Revision Test Paper

Advanced Financial Management

June 2017
Question Paper

Q.1 You have been conducting a detailed review of an investment project proposed by one of
the divisions of your business. Your review has two aims: first to correct the proposal for any
errors of principle and second, to recommend a financial measure to replace payback as one of
the criteria for acceptability when a project is presented to the company’s board of directors
for approval. The company’s current weighted average cost of capital is 10% per annum.

The initial capital investment is for $150 million followed by $50 million one year later. The post
- tax cash flows, for this project, in $million, including the estimated tax benefit from capital
allowances for tax purposes, are as follows:

Year 0 1 2 3 4 5 6
Capital investment (plant and machinery):
First phase –127·50
Second phase –36·88
Project post-tax cash flow ($ millions) 44·00 68·00 60·00 35·00 20·00

Company tax is charged at 30% and is paid/recovered in the year in which the liability is
incurred. The company has sufficient profits elsewhere to fully utilize capital allowances on this
project. Capital investment is eligible for an initial capital allowance of 50% followed by writing
down allowances of 25% per annum on a reducing balance basis.

You notice the following points when conducting your review:

An interest charge of 8% per annum on a proposed $50 million loan has been included in the
project’s post-tax cash flow before tax has been calculated.

Depreciation for the use of company shared assets of $4 million per annum has been charged in
calculating the project post-tax cash flow.

Activity based allocations of company indirect costs of $8 million have been included in the
project’s post-tax cash flow. However, additional corporate infrastructure costs of $4 million
per annum have been ignored which you discover would only be incurred if the project
proceeds.

It is expected that the capital equipment will be written off and disposed of at the end of year
six. The proceeds of the sale of the capital equipment are expected to be $7 million which have
been included in the forecast of the project’s post-tax cash flow. You also notice that an
estimate for site clearance of $5 million has not been included nor any tax saving recognized on
the unclaimed writing down allowance on the disposal of the capital equipment.
Required:
(a) Prepare a corrected project evaluation using the net present value technique supported by a
separate assessment of the sensitivity of the project to a $1 million change in the initial capital
expenditure.
(b) Estimate the discounted payback period and the duration for this project.

Q.2 A sum of $400,000 is to be borrowed for 3 years and repaid in equal instalments. The risk-
free rate is 10% and all debt is assumed to be risk free. Calculate the present value of the tax re
lief on the debt interest if the corporation tax rate is 30%. Assume that tax is delayed 1 year.
Q.3
Inflation is currently 80% in Brazil, although the government hopes to reduce it each year by 25
% of the previous year’s rate. What will the inflation rate be in Brazil over the next four years?
Q.4
A project carried out by a US subsidiary of a UK company is due to earn revenues of $ 100m in
the US in year 2 with associated cost of $ 30m. Royalty payments of $10m will be made by the
US subsidiary to the UL. Assume tax is paid at 25% in the US and 33% in the UK; and assume a
forecast $/£ spot rate of $1.50 / £. What the cash flows associate with the project?.
Q.5
The following information has been taken from the income statement and statement of
financial position of A Co:
Revenue $350m
Production expenses $210m
Administrative expenses $24m
Tax allowable depreciation $31m
Capital investment in year $48m
Corporate debt $14m trading at 130%
Corporate tax is 30%
The WACC is 16.6%. Inflation is 6%.
These cash flows are expected to continue every year for the foreseeable future.
Required: Calculate the value of equity.
Q.6
A company has issued some 9% debentures, which are now redeemable at par in three years’
time. Investors now require a redemption yield of 10%. What will be the current market value
of each $100 of debenture?
Q.7
Mr. Kiran can earn a return of 16 % by investing in equity shares on his own. Now he is
considering a recently announced equity based mutual fund scheme in which initial expenses
are 5.7% and annual recurring expenses are 1.7 %. How much should the mutual fund earn to
provide Mr. Kiran a return of 16%?
Q.8
Das Ltd. an Indian company is evaluating an investment in Hong Kong. The project costs 300
Million Hong Kong Dollars. It is expected to generate an income of 100 Million HKDs a year in
real terms for the next 4 years (project duration). Expected inflation rate in Hong Kong is 6%
p.a. Interest rate in India is 7% p.a. while in Hong Kong it is 10% p.a. The risk premium for the
project is 6% in absolute terms, over the risk free rate. The project beta is 1.25. Spot Rate per
HKD is Rs. 5.75.
Evaluate the project in Rupees, if the investment in the project is out of retained earnings.
Q.9
Nelon Company a UK Company is considering undertaking a new project in Australia. The
project would require immediate capital expenditure of $10 Lakhs, plus $ 5 Lakhs of working
capital which would be recovered at the end of the project’s four year life. The net cash flows
expected to be generated from the project are $ 13 Lakhs before tax. Straight line depreciation
over the life of the project is an allowable expense against company tax in Australia, which is
charged at the rate of 50 % payable at each year without delay. The project will have zero scrap
value.
Nelon Company will not have to pay any UK tax on the project due to a double taxation
avoidance agreement. The $/ UKP spot rate is 2.0 and $ is expected to depreciate against the
UKP by 10 % per year. A similar risk, UK - based project would be expected to generate a
minimum return of 20 % after tax. Evaluate the Cash Flows of the Project in £ and $ and
Comment on the same.
Q.10

MP Limited has made plans for the next year 2014-15. It is estimated that the company will
employ total assets of Rs. 25,00,000; 30% of assets being financed by debt at an interest cost of
9% p.a. the direct costs for the year are estimated at Rs. 15,00,000 and all other operating
expenses are estimated at Rs. 2,40,000. The sales revenue are estimated at Rs. 22,50,000. Tax
rate is assumed to be 40%. Required to calculate:
(i) Net profit margin
(ii) Return on assets
(iii) Asset turnover
(iv) Return on equity

Q.11
X Ltd has 8 lakhs equity shares outstanding at the beginning of the year 2012. The current
market price per share is Rs. 120. The board of directors of the company is contemplating Rs.
6.4 per share as dividend. The rate of capitalization, appropriate to the risk-class to which the
company belongs, is 9.6%.
I. Based on MM approach, calculate the market price of the shares of the company, when
the dividend is (a) declared and (b) not declared.
II. How many new shares are to be issued by the company, if the company desires to fund
an investment budget of Rs. 3.20 crores by the end of the year assuming net income for
the year will be Rs. 1.60 crores.

Q.12
NSE 5000
Value of Portfolio Rs, 10,10,000
Risk free interest rate 9% p.a
Dividend yield on index 6% p.a
Beta of portfolio 1.5
We assume that a future contract on the NSE index with four months maturity is used to hedge
the value of portfolio over next three months. One future contract is for delivery of 50 times
the index.
Based on above information calculate:
(i) Price of future contract
(ii) The gain on short futures position if index turns out to be 4,500 in three months.
(iii) Value of portfolio using CAPM

Q. 13
Hanky Ltd., and Shanky Ltd., operate in the same field, manufacturing newly born babies cloths.
Although Shanky Ltd., also has interest in communication equipment’s Hanky is planning to
take over Shanky Ltd., and the shareholders of Shanky Ltd., do not regard it as a hostile bid.
The following information is available about the two companies:
Particulars Hanky Ltd Shanky Ltd
Current Earning Rs. 6,50,00,000 Rs. 2,40,00,000
Number of Shares 50,00,000 15,00,000
Percentage of retained earnings 20% 80%
Return on new investment 15% 15%
Return required by equity shareholders 21% 24%

Dividends have just been paid and the retained earnings have already been reinvested in the
new projects. Hanky Ltd., plans to adopt a policy of retaining 35% of earnings after the takeover
and expects to achieve a 17% return on new investments.
Saving due to economies of scale are expected to be Rs. 85,00,000 per annum.
Required return to equity shareholders will fall to 20% due to portfolio effects.
Requirements:
a) Calculate the existing share prices of both the companies.
b) Find the value of Hanky Ltd., after the takeover;
c) Advise Hanky Ltd., on the maximum amount it should pay to Shanky Ltd.

Q.14
A unit trust wants to hedge its portfolios of shares worth Rs. 10 million using the BSE-SENSEX
index futures. The contract size is 100 times the index. The index is currently quoted at 6,840.
The beta of the portfolio is 0.8. The beta of the index may be taken as 1. What is the number of
contracts to be traded?
Q.15
Aggressive Leasing Company is considering a proposal to lease out a tourist bus. The bus can be
purchased for Rs. 5,00,000 and, in turn, be leased out at Rs. 1,25,000 per year for 8 years with
payments occurring at the end of each year :
(i) Estimate the internal rate of return for the company assuming tax is ignored.
(ii) What should be the yearly lease payment charged by the company in order to earn 20%
annual compound rate of return before expenses and taxes?
(iii) Calculate the annual lease rent to be charged so as to amount to 20% after tax annual
compound rate of return, based on the following assumptions:
 Tax rate is 40%
 Straight line depreciation
 Annual expenses of Rs. 50,000 and
 Resale value Rs. 1,00,000 after the turn.

Q. 16
A company is considering investing $4.5m in a project to achieve an annual increase in revenues
over the next five years of $2m.The project will lead to an increase in wage costs of $0.4m pa
and will also require expenditure of $0.3m pa to maintain the level of existing assets to be used
on the project. Additional investment in working capital equivalent to 10% of the increase in
revenue will need to be in place at the start of each year.
The following forecasts are made of the rates of inflation each year for the next five years:
Revenues 10%
Wages 5%
Assets 7%
General prices 6.5%
The real cost of capital of the company is 8%.
All cash flows are in real terms. Ignore tax.

Find the free cash flows of the project and determine whether it is worthwhile.
Q.17
The finance director of Kulpar Co is concerned about the impact of capital structure on the
company’s value, and wishes to investigate the effect of different capital structures. He is
aware that as gearing increases the required return on equity will also increase, and the
company’s interest cover is likely to decrease. A decrease in interest cover could lead to a
change in the company’s credit rating by the leading rating agencies. He has been informed that
the following changes are likely:

Interest cover Credit rating Cost of long term debt

More than 6·5 AA 8·0%
4·0 – 6·5 A 9·0%
1·5 – 4·0 BB 11·0%
The company is currently rated A.

Summarized financial data:

$ million
Net operating income 110
Depreciation 20
Earnings before interest and tax 90
Interest 22
Taxable income 68
Tax (30%) 20·4
Net income 47·6
Capital spending 20

Market value of equity is $458 million, and of debt $305 million.

Kulpar’s equity beta is 1·4. The beta of debt may be assumed to be zero.
The risk free rate is 5·5% and the market return 14%.
The company’s growth rate of cash flow may be assumed to be constant, and to be unaffected
by any change in capital structure.
Determine the likely effect on the company’s cost of capital and corporate value if the
company’s capital structure was:
(i) 80% equity, 20% debt by market values;
(ii) 40% equity, 60% debt by market values.
Recommend which capital structure should be selected.

Q.18 Discuss on
1. Unsystematic Risk
 2. A high EPS may not always maximize the stock price. Do you agree?
3. Leveraged lease
4. Bonus debentures

Revision Test Paper

Advanced Financial Management
June 2017
Answer Sheet

Ans.1
(a) The adjusted project cash flow and net present value calculation for this project are:
0 1 2 3 4 5 6
Project after tax
Cash flow –127·50 –36·88 44·00 68·00 60·00 35·00 20·00
Add back net interest 2·80 2·80 2·80 2·80 2·80
Add back depreciation (net of tax) 2·80 2·80 2·80 2·80 2·80
Add back ABC charge (net of tax) 5·60 5·60 5·60 5·60 5·60
Less corporate infrastructure costs –2·80 –2·80 –2·80 –2·80 –2·80
Estimate for site clearance –3·50
Tax benefit of unrecovered balancing allowances 3·68
______________________________________________________________________________
Adjusted cash flow –127·50 –36·88 52·40 76·40 68·40 43·40 28·58
____________________________________________________________________________
Discount factor 1·0000 0·9091 0·8264 0·7513 0·6830 0·6209 0·5645
Discounted cash flow at 10% –127·50 –33·52 43·31 57·40 46·72 26·95 16·14
Net present value 29·48

Sensitivity to a $1 million increase in CAPEX at year 0

0 1 2 3 4 5 6
Equipment purchase/written down value 1 0·50 0·37 0·28 0·21 0·16 0·12
FYA –0·5
WDA –0·13 –0·09 –0·07 –0·05 –0·04 –0·03
______________________________________________________________________________
Balance 0·5 0·37 0·28 0·21 0·16 0·12 0·09
______________________________________________________________________________
Impact upon CAPEX –1
Tax saving due to WDA and FYA 0·15 0·039 0·028 0·021 0·015 0·012 0·009
Unrecovered allowance 0·027
______________________________________________________________________________
Net impact –0·85 0·039 0·028 0·021 0·015 0·012 0·036
______________________________________________________________________________
Discount factor 1·0000 0·9091 0·8264 0·7513 0·6830 0·6209 0·5645
Discounted cash flow –0·85 0·0355 0·0223 0·0158 0·0102 0·00750·0203
Net present value –0·63

Thus an increase in CAPEX by $1 million results in a loss of NPV of $0·63 million due to the
benefit of the capital allowances available discounted over the life of the project.

(b) Discounted payback and duration

0 1 2 3 4 5 6
Discounted cash flows from project –127·50 –33·52 43·31 57·40 46·72 26·95 16·14
Cumulative discounted cash flow –127·50 –161·02–117·72–60·32–13·60 13·35 29·48
Payback (discounted) 4·50

The duration of a project is the average number of years required to recover the present value
of the project.
Duration 0 1 2 3 4 5 6
Discounted cash flow at 10% 43·31 57·40 46·72 26·95 16·14
Present value of return phase 190·52
Proportion of present value in each year 0·2273 0·3013 0·2452 0·1415 0·0847
Weighted years 0·4546 0·9039 0·9809 0·7073 0·5082
Duration (= sum of the weighted years) = 3·55 years.

Ans.2

Equal annual repayment = 400,000 / 3yr AF@10% = 400,000/2.487 = $160,836

Year Opening Balance Interest @ 10% Repayment
Closing Balance
1 400,000 40,000 160,836 279,164
2 279,164 27,916 160,836 146,244
3 146,244 14,624 160,836 32 (Rounding
diff.)

Year Interest cost Tax relief @30% Timing of tax 10% DCF PV
1 40,000 12,000 Year 2 0.826 9,912
2 27,916 8,375 Year 3 0.751 6,290
3 14,624 4,387 Year 4 0.683 2,932
PV of tax relief = $19,134

Ans.3

Year 1 80% × 0.75 = 60%

Year 2 60% × 0.75 = 45%
Year 3 45% × 0.75 = 34%
Year 4 34% × 0.75 = 26%

Ans.4
Year2 $m
Revenues 100
Costs -30
Royalties -10
Pre-tax Profit 60
25% US Tax -15
Remit to Parent@ spot rate $/£ = 1.5 45/1.5 = £30

Cash Flow in £
Profit 30
Royalties =$ 10 / 1.5 6.7
UK tax (working-1) -5.4
After tax cash flow £31.3m

Working - 1
UK tax computation
UK tax on $ profits = 33% - 25% = 8%
8% UK tax on $ profits: $60m ÷ 1.50 £40m
£40m × 0.08 = £3.2m
33% UK tax on royalties: £6.7m × 0.33 = £2.2m
UK tax payable £5.4m

Ans.5

Operating profits = $(350m – 210m – 24m) = $116m

Tax on operating profits = $116m x 30% = $34.8m
Allowable depreciation = $31m (assumed not included in production or administration
expenses)
Tax relief on depreciation = $31m x 30% = $9.3m
Therefore net cash flow = 116m – 34.8m + 9.3m – 48m = $42.5m
The real discount rate is: 1.166 / 1.06 = 10%
The corporate value is = $42.5m / 10% = $425m
Equity = $425m – $(14m x 1.3) = $406.8m
Note: because the cash flow is a perpetuity real cash flow and the real discount rate were used.

Ans.6
Year Cash flow ($) DF at 10% PV ($)
1 Interest 9 0.909 8.18
2 Interest 9 0.826 7.43
3 Interest 9 0.751 6.76
3 Redemption value 100 0.751 75.10
97.47
Each $100 of debenture will have a market value of $97.47.
Ans.7
Let the Return on Mutual Funds be X
Returns from Mutual Fund = (Investors Expectation / 100-Issue Expenses) + Annual Recurring
Expenses
Or X = 16 / (100-5.7)% + 1.7= 16.96 + 1.70 = 18.66 %
Ans.8
1. Inflation Adjusted Cash Flows (in HKD Millions)
Year Real Cash Flow Inflation Factor Adjusted Cash Flows
1 100 1.0600 106.00
2 100 1.0600 x 1.06 = 1.1236 112.36
3 100 1.1236 x 1.06 = 1.1910 119.10
4 100 1.1910 x 1.06 = 1.2625 126.25
 2. Expected Future Spot Rates (under Interest Rate Parity Theory)
Future Spot Rate =Opening Spot Rate = 1+Home Currency Rate / 1+ Foreign Currency Rate
Year Opening Spot Rate (Rs. / HKD) Closing Spot Rate
1 5.750 Rs. 5.750 x (1 + 0.07) / (1 + 0.10) = Rs. 5.593
2 5.593 Rs. 5.593 x (1 + 0.07)/ (1 + 0.10) = Rs. 5.441
3 5.441 Rs. 5.441 x (1 + 0.07) / (1 + 0.10) = Rs. 5.292
4 5.292 Rs. 5.292 x (1 + 0.07) / (1 + 0.10) = Rs. 5.148

3. Evaluation of Project (Rs. Millions)

Year Cash Flow Conversion Cash Flow Rs. PV Factor @ Discounted

(HKD) Rate Rs. 14.50% Cash Flow Rs.
0 -300.00 5.750 -1725.000 1.000 -1725.000
1 106.00 5.593 592.858 0.873 517.565
2 112.36 5.441 611.351 0.763 466.461
3 119.10 5.292 630.277 0.666 419.764
4 126.25 5.148 649.935 0.582 378.262
Net Present Value 57.052

Note: Discount Rate = Risk Free Rate + Project Beta x Risk Premium
7% -f 1.25 x 6% = 7% + 7.5% = 14.50%
Conclusion: Since the NPV is positive, investment in Hone Kong can be proceeded with.
Ans.9
1. Computation of NPV
Amount in Lakh
Year CFAT in Exchange Rate Net CFAT £ Disc. Factor@ 20% DCFAT £
$
1 7.75 2.00+10%= 2.20 3.52 0.8333 2.9332
2 7.75 2.20+10%= 2.42 3.20 0.6944 2.2221
3 7.75 2.42+10%= 2.66 2.91 0.5787 1.6840
4 12.75 2.66+10%= 2.93 4.35 0.4823 2.0980
Total DCFAT 8.9373
Less: Initial Investment ($ 15 / 2.00) = £ 7.5 7.5000
Net Present Value 1.4373
 2. Cash flow for the project lifespan of years 1 to 3

Particulars Amount in
$ Lakhs
Contribution 13.00
Less: Depreciation 10.50 / 4 years -2.50
Profit before tax 10.50
Less: Tax at 50% -5.25
Profit after tax 5.25
Cash Flow after tax (PAT + Dep.) 7.75
Cash Flow during year 4
Cash Flow after tax 7.75
Add: Repayment of working capital 5.00
Total Cash Flow in Year 5 12.75

3. Using Interest Rate Parity Method

Forward Rate = Spot Rate X (1+Annual Discount Rate in Australia) ÷ (1+Annual Discount
Rate-in UK)
2.20 = 2.00 x (1 +20%)/ (1 + Annual Interest Rate in UK) Annual Interest Rate in UK =
2.20 X 1.20 ÷ 2.00 = 32%

Year CFAT in Disc. Factor@ 32% DCFAT £

$
1 7.75 0.7576 5.8714
2 7.75 0.5740 4.4585
3 7.75 0.4348 3.3697
4 12.75 0.3294 4.1999
Total DCFAT 17.8995
Less: Initial Investment -15.0000
Net Present Value 2.8995
NPV in £ ($ 2.8995 / 2) 1.44975
Conclusion: Since NPV is approximately same. Interest Rate Parity Theory holds true.
Ans.10
The net profit is calculated as follows:

Particulars Rs.
Sales Revenue 22,50,000
Less: Direct Costs 15,00,000
Gross Profits 7,50,000
Less: Operating Expense 2,40,000
EBIT 5,10,000
 Less: Interest (9% × 7,50,000) 67,500
EBT 4,42,500
Less: Taxes (@ 40%) 1,77,000
PAT 2,65,500

i. Net Profit Margin =

Rs. 5,10,000 X (1-0.4)/ Rs. 22,50,000 = 13.6%

ii. Return on Assets (ROA) =

Rs. 5,10,000 X (1-0.4) / Rs. 25,00,000 = Rs. 3,06,000 / Rs. 25,00,000 = 0.1224 0r
12.24%

iii. Asset Turnover =

Rs. 22,50,000 / Rs. 25,00,000 = 0.9

iv. Return on Equity =

Rs. 2,65,500 / Rs. 17,50,000 = 15.17%

Ans.11
MM – Divided Irrelevancy Model: Po = Pi + Di / 1 + Ke

Po = Existing market price per share = Rs. 120

Pi = Market price of the share at the year end
Di = Contemplated dividend per share = Rs. 6.40
Ke = Capitalization rate = 9.6%

(i) (a) Calculation of share price when dividend is declared

Rs.120 = Pi + 6.4 / 1 + 0.096

Rs. 120 X 1.096 = Pi + 6.4
Pi = 120 X 1.096 - 6.4 = Rs. 125. 12

(b) Calculation of share price when dividend is not declared

Rs.120 = Pi + 0 / 1 + 0.096
Rs. 120 X 1.096 = Pi + 0
Pi = 120 X 1.096 = Rs. 131.52

(ii) Calculation of No. of shares to be issued:

Rs. Lakhs
Particulars If dividend If dividend is
is declared not declared
Net Income 160.00 160.00
 Less: Dividend Paid 51.20 _
Retained Earning 108.80 160.00
Investment Budget 320.00 320.00
Amount to be raised by issuing new shares 211.20 160.00
Market price per share 125.12 131.52
No. of new shares to be issued 168,797.95 121,654.50
Or Say 168,798 121,655

Ans.12
(i) Current future price of the index = 5000 +5000 (0.09 – 0.06) X 4/12 = 5050
Price of the future contract = Rs. 50 X 5050 = Rs. 2,52,500

(ii) Hedge ratio = (10,10,000 / 2,52,500) X 1.5 = 6 months

Index after 3 months turns out to be 4500
Future price will be =4500 +4500 (0.09 – 0.06) X 1/12 = 4,521.25
Therefore, gain from the short future position is =
6 X (5050-4521.25) x 50 = Rs. 1,61,625

(iii) To use CAPM we require risk-free rate of return, beta of portfolio and market
return. Since, risk free rate of return and beta of portfolio is given first we shall
calculate market return as under:
Change in index value = 4500-5000= -500
Return from index = (-500 / 5000)X 100 = -10% for 3 months.
Dividend yield on index p.a = 6% and for 3 months shall be 1.5%
Thus return to investor for investment in index for 3 months = -10% + 1.5% = -
8.5%
Now we can use CAPM to compute the expected return for three months :

Expected Return = 2.25% + 1.50 (-8.5% -2.25%)

= 2.25% + 1.50 ( -10.75%)
= -13.875%
The expected value of portfolio (without hedging) after 3 months shall be =
Rs, 10,10,000 { 1 + (-0.13875)} = Rs. 8,69,862.25
The expected value of portfolio with hedging after 3 months shall be =
Rs. 8,69,862.25 + Rs. 1,61,625 = 10,31,487.25

Ans.13
(a) Existing share price of Hanky Ltd
‘g = r X b
 ‘r = 15%
‘b = 20%
‘g = 0.15 X 0.20% = 0.03
Ex-Dividend Market Value = Next year’s dividend / Ke –g
= Rs. 6,50,00,000 X 0.8 X 1.03 / 0.21 – 0.03 = Rs. 29,75,55,556
Or Value per share = Rs. 29,75,55,556 / 50,00,000 = Rs. 59.51 per share
Existing share price of Shanky Ltd
‘r = 15%
‘b = 8%
‘g = 0.15 X 0.8% = 0.12
Ex-Dividend Market Value = Next year’s dividend / Ke –g
= Rs. 2,40,00,000 X 0.2 X 1.12 / 0.24 – 0.12 = Rs. 4,48,00,000
Or Value per share = Rs. 4,48,00,000 / 15,00,000 = Rs. 29.87 per share
(a) Value of Hanky Ltd., after takeover
Growth rate for combined firm g = 0.17 X 0.35 = 0.0595
New cost of equity = 20%
Next year’s earning = Rs. 6,50,00,000 X 1.03 + Rs. 2,40,00,000 X 1.12 + Rs. 85,00,000 =
Rs. 10,23,30,000
Next Year’s dividend = Rs. 10,23,30,000 X 0.65 = Rs. 6,65,14,500
Market Value = Rs. 6,65,14,500 / 0.20 – 0.0595 = Rs. 47,34,12,811
© Maximum Hanky Ltd., should pay for Hanky Ltd.
Combined Market Value Rs. 47,34,12,811
Present Value of Hanky Ltd Rs. 29,75,55,556

Rs. 17,58,57,255

Ans. 14
Beta of Portfolio = β1 = 0.8
Beta of Index = βN = 1
Value per Futures Contract = VF = Rs. 6,840 X 100 = Rs. 6.84 Lakhs
Value of the Portfolio = VP = Rs. 100 Lakhs
Hedge Ratio = Beta of the Portfolio ÷ Beta of the Index = 0.8 ÷ 1 = 0.8
No. of Futures Contract to be traded: =
Rs. 100 Lakhs x [0.8 ÷ Rs. 6.84 Lakhs] = 11.70 i.e. 12 Contracts

Ans. 15
(i) Payback period = 5,00,000 / 1,25,000 = 4 years
PV factor close to 4,000 in 8 years is 4.0776 at 18%
Therefore, IRR = 18% (approx.)
We can arrive at 18.63% instead of 18% if exact calculations are made as follows:
PV factor in 8 years at 19% is 3.9544
By interpolating, we can get
IRR = 18% + (4.0776 – 4.000) / (1.0776 -3.9544) X 1% = 18.63%

(ii) Desired lease rent to earn 20% IRR before expenses and taxes
Present value of inflow annually for 8 years @ 20% = 3.837
Lease Rent = Rs. 5,00,000/ 3.837 = 1,30,310 p.a

(iii) Revised lease rental on tourist bus to earn 20% return based on the given conditions
PV factor [( X – Expenses – Depreciation) ( 1 – T) + D] + (PV factor x Salvage value) =
3.837 [(X – 50,000 – 50,000) (1 – 0.4) + 50,000] + (0.233 x 1,00,000) = 5,00,000
3.837 [0.6 x – 60,000 + 50,000] + 23,000 = 5,00,000
2.3022 x = 5,15,070
X = 2,23,730

Ans.16
$000
T0 T1 T2 T3 T4 T5
Increased revenues
(infl. @10%) 2,200 2,420 2,662 2,928 3,221
Increased wage costs
(infl. @5%) (420) (441) (463) (486) (510)
Operating cash flows 1,780 1,979 2,199 2,442 2,711
New investment (4,500)
Asset replacement spending
(infl. @7%) (321) (343) (367) (393) (421)
Working capital injection (W1) (220) (22) (24) (27) (29) (322)
Free cash flows (4,720) 1,437 1,612 1,805 2,020 2,612
PV factor @15% (W2) 1.000 0.870 0.756 0.658 0.572 0.497
PV of free cash flows (4,720) 1,250 1,219 1,187 1,155 1,298
Since, the NPV = $1,389,000 which suggests that the project is worthwhile.
W1- Working Capital Injection

T0 T1 T2 T3 T4 T5
Increased revenues 2,200 2,420 2,662 2,928 3,221
Working capital required 220 242 266 293 322
10% in advance
Working capital injection (220) (22) (24) (27) (29) 322
W2- Cost of Capital
(1 + i) = (1 + r) (1 + h) = (1.08) (1.065) = 1.15, giving i = 15%

Ans. 17
Impact of capital structure on cost of capital and corporate value
The company’s existing gearing is $458 million equity to $305 million debt, or 60% equity, 40%
debt. A change in gearing will result in a change in the equity beta.

Assuming the beta of debt is zero, the equity beta with no gearing may be estimated by:

1·4 × 60 / (40 + 60) X (1 - 0·3) = 0·9545

If gearing was 80% equity, 20% debt by market values, the “ungeared” beta may be “regeared”
to find the new equity beta.
0.9545 X ((80 + 20) X (1-0.3))/80 = 1.122
Using CAPM = 5.5 % + 1.122 (14%-5.5%) = 15.04%

If gearing was 40% equity, 60% debt by market values, this may be “regeared” to find the new
equity beta
0.9545 X ((40 + 60) X (1-0.3))/40 = 1.957
Using CAPM = 5.5 % + 1.957 (14%-5.5%) = 22.13%

The cost of debt depends on interest cover and the credit rating.
80%E, 20%D 40%E, 60%D
Net operating income 110 110
Depreciation 20 20
Earnings before interest and tax 90 90
Interest 12·21 50·36
Interest cover 7·37 1·79
Cost of debt 8·0% 11·0%
The interest payable is found by examining different interest rate and interest cover
possibilities.

80% equity 20% debt must fall into the AA rating (if the interest rate was 9%, interest would be
$13·73 million and cover 6·55, still AA cover).

40% equity, 60% debt must fall into the BB rating (interest of 9% would be $41·20 million, and
cover 2·18 still in the BB rating).
WACC at 80% equity, 20% debt = 15·04% × 0·80 + 8·0% (1 – 0·3) 0·20 = 13·15%

WACC at 40% equity, 60% debt = 22·13% × 0·40 + 11·0% (1 – 0·3) 0·60 = 13·47%

Existing cost of equity is: 5·5% + (14% – 5·5%) 1·4 = 17·4%

Existing WACC is 17·4% × 0·60 + 9% (1 – 0·3) 0·40 = 12·96%

The two alternative capital structures are expected to increase the cost of capital from its
current level.

Corporate value

Using the suggested equation, company cash flow = 90 (1 – 0·3) + 20 – 20 = 63

The growth rate is unknown. However, existing corporate value, company cash flow and
weighted average cost of capital are known, allowing the growth rate to be estimated.
763 = (63 X (1+g)) / 0.1296g = 0.043 0r 4.3%
Assuming this growth rate remains unchanged corporate value with different gearing levels is
estimated to be

80% equity, 20% debt = 63 X (1 + 0·043) / (0·1315- 0·043) = $742m

40% equity, 60% debt = 63 X (1 + 0·043) / (0·1347- 0·043) = $717m
Altering the capital structure to either of the two suggested levels is expected to reduce
corporate value from its current level of $763 million. It is recommended that the capital
structure is kept at its current level of 60% equity, 40% debt.

Q.18 Discuss on
1. Unsystematic Risk
2. A high EPS may not always maximize the stock price. Do you agree?
3. Leveraged lease
4. Bonus debentures

Ans. 18
(1) Unsystematic Risk: These are risks that emanate from known and controllable factors,
which are unique and / or related to a particular security or industry. These risks can be
eliminated by diversification of portfolio.

Business Risk: It is the volatility in revenues and profits of particular Company due to its
market conditions, product mix, competition, etc. It may arise due to external reasons
or (Government policies specific to that kind of industry) internal reasons (labor
efficiency, management, etc.)
 Financial Risk (RTP): These are risks that are associated with the Capital Structure of a
Company. A Company with no Debt Financing, has no financial risk. Higher the Financial
Leverage, higher the Financial Risk. These may also arise due to short term liquidity
problems, shortage in working capital due to funds tied in working capital and
receivables, etc.

Default Risk: These arise due to default in meeting the financial obligations on time.
Non-payment of financial dues on time increases the insolvency and bankruptcy costs.

(2) The statement is true due to the following reasons:

EPS may be high due to profit maximization, which itself is not a sure shot for a high
stock price.
High EPS may be due to financial leverage effect, which increase a firm’s risk prospects
of growth rate.
If the business prospects of a company are not good the stock price may not go up in
spite of high EPS.
The nature of business and the industry in which the company operates also affects the
stock price and not the EPS alone.

(3) It is special form of leasing. In this form, lessor borrowed the majority of funds required
to purchase the leased property from a bank or other lender. Thus, in case of leverage
lease there are three parties to the lease transaction-the lessee, the lessor and the
lender. These types of leases are popular in financing of assets which require larger
capital outlays. From the lessee’s point of view, however there is no difference between
a leveraged lease and a non-leveraged lease except that in the case of the former, the
lessee may be required to guarantee the debt incurred by the lessor. The loan is usually
secured by a mortgage on the asset, as well as by the assignment of the lease and the
lease payments. As owner of the asset, the lessor is entitled to deduct all depreciation
charges associated with the leased asset and residual value, if any, at the end of the
lease period.

(4) The issue bonus debentures, the company capitalizes its retained earnings into
debentures. Bonus debentures are like Bonus Shares. There are a number of benefits to
the issuing company, namely:
 The following stock of shares in the market does not increase.
 Company gets tax advantage on interest payments on debentures.

 These are issued when the issuing company anticipates that in the coming years, the
company will have cash balances and the same would not been needed for financing.
The expected return on internal retention would be lower than market return. In such
circumstances cash outflows in redeeming the debentures would not affect the
company’s liquidity position.
 The cost of debt Capital (Kd) would be lower than cost of equity (Ke).