CA - IPCC. Quality Education beyond your imagination...! Solutions to Assignment Problems in Financial Management_31e

CA - IPCC COURSE MATERIAL Quality Education beyond your imagination...! Solutions to Assignment Problems in Financial Management_31e Visit us @ www.gntmasterminds.com, Mail : mastermindsinfo@ymail.com Page 1

Index S.No. Chapter Name No.of Assignment Problems Pages 1. Time Value of Money - - 2. Capital Budgeting 19 3-22 3. Advanced Concepts in Capital Budgeting 6 23-29 4. Cost of Capital 11 30-33 5. Capital Structure 14 34-41 6. Leverages 9 42-47 7. Working Capital Management 8 48-52 8. Ratio Analysis 3 53-56 9. Funds Flow Statement 4 57-63 Total 74 2

No.1 for CA/CWA & MEC/CEC MASTER MINDS 4,000X100 Payback reciprocal 20% 20,000 SOLUTIONS TO ASSIGNMENT PROBLEMS Problem No.1 2. CAPITAL BUDGETING The above payback reciprocal provides a reasonable approximation of the internal rate of return, i.e. 19%. W.N.-1: Calculation of depreciation per annum Cost - Scrap Value Depreciation p.a. Life W.N.-2: Calculation of PAT p.a. Problem No.2 80,000 10,000 Rs.14,000 p.a. 5 Year PBDT Depreciation PBT / PAT (PBDT Dep.) 1 20,000 14,000 6,000 2 40,000 14,000 26,000 3 30,000 14,000 16,000 4 15,000 14,000 1,000 5 5,000 14,000 (9,000) Since Income tax rate is not given in the problem, PBT PAT. Step-1: Calculation of Average Profit after Tax Calculation of ARR 6,000 + 26,000 + 16,000 + 10,000 9,000 Average Profit after tax 5 Rs. 8,000 p.a Step-2: Calculation of Average Investment 1 Average investment ( Initial Cost - Salvage Value) + Salvage Value 2 1 ( 80,000-10,000) + 10,000 Rs.45,000 2 Step-3: Calculation of Accounting Rate of Return (ARR) (Return on Avg. Capital Employed) ARR AveragePAT 8,000 x100 17.77% Average investment 45,000 Step-4: Return on Original Capital employed Average PAT 8,000 Return on Original Capital employed x100 x100 10% Orginal Investment 80,000 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 3

Ph: 0863 22 42 355 www.gntmasterminds.com W.N. 1: Calculation of depreciation per annum Problem No.3 Depreciation p.a. Cost - Scrap Value Life 80,000 0 Rs.16,000 p.a. 5 Calculation of NPV using Incremental approach Step-1: Calculation of Present Value of Cash Outflows: Particulars Amount Investment in new equipment 80,000 Additional working capital 1,50,000 Total 2,30,000 Step-2: Calculation of Present Value of Operating Cash Inflows: Incremental net cash in flow Less: additional wages Depreciation(w.n.1) Incremental PBT Less: Tax @ 40 % Incremental PAT Add: depreciation Incremental CFAT p.a Particulars Amount Rs. Amount Rs. Therefore, Present Value of Operating Cash Inflows 42,000 X PVAF(13%,5) 42,400 X 3.517 1,49,120 40,000 16,000 Step 3: Present Value of Terminal Cash Inflows Gsp or Nsp on sale of initial equipment 0 Recovery of additional working capital 1,50,000 1,50,000 PV there off 1,50,000 * PVF (13%, 5) 1,50,000 X 0.543 81,450 To MASTER MINDS, Guntur Step 4: Calculation of NPV NPV PV of cash inflows PV of cash outflows PV of Operating Cash Inflows +PV of Terminal Cash Inflows PV of cash outflows. 1,49,120 + 81,450-2,30,000 Rs.570 Conclusion: Since NPV is positive it is advisable to accept. 1,00,000 56,000 44,000 17,600 26,400 16,000 42,400 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 4

No.1 for CA/CWA & MEC/CEC MASTER MINDS Problem No.4 W.N 1: Calculation of depreciation p.a. (Rs. in Lakhs) Depreciation p.a. Cost - Scrap Value Life 10 1 On supplementary equipment 1.5 lakhs pa 6 140 0 Rs. 17.5 lakhs p.a. 8 Calculation of NPV using Incremental approach Step-1: Calculation of Present Value of Cash Outflows: Cost of initial equipment Cost of additional working capital Less: tax free subsidy from government Particulars Add: cost of supplementary equipment - 10 Present value there off - 10* pvf ( 12%, 2 ) - 10* 0.797 Present value of cash out flows Amount 140 15 155 20 135 7.97 142.97 Step-2: Calculation of Present Value of Operating Cash Inflows Selling price per unit 100 Less: - variable cost @ 40% 40 Contribution per unit 60 Particulars Y 1 Y 2 Y 3 to 5 Y 6 to 8 a. Sales volume (lakhs of unit) 0.8 1.2 3.0 2.0 b. Total contribution ( a * Rs. 60 per unit) 48 72 180 120 c. Fixed cost 16 16 16 16 d. Advertisement cost 30 15 10 4 e. Depreciation (WN 1) 17.5 17.5 19(17.5+1.5) 19 f. PBF (b-c-d-e) (loss) (15.5) 23.5 135 81 g. Tax @ 50% (7.75) 11.75 67.5 40.5 h. PAT (f-g) (7.75) 11.75 67.5 40.5 i. CFAT (h+e) 9.75 29.25 86.5 59.5 j. PVF @ 12 % 0.893 0.797 1.915 1.363 k. Present value 8.706 23.31 165.64 278.765 Therefore, Present Value of Operating Cash Inflows Rs.278.765 Present value factor for years 3 to 5 PVF (12%, 3) + PVF (12%, 4) + PVF (12%, 5) 0.712+0.636+0.567 1.915 (or) PVAF (12%, 5) - PVAF (12%, 2) To MASTER MINDS, Guntur 3.605-1.690 1.915 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 5

Ph: 0863 22 42 355 www.gntmasterminds.com Present value factor for years 6 to 8 PVF ( 12%, 6) + PVF (12%, 7) + PVF (12%, 8) 0.507+0.452+0.404 1.363 (or) PVAF(12%, 8) - PVAF (12%, 5) 4.968-3.605 1.363 Step-3: Present Value of Terminal Cash Inflows Gsp or Nsp on sale of initial equipment - 0 Gsp or Nsp on sale of supplementary equipment - 1 Recovery of working capital - 15 16 Pv there off 16 * PVF (12%, 8) 16 * 0.404 6.464 Step-4: Calculation of NPV NPV PV of cash inflows PV of cash outflows PV of Operating Cash Inflows +PV of Terminal Cash Inflows PV of cash outflows. 278 + 65 6.464 Rs. 142.97 Conclusion: Since NPV is positive it is advisable to accept the project. Note: It is given that the company has other profitable businesses and the loss from one business can be set off against profit of other business. Alternatively it can also be assumed that the loss is carried forward and setoff against future profit. Problem No.5 Calculation of NPV To MASTER MINDS, Guntur a. Step 1: Calculation of Present Value of Cash Outflows: Particulars Amount Cost of machinery 4,00,000 Present Value of Cash Outflows 4,00,000 Step 2: Calculation of Present Value of Operating Cash Inflows: Particulars a. Sales volume b. Contribution per unit (10-6) c. Total contribution (axb) d. Fixed cost e. CFAT (c-d) Amount 40,000 units Rs.4 1,60,000 20,000 1,40,000 p.a PV thereof 1,40,000 X PVAF(15%,6) 1,40,000 X 3.784 5,29,760 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 6

No.1 for CA/CWA & MEC/CEC MASTER MINDS Step-3: Present Value of Terminal Cash Inflows G.S.P/N.S.P on sale of machinery 20,000 PV thereof 20,000 X PVF(15%,6) 20,000 X 0.432 8,640 Step-4: Calculation of NPV NPV PV of cash inflows PV of cash outflows PV of Operating Cash Inflows +PV of Terminal Cash Inflows PV of cash outflows. 5,29,760+8,640-4,00,000 1,38,400 Conclusion: Since NPV is positive it is advisable to accept the project. b. Let, x represents the sale volume required to justify the project. The project is acceptable if NPV is at least equal to zero Step-1: same as above 4,00,000. Step-2: present value of operating cash inflows Particulars Amount (Rs.) a. Sales volume X unit b. Contribution per unit (10 6) 4 c. Total contribution 4X d. Fixed cost 20,000 e. CFAT (c-d) 4X-20,000 Present value there of (4X 20,000) * PVAF (15%, 6 years) (4X 20,000) *3.784 Step-3: same as above 8,640 Step-4: Finding the value of X To MASTER MINDS, Guntur Since NPV is 0 then present value of cash inflows present value of cash outflows present value of operating cash inflows + present value of terminal cash inflows present value of cash out flows (4X 20,000) * 3.784 + 8,640 4,00,000 (4X 20,000) 1,03,424 4X 1,23,424 X Given information: 30,856 units pa Problem No.6 Project Investment NPV A 1,00,000 1,25.000 B 1,50,000 45,000 A&B 2,50,000 2,00,000 C 1,50,000 90,000 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 7

Ph: 0863 22 42 355 www.gntmasterminds.com a. Selection of the projects if the firm has no budget constraint: Given that all the projects have positive NPV therefore it is beneficial to select all the projects I.e A,B & C. b. Selection of projects if there is a budget constraint of 2,50,000: Combination NPV A&B 2,00,000 A&C 2,15,000(1,25,000+90,000) Since NPV is more in case of projects A&C, it is beneficial to invest in project A&C. Problem No.7 W.N - 1: Calculation of depreciation per annum Cost of Machinery 2,50,000 Less: Salvage value 30,000 Depreciable amount 2,20,000 To MASTER MINDS, Guntur Sum of the years digits 1 + 2 + 3 +.. + 10 55. Dep. for 1 st year 2,20,000 x 10 Rs.40,000 2 nd 2, 20, 000 year x 9 55 55 Rs.36,000 3 rd year 2,20,000 x 8 Rs. 32,000 4 th 2,20,000 year x 7 55 55 Rs. 8,000 5 th year 2,20,000 x 6 55 Rs.24,000 W.D.V at the end of 5th year Cost depreciation 2,50,000 1,60,000 Rs. 90,000 Book value of machine after capital expenditure 90,000 + 60,000 Rs. 1,50,000 Depreciable amount from 6th to 10th year 1,50,000 30,000 Rs. 1,20,000 Sum of the years digits 1 + 2 + 3 + 4 + 5 15 Dep. for 6 th 1,20,000 year x 5 Rs. 40,000 7 th 1, 20,000 year x 4 Rs. 32,000 15 15 8 th 1,20,000 year x 3 Rs. 24,000 9 th 1,20,000 year x 2 Rs. 16,000 15 15 10 th 1, 20, 000 year x1 Rs. 8,000 15 Calculation of NPV Step-1: Calculation of Present Value of Cash Outflows Particulars Cost of Machinery Add: Working capital Add: Cost of Additional equipment [60,000 x PVF (20%, 5y)] Amount 2,50,000 50,000 24,120 Present value of Cash Outflows 3,24,120 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 8

No.1 for CA/CWA & MEC/CEC Step-2: Calculation of Present Value of Operating Cash Inflows. MASTER MINDS (Rs. in Lakhs) Particulars Y 1 Y 2 Y 3 Y 4 Y 5 Y 6 Y 7 Y 8 Y 9 Y 10 PBDT Less: Dep.(W.N-1) P.B.T Less: Tax @ 40% P.A.T Add:Depreciation C.F.A.T. X P.V.F (20%, n) 1.0 0.4 0.6 L 0.24 L 0.36 0.4 0.76 0.833 1.0 0.36 0.64 0.256 0.384 0.36 0.744 0.694 1.0 0.32 0.68 0.272 0.408 0.32 0.728 0.579 1.0 0.28 0.72 0.288 0.432 0.28 0.712 0.482 1.0 0.24 0.76 0.304 0.456 0.24 0.696 0.402 1.0 0.40 0.60 0.24 0.36 0.40 0.76 0.335 1.0 0.32 0.68 0.272 0.408 0.32 0.728 0.279 1.0 0.24 0.76 0.304 0.456 0.24 0.696 0.233 1.0 0.16 0.84 0.336 0.504 0.16 0.664 0.194 1.0 0.08 0.92 0.368 0.552 0.08 0.632 0.162 P.Value 0.634 0.516 0.422 0.343 0.279 0.255 0.203 0.162 0.128 0.102 Therefore, Present Value of operating cash inflows Rs.3,04,498 Step-3: Calculation of Present Value of Terminal Cash Inflows (At the end of the project) Particulars G.S.P/N.S.P on sale of machinery Add: Recovery of working capital Amount 30,000 50,000 Total of Terminal Cash Inflows 80,000 Present Value thereof 80,000 X PVF (20%, 10y) 80,000 X 0.162 Rs.12,960 Step-4: Calculation of NPV NPV PV of cash inflows PV of cash outflows PV of Operating Cash Inflows + PV of Terminal Cash Inflows PV of Cash Outflows 3,04,498 + 12,960 3,24,120 - Rs. 6662 Conclusion: Since NPV is negative it is not advisable for the company to accept the project. Assumptions: Cash flows are assumed to accrue at the end of each year. Interim cash inflows at the end of each year are assumed to be reinvested at the rate of cost of capital. Cash flows given in the problem are assumed to be certain. Problem No.8 To MASTER MINDS, Calculation of IRR: (Single out flow & multiple even cash inflows) From the given information, PVA 36,000 periodic payment 11,200 term of annuity 5 years We know that, PVA P.P X PVAF (r%, 5 yrs) 36,000 11,200 X PVAF PVAF 3.214 Trace the PVAF in the PVAF table against 5 years Therefore IRR 17% approximately IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 9

Ph: 0863 22 42 355 Step-1: Calculation of Pay Back Period Problem No. 9 www.gntmasterminds.com (Rs. In Lakhs) Year 1 2 3 4 5 Machine A Machine B CFAT Accumulated CFAT CFAT Accumulated CFAT 1.5 2.0 2.5 1.5 1.0 Pay Back Period 2 + 5.0 3.5 2.5 1.5 3.5 6.0 7.5 8.5 0.5 1.5 2.0 3.0 2.0 2.6 Years 3 + 5.0 4.0 3.0 Since Pay Back Period is less for Machine A, it is beneficial to purchase Machine A. Step-2: Present Value of Cash Out flows 0.5 2.0 4.0 7.0 9.0 3.33 years Particulars Amount Cost of Machinery Present Value of Cash Outflows 5,00,000 5,00,000 Step-3: Present Value of Operating Cash Inflows Year Machine A Machine B CFAT PVF @ 10% PV Y 1 Y 2 Y 3 Y 4 Y 5 Y 1 Y 2 Y 3 Y 4 Y 5 1.5 0.909 1.3635 2.0 0.826 1.652 2.5 0.751 1.8775 1.5 0.683 1.0245 1.0 0.621 0.621 0.5 0.909 0.4545 1.5 0.826 1.239 2.0 0.751 1.502 3.0 0.683 2.049 2.0 0.621 1.242 Present Value there of for Machine A 6.5385 Present Value there of for Machine B 6.4865 Step-4: Present Value of Terminal Cash Inflows - Nil Step-5: Calculation of NPV and Profitability Index Particulars Machine A Machine B Present Value of cash inflows Present Value of cash outflows NPV @ 10% Profitability Index (P.V of Cash Inflows / Cash Outflows) 6.5385 (5.0) 1.5385 1.31 Since NPV and P.I. are higher for Machine A, it is beneficial to purchase Machine A. Step-6: Calculation of I.R.R for Machine A 6.4865 (5.0) 1.4865 1.30 Year 0 1 2 Cash flow 5.0 1.5 2.0 NPV @ 20% NPV @ 24% PVF P V PVF P V 1.0 0.833 0.694 (5.0) 1.25 1.39 1.0 0.806 0.650 (5.0) 1.21 1.30 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 10

No.1 for CA/CWA & MEC/CEC MASTER MINDS 3 4 5 2.5 1.5 1.0 0.579 0.482 0.402 1.45 0.72 0.40 0.524 0.423 0.341 1.31 0.63 0.34 NPV 0.21 (0.21) Using Interpolation IRR L l + NPV@L 1 NPV@L 1 NPV@ L 2 Step-7: Calculation of IRR for Machine B 0.21 0.21+ 0.21 (L 2 L 1 ) 20 + ( 4) 22%. Year 0 1 2 3 4 5 Cash flow 5.0 0.5 1.5 2.0 3.0 2.0 NPV @ 18% NPV @ 20% PVF P V PVF P V 1.0 0.847 0.718 0.609 0.516 0.437 (5.0) 0.42 1.08 1.22 1.55 0.87 1.0 0.833 0.694 0.579 0.482 0.402 (5.0) 0.42 1.04 1.16 1.45 0.80 0.14 (0.13) Using Interpolation IRR L l + NPV@L 1 NPV@L 1 NPV@ L 2 (L 2 L 1 ) 0.14 18 + 0.14 + 0.13 2 18 + 1.012 19.04% 19.04% To MASTER MINDS, Since IRR is high for Machine A, it is beneficial to purchase Machine A. Step-8: Calculation of Average Rate of Return Particulars Machine A Machine B Cost Scrap 1. Depreciation Life 2. Average Investment 1 Initial Investment Scrap + Scrap + 2 ( ) Add.W/cap 3. Average PAT. p.a. (Avg CFAT Depreciation) 1,00,000 1,00,000 2,50,000 2,50,000 70,000 1.5 + 2 + 2.5 + 1.5 + 1 1 5 80,000 0.5 + 1.5 + 2 + 3 + 2 1 5 4. Average Rate of Return (3) / (2) 0.28 (70,000/2,50,000) 0.32 (80,000/2,50,000) Since machines are mutually exclusive and A.R.R. is high for Machine B, it is beneficial to purchase Machine B. Conclusion: In all the above cases except in the case of A.R.R - purchase of Machine - A is beneficial. IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 11

Ph: 0863 22 42 355 www.gntmasterminds.com Assumptions: 1. For Pay back period: Cash flows are assumed to accrue evenly throughout the year. 2. For NPV Cash flows are assumed to accrue at the end of each year. Interim cash inflows at the end of each year are assumed to be reinvested at the rate of cost of capital. Cash flows given in the problem are assumed to be certain. To MASTER MINDS, 3. For IRR Cash flows are assumed to accrue at the end of each year. Interim cash inflows at the end of each year are assumed to be reinvested at the rate of IRR. Cash flows given in the problem are assumed to be certain. Step-1: Calculation of CFAT p. a Estimated savings in cost Estimated savings in Wages Less: Additional cost of maintenance Additional cost of supervision Problem No. 10 Particulars Machine X Machine Y 500 6,000 800 1,200 800 8,000 1,000 1,800 CFAT p.a 4,500 6,000 Step-2: Calculation of Pay back period Particulars Machine X Machine Y Payback period Initial Investment CFAT 9000 2yrs. 18000 3 yrs. 4500 6000 Assumption: The two machines are mutually exclusive. Conclusion: It is beneficial to select the machine with least pay back period i.e. Machine X. Problem No.11 (a) (i) Payback Period Project A: 10,000/10,00 Project B: 10,000/7,500 Project C: 2 years + Project D: 1 year. 1 year 1 1/3 years. 10,000 6,000 12,000 1 2 3 years (ii) ARR (10,000 10,000)1/ 2 Project A: 0 (10,000)1/ 2 To MASTER MINDS, Guntur IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 12

No.1 for CA/CWA & MEC/CEC (15,000 10,000)1/ 2 2,500 Project B: 50% (10,000)1/ 2 5,000 (18,000 10,000)1/ 3 2,667 Project C: 53% (10,000)1/ 2 5,000 (16,000 10,000)1/ 3 2,000 Project D: 40% (10,000)1/ 2 5,000 MASTER MINDS To MASTER MINDS, Guntur Note: This net cash proceed includes recovery of investment also. Therefore, net cash earnings are found by deducting initial investment. (iii) IRR Project A: Project B: Project C: The net cash proceeds in year 1 are just equal to investment. Therefore, r 0% This project produces an annuity of Rs.7,500 for two years. Therefore, the required PVAF is: 10,000/7,500 1.33. This factor is found under 32% column. Therefore, r 32% Since cash flows are uneven, the trail and error method will be followed. Using 20% rate of discount the NPV is + Rs.1,389. At 30% rate of discount, the NPV is Rs.633. The true rate of return should be less than 30%. At 27% rate of discount it is found that the NPV is Rs.86 and at 26% + Rs.105. Through interpolation, we find r 26.5% Project D: In this case also by using the trail and error method, it is found that at 37.6% rate of discount NPV becomes almost zero. Therefore, r 37.6% (iv) NPV Project A: at 10% -10,000+10,000x0.909-910 at 30% -10,000+10,000x0.769-2,310 Project B: at 10% -10,000+7,500(0.909+0.826) 3,013 at 30% -10,000+7,500(0.769+0.592) +208 Project C: at 10% -10,000+2,000x0.909+4,000x0.826+12,000x0.751 +4,134 at 30% -10,000+2,000x0.769+4,000x0.592+12,000x0.455-633 Project D: at 10% -10,000+10,000x0.909+3,000x(0.826+0.751) +3,821 at 30% -10,000+10,000x0.769+3,000x(0.592+0.4555) +831 The Project are ranked as follows according to the various methods: Ranks Projects PB 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 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 13

Ph: 0863 22 42 355 www.gntmasterminds.com (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. Problem No.12 (a) Payback Period Method: A 5 + (500/900) 5.5 years B 5 + (500/1200) 5.4 years C 2 + (1000/2000) 2.5 years Net Present Value: NPV A (- 5000) + (900-6.145) (5000) + 5530.5 Rs.530.5 NPV B is calculated as follows: Year Cash flow (Rs.) 10% discount factor Present value (Rs.) 0 (5,000) 1.000 (5,000) 1 700 0.909 636 2 800 0.826 661 3 900 0.751 676 4 1,000 0.683 683 5 1,100 0.621 683 6 1,200 0.564 677 7 1,300 0.513 667 8 1,400 0.467 654 9 1,500 0.424 636 10 1,600 0.386 618 1591 NPV C (-5000) + (2000 2.487) + (1000 0.683) Rs.657 Internal Rate of Return If NPV A 0, present value factor of IRR over 10 years 5000/900 5.556 From tables, IRR A 12 per cent. To MASTER MINDS, Guntur IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 14

No.1 for CA/CWA & MEC/CEC MASTER MINDS IRR B Year Cash flow (Rs.) 10% discount factor Present value (Rs.) 20% discount factor Present value (Rs.) 0 (5,000) 1.000 (5,000) 1.000 (5,000) 1 700 0.909 636 0.833 583 2 800 0.826 661 0.694 555 3 900 0.751 676 0.579 521 4 1,000 0.683 683 0.482 482 5 1,100 0.621 683 0.402 442 6 1,200 0.564 677 0.335 402 7 1,300 0.513 667 0.279 363 8 1,400 0.467 654 0.233 326 9 1,500 0.424 636 0.194 291 10 1,600 0.386 618 0.162 259 1,591 (776) 1,591x10 Interpolating: IRR B 10 + 10+6.72 16.72 per cent (1,591+ 776) IRR C Year Cash flow (Rs.) 15% discount factor Present value (Rs.) 18% discount factor Present value (Rs.) 0 (5,000) 1.000 (5,000) 1.000 (5,000) 1 2,000 0.870 1,740 0.847 1,694 2 2,000 0.756 1,512 0.718 1,436 3 2,000 0.658 1,316 0.609 1,218 4 1,000 0.572 572 0.516 516 140 136 140x3 Interpolating: IRR C 15 + 15 + 1. 52 16.52 per cent (140 + 136) Accounting Rate of Return 5,000 ARR A : Average capital employed Rs.2,500 2 ( 9,000 5,000) Average accounting profit Rs.400 10 (400x100) ARR A 16 per cent 2,500 ( 11,500 5,000) ARR B : Average accounting profit Rs.650 10 (650x100) ARR B 26 per cent 2,500 ( 7,000 5,000) ARR C Average accounting profit Rs.500 4 (500x100) ARR C 20 per cent 2,500 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 15

Ph: 0863 22 42 355 www.gntmasterminds.com (b) Summary of Results Project A B C Payback (years) 5.5 5.4 2.5 ARR (%) 16 26 20 IRR (%) 12.4 16.7 16.5 NPV (Rs.) 530.5 1,591 657 Comparison of Rankings Method Payback ARR IRR NPV 1 C B B B 2 B C C C 3 A A A A Calculation of NPV & IRR: Year Using interpolation, Cash flow Problem No.13 NPV at the rate of 12% NPV at the rate of 13% PVF @12% PV PVF @13% PV 0 (35,00,000) 1 (35,00,000) 1 (35,00,000) 1-4 10,00,000 3.037 30,37,000 2.974 29,74,000 5 5,00,000 0.567 2,83,500 0.543 2,71,500 6 5,00,000 0.507 2,53,500 0.48 2,40,000 NPV 74,000 (14,500) NPV @l1 IRR l1 + (l2 l1) NPV @l NPV @l 74,000 12% + (13% 12%) 88,500 12.836% 1 2 To MASTER MINDS, Guntur Since NPV is positive, it is beneficial for the company to accept the proposal. Since IRR is > cost of capital, it is beneficial for the company to accept the proposal. Problem No.14 1. Computation of Net Present Values of Projects: Year Project A Rs. (1) Cash flows Project B Rs. (2) (3) Discounting Factor @ 16% Project A Rs. (3) x (1) Discounted Cash flow Project B Rs. (3) x (2) 0 1,35,000 2,40,000 1.000 1,35,000 2,40,000 1-60,000 0.862-51,720 2 30,000 84,000 0.743 22,290 62,412 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 16

No.1 for CA/CWA & MEC/CEC MASTER MINDS 3 1,32,000 96,000 0.641 84,612 61,536 4 84,000 1,02,000 0.552 46,368 56,304 5 84,000 90,000 0.476 39,984 42,840 Net present value 58,254 34,812 2. Computation of Cumulative Present Values of Projects Cash inflows: Project A Project B Year PV of cash Cumulative PV of Cumulative inflows PV cash inflows PV Rs. Rs. Rs. Rs. 1 - - 51,720 51,720 2 22,290 22,290 62,412 1,14,132 3 84,612 1,06,902 61,536 1,75,668 4 46,368 1,53,270 56,304 2,31,972 5 39,984 1,93,254 42,840 2,74,812 (i) Discounted payback period: (Refer to Working note 2) Cost of Project A Rs.1,35,000 Cost of Project B Rs.2,40,000 Cumulative PV of cash inflows of Project A after 4 years Rs.1,53,270 Cumulative PV of cash inflows of Project B after 5 years Rs.2,74,812 A comparison of projects cost with their cumulative PV clearly shows that the project A s cost will be recovered in less than 4 years and that of project B in less than 5 years. The exact duration of discounted pay back period can be computed as follows: Excess PV of cash inflows over the Project A Project B 18,270 34,812 Project cost (Rs.) (Rs.1,53,270 Rs.1,35,000) (Rs.1,53,270 Rs.1,35,000) Computation of period required To recover excess amount of cumulative PV over project cost (Refer to Working note2) (Rs.18,270 / Rs.46,368) 0.39 year 0.81 years (Rs.34,812 / Rs.42,840) Discounted payback period 3.61 year 4.19 years Sumofdiscountcashinf lows (ii) Profitability Index : initiancashoutlay Profitability Index (for Project A) Rs.1,93,254 Rs.1,35,000 Profitability Index (for Project B) Rs.2,74,812 Rs.2,40,000 (iii) Net present value (for Project A) Rs.58,254 (Refer to Working note 1) Net present value (for Project B) Rs.34,812 (4 0.39 years (5 0.81) years 1.43 1.15 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 17

Ph: 0863 22 42 355 www.gntmasterminds.com Problem No.15 Advise to the Hospital Management: Sales Revenue Less: Operating Cost Less: Depreciation (80,000 6,000)/8 Net Income Tax @ 30% Earnings after Tax (EAT) Add: Depreciation Cash inflow after tax per annum Less: Loss of Commission Income Net Cash inflow after tax per annum In 8th Year : New Cash inflow after tax Add: Salvage Value of Machine Net Cash inflow in year 8 Determination of Cash inflows Amount 40,000 7,500 32,500 9,250 23,250 6,975 16,275 9,250 25,525 12,000 13,525 13,525 6,000 19,525 Calculation of Net Present Value (NPV): 1 to 7 8 Year CFAT PV Factor @10% Less: Cash Outflows 13,525 19,525 NPV 4.867 0.467 Present Value of Cash inflows 65,826.18 9,118.18 74,944.36 80,000.00 (5,055.64) Sum of discounted cash inflows 74,944.36 Profitabil ity Index 0.937 Present value of cash outflows 80,000 Advise: Since the net present value is negative and profitability index is also less than 1, therefore, the hospital should not purchase the diagnostic machine. Note: Since the tax rate is not mentioned in the question, therefore, it is assumed to be 30 percent in the given solution. (i) Payback Period of Projects Problem No.16 Particulars C 0 C 1 C 2 C 3 A (10,000) 6,000 2,000 2,000 3 years B (10,000) 2,500 2,500 5,000 3 years C (3,500) 1,500 2,500 1 year and 9.6 months D (3,000) 0 0 3,000 3 years 12 i.e. x2, 000 2,500 (ii) If standard payback period is 2 years, Project C is the only acceptable project. But if standard payback period is 3 years, all the four projects are acceptable. IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 18

No.1 for CA/CWA & MEC/CEC MASTER MINDS (iii) Discounted Payback Period (Cash flows discounted at 10%) A 10,000 + 5,454.6 + 1,652.8 + 1,502.6 + 8,196 12 3 years + x1,390 3 years and 2 months 8,196 B 10,000 + 2,272.75 + 2,066 + 3,756.5 + 5,122.50 12 3 years + x1,904.75 3 years and 4.6 months 5,122.55 C 3,500 + 1,363.65 + 2,066 + 375.65 + 3,415 12 2 years + x70.35 2 years and 2.25 months 375.65 D 3,000 + 0 + 0 + 2,253.9 + 4,098 12 3 years + x746.10 3 years and 2.18 months 4,098 If standard discounted payback period is 2 years, no project is acceptable on discounted payback period criterion. If standard discounted payback period is 3 years, Project C is acceptable on discounted payback period criterion. Problem No.17 Recommendations regarding Two Alternative Proposals: (i) Net Present Value Method: Computation of Present Value Project A Rs.4,00,000 x 3.791 Rs.15,16,400 Project B Rs.5,80,000 x 3.791 Rs.21,98,780 Computation of Net Present Value: Project A Rs.15,16,400 12,00,000 Rs.3,16,400 Project B Rs.21,98,780 18,00,000 Rs.3,98,780 Advise: Since the net present value of Project B is higher than that of Project A, therefore, Project B should be selected. (ii) Present Value Index Method: Pr esentvalueofcashinf low Present Value Index InitialInvestment 15,16,400 Project A 12,00,000 1.264 21,98,780 Project B 18,00,000 1.222 To MASTER MINDS, Guntur Advise: Since the present value index of Project A is higher than that of Project B, therefore, Project A should be selected. IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 19

Ph: 0863 22 42 355 www.gntmasterminds.com (iii) Internal Rate of Return (IRR): Project A: InitialInvestment 12,00,000 P.V. Factor 3 AnnualCashInflow 4,00,000 PV factor falls between 18% and 20% Present Value of cash inflow at 18% and 20% will be: Present Value at 18% 3.127 x 4,00,000 12,50,800 Present Value at 20% 2.991 x 4,00,000 11,96,400 12,50,800 12,00,000 IRR 18 + x(20 18) 12,50,800 11,96,400 50,800 18 + x2 54,400 18 + 1.8676 19.868% To MASTER MINDS, Guntur Project B: 18,00,000 P.V. Factor 3. 103 5,80,000 Present Value of cash inflow at 18% and 20% will be: Present Value at 18% 3.127 x 5,80,000 18,13,660 Present Value at 20% 2.991 x 5,80,000 17,34,780 18,13,660 18,00,000 IRR 18 + x(20 18) 18,13,660 17,34,780 13,660 18 + x2 78,880 18 + 0.3463 18.346% Advise: Since the internal rate of return of Project A is higher than that of Project B, therefore, Project A should be selected. Problem No.18 Working notes: Depreciation on machine. X Depreciation on machine. Y Cost Cost - Scrap Value Life - Scrap Value Life 1,50,000 Rs.30,000 5 2,40,000 Rs.40,000 6 Annual savings: Wages Scrap Total savings(a) Particulars Machine X Machine Y 90,000 10,000 1,00,000 1,20,000 15,000 1,35,000 Annual estimated cash cost: Indirect material Supervision Maintenance Total cash cost(b) 6,000 12,000 7,000 25,000 8,000 16,000 11,000 35,000 IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 20

No.1 for CA/CWA & MEC/CEC Annual cash savings(a-b) Less: depreciation Annual savings before tax Less: tax @ 30 % Annual profit after tax Add: depreciation Annual cash in flows 75,000 30,000 45,000 13,500 31,500 30,000 MASTER MINDS 1,00,000 40,000 60,000 18,000 42,000 40,000 61,500 82,000 Evaluation of alternatives: (i) ARR average annual net savings Average investment 31,500 Machine X x100 42% 75,000 42,000 Machine Y x100 35% 1,20,000 To MASTER MINDS, Guntur Decision: Machine X is better. [Note: ARR can be computed alternatively taking initial investment as the basis forcomputation (ARR Average Annual Net Income/Initial Investment). The value ofarr for Machines X and Y would then change accordingly as 21% and 17.5%respectively] (ii) Present Value Index Method Present Value of Cash Inflow Annual Cash Inflow x P.V. Factor @ 10% Machine X 61,500 x 3.79 Rs.2,33,085 Machine Y 82,000 x 4.354 Rs.3,57,028 P.V index present value of cash inflow Investment 2,33,085 Machine X 1. 5539 1,50,000 3,57,028 Machine Y 1. 4876 2,40,000 Decision: Machine X is better. Project Present Value of Cash Inflows Problem No.19 PART A Initial cash outlay NPV P.I Ranking as per NPV Ranking as per P.I A 1,87,600 x PVAF (12%, 2y ) 317044 3,00,000 17,044 1.057 IV V B 66,000 x PVAF (12%, 5y ) 2,37,930 2,00,000 37,930 1.19 III III C 1,00,000 x PVAF (12%, 3y) 2,40,200 2,00,000 40,200 1.201 II II D 20,000 x PVAF (12%, 9y) 1,06,560 1,00,000 6,560 1.066 V IV E 66,000 x PVAF (12%, 10y) 3,72,900 3,00,000 72,900 1.243 I I IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 21

Ph: 0863 22 42 355 www.gntmasterminds.com PART B All the projects have positive NPV. So, we can accept all the projects subject to availability of funds. It is also given that the company is having limited funds of Rs.4,00,000 and we need Rs.11,00,000 to invest in all the projects. So, it is required to do capital rationing. Capital Rationing, assuming that the projects are divisible Project Cash Outflow NPV Surplus funds E 3,00,000 72,900 1,00,000 C 1,00,000 40,200 20,100 x1,00,000 2,00,000 - Total 93,000 - PART - C All the projects have positive NPV. To accept all the projects we need initial investment of Rs.11,00,000. But the available funds are just Rs.5,00,000. Therefore, it is necessary to do capital rationing. Assumptions: Capital Rationing, assuming that the projects are divisible Project Cash outlay NPV Surplus funds E 3,00,000 72,900 2,00,000 C 2,00,000 40,200 --- Total 1,13,100 Perfect linear relationship is assumed to exist between inflows and outflows. In other words, NPV changes proportionately to changes in investment. It is assumed that there is scarcity of funds in the current year only. In other words, there is no scarcity of funds in subsequent years. The given projects are mutually independent. A project can be accepted only once. A project can either be accepted now or rejected. In other words, there is no question of postponement. THE END IPCC_31e_F.M_ Capital Budgeting_Assignment Solutions 22

No.1 for CA/CWA & MEC/CEC MASTER MINDS 3. ADVANCED CAPITAL BUDGETING SOLUTIONS TO ASSIGNMENT PROBLEMS PROBLEM NO.1 Calculation of NPV: X Y Step 1: PV of Initial Cash out flow 10,000 10,000 Step 2: PV of Operating cash inflows Year Cash flows PV PVF @ 10% X Y X Y 1 2,000 10,000 0.909 1,818 9,090 2 4,000 3,000 0.826 3,304 2,478 3 12,000 3,000 0.751 9,012 2,253 14,134 13,821 Step 3: NPV PV of Cash outflows PV of Cash inflows Project X NPV 14,134 10,000 4,134 Project Y NPV 13,821 10,000 3,821 Calculation of IRR: Project X: Year Cash flows NPV at the 1 st guess rate of 26% NPV at the 2 nd guess rate of 27% PVF @ 26% PV PVF @ 27% PV 0-10,000 1-10,000 1-10,00 1 2,000 0.794 1,588 0.787 1,574 2 4,000 0.630 2,520 0.620 2,480 3 12,000 0.5 6,000 0.488 5,856 NPV 108-20 108 Using Interpolation, IRR 26% + (27% 26%) 108 + 90 26% + 0.545 26.545% Project Y: Year Cash flows NPV at the 1 st guess rate of 37% NPV at the 2 nd guess rate of 38% PVF @ 37% PV PVF @ 38% PV 0-10,000 1-10,000 1-10,00 1 10,000 0.729 7,290 0.724 7,240 2 3,000 0.532 1,596 0.525 1,575 3 3,000 0.388 1,164 0.381 1,143 NPV 50-42 50 Using Interpolation, IRR 37 + (38% - 37%) 37.543% 50 + 42 IPCC_31e_F.M_Capital Budgeting_Assignment Solutions 23

Ph: 0863 22 42 355 www.gntmasterminds.com Project X Project Y NPV 4,134 2,821 IRR 26.545% 37.543% According to NPV Project X is preferable. According to IRR Project Y is preferable. Hence there is a conflict between NPV & IRR. Reasons for Conflict: i. Projects are mutually Exclusive ii. Cash flow disparity or time disparity iii. Disparity in reinvestment rates. The main objective of financial management is to maximize the shareholders wealth. NPLV ranks the proposal on the basis of this objective. Hence the project is selected on the preference made by NPV i.e. Project X PROBLEM NO.2 i. Estimation of net present value (NPV) of the Project P and J using 15% as the hurdle rate: NPV of Project P : 13,000 8,000 14,000 12,000 11,000 15,000-40,000 + 1 + 2 + 3 + 4 + 5 + 6 (1.15) (1.15) (1.15) (1.15) (1.15) (1.15) - 40,000 + 11,304.35 + 6,049.15 + 9,205.68 + 6,861.45 + 5,469.37 + 6,485.65 Rs. 5,375.65 OR Rs. 5,376 NPV of Project J : 7,000 13,000 12,000-20,000 + + + 1 2 3 (1.15) (1.15) (1.15) - 20,000 + 6,086.96 + 9,829.87 + 7,890.58 Rs. 3,807.41 To MASTER MINDS, Guntur ii. Estimation of internal rate of return (IRR) of the Project P and J : Internal rate of return r (IRR) is that rate at which the sum of cash inflows afterdiscounting equals to the discounted cash out flows. The value of r in the case of givenprojects can be determined by using the following formula: CO 0 CF0 CF1 CFn SV + WC 0 + 1 + - - - - - - - - - - + n + n (1+ r) (1+ r) (1+ r) (1+ r) Where Co Cash flows at the time 0 CF t Cash flows at the end of year t R Discount rate N Life of the Project SV & WC Salvage Value and working capital at the end of n years. In the case of project P the value of r (IRR) is given by the following relation: 40,000 13,000 8,000 14,000 12,000 11,000 15,000 1 + 2 + 3 + 4 + 5 + 6 (1+ r%) (1+ r%) (1+ r%) (1+ r%) (1+ r%) (1+ r%) r 19.73% IPCC_31e_F.M_Capital Budgeting_Assignment Solutions 24

No.1 for CA/CWA & MEC/CEC MASTER MINDS Similarly we can determine the internal rate of return for the project J. In the case of project J it comes to: r 25.20% iii. The conflict between NPV and IRR rule in the case of mutually exclusive project situation arises due to re-investment rate assumption. NPV rule assumes that intermediate cash flows are reinvested at k and IRR assumes that they are reinvested at r. The assumption of NPV rule is more realistic. iv. When there is a conflict in the project choice by using NPV and IRR criterion, we would prefer to use Equal Annualized Criterion. According to this criterion the net annual cash inflow in the case of Projects P and J respectively would be: Project P (Net present value/ cumulative present value of Re.1 p.a @15% for 6 years) (Rs. 5,375.65 / 3.7845) Rs. 1,420.44 Project J (Rs. 3807.41/2.2832) Rs. 1667.58 Advise : Since the cash inflow per annum in the case of project J is more than that of project P, so Project J is recommended. Year Cash flow PVF PROBLEM NO.3 Calculation of NPV & IRR of Project X NPV @ 10% Present Value NPV at first guess rate of 15% NPV at second guess rate of 16% IPCC_31e_F.M_Capital Budgeting_Assignment Solutions 25 PVF Present Value PVF Present Value 0 (200) 1 (200) 1 (200) 1 (200) 1 35 0.909 31.82 0.870 30.45 0.862 30.17 2 80 0.826 66.08 0.756 60.48 0.743 59.44 3 90 0.751 67.59 0.658 59.22 0.641 57.69 4 75 0.683 51.23 0.572 42.90 0.552 41.40 5 20 0.621 12.42 0.497 9.94 0.476 9.52 29.13 2.99 (1.78) Using Interpolation, NPV@l1 2.99 IRR l1 + x(l2 l1) 15 + NPV@l2 NPV@l1 4.77 X (16 15) IRR 15.626% Year Cash flow PVF Calculation of NPV & IRR of Project Y NPV @ 10% Present Value NPV at first guess rate of 18% PVF Present Value NPV at second guess rate of 19% PVF Present Value 0 (200) 1 (200) 1 (200) 1 (200) 1 218 0.909 198.16 0.847 184.65 0.840 183.12 2 10 0.826 8.26 0.718 7.18 0.706 7.06 3 10 0.751 7.51 0.609 6.09 0.593 5.93 4 4 0.683 2.73 0.516 2.06 0.499 1.99 5 3 0.621 1.86 0.437 1.31 0.414 1.36 18.53 1.29 (0.64)

Ph: 0863 22 42 355 Using Interpolation, NPV@l1 IRR l1 + x(l2 l1) 18 + NPV@l2 NPV@l1 IRR 18.669% 1.29 1.93 X (19 18) www.gntmasterminds.com According to NPV Project X is beneficial and according to IRR project Y is beneficial. So, there is a conflict between NPV and IRR. Reasons for this conflict: 1. Projects are mutually exclusive 2. Cash flow disparity / Time disparity 3. Difference in reinvestment rates. To MASTER MINDS, Guntur Conclusion: The objective of the financial management is to maximize the benefit to equity shareholders. NPV ranks the proposal in accordance with this objective. So it is beneficial to accept the project being preferred with highest NPV i.e. Project X. Assumptions: 1. For NPV: Cash flows are assumed to accrue at the end of each year. Interim cash inflows at the end of each year are assumed to be reinvested at the rate of cost of capital. Cash flows given in the problem are assumed to be certain. 2. For IRR: Cash flows are assumed to accrue at the end of each year. Interim cash inflows at the end of each year are assumed to be reinvested at the rate of IRR. Cash flows given in the problem are assumed to be certain. i. Calculation of Net Initial Cash Outflows: PROBLEM NO.4 Rs. Cost of new machine 10,00,000 Less: Sale proceeds of existing machine 2,00,000 Net initial cash outflows 8,00,000 ii. Calculation of annual depreciation: On old machine On new machine 3,30,000 11years Rs. 30,000 per annum. 10,00,000-40,000 Rs.1,20,000 per annum. 8 years iii. Calculation of annual cash inflows from operation: Particulars Existing machine New machine Differential (1) (2) (3) (4) (3) (2) Annual output 30,000 units 75,000 units 45,000 units Rs. Rs. Rs. A. Sales revenue @ Rs.15 per unit 4,50,000 11,25,000 6,75,000 IPCC_31e_F.M_Capital Budgeting_Assignment Solutions 26

No.1 for CA/CWA & MEC/CEC MASTER MINDS B. Less: Cost of Operation Material @ Rs. 4 per unit 1,20,000 3,00,000 1,80,000 Labour Old 3,000 X Rs. 40 1,20,000 90,000 New 3,000 X Rs. 70 2,10,000 Indirect cash cost 50,000 65,000 15,000 Depreciation 30,000 1,20,000 90,000 Total Cost (B) 3,20,000 6,95,000 3,75,000 Profit Before Tax(A - B) 1,30,000 4,30,000 3,00,000 Less: Tax @ 30% 39,000 1,29,000 90,000 Profit After tax 91,000 3,01,000 2,10,000 Add: Depreciation 30,000 1,20,000 90,000 Annual Cash Inflows 1,21,000 4,21,000 3,00,000 iv. Calculation of Net Present Value: Present value of annual net cash Inflows: 1-8 years Rs. 3,00,000 X 4.968 14,90,400 Add: Present value of Salvage value of new machine at the end of 8 th year (Rs. 40,000 X 0.404) 16,160 Total present value 15,06,560 Less: Net Initial Cash outflows 8,00,000 NPV 7,06,560 Advice: Hence, existing machine should be replaced because NPV is positive. W.N-1: Calculation of depreciation per annum. Old Machine: PROBLEM NO.5 Year 1 2 3 4 5 6 7 3,33,333 2,22,222 1,48,148 98,765 65,844 43,896 29264 Depreciation d d d d d d d dd > dddddd dddddd ddedde eeeed ededd ddeee d d d d d d d New Machine: Year 1 2 3 4 5 Depreciation 533333 1 16 L x 3 Incremental Depreciation: Year Depreciation on New Machine 355556 2 533333 x 3 2,37,037 2 355556 x 3 Depreciation on Old Machine IPCC_31e_F.M_Capital Budgeting_Assignment Solutions 27 1,58,025 2 2,37,037 x 3 Rs. 1,05,350 2 1,58,025 x 3 Incremental Depreciation 1 5,33,333 1,48,148 3,85,185 2 3,55,555 98,765 2,56,790 3 2,37,037 65,844 1,71,193

Ph: 0863 22 42 355 www.gntmasterminds.com 4 1,58,025 43,896 1,14,129 5 1,05,350 29,264 76,086 13,89,300 3,85,,917 10,03,384 W.N-2: Calculation of NSP of old asset as on today. Book value of old asset as on today (10,00,000 3,33,333 2,22,222) Rs. 4,44,445 It is given in the problem that the old asset will be sold at book value. GSP Book value. As a consequence there is no question of capital gains tax or tax shield. Book value GSP NSP Rs. 4,44,445 W.N-3: Calculation of NSP of old asset after 5 years GSP NSP Book value cost accumulated dep. for 7 years 10,00,000 9,41,472 Rs. 58,528 W.N-4: Calculation of NSP of new asset after 5 years. GSP NSP Book value cost - accumulated dep. for 5 years 16,00,000-13,89,301 Rs.2,10,699 Calculation of NPV using Incremental approach Step 1: Calculation of Present Value of Cash Outflows or initial investment Particulars Cost of new machine Less: NSP of old machine as on today (W.N 2) Amount 16,00,000 4,44,445 Present Value of cash outflows 11,55,555 Step 2: Calculation of Present Value of Operating Cash Inflows Particulars Y1 Y2 Y3 Y4 Y5 Incremental revenue Add: Savings in expenses 2,00,000 1,50,000 2,00,000 1,50,000 2,00,000 1,50,000 2,00,000 1,50,000 2,00,000 1,50,000 Incremental PBDT(A) 3,50,000 3,50,000 3,50,000 3,50,000 3,50,000 Less: Incremental dep. (W.N.-1) (B) 3,85,185 2,56,791 1,71,193 1,14,129 76,086 PBT (A-B) Less: Tax @ 30% / (tax shield) PAT Add: Incremental Dep. (35,185) (10,555.5) (24,629.5) 3,85,185 93,209 27,963 65,246 2,56,791 1,78,807 53,642 1,25,165 1,71,193 2,35,871 70,761 1,65,110 1,14,129 2,73,914 82,174 1,91,740 76,086 CFAT 3,60,555.5 3,22,037 2,96,358 2,79,239 2,67,826 P.V.F @ 10% 0.909 0.826 0.751 0.683 0.621 Present Value 3,27,745 2, 66,003 2,22,565 1,90,720 1,66,320 Present Value of operating cash inflows Rs. 11,73,353 Step 3: Calculation of Present Value of Terminal Cash Inflows (at the end of the period) NSP of new asset after 5 years 2,10,699 Less: NSP of old asset after 5 years 58,528 1,52,171 Present value there of 1,52,171 PVF (5y,10%) 1,52,171 0.621 Rs. 94,499 Step 4: Calculation of NPV NPV PV of cash inflows PV of cash outflows IPCC_31e_F.M_Capital Budgeting_Assignment Solutions 28

No.1 for CA/CWA & MEC/CEC MASTER MINDS PV of Operating Cash Inflows + PV of Terminal Cash Inflows - PV of cash outflows 11,73,353 +152,171 11,55,555 Rs. 1,12,297 Conclusion: Since NPV is positive it is better to replace the existing machinery with new one. Assumptions: Cash flows are assumed to accrue at the end of each year. Interim cash inflows at the end of each year are assumed to be reinvested at the rate of cost of capital. Cash flows given in the problem are assumed to be certain. Calculation of NPV: PROBLEM NO.6 Step 1: PV of cash outflows (or) Initial Investment (or) Cost of heating system 4,400 Step 2: PV of operating cash inflows: Year Fuel bill Fuel bill @ 10% PVF @ 14% PV 1 10,500 1,050 0.877 921 2 11,025 1,102 0.769 848 3 11,576 1,158 0.675 782 4 12,155 1,215 0.592 719 5 12,763 1,276 0.519 662 6 13,401 1,340 0.456 611 PV of operating cash Inflows 4,543 Step 3: PV of terminal cash inflows 0 Step 4: Calculation of NPV: NPV PV of cash inflows PV of cash outflows 4,544 4,400 144 To MASTER MINDS, Guntur Conclusion: Since NPV is +ve it is beneficial for XYZ Ltd. to replace the heating system. Note: Saving in the fuel bill is considered as the inflow (or) benefit. THE END IPCC_31e_F.M_Capital Budgeting_Assignment Solutions 29

Ph: 0863 22 42 355 www.gntmasterminds.com 4. COST OF CAPITAL SOLUTIONS TO ASSIGNMENT PROBLEMS Problem No.1 Coupon rate of interest 15% Issue price Rs.97.75 Redemption value Rs.105 Tax rate 55% Redemption period (n) 7-years I(1- t) + (RV - B0 )/n Post tax cost of bonds (K d ) (RV + B0 )/2 0.0768 7.68% To MASTER MINDS, Guntur 100X15%(1 0.55) + (105 97.75) / 7 (105 + 97.75)/ 2 Problem No.2 Rate of interest 12%. Tax rate 35%. n 5 Redemption value Rs.105 Issue price Rs.90 I(1- t) + (RV - B0 )/n Post tax cost of bonds (K d ) (RV + B0 )/2 0.1107 11.07% 100X12%(1 0.35) + (105 90)/ 5 (105 + 90) / 2 Problem No.3 Calculation of post tax cost of debentures Step-1: Identification of cash flows in different years Year Repayment Tax Shield on Post Tax Net Total Principal Interest interest @ 50% cash Outflows 1 200 150 350 75 275 2 200 120 320 60 260 3 200 90 290 45 245 4 200 60 260 30 230 5 200 80 230 15 215 Net sale proceeds on issue of each debenture 1,000-100 Rs.900 Step-2: Calculation of Post Tax cost of debenture Year Cash flow NPV @ 10% NPV @ 12% PVF Present Value PVF Present Value 0 900 1 900 1 900 1 275 0.909 (249.98) 0.893 (245.58) IPCC_31e_F.M_Cost of Capital_Assignment Solutions 30

No.1 for CA/CWA & MEC/CEC MASTER MINDS 2 260 0.826 (214.76) 0.797 (207.22) 3 245 0.751 (183.90) 0.712 (174.44) 4 230 0.683 (157.09) 0.636 (146.28) 5 215 0.621 (133.52) 0.567 (121.91) (39.34) 4.58 Using Interpolation, NPV@l1 IRR l1 + x(l2 l1) 10 + NPV@l NPV@l IRR 11.79% 2 1 39.34 4.58 + 39.34 X (12 10) Problem No.4 Preference dividend (DPS) 100 X 15% Rs.15 Flotation cost 100 X 4% Rs.4 To MASTER MINDS, Guntur Net sale proceeds 100-4 96 Cost of preference shares (K P ) DPS MP 0 15/96 0.1562 15.62% Problem No.5 Particulars 5% discount 5% premium Face value 100 100 issue price 95 105 Preference dividend per share 10 10 DPS Cost of preference share (K P ) MP 0 a. 10/95 10.5% b. 10/105 9.5% Ke Rf + b (Rm rrf) Problem No.6 Ke 0.10 + 1.75 (0.15 r0.10) 0.10 + 1.75 (0.05) 0.1875 Problem No.7 Market price as on today (MP 0 ) 168 Dividend per share as on today 100 X 15% Rs.15 Growth rate in dividends (g) 12% Cost of equity share capital (K e ) 15X112% 16.8 + 0. 12 + 0. 12 168 168 DPS MP 0 1 + g 0.1+0.12 0.22 22% IPCC_31e_F.M_Cost of Capital_Assignment Solutions 31

Ph: 0863 22 42 355 Problem No.8 www.gntmasterminds.com The current value of equity share of D Ltd. is sum of the following: i. Presently value (PV) of dividends payments during 1-4 years; and ii. Present value (PV) of expected market price at the end of the fourth year based on constant growth rate of 8 per cent. Year Dividend PV factor at 16% Total PV (in Rs.) 1 1.50 (1 + 0.12) 1.68 0.862 1.45 2 1.68 (1 + 0.12) 1.88 0.743 1.40 3 1.88 (1 + 0.10) 2.07 0.641 1.33 4 2.07 (1 + 0.10) 2.28 0.552 1.26 Total 5.44 Present value of the market price ( P 4 ): end of the fourth year- P 4 D 5 / (Ke g) Rs. 2.28 (1.08) / (16% - 8%) Rs. 30.78 PV of Rs. 30.78 Rs. 30.78 x 0.552 Rs. 16.99 Hence, Value of equity shares Rs. 5.44 + Rs. 16.99 Rs. 22.43 Problem No.9 From the given information it is not possible to calculate cost of equity capital directly. So let us calculate IRR from investors point of view. Year Particulars Cash flow PVF@11% P.V PVF@12% P.V 01-01-1990 Purchase of share (318) 1 (318) 1 (318) 31-12-1990 Dividend 20 0.900 18 0.892 17.84 31-12-1991 Dividend 20 0.812 16.24 0.797 15.94 31-12-1992 Dividend 20 0.731 16.082 0.711 15.642 31-12-1993 Dividend 22.25 0.658 14.6405 0.636 14.151 31-12-1993 Sale of shares 400 0.658 263.2 0.636 254.4 10.1625 0.027 Using interpolation, NPV @l1 IRR l1 + X(l2 l1) NPV @l NPV @l 1 10.1625 IRR 11+ [( 12) ( 11) ] 10.1625 + 0.027 2 10.1625 11+ 11.99% 10.1895 To MASTER MINDS, Guntur Problem No.10 PART A Step 1: Specific cost of capital K DPS1 9. g + 0.05 13. 82, Kp 9%, K d 10% (1 0.50) 5% MP 102 e + 0 IPCC_31e_F.M_Cost of Capital_Assignment Solutions 32

No.1 for CA/CWA & MEC/CEC Step 2: 500000 200000 300000 WACC 13.82 + 9 + 5 10.21% 1000000 1000000 1000000 MASTER MINDS PART B Step 1: Specific cost of capital K DPS1 9. g + 0.05 14. 375 MP 96 e + 0 KP 9%,Kd 10%(1 0.5) 5% Cost of term loan 12% (1-0.5) 6% To MASTER MINDS, Guntur 5L 2L 3L 5L Step 2: WACC 14.375 + 9 + 5 + 6 8.99 nearly 9% 15L 15L 15L 15L Problem No.11 Step 1: Specific cost of capital 2 X110% Ke + 0.10 18% 27.5 I 12 X 4,00,000 Kd 15% Bo 4,00,000 x 80% Step 2: WACC based on Market value weights 8,00,000 MV of equity x 27. 5 2200000 10 (indudes all the funds belonging to equty shares) 320000 MV of debt 400000 x 80% 2520000 2200000 320000 18 + 15 17.62% 2520000 2520000 THE END IPCC_31e_F.M_Cost of Capital_Assignment Solutions 33

Ph: 0863 22 42 355 www.gntmasterminds.com 5. CAPITAL STRUCTURE SOLUTIONS TO ASSIGNMENT PROBLEMS Problem No.1 Evaluation of different capital structures given in the problem: % of debt % of equity Cost of debt(k i ) Cost of equity(k e ) WACC (K O ) 0% 100% 6% 11.5% 11.5% 10% 90% 6% 12% 6*10%+12*90%11.4% 20% 80% 6% 12% 6*20%+12*80%10.8% 30% 70% 6.5% 13% 6.5*30%+13*70%11.05% 40% 60% 7% 15% 7*40%+15*60%11.8% 50% 50% 7.5% 17% 12.25% 60% 40% 8% 20% 12.8% Decision: since the WACC is minimum 20% of debt and 80% equity represents optimum capital structure. Problem No.2 Calculation of EPS under all the three options (Rs. In Lakhs) Equity Debt Particulars Option I Option II Option III 22.5 2.5 EBIT 5 5 5 Less: Interest (2.5 X 10%) 0.25 (2.5X10%+75X15%) 1.375 (1.375+5X20%) 2.375 EBT Less: Tax @ 50% 4.75 2.375 IPCC_31e_F.M_Capital Structure_Assignment Solutions 34 15 10 3.625 1.8125 10 15 2.625 1.3125 EAT /EAESH (A) 2.375 1.8125 1.3125 No. of shares (B) 22.5 0.15 150 15 0.1 150 10 0.08 125 EPS (A/B) 15.83 18.125 16.41 Conclusion: The objective of the financial management is to maximize the benefits of equity share holders. Since EPS is maximum in option II, it is beneficial to raise the required funds of 25,00,000 as 15,00,000 through equity and 10,00,000 through debt. EBIT - Existing - New Problem No.3 Statement showing the selection of best finance option Particulars Debt Equity 31,000 15,000 31,000 15,000 Total EBIT 46,000 46,000 Less: Interest - Existing - New EBT Less: Tax @ 35% (Note) 1,000 (20KX7%) 3,500 (50000X7%) 41,500 14,525 1,000 < 45,000 15,750

No.1 for CA/CWA & MEC/CEC MASTER MINDS EAT /EAESH (A) 26,975 29,250 No. of shares Existing - New EPS (A / B) PE ratio MP (EPS X PE ratio) 5,000-5,000 50,000 2,000 25 (B) 5,000 7,000 5.395 6 32.37 10,500 Note: Income Tax rate 100 35% 30,000 Conclusion: Since Market Price higher, in case of debt, it is the best capital structure. Problem No.4 4.18 7 29.25 Calculation of interest coverage ratio (Rs. in Lakhs) Particulars Before Additional borrowings After Additional borrowings EBIT (A) 22 26.4 (22X120%) Interest on term loan (40 X 11%) Interest on bank borrowings (30X16%) Interest on public deposit (15X12%) Interest on additional Bank borrowing IPCC_31e_F.M_Capital Structure_Assignment Solutions 35 4.4 4.8 1.8 --- 4.4 4.8 1.8 4 (25X16%) Total interest (B) 11 15 Interest Coverage Ratio (A/B) 2 times 1.76 times Conclusion: The interest coverage ratio has decrease from 2 times to 1.76 times. This is not a favourable situation for money lender / creditor. Problem No.5 Evaluation of the given four financial plans on the basis of EPS (Rs. in lakhs) Particulars Option A Option B Option C Option D Existing equity share capital 40 40 40 40 Fresh issue of equity 40 20 10 20 Debt - 20 30 - Preference shares - - - 20 Particulars Option A Option B Option C Option D EBIT 15 15 15 15 Less: interest - 1.8(20*9%) 3.0(30*10%) - EBT 15 13.2 12 15 Less: tax @ 50% 7.5 6.6 6 7.5 EAT/EASH 7.5 6.6 6 7.5 Less: preference dividend 1.5(20*7.5%) EAESH(A) 7.5 6.6 6 6 No. of equity shares Existing(40/100) 0.4 0.4 0.4 0.4 NEW 0.4(40/100) 0.2(20/100) 0.1(10/100) 0.2(20/100) Total (B) 0.8 0.6 0.5 0.6 EPS (A/B) 9.375 11 12 10