Unit III Capital Budgeting

Problem 1
Bharat Pumps & Compressors (BPC) is considering investing in a project. The expected original
investment in the project will be Rs 2,00,000, the life of project will be 5 years with no salvage
value. The expected net cash inflow after depreciation but before tax during the life of the project
will be as following:
Year 1 2 3 4 5
₹ 85,000 1,00,000 80,000 80,000 40,000
The project will be depreciated at the rate of 20% on original cost. The company is subjected to
30% tax rate.
Calculate cash inflow.
Solution
Calculation of Cash Inflow
Year Net Profit -Tax @ 30% =Net Profit +Depreciation Cash Inflow
before Tax After Tax =
1 85,000 25,500 59,500 40,000 99,500
2 1,00,000 30,000 70,000 40,000 1,10,000
3 80,000 24,000 56,000 40,000 96,000
4 80,000 24,000 56,000 40,000 96,000
5 40,000 12,000 28,000 40,000 68,000
Total 2,69,500 4,69,500
Average 53,900 93,900
Depreciation= 2,00,000 x 20%=40,000

Problem 2
A project needs an initial investment of Rs 50,000. Tax rate is 55%. The Company follows straight
line depreciation and the proposed inflows (before tax and depreciation) over its expected useful
life are:
Year 1 2 3 4 5
Inflows ₹ 10,000 10,000 15,000 15,000 25,000
Determine:
1. Pay-Back Period and Profitability
2. Average Rate of Return
Solution:
Calculation of Cash Inflow
Year Cash Depreciation Net Tax Cash Depreciation Cash Cumulative
Inflow - Profit 55% Inflow + Inflow Cash
Before Before - after (CIF) Inflow
Dep & Tax tax = (CCIF)
Tax = =
1 10,000 10,000 --- --- --- 10,000 10,000 10,000
2 10,000 10,000 --- --- --- 10,000 10,000 20,000
3 15,000 10,000 5,000 2,750 2,250 10,000 12,250 32,250
4 15,000 10,000 5,000 2,750 2,250 10,000 12,250 44,500
5 25,000 10,000 15,000 8,250 6,750 10,000 16,750 61,250
11,250
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 50,000−0
Depreciation = = = 10,000
𝑙𝑖𝑓𝑒 5

a. Calculation of Payback period

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝐶𝐶𝐼𝐹 𝑙𝑒𝑠𝑠 𝑡ℎ𝑎𝑛 𝐶𝑂𝐹
Payback period= Year in CCIF less than COF + 𝐶𝐼𝐹 𝑖𝑛 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

50,000−44,500
=4 years + 16,750

5,500
= 4 years + 16,750

= 4 years + 0.328
= 4.328 years
b. Pay-Back Profitability = Total Cash Inflows – Initial Cost
=61,250 – 50,000
=11,250
c. Calculation of Average Rate of Return
𝑇𝑜𝑡𝑎𝑙 𝑁𝐴𝑇
Average Annual NAT=𝑇𝑜𝑡𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑
11,250
= =2,250
5

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒

Average Investment = 2
50,000−0
= 2
=25,000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝐴𝑇
ARR= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 x 100

2,250
= 25,000 x100 = 9%
Problem 3
Management of Container Corporation of India is considering buying a machine for
manufacturing purpose. There are two machines available in the market which could
serve the purpose. Details about these two machines are as below:
Particulars Machine X Machine Y
Initial Investment ₹ 90,000 ₹ 90,000
Estimated life 5 years 5 years
Average income tax rate 50% 50%
Annual income estimated after depreciation but before tax:
Particulars ₹ ₹
st
1 Year 33,000 40,200
2nd Year 48,000 43,200
3rd Year 50,400 51,000
4th Year 52,800 42,000
5th Year 54,000 52,800
Calculate:
a. Payback Pay Period of both machines.
b. Accounting rate of return of both machines
Solution:
Calculation of cash inflow
Machine X
Year Income Tax @ Income (+ ) Dep Net CIF Cumulative
after dep. 50% after tax CIF
But before (-)
tax ₹ ₹ ₹ ₹ ₹ ₹
1 33,000 16,500 16,500 18,000 34,500 34,500
2 48,000 24,000 24,000 18,000 42,000 76,500
3 50,400 25,200 25,200 18,000 43,200 1,19,700
4 52,800 26,400 26,400 18,000 44,400 1,64,100
5 54,000 27,000 27,000 18,000 45,000 2,09,100
1,19,100

𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 90,000−0
Depreciation = = = 18,000
𝑙𝑖𝑓𝑒 5
 Machine Y
Year Income Tax @ Income ( +) Dep Net CIF Cumulative
after dep. 50% after tax CIF
But before (-)
tax ₹ ₹ ₹ ₹ ₹ ₹
1 40,200 20,100 20,100 18,000 38,100 38,100
2 43,200 21,600 21,600 18,000 39,600 77,700
3 51,000 25,500 25,500 18,000 43,500 1,21,200
4 42,000 21,000 21,000 18,000 39,000 1,60,200
5 52,800 26,400 26,400 18,000 44,400 2,04,600
1,14,600

𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 90,000−0
Depreciation = = = 18,000
𝑙𝑖𝑓𝑒 5

a. Calculation of Payback period

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝐶𝐶𝐼𝐹 𝑙𝑒𝑠𝑠 𝑡ℎ𝑎𝑛 𝐶𝑂𝐹
Payback period= Year in CCIF less than COF + 𝐶𝐼𝐹 𝑖𝑛 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

90,000−76,500
Machine X = 2 years +
43,200
13,500
= 2 years +
43,200

= 2 years + 0.31
= 2.31 years
90,000−77,700
Machine Y = 2 years +
43,500
12,300
= 2 years +
43,500

= 2 years + 0.28
= 2.28 years
 b. Calculation of Average Rate of Return
𝑇𝑜𝑡𝑎𝑙 𝑁𝐴𝑇
Average Annual NAT=
𝑇𝑜𝑡𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑
1,19,100
Machine X = = 23,820
5
1,14,600
Machine Y = = 22,920
5
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
Average Investment =
2
90,000−0 90,000−0
Machine X = =45,000 Machine Y= =45,000
2 2
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝐴𝑇
ARR= x 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
23,820
Machine X = x100 = 52.93%
45,000
22,920
Machine Y = x100 = 50.93%
45,000

Problem 4
State Trading Corporation of India is considering the purchase of a machine. Two
machines A and B are available, the details of which are given below. You are
requested to advise the company to which machine is profitable.
i) Payback period method
ii) Average rate of return method
The income tax rate is 50%
Particulars Machine A Machine B
Cost ₹ 2,50,000 ₹ 3,00,000
Life 6 years 6 years
Scrap value ₹ 10,000 Nil
Profits (before depreciation and taxes) ₹ ₹
1st Year 1,00,000 80,000
2nd Year 1,20,000 1,40,000
3rd Year 1,40,000 1,60,000
4th Year 80,000 80,000
5th Year 1,00,000 80,000
6th Year 60,000 60,000
Solution:
Calculation of cash inflow
Machine A
Year NP (-) Dep NBT (-) Tax NAT (+) Dep CIF Cumulative
before @ 50% CIF
Dep & T
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
1 1,00,000 40,000 60,000 30,000 30,000 40,000 70,000 70,000
2 1,20,000 40,000 80,000 40,000 40,000 40,000 80,000 1,50,000
3 1,40,000 40,000 1,00,000 50,000 50,000 40,000 90,000 2,40,000
4 80,000 40,000 40,000 20,000 20,000 40,000 60,000 3,00,000
5 1,00,000 40,000 60,000 30,000 30,000 40,000 70,000 3,70,000
6 60,000 40,000 20,000 10,000 10,000 40,000 50,000 4,20,000
1,80,000
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 2,50,000−10,000
Depreciation = = = 40,000
𝑙𝑖𝑓𝑒 6

Calculation of cash inflow

Machine B
Year NP (-) Dep NBT (-) Tax NAT (+) Dep CIF Cumulative
before @ 50% CIF
Dep
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
1 80,000 50,000 30,000 15,000 15,000 50,000 65,000 65,000
2 1,40,000 50,000 90,000 45,000 45,000 50,000 95,000 1,60,000
3 1,60,000 50,000 1,10,000 55,000 55,000 50,000 1,05,000 2,65,000
4 80,000 50,000 30,000 15,000 15,000 50,000 65,000 3,30,000
5 80,000 50,000 30,000 15,000 15,000 50,000 65,000 3,95,000
6 60,000 50,000 10,000 5,000 5,000 50,000 55,000 4,50,000
1,50,000
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 3,00,000−0
Depreciation = = = 50,000
𝑙𝑖𝑓𝑒 6

a. Calculation of Payback period

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝐶𝐶𝐼𝐹 𝑙𝑒𝑠𝑠 𝑡ℎ𝑎𝑛 𝐶𝑂𝐹
Payback period= Year in CCIF less than COF + 𝐶𝐼𝐹 𝑖𝑛 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

2,50,000−2,40,000
Machine A = 3 years +
60,000
10,000
= 3 years +
60,000

= 3 years + 0.17
= 3.17 years
 3,00,000−2,65,000
Machine B = 3 years +
65,000
35,000
= 3 years +
65,000

= 3 years + 0.54
= 3.54 years
b. Calculation of Average Rate of Return
𝑇𝑜𝑡𝑎𝑙 𝑁𝐴𝑇
Average Annual NAT=
𝑇𝑜𝑡𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑
1,80,000
Machine A = = 30,000
6
1,50,000
Machine B = = 25,000
6
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
Average Investment =
2
2,50,000−10,000 3,00,000−0
Machine A = =1,20,000 Machine B= =1,50,000
2 2
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝐴𝑇
ARR= x 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
30,000
Machine A = x 100 = 25%
1,20,000
25,000
Machine B = x 100 = 16.67%
1,50,000

Recommendation:
On the basis of payback period and Accounting Rate of Return Machine A is
recommended as payback period of Machine A is shorter than Machine B and ARR
of Machine A is higher than Machine B
Problem 5
Engineers India Ltd. (EIL) is considering the purchase of a machine. Two machines
are available A and B, the cost of each machine is ₹ 2,00,000. Each has an expected
life of 5 years.
The estimated profit before depreciation and tax of both the machines are as follows:
Year Machine A Machine B
₹ ₹
1 70,000 78,000
2 72,000 75,000
3 76,000 72,000
4 78,000 75,000
5 75,000 80,000
6 85,000 85,000
Both the machines have to be depreciated under the straight line method and the
average rate of income tax may be taken at 50 %. Ascertain which of the two
machines will be profitable under:
i. Payback Period method
ii. Average Rate of Return Method
Solution:
Calculation of cash inflow
Machine A
Year NP (-) Dep NBT (-) Tax NAT (+) Dep CIF Cumulative
before @ 50% CIF
Dep
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
1 70,000 40,000 30,000 15,000 15,000 40,000 55,000 55,000
2 72,000 40,000 32,000 16,000 16,000 40,000 56,000 1,11,000
3 76,000 40,000 36,000 18,000 18,000 40,000 58,000 1,69,000
4 78,000 40,000 38,000 19,000 19,000 40,000 59,000 2,28,000
5 75,000 40,000 35,000 17,500 17,500 40,000 57,500 2,85,500
85,500
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 2,00,000−0
Depreciation = = = 40,000
𝑙𝑖𝑓𝑒 5
Calculation of cash inflow
Machine B
Year NP (-) Dep NBT (-) Tax NAT (+) Dep CIF Cumulative
before @ 50% CIF
Dep
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
1 78,000 40,000 38,000 19,000 19,000 40,000 59,000 59,000
2 75,000 40,000 35,000 17,500 17,500 40,000 57,500 1,16,500
3 72,000 40,000 32,000 16,000 16,000 40,000 56,000 172,500
4 75,000 40,000 35,000 17,500 17,500 40,000 57,500 2,30,000
5 80,000 40,000 40,000 20,000 20,000 40,000 60,000 2,90,000
90,000
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 2,00,000−0
Depreciation = = = 40,000
𝑙𝑖𝑓𝑒 5

a. Calculation of Payback period

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝐶𝐶𝐼𝐹 𝑙𝑒𝑠𝑠 𝑡ℎ𝑎𝑛 𝐶𝑂𝐹
Payback period= Year in CCIF less than COF + 𝐶𝐼𝐹 𝑖𝑛 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

2,00,000−1,69,000
Machine A = 3 years +
59,000
31,000
= 3 years +
59,000

= 3 years + 0.53
= 3.53 years
2,00,000−1,72,500
Machine B = 3 years +
57,500
27,500
= 3 years +
57,500

= 3 years + 0.48
= 3.48 years
 b. Calculation of Average Rate of Return
𝑇𝑜𝑡𝑎𝑙 𝑁𝐴𝑇
Average Annual NAT=
𝑇𝑜𝑡𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑
85,500
Machine A = = 17,100
5
90,000
Machine B = = 18,000
5
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
Average Investment =
2
2,00,000−0 2,00,000−0
Machine A = =1,00,000 Machine B= =1,00,000
2 2
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝐴𝑇
ARR= x 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
17,100
Machine A = x100 = 17.10%
1,00,000
18,000
Machine B = x100 = 18%
1,00,000

Recommendation:
On the basis of payback period and Accounting Rate of Return Machine B is
recommended as payback period of Machine B is shorter than Machine A and ARR
of Machine B is higher than Machine A.

Problem 6
A project of 20 years life requires an original investment of ₹ 1,00,000. The other
relevant information is given below:
Average annual earnings before depreciation and tax: ₹20,000
Annual Tax rate : 50%
Calculate:
1. Pay Back Period 3. Average Rate of Return
2. Pay Back Profitability 4. Rate of Return on Original Investment
Solution:
1. Pay Back Period:
Net Profit before depreciation and tax 20,000
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 1,00,000−0
Less depreciation = =
𝑙𝑖𝑓𝑒 20 5,000
Net Profit before tax 15,000
Less Tax @ 50% 15,000 x 50% 7,500
Net Profit after tax 7,500
Add Depreciation 5,000
Annual Cash Inflow 12,500

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤

1. Pay Back period=
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
1,00,000
=
12,500
= 8 years
2. Pay Back Profitability = Total Cash Inflows – Initial Cost
= (12,500 x 20) – 1,00,000
= 2,50,000 – 1,00,000
=₹ 1,50,000
3. Average Rate of Return
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
Average Investment =
2
1,00,000−0
= =50,000
2
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝐴𝑇
ARR= x 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
7,500
= x100 = 15%
50,000
𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥)
4. Rate of Return on Original Investment = x 100
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠
7,500
= x 100
1,00,000
=7.5%
Problem 7
Find the present value of the cash flow in following two cases:
Year Cash Flow ₹
1 10,000
2 15,000
3 18,000
4 14,000
5 12,000
Case I: Discount Factor 10%
Case II: Discount Factor 12%
PV factor of ₹ 1:
Year 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
Solution:
Calculation of Present Values of Cash Flows
Year Cash Flow ₹ PV Factor PV of Cash PV Factor PV of Cash
at 10% Flow ₹ at 12% Flow ₹
1 10,000 0.909 9,090 0.893 8,930
2 15,000 0.826 12,390 0.797 11,955
3 18,000 0.751 13,518 0.712 12,816
4 14,000 0.683 9,562 0.636 8,904
5 12,000 0.621 7,452 0.567 6,804
PV of Cash Flow 52,012 49,409

Problem 8
The Engineering Projects is considering a proposal for the investment of ₹ 5,00,000 on product
development which is expected to generate net cash inflows for 6 years as under:
Year Net Cash Flows
1 Nil
2 1,00,000
3 1,60,000
4 2,40,000
5 3,00,000
6 6,00,000
The following are the present value factors @ 15% p.a.:
Year Factor
1 0.87
2 0.76
3 0.66
4 0.57
5 0.50
6 0.43
Solution:
Calculation of Net Present Value
Year Cash Inflows ₹ PV Factor Present Values ₹
1 Nil 0.87 Nil
2 1,00,000 0.76 76,000
3 1,60,000 0.66 1,05,600
4 2,40,000 0.57 1,36,800
5 3,00,000 0.50 1,50,000
6 6,00,000 0.43 2,58,000
Total 7,26,400
Less: Cash Outlay 5,00,000
Net Present Value 2,26,400

Problem 9
Ferro Scrap Nigam Ltd. wants to introduce a new product well estimated sales life of five years.
The manufacturing equipment will cost ₹ 5,00,000 with scrap value of ₹ 30,000 at the end of five
years. The working capital requirement is ₹ 40,000, which will be released after five years.
The annual cash inflows and PV factor @ 10% are:
Year P. V. Factor Cash Inflow ₹
1 0.909 2,50,000
2 0.826 3,00,000
3 0.751 3,75,000
4 0.683 3,60,000
5 0.621 2,25,000
The depreciation to be charged under straight line method ₹ 1,00,000.
Tax applicable @ 40%
Evaluate the proposal under various alternatives.
Solution:

Computation of PV of Cash Outlays

₹
Initial Investment 5,00,000
Additional Working Capital 40,000
Total Cash Outlays 5,40,000
Computation of PV of Cash Inflows
Year Cash (-) Dep NBT (-) Tax Cash Inflow PV PV
Inflows @ 40% After Tax Factors Cash
₹ ₹ ₹ ₹ ₹ @ 10% Inflow
₹ ₹
1 2,50,000 1,00,000 1,50,000 60,000 90,000+1,00,000=1,90,000 0.909 1,72,710
2 3,00,000 1,00,000 2,00,000 80,000 120,000+100000=2,20,000 0.826 1,81,720
3 3,75,000 1,00,000 2,75,000 1,10,000 165000+100000=2,65,000 0.751 1,99,015
4 3,60,000 1,00,000 2,60,000 1,04,000 156000+100000=2,56,000 0.683 1,74,848
5 2,25,000 1,00,000 1,25,000 50,000 75000+100000=1,75,000 0.621 1,08,675
 ₹
Present Value of all CFAT 836968
Add: PV of Salvage Value (30,000 x 0.621) 18630
Total Cash Inflows 855598
Less: PV of Cash Outflow 540000
315598

Problem 10
RITES is considering investment in a Project requiring capital outlay of ₹ 2,00,000. Forecast for
annual income after depreciation but before tax and PV factor at 10% are as follows:
Year Discount Factor @ 10% Cash Inflow ₹
1 0.909 1,00,000
2 0.826 1,00,000
3 0.751 80,000
4 0.683 80,000
5 0.621 40,000
Depreciation may be taken at 20% on original cost and tax rate at 50% of net income.
You are required to calculate:
1. Discounted Cash Flow Method taking cost of capital as 10%.
2. Net Present Value Index Method.
Solution:
1. Discounted Cash Flow (Cost of Capital 10%)
Discounted Cash Flow
Year NBT (-) Tax @ NAT + Dep Cash Discount PV of Cash
50% Inflow Factors @ Inflow
After Tax 10% ₹
₹ ₹ ₹ ₹ ₹ ₹
1 1,00,000 50,000 50,000 40,000 90,000 0.909 81,810
2 1,00,000 50,000 50,000 40,000 90,000 0.826 74,340
3 80,000 40,000 40,000 40,000 80,000 0.751 60,080
4 80,000 40,000 40,000 40,000 80,000 0.683 54,640
5 40,000 20,000 20,000 40,000 60,000 0.621 37,260
Present Value of Cash Inflow 3,08,130
Less: Cash Outflow 2,00,000
Net Present Value 1,08,130
Depreciation = 2,00,000 x 20% = 40,000
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
2. Net Present Value Index Method=
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠
3,08,130
=
2,00,000
=1.54
Problem 11
Your Company is considering investing in a project for which the investment data are as follows:
Capital Outlay: ₹ 2,00,000. Depreciation Charges: 20% p.a.
Forecasted annual income after charging depreciation and after all other charges:
Year ₹
1 140000
2 140000
3 120000
4 120000
5 80000
600000
In connection with the foregoing, you are asked to employ methods of measuring the return on the
capital employed with a view to ascertain the value to the company of the proposed investment.
On the basis of the figures given above, set out calculations illustrating and comparing the
following methods of evaluating the return on capital employed.
Discounted cash flow at 9% discount factor.
Taxation maybe assumed at 35%.
The present value of 1 at 9% is as follows;
Year ₹
1 0.917
2 0.842
3 0.772
4 0.708
5 0.650

Solution:
Discounted Cash Flow
Year NBT (-) Tax @ NAT + Dep Cash Discount PV of Cash
35% Inflow Factors @ Inflow
After Tax 9% ₹
₹ ₹ ₹ ₹ ₹ ₹
1 1,40,000 49,000 91,000 40,000 1,31,000 0.917 1,20,127
2 1,40,000 49,000 91,000 40,000 1,31,000 0.842 1,10,302
3 1,20,000 42,000 78,000 40,000 1,18,000 0.772 91,096
4 1,20,000 42,000 78,000 40,000 1,18,000 0.708 83,544
5 80,000 28,000 52,000 40,000 92,000 0.650 59,800
Present Value of Cash Inflow 4,64,869
Less: Cash Outflow 2,00,000
Net Present Value 2,64,869
Depreciation = 2,00,000 x 20% = 40,000
Problem 12
Bharat Electronics Ltd (BEL) is considering the purchase of a new machine. Two alternative
machines A and B suggested each costing ₹ 4,00,000. Earnings after taxation are expected to be
as follows:
Year PV of ₹ 1 @ 10% Machine A Machine B
1 0.91 40,000 1,20,000
2 0.83 1,20,000 1,60,000
3 0.75 1,60,000 2,00,000
4 0.68 2,40,000 1,20,000
5 0.62 1,60,000 80,000
The company’s target return on capital is 10%. You are required to compare the profitability of
the machines and state which alternative of the machines is financially preferable. Adopt NPV
method and Profitability Index method.
Solution:
Calculation of NPV

Year Discounting Machine A Machine B

Factor @ 10% CIF PV CIF PV
1 0.91 40,000 36,400 1,20,000 1,09,200
2 0.83 1,20,000 99,600 1,60,000 1,32,800
3 0.75 1,60,000 1,20,000 2,00,000 1,50,000
4 0.68 2,40,000 1,63,200 1,20,000 81,600
5 0.62 1,60,000 99,200 80,000 49,600
Total PV of CIF 5,18,400 5,23,200
Less Initial Cash Outflow 4,00,000 4,00,000
Net Present Value 1,18,400 1,23,200

b. Calculation of Profitability Index

𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability Index =
𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
5,18,400
Machine A = = 1.296
4,00,000
5,23,200
Machine B = = 1.308
4,00,000
Problem 13
There are two mutually exclusive projects under active consideration of a company. Both the
projects have a life of five years and have initial cash outlays of Rs 1,00,000 each. The company
pays tax at 50% rate and the maximum required rate of the company has been given as 10%. The
straight-line method of depreciation will be charged on the projects. The projects are expected to
generate a net cash inflow before taxes as follows:
Year Project X (Rupee) Project Y (Rupee)
1 40,000 60,000
2 40,000 30,000
3 40,000 20,000
4 40,000 50,000
5 40,000 50,000
PV factor of ₹ 1:
Year 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621
With the help of above information, you are required to calculate:
a. The Payback period of each project
b. The Average rate of return
c. The Net Present Value at 10%
d. Profitability index at 10% discount rate.

Solution:
Calculation of cash inflow
Project X
Year NBT - Tax =NAT + Dep =CIF Cumulative
Rs Rs Rs Rs Rs CIF
1 40,000 20,000 20,000 20,000 40,000 40,000
2 40,000 20,000 20,000 20,000 40,000 80,000
3 40,000 20,000 20,000 20,000 40,000 1,20,000
4 40,000 20,000 20,000 20,000 40,000 1,60,000
5 40,000 20,000 20,000 20,000 40,000 2,00,000
1,00,000
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 1,00,000−0
Depreciation = 𝑙𝑖𝑓𝑒 = = 20,000
5

Project Y
Year NBT - Tax =NAT + Dep =CIF Cumulative
Rs Rs Rs Rs Rs CIF
1 60,000 30,000 30,000 20,000 50,000 50,000
2 30,000 15,000 15,000 20,000 35,000 85,000
3 20,000 10,000 10,000 20,000 30,000 1,15,000
4 50,000 25,000 25,000 20,000 45,000 1,60,000
5 50,000 25,000 25,000 20,000 45,000 2,05,000
1,05,000
a. Calculation of Payback period
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
Payback period= 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
1,00,000
Project X = = 2.5 years
40,000

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝐶𝐶𝐼𝐹 𝑙𝑒𝑠𝑠 𝑡ℎ𝑎𝑛 𝐶𝑂𝐹

Payback period= Year in CCIF less than COF + 𝐶𝐼𝐹 𝑖𝑛 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

1,00,000−85,000
=2 years + 30,000

15,000
= 2 years + 30,000

= 2 years + 0.5
= 2.5 years
b. Calculation of Average Rate of Return
𝑇𝑜𝑡𝑎𝑙 𝑁𝐴𝑇
Average Annual NAT=𝑇𝑜𝑡𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑
1,00,000
Project X = =20,000
5
1,05,000
Project Y = =21,000
5
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
Average Investment = 2
1,00,000−0
Project X = =50,000
2
1,00,000−0
Project Y = =50,000
2
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝐴𝑇
ARR= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 x 100
20,000
Project X = 50,000 x100 = 40%
21,000
Project Y = x100=42%
50,000
 c. Calculation of NPV

Year Discounting Project X Project Y

Factor @ CIF PV CIF PV
10%
1 0.909 40,000 36,360 50,000 45,450
2 0.826 40,000 33,040 35,000 28,910
3 0.751 40,000 30,040 30,000 22,530
4 0.683 40,000 27,320 45,000 30,735
5 0.621 40,000 24,840 45,000 27,945
Total PV of CIF 1,51,600 1,55,570
Less Initial Cash Outflow 1,00,000 1,00,000
Net Present Value 51,600 55,570

d. Calculation of Profitability Index

𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability Index =𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
1,51,600
Project X = 1,00,000 = 1.516
1,55,570
Project Y = 1,00,000 = 1.555

Problem 14
Water and Power Consultancy Services wants to install a new machine in place of existing old
machine, which became obsolete. Two machines are considered for this purpose. The two models
differ in cost, output and cash flows. The estimated life of both the machines is 5 years.
Machine A Machine B
Capital outlay Rs 2,50,000 Rs 4,00,000
Anticipated after tax cash flows
Rs Rs
Year 1 ---- 1,00,000
Year 2 50,000 1,40,000
Year 3 2,00,000 1,60,000
Year 4 1,40,000 1,70,000
Year 5 60,000 80,000
The company follows a straight-line method of depreciation.
The company’s cost of capital is 16%.
Year Discounting
Factor @
16%
1 0.826
2 0.743
3 0.640
4 0.552
5 0.476
You are required to make appraisal of the two offers and then advice the firm by using the
following:
a. Payback period
b. Average rate of return
c. Profitability index
d. Net present value
Solution:
Calculation of cash inflow
Machine A
Year NAT + Dep =CIF Cumulative
Rs Rs Rs CIF
1 --- 50,000 50,000 50,000
2 50,000 50,000 1,00,000 1,50,000
3 2,00,000 50,000 2,50,000 4,00,000
4 1,40,000 50,000 1,90,000 5,90,000
5 60,000 50,000 1,10,000 7,00,000
4,50,000

𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 2,50,000−0
Depreciation = = = 50,000
𝑙𝑖𝑓𝑒 5
Machine B
Year NAT + Dep =CIF Cumulative
Rs Rs Rs CIF
1 1,00,000 80,000 1,80,000 1,80,000
2 1,40,000 80,000 2,20,000 4,00,000
3 1,60,000 80,000 2,40,000 6,40,000
4 1,70,000 80,000 2,50,000 8,90,000
5 80,000 80,000 1,60,000 10,50,000
6,50,000
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 4,00,000−0
Depreciation = = = 80,000
𝑙𝑖𝑓𝑒 5

a. Calculation of Payback period

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝐶𝐶𝐼𝐹 𝑙𝑒𝑠𝑠 𝑡ℎ𝑎𝑛 𝐶𝑂𝐹
Payback period= Year in CCIF less than COF +
𝐶𝐼𝐹 𝑖𝑛 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

2,50,000−1,50,000
Machine A =2 years + 2,50,000

1,00,000
= 2 years + 2,50,000

= 2 years + 0.4
= 2.4 years
Machine B= 2 years
b. Calculation of Average Rate of Return
𝑇𝑜𝑡𝑎𝑙 𝑁𝐴𝑇
Average Annual NAT=𝑇𝑜𝑡𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑
4,50,000
Machine A = =90,000
5
6,50,000
Machine B = =1,30,000
5
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
Average Investment = 2
2,50,000−0
Machine A = =1,25,000
2
4,00,000−0
Machine B = =2,00,000
2
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝐴𝑇
ARR= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 x 100
90,000
Machine A = 1,25,,000 x100 = 72%
1,30,000
Machine B = 2,00,000 x100=65%

c. Calculation of NPV

Year Discounting Machine A Machine B

Factor @ CIF PV CIF PV
16%
1 0.826 50,000 41,300 1,80,000 1,48,680
2 0.743 1,00,000 74,300 2,20,000 1,63,460
3 0.640 2,50,000 1,60,000 2,40,000 1,53,600
4 0.552 1,90,000 1,04,880 2,50,000 1,38,000
5 0.476 1,10,000 52,360 1,60,000 76,160
Total PV of CIF 4,32,840 6,79,900
Less Initial Cash Outflow 2,50,000 4,00,000
Net Present Value 1,82,840 2,79,900

d. Calculation of Profitability Index

𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability Index =𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
4,32,840
Machine A = 2,50,000 = 1.73
6,79,900
Machine B = 4,00,000 = 1.70
 Machine A Machine B Recommendation
1 Payback period 2.4 years 2 years B
2 ARR 72 % 65 % A
3 NPV 1,82,890 2,79,900 B
4 Profitability Index 1.73 1.70 A

Problem 15
Rail Vikas Nigam Ltd. is planning to invest ₹ 10,00,000 in two projects X and Y which will
require an investment of ₹ 6,00,000 and ₹ 4,00,000 respectively. Profit before depreciation and
tax is given below:
Year X Y
(₹) (₹)
1 2,00,000 3,00,000
2 1,50,000 1,00,000
3 1,00,000 1,50,000
4 1,50,000 1,50,000
5 3,00,000 2,00,000
Assume discount rate of 10% and tax rate of 30%. Project will have life of 10 years and their
scrap values will be ₹ 40,000 and ₹ 60,000 for project X and Y at the end of its life.
PV factor of ₹ 1:
Year 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621
Compute:
a. Discounted Payback Period
b. NPV
c. PI

Solution:
Calculation of cash inflow
Project X
Year NP before (-) Dep NBT (-) Tax NAT (+) Dep CIF
Dep & T @ 30%
₹
₹ ₹ ₹ ₹ ₹ ₹
1 2,00,000 56,000 1,44,000 43,200 1,00,800 56,000 1,56,800
2 1,50,000 56,000 94,000 28,200 65,800 56,000 1,21,800
3 1,00,000 56,000 44,000 13,200 30,800 56,000 86,800
4 1,50,000 56,000 94,000 28,200 65,800 56,000 1,21,800
5 3,00,000 56,000 2,44,000 73,200 1,70,800 56,000 2,26,800
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 6,00,000−40,000
Depreciation = = = 56,000
𝑙𝑖𝑓𝑒 10
Calculation of cash inflow
Project Y
Year NP before (-) Dep NBT (-) Tax NAT (+) Dep CIF
Dep & T @ 30%
₹
₹ ₹ ₹ ₹ ₹ ₹
1 3,00,000 34,000 2,66,000 79,800 1,86,200 34,000 2,20,200
2 1,00,000 34,000 66,000 19,800 46,200 34,000 80,200
3 1,50,000 34,000 1,16,000 34,800 81,200 34,000 1,15,200
4 1,50,000 34,000 1,16,000 34,800 81,200 34,000 1,15,200
5 2,00,000 34,000 1,66,000 49,800 1,16,200 34,000 1,50,200
𝐶𝑜𝑠𝑡−𝑆𝑐𝑟𝑎𝑝 4,00,000−60,000
Depreciation = = = 34,000
𝑙𝑖𝑓𝑒 10

Calculation of PV of cash inflows

Year Discounting Project X Project Y
Factor @ 10%
CIF PV Cum CIF PV Cum
1 0.909 1,56,800 1,42,531 1,42,531 2,20,200 2,00,162 2,00,162
2 0.826 1,21,800 1,00,607 2,43,138 80,200 66,245 2,66,407
3 0.751 86,800 65,187 3,08,325 1,15,200 86,515 3,52,922
4 0.683 1,21,800 83,189 3,91,514 1,15,200 78,682 4,31,604
5 0.621 2,26,800 1,40,843 5,32,357 1,50,200 93,274 5,24,878
5,32,357 524,878
a. Discounted Payback period
Project X= 5 years + future CIF = More than 5 years
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝐶𝐶𝐼𝐹 𝑙𝑒𝑠𝑠 𝑡ℎ𝑎𝑛 𝐶𝑂𝐹
Project Y= Year in CCIF less than COF +
𝑃𝑉 𝑖𝑛 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟
4,00,000−3,52,922
=3 years +
78,682
47,078
= 3 years +
78682

= 3 years + 0.60
= 3.60 years
b. Calculation of NPV
NPV = Total PV of CIF – Initial Cost
Project X = 5,32,357 – 6,00,000 = (-) 67,643
Project Y = 5,24,878 – 4,00,000 = 1,24,878

c. Calculation of Profitability Index

 𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability Index =
𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
5,32,357
Project X = = 0.89
6,00,000
5,24,878
Project Y = = 1.31
4,00,000

Problem 16
Broadcast Engineering Consultant India is considering the purchase of a new machine which
will replace some operations. There are two alternatives A and B. from the following
information, prepare a profitability statement and work out the payback period for each.
Model A Model B
Cost of the machine ₹ 1,50,000 2,50,000
Estimated life years 5 5
Additional Cost of Indirect Materials ₹ 6,000 8,000
Estimated Savings in scrap ₹ 10,000 15,000
Additional Cost of Maintenance ₹ 19,000 27,000
Estimated Savings in Direct Wages:
Employees not required 15 20
Wages per employee p.a. ₹ 6,000 6,000
Tax rate is 50%. Suggest which machine should be preferred.
Solution

Profitability Statement
Model A Model B
Estimated Savings:
Scrap 10,000 15,000
Wages A (15 x 6000) B (20 x 6000) 90,000 1,20,000
Total A 1,00,000 1,35,000
Additional Cost
Indirect Materials 6,000 8,000
Maintenance 19,000 27,000
Total B 25,000 35,000
Net Savings A-B 75,000 1,00,000
Less Depreciation 1,50,000 - 10000/5; 250,000 - 15000/5 28,000 47,000
Net Profit Before Tax 47,000 53,000
Less tax 50% 23,500 26,500
Net Profit After Tax 23,500 26,500
Add: Depreciation 28,000 47,000
Annual Cash Inflow 51,500 73,500

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤

1. Pay Back period=
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
 1,50,000
Model A =
51,500
= 2.91 years
2,50,000
Model B =
73,500
= 3.40 years
Payback period of Model A is less. Hence, it is recommended.
Problem 17
Central Mine Planning and design Institute provided the following information:
Purchase price of Machine ₹ 1,60,000
Installation charges ₹ 40,000
Salvage Value ₹ 80,000
Economic Life 4 years
Working Capital required ₹ 20,000
Annual Earnings before Depreciation and Tax ₹ 1,30,000
Rate of Tax 30%
Calculate ARR id the method of depreciation is straight line.
Solution:
Annual Average Earnings after tax:
Annual Earnings before depreciation ₹ 1,30,000
2,00,000−80,000 1,20,000 ₹ 30,000
Less: Depreciation = 4
4

Earnings before Tax ₹ 1,00,000

Less: Tax 30% ₹ 30,000
Annual Earnings after Tax ₹ 70,000

1
Average Investment = 2(Original Cost – Salvage Value) + Salvage Value + Working Capital
1
=2(2,00,000 – 80,000) + 80,000 + 20,000
=1,60,000

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠

ARR= x 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

70,000
=1,60,000 x 100

=43,75%