1  

LONG TERM INVESTMENT ANALYSIS

2  

Debt Policy of a Company

Modigliani and Miller View :

There are two propositions as per Modigliani and Miller in terms of capital structure

of the Company .

Proposition I :

The propositions I states that in a perfect capital market the value of the firm does

not depend on the capital structure. Actually the value of the firm is dependent on

its productive capacity and the productive capacity is dependent on the fixed asset

of the company . Since the fixed asset of the firm would remain constant , the

productive capacity would also remain constant and this results in the valuation of

the firm unchanged.

Let us give an example to clear this concept. Suppose there are two firms and both

are having Rs 10,000 investment in fixed asset . One firm financed this fixed asset

entirely by equity and the second firm financed it with 50% debt and 50% equity. As

per Modigliani and Miller hypothesis I both the firm would have the same value as

the productive capacity is same and in a perfect capital market the valuation of the

firm does not depend on the capital structure ( for example see page no 448 to 450.

Proposition II :

This states that the expected return of stock on a firm increases with the degree of

financial leverage. Though the overall cost of capital remains the same, the expected

return on equity goes up with the degree of leverage and the benefit arising out of

low cost debt would be compensated with the increase in required return on equity

resulting in the overall return on asset of the firm unchanged. ( for calculation see

page no 454 , 455 ) . This is represented by the following equation :

3  

rE = rA + ( rA – rD ) [D/E] …………………………….1

rE = Required return on equity

rA = Return on asset

rD = Return on Debt

D = Market Value of debt

E = Market Value of Equity

Problem 1 : Hubbard’s Pet food is financed by 80 percent by common stock and 20

percent by bonds. The expected return on the common stock is 12 percent and the

rate of interest on the bonds is 6 percent. What would be the expected return on

equity at 30% and 50% debt to equity ratio?

Solution : The Company’s cost of capital is :

rA = ( 0.8* 12% ) + (0.20* 6%) = 10.8% ;

at 30% leverage the required return on equity is given by rE = rA + ( rA – rD )

[D/E] = 10.8% + (10.8% -6% ) * (0.30/0.70) = 12.86% and at 50% debt and

50% equity we have the required return of equity is 15.60% .

The proposition II explains why the value of the firm remains the same even when

we change the capital structure.

An important formula :

4  

The beta of the firm’s asset is the weighted average of the betas of the individual

securities. This is explained with the help of the following equation :

Beta asset = ( proportion of debt * debt beta ) + ( proportion of equity * beta

equity )

βA = [ D/(D+E)] * βD + [ E/(D+E) ] * βE ……………………..2.

Problem 2 : Schuldenfrei pays no taxes and is financed entirely by common stock.

The stock has a beta of 0.8 , price earning ratio of 12.5 and is priced to offer 8%

expected return. Schuldenfrei now decides to repurchase half of the common stock

and substitute with an equal value of debt. If debt yields a risk free 5 percent ,

calculate the beta of the company after the refinancing , the required return and risk

premium on the stock before the refinancing and the required return and risk

premium on the stock after the refinancing.

Solution : Before the refinancing, Schuldenfrei is all equity financed. The equity beta

is 0.8 and the expected return on equity is 8%. Thus, the firm’s asset beta is 0.8 and

the firm’s cost of capital is 8%. We know that these overall firm values will not

change after the refinancing and that the debt is risk-free.

a. ⎟⎟⎠

⎞⎜⎜⎝

⎛×

++⎟⎟

⎠

⎞⎜⎜⎝

⎛×

+= EDA β

EDEβ

EDDβ

0.8 = (0.5 × 0) + (0.5 × βE)

βE = 1.60

b. Before the refinancing, the stock’s required return is 8% and the risk-

free rate is 5%; thus, the risk premium for the stock is 3%.

5  

c. After the refinancing:

⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛×

++×

+= Er

EDE

Dr ED

DAr

0.08 = (0.5 × 0.05) + (0.5 × rE)

rE = 0.11 = 11.0%

After the refinancing, the risk premium for the stock is 6%.

The traditional view of capital structure :

The expected return on portfolio of all the securities of a company is often referred

to as the weighted average cost of capital :

Weighted Average Cost of Capital = rA = ( D/V) * rD + rE * ( E/V) .

It is used in capital budgeting decisions to find the net present value of projects that

would not change the business risk of the firm.

In many times we are confused with the goal of a company . Out of the following

two options what is the goal of the company ?

1. Maximising the value of the firm .

2. Minimising the weighted average cost of capital ;

The value of the firm is given by the present value of discounted future cash flows .

So the value of the firm is given by :

Value of the firm = Σ Present value of the cash flows of the firm

= Σ ( Future cash flow of the firm )/ ( appropriate discount

rate time adjusted )

If the cash flow of the firm does not change with the change in discount rate,

then the minimization of the denominator i.e. the minimization of weighted

average cost of capital would maximise the value of the ratio. However if the

future cash flow of the firm changes due to change in weighted average cost of

capital , then the valuation of the firm does changes. In such case the goal of the

firm should be maximising the value of the firm not the minimization of the

weighted average cost of capital .

6  

According to the traditional view of the capital structure of the firm, they hold that

the valuation of the firm does depend on the capital structure . As per their view ,

the required return on equity does increases with the increase in leverage but not in

the same degree as prescribed by the MM II. So the increase in required return on

equity on levered firm is less than the benefit derived from low cost financing of

debt and this resulted in the maximization of the value of the firm at a particular

debt to equity ratio. So as per their stand point, a firm can have a optimum debt

equity ratio at which the valuation of the firm is maximum. However when an

irresponsible firms borrow excessively then the required return on equity shoots up

faster than MM II proposition and this would reduce the valuation of the firm. For

pictorial comparison of these two theory please see fig 17.3 page number 460.

Problem 3 : Capital Netto is financed solely by common stock , which offers an

expected return of 13 percent. Suppose now that the Company issues debt and

repurchases stock so that its debt ratio is 0.4. Investors note the extra risk and raise

their required return on the stock to 15 percent. What is the interest rate on debt ? If

the debt is risk free and beta of the equity after refinancing is 1.5 , what is the

expected return on the market ?

Solution :

Since in this case the company is fully equity financed, the return on asset rA is 13%

which is equal to return on equity. Now by using the equation 1 , we get :

15% = 13% + (13% -rD ) * ( 0.4/0.6)

Solving this we get rD 10% .

The required return on equity is given by the CAPM as per the following :

rE = rf + β (rm - rf )

15% = 10% + 1.5 (rm – 10% )

7  

rm = 13.33% .

Problem 4: Executive Cheese has issued debt with a market value of USD 100

million and has outstanding 15 million shares with a market price of USD 10 a

share. It now announces that it intends to issue a further USD 60 million of debt and

to use the proceeds to buy back common stock. Debtholders , seeing the extra risk,

mark the value of the existing debt down to USD 70 million .

a) How is the market value of the stock affected by the announcement ?

b) How many shares can the Company buy back with USD 60 million of new

debt that it issues?

c) What is the market value of the firm ( equity plus debt ) after the change of

capital structure ) ?

d) What is the debt ratio after the change in structure ?

e) Who gains or losses?

Solution :

a) The value of the existing debt goes down by USD 30 million and this is the

gain of the equity holder as the total value of the firm remains unchanged.

So the value of the equity would be USD 10 * 15 million plus USD 30

million i.e. USD 180 million . The value of per share would be USD 180

million / 15 = USD 12 . The share value gains by USD 2 per share.

b) The number of shares can be bought = USD 60 million/ USD 12 = 5

million;

c) The market value of the firm would remain unchanged.

d) The debt ratio after the change in structure would be 130/250 = 0.52;

e) The gain is for equity holders and the loss is for old debt holders.

8  

Borrowing Capacity of the firm In the previous section we have not considered the concept of certain benefits which

debt enjoys compared to that equity financing. In the case of debt the amount of

interest paid is tax deductible and for this amount the firm would not pay any tax.

So if a Company finance its capital structure with a debt , then the firm as a whole

enjoys certain benefits . This can be understood clearly with the help of the following

example :

Two firms wants to purchase one fixed asset each and the nature of fixed asset is

same. Let us assume that the cost of the fixed asset is Rs 100 lacs. One firm decides

to fund this fixed asset with 100 % equity and another firm with 50% debt and 50%

equity. The return on asset would be paid back to the lenders consisting of both debt

and equity holder ( this is important as many time we find that return is only for the

equity holder ) . Now firm A and Firm B would be having same amount of

operating cash flow since it is the fixed asset which determines the production

capacity. Let us assume that the firm’s EBIT is Rs 10 lacs and the cost of debt is 10% .

Now the tax structure is as follows :

For debt borrowing the entire interest payment is deductible ;

For interest earning of the lender , the interest income is taxed at 20% ;

For equity , dividend payment attracts dividend distribution tax at 10% ;

For equity in the case of lender , the dividend income is tax free.

Corporate tax is 30% ;

Based on the above we shall calculate the total return on the lender i.e. both debt

holder and equity holder :

( Rs in lacs)

Firm A Firm B

EBIT 10 10

Interest 0 5 ( @10% on Rs 50 lacs)

EBT 10 5

Tax @ 30% 3 1.5

9  

EAT 7 3.5

Dividend Distribution

tax

0.70 0.035

Dividend to be paid to

equity lender

6.30 3.465

Income to equity holder

Income to equity Holder

i.e. Dividend

6.30 3.465

Tax on dividend income 0 0

Income to equity holder 6.30 3.465

Income to debt holder

Interest Income 0 5

Tax on interest Income @

20%

0 1

Income to debt holder 0 4

Total Income to lender

i.e. equity holder and

debt holder

6.30 7.465

If we see from the above example , we find that the return to the lender is increased

from Rs 6.30 lacs for firm A all equity finance to Rs 7.465 lacs for firm B due to tax

shields on interest paid and also due to income from equity is taxed at a lower rate.

So it shows that the value of the firm does change due to change in capital structure .

For relative tax advantage see page no 494 and 495.

Problem 1: Compute the present value of interest tax shields generated by these

three debt issues . The marginal tax rate is 35% :

a) A USD 1000 , one year loan at 8 percent ;

b) A five year loan of USD 1000,at 8 percent , assume no principal payment

until maturity;

10  

c) A five year loan of USD 1000, at 8 percent , with equal annual principal

payment for 5 years ;

d) A USD 1000 perpetuity at 7 percent ;

Solution :

a) The tax shield is USD 1000 * 8% * 0.35= 28 ; The present value of tax

shield is Rs 28/1.08 = Rs 25.93;

b) The tax shield for this debt repayment is calculated as below :

Year Principal

Interest

rate Interest Amount

Discount

factor at

8%

discount

rate

PV of

tax

shield

on

interest

1 1000 8% 28 1.08 25.9259

2 1000 28 1.1664 24.0055

3 1000 28 1.259712 22.2273

4 1000 28 1.360489 20.5808

5 1000 28 1.4693281 19.0563

111.796

c)

Year Principal

Interest

rate Interest Amount

Discount

factor at

8%

discount

rate

PV of

tax

shield

on

interest

11  

1 1000 8% 28 1.08 25.9259

2 800 22.4 1.1664 19.2044

3 600 16.8 1.259712 13.3364

4 400 11.2 1.360489 8.23233

5 200 5.6 1.4693281 3.81127

70.5103

d) The interest tax shield is given by = (1000 *0 .08 * 0.35) /0.08 = USD 350;

Problem no 2 : The following is the book and market value balance sheet of the

United Frypan Company ( UF) :

( USD )

Book Value Market Value

Debt $ 40 CA –

CL

$20 Debt $ 40 CA -

CL

$20

Equity $ 60 Long

Term

Asset

$ 80 Equity $120 Long

Term

Asset

$ 140

$ 100 $ 100 $ 160 $ 160

Assume that MM theory holds with taxes. There is no growth , and the $ 40 of debt is

expected to be permanent. Assume a 40 percent corporate tax rate.

a) How much of firm’s value is accounted for by the debt generated tax

shield ?

b) How much better off will UF’s shareholders be if the firm borrows $ 20

more and uses it to repurchase stock?

c) Now suppose that subsequently Congress of US , passes a law which

eliminates the deductibility of interest for tax purpose after a grace

12  

period of five year what would be the new value of the firm ( assume an

8 percent borrowing rate ) .

Solution :

a) PV of tax shield is the value of the firm increased because of debt

financing . So the value of the firm which is increased because of this is

40*0.40= USD 16 ;

b) The stock holders would be better off by the tax shield = 20 * 0.40=

USD 8 ;

c) The PV of tax shield is :

Year Principal

Interest

rate Interest Amount

Discount

factor at

8%

discount

rate

PV of

tax

shield

on

interest

1 60 8% 1.92 1.08 1.77778

2 60 1.92 1.1664 1.64609

3 60 1.92 1.259712 1.52416

4 60 1.92 1.360489 1.41126

5 60 1.92 1.4693281 1.30672

7.666

The Company value is 168-24+7.67= 151.67;

Problem 3 : a) What is the relative tax advantage of corporate debt if the corporate

tax rate is Tc = 0.35 , the personal tax rate is 0.31 , but all equity income is received as

capital gains and escapes tax entirely . b)How does the relative tax advantage change

if the company decides to pay out all equity income as cash dividend?

13  

Solution : Relative advantage of debt = ( 1- Tp ) / [ ( 1- TpE) (1- Tc ) = 0.69/[(1)(0.65)]

= 1.06;

b. Relative Advantage = 0.69/(0.69)*(0.65) = 1.54;

We have seen that borrowing in the form of debt helps the firm to increase the value.

However, along with the borrowing , we can have another problem which is called

cost of financial distress. This cost has to be deducted to find out the value of the

firm. So value of the firm can be found out by using the following formula :

Value of the firm = Value if all equity financed + PV ( tax Shield ) – PV ( cost of

financial distress) .

Financial distress can be of two nature one is the bankruptcy cost ( page no 497 to

503) and other is the cost before bankruptcy ( 503 to 507) . In case a firm has not

gone bankrupt , then equity holder and debt holder would behave differently . In

the time of distress , the equity holder would go ahead with more risky project

without taking the safe project ( page no 503 ) . The equity holder would also not

likely to contribute to the equity capital required for a project which would increase

the valuation of the firm. This results in the conflict of interest. So to protect the

interest of the debt lenders so that such situation does not arise , at the time of

lending it self debt holders would put negative covenants. This cost of distress varies

from industry to industry depending on the nature of asset financed out of

borrowing. In the case of industry which require more real asset like steel , power

etc, the cost of distress would be less and accordingly we can find that such type of

industry would have more debt than industry like software where the asset is

mostly intangible. So the nature of industry would also like to have a role on the

capital structure .

This would led to trade off theory . This theory states that the Company’s borrowing

strategy in terms of loan depends on the advantage of tax shield and disadvantage of

cost of financial distress. Firms depending on the nature of industry have different

target ratios. Company’s having more tangible asset would like to set higher debt to

equity target ratio whereas companies having lower tangible asset would be having

14  

low debt to equity target ratio. Unlike MM theory which says that the firm should

take more and more debt , trade off theory suggests that the firms should avoid

extreme situation and rationalise moderate debt ratios.

Pecking Order theory of financing choices :

As per this theory a firm would raise fund by issuing the securities in the following

sequence :

First it would prefer internal finance;

They adapt their target dividend payout ratios to their investment

opportunities , while trying to avoid sudden changes in dividends ;

Sticky dividend policies , plus unpredictable fluctuations in profitability and

investment opportunities mean that internally generated cash flows are some

time more or less than the capital expenditure and depending on the amount

the firm pays off or draws down marketable securities;

If external finance is required , firms issue the safest security first. That is they

start with debt , then possibly hybrid securities such as convertible bonds and

then perhaps equity as the last resort.

For financial slack please see page 514.

Problem 4 : The following is the balance sheet of a firm Circular File in terms of

market value :

Liability Asset

Bond outstanding 25 CA-CL 20

Common Stock 5 Fixed Asset 10

Total 30 Total 30

Who gains and who loses from the following maneuvers ?

a. Circular scrapes up $ 5 in cash and pays cash dividend.

b. Circular halts operations, sells its fixed assets , and converts its net

working capital into $ 20 cash. Unfortunately the fixed assets fetch

only $ 6 c on the second hand market. The $26 cash is invested in

treasury bills ;

15  

c. Circular encounters an acceptable investment opportunity , NPV=0

, requiring an investment of $ 10 . The firm borrows to finance the

project . The new debt has the same security , seniority etc.

d. Suppose that the new project has NPV +2 and is financed by an

issue of preferred stock.

e. The lender agrees to extend the maturity of their loan from one year

to two in order to give Circular a chance to recover.

Solution : Gainers : a. Stock holder; b. Bond Holders ; c. Stock Holders; d.

Bond Holders; Stock Holders.

Weighted Average Cost of Capital :

Weighted Average Cost of Capital (WACC) = rD ( 1- Tc) [D/V] + rE [ E/V]

The opportunity cost of capital would be r = rD [D/V] + rE [ E/V]

If we see the above two equations we find out that WACC is less than

opportunity cost of capital because of tax shield. WACC should be applied to

only those project which is of similar risk like the existing one and the D/E

ratio is maintained at the same level during the period of the project.

Find out the cost of debt : rD :

The debt can be loan , debenture. Both loan and debenture can be valued by

using the following bond valuation formula :

P0 = [C1/(1+rD)1] +[C2/(1+rD)2] + [C3/(1+rD)3]+ [C4/(1+rD)4]

+…….+[Cn/(1+rD)n]

Let us try to value both loan and debenture with the help of the above

equation :

16  

Problem 1 : What is the cost of debt of a loan of Rs 10000 where interest is

paid annually at 10% and principal is paid at the end of the tenure that is

after 5 years .

Solution :

Year Principal Interest

Interest

Amount Installment Interest Principal

Discount

rate

Discount

factor PV

1 10000 10% 1000 1000 0 10% 0.909091 909.0909

2 10000 1000 1000 0.826446 826.4463

3 10000 1000 1000 0.751315 751.3148

4 10000 1000 1000 0.683013 683.0135

5 10000 1000 11000 1000 10000 0.620921 6830.135

10000

Cost of loan is 10% .

b) What is the cost of a loan when the principal of the loan is paid in 5 annual

installment and interest is paid yearly.

Year Principal Interest

Interest

Amount Installment Interest Principal

Discount

rate

Discount

factor PV

1 10000 10% 1000 2000 1000 2000 10% 0.909091 2727.273

2 8000 800 2000 800 2000 0.826446 2314.05

3 6000 600 2000 600 2000 0.751315 1953.418

4 4000 400 2000 400 2000 0.683013 1639.232

17  

5 2000 200 2000 200 2000 0.620921 1366.027

10000

c) What is the cost of a loan when the principal of the loan is paid in 20 equated

quarterly installment.

Year Principal Interest

Interest

Amount Installment Interest Principal

Principal

Outstanding

Discount

rate

Discount

factor PV

1 10000 10% 250 641.471 250 391.471 9608.53 2.50% 1.025 625.826

2 9608.53 240.213 641.471 240.213 401.258 9207.27 1.05063 610.562

3 9207.27 230.182 641.471 230.182 411.29 8795.98 1.07689 595.67

4 8795.98 219.9 641.471 219.9 421.572 8374.41 1.10381 581.141

5 8374.41 209.36 641.471 209.36 432.111 7942.3 1.13141 566.967

6 7942.3 198.557 641.471 198.557 442.914 7499.38 1.15969 553.139

7 7499.38 187.485 641.471 187.485 453.987 7045.4 1.18869 539.647

8 7045.4 176.135 641.471 176.135 465.336 6580.06 1.2184 526.485

9 6580.06 164.502 641.471 164.502 476.97 6103.09 1.24886 513.644

10 6103.09 152.577 641.471 152.577 488.894 5614.2 1.28008 501.116

11 5614.2 140.355 641.471 140.355 501.116 5113.08 1.31209 488.894

12 5113.08 127.827 641.471 127.827 513.644 4599.44 1.34489 476.97

13 4599.44 114.986 641.471 114.986 526.485 4072.95 1.37851 465.336

14 4072.95 101.824 641.471 101.824 539.647 3533.3 1.41297 453.987

18  

15 3533.3 88.3326 641.471 88.3326 553.139 2980.17 1.4483 442.914

16 2980.17 74.5041 641.471 74.5041 566.967 2413.2 1.48451 432.111

17 2413.2 60.33 641.471 60.33 581.141 1832.06 1.52162 421.572

18 1832.06 45.8014 641.471 45.8014 595.67 1236.39 1.55966 411.29

19 1236.39 30.9097 641.471 30.9097 610.562 625.826 1.59865 401.258

20 625.826 15.6456 641.471 15.6456 625.826 0.00 1.63862 391.471

10000

It means that for all the type of loan ( irrespective of their payment schedule ) the

cost of the debt is interest cost charged on the loan.

e) If the debenture is issued at a premium of Rs 100 /- and face value of the

debenture is Rs 10,000/- and the coupon is 10% and the principal and

interest to be paid in 20 equal quarterly instalment .

Year Principal Interest

Interest

Amount Installment Interest Principal

Principal

Outstanding

Discount

rate

Discount

factor PV

1 10000 10% 250 641.471 250 391.471 9608.53 2.39% 1.02395 626.468

2 9608.53 240.213 641.471 240.213 401.258 9207.27 1.04847 611.816

3 9207.27 230.182 641.471 230.182 411.29 8795.98 1.07358 597.506

4 8795.98 219.9 641.471 219.9 421.572 8374.41 1.09929 583.531

5 8374.41 209.36 641.471 209.36 432.111 7942.3 1.12562 569.883

6 7942.3 198.557 641.471 198.557 442.914 7499.38 1.15258 556.554

7 7499.38 187.485 641.471 187.485 453.987 7045.4 1.18018 543.537

19  

8 7045.4 176.135 641.471 176.135 465.336 6580.06 1.20844 530.824

9 6580.06 164.502 641.471 164.502 476.97 6103.09 1.23739 518.409

10 6103.09 152.577 641.471 152.577 488.894 5614.2 1.26702 506.284

11 5614.2 140.355 641.471 140.355 501.116 5113.08 1.29736 494.442

12 5113.08 127.827 641.471 127.827 513.644 4599.44 1.32843 482.878

13 4599.44 114.986 641.471 114.986 526.485 4072.95 1.36025 471.584

14 4072.95 101.824 641.471 101.824 539.647 3533.3 1.39282 460.554

15 3533.3 88.3326 641.471 88.3326 553.139 2980.17 1.42618 449.782

16 2980.17 74.5041 641.471 74.5041 566.967 2413.2 1.46034 439.262

17 2413.2 60.33 641.471 60.33 581.141 1832.06 1.49531 428.989

18 1832.06 45.8014 641.471 45.8014 595.67 1236.39 1.53112 418.955

19 1236.39 30.9097 641.471 30.9097 610.562 625.826 1.56779 409.156

20 625.826 15.6456 641.471 15.6456 625.826 0.00 1.60534 399.586

10100

In this case the cost of debenture is 2.39% * 4 = 9.56%.

Cost of equity can be found out by CAPM :

Ke = Rf + βE ( Rm – Rf ) .

While calculating the beta , we have to use the following methods :

Step 1 : Find out the levered beta at a particular debt to equity ratio.

20  

Step 2 : Convert the levered beta into un levered beta by using the following

equation :

βUL = βL/ [1+(1-T)*D/E]

Step 3 : Convert this un levered beta into levered beta at a targeted debt equity ratio

:

βL = βUL * [1+(1-T)*D/E]

Step 4 : Finding out the appropriate risk free rate

Step 5 : Finding out the risk premium and then use of the equation:

Ke = Rf + β ( Rm-Rf)

Problem 1 : Calculate the WACC for Federal Junkyard of America, using the

following information :

Debt $ 75,000,000 book value outstanding . The debt is trading 90 percent of

par value . The YTM is 9 % .

Equity 2,500,000 shares selling at $42 per share. Assume that the expected rate

of return on equity is 18 %;

The marginal tax rate is 35%;

Solution : D = $ 69,500,000, Kd = 9% ; E = $ 105,000,000 ; Ke = 18% ;

21  

WACC = 9% *(0.65) * 0.0.398+ 18% * 0.602 = 13.16% ;

Problem 2 : Suppose that the Company decides to move to a more conservative debt

policy. A year later its debt ratio is down to 15% ( D/V) and the interest rate has

dropped to 8.6% . Recalculate the WACC .

Solution : rA = 0.09*0.398 + 0.18*0.602 = 14.42%

Now rE = [ 14.42% - 8.6%*0.15]/0.85 = 15.44% ;

WACC = 8.6% 0.650.15+ 15.44%*0.85= 13.96% ;

Valuing companies : WACC vs Flow to Equity method :

WACC is normally used as a hurdle rate or discount rate to value proposed capital

investments. But sometimes, it is used as a discount rate for valuing the whole

company . However the following need to be kept in mind while using WACC for

valuation of a company :

Cash flows should not deduct interest . Calculate the tax as if the company is

all equity financed; The value of interest tax shield is picked up in the WACC

formula; Be careful in determining the terminal value; Discounting at WACC we get the value of the firm. If our intention is to get

the value of the equity , we have to deduct the debt part.

22  

Problem 3 : The following is the balance sheet of a company :

( in $ ‘000)

Liability Asset

Share Holders

Equity

246,300 Property , Plant

and Equipment

302,000

Deferred taxes 45,000 Other Asset 89,000

Long term debt 208,600 Inventories 125,000

Short term debt 75,600 Accounts

Receivable

120,000

Accounts Payable 62,000 Cash and

Marketable

Securities

1,500

Total Current

Liability

137,600 Total Current

Asset

246,500

Total Liability 637,500 Total Asset 637,500

The Company’s operating income is $ 100.5 million . Assume for simplicity that this

figure is expected to remain constant for ever. The long term debt cost is 8 percent,

the short term debt cost is 6% , the expected return on equity is 15 percent. There are

7.46 million shares outstanding , and the shares are trading at $ 46. The tax rate is

35% .

Value the Company by the flow to equity method.

23  

Solution :

Pre-tax operating income $100.5

Short-term interest 4.5

Long-term interest 16.7

Earnings before tax $79.3

Tax 27.8

Net income $51.5

Value of equity = $51.5/0.15 = $343.3

Value of firm = $343.3 + $75.6 + $208.6 = $627.5

Adjusted Present Value Method ( APV Method ) :

WACC , as a hurdle rate would be applicable if the project meets the two following

criteria :

The project is of same risk as the existing business;

The project would maintain the constant proportion of debt to equity ratio

during the entire tenure of the project;

If these two are not met , the WACC as a discount rate would not be correct method

for evaluating the project. In such case ,we have to evaluate the project under APV

method :

APV = base case NPV + sum of the present values of the side effects of accepting the

project.

Problem 4 : A project costs $ 1 million and has a base case NPV of exactly zero.

What is the project’s APV in the following cases ?

24  

a) If the firm invests , it has to raise $ 500,000 by stock issue. Issue costs are 15

percent of net proceeds.

b) The firm has ample cash on hand. But if it invests , it will have access to $

500,000 debt financing at a subsidized interest rate . The present value of

subsidy is $ 175,000.

c) If the firm invests its debt capacity increases by $ 500,000. The present value

of interest tax shield on this debt is $ 76,000.

Solution :

a) APV = 0-75000= -75,000;

b) APV = 0+175,000 = 175,000;

c) APV= 0 + 76,000 = 76,000;

Problem 5 : Whispering Pines Inc is all equity financed . The expected rate of return

on the Company’s shares is 12 percent.

a) What is the opportunity cost of capital for an average risk Whispering Pines

investment ?

b) Suppose the company issues debt –repurchases shares and moves to a 30

percent debt to value ( D/V = 0.30) . What will the Company’s WACC a the

new capital structure ? The borrowing rate is 7.5% and the tax rate is 35% ;

Solution : a) The opportunity cost of capital would be 12% ;

c) rE = rA + (rA – rD ) D/E = 12% + (12% -7.5%) * (3/7) = 13.93% ;

WACC = 7.5%*0.3*0.65+13.9% *0.7= 11.19%;

Problem 6 : Consider a project lasting for one year only. The initial outlay is USD

1000 and the inflow is USD 1200 after one year. The opportunity cost of capital is

20% .

a) Calculate the base case of APV of the project .

b) Calculate the APV of the project is the 30% of the project cost is equity

financed , the interest cost is 10% and the tax rate is 35%;

Solution :

25  

a) The base case NPV is = (1000) +1200/1.20 = 0; The opportunity cost of capital

is the all equity discounting rate.

b) APV = 0+ 300*0.35*10%/1.10= 9.55.

APV and hurdle rate :

The opportunity cost of capital is the expected rate of return offered in capital

market by equivalent risk project. This depends on the risk of the project’s cash flow.

The opportunity cost of capital is correct discount rate for the project if it is all equity

financed.

The adjusted opportunity cost of capital or hurdle rate reflects the financing side

effects of an investment project. So when financing affect is important , you have to

take the project with positive APV . But if you know the adjusted cost of capital ,

your decisions parameter is NPV at the adjusted discount rate. The WACC is the

most common way to calculate the adjusted cost of capital . ( page no 543 & 544)

Discounting Safe and nominal cash flow :

In case you have to discount safe and nominal cash flow , you have to discount the

same with the after tax unsubsidized borrowing rate . This should be after tax cost of

debt of the firm.

Problem 7 : The US government has settled a dispute with your Company for USD

16 million and it is committed to pay this amount in exactly 12 months .However ,

your company will have to pay tax on the award at a marginal tax rate of 35 percent .

What is the award worth if one year treasury rate is 5.5 percent ?

Solution : PV = 16 ( 1-0.35)/(1+0.055(1-0.35)) = $ 10.04 million.

Problem 8 : Digital Organics has the opportunity to invest $ 1 million now ( t=0) and

expects after tax returns of $6,000,000 in t=1 and $ 7,000,000 in t =2 ; The project

would last for two years only. The appropriate cost of capital is 12 percent with all

equity financing , the borrowing rate is 8 percent and DO will borrow $ 300,0000

against the project. This debt must be repaid in two equal installment. Assume the

26  

debt tax shields have a net value of $0.30 per dollar interest paid . Calculate the

project’s APV .

Solution : Calculation of Base Case NPV :

 

 

 

 

 

 

 

 

 

  Calculation of Tax Shield :

Calculation of Tax Shield on Interest Payment

Time Principal Interest Rate

Interest

Amount

Principal

Repayment

Closing

Balance

Interest

Tax

Shield

PV of

Interest tax

Shield at a

discount

rate of 8%

Time 0 1 2

Cash Flow -1,000,000 600,000 700,000

Discount

rate for

APV 12%

Present

Value -1000000 535714.2857 558035.714

APV 93750

27  

1 300,000 8% 24000 150,000 150,000 7200 6666.66667

2 150,000 12000 150,000 0 3600 3086.41975

9753.08642

APV of the project = 93750+9753= 103,503.

Problem 9 : Curtis Bog, CFO of Sphagnum Paper Corporation , is reviewing a

consultant’s analysis of the Company’s WACC. The consultant proposes :

WACC = (1-Tc ) rD (D /V) + rE (E/V)

= (1-0.35) (0.103)(0.55)+0.183(0.45)= 11.92% say 12%

Mr Bog wants to check that this calculation is consistent with the CAPM . He has

observed or estimated the following numbers :

Betas Beta ( debt ) = 0.15; Beta ( equity ) = 1.09

Expected market risk premium = 0.085

Risk free interest rate = 9 %

Solution :

Solving for βA, we find that:

⎟⎟⎠

⎞⎜⎜⎝

⎛−

+⎟⎟⎠

⎞⎜⎜⎝

⎛−

−=)D T(V

E)(β)D T(V

D))(βT(1βC

EC

DCA

28  

⎟⎟⎠

⎞⎜⎜⎝

⎛−

+⎟⎟⎠

⎞⎜⎜⎝

⎛−

−=D/V) T(1

E/V)(βD/V) T(1

D/V))(βT(1βC

EC

DCA

0.6738)0.55(0.351

0.45 (1.09))0.55(0.351

0.55 )0.35)(0.15(1βA =⎟⎟⎠

⎞⎜⎜⎝

⎛×−

+⎟⎟⎠

⎞⎜⎜⎝

⎛×−

−=

Using the Security Market Line, we calculate the opportunity cost of capital for

Sphagnum’s assets:

rA = rf + βA (rm – rf) = 0.09 + (0.6738 × 0.085) = 0.147 = 14.7%

Following MM’s original analysis and considering only corporate taxes, we have:

r* = r (1 – TC L)

r* = 0.147 × [1 – (0.35 × 0.55)] = 0.1187 or approximately 12%

This matches the consultant’s estimate for the weighted-average cost of

capital

Risk Adjusted Discount Rate :

A business organisation can have different departments and accordingly capital is

allocated to different department . In many cases , the company allocates the same

WACC for each division to evaluate the performance. The required return on capital

is based on the risk associated with each department. So if an organisation applies

uniform discount rate for each all divisions , it is assuming that all divisions are

having same discount rate . However this may not be the case. So this process is not

correct. Accordingly the organisation has to allocate discount rate for each division

as per the risk associated with the department . Such type of discount rate is called

Risk Adjusted Discount Rate ( RADR). Let us take an example to explain this

phenomena :

Case let 1 : ABC Private Limited is a private limited company having a turn over of

Rs 1500 crores . The company has interest in different business divisions. It has been

operating in Road Sector, Real Estate Sector, Education Sector and Entertainment

Sector. The equity capital allocated in these four division are Rs 150 crores, Rs 50

29  

crores, Rs 30 crores and Rs 50 crores respectively. Since the company’s major income

is coming from road sector, the company allocate a Return On Equity of 18% to all

division. Do you think the company is doing the correct practices?

Solution : No the company is not doing the correct practices. The risk of four

divisions are different and accordingly different divisions should be charge with

different ROE. The ROE can be calculated for each division by adopting the

following method :

For Real Estate Sector , the company would follow the following steps:

Step 1: Identify three proxy companies which are listed

Step 2 : Calculate the levered beta of these three proxy companies by using the stock

price and index price .

Step 3 : Calculate the unlevered beta of the industry by using the levered to

unlevered equation :

βL = βUL  1  DE  1 t

Step 4 : Calculate the Levered beta of the division by using the debt equity ratio of

the division and using the same formula

Step 5 : Now calculate the Return on Equity by using the Capital Asset Pricing

Model

Similarly for other divisions the Return On Equity is calculated.

If after using these methodologies we have calculated the ROE for Real Estate is 25%

, For Education is 13% and For Entertainment is 21% , now the Weighted Average

Cost of Equity Would be :

ROE =    18%  25%  13%  21% = 19.25%

30  

Capital Budgeting Decisions :

When we decide for undertaking investment in a capital project , the following is

the characteristics :

Money is invested at a time i.e. out flow of fund takes place at a time;

Inflow of fund is taking place at different point of time;

So there is time value of money concept is involved in analysing the capital

investment decision since there is a considerable difference between the

inflow and outflow of fund .

So any good project evaluation criteria must consider this time value of money.

However , even today there are certain criteria which does not takes into affect the

time value of money criteria. However this type of evaluation must not be adopted.

Based on this ,we are making a list of different evaluation criteria . The entire

evaluation criteria is divided into two category :

Category I ( where time value of cash flow is not considered )

o Pay Back method

o Book of return

Category II ( where time value of cash flow is considered )

o Discounted Pay back

o Net Present Value

o Internal Rate of Return

Since this method is more scientific, we shall concentrate our discussion only in the

Category II evaluation criteria.

Discounted Payback :

31  

In this case we do take the discounted value of the cash flow and from this

discounted value we try to find out in how many years the initial outflow is

recovered. Let us take an example :

A Company wants to invest Rs 100 lacs for installation of a plant and machinery.

After the installation of plant and machinery , the machinery would generate the

following cash flows :

Time ( in

years )

1 2 3 4

Cash Flow ( in

rupees lacs )

20 30 50 60

If the discount rate is 12% , find the discounted pay back period.

Time Cash flow

Discounted

Factor @ 12 %

discount

Discounted

Cash Flow

Cumulative

Discounted

cash flow

1 20 0.892857143 17.8571429 17.85714286

2 30 0.797193878 23.9158163 41.77295918

3 50 0.711780248 35.5890124 77.36197157

4 60 0.635518078 38.1310847 115.4930563

32  

Discounted pay back period is 3.59 years while the pay back period is 3 years.

NPV : This is the most scientific method of evaluation of the project. This is arrived

at with the help of the following formula :

NPV = [ C0 ] +[C1/(1+r)1] +[C2/(1+r)2] + [C3/(1+r)3]+ [C4/(1+r)4]

+…….+[Cn/(1+r)n]

Where r is the appropriate discount rate we arrive after applying the concept we

have learnt in chapter 18 and 19. If the project is of same risk and the project does not

involve change in capital structure, this is WACC.

If we take the above mentioned example , then the NPV of the project is calculated

as follows :

Time Cash flow

Discounted

Factor @ 12 %

discount

Discounted

Cash Flow

0 (100) -100

1 20 0.892857143 17.8571429

2 30 0.797193878 23.9158163

3 50 0.711780248 35.5890124

4 60 0.635518078 38.1310847

NPV 15.4930563

IRR of the project : The IRR of the project would be obtained by putting the NPV

value is equal to zero and then solving for r. IRR is the internal rate of return of the

project generates and if the internal rate of return of the project is more than the

required return of the project we shall accept the project.

33  

In the above example the IRR of the project is :

Time Cash flow

Discounted

Factor @ 18 %

discount

Discounted

Cash Flow

0 -100 -100

1 20 0.84784972 16.96

2 30 0.718849148 21.57

3 50 0.609476048 30.47

4 60 0.516744097 31.00

NPV 0.00

The IRR of the project is 18% .

( you can use the MS Excel sheet to get the IRR).

Comparison of NPV and IRR :

The reinvestment rate assumption :

The correct interpretation for the reinvestment rate is that it is really the same thing

as the opportunity cost of capital. Both the NPV and the IRR rule make implicit

assumption about the reinvestment . The NPV rule assumes that the shareholders

can reinvest the money at the opportunity cost of capital , so it is the correct discount

rate. However, in the case of IRR rule, the assumption is that the investors can

reinvest the amount at the IRR of the project. This is wrong assumption.

34  

The Value additivity Principle :

The project manager must be able to consider one project independently of all

others. This is knows as Value Additivity principle. To demonstrate that the IR rule

violates this principle, let us take the following example :

Year Project 1 Project 2 Project 3 PV factor

at 10%

1+3 2+3

0 -100 -100 -100 1.000 -200 -200

1 0 225 450 0.909 450 675

2 550 0 0 0.826 550 0

Project NPV at 10% IRR

1 354.30 134.5%

2 104.53 125.0%

3 309.05 350%

1+3 663.35 212.8%

2+3 413.58 237.5%

Projects 1 and 2 are mutually exclusive and project 3 is independent . If the value

additivity principle holds , we should be able to choose the better of the two

mutually exclusive projects without having to consider the independent project. If

we use the IRR rule we select project 1 . But if we consider combinations of projects,

then the IRR rule would prefer projects 2 and 3 to projects 1 and 3. The IRR rule

prefers project 1 in isolation but project 2 in combination with independent project.

So IRR rule does not hold value additivity principle. The implication is that the

35  

management would have to consider all the possible combinations. However NPV

principle holds value additivity principle and accordingly we shall choose 1 in

isolation and 1+3 in combination.

Multiple rate of return :

If the projects cash flow involves more than one change in sign ( i.e. project involves

more than one outflow at different point of time during the tenure of the project )

we shall have more than 1 IRR. We have to decide which IRR is to adopt. So in such

case we can not select which IRR we have to take. But such problem would not

happen with NPV.

Capital Investment when resources are limited :

When the capital required for investment is limited, we have to find out a new

measurement called Profitability Index. The method of evaluation criteria is as

follows :

First we shall find out the NPV of each project independently.

Now we shall find out the Profitability Index of each project by applying the

following formula : NPV/Investment;

Now we shall calculate the weighted average Profitability Index of all the

possible combination within the overall capital constraints and we shall

accept that combination which is showing the highest value ( See Page no 105

to 107).

Problem 1 : Consider the following projects Alpha and Beta :

Cash flow

Project C0 C1 C2 IRR ( %)

Alpha -4,00,00 +241000 +293000 21

Beta -2,00,00 +131000 +172000 31

36  

The opportunity cost of capital is 8 percent. Suppose you have to choose either

Alpha or Beta but not both, what project would you choose using the IRR rule ?

Solution :

The incremental flows from investing in Alpha rather than Beta are –200,000 and

+110,000 and +121,000 . The IRR on the incremental cash flow is 10 % ( i.e. –

200+110/1.10+121/1.102 = 0). The IRR on beta exceeds the cost of capital and so does

the IRR on Incremental investment in Alpha . Choose Alpha.

Problem 2 :

Borghia Pharmaceutical has $1 million allocated for capital expenditure. Which of

the following projects should be company accept to stay within the $ 1 million

budget ? How much does the budget limit cost the Company in terms of its market

value ? The opportunity cost of capital for each project is 11 percent .

Project Investment

( $ thousands)

NPV

( $ thousands )

IRR (%)

1 300 66 17.2

2 200 -4 10.7

3 250 43 16.6

4 100 14 12.1

5 100 7 11.8

6 350 63 18.0

37  

7 400 48 13.5

Solution :

Using the fact that Profitability Index = (Net Present Value/Investment), we find

that:

Project Profitability Index

1 0.22

2 -0.02

3 0.17

4 0.14

5 0.07

6 0.18

7 0.12

Thus, given the budget of $1 million, the best the company can do is to accept

Projects 1, 3, 4, and 6.

If the company accepted all positive NPV projects, the market value

(compared to the market value under the budget limitation) would increase

by the NPV of Project 5 and the NPV of Project 7: ($7,000 + $48,000) = $55,000.

Thus, the budget limit costs the company $55,000 in terms of its market value.

Problem 10 : You are considering a five year lease of office space for R& D purpose .

Once signed , the lease can not be canceled. It would commit your firm to six annual

$100,000 payments with the first payment due immediately . What is the present

value of the lease if your Company’s borrowing rate is 9 percent and the tax rate is

35 percent .

38  

Solution :

[$100,000 × (1 - 0.35)] + [$100,000 × (1 - 0.35) × (Annuity Factor5/9 (1 – 0.35)%)]

= $65,000 + $274,925 = $339,925

Making Investment Decisions with NPV Rule

While arriving at the NPV we have seen that there are two things we need to know .

They are :

Cash flows :

Discount Rate ;

We have already discussed in detail about different aspects of discount rate and

what would be the appropriate discount rate for a cash flow. We have discussed that

if the project is of similar risk and the project does not change the capital structure of

the Company , we can use WACC as the appropriate discount rate. However if both

the above conditions are not met ,we have to use the APV rule which says that first

we discount the cash flows with all equity finance rate which is the opportunity cost

of capital and then we add all the benefit of the financing structure and then

deducting the cost associated with such financing structure .

Now we have to decide the determination of cash flows . While calculating the cash

flow we have to adopt the following principles :

We have to always take the incremental cash flow i.e. fist we draw the cash

flow without the project and then with the project and the difference we get

the incremental cash flow ;

In the cash flow we have to include the opportunity cost and we shall not

include the sunk cost;

Working capital adjustment is required to arrive at the cash flow;

We have to treat inflation consistently i.e. if we take nominal cash flow then

the discount rate is nominal and vice versa with respect to real cash flow and

real interest rate.

39  

Problem 1 : Naveen Enterprise is considering a capital project about which the

following information is available :

1. The investment outlay will be Rs 100 million. This consists of Rs 80 million on

Plant and Machinery and Rs 20 million in net working capital. The entire

outlay would take place at the beginning of the project.

2. The project will be financed with Rs 45 million equity capital , Rs 5 million of

preference capital , and Rs 50 million of debt capital. Preference capital would

carry a dividend rate of 15 percent , debt capital will carry an interest rate of

15 percent.

3. The life of the project is 5 years . At the end of 5 years, fixed assets will fetch a

net salvage value of Rs 30 million where as the net working capital will be

liquidated at the book value .

4. The project is expected to increase the revenues of the firm by Rs 120 million

per year. The increase in costs on account of the project is expected to be Rs

80 million per year ( this includes all costs excepts depreciation , interest and

tax ) .

5. Plant and Machinery will be depreciated at the rate of 25 percent as per the

written down method . Here the depreciation charge will be :

a. First Year : Rs 20.0 million;

b. Second Year : Rs 15.00 million;

c. Third year : Rs 11.25 million ;

d. Fourth Year : Rs 8.44 million;

e. Fifth Year : Rs 6.33 million.

Calculate the project cash flow .

40  

Solution :

( Rs in million)

0 1 2 3 4 5

Fixed Asset (80.00)

Net

Working

Capital

(20.00)

Revenues 120 120 120 120 120

Cost 80 80 80 80 80

Depreciation 20 15 11.25 8.44 6.33

Profit Before

Tax

20 25 28.75 31.56 33.67

Tax 6 7.5 8.63 9.47 10.10

Profit After

Tax

14 17.5 20.12 22.09 23.57

Net Salvage

Value of

Fixed Asset

30.00

Recovery of

Net

Working

Capital

20.00

41  

Initial

Outlay

(100.00)

Operating

Cash flow

34.0 32.5 31.37 30.53 29.90

Terminal

Cash flow

50.00

Net cash

flow

(100) 34.0 32.5 31.37 30.53 79.90

Book Value

of

Investment

100 80 65 53.75 45.31

Problem 2 :

Ojus Enterprises is determining the cash flow for a project involving replacement of

an old machinery by a new machine. The old machine bought a few years ago has a

book value of Rs 4,00,000/- and it can be sold to realise a post tax salvage value of Rs

160,000/- . It is being depreciated annually at a rate 25 percent under the written

down value method. The working capital required for the old machine is Rs

4,00,000.

The new machine costs Rs 1,600,000 . It is expected to fetch a net salvage value of Rs

8,00,000 after 5 years when it will no longer be required. The depreciation rate

applicable to it is 25 percent under the written down value method. The net working

capital required for the new machine is Rs 500,000. The new machine is expected to

bring a saving of Rs 3,00,000 annually in manufacturing costs ( other than

depreciation ). The tax rate applicable to the firm is 40 percent.

42  

Solution :

( Rs in ‘000)

year 0 1 2 3 4 5

1. Investment

Outlay

1. Cost of new

asset

(1600)

2.Salvage

value of old

asset

5000

3. Increase in

Net working

capital

(100)

4.Total net

investment

(1200)

II Operating

Cash flow

5. After tax

savings in

manufacturing

cost

180 180 180 180 180

6.

Depreciation

on new

machine

400 300 225 168.8 126.6

7.

Depreciation

on old

machine

100 75 56.3 42.2 31.6

8. Incremental

Depreciation (

6-7)

300 225 168.7 126.6 95

9. Tax saving

on

incremental

depreciation

120 90 247.5 230.6 218

43  

(8*0.40)

10.Net

Operating

Cash flow

(5+9)

300 270 247.5 230.6 218

III Terminal

cash flow

11.Net

terminal value

of new

machine

800

12. Net

terminal value

of old machine

160

13. recovery of

incremental

net working

capital

100

14. Total

terminal cash

flow (11-

12+13)

740

15. Net cash

flow

(1200) 300 270 247.5 230.6 958

Problem 3 : M Loup Garou will be paid 1,00,000 euros one year hence. This is a

nominal flow which he discounts at 8 percent nominal discount rate :

PV = 100000/1.08 = 92,593

The inflation rate is 4 percent. Calculate the PV of M Garou’s payment using the

equivalent real cash flow and real discount rate .

Solution : Real cash flow = 100000/1.04= 96,154;

Real discount rate= (1.08/1.04) -1 = 0.0385

PV = 96,154/1.0385 = 92,589 euro.

44  

Project of unequal life :

In many cases we have to evaluate projects of unequal life . In such case if we

calculate the NPV it would not give you a correct picture . In such case the

Equivalent Annual Method is applied. Under this method first we calculate the NPV

of the project and then convert that into annual revenue with the help of present

value of an annuity of the corresponding period. The project which is of higher

annual revenue / minimum annual cost would be selected .

Problem 4 : Machine C was purchased 5 years ago for $ 2,00,000 and produces an

annual cash flow of $ 80,000 . It has no salvage value but is expected to last for

another 5 years. The company can replace machine C with machine B in the previous

example either now or at the end of five years. Which it should do ?

Solution : You can replace it only at the end of 5 years since then it would be

producing cash flow $ 80,000 more than the $ 72,380.

Uncertainty Capturing of Capital Budgeting :

In all the above case , we have calculated one NPV. This is the base case NPV.

However it does not take into the account the uncertainty associated with any real

life project. So we have to build on the uncertainty associated with the project. While

calculating the uncertainty ,we segregate the problem into two categories :

Category I : In this type of project , the project completion does not have much of

uncertainty . For example , setting up a steel plant when the land has already

acquired. For this category of project, we can capture uncertainty by using :

• Sensitivity analysis

• S

Category

of unce

explorat

last stag

can capt

• D

• R

The en

help of t

Sensitivi

is chang

used to

unimpor

This is e

• L

SenA

imulation R

y II : In this

ertainty ass

tion project

ge is reache

ture the unc

Decision Tre

Real Option

ntire uncert

the followin

ity analysis

ged over the

calculate w

rtant variab

explained w

Let us take a

Pcomp

c

nsitivity Analysis

Run or Sce

s type of pr

sociated w

t. There is

ed , the pro

certainty by

ee Analysis

n Analysis

tainty analy

ng diagram

s : In this ty

e base case

which vari

ble so that s

with the help

an example

Project pletion is ertain

Simru

scean

nario Analy

roject, the p

with the co

no guarant

oject can be

y using :

s

ysis aspect

m :

ype of uncer

while the o

iable is mo

scenario an

p of an exam

e :

UnceAn

miulation un or enario

nalysis

45

ysis

project may

ompletion o

tee that Oi

e cancelled.

of capital

rtainty ana

other variab

ost importa

nalysis is car

mple :

ertainty nalysis

DecisAn

y not be com

of the pro

l would be

. For this c

budgeting

lysis captur

bles are kep

ant so that

rried on su

Procompl

unce

son Tree alysis

mpleted and

oject. For e

e found and

category of

g is present

ring , only

pt constant

t we can e

ch variable

oject letion is ertain

Real OAna

d there is lo

example, o

d before th

f project, w

ted with th

one variabl

. This step

liminate th

es.

Option alysis

ot

oil

he

we

he

le

is

he

46  

– Suppose you are investing in a project for manufacturing of scooters

for which investment of Rs 15 billion is required ;

– The cash flow in each year is calculated and it shows that each year

there is a cash inflow Rs 3 billion.

– Now the life of the project is 10 years.

– The NPV at 10% discount rate comes to Rs 3.43 billion.

• Now we identify the uncertainty variables :

– Revenue side the uncertainty is :

• Market Size

• New Product’s share in the market ;

• Unit Price ;

– Cost side the uncertainty is :

• Unit variable cost ;

• Fixed Cost ;

• Now we shall recalculate the NPV in the following situation of this

uncertainties :

Variable

Pessimistic Expected

Optimistic

Market Size (

In units ) 900000 1000000 1100000

Market Share (

in numbe

rs ) 0.04 0.1 0.16Unit

Price (

47  

48  

Now we know that the following factors are important which can

change the NPV most :

– Market Share ;

– Unit Price;

– Variable Cost;

• Now we can do simulation run for this three variables in each year to

find out the NPV under different simulation run.

Variable Pessimistic Expected OptimisticMarket

Size 1.1 3.43 5.7Market Share -10.4 3.43 17.3

Unit Price -4.2 3.43 5Unit

Variable Cost -15 3.43 11.1

Fixed Cost 0.4 3.43 6.5

NPV

49  

• From this we get the probability distribution of NPV in each year and

then we try to see our most likely NPV versus best and worst case

NPV.

• If our most likely NPV is favourable then we shall go for the project

otherwise not.

Decision Tree :

In the case of both sensitivity analysis and Monte Carlo simulation we

assume that the project would be in operation through out the period once

we start it. The option of abandonment or expansion is not calculated in this

assessment.

For this we have to resort to first decision tree analysis and then real option

on project finance. Decision tree is capturing the present value of the project

by taking into account the scope for abandonment and expansion in

subsequent years.

We calculate from right most side of the decisions tree and proceed towards

the left and calculate the present NPV.

50  

Probability of

Success 0.5

Probability of

Success 0.7

Probability of

failure 0.5

Probability of

Failure 0.3 Develop a Product - Rs 1 million

Launch Product -Rs 2 million

Collect Pay Off+ Rs 15 million

Abandon Project

Abandon Project

Decision Tree Ca

51  

• Using the DTA , you can also gain further insight by considering the

best, worst and most likely case scenarios for the above two examples.

Best case represents the scenario where only the best outcomes are

experienced and worst case represents the scenario where only the

worst outcomes. For the above example , the best case is where the

product development and commercialization efforts are successful ,

while the worst case involves successful development followed by

commercial failure.

• The most likely case is represented by the project’s expected NPV

today , which corresponds to decision node 1 in the decision tree or

time = 0. The best case NPV is Rs 9.58 million, the worst case NPV is –

Rs2.82 million and the most likely case NPV is Rs 2.43 million.

• If the most likely case is close to the best case , there is an excellent

chance of success and vice versa.

Real Option Analysis :

DCF and DTA are standard tools used by analysts and other professionals

in project valuation and they serve the purpose very well in many

applications. In case of uncertainty and involvement of contingent decision ,

these tools may not give a correct picture. These can be captured with the

help of Real Option analysis.

Let us start with an example to illustrate how the real options approach is

different .

– Suppose you have a chance to invest Rs 100 in a project. The

pay off is expected to be between Rs 60 and Rs 160 with an

average of Rs 110. The DCF analysis which does not account for

the uncertainty will put the NPV at Rs 10.

– Let us assume that this return does not meet your corporate

standard : therefore your decision will be not to invest in the

52  

project. But what if an initial small investment ( say Rs 10) will

help settle the uncertainty and give you an option to fully invest

in the project at a later date only if the return is favourable .

You will buy this idea.

• You have a chance to invest Rs 100 in a project today that is

estimated to yield a return of Rs 125 one year from now with a 50-50

chance that it may go up to Rs 170 ( good case) or down to Rs 80 ( bad

case) . But you also have the choice to defer the decision for a year ,

by which time the uncertainty about the payout is expected to clear.

As given below, using the standard DCF method with a discount rate

of 15% , the project value today ,, represented by its NPV , is Rs 9.

Assuming that this return is acceptable , you may want to invest in it

.

Time T= 0 T=1 Cash Flow -Rs 100 Rs 125

Discount Rate 15% p.a.

NPV =[ Rs 125 /( 1+0.15) 1]-Rs 100= Rs 9

• As mentioned, there is also a mutually exclusive alternative of

deferring the decision until one year from now, by which time the

uncertainty of the cash flows is expected to clear.

• Let’s evaluate the value of the project at that time for the good and

bad cases (each with a probability of 0.5), assuming the same

conditions, so you can decide whether it will be to your advantage to

wait for a year.

Time T=0 T=1 T=2 Amount Rs 170 Probability 0.5 Amount Rs 80 Probability 0.5 Discount Rate =15% p.a.

53  

NPV = 0.5 [ - {Rs 100/(1+0.15)1 }+{170/(1+0.15)2}= Rs 21;

The expected NPV for the bad case is : = .5 [ - {Rs 100/(1+0.15)1

}+{80/(1+0.15)2}= -Rs 13 .The decision to defer one year is worth Rs 21

today. However the decision to invest now is only Rs 9 NPV today with

DCF.

Therefore the value added because of the option to defer is Rs 12.

If the uncertainty goes up by having the value of Rs 200 and Rs 50 the

value of the option goes up to Rs 23.

• DCF is a deterministic model , ROA accounts for change in the

underlying asset value due to uncertainty over the life of the project.

• In the above example we have calculated only the two uncertainties

but we can capture a whole lot of uncertainty and can calculate the

composite value of the project.

• DCF accounts for the downside of the project by using a Risk Adjusted

Discount Rate . ROA on the other hand , captures the value of the

project for its upside potential by accounting for proper managerial

decisions that would presumably be taken to limit the downside risk.

Comparison between DTA and ROA :

• Both DTA and ROA are applicable when there is uncertainty about

project outcomes and opportunity for contingent decision exists. There

are two basic differences between them :

– DTA accounted for both Private and Market Risk where as ROA

only accounts for Market Risk;

DTA accounts for limited number of outcomes but ROA accounts for a

larger number of outcomes.

54  

Multiple Choice Questions :

1. What do you understand by business return ?

a. PAT of the borrowing company

b. EBITDA of the borrowing company

c. Economic profit of the borrowing company

d. None of the above

2. What do you understand by required return ?

a. Required return is the return required by the lender to the

business

b. Required return is the IRR of the business

c. Required return is objective

d. None of the above

3. If the cost of debt of a business is 13% p.a. when the debt equity ratio

is 3:1 , what would be the cost of debt of the same business when the

debt equity ratio would be 4:1 other things remaining same :

a. More than 13% p.a.

b. 13% p.a.

c. Less than 13% p.a.

d. None of the above

4. What is the correct formula of required return of Equity under CAPM

Model ?

a. Return on Equity = Risk Free Rate + Debt Premium

b. Return on Equity = Risk Free Rate + Equity Premium

c. Return on Equity = Risk Free Rate + Debt Premium + Equity

Premium

d. None of the above

5. What is unlevered beta of a business ?

a. Unlevered beta is project beta

b. Unlevered beta is debt beta

c. Unlevered beta indicated the riskiness of a particular project

both financial risk and business risk

d. None of the above

55  

6. Between IRR and NPV which one is the superior evaluation method ?

a. IRR

b. NPV

c. Can not be said

7. What method should be used to capture uncertainty in case the

project completion risk is lowest ?

a. Sensitivity Analysis

b. Simulation Exercise

c. Real Option Analysis

d. Both a and b

8. In which case real option would give the best result ?

a. When the project has least uncertainty in pre construction stage

and least uncertainty in revenue projections

b. When the project has highest uncertainty in pre construction

stage and least uncertainty in revenue projections

c. When the project has highest uncertainty in pre

construction stage and highest uncertainty in revenue

projections

d. Both a and b

9. If we use the NPV method of project evaluation what would be the

formula :

a. NPV> IRR

b. NPV>0

c. NPV>WACC

d. None of the above

10. If we use the IRR method of evaluation ,what would be the formula :

a. IRR>NPV

b. IRR>WACC

c. IRR> DSCR

d. None of the above

Short Answer Question :

56  

Question No 1 As a result in improvement in product engineering , United

Automation is able to sell one of its two milling machines. Both machines perform

the same function but differ in age. The newer machine could be sold today for $

50,000 . Its operating cost are $ 20,000 a year but in Five years the machine will

require $20,000 overhaul. Thereafter operating costs will be $30,000 until the

machine is finally sold in year 10 for $ 5000.

The older machine could be sold today for $25,000 . If it is kept , it will need an

immediate $20,000 overhaul . Thereafter operating costs will be $30,000 a year until

the machine is finally sold in year 5 for $5000.

Both machines are fully depreciated for tax purposes. The company pays tax at 35% .

Cash flows have been forecasted in real terms . The real cost of capital is 12 percent .

Which machine should United Automation sell ?

Solution :

In order to solve this problem, we calculate the equivalent annual cost for each of the two alternatives. (All cash flows are in thousands.)

Alternative 1 – Sell the new machine: If we sell the new machine, we receive the cash flow from the sale, pay taxes on the gain, and pay the costs associated with keeping the old machine. The present value of this alternative is:

54321 1.1230

1.1230

1.1230

1.1230

1.1230200)].35(50[050PV −−−−−−−−=

$93.801.12

0)(50.351.12

555 −=−

−+

The equivalent annual cost for the five-year period is computed as follows: PV1 = EAC1 × [annuity factor, 5 time periods, 12%]

-93.80 = EAC1 × [3.605]

EAC1 = -26.02, or an equivalent annual cost of $26,020

57  

Alternative 2 – Sell the old machine: If we sell the old machine, we receive the cash flow from the sale, pay taxes on the gain, and pay the costs associated with keeping the new machine. The present value of this alternative is:

54322 1.1220

1.1220

1.1220

1.1220

1.12200)][0.35(2525PV −−−−−−−=

1098765 1.1230

1.1230

1.1230

1.1230

1.1230

1.1220

−−−−−−

$127.511.12

0)(5.350 1.12

51010 −=−

−+

The equivalent annual cost for the ten-year period is computed as follows: PV2 = EAC2 × [annuity factor, 10 time periods, 12%]

-127.51 = EAC2 × [5.650]

EAC2 = -22.57, or an equivalent annual cost of $22,570

Thus, the least expensive alternative is to sell the old machine because this alternative has the lowest equivalent annual cost.

One key assumption underlying this result is that, whenever the machines

have to be replaced, the replacement will be a machine that is as efficient to operate as the new machine being replaced.

Question No 2 : Problem 4 : Machine A and B are mutually exclusive and are

expected to produce the following cash flows :

Cash flow in ‘000 dollars

Machine C0 C1 C2 C3

A -100 +110 +121

B -120 +110 +121 +133

The real opportunity cost of capital is 10 percent .

a. calculate the NPV of each machine;

b. Calculate the equivalent annual cash flow from each machine;

c. Which machine you will select.

58  

Solution :

Year 0 1 2 3

A -100 110 121

PV @ 10%

disocunt

rate 1 0.909090909 0.82645

PV of cash

flow -100 100 100

NPV 100

Year 0 1 2 3

B -120 110 121 133

PV @ 10%

disocunt

rate 1 0.909090909 0.82645 0.75131

PV of cash

flow -120 100 100 99.9249

NPV 180

b. Equivalent annual cash flow = NPV / Present value of an annuity =

i. For project A it is $57,620 and for project B it is $72,380.

( use PMT function in MX Excel ; put 0.10 in Rate field, for NPER

put 2 for project A and 3 for project B , For PV put -100 for A and -

180 for B ( here – is for excel operation) .

59  

c. Definitely you will go for B ;

Question No 3 : “A banker should calculate only the DSCR of the project ,

as banker is interested only on the repayment of debt “- Do you support this

view ?

Answers : It is true that banker would be concerned about the repayment of

debt. But the project would be run by the promoter. Under such situation ,

if the banker is not convinced that the project is generating return to the

promoter also , then we have to analyse the interest of the promoter to run

the business. So banker should not only to check the bankability of the

project which can be found out by calculating the DSCR but also the

financial viability of the project which can be calculated by the IRR > WACC

or NPV>0 criteria .

Question No 4 : If the IRR of the project is 15% p.a. and the Weighted

Average Cost of Capital is 16% p.a. find out the NPV of the project .

Answer : The NPV of the project is less than zero . This is due to the fact

that NPV , by definition , is the extra amount in rupees generated from the

project after meeting the lenders expectation. In the present case , the

lenders expectation is 16% p.a. which is represented by WACC. The

business is generated a return of 15% p.a. So the business is not generating

the expectation of lender itself. Accordingly , the NPV of the business is less

than 0 .

Question No 5 : Compare sensitivity analysis with simulation method of

capturing uncertainty of a project .

In the case of sensitivity analysis only one variable is changed whereas the

other variables are kept constant . For example, we want to find out what

would be impact of DSCR in case sales price goes down by 5% keeping other

things remaining constant. In the case of Simulation , all the factors are

changed simultaneously. For example, what would be the impact of DSCR in

a situation when the sales would go down by 5%, raw material cost would go

60  

up 5% and interest cost would go up by 1% . So simulation is better method

of capturing uncertainty . However, the sensitivity analysis is carried out to

identify the critical variables and from critical variables the simulation is

run.

Case Study On Capital Budgeting :

Introduction :

ABC Private Limited is in the business of manufacturing of specialised engineering

goods which are used in the automobile industry. The company wants to build up a

new plant . The details of the new plant is given below:

1. The proposed land requirement of the proposed plant is 10 acres. The

company has identified a land nearby to its factory and the cost of the land is

Rs 50 lacs per acre. The land registration cost would be 10% of the total sale

value.

2. The proposed building would be of 50,000 square feet and the cost per square

feet of industrial construction is expected to be Rs 1000/- per square feet.

3. The company would have to purchase plant and machinery both from

domestic as well as from abroad supplier. The plant and machinery break up

is shown below :

( Rs in lacs )

Cost of Machine Installation

Cost

Domestic Machine 800 100

Imported Machine 500 50

The installation agency is different from supplier of machine. The supplier of

machine does not carry out the installation and it has tie up with local vendors.

61  

These local vendors carries out the installation and subsequently looks after the

Annual Maintenance Contract ( AMC) on behalf of supplier.

4. The company would install IT systems consisting of Hard ware and Software.

The break up of hard ware and software is given below :

( Rs in lacs)

Hardware 100

Software 50

5. The company would purchase furniture and fixtures as part of project cost.

The amount for which the furniture and fixtures would be purchased is Rs

200 lacs.

6. The company has also projected a contingency of Rs 250 lacs for the project

and the contingency amount would be paid in 6 months . This would be

deducted over a period of 10 years at an uniform rate.

7. The project implementation time is 12 months from the purchase of land and

the interest during this period would be capitalized.

8. The company has projected the following holding level for its current asset for

the entire life of the proposed term loan ( 5 years ) :

( No of Months)

1 2 3 4 5

RM 2 1.5 1.3 1.2 1.1

62  

WIP 0.5 0.20 0.20 0.20 0.20

FG 2 1.2 1 1 1

Receivable 2 1.5 1 1 1

Creditor ( of

raw material

consumption

)

1 0.5 0.5 0.4 0.35

Other

Current

Asset as a %

of Inventory

and

Receivable

outstanding

7% 7% 6% 5% 5%

The working capital would be available at the time of starting the commercial

production.

9. The key assumptions about the projected performance of the company is

given as below :

• The installed capacity would be 1 lac unit per annum;

• The capacity utilisation would be as follows :

i. 1st Year 50%

ii. 2nd Year 75%

iii. 3rd Year 80% , 4th Year 85% and 5th Year 85% .

• The per unit production of the product requires the following raw

material:

i. Per unit of product would require 0.500 MT steel for first three

years and then the steel requirement would be increased to

0.550 MT .

63  

ii. The price of steel is assumed as below :

( Rs )

1 2 3 4 5

Steel Price

Per MT

28000 28000 30000 30000 32000

• The per unit production of the product would be requiring 10 units of

industrial units of electricity . As the machines get older, the same

would require 12 units of industrial unit of electricity from 3 rd year

onward till 5th year. The price per unit of Electricity is assumed as

follows : ( Rs)

1 2 3 4 5

Electricity

Price

3.30 3.30 4 4.10 4.10

• The salary and wages have been assumed as per the following :

( Rs in lacs)

1 2 3 4 5

Salary and

Wages

55 65 75 80 100

• The other manufacturing expenses are assumed as follows : ( Rs in lacs )

64  

1 2 3 4 5

Other

Manufacturing

Expenses

12 15 15 18 20

• The selling and distribution expenses have been assumed as follows :

1 2 3 4 5

% of sales

value for the

month

10% 8% 7% 6% 5%

• The company has assumed the following depreciation for the assets to be procured for the project :

Asset Name % on WDV

Building (Factory) 10%

Plant and

Machinery

15.33%

Computers 40%

Furniture and

Fixture

18.1%

• Schedule of installation of fixed asset :

65  

Asset Name

Land T=0

Building (Factory) T=3-6 months

Plant and

Machinery

T=6-9 months

Computers T=9-12 months

Furniture and

Fixture

T=9-12 months

The company would make payment of the asset at the beginning of the

time period .

The company has assumed the following sales for the next 5 Years :

1 2 3 4 5

Production

( no of

units )

50000 75000 80000 85000 85000

Sales ( no

of units )

45000 77000 79000 84500 84500

Sales Price

Per unit ( in

Rs )

18000 18000 19500 21000 22500

The total project cost would be funded by way of Debt : Equity of 2:1 . The company

would bring in the margin money requirement as per 2nd Method of lending under

MPBF. The term loan would be paid in 5 year from the start of the project operation

date in equal annual installment. The working capital would attract an interest rate

66  

of 11% p.a. and term loan would attract an interest rate of 12% p.a. The return on

equity is calculated at 17% p.a. under CAPM model.

Carry out the capital budget evaluation process :

Step No 1 Determination of Fixed Asset Cost Original Fixed Asset Cost

Interest During Construction

Final Fixed Asset Cost

Land 550 44 594 Building 500 30 530 Plant and Machinery 1450 58 1508 IT 150 3 153 Furniture and Fixture 200 4 204

2850 139 2989 Step No 2 Determination of Means of Finance

Debt to Equity Ratio 2:1

Original Fixed Asset Cost

Debt Finance Equity Finance

Land 550 367 183 Building 500 333 167 Plant and Machinery 1450 967 483 IT 150 100 50 Furniture and Fixture 200 133 67

2850 1900 950

Step No 3 Determination of Term Loan Interest

67  

Term Loan Interest 12%

Step No 4 Project Implementation Period Project Implementation Period Months 12 Step No 5 Determination of IDC

Land Building Plant and

Machinery IT

Furniture and Fixtures

0 3 6 9 9 Amount 550 500 1450 150 200 Debt Part 367 333 967 100 133 IDC Calculation

Opening Balance of Debt 0 0 0 0 0

Disbursement of Term Loan 367 333 967 100 133

Closing Balance of Term Loan 367 333 967 100 133 Tenure of Outstanding 12 9 6 3 3 Interest Rate of Term Loan ( % p.a.) 12% 12% 12% 12% 12%

Interest during construction 44 30 58 3 4

Equity Part

Original Value 183 167 483 50 67 IDC Part 44 30 58 3 4 Total Equity Required 227 197 541 53 71

Step 6 Determination of Final Fixed Asset Cost

68  

Original Fixed Asset Cost

Interest During Construction

Final Fixed Asset Cost

Land 550 44 594 Building 500 30 530 Plant and Machinery 1450 58 1508 IT 150 3 153 Furniture and Fixture 200 4 204

2850 139 2989 Step 7 Means of finance for fixed assets

Debt to Equity Ratio 2:1

Debt Finance Equity Finance

Land 367 227 594 Building 333 197 530 Plant and Machinery 967 541 1508 IT 100 53 153 Furniture and Fixture 133 71 204

1900 1089 2989

Step 8 Determination of Miscellaneous Expenses Miscellaneous expenses 250

Step 9 Determination of IDC on Miscellaneous Expenses

Original Cost 250 Debt 166.67

Opening Balance 0

Disbursement 167

Closing Balance 167 Tenure 6 Interest Rate 12% IDC 10

69  

Equity Original Amount 83.33 IDC 10.00

93.33

Step 10 Final Miscellaneous Expenses

Miscel Exp Original IDC Total 250 10 260

Step 11 Final Means of Finance for Miscellaneous expense Debt 166.67 Equity 93.33

260 Total Project Cost

Original IDC Total Fixed Asset 2850 139 2989

Misc Expenses 250 10 260 MMWC 1029 0 1029

4129 149 4278 Total Means of Finance

Debt 2753 Equity 1525

4278 0

Calculation of Margin Money for Working Capital 1 2 3 4 5 6

Step 1 : Estimate the sales

Plant Capacity 10000

0 10000

0 10000

0 100000 100000 10000

0

Capacity Utilisation (%) 50% 75% 80% 85% 85% 85% Production ( Unit ) 50000 75000 80000 85000 85000 85000 Sales ( no of units ) 45000 77000 79000 84500 84500 84500

70  

Price Per unit 18000 18000 19500 21000 22500 22500 Sales in Rs Lacs 8100 13860 15405 17745 19013 19013

Step2 : Estimate the consumption

Qty of steel required for Per unit of Production 0.5 0.5 0.5 0.55 0.55 0.55

Total QTY of steel required ( MT) 25000 37500 40000 46750 46750 46750 Steel Price Per MT 28000 28000 30000 30000 32000 32000

Consumption of Raw Material ( Rs lacs ) 7000 10500 12000 14025 14960 14960

Step 3 : Estimate the Power and Fuel

Unit of electricity required per unit of production 10 10 12 12 12 12

Total Unit of electricity required for production

500000

750000

960000

1020000

1020000 1E+06

Cost per unit of Electricity ( Rs ) 13 13 14.3 14.3 15.73 15.73

Total Cost of Electricity ( Rs lacs ) 65 97.5 137.28 145.86 160.446 160.45

Step 4 Estimate Salary and Wages Salary and Wages 55 65 75 80 100 100

Step 5 Estimate Other Manufacturing Expenses

Other Manufacturing Expenses 12 15 15 18 20 20

71  

Step 6 Estimate Depreciation

Depreciation 382 310 255 212 178 178 Step 7 Estimate the Opening WIP

WIP 0 301 185 208 241 257 Step 8 Estimate the Closing WIP

Closing WIP 301 185 208 241 257 257 Step 9 Estimate the COP

COP 7214 11103 12460 14448 15403 15418 Step 10 Estimate the Opening stock of FG

Opening Stock FG 1031 1103 1043 1192 1276

Step 11 Estimate the Closing stock of FG Closing FG 1031 1103 1043 1192 1276 1284

Step 12 Estimate the Cost of Sales

Cost of Sales 6183 11031 12520 14300 15318 15411 Step 13 Estimate the Raw Material and Receivable

Consumption 7000 10500 12000 14025 14960 14960 HL 2 1.5 1.3 1.2 1.1 1.1

Raw Material in Rs lacs 1167 1313 1300 1403 1371 1371 Sales 8100 13860 15405 17745 19013 19013 HL 2 1.5 1 1 1 1 Receivable in Rs lacs 1350 1733 1284 1479 1584 1584

Step 14 Determine RM, WIP, FG and Receivable RM 1167 1313 1300 1403 1371 1371 WIP 301 185 208 241 257 257 FG 1031 1103 1043 1192 1276 1284 Receivable 1350 1733 1284 1479 1584 1584

3848 4333 3835 4314 4489 4497 Step 15 Estimate OCA

% of Inventory and Receivable 7% 7% 6% 5% 5% 5% OCA in Rs Lacs 269 303 230 216 224 225

Step 16 Estimate Total Current Asset

Total Current Asset 4117 4636 4065 4529 4713 4722

Step 17 Determination of Margin Money for Working Capital

72  

Margin Money for working capital 1029 1159 1016 1132 1178 1180

Estimate the Creditor Level

Step 1 Purchase 8167 10646 11988 14128 14929 14960 Consumption 7000 10500 12000 14025 14960 14960

Closing stock of RM 1167 1313 1300 1403 1371 1371

Opening stock of RM 0 1167 1313 1300 1403 1371

Step 2 HL 1 0.5 0.5 0.4 0.35 0.35 Step 3 Creditor 681 444 499 471 435 436

Calculation of Working Capital Total Current Asset 4117 4636 4065 4529 4713 4722 Total OCL 681 444 499 471 435 436 Total WCG 3437 4193 3565 4058 4278 4285 MMWC 1029 1159 1016 1132 1178 1180 BBWC 2407 3034 2549 2926 3100 3105

Calculation of Interest on Term Loan 1 2 3 4 5 6

Opening balance at the time of starting of commercial production 2753 2202 1652 1101 551 Repayment 551 551 551 551 551 Closing balance 2202 1652 1101 551 0 Average Balance 2478 1927 1376 826 275 Interest Rate 12% 12% 12% 12% 12% Interest Amount 297 231 165 99 33

Calculation of Interest of Working Capital Finance from Bank Opening balance BBWC 2407 3034 2549 2926 3100 3105 Int Rate 11% 11% 11% 11% 11% 11% Interest 265 334 280 322 341 342

73  

Amount

Profit and Loss 1 2 3 4 5

Sales 8100 13860 15405 17745 19013

Total 8100 13860 15405 17745 19013

Expenses

Consumption 7000 10500 12000 14025 14960 Power and

Fuel 65 97.5 137.28 145.86 160.446 Salary and

wages 55 65 75 80 100 OME 12 15 15 18 20

Depreciation 382 310 255 212 178

Opening WIP 0 301 185 208 241 Closing WIP 301 185 208 241 257

Cost of Production 7214 11103 12460 14448 15403 Opening FG 0 1031 1103 1043 1192 Closing FG 1031 1103 1043 1192 1276

Cost of Sales 6183 11031 12520 14300 15318 Selling and Distribution 810 1109 1078 1065 951

Interest 562 565 446 421 374 Sub total 7555 12705 14044 15786 16642 Misc Exp write off 26 26 26 26 26 Sub total 7581 12731 14070 15812 16668

Profit Before Tax 519 1129 1335 1933 2344 Tax 156 339 401 580 703

74  

Profit After Tax 363 791 935 1353 1641

Estimating Depreciation Calculation 1 2 3 4 5

Fixed Amount Name

Final Fixed Asset Cost

Depreciation Rate ( %)

Land 594 0% 0 0 0 0 0 Building 530 10% 53 48 43 39 35 Plant and Machinery 1508 15.33% 231 196 166 140 119 IT 153 40% 61 37 22 13 8 Furniture and Fixture 204 18.10% 37 30 25 20 17

382 310 255 212 178

Misc Exp 260 10% 26 26 26 26 26

Projected Cash Flow Statement 0 1 2 3 4 5

PAT 363 791 935 1353 1641 Depreciation 382 310 255 212 178 Amortisation 26 26 26 26 26

Increase in TL Increase in

Equity Increase in

BBWC 626 -485 377 173 5 Increase in

Creditor -237 56 -29 -35 1

75  

Total 0 1161 698 1565 1730 1851

Increase in Fixed Asset

Repayment of Term Loan 551 551 551 551 551

Increase in RM 146 -13 103 -31 0 Increase in

WIP -116 23 33 16 0

Increase in FG 73 -60 148 85 8 Increase in Receivable 383 -449 195 106 0 Increase in

OCA 34 -73 -14 9 0

Total 0 1070 -21 1015 735 559

Cash surplus/deficit 0 91 719 549 995 1292

Opening Cash &Bank Balance 0 91 810 1360 2355 Closing Cash

& Bank Balance 0 91 810 1360 2355 3647

Balance Sheet 0 1 2 3 4 5

Equity 1525 1525 1525 1525 1525 1525 Reserves 363 1154 2088 3442 5083

Term Loan 2753 2202 1652 1101 551 0 BBWC 2407 3034 2549 2926 3100 3105

Creditor 681 444 499 471 435 436

Total 7366 7568 7379 8112 9053 10149

76  

Fixed Asset 2989 2989 2989 2989 2989 2989

Accumulated Depreciation 0 382 693 948 1161 1339

Net Fixed Asset 2989 2607 2296 2041 1828 1650

Misc Exp 260 234 208 182 156 130 RM 1167 1313 1300 1403 1371 1371 WIP 301 185 208 241 257 257 FG 1031 1103 1043 1192 1276 1284

Receivable 1350 1733 1284 1479 1584 1584 OCA 269 303 230 216 224 225 C&B 91 810 1360 2355 3647

Total 7366 7568 7379 8112 9053 10149

DSCR Calculation

DSCR Calculation 1 2 3 4 5

PAT 363 791 935 1353 1641 D 382 310 255 212 178

Amortisation 26 26 26 26 26 Interest on

TL 297 231 165 99 33 Subtotal 1069 1358 1381 1691 1878 MMWC 130 -143 116 46 2

Total 939 1501 1265 1645 1876

Term Loan 848 782 716 650 584 P 551 551 551 551 551 I 297 231 165 99 33

DSCR 1.11 1.92 1.77 2.53 3.21

IRR Calculation :

0 0.25 0.5 0.75 1 2 3 4 5 6 -550 -500 -1700 -350 -1178 939 1501 1265 1645 1876 100% 96% 93% 90% 86% 75% 64% 56% 48% 42%

77  

-550 -482 -1580 -314 -1018 700 967 704 791 779 IRR 15.77%

WACC of the project :

Debt 2753 12% 30% 8.40% 0.64 5.40% Equity 1525 17% 0.36 6.06%

4278 11.47%

Hence the project is acceptable.