Slides of Lecture#09

Corporate Finance (FIN-622)

Weighted Average Cost of Capital:

EXAMPLE:
– CAPITAL STRUCTURE OF A COMPANY CONSIST OF:
• LONG TERM LOANS 157,500 @ 12%
• SHORT TERM LOANS 67,500 @ 08%
• EQUITY 225,000
• NEXT DIVIDEND / SHARE Rs. 3/ SHARE
• CURRENT SHARE MARKET PRICE Rs 40/-
• DIV GROWTH RATE 5%

• CALCULATE WACC?
SOLUTION:

• BEFORE CALCULATION WACC, WE NEED TO FIND OUT COST OF EQUITY.

• DIV GROWHT MODEL EQUATION:

P0 = D1 / r – g
Or
r = D1/P0 + g
r = 3 / 40 + 0.05
= 0.125 or 12.50%

Weighted Average Cost of Capital

Total Capital= 450,000

Weighted Average Cost of Capital

PARTICULARS Interest Weight Weighted

Rs. Rate Int. Rate

LONG TERM LOANS 157,500 12.00% 0.35 0.0420

SHORT TERM LOANS 67,500 8.00% 0.15 0.0120

EQUITY 225,000 12.50% 0.50 0.0625

450,000 0.1165 11.65%

NPV-Example (With Opportunity Cost)
M/s Dark Cloud Ltd., is considering an investment opportunity to manufacture a new product
“Silver-Lining” which would involve use of both new and existing plant. The new plant having 5 years useful
economic life will cost Rs. 1,450,000/-. The existing machine was acquired two years ago at a cost of Rs.
1,000,000/-. This machine has ample surplus capacity or is under-utilized at present. The new product annual
sales are estimated to 5000 units per year and the selling price would be Rs. 320/- per unit.

The unit cost will be as under:

Direct Materials Rs. 70

Direct Labor (4 hrs x Rs.20/hr) Rs. 80
Fixed Costs including depreciation Rs. 90

The new plant life is 5 years and after that it could be sold for Rs. 145,000/-.

The skilled labor required for the manufacturing of silver-lining is in short supply and labor resources would
have to be switched over to this project. The labor is earning contribution margin of Rs. 15.00 per hour.

Working capital of Rs. 150,000 will be required in first year and shall be recovered at the end of
project life. The company’s cost of capital is 20%. Assess whether project is financially viable?

Discount
Initial Working Net Factor PV of
Year Investment Capital Benefit CM 20% CF
Unit Price 320
DM 70 0 (1,450,000.00) (150,000.00) (1,600,000.00) 1.00 1,600,000.00)
DL 80 1 550,000.00 0.83 458,315.00
4Hrs x Rs.20 2 550,000.00 0.69 381,920.00
Fixed Cost 90 3 550,000.00 0.58 318,285.00
240 4 550,000.00 0.48 265,265.00
5 145,000.00 150,000.00 550,000.00 0.40 221,045.00
CM
Foregone/Per
Hr 15 NPV 44,830.00

Contribution Margin Earned - New Product 170.00

Additional Units to be produced 5,000.00
Total CM - New Product 850,000.00
CM surrendered
Labor hour required for New Product 20,000.00
CM lost / Hr 15.00
Total CM lost 300,000.00
Net CM - Benefit 550,000.00

CAPITAL BUDGETING
 Initial Working Net Discount PV of
Year Investment Capital Benefit CM Factor 20% CF
0 (1,450,000.00) (150,000.00) (1,600,000.00) 1.00 (1,600,000.00)
1 550,000.00 0.83 458,315.00
2 550,000.00 0.69 381,920.00
3 550,000.00 0.58 318,285.00
4 550,000.00 0.48 265,265.00
5 145,000.00 150,000.00 550,000.00 0.40 221,045.00
NPV 44,830.00

NPV-Example (With more Complex situation)

M/s Hi-Mountain Ltd., - specialized chemical manufacturer are looking an untapped investment opportunity. This
involves manufacturing of a new chemical to be used in textile industry. For this, the company must add a piece of plant
with estimated life of 5 years, costing Rs. 2 million.
Other acquisition cost would be Rs. 50,000/- at the end of first year. A consultant would be hired for technical aspect of
the project at a cost of Rs. 50,000/-. However, if the project does not turn out financially feasible, his contract would be
cancelled by paying him Rs. 15,000/-. Working capital requirement would be Rs. 300,000/- in first year and rising to Rs.
400,000/- in second year.
All the working capital would be recovered at the end of fifth year. Due to technological obsolescence the plant will not
be useable after fifth year and the salvage value is estimated around Rs. 125,000/-.
Cash flow emerging from the additional sales would be Rs. 600,000 in first and second years each, Rs. 550,000/- in third
year, Rs. 700,000/- in forth and Rs. 750,000/- in last year.
The company shall depreciate the asset on straight line over its useful life. Tax rate is 20%.
Company requires 10% rate of return on such projects.
EVALUATE THE PROJECT IS WORTH UNDERTAKING?

SOLUTION:

CAPITAL BUDGETING
Year Initial Cost Benefit Total
Capital W. Capital Consultant Others Benefits
0 (2,000,000.0 (300,000. -
0) 00)
1 (100,000. (50,000.00 600,000. 515,000.
(35,000.00)
00) ) 00 00
2 600,000. 600,000.
00 00
3 550,000. 550,000.
00 00
4 700,000. 700,000.
00 00
5 125,000.0 400,000. 750,000. 750,000.
0 00 00 00
 Revenue
Revenue
& Capital
Net
benefit Benefit Total df @ PV of Total
Depreciation Tax 20%
Tax after Tax Benefit 10% Benefit
purposes
1.000
- - - - (2,300,000.00) (2,300,000.00)
0
225,000.0 45,000.0 555,000.0 0.909
(375,000.00) 455,000.00 413,640.50
0 0 0 1
225,000.0 45,000.0 555,000.0 0.826
(375,000.00) 555,000.00 458,652.00
0 0 0 4
175,000.0 35,000.0 515,000.0 0.751
(375,000.00) 515,000.00 386,919.50
0 0 0 3
325,000.0 65,000.0 635,000.0 0.683
(375,000.00) 635,000.00 433,705.00
0 0 0 0
375,000.0 75,000.0 675,000.0 0.620
(375,000.00) 1,200,000.00 745,080.00
0 0 0 9

NPV 137,997.00

Assumptions

 Taxes are paid in the same year of benefit occurring.

 Consultant and Other costs are supposed to occur at the end of first year.
 Inflation assumed 0%.