JGU Id. No.

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Jindal Global Business School

End-term Examination

Course Name : Financial Management and Valuation

Course Code : BS-OMBA-FMV-001
Programme : 1 year MBA upGrad 2023 Cohort-2
Duration : 3 Hours
Maximum Marks : 50

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End-term Examination – Spring’2024 Page 1

Question 1: (2 x 15 marks)
Based on the data given below, calculate:
a. The FCFF (Free Cash Flow to the Firm) for the high growth phase and stable phase
b. The terminal value of the firm

Base year Values (in lakhs)

Revenues 5000
EBIT 1200
Capex 400
Depreciation 250
Net working Capital 25% of Revenues
Corporate tax 25%
Paid up Equity 500
Market value of Debt 1200

High growth period 4 years

Revenues 25%
EBIT 25%
Depreciation 25%
Capex 25%
Net working Capital 25%
D/E ratio 1:1
Cost of debt 6
Risk free rate 7
Risk premium 10
Beta 1.2

Stable Phase
Revenues 10%
EBIT 10%
Depreciation -
Zero by adjusting for
Capex depreciation
Net working Capital 25
D/E ratio 2:3
Cost of debt 6
Risk free rate 6
Risk premium 11
Beta 1.1

Question 2: (20 marks)

a. Calculate the Weighted Average Cost of Capital (WACC) using the net income approach for the following
three cases.

End-term Examination – Spring’2024 Page 2

b. Take reasonable assumptions and explain, with an example, how the WACC would have changed in the
traditional view of capital structure.

Case 1 Case 2 Case 3

Debt/market value of debt (in Lakhs) - 10,000.00 20,000.00
Cost of debt - 5% 5%
Cost of equity 10% 10% 10%
Income (in Lakhs) 5,000.00 5,000.00 5,000.00

End-term Examination – Spring’2024 Page 3

 Answers

Q1

a.

To calculate the Free Cash Flow to the Firm (FCFF) for both the high growth and stable phases, and the terminal value of
the firm, we need to follow these steps:

1. Calculate FCFF for each year during the high growth phase.
2. Calculate the terminal value at the end of the high growth phase.
3. Discount FCFFs and the terminal value to the present value.

Assumptions and Definitions

1. FCFF Formula:

FCFF=EBIT×(1−Tax Rate)+Depreciation−Capex−ΔNWC\text{FCFF} = \text{EBIT} \times (1 - \text{Tax Rate}) +

\text{Depreciation} - \text{Capex} - \Delta \text{NWC}FCFF=EBIT×(1−Tax Rate)+Depreciation−Capex−ΔNWC

2. High Growth Phase:

o Duration: 4 years
o Growth rates: 25% per year for Revenues, EBIT, Depreciation, Capex, and NWC
o
3. Stable Phase:

• Growth rates: 10% per year for Revenues, EBIT

• Capex: Equal to Depreciation
• NWC: Fixed at 25 lakhs

4. Discount Rate Calculation:

• Cost of Equity: Re=Risk-free Rate+β×Risk PremiumR_e = \text{Risk-free Rate} + \beta \times \text{Risk
Premium}Re=Risk-free Rate+β×Risk Premium
• WACC: Weighted Average Cost of Capital

High Growth Phase Calculations

Year 0 (Base Year)

• Revenues: 5000 lakhs

• EBIT: 1200 lakhs
• Depreciation: 250 lakhs
• Capex: 400 lakhs
• NWC: 25%×5000=125025\% \times 5000 = 125025%×5000=1250 lakhs
• Tax Rate: 25%

End-term Examination – Spring’2024 Page 4

Yearly Growth Calculations

For each year ttt during the high growth phase:

• Revenues grow at 25% per year

• EBIT grows at 25% per year
• Depreciation grows at 25% per year
• Capex grows at 25% per year
• NWC changes based on the new revenues each year

FCFF Calculation for High Growth Phase

Year 1:

• Revenues: 5000×1.25=6250
• EBIT: 1200×1.25=1500
• Depreciation: 250×1.25=312.5
• Capex: 400×1.25=500
• NWC: 6250×0.25=1562.5
• Change in NWC: 1562.5−1250=312.5

FCFF1=1500×(1−0.25)+312.5−500−312.5=1500×0.75+312.5−500−312.5=1125+312.5−500−312.5=625
Year 2:

• Revenues: 6250×1.25=7812.5
• EBIT: 1500×1.25=1875
• Depreciation: 312.5×1.25=390.625
• Capex: 500×1.25=625
• NWC: 7812.5×0.25=1953.125
• Change in NWC: 1953.125−1562.5=390.625

FCFF2=1875×0.75+390.625−625−390.625=1406.25+390.625−625−390.625=781.25
Year 3:

• Revenues: 7812.5×1.25=9765.625
• EBIT: 1875×1.25=2343.75
• Depreciation: 390.625×1.25=488.28125
• Capex: 625×1.25=781.25
• NWC: 9765.625×0.25=2441.40625
• Change in NWC: 2441.40625−1953.125=488.28125

FCFF3=2343.75×0.75+488.28125−781.25−488.28125=1757.8125+488.28125−781.25−488.28125=976.5625

Year 4:

• Revenues: 9765.625×1.25=12207.
• EBIT: 2343.75×1.25=2929.6875
• Depreciation: 488.28125×1.25=610.3515625
• Capex: 781.25×1.25=976.5625
• NWC: 12207.03125×0.25=3051.7578125
• Change in NWC: 3051.7578125−2441.40625=610.3515625

End-term Examination – Spring’2024 Page 5

FCFF4.
=2929.6875×0.75+610.3515625−976.5625−610.3515625=2197.265625+610.3515625−976.5625−610.3515625=1220.703
125

Stable Phase Calculations

For the stable phase, assume a growth rate of 10% for revenues and EBIT. Capex equals depreciation, and NWC is fixed
at 25 lakhs.

Terminal Value Calculation

!"!!#
Terminal Value = %&'

Where:

• FCFF5\text{FCFF}_5FCFF5 is the FCFF in year 5 (start of the stable phase)

• rrr is the discount rate (WACC)
• ggg is the growth rate in the stable phase (10%)

Cost of Equity and WACC Calculations

High Growth Phase:

Re=Risk-free Rate+β×Risk Premium=7%+1.2×10%=19%

table Phase:

Re=Risk-free Rate+β×Risk Premium=6%+1.1×11%=18.1

WACC Calculation:

D/E Ratio in High Growth Phase=1:1

D/E Ratio in Stable Phase=2:3

High Growth Phase:

E/V=0.5

D/V=0.5

( *
WACC=() ×Re)+() ×Rd×(1−Tax Rate))

WACC=0.5×19%+0.5×6%×(1−0.25)=9.5%+2.25%=11.75%

Stable Phase:

E/V=3/5=0.6

D/V=2/5=0.4

WACC=0.6×18.1%+0.4×6%×(1−0.25)=10.86%+1.8%=12.66%

End-term Examination – Spring’2024 Page 6

FCFF for the high growth phase and stable phase:

• High Growth Phase: 625, 781.25, 976.5625, 1220.703125

• Stable Phase: 1342.7734375 (Year 5, start of stable phase)

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b.

Terminal Value Calculation:

FCFF5=FCFF4×(1+g)=1220.703125×1.10=1342.7734375

+,-..00,-,-0# +,-..00,-,-0#
Terminal Value=1.+.22&1.+1+,-.= 1.+.22
=50440.8

Present Value of FCFFs and Terminal Value:

PV=t=1∑4(1+WACC)tFCFFt+(1+WACC)4Terminal Value

PVFCFF=(1+0.1175)1625+(1+0.1175)2781.25+(1+0.1175)3976.5625+(1+0.1175)41220.703125

PVFCFF=1.1175625+1.2489781.25+1.3963976.5625+1.56131220.703125=559.38+625.38+699.4+781.6=2665.76

PVTerminal Value=(1+0.1175)450440.8=1.561350440.8=32306.7

PVTotal=PVFCFF+PVTerminal Value=2665.76+32306.7=34972.46

Summary:

a. Terminal value of the firm:

• Terminal Value: 50440.8

b. Present Value of the firm:

• PV of FCFFs: 2665.76
• PV of Terminal Value: 32306.7
• Total PV: 34972.46
•

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End-term Examination – Spring’2024 Page 7

Q2

To calculate the Weighted Average Cost of Capital (WACC) using the net income approach for the given cases, we need
to consider the following formula for WACC:

WACC=(VE×Re)+(VD×Rd×(1−T))

Where:

• EEE is the market value of equity

• DDD is the market value of debt
• V=E+DV = E + DV=E+D is the total market value of the firm's financing (equity + debt)
• ReR_eRe is the cost of equity
• RdR_dRd is the cost of debt
• TTT is the corporate tax rate

For the given cases, we need to find the market value of equity (E) for each case.

Case 1: No Debt

• Market value of debt (D): 0

• Cost of debt (R_d): Not applicable
• Cost of equity (R_e): 10%
• Income: 5,000 lakhs

Since there is no debt in this case, the entire value is from equity:

V=E=Income=5000lakhs

The WACC for Case 1 is simply the cost of equity since there is no debt:

WACC1=Re=10

Case 2: Debt of 10,000 lakhs

• Market value of debt (D): 10,000 lakhs

• Cost of debt (R_d): 5%
• Cost of equity (R_e): 10%
• Income: 5,000 lakhs

For Case 2, we need to determine the market value of equity (E):

V=E+D=E+10,000 lakhs

Using the net income approach, the firm's value (V) is the same as the income provided (5000 lakhs), assuming the net
income represents the value attributable to equity holders:

E=5000 lakhs

End-term Examination – Spring’2024 Page 8

Now we can calculate the total value of the firm:

V=E+D=5000+10000=15000

Now, the WACC for Case 2:

WCC2 =( V ×R e )+( V ×R d ×(1−T))

Since the corporate tax rate (T) is not given, we'll assume it is 0 for simplicity:

WACC2=(150005000×10%)+(1500010000×5%×(1−0))

WACC2=(31×10%)+(32×5%)

WACC2=(310)%+(310)%

WACC2=3.33%+3.33%=6.67%

Case 3: Debt of 20,000 lakhs

• Market value of debt (D): 20,000 lakhs

• Cost of debt (R_d): 5%
• Cost of equity (R_e): 10%
• Income: 5,000 lakhs

For Case 3, we need to determine the market value of equity (E):

V=E+D=E+20,000lakhs

Using the net income approach, the firm's value (V) is the same as the income provided (5000 lakhs):

E=5000 lakhs

Now we can calculate the total value of the firm:

V=E+D=5000+20000=25000 lakhs

Now, the WACC for Case 3:

WCC3 =( V ×R e )+( V ×R d ×(1−T))

Again, assuming the corporate tax rate (T) is 0 for simplicity:

WACC3=(250005000×10%)+(2500020000×5%×(1−0))
WACC3=(51×10%)+(54×5%)
WACC3=2%+4%=6%

End-term Examination – Spring’2024 Page 9

Summary:

• Case 1:
o WACC = 10%
• Case 2:
o WACC = 6.67%
• Case 3:
o WACC = 6%
•

__________________________________________________________________________________________________

b)

To explain how the WACC changes in the traditional view of capital structure, let's revisit the concept with the given
cases and make reasonable assumptions to demonstrate the changes.

Assumptions:

1. Corporate Tax Rate (T): 25%

2. Cost of Debt (R_d): 5% (remains constant for simplicity)
3. Cost of Equity (R_e) without Debt: 10%
4. Market Value of Equity (E): Derived from total firm value minus debt
5. Income: 5,000 lakhs, assumed to represent the total value attributable to equity holders

Case 1: No Debt

• Market value of debt (D): 0 lakhs

• Cost of debt (R_d): Not applicable
• Cost of equity (R_e): 10%
• Income: 5,000 lakhs
• Market Value of Equity (E): 5,000 lakhs (since all value is from equity)

WACC1=Re=10%\text{WACC}_1 = R_e = 10\%

Case 2: Debt of 10,000 lakhs

• Market value of debt (D): 10,000 lakhs

• Cost of debt (R_d): 5%
• Cost of equity (R_e): 10% (initially, before adjusting for leverage)
• Income: 5,000 lakhs

Adjusting Cost of Equity due to Leverage:

Using the traditional view, the cost of equity increases with leverage. Assume the cost of equity increases linearly with
the debt-to-equity ratio. For simplicity, let's assume the adjusted cost of equity is 11% with this level of debt.

• Market Value of Firm (V): 5,000 + 10,000 = 15,000 lakhs

• Market Value of Equity (E): 5,000 lakhs
End-term Examination – Spring’2024 Page 10
WACC2=(EV×Re)+(DV×Rd×(1−T))

WACC2=(15,0005,000×11%)+(15,00010,000×5%×(1−0.25))

WACC2=(13×11%)+(23×3.75%)

WACC2=3.67%+2.5%=6.17%

Case 3: Debt of 20,000 lakhs

• Market value of debt (D): 20,000 lakhs

• Cost of debt (R_d): 5%
• Cost of equity (R_e): 10% (initially, before adjusting for leverage)
• Income: 5,000 lakhs

Adjusting Cost of Equity due to Leverage:

Assume the cost of equity increases further due to higher leverage. Let's assume the adjusted cost of equity is 13%.

• Market Value of Firm (V): 5,000 + 20,000 = 25,000 lakhs

• Market Value of Equity (E): 5,000 lakhs

WACC3=(EV×Re)+(DV×Rd×(1−T

WACC3=(5,00025,000×13%)+(20,00025,000×5%×(1−0.25

WACC3=(15×13%)+(45×3.75

WACC3=2.6%+3%=5.6

Summary of WACC in Traditional View:

• Case 1 (No Debt): 10%

• Case 2 (10,000 Debt): 6.17%
• Case 3 (20,000 Debt): 5.6%

Explanation:

• Case 1: With no debt, the WACC equals the cost of equity, which is 10%.
• Case 2: Introducing debt lowers the WACC initially because debt is cheaper than equity, and there is a tax shield
from the interest payments. The cost of equity increases slightly due to the additional financial risk.
• Case 3: As more debt is introduced, the WACC further decreases because the firm still benefits from the tax
shield and the cost of debt remains lower than equity. However, the cost of equity increases more due to the
higher financial risk.

In the traditional view, WACC decreases initially as low levels of debt are introduced due to the tax benefits and lower
cost of debt. As debt levels increase, the WACC reaches a minimum point and then starts to rise as the cost of equity
increases significantly due to the increased financial risk, eventually outweighing the benefits of the cheaper debt. In this
example, with the given assumptions, the WACC continues to decrease, suggesting that we haven't reached the
minimum WACC point yet.

End-term Examination – Spring’2024 Page 11