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ALLAMA IQBAL OPEN UNIVERSITY ISLAMABAD
SEMESTER AUTUMN 2024
COURSE CODE 8422-8513-5040-5042-9521
SOLVED BY KHAN BHAI
CONTACT FOR MORE 0325-9594602
Q No. 1 (Marks: 20)
A company has the following capital structure and costs:
Debt: ₹500,000 at an interest rate of 8% (tax rate is 30%).
Preferred Stock: ₹200,000 with a dividend rate of 10%.
Common Equity: ₹300,000 with a cost of equity of 12%.
Tasks:
Calculate the Weighted Average Cost of Capital (WACC) for the company.
Explain the significance of WACC in financial decision-making.
Part A: Calculation of WACC
Given:
Debt (D): ₹500,000
Interest Rate on Debt (rd): 8%
Tax Rate (T): 30%
Preferred Stock (P): ₹200,000
Dividend Rate on Preferred Stock (rp): 10%
Common Equity (E): ₹300,000
Cost of Equity (re): 12%
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Step 1: Calculate After-Tax Cost of Debt
After − tax cost of debt = 𝑟𝑑 × (1 − 𝑇) = 8% × (1 − 0.30) = 8% × 0.70 = 5.6%
Step 2: Calculate Total Capital
Total Capital = 𝐷 + 𝑃 + 𝐸 = 500,000 + 200,000 + 300,000 = ₹1,000,000
Step 3: Calculate Proportion of Each Component
Weight of Debt (Wd):
500,000
= 0.50
1,000,000
Weight of Preferred Stock (Wp):
200,000
= 0.20
1,000,000
Weight of Equity (We):
300,000
= 0.30
1,000,000
Step 4: Apply WACC Formula
WACC = (𝑊𝑑 × 𝑟𝑑 (1 − 𝑇)) + (𝑊𝑝 × 𝑟𝑝 ) + (𝑊𝑒 × 𝑟𝑒 )
WACC = (0.50 × 5.6%) + (0.20 × 10%) + (0.30 × 12%)
WACC = 2.8% + 2.0% + 3.6% = 8.4%
✅ Final Answer:
WACC = 8.4%
Part B: Significance of WACC in Financial Decision-Making
The Weighted Average Cost of Capital (WACC) is a critical financial metric that represents a company’s
average cost of raising capital from all sources — debt, preferred stock, and equity — weighted by their
proportion in the total capital structure.
Significance:
1. Investment Appraisal: WACC is used as the discount rate in Net Present Value (NPV) and Internal
Rate of Return (IRR) calculations. A project is acceptable if it provides returns greater than the
WACC.
2. Capital Budgeting Decisions: Helps managers decide whether to proceed with projects. If the project
return exceeds WACC, it adds value to the firm.
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3. Valuation of Firms: WACC is used as a discount rate in Discounted Cash Flow (DCF) valuation of
companies. A lower WACC increases the present value of future cash flows, indicating higher firm
value.
4. Performance Benchmarking: WACC acts as a minimum hurdle rate. It is a benchmark for
comparing the profitability of new ventures or business units.
5. Optimal Capital Structure Planning: Helps in determining the best mix of debt, equity, and
preferred stock that minimizes WACC and maximizes firm value.
6. Shareholder Wealth Maximization: A firm that maintains a lower WACC relative to returns is more
likely to increase shareholder wealth.
Q No. 2 (Marks: 20)
A company is considering investing in a project with the following cash flows:
Year Cash Flow (₹)
0 -500,000
1 150,000
2 200,000
3 250,000
4 300,000
The company’s required rate of return is 10%.
Tasks:
Calculate the Net Present Value (NPV) of the project.
Calculate the Payback Period of the project.
Calculate the Profitability Index (PI) of the project.
Based on your calculations, advise whether the company should accept or reject the project.
Given:
Initial Investment: ₹500,000 (cash outflow at Year 0)
Cash Inflows:
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o Year 1: ₹150,000
o Year 2: ₹200,000
o Year 3: ₹250,000
o Year 4: ₹300,000
Required Rate of Return: 10%
✅1. Net Present Value (NPV)
Formula:
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ ( ) − 𝐶0
(1 + 𝑟)𝑡
Where:
𝐶𝐹𝑡 = Cash Flow in year t
𝑟 = discount rate (10%)
𝐶0 = Initial investment = ₹500,000
Now we calculate the present values:
150,000 150,000
𝑃𝑉1 = = = 136,364
(1 + 0.10)1 1.10
200,000 200,000
𝑃𝑉2 = = = 165,289
(1 + 0.10)2 1.21
250,000 250,000
𝑃𝑉3 = = = 187,855
(1 + 0.10)3 1.331
300,000 300,000
𝑃𝑉4 = = = 204,865
(1 + 0.10)4 1.4641
Total PV of Inflows = 136,364 + 165,289 + 187,855 + 204,865 = ₹694,373
𝑁𝑃𝑉 = 694,373 − 500,000 = ₹194,373
✅2. Payback Period
We accumulate cash flows year by year until the initial investment of ₹500,000 is recovered.
Year Cash Flow Cumulative Cash Flow
0 -500,000 -500,000
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Year Cash Flow Cumulative Cash Flow
1 150,000 -350,000
2 200,000 -150,000
3 250,000 +100,000
So, investment is recovered between Year 2 and Year 3.
Amount remaining after Year 2 = ₹150,000 Cash flow in Year 3 = ₹250,000
150,000
Fraction of Year = = 0.6
250,000
Payback Period = 2 + 0.6 =∗∗ 2.6𝑦𝑒𝑎𝑟𝑠 ∗∗
✅3. Profitability Index (PI)
Formula:
Present Value of Future Cash Flows
𝑃𝐼 =
Initial Investment
694,373
𝑃𝐼 = =∗∗ 1.39 ∗∗
500,000
✅4. Decision: Accept or Reject the Project?
Summary of Results:
NPV = ₹194,373 (positive ✅)
Payback Period = 2.6 years (reasonable recovery time ✅)
Profitability Index = 1.39 (greater than 1 ✅)
Q No. 3 (Marks: 20)
A non-zero coupon bond has a face value of $1,000, an annual coupon rate of 6%, and a maturity of 5
years. The bond pays coupons annually. If the required rate of return (yield to maturity) is 8%,
calculate the bond’s current market price. Also, explain the relationship between the bond’s coupon
rate, yield to maturity, and market price.
Step 1: Given Information
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Face Value (FV): $1,000
Coupon Rate: 6%
Annual Coupon Payment (PMT): 6% of $1,000 = $60
Maturity: 5 years
Yield to Maturity (YTM) / Required Rate of Return: 8%
Number of periods (n): 5 years
We will calculate the current market price of the bond using the following bond valuation formula:
𝑛
𝑃𝑀𝑇 𝐹𝑉
Bond Price = ∑ +
(1 + 𝑟)𝑡 (1 + 𝑟)𝑛
𝑡=1
Where:
𝑃𝑀𝑇 = Annual coupon payment = $60
𝑟 = Yield to maturity = 8% or 0.08
𝑛 = Number of years = 5
𝐹𝑉 = Face value = $1,000
Step 2: Calculate Present Value of Coupon Payments
This is an annuity:
1 − (1 + 𝑟)−𝑛
𝑃𝑉Coupons = 𝑃𝑀𝑇 × [ ]
𝑟
1 − (1 + 0.08)−5 1 − (1.4693)−1
= 60 × [ ] = 60 × [ ]
0.08 0.08
First, calculate (1 + 0.08)−5 :
(1.08)−5 = 0.6806
Now:
1 − 0.6806 0.3194
𝑃𝑉Coupons = 60 × [ ] = 60 × [ ] = 60 × 3.9925 = 𝟐𝟑𝟗. 𝟓𝟓
0.08 0.08
Step 3: Calculate Present Value of Face Value (Lump Sum)
𝐹𝑉 1000 1000
𝑃𝑉Face Value = = = = 𝟔𝟖𝟎. 𝟓𝟖
(1 + 𝑟)𝑛 (1.08)5 1.4693
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Step 4: Add Both Present Values
Bond Price = 𝑃𝑉Coupons + 𝑃𝑉Face Value = 239.55 + 680.58 = $920.13
Answer: The Current Market Price of the Bond is $920.13
Explanation: Relationship between Coupon Rate, Yield to Maturity, and Market Price
1. Coupon Rate < Yield to Maturity (6% < 8%) → Bond Price < Face Value
o This is called a discount bond. Investors are willing to pay less than face value because the
bond's coupon payments are less attractive compared to new bonds in the market.
2. Coupon Rate = Yield to Maturity → Bond Price = Face Value
o When the bond's coupon rate matches the market's required return, its price is exactly equal to its
face value.
3. Coupon Rate > Yield to Maturity → Bond Price > Face Value
o This is a premium bond. It pays more interest than the market requires, so investors are
willing to pay more for it.
Q No. 4 (Marks: 20)
Burp-Cola Company just finished making an annual dividend payment of $2 per share on its common
stock. Its common stock dividend has been growing at an annual rate of 10 percent. Kelly Scott
requires a 16 percent annual return on the stock. What intrinsic value should Kelly place on one share
of Burp-Cola common stock?
Situations:
1. Dividends are expected to continue growing at a constant 10 percent annual rate.
2. The annual dividend growth rate is expected to decline to 5 percent and to remain constant at
that level.
3. The annual dividend growth rate is expected to increase to 11 percent and to remain constant at
that level.
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To calculate the intrinsic value of a stock based on expected dividend growth, we use the Gordon Growth
Model (GGM) or Dividend Discount Model (DDM):
𝐷1
𝑃0 =
𝑟−𝑔
Where:
𝑃0 = Intrinsic value of the stock
𝐷1 = Dividend in the next year = 𝐷0 × (1 + 𝑔)
𝑟 = Required rate of return
𝑔 = Dividend growth rate
𝐷0 = Recently paid dividend = $2.00
Given:
𝐷0 = 2.00
𝑟 = 16% = 0.16
Situation 1: Dividends grow at 10% (i.e., 𝑔 = 0.10)
𝐷1 = 2.00 × (1 + 0.10) = 2.20
2.20 2.20
𝑃0 = = = 36.67
0.16 − 0.10 0.06
✅Intrinsic value: $36.67
Situation 2: Dividend growth declines to 5% (i.e., 𝑔 = 0.05)
𝐷1 = 2.00 × (1 + 0.05) = 2.10
2.10 2.10
𝑃0 = = ≈ 19.09
0.16 − 0.05 0.11
✅Intrinsic value: $19.09
Situation 3: Dividend growth increases to 11% (i.e., 𝑔 = 0.11)
𝐷1 = 2.00 × (1 + 0.11) = 2.22
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2.22 2.22
𝑃0 = = = 44.40
0.16 − 0.11 0.05
✅Intrinsic value: $44.40
Summary of Results:
Situation Growth Rate (g) Intrinsic Value (P₀)
1 10% $36.67
2 5% $19.09
3 11% $44.40
Q No. 5 (Marks: 20)
You are given the historical annual returns for two securities, Security A and Security B, over the past
5 years:
Year Security A Return (%) Security B Return (%)
1 12 18
2 8 12
3 10 15
Task:
Calculate the average return, standard deviation, and coefficient of variation for both securities.
Step 1: Data Provided
Year Security A Return (%) Security B Return (%)
1 12 18
2 8 12
3 10 15
Step 2: Calculate Average Return (Mean)
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Formula:
∑𝑅𝑖
Average Return =
𝑛
Security A:
12 + 8 + 10 30
= = 10%
3 3
Security B:
18 + 12 + 15 45
= = 15%
3 3
Step 3: Calculate Standard Deviation (σ)
Formula:
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𝜎 = √ ∑(𝑅𝑖 − 𝑅‾ )2
𝑛
Security A:
Year Return Deviation from Mean (10) Squared Deviation
1 12 2 4
2 8 -2 4
3 10 0 0
Total = 8
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𝜎𝐴 = √ = √2.67 ≈ 1.63%
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Security B:
Year Return Deviation from Mean (15) Squared Deviation
1 18 3 9
2 12 -3 9
3 15 0 0
Total = 18
18
𝜎𝐵 = √ = √6 ≈ 2.45%
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Step 4: Calculate Coefficient of Variation (CV)
Formula:
𝜎
𝐶𝑉 = × 100
𝑅‾
Security A:
1.63
𝐶𝑉𝐴 = × 100 = 16.3%
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Security B:
2.45
𝐶𝑉𝐵 = × 100 ≈ 16.33%
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Final Answers:
Measure Security A Security B
Average Return 10% 15%
Standard Deviation 1.63% 2.45%
Coefficient of Variation 16.3% 16.33%
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