Test 15: answer key

Question 1 · 2 marks · Investment Decisions - Capital Budgeting · medium

Scenario. Apex Mega Corp is evaluating a four-year capital expenditure proposal. Equipment cost is ₹1,20,00,000 and installation cost is ₹8,00,000. An initial working capital of ₹12,00,000 is required. Annual net cash inflow after tax from operations is ₹42,00,000 for each of the four years. Terminal salvage value is ₹15,00,000 and working capital is released at the end of year 4. The discount rate is 12 percent. PVAF 12 percent for 4 years is 3.037 and PVIF 12 percent for year 4 is 0.636. The company uses NPV and IRR for appraisal.

What is the initial cash outflow for the Apex Mega Corp project?

1. ₹1,40,00,000 (correct answer)
2. ₹1,28,00,000
3. ₹1,52,00,000
4. ₹1,32,00,000

Answer: A — ₹1,40,00,000

Working. Initial outflow = Equipment cost + Installation cost + Initial working capital = ₹1,20,00,000 + ₹8,00,000 + ₹12,00,000 = ₹1,40,00,000.

Explanation. Initial cash outflow includes the equipment cost, installation cost and initial working capital. The salvage value and release of working capital occur at the terminal year and are not part of initial outflow.

Where it goes wrong. Adding salvage value to initial outflow or omitting installation or working capital.

Authority. Chapter 7: Investment Decisions - Capital Budgeting, Estimation of Project Cash Flows

Question 2 · 2 marks · Investment Decisions - Capital Budgeting · hard

What is the net present value of the Apex Mega Corp project?

1. ₹3,10,400
2. ₹2,80,600
3. ₹4,72,600 (correct answer)
4. ₹5,12,800

Answer: C — ₹4,72,600

Working. PV of annual inflows = ₹42,00,000 × 3.037 = ₹1,27,55,400. Terminal inflow = ₹15,00,000 + ₹12,00,000 = ₹27,00,000. PV of terminal inflow = ₹27,00,000 × 0.636 = ₹17,17,200. Total PV of inflows = ₹1,44,72,600. NPV = ₹1,44,72,600 - ₹1,40,00,000 = ₹4,72,600.

Explanation. NPV equals present value of operating inflows plus present value of terminal salvage and working capital release less initial outflow. The resulting NPV is positive and supports acceptance under the NPV rule.

Where it goes wrong. Ignoring terminal working capital release or applying PVIF to annual inflows instead of PVAF.

Authority. Chapter 7: Investment Decisions - Capital Budgeting, Net Present Value Technique

Question 3 · 2 marks · Investment Decisions - Capital Budgeting · hard

Using interpolation between 12 percent and 14 percent, what is the approximate IRR of the Apex Mega Corp project?

1. 11.80 percent
2. 13.49 percent (correct answer)
3. 14.20 percent
4. 12.00 percent

Answer: B — 13.49 percent

Working. NPV at 14 percent = ₹42,00,000 × 2.914 + ₹27,00,000 × 0.592 - ₹1,40,00,000 = ₹1,22,38,800 + ₹15,98,400 - ₹1,40,00,000 = -₹1,62,800. IRR = 12 + 4,72,600 ÷ (4,72,600 + 1,62,800) × 2 = 12 + 1.49 = 13.49 percent approximately.

Explanation. At 12 percent NPV is positive and at 14 percent NPV is negative. Interpolation between these rates gives an IRR above 12 percent and below 14 percent.

Where it goes wrong. Using the discount rate as IRR or ignoring terminal salvage and working capital release while computing NPV at 14 percent.

Authority. Chapter 7: Investment Decisions - Capital Budgeting, Internal Rate of Return Method

Question 4 · 2 marks · Cost of Capital · medium

Scenario. Apex Mega Corp has equity of ₹600 lakh and debt of ₹400 lakh. Cost of equity is 15 percent. Pre-tax cost of debt is 10 percent and tax rate is 30 percent. EBIT is ₹250 lakh. Capital employed is ₹1,000 lakh. The finance team computes NOPAT, WACC and Economic Value Added for internal performance review.

What is the weighted average cost of capital of Apex Mega Corp?

1. 10.20 percent
2. 11.80 percent (correct answer)
3. 12.40 percent
4. 9.00 percent

Answer: B — 11.80 percent

Working. After-tax Kd = 10 × (1 - 0.30) = 7 percent. WACC = 0.60 × 15 + 0.40 × 7 = 9.00 + 2.80 = 11.80 percent.

Explanation. WACC uses after-tax cost of debt and the book value weights of equity and debt given in the scenario. The debt weight is 40 percent and equity weight is 60 percent.

Where it goes wrong. Using pre-tax cost of debt or reversing equity and debt weights.

Authority. Chapter 4: Cost of Capital, Weighted Average Cost of Capital

Question 5 · 2 marks · Cost of Capital · medium

What is the NOPAT of Apex Mega Corp?

1. ₹250 lakh
2. ₹105 lakh
3. ₹70 lakh
4. ₹175 lakh (correct answer)

Answer: D — ₹175 lakh

Working. NOPAT = EBIT × (1 - tax rate) = ₹250 lakh × (1 - 0.30) = ₹175 lakh.

Explanation. NOPAT is EBIT multiplied by one minus tax rate. Interest is not deducted because EVA is based on operating profit after tax before financing costs.

Where it goes wrong. Deducting interest before tax or applying tax to net profit instead of EBIT.

Authority. Chapter 4: Cost of Capital, Economic Value Added

Question 6 · 2 marks · Cost of Capital · hard

What is the Economic Value Added of Apex Mega Corp?

1. ₹57 lakh (correct answer)
2. ₹118 lakh
3. ₹175 lakh
4. ₹43 lakh

Answer: A — ₹57 lakh

Working. Capital charge = ₹1,000 lakh × 11.80 percent = ₹118 lakh. EVA = ₹175 lakh - ₹118 lakh = ₹57 lakh.

Explanation. EVA equals NOPAT less capital charge, where capital charge is capital employed multiplied by WACC. A positive EVA indicates value creation over the required return.

Where it goes wrong. Using EBIT instead of NOPAT or omitting the capital charge.

Authority. Chapter 4: Cost of Capital, Economic Value Added

Question 7 · 2 marks · Financing Decisions - Capital Structure and Leverage · medium

Scenario. Apex Mega Corp reports sales of ₹500 lakh with a variable cost ratio of 60 percent. EBIT is ₹120 lakh. Interest on existing debt is ₹40 lakh and annual installment payable is ₹25 lakh. Depreciation is ₹15 lakh and tax rate is 30 percent. The bank covenant requires a Debt Service Coverage Ratio of at least 1.50. The treasury team is assessing combined leverage and additional annual debt service capacity under the covenant.

What is the degree of combined leverage of Apex Mega Corp?

1. 1.50
2. 1.67
3. 2.50 (correct answer)
4. 3.00

Answer: C — 2.50

Working. Contribution = 500 - 300 = 200. DOL = 200 / 120 = 1.67. DFL = 120 / 80 = 1.50. DCL = 1.67 * 1.50 = 2.50.

Explanation. Contribution equals Sales ₹500 lakh less variable cost 60 percent = ₹200 lakh. Degree of Operating Leverage (DOL) = Contribution / EBIT = ₹200L / ₹120L = 1.67. Degree of Financial Leverage (DFL) = EBIT / (EBIT - Interest) = ₹120L / (₹120L - ₹40L) = 1.50. Degree of Combined Leverage (DCL) = DOL x DFL = 1.67 x 1.50 = 2.50.

Where it goes wrong. Using PAT instead of EBIT in DFL or omitting interest from DFL.

Authority. Chapter 5: Financing Decisions - Capital Structure and Leverage, Combined Leverage

Question 8 · 1 marks · Financing Decisions - Capital Structure and Leverage · medium

What is the maximum additional annual debt service permitted under the DSCR covenant of 1.50?

1. ₹25 lakh
2. ₹15 lakh
3. ₹0 lakh
4. ₹9 lakh (correct answer)

Answer: D — ₹9 lakh

Working. Earnings available = (₹120 lakh - ₹40 lakh) × (1 - 0.30) + ₹15 lakh + ₹40 lakh = ₹56 lakh + ₹55 lakh = ₹111 lakh. Maximum total debt service = ₹111 lakh ÷ 1.50 = ₹74 lakh. Existing debt service = ₹40 lakh + ₹25 lakh = ₹65 lakh. Additional capacity = ₹74 lakh - ₹65 lakh = ₹9 lakh.

Explanation. Earnings available for debt service is computed after tax and after adding back depreciation and interest. Maximum total debt service under covenant is earnings available divided by 1.50. Headroom is maximum total debt service less existing interest and installment.

Where it goes wrong. Using EBIT directly as earnings available for debt service or ignoring existing installment.

Authority. Chapter 5: Financing Decisions - Capital Structure and Leverage, Debt Service Coverage Ratio