Q1.

True or False

a.      Pecking order theory implies that external financing is always favoured over the internal financing.

b.        The  holder  of  an  INR  1,000  face  value  bond  can  exchange  the  bond  any  time  for  25  shares  of  stock. Then  the 
conversion ratio is 40. 
c. Under no tax, no bankruptcy costs and perfect capital market assumptions, Modigliani-Miller proposition states that 
any firm would be indifferent to whether it issues stock or it issues debt.
d.        Issuing  convertible  bonds  instead  of  straight  bonds  will  increase  the  agency  conflicts  between  the 
bondholders and the shareholders of the issuing firm.
e.      The IRR of normal Project X is equal to the IRR of normal Project Y, and both IRRs are 25%. At zero cost of
capital the NPV of X is much greater than Y. Thus, at any cost of capital less than the IRR, X should be
generally preferred over Y.
f.        The coupon rate on a convertible bond is higher than an otherwise identical straight bond.
g.       A project accepted based on Payback period approach may have an IRR that is lower than its discount
rate.
h.      If the IRR of normal Project X is greater than the IRR of mutually exclusive Project Y (also normal), we can
conclude that the firm will select X rather than Y if Project X has a positive NPV.
i.        Payback period approach is biased towards long term projects.
  j. When warrants are exercised, it brings in additional cash to the firm which has issued the warrants, and
also increases the number of shares outstanding of the firm.
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1
0

0
0

1
 Option Option
Option Eat-well Option Cook-well t Eat-well Cook-well

Initial cost 150,000 210,000 0 -150,000 -210,000

Annual maintenance cost 9,000 6,000 1 -9000 -6000
Life (years) 2 3 2 -9000 -6000
Ans. a. 3 -6000
Net Present Value -165619.83 -224921.11

Equivalent Annual Cost ₹ -95,428.57 ₹ -90,444.11

Option Cook-well has the lowest Equivalent Annual Cost, therefore,

we will pick Option Cook-well

Ans. b.
These cash flow streams have no IRR
Discount
rate 10% Ans. a. Alternatively, using Replacement Chain Approach, repeating the projects til

Option Cook-
t Option Eat-well well
0 -150,000 -210,000
1 -9000 -6000
2 -159,000 -6000
3 -9,000 -216,000
4 -159,000 -6,000
5 -9,000 -6,000
6 -9,000 -6,000

NPV -415616.31 -393907.67

The lower NPV of Option Cook-well suggests the choice of Option Cook-w
roach, repeating the projects till the lives are matched

sts the choice of Option Cook-well.

 Initial
investme NPV Present Value of
Investment option nt Future Investments Profitability Index Rank
(INR (INR
millions) millions)
Option 1 20 6 26 1.30 3
Option 2 10 5 15 1.50 2
Option 3 30 8 38 1.27 4
Option 4 10 8 18 1.80 1

Select Option 4, 2
Ans. and 1
To cross-check
Possible Combinations NPV
Option 1, 2 and 4 19
Option 2 and Option 3 13
Option 3 and Option 4 16