K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

CHAPTER 1 CAPITAL BUDGETING PART 1

Q.1 A company proposes to install a machine involving a capital cost of Rs. 3,60,000.
The life of the machines is 5 years and its salvage value at the end of the life is Nil. The
machine will produce the net operating income after depreciation of Rs. 68,000 per
annum. The company’s tax rate is 45%. The present value factors for 5 years are as
under:
Discounting Rate 14% 15% 16% 17% 18%
Cumulative Factors 3.43 3.35 3.27 3.20 3.13
You are required to calculate the internal rate of return of the proposal:
Solution:
Computation of Cash Inflow
A. Net operating income Per annum 68,000
B. Less: Tax @ 45% (30,600)
C. Profit after tax 37,400
D. Add: Depreciation (Rs. 3,60,000/ 5 years) 72,000
E. Cash inflow p.a. 1,09,400
The IRR of the investments can be found as follows:
NPV = - Rs. 3,60,000 + Rs. 1,09,400 (PVAF5,r) =0
𝑅𝑠.3,60,000
Or, PAVF5r (cumulative factors) = 𝑅𝑠.1,09,400 = 3.29

Computation of internal Rate of return

A. Discounting rate 15% 16%
B. Cumulative factors 3.35 3.27
C. Total cash inflow 3,66,490 3,57,738
(Rs. 1,09,400×3,350) (Rs.1,09,400×3.27)
D. Initial Outlay (Rs.) 3,60,000 3,60,000
E. NPV (Rs) [C – D] 6,490 (2,262)

6,490
IRR = 15% +[6,490+2,262] = 15% + 0.74% = 15.74%

Alternatives Method
𝑃𝑉𝐴𝐹 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒−𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑
IRR = Lower Rate + 𝑃𝑉𝐴𝐹 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒−𝑃𝑉𝐴𝐹 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒

3.35−3.29
= 15% + 3.35−3.27 = 15.75%.

Q.2 A company is considering the proposals of takings up a new projects which

requires an investments of Rs. 400 lakhs on machinery and other assets. The projects is
expected to yield the followings earnings (before depreciation and taxes) over the
next five years.
Year 1 2 3 4 5
Earnings (Rs.in lakhs) 160 160 180 180 150
The cost of raising the additional capital is 12% and assets have to be
depreciation at 20% on Written Down value bases. The scrap value at the end of the
five years. Period may be taken as zero income tax applicable to the company is 50%.
Required: Calculate the net present value of the project and advise the
managements to take appropriate decision. Also calculate the internal Rate of
Return of the project.

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Note: Present value of Re. 1 at different rates of interest are as follows.

Year 10% 12% 14% 16%
1 0.91 0.89 0.88 0.86
2 0.83 0.80 0.77 0.74
3 0.75 0.71 0.67 0.64
4 0.68 0.64 0.59 0.55
5 0.62 0.57 0.52 0.48
Solution:
Statements Showing The Computation Of Cash Inflows After Tax [CFAT]
Particulars Year 1 Years 2 Year 3 Year 4 Year 5
Earnings before depreciation% 16,000 16,000 18,000 18,000 15,000
tax (8,000) (6,400) (5,120) (4,096) (3,277)
Less: Depreciation 8,000 9,600 12,880 13,904 11,723
Earnings before tax (4,000) (4,800) (6,440) (6,952) (5,862)
Less: Tax @ 50% 4,000 4,800 6,440 6,952 5,861
Earnings after tax 8,000 6,400 5,120 4,096 3,277
Add: Depreciation 12,000 11,200 11,560 11,048 9,138
Cash flow after taxes (CFAT)
Add: Tax savings on loss - - - 6,554
[50% of (Rs. 13,107 – 0 ) 15,692

Statements Showing The Computation of Net Present Value

Particulars Year Amt. PV PV PV PV PV factor PV
Factor Factor At 16%
at 12% At 14%
Purchase price of 0 40,000 1 40,000 1 40,000 1 40,000
New machinery
CFAT of year 1 12,000 0.89 10,680 0.88 10,580 0.86 10,320
CFAT of year 2 11,200 0.80 8,960 0.77 8,624 0.74 8,288
CFAT of year 3 11,560 0.71 8,208 0.67 7,745 0.64 7,398
CFAT of year 4 11,048 0.64 7,071 0.59 6,518 0.55 6,076
CFAT of year 5 15,692 0.57 8,944 0.52 8,160 0.48 7,532
NPV 3,863 1,607 (386)
Recommendation: Company should accept the projects at 12% since NPV is potive.

(ii)Calculation of internal Rate of Return (IRR)

1,607
IRR = 14% + 1,607+386 × (16% − 14%)

IRR = 14% + 1.61% = 15.61%.

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Q.3 XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The
projects is to be set up in special Economic Zone (SEZ), qualifies for one time (at starting
) tax free subsidy from the state Goverment of Rs. 25,00,000 on Capital investments.
Initial equipments cost will be Rs. 1.75 crores. Additional equipments costing Rs.
12,50,000 will be purchase at the end of the third year from the cash inflow of thisyears.
At the end of 8 years, the original equipments will have no resale value, but additional
equipments can be sold for Rs. 1,25,000. A working capital Of Rs. 20,00,000 will be
needed and it will be released at the end of eighth years. The projects will be financed
with sufficient amt. of Equity capital . The sales volumes over eight years have been
estimated as follows:
Years 1 2 3 4th 5
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000
A selling price of Rs. 120 per unit is expected and variable expenses will amount
to 60% of sales revenue. Fixed cash operating Costs will amount rs. 1,80,000 per years.
The loss of any year will be set off from the profits of subsequent two years. The
company is subjects to 30 per cent tax rate and considers 12 per cent to be an
appropriates after tax costs of capital for this projects. The company follows straight
line method of depreciation.
Required: Calculate the net present value of the project and advise the
managements to take appropriate decision.
(Figures should be rounded off in the multiple of 1,000)
Note: The present value factors @ 12% discount rate are as follows,
Year 1 2 3 4 5 6 7 8
Present value factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404
Solution:
Computation of Cash Inflows After Tax (CFAT) in ooo’s
Particulars Year 1 Year 2 Year 3 Year Year
4/5 6to 8
yrs
A.Sales Units 72 108 260 270 180
B. selling price per unit (Rs.) 120 120 120 120 120
C. Sales [A – B] 8,640 12,960 31,200 32,400 21,600
D. Less: Total cost:
Variable costs @ 60% of sale 5,184 7,776 18,720 19,440 12,960
Depreciation 2,188 2,188 2,188 2,413 2,413
Other fixed costs 1,800 1,800 1,800 1,800 1,800
Total cost 9,172 11,764 22,708 (23,653) (17,173)
E. Earnings before tax (532) 1,196 8,492 8,747 4,427
F. less: Tax @ 30% - (199) 2,548 (2,624) (1,328)
G. Earnings after tax (532) 997 5,944 6,123 3,099
H. Add: Depreciation 2,188 2,188 2,188 2,413 2,413
I. Cash flow after taxes (CFAT 1,656 3,185 8,132 8,536 5,512
(for year other than last year
J. Add: release of working capital 2,000
K. Add: cash Salvage value of asset 125
L. Total CFAT for the last years. 7,637

Computation of Net Present Value

Particulars Year PV factor Amount PV

Purchase price of New machinery 0 1 (17,500) (17,500)

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Subsidy from Govt. 0 1 2,500 2,500

Working Capital 0 1 (2,000) (2,000)
Additional Equipments 3 0.712 (1,250) (890)
CFAT of year 1 1 0.893 1,656 1,479
CFAT of Year 2 2 0.797 3,185 2,538
CFAT of year 3 3 0.712 8,132 5,790
CFAT of Year 4 4 0.636 8,536 5,429
CFAT of Year 5 5 0.567 8,536 4,840
CFAT of Year 6 6 0.507 5,512 2,795
CFAT of Year 7 7 0.452 5,512 2,491
CFAT of Year 8 8 0.404 7,637 3,085
NPV 10,557
Recommendation : The company Should accept the projects since NPV is positive.
Note: The tax for the second years has been calculated after set off of brought
forward loss of the first years. [I.e. 30% of (Rs. 1,196 – Rs. 532)].

Q.4 Consider the following mutually exclusive projects.

Projects Cash flow (Rs.)
C0 C1 C2 C3 C4
A -10,000 6,000 2,000 2,000 12,000
B -10,000 2,500 2,500 5,000 7,500
C -3,500 1,500 2,500 500 5,000
D -3,000 0 0 3,000 6,000
Required:
(i)Calculate the payback period for each project:
(ii)If the standard payback period is 2 years, which project will you select ? will your
answer differ, if standard payback period is 3 years?
(iii)If the cost Of capital is 10%. Compute the discounted payback period for each
projects Which projects, will you recommend if standard discounted payback period
is (i)2 years ; (ii)3 years?
(iv)Compute NPV of each projects, which projects will you recommends on the NPV
criterion? The cost of capital is 10%. What will be the appropriate choice criteria in the
case? The PV factors at 10% are:
Years 1 2 3 4
PV Factors at 10% 0.9091 0.8264 0.7513 0.6830

Solution:
(i)Payback Period
Years Projects A Project B Project C Project D
CI Cum. CI CI Cum. CI Cum.CI CI Cum.Ci
CI
1 6,000 6,000 2,500 2,500 1,500 1,500 0 0
2 2,000 8,000 2,500 5,000 2,500 4,000 0 0
3 2,000 10,000 5,000 10,000 500 4,500 3,000 3,000
4 12,000 22,000 7,500 17,500 5,000 9,500 6,000 9,000

(ii) If the standard payback period is 2 years only projects C can be selected.
If the standard payback period is 3 years , all the 4 projects can be selected.

(iii)Discounted payback Period

PVF @ Project A Project B Project C Project D

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Year 10% DCI Cum.DCI DCI Cum.DCI DCI Cum.CI DCI Cum.DCI
0.9091 5,454.6 5,454.6 2,272.75 2,272.75 1,363.65 1,363.65 0 0
0.8264 1,652.8 7,107.4 2,066.00 4,338.75 2,066.00 3,429.65 0 0
0.7513 1,502.6 8,610.0 3,756.50 8,095.25 375.65 3,805.30 2,253.90 2,253.90
0.6830 8,196.0 16,806.0 5,122.50 13,217.75 3,415.00 7,220.30 4,098.0 6,351.90

1390
Discounted payback period (A) = 3 years + = 3.17 Years or 3 years;2 month;1 day
8196

1904.75
Discounted payback period (B)= 3 years +5122.50 =3,372 yrs or 3 yrs’4 months;14 days

70.35
Discounted payback period(C) = 2 years +375.65= 2,187 yrs or 2 yrs;2 months; 7 days.

746.10
Discounted payback period (D) = 3 years + 4098
=3,182 yrs or 3 yrs; 2months; 6 days

If standard discounted payback period is 2 yrs no, projects is acceptable.

If standard discounted payback period is 3 yrs, project ‘C’ is acceptable.

(IV)Evaluation of Projects On NPV Criterion

NPV = Discounted cash Inflows – Discounted Cash Outflow
NPV of projects A = -10,000 + 5,454.6 + 1,652.8+ 1,502.60+ 8,196 = Rs. 6,806
NPV of projects B = -10,000 +2,272.75+ 2,066 + 4,756.5+5,122.5 = Rs. 3,217.75
NPV of projects C= - 3,500+ 1,363.65+2,066 + 375,65 +3,415.00= Rs. 3,720.3
NPV of projects D = -3,000 + 0 + 0 + 2,253.9 + 4,098 = Rs. 3,351.9.

Ranking of mutually Exclusive Projects On NPV Criterion

Project NPV Rs. Ranking as per NPV
A 6,806.20 I
B 3,217.75 IV
C 3,720.30 II
D 3,351.90 III
Recommendation : Projects A is Acceptable under the NPV method.

Q.6 C Ltd. is considering investing in a project. The expected original investments in

the projects will be Rs.2,00,000 the life of project will be 5 years with no Salvage
value. The expected net cash Inflows after depreciation but before tax during the
life of the projects will be as follows.
Years 1 2 3 4 5
Rs. 85,000 1,00,000 80,000 80,000 40,000
The project will be depreciated at the rate of 20% on original cost. The company is
subjects to 30% tax rate.
Required:
(i)Calculate pay back period.
(ii)Average rate of return (ARR)
(iii)Calculate Net present Value and net present value index, if cost of capital is 10%
(iv)Calculate internal Rate of return.
Note: The P.V. factors are.

Years P.V. at 10% P.V.at 37% P.V. at 38% P.v. at 40%

1 0.909 0.730 0.725 0.714

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

2 0.826 0.533 0.525 0.510

3 0.751 0.389 0.381 0.364
4 0.683 0.284 0.276 0260
5 0.621 0.207 0.200 0.186
Solution: Calculation of Cash Flow After Tax (CFAT)
Years 1 (Rs.) 2 (Rs.) 3 (Rs.) 4 (Rs.) 5 (Rs.)
Earnings after depreciation 85,000 1,00,000 80,000 80,000 40,000
but before tax
Less: Tax @ 30% (25,500) (30,000) (24,000) (24,000) (12,000)
Earnings after tax 59,500 70,000 56,000 56,000 28,000
Add: 40,000 40,000 40,000 40,000 40,000
Depreciation(Rs.2,00,000/5) 99,500 1,10,000 96,000 96,000 68,000
CFAT [Cumulative] 99,500 2,09,500 4,01,500 4,01,500 4,69,500

1,00,500
(i)Payback period = 1 years + = 1.914 years or 1 year, 10 months and 29 days
1,10,000

(ii)Average Rate OF Return (ARR)

Step 1:
𝑅𝑠.59,500+𝑅𝑠.70,000+𝑅𝑠.56,000+𝑅𝑠.56,000+𝑅𝑠.28,000
= 5
= 𝑅𝑠. 53,900.
Step 2 : Average Investments – ½ (Original Cost – Salvage Value) + Salvage value+
= ½ (Rs. 2,00,000 – 0 )+ 0 + 0 = Rs. 1,00,000

Step 3 : Average Rate Of Return (ARR)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑅𝑠.53,900
= × 100 = × 100 = 𝟓𝟑. 𝟗%
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 𝑅𝑠.1,00,000

(ii)NPV and NPV Index

Particulars Years PV factors Amount PV
Investments 0 1,000 (2,00,000) (2,00,000)
CAFT 1 0.909 99,500 90,445.50
CAFT 2 0.826 1,10,000 90,860.00
CAFT 3 0.751 96,000 72,096.00
CAFT 4 0.683 96,000 65,568.00
CAFT 5 0.621 68,000 42,228.00
NPV 1,61,197.50
𝑁𝑃𝑉 𝑅𝑠.1,61,197.50
NPV Index = 𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤 = 𝑅𝑠.1,00,000 = 𝟎. 𝟖𝟏.
(ii)Internal rate of return (IRR)
Step 1 : Average annual Cash Flow
𝑅𝑠.99,500+𝑅𝑠.1,10,000+𝑅𝑠.96,000+𝑅𝑠.96,000+𝑅𝑠.68,000
=
5
= 93,900

𝐶𝐴𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 𝑅𝑠.2,00,000

Step 2 : Fake payback period = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝑅𝑠.93,900
= 2.13

Ste 3 : Two present value of annuity factor within which fake payback period lies are
2,143 and 2,106 which correspond to discount rates of 37% and 38% respectively.
Step 4 : Calculation of NPV at 37% and 38%.
Particulars Yrs Amt. PVF @ PV at PVF @ PV at PVF@ PV at
37% 37% 38% 38% 40% 40%
Investments 0 (2,00,000) 1,000 (2,00,000) 1.000 (2,00,000 1.000 2,00,000

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CFAT 1 99,500 0,730 72,635 0.725 72,138 0.714 71,043

CFAT 2 1,10,000 0.533 58,630 0.525 57,750 0.510 56,100
CFAT 3 96,000 0.389 37,344 0.381 36,576 0.364 34,944
CFAT 4 96,000 0.284 27,264 0.276 26,496 0.260 24,960
CFAT 5 68,000 0.207 14,076 0.200 13,600 0.186 12,648
NPV 9,949 6,560

𝑁𝑃𝑉 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒

IRR = Lower Rate + 𝑁𝑃𝑉 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒−𝑁𝑃𝑉 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒 × (𝐻 − 𝐿)

6560
= 38% + 6560−(−305) × (40% − 38%) = 39.91%.

Q.7 A firm can make investments in either of the following two projects. The firms
anticipates is cost of capitals to be 10% and the net (after tax) cash flows of the
projects for five years are as follows: (Rs.000)
Years 0 1 2 3 4 5
Project –A (500) 85 200 240 220 70
Project –B (500) 480 100 70 30 20

The discount factor are as under:

Years 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62
PVF (20%) 1 0.83 0.69 0.58 0.48 0.41
Required:
(i)Calculate the NPV and IRR of each projects.
(ii)State with reasons Which projects you would recommend.
(iii)Explain the inconsistency in rakings of two projects.
Solution:
(i)Computation of NPV and IRR

NPV for projects A at 10% and 20%

Year Cash flows PVF @ 10% P.V. @ 10% PVF @ 20% P.V. @ 20%
Rs’000’ Rs.’000’ Rs. ‘000
0 (500) 1.00 (500.00) 1.00 (500.00)
1 85 0.91 77.35 0.83 70.55
2 200 0.83 166.00 0.69 138.00
3 240 0.75 180.00 0.58 139.20
4 220 0.68 149.60 0.48 105.60
5 70 0.62 43.40 0.41 28.70
+116.35 (17.95)

NPV of project A (at 10% Cost of Capital ) = Rs. 1,16,350

𝑁𝑃𝑉 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒

IRR = Lower rate +𝑁𝑃𝑉 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒−𝑁𝑃𝑉 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒 × (𝐻 − 𝐿)

NPV for project B at 10% and 20%

Year Cash flows PVF @ 10% P.V.@ 10% PVF @ P.V.@ 20%
Rs. ‘000’ Rs. ‘000’ 20%
0 (500) 1.00 (500.00) 1.00 (500.00)

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1 480 0.91 436.80 0.83 398.40

2 100 0.83 83.00 0.69 69.00
3 70 0.75 52.50 0.58 40.60
4 30 0.68 20.40 0.48 14.40
5 20 0.62 12.40 0.41 8.20
NPV + 105.10 + 30.60
NPV of project B (At 10% cost of capital)=Rs. 1,05,100.

105.10
IRR = 10 + 105.10−30.60 × (20 − 10)% = 24.107%
Note : Though in above solution discounting factors of 10% and 20% have been used.
However, instead of 20% students may assume any rate beyond 20% say 26% then
NPV becomes. In such a case the answer of IRR of projects may slightly varied frims
24.10.
(ii)The ranking of The projects will be as under:
Ranking as per NPV Ranking as per IRR
Projects A 1 2
Projects B 2 1
Where an inconsistency is experienced the projects yielding larger NPV is
preferred because of larger cash flows which it generates. IRR criterion is rejected
because of the followings reasons.
(a)IRR assumes that all cash flows are re-invested at IRR.
(b)IRR is a percentage but the magnitude of cash flow is importants.
(c)Multiple IRR may Arise if the projects have non-conventional cash flows.
(iii) Inconsistency in ranking is due to the difference in the pattern of cash flows.

Q.8 A company wants to invest in a machinery that would cost Rs. 50,000 at the
beginnings of year 1. It is estimated that the net cash inflows from operations will be
Rs. 18,000 per annum for 3 years. IF the company opts to service a part of the machine
at the end of the year 1 at Rs. 10,000 then the scrap value at the end of the year 3 will
be Rs. 12500. However if the company decides not to services the part, it will have to
be replaced at the end of the year 2 at Rs. 15,400. But in this case, the machine will
work for the 4th year also and get operational cash inflows of Rs. 18,000 for the 4th year.
It will have to be scrapped at the end of the year 4 at Rs. 9,000. Assuming cost of
capital at 10% and ignoring taxes, will you recommend the purchase of this machine
based on the net present value of its cash flows?

Solution:
(a)If part of machine is serviced
Statements Showings Net present value
Particulars Year PV factor Amount PV at 10%
At 10% Rs. Rs.
Purchase price 0 1 (50,000) (50,000)
Cost of service 1 0.9091 (10,000) (9,091)
CFAT for 1 – 2 years 1 to 2 1.7355 18,000 31,239
CFAT for 3rd year 3 0.7513 30,500 22,915
NPV (4,937)
PVAF of 3 years @ 10% 2.4868
Annualized NPV (NPV/PVAF) (1985.28)

(b)If part of machine is Replaced

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Statements Showing Net Present Value

Particulars Year PV factor Amount PV at 10%
At 10% Rs. Rs.
Purchase price 0 1 (50,000) (50,000)
Cost of replacements 2 0.8264 (15,400) (12,727)
CFAT for 1-3 years 1 to 3 2.4868 18,000 44,762
CFAT for 4 years
th 4 0.6830 27,000 18,441
NPV 476
PVAF of 4 years @ 10% 3.1698
Annualized NPV (NPV/PVAF) 150.17

Recommendation (without considering supplier’s discount): The machine should be

purchased with alternative of replacing the part since this alternative has higher
annualized NPV.

Q.9 A company is required to choose between two machine A and B. The two
machines are designed differently but have identical capacity and do exactly the
same job. Machine A costs Rs. 6,00,000 and will last for 3 years. It costs rs. 1,20,000 per
years to run.
Machine B is an economy model costing Rs, 4,00,000 but will last only for two
years Rs. 1,80,000 per years to run. These are real cash flows. The costs are forecasted
in rupees of constant purchasing power. Opportunity cost of capital is 10%. Which
machine company should buy? Ignore tax .
PVIF0.10.1 = 0.9091, PVIF0.10.2 = 0.8264, PVIF0.10.3 = 0.7513.
Solution:
Statements Showing Evaluation of Two Machines
Machine A B
Running cost of machine p.a. (Rs.) 1,20,000 1,80,000
Cumulative present value factor@ 10% 2.4868 1.7355
Present value of running cost (Rs.) 2,98,416 3,12,390
Purchase cost (Rs.): 6,00,000 4,00,000
Cash outflow of machine (Rs.) 8,98,416 7,12,390
Equipments present value of annual cash outflow (Rs.) 3,61,273.93 4,10,481.13
Recommendation: The company should buy machine A since its equipments cash
outflow is less than that of machines B.

Q.10 Given below are the data on a capital projects ‘M’.

Annual cost saving Rs. 60,000 Profitability index 1.064
Useful life 4 years Salvage value 0
Internal rate of return 15%
You are required to calculate for this project M:
(i)Cost of projects
(ii)payback period
(iii)Cost of capita
(iv)Net present value.
Given the following table of discount factor.
Discount factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 years 0.756 0.769 0.783 0.797
3 years 0.658 0.675 0.693 0.712
4 years 0.572 0.592 0.613 0.636

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

2.855 2.913 2.974 3.038

Solution:
(i)Cost of project ‘M’
At 15% internal rate of return (IRR)the sum of total cash inflows = cost of the
projects i.e. initial cash out lay
Hence total cash inflows for 4 years for projects M= 60,000×2,855 = Rs. 1,71,300
Hence cost of the projects = Rs. 1,71,300

(ii)Payback period

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑅𝑠.1,71,300

Profitability index = = = 2.855 years.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑅𝑠.60,000

𝑆𝑢𝑚 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

1.064 =
1,71,300
Sum of discounted cash inflows = Rs.1,82,263.20
Since, Annual cost saving= Rs.60,000
𝑅𝑠.1,82,263.20
Hence, cumulative discount factor for 4 years. = 60,000
= 3.038
From the discount factor table at discount rate of 12% the cumulate discount factor
for 4 years is 3.038.
Hence, Cost of Capital = 12%.

(iv)Net present value (NPV)

NPV = Sum of present values of cash inflows – Cost of the project.
= Rs. 1,82,263.20 – 1,71,300 = Rs. 10,963.20.

Q.11 PR Engineering Ltd. is considering the purchase of a new machine which will
carry out some Operations which are the present performed by manual labour. The
followings information related to the two alternative models – ‘MX’ and ‘MY’ are
available:
Machine Machine ‘MX’ Machine ‘MY’
Cost of machine Rs.8,00,000 Rs. 10,20,000
Expected life 6 years 6 years
Scrap value Rs. 20,000 Rs. 30,000
Estimated net income before depreciation and tax.
Year Rs. Rs.
1 2,50,000 2,70,000
2 2,30,000 3,60,000
3 1,80,000 3,80,000
4 2,00,000 2,80,000
5 1,80,000 2,60,000
6 1,60,000 1,85,000
Corporate tax rate this company is 30 percent and company required rate of
return on investments proposals is 10 percent. Depreciation will be charged on
straight basis.
You are required to:
(i)Calculate the pay-back of each proposal.

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(ii)Calculate the net present value of each proposal if the P.V. factor at 10% is 0.909,
0.826,0.751,0.683,0.621 and 0.564.
Solution:
(i)Calculation of payback period
Cumulative Cash Inflows
Years
1 2 3 4 5 6
Machine ‘MX’ 2,14,000 4,14,000 5,79,000 7,58,000 9,23,000 10,74,000
Machine ‘MY’ 2,38,500 5,40,000 8,55,500 11,01,000 13,32,500 15,11,500
Pay-back period ‘MX’
(8,00,000−7,58,000) 42,000
=4+ 1,65,000
= 4 + 1,65,000 = 4 + 0.25
= 4.25 years or 4 years and 3 months.
Pay-back period for ‘MX’ = 4.25 years or 4 years and 3 monts.
Pay-back period for ‘MY’

(10,20,000−8,55,000) 1,64,500
=3+ =3+ = 3 + 0.67
2,45,000 2,45,500
= 3.67 years or 3 years and 8 months.
Payback period for ‘MY’ = 3.67 year or 3 years or 3 months
(ii)Calculation of Net Present value (NPV)
Machine ‘MX’ Machine ‘MY’
Year PV factor Cash inflow Present value Cash inflow Present value
Rs. Rs. Rs.
0 1.000 (8,00,000) (8,00,000) (10,20,000) (10,20,000)
1 0.909 2,14,000 1,94,526 2,38,500 2,16,797
2 0.826 2,00,000 1,65,200 3,01,500 2,49,039
3 0.751 1,65,000 1,23,915 3,15,500 2,36,941
4 0.683 1,79,000 1,22,257 2,45,500 1,67,677
5 0.621 1,65,000 1,02,465 2,31,500 1,43,762
6 0.564 1,51,000 85,164 1,79,000 1,00,956
0.564 20,000 11,280 30,000 16,920
4,807 1,12,092
Net present value of machine ‘MX’ = Rs. 4,807
Net present value of machine ‘MY’ = Rs. 1,12,092
(iii)Recommendation
Machine ‘MX Machine ’MY’
Ranking according to pay-back period II I
Ranking according to Net present value(NPV) II I
Advise: Since machine ‘MY’ has higher ranking than machine ‘MX’ according to
both the partners. i.e. payback period as well as net present value. Therefore
machine ‘MY’ is recommendation.

𝑅𝑠.8,00,000−𝑅𝑠.20,000
(i)Depreciation of machine ‘MX’= 6
= Rs. 1,30,000

𝑅𝑠.10,20,000−𝑅𝑠.30,000
(ii)Depreciation of machine ‘MY’ = 6
=Rs. 1,65,000.

(iii)Cash Inflows Of Machine ‘MX’

Years
1 2 3 4 5 6
Earnings before 2,50,000 2,30,000 1,80,000 2,00,000 1,80,000 1,60,000

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Depreciation & tax

Less: Depreciation 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000
EBIT 1,20,000 1,00,000 50,000 70,000 50,000 30,000
Less: Tax 36,000 30,000 15,000 21,000 15,000 9,000
EBT 84,000 70,000 35,000 49,000 35,000 21,000
Add: Depreciation 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000
CFAT 2,14,000 2,00,000 1,65,000 1,79,000 1,65,000 1,51,000

(iv)Cash Inflow of machine ‘MY’

Years
1 2 3 4 5 6
Earnings before 2,70,000 3,60,000 3,80,000 2,80,000 2,60,000 1,85,000
Depreciation, tax
Less: Depreciation 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000
EBT 1,05,000 1,95,000 2,15,000 1,15,000 95,000 20,000
Less: Tax 31,500 58,500 64,500 34,500 28,500 6,000
EAT 93,500 1,36,500 1,50,500 80,500 66,500 14,000
Add: Depreciation 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000
CFAT 2,38,500 3,01,500 3,15,500 2.45,000 2,31,500 1,79,000.

Q.12 A doctor is planning to buy an X-ray machine for his hospital. He has two options.
He can either purchase it by making a cash payment of Rs. 5 lakhs or Rs. 6,15,000 are
to be paid in six equal annual annual installments. Which option do you suggest to the
doctor assuming the rate of return is 12 percent? Present value of annuity of Rs. 1 at
12 percent rate of discount for six years is 4.111.
Solution:
Option I : Cash down payment = Rs. 5,00,000
Option II: Annual Installment Basis
Annual installment = 6,15,000 × 1/6 = Rs. 1,02,500
Present value of 1 to 6 installments @ 12% = 1,02,500 ×4.111=Rs. 4,21,378
Advise: The doctor should buy X-Ray machine on installment basis because the
present value of cash out flows is lower than cash down payment. This means Option
II is better than Option I.

Q.13 A hospital is considering to purchases a diagnostic machine costing Rs. 80,000.

The projected life of the machine is 8 years and has an expected salvage value of
Rs. 6,000 at the end of 8 years. The annual Operating cost of the machine is Rs. 7,500.
It is expected to generate revenues of Rs. 40,000 per year for eight years. Presently,
the hospital is outsourcing the diagnostic work and is earnings commission income
of Rs. 12,000 per annum ; net of taxes.
Required: Whether it would be profitable for the hospital to purchase the machine?
Give your recommendation under.
(i)Net present value method.
(ii)Profitability index method.
PV factors at 10% are given below.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
Solution :
Calculation of cash inflows
Sales Revenue 40,000
Less: Operating cost 7,500

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Less: Depreciation [(80,000-6,000)/8] 9,250

Earnings before tax 23,250
Tax @ 30% 6,975
Earnings after tax (EAT) 16,275
Add: Depreciation 9,250
Cash inflows after tax per annum 25,525
Less: Loss of commission income 12,000
Net cash inflow after tax per annum 13,525
In 8th year:
New cash inflow after tax 13,525
Add: salvage value of machine 6,000
Net cash inflow in year 8 19,525
Calculation of Net present value (NPV)
Year CFAT PV factor @ Present value of
10% cash inflows
1 to 7 13.525 4.867 65,826.18
8 19.525 0.467 9,118.18
74,944.36
Less: cash outflows 80,000.00
(5,055.64)

𝑆𝑢𝑚 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 74,944.36

Profitability Index = = = 0.937
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 80,000
Advise : Since the net present value is negative and profitability index is also less
than 1, therefore , the hospital should not purchase the diagnostic machine.
Note: Since the tax rate is not mentioned in the question therefore it is assumed to
be 30 percent in the given solution.

Q.14 The management of P limited is considering selecting a machine out of two

mutually EXCLUSIVE machines. The company’s cost of capital is 12 percent and
corporate tax rate for the company is 30 percent details of the machines are as
follows:
Machine-I Machine-II
Cost of machine Rs.10,00,000 Rs.15,00,000
Expected life 5 years 6 years
Annual income before tax and depreciation Rs.3,45,000 Rs. 4,55,000
Depreciation is to be straight the basis
You are required to :
(i)Calculate the discounted pay-back period, net present value and internal rate of
return for each machine.
(ii)Advise the management of P limited as to which machine they should take up.
The present value factor of Re. 1 are as follows.
Year 1 2 3 4 5 6
At 12% .893 .797 .712 .636 .567 .507
At 13% .885 .783 .693 .613 .543 .480
At 14% .877 .769 .675 .592 .519 .456
At 15% .870 .756 .658 .572 .497 .432
At 16% .862 .763 .641 .552 .476 .410
Solution:
(a)(i)Computation of Discounted payback period. Net present value (NPV) and
internal rate of return (IRR) for two machines.

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Calculation of cash inflows

Machine I Machine II
Rs. Rs.
Annual income before tax and depreciation 3,45,000 4,55,000
Less; depreciation 2,00,000 2,50,000
Income before tax 1,45,000 2,05,000
Less: Tax @ 30% 43,500 61,500
Income after tax 1,01,500 1,43,500
Add: Depreciation 2,00,000 2,50,000
Annual cash Inflows 3,01,500 3,93,500

Machine - I Machine –II

Year PV of Cash P.V. Cumulative Cash P.V. Cumulative
Re. flow P.V. flow P.V.
1 @ 12%
1 0.893 3,01,500 2,69,240 2,69,240 3,93,500 3,51,396 3,51,396
2 0.797 3,01,500 2,40,296 5,09,536 3,93,500 3,13,620 6,65,016
3 0.712 3,01,500 2,14,668 7,24,204 3,93,500 2,80,172 9,45,188
4 0.636 3,01,500 1,91,754 9,15,958 3,93,500 2,50,266 11,95,454
5 0.567 3,01,500 1,70,951 10,86,909 3,93,500 2,23,115 14,18,569
6 0.507 - - - 3,93,500 1,99,505 16,18,074

Discounted payback period for :

Machine - I Machine – II
(10,00,000−9,15,958) (15,00,000−14,18,569)
=4 + 1,70,951
=5+ 1,99,505

84,042 81,431
=4 + = 4 + 0.4916 =5+ 1,99,505 = 5+0.4082
1,70,951

=4.49 yrs or 4 yrs and 5.9 months =5.41 yrs or 5 yrs and 4.9 months
Net present Rate of return (IRR) for :
Machine – I

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 10,00,000

P.V. factor = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 = 3,01,500
= 3.3167
PV factor falls between 15% and 16%
Present value of cash inflow at 15% and 16% will be:
Present value at 15% = 3.353 ×3,01,500=10,10,930
Present value at 16% = 3.274 ×3,01,500= 9,87,111

15,00,00
IRR = 15+ = 3.8199
3,93,500
Present value of cash inflow at 14% and 15% will be:
Present value at 14% = 3.888 ×3,93,500 = 15,29,928
Present value at 15% = 3.785 ×3,93,500 = 14,89,398

15,29,928−15,00,000 29,928
IRR = 14+ 15,29,928−14,89,398 × (15 − 14) = 14 + 40,530 × 1 = 14.7384% = 𝟏𝟒. 𝟕𝟒%
(ii)Advise to the management
Ranking of machines in terms of the three methods
Machine I Machine II

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Discounted I II
Net present value II I
Internal Rate of return I II
Advise: Since machine – I has better ranking than machine – II, therefore machine-I
should be selected.

Q.15 A company has to make a choice between two machines X and Y. The two
machines are designed differently , but have identical capacity and do exactly the
same job. Machine ‘X’ cost Rs. 5,50,000 and will last for three years. It costs Rs. 1,25,000
per year to run. Machine ‘Y’ is an economy model costing Rs. 4,00,000, but will last for
two years and costs Rs. 1,50,000 per year to run. These are real cash flows. The costs re
forecasted in Rupees of constant purchasing power. Opportunity cost of capital is
12%. Ignore taxes. Which machine company should buy?
PVIFO .12
PVIFA0.12%.2YRS = 1.6901
PVIFA0.12%.3YRS= 2.4019
Solution:
Statement Showing The Calculation Of Annualized NPV
Particulars Yrs PV factor Machine X Machine Y
Amt. PV Amt. PV
Purchase price 0 1 5,50,000 5,50,000 4,00,000 4,00,000
Cash outflow for 1-3 1-3 2,4019 1,25,000 3,00,238 - -
yrs 1-2 1.6901 - - 1,50,000 2,53,515
Cash outflow for 1-2 8,50,238 6,53,515
yrs 3/2 2.4019/1.6901 2.4019 1.6901
PV of cash outflow
Annuity factor 3,53,985 3,86,672
Annualized present
value
[PV/Annuity factor]
Recommendation: Machine X should be purchased sine its annualized present value
of cash outflow is less than that of machine Y.

Q.16 A Ltd. is considering the purchase of a machine which will perform some
operation which are at present performed by workers. Machine X and Y are
alternatives models. The followings details are available.
Machine X(Rs.) Machine Y(Rs.)
Cost of machine 1,50,000 2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance p.a. 7,000 11,000
Estimated cost of indirect material p.a. 6,000 8,000
Estimated saving in scrap p.a. 10,000 15,000
Estimated cost of supervision p.a. 12,000 16,000
Estimated saving in wages p.a. 90,000 1,20,000
Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the
alternative according to:
(i)Average rate of return method and
(ii)Present value index method assuming cost of capital being 10%
(The present value of re. 1.00 @ 10% p.a. for 5 years is 3.79 and for 6 years is 4.354)
Solution:
Evaluation of Alternative

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𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒏𝒏𝒖𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆

(i)Average Rate of return (ARR) = 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

31,500 42,000
Machine X = × 100 = 42%. machine Y = × 100= 35%.
75,000 1,20,000
Decision : Machine X is better.
(ii)Present value index method:
Present value = Annual cash inflow P.V. factor @ 10%
Machine X = 61,500 ×3.79 = Rs. 2,33,085
Machine Y = 82,000 ×4.354 = Rs. 3,57,028

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒
P.V. Index = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠

2,33,085 3,57,028
Machine X = 1,50,000 = 1.5539 Machine Y = 2,40,000= 1.4876
Decision: Machine X is better.
Q.17 ANP Ltd. is providing the following information:
Annual cost of saving Rs.96,000
Useful life 5 years
Salvage Value zero
Internal rate of return 15%
Profitability index 1.05
Table of discount factor:
Years
Discount 1 2 3 4 5 Total
15% 0.870 0.756 0.658 0.572 0.497 3.353
14% 0.877 0.769 0.675 0.592 0.519 3.432
13% 0.886 0.783 0.693 0.614 0.544 3.520
You are required to calculated:
(i)Cost of the project
(ii)Pay back period
(iii)Cost of capital
(iv)Net present value of cash inflow.
Solution:
(i)Cost of project ‘M’
PV OF CASH INFLOW = COST OF THE PROJECT
PVAF@15%,5YRS x CFAT = CODY OF PROJECT
3.353 x 96000 = COST OF PROJRCT
Cost of the project = Rs. 3,21,888

(ii)Payback period
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑅𝑠.3,21,888
Payback period = 𝐴𝑛𝑛𝑢𝑎𝑙 cost 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 = 96,000
= 3.353 years
(ii)Cost of capital
𝑆𝑢𝑚 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
Profitability index =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡

𝑆𝑢𝑚 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

1.05 = 3,21,888
Sum of discounted cash inflows = Rs. 3,37,982.40
Since, annual cost saving = Rs. 96,000
𝑅𝑠.3,37,982.40
Hence, cumulative discount factor for 5 years = 96,000
= 3.52065

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From the discount factor table, at discount rate of 13% the cumulative discount
factor for 5 years is 3.52065.
Hence, Cost of capital = 13%
(iv)Net present Value (NPV)
NPV = Sum of present values of cash inflows- Cost of the project
= Rs. 3,37,982.40 – Rs. 3,21,888 = Rs. 16,094.40.

Q.18 SS Limited is considering the purchase of a new automatic machine which will
carry some operation which are at present performed by manual labour ,NM – A1
and NM – A2, two alternative models are available in the market. The followings
details are collected:
Machine
NM-A1 NM-A2
Cost of machine (Rs.) 20,00,000 25,00,000
Estimated working life 5 years 5 years
Estimated saving in direct wages per annum (Rs.) 7,00,000 9,00,000
Estimated saving in scrap per annum (Rs.) 60,000 1,00,000
Estimated additional cost of indirect material per annum (Rs.) 30,000 90,000
Estimated additional cost of indirect labour per annum (Rs.) 40,000 50,000
Estimated additional cost of repairs & maintenance per annum 45,000 85,000
Depreciation will be charged on a straight line method. Corporate tax rate is 30
percent and expected rate of return may be 12 percent.
You are required to evaluate the alternative by calculating the:
(i)Pay-back period
(ii)Accounting (Average) Rate of return and
(iii)Profitability index or P.V. Index (P./V. factor for Rs. 12% 0.893;
0.797;0.712;0.636;0.567;0.507)
Solution:
Depreciation of machine NM – A 1 = 20,00,000/5 = 4,00,000
Depreciation on machine NM – A 2 = 25,00,000/5 = 5,00,000
Evaluation Of Alternative
Particulars Machine NMA Machine NMA
(Rs.) (Rs.)
Annual savings:
Direct wages 7,00,000 9,00,000
Scraps 60,000 1,00,000
(A)Total Savings 7,60,000 10,00,000
Annual Estimated Cash Cost :
Indirect Material 30,000 90,000
Indirect Labour 40,000 50,000
Repairs and maintenance 45,000 85,000
(B)Total Cost 1,15,000 2,25,000
(C)Annual Cash Savings (A – B) 6,45,000 2,75,000
Less: Depreciation 4,00,000 5,00,000
Annual savings before tax 2,45,000 2,75,000
Less: Tax @ 30% 73,500 82,5000
Annual Savings /profits after tax 1,71,500 1,92,500
Add: Depreciation 4,00,000 5,00,000
Annual Cash Inflows. 5,71,500 6,92,500
𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠
(i)Payback period = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

20,00,000
Machine NM A1 = 5,71,500
= 3.50 years

25,00,000
Machine NM- A2 = = 3.61 years
6,92,500
Decision : Machine NM – A1 is better.

𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘

(ii)Profitability index or PV index= 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
Present value cash inflow = Annual cash inflow ×PV factor at 12%
Machine NM – A1 = 5,71,500 × 3.605 = Rs. 20,60,258
Machine NM – A2 = 6,92,500 × 3.605 = Rs. 24,96,463
20,60,258
Machine NM – A1 = 20,00,000 = 1.03

24,96,463
Machine NM – A2 = 25,00,000 = 0.9
Decision : Machine NM – A1 is better.
Q.19 PQR company ltd. is considering to select a machine out of two mutually
exclusive machine. The company cost of capital is 12 per cent and corporate tax
rate is 30 per cent. Other information relating to both machines is as follows:
Machine – I Machine – II
Cost of machine Rs. 15,00,000 Rs.20,00,000
Expected life 5 yrs 5 yrs
Annual income (Before tax and depreciation) Rs. 6,25,000 Rs. 8,75,000
Your are required to calculate: Discounted pay back period ; Net present value ;
profitability index. The present value factor of Rs. 1 @ 12% are as follows:

Year 01 02 03 04 05
PV factor @ 12% 0.893 0.797 0.712 0.636 0.567
Solution:
Discounted Payback Period
Machine – 1
(15,00,000−12,67,056)
Discounted payback period = 3 + 3,35,490
= 3 + 0.6943 = 3 Years 8.28 months.
Machine – II
(20,00,000−17,59,466)
Discounted payback period = 3 + = 3 + 0.5163
4,65,870
= 3 years 6.24 months.
(ii)Net present value (NPV)
NPV of machine – I = 19,01,639 – 15,00,000 = Rs. 4,01,639
NPV of machine – II = 26,40,664 – 20,00,000 = Rs. 6,40,664
(iii)Profitability index
NPV of machine – I = 19,01,639/15,00,000 = 1.268
NPV of machine – II = 26,40,664/20,00,000 = 1.320
Method Machine-I Machine-II Rank
Discounted payback period 3.69 years 3.52 years II
Net present value Rs.4,01,639 Rs. 6,40,664 II
Profitability index 1,268 1,320 II.

Q.20 APZ limited is considering to select a machine between two machines ‘A’ and
‘B’ The two machines have identical capacity , do exactly the same job but
designed differently.

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Machine ‘B’ is an economy model costing Rs. 6,00,000, having useful life of
two years. It costs Rs. 2,50,000 per year to run.
The cash flows of machine ‘A’ and ‘B’ are real cash flows. The costs
forecasted in rupees of constant purchasing power. Ignore taxes.
The opportunity cost of capital is 10%. The present value factors at 10% are:
Year t1 t2 t3
PVIF0.10.1 0.9091 0.8264 0.7513
PVIFA0.10.2 = 1.7355
PVIFA0.10.5 = 2.4868
Which machine would you recommend the company to buy?
Solution:
Statement Showing Evaluation Of Two Machine
Particulars Machine A Machine B
Running cost of machine p.a. (Rs.) 1,30,000 2,50,000
Cumulative present value factor @ 10% 2.4868 1.7355
PSresent value of running cost (Rs.) 3,23,284 4,33,875
Purchase cost : (Rs.) 8,00,000 6,00,000
Cash outflow of machines (Rs.) 11,23,284 10,33,875
Equivalent present value of annual cash outflow (Rs.) 4,51,699 5,95,722
Recommendation: The company should buy machine A since its equivalent cash
outflow is less than that of machine B.
Note : Tax saving on depreciation has been ignored in the absence of tax rate.

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

CHAPTER 2

RISK & UNCERTAINTY IN CAPITAL BUDGETING

INTRODUCTION

Basic difference between Risk vs Uncertainty

General!y, the two terms "Risk" and "Uncertainty" are used inter—changeably. However,
the points of difference are —

Risk Uncertainty
1. It is the possibility of deviation from It is a situation in which something is
expected earnings or expected not known, or something that is not
outcome. It is the variability in terms of known or certain.
actual returns comparing with the
estimated returns.
2. Probability Distribution of Cash Flow No information is known to
is known. So,when Cash Flows involve risk, formulate probability distribution of
Probability can be assigned for each Cash Flows.
possible Cash Flow.

Need for recognising Risk in Capital Budgeting Decisions:

Risk Adjustment is necessary —

1. To know the real value of the Cash Inflows,

2. To check whether the Project generates surplus over and above the
Opportunity Cost of Capital,
3. To evaluate whether the Returns out of the project are
proportionate/commensurate with the risks borne,

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 K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

4. To examine whether the Cost of Capital used for discounting sufficiently covers
the Risk and Uncertainty,
5. To check whether it is worth investing in the project over the other investment
options available.

Sources of Risk

In relation to Capital Budaetino, some sources of risk are —

Item Description Examples

These are risks specifically related to A New Project whose Target
a particular project. It includes risk as Customers are abroad, has
to completion of the project in Foreign Exchange Rate
1. Project Specific scheduled time, error of estimation Risk, which may not be
Risk in resources and allocation, applicable if all Target
estimation of Cash Flows, etc. Customers are in Home Country.

These are Risks which arise Different Entities in the same sector
due to Entity—specific factors, have different risk profile, e.g. 2 or
like change in Key more Airline Companies, 2 or
2. Company Specific Management Personnel, more Banks, have different risk
Risk
downgrading of Credit Rating, profiles.
cases for legal violations,
disputes with workers, etc.

3. Industry Specific These are Risks which affects the Fuel Price Variations have an
Risk whole industry in which the Entity impact on the entire
operates, like regulatory restrictions Transportation Industry, Airline
on industry, changes in Industry, etc.
technologies, etc.
4. Market Risk These are Risks that arise due A project for Smartphone
to market—related production h higher risk based
conditions like changes in demand on market demand
conditions, availability and access factors, than a Pharma product.
to resources, etc.

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 K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

5. Competi tion Risk These are Risks related with Same as above.
competition in the market in which [Note: Generally, Market Risk and
an Entity operates, and includes Competition Risk are considered to
factors like risk of entry of rivals, be the
product dynamism, change in taste same.]
and preference of consumers etc.
6. Macro - Economic These are Risks which are related Availability or Non—Eligibility of GST
Risk with macro—economic conditions Input Tax Credit on certain items,
7. International Risk like
Thesechanges
are Risksinrelated
monetary withpolicies
global has an impact
Restriction on onoutsourcing
the product of
by RBI, changes
economic in fiscal policies,
conditions, like prices
jobs toand hence themarkets,
overseas Project's Risk.
inflation, changes
restriction in GDP, changes
on free trade, change in "Most
in savings and
restrictions net
on disposable
market
income, etc.
access, recessions, bilateral Preferred Nation"status, etc
agreements, political has an impact on related Foreign
and geographical Projects.
conditions, etc.

Statistical Concepts in Risk Analysis

The following concepts and principles are used in Risk Analysis —

Concept Computation
 Probability (P) is a measure about the chances that an Event will occur.
 The Value of Probability ranges from 0 to 1.
Probability  When an event is certain to occur, its' Probability will be 1 and when there is no
chance of happening of an event, its' Probability will be 0.

Expected Value = Given Value of an Event x Probability or Chance of that Event's

occurrence. Thus, using Probability Principles, the Expected NPV (E.NPV) of a Project may
be computed as under —
Expecte
d Value 1. Expected Cash Flow (E.CF) = Given Cash Flow x Probability (P) of that Cash Flow.
2. Expected Net Present Value (E.NPV) = Sum Total of (Expected Cash Flows x
Appropriate PVF)
Note: This Expected Value (E.CF or E.NPV) is also referred as Mean CF or Mean
NPV.
Variance is the measurement of difference (dispersion) between the average of the data
Varianc set from every number of the data set. Variance and Standard Deviation is calculated in
e and the following manner —

Standard 1. Com puted Expected Val ue as above. [E.CF or E.NPV as

Deviation required]
2 . Compute Deviation (D) = [Given Value less Expected Value], for every situation /
event.
3 . Compute D2 for every situation / event.
4 . Compute Probability x D2 for every situation / event.
5. Variance (a2) = I (P x D2) = Total of (Px D2) = Total of Values in Step Page
4 above.
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 K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

6. Standard Deviation of the Project (a)= 11(P x D2)

Note: Standard Deviation is a useful measure of calculating the risk associated with the
Estimated Cash Inflows from an Investment.
 Co—Efficient of Variation seeks to calculate the risk borne for every percent of
Expected Return.
Co—  Co—Efficient of Variation —Standard Deviation
Efficient of
Variation Expected Value (E.NPV or E.CF)
 If the Co—Efficient of Variation is lower, the Risk — Return Trade Off is better. Hence, Projects
with Lower Co—Efficient of Variation have lower risk, and vice—versa.

P R O J EC T E V A L UA T I O N T E C H N IQ UE S

R is k Ad ju st ed Di s count R at e

A. Concept
An Appropriate Discount Rate (RD) for a given project is a function of the following factors —

1. Risk Free Return [RF]: This is the Return on Investments with Nil Risk. Generally, Return on
Government Securities / T—Bills may be taken as RF. If a Project with a risk is going to yield a return
lower than RF, the Firm would prefer to invest its funds in the risk—free security. So, RF is the
minimum return expected of any other investment alternative.
2. Risk Premium: Extra Return would mean extra risk. Risk Premium is the additional return that is
expected for any risky investment. It comprises of the following —
(a) Firm's Normal Risk [RN]: This is an adjustment for the Firm's normal risk. This may arise due to its
capital structure, financing policy, management risk, nature of its constitution, etc.
(b) Project's Risk [Rp]: This is an adjustment for the differential risk for a particular project. Example:
For a new project, whose target customers are all abroad, the Cash Flows will be affected by
Exchange Rate fluctuations. Hence, this project will carry a higher risk than other existing projects,
where this exchange rate fluctuation is not a factor.

B. Formula

The Appropriate Discount Rate is the sum of the Risk Free Rate and the Risk Premium.
Mathematically, the relationship is expressed as follows —

1 + RD = (1 + RF) X (1 + RN) x (1 + Rp)

where, (1 + RF) x (1 + RN) constitutes the Firm's Cost of Capital.

So, Risk Adjusted Discount Rate (RADR) (RD) = [(1 + RF) x (1 + RN) x (1 + Rp)] — 1

Or = [(1 + Cost of Capital) x (1 + Premium for Risk)] — 1

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C. Merits and Demerits

Merits Demerits
1. It is simple to understand. 1.It is difficult to estimate Risk Premium associated
withAdjustment
Risk a project, properly.
is estimated on an adhoc,
2. It is easy to operate.
2. unscientific and naive basis.
3. More Risky projects are discounted 3.This method assumes that risk increases with time
using a higher rate, thus Risk Factor at a constant rate, which may not always be
is incorporated in the discounrt rate. valid. It assumes that Investors are always risk—
averse, which may not be true.

D. Identification of Risky Projects

Companies may classify projects based on their type, and apply pre--determined Risk
Premiums, e.g.

1. Replacement Projects in existing business

2. Balancing equipments in existing projects
3. Marginal Increase in capacity
4. Significant increase in capacity (organic growth)
5. Forward or Backward Integration Projects
6. Diversification Projects
7. Foreign Projects, etc.

CERTAINTY EQUIVALENT APPROACH

A. Concept

1. Certainty Equivalent approach recognizes risk in Capital Budgeting, by adjusting the

estimated Cash Flows and then employs the Risk Free Rate to discount the Adjusted Cash
Flows.
2. This approach allows the decision—maker to incorporate his or her Utility Function into the
analysis. In this approach, a set of Riskless Cash Flows is generated in place of the Original
Cash Flows.
3. Thus Certainty Equivalent reflects two aspects, viz. — (i) Variability of Outcomes, and (ii)
Attitude towards Risk.
4. Expected Cash Flows are converted to equivalent riskless amounts. The greater the risk
of Expected Cash Flow, the smaller is the Certainty Equivalent value for receipts, and longer
the Certainty Equivalent value for payment.
5. This approach explicitly recognizes risk, but the procedure for reducing the forecasts of
Cash Flows is implicit, and likely to be inconsistent from one investment to another.
B. Steps

1. Compute Certainty Equivalent Coefficient (CE):

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 K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

t = Certain Cash Flow t NOTE : 0 < t < 1

Risky or Expected Cash Flow t

2. Compute Equivalent Certain Cash Flows (ECF) = Expected Cash Flowt x t

3. Use Rf (i.e. Risk Free Return) for discounting ECF as above, to compute PV, NPV, etc.
(Note: Cost of Capital should not be used for discounting, since Risk is already adjusted
in computing ECF).
Note: For IRR based evaluation, IRR should be compared with RF rather than the
Firm's Required Rate of Return or Firm's Cost of Capital.
C. Merits and Demerits

Merits
1. It is simple to understand.
2. It is easy to operate.
3 It can be easily applied for different
risk levels relating to different Cash
Flows. NPV can bere—computed
based on revised CE for that year.
Demerits
There is no objective or scientific method to
determine CE Values.
Risk Adjustment is done on an adhoc,
unscientific and Values are highly subjective, and
differ from person to person.
This method assumes that Investors are always
risk—averse, which may not be true. This Method
assumes that a Series of CE Values will be
applicable for various years in a project, which
may not always be true.

D. Certainty Equivalent vs RADR Approach

Point Certainty Equivalent Method Risk Adjusted Discount Rate Method

Factor This Method adjusts the Cash Flows of a This Method adjusts the Discount Rate
adjusted Project for risk. (WACC) for risk.

Time effect Cash Flows are adjusted for risk over time This method assumes that risk increases with
under this method. time at a constant rate.

Ease It is difficult to specify a series of CE Co— It is comparatively easier to adjust Discount

efficients. Rates.
This is superior to the Risk Adjusted Discount Risk is adjusted only in the Discount Rates, and is
Rate approach, as it can measure risk not recognised in the Cash Flows. However,
Accuracy
more accurately. Cash Flows are more uncertain than the Cost
of Capital.

SENSITIVITY ANALYSIS

A. Concept
1. Sensitivity Analysis is a study which determines how changes in the values of Parameters
(called Variables) affect the Output (i.e. Decision or Result, e.g. NPV / IRR / PI of a Project)
of a model.

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 K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

2. Sensitivity Analysis shows the measure of sensitivity of a decision / result, due to changes
in the values of one or more Parameters / Variables.
3. Sensitivity Analysis in Capital Budgeting seeks to identify the effect of changes in any one
variable, e.g. Initial Investment, Project Life, Discount Rate, Product Sale Price p.u. Product
Cost p.u. Product Sale Quantity, etc. on the NPV / IRR / PI, by keeping all other variables
constant.
4. Sensitivity Analysis seeks to provide the decision maker with information concerning —
(a) the behaviour of the measure of economic effectiveness due to errors in estimating
various values of parameters, and
(b) the potential for reversal in the preferences as for economic investment alternatives.

B. Steps

Step Description
1 Compute NPV/IRR/PI of the Project, based on the given value of variables (This is called Base
2 Case Analysis).
Identify Key Assumptions / Parameters (Variables) made in the Base Case Analysis.

3 Change one Variable at a time, and find (re—compute) the NPV, IRR or PI after the change.
4 Determine the extent of change in NPV / IRR / PI, due to change in variables, i.e. extent of
5 sensitivity the conclusions based on findings obtained in Step 4.
Summarize
C. Merits

(a) This analysis seeks to identify the effect of all critical factors one at
a
(b)time.This analysis is simple to understand and implement.

D. Demerits

a) It assumes variables to be completely unrelated to each other. However, only when

the
combined effect of changes in the set of inter—related variables is considered, a proper
conclusion can be arrived at.

b) While using Sensitivity Analysis, the Financial Analyst may use

different
uncertain values
variables of the
purely on adhoc basis. Assigning values in such an arbitrary fashion is
unscientific.
(c)This analysis does not analyse the probability of changes in the variables.
(d) This analysis provides only a rough idea of "what if", and does not actually aid decision-
making.

Scenario Analysis

A. Concept

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 K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

1. Scenario Analysis is an analysis of the NPV / IRR of a Project under a series of specific
scenarios, considering the effect of changes in more than one variable at a time, e.g.
an Increase in Sale Price and Decrease in Cost per unit.
2. This Analysis seeks to establish "worst case" (most pessimistic levels) and "best case" (most
optimistic levels) scenarios, so that the whole range of possible outcomes can be
considered.

B. Steps

Step Description
1 Identify the various sources of uncertainty for the future success of the project. These are the
basic factors around which scenarios will be built.
2 Determine the scenarios for each factor, viz. Best Case, Average or Most Likely, and Worst
Case.
Estimate the values of each of the variables in the Investment Analysis (Revenues, Growth,
3
Operating Margin, etc.) under each scenario.

4 Assign Probability of occurrence for each of the scenarios, based on macro and micro
factors.
5 Compute the NPV and IRR under each scenario.
6 Arrive at the appropriate decision on the Project, based on the NPV under all scenarios,
rather than just Base Case NPV or Mean NPV.

C. Merits and Demerits

Merits Demerits
This analysis brings in the probabilities of There are no clearly delineated scenarios in
changes in key variables. many cases.

If there are many important variables to

This analysishelps the Analyst to
change more than one variable at a time.
D. Sensitivity Analysis vs Scenario Analyis
consider, there may give rise to a huge
number of scenarios for analysis.
There is no clear guiding principle to
indicate how the decision—maker will use
results of Scenario Analysis.

Point Sensitivity Analysis Scenario Analysis

No. of This Method recognises the effect of This Method recognises the effect of
Variables change in variables, one at a time. simultaneous change in two or more
variables.

Proba— This Method does not involve the use of This Method may require the assignmen
bility probability as such. of Probability for each scenario, for further
evaluation.

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K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

Best or This Method does not evaluate whether This Method involves the identification of
Worst the effect of change in variable is "best" "Best Case" and "Worst Case" NPVs, in
or "worst". certain situations.

SOLVED PROBLEMS
1. Expected NPV, Std Deviation, Real & Nominal CFs, etc
Prob. 1. 1. Expected NPV, Standard Deviation - Basics

A Company is considering two mutually exclusive Projects X and Y. Project X costs Z 30,000 and
Project Y costs Z 36,000. The NPV Probability Distribution for each Droiect is given below:

Project X Project Y
NPV Estimate (Z) Probability NPV Estimate (Z) Probability
3,000 0.1 3,000 0.2
6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2

1. Compute the Expected Net Present Value of Projects X and Y.

2. Compute the risk attached to each Project, i.e. Standard Deviation of each Probability
Distribution.
3. Which Project is more risky and why?
Solution: (in 000s) Project X Project Y

NPV Prob=P PxNPV D D2 PxD2 NPV Prob=P PxNPV D D2 PxD2

3 0.1 0.3 3-9 = -6 36 3.6 3 0.2 0.6 3-9 = -6 36 7.2

6 0.4 2.4 6-9 = -3 9 3.6 6 0.3 1.8 6-9 = -3 9 2.7
12 0.4 4.8 12-9 = 3 9 3.6 12 0.3 3.6 12-9 = 3 9 2.7
15 0.1 1.5 15-9 = 6 36 3.6 15 0.2 3.0 15-9 = 6 36 7.2
Total E.NPV 9 14.4 9 19.8
Expected NPV (E.NPV) = 9 Expected NPV (E.NPV) = 9
Standard Deviation = 3.79 Standard Deviation
= VP x D2 = V14.40 = VP x D2 = = -49.80 = 4.45
Standard Deviation Standard Deviation
CoefficientofVariation = - 0.42 CoefficientofVariation = - 1.25
Expected NPV Expected NPV

Observation: Project Y is more risky, due to higher Standard Deviation and higher Coefficient of Variation.

2. Expected NPV and Risk - Basics

Prob. 2. XYZ is planning to procure a machine at a cost of Z40 Lakhs. The Expected Cash Flow
after Tax for next 3 years is-('Lakhs

Year 1 Year 2 Year 3

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 K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

CFAT Probability CFAT Probability CFAT Probabilit

12 0.1 12 0.1 18 0.2
y
15 0.2 18 0.3 20 0.5
18 0.4 30 0.4 32 0.2
32 0.3 40 0.2 45 0.1
The Company wishes to consider all possible risks factors relating to the Machine. The Company wants to
know -

1. Expected NPV of this proposal, assuming independent probability distribution with 7% Risk Free Rate of
Interest.
2. Possible Deviations on Expected Values.

Year 1 Year 2 Year 3

CF Prob=P PxCF PxCF2 CF Prob=P PxCF PxCF2 CF Prob=P PxCF PxCF2

12 0.1 1.2 14.40 12 0.1 1.20 14.40 18 0.2 3.60 64.80
15 0.2 3.0 45.00 18 0.3 5.40 97.20 20 0.5 10.00 200.00
18 0.4 7.2 129.60 30 0.4 12.00 360.00 32 0.2 6.40 204.80
32 0.3 9.6 307.20 40 0.2 8.00 320.00 45 0.1 4.50 202.50
Total 21 496.20 26.60 791.60 24.50 672.10

Calculation of Net Present Value

Y PVF 7% Expected CF PV of Exp.CF

SD = VP x CF - (P x CF)
2 2
PV of SD (PV of SD)2

1 0.9346 21.00 19.6266 1 1496.20 - (21)2 = 7.43 6.94 48.16

2 0.8734 26.60 23.2324 V791.60 - (26.6)2 = 9.17 8.01 64.16

3 0.8163 24.50 19.9994 V672.10 - (24.5)2 = 8.48 6.92 47.88

62.8584 160.20
Less: Investment (40.0000)
NPV 22.8584 SD = \/(PV of SD)2 12.66

2. Risk Adjusted Discount Rate

Choice of Discount Rate - Risk Premium Model

Prob. 3. From the following particulars, ascertain the appropriate Discount Rate -

(a) Project A: Risk Free Rate is 10%. The project is to be funded with a Debt Equity Mix of 9 : 1, which is
significantly higher than the existing Debt Equity Mix of the Company. A premium of 9% is
considered appropriate for such a high risk debt equity mix. The project offers little or no risk, which
is comparable to investment in Government Bonds. Such an investment commands a risk
discount of 2%.
(b) Project B: Existing Cost of Capital is 15%. The Firm adheres to Sustainable Growth Rate model. The
proposed investment is considered to be riskier than the Firm's other investments. The Management
considers a risk premium of 5% for such projects.

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 K.J.SOMAIYA COLLEGE OF SCEINCE AND COMMERCE T.Y.B.M.S.

(c) Project C: The Cash Inflows from the Project have been estimated at the most conservative basis.
Inflows have been measured based on only 80% of guaranteed orders. Risk Free Rate is measured
at 8%. Risk Premium for the class to which the Firm belongs is 7%. Risk Premium for the project is
considered at 3%.

Solution:

1. Appropriate Discount Rate

Project Discount Rate (Rp) = Risk Free Rate of Return (RF) + Risk Premium for the Class of Company (or)
Financing Structure (Re) + Risk Premium for the Project (Rp)

So, 1 + Rp = (1 + RF) x (1 + x (1 + Rp) Where, (1 + RF) x (1 + Rd constitutes the Firm's Cost of Capital i.e. (1 + Ko)

2. Computation of Project Discount Rate appropriate for each Project

Project Computation Discount Rate

1+Rp = (1 + RF) x (1 + Rd x (1 + Rp)
A = (1 + 10%) x (1 + 9%) x (1 - 2%) = 1.10 x 1.09 x 0.98 17.50%
1+Rp = 1.17502 So, Rp = 1.17502 - 1 = 0.175
1 + Rp = [(1 + RF) x (1 + Rc)] x (1 + Rp)

B = (1 + Ko) x (1 + Rp) 8.75%

= (1 + 15%) x (1 + 5%) = 1.15 x 1.05
1 + Rp = 1.875 So, Rp = 1.875 - 1 = 0.875
1+ Rp = [(1 + RF) x (1 + Rc)] x (1 + Rp)
C = (1 + 8%) x (1 + 7%) = 1.08 x 1.07 15.56%
1+Rp = 1.1556 So, Rp = 1.1556 - 1 = 0.1556
Note: Risk Premium for Project C 3% is not considered, since the Cash Inflows themselves have been taken only at a
conservative estimate of 80% of guaranteed orders, which implies the risk associated with the Project have been
eliminated while considering the Cash Flows themselves.

Risk Adjusted Discount Rate

Prob. 4. Determine the risk adjusted Net Present Value of the following projects -

Particulars X Y Z
Net Cash Outlays (Z) 2,10,000 1,20,000 1,00,000
Project Life 5 years 5 years 5 years
Annual Cash Inflow (Z) 70,000 42,000 30,000
Coefficient of Variation 1.2 0.8 0.4

The Company selects the Risk Adjusted Rate of Discount, on the basis of the Coefficient of Variation -

Coefficient of Variation 0.0 0.4 0.8 1.2 1.6 2.0 More than 2
Risk - Adjusted Rate of Return 10% 12% 14% 16% 18% 22% 25%
PV Factor 1 to 5 years at Risk Adjusted Rate of Discount 3.791 3.605 3.433 3.274 3.127 2.864 2.689

Solution: Computation of Risk Adjusted Net Present Value

Particulars Project X Project Y Project Z

Co-efficient of Variation 1.20 0.80 0.40
Therefore, Risk Adjusted Rate of Return 16% 14% 12%
PV of Annuity Factor for 5 Years 3.274 3.433 3.605

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Annual Cash Inflows Z 70,000 Z 42,000 Z 30,000

PV of Cash Inflows 2,29,180 1,44,186 1,08,150
[Annual Cash Inflow x PV of Annuity Factor] [70 x 3.274] [42 x 3.433] [30 x 3.605]
Less: Investment in Year 0 (2,10,000) (1,20,000) (1,00,000)
Net Present Value 19,180 24,186 8,150

Risk Adjusted Discount Rate

Prob. 5. MNL Ltd is considering investment in one of three mutually exclusive projects: AB, BC,
CD. Company's Cost of Capital is 15%.Risk-Free Rate is 10%. Tax is 34%. MNL has gathered the
following basic Cash Flows &Risk Index data for each project:

Projects AB BC CD
Initial Investment 12,00,000 10,00,000 15,00,000
Risk Index 1.8 1 0.6
Year 1- 4 Yr 1 Yr 2 Yr 3 Yr 4 Yr 1 Yr 2 Yr 3 Yr 4
Cash Inflows 5,00,000 5,00,000 4,00,000 5,00,000 3,00,000 4,00,000 5,00,000 6,00,000 10,00,000
Using Risk Adjusted Discount Rate, determine risk adjusted NPV for each of the Project. Which
Project should be accepted?

Solution:

1. Computation of Market Return and Risk Adjusted Discount Rate based on CAPM

Under CAPM, Expected Return = Risk Adjusted Discount Rate

= Market Return + (Risk Index x Risk Premium)

Risk Premium = Cost of Capital of the Company (-) Risk Free Rate of Return = 15% - 10% = 5%

Risk Adjusted Discount Rate

Project AB 10% + (1.8 x 5%) = 19%

Project BC 0% + (1.0 x 5%) = 15%

Project CD 10% + (0.6 x 5%)= 13%

2. Computation of NPV of the Projects

Project AB Project BC Project CD

Yr PVAF 19% CF DCF Yr PVF 15 /0
0 CF DCF Year PVF 13% CF DCF
1-4 2.6385 5,00,000 13,19,250 1 0.8696 5,00,000 4,34,800 1 0.8849 4,00,000 3,53,960
- - - - 2 0.7561 4,00,000 3,02,440 2 0.7831 5,00,000 3,91,550

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- - - - 3 0.6575 5,00,000 3,28,750 3 0.6931 6,00,000 4,15,860

- - - - 4 0.5718 3,00,000 1,71,540 4 0.6134 10,00,00 6,13,400
PV of Cash Inflows 13,19,250 12,37,530 0 17,74,77
Less: Initial Investment 12,00,000 10,00,000 15,00,00
0
Net Present Value 1,19,250 2,37,530 2,74,770
0
Conclusion: Since the NPV of Project CD is greater than that of the other Projects, it is
preferable.

Real vs Nominal Cash Flows — Discount Rate

Prob. 6. Following are the expected Nominal Cash Flows of Project A, requiring an initial outlay
of Rs 1,00,000.

Year 1 2 3 4
Cash Flow Rs 30,000 Rs 60,000 Rs 40,000 Rs 10,000
If the Cost of Capital of the Company in a static economy is 8%, and Inflation Rate is 5%, what is the
appropriate Discount Rate for the Project? Should the Project be accepted if the minimum desired
Benefit Cost Ratio is 10% above Indifference Point?

Solution: 1. Determination of Discount Rate

Since cash-flows are expressed in Nominal Terms (after including the impact of
inflation), the discount rate chosen should also be Nominal Discount Rate, i.e. Real
Discount Rate adjusted for inflation.

Hence, (1 + RN) = (1 + RR) x (1 + I )

Where, RN = Nominal Discount Rate (1 + RN) = (1 + 8%) x (1 + 5%)

RR = Real Discount Rate (Without effects of inflation)= 1.08 x 1.05 = 1.134

I = Inflation Rate

RN = 1.134 - 1 = 0.134 or 13.4%

Therefore, appropriate Discount Rate is 13.40% for evaluating the project.

2. Evaluation of Proiiect

Particulars YR Disc. Factor @ 13.4% Cash Flow DCF

Annual Operating Cash Inflow 1 0.882 30,000 26,460
2 0.777 60,000 46,68
3 0.686 40,000 27,440
4 0.605 10,000 6,050
Total Present Value of Cash Inflows 1,06,570
Less: Initial Investment 0 1.000 1,00,000 (1,00,000)
Net Present Value 6,570

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Profitability index = PV of cash inflows / PV of outflows

= 106570 / 100000 = 1.07
Desired profitability index = indifeerence point + 10% = 1 + 10% = 1.10
Since Project PI (1.07) is lower the minimum desired PI (1.10), the Management may not
opt for the project.

Prob. 7. NPV Computation — with Real and Nominal Cash Flows N 18 (New)

A Company is evaluating a Project that requires Initial Investment of Rs 60 Lakhs in

Fixed Assets and Rs 12 Lakhs towards Additional Working Capital. The Project is
expected to increase Annual Real Cash Inflow before Taxes by Rs 24,00,000 during its
life. The Fixed Assets would have Zero Residual Value at the end of life of 5 years. The
Company follows Straight Line Method of Depreciation which is expected for Tax
purposes also. Inflation is expected to be 6% per year. For evaluating similar Projects,
the Company uses Discounting Rate of 12% in real terms. Company's Tax Rate is 30%.

Advise whether the Company should accept the Project, by calculating NPV in real
terms. Take PVF upto 3 places after decimal.
SOLUTION:
If the Annual Cash Flows are Nominal Cash Flows, the Evaluation of Project will be as under - in Lakhs

Year Nominal CF PVF @ 60/0 Real CF = Nom CF x PVF @ 6% PVF @ 12% DCF = Real CF x PVF @ 12%
1 16.80 0.943 15.84 0.893 14.15
2 16.80 0.890 14.95 0.797 11.92
3 16.80 0.840 14.11 0.712 10.05
4 16.80 0.792 13.31 0.636 8.46
5 16.80 0.747 12.55 0.567 7.11
Total Present Value of Cash Inflows 51.69

Evaluation of Project (Z in Lakhs)

P a r ti c u l a r s CASH FLOW PVF 12% DCF

Present Value of Cash Inflows 51.690

Add: Tax Savings on Depreciation 60 / 5 YRS x30% = 3.60 3.605 12.978

Recovery of Working Capital 12.00 0.567 6.804

Total Present Value of Cash Inflows 71.472

Less: Initial Investment (60 + 12 ) = 72 Lakhs (72.00)
Net Present Value (0.528)
Recommendation: Since NPV is Negative, this Project is not preferable.

NET PRESENT VALUE - INFLATION EFFECT ON CASH FLOWS

Prob. 8. Krishnan Ltd requires Z 15,00,000 for a new project. Useful Life of Project is 3 years.
Salvage Value - Nil. Depreciation is Z 5,00,000 p.a. Applicable Tax Rate is 35%. Assume Cost of
Capital to be 14% (after tax).

Projected Revenues & Costs (excluding Depreciation) ignoring Inflation Rates for Revenues & Costs are as
Year inflation:
1 2 3 Year under: %
Revenue Costs %
Revenues (Z) 10,00,000 13,00,000 14,00,000 1 9 10

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Costs in (Z) 5,00,000 6,00,000 6,50,000 2 8 9

3 6 7
Show amount to the nearest rupee in calculations. You are required to calculate Net Present Value of
the Project.

SOLUTION:

1. Computation of Nominal Cash Flows i.e. after Inflation Note: Nominal Cash
Flow = Real Cash Flow x (1 + Inflation Rate

Year Revenue Inflation Factor Revenue Cost Inflation Factor Cost

(Real) (Nominal) (Real) (Nominal)
1 10,00,000 1.09 = 1.09 10,90,000 5,00,000 1.10 = 1.10 5,50,000
2 13,00,000 1.09 x 1.08 = 1.1772 15,30,360 6,00,000 1.1 x 1.09 = 1.199 7,19,400
3 14,00,000 1.09 x 1.08 x 1.06 = 1.2478 17,46,965 6,50,000 1.1 x 1.09 x 1.07 = 1.2829 8,33,905

2. Computation of Net Present Value

Year Revenue Cost Depn. PBT Tax @ 350/0 PAT CFAT PVIF 14% DCF
1 10,90,000 5,50,000 5,00,000 40,000 14,000 26,000 5,26,000 0.877 4,61,302
2 15,30,360 7,19,400 5,00,000 3,10,960 1,08,836 2,02,124 7,02,124 0.769 5,39,933
3 17,46,965 8,33,905 5,00,000 4,13,060 1,44,591 2,68,489 7,68,489 0.675 5,18,730
Total Discounted Cash Inflows 15,19,965
Less: Initial Investment 15,00,000
Net Present Value 19,965
Note: It is assumed that the Cost of Capital is after Inflation

PROBLEMS BASED ON CERTAINITY EQUIVALENT APPROACH

Prob. 9. Certainty Equivalent Approach

The Globe Manufacturing Company Ltd is considering an investment in one of the two mutually
exclusive proposals -Projects X and Y, which require Cash Outlays of 3,30,000 and 3,30,000
respectively. The Certainly -Equivalent (C.E) approach is used in incorporating risk in capital budgeting
decisions. The current yield on Government Bonds is 8% and this may be used as the riskless rate. The
expected Net Cash Flows and their Certainty Equivalents are as follows -

Project X Project Y
Year end Cash Flow Z C.E Cash Flow Z C.E
1 1,80,000 0.8 1,80,000 0.9
2 2,00,000 0.7 1,80,000 0.8
3 2,00,000 0.5 2,00,000 0.7
Required:

(a) Which Project should be accepted?

(b) If Risk Adjusted Discount Rate method is used, which Project would be analyzed with a higher
rate?
1. Computation of NPV

PV Factor Project X Project Y

Year
@ 8% Cash Flow CE Factor Adj. Cash Disc. Cash Cash Flow CE Factor Adj. Cash Disc. Cash
Flow Flow
Flow Flow
1 0.926 1,80,000 0.8 1,44,000 1,33,344 1,80,000 0.9 1,62,000 1,50,012
2 0.857 2,00,000 0.7 1,40,000 1,19,980 1,80,000 0.8 1,44,000 1,23,408
3 0.794 2,00,000 0.5 1,00,000 79,400 2,00,000 0.7 1,40,000 1,11,160

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Present Value of Cash Inflows 3,32,724 3,84,580

Less: Initial Investment
(3,30,000) (3,30,000)

Net Present Value 2,724 54,580

Recommendation: NPV of Project Y is higher. Therefore, Project Y should be accepted and implemented. The certainties
associated with Project Y [2.40] is also higher than that of Project X [2.00], signifying that risk associated with Cash
Flows in Project Y is comparatively lower than Project X. Also, the Project X has a lower NPV against a significantly high
Positive NPV for Project Y.

Application of Risk Adjusted Discount Rate

If Risk Adjusted Discount Rate is used, Project X will be subjected to a higher discount rate than Project Y. This is
because the Certainty Factor associated with Project X is lower than Project Y. This signifies a higher risk association
for Cash Flows in Project X than Project Y.

CERTAINTY EQUIVALENT APPROACH

Prob. 10. The Textile Manufacturing Company Ltd is considering one of two mutually exclusive
proposals, Projects M and N, which require cash outlays of Rs8,50,000 and Rs 8,25,000
respectively. The Certainty-Equivalent (C.E) approach is used in incorporating risk in capital
budgeting decisions. The current yield on Government Bonds is 6% and this is the risk free rate.

The expected Net Cash Flows and their Certainty Equivalents are as follows

Project M Project N
Year end Cash Flow Z C.E. Cash Flow Z C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Required- (a) Which project should be accepted? (b) If risk adjusted discount rate method is used, which
project would be appraised with a higher rate and why?

Solution: 1. Computation of NPV of Project M and N

Year
Project M Project N
PV Factor
Cash Flow CE Factor Adj. CF DCF Cash Flow CE Factor Adj. CF DCF
@ 6%
1 0.943 4,50,000 0.8 3,60,000 3,39,480 4,50,000 0.9 4,05,000 3,81,915
2 0.890 5,00,000 0.7 3,50,000 3,11,500 - 4,50,000 0.8 3,60,000 3,8,400
3 0.840 5,00,000 0.5 2,50,000 2,10,000 5,00,000 0.7 3,50,000 2,94,000
Present Value of Cash Inflows 8,60,980 9,96,315
Less: Initial Investment
(8,50,000) (8,25,000)
Net Present Value 10,980 1,71,315

Recommendation:NPV of Project N is higher. Therefore, Project N should be accepted and implemented. The
certainties associated with Project N [2.40] are also higher than that of Project M [2.00], signifying that risk associated
with cash flows in Project N is comparatively lower than Project M.

2. Application of Risk Adjusted Discount Rate

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If Risk Adjusted Discount Rate is used, Project M will be subjected to a higher discount rate than Project N. This is
because the Certainty Factor associated with Project M is lower than Project N. This signifies a higher risk association
for Cash Flows in Project M than Project N.

SENSITIVITY ANALYSIS
Prob. 11. Sensitivity Analysis for a given change in Variable N 18 (New)
From the following details relating to Project, analyse the Sensitivity of the Project to changes in
the Initial Project Cost, Annual Cash Inflow and Cost of Capital:

Initial Project Cost Annual Cash Inflow Project Life Cost of Capital
! 2,00,00,000 Z 60,00,000 5 years 10%
To which of the 3 Factors, the Project is most sensitive if the Variable is adversely affected by 10%? Cumulative
Present Value Factor for 5 years for 10% is 3.791 and for 11% is 3.696.

SOLUTION : Amounts in Rs Lakhs

Variables Base Case Project Cost Cash Inflow Cost of Capital

Revised Value of Variables 200 + 10% = 220 60 - 10% = 54 10% + 10% = 11%

Disc. Cash Inflow 60 x 3.791 = 227.46 227.46 54 x 3.791 = 204.71 60 x 3.696 = 221.76

Less: Initial Investment (200.00) (220.00) (200.00) (200.00)

Net Present Value 27.46 7.46 4.71 21.76

Change in NPV 27.46 - 7.46 = 20 27.46 - 4.71 = 22.75 27.46 - 21.76= 5.70
20.00 / 27.46 =
of Change 22.75/27.46 = 82.83% 5.70/27.46 = 20.76%
72.83%

Here, % A NPV is highest for change in Annual Cash Inflow. So, the Project is most sensitive to Cash Inflow.

Sensitivity Analysis [ PRACTICE PROBLEM]

Prob. 12. From the following details relating to a Project, analyse the sensitivity of the project to
changes in Initial Project Cost, Annual Cash Inflow and Cost of Capital:

Initial Project Cost Annual Cash Inflow Project Life Cost of Capital
Rs. 1,20,000 Rs 45,000 4 years 10%
To which of the three factors, the Project is most sensitive? (Use Annuity Factors: for 10%= 3.169 and
11%=3.109).

Prob. 13. SENSITIVITY ANALYSIS

Red Ltd is considering a project with the following cash flows in Rs and the cost of
capital is 9%

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Years Cost of Plant Recurring Cost

Savings
0 10,000
1 4,000 12,000
2 5,000 14,000
Measure the Sensitivity of the project to changes in the levels of Plant Value. Running Cost
and Savings (considering each factor at a time) such that NPV becomes zero. Which factor is the most sensitive
to affect the acceptability of the project?

Solution: 1. Computation of NPV with given Variables (Base Case Analysis

Particulars Cash Flows Year PVF @9% Disc. CF

1. Net Savings (Recurring Cost - Savings)
(a) Year1 8,000 1 0.917 7,336
(b) Year2 9,000 2 0.842 7,578
2. PV of Inflows 14,914
3. Less: Cost of Plant (10,000)
4. Net Present Value (NPV) 4,914

2. Measure of Sensitivity due to different factors

Factors Invt Recurring Cost Savings

(4,000x0.917)+(5,000x0.842)=
Rs 10000 (12,000x0.917)+(14,000x0.842)= Z 22,792
(a) Base
Rs 7,878
Rs 14,914 7,878 + 4,914 = Rs 12,792 22,792 - 4,914 = Z 17,878
(b) Value at which NPV="0"

Rs 4,914 Rs 4,914 Rs 4,914

(c) Change between (a)&(b)

Change 49.14% 62.38% 21.56%

Base
(d) SValue
e nsitiv ity -

Conclusion: Hence NPV is most sensitive to Changes in Savings.

Prob. 14. SENSITIVITY ANALYSIS

XYZ Ltd is considering a project for which the following estimates are available —

Particulars Z Sales Volumes Units

Initial Cost of the project 10,00,000 Year 1 20,000
Sales Price / Unit 60 Year 2 30,000
Cost / Unit 40 Year 3 30,000
You are required to measure the sensitivity of the project in relation to each of the following
parameters—

(a) Sales Price/ Unit, (b) Unit Cost, (c) Sales Volume, (d) Initial Outlay, and (e) Project lifetime.
Taxation may be ignored. Discount Rate 10% p.a.

Solution: 1. Computation of NPV with given Variables (Base Case Analysis)

Particulars Cash Flow Years PVIF @ 10% Disc. CF

Cash Inflow [20,000 Units x Profit Rs 20 per Unit] 4,00,000 1 0.909 3,63,600
[30,000 Units x Profit Rs 20 per Unit] 6,00,000 2 0.826 4,95,600
[30,000 Units x Profit Rs 20 per Unit] 6,00,000 3 0.751 4,50,600

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Present Value of Cash Inflows 13,09,800

Less: Initial Investment (10,00,000)
Net Present Value 3,09,800

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