Questions for Group 1

1. A firm which adopted a residual dividend approach has $30,000 in earnings and a debt/equity ratio of 1/3.

a) What is the maximum amount of capital spending possible if the firm does not obtain any new
equity financing and maintains the current debt/equity ratio?
b) Suppose the firm has positive NPV projects available which require the investment of $24,000.
How will these projects be financed? How much will the firm pay in dividends?
c) Suppose the firm has $60,000 of positive NPV projects available. How will these projects be
financed? How much will the firm pay in dividends?
2. Himalayan Bottlers is contemplating the replacement of one of its bottling machines with a newer and
more efficient one. The old machine has a book value of Rs 500,000 and a remaining useful life of 5
years. The firm does not expect to realize any return from scrapping the old machine in five years; but it
can sell the machine new to another firm in the industry for Rs 300,000. Pre-MACRS straight line
depreciation was used for the old machine.
The new machine has a purchase price of Rs 1.1 million, an estimated useful life of 5 years, and an
estimated salvage value of Rs 200,000. It is expected to economize on electric power usage, labor and
repair costs and reduce the number of defective bottles. In total, an annual savings of Rs 250,000 will be
realized if the new machine is installed. The company is in the 40% tax bracket, has a 10% cost of
capital, and will use MACRS 5 year class life depreciation on the new machine.

a) What is the initial cash outlay required for the new machine ?
b) Should Himalayan Bottlers purchase the new machine ? Support your answer.

Year 1 2 3 4 5 6 7 8
Depreciation rate 20% 32% 19.20% 11.52% 11.52% 5.76 - -

Questions for Group 2

3. Compute the cost of equity for each of the following cases:

i. Common stock with most recent dividend yield of 5% and constant growth rate of 6%
ii. Common stock with most recent dividend per share of Rs 2, constant growth rate of 10% and net
proceeds of Rs 98
iii. Next expected DPS of Rs 5, expected growth rate of 8% per year, current market price of Rs 95
and 5% floatation cost
iv. Risk free rate of return of 5%, systematic risk coefficient, beta of 1.20 and market risk premium
of 6%.
v. Risk free rate of return of 6%, systematic risk coefficient, beta of 1.20 and expected return of
market portfolio equals to 14%

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4. Lobears Inc is considering two investment proposals, labeled Project A and Project B, with the
characteristics shown in the accompanying table
Project A Project B
Cost PAT Net Cost PAT Net
Period (Rs) (Rs) Cash (Rs) (Rs) Cash
Flow Flow
(Rs) (Rs)
0 9,000 - 12,000
1 1,000 5,000 1,000 5,000
2 1,000 4,000 1,000 5,000
3 1,000 3,000 4,000 8,000

i. Calculate each project’s ARR

ii. Calculate each project’s NPV

5. Barnes Company has 500,000 shares of common stock outstanding. Its capital/common stock account is
Rs 500,000, and retained earnings are Rs 2 million. Barnes is currently selling for Rs 10 per share and
has declared a 10% stock dividend. After distribution of the stock dividend, what balances will the
retained earnings and capital stock accounts show ?

Questions for Group 3

6. The Starbuck Compnay is considering the purchase of a new machine tool to replace an obsolete one.
The machine being used for the operation has both a tax book value and a market value to zero, it is in
good working order and will last, physically, for at least 5 years. The proposed machine will perform the
operation so much more efficiently that Starbuck engineers estimate that labor, material, and other direct
costs on the operation will be reduced Rs 6,500 a year if it is installed. The proposed machine costs Rs
30,000 delievered and installed, and its economic life is estimated to be 10 years, with zero salvage
value. The company expects to earn 12% on its investment after taxes. The tax rate is 40% and the firm
has been advised that the new equipment will qualify for a MACRS 7 year class life.
a) Should Starbuck buy the new machine ?
b) Assume that the tax book value of the old machine is Rs 6,000, that the annual depreciation charge is
Rs 400, and that the machine has no market value. How do these assumptions affect your answer?

7. Singleton Electronics Company repurchased 1 million of 14 million shares outstanding at Rs 98 a share.

Immediately before the announcement, market price per share was Rs 91.

a. Was the offer price by the company the correct repurchase price?

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 b. After the repurchase, share price went up to Rs 105. What would explain this rise if there were
no other information concerning the company or stocks in general?

Questions for Group 4

8. The Fast Byte Co. has recently completed a $250,000, two-year marketing study. Based on the results of
the study, Fast Byte estimates that 5,000 of its new electro-optical switching hardware could be sold
annually over the next 6 years, at a price of $10,000 each. Variable costs per unit are $5,500, and fixed
costs total $6.0 million per year.

Start-up costs include $18 million to build production facilities, $2 million for land, and $4 million in
net working capital. The $18 million facility will be depreciated on a straight-line basis to a value of
zero over the six-year life of the project. At the end of the project’s life, the facilities (including the land)
will be sold for an estimated $6 million. The value of the land is not expected to change during the six-
year period.

Finally, start-up would also entail tax-deductible expenses of $0.5 million at year zero. Fast Byte is an
ongoing, profitable business and pays taxes at a 40% rate. Fast Byte believes that 20% is the appropriate
opportunity cost for projects of this type.

(a) What operating cash flow does Fast Byte’s project generate for years 1 through 6?
(b) What is the initial cash flow at year 0?
(c) What is the terminal year non-operating cash flow?

(d) What are the internal rate of return and net present value of the project?

9. Johore Trading Company has 2.4 million shares of common stock outstanding, and the present market
price per share is Rs 36. Its equity capitalization is as follows:

Common stock Rs 2 par Rs 4,800,000

Additional paid-in capital Rs 5,900,000
Retained Earnings Rs 87,300,000
Shareholder’s Equity Rs 98,000,000

What would happen to these accounts if the company were to declare 5% stock dividend ?

Questions for Group 5

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10. Carbide Chemical Company is considering the replacement of two old machines with a new, more
efficient machine. The old machines could be sold for Rs 70,000 in the secondary market. Their
depreciated book value is Rs 120,000 with a remaining useful and depreciable life of 8 years. Straight-
line depreciation is used on these machines.
The new machine can be purchased and installed for Rs 480,000. It has a useful life of 8 years, at the
end of which, a salvage value of Rs 40,000 is expected. The machine falls into the 5 year property class
for accelerated cost recovery (depreciation) purposes. Due to its greater efficiency, the new machine is
expected to result in incremental annual savings of Rs 120,000. The Company’s corporate tax rate is
34%, and if a loss occurs in any year on the project, it is assumed that the Company will receive a tax
credit of 34% of such loss.
(a) What are the incremental cash flows over the 8 years and what is the incremental cash outflow at
time 0 ?
(b) What is the project’s NPV if the required rate of return is 14% ?

MACRS 5 year asset class depreciation rates

Year 1 2 3 4 5 6 7 8
Depreciation rate 20% 32% 19.20% 11.52% 11.52% 5.76 - -

11. You buy a share of The Ludwig Corporation stock for Rs 21.40. You expect it to pay dividends of Rs
1.07, Rs 1.1449 and Rs 1.2250 in years 1, 2 and 3 respectively, and you expect to sell it at a price of Rs
26.22 at the end of 3 years.
i. Calculate the growth rate in dividends
ii. Calculate the expected dividend yield

Questions for Group 6

12. Future Limited is considering a project with an investment outlay of Rs 200 million. This consists of Rs
150 million on the Plant and Machinery and Rs 50 million on working capital. The entire outlay will be
incurred in the beginning. The life of the project is expected to be 7 years. At the end of the 7 years,
fixed assets will fetch a net salvage value of Rs 48 million whereas working capital will be liquidated at
its book value. The project is expected to increase the revenues of the firm by Rs 600 million per year.
Additional expenses are expected to be Rs 350 million per year (including all items other than
depreciation, interest and tax). The tax rate is 30% and plant and machinery will be depreciated at 25 %
per year as per the declining balance method. The discount rate used by the firm to evaluate capital
projects is 15 %. Calculate the IRR of the project and decide if the firm should accept the project. [Note:
Do not consider the tax treatment on difference between Book Salvage Value and Cash Salvage Value]

13. LCH Limited manufactures product X which it sells for $5 per unit. Variable costs of production are
currently $ 3 per unit, and fixed costs 50 cents per unit. A new machine is available which would cost $
90,000 but which could be used to make product X for a variable cost of only $ 2.50 per unit. Fixed

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 costs, however could increase by $ 7500 per annum as a direct result of purchasing the machine. The
machine would have an expected life of 4 years and a resale value after that time of $ 10,000. Sales of
product X are estimated to be 75,000 units per annum. LCH expects to earn at least 12% per annum for
its investments. Decide whether LCH limited should purchase the machine. Use straight line
depreciation method and ignore the tax treatment.

Questions for Group 7

3. Compute the cost of equity for each of the following cases:

i. Common stock with most recent dividend yield of 5% and constant growth rate of 6%
ii. Common stock with most recent dividend per share of Rs 2, constant growth rate of 10% and net
proceeds of Rs 98
iii. Next expected DPS of Rs 5, expected growth rate of 8% per year, current market price of Rs 95
and 5% floatation cost
iv. Risk free rate of return of 5%, systematic risk coefficient, beta of 1.20 and market risk premium
of 6%.
v. Risk free rate of return of 6%, systematic risk coefficient, beta of 1.20 and expected return of
market portfolio equals to 14%

4. Lobears Inc is considering two investment proposals, labeled Project A and Project B, with the
characteristics shown in the accompanying table
Project A Project B
Cost PAT Net Cost PAT Net
Period (Rs) (Rs) Cash (Rs) (Rs) Cash
Flow Flow
(Rs) (Rs)
0 9,000 - 12,000
1 1,000 5,000 1,000 5,000
2 1,000 4,000 1,000 5,000
3 1,000 3,000 4,000 8,000

iii. Calculate each project’s ARR

iv. Calculate each project’s NPV

5. Barnes Company has 500,000 shares of common stock outstanding. Its capital/common stock account is
Rs 500,000, and retained earnings are Rs 2 million. Barnes is currently selling for Rs 10 per share and

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 has declared a 10% stock dividend. After distribution of the stock dividend, what balances will the
retained earnings and capital stock accounts show ?

Questions for Group 8

12. Future Limited is considering a project with an investment outlay of Rs 200 million. This consists of Rs
150 million on the Plant and Machinery and Rs 50 million on working capital. The entire outlay will be
incurred in the beginning. The life of the project is expected to be 7 years. At the end of the 7 years,
fixed assets will fetch a net salvage value of Rs 48 million whereas working capital will be liquidated at
its book value. The project is expected to increase the revenues of the firm by Rs 600 million per year.
Additional expenses are expected to be Rs 350 million per year (including all items other than
depreciation, interest and tax). The tax rate is 30% and plant and machinery will be depreciated at 25 %
per year as per the declining balance method. The discount rate used by the firm to evaluate capital
projects is 15 %. Calculate the IRR of the project and decide if the firm should accept the project. [Note:
Do not consider the tax treatment on difference between Book Salvage Value and Cash Salvage Value]

13. LCH Limited manufactures product X which it sells for $5 per unit. Variable costs of production are
currently $ 3 per unit, and fixed costs 50 cents per unit. A new machine is available which would cost $
90,000 but which could be used to make product X for a variable cost of only $ 2.50 per unit. Fixed
costs, however could increase by $ 7500 per annum as a direct result of purchasing the machine. The
machine would have an expected life of 4 years and a resale value after that time of $ 10,000. Sales of
product X are estimated to be 75,000 units per annum. LCH expects to earn at least 12% per annum for
its investments. Decide whether LCH limited should purchase the machine. Use straight line
depreciation method and ignore the tax treatment.

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