TIME VALUE OF MONEY1. Find Out the future value if Mr. X deposits today Rs. 20,000 for 5 years @ interest rate 8% and the compounding is done annually.2. Find out the number of years if Mr. Y deposits Rs. 30,000 today expecting the future value to be Rs. 2,01,825 with an interest rate @ 10% compounding annually.3. At what % of interest rate compounded annually, principal amount of Rs. 20,000 becomes Rs. 30,772 in 5 years?4. Mr. Bond is investing today a sum Rs. 20,000 for the 5 years period with an interest rate of 10% find out the future value at the end of the 5th year under the following each situation;(a) If compounding is done monthly,(b) If compounding is done quarterly,(c) If compounding is done half yearly (semi annually).5. Find out the future value at the end of the 5th year if Kushal deposits Rs. 25,000 p.a. for the next five years starting from the end of the next year at an interest rate of 10% compounded annually.6. Mr. A starts to deposit 10 annal installment each of Rs. 30,000 from the 4th year end. The rate of interest is 9% compounded annually. Find out the future value at the end of the year 13th and 15th 7. Darshan starts to deposit Rs. 10,000 p.a. for the next 3 year, Rs. 12,000 p.a. from 4th year to 7th year. Find out the future value assuming the interest rate being 11.5% compound annually.8. Mr. X expecting to receive Rs. 5,00,000 at the end of the 5th year from now with an interest rate of 8% compounded annually, how much should he invest today to receive above sum?9. If Murli pays Rs. 10,000 p.a. for 10 years from now to payoff the loan amount, what would be the loan amount if interest rate is 11% p.a. compounded annually?10. If A pays Rs. 10,000 p.a. for 10 years from now to payoff the loan amount which is Rs. 58,892. Find out the compounded interest rate.11. A has invested into a project a sum of Rs. 41,088 today for which he is expecting to have the future cash infloes as under:Rs. 6,000 p.a. for the next 5 years, Rs. 8,000 p.a. from the 6th year to the 9th year, Rs. 9,000 p.a. from the 10th year to the 12th year. Find out the interest rate compounded annually.12. Mr. Dinanath deposit Rs.15,000 p.a. from the end of the 5th year for 5 years with an interest rate of 9% compounded annually. Find out the Present value as on today.13. Mr. Y deposits 10 annual installment each of Rs. 10,000 from the end of the 5th year. Find out the present value at the beginning of the 4th year and also as on today. Rate of interest is 11% compounded annually.14. Diya starts to deposit Rs. 20,000 p.a. for the next 4 years, Rs. 25,000 p.a. from the 5th year to the 9th year. Find out the present value assuming the interest rate being 9% compounded annually.15. An investor is likely to retire at the end of the 15th year. In order to receive Rs. 1,50,000 annually for 10 years after the date of retirement, how much amount should he have at the time of retirement? Interest rate is 10% compounded annually.16. An investor is likely to retire at the end of the 15th year. In order to receive Rs. 1,50,000 annually for 10 years after the date of retirement, how much amount should he save annually for 15 years till the date of retirement? Interest rate is 10% compounded annually.17. Y starts to deposit Rs. 10,000 per annum from today onwords and he would like to continue the same upto 15th year. Calculate the future value and also the present value of the sum invested if interest is 10% compounded annually.18. A company offeres a fixed deposit scheme whereby Rs. 20,000 matures to Rs. 28,858 after 3 years, on a yearly compounding basis. If the company wishes to amend he scheme by compounding interest every quarter what will be the revised maturity value?19. A person opened an account on April 1st 2010 with a deposit of Rs. 8000. The bank paid 9% interest compounded quarterly. On October 1st 2010, he closed the account and added enough money to invest in a 6-month Time Deposit for Rs. 10,000 earning 9% compounded monthly.(a) How much additional amount did the person invest on October 1st ?(b) What was the maturity value of this time deposit on April 1st 2011?(c) How much total interest was earned?20. If Rs. 5,000 is invested at the end of each month having 9% interest rate compounded monthly what would be the future value at the end of 10th payment or 10th month?21. Mr. B plans to receive an annuity of Rs. 10,000 semi-annually for 0 years after he retires in 18 years. Money is worth 9% compounded semi-annually.(a) How much amount is required to finance the annuity?(b) What amount of single deposit made now would provide the funds for the annuity?(c) How much will Mr. B receive from the annuity?22. Mr. A has retired recently. He received Rs. 5,00,000 as his retirement benefit from the company, which he invested in a bank at 15% p.a. interest rate. He expect to live independently for another 15 years. How much amount he can withdraw at the end of each year, so as to leave nil balance in his account at the time of maturity?23. A person deposit a fixed sum in a bank at the begginning of every year up to 5th yar. Maturity amount at the end of 5th year would be equal to Rs. 10,00,000. The interest rate is 12% p.a. Calculate the amount of investment for each year to get Rs. 10,00,000.24. Mr. X has made investment in real estate for Rs. 12,000 which he expects will have a maturity value equivalent to interest at 12% compounded monthly for 5 years. If most savings institutions currently pay 8% compounded quaterly on 5 years term, what is the least amount for which Mr. X should sell his property?25. Mr. A wants to retire and receive Rs. 3,00,000 p.a. till death. He can earn an interest of 9% compounded annually. How much will he needed to set aside to achieve his perpetuity goal?

COST OF CAPITALCost of Capital:The main object of the business is to maximize the wealth of shareholder in the long run; the management should only invest in projects, which give a return in excess of cost of funds invested in the business. The various sources of funds to the company are in the form of equity and debt.Cost of the Equity:Cost is an important consideration in capital structure decisions. The funds required for the project are raised from the Equity shareholders, which are of permanent nature. These funds need not to be repayable during the life time of the organization. The main objective of the firm is to maximize the wealth of the shareholders. Equity share capital is the risk capital of the company. If the companys business is doing well the ultimate beneficiaries are the equity shareholders who will get the return in the form of dividends from the company and the capital appreciation for their investment. If company comes for liquidation, the ultimate sufferers are the equity shareholders. Sometimes they may not get their investment back during the liquidation process. Profit after tax less dividends paid out to the shareholders which have been reinvested in the company therefore those retained funds should be invested in the category of equity. Thus, Cost of equity may be defined as the minimum rate of return that a company must earn on the equity financed portion of an investment project so that market price of the shares remains unchanged. Following Methods are used in calculation of Cost of equity:

1. Dividend Price Method:The dividend yield per share is expected on the Current market price per share. The company is expected to earn at least this yield to keep the shareholders content. The main drawback with this method, as it does not allow for any growth rate. This approach has no relevance to the company.l. Earning Price Method:2. Dividend Price + growth Method:In this Method, an allowance for future growth in dividend is added to the current dividend yield. It is recognized that the current market price of share reflects expected future dividend. Which approach to use: In the case of companies with stable income and with stable dividend policies, the D/P approach may be good way of measuring the cost of ordinary share capitalIn the case of companies whose earnings accrue in cycles, it would be better if the E/P approach is used, but representative figure should be taken into account to include one complete cycle. In case of growth companies, where expectations of growth are more important, the cost of ordinary than capital may be determined on the basis of the DP + G approach.Cost of the equity by IRR Method:Where, Po = current market (purchase) price of the share D = dividend of the respective yearsPn = price of the share after n yearThis means, current market price of shares must equal to all future benefit (i.e. Dividend + realized value) of that shares.If there is a constant growth rate in Dividend:By solving it, Po = (D1 / Ke g, this formula is when there is constant growth and Growth < KeG=b.rWhere b = retention rate and r = rate of returnEarning Price Method:Cost of the Retained Earnings:The retained earnings is one of` the major sources of finance available for the established companies to finance its expansion and diversification programme. These are funds accumulated over the years of the company by keeping part of the funds generated without distribution. So profit retained by company and used in expansion also entail cost. This may be termed as opportunity cost of retained earnings. i.e. suppose these earnings are not retained and are passed on to share holders; suppose further that share holder invest same in new ordinary shares. This expectation of the investor from the new ordinary share should be opportunity cost. Kr = Ke

Cost of Preferred Capital:The cost of preference capital is the rate of return that must be earned on preference capital financed investments to keep unchanged the earnings available to the ordinary shareholders. `CDT = Corporate Dividend TaxCost of redeemable preference shares - The cost of redeemable preference shares is calculated as follows:

Where,Kp = Cost of redeemable preference sharesD = Constant annual dividend paymentN = Years of life to redemption of preference sharesRv = Redeemable value of preference shares at the time of maturitySv = Sale out value of preference shares less discount and flotation expenses.Cost of Debt:The cost of Debt is defined as the rate of return that must be earned on debt financed investments to keep unchanged the earning available to the equity shareholders. In calculation of cost of debt, the cost of debt raised from FIS, Banks or Issue of debs are to be calculated which requires the following information. Net cash inflow from each source of debt and The amount of, periodic interest payment and principal repayment on maturityCost of Irredeemable debt,Where,KD = Cost of DebtI = Annual interest paymentT = Companys effective corporate tax rateD = Net proceeds of issue of debtCost of redeemable debt: If debt raised is certain of its redemption at the end of specified period, the cost of capital can be calculated on, internal rate of return basis i.e. cost of redeemable debt is rate of discount at which present value of all inflows equals to present value of cash out flows.ORWhere, KD = Cost of debtI = Annual interest paymentN = Term of maturity periodT = Companys effective tax rateRv = Redeemable value of debt at the time of maturitySv = Sale value less discount and flotation expenses.This formula is for the traditional type of debt only, i.e. only one issue price realize, regular interest payment, repayment of principal at maturity.

Weighted Average Method: The composite or overall cost of capital of a firm is the weighted average of the cost of the various sources of funds. Weights are taken to be the proportion of each source of funds in the capital structure.Ko = KdWd + KpWp + KeWe + KrWrMarginal Cost of capital:The marginal cost of capital is the cost of obtaining an extra Re l of finance. The theory of capital budgeting leads to the conclusion that projects should be accepted if they have a positive net present value calculated after discounting the revenue and cost streams at the marginal cost of capital to the firm.Using the alternative, IRR criteria, all projects would be accepted that have an IRR greater than the marginal cost of capital. Emphasis is being placed on the marginal cost of capital, for its only earning above this cost that add to the total profits of the firm. The economic theory of firm operates via the principal that the firm should operate at a level where marginal revenue is equal to marginal costs. When this is applied to capital investment decisions, shareholders wealth is maximized.Arbitrage:The term arbitrage is used in many areas of finance. It refers to the process of buying and selling securities. The sales purchase takes place within an unstable capital market. The prices are affected by supply and demand and arbitrage helps in adjusting the market to equilibrium. The process of buying in one market and selling the same in another market is known as arbitrage.M & M have suggested that if two companies have the same level of business, as such they must, all things being equal have the same weighted average cost of capita, and if they also have the same level of earnings, the companies will have the same total market value. Lf this situation does not prevail, as is proposed by the traditional theory, M & M argue that shareholders will undertake arbitrage operation, which will result in share prices returning to equilibrium.The transaction involved in arbitrage process are that shareholders in a company with the lower weighted average cost of capital sell their shares and purchase shares in the company with the higher weighted average cost of capital borrowing and leading to maintain the same level of risk return before and after. Security prices are adjusts as market participants search for arbitrage profits. When such opportunities have been exhausted, security prices indifferent.(CAPM ) The expected returns can of two types,1. Based on market analysis.2. Based on our Risk factor. In CAPM we take only the risk factor analysis. It shows the relationship between the risk and the expected return and also the behaviour of the security prices.

CAPM is applied to find out desired (expected ) return on a particular security based on its risk level or systematic risk which is measured by Beta.

Beta is a measure of systematic risk / non diversifiable risk. It is the sensitivity of% change in return of a particular security ( Rj ) and the l % change in the return of market portfolio as a whole ( Rm ),

Eg. On the basis of the following information find out the Beta.NSE Nifty On 01-1-2007 = 5,000On 31-l-2007 = 5,200Price of a security( Share ) HindalcoOn 01-l-2007 = 190 Rs.On 31-l-2007 = 220 Rs.Rm-Market ReturnRj-Return on Share Hindalco

Beta=So we can say that the Beta of share Hindalco is 3.95 times higher than that of the market beta. i.e. return on individual security is higher than that of the market return. It can be reversed also. Market portfolio is a well diversified portfolio which includes different securities - shares in the same ratio as they are in the market index.Risk is a fluctuation either on the positive or negative side.Impact of Beta : If Beta is very high then the security is said to be very risky. If Beta is very low then the security is said to be less risky. If Beta is Zero then there is no risk at all. If Beta is l Risk involved is equal to the risk involved in the market portfolio.

Relation between Beta & Operating Leverage : Beta is the measure of volatility of the risk of a particular security against the market risk. Whereas the Operating Leverage implies the Operating risk i.e. impact on the fixed overheads cost.-Both implies the measure of risk. Therefore we can say that,DOLRISKBETAHIGH HIGH HIGHLOW LOW LOWThe Beta concept is used to estimate the expected return of a security ( Rj ) or ( Ke )"using the CAPM. SO, Ke according to this model is as under;Ke=Rf+B(Rm-Rf)Ke = Expected return on basis of risk factor beta .Rf = Risk free return on securities like Govt. Sec./bonds, Treasury bills etc.B = Beta factor (risk factor)Rm = Market risk return as a whole(Rm-Rf ) = Risk Premium i.e. Premium on market portfolio over risk free return security( Ke-Rf ) = Premium of a particular security over risk tree security.

Example : Suppose an investor wants to invest in Govt. Bonds then he can earn say 5% on it. But if he invest into a particular security say SAIL ( Steel Authority of India Limited ) then his investment would be considered to be risky then the Govt. Bonds. So naturally he would expect more return on SAIL than on Bonds. Suppose overall market return 15% and return on SAIL is l.5 times higher than the market return then his expectation would be higher than that of the market return, which is as under on the basis of CAPM;Rf=5%, Rm=l5%, Beta=l.5,Ke=Rf+Beta(Rm-Rf) =5%+1.5(15%-5%) =20%

From the above graph we can say that if a particular security provides higher return then by introduction of such security in such portfolio expected return is also increased. i.e. more risk more return. Same way if the risk is lower for a particular security then by introducing such security the overall return is also reduced due to lower return of such security. If a security is correctly priced, then its risk return combinations must lie on Security Market Line otherwise it is not a correctly priced security. Any risk - return combination lying above SML represents an undervalue of security while any Risk return combination lying below SML represents over value of security.Levered BetaIt is the Beta of equity of a levered company having equity and debt in its capital structure. As outside debt Introduced in the capital structure, risk is increased to that extent and therefore the financial risk of the Beta, in such company is always higher.Unlevered BetaIt is the Beta of equity of unlevered company having only equity capital in its capital structure. So the risk of Beta of such company is less compared to the financial risk of Beta of levered company.QUESTIONQ~1A company has 10 per cent perpetual debt of Rs. 1,00,000. The tax rate is 30 per cent. Determine Kd (before tax as well as after tax) assuming the debt is issued at (i) par, (ii) 10% discount, and (iii) 10%premium.Q~2A company issues a new 10 per cent debentures of Rs. 1,000 face value to be redeemed after 10 years. The debenture is' expected to be sold at 5 per cent discount. It will also invoice floatation costs of 5 per cent of face value. The companys tax rate is 30 per cent. What would the cost of debt be? Illustrate the computations using (i) trial and error approach and (ii) shortcut method.Also calculate Kd( shortcut method) if in above case if the debentures are sold at a premium of 10%.Q~3A Ltd. issued 10,00,000 equity shares each of Rs. 100 at par. The current market price of the share is Rs.140. The company has recently declared 20% dividend. The company has an opportunity to issue the same type of shares at a premium of 30%. The floatation cost in this C356 would be 5% of the face value. It is expected that A Ltd. will grow at a constant rate of 5%p.a.Calculate the cost of equity.Q~4A company issues ll per cent irredeemable preference shares of the face value of Rs 100 each. Flotation costs are estimated at 5 per cent of the expected sale price. (a) What is the kp if preference shares are issued 10 per cent premium,? (b) Also, compute kp in these situations assuming 15 per cent dividend tax. Calculate Kp in above case if it is assumed that the preference shares are redeemable at par after five years.Q~5The following is the information relates to X Ltd.:(i.) Current market price of a share = Rs 150.(ii.) Cost of floatation per share on new shares, Rs 3.(iii.)Dividend paid on the outstanding shares over the past five years.` Year Dividend per share1 Rs 10.502 11.023 11.584 12.165 12.766 13.40(iv.) Assume a fixed dividend pay out ratio.(v.) Expected dividend on the new shares at the end of the current year is Rs 14.10 per share.You are required to;(1) Determine the cost of equity shares.(2) Calculate the current dividend yield.(3) Calculate the rate of return of Mr. X on his equity investments.Q~6The following is the capital structure of Co. A:8% Debt Rs. 3,00,000SourceAmount

8% DebtRs. 3,00,000

14% Preference capital2,00,000

Equity5,00,000

Total10,00,000

The expected dividend for the next year is Rs.5 and the current market price of the share is Rs.50.The constant growth of 5%p.a. is expected. The corporate tax rate is 30%.Calculate the weighted average cost of capital( ko).Q~7A company is considering raising Rs 100 lakh by one of the two alternative methods, viz. 14 per cent institutional term loan and 13 per cent non-convertible debentures. The term loan option would attract no major incidental cost. The debentures would have to be issued at a discount of 2.5 per cent and would involve Rs 1 lakh as cost of issue.Advice the company as to the better option based on the effective cost of capital in each case. Assume a tax rate of 30 per cent.Q-8A company has on its books the following amounts and specific costs of each type of capital.Type of CapitalBook valueMarket ValueSpecific Costs(%)

DebtRs 4,00,000Rs 3,80,0005

Preference1,00,0001,10,0008

Equity6,00,00015

Retained Earning2,00,00012,00,00013

13,00,00016,90,000

Determine the weighted average cost of capital using (a) Book value weights and, (b) Market value weights. Why are they different? Can you think of a situation where the weighted average cost of capital would be the same using either of the weights?Q~9Two companies A and B are in the same business and hence have similar operating risks. However, the capital structure of each of them is different. The following are the details:

AB

Equity share capital (Rs.)(Face value Rs l0 per share)4,00,0002,50,000

Market value per share (Rs.)1520

Dividend per share (Rs.)2.704

Debentures(Rs)(Face value Rs. 100 per debenture)NIL1,00,000

Market value (MV) per debenture (Rs)-125

Interest Rate-10

Assume the current levels of dividends are generally expected to continue indefinitely and the income-tax rate is 30 per cent You are required to compute the weighted average cost of capital (ko) of each company.Q~10As a financial analyst of a large electronics company, you are required todetermine the weighted average cost of capital of the company using (a) book value weights and (b) market value weights. The following information is available for your perusal.The companys present book value capital structure is:Debentures (Rs 100 per debenture) Rs 16,00,000Preference shares (Rs 100 per share) 4,00,000Equity shares (Rs 10 per share) 20,00,000 40,00,000All these securities are traded in the capital markets. Recent prices are:Debentures, Rs 110 per debenturePreference shares, Rs 120 per shareEquity shares, Rs 22 per share

Anticipated external financing opportunities are: , _(i)Rs 100 per debenture redeemable at par; 10 year maturity, 11 per cent coupon rate, 4per cent flotation costs, sale price, Rs 105 . (ii)Rs 100 preference share redeemable at par; 10 year maturity, 12 per cent dividend rate, 5 per cent flotation costs, sale price Rs 110.(iii)Equity shares: Rs 2 per share flotation costs, sale price = Rs 20.In addition the dividend expected on the equity share at the year end is Rs 2 per share; the anticipated growth rate in dividends is 7 per cent and the firm has the practice of paying all its earnings in the form of dividends. The corporate tax rate is 30 per cent.Q~11Malaysian Paints (India) Limited has paid a dividend of_30 per cent on its shares of Rs I0 each in the current financial year. In the opinion of Choksi, finance director the dividend is expected to grow @ 5 percent annum. The required rate of return of the company is 15 per cent.It suggested the following alternative courses of action for the consideration of the Board:(i.) To increase the dividend growth rate to 6 per cent and lower the required rate of return to l4 per cent.(ii.) To increase the dividend growth rate 7 per cent and raise the required rate of return to 17 per cent.(iii.) To raise the required rate of return to 16 per cent and reduce the growth rate of dividend to 4 per cent.(iv.) (To increase the dividend growth rate to 8 per cent and increase the required rate of return to 17 per cent.You are the finance manager of the company. The Board of Directors have confidence in your abilities because in the past you have helped the Board in making such decisions. The Board has requested you to Suggest, with calculations the most suitable course of action for the company (assuming the firm has an objective of maximizing its shareholders wealth).Q~l2 . '(a) A companys debentures of the face value of Rs 100 bear an 8 per cent coupon rate. Debentures of this type currently yield l0 per cent. What is the market price of debentures of the company?(b) What would happen to the market price of the debentures if interest rises to (i) 16 per cent and (ii)Drops to 12percent? (c) What would be the market price of the debentures in situation (a) if it is assumed that debentureswere originally having a 15 year maturity period and the maturity period is 4 years away from now?(d) Would you pay Rs 90 to purchase debentures specified in situation (c)? Explain.Q~13XYZ Ltd is contemplating a debenture issue on the following terms:Face value Rs 100 per debentureTerm of maturity 4 yearsYearly coupon rate of interestYears 1 - 2 9 %3 - 4 10 %The current market rate on similar debentures is 11 per cent per annum. The company proposes to price the issue so as to yield a (compounded) return of 12 per annum to the investors. Determine the Debentures issue price. Assume the redemption premium of 5 per cent on face value. The corporate tax rate is 30%.Q~l4XYZ Ltd (in 30% Tax bracket) has the following book value capital structure:Equity Capital (in shares ofRs.10 each, fully paid-up at par)Rs. 15crores11% Preference Capital (in shares ofRs.100 each, fully paid-up at par)Rs. 1 croreRetained EarningsRs. 20 crores13.5% Debentures (ofRs.l00 each)Rs. 10 crore15% Terms LoansRs. 12.5 crores The net expected dividend on equity shares is Rs.3.60 per share. Dividends are expected to grow at 7% and the Market price per share is Rs.40. Preference Stock, redeemable after ten years, is currently selling at Rs_75 per share. Debentures, redeemable after 6 years, are selling at Rs.8O per debenture.Required :l. Compute the present WACC Market Value Proportions.2. Compute the weighted Marginal Cost of Capital if the Company raises Rs.10 Crores , given the following information: The amount will be raised by equity and debt in equal proportions. The Company expects to invest Rs.l.5 Crores retained earnings. The additional issue of equity shares will result in the net price per share being fixed at Rs.32. The Debt capital raised by way of term loans will cost 15% for the first Rs.2.5 Crores and 16% for the next Rs.2.5 Crores.Q~15A Limited wishes to raise additional finance of Rs. 10 lakhs for meeting its investment plans. It has Rs. 2,l0,000 in the form of retained earnings available for investment purposes. The following are the further details:(1) Debt/equity mix 30%: 70%(2) Cost of debtUp to Rs. l,80,000 10% (before tax)beyond Rs. l,80,000 16% (before tax)(3) Earnings per share Rs. 4(4) Dividend Pay Out 50% of earnings(5) Expected growth rate in dividend 10%(6) Current market price per share RS_ 44(7) Tax rate 30%(8) Personal Tax rate of the investor 20%You are required:(a) To determine the pattern for raising the additional finance.(b) To determine the post-tax( after tax ) average cost of additional debt.(c) To determine the cost of retained earnings and cost of equity, and(d) Compute the overall-weighted average after tax cost of additional Finance.Q~16Suppose the required rate of return on a portfolio with beta of 1.2 is 18 per cent and the risk-free rate is 6per cent. According to the CAPM :(a) What is the expected rate of return on the market portfolio? (b) What is the expected return of a zero beta security?(c) Suppose you choose to buy a stock Z for Rs. 50. The stock is expected to pay Rs. 2 as dividend next year and is hoped to sell at Rs. 53. The stock has been evaluated at B = -0.5. Is the stock fairly priced?What is the implication of including stock Z in the portfolio?Q~17Mr. Azad holds the following portfolio Share Beta Investment

Alpha 0.6 Rs.3,00,000

Beta 1.0 1,80,000

Carrot 1.2 1,20,000

What is the expected rate of return his port folio, if the risk-free rate is 6per cent and the expected return on market portfolio is 15 per cent? Q~18 The following facts are available Risk-free rate, 9 per cent Required rate of return on market portfolio, 18 per cent Beta coefficient of the shares of ABC Ltd., 1.5 Expected dividend during the next year, Rs. 3 Growth rate in dividends/ earnings, 8 per centCompute the price at which the shares of ABC Ltd. should sell.Q~19Assume the following facts :Risk -free return, rf 7.75 per centBeta 2,Expected return of investors, r, 16 per centApplying CAPM, compute the expected market return (rm).Q~20 B Limited, an all equity firm, is evaluating the following projects:ProjectBetaExpected return (%)

P0.613

Q0.914

R1.516

S1.520

The risk-free rate is 10 per cent and the expected market premium is 8 per cent. The co.s cost of capital is 18 per cent. Which projects would be accepted or rejected on the basis of the firms cost of capital as a hurdle rate?

Q~21You are analysing the beta for ABC Computers Ltd. and have divided the Company into four broad business groups, with market values and betas for each group.Business group Market value Unleveragedof equity betaMain frames Rs. 100 billion l.l0Personal Computers Rs. 100 billion 1.50Software Rs. 50 billion 2.00Printers Rs. l50 billion 1.00ABC Computers Ltd. had Rs. 50 billion in debt outstanding.Required :(i) Estimate the beta for ABC Computers Ltd. as a Company. Is this beta going to be equal to the beta estimated by regressing past returns on ABC Computers stock against a market index. Why or why not ?(ii) If the treasury bond rate is 7.5%, estimate the cost of equity for ABC Computers Ltd. Estimate thecost of equity for each division. Which cost of equity would you use to value the printer division ?The average market risk premium is 8.5%.

CAPITAL STRUCTUREThe capital structure of a company refers to the mix of the long term finances used by the firm. It is the financing plan of the company. The objective of any company is to mix the permanent source of funds used by it in a manner that will maximize the companys market price. In other words companies seek to minimize their cost of capital. This proper mix of funds referred to as the optimum capital structure.In planning the capital structure, the following issues must be kept in mind:1. There is no definite model, which can be used as an ideal for all business undertakings. This is because the circumstances of various business undertakings differ. The capital structure depends primarily on a number of factors like the nature of industry, gestation period, certainty with which the profits will accrue after the undertaking goes in to commercial production & the likely quantum of return on investment. It is, therefore, important to understand that different types of capital structure would be required for different types of undertakings.2. Government policy is a major factor in planning capital structure. For example, a change in the lending policy of financial institutions may mean a complete change in the financial pattern.Capital Structure planningThe three major considerations in Capital Structure Planning are z(a) Risk, (b) Cost and (c) controlThese differ for various components of Capital i.e. Own Funds and Loan Funds. A comparative analysis is given as under :Types of fundRiskCostControl

Equity CapitalLow Risk - no question of of capital except the company is under liquidation- Hence best from viewpoint of risk.Most expensive - dividend Expectations of shareholders are higher than interest rates. Also, dividends are not tax-deductible.

Dilution of control Since the capital base might be expanded and new shareholders / public are involved.

Preference Capital Slightly higher risk whencompared to Equity Capital - is redeemable after a certain period even ifdividend payment is based on profit.

Slightly cheaper cost thanEquity but higher thanInterest rate on loan funds.Further, preference dividendsare not tax-deductible.

No dilution of control since voting rights are restricted

Loan fundsHigh risk - Capital should berepaid as per agreement;,Interest should be paidirrespective of performanceor profits.Comparatively cheaper prevailing interest rates are considered only to the extent of after tax impact.No dilution of control - butsome financial institutions may insist on nomination of their representatives in theBoard of Directors.

Features of optimum capital structure:1. Profitability ._2. Flexibility3. Conservation4. Solvency5. ControlPeeking order theory of capital structureThe pecking order theory was proposed by Donaldson in 1961. The pecking order theory suggests that firm rely for finance, as much as they can, on internally generated funds. If internally generated funds are not enough then they will move to additional debt finance then equity. This is because the issue cost of internally generated funds have the lowest issue cost and cost of new equity is the highest. Myers has suggested that the firm follows a 'modified pecking order' in their approach to financing. Myers has suggested asymmetric information as a reason for heavy reliance on internal generated funds. He demonstrate that with asymmetric information, equity shares are interpreted by the market as bad news since managers are only motivated to issue equity share when share markets are undeveloped. Further, the use of internal finance ensure that there is regular source of finance which might be in line with companys expansion programme. If additional funds are required over and above internally generated funds, then borrowings will be next alternative in this theory.Thus pecking order theory rests on:1. Stickly dividend policy.2. A preference for internal funds.3. An aversion to issue equity shares.Financial Engineering'Financial Engineering' involves the design, development and implementation of innovative financial instruments and processes and the formulation of creative solutions to problems in finance. Financial Engineering lies in innovation and creativity to promote market efficiency. It involves construction of innovative asset-liability structures using a combination of basic instruments so as to obtain instruments which may either provide a risk-return configuration otherwise unviable or result in gain by heading efficiently, possibly by creating an arbitrage opportunity. It is of great help in corporate finance, investment management, money management, trading activities and risk management.Over the years, Financial Managers have been coping up with the challenges of changing situations. Different new techniques of financial analysis and new financial instruments have been developed. The process that seeks to adopt existing financial instruments and develop new ones so as to enable financial market participants to cope more effectively with changing conditions is known as financial engineering.In recent years, the rapidity with which corporate finance and investment finance have changed in practice has given birth to a new area of study known financial engineering. It involves use of complex mathematical modelling and high speed computer solutions. Financial Engineering refers to and includes all this. It also involves any moral twist to an existing idea and is not limited to corporate finance. It has been practised by commercial banks in offering new and tailor made products to different types of customers. Financial engineering has been used in schemes of mergers and acquisitions.The term financial engineering is often used to refer to risk management also because it involves a strategic approach to risk management.QUESTIONSQ~1The Hypothetical Ltd.s current earnings before interest and taxes are Rs. 4,00,000. It currently has outstanding debts of Rs. 15 lakh at an average cost (Ki) of 10 per cent. Its cost of equity capital is estimated to be 16 per cent.(i) Determine the current value of the firm using the traditional approach.(ii) The firm is considering reducing its leverage by selling Rs. 5 lakh of equity shares in order to redeem Rs. 5 lakh debt. The cost of debt is expected to be unaffected. However, the cost of equity capital is to be reduced to I4 per cent. Would you recommend the proposed action ?Q-2The following information is relates to X Ltd.Expected Net Operating Income Rs. 4,80,00010% Debt Rs. 14,40,000Ke ( Equity Capitalization Rate) 20%You are required to calculate:i) The value of firm and Ko as per NI Approach.ii) Calculate the value of firm and Ko under the following situations:i. If the company raises the debt by Rs. 7,60,000 to buyback the sharesii. If the company issues the equity shares by Rs.7,60,000 to redeem the debt.Q-3The following information is relates to Y Ltd.Expected Net Operating Income( EBIT) Rs. l,20,()O010% Debt Rs. 3,60,000Ko ( The Overall Capitalization Rate) 20%You are required to calculate:i)The value of firm and Ke as per NOI Approach.ii) Calculate the value of firm and Ke under the following situations:a) If the company raises the debt by Rs. 1,90,000 to buyback the sharesb) If the company issues the equity shares by Rs. l ,90,000 to redeem the debt.Q-4The following information is relates to Y l,td.Expected Net Operating Income( EBIT) Rs. l2,00,00010% Debt Rs. 36,00,000Ke 20%You are required to calculate:(1) The value of fiRM and Ko as per Traditional Approach.(2) Determine the Firms leverage ratios 1 (a) B/S and (b) B/V.(3) State how the following will effect on the value of firm and Ko.a) If the company raises the debt by Rs. 750,000 to buy back the shares and due to this the financial risk(kd) and Ke to would increase to 11% and 21% respectively.b) lf the company raises the debt by Rs.8,50,000 to buy back the shares and due to this the financial risk(kd) and Ke to would increase to 12% and 2l% respectively.Q-5R Ltd. is an all equity firm with a market value of Rs. 25,00,000 and the Ke = 21%. The firm wants to buyback the shares worth Rs.5,00,000 by issuing and raising 15% perpetual debt of the same amount. The tax rate may be taken as 30%. After the capital restructuring and applying MM Model (with tax ), you are required to calculate :l. Market value of R Ltd.2. Ke3. Ko and comment on it.Q~6The earnings before interest and taxes are Rs. 20 lakh for companies L and U. they are alike in all respects except that firm L uses 15 per cent Debt aggregating Rs. 40 lakh. Given a tax rate of 30 percent, determine the income to be received by the stakeholders of the two firms.Q~7From the following selected data, determine the value of the firms, P and Q belonging to the homogeneous risk class under (a) NI approach, and (b) the NOI approach.Firm P Firm QEBIT Rs. 2,25,000 Rs. 2,25,000Interest (0.15) 75,000Equity capitalisation rate (Ke) 0.20Tax rate 0.30Which of the two firms has an optimal capital structure?Q~8The following are the equilibrium values of two firms belonging to the homogeneous risk class according to the NOI approach.

Xy

Expected NOI (net operating income)Rs. 25,000Rs. 25,000

Less cost of debt (I)= (Ki x B)5,000-

Net income for equity-holders(EBIT-I)20,00025,000

Equilibrium cost of capital (Ko)0.1250.125

Total value (V), ENIT/Ko2,00,0002,00,000

Market value of debt (B)1,00,000-

Market value of equity (V-B)1,00,0002,00,000

Cost of equity0.200.125

Determine the values of the firms, X and Y under the traditional approach, assuming the Ke for company Y as 11 per cent and for X as 14 per cent.Q~9Two companies, X and Y belong to equivalent risk group. The two companies are identical in every respect except that company Y is levered, while X is unlevered. The outstanding amount of debt of the levered company is Rs. 6,00,000 in 10 per cent debentures. The other information for the two companies is as follows :xy

NOI (net operating income)Rs. 1,50,000Rs. 1,50,000

Interest on debt --60,000

Earnings equity-holders(EBIT-I)1,50,00090,000

Earnings to capitalisation rate0.150.20

Market value of equity2,00,0004,50,000

Market value of debt (B)-6,00,000

Total value of firm1,00,00010,50,000

Overall capitalisation rate0.150.143

Debt/ equity ratio01.33

An investor owns 5 per cent equity shares of company Y. Show the process and the amount by which he could reduce his outlay through use of the arbitrage process. Are there any limits to the process?Q~10The value of a firm is independent of the proportion of debt to total capitalisation. The arbitrage process will establish a market equilibrium in which the total value of the firm will depend only on investors estimate of the firms business risk, and its expected future income. Explain the above mentioned statement with the help of the following data regarding two companies, A and B with the same expected annual income and same risk class.VariablesCompany ACompany B

Expected annual income(Y)RS 30,000RS 30,000

Market value of debt(L)--1,20,000

Rate of interest on debt(i)--0.125

Required rate of return on equity (K)0.150.16

Market value equity (E)??

Market value of company(V), where v= L+E??

Q-11The King Ltd has to make a choice between debt issue and equity issue and equity issue for its expansion programme. Its current position is as follows:5% DebtRs 20,000

Equity capital (Rs. 10 per share)50,000

Surpluses30,000

Total capitalization1,00,000

Sales3,00,000

Total costs2,69,000

Income before interest and taxes31,000

Interest1,000

Earnings before taxes30,000

Income tax10,500

Income after taxes19,500

The expansion programme is estimated to cost Rs. 50,000. If this is financed through debt, the rate of interest on new debt will be 7 per cent and the price-earnings ratio will be 6. If the expansion programme is financed through equity, new shares can be sold netting Rs. 25 per share; and the price-earnings ratio will be 7. The expansion will generate additional sales of Rs. l,50,000 with a return of 10 per cent on sales before interest and taxes.If the company is to follow a policy of maximizing the market value of its shares, which form of financing should it choose ?Q~l2AB Limited provides you with the following information :ProfitRs 3,00,000

Less Interest on debenture (0.12)60,000

Earnings before taxes2,40,000

Les taxes (0.35)84,000

Earnings after taxes1,56,000

No. Of Equity shares (Rs. 10 per share)40,000

Earnings per share3.9

Ruling market price39

P/E ratio (Price/ EPS)10 times

The company has undistributed reserves, Rs. 6,00,000. It needs Rs. 2,00,000 for expansion which will earn the same rate as funds already employed.You are informed that a debt-equity ratio (debt/debt equity) higher than 35 per cent will push the P/E ratio down to 8 and raise the interest rate on additional amount borrowed to 14 per cent.You are required to ascertain the probable price of the shares:(a) If the additional funds are raised as debt; and(b) If the amount is raised by rising equity shares (at current market price).Q~13The Evergreen Company has the choice of raising an additional sum of Rs. 50 lakh either by the sale of 10 per cent debentures or by issue of additional equity shares of Rs. 50 per share. The current capital structure of the company consists of 10 lakh ordinary shares.At what level of earnings before interest and tax (EBIT) after the new capital is required, would earnings per share (EPS) be the same whether new funds are raised by issuing ordinary shares or by issuing debentures? Also, determine the level of EBIT at which uncommitted earnings per share (UEPS) would be the same if sinking fund obligations amount to Rs. 5 lakhs per year. Assume a 35 per cent tax rate. Discuss the relevance of the calculation.Q~14ABC Ltd. wants to raise Rs. 5,00,000 as additional capital. It has two mutually exclusive alternative financial plans. The current EBIT is Rs. l7,00,000 which is likely to remain unchanged. The relevant information is 2 Present capital structure : 3,00,000 Equity shares of Rs. 10 each and 10% Bonds of Rs.20,00,000Tax rate : 50%Current EBIT : Rs. l7,00,000Current EPS : RS_ 2_50Current market price : Rs. 25 per shareFinancial Plan I : 20,000 Equity Shares at Rs. 25 per shareFinancial Plan II : 12% Debentures of Rs. 5,00,000.What is the indifference level of EBIT? Identify the financial break-even levels and plot the EBlT~EPS line son graph paper. Which alternative financial plan is better ?Q~15In considering the most desirable capital structure of a company, the following estimates of the cost of debt and equity capital (after tax) have been made at various levels of debt-equity mix :Debts as percentage of total capital employedCost of debt (percent)Cost of equity

05.012.0

105.012.0

205.012.5

305.513.0

406.014.0

506.516.0

607.020.0

Q~17Excel Limited is considering three financing plans. The key information is as follows:(a) Total funds to be raised, Rs. 2,00,000.(b) Financing plansPlansEquityDebtPreferences

A100 percent----

B5050 percent--

C50--50 percent

(c) Cost of debt 8 per cent; cost of preference shares 8 per cent(d) Tax rate, 30 per cent(e) Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per share.(f) Expected EBIT, Rs. 80,000.Determine for each plan :(i) Earnings per share (EPS).(ii) Compute the EBIT range among the plans for indifference and indicate if any of the plans dominate.(iii) Compute the financial break-even point.

LEVERAGECONCEPT OF LEVERAGEThe term Leverage in general refers to a relationship between two interrelated variables. In financial analysis it represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings Before Interest & Tax (E.B.I.T.), Earning Per Share (E.P.S.) etc.In financial analysis. These are (i) Operating Leverage(ii) Financial Leverage(iii) Combined LeverageOPERATING LEVERAGEOperating leverage is defined as the firms ability to use fixed operating costs to magnify effects of changes in sales on its earnings before interest and taxes.When there is an increase or decrease in sales level the E.B.I.T. also changes. The effect of change in sales on the level E.B. I. T. is measured by operating leverage. The operating leverage is calculated as :A firm will not have an operating leverage if there are not fixed costs and the total cost is variable in nature. In such cases, the operating profits or E.B.I.T. varies in direct proportion to the changes is sales level.Significance of operating leverage : Analysis of operating leverage of a firm is very useful to the financial manager. It tells the impact of changes in sales on operating income. A firm having higher D.O.L. (Degree of Operating Leverage) can experience a magnified effect on E.B.I.T. for even a small change in sales level. Higher D.O.L. can dramatically increase the operating profits. But if there is decline in sales level, E.B.I.T. may be wiped out and a loss may be operated.As explained earlier the operating leverage depends on fixed costs. If the fixed costs are higher, the higher would be firms operating leverage and its operating risks. If Operating leverage is high, it automatically means that the break-even point would also be reached at a high level of sales. Also, in the case of higher operating leverage, the margin of safety would be low. Therefore, it is preferred to operate sufficiently above break-even point to avoid the danger of fluctuations in sales and profits.FINANCIAL LEVERAGEFinancial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in E.B.I.T. / Operating profits, on the firms earning per share. The financial leverage occurs when a fim1s capital structure contains obligation of fixed financial charges e.g. interest on debentures, dividend on preference shares etc. along with owners equity to enhance earnings of equity shareholders. The fixed financial charges do not vary with the operating profits or E.B.I.T. They are fixed and are to be paid irrespective of level of operating profits or E.B.I.T. The ordinary shareholders of firm are entitled to residual income i.e. Earnings after fixed financial charges.The financial leverage is favourable when the firm earn more on the investment/assets financed by the sources having fixed charges. It is obvious that shareholders gain in a situation where the company earns a high rate of return and pays a lower rate of return to the supplier of long term funds. Financial leverage in such cases is therefore also called Trading on Equity.Thus gain from financial leverage has arisen due to :(a) Excess of return on investment over effective cost (cost after considering taxation effect of funds.)(b) Reduction in the number of share issued due to the use of debt funds.The financial leverage at the levels of E.B.I.T. is called degree of financial leverage and it is calculated as ratio of E.B.I.T. to the Profit before tax.Significance of Financial Leverage : Financial leverage helps the finance manager in designing the appropriate Capital Structure. One of the objective of planning an appropriate capital structure is to maximize the return on equity shareholders funds or maximize the earning per share.Financial leverage is double edged sword. On the one hand it increases earning per share and on the other hand it increases financial risk. A high financial leverage means high fixed financial costs and high financial risk i.e. as the debt component in capital structure increases, the financial leverage increases and at the same time the financial risk also increases i.e. risk of insolvency increases.The finance manager therefore is required to trade off i.e. has to bring a balance between risk and return for determining the appropriate amount of debt in the capital structure of a firm. Thus the analysis of financial leverage is most important tool in the hands of finance managers who are engaged in financing the capital structure of business firms, keeping in view the objectives of their firm.COMBINED LEVERAGEWe have seen above that operating leverage explains the operating risk and financial leverage explains the financial risk of firm. However, a firm has to look into overall risk or total risk of the firm i.e. Operating risk as well as Financial risk. Hence, if we combine the operating leverage and financial leverage the result is combined leverage. Significance of combined leverage : The ratio of contribution to earnings before tax, given by combined leverage shows the combined effect of financial and operating leverage. A high operating leverage and a high financial leverage combination is very risky. If the company is producing and selling at a high level, it will make extremely high profit for its shareholders. But even a small fall in the level of operations would result in a tremendous fall in earnings per share. A company must, therefore maintain a proper balance between these two leverage.A high operating leverage and a low financial leverage indicate that the management is careful since the higher amount of risk involved in high operating leverage has been sought to be balanced by low financial leverage. However, a more preferable situation would be to have a low operating leverage and a high financial leverage. A low operating leverage would automatically imply that the company reaches its break-even point at a low level of sales. Therefore, risk is diminished. A highly cautious and conservative manager will keep both its operating and financial leverage at very low levels. The approach may, however, mean that the company is losing profitable opportunities.IMPACT OF LEVERAGE ON CAPITAL TURNOVER RATIO AND WORKING CAPITAL RATIOAn Increase in sales improves the net profit ratio, raising the Return on Investment (R.O.I.) to a higher level. A student may rightly wonder that this situation should be very attractive for the management, which may be tempted to try to raise their Capital Turnover Ratio without restraint. This however, is not possible in all situations-a-rise in capital turnover must be supported by an adequate capital base. Normally, therefore, as capital turnover ratio increases, working capital ratio deteriorates. Thus management cannot increase its capital turnover ratio beyond a certain limit.The main reasons for a fall in ratios showing the working capital position due to increase in turnover ratios is that as the activity increases without a corresponding rise in working capital, the working capital position becomes tight. As the sales increases, both the current assets, and current liabilities also increases but not in proportion to the current ratio. If current ratios is to be maintained at 2, each increase in sales must result in a two-fold rise in the current assets as compared to current liabilities. But this does not happen with the same amount of funds; hence a fall in the current ratio.Therefore, it must be ensured that when the capital turnover ratio is sought to be increased, its effect on the working capital situation is to be carefully considered. If the current ratio and the acid test ratio are high, it is apparent that the capital turnover ratio can be increased without any problem. However, it may be very risky to increase capital turnover ratio when the working capital position is not satisfactory.Discuss the relationship between the financial leverage and fi1ms required rate of return to equity shareholders as per Modigliani and Miller Proposition II.Relationship between the financial leverage and firm's required rate of return to equity shareholders with corporate taxes is given by the following relation.where,rg = required rate of return to equity shareholdersro = required rate of return for an all equity firmD = Debt amount in capital structureE = Equity amount in capital structureTC = Corporate tax raterg = required rate of return to lenders

Discuss the Return on assets (ROA) and Ret1u'n on Equity (ROE) by bringing out clearly the unpact of financial leverageReturn on assets is a ratio which measures the profitability of the firm in terms of assets employed in the firm. Mathematically:Return on equity measures the profitability of equity funds invested in the firm. This ratio reveals how profitability of the owner's funds have been utilized by the firm. This ratio is computed as:Return on equity (ROE) = ROA + Debt/Equity (ROA - i x (l - Tc))Where (i) is the rate of interest on debt and Tc is the tax rate.

Impact of financial leverage on return on equity:Let ROA be 15% and 5%, the ratio of (debt/equity) be equal to (0.2/0.8); 9% be the rate of interest of the debt and 35% is the tax rate, then the impact of financial leverage on return on equity will be as follows:

Positive or favourable impact of financial leverage on return on equity.And at ROA = 5%QUESTIONSQ1The following summarizes the percentage in operating income, percentage changes in revenues and betas four pharmaceutical firmsFirm Change in Change in Betarevenue operating incomePQR Ltd. 27% 25% 1-00RST Ltd. 25% 32% 1-15TUV Ltd. 23% 36% 1-30WXY Ltd. 21% 40% 1-40Required :(i) Calculate the degree of operating leverage for each of these firms. Comment also.(ii) Use the operating leverage to explain why these firms have different beta.Q~2The following figures relate to two companies:Rs . in lakhs

P. LTDQ. Ltd

Sale5001,000

Less: variables costs200300

Contribution300700

Less Fixed costs 150400

E.B.I.T150300

Less : Interest50100

Profit before tax (PBT)100200

You are required to:(i) Calculate the operating financial and combined leverages for the two companies: and(ii) Comment on the relative risk position of them.Q~3The capital structure of ABC Ltd. consist of an ordinary share capital of Rs.5,00,000 (equity shares of Rs.100 each at par value) and Rs.5,00,000 (10% debenture of Rs.100 each). Sales increased from 50,000 units to 60 000 units the selling rice is Rs.12 per unit, variable cost amounts to Rs.8 per unit and fixed expenses amount to Rs.1,00,000. The income tax rate is assumed to be 30%. You are required to calculate the following:(a) The percentage increase in earning per share:(b) The degree of financial leverage at 50,000 units and 60,000 units;(c) The degree of operating leverage at 50,000 units and 60,000 units;(d) Comment on the behaviour E.P.S., operating and financial from 50,000 units to 60,000 units. Q~4A firm has sales of Rs.75,00,000 variable cost of Rs of Rs.45,00,000 at 9% and equity of Rs.55,00,000.(i) What is the firms R.O.I.?(ii) Does it have favourable financial leverage?(iii) What are the operating, financial and combined leverage of the firm?(iv) If the sales drop to Rs.50,00,000, what will be the new E.B.I.T. ?Q~5Calculate the operating leverage, financial leverage and combined leverage from the following data under situations I and II and Financial Plan A and B:Installed Capacity 4,000 unitsActual Production and Sales 75% of the CapacitySelling Price Rs.30 Pei UnitVariable Cost Rs. 15 Per UnitFixed Cost:Under Situation I Rs.l5,000Under Situation II Rs.20,000Financial PlanA BRs. Rs.Equity 10,000 15,000Debt (Rate of Interest at 20%) 10,000 5,00020,000 20,000Q~6From the following prepare Income statement of Company A,B and C.Company A B CFinancial Leverage 321 421 2:1Interest Rs.200 Rs.300 Rs.l,000Operating Leverage 4:1 5:1 3:1Variable cost as a percentage to sales 66 2/3% 75% 50%Income tax rate 30% 30% 30%Comment on the financial position and structure of these companies.Q~7 A Ltd. Furnished the following balance sheet as on 315' March 2011.LiabilitiesRsAssets Rs.

Equity share capital(50,000 Equity share each of rs. 10)5,00,000Fixed Assets 15,00,000

General Reserves1,00,000Current assets9,00,000

15% debts14,00,000

Current liabilities4,00,000

24,00,00024,00,000

3. The total Assets Turnover ratio is 2.5.4. Tax rate is 30%.Required:Calculate EPS and Combined Leverage.Q~8Average Kd ( before tax ) 10%Tax rate 30%Financial Leverage ratio = 0.60ROI = 20% ( before tax )Calculate ROE.Q~9The financial manager of the Hypothetical Ltd. expects that its earnings before interest and taxes (EBIT) in the current year would amount to Rs.l0,000. The firm has capital of 5 per cent bonds aggregating Rs.40,000, while the 10 per cent preference shares amount to Rs.20,000. What would be the earnings per share (EPS)? Assuming the EBIT being (i) Rs.6,000 and (ii) Rs.l4,000 how would the EPS be affected? The firm can be assumed to be in the 30 per cent tax bracket. The number of outstanding ordinary shares is l,000.Q~10Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to Rs.10,00,000.For expansion it wants to raise additional l0,00,000. The firm has four alternative financial plans:(A) It can raise the entire amount in the form of Equity Capital.(B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures.(C) It can raise the entire amount as 6% debentures.(D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference capital.Further assume that the existing EBIT are Rs.l,20,000 and the tax rate is 30 per cent, outstanding ordinary shares are l0,000 and the market price per share is Rs. |00 under all the four alternatives.Which financing plan should the firm select? (take suitable assumptions if required)Q~11The following is the income statement of X Ltd. for the year ended 31st March, 2011.Sales225.00

Less: Opening Expenses

Variables 45

Fixed 90135.00

EBIT90.00

Interest @18%22.50

EBT65.50

Tax @ 35%23.63

PAT43.87

Numbers of shares outstanding10,00,000

The company is wishing to raise Rs. 1.20 crore during 2011-12 for up gradation of its spinning unit. It is considering the following two alternative for raising funds :1. Issue only equity sharesii. 50 percent equity and 50 percent debt. Equity can be issued at a premium of Rs. 5 and interest rate on debt up to Rs.50 lakhs is 18% and above that is 20%. That are expected to increased by 20% during 2011-12, fixed operating cost remains constant and the variable cost ratio and the tax rate remains unchanged.Required :a. Calculate the DOL, DFL, and DTL for the above two plans.b. If sales are expected to increase by 15% during 2012-2013, then forecast the EPS for the year 2012- 2013.Q~12 'The following estimates are made of Elxi India Ltd. for the year 2010-2011 :i. The degree of operating leverage is expected to be 1.30.ii. Fixed costs are estimated to be Rs. 2.50 lakhs.iii. Interest on Rs. 30 lakhs debt will be paid @ 15% p.a.iv. The EPS of the company is expected to be Rs. 2.You are required to calculatea. Degree of financial leverage for the company.b. Degree of total average for the company.c. Percentage decline in sales which will wipe out profit before tax.Q-13The operating and financial break even points of a firm are 48000 units and Rs. 30,000 respectively. Its degree of operating leverage at a sale level of Rs. 4,00,000 is 2.5. Its fixed costs are Rs. 1,20,000. You are required to calculatea. Degree to total leverage.b. Percentage change in EPS if quantity increases by 5%.Q-l4Madan, Mohan, Finance Controller of Big Five Ltd. recently attended a seminar on the benefits of financial leverage. The Company has assets of Rs. 40 lakhs financed entirely with 2,00,000 shares of equity currently selling at Rs. 20 per share. Madan is considering retiring some of the shares with borrowed funds, which he can obtain at an interest rate of 18%. He expects the company to earn Rs. 10 lakhs next year before interest and taxes. The companys tax rate is 30%.(a) What would be the effect of leverage on expected EPS and ROE?(b) Madan is considering two alternative leverage ratios, 25% debt and 50% debt (percent debt to total assets).Calculate expected EPS and ROE for each of these debt ratios at next years expected EBIT.Q~l5The following data is given is respect of a company. Compute (a) Degree of Financial Leverage (b) EPS if rate of EBIT on Capital Employed is 8%.Particulars Rs.

Equity shares capitalRs. 1 lakh

10% DebenturesRs. 9 lakhs

Total capital EmployedRs. 10 lakhs

Q~l6The ABC Ltd. has the following balance sheet and income statement informationLiabilitiesAssets

Equity capital (Rs, 10 per share)Rs 8,00,000Net fixed assetsRs. 10,00,000

10% debt6,00,000Current assets9,00,000

Retained earning3,50,000

Current Liabilities1,50,000

19,00,00019,00,000

Income statement for the year ending MarchSales Rs, 3,40,000Operating expenses (including Rs. 60,000 depreciation) l,20,000EBIT 2,20,000Less interest 60,000Earnings before tax 1,60,000Less taxes 56 000Net earnings (EAT) l,04,000(a) Determine the degree of operating, financial and combined sales level if all the operating expenses, other than depreciation. are variable costs.(b) If total assets remain at the same level, but sales (i) increase by 20 per cent and (ii) decrease b 20%, what will be the earnings per share in the new situation?Q-17The Net Sales of A Ltd is Rs 30 Cr. EBIT of the Company as the % of Net Sales is l2%. The Capital Employed comprises Rsl0 Cr. Equity Share Capital, Rs 2 Cr 13% Cumulative Pref. Share Capital & Rs 6 Cr. l5% Debt. The tax-Rate is 30%Required :l) Calculate ROE for the Company & indicate its segments due to presence of Pref. Share Capital & Debt.2) Calculate the operating leverage if the combined leverage is 3.

CAPITAL BUDGETINGMEANING OF CAPITAL BUDGETING The term capital budgeting means planning for capital assets. The capital budgeting decision means a decision as to whether or not money should be invested in long-term projects. Such projects may include the setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside. It includes a financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives. The finance manager has various tools and techniques by means of which he assists the management in taking a proper capital budgeting decisions.The capital budgeting decisions therefore evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit which may arise from capital budgeting decisions may be either in the firm of increased revenues or reduction in costs. A capital budgeting decision requires evaluation of a proposed project to forecast the likely or expected return from the project and determine whether return from the project is adequate. Further, since business is a part of society, it is therefore also the moral responsibility of a finance manager to undertake only those projects which are socially desirable.REASONS FOR THE IMPORTANCE OF CAPITAL BUDGETING DECISIONSThe capital budgeting decisions are important, crucial and critical business decisions due to following cases:l. Substantial expenditure: Capital budgeting decisions involves the investment of substantial amount of funds. It is therefore necessary for a firm to make such decisions after a thoughtful consideration so as to result in the profitable use of its scarce resources.The hasty and incorrect decisions would not only result into huge losses but may also account for the failure of the firm.2. Long time period: The capital budgeting decision has its effect over a long period of time. These decisions not only affect the future benefits and costs of the firm but also influence the rate and direction of growth of the firm.3. Irreversibility: Most of the investment decisions are irreversible. Once they are taken, the firm may not be in a position to reverse them back. This is because, as it is difficult to find a buyer for the second- hand capital items.4. Complex decision: The capital investment decisions involves an assessment of future events, which in fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms all the benefits or the costs relating to a particular investment decision.TYPES OF CAPITAL INVESTMENTSThere are many ways to classify the capital budgeting decision. Generally capital investments are classified in two ways. One way is to classify them on the basis of firms existence. Another way is to classify them on the basis of decision situation.On the basis of Firms existence : The capital budgeting decisions are taken by both newly firms as well as by existing firms. The new firms may be required to take decision in respect of a plant to be installed. The existing firm may be required to take decisions to meet the requirement of new environment or to face the challenges of competition. These decisions may be classified into:

(i) Replacement and Modernisation decisions(ii) Expansion decisions(iii) Diversification decisionsOn the basis of decision situation: The capital budgeting decisions on the basis of decision situation are classified as follows:(i) Mutually exclusive decisions(ii) Accept-reject decisions(iii) Contingent decisionsInvestment Appraisal TechniquesThe techniques available for appraisal of investment proposals are classified under three heads :1. Techniques that recognize payback of capital employed:Payback period method2. Techniques that use accounting profit for project evaluation:a. Accounting rate of return methodb. Earnings per share3. Techniques that recognize time value of money:a. Net present value methodb. Internal rate of return methodc. Net terminal value methodd Profitability index methode. Discounted payback period methodEach of the above methods are discussed below in detail:Payback period methodThe payback period is usually expressed in years, which it takes the cash inflows from a capital investment project to equal the cash outflows. When deciding between two or more competing projects the usual decision is to accept the one with the shortest payback. Payback is commonly used as a first screening method. It is a rough measure of liquidity and rate of profitability. This method recognizes the recovery of the original capital invested in a project. The basic element of this method is a calculation of recovery time; by accumulation the cash inflows (inclusive of depreciation) year by year until the cash flows equal the amount of the original investment. The length of time this process takes gives the payback period for the project. In simple terms it can be defined as the number of years required to recover the cost of the investment.Merits and Demerits The merits and demerits in using payback period method are summarized below:Merits It is simple to apply, easy to understand and of particular importance to business which lack the appropriate skills necessary for more sophisticated techniques. In case of capital rationing, a company is compelled to invest in projects having shortest payback period. This method is most suitable when the future is very uncertain. The shorter the payback period, the less risky is the project. Therefore, it can be considered as an indicator of risk. This method gives an indication to the prospective investors specifying when their funds are likely to be rapid. It does not involve assumptions about future interest rates. Ranking projects according to their ability to repay quickly may be useful to firms when experiencing liquidity constraints. They will need to exercise careful control over cash requirements.Demerits It does not indicate whether an investment should be accepted or rejected, unless the payback period is compared with an arbitrary managerial target. The method ignores cash generation beyond the payback period and this can be seen more a measure of liquidity than of profitability. It fails to take into account the timing of returns and the cost of capital. It fails to consider the whole life time of a project. It is based on a negative approach and gives reduced importance to the going concern concept and stress on the return of capital invested rather than on the profits occurring from the venture. The object of the business organisation is certainly not to recover the capital but to earn profits on it. The traditional payback approach does not consider the salvage value of an investment. It fails to determine the payback period required in order to recover the initial outlay if things go wrong. The bailout payback method concentrates on this abandonment alternative. This method make no attempt to measure a percentage return on the capital invested and is often used in conjunction with other methods. The projects with long payback periods are characteristically those involved in long-term planning. And which determine an enterprises future. However. they may not yield their highest returns for a number of years and the result is that the payback method is biased against the very investments that are most important to long-term,Payback Period Reciprocal - An alternative way of expressing the payback period the 'payback period reciprocal which is expressed as :Thus if a project has a payback period of 2.5 years, then the payback period reciprocal would be :The higher the payback period reciprocal (and hence the lower the payback period) the more worth while the project becomes. The only real relevance of this calculation is that laymen may be happier in discussing percentages measure.

Accounting Rate of Return MethodThe Accounting rate of return (also known as return on investment or return on capital employed) methodemploy the normal accounting technique to measure the increase in profit expected to result from an investment by expressing the net accounting profit arising from the investment as a percentage Of that capital investment. In this method, most often the following formulas is applied to arrive at the accounting rate of return.

Sometimes, initial investment is used in place of average investment. Of the various accounting rates of return on different alterative proposals, the one having highest rate of return is taken to the best investment proposal. For example, in three alternative proposals. A, B and C with expected accounting rates of return of 10%, 20% and 18% respectively. Projects will be selected in order of B, C and A. If the prevailing rates of interest is taken to be 15% p.a., only proposals B and C will qualify for consideration and in that order.Merits and Demerits - The merits and demerits of accounting rate of return method are summarized as follows:Merits It is easy to calculate because it makes use of readily available accounting information. It is not concerned with cash flows but rather based upon profits which are reported in annual accounts and sent to shareholders. Unlike payback period method. This method does take into consideration all the years involved in the life of a project. Where a number of capital investment proposals are being considered, a quick decision can be taken by use of ranking the investment proposals. If high profits are required, this is certainly a way of achieving them.Demerits It does not take into account time value of money. It fails to measure properly the rates of return on a project even if the cash flows are even over the project life. It uses the straight line method of depreciation Once a change in method of depreciation takes place, the method will not be easy to use and will not work practically. This method fails to distinguish the size of investment required for individual projects. Competing investment proposals with the same accounting rate of return may require different amounts of investment. It is biased against short-term projects in the same way that payback is biased against longer-term ones. Several concepts of investment are used for working out accounting rates of return. Thus, there is no full agreement on the proper measure of the term investment. Thus different managers have different meanings when they refer to accounting rate of return. The accounting rates of return does not indicate whether an investment should be accepted or rejected, unless the rates of return is compared with the arbitrary management target. It measures the returns in relation to the outlay and does not evaluate the absolute worth of the returns. Problem the returns in relation to the outlay and does not evaluate the absolute worth of the returns. Problem can arise in defining yearly profits, which will depend, to a certain extent, on the accounting policies adopted by the firm with respect to such items as stock valuation, treatment of depreciation, research and development etc.Earnings per Share (EPS)EPS is calculated the dividing Accounting Profit by the number of shares in issue. The value of the firm is maximized when market price of equity shares is maximized. EPS has been advocated as an appropriate and operationally feasible criterion to choose among the alternative financial actions. In practice, the performance of a corporation is better judged in terms of EPS. EPS is one of the important measures of capital investment appraisal.EPS is calculated as follows:Where,EBIT = Earnings before interest and taxI = InterestT = Corporate tax rateD = Preference dividendN = Number of Equity sharesThe main drawback of this method is it ignores cash flows, timing and risk.Net Present Value (NPV) MethodThe objective of the firm is to create wealth by using existing and future resources to produce goods and services. To create wealth, inflows must exceed the present value of all anticipated cash outflows. Net present value is obtained by discounting all cash outflows and inflows attributable to a capital investment project by a chosen percentage e. g., the entity weighted average cost of capital. The method discounts the net cash flows from the investment by the minimum required rate of return, and deducts the initial investment to give the yield from the funds invested lf yields positive the project is acceptable. If it is negative the project is unable to pay for itself and is thus unacceptable.The exercise involved in calculating the present value is known as discontinuing and the factors by which we have multiplied the cash flows are known as the discount factors. The discount factor is given by the following expression:Where r is the rate of interest per annum and n is the number of years over which we are discontinuing.Discounted cash flow is an evaluation of the future net cash flows generated by a capital project, by discontinuing them to their present day value. One of the main disadvantages of both payback and accounting rates of return methods is that they ignore the fact that money has time value. The discontinuing technique converts cash inflows and outflows for different years into their respective values at the same point of time, allows for the time value of money.Merits and demerits-The merits and demerits of NPV methods are summarized below:

Merits It is based on the assumption that cash flows, and hence dividends, determine shareholders wealth. Cash flows are subjective than profits. It recognizes the time value of money. It considers the total benefits arising out of proposals over its lifetime. The future discount rate normally varies due to longer time span. This rate can be applied in calculating the NPV by altering the denominator. This method is particularly useful for the selection of mutually exclusive projects. (In mutually exclusive projects acceptance of one project tantamount to rejection of the other project). This method of project selection is instrument in achieving the financial objective, i.e. the maximization of the shareholders wealth.In brief; the NPV method is a sound technique for the selection of investment projects.Demerits It is difficult to calculate as well as understand it as compared to accounting rate of return method or payback method. Calculation of the desired rates of return presents serious problems. Generally cost of capital is the basis of determining the desired rate. The calculation of cost of capital is itself complicated. Moreover. desired rates of return will vary from year to year. This method is an absolute measure. When two projects are being considered, this method will Ravour the project which has higher NPV. This method may not give satisfactory results where two projects having different effective lives are being compared. Normally, the project with shorter economic life is preferred, if other things are equal. This method does not attach importance to the shorter economic life of the project. This method emphasizes the comparison of net present value and disregards the initial investment involved. Thus, this method may not give dependable results.Internal Rate of Return (IRR) MethodInternal rate of return is a percentage discount rate used in capital investment appraisals which brings the cost of a project and its future cash inflows into equality. lt is the rate of return which equates the present value of anticipated net cash flows with the initial outlay. The IRR is also defined as the rate at which the net present value is zero. The rate for computing IRR depends as bank lending rate or opportunity cost of funds to invest which is often called as personal discontinuing rate or accounting rate. The test of profitability of a project is the relationship between the internal rate of return (%) of the project and the minimum acceptable rate of return (%)Merits and Demerits - The merits and demerits of IRR method are summarized as below:Merits It considers the time value of money. It takes into account the total cash inflows and cash outflows. It is easier to understand by executives and non-technical personnel. For example, business executives will understand the investment proposal on a better way if told that IRR of an investment is 20% against the desired rate of an investment is Rs. l5,396. It does not use the concept of desired rate of return whereas it provides the rate of return which is indicative of the profitability of investment proposal.Demerits It involves tedious calculations, based on trial and error method. It produces multiple rates which can be confusing. Projects selected based on higher IRR may not be profitable. Unless the life of the project can be accurately estimated, assessment of cash flows cannot be correctly made. Single discount rate ignores the varying future interest rates.Relative ranking of projects : IRR vs. NPV : The relative ranking of projects. using the different DCF methods will be considered initially in simple accept / reject situations. This will be extended later to a detailed assessment of situations where a choice has to be made between two or more alternatives. In simple accept / reject situations a firm is able to implement all projects showing a return at or above the firms cost of capital. Both NPV and IRR would appear to be equally valid in the sense that they will both lead to accept or reject the same periods.Using NPV, all projects with a positive net present value, when discounted at the firms cost of capital, will be accepted. Using IRR all projects which yield an internal rate of return in excess of the firms cost of capital will be chosen.However, although IRR and NPV lead to the same conclusion regarding project acceptability, the ranking of a set of projects obtained from IRR does not necessarily agree with that produced using NPV, Since. In the latter case, the ranking may vary according to particular discount rate used.Argument about the merits of the relative rankings in simple accept/ reject situations is thus concerned with the question of value. It is argued that the IRR measures only the quality of the investment while NPV takes into account both the quality and the scale. This is because the IRR provides a relative measure of value (% IRR) while the NPV provides an absolute measure (Rs. surplus). Thus the IRR would rank, for example. At 100% return on an investment of Re. I considerably higher than a 20% return on an investment of Rs. 10 lakhs, whereas the reverse would be true using NPV (as long as the cost of capital is below 20%).While one project may have a higher rate of profit per unit of capital invested than another. it` it has fewer units of capital invested in it, it may make a smaller contribution to the wealth of the firm. Thus it the objective is to maximize the finds wealth, then the ranking of project NPVs provides the correct measure It the objective is to maximize the rate of profitability per unit of capital invested, then IRR would provide the correct ranking of projects, but this objective could be achieved by rejecting all but the most highly profitable projects. This is clearly unrealistic and, therefore, one would conclude that NPV ranking is correct and IRR unsatisfactory as a measure of relative project value.

When two investment proposals are mutually exclusive, both methods will give contradictory results When two mutually exclusive projects are not expected to have the same life, NPV and IRR methods will give conflicting ranking.Profitability index (PI) methodIt is a method of assessing capital expenditure opportunities in the profitability index, sometimes called the cost-benefit ratio. The profitability index is the present value of an anticipated net future cash flows divided by the initial outlay. The only difference between the Net Present Value method and profitability index method is that when using the NPV technique the initial outlay is deducted from the present value of anticipated cash flows, whereas with profitability index approach the initial outlay is used as a divisor, In general terms, a project is acceptable if its profitability index value is greater than 1 clearly a project offering a profitability index greater than l must also offer a net present value which is positive.Mathematically, PI (profitability index) can be expressed as follows: Present value of cash inflowProfitability Index (PI) = Present value of cash outlay

This method is also called cost-benefit ratio or desirability ratio methodDiscounted payback period methodIn this method the cash flows involved in a project are discounted back to present value tends are discussed below. The cash inflows are then directly compared to the original investment in order to identify the period taken to pay back the original investment in present values tends. This method overcomes one of the main objections to the original payback method in that it now fully allows for the timing of the cash flows, but it still does not take into account those cash flows which occur subsequent to the payback period and which may be substantial.This method is a variation of payback period method, which can be used if DCF methods are employed. This is calculated in much the same way as the payback, except that the cash flows accumulated are the base year value cash flows which have been discounted at the discount rate used in the NPV method (i.e., the required return on investment). Thus, in addition to the recovery of cash investment, the cost of financing the investment during the time that part of the investment remains unrecovered is also provided for. It thus, unlike the ordinary payback method, ensures the achievement of at least the minimum required return, as long as nothing untoward happens after the payback period.Assumptions in use of DCF techniquesIn use of discounted cash flow techniques the following assumptions should be given consideration: The discount rate is constant over the life of the investment. All cash flows can be predicted with certainty so that a risk premium need not be added to the discount rate in order to compensate for risk. The unadjusted rate represents the risk free and is the discount rate used to allow for time value of money. In project appraisal, managers work with uncertain future events and estimated cash flows expected to occur in future years. This involves a substantial amount of estimation which in practical terms, means that spurious accuracy is something which needs to be avoided. The discount figures used can be calculated with great accuracy but when they are applied to these future estimated cash flows, the resultant calculation is only as accurate as the cash flows estimates. In many companies there is a tendency to produce discounted cash flow computation with several decimal places on each of the present values. This creates a totally fallacious appearance of accuracy in the evaluation process. To enable convenient calculations, to be performed, it is normal practice is capital project evaluations to assume that all cash flows take place at the end of the year. The initial cash outflows or investment in a project is assumed to take place now. The cash flows which go out now are taken to be at year O. The concept of year O does not mean a year in general tem1s, but a point in time, i.e., today. Year 1 cash flows are assumed to take place at the end of the first year. The second year cash flows occurring at the end of the year 2 and similarly for subsequent years. In appraising long projects, it is normal to use an arbitrary horizon period of 10 to l5 years. Finns do not consider cash flows beyond the horizon even if they expect the project to last longer.Capital RationingCapital rationing is a situation where a constraint or budget ceiling is placed on the total size of capital expenditures during a particular period. Often firms draw up their capital budget under the assumption that the availability of financial resources is limited.Capital rationing refers to a situation where a company cannot undertake all positive NP V projects it has identified because of shortage of capital. Under this situation, a decision maker is compelled to reject some of the viable projects having positive net present value because of shortage of funds. It is known as a situation involving capital rationing.In terms of financing investment projects, the following important questions are to be answered: What would be the requirement of funds for capital investment decisions in the forthcoming planning period? How much quantum of funds available for capital investment How to assign th