prasanna chandra math
TRANSCRIPT
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Chapter 4
MARKET AND DEMAND ANALYSIS
1. We have to estimate the parameters aand bin the linear relationshipYt= a+ bT
Using the least squares method.According to the least squares method the parameters are:
T Yn T Yb=
T 2n T 2
a= YbTThe parameters are calculated below:
Calculation in the Least Squares Method
T Y TY T 21 2,000 2,000 12 2,200 4,400 4
3 2,100 6,300 94 2,300 9,200 165 2,500 12,500 256 3,200 19,200 367 3,600 25,200 498 4,000 32,000 649 3,900 35,100 81
10 4,000 40,000 100
11 4,200 46,200 12112 4,300 51,600 14413 4,900 63,700 16914 5,300 74,200 196
T = 105 Y = 48,500 TY =421,600 T = 1,015
T= 7.5 Y= 3,464
T Yn T Y 421,60014 x 7.5 x 3,464
b= = T
2n T 2 1,01514 x 7.5 x 7.5
57,880= = 254
227.5a = YbT
= 3,464254 (7.5)
= 1,559
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Thus linear regression isY= 1,559 + 254 T
2. In general, in exponential smoothing the forecast for t+ 1 isFt+ 1 =Ft+ et
WhereFt+ 1 = forecast for year ) = smoothing parameteret = error in the forecast for year t= St =Ft
F1is given to be 2100 and is given to be 0.3The forecasts for periods 2 to 14 are calculated below:
Period t Data (St) Forecast
(Ft)
Error
(etSt =Ft)
Forecast for t + 1
(Ft + 1 = Ft+ et)
1 2,000 2100.0 -100 F2 = 2100 + 0.3 (-100) = 2070
2 2,200 2070 130 F3 = 2070 + 0.3(130) = 2109
3 2,100 2109.0 -9 F4 = 2109 + 0.3 (-9) = 2111.7
4 2,300 2111.7 188.3 F5 = 2111.7 + 0.3(188.3) = 2168.19
5 2,500 2168.19 331.81 F6 = 2168.19 + 0.3(331.81) = 2267.7
6 3,200 2267.7 932.3 F7 = 2267.7 + 0.3(9332.3) = 2547.4
7 3,600 2547.4 1052.6 F8 = 2547.4 + 0.3(1052.6) = 2863.28 4,000 2863.2 1136.8 F9 = 2863.2 + 0.3(1136.8) = 3204.24
9 3,900 3204.24 695.76 F10 = 33204.24 + 0.3(695.76) = 3413.0
10 4,000 3413 587.0 F11 = 3413.0 + 0.3(587) = 3589.1
11 4,200 3589.1 610.9 F12 = 3589.1 + 0.3(610.9) = 3773.4
12 4,300 3772.4 527.6 F13 = 3772.4 + 0.3(527.6) = 3930.7
13 4,900 3930.7 969.3 F14 = 3930.7 + 0.3(969.3) = 4221.5
3. According to the moving average methodSt + St1++Stn +1
Ft+ 1 =n
whereFt+ 1 = forecast for the next periodSt = sales for the current periodn = period over which averaging is done
Given n= 3, the forecasts for the period 4 to 14 are given below:
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Period t Data (St) Forecast
(Ft)
Forecast for t + 1
Ft + 1 = (St+ St1+
St2)/ 3
1 2,000
2 2,200
3 2,100 F4 = (2000 + 2200 + 2100)/3 = 2100
4 2,300 2100 F5 =(2200 + 2100 + 2300)/3= 2200
5 2,500 2200 F6 = (2100 + 2300 + 2500)/3 = 2300
6 3,200 2300 F7 = (2300 + 2500 + 3200)/3= 2667
7 3,600 2667 F8 = (2500 + 3200 + 3600)/3 = 31008 4,000 3100 F9 = (3200 + 3600 + 4000)/3 = 3600
9 3,900 3600 F10 = (3600 + 4000 + 3900)/3 = 3833
10 4,000 3833 F11 = (4000 + 3900 + 4000)/3 =3967
11 4,200 3967 F12 =(3900 + 4000 + 4200)/3 = 4033
12 4,300 4033 F13 = (4000 + 4200 + 4300)/3 = 4167
13 4,900 4167 F14 = (4200 + 4300 + 4900) = 4467
14 5,300 4467
4.Q1 = 60Q2 = 70I1 = 1000I2 = 1200
Q1Q2 I1 +I2
Income Elasticity of DemandE1 = xI2 -I1 Q2Q1E1 = Income Elasticity of DemandQ1 = Quantity demanded in the base yearQ2 = Quantity demanded in the following yearI1 = Income level in base yearI2 = Income level in the following year
7060 1000 + 1200E1 = x
12001000 70 + 60
22000E1 = = 0.846
26000
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5.P1 = Rs.40
P2 = Rs.50Q1 = 1,00,000Q2 = 95,000
Q2Q1 P1 +P2Price Elasticity of Demand = Ep = x
P2P1 Q2 + Q1
P1 , Q1 = Price per unit and quantity demanded in the base yearP2, Q2 = Price per unit and quantity demanded in the following yearEp= Price Elasticity of Demand
95000 - 100000 40 + 50Ep= x
50 - 40 95000 + 100000
- 45Ep= = - 0.0231
1950
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Chapter 6
FINANCIAL ESTIMATES AND PROJECTIONS
1.Projected Cash Flow Statement (Rs. in million)
Sources of Funds
Profit before interest and tax 4.5Depreciation provision for the year 1.5Secured term loan 1.0
Total (A) 7.0
Disposition of Funds
Capital expenditure 1.50
Increase in working capital 0.35Repayment of term loan 0.50Interest 1.20
Tax 1.80Dividends 1.00
Total (B) 6.35
Opening cash balance 1.00Net surplus (deficit) (AB) 0.65Closing cash balance 1.65
Projected Balance Sheet
(Rs. in million)
Liabilities Assets
Share capital 5.00 Fixed assets 11.00Reserves & surplus 4.50 Investments .50Secured loans 4.50 Current assets 12.85Unsecured loans 3.00 * Cash 1.65
Current liabilities 6.30 * Receivables 4.20& provisions 1.05 * Inventories 7.00
24.35 24.35
Working capital here is defined as :
(Current assets other than cash)(Current liabilities other than bank borrowings)In this case inventories increase by 0.5 million, receivables increase by 0.2 million and current liabilities
and provisions increase by 0.35 million. So working capital increases by 0.35 million
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2. Projected Income Statement for the 1stOperating Year
Rs.Sales 4,500Cost of sales 3,000Depreciation 319Interest 1,044Write off of Preliminary expenses 15Net profit 122
Projected Cash Flow Statements
Construction period 1stOperating year
Sources
Share capital 1800 -Term loan 3000 600Short-term bank borrowing 1800Profit before interest and tax 1166Depreciation 319Write off preliminary expenses 15
4800 3900Uses
Capital expenditure 3900 -Current assets (other than cash) - 2400Interest - 1044Preliminary expenses 150 -Pre-operative expenses 600 -
4650 3444
Opening cash balance 0 150Net surplus / deficit 150 456Closing balance 150 606
Projected Balance Sheet
Liabilities 31/3/n+1 31/3/n+2 Assets 31/3/n+1 31/3/n+2
Share capital 1800 1800 Fixed assets (net) 4500 4181
Reserves & surplus - 122
Secured loans : Current assets
- Term loan 3000 3600 - Cash 150 606- Short-term bank
borrowing1800 Other current assets 2400
Unsecured loans - - Miscellaneousexpenditures & losses
Current liabilities andprovisions
- Preliminaryexpenses
150 135
4800 7322 4800 7322
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Notes :
i. Allocation of Pre-operative Expenses : Rs.
Type Costs before
allocation
Allocation Costs after
allocation
Land 120 19 139
Building 630 97 727
Plant & machinery 2700 415 3115
Miscellaneous fixed assets 450 69 519
3900 600 4500
ii. Depreciation Schedule :
Land Building Plant & machinery M.Fixed
assets
Total (Rs.)
Opening balance 139 727 3115 519 4500
Depreciation - 25 252 42 319
Closing balance 139 702 2863 477 4181
iii. Interest Schedule :Interest on term loan of Rs.3600 @20% = Rs.720Interest on short term bank borrowings of Rs,1800 @ 18% = Rs.324
= Rs.1044
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Chapter 7
THE TIME VALUE OF MONEY
1. Value five years hence of a deposit of Rs.1,000 at various interest rates is asfollows:
r = 8% FV5 = 1000 x FVIF (8%, 5 years)= 1000 x 1.469 = Rs.1469
r = 10% FV5 = 1000 x FVIF (10%, 5 years)= 1000 x 1.611 = Rs.1611
r = 12% FV5 = 1000 x FVIF (12%, 5 years)= 1000 x 1.762 = Rs.1762
r = 15% FV5 = 1000 x FVIF (15%, 5 years)= 1000 x 2.011 = Rs.2011
2. Rs.160,000 / Rs. 5,000 = 32 = 25
According to the Rule of 72 at 12 percent interest rate doubling takes placeapproximately in 72 / 12 = 6 years
So Rs.5000 will grow to Rs.160,000 in approximately 5 x 6 years = 30 years
3. In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 23 times the initialdeposit. Hence doubling takes place in 12 / 3 = 4 years.
According to the Rule of 69, the doubling period is:
0.35 + 69 / Interest rate
Equating this to 4 and solving for interest rate, we get
Interest rate = 18.9%.
4. Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter isequivalent to saving Rs.2000 a year for 15 years and Rs.1000 a year for theyears 6 through 15.
Hence the savings will cumulate to:
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2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)= 2000 x 31.772 + 1000 x 15.937 = Rs.79481.
5. LetAbe the annual savings.
Ax FVIFA (12%, 10 years) = 1,000,000Ax 17.549 = 1,000,000
So A = 1,000,000 / 17.549 = Rs.56,983.
6. 1,000 x FVIFA (r, 6 years) = 10,000
FVIFA (r, 6 years) = 10,000 / 1000 = 10
From the tables we find that
FVIFA (20%, 6 years) = 9.930FVIFA (24%, 6 years) = 10.980
Using linear interpolation in the interval, we get:
20% + (10.0009.930)r= x 4% = 20.3%
(10.9809.930)
7. 1,000 x FVIF (r, 10 years) = 5,000FVIF (r,10 years) = 5,000 / 1000 = 5
From the tables we find thatFVIF (16%, 10 years) = 4.411FVIF (18%, 10 years) = 5.234
Using linear interpolation in the interval, we get:
(5.0004.411) x 2%
r= 16% + = 17.4%(5.2344.411)
8. The present value of Rs.10,000 receivable after 8 years for various discountrates (r) are:r= 10% PV = 10,000 x PVIF(r= 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670
r= 12% PV = 10,000 x PVIF (r= 12%, 8 years)
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= 10,000 x 0.404 = Rs.4,040
r= 15% PV = 10,000 x PVIF (r= 15%, 8 years)= 10,000 x 0.327 = Rs.3,270
9. Assuming that it is an ordinary annuity, the present value is:2,000 x PVIFA (10%, 5years)= 2,000 x 3.791 = Rs.7,582
10. The present value of an annual pension of Rs.10,000 for 15 years when r= 15%is:
10,000 x PVIFA (15%, 15 years)= 10,000 x 5.847 = Rs.58,470
The alternative is to receive a lumpsum of Rs.50,000.
Obviously, Mr. Jingo will be better off with the annual pension amount ofRs.10,000.
11. The amount that can be withdrawn annually is:100,000 100,000
A= ------------------ ------------ = ----------- = Rs.10,608PVIFA (10%, 30 years) 9.427
12. The present value of the income stream is:1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)
= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.
13. The present value of the income stream is:2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)= 2,000 x 3.791 + 3000/0.10 x 0.621= Rs.26,212
14. To earn an annual income of Rs.5,000 beginning from the end of 15 years fromnow, if the deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000
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is required at the end of 14 years. The amount that must be deposited to get thissum is:
Rs.50,000 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165
15. Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years)PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00
From the tables we find that:
PVIFA (15%, 10 years) = 5.019PVIFA (18%, 10 years) = 4.494
Using linear interpolation we get:
5.0195.00r= 15% + ---------------- x 3%
5.0194.494= 15.1%
16. PV (StreamA) = Rs.100 x PVIF (12%, 1 year) + Rs.200 xPVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 xPVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +Rs.1,000 x PVIF (12%, 10 years)
= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712
+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361+ Rs.1,000 x 0.322
= Rs.2590.9
Similarly,PV (StreamB) = Rs.3,625.2
PV (Stream C) = Rs.2,851.1
17. FV5 = Rs.10,000 [1 + (0.16 / 4)]5x4
= Rs.10,000 (1.04)20= Rs.10,000 x 2.191= Rs.21,910
18. FV5 = Rs.5,000 [1+( 0.12/4)]5x4
= Rs.5,000 (1.03)
20
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= Rs.5,000 x 1.806= Rs.9,030
19. A B C
Stated rate (%) 12 24 24Frequency of compounding 6 times 4 times 12 timesEffective rate (%) (1 + 0.12/6)6- 1 (1+0.24/4)41 (1 + 0.24/12)12-1
= 12.6 = 26.2 = 26.8Difference between theeffective rate and stated
rate (%) 0.6 2.2 2.8
20. Investment required at the end of 8th year to yield an income of Rs.12,000 peryear from the end of 9thyear (beginning of 10thyear) for ever:
Rs.12,000 x PVIFA(12%, )= Rs.12,000 / 0.12 = Rs.100,000
To have a sum of Rs.100,000 at the end of 8thyear , the amount to be depositednow is:
Rs.100,000 Rs.100,000= = Rs.40,388
PVIF(12%, 8 years) 2.476
21. The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu ofRs.5,000 now is:
Rs.5,000 x FVIF (r,10 years) = Rs.20,000
Rs.20,000FVIF (r,10 years) = = 4.000
Rs.5,000
From the tables we find thatFVIF (15%, 10 years) = 4.046
This means that the implied interest rate is nearly 15%.I would choose Rs.20,000 for 10 years from now because I find a return of 15%quite acceptable.
22. FV10 = Rs.10,000 [1 + (0.10 / 2)]10x2
= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653
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= Rs.26,530
If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, interms of the current rupees is:Rs.26,530 x PVIF (8%,10 years)= Rs.26,530 x 0.463 = Rs.12,283
23. A constant deposit at the beginning of each year represents an annuity due.
PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit shouldbe
Rs.50,000A = FVIFA(12%, 10 years) x (1.12)
Rs.50,000= = Rs.2544
17.549 x 1.12
24. The discounted value of Rs.20,000 receivable at the beginning of each year from2005 to 2009, evaluated as at the beginning of 2004 (or end of 2003) is:
Rs.20,000 x PVIFA (12%, 5 years)= Rs.20,000 x 3.605 = Rs.72,100.
The discounted value of Rs.72,100 evaluated at the end of 2000 is
Rs.72,100 x PVIF (12%, 3 years)= Rs.72,100 x 0.712 = Rs.51,335
IfAis the amount deposited at the end of each year from 1995 to 2000 thenA x FVIFA (12%, 6 years) = Rs.51,335A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115 = Rs.6326
25. The discounted value of the annuity of Rs.2000 receivable for 30 years,evaluated as at the end of 9thyear is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)= Rs.18,854 x 0.424
= Rs.7,994
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26. 30 percent of the pension amount is0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rateof 12% is 1%, the discounted value of an annuity of Rs.180 receivable at the end of
each month for 180 months (15 years) is:Rs.180 x PVIFA (1%, 180)
(1.01)180- 1Rs.180 x ---------------- = Rs.14,998
.01 (1.01)180
If Mr. Ramesh borrows Rs.Ptoday on which the monthly interest rate is 1%
P x (1.01)60 = Rs.14,998P x 1.817 = Rs.14,998
Rs.14,998P = ------------ = Rs.8254
1.817
27. Rs.300 x PVIFA(r, 24 months) = Rs.6,000PVIFA (4%,24) = Rs.6000 / Rs.300 = 20
From the tables we find that:PVIFA(1%,24) = 21.244PVIFA (2%, 24) = 18.914
Using a linear interpolation
21.24420.000r = 1% + ---------------------- x 1%
21.24418,914
= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.The corresponding effective rate of interest per annum is
[ (1.0153)121 ] x 100 = 20%
28. The discounted value of the debentures to be redeemed between 8 to 10 yearsevaluated at the end of the 5thyear is:
Rs.10 million x PVIF (8%, 3 years)+ Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)
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= Rs.10 million (0.794 + 0.735 + 0.681)= Rs.2.21 million
IfAis the annual deposit to be made in the sinking fund for the years 1 to 5, thenA x FVIFA (8%, 5 years) = Rs.2.21 millionA x 5.867 = Rs.2.21 millionA = 5.867 = Rs.2.21 millionA = Rs.2.21 million / 5.867 = Rs.0.377 million
29. Let `n be the number of years for which a sum of Rs.20,000 can be withdrawnannually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 5.000From the tables we find that
PVIFA (10%, 7 years) = 4.868PVIFA (10%, 8 years) = 5.335
Thus n is between 7 and 8. Using a linear interpolation we get
5.0004.868n= 7 + ----------------- x 1 = 7.3 years
5.3354.868
30. Equated annual installment = 500000 / PVIFA(14%,4)= 500000 / 2.914= Rs.171,585
Loan Amortisation Schedule
Beginning Annual Principal RemainingYear amount installment Interest repaid balance
1 500000 171585 70000 101585 3984152 398415 171585 55778 115807 2826083 282608 171585 39565 132020 1505884 150588 171585 21082 150503 85*
(*) rounding off error
31. Define nas the maturity period of the loan. The value of n can be obtainedfrom the equation.
200,000 x PVIFA(13%, n) = 1,500,000PVIFA (13%, n) = 7.500
From the tables or otherwise it can be verified that PVIFA(13,30) = 7.500Hence the maturity period of the loan is 30 years.
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32. Expected value of iron ore mined during year 1 = Rs.300 millionExpected present value of the iron ore that can be mined over the next 15 yearsassuming a price escalation of 6% per annum in the price per tonne of iron
1(1 +g)n/ (1 + i)n= Rs.300 million x ------------------------
i-g
= Rs.300 million x 1(1.06)15/ (1.16)15
0.160.06
= Rs.300 million x (0.74135 / 0.10)= Rs.2224 million
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Chapter 8
INVESTMENT CRITERIA
1.(a) NPV of the project at a discount rate of 14%.
100,000 200,000= - 1,000,000 + ---------- + ------------
(1.14) (1.14)2
300,000 600,000 300,000
+ ----------- + ---------- + ----------(1.14)3 (1.14)4 (1.14)5
= - 44837
(b) NPV of the project at time varying discount rates= - 1,000,000
100,000+
(1.12)
200,000+
(1.12) (1.13)
300,000+
(1.12) (1.13) (1.14)
600,000+
(1.12) (1.13) (1.14) (1.15)
300,000+
(1.12) (1.13) (1.14)(1.15)(1.16)
= - 1,000,000 + 89286 + 158028 + 207931 + 361620 + 155871= - 27264
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2. InvestmentAa) Payback period = 5 yearsb) NPV = 40000 x PVIFA (12%,10)200 000
= 26000c) IRR (r) can be obtained by solving the equation:
40000 x PVIFA (r, 10) = 200000i.e., PVIFA (r, 10) = 5.000
From the PVIFA tables we find that
PVIFA (15%,10) = 5.019PVIFA (16%,10) = 4.883
Linear interporation in this range yields
r = 15 + 1 x (0.019 / 0.136)= 15.14%
d) BCR = Benefit Cost Ratio= PVB / I= 226,000 / 200,000 = 1.13
Investment B
a) Payback period = 9 years
b) NP V = 40,000 x PVIFA (12%,5)+ 30,000 x PVIFA (12%,2) x PVIF (12%,5)+ 20,000 x PVIFA (12%,3) x PVIF (12%,7)- 300,000
= (40,000 x 3.605) + (30,000 x 1.690 x 0.567)+ (20,000 x 2.402 x 0.452)300,000
= - 105339
c) IRR (r) can be obtained by solving the equation40,000 x PVIFA (r, 5) + 30,000 x PVIFA (r, 2) x PVIF (r,5) +20,000 x PVIFA (r, 3) x PVIF (r, 7) = 300,000
Through the process of trial and error we find thatr= 1.37%
d) BCR = PVB /I
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= 194,661 / 300,000 = 0.65
Investment C
a) Payback period lies between 2 years and 3 years. Linear interpolation inthis range provides an approximate payback period of 2.88 years.
b) NPV = 80.000 x PVIF (12%,1) + 60,000 x PVIF (12%,2)+ 80,000 x PVIF (12%,3) + 60,000 x PVIF (12%,4)
+ 80,000 x PVIF (12%,5) + 60,000 x PVIF (12%,6)
+ 40,000 x PVIFA (12%,4) x PVIF (12%,6)- 210,000
= 111,371
c) IRR (r) is obtained by solving the equation80,000 x PVIF (r,1) + 60,000 x PVIF (r,2) + 80,000 x PVIF (r,3)+ 60,000 x PVIF (r,4) + 80,000 x PVIF (r,5) + 60,000 x PVIF (r,6)+ 40000 x PVIFA (r,4) x PVIF (r,6) = 210000
Through the process of trial and error we getr= 29.29%
d) BCR = PVB /I = 321,371 / 210,000 = 1.53
Investment D
a) Payback period lies between 8 years and 9 years. A linear interpolationin this range provides an approximate payback period of 8.5 years.8 + (1 x 100,000 / 200,000)
b) NPV = 200,000 x PVIF (12%,1)+ 20,000 x PVIF (12%,2) + 200,000 x PVIF (12%,9)+ 50,000 x PVIF (12%,10)- 320,000
= - 37,160
c) IRR (r) can be obtained by solving the equation200,000 x PVIF (r,1) + 200,000 x PVIF (r,2)+ 200,000 x PVIF (r,9) + 50,000 x PVIF (r,10)
= 320000Through the process of trial and error we get r= 8.45%
d) BCR = PVB / I = 282,840 / 320,000 = 0.88
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Comparative Table
Investment A B C D
a) Payback period(in years) 5 9 2.88 8.5
b) NPV @ 12% 26000 -105339 111371 -37160
c) IRR (%) 15.14 1.37 29.29 8.45
d) BCR 1.13 0.65 1.53 0.88
Among the four alternative investments, the investment to be chosen is C
because it has the a. Lowest payback periodb. Highest NPVc. Highest IRRd. Highest BCR
3. IRR (r) can be calculated by solving the following equations for the value of r.60000 x PVIFA (r,7) = 300,000i.e., PVIFA (r,7) = 5.000
Through a process of trial and error it can be verified that r= 9.20% p.a.
4. The IRR (r) for the given cashflow stream can be obtained by solving thefollowing equation for the value of r.
-3000 + 9000 / (1+r)3000 / (1+r) = 0Simplifying the above equation we get
r = 1.61, -0.61; (or) 161%, (-)61%
Note : Given two changes in the signs of cashflow, we get two values for theIRR of the cashflow stream. In such cases, the IRR rule breaks down.
5. Define NCF as the minimum constant annual net cashflow that justifies thepurchase of the given equipment. The value of NCF can be obtained from theequation
NCF x PVIFA (10%,8) = 500000NCF = 500000 / 5.335
= 93271
6. DefineIas the initial investment that is justified in relation to a net annual cashinflow of 25000 for 10 years at a discount rate of 12% per annum. The value
ofIcan be obtained from the following equation
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25000 x PVIFA (12%,10) = Ii.e.,I = 141256
7. PV of benefits (PVB) = 25000 x PVIF (15%,1)+ 40000 x PVIF (15%,2)+ 50000 x PVIF (15%,3)+ 40000 x PVIF (15%,4)+ 30000 x PVIF (15%,5)= 122646 (A)
Investment = 100,000 (B)Benefit cost ratio = 1.23 [= (A) / (B)]
8. The NPVs of the three projects are as follows:
ProjectP Q R
Discount rate
0% 400 500 6005% 223 251 312
10% 69 40 7015% - 66 - 142 - 13525% - 291 - 435 - 46130% - 386 - 555 - 591
9. NPV profiles for ProjectsPand Qfor selected discount rates are as follows:(a)
Project
P QDiscount rate (%)
0 2950 5005 1876 20810 1075 - 2815 471 - 22220 11 - 382
b) (i) The IRR (r) of projectPcan be obtained by solving the followingequation for `r.
-1000 -1200 x PVIF (r,1)600 x PVIF (r,2)250 x PVIF (r,3)+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5) = 0
Through a process of trial and error we find that r = 20.13%
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(ii) The IRR (r') of project Q can be obtained by solving the followingequation for r'
-1600 + 200 x PVIF (r',1) + 400 x PVIF (r
',2) + 600 x PVIF (r
',3)+ 800 x PVIF (r',4) + 100 x PVIF (r',5) = 0
Through a process of trial and error we find that r'= 9.34%.
c) From (a) we find that at a cost of capital of 10%NPV (P) = 1075NPV (Q) = - 28
Given that NPV (P), NPV (Q) and NPV (P) > 0, I would choose projectP.From (a) we find that at a cost of capital of 20%
NPV (P) = 11NPV (Q) = - 382
Again NPV (P) > NPV (Q); and NPV (P) > 0. I would choose projectP.
d) Project PPV of investment-related costs
= 1000 x PVIF (12%,0)+ 1200 x PVIF (12%,1) + 600 x PVIF (12%,2)+ 250 x PVIF (12%,3)
= 2728TV of cash inflows = 2000 x (1.12) + 4000 = 6240The MIRR of the projectPis given by the equation:
2728 = 6240 x PVIF (MIRR,5)(1 + MIRR)5 = 2.2874MIRR = 18%
(c) ProjectQPV of investment-related costs = 1600TV of cash inflows @ 15% p.a. = 2772The MIRR of project Qis given by the equation:
16000 (1 + MIRR)5 = 2772MIRR = 11.62%
10.
(a) ProjectANPV at a cost of capital of 12%
= - 100 + 25 x PVIFA (12%,6)= Rs.2.79 million
IRR (r) can be obtained by solving the following equation for r.25 x PVIFA (r,6) = 100i.e., r= 12,98%
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Project B
NPV at a cost of capital of 12%= - 50 + 13 x PVIFA (12%,6)= Rs.3.45 million
IRR (r') can be obtained by solving the equation
13 x PVIFA (r',6) = 50
i.e., r'= 14.40% [determined through a process of trial and error]
(b) Difference in capital outlays between projectsAandBis Rs.50 millionDifference in net annual cash flow between projectsAandBis Rs.12 million.NPV of the differential project at 12%
= -50 + 12 x PVIFA (12%,6)= Rs.3.15 million
IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6) = 50
i.e., r'' = 11.53%
11.(a) ProjectM
The pay back period of the project lies between 2 and 3 years. Interpolating inthis range we get an approximate pay back period of 2.63 years.
Project N
The pay back period lies between 1 and 2 years. Interpolating in this range weget an approximate pay back period of 1.55 years.
(b) ProjectMCost of capital = 12% p.aPV of cash flows up to the end of year 2 = 24.97PV of cash flows up to the end of year 3 = 47.75PV of cash flows up to the end of year 4 = 71.26
Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in
this range we get an approximate DPB of 3.1 years.
Project N
Cost of capital = 12% per annumPV of cash flows up to the end of year 1 = 33.93PV of cash flows up to the end of year 2 = 51.47
DPB lies between 1 and 2 years. Interpolating in this range we get an
approximate DPB of 1.92 years.
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(c) ProjectMCost of capital = 12% per annumNPV = - 50 + 11 x PVIFA (12%,1)
+ 19 x PVIF (12%,2) + 32 x PVIF (12%,3)+ 37 x PVIF (12%,4)
= Rs.21.26 millionProject N
Cost of capital = 12% per annumNPV = Rs.20.63 million
Since the two projects are independent and the NPV of each project is (+) ve,
both the projects can be accepted. This assumes that there is no capitalconstraint.
(d) ProjectMCost of capital = 10% per annumNPV = Rs.25.02 million
Project N
Cost of capital = 10% per annumNPV = Rs.23.08 million
Since the two projects are mutually exclusive, we need to choose the projectwith the higher NPV i.e., choose projectM.
Note : The MIRR can also be used as a criterion of merit for choosing betweenthe two projects because their initial outlays are equal.
(e) Project MCost of capital = 15% per annumNPV = 16.13 million
Project N
Cost of capital: 15% per annumNPV = Rs.17.23 million
Again the two projects are mutually exclusive. So we choose the project with thehigher NPV, i.e., choose projectN.
(f) ProjectMTerminal value of the cash inflows: 114.47MIRR of the project is given by the equation
50 (1 + MIRR)4 = 114.47
i.e., MIRR = 23.01%
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Project N
Terminal value of the cash inflows: 115.41MIRR of the project is given by the equation
50 ( 1+ MIRR)4 = 115.41i.e., MIRR = 23.26%
12. The internal rate of return is the value of rin the equation2,000 1,000 10,000 2,000
8000 = - + +(1+r) (1+r)2 (1+r)3 (1+r)4
At r= 18%, the right hand side is equal to 8099At r= 20%, the right hand side is equal to 7726Thus the solving value of ris :
8,0998,00018% + x 2% = 18.5%
8,0997,726
Unrecovered Investment Balance
Year Unrecoveredinvestment balance at
the beginning Ft-1
Interest for theyear Ft-1(1+r)
Cash flow at theend of the year CFt
Unrecoveredinvestment balance at
the end of the year Ft-1
(1+r) + CFt
1 -8000 -1480 2000 -7480
2 -7480 -1383.8 -1000 -9863.8
3 -9863.8 -1824.80 10000 -1688.60
4 -1688.60 -312.39 2000 0
13. Rs. in lakhsYear 1 2 3 4 5 6 7 8 Sum Average
Investment 24.0 21.0 18.0 15.0 12.0 9.0 6.0 3.0 108 13.500
Depreciation 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 24.0 3.000
Income beforeinterest and tax
6.0 6.5 7.0 7.0 7.0 6.5 6.0 5.0 51.0 6.375
Interest 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 20.0 2.500
Income before tax 3.5 4.0 4.5 4.5 4.5 4.0 3.5 2.5 31.0 3.875
Tax - 1.0 2.5 2.5 2.5 2.2 1.9 1.4 14.0 1.750Income after tax 3.5 3.0 2.0 2.0 2.0 1.8 1.6 1.1 17.0 2.125
Measures of Accounting Rate of Return
A. Average income after tax 2.125= = 8.9%
Initial investment 24
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B. Average income after tax 2.125= = 15.7%
Average investment 13.5
C. Average income after tax but before interest 2.125 + 2.5= = 19.3%
Initial investment 24
D. Average income after tax but before interest 2.125 + 2.5= = 34.3%
Average investment 13.5
E. Average income before interest and taxes 6.375= = 26.6%
Initial investment 24
F. Average income before interest and taxes 6.375= = 47.2%
Average investment 13.5
G. Total income after tax but beforeDepreciationInitial investment 17.0 + 24.024.0
=(Initial investment / 2) x Years (24 / 2) x 8
= 17.0 / 96.0 = 17.7%
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Chapter 9
PROJECT CASH FLOWS
1.(a) Project Cash Flows (Rs. in million)
Year 0 1 2 3 4 5 6 7
1. Plant & machinery (150)
2. Working capital (50)
3. Revenues 250 250 250 250 250 250 250
4. Costs (excluding de-preciation & interest) 100 100 100 100 100 100 100
5. Depreciation 37.5 28.13 21.09 15.82 11.87 8.90 6.67
6. Profit before tax 112.5 121.87 128.91 134.18 138.13 141.1 143.33
7. Tax 33.75 36.56 38.67 40.25 41.44 42.33 43.0
8. Profit after tax 78.75 85.31 90.24 93.93 96.69 98.77 100.33
9. Net salvage value of
plant & machinery 48
10. Recovery of working 50capital
11. Initial outlay (=1+2) (200)
12. Operating CF (= 8 + 5) 116.25 113.44 111.33 109.75 108.56 107.67
107.00
13. Terminal CF ( = 9 +10) 98
14. NCF (200) 116.25 113.44 111.33 109.75 108.56 107.67 205
(c) IRR (r) of the project can be obtained by solving the following equation for r
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-200 + 116.25 x PVIF (r,1) + 113.44 x PVIF (r,2)+ 111.33 x PVIF (r,3) + 109.75 x PVIF (r,4) + 108.56 x PVIF (r,5)+107.67 x PVIF (r,6) + 205 x PVIF (r,7) = 0
Through a process of trial and error, we get r = 55.17%. The IRR of theproject is 55.17%.
2. Post-taxIncremental Cash Flows (Rs. in million)Year 0 1 2 3 4 5 6 7
1. Capital equipment (120)2. Level of working capital 20 30 40 50 40 30 20
(ending)3. Revenues 80 120 160 200 160 120 804. Raw material cost 24 36 48 60 48 36 245. Variable mfg cost. 8 12 16 20 16 12 86. Fixed operating & maint. 10 10 10 10 10 10 10
cost
7. Variable selling expenses 8 12 16 20 16 12 88. Incremental overheads 4 6 8 10 8 6 49. Loss of contribution 10 10 10 10 10 10 1010.Bad debt loss 411. Depreciation 30 22.5 16.88 12.66 9.49 7.12 5.3412. Profit before tax -14 11.5 35.12 57.34 42.51 26.88 6.6613. Tax - 4.2 3.45 10.54 17.20 12.75 8.06 2.0014. Profit after tax - 9.8 8.05 24.58 40.14 29.76 18.82 4.66
15. Net salvage value ofcapital equipments 25
16. Recovery of working 16capital
17. Initial investment (120)18. Operating cash flow 20.2 30.55 41.46 52.80 39.25 25.94 14.00
(14 + 10+ 11)
19. Working capital 20 10 10 10 (10) (10) (10)
20. Terminal cash flow 41
21. Net cash flow (140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00(17+18-19+20)
(b) NPV of the net cash flow stream @ 15% per discount rate= -140 + 10.20 x PVIF(15%,1) + 20.55 x PVIF (15%,2)
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+ 31.46 x PVIF (15%,3) + 62.80 x PVIF (15%,4) + 49.25 x PVIF(15%,5)+ 35.94 x PVIF (15%,6) + 55 x PVIF (15%,7)
= Rs.1.70 million
3.(a) A. Initial outlay (Time 0)
i. Cost of new machine Rs. 3,000,000
ii. Salvage value of old machine 900,000iii Incremental working capital requirement 500,000iv. Total net investment (=iii + iii) 2,600,000
B. Operating cash flow (years 1 through 5)Year 1 2 3 4 5
i. Post-tax savings inmanufacturing costs 455,000 455,000 455,000 455,000 455,000
ii. Incrementaldepreciation 550,000 412,500 309,375 232,031 174,023
iii. Tax shield onincremental dep. 165,000 123,750 92,813 69,609 52,207
iv. Operating cashflow ( i + iii) 620,000 578,750 547,813 524,609 507,207
C. Terminal cash flow (year 5)i. Salvage value of new machine Rs. 1,500,000ii. Salvage value of old machine 200,000
iii. Recovery of incremental working capital 500,000iv. Terminal cash flow ( iii + iii) 1,800,000
D. Net cash flows associated with the replacement project (in Rs)Year 0 1 2 3 4 5
NCF (2,600,000) 620000 578750 547813 524609 307207
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(b) NPV of the replacement project
= - 2600000 + 620000 x PVIF (14%,1)+ 578750 x PVIF (14%,2)+ 547813 x PVIF (14%,3)+ 524609 x PVIF (14%,4)+ 2307207 x PVIF (14%,5)
= Rs.267849
4. Tax shield (savings) on depreciation (in Rs)
Depreciation Tax shield PV of tax shield
Year charge (DC) =0.4 x DC @ 15% p.a.
1 25000 10000 8696
2 18750 7500 5671
3 14063 5625 3699
4 10547 4219 2412
5 7910 3164 1573--------22051--------
Present value of the tax savings on account of depreciation = Rs.22051
5. A. Initial outlay (at time 0)
i. Cost of new machine Rs. 400,000ii. Salvage value of the old machine 90,000iii. Net investment 310,000
B. Operating cash flow (years 1 through 5)
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Year 1 2 3 4 5
i. Depreciationof old machine 18000 14400 11520 9216 7373
ii. Depreciationof new machine 100000 75000 56250 42188 31641
iii. Incremental depre-ciation ( iii) 82000 60600 44730 32972 24268
iv. Tax savings on inc-remental depreciation( 0.35 x (iii)) 28700 21210 15656 11540 8494
v. Operating cash flow 28700 21210 15656 11540 8494
C. Terminal cash flow (year 5)i. Salvage value of new machine Rs. 25000ii. Salvage value of old machine 10000iii. Incremental salvage value of new
machine = Terminal cash flow 15000
D. Net cash flows associated with the replacement proposal.Year 0 1 2 3 4 5
NCF (310000) 28700 21210 15656 11540 23494
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6. Net Cash Flows Relating to Equity(Rs. in million)
Particulars Year0 1 2 3 4 5 6
1. Equity funds (100)2. Revenues 500 500 500 500 500 5003. Operating costs 320 320 320 320 320 3204. Depreciation 83.33 55.56 37.04 24.69 16.46 10.975. Interest on working capital
advance18.00 18.00 18.00 18.00 18.00 18.00
6. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.507. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.538. Tax 24.335 38.97 51.23 60.405 67.52 73.2659. Profit after tax 24.335 38.97 51.23 60.405 67.52 73.26510. Preference dividend11.Net salvage value of fixed assets 20012.Net salvage value of current
assets- 40 40 40 40 40
13. Repayment of term-loans14. Redemption of preference capital15. Repayment of short-term bank
borrowings100
16.
Retirement of trade creditors 5017. Initial investment (1) (100)18. Operating cash flows (9-10+4) 107.665 94.53 88.27 85.095 83.98 84.23519. Liquidation and retirement cash
flows (11+12-13-14-15-16)107.665 54.53 48.27 45.095 43.98 90
20.Net cash flows (17+18+19) (100) 107.665 54.53 48.27 45.095 43.98 174.235Net Cash Flows Relating to Long-term Funds (Rs. in million)
Particulars Year
0 1 2 3 4 5 61. Fixed assets (250)2. Working capital margin (50)3. Revenues 500 500 500 500 500 5004. Operating costs 320 320 320 320 320 3205. Depreciation 83.33 55.56 37.04 24.69 16.46 10.976. Interest on working capital
advance18.00 18.00 18.00 18.00 18.00 18.00
7. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.508. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.539. Tax @ 50% 24.335 38.97 51.23 60.405 67.52 73.26510. Profit after tax 24.335 38.97 51.23 60.405 67.52 73.26511.Net salvage value of fixed assets 8012.Net recovery of working capital
margin50
13. Initial investment (1+2) (300)14. Operating cash inflow (9+5+7
(1-T) )122.665 108.78 99.52 93.345 89.23 86.845
15. Terminal cash flow (11+12) 130.0016.Net cash flow (13+14+15) (300) 122.665 108.78 99.52 93.345 89.23 216.485
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Cash Flows Relating to Total Funds(Rs. in million)
Year0 1 2 3 4 5 6
1. Total funds (450)2. Revenues 500 500 500 500 500 5003. Operating costs 320 320 320 320 320 3204. Depreciation 83.33 55.56 37.04 24.69 16.46 10.975. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.506. Interest on working capital
advance18.00 18.00 18.00 18.00 18.00 18.00
7. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.538. Tax 24.34 38.97 51.23 60.41 67.52 73.2659. Profit after tax 24.34 38.97 51.23 60.41 67.52 73.26510.Net salvalue of fixed assets 8011.Net salvage value of current assets 20012. Initial investment (1) (450)13. Operating cash inflow 9+4+6 (1-t)
+ 5(1-t)131.67 117.78 108.52 102.35 98.23 95.485
14. Terminal cash flow (10+11) 28015.Net cash flow (12+13+14) (450) 131.67 117.78 108.52 102.35 98.23 375.485
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Chapter 10
THE COST OF CAPITAL
1(a) Define rDas the pre-tax cost of debt. Using the approximate yield formula,rDcan be calculated as follows:
14 + (100108)/10rD = ------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108
(b) After tax cost = 12.60 x (10.35) = 8.19%
2. Define rpas the cost of preference capital. Using the approximate yield formularp can be calculated as follows:
9 + (10092)/6rp = --------------------
0.4 x100 + 0.6x92
= 0.1085 (or) 10.85%
3. WACC = 0.4 x 13% x (10.35)+ 0.6 x 18%
= 14.18%
4. Cost of equity = 10% + 1.2 x 7% = 18.4%(using SML equation)Pre-tax cost of debt = 14%After-tax cost of debt = 14% x (10.35) = 9.1%Debt equity ratio = 2 : 3WACC = 2/5 x 9.1% + 3/5 x 18.4%
= 14.68%
5. Given 0.5 x 14% x (10.35) + 0.5 x rE= 12%
where rEis the cost of equity capital.Therefore rE14.9%Using the SML equation we get
11% + 8% x = 14.9%where denotes the beta of Azeezs equity.Solving this equation we get = 0.4875.
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6 (a) The cost of debt of 12% represents the historical interest rate at the time the debt
was originally issued. But we need to calculate the marginal cost of debt (cost
of raising new debt); and for this purpose we need to calculate the yield tomaturity of the debt as on the balance sheet date. The yield to maturity will notbe equal to 12% unless the book value of debt is equal to the market value ofdebt on the balance sheet date.
(b) The cost of equity has been taken asD1/P0( = 6/100) whereas the cost of equityis (D1/P0) +gwhere grepresents the expected constant growth rate in dividendper share.
7. The book value and market values of the different sources of finance areprovided in the following table. The book value weights and the market valueweights are provided within parenthesis in the table.
(Rs. in million)
Source Book value Market valueEquity 800 (0.54) 2400 (0.78)
Debenturesfirst series 300 (0.20) 270 (0.09)Debenturessecond series 200 (0.13) 204 (0.06)Bank loan 200 (0.13) 200 (0.07)Total 1500 (1.00) 3074 (1.00)
8.
(a) GivenrDx (10.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pre-tax cost of debt.
(b) Given13% x (10.3) x 4/9 + rE x 5/9 = 15%rE = 19.72%, where rErepresents the cost of equity.
9. Cost of equity = D1/P0+g
= 3.00 / 30.00 + 0.05= 15%
(a)The first chunk of financing will comprise of Rs.5 million of retainedearnings costing 15 percent and Rs.25 million of debt costing 14 (1-.3) = 9.8percent.The second chunk of financing will comprise of Rs.5 million of additionalequity costing 15 percent and Rs.2.5 million of debt costing 15 (1-.3) = 10.5percent.
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(b)The marginal cost of capital in the first chunk will be :
5/7.5 x 15% + 2.5/7.5 x 9.8% = 13.27%
The marginal cost of capital in the second chunk will be :5/7.5 x 15% + 2.5/7.5 x 10.5% = 13.50%
Note: We have assumed that(i) The net realisation per share will be Rs.25, after floatation costs, and(ii) The planned investment of Rs.15 million is inclusive of floatation costs
10. The cost of equity and retained earningsrE = D1/PO+g
= 1.50 / 20.00 + 0.07 = 14.5%The cost of preference capital, using the approximate formula, is :
11 + (100-75)/10rE = = 15.9%
0.6x75 + 0.4x100The pre-tax cost of debentures, using the approximate formula, is :
13.5 + (100-80)/6
rD = = 19.1%0.6x80 + 0.4x100
The post-tax cost of debentures is19.1 (1-tax rate) = 19.1 (10.5)
= 9.6%The post-tax cost of term loans is
12 (1-tax rate) = 12 (10.5)
= 6.0%
The average cost of capital using book valueproportions is calculated below:
Source of capital Component Book value Book value Product of
cost Rs. in million proportion (1) & (3)(1) (2) (3)
Equity capital 14.5% 100 0.28 4.06Preference capital 15.9% 10 0.03 0.48Retained earnings 14.5% 120 0.33 4.79Debentures 9.6% 50 0.14 1.34Term loans 6.0% 80 0.22 1.32
360 Average cost 11.99%capital
The average cost of capital usingmarket valueproportions is calculated below :
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Source of capital Component Market value Market value Product ofcost Rs. in million
(1) (2) (3) (1) & (3)
Equity capitaland retained earnings 14.5% 200 0.62 8.99Preference capital 15.9% 7.5 0.02 0.32Debentures 9.6% 40 0.12 1.15Term loans 6.0% 80 0.24 1.44
327.5 Average cost 11.90%
capital
11.(a) WACC = 1/3 x 13% x (10.3)
+ 2/3 x 20%= 16.37%
(b) Weighted average floatation cost= 1/3 x 3% + 2/3 x 12%= 9%
(c) NPV of the proposal after taking into account the floatation costs= 130 x PVIFA (16.37%, 8)500 / (1 - 0.09)= Rs.8.51 million
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Chapter 11
RISK ANALYSIS OF SINGLE INVESTMENTS
1.(a) NPV of the project = -250 + 50 x PVIFA (13%,10)
= Rs.21.31 million
(b) NPVs under alternative scenarios:(Rs. in million)
Pessimistic Expected Optimistic
Investment 300 250 200Sales 150 200 275Variable costs 97.5 120 154Fixed costs 30 20 15Depreciation 30 25 20Pretax profit - 7.5 35 86Tax @ 28.57% - 2.14 10 24.57
Profit after tax - 5.36 25 61.43Net cash flow 24.64 50 81.43Cost of capital 14% 13% 12%
NPV - 171.47 21.31 260.10
Assumptions: (1) The useful life is assumed to be 10 years under all threescenarios. It is also assumed that the salvage value of the
investment after ten years is zero.
(2) The investment is assumed to be depreciated at 10% perannum; and it is also assumed that this method and rate ofdepreciation are acceptable to the IT (income tax)authorities.
(3) The tax rate has been calculated from the given table i.e.10 / 35 x 100 = 28.57%.
(4) It is assumed that only loss on this project can be offsetagainst the taxable profit on other projects of thecompany; and thus the company can claim a tax shield onthe loss in the same year.
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(c) Accounting break even point (under expected scenario)Fixed costs + depreciation = Rs. 45 millionContribution margin ratio = 60 / 200 = 0.3
Break even level of sales = 45 / 0.3 = Rs.150 millionFinancial break even point (under expected scenario)
i. Annual net cash flow = 0.7143 [ 0.3 x sales45 ] + 25= 0.2143 sales7.14
ii. PV (net cash flows) = [0.2143 sales7.14 ] x PVIFA (13%,10)= 1.1628 sales38.74
iii. Initial investment = 200
iv. Financial break even levelof sales = 238.74 / 1.1628 = Rs.205.31 million
2.(a) Sensitivity of NPV with respect to quantity manufactured and sold:
(in Rs)Pessimistic Expected Optimistic
Initial investment 30000 30000 30000Sale revenue 24000 42000 54000Variable costs 16000 28000 36000Fixed costs 3000 3000 3000Depreciation 2000 2000 2000
Profit before tax 3000 9000 13000Tax 1500 4500 6500Profit after tax 1500 4500 6500Net cash flow 3500 6500 8500NPV at a cost ofcapital of 10% p.aand useful life of5 years -16732 - 5360 2222
(b) Sensitivity of NPV with respect to variations in unit price.Pessimistic Expected Optimistic
Initial investment 30000 30000 30000Sale revenue 28000 42000 70000Variable costs 28000 28000 28000Fixed costs 3000 3000 3000
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Depreciation 2000 2000 2000Profit before tax -5000 9000 37000Tax -2500 4500 18500
Profit after tax -2500 4500 18500Net cash flow - 500 6500 20500NPV - 31895 (-) 5360 47711
(c) Sensitivity of NPV with respect to variations in unit variable cost.Pessimistic Expected Optimistic
Initial investment 30000 30000 30000Sale revenue 42000 42000 42000Variable costs 56000 28000 21000Fixed costs 3000 3000 3000Depreciation 2000 2000 2000Profit before tax -11000 9000 16000Tax -5500 4500 8000Profit after tax -5500 4500 8000
Net cash flow -3500 6500 10000NPV -43268 - 5360 7908
(d) Accounting break-even pointi. Fixed costs + depreciation = Rs.5000ii. Contribution margin ratio = 10 / 30 = 0.3333iii. Break-even level of sales = 5000 / 0.3333
= Rs.15000
Financial break-even point
i. Annual cash flow = 0.5 x (0.3333 Sales5000) = 2000ii. PV of annual cash flow = (i) x PVIFA (10%,5)
= 0.6318 sales1896iii. Initial investment = 30000
iv. Break-even level of sales = 31896 / 0.6318 = Rs.50484
2. DefineAtas the random variable denoting net cash flow in year t.A1 = 4 x 0.4 + 5 x 0.5 + 6 x 0.1
= 4.7
A2 = 5 x 0.4 + 6 x 0.4 + 7 x 0.2= 5.8
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A3 = 3 x 0.3 + 4 x 0.5 + 5 x 0.2
= 3.9
NPV = 4.7 / 1.1 +5.8 / (1.1)2+ 3.9 / (1.1)310= Rs.2.00 million
12 = 0.41
22 = 0.56
32 = 0.49
12 22 322NPV = + +
(1.1)2 (1.1)4 (1.1)6
= 1.00
(NPV) = Rs.1.00 million
3. Expected NPV4 At
= - 25,000t=1 (1.08)t
= 12,000/(1.08) + 10,000 / (1.08)2+ 9,000 / (1.08)3+ 8,000 / (1.08)425,000
= [ 12,000 x .926 + 10,000 x .857 + 9,000 x .794 + 8,000 x .735]
- 25,000= 7,708
Standard deviation of NPV
4 tt=1 (1.08)t
= 5,000 / (1.08) + 6,000 / (1.08)2+ 5,000 / (1,08)3+ 6,000 / (1.08)4= 5,000 x .926 + 6,000 x .857 + 5000 x .794 + 6,000 x .735= 18,152
4. Expected NPV4 At
= - 25,000 . (1)t=1 (1.06)t
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A1 = 2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3= 3,100
A2 = 3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3= 3,900
A3 = 4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2= 4,900
A4 = 2,000 x 0.2 + 3,000 x 0.4 + 4,000 x 0.4= 3,200
Substituting these values in (1) we get
Expected NPV = NPV
= 3,100 / (1.06)+ 3,900 / (1.06)2 + 4,900 / (1.06)3 + 3,200 / (1,06)4
- 10,000 = Rs.3,044The variance of NPV is given by the expression
4 2
t
2 (NPV) = .. (2)t=1 (1.06)2t
12 = [(2,0003,100)2x 0.2 + (3,0003,100)2 x 0.5
+ (4,0003,100)2x 0.3]= 490,000
22
= [(3,0003,900)2
x 0.4 + (4,0003,900)2
x 0.3+ (5,0003900)2x 0.3]
= 690,000
32 = [(4,0004,900)2x 0.3 + (5,0004,900)2x 0.5
+ (6,0004,900)2 x 0.2]= 490,000
42
= [(2,0003,200)2
x 0.2 + (3,0003,200)2
x 0.4+ (4,0003200)2 x 0.4]
= 560,000
Substituting these values in (2) we get490,000 / (1.06)2+ 690,000 / (1.06)4
+ 490,000 / (1.06)6+ 560,000 / (1.08)8[ 490,000 x 0.890 + 690,000 x 0.792
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+ 490,000 x 0.705 + 560,000 x 0.627 ]= 1,679,150
NPV = 1,679,150 = Rs.1,296
NPVNPV 0 -NPVProb (NPV < 0) = Prob. 0.2 x 10,000)Prob (NPV > 2,000)
Prob (NPV >2,000)= Prob (Z> 2,000- 3,044 / 1,296)Prob (Z> - 0.81)
The required probability is given by the shaded area of the following normalcurve:
P(Z> - 0.81) = 0.5 +P(-0.81
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5
[Q(PV)3,0002,000] (0.5)+ 2,000 0t=1
NPV = ---------------------------------------------------------- + ------- - 30,000(1.1)t (1.1)5
5
0.5 Q(PV)500t=1
= ------------------------------------ - 30,000(1.1)t
= [ 0.5Q(PV)500] x PVIFA (10,5)30,000= [0.5Q(PV)500] x 3.79130,000= 1.8955Q(PV)31,895.5
Exhibit 1 presents the correspondence between the values of exogenousvariables and the two digit random number. Exhibit 2 shows the results of thesimulation.
Exhibit 1Correspondence between values of exogenous variables and
two digit random numbers
QUANTITY PRICE VARIABLE COST
Value Prob
Cumulative
Prob.
Two digit
random
numbers Value Prob
Cumulative
Prob.
Two digit
random
numbers Value Prob
Cumu-
lative
Prob.
Two digit
random
numbers
800 0.10 0.10 00 to 09 20 0.40 0.40 00 to 39 15 0.30 0.30 00 to 291,000 0.10 0.20 10 to 19 30 0.40 0.80 40 to 79 20 0.50 0.80 30 to 79
1,200 0.20 0.40 20 to 39 40 0.10 0.90 80 to 89 40 0.20 1.00 80 to 99
1,400 0.30 0.70 40 to 69 50 0.10 1.00 90 to 99
1,600 0.20 0.90 70 to 89
1,800 0.10 1.00 90 to 99
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Exhibit 2
Simulation Results
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Run Random
Number
Corres-
ponding
Value
Random
Number
Corres-
ponding
value
Random
Number
Corres-
ponding
value
1.8955Q(P-V)-31,895.5
1 03 800 38 20 17 15 -24,314
2 32 1,200 69 30 24 15 2,224
3 61 1,400 30 20 03 15 -18,627
4 48 1,400 60 30 83 40 -58,433
5 32 1,200 19 20 11 15 -20,5236 31 1,200 88 40 30 20 13,597
7 22 1,200 78 30 41 20 -9,150
8 46 1,400 11 20 52 20 -31,896
9 57 1,400 20 20 15 15 -18,627
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Run Random
Number
Corres-
ponding
Value
Random
Number
Corres-
ponding
value
Random
Number
Corres-
ponding
value
1.8955 Q(P-V)-31,895.5
10 92 1,800 77 30 38 20 2,224
11 25 1,200 65 30 36 20 -9,150
12 64 1,400 04 20 83 40 -84,970
13 14 1,000 51 30 72 20 -12,941
14 05 800 39 20 81 40 -62,224
15 07 800 90 50 40 20 13,597
16 34 1,200 63 30 67 20 -9,150
17 79 1,600 91 50 99 40 -1,568
18 55 1,400 54 30 64 20 -5,359
19 57 1,400 12 20 19 15 -18,627
20 53 1,400 78 30 22 15 7,91021 36 1,200 79 30 96 40 -54,642
22 32 1,200 22 20 75 20 -31,896
23 49 1,400 93 50 88 40 -5,359
24 21 1,200 84 40 35 20 13,597
25 08 .800 70 30 27 15 -9,150
26 85 1,600 63 30 69 20 -1,568
27 61 1,400 68 30 16 15 7,910
28 25 1,200 81 40 39 20 13,597
29 51 1,400 76 30 38 20 -5,35930 32 1,200 47 30 46 20 -9,150
31 52 1,400 61 30 58 20 -5,359
32 76 1,600 18 20 41 20 -31,896
33 43 1,400 04 20 49 20 -31,896
34 70 1,600 11 20 59 20 -31,896
35 67 1,400 35 20 26 15 -18,627
36 26 1,200 63 30 22 15 2,224
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Run Random Corres- Random Corres- Random Corres- 1.8955 Q(P-V)-31,895.5
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Number ponding
Value
Number ponding
value
Number ponding
value
37 89 1,600 86 40 59 20 28,761
38 94 1,800 00 20 25 15 -14,83639 09 .800 15 20 29 15 -24,314
40 44 1,400 84 40 21 15 34,447
41 98 1,800 23 20 79 20 -31,896
42 10 1,000 53 30 77 20 -12,941
43 38 1,200 44 30 31 20 -9,150
44 83 1,600 30 20 10 15 -16,732
45 54 1,400 71 30 52 20 -5,359
46 16 1,000 70 30 19 15 -3,463
47 20 1,200 65 30 87 40 -54,642
48 61 1,400 61 30 70 20 -5,35949 82 1,600 48 30 97 40 -62,224
50 90 1,800 50 30 43 20 2,224
Expected NPV = NPV50
= 1/ 50 NPVii=1
= 1/50 (-7,20,961)= 14,419
50
Variance of NPV = 1/50 NPViNPV)2
i=1
= 1/50 [27,474.047 x 106]
= 549.481 x 10
6
Standard deviation of NPV = 549.481 x 106= 23,441
6. To carry out a sensitivity analysis, we have to define the range and the mostlikely values of the variables in the NPV Model. These values are definedbelow
Variable Range Most likely value
I Rs.30,000Rs.30,000 Rs.30,000k 10% - 10% 10%F Rs.3,000Rs.3,000 Rs.3,000D Rs.2,000Rs.2,000 Rs.2,000T 0.50.5 0.5N 55 5
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S 00 0Q Can assume any one of the values - 1,400*
800, 1,000, 1,200, 1,400, 1,600 and 1,800
P Can assume any of the values 20, 30, 30**40 and 50
V Can assume any one of the values 20*15,20 and 40
----------------------------------------------------------------------------------------* The most likely values in the case ofQ,Pand Vare the values that
have the highest probability associated with them
** In the case of price, 20 and 30 have the same probability ofoccurrence viz., 0.4. We have chosen 30 as the most likely valuebecause the expected value of the distribution is closer to 30
Sensitivity Analysis with Reference to Q
The relationship between Qand NPV given the most likely values of othervariables is given by
5 [Q(30-20)3,0002,000] x 0.5 + 2,000 0NPV = + - 30,000
t=1 (1.1)t (1.1)5
5 5Q- 500
= - 30,000t=1 (1.1)t
The net present values for various values of Qare given in the following table:
Q 800 1,000 1,200 1,400 1,600 1,800NPV -16,732 -12,941 -9,150 -5,359 -1,568 2,224
Sensitivity analysis with reference to P
The relationship betweenPand NPV, given the most likely values of othervariables is defined as follows:
5 [1,400 (P-20)3,0002,000] x 0.5 + 2,000 0
NPV = + - 30,000 t=1 (1.1)t (1.1)5
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5 700P14,500
= - 30,000t=1 (1.1)t
The net present values for various values ofPare given below :P(Rs) 20 30 40 50NPV(Rs) -31,896 -5,359 21,179 47,716
8. NPV - 5 0 5 10 15 20(Rs.in lakhs)PI 0.9 1.00 1.10 1.20 1.30 1.40
Prob. 0.02 0.03 0.10 0.40 0.30 0.15
6
Expected PI = PI= (PI)jPjj=1
= 1.24
6Standard deviation = (PIj - PI)
2Pjo fP1 j=1
= .01156= .1075
The standard deviation ofP1is .1075 for the given investment with an expectedPI of 1.24. The maximum standard deviation of PI acceptable to the companyfor an investment with an expected PI of 1.25 is 0.30.
Since the risk associated with the investment is much less than the maximumrisk acceptable to the company for the given level of expected PI, the companyshould accept the investment.
9. Investment AOutlay : Rs.10,000Net cash flow : Rs.3,000 for 6 years
Required rate of return : 12%
NPV(A) = 3,000 x PVIFA (12%, 6 years)10,000= 3,000 x 4.1110,000 = Rs.2,333
Investment B
Outlay : Rs.30,000Net cash flow : Rs.11,000 for 5 years
Required rate of return : 14%
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NPV(B) = 11,000 x PVIFA (14%, 5 years)30,000= Rs.7763
10. The NPVs of the two projects calculated at their risk adjusted discount rates areas follows:
6 3,000
ProjectA: NPV = - 10,000 = Rs.2,333t=1 (1.12)t
5 11,000
ProjectB: NPV = - 30,000 = Rs.7,763
t=1 (1.14)t
PIand IRR for the two projects are as follows:
Project A B
PI 1.23 1.26IRR 20% 24.3%
Bis superior toAin terms of NPV, PI, and IRR. Hence the company mustchooseB.
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Chapter 12
RISK ANALYSIS OF SINGLE INVESTMENTS
1. 2p = wiwjijij
2p= w21
21 +w
22
22 + w
23
23 + w
24
24 + w
25
25
+ 2w1w2 12 12 + 2w1w3 13 13 + 2w1w4 14 14 + 2w1w5 1515 + 2w2w3 23 23 + 2w2w4 24 24 + 2w2w5 25 25 + 2w3w434 34 + 2w3w5 35 35 + 2w4w5 45 45
= 0.12 x 82 + 0.22 x 92 + 0.32x 102+ 0.32x 162+ 0.12x 122
+ 2 x 0.1 x 0.2 x 0.1 x 8 x 9 + 2 x 0.1 x 0.3 x 0.5 x 8 x 10+ 2 x 0.1 x 0.3 x0.2 x 8 x 16 + 2 x 0.1 x 0.1 x 0.3 x 8 x 12+ 2 x 0.2 x 0.3 x 0.4 x 9 x 10 + 2 x 0.2 x 0.3 x 0.8 x 9 x 16+ 2 x 0.2 x 0.1 x 0.2 x 9 x 12 + 2 x 0.3 x 0.3 x0.1 x 10 x 16+ 2 x 0.3 x 0.1 x 0.6 x 10 x 12 + 2 x 0.3 x 0.1 x 0.1 x 16 x 12
= 66.448
p = (66.448)1/2= 8.152
2. (i) Since there are 3 securities, there are 3 variance terms and 3 covarianceterms. Note that if there are nsecurities the number of covariance terms are: 1 +2 ++ (n+ 1) = n(n1)/2. In this problem all the variance terms are the same
(2A) all the covariance terms are the same (AB) and all the securities areequally weighted (wA )
So,
2p = [3 w2A
2A+ 2 x 3 AB]
2p = [3 w2A
2A + 6 wA wBAB]
1 2 1 1= 3 x x 2A + 6 x x x AB
3 3 31 2
= 2A + AB3 3
(ii) Since there are 9 securities, there are 9 variance terms and 36 covarianceterms. Note that if the number of securities is n, the number of covariance
terms is n(n1)/2.In this case all the variance terms are the same (2A), all the covariance terms are
1
the same (AB) and all the securities are equally weighted wA9
So,
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n(n-1)
2p = 9w2A
2A t 2 x wA wBAB
2
1 2 1 1
= 9 x x 2A + 9(8) x x AB9 9 9
1 72
= 2A + AB9 81
3. The beta for stock B is calculated below:Period Return of
stock B,
RB (%)
Return on
market
portfolio,
RM (%)
Deviation of
return on
stock B from
its mean
(RB - RB)
Deviation
of return
on market
portfolio
from its
mean
(RMRM)
Product of
the
deviation
(RBRB)
(RMRM)
Square of
the
deviation
of return
on market
portfolio,
from its
mean(RMRM)
2
1 15 9 6 -1 -6 12 16 12 7 2 14 43 10 6 1 -4 -4 164 -15 4 -24 -6 144 365 -5 16 -14 6 -84 366 14 11 5 1 5 1
7 10 10 1 0 0 08 15 12 6 2 12 49 12 9 3 -1 -3 110 -4 8 -13 -2 26 411 -2 12 -11 2 -22 412 12 14 3 4 12 1613 15 -6 6 -16 -96 25614 12 2 3 -8 -24 64
15 10 8 1 -2 -2 416 9 7 0 -3 0 917 12 9 3 -1 -3 118 9 10 0 0 0 019 22 37 13 27 351 72920 13 10 4 0 0 0
180 200 (RBRB) (RBRB)RB = 180 RM = 200 (RMRM) = 1186R
B= 9% R
M= 10% = 320
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Beta of stock B is equal to:
Cov (RB,RM)
2M (RB -RB) (RMRM) 320
Cov (RB,RM) = = = 16.84n1 19
(RMRM)2 1186
2M = = = 62.42n1 19
So the beta for stockBis:16.84
= 0.27062.42
4. According to the CAPM, the required rate of return is:E(Ri) =Rf+ (E(RMRf)i
Given a risk-free rate (Rf ) of 11 percent and the expected market risk premium(E(RMRf ) of 6 percent we get the following:
Project Beta Required rate(%) Expected rate (%)
A 0.5 11 + 0.5 x 6 = 14 15B 0.8 11 + 0.8 x 6 = 15.8 16
C 1.2 11 + 1.2 x 6 = 18.2 21D 1.6 11 + 1.6 x 6 = 20.6 22E 1.7 11 + 1.7 x 6 = 21.2 23
a. The expected return of all the 5 projects exceeds the required rate as per the CAPM.So all of them should be accepted.
b. If the cost of capital of firm which is 16 percent is used as the hurdle rate, project Awill be rejected incorrectly.
5. The asset beta is linked to equity beta, debt-equity ratio, and tax rate as follows:
EA =
[1 +D/E(1T)]
The asset beta of A, B, and C is calculated below:
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Firm Asset Beta1.25
A = 0.49
[1 + (2.25) x 0.7]
1.25B = 0.48
[1 + (2.00) x 0.7]
1.10
C = 0.45[1 + (2.1) x 0.7]
0.49 + 0.48 + 0.45Average of the asset betas of sample firms = = 0.47
3The equity beta of the cement project is
E = A [ 1 +D/E(1T)]
= 0.47 [1 + 2 (1-0.3)] = 1.128
As per the CAPM model, the cost of equity of the proposed project is:12% + (17% - 12%) x 1.128 = 17.64%
The post-tax cost of debt is:16% (10.3) = 11.2%
The required rate of return for the project given a debt-equity ratio of 2:1 is:1/3 x 17.64% + 2/3 x 11.2% = 13.35%
6. EA =
[1 +D/E(1T)]
E = 1.25 D/E = 1.6 T= 0.3
So, Pariman Companys asset beta is:1.25= 0.59
[1 + 1.6 (0.7)]
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7. (a) Asset beta for a petrochemicals project is:
E 1.30
A = =[1 +D/E ( 1T)] [1 + 1.5 (1.4)]
= 0.68
The equity beta (systematic risk) for the petrochemicals project of Growmore,whenD/E= 1.25 and T= 0.4, is
0.68 [1 + 1.25 (1.4)] = 1.19
(b) The cost of equity for the petrochemicals project is12% + 1.19 (18% - 12%) = 19.14%
The cost of debt is12% (10.4) = 7.2%
Given, a debtequity ratio of 1.25 the required return for the petrochemicalsproject is
1 1.25
19.14% x + 7% x = 12.4%2.25 2.25
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Chapter 13
SPECIAL DECISION SITUATIONS
1. PV CostUAE =
PVIFAr,n
Cost of plastic emulsion painting = Rs.3,00,000 Life = 7 yearsCost of distemper painting = Rs. 1,80,000 Life = 3 yearsDiscount rate = 10%
UAEof plastic emulsion painting = Rs.3,00,000 / 4.868 = Rs.61,627UAEof distemper painting = Rs.1,80,000 / 2.487 = Rs.72,376
Since plastic emulsion painting has a lower UAE, it is preferable.
2. Present value of the operating costs :3,00,000 3,60,000 4,00,000 4,50,000 5,00,000
= + + + +
1.13 (1.13)
2
(1.13)
3
(1.13)
4
(1.13)
5
= Rs.1,372,013Present value of salvage value = 3,00,000 / (1.13)5 = Rs.162,828Present value of costs of internal transportation = 1,500,0001,372,013system 162,828 = Rs.27,09,185UAEof the internal transportation system = 27,09,185 / 3.517 = Rs.7,70,311
3. Cost of standard overhaul = Rs.500,000Cost of less costly overhaul = Rs.200,000Cost of capital = 14%UAEof standard overhaul = 500,000 / 3.889 = Rs.128,568UAEof less costly overhaul = 200,000 / 1.647 = Rs.121,433
Since the less costly overhaul has a lower UAE, it is the preferred alternative
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4. The details for the two alternatives are shown below :
Gunning plow Counter plow
1. Initial outlay Rs.2,500,000 Rs.1,500,0002. Economic life 12 years 9 years3. Annual operating and maintenance costs Rs.250,000 Rs.320,0004. Present value of the stream of operating
and maintenance costs at 12% discount rateRs.1,548,500 Rs.1,704,960
5. Salvage value Rs.800,000 Rs.500,0006. Present value of salvage value Rs.205,600 Rs.180,5007. Present value of total costs (1+4-6) Rs.3,842,900 Rs.3,024,4608. UAEof 7 Rs.3,842,900
PVIFA (12%,12)= 3,842,900
6.194= Rs.620,423
Rs.3,024,460PVIFA (12%,9)= 3,024,460
5.328= Rs.567,654
The Counter plow is a cheaper alternative
5. The current value of different timing options is given below :
Time Net Future Value Current Value
Rs. in million Rs. in million
0 10 101 15 13.3952 19 15.143
3 23 16.3764 26 16.536
The optimal timing of the project is year 4.
6. Calculation of UAE (OM) for Various Replacement Periods(Rupees)
Time
(t)
Operating
and
maintenance
costs
Post-tax
operating &
maintenance
costs
PVIF
(12%,t)Present
value of
(3)
Cumulative
present
value
PVIFA
(12%,t)UAE
(OM)
(1) (2) (3) (4) (5) (6) (7) (8)1 20,000 12,000 0.893 10,716 10,716 0.893 12,0002 25,000 15,000 0.797 11,955 22,671 1.690 13,4153 35,000 21,000 0.712 14,952 37,623 2.402 15,6634 50,000 30,000 0.636 19,080 56,703 3.037 18,6715 70,000 42,000 0.567 23,814 80,517 3.605 22,335
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Calculation of UAE (IO) for Various Replacement Periods
Time (t) Investment Outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.1 80,000 0.893 89,586
2 80,000 1.690 47,3373 80,000 2.402 33,3064 80,000 3.037 26,3425 80,000 3.605 22,191
Calculation of UAE (DTS) for Various Replacement PeriodsTime
(t)
Depreciation
charge R.s.
Depreciation
tax shield
PVIF
(12%, t)PV of
depreciation
tax shield Rs..
Cumulative
present
value Rs..
PVIFA
(12%, t)UAE of
depreciation
tax shield Rs..
(1) (2) (3) (4) (5) (6) (7) (8)1 20,000 8,000 0.893 7,144 7,144 0.893 8,0002 15,000 6,000 0.797 4,782 11,926 1.690 7,0573 11,250 4,500 0.712 3,204 15,130 2.402 6,2994 8,438 3,375 0.636 2,147 17,277 3.037 5,6895 6,328 2,531 0.567 1,435 18,712 3.605 5,191
Calculation of UAE (SV) for Various Replacement Periods
Time Salvage
value Rs.
PVIF
(12%, t)Present value of
salvage value Rs.
PVIFA
(12%, t)UAE of salvage
value Rs. (4) / (5)(1) (2) (3) (4) (5) (6)1 60,000 0.893 53,580 0.893 60,0002 45,000 0.797 35,865 1.690 21,2223 32,000 0.712 22,784 2.402 9,4854 22,000 0.636 13,992 3.037 4,6075 15,000 0.567 8,505 3.605 2,359
Summary of Information Required to Determine the Economic Life
Replacement
period
UAE
(OM) Rs.
UAE (IO)
Rs.
UAE
(DTS) Rs.
UAE (SV)
Rs.
UAE
(CC) Rs.
UAE
(TC) Rs.
(1) (2) (3) (4) (5) (6) (7)1 12,000 89,586 8,000 60,000 21,586 33,5862 13,415 47,337 7,057 21,222 19,058 32,4733 15,663 33,306 6,299 9,485 17,522 33,1854 18,671 26,342 5,689 4,607 16,046 34,717
5 22,335 22,191 5,190 2,359 14,642 36,977
OM - Operating and Maintenance CostsIO - Investment OutlayDTS - Depreciation Tax ShieldSV - Salvage ValueCC - Capital CostTC - Total Cost
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UAE (CC) = UAE (IO)[UAE (DTS) + UAE (SV)]UAE (TC) = UAE (OM) + UAE (CC)
7. Calculation of UAE (OM) for Various Replacement periodsTime O&M costs
Rs.
Post-tax
O&M costs
Rs.
PVIF
(12%,t)PV of post-
tax O&M
costs Rs.
Cumulative
present
value Rs.
PVIFA
(12%,t)UAE of
O&M
costs Rs.(1) (2) (3) (4) (5) (6) (7) (8)1 800,000 560,000 0.893 500,080 500,080 0.893 560,0002 1,000,000 700,000 0.797 557,900 1,057,980 1.690 626,0243 1,300,000 910,000 0.712 647,920 1,705,9000 2.402 710,2004 1,900,000 1,330,000 0.636 845,880 2,551,780 3.037 840,230
5 2,800,000 1,960,000 0.567 1,111,320 3,663,100 3.605 1,016,117
Calculation of UAE (IO) for Various Replacement Periods
Time Investment outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.1 4,000,000 0.893 4,479,2832 4,000,000 1.690 2,366,8643 4,000,000 2.402 1,665,2794 4,000,000 3.037 1,317,089
5 4,000,000 3.605 1,109,570
Calculation of UAE (DTS) for Various Replacement PeriodsTime
(t)
Depreciation
charge Rs.
Depreciaton
tax shield
Rs.
PVIF
(12%, t)PV of
depreciation
tax shield Rs.
Cumulative
present
value Rs.
PVIFA
(12%, t)UAE of
depreciation
tax shield Rs.
1 1,000,000 300,000 0.893 267,940 267,900 0.893 300,0002 750,000 225,000 0.797 179,325 447,225 1.690 264,6303 562,500 168,750 0.712 120,150 567,375 2.402 236,209
4 421,875 126,563 0.636 80,494 647,869 3.037 213,3255 316,406 94,922 0.567 53,821 701,690 3.605 194,643
Calculation of UAE (SV) for Various Replacement Peiods
Time Salvage
value Rs.
PVIF
(12%, t)Present value of
salvage value Rs.
PVIFA
(12%, t)UAE of salvage
value Rs. (4)/ (5)(1) (2) (3) (4) (5) (6)1 2,800,000 0.893 267,900 0.893 2,800,0002 2,000,000 0.797 1,594,000 1.690 943,1953 1,400,000 0.712 996,80 2.402 414,9884 1,000,000 0.636 636,000 3.037 209,4175 800,000 0.567 453,600 3.605 125,825
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Summary of Information Required to Determine the Economic LifeReplacement
period
UAE
(OM)
Rs.
UAE (IO)
Rs.
UAE
(DTS)
Rs.
UAE (SV)
Rs.
UAE (CC)
Rs.
UAE (TC)
Rs.1 560,000 4,479,283 300,000 2,800,000 (-)1,379,283 -819,2832 626,024 2,366,864 264,630 943,195 1,159,039 1,785,0633 710,200 1,665,279 236,209 414,988 1,014,082 1,724,2824 840,230 1,317,089 213,325 209,417 894,347 1,734,5775 1,016,117 1,109,570 194,643 125,825 789,102 1,805,219
The economic life of the well-drilling machine is 3 years
8. Adjusted cost of capital as per ModiglianiMiller formula:r
* = r (1TL)r* = 0.16 (10.5 x 0.6)
= 0.16 x 0.7 = 0.112Adjusted cost of capital as per MilesEzzell formula:
1 + rr
* = rLrDT1 + rD
1 + 0.16= 0.160.6 x 0.15 x 0.5 x1 + 0.15
= 0.115
9.a. Base case NPV = -12,000,000 + 3,000,000 x PVIFA (20%, b)
= -12,000,000 + 3,000,000 x 3,326
= - Rs.2,022,000
b. Adjusted NPV = Base case NPVIssue cost + Present value of tax shield.Term loan = Rs.8 million Equity finance = Rs.4 millionIssue cost of equity = 12%
Rs.4,000,000Equity to be issued = = Rs.4,545,455
0.88Cost of equity issue = Rs.545,455
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Computation of Tax Shield Associated with Debt Finance
Year (t) Debt outstanding
at the beginning
Rs.
Interest
Rs.
Tax shield
Rs.
Present value of
tax shield
Rs.1 8,000,000 1,440,000 432,000 366,1022 8,000,000 1,440,000 432,000 310,2563 7,000,000 1,260,000 378,000 230,0624 6,000,000 1,080,000 324,000 167,1165 5,000,000 900,000 270,000 118,0196 4,000,000 720,000 216,000 80,013
1,271,568
Adjusted NPV = - Rs.2,022,000Rs.545,455 + Rs.1,271,568= - Rs.1,295,887
Adjusted NPV if issue cost alone is considered = Rs.2,567,455Present Value of tax shield of debt finance = Rs.1,271,568
10.
a. Base Case NPV = - 8,000,000 + 2,000,000 x PVIFA (18%, 6)= - 8,000,000 + 2,000,000 x 3,498= - Rs.1,004,000
b. Adjusted NPV = Base case NPVIssue cost + Present value of tax shield.Term loan = Rs.5 millionEquity finance = Rs.3 millionIssue cost of equity = 10%
Rs.3,000,000Hence, Equity to be issued = = Rs.3,333,3330.90
Cost of equity issue = Rs.333,333
Computation of Tax Shield Associated with Debt Finance
Year Debt outstanding at the
beginning
Interest Tax shield Present value of tax
shield
1 Rs.5,000,000 Rs.750,000 Rs.300,000 Rs.260,8692 5,000,000 750,000 300,000 226,8433 4,000,000 600,000 240,000 157,8044 3,00,000 450,000 180,000 102,9165 2,000,000 300,000 120,000 59,666 1,000,000 150,000 60,000 25,940
843,033
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Adjusted NPV = - 1004000333333 + 834033 = - Rs.503,300Adjusted NPV if issue cost of externalequity alone is adjusted for = - Rs.1,004000Rs.333333
= Rs.1337333
c. Present value of tax shield of debt finance = Rs.834,033
11. Adjusted cost of capital as per ModiglianiMiller formula:r
* = r (1TL)r
* = 0.19 x (10.5 x 0.5) = 0.1425 = 14.25%
Adjusted cost of capital as per Miles and Ezzell formula:1 + r
r* = rLrDT
1 + rD1 + 0.19
= 0.190.5 x 0.16 x 0.5 x1 + 0.16
= 0.149 = 14.9%
12. S0 = Rs.46 , rh = 11 per cent , rf = 6 per centHence the forecasted spot rates are :
Year Forecasted spot exchange rate
1 Rs.46 (1.11 / 1.06)1 = Rs.48.172 Rs.46 (1.11 / 1.06)2 = Rs.50.443 Rs.46 (1.11 / 1.06)3 = Rs.52.824 Rs.46 (1.11 / 1.06)4 = Rs.55.315 Rs.46 (1.11 / 1.06)5 = Rs.57.92
The expected rupee cash flows for the project
Year Cash flow in dollars Expected exchange Cash flow in rupees
(million) rate (million)0 -200 46 -92001 50 48.17 2408.52 70 50.44 3530.83 90 52.82 4753.84 105 55.31 5807.65 80 57.92 4633.6
Given a rupee discount rate of 20 per cent, the NPV in rupees is :
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2408.5 3530.8 4753.8NPV = -9200 + + +
(1.18)2 (1.18)3 (1.18)4
5807.6 4633.6+ +
(1.18)5 (1.18)6
= Rs.3406.2 million
The dollar NPV is :
3406.2 / 46 = 74.05 million dollars
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Chapter 14
SOCIAL COST BENEFIT ANALYSIS
1. Social Costs and Benefits
Nature Economic
value (Rs
in million)
Explanation
Costs
1. Construction cost One-shot
400
2. Maintenance cost Annual 3Benefits
3. Savings in the operationcost of existing ships
Annual 40
4. Increase in consumersatisfaction
Annual 3.6 The number of passenger hourssaved will be : (75,000 x 2 +50,000 + 50,000 x 2) = 600000.
Multiplying this by Rs.6 givesRs.3.6 million
The IRR of the stream of social costs and benefits is the value of rin theequation
50 40 + 3.63.0 50 40.6
400 = = t=1 (1+r)
t
t=1 (1+r)
t
The solving value ris about 10.1%
2. Social Costs and BenefitsCosts
Decrease in customer satisfaction as reflected Rs.266,667in the opportunity cost of the extra time takenby bus journey
800 x (2/3) x 250 x Rs.2
Benefits
1. Resale value of the diesel train (one time) Rs.240,0002. Avoidance of annual cash loss Rs.400,000
Fare collection = 1000 x 250 x Rs.4= Rs.1,000,000
Cash operating expenses = Rs.1,400,000
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3. The social costs and benefits of the project are estimated below:Rs. in million
Costs & Benefits Time Economic
value
Explanation
1. Construction cost 0 242. Land development cost 0 1503. Maintenance cost 1-40 14. Labour cost 0 40 This includes the cost of
transport and rehabilitation
5. Labour cost 1-40 12 The shadow price of labourequals what others are willing
to pay.
6. Decrease in the value of the timberoutput
2-40 4
Benefits7. Savings in the cost of shipping the
agriculture produce1-40 0.5
8. Income from cash crops 1-5 109. Income from the main crop 6-40 5010.Increase in the value of timber output 1 20Assuming that the life of the road is 40 years, the NPV of the stream of social costs and benefitsat a discount rate of 10 percent is:
40 1 + 12 40 4
NPV = - 24 - 150 - 40 - - t=1 (1.1)t t=2 (1.1)t
40 0.5 5 10 40 50 20+
t=1 (1.1)t t=1 (1.1)t t=6 (1.1)t (1.1)1 = - Rs.9.93 million
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4.Table 1
Social Costs Associated with the Initial Outlay
Rs. in millionItem Financial
cost
Basis of
conversion
Tradeable value
ab initio
T L R
Land 0.30 SCF = 1/1.5 0.20Buildings 12.0 T=0.50,L=0.25
R=0.256.0 3.0 3.0
Imported equipment 15.0 CIF value 9.0Indigeneous equipment 80.0 CIF value 60.0
Transport 2.0 T=0.65,L=0.25R=0.10
1.3 0.5 0.2
Engineering and know-howfees
6.0 SCF=1.5 9.0
Pre-operative expenses 6.0 SCF=1.0 6.0Bank charges 3.7 SCF=0.02 0.074Working capitalrequirement
25.0 SCF=0.8 20.0
150.0 104.274 7.3 3.5 3.2
Table 2
Conversion of Financial Costs into Social Costs
Rs. in millionItem Financial
cost
Basis of
conversion
Tradeable value
ab initio
T L R
Indigeneous raw materialand stores
85 SCF=0.8 68
Labour 7 SCF=0.5 3.5Salaries 5 SCF=0.8 4.0Repairs and maintenance 1.2 SCF=1/1.5 0.8Water, fuel, etc 6 T=0.5,L=0.25
R=0.253 1.5 1.5
Electricity (Rate portion) 5 T=0.71,L=0.13R=0.16
3.55 0.65 0.8
Other overheads 10 SCF=1/1.5 6.667119.2 82.967 6.55 2.15 2.3
As per table 1, the social cost of initial outlay is worked out as follows :
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Rs. in millionTradeable value ab initio 104.274Social cost of the tradeable component 4.867
(7.3 / 1.5)Social cost of labour component 1.75
(3.5 x 0.5)Social cost of residual component 1.60
(3.2 x 0.5)Total 112.491
As per Table 2, the annual social cost of operation is worked out as follows :
Tradeable value ab initio 82.967Social cost of the tradeable component 4.367
( 6.55 x 1/1.5 )Social cost of labour component 1.075
(2.15 x 0.5)Social cost of residual component 1.150
(2.3 x 0.5)
Total 89.559
The annual CIF value of the output is Rs.110 million. Hence the annual socialnet benefit will be : 11089.559 = Rs.20.441 millionWorking capital recovery will be Rs.20 million at the end of the 20thyear.
Putting the above figures together the social flows associated with the projectwould be as follows :
Year / s Social flow (Rs. in million)
0 -112.4911-19 20.441
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Chapter 15
MULTIPLE PROJECTS AND CONSTRAINTS
1. The ranking of the projects on the dimensions of NPV, IRR, and BCR is given below
Project NPV (Rs.) Rank IRR (%) Rank BCR Rank
M 60,610 3 34.1 2 2.21 1N 58,500 4 34.9 1 1.59 3O 40,050 5 18.6 4 1.33 5P 162,960 1 26.2 3 2.09 2Q 72,310 2 14.5 5 1.36 4
2. The ranking of the projects on the dimensions of NPV and BCR is given below
Project NPV (Rs.) Rank BCR Rank
A 61,780 5 1.83 2B 208,480 2 1.52 3C 315,075 1 2.05 1D 411,90 6 1.14 6E 95,540 4 1.38 4
F 114,500 3 1.23 5
3. The two hypothetical projects are:
A B
Initial outlay 10000 1000Cash inflows
Year 1 5000 600
Year 2 5000 600Year 3 5000 600
NPV @ 10% Rank IRR Rank
A 2435 1 about 23% 2B 492 2 above 35% 1
4. The two hypothetical 4-year projects for which BCR and IRR criteria give different
rankings are given belowProject A B
Investment outlay 20000 20000Cash inflow
Year 1 2000 8000Year 2 2000 8000Year 3 2000 8000Year 4 31500 8000
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Project NPV Rank IRR Rank
A 4822 1 19% 2B 4296 2 about 22% 1
5. The NPVs of the projects are as follows:NPV (A) = 6000 x PVIFA(10%,5) + 5000 x PVIF(10%,5)20,000 = Rs.5851NPV (B) = 8000 x PVIFA(10%,8)50,000 = - Rs.840NPV (C) = 15,000 x PVIFA(10%,8)75,000 = Rs.5025NPV (D) = 15,000 x PVIFA(10%,12)100,000 = Rs.6,995NPV (E) = 25,000 x PVIFA (10%,7) + 50,000 x PVIF(10%,7)
150,000 = Rs.2,650
SinceBandEhave negative NPV, they are rejected. So we consider onlyA, C,andD. Further CandD are mutually exclusive. The feasible combinations, theiroutlays, and their NPVs are given below.
Combination Outlay
(Rs.)
NPV
(Rs.)
A 20,000 5,851
C 75,000 5,025D 100,000 6,995
A & C 95,000 10,876A & D 120,000 12,846
The preferred combination isA&D.
6. The linear programming formulation of the capital budgeting problem under various
constraints is as follows:Maximise 10X1+ 15X2 + 25X3 + 40X4 + 60X5 + 100X6
Subject to15X1+ 12X2 + 8X3 + 35X4 + 100X5+ 50X6 + SF1 = 150 Funds constraint for year 1
5X1+ 13X2 + 40X3 + 25X4 + 10X5+ 110X
6 200 + 1.08 SF
1 Funds constraint for year 2
5X1+ 6X2 + 5X3 + 10X4 + 12X5+ 40X6 60 Power constraint
15X1+ 20X2 + 30X3 + 35X4 + 40X5+ 60X6 120 Managerial constraint
0 Xj 1 (j= 1,.8) and SF1 0
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Rupees are expressed in 000s. Power units are also expressed in 000s.
7. Given the nature of the problem, in addition to the decision variablesX1 throughX10
for the original 10 projects, two more decision variables are required as follows:
X11 is the decision variable to represent the delay of projects 8 by one yearX12 is the decision variable for the composite project which represents the
combination of projects 4 and 5.The integer linear programming formulation is as follows:
Maximise 55X1+ 75X2 + 50X3 + 60X4 + 105X5 + 12X6 + 60X7+ 120X8
+ 50X9 + 40X10 + 100X11+ 178.2X12
Subject to 75X1+ 80X2 + 75X3 + 35X4 + 80X5 + 20X6 + 70X7+ 155 X8 +55X9 + 10X10 + 109.3X12+ SF1 = 400
40X1+ 85X2 + 8X3 + 100X4 + 160X5 + 9X6 + 5X7+ 100 X8 + 20X9 + 90X10 + 155X11+ 247X12 +SF2 = 350 + SF1 (1 + r)
X3 +X7 1X5 +X8 +X9 +X10 2X2 X6X8 X9X4 +X5 +X12 1X8 +X11 1
Xj = {0,1} j = 1, 2.12SFi 0 i = 1, 2
It has been assumed that surplus funds can be shifted from one period to the nextand they will earn a post-tax return of rpercent.
+
8. Minimise [P1(3d1+ 2d2+ d3) +P2(4d4+ 2d5+ d6) +P3(d7d 7)]
Subject to:Economic Constraints
12X1+ 14X2 + 15X3 + 16X4 + 11X5 + 23X6 + 20X7 65
Goal Constraints
1.2X1+ 1.6X2 + 0.6X3 + 1.5X4 + 0.5X5
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+
+ 0.9X6 + 1.8X7+ d 1d 1= 6 Net income for year 1
1.1X1+ 1.2X2 + 1.2X3 + 1.6X4 + 1.2X5 +
+ 2.5X6 + 2.0X7+ d 2d 2= 8 Net income for year 2
1.6X1+ 1.5X2 + 2.0X3 + 1.8X4 + 1.5X5 +
+ 4.0X6 + 2.2X7+ d 3d 3= 10 Net income for year 3
1.0X1+ 1.2X2 + 0.5X3 + 1.8X4 + 0.6X5 +
+ 1.0X6 + 2.0X7+ d 4d 4= 6 Sales growth for year 1
1.5X1+ 1.0X2 + 1.2X3 + 2.0X4 + 1.4X5 +
+ 3.0X6 + 3.0X7+ d 5d 5= 8 Sales growth for year 2
1.8X1+ 1.2X2 + 2.5X3 + 2.2X4 + 1.8X5 +
+ 3.5X6 + 3.5X7+ d 6d 6= 10 Sales growth for year 3
4X1+ 5X2 + 6X3 + 8X4 + 4X5 +
+ 9X6 + 7X7 + d 7d 7 = 50 NPV
+
Xj
0 di, d
i0
9. The BCRs of the projects are converted into NPVs as of now as follows
Project Outlay (Rs.) BCR NPV (Rs.)
1 800,000 1.08 64,0002 200,000 1.35 70,0003 400,000 1.20 80,0004 300,000 1.03 9,000
5 200,000 0.98 - 4,0006 500,000 1.03 15,000/1.10 = 13,6367 400,000 1.21 84,000/1.10 = 76,3648 600,000 1.17 102,000/1.10 = 92,7279 300,000 1.01 3,000/1.10 = 2,727
The integer linear programming formulation of the problem is as follows :
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Maximise 64,000X1 + 70,000X2 + 80,000X3+ 9,000X4+ 13,636X6+ 76,364X7+ 92,727X8+ 2,727X9
Subject to800,000X1 + 200,000X2+ 400,000X3+ 300,000X4+ SF1 = 20,00,000500,000X6 + 400,000X7+ 600,000X8+ 300,000X9 500,000 + SF1 (1.032)
Xj = {0,1} j = 1, 2, 3, 4, 6, 7, 8, 9
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Chapter 16
VALUATION OF REAL OPTIONS
1. S= 100 , uS= 150, dS= 90u = 1.5 , d= 0.9, r= 1.15 R= 1.15E = 100
Cu= Max (uSE, 0) = Max (150100,0) = 50Cd= Max (dSE, 0) = Max (90100,0) = 0
CuCd 50 = = = 0.833(u-d)S 0.6 x 100
uCddCu 00.9 x 50B = = = - 65.22
(u-d)R 0.6 x 1.15
C = S +B = 0.833 x 10065.22 = 18.08
2. S= 60 , dS= 45, d = 0.75,C = 5r= 0.16, R= 1.16, E = 60
Cu= Max (uSE, 0) = Max (60uE, 0)Cd= Max (dSE, 0) = Max (4560, 0) = 0
Cu
Cd 60u60 u1
= = =(u-d)S (u0.75)60 u0.75
uCddCu 0.75 (60u60) 45 (1u)B = = =
(u-d)R (u0.75) 1.16 1.16 (u0.75)
C = S +B
(u1) 60 45 (1u)5 = +
u0.75 1.16 (u0.75)Multiplying both the sides by u0.75 we get
455(u0.75) = (u1) 60 + (1u)
1.16
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Solving this equation for uwe get
u= 1.077
So Betas equity can rise to60 x 1.077 = Rs.64.62
3. EC0= S0N(d1) - N(d2)
ert
S0 = 70,E= 72, r= 0.12, 0.3, t= 0.50
S0 1
ln + r+ 2
t
E 2d1=
t70
ln + (0.12 + 0.5 x .09) x 0.50
72=
0.30 0.50
- 0.0282 + 0.0825= = 0.2560
0.2121
d2 = d1 - t = 0.25600.30 0.50 = 0.0439
N(d1) = 0.6010N(d2) = 0.5175
E 72= = 67.81
ert e0.12x 0.50
C0= S0x 0.601067.81 x 0.5175= 70 x 0.601067.81 x 0.5175 = Rs.6.98
4. EC0= S0N(d1) - N(d2)
ert
E= 50, t = 0.25,S= 40, 0.40, r = 0.14
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S0 1
ln + r+ 2
t
E 2
d1= t
40ln + (0.14 + 0.5 x 0.16) 0.25
50d1=
0.40 0.25
- 0.2231 + 0.055= = - 0.8405
0.20
d2 = d1 - t = - 0.84050.40 0.25 = -1.0405
N(d1) = 0.2003
N(d2) = 0.1491E 50= = 48.28
ert e0.14 x 0.25
C0= S0x 0.200348.28 x 0.1491= 40 x 0.200348.28 x 0.1491 = 0.8135
5. The NPV of the proposal to make Comp-I is:20 50 50 20 + 10-100 + + + +
1.20 (1.20)2 (1.20)3 (1.20)4
= -100 + 16.66 + 34.70 + 28.95 + 14.46= - Rs.5.23 million
The present value of the cash inflows of Comp II proposal, four years from nowwill be Rs.189.54 million (Two times the present value of the cash inflows of Comp-I).
So, we haveS0 = present value of the asset = 189.54 x e
0.20 x 4 = Rs.85.17 millionE = exercise price = $ 200 million
= 0.30t = 4 yearsr = 12
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Step 1: Calculate d1 and d2
S0 2
ln + r+ tE1 2 -0.854 + (0.12 + (.09/2)) 4 -0.194
d1 = = = = -0.323
t 0.3 4 0.6
d2 = d1- t = -0.3230.60 = -0.923
Step 2: FindN(d1) andN(d2)
N(d1) = 0.3733N(d2) = 0.1780
Step 3: Estimate the present value of the exercise priceE . e-rt = 200 / 1.6161 = Rs.123.76 million
Step 4: Plug the numbers obtained in the previous steps in the Black-Scholes formula:C0 = 85.17 x 0.3733123.76 x 0.1780
= Rs.9.76
6. Presently a 9 unit building yields a profit of Rs.1.8 million (9 x 1.29) and a 15 unitbuilding yields a profit of Rs.1.0 million (15 x 1.217). Hence a 9 unit building isthe best alternative if the builder has to construct now.
However, if the builder waits for a year, his payoffs will be as follows:
Market Condition
Alternative Buoyant (Apartment price:
Rs.1.5 million)
Sluggish (Apartment price:
Rs.1.1million)9unit building 1.5 x 99 = 4.5 1.1 x 99 = 0.9
15unit building 1.5 x 1517 = 5.5 1.1 x 1517 = -0.5
Thus, if the market turns out to be buoyant the best alternative is the 15unitbuilding (payoff: Rs.5.5 million) and if the market turns out to be sluggish the bestalternative is the 9unit building (payoff: Rs.0.9 million).
Given the above information, we can apply the binomial method for valuing the
vacant land:
Step 1: Calculate the risk-neutral probabilities.
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The binomial tree of apartment values is
Rs.1.60 million (1.6 + 0.1)
pRs.1.2 million
1-p Rs.1.20 million (1.1 + 0.1)
Given a risk free rate of 10 percent, the risk-neutral probabilities must satisfy thefollowing conditions:
px 1.6 + (1p) x 120
1.2 million = 1.10Solving this we get p= 0.3
Step 2: Calculate the expected cash flow next yearThe expected cash flow next year is:
0.3 x 5.5 + 0.7 x 0.9 = Rs.2.28 million
Step 3: Compute the current value2.28/ 1.10 = Rs.2.07 million
Since Rs.2.07 million is greater than Rs.1.80 million, the profit fromconstructing a 9 unit building now, it is advisable to keep the vacant land. The value ofthe vacant land is Rs.2.07 mi