Assignment questions

PGPBL
September 2020

(1) Walks Softly sells customized shoes. Currently, it sells 14,800 pairs of shoes annually
at an average price of $59 a pair. It is considering adding a lower-priced line of shoes
that will be priced at $39 a pair. Walks Softly estimates it can sell 6,000 pairs of
the lower-priced shoes but will sell 3,500 less pairs of the higher-priced shoes by
doing so. What annual sales revenue should be used when evaluating the addition
of the lower-priced shoes?
(2) Jamie’s Motor Home Sales currently sells 1,100 Class A motor homes, 2,200 Class
C motor homes, and 2,800 pop-up trailers each year. Jamie is considering adding
a mid-range camper and expects that if she does so she can sell 1,500 of them.
However, if the new camper is added, Jamie expects that her Class A sales will
decline to 850 units while the Class C camper sales decline to 2,000. The sales of
pop-ups will not be affected. Class A motor homes sell for an average of $140,000
each. Class C homes are priced at $59,500 and the pop-ups sell for $5,000 each.
The new mid-range camper will sell for $42,900. What is the erosion cost of adding
the mid-range camper?
(3) Peter’s Boats has sales of $760,000 and a net profit margin of 5 percent. The annual
depreciation expense is $80,000. What is the amount of the operating cash flow if
the company has no long-term debt and no working capital expense?
(4) Thornley Machines is considering a 3-year project with an initial cost for fixed
assets of $618,000. The project will reduce operating costs by $265,000 a year. The
equipment will be depreciated straight-line to a zero book value over the life of the
project. At the end of the project, the equipment will be sold for an estimated
$60,000. The tax rate is 34 percent. The project will require $23,000 in extra
inventory over the project’s life. What is the NPV if the discount rate assigned to
the project is 14 percent?
(5) Matty’s Place is considering the installation of a new computer system that will
cut annual operating costs by $12,000. The system will cost $42,000 to purchase
and install. This system is expected to have a 5-year life and will be depreciated
to zero using straight-line depreciation. What is the amount of the earnings before
interest and taxes for each year of this project?
(6) Tool Makers manufactures equipment for use by other firms. The initial cost of
one customized machine is $850,000 with an annual operating cost of $10,000, and
a life of 3 years. The machine will be replaced at the end of its life. What is the
equivalent annual cost of this machine if the required rate of return is 15 percent
and we ignore taxes?

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 (7) Kay’s Nautique is considering a project which will require additional inventory of
$128,000 and will also increase accounts payable by $45,000. Accounts receivable
are currently $80,000 and are expected to increase by 10 percent if this project is
accepted. What is the initial project cash flow needed for net working capital?
(8) Tech Enterprises is considering a new project that will require $325,000 for fixed
assets, $160,000 for inventory, and $35,000 for accounts receivable. Short-term debt
is expected to increase by $100,000. The project has a 5-year life. The fixed assets
will be depreciated straight-line to a zero book value over the life of the project. At
the end of the project, the fixed assets can be sold for 25 percent of their original
cost and the net working capital will return to its original level. The project is
expected to generate annual sales of $554,000 and costs of $430,000. The tax rate
is 35 percent and the required rate of return is 15 percent. What is the net present
value of this project?
(9) The Down Towner is considering a 4-year project that will require $164,800 for fixed
assets and $42,400 for net working capital. The fixed assets will be depreciated
straight-line to a zero book value over the life of the project. At the end of the
project, the fixed assets can be sold for $37,500 and the net working capital will
return to its original level. The project is expected to generate annual sales of
$195,000 and costs of $117,500. The tax rate is 35 percent and the required rate of
return is 13 percent. What is the project’s net present value?
(10) Lew’s Market invested in a project that returned 16.67 percent during a period
when inflation averaged 3.26 percent. What real rate of return did Lew’s earn on
its project?
(11) You are working on a bid for a contract. Thus far, you have determined that you
will need $156,000 for fixed assets and another $32,000 for net working capital at
Time 0. You have also determined that you can recover $68,400 aftertax for the
combined fixed assets and net working capital at the end of the 4-year project.
What operating cash flow will be required each year for the project to return 16
percent in nominal terms?
(12) In working on a bid project you have determined that $318,000 of fixed assets will
be required and that they will be depreciated straight-line to zero over the 6-year
life of the project. You have also determined that the discount rate should be 18
percent and the tax rate will be 35 percent. In addition, the annual cash costs will
be $198,200. After considering all of the project’s cash flows you have determined
that the required operating cash flow is $92,400. What is the amount of annual
sales revenue that is required?
(13) A $218,000 project has equal annual cash flows over its 7-year life. If the discounted
payback period is seven years and the discount rate is 0%, what is the amount of
the cash flow in each of the seven years?
(14) A proposed new venture will cost $175,000 and should produce annual cash flows of
$48,500, $85,000, $40,000, and $40,000 for Years 1 to 4, respectively. The required
payback period and discounted payback period is 3 years. The discount rate is 9
percent. Which methods indicate project acceptance and which indicate project
rejection?

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(15) Project A has an initial cost of $75,000 and annual cash flows of $33,000 for three
years. Project B costs $60,000 and has cash flows of $25,000, $30,000, and $25,000
for Years 1 to 3, respectively. Projects A and B are mutually exclusive. What is the
incremental IRR? If the required rate is higher than the crossover rate then which
project should be accepted?

(16) Kali’s Ski Resort, Inc. stock is quite cyclical. In a boom economy, the stock is
expected to return 30 percent in comparison to 12 percent in a normal economy
and a negative 20 percent in a recessionary period. The probability of a recession
is 15 percent while there is a 30 percent chance of a boom economy. The remainder
of the time, the economy will be at normal levels. What is the standard deviation
of the returns?

(17) A portfolio consists of Stocks A and B and has an expected return of 11.6 percent.
Stock A has an expected return of 17.8 percent while Stock B is expected to return
8.4 percent. What is the portfolio weight of Stock A?

(18) There is a 20 percent probability the economy will boom, 70 percent probability
it will be normal, and a 10 percent probability of a recession. Stock A will return
18 percent in a boom, 11 percent in a normal economy, and lose 10 percent in a
recession. Stock B will return 9 percent in boom, 7 percent in a normal economy,
and 4 percent in a recession. Stock C will return 6 percent in a boom, 9 percent in
a normal economy, and 13 percent in a recession. What is the expected return on
a portfolio which is invested 20 percent in Stock A, 50 percent in Stock B, and 30
percent in Stock C?

(19) A portfolio has 38 percent of its funds invested in Security C and 62 percent invested
in Security D. Security C has an expected return of 8.47 percent and a standard
deviation of 7.12 percent. Security D has an expected return of 13.45 percent and a
standard deviation of 16.22 percent. The securities have a coefficient of correlation
of .89. What are the portfolio rate of return and variance values?

(20) Stock S is expected to return 12 percent in a boom, 9 percent in a normal economy,

and 2 percent in a recession. Stock T is expected to return 4 percent in a boom, 6
percent in a normal economy, and 9 percent in a recession. There is a 10 percent
probability of a boom and a 25 percent probability of a recession. What is the
standard deviation of a portfolio which is comprised of $4,500 of Stock S and $3,000
of Stock T?

(21) If the BSE Sensex index value was 31,000 when you invested |1,000 exactly 5
years back and the sensex value is currently at 36,000, then what is the geometric
average return for your investment in a portfolio that exactly move (track) with
BSE Sensex?

(22) You were expected to compute an adequate cost of capital for your firm. The firm is
an all equity firm which is listed in the market. After considerable effort, you arrived
at the beta estimate of your firm, which is 1.5. The risk free rate after checking
with your other colleagues was taken as 6 percent. The market risk premium was 7
percent. You computed the expected return of the firm as 16.5 percent. Suddenly
at the end of the day, the manager comes in and asks you to re-evaluate the cost

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 of capital with the following two information. She expects an announcement by
the RBI that will drop the nominal benchmark rate by 100 bps to boost the muted
demand. The second input she gave you was that the overall risk aversion in Indian
market has gone up by 150 bps. Based on these two inputs, what would be your
new estimate of the cost of capital of this firm ?

(23) In the beginning of January 2025, a start-up firm founded in 2021 by five students
from the PGPBL 2020 batch at IIMK is considering a 3-year project with an initial
cost for fixed assets of |1.6 crores. The project will reduce current operating costs
by |50 lakhs a year. The equipment will be depreciated straight-line to |10 lakhs
book value at the end of 3 years.
At the end of the project, the equipment will be sold for an estimated |30 lakhs.
The tax rate is 25 percent. The project will require an initial investment of |10
lakhs in accounts receivables (a current asset) and will be recovered by the end of
the project’s life. What is the NPV (in the beginning of year 2025) if the discount
rate assigned to the project is 10 percent? Will you accept this project in the
beginning of 2025?

(24) LUMA dairy, a start-up, did a market research and found that there is huge de-
mand for dairy products in India, but the market is under-served. The management
of LUMA is also pretty condent that it is less likely for India to sign the RCEP
with countries in Asia-Pac region and hence there is no threat to the firm’s going
concern status. Otherwise, dairy products from New Zealand would have given stiff
competition to Indian products and would have threatened the projected margins
of LUMA. In addition, the new corporate tax regime has slashed the corporate in-
come tax for new companies to 15%. The investors of LUMA is expecting a return
of 15% on the investment.

LUMA has two options in terms of the equipment used for the pasteurisation pro-
cess. One, a German made machine that costs |500 crores and has a useful life
of 2 years. The post-tax operating costs (including depreciation tax shield) of the
German machine is |150 and |200 crores respectively for the two years. The second
is a Japanese machine that costs |700 crores and has a useful life of 3 years. The
pre-tax operating costs (excluding depreciation) of the Japanese machine is |100,
|150 and |200 crores respectively for the three years. Both machines are depreci-
ated to zero using straight-line method. LUMA has approached IIMK as part of
the student consulting program and this problem was assigned to FAMV students.
Which machine should LUMA dairy choose ? During the session, you have been
taught the present value of the annuity factor formula and you are contemplating
to apply that learning in this question.

(25) Miranda, a project manager, wants to invest in a project with an initial cost of |60
million and cash inows of |32 million and |39 million in the rst and second year.
She has been told by the management that the minimum required rate of return is
10%. In addition, she has been told that for every |1 invested, the rm expects a
return of |1.10 in present value terms. Is this project the right choice for Miranda?

(26) You have been approached by a fund manager. The fund manager was trying to
divert discussion around the topic of risk whenever you asked him on the standard

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 deviation of their fund returns. He was using a lot of jargons during the discussion.
In between the discussion, the fund manager mentioned that their portfolio delivers
superior Sharpe ratio and it is around 0.8. You were earlier told by the fund manager
that the expected return on their portfolio is 16 percent. While he was talking, you
checked up the web and found that the risk free rate is 6.5 percent. You shocked
him when you told him that the standard deviation of the portfolio was Y percent.
What is Y? (1 mark)

(27) The expected dividend in the coming year is INR 11 and the expected subsequent
dividend growth is 6% per annum. The company is expected to pay these dividends
in perpetuity. The current share price of a firm that you are tracking is INR 50
per share. You go back to basics and look at this firm’s returns over the past 5
years and using the monthly returns, you arrive at a beta of 2.5. The market risk
premium for the market where this share is traded is 7.2 percent. The yield for the
government security which is typically considered to be risk free is 6 percent. What
do you think about this stock’s current price in the market?

(28) If your cousin who is market savvy approached you and requested an advice on
identifying the overvalued stock from a set of three stocks in the market that she
is tracking. Based on the current market price, the three stocks Alpha, Beta and
Gamma have a required return of 18 percent, 15 percent and 12 percent respectively.
You computed their expected returns based on CAPM and arrived at returns of 19
percent, 13 percent and 14 percent respectively. Which stock(s) is(are) overvalued
among the three stocks?

(29) You are a manager in High-Tech hospital, a super-speciality hospital in Mumbai.

To further enhance the treatment outcomes in patients with chronic pain, you are
considering to invest in a new project that will revolutionize the way we treat pain.
You are planning to employ Virtual Reality (VR) and Spastic suits in patients for
pain management in your hospital. The technology and the prototype has been
patented by a start-up firm, NoPain Tech, based in India. You have an initial
investment requirement of |75 million for a set of suits for various functions and
|60 million investment in the VR equipment by NoPain. Both equipment and the
suits have a useful life of 4 years and the hospital is planning to employ a straight
line method of depreciation to |10 million book value for the suits and |0 million
book value for the VR equipment. You don’t expect the equipment and the suit to
fetch any salvage value at the end of the project.
The number of patients that you are expecting in the next 4 years is as follows:
1000, 2500, 5000, and 10000. The revenue expected per patient is |15,000 and the
cost is |10,000 for labour and general administration. Since this a new treatment,
the insurance companies have not approved this treatment. Hence, all patients are
expected to settle in cash. You have managed to secure debt financing of |50 million
at a real interest rate of 15% per annum. The weighted average cost of capital
arrived by the management for this project is 18% in real terms, high compared
to industry benchmark, as the technology is new and untested. The inflation rate
is 4%. What are the operating cash flows of this project ? What is the NPV of
this project ? Should this hospital adopt this technology? (Hint, convert the real
discount rate to nominal discount rate by adding (approx) inflation)

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(30) You are considering purchasing blast hole drills for a new site. You have been
approached by SBSH and Komatsu with quotes for their latest 250mm blast hole
drills. SBSH product has a purchase price of |10 crores and has a useful life of 10
years. Whereas, the Komatsu one has a initial purchase price of |15 crores and a
useful life of 15 years. However, the maintenance cost of the SBSH equipment is |50
lakhs per year and the Komatsu has a maintenance of |30 lakhs per year. Which
drill should you choose ? Assume the tax rate is 20% and discount rate for DMDC
Ltd is 15%. DMDC has decided to employ Straight line method of depreciation to
zero book value. SBSH drills doesn’t have any salvage value, whereas the Komatsu
one has a salvage value in the second hand market of 2 crores. Which option should
you choose ?