Q1. The following data is available in respect of a company : Equity Rs.10lakhs,cost of capital 18%
Debt Rs.5lakhs,cost of debt 13%
Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40%. Answer: We Know that,
WACC = We Ke + WpKp +Wr Kr + WdKd + WtKt WACC = 0.67*.18+0.33*13(1-.40) =0.146 or 14.6%
A calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.
Q2. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL.
Q3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
S= 1000,000/.22 =4545454.5
=K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22 0.0496+.142 =.1915 or 19.15%
V = 5000000/0.1915 = 26,109,660.57
* Critical assumption is ko remains constant.
* An increase in cheaper debt funds is exactly offset by an increase in the required rate of return on equity. * As long as ki is constant, ke is a linear function of the debt-to-equity ratio. Thus, there is no one optimal capital structure
Q4. Examine the importance of capital budgeting.
Answer: Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organization. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into: • Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions • Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution • Decisions for production of new goods or rendering of new services • Decisions on penetrating into new geographical area
• Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act • Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant The reasons that make the capital budgeting decisions most crucial for finance managers are: • These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast. • For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box...
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