Techniques of capital budgeting

Payback period

When cash flow is constant

A project requires initial investment of Rs. 40,000 and it will generate an annual cash inflow of Rs.
10,000 for 6 years. You are required to find out pay-back period. (4)

PBP = 100000/20000 = 5 Years

PBP= 40000/10000 = 4Years remaining 2 years – profit = 20000

If an investment of Rs. 100000 in a machine is expected to generate cash inflow of Rs. 20,000 p.a.
for 10 years. (5)

PBP= 100000/20000 = 5 Years remaining 5 years = profit 100000

A project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years.
The payback period for the project is (4)
50000/ 12500

In the case of Uneven or Unequal Cash Inflows:

A project requires initial investment of Rs.40,000 and generate cash inflows of Rs. 16,000, Rs.
14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth year respectively.
Solution:
Year Annual Cash Inflows Rs. Cumulative Cash Inflows Rs.

1 16,000 16,000
2 14,000 30,000 (16000+140000)
3 8,000 38,000 (30000+8000) 40000
4 6,000 44,000(38000+6000)

Calculation Pay-back Period with the help of "Cumulative Cash Inflows"

The above table shows that at the end of 4th years the cumulative cash inflows exceeds the
investment of Rs.40,000.(3 yr and 4 months)

3years + 2000/6000 x12= 3 years and 4 months

40000 − 38000 2000

3𝑦𝑒𝑎𝑟𝑠 + × 12 = 3𝑦𝑒𝑎𝑟𝑠 + × 12
6000 6000

= 3𝑦𝑒𝑎𝑟𝑠 &4𝑚𝑜𝑛𝑡ℎ𝑠
Suppose that a project requires a cash outlay (Initial Investment) of Rs 20,000, and generates cash
inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the
project’s payback?

No of years Cash Inflow Cumulative cash Inflow

1 8000 8000
2 7000 15000
3 4000 19000
4 3000 21000

20000-19000= 1000

Years + Initial investment – cumulative cash flow / cash inflow of next year’s x 12 months

3 years + 1000/3000 x12 = 3years+.33*12

3yers and 4 months

CCF= 8000,15000,19000,21000

(3 yr and 4 months)
20000 − 19000 1000
3𝑦𝑒𝑎𝑟𝑠 + × 12 = 3𝑦𝑒𝑎𝑟𝑠 + × 12
3000 6000

= 3𝑦𝑒𝑎𝑟𝑠 &4𝑚𝑜𝑛𝑡ℎ𝑠

A firm requires an initial cash outflow of Rs. 20,000 and the annual cash inflows for 5 years are
Rs. 6000, Rs. 8000, Rs. 5000, Rs. 4000 and Rs. 4000 respectively. Calculate PBP.

PBP is 3 years and 3 months

20000 − 19000 1000
3𝑦𝑒𝑎𝑟𝑠 + × 12 = 3𝑦𝑒𝑎𝑟𝑠 + × 12
4000 4000

= 3𝑦𝑒𝑎𝑟𝑠 & 3 𝑚𝑜𝑛𝑡ℎ𝑠

There are two projects (Project A and B) available for a company with life of 6 years each of Rs
10,000, and generates cash inflows of project A Rs 3000, Rs3500, Rs3500 Rs1500, Rs 1500 and
Rs, 3000. = PBP = 3 Years
Generates cash inflows of project B Rs2, 000; Rs2500; Rs 2500; Rs 2500, Rs 2500 and Rs 5500
during the next 6 years. Which of the two projects should be selected? PBP = 4 years
A- 3 Yr remaining 3 years = profit
B- 4 Yr and 2 months = profit – 2 years

CCF=2000, 4500, 7000,9500,15000

10000 − 9500 500

3𝑦𝑒𝑎𝑟𝑠 + × 12 = 3𝑦𝑒𝑎𝑟𝑠 + × 12
2500 2500

= 4𝑦𝑒𝑎𝑟𝑠 & 2𝑚𝑜𝑛𝑡ℎ𝑠

From the following information advice the management as to which project is preferable based on
pay-back period. Two projects X and Y, each project require an investment of Rs. 30,000. The
standard cut off period for the company is 5 years.
(Net profit before depreciation and after tax)
Solution:
Years Project X Project Y
st
I 10,000 8,000
IInd 10,000 8,000
IIIrd 4,000 12,000
IVth 6,000 6,000
Vth 8,000 7000

Discounted Pay Back Period

The company is considering investment of Rs. 1, 00,000 in a project. The following are the income
forecasts, after depreciation and tax, 1st year Rs. 10,000, 2nd year Rs. 40,000, 3rd year Rs. 60,000,
4thyear Rs. 20,000 and 5th year Rs. Nil.
From the above information you are required to calculate: (1) Pay-back Period (2) Discounted Pay-
back Period at 10% interest factor.(Discounting factor)

(2) Calculation of Discounted Pay-back Period 10% Interest Rate:

50000
𝑃𝐵𝑃 = 2𝑦𝑒𝑎𝑟𝑠 + × 12 = 2𝑦𝑒𝑎𝑟𝑠 & 1𝑚𝑜𝑛𝑡ℎ
60000

Discounting Factor (1/1+I) n

Year Cash Inflows Discounting Present Value Cumulative Value of

I234 Rs. Present Value of Cash Inflows Cash Inflows Rs.
Factor at 10%Rs. (2 x3) Rs.
1 10,000 0.9091 9,091 9,091
2 40,000 0.8265 33,060 42,151(9091+33060)
3 60,000 0.7513 45,078 87,229(42151+45078)
4 20,000 0.6830 13,660 1,00,889
5 - 0.6209 - 1,00,889

12771
DPBP = 3𝑦𝑒𝑎𝑟𝑠 + 13660 × 12 = 3𝑦𝑒𝑎𝑟𝑠 & 11𝑚𝑜𝑛𝑡ℎ𝑠 100000-87229 = 12771

PBP – 2 years and 10 months

One project requires investment of Rs. 80,000 and it generates cash flow for 5 years as follows.
1st year Rs. 22000, 2nd year Rs. 30000, 3rd year Rs. 40000, 4thyear Rs. 32000and 5th year Rs.
16000 Discount interest rate @ 20%
Find out PBP and Discounted PBP
CCF=22000, 52000, 92000,124000,140000
80000−52000 28000
𝑃𝐵𝑃 = 2𝑦𝑒𝑎𝑟𝑠 + × 12 = 2𝑦𝑒𝑎𝑟𝑠 + × 12
40000 40000
= 2𝑦𝑒𝑎𝑟𝑠 & 8𝑚𝑜𝑛𝑡ℎ𝑠

Year Cash Inflows Discounting Present Value of Cumulative Value

I234 Rs. Present Value Cash Inflows (2 of
Factor at 10%Rs. x3) Rs. Cash Inflows Rs.
1 22,000 0.8333 18332 18332
2 30,000 0.6944 20832 39164
3 40,000 0.5787 23148 62312
4 32,000 0.4822 15430 77742
5 16000

80000−52000 28000
𝐷𝑃𝐵𝑃 = 2𝑦𝑒𝑎𝑟𝑠 + × 12 = 2𝑦𝑒𝑎𝑟𝑠 + 40000 × 12
40000
= 2𝑦𝑒𝑎𝑟𝑠 & 8𝑚𝑜𝑛𝑡ℎ𝑠

Year Cash Discounting Present Value of Cumulative Value

Inflows Present Value Cash Inflows (2 x3) of
Rs. Factor at 10% Rs. Cash Inflows
Rs. Rs.
1 (20000) 0.909 -18,180 -18,180
2 30000 0.826 24,780 6,600
3 35000 0.751 26,285 32,885
4 40000 0.683 27,320 60,205
5 150000 0.621 93,150 1,53,365
An
investment with expenditure of Rs.80, 000 is expected to produce the following profits (after
deducting depreciation)
1st Year Rs. (20000)
2nd Year Rs. 30,000
3rd Year Rs. 35,000
4th Year Rs. 40,000
5th Year Rs.1, 50,000
With 10% interest rate
AVERAGE RATE OF RETURN

A project requires an investment of Rs. 10, 00,000. The plant & machinery required under the
project will have a scrap value of Rs. 80,000 at the end of its useful life of 5 years.

Year 1 2 3 4 5

PAT (Rs) 50,000 75,000 1,25,000 1,30,000 80,000

𝐴𝑣𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 92000

𝐴𝑅𝑅 = = × 100 = 17.04%
𝐴𝑣𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 540000

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑡𝑚𝑠𝑛𝑡 + 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒 10,00,000 + 80000

𝐴𝑣𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = = 5,40,000
2 2
𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 50,000 + 75000 + 1,25,000 + 1,30,000 + 80,000
𝐴𝑣𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 = =
𝑁𝑜 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 5
460000
= = 92000
5
The initial capital expenditure requirements are Rs.10,00,000 for a machine that will have a five
years useful life. Depreciation is calculated on a straight line basis. The scrap value of the machine
is Rs.10,000. The project is expected to have Rs.30,000 average profit.

𝐴𝑣𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 12000

𝐴𝑅𝑅 = = × 100 = 21.81%
𝐴𝑣𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 55000

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑡𝑚𝑠𝑛𝑡 + 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒 10,00,000 + 10000

𝐴𝑣𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = = 55,000
2 2
𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥
𝐴𝑣𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 = = 30000 − 18000 = 12000
𝑁𝑜 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

An investment with expenditure of Rs.30000 is expected to produce the following profits (after
deducting depreciation)

1st Year Rs. 80,000

2nd Year Rs. 1,60,000
3rd Year Rs. 1,80,000
4th Year Rs. 60,000
4)

A project costs Rs. 5,00,000 and has a scrap value of 1,00.000 after 5 years. The (Cash Flow or
Revenue ) net profit before depreciation and taxes for the five years period are expected to be Rs.
1,00.000. Rs. 1,20,000. Rs. 1.40,000, Rs. 1,60.000 and Rs. 2.00,000. You are required to calculate
the Accounting Rate of Return, assuming 40% rate of tax and depreciation on straight-line method.
Assume a company invests 400,000 in Machinery depreciated using straight-line method over 4
years with zero salvage value

Net Profit (Incremental cash flow)

Step -1 – Cash flow (Revenue)

Step -2 deducting Expenses

Step-3 Deducting Depreciation = Profit before tax

Step -4 Deducting Tax Rate = Profit after Tax = Net profit

ARR= Avg. Net Profit / Avg. Investment x 100

Avg. Net Profit = Net profit (profit after tax ) / no of years

Particulars Year -1 Year-2 Year-3 Year-4 Year-5

Revenue 100,000 120,000 140,000 160,000 200,000

Operating Exp - - - - -

- Dep 100,000 100,000 100,000 100,000 100,000

PBT 0 20000 40000 60000 100000

- Tax @40% 0 8000 16000 24000 40000

PAT 0 12000 24000 36000 60000

Dep = 400000/4 years = 100,000

Avg. Profit = PAT / No of years

Avg. Profit = 132000/5

Avg. Profit = 26400

Avg. Investment = Original Investment + Scrape value /2

Avg. Investment = 500000+100000/2

Avg. Invest = 300000

ARR = Avg. Profit/Avg. Investment X 100

ARR= 26400/300000 X 100 = 8.8%

Example: Assume a company invests 400,000 in project depreciated using straight-line method

over 4 years with zero salvage value. The following table shows the revenues and operating

expenses. Calculate ARR using 50% tax rate:

Year 1 2 3 4

Revenue (Cash Flow) 200,000 250,000 300,000 320,000

Operating Expenses 90,000 100,000 120,000 90,000

Particulars Year -1 Year -2 3 4

Revenue 200000 250000 300000 320000

-Operating Exp 90000 100000 120000 90000

Operating Profit 110000 150000 180000 230000

- Dep 100000 100000 100000 100000

400000/4

PBT 10000 50000 80000 130000

- Tax Rate 5000 25000 40000 65000

@50%

PAT 5000 25000 40000 65000

Avg Investment = Original Investment + Scrape Value /2

Avg. Annual Profit = PAT /Years

AVg. Annual Profit = 5000+25000+40000+65000= 135000 /4 =33750

Avg Investment = Original Investment /2 = 400000/2= 200000

ARR= Avg. Annual Profit / Avg. Investment *100

ARR= 33750/200000*100

ARR= 0.16875*100

ARR= 16.875%
Total NET profit = 5000+25000+40000+65000= 135000

Year 1 2 3 4

Revenue 200,000 250,000 300,000 320,000

(-) Operating Expenses 90,000 100,000 120,000 90,000

(-)Depreciation 100,000 100,000 100,000 100,000

(-)Taxes = 0.4 (R-OE-D) 4,000 20,000 32,000 52,000

Net Income 6,000 30,000 48,000 78,000

First, we find the net income where depreciation = (book value – salvage value)/ useful life.

Deprecation is 400,000/4 = 100,000

Average net income = (6,000 + 30,000 + 48,000 + 78,000)/4= 40,500

Average book value = (400,000-0)/2= 200,000

Sum-1

An Investment in project of 200000

The following table shows profit after depreciation and taxes.

Year 1 2 3 4 Total

PAT (Rs) 20,000 28000 30000 18000 96000

Calculate average rate of return

Sum -2

An investment of 600,000 is expected to give returns as follows: Year 1 (50,000), Year 2

(150,000), Year 3 (80,000), Year 4 (20,000).Calculate the average rate of return.

Sum-3

Western Ltd has an option of two projects: C and D, with the same initial capital investment of

1, 00,000. The profits for both projects are as follows:

Project C: Year 1 (10,000), Year 2 (5,000), Year 3 (15,000)

Project D: Year 1 (12,000), Year 2 (11,000), Year 3 (4,000)

The estimated resale value of both projects at the end of year 3 is 22,000.Calculate the ARR for

each project and advise the firm.

Sum-4
Calculate the Average Rate of Return for project' A' and 'B' from the following information:
Project A Project B
Investments (Rs.) 25,000 37000
Expected Life (in years) 4 5
Net earnings
(After Depreciation &Taxes)
Years Project A Project B
1st Year Rs. Rs.
2,500 3,750
2nd Year 1,875 3,750
3rd Year 1,875 2,500
4th Year 1,250 1,250
5th Year - 1,250
Total 7,500 12,500

If the desired rate of return is 12%, which project should be selected?

NPV
1)
Calculate the Net Present Value of the following project requiring initial cash outlays of Rs.
20,000 and has a no scrap value after 6 years. The net profits after depreciation and taxes for each
year of Rs. 6,000 for six years. Assume the present value of an annuity of Re.1 for 6 years at 8%
p.a. interest is Rs.4.623.

P.V of Cash flow = Cash flow X annuity Interest Factor

P.V of cash Flow = 6000 x 4.623 = 27738

𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤

NPV = 27738- 20000= 7738 Accepted

2)
A project cost Rs. 25,000 and it generates cash inflows through a period of five years Rs. 9,000,
Rs. 8,000, Rs. 7,000, Rs. 6,000 and Rs. 5,000. The required rate of return is assumed 10%. Find
out the Net Present Value of the project.

𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤

Present Value cash flow
1. Cash flow
2. Find out Discounting factor
3. Multiply Cash flow with discounting factor

Year (1) Cash Flow(2) Discounting Discounting Factor P.V. of cash Flow
Factor @ Rs. 1 @ Rs. 1 ( 1/1+r)n (2 ) X (3)
( 1/1+r)n @ @ 10%
20% (3)
1 9000 0.8333 0.9091 8181
2 8000 0.6944 0.8264 6611
3 7000 0.5787 0.751 5257
4 6000 0.4823 0.684 4104
5 5000 0.4019 0.621 3105
Total P.V. of Cash 27258
flow

NPV= 27258- 25000= 2258 Accepted

Value of Rs. 1 @ the end of n years

1st Year = (1/1+0.10)1 = 0.9091
1st Year = (1/1+0.20)1 = 0.8333
2nd Year = (1/1+0.10)2 = 0.8264
2nd year = (1/1.20)2 = .6944
3rd Year = (1/1.10)3 = 0.751
4th year = (1/1.10)4 =0.684
5th Year = (1/1.10)5 = 0.621
Years Cash Inflow Interest C.F @ P.V
factor
1st Year 9000 0.9091 8181
2nd Year 8000 0 .8264 6608
3rd Year 7000 0.7513 5257
4th Year 6000 0.6830 4098
5th Year 5000 0.6209 3100
Present value cash Inflow 27244

𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 = 27244 − 25000 =
𝑅𝑠. 2244/-

3)
Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs
900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital
may be assumed to be 10 per cent.

Profitability Index
1)
A project is in the consideration of a firm. The initial outlay of the project is Rs. 10,000 and it is
expected to generate cash inflows of Rs. 4,000, Rs. 3,000, Rs. 5,000 and Rs. 2,000 in four years to
follow. Assuming 10% rate of discount, calculate the Net Present Value and Benefit Cost Ratio of
the project.

Years Cash Inflow Interest C.F @ P.V

factor @
10%
1st Year 4000 0.9091 3636
2nd Year 3000 0 .8264 2478
3rd Year 5000 0.7513 3755
4th Year 2000 0.6830 1366
Present value cash Inflow 11235

𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 = 11235 − 10000 =
𝑅𝑠. 1235/-
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 11235
𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝑰𝒏𝒅𝒆𝒙 = = = 1.1235
𝑖𝑛𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑜𝑤 10000

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑒𝑡𝑖𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 − 1 = 1.1235 − 𝟏 = 𝟎. 𝟏𝟐𝟑𝟓

Profitability Index indicates less than one, so the project should not be accepted.
IRR
1)
A project costs Rs. 32,000 and is expected to generate cash inflows of Rs. 16,000, Rs.14,000 and
Rs. 12,000 at the end of each year for next 3 years. Calculate IRR.

𝑁𝑃𝑉 𝑜𝑓 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒

𝐼𝑅𝑅 = 𝐿𝑜𝑤𝑒𝑟 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + × (𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒
𝑁𝑃𝑉 𝑜𝑓 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 − 𝑁𝑃𝑉 𝐻𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒
− 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒)
Year Value of Cash Inflow Discounted Rate @ CI X DR
20% P.V. of Cash Inflow
1 16000 0.833 13328
2 14000 0.694 9716
3 12000 0.579 6948
29992

𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤

NPV= 29992 - 32000 = (-) 2008

Year Value of Discounted CI X DR Discounted CI X DR Discounted CI X DR

Cash inflow rate @ rate @ rate @
14% 15% 16%
1 16000 0.877 14032 0.869 13904 0.862 13792
2 14000 0.769 10766 0.756 10584 0.743 10402
3 12000 0.675 8100 0.656 7872 0.641 7692
32898 32360 31886
-32000 -32000 -32000
+898 +360 -114

𝑁𝑃𝑉 𝑜𝑓 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒

𝐼𝑅𝑅 = 𝐿𝑜𝑤𝑒𝑟 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + × (𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒
𝑁𝑃𝑉 𝑜𝑓 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 − 𝑁𝑃𝑉 𝐻𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒
− 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒)
IRR= 15+ 360/ 360- (-114) X (16-15)
IRR = 15+ 360/474 X 1
IRR= 15.759
IRR= 15.76
At which NPV = 0

Let Us begin with the 20% for the NPV

Years Cash Inflow Interest factor C.F @ P.V
@20%
1st Year 16000 0.833 13328
2nd Year 14000 0.694 9716
3rd Year 12000 0.597 6948
Present value cash Inflow 29992
𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 = 29992 − 32000 =
𝑅𝑠. −2408/-
So here 20% interest factor shows the negative NPV so now lower rate should be tried for getting
NPV equal to zero

For example if we are taking 16% and 15 % for the calculation of NPV

Years Cash Interest C.F @ Interest C.F @ Interest C.F @

Inflow factor P.V factor @ P.V factor P.V
@ 14% 15% @ 16%
1st Year 16000 0.877 14032 0.870 13920 0.862 13792
2nd Year 14000 0.769 10766 0.756 10584 0.743 10402
3rd Year 12000 0.675 8100 0.658 7896 0.641 7692
Present value cash Inflow 32898 32400 31886
Cash Outflow 32400 32400 32400
NPV 498 0 -514

𝑁𝑃𝑉 𝑜𝑓 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒

𝐼𝑅𝑅 = 𝐿𝑜𝑤𝑒𝑟 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + × (𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒
𝑁𝑃𝑉 𝑜𝑓 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 − 𝑁𝑃𝑉 𝐻𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒
− 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒)
498 498
𝐼𝑅𝑅 = 14 + × (16 − 14) = 14 + × 2 = 14 + 0.4921 × 2 = 14.98% = 15%
498 − 514 1012

An investment requires an initial investment of Rs. 6,000. The annual cash flow is estimated at Rs.
2000 for 5 years. Calculate the IRR.

2)
There are two mutually exclusive projects under active consideration of a company. Both the
projects have a life of 5 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:

Years X y
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

FIND OUT PAY BACK PERIOD, NPV, ARR, PI, IRR

PBP =
Years Project X CCF Project Y CCF
1 40.000 40000 60,000 60000
2 40,000 80000 30,000 90000
3 40,000 120000 20,000 110000
4 40,000 160000 50,000 160000
5 40,000 200000 50,000 210000

PBP = Years + Initial investment – cumulative cash flow / cash inflow of next year’s x 12 months

Year Cash Depreciation PBT Tax Net Income Net Cash CCF
Inflows @50% PAT Flow
X C.F – Net
Income
1 40000 20000 20000 10000 10000 30000
2 40000 20000 20000 10000 10000 30000
3 40000 20000 20000 10000 10000 30000
4 40000 20000 20000 10000 10000 30000
5 40000 20000 20000 10000 10000 30000

1 60000 20000 40000 20000 20000 40000 40000

2 30000 20000 10000 5000 5000 25000 65000
3 20000 20000 0 0 0 20000 85000
4 50000 20000 30000 15000 15000 35000 120000
5 50000 20000 30000 15000 15000 35000 155000

𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑙𝑎𝑦 100000

𝑃𝐵𝑃 = = = 3 𝑦𝑒𝑟𝑎𝑠 𝑎𝑛𝑑 33 𝑚𝑜𝑛𝑡ℎ𝑠
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 40000

85000 − 100000 15000

3𝑦𝑒𝑎𝑟𝑠 + × 12 = 3𝑦𝑒𝑎𝑟𝑠 + × 12 = 3 𝑦𝑒𝑎𝑟𝑠 𝑎𝑛𝑑 5 𝑚𝑜𝑛𝑡ℎ𝑠
35000 35000

𝐴𝑣𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 10000

𝐴𝑅𝑅 = = × 100 = 20%
𝐴𝑣𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 50000

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑡𝑚𝑠𝑛𝑡 + 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒 100000 + 0

𝐴𝑣𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = = 50,000
2 2
𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 50000
𝐴𝑣𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 = = = 10000
𝑁𝑜 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 5

𝐴𝑣𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 11000

𝐴𝑅𝑅 = = × 100 = 22%
𝐴𝑣𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 50000

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑡𝑚𝑠𝑛𝑡 + 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒 100000 + 0

𝐴𝑣𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = = 50,000
2 2
 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 55000
𝐴𝑣𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 = = = 11000
𝑁𝑜 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 5
For the company X the present value of rupee one for an annuity for 5 years @10%rate of
interest is 3.791 = 30000× 3.971 = 113730

𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 = 113730 − 100000 =
𝑅𝑠. 13730/-

Years Cash Inflow Interest C.F @ P.V

factor
1st Year 40000 0.9091 36630
2nd Year 25000 0 .8264 20650
3rd Year 20000 0.7513 15020
4th Year 35000 0.6830 23905
5 35000 0.621 21735
Present value cash Inflow 117940

𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 = 117940 − 100000 =
𝑅𝑠. 17940/-

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 113730

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = = = 1.137
𝑖𝑛𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑜𝑤 100000
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 117940
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = = = 1.179
𝑖𝑛𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑜𝑤 100000