Notes on Capital Budgeting

1. Cash Flow Estimation

2. Evaluation Techniques
3. Risk Analysis in Capital Budgeting

1. Cash Flow Estimation

Cash Flow Vs Profit
Cash Flow = Profit + depreciation-Capex-Change in Net Working capital
Profit= Revenue-Expenses-Depreciation-tax {Profit is Profit after tax}
Or
Cash Flow=EBDIT(1-tax rate)+ tax rate*Depreciation – Change(NWC)-Capex
{EBDIT is earnings before depreciation and tax}
2. Evaluation Techniques
Non- Discounting: 1. Payback period method 2. Accounting rate of return
Discounting:
1. Net Present Value (NPV) = Sum of PV of all cash inflow – sum of PV of all cash outflow
NPV >= 1 (accept) else (reject)
2. Internal Rate of Return (IRR) = rate at which NPV of project is zero
PV @ lower rate at which NPV is positive = NPV1 @PV1
PV @ higher rate at which NPV is negative= NPV2 @PV2
𝑁𝑃𝑉1
Actual IRR = 𝑃𝑉1 + 𝑁𝑃𝑉1−𝑁𝑃𝑉2 ∗ (𝑃𝑉2 − 𝑃𝑉1)

3. Profitability Index (PI) = Sum of PV of all Cash inflow/ sum of PV of all cash outflow
 Practice Questions
1. The G.K. company is evaluating a project with following cash inflows:
Cash Flow (Rs.)
C1 C2 C3 C4 C5 C6
1000 800 600 400 400 200
The cost of capital is 12%. What is the maximum amount the company should pay for the
machine?
2. A project costs Rs. 81,000 and is expected to generate net cash inflow of Rs. 40,000, Rs.
35,000 and Rs. 30,000 over its life of three years. Calculate the internal rate of return of
project.
3. A company is considering two mutually exclusive projects. Both require an initial cash
outlay of Rs. 10000 each and have a life of five years. The company’s required rate of
return is 10% and pays tax at the rate of 50%. The project will be depreciated on a straight
line basis. The before taxes cash flows expected to be generated by the project are as
follows:
Before tax Cash Flow (Rs)
Project 1 2 3 4 5
A 4000 4000 4000 4000 4000
B 6000 3000 2000 5000 5000
Calculate for each project: 1) payback period 2) average rate of return 3) net present value
4) internal rate of return 5) profitability index. Which project should be accepted and why?
4. A company has to choose one of the following two mutually exclusive projects. Both the
projects will be depreciated on a straight line method. The firm’s cost of capital is 10% and
tax rate is 35%. The before tax cash flows are:
Project C0 C1 C2 C3 C4 C5
X -20000 4200 4800 7000 8000 2000
Y -15000 4200 4500 4000 5000 1000
Which project should the firm accept if the following criteria are used: a) payback period
method b) internal rate of return c) net present value d) profitability index?
5. XY Ltd. wants to install a new machine in place of an existing old one which has become
obsolete. The company made an extensive enquiries and from the replies received has
short-listed two offers. The estimated life of both the machines is five years. There will be
only negligible salvage value at the end of fifth year. The details are:
Anticipated after tax cash flow (Rs. Lakhs)
Machine Cost 1 2 3 4 5
A 25 - 5 20 14 6
B 40 10 14 16 17 8
The company’s cost of capital is 15%. Which machine should be selected based on a)
payback period b) net present value c) profitability index d) internal rate of return
6. Claross, Inc. wishes to determine the relevant operating cash flows associated with the
proposed purchase of a new piece of equipment having an installed cost of $10 million and
falling into the 5-year MACRS asset class. The firm’s financial analyst estimated that the
relevant time horizon for analysis is 6 years. She expects the revenues attributable to the
 equipment to be $15.8 million in the first year and to increase at 5% per year through year
6. Similarly, she estimates all expenses other than depreciation attributable to the
equipment to total $12.2 million in the first year and to increase by 4% per year through
year 6. She plans to ignore any cash flows after year 6. The firm has a marginal tax rate of
40% and its required return on the equipment investment is 13%.
a) Find the relevant incremental cash flows for years zero through 6.
b) Using the cash flows found in part a, determine the NPV and IRR for the proposed
equipment purchase.
c) Based on your findings in part b, would you recommend that Claross, Inc. purchase the
equipment? Why?
7. Adam Smith is considering automating his pin factory with the purchase of a $475,000 machine.
Shipping and installation would cost $5,000. Smith has calculated that automation would result in
savings of $45,000 a year due to reduced scrap and $65,000 a year due to reduced labor costs. The
machine has a useful life of 4 years and uses straight line depreciation method. The estimated final
salvage value of the machine is $120,000. The firm's marginal tax rate is 34 percent. What is the
incremental cash outflow at time period 0?
8. BackInSoon, Inc., has estimated that a proposed project's 10-year annual net cash benefit,
received each year end, will be $2,500 with an additional terminal benefit of $5,000 at the end of
the tenth year. Assuming that these cash inflows satisfy exactly BackInSoon's required rate of
return of 8 percent, calculate the initial cash outlay.
9. Woatich Windmill Company is considering a project that calls for an initial cash outlay of
$50,000. The expected net cash inflows from the project are $7,791 for each of 10 years. What is
the IRR of the project?