4 ANTECEDENTES Y MARCO TEÓRICO
4.2 Marco Teórico
expansion benefits will last for 12 years and it will increase revenue by Rs 10 crore
growing at 10 percent each year for three years, then at 5 percent each year for next
four years followed by no growth period of the last four years. The cost of goods sold
is expected to be 60 percent and other expenses 15 percent of revenue. Depreciation
will be charged on straight-line basis. Working capital is estimated to be 25 percent of
the revenue to be incurred at the end of the previous period. The corporate tax rate is
34 percent. The firm has debt-equity ratio of 1:1 and its levered beta and the cost of
equity are 1.20 and 22 percent, respectively. The risk-free rate of return is 10 percent.
The project has 1.5 times of the firm’s business risk. The market cost of debt is 10
percent per annum. The firm will be able to raise subsidised loan of Rs 12 crore from
the government of India’s rural development funds at 8 percent annual interest. The
loan will be paid at the end of year 12. Find out project’s APV. What is the value of
the subsidised loan?
12. Dhatu Industries Limited is a manufacturer of iron and steel. It has an equity beta of 1.10. The target debt-equity ratio of the company is 2:1. The company is intending to diversify into different lines of businesses. It is considering a cement project requiring an investment of Rs 105 crore. The company will be able to raise Rs 70 crore loan from a financial institution at 10 per cent p.a. The loan is repayable at the end of 5 years. The project is expected to generate annual profit before interest and taxes of Rs 22 crore for 7 years. Assume that the project’s cost can be depreciated over its life of 7 years on the straight-line basis. The company has identified one public limited cement company as a proxy for the project. This company has an equity beta of 1.3 and debt-equity ratio of 1.5:1. The risk- free rate is 7 per cent and the market risk premium is 8 per cent. The corporate tax rate is 30 per cent. Should Dhatu undertake the cement project?
13. Suppose that Dhatu Industries Limited in (9) above decides to locate the cement project in an economically backward area. As a consequence, it is able to negotiate the loan amount from the financial institution at 8 per cent instead of the market rate of interest of 10 per cent. Evaluate the viability of the project showing the sources of value for the project.
14. Suppose that Dhatu Industries Limited in (9) above does not have to pay any taxes on the income of the cement project since it is located in the backward area. How does this affect the profitability of the project?
15. A firm has debt capacity equal to debt-equity ratio of 1:1. The firm’s interest payments are Rs 5 lakh
per year. The risk-free rate is 8 percent and the market risk premium is 9 percent. The unlevered beta of the firm is 1.20 and beta of debt is zero. The firm’s annual revenues are estimated as Rs 100 lakh each year; the cost of goods sold will be Rs 45 lakh and general and administrative expenses will be Rs 20 lakh. All revenues and expenses are on cash basis and are expected to remain same forever. The corporate tax rate is 34 percent. What is the value of the firm’s equity? What is the total value of the firm?
16. PQR Ltd is an all-equity firm. It has unlevered cost of equity of 20 percent, corporate tax rate of 30
percent, and annual cash flows of Rs 40 crore in perpetuity. The firm is thinking of restructuring its capital. It wants to replace its equity by issuing perpetual debt of Rs 25 crore at 12 percent annual interest rate. Calculate (i) PQR’s total value and equity value before restructuring; (ii) PQR’s total value and equity value after restructuring.
17. Brite Ltd is considering a project unrelated to its existing business. The firm collected the following
information of similar firms in the industry to determine the risk of the project: Average debt-equity: 0.8:1; average equity beta: 1.6 and average cost of debt: 12 percent. The project’s target debt-equity is 0.5:1. The risk-free rate is 6 percent and the market risk premium is 9 percent. Brite’s corporate tax rate is 35 percent. The initial outlay on project is estimated as Rs 50 crore. (i) The expected post-tax
free cash flows at the end of the first year are Rs 5 crore which will remain constant thereafter for indefinite period. Should the investment be made? (ii) Suppose that the expected post-tax free cash flows of Rs 5 crore at the end of the first year will grow at 8 percent per year until the end of sixth year and will remain constant thereafter for indefinite period. What is the value of investment? (iii) Suppose that the expected post-tax free cash flows of Rs 5 crore at the end of the first year will grow at 6 percent per year until the end of sixth year and at 2 percent thereafter for indefinite period. What is the value of investment?
18. The following information relate to NM Company: target debt-equity ratio 0.75:1; the unlevered cost
of capital 18 percent; the annual interest rate 10 percent; corporate tax rate 35 percent; expected pre-tax cash flows for indefinite period Rs 10.80 crore. (i) What is the value of NM Company if it is entirely financed by equity? (ii) If the firm is levered, what is its cost of equity? (iii) Calculate the levered firm’s weighted average cost of capital. What is the value of the firm under the FCF approach? (iv) Calculate the value of the firm’s equity using flow-to-equity approach and APV approach.
19. The market value of equity of XYZ Ltd is Rs 140 crore. It has 10 crore outstanding shares. The market value of the firm’s debt is Rs 70 crore. The firm intends to maintain the current market value debt ratio forever. The expected interest rate is 12 percent. The firm’s equity beta is 1.20 and the corporate tax rate is 30 percent. The risk free rate is 6 percent and the risk premium is 8.5 percent. The firm’s expected post-tax free cash flows next year are Rs 25 crore. The free cash flows are expected to grow at 10 percent for eight years and thereafter, at 5 percent for ever. How much is the value of the firm? What is the value of equity? How much is the value per share?
20. The market value of equity of a firm is Rs 200 crore. It has one crore outstanding shares. The firm intends to maintain the market value debt ratio of 40 percent forever. The expected interest rate is 10 percent. The firm’s equity beta is 1.50 and the corporate tax rate is 30 percent. The risk free rate is 6 percent and the risk premium is 8.5 percent. The firm’s expected post-tax free cash flows next year are Rs 40 crore. The free cash flows are expected to grow at 12 percent for five years, at 8 percent for next five years and thereafter, at 5 percent forever. How much is the value of the firm? What is the value of equity? How much is the value per share?
Chapter 17
Problems1. A company earns Rs 10 per share at an internal rate of 15 per cent. The firm has a policy of paying 40 per cent of earnings as dividends. If the required rate of return is 10 per cent, determine the price of the share under (i) Walter’s model, (ii) Gordon’s model.
2. Saraswati Glass Works has an investment of Rs 30 crore divided into 30 lakh ordinary shares. The profitability rate of the firm is 20 per cent and the capitalisation rate is 12.5 per cent. What is the optimum dividend payout for the firm if Walter’s model is used? What shall be the price of the share at optimum payout? Shall your answer change if the profitability rate is assumed to be 15 per cent? What would happen if profitability rate is 10 per cent? Show computations.
3. The following data relate to a firm: earnings per share Rs 10, capitalisation rate 10 per cent, retention ratio 40 per cent. Determine the price per share under Walter’s and Gordon’s models if the internal rate of return is 15 per cent, 10 per cent and 5 per cent.
4. Manex Company has outstanding 50 lakh shares selling at Rs 120 per share. The company is thinking of paying a dividend of Rs 10 per share at the end of current year. The capitalisation rate for the risk class of this firm is 10 per cent. Using Modigliani and Miller’s model you are required: (i) to calculate the price of the share at the end of the current year if dividends are paid and if they are not paid; ( ii) to determine the number of shares to be issued if the company earns Rs 9 crore, pays dividends and makes new investments of Rs 6.60 crore?
5. A company has outstanding 10 lakh shares. The company needs Rs 5 crore to finance its investments, for which Rs 1 crore is available out of profits. The market price of per share at the end of current year is expected to be Rs 120. If the discount rate is 10 per cent, determine the present value of a share using the MM model.
6. The current market price of a company’s shares is Rs 125 per share. The expected earnings per share and dividend per share are Rs 10 and Rs 5 respectively. The shareholders’ expected rate of return is 15 per cent. Suppose the company declares that it will switch to 100 per cent payout policy, issuing shares as necessary to finance growth. Use the perpetual-growth model to show that current price of share is unchanged.
Rs in crore
Share capital (at Rs 10 per share) 12.50
Reserve 7.50
Profit after tax 1.85
Dividends paid 1.50
P/E ratio 13.33
You are required (a) to comment on the firm’s dividend policy using Walter’s model; (b) to determine the optimum payout ratio using Walter’s model; (c) to determine the price – earnings ratio at which dividend payout will have no effect on share price.
8. Turant Pharma is thinking of diversifying its business in the field of energy. The firm has decided to make a capital expenditure of Rs 35 crore in an energy project. The project is expected to yield a positive net present value of Rs 25 crore. The firm is also considering a payment of dividends of Rs 20 crore. The internal funds available with the firm are Rs 10 crore. It has a paid-up share capital of Rs 50 crore divided into 5 crore shares of Rs 10 each. The current price of the firm’s share is Rs 25. The firm has not borrowed funds in the past, and would continue with this policy in the future.
Given the firm’s capital expenditure and the policy of zero borrowing, show the implications of the payment of dividends for the shareholder value. Will your answer be different if Turant decides not to pay any dividends? Assume no taxes and no issue costs.
9. The share of X Company is selling for Rs 100. It is a no-tax paying company. The price of X’s share is
expected to be
Rs 115 after one year. Company Y is identical to company X in terms of risk and the future earnings potential. It is a dividend paying company, and is expected to pay a dividend of Rs 10 per share after one year. Assume dividend income is taxed at 35 per cent and there is no tax on capital gains. What should be the current price of B’s share and how much should be its before-tax expected return? 10. The shares of Firm A and Firm B have identical risk. Both have an after-tax required rate of return of
15 per cent. Firm A pays no dividend, while Firm B is a high dividend paying firm. The price of Firm A’s share is expected to be Rs 60 after one year and the price of Firm B Rs 50 with Rs 10 dividend per share. Assume that the income tax rate is 40 per cent and capital gain tax rate is 20 per cent. Determine the current prices of Firm A’s and Firm B’s shares.
11. The expected before-tax incomes (consisting of dividend and capital gains) on shares of firms X, Y and Z are given below:
Share Dividend income (Rs) Capital gain (Rs)
X 0 10
Y 5 5
Z 10 0
Suppose that the current price of each share is Rs 60. Further, an investor is in 50 per cent tax bracket and capital gain tax rate is 20 per cent. Which share will give highest after-tax return to the investor? Now suppose that the each share was expected to have expected after-tax yield of 12 per cent for the investor. Determine the price of each share.
Chapter 18
PROBLEMS1. B. Das Co. has been a fast-growing firm and has been earning very high return on its investment in the past. Because of the availability of highly profitable investment internally, the company has been following a policy of retaining 70 per cent of earnings and paying 30 per cent of earnings as dividends. The company has now grown matured and does not have enough profitable internal opportunities to reinvest its earnings. But it does not want to deviate from its past dividend policy on the ground that investors have been accustomed to it and any change may not be welcome by them. The company, thus, invests retained earnings in the short-term government securities. Is the company justified in following the current dividend policy? Give reasons to support your answer.
2. D. Damodar Co. is a fast-growing firm in the engineering industry. In the past, the firm has earned a return of 25 per cent on its investments and this trend is likely to continue. The firm has been retaining 25 per cent of its earnings and paying 75 per cent of earnings as dividends. This policy has been justified on the grounds that dividends are generally preferred over retained earnings by shareholders.
Is the current dividend policy justified if most of the shareholders are wealthy persons in high tax brackets? Will your answer change if most of the shareholders of the company were (a) retired persons with no other source of income and (b) the financial institutions?
3. The following data relate to the Brown Limited and the Crown Limited which belong to the same industry and sell the same product:
Brown Ltd
Market Price
Year EPS DPS High Low Book value
Rs Rs Rs Rs Rs* 2005 3.60 2.00 48 52 37.20 2006 3.90 2.00 53 34 38.80 2007 3.70 2.00 51 30 40.60 2008 3.20 2.00 59 31 42.30 2009 3.80 2.00 60 35 43.20
*The face value per share is Rs 10. Crown Ltd
Market Price
Year EPS DPS High Low Book value
Rs Rs Rs Rs Rs* 2005 3.50 1.75 38 34 30.50 2006 3.00 1.50 42 32 32.50 2007 2.50 1.25 42 28 33.75 2008 6.00 3.00 50 30 36.50 2009 5.00 2.50 48 27 38.50
*The face value per share is Rs 10.
Calculate payout ratio, dividend yield, earnings yield and price–earning ratio. Which company is more profitable? Explain the reason for the difference in the market prices of the two companies’ shares.
4. A multinational pharmaceutical company in India has following information about its EPS and dividends payment from 1987 to 2004.
You are required to answer the following questions: (a) What minimum annual percentage dividend increase the company intends to give to its shareholders? (b) Is there any relationship between the earnings increase and the rise in dividends? (c) Do you think that the company has a long-term target payout ratio? (d) The company’s payout in 2003 was 150 per cent. How will you explain this? (e) What clientele does the company have?
EPS Change in DPS Change in Payout Year Rs EPS (%) Rs DPS (%) (%) 1992 13.9 –7.2 5.3 11.7 37.9 1993 15.9 14.2 5.9 11.7 37.0 1994 16.4 3.1 6.5 10.5 39.7 1995 18.4 12.8 7.4 14.3 40.2 1996 19.8 7.4 8.3 11.7 41.8 1997 23.6 19.3 9.4 13.4 39.7 1998 24.7 4.7 10.5 11.8 42.4 1999 25.9 4.5 11.5 9.4 44.4 2000 27.8 7.6 13.0 12.9 46.6 2001 30.7 10.2 14.2 9.5 46.3 2002 30.1 –2.0 15.1 6.1 50.1 2003 31.2 3.7 15.9 5.7 51.1 2004 33.9 8.7 17.2 7.7 50.7 2005 34.9 2.9 19.1 11.5 54.9 2006 81.8 134.5 21.6 12.9 26.4 2007 44.9 –45.1 23.5 8.6 52.3
2008 53.6 19.5 80.5 243.1 150.1
2009 36.5 –32.0 28.2 –65.0 77.2
5. Ashoka Ltd has a capital structure shown below:
Rs (crore)
Equity share capital (Rs 10 par, 5 crore shares) 50
Preference share capital (Rs 100 par, 50 lakh shares) 50
Share premium 50
Reserves and surpluses 80
Net worth 230
Show the changed capital structure if the company declares a bonus issue of shares in the ratio of 1:5 to ordinary shareholders when the issue price per share is Rs 100. How would the capital structure be affected if the company had split its stock five-for-one instead of declaring bonus issue?
6. Polychem Co.’s current capital structure as on 31 March, 2009 is as follows:
Rs (crore)
Share capital (Rs 100 par, 2 crore shares) 200
Share premium 100
Reserves and surpluses 190
490
The current market price of the company’s shares is Rs 140 per share. The earnings per share for the year 2008 was Rs 17. The company has been paying a constant dividend of Rs 6.50 per share for the last ten years.
What shall be the effect on earnings per share, dividend, share price and the capital structure if the company (i) splits its shares two-for-one or (ii) declares a bonus issue of one-for-twenty?
7. Surendra Auto Limited is considering a bonus shares issue. The following data are available:
Rs (crore)
Paid up share capital 12
Reserves 16
Previous three years’ pre-tax profit Year 1 8.0 Year 2 8.6 Year 3 8.3 Recommend the maximum bonus ratio. Give reasons.