Capital Budgeting, Cost of Capital, Risk and Return Analysis

This document provides expert analysis on Capital Budgeting, Cost of Capital, and Risk and Return. It includes calculations for payback period, NPV, WACC, and valuation of shares using Gordon's Growth Model. It also discusses diversification, beta, and standard deviation as measures of risk. The document includes references for further reading.

QUESTION 1 Capital Budgeting
PART A
Maximum Pay Back Period Available= 3.5 years
Initial Cost= $ 500000
Total Operating Cash Flows= ($180,000 + $190,000 + $70,000 + $180,000) = $
620000.
Therefore, the payback period in which the initial cost would be recovered would be
=3.4 years, as shown in calculation below.
YEAR CASH INFLOWS INITIAL COST RECOVERED
1 180000 180000
2 190000 370000
3 70000 440000
3 YEARS, 4 MONTHS 60000 500000
Hence, the proposal should be accepted, as the actual payback period is less than
the maximum available payback period.
PART B
Year Cash Flows ($) PVF@15% Present value
0 (1,00,000.00) 1.000 (1,00,000.00)
1 25,000.00 0.870 21,739.13
2 10,000.00 0.756 7,561.44
3 50,000.00 0.658 32,875.81
4 10,000.00 0.572 5,717.53
5 10,000.00 0.497 4,971.77
6 60,000.00 0.432 25,939.66
(1,194.67)
Net present value
NPV
As seen from the above calculation, the NPV of the given project at the given
discount rate of 15 percent, amounts to be negative. Hence, the proposal should be
rejected.
PART C
The most striking theoretical and practical strength of the NPV and the IRR
methods of the investment proposal is that the both the techniques use the time
value of money. The conflicts between the two methods arise in the event of the

comparison of the two mutually exclusive projects. There can be a range of reasons
leading to the conflicting results between the NPV and IRR, listed as follows. The
size and the investment amount of the projects can lead to the conflicting results
because a small project may have low NPV but higher IRR. In addition, the patterns
of the cash flows lead to the conflicting results, where one of the projects lead to the
lump sum cash flows in the last year, and no cash flows during other years. In this
case, the IRR of the said project can be lower while NPV can be higher.
PART D
Year Cash Flows ($) PVF@10% Present value
0 (2,50,000.00) 1.000 (2,50,000.00)
1 75,000.00 0.909 68,181.82
2 75,000.00 0.826 61,983.47
3 75,000.00 0.751 56,348.61
4 75,000.00 0.683 51,226.01
5 75,000.00 0.621 46,569.10
34,309.01
Net present value- MACHINE A
NPV
Year Cash Flows ($) PVF@10% Present value
0 (3,50,000.00) 1.000 (3,50,000.00)
1 2,00,000.00 0.909 1,81,818.18
2 1,50,000.00 0.826 1,23,966.94
3 1,00,000.00 0.751 75,131.48
4 -
5 -
30,916.60
Net present value- MACHINE B
NPV
Machine A has higher NPV that is of 34309, than that of the Machine B that is
30917. Hence as per the NPV, Machine A must be chosen over the Machine B.
The formula for EAA =
C = (r x NPV) / (1 - (1 + r)-n )
Where:
C = equivalent annuity cash flow
NPV = net present value

r = interest rate per period
n = number of periods
Accordingly,
EAA Machine A = (0.10 x $34309) / (1 - (1 + 0.10)-5) = $9050.63
EAA Machine B = (0.10 x $30917) / (1 - (1 + 0.10)-3) = $12432.18
Hence, as evident above, as per EAA, Machine B is more feasible.
The decision is that Machine B must be chosen for the investment.

QUESTION 2 COST OF CAPITAL
i)
Weights for WACC
in millions Weights
Market value of Debt 100 25%
Market value of Equity 300 75%
Total value 400 100%
ii)
COST OF EQUITY UNDER DDM
Income =( EPS * OUTSTANDING SHARES) 50
D1 per share 0.25
P0 3
Growth rate 0.08
Ke 15.83%
iii)
COST OF THE EQUITY UNDER CAPM MODEL
Risk free rate of return 5%
Beta 1.4
Market Risk Premium 7%
COST OF EQUITY 7.80%
iv) The major difference between the calculations by the models is in the parameters
that have been used to calculate the cost of equity. The cost of under the dividend
discount model involves three parameters such as dividend per share, share price
and the existing growth rate. On the contrary under the CAPM model, the factors like
risk free rate of return, market risk premium and beta value is considered. In the
previous method the dividend is divided by the share price and summed up with the
growth rate. In the CAPM model, the beta value is multiplied with the difference of
the market risk premium and risk free rate of return. Further the value has been
added to risk free rate of return. Hence in terms of the parameters and the
calculation both the methods are different (Jawadi & Prat, 2017).

v)
WACC
COST OF EQUITY 7.80%
COST OF DEBT 10.0%
Tax Rate 28.0%
MARKET VALUE OF EQUITY 200
MARKET VALUE OF DEBT 100
TOTAL 300
WACC 7.60%
vi) The basic assumption taken while calculating WACC is that, the capital
structure remains the same as on the date of the balance sheet. For the proposed
new investment in the automated factory WACC is apt, as it’s easy to use, it helps in
prompt decision making and moreover it is used as the hurdle rate. Also, the cost of
equity under the DDM model is 15.83% whereas in case of the CAPM model, it’s just
7.80%. The basic notion of the WACC is that it shall be lower in order to have less
risk for the operations of the firm. Hence, it is advised to MPL, to use WACC with the
CAPM model for better growth and opportunities (Brusov, Filatova, Orekhova &
Eskindarov, 2018).

QUESTION 3 RISK AND RETURN
PART A
i) The valuation of shares of the firm as per the Gordon’s Growth Model
has been computed as follows.
Value of stock = D1 / (k - g)
where:
D1 = next year's expected annual dividend per share.
k = required rate of return as estimated using the Capital Asset Pricing Model
(CAPM) or the Dividend Growth Model.
g = the expected dividend growth rate.
Growth rate = 25.93%
Annual compound rate = 8.64 %
Ke = 14.5 %
Therefore, VALUE OF SHARES =D1 / (k - g)
D1= 3.69
VALUE= 3.69/(14.5-8.64)
THEREFORE, VALUE = $ 62.96
ii) Diversification is stated to be the means of reduction of risk by the
allocation of the investments among the various financial instruments, of different
industries, and wide range of categories. The reason the risk is reduced by
diversification is that as the portfolio is comprised of various financial instruments,
these individually react differently to the same economic or financial event. Thus, a
balance is created in the event of the negative financial happenings for the investor
at an overall level. Though, the diversification does not guarantee that an investor is
immune to the financial losses, yet one can minimize it to the maximum extent

possible, if the exercise is done involving the evaluation of the risk and returns of the
individual securities.
iii) Both beta and the standard deviation are used to predict future
volatility. Stock Beta is the indicator of the volatility of a particular stock, in relation to
the overall market trend. A beta of less than 1 indicates less volatile stock as
compared to the market and a beta of greater than 1 is indicator of the security's
price being more volatile than the market conditions. In contrast to this, the standard
deviation refers to a historical report of the volatility of stock over a period of time in
the past. The reason the Beta is taken as the more relevant measure of risk is
because Beta is descriptive of the stock volatility in terms of the current market
trends, while the standard deviation is descriptive of volatility as per the historical
trends. Further, the reason for relevancy is that the unique risk can be diversified
away, and only undiversifiable risk should be priced.
PART B
i)
Cost of Equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend
Growth Rate.
Cost of Equity (Ordinary Shares) = (1.06/10) + 6 %
Cost of Equity for ordinary shares = 17 PERCENT
Cost of Equity (Preference Shares) = (1.20/11.50) + 0 %
Cost of Equity for preference shares = 10 PERCENT
ii) The difference is due to the growth in the payment of the dividends.

References
Brusov, P., Filatova, T., Orekhova, N., & Eskindarov, M. (2018). New meaningful
effects in modern capital structure theory. In Modern Corporate Finance,
Investments, Taxation and Ratings, UK: Springer, 537-568.
Jawadi, F., & Prat, G. (2017). Equity prices and fundamentals: a DDM–APT mixed
approach. Review of Quantitative Finance and Accounting, 49(3), 661-695.