BCOE-143 Solved Assignment 2025

What is capital asset pricing model and arbitrage pricing theory? Differentiate between them.

Answer:

Discuss NPV method for making capital budgeting decisions with suitable examples.

Answer:

• $R_t$$R_t$R_(t)R_t$R_t$ = Net cash inflow during period $t$$t$tt$t$
• $r$$r$rr$r$ = Discount rate (reflecting risk and opportunity cost)
• $C_0$$C_0$C_(0)C_0$C_0$ = Initial investment cost

• Year 1: ₹1,50,000 / (1.10)¹ = ₹1,36,364
• Year 2: ₹1,50,000 / (1.10)² = ₹1,23,967
• … Summing these and subtracting ₹5,00,000 yields NPV. If positive, the project is viable.

• Time Value of Money: NPV adjusts future cash flows for inflation and risk, providing a realistic valuation.
• Holistic Cash Flow Analysis: It considers all cash inflows and outflows, unlike methods such as payback period.
• Risk Integration: The discount rate can be adjusted to reflect project-specific risks.
• Objective Decision-Making: A positive NPV directly indicates value creation, aligning with shareholder wealth maximization.

• Dependence on Accurate Forecasts: Errors in cash flow projections or discount rate assumptions distort NPV results.
• Discount Rate Sensitivity: Small changes in the discount rate significantly alter NPV, complicating decisions.
• Ignores Project Scale: A larger project may have a higher NPV but a lower return percentage than a smaller one.
• Reinvestment Assumption: NPV assumes cash flows are reinvested at the discount rate, which may not be realistic.

• Internal Rate of Return (IRR): While IRR identifies break-even returns, NPV provides absolute value, avoiding multiple IRR issues in unconventional cash flows.
• Payback Period: NPV surpasses this method by accounting for cash flows beyond the payback period and incorporating time value of money.
• Profitability Index: Useful for ranking projects, but NPV remains superior for absolute profitability measurement.

Explain different stages involved in operating cycle. Distinguish between gross operating capital and net working capital.

Answer:

• Procurement of Inventory: The cycle initiates with the purchase of raw materials or finished goods. For manufacturing firms, this includes acquiring inputs for production, while retailers purchase inventory for resale.
• Production/Processing: In manufacturing, raw materials undergo transformation into finished goods. This stage includes labor, overhead costs, and quality control before products are ready for sale.
• Inventory Holding: Finished goods are stored until sold. The duration of this phase impacts cash flow, as prolonged storage increases holding costs.
• Sales on Credit: Businesses often sell goods on credit, creating accounts receivable. The credit terms (e.g., net-30 days) determine how long cash remains tied up.
• Cash Collection: The final stage involves receiving payments from customers. Efficient collection processes shorten the cycle, improving liquidity.

• Gross Working Capital: Represents the total current assets (cash, inventory, receivables, etc.). It indicates liquidity but ignores liabilities, potentially overstating financial stability.
• Net Working Capital: Calculated as Current Assets – Current Liabilities, it provides a realistic view of liquidity by factoring in short-term debts (e.g., payables, short-term loans). A positive value signals solvency, while a negative value may indicate cash flow risks.

• Inventory Management: Adopting Just-in-Time (JIT) systems to minimize holding periods.
• Receivables Control: Tightening credit policies or offering early-payment discounts.
• Payables Optimization: Negotiating longer supplier terms without harming relationships.

Discuss with suitable examples various types of risks involved in capital budgeting decisions.

Answer:

• Economic Fluctuations: Recessions or economic downturns can drastically reduce consumer demand, impacting projected revenues. For instance, a manufacturing firm investing in a new plant may face lower-than-expected sales if a recession hits, rendering the project unprofitable.
• Interest Rate Volatility: Changes in interest rates influence borrowing costs and discount rates used in Net Present Value (NPV) calculations. A rise in rates increases the cost of debt-financed projects, potentially turning a positive NPV into a negative one.
• Inflation Risk: Rising inflation erodes the real value of future cash flows. A real estate developer might see construction costs escalate due to inflation, squeezing profit margins despite stable selling prices.
• Currency Risk: For multinational corporations, exchange rate fluctuations can alter the profitability of overseas investments. An Indian IT company expanding to the U.S. could suffer reduced rupee-denominated returns if the dollar weakens against the rupee.

• Cost Overruns: Initial budget estimates often prove optimistic. Construction projects, such as highways or airports, frequently exceed budgets due to unforeseen delays, material shortages, or labor disputes. The Channel Tunnel between England and France, for example, cost nearly double its original estimate.
• Technological Obsolescence: Rapid advancements can make projects obsolete before completion. A telecom company investing in 4G infrastructure might find its investment redundant if 5G adoption accelerates unexpectedly.
• Managerial Shortcomings: Inadequate expertise or poor decision-making during execution can lead to failures. Kodak’s late pivot to digital photography, despite early innovation, exemplifies how managerial missteps can nullify capital investments.

• Supply Chain Vulnerabilities: Dependence on specific suppliers can be risky. The global semiconductor shortage disrupted automotive production, delaying returns on investments in electric vehicle manufacturing.
• Regulatory Compliance: Changing laws may impose unexpected costs. Pharmaceutical companies face stringent clinical trial regulations, which can prolong drug development and increase capital outlays.
• Labor Issues: Strikes or skill shortages can halt operations. Airlines investing in new fleets may encounter pilot shortages, delaying revenue generation.

• Competitor Actions: A rival’s innovation or pricing strategy can undermine a project’s viability. Netflix’s shift to streaming eroded the value of Blockbuster’s physical store investments.
• Commodity Price Volatility: Industries like oil and gas are vulnerable to price swings. A shale gas project may become unprofitable if global oil prices plummet.
• Technological Disruption: Entire industries can be upended. The rise of renewable energy has threatened coal-powered plants, stranding assets prematurely.

• Political Instability: Expropriation or civil unrest in host countries can jeopardize investments. Venezuela’s nationalization of oil assets forced many firms to write off billions.
• Trade Policies: Tariffs or sanctions can disrupt supply chains. The U.S.-China trade war impacted manufacturers reliant on cross-border component sourcing.
• Legal and Ethical Risks: Non-compliance with local laws or ESG (Environmental, Social, and Governance) standards can lead to fines or reputational damage. Mining companies face scrutiny over environmental degradation, affecting project approvals.

• Scenario Analysis: Evaluating projects under optimistic, pessimistic, and baseline conditions. For example, an automaker might test an EV project’s viability under different oil price and regulatory scenarios.
• Monte Carlo Simulations: Using probabilistic models to assess a range of outcomes. Oil companies employ this to estimate reserve valuations amid price volatility.
• Real Options Analysis: Building flexibility into projects. A tech firm might stage investments in AI research, scaling up only after hitting milestones.
• Hedging: Using financial instruments to offset currency or commodity risks. Airlines often hedge fuel prices to stabilize costs.

Explain the various approaches to calculate cost of equity with help of examples.

Answer:

Explain future value and present value of money giving examples.

Answer:

Future Value (FV)

• $PV$$PV$PVPV$PV$ = Present Value
• $r$$r$rr$r$ = Interest rate per period
• $n$$n$nn$n$ = Number of periods

Present Value (PV)

Key Differences & Applications

• FV helps in saving and investing decisions (e.g., retirement planning).
• PV helps in loan pricing, bond valuation, and investment appraisal.

• A company may use PV to decide whether receiving $10,000 today is better than $12,000 in 5 years.
• An investor may calculate FV to see how much their $5,000 deposit will grow in 10 years at 8% interest.

What is payback period? Explain the acceptance criteria using payback period method.

Answer:

Payback Period: Meaning and Acceptance Criteria

Calculation of Payback Period

• For Even Cash Flows:$$\text{Payback Period}=\frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}$$$$\text{Payback Period}=\frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}$$“Payback Period”=(“Initial Investment”)/(“Annual Cash Inflow”)\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}$$\text{Payback Period}=\frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}$$
• For Uneven Cash Flows:
  The payback period is determined by adding up cash inflows each year until the cumulative amount equals the initial investment.

1. Even Cash Flows: A project costs $50,000 and generates $10,000 annually.$$\text{Payback Period}=\frac{50,000}{10,000}=5\text{years}$$$$\text{Payback Period}=\frac{50,000}{10,000}=5\text{ years}$$“Payback Period”=(50,000)/(10,000)=5″ years”\text{Payback Period} = \frac{50,000}{10,000} = 5 \text{ years}$$\text{Payback Period}=\frac{50,000}{10,000}=5\text{ years}$$
2. Uneven Cash Flows: An investment of $60,000 generates cash inflows of $20,000, $25,000, $30,000, and $35,000 over four years.
   • Cumulative cash flow after 2 years: $45,000
   • Remaining amount: $15,000 (recovered in 0.5 years from Year 3)
   • Total Payback Period = 2.5 years

Acceptance Criteria Using Payback Period

1. Stand-Alone Projects:
   • Accept if the payback period is less than a predetermined cutoff period set by management.
   • Reject if it exceeds the cutoff.
   • Example: If a company’s maximum acceptable payback is 4 years, a project with a 3-year payback is accepted.
2. Mutually Exclusive Projects:
   • The project with the shortest payback period is preferred.
   • Example: If Project A has a payback of 2 years and Project B has 4 years, Project A is chosen.

Advantages & Limitations

• Advantages: Simple, easy to understand, emphasizes liquidity, and reduces risk by favoring quick returns.
• Limitations: Ignores cash flows after payback, does not consider the time value of money (unlike Discounted Payback Period), and may reject profitable long-term projects.

Explain the dual method for the valuation of shares.

Answer:

Dual Method for the Valuation of Shares

1. Asset-Based Valuation (Net Asset Value Method)

• Suitable for: Liquidation scenarios, asset-heavy companies (e.g., real estate, manufacturing).
• Limitation: Ignores future earnings potential and goodwill.

2. Earnings-Based Valuation (Dividend or P/E Ratio Method)

• Dividend Discount Model (DDM):$$\text{Value per Share}=\frac{\text{Expected Dividend per Share}}{\text{Required Rate of Return}-\text{Growth Rate}}$$$$\text{Value per Share}=\frac{\text{Expected Dividend per Share}}{\text{Required Rate of Return}-\text{Growth Rate}}$$“Value per Share”=(“Expected Dividend per Share”)/(“Required Rate of Return”-“Growth Rate”)\text{Value per Share} = \frac{\text{Expected Dividend per Share}}{\text{Required Rate of Return} – \text{Growth Rate}}$$\text{Value per Share}=\frac{\text{Expected Dividend per Share}}{\text{Required Rate of Return}-\text{Growth Rate}}$$
• Price-to-Earnings (P/E) Ratio:$$\text{Value per Share}=\text{EPS}\times \text{Industry P/E Ratio}$$$$\text{Value per Share}=\text{EPS}\times \text{Industry P/E Ratio}$$“Value per Share”=”EPS”xx”Industry P/E Ratio”\text{Value per Share} = \text{EPS} \times \text{Industry P/E Ratio}$$\text{Value per Share}=\text{EPS}\times \text{Industry P/E Ratio}$$
• Suitable for: Profitable, dividend-paying companies.
• Limitation: Highly sensitive to growth assumptions and market conditions.

Dual Method: Combining Both Approaches

Example:

• Net assets = $10 million
• Shares outstanding = 1 million
• Expected earnings value per share = $15
• Asset-based value per share = $10

Advantages of Dual Method:

• Balances book value and market expectations.
• Useful for companies with both substantial assets and strong earnings.
• Reduces valuation bias from a single approach.

Conclusion

Discuss the conditions under which dividends can’t be declared.

Answer:

Conditions Under Which Dividends Cannot Be Declared

1. Insufficient Profits or Retained Earnings

• Dividends can only be paid out of current profits or accumulated retained earnings.
• If a company incurs losses or has negative retained earnings, it cannot legally declare dividends in most jurisdictions.

2. Violation of Debt Covenants

• Loan agreements often impose restrictive clauses prohibiting dividend payments if financial ratios (e.g., debt-to-equity) are not met.
• Declaring dividends in such cases may trigger defaults, leading to legal action by creditors.

3. Liquidity Constraints

• A company may have accounting profits but lack cash flow to distribute dividends.
• High working capital needs or upcoming debt obligations may restrict dividend payouts.

4. Legal Restrictions (Company Law Provisions)

• Capital Maintenance Rule: Dividends cannot be paid if they erode the company’s stated capital, protecting creditors.
• Solvency Test: Some jurisdictions require directors to confirm that the company remains solvent after dividend payments.

5. Regulatory Restrictions (Banking & Insurance Sectors)

• Financial institutions must comply with regulatory capital requirements (e.g., Basel norms for banks).
• Dividend restrictions may be imposed during economic downturns to preserve capital.

6. Pending Legal Disputes or Insolvency Proceedings

• Courts may freeze dividend payments if the company faces litigation or insolvency risks.
• Once insolvency proceedings begin, dividends cannot be declared to protect creditors’ interests.

7. Board or Shareholder Disapproval

• Even if profits exist, the board of directors may withhold dividends to reinvest in growth opportunities.
• Some companies follow a residual dividend policy, paying dividends only after funding all viable projects.

Conclusion

Explain the concepts of factoring and forfaiting.

Answer:

Factoring and Forfaiting: A Comparative Overview

Factoring

1. Recourse vs. Non-Recourse:
   • Recourse Factoring: The business must buy back unpaid invoices.
   • Non-Recourse Factoring: The factor bears the risk of non-payment (for a higher fee).
2. Services Provided:
   • Immediate cash advance (typically 70-90% of invoice value).
   • Collection management and credit risk assessment.
3. Suitable For: Short-term receivables, SMEs needing working capital.

Forfaiting

1. No Recourse: The exporter is completely free from payment default risk.
2. Fixed-Rate Discounting: The forfaiter purchases the debt at a fixed discount rate.
3. Instruments Used: Bills of exchange, promissory notes, or letters of credit.
4. Suitable For: Large-value, capital goods exports with credit periods of 6 months to 7 years.

Comparison

Conclusion

Write short notes on:

Answer:

a) Financial Leverage

1. Formula:
   $$\text{Financial Leverage}=\frac{\text{Total Debt}}{\text{Total Equity}}$$$$\text{Financial Leverage}=\frac{\text{Total Debt}}{\text{Total Equity}}$$“Financial Leverage”=(“Total Debt”)/(“Total Equity”)\text{Financial Leverage} = \frac{\text{Total Debt}}{\text{Total Equity}}$$\text{Financial Leverage}=\frac{\text{Total Debt}}{\text{Total Equity}}$$
   A higher ratio indicates greater reliance on debt.
2. Impact on Returns:
   • Positive Leverage: When the return on investment (ROI) exceeds the cost of debt, profits increase for equity holders.
   • Negative Leverage: If ROI is less than the interest rate, losses magnify, increasing financial risk.
3. Effects on Risk:
   • Increases volatility in earnings due to fixed interest obligations.
   • Raises bankruptcy risk if the company cannot service debt.
4. Trade-Off Theory:
   Companies balance tax benefits (interest is tax-deductible) against bankruptcy costs.

b) Gordon’s Model of Dividend

1. Formula:
   $$P=\frac{D_1}{r-g}$$$$P=\frac{D_1}{r-g}$$P=(D_(1))/(r-g)P = \frac{D_1}{r – g}$$P=\frac{D_1}{r-g}$$
   Where:
   • $P$$P$PP$P$ = Stock price
   • $D_1$$D_1$D_(1)D_1$D_1$ = Expected dividend next year
   • $r$$r$rr$r$ = Required rate of return
   • $g$$g$gg$g$ = Constant dividend growth rate
2. Assumptions:
   • Dividends grow indefinitely at a constant rate (g).
   • Growth rate ($g$$g$gg$g$) must be less than the discount rate ($r$$r$rr$r$).
3. Interpretation:
   • Higher growth ($g$$g$gg$g$) increases stock value.
   • If $g\ge r$$g\ge r$g >= rg \geq r$g\ge r$, the model fails (denominator becomes zero/negative).

• Unsuitable for non-dividend-paying stocks.
• Overly simplistic (assumes perpetual growth).

Distinguish between:

Answer:

Distinction Between Equity Shares and Preference Shares

1. Ownership & Voting Rights

• Equity Shares: Represent ownership in the company, granting shareholders voting rights in major decisions (e.g., board elections).
• Preference Shares: Do not usually carry voting rights but have priority in dividend payments and capital repayment.

2. Dividend Payments

• Equity Shares: Dividends are not fixed and depend on company profits. Shareholders bear higher risk.
• Preference Shares: Receive fixed dividends before equity shareholders. Cumulative preference shares ensure unpaid dividends accumulate.

3. Liquidation Preference

• Equity Shares: Rank last in liquidation; paid only after creditors and preference shareholders.
• Preference Shares: Have priority over equity shares in asset distribution during liquidation.

4. Convertibility & Redemption

• Equity Shares: Generally non-redeemable and cannot be converted.
• Preference Shares: May be convertible (into equity) or redeemable (repurchased by the company).

5. Risk & Return

• Equity Shares: Higher risk (no fixed returns) but potential for capital appreciation.
• Preference Shares: Lower risk (fixed dividends) but limited upside.

Net Income Approach vs. Net Operating Income Approach

1. Core Assumption

• Net Income (NI) Approach: Assumes cost of debt (Kd) and cost of equity (Ke) remain unchanged with leverage. Debt is cheaper, so increasing debt reduces WACC and raises firm value.
• Net Operating Income (NOI) Approach: Assumes WACC remains constant regardless of leverage. Increased debt raises Ke, offsetting the benefit of cheaper debt.

2. Impact of Leverage

• NI Approach: Firm value increases with higher debt due to tax savings and lower WACC.
• NOI Approach: Firm value is unaffected by debt; only operational profits determine value.

3. Risk Perception

• NI Approach: Ignores increased financial risk from higher debt.
• NOI Approach: Recognizes that higher debt raises equity risk, increasing Ke proportionally.

4. Practical Applicability

• NI Approach: Supports aggressive leverage for tax benefits.
• NOI Approach: Suggests capital structure is irrelevant (aligns with Modigliani-Miller without taxes).

• NI View: A firm with 50% debt may have a lower WACC (8%) than one with 20% debt (10%).
• NOI View: Both firms have the same WACC (12%) regardless of debt.