(a) (i) Initial Investment
Using IRR = 12%, the NPV is zero. So, the initial investment is equal to
the present value of inflows at 12%.
Year
Cash Inflows (`)
PVF@12%
Present Value (`)
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
3,08,640
Total Present Value = ₹ 3,08,640. So, Initial Investment = ₹ 3,08,640.
(ii) Net Present Value (NPV)
Year
Cash Flows (`)
PVF@10%
Present Value (`)
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 Cash Inflows
3,22,370
NPV
(3,22,370-3,08,640)
13,730
FINANCIAL MANAGEMENT AND
STRATEGIC MANAGEMENT
(iii) Profitability Index (PI)
PI =
Sum of PV of Cash Inflows
Initial Cash Outflow
=
₹ 3,22,370
₹ 3,08,640 = 1.0445
(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 (including
salvage)
0.683
88,790
3,22,370
So, discounted payback = 3 years + ₹ 3,08,640 – ₹ 2,33,580
₹ 88,790
= 3.845
years OR 3.85 years OR 3 years 10 months 4 days approx.
(v) Modified Internal Rate of Return (MIRR)
Terminal value of cash inflows compounded to year 4 using 10%:
Year
Cash Inflows (`) @ 10% reinvestment
rate factor
Present
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
4,72,100
Total Terminal Value
= ₹ 4,72,100
Now, 3,08,640/4,72,100
= 0.6537 or 0.654
If we see 0.654 in year of present value discount table, the rate which
is coming is around 11.20%. So, MIRR is around 11.20%.
Alternatively, solution can be presented in following way for
MIRR:
Total Return = 4,72,100/3,08,640 = 1.5296
(1+r)4
= 1.5296
MIRR
= (1.5296) (1/4) – 1 = 11.20% (Approx)
(b) Market Value of Equity
=
Net income (NI) for equity holders
Ke
₹ 1,400 lakhs
=
Net income (NI) for equity holders
0.18
Net Income to equity holders/EAT
= ₹ 252 lakhs
Therefore, EBIT =
EAT
(1-t)
=
252 lakhs
(1 – 0.3) = ₹ 360 lakhs
Income Statement
All Equity
(` In lakhs)
Equity & Debt
(` In lakhs)
EBIT (as calculated above)
Interest on ₹ 300 lakhs @ 12%
EBT
Tax @ 30%
Income available to equity holders
360
-
360
108
252
360
36
324
97.2
226.8
(i) Market value of Z Ltd
Market value of levered firm = Value of unlevered firm + Tax Advantage
= ₹ 1,400 lakhs + (₹ 300 lakhs x 0.3)
= ₹ 1,490 lakhs
Change in market value of the company = 1,490 lakhs – 1,400 lakhs
= ₹ 90 lakhs
The impact is that the market value of the company has increased by ₹ 90
lakhs due to replacement of equity with debt.
FINANCIAL MANAGEMENT AND
STRATEGIC MANAGEMENT
(ii) Overall Cost of Capital
Market Value of Equity
= Market value of levered firm - Equity
repurchased
= ₹ 1,490 lakhs – ₹ 300 lakhs = ₹ 1,190 lakhs
Cost of Equity (Ke)
=
Net Income to equity holders
Market value of equity
× 100
=
₹ 226.8 lakhs
₹ 1190 lakhs × 100 =19.06% (approx.)
Cost of debt (Kd)
= I (1 - t) = 12 (1 - 0.3) = 8.4%
Components
Amount
(` In lakhs)
Cost of
Capital %
Weight
WACC
(Ko) %
Equity
Debt
1,190
300
19.06
8.4
0.80(approx.)
0.20(approx.)
15.25
1.68
1490
1
16.93
(Note: If we take the weight of Equity as 0.7986 and weight of Debt as
0.2013 then WACC will be 16.91%).
Impact on Market value and Overall cost of capital of Z Ltd.
Particulars
Before
restructure
After
restructure
Impact
Market value of
company
₹ 1,400 lakhs
₹ 1,490 Lakhs
Increase due to
import of debt
Cost of equity
18%
19.06%
Increase
Overall
cost
of
capital
18%
16.93%
Decrease
So, the impact is that the Overall Cost of Capital or Ko has fallen by
1.07% (18% - 16.93%) due to the benefit of tax relief on debt interest
payment.
(iii) Cost of Equity
The impact is that cost of equity has risen by 1.06% (19.06% - 18%) due
to the presence of financial risk i.e. introduction of debt in capital
structure.
Note: Cost of Capital and Cost of equity can also be calculated with
the help of following formulas,
Cost of Capital (Ko) = Keu [1 – (t x L)]
Where,
Keu = Cost of equity in an unlevered company
t
= Tax rate
L =
Debt
Debt + Equity
So, Ko = 0.18 ቂ1- ቀ0.3 ×
₹ 300 lakhs
₹ 1490 lakhsቁቃ= 0.1691 or 16.91% (approx.)
Cost of Equity (Ke) = Keu + (Keu – Kd)
Debt (1-t)
Equity
Where,
Keu
= Cost of equity in an unlevered company
Kd
= Cost of debt
t
= Tax rate
So, Ke
= 0.18 + ቀ(0.18-0.12) ×
₹ 300 lakhs (1-0.3)
₹ 1190 lakhs
ቁ
= 0.1906 or 19.06%