Kirloskar Institute of Advanced Management Studies

Corporate Finance – B8
Answer sheet

1.Your Father has promised to give you Rs 1,00,000 in cash on your 25th birthday. Today
is your 16th birthday. He wants to know two things
a. If he decides to make annual payments into a fund after one year, how much
will each have to be if the fund pays 8 percent?
b. If he decides to invest a lump sum in the account after one year and let it
compounded annually, how much will the lump sum be?
Notes:
(CVFA 9, 8 %) or (FVA 9, 8 %) = 12.488
(CVF 9, 8 %) or (FV 9, 8 %) = 1.99
(PVIF 9, 8 % ) = 0.500
(PVIFA 9, 8 % ) = 6.247

Answer
a. Let the annual payment be P
P x (CVFA 9, 8 %) = 1,00,000
P x 12.488 = 1,00,000
P = 1,00,000/12.488 = Rs 8007.69

Annual Payment = Rs 8007.69 1.5 marks

b. Let the amount invested be P

P x (FV 9, 8 % ) = 1,00,000
P x 1.99 = 1,00,000
P = 1,00,000 / 1.99 = Rs 50. 025

Investment to be made = Rs 50,025 1.5 marks

2.You want to buy a house after 5 years when it is expected to cost Rs 20,00,000. How
much should you save annually if your savings earn a compound return of 12%.
(CVFA 5, 12 %) = 6.353
(PVIFA 5, 12 % ) = 3.605
(PVIF 5, 12% ) = 0.567

Answer
Let the annual savings be P
P x (CVFA 5, 12 %) = 20,00,000
P x 6.353 = 20,00,000
P = 20,00,000/6.353 = Rs 3,14,812

Annual Savings = Rs 3,14,812 3 marks

3.An investor has two options to choose from
a.Rs 6000 after 1 year
b.Rs 9000 after 4 years
Assuming a discount rate of i) 10 percent and ii) 20 percent, which alternative should he
opt for?

Answer
i) 10 percent discount rate:

a. Rs 6000 after 1 year

0 1

6000
(1.10)

0.5 marks
5455

b.Rs 9000 after 4 years

0 4

9000
(1.10)4

0.5 marks
6147

ii) 20 percent discount rate

a. Rs 6000 after 1 year

0 1

6000
(1.20)

0.5 marks
5118
b.Rs 9000 after 4 years

0 4

9000
(1.20)4

0.5 marks
4338

Rs 9000 after 4 years/ Rs 6000 after 1 year at 20 % discount 1 mark

4. Infosys, an all equity firm, is evaluating the following projects

Project Beta Expected return

A 0.6 20
B 0.9 14
C 1.5 16
D 1.5 13

The risk free rate is 10 % and the expected market premium is 8 %.

Infosys's cost of capital is 18 %. Which projects would be accepted on the basis of the
firm's cost of capital as a hurdle rate?
Note: Show your calculation

Stock rf + β (km-rf) Required Return

A 10 + 0.6 (10) 16 %
B 10 + 0.6 (4) 13.6 %
C 10 + 1.5(6) 19 %
D 10 + 1.5 (3) 14.5 %
Stock rf + β (km-rf) Required Return
A 10 + 0.6 (8) 14.8 %
B 10 2+ marks
0.6 (8) 17.2 %
1 mark for Answer
C 10 + 1.5(8) 22 %
D 10 + 1.5 (8) 22 %
5. Multimedia network has the following book value capital structure

Equity capital (10 million shares, Rs 10 par) Rs 100 million

Preference capital, 11 percent (100,000 shares, Rs 100 par) Rs 10 million
Retained Earnings Rs 129 million
13.5 % (500,000 debentures, Rs 100 par) Rs 50 million
Terms loans 12 % Rs 80 million
--------------------
Rs 369 million
-------------------
The next expected dividend per share is Rs 1.50. The dividend per share is expected to
grow at the rate of 7 %. The market price per share is Rs 20.00. Preference stock
redeemable after 10 years is currently selling for Rs 75.00 per share. Debentures,
redeemable after 6 years, are selling for Rs 80.00 per debenture. The tax rate for the
company is 50 %.
Calculate the overall cost of capital using market value weights.
Answer
Cost of Equity share:
Ke = d/p + g
Ke = 1.50/20 + 0.07 = 14.5 %
Cost of Equity = 14.5 % 0.5 mark

Cost of Preference Shares

Kp = d + ( f + d + pr - pi ) /n

(RV + SV)/2

Kp = Rs 11 + (f + d + pr - pi) /n = 11 %

(100 + 100)/2

Cost of Preference Share = 11 % 0.5 mark

Cost of Redeemable Debentures

Kd = I(1-t) + ( f + d + pr - pi ) /n

(RV + SV)/2

Kd = 13.5(1-0.5) + ( f + d + pr - pi ) /n = 6.75 %

(100 + 100)/2

Cost of Redeemable Debenture = 6.75 % 0.5 mark

%
Cost of Term loan = 6 % 0.5 mark
Cost of Retained Earnings = 14.5 %

Calculation of Overall Cost of Capital Using Market Value Weights

Particulars Market Value Weight Specific Cost Total Weight

Equity Shares 200 million 0.44 0.147 0.065
10 million x Rs 20
Preference shares 7.5 million 0.02 0.11 0.002
1,00,000 x 75
Debentures 40 million 0.09 0.675 0.061
5,00,000 x 80
Term loans 80 million 0.17 0.06 0.010
Retained Earnings 129 million 0.28 0.145 0.041
Total 456.5 1.00 0.179

Overall Cost of Capital = 17.9 % 1 mark

6.Why does money have time value? Calculate the present value of the following cash
stream if the discount is 14 %.

Year 0 1 2 3 4 5
Cash flow -5000 0 5000 14000 -2000 10000

Year Cash inflows PV @ 14 % PV of cash flows @ 14 %

0 -5000 - -5000
1 0 0.877 0
2 5000 0.769 3845
3 14000 0.675 9450
4 -2000 0.592 -1184
5 10000 0.519 5190
Total present value 12,301

1.5 marks/ 0.5 marks for (1 – 5)

7.Bank of Baroda has two bonds issues outstanding. Both bonds pay Rs 100 annual
interest plus Rs 1000 at maturity. Bond A has 10 years to maturity and Bond B has 4
years left to maturity. What will the value of these bonds if the on going interest rate in
the market is 12 %.
Bond A

Year Cash inflows PV @ 12 % PV of cash inflows

1 100 0.893 89.3
2 100 0.797 79.7
3 100 0.712 71.2
4 100 0.635 1.5 + 1.5 = 363.5
5 100 0.567 56.7
6 100 0.507 50.7
7 100 0.452 45.2
8 100 0.404 40.4
9 100 0.361 36.1
10 1100 0.322 354.2
Total PV 887

Bond B

Year Cash inflows PV @ 12 % PV of cash inflows

1 100 0.893 89.3
2 100 0.797 79.7
3 100 0.712 71.2
4 1100 0.635 699.0
Total PV 939.2

8.Suppose ACC Ltd sold an issue of bonds with a 10-year maturity, a Rs 1000 par value,
a 10 percent coupon rate and annual interest payment.
a. Two years after the bonds were issued, the going rate of interest on bonds such
as these fell to 6 percent. At what price would the bonds sell?
c. Two years after the bonds were issued, the going rate of interest on bonds
such had risen to 12 percent. At what price would the bonds sell?

Year Cash inflows PV @ 6 % PV of cash inflows

1 100 0.943 94.3
2 100 0.890 89.0
3 100 0.840 84.0
4 100 0.792 79.2
5 100 0.747 74.7
6 100 0.705 70.5
7 100 0.665 66.5
8 1100 0.627 689.7
Total PV 1247.9
b. At 12 % interest rate

Year Cash inflows PV @ 12 % PV of cash inflows

1 100 0.893 89.3
2 100 0.797 79.7
3 100 0.712 71.2
4 100 0.635 63.5
5 100 0.567 56.7
6 100 0.507 50.7
7 100 0.452 45.2
8 1100 0.404 40.4
Total PV 496.7

9.An individual has Rs 35,000 invested in a stock, which has a beta of 0.8 and Rs 40,000
invested in a stock with a beta of 1.4
a. If these are the only investments in his portfolio, what is his portfolio’s beta?
b. Suppose he invests Rs 20,000 in another stock, which has a beta of 0.8, what
will be the new beta of his portfolio?

a. Portfolio Beta

β = (35,000/75000) 0.8 + (40,000/75000)1.4

0.47 x 0.8 + 0.53 x 1.4 = 1.12

Portfolio Beta = 1.12 1.5 marks

b. New Portfolio Beta

β = (35,000/95000) 0.8 + (40,000/95000) 1.4 + (20000/95000) 0.8

= 0.368 x 0.8 + 0.421 x 1.4 + 0.211 x 0.8 = 1.05

New Portfolio Beta = 1.05 1.5 marks

10.Suppose you are an investor have a portfolio of Rs 13,00,000. Your portfolio consists
of 4 stocks with the following investments and betas:

Stock Investment (Rs) Beta

Aravind mills 4,00,000 1.50
Suzlon Energy ltd 6,00,000 0.50
Patni Computers 1,00,000 1.25
PVR cinemas 2,00,000 0.75

If the market required rate of return is 14 percent and the risk free rate is 6 percent,
What is the fund required rate of return?

Fund’s required rate of return Ke = rf + β (km-rf)

=6+β (8)
β = ( 4/13 )1.50 + (6/13) 0.50 + (1/13) 1.25 + (2/13) 0.75
β = 0.91

1 mark

Ke = 6 + 0.91 (8) = 13.28

Fund’s required rate of return = 13.28 %

2 marks

11. HAL has the following capital structure

Ordinary shares (200,000 shares) 4,000
10 % preference shares 1,000
14 % debentures 3,000
8,000
-------

The share of the company sells for Rs 20.it is expected that company will pay next year a
dividend of Rs 2 per share, which will grow at 7 percent forever. Assume a 50 percent
tax rate. You are required to compute the weighted average cost of capital based on the
existing capital structure.

Cost of Equity Share

Ke = d/p + g
(2 / 20) + 0.07 = 17 %

Cost of Equity Share = 17 % 0.5 marks

Cost of debenture = 14 (1- 0.5) = 7 %

Cost of Debentures = 7 % 0.5 mark

Overall Cost of Capital

Particulars Book/Market value Weight Specific Cost Total Weight

Equity shares 4000 0.5 0.17 0.085
Preference Shares 1000 0.125 0.10 0.013
Debentures 3000 0.375 0.07 0.026
Total 8000 1.000 0.124

Overall cost of capital = 12.4 % 2 marks

12.What are the major types of financial management decisions that business firms take?
Describe each.

13.Explain the concepts of 'profit maximization' and 'wealth maximization'. Which of

these, do you think, is a better operational guide for manager.