A team of young technocrats formed a startup named iNova Softech. The startup has developed an ERP software for leading Cargo firm, with estimated project cost is ₹10 Crore. The team is able to invest only a sum of ₹5 Cr

CS Professional · Capital Commodity and Money Market · PYQS · June 2021
A team of young technocrats formed a startup named iNova Softech. The startup has developed an ERP software for leading Cargo firm, with estimated project cost is ₹10 Crore. The team is able to invest only a sum of ₹5 Crore as equity at a face value of ₹100 each, the balance is proposed to be financed through Venture Capital. The company offers two alternate investment packages to the Venture Capital (VC) firm: (i) Straight Equity Investment. (ii) Fully Convertible Debentures (FCDs) with a coupon of 20%. At the end of 4 years, which would be converted into Equity Shares. This conversion would be at a P/E ratio of 10 on the weighted average EPS of the preceding three years with weights of 1, 2 and 3 for the EPS of 2nd, 3rd and 4th year respectively. The startup is planning to launch an IPO at the beginning of 6th year, which is expected to be priced at P/E multiple of 12 on the EPS of the 5th year. The VC firm intends to divest its holding at the time of the IPO. It has proposed to maintain a Dividend Pay-out Ratio of 10% for all 5 years. The expected EBIT for the 5 years is as under: Probability 0.2 0.5 0.3 Year 1 4.0 8.0 10.0 Year 2 8.0 10.0 12.0 Year 3 10.0 12.0 14.0 Year 4 12.0 16.0 18.0 Year 5 16.0 20.0 24.0 Ignore Taxes. As a financial advisor you are required to choose the alternative investment to be made by VC firm if its required rate of return is 14%. Present Value Factor @ 14% Year 1 2 3 4 5 PV Factor 0.877 0.769 0.675 0.592 0.519

Answer & Explanation:

Calculations for iNova Softech The EBIT for the 5 years (₹ in Crore) Year Calculation EBIT (₹ in Crore) Year 1 (0.2 * 4.0) + (0.5 * 8.0) + (0.3 * 10.0) = 0.8 + 4.0 + 3.0 7.8 Year 2 (0.2 * 8.0) + (0.5 * 10.0) + (0.3 * 12.0) = 1.6 + 5.0 + 3.6 10.2 Year 3 (0.2 * 10.0) + (0.5 * 12.0) + (0.3 * 14.0) = 2.0 + 6.0 + 4.2 12.2 Year 4 (0.2 * 12.0) + (0.5 * 16.0) + (0.3 * 18.0) = 2.4 + 8.0 + 5.4 15.8 Year 5 (0.2 * 16.0) + (0.5 * 20.0) + (0.3 * 24.0) = 3.2 + 10.0 + 7.2 20.4 (i) In case of Equity Investment of ₹50 lakh by the VCF The dividend for the 5 years (₹ in lakh) Year EBIT (₹ in lakh) Dividend Pay-out (10% of EBIT) (₹ in lakh) Dividend inflow to VCF (50% of Dividend Pay-out) (₹ in lakh) Year 1 780 78 39 Year 2 1,020 102 51 Year 3 1,220 122 61 Year 4 1,580 158 79 Year 5 2,040 204 102 Initial Equity by Technocrats = ₹5 Crore = ₹500 lakh. Face value ₹100. So, 500 lakh / 100 = 5 lakh shares. VC firm invests ₹5 Crore = ₹500 lakh. Face value ₹100. So, 500 lakh / 100 = 5 lakh shares. Total Equity Shares = 5 lakh (Technocrats) + 5 lakh (VC) = 10 lakh shares. The EPS for the 5th year is = PAT / No. of Shares Since taxes are ignored, PAT = EBIT. EPS for 5th year = ₹2,040 lakh / 10 lakh shares = ₹204 Hence the divestment price = EPS (5th year) * P/E multiple (IPO) = ₹204 * 12 = ₹2,448 per share. Cash inflow from divestment = ₹2,448 * 5 lakh shares (VC holding) = ₹12,240 lakh. The NPV for the investment will be: Year Cash Flow (₹) Present Value Factor @ 14% Present Value (₹) Year 0 (5,00,00,000) 1.000 (5,00,00,000) Year 1 39,00,000 0.877 34,20,300 Year 2 51,00,000 0.769 39,21,900 Year 3 61,00,000 0.675 41,17,500 Year 4 79,00,000 0.592 46,76,800 Year 5 12,34,20,000* 0.519 6,40,54,980

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