Read the following case situation carefully and answer the questions that

follow.
You have just graduated from a reputed university. You dream is to run own business. So you want to
start your own business firm. Your father is ready to give you amount sufficient to start new project. You
are interested to purchase at least one established franchise. You have narrowed your selection down to
two choices: (1) Franchise A and (2) Franchise B. Franchise A and Franchise B are mutually exclusive
projects. Information related to Franchise A and Franchise B are as follows:

Franchise A

The required equipment will cost Rs 1,900,000. In addition to the equipment cost you have to pay Rs
600,000 for installation. It will need an additional investment of Rs 500,000 in working capital. The new
production unit will generate Rs 1,600,000 sales revenue in each year for 5 years and operating cost
excluding depreciation will be Rs 600,000 in each year. The company will follow the straight line
depreciation method to depreciate the equipment. At the end of the fourth year, equipment will have
zero book value but it will be worth for Rs 900,000 in the market. The company's marginal corporate tax
rate is 30 percent.

Franchise B

Initial investment Rs 2,500,000

Year Cash Flow after Tax (CFAT)

1 950,000
2 850,000
3 750,000
4 650,000
5 400,000

Based on the subjective risk assessments, both Franchises have risk characteristics that require a
return of 10 percent.

a. Why is capital budgeting decision so important to a business firm? Explain.

ANS: Capital budgeting is an important function because it impact is long lasting and is not
easily revocable. for example if we install a plant of soap factory and after one year if the
demand for soap decreases, then we cannot easily trade off existing Plant with another one that
matches the production capacity with market demand. In such cases we have to incur high
depreciation cost, high maintenance cost and other related overhead cost. Similarly Capital
budgeting involves in the huge amount of funds which implies the commitment of high fixed
operating cost and financial costs. Magnitude of the funds involved as result of the capital
budgeting decision depends on the correct forecasting of the demand for the intended
products. Installed capacity may remain idle due to incorrect demand forecast of the intended
 products and company may sustain loss and capital budgeting decision based on incorrect
demand forecast may hamper the existence of a company. So effective capital budgeting may
increase the market share. We can analyze the market demand for our product, forecast the
sale and plan the required capacity of plan. Effective capital budgeting can improve both timing
and quality of required asset acquisition.

b. Explain the different types of capital projects with illustration. Also discuss the steps of capital
budgeting process.
ANS: Following are the types of capital project
Independent projects: in such project, selection of one project does not preclude the selection
of next project i.e. independent projects are those projects whose cash flows are independent
on each other. For example installation of cement factory and installation of sugar mill are
independent projects.

Dependent Project: the projects falling in this category affect the cash flow of each other. I.e.
acceptance of one project compels to accept another project. For example construction of road
and construction of bridge cannot be taken independently.

Mutually exclusive projects: the project in a set is said to be mutually exclusive if only one
project is selected among available projects.i.e in this case of mutually exclusive projects,
acceptance of on project implies the ruling out of others. For example to buy a motorcycle we
have to buy one brand of motorcycle and rejection of other brands.

Replacement Projects: due to wear and tear, advancement of technology, existing machine
need to be replaced with new one. Thus the project falling in this class are classified into two
maintenance of business and cost reduction.

Expansion of the business: expansion may be done in terms of output of existing product, retail
outlet and distribution channel. The available capacity may not be sufficient to meet the
growing demand for existing product. In such case, production capacity has to add to the
existing one in order to meet the growing demand for the product. So management may expand
its business in different geographical regions and open new retail outlets.

Diversification Projects: entering either into the new products or into the new markets is
diversification projects. Former type of diversification requires for the acquisition of new
equipment and plant and latter one requires huge amount of money.

Following are the steps of capital budgeting process

Generation of investment proposals: investment proposal may origin from different sources.
For example, replacement proposal may come up from operational department. Similarly
 expansion proposal may originate at marketing department. Research and development
department may put up the proposal for the department of new product. Any board members
may have an idea about the profitable investment opportunities.

Estimation of cash flows for the proposal: cost and benefits of the investment proposal are
measured in terms of cash flows. After generating the investment proposal, expected cash flows
of the proposed project over the project period are estimated. First, net cash outlay of the
project Is estimated and then expected annual cash flows of the proposed investment project
are worked out. Finally terminal cash flow is worked out for the final year of the project.

Evaluation of the proposals: next step after estimating the cash flows is the evaluation of he
proposals. There is an array of methods for evaluation. Discounted cash flow methods or
undiscounted cash flows are used or in combination of both

Post completion audits of proposals: project proposals should go through different levels of
authority for their final approval. The hierarchy of the authority may run from chief to president
of the corporation. Post completion audit provides the information on forecasting biases, serves
for financial control purposes and guides the future capital investment decision

c. Calculate Net cash outlay (NCO), annual cash flow after tax (CFAT) and final year’s CFAT for
Franchise A

ANS: calculation of initial Investment outlay

Cost of equipment 1900,000

Installation cost 600,000
Investment in working capital 500,000
Initial cash outlays 3000,000

Annual depreciation of equipment

Depreciation basis
Price of equipment 1900,000
Installation cost 600000
Depreciation basis 2500,000

Annual depreciation = total cost – scrap value/n

= (2500000-0)/5 = Rs 500,000
Calculation of annual cash flow

Annual sales revenue 1600,000

Less annual operating cost (600,000)
Earnings before depreciation and taxes(EBDT) 1000,000
Less annual depreciation (500,000)
Earning before tax(EBT) 500,000
Less taxes at 30% (150000)
Earning after tax (EAT)/net income 350,000
Add back annual depreciation 500000
Annual cash flow 850000
Annual CFAT = Rs 850000

Additional cash flow in terminal year

Release of working capital 500,000

Market value of equipment 900,000
Tax gain from sale of equipment (0.3* 900000) (270000)
Additional cash flow in terminal year 1130,000

Final years CFAT = operating cash flow + non operating cash flows

= 850000 + 1130000

= Rs 1980,000

d. Discuss the merits and demerits of payback period. How does the discounted payback period
overcome the problems of regular payback period? Explain.

ANS: Payback period is very simple project evaluation technique. It tells how soon the firm will get
back its investment. Following are merits and demerits of Payback period.

Merits

 It is very simple to understand and easy to calculate

 It requires less cost, time and labor when compared to other methods of capital budgeting.
 This method reduces or avoids the loss through obsolescence since shorter payback period is
preferred to longer payback period.
 This method is mostly suitable to a company which has fewer amounts of cash in hand and a
company whose liquidity position is very weak.
 It gives much importance to the speedy recovery of investment in capital assets.

Demerits

 This method ignores the short term solvency or liquidity of the business concern.
 It ignores capital wastage and economic life by restricting consideration to the project’s gross
earnings.
 The time value of money is not considered in the payback period method.
 It overlooks the cost of capital which is a main factor in sound capital budgeting decision. This
method does not consider the cash inflows arising after the payback period.
 This could be misleading in capital budgeting decisions.

Discounted payback period is slightly modified version of payback period. As we know regular
payback period does not consider the time value of money and risk involved in the project. This
technique does away these drawbacks by incorporating the time value of money and risk of the
project. The cash flow is discounted at given cost of capital and then following the same procedure
of regular payback period.

e. Determine the NPV of each Franchise. According to NPV, which Franchise/s should be
accepted?

ANS:

FRANCHISE A FRANCHISE B
year PVIF CASH FLOW PV (Rs) CASH FLOW PV(Rs)
1 0.9091 850000 772735 950000 863645
2 0.8264 850000 702440 850000 702440
3 0.7513 850000 638605 750000 563475
4 0.6830 850000 580550 650000 443950
5 0.6209 850000 527765 400000 248360
Terminal cash flow 1980,000 1229382

Total PV 4451,562 2,821,870

Less initial investment 3000,000 2,500,000

NPV 1,451,562 321,870

Since the projects are mutually exclusive, the NPV of franchise A has higher NPV than Franchise so
franchise A should be accepted.

f. What is each Franchise’s IRR? Which Franchise should be accepted? Is there any confliction in
ranking of the Franchises according to NPV and IRR method? If these two methods give conflicting
ranking of the Franchises, which method would you prefer? Why?

ANS:
FRANCHISE A

Payback period = I/CFA

= 3000000/850000

= 3.53 yrs

Finding our discount rate for interpolation by looking at the present value interest factor for annuity
table for 5 years which lies between 12% and 13% rate

PVIFA at 12% = 3.6048

PVIFA at 13% = 3.5172

IRR = LR + (PVIFALR – PBP) X (HR-LR)

PVIFALR - PVIFAHR
= 12 + (3.6048 -3.53) X (13-12)
(3.6048- 3.5172)
= 12.85%

FRANCHISE B

 Fake annuity = 3600000/5

= 720,000

Fake payback period = 2,500,000/ 720000 = 3.472 yrs

Looking at the table across 5 period, we find 3.4331 is closet to 3.472 which corresponds to 14%
Since cash inflows in the earlier years are larger than average cash flows the IRR should be greater
than 14 %. So let’s try at 15% and 16 %

year Cash flows PV factor @ 15% PV PV factor @ PV

16%
0 (2500000) 1 (2500000) 1 (2500000)
1 950000 0.8696 826120 0.8621 818995
2 850000 0.7561 642685 0.7432 631720
3 750000 0.6575 493125 0.6407 480525
4 650000 0.5718 371670 0.5523 358995
5 400000 0.4972 198880 0.4761 190440
NPV -19325
32480

We know that
IRR = LR + NPVLR X (HR-LR)
NPVLR-NPVHR
 = 15% + 32480 X (16-15) = 15.62%
32480-(-19325)
AS the projects are mutually exclusive, IRR of both franchises are greater than their cost of capital
but franchise B has greater IRR so Franchise B is accepted.
There is conflict of ranking between NPV method and IRR method. In such situation I prefer NPV
method because this method is based on valid reinvestment rate assumption that projects cash
flows are reinvested at cost of capital. Whereas IRR method assumes that projects cash flows are
reinvested at the IRR itself.

Submitted By
Bhuwan Pandey
76341046