Name: Duration: 2 Hours 15 mins Sec:

Roll No.: Finance II Mid-term Examination 13th Feb 2020

Answer all the questions in the answer booklet only. DO NOT write with pencil. Untidy
work will be penalized. Rough work should be done at the end of the answer sheet. Only
Pen and Calculator are allowed.

Maximum Marks 45

Part A: State TRUE or FALSE for the sub-questions (Negative 50% Penalty for Wrong
Attempts): (15 marks). RESPOND ONLY IN THE ANSWER BOOKLET.

1. The discounted payback rule calculates the payback period and then discounts the
payback period at the opportunity cost of capital.
2. The phenomenon called "multiple internal rates of return" arises when two or more
mutually exclusive projects that have different lives are being compared.
3. An NPV profile graph is designed to give decision makers an idea about how a
project’s contribution to the firm’s value varies with the cost of capital.
4. The payback rule does not ignore cash flows after the cut-off or break-even time.
5. In the case of a loan project (borrowing), one should accept the loan if the IRR of the
loan cash flows is more than the cost of capital.
6. A project's internal rate of return depends on the scale of investment.
7. For a value creating project having more than one IRR, both IRRs must be greater
than the WACC.
8. Project X has the following cash flows to an entrepreneur: C0 = +2,000, C1 = -1,300,
and C2 = -1,500. If the IRR of the project is 25% and if the cost of capital is 18%,
project should be rejected by the entrepreneur.
9. Firms with high business risk tend to have higher asset betas for firms within a given
sector.
10. A project that has been accepted based payback period approach may have an IRR
that is lower than its discount rate.
11. A stream of cash flows with no sign change, that is all positive cash flows, will have
no IRR.
12. If a diversified firm uses same cost of capital for evaluating investments in different
divisions then it might end up selecting poor projects.
13. A pure play firm is typically a comparable firm in the same industry that specializes
in one activity, and is not diversified.
14. To estimate the market risk premium from historical data, the current government
bond yield-to-maturity is deducted from the historical average return on a broader
market index.
15. For positive cost of equity and debt, the WACC is always equal to or less than the
cost of equity.
Part B

Question 1. You are analysing whether a project is viable investment opportunity. As part of
the analysis you have conducted a focus group study costing Rs. 100,000 to understand the
demand for the product. The findings of the focus group study were presented to the board of
directors. The directors were impressed with the findings and have now approved considering
the following project only if it a value creating opportunity.

The project will last three years, and following are the relevant estimates related to it:

Your estimates suggest that you will be able to sell 12500, 13250 and 13750 units of the
product over next three years and revenue per unit will be Rs. 120 per unit. The EBITDA
(Earnings before interest, tax and depreciation) or gross margin expected on these sales is
40%.

This project requires capital expenditure of Rs. 1,200,000 in plant and machinery. Two-thirds
of this expenditure will be made now and the balance at the end of the first year. The plant
and machinery would be available for use from the very first year of the project.

The plant will be set up in premises owned by your company. The premises generally were
rented out to a third party for Rs. 50,000 every year.

The depreciation on plant and machine is Rs. 400,000 every year for the next 3 years. The
sale of plant and machinery will fetch Rs. 250,000, when the project is over.

The project requires working capital of 5% of revenues every year; however, this investment
will be made at the beginning of the year (beginning of year 1, year 2 and so on). The
working capital would be recovered in full at the end of the third year.

The appropriate marginal tax rate is 34%. The company pays the same rate as the capital gain
tax.

a. Calculate the net operating profit after tax (4 marks)

b. Calculate the Free cash flows (net cash flows from operations) for the project. (4 marks)

b. If the opportunity cost of capital is 15%, what is the NPV of the project. (1 mark)
Question 2. Indian Dairy Ltd. (IDL) is a firm with 2 divisions. IDL is in the business of a.
supplying liquid milk to milk depots, hotels, hostels and messes, and b. dairy products which
includes butter, paneer, ghee etc.

IDL has estimated that their current debt-to-total value ratio is 35% and the company is
targeting for debt-to-total value of 55%. The company estimates that default risk premium
would increase to 180 basis points1 at the debt-to-total value ratio of 55%.

Given that the demand for chocolates has increased 24% between 2017 and 2019 and India is
one of the fastest growing chocolate markets, IDL wants to diversify into chocolates. The
chocolate unit would be their third division. However, IDL is in dilemma how to estimate the
cost of capital for their new division (i.e., chocolate division).
The company wants to keep a target debt-to-total value ratio of chocolate division at 45%,
and at this debt-to-total value ratio, the new division faces a default risk premium of 220
basis points, if operating as an individual and independent entity. The applicable tax rate is
30%.
The beta of IDL is estimated at 1.4 before the changes in capital structure and before the
introduction of chocolate division.

You have found following Indian Govt. interest rates.

Maturity Rate
1-year T-bill 5.50%
1-year Govt. bond 6.25%
10-year Govt. bond 7.5%

You have gone through many reports and historical data to find risk premium. You
have found the following risk premiums.

Spread between S&P 500 returns and long-term Arithmetic 6.75%

Spread
bonds between S&P 500 returns and long-term Geometric
return 6.25%
bonds return
In order to compare the new division of IDL, you have collected various information of
chocolate companies

Company Levered Debt (Rs. In Market value of Sales

beta crore) equity (in Rs. (in Crore)
Crore)
Hindustan Confectionary Ltd. 1.25 2000 3500 150
Tasty Bytes Chocolates Ltd. 1.75 2500 4500 120
Bournville Ltd. 0.95 1000 1800 75
Crunchy Munchy Ltd. 1.10 1500 2200 60

1
100 basis points are equal to 1 percentage point.
I. Assuming that you consider it appropriate to use a historical market risk premium,
calculate IDL’s weighted average cost of capital before the introduction of chocolate division
but after incorporating proposed changes in the capital structure. State your assumptions
clearly. (3 marks).

II. Assuming that you consider it appropriate to use a historical market risk premium,
calculate the following for the Chocolate division (State your assumptions clearly):

a. The cost of debt (1 mark)

b. Appropriate beta for the division (3 marks)

c. The cost of equity as per CAPM (2 marks)

d. The weighted average cost of capital (1 mark)

III. You find that dairy products division of IDL has a distinct 35% debt-to-total value, with a
default risk premium of 160 basis points, if operating as an individual and independent entity.
The identifiable assets of three divisions are Rs.2200 crores, Rs.1700 crores, and Rs.650
crores for milk supply, dairy product and chocolate divisions, respectively. Assume levered
beta of the milk supply division is 1.25 at a debt-to-total value of 40%, when operating as an
independent entity, and the firm’s levered beta to remain same as before.

a. Calculate the Beta of dairy product division (2 marks)

b. Calculate cost of debt and cost of equity (2 marks)
c. Weighted average cost of capital for the dairy division (1 mark)

Question 3. Consider the following cash flows of two mutually exclusive projects with
similar risk:

Time 0 1 2 3
Cash flows of Project A -50000 35000 20000 x
Cash flows of Project B -50000 y 10000 55000

The IRR of Project A is 18.17% approximately. The projects have same net present value at
the discount rate of 15.65%.

a. Compute the value of x (2 marks)

b. How much will be the present value of the subsidy to bring the project A at 20% IRR.
What will be the timing of the subsidy if the cost of capital for the subsidy donor is 15%, (2
marks)

c. What is the value of y? (2 marks)