Strategic Financial Management Lecture 18 Numerical Examples in SFM

Problem 1 Gujarat Fertilizers Ltd. is considering a capital project requiring an outlay of 15 million. Net cash flows per year for 6 years= 4 million. Opportunity cost of capital = 18%. It can raise a term loan of Rs. 10 million at 16%. Repayable in 5 equal installments, first installment payable at end of 2 nd year. Balance amount can be raised by equity. Cost of equity issue is 8%. Tax rate is 50%. Calculate: Base case NPV. PV of tax shields. Adjusted NPV.

Problem 2 Gujarat Fertilizers Ltd. is considering buying a new plant requiring an outlay of 50 million. Sulabh Leasing approaches GFL with the proposal to lease the plant at lease rental (payable in advance) of 14 million for 5 years. Depreciation is 25% by WDV method and net salvage value at the end of 5 years is expected to be Rs. 10 million. GFL’s tax rate is 35% and its post tax cost of debt is 8%. Should GFL lease it or borrow and buy it?

Problem Cost of plant Depreciation Loss of tax shield Lease Pmt Tax shield Loss of salvage value Cash flow =

Problem 3 The present D/E ratio of a company is 0.25 and it’s beta is It is proposing to evaluate a project to be financed by 40% debt. The return on market is 18% and risk- free rate is 6%. What should be the appropriate cost of equity to be used for evaluating the project by the process of un-levering and re-leveing the beta?

Problem 3 The question is incorrect! Why? No mention of tax rate of company. However, it can be ignored. But what about effect of new project on company as a whole? Un-levered Beta = Current Beta 1 + (1 – t) (Avg. D/E) Required return on equity = Rf + Beta (Rm – Rf).

Problem 4 GFL’s new plant entails an investment of 250 million in fixed assets and 50 million (realizable at par at end of project) in working capital. Economic life = 14 years and yearly NOPAT = Depreciation by SLM. Cost of capital = 10%.. Calculate: ROCE & ROGI for year 5. Economic depreciation for year5. CVA for year 5.

Problem 4 ROCE = NOPAT/Capital employed. ROGI = (NOPAT + Dep.) /Capital employed. Economic Depreciation: 250 = E.D * FVIFA (10%, 14 years). CVA = (NOPAT + Dep.) – Economic Dep. – (Cash invested * Cost of capital).

Problem 5 GFL has 40 million shares, presently selling at $20 per share. Present debt equity ratio is 0.25 and stock beta is The cost of borrowing is 10%, T-bond rate is 8% and market risk premium is 5.5%. Tax rate = 40%. Calculate: Firm’s present WACC. GFL is considering borrowing additional 200 million and repurchasing stock. Suppose the interest rate increases to 11%, then what is the new WACC? What will be the new stock price after this move (repurchase)?

Problem 5 Market Value of Equity = 40 million * $ 20 = 800 million. Cost of Equity = 8% (5.5%) = 14.33%. Cost of Capital = 14.33% (0.8) + 10% (1-.4) (0.2) = 12.66%.

Problem 5 If the firm borrows $ 200 million and buys back stock, Equity will drop to $ 600 million. New Debt/Equity Ratio = 400/600 = Un-levered Beta = 1.15 / ( *0.25) = New Beta = 1.00 (1+0.6*0.67) = New Cost of Equity = 8% (5.5%) = 15.70%. New Cost of Capital = 15.70% (0.6) + 11% (1-0.4) (0.4) = 12.06%.

Problem 5 Increase in firm value from moving to optimal = ( )(1000)/.1206 = $49.75 million. Increase in Stock Price = $ 49.75/40 = $1.24.