Workbook (Time Value of Money and Capital Budgeting) 1.

As a newly-minted BBA embarking on a career in investment banking, you naturally must own a BMW 325is immediately. The car costs $28,320. You also have to spend $3,248 on blue pin-stripe suits. Your salary this year is $42,000, and next year it will be $46,000. Your routine living expenses this year will be $34,000. You plan to make up the difference between current income and current consumption by borrowing; the interest rate for the loan is 14% and you intend to repay the loan, plus interest, in one year. How much will you have left to spend next year? Solution: This year you need a total of ($28,320 + $3,248 + $34,000) = $65,568. So you must borrow ($65,568 $42,000) = $23,568 this year. The amount you will have to repay next year is: FV1 = 23,568 1.14 = $26,867.52 Therefore, you will have ($46,000 - $26,867.52) = $19,132.48 of next year's income left to spend. 2. For each of the following, calculate the effective annual rate (EAR): Stated rate 5% 11% 16% Solution: Stated rate 5% 11% 16% Compounding frequency semiannually quarterly daily Effective rate 5.063% 11.462% 17.347% Number of times compounded semiannually quarterly daily Effective rate

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3. An investment will increase in value by 270% over the next 17 years. What is the annual interest rate which, when compounded quarterly, provides this return? Solution: Solve the following equation for r (where PV is the beginning amount): PV (1 + r/4)68 = PV (1 + 2.70) = 3.70C r/4 = (3.70)1/68 - 1 = .019426 r = .07770 = 7.770%. 4. What is the PV of an income stream which provides Rs 2,000 a year for the first five years and then Rs 3,000 a year forever thereafter, if the discount rate is 10 %? Solution: Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is equivalent to saving Rs.2000 a year for 15 years and Rs.1000 a year for the years 6 through 15. Hence the savings will cumulate to: 2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years) = 2000 x 31.772 + 1000 x 15.937 = Rs.79481. Suppose someone offers you the following financial contract. If you deposit Rs 20,000 with him, he promises to pay Rs 4,000 annually for 10 years. What interest rate would you earn on this deposit? Solution: Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years) PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00 From the tables we find that: PVIFA (15%, 10 years) = PVIFA (18%, 10 years) = Using linear interpolation we get: r = 15% + = 15.1% 5.019 5.00 ---------------5.019 4.494 x 3% 5.019 4.494

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5. Suppose you deposit Rs 10,000 with an investment company which pays 16% interest with quarterly compounding. How much will this deposit grow to in 5 years? Solution: FV5

= = = =

Rs.10,000 [1 + (0.16 / 4)]5x4 Rs.10,000 (1.04)20 Rs.10,000 x 2.191 Rs.21,910

6. If the interest rate is 12 % how much investment is required now to yield an income of Rs 12,000 per year from the beginning of the 10th year and which continues thereafter forever? Solution: Investment required at the end of 8th year to yield an income of Rs.12,000 per year from the end of 9th year (beginning of 10th year) for ever: Rs.12,000 x PVIFA(12%, ) = Rs.12,000 / 0.12 = Rs.100,000 To have a sum of Rs.100,000 at the end of 8th year , the amount to be deposited Rs.100,000 = PVIF(12%, 8 years) 2.476 Rs.100,000 = Rs.40,388 now is:

7. Company A has to retire Rs 10 million of debentures each at the end of 8,9, and 10 years from now. How much should the firm deposit in a sinking fund account annually for 5 years, in order to meet the debenture retirement need? The net interest rate earned is 8%. Solution: The discounted value of the debentures to be redeemed between 8 to 10 years evaluated at the end of the 5th year is: Rs.10 million x PVIF (8%, 3 years) + Rs.10 million x PVIF (8%, 4 years) + Rs.10 million x PVIF (8%, 5 years) = Rs.10 million (0.794 + 0.735 + 0.681) = Rs.2.21 million If A is the annual deposit to be made in the sinking fund for the years 1 to 5, then A x FVIFA (8%, 5 years) = Rs.2.21 million A x 5.867 = Rs.2.21 million A = 5.867 = Rs.2.21 million A = Rs.2.21 million / 5.867 = Rs.0.377 million 8. Phoenix Company borrows Rs 500,000 at an interest rate of 14 %. The loan is to be repaid in 4 equal installments payable at the end of each of the next 4 years. Prepare a loan amortization schedule.
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Solution: Equated annual installment Loan Amortisation Schedule Year 1 2 3 4 Beginning amount 500000 398415 282608 150588 Annual installment 171585 171585 171585 171585 Interest repaid 70000 55778 39565 21082 Principal balance 101585 115807 132020 150503 Remaining 398415 282608 150588 85* = 500000 / PVIFA(14%,4) = 500000 / 2.914 = Rs.171,585

(*) rounding off error 9. Cash Enterprises is considering a capital project about which the following information is available: The investment outlay on the project will be Rs 100 million. This consists of Rs 80 million on the plant and machinery and Rs 20 million on net working capital. The entire outlay will be incurred at the beginning of the project. The project will be financed with Rs 45 million of equity capital, Rs 5 million of preference capital, and Rs 50 million of debt capital. Preference capital will carry a dividend rate of 15 %; debt capital will carry an interest rate of 15 %. The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will fetch a net salvage value of Rs 30 million, whereas net working capital will be liquidated at its book value. The project is expected to increase the revenues of the firm by Rs 120 million per year. The increase in costs on account of the project is expected to be Rs 80 million per year. (This includes all items of costs other than depreciation, interest and tax). The effective tax rate will be 30 %. Plant and machinery will be depreciated at the rate of 25 % per year as per the written down value method. Hence, the depreciation charges will be: First year : Rs 20.00 million Second year : Rs 15.00 million Third year : Rs 11.25 million

Fourth year : Rs 8.44 million Fifth year : Rs 6.33 million

Given the above details, the project cash flows are shown below:

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Year 1. Fixed Assets 2. Net working capital 3. Revenues 4. Costs (other than depreciation and interest) 5. Depreciation 6. Profit before tax 7. Tax 8. Profit after tax 9. Net salvage value of fixed assets 10. Recovery of net working capital 11. Initial outlay 12. Operating cash flow (8+5) 13. Terminal Cash flow (9+10) 14. Net cash flow (11+12+13) Book Value of Investment

0 (80.00) (20.00)

Rs in million 2 3

120 80 20 20 6 14.0

120 80 15 25 7.5 17.5

120 80 11.25 28.75 8.63 20.12

120 80 8.44 31.56 9.47 22.09

120 80 6.33 33.67 10.10 23.57 30.00 20.00 29.90 50.00 79.90

(100.00) 34.0 (100.00) 100 34.0 80 32.5 32.5 65 31.37 31.37 53.75 30.53 30.53 45.31

10.Pharma Ltd is engaged in the manufacture of pharmaceuticals. The company was established in 1991 and has registered a steady growth in sales since then. Presently, the company manufactures 16 products and has an annual turnover of Rs 2200 million. The company is considering the manufacture of a new antibiotic preparation, K-cin, for which the following information has been gathered. a) K-cin is expected to have a product life cycle of five years and thereafter it would be withdrawn from the market. The sales from this preparation are expected to be as follows: Year Sales (in million Rs) 1 2 3 4 5 100 150 200 150 100

b) The capital equipment required for manufacturing K-cin is Rs 100 million and it will be depreciated at the rate of 25 % per year as per the WDV method for tax purposes. The expected net salvage value after 5 years is Rs 20 million. c) The working capital requirement for the project is expected to be 20 % of sales. At the end of 5 years, working capital is expected to be liquidated at par, barring an estimated loss of Rs 5 million on account of bad debt. The bad debt loss will be a tax deductible expense. Page 5

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d) The accountant of the firm has provided the following cost estimates for Kcin: Raw material cost : 30 % of sales Variable labor cost : 20 % of sales : Rs 5 million

Fixed annual operating and maintenance cost Overhead allocation (excluding depreciation, Maintenance and interest )

: 10 % of sales

While the project is charged on an overhead allocation, it is not likely to have any effect on overhead expenses as such. e) The manufacturer of K-cin would also require some of the common facilities of the firm. The use of these facilities would call for reduction in the production of other pharmaceutical preparations of the firm. This would entail a reduction of Rs 15 million of contribution margin. f) The tax rate applicable to the firm is 40 %. Hints: The loss of contribution is an opportunity cost Overhead expenses allocated to the project have been ignored as they do not represent incremental overhead expenses for the firm as a whole. It is assumed that the level of working capital is adjusted at the beginning of the year in relation to the expected sales for the year. For example, working capital at the beginning of the year 1 (i.e. at the end of year 0) will be Rs 20 million, that is 20 % of the expected revenues of Rs 100 million for year 1. Likewise, the level of working capital at the end of year 1 (i.e. at the beginning of year 2) will be Rs 30 million that is 20 % of the expected revenues of Rs 150 million for year 2.

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1. Capital Equipment 2. Level of working capital (ending) 3. Revenues 4. Raw material cost 5. Labour cost 6. Operating and maintenance cost 7. Loss of contribution 8. Depreciation 9. Bad debt loss 10. Profit before tax 11. Tax 12. Profit after tax 13. Net salvage value 14 Recovery of WC 15. Initial Investment 16. Operating Cash flow (12+8+9) 17. Change in WC 18. Terminal Cash flow (13+14) 19. Net cash flow (15+16-17+18)

0 (100) 20

1 30 100 30 20 5 15 25 5 2 3

Rs in million 2 3 40 150 45 30 5 15 18.8 36.2 14.5 21.7 30 200 60 40 5 15 14.1 65.9 26.4 39.5

4 20 150 45 30 5 15 10.5 44.5 17.8 26.7

5 0 100 30 20 5 15 7.9 5 17.1 6.8 10.3 20 20 23.2 40 63.2

(100) 20 (120) 28 10 18 40.5 10 30.5 53.6 (10) 63.6 37.2 (10) 47.2

11.Aunt Sally's Sauces, Inc., is considering expansion into a new line of all-natural, cholesterol-free, sodium-free, fat-free, low-calorie tomato sauces. Sally has paid $50,000 for a marketing study which indicates that the new product line would have sales of $650,000 per year for each of the next six years. Manufacturing plant and equipment would cost $500,000, and will be depreciated according to ACRS as a five-year asset. The fixed assets will have no market value at the end of six years. Annual fixed costs are projected at $80,000 and variable costs are projected at 60% of sales. Net working capital requirements are $75,000 for the six-year life of the project; the outlay for working capital will be recovered at the end of six years. Aunt Sally's tax rate is 34% and the firm requires a 16% return. a) Compute the annual depreciation and the ending book value for the fixed assets. [ Ans: Dep for year 4 = 57,600, BV for year 5 = 28,800]

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b) Prepare pro forma income statements for the project for years 1 through 6. [ Ans: NI for year 4 = 80,784, for year 6 = 99,792]

c) Compute operating cash flow for the project for years 1 through 6. [ Ans: OCF for year 3 = 151,440; year 6 = 128,592]

d) Compute total projected cash flows for years 0 through 6 for the project. [Ans: Total inflow for year 6 is $203,592 ] Initial cash outflow is $575,000 (= $500,000 + 75,000). For year 6, recovery of net working capital results in a cash inflow of $75,000. Fixed assets are fully depreciated at the end of year 6 and have zero market value, so there are no consequences for cash flows from disposal of fixed assets at the end of the project's life. Total inflow for year 6 is $203,592 (= $128,592 + $75,000). e) Compute the net present value and the internal rate of return for the new product line. [ Ans: $8,338.58, 16.539%.] PV = $152,800/(1.16) + $173,200/(1.16)2 + $151,440/(1.16)3 + $138,384/(1.16)4+ $138,384/(1.16)5 + $203,592/(1.16)6 = $583,338.58. The NPV is ($583,338.58 - $575,000) = $8,338.58, so the new product line is an acceptable investment. The $50,000 marketing study is a sunk cost and irrelevant. IRR is 16.539%. [Read the book for the following three approaches to compute operating cash flows] f) Use the tax-shield approach to compute the operating cash flow for years 1 through 6.
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g) Use the 'bottom-up' approach to compute the operating cash flow for years 1 through 6.

h) Use the 'top-down' approach to compute the operating cash flow for years 1 through 6.

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