders Funds 1190 1440 Medium and long term Bank Loan 350 520
1540 1960
Pre-tax accounting profit is taken after deducting the economic depreciation of the company’s fixed assets (also the depreciation used for tax purposes).
Additional Information:
i) Economic depreciations were Rs 190 lakh in 20×1 and Rs. 210 lakh in 20 × 2. ii) Interest expenses were Rs.26 lakh in 20×1 and Rs 36lakh in 20×2
iii) Other non-cash expenses were Rs.64 lakh in 20×1 and Rs 72 lakh in 20×2. iv) The tax rate in 20×1 and 20×2 was 30%
v) Morning Glory Limited has non-capitalized valued at Rs.70 lakh in each year, 20 ×0 to 20×2. vi) The Company’s pre-tax cost of debt was estimated as 7% in 20×1 and 8% in 20×2.
vii) The company’s cost of equity was estimated as 14% in 20×1 and 16% in 20×2. viii) The target capital structure is 75% equity and 25%debt.
ix) Balance sheet capital employed at the end of 20×0 was a Rs 1390 lakh.
Estimate the economic value added for Morning Glory Limited for 20×1 and 20×2.
Problem No 29
Calculate the EVA from the following data:
(Rs.Crores) 2001
Average Debt 50
Average Equity 2766
Cost of Debt Post tax% 7.72
Cost of Equity% 16.70
Weighted Average Cost of Capital % 16.54 Profit after tax, before exceptional item 1541
Interest after taxes 5
Brand Valuation Problem No 30
Consider the extract of profit & Loss Statements of ABC Ltd for the past three years:
Year ended 31.03 2005 2006 2007 2008 (Projected) Sales 2526 2730 2975 3010 Other Income 30 35 32 40 PBIT 126 140 149 158 Interest 20 24 21 25 Tax 21 28 32 27
Profit after tax 74 88 96 106
Inflation index for the past three years: 31.03.2005 100 31.03.2006 105 31.03.2007 109
Sales figures include sale proceeds from unbranded product as well, on which the company earns a modest profit of 3%. Unbranded sales were:
Year ended Rs. in lacs
31.03.2005 250
31.03.2006 240
31.03.2007 265
The average capital employed of ABC Ltd (calculated on past three year’s figures) is Rs 1200 lacs. ABC Ltd estimates that 5% return on average capital employed is the minimum level of earnings the company would have got by selling equivalent unbranded products. The marketing department of ABC Ltd assigns the score of 74 out of 100 for its brand strength and recommends a multiple of 15 to be applied on earnings to value brand. Show the brand valuation by following earnings multiple methods.
Problem No 31
ABC Ltd. Is run and managed by an efficient team that insists on reinvesting 60% of its earnings in projects that provide an ROE of 10%, despite the fact that the firm’s capitalization rate (K) is 15%. The firms current year’s earnings is Rs. 10 per share.
At what price will the stock of ABC Ltd. Sell? What is the present value of growth opportunities? Why would such a firm be a takeover target?
CAPITAL BUDGETING
Problem No 1Find out the cash flow for investing decision.
Sales Cost
Profit before interest and tax Interest
Profit before tax Tax
Profit after tax
400 5000 2250 270 2750 1000 130 2250 1250 30 675 250 100 1575 1000 40 575 300 60 1000 700 Problem No 2
Find out the missing figures from the following.
S. No. Real Cost Inflation rate Money Rate
1 10 5 ?
2 8 ? 17.72
3 ? 6 12.35
Problem No 3
PQR Company is examining an investment proposal requiring an initial outflow of Rs.8 lacs and expected inflow in real terms (i.e. today’s purchasing power) is Rs.2, 80,000 per year for the next 4 years. The company’s out of pocket monetary cost capital is 9% and inflation is expected to be 3.2% p.a. over the next four years.
(i) Compute the company’s real (net of inflation) cost of capital.
(ii) What is the present value of cash inflows if real cost of capital is taken into consideration?
(iii) Compute nominal cash inflow from real cash inflows and also calculate present value on the basis of nominal cash inflows.
Problem No 4
A company is considering a new project requiring an outlay of Rs.1 Lac. The firm’s existing cost a capital is 10% for its market value of Rs.10 lacs. The new project under consideration would place the firm into a new higher risk category, requiring a revised cost of capital at 11%.
1) What is the new project’s minimum required rate of return?
2) In case, the expected annual incremental cash flow due to the new project (perpetuity) is Rs.30000. Should the company accept the project?
Problem No 5
One project of a company is doing poorly and is being considered for replacement. Three mutually exclusive projects A,B & C have been proposed. The projects are proposed to require Rs.200000 each and have an estimated life of 5, 4, 3 years respectively and have no salvage value. The company’s required rate of return is 10%. The anticipated cash inflows after taxes for the three projects are as follows:
Year A B C 1 50000 80000 100000 2 50000 80000 100000 3 50000 80000 10000 4 50000 30000 5 190000 ---
---Rank each project applying the methods of Pay-back, Average rate of return.
Problem No 6
Zenith Industries Ltd. are thinking of investing in a project costing Rs.. 20 lakhs. The life of the project is five years and the estimated salvage value of the project is zero. Straight line method of charging depreciation is followed. The tax rate is 50%. The expected cash flows before tax are as follows:
Year 1 2 3 4 5 Estimated cash flow before depreciation 4 6 8 8 10 You are required to determine the:
(i) Payback period for the investment (ii) Average rate of return on the investment (iii) Net present value at 10% cost of capital (iv)Benefit-cost ratio.
Problem No 7
United Industries Ltd has an investment budget of Rs. 100 lakhs for 2005-06. It has short listed two projects A and B after completing the market and technical appraisals. The management
wants to complete the financial appraisal before making the investment. Further particulars regarding the two projects are given below:
Particulars A B Investment required 100 90 Average annual cash inflow before dep and tax (estimate) 28 24 Salvage value –Nil for both projects Estimate life – 10 years for both projects P.V. of an annuity of Re. 1 for ten years at different discount rates is given below: Rate % 10 11 12 13 14 15 Annuity - 10 years 6.145 5.899 5.650 5.426 5.216 5.019 The company follows straight line method of depreciation. Its tax rate is 50%.
You are required to calculate: a. Payback period and b. I.R.R of the two projects.
Problem No 8
The cash flows of two mutually exclusive projects are as under:
t0 t1 t2 t 3 t 4 t 5 t 6
Project ‘P’
Project ‘J’ (40,000)(20,000) 13,0007,000 8,00013,000 14,00012,000 12,000-- 11,000-- 15,000 --Required:
(i) Estimate the net present value (NPV) of the Project ‘P’ and ‘J’ using 15% as the burled rate.
(ii) Estimate the internal rate of return (IRR) of the Project ‘P’ and ‘J’.
(iii) Why there is a conflict in the project choice by using NPV and IRR criterion?
(iv) Which criteria you will use in such a situation? Estimate the value at that criterion. Make a project choice.
The present value interest factor values at different rates of discount are as under: Rate of discount t0 t1 t2 t 3 t 4 t 5 t 6 0.15 0.18 0.20 0.24 0.26 1.00 1.00 1.00 1.00 1.00 0.8696 0.8475 0.8333 0.8065 0.7937 0.7561 0.7182 0.6944 0.6504 0.6299 0.6575 0.6086 0.5787 0.5245 0.4999 0.5718 0.5158 0.4823 0.4230 0.3968 0.4972 0.4371 0.4019 0.3411 0.3149 0.4323 0.3704 0.3349 0.2751 0.2499 Problem No 9
Following are the data on a capital project being evaluated by the management of M Ltd. Project M
Annual Cost saving = Rs.40, 000 Useful life = 4 years IRR = 15% Profitability Index = 1.064 NPV = ? Cost of capital (%) = ? Cost of project (Rs.) = ? Payback period = ? Salvage value = 0
Find out the missing values considering the following table of discount factor only. ___________________________________________ Discount factor 15% 14% 13% 12% ____________________________________________ 1 year 0.869 0.877 0.885 0.893 2 year 0.756 0.769 0.783 0.797 3 year 0.658 0.675 0.693 0.712 4 year 0.572 0.592 0.613 0.636 _____________________________________________ 2.855 2.913 2.974 3.038 _____________________________________________ Problem No 10
Following cash flow details are available for project A and B having an initial outlay of Rs.5.4 crores and 4.7 crores respectively.
Project A Project B
Years PAT Depreciation Interest PAT Depreciation Interest 0 (540) (470) 1 185 50 60 100 45 50 2 110 50 50 105 45 40 3 195 50 40 135 45 30 4 225 50 30 125 45 20 5 175 50 20 175 45 10 Tax rate is at 30%
Cost of capital is to be applied at 20%. Only one of the two projects can be chosen. Which of the projects is to be chosen based on (a) NPV (b) PI (benefit cost ratio)?
S Ltd. has Rs.10,00,00 allocated for capital budgeting purposes. The following proposals and associated profitability indexes have been determined:
Project Amount (Rs.) Profitability Index 1 2 3 4 5 6 3,00,000 1,50,000 3,50,000 4,50,000 2,00,000 4,00,000 1.22 0.95 1.20 1.18 1.20 1.05
Which of the above investments should be undertaken? Assume that projects are indivisible and there is no alternative use of the money allocated for capital budgeting.
Problem No 12
Five Projects M, N, O, P and Q are available to a company for consideration. The investment required for each project and the cash flows it yields are tabulated below. Projects N and Q are mutually exclusive. Taking the cost of capital @ 10%, which combination of projects should be taken up for a total capital outlay not exceeding Rs.3 lakhs on the basis of NPV and Benefit-Cost Ratio (BCR)?
Project Investment Cash flow p.a. No. of years P.V. @ 10% M N O P Q 50,000 1,00,000 1,20,000 1,50,000 2,00,000 18,000 50,000 30,000 40,000 30,000 10 4 8 16 25 6.145 3.170 5.335 7.824 9.077 Problem No 13
A project analyst is allotted with Rs.7000 for independent capital investment projects. He had prepared certain computations for your perusal. The details are as follows:
Projects DISCCO DISCCI NPV Profitability Index Rank (PI) A 4000 4801 801 =4801 / 4000 → 1.20 2 B 5000 5600 600 1.12 4 C 2000 2377 377 1.19 3 D 1800 2274 474 1.26 1
You are asked to find out the best combination of projects on the following assumptions: a. Projects are divisible.
b. Projects are indivisible
Problem No 14
(1) Produce a new line of aluminum skillets
(2) Expand its existing cooker line to include several new sizes, and (3) Develop a new higher-quality line of cookers.
If only the project in question is undertaken the expected present values and the amounts of investment.
_____________________________________________ Project Investment Required Present value of Future cash flows ______________________________________________ 1 2, 00,000 2, 90,000
2 1, 15,000 1, 85,000 3 2, 70,000 4, 00,000 _____________________________________________
(i) If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and present values will simply be the sum of the parts.
(ii) With projects 1 and 3 economies are possible In investment because one of the machines acquired can be used in both production processes.
(iii) The total investment required for projects 1 and 3 combined is Rs.4,50,000;
(iv) If projects 2 and 3 are undertaken there are economies to be achieved in marketing and producing the projects but not in investment.
(v) The expected present value of future cash flows for projects 2 and 3 is Rs.6, 20,000. (vi) If all three projects are undertaken simultaneously, the economies noted will still
hold. However, an Rs.1,25,000 extensions on the plant will be necessary, as space is not available for all three projects.
Which project or projects should be chosen?
Problem No 15
Following are the cash flows for G Ltd: Year Cash flow (Rs) ---0 (1, ---0---0,---0---0---0) 1 30, 000 2 40, 000 3 50, 000 4 60, 000 ---Discount rate is 15%.
i. Find the modified IRR (MIRR)
ii. Compute NPV using Front end and Back end analysis
SS Engineering Ltd is considering including two pieces of equipment, a truck and for overhead pulley system, in this year’s capital budget. The projects are independent. The cash outlay for the truck is Rs.17, 100, and that for the pulley system is Rs.22, 430. The firm’s cost of capital is 14 percent. After-tax cash flows, including depreciation, are as follows:
_______________________________ Year Truck Pulley ________________________________ 1 Rs.5, 100 Rs.7, 500 2 Rs.5, 100 Rs.7, 500 3 Rs.5, 100 Rs.7, 500 4 Rs.5, 100 Rs.7, 500 5 Rs.5, 100 Rs.7, 500 _________________________________
Calculate the IRR, the NPV and the MIRR for each project, and indicate the correct accept / reject decision for each.
Problem No 17
Devaraj Ind. Ltd must choose between a gas-powered and an electric-powered fork-lift truck for moving material to its factory. Since both fork-lifts perform the same function the firm will choose only one. The electric powered truck will cost more, but it will be less expensive to operate. It will cost Rs.22, 000, whereas the gas-powered truck will cost Rs.17, 500. The cost of capital that applies to both investments is 12 percent. The life for each type of truck is estimated to be 6 years, during which time the net cash flows for the electric-powered truck will be Rs.6, 290 per year and those for the gas-powered truck will be Rs.5, 000 per year. Annual net cash flows include depreciation expenses.
Calculate the NPV and IRR for each type of truck, and decide which to recommend.
Problem No 18
Office Automation company Ltd is obliged to choose between two copies HP or Epson. HP costs less than Epson, but its economic life is shorter. The costs and maintenance expenses of these two copiers are given as follows. These cash flows are expressed in real terms.
Copier Year 0 Year 1 Year 2 Yea 3 Year 4 Year 5 HP Rs.700 Rs.100 Rs.100 Rs.100 --- Epson Rs.900 Rs.110 Rs.110 Rs.110 Rs.110 Rs.110
The inflation rate is 5% and the nominal discount rte is 14%. Assume that revenues are the same regardless of the copier, and that whichever copier the company chooses, it will buy the model forever. Which copier should the company choose? Ignore taxes and depreciation.
Problem No 19
Photolysis Ltd uses a 10% discount rate for project appraisal. It is considering purchasing a machine which, when it comes to the end of its economic life, is expected to be replaced by an identical machine and so on, continuously. The machine has a maximum life of three years but, as its productivity declines with age, it could be replaced after either just one of two years. The financial details are as follows (all figures in Rs.000).
Years 0 1 2 3 Outlay -1000 Revenues +900 +800 +700 Costs -400 -350 -350 Scrap value +650 +400 +150
What is the appropriate replacement cycle?
Problem No 20
To carry out identical tasks, a company uses several machines of the same type, but of varying ages. They have a maximum life of five years. Typical financial data for a machine are given below.
Time Now After After After After After Rs. 1 yr Rs. 2 yrs. Rs. 3 yrs. Rs. 4 yrs. Rs. 5 yrs. Rs. Initial cost 10, 000
Maintenance and service
Costs 1, 000 1, 500 2, 000 2, 500 3, 000 5, 000 Resale value if sold 7, 000 5, 000 3, 500 2, 500 2, 000 The rate of interest is 15%
These machines are assumed to produce flows of revenue which are constant. Required:
(a) Calculate the present values of keeping one machine for one, two, three, four or five years. (b) Convert these to annual equivalent annuities and find the most economical age at which to replace the machines.
Problem No 21
S Engineering Company is considering replacing or repairing a particular machine, which has just broken down. Last year this machine cost Rs.20,000 to run and maintain. These costs have been increasing in real terms in recent years with the age of the machine. A further useful life of 5 years is expected, if immediate repair of Rs.19,000 are carried out. If the machine is not repaired it can be sold-immediately to realize about Rs.5,000 (Ignore loss / gain on such disposal).
Alternatively, the company can buy a new machine for Rs.49, 000 with an expected life of 10 years with no salvage value after providing depreciation on straight line basis. In this case, running and maintenance costs will reduce to Rs.14, 000 each year and are not expected to increase much in real terms for a few years at least. S Engineering Company regards a normal return of 10% p.a. after tax as a minimum requirement on any new investment. Considering capital budgeting techniques, which alternatively will you choose? Take corporate tax rate of 50% and assume that depreciation on straight line basis will be accepted for tax purpose also.
A company is exploring the installation of a new polishing machine Details of the two machines under consideration are:
Machine A B
Initial Cost Rs.50, 000 Rs.90, 000 Life-Years 4 7 Salvage Value at the end of
Year 4 Rs.5, 000 ---Year 7 --- Rs.7, 000 Annual running costs Rs.10, 000 Rs.8, 000
Both machines fulfill the same function and have equal capacities. The appropriate discount rate is 10%. Taxation may be ignored.
(i) Determine which machine should be purchased.
(ii) To what amount would the initial cost of machine A be required to alter in order that the two machines were then of equal financial attractiveness?
Problem No 23
Excel operations Ltd. is proposing to replace its fully depreciated machine by a new one costing Rs.1.5 lacs. The current market value of the old machine is Rs.0.20 lacs. The salvage value after 6 years is zero. The salvage value of the new machine after 6 years is expected to be Rs.16, 000. With the use of the new machine, sales are expected to increase by Rs.20, 000 per annum and operating expenses to decrease by Rs.12, 000 per annum. If the company follows a 30% WDV depreciation policy, has a marginal cost of capital of 12% and attracts a marginal tax rate of 30%, should the company replace the old machine?
Problem No 24
Nine Gems Ltd. has just installed Machine R at a cost of Rs. 2,00,000. The machine has a five year life with no residual value. The annual volume of production is estimated at 1,50,000 units, which can be sold at Rs. 6 per unit. Annual operating costs are estimated at Rs. 2,00,000 (excluding depreciation) at this output level. Fixed costs are estimated at Rs. 3 per unit for the same level of production.
Nine Gems Ltd. has just come across another model called Machine S capable of giving the same output at an annual operating cost of Rs. 1,80,000 (exclusive of depreciation). There will be no change in fixed costs. Capital cost of this machine is Rs. 2,50,000 and the estimated life is for five years with nil residual value.
The company has an offer for sale of Machine R at Rs. 1,00,000. But the cost of dismantling and removal will amount to Rs. 30,000. As the company has not yet commenced operations, it wants to sell Machine – R and purchase Machine S.
Nine Gems Ltd. will be a zero-tax company for seven years in view of several incentives and allowances available.
The cost of capital may be assumed at 14%. P.V. factors for five years are as follows: Year P.V. Factors
1 0.877
2 0.769
3 0.675
4 0.592
5 0.519
(i) Advise whether the company should opt for the replacement.
(ii) Will there be any change, if Machine R has not been installed but the company is in the process of selecting one or the other machine?
Problem No 25
New Style Ltd is considering the replacement of one of its moulding machines. The existing machine is in good operating condition, but is smaller than required if the firm is to expand its operations. The old machine is 5 years old, and has remaining depreciable life of 10 years. The machine was originally purchased for Rs.1, 50,000 and is being depreciated at Rs.10, 000 per year for tax purposes.
The new machine will cost Rs.2, 20,000 or Rs.1, 70,000 if exchanged with the existing machine. It will be depreciated on a straight line basis for 10 years, with no salvage value. The management anticipates that, with the increased operations, there will be need for an additional net working capital of Rs.30, 000. The new machine will allow the company to expand current operations, thereby increasing annual revenue by Rs.60, 000 and variable operating costs from Rs.2, 00,000 to Rs.2, 20,000.
The company’s tax rate is 35% and its cost of capital is 10%.
Should the company replace its existing machine? Assume that the loss on exchange of existing machine can be claimed as short-term capital loss at Y0.
Problem No 26
A company is considering the possibility of manufacturing a particular component which at present is being bought from outside. The manufacture of the component would call for an investment of Rs.7, 50,000 in a new machine besides an additional investment of Rs.50, 000 in working capital. The life of the machine would be 10 years with a salvage value of Rs.50, 000. The estimated savings (after incremental depreciation but before tax) would be Rs.1, 80,000 per annum. The income tax rate is 50%. The company’s required rate of return is 10%. Depreciation is provided on straight-line system. Should the company make this investment? Working should part of your answer.
Problem No 27
A Cosmetic company is considering introducing a new lotion, which is useful both in winters and summers. The manufacturing equipment will cost Rs.5, 60,000. The expected life of the equipment is 8 years. The company is thinking of selling the lotion in a single standard pack of 50 grams at Rs.12 each pack. It is estimated that variable cost per pack would be Rs.6 and annual
fixed cost, Rs.4, 20,000. Fixed cost includes (straight-line) depreciation of Rs.70, 000 and allocated overheads of Rs.30, 000. The company expects to sell 1 lakh packs of lotion each year. Assume that the tax paid is 45% and straight-line depreciation is allowed for tax purposes. The opportunity cost of capital is 12%. Should the company manufacture the lotion?
Problem No 28
Cadbury choco has been studying an investment project calling for the manufacture and introduction of a new candy bar called Yuppie Nougat, targeted (you guessed it) for the yuppie market. As a consequence, Cadbury Choco expects to use the finest foreign chocolate and to price the candy very high relative to its cost; otherwise no self-respecting yuppie would even think of buying it. Part of the expenses will consist of a vast marketing program, complete with endorsements by yuppie heroes.
The project is expected to last eight years, after which time yuppies will be more interested in dentures than candy bars. The introduction of the candy bar requires 400 new machines costing Rs.10, 000 each. Installing each machine costs Rs.100. The machines will be depreciated on a straight-line basis over five years. The production facility will be located at a site the company already owns. The company could rent the space that the candy facility will occupy for Rs.500, 000 per year.
Cadbury choco expects to sell 2 million bars per year for the entire life of the project. The price will be Rs.2.50 per candy bar, with a production cost of Rs.0.50. The plan schedules the marketing expenses per candy bar at Rs.1.00. Outlets for the candy bar have been chosen with yuppies in mind. The firm expects to maintain an average inventory of about 500, 000 bars, and expects no other increase in working capital. The appropriate after-tax discount rate for Yuppie Nougat is 18 per cent.
Calculate NPV of the projects cash flows.
You may consider the following while doing your calculations:
(a) For tax purpose, depreciate the machine, including installation cost, using straight-line method.
(b) Estimate working capital in terms of production costs, and consider the amount as investment in the zero year.
(c) Assume salvage value equal to recovery of working capital. (d) Assume tax rate of 34 per cent.
Should Cadbury Choco help sweeten the world with Yuppie Nougat?
Problem No 29
Multiplex Limited is considering a capital investment for which the following detailed information is available:
(i) Cost of the project is estimated to be Rs.435 crores which includes: (a) Contingencies of Rs.30 crores;
(b) Margin money for working capital of Rs.10.5 crores;
(c) Interest during construction of Rs.31 crores and (d) capital issue expenses of Rs.13.5 crores.
