FIN303 Financial Management

ANSWER 1

Part A (i)

The amount of interest that shall be paid in the first month of the twenty fifth year is $ 705.6246.

The computation has been done by using IPIM formula in excel.

Sl No	Particulars	Amount ($)
1	Loan amount	800000
2	Tenure	30 years
3	Saving Interest Rate	1.20%
4	Loan Interest rate	3.60%
5	Monthly EMI	3637.16
6	Total Amount of Emi	1309378.61
7	Interest	509378.61
8	Computation of interest at the beginning of 25th Year	705.62

Part A (ii)

The interest component of EMI over the life of the loan has been computed at $509378.61.

(For Computation refer Above)

Part B

On perusal of the details presented in excel along with amortisation schedule for cross verification, it can be seen that under the proposed loan arrangement, the principal component is $ 800,000 and interest computed on the principal over 360 months i.e. tenure of the project is $5,09,378. The interest component represent approximately 60% of principal and has been generated over the years.  It shall also be pertinent to note that for repayment of loan, the amount initially is set against the principal and then against the interest, as result the same piled upto 60% over a period of 30 years. In addition, the interest amount is higher under the initial stage of loan and the same decreases as the loan maturity approaches.

The following assumptions have been undertaken while computation:

• There has been no prepayment of loan;
• There has been no intention to set off the loan earlier;
• There has been no change in rate of interest;
• There is no default of loan

Part C

The answer to the question of Present value of loan by discounting @1.2 % compounded monthly is $ 1,09,9143.923. (Refer Appendix-1)

Part D

On perusal of the computation in Excel, it shall be seen that the present value of loan when discounted @1.2% is greater than the initial amount of principal lent under the agreement. Further, the method is based on time value of money and the difference arise on account of different in rate of interest used. In addition, the rate of discount used for the purpose of computation of present value is risk free interest rate as interest on savings is nearly equivalent to risk free interest. Also, the discounted EMI includes both interest and principal.

The difference between the principal actually granted initially and the computed value of present loan by discounting @1.2% $ 2,99,143.9229. The same implies that I am paying extra amount to lender on account of risk that has been borne by him by giving me loan. The amount that has been awarded to lender on account of extra risk borne by him stands at $ 2,99,143.9229

Thus, in short the rationale for difference in interest rate and difference in principal computed and the principal actually is isk undertaken by the person lending the money.

 Question 2

Part A (i)

The computation of WACC is presented here-in-below:

Weighted Average Cost of capital
Sl NO	Particular	Cost
1	Cost of Debt	8%
2	Cost of Debt post tax	6.4%
3	Risk Free rate	5%
4	Market return	15%
5	Risk Premium	10%
6	Beta	1.20
7	Cost of Equity	17.00%
8	Weight of Debt	3.00
9	Weight of Equity	6
10	Weight of Debt	3
11	WACC	13.47%

 

Computation of beta
Sl NO	Particular	Cost
1	Beta Levered	1.2
2	Beta Unlevered	0.857142857
3	Beta of Proposed project	1.2

It shall be pertinent to note that for deriving the cost of equity of the tested company only Bad Inc.  Beta has been taken as the company activities are similar to the tested company. Accordingly, the cost of equity stands at 13.47%.

Part A (ii)

The discount rate which has been used for the purpose of analysing the project is 13.47%. The rationale for using the said rate as it encompasses the desired rate of return by the financers of the project i.e. cost and equity. Further, the rate specifies the minimum rate below which the company should not accept the project. (CFI Education Inc., 2018)

In addition, it has been assumed that MM approach holds good, hence even if the capital structure changes the cost of capital shall remain constant at 13.47%. Besides, the above stated rate represent the desired rate of return by equity and debt shareholders and serve as hurdle rate for the said project.

Part B (i)

The details of the cash flow for first five years of the project has been provided here-in-under:

Sl No	Particular	year 0	year 1	year 2	year 3	year 4	year 5	Terminal Value
1	Revenue		800	960	1152	1382.4	1658.88
2	Annual Working Cost (Variable)		-240	-288	-345.6	-414.72	-497.664
3	Fixed Cost		-80	-80	-80	-80	-80
4	Depreciation		-120	-120	-120	-120	-120
5	EBIT (1-2-3-4)		360	472	606.4	767.68	961.216
6	Tax (5*20%)		-72	-94.4	-121.28	-153.536	-192.2432
7	EBI (5-6)		288	377.6	485.12	614.144	768.9728
8	Depreciation		120	120	120	120	120
9	OCF		408	497.6	605.12	734.144	888.9728

Part B(ii)

The details of change in working capital has been provided in the solution above

Sl No	Particular	year 0	year 1	year 2	year 3	year 4	year 5	Terminal Value
1	Net Working Capital Level		80	96	115.2	138.24	165.888
2	Change in Net Working Capital		80	16	19.2	23.04	27.648
3	Net Cash flow from sale of Asset							240
4	Realisation of Net working capital at end							165.888

Part B(iii)

Sl No	Particular	year 0	year 1	year 2	year 3	year 4	year 5	Terminal Value
1	Infrastructural Investment	-600
2	Depreciation		-120	-120	-120	-120	-120
3	Salvage Value							240
4	Revenue		800	960	1152	1382.4	1658.88
5	Annual Working Cost		-240	-288	-345.6	-414.72	-497.664
6	Working Capital		-80	-16	-19.2	-23.04	-27.64	165.88
7	Fixed Cost		-80	-80	-80	-80	-80
8	Net Cash Flow		280	456	587.2	744.64	933.576	405.88
9	Tax		-72	-94.4	-121.28	-153.536	-192.2432
10	Cash Flow after Tax		208	361.6	465.92	591.104	741.3328	405.88
11	Depreciation		120	120	120	120	120
12	Cash Flow after Tax & Depreciation		328	481.6	585.92	711.104	861.3328	405.88
13	Discounting factor	1	0.881316	0.776718	0.684534	0.603291	0.53169003	0.53169003
14	Present Value of Cash flows	-600	289.0717	374.0674	401.0822	429.0026	457.9620621	215.8023493
15	Net Present Value	1566.988

Assumption

• Fees paid in Annual instalment is sunk cost
• Changes in Working Capital is realised at end

Part B(iv)

On the basis of above computation, the project shall be accepted as the Net present value computed stands at $1567.651at a discounting rate of 13.47 %. Since Net Present Value is positive, project shall be accepted.

Question 3

PART A (i)

Sl No	Particulars	Quantity	Rate	Amount
1	Share	5000	60	300000
2	10 Year Bond	150	1000	150000
3	Buy Back Shares	2500	60	150000
4	Cost of Debt before Tax			6%
5	Earnings Before Interest and Tax			28000
6	Tax Rate			NiL
7	Profit after Taxt			28000
8	Dividend Per Share			5.6
9	Dividend received by Maureen	100	5.6	560	Answer (a(i))

PART A (ii)

Sl No	Particulars	Quantity	Rate	Amount
1	Share	5000	60	300000
2	10 Year Bond	150	1000	150000
3	Buy Back Shares	2500	60	150000
4	Cost of Debt before Tax			6%
5	Earnings Before Interest and Tax			28000
6	Tax Rate			NiL
7	Profit after Tax			28000
8	Dividend Per Share			5.6
9	Dividend received by Maureen	100	5.6	560
10	Buy Back Shares	2500	60	150000	Answer (a(ii))

PART A (iii)

Sl No	Particulars	Quantity	Rate	Amount
1	Share	5000	60	300000
2	10 Year Bond	150	1000	150000
3	Buy Back Shares	2500	60	150000
4	Cost of Debt before Tax			6%
5	Earnings Before Interest and Tax			28000
6	Tax Rate			NiL
7	Profit after Tax			28000
8	Dividend Per Share			5.6
9	Dividend received by Maureen	100	5.6	560
10	Buy Back Shares	2500	60	150000
11	Earnings Before Interest and Tax			28000
12	Interest			9000
13	Profit after Tax			19000
14	Dividend per share			7.6
15	Dividend received by Maureen	100	7.6	760	Answer (a(iii))

PART A (iv)

Sl No	Particulars	Amount
1	No of shares under existing Capital Structure	100
2	Proportion of debt in the capital structure of the company	50%
3	Total Capital of Maureen	6000
4	Total  value of shares to be sold	3000
5	Total debt to be let out	3000
6	Receipt of dividend	380
7	Interest	180
8	Total Receipt	560

PART A (v)

As per Modigliani Miller theory, it is irrelevant to analyse the capital structure as the same does not contribute to the value of the company rather the same is derived by the net operating cash flow of the company. However, under such thesis there is no transaction cost and taxes. The assumption behind the same proposition is that there are no taxes and transaction cost for raising finance. However, the above proposition does not hold true when the aforesaid assumptions are violated. In such a scenario, MM has proposed that the value of the company shall be increased by the present value of tax savings on account of interest on debt.

In addition the theory holds that WACC of the company remains consistent and addition of debt in the company capital structure increased cost of equity.

PART B (i,ii &iii)

Sl No	Particulars	Quantity	Rate	Amount
1	Share	5000	60	300000
2	10 Year Bond	150	1000	150000
3	Buy Back Shares	2500	60	150000
4	Cost of Debt before Tax			6%
5	Earnings Before Interest and Tax			28000
6	Tax Rate			20%
7	Profit after Tax			22400
8	Dividend Per Share			4.48
9	Dividend received by Maureen	100	4.48	448
10	Buy Back Shares	2500	60	150000
11	Earnings Before Interest and Tax			28000
12	Interest			9000
13	Profit after Tax			15200
14	Dividend per share			6.08
15	Dividend received by Maureen	100	6.08	608

PART B (iv)

Sl No	Particulars	Amount
1	No of shares under existing Capital Structure	100
2	Proportion of debt in the capital structure of the company	50%
3	Total Capital of Maureen	6000
4	Total  value of shares to be sold	3000
5	Total debt to be let out	3000
6	Receipt of dividend	304
7	Interest	180
8	Total Receipt	484

PART B (v)

As per Modigliani Miller theory, it is irrelevant to analyse the capital structure as the same does not contribute to the value of the company rather the same is derived by the net operating cash flow of the company. However, under such thesis there is no transaction cost and taxes. The assumption behind the same proposition is that there are no taxes and transaction cost for raising finance. However, the above proposition does not hold true when the aforesaid assumptions are violated. In such a scenario, MM has proposed that the value of the company shall be increased by the present value of tax savings on account of interest on debt.

In addition the theory holds that WACC of the company remains consistent and addition of debt in the company capital structure increased cost of equity.

References:

CFI Education Inc. (2018). WACC. Retrieved October 3, 2018, from corporatefinanceinstitute.com: https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-wacc-formula/

Study.com. (2018). The Modigliani-Miller Theorem: Definition, Formula & Examples. Retrieved October 3, 2018, from Study.com: https://study.com/academy/lesson/the-modigliani-miller-theorem-definition-formula-examples.html