MMPC-014 Solved Assignment

Question 1

Risk preference in practice: comparing two retail investors’ investing behaviour

In the risk–return discussion, investors are commonly described as having three broad risk preference behaviours: risk aversion, risk indifference, and risk seeking. In simple terms, these behaviours explain how strongly an investor dislikes (or likes) uncertainty in returns while choosing among investment alternatives.

Brief conceptual base (from the course)

• Risk-averse behaviour: prefers more stable outcomes and typically accepts a lower expected return if it reduces uncertainty.
• Risk-indifferent behaviour: focuses primarily on expected return and is comparatively less sensitive to risk while choosing between alternatives.
• Risk-seeking behaviour: is willing to accept higher uncertainty for the possibility of higher gains.

Investor A (Retail Investor): conservative, income-and-safety oriented

I interacted with Investor A, a salaried retail investor who invests mainly to protect savings and generate stable cash flows. The investing choices and reactions reflected risk-averse behaviour.

• Product preference: prefers comparatively stable instruments (for example, high-quality bonds/deposits and well-established dividend-paying shares/funds), aiming for a steady stream of returns rather than aggressive growth.
• Primary decision rule: asks “How safe is my capital?” before asking “How high is the return?”—showing a strong preference to limit uncertainty (risk) in outcomes.
• Reaction to losses: if prices fall, tends to reduce exposure or shift toward safer holdings rather than increasing risk.
• Risk language used: commonly speaks about “stability”, “regular income”, and “avoiding big fluctuations”, which aligns with the course’s treatment of risk aversion.

Investor B (Retail Investor): aggressive, return-maximization oriented

I interacted with Investor B, a small-business retail investor who actively looks for higher returns and is comfortable with fluctuating market prices. The behaviour reflected risk-seeking tendencies.

• Product preference: prefers higher-volatility equity opportunities (including trend-based picks) and is willing to tolerate short-term losses for potential higher upside.
• Primary decision rule: focuses on “return potential” first and accepts uncertainty as a normal part of investing, consistent with risk-seeking behaviour.
• Reaction to losses: often treats price falls as a chance to “average” or continue holding, instead of immediately shifting to safer assets.
• Risk language used: commonly speaks about “high growth”, “big upside”, and “market opportunity”, indicating comfort with uncertainty in returns.

Comparison of their strategies (risk preference lens)

• Return vs. certainty: Investor A prioritizes certainty/stability; Investor B prioritizes higher expected return even when outcomes are uncertain.
• Portfolio posture: Investor A keeps a defensive posture; Investor B accepts aggressive positioning and higher variability in outcomes.
• Comfort with systematic market movement: Investor B is more willing to hold positions that move strongly with the market (often discussed using the β concept in risk measurement), whereas Investor A prefers avoiding large swings.

Question 2

Why cost of capital matters to a firm, and how to compute the cost of equity (with examples)

Why cost of capital is important

Cost of capital is treated as a central input in financial decision-making because it represents the minimum return a business should generate to justify raising and using funds. If expected returns are below the cost of capital, the decision does not create adequate financial justification in the course framework.

• Capital expenditure decisions: cost of capital becomes the acceptance benchmark for appraising new projects.
• Capital structure choice: helps managers evaluate and decide an appropriate/optimal mix of financing.
• Performance evaluation: used as a reference for evaluating financial performance of top management.
• Policy decisions: supports decisions on dividend policy and working capital policy.
• Valuation use: can serve as a capitalization rate for valuing a new firm.

Methods of computing cost of equity capital (Ke)

The course notes that estimating the cost of equity is comparatively difficult, and lists six approaches: E/P, E/P + Growth, D/P, D/P + Growth, realized yield, and β (Beta) coefficient method.

1) E/P method (Earnings yield approach)

$$ K_e = \frac{E}{P} $$

Example: If EPS (E) = 6 and market price (P) = 120, then:

$$ K_e = \frac{6}{120} = 0.05 = 5\% $$

This approach is aligned with the course’s positioning of earnings/price type estimation within the equity cost approaches list.

2) E/P + Growth method

$$ K_e = \frac{E}{P} + g $$

Example (numbers consistent with the unit activity): EPS = 3, price = 100, expected growth (g) = 10%.

$$ K_e = \frac{3}{100} + 0.10 = 0.13 = 13\% $$

This matches the unit’s activity-style application of EPS, price, and growth in estimating equity cost.

3) D/P method (Dividend yield approach)

$$ K_e = \frac{D}{P} $$

Example: Dividend per share (D) = 5 and price (P) = 100.

$$ K_e = \frac{5}{100} = 0.05 = 5\% $$

This sits within the course’s dividend/price approach to equity cost estimation.

4) D/P + Growth method (Constant dividend growth style)

In the constant growth framing, the unit derives the relationship where growth is incorporated with dividend yield (with the typical condition that Ke is greater than growth).

$$ K_e = \frac{D_1}{P_0} + g $$

Example (using the activity-style numbers): Current dividend D₀ = 5, growth g = 10%, price P₀ = 100, so D₁ = 5(1+0.10) = 5.5.

$$ K_e = \frac{5.5}{100} + 0.10 = 0.155 = 15.5\% $$

The course’s constant growth valuation expressions support this structure.

5) Realized yield method

This method uses the actual realized return earned by equity investors over a period (typically combining dividend income and price movement) as an indicator of equity return expectations.

Illustration: If an investor bought a share at 100, received dividend of 4, and sold later at 110:

$$ \text{Realized return} = \frac{4 + (110-100)}{100} = \frac{14}{100} = 14\% $$

6) β (Beta) coefficient method (CAPM style)

The unit explains using β to incorporate risk analysis and provides an illustration with a risk-free rate and market return.

$$ K_e = R_f + (R_m – R_f)\beta $$

Example (as illustrated): R_f = 4%, R_m = 12%, β = 1.4.

$$ K_e = 4\% + (12\%-4\%)\times 1.4 = 4\% + 11.2\% = 15.2\% $$

The course notes this approach is strong because it explicitly incorporates risk.

Question 3

Financial leverage (Trading on Equity) and its effect on EPS

Meaning of financial leverage

Financial leverage (also called trading on equity) refers to using fixed-cost sources of finance (especially debt, and also preference capital in the broader course discussion) to fund assets. The key idea is: if the return on debt-financed assets exceeds the cost of debt, then earnings per share (EPS) can increase without increasing owners’ equity investment.

Why it is called “Trading on Equity”

• It is called trading on equity because the firm uses fixed-cost funds (like debt) to potentially increase the return available to equity shareholders—i.e., it “trades” on the equity base.
• The course highlights that the leverage impact is stronger with debt because interest is tax-deductible, while preference dividends are not deducted for tax purposes.

EPS impact logic

Because interest is a fixed financial charge, changes in EBIT can cause a proportionately larger change in EPS—this is the risk/return amplification effect of financial leverage discussed in the financing decisions block.

$$ EPS = \frac{(EBIT – I)(1-T) – PD}{N} $$

Where I is interest, T is tax rate, PD is preference dividend (if any), and N is number of equity shares (all consistent with the unit’s EBIT–EPS style analysis).

Example: effect of increasing debt on EPS (same EBIT, different financing)

Assume: Total capital required = Rs. 3,00,000; EBIT = Rs. 75,000; tax rate = 50%; face value per equity share = Rs. 10; no preference shares (to keep the illustration focused on debt vs equity).

• Plan A (All equity): Equity = 3,00,000 ⇒ shares N = 30,000; Interest = 0 $$ EBT = 75,000;\quad Tax = 37,500;\quad EAT = 37,500;\quad EPS = \frac{37,500}{30,000} = 1.25 $$
• Plan B (50% debt @ 10%, 50% equity): Debt = 1,50,000 ⇒ Interest = 15,000; Equity = 1,50,000 ⇒ N = 15,000 $$ EBT = 75,000-15,000=60,000;\quad Tax = 30,000;\quad EAT = 30,000;\quad EPS = \frac{30,000}{15,000} = 2.00 $$
• Plan C (75% debt @ 10%, 25% equity): Debt = 2,25,000 ⇒ Interest = 22,500; Equity = 75,000 ⇒ N = 7,500 $$ EBT = 75,000-22,500=52,500;\quad Tax = 26,250;\quad EAT = 26,250;\quad EPS = \frac{26,250}{7,500} = 3.50 $$

Interpretation: Even though earnings after taxes decline when interest rises, the number of equity shares also declines sharply under higher leverage, so EPS can rise. This is exactly the kind of EBIT–EPS comparative logic used in the course’s leverage discussion.

Question 4

Dividend policy for a normal firm when r = k: identify the model and explain

The dividend-theory unit explains that models like Walter’s and Gordon’s classify firms as growth, normal, and declining depending on the relationship between the firm’s internal return (r) and its cost of capital (k). For a normal firm, r = k, and the recommended stance is an indifference dividend policy (i.e., dividend payout does not change the value/price under the model’s structure).

Identified model: Walter’s Dividend Model

Walter’s model links the market price of a share to earnings, dividends, the firm’s internal rate of return (r), and cost of capital (k). Under its framework, dividend policy becomes relevant or irrelevant depending on whether r is greater than, equal to, or less than k.

Core relationship (Walter’s model)

$$ P = \frac{D + \frac{r}{k}(E-D)}{k} $$

Where P is price per share, D is dividend per share, E is earnings per share, r is internal rate of return on reinvested earnings, and k is the cost of capital.

Why dividend policy is “indifferent” when r = k

Substitute r = k into the model:

$$ P = \frac{D + \frac{k}{k}(E-D)}{k} = \frac{D + (E-D)}{k} = \frac{E}{k} $$

This shows that when r = k, the share price becomes dependent on E and k only, not on the dividend amount D. Therefore, the firm can follow an indifference dividend policy (any reasonable payout ratio), because payout does not affect valuation under the model.

Contextual note (how the model differentiates firm types)

• If r > k (growth firm): retention is preferable (lower dividend).
• If r < k (declining firm): higher payout is preferable.
• If r = k (normal firm): dividend policy is indifferent.

Question 5

Corporate restructuring: meaning, reasons, and modes

Meaning

Corporate restructuring refers to a set of actions undertaken to change the “complexion” or structure of a business, commonly through takeovers, mergers, acquisitions, or through major financial changes. Financial restructuring is highlighted as a major aspect within corporate restructuring and focuses on reorganizing the finances of the business.

Why firms go for corporate restructuring

The restructuring unit emphasizes that whichever method is adopted, it should aim at maximization of firm value. Firms typically consider restructuring to improve competitiveness, correct financial stress, or realign strategy to enhance long-term value creation.

• Value improvement objective: restructuring choices should contribute to maximizing firm value.
• Financial reorganization need: when the company’s finances require rebalancing—such as changing repayment schedules, converting claims, or altering the capital structure.
• Strategic/ownership change: when firms seek rapid change in control or scale through combinations (mergers/acquisitions/takeovers).

Different modes of corporate restructuring (as covered in the unit)

• Takeovers, mergers, and acquisitions: corporate-level changes that alter ownership/control or combine businesses.
• Buyback of shares: part of financial restructuring where the company repurchases its shares as one possible method of reorganizing finances.
• Conversion of debt into equity: restructures claims on the firm by replacing debt obligations with ownership claims.
• Debt restructuring: involves adjusting repayment schedules in line with applicable guidelines.
• Leveraged buyouts (LBOs): acquiring a company using borrowed funds (loan-financed acquisition) to obtain ownership.
• Equity restructuring: actions such as stock dividend, stock split, spin-off, etc., to reorganize the equity structure.
• Divestiture: selling/disposal of a unit/branch/factory/service centre, etc., to reshape the business.
• Disinvestment: withdrawal of investment through sale of assets/shares and related measures.
• Changes in the capital structure: broader reshaping of debt–equity mix as part of restructuring.