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LONG TERM INVESTMENT ANALYSIS

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 :

rE = rA

+(

rA rD ) [D/E]

.1

rE = Required return on equity


rA =
rD

Return on asset

= Return on Debt

D = Market Value of debt


E

= Market Value of Equity

Problem 1 : Hubbards 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 Companys 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 :

The beta of the firms 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 )

A = [ D/(D+E)] * D + [ E/(D+E) ] * E ..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 firms asset beta is 0.8 and
the firms 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.

D
E

D +
E
A =
D + E
D+E

0.8 = (0.5 0) + (0.5 E)


E = 1.60

b.

Before the refinancing, the stocks required return is 8% and the riskfree rate is 5%; thus, the risk premium for the stock is 3%.

c.

After the refinancing:

D
E

r =
r +
r
A D + E
D D + E
E
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 =
=

Present value of the cash flows of the firm


( 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 .

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 + (rm - rf )
15% = 10% + 1.5 (rm 10% )

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.

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 firms 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

5 ( @10% on Rs 50 lacs)

EBT

10

Tax @ 30%

1.5

EAT

3.5

Dividend Distribution

0.70

0.035

6.30

3.465

6.30

3.465

Tax on dividend income

Income to equity holder

6.30

3.465

Interest Income

Tax on interest Income @

6.30

7.465

tax
Dividend to be paid to
equity lender
Income to equity holder
Income to equity Holder
i.e. Dividend

Income to debt holder

20%
Income to debt holder
Total Income to lender
i.e. equity holder and
debt holder

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;

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 :

Interest

Discount

PV of

factor at

tax

8%

shield

discount

on

Year

Principal

rate

Interest Amount

rate

interest

1000

8%

28

1.08

25.9259

1000

28

1.1664

24.0055

1000

28

1.259712

22.2273

1000

28

1.360489

20.5808

1000

28

1.4693281 19.0563
111.796

c)

Interest
Year

Principal

rate

Interest Amount

10

Discount

PV of

factor at

tax

8%

shield

discount

on

rate

interest

28

1.08

25.9259

800

22.4

1.1664

19.2044

600

16.8

1.259712

13.3364

400

11.2

1.360489

8.23233

200

5.6

1.4693281 3.81127

1000

8%

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
Debt

$ 40

CA

Market Value

$20

Debt

$ 40

CL
Equity

$ 60

$ 100

Long

CA

$20

CL
$ 80

Equity

$120

Long

Term

Term

Asset

Asset
$ 100

$ 160

$ 140

$ 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 firms value is accounted for by the debt generated tax
shield ?

b)

How much better off will UFs 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

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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 :

Interest

Discount

PV of

factor at

tax

8%

shield

discount

on

Year

Principal

rate

Interest Amount

rate

interest

60

8%

1.92

1.08

1.77778

60

1.92

1.1664

1.64609

60

1.92

1.259712

1.52416

60

1.92

1.360489

1.41126

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?

12

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 Companys 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. Companys having more tangible asset would like to set higher debt to
equity target ratio whereas companies having lower tangible asset would be having

13

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

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 ;

14

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] +
The opportunity cost of capital would be r

rE [ E/V]

= 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 :

15

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 :
Interest
Year

Principal Interest

10000

Discount Discount

Amount Installment Interest Principal

10%

PV

1000

10000

1000

1000

0.826446 826.4463

10000

1000

1000

0.751315 751.3148

10000

1000

1000

0.683013 683.0135

10000

1000

1000

10%

factor

1000

11000

rate

10000

0.909091 909.0909

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.
Interest
Year

Principal Interest

10000

Amount Installment Interest Principal

rate

PV

2000

1000

2000

8000

800

2000

800

2000

0.826446

6000

600

2000

600

2000

0.751315 1953.418

4000

400

2000

400

2000

0.683013 1639.232

16

10%

factor

1000

10%

Discount Discount

0.909091 2727.273
2314.05

2000

200

200

2000

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.

Interest

Principal Discount Discount

Year Principal Interest Amount Installment Interest Principal Outstanding


1

10000

250

641.471

9608.53

240.213

9207.27

250

PV

9608.53

641.471

240.213 401.258

9207.27

1.05063 610.562

230.182

641.471

230.182 411.29

8795.98

1.07689 595.67

8795.98

219.9

641.471

219.9

421.572

8374.41

1.10381 581.141

8374.41

209.36

641.471

209.36 432.111

7942.3

1.13141 566.967

7942.3

198.557

641.471

198.557 442.914

7499.38

1.15969 553.139

7499.38

187.485

641.471

187.485 453.987

7045.4

1.18869 539.647

7045.4

176.135

641.471

176.135 465.336

6580.06

1.2184 526.485

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

17

2.50%

factor

391.471

10%

rate

1.025 625.826

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

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

60.33

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 .

Interest

Principal Discount Discount

Year Principal Interest Amount Installment Interest Principal Outstanding


1

10000

250

641.471

9608.53

240.213

9207.27

250

PV

9608.53

641.471

240.213 401.258

9207.27

1.04847 611.816

230.182

641.471

230.182 411.29

8795.98

1.07358 597.506

8795.98

219.9

641.471

219.9

421.572

8374.41

1.09929 583.531

8374.41

209.36

641.471

209.36 432.111

7942.3

1.12562 569.883

7942.3

198.557

641.471

198.557 442.914

7499.38

1.15258 556.554

7499.38

187.485

641.471

187.485 453.987

7045.4

1.18018 543.537

18

2.39%

factor

391.471

10%

rate

1.02395 626.468

7045.4

176.135

641.471

176.135 465.336

6580.06

1.20844 530.824

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

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

60.33

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 + E ( 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.

19

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

UL = L/ [1+(1-T)*D/E]

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

L = UL * [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 + ( 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% ;

20

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.

21

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


( in $ 000)

Liability
Share Holders

Asset
246,300

Equity

Property , Plant

302,000

and Equipment

Deferred taxes

45,000

Other Asset

89,000

Long term debt

208,600

Inventories

125,000

Short term debt

75,600

Accounts

120,000

Receivable
Accounts Payable

62,000

Cash and

1,500

Marketable
Securities
Total Current

137,600

Total Current

Liability
Total Liability

246,500

Asset
637,500

Total Asset

637,500

The Companys 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.

22

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 projects APV in the following cases ?

23

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 Companys 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 Companys 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 :

24

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 projects 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

25

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

Solution : Calculation of Base Case NPV :


Time

Cash Flow -1,000,000

600,000

700,000

Discount

rate for
APV

12%

Present

Value

-1000000

APV

93750

535714.2857 558035.714

Calculation of Tax Shield :

Calculation of Tax Shield on Interest Payment


PV of
Interest tax
Interest Shield at a
Interest
Time

Principal

Interest Rate

Amount

26

Principal

Closing

Tax

Repayment Balance Shield

discount
rate of 8%

300,000

150,000

8%

24000

150,000

150,000

7200

6666.66667

12000

150,000

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


consultants analysis of the Companys 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 A, we find that:

D
E
+ (E )

A = (1 TC )(D )
V ( TC D )
V ( TC D )

27

D/V
E/V

+ (E )
A = (1 TC )(D )

(
T
D/V)
1
(
T
D/V)
C
C

0.45
0.55
+ (1.09)
= 0.6738
A = (1 0.35)(0.15)
1 (0.35 0.55 )
1 (0.35 0.55 )
Using the Security Market Line, we calculate the opportunity cost of capital for
Sphagnums assets:

rA = rf + A (rm rf) = 0.09 + (0.6738 0.085) = 0.147 = 14.7%


Following MMs 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 consultants 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

28

crores, Rs 30 crores and Rs 50 crores respectively. Since the companys 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 :
L = UL 1

1
E

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%

29

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 :

30

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

20

30

50

60

years )
Cash Flow ( in
rupees lacs )

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

Discounted

Cumulative

Factor @ 12 % Discounted Discounted

Time

Cash flow

20

0.892857143 17.8571429 17.85714286

30

0.797193878 23.9158163 41.77295918

50

0.711780248 35.5890124 77.36197157

60

0.635518078 38.1310847 115.4930563

discount

31

Cash Flow

cash flow

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 :

Discounted
Factor @ 12 % Discounted
discount

Cash Flow

Time

Cash flow

(100)

20

0.892857143 17.8571429

30

0.797193878 23.9158163

50

0.711780248 35.5890124

60

0.635518078 38.1310847

-100

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.

32

In the above example the IRR of the project is :


Discounted
Factor @ 18 % Discounted
discount

Cash Flow

Time

Cash flow

-100

20

0.84784972

16.96

30

0.718849148

21.57

50

0.609476048

30.47

60

0.516744097

31.00

NPV

0.00

-100

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.

33

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

1+3

2+3

at 10%
0

-100

-100

-100

1.000

-200

-200

225

450

0.909

450

675

550

0.826

550

Project

NPV at 10%

IRR

354.30

134.5%

104.53

125.0%

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

34

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

35

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

NPV

( $ thousands)

( $ thousands )

300

66

17.2

200

-4

10.7

250

43

16.6

100

14

12.1

100

11.8

350

63

18.0

36

IRR (%)

48

400

13.5

Solution :

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

Profitability Index

0.22

-0.02

0.17

0.14

0.07

0.18

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 Companys borrowing rate is 9 percent and the tax rate is
35 percent .

37

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.

38

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 .

39

Solution :
( Rs in million)
0

Revenues

120

120

120

120

120

Cost

80

80

80

80

80

Depreciation

20

15

11.25

8.44

6.33

Profit Before

20

28.75

31.56

33.67

Fixed Asset

(80.00)

Net

(20.00)

Working
Capital

25

Tax
Tax

7.5

8.63

9.47

10.10

Profit After

14

17.5

20.12

22.09

23.57

Tax
Net Salvage

30.00

Value of
Fixed Asset
Recovery of

20.00

Net
Working
Capital

40

Initial

(100.00)

Outlay
Operating

34.0

32.5

31.37

30.53

29.90

Cash flow
Terminal

50.00

Cash flow
Net cash

(100)

34.0

32.5

31.37

30.53

100

80

65

53.75

45.31

79.90

flow
Book Value
of
Investment

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.

41

Solution :
( Rs in 000)
year

180

180

180

180

180

400

300

225

168.8

126.6

100

75

56.3

42.2

31.6

300

225

168.7

126.6

95

120

90

247.5

230.6

218

1. Investment
Outlay
1. Cost of new

(1600)

asset
2.Salvage

5000

value of old
asset
3. Increase in

(100)

Net working
capital
4.Total net

(1200)

investment
II Operating
Cash flow
5. After tax
savings in
manufacturing
cost
6.
Depreciation
on new
machine
7.
Depreciation
on old
machine
8. Incremental
Depreciation (
6-7)
9. Tax saving
on
incremental
depreciation

42

(8*0.40)
10.Net

300

270

247.5

230.6

218

Operating
Cash flow
(5+9)
III Terminal
cash flow
11.Net

800

terminal value
of new
machine
12. Net

160

terminal value
of old machine
13. recovery of

100

incremental
net working
capital
14. Total

740

terminal cash
flow (1112+13)
15. Net cash

(1200)

300

270

247.5

230.6

958

flow

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 Garous 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.

43

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

44

Simulation Run
R
or Scenario Analy
ysis

Category
y II : In thiss type of prroject, the p
project may
y not be com
mpleted and
d there is lo
ot
of unceertainty asssociated with
w
the co
ompletion of
o the pro
oject. For example,
e
o
oil
explorattion projectt. There is no guaranttee that Oil would bee found and
d before th
he
last stag
ge is reacheed , the pro
oject can bee cancelled.. For this ccategory off project, we
w
can captture the unccertainty by
y using :

D
Decision
Treee Analysiss

R
Real
Option
n Analysis

The en
ntire uncerttainty analy
ysis aspect of capital budgeting
g is presentted with th
he
help of the
t followin
ng diagram
m:

Unceertainty
An
nalysis

Project
P
comp
pletion is
certain

Sen
nsitivity
A
Analysis

Pro
oject
complletion is
unceertain

Sim
miulation
ru
un or
sceenario
an
nalysis

Decisson Tree
Analysis

Real Option
O
Anaalysis

Sensitiviity analysiss : In this ty


ype of uncerrtainty analysis capturring , only one variablle
is chang
ged over thee base case while the o
other variab
bles are kep
pt constant. This step is
used to calculate which
w
variiable is mo
ost importaant so thatt we can eliminate th
he
unimporrtant variab
ble so that scenario
s
an
nalysis is carrried on such variablees.
This is explained
e
with
w the help
p of an exam
mple :

L us take an
Let
a examplee :
45

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 Products 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 :

Variabl Pessimisti
e
c
Market
Size (
In
units )
900000

Market
Share (
in
numbe
rs )
Unit
Price (

Expected

Optimist
ic

1000000

1100000

0.1

0.16

46
0.04

47

NPV
Variable Pessimistic Expected
Market
Size
1.1
3.43
Market
Share
-10.4
3.43
Unit Price
Unit
Variable
Cost
Fixed
Cost

Optimistic
5.7
17.3

-4.2

3.43

-15

3.43

11.1

0.4

3.43

6.5

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.

48

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.

49

Probability

of

Success 0.7

Probability

of

Success 0.5

Launch Product
-Rs 2 million

Probability

of

Failure 0.3

Develop a Product
- Rs 1 million

Probability

Collect Pay Off


+ Rs 15 million

Abandon Project

of

failure 0.5

Abandon Project

50

Decision Tree Ca

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 projects 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

51

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
Cash Flow
Discount Rate

T= 0
-Rs 100

T=1
Rs 125
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.

Lets 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
Amount
Probability
Amount
Probability

Discount Rate =15% p.a.

52

T=2
Rs 170
0.5
Rs 80
0.5

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.

53

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

54

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

construction stage and highest

uncertainty

in

pre

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 :

55

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:
PV1 = 50 [0 .35(50 0)] 20
+

30
30
30
30
30

2
3
4
1.12 1.12
1.12
1.12
1.125

5
0.35 (5 0)

= $93.80
5
1.12
1.12 5

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

56

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:
PV2 = 25 [0.35(25 0)]

20
20
20
20
20

2
3
4
1.12 1.12
1.12
1.12
1.12 5

20
30
30
30
30
30

5
6
7
8
9
1.12
1.12
1.12
1.12
1.12
1.1210
5
0 .35 (5 0)

= $127.51
10
1.12
1.1210

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

-100

+110

+121

-120

+110

+121

C3

+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.

57

Solution :
Year

-100

110

121

0.909090909

0.82645

flow

-100

100

100

NPV

100

Year

-120

110

121

133

0.909090909

flow

-120

100

NPV

180

PV @ 10%
disocunt
rate
PV of cash

PV @ 10%
disocunt
rate

0.82645 0.75131

PV of cash
100

99.9249

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) .

58

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

59

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.

60

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)

RM

1.5

1.3

1.2

1.1

61

WIP

0.5

0.20

0.20

0.20

0.20

FG

1.2

Receivable

1.5

Creditor ( of

0.5

0.5

0.4

0.35

7%

7%

6%

5%

5%

raw material
consumption
)
Other
Current
Asset as a %
of Inventory
and
Receivable
outstanding
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 .

62

ii. The price of steel is assumed as below :

( Rs )

Steel Price

28000

28000

30000

30000

32000

Per MT

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 :

Electricity

( Rs)

3.30

3.30

4.10

4.10

Price

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

( Rs in lacs)

Salary and

55

65

75

80

100

Wages

The other manufacturing expenses are assumed as follows :


( Rs in lacs )

63

Other

12

15

15

18

20

Manufacturing
Expenses

% of sales

The selling and distribution expenses have been assumed as follows


:

10%

8%

7%

6%

5%

value for the


month

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

15.33%

Machinery
Computers

40%

Furniture and

18.1%

Fixture

Schedule of installation of fixed asset :

64

Asset Name
Land

T=0

Building (Factory)

T=3-6 months

Plant and

T=6-9 months

Machinery
Computers

T=9-12 months

Furniture and

T=9-12 months

Fixture
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 :

Production

50000

75000

80000

85000

85000

45000

77000

79000

84500

84500

18000

18000

19500

21000

22500

( no of
units )
Sales ( no
of units )
Sales Price
Per unit ( in
Rs )

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

65

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

Original
Fixed
Interest
Asset
During
Final Fixed
Cost
Construction Asset Cost
550
44
594
500
30
530

Land
Building
Plant and
Machinery
IT
Furniture and
Fixture

1450
150

Step No

Debt to Equity
Ratio
Land
Building
Plant and
Machinery
IT
Furniture and
Fixture

Step No

Determination of Fixed Asset Cost

2:1

58
3

1508
153

200
4
204
2850
139
2989
2
Determination of Means of Finance
Original
Fixed
Asset
Debt
Cost
Finance
Equity Finance
550
367
183
500
333
167

1450
150

967
100

483
50

200
2850

133
1900

67
950

Determination of Term Loan Interest


66

Term Loan
Interest

12%

Step No
4
Project
Implementation
Period
Months
Step No
5

Land
Amount
Debt Part
IDC
Calculation
Opening
Balance of Debt
Disbursement
of Term Loan
Closing Balance
of Term Loan
Tenure of
Outstanding
Interest Rate of
Term Loan ( %
p.a.)
Interest during
construction

Project Implementation Period

12
Determination of IDC
Plant and
Machinery

IT

Furniture
and
Fixtures
9
9
150
200
100
133

0
550
367

Building
3
500
333

367

333

967

100

133

367

333

967

100

133

12

12%

12%

12%

12%

12%

44

30

58

183
44

167
30

483
58

50
3

67
4

227

197

541

53

71

6
1450
967

Equity Part
Original Value
IDC Part
Total Equity
Required
Step 6

Determination of Final Fixed Asset Cost

67

Original
Fixed
Interest
Final Fixed
Asset
During
Cost
Construction Asset Cost
550
44
594
500
30
530

Land
Building
Plant and
Machinery
IT
Furniture and
Fixture

1450
150

Step 8
Miscellaneous
expenses
Step 9

2:1

Debt
Finance

Equity Finance
367
227
333
197
541
53

1508
153

133
1900

71
1089

204
2989

250
Determination of IDC on Miscellaneous Expenses
250
166.67

Opening
Balance

Disbursement

167

Closing Balance
Tenure
Interest Rate
IDC

167
6
12%
10
68

594
530

967
100

Determination of Miscellaneous Expenses

Original Cost
Debt

1508
153

200
4
204
2850
139
2989
Means of finance for fixed assets

Step 7
Debt to Equity
Ratio
Land
Building
Plant and
Machinery
IT
Furniture and
Fixture

58
3

Equity
Original
Amount
IDC

83.33
10.00
93.33

Step 10

Final Miscellaneous Expenses

Miscel Exp

Original
IDC
250

Step 11
Debt
Equity

Fixed Asset

Total
10

260

Final Means of Finance for Miscellaneous expense


166.67
93.33
260
Total Project Cost
Original
IDC
Total
2850
139
2989

Misc Expenses
MMWC

250
1029
4129
Total Means of Finance

10
0
149

260
1029
4278

Debt
Equity

2753
1525
4278

Calculation of Margin Money for Working Capital


1
2
3
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

69

Price Per unit


Sales in Rs
Lacs

18000

18000

19500

21000

22500

22500

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

50000
0

75000
0

96000
0

102000
0

102000
0

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

80

100

100

18

20

20

Step 4

Estimate Salary and Wages


Salary and
Wages

Step 5

65

75

Estimate Other Manufacturing Expenses


Other
Manufacturin
g Expenses

55

12

70

15

15

Step 6

Estimate Depreciation
Depreciation

Step 7
WIP
Step 8
Closing WIP
Step 9
COP
Step 10
Opening
Stock FG
Step 11
Closing FG
Step 12
Cost of Sales
Step 13

178

178

208

241

257

301
185
208
Estimate the COP
7214 11103 12460
Estimate the Opening stock of FG

241

257

257

14448

15403

15418

1043

1192

1276

1192

1276

1284

6183
11031 12520
14300
Estimate the Raw Material and Receivable

15318

15411

1031
1103
Estimate the Closing stock of FG
1031
1103
1043
Estimate the Cost of Sales

7000
2

10500
1.5

12000
1.3

14025
1.2

14960
1.1

14960
1.1

Raw Material
in Rs lacs
Sales
HL

1167
8100
2

1313
13860
1.5

1300
15405
1

1403
17745
1

1371
19013
1

1371
19013
1

1479

1584

1584

1403
241
1192
1479
4314

1371
257
1276
1584
4489

1371
257
1284
1584
4497

6%

5%

5%

5%

269
303
230
Estimate Total Current Asset

216

224

225

4713

4722

Step 14
RM
WIP
FG
Receivable
Step 15
% of
Inventory and
Receivable
OCA in Rs
Lacs
Step 16
Total Current
Asset

212

Consumption
HL

Receivable in
Rs lacs

Step 17

382
310
255
Estimate the Opening WIP
0
301
185
Estimate the Closing WIP

1350
1733
1284
Determine RM, WIP, FG and Receivable
1167
1313
1300
301
185
208
1031
1103
1043
1350
1733
1284
3848
4333
3835
Estimate OCA

7%

7%

4636
4065
4529
4117
Determination of Margin Money for Working Capital

71

Margin
Money for
working
capital

1029

1159

1016

1132

1178

1180

Estimate the Creditor Level


Step 1

Step 2
Step 3
Total
Current
Asset
Total OCL
Total WCG
MMWC
BBWC

Purchase

8167

10646

11988

14128

14929

14960

Consumptio
n

7000

10500

12000

14025

14960

14960

Closing stock
of RM

1167

1313

1300

1403

1371

1371

Opening
1167
stock of RM
0
HL
1
0.5
Creditor
681
444
Calculation of Working Capital

1313
0.5
499

1300
0.4
471

1403
0.35
435

1371
0.35
436

4065
499
3565
1016
2549

4529
471
4058
1132
2926

4713
435
4278
1178
3100

4722
436
4285
1180
3105

4117
681
3437
1029
2407

4636
444
4193
1159
3034

Calculation of Interest on Term Loan


1
2
Opening
balance at
the time of
starting of
commercia
l
production
Repaymen
t
Closing
balance
Average
Balance
Interest
Rate
Interest
Amount
Opening
balance
BBWC
Int Rate
Interest

2753

2202

1652

1101

551

551

551

551

551

551

2202

1652

1101

551

2478

1927

1376

826

275

12%

12%

12%

12%

12%

99

33

2926
11%
322

3100
11%
341

297
231
165
Calculation of Interest of Working Capital Finance from Bank

2407
11%
265

72

3034
11%
334

2549
11%
280

3105
11%
342

Amount

Sales

Profit and Loss


1
2
3
8100
13860
15405

4
17745

5
19013

Total

8100

13860

15405

17745

19013

Consumption
Power and
Fuel
Salary and
wages
OME
Depreciation

7000

10500

12000

14025

14960

65

97.5

137.28

145.86

160.446

55
12
382

65
15
310

75
15
255

80
18
212

100
20
178

Opening WIP
Closing WIP
Cost of
Production
Opening FG
Closing FG
Cost of Sales
Selling and
Distribution
Interest
Sub total
Misc Exp
write off
Sub total
Profit Before
Tax
Tax

0
301

301
185

185
208

208
241

241
257

7214
0
1031
6183

11103
1031
1103
11031

12460
1103
1043
12520

14448
1043
1192
14300

15403
1192
1276
15318

810
562
7555

1109
565
12705

1078
446
14044

1065
421
15786

951
374
16642

26
7581

26
12731

26
14070

26
15812

26
16668

519
156

1129
339

1335
401

1933
580

2344
703

Expenses

73

Profit After
Tax

363

791

935

Estimating Depreciation Calculation


1
2
3
Fixed
Amount
Name
Land
Building
Plant and
Machinery
IT
Furniture
and
Fixture

Final
Fixed
Asset Depreciation
Cost Rate ( %)
594
0%
530
10%
1508
153

204

0
53

0
48

0
43

1353

0
39

0
35

1641

15.33% 231 196 166 140 119


40% 61 37 22 13
8

18.10%

37

30

25

20

17

382 310 255 212 178


Misc Exp

PAT
Depreciation
Amortisation
Increase in TL
Increase in
Equity
Increase in
BBWC
Increase in
Creditor

260

10%

26

26

26

Projected Cash Flow Statement


0
1
2
3
363
791
935
382
310
255
26
26
26

26

26

4
1353
212
26

5
1641
178
26

626

-485

377

173

-237

56

-29

-35

74

Total

1161

698

1565

1730

1851

551

551

551

551

551

146

-13

103

-31

-116

23

33

16

73

-60

148

85

383

-449

195

106

34

-73

-14

Increase in
Fixed Asset
Repayment of
Term Loan
Increase in RM
Increase in
WIP
Increase in FG
Increase in
Receivable
Increase in
OCA
Total

1070

-21

1015

735

559

Cash
surplus/deficit

91

719

549

995

1292

91

810

1360

2355

91

810

1360

2355

3647

Opening Cash
&Bank Balance
Closing Cash
& Bank
Balance

Equity
Reserves
Term Loan
BBWC
Creditor

2753
2407
681

Balance Sheet
1
2
1525
1525
363
1154
2202
1652
3034
2549
444
499

Total

7366

7568

0
1525

7379

75

3
1525
2088
1101
2926
471

4
1525
3442
551
3100
435

5
1525
5083
0
3105
436

8112

9053

10149

Fixed Asset

Accumulated
Depreciation
Net Fixed
Asset
Misc Exp
RM
WIP
FG
Receivable
OCA
C&B
Total

2989

2989

2989

2989

2989

2989

382

693

948

1161

1339

2989
260
1167
301
1031
1350
269

2607
234
1313
185
1103
1733
303
91

2296
208
1300
208
1043
1284
230
810

2041
182
1403
241
1192
1479
216
1360

1828
156
1371
257
1276
1584
224
2355

1650
130
1371
257
1284
1584
225
3647

7366

7568

7379

8112

9053

10149

DSCR Calculation

1
363
382
26

DSCR Calculation
2
791
310
26

3
935
255
26

4
1353
212
26

5
1641
178
26

PAT
D
Amortisation
Interest on
TL
Subtotal
MMWC
Total

297
1069
130
939

231
1358
-143
1501

165
1381
116
1265

99
1691
46
1645

33
1878
2
1876

Term Loan
P
I
DSCR

848
551
297
1.11

782
551
231
1.92

716
551
165
1.77

650
551
99
2.53

584
551
33
3.21

0.75
-350
90%

1
-1178
86%

2
939
75%

IRR Calculation :
0
-550
100%

0.25
-500
96%

0.5
-1700
93%

76

3
1501
64%

4
1265
56%

5
1645
48%

6
1876
42%

-550
IRR

-482
15.77%

-1580

-314

-1018

700

967

704

8.40%
17%

0.64
0.36

5.40%
6.06%
11.47%

WACC of the project :


Debt
Equity

2753
1525
4278

12%

30%

Hence the project is acceptable.

77

791

779

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