2 - CH 16 (ICAP Book) - Introduction To Project Appraisal - Final

Chapter 17: Introduction to project appraisal Page 1
Ch # 17 introduction to project appraisal
LO1: INTRODUCTION TO CAPITAL INVESTMENT APPRAISAL
1.1) Capital investments
▪ All investments which have future economic benefit for more than one year are known as
capital investments.
▪ Examples of capital investments may include:
- Investment in machine or plant for manufacturing of new product
- Establishment of a new factory or new business
- Expansion of current production capacity
- Replacement of existing machinery or any other asset
- Acquisition of a running business
1.2) Purpose of Capital investments
Capital investments are made with the following aims:

▪ To maintain the existing profit of the business
▪ To increase profit of the business by making expansion or launch of new product
▪ To save cost by making investment in new technology
▪ To obtain fewer tangible benefits such as image enhancement of the entity
1.3) Capital investment appraisal (Capital budgeting)
Capital investment appraisal or project appraisal or capital budgeting is the process of

evaluating and selecting long-term investments that are consistent with the firm’s goal of
maximizing shareholders’ wealth.
Features of capital investment projects
Many investment projects have the following characteristics:
▪ The project involves:
- the purchase of an asset or purchase of any other business with an expected life of
several years, and
- the payment of a large sum of money at the beginning of the project.
▪ Returns on the investment consist largely of net income from additional profits over the
course of the project’s life.
▪ The asset might also have a disposal value (residual value) at the end of its useful life.
▪ A capital project might also need an investment in working capital. Working capital also
involves an investment of cash.
1.4) Capital investment appraisal techniques
▪ To ensure that the investment projects selected have the best chance of increasing the
value of the firm and wealth of shareholders; finance managers need tools to help them
evaluate the merits of individual projects and to rank competing investments.
▪ A number of techniques are available for performing such analyses such as:
- Payback period
- Net present value (NPV)
- Internal rate of return (IRR)
LO2 : PAYBACK PERIOD ( PP)
2.1) Definition
▪ Payback period is the time period to recover initial capital investment of the project.
▪ It is also known as recovery period of the project.
2.2) Computation of payback period
▪ Payback period is computed according to the nature of annual cash inflows:

(a) Payback period for equal annual cash inflows
▪ In case of even annual cash inflows, payback period will be computed by using following
formula:
Payback period = Initial capital investment of project = Ans (in years)
Annual cash inflows
▪ For example, a company is planning to make a capital investment of Rs. 100,000 and
expects to have annual cash inflows of Rs. 20,000 per annum for next 8 years. Company
will be able to recover its entire investment of Rs. 100,000 within 5 years so payback
period will be 5 years.
(b) Payback period for unequal annual cash inflows
▪ In case of uneven annual cash inflows, payback period will be computed by using table of
cumulative cashflows:
▪ For example, a company in planning to make of Rs. 100,000 again but having mixed annual
cash inflows as follows:
Years Cash Flows Cumulative Cash
(Rs.) Flows (Rs.)
0 (100,000) (100,000)
1 20,000 (80,000)
2 30,000 (50,000)
3 35,000 (15,000)
4 25,000 10,000
5 20,000 30,000
6 15,000 45,000
▪ If annual cash inflows occur at the end of each year, then payback will be 4 years but if
annual cash inflows occur evenly throughout the year, then payback period will be more
than 3 years but less than 4 years. So, payback period will be computed as follows:
- Payback period = 3 years + (Recoverable amount ÷ Recovered amount)
- Payback period = 3 years + (15,000 ÷ 25,000) = 3.6 years
Notes:
▪ In payback period, net annual cash flows after tax will be used.
▪ If annual accounting profit is given then straight line depreciation expense is added back to
find out annual cash flows:
- Annual Cash Flows = Annual Profit + Annual depreciation expense

2.3) Decision making rule for payback period
▪ If project payback period ≤ Acceptable payback period then company will accept the
project otherwise company will reject it.
▪ If company has multiple investment projects, then any project with quickest payback
period will be better.
Example 17.1
A company is considering an investment with an initial outlay of Rs 100,000. The net annual
cash inflows for the next 10 years will be 9,500 per annum.
Required: Find the payback period?
Solution
Payback period (PP)
Payback period = Initial investment ÷ Annual cash inflows
Payback period = 100,000 ÷ 9,500 p.a. = 10.53 years
Example 17.2
Consider the following three projects “A, B and C” having expected investment and
benefits as under:
Project A Project B Project C
Initial Investment Initial Investment Initial Investment
Rs. 5000,000 Rs. 2000,000 Rs. 4000,000
Cash Flows (Rs.) Profits (Rs.) Cash Flows (Rs.)
1000,000 p.a. Y 1 : 200,000 Y1: 800,000
Life: 8 Years Y2: 400,000 Y2: 1200,000
Y3: 200,000 Y3: 1000,000
Y4: 100,000 Y4: 2000,000
Y5: 50,000 Y5: 2200,000
Required: Calculate Payback period of all projects and state which one is better. Company
uses straight line method of depreciation.
Solution
Payback period of project A
Payback period = Initial investment
Annual Cash Flows
Payback period = Rs. 5 million ÷ Rs. 1 million p.a.
Payback period = 5 years
Payback period of project B
Years Profit Depreciation Cash Flows Balance
(Rs.’000) expense (Rs.’000) (Rs.’000)
0 (2,000) (2,000)
1 200 400 600 (1,400)
2 400 400 800 (600)
3 200 400 600 0
4 100 400 500
5 50 400 450
Payback period = 3 years

(W1) Annual depreciation expense
Annual Depreciation = Cost of asset – Scrap value
Life
= Rs. 2000,000 – 0 = Rs. 400,000 p.a.
5 years
Payback period of project C
Years Cash Flows Balance
(Rs.’000) (Rs.’000)
0 (4,000) (4,000)
1 800 (3,200)
2 1,200 (2,000)
3 1,000 (1,000)
4 2,000 1,000
5 2,200
Payback period = 3 years + 0.5 years (1,000,000 ÷ 2,000,000)
Payback period = 3.5 years
Example 17.3
A company requires all investment projects to payback their initial investment within three
years. It is considering a new project requiring a capital outlay of Rs.140,000 on plant and
equipment and an investment of Rs. 20,000 in working capital. The project is expected to earn
the following net annual cash receipts:
Year Rs.
1 40,000
2 50,000
3 90,000
4 25,000
Required: Should the investment be undertaken?
Solution
Working capital investment
▪ At the beginning of project, the investment in working capital should be included in initial
investment as an outflow of cash because when there is an increase in working capital, cash
flows are lower than cash profits by the amount of the increase.
▪ At the end of project, working capital is reduced to nil and the reduction is added to cash
flows because when there is a reduction in working capital, cash flows are higher than cash
profits by the amount of the reduction.
Start of End of
project project
Initial investment 140,000 Cash Inflow 25,000
+Working Capital investment 20,000 + Working capital 20,000
recovery
= Total initial investment 160,000 = Cash inflow 45,000
Payback period
Years Cash Flows Cumulative Cash
(Rs.) Flows (Rs.)

0 (160,000) (160,000)
1 40,000 (120,000)
2 50,000 (70,000)
3 90,000 20,000
4 45,000 65,000
▪ If we assume all cash flows arise at the end of each year then payback period will be 3
years.
▪ If we assume that all cash flows arise evenly throughout the year then payback period will
be 2.79 years [2 years + 0.78 years (70,000 ÷ 90,000)].
3.4) Merits and demerits payback period
The advantages of the payback method for investment appraisal are as follows:
- Simplicity – The payback is easy to calculate and understand.
- The method analyses cash flows, not accounting profits. Investments are about investing
cash to earn cash returns. In this respect, the payback method is better than the ARR
method.
- Payback concentrate on earlier cash flows in the project’s life time, which are more certain
and more important if the firm has liquidity concerns.
The disadvantages of the payback method are as follows:

- It is not linked to the wealth maximisation objective. In other words, it does not select
projects based on their ability to increase the wealth of the owners of the company. There
is no measure of the change in wealth either in absolute (Rs) or relative (%) terms.
- Setting an acceptable payback period is very subjective. (Note: The deep you go in time
period to collect cash from the project, less attractive it would be due to higher uncertainty
and risks).
- Target payback period may cause the company to select a less attractive project in terms of
NPV just because it’s payback period is more than target payback period.
- It ignores all cash flows after the payback period, and so ignores the total cash returns from
the project. This is a significant weakness with the payback method.
- It ignores the timing of the cash flows during the payback period.
For example, for an investment of Rs. 100,000, cash flows of Rs. 10,000 in Year 1 and
Rs.90,000 in Year 2 are no different from cash flows of Rs. 90,000 in Year 1 and Rs. 10,000
in Year 2, because both pay back after two years. However, it is clearly better to receive
Rs.90,000 in Year 1 and Rs.10,000 in Year 2 than to receive Rs.10,000 in Year 1 and
Rs.90,000 in Year 2.
LO3 : TIME VALUE OF MONEY
3.1) Introduction to time value of money
Time value of money (TVM) concept

▪ Money loses its value (worth) with the passage of time. or
▪ It can be stated alternatively, “$1 received today is better than $1 to be received in future”
▪ Future cash flows have lower worthy as compared to present cash flows.
▪ This reduction in the value of money occurs due to:
- Inflation in the economy
- Opportunity cost of sacrificing the funds
- Risk and uncertainty in future cash flows
Importance of TVM concept

▪ Concept of TVM is important for long term decision making of investment projects.
▪ Unrealistic decision making will be undertaken when time value of money concept is not
used.
Application of TVM concept

▪ Concept of TVM will be used in decision making when:
- Future costs and benefits are available for more than 1 year.
- Cost of capital rate (%) is available or can be computed.
Concept of time line

▪ Time line is prepared to present future cash inflows and cash outflows of the project.
▪ At time line:
- T0 is known as:
➢ today,
➢ now,
➢ immediately,
➢ currently,
➢ presently,
➢ date of investment
➢ start of commercial production
➢ start of project or
➢ start of accounting period.
- T1 is known as:
➢ end of period 1,
➢ end of year 1
➢ one year from now.
➢ Start of year 2
- T2 is known as:
➢ end of year 2
➢ two years from now.
➢ Start of year 3
- T3 is known as:
➢ end of year 3
➢ three years from now
➢ Start of year 4.
Assumptions for timing of Cash Flows

▪ Initial investment is made immediately.
▪ First cash inflow will be received and recorded at the end of first year.
▪ During the year cash flows will be recorded at the end of that relevant year.
▪ Start of the year cash flows will be recorded at the end of previous year.
▪ If initial investment is incurred at T0 and T1 then cash inflows will be recorded from T2
onward (First year of operation).
3.2) Concept of compounding and discounting
Compound interest
▪ Compound interest is where the annual interest is based on the principal amount plus
interest accrued to date.
▪ The interest accrued to date increases the amount in the account and interest is then
charged on that new amount
Compounding
▪ Compounding is the process to compute future value (FV) from:
- given present values (PV) at
- given rate (r) and
- for specific time period (n).
Discounting
▪ Discounting is the reversal of compounding and aims to compute present value (PV) from
- given future value (FV), at
- given discount rate (r), and
- for specific time period (n).
3.3) Computation of future value and present value
Future value
▪ Future value can be computed as follows:
FV = PV (1 + r) n
▪ Where
- FV = Future value
- PV = Present value
- r = rate of inflation (or) rate of interest (or) growth rate (or) increase rate
- n = number of periods (generally in years)
Example 17.4
a) Calculate the future value at the end of 5 years’ time if we invest Rs. 10,000 today in a bank
at 10% p.a.?
b) Calculate the future value of Rs. 38,000 invested today for 7 years at 5% per annum?
Solution
a) Future value at the end of 5 years’ time
Present value of investment (PV) = Rs. 10,000
Annual interest rate (r) = 10% or 0.10
Number of periods (n) = 5 years
Future value (FV) =?
FV = PV (1 + r) n
FV = Rs. 10,000 (1 + 0.10)5 = Rs. 16,105
b) Future value at the end of 7 years’ time
Present value of investment (PV) = Rs. 38,000
Annual interest rate (r) = 5% or 0.05
Future value (FV) =?
FV = PV (1 + r) n
FV = Rs. 38,000 (1 + 0.05)7 = Rs. 53,470
Present value
▪ Present value can be computed as follows:
PV = FV (1 + r) -n
▪ Where
- FV = Future value
- PV = Present value
- r = Discount rate (or) cost of capital rate
- n = number of periods (generally in years)
- (1 + r)-n = Discount factor which can be computed
Example 17.5
a) What is present value of an amount of Rs. 10,000 to be received in 4 years’ time if discount
rate is 8% per annum?
b) Calculate present value of following cash flows of three years at a discount rate of 10%.
Years Cash flows
(Rs.)
1 5,000
2 3,000
3 7,000
Solution
a) Present value at 8%
Future value (FV) = Rs. 10,000
Discount rate (r) = 8% or 0.08
Present value (PV) =?
PV = FV (1 + r) -n
PV = Rs. 10,000 (1 + 0.08)-4 = Rs. 7,350
b) Present value at 10%
1 2 3
Cash Flows (FV) 5,000 3,000 7,000
x Discount factor at 10% - (1 + 0.10)-n 0.909 0.826 0.751
= Present value 4,545 2,478 5,257
Present value at 10% = 4,545 + 2,478 + 5,257 = Rs. 12,280
LO4 : SIMPLE NET PRESENT VALUE ( NPV )
4.1) Introduction to net present value
▪ NPV is the excess amount of present value of future cash inflows over present value of
initial capital investment.
▪ NPV is linked to shareholder’s wealth maximisation which means it will increase market
value of company’s share at stock exchange.
▪ It can be computed as follows:
NPV = PV of future cash inflows – PV of initial investments
4.2) Types of cash flows used in net present value
▪ There are thrr types of cash flows related to investment project:

- Operating cash flows of the project
- Investing cash flows of the project
- Financing cash flows of the project
▪ Each of the above cash flows are explained below in the following table:
Sr. # Types Description Usage in NPV
(i) Operating cash Operating cash flows are related to annual Annual operating cash
flows incomes and annual expenses of the flows are used in NPV.
product.
(ii) Investing cash Investing cash flows are related to Investing cash flows are
flows purchase and sales of assets. also used in NPV.
(iii) Financing cash Financing cash flows are related to Financing cash flows
flows payments and/or receipts from equity or are not used in NPV
debt investors. For example, because such cash flows
- loan taken for investment project are used to compute
- Repayment of loan cost of capital rate.
- Funds raised through issue of shares
- Dividend payment
- Interest payment
4.3) Decision making rule for net present value
▪ If company has single investment project and such project has positive NPV then company
will accept the project. In vice versa case company will reject the project.
▪ If company has multiple investment projects, then any project with highest positive NPV
will be better.
Example 17.6
Following cash flows are related to one project:
Years T0 T1 T2 T3 T4 T5
Cash Flows (35,000) 8,000 9,000 12,000 10,000 9,000
Required: Calculate NPV of the project at 8% cost of capital and 12% cost of capital.
Solution
NPV at 8%
Cash Flows (35,000) 8,000 9,000 12,000 10,000 9,000
DF at 8%: (1.08)-n 1.00 0.926 0.857 0.794 0.735 0.681
Present Value (35,000) 7,408 7,713 9,528 7,350 6,129
Net Present value = Rs. 3,128
NPV at 12%
Cash Flows (35,000) 8,000 9,000 12,000 10,000 9,000
DF at 12%: (1.12)-n 1.00 0.893 0.797 0.712 0.636 0.567
Present Value (35,000) 7,144 7,173 8,544 6360 5,103
Net Present value = (Rs. 676)
Example 17.7 – ICAP Study Text (Ex. 31)
A company is considering whether to invest in a new item of equipment costing Rs. 53,000 to
make a new product. The product would have a four-year life, and the estimated cash profits
over the four-year period are as follows:
Years Rs.
1 17,000
2 25,000
3 16,000
4 12,000
Required: Compute NPV of the project using a discount rate of 11% and advise whether
project is viable or not?
Solution
NPV at 11%
Years T0 T1 T2 T3 T4
Cash Flows (53,000) 17,000 25,000 16,000 12,000
DF at 11%: (1.11)-n 1.00 0.901 0.812 0.731 0.659
Present Value (53,000) 15,317 203,00 11,696 7,908
Decision: The NPV is positive so project should be accepted.

A company is considering whether to invest in a new item of equipment costing Rs. 65,000 to
make a new product. The product would have a three-year life, and the estimated cash profits
over this period are as follows:
Year Rs.
1 27,000
2 31,000
3 15,000
Required: Compute NPV of the project using a discount rate of 8% and advise whether project
is viable or not?
Solution
NPV at 8%
Years T0 T1 T2 T3
Cash Flows (65,000) 27,000 31,000 15,000
DF at 8%: (1.08)-n 1.00 0.926 0.857 0.794
Present Value (65,000) 25,002 26,567 11,910
Net Present value = (Rs. 1,521)
Decision: The NPV is negative so project should not be accepted.
A company is considering whether to undertake an investment. The cost of capital is 10%. The
initial cost of the investment would be Rs. 50,000 and the expected annual cash flows from the
project would be:
Net cash
Year Revenue Costs
flow
Rs. Rs. Rs.
1 40,000 30,000 10,000
2 55,000 35,000 20,000
3 82,000 40,000 42,000
Required:
a) Calculate future value of the project after 3 years at 10% cost of capital by using concept
of compounding and advise whether project is financially viable.
b) Calculate net present value of the project at 10% cost of capital by using concept of
discounting and advise whether project is financially viable.
c) Reconcile the answers of part (a) and (b) by using present value and future value of the
concept.
Solution
a) Future value of project at the end of year 3 by using compounding concept
Time Description Rs.
0 Initial investment in project by using funds having cost of capital of 10% (50,000)
Y1 Add: Required cost of funds at 10% (50,000 x 10%) (5,000)
= Return required at the end of year 1 (55,000)
Less: Cash inflows from the project in year 1 10,000
(45,000)
Y2 Add: Required cost of funds at 10% (45,000 x 10%) (4,500)
Net cash inflows from the project in year 2 20,000
(29,500)
Y3 Add: Required cost of funds at 10% (29500 x 10%) (2,950)
Less: Cash inflows from the project in year 3 42,000
= Future value at the of year 3 9,550
Decision: At the end of 3 years, future value is positive so project should be accepted.
b) NPV of project at 10% by using discounting concept
Years T0 T1 T2 T3
Cash Flows (50,000) 10,000 20,000 42,000
DF at 10%: (1.10)-n 1.00 x 1.10-1 x 1.10-2 x 1.10-3
Present Value (50,000) 9,091 16,529 31,555
Decision: The NPV is positive so project should be accepted.
c) Reconciliation
Decision making of investment project can be undertaken through compounding method or
discounting method. Both methods produce the same decision and its results can be
reconciled through present value and future value equation.
If we use future value formula to reconcile present value of project to the future value at the
end of year 3.
FV = PV (1 + r) n
FV = 7,152 (1 + 0.10)3 = 9,550
If we use present value formula to reconcile the future value of the project to the net present
value of project.
PV = FV (1 + r) -n
PV = 9,550 (1 + 0.10)-3 = 7,175
This example shows how project appraisal can be undertaken through compounding method
and discounting method. We will prefer to use NPV (discounting method) for decision making.
4.4) Practice of simple NPV
➢ ICAP CAF (08) Question Bank Q 16.1 – Class Notes (Q 1)
4.5) Net present value of annuity cash flows
Definition of annuity cash flows

▪ Annuity is the:
- series of equal cash flows
- at regular intervals
- for limited period of time.
▪ For example, annual rental payment for premises amounting Rs. 250,000 is an example of
annuity cash flows.
Types of annuities
▪ There are three types of annuities in real world:
Type of Description Present value
annuities
Ordinary - Series of equal cash flows will PV = Annual CF x Annuity factor
annuity arise at the end of each year, and
- first equal amount will occur
from T1.
Annuity due - Series of equal cash flows will PV = Annual CF + (Annual CF x
arise at the beginning of each Annuity factor)
year, and
from T0.
Delayed - Series of equal cash flows will PV = Annual CF x Annuity factor x
annuity arise at the end of each year, and DF of previous year
after T1.
Note: Annuity factor can be computed or can be taken from annuity table.
Annuity factor = [(1 – (1 + r)-n) ÷ r] where r = discount rate
n = number of equal cash flows
Example 17.10
A company is planning to investment Rs. 2,000 and expects five equal annual cash flows
a) Rs. 1000 p.a. received from end of Year 1 onward or
b) Rs. 1000 p.a. received from end of Year 2 onward or
c) Rs. 1000 p.a. received from now onwards
The discount rate is 10% per annum
Required
(i) Prepare time line for each case of above annuity cash flows
(ii) Calculate NPV of the project under each case of annuity separately.
Solution
(i) Time line of annuity cash flows
Ordinary annuity 0 1 2 3 4 5
Cash Flows (2,000) 1,000 1,000 1,000 1,000 1,000
Delayed annuity 0 1 2 3 4 5 6
Cash Flows (2,000) -- 1,000 1,000 1,000 1,000 1,000
Annuity Due 0 1 2 3 4
Initial investment (2,000)
Cash Flows 1,000 1,000 1,000 1,000 1,000
(ii) NPV of annuity cash flows at 10%

a) NPV of project at 10%
Years Rs.
0 Initial investment (2,000)
1-4 PV of annual cash flows (Rs. 1,000 x Annuity factor 10%, 3,791
5)
= Net present value + 1,791
b) NPV of project at 10%
Years Rs.
2–6 PV of annual cash flows
(Rs. 1,000 x Annuity factor 10%, 5) x 1.10-1 3,446
c) NPV of project at 10%
Years Rs.
0-3 PV of annual cash flows
Rs. 1,000 + (Rs. 1,000 x Annuity factor 10%, 4) 4,170
Example 17.11
A company is planning to make investment of Rs. 5,000 and expects five equal annual cash
flows of Rs. 1000 p.a. from now onward and then later on four equal annual cash flows of Rs.
500 each. The discount rate is 10% per annum.
Required: Calculate NPV of the project.
Solution
Years Rs.
(Rs. 500 x Annuity factor 10%, 4) x 1.10^-4 1,082
5,252
= Net present value + 252
a) A company has estimated that its cost of capital is 8.8%. It is deciding whether to invest in
a project that would cost Rs. 325,000. If annual cash flows from year 1 – 6: Rs. 75,000 p.a.
then compute NPV of the project and advise whether project is financially viable or not.
Solution
Years Rs.
(Rs. 75,000 p.a. x Annuity factor at 8.8%, 6) 338,460
Decision: The project has a positive NPV and should be undertaken.
b) A company has estimated that its cost of capital is 8.8%. It is deciding whether to invest in
a project that would cost Rs. 325,000. If annual cash flows are as follows:
Year Rs.
1 50,000
2–6 75,000 p.a.
Required: Compute NPV of the project and advise again whether project is financially
viable or not.
Solution
Years Rs.
1 PV of cash flow (Rs. 50,000 x 1.088-1) 45,956
(Rs. 75,000 p.a. x Annuity factor at 8.8%, 5) x 1.088-1 269,526
= Net present value (9,518)
Decision: The project has a negative NPV and should not be undertaken.
4.6) Net present value of perpetuity cash flows
Definition of perpetuity cash flows

▪ Perpetuity is the:
- series of equal cash flows
- at regular intervals
- for unlimited period of time.
▪ For example, annual interest payment for irredeemable debentures is an example of
perpetuity cash flows in which annual interest is paid for foreseeable future.
Types of perpetuities
▪ There are three types of perpetuities in real world:
Type of Description Present value
perpetuities
Ordinary - Series of equal cash flows will PV = Annual CF ÷ r
perpetuity arise at the end of each year, and
from T1.
Advanced - Series of equal cash flows will PV = Annual CF + (Annual CF ÷ r)
perpetuity arise at the beginning of each
year, and
from T0.
Delayed - Series of equal cash flows will PV = (Annual CF ÷ r) x DF of
perpetuity arise at the end of each year, and previous year
after T1.
Note: where r = discount rate
Example 17.13
A company is planning to investment Rs. 2,000 and expects equal annual cash flows for
foreseeable future:
a) Rs. 1000 p.a. received from end of Year 1 onward or
b) Rs. 1000 p.a. received from end of Year 2 onward or
c) Rs. 1000 p.a. received from now onwards
The discount rate is 10% per annum
Required Calculate NPV of the project under each case of perpetuity separately.
Solution
NPV of perpetuity cash flows at 10%
a) NPV of project at 10%
Years Rs.
1-∞ PV of annual cash flows (Rs. 1,000 ÷ 0.10) 10,000
b) NPV of project at 10%
Years Rs.
2–∞ PV of annual cash flows
(Rs. 1,000 ÷ 0.10) x 1.10-1 9,091
c) NPV of project at 10%
Years Rs.
0-∞ PV of annual cash flows
Rs. 1,000 + (Rs. 1,000 ÷ 0.10) 11,000
Example 17.14
A company is planning to make investment of Rs. 5,000 and expects five equal annual cash
flows of Rs. 2000 p.a. from now onward then later on four equal annual cash flows of Rs. 1,000
each and then Rs. 500 per annum to infinity. The discount rate is 10% per annum
Required: Calculate NPV of the project.
Solution
Years Rs.
(Rs. 1,000 x Annuity factor at 10%,4) x 1.10-4 2,165
(Rs. 500 ÷ 0.10) x 1.10-8 2,333
12,838
= Net present value +7,838
Example 17.15 – ICAP CAF 08 Question Bank
a) A company has estimated that its cost of capital is 8.8%. It is deciding whether to invest in
a project that would cost Rs. 325,000.
Required: Calculate the NPV if the net annual cash flows of the project after investment
are Rs. 75,000 per year from year 1 to 6.
b) Calculate the NPV if the net cash flows of the project after Year 0 are:
Years Cash Flows (Rs.)
1 50,000
2–6 75,000 per annum
c) Calculate the NPV if the net annual cash flows of the project are Rs. 50,000 every year in
perpetuity.
Solution
a) NPV at 8.8%
Years Rs.
(Rs. 75,000 x Annuity factor 8.8%, 6) 338,460
b) NPV at 8.8%
Years Rs.
1 PV of cash flows
(50,000 x 1.088-1) 45,956
(Rs. 75,000 x Annuity factor 8.8%, 5) x 1.088^-1 269,526
315,482
= Net present value (9,518)
c) NPV at 8.8%
Years Rs.
(50,000 ÷ 0.088) 568,182
Example 17.16 – ICAP CAF (08) Question Bank
Calculate the NPV and IRR of an investment with the following estimated cash flows, assuming
a cost of capital of 8%:
Annual Cash flows
Years
(Rs.’000)
0 (3,000)
1–4 500
5–8 400
9 – 10 300
11 – perpetuity 100
Solution
Years Rs.’000
(Rs. 500 x Annuity factor 8%, 4) 1,656
(Rs. 400 x Annuity factor at 8%,4) x 1.08-4 974
9 – 10 PV of annual cash flows
(Rs. 300 x Annuity factor at 8%,2) x 1.08-8 289
11 - ∞ PV of annual cash flows
(Rs. 100 ÷ 0.08) x 1.08-10 579
3,498
= Net present value +498
4.7) Advantages and disadvantages of NPV
Advantages of NPV
The advantages of the NPV method of investment appraisal are that:
▪ NPV takes account of the timing of the cash flows by calculating the present value for each
cash flow at the investor’s cost of capital.
▪ DCF is based on cash flows.
▪ It evaluates all cash flows from the project which means cash flows of whole life are
considered.
▪ It gives a single figure, the NPV, which can be used to assess the value of the investment
project. The NPV of a project is the amount by which the project should add to the value of
the company, in terms of ‘today’s value’.
▪ The NPV method provides a decision rule which is consistent with the objective of
maximization of shareholders’ wealth. In theory, a company ought to increase in value by
the NPV of an investment project (assuming that the NPV is positive).
Disadvantages of NPV
The main disadvantages of the NPV method are:
▪ The time value of money and present value are concepts that are not easily understood.
▪ There might be some uncertainty about what the appropriate cost of capital or discount
rate should be for applying to any project.
▪ It does not take into account the risk and uncertainty of estimates and scarcity of
resources.
▪ It fails to relate the return of the project to the size of the initial cash outlay (Capital
investment).
LO5 : INTERNAL RATE OF RETURN ( IRR)
5.1) Definition of internal rate of return (IRR)
▪ Internal rate of return (IRR) is the cash based annual return expected from capital
investment project. or
▪ It is defined as the discount rate that sets NPV of project to zero.
5.2) Computation of internal rate of return (IRR)
▪ IRR can be computed by using:

- Trial and error method or
- Interpolation method
(A) Computation of IRR – Trial and error method
▪ In order to calculate IRR through trial-and-error method following approach is used:
- Different discount rates are selected
- NPV is calculated at each selected discount rate
- Identify the discount rate (as IRR) where NPV becomes zero.
Example 17.17
A project requires initial investment of Rs. 1,000 and expects to generate cash flow of Rs.
1,400 at the end of year 1.
Required:
a) Calculate NPV of this project at following discount rates:
Discount rates 10% 20% 30% 40% 50% 60% 70% 80%
b) Also prepare graph of NPV with respect to discount rate and identify IRR from graph as
well.
Solution
a) NPV at different discount rates
Discount rates 0% 10% 20% 30% 40% 50% 60% 70% 80%
NPV 400 248 139 59 0 (44) (78) (104) (123)
b) Graph
(B) Computation of IRR – Interpolation method

This method has following steps:
▪ Step 1 - Calculate NPV of the project at given cost of capital rate
▪ Step 2 - Select second discount rate and calculate second NPV:
- If first NPV is positive then select higher discount rate to find out negative NPV or
- If first NPV is negative then select lower discount rate to find out positive NPV
▪ Step 3 - Use interpolation formula to estimate IRR
IRR = L% + [(NPVL ÷ (NPVL – NPVH)) x (H% - L%)]
Where
L% = Low discount rate
NPVL = + ve NPV at low discount rate
H% = High discount rate
NPVH = - ve NPV at high discount rate
Example 17.18
Using the following data from solution of example 17.6, estimate internal rate of return of the
project.
Discount rates 8% 12%
Net present values Rs. 3,128 (Rs. 676)
Solution
L% = Low discount rate = 8% NPVL = + ve NPV at low discount rate = Rs. 3,128
H% = High discount rate = 12% NPVH = -ve NPV at high discount rate = (Rs. 676)
IRR = 8% + [(3,128 ÷ (3128 – (-676))) x (12% - 8%)] = 11.29%
5.3) Decision making rule of IRR
▪ If company has single investment project and IRR (%) of the project is more than given cost
of capital then company will accept the project. In vice versa case company will reject the
project.
▪ If company has multiple investment projects, then any project with highest IRR (%) will be
better.
A business requires a minimum expected rate of return of 12% on its investments. A proposed
capital investment has the following expected cash flows and net present value:
Discount Present Discount Present
Cash flows
Year factor at value at factor at value at
(Rs.)
10% 10% 15% 15%
0 (80,000) 1.000 (80,000) 1,000 (80,000)
1 20,000 0.909 18,180 0.870 17,400
2 36,000 0.826 29,736 0.756 27,216
3 30,000 0.751 22,530 0.658 19,740
4 17,000 0.683 11,611 0.572 9,724
NPV + 2,057 (5,920)
Required: Compute IRR of the project and decide whether project is financially viable or not?
Solution
H% = High discount rate = 15% NPVH = -ve NPV at high discount rate = (Rs. 5,920)
IRR = 10% + [(2,057 ÷ (2,057 – (-5,920))) x (15% -10%)] = 11.30%
Decision: The IRR of the project (i.e., 11.3%) is less than required rate of return (i.e., 12%) so
project should not be undertaken.
The following information is about a project.
Year Rs.
0 (53,000)
1 17,000
2 25,000
3 16,000
4 12,000
This project has an NPV of Rs. 2,210 at a discount rate of 11%.
Required: Calculate expected IRR of the project.
Solution
There is positive NPV of Rs. 2,210 at 11% so we have to assume a higher discount rate (say
15%) to find out negative NPV.
H% = High discount rate = 15% NPVH = -ve NPV at high discount rate = ?
NPV at 15%
Cash Discount Present value
Years
flow factor at 15% at 15%
0 (53,000) 1.000 (53,000)
1 17,000 0.870 14,790
2 25,000 0.756 18,900
3 16,000 0.658 10,528
4 12,000 0.572 6,864
NPV (1,918)
IRR = 11% + [(2,210 ÷ (2,210 – (-1,918))) x (15% -11%)] = 13.14%
5.4) Advantages of disadvantages of IRR
Advantages
The main advantages of the IRR method of investment appraisal are:
▪ As a DCF appraisal method, it is based on cash flows, not accounting profits.
▪ Like the NPV method, it recognizes the time value of money.
▪ It is easier to understand an investment return as a percentage return on investment than
as a money value NPV in Rs.
▪ For accept/reject decisions on individual projects, the IRR method will reach the same
decision as the NPV method If company has single investment project and IRR (%) of the
project is more than given cost
Disadvantages
The main disadvantages of the IRR method of investment appraisal are:
▪ It is a relative measure (% on investment) not absolute measure in Rs... Because it is a
relative measure, it ignores the absolute size of the investment. For example, which is the
better investment if the cost of capital is 10%:
- An investment with an IRR of 15% or
- An investment with an IRR of 20%.
▪ If the investments are mutually exclusive, and only one of them can be undertaken the
correct answer is that it depends on the size of each of the investments. This means that
the IRR method of appraisal can give an incorrect decision if it is used to make a choice
between mutually exclusive projects.
▪ Unlike the NPV method, the IRR method does not indicate by how much an investment
project should add to the value of the company
5.5) Comparison of NPV and IRR
The key points to note are that:

▪ It is often equally as good to use NPV or IRR.
▪ However, NPV has two advantages over IRR:
- The NPV method indicates the value that the investment should add (if the NPV is
positive) or the value that it will destroy (if the NPV is negative).
- When there are two or more mutually exclusive projects, the NPV will always identify
the project that should be selected. This is the project that will provide the highest
value (NPV).
- Another disadvantage of the IRR method is that a project might have two or more
different IRRs, when some annual cash flows during the life of the project are
negative. (The mathematics that demonstrate this point are not shown here.)
▪ The IRR method has the advantage of being more easily understood by non-accountants
so it is mostly used in practice.
5.6) Practice Questions of IRR
➢ ICAP past papers CAF (08) - Autumn 2015 (Q2) – Class Notes (Q 2)
➢ ICAP past papers CAF (08) – Spring 2016 (Q 4) – Class Notes (Q 3)
LO6 : RELEVANT COSTING PRINCIPLES IN PROJECT APPRAISAL
6.1) Definition of relevant cost and its features
Definition of relevant cost

▪ Relevant costs are defined as:
- future costs
- that will be paid in cash
- as a result of implementing a particular decision proposal.
Features of relevant costs
▪ Relevant costs are costs that will occur in the future. They cannot include any costs that
have already occurred in the past.
▪ Relevant costs are the costs that will occur as a result of making the particular decision.
Costs that will occur anyway, no matter what decision is taken, cannot be relevant to the
decision.
▪ Relevant costs are cash flows. Notional costs, such as depreciation charges, notional
interest costs and absorbed fixed costs cannot be relevant to a decision.
6.2) Types of relevant costs
Incremental costs
▪ An incremental cost means an additional cost that will be occurred and paid in cash due to
implementation of a particular decision.
▪ For example, A company is planning to launch a new product and company would appoint
a new supervisor for the manufacturing of this new product. Salary cost of this additional
new supervisor will be an incremental cost.
Avoidable costs
▪ An avoidable cost is a cost that would be saved or avoided or eliminated or reduced due to
implementation of a particular decision.
▪ For example, a company currently pays rent of Rs. 10,000 for a special warehouse used for
storage of product X. If company plans to close (shut down) this product then warehouse
is left. Rent cost of Rs. 10,000 can be saved or avoided due to shut down decision. So, this
cost of Rs. 10,000 can be said as avoidable cost for shut down decision.
Differential costs
▪ Differential cost means any existing cost that will change in future as a consequence of
implementation of particular decision.
▪ For example, a company currently pays managerial salaries of Rs. 100,000 per annum. If
company undertakes investment project, then bonus of Rs. 20,000 per annum will be
granted to existing managerial staff. So, this bonus cost is known as incremental cost as
well as differential cost.
Opportunity costs
▪ Opportunity cost is a possible future cash benefit of best alternative opportunity forgone
due to implementation of a particular decision.
▪ Examples of opportunity cost may include:

- Annual rental income of premises forgone due to investment project
- Annual contribution forgone due to new investment project
- Sales revenue forgone
- Sale value of any asset forgone
6.3) Types of irrelevant costs
Sunk costs
▪ Sunk cost means any cost that has already been incurred or paid in past and that cost
cannot be reversed.
▪ For instance, a company is planning to make capital investment in machine to launch a
new product in to the market. It has spent Rs. 500,000 on developing the new product,
and a further cost of Rs. 40,000 on market research. Both these costs are sunk because
these costs were already paid in past and these costs can’t be refunded whether the
product is launched or not.
Unavoidable costs
▪ An unavoidable cost is a cost that will be incurred anyway and cannot be saved/ avoided
in any case.
▪ For example, a company currently pays rent of Rs. 100,000 for a warehouse used for all
products. If any product is closed then warehouse will be used for other products and this
rent cannot be saved or avoided.
Committed costs
▪ Committed cost refers to any cost that was agreed (promised) due to contractual obligation
in past but cash will be paid in future whether decision is implemented or not.
▪ For instance, A building was acquired 3 years ago at annual rentals of Rs. 200,000 for 10
years. All previous rentals are sunk cost and remaining future rentals are committed costs.
Notional costs
▪ Any cost which is not actually paid in cash but accounted for calculation of accounting
profit.
▪ Examples of notional costs may include:
- Depreciation expense of existing non-current assets,
- Provision for doubtful debts
- Allocation or absorption or apportionment of fixed cost by using absorption rate.
- Allocated or absorbed or apportioned fixed costs
- Other non-cash expenses
6.4) Relevant cost of material, labour, overheads and non-current assets
(A) Relevant cost of material

▪ If company normally purchases raw material from supplier, then relevant cost of material
required for investment project can be determined as follows:
Sr. Situation Relevant items
No.
1 Material is not available in stock Purchase cost is an incremental cost.
2 Material is available in stock and has Purchase cost is an incremental cost.
frequent use
3 Material is available in stock and has no regular use:
(i) Can be disposed of at a cost. Disposal cost’s saving is an avoidable cost and
will be recorded as relevant benefit.
(ii) Can’t be sold as scrap & has no Nothing is relevant cost.
alternative use.
(iii) Can be sold as scrap only Scrap value forgone is an opportunity cost.
(iv) Can be sold as scrap or it has some a) Scrap value
alternative use b) Benefit of alternative use
Higher of (a) or (b) will be forgone so it will be
an opportunity cost.
▪ If company normally manufactures the raw material in house, then relevant cost of
material required for investment project can be determined as follows:
Relevant cost of internally produced material Rs.
Material cost x
Add: Labour cost x
Add: Variable factory overheads cost x
Add: Additional fixed factory overheads cost (if given) x
= Relevant cost of material x
Example 17.21
A company is taking a decision for an investment project that requires three types of material (A,
B and C). Data relating to the material requirements are as follows:
Materials Annual Inventory Original Current Scrap
Requirement (Kgs) purchase cost Purchase Value (Rs.
(Kgs) (Rs. /Kg) price (Rs./Kg) /Kg)
A 500 100 40 55 25
B 400 250 55 52 45
C 350 300 30 45 18
- Material A is regularly used by the company in normal production.
- Material B is no longer in use by the company and has no alternative use but it can be sold
as a scrap.
- Material C is not frequently used; it can be sold as a scrap or can be used as a substitute
material in place of Material Z which has current cost of Rs. 25 per kg.
Required: Calculate total relevant cost of material for investment project of 3 years assuming
purchase cost is not expected to increase in future.
Solution
1 2 3
Rs. Rs. Rs.
Material A cost
(Rs. 55 per kg x 500 Kgs p.a.) (N1) 27,500 27,500 27,500

Material B cost:
Scrap value forgone (Rs. 45 per kg x 250 Kgs) 112,50 - -
Purchase cost (Rs. 52 x 150 Kgs) (Rs. 52 x 400 Kgs) 7,800 20,800 20,800
Material C cost
Saving in purchase cost of Z forgone (Rs. 25 x 300 Kgs) (N2) 7,500 - -
Purchase cost (Rs. 45 x 50 Kgs) (Rs. 45 x 350 Kgs) 2,250 15,750 15,750
= Total relevant cost of material for 3 years. 56,300 64,050 64,050
N1) Since, material A has regular use, therefore purchase cost will be considered as relevant
cost.
N2) Material C is also available in stock and has no frequent use. In year 1, for 300 Kgs of
material C opportunity cost will be relevant whereas for 50 Kgs purchase cost will be relevant.
Opportunities of Material C for 300 Kgs
(i) Scrap value = Rs. 18 per Kg
(ii) Saving in purchase cost of Material Z = Rs. 25 per Kg
If we use, material C for special project then benefit of best opportunity will be forgone and in
subsequent years, purchase cost will be relevant.
(B) Relevant cost of labour

▪ If company pays fixed monthly or fixed annual salary then nothing will be relevant cost
except some bonus is paid by company due to investment project.
▪ If company pays hourly wages to workers for guaranteed hours, then relevant cost will be
determined as follows:
No.
1 Labour has spare hours (i.e., paid hours are more than working hours).
(i) Full wages rate is committed to pay in spare hours Nothing is relevant because there is no
incremental cost.
(ii) Partial wages rate is committed to pay in spare Incremental wages rate is relevant
hours cost.
(iii) Full wages rate is committed to pay in spare hours Hiring cost of new short worker is an
but worker is temporarily posted in place of other incremental cost and relevant cost.
type of short worker.
2 Labour has no spare hours or labour is fully employed.
(a) Hiring cost = Recruitment and training cost of new worker
(b) Overtime cost = Normal wages rate per hour + Overtime premium per hour
(c) Diversion cost = Normal wages rate per hour + Contribution forgone per hour
Lower of (a) or (b) or (c) is relevant cost
Example 17.22
A company is considering a project that will require labour time in following three
departments:
Department 1: The project would require 200 hours of work in department 1, where the
work force is normally paid Rs. 10 per hour. There is currently 500 spare labour capacity in
department 1 and 80% of normal rate is already paid in spare hours.
Department 2: The project would require 100 hours of work in department 2 where the
workforce is paid Rs. 12 per hour. This department is currently working at full capacity. The
company could ask the work force to do overtime work, paid for at the normal rate per hour
plus 50% overtime premium. Alternatively, the workforce could be diverted from other work
that earns a contribution of Rs. 4 per hour.
Department 3: The project would require 300 hours of work in department 3 where the
workforce is paid Rs. 20 per hour. Labour in this department is in short supply and all the
available time is currently making product Z, which earns the following contribution:
Rs. Rs.
Selling price per unit 90
Less: Variable cost per unit
Material cost per unit 20
Labour cost (2 hours per unit) 40
Variable overheads cost 10 (70)
= Contribution per unit of product Z 20

Required: What is the relevant cost for the project of labour in the three departments?
Solution
Relevant Labour cost of 3 Departments
Note Rs.
Department 1 (N1) 400
Department 2 (N2) 1,600
Department 3 (N3) 9,000
11,000
(N1) Department 1
The labour hours required for this contract is 200 hours in department 1. There are 500 hours
of spare labour capacity for which 80% of normal wage rate is committed cost and remaining
20% will be incremental cost for 200 hours due to special contract.
Incremental cost of 200 hours = Rs. 10 x 20% = Rs. 2 per hour x 200 hours = Rs. 400
(N2) Department 2
In Department 2, labour is fully employed so there are two alternatives for 100 hours required
for contract:
i. Overtime payment equal to Rs. 18 per hour (Rs. 12 per hour + Rs. 6 per hour)
ii. Diversion from product OT at cost of Rs. 16 per hour
(Rs. 12 per hour + Rs. 4 per hour) = Rs. 16 per hour
Lower of overtime payment or diversion cost will be relevant cost for 100 hours so relevant
cost will be:
Labour cost of 100 hours = Rs. 16 per hour x 100 hours = Rs. 1,600
(N3) Department 3
The labour hours required for production is 300 hours. The department is currently working
at full capacity and labour in this department is in short supply. Therefore, the relevant cost of
these 300 hours will be the contribution forgone of another product Z from which the labour
is diverted. The product Z earns the contribution of Rs. 10 per hour.
Diversion from product Z
= Normal rate per hour + Contribution forgone per hour
= Rs. 20 per hour + Rs. 10 per hour
= Rs. 30 per hour

Total Diversion cost of 300 hours = Rs. 30 per hour x 300 hours = Rs. 9,000
(C) Relevant cost of overheads

▪ Variable overheads are incurred when products are manufactured and sold so variable
overheads will always be relevant cost.
▪ It is not compulsory that fixed overheads will be incurred due to every next unit of
product manufactured and sold. Fixed overheads
▪ Existing fixed overheads cost of the business will not be relevant cost for project and it be
given in the exam question as:
- Allocation of fixed cost (or allocated fixed cost)
- Apportionment of fixed cost (or apportioned fixed cost)
- Absorption of fixed cost (or absorbed fixed cost)
▪ If fixed cost is increased due to investment project, then this additional amount of fixed
cost will be relevant cost and it is known as:
- Additional fixed cost
- Incremental fixed cost
- Directly attributable fixed cost
Example 17.23
Jahangir Ltd absorbs overheads on a machine hour rate, currently Rs. 20 per machine hour,
out of which Rs. 7 is for variable overheads and Rs. 13 for fixed overheads. The company is
deciding whether to undertake an investment project for which 2,000 machine hours will be
needed for next four years. If the project is undertaken, it is estimated that fixed costs will
increase for the duration of the project by Rs. 32,000 p.a.
Required: Calculate relevant variable and fixed overhead cost for this project.
Solution
Variable overheads cost of each year = Rs. 7 per machine hour x 2,000 hours = Rs. 14,000
Additional fixed overheads cost = Rs. 32,000 p.a.
Note: Fixed overheads absorbed cost is not relevant cost for the project.
(D) Relevant cost of non-current asset

▪ Relevant cost of using non-current asset for the project is determined as follows:
No.
1 Assets is acquired on rent for the Annual rental expense is relevant cost
project
2 New asset is purchased for the project Purchase cost is an incremental cost and scrap
value of asset is relevant benefit at the end of
project life.
3 Existing asset is used for the project Current market value of asset forgone is an
opportunity cost now and scrap value of asset
is relevant benefit at the end of project life.
6.5) NPV with relevant costing
0 1 2 3 4
Rs.’000
Annual income x x x x
Less: Annual variable costs:
Material cost:
Opportunity cost
Purchase cost (x) (x) (x) (x)
Production cost (x) (x) (x) (x)
Labour cost:
Spare capacity @ full rate - - - -
Spare capacity @ remaining rate (x) (x) (x) (x)
Fully employed @ lower of hiring/overtime/diversion (x) (x) (x) (x)
Variable factory overheads (x) (x) (x) (x)
Variable selling and marketing cost (as a % of sales) (x) (x) (x) (x)
Less: Incremental fixed costs:
Annual rental expense (x) (x) (x) (x)
Annual insurance premium (x) (x) (x) (x)
Annual license fee (x) (x) (x) (x)
Annual fixed factory overheads (x) (x) (x) (x)
Annual salaries (x) (x) (x) (x)
Less: Annual opportunity cost:
Annual rental income forgone (x) (x) (x) (x)
Annual contribution forgone (x) (x) (x) (x)
= Annual operating cash flows of the project x x x x
Initial investment and scrap value:
Land (x) x
Building (x) x
Plant & machinery (x) x
= Net Cash flows of the project (x) x x x x
x Discount factor @ 10% x x x x x
= PV of cash flows (x) x x x x
NPV = PV of future cash inflows – PV of initial investment
Example 17.24
X Ltd. is proposing to invest Rs. 100,000 into new machine for increasing the production of
A22 with remaining four years life. At the end of four years, this equipment would have scrap
value of Rs. 20,000.
Company has already incurred Rs. 10,000 as market research cost to assess the existing
market demand for the product A22. From market survey it is expected that market demand
of product A22 is 10,000 units p.a.
Although presently company is able to meet existing demand of 2,000 units for product A22
but after investment into new machine company will be able to meet additional market
demand. X Ltd. will be able to sell the product at a price of Rs. 25 per unit and variable
production and marketing cost of 10 per unit.
Presently fixed cost of X Ltd. is Rs. 50,000 p.a. (including depreciation charge of Rs. 20,000
p.a.) and after this new investment fixed cost of X Ltd. will increase to Rs. 90,000 p.a.
(including annual depreciation charge of old and new asset).
Required: Calculate NPV of the investment project at 5% cost of capital.
Solution
NPV at 5% 0 1 2 3 4
Annual sales revenue
(Rs. 25 per unit x 8,000 units) 200,000 200,000 200,000 200,000
Less: Annual variable costs
(Rs. 10 per unit x 8,000 units) (80,000) (80,000) (80,000) (80,000)
Less: Annual incremental fixed cost (20,000) (20,000) (20,000) (20,000)
100,000 100,000 100,000 100,000
Initial investment and scrap value (100,000) 20,000
= Net cash flows (100,000) 100,000 100,000 100,000 120,000
Discount factor at 5% 1.000 1.05-1 1.05-2 1.05-3 1.05-4
Present value at 5% (100,000) 95,238 90,703 86,384 98,724
NPV at 5% = + Rs. 271,049
Example 17.25
X Ltd. is considering investing Rs. 1 million in a new machine to manufacture and sell a new
toy.
Following estimates have been made:
- Sales price per unit Rs. 25
- Material Cost per unit Rs. 10 and other variable cost per unit Rs. 8
Annual fixed FOH Rs. 180,000 per annum (50% of fixed overheads will be allocation
of general fixed cost of business).
- Life of project 4 years
- Sales volume 50,000 units in first year, rising by 10,000 units per annum
Required:
(i) Calculate NPV of project assuming cost of capital of 8% and advise whether project is
viable or not.
(ii) Calculate IRR of project and advise whether project is viable or not.
(iii) Calculate payback period.
(iv) Recalculate NPV of project, if annual production and sale is 65,000 units.
Solution
(i) Net present value of project at 8%
NPV at 8% 0 1 2 3 4
Sales units 50,000 60,000 70,000 80,000
Rs.’000
(Rs. 25 per unit x Sale units) 1,250 1,500 1,750 2,000
Less: Annual variable cost
(Rs. 18 per unit x Production units) (900) (1,080) (1,260) (1,440)
Less: Annual incremental fixed costs
(Rs. 180,000 x 50%) (90) (90) (90) (90)
= Annual operating cash flows 260 330 400 470

x: Discount factor @ 8% - 1.08-n 1.000 1.08-1 1.08-2 1.08-3 1.08-4
= PV of cash flows (1,000) 240.74 282.92 317.53 345.46
NPV = Rs. 186.65 or Rs. 186,650
Decision: The project has positive NPV so it should be undertaken.
(ii) Internal rate of return (IRR)
L% = 8% NPVL = Rs. 186,650
H% = 15% NPVH =?
NPV at 15% 0 1 2 3 4
x: Discount factor @ 15% 1.000 1.15-1 1.15-2 1.15-3 1.15-4
= PV of cash flows (1,000) 226.09 249.53 263.01 268.72
NPV at 15% = 7.35 or Rs. 7,350
IRR = 18% + [(186,650 ÷ (186,650 – 7,350))) x (15% - 8%)] = 15.29%
Decision: The internal rate of return of project is more than cost of capital of 8% so project
should be undertaken.
(iii) Payback period
Years Cash Flows Balance
(Rs.’000) (Rs.’000)
0 (1,000) (1,000)
1 260 (740)
2 330 (410)
3 400 (10)
4 470 460
Payback period = 3 years + 0.02 years (10,000 ÷ 470,000)
Payback period = 3.02 years
(iv) Revised net present value at 8%

0 1–4
Revised NPV at 8% Rs.’000
(Rs. 25 per unit x 65,000 units) 1,625
(Rs. 18 per unit x 65,000 units) (1,170)
Less: Annual incremental fixed cost (90)
= Annual operating cashflows 365
Initial investment (1,000) 3.312*
Discount factor at 8% 1.000 1,208.9
Revised NPV at 8% = + Rs. 208.9 or Rs. 208,900
*Annuity factor = [(1 – (1.08)-4) ÷ 0.08] = 3.312
(OR)
Years Description Cash Flows DF @ 8% Present
value
0 (Investment) (1,000) 1.00 (1,000)
1–4 Annual sales 1,625 p.a. 3.312 5,382
1–4 Annual variable cost (1,170) p.a. 3.312 (3,875)
1–4 Annual fixed cost (90) p.a. 3.312 (298)
+ 209
6.6) Practice Question on NPV with relevant costing
LO7 : INFLATION IN PROJECT APPRAISAL
7.1) Definition of inflation
▪ When a company makes a long-term capital investment project, then costs and benefits
will be available for a number of years.
▪ It is unlikely that such costs and benefits will remain constant throughout project life.
▪ It is probable that future cash flows will be affected by sales price inflation and inflation in
costs.
▪ So, a question arises what is inflation?
▪ Inflation is defined as ‘increase in general price level’.
7.2) Types of inflation rates
General inflation rate

▪ General inflation is the overall change in the prices of goods and services.
▪ It is also known as single inflation rate for whole economy.
▪ It is calculated as an average of the specific inflation rates.
Specific inflation rate

▪ Specific inflation rate is the change in prices of each individual good and service.
▪ It is separate inflation rate for each cash flow of the economy.
▪ It is more accurate representation of inflation rate than general inflation rate.
▪ For example, the specific inflation rate fuel oil prices might be 10% whereas the specific
rate of rice inflation might be 1%.
7.3) Impact of inflation rate in NPV
In computation of NPV, inflation has impact on cash flows and cost of capital rate:
▪ Cash Flows (in Rs.) will increase due to specific inflation rates for sale price and costs.
▪ Cost of capital rate (%) will also increase but due to general inflation rate because investor
require higher return to cover inflation in economy.
Note: In absence of specific inflation rates, cash flows may inflate by using general inflation rate.
7.3) Real method of NPV vs Nominal method of NPV
▪ The term real means non-inflated figures.

▪ The term nominal means inflated figures.
▪ Both the terms of real and nominal are used for cash flows and cost of capital.
▪ Non-inflated cash flows are known as real cash flows or current price cash flows whereas
inflated cash flows are known as nominal cash flows or money cash flows.
▪ Non-inflated cost of capital is known as real cost of capital whereas inflated cost of capital
is known as nominal cost of capital or money cost of capital.
▪ Following table can be used to summarise the real and nominal NPV.
Non-inflated Inflated
Cash Flows (Rs.) ▪ Real cash flows ▪ Nominal cash flows

▪ Current price cash flows ▪ Money cash flows
Cost of capital ▪ Real cost of capital ▪ Nominal cost of capital
(%) ▪ Real discount rate ▪ Money cost of capital
Real method of NPV = Nominal method of NPV

▪ In presence of inflation, any of the following two approaches can be used:
- Under real method of NPV real cash flows are discounted at real cost of capital to find
out NPV.
- Under nominal method or money method of NPV, nominal or money cash flows are
discounted at money cost of capital to find out NPV.
7.4) Inflating the cashflows
▪ Sale price, variable cost, attributable fixed costs and all other cash flows will inflate.
▪ Cash flows can be inflated by using either of the following formula:
Same inflation rate for each year
Inflated cash flows = Non-inflated cash flows x (1 + specific inflation rate)n
Where n = number of inflationary periods
Different inflation rates for each year
Inflated cash flow = Previous cash flows x (1 + specific inflation rate)
▪ For example, present sale price of the product is Rs. 20 per unit and it is expected that sale
price will inflate by 10% p.a. So, inflated sale price per unit for each year will be as
follows:
- Sale price per unit after 1 year = Rs. 20 x 1.101= Rs. 22 per unit
- Sale price per unit after 2 years = Rs. 20 x 1.102= Rs. 24.20 per unit
▪ Continuing the above example again, present sale price of the product is Rs. 20 per unit
and it is expected that sale price will inflate by 5% in year 1, 8% in year 2, 6% in year 3
and 9% in year 4. So, inflated sale price per unit for each year will be as follows:
- Sale price per unit after 1 year = Rs. 20 x 1.05= Rs. 21 per unit
- Sale price per unit after 3 years = Rs. 22.68 x 1.06 = Rs. 24.04 per unit
- Sale price per unit after 4 years = Rs. 24.04 x 1.09= Rs. 26.20 per unit
7.5) Timing for cashflows inflation
▪ If sale price, variable cost, attributable fixed costs and all other cash flows are given at
current price or present-day terms then inflate the cash flows from Year 1.
▪ If sale price, variable cost, attributable fixed costs and any other cash flow are given for
Year 1 then inflate the cash flows from Year 2.
▪ If sale price, variable cost, attributable fixed costs and all other cash flows are given
without clear statement then you can take reasonable assumption.
Example 17.26
Following data is given for an investment project having life of 3 years.
- Current sale price per unit is Rs. 5 per unit and expected to increase by 10% due to
inflation.
- Currently material cost is Rs. 2 per unit and expected to inflate by 5% whereas
current labour cost per unit is Rs. 1.75 and it is expected to inflate by 4% p.a.
- Attributable fixed overheads in Year 1 would be 1,000 p.a. and will inflate by 3% p.a.
- Annual sales volume = 2,000 units p.a.
Required: Calculate annual operating cash flows of the project in nominal terms.
Solution
Inflated sale price per unit 1 2 3
Current sale price per unit (Rs.) 5 5 5
x Inflation at 10% p.a. x 1.101 x 1.102 x 1.103
= Inflated sale price per unit 5.50 6.05 6.65
Inflated material cost per unit 1 2 3

Current material cost per unit (Rs.) 2 2 2
= Inflated material cost per unit (Rs.) 2.10 2.21 2.32
Inflated labour cost per unit 1 2 3

Current labour cost per unit (Rs.) 1.75 1.75 1.75
= Inflated labour cost per unit (Rs.) 1.82 1.89 1.97
Inflated annual fixed costs 1 2 3

Fixed cost in year 1 (Rs.) 1,000 1,000 1,000
x Inflation at 3% p.a. from Year 2 - x 1.031 x 1.032
= Inflated annual fixed cost (Rs.) 1,000 1,030 1,061
Annual operating cash flows 1 2 3

Annual Sales (Sale price x 2,000 units) 11,000 12,100 13,310
Less: Material costs (Material cost per unit x 2,000 (4,200) (4,420) (4,640)
units)
Less: Labour costs (Labour cost per unit x 2,000 units) (3,640) (3,780) (3,940)
Less: Annual fixed costs (1,000) (1,030) (1,061)
= Annual operating cash flows (Rs.) 2,160 2,870 3,669
7.6) Inflating the cost of capital (%)
▪ Cost of capital (%) can be inflated from real rate to nominal rate by using Fisher equation.
▪ The formula for Fisher equation nis as follows:
(1 + n) = (1 + r) x (1 + i)
(OR)
(1 + nominal rate) = (1 + real rate) x (1 + General inflation rate)
▪ For example, real cost of capital is 10% and inflation rate is 5% then nominal cost of
capital would be as follows:
(1 + nominal rate) = (1 + 0.10) x (1 + 0.05)

(1 + nominal rate) = 1.155
Nominal rate = 1.155 – 1 = 0.155 or 15.5%
▪ Fisher equation can be used to convert real cost of capital into nominal cost of capital and
vice versa.
Note: If question is silent then we will assume that nominal cost of capital is given to compute
nominal NPV.
Example 17.27
a) Real rate of return = 8%, Inflation rate = 15%
Required: Calculate nominal rate of return by using Fisher Formula.
b) Nominal rate of return = 26.5%, General inflation rate = 15%
Required: Compute real rate of return using Fisher Formula.
Solution
a) Nominal rate of return
(1 + nominal rate) = (1 + real rate) x (1 + general inflation rate)
(1 + nominal rate) = (1 + 0.15) x (1 + 0.08)
(1 + nominal rate) = 1.242
Nominal rate = 1.242 – 1 = 0.242 or 24.2%
b) Real rate of return
(1 + nominal rate) = (1 + real rate) x (1 + general inflation rate)
(1 + 0.265) = (1 + real rate) x (1 + 0.15)
(1 + nominal rate) = 1.265 ÷ 1.15 = 1.10 – 1 = 0.10 or 10%
Example 17.28
Storm Ltd is evaluating project X. which requires an initial investment of Rs. 100,000.
Expected annual sales revenue is Rs. 80,000, annual variable costs are Rs. 30,000 and
attributable fixed costs are Rs. 10,000 p.a. for 4 years at today’s prices. However, these cash
flows are expected to rise by 5.5% per annum because of inflation. The firm’s nominal cost of
capital is 15%.
Required: Find the NPV by:
a) Discounting the real cash flows at real cost of capital
b) Discounting the money (nominal) cash flows at nominal cost of capital
Solution
a) NPV of project under real method
Years Description Cash Flows DF @ 9% (W1) Present value
0 Initial investment (100,000) 1.00 (100,000)
1–4 Annual real cash flows 40,000 p.a. 3.240 129,600
NPV +29,600
b) NPV of project under nominal method
Years 0 1 2 3 4
Initial Investment (100,000)
Annual cash Flows (W2) -- 42,200 45,521 46,970 49,553
P.V Factor 15% 1.00 0.870 0.756 0.658 0.572
Present Value (100,000) 36,714 33,656 30,904 28,344
Note: NPV under real method and nominal method is approximately same. Difference of Rs. 18 is
due to rounding off error.
(W1) Real cost of capital
(1 + nominal rate) = (1 + real rate) x (1 + inflation rate)
(1 + 0.15) = (1 + real rate) x (1 + 0.055)
(1 + real rate) = 1.15/1.055
(1 + real rate) = 1.0900
Real rate = 1.0900 – 1 = 0.09 or 9%
(W2) Annual nominal cash flows
Year 1 = Rs. 40,000 x (1.055)1 = Rs. 42,200
Year 2 = Rs. 40,000 x (1.055)2 = Rs. 44,521
Year 3 = Rs. 40,000 x (1.055)3 = Rs. 46,970
Year 4 = Rs. 40,000 x (1.055)4 = Rs. 49,553
7.7) Exam guidance regarding real method vs nominal method of NPV
▪ If examiner is silent about whether to calculate NPV under nominal method or real
method then we will use following guidance:
Sr. Situation Method to calculate NPV
#
(i) If single inflation - In this case, NPV can be calculated by using real method
rate is given in or normal method. Both methods are acceptable and have
question. equal answer but nominal method is normally used in
ICAP solutions.
- If cash flows and/or cost of capital are given in real terms
then we will inflate them.
(ii) If multiple inflation - In this case, NPV will be calculated by using normal
rates are given in method.
question. - Normally cashflows are given in real terms so we will
inflate the cash flows.
Example 17.29
A project under consideration has the following projected data. All cash flows are given in
current prices.
Years 0 1 2 3 to 10
Cash Flows (Rs.’000) (3,400) 200 400 600 p.a.
The rate of inflation is 3% and all cash flows will inflate at this inflation rate. Firm’s cost of
capital is 11.24%.
Required: Calculate the NPV of the project and determine whether the project is worthwhile
or not.
Solution
Rs.’000
Years 0 1 2 3 – 10
Initial Investment (3400)
Annual real cash flows -- 200 400 600 p.a.
DF @ 8 % (W1) 1.00 1.08-1 1.08-2 4.927 (W2)
Present value (3400) 185.2 342.9 2956.2
Net present value = + Rs. 84,300
(W1) Real cost of capital rate

(1 + nominal rate) = (1 + real rate) x (1 + inflation rate)
(1 + 0.1124) = (1 + real rate) x (1 + 0.03)
(1 + real rate) = 1.1124/1.03
(1 + real rate) = 1.08
Real rate = 1.08 – 1 = 0.08 or 8%
(W2) Annuity factor at 8% from year 3 to 10
Annuity factor = [(1 - (1 + 0.08)-8) ÷ 0.08] x 1.08-2 = 4.927
Student’ note: NPV may be computed by using nominal method but here real method of NPV is
used to save time.
Example 17.30
A company is considering a cost-saving project. This project involves purchasing a machine
costing Rs. 14,000, which will result in annual savings (in current prices) on wages costs of Rs.
2,000 and on material costs of Rs. 800. The following forecasts are made of the rates of
inflation each year for the next five years:
Wage cost inflation rate 10% p.a.
Material costs inflation rate 5%. p.a.
General inflation rate 6% p.a.
Required: Calculate NPV of the project and evaluate whether the investment in machine
should be undertaken or not assuming that cost of capital is 15% and taxation should be
ignored.
Solution
NPV of the project at 15%
Years 0 1 2 3 4 5
Annual saving in material cost
(800 x 1.05n, n=1 from Y1) 840 882 926 972 1,021
Annual saving in wages cost
(2,000 x 1.10n, n=1 from Y1) 2,200 2,420 2,662 2,928 3,221
Annual cash Flows 3,040 3,302 3,588 3,900 4,242
P.V Factor 15% 1.00 1.15-1 1.15-2 1.15-3 1.15-4 1.15-5
Present Value (14,000) 2,643 2,497 2,359 2,230 2,109
NPV at 15% = Rs. (2,162)
Decision: Project should not be undertaken due to negative NPV.
7.8) Practice Questions of NPV with inflation
➢ ICAP past papers CA Final (BFD) – Class Notes (Q 5)

LO8 : TAXATION IN PROJECT APPRAISAL
8.1) Implications of taxation in NPV
When tax rate is given in question then there are three main implications of taxation in NPV:
▪ Tax allowable depreciation on non-current assets of the project
- Tax allowable depreciation is an admissible expense for tax purpose.
- Although it is non-cash expense but it reduces taxable profit of the project and
consequently tax liability is saved due to it.
- Initially annual tax depreciation is deducted from annual operating cash flows of the
project and then add back into profit after tax because non-cash items are not
relevant for NPV.
▪ Tax gain or loss on disposal of non-current assets
- At the end of project life, non-current assets of the project are sold at scrap value
and tax allowable gain or loss on disposal of assets will arise in last year.
▪ Tax payment or tax saving
- Companies make tax payment on taxable profit of the project and it is treated as
relevant cash outflow.
- Companies enjoy tax saving on taxable loss or tax saving on any admissible expense
and it is recorded as relevant cash inflow of the project.
8.2) Tax allowable depreciation
Concept of tax allowable depreciation

▪ Tax allowable depreciation is calculated as per the rates and method given in income tax
law.
▪ It is also known as capital allowances.
Types of tax depreciation
▪ Three main types of tax allowable depreciations which can be treated in NPV:
- Initial allowance is only charged only in the year of purchase at given rate.
- Normal tax depreciation is charged in every year at given rate.
- Tax loss or gain on disposal of assets at the end of project.
Methods of tax depreciation
▪ Tax depreciation is normally calculated by using reducing balance method but examiner
may require to charge tax depreciation on straight line basis.
▪ Tax depreciation under straight line method can be computed by using following formula:
Annual tax depreciation = (Cost of assets – Scrap value) ÷ Useful Life
▪ For example, cost of new plant for investment project is Rs. 100,000 with an estimated life
of 4 years. At the end of project, plant would be sold at Rs. 30,000. So, annual tax
depreciation would be Rs. 17,500 [(Rs. 100,000 – Rs. 30,000) ÷ 4 years].
▪ Tax depreciation under reducing balance method can be computed as follows:
Years Tax Depreciation Rs.
1 Initial allowance
(Cost of asset x rate of initial allowance) x
Normal depreciation
(Cost of asset – Initial allowance) x rate of normal depreciation x
2 Normal depreciation
(100% - rate of normal depreciation) x Previous normal x
depreciation
depreciation
depreciation
Exam notes:
(a) Initial allowance is only charged when it is clearly stated in question.
(b) As per tax laws, normal depreciation is not taken in the year of disposal but here in MFA we
have a choice either to consider normal depreciation in last year or ignore it. So, we will take
normal tax depreciation in the last year similar to accounting depreciation.
8.3) Tax gain or tax loss on disposal of assets
Computing tax gain or loss under straight line method of depreciation

▪ Under straight line method, tax gain or tax loss on disposal of asset is not charged in the
last year because scrap value of asset will be equal to carrying value of asset.
▪ Continuing to the previous example of straight-line method:
- Cost of asset is Rs. 100,000;
- Annual tax depreciation is Rs. 17,500.
- Accumulated depreciation for the four years would be Rs. 70,000 (Rs. 17,500 x 4
years).
- Carrying value of the asset at the end of four years would be Rs. 30,000 (Rs. 100,000
– Rs. 30,000) which is equal to scrap value of asset.
- So, no gain or loss will arise in the last year of project.
Computing tax gain or loss under reducing balance method of depreciation
▪ Under reducing balance method, tax gain or tax loss on disposal of asset will be charged in
the last year because scrap value of asset will not be equal to carrying value of asset.
▪ If question clearly states that at the end of project life carrying value of asset is equal to
scrap value of asset, then no gain or loss will arise.
▪ Tax gain or tax loss will be computed by using following formula:
Tax gain or loss = Scrap value of asset – Carrying value of asset
where
Carrying value of asset = Cost of asset – Accumulated tax depreciation
▪ When scrap value of asset is more than carrying value then tax gain will arise.
▪ When scrap value of asset is less than carrying value then tax loss will arise.
Treatment in NPV for tax gain or loss on disposal
▪ Tax gain or tax loss is also a non-cash item similar to tax depreciation so its treatment will
be similar to depreciation.
▪ Initially tax gain on disposal of asset will be added in operating cash flows before tax of
the last year and then subsequently deducted from profit after tax.
▪ Similarly, tax loss of disposal will be deducted initially from operating cash flows before
tax of last year and then later on added back in profit after tax.
Example 17.31
An asset is bought for Rs. 10,000 and will be used for four years and at the end of fourth year it
will be sold at a scrap of Rs. 2,500. Initial allowance is charged at 10% and normal
depreciation is allowed at 25% p.a. reducing balance method.
Required:
a) Calculate amount of tax depreciation (capital allowances) for each year.
b) Calculate amount of tax gain or loss in year of disposal.
Solution
a) Annual tax depreciation
1 Initial allowance (Rs. 10,000 x 10%) 1,000
Normal depreciation (Rs. 10,000 – Rs. 1,000) x 25% 2,250
3,250
2 Normal depreciation (Rs. 2,250 x 75%) 1,688
= Accumulated tax depreciation 7,154
b) Tax gain or tax loss in year of disposal
Rs.
Scrap value of asset at the end of 4 years 2,500
Less: Carrying value at the end of 4 years (Rs. 10,000 – Rs. 7,154) (2,846)
= Tax loss on disposal of asset 346
8.4) Tax payment or tax saving
▪ Annual tax payment will be computed on taxable profits from year 1 onwards and:
- Tax can be paid in the same year; or
- Tax can be paid in the next year/ in the following year/one year in arrears.
▪ In case of taxable loss in any year, tax saving will be computed rather than tax payment.
▪ Any cash flows received or paid at T0 will have tax payment or tax saving from end of year
1 because T0 is the start of tax year.
8.5) Exam standard format of NPV with inflation and taxation effects
▪ Following format can be used to computed net cash flows and NPV of the project with
inflation and taxation effects.
0 1 2 3 4
Net present value under nominal -- Rs.’000 --
method
Inflated annual sales or annual income x x x x
Less: inflated annual variable costs (x) (x) (x) (x)

Less: Inflated annual attributable fixed (x) (x) (x) (x)
costs
Less: Inflated annual opportunity costs (x) (x) (x) (x)
= Annual operating cash flows before tax x x x x
Less: Annual tax depreciation (x) (x) (x) (x)
Add/Less: Tax gain or loss on disposal x/(x)
= Annual taxable profit & loss x x x x
Less: Tax payment or tax saving (x) (x) (x) (x)
= Annual profit & loss after tax x x x x
Add: Annual tax depreciation x x x x
Less/Add: Tax gain or loss on disposal (x)/x
= Annual operating cashflows after tax x x x x
Initial investment in assets and scrap value (x) x
= Net cash flows in nominal terms x x x x
x DF @ nominal cost of capital x x x x
= Present value of cash flows x x x x
Example 17.32
Sarwar Limited (SL) produces accounts annually and has year-end on 31st December each
year. A project is under consideration as follows:
Initial Investment in equipment on 1st January, 2022 Rs. 90,000
Cash Inflows: 31st December 2022 Rs. 45,000
Cash inflows: 31st December, 2023 Rs. 60,000
The equipment has a scrap value of Rs. 52,000 on 31st December 2023. The company pays
corporation tax at the rate of 30% at the end of the same year. The investment will qualify for
tax depreciation at 25% p.a. on the reducing balance.
Required: If the company’s weighted average cost of capital is 12%, calculate NPV of project
and advise about feasibility of project?
Solution
0 1 2
Annual operating cash flows 45,000 60,000
Less: Annual tax depreciation (W1) (22,500) (16,875)
Add: Tax gain on disposal (W1) 1,375
= Annual taxable P& L 22,500 44,500
Less: Tax payment at 30% (6,750) (13,350)
Add: Annual tax depreciation 22,500 16,875
Less: Tax gain on disposal (1,375)
= Annual operating cash flows after tax 38,250 46,650
= Net cash flows (90,000) 38,250 98,650
x DF @ 12% x 1.00 x 1.12-1 x 1.12-2
= Present values (90,000) 34,152 78,643
NPV at 12% = Rs. 22,795
Decision: The project should be undertaken because it has positive NPV.
(W1) Annual tax depreciation and tax gain/loss on disposal

Tax gain or tax loss Rs.
Less: Carrying value at the end of 2 years (Rs. 90,000 – Rs. (50,625)
39,375)
= Tax gain on disposal of asset 1,375
Example 17.33
Fawad Limited (FL) is considering whether or not to purchase an item of machinery costing
Rs. 40,000. It would have a life of four years, and at the end of 4th year it would be sold for Rs.
5,000. The machinery would create annual operating cost savings in cash of Rs. 14,000.
The machinery would attract tax allowable depreciation of 25% on the reducing balance basis.
The rate of corporation tax is 30%. Tax is paid in the following year and after-tax cost of
capital is 8%.
Required: Should the machinery be purchased? Advise.
Solution
0 1 2 3 4 5
Annual operating cost savings 14,000 14,000 14,000 14,000
Less: Annual tax depreciation (W1) (10,000) (7,500) (5,625) (4,219)
Add: Tax gain on disposal (7,656)
= Annual taxable profit & loss 4,000 6,500 8,375 2,125
Less: Tax payment at 30% (1,200) (1,950) (2,513) (638)
Add: Annual tax depreciation 10,000 7,500 5,625 4,219
Less: Tax gain on disposal 7,656
= Annual operating cashflows after tax 14,000 12,800 12,050 11,488 (638)
= Net Cash flows (40,000) 14,000 12,800 12,050 16,488 (638)
x DF at 8% 1.00 1.08-1 1.08-2 1.08-3 1.08-4 1.08-5
= Present value (40,000) 12,963 10,974 9,566 12,199 (434)
NPV at 8% = Rs. 5,187
Decision: Company should purchase the machinery because it has positive NPV.
(W1) Annual tax depreciation and tax gain/loss on disposal
4 Normal depreciation 4,219
Tax gain or tax loss Rs.

Less: Carrying value at the end of 4 years (Rs. 40,000 – Rs. (12,656)
27,344)
= Tax loss on disposal of asset 7,656
8.6) Practice Questions for project appraisal with inflation and taxation effects

➢ ICAP past paper CAF (08) – Spring 2017 (Q 7) – Class Notes (Q 9)
➢ ICAP past paper CAF (08) – Autumn 2017 (Q 4) – Class Notes (Q 10)
➢ ICAP past paper CAF (08) – Autumn 2018 (Q 5b) – Class Notes (Q 19)
➢ ICAP past paper CAF (08) – Spring 2021 (
LO9 : WORKING CAPITAL CHANGES IN PROJECT APPRAISAL
9.1) Basic concepts of working capital
▪ Working capital means investment in net current assets which is equal to current assets
minus current liabilities.
▪ Working capital requirement means funds required for investment in net current
assets.
▪ Working capital changes means change in cash flows due to increase or decrease of
working capital requirement. In project appraisal, following working capital changes are
normally expected:
- At start of project, investment in working capital will be cash outflow;
- During life of project, increase in working capital will be cash outflow and vice versa;
- At the end of project, recovery of working capital will be cash inflow
9.2) Computation of working capital changes
In computation of working capital changes for project, any one of the following four situations
may occur:
▪ Situation 1 – Amount of working capital investment is given without any inflation rate.
▪ Situation 2 – Amount of investment in working capital is given with its inflation rate.
▪ Situation 3 – Amount of investment in working capital is given as a percentage of sales
without any inflation rate.
▪ Situation 4 – Amount of investment in working capital is given as a percentage of sales
with inflation rate.
Situation 1
In situation 1, amount of investment in working capital will be given without any inflation rate
so:
▪ initial investment in working capital will be recorded as cash outflow at start of project,
▪ there will be no change in change in working capital during life of project and hence no
cash inflow or outflow;
▪ recovery of working capital will be recorded as cash inflow in the last year of project
Example 17.34
A project will require investment in working capital equal to Rs. 100,000 at the start of project
and will remain same throughout project life. This amount of working capital will be
recovered at the end of 3 years’ project life.
Required: Calculate working capital changes for each year.
Solution
0 1 2 3
Working capital required 100,000 100,000 100,000 Nil
Working capital changes (100,000) - - 100,000
Note: Working capital changes of each year are recorded in NPV table.
Situation 2
In situation 2, amount of investment in working capital will be given with its inflation rate so:
▪ initial investment in working capital will be recorded as cash outflow at start of project,
▪ there will be increase in working capital in each year so cash outflow will be recorded;
Example 17.35
A project will require investment in working capital equal to Rs. 100,000 at the start of project
and will inflate by 10% per annum. This amount of working capital will be recovered at the
end of 3 years’ project life.
Required: Calculate working capital changes for each year.
Solution
0 1 2 3
Working capital requirement 100,000 100,000 100,000 Nil
x: Inflation at 10% p.a. - x 1.101 x 1.102 -
Inflated working capital requirement 100,000 110,000 121,000 Nil
Inflated working capital changes (100,000) (10,000) (11,000) 121,000
Situation 3
In situation 3, amount of investment in working capital will be given as a percentage of sales
without inflation rate so:
▪ Working capital required will be computed for each year as a percentage of sales.
▪ Initial investment in working capital will be recorded as cash outflow at start of project,
▪ there will be change in working capital in each year with respect to change in sales so cash
outflow will be recorded when sales increases and vice versa;
Example 17.36
A company anticipates sales for the new venture to be Rs. 300,000 in the first year and sales is
expected to remain same over the three years life of the project. Working capital investment
equal to 10% of annual sales is required and needs to be in place at the start of each year.
Required: Calculate the working capital changes of each year.
Solution
0 1 2 3
Annual sales revenue (Rs.) 300,000 300,000 300,000
Working capital requirement
10% of sales 30,000 30,000 30,000 Nil
Inflated working capital changes (30,000) - - 30,000
Situation 4
In situation 4, amount of investment in working capital will be given as a percentage of sales
with inflation rate so:
▪ Annual sales revenue will be inflated at first; then
▪ Working capital requirement of each year will be computed as a percentage of sales.
▪ Initial investment in working capital will be recorded as cash outflow at start of project,
▪ there will be increase in working capital in each year due to inflation so cash outflow will
be recorded;
Example 17.37
A company anticipates sales for the new venture to be Rs. 300,000 in the first year and sales is
expected to increase at the rate of 8% per annum. Working capital investment equal to 10% of
annual sales is required and needs to be in place at the start of each year. Project has a life of
three years.
Required: Calculate the working capital changes of each year.

Solution
0 1 2 3
Annual sales revenue 300,000 300,000 300,000
x: Inflation at 10% p.a. - x 1.082 x 1.083
Inflated annual sales revenue (Rs.) 300,000 324,000 349,920
Inflated working capital requirement
(10% of sales) 30,000 32,400 34,992 Nil
Working capital changes (30,000) (2,400) (2,592) 34,992
9.3) Practice Question for project appraisal

➢ ICAP past paper CAF (08) – Spring 2018 (Q 2b) – Class Notes (Q 14)
➢ ICAP past paper CAF (08) – Spring 2019 (Q 3b) – Class Notes (Q 15)
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C H A PTER 9 : T IM E V ALUE O F M ONEY
Question 1 ICAP – COST ACCOUNTING – CAF 8 - QUESTION BANK – Q 16.1

Conto Company is considering an investment in a new machine that would be used to manufacture a
new product at its existing production center. The product and the machine are both expected to have
an economic life of four years. The following estimates of revenues and costs have been made.
Year 1 2 3 4
Selling price per unit Rs. 8 Rs. 9 Rs. 10 Rs. 10
Variable cost per unit Rs. 4 Rs. 4.50 Rs. 5 Rs. 5.5
Sale volume (unit s) 30,000 40,000 50,000 20,000
It has been estimated that there would be no increase at all in fixed costs, except for depreciation of
the new machine. The machine would cost Rs. 440,000 and at the end of its four-year life it would
have no residual value. The company has a cost of capital of 9%.
Required: Calculate the net present value of the proposed project (08)
Question 2 ICAP – COST ACCOUNTING – CAF 8 - AUTUMN 2015- Q2
Sona Limited (SL) is considering investment in a joint venture. The entire c ash outlay of the project is
Rs. 175 million which would require to be invested by SL immediately. The joint venture partner,
Chandi Limited (CL) would provide all the necessary technical support. The other details of the project
are estimated as follows: The project would extend over a period of four years.
i. Sales are estimated at Rs. 155 million per annum for the first two years and Rs. 65 million per
annum during the last two years.
ii. Cost of sales and operating expenses excluding depreciation would be 50% and 10% of sales
respectively.
iii. CL would be entitled to share equal to 5% of sales and the remaining profit would belong to SL.
iv. At the end of the project, SL would be able to recover Rs. 100 million of the invested amount.
Required: Calculate the project ’s internal rate of return. (09)
Assume that all cash flows other than the initial cash outlay arise annually in arrears.
Question 3 ICAP – COST ACCOUNTING – CAF 8 - SPRING 2016- Q4
Digital Electronics (DE) acquired a plant on 1 January 2016 under a lease arrangement on the following
terms:
Lease period (commencing from 1 January 2016) 3 years
Down payment on commencement of lease Rs. 2.00 million
Lease installments payable annually in arrears Rs. 3.90 million
Amount payable on expiry of the lease term Rs. 0.89 million
On the date of acquisition, fair value of the plant was Rs. 10 million. DE depreciates its property, plant
and equipment over their useful life. The disposal price of the plant at the end of the useful life of four
years is estimated at Rs. 0.50 million. Net cash inflows from the use of the plant are estimated as
under:
Year 2016 2017 2018 2019
Amount (Rs. in million) 5.90 5.20 2.45 1.00
It may be assumed that all cash inflows arise at the end of the year.
Required: Compute internal rate of return (IRR) and advise whethe r it is feasible to acquire the plant
assuming that DE’s cost of capital is 15%. (08)
Question 4 ICAP – BFD – CFAP 04 - QUESTION BANK – Q 3.1
Badger plc., a manufacturer of car accessories is considering a new product line. This project would commence
at the start of Badger plc.’s next financial year and run for four years. Badger plc.’s next year end is 31st
December 2016.
The following information relates to the project:
A feasibility study costing Rs. 8 million was completed earlier this year but will not be paid for until March 2017.
The study indicated that the project was technically viable.
Capital expenditure
If Badger plc. proceeds with the project it would need to buy new plant and machinery costing Rs. 180 million
to be paid for at the start of the project. It is estimated that the new plant and machinery would be
sold for Rs. 25 million at the end of the project.
If Badger plc. undertakes the project it will sell an existing machine for cash at the start of the project for
Rs. 2 million. This machine had been scheduled for disposal at the end of 2020 for Rs. 1 million.
Market research
Industry consultants have supplied the following information:
Market size for the product is Rs. 1,100 million in 2016. The market is expected to grow by 2% per annum.
Market share projections should Badger plc. proceed with the project are as follows:
Market share Cost 2017 2018 2019 2020
data:
7% 9% 15% 15%
2017 2018 2019 2020

Rs.m Rs. m Rs. m Rs. m
Purchases 40 50 58 62
Payables (at the year end) 8
10 11 nil
Payment to sub-contractors, 6
9 8 8
Fixed Overheads (Total for Badger plc)

With new line Without 133 110 99 90
new line
120 100 90 80
Labour costs
At the start of the project, employees currently working in another department would be
transferred to work on the new product line. These employees currently earn Rs. 3.6 million per annum.
They will not be replaced if they work on the new project.
An employee currently earning Rs. 2 million per annum would be promoted to work on the new line at a
salary of Rs. 3 million per annum. A new employee would be recruited to fill the vacated position.
As a direct result of introducing the new product line, employees in another department currently earning Rs. 4
million per annum would have to be made redundant at the end of 2017 and paid redundancy pay of Rs. 6.2
million each at the end of 2018.
Material costs
The company holds a stock of Material X which cost Rs. 6.4 million last year. There is no other use for this
material. If it is not used the company would have to dispose of it at a cost to the company of Rs. 2 million in
2017. This would occur early in 2017.
Material Z is also in stock and will be used on the new line. It cost the company Rs. 3.5 million some years ago.
The company has no other use for it, but could sell it on the open market for Rs. 3 million early in 2017.
Further information
The year-end payables are paid in the following year.
The company’s cost of capital is a constant 10% per annum.

It can be assumed that operating cash flows occur at the year end.
Time 0 is 1st January 2017 (t1 is 31st December 2017 etc.)
Required (17)
Calculate the net present value of the proposed new product line (work to the nearest million).
Question 5 ICAP – CA FINAL - BUSINESS FINANCE DECISIONS
Zuhair Limited is considering introducing a new product. Market research was carried out by the
company to determine the sales potential of the product, which had cost Rs 175,000. Research
suggested that the demand will last for 4 years and the company will be able to manufacture and sell
100,000 units each year. The initial sale price shall be Rs 110 per kg and will increase at a constant rate
of 10% per annum. Production batch size shall continue to be of 12,500 units.
Material: Three types of raw material will be required to manufacture this product. The relevant
information is as under:
Material Available in Requirement Original Current Resale
Stock (Kgs) per unit Purchases purchases price
(Rs. /kg) (Rs./kg) Rs./kg
A 100,000 1.0 Kg 10 8 6
B 120,000 0.5 Kg 12 17 15
C 150,000 2.0 Kg 18 20 16
Prices of raw material are expected to remain constant throughout the period. Material A is in regular use
of the company. Material B would be sold if not used. Material C was purchased few years back and is
considered obsolete.
Labour:
Labour related information is as follows:
Labour Rate Man hours Surplus Labour hours

Type (Rs. per hour) per batch
Skilled 100 6250 20,000 hours available in

Year 1 and Year 2
Unskilled 40 5000 NIL
Labour charges are expected to increase by 5% per annum
Machines:
The production will be carried out on two machines RR and YY.
• RR was purchased two years ago at a cost of Rs 900,000 and presently it is working below
capacity and can easily be used for producing the required quantity of the new product.
• Machine YY is available in the market at a cost of Rs. 750,000.
• Resale values of machines RR and YY after the end of the project life are estimated at Rs 90,000
and Rs 75,000 respectively.
The company has a policy to depreciate t he assets on straight line basis over the useful life of the
machines.
Zuhair Limited cost of capital is 20% per annum. All the payments and receipts are expected to arise at
the end of each year except where otherwise stated.
Required: Determine whether Zuhair Limited should introduce the new product. Ignore taxation. (17)

The cash flows for an investment project have been estimated at current prices, as follows:
0 1 2 3 4
Equipment (900,000) 200,000
Revenues 800,000 800,000 600,000 400,000
Running costs (400,000) (400,000) (350,000) (300,000)
It is expected that the cash flows will differ because of inflation. The annual rates of inflation are
expected to be:
 Equipment value: 4% per year
 Revenue: 3% per year
 Running costs: 5% per year.
The cost of capital is 12%.
Required: Calculate NPV of project after allowing for inflation.

ASD, a manufacturing company, is considering a proposal to invest in machinery that it will use this
machine to meet additional sales demand of 10,000 units in each of the next five years. The full
purchase cost of the machinery would be Rs. 225,000. This price includes a payment of Rs. 20,000
made 12 months ago to the machinery supplier for a non-refundable down-payment for purchase of
the machinery.
The company currently makes and sells a single product. Currently product has a selling price of Rs.
15 per unit, direct material costs of Rs. 3.75 per unit and direct labour cost of Rs. 2.50 per unit.
Incremental production overheads (all cash expenses) would be Rs. 37,500 in each year, at current
price levels. Assume that all cash flows occur at the end of the year to which they relate.
Because of inflation, selling prices will rise by 7% in each year. Material costs will rise by 5% each
year, labour costs by 6% each year and overheads by 2% each year. ASD’s cost of capital is 10%.
Required: Calculate the NPV of the project and comment whether is it financially viable or not?

Baypack Company is considering whether to invest in a project which will involve the purchase of
equipment costing Rs. 2,000,000. The equipment will be used to produce a range of products for which
the following estimates have been made.
Year 1 2 3 4
Average unit sales price Rs. 73.55 Rs. 76.03 Rs. 76.68 Rs. 81.86
Average unit variable cost Rs. 50.00 Rs. 50.00 Rs. 45.00 Rs. 45.00
Incremental annual fixed Costs (Rs.) 1,200,000 1,200,000 1,200,000 1,200,000
Sales volume (units) 65,000 100,000 125,000 80,000
The sales prices have already allowed for expected price increases over the period. However, cost
estimates are based on current costs, and do not allow for expected inflation in costs. Inflation is
expected to be 3% per year for variable costs and 4% per year for fixed costs. The incremental fixed
costs are all cash expenditure items. Tax on profits is at the rate of 30%, and tax is payable in the
same year in which the liability arises.
Baypack Company uses a four-year project appraisal period, but it is expected that the equipment will
continue to be operational and in use for several years after the end of the first four-year period. The
company’s cost of capital for investment appraisal purposes is 10%.
Required: Calculate the net present value of the project. (15)
Question 9 ICAP – COST ACCOUNTING – CAF 8 – SPRING 2017 Q7

Modern Transport Limited (MTL) is considering an investment proposal from Burraq Cab Services
(BCS). As per the proposal, MTL would provide branded cars to BCS under the following terms and
conditions:
i. BCS would pay rent of Rs. 1.8 million per annum per car to MTL. The cars would operate on
a 24-hour basis. The payment would be made at the end of year.
ii. Cost of the drivers and maintenance cost of the car would initially be paid by BCS but would
be adjusted against car rentals payable to MTL at the end of each year.
iii. MTL would provide a smart mobile to each driver.
MTL has estimated the following costs for deployment of a car with BCS:
Description Rupees Remarks
Car purchase price 2,000,000 Estimated useful life and residual value of
the car is 4 years and Rs. 0.75 million respectively.
Car registration fee 35,000 One-time payment on registration of the car.
Mobile phone price per 15,000 To be charged-off in the year of purchase
set
Insurance premium 50,000 To be paid at the beginning of each year. It would
reduce by Rs. 5,000 each year due decrease in
W DV of the car.
Annual salaries per 300,000 W ould work in 8-hour shifts.
driver
Annual maintenance 60,000 Due to ageing of cars, frequency of repairs &
cost maintenance would increase by 10% each year.
Additional information:
The car would be depreciated at the rate of 25% under the reducing balance method.
 Tax depreciation is to be calculated on the same basis.
 Applicable tax rate is 30% and tax is payable in the year in which the liability arises.
 Inflation is estimated at 5% per annum.
 MTL's cost of capital is 12% per annum.
Required: Advise whether MTL should accept BCS’s proposal. (16)
Question 10 ICAP – COST ACCOUNTING – CAF 8 – AUTUMN 2017 Q4
Cloudy Company Limited (CCL) manufactures and sells specialized machine X85. A newer version of
the machine is gaining popularity in the market and CCL is therefore considering to introduce a similar
version i.e. D44. Detailed research in this respect has been carried out during the last six months at a
cost of Rs. 3.25 million. The related information is as under:
i Initial investment in the new plant for manufacturing D44 would be Rs. 450 million including
installation and commissioning of the plant.
ii Projected production and sales of D44 are as follow s:
Year 1 Year 2 Year 3 Year 4
----------------- No. of units ------------------
20,000 25,000 27,000 29,000
Sales volume of X85 in the latest year was 30,000 units. It is estimated that introduction of
D44 would reduce the sale of X85 by 2,000 units every year.
iii. Estimated selling price and variable cost per unit of D44 in year 1 is estimated at Rs. 40,000
and Rs. 32,000 respectively. The contribution margin on X85 in year 1 is estimated at Rs.
5,500 per unit.
iv. Fixed costs in year 1 are estimated at Rs. 45 million. However, if the new plant is installed
these costs would increase to Rs. 75 million.
v. Impact of inflation on selling price, variable cost and fixed cost would be 10% for both the
machines/plants.
vi. The new plant would be depreciated at the rate of 25% under the reducing balance method.
Tax depreciation is to be calculated on the same basis. The residual value of the plant at the
end of its useful life of four years is expected to be equal to its carrying value.
vii. Applicable tax rate is 30% and tax is paid in the year in which the liability arises.
viii. CCL’s cost of capital is 12%.
Required: Compute internal rate of return (IRR) of the new plant and advise whether CCL should
introduce D44. (Assume that all cash flows would arise at the end of the year unless stated
otherwise) (15)
Consolidated Oil wants to explore for oil near the coast of Ruritania. The Ruritanian government is
prepared to grant an exploration licence for a five-year period for a fee of Rs. 300,000 per annum. The
licence fee is payable at the start of each year.
The option to buy the licence must be taken immediately or another oil company will be granted the
licence. However, if it does take the licence now, Consolidated Oil will not start its explorations until
the beginning of the second year.
To carry out the exploration work, the company will have to buy equipment now. This would cost Rs.
10,400,000, with 50% payable immediately and the other 50% p ayable one year’s later. The company
hired a specialist firm to carry out a geological survey of the area. The survey cost Rs. 250,000 and is
now due for payment.
The company’s financial accountant has prepared the following projected income statements. T he
forecast covers years 2-5 when the oilfield would be operational.
Projected income statement
Year 2 3 4 5
Rs. ‘000 Rs. ‘000 Rs. ‘000 Rs. ‘000
Sales 7,400 8,300 9,800 5,800
Minus expenses
W ages and salaries 550 580 620 520
Materials and consumables 340 360 410 370
Licence fee 600 300 300 300
Overheads 220 220 220 220
Depreciation 2,100 2,100 2,100 2,100
Survey cost written off 250 - - -
Interest charges 650 650 650 650
Profit 2,690 4,090 5,500 1,640
Notes:
i. The licence fee charge in Year 2 includes the payment that would be made at the beginning
of year 1 as well as the payment at the beginning of Year 2. The licence fee is paid to the
Ruritanian government at the beginning of each year.
ii. The overheads include an annual charge of Rs. 120,000 which represents an apportionment
of head office costs. The remainder of the overheads is directly attributable fixed overheads
to the project.
iii. The survey cost is for the survey that has been carried out by the firm of specialists.
iv. The new equipment costing Rs. 10,400,000 will be sold at the end of Year 5 for Rs.
2,000,000.
v. A specialised item of equipment will be needed for the project for a brief period at the end
of year 2. This equipment is currently used by the company in another long -term project.
The manager of the other project has estimated that he will have to hire machinery at a
cost of Rs. 150,000 for the period the cutting tool is on loan.
vi. The project will require an investment of Rs. 650,000 working capital from the end of the
first year to the end of the licence period.
vii. The company has a cost of capital of 10%. Ignore taxation.
Required: Calculate the NPV of the project. (15)
Question 12 ICAP – COST ACCOUNTING – CAF 8 – AUTUMN 2016-Q2
Tropical Juices (TJ) is planning to expand its production capacity by installing a plant in a building
which is owned by TJ but has been rented out at Rs. 6 million per annum. The relevant details are as
under:
i. The cost of the building is Rs. 40 million and it is depreciated at 5% per an num.
ii. The rent is expected to increase by 5% per annum.
iii. Cost of the plant and its installation is estimated at Rs. 60 million. TJ depreciates plant and
machinery at 25% per annum on a straight line basis. Residual value of the plant after four years
is estimated at 10% of cost.
iv. Additional working capital of Rs. 25 million would be required on commencement of production.
v. Selling price of the juices would be Rs. 350 per litre in year 1. Sales quantity is projected as under:
Year 1 Year 2 Year 3 Year 4
Litres 250,000 300,000 320,000 290,000
vi. In year 1, variable cost would be Rs. 180 per litre. Fixed cost is estimated at Rs. 100 per litre
based on normal capacity of 280,000 litres. Fixed cost includes yearly depreciation amounting to
Rs. 16 million.
vii. Rate of inflation is estimated at 5% per annum and would affect the revenues as well as expenses.
viii. TJ's cost of capital is 15%.
Required: Compute net present value (NPV) of the project and advise whether it would be feasible
to expand the production capacity. (Assume that all cash flows other than acquisition of plant
and additional working capital would arise at the end of the year) (11)
Question 13 ICAP – COST ACCOUNTING – CAF 8 - SPRING 2015- Q2
Diamond Investment Limited (DIL) is considering to set-up a plant for the production of a single
product X-49. The details relating to the investment are as under:
i. The cost of plant amounting to Rs. 160 million would be payable in advance. It includes
installation and commissioning of the plant.
ii. W orking capital of Rs. 20 million would be required at the commencement of the commercial
operations.
iii. DIL intends to sell X-49 at cost plus 25% (cost does not include depreciation on plant). Sales
for the first year are estimated at Rs. 300 million. The sales quantity would increase at 6%
per annum.
iv. The plant would be depreciated at the rate of 20% under the reducing balance method. Tax
depreciation is to be calculated on the same basis. Estimated residual value of the plant at
the end of its useful life of four years would be equal to its carrying value.
v. Tax rate is 34% and tax is payable in the year the liability arises.
vi. DIL’s cost of capital is 18%. All costs and prices are expected to increase at the rate of 5%
per annum.
Required: Compute the following:
a) Net present value of the project (12)
b) Internal rate of return of the project (05)
Assume that unless otherwise specified, all cash flows would arise at the end of the year.
Question 14 ICAP CAF8 – CMA - SPRING 2018 – Q 2b
Valika Limited (VL) plans to introduce a new product AX which would be used in hybrid cars.
Following information is available in this regard:
i. Initial investment in the new plant including installation and commissioning is estimated at Rs. 50
million. The plant is expected to have a useful life of four years and would have annual capacity
of 200,000 units.
ii. The demand of AX for the first year is expected to be 180,000 units which would increase by 10%
per annum in year 2 and 3. However, in year 4 the demand is expected to decline by 10%.
iii. The contribution margin for the first year is estimated at Rs. 100 per unit which is expected to
increase by 5% each year.
iv. The new plant would be installed at VL’s premises which are presently rented out at Rs. 1.8 million
per annum. As per the terms of rent agreement, the rent is received in advance and is subject to
7% increase per annum.
v. W orking capital of Rs. 10 million would be required at the commencement of the project. Working
capital is expected to increase by 10% each year.
vi. The new plant would be depreciated at the rate of 25% under the reducing balance method.
Tax depreciation is to be calculated on the same basis. The residual value of the plant at the end
of useful life is expected to be equal to its carrying value.
vii. VL’s cost of capital is 10%.
viii. Tax rate is 30% and is paid in the year in which the tax liability arises.
Required: On the basis of net present value, advise whether VL should invest in the above project.
(Assume that except stated otherwise, all cash flows would arise at the end of year) (17)
Question 15 ICAP CAF 8 – CMA - SPRING 2019 – Q 3b

Lotus Enterprises (LE) is engaged in trading o f various locally manufactured products. Hope Limited
(HL), a company incorporated outside Pakistan has offered to assist LE in establishing a manufacturing
facility in Pakistan for producing its products. LE has gathered the following information in respe ct of
HL’s offer:
(i) The manufacturing facility will be set up on a land which was acquired by LE three years ago for
Rs. 40 million. Market value of the land at the commencement of the project is estimated at Rs.
60 million. Cost of the manufacturing facility is estimated as under:
Rs. in million
Factory building 30
Plant including its installation 100
Other fixed assets 10
(ii) Sales for the first year of production is estimated at Rs. 500 million. It is expected that sales
demand would increase by 5% in each subsequent year.
(iii) Under the product licensing agreement, HL would be paid a royalty equal to 15% of sales.
(iv) It is expected that cost of production in the first year of production would be 75% of sales
including fixed costs of Rs. 50 million.
(v) Additional working capital of Rs. 35 million would be required for the first year of production.
W orking capital requirement would increase by Rs. 5 million each year.
(vi) Rate of inflation is estimated at 8% per annum with effect from 2nd year onward. It would affect
revenues as well as all the costs (excluding depreciation).
(vii) Factory building would be depreciated at 5% whereas plant and other fixed assets would be
depreciated at 25% using reducing balance method. It is estimated that at the end of plant’s
useful life of four years:
 market value of the land would be Rs. 75 million; and
 residual value of all the assets would be equal to their carrying value.
(viii) Applicable tax rate is 30% and tax is payable in the year in which the liability arises.
(ix) There would be no temporary or permanent timing difference between accounting profit and
taxable income.
(x) LE’s cost of capital is 15%.
Required: Compute the net present value (NPV) of the project and advise whether it would be feasible
to accept HL’s offer. (Assume that except where stated otherwise, all cash flows would arise at the
end of the year). (15)
Question 16 ICAP – COST ACCOUNTING – CAF 8 - AUTUMN 2014 – Q 3
Omega Limited (OL) is the sole distributor of goods produced by ABC Limited which is a leading brand
in the international market. OL is now planning to establish a factory in collaboration with ABC Limited.
The factory would be established on a land which was purchased at a cost of Rs. 20 million in 2005.
The existing market value of the land is Rs. 40 million. The cost of factory building and plant is
estimated at Rs. 30 million and Rs. 100 million respectively.
The factory will produce goods which are presently supplied by ABC Limited. The sale for the first year
of production is estimated at Rs. 300 million. The existing profit margin is 20% on sales. As a result of
own production, cost per unit (inclusive depreciation) would decrease by 10%. The sale price and cost
of production per unit (excluding depreciation) are expected to increase by 10% and 8% respectively,
each year.
Following further information is available:
 ABC Limited would assist in setting up of the factory for which it would be paid immediately
an amount of Rs. 10 million at the time of signing the agreement
and remaining Rs. 20 million at the time of completion of factory building. In addition, ABC
Limited would be paid a royalty equal to 3% of sales.
 The factory building and installation of plant would be completed and commercial production
would start one year after signing the agreement.
 50% of the cost of plant would be financed through a five year loan with interest payable
annually at 10% per annum. Principal would be repaid at the end of project life.
 A working capital injection of Rs. 15 million would be required at the commencement of
commercial production.
 OL charges depreciation on factory building and plant under the straight line method.
 The residual value of the factory building and plant after five years' operation would be
estimated at 50% and 10% of cost respectively.
 The market value of the land at the end of project life is estimated to be Rs. 70 million.
 OL's cost of capital is 12%.
Required: Calculate the net present value of the project assuming that unless otherwise specified,
all cash inflows/outflows would arise at the end of year. Ignore taxation. (15)
Question 17 ICAP CAF 8 – CMA - AUTUMN 2019 – Q 2
Latte Limited (LL) is considering to accept a five -year proposal from Mocha Limited (ML) for supply of
a product namely K44. ML would use K44 as a raw material for its main product. Details of the proposal
and related matters are summarized as follows:
(i) Initial investment in the specialized machinery is estimated at Rs. 60 million. At the beginning
of year 4, LL would require a major overhauling on this machinery amounting to Rs. 10 million.
The machinery can be disposed of at 80% of written down value at the end of project.
(ii) In year 1, LL would supply 18,000 units of K44 to ML at Rs. 5,000 per unit. The supply would
increase by 5% per annum from year 2 onward.
(iii) Variable cost is estimated at Rs. 4,000 per unit for year 1. Fixed cost associated with the
proposal (other than depreciation) is expected to be Rs. 250,000 per month, out of which Rs.
50,000 would be allocated overheads.
(iv) Impact of inflation on revenues as well as all costs would be 7%.
(v) Tax rate would be applicable at 30% and tax would be payable in the year in which liability
would arise. Tax depreciation on machinery would be allowed at the rate of 25% under reducing
balance method.
(vi) The cost of capital of LL is 15%.
Assume that except stated otherwise, all cash flows would arise at the end of year.
Required:
(a) Using net present value method, advise whether LL should accept the proposal. (11)
(b) Determine the minimum discount rate at which the proposal would be acceptable to
LL. (03)
Question 18 ICAP CAF 8 – CMA - AUTUMN 2020 – Q 6

Question 19 ICAP CAF 8 – CMA - AUTUMN 2018 – Q 5b

Golf Limited (GL) is engaged in the manufacturing and sale of a single product ‘Smart -X’. The existing
manufacturing plant is being operated at full capacity but the production is not sufficient to meet the
growing demand of Smart -X. GL is considering replacing it with a new Japanese plant. The production
capacity of new plant would be 50% more than the existing capacity.
To assess the viability of this decision, the following information has been gathered:
(i) The purchase and installation cost of new plant would be Rs. 500 million and Rs. 25 million
respectively. The supplier would send a t eam of engineers to Pakistan for final inspection of the
plant before it is commissioned. 50% of the total cost of Rs. 12 million to be incurred on the
visit, would be borne by GL.
(ii) As a result of installation of the new plant, fixed costs other than depreciation would increase
by Rs. 30 million.
(iii) The existing plant has an estimated life of 10 years and is in use for the last 6 years. Plant’s tax
carrying value is Rs. 50 million. A machine supplier has offered to purchase the existing plant
immediately at Rs. 45 million.
(iv) During the latest year, 6 million units were sold at an average selling price of Rs. 550 per unit.
Variable manufacturing cost was Rs. 450 per unit. GL expects that it can increase the sales
volume by 25% in the first year after the plant’s installation. Thereafter, the sales volume would
increase by 4% per annum.
(v) The new plant would be depreciated under the straight line method. Tax depreciation is
calculated on the same basis. The residual value of the plant at the end of its useful life of 4
years is estimated at Rs. 60 million.
(vi) Applicable tax rate is 30% and tax is paid in the year in which the liability arises.
(vii) Rate of inflation is estimated at 5% per annum and would affect the revenues as well as
expenses.
(viii) GL’s cost of capital is 12%.
(ix) All receipts and payments would arise at the end of the year except cost of setting up the plant
which would arise at the beginning of the year. It may be assumed that the new plant would
commence operations at the start of year 1.
Required: On the basis of internal rate of return (IRR), advise whether GL should acquire the new
plant. (17)
Question 20 ICAP CAF 8 – CMA - SPRING 2020 – Q 3
Question 21 Autumn 2021 – Q 1
Question 22 Spring 2022 – Q 10
(THE END)
Rs. in thousands
Q 1: Net present value 0 1 2 3 4
Annual sales revenue (W1) 240 360 500 200
Less: Annual variable costs (W2) (120) (180) (250) (110)
= Annual operating Cash flows 120 180 250 90
Initial investment (440)
= Net Cash Flows (440) 120 180 250 90
= Present value at 9% (440) 110 152 193 64
Net present value 78
(W1) Annual Sales revenue 1 2 3 4

Annual sale units 30,000 40,000 50,000 20,000
x Sale price per unit (Rs.) 8 9 10 10
= Annual sales revenue (Rs.'000) 240 360 500 200
(W2) Annual Variable costs 1 2 3 4

Annual sale units 30,000 40,000 50,000 20,000
x Variable cost per unit (Rs.) 4 4.5 5 5.5
= Annual variable costs (Rs.'000) 120 180 250 110
Rs. in million
Annual sales revenue 155 155 65 65
Less: Annual cost of sales at 50% (78) (78) (33) (33)
Less: Annual operating expenses at 10% (16) (16) (7) (7)
Less: CL's share (5% of sales) (8) (8) (3) (3)
Less: Initial investment and scrap value (175) 100
= Net Cash Flows (175) 54 54 23 123
= Present value at 10% (175) 49 45 17 84
Net Cash Flows (175) 54 54 23 123

Present value at 17% (175) 46 40 14 66
Net present value (9)
Internal rate of return (IRR)

Low discount rate 10%
NPV at low discount rate 20
High discount rate 17%
NPV at high discount rate (9)

= 10% + (20 ÷ (20 - (-9)) x (17% - 10%)) 14.79%
Rs. in million
Annual cash inflows 5.90 5.20 2.45 1.00
Less: Annual lease payment (3.90) (3.90) (3.90)
= Annual operating cash flows 2.00 1.30 (1.45) 1.00
Less: Down payment (2.00)
Less: Payment at exiry of lease term (0.89)
Add: Scrap value of plant 0.50
= Net Cash Flows (2.00) 2.00 1.30 (2.34) 1.50
Present value at 15% (2.00) 1.74 0.98 (1.54) 0.86
Net present value 0.04
= Net Cash Flows (2.00) 2.00 1.30 (2.34) 1.50

Present value at 19% (2.00) 1.68 0.92 (1.39) 0.75
Net present value (0.04)

NPV at low discount rate 0.04
NPV at high discount rate (0.04)

= 15% + (0.04 ÷ (0.04 - (-0.04)) x (19% - 15%)) 16.98%
Decision
IRR is more than cost of capital of 15%, so project should be undertaken.
Rs. in million
Annual Sales revenue (W1) 79 103 175 179
Less: Purchase cost payment (W2) (32) (48) (57) (73)
Less: Payment to sub-contractor (6) (9) (8) (8)
Less: Incremental fixed costs (13) (10) (9) (10)
Labour:
Less: Incremental pay of promoted worker (1) (1) (1) (1)
Less: Incremental pay of new employee (2) (2) (2) (2)
Add: Annual saving in labour cost 4 4 4 4
Less: Redundancy payment (6)
Material:
Add: Material X 2
Less: Material Y (3)
= Annual operating cash flows (1) 29 31 102 89
New machine (180) 25
Existing machine 2 (1)
= Net Cash flows (179) 29 31 102 113
Present value at 10% (179) 26 26 77 77
(W1) Annual Sales Revenue 1 2 3 4

Annual market size after 2% p.a. growth 1,122 1,144 1,167 1,191
x Market share 7% 9% 15% 15%
= Annual sales Revenue 79 103 175 179
(W2) Purchase cost payment 1 2 3 4

Beginning balance of payables 0 8 10 11
Add: Purchase cost 40 50 58 62
40 58 68 73
Less: Ending balance of payables (8) (10) (11) -
= Cash paid for purchase cost 32 48 57 73
Q 5: Net present value at 10% 0 1 2 3 4
Annual Sales Revenue
(Rs. 110 pu x1.10 n x 100,000), n=1 from Y2 11,000 12,100 13,310 14,641
Less: Annual material costs:
Material A
(1kg p.u x 100,000 units) x Rs.8/kg (800) (800) (800) (800)
Material B
Scrap value foregone (Rs. 15 x 50,000 kg;50,000 kg; 20,000 kg) (750) (750) (300)
Purchase Cost (Rs. 17 x 30,000 kg);(Rs.17 x 50,000 kg) (510) (850)
Material C
Scrap value foregone (150,000 x Rs.16) (2,400)
Purchase Cost (Rs. 20 x 50,000;200,000) (1,000) (4,000) (4,000) (4,000)
Less: Annual Labour Cost
Skilled Labor
Spare 20,000 hours @ Nil - - - -
Incremental (Rs. 100 x 1.05^n) hours ; n=1 from Y2 (3,000) (3,150) (5,513) (5,788)
Unskilled Labor
(Rs. 40/hr x 1.05^n) x 40000 hours ; n=1 from Y2 (1,600) (1,680) (1,764) (1,852)
= Annual operating cash flows 1,450 1,720 423 1,351
Initial investment and scrap value of new assets:
New plant and machinery (750) 75
Existing assets are used for project 0 90
= Net Cash Flows of project (750) 1,450 1,720 423 1,516
PV of net cash flows at 20% (750) 1,208 1,194 245 731
Net present value 2,629
(W1) Annual Labour hours required

Number of batches to be produced per annum (100,000 units ÷ 12,500 units) 8
Skilled Labour hours required per annum (8 batches x 6,250 hours) 50,000
Incremental skilled labour hours (50,000 hours - 20,000 spare hours) 30,000
Unskilled labour hours required p.a. (8 batches x 5,000 hours) 40,000

Q6 Net present value at 12% 0 1 2 3 4
Annual Revenue
(Revenue x 1.03^n); n=1 from year 1 824,000 848,720 655,636 450,204
Less: Annual running costs
(Running costs x 1.05^n); n=1 from year 1 (420,000) (441,000) (405,169) (364,652)
= Annual operating cashflows 404,000 407,720 250,467 85,552
Initial investment in equipment (900,000)
Scrap value (Rs. 200,000 x 1.04 4 ) 233,972
= Net Cash Flows of project (900,000) 404,000 407,720 250,467 319,524
Present values at 12% (900,000) 360,714 325,032 178,277 203,063
Q7 Net present value at 10% 0 1 2 3 4 5
(10,000 units x Rs. 15 p.u) x1.07^n; n=1 from Y1 160,500 171,735 183,756 196,619 210,383
Less: Annual material cost
(10,000 units x Rs 3.75 p.u) x1.05^n; n=1 from Y1 (39,375) (41,344) (43,411) (45,581) (47,861)
Less: Annual labour cost
(10,000 units x Rs. 2.5 p.u) x 1.06^n; n=1 from Y1 (26,500) (28,090) (29,775) (31,562) (33,456)
(37,500 x 1.02^n); n=1 from Y1 (38,250) (39,015) (39,795) (40,591) (41,403)
= Annual operating cash flows 56,375 63,286 70,775 78,885 87,664
Investment in Machinery (205,000)
= Net Cash Flows of project (205,000) 56,375 63,286 70,775 78,885 87,664
Present values at 10% (205,000) 51,250 52,303 53,174 53,879 54,432
Conclusion: NPV of project is postive so ASD should accept the project.

Rs.'000
(Sale price per unit x Sales volume) 4,781 7,603 9,585 6,549
n
(Variable cost p.u. x 1.03 x sales volume) where n=1 from Y1 (3,348) (5,305) (6,147) (4,052)
Less: Incremental annual fixed costs
n
(Rs. 1,200,000 x 1.04 ) where n=1 from Y1 (1,248) (1,298) (1,350) (1,404)
= Annual operating cash flows 185 1,001 2,089 1,093
Less: Tax payment at 30% (56) (300) (627) (328)
= Annual operating cash flows after tax 130 700 1,462 765
Investment in equipment (2,000)
= Net cash flows of the proejct (2,000) 130 700 1,462 765
Present value of cash flows at 10% (2,000) 118 579 1,098 523

Rs.'000
Annual rental income
(Rs. 1.8 million x 1.05 n ) where n=1 from Y2 1,800 1,890 1,985 2,084
Less: Annual salaries of drivers
(Rs. 0.3 million x 3 drivers) x 1.05 n where n=1 from Y2 (900) (945) (992) (1,042)
Less: Annual maintenance cost
(Rs. 60,000 x 1.05n x 1.05 n ) where n=1 from Y2 (60) (69) (80) (92)
Less: Annual tax depreciation of car
(Rs. 2,035,000 x 25%) (Previous dep x 75%) (509) (382) (286) (215)
Less: Tax depreciation of mobile phones (45)
Add: Tax gain on sale of car 106
= Taxable profit & loss 286 494 626 841
Less: Tax payment at 30% (86) (148) (188) (252)
Add: Annual tax depreciation of car 509 382 286 215
Add: Tax depreciation of mobile phones 45
Less: Tax gain on sale of car (106)
754 727 724 697
Less: Insurance premium (at start of each year) (50) (45) (40) (35)
Add: Tax saving on insurance premium cost 15 14 12 11
= Annual operating cash flows after tax (50) 724 701 701 708
Initial investment and scrap value
Motor car (2,035) 750
Mobile phones (Rs. 15,000 x 3 phones) (45)
= Net cash flows of the project (2,130) 724 701 701 1,458
Present value of cash flows at 12% (2,130) 647 559 499 926
Decision: BCS company should undertake this proposal due to positive NPV.
Rs.'000
Q 10 Net present value at 12% 0 1 2 3 4
Annual contribution of D44
(Rs. 8,000 p.u. x 1.10 n ) x Sale units where n=1 from Y2 160,000 220,000 261,360 308,792
Less: Incremental annual fixed cost
(Rs. 75 m - Rs. 45 m) x 1.10 n where n=1 from Y2 (30,000) (33,000) (36,300) (39,930)
Less: Annual contribution forgone for X85
n
(Rs. 5,500 p.u. x 1.10 ) x Reduction in Sale units where n=1 from Y2 (11,000) (24,200) (39,930) (58,564)
Less: Annual tax depreciation
(Rs. 450 million x 25%) (Previous dep x 75%) (112,500) (84,375) (63,281) (47,461)
= Taxable profit & loss 6,500 78,425 121,849 162,837
Less: Tax payment at 30% (1,950) (23,528) (36,555) (48,851)
Add: Annual tax depreciation 112,500 84,375 63,281 47,461
= Annual operating cash flows after tax 117,050 139,273 148,575 161,447
Initial investment in machine (450,000)
Scrap value of machine (equal to carrying value) 142,383
= Net cash flows of the project (450,000) 117,050 139,273 148,575 303,830
Present value of cash flows at 12% (450,000) 104,509 111,027 105,753 193,089
NPV at 12% 64,378
NPV at 20% (23,237)

NPV at low discount rate 64,378
NPV at high discount rate (23,237)

= 10% + (64,378 ÷ (64,378 - (-3,237)) x (20% - 10%)) 17.88%
Decision: Project should be undertaken because IRR is more than cost of capital.
Rs.'000
Q 11 Net present value at 10% 0 1 2 3 4 5
Annual Sales revenue 7,400 8,300 9,800 5,800
Less: Wages and salaries cost (550) (580) (620) (520)
Less: Material and consumables (340) (360) (410) (370)
Less: Attributable fixed costs
(Rs. 220,000 - Rs. 120,000) (100) (100) (100) (100)
Less: License fee (at start of each year) (300) (300) (300) (300)
= Annual operating cash flows (300) 6,110 6,960 8,370 4,810
Initial investment in machine (5,200) (5,200)
Scrap value of machine 2,000
Working capital changes (650) - - - 650
= Net cash flows of project (5,200) (6,150) 6,110 6,960 8,370 7,460
Present value at 10% (5,200) (5,591) 5,050 5,229 5,717 4,632
Rs.'000
(W1) Working capital changes 0 1 2 3 4 5
Working capital required 650 650 650 650 -
Working capital changes (650) - - - 650
(W1) Reduction in sale volume of X85 1 2 3 4

Sales units of X85 (if D44 is not launched) 30,000 30,000 30,000 30,000
Less: Sales units of X85 (if D44 is launched) (28,000) (26,000) (24,000) (22,000)
Reduction in sale units of X85 2,000 4,000 6,000 8,000
Rs.'000
(Rs. 350 p.u x 1.05 n ) x Sale units where n=1 from Y2 87,500 110,250 123,480 117,499
(Rs. 180 p.u x 1.05 n ) x Sale units where n=1 from Y2 (45,000) (56,700) (63,504) (60,428)
(Rs. 100 p.u x 280,000 liters) - Rs. 16 m x 1.05 n (12,000) (12,600) (13,230) (13,892)
Less: Annual rental income forgone
(Rs. 6 million x 1.05 n where n=1 from Y1) (6,300) (6,615) (6,946) (7,293)
= Annual operating cash flows 24,200 34,335 39,800 35,886
Initial investment and scrap value of machine (60,000) 6,000
Working capital changes (25,000) 25,000
= Net cash flows of the project (85,000) 24,200 34,335 39,800 66,886
Net present value at 12% 34,815
Decision: Project should be undertaken because of positive NPV.
Rs.'000
(W1) Working capital changes 0 1 2 3 4
Working capital required 25,000 25,000 25,000 25,000 -
Working capital changes (25,000) - - - 25,000
Diamond investment Limited Rs. in million
(Rs. 300 m x 1.06^n x 1.05^n) where n=1 from Y2 300.00 333.90 371.63 413.62
Less Annual variable costs
(Rs. 300 m ÷ 1.25 = Rs. 240 m x 1.06^n x 1.05^n) (240.00) (267.12) (297.30) (330.90)
(Rs. 160 m x 20%) (Previous dep. x 80%) (32.00) (25.60) (20.48) (16.38)
= Taxable profit & loss 28.00 41.18 53.85 66.34

Less: Tax payment at 34% (9.52) (14.00) (18.31) (22.56)
Add Annual tax depreciation 32.00 25.60 20.48 16.38
= Annual operating cash flows after tax 50.48 52.78 56.02 60.17
Initial investment (160.00)
Scrap value of machine (equal to carrying value) 65.54
Working capital changes (20.00) 20.00
= Net cash flows of the project (180.00) 50.48 52.78 56.02 145.71
Present value of cash flows at 18% (180.00) 42.78 37.90 34.09 75.15
Net cash flows of the project (180.00) 50.48 52.78 56.02 145.71
Present value of cash flows at 22% (180.00) 41.38 35.46 30.85 65.77
(6.54)
NPV at low discount rate 9.93
NPV at high discount rate (7)

= 10% + (9.93 ÷ (9.93 - (-6.54)) x (22% - 18%)) 20.41%
Rs. in millions
Annual contribution margin
(Rs. 100 p.u. x 1.05^n) x Sale units where n= 1 from Y2 (W1) 18.00 20.79 22.05 22.69
(Rs. 50 m x 25%) (Previous dep. x 75%) (12.50) (9.38) (7.03) (5.27)
= Annual taxable profit/ (loss) 5.50 11.42 15.02 17.42
Less: Tax payment or Tax saving @ 30% (1.65) (3.42) (4.51) (5.23)
Add: Annual tax depreciation 12.50 9.38 7.04 5.28
Less: Rent income lost every year (1.8x1.07^n); n=1 from Y1 (1.93) (2.06) (2.21) (2.36)
Add: Tax saving on rent expense @ 30% ( rent income x 30%) 0.58 0.62 0.66 0.71
= Annual operating cash flows after tax (1.93) 14.87 15.78 15.86 18.18
Machinery (50.00)
Residual value (Rs. 50 m - Rs. 34.2 m accumulated dep.) 15.80
Working capital changes (W2) (10.00) (1.00) (1.10) (1.21) 13.31
Net Cash Flows of project (61.93) 13.87 14.68 14.65 47.29
Present value at 10% (61.93) 12.61 12.14 11.00 32.30
Net present value at 10% 6.12
Decision: Valika Limited should undertake the project because of positive NPV.
(W1) Annual production and sale units 1 2 3 4

Annual demand (180,000 units x 1.10^n where n=1 from Y2)(units) 180,000 198,000 217,800 196,020
Maximum production capacity (units) 200,000 200,000 200,000 200,000
Annual production and sales volume (units) 180,000 198,000 200,000 196,020
(W2) Working captial changes 0 1 2 3 4

Working capital requirement
(Rs. 10 million x 1.10^n where n=1 from Y2) 10.00 11.00 12.1 13.31 0
Working capital changes (10.00) (1.00) (1.10) (1.21) 13.31
Rs. in millions
(Rs. 500 m x 1.05^n x 1.08^n) where n=1 from Y2 500.00 567.00 642.98 729.14
Less: Variable costs
(Rs. 500 m x 75%) - Rs. 50m = Rs. 325m x 1.05^n x 1.08^n (325.00) (368.55) (417.94) (473.94)
Royalty payment (15% of sales) (75.00) (85.05) (96.45) (109.37)
Less: Annual fixed overheads
(Rs. 50 m - Rs. 21m dep.) x 1.08^n where n=1 from Y2 (21.00) (22.68) (24.49) (26.45)
Less: Annual tax depreciation:
Factory Building (Rs. 30m x 5%) (Previous dep x 95%) (1.50) (1.43) (1.36) (1.29)
Plant and other fixed assets
(Rs. 110m x 25%) (Previous dep. x 75%) (27.50) (20.63) (15.47) (11.60)
Annual taxable profit/ (loss) 50.00 68.66 87.27 106.48
Less: Tax payment or Tax saving @ 30% (15.00) (20.60) (26.18) (31.94)
Add: Annual tax depreciation:
Factory Building 1.50 1.43 1.36 1.29
Plant and other fixed assets 27.50 20.63 15.47 11.60
= Annual operating cash flows after tax 64.00 70.12 77.92 87.43
Land (60.00) 75.00
Building (30.00) 24.42
Plant and its installion and other assets (110.00) 34.80
Working capital changes (35.00) (5.00) (5.00) 45.00
= Net Cash Flows of project (200.00) 29.00 65.12 72.92 266.65
Present value at 15% (200.00) 25.22 49.24 47.94 152.46
Net present value at 15% 74.86 million
Conclusion: Since NPV is positve it is feasible to accept HL's offer.

Q 16: Net present value 0 1 2 3 4 5 6
(Rs. 300 m x 1.10^n) where n=1 from Y3 300.00 330.00 363.00 399.30 439.23
Less: Production costs (other than dep.) - (W1) (195.00) (210.60) (227.45) (245.64) (265.30)
Less: Royalty payment @ 3% of sales (9.00) (9.90) (10.89) (11.98) (13.18)
= Annual operating cash flows 96.00 109.50 124.66 141.68 160.76
Initial investment and scrap value
Land (40.00) 70.00
Factory building (10.00) (20.00) 15.00
Plant and machinery (100.00) 10.00
Working capital changes (15.00) 15.00
= Net cash flows (50.00) (135.00) 96.00 109.50 124.66 141.68 270.76
Present value of cash flows at 12% (50.00) (120.54) 76.53 77.94 79.22 80.39 137.17
(W1) Production cost (Other than depreciation) Rs.'m

Sale revenue in year 1 300.00
Less: Profit margin (Rs. 300 million x 20%) (60.00)
= Cost of sales (If ABC company purchases) 240.00
Less: 10% reduction in cost due in house manufacturing (24.00)
= Production cost 216.00
Less: Depreciation of manufacturing assets
Building (Rs. 30 m - Rs. 15 m) ÷ 5 years (3.00)
Plant (Rs. 100 m - Rs. 10 m) ÷ 5 years (18.00)
= Production cost (Other than depreciation) 195.00
Rs.'000
Q 17: (a) Net present value at 15% 0 1 2 3 4 5
(18,000 units x 1.05^n)× (Rs. 5,000 p.u. x 1.07^n) 90,000 101,115 113,603 127,633 143,396
(18,000 units x 1.05^n)× (Rs. 4,000 p.u. x 1.07^n) (72,000) (80,892) (90,882) (102,106) (114,716)
Less: Annual incremental fixed costs (other than dep)
((Rs. 250,000 –Rs. 50,000)×12 months × 1.07^n) (2,400) (2,568) (2,748) (2,940) (3,146)
Less: Annual tax depreciation (15,000) (11,250) (8,438) (8,828) (6,621)
Less: Tax loss on disposal of asset (3,973)
= Annual taxable profit/ (loss) 600 6,405 11,535 13,759 14,940

Less: Tax payment or Tax saving @ 30% (180) (1,922) (3,461) (4,128) (4,482)
Add: Annual tax depreciation 15,000 11,250 8,438 8,828 6,621

Add: Tax loss on disposal of asset 3,973
= Annual operating cash flows after tax 15,420 15,734 16,513 18,459 21,052
Plant and machinery (60,000) 15,890
Overhauling cost (10,000)
= Net Cash Flows of project (60,000) 15,420 15,734 6,513 18,459 36,942
Present values (60,000) 13,409 11,897 4,282 10,554 18,367

Net present value (1,492)
Conclusion: Project should not be undertaken because NPV is negative.

(b) Determination of minimum discount rate
Net Cash Flows of project (60,000) 15,420 15,734 6,513 18,459 36,942
Present value at 10% (60,000) 14,018 13,003 4,893 12,608 22,938
Net present value at 10% 7,460
IRR=10%+(7460/(7460 -(-1492)))*(15%-10%) 14.17%
Rs.'000
Q 18:Net present value of costs under proposal 1 0 1 2 3 4 5
Annual variable production costs
[units produced (W1) ×Rs. 400 p.u. ×1.06 ^ n where n=1 from Y1] (3,339) (3,716) (4,136) (4,604) (5,124)
Plant operation cost
[Rs. 90,000 p.m × 12 months ×1.06^n where n=1 from Y1] (1,145) (1,213) (1,286) (1,363) (1,445)
Annual maintenance cost
(Rs. 1380,000 x 1.06^n where n=1 from Y1) (1,463) (1,551) (1,644) (1,742) (1,847)
Annual tax depreciation (W2) (1,167) (1,167) (653) (653) (653)
= Total cash outflow (7,113) (7,647) (7,719) (8,362) (9,069)
Tax saving at 30% 2,134 2,294 2,316 2,509 2,721
Annual tax depreciation 1,167 1,167 653 653 653
= Annual operating cash flows after tax (3,813) (4,186) (4,750) (5,201) (5,695)
Plant and machinery (3,500)
Residual values 669
Overhauling Cost (1,461)
= Net Cash outflows of project (3,500) (3,813) (5,647) (4,750) (5,201) (5,026)
Present values of cash outflow at 14% (3,500) (3,344) (4,345) (3,206) (3,079) (2,610)
NPV of costs under proposal I (20,086)
(W1) Annual production units and purchase units 1 2 3 4 5

Units of PQR required (7500×1.05 ^ n where n= 1 from Y2) 7,875 8,269 8,682 9,116 9,572
Annual Capacity of Machine under proposal-2 9,000 9,000 9,000 9,000 9,000
Annual purchase quantity under proposal 2 116 572
(W2) Annual tax depreciation and tax gain/loss Rs.'000

Proposal 1
Depreciation of first 2 years (Rs. 3500,000 / 3 years) 1,167
Depreciation of next 3 years (after overhauling)
Written down value at start of Y3 (Rs. 3500 - (Rs. 1,167 x 2 years)) 1,166
Add: Overhauling cost (Rs. 1,300 x 1.06^2) 1,461
2,627
Less: Residual value (Rs. 500 x 1.06^5) (669)
= Depreciable value 1,958
÷ Life (years) 3
Annual depreciation 653
Note: No tax gain or loss under straight line method of depreciation
Proposal 2 Rs.'000
Cost of plant 5,000
Less: Residual value (Rs. 1,000 x 1.06^5) (1,338)
= Depreciable value 3,662
÷ Life (years) 5
Annual depreciation 732
Rs.'000
Q 18 Net present value of costs under proposal 2 0 1 2 3 4 5
Annual variable production costs
[units produced (W1) ×Rs. 380 p.u. ×1.06 ^ n where n=1 from Y1] (3,172) (3,530) (3,929) (4,545) (4,818)
Plant operation cost
[Rs. 70,000 p.m × 12 months ×1.06^n where n=1 from Y1] (890) (944) (1,000) (1,060) (1,124)
Annual maintenance cost
(Rs. 1200,000 x 1.06^n where n=1 from Y1) (1,272) (1,348) (1,429) (1,515) (1,606)
Annual tax depreciation (W2) (732) (732) (732) (732) (732)
Total cash outflow (6,066) (6,555) (7,091) (7,852) (8,280)
Tax saving at 30% 1,820 1,966 2,127 2,356 2,484
Annual tax depreciation 732 732 732 732 732
Annual operating cash flows after tax (3,515) (3,856) (4,232) (4,765) (5,064)
Plant and machinery (5,000)
Residual values 1,338
Net Cash outflows of project (5,000) (3,515) (3,856) (4,232) (4,765) (3,725)
Present values of cash outflow at 14% (5,000) (3,083) (2,967) (2,856) (2,821) (1,935)
NPV of costs under proposal 2 (18,662)
Decision: Company should select proposal 2 due to lower present value of costs.
Rs.'000
Q 19 Net present value under replacement decision 0 1 2 3 4
Incremental contribution margin
(Rs. 550 - Rs. 450) x 1.05^n x incremental units (W1) 157,500 198,450 244,490 296,156
Less: Incremental fixed costs
(Rs. 30 million x 1.05^n where n = 1 from Y 2) (30,000) (31,500) (33,075) (34,729)
Less: Incremental annual tax depreciation (W2) (105,250) (105,250) (105,250) (105,250)
Tax loss on disposal of old plant (Rs. 45 m - Rs. 50 m) (5,000)
= Taxable profit & loss (5,000) 22,250 61,700 106,165 156,177
Tax payment or tax saving (5,175) (18,510) (31,850) (46,853)
Add: Incremental annual tax depreciation 105,250 105,250 105,250 105,250
Less: Tax loss on disposal of old plant 5,000
Annual operating cash flows after tax - 122,325 148,440 179,566 214,574
Investment in new plant (Rs. 500 m + Rs. 25 m + Rs. 6 m) (531,000)
Scrap value of old plant and new plant 45000 60,000
Net cash flows of the project (486,000) 122,325 148,440 179,566 274,574
Present values of cash flows at 12% (486,000) 109,219 118,335 127,811 174,497
Present values of cash flows at 17% (486,000) 104,551 108,437 112,116 146,526
Net present value (14,369)

NPV at low discount rate 43,862
NPV at high discount rate (14,369)

= 12% + (43,862 ÷ (43,862 - (-14,369)) x (17% - 12%)) 15.77%
Decision: Since IRR is more than cost of capital of 12% so company should replace the machine.
(W1) Incremental production units 1 2 3 4

Production with new plant (6,000 x 1.25) (7,500 x 1.04^n) 7,500 7,800 8,112 8,436
Less: Production with old plant (6,000) (6,000) (6,000) (6,000)
= Incremental production units 1,500 1,800 2,112 2,436
(W2) Incremental tax depreciation

Annual tax depreciation of new plant
(Rs. 531 million - Rs. 60 million ) / 4 years 117,750
Annual tax depreciation of old plant
(Rs. 50 million / 4 years) (12,500)
105,250
Rs.'000
Q 20 Net present value - If continue for more 3 years 1 2 3
(Last year sales x 1.20) 10,800 12,960 15,552
(Last year variable cost x 1.18) (8,354) (9,858) (11,633)
Less: Annual attributable fixed costs
(Last year fixed cost x 1.05) (551) (579) (608)
Less: Annual rent expense (Rs. 660 x 1.10^n where n=1 from Y1) (726) (799) (878)
Less: Tax allowable depreciation (703) (527) (396)
Less: Tax loss on diposal of plant (187)
Taxable profit and loss 465 1,197 1,851

Tax at 30% (140) (359) (555)
Add: Tax allowable depreciation 703 527 396
Add: Tax loss on disposal 187
Annual operating cash flows after tax 1,029 1,365 1,878
Residual value of plant 1,000
Net cash flows 1,029 1,365 2,878
Present value of net cash flows at 16% 887 1,015 1,844
Present value of cash inflows - if continue for more 3 years 3,745
Present value of cash flows - If discontinued now Rs.'000

Scrap value of equipment 4,000
Tax payment on gain (Rs. 1,188 x 30%) (356)
3 months rent expense payment during notice period
(Rs. 726,000 x 3/12) (182)
Tax saving on rent expense payment 54
Present value of cash inflows - if closed now 3,517
Decision: Company should continue for more 3 years because this option has greater present value of cash inflows.
(W1) Annual growth rates

Annual growth rate of sales (Rs. 9 m - Rs. 7.5 m)/Rs. 7.5 m 20%
Growth rate of variable cost (Rs. 7.08 m - Rs. 6 m)/Rs. 6 m 18%
Growth rate of fixed cost (other than dep) (Rs. 525000 - Rs. 500,000)/Rs. 500,000 5%
(W2) Tax allowable depreciation and gain/loss on disposal Rs.'000

Depreciation of 1st year in past (Rs. 5 million x 25%) 1,250
Depreciation of 2nd year in past 938
Depreciation of 3rd year 703
Depreciation of 4th year 527
Depreciation of 5th year 396
3,813
Tax gain or loss in disposal of plant at the end of 5 years
Less: Carrying value (Rs. 5,000 - Rs. 3,813) (1,187) 187 loss
Tax gain or loss on diposal - if disposed off now after 2 years
Less: Carrying value (Rs. 5,000 - 1,250 - 938) (2,813) 1,188 gain
Rs.'000
Q 21 Net present value - If continue for more 3 years 3 4 5
(Rs. 1,000 p.u. x 1.10 2,3,4 ) x Paid sales units 4,414 5,564 6,676
Less: Annual material cost
(Rs. 375 p.u. x 1.05 2 ) x Production units (967)
,3,4
(Rs. 300 p.u. x 1.05 ) x Production units (1,528) (1,750)
Less: Annual labour cost
(Rs. 180 p.u. x 1.05 2,3,4 ) x Production units (464) (917) (1,050)
Less: Annual variable overheads cost
(Rs. 120 p.u. x 80% x 1.05 2,3,4 ) x Production units (248) (489) (560)
Less: Annual other fixed cost
(Rs. 500,000 p.a. x 80% x 1.05 2,3,4 ) (441) (463) (486)
Less: Annual rental expense
(Rs. 500,000 p.a. x 1.10 2,3,4 ) (605) (666) (732)
Less: Annual marketing expense
(Rs. 500,000 p.a. x 80% x 1.05 1,2,3 ) (525) (551) (579)
(Previous tax depreciation x 75%) (281) (211) (158)
= Taxable profit and loss 882 739 1,360
Less: Taxation @ 30% (265) (222) (408)
Add: Annual tax depreciation 281 211 158
= Annual operating cash flows after tax 899 728 1,110
Scrap value of machine (2,000,000 x 0.75 5 ) 475
Net cash flows 899 728 1,585
Present value of cash flows at 15% 782 551 1,042
Present value of cash inflows - if continue for more 3 years 2,374
Present value of cash flows - If discontinued now Rs.'000

2
Sale of opening stock (1,500 units x Rs. 1,000 x 1.10 x 0.75) x 0.7 952.88
Tax payment on gain (Rs. 1,500 - (2,000 x 0.75 2 )) x 30% (113)
6 months rent expense as penalty (after tax)
(Rs. 605,000 x 6/12) x 0.70 (212)
Present value of cash inflows - if closed now 2,129
Decision: Company should continue for more 3 years because this option has greater present value of cash inflows.
(W1) Paid sales units 3 4 5

Revised sales units (80% x original sales units) 3,840 4,400 4,800
Less: Free sale units at 5% (192) (220) (240)
Paid sale units 3,648 4,180 4,560
(W2) Production units 3 4 5

Paid sale units to be produced 3,648 4,180 4,560
Add: Free sale units to be produced 192 220 240
Total production required 3,840 4,400 4,800
Less: Opening stock (1,500)
= Production units 2,340 4,400 4,800
Rs.'000
Q 22: Net present value of 4 Kiosks 0 1 2 3
Annual sales revenue from Kiosks
Rs. 2,500 p.u. x (1.10) 0,1,2 x (1 - discount rate) x sale units 8,500 10,395 12,006
Less: Annual variable cost of goods sold
Rs. 1,375 p.u. x (1.10) 0,1,2 x sale units (5,500) (6,353) (7,337)
Less: Annual rental expense
Rs. 150,000 per kiosk x 4 kiosks x (1.10) 0,1,2 (600) (660) (726)
Less: Annual salares of sales persons
Rs. 20,000 per month x 12 months x 4 persons x x (1.10) 0,1,2 (960) (1,056) (1,162)
Less: 1% commission to sales persons (85) (104) (120)
Less: Annual marketing expense
Rs. 50,000 x 0.50 x (1.10) 1,2 (50) (28) (30)
Less: Annual gross profit forgone from retail outlets
Rs. 5,625,000 x (1.05) 1,2,3 volume x (1.10) 0,1,2 inflation x 20% (1,181) (1,364) (1,576)
(Rs. 1 m x 40%), (Previous tax depreciation x 60%) (400) (240) (144)
Less: Loss on disposal of Kiosks
Rs. 1 million x (0.60)3 (216)
= Taxable profit and loss (276) 591 695
Less: Taxation at 30% 83 (177) (209)
Add: Annual tax depreciation 400 240 144
Add: Loss on disposal of Kiosks 216
= Annual operating cash flows after tax 207 653 847

Investment in 4 new Kiosks (Rs. 250,000 x 4) (1,000)
Net cash flows (1,000) 207 653 847
Present value of net cash flows at 18% (1,000) 175 469 515
Decision: CWL should setup Kiosks because it generates postive NPV of Rs. 160,000
(W1) Sales units of Kiosks 1 2 3

Sales units after 5% growth per annum (Last year sale x 1.05) 4,000 4,200 4,410

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Chapter 17: Introduction to project appraisal Page 1

Ch # 17 introduction to project appraisal

LO1: INTRODUCTION TO CAPITAL INVESTMENT APPRAISAL

1.1) Capital investments

1.2) Purpose of Capital investments

Capital investments are made with the following aims:

1.3) Capital investment appraisal (Capital budgeting)

Capital investment appraisal or project appraisal or capital budgeting is the process of

1.4) Capital investment appraisal techniques

LO2 : PAYBACK PERIOD ( PP)

2.2) Computation of payback period

▪ Payback period is computed according to the nature of annual cash inflows:

- Annual Cash Flows = Annual Profit + Annual depreciation expense

Payback period = 3 years

(Rs.) Flows (Rs.)

3.4) Merits and demerits payback period

The disadvantages of the payback method are as follows:

LO3 : TIME VALUE OF MONEY

3.1) Introduction to time value of money

Time value of money (TVM) concept

Importance of TVM concept

Application of TVM concept

Concept of time line

Assumptions for timing of Cash Flows

3.2) Concept of compounding and discounting

3.3) Computation of future value and present value

LO4 : SIMPLE NET PRESENT VALUE ( NPV )

4.1) Introduction to net present value

4.2) Types of cash flows used in net present value

▪ There are thrr types of cash flows related to investment project:

4.3) Decision making rule for net present value

Example 17.8 – ICAP Study Text (Ex. 32)

4.5) Net present value of annuity cash flows

Definition of annuity cash flows

(ii) NPV of annuity cash flows at 10%

Definition of perpetuity cash flows

4.7) Advantages and disadvantages of NPV

LO5 : INTERNAL RATE OF RETURN ( IRR)

5.1) Definition of internal rate of return (IRR)

5.2) Computation of internal rate of return (IRR)

▪ IRR can be computed by using:

(B) Computation of IRR – Interpolation method

5.3) Decision making rule of IRR

5.4) Advantages of disadvantages of IRR

The key points to note are that:

5.6) Practice Questions of IRR

LO6 : RELEVANT COSTING PRINCIPLES IN PROJECT APPRAISAL

6.1) Definition of relevant cost and its features

Definition of relevant cost

6.2) Types of relevant costs

▪ Examples of opportunity cost may include:

6.3) Types of irrelevant costs

6.4) Relevant cost of material, labour, overheads and non-current assets

(A) Relevant cost of material

(Rs. 55 per kg x 500 Kgs p.a.) (N1) 27,500 27,500 27,500

(B) Relevant cost of labour

= Contribution per unit of product Z 20