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 Highlights of Main Book
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 INDEX
Sr Page Question No.
No. Chapter Name No.
as per SPC
Book
1.1 to Q 10, 16, 18,
1) Investment Decisions
1.19 19,21,26,31,44

2) Financing Decisions - 2.1 to Q 15, 17, 19,

Leverage 2.15 21,18

3.1 to Q 6, 6a, 6b,

3)
) Cost of Capital
3.23 6c, 18, 19, 15

4.1 to Q 1, 2, 3, 8, 9,
4) Capital Structure
4.18 10, 13, 17, 18

5.1 to Q 5, 8, 13, 16,

5) Dividend Decisions
5.15 25

Types of Financing 6.1 to

6) -
6.8
Chapter 1

Following are the 8 Important questions out of total 45 questions from

CH 1 – Capital Budgeting
Which cover all the Important Adjustments

Q 1. SPC – Module 1 - Q 10
Reverse Working with IRR, PI and NPV
Given below are the data on a capital project ‘A’
Annual cost of saving - ₹ 60,000
Useful life – 4 years
Profitability Index – 1.064
Internal rate of return – 15%
Salvage value – 0
Calculate - i) Cost of project ii) Payback period iii) Net present
value (NPV) iv) Cost of capital.

Solution :-
i) Calculation of Annuity factor of P.V @ IRR 15% = 2.8549
IRR = P.V of D.C.F - Initial Investment =0
60,000 × 2.8549 – Initial Investment = 0
Initial Investment = 1,71,298
Cost of Project = 1,71,298

ii) Calculation of Profitability Index

Profitability Index = P.V. of Inflows
Initial Investment
1.064 = P.V. Of Inflows
1,71,298
P.V. of Inflows = 1,71,298 × 1.064

1.3
 Chapter 1
P.V. of Inflows = 1,82,261

iii) Calculation Cost of Capital

60,000 × ∑ 1 4 = 1,82,261
1+r
If r = 12.1 = 1,82,241
Cost of Capital = 12.1

iv) Calculation of NPV

Year Cash Flow DF@ 12.1 D.C.F Cum.CF
0 60,000 0.8928 53,571 53,571
2 60,000 0.7971 47,832 1,01,403
3 60,000 0.7117 42,706 1,44,109
4 60,000 0.6355 38,131 1,82,240

NPV = 1,82,240 - 1,71,298 = 10,942

v) Calculation of Payback Period

1,44,109 1,71,298 1,82,240

+ 27189 - 10,942
In 12 Month Changes in Inflows = 1,82,240
- 1,44,109
38,131
So, for getting inflows of 27,189 Required Months = 12 × 27,189
38,131
= 8.55 months 9 months
So, payback Period = 3 years & 9 Months (Approximate)

1.4
Chapter 1

Q 2. SPC – Module 1 - Q 16
Mutually Exclusive Projects – Differential project lives – Use
of Equivalent NPV
Moon Ltd is considering the purchase of a machine which will perform
operations which are at present performed by workers. Machines X and
Y are the alternative models. The following details are available-

Particulars Machine X Machine Y

Cost of Machine ₹ 1,50,000 ₹ 2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance p.a. ₹ 7,000 ₹ 11,000
Estimated cost of indirect material p.a. ₹ 6,000 ₹ 8,000
Estimated savings in scrap p.a. ₹ 10,000 ₹ 15,000
Estimated cost of supervision p.a. ₹ 12,000 ₹ 16,000
Estimated savings in wages p.a. ₹ 90,000 ₹ 1,20,000

Solution :-
Computation of NPV, ARR, P.I.

Particulars Machine – X Machine – Y

Saving in Direct Wages 90,000 1,20,000
Saving in Scrap 10,000 15,000
Estimated Cost of (12,000) (16,000)
Supervision (7,000) (11,000)
Cost of Maintenance (6,000) (8,000)
Cost of indirect 75,000 1,00,000
Material (30,000) 40,000
CFBT 45,000 60,000

1.5
(-) Depreciation (30,000) (40,000)

Chapter 1
PBT 45,000 60,000
(-) Tax @ 30% 13,500 18,000
PAT 31,500 42,000
(+) Depreciation 30,000 40,000
CFAT 61,500 82,000
PVAF @ 10.1 3.7907 4.3552
PV of DCF 2,33,128 3,57,126
Less: Initial Investment 1,50,000 2,40,000
NPV 83,128 1,17,126
ARR 31,500 × 100 42,000 × 100
1,50,000 2,40,000
= 21 % = 17.5 %
P.I 2,33,128 3,57,126
1,50,000 2,40,000
= 1.5541 = 1.4880

 As per NPV. Method machine –y is better than Machine –x

 As per ARR method machine-x is better than machine- y
 As per P.I machine-x is better than machine-y

1.6
 Q 3. SPC – Module 1 - Q 18
Chapter 1

Computation of NPV, ARR, P.I.

Spark cooker company is evaluating three investment situation:
a) Produce a new line of Aluminum skillets.
b) Expand its existing cooker line to include several new sizes.
c) Develop a new, higher quality line of cooker.

Project Investment required PV of future cash flows

1 ₹ 2,00,000 ₹ 2,90,000
2 ₹ 1,15,000 ₹ 1,85,000
3 ₹ 2,70,000 ₹ 4,00,000

If Projects 1 and 2 are jointly undertaken, there will be no economies. the

Investments required and Present Values will simply be the sum of the
parts. With Projects 1 and 3, economies are possible in investment, because
one of the Machines acquired can be used in both production processes.

The Total investment required for Projects 1 and 3 combined is ₹ 4.40.000. lf

Projects 2 and 3 is are undertaken, there are economies to be achieved in
marketing and producing the products, but not in Investment.

The expected Present Value of Future Cash Flows for Projects 2 and 3 is ₹
6.20.000. If all three Projects are undertaken simultaneously, the economies
noted will still hold. However, a ₹ 1,25,000 extension on the Plant will be
necessary, as space is not available for all three projects.
Which Project(s) should be chosen?

1.7
Solution :-

Chapter 1
Calculation of NPV

Project Investment Require P.V. of Cf. NPV

1 2,00,000 2,90,000 90,000
2 1,15,000 1,85,000 70,000
3 2,70,000 4,00,000 1,30,000

1&2 31,50,000 4,75,000 1,60,000

(2,00,000 +1,15,000) (2,90,000 +1,85,000)

2&3 3,85,000 6,20,000 2,35,000

(1,15,000 + 2,70,000)

4,40,000 6,90,000 2,50,000

1&3
(2,00,000 + 2,70,000) (2,90,000 +4,00,000)

1 & 2& 4,40,000 6,20,000 2,30,000

3 + 1,50,000 +2,90,000
5,55,000 9,10,000
1,25,000
6,80,000

Since, the NPV of 1 & 3 is Highest among all Project 1& 3 shall be selected.

1.8
Chapter 1

Q 4. SPC – Module 1 - Q 19
Accept – Reject Decision based on NPV
MNP Ltd is planning to introduce a new product with a project life of 8
years. The project is to be set up in Special Economic Zone (SEZ),
qualifies for one time (at starting) tax free subsidy from the State
Government of ₹ 25,00,000 on capital investment. Initial Equipment cost
will be ₹ 1.75 Crores. Additional Equipment costing ₹ 12,50,000 will be
purchased at the end or the third year from the Cash Inflow of this year.
At the end of 8 years, the Original Equipment will have no resale value,
but the Additional Equipment can be sold for ₹ 1,25,000. A Working Capital
of ₹ 20,00,000 will be needed and it will be released at the end of 8 th year.
The project will be financed with sufficient amount of Equity Capital.
The sales volumes over 8 years have been estimated as follows –

Year 1 2 3 4-5 6-8

Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sale price of ₹ 120 per unit is expected and variable expenses will
amount to 60% of sales Revenue. Fixed cash operating costs will amount ₹
18,00,000 per year. The loss of any year will be set off from the profits of
subsequent two years. The company is subject to 30% tax rate and
considers 12 % to be an appropriate after tax cost of capital for this
project. The company follows straight line method of depreciation.
Calculate the Net present value of the project and advise the management
to take appropriate decision.

1.9
 Solution :-

Chapter 1
a) Calculation of Initial Investment

Cost of Equipment 1.75 cr.

(-) Subsidy by Govt. (0.25cr)
(+) Working capital Requirement 0.20 cr
Initial Investment 1.70 cr

b) Calculation of Depreciation
For 1st Machine = 1.75 – 0.25
8
= 18.75 Lakhs
For 2nd machine = 12.50 – 1.25
5
= 2.25 lakhs

c) Inflows from the project

Particulars 1 2 3
Particulars 4 5 6 7 8

Qty 72,000 1,08,000 2,60,000 2,70,000 2,70,000 1,80,000 1,80,000 1,80,000

Cotri. Per unit 48 48 48 48 48 48 48 48
34.56 51.84 124.80 129.60 129.60 86.40 86.40 86.40
Contribution
(-) FC (18) (18) (18) (18) (18) (18) (18) (18)

(-) Dep. (18.75) (18.75) (18.75) (21) (21) (21) (21) (21)

EBT -2.19 15.09 88.05 90.6 90.6 47.4 47.4 47.4

Tax @ 30% 0 3.87 26.415 27.18 27.18 14.22 14.22 14.22
EAT -2.19 11.220 61.635 63.42 63.42 33.18 33.18 33.18
+ Dep. 18.75 18.75 18.75 21 21 21 21 21

CFAT 16.56 29.97 80.385 84.42 84.42 54.18 54.16 54.18

1.10
Chapter 1

d) Calculation of NPV

Year Cf Df D.C.F
0 (170) 1 (170)
1 16.56 0.892 14.785
2 29.97 0.797 23.891
3 80.385-12.5=67.885 0.711 48.319
4 84.42 0.635 53.650
5 84.42 0.567 47.902
6 54.18 0.506 27.449
7 54.18 0.452 24.508
8 54.18+1.25+20=75.43 0.403 24.508
NPV=100.968

Q 5. SPC – Module 1 - Q 21
NPV based evaluation – Replacement decision –
No Tax and Depreciation
Gems ltd has just installed machine R at a cost ₹ 2 lakhs. The machine has a
5 year life with no Residual value. The annual volume of production is
estimated at 1,50,000 units, which can be sold at ₹ 6 per unit. Annual
operating costs are estimated at ₹ 2 Lakhs (excluding depreciation) at this
output level. Fixed costs are estimated ₹ 3 per unit for the same level of
production.

The company has just come across another model Machine S, capable of
giving the same output at an annual operating cost of ₹ 1.80 lakhs (excluding
depreciation). There will be no change in fixed costs. Machine S costs ₹ 2.50
Lakhs, its residual value will be nil after a useful life of 5 years.
1.11
 Chapter 1
Gems Ltd has an offer for sale of Machine R for ₹ 1,00,000. The cost of
dismantling and removal will be ₹ 30,000. As the Company has not yet
commenced operations, it wants to dispose off Machine R and install
Machine S.
The Company will be a zero-tax Company for 7 years in View of Incentives
and Allowances available. Cost of Capital is 14 %.
Advise Whether the Company should opt for replacement. Will your answer
be different if the Company has not installed Machine R and is in the
process of selecting either R or S?

Solution :-
Computation of CFAT and Pure Decision

Particulars Machine R Machine S

Sale Value( 15,00,000 × 6) 9,00,000 9,00,000
Less: Operating 2,00,000 1,80,000
Contribution 7,00,000 7,20,000
Less: Fixed Cost (1,50,000 × 3) 4,50,000 4,50,000
CFAT 2,50,000 2,70,000
P.V.A.F 3.4330 3.4330
P.V of Inflows 8,58,270 9,26,932
Less Initial Investment 2,00,000 2,50,000
NPV 6,58,270 6,76,932

Since, there is no need to Computation of Tax so we will not Going to Deduct &
Add-back Depreciation.
Conclusion: Since, NPV of Machine & is More than machine R. hence,
machine S is better option.

1.12
Chapter 1

Replacement of machine R with S

Sr.no Particulars ₹
a) Purchase the Cost of Machine 2,50,000
b) NRV of Machine R(1,00,000 -30,000) 70,000
c) Net Initial outflow in year 0 Due to Replacement Decision 1,80,000
d) Incremental cash inflow from S (2,70,000 -2,50,000) 20,000
e) P.V Annuity F. @14% 3.432
f) P.V of Incremental Cash Flow Due to Replacement 68,640

Q 6. SPC – Module 1 - Q 26
Mutually Exclusive Decisions – Modify & Retain vs Replace –
Incremental NPV approach
H Ltd has a number of machines that were used to make a product that the
company has phased out of its operations. The existing machine was
originally purchased 6 years ago for ₹ 5,00,000 and is being depreciated by
the straight line method, its remaining life is 4 years. Depreciation charges
are ₹ 50,000 per year.

No Salvage Value is expected at end of its useful life. It can currently be

sold for ₹ 1,50,000. The machine can also be modified at a cost of ₹ 2 Lakhs
to produce another product. Modifications would not affect the useful life, or
salvage value, and would be depreciated using the Straight-Line Method.

If the Company does not modify the existing machine, it will have to buy a
new machine at a cost of ₹ 4,40,000 (no salvage value) and the new
machine would be depreciated over 4 years. The Company's Engineers
estimate that the cash operating Cost with the new machine would be ₹
25,000 per year.
1.13
 Chapter 1
less than with the existing machine.

The cost of capital is 15% and corporate tax rate is 55%. Advice the
company whether the new machine should be bought or the old equipment
modified.

Solution :-
Calculation of Value of Original Machine
Original Purchase cost of Existing machine 5,00,000
(-) Depreciation Charge For 6 Years 3,00,000
Book Value Before Capitalisation of Modification Costs 2,00,000
Add: Modification Cost Capitalized 2,00,000
Machine Value for Depreciation purpose 4,00,000

If old Machine is If New Machine is

Modified Purchased
i) Initial cash Investment 2,00,000 2,90,000
ii) Salvage Value at end of Year Nil Nil
iii) Depreciation 1,00,000 1,10,000
(4,00,000 ÷ 4) (4,40,000 ÷ 4)

Note:- For the Calculation of Depreciation the machine cost is 2,00,000 & =
4,00,000 whereas for calculation of initial investment the amount is 2,00,000
since, current outflow is only 2,00,000

When we buy new machine we have sold out the old machine at 1,50,000 that’s
why this amount is deducted from initial investment.

1.14
Chapter 1

Calculation of CFAT

Particular (Incremental) Computation ₹

Saving with new Machine Given 25,000
Less: Depreciation 1,10,000 – 10000
EBT 1,00,000 15,000
Less: Tax @ 55% 8250
EAT 15,000 × 6750
Add: Depreciation 55% 10,000
CFAT 15000 - 8250 16,750

Calculation of Tax Saving:

Particulars Amount (₹)

Value of Machine 2,00,000
Selling Price 1,50,000
Loss on Sale 50,000
× tax @ less 55% 1st year saving 27,500

Calculation of NPV

Year Cf D.F@15% D.C.F Since, New Machine is

0 90,000 1 90,000 showing the Negative
1 44,250 0.8695 38,475 NPV Company should not
2 16,750 0.7561 12,665 Purchase the new One.
3 16,750 0.6575 11,013
4 16,750 0.5717 9576
NPV (18,271)

1.15
Q 7. SPC – Module 1 - Q 31

Chapter 1
EAB/EAC – Project Life Disparity
OM company which is in the 40% tax bracket, has to purchase any one of
the two machines L and M for one of its factories. The following details
are available in respect of the two machines –

Machine L M
Cost of machine, including installation costs ₹ 20,00,000 ₹ 36,00,000
Useful life 5 years 8 years
Net operating income (before depreciation ) ₹ 6,00,000 ₹ 8,40,000
from use of the machine

Note – The appropriate discount rate for the company is 12%

1. Using appropriate evaluation criterion, determine which machine should be
purchased. Assume cash flows to perpetuity and that the cost of removal of
the assets at the end of their useful life will be equal their salvage values.
2. Would your answer to (1) above be different, if net operating incomes of
machine M were ₹ 8,80,000 instead ₹ 8,40,000.

Solution :-
a) Calculation of Depreciation

Particulars L M
Cost 20,00,000 36,00,000
Useful Life 5 Year 8 Year
Depreciation 4,00,000 4,50,000

1.16
Chapter 1

b) Calculation of EAB/Cost

Particulars L M
CFBT 6,00,000 8,40,000
(-) Depreciation (4,00,000) (4,50,000)
PBT 2,00,000 3,90,000
(-) Tax @40% (80,000) (1,56,000)
PAT 1,20,000 2,34,000
+ Depreciation 4,00,000 4,50,000
CFAT 5,20,000 6,84,000
F.V.A.F 3.60477 4.96763
EAI 554819 724690
EAB /COST 34819 40690

L is Preferred Because of lower EAC

It is Always preferable to use equivalent annual f low method if projects
lives are Different.

Q 8. SPC – Module 1 - Q 44
Capital Rationing
Venture Ltd has ₹ 30 Lakhs available for investment in capital projects. It
has the option of making investment in projects 1, 2, 3 and 4. Each project
is entirely independents and has a useful life of 5 years. The expected
present values of Cash flows from the projects are as follows –

1.17
 Projects Initial Outlay PV of Cash Flows

Chapter 1
1 ₹ 8,00,000 ₹ 10,00,000
2 ₹ 15,00,000 ₹ 19,00,000
3 ₹ 7,00,000 ₹ 11,40,000
4 ₹ 13,00,000 ₹ 20,00,000

Which of the above investments should be undertaken?

Assume that cost of capital is 12% and risk free rate is 10% per annum. Given
compounded sum of ₹ 1 at 10% in 5 years is ₹ 1.611 and discount factor of ₹ 1
at 12% rate for 5 years is 0.567

Solution :-
a) Project Ranking based on NPV and PI

Particulars Project 1 Project 2 Project 3 Project 4

a) Discounted Cash ₹ 10,00,000 ₹ 19,00,000 ₹ 11,40,000 ₹ 20,00,000
Flows (given)
b) Initial Investment ₹ 8,00,000 ₹ 15,00,000 ₹ 7,00,000 ₹ 13,00,000
c) NPV (a – b) ₹ 2,00,000 ₹ 4,00,000 ₹ 4,40,000 ₹ 7,00,000
d) Rank based on NPV IV III II I
e) PI (a ÷ b) 1.25 1.27 1.63 1.54
f) Rank based on PI IV III I II

b) Capital rationing on Divisible projects (i.e. Partial Investment is also allowed)

i) In case of Divisible projects, PI is the criterion for decision – Making.
Hence, the Projects with higher PI will be preferred.
ii) The fund allocation and NPV earned on divisible projects will be as under-

1.18
Chapter 1

PI Rank Project Initial Investment NPV

I (1.63) Project 3 ₹ 7,00,000 ₹ 4,40,000
II (1.54) Project 4 ₹ 13,00,000 ₹ 7,00,000
III (1.27) Project 2 ₹ 10,00,000 (bal. fig.)(Partial Inv.) ₹ 2,66,667
₹ 30,00,000 (Funds available) ₹ 14,06,667
(given)

Note – Pro-rata NPV on project 2 = ₹ 4,00,000 × ₹ 10,00,000 = ₹ 2,66,667

₹ 15,00,000

c) Capital rationing on Indivisible projects (i.e. Partial Investment is not allowed)

Option Description Computation of Return NPV earned

I Invest in Projects 1,2&3 ₹ 2L + ₹4L + ₹ 4.4L ₹ 10,40,000
II totaling ₹ 30L Invest in ₹ 2L +₹4.4L + ₹7L + ₹ 15,22,687
projects 1,3&4, totaling ₹ 1,82,687
₹28L balance ₹ 2L in
risk free deposits

Note:
i) Balance ₹ 2,00,000 invested in Risk Free Deposits, will earn 10% return for 5
years.
ii) So, computed value of ₹ 2,00,000 at the end of 5 years, i.e. Maturity Value -
₹ 2,00,000 × 1.611 = ₹ 3,22,200
iii) Present Value of ₹ 3,22,200 (discounted at company’s Cost of Capital 12%)
= ₹ 3,22,200 × 0.567 = ₹ 1,82,687
Conclusion – The Company may choose projects 1, 3, 4 and invest balance ₹
2 Lakhs at 10% for 5 years
1.19
 Chapter 1
Self Note :-
Chapter 1
Chapter 1
Chapter 1
 Following are the 5 Important questions out of total 21 questions from
CH 2 – FINANCING DECISIONS LEVERAGE.
Which cover all the Important Adjustments.

Q 1. SPC – Module 1 - Q 15
Reverse Working Using Leverages

Chapter 2
From the following financial data of Company A and Company B: Prepare
their Income Statements.

Particulars Company A (₹) Company B (₹)

Variable Cost 56,000 60% of Sales

Fixed Cost 20,000 -
Interest Expenses 12,000 9,000
Financial Leverage 5:1 -
Operating Leverage - 4:1
Income Tax Rate 30% 30%
Sales - 1,05,000

Solution :-
i) Calculation of EBT Company A

DFL = EBIT
EBT
5 = EBIT
EBT
5 = EBT + Interest
EBT
5 = EBT + 12,000
EBT
2.3
 5 EBT = EBT + 12,000
EBT = 3000

ii) Calculation of Contribution & EBIT of Company B

Sales = 1,05,000
Chapter 2

(-) VC @ 60% = (63,000)

Contribution = 42,000
Operating Leverage = Contribution
EBIT
4 = 42,000
EBIT
EBIT = 10,500

iii) Income statement

Particulars Company A (₹) Company B (₹)

Sales 91,000 1,05,000
(-) Vc (56,000) (63,000)
Contribution 35,000 42,000
(-) FC (20,000) (31,500)
EBIT 15,000 10,500
(-) Interest (12,000) (9,000)
EBT 3000 1500
(-) Tax @ 30% (900) (450)
EAT 2100 1050
Note: In this Question, key to Solve the Problem is Financial leverage &
operating Leverage.
2.4
Q 2. SPC – Module 1 - Q 17
Reverse Working with all Leverages –
The following details of RST Limited for the year ended 31st March, 2015 are given
below :-
Operating Leverage 1.4 Times
Combined Leverage 2.8 Times

Chapter 2
Income Tax Rate 30%
Fixed Cost (Excluding Interest) ₹ 2.04 Lakhs
Sales ₹ 30 Lakhs
12% Debentures of ₹ 100 each ₹ 21.25 Lakhs
Equity share capital of ₹ 10 each ₹ 17.00 Lakhs

a) Calculate financial leverage.

b) Calculate P/V ratio and Earning per Share (EPS)
c) If the company belongs to an industry, whose assets turnover is 1.5, does it
have a high or low assets Leverage?
d) At what level of sales the Earning Before Tax (EBT) of the company will be
equal to zero?

Solution :-
i) Calculation of Financial Leverage
Financial Leverage = Combined leverage
Operating Leverage
= 2.8
1.4
= 2 times

2.5
 ii) Calculation of EBT
DFL = EBIT
EBT
2 = EBT + Interest
EBT
2 = EBT + 2,55,000
Chapter 2

EBT
2 EBT = EBT + 2,55,000
EBT = 2,55,000

iii) Calculation of EBIT

EBIT = Interest + EBT
= 2,55,000 + 2,55,000
EBIT = 5,10,000

iv) Calculation of Contribution

Contribution = FC + EBIT
= 2,04,000 + 5,10,000
Contribution = 7,14,000

v) Calculation of PV Ratio
PV Ratio = Contribution
Sales
= 7,14,000 × 100
30,00,000
PV Ratio = 23.79% or 23.8%
Means when I sale for 100 ₹, I get Contribution of 23.8%

2.6
vi) Calculation of EPS
EBIT 5,10,000
(-) Interest (2,55,000)
EBT 2,55,000
(-) Tax @ 30% (76,500)
EAT 1,78,500

Chapter 2
No. of shares 1,70,000
EPS 1.05

 Income Statement

Particulars (₹)
Sales 30,00,000
(-) Vc (22,86,000)
Refer 4 Contribution 7,14,000
(-) FC (2,04,000)
3 EBIT 5,10,000
(-) Interest (2,55,000)
2 EBT 2,55,000
(-) Tax @ 30% (76,500)
EAT 1,78,500

 Calculation of Assets T/ O (Total Assets – Total Liability)

Assets T/O = Sales
Total Asset
= 30,00,000
38,25,000
= 0.7843

2.7
  Calculation of Total Assets
Total Assets = Total Funds
= Debt + Equity
= 21.25 lakhs + 17.00 lakhs
= 38.25 lakhs
Conclusion: Compare to Industry standard, the firm has low asset leverage.
Chapter 2

 Calculation of Sales to get EBT Zero

Particulars (₹)

Sales 19,28,571
(-) Vc (14,69,571)
Reverse
Contribution 4,59,000
Calculation
(-) FC (2,04,000)
EBIT 2,55,000
(-) Interest (2,55,000)
EBT 0

P V Ratio = 4,59,000 – 23.8%

? – 100.00%
Sales = 4,59,000 × 100
23.8
= 19,28,571

2.8
Q 3. SPC – Module 1 - Q 19
WACC, ROI, ROE, Segmentation of ROE and Leverage with
Preference Capital
The net sales of A Ltd. is ₹ 30 crores. Earnings before interest and tax of
the company as a percentage of net sales is 12%. The capital employed
comprises ₹ 10 crores of equity, ₹ 2 crores of 13% Cumulative Preference

Chapter 2
Share Capital and 15% Debentures of ₹ 6 crores. Income-tax rate is
40%.
i) Calculate the Return-on-equity for the company and indicate its
segments due to the presence of Preference Share Capital and
Borrowing (Debentures).
ii) Calculate WACC for the above company.
iii) Calculate the Operating Leverage of the Company given that combined
leverage is 3

Solution :-
Profitability Statement

Particulars Amount (₹)

EBIT × 30 ( r × 12%) 3,60,00,000
(-) Interest 6 (r = 15%) 90,00,000
EBT 2,70,00,000
(-) Tax (r -40%) x 2,70,00,000 1,08,00,000
EAT 1,62,00,000
(-) Pref. Dividend (13 % x 2,00,00,000) 26,00,000
EPES 1,36,00,000
Equity 10,00,00,000
Total Instrument (10 + 2+ 6) 18,00,00,000

2.9
 Return on Equity = Residual
Total Equity
= 1,36,00,000
10,00,00,000
= 13.6%
Chapter 2

Return on Invest ment = EBIT

Total Investment
= 3,60,00,000
18,00,00,000
= 20%

Degree of Financial Leverage = EBIT

EBT
= 3,60,00,000
2,70,00,000 – 43,33,333
= 3,60,00,000
2,26,66,667
= 1.5882 times
Since, the Dividend is Not Debited to P & I all he Could not get the tax
benefit if Preferential Dividend Would have Debited to P & I all then
Company Would have to pay lesser tax, in fact Company has lost the
benefit of tax.
Hence, 26,00,000 ÷ 60% = 43,33,333
DCL = DOL * DFL
3 = DOL = 1.5882
DOL =1.5889

2.10
 In above questions, the Key was financial leverage Very Important to
understand & remember effect of Pref. Dividend, ROE & ROI.

Q 4. SPC – Module 1 - Q 21
ROI and Effect of Change in EBIT on Leverage
A firm has sales of ₹ 75,00,000 variable cost is 56% and fixed cost is ₹

Chapter 2
6,00,000. It has a debt of ₹ 45,00,000 at 9% and equity of ₹ 55,00,000.
i) What is the firm’s ROI?
ii) Does it have favorable financial leverage?
iii) If the firm belongs to an industry whose capital turnover is 3, does it have
a high or low capital turnover?
iv) What are the operating, financial and combined leverages of the firm?
v) If the sales is increased by 10% by what percentage EBIT will increase?
vi) At what level of sales the EBT of the firm will be equal to zero?
vii) EBIT increases by 20%, by what percentage EBT will increase?

Solution :-
Income Statement
Particulars Amount (₹)
Sales 75,00,000
(-) Variable Cost (56% of 75,00,000) 42,00,000
Contribution 33,00,000
(-) Fixed Costs 6,00,000
Earning before Interest & Tax (EBIT) 27,00,000
(-) Interest on Debt (@ 9% on ₹ 45 Lakhs) 4,05,000
Earning before Tax (EBT) 22,95,000

2.11
 1) ROI = EBIT × 100
Capital Employed
= EBIT × 100
Equity + Debt
= 27,00,000 × 100
55,00,000 + 45,00,000
Chapter 2

= 27% (ROI is calculated on Capital Employed)

2) ROI = 27% and Interest on debt is 9%, hence, it has a favorable financial
leverage.

3) Capital Turnover = Net Sales

Capital
= ₹ 75,00,000
₹ 1,00,00,000
= 0.75
Which is very low as compared to industry average of 3.

) 4) Calculation of Operating, Financial and Combined leverages

)
a) Operating Leverage = Contribution = 33,00,000 = 1.22
EBIT 27,00,000

b) Financial Leverage = EBIT = 27,00,000 = 1.18

EBT 22,95,000

c) Combined Leverage = Contribution = 33,00,000 = 1.44

EBT 22,95,000

2.12
 Or = Operating Leverage × Financial Leverage = 1.22 × 1.18 = 1.44

4) Operating leverage is 1.22. So if sales is increased by 10%. EBIT will be increased

by 1.22 × 10 i.e. 12.20% (approx)

5) Since the combined Leverage is 1.44, sales have to drop by 100/1.44 i.e.

Chapter 2
69.44% to bring EBT to Zero
Accordingly, New Sales = ₹ 75,00,000 × (1 - 0.6944)
= ₹ 75,00,000 × 0.3056
= ₹ 22,92,000 (approx)
Hence at ₹ 22,92,000 sales level EBT of the firm will be equal to Zero.
Financial leverage is 1.18. So, if EBIT increases by 20% then EBT will
increase by 1.18 × 20 = 23.6% (approx)

Q 5. SPC – Module 1 - Q 18
Financing Pattern and effect on EPS
Delta Ltd. currently has an equity share capital of ₹ 10,00,000 consisting of
1,00,000 Equity share of ₹ 10 each. The company is going through a major
expansion plan requiring to raise funds to the tune of ₹ 6,00,000. To finance the
expansion the management has following plans:
Plan-I : Issue 60,000 Equity shares of ₹ 10 each
Plan-II : Issue 40,000 Equity shares of ₹ 10 each and the balance through long-
term borrowing at 12% interest p.a.
Plan-III : Issue 30,000 Equity shares of ₹ 10 each and 3,000, 9% Debentures of ₹
100 each
Plan-IV : Issue 30,000 Equity shares of ₹ 10 each and the balance through 6%
preference shares.

2.13
 The EBIT of the company is expected to be ₹ 4,00,000 p.a. assume
corporate tax rate of 40%. Required:
i) Calculate EPS in each of the above plans.
ii) Ascertain financial leverage in each plan

Solution :-
Chapter 2

Calculation of EPS

Particulars Plan I Plan II Plan III Plan IV

No. of Eq. shares 6,00,000 4,00,000 3,00,000 3,00,000
issued ( 60,000×10) (40,000×10) (30,000×10 ) (30,000×10)
Long-Term - 2,00,000 - -
Borrowings@12%
9% Debenture - - 3,00,000 -
(3000 × 100)
6% Pref. share - - - 3,00,000
Interest on Long- - 24,000 - -
Term Borrowings
Interest on - - 27,000 -
Debenture
Dividend on Pref. - - - 18,000
share
EBIT 4,00,000 4,00,000 4,00,000 4,00,000
(-) Interest - (24,000) (27,000) -
EBT 4,00,000 3,76,000 3,73,000 4,00,000
(-) Tax @ 40% (1,60,000) (1,50,400) (1,49,200) (1,60,000)
EAT 2,40,000 2,25,600 2,23,800 2,40,000
(-) Pref Div. - - - 18,000

2.14
 Earnings for 2,40,000 2,25,600 2,23,800 2,22,000
eq. holders
No. of Share 60,000 40,000 30,000 30,000
EPS 4 5.64 7.46 7.4
Financial
Leverage

Chapter 2
1 1.063 1.072 1.04
= EBIT
EBT

Plan IV

DFL = EBIT
EBT – Preference Dividend
= 4,00,000
4,00,000 - 30,000
= 1.08
60% = 18,000
100% = 18,000 × 100
60
= 30,000
= In short, we are not going tax saving on preference Dividend

2.15
 Self Note:-
Chapter 2
Chapter 2
 3.6
Chapter 2
Chapter 2
 Following are the 8 Important questions out of total 21 questions from
CH 3 – Cost of Capital.
Which cover all the Important Adjustments.

Q 1. SPC – Module 1 - Q 6
Computation of Cost of Equity, Cost of Debt
ABC Company’s Equity share is quoted in the market at ₹ 25 per share
currently. The company pays a dividend of ₹ 2 per share and the investor’s
market expects a growth rate of 6% per year. You are required to:
a) Calculate the company’s Cost of Equity Capital.
b) If the Anticipated Growth Rate is 8% p.a., calculate the indicated
Market price per share.
Chapter 3

c) If the company issues 10% Debentures of face value of ₹ 100 each and
realizes ₹ 96 per Debenture while the debenture are redeemable after 12
years at a premium of 12 %, what will be the cost of debentures? (Tax
= 50%)

Solution :-
a) Calculation of Cost of Equity Capital

Ke = D1 + g
P0
= 2 + 6% + 6%
25
= 2.12 + 6%
25
= 14.48%

3.3
b) Calculation of Market price per share

Ke = D1 + g
P0
14.48 = 2.16 + 8%
P0
6.48 = 2.16
P0
P0 = 33.33 %

c) Calculation of Cost of Debenture

Chapter 3
Interest × (1 - tax ) + RV - NP
Kd = n
RV + NP
2
10 (1 - 0.50) + 112 – 96 ( without Tax)
Kd = 12
112 + 96
2
= 6.08%
OR
10 (1 - 0.50) + 112 – 96 × ( 1 - 0.5)
Kd = 12
112 + 96
2
= 5.12%

3.4
 Q 2. SPC – Module 1 - Q 6a
Cost of Equity – Different Approaches
Pogo Ltd has an EPS of ₹ 9 per share. Its Dividend payout ratio is 40%. Its
Earning and Dividends are expected at 5% per annum. Find out the cost of
Equity Capital under various approaches, if its Market Price is ₹ 36 per
share.

Solution :-
a) Dividend price approach

Ke = D1
P0
Chapter 3

= 3.78
36
= 10.5%

b) Divided Price with Growth

Ke = D1 + g
P0
= 3.78 + 5%
36
= 15.5%

c) Earning price Approach

Ke = EPS1
P0

3.5
 = 9. 45
P0
= 26.25%

d) Earning price Approach with growth

Ke = EPS1 + g
P0
= 9.45 + 5%
36
= 31.25%

Chapter 3
Q 3. SPC – Module 1 - Q 6b
Cost of Equity – Realized Yield Approach
GTAYCT Ltd is a large company with several thousand shareholders.
Investors buy 100 shares of the company at the beginning of the year at a
market price of ₹ 225. The par value of each share is ₹ 10. During the
year, the company pays a dividend at 25%. The price of the share at the
end of the year is ₹ 267.50. Calculate the total return on the investment.
Suppose the investor seels the shares ta end of the year, what would be
the cash inflows at the end of the year.

Solution :-

a) Calculation of Cost of Equity

Ke = D1 (P1 – P0)
P

3.6
 = 100 × 2.5 + (267.50 – 225 ) × 100
225 × 100
= 4500 × 100
22,500
= 20 % (Ke as per Realized Yield Approach)

b) Calculation of total Return / Earning

Total Return / Earning = Ke × Market price per share × No. of shares

= 20% × 225 × 100
= 4500
Chapter 3

c) Calculation of Cash Inflow

Cash Inflow = (Market price at the end of the year × No. of Share) +
(Dividend per share × No. of share)
= (267.50 × 100) + (2.5 × 100)
= 27,000

Q 4. SPC – Module 1 - Q 6c
Cost of Equity – CAPM Approach
Calculate the Cost of Equity Capital of H Ltd whose Risk Free Return equals
10%. The firm’s beta is 1.75 and the Return on the Market Portfolio is 15%.

Solution :-
Ke = Rf + ß( Rm –Rf)
= 10% + 1.75 (15 -10)
= 10 + 8.75 = 18.75%
3.7
Q 5. SPC – Module 1 - Q 18
Computation of WACC
Pooja Ltd. has the following book value capital structure:

Particulars Amt (₹)

Equity Capital (in shares of ₹ 10 each, fully paid up- at par) ₹ 15 Cr
11% Pref. Capital (In shares of ₹ 100 each, fully paid up- at ₹ 1 Cr
par)
Retained Earnings ₹ 20 Cr
13.5% Debentures (of ₹ 100 each) ₹ 10 Cr
15% Term Loans ₹ 12.5 Cr

Chapter 3
The next expected dividend on equity shares per share is ₹ 3.60; the
dividend per share is expected to grow at the rate of 7%. The market price
per share is ₹ 40.
Preference stock, redeemable after 10 years, is currently selling at ₹ 75 per
share.
Debentures, redeemable after six years, are selling at ₹ 80 per debenture.
The Income tax rate for the company is 40%.

i) Required Calculate the current weighted average cost of capital using:

a) book value proportions; and
b) market value proportions.

ii) Define the weighted marginal cost of capital schedule for the company, if it
raises ₹ 10 crores next year, given the following information:
a) The amount will be raised by equity and debt in equal proportions;
b) The company expects to retain ₹ 1.5 crores earnings next year;

3.8
 c) The additional issue of equity shares will result in the net price per share
being fixed at ₹ 32;
d) The debt capital raised by way of term loans will cost 15% for the
first ₹ 2.5 crores and 16% for the next ₹ 2.5 crores.

Solution :-
i) Statement showing computation of weighted average cost of capital by
using Book value proportions.

Amt Weight (BV Cost of Weighted

Source of (Book proportion) capital cost of
finance value) (a) (%) capital (%)
Chapter 3

(₹ in cr.) (b) (c)=(a)× (b)

Equity capital 15.00 0.256 16.00 4.096
(W.N.1)
11% Preference 1.00 0.017 15.43 0.262
capital (W.N.2)
Retained 20.00 0.342 16.00 5.472
Earnings
(W.N.1)
13.5% 10.00 0.171 12.70 2.171
Debentures
(W.N.3)
15% term loans 12.50 0.214 9.00 1.926
(W.N.4)
58.50 1.00 13.927

3.9
ii) Statement showing computation of weighted average cost of capital by using
market value proportions.

Amount Weight Cost of Weighted

Source of (Book (Book value capital cost of
finance value) proportion) (%) capital (%)
(₹ in cr.) (a) (b) (c) = (a)× (b)
Equity capital 60.00 0.739 16.00 11.824
(W.N.1) (1.5cr × ₹ 40)
11% 0.75 0.009 15.43 0.138
Preference (1L × ₹ 75)
capital

Chapter 3
(W.N.2)
13.5% 8.00 0.098 12.70 1.245
Debentures (10L × ₹ 75)
(W.N.3)
15% term 12.50 0.154 9.00 1.386
loans (W.N.4)
81.25 1.00 14.593

[Note: Since retained earnings are treated as equity capital for purposes of
calculation of cost of specific source of finance, the market value of the
ordinary shares may be taken to represent the combined market value of
equity shares and retained earnings. The separate market values of retained
earnings and ordinary shares may also be worked out by allocating to each
of these a percentage of total market value equal to their percentage share
of the total based on book value.]

3.10
 Working Notes (W.N.):
1) Cost of equity capital and retained earnings (Ke)
Ke = D1 + g
P0
Where,
Ke = Cost of equity capital
D1 = Expected dividend at the end of year 1
P0 = Current market price of equity share
g = Growth rate of dividend
Now, it is given that D1 = ₹3.60, P0 = ₹ 40 and g = 7%
Therefore,
Chapter 3

Ke = ₹ 3.60 + 0.07
₹ 40
Ke = 16%

2) Cost of Preference Share Capital (Kp)

PD+ RV – NP
Kp = n
RV + NP
2
Where,
PD = Preference dividend
RV = Redeemable value of preference shares
NP = Current market price of preference shares
N = Redemption period of preference shares
Now, it is given that PD = 11%, RV = ₹ 100, NP = ₹ 75 and n = 10 years

3.11
 ₹ 11 + ₹ 100 - ₹ 75
Therefore, Kp = 10 × 100
₹ 100 + ₹ 75
2
Kp = 15.43%

3) Cost of Debenture (Kd)

I (1- t) RV - NP
Kd = n
RV + NP
2

Chapter 3
Where,
I = Interest payment
t = Tax rate applicable to the company
RV = Redeemable value of debentures
NP = Current market price of debentures
n = Redemption period of debentures
Now it is given that I = 13.5, t = 40%, RV = ₹100, NP = ₹80 and n = 6 yr
₹ 13.5 ( 1- 0.40) + ₹ 100 - ₹80
Therefore, Kd = 6 × 100
₹ 100 + ₹ 80
2
Kd = 12.70%

4) Cost of Term Loans (Kt)

Kt = r (1-t)
Where, r = Rate of interest on term loans
t = Tax rate applicable to the company

3.12
 Now, r = 15% and t = 40%
Therefore, Kt = 15% (1 - 0.40)
Kt = 9%

iii) Statement showing weighted marginal cost of capital schedule for the
company, if it raises ₹ 10 crores next year, given following information:

Source of Amount Weight (a) After tax Cost WACC (%)

finance (₹ in cr) of capital (%) (c) = (a) x
(b) (b)
Equity shares 3.5 0.35 18.25 6.387
(W.N.5)
Chapter 3

Retained 1.5 0.15 18.25 2.737

earnings
15 % Debt 2.5 0.25 9.00 2.250
(W.N. 6)
16% Debt 2.5 0.25 9.60 2.400
(W.N. 6)
10.00 1.00 13.774

Working Notes (W.N.):

5) Cost of Term Loans (Kt) (including fresh issue of equity shares)

Ke = D1 + g
P0
Now, D1 = ₹ 3.60, P0 = ₹ 32 and g = 0.07
Therefore, Ke = ₹ 3.60 + 0.07
₹ 32
= 18.25%

3.13
 6) Cost of debt (Kd) = r (1- t) (For first ₹ 2.5 crores)
r = 15% and t = 40%
Therefore, Kd = 15% (1- 40%) = 9% (For the next 2.5 crores )
r = 16% and t = 40%
Therefore, Kd = 16% (1 - 40%)
Kd = 9.6%

Q 6. SPC – Module 1 - Q 19
Cost of Capital – Cost of Equity, Debt, Preference, WACC, Marginal WACC
The Sneha Ltd. has following capital structure at 31st December 2015, which is
considered to be optimum:

Chapter 3
Particulars Amount (₹)
13% Debenture 3,60,000
11% Preference share capital 1,20,000
Equity share capital (2,00,000 shares) 19,20,000

The company’s share has a current market price of ₹ 27.75 per share. The
expected dividend per share in next year is 50 percent of the 2015 EPS. The EPS
of last 10 years is as follows. The past trends are expected to continue.

Year 2006 2007 2008 2009 2010 2011 2012

EPS (₹) 1.00 1.120 1.254 1.405 1.574 1.762 1.974

The company can issue 14 percent new debenture. The company’s debenture is
currently selling at ₹ 98. The new preference issue can be sold at a net price of
₹ 9.80, paying a dividend of ₹ 1.20 per share. The company’s marginal tax rate
is 50%.

3.14
 i) Calculate the after tax cost (a) of new debts & new preference share capital,
(b) of ordinary equity, assuming new equity comes from retained earnings.
ii) Calculate the marginal cost of capital.
iii) How much can be spent for capital investment before new ordinary share
must be sold? (Assuming that retained earnings available for next year’s
investment is 50% of 2015 earnings.)
iv) What will be marginal cost of capital (cost of fund raised in excess of
amount calculated in part (iii) if the company can sell new ordinary shares
to net ₹ 20 per share ? Cost of debt and of preference capital is constant.

Solution :-
Chapter 3

a) Calculation of Growth Rate

Year 2007 2008 2009 2010 2011 2012 2013 2014 2015
Increme- 0.12 0.134 0.151 0.169 0.188 0.262 0.2369 0.2653 0.2971
ntal EPS

(₹)

EPS0 1 1.120 1.254 1.405 1.574 1.762 1.974 2.2109 2.4762

Growth 12.1 11.96 12.04 12.02 11.94 12.03 12.00 11.99 11.99

b) Calculation of Cost of Equity

Ke = D1 + g
P0
= 2.7733 × 50% + 0 .12
27.75
= 16.99 %
3.15
c) Calculation of Cost of Preference shares
Kp = PD × 100
NP
= 1.20 × 100
9.80
= 12.24 %

d) Calculation of Cost of Debt

Kd = Interest × (1 – t)
NP
= 14 × (0.50)
98

Chapter 3
= 7.14 %

e) Calculation of WACC

Type Amount Weight Cost WACC

Equity 19,20,000 80 17 13.6
Preference 1,20,000 5 12.24 0.612
Debenture 3,60,000 15 7.14 1.071
15.283

Note:
Since, it is given in the question. That existing Combination is optimum
means this Combination is gaining minimum WACC, so Company will issue
new capital in same Proportion.

3.16
 2,77,300 = 80%
? = 100%
3,46,625 = 100%

Equity Debt Preference

80% 15% 5%
2,77,300 51,994 17,331

Retained Earnings available for Further Investment

= 50% of 2015 EPS
= 50% × 2.7733 × 2,00,000 = 2,77,300
Hence, the amount to be used by way of Retained Earnings, before selling
Chapter 3

new ordinary share = 2,77,300

As Equity = 80% of Total Funds,
The Total Capital before issuing fresh Equity shares = 2,77,300
80%
= 3,46,625
New Ke = 50% × 2.7733 + 0.12
20
= 18.93%

WACC Calculation
Type Amount Weight Cost WACC
Equity 19,20,000 80 18.93 15.144
Preference 1,20,000 5 12.24 0.612
Debenture 3,60,000 15 7.14 1.071
16.827

3.17
 Q 7. SPC – Module 1 - Q 15
Computation of Kd , Ke and WACC
Macro Limited wishes to raise additional finance of ₹ 10 lakhs for meeting
its investment plans. It has ₹ 2,10,000 in the form of retained earnings
available for investment purposes. Further details are as following-

1) Debt / equity mix 30% / 70%

2) Cost of debt - Upto ₹ 1,80,000 10% (before Tax)
- Beyond ₹ 1,80,000 16% (before Tax)
3) Earnings per share ₹4
4) Dividend pay out 50% of earnings

Chapter 3
5) Expected growth rate in dividend 10%
6) Current market price per share ₹ 44
7) Tax rate 50%

You are required:

a) To determine the pattern for raising the additional finance.
b) To determine the post-tax average cost of additional debt.
c) To determine the cost of retained earnings and cost of equity, and
d) overall weighted average after tax cost of additional finance.

Solution:-
a) Pattern of Raising additional Finance
Equity 70% of ₹ 10,00,000 = ₹ 7,00,000
Debt 30% of ₹ 10,00,000 = ₹ 3,00,000
The capital structure after raising additional Finance

3.18
 Particulars Amount (₹)
Equity Capital of ( 7,00,000 - 2,10,000) 4,90,000
Retained Earnings 2,10,000
Debt (Internet at 10% P.a) 1,80,000
Debt (Internet at 16% P.a) (3,00,000 -1,80,000) 1,20,000
Total Funds 10,00,000

b) Calculation of Cost of Equity

Ke = D1 + g
P0
= (4 × 50% ) + 10% + 10%
44
Chapter 3

= 2+ 10% + 10%
44
= 2.2 + 10%
44
= 5% + 10%
= 15%

Calculation of WACC
Type Amount Weight Cost WACC
Equity 4,90,000 49% 15% 7.35%
Retained Earning 2,10,000 21% 15% 3.15%
Debt 1,80,000 5% 5% 0.9%
Debt 1,20,000 8% 8% 0.96%
12.36%

3.19
 Note: It is assumed that investor is not getting tax benefit an retained
earning.
Conclusion:
If the Proposed Investment is giving higher return than 12.36% then Company
should invest.

Q 8. The Capital Structure of SPAV Ltd. Is As Follows :-

Particulars Amount (₹)

11% Debenture ₹ 8,50,000
16% Preference Share ₹ 9,00,000
Equity share Capital ₹ 15,00,000 (₹ 10 each)

Chapter 3
Retained Earning ₹ 7,50,000

i) On retained earnings, the expected Rate of Return to the shareholders, if

they had Invested the funds else were is 10% and Brokerage is 3%.
ii) 100 per Debenture, Redeemable at par has Flotation Cost of 3% and 10
years of Maturity. The market price per Debenture is 105 Rs.
iii) 100 per Pref. share redeemable at par has 3 % Flotation cost and 5 Years
maturity. The market price per Pref. share is 106.
iv) Equity shares has ₹ 5 Flotation cost and market price per share is
₹30.EPS of the Company is ₹ 5 with Dividend pay-out Ratio of 50% and
Annual growth is 10%.
v) Tax rate is applicable @ 30 % for all. You are required to calculate WACC
with both Values i.e. market & Book Values.

3.20
 Solution :-

a) Computation of Ke
WN-1 Dividend per share = EPS × Payout Ratio
= 5 × 50%
= 2.50
Ke = D1 +g
P0
= 2.50 + 10% + 0.10
30 - 5
= 2.75 + 0 .10
25
Chapter 3

= 21%

b) Computation of Kp
Kp = PD + (RV –NP)
n
(RV + NP)
2
= 16 + 100 - 103
5
100 + 103
2
= 16 – 0.6
101.5
= 15.172 %

3.21
c) Computation of Kd
Kd = Interest × (1- Tax) + RV –NP
n
RV + NP
2
= 11 × (1 -.30) + 100 -102
10
100 + 102
2
= 7.7 – 0.2
101
= 7.425%

Chapter 3
d) Computation of Kr
Kr = (7,50,000 × 10%) - 3% × (1- .30)
7,50,000
= 6.79%

e) Computation of WACC as per Book Value Weights

Types Amount Weight Cost WACC

Equity 15,00,000 0.375 21% 7.875
Preference 9,00,000 0.225 15.172% 3.4137
Debenture 8,50,000 0.2125 7.425% 1.5778
Retained 7,50,000 0.1875 6.79% 1.2731
14.1396

3.22
 f) Computation of WACC as per market Value weights

Type Amount Weight Cost WACC

Equity 45,00,000 70.90 21% 14.889
Preference 9,54,000 15.03 15.1721% 2.280
Debenture 8,92,500 14.06 7.425% 1.044
18.213%
Chapter 3

3.23
Self Note:-

Chapter 3
Chapter 3
Chapter 3
Chapter 3
Steps
 Following are the 9 Important questions out of total 24 questions from
CH 4 – Capital Structure.
Which cover all the Important Adjustments.

Q 1. SPC – Module 1 - Q 1
Net Income Approach – Valuation of Firm
The following data relates to four Firms –

Firm A B C D
EBIT ₹ 2,00,000 ₹ 3,00,000 ₹ 5,00,000 ₹ 6,00,000
Interest ₹ 20,000 ₹ 60,000 ₹ 2,00,000 ₹ 2,40,000
Equity Capitalization Rate 12% 16% 15% 18%

Assuming that there are no taxes and Interest rate on debt is 10%, Determine
the value and WACC of each firm using the Net Income Approach. What
happens if firm A borrows ₹ 2,00,000 at 10% to repay Equity Capital?

Solution :-
a) Computation of WACC

Chapter 4
Firm A B C D

EBIT 2,00,000 3,00,000 5,00,000 6,00,000

(-) Interest (20,000) (60,000) (2,00,000) (2,40,000)
EBT 1,80,000 2,40,000 3,00,000 3,60,000
Ke (given) 12% 16% 15% 18%
Value of Equity (s )= EBT 15,00,000 15,00,000 20,00,000 20,00,000
Ke
Value of Debt (D )= Int. 20,000 60,000 2,00,000 2,40,000
Kd
10% 10% 10% 10%
= 2,00,000 = 6,00,000 =20,00,000 =24,00,000
4.3
 Value of firm (V) 15L + 2L 15L + 6L 20L + 20L 20L + 24L
= (S +D) = 17L =21,00,000 =40,00,000 =44,00,000
WACC=EBIT × 100 2L × 100 3L × 100 5L × 100 6L × 100
V 17L 21L 40L 4.4L
= 11.76% = 14.29% = 12.5% =13.64%

b) When firm A borrows ₹ 2,00,000 at 10% interest, repay Equity Capital, the
effect on WACC will be as under.

Firm Before After

EBIT 2,00,000 3,00,000
(-) Interest (20,000) (40,000)
EBT 1,80,000 1,60,000
Ke (given) 12% 12%
Value of Equity (s ) = EBT 15,00,000 13,33,333
Ke
Value of Debt (D ) = Interest 20,000 40,000
Kd
Chapter 4

10% 10%
= 2,00,000 = 4,00,000
Value of firm (V) = (S +D) 15L + 2L 13,33,333 + 6L
= 17L =17,33,333

WACC = EBIT × 100 = 11.76% = 11.54%

V

Conclusion: More proportion of Debt = Reduced WACC

4.4
Q 2. SPC – Module 1 - Q 2
Optimum Capital Structure –Traditional Theory
RST Ltd is expecting an EBIT of ₹ 4 Lakhs for F.Y. 2015- 16. Presently the
company is financed entirely by Equity Share Capital of ₹ 20 Lakhs with
equity capitalization rate of 16%. The company is contemplating to redeem a
part of the capital by introducing Debt Financing. The company has two
options to raise Debt to the extent of 30% or 50% of the total fund.
It is expected that for debt financing upto 30%, the rate of Interest will be 10%
and equity Capitalization rate will increase to 17%. If the company opts for
50% debt, then the interest rate will be 12% and Equity Capitalization rate will
be 20%.
You are required to compute the Value of the Company and its overall Cost of
Capital under different options, and also state which is the best option.

Solution :-
Computation of WACC
Plan Present – Plan 1 – Plan 2 –

Chapter 4
0% Debt 30% Debt 50% Debt
Debt Nil 6,00,000 10,00,000
Equity Capital 20,00,000 14,00,000 10,00,000
EBIT 4,00,000 4,00,000 4,00,000
(-) Interest Nil 60,000 1,20,000
EBT 4,00,000 3,40,000 2,80,000
Ke 16% 17% 20%
Value of Equity (S) 25,00,000 20,00,000 14,00,000
EBT
Ke

4.5
 Value of Debt (D) 0 6,00,000 10,00,000
Value of Firm (V = S + D) 25,00,000 26,00,000 24,00,000
WACC = EBIT × 100 16% 15.38% 16.67%
V

Therefore, Plan I is the best.

Q 3. SPC – Module 1 - Q 3
Net Operating Income Approach
Alpha Limited and Beta Limited are identical except for capital structures.
Alpha Ltd. has 50 per cent debt and 50 per cent equity, whereas Beta Ltd.
has 20 per cent debt and 80 per cent equity. (All percentages are in market-
value terms). The borrowing rate for both companies is 8 per cent in a no-tax
world, and capital markets are assumed to be perfect.

(a) i) If you own 2 per cent of the shares of Alpha Ltd., what is your return
if the company has net operating income of ₹ 3,60,000 and the
Chapter 4

overall capitalisation rate of the company, Ko is 18 per cent?

ii) What is the implied required rate of return on equity?
(b) Beta Ltd. has the same net operating income as Alpha Ltd.
i) What is the implied required equity return of Beta Ltd.?
ii) Why does it differ from that of Alpha Ltd.?

Solution:-
Computation of Return on equity

4.6
 Particulars Alpha Beta
EBIT 3,60,000 3,60,000
Ko = EBIT × 100 18%= 3,60,000 18% = 3,60,000
V V V
V= 20,00,000 V= 20,00,000
Value of Debt (D) 50% = 10,00,000 20% = 4,00,000
Value of equity(S) 10,00,000 16,00,000
Interest 10,00,000 X 8% 4,00,000 X 8%
= 80,000 =32,000
EBT = EBIT -Interest 2,80,000 3,28,000
Ke = NI 2,80,000 3,28,000
value 10,00,000 16,00,000
= 28% = 20.5%

Because Alpha is taking more Debt =

More Financial Leverage = More Risk =Shareholders will expect more Returns

Chapter 4
Q 4. SPC – Module 1 - Q 8
M & M (with taxes) – Levered v/s Unlevered Firm
RES Ltd. is an all equity financed company with a market value of ₹
25,00,000 and cost of equity (Ke) 21%. The company wants to buyback
equity shares worth ₹ 5,00,000 by issuing and raising 15% perpetual debt
of the same amount. Rate of tax may be taken as 30%. After the capital
restructuring and applying MM Model (with taxes), you are required to
calculate:
i) Market value of RES Ltd.
ii) Cost of Equity (Ke)
iii) Weighted average cost of capital (using market weights)and comment on it.

4.7
 Solution :-
i) Market Value of Levered Firm
= Market Value of Unlevered Firm + (Debt × Tax Rate)
= 25,00,000 + ( 5,00,000 X 30%)
= 26,50,000

ii) Cost of Eq. of new Structure

= 26,50,000 – 5,00,000
= 21,50,000

iii) Cost of Equity

Ke = EAT
Value of Equity
21% = EAT
25,00,000

EAT = 5,25,000
Chapter 4

PROFIT STATEMENT
To know EAT of New Structure

Particulars Pure Equity Debt of Equity

EBIT 7,50,000 7,50,000
(-) Interest - 75,000
EBT 7,50,000 6,75,000
(-) TAX 2,25,000 2,02,500
EAT 5,25,000 4,72,500

4.8
 Calculation of New Ke = EAT
Eq. value (new)
= 4,72,500
21,50,000
= 21.97%
Calculation of WACC

Component ₹ weight Individual Cost WACC

Eq. 21,50,000 0.8113 21.97% 17.82
Debt 5,00,000 0.1886 10.5% 1.9803
19.80

Q 5. SPC – Module 1 - Q 9
Arbitrage under M&M Approach
The data relating to two companies Karna Ltd and Arjun Ltd, belonging to the
same risk class, are as under –

Chapter 4
Particulars Karna Ltd. Arjun Ltd.
Number of Equity Shares 90,000 1,50,000
Market price per share ₹ 1.20 ₹ 1.00
6% Debentures ₹ 60,000 NIL
Profit Before Interest ₹ 18,000 ₹ 18,000

There are no taxes. Bheem is an Investor holding 10% stake in Karna Ltd.
What is the benefit / loss to bheem, if he switches his holding to Arjun Ltd?
When will this arbitrage process end?

4.9
 Solution :-
a) On the basis of given data, we understand risk of karna ltd is more since, it
has debt Component. And obviously the cost of karna is less than arjun ltd.
That is why, Market price of Karna Ltd. Will be Higher.

b) Since, both the companies are hawing same level of Performance, Bheem
will sell the share of Karna @ ₹ 1.20 & will buy shares of Arjun @₹ 1.00

c) Total value of Karna = 1.20 × 90,00 = 1,08,000

Share of Bheem in Karna is 10%
Sales Value =1,08,000 ×10% = ₹ 10,800

d) Why Bheem will switch from Karna to Arjun ?

Since, we are Comparing returns at the end, we Should first match the risk
of Karna & Arjun Both. Thus, the investor (Bheem) has to personally barrow
6000₹ @ 6% which is Equivalent to 10% of karna’s debenture i.e 60,000.
Chapter 4

e) Computation of amount available as surplus cash-

Particulars ₹
Amount Received by Selling shares of Karna Ltd 10,800
(+) Personal Borrowing 6,000
Total Amount Received 16,800
(-) 10% shares of Arjun Ltd (1,50,000 X 10%) 15,000
Surplus cash Available 1,800

4.10
 This, 1,800 will Motivate Bheem to sell Karna Ltd & Arjun. In short, Bheem is
taking equal stake in Arjun. That too with surplus of ₹ 1,800. Provided returns
of Both the Companies shall remain Same.

f) Position of Investor before & after Switching-

Particulars Karna Arjun

EBIT 18,000 18,000
(-) Interest @ 6%(60,000 X 6%) 3,600 -
EBT 14,400 18,000
% of Holding 10% 10%
Dividend Receivable 1,440 1800
(-) Interest on Borrowing (6000 X 6%) - 360
Net Earnings 1,440 1,440

g) Then why Arjun???

Because all through returns are same i.e. ₹ 1,440 but Bheem is getting

Chapter 4
additional surplus of ₹1,800.

h) Conclusion-
As the investor is better off in switching his holding from Karna to arjun it
means there will be more demand of arjun & there will be more sell of
karna. So, an the supply. Since, the demand of Arjun will increase & the
Price of karna will Decrease until Value of Both the Companies is Not
same.

i) Then Why unnecessary people will shift from Karna to Arjun ?When MP of Both
the Companies are same?

4.11
 Temporary we may find NI Approach is Correct but in the Long-Run, we
find MM Approach in Correct.

Q 6. SPC – Module 1 - Q 10
Effect of Debt funding on value of Equity Shares
Zeta Ltd is presently financed entirely by equity shares. The current Market
value is ₹ 6,00,000. A Dividend of ₹ 1,20,000 has just been paid. This level of
dividend is expected to generate Net cash receipts of ₹ 1,05,000 per annum
indefinitely. The project would be financed by issuing ₹ 5,00,000 debentures
at 18% Interest Rate. Ignoring tax consideration –
a) Calculate the value of Equity shares & the gain made by shareholders,
if the cost of equity rises to 21.6%
b) Prove that the weighted Average Cost of Capital is not affected by
gearing

Solution:-
a) Present Ke = ₹ 1,20,000 = 20% i.e. K0 = 20%
₹ 6,00,000
Chapter 4

b) Effect of New Project

Particulars ₹
EBIT ₹ 1,05,000
(-) Interest ₹ 90,000
Surplus available for Dividends ₹ 15,000
(+) Existing Dividend ₹ 1,20,000
Total Dividend to Equity holders ₹ 1,35,000
New Market Value of Equity = 1,35,000 ₹ 6,25,000
21.6%

4.12
 Existing Market Value ₹ 6,00,000
Gain to Equity Share Holders ₹ 25,000

Calculation of WACC

Component ₹ Weight Individual Cost WACC

Equity 6,25,000 0.55 21.6% 11.99
Debt 5,00,000 0.44 18% 7.99
20%

Q 7. SPC – Module 1 - Q 13
Financing Decision and EPS Maximization
India limited requires ₹ 50,00,000 for a new plant. This plant is expected to
yield earnings efore interest and taxes of ₹ 10,00,000. While deciding about the
financial plan, the company considers the objective of maximizing Earnings per
share.
It has 3 alternatives to finance the project – by raising Debt of ₹ 5,00,000

Chapter 4
or ₹ 20,00,000 or ₹ 30,00,000 and the balance in each case, by isuuing
equity shares. The company’s share is currently selling at ₹ 150, but it is
expected to decline to ₹ 125 in case the funds are borrowed in excess of ₹
20,00,000. The funds can be borrowed at the rate of 9% upto ₹ 5,00,000,
at 14% over ₹ 5,00,000 and upto ₹ 20,00,000 and at 19% over ₹
20,00,000. The tax rate applicable to the company is 40%. Which form of
financing should the company choose? Show EPS amount upto two
decimal points.

4.13
 Solution:-
We Know that ROCE = EBIT
Capital Employed
= 4,20,000
30,00,000
ROCE = 14.1%

Statement Showing EPS under the different schemes

Particulars Scheme I Scheme II Scheme III

Capital Employed 50,00,000 50,00,000 50,00,000
Debt 5,00,000 20,00,000 30,00,000
Equity 45,00,000 30,00,000 20,00,000
( ÷)Market Value 150 150 125
Number of Equity 30,000 20,000 16,000
EBIT 10,00,000 10,00,000 10,00,000
(-) Interest 45,000 2,55,000 4,45,000
Chapter 4

EBT 9,55,000 7,45,000 5,55,000

(-) Tax @ 40% 3,82,000 2,98,000 2,22,000
EAT 5,73,000 4,47,000 3,33,000
(÷)Number of Equity 30,000 20,000 16,000
EPS 19.1 22.35 20.8215

Scheme- II is better Option to Opt. Focus on No. of Share & Interest

with slab rate.

4.14
Q 8. SPC – Module 1 - Q 17
EBT – EPS Indifference Point –
Reverse working for Preference dividend rate
X Ltd. is considering the following two alternative financing plans:
Particulars Plan – I (₹) Plan – II (₹)
Equity shares of ₹ 10 each 12% 4,00,000 4,00,000
Debentures 2,00,000 -
Preference Shares of ₹ 100 each - 2,00,000
6,00,000 6,00,000
The indifference point between the plans is ₹ 2,40,000. Corporate tax rate is
30%. Calculate the rate of dividend on preference shares.

Solution :-
Computation of No. of Equity Shares

Particulars Plan 1 Plan 2

EBIT 2,40,000 2,40,000
(-) interest 24,000 -

Chapter 4
EBT 2,16,000 2,16,000
(-)Tax 64,800 72,000
EAT 1,51,200 1,68,000
(-)Preference Dividend - X
DI 1,51,200 1,68,000 - X
Number of Equity Share 40,000 40,000
1,51,200 = 1,68,000 - X
40,000 40,000
X = 16,800

4.15
 Rate of Pref. Dividend = 16,800 × 100
2,00,000
= 8.4%

Q 9. SPC – Module 1 - Q 18
Financial BEP and EBIT – EPS Indifference Point
The management of Z Company Ltd. wants to raise its funds from market
to meet out the financial demands of its long-term projects. The company
has various combinations of proposals to raise its funds. You are given the
following proposals of the company:

Proposal Equity Shares (%) Debts (%) Preference Shares (%)

P 100 - -
Q 50 50 -
R 50 - 50

i) Cost of debt and preference shares is 10% each.

Chapter 4

ii) Tax rate – 50%

iii) Equity shares of the face value of ₹ 10 each will be issued at a
premium of ₹ 10 per share.
iv) Total investment to be raised ₹ 40,00,000.
v) Expected earnings before interest and tax ₹ 18,00,000.
From the above proposals the management wants to take advice from you
for appropriate plan after computing the following:
 Earnings per share
 Financial break-even-point

4.16
 Solution :-
a) Computation Of EPS with given EBIT of ₹ 18,00,000
Particulars P Q R
Equity 40,00,000 20,00,000 20,00,000
Debt - 20,00,000 -
Preference share Capital - - 20,00,000
EBIT 18,00,000 18,00,000 18,00,000
(-) Interest - 20,00,000 -
EBT 18,00,000 16,00,000 18,00,000
(-) Tax 9,00,000 8,00,000 9,00,000
EAT 9,00,000 8,00,000 9,00,000
Pref. Dividend - - 20,00,000
DI 9,00,000 8,00,000 7,00,000
No. of Share (Issue Price) 2,00,000 1,00,000 1,00,000
EPS 4.5 8 -

b) Computation Of Financial BEP

Particulars P Q R

Chapter 4
EBIT 0 2,00,000 4,00,000
(-) Interest 0 2,00,000 -
EBT 0 - 4,00,000
(-) TAX 0 0 2,00,000
(-) EAT 0 0 2,00,000
(-) Pref. 0 0 2,00,000
DI 0 0 0
BEP = 0 2,00,000 4,00,000

4.16
 c) Computation Of EBIT – EPS Indifference Point
Particulars P Q R
EBIT X X X
(-) Interest - 2,00,000 X
EBT X x-2,00,000 X
(-) Tax 0.5x 0.5x -1,00,000 0.5 x
EAT 0.5x 0.5x – 1,00,000 0.5 x
(-) Pref. Div. - - 2,00,000
DI 0.5 x 0.5x – 1,00,000 0.5x – 2,00,000
No. of Share 2,00,000 1,00,000 2,00,000

 Indifference of
i) P & Q - 0.5 x = 0.5x – 1,00,000
2,00,000 1,00,000
X = 4,00,000

ii) Q & R - 0.5 x – 1,00,000 = 0.5x – 2,00,000

1,00,000 1,00,000
Chapter 4

Hence, There is zero (0) no indifference point

iii) P & R - 0.5 x = 0.5x – 2,00,000

2,00,000 1,00,000
0.25x = 0.5 – 2,00,000
X = 8,00,000

4.18
Self Note:-

Chapter 4
Chapter 4
Chapter 4
Chapter 4
 Following are the 5 Important questions out of total 25 questions from
CH 5 – DIVIDEND DECISIONS.
Which cover all the Important Adjustments.

Q 1. SPC – Module 1 – Q 5
Walter’s Model
The earnings per share of a company is ₹ 10 and the rate of capitalisation
applicable to it is 10 per cent. The company has three options of paying
dividend i.e.(i) 50%, (ii) 75% and (iii) 100%. Calculate the market price
of the share as per Walter’s model if it can earn a return of (a) 15, (b) 10 and
(c) 5 per cent on its retained earnings.

Solution :-

P = D + r (E – D)
Ke
Ke
Where
P = Price of Share
R = Rate of Earning
Ke = Rate of Capitalisation or Cost of Equity
EPS = 10 , Ke = 10%
Chapter 5

5.3
 Particulars 1 2 3
DP Ratio= 50% DP Ratio =75% DP= 100%
a) Price of
share if D + (E- D) × r D + (E- D) × r D + (E- D) × r
r = 15% Ke Ke Ke
Ke Ke Ke

= 5 + (10 – 5) × 15 = 7.5 + (10–7.5)× 15 = 100+(10–10)× 15

10 10 10
10% 10% 10%
= 125 = 112.5 = 100

b) Price of = 5 + (10 – 5) × 10 =7.5 + (10–7.5) × 10 =10 +(10 –10)× 10

share if 10 10 10
r = 10% 10% 10% 10%

= 100 = 100 = 100

c) Price of
= 5 + (10 – 5) × 5 =7.5 + (10–7.5) × 5 =10 +(10 –10)× 5
share if 10 10 10
r = 5% 10% 10% 10%
= 75 = 87.5 = 100
Chapter 5

5.4
Q 2. SPC – Module 1 – Q 8
Walter’s Model – Evaluation of Company’s Dividend Policy
The following information is supplied to you:

Particulars Amount (₹)

Total Earnings 2,00,000
No. of equity shares (of ₹ 100 each) 20,000
Dividend Paid 1,50,000
Price / Earning Ratio 12.5

i) Ascertain whether the company is the following an optimal dividend policy.

ii) Find out what should be the P/E ratio at which the dividend policy will have
no effect on the value of the share.
iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?

Solution :-
i) whether the company is the following an optimal dividend policy
a) Calculation of EPS
EPS = Total Earnings
No. of eq. shares
= 2,00,000
20,000
= 10
Chapter 5

b) Calculation of Dividend per share

Dividend per share = Dividend paid
No. of Shares
= 1,50,000
20,000
= 7.5
5.5
 c) Calculation Present Ke
Ke = 1
PE Ratio
= 1
12.5
= 8%
d) Calculation of Present Return on Investment
r = Total earing
NOS × Face Value
= 2,00,000 × 100
20,00,000
= 10%
e) Calculation of Market Price as per Walter’s Formula
MP = D + (E – D) × r
Ke
Ke
= 7.5 + (10 – 7.5) × 10
8
8%
= 132.81
r > Ke, company should not distribute dividend. Dividend should be Zero.
Since, Dividend Payout ratio of company is 1,50,000 = 75%, it is not
2,00,000
Chapter 5

following the Optimal Policy.

f) Calculation of Market price when Dividend is Zero.
MP = D + (E – D) × r
Ke
Ke

5.6
 = 0 + (10 – 0) × 10
8
8%
= 156.25

Impact an dividend when-

Ke > r Ke < r Ke = r
Give Maximum r = 10% r = 10%
Dividend Ke=8% Ke=10%
In this case the
This condition has an Dividend = 0 company can give the
impact on dividend. Dividend on the
This condition has an willing ness it want to
impact on dividend. give.

This condition has no

impact on Dividend.

Ke= r
r= 10%
Ke =10%

Chapter 5
ii) Calculation of PE Ratio
Ke = 1
PE Ratio
PE Ratio = 1
Ke
= 1
10%
5.7
 PE Ratio = 10 times

iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?
If the P/E is 8 instead of 12.5, then the ke which is the inverse of P/E ratio,
would be 12.5 and in such a situation ke > r and the market price, as per
Walter’s model would be
MP = D + (E – D) × r
Ke
Ke
= 7.5 + ( 10 – 7.5) × 10
12.5
12.5%

= ₹ 76
The optimal dividend policy for the firm would be to pay 100% dividend and
market price of share in such case would be
Mp = 10 + ( 10 – 10) × 10
12.5
12.5%
= ₹ 80
Chapter 5

5.8
Q 3. SPC – Module 1 – Q 13
Mr. A is contemplating purchase of 1,000 equity shares of a Company. His
expectation of return is 10% before tax by way of dividend with an annual
growth of 5%. The Company’s last dividend was ₹ 2 per share. Even as he is
contemplating, Mr. A suddenly finds, due to a Budget announcement
Dividends have been exempted from Tax in the hands of the recipients. But
the imposition of Dividend Distribution Tax on the Company is likely to lead
to a fall in dividend of 20 paise per share. A’s marginal tax rate is 30%.
Required:
Calculate what should be Mr. A’s estimates of the price per share before
and after the Budget announcement?

Solution :-
The formula for determining value of a share based on expected dividend is:
P0 = D0 ( 1 + g)
K-g
Where,
P0 = Price (or value) per share
D0 = Dividend per share
g = Growth rate expected in dividend
k = Expected rate of return

Particulars Before Budget After Budget

Chapter 5
Announcement Announcement
Growth 5% 5%
Ke 10% 7%
D1 2 + 5% = 2% 2 – 0.2 = 1.8
1.8 + 5% = 1.89

5.9
 P0 = D1 2.1 1.89
Ke - g 10% - 5% 7% - 5%
= ₹ 42 = ₹ 42

Q 4. SPC – Module 1 – Q 16
X Ltd. is a Shoes manufacturing company. It is all equity financed and has
a paid up Capital of ₹ 10,00,000 (₹ 10 per share)
X Ltd. has hired Swastika consultants to analyse the future earnings. The
report of Swastika consultants states as follows:
i) The earnings and dividend will grow at 25% for the next two years.
ii) Earnings are likely to grow at the rate of 10% from 3rd year and
onwards.
iii) Further, if there is reduction in earnings growth, dividend payout ratio
will increase to 50%.
The other data related to the company are as follows:

Year EPS (₹) Net Dividend per share (₹) Share Price (₹)
2010 6.30 2.52 63.00
2011 7.00 2.80 46.00
2012 7.70 3.08 63.75
2013 8.40 3.36 68.75
2014 3.84 93.00
Chapter 5

9.60
You may assume that the tax rate is 30% (not expected to change in
future) and post-tax cost of capital is 15%.
By using the Dividend Valuation Model, calculate
i) Expected Market Price per share
ii) P/E Ratio.
5.10
 Solution :-
It is assumed Dividend growth rate is 10%; Ke=15%
Year EPS ₹ DPS ₹ PVF @ 15% PV of DPS ₹
2015 12(9.6 + 25%) 4.8 (3.84 + 25%) 0.8695 4.1736
2016 15 6 0.7561 4.536
2017 16.5 (15+ 10%) 8.25 (16.5 *50%) 0.6575 5.424
14.141

i) Calculation of [perpetual & Constant Growth] market price

P0 = D1
Ke – g
= 8.25 + 10%
15% - 10%
= 9.075
5%
= 181.5
This is the value of 3rd Year
PV of 181.5 which is received at the end of 3rd Year
PV of 181.5 = 181.5 × 0.6575
= 119.34
Total value = Value gained in first 3rd Year + value gained in perpetually
= 14.141 + 119.34
Chapter 5
= 133.481

ii) Calculation of PE Ratio

P/E Ratio = MPS
EPS
= 133.481 = 13.90
9.60
5.11
 Q 5. SPC – Module 1 – Q 25
M – M Approach
ABC Ltd. has 50,000 outstanding shares. The current market price per share
is ₹ 100 each. It hopes to make a net income of ₹ 5,00,000 at the end of
current year. The Company’s Board is considering a dividend of ₹ 5 per
share at the end of current financial year. The company needs to raise ₹
10,00,000 for an approved investment expenditure. The company belongs to
a risk class for which the capitalization rate is 10%. Show, how the M-M
approach affects the value of firm if the dividends are paid or not paid.

Solution :-
1) Calculation of Price of Shares :-
a) When Dividend is not paid
P1 = P0 ( 1+ ke)
= 100 ( 1+ 0.10)
P1 = 110
b) When Dividend Declared /paid
P1 = P0 ( 1+ ke)- D1
= 100 ( 1+ 0.10)- 5
= 110-5
P1 = 105
Chapter 5

2) Calculation of Number of Shares :-

a) When dividend is not paid
Δn = I – ( E- D)
P1
= 10,00,000 –( 5,00,000 – 0)
110

5.12
 = 4545 shares
b) When Dividend is paid
Δn = I – ( E- D)
P1
= 10,00,000 –( 5,00,000 – 2,50,000)
105
= 7142 shares

3) Market value of firm

a) When Dividend is not Declared
MV1 = n1 × P1
= (50,000 + 4545) × 110
= 59,99,950
b) When Dividend is paid
MV1 = n1 × P1
= (50,000 + 7142) × 105
= 59,99,910

Q 6. SPC – Module 1 – Q15

In December, 2011 AB Co.'s share was sold for ₹ 146 per share. A long term
earnings growth rate of 7.5% is anticipated. AB Co. is expected to pay
dividend of ₹ 3.36 per share.
i) What rate of return an investor can expect to earn assuming that
Chapter 5
dividends are expected to grow along with earnings at 7.5% per year in
perpetuity?
ii) It is expected that AB Co. will earn about 10% on book Equity and shall
retain 60% of earnings. In this case, whether, there would be any
change in growth rate and cost of Equity?

5.13
 Solution :-
i) According to Dividend Discount Model approach the firm’s expected or
required return on equity is computed as follows:
Ke = D1 + g
P0
= 3.36 + 7.5%
146
= 9.80%

ii) With rate of return on retained earnings (r) 10% and retention ratio (b)
60%, new growth rate will be as follows:
g=br
= 0.10 X 0.60
= 0.06
Accordingly dividend will also get changed and to calculate this, first we
shall calculate previous retention ratio (b1) and then EPS assuming that
rate of return on retained earnings (r) is same.

With previous Growth Rate of 7.5% and r =10% the retention ratio comes out
to be: 0.075 = b1 X 0.10
b1 = 0.75 and payout ratio = 0.25
With 0.25 payout ratio the EPS will be as follows:
Chapter 5

3.36 = 13.44
0.25

With new 0.40 (1 – 0.60) payout ratio the new dividend will be
D1 = 13.44 X 0.40 = 5.376

5.14
Accordingly new Ke will be
Ke = 5.376 + 6%
146
= 9.68%

Chapter 5

5.15
 Self Note:-
Chapter 5
Chapter 5
Chapter 5
Chapter 5
 Self Note:-
Chapter 6
Chapter 6
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