Question
ABC Ltd. is considering the purchase of a machine costing ₹1,50,000. The project requires an additional investment in working capital of ₹20,000, which is recoverable at the end of the project's life. The expected cash flows are as follows:
Year 1: ₹25,000
Year 2: ₹35,000
Year 3: ₹45,000
Year 4: ₹55,000
Year 5: ₹60,000
The machine is expected to have a salvage value of ₹15,000 at the end of Year 5.
Required:
Calculate the Payback Period.
Comment on the project’s liquidity position based on the payback criterion.
a) Dividend policy plays a significant role in determining the market value of equity shares. Discuss the concept of dividend-based share valuation and explain the major models used for valuing equity shares. (10+10)
b) An equity analyst is evaluating the shares of ABC Ltd. The company has recently paid a dividend of ₹6 per share. Dividends are expected to grow at a constant rate of 5% per annum in the future. The required rate of return expected by investors is 15%.
Required:
Calculate the intrinsic value of the equity share using Gordon’s Growth Model.
If the current market price of the share is ₹78, determine whether the share is overvalued or undervalued.
Answer :
Word Count : 1268
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Skip in 10
ABC Ltd. is considering an investment in a machine costing ₹1,50,000 along with an additional working capital investment of ₹20,000. Since the working capital is recoverable at the end of the project, the total initial investment for the purpose of calculating the Payback Period is ₹1,70,000. The Payback Period is the time required to recover the initial investment from the cash inflows generated by the project. It is an important capital budgeting technique because it indicates the period for which the funds remain tied up in the project and provides an indication of the project's liquidity and risk. The initial investment is: Machine cost = ₹1,50,000 Working capital investment = ₹20,000 Total initial investment = ₹1,70,000 The expected annual cash inflows are: | Year | Cash Flow (₹) | Cumulative Cash Flow (₹) | | ---- | ------------: | -----------------------: | | 1 | 25,000 | 25,000 | | 2 | 35,000 | 60,000 | | 3 | 45,000 | 1,05,000 | | 4 | 55,000 | 1,60,000 | | 5 | 60,000 | 2,20,000 | At the end of Year 4, cumulative cash inflows are ₹1,60,000. Therefore, ₹10,000 of the initial investment remains unrecovered. Cash flow during Year 5 = ₹60,000 Fraction of Year 5 required to recover ₹10,000: ₹10,000 / ₹60,000 = 0.1667 year Therefore, Payback Period = 4 + 0.1667 = 4.17 years approximately. Thus, the Payback Period is approximately 4 years and 2 months. The salvage value of ₹15,000 and recovery of working capital of ₹20,000 will be received at the end of Year 5. These terminal cash flows increase the overall cash recovery from the project but do not affect the point at which the initial investment is recovered during Year 5. If the project is evaluated on the basis of total terminal recovery, the project generates an additional ₹35,000 at the end of Year 5, making the overall terminal-year cash flow ₹95,000. However, the conventional Payback Period based on annual operating cash flows remains approximately 4.17 years. From the liquidity perspective, the project has a relatively long Payback Period of about 4.17 years. This means that ABC Ltd. will have its initial investment tied up for more than four years before recovering it through operating cash inflows. A shorter Payback Period generally indicates better liquidity and lower investment risk, while a longer Payback Period suggests greater exposure to uncertainty and delayed recovery of funds. Nevertheless, the project recovers the investment before the end of its five-year life, which is a positive feature. The recovery of ₹20,000 working capital and ₹15,000 salvage value at the end of Year 5 further improves the project's total cash recovery position. However, the Payback Period ignores cash flows occurring after the recovery point and also
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