CAIIB Paper 3 Module B Quiz 8

WACC weights the relevant financing components by their capital proportions and costs. It is commonly used as a discount rate for projects with risk similar to the firm’s existing operations.

A project with different business or country risk may require a different hurdle rate. Applying the company-wide WACC indiscriminately can overvalue high-risk projects or undervalue low-risk projects.

Marginal cost of capital is the cost of raising additional financing. It can rise as cheaper sources are exhausted or as additional debt increases financial risk.

Retained earnings belong economically to shareholders. Their cost reflects the return shareholders could earn on comparable-risk investments, even though no explicit issue or interest payment occurs.

For irredeemable preference capital, a basic cost estimate is annual preference dividend divided by net proceeds. More complex treatment is needed for redeemable instruments and flotation costs.

After-tax debt cost = 10% × (1 − 0.25) = 7.5%, assuming the firm can use the interest tax shield and ignores fees and other adjustments.

Flotation costs reduce the amount received by the company relative to gross issue proceeds. The effective cost of new equity should account for net proceeds where material.

Preserving debt capacity can allow a firm to finance future opportunities or withstand shocks. The right balance depends on cash flows, investment pipeline and financing access.

Debt covenants set obligations or restrictions, such as leverage limits, interest coverage tests or reporting requirements. Breach may trigger remedies under the loan agreement.

Short-term funding creates a need to roll over liabilities before long-term assets generate cash. If markets tighten or lenders refuse renewal, liquidity pressure can arise.

Depreciation is a non-cash accounting charge. Its tax effect may matter, but the depreciation amount itself is not a cash outflow.

Tax shield = depreciation × tax rate = ₹4 lakh × 25% = ₹1 lakh, assuming the deduction can be used in the relevant year.

Initial outlay generally includes the asset purchase price, installation and other incremental setup costs, as well as initial working capital. Sunk costs are excluded.

Terminal cash flow may include working-capital recovery, after-tax salvage value and closure costs. These should be estimated realistically and included only once.

NPV values the timing and amount of cash flows. Accounting profit includes non-cash items and accruals, so it does not directly measure cash available to investors.

Forecasts should incorporate material new information and revised assumptions. Reassessment helps management decide whether to proceed, modify, delay or abandon the project.

Social appraisal may use a social discount rate reflecting the opportunity cost of resources and public-policy guidance. It should be selected consistently with the framework and purpose of the appraisal.

Benefits such as time savings, accessibility and reduced congestion may accrue to users or third parties and may not be fully captured in project revenue. Social appraisal attempts to measure them.

Sensitivity break-even analysis identifies the value of an input—such as sales volume or price—at which NPV becomes zero. It does not itself provide the probability of reaching that value.

Positive NPV is important but not sufficient if the project cannot be funded, breaches legal requirements, conflicts with strategy or exceeds the organisation’s risk capacity.