Strategic Financial Management

Question 1
To perform the capital budgeting analysis, we'll calculate the following:

1. Annual cash flows
2. Net present value (NPV)
3. Internal rate of return (IRR)
4. Payback period
Let's start by calculating the annual cash flows:
1. Annual Revenue: Rs. 40,000
2. Annual Operating Costs: Rs. 10,000
3. Annual Depreciation: Rs. 20,000
The annual cash flow can be calculated as follows:
Annual Cash Flow=Revenue−Operating Costs−Depreciation
Annual Cash Flow= Rs.40,000 – Rs.10,000 – Rs.20,000
Annual Cash Flow= Rs.10,000
Now, let's calculate the annual cash flows for each year:
Year 1: Rs. 10,000
Year 2: Rs. 10,000
Year 3: Rs. 10,000
Year 4: Rs. 10,000
Year 5: Rs. 10,000
Next, we'll calculate the NPV using the discount rate of 10%. NPV is calculated as the sum of
the present values of all cash flows minus the initial investment cost:
NPV= ∑ = − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

( )
, , , , ,
NPV= ( )
+ ( )
+ ( )
+ ( )
+ ( )
− 1,00,000
. . . . .
, , , , ,
NPV= + + + + − 1,00,000
. . . . .
, , , , ,
NPV= + + + + − 1,00,000
. . . . .
NPV= 9,090,91 + 8,264.46 + 7,512.32 + 6,829.38 + 6,207.62 – 1,00,000

NPV= 37,904.69 – 1,00,000
NPV= −62,095.31
Now, let's calculate the IRR using the NPV function:
NPV=0= ∑ − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

( )
IRR=Discount Rate
So, the IRR is 10%, which is equal to the discount rate.
Next, let's calculate the payback period:
Payback Period = Initial Investment / Annual Cash Flow
Payback Period = Rs. 100,000 / Rs. 10,000 = 10 years
Since the payback period is longer than the useful life of the machinery (5 years), it's not
considered a favorable investment.
Based on the calculations, the NPV is negative, the IRR is equal to the discount rate, and the
payback period is longer than the useful life of the machinery. Therefore, I would not
recommend going ahead with the investment in this machinery.
Question 2
To calculate the total profit or loss for an investor who buys one call option contract, we need
to consider different scenarios of the stock price at expiration and compare them to the strike
price.
Given:
 Option Type: Call Option
 Strike Price: Rs. 105 per share
 Premium (Cost of the Option): Rs. 5 per share
 Expiration Date: 30 days from now
Let's consider different scenarios:
If the stock price at expiration is below the strike price (Rs. 105 per share):
In this case, the option will expire worthless because it wouldn't make sense to exercise the
option when the stock price is lower than the strike price.
Total loss = Premium paid
= Rs. 5 per share * 100 shares
= Rs. 500
If the stock price at expiration is equal to the strike price (Rs. 105 per share):
In this case, the option holder might exercise the option, but there won't be any profit or loss
from exercising the option.
Total profit or loss = Premium paid
= Rs. 5 per share * 100 shares
= Rs. 500
If the stock price at expiration is above the strike price (Rs. 105 per share):
In this case, the option holder will exercise the option and buy the stock at the strike price,
then sell it at the market price.
Total profit or loss = (Stock price at expiration - Strike price - Premium) * Number of shares
= (Market price - Rs. 105 per share - Rs. 5 per share) * 100 shares
Now, let's calculate the total profit or loss for different scenarios of the stock price at
expiration:
 If the stock price at expiration is Rs. 100 per share: Total loss = Rs. 500
 If the stock price at expiration is Rs. 105 per share: Total profit or loss = Rs. 500
 If the stock price at expiration is Rs. 110 per share: Total profit or loss = (Rs. 110 per
share - Rs. 105 per share - Rs. 5 per share) * 100 shares = Rs. 500
 If the stock price at expiration is Rs. 115 per share: Total profit or loss = (Rs. 115 per
share - Rs. 105 per share - Rs. 5 per share) * 100 shares = Rs. 1,000
In summary, the investor will incur a loss of Rs. 500 if the stock price at expiration is below
the strike price, will break even if the stock price is equal to the strike price, and will make a
profit equal to the difference between the stock price and the strike price minus the premium
if the stock price is above the strike price.
Question 3a
The Yield to Maturity (YTM) is the internal rate of return (IRR) of a bond, representing the
total return anticipated on a bond if it is held until it matures. The YTM is calculated by
solving the present value equation for the bond's future cash flows, considering the current
market price.
The formula for YTM on a bond with annual coupon payments is as follows:
P= + + ⋯+
( ) ( ) ( )
Where:
 P is the current market price of the bond (INR 950 in this case).
 C is the annual coupon payment (6% of the face value, which is INR 1000, so
C=0.06×1000).
 F is the face value of the bond (INR 1000).
 n is the number of years to maturity (5 years).
Let's plug in the values and solve for r using an iterative approach:
950= + + + +
( ) ( ) ( ) ( ) ( )
We'll use a numerical method such as trial and error or software tools to solve this equation.
Let's assume that the YTM is approximately 6%.
950= + + + +
( ) ( ) ( ) ( ) ( )
950 ≈ +( )
+( )
+ ( . )
+ ( . )
. . .
Now, calculate the right-hand side:

950≈56.6038+53.4597+50.4312+47.6134+747.2582
950≈955.3663
The result is close to the market price of the bond, indicating that the assumed YTM of 6% is
reasonable.
Thus, the Yield to Maturity (YTM) of the bond is approximately 6%.
Question 3b
Walter's model, also known as the dividend relevance model, suggests that the value of a firm
is influenced by its dividend policy. According to this model, the optimal dividend payout
ratio (r) can be calculated using the following formula:
r= −𝑏
Where:
 E = Earnings per share (EPS)
 ke = Required rate of return by shareholders
 b = Retention ratio (the proportion of earnings retained)
Given:
Earnings per share (EPS) = Rs. 5
Shareholders' required rate of return (ke) = 10%
Retention ratio (b) = 60%
First, let's calculate the retained earnings per share (RE):
RE = EPS x b
RE = 5 x 0.6 = Rs.3
Now, let's calculate the dividend payout ratio (r) using Walter's formula:
r= −𝑏
r= − 0.6
.
r = 50 − 0.6
r = 49.4%
So, the optimal dividend payout ratio according to Walter's model would be 49.4%.

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Question 1

To perform the capital budgeting analysis, we'll calculate the following:

NPV= ∑ = − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

NPV= 9,090,91 + 8,264.46 + 7,512.32 + 6,829.38 + 6,207.62 – 1,00,000

NPV=0= ∑ − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Let's consider different scenarios:

Now, calculate the right-hand side:

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