FINANCIAL MANAGEMENT

Chapter – 5 CAPITAL BUDGETING

1) MEANING OF CAPITAL BUDGETING

Capital Budgeting involves the Process of:
a) Decision making with regard to investment in Fixed Assets (Capital Projects) &
Long-Term Projects; or
b) Evaluation of Expenditures Decisions, which involve current outlays/outflows but are likely to
produce benefits over a longer period of time; or
c) Forecast of likely or Expected Returns from a new investment project and to determine whether
returns are adequate.
d) However, Capital Budgeting excludes certain investment decisions, wherein, the benefits of
investment proposals cannot be directly quantified.

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3) TYPES OF CAPITAL INVESTMENT DECISIONS

4) TECHNIQUES OF CAPITAL BUDGETING

Ø Techniques of Capital Budgeting refer to the criteria used to evaluate the project.
Ø Some of the techniques of capital budgeting assuming that the proposed investment
project does not involve any risk are:

1) Accounting Rate of Return is also known as average rate of return, annual rate of return.
2) Accounting or Average Rate of Return (ARR) means the average annual yield on the project. It is
found out by dividing the annual average profits after taxes by the average investments.
3) ARR can be calculated in three ways as given below. a) Based on Initial Investment
ARR = Average PAT * 100
Initial Investment
b) Based on Net Investment
ARR = Average PAT * 100
Net Investment
Net investment = initial investment – salvage value

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c) Based on Average Investment
ARR = Average PAT * 100
Average Investment
Average Investment = Salvage value + ½(Initial Investment – Salvage Value)

Merits and Demerits of ARR Techniques:

The Merits and Demerits of ARR technique are as follows:
Merits Demerits

It is easy to understand and calculate It ignores the time value of money

It considers the entire profits over the entire

life of the projects It does not use the cash flows

It uses the accounting data with which There is no objective way to determine the
managers are familiar Minimum Acceptable Rate of Return

Pay Back Period =

(Year up to which Cumulative
CFAT is less than Total Cash
Outflow)
Total Cash Outflow – Cumulative CFAT of the year in which
Cumulative CFAT is less than Total Cash
+ Outflow
CFAT in next year following the year for which
Cumulative CFAT has been considered in numerator

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Step 1: prepare Cumulative cash flows after tax table (CCFAT). For Eg;
YEAR CASH FLOWS (CFAT) CUMULATIVE CASH
FLOWS (CCFAT)

1 1,25,000 1,25,000

2 1,00,000 2,25,000

3 1,50,000 3,75,000

4 2,50,000 6,25,000

Step 2: Apply interpolation technique

Investment - CCFATLP
PBP = LP + X (HP - LP)
CFATHP
1) Till the end of 3rd year I got 375000
2) In 4th year I got 250000
3) In 4th year how much we want? 125000 [500000 – 375000]
4) If we receive 250000 in 4th year (full year) and we need only 125000 for payback period, what portion of
4th year has given this 125000 required.
5) Till 3 year – recovered = 375000 = 3 years
6) In 4th year – recovered = 125000 = 0.5 years
7) Total recovery period is equal 3.5 years

Merits and Demerits

The merit and demerits of Payback Period are as follows:
Merits Demerits

It is easy to understand and calculate It ignores the time value of money

It emphasizes liquidity by stressing earlier cash It ignores the cash flows occurring after the
inflows payback period

It uses the cash flows rather than accounting data There is no objective way to determine the
maximum acceptable payback period

It enables the management to cope with the risk It is not a measure of profitability since the
associated with the project by having a shorter cash flows occurring after the payback period
payback period are ignored

The reciprocal of the payback is a close

approximation of the internal rate of return if the
life of the project is atleast twice the payback It does not necessarily maximize the wealth of
period and the project generates equal annual cash the shareholders
inflows

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Payback Reciprocal:
As the name indicates it is the reciprocal of payback period.
The payback reciprocal can be calculated as follows:
Average annual cash inflow * 100
Initial investment
7) DISCOUNTED PAYBACK PERIOD
Meaning:
Discounted Payback Period refers to the period within which the entire cost of the project is expected to
be completely recovered by way of discounted cash inflows. Cash inflow means earnings after tax but
before depreciation. Discounted Cash inflow means present value of cash inflows using cost of capital as
discount rate.

Computation: Discounted payback period is calculated by computing cumulative discounted cash inflows
till the cumulative discounted cash inflows become equal to the present value of Cash Outflows.

Step 1: Calculate Cash Inflows after Tax (CFAT)

Step 2: Calculate Cash Outflows

Step 3: Calculate Present Value of all Cash Inflows (CFAT)

Step 4: Calculate Present Value of all Cash Outflows

Step 5: Calculate Cumulative CFAT

Step 6: Calculate discounted Pay back Period as follows:

Merits Demerits

It is easy to understand and calculate It ignores the cash flows occurring after the
payback period

It emphasizes liquidity by stressing earlier cash There is no objective way to determine the
inflows maximum acceptable payback period

It uses the cash flows rather than accounting data It is not a measure of profitability since the cash
flows occurring after the payback period are
ignored

It enables the management to cope with the risk It does not necessarily maximize the wealth of the
associated with the project by having a shorter shareholders
payback period

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The reciprocal of the payback is a close
approximation of the internal rate of return if the life
of the project is atleast twice the payback period and
the project generates equal annual cash inflows

8) PROFITABLE INDEX / DESIRABILITY FACTOR / PRESENT VALUE

INDEX METHOD
Profitability Index/Desirability Factor technique is one of the discounted cash flow techniques, which
takes into account the Time Value of Money.
Profitability index/Desirability Factor refers to the Ratio of the Present Value of all Cash Inflows to
the Present Value of all Cash Outflows associated with the project.
The present value is ascertained using the firm’s Cost of Capital as the Discount Rate.

Computation
Step 1: Calculate all the Cash Outflows associated with the Project
Step 2: Calculate all the Cash Inflows associated with the Project
Step 3: Calculate the Present Value of all cash Outflows associated with the project.
Step 4: Calculate the present value of all cash inflows associated with the project.
Step 5: Calculate Profitability Index/Desirability Factor as follows

Merits and Demerits

Merits
It considers the time value of money
It considers entire cash flows over
entire life of the project
It is a relative measure of
profitability since the ratio of cash
inflows to cash outflows is
considered
It guides in resolving capital
rationing where projects are divisible
It guides the selection of Mutually
Exclusive Projects having same Net
Present Value
Demerits
It requires the estimation of cash inflows and cash outflows,
which is a difficult task.
It requires the computation of the cost of capital to be used
as discount rate
The ranking of projects depends upon the discount rate
It ignores the difference in initial cash outflows, size of
different projects, etc., while evaluating mutually exclusive
projects
it fails to guide in resolving capital rationing where projects
are indivisible
It ignores the absolute amount of NPV while taking decision.
A project having lower PI but higher absolute NPV may be
rejected although it increases the shareholder’s wealth
It is not consistent with the objective of maximizing the
wealth of owners since PI may not be interpreted as
immediate increase in firm’s wealth if the project is accepted

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9) NET PRESENT VALUE

Net Present Value technique is one of the discounted cash flow techniques which takes into account
the time value of money.
It refers to difference between the present value of cash inflows and the present value of the cash
outflows.
PV is ascertained using the Firm’s overall Cost of Capital as the Discount Rate.

Computation

If Decision

NPV > 0 Accept the Project. Surplus over and above the cut-off rate is obtained

NPV = 0 Project generates cash flows at a rate just equal to the Cost of Capital. Hence, it may be accepted
or rejected. This constitutes an Indifference point.

NPV < 0 Reject the Project.

The Project does not provide returns even equivalent to the cut–off rate.

Step 1: Calculate all the cash outflows associated with the project.

Step 2: Calculate all the cash Inflows associated with the project

Step 3: Calculate the Present Value of all cash Outflows associated with the project

Step 4: Calculate the Present Value of all cash Inflows associated with the project

Step 5: Calculate Net Present Value as follows:

Net Present Value = Present Value of all Cash Inflows – Present Value of all cash Outflows

Acceptance Rule:

Merits Demerits

It requires the estimation of cash Inflows and cash

It considers the time value of money. outflows, which is a difficult task.

It considers entire cash flows over entire life of the It requires the computation of the cost of capital
project. to be used as discount rate.

It may not provide satisfactory results in case of –

It is consistent with the objective of maximizing the a. Projects involving different amounts of
wealth of owners since NPV may be interpreted as an cash outflows.
immediate increase in firm’s wealth if the project is b. Projects having different lives.
accepted. c. Both (a) & (b)

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It is measure of profitability since entire cash flows Merits
over entire life of the project are considered. The ranking of projects depends upon the discount and
rate.

It is an absolute measure. It ignores the difference

in initial cash outflows, size of different projects,
etc. while evaluating mutually exclusive projects

10) INTERNAL RATE OF RETURN Meaning:

Internal rate of return (IRR) is the rate at which the sum total of discounted cash inflows equals the
discounted cash outflows.
The internal rate of return of a project is the discount rate, which makes net present value of the project
equal to zero.
The Discounted Rate i.e. Cost of Capital is assumed to be known in the determination of net present
value.
While in the Internal Rate of Return calculation, the Net Present Value is set equal to zero and the
discount rate, which satisfies this condition, is determined.

If Decision

IRR > Ko Accept the Project. Surplus over and above the cut-off rate is obtained

IRR = Ko Project generates cash flows at a rate just equal to the Cost of Capital.
Hence, it may be accepted or rejected. This constitutes an Indifference Point.

IRR < Ko Reject the Project.

The Project does not provide returns even equivalent to the cut-off rate

Merits Demerits

It is tedious to compute in case of multiple cash

Time value of money is taken into outflows. Multiple IRR’s may result, leading to
account difficulty in interpretation.

All cash inflows of the project arising

at different points of time are It may conflict with NPV in case inflow/ outflow patterns
considered. are different in alternative proposals.

Decisions are immediately taken by

comparing IRR with the Cost of
Capital. The presumption that all the future cash flows of a
proposal are reinvested at a rate equal to the IRR may
It helps in achieving the basic not be practically valid.
objective of maximizations of
shareholders Wealth

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11) MODIFIED INTERNAL RATE OF RETURN (MIRR)

In order to cope up with various limitations of the conventional internal rate of return, modified internal
rate of return was developed.
MIRR results in an single stream of cash inflows in the terminal year.
Modified Internal Rate of Return is that rate of compounding which makes the initial cash outflow in
0th year equal to the terminal value of the cash inflows.
Computation of MIRR
The calculation of MIRR consists of the following practical steps:
Step 1: Calculate Total Terminal value as follows:
Terminal Value of Cash Inflow of Year 1 = CI1 x (1+k)n-1
Terminal Value of Cash Inflow of Year 2 = CI2 x (1+k)n-2 Terminal Value of Cash Inflow of Year 2 = CI3 x
(1+k)n-3 and so on ……
k = Reinvestment Rate (Usually the Cost of Capital) r = Modified Internal Rate of Return Step 2: Calculate
MIRR as follows:
Initial Cash Outflow (1+r) = Total Terminal Value of all Cash Inflows

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IRR differs from MIRR in the following respects:

Basis of
distinction IRR MIRR

It assumes that intermediate cash It assumes that intermediate cash

Reinvestment Rate inflows are reinvested at inflows are reinvested at
IRR Cost of Capital

It may yield negative It does not yield negative

Negative Rates / rates/multiple rates under certain rates/multiple rates under any
Multiple Rates circumstances circumstances.

12) CONFLICTS BETWEEN NPV, PI & IRR

All the three techniques viz. NPV, PI and IRR use the time value of money, But there are some conflicts
among them.
NPV versus PI:
The Discount Rates used in NPV and PI methods are the same. Hence for a given project NPV and PI
method give the same result, i.e. accept or Reject.
However if we have to select one project out of two mutually excusive projects, the NPV method
should be preferred.
This is because the NPV indicates the economic contribution or surplus of the project in absolute terms.
The higher the NPV, the better it is.

NPV versus IRR:

Higher the NPV, higher will be the IRR However, NPV and IRR may give conflicting results in certain
cases particularly when:
Cash Outflows arise at different points of time, rather than as Initial Investment only.
There is a huge difference between initial CFAT and later years CFAT.

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A project with heavy initial CFAT than compared to later years will have higher IRR and vice-versa.
The NPV method considers the timing differences at the appropriate discount rate.
The presumption in IRR is that intermediate cash inflows will be reinvested at that rate
(IRR);
Where as in the case of NPV method; intermediate cash inflows are presumed to be reinvested at the
cut-off rate.
The latter presumption viz. Reinvestment at the Cut-off Rate is more realistic than reinvestment at
IRR.
Hence in case of conflicting decisions based on NPV and IRR, the NPV method must prevail.
13) LIFE DISPARITY
It means projects having unequal lives.
Conflict Resolution:
Equated Annual Benefit Method (EAB)
EAB represents the annuity which is desired in order to get the original NPV.

14) CAPITAL RATIONING Resource Constraint:

When the most important resource in investment decisions i.e funds, are not fully available, it is said
to be a Resource Constraint situation.
Generally, firms fix up maximum amount that can be invested in capital project, during a given period
of time, say a year.
Return Maximisation:
In case of restricted availability of funds, the objective of the firm is to maximise the wealth of
shareholders with the available funds.
Such investment planning is called Capital Rationing.

Classification of Investment Proposals:

For Capital Rationing purposes, the investment proposals are classified as under.

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PROBLEMS

Problem No. 1
Compute ARR from the following information.
Cost of Asset is Rs.2,00,000;
Useful Life = 5 years;
Cash Flows after Taxes = Rs.86,000 p.a.

Problem No. 2
Project L requires an investment of Rs.10 lakhs and yields Profit After Tax and Depreciation as follows:-
Year 1 2 3 4 5

Profit after Tax and Depreciation (Rs.) 50,000 75,000 1,25,000 1,30,000 80,000
At the end of 5 years, the plant can be sold for Rs. 80,000. You are
required to calculate ARR based on a) Initial Investment
b) Net Investment and
c) Average Investment

Problem No. 3
A project has an initial investment of Rs.1,00,000. It will produce Cash Flow after Tax of Rs.25,000 per annum
for seven years. Compute the payback period for the project.

Problem No. 4
Project X has an initial investment of Rs.10 lakhs. Its Cash Flows for five years are Rs.3,00,000; Rs.3,60,000;
Rs.3,00,000; Rs.2,64,000 and Rs.2,40,000. Calculate the payback period.

Problem No. 5
Payoff Ltd., is producing articles mostly by manual labour and is considering to replace it by a new machine.
There are two alternative models M and N of new machine. Prepare a statement of profitability showing the
pay–back period from the following information.
Particulars Machine M Machine N

Estimated life of machine 4 years 5 years

Cost of machine Rs. 9,000 Rs. 18,000

Estimated saving in RM 500 800

Estimated savings in direct wages 6,000 8,000

Additional cost of maintenance 800 1,000

Additional cost of supervision 1,200 1,800

Ignore taxation

Problem No. 6
An engineering company is considering the purchase of a new machine for its immediate expansion
programme. There are three possible machines suitable for the purpose. Their details are as follows:

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Particulars Machine 1 Machine 2 Machine 3

Capital cost 3,00,000 3,00,000 3,00,000

Sales (at standard prices) 5,00,000 4,00,000 4,50,000

Net Cost of Production:

Direct Material 40,000 50,000 48,000

Direct Labour 50,000 30,000 36,000

Factory Overheads 60,000 50,000 58,000

Administration Costs 20,000 10,000 15,000

Selling and Distribution 10,000 10,000 10,000

Costs
The economic life of machine No.1 is 2 years, while it is 3years for the other two.
The scrap values are Rs.40,000, Rs.25,000 and Rs.30,000 respectively.
Sales are expected to be at the rates shown for each year during the full economic life of the machines. The
costs relate to annual expenditure resulting from each machine.
Tax to be pad is expected at 50% of the net earnings of each year. It may be assumed that all payables and
receivables will be settled promptly, strictly on cash basis with no outstanding from one accounting year to
another. Interest on capital has to be paid at 8% per annum.
You are requested to show which machine would be the most profitable investment on the principle of “Pay-
back method”.

Problem No. 7
Calculate Payback reciprocal from the following information.
Cost of the Asset is Rs. 20,000.
Estimated useful life of the asset is – 7 years.
The asset yields average cash inflow of Rs. 4,000 per annum.

Problem No. 8
Project K has an initial investment of Rs.10 lakhs. Its Cash Flows for five years are Rs.3,00,000; Rs.3,60,000;
Rs.3,00,000; Rs.2,64,000 and Rs.2,40,000. Assuming a discount rate of 10% p.a., calculate
a) Net Present Value
b) Profitability Index
c) Discounted Pay Back Period.

Problem No. 9
A Company has to make a choice between 2 projects namely A and B. The initial capital outlay of two projects
are Rs.1,35,000 and Rs.2,40,000 respectively for A and B. There will be no scrap value at the end of the life of
both the project. The opportunity Cost of Capital of the
Company is 16%. The Annual Incomes are as under: -
Year Project A (Rs.) Project B (Rs.) Discounting
Factor at 16%

1 ---- 60,000 0.862

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2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
84,000 90,000
5 0.476
Calculate the following, for each project (1) Discounted Payback Period (2) Profitability Index
(3) Net Present Value.

Problem No. 10
A Company proposes to install a machine involving a capital cost of Rs.3,60,000. The life of the machine is 5
years and its salvage value at the end of the life is nil. The machine will produce the net operating income after
deprecation of Rs.68,000 per annum. The Company’s tax rate is 45%. Calculate Internal Rate of Return of the
proposal. The Present Value Factors for 5 years is as under –
Discounting Factor 14 15 16 17 18
Cumulative Factor 3.43 3.35 3.27 3.20 3.13

Problem No. 11
Bhilwara co’s cost of capital is 10% and it is subject to 50% tax rate. The Company is considering buying a
new finishing machine. The machine will cost Rs. 2 lakhs and will reduce materials waste by an estimated
amount of Rs. 50,000 a year. The machine will last for 10 years and will have a zero salvage value. Assume
straight-line method of depreciation on asset.
i) Prepare a statement to show the relevant annual cash inflows ii) Compute the
Present Value, Net Present Value, and Profitability Index iii) Should the Company
purchase the new finishing machine?

Problem No. 12
A Company is considering which of two mutually exclusive projects it should undertake. The finance Director
thinks that the project with higher NPV should be chosen whereas the Managing director thinks that the one
with the higher IRR should be undertaken especially as both projects have the same initial outlay and length
of life.
The Company anticipates a cost of capital of 10% and the net after tax cash flows of the projects are as follows:-
Year 0 1 2 3 4 5

Cash flows-figures in Rs.000’s

Project X Project (200) 35 80 90 75 20
Y (200) 218 10 10 4 3
You are required to –
1. Calculate the NPV and IRR of each project
2. State, with reasons which project you would recommend
3. Explain the inconsistency in the ranking of the two projects.
The discount factors are as follows –
Year 0 1 2 3 4 5

Discount factors 10% 1.00 0.91 0.83 0.75 0.68 0.62

20% 1.00 0.83 0.69 0.58 0.48 0.41

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Problem No. 13
The cash flows of two mutually exclusive projects are as under (in Rs.) –
Project T0 T1 T2 T3 T4 T5 T6

Project P (40,000) 13,000 8,000 14,000 12,000 11,000 15,000

Project J (20,000) 7,000 13,000 12,000 ----- ----- -----
Estimate the net present value (NPV) of the projects P and J using 15% as the hurdle rate.
Estimate the internal rate of return (IRR) of the projects P and J.
Why is there a conflict in the project choice by using NPV and IRR criteria?
Which criterion will you use in such a situation? Estimate the value at that criterion. Make a project choice.
The present value interest factor values at different rates of discount are as under: -
Rate of T0 T1 T2 T3 T4 T5 T6
Discount

0.15 1.00 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323

0.18 1.00 0.8475 0.7182 0.6086 0.5158 0.4371 0.3904

0.20 1.00 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349
0.24 1.00 0.8065 0.6504 0.5245 0.4230 0.3411 0.2751
0.26 1.00 0.7937 0.6299 0.4999 0.3968 0.3149 0.2499

Problem No. 14
A company has to choose between two machines A and B. Two machines are designed differently but have
identical capacity and do the same job. Machine A costs Rs. 6,00,000 and will last for 3 years. It costs Rs.
1,20,000 per year to run.
Machine B is an economy model costing Rs. 4,00,000 but will last only for two years and will cost Rs. 1,80,000
per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing power.
Opportunity cost of capital is 10%. Which machine company should buy? Ignore taxation.
PVIF10,1 = 0.9091 PVIF10,2 = 0.8264 PVIF10,3 = 0.7513

Problem No. 15
Company X is forced to choose between two machines A and B. The two machines are designed differently,
but have identical capacity and do exactly the same job. Machine costs Rs. 1,50,000 and will last for 3 years.
It costs Rs. 40,000 per year to run. Machine B is an ‘economy’ model costing only Rs. 1,00,000, but will last
only for 2 years, and costs 60,000 per year to run. These are real cash flows. The costs are forecasted in rupees
of constant purchasing power. Ignore tax. Opportunity cost of capital is 10 per cent. Which machine company
X should buy?

Problem No. 16
A firm has the following investment opportunities.
Proposals Initial outlay Profitability index

1 2,00,000 1.15
2 1,25,000 1.13
3 1,75,000 1.11
4 1,50,000 1.08
The available funds are Rs.3,00,000. Which proposal(s) the firm should accept?

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Problem No. 17
Alpha Ltd., is considering five capital projects for the years 2000, 2001, 2002 and 2003. The company is
financed by equity entirely and its cost of capital is 12%. The expected cash flows of the projects are as follows:
Year and Cash flows (Rs.’000)
Project 2000 2001 2002 2003

A (70) 35 35 20
B (40) (30) 45 55
C (50) (60) 70 80
D ---- (90) 55 65
E (60) 20 40 50
Note: Figures in brackets represent cash outflows.
All projects are divisible i.e., size of investment can be reduced, if necessary in relation to availability of funds.
None of the projects can be delayed or undertaken more than once.
Calculate which project Alpha Ltd., should undertake if the capital available for investment is limited to
Rs.1,10,000 in year 2000 and with no limitation in subsequent years.
For you analysis, use the following present value factors:
Year 2000 2001 2002 2003

Discounting factor 1.00 0.89 0.80 0.71

Problem No. 18
Arun Ltd., an existing profit-making Company, is planning to introduce a new product with a projected life of
8 years. Initial equipment cost will be Rs.120 lakhs and additional equipment costing Rs.10 lakhs will be
required at the beginning of the 3rd year. At the end of the 8th year, the original equipment will have a resale
value equivalent to the cost of removal, but the additional equipment would be sold for Rs.1 lakh. Working
Capital of Rs.15 lakhs will be needed. The full capacity of the plant is 4,00,000 units per annum, but the
production and sales volume expected are as under –
Year 1 2 3-5 6-8

Capacity in % 20% 30% 75% 50%

A Sale Price of Rs.100 per unit, with a PV Ratio of 60% is likely to be obtained. Fixed Operating Cash Costs
are estimated at Rs.16 lakhs per annum. In additional to this, advertisement expenditure would be incurred as
under –
Year 1 2 3-5 6-8

Expenditure per year Rs. 30 lakhs Rs. 15 lakhs Rs. 10 lakhs Rs. 4 lakhs

The Company is in 50% tax bracket and follows SLM Depreciation (permissible for tax purposes also) Taking
12% after tax Cost of Capital, should the project be accepted?
(Note: In case of Loss for any year, tax saving may be Ignored)

Problem No. 19
A company is considering the proposal of taking up a new project which requires an investment of Rs. 400
lakhs on machinery and other assets. The project is expected to yield the following earnings (before
depreciation and taxes) over the next five years:
Year Earnings (Rs. in lakhs)

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1 160
2 160
3 180
4 180
5 150
The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on ‘Written Down
Value’ basis. The scrap value at the end of the five years’ period may be taken as zero. Income-tax applicable
to the company is 50%. You are required to calculate the net present value of the project and advise the
management to take appropriate decision. Also calculate the Internal Rate of Return of the Project.

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

Year 10% 12% 14% 16%
1 0.91 0.89 0.88 0.86
2 0.83 0.80 0.77 0.74
3 0.75 0.71 0.67 0.64
4 0.68 0.64 0.59 0.55
5 0.62 0.57 0.52 0.48
Problem No. 20

A Company is considering a proposal of installing a drying equipment. The equipment would involve a Cash
outlay of Rs. 6,00,000 and net Working Capital of Rs. 80,000. The expected life of the project is 5 years
without any salvage value. Assume that the company is allowed to charge depreciation on straight-line basis
for Income-tax purpose. The estimated before-tax cash inflows are given below:

Before-tax Cash inflows (Rs. ‘000)

Year 1 2 3 4 5
240 275 210 180 160
The applicable Income-tax rate to the Company is 35%. If the Company’s opportunity Cost of Capital is
12%, calculate the equipment’s discounted payback period, payback period, net present value and internal
rate of return.

The PV factors at 12%, 14% and 15% are:

Year 1 2 3 4 5

PV factor at 12% 0.8929 0.7972 0.7118 0.6355 0.5674

PV factor at 14% 0.8772 0.7695 0.6750 0.5921 0.5194

PV factor at 15% 0.8696 0.7561 0.6575 0.5718 0.4972

Problem No. 21

Given below are the data on a capital project ‘M’:

Annual cost saving Rs. 60,000
Useful life 4 years

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PR Engineering Ltd. is considering the purchase of a new machine which will carry out some operations
which are at present performed by manual labour. The following information related to the two alternative
models – ‘MX’ and ‘MY’ are available:

Machine ‘MX’ Machine ‘MY’

Cost of Machine Rs. 8,00,000 Rs. 10,20,000

Expected Life 6 years 6 years

Scrap Value Rs.20,000 Rs. 30,000

Estimated net income before depreciation and tax:
Year Rs. Rs.

1 2,50,000 2,70,000
2 2,30,000 3,60,000

3 1,80,000 3,80,000

4 2,00,000 2,80,000

5 1,80,000 2,60,000

6 1,60,000 1,85,000
Corporate tax rate for this company is 30 percent and company’s required rate of return on investment proposals
is 10 percent. Depreciation will be charged on straight line basis.

You are required to:

1. Calculate the pay-back period of each proposal.

RAHUL KP 52 FINANCIAL MANAGEMENT