The Hindu Business Line : DCF analysis in lease versus borrow

ABC Ltd is considering a proposal to acquire a machine costing Rs 1,10,000, involving a down payment of Rs 10,000 and the balance payable in 10 annual equal instalments at the end of each year, which includes interest chargeable at 15 per cent. Another option before it is to acquire the asset on a lease rental of Rs 15,000 per annum payable at the end of each year for 10 years. The following information is also available:

i) Terminal scrap value of Rs 20,000 is realisable if the asset is purchased.

ii) The company provides 10 per cent depreciation on straight-line method on the original cost.

iii) The income-tax rate is 50 per cent.

You are required to compute and analyse cash flows and advise as to which option is better.

Answer: Working note 1 (WN1): Interest at 15 per cent, tax rate is 50 per cent. After-tax cost of debt is 15 per cent (1 - 0.5) = 7.5 per cent. Hence, both the options are discounted at 8 per cent.

WN2: Balance payable in 10 annual equal instalments at the end of each year inclusive of interest chargeable at 15 per cent.

Cost — Rs 1,10,000

Less: Down payment — Rs 10,000

Balance — Rs 1,00,000 in 10 instalments.

EYI (Equated yearly instalments): 100000 / Annuity factor at 15 per cent for 10 years, that is, 5.0188 = Rs 19,925

WN3: Calculation of interest in instalment payments is presented in Table 1.

Option to borrow funds and purchase the machine is presented in Table 2.

Option to acquire the asset on lease: Lease rental 15,000 x (1 - tax 50 per cent ) = Rs 7,500 per annum for 10 years

PV of net cash outflow = 7,500 x 6.7101 = Rs 50,326

Advice: Using discounted cash flow (DCF) analysis it is found that the leasing option is the better one because its discounted cash outflow is lower than that of the borrowing and purchase option.

Merger and EPS

XYZ Ltd is considering merger with ABC Ltd. XYZ Ltd's shares are currently traded at Rs 25. It has 2,00,000 shares outstanding and its earning after taxes (EAT) amounts to Rs 4,00,000. ABC Ltd has 1,00,000 shares outstanding; its current market price is Rs 12.50 and its EAT, Rs 1,00,000. The merger will be effected by means of a stock swap (exchange). ABC Ltd has agreed to plan, under which, XYZ Ltd will offer the current market value of ABC Ltd's shares. What is the pre-merger earnings per share (EPS) and PE ratios of both the companies?

If ABC's PE ratio is eight, what is its current market price? What is the exchange rate? What will XYZ's post-merger EPS be? What must the exchange ratio be for XYZ's pre-merger and post-merger EPS to be the same?

Answer: The working note is presented in Table 3.

i) EPS = Rs 4,00,000/2,00,000 shares = Rs 2 for XYZ and Re 1 for ABC

The PE ratio = Rs 25/2 = 12.5 for XYZ and 12.5 for ABC

(ii)(a) If ABC's PE ratio is eight, its current market will be Rs 8 only (8 x 1)

b) Then, the exchange ratio will be 8/25, that is, 32/100. For every 100 shares of ABC, 32 shares of XYZ will be issued. 1,00,000/100 x 32 = 32,000 shares of XYZ will be issued to all the shareholders of ABC Ltd.

c) Total earnings/total shares = Rs 5,00,000 / 2,32,000 equity shares = Rs 2.16 post-merger EPS of XYZ.

iii) Total earnings Rs 5,00,000 / EPS of Rs 2 = 2,50,000 equity shares, that is, 50,000 share of XYZ will have to be issued to the shareholders of ABC, that is, one share of XYZ will be issued for every two shares held by ABC shareholders

Then, pre-merger and post-merger EPS of XYZ will be the same as follows:

Pre-merger EPS of XYZ: Rs 2

Post-merger EPS of XYZ = Rs 5,00,000 / 2,50,000 equity shares = Rs 2.

Note: The same question appeared in the June 2001 CS (Final) exam.

CAPM formula

A COMPANY pays a dividend of Rs 2 per share with a growth rate of 7 per cent. The risk-free rate is 9 per cent and the market rate of return, 13 per cent. The company has a beta factor of 1.50. However, due to a decision of the Finance Manager, beta is likely to increase to 1.75. Find out the present as well as the likely value of the share after the decision.

Answer: a) CAPM Formula: Re =Rf + â (Rm - Rf)

= 9 per cent + 1.50 (13 per cent - 9 per cent)

9 per cent + 6 per cent = 15 per cent

Re is taken as Ke.

Dividend growth model: Ke = D1/ Po + g

15 per cent = 2.14/Po + 7 per cent

15 per cent - 7 per cent = 2.14/Po

Po = 2.14/8 per cent = Rs 26.75 present value of share.

b) Beta increases to 1.75 :

Re = 9 per cent + 1.75 (13 per cent - 9 per cent)

9 per cent + 7 per cent = 16 per cent

Re is taken as Ke.

16 per cent = 2.14/Po + 7 per cent

16 per cent - 7 per cent = 2.14/Po

Po = 2.14/9 per cent = Rs 23.78 value of share after decision.

Treasury bills

RBI sold 91-day T-bills of face value of Rs 100 at an yield of 6 per cent. What was the issue price?

Simple interest formula:

I = PNR / 100

P is issue price to be ascertained.

Rs 100 - P = P x 91/365 x 6/100

- P = 0.0149589 P

100 = P + 0.0149589 P

i.e. 100 = 1.0149589 P

P = 100/1.0149589 = Rs 98.53 issue price.

Alternative formula: P = Maturity value/(N x R) + 1

Inflation and NPV

A FIRM has projected the following cash flows from a project under evaluation: Year 0, Rs (70) lakh; Year 1, Rs 30 lakh; Year 2, Rs 40 lakh; and Year 3, Rs 30 lakh. The above cash flows have been made at expected prices after recognising inflation. The firm's cost of capital is 10 per cent. The expected annual rate of inflation is 5 per cent. Show how the viability of the project is to be evaluated.

Answer: Statement of NPV is presented in Table 4.

Viability of project: The cash flows have been made at expected prices after recognising inflation. Even then, the project will result in a positive NPV of Rs 13 lakh. Hence, it should be accepted.

Walter's model

THE following figures are collected from the annual report of XYZ Ltd: Net profit, Rs 30 lakh; outstanding 12 per cent preference shares, Rs 100 lakh; No. of equity shares, Rs 3 lakh; and return on investment, 20 per cent.

What should be the approximate dividend payout ratio so as to keep the share price at Rs 42 by using Walter model?

WN1: Net profit, Rs 30 lakh

Less: Preference dividend, 12 per cent of 100 lakh — Rs 12 lakh

Profit available to equity shareholders — Rs 18 lakh

EPS = Rs 18 lakhs / 3-lakh shares = Rs 6

Dividend payout ratio = DPS/EPS x 100

Cost of capital (k) is not given in the question.

WN2: Capital structure:

Net profit, Rs 30 lakh; ROI, 20 per cent

That is, investment, Rs 150 lakh

Less: Preference capital, Rs 100 lakh

Equity funds, Rs 50 lakh