Amrut Mody School of Management

FAC331 – Corporate Finance

COURSE OUTLINE ................................................................................................ 2

SESSION PLAN.................................................................................................. 4
DIVIDEND POLICY THEORIES & SHARE VALUATION .................................. 6
BASIC CONCEPTS AND FORMULAE .............................................................. 6
WALTER’S MODEL SUMS.................................................................................7
GORDON’S MODEL SUMS................................................................................9
MM DIVIDEND I RRELEVANCE THEORY ................................................................. 10
ADVANCED CAPITAL BUDGETING................................................................. 12
BASIC CONCEPTS AND FORMULAE ............................................................. 12
REVISION......................................................................................................... 17
CAPITAL RATIONING .................................................................................... 19
INFLATION ADJUSTMENT............................................................................ 20
TREATMENT OF LOSSES ................................................................................ 22
UNEQUAL PROJECT LIVES ............................................................................ 22
REPLACEMENT OF ASSETS............................................................................ 23
RISK ANALYSIS IN CAPITAL BUDGETING ..................................................... 27
PROBABILITY DISTRIBUTION ...................................................................... 29
SENARIO ANALYSIS ....................................................................................... 30
SENSITIVITY ANALYSIS ............................................................................... 31
RISK ADJUSTED DISCOUNT RATE ............................................................... 32
DECISION TREE ANALYSIS ........................................................................... 33
CERTAINTY EQUIVALENT APPROACH (CE) .............................................. 33
LEASING............................................................................................................... 35
APPENDIX............................................................................................................47
NEWSPAPER ARTICLES..................................................................................47
Article 1: 10 crazy dividend paying stocks in Indian stock market by Somay Jain ..................47
Article 2: How investors stand to benefit from dividend payout policy.................................. 49
Article 3: Limited investment options trigger a dividend bonanza ........................................... 51
Article 4: Once-in-a-Lifetime Dealmaking Spree Underway in India ...................................54
FINANCIAL TABLES........................................................................................ 57

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COURSE OUTLINE

Faculty Ms. Karishma Dalal Sections 1

Name
Contact [email protected] Asynchronously
Hours
School Amrut Mody School of Management
Semester Winter Credits 3
Lecture time Sec 1: Tue & Thu: 9:30 to 11:00 Location Online
&
Weekdays
Course This course introduces students to the basic concepts and methods that
Description financial managers use to make effective investing and financing
decisions, and explore the ways in which value is created and measured.
The course lays emphasis on specific finance concepts vis-e-vie the risk
and return relation, capital budgeting decision-analysis tools, dividend
policy, and an overview of Leasing.
Course The course is designed with a specific purpose to learn, using real -life
Objectives examples, how companies manage their finances. It concentrates on
practical aspects that a manager, an entrepreneur or a business leader
needs to know in corporate world.
Learning Upon successful completion of the course, students will have ability to -
Outcomes 1) Analyze the drivers of corporate performance and develop a strategic
vision for future value creation
2) Understand the relevance and implications of strategic financial
decisions on company value like Project Evaluation, Leasing, and
impact of Dividends on corporate valuation.
Pedagogy * The course will consist of Lectures, Class Discussion, Case Studies, and
Practice Assignments. Discussions on contemporary matters involving
examples sourced from financial dailies, periodicals and Journals.
Expectations The fundamental concepts of investing in finance require regular
from practice based on classroom discussions and assignments provided along
Students * with prescribed reference books.
1. Students are expected to be thorough with the basic concepts covered
in FM-II/FM
2. Students are required to read before every class as prescribed by
faculty members. Reading can be in the form of articles, case studies or
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even text book chapters. Without prior preparation by students, the class
will not be effective.
3. The course will have in class exercises and case discussions. Students
are required to show their full cooperation.
4. Carry a simple calculator and course pack to every class; you will be
required to use the same, without which entry to class will be barred.
5. Students are expected to show high degree of academic ethics and not
indulge in Plagiarism. Unethical behaviour, copying or plagiarism would
invite disciplinary action as per the policy of Ahmedabad University.
Assessment Assignment – 10%
/ Evaluation Quizzes – 25%
Class Participation – 10%
Mid Semester – 25%
End Semester – 30%

Quizzes and Exams will be administered online through LMS. Quizzes

would quiz on conceptual clarity. You are expected to be prepared once
the topic is covered in the class.
Make-up quiz or exam will be allowed only in case of medical reasons as
approved by the UG Programme office after submission of documents
duly approved b y SSETU.
Attendance Students are expected to attend all lectures, however, we do understand
Policy that due to personal situations they may miss few lectures; therefore, the
grade drop will begin once the student goes below 80% attendance in the
course. In case of re-scheduling of lectures, new time slot will be
announced in advanced via e-mail, you are required to attend all such re-
scheduled classes.
Course F AC132 Course Pack
Material Suggested Text: M. Khan and Jain P., “Financial Management: Texts,
Problems and Cases”, 8th Ed., McGraw Hill (India) Private Limited.

Suggested Reference Books:

Chandra, P., “Financial Management”, 9th Ed., McGraw Hill (India)
Private Limited

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SESSION PLAN
Topic Readings, Cases,
S. No. Topic & Subtopic Details Activities
Title etc.
Dividend 1 Introduction to Dividends, Article 1 – Dividends and
Policy Legal and Procedural Course Pack Payment
Theories aspects of dividend, Factors Dates
and Share affecting Dividend Decision https://www.
Valuation youtube.com/
watch?v=2wn5
qWYAjS8
2 Types of Dividend Policies
and application of theory
for Corporates
3 Relevance & Irrelevance Practical
Theory. Implications of Exercises
Walter’s Model
4 Implications of Gordon’s Practical
Model Exercises
5 Introduction to irrelevance Irrelevance of Practical
Theory – Modigliani and Dividends. Exercises
Miller’s Model https://www.yo
utube.com/watc
h?v=f5j9v9dfinQ
Advanced 6 Capital Budgeting Cash Practical
Capital flow Estimation – Exercises
Budgeting Introduction and Practice
7 Capital Rationing Practical
Exercises
8 Unequal life of Projects – Practical
Equalised NPV Exercises
9 Inflation & Capital https://www.yo Practical
Budgeting utube.com/watc Exercises
10 Inflation & Capital h?v=LLvL3VrpU Practical
Budgeting p8 Exercises
11 Replacement Decisions Practical
Exercises
12 Replacement Decisions Practical
Exercises
13 Replacement Decisions – Practical

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Loss set off along with Exercises

inflation
14-15 Replacement Decisions – Practical
Loss set off along with Exercises
inflation.
Mid - Term Exam
Advanced 16 Block of Assets and Capital Practical
Capital Budgeting Exercises
Budgeting 17-18 Capital Gain and Capital Practical
Budgeting Exercises
19 Capital Gain and Capital Practical
Budgeting Exercises
Risk 20 Introduction to Risk and Practical
Analysis Uncertainty, Risk Exercises
in Capital Evaluation Approaches
Budgeting 21 Sensitivity Analysis and Practical
risk adjusted Discount Rate, Exercises
22 Analysis of Risk by use of Practical
Decision Tree Approach Exercises
and practice
Leasing 23 Fundamentals and Types of Course Pack
Lease, Finance & Operating Notes
Lease, Break – Even Lease,
Percentage Lease, Sale &
Lease back and Net net net
Lease
24 Lease Vs. Buying, Course Pack
Borrowing, Hire Purchase Notes
and application of Leasing
fundamentals into practice
25 Practical application of Practical
Leasing Decision Exercises
26 Practical
Revision
Exercises
E n d - Term E xa m

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DIVIDEND POLICY THEORIES & SHARE

VALUATION
BASIC CONCEPTS AND FORMULAE
Dividend Dividend is that part of profit after tax which is distributed to the
shareholders of the company. In other words, the profit earned by
a company after paying taxes can be used for: i) Distribution of
dividend or ii) Can be retained as surplus for future growth
Gordon’s Model 𝐸 (1 − 𝑏)
𝑃0 =
𝐾0 − (𝑏 × 𝑟)

Where, P0= Price per share, E = Earnings per share, b = Retentio n ratio, (1 -b)
= Proportio n of firm’s earnings distributed as dividends, K 0= Capitaliz atio n
rate or Cost of capital or required return by equity shareho lders, r= Rate of
returns earned on investment made by the firm,
g= b*r= Growth rate
Walter’s Model 𝑟
𝐷 + 𝑘 (𝐸 − 𝐷)
𝑃0 =
𝑘
Where, P0= Price per share, D= Dividend per share, E = Earnings per share,
(E-D) = Retained earnings per share, K 0= Overall Capitaliz atio n rate or
Overall Cost of capital, r= Rate of returns earned on investment made by the
firm.
Modigliani and Miller Modigliani – Miller theory was proposed by Franco Modigliani
(MM) Hypothesis and Merton Miller in 1961. MM approach is in support of the
irrelevance of dividends i.e. firm’s dividend policy has no effect on
value of the firm.
Dividend Pay-out DPS
Ratio EPS
Dividend Yield Model DPS
Ke =
MPS
P/E Ratio or Earnings EPS
Ke =
Yield Model MPS

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WALTER’S MODEL SUMS

1. ABC Limited has capitalization rate of 10%. Its earnings per share are Rs.
20. The company declares Rs. 10 as dividend. Calculate the share price as
per Walter’s Model assuming 20% returns on investment.

2. Calculate the share price as per Walter’s Model from the following data for
the two companies and comment which company maximized shareholder
value.

Particulars A Limited B Limited

Earnings per Share (Rs.) 10 10
Cost of Capital (%) 12 12
Return on Investment (%) 15 15
Dividend per Share (Rs.) 8 5

3. The following data is available for Murugan Limited.

Particulars
EPS (Rs.) 40
Cost of Capital (%) 10
ROI (%) (a) 13 ; (b) 10; (c) 8
D/P Ratio (%) (a) 0 ; (b) 25; (c) 37.5; (d)50 (e) 75; (f) 100

As per the Walter’s Model show the effect of dividend payment on the
market price per share for each of the above cases and comment on the
relation between Cost of Capital and Return on Investment.

4. The following information is available for Skylark Limited. You are

required to determine the price of the share using Walter’s model, and
suggest the optimum dividend policy. EPS= Rs. 20, D/P = 50%, P/E = 10,
IRR =15%.

5. ABC Company which earns Rs. 10 per share is capitalized at 10 percent and
has a return on investment of 12 percent. Determine the optimum dividend

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pay-out ratio and the price of the share at the payout using Walter’s
dividend policy model.

6. Best of Luck Limited is expecting a 10% return on total assets of Rs. 50

lakhs. The company has outstanding shares of 20,000. The BOD of the
company have decided to pay 40% of the earnings as dividends. The rate of
return required by shareholders is 12.5%; rate of return expected on
investment is 15%. You are required to determine the price of the share
using Walter’s model. Are you satisfied with the current dividend policy of
the company? If not why?

7. The following data is available for S. Kumar and Company Limited:

Rs.
Return on Investment (%) 20
Outstanding 12% preference capital 100 lakhs
Net Profit 30 lakhs
No. of equity shares 3 lakhs

What should be the approximate dividend pay-out ratio so as to keep the

share price at Rs. 42 by using Walter’s model?

8. The following data is available for Natraj Limited.

Particulars
Earnings per Share (Rs.) 10
Capitalization Rate (%) 15
Return on Investment (%) (a) 20 ; (b) 15; (c) 10
Dividend Payout Ratio (%) (a) 0 ; (b) 25; (c) 37.5; (d)50 (e) 75; (f) 100

As per the Walter’s Model show the effect of dividend payment on the
market price per share for each of the above cases and comment on the
relation between the Capitalization rate and Return on Investment.

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GORDON’S MODEL SUMS

9. The following data is available, you are requested to determine the share
price: EPS = Rs. 10, Retention ratio = 40%, Capitalization rate = 15%, Return
on investment = 14%.

10. From the following data of Shri Sai Limited, calculate the value of the
firm’s share in each case if: earnings per share is Rs. 10, Cost of capital is
15%. The rate of return on investments is (a) 16%; (b) 15%; (c) 14%. The
Retention Ratio varies as the following
1 2 3 4 5 6
Retention Ratio 90 80 70 60 50 20

11. Good Luck Limited’s earnings are Rs. 200,000 and outstanding equity
shares are 10,000. The company’s cost of capital is 15%. Rate of return on
investment is 20%. Determine the equity share price assuming a 60% D/P
ratio.

12. A firm has total assets of Rs. 2000,000 and 100,000 outstanding equity
shares of Rs. 10 per share. It earns 20% return on the assets. What would be
the share price of the firm if the capitalization rate is 15% and the retention
ratio is 80%. What will happen to the share price is the D/P varies at (a)
50%; (b) 75%; (c) 100%. Assume IRR is 16%.

13. From the following data determine share price using Walter’s and
Gordon’s Model, if IRR is 5%, 10% and 15%. Earnings per share is Rs. 20;
Capitalization rate is 10% and Retention ratio is 60%

14. The EPS of Bhatt Limited is Rs. 18. The cost of capital is 15%. Return on
investments of the company yield a 10% return. The company is
considering a pay-out of 0%, 25%, 50%, 75% and 100%. Which of the
alternative cases would maximize shareholder wealth as per Walter’s as
well as Gordon’s Model? Will your decision change if the P/E ratio comes
down by 2?

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MM DIVIDEND IRRELEVANCE THEORY

Step1: Calculate the future price of the share
Step2: Using Net Profit data calculate Retained Earnings for re-investment purposes
Step3: Using New investment data calculate # of shares required
Step4: Calculate the value

1. ABC Ltd. has a capital of Rs. 1000,000 in equity shares of Rs.100 each. The
shares are currently quoted at par. The company proposes to declare a
dividend of Rs.10 per share at the end of the current financial year. The
capitalization rate is 12%.
a. What will be the price of the share at the end of the current year if a
dividend is declared;
b. What will be the price if dividend is not declared?
c. Further assume that the company pays dividend and has a net profit
of Rs. 500,000 and makes new investment of Rs. 1000,000 during the
period, how many new shares must issue?
d. Calculate the value of the firm in both the cases

2. Agile Ltd. belongs to a risk class of which the appropriate capitalization

rate is 10%. It currently has 100,000 shares selling at Rs.100 each. The firm is
contemplating declaration of a dividend of Rs.6 per share at the end of the
current fiscal year which has just begun. Answer the following questions
based on Modigliani and Miller Model:
a. What will be the price of the shares at the end of the year if a
dividend is declared?
b. What will be the price if dividend is not declared?
c. Assuming that the firm pays dividend, has net income of Rs.10 lakhs
and makes new investments of Rs.20 lakhs during the period, how
many new shares must be issued?
d. Calculate the value of the firm in both the cases

3. AB Engineering ltd. belongs to a risk class for which the capitalization rate
is 10%. It currently has outstanding 10,000 shares selling at Rs. 100 each.
The firm is contemplating the declaration of a dividend of Rs. 5 per share at
the end of the current financial year.

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a. What will be the price of the shares at the end of the year if a
dividend is declared?
b. What will be the price if dividend is not declared?
c. If it expects to have a net income of Rs. 100,000 and has a proposal for
making new investments of Rs. 200,000, how many new shares must
be issued?
d. Calculate the value of the firm in both the cases

4. RST Ltd. has a capital of Rs. 1000,000 in equity shares of Rs. 100 each. The
shares are currently quoted at par. The company proposes to declare a
dividend of Rs. 10 per share at the end of the current financial year. The
capitalization rate for the risk class of which the company belongs is 12%.
What will be the market price of the share at the end of the year, if
a. A dividend is not declared?
b. A dividend is declared?
c. Assuming that the company pays the dividend and has net profits of
Rs. 500,000 and makes new investments of Rs. 1000,000 during the
period, how many new shares must be issued? Use the MM model.

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ADVANCED CAPITAL BUDGETING

BASIC CONCEPTS AND FORM ULAE

Income Sales
Statement (-) Total Variable Cost
(-) Total Fixed Cost
(-) Interest
= EBDT
(-) Depreciation
= EBT
(-) Tax
= EAT
(+) Depreciation
(+) NWC Recovered in terminal year
(+) SV recovered in terminal year
= CFAT
(X) PVIFr,n
= PV of CFAT
Accounting Rate The accounting rate of return of an investment
of Return measures the average incremental annual net
income of the project as a percentage of the
investment.

Average Annual PAT

𝐀𝐑𝐑 = × 100
Average Investment ∗

When Depreciation is by SLM:

1
𝐀𝐈 = [ (Net Cost − SV)] + NWC + SV
2

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When Depreciation is by WDV:

∗ Opn invest. +Cls invest.
𝐀𝐯𝐠. 𝐈𝐧𝐯𝐞𝐬𝐭. = ( )
2
* Include NWC in Opening Investment
Payback Period The length of time required for an investor to recover the
money invested in the project.
Initial Cash Outflows
𝐏𝐁𝐏 (𝐞𝐪𝐮𝐚𝐥 𝐜/𝐟) =
Annual CFAT

𝐏𝐁𝐏 (𝐔𝐧𝐞𝐪𝐮𝐚𝐥 𝐜/𝐟)

= Yr where CCFAT  Total COF
Total COF − (Yr upto which CCFAT < Total COF)
+[ ]
CFAT in the next year

Net Present Difference between the benefit (cash inflows) arising from
Value the project and the investment incurred (cash outflows) due
to undertaking of the project.

𝑵𝑷𝑽 = 𝑃𝑉 𝑜𝑓 𝐶𝐼𝐹 − 𝑃𝑉 𝑜𝑓 𝐶𝑂𝐹

Decision Rule
If NPV ≥ 0 Accept the Proposal
If NPV ≤ 0 Reject the Proposal
For mutually exclusive projects, the one with the higher
NPV should be selected.

Benefit Cost Ratio of the benefit (cash inflows) arising from the project
Ratio or as against the investment incurred (cash outflows) due to
Profitability undertaking of the project.
Index
PV of CIF
𝐁𝐂𝐑 =
PV of COF

Decision Rule
If BCR ≥ 1 Accept the Proposal
If BCR ≤ 1 Reject the Proposal
For mutually exclusive projects, project with higher BCR
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should be selected

Internal Rate of IRR is the discount rate that equates the present values of
Return cash inflows with the initial investment associated with a
project, thereby causing NPV = 0. The project will be
accepted when IRR exceeds the required rate of return. This
IRR is then compared to a criterion rate of return that can
be the organization’s desired rate of return for evaluating
capital investments.
Steps to Calculate IRR:
Step 1: Compute approximate payback period also called
fake payback period.
Step 2: Locate this value in PVIFA table corresponding to
period of life of the project. The value may be falling
between two discounting rates.
Step 3: Discount cash flows using these two discounting
rates to find a break even range.
Step 4 : Use following Interpolation Formula:

(NPV @ LDF)
𝐈𝐑𝐑 = LDF +
NPV@LDF − NPV@HDF
Here, LDF = Lower Discount Factor & HDF= Higher
Discount Factor

Decision Rule
If IRR ≥ Cut-off Rate or WACC, Accept the Proposal
If IRR ≤ Cut-off Rate or WACC, Reject the Proposal

r = Discount Theoretically, the discount rate or desired rate of return on

Rate, rate or an investment is the rate of return the firm would have
return on earned by investing the same funds in the best available
investment, cost alternative investment that has the same risk. Determining
of capital, the best alternative opportunity available is difficult in
WACC, practical terms so rather than using the true opportunity
expected rate of cost, organizations often use an alternative measure for the
return, desired rate of return. An organization may establish a
opportunity cost minimum rate of return that all capital projects must meet;
of capital this minimum could be based on an industry average or the
cost of other investment opportunities. Many organizations
choose to use the overall cost of capital or Weighted

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Average Cost of Capital (WACC) that an organization has

incurred in raising funds or expects to incur in raising the
funds needed for an investment.
Estimation of Capital Budgeting analysis considers only incremental cash
Project Cash flows from an investment likely to result due to acceptance
Flows of any project. Therefore, one of the most important tasks
in capital budgeting is estimating future cash flows for a
project.
Separation Principle
 Cash flows associated with the investment side and the
financing side of the project should be separated.
 While defining the cash flows on the investment side,
financing costs should not be considered because they
will be reflected in the cost of capital figure against
which the rate of return figure will be evaluated.
I ncremental Principle
 To ascertain a project’s incremental cash flows you have
to look at what happens to the cash flows of the firm
with the project and without the project
 Ignore sunk costs
 Include opportunity costs
 Question the allocation of overhead costs
 Estimate working capital properly
Initial All Outflows of year zero; i.e. Purchase Price + Installation
Investment expense + Workers’ training expense to put the asset at use
 Subsidy from Govt. + NWC
Net Cost of the Purchase Price + Installation Exp. + Workers’ training
Asset expense to put the asset to use  Subsidy from Govt.
Depreciation Net Cost of the Asset − Salvage Value
(SLM) Life of the Asset
Depreciation Net Cost of the Asset
(WDV) Less: Depreciable Amount
Balance at the end of the Yr.
Further notes on  In India, depreciation is allowed as deduction every year
Depreciation on the written-down value basis in respect of fixed
assets as per the rates prescribed in the Income Tax
rules.
 According to the provisions of the Income Tax Act
depreciation is computed on the written down value and
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charged not on an individual asset but on a block of

assets.
 Block of Assets: a group of assets falling within a class of
assets being buildings, machinery, plant or furniture, in
respect of which some percentage of depreciation is
prescribed by the Indian Income tax rules.
 Depreciation Base: In a replacement decision, the
depreciation base of a new asset will be equal to: Written
down value of old Asset + Net Cost of new Asset –
Salvage value of the old Asset.
 Single Asset: In case a block consists of a single asset, no
depreciation is to be charged in the terminal year in
which it is sold.
 Cash Outflow in Replacement Situation: Net Cost of new
Asset + WK – Sales Proceeds of the old Asset

Capital Gain or  As per the current Income tax laws in India, if the rate
Loss due to of depreciation is same, no immediate tax liability (or
Replacement of tax savings) will arise on the sale of an asset because the
Asset block of assets still exists. And the value of the asset sold
is adjusted in the depreciable base of assets.
 Capital Gain/Loss can arise in these situations:
1) if SV < WDV: Capital Loss leads to Tax Savings and
2) if, SV > WDV: Capital Gain: Tax Liability

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REVISION

1. From the following information calculate present values of cash outflows:

Purchas price of new machine 1000,000
Installation expenses 150,000
Workers’ training expense incurred 50,000
to put the asset to use
Subsidy from Govt. received at the 50% of purchase
end of the 1st year price
Subsidy from Govt. received at the 10% of purchase
beginning of 5th year price
Working Capital required now 200,000
Working Capital required at the 100,000
beginning of the 3 rd year
Cost of Capital 10%

2. Moon limited provides you with the following information:

(Rs.)
Purchase price of machine 80,000 Calculate the ARR if (i) The
Installation charges 20,000 machine is depreciated using SLM.
Working capital 10,000 (ii) The machine is depreciated @
Life of machine (yrs.) 4 20% WDV
Scrap Value of machine 40,000
Tax Rate (%) 30
Annual EBDT 65,000

3. Naveen enterprises is considering a capital project, calculate project cash

flows if the following information is available:
i. The investment outlay on the project will be Rs. 120 million. This
consists of Rs. 100 million on plant and machinery and Rs. 20 million
on NWC. The entire outlay will be incurred at the beginning of the
project.

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ii. The project will be financed with Rs. 45 million equity capitals, Rs. 5
million preference capitals and Rs. 50 million debt capitals. Preference
capital will carry a dividend rate of 15% while coupon rate is 20%.
iii. The life of the project is 5 years. At the end of the 5 years Fixed
Assets will fetch a net salvage value of Rs. 30 million whereas net
working capital will be liquidated at its book value.
iv. The project is expected to increase revenues of the firm by Rs. 120
million per year. The increase in cost on account of the project is
expected to be Rs. 80 million per year. The effective tax rate is 30%.
v. Plant and machinery will be depreciated at 25% WDV.
vi. Assume a 20% discount rate

4. ABC Pharma Limited is engaged in the manufacture of a new drug

Floxxin, calculate project cash flows if the following info is available:
i. Floxxin is expected to have a PLC of 7 years and thereafter it would
be withdrawn from the market. The sales from this preparation ware
expected to be as follows (in Rs. Million): 80, 120, 160, 200, 160, 120, 80
ii. The capital equipment required for manufacture of Floxxin is Rs. 120
ml and it will be depreciation at 25% WDV for tax purpose. The
expected NSV after 7 years is Rs. 25 ml
iii. The NWC for the project is 25% of sales. At the end of 7 years, NWC
is expected to be liquidated at par, barring an estimated loss of Rs. 4
ml on account of bad debt.
iv. The accountant of the firm has provided the following cost estimates
for Floxxin:
a. Raw material cost: 30% of sales
b. Variable labour cost: 10% of sales
c. Fixed annual operating and maintenance cost: Rs. 10 ml
d. Variable selling expenses: 10% of sales
e. The incremental overhead attributable is expected to be 5% of
sales.
v. The manufacture of Floxxin would cut into the existing sales of a
product and thus entail a deduction of Rs. 10 ml of contribution
margin per year
vi. The tax rate applicable to the firm is 30%. Assume a 15% discount rate
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5. Maruti Communication Limited is contemplating either of two projects

having 5 years estimated life. Cost of capital is 11%. The following details
are available:

Particulars 0 1 2 3 4 5
Project A (105,000) 10,000 15,000 20,000 25,000 35,000
EAT
Project B (165,000) 15,000 20,000 25,000 30,000 40,000

Select the best project under the following methods:

a. ARR b. PBP c. Disc. PBP d. NPV e. BCR f. IRR

CAPITAL RATIONING

6. Cortana Limited has identified the following proposals, the following data
is available:
Project Cash Outlay BCR
A 100,000 1.22
B 50,000 1.17
C 40,000 1.46
D 30,000 1.72
E 20,000 1.13
F 10,000 1.04
Which project would you choose if the firm has a budget of Rs. 150,000 for
capital expenditure if the projects are (i) Indivisible (ii) Divisible?

7. A firm is unable or unprepared to invest more than Rs. 400,000 in the

current year, but has the following projects available. Select which projects
should be undertaken and in which order, if the projects are (i) Indivisible;
(ii) Divisible.

Project Cash Outlay NPV

1 140,000 31,000
2 150,000 29,000
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3 100,000 15,000
4 180,000 36,000
5 210,000 22,000

8. Foundry Corp. has a capital budget of Rs. 1000,000 for capital expenditure.
It has before it the following proposals. What will be your answer if
projects are (i) Divisible (ii) Indivisible?

Project Cash Outlay PI

U 500,000 1.22
V 150,000 0.95
W 350,000 1.20
X 450,000 1.18
Y 200,000 1.19
Z 400,000 1.05

INFLATION ADJUSTMENT

9. If a firm expects 10% real rate of return from an investment project and the
expected inflation rate is 7%, calculate the nominal required rate of return.

10. The nominal rate of return is 14% and inflation is at 7%. Calculate: (i)
NPV from the real cash flows given; (ii) Calculate cash flows in nominal
terms and calculate NPV.
Year 0 1 2 3 4
Cash Flows (10,000) 3000 3000 3000 3000

11. Neptune Limited is considering a new proposal and needs to evaluate the
new proposal with respect to changes due to inflation. The proposals real
cost of capital is 10% and nominal cost is 17.7%. Calculate the net present
value of the proposal (i) with inflation; (ii) without inflation. It has
following information (in Rs. Lakhs):
Year 0 1 2 3 4 5
Cash Flows (10) 6 3 2 5 5
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12. Determine NPV of the project with the following information. (i) Restate
the cash flow in nominal term and discount at 12%; (ii)Restate the discount
rate in real terms and use this to discount the real cash flows:
Initial Outlay of project Rs. 40,000
Annual revenues (Without inflation) Rs. 30,000
Annual costs (Without inflation) Rs. 10,000
Useful life 4 years
Tax Rate 50%
Cost of Capital (Including inflation premium of 10%) 12%

13. An FMCG company is planning to introduce new product “Chatpata

Ketchup”. The manufacturing equipment for this will cost Rs. 560,000. The
expected life of the equipment is 8 years and will fetch nothing in terminal
year. The company is thinking of selling the ketchup in a Pichkoo pack of
80 grams at Rs. 7.5 per pack. Pichkoo is a small pack which makes Chatpata
Ketchup affordable to a host of new consumers at the bottom of the
pyramid. It is estimated that variable cost per pack would be Rs. 6 and
annual fixed cost would be Rs. 420,000. Fixed cost includes depreciation
and overheads of Rs. 30,000. Advertising expense for first two years will be
Rs. 200,000 and 50,000 respectively. The company expects to sell 50,00,000
Pichkoo packs p.a. If this new product is introduced there is expected to be
reduction in contribution from the existing Tomato Ketchup brand that the
firm manufactures. Figures if Rs. Thousands.
Year 1 2 3 4 5 6 7 8
Reduction in
100 100 80 80 70 70 60 60
Contribution

All of the above cash flows have been expressed in real terms. Inflation is
expected to be at about 5% p.a. over the next decade. All of the relevant
cash flows are expected to increase at this annual rate. The firm’s nominal
rate of discounting is 14.45% p.a. Working Capital of Rs. 50,000 will be
required from the start of the project and will be recovered with a loss of
Rs. 4,000 in terminal year. Assume that the tax rate is 40%. Use real cash
flows and suggest giving reasons, should the project be undertaken or not?
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TREATMENT OF LOSSES
14. Cash flows for a project are given below. Assuming losses of one year can
be carried forward & set off in next year, calculate cash inflows of the
project. Calculate NPV, if the cost of capital is 10% and tax rate is 30%.
Figures are in Rs. Thousands.
Year 0 1 2 3 4 5
EBT (600) (90) 80 125 150 250

15. Cash outflow for an expansion project will be Rs. 1500,000 and the useful
life is 5 years. Assuming that losses of one year can be carried forward &
set off in next year, calculate NPV of the project.
Years 1 2 3 4 5
PBT (Rs.’ 000) (50) (180) 120 250 300

UNEQUAL PROJECT LIVES

The choice between projects which have different lives should be made by
evaluating them for equal periods of time.

16. PQR Limited needs to select one from following two mutually exclusive
proposals. Based on the following information which proposal should they
should select if the tax rate is 30% and depreciation is calculated though
straight line method:
Figures in Rs. Lakhs
Proposal I Proposal II
Initial Investment (35) (30)
PBT 1 6 13
2 12 10
3 10 8
4 7.5 -
Life of the Machine 4 years 3 years

17. ABC Pharma Ltd. is considering two mutually exclusive proposals for its
expansion programme. The firm’s tax rate is 35%, and its required rate of
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return is 12%. Which of the two proposals should be chosen if the following
information is available:
Proposal I Proposal II
Purchase price of equipment Rs. 800,000 Rs. 1940,000
Salvage Value in the terminal year Rs. 100,000 Rs. 180,000
Useful Life (years) 7 11
Incremental Revenue p.a. Rs. 500,000 Rs. 750,000
Incremental Costs p.a. Rs. 240,000 Rs. 360,000

REPLACEMENT OF ASSETS
The replacement decisions aims at improving operating efficiency and to
reduce cost. Generally, all types of plant and machinery require replacement
either because of the economic life of the plant or machinery is over or
because it has become technologically outdated. The former decision is known
as replacement decisions.

18. A plastic manufacturer has under consideration the proposal of production

of high quality plastic glasses. The necessary new equipment to
manufacture the same will cost Rs. 1 lakh and would last for 5 years. The
expected salvage value is Rs. 10,000. Depreciation is @ 25% and it is the
only asset in the block. Existing Machine, purchased two years back, has
the book value Rs. 28,125 today. It can be sold today for Rs. 12,000 and will
fetch nothing at the end of 5 years. The glass can be sold for Rs. 4 each.
Regardless of level of production manufacturer will incur a cash cost of Rs.
25,000 each year if the project is undertaken. Overhead cost allocated to this
new project is Rs. 5000. Variable costs are estimated at Rs. 2 per glass.
Manufacturer estimates to sell 75,000 glasses per year. Tax rate is 35%.
Should the proposed equipment be purchased? Cost of capital 20% and
additional working capital requirement is Rs. 50,000. Assume that profit or
loss from sale of assets is taxed at 30%.

19. Metcalf Engineering is considering a proposal to replace one of its

hammers. The following information is available. The existing hammer

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was bought 2 years ago for Rs. 10 lakh. It has been depreciated at the rate of
331/3 % per annum. It can be presently sold at its book value. It has a
remaining life of 5 years after which, on disposal, if would fetch a value
equal to its then book value. This existing hammer will incur maintenance
cost of Rs. 50,000 p.a. from 3 rd year onwards of its life.
The new hammer costs Rs. 16 lakhs. It will be subject to a depreciation rate
of 331/3%. After 5 years it is expected to fetch a value equal to its .book
value. The replacement of the old hammer would increase revenues by Rs.
2 lakhs per’ year and reduce operating cost by Rs. 15 lakh per year. Compute
the incremental post-tax cash flows associated with the replacement
proposal, assuming a tax rate of 50%.

20. A Chemical company owns a machine with the following

characteristics:
Particulars Amount
Book value 110,000
Current Market Value 80,000
Expected Salvage Value at the end of 5 Nil
years remaining useful life
Annual cash operating costs 36,000
The firm’s cost of capital is 15%; its tax rate is 55%. The company follows
the straight-line method of depreciation. The management of the company
is considering selling the machine. If it does so, the total cash operating
costs to perform the work now done by the machine will increase by Rs.40,
000 per year to Rs. 76,000 per year. Advise whether the machine should be
sold.

21. Techtronic limited an existing company, are considering a new project for
manufacturing of pocket video games involving a capital expenditure of Rs.
600Lakhs and Rs. 200 lakhs in current assets. Project will have capacity of
production of 12 lakhs units per annum and capacity utilisation during the 6
years works life of the project is expected to be as indicated below:
Year Capacity Utilisation %
1 33 1/3%
2 66 2/3%
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3 90%
4-6 100%
The average price per unit of the product is expected to be Rs. 200 netting a
contribution of 40%. Annual fixed costs, excluding depreciation, are
estimated to be Rs. 480 lakhs per annum from the third year onwards; for
the first and second year it would be Rs. 240 lakhs and Rs. 360 lakhs
respectively. The average rate of depreciation for tax purpose is 33-1/3% on
the capital assets, no other tax relief are anticipated. The rate of income tax
may be taken at 35%. At the end of the 3 rd year an additional investment of
Rs. 100 lakhs would be required for working capital. The company has
targeted for a rate of return of 15%. You are required to indicate whether
the proposal is viable giving your workings notes and analysis. Terminal
value of the fixed assets may be taken at 10% and for the current assets at
100%. Calculation may round off to lakhs of rupees.

22. Beta Company Limited is considering replacement of its existing machine

by a new machine, which is expected to cost Rs. 264,000. The new machine
will have a life of five years and will yield annual cash revenues of Rs.
568,750 and incur annual cash expenses of Rs. 295,750. The estimated
salvage value of the new machine is Rs. 18,200. The existing machine has a
book value of Rs. 91,000 and can be sold for Rs. 45,500 today. The existing
machine has a remaining useful life of five years. The cash revenues will be
Rs. 455,000 and associated cash expenses will be Rs. 318,500. The existing
machine will have a salvage value of Rs. 4550, at the end of five years. The
Beta Company is in 35% tax-bracket, and writes off depreciation at 25%, on
written-down value method. The Beta Company has a target debt to value
ratio of 15%. The Company in the past has raised debt at 11% and it can
raise fresh debt at 10.5%. Beta Company plans to follow dividend discount
model to estimate the cost of equity capital. The Company plans to pay a
dividend of Rs. 2 per share in the next year. The current market price of
Company’s equity share is Rs. 20 per equity share. The dividend per equity
share of the Company is expected to grow at 8% p.a.
Required: (a) Compute the incremental cash flows of the replacement
decision. (b) Compute the weighted average cost of capital of the
Company. (c) Find out the net present value of the replacement decision.
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(d) Estimate the discounted payback period of the replacement decision. (e)
Should the Company replace the existing machine? Advice.

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RISK ANALYSIS IN CAPITAL BUDGETING

A. Statistical Techniques
Probability Probability is a measure about the chances that an
event will occur. When an event is certain to occur,
probability will be 1 and when there is no chance of
happening an event probability will be 0.

Expected Value E(V) or For data that is forecasted e.g. Forecasted Cash flows,
Expected Return E(R) expected value is nothing but the Weighted Mean of
the data.

(a) Expected Net Cash Flows: calculated as the sum

of the likely Cash flows of the project multiplied by
the probability of cash flows.
𝐸𝑁𝐶𝐹 = ∑ 𝑥𝑖 . 𝑝𝑖

(b) Expected Net Present Value:

𝐸𝑁𝑃𝑉 = 𝑁𝐶𝐹 × 𝑃𝑉𝐼𝐹

Standard Deviation & SD = σ= Measures the dispersion from expected mean.

Variance 𝑉𝑎𝑟 = 𝜎 2 = Average squared difference of the values
from the mean
𝜎 2 = ∑(𝑥 − 𝑥̅ )2 × 𝑝
Coefficient of Variation Measures relative dispersion, represents the ratio of
the Standard Deviation to the Mean
𝜎
𝐶𝑉 =
𝑥̅
B. Conventional techniques
Risk-adjusted discount A risk adjusted discount rate is a sum of risk free rate
rate and risk premium. The risk premium depends on the
perception of risk by the investor of a particular
investment and risk appetite of the investor.
So RADR = Risk free rate+ Risk premium
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Rf = Risk Free Rate: It is the rate of return on

Investments that bear no risk.
Risk Premium: It is the rate of return over and above
the risk-free rate, expected by the investors as a
reward for bearing extra risk. For high risk project,
the risk premium will be high and vis-a-versa.
Certainty equivalents Expressing risky future cash flows in terms of the
certain cash-flow which would be considered, by the
decision maker, as their equivalent. Discounted value
of cash flow is obtained by applying risk less rate of
interest.
C. Others techniques
Sensitivity analysis Used to study the impact of changes in the input
variables (selling price, costs, quantity etc.) on the
outcome of the project. The project outcome is
studied after taking into consideration the change in
only one variable at a time. The more sensitive is the
NPV, the more critical is that variable.
Scenario analysis Calculates the outcome of the project considering this
scenario where the variables have changed
simultaneously. The variability in the outcome under
the three different scenarios – Best, Expected, and
Worst- would help the management to assess the risk
a project carries. Scenario analysis is far more
complex than sensitivity analysis because in scenario
analysis all inputs are changed simultaneously
considering the situation in hand while in sensitivity
analysis only one input is changed and others are kept
constant.
Decision tree A technique to handle sequential decisions is done
through Decision Tree technique. A Decision tree is a
graphical representation of relationship between
future decisions and their consequences. The
sequence of events is shown in a format resembling
branches of tree, each branch representing a single
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possible decision, its alternatives and the probable

result in terms of NPV. The alternative with the
highest amount of expected monetary value is
selected.

PROBABILITY DISTRIBUTION
1. From the following given information, calculate the Expected Net
Cashflow (ENCF), Expected NPV (ENPV), Standard Deviation (SD),
Variance (Var) and Coefficient of Variation (CV). Assume Cost of
Capital at 10%.
Project A
Events Probability
CIF
(%)
1 5000 10
2 6000 20
3 7000 30
4 8000 20
5 9000 20

2. From the following given information, calculate the ENCF, ENPV, SD,
Var and CV. Assume Cost of Capital at 20%.
Project A Project B
Years Probability Probability
CF CF
(%) (%)
1 4000 10 12,000 10
2 5000 20 6000 15
3 6000 40 4000 10
4 7000 20 10,000 15
5 8000 10 8000 50

3. From the following given information, calculate the ENPV assuming a 10%
Cost of Capital.

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Year 1 Year 2 Year 3

Situation Prob. Prob. Prob.
CIF CIF CIF
(%) (%) (%)
Pessimistic 2000 20 2000 40 2000 25
Expected 5000 60 5000 50 5000 35
Optimistic 7000 20 7000 10 7000 40

SENARIO ANALYSIS
4. The following information is available with respect to a new project:
Pessimistic Expected Optimistic
Particulars
Rs. Rs. Rs.
Initial Investment 30,000
Selling price per unit 75 100 150
Variable costs per unit 40 20 15
Fixed cost 3000
Sales volume (units) 800 1400 1800
Life (years) 5
Discount rate 10%
Tax Rate 50%
Depreciation 6000
Calculate the project’s NPV and show how sensitive the results are to
show how sensitive the results are to the three different situations.

5. The following information applies to a new project:

Particulars Pessimistic Expected Optimistic
Initial Investment 125,000
Selling price per unit 100 150 200
Variable costs per unit 30 20 15
Fixed costs 100,000
Sales volume (units) 2000 3000 5000
Life (years) 5
Discount rate 10%
Calculate the project’s NPV and show how sensitive the results are to the
three different situations.
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6. The following information is available with respect to a new project:

Project Project
Particulars Q R
Rs. Rs.
Initial Investment 65000
CIF
Pessimistic 20,000 10,000
Expected 25,000 25,000
Optimistic 35,000 45,000
Calculate the project’s NPV if cost of capital is 16% and show how
sensitive the results are to show how sensitive the results are to the three
different situations and which project will be selected.

SE NSITIVITY ANALYSIS
7. The following information applies to a new project: Initial Investment Rs.
125,000; selling price per Unit Rs. 100; Variable costs per unit Rs. 30; Fixed
costs for the period Rs. 100,000; Sales volume 2,000 units; Life 5 years;
Discount rate 10%. Required: Project’s NPV and show how sensitive the
results are to various input factors.

8. X Ltd is considering its New Product with the following details

Sr. No. Particulars Figures

1 Initial capital cost Rs. 400 Cr
2 Annual unit sales Rs. 5 Cr
3 Selling price per unit Rs. 100
4 Variable cost per unit Rs. 50
5 Fixed costs per year Rs. 50 Cr
6 Discount Rate 6%

a) Calculate the NPV of the project.

b) Find the impact on the project’s NPV of a 2.5 per cent adverse
variance in each variable. Which variable is having maximum effect?

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RISK ADJUSTED DISCOUNT RATE

9. A project is required to invest Rs. 100,000 and it is expected to generate
cash flow after tax over its economic life of 5 years of Rs. 20,000, Rs. 30,000,
Rs. 35,000, Rs. 55,000 and Rs. 10,000. Risk free rate is 7%and the decision
makers are interested to add 3% as risk premium for the project. You are
required to calculate NPV using RADR approach and suggest whether the
project is acceptable or not.

10. A project has an initial investment of Rs. 40,000 and it is expected to

generate annual cash inflows of Rs. 16,000 for 4 years. The Projects RADR
is 20%. You are required to calculate IRR and suggest whether the project is
acceptable or not.

11. A company engaged in manufacturing of toys is considering a line of

stationary items with an expected life of five years. From past experience
the company has a conservative view in its investment in new products.
Accordingly company considers the stationary items an abnormally risky
project. The company’s management is of view that normally required rate
of return of 10% will not be sufficient and hence minimum required rate of
return should be 15%. The initial investment in the project will be of Rs.
110,00,000 and expected free cash flows to be generated from the project is
Rs. 30,00,000 for 5 years. Determine whether project should be accepted or
not.

12. A pencil manufacturing company is considering the introduction of a line

of gel pen with an expected life of five years. In the past the firm has been
quite conservative in its investment in new projects, sticking primarily to
standard pencils. In this context, the introduction of a line of gel pen is
considered an abnormal risky project. The CEO of the company is of
opinion that the normal required rate of return for the company of 12% is
not sufficient. Therefore, the minimum acceptable rate of return of this
project should be 18%. The initial outlay of the project is Rs. 10,00,000 and
the expected free cash flows from the projects are given below (In Rs.
Lakhs):

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Yea rs 1 2 3 4 5
Ca sh Flo ws 2 3 4 3 2

DECISION TREE ANALYSIS

13. Anisha a BBA student is considering starting a business after graduation.
This new project will cost Rs. 2000,000. She has calculated the Net Cash-
flows over the proposals life of estimated next 2 years.
Year 1 Probability Year 2 Probability
900,000 0.6
1100,000 0.4
1200,000 0.4
1700,000 0.5
1300,000 0.6
2100,000 0.5
Use a decision tree approach to structure the alternatives available, and
calculate the NPV. The discount rate is 14%.

14. Venkat Limited provides the following estimates for the proposal of plant
expansion. Initial investment required is Rs. 400,000. Advise the company
using decision tree approach on the feasibility of the project.

PV of CFAT
Probability
With Expansion Without Expansion
450,000 200,000 0.2
700,000 350,000 0.3
500,000 500,000 0.5

CERTAINTY EQUIVALENT APPROACH (CE)

15. From the following given information about Green Field Limited,
Calculate NPV and suggest which project should be selected if the risk-free
cost of capital is 6%?
Years 0 1 2 3 4 5
Cash Flows (20) 6 3 7 8 9
CE Coefficient 1.00 0.90 0.85 0.80 0.75 0.60

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16. From the following given information (Cf’s In Rs. Lakhs), Calculate NPV
and suggest which project should be selected if the risk-free cost of capital
is 5%?
Years 0 1 2 3 4
Cash Flows (45) 10 15 20 25
CE Coefficient 1.00 0.90 0.85 0.82 0.78

17. From the following given information about White Field Limited,
Calculate IRR and suggest which project should be selected if the risk-free
cost of capital is 7%?
Years 0 1 2 3 4
Cash Flows (11,000) 6667 2500 2000 12,500
CE Coefficient 1.00 0.90 0.80 0.50 0.40

18. XYZ Limited employs certainty-equivalent approach in the evaluation of

risky investments. The firm’s cost of equity capital is 18%; its cost of debt
is 9% and the riskless rate of interest in the market on the treasury bonds is
6%. If the finance department of the company has developed the following
information regarding a new project, should the project be accepted?
(Figures in Rs. ‘000)

Years 0 1 2 3 4 5
Cash Flows (200) 160 140 130 120 80
CE Coefficient 1.00 0.8 0.7 0.6 0.4 0.3

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LEASING

Originated in Western Countries, Leasing activity in India was initiated in

1973, in 1973 “First Leasing Company of India Ltd.” established, by Farokh
Irani

1. Meaning: Ind AS17: A lease is an agreement whereby the lessor conveys to

the lessee in return for a payment or series of payments the right to use an
asset for an agreed period of time.
A lease is classified as a finance lease if it transfers substantially all risks
and rewards incident to ownership. All other leases are classified as
operating leases. Classification is made at the inception of the lease.
Whether a lease is finance lease or an operating lease depends on the
substance of the transaction rather than the form. Contextually under
finance lease agreement the ownership passes on to the lessee on
completion of the lease and in the case of an operating lease the ownership
always remains with the Lessor.

2. Lessor: The actual owner of equipment permitting use to the other party on
payment of periodical amount. The lessor can be either the asset’s
manufacturer or an independent leasing company

3. Lessee: acquires the right to use the equipment on payment of periodical

amount.

4. Laws and Acts Governing Leasing in India: Reserve Bank of India Act 1943
in case of involvement of NBFCs, FEMA Laws, FDI Rules in case of
companies having FDI, Sale of Goods Act, 1930; Indian Contract Act, 1872;

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Transfer of Property Act, 1882; Income Tax Act, 1961; Limitation Act, 1930;
Indian Stamp Act, 1899; Arbitration Act, 1940; VAT Rules

5. Lease period: The term of lease, or lease period, is the period for which the
agreement of lease shall be in operation. As an essential element in a lease
is redelivery of the asset by the lessee at the end of the lease period, it is
necessary to have a certain period of lease. During this certain period, the
lessee may be given a right of cancellation, and beyond this period, the
lessee may be given a right of renewal, but essentially, a lease should not
amount to a sale: that is, the asset being given permanently to the lessee.

6. Lease Payments: Depending on the payment modules of leasing, it may be

of two types – up-fronted leases and back-ended leases. The concept of
back-ended leases is just opposite to the concept of the up-fronted leases.
Up-fronted Leases: In case of the up-fronted leases, lessees are asked to pay
more rentals in the initial years and fewer rentals in the final years of the
leasing contract. Lessors may require one or more of the following upfront
payments from a lessee: Initial lease rental or initial hire or down payment,
Advance lease rental, Security deposit, Initial fees.

7. Advantages of Leasing to the Lessor: Stable Business – Lessee’s continued

patronage; Sale of spare parts; Second-hand market; Tax benefits; Boost to
capital market; Easy finance

8. Advantages of Leasing to the Lessee: Efficient use of funds -No capital

investment; Cheaper Source-than buying option; Enhanced borrowing
capacity as lower Debt/Equity Ratio; Off-balance sheet borrowing; Tax
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benefits; Guard against obsolescence as Lessee can terminate the lease at

any time and take up another asset under fresh lease.

9. Disadvantages of Leasing: Disguised form of debt financing; Loss of

depreciation tax shield, when depreciation rates are high and leasing is
preferred over buying; Possibility of double sales tax in certain states;
Unfavourable capital gearing for the lessee; No ownership; Default Risk;
Working Capital not considered

10. Primary & Secondary Lease Period: In financial leases, is common to

differentiate between the primary lease period and the secondary lease
period. The former would be the period over which the lessor intends
recovering his investment; the latter intended to allow the lessee to exhaust
a substantial part of the remaining asset value. The primary period is
normally non-cancellable, and the secondary period is normally cancellable.

The first 5 years are called the primary lease period and the extended
period is called the secondary lease period. The lease is non-cancellable
during the primary lease period - that is, the lessee cannot return the asset
and not pay balance of the lessor's rentals.

For the secondary period, the lessee will have no incentive of returning
the asset, as what the lessee has to pay is nominal, whereas the asset might
still carry substantial value.

11. Operating/Service Lease: It does not transfer all the risks and rewards
incidental to ownership. Short term or cancellable during the contract
period at the option of the lessee.
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a) It is a short-term arrangement.
b) It can be cancelled by the lessee prior to its expiration date.
c) The lease rental is generally not sufficient to fully amortize the cost of
the asset.
d) The costs of maintenance, taxes, insurance are the responsibility of the
lessor.
e) The lessee is protected against the risk of obsolescence.
f) The lessor has the option to recover the cost of the asset from another
party on cancellation of the lease by leasing out the asset.
g) The lease term is significantly less than the economic life of the
equipment.

These Agreements may generally be preferred by the lessee in the following

circumstances:
a) When the long-term suitability of asset is uncertain.
b) When the asset is subject to rapid obsolescence
c) When the asset is required for immediate use to tide over a temporary
problem.
d) Computers & other office equipment’s are very common assets which
form subject matter of many operating lease agreements.

12. Financial/Capital Lease: it transfers all the risks and rewards incidental to
ownership. Extends over the estimated economic life of the asset, can be
cancelled only if the lessor is reimbursed for any losses. Provides the lessee
with a fixed purchase option

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a) It is a long-term arrangement.
b) During the primary lease period, the lease cannot be cancelled.
c) The lease is more or less fully amortized during the primary lease
period.
d) The cost of maintenance, taxes, insurance etc., is to be incurred by the
lessee unless the contract provides otherwise.
e) The lessee is required to take the risk of obsolescence.
f) The lease term generally covers the full economic life of the equipment.

13. Risks incidental to ownership: Losses from idle capacity, Technological

obsolescence, Changes in value due to changing economic conditions, etc.

14. Rewards incidental to ownership: Profits over the asset’s economic life,
Gain from appreciation in value, Realisation of a residual value, etc.

15. Difference: Operating & Financial Lease

Point of Difference Operating lease Financial lease

Term Short-Term Long-Term
Cancelability Cancelable Non-cancelable
Less than the life of Equals life of
Lease period
the asset the asset
Transfer of all risks &
Does not transfer Transfers
returns
Maintenance Insurance Payable by
Payable by lessor
& taxes lessee
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Falls on the
Risk of Obsolescence Falls on the lessor
lessee
In the books of
Lease capitalization In the books of lessor
lessee

16. Sales and Lease Back: Leaseback, short for ‘sale-and-leaseback,’ is a

financial transaction, where one sells an asset and leases it back for the
long-term; therefore, one continues to be able to use the asset but no longer
owns it. Mostly used in the real estate sector. After purchasing an asset, the
owner enters into a long term agreement by which the property is leased
back to the seller, at an agreed rate. One reason for leaseback is for the
seller to raise money by off-loading a valuable asset to a buyer who is
presumably interested in making a long-term secured investment.

17. Wet Lease: Form of a leasing agreement that provides multiple services to
the lessee leasing the asset. This type of lease typically applies to the airline
industry and under this agreement the owner will provide a crew,
maintenance, and other services needed for the aircraft.
Dry Lease: Only Financing

18. Direct Leasing: A firm acquires the right to use an asset from the
manufacturer directly. The ownership of the asset leased out remains with
the manufacturer itself.

19. Leveraged Lease: A type of financial lease. A three-sided arrangement

between the lessee, the lessor, and lenders. The lessor owns the asset and
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for a fee allows the lessee to use the asset. The lessor borrows to partially
finance the asset. The lenders typically use a nonrecourse loan. This means
that the lessor is not obligated to the lender in case of a default by the
lessee.

19. Domestic & International/Cross-border Lease: In domestic lease, all

parties of a lease transaction are domiciled in the same country. In
international lease, parties to the lease transactions are domiciled in
different countries.
20. Master Lease: A lease between the owner of the property and its direct
tenant, with all other leases subject to the first one.
A tenant may sublease or assign part or all of its space
on its own terms and conditions, but the parties will always be bound by the
master lease because they are subordinate to it

20. Net Net Net Lease: Also called triple net lease. A Lease arrangement in
which the lessee pays not only the rental but is also responsible for the
associated general expenses. In case of property leases, the lessee may pay
for garbage collection, security, and utilities. In case of equipment lease, the
lessee pays all maintenance, operating, repair costs associated with the use
of leased equipment plus insurance and taxes. A capital lease is a net lease
whereas an operating lease is not.

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21. Percentage Lease: Provides for Fixed Rent plus Some percentage of
previous year’s gross revenue to be paid to lessor. Ensures protection
against Inflation

22. Update Lease: Intended to protect the lessee against risk of obsolescence.
Lessor agrees to replace obsolete asset with ne w one at specified lease
rental.

23. Legal Aspects of Lease: Lessor has duty to deliver the Asset to Lessee.
Lessee has an obligation to pay the lease rentals.

24. Taxation: In Finance & Operating Lease, Depreciation can be claimed by

lessor & not lessee. Lease rentals received by lessor, taxable under the head
Profits and Gains from Business and Profession. Lease rentals paid by
Lessee are Tax deductible expenses for Lessee.

25. Accounting Treatment for Operating Lease: In Lessor’s Books- Asset

shown in asset side; lease rent treated as income; depreciation claimed by
lessor. In Lessee’s Books: Asset is off-balance sheet; not eligible to deduct
depreciation; lease rent is shown as expense in P&L Account

26. Accounting Treatment for Financial Lease: In Lessor’s Books: Asset is not
shown in lessor books; only lease rent is shown as income In Lessee’s
Books: Asset is shown in lessee balance sheet; lease rent is split into
principal and interest; asset is depreciated in the books of lessee. Such

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leases usually: Provides the lessee with a fixed purchase option; the lease
agreement covers 75% of the economic life of the asset; Is structured so that
the present value of lease payments exceeds 90% of the cost.

27. Break-Even Lease Rentals: The break-even lease rental (BELR) is the rental
at which the lessee is indifferent between lease financing and borrowing,
and buying. It reflects the maximum level of rental which the lessee would
be willing to pay. If the BELR exceeds the actual lease rental, the lease
proposal would be accepted, otherwise rejected.

28. Hire purchase agreement: is a contract, more fully called contract of hire
with an option of purchase, in which a person hires goods for a specified
period and at a fixed rent, with the added condition that if he retains the
goods for the full period and pay all the instalments of rent as they become
due, the contract shall determine and the title vest absolutely in him.

29. Financial leases and Hire-purchase: A hire-purchase transaction is usually

defined as one where the hirer (user) has, at the end of the term an option
to buy the asset. In other words, financial leases with a bargain buyout
option at the end of the term can be called a hire-purchase transaction.
 Hire-purchase is decisively a financial lease transaction, but in some
cases, it is necessary to provide the cancellation option in hire-purchase
transactions by statute: that is, the hirer has to be provided with the
option of returning the asset and walking out from the deal.

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 If such an option is embedded, hire-purchase becomes significantly

different from a financial lease: the risk of obsolescence gets shifted to
the hire-vendor.
 If the asset were to become obsolete during the pendency of the hire
term, the hirers may off-hire the asset and close the contract, leaving the
owner with less than a full-pay-out.
 Hire-purchase is of British origin - the device originated much before
leases became popular, and spread to countries which were then British
dominions. The device is still popular in Britain, Australia, New
Zealand, India, Pakistan, etc. Most of these countries have enacted, in
line with United Kingdom, specific laws dealing with hire-purchase
transactions

30. Difference between Hire-purchase and Lease

Point of
Hire Purchase Lease
Difference
Transferred after the
Ownership
payment of last Never transferred
transfer
installment
Only interest
Complete lease rent is
component is allowed
Tax benefit allowed for tax
tax deduction and not
deduction
principle
Lessee cannot enjoy the
Benefit of Hirer enjoys benefit of
benefit of scrap value,
scrap value scrap value
because he/she is not

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the owner of asset

If the lease is finance
lease, lessee pays
Maintenance Hirer has to spent
maintenance cost,
of the asset money on maintenance
otherwise lesser pays
maintenance cost
Hirer gets Tax shield on Lessee doesn’t get Tax
Depreciation
Depreciation shield on Depreciation

31. Debt financing: Borrowing money and not giving up ownership. Debt
financing often comes with strict conditions or covenants in addition to
having to pay interest and principal at specified dates.

32. Buying verses Leasing:

Buying Leasing
Advantages Disadvantages Advantages Disadvantages
Outright asset Major capital Cash-flow No asset
ownership outlay up- effective ownership.
front. method for
gaining access
to assets as no
major capital
outlay up-
front.
Assets can be Entity incurs Entity may not Assets may not
modified at maintenance incur repair be able to be
any stage to and repairs and modified to
suit changing costs which maintenance suit changing
business typically costs as assets business

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requirements. increaseas may fall under requirements

assets age.the warranty of without lessor
the lessor over approval and
the term of the attracting fees.
lease.
Asset can be Entity incurs The entity Lease terms are
replaced or costs for the may not incur generally fixed
disposed of at replacement or costs associated so asset
any time. disposal of with disposal replacements
assets at the and and early
end of their replacement of terminations at
useful lives. assets at the the request of
end of their the entity
useful lives. may attract
penalties and
fees.

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APPENDIX
NEWSPAPER ARTICLES

ARTICLE 1: 10 CRAZY DIVIDEND PAYING STOCKS IN INDIAN STOCK MARKET BY SOMAY JAIN
Source: https://sowmayjain.co m/2016/08/09/10-crazy-dividend-paying-stocks-in-indian-stock-market-
with-pros-cons-and-so me-faqs/

History says that high dividend paying stocks outperform the market in long run.
When I ask people to invest in this category of stocks, they just look at me with
amazement. What they like more is capital appreciation.

Generally, people underestimate the power of dividend income. I have got a live example
of a person who is living on dividend income –this man received Rs.180 crores as
dividend over the past 35 years.

Let me clear it out. There are 2 types of benefit from stock market:

 Capital Appreciation
 Dividend Income

For a second, imagine yourself as a cattle farmer. You bought a cow, feed it and fetched
some milk to earn income from dairy products. Apart from this, after 2 year, due to high
demand of cow in the market, you sold it at double price.

That’s how people earn in the stock market. They buy stocks at low, retain dividends and
then sell it at high.

So the profit earned from selling high is Capital Appreciation Profit, and the sum of
money paid by a company to its shareholders out of its profits is known as Dividend
Profits. In short:

 Capital appreciation = profit from price fluctuation in stocks = from selling cow at
double price.
 Dividend profits = time to time dividend distribution = income from dairy products.

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So while you earn from dairy products you still have that cow but after selling the cow
you’ve nothing as a source of income. Same as, while you receive dividends, you still
have that stock but after you sell it, you’ve nothing as a source of income.

Truly speaking, nobody likes dividend paying stocks.They like capital appreciation more
than dividend profits.

No doubt profits from dividends are much lower than capital appreciation but what if I
say there is a high correlation between both o f them.

If you look at the portfolio of the most successful investor of all time –Warren
Buffet then you can find that all of the top holdings in his portfolio have high dividend
paying stocks with high payout and yield.

But it doesn’t mean that the company with low or no dividends are not good. Here’s the
authenticity – World’s most expensive stock (It cost more than 1 crore in INR) –Berkshire
Hathaway (class-A) doesn’t pay dividends at all.

“A number of Berkshire shareholders — including some of my good friends — would like

Berkshire to pay a cash dividend. It puzzles them that we relish the dividends we receive from most
of the stocks that Berkshire owns, but pay out nothing ourselves” Warren Buffet wrote in
his 2012 letter to investors.

The company has paid only one dividend of 10 cents during his reign, in 1967, andBuffett
later joked he must have been in the bathroom when the decision was made. Buffett uses
that cash to grow company financials that eventually contribute to shareholder wealth.
The result is: Company’s stock price increased by almost 700,000 % between 1964 and 2016.

So the conclusion is:

 Company paying high consistent dividends is an excellent company. It’s a universal

truth.
 Company paying inconsistent or low or no dividends may or may not be an
excellent company.

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ARTICLE 2: HOW INVESTORS STAND TO BENEFIT FROM DIVIDEND PAYOUT POLICY.

Source:http://eco no mictimes.indiatimes.co m/articleshow/53349605.cms?utm_source=co ntentofinterest
&utm_medium =text&utm_campaign=cppst

Soon, the top 500 companies by market capitalization will have to formulate a dividend
distribution policy and make it public in their annual reports and on their websites.
Here’s how such a policy stands to benefit investors. Less ambiguity
India Inc’s dividend payouts have steadily increased over the last few years. For S&P
BSE 500 companies, dividend payouts have outpaced net profit growth over the past five
years. Median dividend payout ratio increased to 24% in 2014-15 from 21% in 2009-10.
Dividends, in absolute amounts, have grown at a compounded annual growth rate of 14%,
while profits have grown at half that rate—7%, between 2009-10 and 2014-15. Despite this,
at least 73 of the S&P BSE 500 companies could double the amount of dividend payouts.

However, there are many companies that regularly earn profits but either don’t pay
dividend, or pay very low dividends, or are irregular in payouts. For instance, companies
such as Gujarat Pipavav Port, Whirlpool of India and 3M India, have not paid dividends
over the past three years, despite reporting profits for each of these years. On the
contrary, some companies have doled out hefty dividends even after reporting losses
during the year. Bajaj Electricals and Sun Pharmaceuticals paid dividends in 2014-15
despite losses.

Now, under mandatory disclosure, all companies will have to clearly outline their
dividend distribution policy. “This will bring an element of predictability for investors as
to what they can expect going forward,” says Amit Tandon, Founder, IiAS, who has
been advocating a clear dividend policy. Alok Churiwala, MD, Churiwala Securities,
feels a transparent dividend distribution policy will allow investors to take more
informed decisions. “An upfront dividend policy will go a long way in showing the
company management’s willingness to share profits with shareholders,” adds Churiwala.
While a company’s track record of dividend payout can give investors some idea about
the company’s approach to dividend payouts, a formally worded policy provides greater
clarity and enforces discipline among companies. “Companies will be forced to explain
reasons for any deviation from the stated dividend policy,” says Tandon.
Besides, companies will also be required to outline a policy on how the retained earnings
will be utilized. Raamdeo Agrawal, Joint MD, Motilal Oswal Financial Services, says,
“The retention policy will reveal what a firm intends to do with the cash not returned to
shareholders. This is perhaps more critical than the dividend policy itself.” If a firm
outlines some expansion opportunities as rationale for retaining earnings, instead of
sharing profits with investors, it may be compelled to adhere to a timeline to execute the
expansion or risk the wrath of shareholders and the market regulator.
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Policy types: Experts argue that a dividend distribution policy will help investors better
align their own objectives with the right firms. Particularly, investors may be able to tell
apart a stable dividend policy from others. Under this policy, the company aims for a
steady dividend payout every year, regardless of the profits it makes. “This gives a
visible and guaranteed dividend flow to shareholders,” says Agrawal. Some companies
may prefer a fixed dividend policy, wherein a specified percentage, typically a percentage
range, of the company’s earnings is paid out as dividends every year. At the other end of
the spectrum is a ‘residual’ dividend policy wherein dividend is paid from the funds left
after apportioning towards capital expenditure requirements of the firm. Here, the
management is free to pursue business growth opportunities without worrying about
dividend constraints. As such, the dividend payments can be erratic.

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ARTICLE 3: LIMITED INVESTMENT OPTIONS TRIGGER A DIVIDEND BONANZA

Source: https://www.livemint.co m/Ho me-Page/THZeLynVIanR9BP8LUNLoK/Limited-investment-
options-trigger-a-dividend-bo nanza.html

BSE 500 firms paid out 39.6% of profits to shareholders in FY2018, highest in at least 10
years. Listed non-financial firms saw a rise in cash and cash equivalents to ₹15.1 trillion in
2017-18 from ₹14.7 trillion a year earlier. Publicly traded companies in India handed out
the biggest dividends in at least 10 years during 2017-18 as investment opportunities to
expand and grow dried up, a Mint analysis showed.
Dividend payout ratio—dividends as a share of earnings—of 457 companies on the BSE
500 index hit 39.6% in 2017-18, more than double the previous year’s 16.6%, according to
data compiled by Capitaline. The ratio was the highest since 23.19% in 2008-09, the
earliest year for which data is available.
A higher dividend payout ratio typically signals inability to find suitable investment
options to expand, increase capacity or make acquisitions, prompting firms to hand out
surplus cash to shareholders.

According to Vinod Karki, vice-president, strategy, at ICICI Securities Ltd, dividend

payouts typically rise when cash piles up without corresponding investment
opportunities. “Since capex recovery has not picked up in India, companies are piling on
cash. Capacity utilization is still low. Return on capital is still not good for companies to
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generate spreads over their cost of capital. Both return on capital and return on equity of
India Inc. have bottomed out in the past two-three years, but it is not yet that good for
companies to get attracted to invest.”
A 3 July ICICI Securities report by Karki and Siddharth Gupta said 3,500 listed non -
financial Indian firms saw a rise in cash and cash equivalents to ₹15.1 trillion in FY18
from ₹14.7 trillion in FY17.
The report said companies avoiding investments despite sufficient funds “reflects an
environment of spare capacity in the system (despite a rise, capacity utilisation for the
third quarter of FY18 still stands at 74%) and inadequate return on operating assets
(RoOA) from heavy capex sectors, such as infrastructure, in a rising ‘cost of capital’
environment. Incidentally, RoOA for industrial firms has also bottomed out and stands
at 9.8% in FY18.”
The higher payout ratios can be interpreted in two ways, said Deepak Jasani, head of
retail research at HDFC Securities. “Either companies are too afraid to commit funds in
a dynamic environment, where imports are freely made and their business models can
get topsy-turvy anytime. The second reason is companies need relatively less capital to
create more output, except for large capex-intensive sectors such as power, steel and
logistics,” said Jasani.
Investors also see bigger dividends as indicating a company’s strength and the
management’s positive expectations for future earnings. This, again, makes the stock
more attractive.
Analysis of Capitaline data showed that out of the total payouts, the ratio of 386 private
sector companies stood at a three-year high of 27.05% in FY18, from 10.66% in FY17. For
71 state-run companies, the ratio surged to 122% in FY18 from 34.1% in the year-ago period.
This is the highest dividend payout ratio by public sector enterprises in the last 10 years,
despite 21 state-run banks not paying a single penny during the year.
“The percentages may be misleading, because if you exclude FMCG, PSU and IT
companies, then the difference between FY18 and FY17 won’t be that big. Also, due to
wide variations in profitability of PSU banks and oil and gas companies,” said Jasani.
“FMCG companies would typically want to distribute maximum by way of dividend to
take out money from India, given that their cash flow requirement for growth is limited.
For PSUs, the government has a compulsion about revenue resulting in high dividend
payouts. Similarly, IT companies are giving away bigger percentage of their earnings as
dividend or buybacks because they don’t have use of large surpluses generated year after
year,” he added.
According to Jasani, the payout ratio may seem to have grown faster for public sector
units because, overall, their profits have shrunk due to losses incurred by state-owned
banks. Among state-run firms, dividend payout was the highest at Indian Oil Corp. Ltd,
Coal India Ltd, Oil and Natural Gas Corp. Ltd, Bharat Electronics Ltd, Bharat Petroleum
Corp. Ltd and NTPC Ltd. Among private sector firms, Tata Consultancy Services Ltd,

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Infosys Ltd, Vedanta Ltd, ITC Ltd, Hindustan Unilever Ltd and Reliance Industries Ltd
saw high payouts.
However, analysts said the capex revival was focused around a few sectors and
companies. ICICI Securities said that although there were signs of improvement in
utilization levels (reflected in improving capex in certain sectors), overall capacity
utilization levels are still low and “cash plus investments” will continue to rise.
Therefore, the industry credit cycle is not expected to pick up in short term, it said.
The ICICI Securities analysis indicates that the balance sheet strengthening process of
Indian firms is structurally positive for the long term, and lays the foundation for kick-
starting the next leg of private capex cycle as demand picks up.
“Whatever the stated policy, investors would be in a better position to know how, when,
and how much dividend they can expect,” says Agrawal. When the company proposes to
declare dividend on the basis of parameters other than what is mentioned in the policy,
or proposes to change its dividend distribution policy, it will have to be disclosed along
with the reasons for the change. For instance, a firm may be inclined to pursue a new,
unforeseen opportunity for which it would need to plough back its profits into the
business over the coming years, warranting a change in dividend policy. “A change in the
policy could raise a red flag. But investors would now be in a position to understand the
reason and act accordingly,” says Churiwala.

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ARTICLE 4: ONCE-IN-A-LIFETIME DEALMAKING SPREE UNDERWAY IN INDIA

Source:https://www.bloo mberg.co m/news/articles/2018-09-09/o nce-in-a-lifetime-deals-fuel-a-100-
billio n-india-m-a-boom

The biggest mergers-and-acquisitions boom in Indian history has investment bankers

preparing for even more deal making to come. Transactions involving Indian companies
have reached $104.5 billion in 2018, trouncing the previous annual record with almost four
months left in the year, according to data compiled by Bloomberg. The tally may surpass
$100 billion again in 2019, said Sanjeev Krishan, a Gurgaon-based partner at PwC India
who focuses on private equity and deals.

Record Year
India M&A jumps to an all-time high with almost four months left in 2018.

The combination of a new bankruptcy law, a race for dominance in the e-commerce
industry and a record war chest at Asia-focused private equity funds has created what
some are calling an unprecedented opportunity for dealmaking in the world’s fastest-
growing major economy. The burst of activity is not only good news for investment
bankers, it’s also helping to rid the Indian financial system of bad debt and modernize a
retail sector that serves 1.3 billion people. “It’s a once-in-a-lifetime opportunity,” said
Atul Mehra, co-chief executive officer of investment banking at JM Financial Ltd. in
Mumbai. The new Indian bankruptcy code has put dozens of delinquent borrowers on
the block, spanning industries from steel to power and infrastructure. The more than $5
billion purchase of bankrupt Bhushan Steel Ltd. by Tata Steel Ltd. in May was this year’s
secondbiggest deal between two Indian companies. “The new Indian bankruptcy code

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has led to consolidation” in industries like steel, said Utpal Oza, head of India
investment banking at Nomura Holdings Inc.
The consumer sector is another M&A hot spot. Walmart Inc.’s $16 billion acquisition of
ecommerce giant Flipkart Online Services Pvt this year was the biggest-ever takeover by
a foreign buyer in India. Amazon.com Inc., Alibaba Group Holding Ltd. and Tencent
Holdings Ltd. are also acquiring stakes in local companies to increase their India
presence, while Warren Buffett’s Berkshire Hathaway Inc. agreed in August to invest in
the company behind digital payments leader Paytm. Annual spending by India’s online
shoppers may jump more than six fold to $200 billion in about a decade amid a
proliferation of smartphones and cheap data plans, according to Morgan Stanley. India’s
consumer market is “the next big battlefield, and strategics recognize that,” said Gaurav
Mehta, the Mumbai-based country head at Raine Group LLC, a boutique advisory firm
focused on the technology, media and telecom industries.
Leading the Pack
International banks rule the roost on India deals this year

A sustained deal making boom is far from guaranteed. India’s rupee has slumped to an
all-time low amid an investor exodus from emerging markets, threatening to dent
business confidence and prompt foreign acquirers to wait for even more currency
weakness before stepping in. Some buyers may also pause until they see the outcome of
national elections next year. For now though, the pipeline for Indian deals looks strong.
U.K. pharmaceutical giant GlaxoSmithKline Plc has requested bids by mid-September
for a controlling stake in its $4.2 billion Indian consumer-health unit, people with
knowledge of the matter said last month. Kraft Heinz Co. has narrowed the list of
bidders for a portfolio of Indian businesses it’s trying to sell for about $1 billion, while
bankrupt Essar Steel India Ltd. has attracted bids from groups backed by ArcelorMittal
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and VTB Capital. Meanwhile, Asian private-equity funds are flush with cash and
looking for opportunities. They had a record $225 billion available to deploy at the end of
2017, according to Bain & Co. Private equity and venture capital funds boosted their
investments in India by 46 percent to $15.2 billion in the first half, data compiled by EY
show. “We expect 2018 to be a blockbuster year for M&A,” said PwC’s Krishan. “Many
of the deal drivers visible currently are expected to continue next year.”

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FINANCIAL TABLES

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