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Financial Management

Jun 2026 Examination

 

 

Q1. An Indian manufacturing company is evaluating three alternative capital structures – Pure Equity, Leveraged (Debt + Equity), and Hybrid (Debt + Preference Shares + Equity). The company is considering a new plant that will generate a constant annual EBIT of Rs.3,00,00,000 for the foreseeable future. The financing plans are as follows: Plan: Pure Equity – Equity Capital (Shares, Rs.100 each): 4,00,000; Debt (10% p.a.): -; Preference Shares (12% p.a.): -. Plan: Leveraged – Equity Capital (Shares, Rs.100 each): 2,00,000; Debt (10% p.a.): Rs.2,00,00,000; Preference Shares (12% p.a.): -. Plan: Hybrid – Equity Capital (Shares, Rs.100 each): 2,00,000; Debt (10% p.a.): Rs.1,00,00,000; Preference Shares (12% p.a.): Rs.1,00,00,000. The corporate tax rate is 30%. Preference dividends are not tax-deductible. Debt is perpetual. Assume all plans require equal total funding. If the market capitalization rate for equity is 12% (Pure Equity), 15% (Leveraged), and 16% (Hybrid), calculate for each plan: (a) EPS, (b) Total market value of the firm (including equity, debt, and preference shares), and (c) Weighted Average Cost of Capital (WACC). Based on your calculations, determine which capital structure is optimal in terms of maximizing firm value and minimizing WACC.

Ans 1.

Introduction

Capital structure is one of the most important financial decisions taken by a company, as it determines how the firm finances its operations through a mix of equity, debt, and preference shares. The choice of capital structure directly affects the company’s risk, profitability, and market valuation. The main objective is to select a financing pattern that minimizes the cost of capital and maximizes firm value. In this case, an Indian manufacturing company is evaluating three alternative capital structures for a project generating constant EBIT. The decision is based on comparing Earnings Per Share, total firm value, and Weighted Average Cost of Capital.

Concept and Application

Capital structure refers to the proportion of different sources of finance used by a firm, including

 

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Q2 (A). A mid-sized Indian manufacturing company is considering two mutually exclusive projects for expansion. Project A offers steady cash inflows but requires a substantial upfront investment, while Project B promises variable but potentially higher returns over time. The company’s finance team uses discounted cash flow (DCF) analysis, sensitivity scenarios, and considers market volatility predictions from recent economic data in the Indian context. Several board members are concerned about the reliability of the discount rate choices, inflation impact, and how non-monetary benefits such as sustainability may factor into the decision. Critically evaluate the board’s concerns regarding the application of DCF and scenario analysis in this capital budgeting decision. Assess the robustness of the chosen financial modeling techniques, and justify what improvements or alternative approaches the company should consider to ensure a well-rounded investment decision in the context of the Indian market.

Ans 2a.

Introduction

DCF analysis and scenario testing are standard tools in capital budgeting. But the board’s concerns in this case are well-founded. In India’s volatile macroeconomic environment, where inflation fluctuates, policy changes are frequent, and sustainability pressures are rising, standard DCF models can give a false sense of precision. The concerns about discount rate reliability, inflation impact, and non-monetary benefits each point to a real limitation that the finance team

 

Q2 (B). A company is evaluating two mutually exclusive projects, A and B. Both projects require an initial investment outlay of Rs.75,00,000 and have an expected project life of 5 years with no salvage value. The finance team estimates the cost of capital at 12%. Project A expects cash inflows growing at 10% per annum, starting with Rs.18,00,000 in Year 1. Project B expects constant cash inflows, but in Year 2, due to a regulatory change, there is a 20% probability that the project’s inflow in years 3-5 will decrease by 30%. If the expected annual inflow in Project B is Rs.19,00,000 assuming no regulation change, calculate: (i) The Net Present Value (NPV) of both projects, (ii) Which project should be selected based on financial criteria, and (iii) Explain the effect of risk-adjusted cash flows in this context.

Ans 2b.

Introduction 

Net Present Value (NPV) is one of the most widely used techniques in capital budgeting for evaluating investment decisions. It measures the difference between the present value of future cash inflows and the initial investment. A positive NPV indicates that the project is expected to generate value for the firm, while a negative NPV suggests that the project may lead to a loss. In the case of mutually exclusive projects, the project with the higher NPV is preferred as it