CA INTERMEDIATE

FINANCIAL MANAGEMENT
VOLUME II

By
CA. Namit Arora Sir

This book is dedicated to my Father

‘MR. SURESK KUMAR ARORA’

ABOUT THE AUTHOR

Mr. Namit Arora is a First class commerce graduate and member of The
Institute of Chartered Accountants of India (ICAI). He has cleared both groups of
PCC examination and final examination in his first attempt.
He has vast experience of teaching even at such young age. He has taught
large number of students of various professional courses such as CA, CS, CMA
and also of undergraduate and post graduate course for university
examinations. He is also author of Taxmann.
His specialized knowledge helps the students to understand the topic
easily and his expert advice makes the revision very easy and fast.
He gives practical examples that help students to visualize the concepts
and his teaching style is very famous among the students.
 PREFACE TO THIS EDITION
This is a comprehensive book having thoroughly explained concepts with lucid and systematic
presentation of the subject matter. All attempts are made in this book to keep concept easier
to understand and remember.
A special attention is given to presentation keeping in mind the examination needs to
the student. The book is primarily written for CA – INTERMEDIATE exams.

For any suggestion please mail me at canamitarora@gmail.com

A word to the students

My dear student, hard work is the key to success. Though smart work is publicized in today’s
world but to be smart, you have to work hard. So always be attentive in class and have
thorough revision after the class. It is also important to be motivated and inspired for working
hard. The key for success is:

“Work hard in class, be attentive and grab the concepts

&
Work smart during revision, select important questions for next
revision.”

ALL THE BEST

CA. NAMIT ARORA
 INDEX
S. NO. CHAPTERS NAME PAGE NO. WEIGHTAGE

0 INTRODUCTION 0.1 – 0.3 –

1 CAPITAL STRUCTURE - EBIT & EPS ANALYSIS 1.1 – 1.23 5 – 10

2 LEVERAGES 2.1 – 2.39 5 – 10

3 MANAGEMENT OF RECEIVABLES & PAYABLES 3.1 – 3.21 5 – 10

4 MANAGEMENT OF WORKING CAPITAL 4.1 – 4.24 5 – 10

5 TREASURY & CASH MANAGEMENT 5.1 – 5.18 5

6 RATIO ANALYSIS 6.1 – 6.53 5 – 10

7 CAPITAL BUDGETING/INVESTMENT DECISION 7.1 – 7.62 10

8 COST OF CAPITAL 8.1 – 8.37 5 – 10

9 CAPITAL STRUCTURE 9.1 – 9.18 5 – 10

10 DIVIDEND DECISIONS 10.1 – 10.23 5

11 TABLES – –
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

TRADITIONAL TECHNIQUES

BQ 1
A project requiring an investment of `10,00,000 and it yields profit after tax and depreciation which is
as follows:
Year Profit after tax and depreciation (`)
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000

At the end of the 5th year, the plant and machinery of the project can be sold for `80,000.

Determine Accounting (Book) Rate of Return.

Answer
Alternative 1 (Average Investment Basis):
Average Pr ofit After Tax
Accounting Rate of Return = × 100
Average Investment
92 ,000
= × 100 = 17.04%
5 ,40 ,000

Alternative 2 (Total Investment Basis):

Average Pr ofit After Tax
Accounting Rate of Return = × 100
Initial Investment
92 ,000
= × 100 = 9.20%
10 ,00 ,000

Alternative 3 (Annual Basis):

Pr ofit After Tax
Accounting Rate of Return = × 100
Investment at the beginning of the year

50 ,000
Year 1 = × 100 = 5.00%
10 ,00 ,000

75,000
Year 2 = × 100 = 9.19%
8 ,16 ,000

1 ,25 ,000
Year 3 = × 100 = 19.78%
6 ,32 ,000

1 ,30 ,000
Year 4 = × 100 = 29.02%
4 ,48 ,000

80 ,000
Year 5 = × 100 = 30.30%
2,64 ,000

7.1
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Average ARR = (5% + 9.19% + 19.78% + 29.02% + 30.30%) ÷ 5 years

= 18.66%

Working Notes:

Average Profit After Tax = (50,000 + 75,000 + 1,25,000 + 1,30,000 + 80,000) ÷ 5

= 92,000 per annum

Average Investment = (10,00,000 + 80,000) ÷ 2 = 5,40,000

Depreciation per annum = (10,00,000 – 80,000) ÷ 5 years = 1,84,000

BQ 2
Times Ltd. is going to invest in a project a sum of `3,00,000 having a life span of 3 years. Salvage value
of machine is `90,000. The profit before depreciation for each year is `1,50,000.

Determine Accounting (Book) Rate of Return.

Answer
Alternative 1 (Average Investment Basis):
Average Pr ofit After Tax
Accounting Rate of Return = × 100
Average Investment
80 ,000
= × 100 = 41.03%
1 ,95 ,000

Alternative 2 (Total Investment Basis):

Average Pr ofit After Tax
Accounting Rate of Return = × 100
Initial Investment
80 ,000
= × 100 = 26.67%
3 ,00 ,000

Alternative 3 (Annual Basis):

Pr ofit After Tax
Accounting Rate of Return = × 100
Investment at the beginning of the year

80 ,000
Year 1 = × 100 = 26.67%
3 ,00 ,000

80 ,000
Year 2 = × 100 = 34.78%
2,30 ,000

80 ,000
Year 3 = × 100 = 50.00%
1 ,60 ,000

Average ARR = (26.67% + 34.78% + 50.00%) ÷ 3 = 37.15%

Working Notes:
Average Profit After Tax = Profit before depreciation – depreciation
= 1,50,000 - 70,000 = 80,000

Average Investment = (3,00,000 + 90,000) ÷ 2 = 1,95,000

7.2
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Depreciation per annum = (3,00,000 – 90,000) ÷ 3 years = 70,000

BQ 3
Times Ltd. is going to invest in a project a sum of `3,00,000 having a life span of 3 years. Salvage value
of machine is `90,000. The profit after depreciation for each year is `80,000. Additional working capital
requirement is `45,000

Determine Accounting (Book) Rate of Return on the basis of average investment.

Answer
Average Pr ofit After Tax
Accounting Rate of Return = × 100
Average Investment

80 ,000
= × 100 = 33.33%
2,40 ,000

Average Investment = [(3,00,000 + 45,000) + (45,000 + 90,000)] ÷ 2

= 2,40,000

BQ 4
Project A costs `2,00,000 and Project B costs `3,00,000 both have a ten year life. Uniform cash receipts
expected are A `40,000 p.a. and B `80,000 p.a.

Calculate traditional payback period.

Answer

Total Initial Capital Investment

Payback Period =
Annual Expected CFAT

2,00 ,000
Project A = = 5 Years
40 ,000

3 ,00 ,000
Project B = = 3.75 Years
80 ,000

BQ 5
The project involves a total initial expenditure of `2,00,000 and it is estimated to generate future cash
inflow of `30,000, `38,000, `25,000, `22,000, `36,000, `40,000, `40,000, `28,000, `24,000 and `24,000
in its last year.

Calculate traditional payback period.

Answer
Payback Period = 6 year + 9,000/40,000 = 6.225 Years

Working Notes:
Calculation of Cumulative Cash Inflows:
Year Annual Cash Inflows Cumulative Cash Inflows
1 `30,000 `30,000

7.3
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

2 `38,000 `68,000
3 `25,000 `93,000
4 `22,000 `1,15,000
5 `36,000 `1,51,000
6 `40,000 `1,91,000
7 `40,000 `2,31,000
8 `28,000 `2,59,000
9 `24,000 `2,83,000
10 `24,000 `3,07,000

DISCOUNTED PAYBACK, NPV & PI TECHNIQUES (DCF)

BQ 6
Geeta Ltd. is implementing a project with capital outlay of `7,600. Its cash inflows are as follows:
Year `
1 6,000
2 2,000
3 1,000
4 5,000
The expected rate of return on the capital invested is 12% p.a.

Calculate the discounted payback period of the project.

Answer
Calculation of Cumulative Discounted Cash Flow
Year Cash Inflow DF @ 12% p.a. Discounted CF Cumulative DCF
1 6,000 0.8929 5,357 5,357
2 2,000 0.7972 1,594 6,951
3 1,000 0.7118 712 7,663
4 5,000 0.6355 3,178 10,841
7,600 − 6,951
Discounted Payback period = 2 years + = 2.91 years
712

BQ 7
Compute the net present value for a project with a net investment of `1,00,000 and net cash flows year
one is `55,000; for year two is `80,000 and for year three is `15,000. Further, the company’s cost of
capital is 10%? [PVIF @ 10% for three years are 0.909, 0.826 and 0.751]

Answer
Statement of NPV
Years Particulars ` DF @ 10% PV
0 Investment (outflow) (1,00,000) 1.000 (1,00,000)
1 Cash inflow 55,000 0.909 49,995
2 Cash inflow 80,000 0.826 66,080
3 Cash inflow 15,000 0.751 11,265
NPV 27,340
Since the net present value is positive, investment in the project should be made.

7.4
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

BQ 8
ABC Ltd. is a small company that is currently analyzing capital expenditure proposals for the purchase
of equipment; the company uses the net present value technique to evaluate projects. The capital budget
is limited to `500,000 which ABC Ltd believes is the maximum capital it can raise. The initial investment
and projected net cash flows for each project are shown below. The cost of capital of ABC Ltd is 12%.

You are required to compute the NPV of the different projects.

Particulars Project A Project B Project C Project D

Initial Investment (outflow) 2,00,000 1,90,000 2,50,000 2,10,000
Projected Cash Inflows:
Year 1 50,000 40,000 75,000 75,000
Year 2 50,000 50,000 75,000 75,000
Year 3 50,000 70,000 60,000 60,000
Year 4 50,000 75,000 80,000 40,000
Year 5 50,000 75,000 1,00,000 20,000

Answer
Statement of NPV
Period PV factor Project A Project B Project C Project D
0 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000)
1 0.893 44,650 35,720 66,975 66,975
2 0.797 39,850 39,850 59,775 59,775
3 0.712 35,600 49,840 42,720 42,720
4 0.636 31,800 47,700 50,880 25,440
5 0.567 28,350 42,525 56,700 11,340
Net Present Value (19,750) 25,635 27,050 (3,750)

BQ 9
Suppose we have three projects involving discounted cash outflow of `5,50,000, `75,000 and
`1,00,20,000 respectively. Suppose further that the sum of discounted cash inflows for these projects
are `6,50,000, `95,000 and `1,00,30,000 respectively.

Calculate the desirability factors for the three projects.

Answer
PV of Inflows
Desirability factor =
PV of Outflows
6 ,50 ,000
Project 1 = = 1.18
5 ,50 ,000
95 ,000
Project 2 = = 1.27
75 ,000
1 ,00 ,30 ,000
Project 3 = = 1.001
1 ,00 ,20 ,000

BQ 10
A Company is considering whether it should spend `4,00,000 on a project to manufacture and sell a new
product. The unit variable cost of the product is `6. It is expected that the new product can be sold at
`10 per unit. The annual fixed costs (only cash) will be `20,000. The project will have a life of six years

7.5
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

with a scrap value of `20,000. The cost of capital of the company is 15%. The only uncertain factor is the
volume of sales. To start with the company expects to sell at least 40,000 units during the first year.

Required:
(1) Net present value of the project based on the sales expected during the first year and on the
assumption that it will continue at the same level during the remaining years.
(2) The minimum volume of sales required to justify the project.

Note: Annuity of `1 at 15% for six years has a present value of `3.7845 and present value of `1 received
at the end of sixth year at 15% is `0.4323.
[(1) NPV 1,38,476; (2) 30,853 units]

BQ 11
Cello Limited is considering buying a new machine which would have a useful economic life of five years,
a cost of `1,25,000 and a scrap value of `30,000, with 80 per cent of the cost being payable at the start
of the project and 20 per cent at the end of the first year. The machine would produce 50,000 units per
annum of a new project with an estimated selling price of `3 per unit. Direct costs would be `1.75 per
unit and annual fixed costs, including depreciation calculated on a straight line basis, would be `40,000
per annum. In the first year and the second year, special sales promotion expenditure, not included in
the above costs, would be incurred, amounting to `10,000 and `15,000 respectively.

Evaluate the project using the NPV method of investment appraisal, assuming the
company’s cost of capital to be 10 percent.

Answer
Statement of NPV
Year Particulars ` DF @ 10% PV
0 Initial outflows (80% of 1,25,000) (1,00,000) 1.000 (1,00,000)
1 Cash inflow – Outflow 6,500 0.909 5,909
(31,500 – 20% of 1,25,000)
2 Cash inflow 26,500 0.826 21,889
3-5 Cash inflow 41,500 2.055 85,283
5 Salvage 30000 0.621 18,630
NPV 31,710

Working Note:
(a) Calculation of Annual Cash Inflow
Particulars 1 2 3-5
Sales value @ `3 per unit of 50,000 units 1,50,000 1,50,000 1,50,000
Less: Direct costs @ `1.75 per unit 87,500 87,500 87,500
Less: Annual cash fixed cost (40,000 – 19,000) 21,000 21,000 21,000
Less: Special sales promotion expenses 10,000 15,000 -
Cash Inflow 31,500 26,500 41,500

(b) Depreciation = (Cost of machine – Scrap value) ÷ Life

= (1,25,000 – 30,000) ÷ 5 years
= 19,000 per annum

Advise: Cello limited should buy machine having positive NPV.

7.6
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

BQ 12
XYZ Ltd is planning to introduce a new product with a projected life of 8 years. The project to be set up
in a backward region, qualifies for a one time (as its starting) tax free subsidy from the government of
`20,00,000 equipment cost will be `140 lakhs and additional equipment costing `10,00,000 will be
needed at the beginning of the third year. At the end of 8 years the original equipment will have no resale
value but the supplementary equipment can be sold for `1,00,000. A working capital of `15,00,000 will
be needed.

The sales volume over the eight years period has been forecasted as follows:
Year Units
1 80,000
2 1,20,000
3-5 3,00,000
6-8 2,00,000

A sale price of `100 per unit is expected and variable expenses will amount to 40% of sales revenue.
Fixed cash operating costs will amount to `16,00,000 per year. In addition an extensive advertising
campaign will be implemented requiring annual outlays as follows:
Year (` in lakhs)
1 30
2 15
3-5 10
6-8 4

The company is subject to 50% tax rate and considers 12% to be an appropriate after tax cost of
capital for this project. The company follows the straight line method of depreciation.

Should the project be accepted?

Answer
Net Present Value
Year Particulars ` DF @ 12% PV
0 Initial outflows (1,35,00,000) 1.000 (1,35,00,000)
(140 – 20 + 15) Lakhs
1 CFAT 2,00,000 0.893 1,78,600
2 CFAT less Additional Equipment 24,50,000 0.797 19,52,650
(34,50,000 – 10,00,000)
3-5 CFAT 85,25,000 1.915 1,63,25,375
6–8 CFAT 58,25,000 1.363 79,39,475
8 Working Capital and Salvage 16,00,000 0.404 6,46,400
(15,00,000 + 1,00,000)
NPV 1,35,42,500

Company should accept the proposal having positive NPV of the project.

Working Notes:
1. Statement of CFAT
Particulars 1 2 3–5 6–8
Units sold 80,000 1,20,000 3,00,000 2,00,000

7.7
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Sales @ `100 p.u. 80,00,000 1,20,00,000 3,00,00,000 2,00,00,000

Less: VC @ 40% 32,00,000 48,00,000 1,20,00,000 80,00,000
Contribution 48,00,000 72,00,000 1,80,00,000 1,20,00,000
Less: Advertisement expenses (30,00,000) (15,00,000) (10,00,000) (4,00,000)
Less: Cash fixed cost (16,00,000) (16,00,000) (16,00,000) (16,00,000)
Less: Depreciation (15,00,000) (15,00,000) (16,50,000) (16,50,000)
PBT (13,00,000) 26,00,000 1,37,50,000 83,50,000
Less: Tax @ 50% - (6,50,000) (68,75,000) (41,75,000)
PAT (13,00,000) 19,50,000 68,75,000 41,75,000
Add: Depreciation 15,00,000 15,00,000 16,50,000 16,50,000
CFAT 2,00,000 34,50,000 85,25,000 58,25,000

2. Depreciation:
Original Cost  Subsidy  Salvage 1 ,20 ,00 ,000
Main equipment (t0 - t8) = =
Life of Equipment 8 Years
= 15,00,000

Original Cost  Salvage 9 ,00 ,000

Additional equipment (t3 - t8) = =
Life of Equipment 6 Years
= 1,50,000

3. Tax for year 2 = 50% of (26,00,000 – 13,00,000) = 6,50,000

Note: As per section 32 of Income Tax Act “Depreciation is not allowed on subsidized part of asset”

BQ 13
XYZ Ltd. is planning to introduce a new product with a project life of 8 years. Initial equipment cost will
be `3.5 crores. Additional equipment costing `25,00,000 will be purchased at the end of the third year
from the cash inflow of this year. At the end of 8 years, the original equipment will have no resale value,
but additional equipment can be sold for `2,50,000. A working capital of `40,00,000 will be needed and
it will be released at the end of eighth year. The project will be financed with sufficient amount of equity
capital. The sales volumes over eight years have been estimated as follows:

Year 1 2 3 4−5 6−8

Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sales price of `240 per unit is expected and variable expenses will amount to 60% of sales revenue.
Fixed cash operating costs will amount `36,00,000 per year. The loss of any year will be set off from the
profits of subsequent two years. The company is subject to 30 per cent tax rate and considers 12 per
cent to be an appropriate after tax cost of capital for this project. The company follows straight line
method of depreciation.

Calculate the net present value of the project and advise the management to take
appropriate decision.

The PV factors at 12% are

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

7.8
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Answer
Net Present Value
Year Particulars ` DF @ 12% PV
0 Initial Equipment cost plus working capital (3,90,00,000) 1.000 (3,90,00,000)
(350 + 40) Lakhs
1 CFAT 33,12,000 0.893 29,57,616
2 CFAT 63,69,000 0.797 50,76,093
3 CFAT less Additional Equipment 1,37,64,500 0.712 98,00,324
(1,62,64,500 – 25,00,000)
4-5 CFAT 1,70,71,500 1.203 2,05,37,015
6-8 CFAT 1,10,23,500 1.363 1,50,25,031
8 Working Capital and Salvage 42,50,000 0.404 17,17,000
(40,00,000 + 2,50,000)
NPV 1,61,13,079

Company should accept the proposal having positive NPV of the project.

Working Notes: 1. Statement of CFAT

Particulars 1 2 3 4-5 6–8
Units sold 72,000 1,08,000 2,60,000 2,70,000 1,80,000
Sales @ `240 p.u. 1,72,80,000 2,59,20,000 6,24,00,000 6,48,00,000 4,32,00,000
Less: VC @ 60% 1,03,68,000 1,55,52,000 3,74,40,000 3,88,80,000 2,59,20,000
Contribution 69,12,000 1,03,68,000 2,49,60,000 2,59,20,000 1,72,80,000
Less: Cash fixed cost 36,00,000 36,00,000 36,00,000 36,00,000 36,00,000
Less: Depreciation 43,75,000 43,75,000 43,75,000 48,25,000 48,25,000
PBT (10,63,000) 23,93,000 1,69,85,000 1,74,95,000 88,55,000
Less: Tax @ 30% - (3,99,000) (50,95,500) (52,48,500) (26,56,500)
PAT (10,63,000) 19,94,000 1,18,89,500 1,22,46,500 61,98,500
Add: Depreciation 43,75,000 43,75,000 43,75,000 48,25,000 48,25,000
CFAT 33,12,000 63,69,000 1,62,64,500 1,70,71,500 1,10,23,500

2. Depreciation:
Original Cost 3 ,50 ,00 ,000
Main equipment (t0 - t8) = = = 43,75,000
Life of Equipment 8 Years

Original Cost  Salvage 22 ,50 ,000

Additional equipment (t4 - t8) = = = 4,50,000
Life of Equipment 5 Years

3. Tax for year 2 = 30% of (23,93,000 – 10,63,000) = 3,99,000

BQ 14
A chemical company is presently paying an outside firm `1 per gallon to dispose off the waste resulting
from its manufacturing operations. At normal operating capacity, the waste is about 50,000 gallons per
year.
After spending `60,000 on research, the company discovered that the waste could be sold for
`10 per gallon if it was processed further. Additional processing would, however, require an investment
of `6,00,000 in new equipment, which would have an estimated life of 10 years with no salvage value.
Depreciation would be calculated by straight line method.
Except for the costs incurred in advertising `20,000 per year, no change in the present selling

7.9
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

and administrative expenses is expected, if the new product is sold. The details of additional processing
costs are as follows:
Variable : `5 per gallon of waste put into process.
Fixed : `30,000 per year (Excluding Depreciation).

There will be no losses in processing, and it is assumed that the total waste processed in a given year
will be sold in the same year. Estimates indicate that 50,000 gallons of the product could be sold each
year.
The management when confronted with the choice of disposing off the waste or processing it further
and selling it, seeks your advice. You should consider Present value of Annuity of ` 1 per year @ 15%
p.a. for 10 years as 5.019.

Which alternative would you recommend? Assume that the firm's cost of capital is 15% and
it pays on an average 50% Tax on its income.

Answer
Statement of NPV
Year Particulars ` DF @ 15% PV
0 Initial outflows (6,00,000) 1.000 (6,00,000)
1 – 10 Annual CFAT 1,55,000 5.019 7,77,945
NPV 1,77,945

Working Note:
Calculation of CFAT
Particulars `
Sales value of waste (50,000 gallon × `10) 5,00,000
Add: Saving in Disposal cost (50,000 gallon × `1) 50,000
Less: Variable processing cost (50,000 gallon × `5) (2,50,000)
Less: Fixed processing cost (excluding depreciation) (30,000)
Less: Advertisement cost (20,000)
Less: Depreciation (6,00,000 ÷ 10 years) (60,000)
PBT 1,90,000
Less: Tax @ 50% (95,000)
PAT 95,000
Add: Depreciation 60,000
Annual CFAT 1,55,000

Recommendation: Processing of waste is a better option as it gives a positive NPV.

Note: Research cost of 60,000 is not relevant for decision making as it is sunk cost.

BQ 15
Manoranjan Ltd is a News broadcasting channel having its broadcasting Centre in Mumbai. There are
total 200 employees in the organisation including top management. As a part of employee benefit
expenses, the company serves tea or coffee to its employees, which is outsourced from a third-party.
The company offers tea or coffee three times a day to each of its employees. 120 employees prefer tea
all three times, 40 employees prefer coffee all three times and remaining prefer tea only once in a day.
The third-party charges `10 for each cup of tea and `15 for each cup of coffee. The company works for
200 days in a year.

7.10
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Looking at the substantial amount of expenditure on tea and coffee, the finance department has
proposed to the management an installation of a master tea and coffee vending machine which will cost
`10,00,000 with a useful life of five years. Upon purchasing the machine, the company will have to enter
into an annual maintenance contract with the vendor, which will require a payment of `75,000 every
year. The machine would require electricity consumption of 500 units p.m. and current incremental cost
of electricity for the company is `12 per unit. Apart from these running costs, the company will have to
incur the following consumables expenditure also:
1. Packets of Coffee beans at a cost of `90 per packet.
2. Packet of tea powder at a cost of `70 per packet.
3. Sugar at a cost of `50 per Kg.
4. Milk at a cost of `50 per litre.
5. Paper cup at a cost of 20 paise per cup.

Each packet of coffee beans would produce 200 cups of coffee and same goes for tea powder packet.
Each cup of tea or coffee would consist of 10g of sugar on an average and 100 ml of milk. The company
anticipate that due to ready availability of tea and coffee through vending machines its employees would
end up consuming more tea and coffee.
It estimates that the consumption will increase by on an average 20% for all class of employees. Also,
the paper cups consumption will be 10% more than the actual cups served due to leakages in them.
The company is in the 25% tax bracket and has a current cost of capital at 12% per annum. Straight line
method of depreciation is allowed for the purpose of taxation.

You as a financial consultant is required to ADVISE on the feasibility of acquiring the

vending machine.

PV factors @ 12%:
Year 1 2 3 4 5
PVF 0.8929 0.7972 0.7118 0.6355 0.5674

Answer
Statement of NPV
Year Particulars ` DF @ 12% PV
0 Initial outflows (10,00,000) 1.000 (10,00,000)
1–5 Annual CFAT 2,39,438 3.6048 8,63,126
NPV (1,36,874)

Since NPV of the machine is negative, it should not be purchased.

Working Note:
Calculation of CFAT
Particulars `
Saving in Existing Tea & Coffee Charges 11,60,000
(120 × 10 × 3 × 200) + (40 × 15 × 3 × 200) + (40 × 10 × 1 × 200)
Less: AMC of Machine (75,000)
Less: Electricity Charges (500 × 12 × 12) (72,000)
Less: Coffee beans (144 × 90) (12,960)
Less: Tea powder (480 × 70) (33,600)
Less: Sugar (1,248 × 50) (62,400)
Less: Milk (12,480 × 50) (6,24,000)

7.11
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Less: Paper cup (1,37,280 × 0.20) (27,456)

Less: Depreciation (10,00,000 ÷ 5 years) (2,00,000)
PBT 52,584
Less: Tax @ 25% (13,146)
PAT 39,438
Add: Depreciation 2,00,000
Annual CFAT 2,39,438

Computation of Qty of consumable:

No. of Tea Cups = [(120 × 3 × 200 days) + (40 × 1 × 200 days) × 1.2 = 96,000

No. of Coffee cups = 40 × 3 × 200 days × 1.2 = 28,800

No. of coffee beans packet = 28,800/200 = 144

No. of Tea Powder Packets = 96,000/200 = 480

Qty of Sugar = (96,000 + 28,800) × 6,000/1,000 g = 1,248 kgs

Qty of Milk = (96,000 + 28,800) × 6,000/1,000 ml = 12,480 litres

No. of paper cups = (96,000 + 28,800) × 1.1 = 1,37,280

UNEQUAL LIFE OF PROJECTS

BQ 16
APZ limited is considering selecting a machine between two machines ‘A’ and ‘B’. The two machines
have identical capacity, do exactly the same job, but designed differently.

Machine A costs `8,00,000, having useful life of three years. It costs `1,30,000 per year to run.
Machine B is an economic model costing `6,00,000, having useful life of two years. It costs `2,50,000 per
year to run.

The cash flows of machine ‘A’ and ‘B’ are real cash flows. The costs are forecasted in rupees of
constant purchasing power. Ignore taxes. The opportunity cost of capital is 10%.

The present value factors at 10% are:

Years t1 t2 t3
PVIF0.10t 0.9091 0.8264 0.7513
PVIFA0.10.2 = 1.7355
PVIFA0.10.3 = 2.4868

Which machine would you recommend the company to buy?

Answer
Statement Showing Evaluation of Two Machines
Particulars Machine ‘A’ Machine ‘B’
Initial outflow/ Purchase cost of machines 8,00,000 6,00,000

7.12
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Annual running cost 1,30,000 2,50,000

Life of machines 3 years 2 years

PV of annual running cost 3,23,284 4,33,875

(Annual running cost × PVIFA) (1,30,000 × 2.4868) (2,50,000 × 1.7355)

Present value of total outflow 11,23,284 10,33,875

(Initial outflow + PV of annual running cost)
÷ PVIFA ÷ 2.4868 ÷ 1.7355

Equivalent Annual outflow 4,51,699 5,95,722

Select the Machine A having lower equivalent annualized outflow.

BQ 17
Ae Bee Cee Ltd. is planning to invest in machinery, for which it has to make a choice between the two
identical machines, in terms of Capacity, ‘X’ and ‘Y’. Despite being designed differently, both machines
do the same job. Further, details regarding both the machines are given below:

Particulars Machine ‘X’ Machine ‘Y’

Purchase Cost of the Machine (`) 15,00,000 10,00,000
Life (years) 3 2
Running cost per year (`) 4,00,000 6,00,000

The opportunity cost of capital is 9%.

You are required to identify the machine the company should buy?

The present value (PV) factors at 9% are:

Year t1 t2 t3
PVIF0.09.t 0.917 0.842 0.772

Answer
Statement Showing Evaluation of Two Machines
Particulars Machine ‘X’ Machine ‘Y’
Initial outflow/ Purchase cost of machines 15,00,000 10,00,000
Annual running cost 4,00,000 6,00,000
Life of machines 3 years 2 years

PV of annual running cost 10,12,400 10,55,400

(Annual running cost × PVIFA) (4,00,000 × 2.531) (6,00,000 × 1.759)

Present value of total outflow 25,12,400 20,55,400

(Initial outflow + PV of annual running cost)
÷ PVIFA ÷ 2.531 ÷ 1.759
Equivalent Annual outflow 9,92,651 11,68,505

Select the Machine X having lower equivalent annualized outflow.

7.13
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

CAPITAL RATIONING

BQ 18
Shiva Limited is planning its capital investment programme for next year. It has five projects all of which
give a positive NPV at the company cut-off rate of 15 percent, the investment outflows and present
values being as follows:

Project Name Initial Investment NPV @ 15%

A `50,000 `15,400
B `40,000 `18,700
C `25,000 `10,100
D `30,000 `11,200
E `35,000 `19,300

The company is limited to a capital spending of `1,20,000.

You are required to optimise the returns from a package of projects within the capital
spending limit. The projects are independent of each other and are (a) divisible, (b) indivisible.

Answer
(a) Statement of Rank and Selection of Projects
(Divisible Situation)

Projects PI (1+ NPV/Investment) Rank Project Cost Project (%) Investment

A 1 + 15,400/50,000 = 1.31 5 `50,000 - -
B 1 + 18,700/40,000 = 1.47 2 `40,000 100% `40,000
C 1 + 10,100/25,000 = 1.40 3 `25,000 100% `25,000
D 1 + 11,200/30,000 = 1.37 4 `30,000 66.67% `20,000 (b.f.)
E 1 + 19,300/35,000 = 1.55 1 `35,000 100% `35,000
Total Investment `1,20,000

Optimum investment: 100% of B, C, E and 2/3 D.

(b) Statement of Possible Combinations and Combined NPV

(Indivisible Situation)

Possible Combinations Combined Investment Combined NPV

A+B+C `1,15,000 `44,200
A+B+D `1,20,000 `45,300
A+C+D `1,05,000 `36,700
A+C+E `1,10,000 `44,800
A+D+E `1,15,000 `45,900
B+C+D `95,000 `40,000
B+C+E `1,00,000 `48,100
B+D+E `1,05,000 `49,200
C+D+E `90,000 `40,600

Invest in combination of B, D and E having highest combined NPV and invest remaining `15,000
elsewhere.

7.14
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

REPLACEMENT DECISION

BQ 19
P Ltd. has a machine having an additional life of 5 years which costs `10,00,000 and has a book value of
`4,00,000.
A new machine costing `20,00,000 is available. Though its capacity is the same as that of the old
machine, it will mean a saving in variable costs to the extent of `7,00,000 per annum. The life of the
machine will be 5 years at the end of which it will have a scrap value of `2,00,000.
The rate of income tax is 46% and P Ltd's policy is not to make an investment if the yield is less
than 12% per annum.
The old machine, if sold today will realise `1,00,000; it will have no salvage value if sold at the
end of 5th year. Advise P Ltd. whether or not the old machine should be replaced.
Present value of `1 receivable annually for 5 years at 12% is 3.605, present value of `1 receivable
at the end of 5 year at 12% per annum is 0.567. Capital gain is tax free. Ignore income tax savings on
depreciation as well as on loss due to sale of existing machine.

Answer
Statement of NPV
Years Particulars ` PVF @ 12% PV
0 Initial outflow (19,00,000) 1.000 (19,00,000)
1-5 CFAT 3,78,000 3.605 13,62,690
5 Scrap value of new assets 2,00,000 0.567 1,13,400
NPV (4,23,910)

Working notes:
1. Calculation of initial outflow:
Cost of new machine `20,00,000
Less: Sale proceeds of old machine `1,00,000
Initial outflow `19,00,000

2. Calculation of incremental CFAT:

Annual savings
`7,00,000
Less: Tax @ 46% `3,22,000
Profit after tax/ CFAT `3,78,000

Analysis: P Ltd should not replace the machine.

BQ 20
ABC Ltd. is considering the replacement of one of its molding machines. The existing machine is in good
operation condition but is smaller than required if the firm is to expand its operations. The old machine
is 5 years old and has remaining depreciable life of 10 years. The machine was originally purchased for
`1,50,000 and is being depreciated at `10,000 per year for tax purposes.
The new machine will cost `2,20,000 or `1,70,000 if exchanged with the existing machine. It will
be depreciated on a straight line basis for 10 years with no salvage value. The management anticipates
that with the increased operations there will be need for an additional net working capital of `30,000.
The new machine will allow the company to expand current operations thereby increasing

7.15
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

annual revenue by `60,000 and variable operating costs from `2,00,000 to `2,20,000. The company's
tax rate is 35% and its cost of capital is 10%.
Should the company replace its existing machine? Assume that the loss on exchange of
existing machine can be claimed as short term capital loss in the current year itself.

Answer
Statement of NPV
Years Particulars ` PVF @ 10% PV
0 Initial outflow (1,82,500) 1.000 (1,82,500)
1 - 10 CFAT 30,200 6.145 1,85,579
10 Working capital 30,000 0.386 11,580
NPV 14,659
Working notes:
a. Calculation of initial outflow:
Cost of new machine `2,20,000
Less: Exchange value of old machine (`50,000)
Less: Tax saving on loss on sale of old machine (`17,500)
[50,000 – 1,00,000 (1,50,000 – 10,000 × 5 years)] × 35%
Add: Additional working capital `30,000
Initial outflow `1,82,500

b. Calculation of incremental CFAT:

Increase in sales `60,000
Less: Increase in operating cost (`20,000)
Less: Increase in depreciation (22,000 – 10,000) (`12,000)
Profit before tax `28,000
Less: Tax @ 35% (`9,800)
Profit after tax `18,200
Add: Depreciation `12,000
CFAT `30,200

Decision: ABC Ltd should exchange the machine.

BQ 21
MNP Limited is thinking of replacing its existing machine by a new machine which would cost `60 lakhs.
The company’s current production is `80,000 units, and is expected to increase to 1,00,000 units, if the
new machine is bought. The selling price of the product would remain unchanged at `200 per unit. The
following is the cost of producing one unit of product using both the existing and new machine:
Existing Machine New Machine
Particulars Difference
(80,000 units) (1,00,000 units)
Materials 75.00 63.75 (11.25)
Wages and Salaries 51.25 37.50 (13.75)
Supervision 20.00 25.00 5.00
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.00 4.75
Allocated Corporate OH 10.00 12.50 2.50
Total 183.25 165.50 (17.75)

7.16
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

The existing machine has an accounting book value of `1,00,000, and it has been fully depreciated for
tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine has
offered to accept the old machine for `2,50,000. However, the market price of old machine today is
`1,50,000 and it is expected to be `35,000 after 5 years. The new machine has a life of 5 years and a
salvage value of `2,50,000 at the end of its economic life.

Assume corporate Income tax rate at 40%, and depreciation is charged on straight line basis for Income-
tax purposes. Further assume that book profit is treated as ordinary income for tax purpose. The
opportunity cost of capital of the Company is 15%.

Required:
(i) Estimate net present value of the replacement decision.
(ii) Should Company go ahead with the replacement decision? Suggest.

Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.8000 0.6400 0.5120 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

Answer
(i) Statement of NPV
Year Particulars ` DF @ 15% PV
0 Initial outflows (58,50,000) 1.0000 (58,50,000)
1-5 Cash Flow After Tax 22,84,000 3.3522 76,56,425
5 Net Salvage 2,50,000 – 35,000 (1 – 0.40) 2,29,000 0.4972 1,13,859
NPV 19,20,284

Working Notes:
1. Calculation of initial outflow:
Cost of new machine `60,00,000
Less: Exchange value of old machine (`2,50,000)
Add: Tax payment on profit on exchange of old machine `1,00,000
(2,50,000 – Nil) × 40%
Initial outflow `58,50,000

2. Calculation of incremental CFAT:

Increase in sales (200 × 20,000 units) `40,00,000
Less: Increase in operating cost (1,00,000 × 148) – (80,000 × 173) `9,60,000
(excluding Depreciation and Allocated overheads)
Less: Increase in depreciation [(60,00,00 – 2,50,000) ÷ 5] – Nil `11,50,000
Profit before tax `18,90,000
Less: Tax @ 40% `7,56,000
Profit after tax `11,34,000
Add: Depreciation `11,50,000
Incremental CFAT `22,84,000

3. Calculation of Incremental Salvage:

Salvage of new machine (Salvage = WDV; no gain or loss) `2,50,000

7.17
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Less: Salvage of old machine (Salvage > WDV) `35,000

Tax on gain 40% of 35,000 (35,000 - Nil) `14,000 `21,000
Incremental Salvage `2,29,000
Notes:
(a) The old machine could be sold for `1,50,000 in the market. Since exchange value is more than the
market value, company will exchange it at `2,50,000.
(b) Old machine has fully depreciated for tax purpose, therefore depreciation of old machine as well
as WDV are NIL.
(c) Allocated overheads are allocations from corporate office therefore they are irrelevant for
computation of CFAT.

(ii) Advise: The company should go ahead with replacement project, since it has positive NPV.

BQ 22
HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine.
The old machine had been fully depreciated for tax purpose but has a book value of `2,40,000 on 31st
March . The machine has begun causing problems with breakdowns and it cannot fetch more than
`30,000 if sold in the market at present.
It will have no realizable value after 10 years. The company has been offered `1,00,000 for the old
machine as a trade in on the new machine which has a price (before allowance for trade in) of `4,50,000.
The expected life of new machine is 10 years with salvage value of `35,000.
Further, the company follows straight line depreciation method but for tax purpose, written down value
method depreciation @ 7.5% is considering that this is the only machine in the block of assets.
Given below are the expected sales and costs from both old and new machine:
Particulars Old Machine (`) New Machine (`)
Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @30% 97,425 1,16,175
PAT 2,27325 2,71,075

From the above information, ANALYSE whether the old machine should be replaced or not if
required rate of return is 10%? Ignore capital gain tax.

PV factors @ 10%:
Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

Answer
Calculation of Incremental CFAT & NPV
Year PVF PBDT Dep @ 7.5% PBT Tax @ 30% Cash Inflow PV
1 0.909 80,000 26,250 53,750 16,125 63,875 58,062
2 0.826 80,000 24,281 55,719 16,716 63,284 52,273

7.18
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

3 0.751 80,000 22,460 57,540 17,262 62,738 47,116

4 0.683 80,000 20,776 59,224 17,767 62,233 42,505
5 0.621 80,000 19,217 60,783 18,235 61,765 38,356
6 0.564 80,000 17,776 62,224 18,667 61,333 34,592
7 0.513 80,000 16,443 63,557 19,067 60,933 31,259
8 0.467 80,000 15,210 64,790 19,437 60,563 28,283
9 0.424 80,000 14,069 65,931 19,779 60,221 25,534
10 0.386 80,000 13,014 66,986 20,096 59,904 23,123
3,81,103
Add: PV of salvage of new machine (35,000 × 0.386) 13,510
3,94,613
Less: Initial Outflow (3,50,000)
Incremental NPV 44,613

Analysis: Since the Incremental NPV is positive, the old machine should be replaced.

Working Notes:
1. Calculation of Base for Depreciation or Cost of New Machine:
Cost of new machine `4,50,000
Less: Sale value of old machine (`1,00,000)
`3,50,000

2. Calculation of Profit before tax and depreciation (PBTD) as per books:

Particulars Old Machine (`) New Machine (`) Difference (`)
PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per books 24,000 41,500 17,500
PBTD 3,48,750 4,28,750 80,000

BQ 23
Xavly Ltd. has a machine which has been in operation for 3 years. The machine has a remaining
estimated useful life of 5 years with no salvage value in the end. Its current market value is `2,00,000.
The company is considering a proposal to purchase a new model of machine to replace the existing
machine. The relevant information is as follows:
Particulars Existing machine New machine
Cost of machine `3,30,000 `10,00,000
Estimated life 8 years 5 years
Salvage value Nil `40,000
Annual output 30,000 units 75,000 units
Selling price per unit `15 `15
Annual operating hours 3,000 3,000
Material cost per unit `4 `4
Labour cost per hour `40 `70
Indirect cash cost per annum `50,000 `65,000

The company uses written down value of depreciation @ 20% and it has several other machines in the
block of assets. The Income tax rate is 30 per cent and Xavly Ltd. does not make any investment, if it
yields less than 12 per cent.

PV factors @12%:

7.19
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Year 1 2 3 4 5
PVF 0.893 0.797 0.712 0.636 0.567

Advise Xavly Ltd. whether the existing machine should be replaced or not.

Answer
Statement of NPV
Year Particulars ` DF @ 12% PV
0 Initial outflows (8,00,000) 1.000 (8,00,000)
1 Incremental CFAT 3,21,000 0.893 2,86,653
2 Incremental CFAT 3,11,400 0.797 2,48,186
3 Incremental CFAT 3,03,720 0.712 2,16,249
4 Incremental CFAT 2,97,576 0.636 1,89,258
5 Incremental CFAT + Incremental Salvage 3,32,661 0.567 1,88,619
(2,92,661 + 40,000)
NPV 3,28,965

Advise: The company should go ahead with replacement of machine, since it has positive NPV.

Working Notes:
1. Calculation of initial outflow:
Cost of new machine `10,00,000
Less: Sales value of old machine (`2,00,000)
Initial outflow `8,00,000

2. Increase in output = 75,000 units – 30,000 units = 45,000 units

3. Base for incremental Depreciation:

Particulars `
(A) WDV of Existing Machine:
Purchase price of existing machine 3,30,000
Less: Depreciation year 1 (3,30,000 × 20%) (66,000)
Less: Depreciation year 2 (2,64,000 × 20%) (52,800)
Less: Depreciation year 3 (2,11,200 × 20%) (42,240)
WDV of Existing Machine (A) 1,68,960

(B) Depreciation Base of New Machine:

Purchase price of new machine 10,00,000
Add: WDV of existing Machine 1,68,960
Less: Sale value of existing machine (2,00,000)
Depreciation Base of New Machine (B) 9,68,960

(C) Base for incremental Depreciation (B – A) 8,00,000

4. Calculation of incremental CFAT:

Particulars 1 2 3 4 5
Increase in Sales (45,000 × `15) 6,75,000 6,75,000 6,75,000 6,75,000 6,75,000
Less: Increase in Material cost (1,80,000) (1,80,000) (1,80,000) (1,80,000) (1,80,000)
(45,000 units × `4)

7.20
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Less: Increase in Labour cost (90,000) (90,000) (90,000) (90,000) (90,000)

{3,000 hours × (70-40)}
Less: Increase in Indirect cash cost (15,000) (15,000) (15,000) (15,000) (15,000)
(65,000 – 50,000)
Less: Increase in Depreciation (1,60,000) (1,28,000) (1,02,400) (81,920) (65,536)
(Base: 8,00,000)
Incremental PBT 2,30,000 2,62,000 2,87,600 3,08,080 3,24,464
Less: Tax @ 30% (69,000) (78,600) (86,280) (92,424) (97,339)
Incremental PAT 1,61,000 1,83,400 2,01,320 2,15,656 2,27,125
Add: Incremental Depreciation 1,60,000 1,28,000 1,02,400 81,920 65,536
Incremental CFAT 3,21,000 3,11,400 3,03,720 2,97,576 2,92,661

Notes: Since company has several machines in 20% block of assets, there is no tax benefit or tax payment
on loss or profit on sale of machine respectively because block will remain in existance.

BQ 24
A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it. A
& Co. currently pays no taxes. The replacement machine costs `90,000 now and requires maintenance
of `10,000 at the end of every year for eight years. At the end of eight years it would have a salvage value
of `20,000 and would be sold. The existing machine requires increasing amounts of maintenance each
year and its salvage value falls each year as follows:
Year Maintenance (`) Salvage (`)
Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0

The opportunity cost of capital for A & Co. is 15%. When should the company replace the machine?

Note: Present value of an annuity of Re. 1 per period for 8 years at interest rate of 15% : 4.4873; present
value of Re. 1 to be received after 8 years at interest rate of 15% : 0.3269

Answer
PV of Cost of Replacing the Old Machine in each 4 years with New Machine
Scenario Year Cash Flow (`) PV @ 15% PV (`)
Replace Immediately 0 (28,600) 1.000 (28,600)
40,000 1.000 40,000
11,400
Replace in one year 1 (28,600) 0.870 (24,882)
1 (10,000) 0.870 (8,700)
1 25,000 0.870 21,750
(11,832)
Replace in 2 years 1 (10,000) 0.870 (8,700)
2 (28,600) 0.756 (21,622)
2 (20,000) 0.756 (15,120)
2 15,000 0.756 11,340
(34,102)
Replace in 3 years 1 (10,000) 0.870 (8,700)
2 0.756 (15,120)

7.21
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

3 (20,000) 0.658 (18,819)

3 (28,600) 0.658 (19,740)
3 (30,000) 0.658 6,580
10,000 (55,799)
Replace in 4 years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)
3 (30,000) 0.658 (19,740)
4 (28,600) 0.572 (16,359)
4 (40,000) 0.572 (22,880)
(82,799)

Working Notes:
Calculation of Equivalent Cost of New Machine:
Particulars `
Cost of new machine now 90,000
Add: PV of annual repairs @ 10,000 per annum for 8 years (10,000 × 4.4873) 44,873
Less: PV of salvage value at the end of 8 years (20,000 × 0.3269) (6,538)
Total PV of Outflows 1,28,335
Equivalent annual cost (1,28,335 ÷ 4.4873) 28,600

Advice: The company should replace the old machine immediately because the PV of cost of replacing
the old machine with new machine is least.

ADJUSTED PV & ADJUSTED DISCOUNT RATE

BQ 25
XYZ Ltd. is presently all equity financed. The directors of the company have been evaluating investment
in a project which will require `270 lakhs capital expenditure on new machinery. They expect the capital
investment to provide annual cash flows of `42 lakhs indefinitely which is net of all tax adjustments. The
discount rate which it applies to such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take advantage of tax
benefits of debt and propose to finance the new project with undated perpetual debt secured on the
company's assets. The company intends to issue sufficient debt to cover the cost of capital expenditure
and the after tax cost of issue.
The current annual gross rate of interest required by the market on corporate undated debt of similar
risk is 10%. The after tax costs of issue are expected to be `10 lakhs. Company's tax rate is 30%.

You are required to:

(a) Calculate the adjusted present value of the investment,
(b) Calculate the adjusted discount rate and
(c) Explain the circumstances under which this adjusted discount rate may be used to evaluate future
investments.

Answer
(a) Calculation of Adjusted Present Value of Investment (APV):

Adjusted PV = Base Case PV + PV of financing decisions associated with the project

7.22
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Base Case NPV for the project:

(-) `270 lakhs + (`42 lakhs / 0.14) = (-) `270 lakhs + `300 lakhs = `30 lakhs

Issue costs = `10 lakhs

Thus, the amount to be raised = `270 lakhs + `10 lakhs = `280 lakhs

Annual tax relief on interest = `280 × 0.1 × 0.3 = `8.4 lakhs p.a.

The value of tax relief in perpetuity = `8.4 lakhs / 0.1 = `84 lakhs

Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= `30 lakhs – `10 lakhs + `84 lakhs = `104 lakhs

(b) Calculation of Adjusted Discount Rate (ADR):

Annual Income or Savings required to allow an NPV to zero

(-) `280 lakhs + (Annual Income / 0.14) = (-) `104 lakhs

Annual Income / 0.14 = (-) `104 lakhs + `280 lakhs
Therefore, Annual income = `176 × 0.14 = `24.64 lakhs

Adjusted discount rate = (`24.64 lakhs / `280 lakhs) × 100

= 8.8%

(c) Useable circumstances:

This ADR may be used to evaluate future investments only if the business risk of the new venture
is identical to the one being evaluated here and the project is to be financed by the same
method on the same terms. The effect on the company’s cost of capital of introducing debt into
the capital structure cannot be ignored.

INTERNAL RATE OF RETURN (IRR)

BQ 26
Using details given below, calculate IRR of an investment of `1,36,000:
Year Cash Inflows
1 `30,000
2 `40,000
3 `60,000
4 `30,000
5 `20,000

Answer
Let us calculate NPV by 10% randomly:
Years ` PVF @ 10% PV
0 (1,36,000) 1.000 (1,36,000)
1 30,000 0.909 22,270
2 40,000 0.826 33,040

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

3 60,000 0.751 45,060

4 30,000 0.683 20,490
5 20,000 0.621 12,420
NPV 2,280

The net present value at 10% comes to `2,280. Therefore, a higher discount rate is suggested, say, 12%.

NPV by 12% randomly:

Years ` PVF @ 12% PV
0 (1,36,000) 1.000 (1,36,000)
1 30,000 0.893 26,790
2 40,000 0.797 31,880
3 60,000 0.712 42,720
4 30,000 0.636 19,080
5 20,000 0.567 11,340
NPV (4,190)

The internal rate of return is, thus, more than 10% but less than 12%. The exact rate can be obtained by
interpolation:
NPVL 2,280
IRR = L+  (H  L ) = 10% + × (12% - 10%)
NPVL  NPVH 2 ,280  (  4 ,190 )
= 10.70%

BQ 27
A Ltd. is evaluating a project involving an outlay of `10,00,000 resulting in an annual cash inflow of
`2,50,000 for 6 years. Assuming salvage value of the project is zero determine the IRR of the project.

Answer
First of all we shall find an approximation of the payback (PVIFAIRR) period:

PVIFAIRR = 10,00,000 ÷ 2,50,000 = 4

Now we shall search this figure in the PVAF table corresponding to 6 years row. The value 4 lies between
values 4.111 and 3.998 correspondingly discounting rates 12% and 13% respectively.

NPV12% = (10,00,000) + 4.111 × 2,50,000 = 27,750

NPV13% = (10,00,000) + 3.998 × 2,50,000 = (500)

The internal rate of return is, thus, more than 12% but less than 13%. The exact rate can be obtained by
interpolation:
2 ,775
IRR = 12% + × (13% - 12%) = 12.98%
2 ,775  (  50 )

BQ 28
A Company proposes to install a machine involving a capital cost of `3,60,000. The life of the machine is
5 years and its salvage value at the end of the life is nil. The machine will produce the net operating
income after depreciation of `68,000 per annum. The Company’s tax rate is 45%.

The Net Present Value factors for 5 years as under:

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Discounting Rate: 14% 15% 16% 17% 18%

Cumulative factor: 3.43 3.35 3.27 3.20 3.13

You are required to calculate the internal rate of return of the proposal.

Answer
PV of outflow 3 ,60 ,000
Sum of DF @ IRR for 4 years = = = 3.29
Annual CFAT 1 ,09 ,400

The internal rate of return is, thus, more than 15% but less than 16%. The exact rate can be obtained by
interpolation:

NPVLR 6,490
IRR = LR + NPV − NPVHR
× (HR - LR) = 15% + 6,490 + 2,262 × (16% - 15%)
LR
= 15.74%

Calculation of NPV at 15% and 16%:

NPV15% = (3,60,000) + 3.35 × 1,09,400 = 6,490

NPV16% = (3,60,000) + 3.27 × 1,09,400 = (2,262)

Computation of cash inflow per annum:

Net operating income per annum `68,000
Less: Tax @ 45% `30,600
Profit after tax `37,400
Add: Depreciation (`3,60,000 ÷ 5 years) `72,000
Cash inflow (CFAT) `1,09,400

BQ 29
The cash of flows of projects X and Y are given below:

Cash Flow (`)

Projects Year 0 Year 1 Year 2 Year 3 NPV @ 10% IRR
X -10,000 +2,000 +4,000 +12,000 +4,134 26.5%
Y -10,000 +10,000 +3,000 +3,000 +3,821 37.6%

(a) Why is there a conflict in ranking?

(b) Why should you recommend project X in spite of a lower rate of return?

Answer
(a) Out of the two projects X and Y, the former is having higher NPV (10% rate) of `4,134 and is
preferable. However, as per the IRR method the Project Y is preferable as it having IRR of 37.6%. So,
there is a conflict in ranking of projects.

The reason for this conflict may be traced in the pattern of cash inflows estimating from two
projects. It may be noticed that inflows from project X are higher is later years while from Project Y the
cash inflows are higher in earlier years. The reinvestment rate assumption implies that inflows are
reinvested in the NPV method at the discount rate, while in case of IRR method the inflows are
reinvested at IRR rate itself. The pattern of inflows and the reinvestment rate assumption make the
ranking to differ from each other.

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

(b) Inspite of lower IRR of 26.5% the project X may be recommended as it is having the incremental
NPV of `313 (`4,134 - `3,821) and will lead to higher increase in the wealth of the shareholders.

MODIFIED INTERNAL RATE OF RETURN (MIRR)

BQ 30
Using details given below, calculate MIRR considering 8% cost of Capital.

Year Cash Flow

0 (`1,36,000)
1 `30,000
2 `40,000
3 `60,000
4 `30,000
5 `20,000

Answer
Statement of Compounding Value
Years Particulars ` CVF @ 8% CV
1 Cash inflow 30,000 1.3605 40,815
2 Cash inflow 40,000 1.2597 50,388
3 Cash inflow 60,000 1.1664 69,984
4 Cash inflow 30,000 1.0800 32,400
5 Cash inflow 20,000 1.0000 20,000
Compound Value of Cash Inflow 2,13,587

Calculation of MIRR:
Compound value of inflow 2,13,587
Compound Factor = = = 1.5705
Initial outflow 1,36,000

5
MIRR = √1.5705 - 1 = 9.45%

MISCELLANEOUS

BQ 31
Navjeevani hospital is considering to purchase a machine for medical projectional radiography which is
priced at `2,00,000. The projected life of the machine is 8 years and has an expected salvage value of
`18,000 at the end of 8th year. The annual operating cost of the machine is `22,500. It is expected to
generate revenues of `1,20,000 per year for eight years. Presently, the hospital is outsourcing the
radiography work to its neighbour Test Center and is earning commission income of `36,000 per
annum, net of taxes. Consider tax @30%.

Analyse whether it would be profitable for the hospital to purchase the machine? Give your
recommendation under:

(i) Net Present Value method,

(ii) Profitability Index method.

PV factors at 10% are given below:

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Answer
(i) Net Present Value
Year Particulars ` DF @ 10% PV
0 Initial outflows (2,00,000) 1.000 (2,00,000)
1–8 Cash Flow After Tax 39,075 5.334 2,08,426
8 Salvage 18,000 0.467 8,406
NPV 16,832

PV of Inflows 2,16 ,832

(ii) Profitability Index = = = 1.084
PV of Outflows 2 ,00 ,000

Working Notes:
Calculation of CFAT:
Particulars `
Sales 1,20,000
Less: Operating cost 22,500
Less: Depreciation (2,00,000 – 18,000) ÷ 8 years 22,750
Net Income 74,750
Less: Tax @ 30% 22,425
PAT 52,325
Add: Depreciation 22,750
Cash inflows after tax per annum 75,075
Less: Loss of commission income 36,000
Net CFAT 39,075
Advise: Since the net present value (NPV) is positive and profitability index is also greater than 1, the
hospital may purchase the machine.

BQ 32
Lockwood Limited wants to replace its old machine with a new automatic machine. Two models A and
B are available at the same cost of `5 lakhs each. Salvage value of the old machine is `1 lakh. The utilities
of the existing machine can be used if the company purchases A. Additional cost of utilities to be
purchased in that case are `1 lakh. If the company purchases B then all the existing utilities will have to
be replaced with new utilities costing `2 lakhs. The salvage value of the old utilities will be `0.20 lakhs.
The cash flows after taxation are expected to be:
Year A B
1 `1,00,000 `2,00,000
2 `1,50,000 `2,10,000
3 `1,80,000 `1,80,000
4 `2,00,000 `1,70,000
5 `1,70,000 `40,000
Salvage Value at the end of Year 5 `50,000 `60,000
The targeted return on capital is 15%.
You are required to:
(a) Compute, for the two machines separately, Net Present Value, Discounted Payback Period and
Desirability Factor and

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

(b) Advice which of the machines is to be selected?

Answer
(a) Net Present Value
NPV Factor @ Machine A Machine B
Year
15% Cash Inflows Discounted CF Cash Inflows Discounted CF
0 1.0000 (5,00,000) (5,00,000) (5,80,000) (5,80,000)
1 0.8696 1,00,000 86,960 2,00,000 1,73,920
2 0.7561 1,50,000 1,13,415 2,10,000 1,58,781
3 0.6575 1,80,000 1,18,350 1,80,000 1,18,350
4 0.5718 2,00,000 1,14,360 1,70,000 97,206
5 0.4972 1,70,000 84,524 40,000 19,888
Salvage 0.4972 50,000 24,860 60,000 29,832
NPV 42,469 17,977

Discounted Payback Period

Machine A Machine B
Year
Discounted CF Cum Discounted CF Discounted CF Cum Discounted CF
1 86,960 86,960 1,73,920 1,73,920
2 1,13,415 2,00,375 1,58,781 3,32,701
3 1,18,350 3,18,725 1,18,350 4,51,051
4 1,14,360 4,33,085 97,206 5,48,257
5 1,09,384 5,42,469 49,720 5,97,977

5,00,000 − 4,33,085
Machine A = 4 years + = 4.612 years
1,09,384

5,80,000 − 5,48,257
Machine B = 4 years + 49,720
= 4.638 years

PV of Inflows
Profitability Index (PI) =
PV of Outflows

5,42,469
Machine A = = 1.085
5,00 ,000

5,97 ,977
Machine B = = 1.031
5,80 ,000

Working note:
Calculation of Initial Investment
Particulars Machine A Machine B
Cost of Machine 5,00,000 5,00,000
Add: Cost of Utilities 1,00,000 2,00,000
Less: Salvage of Old Machine (1,00,000) (1,00,000)
Less: Salvage of Old Utilities - (20,000)
Initial Investment `5,00,000 `5,80,000

(b) Since the absolute surplus in the case of A is more than B and also the desirability factor, it is better
to choose A. The discounted payback period in both the cases is same, also the net present value is

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

positive in both the cases but the desirability factor (profitability index) is higher in the case of
Machine A, it is therefore better to choose Machine A.

BQ 33
Hindlever Company is considering a new product line to supplement its range line. It is anticipated that
the new product line will involve cash investments of `7,00,000 at time 0 and `10,00,000 in year 1.
After-tax cash inflows of `2,50,000 are expected in year 2, `3,00,000 in year 3, `3,50,000 in year 4 and
`4,00,000 each year thereafter through year 10. Although the product line might be viable after year 10,
the company prefers to be conservative and end all calculations at that time.
(a) If the required rate of return is 15 per cent, what is the net present value of the project? Is it
acceptable?
(b) What would be the case if the required rate of return were 10 per cent?
(c) What is its internal rate of return?
(d) What is the project’s payback period?

Answer
(a) Statement of NPV
Years Cash Inflow (`) PVF @ 15% Present Value
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.870 (8,70,000)
2 2,50,000 0.756 1,89,000
3 3,00,000 0.658 1,97,400
4 3,50,000 0.572 2,00,200
5 - 10 4,00,000 2.164 8,65,600
NPV (1,17,800)

(b) Statement of NPV

Years ` PVF @ 10% PV
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.909 (9,09,000)
2 2,50,000 0.826 2,06,500
3 3,00,000 0.751 2,25,300
4 3,50,000 0.683 2,39,050
5 - 10 4,00,000 2.975 11,90,000
NPV 2,51,850

NPVLR 2,51,850
(c) IRR = LR + NPV − NPVHR
× (HR - LR) = 10% + 2,51,850 + 1,17,800 × (15% - 10%)
LR
= 13.41%

(d) Payback Period = -7,00,000 – 10,00,000 + 2,50,000 + 3,00,000 + 3,50,000 + 4,00,000 +

4,00,000
= 6 Years

BQ 34
Elite Cooker Company is evaluating three investment situations: (1) produce a new line of aluminum
skillets, (2) expand its existing cooker line to include several new sizes, and (3) develop a new, higher-
quality line of cookers. If only the project in question is undertaken, the expected present values and the
amounts of investment required are:

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Project Investment required PV of future cash flows

1 `2,00,000 `2,90,000
2 `1,15,000 `1,85,000
3 `2,70,000 `4,00,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and
present values will simply be the sum of the parts. With projects 1 and 3, economies are possible in
investment because one of the machines acquired can be used in both production processes. The total
investment required for projects 1 and 3 combined is `4,40,000. If projects 2 and 3 are undertaken,
there are economies to be achieved in marketing and producing the products but not in investment. The
expected present value of future cash flows for projects 2 and 3 is `6,20,000. If all three projects are
undertaken simultaneously, the economies noted will still hold. However, a `1,25,000 extension on the
plant will be necessary, as space is not available for all three projects.

Which project or projects should be chosen?

Answer
Statement of Cumulative NPV of Different Combinations
Project Investment required PV of future CF Net Present Value
1 `2,00,000 `2,90,000 `90,000
2 `1,15,000 `1,85,000 `70,000
3 `2,70,000 `4,00,000 `1,30,000
1 and 2 `3,15,000 `4,75,000 `1,60,000
1 and 3 `4,40,000 `6,90,000 `2,50,000
2 and 3 `3,85,000 `6,20,000 `2,35,000
1, 2 and 3 `6,80,000* `9,10,000 `2,30,000
(Refer working note)

Calculation of total investment required if all the three projects are undertaken simultaneously:

Total investment = Investment in project 1&3 + Investment in project 2 + Plant extension cost
= 4,40,000 + 1,15,000 + 1,25,000 = `6,80,000

Advise: Projects 1 and 3 should be chosen, as they provide the highest net present value.

BQ 35
Following data has been available for a capital project:
Annual cost of saving `1,00,000
Useful life 4 years
Salvage value zero
Internal rate of return 12%
Profitability index 1.064

You are required to calculate the following for this project:

(a) Cost of the project
(b) Cost of capital
(c) Net present value
(d) Payback period

PV factors at different rates are given below:

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Years
Discount Factor
1 2 3 4
12% 0.893 0.797 0.712 0.636
11% 0.901 0.812 0.731 0.659
10% 0.909 0.826 0.751 0.683
9% 0.917 0.842 0.772 0.702

Answer
(a) Cost of the project:
At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cost of saving × Cumulative discount factor
@ IRR 12% for 4 years
= `1,00,000 × 3.038

Cost of project = `3,03,800

(b) Cost of Capital:

Pr esent Value of Inflows 3,23 ,243 .20
Cum DF @ cost of capital for 4 years = =
Annual Inflows 1 ,00 ,000
= 3.232

From the discount factor table, at discount rate of 9%, the cumulative discount factor for four years
is 3.233 (0.917 + 0.842 + 0.772+ 0.702)

Hence, Cost of capital = 9%

(c) Net Present Value of cash inflows:

PV of Inflows
PI =
PV of Outflows
PV of Inflows
1.064 =
3,03,800
PV of Inflows = 3,03,800 × 1.064 = `3,23,243

NPV = PV of inflows – PV of outflows

= `3,23,243.20 – `3,03,800 = `19,443.20

(d) Payback Period:

Initial Outflow 3 ,03 ,800
Payback period = =
Equal Annual Cash Inflows 1 ,00 ,000
= 3.038 years

BQ 36
Alley Pvt. Ltd. is planning to invest in a machinery that would cost `1,00,000 at the beginning of year 1.
Net cash inflows from operations have been estimated at `36,000 per annum for 3 years. The company
has two options for smooth functioning of the machinery: one is service, and another is replacement of
parts. If the company opts to service a part of the machinery at the end of year 1 at `20,000, in such a
case, the scrap value at the end of year 3 will be `25,000. However, if the company decides not to service
the part, then it will have to be replaced at the end of year 2 at `30,800 and in this case, the machinery

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

will work for the 4th year also and get operational cash inflow of `36,000 for the 4th year. It will have to
be scrapped at the end of year 4 at `18,000.

Assuming cost of capital at 10% and ignoring taxes, determine the purchase of this
machinery based on the net present value of its cash flows? If the supplier gives a discount of
`10,000 for purchase, what would be your decision?

The PV factors at 10% are:

Year 0 1 2 3 4 5 6
PV Factor 1 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645

Answer
Option 1 (Part of the Machine is serviced):
Statement of NPV
Year Particulars ` PV Factor @ 10% PV of Cash flow
0 Initial Outflows (1,00,000) 1.0000 (1,00,000)
1 Inflows – Service 36,000 – 20,000 0.9091 14,546
2 Charges 36,000 0.8264 29,750
3 Inflows 36,000 + 25,000 0.7513 45,829
Inflows + Salvage
NPV (9,875)

Option 2 (Part of the Machine is replaced):

Statement of NPV
Year Particulars ` PV Factor @ 10% PV of Cash flow
0 Initial Outflows (1,00,000) 1.0000 (1,00,000)
1 Inflows 36,000 0.9091 32,728
2 Inflows – Replacement 36,000 – 30,800 0.8264 4,297
3 Inflows 36,000 0.7513 27,047
4 Inflows + Salvage 36,000 + 18,000 0.6830 36,882
NPV 954

Decision: Option I has a negative NPV whereas option II has a positive NPV `954. Therefore, option II
(replacement of part) shall be opted.

If the supplier gives a discount of `10,000 for purchases:

Option 1: NPV = (9,875) + 10,000 = 125

Option 2: NPV = 954 + 10,000 = 10,954

Decision: Option I with very small NPV is not considerable, Option II having higher NPV shall be opted
(student can also show annualized NPV due to difference in life of projects).

BQ 37
A large profit making company is considering the installation of a machine to process the waste
produced by one of its existing manufacturing process to be converted into a marketable product. At
present, the waste is removed by a contractor for disposal on payment by the company of `150 lakh per

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

annum for the next four years. The contract can be terminated upon installation of the aforesaid machine
on payment of a compensation of `90 lakh before the processing operation starts. This compensation is
not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost `600 lakh. At the end of the 4th year, the
machine can be sold for `60 lakh and the cost of dismantling and removal will be `45 lakh.
Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:
(` In Lakh)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63

Initial stock of materials required before commencement of the processing operations is `60 lakh at the
start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be `165
lakh and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would
otherwise have been rented out for `30 lakh per annum. Labour costs include wages of 40 workers,
whose transfer to this process will reduce idle time payments of `45 lakh in the year 1 and `30 lakh in
the year 2. Factory overheads include apportionment of general factory overheads except to the extent
of insurance charges of `90 lakh per annum payable on this venture. The company’s tax rate is 30%.

Present value factors for four years are as under:

Year 1 2 3 4
PV Factors @14% 0.877 0.769 0.674 0.592

Advise the management on the desirability of installing the machine for processing the
waste. All calculations should form part of the answer.

Answer
Net Present Value (` In Lakh)
Year Particulars ` DF @ 14% PV
0 Initial outflows (Cost of Machine + Compensation (750) 1.000 (750)
+ Material stock) (600 + 90 + 60)
1 CFAT – Increase in stock (469.2 – 105) 364.2 0.877 319.40
2 CFAT 416.4 0.769 320.21
3 CFAT 453.6 0.674 305.73
4 CFAT + Decrease in stock + Net salvage 562.2 0.592 332.82
(382.2 + 165 + 15)
NPV 528.16

Advice: Since the net present value of cash flows is `528.16 lakhs which is positive the management
should install the machine for processing the waste.

Working Notes: Statement of CFAT (` In Lakh)

Particulars 1 2 3 4
Sales 966 966 1,254 1,254
Add: Saving in Contract payment 150 150 150 150

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Less: Material consumption (90) (120) (255) (255)

Less: Wages (net of reduction in idle time) (180) (195) (255) (300)
Less: Other expenses (120) (135) (162) (210)
Less: Factory overheads (only insurance charges) (90) (90) (90) (90)
Less: Loss of rent (opportunity cost) (30) (30) (30) (30)
Less: Depreciation (as per income tax rules) (150) (114) (84) (63)
PBT 456 432 528 456
Less: Tax @ 30% (136.8) (129.6) (158.4) (136.8)
PAT 319.2 302.4 369.6 319.2
Add: Depreciation 150 114 84 63
CFAT 469.2 416.4 453.6 382.2

Notes:
1. Material stock increases are taken in cash flows.
2. Idle time wages have also been considered.
3. Apportioned factory overheads are not relevant only insurance charges of this project are
relevant.
4. Sale of machinery - Net income after deducting removal expenses taken. Tax on Capital gains is
ignored.
5. Saving in contract payment and income tax thereon is considered in the cash flows.

BQ 38
Alpha Company is considering the following investment projects:
Cash Flows (`)
Projects
C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +7,500 +7,500
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000

(a) Rank the projects according to each of the following methods: (i) Payback, (ii) ARR, (iii) IRR and
(iv) NPV, assuming discount rates of 10 and 30 per cent.
(b) Assuming the projects are independent, which one should be accepted? If the projects are
mutually exclusive, which project is the best?

Answer
(a) Calculation of Payback, ARR, IRR and NPV:
(i) Payback Period:
Project A = 10,000÷10,000 = 1 year
Project B = 7,500 + 2,500÷7,500 = 1.33 years
Project C = 2,000 + 4,000 + 4,000÷12,000 = 2.33 years
Project D = 10,000÷10,000 = 1 year

(ii) ARR using average investment base:

(10 ,000  10 ,000 )

Project A = ×100 = 0%
10 ,000  ½

(15 ,000  10 ,000 )  2

Project B = ×100 = 50%
10 ,000  ½

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

(18 ,000  10 ,000 )  3

Project C = ×100 = 53.33%
10 ,000  ½
(16 ,000  10 ,000 )  3
Project D = ×100 = 40%
10 ,000  ½

Note: Average book profit is found by deducting initial investment, otherwise student may deduct
depreciation year wise.

(iii) IRR:
Project A (The net cash proceeds in year 1 are just equal to investment):
IRR = 0%

Project B (Uniform cash inflow, so we can calculate IRR by PVAF):

PVAF for 2 years = 10,000÷7,500 = 1.33 (This factor is found under 32%)
IRR = 32%

Project C (Unequal cash inflow, so we can calculate IRR by computing NPV using random rates):
NPV at 20% = 2,000 × 0.833 + 4,000 × 0.694 + 12,000 × 0.579 - 10,000 = +1,390

NPV at 30% = 2,000 × 0.769 + 4,000 × 0.592 + 12,000 × 0.455 - 10,000 = -634

NPV L 1 ,390
IRR = L+  (H  L ) = 20% +  (30 %  20 %)
NPV L  NPV H 1 ,390  ( 634 )
= 26.87%

Project D (Unequal cash inflow, so we can calculate IRR by computing NPV using random rates):
NPV at 30% = 10,000 × 0.769 + 3,000 × 0.592 + 3,000 × 0.455 - 10,000
= +831
NPV at 40% = 10,000 × 0.714 + 3,000 × 0.510 + 3,000 × 0.364 - 10,000
= -238
NPV L 831
IRR = L+  (H  L ) = 30% +  ( 40 %  30 %)
NPV L  NPV H 831  ( 238 )
= 37.77%
(iv) NPV:
Project A:
NPV at 10% = 10,000 × 0.909 – 10,000 = - 9 10

NPV at 30% = 10,000 × 0.769 = -2,310

Project B:
NPV at 10% = 7,500 × (0.909 + 0.826) – 10,000 = +3,013
NPV at 30% = 7,500 × (0.769 + 0.592) – 10,000 = +208
Project C:
NPV at 10% = 2,000 × 0.909 + 4,000 × 0.826 +12,000 × 0.751 – 10,000

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

= +4,134
NPV at 30% = 2,000 × 0.769 + 4,000 × 0.592 + 12,000 × 0.455 – 10,000
= -633
Project D:
NPV at 10% = 10,000 × 0.909 + 3,000 × (0.826 + 0.751) – 10,000 = +3,821
NPV at 30% = 10,000 × 0.769 + 3,000 × (0.592 + 0.455) – 10,000 = +831

The projects are ranked as follows according to the various methods:

Ranks
Projects PBP ARR IRR NPV 10% NPV 30%
A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3
D 1 3 1 2 1

(b) Payback and ARR are theoretically unsound method for choosing between the investment
projects. Between the two time-adjusted (DCF) investment criteria, NPV and IRR, NPV gives consistent
results. If the projects are independent (and there is no capital rationing), either IRR or NPV can be used
since the same set of projects will be accepted by any of the methods. In the present case, except Project
A all the three projects should be accepted if the discount rate is 10%. Only Projects B and D should be
undertaken if the discount rate is 30%.

If it is assumed that the projects are mutually exclusive, then under the assumption of 30%
discount rate, the choice is between B and D (A and C are unprofitable). Both criteria IRR and NPV give
the same results – D is the best. Under the assumption of 10% discount rate, ranking according to IRR
and NPV conflict (except for Project A). If the IRR rule is followed, Project D should be accepted. But the
NPV rule tells that Project C is the best. The NPV rule generally gives consistent results in conformity
with the wealth maximization principle. Therefore, Project C should be accepted following the NPV rule.

BQ 39
The expected cash flows of three projects are given below. The cost of capital is 10 per cent.

(a) Calculate the payback period, net present value, internal rate of return and accounting rate of
return using average investment base of each project.
(b) Show the rankings of the projects by each of the four methods.

Period Project A (`) Project B (`) Project C (`)

0 (5,000) (5,000) (5,000)
1 900 700 2,000
2 900 800 2,000
3 900 900 2,000
4 900 1,000 1,000
5 900 1,100 -
6 900 1,200 -
7 900 1,300 -
8 900 1,400 -
9 900 1,500 -

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

10 900 1,600 -
Answer
(a) Calculation of Payback, NPV, IRR and ARR:

Payback Period:
Project A = 5,000 ÷ 900 = 5.56 years

Project B = 700 + 800 + 900 + 1,000 + 1,100 + 500 ÷ 1,200 = 5.42 years

Project C = 2,000 + 2,000 + 1,000 ÷ 2,000 = 2.50 years

NPV:
Project A:
NPV at 10% = 900 × 6.145 – 5,000 = 530.50

Project B:
NPV at 10% = 700 × 0.909 + 800 × 0.826 + 900 × 0.751 + 1,000 × 0.683 + 1,100 × 0.621
+ 1,200 × 0.564 + 1,300 × 0.513 + 1,400 × 0.467 + 1,500 × 0.424 + 1,600 ×
0.386 – 5,000 = 1,590.20

Project C:
NPV at 10% = 2,000 × 0.909 + 2,000 × 0.826 + 2,000 × 0.751 + 1,000 × 0.683 – 5,000
= 655

IRR:
Project A (Uniform cash inflow, so we can calculate IRR by PVAF):

PVAF10 years = 5,000 ÷ 900 = 5.55

(This factor is found between 12% and 13%)

NPV at 12% = 900 × 5.650 – 5,000 = 85.00

NPV at 13% = 900 × 5.426 – 5,000 = (116.60)

NPV L 85
IRR = L+  (H  L ) = 12% + 85 + 116.60 (13% - 12%)
NPV L  NPV H
= 12.42%

Project B (Unequal cash inflow, so we can calculate IRR by computing NPV using random rates):

NPV at 10% = 1,590.20

NPV at 20% = 700 × 0.833 + 800 × 0.694 + 900 × 0.579 + 1,000 × 0.482 + 1,100 × 0.402
+ 1,200 × 0.335 + 1,300 × 0.279 + 1,400 × 0.233 + 1,500 × 0.194 + 1,600 ×
0.162 – 5,000 = (775.30)

NPV L 1,590.20
IRR = L+  (H  L ) = 10% + 1,590.20 + 775.30 (20% - 10%)
NPV L  NPV H
= 16.72%

Project C (Unequal cash inflow, so we can calculate IRR by computing NPV using random rates):

7.37
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

NPV at 15% = 2,000 × 0.870 + 2,000 × 0.756 + 2,000 × 0.658 + 1,000 × 0.572 – 5,000
= 140

NPV at 18% = 2,000 × 0.847 + 2,000 × 0.718 + 2,000 × 0.609 + 1,000 × 0.516 – 5,000
= (136)

NPV L
IRR = L+  (H  L )
NPV L  NPV H
140
= 15% + (18% - 15%)
140 + 136

= 16.52%

ARR using average investment base:

Average Pr ofit
ARR = × 100
Average investment

400
Project A = 5,000 × 1/2
×100 = 16%

650
Project B = ×100 = 26%
5,000 × 1/2

500
Project C = 5,000 × 1/2
×100 = 20%

Working Note:

Total Cash Inflow − Initial Investment

Average Profit= Life

9,000 − 5,000
Project A = 10 Years
= 400 per annum

11,500 − 5,000
Project B = 10 Years
= 650 per annum

7,000 − 5,000
Project A = 4 Years
= 500 per annum

Note: Average book profit is found by deducting initial investment, otherwise student may deduct
depreciation year wise.

(b) The projects are ranked as follows according to the various methods:
PBP ARR IRR NPV
Projects PBP ARR IRR NPV
(Years) (%) (%) (`)
A 5.56 16 12.42 530.50 3 3 3 3
B 5.42 26 16.72 1,590.20 2 1 1 1
C 2.50 20 16.52 655 1 2 2 2

BQ 40

7.38
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

R plc is considering modernizing its production facilities and it has two proposals under consideration.
The expected cash flows associated with these projects and their NPV as per discounting rate of 12%
and IRR is as follows:
Cash Flow
Year
Project A (`) Project B (`)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000 -
5 11,00,000 -
6 10,00,000 -
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%

Identify which project should R plc accept?

Answer
Although from NPV point of view Project A appears to be better but from IRR point of view Project B
appears to be better. Since, both projects have unequal lives selection on the basis of these two methods
shall not be proper. In such situation we shall use Equivalent Annualized Criterion:

Year Project A Project B

NPV @ 12% `6,49,094 5,15,488
÷ PVAF @ 12% ÷ 4.112 ÷ 2.402
Equivalent Annualized Criterion `1,57,854 `2,14,608

Thus, Project B should be selected.

7.39
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

PAST YEAR QUESTIONS

PYQ 1
FH Hospital is considering to purchase a CT- Scan machine. Presently the hospital is outsourcing the CT-
Scan Machine and is earning commission of 15,000 per month (net of tax). The following details are
given regarding the machine:
Cost of CT-Scan machine `15,00,000
Operating cost per annum (excluding depreciation) `2,25,000
Expected revenue per annum `7,90,000
Salvage value of machine (after 5 years) `3,00,000
Expected life of machine 5 years

Assuming tax rate @ 30%, whether it would be profitable for the hospital to purchase the machine?

Give your recommendation under:

(i) Net Present Value Method, and
(ii) Profitability Index Method.

PV factors at 12% are given below:

Year 1 2 3 4 5
PV factor 0.893 0.797 0.712 0.636 0.567
[(8 Marks) May 2014]

Answer
(i) Net Present Value
Year Particulars ` DF @ 12% PV
0 Cost of CT-Scan machine (15,00,000) 1.000 (15,00,000)
1-5 Cash Flow After Tax 2,87,500 3.605 10,36,438
5 Salvage at the end 3,00,000 0.567 1,70,100
NPV (2,93,462)

Recommendation: CT-Scan machine should not be purchased having negative NPV.

(ii) Calculation of Profitability Index:

PV of Inflows 12 ,06 ,538
Profitability Index = = = 0.804
PV of Outflows 15 ,00 ,000

Recommendation: Since PI is less than 1, CT-Scan machine should not be purchased.

Working Notes:
Calculation of Incremental CFAT:
Particulars `
Expected revenue per annum 7,90,000
Less: Operating cost per annum (excluding depreciation) (2,25,000)
Less: Depreciation (15,00,000 - 3,00,000) ÷ 5 years (2,40,000)

7.40
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

PBT 3,25,000
Less: Tax @ 30% (97,500)
PAT 2,27,500
Less: Loss of commission income per annum (15,000 × 12) (1,80,000)
Add: Depreciation 2,40,000
CFAT 2,87,500

PYQ 2
Given below are the data on a capital project ‘M’:
Annual cash inflow `60,000
Useful life 4 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.064

Table of discount factor:

Years
Discount Factor
1 2 3 4
15% 0.870 0.756 0.658 0.572
14% 0.877 0.769 0.675 0.592
13% 0.886 0.783 0.693 0.614
12% 0.893 0.797 0.712 0.636

You are required to calculate:

(i) Cost of the project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value of cash inflow
[(8 Marks) May 2015]

Answer
(a) Cost of the project:

At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cost of saving × Cumulative discount factor
@ IRR for 4 years
= `60,000 × 2.855
Cost of project = `1,71,300

(b) Payback Period:

Initial Outflow 1,71 ,000
Payback period = =
Equal Annual Cash Inflows 60 ,000
= 2.855 years

(c) Cost of Capital:

Pr esent Value of Inflows 1 ,82 ,263 .20
Cum DF @ cost of capital for 4 years = =
Annual Inflows 60 ,000
= 3.038

7.41
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

From the discount factor table, at discount rate of 12%, the cumulative discount factor for four
years is 3.038 (0.893 + 0.797 + 0.712 + 0.636)
Hence, Cost of capital = 12%

(d) Net Present Value of cash inflows:

PV of Inflows
PI =
PV of Outflows
PV of Inflows
1.064 =
1 ,71 ,300
PV of Inflows = 1,71,300 × 1.064 = `1,82,263.2

NPV = PV of inflows – PV of outflows

= `1,82,263.20 – `1,71,300 = `10,963.20

PYQ 3
Domestic services (P) Ltd. is in the business of providing cleaning sewerage line services at homes. There
is a proposal before the company to purchase a mechanised sewerage cleaning system for a sum of `20
lakhs. The present system of the company is to use manual labour for the job.

You are provided with the following information:

Proposed Machanised System:

Cost of machine `20 lakhs
Life of machine 10 years
Depreciation (on straight line basis) 10%
Cash Operating cost of machanised system `5 lakhs per annum

Present System (manual):

Manual labour 200 persons

Cost of manual labour `10,000 per person per annum

The company has after tax cost of fund at 10% per annum. The applicable tax rate is 30%.

PV factor for 10 years at 10% are as given below:

Years 1 2 3 4 5 6 7 8 9 10
PV factor 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

You are required to find out whether it is advisable to purchase he machine. Give your
recommendation with workings.
[(8 Marks) June 2015]

Answer
Net Present Value
Year Particulars ` DF @ 10% PV
0 Cost of Machine (20,00,000) 1.000 (20,00,000)
1 - 10 Incremental CFAT 11,10,000 6.144 68,19,840
NPV 48,19,840

7.42
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Recommendation: Company should purchase the machine having positive NPV.

Working Notes:
Calculation of Incremental CFAT:
Particulars `
Saving in labour cost (200 persons @ `10,000 p.a.) 20,00,000
Less: Cash Operating cost of mechanized system p.a. (5,00,000)
Less: Depareciation (2,00,000)
PBT 13,00000
Less: Tax @ 30% (3,90,000)
PAT 9,10,000
Add: Depreciation (20,00,000 ÷ 10 years) 2,00,000
CFAT 11,10,000

PYQ 4
Given below are the data on a capital project ‘C’:
Cost of the project `2,28,400
Useful life 4 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.0417

You are required to calculate:

(a) Annual cash flow
(b) Cost of capital
(c) Net present value (NPV)
(d) Discounted Payback period

Table of discount factor:

Years
Discount Factor
1 2 3 4
15% 0.869 0.756 0.658 0.572
14% 0.877 0.769 0.675 0.592
13% 0.885 0.783 0.693 0.613
12% 0.893 0.797 0.712 0.636
[(8 Marks) May 2016]

Answer
(a) Annual cash flow:
At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cash inflow × Cumulative discount factor @ IRR for
4 years
2,28,400 = Annual cash inflow × 2.855
Annual cash Inflow = `80,000

(b) Cost of Capital:

7.43
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Present value of inflows = Annual cash inflow × Cumulative discount factor @ Cost of
Capital for 4 years
Cost of project + NPV = 80,000 × Cumulative discount factor @ Cost of Capital for 4
years
2,28,400 + 9,524 = 80,000 × PVIFA4
PVIFA 4 years = 2.974

Cost of capital = 13%

Alternatively
Pr esent Value of Inflows 2,37 ,924
Cum DF @ cost of capital4 years= =
Annual Inflows 80 ,000
= 2.974
Cost of capital = 13%

From the discount factor table, at discount rate of 13%, the cumulative discount factor for four years is
2.974 (0.885 + 0.783 + 0.693 + 0.613)

(c) Net Present Value (NPV):

NPV = Cost of project × (PI - 1) = 2,28,400 × (1.0417 - 1) = `9,524

(d) Discounted Payback Period:

Initial Outflows  Cumulative PV upto LLY

Discounted Payback Period = LLY +
PV of inf lows of ULY

= 3 years + 2 ,28 ,400  1 ,88 ,880 = 3.806 years

49 ,040

Working notes:
Calculation of PV of cash inflow cumulative PV of cash inflow:
Years PV of cash inflow Cumulative PV of cash inflow
1 80,000 × 0.885 = 70,800 70,800
2 80,000 × 0.783 = 62,640 1,33,440
3 80,000 × 0.693 = 55,440 1,88,880
4 80,000 × 0.613 = 49,040 2,37,920

PYQ 5
X Limited is considering to purchase of new plant worth `80,00,000. The rate of cost of capital is 10%.
You are required to calculate:
(a) Pay-back period
(b) Net present value at 10 discount factor
(c) Profitability index at 10 discount factor
(d) Internal rate of return with the help of 10% and 15% discount factor.

The expected net cash flows after taxes and before depreciation and present value table are as follows:

7.44
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Net Cash Flow Present value of 1 at Present value of 1 at

Year
(`) 10% discount rate 15% discount rate
1 14,00,000 .909 .870
2 14,00,000 .826 .756
3 14,00,000 .751 .658
4 14,00,000 .683 .572
5 14,00,000 .621 .497
6 16,00,000 .564 .432
7 20,00,000 .513 .376
8 30,00,000 .467 .327
9 20,00,000 .424 .284
10 8,00,000 .386 .247
[(8 Marks) May 2017]

Answer
(a) Payback period:
Payback period = 14,00,000 + 14,00,000 + 14,00,000 + 14,00,000 + 14,00,000 +
10,00,000/16,00,000 = 5.625 Years

(b) Calculation of NPV

Years Cash Inflow PVIF @ 10% Present value
0 80,00,000 1.000 (80,00,000)
1 14,00,000 .909 12,72,600
2 14,00,000 .826 11,56,400
3 14,00,000 .751 10,51,400
4 14,00,000 .683 9,56,200
5 14,00,000 .621 8,69,400
6 16,00,000 .564 9,02,400
7 20,00,000 .513 10,26,000
8 30,00,000 .467 14,01,000
9 20,00,000 .424 8,48,000
10 8,00,000 .386 3,08,800
NPV 17,92,200

(c) Calculation of PI:

Profitability index = PV of Inflow ÷ PV of Outflow

= 97,92,200 ÷ 80,00,000 = 1.224

(d) Calculation of IRR:

NPV at 10% = 17,92,200

NPV at 15% = 14,00,000 × 3.353 + 16,00,000 × .432 + 20,00,000 × .376 +

30,00,000 ×.327 + 20,00,000 × .284 + 8,00,000 × .247 – 80,00,000
= - 1,16,000

NPV L 17 ,92 ,200

IRR = L+ H L = 10% + × 5%
NPV L  NPV H 17 ,92 ,200 ( 1 ,16 ,000 )
= 14.70%

7.45
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

PYQ 6
A firm can make investment in either of the following projects. The firm anticipates its cost of capital to
be 10%. Pre-tax cash flows of the projects for five years are as follows:
Year 0 1 2 3 4 5
Project A (`) (2,00,000) 35,000 80,000 90,000 75,000 20,000
Project B (`) (2,00,000) 2,18,000 10,000 10,000 4,000 3,000

Ignore taxation. An amount of `35,000 will be spent on account of sales promotion in year 3 in case of
project A. this has not been taken into account in pre-tax cash inflows.

The discount factors are as under:

Year 0 1 2 3 4 5
PVF at 10% 1 0.91 0.83 0.75 0.68 0.62

You are required to calculate for each project:

(a) The payback period
(b) The discounted payback period
(c) Desirability factor
(d) Net present value
[(8 Marks) Nov 2017]

Answer
(a) Payback period:
Payback period A = 35,000 + 80,000 + 55,000 + 30,000/75,000 = 3.4 Years

Payback period B = 2,00,000/2,18,000 = 0.92 Years

Calculation of Present Value of pre-tax cash inflows:

Years Cash Inflow A Cash Inflow B PVIF @ 10% Present value Present value
A B
1 35,000 2,18,000 .91 31,850 1,98,380
2 80,000 10,000 .83 66,400 8,300
3 55,000 10,000 .75 41,250 7,500
4 75,000 4,000 .68 51,000 2,720
5 20,000 3,000 .62 12,400 1,860
Total 2,02,900 2,18,760

(b) Discounted payback period:

Discounted payback A = 31,850 + 66,400 + 41,250 + 51,000 + 9,500/12,400
= 4.77 Years
Discounted payback B = 1,98,380 + 1,620/8,300 = 1.2 Years

(c) Desirability factor:

Desirability factor = PV of Inflow ÷ PV of Outflow
Project A = 2,02,900 ÷ 2,00,000 = 1.0145
Project B = 2,18,760 ÷ 2,00,000 = 1.0938

7.46
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

(d) NPV:

NPV = PV of Inflow - PV of Outflow

Project A = 2,02,900 - 2,00,000 = 2,900

Project B = 2,18,760 - 2,00,000 = 18,760

PYQ 7
A proposal to invest in a project, which has a useful life of 5 years and no salvage value at the end of
useful life, is under consideration of a firm. It is anticipated that the project will generate a steady cash
inflow of `70,000 per annum. After analyzing other facts of the project, the following information were
revealed:
Internal rate of return 13%
Profitability index 1.07762

Table of discount factor:

Discount Years
Total
Factor 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621 3.790
11% 0.901 0.812 0.731 0.659 0.593 3.696
12% 0.893 0.797 0.712 0.636 0.567 3.605
13% 0.885 0.783 0.693 0.613 0.543 3.517

You are required to calculate:

(1) Cost of the project
(2) Payback period
(3) Net present value
(4) Cost of capital
[(8 Marks) May 2018]

Answer
(1) Cost of the project:
At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cash inflows × Cumulative discount factor
@ IRR for 5 years
= `70,000 × 3.517
Cost of the project = `2,46,190

(2) Payback Period:

Initial Outflow 2,46,190
Payback period = Annual Cash Inflow
= 70,000
= 3.517 years

(3) Net Present Value:

PV of Inflows PV of Inflow
PI = = 2,46,190
PV of Outflows
PV of Inflows = 2,46,190 × 1.07762 = `2,65,299

NPV = PV of inflows – PV of outflows

7.47
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

= `2,65,299 – `2,46,190 = `19,109

(4) Cost of Capital:

Pr esent Value of Inflows 2,65,299
Cum DF @ cost of capital for 5 years = = 70,000
Annual Inflows
= 3.790
Cost of capital = 10% (Given in table)

PYQ 8
PD Ltd. an existing company is planning to introduce a new product with projected life of 8 years. Project
cost will be `2,40,00,000. At the end of 8 years no residual value will be realized. Working capital of
`30,00,000 will be needed. The 100% capacity of the project is 2,00,000 units p.a. but the production
and sales volume are expected as under:
Year Units
1 60,000
2 80,000
3-5 1,40,000
6-8 1,20,000

Other information:
1. Selling price per unit `200.
2. Variable cost is 40% of sales.
3. Fixed cost p.a. `30,00,000.
4. In addition to these advertisement expenditure will have to be incurred as under:
Year (` in lacs)
1 50
2 25
3-5 10
6-8 5
5. Income tax is 25%.
6. Straight line method of depreciation is permissible for tax purpose.
7. Cost of capital is 10%.
8. Assume that loss cannot be carried forward.
Present value table
Year 1 2 3 4 5 6 7 8
PVF@10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
Advise about the project acceptability.
[(10 Marks) Nov 2018]

Answer
Net Present Value
Year Particulars ` DF @ 10% PV
0 Initial outflows (2,40,00,000 + 30,00,000) (2,70,00,000) 1.000 (2,70,00,000)
1 CFAT (8,00,000) 0.909 (7,27,200)
2 CFAT 38,25,000 0.826 31,59,450
3-5 CFAT 1,03,50,000 2.055 2,12,69,250
6–8 CFAT 89,25,000 1.544 1,37,80,200

7.48
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

8 Working Capital 30,00,000 0.467 14,01,000

NPV 1,18,82,700
Company should accept the proposal having positive NPV of the project.
Working Notes:
Original Cost less Salvage 2 ,40 ,00 ,000
1. Depreciation: = = = 30,00,000
Life of Equipment 8 Years

2. Statement showing CFAT:

Particulars 1 2 3–5 6–8
Units sold 60,000 80,000 1,40,000 1,20,000
Sales @ `200 p.u. 1,20,00,000 1,60,00,000 2,80,00,000 2,40,00,000
Less: VC @ 40% 48,00,000 64,00,000 1,12,00,000 96,00,000
Contribution 72,00,000 96,00,000 1,68,00,000 1,44,00,000
Less: Advertisement expenses (50,00,000) (25,00,000) (10,00,000) (5,00,000)
Less: Cash fixed cost (30,00,000) (30,00,000) (30,00,000) (30,00,000)
Less: Depreciation (30,00,000) (30,00,000) (30,00,000) (30,00,000)
PBT (38,00,000) 11,00,000 98,00,000 79,00,000
Less: Tax @ 25% - (2,75,000) (24,50,000) (19,75,000)
PAT (38,00,000) 8,25,000 73,50,000 59,25,000
Add: Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
CFAT (8,00,000) 38,25,000 1,03,50,000 89,25,000

PYQ 9
AT Limited is considering three projects A, B and C. the cash flows associated with the projects are given
below:
Projects Co C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000

You are required to:

(a) Calculate the payback period of each of the three projects.
(b) If the cut-off period is two years, then which projects should be accepted?
(c) Projects with positive NPV’s if the opportunity cost of capital is 10 percent.
(d) “Payback gives too much weight to cash flows that occur after the cut-off date”. True or false?
(e) “If a firm used a single cut-off period for all projects, it is likely to accept too many short lived
projects.” True or false?

Present value table

Year 0 1 2 3 4 5
PVF@10% 1.000 0.909 0.826 0.751 0.683 0.621
[(10 Marks) May 2019]

Answer
(a) Calculation of Cumulative Cash Flows:
Project A Project B Projects C
Years
Cash Flow Cum. CF Cash Flow Cum. CF Cash Flow Cum. CF
1 2,000 2,000 0 0 2,000 2,000

7.49
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

2 2,000 4,000 2,000 2,000 2,000 4,000

3 6,000 10,000 4,000 6,000 6,000 10,000
4 - - 6,000 12,000 10,000 20,000
Payback Period:
Project A = 3 Years
Project B = 2 Years
Project C = 3 Years

(b) If cut-off period is two years then company should accept projects B.

(c) NPV:
NPV = Present value of Inflow – Present value of outflow

Project A = 2,000 × 0.909 + 2,000 × 0.826 + 6,000 × 0.751 – 10,000 = (2,024)

Project B = 0 × 0.909 + 2,000 × 0.826 + 4,000 × 0.751 + 6,000 × 0.683 – 2,000

= 6,754

Project C = 2,000 × 0.909 + 2,000 × 0.826 + 6,000 × 0.751 + 10,000 × 0.683 – 10,000
= 4,806

Project B and C have positive NPV.

(d) False: Payback only considers cash flows from the initiation of the project till it’s payback period is
being reached, and ignores cash flows after the payback period.
(e) True: When a firm use a single cut-off period for all projects, it is likely to accept too many short
lived projects having payback period within such cut-off date. Long term projects take time to reach
at payback, in case of single cut-off date these long term projects are ignored. Thus, payback is biased
towards short-term projects.

PYQ 10
A company has `1,00,000 available for investment and has identified the following four investment in
which to invest:
Project Name Initial Investment NPV
C `40,000 `20,000
D `1,00,000 `35,000
E `50,000 `24,000
F `60,000 `18,000

You are required to optimise the returns from a package of projects within the capital
spending limit if:
(a) The projects are independent of each other and are divisible.
(b) The projects are not divisible.
[(5 Marks) Nov 2019]

Answer
(a) Statement of Rank and Selection of Projects (Divisible Situation)
Projects PI (1+ NPV/Investment) Rank Project Cost Project (%) Investment
C 1 + 20,000/40,000 =1.50 1 `40,000 100% `40,000
D 1 + 35,000/1,00,000 = 1.35 3 `1,00,000 10% `10,000

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

E 1 + 24,000/50,000 = 1.48 2 `50,000 100% `50,000

F 1 + 18,000/60,000 = 1.30 4 `60,000 - -
Total Investment `1,00,000
Optimum investment: 100% of C, E and 1/10 of D.

(b) Statement of Possible Combinations and Combined NPV (Indivisible Situation)

Possible Combinations Combined Investment Combined NPV
C+E `90,000 `44,000
C+F `1,00,000 `38,000
D `1,00,000 `35,000

Invest in combination of C and E having highest combined NPV and invest remaining `10,000
elsewhere.

PYQ 11
CK Ltd. is planning to buy a new machine. Details of which are as follows:
Cost of the machine at the commencement `2,50,000
Economic life of the machine 8 years
Residual value Nil
Annual production capacity of the machine 1,00,000 units
Estimated selling price per unit `6
Estimated variable cost per unit `3
Estimated annual fixed cost `1,00,000
(Excluding depreciation)
Advertisement expenses in 1st year in addition of fixed cost `20,000
Maintenance expenses in 5th year in addition of fixed cost `30,000
Cost of capital 12%
Ignore tax.

Analyse the above mentioned proposal using the Net Present Value method and advice.

The PV factors at 12% are:

Year 1 2 3 4 5 6 7 8
PV Factor .893 .797 .712 .636 .567 .507 .452 .404
[(5 Marks) Nov 2020]

Answer
Statement of NPV
Year Particulars ` DF @ 12% PV
0 Initial outflows (2,50,000) 1.000 (2,50,000)
1 Cash inflow 1,80,000 0.893 1,60,740
2-4 Cash inflow 2,00,000 2.145 4,29,000
5 Cash inflow 1,70,000 0.567 96,390
6-8 Cash inflow 2,00,000 1.363 2,72,600
NPV 7,08,730

Working Note:
(a) Calculation of Annual Cash Inflow
Particulars 1 2-4 5 6-8

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Sales value @ `6 per unit of 1,00,000 units 6,00,000 6,00,000 6,00,000 6,00,000
Less: Variable costs @ `3 per unit 3,00,000 3,00,000 3,00,000 3,00,000
Less: Annual cash fixed cost
Less: Advertisement expenses 1,00,000 1,00,000 1,00,000 1,00,000
Less: Maintenance expenses 20,000 - - -
Cash Inflow - - 30,000 -
1,80,000 2,00,000 1,70,000 2,00,000

Advise: CK limited should buy machine having positive NPV.

PYQ 12
A company wants to buy a machine, and two different models namely A and B are available. Following
further particulars are available:
Particulars Machine A Machine B
Original Cost (`) 8,00,000 6,00,000
Estimated life in years 4 4
Salvage value (`) 0 0

The company provides depreciation under straight line method. Income tax rate applicable is 30%. The
present value of `1 at 12% discounting factor and net profit before depreciation and tax are as under:
Net Profit before Depreciation and Tax
Year PV Factor
Machine A Machine B
1 2,30,000 1,75,000 0.893
2 2,40,000 2,60,000 0.797
3 2,20,000 3,20,000 0.712
4 5,60,000 1,50,000 0.636

Calculate:
(1) NPV (Net Present Value)
(2) Discounted Pay- back Period
(3) PI (Profitability Index)
[(10 Marks) Jan 2021]

Answer
(1) NPV = PV of Inflows – PV of Outflows
Machine A = 8,18,909 – 8,00,000 = 18,909
Machine B = 6,17,425 – 6,00,000 = 17,425

(2) Discounted pay-back Period

Machine A = 3 years + (8,00,000 – 5,31,437)/2,87,472 = 3.93 years
Machine B = 3 years + (6,00,000 – 5,22,025)/95,400 = 3.82 years

(3) PI = PV of Inflows ÷ PV of Outflows

Machine A = 8,18,909 ÷ 8,00,000 = 1.023
Machine B = 6,17,425 ÷ 6,00,000 = 1.029

7.52
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Suggestion: As per NPV method Machine A is more beneficial and as per Discounted pay-back period
method and PI method Machine B is more beneficial.

Working Notes:
1. Statement showing Present Value of CFAT and cumulative PV of CFAT of Machine A:
Particulars 1 2 3 4
Net Profit before Depreciation and Tax 2,30,000 2,40,000 2,20,000 5,60,000
Less: Depreciation (8,00,000 ÷ 4 years) (2,00,000) (2,00,000) (2,00,000) (2,00,000)
PBT 30,000 40,000 20,000 3,60,000
Less: Tax @ 30% (9,000) (12,000) (6,000) (1,08,000)
PAT 21,000 28,000 14,000 2,52,000
Add: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
CFAT 2,21,000 2,28,000 2,14,000 4,52,000
× PV Factor 0.893 0.797 0.712 0.636
Present Value of CFAT 1,97,353 1,81,716 1,52,368 2,87,472
Cumulative PV of CFAT 1,97,353 3,79,069 5,31,437 8,18,909

2. Statement showing Present Value of CFAT and cumulative PV of CFAT of Machine B:

Particulars 1 2 3 4
Net Profit before Depreciation and Tax 1,75,000 2,60,000 3,20,000 1,50,000
Less: Depreciation (6,00,000 ÷ 4 years) (1,50,000) (1,50,000) (1,50,000) (1,50,000)
PBT 25,000 1,10,000 1,70,000 -
Less: Tax @ 30% (7,500) (33,000) (51,000) -
PAT 17,500 77,000 1,19,000 -
Add: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
CFAT 1,67,500 2,27,000 2,69,000 1,50,000
× PV Factor 0.893 0.797 0.712 0.636
Present Value of CFAT 1,49,578 1,80,919 1,91,528 95,400
Cumulative PV of CFAT 1,49,578 3,30,497 5,22,025 6,17,425

PYQ 13
An existing company has a machine in operation for two years, its estimated life is 4 years with no
residual value in the end. Its current market value is `3 lakhs. The management is considering a proposal
to purchase an improved model of a machine which gives increase output. The details are as under:
Particulars Existing Machine New Machine
Purchase price `6,00,000 `10,00,000
Estimated life 6 years 4 years
Residual value 0 0
Annual operating days 300 300
Operating hour per day 6 6
Selling price per unit `10 `10
Material cost per unit `2 `2
Output per hour in units 20 40
Labour cost per hour `20 `30
Fixed overhead per annum excluding depreciation `1,00,000 `60,000
Working capital `1,00,000 `2,00,000
Income tax rate 30% 30%
Assuming that cost of capital is 10% and the company uses written down value of depreciation @ 20%
and it has several machines in 20% block.

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Advice the management on the replacement of machine as per NPV method.

The discounting factor table given below:

Discounting Factors Year 1 Year 2 Year 3 Year 4
10% 0.909 0.826 0.751 0.683
[(10 Marks) July 2021]

Answer
Statement of NPV
Year Particulars ` DF @ 10% PV
0 Initial outflows (8,00,000) 1.000 (8,00,000)
1 Incremental CFAT 2,59,000 0.909 2,35,431
2 Incremental CFAT 2,50,600 0.826 2,06,996
3 Incremental CFAT 2,43,880 0.751 1,83,154
4 Incremental CFAT + Working Capital 3,38,504 0.683 2,31,198
(2,38,504 + 1,00,000)
NPV 56,779

Advise: The company should go ahead with replacement of machine, since it has positive NPV.

Working Notes:
1. Calculation of initial outflow:
Cost of new machine `10,00,000
Less: Sales value of old machine (`3,00,000)
Add: Increase in Working Capital `1,00,000
Initial outflow `8,00,000

2. Total operating hours = 300 days × 6 hours = 1,800 hours

3. Increase in output = 1,800 hours × (40 - 20) = 36,000 units

4. Base for incremental Depreciation:

Particulars `
(A) WDV of Existing Machine:
Purchase price of existing machine 6,00,000
Less: Depreciation year 1 (6,00,000 × 20%) (1,20,000)
Less: Depreciation year 2 (4,80,000 × 20%) (96,000)
WDV of Existing Machine (A) 3,84,000

(B) Depreciation Base of New Machine:

Purchase price of new machine 10,00,000
Add: WDV of existing Machine 3,84,000
Less: Sale value of existing machine (3,00,000)

Depreciation Base of New Machine (B) 10,84,000

(C) Base for incremental Depreciation (B – A) 7,00,000

5. Calculation of incremental CFAT:

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Particulars 1 2 3 4
Increase in Sales (36,000 units × `10) 3,60,000 3,60,000 3,60,000 3,60,000
+ Decrease in Cash Fixed cost (1,00,000 – 60,000)
- Increase in Material cost (36,000 units × `2) 40,000 40,000 40,000 40,000
- Increase in Labour cost {1,800 hours × (30-20)} (72,000) (72,000) (72,000) (72,000)
Less: Increase in Depreciation (Base: 7,00,000) (18,000) (18,000) (18,000) (18,000)
Incremental PBT (1,40,000) (1,12,000) (89,600) (71,680)
Less: Tax @ 30% 1,70,000 1,98,000 2,20,400 2,38,320
Incremental PAT (51,000) (59,400) (66,120) (71,496)
Add: Incremental Depreciation 1,19,000 1,38,600 1,54,280 1,66,824
Incremental CFAT 1,40,000 1,12,000 89,600 71,680
2,59,000 2,50,600 2,43,880 2,38,504

Notes: Since company has several machines in 20% block of assets, there is no tax benefit on loss on sale
of machine because block will remain in existance.

PYQ 14
Stand Ltd is contemplating replacement of one of it’s machine which has become outdated and
inefficient. It’s financial manager has prepared a report outlining two possible replacement machines.
The details of each machine are as follows:
Machine 1 Machine 2
Initial investment `12,00,000 `16,00,000
Estimated useful life 3 Years 5 Years
Residual value `1,20,000 `1,00,000
Contribution per annum `11,60,000 `12,00,000
Fixed maintenance costs per annum `40,000 `80,000
Other fixed operating costs per annum `7,20,000 `6,10,000
The maintenance costs are payable annually in advance. All other cash flows apart from the initial
investment assumed to occur at the end of each year. Depreciation has been calculated by straight line
method and has been included in other fixed operating costs. The expected cost of capital for this project
is assumed as 12% p.a.

Which machine is more beneficial, using Annualized Equivalent Approach? Ignore tax.
Year 1 2 3 4 5 6
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567 0.507
PVIFA0.12,t 0.893 1.690 2.402 3.038 3.605 4.112
[(10 Marks) Dec 2021]

Answer
(i) Statement Showing Evaluation of Two Machines
Particulars Machine 1 Machine 2
(A) Initial investment 12,00,000 16,00,000
(B) PV of Contribution 27,86,320 43,26,000
(11,60,000 × 2.402) (12,00,000 × 3.605)
(C) PV of Cash fixed operating costs 8,64,720 11,17,550
(3,60,000 × 2.402) (3,10,000 × 3.605)
(D) PV of Fixed maintenance costs 1,07,600 3,23,040
{40,000 × (1.690+1)} {80,000 × (3.038+1)}
(E) PV of residual value 85,440 56,700

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

(1,20,000 × 0.712) (1,00,000 × 0.567)

Net present value (B + E – A – C - D) 6,99,440 13,42,110
÷ PVIFA ÷ 2.402 ÷ 3.605
Annualized Equivalent NPV
2,91,191 3,72,291
Select the Machine 2 having higher annualized equivalent NPV

Working Notes:
1. Depreciation: = (Initial investment – Residual value) ÷ Useful life

Machine 1 = (`12,00,000 – `1,20,000) ÷ 3 years = `3,60,000

Machine 2 = (`16,00,000 – `1,00,000) ÷ 5 years = `3,00,000

2. Cash fixed operating costs = Fixed operating costs – Depreciation

Machine 1 = `7,20,000 – `3,60,000) = `3,60,000

Machine 2 = `6,10,000 – `3,00,000 = `3,10,000

PYQ 15
Alpha Limited is a manufacturer of computers. It wants to introduce artificial intelligence while making
computers. The estimated annual saving from introduction of the artificial intelligence (AI) is as follows:
 Reduction of five employees with annual salaries of `3,00,000 each
 Reduction of `3,00,000 in production delays caused by inventory problem.
 Reduction in lost sales `2,50,000 and
 Gain due to timely billing `2,00,000

The purchase price of the system for installation of artificial intelligence is `20,00,000 and
installation cost is `1,00,000. 80% of the purchase price will be paid in the year of purchase and
remaining will be paid in next year.
The estimated life of the system is 5 years and it will be depreciated on a straight-line basis.
However, the operation of the new system requires two computer specialists with annual salaries of
`5,00,000 per person.

In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in `)
Year 1 2 3 4 5
Maintenance & Operating Cost 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000

Maintenance and operating cost are payable in advance. The company’s tax rate is 30% and its required
rate of return is 15%.
Year 1 2 3 4 5
PVIF0.10,t 0.909 0.826 0.751 0.683 0.621
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567
PVIF0.15,t 0.870 0.756 0.658 0.572 0.497

Evaluate the project by using Net Present Value and Profitability Index.
[(10 Marks) May 2022]

7.56
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

Answer
(1) Net Present value (NPV)
Year Particulars ` PVIF @ 15% PV
0 Initial Outflows:
80% of Purchase price (20,00,000 × 80%) (16,00,000) 1.000 (16,00,000)
Installation cost (1,00,000) 1.000 (1,00,000)
1 20% of Purchase Cost (4,00,000) 0.870 (3,48,000)
PV of Outflows 20,48,000
0 Maintenance & Operating cost for year 1 (2,00,000) 1.000 (2,00,000)
1 CFAT 8,81,000 0.870 7,66,470
2 CFAT 8,95,000 0.756 6,76,620
3 CFAT 9,09,000 0.658 5,98,122
4 CFAT 9,23,000 0.572 5,27,956
5 CFAT 10,37,000 0.497 5,15,389
PV of Inflows 28,84,557
NPV 8,36,557

Advice: Accept the proposal having positive NPV.

(2) Profitability Index = PV of Inflows ÷ PV of Outflows

= 28,84,557 ÷ 20,48,000 = 1.41

Advice: Accept the proposal having PI higher than 1.

Working Note:
Statement of CFAT
Particulars 1 2 3 4 5
Saving in employees salaries 15,00,000 15,00,000 15,00,000 15,00,000 15,00,000
(`3,00,000 × 5)
+ Reduction in prod. delays 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
+ Reduction in lost sales 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
+ Gain due to timely billing 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
- Salaries computer specialist
(`5,00,000 × 2) (10,00,000) (10,00,000) (10,00,000) (10,00,000) (10,00,000)
- Maintenance & Op. cost (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000)
- Depreciation (4,20,000) (4,20,000) (4,20,000) (4,20,000) (4,20,000)
(21,00,000 ÷ 5 years)
PBT 6,30,000 6,50,000 6,70,000 6,90,000 7,10,000
- Tax @ 30% (1,89,000) (1,95,000) (2,01,000) (2,07,000) (2,13,000)
PAT 4,41,000 4,55,000 4,69,000 4,83,000 4,97,000
+ Depreciation 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000
+ Maint. & Op. cost (accrual) 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
- Maint. & Op. cost (Cash) (1,80,000) (1,60,000) (1,40,000) (1,20,000) -
CFAT 8,81,000 8,95,000 9,09,000 9,23,000 10,37,000

PYQ 16
A firm is in need of a small vehicle to make deliveries. It is intending to choose between two options. One
option is to buy a new three wheeler that would cost `1,50,000 and will remain in service for 10 years.

7.57
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

The other alternative is to buy a second hand vehicle for `80,000 that could remain in service for
5 years. Thereafter the firm, can buy another second hand vehicle for `60,000 that will last for another
5 years.

The scrap value of the discarded vehicle will be equal to it written down value (WDV). The firm
pays 30% tax and is allowed to claim depreciation on vehicles @ 25% on WDV basis. The cost of capital
of the firm is 12%.
You are required to advise the best option.

Given:
t 1 2 3 4 5 6 7 8 9 10
PVIF (t, 12%) 0.892 0.797 0.711 0.635 0.567 0.506 0.452 0.403 0.360 0.322
[(10 Marks) Nov 22]

Answer
Statement of PV of outflow under Option 1
Year Particulars ` DF @ 12% PV
1 Tax Shield on depreciation (37,500 × 0.3) 11,250 0.892 10,035
2 Tax Shield on depreciation (28,125 × 0.3) 8,438 0.797 6,725
3 Tax Shield on depreciation (21,094 × 0.3) 6,328 0.711 4,499
4 Tax Shield on depreciation (15,820 × 0.3) 4,746 0.635 3,014
5 Tax Shield on depreciation (11,865 × 0.3) 3,560 0.567 2,019
6 Tax Shield on depreciation (8,899 × 0.3) 2,670 0.506 1,351
7 Tax Shield on depreciation (6,674 × 0.3) 2,002 0.452 905
8 Tax Shield on depreciation (5,006 × 0.3) 1,502 0.403 605
9 Tax Shield on depreciation (3,754 × 0.3) 1,126 0.360 405
10 Tax Shield on depreciation (2,816 × 0.3) 845 0.322 272
10 Scrap value new three wheeler 8,447 0.322 2,720
PV of Inflows 32,550
PV of Outflows (Initial Cost of new three wheeler) 1,50,000
Net PV of Outflows (1,50,000 – 32,550) 1,17,450

Statement of PV of outflow under Option 2

Year Particulars ` DF @ 12% PV
1 Tax Shield on depreciation (20,000 × 0.3) 6,000 0.892 5,352
2 Tax Shield on depreciation (15,000 × 0.3) 4,500 0.797 3,587
3 Tax Shield on depreciation (11,250 × 0.3) 3,375 0.711 2,400
4 Tax Shield on depreciation (8,438 × 0.3) 2,531 0.635 1,607
5 Tax Shield on depreciation (6,328 × 0.3) 1,898 0.567 1,076
5 Scrap value of second hand vehicle 1 18,984 0.567 10,764
6 Tax Shield on depreciation (15,000 × 0.3) 4,500 0.506 2,277
7 Tax Shield on depreciation (11,250 × 0.3) 3,375 0.452 1,526
8 Tax Shield on depreciation (8,438 × 0.3) 2,531 0.403 1,020
9 Tax Shield on depreciation (6,328 × 0.3) 1,898 0.360 683
10 Tax Shield on depreciation (4,746 × 0.3) 1,424 0.322 459
10 Scrap value of second hand vehicle 2 14,238 0.322 4,585
PV of Inflows 35,336
PV of Outflows (80,000 + 60,000 × 0.567) 1,14,020
Net PV of Outflows (1,14,020 – 35,336) 78,684
Advise: Select option 2 having lower Net PV of Outflows.

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 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

PYQ 17
A hospital is considering to purchase a diagnostic machine costing `80,000. The projected life of the
machine is 8 years and has an expected salvage value of `6,000 at the end of 8 years. The annual
operating cost of the machine is `7,500. It is expected to generate revenues of `40,000 per year for eight
years. Presently, the hospital is outsourcing the diagnostic work and is earning commission income of
`12,000 per annum. Consider tax rate of 30% Discounting Rate as 10%.

Advise: Whether it would be profitable for the hospital to purchase the machine?

Give your recommendation as per Net Present Value method and Present Value Index method under
below mentioned two situations:
(i) If Commission income of `12,000 p.a. is before taxes.
(ii) If Commission income of `12,000 p.a. is net of taxes.

t 1 2 3 4 5 6 7 8
PVIF (t, 10%) 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
[(10 Marks) Nov 2022]

Answer
(i) Net Present Value and Present Value Index when commission income is before tax:
Net Present Value
Year Particulars ` DF @ 10% DCF
0 Initial Outflows (80,000) 1.000 (80,000)
1–8 Cash Flow After Tax 17,125 5.334 91,345
8 Salvage 6,000 0.467 2,802
NPV 14,147

PV of Inflows 94 ,147
Profitability Index = = = 1.18
PV of Outflows 80 ,000

Advise: Since the net present value (NPV) is positive and profitability index is also greater than 1, it is
profitable for the hospital to purchase the machine.

(ii) Net Present Value and Present Value Index when commission income is before tax:

Net Present Value

Year Particulars ` DF @ 10% DCF
0 Initial Outflows (80,000) 1.000 (80,000)
1–8 Cash Flow After Tax 13,525 5.334 72,142
8 Salvage 6,000 0.467 2,802
NPV (5,056)

PV of Inflows 74 ,944
Profitability Index = = = 0.94
PV of Outflows 80 ,000

Advise: Since the net present value (NPV) is negative and profitability index is also lower than 1, it is not
profitable for the hospital to purchase the machine.
Working Notes:

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 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Calculation of CFAT:
Particulars Case (i) Case (ii)
Sales 40,000 40,000
Less: Operating cost 7,500 7,500
Less: Depreciation (80,000 – 6,000) ÷ 8 years 9,250 9,250
Less: Loss of commission income before tax (12,000) -
Net Income 11,250 23,250
Less: Tax @ 30% (3,375) (6,975)
PAT 7,875 16,275
Add: Depreciation 9,250 9,250
Cash inflows after tax per annum 17,125 25,525
Less: Loss of commission income after tax - (12,000)
Net CFAT 17,125 13,525

PYQ 18
Four years ago, Z Ltd. had purchased a machine of `4,80,000 having estimated useful life of 8 years with
zero salvage value. Depreciation charged using SLM method over the useful life. The company want to
replace this machine with a new machine. Details of new machine are as below:

 Cost of new machine is `12,00,000 Vendor of this machine is agreed to take old machine at a value
of `2,40,000. Cost of dismantling and removal of old machine will be `40,000. 80% of net purchase
price will be paid on spot and remaining will be paid at the end of one year.
 Depreciation will be charged @ 20% p.a. under WDV method.
 Estimated useful life of new machine is four years and it has salvage value of `1,00,000 at the end
of year four.
 Incremental annual sales revenue is `12,25,000.
 Contribution margin is 50%.
 Incremental indirect cost (excluding depreciation) is `1,18,750 per year.
 Additional working capital of `2,50,000 is required at the beginning of the year one and `3,00,000
at the beginning of the year three. Working capital at the end of the year four will be nil.
 Tax rate is 30%
 Ignore tax on capital gain.
 Z Ltd. will not make any additional investment, if it yields less than 12%.

Advise, whether existing machine should be replaced or not.

Year 1 2 3 4 5
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567
[(10 Marks) May 23]

Answer
Statement of NPV
Year Particulars ` DF @12% PV
0 Initial outflows (10,50,000) 1.000 (10,50,000)
1 Incremental CFAT – 20% of Net purchase price 1,99,625 0.893 1,78,265
(3,99,625 – 20% of 10,00,000)
2 Incremental CFAT – Additional Working 85,225 0.797 67,924
Capital

7.60
 CHAPTER 7 CAPITAL BUDGETING OR INVESTMENT DECISION

3 (3,85,225 – 3,00,000) 3,73,705 0.712 2,66,078

4 Incremental CFAT 10,14,489 0.636 6,45,215
Incremental CFAT + Incremental Salvage + WC
(3,64,489 + 1,00,000 + 5,50,000)
NPV 1,07,482
Advise: The company should replace existing machine with new machine having positive NPV

Working Notes:

1. Calculation of initial outflow:

Cost of new machine 12,00,000
Less: Sales value of old machine net of disposal (2,40,000 – 40,000) (2,00,000)
Net Purchase Price 10,00,000
Initial Outflow:
80% of Net purchase price (80% of 10,00,000) 8,00,000
Add: Additional Working Capital 2,50,000
10,50,000

2. Calculation of incremental CFAT:

Particulars 1 2 3 4
Incremental Contribution (12,25,000 × 6,12,500 6,12,500 6,12,500 6,12,500
50%) (1,18,750) (1,18,750) (1,18,750) (1,18,750)
Less: Incremental indirect cost (1,80,000) (1,32,000) (93,600) (62,880)
Less: Incremental Depreciation 3,13,750 3,61,750 4,00,150 4,30,870
Incremental PBT (94,125) (1,08,525) (1,20,045) (1,29,261)
Less: Tax @ 30% 2,19,625 2,53,225 2,80,105 3,01,609
Incremental PAT 1,80,000 1,32,000 93,600 62,880
Add: Incremental Depreciation 3,99,625 3,85,225 3,73,705 3,64,489
Incremental CFAT

3. Incremental Depreciation:

Year 1 = 12,00,000 × 20% - (4,80,000 ÷ 8 years) = `1,80,000

Year 2 = 9,60,000 × 20% - 60,000 = `1,32,000
Year 3 = 7,68,000 × 20% - 60,000 = `93,600
Year 4 = 6,14,400 × 20% - 60,000 = `62,880

PYQ 19
ABC Ltd. is considering to purchase a machine which is priced at `5,00,000. The estimated life of
machine is 5 years and has an expected salvage value of `45,000 at the end of 5 years. It is expected to
generate revenue of `1,50,000 per annum for five years. The annual operating cost of the machine is
`28,125, Corporate Tax Rate is 20% and the cost of capital is 10%.

You are required to analyse whether it would be profitable for the company to purchase the
machine by using;

(a) Payback period Method

(b) Net Present value method
(c) Profitability Index Method
[(10 Marks) Nov 23]

7.61
 CAPITAL BUDGETING OR INVESTMENT DECISION CHAPTER 7

Answer
(a) Payback period = 5,00,000 ÷ 1,15,700 = 4.32 years

Project should be accepted having payback period less than life of project.
(b) Statement of NPV
Years Particulars ` DF @ 10% PV
0 Investment (outflow) (5,00,000) 1.000 (5,00,000)
1–5 CFAT 1,15,700 3.791 4,38,619
5 Salvage 45,000 0.621 27,945
NPV (33,436)

Project should be rejected having negative NPV.

(c) Profitability Index = 4,66,564 ÷ 5,00,000 = 0.93

Project should be rejected having PI less than 1.

Working Note:
Calculation of CFAT
Particulars `
Sales value 1,50,000
Less: Operating cost (50,000 gallon × `5) (28,125)
Less: Depreciation (5,00,000 – 45,0000 ÷ 5 years (91,000)
PBT 30,875
Less: Tax @ 20% (6,175)
PAT 24,700
Add: Depreciation 91,000
Annual CFAT 1,15,700

SUGGESTED REVISION FOR EXAM:

BQ: 2, 12, 14, 15, 16, 18, 21, 22, 23, 24, 25, 28, 30, 31, 34, 35, 36, 37

PYQ: 6, 9, 13, 14, 15

7.62
 CHAPTER 8 COST OF CAPITAL

CHAPTER 8 COST OF CAPITAL

COST OF DEBT (Kd)

BQ 1
Vishnu steels Ltd. has issued 30,000 irredeemable 14% debentures of `150 each. The cost of flotation
of debentures is 5% of the total issued amount. The company's taxation rate is 40%.

Calculate the cost of debt.

[Kd 8.84%]

BQ 2
Five years ago, Sona Limited issued 12 per cent irredeemable debentures at `103, at `3 premium to
their par value of `100. The current market price of these debentures is `94. If the company pays
corporate tax at a rate of 35 per cent What is its current cost of debenture capital?
[Kd 8.30%]

BQ 3
Surya Industries Ltd. has raised funds through issue of 10,000 debentures of `150 each at a discount of
`10 per debenture with 10 years maturity. The coupon rate is 16%. The flotation cost is `5 per
debenture. The debentures are redeemable with a 10% premium. The corporate taxation rate is 40%.

Calculate the cost of debenture.

[Kd 11.60%]

BQ 4
Business machines Ltd. has issued redeemable debentures of `100 each repayable at the end of 8 year
period on a coupon rate of 14%. The flotation expenses are 10% of issue amount.

Calculate the cost of debt.

[Kd 16.05%]

BQ 5
A company issued 10,000, 10% debentures of `100 each at a premium of 10% on 1.4.2020 to be matured
on 1.4.2025. The debentures will be redeemed on maturity. Compute the cost of debentures assuming
35% as tax rate.
[Kd 4.28%]

BQ 6
A company issued 10,000, 10% debentures of `100 each on 1.4.2020 to be matured on 1.4.2025. The
company wants to know the current cost of its existing debt and the market price of the debentures is
`80. Compute the cost of existing debentures assuming 35% tax rate.
[Kd 11.67%]

BQ 7
Express cargo Ltd has issued 4 years Zero Coupon Bonds of `1,000 each at a price of `636.

Calculate the cost of debt. [Kd 11.98%]

8.1
 COST OF CAPITAL CHAPTER 8

BQ 8
Institutional Development Bank (IDB) issued Zero interest deep discount bonds of face value of
`1,00,000 each issued at `2,500 & repayable after 25 years.

Compute the cost of debt if there is no corporate tax.

Answer
Here,
Redemption Value (RV) = `1,00,000
Net Proceeds (NP) = `2,500
Interest = 0
Life of bond = 25 years

There is huge difference between RV and NP therefore in place of approximation method we should use
trial & error method.

FV = PV × (1 + r)n
1,00,000 = 2,500 × (1 + r)25
40 = (1 + r)25

Trial 1: r = 15%, (1.15)25 = 32.919

Trial 2: r = 16%, (1.16)25 = 40.874
Here:
L = 15%
H = 16%
NPVL = 32.919 – 40 = - 7.081
NPVH = 40.874 – 40 = + 0.874
NPVL
IRR/Kd = LR + × (H - L)
NPVL  NPVH

−7.081
= 15% + −7.081−0.874 × (16% - 15%) = 15.89%

BQ 9
A company issued 10,000, 10% debentures of `100 each on 1.4.2020 to be matured on 1.4.2025. The
company wants to know the current cost of its existing debt and the market price of the debentures is
`80.
Compute the cost of existing debentures by using Present value method/Yield to maturity
approach (YTM) assuming 35% tax rate.

Answer
(a) Identification of relevant cash flows:
Year Cash Flows
0 Current market price (P0) = `80
1 to 5 Interest net of tax [I (1 - t)] = 10% of `100 (1 – 0.35) = `6.5
5 Redemption value (RV) = Face value i.e. `100

(b) Calculation of NPV at two discount rates:

Present Value Present Value
Year Cash Flow
10% DCF 15% DCF

8.2
 CHAPTER 8 COST OF CAPITAL

0 80 1.000 (80) 1.000 (80)

1-5 6.5 3.791 24.64 3.352 21.79
5 100 0.621 62.10 0.497 49.70
NPV +6.74 -8.51

(c) Calculation of IRR/Kd

NPVL 6.74
IRR/Kd = LR + × (H - L) = 10% + × (15% - 10%)
NPVL  NPVH 6.74  ( 8.51 )
= 12.21%

YTM or present value method is a superior method of determining cost of debt of a company to
approximation method and it is also preferred in the field of finance.

BQ 10
A company issued 10,000, 15% Convertible debentures of `100 each with a maturity period of 5 years.
At maturity the debenture holders will have the option to convert the debentures into equity shares of
the company in the ratio of 1:10 (10 shares for each debenture). The current market price of the equity
shares is `12 each and historically the growth rate of the shares are 5% per annum.
Compute the cost of debentures assuming 35% tax rate.

Answer
Determination of Redemption value:

Higher of
(i) The cash value of debentures = `100
(ii) Value of equity shares = 10 shares × `12(1 + 0.05)5
= 10 shares × `12 × 1.276 = `153.12

`153.12 will be taken as redemption value as it is higher than the cash option and attractive to the
investors.
Calculation of Cost of Convertible debenture:

Alternative 1: Using approximation method:

RV−NP 153.12−100
I (1 − t) + 15 (1 − 0.35) +
Kd = RV+NP
n
× 100 = 153.12+100
5
× 100 = 16.09%
2 2

Alternative 2: Using present value method:

Calculation of NPV at two discount rates:

Present Value Present Value
Year Cash Flow
15% DCF 20% DCF
0 100 1.000 (100) 1.000 (100)
1-5 9.75 3.352 32.68 2.991 29.16
5 153.12 0.497 76.10 0.402 61.55
NPV +8.78 -9.29

NPVL 8.78
IRR/Kd = LR + × (H - L) = 15% + × (20% - 15%) = 17.43%
NPVL  NPVH 8.78  ( 9.29 )

8.3
 COST OF CAPITAL CHAPTER 8

BQ 11
RBML is proposing to sell a 5-year bond of ` 5,000 at 8 per cent rate of interest per annum. The bond
amount will be amortised equally over its life.

What is the bond’s present value for an investor if he expects a minimum rate of return of 6
per cent?

Answer
The amount of interest will go on declining as the outstanding amount of bond will be reducing due to
amortisation. The amount of interest for five years will be:
First year : `5,000 × 0.08 = `400
Second year : (`5,000 – `1,000) × 0.08 = `320
Third year : (`4,000 – `1,000) × 0.08 = `240
Fourth year : (`3,000 – `1,000) × 0.08 = `160; and
Fifth year : (`2,000 – `1,000) × 0.08 = `80.

The outstanding amount of bond will be zero at the end of fifth year. Since RBML will have to return
`1,000 every year, the outflows every year will consist of interest payment and repayment of principal:
First year : `1,000 + `400 = `1,400
Second year : `1,000 + `320 = `1,320
Third year : `1,000 + `240 = `1,240
Fourth year : `1,000 + `160 = `1,160; and
Fifth year : `1,000 + `80 = `1,080.

The above cash flows of all five years will be discounted with the cost of capital. Here the expected rate
i.e. 6% will be used. Value of the bond is calculated as follows:
1,400 1,320 1,240 1,160 1,080
VB = + + + +
(1.06 )1 (1.06 )2 (1.06 )3 (1.06 )4 (1.06 )5
= `1,320.75 + `1,174.80 + `1,041.14 + `918.88 + `807.05 = ` 5,262.62

COST OF PREFERENCE SHARE CAPITAL (Kp)

BQ 12
XYZ Ltd. issues 2,000 10% preference shares of `100 each at `95 each. The company proposes to redeem
the preference shares at the end of 10th year from the date of issue.

Calculate the cost of preference share capital.

Answer
 RV  NP   100  95 
PD    10   
 n  × 100  10 
Kp = = × 100 = 10.77%
RV  NP 100  95
2 2

BQ 13
XYZ & Co. issues 2,000 10% preference shares of `100 each at `95 each.

Calculate the cost of preference share capital.

8.4
 CHAPTER 8 COST OF CAPITAL

Answer
PD 10
Kp = × 100 = × 100 = 10.53%
NP 95

BQ 14
If R Energy is issuing preferred stock at `100 per share, with a stated dividend of `12, and a floatation
cost of 3% then,

What is the cost of preference share?

Answer
PD 12
Kp = × 100 = × 100 = 12.37%
IP (1  Floatation Cost ) 100 (1  .03 )

COST OF EQUITY SHARE CAPITAL (Ke)

BQ 15
Radiant Ltd. has disbursed a dividend of `30 on each Equity share of `10. The current market price of
share is `80.

Calculate the cost of equity as per dividend yield method.

[Ke 37.50%]

BQ 16
Prabhat Ltd. has 50,000 equity shares of `10 each and its current market value is `45 each. The after tax
profit of the company for the year is `9,60,000.

Calculate the cost of equity based on price earnings/yield method.

Answer
EPS 19.20
Ke = × 100 = × 100 = 42.67%
MPS 45.00

Earnings 9 ,60 ,000

EPS = = = `19.20
No . of Equity shares 50 ,000

BQ 17
Fox Ltd. issued new 10,000 equity shares of `10 each at a premium of `2 each. The company has incurred
issue expenses of `5,000. The equity shareholder’s expects the rate of dividend to 18% p.a.

Calculate the cost of equity share capital. Will your answer be different if these shares are
existing shares and the current market price of share is `21?

Answer
(a) Since the Equity shares are newly issued, the cost of equity of it can be calculated as follows:

Ke (New share) = Expected dividend × 100

Net proceeds
= 1.80 × 100 = 15.65%
11.50

8.5
 COST OF CAPITAL CHAPTER 8

Net proceeds per share = 10 ,000 Equity shares  12 .00   5,000 = `11.50
10 ,000 Shares

(b) In case of existing equity shares, market price is to be taken as basis for calculation of cost
of equity capital as follows:

Expected dividend 1.80

Ke = × 100 = × 100 = 8.57%
Current market price 21 .00

BQ 18
A company has paid dividend of `1 per share (of face value of `10 each) last year and it is expected to
grow @10% next year. Calculate the cost of equity if the market price of share is `55.

Calculate the cost of equity.

Answer
D1 1 (1  0.10)
Ke = +g = + .10 = 12%
P0 55

BQ 19
The equity of Mercury Ltd. are traded in the market at `90 each. The current year expected dividend per
share is `18. The subsequent growth in dividends is expected at the rate of 6%.

Calculate the cost of equity capital.

[Ke 26%]

BQ 20
Bright Star Ltd. has its equity shares of `10 each quoted in a stock exchange has market price of `56. A
constant expected annual growth rate of 6% and a dividend of `3.60 per share has been paid for the
current year.

Calculate the cost of capital.

[Ke 12.81%]

BQ 21
(a) A Company's shares are quoted at `250. The dividend just paid was `50. Face value per share
`100. No growth in dividend is expected. Compute Ke.
(b) Presume in the above part the anticipated growth rate in dividend is 10% p.a. Compute Ke.
(c) Presume in part (a), investors in the company have a required rate of return of 15%. Current
dividends of `30 per share have just been paid. No increase is anticipated. Estimate the share price
today.
(d) Presume in part (c), dividends are expected to grow @ 5% p.a. Estimate share price today.
[(a) Ke 20%, (b) Ke 32%, (c) P0 `200, (d) P0 `315]

BQ 22
Sun Ltd. has its shares of `10 each quoted on the stock exchange; the current price per share is `24.
During the previous 3 years, dividends have steadily increased from `1.20 to `1.60 per share.

Calculate the cost of equity shares.

[g 10%; Ke 17.33%]

8.6
 CHAPTER 8 COST OF CAPITAL

BQ 23
Calculate the cost of equity capital of H Ltd., whose risk free rate of return equals 10%. The firm’s beta
equals 1.75 and the return on the market portfolio equals to 15%.

Answer
Ke = Rf +  (Rm - Rf) = 10% + 1.75 × (15% - 10%) = 18.75%

BQ 24
The risk free return is 10% and the risk premium is 5% with beta of a company is 1.6. During the
previous 5 years, dividends have steadily increased from `2.115 to `2.966 per share. The company's
earnings and the dividend experienced constant growth.

Find out the intrinsic value (Market value of share) of the shares.

Answer
D1 3 (1  .07 )
P0 = = = `29.18
Ke  g 18 %  7 %

Ke = Rf +  (Rm - Rf) = 10% + 1.6 × (5%) = 18%

5 Latest Dividend 5 2.966

Growth rate = √
First Dividend
–1 = √2.115 – 1 = 7%

BQ 25
Mr. Mehra had purchased a share of Alpha Limited for `1,000. He received dividend for a period of five
years at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for `1,128.

You are required to compute the cost of equity as per realised yield approach.

Answer
Calculation of NPV at two discount rates:
Present Value Present Value
Year Cash Flow
11% DCF 13% DCF
0 1,000 1.000 (1,000) 1.000 (1,000)
1-5 100 3.696 369.60 3.517 351.70
5 1,128 0.593 668.90 0.543 612.50
NPV +38.50 -35.80

Calculation of IRR/Ke:

NPVL 38 .50
Ke = LR + × (H - L) = 11% + × (13% - 11%) = 12.04%
NPVL  NPVH 38 .50  ( 35 .80 )

BQ 26
Calculate the cost of equity from the following data using realized yield approach:

Year 1 2 3 4 5

Dividend per share 1.00 1.00 1.20 1.25 1.15

Price per share (at the beginning) 9.00 9.75 11.50 11.00 10.60

8.7
 COST OF CAPITAL CHAPTER 8

Answer
In this questions we will first calculate yield for last 4 years and then calculate it geometric mean as
follows:
D1 + P1 1+9.75
1 + Y1 = = = 1.1944
P0 9

D2 + P2 1+11.50
1 + Y2 = P1
= 9.75
= 1.2821

D3 + P3 1.2+11
1 + Y3 = P2
= 11.50
= 1.0609

D4 + P4 1.25+10.60
1 + Y4 = = = 1.0772
P3 11

Geometric mean:

Ke = [(1 + Y1) × (1 + Y2) ×……(1 + Yn)]1/n – 1

Ke = [1.1944 × 1.2821 × 1.0609 × 1.0772]1/4 – 1 = 0.15 or 15%

BQ 27
ABC Company’s equity share is quoted in the market at `25 per share currently. The company pays a
dividend of `2 per share and the investor’s market expects a growth rate of 6% per year.

You are required to:

(i) Calculate the company’s cost of equity capital.
(ii) If the company issues 10% debentures of face value of `100 each and realises `96 per debenture
while the debentures are redeemable after 12 years at a premium of 12%, calculate cost of
debenture using YTM?

Assume Tax Rate to be 50%.

Answer
(i) Cost of Equity Capital (Ke):
D1 2(1 + 0.06 )
Ke = +g = + .06 = 14.48%
P0 25

Note: Dividend `2 is treated as D0, student may treat it as D1 and answer will change accordingly.

(ii) Cost of Debenture (Kd):

Identification of relevant cash flows:
Year Cash Flows
0 Current market price (P0) = `96
1 to 12 Interest net of tax [I (1 - t)] = 10% of `100 (1 – 0.50) = `5
12 Redemption value (RV) = `112

Calculation of NPV at two discount rates

Present Value Present Value
Year Cash Flow
5% DCF 10% DCF

8.8
 CHAPTER 8 COST OF CAPITAL

0 96 1.000 (96) 1.000 (96)

1 - 12 5 8.863 44.32 6.814 34.07
12 112 0.557 62.38 0.319 35.73
NPV +10.70 -26.20

Calculation of IRR/Kd

NPVL 10.70
IRR/Kd = LR + × (H - L) = 5% + 10.70 −(26.20) (10% - 5%) = 6.45%
NPVL  NPVH

COST OF RETAINED EARNINGS (Kr)

BQ 28
ABC Company provides the following details:

D0 = `4.19 P0 = ` 50 g = 5%

Calculate the cost of retained earnings.

Answer
D1 4.19 (1  .05)
Kr = +g = + 0.05 = 13.80%
P0 50

BQ 29
ABC Company provides the following details:

Rf = 7% ß = 1.20 Rm – Rf = 6%

Calculate the cost of retained earnings based on CAPM method.

Answer
Kr = Rf +  (Rm - Rf) = 7% + 1.2 × (6%) = 14.20%

BQ 30
Face value of equity shares of a company is `10, while current market price is `200 per share. Company
is going to start a new project, and is planning to finance it partially by new issue and partially by
retained earnings.

You are required to calculate cost of equity shares as well as cost of retained earnings if issue price
will be `190 per share and floatation cost will be `5 per share. Dividend at the end of first year is
expected to be `10 and growth rate will be 5%.

Answer
D1 10
Kr = +g = + 0.05 = 10%
P0 200

D1 10
Ke (New Shares) = NP
= + 0.05 = 10.41%
185

8.9
 COST OF CAPITAL CHAPTER 8

WEIGHTED AVERAGE COST OF CAPITAL (Ko)

BQ 31
The Capital structure of Vikas Ltd. is as follows:
Sources of Fund Book Value Market Value
Equity Share Capital `10,00,000 `20,00,000
Retained Earnings `5,00,000 Nil
14% Preference Share Capital `7,00,000 `7,00,000
12% Debentures `6,00,000 `6,00,000

After tax, cost of capital of these different sources is Equity share capital 18%, Retained earnings
15%, Preference share capital 14%, and Debentures 8%. Calculate the weighted average cost of capital
of the company on the basis of (a) Book Value Weights and (b) Market Value Weights.

Answer
(a) Statement of WACC (Book Value Weights)
Capital Structure Amount Weight Specific Cost Cost of Capital
Equity Share Capital 10,00,000 0.357 0.18 0.0643
Retained Earnings 5,00,000 0.179 0.15 0.0268
14% Preference Share Capital 7,00,000 0.250 0.14 0.0350
12% Debentures 6,00,000 0.214 0.08 0.0171
Total 28,00,000 1.000 WACC 0.1432

(b) Statement of WACC (Market Value Weights)

Capital Structure Amount Weight Specific Cost Cost of Capital
Equity Share Capital *13,33,333 0.404 0.18 0.0727
Retained Earnings *6,66,667 0.202 0.15 0.0303
14% Preference Share Capital 7,00,000 0.212 0.14 0.0297
12% Debentures 6,00,000 0.182 0.08 0.0146
Total 33,00,000 1.000 WACC 0.1473

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.

BQ 32
Cost of equity of a company is 10.41% while cost of retained earnings is 10%. There are 50,000 equity
shares of `10 each and retained earnings of `15,00,000. Market price per equity share is `50.

Calculate WACC using market value weights if there is no other sources of finance.

Answer
Book value of paid up equity capital = `5,00,000
Book value of retained earnings = `15,00,000
Ratio Paid up equity capital & retained earnings = 500000 : 1500000 =1:3
Market value of paid equity capital & retained earnings = `50,000 × `50 = `25,00,000
Market value of paid up equity capital = `25,00,000 × ¼ = `6,25,000
Market value of retained earnings = `25,00,000 × ¾ = `18,75,000

8.10
 CHAPTER 8 COST OF CAPITAL

Statement of WACC (Market Value Weights)

Capital Structure Amount Weight Specific Cost Cost of Capital
Equity Shares *6,25,000 0.25 0.1041 0.0260
Retained Earnings *18,75,000 0.75 0.1000 0.0750
Total 25,00,000 1.00 WACC 0.1010

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.

BQ 33
The capital structure of Bombay Traders Ltd. as on 31.03.2022 is as follows:
(` Crores)
Equity Share Capital (100 lakhs equity shares of `10 each) 10
Reserves 2
14% Debentures of `100 each 3

For the year ended 31.03.2023 the company is likely to pay equity dividend at 20%. As the company is
a market leader with good future, dividend is likely to grow by 5% every year. The equity shares are
now traded at `80 per share in the stock exchange. Income-tax rate applicable to the company is 50%.

Required:
(a) The current weighted cost of capital.
(b) The company has plans to raise a further `5 crores by way of long term loan at 16% interest. When
this take place the market value of the equity shares is expected to fall to `50 per share. What will
be the new weighted average cost of capital of the company?
[(a) Ke 7.50%, Kr 7.50%, Kd 7%, Ko 7.40%; (b) Ke 9%, Kr 9%, Kd 7%, KTL 8%, Ko 8.45%]

BQ 34
Gamma limited has in issue 5,00,000; `1 ordinary shares whose current ex-dividend market price is
`1.50 per share. The company has just paid a dividend of 27 paise per share, and dividends are expected
to continue at this level for some time.

If the company has no debt capital, compute the weighted average cost of capital?

Answer
D1 0.27
Ke = = = 18%
P0 1.50

Since, there is no debt capital, WACC = Ke = 18%

BQ 35
Determine cost of capital using market value weights as well as book value weights using following
data:

Book value of capital structure:

Debenture (`1,000 each) `16,00,000
Preference Shares (`10 each) `4,00,000
Equity share Capital (Shares of `100 each) `20,00,000
`40,00,000

8.11
 COST OF CAPITAL CHAPTER 8

Market price:
Debentures `1,100 each
Preference Shares `12 each
Equity Shares `200 each

Debentures carry 8 percent interest, issued at par, redeemable at par, maturity period 20 years.
Flotation cost 4 percent. Preference shares carry 10 percent dividend rate, issue and redemption at par.
Maturity period 15 years. Flotation cost 5 percent. Equity dividend expected at the end of the year, i.e.
`20 per share. Anticipated growth rate in dividends is 5 percent. Corporate tax rate 55 percent.

Answer
 RV  NP   1,000  960 
I 1  t     80 1  0.55    
Kd =  n  × 100 =  20  × 100 = 3.88%
RV  NP 1,000  960
2 2

 RV  NP   10  9.50 
PD    1 .00   
Kp =  n  × 100 =  15  × 100 = 10.60%
RV  NP 10  9.50
2 2

D1 20
Ke = +g = + 0.05 = 15%
P0 200

Statement of WACC (Book Value Weights)

Capital Structure Amount Weight Specific Cost Cost of Capital
Debentures 16,00,000 0.40 3.88% 1.552%
Preference Share Capital 4,00,000 0.10 10.60% 1.06%
Equity Share Capital 20,00,000 .050 15% 7.50%
Total 40,00,000 1.00 WACC 10.112%

Statement of WACC (Market Value Weights)

Capital Structure Amount Weight Specific Cost Cost of
Capital
Debentures 17,60,000 0.2821 3.88% 1.095%
Preference Share Capital 4,80,000 0.0769 10.60% 0.815%
Equity Share Capital 40,00,000 0.6410 15% 9.615%
Total 62,40,000 1.00 WACC 11.525%

BQ 36
Masco Limited wishes to raise additional finance of `10 lakhs for meeting its investment plans. It has
`2,10,000 in the form of retained earnings available for investment purposes. The following are further
details:
Debt-equity mix 3:7
Cost of debt:
Upto `1,80,000 10% (before tax)
beyond `1,80,000 16% (before tax)
Current Earning per share `4
Dividend payout 50% of earnings

8.12
 CHAPTER 8 COST OF CAPITAL

Expected growth rate in dividend 10%

Current market price per share `44
Tax rate 50%

You are required:

(a) To determine the pattern for raising the additional finance.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity, and
(d) Compute the overall weighted average after tax cost of additional finance.
[(a) 3,00,000 Debt (1,80,000 @ 10% and balance 1,20,000 @ 16%) and 7,00,000 Equity (2,10,000
through retained earnings and 4,90,000 through fresh issue); (b) Kd 6.2%; (c) Ke 15%, Kr 15%; (d)
Ko 12.36%]
Assumption: DPS is treated at Do.

BQ 37
As a financial analyst of a large electronics company, you are required to determine the weighted
average cost of capital of the company using (a) book value weights and (b) market value weights. The
following information if available for your perusal.

The company’s present book value capital structure is:

Debentures (`100 per debenture) `8,00,000
Preference shares (`100 per share) `2,00,000
Equity shares (`10 per share) `10,00,000

All these securities are traded in capital markets. Recent price are:

Debentures `110 per debenture

Preference shares `120 per share
Equity shares `22 each

Anticipated external financing opportunities are:

(i) `100 per debenture redeemable at par, 11% coupon rate, 4% floatation cost, 10 years of
maturity, sale price, `100.
(ii) `100 per preference share redeemable at par, 12% dividend rate, 5% floatation cost, 10 years of
maturity, sale price, `100.
(iii) Equity share has `2 floatation cost and sale price per share of `22.

In addition, the dividend expected on the equity share at the end of the year is `2 per share with annual
growth of 7%. The firm has a practice of paying all earnings in the form of dividends. Corporate Income-
tax rate is 35%.

Answer
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
Particular Book Value Weight Cost (K) Weighted cost
11% Debenture 8,00,000 0.40 7.70% 3.080%
12% Preference share 2,00,000 0.10 12.82% 1.282%
Equity Share Capital 10,00,000 0.50 17.00% 8.500%
Total 20,00,000 1.00 WACC 12.862%

8.13
 COST OF CAPITAL CHAPTER 8

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particular Market value Weight Cost (K) Weighted cost
11% Debenture 8,80,000 0.265 7.70% 2.041%
12% Preference share 2,40,000 0.072 12.82% 0.923%
Equity Share Capital 22,00,000 0.663 17.00% 11.271%
Total 33,20,000 1.000 WACC 14.235%

Working notes:

D1 2
Ke = g =  0.07 = 17%
P0  F 22  2

 RV  NP   100  96 
I 1  t     11 1  0.35    
Kd =  n  × 100 =  10  × 100 = 7.70%
RV  NP 100  96
2 2
 RV  NP   100  95 
PD    12   
Kp =  n  × 100 =  10  × 100 = 12.82%
RV  NP 100  95
2 2

BQ 38
Calculate the WACC using the following data by using:

(a) Book value weights

(b) Market value weights

The capital structure of the company is as under:

Debentures (`100 per debenture) `5,00,000

Preference shares (`100 per share) `5,00,000
Equity shares (`10 per share) `10,00,000

The market prices of these securities are:

Debentures `105 per debenture

Preference shares `110 per share
Equity shares `24 each

Additional information:

(i) `100 per debenture redeemable at par, 10% coupon rate, 4% floatation cost, 10 years of
maturity. The market price per debenture is `105.
(ii) `100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost, 10 years of
maturity.
(iii) Equity share has `4 floatation cost and market price per share of `24.

The next year expected dividend is `1 per share with annual growth of 5%. The firm has a practice of
paying all earnings in the form of dividends. Corporate tax rate is 30%. Use YTM method to calculate
cost of debentures and preference shares.

8.14
 CHAPTER 8 COST OF CAPITAL

Answer
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
Particular Book Value Weight Cost (K) Weighted cost
10% Debenture 5,00,000 0.25 6.89% 1.72%
5% Preference share 5,00,000 0.25 4.09% 1.02%
Equity Share Capital 10,00,000 0.50 10.00% 5.00%
Total 20,00,000 1.00 WACC 7.74%

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particular Market value Weight Cost Weighted cost
10% Debenture 5,25,000 0.151 6.89% 1.04%
5% Preference share 5,50,000 0.158 4.09% 0.65%
Equity Share Capital 24,00,000 0.691 10.00% 6.90%
Total 34,75,000 1.000 WACC 8.59%

Working notes:
D1 1
(a) Ke = g =  0.05 = 10%
P0  F 24  4

(b) Cost of Debt (Kd):

Calculation of IRR/Kd
NPVL 14 .65
IRR/Kd = LR + × (H - L) = 5% + × (7% - 5%)
NPVL  NPVH 14 .65  (  0.83)
= 6.89%

Calculation of NPV at discount rate of 5% and 7%

Present Value Present Value
Year Cash Flow
5% DCF 7% DCF
0 105 – 4% of 105 1.000 (100.80) 1.000 (100.80)
1 - 10 10 (1 – 0.30) 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV +14.65 -0.83

(c) Cost of Preference shares (Kp):

Calculation of IRR/Kd
NPVL 9.25
IRR/Kd = LR + × (H - L) = 3% + × (5% - 3%)
NPVL  NPVH 9.25  ( 7.79 )
= 4.09%

Calculation of NPV at discount rate of 3% and 5%

Present Value Present Value
Year Cash Flow
3% DCF 5% DCF
0 110 – 2% of 110 1.000 (107.80) 1.000 (107.80)
1 - 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +9.25 -7.79

8.15
 COST OF CAPITAL CHAPTER 8

BQ 39
Determine the cost of capital of Best Luck Limited using the book value (BV) and market value (MV)
weights from the following information:
Sources of Fund Book Value Market Value
Equity Shares `1,20,00,000 `2,00,00,000
Retained Earnings `30,00,000 Nil
Preference Shares `36,00,000 `33,75,000
Debentures `9,00,000 `10,40,000

Additional Information:
1. Equity: Equity shares are quoted at `130 per share and a new issue priced at `125 per share will be
fully subscribed; flotation costs will be `5 per share.

2. Dividend: During the previous 5 years, dividends have steadily increased from `10.60 to `14.19 per
share. Dividend at the end of the current year is expected to be `15 per share.

3. Preference Shares: 15% Preference shares with face value of `100 would realise `105 per share.

4. Debentures: The company proposes to issue 11 year 15% debentures but the yield on debentures
of similar maturity and risk class is 16%; flotation cost is 2%.

5. Tax: Corporate tax rate is 35%. Ignore dividend tax.

Floatation cost would be calculated on face value.

Answer
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
Particulars Book Value Weight (W) Cost (K) Weighted cost
Equity Shares `1,20,00,000 0.615 0.1850 0.1138
Retained Earnings `30,00,000 0.154 0.1800 0.0277
Preference Shares `36,00,000 0.185 0.1429 0.0264
Debentures `9,00,000 0.046 0.1095 0.0050
Total `1,95,00,000 1.000 WACC 0.1729

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particulars Market Value Weight (W) Cost (K) Weighted cost
*Equity Shares `1,60,00,000 0.655 0.1850 0.1212
*Retained Earnings `40,00,000 0.164 0.1800 0.0295
Preference Shares `33,75,000 0.138 0.1429 0.0197
Debentures `10,40,000 0.043 0.1095 0.0047
Total `2,44,15,000 1.000 WACC 0.1751

Working notes:
D1 15
Ke = g = + 6% = 18.50%
P0  F 125 −5

5 14.19
g = √10.60 = 6%

8.16
 CHAPTER 8 COST OF CAPITAL

D1 15
Kr = +g = + 6% = 18%
P0 125

RV−NP 100−91.75
I (1−t) + ( ) 15 (1−0.35) + ( )
Kd = RV + NP
n
× 100 = 100 + 91.75
11
× 100
2 2
= 10.95%

PD 15
Kp = NP
× 100 = 105
× 100 = 14.29%

Interest 15% of 100

MV of Debenture = Market rate of Interest
= 16%
× 100 = `93.75

NP of Debenture = MV of Debenture – Floatation Cost

= `93.75 - `2 (2% of `100) = `91.75

*Since yield on similar type of debentures is 16 per cent, the company would be required to offer
debentures at discount.

Market value of Equity Shares = `2,00,00,000 × 120/150 = `1,60,00,000

Market value of Retained Earnings = `2,00,00,000 × 30/150 = `40,00,000

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.

BQ 40
Kalyanam Ltd. has an operating profit of ₹34,50,000 and has employed Debt which gives total Interest
Charge of ₹7,50,000. The firm has an existing Cost of Equity and Cost of Debt as 16% and 8%
respectively. The firm has a new proposal before it, which requires funds of ₹75 Lakhs and is expected
to bring an additional profit of ₹14,25,000. To finance the proposal, the firm is expecting to issue an
additional debt at 8% and will not be issuing any new equity shares in the market. Assume no tax culture.

You are required to calculate the Weighted Average Cost of Capital (WACC) of Kalyanam Ltd.:

(a) Before the new Proposal

(b) After the new Proposal.

Answer
Interest 7,50,000
(1) Value of Debt = Cost of debt (Kd )
= 8%

= `93,50,000
Operating Profit − Interest 34,50,000 − 7,50,000
(2) Value of Equity Capital = Cost of equity (Ke )
= 16%

= `1,68,75,000

(3) New cost of Equity after proposal:

Operating Profit − Interest
= Equity Capital

34,50,000 + 14,25,000 − 7,50,000 − 8% of 75,00,000

= 1,68,75,000
= 20.90%

8.17
 COST OF CAPITAL CHAPTER 8

(a) Calculation of WACC Before the New Proposal

Particulars Book Value Weight (W) Cost (K) Weighted cost
Equity Shares `1,68,75,000 0.6429 0.16 0.1029
Debt `93,75,000 0.3571 0.08 0.0286
Total `2,62,50,000 1.000 WACC 0.1315

(b) Calculation of WACC After the New Proposal

Particulars Book Value Weight (W) Cost (K) Weighted cost
Equity Shares `1,68,75,000 0.5 0.209 0.1045
Debt (`93,75,000 + `75,00,000) `1,68,75,000 0.5 0.080 0.0400
Total `3,37,50,000 1.0 WACC 0.1445

MARGINAL WEIGHTED AVERAGE COST OF CAPITAL (MACC)

BQ 41
Bulldog Ltd. has a debt of 14% in the past. It can raise a fresh debt at 12.5%. The company is in a tax
bracket of 35%. Bulldog Ltd. plans to follow dividend discount model to estimate the cost of equity. The
company plans to pay `4 per share as dividends in the next year. The DPS of the company is expected to
grow at the rate of 8% p.a. The current MPS of the company's equity shares is `40.

You are required to compute the marginal weighted average cost of capital if the target debt
to value ratio of the company is 20%.

Answer
Marginal WACC = KeWe + KdWd = 18% × 0.80 + 8.125% × 0.20 = 16.025%

Calculation of Marginal Ke and Kd

D1 4
Ke = +g = + .08 = 18%
P0 40
Kd = I (1 - t) = 12.50% (1 – 0.35) = 8.125%

BQ 42
ABC Ltd. has the following capital structure, which is considered to be optimum at on 31st March,
2022:
14% debenture `30,000
11% preference share capital `10,000
Equity share capital (10,000 shares) `1,60,000

The company's share has a current market price of `23.60 per share. The expected dividend per
share in next year is 50 percent of the 2021 EPS. The EPS of last 10 years is as follows. The past trends
are expected to continue:
Year 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
EPS (`) 1.00 1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.15 2.36

The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is `96. Preference shares `9.20 (with dividend of `1.1 per share) were also issued. The
company is in 50% tax bracket.

8.18
 CHAPTER 8 COST OF CAPITAL

(i) Calculate the after tax (a) Cost of New Debts, (b) Cost of New Preference Share, and (c) Cost of
New Equity Share (assuming new equity from retained earnings).
(ii) Calculate the marginal cost of capital when no new share was issued.
(iii) Determine the amount that can be spent for capital investment before new ordinary shares must
be sold. Assuming that retained earnings for next year's investment are 50% of 2021.
(iv) Compute marginal cost of capital when the fund exceeds the amount calculated in (iii), assuming
new equity is issued at `20 per share?

Answer
(i) (a) After tax cost of new debt
I(1  t ) 16(1  .50)
Kd = × 100 = × 100 = 8.33%
NP 96

(b) After tax cost of new preference shares

PD 1.10
Kp = × 100 = × 100 = 11.96%
NP 9.20

(c) Cost of new equity or cost of retained earnings

D1 2.36  50%
Kr = +g = + 0.10 = 15%
P0 (old ) 23.60

(ii) MCC (Ko) when no new equity share was issued:

KdWd + KpWp + KrWr = 8.33% × .15 + 11.96% × .05 + 15% × .80 = 13.85%

(iii) The company can pay the following amount before issue of new shares:

Equity (retained earnings in this case) = 80% of the total capital

11 ,800
Therefore, investment before new issue = = `14,750
80 %

Retained earnings = `2.36 × 50% × 10,000 = `11,800

(iv) MCC (Ko) when funds exceeds `14,750

KdWd + KpWp + KeWe = 8.33% × .15 + 11.96% × .05 + 15.90% × .80 = 14.57%

If the company pay more than `14,750, it will have to issue new shares. The cost of new issue of
ordinary share is:
D1 1.18
Ke = +g = + 0.10 = 15.90%
P0 ( new ) 20

WN: Calculation of growth:

Growth from year 2012 to 2013 = (1.10 – 1.00) ÷ 1.00 = 10%

[Same rate of growth is found in future years]

8.19
 COST OF CAPITAL CHAPTER 8

BQ 43
M/s Navya Corporation has a capital structure of 40% debt and 60% equity. The company is presently
considering several alternative investment proposals costing less than `20,00,000. The corporation
always raises the required funds without disturbing its present debt equity ratio. The cost of raising the
debt and equity are as under:
Project cost Cost of debt Cost of equity
Upto `2,00,000 10% 12%
Above `2,00,000 & upto `5,00,000 11% 13%
Above `5,00,000 & upto `10,00,000 12% 14%
Above `10,00,000 & upto `20,00,000 13% 14.5%

Assuming tax rate at 50%, calculate:

(a) Cost of capital of two projects X and Y whose funds requirements are `6,50,000 and `14,00,000
respectively.
(b) If a project is expected to give after tax return of 10%, determine under what conditions it would
be acceptable?

Answer
(a) Statement Showing Weighted Average Cost of Capital
Project cost Financing Weight (W) Cost (K) Weighted cost
Upto `2,00,000 Debt 0.4 10% (1 – 0.50) = 5% 2.00%
Equity 0.6 12% 7.20%
9.20%
Above `2,00,000 & upto Debt 0.4 11% (1 – 0.50) = 5.5% 2.20%
`5,00,000 Equity 0.6 13% 7.80%
10.00%
Above `5,00,000 & upto Debt 0.4 12% (1 – 0.50) = 6% 2.40%
`10,00,000 Equity 0.6 14% 8.40%
10.80%
Above `10,00,000 & upto Debt 0.4 13% (1 – 0.50) = 6.5% 2.60%
`20,00,000 Equity 0.6 14.50% 8.70%
11.30%

Project Fund requirement Cost of capital

Project X `6,50,000 10.80%
Project Y `14,50,000 11.30%

(b) If a project is expected to give after tax return of 10%, it would be acceptable provided its cost
does not exceeds 5,00,000 or, after tax return should be more than or at least equal to the weighted
average cost of capital.

8.20
 CHAPTER 8 COST OF CAPITAL

PAST YEAR QUESTIONS

PYQ 1
The following details are provided by GPS Limited:
Equity Share capital `65,00,000
12% Preference Share Capital `12,00,000
15% Redeemable Debentures `20,00,000
10% Convertible Debentures `8,00,000

The cost of equity capital for the company is 16.30% and Income Tax rate for the company is 30%.

You are required to calculate the Weighted Average Cost of Capital (WACC) of the
company.
[(5 Marks) May 2014]

Answer
WACC = KeWe + KpWp + KrdWrd + KcdWcd
65 12 20 8
= 16.30% × + 12% × + 10.50% × + 7% × = 13.9952%
105 105 105 105

Working Notes:
(i) Calculation of cost of Preference Share Capital (Kp):

Kp = Rate of Preference Dividend = 12%

(ii) Calculation of cost of Redeemable Debentures (Krd):

Krd = I (1 - t) = 15% (1 - 0.30) = 10.50%

(iii) Calculation of cost Convertible Debentures (Kcd):

Kcd = I (1 - t) = 10% (1 - 0.30) = 7%

PYQ 2
A Ltd. wishes to raise additional finance of `30 lakhs for meeting its investment plans. The company has
`6,00,000 in the form of retained earnings available for investment purposes. The following are the
further details:
Debt equity ratio : 30 : 70
Cost of debt:
Upto `3,00,000 : 11% (before tax) and
Beyond `3,00,000 : 14% (before tax)
Earning per share : `15 per share
Dividend payout : 70% of earnings
Expected growth rate : 10%
Current market price : `90 per share
Company’s tax rate : 30%
Shareholder’s personal tax rate : 20%.

You are required to:

8.21
 COST OF CAPITAL CHAPTER 8

1. Calculate the post tax average cost of additional debt.

2. Calculate the cost of retained earnings and cost of equity.
3. Calculate the overall weighted average (after tax) cost of additional finance.
[(8 Marks) May 2015]

Answer
Total capital required is `30 lakhs. With a debt - equity ratio of 30 : 70. It means `9 lakhs is to be raised
through debt and `21 lakhs through equity. Out of `21 lakhs, `6 lakhs are available in the form of
retained earnings hence `15 lakhs will have to raise by issuing equity shares.

1. Post tax average cost of additional debt:

Kd1 = I (1 - t) = 11% (1 – 0.30) = 7.70%

Kd2 = I (1 - t) = 14% (1 – 0.30) = 9.80%
Average Kd = Kd1Wd1 + Kd2Wd2 = 7.7% × 3 + 9.8% × 6 = 9.10%
9 9
2. Cost of retained earning & cost of equity:

D1 10.50  10%
Ke = +g = + 0.10 = 22.83%
P0 90

Kr = Ke (1 - PT) = 22.83% (1 - .20) = 18.27%

D0 = `15 × 70% = `10.50

3. Overall cost of additional finance:

Ko = KeWe + KrWr + KdWd

= 22.83% × 15 + 18.27% × 6 + 9.10% × 9 = 17.80%
30 30 30

Assumption: DPS `10.50 is treated at Do.

PYQ 3
A company issues 25,000, 14% debentures of `1,000 each. The debentures are redeemable after the
expiry period 5 years. Tax rate applicable to the company is 35%.

Calculate the cost of debt after tax if debentures are issued at 5% discount with 2% flotation cost.
[(5 Marks) Nov 2015]

Answer
 RV  NP   1000  930 
I 1  t     140 1  0.35    
Kd =  n  × 100 =  5  × 100
RV  NP 1000  930
2 2
= 10.88%

Net Proceeds = 1,000 – 5% Discount – 2% Flotation cost = 930

Note: Floatation cost has been calculated on the basis of face value (i.e. 2% of `1,000 or `950 whichever
is higher).

8.22
 CHAPTER 8 COST OF CAPITAL

PYQ 4
The X Company has following capital structure at 31st March, 2015, which is considered to be
optimum:

14% debenture `3,00,000

11% preference share capital `1,00,000
Equity share capital (1,00,000 shares) `16,00,000

The company's share has a current market price of `23..60 per share. The expected dividend per
share in next year is 50 percent of the 2015 EPS. The EPS of last 10 years is as follows. The past trends
are expected to continue:

Year 2006 2007 2008 2009 2010 2011 2012 2013 2015 2015
EPS (`) 1.00 1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.15 2.36

The company issued new debentures carrying 16% rate of interest and the current market price
of debenture is `96. Preference shares `9.20 (with dividend of `1.1 per share) were also issued. The
company is in 50% tax bracket.

(i) Calculate the after tax cost of (a) New Debts, (b) New Preference Share, and (c) New Equity Share
(assuming new equity from retained earnings).
(ii) Calculate the marginal cost of capital when no new share was issued.
(iii) How much can be spent for capital investment before new ordinary shares must be sold?
Assuming that retained earnings for next year's investment are 50% of 2015.
(iv) What will be marginal cost of capital when the fund exceeds the amount calculated in (iii),
assuming new equity is issued at `20 per share?
[(8 Marks) May 2016]

Answer
(i) (a) After tax cost of new debt
I(1  t ) 16(1  .50)
Kd = × 100 = × 100 = 8.33%
NP 96

(b) After tax cost of new preference shares

PD 1.10
Kp = × 100 = × 100 = 11.96%
NP 9.20

(a) Cost of new equity or cost of retained earnings

D1 2.36  50%
Kr = +g = + 0.10 = 15%
P0 (old ) 23.60

(ii) MCC (Ko) when no new equity share was issued:

KdWd + KpWp + KrWr = 8.33% × .15 + 11.96% × .05 + 15% × .80 = 13.85%

(iii) The company can pay the following amount before issue of new shares:

Equity (retained earnings in this case) = 80% of the total capital

8.23
 COST OF CAPITAL CHAPTER 8

1 ,18 ,000
Therefore, investment before new issue = = `1,47,500
80 %

Retained earnings = `2.36 × 50% × 1,00,000 = `1,18,000

(iv) MCC (Ko) when funds exceeds `1,47,500

KdWd + KpWp + KeWe = 8.33% × .15 + 11.96% × .05 + 15.90% × .80 = 14.57%

If the company pay more than `1,47,500, it will have to issue new shares. The cost of new issue
of ordinary share is:
D1 1.18
Ke = +g = + 0.10 = 15.90%
P0 ( new ) 20

WN: Calculation of growth:

Growth from year 2006 to 2007 = (1.10 – 1.00) ÷ 1.00 = 10%
[Same rate of growth is found in future years]

PYQ 5
ABC Company’s equity share is quoted in the market at `25 per share currently. The company pays a
dividend of `2 per share and the investor’s market expects a growth rate of 6% per year.

You are required to:

(i) Calculate the company’s cost of equity capital.
(ii) If the anticipated growth rate is 8% per annum, calculate the indicated market price per share.
(iii) If the company issues 10% debentures of face value of `100 each and realises `96 per debenture
while the debentures are redeemable after 12 years at a premium of 12%, what will be the cost
of debenture? Assume Tax Rate to be 50%.
[(5 Marks) Nov 2016]

Answer
D1 2
(i) Ke = +g = + 0.06 = 14%
P0 25
Note: The cost of equity can be calculated with taking the effect of growth on dividend (i.e. D1 = 2.12).

D1 2
(ii) Po = = = `33.33
Ke  g 14 %  8%

 RV  NP   112  96 
I 1  t     10 1  0.50    
(iii) Kd =  n  × 100 =  12  × 100
RV  NP 112  96
2 2
= 6.089%

PYQ 6
Following is the capital structure of RBT Ltd. As on 31st March 2016:

Sources of Fund Book Value Market Value

8.24
 CHAPTER 8 COST OF CAPITAL

Equity Share of `10 each `50,00,000 `1,05,00,000

Retained Earnings `13,00,000 Nil
11% Preference Share of `100 each `7,00,000 `9,00,000
14% Debentures of `100 each `30,00,000 `36,00,000

Market price of equity shares is `40 per share and it is expected that a dividend of `4 per share would
be declared. The dividend per share is expected to grow at the rate of 8% every year. Income tax rate
applicable to the company is 40% and shareholder’s personal income tax rate is 20%.

You are required to calculate:

(i) Cost of capital for each source of capital,
(ii) Weighted average cost of capital on the basis of book value weights,
(iii) Weighted average cost of capital on the basis of market value weights.
[(8 Marks) Nov 2016]

Answer
(i) Calculation of cost of capital for each source of capital:

D1 4
Ke = +g = + 0.08 = 18%
P0 40

Kr = Ke (1 - PT) = 18% (1 – 0.20) = 14.40%

Kd = I (1 - t) = 14% (1 – 0.40) = 8.40%

Kp = Rate of PD = 11%

(ii) Calculation of WACC (Ko) using book value proportions

Name of Source Amount Proportion K Ko
Equity Share Capital 50,00,000 0.50 18% 9.00%
Retained Earnings 13,00,000 0.13 14.40% 1.87%
Preference Share Capital 7,00,000 0.07 11% 0.77%
Debentures 30,00,000 0.30 8.40% 2.52%
Total 1,00,00,000 1.00 WACC 14.16%

(iii) Calculation of WACC (Ko) using market value proportions

Name of Source Amount Proportion K Ko
Equity Share Capital 83,33,333 0.555 18% 9.99%
Retained Earnings 21,66,667 0.145 14.40% 2.09%
Preference Share Capital 9,00,000 0.060 11% 0.66%
Debentures 36,00,000 0.240 8.40% 2.02%
Total 1,50,00,000 1.000 WACC 14.76%

Market value of Equity Share Capital = `1,05,00,000 × 50/63 = `83,33,333

Market value of Retained Earnings = `1,05,00,000 × 13/63 = `21,66,667

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.

8.25
 COST OF CAPITAL CHAPTER 8

PYQ 7
JC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of `20 and proposes
to pay 60% dividend at the current year end with a P/E ratio 6.25, it wants to offer the issue at market
price. The flotation cost is expected to be 4% of the issue price.
You are required to determine rate of return for equity share (cost of equity) before the issue
and after the issue.
[(5 Marks) May 2018]

Answer
Market price of share (P0) = EPS × PE = `20 × 6.25 = `125

Net proceeds = 125 – 4% = `120

Return on Equity (ROE) = 1/PE = 1/6.25 = 16%

Growth rate = r×b = 16% × 40% = 6.40%

D1 60% of 20
Ke (before issue) = P0
+g = 125
+ 6.40% = 16%

D1 60% of 20
Ke (after issue) = +g = + 6.40% = 16.40%
NP 120

PYQ 8
Alpha Ltd. has furnished the following information:
Earning per share (EPS) : `4.00
Dividend payout ratio : 25%
Market price per share : `50
Rate of tax : 30%
Growth rate of dividend : 10%

The company wants to raise additional capital of `10 lakhs including debt of `4 lakhs. The cost
of debt (before tax) is 10% upto `2 lakhs and 15% beyond that.

Compute the after tax cost equity and debt and the weighted average cost of capital.
[(5 Marks) May 2019]

Answer
D1 4.00 × 25% × 110%
Ke = +g = + 0.10 = 12.20%
P0 50

Kd1 = I (1 - t) = 10% (1 – 0.30) = 7%

Kd2 = I (1 - t) = 15% (1 – 0.30) = 10.50%

Ko = KeWe + Kd1Wd1 + Kd2Wd2

= 12.20% × 6 + 7% × 2 + 10.50% × 2 = 10.82%
10 10 10

PYQ 9
A company wants to raise additional finance of `5 crore in next year. The company expected to retain

8.26
 CHAPTER 8 COST OF CAPITAL

`1 crore in next year. Further details are as follows:

(i) The amount will be raised by equity and debt in the ratio of 3 : 1.
(ii) The additional issue of equity shares will result in price per share being fixed at `25.
(iii) The debt capital raised by way of term loan will cost 10% for the first `75 lakh and 12% for the
next `50 lakh.
(iv) The net expected dividend on equity shares is `2.00 per share. The dividend is expected to grow
at the rate of 5%.
(v) Income tax rate of 25%.

You are required:

(a) To determine the amount of equity and debt for raising additional finance.
(b) To determine the post tax average cost of additional debt.
(c) To determine the cost of retained earning and cost of equity.
(d) To compute the overall weighted average cost of additional finance after tax.
[(10 Marks) Nov 2019]

Answer
(a) Total capital required is `5 crore. With a debt-equity ratio of 1:3. It means `1.25 crore is to be
raised through debt and `3.75 crores through equity. Out of `3.75 crore, `1 crore are available
in the form of retained earnings hence `2.75 crore will have to raise by issuing equity shares.

(b) Post tax average cost of additional debt:

Kd1 = I (1 - t) = 10% (1 – 0.25) = 7.5%

Kd2 = I (1 - t) = 12% (1 – 0.25) = 9%

Average Kd = Kd1Wd1 + Kd2Wd2 = 7.5% × 75 + 9% × 50 = 8.10%

125 125

(c) Cost of retained earning & cost of equity:

D1 2
Ke = +g = + 0.05 = 13%
P0 25

Kr = Ke = 13%

(d) Overall cost of additional finance:

Ko = KeWe + KrWr + KdWd

= 13% × 275 + 13% × 100 + 8.10% × 125 = 11.78%
500 500 500

PYQ 10
TT Ltd. issued 20,000, 10% Convertible debentures of `100 each with a maturity period of 5 years. At
maturity the debenture holders will have the option to convert the debentures into equity shares of the
company in the ratio of 1:5 (5 shares for each debenture). The current market price of the equity shares
is `20 each and historically the growth rate of the shares are 4% per annum. Assuming tax rate is 25%.

8.27
 COST OF CAPITAL CHAPTER 8

Compute the cost of 10% debentures using Approximation Method and Internal Rate of
Return Method.

PV Factor are as under:

Year 1 2 3 4 5
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
PV Factor @ 15% 0.870 0.756 0.658 0.572 0.497
[(5 Marks) Nov 2020]

Answer
(a) Calculation of Cost of Convertible debenture using Approximation Method:
CV−NP 121.67−100
I (1 − t) + 10 (1 − 0.25) +
Kd = CV+NP
n
× 100 = 121.67+100
5
× 100 = 10.68%
2 2

(b) Calculation of Cost of Convertible debenture using IRR Method

Calculation of NPV at two discount rates:

Present Value Present Value
Year Cash Flow
10% DCF 15% DCF
0 (100) 1.000 (100) 1.000 (100)
1-5 7.50 3.790 28.43 3.353 25.15
5 121.67 0.621 75.56 0.497 60.47
NPV +3.99 -14.38

NPVL 3.99
IRR/Kd = LR + × (H - L) = 10% + × (15% - 10%)
NPVL  NPVH 3.99−(−14.38)

= 11.09%

Determination of Convertible value:

Higher of:
(i) The cash value of debentures = `100

(ii) Value of equity shares = 5 shares × `20 (1 + 0.04)5

= 5 shares × `24.333 = `121.67

`121.67 will be taken as redemption value as it is higher than the cash option and attractive to the
investors.

PYQ 11
The capital structure of PQR Ltd. is as follows:
10% Debentures `3,00,000
12% Preference shares `2,50,000
Equity shares (face value `10 per share) `5,00,000

Additional information:
(i) `100 per debenture redeemable at par has 2% floatation cost & 10 years of maturity. The market
price per debenture is `110.

8.28
 CHAPTER 8 COST OF CAPITAL

(ii) `100 per preference share redeemable at par has 3% floatation cost & 10 years of maturity. The
market price per preference share is `108.
(iii) Equity share has `4 floatation cost and market price per share of `25.
The next year expected dividend is `2 per share with annual growth of 5%. The firm has a
practice of paying all earnings in the form of dividends.
(iv) Corporate Income tax rate is 30%.

Calculate Weighted Average Cost of Capital (WACC) using market value weights.
[(10 Marks) Jan 2021]

Answer
Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particular Market value Weight Cost Weighted cost
10% Debenture 3,30,000 0.178 7.27% 1.294%
12% Preference share 2,70,000 0.146 12.49% 1.823%
Equity Share Capital 12,50,000 0.676 14.52% 9.816%
Total 18,50,000 1.000 WACC 12.933%

Working notes:

1. Calculation of specific cost of various sources of funds:

D1 2
Ke = g = + .05 = 14.52%
P0  F 25−4

 RV  NP 
I 1  t     10 (1−0.30)+ (
100−98
)
Kd =  n  × 100 = 100+98
10
× 100 = 7.27%
RV  NP 2
2
 RV  NP 
PD    12 + (
100−97
)
Kp =  n  × 100 = 10
100+97 × 100 = 12.49%
RV  NP 2
2

2. Calculation of market value of various sources of funds:

Debentures = 3,00,000 × 110/100 = 3,30,000

Preference shares = 2,50,000 × 108/100 = 2,70,000

Equity shares = 5,00,000 × 25/10 = 12,50,000

PYQ 12
Following are the information of TT Ltd.:

Particulars
Earnings per share `10
Dividend per share `6
Expected growth rate in dividend 6%
Current market price per share `120
Tax rate 30%
Requirement of additional finance `30,00,000

8.29
 COST OF CAPITAL CHAPTER 8

Debt Equity ratio (for additional finance) 2:1

Cost of Debt:
0 – 5,00,000 10%
5,00,001 – 10,00,000 9%
Above 10,00,000 8%

Assuming that there is no Reserve and Surplus available in TT Ltd.

You are required to:

(a) Find the pattern of finance for additional requirement.
(b) Calculate post tax average cost of additional debt.
(c) Calculate cost of equity.
(d) Calculate overall weighted average after tax cost of additional finance.
[(10 Marks) July 2021]

Answer
(a) Pattern for additional requirement: Total requirement of additional fund is `30,00,000. With a
Debt Equity ratio of 2 : 1. It means `20,00,000 is to be raised through debt and `10,00,000 through
equity. Out of `20,00,000 debt, first `5,00,000 @10%, next `5,00,000 @9% and remaining
`10,00,000 @8%. Entire equity finance of `10,00,000 through issuing equity shares.

(b) Post tax average cost of additional debt:

Kd1 = I (1 - t) = 10% (1 – 0.30) = 7%

Kd2 = I (1 - t) = 9% (1 – 0.30) = 6.30%

Kd3 = I (1 - t) = 8% (1 – 0.30) = 5.60%

Average Kd = Kd1Wd1 + Kd2Wd2 + Kd3Wd3

= 7% × 5/20 + 6.30% × 5/20 + 5.60% × 10/20 = 6.125%

(c) Cost of Equity:

D1 6 (1 + 0.06 )
Ke = +g = + 0.06 = 11.30%
P0 120

(d) Overall WACC after tax of additional finance:

Ko = KeWe + KdWd = 11.30% × 10
+ 6.125% × 20
30 30
= 7.85%

Assumption: DPS is treated at Do.

PYQ 13
Book value of capital structure of B Ltd. is as follows:
Sources Amount
12% 6,000 Debentures @ `100 each `6,00,000
Retained earnings `4,50,000
4,500 Equity shares @ `100 each `4,50,000
`15,00,000

8.30
 CHAPTER 8 COST OF CAPITAL

Currently the market value of debenture is `110 per debenture and equity share is `180 per share. The
expected rate of return to equity shareholder is 24% p.a. Company is paying tax @30%.

Calculate WACC on the basis of market value weights.

[(5 Marks) Dec 2021]

Answer
Statement of WACC (Market Value Weights)
Capital Structure Amount Weight Specific Cost Cost of Capital
12% Debentures 6,60,000 0.449 0.0764 0.0343
Equity Fund including 8,10,000 0.551 0.1333 0.0734
Retained earning
Total 14,70,000 1.000 WACC 0.1077

WACC (Ko) = 0.1077 or 10.77%

Working Notes:

(1) Calculation of Market Value:

Market value of debenture = (`6,00,000 ÷ `100) × `110 = `6,60,000

Market value of Equity and Retained earnings:

= (`4,50,000 ÷ `100) × `180 = `8,10,000

(2) Calculation of Ke:

D1 24% of 100
Ke = × 100 = = 13.33%
P0 180

(3) Calculation of Kd:

I (1  t ) 12% of 100 (1  0.3)
Kd = × 100 = × 100 = 7.64%
NP 110
PYQ 14
A company issues:

 15% convertible debentures of `100 each at par with a maturity period of 6 years. On maturity, each
debenture will be converted into 2 equity shares of the company. The risk-free rate of return is 10%,
market risk premium is 18% and beta of the company is 1.25. The company has paid dividend of
`12.76 per share. Five year ago, it paid dividend of `10 per share. Flotation cost is 5% of issue
amount.

 5% preference shares of `100 each at premium of 10%. These shares are redeemable after 10 years
at par. Flotation cost is 6% of issue amount.

Assuming corporate tax rate is 40%.

(a) Calculate the cost of convertible debentures using the approximation method.
(b) Use YTM method to calculate cost of preference shares.

8.31
 COST OF CAPITAL CHAPTER 8

Year 1 2 3 4 5 6 7 8 9 10
PVIF0.03,t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF 0.05,t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA0.03,t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
PVIFA0.05,t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828
[(10 Marks) May 2022]

Answer
(a) Calculation of cost of Convertible Debentures using Approximation method:
RV−NP 130.58−95
I (1 − t) + 15 (1 − 0.40) +
Kd = RV+NP
n
× 100 = 130.58+95
6
× 100 = 13.24%
2 2

Working Notes:

Determination of Redemption value:

Higher of:
(i) The cash value of debentures = `100

(ii) Value of equity shares = 2 shares × `48.72 (1 + 0.05)6 = `130.58

`130 will be taken as redemption value as it is higher than the cash option and attractive to the investors.

Calculation of Value of Share today:

D1 12.76 (1+0.05)
P0 = Ke −g
= 32.50%−5%
= `48.72

Ke = Rf + β (Rm - Rf) = 10% + 1.25 × 18% = 32.50%

5 12.76
g = √10.00 = 5% or

g = 12.76 ÷ 10.00 = 1.276 (5% for 5 year; given in interest rate table)

(b) Calculation of Cost of Preference shares using YTM method::

Calculation of NPV at two discount rates:

Present Value Present Value
Year Cash Flow
3% DCF 5% DCF
0 103.40 1.000 (103.40) 1.000 (103.40)
1 - 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +13.65 -3.39

8.32
 CHAPTER 8 COST OF CAPITAL

NPVL 13 .65
IRR/Kd = LR + × (H - L) = 3% + × (5% - 3%)
NPVL  NPVH 13 .65  (  3.39 )
= 4.60%

Working Note:
Net Proceeds = Issue Price – Flotation Cost
= (100 + 10% Premium) – 6% = `103.40

PYQ 15
The following is the extract of the Balance Sheet of M/s KD Ltd.:
Particulars Amount (`)
Ordinary shares (Face Value `10 per share) 5,00,000
Share Premium 1,00,000
Retained Profits 6,00,000
8% Preference Shares (Face Value `25 per share) 4,00,000
12% Debentures (Face value `100 each) 6,00,000
22,00,000

The ordinary shares are currently priced at `39 ex-dividend and preference share is priced at `18 Cum-
dividend. The debentures are selling at 120 percent ex-interest. The applicable tax rate to D Ltd. is 30
percent. KD Ltd.’s cost of equity has been estimated at 19 percent. Calculate the WACC (weighted
average cost of capital) of KD Ltd. on the basis of market value.
[(5 Marks) Nov 2022]

Answer
Statement of WACC (Market Value Weights)
Capital Structure Amount Weight Specific Cost Cost of
Capital
Ordinary Shares 8,12,500 0.278 0.190 0.0528
Share Prem & Retained Profits 11,37,500 0.389 0.190 0.0739
8% Preference Shares 2,56,000 0.087 0.125 0.0109
12% Debentures 7,20,000 0.246 0.070 0.0172
Total 29,26,000 1.000 WACC 0.1548

WACC (Ko) = 0.1548 or 15.48%

Working Notes:

(1) Calculation of Market Value:

Total Market value of Equity and Retained earnings:

= (`5,00,000 ÷ `10) × `39 = `19,50,000

Market Value of Equity = `19,50,000 × 5/12 = `8,12,500

Market Value of Retained earnings = `19,50,000 × 7/12 = `11,37,500

Market Value of Debentures = (`6,00,000 ÷ `100) × `120 = `7,20,000

Market Value of Preference Shares = (`4,00,000 ÷ `25) × `16* = `2,56,000

8.33
 COST OF CAPITAL CHAPTER 8

*Market value of 1 Preference Share ex-dividend is used i.e. `16 (`18 - 8% of `25).

(2) Calculation of Kr:

Kr = Ke = 19%

(3) Calculation of Kd:

I (1  t ) 12% of 100 (1  0.3)
Kd = × 100 = × 100 = 7%
NP 120

(4) Calculation of Kp:

PD 8% of 25
Kp = × 100 = × 100 = 12.5%
NP 16

PYQ 16
MR Ltd. is having the following capital structure, which is considered to be optimum as on 31.03.2022.

Equity share capital (50,000 shares) `8,00,000

12% Pref. share capital `50,000
15% Debentures `1,50,000
`10,00,000

The earnings per share (EPS) of the company were `2.50 in 2021 and the expected growth in equity
dividend is 10% per year. The next year’s dividend per share (DPS) is 50% EPS of the year 2021. The
current market price per share (MPS) is `25.00. The 15% new debentures can be issued by the company.
The company’s debentures are currently selling at `96 per debenture. The new 12% Pref. Share can be
sold at a net price of `91.50 (face value `100 each). The applicable tax rate is 30%.

You are required to calculate:

(i) After tax cost of
(a) New debt,
(b) New pref. share capital and
(c) Equity shares assuming that new equity shares come from retained earnings.
(ii) Marginal cost of capital.
(iii) How much can be spent for capital investment before sale of new equity shares assuming that
retained earnings for next year investment is 50% of 2021?
[(6 Marks) Nov 2022]

Answer
(i) (a) After tax cost of new debt

I (1  t ) 15 (1  0.30)
Kd = × 100 = × 100 = 10.94%
NP 96

(b) After tax cost of new preference shares

PD 12
Kp = × 100 = × 100 = 13.11%
NP 91.50

8.34
 CHAPTER 8 COST OF CAPITAL

(c) Cost of new equity or cost of retained earnings

D1 2.50  50%
Kr = +g = + 0.10 = 15%
P0 25

(ii) Marginal cost of capital:

KdWd + KpWp + KrWr = 10.94% × .15 + 13.11% × .05 + 15% × .80 = 14.30%

(iii) The company can pay the following amount before issue of new shares:

Equity (retained earnings in this case) = 80% of the total capital

62 ,500
Therefore, investment before new issue = = `78,125
80 %

Retained earnings = `2.50 × 50% × 50,000 shares = `62,500

PYQ 17
Capital structure of D Ltd. as on 31st March, 2023 is given below.
Particular `
Equity share capital (`10 each ) 30,00,000
8% Preference share capital (`100 each ) 10,00,000
12% Debentures (`100 each ) 10,00,000

 Current market price of equity share is `80 per share. The company has paid dividend of `14.07 per
share. Seven years ago, it paid dividend of `10 per share. Expected dividend is `16 per share.
 8% Preference shares are redeemable at 6% premium after five years. Current market price per
preference share is `104.
 12% debentures are redeemable at 20% premium after 10 years, Flotation cost is `5 per debenture.
 The company is in 40% tax bracket.
 In order to finance an expansion plan, the company intends to borrow 15% Long-term loan of
`30,00,000 from bank. This financial decision is expected to increase dividend on equity share from
`16 per share to `18 per share. However, the market price of equity share is expected to decline
from `80 to `72 per share, because investors’ required rate of return is based on current market
conditions.

Required:
(a) Determine the existing Weighted Average Cost of Capital (WACC) taking book value weights.
(b) Compute Weighted Average Cost of Capital (WACC) after the expansion plan taking book value
weights.

Interest Rate 1% 2% 3% 4% 5% 6% 7%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606
[(10 Marks) May 23]

8.35
 COST OF CAPITAL CHAPTER 8

Answer
(a) Calculation of Existing Weighted Average Cost of Capital by taking Book Value Weight
Particulars Book Value Weight (W) Cost (K) Weighted cost
Equity Shares `30,00,000 0.60 0.2500 0.1500
Preference Shares `10,00,000 0.20 0.0800 0.0160
Debentures `10,00,000 0.20 0.0902 0.0180
Total `50,00,000 1.00 WACC 0.1840

Existing WACC = 0.1840 or 18.40%

(b) Calculation of Weighted Average Cost of Capital after expansion by taking Book Value Weight
Particulars Book Value Weight (W) Cost (K) Weighted cost
Equity Shares `30,00,000 0.375 0.3000 0.1125
Preference Shares `10,00,000 0.125 0.0800 0.0100
Debentures `10,00,000 0.125 0.0902 0.0113
Long Term Loan `30,00,000 0.375 0.9000 0.0338
Total `80,00,000 1.000 WACC 0.1676

Revised WACC = 0.1676 or 16.76%

Working notes:
D1 16
Ke = g = + 5% = 25%
P0 80

7 14.07
g = √ –1 = 5%
10
or
g (FVIFi,7) = 14.07÷10 = 1.407 (g = 5% in table)
RV−NP 106−104
PD+ ( ) 8+ ( )
Kp = n
RV + NP × 100 = 5
106 + 104 × 100 = 8%
2 2

RV−NP 120−95
I (1−t) + ( ) 12 (1−0.40) + ( )
Kd = RV + NP
n
× 100 = 120 + 95
10
× 100 = 9.02%
2 2

D1 18
Ke (Revised) = g = + 5% = 30%
P0 72

KTL = I (1 - t) = 15% (1 – 0.4) = 9%

PYQ 18
Z Ltd. wishes to raise additional fund of `25,00,000 for meeting its investment plan. It has `5,25,000 in
the form of retained earnings available for investment purposes. Further details are as following:
Combination of debt and equity 2:3
Cost of debt
Upto `2,50,000 8% (before tax)
Above `2,50,000 and to upto `5,00,000 10% (before tax)
Beyond `5,00,000 12% (after tax)

8.36
 CHAPTER 8 COST OF CAPITAL

Earning of company `50,00,000

Retention Ratio 40%
Expected growth of dividend 15%
Market price per share `500
Number of outstanding equity shares 1,00,000
Tax Rate 30%

You are required to calculate:

(a) Cost of debt
(b) Cost of retained earnings and cost of equity
(c) Weighted average cost of capital [(10 Marks) Nov 23]

Answer
Total capital required is `25 lakhs. With a debt-equity ratio of 2:3. It means `10 lakhs is to be raised
through debt (`2,50,000 @8% next `2,50,000 @10% and `5,00,000 @12%) and `15 lakhs through
equity. Out of `15 lakhs, `5,25,000 are available in the form of retained earnings hence `9,75,000 lakhs
will have to raise by issuing equity shares.
(a) Cost of debt:
Kd1 = I (1 - t) = 8% (1 – 0.30) = 5.60%

Kd2 = I (1 - t) = 10% (1 – 0.30) = 7.00%

Kd3 = 12.00% (after tax given)

Average Kd = 5.6% × 2 .5 + 7% × 2 .5 + 12% × 5 = 9.15%

10 10 10

(b) Cost of retained earning & cost of equity:

D1 30  15%
Ke = +g = + 0.15 = 21.90%
P0 500

Kr = Ke = 21.90%

EPS = `50,00,000 ÷ 1,00,000 Shares = `50

D0 = `50 × 60% = `30

(c) Overall cost of additional finance:
Ko = KeWe + KrWr + KdWd
= 21.90% × 9.75 + 21.90% × 5.25 + 9.15% × 10 = 16.80%
25 25 25

Assumption: DPS is treated at Do.

SUGGESTED REVISION FOR EXAM:

BQ: 8, 10, 11, 21, 24, 25, 26, 27, 30, 33, 37, 38, 39, 42

PYQ: 7, 9, 12, 14, 15, 17

8.37
 CHAPTER 9 CAPITAL STRUCTURE

CHAPTER 9 CAPITAL STRUCTURE

NET INCOME & NET OPERATING INCOME APPROACHES

BQ 1
Rupa Ltd.’s EBIT is `5,00,000. The company has 10%, `20 lakh debentures. The equity capitalization
rate i.e. Ke is 16%.

You are required to calculate:

(1) Market value of equity and value of firm
(2) Overall cost of capital.

Answer
(1) Statement Showing Market Value of Equity and Value of Firm
Particulars `
Net Operating income 5,00,000
Less: Interest on Debt 2,00,000
Earnings for Equity Investors 3,00,000
Equity Capitalization rate 16%
Market Value of Equity (3,00,000  0.16) 18,75,000
Value of debt 20,00,000
Total Value of the Firm 38,75,000

(2) Overall cost of capital:

EBIT 5,00,000
Ko = × 100 = × 100 = 12.90%
V 38,75,000

BQ 2
Indra Ltd. has EBIT of `1,00,000. The company makes use of debt and equity capital. The firm has 10%
debentures of `5,00,000 and the firm’s equity capitalization rate is 15%.

You are required to calculate:

(1) Market value of equity and value of firm
(2) Overall cost of capital.

Answer
(1) Statement Showing Market Value of Equity and Value of Firm
Particulars `
Net Operating income 1,00,000
Less: Interest on Debt 50,000
Earnings for Equity Investors 50,000
Equity Capitalization rate 15%
Market Value of Equity (50,000  0.15) 3,33,333
Value of debt 5,00,000
Total Value of the Firm 8,33,333

9.1
 CAPITAL STRUCTURE CHAPTER 9

(2) Overall cost of capital:

EBIT 1,00,000
Ko = × 100 = × 100 = 12%
V 8,33,333

BQ 3
Amita Ltd’s operating income (EBIT) is `5,00,000. The firm’s cost of debt is 10% and currently the firm
employs `15,00,000 of debt. The overall cost of capital of the firm is 15%.

You are required to calculate:

(1) Market value of firm.
(2) Cost of Equity.

Answer
EBIT 5,00,000
(1) Market Value of Firm = K0
= 15%
= `33,33,333

EBIT − I 5,00,000 − 1,50,000

(2) Cost of Equity = Market value of Equity
× 100 = 18,33,333
× 100
= 19.09%

Working note:
Market value of Equity = Market value of Firm - Market value of Debt
= 33,33,333 – 15,00,000 = 18,33,333

BQ 4
X Ltd. and Y Ltd. are identical except that the former uses debt while the latter does not. Thus levered
firm has issued 10% Debentures of `9,00,000. Both the firms earn EBIT of 20% on total assets of
`15,00,000. Assuming tax rate is 50% and capitalization rate is 15% for an all equity firm.
(i) Compute the value of the two firms using NI approach.
(ii) Compute the value of the two firms using NOI approach.
(iii) Calculate the overall cost of capital, Ko for both the firms using NOI approach.

Answer
(i) Calculation of Value of firms by NI Approach:
Particulars X Ltd (`) Y Ltd (`)
EBIT (20% of `15,00,000) 3,00,000 3,00,000
Less: Interest on Debt 90,000 -
Profit Before Tax 2,10,000 3,00,000
Less: Tax @ 50% 1,05,000 1,50,000
Profit After Tax 1,05,000 1,50,000
Equity Capitalization rate 15% 15%
Market Value of Equity (PAT  Ke) 7,00,000 10,00,000
Value of debt 9,00,000 -
Total Value of the Firm 16,00,000 10,00,000

(ii) Values of the firm as per NOI Approach:

EBIT(1  t ) 3,00 ,000 (1  0.30)

Value of unlevered firm (Y Ltd) = =
Ko 0.15

9.2
 CHAPTER 9 CAPITAL STRUCTURE

= `10,00,000

Value of levered firm (X Ltd) = Value of unlevered firm + Debt × tax

= `10,00,000 + 9,00,000 × 50% = 14,50,000

This value of `14,50,000 can be bifurcated into Debt of `9,00,000 and Equity of `5,50,000.

(iii) Calculation of Ko under NOI Approach:

Y Ltd (Ko) = Ke = 15%

X Ltd (Ko) = KeWe + KdWd

= 19.1% × 5,50 ,000 + 5% × 9 ,00 ,000 = 10.34%
14 ,50 ,000 14 ,50 ,000
Or
EBIT(1 t ) 3 ,00 ,000(1  0.50 )
X Ltd (Ko) = × 100 = × 100
V 14 ,50 ,000
= 10.34%

Working Notes:

Calculation of Ke of X Ltd:
Earning for Equity (3,00,000−90,000) (1−0.50)
Ke = × 100= × 100
Market value of Equity 5,50,000
= 19.10%

BQ 5
Companies P and Q are identical in all respects including risk factors except for debt - equity, P has issued
10% debentures of `18 lakhs while Q has issued only equity. Both the companies earn 20% before
interest and taxes on their total assets of `30 lakhs. Assuming a tax rate of 50% and capitalisation rate
of 15% for an all - equity company.

Compute the value of companies P and Q using:

(a) Net income approach and
(b) Net operating income approach.

Answer
(a) Calculation of Value of firms by NI Approach:
Particulars P Ltd (`) Q Ltd (`)
EBIT (20% of `30,00,000) 6,00,000 6,00,000
Less: Interest on Debt 1,80,000 -
Profit Before Tax 4,20,000 6,00,000
Less: Tax @ 50% 2,10,000 3,00,000
Profit After Tax 2,10,000 3,00,000
Equity Capitalization rate 15% 15%
Market Value of Equity (PAT  Ke) 14,00,000 20,00,000
Value of debt 18,00,000 -
Total Value of the Firm 32,00,000 20,00,000

(b) Values of the firm as per NOI Approach:

9.3
 CAPITAL STRUCTURE CHAPTER 9

EBIT(1  t )
Value of unlevered firm (Q Ltd) = = `20,00,000
Ko

Value of levered firm (P Ltd) = Value of unlevered firm + Debt × tax

= `20,00,000 + 18,00,000 × 50% = `29,00,000

MODIGLIANI & MILLER HYPOTHESIS

BQ 6
One third of the total market value of Sanghmani Limited consists of loan stock, which has a cost of 10
per cent. Another company, Samsui Limited, is identical in every respect to Sanghmani Limited, except
that its capital structure is all equity, and its cost of equity is 16 per cent. According to Modigliani and
Miller, if we ignored taxation and tax relief on debt capital.

Compute the cost of equity of Sanghmani Limited?

Answer
Ko Sanghmani Limited = Ko Samsui Limited = 16%

Ko Sanghmani Limited = KeWe + KdWd

16% = Ke × 2/3 + 10% × 1/3

Ke Sanghmani Limited = 19%

BQ 7
Companies U and L are identical in every respect except that the former does not use debt in its capital
structure, while the latter employs `6,00,000 of 15% debt. Assuming that (a) all the MM assumptions
are met (b) the corporate tax rate is 50%, (c) the EBIT is `2,00,000 and (d) the equity capitalization of
the unlevered company is 20%.

What will be the value of the firms U and L? Also determine the weighted average cost of
capital for both the firms.

Answer
EBIT (1  t ) 2,00 ,000 (1  0.50 )
Value of unlevered firm = = = `5,00,000
Ko 0.20

Value of levered firm = Value of unlevered firm + Debt × tax

= `5,00,000 + 6,00,000 × 50% = `8,00,000

Ko of unlevered firm = Ke = 20%

EBIT(1  t ) 2 ,00 ,000 (1  0 .50 )

Ko of levered firm = = = `12.50%
V 8 ,00 ,000

BQ 8
Blue Ltd., an all equity financed company is considering the repurchase of `275 lakhs equity shares and

9.4
 CHAPTER 9 CAPITAL STRUCTURE

to replace it with 15% debentures of the same amount. Current market value of the company is `1,750
lakhs with its cost of capital of 20%. The company's Earnings before Interest and Taxes (EBIT) are
expected to remain constant in future years. The company also has a policy of distributing its entire
earnings as dividend. Assuming the corporate tax rate as 30%.

You are required to calculate the impact on the following on account of the change in the
capital structure as per Modigliani and Miller (MM) Approach:
(1) Market value of the company,
(2) Overall cost of capital, and
(3) Cost of equity.

Answer
(1) Market Value (MV) of Blue Ltd:

MV before repurchase (VUL) = 1,750 Lakhs

MV after repurchase (VL) = VUL + Debt × Tax

= 1,750 L + 275 L × 30% = 1,832.5 Lakhs

Impact on MV of firm = 1,832.50 L – 1,750 L

= Increase by 82.50 Lakhs

(2) Overall cost of capital:

WACC before repurchase = 20%

EBIT (1  t ) 500 L (1  0.30 )

WACC after repurchase = × 100 = × 100
Value of firm 1 ,832 .50 L
= 19.10%

Impact on Cost of capital = 20% – 19.10% = Decrease by 0.90%

(3) Cost of Equity:

Ke before repurchase = 20%

( EBIT  I) (1  t ) (500 L  15 % of 275 L ) (1  0.30 )

Ke after repurchase = × 100= × 100
MV of Equity 1 ,557 .50 L
= 20.62%

Impact on Ke = 20.62% – 20% = Increase by 0.62%

Workings notes:
EAT
MV of Equity (before repurchase) =
Ke
EAT
1,750 Lakhs =
0.20
EAT = 1,750 Lakhs × 20% = 350 L
EBIT = EAT ÷ (1 – t)
= 350 L ÷ (1 – 0.3) = 500 L

9.5
 CAPITAL STRUCTURE CHAPTER 9

MV of Equity (after repurchase) = Value of firm – Value of Debt

= 1,832.50 L – 275 L = 1,557.5 L

TRADITIONAL APPROACH & MISCELLANEOUS

BQ 9
Determine the optimal capital structure of a company from the following information:
Options Cost of Debt (Kd) in Cost of Equity (Ke) in % of Debt on Total Value (Debt +
% % Equity)
1 11 13 0.00
2 11 13 0.10
3 11.6 14 0.20
4 12 15 0.30
5 13 16 0.40
6 15 18 0.50
7 18 20 0.60

Answer
Calculation of Optimal Debt - Equity Mix
% of Debt in capital % of Equity in capital WACC
Kd in % Ke in %
employed employed Ko = Ke We + KdWd
0.00 11 1.00 13 13.00%
0.10 11 0.90 13 12.80%
0.20 11.6 0.80 14 13.52%
0.30 12 0.70 15 14.10%
0.40 13 0.60 16 14.80%
0.50 15 0.50 18 16.50%
0.60 18 0.40 20 18.80%

Decision: 2nd option is the best because it has lowest WACC.

BQ 10
ABC Ltd. with EBIT of `3,00,000 is evaluating a number of possible capitals below. Which of the capital
structure will you recommend, and why?
Capital Structure Debt Kd Ke
I `3,00,000 10% 12.00%
II `4,00,000 10% 12.50%
III `5,00,000 11% 13.50%
IV `6,00,000 12% 15.00%
V `7,00,000 14% 18.00%

Answer
Statement of Ko and Value of Firm
Particulars Plan I Plan II Plan III Plan IV Plan V
EBIT 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Less: Interest 30,000 40,000 55,000 72,000 98,000
Net profit 2,70,000 2,60,000 2,45,000 2,28,000 2,02,000
÷ Ke 0.12 0.125 0.135 0.15 0.18

9.6
 CHAPTER 9 CAPITAL STRUCTURE

Market value of Equity (E) 22,50,000 20,80,000 18,14,815 15,20,000 11,22,222

Market value of Debt (D) 3,00,000 4,00,000 5,00,000 6,00,000 7,00,000
Market value of firm (V) 25,50,000 24,80,000 23,14,815 21,20,000 18,22,222
Ko (EBIT ÷ V) 11.76% 12.10% 12.95% 14.15% 16.46%

The capital structure (Plan I) having `3,00,000 of debt has the lowest cost of capital
consequently the highest market value, should be accepted.

BQ 11
Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has 50 per cent
debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All
percentages are in market value terms). The borrowing rate for both companies is 8 per cent in a no-tax
world, and capital markets are assumed to be perfect.

(a) (i) If you own 2 per cent of the shares of Alpha Ltd., determine your return if the company has net
operating income of `3,60,000 and the overall capitalisation rate of the company, Ko is 18 per cent?

(ii) Calculate the implied required rate of return on equity?

(b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) Determine the implied required equity
return of Beta Ltd.? (ii) Analyse why does it differ from that of Alpha Ltd.?

Answer
NOI 3,60,000
(a) Value of the Alpha Ltd. =
Ko
=
18%
= `20,00,000

Value of Shares of Alpha Ltd. = 50% of `20,00,000 = `10,00,000

(i) Return on Shares on Alpha Ltd

Particulars `
Net Operating income 3,60,000
Less: Interest on Debt @ 8% on `10,00,0,00 (50% of `20,00,000) 80,000
Earnings for Equity Investors 2,80,000
Return on 2% Shares (2% of `2,80,000) 5,600

2,80,000
(ii) Implied required rate of return on Equity = 10,00,000
× 100 = 28%

(b) (i) Return on Shares on Beta Ltd

Particulars `
Net Operating income 3,60,000
Less: Interest on Debt @ 8% on `4,00,0,00 (20% of `20,00,000) 32,000
Earnings for Equity Investors 3,28,000

Value of Shares of Beta Ltd. = 80% of `20,00,000 = `16,00,000

3,28,000
Implied required rate of return on Equity = 16,00,000
× 100 = 20.50%
(ii) It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its capital structure. As the equity
capitalisation is a linear function of the debt-to-equity ratio when we use the net operating income
approach, the decline in required equity return offsets exactly the disadvantage of not employing so
much in the way of “cheaper” debt funds.

9.7
 CAPITAL STRUCTURE CHAPTER 9

ARBITRAGE PROCESS (VL > VUL)

BQ 12
There are two company N Ltd. and M Ltd., having same earnings before interest and taxes i.e. EBIT of
`20,000. M Ltd. is a levered company having a debt of `1,00,000 @ 7% rate of interest. The cost of equity
of N Ltd. is 10% and of M Ltd. is 11.50%.

Compute how arbitrage process will be carried on?

Answer
NOI−Interest
Value of Equity (S) = Cost of Equity

20,000
SN = 10%
= `2,00,000

20,000−7,000
SM =
11.50%
= `1,13,043

VN = `2,00,000

VM = SM + D
= `1,13,043 + `1,00,000 = `2,13,043

Arbitrage Process:
If you have 10% shares of M Ltd., your value of investment in equity shares is 10% of `1,13,043 i.e.
`11,304.30 and return will be 10% of (`20,000 – `7,000) = `1,300.

Strategy (Same return with lower investnent):

Sell your 10% share of levered firm for `11,304.30 and borrow 10% of levered firms debt i.e. 10% of
`1,00,000 and invest the money i.e. 10% in unlevered firms stock:

Total resources /Money we have = `11,304.30 + `10,000 = `21,304.30

Invest in 10% shares of Unlevered firm = 10% of `2,00,000 = `20,000

Surplus cash available with you = `21,304.3 – `20,000 = `1,304.30

Your return = 10% EBIT of unlevered firm – Interest

= 10% of `20,000 – 7% of `10,000
= `2,000 – `700 = `1,300

Conclusion:
Your return is same i.e. `1,300 which you are getting from N Ltd. before investing in M Ltd. but still you
have `1,304.3 excess money available with you. Hence, you are better off by doing arbitrage.

BQ 13
Following data is available in respect of two companies having same business risk:
Capital employed = `2,00,000
EBIT = `30,000

9.8
 CHAPTER 9 CAPITAL STRUCTURE

Ke = 12.5%

Sources Levered Company (`) Unlevered Company (`)

Debt (@ 10%) 1,00,000 -
Equity 1,00,000 2,00,000

Investor is holding 15% shares in levered company.

Calculate increase in annual earnings of investor if he switches his holding from levered to
unlevered company.

Answer
1. Calculation of Value of firms:
Particulars Levered (`) Unlevered (`)
EBIT 30,000 30,000
Less: Interest @ 10% 10,000 -
Earning available to Equity Shareholders 20,000 30,000
Equity Capitalization rate 12.5% 12.5%
Market Value of Equity (Earning for Equity  Ke) 1,60,000 2,40,000
Value of Debt 1,00,000 -
Value of the Firm 2,60,000 2,40,000

Value of Levered company is more than that of unlevered company therefore investor will sell his shares
in levered company and buy shares in unlevered company. To maintain the level of risk he will borrow
proportionate amount and invest that amount also in shares of unlevered company.

2. Investment & Borrowings:

Sell shares in Levered company (1,60,000 × 15%) 24,000
Borrow money (1,00,000 × 15%) 15,000
Buy shares in Unlevered company 39,000

3. Change in Return:
Income from shares in Unlevered company (39,000 × 12.5%) 4,875
Less: Interest on loan (15,000 × 10%) 1,500
Net Income from unlevered firm 3,375
Income from Levered firm (24000 × 12.5%) 3,000
Incremental Income due to arbitrage 375

ARBITRAGE PROCESS (VUL > VL)

BQ 14
There are two companies U Ltd. and L Ltd., having same NOI of `20,000 except that L Ltd. is a levered
company having a debt of `1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10% and 18%
respectively.

Compute how arbitrage process will work.

Answer
Calculation of Value of firms:

9.9
 CAPITAL STRUCTURE CHAPTER 9

Particulars U Ltd. (`) L Ltd. (`)

EBIT 20,000 20,000
Less: Interest @ 7% of `1,00,000 - 7,000
Earning available to Equity Shareholders 20,000 13,000
Equity Capitalization rate 10% 18%
Market Value of Equity (Earning for Equity  Ke) 2,00,000 72,222
Value of Debt - 1,00,000
Value of the Firm 2,00,000 1,72,222

Assume you have 10% shares of unlevered firm:

Investment = 10% of `2,00,000 = `20,000
Return = 10% on `20,000 = `2,000

Strategy (Same return with lower investnent):

Sell your shares in unlevered firm for `20,000 and buy 10% shares of levered firm’s equity plus debt:

Investment in shares of L Ltd. = 10% of `72,222 = `7,222

Investment in debt of L Ltd. = 10% of `1,00,000 = `10,000

Total investment = `17,222

Surplus cash available = `20,000 – `17,222 = `2,778

Your return in L Ltd. = 10% of Earning available for Equity + Interest on Debt
= 10% of `13,000 + 7% of `10,000
= `1,300 + `700
= `2,000

In both the cases the return received is `2,000 and still you have excess cash of `2,778. Hence, you are
better off. In the above solution we have not invested entire amount received from “sale of shares of
Unlevered company”. Alternatively, we could have invested entire amount in Levered company. In that
case annual earnings would have increased.

BQ 15
Following data is available in respect of two companies having same business risk:

Capital employed = `2,00,000

EBIT = `30,000

Sources Levered Company (`) Unlevered Company (`)

Debt (@ 10%) 1,00,000 -
Equity 1,00,000 2,00,000
Ke 20% 12.5%

Investor is holding 15% shares in Unlevered company.

Calculate increase in annual earnings of investor if he switches his holding from unlevered to
levered company.

9.10
 CHAPTER 9 CAPITAL STRUCTURE

Answer
1. Calculation of Value of firms:
Particulars Levered (`) Unlevered (`)
EBIT 30,000 30,000
Less: Interest @ 10% 10,000 -
Earning available to Equity Shareholders 20,000 30,000
Equity Capitalization rate 20% 12.5%
Market Value of Equity (Earning for Equity  Ke) 1,00,000 2,40,000
Value of Debt 1,00,000 -
Value of the Firm 2,00,000 2,40,000

Value of Unlevered company is more than that of Levered company therefore investor will sell his shares
in unlevered company and buy shares in levered company. Market value of Debt and Equity of Levered
company are in the ratio of `1,00,000 : `1,00,000, i.e., 1:1. To maintain the level of risk he will lend
proportionate amount (50%) and invest balance amount (50%) in shares of Levered company.

2. Investment:
Sell shares in Unlevered company (2,40,000 × 15%) 36,000
Lend money (36,000 × 50%) 18,000
Buy shares in Levered company 18,000
Total investment 36,000

3. Change in Return:
Income from shares in Levered company (18,000 × 20%) 3,600
Add: Interest on money lent (18,000 × 10%) 1,800
Total income after switch over 5,400
Income from Unlevered firm (36,000 × 12.5%) 4,500
Incremental Income due to arbitrage 900

9.11
 CAPITAL STRUCTURE CHAPTER 9

PAST YEAR QUESTIONS

PYQ 1
‘A’ Ltd. and ‘B’ Ltd. are identical in every respect except capital structure. ‘A’ Ltd. does not use any debt
in its capital structure whereas ‘B’ Ltd. employs 12% debentures amounting to `10,00,000. Assumung
that:
(i) All assumptions of MM model are met;
(ii) Income tax rate is 30%;
(iii) EBIT is `2,50,000 and
(iv) The equity capitalization rate of ‘A’ Ltd. is 20%.

Calculate the value of both the companies and also find out Weighted Average Cost of Capital
for both the companies.
[(5 Marks) Nov 2014]

Answer
Calculation of value of ‘A’ Ltd and ‘B’ Ltd:

EBIT (1  t ) 2,50 ,000 (1  .30)

Value of ‘A’ Ltd. (Unlevered) = = = 8,75,000
Ke .20

Value of ‘B’ Ltd. (Levered) = Market value of ‘A’ Ltd + Debt × Tax
= 8,75,000 + 10,00,000 × 30% = 11,75,000

Calculation of WACC of ‘A’ Ltd and ‘B’ Ltd:

K0 of ‘A’ Ltd. = Ke of ‘A’ Ltd = 20%

[In case of All equity company Ko = Ke ]

EBIT (1  t ) 2 ,50 ,000 (1  .30 )

K0 of ‘B’ Ltd. = × 100 = × 100
V 11 ,75 ,000
= 14.89%

PYQ 2
RST Ltd. is expecting an EBIT of `4,00,000 for F.Y. 2015-16. Presently the company is financed by equity
share capital `20,00,000 with equity capitalization rate of 16%. The company is contemplating to
redeem part of the capital by introducing debt financing. The company has two options to raise debt to
the extent of 30% or 50% of the total fund. It is expected that for debt financing upto 30%, the rate of
interest will be 10% and equity capitalization rate will increase to 17%. If the company opts for 50%
debt, then the interest rate will be 12% and equity capitalization rate will be 20%.

You are required to compute value of the company; its overall cost of capital under different
options and also state which is the best option.
[(8 Marks) Nov 2015]

Answer
Statement of Value of Firm and Cost of Capital
Particulars All equity 30% Debt 50% Debt

9.12
 CHAPTER 9 CAPITAL STRUCTURE

Earnings before interest and tax 4,00,000 4,00,000 4,00,000

Less: Interest @ 10% of `6,00,000 or - 60,000 -
@ 12% of `10,00,000 - - 1,20,000
Earning available for Equity 4,00,000 3,40,000 2,80,000
÷ Ke 16% 17% 20%
Value of Equity (E) [PBT ÷ Ke] 25,00,000 20,00,000 14,00,000
Value of Debt (D) - 6,00,000 10,00,000
Value of Firm (V) 25,00,000 26,00,000 24,00,000
Ko (EBIT ÷ V) 16% 15.38% 16.67%

Decision: Company should opt for 30% debt finance having higher Value of firm and lower Ko.

PYQ 3
PNR Limited and PXR Limited are identical in every respect except capital structure. PNR limited does
not employ debts in its capital structure whereas PXR Limited employs 12% Debentures amounting to
`20,00,000.

The following additional information are given to you:

(i) Income tax rate is 30%
(ii) EBIT is `5,00,000
(iii) The equity capitalization rate of PNR Limited is 20% and
(iv) All assumptions of Modigliani - Miller Approach are met.

Calculate:
(i) Value of both the companies,
(ii) Weighted average cost of capital for both the companies.
[(8 Marks) May 2017]

Answer
Calculation of value of ‘PNR’ Ltd and ‘PXR’ Ltd:
EBIT (1  t ) 5,00,000 (1  .30)
Value of ‘PNR’ Ltd. (Unlevered) = =
Ke .20
= 17,50,000

Value of ‘PXR’ Ltd. (Levered) = Market value of ‘PNR’ Ltd + Debt × Tax
= 17,50,000 + 20,00,000 × 30%
= 23,50,000

Calculation of WACC of ‘PNR’ Ltd and ‘PXR’ Ltd:

K0 of ‘PNR’ Ltd. = Ke of ‘PNR’ Ltd = 20%
[In case of All equity company Ko = Ke ]

EBIT (1  t ) 5,00 ,000 (1  .30 )

K0 of ‘PXR’ Ltd. = × 100 = × 100
V 23 ,50 ,000
= 14.89%

PYQ 4
Stopgo Ltd. an all equity financed company is considering the repurchase of `200 Lakhs euity and to
replace it with 15% debentures of the same amount. Current market value of the company is `1140

9.13
 CAPITAL STRUCTURE CHAPTER 9

Lakhs and it’s cost of capital is 20%. It’s earning before interest and tax (EBIT) are expected to remain
constant in future. It’s entire earnings are distributed as dividend. Applicable tax rate is 30%.

You are required to calculate the impact on the following on account of the change in the
capital structure as per MM Hypothesis:

(1) The market value of the company.

(2) It’s cost of capital, and
(3) It’s cost of equity.
[(5 Marks) May 2018]

Answer
(1) Market Value (MV) of Stopgo Ltd:

MV before repurchase (VUL) = 1,140 Lakhs

MV after repurchase (VL) = VUL + Debt × Tax

= 1,140 L + 200 L × 30% = 1,200 Lakhs

Impact on MV of firm = 1,200 L – 1,140 L = Increase by 60 Lakhs

(2) Weighted average cost of capital:

WACC before repurchase = 20%

EBIT (1  t ) 325 .71 L (1  0 .30 )

WACC after repurchase = × 10 = × 100
Value of firm 1 ,200 L
= 19%

Impact on Cost of capital = 20% – 19% = Decrease by 1%

(3) Cost of Equity:

Ke before repurchase = 20%

( EBIT  I) (1  t )
Ke after repurchase = × 100
MV of Equity
(325 .71 L  15 % of 200 L ) (1  0.30 )
= × 100
1 ,000 L
= 20.70%

Impact on Ke = 20.70% – 20% = Increase by 0.70%

Workings notes:
EAT
MV of Equity (before repurchase) =
Ke
EAT
1,140 Lakhs =
0.20
EAT = 1,140 Lakhs × 20% = 228 L

EBIT = EAT ÷ (1 – t)

9.14
 CHAPTER 9 CAPITAL STRUCTURE

= 228 L ÷ (1 – 0.3) = 325.71 L

MV of Equity (after repurchase) = Value of firm – Value of Debt

= 1,200 L – 200 L = 1,000 L

PYQ 5
The following data relate to two companies belonging to the same risk class:

A Ltd. B Ltd.
Expected Net operating Income `18,00,000 `18,00,000
12% Debt `54,00,000 -
Equity Capitalization Rate - 18

Required:
(a) Determine the total market value, Equity capitalization rate and weighted average cost of capital
for each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital
for each company assuming 40% taxes as per M.M. Approach.
[(10 Marks) Nov 2018]

Answer
(a) Various calculation without tax:

Market Value of firms:

Market Value of B Ltd. (VUL) = EBIT ÷ Ke
= `18,00,000 ÷ 18% = `1,00,00,000

Market Value of A Ltd. (VL) = Value of unlevered = `1,00,00,000

Equity Capitalization Rate:

Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) ÷ *E (Value of Equity)

= (`18,00,000 – 12% × `54,00,000) ÷ `46,00,000
= 25.04%

*Value of Equity (E) of A Ltd. = Value of Firm – Debt

= `1,00,00,000 - `54,00,000 = `46,00,000

Weighted Average Cost of Capital:

Weighted Average Cost of Capital (B Ltd.)= Ke = Ko = 18%

Weighted Average Cost of Capital (A Ltd.)= EBIT ÷ V (Value of Firm)

= `18,00,000 ÷ `1,00,00,000 = 18%

(b) Various calculation with tax:

Market Value of firms:

9.15
 CAPITAL STRUCTURE CHAPTER 9

Market Value of B Ltd. (VUL) = EBIT (1 – t) ÷ Ke or Ko

= `18,00,000 (1 – 0.40) ÷ 18% = `60,00,000

Market Value of A Ltd. (VL) = Value of unlevered + Debt × Tax

= `60,00,000 + `54,00,000 × .4 = `81,60,000

Equity Capitalization Rate:

Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) (1 - t) ÷ *E (Value of Equity)

= (`18,00,000–12%×`54,00,000)(1 – .4)÷`27,60,000
= 25.04%

*Value of Equity (E) of A Ltd. = Value of Firm – Debt

= `81,60,000 - `54,00,000 = `27,60,000

Weighted Average Cost of Capital:

Weighted Average Cost of Capital (B Ltd.)= Ke = Ko = 18%

Weighted Average Cost of Capital (A Ltd.)= EBIT (1 - t) ÷ V (Value of Firm)

= `18,00,000 (1 – 0.4) ÷ `81,60,000
= 13.24%

PYQ 6
A Limited and B Limited are identical except for capital structures. A Ltd. has 60 per cent debt and 40
per cent equity, whereas B Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are in
market value terms). The borrowing rate for both companies is 8 per cent in a no-tax world, and capital
markets are assumed to be perfect.
(a) (i) If X, own 3 per cent of the equity shares of A Ltd., determine his return if the Company has net
operating income of `4,50,000 and the overall capitalisation rate of the company, Ko is 18 per cent.
(ii) Calculate the implied required rate of return on equity of A Ltd.

(b) B Ltd. has the same net operating income as A Ltd.

(i) Calculate the implied required equity return of B Ltd.

(ii) Analyse why does it differ from that of A Ltd.

[(10 Marks) Jan 2021]

Answer
NOI 4,50,000
(a) Value of the A Ltd. = Ko
= 18%
= `25,00,000

Value of Shares of A Ltd. = 40% of `25,00,000 = `10,00,000

(i) Return of X on Shares on A Ltd

Particulars `
Net Operating income 4,50,000

9.16
 CHAPTER 9 CAPITAL STRUCTURE

Less: Interest on Debt @ 8% on `15,00,000 (60% of `25,00,000) 1,20,000

Earnings for Equity Investors 3,30,000
Return on 3% Shares (3% of `3,30,000) 9,900

3,30,000
(ii) Implied required rate of return on Equity = 10,00,000
× 100 = 33%

(b) (i) Return on Shares on B Ltd

Particulars `
Net Operating income 4,50,000
Less: Interest on Debt @ 8% on `5,00,000 (20% of `25,00,000) 40,000
Earnings for Equity Investors 4,10,000

Value of Shares of Beta Ltd. = 80% of `25,00,000 = `20,00,000

4,10,000
Implied required rate of return on Equity = 20,00,000
× 100 = 20.50%

(ii) It is lower than the A Ltd. because B Ltd. uses less debt in its capital structure. As the equity
capitalisation is a linear function of the debt-to-equity ratio when we use the net operating income
approach, the decline in required equity return offsets exactly the disadvantage of not employing so
much in the way of “cheaper” debt funds.

PYQ 7
The details about two companies R Ltd. and S Ltd. having same operating risk are given below:
Particulars R Ltd. S Ltd.
Profit before interest and tax `10 Lakhs `10 Lakhs
Equity share capital `10 each `17 Lakhs `50 Lakhs
Long term borrowings @ 10% `33 Lakhs -
Cost of Equity (Ke) 18% 15%

(1) Calculate the value of equity of both the companies on the basis of M.M. Approach without tax.
(2) Calculate the total value of both the companies on the basis of M.M. Approach without tax.
[(5 Marks) July 2021]

Answer
EBIT − I
(1) Value of Equity = Ke

EBIT − I 10,00,000 − 10% of 33,00,000

R Ltd. = Ke
= 18%
= 37,22,222

EBIT − I 10,00,000 − 0
S Ltd. = Ke
= 15%
= 66,66,667

(2) Value of Companies:

Value of S Ltd. (VUL) = EBIT ÷ Ko = 10,00,000 ÷ 15% = 66,66,667

Value of R Ltd. (VL) = Value of S Ltd. (VUL) = 66,66,667

Note: Alternatively Value of R Ltd. can be calculated as: V = S + D (V = 37,22,222 + 33,00,000 =

70,22,222).
9.17
 CAPITAL STRUCTURE CHAPTER 9

PYQ 8
The following are the costs and values for the firms A and B according to the traditional approach.
Particulars Firm A Firm B
Total value of firm, V (in `) 50,000 60,000
Market value of debt, D (in `) 0 30,000
Market value equity, E (in `) 50,000 30,000
Expected net operating income (in `) 5,000 5,000
Cost of debt (in `) 0 1,800
Net Income (in `) 5,000 3,200
Cost of equity, Ke = NI/E 10.00% 10.70%

(i) Compute the Equilibrium value for Firm A and B in accordance with the MM approach. Assume that
(a) taxes do not exist and (b) the equilibrium value of Ke is 9.09%.

(ii) Compute Value of Equity and Cost of Equity for both the firms.
[(4 Marks) Nov 22]

Answer
(i) Equilibrium value of Firm A (Unlevered) = Net operating income ÷ Ke
= `5,000 ÷ 9.09% = `55,006

Equilibrium value of Firm B (Levered) = Value of Firm A (Unlevered)

= `55,006

(ii) Value of Equity Firm A = `55,006

Cost of Equity Firm A = 9.09%

Value of Equity Firm B = Value of Firm B – Value of debt

= `55,006 – `30,000 = `25,006

Cost of Equity Firm B = NI/E

= `3,200 ÷ `25,006 = 12.80%

SUGGESTED REVISION FOR EXAM:

BQ: 5, 6, 8, 10, 11, 12, 14

PYQ: 3, 4

9.18
 CHAPTER 10 DIVIDEND DECISIONS

CHAPTER 10 DIVIDEND DECISIONS

MODIGLIANI AND MILLER (MM) HYPOTHESIS

BQ 1
AB Engineering ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has
outstanding 10,000 shares selling at `100 each. The firm is contemplating the declaration of a dividend
of `5 per share at the end of the current financial year. It expects to have a net income of `1,00,000 and
has a proposal for making new investments of `2,00,000.

Required:
1. Calculate value of firm when dividends are not paid.
2. Calculate value of firm when dividends are paid.

Answer
1. Value of the firm when dividends are not paid:

Step 1: Calculate price at the end of the period:

Ke = 10%, P₀ = `100, D₁ = 0

P1 +D1
Pₒ = 1+Ke

P1 +0
`100 = 1+0.10
or P1 = `110

Step 2: No. of shares required to be issued:

Funds requied−(E−D) 2,00,000−(1,00,000−0)

No. of shares ∆n = = = 909.09 shares
Price at end(P₁) 110

Step 3: Calculation of value of firm:

(n+ Δn)P1 − I+E

nPo = 1+Ke

(10,000+909.09)110−2,00,000+1,00,000
nPo =
(1+.10)
= `10,00,000

2. Value of the firm when dividends are paid:

Step 1: Calculate price at the end of the period:

Ke = 10%, P₀ = `100, D₁ = `5

P1 +D1
Pₒ = 1+Ke

P1 +5
`100 = 1+0.10
or P1 = `105

10.1
 DIVIDEND DECISIONS CHAPTER 10

Step 2: No. of shares required to be issued:

Funds requied−(E−D) 2,00,000−(1,00,000−50,000)

No. of shares ∆n = = = 1,428.57 shares
Price at end(P₁) 105

Step 3: Calculation of value of firm:

(n+ Δn)P1 − I+E

nPo = 1+Ke

(10,000+1,428.57)105−2,00,000+1,00,000
nPo = (1+.10)
= `10,00,000

Thus, it can be seen that the value of the firm remains the same in either case.

BQ 2
RST Ltd. has a capital of `10,00,000 in equity shares of `100 each. The shares are currently quoted at
par. The company proposes to declare a dividend of `10 per share at the end of the current financial
year. The capitalization rate for the risk class of which the company belongs is 12%. Net profit is
`2,50,000 and amount of new investment during the period is `5,00,000. What will be the market price
of the share at the end of the year, if

1. Dividend is not declared?

2. Dividend is declared?
3. Assuming that the company pays the dividend and has net profits of `5,00,000 and makes new
investments of `10,00,000 during the period, how many new shares must be issued? Use the MM
model.

Answer
Given,
Cost of Equity (Ke) 12%
Number of shares in the beginning (n) 10,000
Current Market Price (P0) `100
Net Profit (E) `2,50,000
Expected Dividend `10 per share
Investment (I) `5,00,000

P1 + D1
1. Po = 1+Ke

P1 + 0
`100 = 1+0.12
or P1 = `112 – 0 = `112

P1 + D1
2. Po = 1+Ke

P1 + 10
`100 = 1+0.12
or P1 = `112 – 10 = `102

Funds required−(E−D)
3. No. of shares = Price at end(P1 )

10,00,000−(5,00,000−1,00,000)
∆n = 102
= 5882.35 or 5883 shares

10.2
 CHAPTER 10 DIVIDEND DECISIONS

BQ 3
M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding shares
and the current market price is `100. It expects a net profit of `2,50,000 for the year and the Board is
considering dividend of `5 per share. M Ltd. requires to raise `5,00,000 for an approved investment
expenditure. Show, how the MM approach affects the value of M Ltd. if dividends are paid or not paid?

Answer
Given,
Cost of Equity (Ke) 10%
Number of shares in the beginning (n) 25,000
Current Market Price (P0) `100
Net Profit (E) `2,50,000
Expected Dividend `5 per share
Investment (I) `5,00,000

1. Value of the firm when dividends are not paid:

Step 1: Calculate price at the end of the period:

Ke = 10%, P₀ = `100, D₁ = 0

P1 +D1
Pₒ = 1+Ke

P1 +0
`100 = 1+0.10
or P1 = `110

Step 2: No. of shares required to be issued:

Funds requied−(E−D) 5,00,000−(2,50,000−0)

No. of shares ∆n = Price at end(P₁)
= 110
= 2,272.73 shares

Step 3: Calculation of value of firm:

(n+ Δn)P1 − I+E

nPo =
1+Ke

(25,000+2,272.73)110−5,00,000+2,50,000
nPo = (1+.10)
= `25,00,000

2. Value of the firm when dividends are paid:

Step 1: Calculate price at the end of the period:

Ke = 10%, P₀ = `100, D₁ = `5

P1 +D1
Pₒ =
1+Ke

P1 +5
`100 = 1+0.10
or P1 = `105

Step 2: No. of shares required to be issued:

10.3
 DIVIDEND DECISIONS CHAPTER 10

Funds requied−(E−D) 5,00,000−(2,50,000−1,25,000)

No. of shares ∆n = = = 3,571.43 shares
Price at end(P₁) 105

Step 3: Calculation of value of firm:

(n+ Δn)P1 − I+E

nPo = 1+Ke

(25,000+3,571.43)105−5,00,000+2,50,000
nPo = (1+.10)
= `25,00,000

Thus, it can be seen that the value of the firm remains the same in either case.

BQ 4
Aakash Ltd. has 10 lakh equity shares outstanding at the start of the accounting year 2023. The existing
market price per share is `150. Expected dividend is `8 per share. The rate of capitalization appropriate
to the risk class to which the company belongs is 10%.

1. Calculate the market price per share when expected dividends are: (a) declared, and (b) not
declared, based on the Miller – Modigliani approach.
2. Calculate number of shares to be issued by the company at the end of the accounting year on the
assumption that the net income for the year is `3 crores, investment budget is `6 crores, when (a)
Dividends are declared, and (b) Dividends are not declared.
3. Proof that the market value of the shares at the end of the accounting year will remain unchanged
irrespective of whether (a) Dividends are declared, or (ii) Dividends are not declared.

Answer
1. Calculation of market price per share:

(a) When expected dividends are declared:

Ke = 10%, P₀ = `150, D₁ = `8

P1 +D1
Pₒ =
1+Ke

P1 +8
`150 = 1+0.10
or P1 = `157

(b) When expected dividends are not declared:

Ke = 10%, P₀ = `150, D₁ = `0

P1 +D1
Pₒ = 1+Ke

P1 +0
`150 = 1+0.10
or P1 = `165

2. Calculation of no. of shares required to be issued:

(a) When expected dividends are declared:

10.4
 CHAPTER 10 DIVIDEND DECISIONS

Funds requied−(E−D) 6,00,00,000−(3,00,00,000−80,00,000)

No. of shares ∆n = =
Price at end(P₁) 157

= 2,42,038.22 shares

(b) When expected dividends are not declared:

Funds requied−(E−D) 6,00,00,000−(3,00,00,000−0)

No. of shares ∆n = Price at end(P₁)
= 165

= 1,81,818.18 shares

3. Calculation of market value of shares at the end:

(a) When expected dividends are declared:

Market value of shares = Total shares at the end × Market value per share
= (10,00,000 + 2,42,038.22) × 157 = `19,50,00,000

(b) When expected dividends are not declared:

Market value of shares = Total shares at the end × Market value per share
= (10,00,000 + 1,81,818.18) × 165 = `19,50,00,000

Hence, it is proved that the total market value of shares remains unchanged irrespective of whether
dividends are declared, or not declared.

BQ 5
Ordinary shares of a listed company are currently trading at `10 per share with two lakh shares
outstanding. The company anticipates that its earnings for next year will be `5,00,000. Existing cost of
capital for equity shares is 15%. The company has certain investment proposals under discussion which
will cause an additional 26,089 ordinary shares to be issued if no dividend is paid or an additional
47,619 ordinary shares to be issued if dividend is paid. Applying the MM hypothesis on dividend
decisions.

Calculate the amount of investment and dividend that is under consideration by the
company.

Answer
1. Calculation of Investment:

When no dividend is paid:

Funds requied−(E−D) 𝐼−(5,00,000−0)

No. of shares ∆n = Price at end(P₁)
= 11.50

26,089 × `11.50 = I – `5,00,000

I = `8,00,024

Working Note:

10.5
 DIVIDEND DECISIONS CHAPTER 10

When expected dividends are not declared:

Ke = 15%, P₀ = `10, D₁ = `0

P1 +D1
Pₒ = 1+Ke

P1 +0
`10 = 1+0.15
or P1 = `11.50

2. Calculation of Dividend:

When dividend is paid:

P1 +D1
Pₒ = 1+Ke

P1 +D1
`10 = 1+0.15
or P1 = `11.50 – D1

Now,
I−(E−D) 8,00,024−(5,00,000−2,00,000D1 )
No. of shares ∆n = P₁
= P₁

47,619 × P1 = 3,00,024 + 2,00,000D1 (P1 = 11.50 – D1)

47,619 × (11.50 – D1) = 5,47,619 – 47,619D1 = 3,00,024 + 2,00,000D1

2,47,619D1 = 2,47,595

D1 = `1.00 per share

WALTER MODEL

BQ 6
XYZ ltd. which earns `10 per share is capitalized at 10% and has a return on investment of 12%.
Determine the optimum dividend payout ratio and the price of the share at optimum payout.

Answer
(1) The optimum dividend payout ratio is ‘Zero’, since r > Ke.
(2) Calculation of Price of share at optimum payout:

r 0.12
D + (E−D) × 0+(10−0) ×
P = Ke
Ke
= 0.10
0.10
= `120.00

BQ 7
The following figures are collected from the annual report of XYZ Ltd.:
Net Profit `30 lakhs
Outstanding 12% preference shares `100 lakhs
No. of Equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (K e ) 16%

10.6
 CHAPTER 10 DIVIDEND DECISIONS

What should be the approximate dividend payout ratio so as to keep the share price at `42
by using Walter model?

Answer
PAT−Preference Dividend 30,00,000−12% of 1,00,00,000
EPS =
No of Equity Shares
=
3,00,000
= `6

r 0.20
D + (E−D) × D+(6−D) ×
P = Ke
Ke
= 0.16
0.16
= 42

0.16D+1.2−0.20D
6.72 = 0.16

1.0752 = 1.2 – 0.04D or D = 3.12

Dividend Payout ratio:

DPS 3.12
= × 100 = × 100 = 52%
EPS 6

BQ 8
The following information pertains to M/s XY Ltd.
Earnings of the Company `5,00,000
Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%

1. What would be the market value per share as per Walter’s model?
2. What is the optimum dividend payout ratio according to Walter’s model and the market value of
Company’s share at that payout ratio?

Answer
1. Calculation of market value per share as per Walter’s model:
r 0.15
D + (E−D) × 3+(5−3) ×
P = Ke
Ke
= 0.12
0.12
= `45.83

PAT 5,00,000
EPS = No of Equity Shares
= 1,00,000
= `5

DPS = EPS × Dividend payout ratio = `5 × 60% = `3

2. According to Walter’s model when the return on investment is more than the cost of equity capital,
the price per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend
pay-out ratio in this case is nil.
r 0.15
D + (E−D) × 0+(5−0) ×
P (at 0 Payout) = Ke
Ke
= 0.12
0.12
= `52.08

BQ 9
The earning per share of a company is `10 and the rate of capitalization applicable to it is 10 per cent.

10.7
 DIVIDEND DECISIONS CHAPTER 10

The company has three options of paying dividend i.e. (1) 50%, (2) 75% and (3) 100%.

Calculate the market price of share as per Walter’s model if it can earn a return of (a) 15%,
(b) 10% and (c) 5% on its retained earnings.

Answer
r
D + (E−D) ×
Market value of share (P) = Ke
Ke

Calculation of Market Value per Share as per Walter’s Model

Rate of Earning (r) DP Ratio 50% DP Ratio 75% DP Ratio 100%
(a) 15% .15
5 + (10 − 5) × .10 7.5 + (10 − 7.5) ×
.15
10 + (10 − 10) ×
.15
.10 .10
. 10 . 10 . 10

= `125 = `112.50 = `100

.10 .10 .10

(b) 10% 5 + (10 − 5) × .10
7.5 + (10 − 7.5) × .10
10 + (10 − 10) × .10
. 10 . 10 . 10

= `100 = `100 = `100

.05 .05 .05

5 + (10 − 5) × .10
7.5 + (10 − 7.5) × .10
10 + (10 − 10) × .10
(c) 5% . 10 . 10 . 10

= `75 = `87.50 = `100

BQ 10
The following information is supplied to you:
Total Earnings `2,00,000
No. of equity shares (of `100 each) 20,000
Dividend paid `1,50,000
Price/Earnings ratio 12.5

Applying Walter’s Model:

1. Ascertain whether the company is following an optimal dividend policy.
2. Find out what should be the P/E ratio at which the dividend policy will have no effect on the value
of the share.
3. Will your decision change, if the P/E ratio is 8 instead of 12.5?

Answer
1 1
1. Ke = = = 8%
PE 12.5

Total Earnings 2,00,000

r = × 100 = × 100 = 10%
Total Funds 20,000 Shares ×100 per share

r > Ke, Therefore as per Walter model optimum dividend payout is Nil and company is paying
dividend to shareholders means company is not following optimum dividend policy.

10.8
 CHAPTER 10 DIVIDEND DECISIONS

2. The P/E ratio at which the dividend policy will have no effect on the value of the share is such at
which the ke would be equal to the rate of return (r) of the firm.

Ke = r = 10%
1 1
PE = Ke
= .10
= 10 times

3. If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12.5:
1 1
Ke = = = 12.5%
PE 8

In such a situation Ke > r and optimum dividend payout will be 100%.

GORDON MODEL

BQ 11
X ltd. is a no growth company, pays a dividend of `5 per share. If the cost of capital is 10%, what should
be the current market price of the share?

Answer
D 5
Po = Ke
= 0.10
= `50

BQ 12
XYZ is company having share capital of `10 lakhs of `10 each. It distributed current dividend of 20% per
annum. Annual growth rate in dividend expected is 2%. The expected rate of return on its equity capital
is 15%, what should be the current market price of the share?

Answer
D0 (1+g) 2(1+.02)
Po =
Ke −g
=
0.15−0.02
= `15.69

BQ 13
A firm had paid dividend at `2 per share last year. The estimated growth of the dividends from the
company is estimated to be 5% p.a. Determine the estimated market price of the equity share with 5%
growth rate and if the estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also find
out the present market price of the share, given that the required rate of return of the equity investors
is 15%.

Answer
D0 (1+g) 2(1+.05)
Po = Ke −g
= 0.15−0.05
= `21

1. MPS with 8% growth rate:

D0 (1+g) 2(1+.08)
Po = Ke −g
= 0.15−0.08
= `30.86

2. MPS with 3% growth rate:

D0 (1+g) 2(1+.03)
Po = Ke −g
= 0.15−0.03
= `17.17

10.9
 DIVIDEND DECISIONS CHAPTER 10

BQ 14
By taking the following data of three different firms i.e. growth, normal and declining firm calculate the
current price of share by using the Gordon model after that again calculate revised price of share with
0.4 retained earning and check the relationship between Gordon and Walter model.
Declining
Growth Firm Normal Firm
Factors Firm
r > 𝑲𝒆 r = 𝑲𝒆
r < 𝑲𝒆
R (Rate of Return on Retained Earnings) 15% 10% 8%
K (Cost of Capital) 10% 10% 10%
E (Earning Per Share) `10 `10 `10
B (Retained Earning) 0.6 0.6 0.6
1-B 0.4 0.4 0.4

Answer
Calculation of current price of share as per Gordon model:
𝐷1
Po =
𝐾𝑒 −𝑔

10 ×0.4
Growth = 0.10−0.09
= `400

10 ×0.4
Normal =
0.10−0.06
= `100

10 ×0.4
Declining =
0.10−0.048
= `76.92

Working note:

G = b×r
Growth = 15% × .6 = 9%
Normal = 10% × .6 = 6%
Declining = 8% × .6 = 4.8%

Calculation of revised price of share as per Gordon model when b is 0.4 and payout is 0.6:
10 ×0.6
Growth = 0.10−0.06
= `150

10 ×0.6
Normal = 0.10−0.04
= `100

10 ×0.6
Declining = 0.10−0.032
= `88.23

Working note:

G = b×r
Growth = 15% × .4 = 6%
Normal = 10% × .4 = 4%
Declining = 8% × .4 = 3.2%

From the above analysis it can be concluded that:

10.10
 CHAPTER 10 DIVIDEND DECISIONS

When r > k, the market value increases with retention ratio, when r < k, the market value of share stands
to decrease and when r = k, the market value is not affected by dividend policy.

The conclusion of the Gordon’s model is similar to that of Walter’s model.

BQ 15
The following figures are collected from the annual report of XYZ Ltd.:
Net Profit `30,00,000
Outstanding 12% Preference Shares `1,00,00,000
No. of Equity Shares 3,00,000
Return on Investment 20%
Cost of Capital 16%

Calculate price per share using Gordon’s Model when dividend payout is (1) 25%, (2) 50% and
(3) 100%.

Answer
Calculation of Price of Share as per Gordon model:
𝐷1
Po = 𝐾𝑒 −𝑔

6 ×0.25
(1) When 25% payout = 0.16−0.15
= `150

6 ×0.50
(2) When 50% payout = 0.16−0.10
= `50

6 ×1.00
(3) When 100% payout = 0.16−0.00
= `37.50

Working note:

(a) Growth = b×r

When 25% payout = 20% × .75 = 15%

When 50% payout = 20% × .50 = 10%
When 100% payout = 20% × .00 = 0%

(b) Earning Per Share = (PAT – PD) ÷ Number of shares

= (30,00,000 – 12% of 1,00,00,000) ÷ 3,00,000 = `6

BQ 16
The annual report of XYZ Ltd. provides the following information for the Financial Year 2020-21:
Net Profit `50,00,000
Outstanding 15% Preference Shares `1,00,00,000
No. of Equity Shares 5,00,000
Return on Investment 20%
Cost of Capital i.e. (Ke) 16%

Calculate price per share using Gordon’s Model when dividend payout is (1) 25%, (2) 50%
and (3) 100%.

10.11
 DIVIDEND DECISIONS CHAPTER 10

Answer
Calculation of Price of Share as per Gordon model:

D1
Po =
Ke −g

7 × 0.25
(1) When 25% payout = 0.16 − 0.15
= `175

7 × 0.50
(2) When 50% payout = 0.16 − 0.10
= `58.33

7 × 1.00
(3) When 100% payout =
0.16 − 0.00
= `43.75

Working note:
(a) Growth = b×r

When 25% payout = 20% × .75 = 15%

When 50% payout = 20% × .50 = 10%
When 100% payout = 20% × .00 = 0%

(b) Earning Per Share = (PAT – PD) ÷ Number of shares

= (50,00,000 – 15% of 1,00,00,000) ÷ 5,00,000 = `7

BQ 17
A N Ltd. gives you the following information:

The appropriate market rate of discount is 8% and that the company is expected to enjoy an
above-average performance for eight years with dividends growing at say 10% per annum. After that
time, because of competition and the company losing its present technological or marketing lead, the
growth in dividends will revert to the average for all companies-say 4%. The present dividend is `0.10
per share.

Compute the current value of equity share of the company.

Answer
Calculation of Present Value or Current Market Value of Share
Year Expected benefits PVF @ 8% DCF
1 0.10 + 10% = `0.11 0.926 0.101
2 0.11 + 10% = `0.121 0.857 0.103
3 0.121 + 10% = `0.133 0.794 0.106
4 0.133 + 10% = `0.146 0.735 0.107
5 0.146 + 10% = `0.161 0.681 0.110
6 0.161 + 10% = `0.177 0.630 0.112
7 0.177 + 10% = `0.195 0.583 0.114
8 0.195 + 10% = `0.214 0.540 0.116
(9 to  ) P8 = `5.55 0.540 3.00
Present value of all future benefits or Current market value of Share `3.87

D9 .214  4%
P8 = = = `5.55
Ke  g 8%  4%

10.12
 CHAPTER 10 DIVIDEND DECISIONS

BQ 18
A&R Ltd. is a large-cap multinational company listed in BSE in India with a face value of `100 per share.
The company is expected to grow @ 15% p.a. for next four years then 5% for an indefinite period. The
shareholders expect 20% return on their share investments. Company paid `120 as dividend per share
for the FY 2022-23. The shares of the company traded at an average price of `3,122 on last day.

Find out the intrinsic value of per share and state whether shares are overpriced or under-priced.

Answer
Calculation of Present Value or Current Market Value or Intrinsic Value of Share
Year Expected benefits PVF @ 20% DCF
1 120.00 + 15% = `138.00 0.833 114.95
2 138.00 + 15% = `158.70 0.694 110.14
3 158.70 + 15% = `182.50 0.579 105.67
4 182.50 + 15% = `209.88 0.482 101.16
(5 to  ) P4 = `1,469.16 0.482 708.13
Present value of all future benefits or Intrinsic value of Share `1,140.05
D5 209.88 + 5%
P4 = Ke −g
= 20% − 5%
= `1,469.16

Intrinsic value of share is `1,140.05 as compared to latest market price of `3,122. Market price of a share
is overpriced by `1,981.95.

TRADITIONAL MODEL (GRAHAM AND DODD MODEL)

BQ 19
The following information regarding the equity shares of M ltd. is given that Market price is `58.33,
Dividend per share is `5 and Multiplier is 7.

According to the Graham & Dodd approach to the dividend policy, compute the EPS.

Answer
P = M (D + E/3)
58.33 = 7 (5 + E/3)
E = `9.99 or `10 approx.

BQ 20
The earning per share of a company is `30 and dividend payout is 60%. Multiplier is 2.

Determine the price per share as per Graham & Dodd model.

Answer
Price per share (P) = M (D + E/3)
P = 2 (30 × 0.60 + 30/3)
P = 2 (18 + 10) = `56

BQ 21
The dividend payout ratio of H Ltd. is 40%. If the company follows traditional approach to dividend
policy with a multiplier of 9, what will be the P/E ratio.

10.13
 DIVIDEND DECISIONS CHAPTER 10

Answer
Since the dividend payout ratio is 40%

D = 40% of E i.e. 0.4E

P = M (D + E/3) = 9 (D + E/3) = 9 (0.4E + E/3)

1.2E+E
P = 9 (0.4E + E/3) = 9( 3
) = 3 (2.2E) = 6.6E

MPS P 6.6E
P/E ratio = EPS
= E
= E
= 6.6times

LINTER’S MODEL

BQ 22
Given the last year’s dividend is `9.80, speed of adjustment = 45%, target payout ratio 60% and EPS for
current year `20.

Calculate current year’s dividend using Linter’s model.

Answer
D₁ = D0 + [(EPS × Target payout) – D0] × Af
= 9.80 + [(20 × 60%) – 9.80] × 0.45 = `10.79

MISCELLANEOUS

BQ 23
With the help of following figures calculate the market price of a share of a company by using:
1. Walter’s formula
2. Dividend growth model (Gordon’s formula)
Earning per share (EPS) `10
Dividend per share (DPS) `6
Cost of capital (k) 20%
Internal rate of return on investment 25%
Retention Ratio 40%

Answer
(a) Walter’s formula:
r 0.25
D + (E−D) × 6 + (10−6) ×
P = Ke
Ke
= 0.20
0.20
= `55

(b) Gordon’s formula (Dividend Growth model):

D1 6
Po = Ke −g
= 0.20−0.10
= `60

G = b×r = 25% × .4 = 10%

10.14
 CHAPTER 10 DIVIDEND DECISIONS

BQ 24
The following information is given below in case of Aditya Ltd.:

Earnings per share `60

Capitalisation rate 15%
Return on investment 25%
Dividend payout ratio 30%

(a) Compute price per share using Walter’s Model.

(b) What would be optimum dividend payout ratio per share under Gordon’s Model.

Answer
(a) Price per share using Walter’s Model:
r 0.25
D + (E−D) × 18 + (60−18) ×
P = Ke
Ke
= 0.15
0.15
= `586.67

(b) As per Gordon’s model, when r > Ke, optimum dividend payout ratio is ‘Zero’.

BQ 25
In the month of May of the current financial year, shares of RT Ltd. was sold for `1,460 per share. A long
term earnings growth rate of 7.5% is anticipated. RT Ltd. is expected to pay dividend of `20 per share.

(a) Calculate rate of return an investor can expect to earn assuming that dividends are expected to
grow along with earnings at 7.5% per year in perpetuity?

(b) It is expected that RT Ltd. will earn about 10% on retained earnings and shall retain 60% of
earnings. In this case, State whether, there would be any change in growth rate and cost of Equity?

Answer
D1 20
(a) Ke = Po
+g = 1,460
+ 7.5% = 8.87%

(b) With rate of return on retained earnings (r) 10% and retention ratio (b) 60%, new growth rate
will be as follows:

g (revised growth rate)= b×r = 0.10 × 0.60 = 0.06 or 6%

Accordingly, dividend will also get changed and to calculate this, first we shall calculate previous
retention ratio (b1) and then EPS assuming that rate of return on retained earnings (r) is same. With
previous growth rate of 7.5% and r =10%, the retention ratio comes out to be:

0.075 = b1 × 0.10
b1 = 0.75 and payout ratio = 0.25

EPS = `20 ÷ 0.25 (.75 retention) = `80

Revised D1 = `80 × 0.40 = `32

D1 32
Revised Ke = Po
+g = 1,460
+ 6% = 8.19%

10.15
 DIVIDEND DECISIONS CHAPTER 10

BQ 26
Mr H is currently holding 1,00,000 shares of HM ltd, and currently the share of HM ltd is trading on
Bombay Stock Exchange at `50 per share. Mr A have a policy to re-invest the amount of any dividend
received into the shared back again of HM ltd. If HM ltd has declared a dividend of `10 per share.

Determine the no of shares that Mr A would hold after he re-invests dividend in shares of HM
ltd.

Answer
Ex-dividend price of Share = `40 (50 – 10)
Dividend received = `10,00,000 (1,00,000 shares × `10)
Additional shares purchased = `10,00,000 ÷ `40 = 25,000
Total holding = 1,00,000 + 25,000 = 1,25,000 Shares

BQ 27
Following information is given pertaining to DG ltd:

No of shares outstanding : 1 lakh shares

Earnings Per share : `25 per share
P/E Ratio : 20
Book Value per share : `400 per share

If company decides to repurchase 25,000 shares, at the prevailing market price, what is the
resulting book value per share after repurchasing?

Answer
Current Market price = EPS × P/E = 25 × 20
= `500 per share

Amount paid for repurchase = `1,25,00,000 (25,000 shares × `500 per share)

Book value before repurchase = `4,00,00,000 (`400 × 1 lakh shares)

Book Value after repurchase = `2,75,00,000 (4 Cr. – 1.25 Cr.)

No of shares after repurchase = 75,000 shares

Book value per share = 2,75,00,000 ÷ 75,000

= `367 per share

10.16
 CHAPTER 10 DIVIDEND DECISIONS

PAST YEAR QUESTIONS

PYQ 1
Following information relating to Jee Ltd. are given:

Profit after tax : `10,00,000

Dividend payout ratio : 50%
Number of Equity shares : 50,000
Cost of equity : 10%
Rate of return on investment : 12%

(1) What would be the market value per share as per as per Walter’s Model?
(2) What is the optimum dividend payout ratio according to Walter’s Model and market value of
equity share at that payout ratio?
[(5 Marks) Nov 2018]

Answer
(1) Market value (P) per share as per Walter’s Model:
r 0.12
D + (E−D) × 10+(20−10) ×
P (Market value of share) = Ke
= 0.10
Ke 0.10
= `220.00

E (EPS) = `10,00,000 (PAT) ÷ 50,000 shares

= `20

(2) According to Walter’s Model when the return on investment is more than the cost of equity
capital, the price per share increases as the dividend payout ratio decreases. Hence, the optimum
dividend payout ratio in this case Nil. So, at a payout ratio zero, the market value of company’s
share will be:
𝑟 0.12
𝐷 + (𝐸−𝐷) × 0+(20−0) ×
P (Market value of share) = 𝐾𝑒
= 0.10
𝐾𝑒 0.10
= `240.00

PYQ 2
The following information is supplied to you:

Total Earning : `40,00,000

Number of Equity Shares (of `100 each) : 4,00,000
Dividend Per Share : `4
Cost of Capital : 16%
Internal Rate of Return : 20%
Retention Ratio : 60%

Calculate the market price of a share of company by using:

(1) Walter’s Formula,

(2) Gordon’ Formula.
[(5 Marks) May 2019]

10.17
 DIVIDEND DECISIONS CHAPTER 10

Answer
(1) Market Price of Share (P) as per Walter’s Formula:
r 0.20
D + (E−D) × 4+(10−4) ×
P (Market value of share) = Ke
Ke
= 0.16
0.16

= `71.875

E (EPS) = `40,00,000 (Earning) ÷ 4,00,000 shares

= `10

(2) Market Price of Share (P) as per Gordon’s Formula:

D1 4.00
P0 (Market value of share) =
Ke −g
=
0.16−0.12
= `100.00

G (Growth Rate) = b×r = 20% × .6 = 12%

PYQ 3
Following figures and information were extracted from the company A Ltd.

Earnings of the company `10,00,000

Dividend paid `6,00,000
No. of shares outstanding 2,00,000
Price earnings ratio 10
Rate of return on investment 20%

You are required to calculate:

(1) Current market price of the share.

(2) Capitalization rate of its risk class.
(3) What should be the optimum payout ratio?
(4) What should be the market price per share at optimal payout ratio? (use Walter’s model)
[(5 Marks) Nov 2019]

Answer
(1) Current market price of share:

Current Market Price of Share = EPS × PE Ratio

10,00,000
= 2,00,000
× 10 = `50

(2) Capitalization rate of its risk class:

Capitalization rate (Ke) = 1/PE

= 1/10 = 0.10 or 10%

(3) Optimum payout:

r > Ke, Therefore dividend payout should be Nil.

(4) Market Price of Share (P) as per Walter’s Formula as per optimal payout ratio:

10.18
 CHAPTER 10 DIVIDEND DECISIONS
r 0.20
D + (E−D) × 0+(5−0) ×
P (Market price of share) = Ke
Ke
= 0.10
0.10

= `100

PYQ 4
The following figures are extracted from the annual report of RJ Ltd.:
Net Profit `50 lakhs
Outstanding 13% preference shares `200 lakhs
No. of Equity shares 6 lakhs
Return on Investment 25%
Cost of capital i.e. (K e ) 15%

You are required to compute the approximate dividend payout ratio by keeping the share
price at `40 by using Walter model?
[(5 Marks) Nov 2020]

Answer
PAT−Preference Dividend 50,00,000−13% 𝑜𝑓 2,00,00,000
EPS = No of Equity Shares
= 6,00,000
= `4

r 0.25
D + (E−D) × D+(4−D) ×
P = Ke
Ke
= 0.15
0.15
= 40

0.15D+1−0.25D
6 = 0.15

0.9 = 1 – 0.10D or D = 1
DPS 1
Dividend Payout ratio = EPS
× 100 = 4
× 100 = 25%

PYQ 5
The following information is taken from ABC Ltd.
Net Profit for the year `30,00,000
12% Preference shares capital `1,00,00,000
Equity share capital (Share of `10 each) `60,00,000
Internal rate of return on investment 22%
Cost of Equity capital 18%
Retention ratio 75%

Calculate the market price of the share using:

1. Gordon’s Model
2. Walter’s Model
[(5 Marks) Jan 2021]

Answer
1. Calculation of Price of share as per Gordon model:
D1 3 × 0.25
Po = Ke −g
= 0.18−0.165
= `50

2. Calculation of Price of share as per Walter model:

10.19
 DIVIDEND DECISIONS CHAPTER 10

r 0.22
D + (E−D) × 0.75+(3−0.75) ×
P = Ke
Ke
= 0.18
0.18
= `19.44

Working note:
(a) Growth = b×r = 22% × .75 = 16.50%

(b) EPS = (PAT – PD) ÷ Number of shares

= (30,00,000 – 12% of 1,00,00,000) ÷ 6,00,000 = `3

(c) DPS = EPS × Payout ratio = `3 × 25% = `0.75

PYQ 6
The following information relates to LMN Ltd.
Earnings of the Company `30,00,000
Dividend Payout ratio 60%
No. of shares outstanding 5,00,000
Rate of return on investment 15%
Equity capitalized rate 13%

Required:
1. Determine what would be the market value per share as per Walter’s model?
2. Compute optimum dividend payout ratio according to Walter’s model and the market value of
company’s share at that payout ratio?
[(5 Marks) July 2021]

Answer
1. Calculation of market value per share as per Walter’s model:
r 0.15
D + (E−D) × 3.60 + (6 − 3.60) ×
P =
Ke
Ke
=
0.13
0.13
= `48.99

PAT 30,00,000
EPS = No of Equity Shares
= 5,00,000
= `6

DPS = EPS × Dividend payout ratio = `6 × 60% = `3.60

2. According to Walter’s model when the return on investment is more than the cost of equity capital,
the price per share increases as the dividend pay-out ratio decreases. Hence, the optimum
dividend payout ratio in this case is nil.
r 0.15
D + (E−D) × 0 + (6 − 0) ×
P (at 0 Payout) = Ke
Ke
= 0.13
0.13
= `53.25

PYQ 7
X Ltd. is a manufacturing company. Current market price per share is `2,185. During the F.Y. 2020-21,
the company paid `140 as dividend per share. The company is expected to grow @12% p.a. for next four
years, then 5% p.a. for an indefinite period. Expected rate of return of shareholders is 18% p.a.
(i) Find out intrinsic value per share.
(ii) State whether shares are overpriced or underpriced.

10.20
 CHAPTER 10 DIVIDEND DECISIONS

Year 1 2 3 4 5
Discounting Factor@18% 0.847 0.718 0.608 0.515 0.436

[(5 Marks) Dec 2021]

Answer
(i) Calculation of Intrinsic Value of Share
Year Expected benefits PVF @ 18% DCF
1 140.00 + 12% = `156.80 0.847 132.81
2 156.80 + 12% = `175.62 0.718 126.10
3 175.62 + 12% = `196.69 0.608 119.59
4 196.69 + 12% = `220.29 0.515 113.45
(5 to  ) P4 = `1,779.27 0.515 916.32
Present value of all future benefits or Intrinsic value of Share `1,408.27

𝐷5 220.29 + 5%
P4 = 𝐾𝑒 −𝑔
= 18% − 5%
= `1,779.27

(ii) Intrinsic value of share is `1,408.27 as compared to latest market price of `2,185. Market price of
a share is overpriced by `776.73.

PYQ 8
Following information are given for a company:

Earnings per share `10

P/E ratio 12.5
Rate of return on investment 12%
Market price per share as per Walter’s model `130

You are required to calculate:

(a) Dividend payout ratio.
(b) Market price of share at optimum dividend payout ratio.
(c) P/E ratio, at which the dividend policy will have no effect on the price of share.
(d) Market Price of share at this P/E ratio.
(e) Market price of share using Dividend growth model.
[(5 Marks) May 23]

Answer
r
D + (E−D) ×
(a) Market price of share (P) = Ke
Ke

0.12
D + (10−D) ×
130 = 0.08
0.08

0.12
10.40 = D + (10 – D) × 0.08
10.40 = D + 15 – 1.5 D
.5D = 4.6
D = `9.20
9.20
Dividend Payout = 10.00
× 100 = 92%

10.21
 DIVIDEND DECISIONS CHAPTER 10

Working Note:

Ke = 1/PE = 1/12.5 = 8%

(b) r > Ke, Therefore as per Walter model optimum dividend payout is Nil
r 0.12
D + (E−D) × 0 + (10−0) ×
Market price of share (P) =
Ke
Ke
=
0.08
0.08
= `187.5

(c) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at
which the ke would be equal to the rate of return (r) of the firm.

Ke = r = 12%

PE = 1/Ke = 1/12% = 8.33 times

(d) Market price of share (P) = EPS × PE = 10 × 8.33 = `83.33

(e) Market price of share using Dividend growth model:

D1 9.20
Po = Ke −g
= 0.08−0.0096
= `130.68

Working note:

G = b×r = 12% × .08 = 0.96%

PYQ 9
(a) EPS of a company is `60 and Dividend payout ratio is 60%. Multiplier is 5. Determine price per
share as per Graham & Dodd model.

(b) Last Year’s dividend is `6.34, adjustment factor is 45%, target payout ratio is 60% and current
year’s EPS is `12. Compute current’s year’s dividend using Linter’s model.
[(5 Marks) Nov 23]
Answer
(a) P = M (D + E/3)
= 5 (36 + 60/3) = `280

(b) D₁ = D0 + [(EPS × Target payout) – D0] × Af

= 6.34 + [(12 × 60%) – 6.34] × 0.45 = `6.73

PYQ 10
INFO Ltd is a listed company having share capital of `2,400 Crores of `5 each. During the year:

Dividend distributed 1000%

Expected Annual growth rate in dividend 14%
Expected rate of return on its equity capital 18%

Required:
(a) Calculate price of share applying Gordon’s growth Model.
(b) What will be the price of share if the Annual growth rate in dividend is only 10%?

10.22
 CHAPTER 10 DIVIDEND DECISIONS

(c) According to Gordon’s growth Model, if Internal Rate of Return is 25%, than what should be the
optimum dividend payout ratio in case of growing stage of company? Comment.
[(5 Marks) Nov 23]

Answer
D0 (1+g) 50 (1+.14)
(a) Po =
Ke −g
=
0.18−0.14
= `1,425

D0 (1+g) 50 (1+.10)
(b) Po =
Ke −g
=
0.18−0.10
= `687.50

(c) When r (25%) is higher than Ke (18%) in case of growing stage company, Optimum payout is
Nil.

Working Notes:

D0 = 1,000% of `5 = `50

SUGGESTED REVISION FOR EXAM:

BQ: 1, 5, 7, 10, 14, 17, 18, 21, 22, 25, 27

PYQ: 6, 8

10.23
 TABLE 1

Table I – Present Value Table (PVIF)

Present Value of `1 at the end of n years
Years 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 20% 25% 30%
1 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8333 0.8000 0.7692
2 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.6944 0.6400 0.5917
3 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.5787 0.5120 0.4552
4 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.4823 0.4096 0.3501
5 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4019 0.3277 0.2693
6 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.3349 0.2621 0.2072
7 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.2791 0.2097 0.1594
8 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.2326 0.1678 0.1226
9 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.1938 0.1342 0.0943
10 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.1615 0.1074 0.0725
11 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1346 0.0859 0.0558
12 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1122 0.0687 0.0429
13 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.0935 0.0550 0.0330
14 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.0779 0.0440 0.0254
15 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.0649 0.0352 0.0195
16 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0541 0.0281 0.0150
17 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0451 0.0225 0.0116
18 0.4155 0.3505 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0376 0.0180 0.0089
19 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0313 0.0144 0.0068
20 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0261 0.0115 0.0053
 TABLE 2

Table II – Annuity Factor Table (PVAF)

Present Value of Annuity of `1 per year (Cumulative Discounting Factor)
Years 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 20% 25% 30%
1 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8333 0.8000 0.7692
2 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.5278 1.4400 1.3609
3 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.1065 1.9520 1.8161
4 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.5887 2.3616 2.1662
5 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 2.9906 2.6893 2.4356
6 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.3255 2.9514 2.6427
7 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 3.6046 3.1611 2.8021
8 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 3.8372 3.3289 2.9247
9 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.0310 3.4631 3.0190
10 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.1925 3.5705 3.0915
11 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 4.3271 3.6564 3.1473
12 8.8633 8.3838 9.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 4.4392 3.7251 3.1903
13 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 4.5327 3.7801 3.2233
14 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 4.6106 3.8241 3.2487
15 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 4.6755 3.8593 3.2682
16 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 4.7296 3.8874 3.2832
17 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 4.7746 3.9099 3.2948
18 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 4.8122 3.9279 3.3037
19 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 4.8435 3.9424 3.3105
20 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 4.8696 3.9539 3.3158
 TABLE 3

Table III - Compound Value Table (FVIF)

Compound Value of `1 after n year (Growth Factor)
Years 5% 6% 7% 8% 9% 10% 12% 14% 15% 16% 18% 20% 24% 28% 32%
1 1.050 1.060 1.070 1.080 1.090 1.100 1.120 1.130 1.150 1.160 1.180 1.200 1.240 1.280 1.320
2 1.102 1.124 1.115 1.166 1.188 1.210 1.254 1.300 1.322 1.346 1.392 1.440 1.538 1.638 1.742
3 1.158 1.191 1.225 1.260 1.295 1.331 1.405 1.482 1.521 1.561 1.643 1.728 1.907 2.097 2.300
4 1.216 1.262 1.311 1.360 1.412 1.464 1.574 1.689 1.749 1.811 1.939 2.074 2.364 2.984 3.036
5 1.276 1.338 1.403 1.469 1.539 1.611 1.762 1.925 2.011 2.100 2.288 2.488 2.932 3.436 4.008
6 1.340 1.419 1.501 1.677 1.677 1.772 1.974 2.193 2.313 2.436 2.700 2.986 3.635 4.396 5.290
7 1.407 1.504 1.606 1.714 1.828 1.949 2.211 2.505 2.660 2.826 3.186 3.583 4.508 5.630 6.983
8 1.477 1.594 1.718 1.851 1.993 2.144 2.467 2.853 3.059 3.278 3.759 4.300 5.590 7.206 9.217
9 1.551 1.689 1.838 1.999 2.172 2.358 2.773 3.252 3.518 3.803 4.436 5.160 6.931 9.223 12.116
10 1.629 1.791 1.967 2.159 2.367 2.594 3.106 3.707 4.046 4.411 5.234 6.192 8.594 11.806 16.060
11 1.710 1.898 2.105 2.332 2.580 2.853 3.479 4.206 4.652 5.117 6.176 7.430 10.657 15.112 21.119
12 1.796 2.012 2.252 2.518 2.813 3.138 3.896 4.818 5.350 5.936 7.288 8.916 13.215 19.343 27.983
13 1.888 2.132 2.410 2.730 3.006 3.452 4.363 5.492 6.153 6.886 8.599 10.699 16.386 24.795 36.937
14 1.980 2.261 2.579 2.937 3.342 3.797 4.887 6.261 7.071 7.988 10.147 12.839 20.319 31.691 48.757
15 2.079 2.397 2.579 3.172 3.642 4.177 5.474 7.138 8.13 9.266 11.974 15.407 25.196 40.565 64.359
16 2.186 2.540 2.952 3.426 3.970 4.595 6.130 8.137 9.35 10.748 14.129 18.488 31.243 51.923 84.954
17 2.292 2.613 3.159 3.700 4.328 5.554 6.866 9.276 10.70 12.468 16.672 22.186 38.741 66.461 112.41
18 2.407 2.854 3.380 5.996 4.717 5.560 7.690 10.533 12.3 14.463 19.673 26.623 48.039 85.071 148.02
19 2.527 3.026 3.617 4.316 5.142 6.116 8.613 12.743 14.2 16.777 23.214 31.948 59.568 108.89 159.39
20 2.653 3.207 3.870 4.661 5.604 6.728 9.646 13.743 16.3 19.461 27.393 38.338 73.864 139.38 257.92