COST VOLUME PROFIT ANALYSIS

8.0 MEANING OF COST VOLUME PROFIT (CVP)

This is the study of the relationship between cost, volume and profit at various levels of activities. CVP is
also referred to as Break-even analysis. It assists in decision making by the use of marginal costing approach.
It is used to measure the effect on profit as a result of changes in volume of sales and cost of production.
8.1 BREAKEVEN POINT (BEP)
This is the activity level at which there is neither a profit nor a loss. At this point, the total sales revenue can
only cover the total cost (variable cost + fixed cost) without leaving a profit for the organisation. At BEP,
any sales short of BEP will result into a loss and sales above the BEP will bring about profit for the
organisation. At BEP, Fixed Cost = Total contribution.
8.2 CONTRIBUTION TO SALES (C/S) RATIO/CONTRIBUTION MARGIN RATIO (CMR)
Contribution is the difference between sales revenue and variable costs. In summary, contribution is
calculated as selling price – variable cost (i.e. variable cost of sales). Contribution to sales ratio otherwise
known as contribution margin ratio is the process of expressing contribution as a percentage of sales. The
c/s ratio is used when you are required to find the sales revenue required to breakeven. It is a measure of
how much contribution is earned from each N1 sales. It is calculated as: C/S x 100
8.3 ASSUMPTION OF COST VOLUME PROFIT/BREAKEVEN ANALYSIS
1. All cost can be separated into fixed and variable costs
2. Fixed cost remain constant
3. Variable costs vary proportionally with volume
4. Selling prices does not change as volume changes
5. There will be no change in general price level
6. Cost and revenue behave in a linear fashion
7. There is only one product and in case of a multiple product, the sales mix remains constant
8. There are no variation in stock levels i.e. no closing stocks
9. The efficiency of plant can be predicted
10. Productivity of workers remains mostly unchanged.

8.4 ADVANTAGES OF BREAKEVEN ANALYSIS

1. Simple to operate and easy to understand
2. Removes the complexity of over/under absorption of overhead as it makes use of marginal costing
technique.
3. Helps management in production planning
4. Prevents stock over valuation of fictitious profit since fixed overheads are not considered in stock
valuation
5. It can be used along with standard costing and budgetary control to yield a better result
6. It is used for decision making
7. It is very useful in management reporting
8. It facilitates the study of relative profitability

8.5 LIMITATIONS OF BREAKEVEN ANALYSIS

1. It can only be applied to a single product or a single mix of product
2. It assumes fixed cost are constant at all time
3. It assumes that variable cost are the same per unit at all levels of output
4. It assumes that sales prices are constant at all level of output
5. It ignores inventory levels i.e. it assumes production and sales are the same
6. It ignores the time value of money
7. It ignores the uncertainty in the estimated fixed costs and variable cost per unit.
8. Construction of breakeven chart may be time consuming

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8.6 METHODS OF SOLVING BREAKEVEN ANALYSIS
i. Algebraic method
ii. Graphical method

Some Useful Formula: The following key formula can be used in breakeven analysis:
 BEP (Units) = Total Fixed Cost
Contribution/unit

 BEP (Value i.e. N) = Total Fixed Cost

CMR

 To determine profit before tax:

i. When sales is given in unit, Profit = Units sold X Contribution/unit – Fixed cost
ii. When sales is given in value (N), Profit = Sales value X CMR – Fixed cost

 Sales required (Units) to achieve a target Profit Before Tax (PBT)

Target Profit + Total Fixed Cost
Contribution / unit

 Sales required (value) to achieve a target profit before tax

Target Profit + Total Fixed Cost
CMR

 To convert Profit After Tax (PAT) to Profit Before Tax (PBT)

PBT = PAT .
(1 – Tax rate)
Note that at BEP, Total Fixed Cost = Total Contribution

Illustration 8.1
Expected sales of a company are 10,000 units @ N8 per unit. Variable cost is N5 and fixed cost is N21,000.
Calculate the breakeven sales and the contribution margin ratio.
SUGGESTED SOLUTION:
Contribution = Sales – Variable cost
= (10,000 X ₦8) - (10,000 X ₦5) = ₦80,000 – ₦50,000 = ₦30,000
Or Contribution = ₦8 – ₦5 = ₦3 and CMR = 3/8 = 0.375
CMR = Contribution/Sales = ₦30,000/₦80,000 = 0.375 X 100 = 37.5%
Breakeven sales (units) = FC/C = ₦21,000/3 = 7,000 units
Breakeven sales (value) = FC/CMR = ₦21,000/0.375 = ₦56,000
Break-Even Arithmetic and Profit Target
AT BEP:
Sales = variable cost + fixed cost
Sales – variable cost = fixed cost (FC)
Sales – variable cost = contribution (this implies that at BEP total contribution = total FC)
Sales – contribution = variable cost
Sales – fixed cost = variable cost

Illustration 8.2
Mary K makes a product which has a variable cost of ₦7 per unit. Required: If fixed costs are ₦63,000,
calculate the selling price per unit if the company wished to breakeven with sales volume of 12,000 units

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SUGGESTED SOLUTION:
Breakeven sales (units) = Fixed costs/Contribution per unit
Fixed cost = ₦63,000
Contribution per unit = Selling price per unit – variable cost per unit = S - ₦7
Hence; 12,000 units = ₦63,000 ► 12,000S – (12,000 x 7) = 63,000
S - ₦7
► 12,000S = 63,000 + 84,000
► Selling price / unit= 147,000/12,000 = ₦12.25

AT PROFIT TARGET:
Sales – total cost = profit
Total cost = variable cost + fixed cost
Sales – (variable cost + fixed cost) = profit
Sales = variable cost + fixed cost + profit
Sales – variable cost = contribution
Contribution – fixed cost = profit
Contribution = fixed cost + profit

Note that to make or achieve a particular profit, the contribution generated must be enough to cover the fixed
cost and the desired profit. Thus:
Contribution 245,000
Fixed cost (135,000)
Profit 110,000
This implies that fixed cost + profit = CONTRIBUTION

Illustration 8.3
Tolulope makes and sells a single product, for which variable costs are as follows:
Direct material N10
Direct labour N8
Variable production overhead N6
The sales price is N30 per unit and fixed costs are N68,000. The company wishes to make a profit of N16,000.
Determine the sales required to achieve this profit both in units and value
SUGGESTED SOLUTION:
Selling price/unit = ₦30
Variable cost/unit = ₦10 + ₦8 + ₦6 = ₦24
Contribution/unit = ₦30 – ₦24 = ₦6
CMR = ₦6/₦30 = 0.2
Target profit = ₦16,000
Fixed cost = ₦68,000
i. Sales units to make target profit = Fixed cost + target profit/contribution =
= (₦68,000 + ₦16,000)/₦6 = 84,000/6 = 14,000 units
ii. Sales value to make target profit = Fixed cost + target profit/CMR
= (₦68,000 + ₦16,000)/0.2 = 84,000/0.2 = ₦420,000

Illustration 8.4
A company makes and sells a product which has a c/s ratio of 40% with a variable cost of N120. Fixed costs
are N240,000 and wishes to make a PAT of N280,000. Tax rate is 30% Required;
a. How many units must be sold to achieve the PAT
b. What is the BEP sales in value
c. Supposing an additional advert of N120,000 is needed, how many units must be sold to achieve the
PAT

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SUGGESTED SOLUTION:
Variable cost/unit = ₦120
Fixed costs = ₦240,000
CMR = 40%
PAT = ₦280,000
Tax rate = 30%
CMR = C/S ► 0.4 = S – V ► 0.4 = 120 -V
S 120
V = 120 – 48 = ₦72
Contribution = S – V = 120 – 72 = ₦48
a. Sales units to make target profit after tax = Fixed cost + PAT
1-T
Contribution
= 240,000 + (280,000/0.7)
48
= 240,000 + 400,000
48 = 13,333 units
b. Breakeven sales in value = ₦240,000/0.4 = ₦600,000
c. Adjusted fixed cost = ₦240,000 + ₦120,000 = ₦360,000
Sales units to make target profit after tax = Fixed cost + PAT
1-T
Contribution
= 360,000 + (280,000/0.7)
48
= 360,000 + 400,000
48 = 15,833 units

8.7 THE MARGIN OF SAFETY (MOS)

This is the difference between the budgeted sales and BEP sales in unit or revenue. It is the unit by which
budgeted sales must not fall below in order to avoid losses. In other words, it is the maximum units/revenue
by which budgeted sales can fall without recording losses. It is expressed as a percentage of budgeted sales
units/revenue.
Illustration 8.6
Ayomide makes and sells a single product which has a variable cost of N30 and sells for N40. Budgeted
fixed costs are N70,000 and budgeted sales are 8,000 units. Calculate the BEP sales and the margin of safety.
SUGGESTED SOLUTION:
CMR = (₦40-₦30)/₦40 = 0.25
Breakeven sales = FC/cmr = 70,000/0.25 = ₦280,000
Margin of safety = Budgeted sales – Breakeven sales
= (8,000 x ₦40) - ₦280,000
= ₦320,000 – ₦280,000
= ₦40,000
8.8 PRACTICE QUESTIONS
1. Explain the meaning of cost volume profit analysis
2. State the assumptions of cost volume profit/breakeven analysis
3. State the advantages and limitations of breakeven analysis
4. Explain the concept of margin of safety
5. The c/s ratio of product W is 20%. If the manufacturer wishes to make a contribution of N50,000 toward
fixed cost, how many units of product W must be sold if the selling price is N10 per unit.

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6. Must Pass Ltd. deals with one product called “Otisese”. The current sales of the product average 2,000
units at N200 each. The costs are:
N
Direct materials 114,000
Direct labour 36,000
Variable overhead 40,000
Fixed overhead 99,759
Required:
i. What is the margin of safety?
ii. How many units must be sold in order to breakeven?
iii. Calculate the additional sales in units required to maintain the current profit level if the selling price
is reduced by 5%
iv. Calculate the net profit if the sales volume (in units) is increased by 10%
v. If the fixed cost increases by N20,000, how many units should be sold in order to earn a profit of
N60,000?
vi. It has been suggested that an advertisement of N40,000 can increase the sales of the product by 300
units. Should the advertisement be embarked upon?
7. A company makes and sells a single product. The variable cost of production is N3 per unit, and variable
cost of selling is N1 per unit. Total fixed cost is N6,000 and the unit selling is N6. The company budgeted
to sell 3,600 units next year.
Required:
i. What is the break-even sale?
ii. What sales gives a profit after tax of N19,500 if tax rate is 35%
8. FP Ltd. started manufacturing and selling of sun glasses in 2008. In 2008 the company sold 8,000 sun
glasses and incurred a loss of N4,000. In 2009, it sold 14,000 sun glasses and made a profit of N11,000.
The company’s plans for 2010 are as follows:
i. Reduce present selling price of N12 by 10%
ii. Reduce present variable cost per unit by 10% through improved methods
iii. Reduce present fixed cost by 5% by cutting down all wasteful expenses
It is expected that due to reduction of selling price, sales volume will increase to 20,000 units in 2010.
You are required to calculate:
a. The estimated profit or loss for 2010, if the above plans are implemented
b. The number of units that will have to be sold in 2010, if the required profit is N25,000
9. a. Defined profit/volume ratio as used in marginal costing
b. Mention at least three ways in which the profit/volume ratio can be improved
c. To what uses can the profit/volume ratio be put?
d. The following information has been summarized from the records of ABC Ltd:
Period 1 period 2
Sales N30,000 N38,000
Profit N8,000 N2,300
You are required to calculate:
i. The profit/volume ratio
ii. The profit when sales are N24,000
iii. The sales required to earn a profit of N4,000
You may make any assumption though reasonable

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10. Grand photos Ltd. Manufactures document reproducing machine which has a variable cost structure as
follows:
Material N80
Labour N20
Variable overhead N8
Its selling price is N180. Sales during the current year are expected to be N2,700,000 and fixed overhead
should be N280,000
Under a wage agreement which was concluded recently, an increase of 10% is payable to all direct workers
from the beginning of the forth coming year while material costs are expected to increase by 7.5% , variable
overhead costs by 5% and fixed overhead by 3%.
You are required to calculate:
a. The new selling price if the current profit volume ratio is to be maintained
b. The quantity to be sold in the forth coming year to yield the same amount of profit as the current year
assuming the selling is to remain at N180
You may ignore the question of stocks and work in progress and may assume that the fixed overhead cost
is applicable to a production level up to 22,000 machines.
11. A summary of a manufacturing company’s budgeted profit statement for its next financial year, when it
is expected to be operating at 75% of its capacity is given below:
N N
Sales 9,000 units at N32 288,000
Less:
Direct materials 54,000
Direct wages 72,000
Production overhead: Fixed 42,000
Variable 18,000 60,000 186,000
Gross profit 102,000
Less:
Admin, selling & distribution cost: fixed 36,000 Variable
27,000 63,000
Net profit 39,000
(a) You are required to:
i. Calculate the breakeven point in units and in value
ii. Draw a profit volume graph on the graph sheet
iii. Ascertain from your answer to (ii) above, what profit could be expected if the company operated at
full capacity
(b) It has been estimated that;
i. If the selling price per unit were reduced to N28, the increased demand would utilize 90% of the
company’s capacity without any additional advertising expenditure; and
ii. To attract sufficient demand to utilize full capacity would require a 15% reduction in the current
selling price and a N5000 special advertising campaign
You are required to present a statement showing the effect of the two alternatives compared with the original
budget and to advice management which of the three possible plans ought to be adopted i.e. the original
budgeted plan or (i) above or (ii) above

(c) An independent market research study shows that by spending N15,000 on a special advertising
campaign, the company could operate at full capacity and maintain the selling price at N32 per unit.
You are required to:
i. Advice management whether this proposal should be adopted and
ii. State any reservation you might have

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12. A company has total fixed cost of N400,000. It sells its product at N100 each and the variable cost per
unit of producing and selling the product is N60.
a. Determine the profit/loss when the following units are sold:
i. 9,000
ii. 12,000
b. Calculate the total number of units that must be sold in order to:
i. Earn a loss of N100,000
ii. Breakeven
iii. Earn a profit of N100,00
iv. Earn a profit after tax of N100,000 assuming that tax rate is 20%

13. A company reports the following: N N

Sales (2,500 units at N40 each) 100,000
Less expenses:
Cost of goods sold (all variable) 45,000
Sales commission 5,000
Rent 5,000
Fixed administrative expenses 18,000
Miscellaneous fixed expenses 2,000
Total expenses 75,000
Net profit 25,000

Required;
i. How many units must be sold before the firm can breakeven
ii. What will be the net profit if sales increased by 30% (assume no in selling price)
iii. If selling price is reduced by 5%, how many units must be sold in order to maintain a profit of N25,000

14. The budget of Ayomide Hospitality Limited for the year ended 2009 is as follows:
No. of rooms available per day 200
No. of days per month 25
Rate per room per day ₦625
Rate charged for meals per day ₦375
Cost composition per month: Variable Fixed
N’000 N’000
Direct materials 750.00
Direct salaries 500.00
Guest service overhead 120.00 375.00
Administrative overhead 187.50 500.00
Assuming that the company is operating at full capacity,
You are required to calculate:
(a) i. The contribution per year in sales value
ii. The contribution sales ratio
(b) The breakeven point in sales value if:
i. Direct materials cost increases by 20%
ii. Fixed cost increases by 10%
iii. Rate charged per room increases by N50 per day

(c) Ayomide wishes to sell 14,000 units of her products which have a variable cost of N15 to make and sell.
Fixed costs are N47,000 and the require profit is N23,000. Calculate the sales price/unit

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15. A product has a sales price of N20 and a marginal cost of 12. Fixed costs attributable to the production
of this product amounted to N120,000 per annum
You are required to calculate:
iv. Number of units to break even
v. Sales in value at breakeven point
vi. Contribution to sales ratio
vii. How many units are to be sold to achieve a profit of N40,000
viii. What level of sales will achieve a profit of N40,000
ix. Marginal cost is expected to rise by N1 per unit and fixed cost will increase to N140,000 per annum.
If the selling price remain constant. How many units is required to maintain a profit after tax of
N40,000
If the tax rate is 40%, how many units would be sold to achieve a profit of N40,000

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 CAPITAL BUDGETING
9.0 MEANING OF CAPITAL BUDGETING
This is the planning of expenditure whose returns extend beyond one year. It is the process of deciding
whether or not to commit resources to a project whose benefit would be spread over several time periods.
The investment decision of a firm (i.e. expansion, acquisition, modernization and replacement of long term
assets) is generally known as capital budgeting decision. The decision taken is centered on the profitability
of the project by comparing the cash outflow and the cash inflow. Capital budgeting decision is taken by the
top management.
9.1 CHARACTERISTICS OF CAPITAL BUDGETING
1. It involves a large outlay of cash
2. It is exchanged of current funds for future benefits
3. The decision taken is irreversible
4. The funds are invested in long term projects
5. The future benefits accrue to the firm over a series of years
6. It is very risky in nature
9.2 TYPES OF PROJECTS
Independent Projects: these are projects that are independent of each other. The acceptance or rejection of
one does not disturb the other. Each project is assessed independently without any recourse to the other
Mutually Exclusive Projects: these are projects that cannot be accepted together. The acceptance of one
means the rejection of the other. For instance, if two projects A and B are being assessed, if project A is
accepted, it means project B must be rejected.
Mutually inclusive Projects: These are projects that are either accepted together or rejected together. If
project A is accepted or rejected, Project B must also be accepted or rejected.
9.3 METHODS OF CAPITAL INVESTMENT APPRAISAL
There are two methods of investment appraisal namely:
1. Traditional method and
2. Discounted cash flow method
Traditional Method
This method ignores the time value of money. There are two techniques under this method. They are:
i. Pay Back Period (PBP)
ii. Accounting Rate of Return (ARR)
1. Payback Period (PBP)
This refers to the length of time (usually in years) it will take to recover all the money invested in a project.
The shorter the payback period the more viable the investment is. It makes use of cash flow items and not
financial accounting profit. Thus, items like depreciation, absorption of overheads, and other notional costs
are excluded. Its focus is on liquidity rather than the profitability of the project. It is calculated as:
a. Constant annual cash flow i.e. the same cash inflow every year:
Initial investment
Annual cash flow
b. Non-constant annual cash flow i.e. irregular yearly cash inflow: This involves the use of cumulative
cash flow method.

Illustration 9.1
Gbamugbamu Jigijigi Plc is considering embarking on a project which requires an outlay of N1,250,000.
The project has an expected useful life of 10 years. What is the payback period if the project generates an
annual cash flow of N125,000 after charging all expenses including depreciation at 10%?. The company set
a payback period of 6 years. Should the project be accepted?

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SUGGESTED SOLUTION
Gbamugbamu Jigijigi Plc
Annual depreciation: 10% of ₦1,250,000 = ₦125,000
Gross Annual cashflow = annual cashflow + depreciation
= ₦125000 + ₦125000 = ₦250,000
Year 0 = ₦1,250,000
Year 1 = (₦250,000)
1,000,000
Year 2 = (₦250,000)
₦750,000
Year 3 = (₦250,000)
₦500,000
Year 4 = ( ₦250,000)
₦250,000
Year 5 = (₦250,000)
Nil
Payback period = 5 years
Or:
Since the cashflow is regular, the PBP can be calculated as:
Initial outlay/(cashflow + depreciation) = ₦1,250,000/₦250,000 = 5 years
Decision; the project should be accepted because the PBP did not exceed the target PBP of 6 years set by the
company.

Illustration 9.2
Apoche Ltd is to undertake a project requiring an initial outlay of N2.5m. The project has the following
inflow
Year Cash flow (N)
1 586,000
2 678,000
3 760,400
4 820,000
5 800,000
6 780,000
a) What is the payback period?
b) Supposing illustration 9.1 and 9.2 are mutually exclusive projects and the company’s PBP remains 6
years. What should be the decision of the company?
SUGGESTED SOLUTION
(a) Apoche LTD
₦
PBP = Year 0 = 2,500,000
Year 1 = (586,000)
1,914,000
Year 2 = (678,000)
1,236,000
Year 3 = (760,400)
475,600
Year 4 = (820,000)

The cash flow of year 4 exceeds the unpaid balance, therefore;

₦475,600/₦820,000 X 12 = 7 months
Hence: PBP = 3 years and 7 months

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(b) Project are said to be mutually exclusive if the undertaking of one prevents the undertaking of the other.
They cannot be executed simultaneously. Hence based on this assumption, the decision should be to execute
the second project because it has a lesser payback period.

Advantages
i. It is simple to calculate and understand
ii. It is a measure of liquidity and not profitability
iii. It is used to measure risk attached to a project
iv. It is used as first screening tool to assess projects for a company facing liquidity problem
Disadvantages
i. To define target payback period may be subjective
ii. It ignores the time value of money
iii. It does not make use of all cash flow for decision making
iv. It does not indicate relative profitability

2. Accounting Rate of Return (ARR)

This method is based on accounting concept It is also known as Return on Investment (ROI). It uses
accounting profit and not cash flow to measure the profitability of an investment. That is to say, it considers
depreciation and other non cash flow items. There are four methods of calculating ARR as follows:
i. ARR = Total Profit x 100
Initial investment

ii. ARR = Total Profit x 100

Average investment

iii. ARR = Average Profit x 100

Initial investment

iv. ARR = Average Profit x 100

Average investment
Where the examiner is silent as to the formula to use, always use formula iv.
Average profit = Total profit – total depreciation
No of years

Average investment = Initial investment + scrap value

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Note: where the scrap value is zero, you still have to add 0 to the initial investment and divide by 2.

Illustration 9.3
A company is to undertake a project requiring an investment of N200,000 on necessary plant and machinery.
The project is to last for 5 years at the end of which the plant will have a scrap vale of N40,000. Profits before
depreciation are as follows:
Year Profit (N)
1 55,000
2 60,000
3 62,000
4 65,000
5 68,000
You are required to calculate the ARR of the project

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SUGGESTED SOLUTION:
Accumulated depreciation: ₦200,000 - ₦40,000 = ₦160,000
ARR = Average profit
Average Investment
Average profit = (Total profit – Depreciation)
No. of years
Average Investment = (Initial outlay + scrap)
2
Total profit = ₦55,000 + ₦60,000 + ₦62,000 + ₦65,000 + ₦68,000 = ₦310,000

Average profit = (₦310,000 – ₦160,000) = ₦30,000

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Average Investment = (₦200,000 + ₦40,000) = ₦170,000
2
ARR = ₦30,000/₦170,000 = 0.25 x 100 = 25%

Advantages
i. It is simple to calculate and understand
ii. It considers all the profit over the life of the project
iii. It uses readily available accounting data
iv. It could be used to compare performance of different companies

Disadvantages
i. It ignores the time value of money
ii. It uses accounting profits, rather than the more superior cash profit
iii. It suffers definition problem in that it can be calculated in several ways
iv. There are no rule for setting the minimum acceptable ARR by the management
v. It ignores risk and management attitude to risk

Discounted Cash flow Method

This represents modern techniques of evaluating the viability of an investment by discounting the associated
cash flow. Discounting means that the future cash flows of a project are to be gradually reduced in order to
take cognisance of the time value of money as N1 today is not the same with N1 tomorrow. This method is
superior to the traditional method. It includes:
i. Net Present Value (NPV) technique and ii. Internal Rate of Return IRR technique
3. Net Present Value
This is the value obtained by discounting all cash outflows and inflows of a project by a chosen ‘rate of
return’ or ‘cost of capital’. The NPV therefore compares the present value of all the cash inflows and outflows
of an investment. The difference between the two is the NPV. A positive NPV gives an indication of a viable
project while a negative NPV means that the project is not profitable. NPV makes use of relevant cost only
Illustration 9.4
Ade-Guru Ltd is considering a capital investment, where the estimated cash flows are:
Year Cash flows before depreciation
N
0 (i.e. now) (60,000)
1 8,000
2 32,000
3 20,000
4 36,000
The company’s cost of capital is 16%. Depreciation is 25% per annum
a) What is the NPV of the project? b) Should the project be undertaken

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SUGGESTED SOLUTION:
Ade-Guru Ltd
(a)
Year Cashflow Discount factor PV
₦ 16% ₦
0 (60,000) 1.0000 (60,000)
1 8,000 .8621 6,897
2 32,000 .7432 23,782
3 20,000 .6407 12,814
4 36,000 .5523 19,883
NPV 3,376

(b) Yes, the project should be undertaken because it yields a positive NPV

Illustration 9.5
Sherry Pat Plc is considering buying a machine which will improve their cash flows by N60,000 per annum
for the next 5 years, at the end of which the machine will be worn out and be of no value. The machine will
cost N150,000 and will be bought for cash. The discount rate is 15%.
Required: Calculate the NPV of this project and comment on it
SUGGESTED SOLUTION:
Sherry Pat Plc
Year Cashflow Discount factor PV
₦ 15% ₦
0 (150,000) 1.0000 (150,000)
1 60,000 .8696 52,176
2 60,000 .7561 45,366
3 60,000 .6575 39,450
4 60,000 .5718 34,308
5 60,000 .4972 29,832
NPV 51,132

Alternatively: since the cash flows are constant the formula below can be used as discount factor.
1 – (1 + r)- n = 1 – (1 + 0.15)- n = 3.3522
r 0.15
PV of cash flows = ₦60,000 X 3.3522 = ₦201,132
NPV = ₦201,132 – ₦150,000 = ₦51,132

Decision: The project should be undertaken because it yields a positive NPV

Note: at times, differences may arise due to approximation in both methods.

Advantages
i. It gives a clear accept or reject decision
ii. It takes into consideration time value of money
iii. It makes use of cash flow which is less subjective
iv. It makes use of all the cash flows of the project
v. It gives absolute figure of profitability
vi. It gives a better ranking for mutually exclusive projects

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Disadvantages
i. It ignores risk and management attitude towards risk
ii. It requires the knowledge of cost of capital
iii. It is difficult for a lay man to grasp
4. Internal Rate of Return (IRR)
This is the rate which equates the present value of cash inflows with the present value of cash outflows of an
investment. It is the rate at which the net present value equals to zero (NPV = 0). It can be determined though
a trial and error method of interpolation. IRR also makes use of relevant cost. It is calculated as:
IRR = LR + NPV (+) [HR – LR]
NPV (+ – )
Where:
LR = lower rate
HR = higher rate
NPV (+) = positive NPV
NPV (+ - ) = absolute NPV

Illustration 9.6
Calculate the IRR of a project having the following cash flows
Year NCF (N)
0 (3,610)
1 1,000
2 2,000
3 3,000

SUGGESTED SOLUTION: Using discount factor 25% and 26% respectively

Sherry Pat Plc
Year Cashflow D.f PV D.f PV
₦ 25% ₦ 26% ₦
0 (3,610) 1.0000 (3,610) 1.0000 (3,610)
1 1,000 .8000 800 .7937 794
2 2,000 .6400 1,280 .6299 1,260
3 3,000 .5120 1,536 .4999 1,500
NPV 6 (56)

Using interpolation:
IRR = LR + NPV(+) X (HR – LR)
NPV(+) - NPV(-)
= 25 + 6 X (26 -25)
6 + 56
IRR = 25.10%
Advantages
i. It considers time value of money
ii. It makes use of all the cash flows
iii. It makes use of cash flows or cash profit which is less subjective than accounting profit

Disadvantages
i. It is too complex to operate in practice
ii. It does not indicate a clear accept or reject decision
iii. It ignores risk and management attitude towards risk

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9.4 PRACTICE QUESTIONS
1. Write short note on the following:
(i) Independent Projects (ii) Mutually Exclusive Projects (iii) Mutually inclusive Projects
2. State the characteristics of capital budgeting
3. Identify 4 methods of capital investment appraisal and state 3 advantages and 2 disadvantage of each
method identified.
4. Apariomoyakuba Industries is considering an investment in a fleet of ten delivery vans to take its products
to customers. The van will cost N30,000 each to buy, payable immediately. The annual running costs are
expected to total N40,000 for each van (including the driver’s salary). The vans are expected to operate
successfully for 6 years, at the end of which they will all have to be scrapped with disposal proceeds expected
to be about N6,000 per van. At present, the business uses a commercial carrier for all its deliveries. It is
expected that this carrier will charge a total of N460,000 each year for the next 6 years to undertake the
deliveries.
Required:
Calculate the ARR and NPV of the project. Use 15% discount rate.
5. Apapa Ltd is considering investments in two projects, but is constrained by limited finance. As a result the
company can only invest in one of these projects. The information below relates to the two projects:
Products; X Y
₦ ₦
Initial capital outlay 228,000 285,000
Net cash flows:
Year 1 114,000 57,000
Year 2 171,000 85,000
Year 3 29,000 144,000
Year 4 14,000 140,000
Year 5 24,000 185,000
The company’s cost of capital is 15%.
You are required to:
a) Assess the viability of each of these two projects using the following methods
i. Payback period
ii. Net present value method
b) State three advantages of the net present value method of capital appraisal
c) State two advantages of the payback period method of capital appraisal
Discounting factor table at 15%
Year Discount factor
0 1.000
1 0.870
2 0.756
3 0.657
4 0.572
5 0.497
6. Yewa Ltd is considering a capital investment, where the estimated cash flows are:
Year Cash flows before depreciation
N
0 (i.e. now) (90,000)
1 28,000
2 45,000
3 28,500
4 36,000
The company’s cost of capital is 20%. Depreciation is 20% per annum. What is the IRR?

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