Answer for Question No.

(1)
For estimating the cost of equity, which is inferred by comparing the investment to other
investments with similar risk profiles. It is commonly computed using the Capital Asset Pricing
Model formula which is;

 Cost of Equity= Risk Free Rate of Return + Premium Expected for Risk
 Cost of Equity= Risk Free Rate of Return + Beta x (Market Rate of Return – Risk Free Rate
of Return)
Where Beta = Sensitive to movements in the relevant market. This in equation we have
Es = Rf + βs (Rm – Rf)
Where,
Es = is the expected rate of security
Rf = is the expected risk free return in the market
βs = is the sensitive to market for the security
Rm = is the return on the market
(Rm – Rf) = is the risk premium of market asset over risk free assets
Now by considering the above, we will calculate the estimate the cost of equity for the given data
of Michelllo Private Limited which is;

 Risk Free of Return is 6%

 Return on Market is 11%
 Beta is 1.1
Cost of Equity/ expected rate of security (ES) = Rf + βs (Rm – Rf)
= 0.06 + 1.1 (0.11 – 0.06)
= 0.06 + 1.1 (0.05)
= 0.06+ 0.05
= 0.115 or 11.50%

Further the opportunity cost of capital is the incremental return on investment that a business
foregoes when it elects to use funds for an internal project, rather than investing cash in a
marketable security. Thus, if the projected return on the internal project is less than the expected
rate of return on a marketable security, one would not invest in the internal project, assuming
that this is the only basis for the decision. The opportunity cost of capital is the difference
between the return on the two projects.
For an investment to be worthwhile, the expected return on capital has to be higher than the
cost of capital. In other words, the cost of capital is the rate of return that capital could be
expected to earn in the best alternative investment of equivalent risk; this is the opportunity of
capital.
Further a company’s securities typically include both and equity, one must therefore calculate
both the cost of debt and equity to determine a company’s cost of capital.
For the calculating the opportunity cost as per CAPM Model, we can calculate the cost of equity
capital under the CAPM method through the below mentioned components:

 The Risk- Free Rate of Return, the return from a risk free investment
 Beta, the measure of system risk (the volatility) of the asset relative to the market. Beta
can be found online or calculated by using regression, dividing the covariance of the asset
and market’s returns by the variance of the market.
Βi < 1: Asset i is less volatile (relative to the market)
βi =1: Asset i’s volatility is the same rate as the market
βi >1: Asset i is more volatile (relative of to the market)
 Expected Market Return, this value typically the average return of the market (which the
underlying security is part of) over a specified period of time (five to ten years is an
appropriate range).

Answer for Question No. (2)

For discussing the Capital Budgeting Process for Mehta & Mehta Constructing Company for its
investment in certain projects, first we have to know the about Capital Budgeting Process.
It is the process of planning which is used to evaluate the potential investments or expenditure
whose amount is significant. It helps in determining the company’s investment in the long term
fixed assets such as investment in the addition or replacement of the plant & machinery, new
equipment, research & development etc. This process the decision regarding the source of
finance and then calculating the return that can be earned from the investment done.
The Capital Budgeting Process can be understood through the below mentioned Chart:
According the above chart,
1. To Identify the Opportunities for Investment, the first process in capital budgeting is to
explore the available investment opportunities. Therefore as financial advisor for Mehta
& Mehta Company, we will require to identify the expected sales in the near future and
after that, we have to do identification of the investment opportunities keeping in mind
the sales target set up by us. There are points which are needed to be taken care of before
starting the search for the best investment opportunities. This include, monitoring of the
external environment regularly to get an idea about the new opportunities of investment,
defining the corporate strategy which is based on the organization’s SWOT analysis i.e.
analysis of its strength, weakness, opportunities and threat and also seeking suggestions
from the organization’s employees by discussing the strategies and objectives with them.

For Example, identification of the underlying trends of market which can be based on the
most reliable information, prior to selecting a specific investment. For instance, before
choosing the investment to be made in the project in the real estate where Mehta &
Mehta wants to invest, firstly the underlying sector’s future direction is needed to be
determined; whether we believe that there are more chances prices of getting declined
or the chances of price rise much higher than its declination.
2. Gathering of the Investment Proposal, after the identification of the investment
opportunities, the second process in Capital Budgeting is to gather investment proposals.
Prior to reaching the committee of the Capital Budgeting process, these proposals are
seen by various authorized persons in the organization to check whether the proposals
given are according to the requirements and then the classification of the investment is
done based on the different categories such as expansion, replacement, welfare
 investment etc. This classification is into different categories is done to make the decision
-making process easier and also to facilitate the process of budgeting and control.

For Example, if Mehta & Mehta Company identified two lands where they can build their
project. Out of the two lands one land is to be finalized. So the proposals from all
departments will be submitted and the same will be seen by the various authorized
persons in the organization to check whether the proposal given are according to the
various requirements. Also the same will then be classified for the better decision making
the process.
3. Decision Making Process in Capital Budgeting, is the third step where in decision making
the executives will have to decide which investment is needed to be done from the
investment opportunities available keeping in mind the sanctioning power available to
them.

For Example, the managers at the lower level of the management like work managers,
plant superintendent, etc. may have the power to sanction the investment up to the limit
of Rs. 10 Lacs for procure something in Mehta & Mehta Company, beyond that the
permission of the board of directors or senior management is required. If the investment
limit extends then lower management has to involve the top management for the
approval of the investment proposal.
4. Capital Budget Preparation and Appropriation, after the step of the decision making the
next step is the classification of the investment outlays into the higher value and smaller
value investment.

For Example, when the value of an investment is lower and is approved by the lower level
of management then for getting speedy actions they are generally covered with the
blanket appropriations. But if the investment outlay is of higher such as Rs. 500 Cr in
Mehta & Mehta Company’s project, then it will become part of the capital budgeting after
taking the necessary approvals. The motive behind these appropriations is to analyze the
investment performance during its implementation.
5. Implementation, after the completion of all the above steps, the investment proposal
under the consideration is implemented i.e. put into concrete project. There are several
challenges that can be faced by the management personnel while implementing the
project as it can be time-consuming. For the implementation at the reasonable cost and
expeditiously the following things could be helpful:
o Formulation of the project
o Use of responsibilities accounting principle
o Network technical use

For Example, for prompt processing, the committee of capital budgeting must ensure that
management has properly done the homework on the preliminary studies and
 compendious formulation of the project before its implementation and after that, the
project is implemented efficiently.
6. Review of Performance, is the final step in the capital budgeting process. In this the
management is required to compare the actual results with the projected results. The
correct time to do this comparison is when the operations get stabilized.

For Example, with this review, we may concludes under capital budgeting on the
following points:
o To what extent the assumptions were realistic
o The efficiency of the decision making
o If there are any judgmental biases
o Whether the hopes of the sponsors of the project is fulfilled
Thus, this is the Capital Budgeting process we can discuss as a financial advisors with Mehta &
Mehta Company.

Answer for Question No. 3(A)

Net Income is the amount of revenue that is left over after subtracting all costs of doing business.
The opposite of net income is net loss, which is when costs and expenses actually exceed income.
Net income is reported on a company’s income statement. If any portion of net income is not
distributed to the owners of the company, it is reflected as retained earnings on a company’s
Balance Sheet.
Further the formula to calculate net income is rather easy;
Net Income= Total Revenue – Total Expenses
Here, in the question, Anna Dude Enterprises has EBIT (Earnings before Interest and Taxes)
Income of Rs. 80,000/- and the tax rate is 40%.
In this scenario, we will calculate the Net Income for Anna Dude Enterprises as per followings:

Particulars Existing EBIT If EBIT Increases By 10% If EBIT Decreases by 10%

EBIT 80,000/- 88,000/- 72,000/-
Less- Taxes @ 40% 32,000/- 35,200/- 28,800/-
Net Income 48,000/- 52,800/- 43,200/-

Interpretation:
1. We calculated here Net Income by deducting the tax from EBIT as the EBIT will find out
after deducting all direct and indirect expenses/ operating expenses i.e. fixed cost as well
as variable cost from total revenue. After getting EBIT we will deduct the interest and
 taxes from it to get EAT (Earnings after Tax) which also called Net Income which is shown
in bottom line of Income Statement of a company.

Answer for Question No. 3(B)

Return on Equity is a ratio that provides investors with insight into how efficiently a company is
handling the funds that shareholders have to it. In other words, it measures the profitability of a
corporation in relation to stockholders’ equity. The higher the ROE, the more efficient a
company’s management is at generating income and growth from its equity financing.
Further ROE is often used to compare a company to its competitors and the overall market. The
formula is especially beneficial when comparing firms of the same industry, since it tends to give
accurate indications of which companies are operating with greater financial efficiency, and for
the evaluation of nearly any company with primary tangible rather than intangible assets.
For calculating the Return on Equity (ROE), the basic formula is-
Return on Equity (ROE) = Net Income (Profit after Tax) / Shareholder Equity
Here, in the question, the total assets that are financed with 100% in Equity and the Net Income
is calculated earlier in question no. 3(a), we can calculate the ROE as per following:

Particulars Existing If EBIT increased by 10% If EBIT Decreases by 10%

Net Income/ PAT 48,000/- 52,800/- 43,200/-
Equity 5,00,000/- 5,00,000/- 5,00,000/-
ROE = (PAT / Equity)*100 9.6% 10.56% 8.64%

Interpretation:
1. The Net Income is the bottom - line profit before common stock dividends are paid
reported on firm’s income statement.
2. Shareholder equity is assets minus liabilities on firm’s balance sheet and in above
scenario, the assets are considered equity as these are 100% financed with Equity.