Paper: Applied Finance Code: 474A

General Instructions: The Student should submit this assignment in the handwritten form (not in the typed format) The Student should submit this assignment within the time specified by the exam dept The student should only use the Rule sheet papers for answering the questions. The student should attach this assignment paper with the answered papers. Failure to comply with the above Four instructions would lead to rejection of assignment.

Specific Instructions:

There are four Questions in this assignment. The student should answer all the four questions. Marks allotted 100.

Each Question carries equal marks (25 marks) unless specified explicitlyQuestion No 1.

Mr. Kiran started at the paper in front of him. He has just finished projection for his startup company Export dotcom Pvt Ltd. He was in need of money and intend to use his valuations for this purpose. He was almost convinced that he would be able to influence leaders about the potential of this start up firm in online- export documentation. However, he was not sure about whether the lenders would accept his valuations. He considered the options in front him.

He considered his projections to be reasonable, although he guessed that he only had a 30% chance of hitting those numbers and an equal 30% chance of achieving half of the projected cash flows. He is also aware that there is a relatively high probability (40%) of not getting any cash flow at all.

In estimating cash flow, Kiran thought that he would only need 5 million in cash to run the business. Anything above Rs.5 million would be considered as excess cash. Because the firm was just getting off the ground, there was no working capital and no fixed assets at the beginning of 2002. Any working capital and net fixed at the end of the year 2002 would be a net investment.

Mr. Kiran has made projections for the next six years (Exhibit I) and he thought that after sixth year the net earnings firm is expected to grow at round 7% per year, although he wondered what a somewhat more modest growth rate is of 4% would do the expected value of the firm.

Mr. Kiran thought if approaching venture capitalists too for raising money. He is fully aware that traditional lending institutions are averse to lending in his kinds of business. But he was aware that venture capitalists are always skeptical about any projections made by the prospective borrower and hence he has decided to show only the best case projections to the venture capitalists. He approached one venture capitalist with his cash flow projections and the venture capitalists has flatly said that they would require a 51% rate if return on their investment in his type of firm.

Mr. Kiran knew that he would not be taking on any debt for the foreseeable future. However, he was wondering how being an all equity firm would affect his cost of capital. The long-term equity risk premium is around 7.5%. However, illiquid stocks carry 100 basis point more premium. Current 364-day treasury bills yield 7% on an effective annual rate. A friend of Kiran has suggested that Export Dotcom might be able to take on debt later once it has stabilized.

Kiran knew that in order to value a startup, he has to gather information on existing pure players or at least comparable firms. He found that three publicity traded firms directly comparable to his kind of business (pure players) (Exhibit 2). He wondered how he should use this information in determining value of his firm. The

following questions came to his mind:

(a) Should he use beta of these publicity trade firms? What about the fact that he was still private?

(b) What is the value of the firm based on discounted cash flows. (use market value weighted beta of the pure players )

(c) Does venture capital method valuation give any better insight? (Use average P/E multiple-equity weighted)

Help Mr.Kiran find answer to these questions. (Refer Exhibits 1&2 given below):

Exhibit 1: Projected Financials (best case) of Export Doctom Pvt. Ltd.(Figs in ‘000s)

  2000 2003 2004 2005 2006 2007

Income Statement Net SalesCost of goods soldSelling and general admn. ExpR & D expensesEBITTax (35%)Net earnings

42,50016,00017,5005,5003,5001,2252,275

75,00028,00027,05012,5007,450

2,607.54,842.5

1,77,50070,00032,00020,50055,00019,25035,750

2,30,00090,50026,50027,00086,00030,10055,900

2,60,0001,00,500

36,00032,50091,00031,85059150

3,00,0001,22,500

39,00035,000

1,03,50036,22567275

Balance Sheet CashAccounts receivableInventoriesOther Net fixed assetsTotal assetsAccounts payableAccrued expensesNet worthTotal liabilities and net worth

5,0007,0852,0001,7704,530

20,3852,6653,035

14,68520,385

5,00012,5003,5003,125

11,50032,6254,6655,355

25,60535,625

23,96529,5858,7507,400

16,00085,70011,66512,68061,35585,700

69,53538,33511,3159,585

20,0001,48,770

15,08516,430

1,17,2551,48,770

1,23,49543,33512,56210,83521,500

2,11,73016,750185.70

1,76,4052,11,725

1,85,21050,00015,31512,50022,500

2,85,52520,41521,430

2,43,6802,85,525

Exhibit 2: Financial details of pure players for the year 2001(firs. in Rs.lakhs)

  Player 1 Player 2 Player 3

Net earningsDebt Net worth

26.3535.960.51.4

108.7534

10561.3

7.50.85

187.81.2

Equity betaP/E Ratio

20 37 20

Question No 2.

Discuss various aspects of computation of Economic Value Added and its application in business planning and Valuation

a) Estimate the brand value of the following information technology firm:

(Rs. in crores)

Year Ended March 31, 2001 2000 1999

PBITNon- branded incomeInflation Compound factor @8% Remuneration of Capital (5% of average capital employed)Tax @ 39.55%Multiple applied

696.0353.431.000

55.57158.5822.186

325.6535.231.087

155.863.46

1.181

Question No 3:

The Cement industry has been through a very trying period in the last five years and the constraints on operations have been removed in the early part of the year. The company hopes to improve its position in the years to come and has plans to put up an additional plant in the neighborhood of the present factory. Increased profits due to expansion in capacity are expected to be 25% of the additional capital investment after meeting interest charges but before depreciation on the additional plant installed. Shares of this Cement company are widely distributed and there is a large majority of holdings in the hands of middle class investors whose average holding do not exceed 500 shares. The following data is also made available to you:

Last five years:

Particulars 1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 (current yr.)

Earning per share (Rs.) 6.00 5.00 4.50 4.50 4.00 17.50

Cash availability per share (Rs.)7.50 6.00 5.00 4.00 4.00 20.00

Dividend /Share (Rs.) 3.00 3.00 3.00 2.00 Nil ?

Payout ratio (%) 50.00 60.00 67.00 45.00 Nil ?

Average Market price (Face value Rs.100)80.00 70.00 70.00 70.00 60.00 150

P/E ratio 13.33 : 1 14 : 1 15.6 : 1 15.6 :1 15 : 1  

Cement Company requires you to advise them with respect to the dividend policy they have to follow for the current year. What recommendations would you make? Give reasons for your answers.

Question No 4.

a) Nimbus Ltd. has 1,000 shares of Rs. 10 each raised at a premium of Rs. 15 per share. The company's retained earnings are Rs. 5,52,500. The company's stock sells for Rs. 20 per share.

If a 10% stock dividend is declared how many new shares would be issued? What would be the market price after the stock dividend? How would the equity account change?

If the company instead declares a 5 : 1 stock split, how many shares will be outstanding? What would be new par value? What would be the new market price?

Suppose if the company declares a 1 : 4 reverse split, how many shares will be outstanding? What would be the new par value? What would be the new market value?

b) Discuss three ways a firm can increase its ROE. Make up an example to illustrate your discussion

c) It is widely known that Retail companies have low profit margins—on average they earn about 1 percent on sales. How would you explain the fact that their ROE is about 12 percent? Does this seem logical?