Assignment Code: MMPF-002/TMA/2024-25

Course Code: MMPF-002

Assignment Name: Capital Investment and Financing Decisions

Year: 2024-2025

Verification Status: Verified by Professor

SECTION A 

Q1) ABC Ltd. has the following book value capital structure as on March, 31, 2024. 

Equity shares capital (2,00,000 shares) 60,00,000 

10% preference shares 10,00,000 

12% Debentures 30,00,000 

100,00,000 

The equity share of the company sells at Rs. 30. It is expected that the company will pay next year a dividend of Rs. 3 per equity share which is expected to grow at 5% p.a. forever, Assume 40% corporate tax rates. 

Based on the above information calculate. 

(a) Weighted average cost of capital (WACC) of the company based on the existing capital structure. 

(b) Compute the new WACC if the company raises an additional 40 Lakh debt by issuing 13% debentures. This would result in increasing the expected dividend to Rs. 3.60 and leave the growth rate unchanged but the price of the equity share will fall to Rs.24. 

Ans) (a) Calculation of Weighted Average Cost of Capital (WACC) based on existing capital structure: 

To calculate WACC, we need to determine the costs of equity, preference shares, and debentures, and then use their proportions in the capital structure. 

1. Cost of Equity (Ke) 

The cost of equity is calculated using the Dividend Discount Model (DDM): 

2. Cost of Preference Shares (Kp) 

The cost of preference shares is: 

3. Cost of Debt (Kd) 

The cost of debt is adjusted for the tax rate: 

 4. Proportions of Capital Components 

5. WACC Calculation 

(b) New WACC after raising additional Rs. 40 lakh debt 

1. New Capital Structure 

2. New Cost of Equity (Ke) 

With the additional debt, the equity price falls to Rs. 24 and the dividend increases to Rs. 3.60. Using the DDM again: 

3. New Cost of Debt (Kd) 

The company is issuing new debentures at 13%, so the new cost of debt is: 

4. New WACC Calculation 

Thus, the new WACC after raising additional debt is 13.18%. 

Q2) How are the Cash Flows for Capital Budgeting estimated? Describe the various methods used for evaluating investment proposals. 

Ans) Estimating Cash Flows for Capital Budgeting 

Capital budgeting involves estimating future cash inflows and outflows to evaluate the profitability of an investment project. Cash flows for capital budgeting are estimated by considering the following key elements: 

1. Initial Investment: The total upfront cost required to start a project, including costs for equipment, installation, working capital, etc. 

2. Operating Cash Flows: Cash generated from the project’s operations, typically calculated as: 

3. Terminal Cash Flow: Cash inflows or outflows at the end of the project’s life, including salvage value of assets and recovery of working capital. 

4. Incremental Cash Flows: Only cash flows directly attributable to the project, i.e., the difference between the firm’s cash flows with and without the project. 

Non-cash expenses (like depreciation) are added back to operating cash flows since they do not involve actual cash outflow. 

Methods for Evaluating Investment Proposals 

1. Payback Period (PP) 

Definition: The time it takes to recover the initial investment from the project’s cash flows. 

Formula: 

Pros: Simple and easy to calculate. 

Cons: Ignores the time value of money and cash flows after the payback period. 

2. Net Present Value (NPV) 

Definition: The difference between the present value of cash inflows and outflows, discounted at the firm’s required rate of return. 

Formula: 

Pros: Considers the time value of money and all cash flows. 

Cons: Requires an accurate estimation of the discount rate. 

3. Internal Rate of Return (IRR) 

Definition: The discount rate that makes the NPV of an investment equal to zero. 

Formula: IRR is found by solving: 

Pros: Provides a rate of return that can be compared with the firm’s cost of capital. 

Cons: May give multiple results for projects with alternating cash flows and does not consider the scale of investment. 

4. Profitability Index (PI) 

Definition: The ratio of the present value of cash inflows to the initial investment. 

Formula: 

Pros: Useful for comparing projects when capital is limited. 

Cons: May lead to conflicting decisions when comparing mutually exclusive projects. 

5. Discounted Payback Period 

Definition: The time it takes to recover the initial investment, considering the time value of money. 

Formula: Similar to the payback period but uses discounted cash flows. 

Pros: Accounts for the time value of money. 

Cons: Ignores cash flows beyond the payback period. 

6. Modified Internal Rate of Return (MIRR) 

Definition: A variation of IRR that assumes reinvestment of cash flows at the firm’s cost of capital. 

Pros: Addresses the reinvestment rate assumption flaw of IRR. 

Cons: More complex to calculate. 

Q3) What do you understand by Certainty and Risk? Describe the techniques used for measurement of Project Risk. 

Ans) Understanding Certainty and Risk 

• Certainty: In decision-making, certainty implies that the outcome of a decision is known with 100% confidence. All variables, factors, and conditions are predictable, and the results are fully assured. In capital budgeting, certainty assumes that future cash flows, project costs, and other variables are known precisely. 

• Risk: Risk refers to the uncertainty surrounding future outcomes. In capital budgeting, this uncertainty stems from the inability to predict future cash flows, costs, and other project factors with complete accuracy. Risk is present when there are multiple possible outcomes, each with a certain likelihood of occurring. Investors or decision-makers are exposed to risk when they face variability in expected returns. 

Techniques for Measuring Project Risk 

Sensitivity Analysis 

• Definition: Sensitivity analysis examines how changes in key variables (such as sales volume, costs, or discount rate) affect a project's profitability (typically measured by NPV or IRR). 

• Process: Each key variable is changed one at a time, while keeping others constant, to observe the impact on project outcomes. This helps identify the most sensitive variables affecting the project. 

• Pros: Simple to apply and identifies the most critical variables. 

• Cons: Does not account for the interdependence between variables, and changing only one variable at a time can provide an incomplete picture of risk. 

Scenario Analysis 

• Definition: Scenario analysis evaluates the project under different possible future scenarios, such as optimistic, pessimistic, and most likely outcomes. 

• Process: For each scenario, cash flows are projected based on different assumptions for key variables. The NPV, IRR, or other project metrics are then calculated for each scenario. 

• Pros: Provides a more comprehensive understanding of potential risks by considering multiple variables together. 

• Cons: Relies on subjective assumptions about the likelihood and nature of each scenario, which may not always be accurate. 

  
  

Simulation (Monte Carlo Simulation) 

• Definition: Simulation models the project’s risk by considering the probability distribution of key variables and simulating numerous outcomes based on random combinations of these variables. 

• Process: Thousands of iterations are run where values for variables like sales, costs, and discount rates are randomly selected from their probability distributions. The result is a distribution of possible outcomes for the project’s NPV or IRR. 

• Pros: Provides a detailed risk assessment by considering a wide range of possible outcomes and their likelihood. It also captures the interdependence between variables. 

• Cons: Complex and requires advanced statistical knowledge and computing resources. 

Decision Tree Analysis 

• Definition: Decision trees map out the potential decisions and the possible outcomes of those decisions over time, considering both risks and rewards. 

• Process: A decision tree outlines different decision points, possible outcomes, and associated probabilities, allowing the decision-maker to evaluate the expected value of each path. 

• Pros: Visually clarifies sequential decisions and incorporates uncertainty at multiple stages. 

• Cons: Can become overly complex with too many decision points or variables. 

Risk-Adjusted Discount Rate (RADR) 

• Definition: This method adjusts the discount rate used in NPV calculations to reflect the risk of the project. Higher-risk projects are evaluated with higher discount rates. 

• Process: The discount rate is increased to account for higher perceived risks, thus reducing the present value of future cash flows and making the project less attractive. 

• Pros: Simple to implement and reflects risk directly in the discount rate. 

• Cons: Determining the correct risk premium can be subjective, and it oversimplifies risk by adjusting only the discount rate. 

Certainty Equivalent Approach 

• Definition: This approach converts uncertain cash flows into "certainty equivalents," which are risk-adjusted cash flows that reflect the decision-maker's risk tolerance. 

• Process: The riskier the cash flow, the lower its certainty equivalent. These adjusted cash flows are then discounted at the risk-free rate to calculate NPV. 

• Pros: Separates risk adjustment from discounting, providing a clearer picture of risk. 

• Cons: Requires subjective judgment to determine certainty equivalents. 

Q4) Explain the following: 

(a) Leasing and Hire Purchase. Discuss the difference between these two. 

(b) Asset Securitization 

Ans) (a) Leasing and Hire Purchase 

Leasing: Leasing is a financing arrangement in which a lessee (the user) obtains the right to use an asset owned by a lessor (the owner) for a specified period in exchange for periodic lease payments. The asset remains the property of the lessor throughout the lease term, and the lessee typically does not own the asset at the end of the lease period, unless there is an option to purchase. 

There are two main types of leases: 

1. Operating Lease: Short-term lease where the lessor retains the risks and rewards of ownership, and the lessee uses the asset without the intention of ownership. 

2. Finance (or Capital) Lease: A long-term lease where the lessee assumes most of the risks and rewards of ownership, and there may be an option to buy the asset at the end of the lease term. 

Hire Purchase: Hire purchase is a type of installment purchase agreement where the buyer (the hirer) agrees to acquire an asset by making an initial down payment followed by regular payments. Ownership of the asset is transferred to the buyer only after all payments have been made. Until then, the seller retains ownership. 

Differences Between Leasing and Hire Purchase: 

1. Ownership: In leasing, ownership of the asset remains with the lessor throughout the lease term, while in hire purchase, the hirer becomes the owner after the final payment. 

2. Risk of Ownership: In a lease, the lessor bears the risks associated with ownership (e.g., obsolescence or depreciation), but in hire purchase, the hirer bears the risk once they assume ownership after the final payment. 

3. Maintenance Responsibility: In leasing, depending on the lease type, the lessor may be responsible for asset maintenance (operating lease), whereas in hire purchase, the buyer typically bears maintenance costs. 

4. Accounting Treatment: Lease payments are treated as expenses in operating leases, whereas hire purchase installments include both interest and principal repayment, with interest being tax-deductible. 

5. Purchase Option: Leasing may or may not include an option to buy the asset at the end of the term, while hire purchase always leads to ownership after completing all payments. 

(b) Asset Securitization 

Asset Securitization: Asset securitization is a financial process where illiquid assets, such as loans or receivables, are pooled together and converted into marketable securities that can be sold to investors. The cash flows generated by the underlying assets (e.g., loan repayments, lease payments, or credit card receivables) are used to pay returns to the investors who buy these securities. 

Process of Asset Securitization: 

1. Pooling Assets: A pool of similar financial assets, such as mortgages, auto loans, or credit card receivables, is created. 

2. Special Purpose Vehicle (SPV): The pooled assets are transferred to a separate legal entity, called an SPV, to isolate the assets from the originator’s balance sheet. 

3. Issuance of Securities: The SPV issues securities (called asset-backed securities or ABS) to investors. These securities are backed by the cash flows generated from the pooled assets. 

4. Cash Flow Distribution: As borrowers repay loans or make payments on the underlying assets, the SPV uses the cash flows to pay interest and principal to investors. 

Advantages of Asset Securitization: 

• Risk Diversification: Investors gain access to a diversified pool of assets. 

• Improved Liquidity: It allows originators to convert illiquid assets into cash. 

• Risk Transfer: Originators can transfer the risk associated with the underlying assets to investors. 

Q5) What is Financial Engineering? Discuss the factors contributing to Financial Engineering. 

Ans) Financial Engineering 

Financial Engineering refers to the application of mathematical, statistical, and computational techniques to solve complex financial problems, design new financial instruments, and optimize financial strategies. It combines elements of finance, economics, mathematics, and computer science to create innovative financial products and processes that help institutions manage risk, enhance returns, and improve market efficiency. Financial engineers often work in areas such as risk management, derivative pricing, portfolio optimization, and structured finance. 

Financial engineering has played a key role in the development of various financial instruments, including derivatives (like options and futures), asset-backed securities, and other structured products that help in managing risk and maximizing returns. These innovations can provide tailored financial solutions to meet the specific needs of individuals, companies, or financial institutions. 

Factors Contributing to Financial Engineering 

1. Risk Management: One of the primary drivers of financial engineering is the need to manage financial risks, including interest rate risk, currency risk, credit risk, and commodity price risk. Financial engineering creates derivatives like options, futures, and swaps, which allow companies to hedge these risks effectively. For example, companies use currency swaps to hedge against foreign exchange risks, while interest rate swaps help them manage interest rate fluctuations. 

2. Regulatory Changes: Changes in financial regulations often create a need for innovative financial solutions. Financial engineering allows firms to comply with new regulatory requirements while optimizing their financial strategies. For instance, when governments impose capital or leverage requirements on banks, financial engineering can develop instruments that enable banks to meet these requirements efficiently, such as through securitization or off-balance-sheet financing techniques. 

3. Technological Advancements: The rise of computational power, big data, and advanced algorithms has significantly contributed to the growth of financial engineering. With powerful computer systems and sophisticated modeling techniques, financial engineers can now analyze large datasets, simulate market scenarios, and create complex financial products tailored to specific needs. Algorithmic trading, for instance, relies heavily on financial engineering to execute trades at lightning speed based on pre-set criteria. 

4. Globalization of Financial Markets: The globalization of financial markets has introduced new opportunities and risks. With companies operating across borders, they are exposed to currency fluctuations, political risks, and varying interest rates in different countries. Financial engineering helps firms manage these international risks through derivatives, hedging instruments, and cross-border financing techniques. Additionally, it enables firms to tap into global capital markets more efficiently. 

5. Increased Volatility: The increased volatility in global markets, driven by economic cycles, political events, and market sentiment, has created a demand for more sophisticated financial tools to manage uncertainty. Financial engineering designs products that mitigate or exploit this volatility, such as volatility indices, derivative contracts, and structured financial products, providing investors and companies with more control over their financial outcomes. 

6. Innovation in Financial Instruments: The need for innovative investment products is another key factor. Financial engineering drives the creation of new instruments like mortgage-backed securities (MBS), collateralized debt obligations (CDOs), and exchange-traded funds (ETFs), which offer investors new ways to diversify portfolios, manage risk, or achieve higher returns. These instruments can cater to specific market demands and enable better liquidity and risk sharing in financial markets. 

7. Tax Optimization: Financial engineering also enables companies and investors to structure their financial activities in a way that minimizes tax liabilities. By using tax-efficient instruments or legal structures, firms can reduce their overall tax burden, increasing profitability. For example, structured finance products may be designed to exploit differences in tax regimes between countries.