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ARIHANT BOHARA ([email protected])

Question 1:
Consider the following cash flows:
Year Project A Project B
($200,000
0 ) ($95,000)
1 $100,000 $20,000
2 $125,000 $27,000
3 $55,000 $26,000
4 $25,000
5 $24,000
6 $23,000
Find the NPV of each project at 9% discount rate using replacement chain analysis and
comment on each of the project.

Solution 1 –
Step 1:
NPV stands for Net present value which is equal to the difference between the present value
of cash inflows minus the Initial Investments
NPV is used for making the investment decisions

Step 2:
Since Project A has a life of only 3 years and Project B has a life of 6 years. So, to make it
comparable we are applying the replacement chain analysis on project A. Therefore, Project
A is replaced at the end of year3

1
Discount Factor=
( 1+r )n

Where r = discount rate per period, n= no of periods

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ARIHANT BOHARA ([email protected])

Values given in the question are as follows –

Discount rate (r) = 9%
A B C D
Year (n) Cashflow Project A ($) Discount factor B*C ($)
0 -200,000 1.000000 -200000.00
1 100000 0.917431 91743.12
2 125000 0.841680 105210.00
3 55000 0.772183 42470.09
3 -200000 0.772183 -154436.70
4 100000 0.708425 70842.52
5 125000 0.649931 81241.42
6 55000 0.596267 32794.70
NPV OF PROJECT A 69865.16

A B C D
Year (n) Cashflow Project B ($) Discount factor B*C ($)
0 -95,000 1.000000 -95000.00
1 20000 0.917431 18348.62
2 27000 0.841680 22725.36
3 26000 0.772183 20076.77
4 25000 0.708425 17710.63
5 24000 0.649931 15598.35
6 23000 0.596267 13714.15
NPV OF PROJECT B 13173.89

Final answer:
NPV of project A i.e. $69865.16 is greater than NPV of project B i.e. $13173.89. Hence, we
will invest in project A

Question 2:
Account 1 has an expected return of 16% and standard deviation of 31%. Account 2 has an
expected return of 10% and standard deviation of 24%. The risk-free rate is 4.50% and the
correlation between Account 1 and 2 is 0.20.
Find the weight of each account, expected return of portfolio and standard deviation of
portfolio.
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ARIHANT BOHARA ([email protected])

Solution 2:
Step1:
We are assuming this portfolio as a minimum risk portfolio so weight of assets in minimum
risk portfolio is calculated using the below formula -

2
σ 2 −σ 1∗σ 2∗r
w 1= 2 2
σ 1 + σ 2 −2∗σ 1∗σ 2∗r

σ1 = Standard deviation of account 1

σ2 = Standard deviation of account 2
w1 =Weight of account 1
r = Correlation between account 1 and account 2

w 2=1−w 1
w2 = Weight of account 2
w1 = Weight of account 1

Values given in the question are as follows –

σ1 = 0.31
σ2 = 0.24
r = 0.20

Putting these values in w1 formula

( 0.24 )2 −0.31∗0.24∗0.20
w 1=
(0.31)2+(0.24)2−2∗0.31∗0.24∗0.20

( 0.0576−0.01488 )
w 1=
(0.0961+0.0576−0.02976)
0.04272
w 1=
0.12394
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ARIHANT BOHARA ([email protected])
w 1=0.34
w 2=1−0.34
w 2=0.66
Step2:
Now we will calculate the expected return of the portfolio using the weights calculated in
above step
ERp=ER 1∗w 1+ ER2∗w 2

ERp = Expected return of portfolio

ER1 = Expected return of account 1
ER2 = Expected return of account 2
w1 = Weight of account 1
w2 = Weight of account 2

Values given in the question are as follows –

ER1 = 16%
ER2 = 10%
w1 = 0.34
w2 = 0.66

Putting values in above equation

ERp=16 %∗0.34+10 %∗0.66

ERp=12.04 %

Step3:
Now we will calculate the standard deviation of portfolio using the below formula

σp=√ (w 12∗σ 12 +w 22∗σ 22 +2∗w 1∗w 2∗r∗σ 1∗σ 2)

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ARIHANT BOHARA ([email protected])

w1 = Weight of account 1
w2 = Weight of account 2
σ1 = Standard deviation of account 1
σ2 = Standard deviation of account 2
r = Correlation between account 1 and account 2
σp = Standard deviation of portfolio

Values given in the question are as follows

w1 = 0.34
w2 = 0.66
σ1 = 0.31
σ2 = 0.24
r = 0.20

Putting these values in above equation

σp=√ ( 0.34 ∗0.31 +0.66 ∗0.24 +2∗0.34∗0.66∗0.20∗0.31∗0.24 )

2 2 2 2

σp=√ (0.1156∗0.0961+0.4356∗0.0576+ 0.006678144)

σp=0.2071

Final answers:
Weight of account 1 = 0.34
Weight of account 2 = 0.66
Expected return of portfolio = 12.04%
Standard deviation of portfolio = 20.71%
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ARIHANT BOHARA ([email protected])

Question 3:
Based on the following information compute the financial break-even point.
Price of machine = $4,000,000
Unit cost per unit = $50,000
Variable cost per unit = $25,000
Fixed costs = $400,000
Discount rate = 15%
Useful life = 5 years
Tax rate = 25%

Solution 3:
Step 1:
Financial breakeven point is the sales quantity where the net present value (NPV) is equal to
zero
Net present value = Present value of cash inflow – Initial Investment

Step 2:
Let us assume no of units sold be N

Cash flow per annum=( ( SP – VC )∗N – FC – D )∗( 1−t ) + D

SP = Price per unit

VC = Variable cost per unit,
FC = Fixed cost
D = Depreciation per year
t = Tax rate
N = No of units sold
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ARIHANT BOHARA ([email protected])

Depreciation per year (D)= Cost of Machine / Useful life

Depreciation per year (D) = $4000000 / 5
Depreciation per year (D) = $800000

Values given in the question are as follows –

Unit cost per unit (SP)= $50,000
Variable cost per unit (VC) = $25,000
Fixed costs (FC) = $400,000
Tax rate (t) = 25%

Putting values in above equation

Cash flow per annum = (($50000-$25000) *N - $400000 - $800000) *(1-0.25) + $800000
Cash flow per annum = ($25000*N - $1200000) *(0.75) + $800000
Cash flow per annum = $18750*N - $900000 + $800000
Cash flow per annum = $18750*N - $100000

Step 3:

C∗( 1 – ( 1+r )−n )

NPV = ​​− Initial Investment
r
Where: C = Cash flow for the period, r=discount rate per period, n= no of periods, NPV = Net
present value

Price of machine = $4,000,000

Discount rate (r) = 15%
Useful life (n) = 5 years
Cash flow per annum (C) = $18750*N - $100000
In financial break even point NPV = 0
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ARIHANT BOHARA ([email protected])

Putting value in the above equation-

0 = ($18750*N - $100000) * (1 – (1+0.15) ^-5) / 0.15 - $4000000
$4000000 = ($18750*N - $100000) * (1 – (1+0.15) ^-5) / 0.15
$4000000 = ($18750*N - $100000) * 3.352155
$1293262.25 = $18750N
N = 68.97 or 69 units

Final Answer –
Financial breakeven point is equal to 69 units

Question 4:
Debt: The firm can sell for $1025 an 8-year, $1,000-par-value bond paying annual interest at
a 9.00% coupon rate. A flotation cost of 3% of the par value is required.
Preferred stock: 7.00% annual dividend preferred stock having a par value of $100 can be
sold for $98. An additional fee of $5 per share must be paid to the underwriters.
Common stock: The firm's common stock is currently selling for $60 per share. Dividends are
paid at $2.50 and expected to grow at 5% thereafter with a return of 10% and the company
will pay $2.50 per share in flotation costs. The firm's tax rate is 24%.
Using the following weights answer the below questions: 35% long-term debt, 25%
preferred stock, and 40% common stock equity retained earnings new common stock, or
both).
a. Calculate the after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock (retained earnings and new common stock).
d. Calculate the WACC.
Solution 4:
Step 1:
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ARIHANT BOHARA ([email protected])

WACC is a percentage that represents the average cost of capital a company incurs from all
sources, including debt and equity. It is calculated by averaging the cost of each source of
capital, weighted by the proportion of each component
Step 2:
(a) Debt:
Flotation cost = Par value * rate
Flotation cost = $1000*3%
Flotation cost = $30

Net issue price of bond (PV) = Price of bond – flotation cost

Net issue price of bond (PV) = $1025 - $30
Net issue price of bond (PV) = $995

No of years (n) = 8
Par value (FV) = $1000
Coupon rate = 9%

Coupon amount (C) = Par value * Rate

Coupon amount (C) = $1000*9%
Coupon amount (C) = $90

YTM =
( C+
FV −PV
n )
( FV +2 PV )
Where C = coupon amount per period
FV = Face value of bond
PV = Present value of bond
n = no of periods
YTM = yield to maturity
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ARIHANT BOHARA ([email protected])

YTM = ($90 + ($1000-$995)/8) / ($1000+$995)/2

YTM = ($90 + $0.625) / $997.5
YTM = 9.08%
Kd = YTM * (1-t)
Kd = After tax cost of debt, t = tax rate, YTM= yield to maturity of bond

Kd = 9.08% * (1 – 0.24)
Kd = 6.9%

Step 3:
(b) Preferred stock:
Flotation cost = $5
Price of preferred stock (P0) = $98
Face value of preferred stock = $100
Dividend rate = 7%

Dividend amount (D) = Face value * Rate of dividend

Dividend amount (D) = $100*7%
Dividend amount (D) = $7

Kp= ( P 0−FC
D
)∗100
Where D = Dividend per share, P0 =Price per share, FC = Flotation cost, Kp = Cost of
preferred stock

Kp = ($7 / ($98 - $5)) *100

Kp = 7.52%
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ARIHANT BOHARA ([email protected])

Step 4:
(c) Common stock

Ke= { P 0−FC }
D 0∗ (1+ g )
∗100+ g

Ke= cost of equity, D0 = Dividend just paid, g= growth rate, P0 = Price per share, FC =
Flotation cost

Ke = ($2.5 * (1+0.05) / ($60 - $2.5)) *100 + 5%

Ke = ($2.625 / $57.5) * 100 + 5%
Ke = 9.56%

Step 5:
(d) WACC
A B C D
Particulars Cost (%) Weight B*C
Debt 6.9 0.35 2.415
Preferred stock 7.52 0.25 1.88
Common stock 9.56 0.4 3.824
WACC 8.119

Final Answers
(a) Post tax Cost of debt (Kd) = 6.9%
(b) Cost of preferred stock (Kp) = 7.52%
(c) Cost of common stock (Ke) = 9.56%
(d) Weight average cost of capital (WACC) = 8.12%

Question 5:
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ARIHANT BOHARA ([email protected])

Calculate the current share price of the following:

Dividends in year 0 = $2
Dividends in year 2 = $2.50
Dividends in year 4 = $2.75
Dividends in year 6 = $3.75
Thereafter dividends grow at 6% annually with a required return of 11%.

Solution 5:
Step1:
We will solve this question using the 2 stages model. In stage1 we will calculate the present
value of dividends and in stage2 we will use the Gordan growth model

Step2:
A B C D
Year (n) Dividend ($) Discount factor B*C ($)
2 $2.50 0.811622 2.03
4 $2.75 0.658731 1.81
6 $3.75 0.534641 2.00
Total of present value of dividends 5.85

Step3:
According to the Gordan growth model
Dn∗( 1+ g )
Pn=
( ℜ−g )
Where Pn = Price at t=n, Dn = Dividend paid at t=n, g =growth rate, Re = Required rate of
return
Values given in the question are as follows –
D6 = $3.75
Re = 11%
g = 6%

Now we will calculate the price at the end of year 6

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ARIHANT BOHARA ([email protected])

P6 = $3.75 * (1+0.06) / (0.11 – 0.06)

P6 = $79.5
Now we will calculate the present value of P6 at t=0
Present value of P6 at t = 0 is given as
= P6/(1+r) ^6
= $79.50 / (1+0.11) ^6
= $42.50

Step4:
Price of share = step2 + step3
Price of share = $5.85 + $42.50
Price of share = $48.35

Final solution:
Current Ex-dividend price of share is equal to $48.35 and we add the recent dividend of $2
then we will get the cum-dividend price of $50.35