Question 1.
FreshBrew is considering two mutually exclusive projects for a new marketing campaign.
The cash flows are as follows (all amounts in ₹):
Yea Project Project
r A B
-
0 -100,000
100,000
1 60,000 15,000
2 60,000 25,000
3 10,000 95,000
The company's cost of capital is 12% per annum.
a) Calculate the Net Present Value (NPV) for both Project A and Project B.
b) Calculate the Payback Period for both projects.
c) Based on your calculations in parts (a) and (b), which project should FreshBrew
accept? Explain the reasoning for your choice, highlighting why one technique might give
a more reliable result than the other in this specific case.
a) NPV Calculation:
Cost of Capital (r) = 12%
PV Factor = 1/(1+r)^t
Project A:
Year 1: ₹60,000 / (1.12)^1 = ₹53,571.43
Year 2: ₹60,000 / (1.12)^2 = ₹47,831.63
Year 3: ₹10,000 / (1.12)^3 = ₹7,117.80
Total PV of Cash Inflows = ₹53,571.43 + ₹47,831.63 + ₹7,117.80 = ₹108,520.86
NPV = PV of Inflows - Initial Investment = ₹108,520.86 - ₹100,000 = ₹8,520.86
Project B:
Year 1: ₹15,000 / (1.12)^1 = ₹13,392.86
Year 2: ₹25,000 / (1.12)^2 = ₹19,929.85
Year 3: ₹95,000 / (1.12)^3 = ₹67,619.10
Total PV of Cash Inflows = ₹13,392.86 + ₹19,929.85 + ₹67,619.10 = ₹100,941.81
NPV = ₹100,941.81 - ₹100,000 = ₹941.81
b) Payback Period Calculation:
Project A:
Cumulative Cash Flow Year 1: ₹60,000
Cumulative Cash Flow Year 2: ₹60,000 + ₹60,000 = ₹1,20,000
The initial investment of ₹100,000 is recovered between Year 1 and Year 2.
Payback Period = 1 year + (₹100,000 - ₹60,000) / ₹60,000 = 1 + 40,000/60,000 = 1.67
years
Project B:
Cumulative Cash Flow Year 1: ₹15,000
Cumulative Cash Flow Year 2: ₹15,000 + ₹25,000 = ₹40,000
Cumulative Cash Flow Year 3: ₹40,000 + ₹95,000 = ₹1,35,000
The initial investment is recovered between Year 2 and Year 3.
Payback Period = 2 years + (₹100,000 - ₹40,000) / ₹95,000 = 2 + 60,000/95,000 = 2.63
years
c) Based on NPV, Project A should be accepted (NPV of ₹8,521 vs. ₹942). The Payback
Period also favours Project A (1.67 years vs. 2.63 years).
However, the NPV is the more reliable techniques. A key limitation of the Payback Period:
it "ignores profitability beyond the payback horizon." Project B has a much larger cash
flow in Year 3, which the Payback Period ignores, but the NPV captures by discounting it
to its present value. While both methods point to Project A here, NPV gives a more
comprehensive view of value creation. The positive NPV of Project A confirms it will
enhance shareholder wealth, which is the primary goal of financial management.
Question 2.
GreenGlow LED Pvt. Ltd. is planning to invest in new machinery costing ₹4,00,000. The
machine has a useful life of 5 years and will be depreciated to a book value of ₹50,000 at
the end of its life. The estimated annual gross profit is ₹1,50,000. The corporate tax rate
is 30%.
a) Calculate the annual Operating Cash Flow (OCF).
b) At the end of Year 5, the machinery is expected to be sold for a salvage value of
₹70,000. Calculate the Terminal Value (Terminal Cash Inflow) at the end of Year 5.
c) If GreenGlow's discount rate is 11%, calculate the NPV of this project. Should the
company accept the project based on the NPV rule?
a) Annual Operating Cash Flow (OCF):
Annual Depreciation = (Cost - Book Value) / Useful Life = (₹4,00,000 - ₹50,000) / 5 =
₹70,000
Pre-Tax Operating Profit = ₹1,50,000
Taxable Income = Pre-Tax Profit - Depreciation = ₹1,50,000 - ₹70,000 = ₹80,000
Tax @30% = ₹80,000 * 0.30 = ₹24,000
Profit After Tax (PAT) = ₹80,000 - ₹24,000 = ₹56,000
OCF = PAT + Depreciation = ₹56,000 + ₹70,000 = ₹1,26,000
b) Terminal Value at Year 5:
Book Value at end of Year 5 = ₹50,000 (given)
Salvage Value = ₹70,000
Since Salvage Value > Book Value, there is a Capital Gain = ₹70,000 - ₹50,000 =
₹20,000
Tax on Capital Gain = ₹20,000 * 0.30 = ₹6,000
Terminal Value = Salvage Value - Tax Payable = ₹70,000 - ₹6,000 = ₹64,000
c) NPV Calculation (r=11%):
Initial Outflow: -₹4,00,000
PV of Annual OCF (Annuity): ₹1,26,000 * [1 - (1.11)^-5] / 0.11 = ₹1,26,000 * 3.6959 =
₹4,65,683.40. The part in RED is nothing but the PV of annuity formula.
PV of Terminal Value: ₹64,000 / (1.11)^5 = ₹64,000 / 1.685058 = ₹37,982.24
Total PV of Inflows = ₹4,65,683.40 + ₹37,982.24 = ₹5,03,665.64
NPV = ₹5,03,665.64 - ₹4,00,000 = ₹103,665.64
Decision: Since NPV > 0, the project should be accepted.
Question 3*
FreshBrew is analyzing a project with the following cash flows:
Initial Investment (Year 0): -₹2,50,000
Year 1 Cash Inflow: ₹80,000
Year 2 Cash Inflow: ₹1,00,000
Year 3 Cash Inflow: ₹1,50,000
a) The project's Internal Rate of Return (IRR) has been calculated (using Excel) as 15.4%.
If FreshBrew's cost of capital is 12%, should the project be accepted based on the IRR
rule? Explain.
b) Calculate the project's NPV at the 12% cost of capital.
c) Now, assume the cost of capital rises to 18%. Without recalculating the NPV, what
would be the correct decision based on the IRR rule? Explain the relationship between
the cost of capital, IRR, and NPV that informs your answer.
a) IRR Decision:
IRR = 15.4%. The company's cost of capital (required rate of return) is 12%. Since IRR
(15.4%) > Cost of Capital (12%), the project should be accepted based on the IRR
rule.
b) NPV Calculation at 12%:
Year 1: ₹80,000 / 1.12 = ₹71,428.57
Year 2: ₹1,00,000 / (1.12)^2 = ₹79,719.39
Year 3: ₹1,50,000 / (1.12)^3 = ₹1,06,767.00
Total PV of Inflows = ₹71,428.57 + ₹79,719.39 + ₹1,06,767.00 = ₹2,57,914.96
NPV = ₹2,57,914.96 - ₹2,50,000 = ₹7,914.96
c) If the cost of capital rises to 18%, and the IRR is 15.4%, then now Cost of Capital
(18%) > IRR (15.4%). Based on the IRR rule, the project should now be rejected. This
demonstrates the direct relationship: when the cost of capital exceeds the IRR, the NPV
becomes negative (as it "costs" more to finance the project than the project returns), and
it destroys value.
Question 4
An investor is analyzing HCL Technologies. The current stock price is ₹1,200. The
investor expects HCL to pay a dividend of ₹30 per share at the end of the year and
believes the stock price will be ₹1,280 just after the dividend is paid.
a) Calculate the expected dividend yield.
b) Calculate the expected capital gains yield.
c) Using the Dividend Discount Model for a one-year investor, calculate HCL's equity cost
of capital.
d) Based on your calculation in (c), what is the total expected return? Verify that it
matches the sum of the yields calculated in (a) and (b).
a) Expected Dividend Yield:
D1 30
Dividend Yield = = = 0.025 or 2.5%
P0 1200
b) Expected Capital Gains Yield:
P 1−P0 1280−1200 80
Capital Gains Yield = = = = 0.0667 or 6.67%
P0 1200 1200
c) Equity Cost of Capital (r):
D 1 + P1
Using the one-period DDM: P 0=
1+r
30+1280 1310 1310
1200= 1200= 1+r = =1.0917 r =1.0917−1=¿∗0.0917∨9.17
1+r 1+r 1200
d) Total Expected Return:
Total Return = Dividend Yield + Capital Gains Yield = 2.5% + 6.67% = 9.17%. This
matches the equity cost of capital calculated in (c), verifying the model's consistency.
Question 5
A stock is expected to pay dividends of ₹10 at the end of Year 1 and ₹11 at the end of
Year 2. The expected stock price at the end of Year 2 is ₹250. The equity cost of capital is
12%.
a) Calculate the price that a one-year investor (who plans to sell after receiving the first
dividend) would be willing to pay.
b) Calculate the price that a two-year investor (who will hold through both dividends and
then sell) would be willing to pay.
c) Show that both investors arrive at the same current stock price, demonstrating the
principle that the valuation is independent of the investor's holding period.
a) Price for a One-Year Investor:
This investor will receive D1 and then sell at P1. We need P1, the price at the end of year
1. The price at the end of year 1 will be the present value, at that time, of the remaining
cash flows (D2 and P2).
D2 + P2 11+ 250 261
P 1= = = =₹ 232.14 Now, the price the one-year investor will pay today
1+r 1+0.12 1.12
(P0) is:
D1 + P1 10+ 232.14 242.14
P 0= = = =₹ 216.20
1+r 1.12 1.12
b) Price for a Two-Year Investor:
This investor will receive D1 and D2 and then sell at P2. The value today is the present
value of all three cash flows.
D1 P = 10 + 11 P =8.93+ 11 + 250 P =8.93+8.77+199.30=₹ 216.20
P 0= 0
1.12 ¿ ¿ 0 1.2544 1.2544 0
¿¿
c) As shown in parts (a) and (b), both the one-year and two-year investors calculate the
same current stock price of ₹216.20. This proves that the value of the stock is the
present value of all its future dividends (and final sale price), regardless of the investor's
holding period. The multi-year investor's valuation incorporates the same cash flows that
determine the price at which the one-year investor can sell. There CANNOT be two
different prices for the same stock, no matter the investment horizon.
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