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Question 3 (a) Capital project data: Annual interim cash inflows for first two years: ₹1,00,000 Annual interim cash inflows for next two years: ₹80,000 Useful life: 4 years; Salvage value at end: ₹50,000; IRR = 12%; Cost of capital = 10% Calculate: (i) Initial investment, (ii) NPV, (iii) Profitability Index, (iv) Discounted Payback Period, (v) MIRR (1+1+1+1+2 = 6 Marks) (b) Z Ltd. is an unlevered company. Wants to repurchase equity shares of ₹300 lakhs by issuing 12% debentures of same amount. Current MV of Z Ltd. = ₹1,400 lakhs, cost of capital = 18%, EBIT maintained, dividend payout = 100%, tax = 30%. As per MM approach, impact on: (i) Market Value of Z Ltd., (ii) Overall cost of capital, (iii) Cost of equity. (4 Marks)

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Detailed Solution & Explanation

## Part (a): Capital Budgeting Analysis

**(i) Initial Investment**

Since IRR = 12%, NPV = 0 at 12%, meaning the initial investment equals the PV of all cash inflows discounted at 12%:

| Year | Cash Inflow (₹) | PVF @ 12% | PV (₹) |
|---|---|---|---|
| 1 | 1,00,000 | 0.893 | 89,300 |
| 2 | 1,00,000 | 0.797 | 79,700 |
| 3 | 80,000 | 0.712 | 56,960 |
| 4 | 80,000 | 0.636 | 50,880 |
| 4 | 50,000 (salvage) | 0.636 | 31,800 |
| **Total PV** | | | **3,08,640** |

\\\boxed{\\text{Initial Investment} = ₹3{,}08{,}640} \

---

**(ii) Net Present Value (NPV) at Cost of Capital = 10%**

| Year | Cash Flows (₹) | PVF @ 10% | PV (₹) |
|---|---|---|---|
| 0 | (3,08,640) | 1 | (3,08,640) |
| 1 | 1,00,000 | 0.909 | 90,900 |
| 2 | 1,00,000 | 0.826 | 82,600 |
| 3 | 80,000 | 0.751 | 60,080 |
| 4 | 80,000 | 0.683 | 54,640 |
| 4 | 50,000 (salvage) | 0.683 | 34,150 |
| **Sum of PV of inflows** | | | **3,22,370** |

\NPV = 3{,}22{,}370 - 3{,}08{,}640 = \\boxed{₹13{,}730} \

---

**(iii) Profitability Index (PI)**

\PI = \\frac{\\text{Sum of PV of Cash Inflows}}{\\text{Initial Investment}} = \\frac{3{,}22{,}370}{3{,}08{,}640} = \\boxed{1.0445} \

Since PI > 1, the project is acceptable.

---

**(iv) Discounted Payback Period**

| Year | Cash Flows (₹) | PVF @ 10% | PV (₹) | Cumulative PV (₹) |
|---|---|---|---|---|
| 1 | 1,00,000 | 0.909 | 90,900 | 90,900 |
| 2 | 1,00,000 | 0.826 | 82,600 | 1,73,500 |
| 3 | 80,000 | 0.751 | 60,080 | 2,33,580 |
| 4 | 1,30,000 (incl. salvage) | 0.683 | 88,790 | 3,22,370 |

Unrecovered investment after 3 years = 3,08,640 − 2,33,580 = ₹75,060
\\\text{Discounted Payback} = 3 + \\frac{75{,}060}{88{,}790} = 3 + 0.845 \\approx \\boxed{3.85 \\text{ years}} \

---

**(v) Modified Internal Rate of Return (MIRR)**

Terminal value of cash inflows reinvested at cost of capital (10%) to year 4:

| Year | Cash Inflow (₹) | Factor @ 10% | Terminal Value (₹) |
|---|---|---|---|
| 1 | 1,00,000 | 1.331 | 1,33,100 |
| 2 | 1,00,000 | 1.210 | 1,21,000 |
| 3 | 80,000 | 1.100 | 88,000 |
| 4 | 80,000 | 1.000 | 80,000 |
| 4 | 50,000 (salvage) | 1.000 | 50,000 |
| **Total Terminal Value** | | | **4,72,100** |

\(1 + MIRR)^4 = \\frac{\\text{Terminal Value}}{\\text{Initial Investment}} = \\frac{4{,}72{,}100}{3{,}08{,}640} = 1.5296 \
\MIRR = (1.5296)^{1/4} - 1 \\approx \\boxed{11.20\\%} \

---

## Part (b): MM Approach — Z Ltd. (Capital Structure Change)

**Preliminary Calculations:**

Unlevered firm: MV = ₹1,400 lakhs, Ke = 18%
\textEAT(NetIncometoequity)=1,400times18\\text{EAT (Net Income to equity)} = 1{,}400 \\times 18\\% = ₹252 \\text{ lakhs} \
\EBIT = \\frac{EAT}{1 - t} = \\frac{252}{0.70} = ₹360 \\text{ lakhs} \

After restructuring (issuing ₹300 lakhs of 12% debentures):
| Particulars | All-Equity (₹ lakhs) | After Restructuring (₹ lakhs) |
|---|---|---|
| EBIT | 360 | 360 |
| Less: Interest (12% × 300) | — | 36 |
| EBT | 360 | 324 |
| Less: Tax @ 30% | 108 | 97.2 |
| **EAT to equity holders** | **252** | **226.8** |

**(i) Market Value of Z Ltd. (Levered)**

\V_L = V_U + (\\text{Tax} \\times \\text{Debt}) = 1{,}400 + (0.30 \\times 300) = 1{,}400 + 90 = \\boxed{₹1{,}490 \\text{ lakhs}} \

**Impact:** Market value **increased by ₹90 lakhs** due to the tax shield on debt interest.

**(ii) Overall Cost of Capital (Ko) after Restructuring**

Market value of equity (after buyback):
\V_E = 1{,}490 - 300 = ₹1{,}190 \\text{ lakhs} \
\Ke=frac226.81,190=19.06K_e = \\frac{226.8}{1{,}190} = 19.06\\% \
\Kdtext(posttax)=12K_d \\text{(post-tax)} = 12\\% \\times (1 - 0.30) = 8.4\\% \

| Component | Amount | Weight | Cost | WACC contribution |
|---|---|---|---|---|
| Equity | 1,190 | 0.80 | 19.06% | 15.25% |
| Debt | 300 | 0.20 | 8.4% | 1.68% |
| **Total** | **1,490** | **1.00** | | **16.93%** |

**Impact:** Overall cost of capital **decreased from 18% to ≈ 16.93%** due to the tax benefit of debt.

**(iii) Cost of Equity after Restructuring**

\K_e = \\frac{226.8}{1{,}190} = \\boxed{19.06\\%} \

**Impact:** Cost of equity **increased from 18% to 19.06%** because shareholders now face additional financial risk due to the introduction of debt in the capital structure.

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