Chapter Capital Budgeting I: Principles and Techniques Learning Objectives . Understand the basic nature of capital budgeting, the importance of, and the difficulties associated with, capital budgeting decisions and the various types of such decisions . Discuss the major components of relevant cash flows, effect of taxes, depreciation, working capital on cash flow patterns/estimates . Calculate the relevant cash flows in single proposals, replacement situa- tions and mutually exclusive projects | Compute, interpret and evaluate the accounting rate of return (ARR) and the widely-used traditional capital budgeting technique—the pay back period . Apply the sophisticated capital budgeting techniques—net present value (NPV) and internal rate of return (IRR)—to relevant cash flows to choose acceptable as well as preferred capital projects ‘Compute and illustrate terminal value (TV) method and profitability index (Pl) as capital budgeting evaluation techniques Summarise capital budget practices by corporates in India INTRODUCTION This Chapter is devoted to a discussion of the principles and techniques of capital budgeting. Sec- tion 1 discusses the nature of capital budgeting in terms of meaning, importance, difficulties, ratio- tale and types. The identification of relevant data for capital budgeting decisions is “plained in Section 2. Section 3 of the chapter examines the evaluation techniques. {aso outlines the capital budgeting practices in India last Section summarises Main points. SE “STON [T |NATURE OF CAPITAL BUDGETING Meaning Capital Teer te budgeting decisions pertain to fixed/long-term assets which by definition assets which are in operation, and yield a return, over @ period of time, a Capital budgeting is the process of evaluating and selecting long- term investments that are consistent with the goal of shareholders (owners) wealth ‘maximisation> 9.4 Financial Management usually, exceeding one year. They, therefore, involve a current outlay gp Capital | onrlays of cash resources in return for an anticipated flow of future heneyt aoemainlgy [other words, the system of capital budgeting is employed 10 evaluate expen chinndetha | decisions which involve current outlays but are likely 10 produce benefie ie Over jonger than one year. These benefits may be either in the fom duced costs. Capital expenditure management cement of fixed is expected tof period of time k produce benefits] increased revenues oF te hen over a period of | includes addition, disposition, modification and repk assets Fe preceding discu y be deduced the following basi features of capil fn" one year. The! (i) potentially large anticipated benefits; (i) a relatively high degree yy tnd (ii) 2 relatively Jong time period between the inital outlay and the amu’ returns. The term capital budgeting is used interchangeably with capital expenditure decision cig Expenditure management, long-term investment decision, management of fixed assets and so > time exceeding, Importance Capital budgeting decisions are of paramount importance in financial decision making. In the fr place, such decisions affect the profitability of a firm. They also have a bearing on the compe tive position of the enterprise mainly because of the fact that they relate to fixed assets. The fixed assets represent, in a sense, the (rue earning assets of the firm, They enable the firm to generate {can ultimately be sold for profit. The current assets are not generally eaming finished goods th assets. Rather, they provide a buffer that allows the firms to make sales and extend credit, Tre, current assets are important to operations, but without fixed assets to generate finished produc, that can be converted into current assets, the firm would not be able to operate, Further, they are ‘strategic’ investment decisions as against ‘tactical —which involve relatively small amount of funds. Therefore, such capi company has been doing in the past. Acceptance of «t strategic investment will involve a sigailicant change in the company’s expected profits and in the risks to which these profits will be subject These changes are likely to lead stockholders and creditors to revise their evaluation of the com pany. Thus, capital budgeting decisions determine the future destiny of the company. An oppomune investment decision can yield spectacular returns. On the other hand, an ill-advised and incorrect decision can endanger the very survival even of the large firms. A few wrong decisions and the firm may be forced into bankruptcy. Secondly, a capital expenditure decision has its effect over a long time span and inevitably fects the company’s future cost structure. To illustrate, if a particular plant has been purchased PY a company to start a new product, the company commits itself to a sizable amount of fixed com in terms of labour, supervisors’ salary, insurance, rent of building, and so on. If the invest tums out to be unsuccessful in future or yields less profit than anticipated, the firm will have bear the burden of fixed costs unless it writes off the investment completely. In shor, future break-even point, sales and profits will all be determined by the selection of assets ‘Thirdly, capital investment decisions, once made, are not easily reversible without mu loss to the firm because there may be no market for second-hand plant and equipment conversion to other uses may not be financially viable. Finally, capital investment involves costs and the majority of the firms have scarce capital This underlines the need for thoughtful, wise and correct investment decisions, # #” decision would not only result in losses but also prevent the firm from earning prolits investments which could not be undertaken for want of funds Al investment decisions may result in a major departure from what theoo Capital Budgeting I: Principles and Techniques piffculties capital expenditure decisions are of considerat the firm depends heavily on then rirtly, the benefits from investi ale significance as the futur ess and eas the future success and growth of But. they are beset with a number of difficulties ts are received in son ne future period. The future is uncertain. ment of tisk is involved. For instance Therefore. an el to last for 15 years requires a 15-year forecast. A failure to forecast correctly will lead to serious emors which can be corrected only ata considerable expense 4 decision to acquire an asset that is going Future revenue involves estimating he size of the market for a product and the expected share of the firm in that. These estimates depend on a variety of factors, including price, advertising and promotion, and sales on Adding to the uncertainties are the possibilities of shifts in consumer preferences, the 56 competitors, technological developments and changes in the economic or political environment Secondly, costs incurred and benefits received from the capital budgeting decisions occur in nt time periods. They are not logically comparable because of the time value of money Thirdly, it is not often possible to calculate in strict quantitative terms all the benefits or the cost relating to a particular investment decision Rationale The rationale underlying the capital budgeting decision is efficiency. Thus, a firm must replace wom and obsolete plants and machinery, acquire fixed assets for current and new products and make strategic investment decisions. This will enable the firm to achieve its objective of maximis ing profits either by way of increased revenues or cost reductions, The quality of these decision: 's improved by capital budgeting. Capital budgeting decision can be of two types: (i) those whict expand revenues, and (ii) those which reduce costs, Investment Decisions Affecting Revenues Such investment decisions are expected to bring in additional revenue, thereby raising the size of the firm's total revenue. They can be the result of either expansion of present operations or the development of new product lines. Both types of ‘investment decisions involve acquisition of new fixed assets and are income-expansionary in nature in the case of manufacturing firms. Investment Decisions Reducing Costs Such decisions, by reducing costs, add to the total earnings of the firm. A classic example of such investment decisions are the replacement proposals when an 4Sset wears out or becomes outdated. The firm must decide whether to continue with the existing “sets or replace them. The firm evaluates the benefits from the new machine in terms of lower Perating cost and the outlay that would be needed to replace the machine. An expenditure on a New machine may be quite justifiable in the light of the total cost savings that result A fundamental difference between the above two categories of investment decision lies in the act that cost-reduction investment decisions are subject to less uncertainty in comparison to the evenue-affecting investment decisions. This is so because the firm has a better ‘feel’ for potential “St savings as it can examine past production and cost data. However, it is difficult to precisely “stimate the revenues and costs resulting from a new product line, particularly when the firm knows ‘elatively litle about the same9.6 Financial Management Capital budgeting process, includes four distinet but interrelated steps used to evaluate and select long- term proposals: proposal generation, evaluation, selection and follow up. Accept reject decision is the evaluation| of capital expenditure: proposal to| determine| whether they] meet the minimum] acceptance| criterion, Mutually exclusive Projects (decisions) are projects that ‘compete with fone another; the acceptance of one eliminates the others from further consideration, Capital rationing is the financial situation in which a firm has only fixed amount to allocate among competing capital expenditures Kinds Capital budgeting process refers to the total process of generatin, i selecting and following up on capital expenditure alternatives The f° ny or budgets financial resources to new investment proposals. Basialy,ipe gl be confronted with three types of capital budgeting decisions: (i) the ys decision; (ii) the mutually exclusive choice decision; and (iii) th : 8 he capital rage decision. ing Accept-reject Decision This is a fundamental decision in capital | !dependegy budgeting. If the project is accepted, the firm would invest in it. if | Projects ate projects the proposal is rejected, the firm does not invest in it. In general aie ph all those proposals which sh fos eld a rate of return greater than a are une certain required rate of return or cost of capital are accepted and | mart, the rest are rejected. By applying this criterion, all independent | one another, Projects are accepted. Independent projects are projects that do. | the acoreee Rot compete with one another in such a way that the acceptance | of one deer of one precludes the possibility of acceptance of another. Under | no! eliminae the accept-reject decision, all independent projects that satisfy the — | the others minimum investment criterion should be implemented. from further consideration Mutually Exclusive Project Decisions Mutually exclusive projects are those which compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The only one may be chosen. Suppose, a company is intending to buy a new folding machine. There are three competing brands, each with a different initial investment and operating costs. The three machines repre: only one of these can be selected. It may be atives are mutu ally exclusive and sent mutually exclusive altematives, 3 noted here that the mutually exclusive Project decisions are not independent of the accept-reject decisions. The project’) should also be acceptable under the latter decision, In brief, in our € cample, if ll the machines are rejected under the a new machine. Mutually more than one pro ept-reject decision, the firm should not buy exclusive investment decisions acquire significance vies posal is acceptable under the accept-reject decision. Then, = technique has to be used to determine the alternative automatically eliminates the othe: Capital Rationing Decision unlimited funds, all inde ing return greater than best’ one. The acceptance of this r alternatives, i sited funds In situation where the firm has _y Unlimited Pendent investment proposals yield- | isthe fem some predetermined level are accepted. | situation which a fim 5 does not prevail in most of the business cio all independ! funds. The firm must, therefore, funds to projects in a'mai Thus, capital rationing projects that ration them. The firm allocates | Pr vide an acceptable Proposals out of many investment propossls reject decision. Capital rationing employs ranking of the under the acceptCapital Budgeting I: Principles and Techniques 9.7 at projects. The projects can be ranked on the basis of a predetermined criterion such as f return. The projects are ranked in the descending order of the rate of return. This aspect developed further in Chapter 10. svestmet ihe rate 0 jus beet IN. "2. | DATA REQUIREMENT: IDENTIFYING RELEVANT cTIO! . CASH FLOWS Cash Flows Vs Accounting Profit capital budgeting is concerned with investment decisions which yield return over a period of time Stpture. The foremost requirement for evaluation of any capital investment proposal is to estimate whe future benefits accruing from the investment proposal. Theoretically, two alternative chteria are tpaiable to quantify the benefits: (2) accounting profit, and (fi) cash flows. The basic. difference eeveen them is primarily due to the inclusion of certain non-cash expenses in the profit and loss unt for instance, depreciation. Therefore, the accounting profit is to be adjusted for non-cash txpenditures to determine the actual cash inflow. The cash flow approach of measuring future henefts of a project is superior to the accounting approach as cash flows are theoretically better measures of the net economic benefits of costs associated with a proposed project Th the fist place, while considering an investment proposal, a firm is interested in estimating its economic value. This economic value is determined by the economic outflows (costs) and inflows ibenefits) related with the investment project. Only cash flows represent the cash transactions, The fim must pay for the purchase of an asset with cash. This cash outlay represents a foregone op- porunity to use cash in some other productive alternatives. Consequently, the firm should measure the furure net benefits in cash terms. On the other hand, under the accounting practices, the cost of the investment is allocated over its economic useful life in the nature of depreciation rather than at the time when costs are actually incurred. The accounting treatment clearly does not reflect the original need for cash at the time of inflows and outflows in later years. Only cash flows reflect the actual cash transactions associated with the project. Since investment analysis is concerned with finding out whether future economic inflows are sufficiently large to warrant the it ial investment, only the cash flow method is appropriate for investment decision analysis.” Secondly, the use of cash flows avoids accounting ambiguities. There are various ways to value inventory, allocate costs, calculate depreciation and amortise various other expenses. Obviously, different net incomes will be arrived at under different accounting procedures. But there is only one set of cash flows associated with the project. Clearly, the cash flow approach to project evaluation is beter than the net income flow approach (accounting approach), Thirdly, the cash flow approach takes cognisance of the time value of money whereas the {ccounting approach ignores it. Under the usual accounting practice, revenue is recognised as me generated when the product is sold, not when. the cash is collected from the sale; revenue ay remain a paper figure for months or years before payment of the invoice is received, Ex: Faralture, too, is recognised as being made when incurred and not when the actual payment is Suc, DePteciation is deducted from the gross revenues to determine the before-tax earnings. von Procedure ignores the increased flow of funds potentially available for other uses. In other ‘sion gpenting profits which are quite useful as performance measures often are less useful as copy ttetia. Therefore, from the viewpoint of capital expenditure management, the cash flow de reg Be meld to be the basis of estimating future benefits from investment proposals. The the cated for the purpose would be cash revenues and cash expenses. The difference between approach and the accounting profit approach is depicted in Table 9.1 acct9.8 Financial Management TABLE 9.1 A Comparison of Cash Flow and Accounting Profit Approaches Gash Flow Approach Toman >—~ wars Baran Accounting Approach Towards Benefits Re 71,000 Tim jevenues ; Less Expenses . Cash expenses %500 00 Depreciation 300 = Eamings betore tax a Taxes (0 35) Net earnings atter taxes/Cash flow 130 Table 91 shows that the accounting profits amounting to 130 are less than the cash 3450) This difference can be attributed to the depreciation charge of %300. The cash m is & h available >», 430. This can be utilised for further investment. The accounting approack only %120 is available and hence gives only a partial picture of the tangible benefits a Clearly, such an approach does not bring out the total benefits of the project €. Therefore. in place of earnings, the cash flow expenditure altematives he indicat available for reinves. information is employed in evaluating capx, Relevant cash] Incremental Cash Flow flow \steincremental] The second aspect of the data required for capital budgeting relates to the be after-tax Sis on which the relevant cash outflows and inflows associated with propos: cash outflow capital expenditure are to be estimated. The widely prevalent practice is to adopt tnd reaulung] incremental analysis, According to incremental analysis, only differences due to the subsequent] decision need be considered, Other factors may be important but not to the dec Jeans ion at hand.® For purposes of estimating cash flows in the analysis of invesmmers ‘roped cptai i8CFemental cash flows, that is, those cash flows Cant only those cash flows) which sr investment project are taken into account. It is fo Incrementay US £02800 that fixed overhead Costs, which remain the same whether the props! cath Bear] is accepted or rejected, are not consi, idered. However, if there is an increase in the ate the additional] Ue 0 the new proposal, they must be considered cahflows] Project may be referred to as a kind of “mini firm” with its own future revent (outflows asf and costs, its own assets, it own earnings and its own cash flows’. well as inflows) expected to Effect of Taxes result from a Proposed capital ally, the incremental cash Hows are Adjusted for tax liability, In other words: &* expenditure. paid ure deducted fiom the , cash flows to estimate of the the benefits arising out ‘nvestment decision, To conclude the the expenses/costs bove discussion relating to the © be considered ecision data required for the capital budgeting © \d irrelevant information i jes the ‘al after-tax cash flows’. Table 9.2 summutt on to asset selection decisions. are ‘increment n rela<< Capital Budgeting 1 Principles and Techniques 9.9 abut 9.2, Relevant and lrrelevant Outlows Sunk costs ABLE = are cash outflow Geevant cash Outflows Irrelevant Cash Outflows that have already © qnable labour expenses 1. Fixed overhead expense (existing) aa 1 Vnable matenal expenses 2. Sunk cost therefore hav 2 bation fixed overhead expenses eee § Goat of the investment Haaherlacd & marginal taxes toa curren gg Mangrng WMS decision cash Flow Pattern ow pattem associated with capital investment projects can be classified as conventional jonvonventional Conventional Cash Flows They consist of an initial cash outlay followed by a se- Conventional soy cash inflows. Most of the capital expenditure decisions display this pattern] 288 flow «cash flow. To illustrate, the firm may spend 1,500 in time period zero and as a an vesul may expect to receive a %300 cash inflow at the end of each year for the next outflow followed s year. The conventional cash flow pattem is diagrammed in Fig. 9.1 by only 2 eres of inflows Non-Conventional Cash Flows They refer to the cash flow pattern in which an) nitia! cash outlay is not followed by a series of inflows. Alternating inflows and | conventional ouflows and an inflow followed by outflows are examples of non-conventional cash J cash flow Jow pattems. A classic example of such cash flow pattems is that of the purchase of J Pattern an asset that generates cash inflows for a period of years, is overhauled, and again a eee generates a stream of cash inflows for a number of years. To illustrate, a machine J outflow is not purchased for 1,000 generates cash inflows of %250 each for five years. In the sixth J followed by car, an outlay of %400 is required to overhaul the machine, after which it generates be of lows of 2250 for four years. Such a non-conventional pattern of cash flows s shown in Fig. 9.2. Cash inflows 0 Cash outtiows 21,500 Years FIGURE 9.1 Conventional Cash Flow Pattern Cath Flow Estimates ty ra cting «to be estimated Se 2PAal budgeting cash flows ave to be ein There are certain ingredients of cash Now9.10. Financial Management Cash inflows 0 Cash outfiows 0 1,000 Years FIGURE 9.2 Non-conventional Cash Flow Pattern Tax Effect It has been already observed that cash flows to be consid bpodgeting are net of taxes. Special consideration needs to be given to tax elleec n cash flong if the firm is incurting losses and, therefore, paying no taxes, The tax lawe Permit carying lose forward to be set off against future income. In such cases, therefore. the Denefits of tax saving would accrue in future years. lered for purposes of cap Effect on Other Projects Cash flow effect nomically independent, on of For instance, if a company is considering the existing products in the product line, flows related to the old product will be the production of a new product which competes sth itis likely that as a result of the new proposal, the cash affected. Assume that there is a decline of &5,000 in the new product conformity with the general rule of the incremental cash in cash flows as a result of undertaking the project being evaluated. Clearly, the cash flow effects of the Project should not be evaluated in isolation, if it affects other project(s) in any way. use. THe x is whether there is any alternative sh flow rule® and if any cash flow is generated, it relevant to the calculations, Thus, the deciding factorCapital Budgeting t: Principles and Techniques 9.11 of Depreciation Depreciation, stthough a non cash item of cost, 1s de. Depreciation penditure in determining taxable income ts non-cash ahuctible eNE Depreci on pr prescribed by the Companies Act for accounting purposes and by the Income Tax plate fe Pe for LANALION. PURPOSES seen The purpose of the provisions of depreciation contained in the Companies Act ihe computation of managerial remuneration, dividend payment and disclosure in financial statement singe companies in India are regulated by the Companies Act, they should provide depreciation in the books of accounts in accordance with Schedule XIV of the Act which prescribes the rate of iepreciation for Various types of depreci ble assets on written down value (WDYV) basis as well a companies to charge depreciation on any other basis provided | hus the effect of writing off 95 per cent of the original cost of the asset on the expiry of the spec fied period and has the approval of the government. In actual practic the provisions of the Income Tax Act with the bas The provisions of Income 1 sight line basis, ICalso permits however, companies follow deductibility objectives of its t ion are contained in Section 32. The section nt conditions for following depreciation, namely, (i) the asset is owned by the assessee, (ii) the asset is used by the assessee for the purpose of business and (iii) the asset is in the form of buildings, furniture, machinery and plants including ships, vehicles, books, scientific apparatus, surgic The amount of annual depreciation on an asset is determined by (a) the and (b) its classification in the relevant block of assets, The actual cost means the cost of acquisition of the asset and the expenses incidental thereto which are necessary to put the ssate, for instance, freight and carriage inwards, installation charges and expenses incurred to facili- tate the use of the asset like expenses on the training of the operator or on essential construction work. Depreciation is charged, with a view to simplify computation, not on an indi- ) piock of assets Vidual asset but on a block of assets. A block of assets defined as a group of J are assets which assets falling within a class of assets, being building, machinery, plant or furniture J fallin the in respect of which the same rate of depreciation is prescribed. Thus, assets which J same class and fall within the same class of assets and in respect of which the same percentage/ | it respect of fate of depreciation has been prescribed irrespective of their nature form one J whieh the same block of assets. For example, all assets under the category of plant and machinery Jie tioieable Which qualify for depreciation at 15 per cent will form one block and deprecia- | irrespective of tion is computed with reference to the actual cost of the block. Similarly, their nature depreciable at 40 per cent will constitute another block; a third block consists of {sets depreciable at 50 per cent, and the fourth block comprises assets subject 100 per cent Write-off, Depreciation is computed at block-wise rates on the basis of writen down value (WDV) method only. Presently, the block-wise rates for plant and machinery 15 per cent, 20 per cent, 30 Per cent, 40 per cent, 50 per cent, 60 per cent, 80 per cent and 100 per cent. The depreciation al- lowance on office buildings and furniture and fitings is 10 per cent. If an asset acquired during a aie ia used for a period of less than 180 clays during the year, depreciation on such assets only at 50 per cent of the computed depreciation according to the relevant rate x Act relating to depre envisages three importa equipments and so on. cost of the asset isset in a usable9.12 Financial Management stion of the computation of the amount of depreciation, 4 5 blocks is that if an asset falling in a block is solq "Rica ton or bakancing charge. The sile proceeds ofthe ut, arise in these situations: ASSet ar [part from the simpliic implication of categorsi is no capital gain oF terminal depr n reduced from the WDV of the block Capital gain/loss can (@ When the sale proceeds exceeds the WDV of the whole block; (i) When the entire block is sold ot and (itd) In case of 100 per cent depreciable assets ‘The terminal loss is not allowed in the relevan 10 be allowed by way of depreciation. f profit, unabsorbed depreciation can be set off against ino te in the case of unabsorbed loss. Jation is illustrated in Example 9.1 Jing assets into lancin| assessment year But iS spread over a numb years ( In case of insufficiency/absence o| under any head against business income as ‘The mechanics of computation of deprec ‘Example 9.1 Assume the following facts relating to Avon Lid (AL): Block of Assets Depreciation Rate WDV as on 1.4.20X7 dition During 20X7-8 a (percentage) @ lakh) @ lakh) A 25 500 a) = B 40 300 150 ) and %50 lakh (Block B). It is expected that fsb and Block B (80 lakh). It is also projected akh in case of Block A and & [Assets sold during 20X7-8 amounted to ®35 lakh (Block A\ investments in assets during 20X8-9 will be: Block A (160 lakh) by the AL that disinvestment proceeds from the assets will amount to M5 lakh in case of Block B. Assume that about 50 per cent of additional investment during 9 will be ma Pacer tment during 20X8-9 will be mde ‘Compute the relevant depr tion o 5 ppreciation charge for 20X7-8 and the projected depreciation charge ‘The relevant depreciation charge for 20X7-8 and the pro} ey projected depreciation charge for 20X8-9 is called for 2088-9, TABLE 9.3. Computation of Depreciation Charge During 20X7-8 Particulars 1. WDV as on 1.4.20 X7 ‘Add: Cost of assets acquired during 20 X7 - 8 250 3, Loss: Sales during 20 X7 ~ 8 "750" o 44. WV (for depreciation) 95 ae 5. Depreciation allowance 715 ~ & Wives on 86-2058 HB eo 3 20> - Capital Budgeting 1: Principles and Techniques 9-15 seus 24 compuaton of Depreciation Charge During 20X8-9 v ( lakh) Particulars Blocks eS A B {woV as on 1-4.20X8 536 240 1 Mie Cos of asses acauted during 20X8-9 fan to 696 20 5 tess Expected proceeds of sales during 20X6-9 le ae + WoV (for depreciation) a # «Depreciation allowance® s fy § WwOV as on 1.4. 20X9 = ue Fpamnal depreciation allowance 188 aa voce Depreciation allowance inadmissible in respect of assets acquired after 30.9.20X8 fa e (80x 025x05) _(40 x 04 * 05) 153, 10 eding (1 + 2) or the sale proceeds Note: If the entire block of assets is sold during a year for an amount exce tal gains subject to tax. Where of the block sold is higher than (1 + 2), the difference represents short-term capi the ale proceeds are lower than (1 + 2), the difference is short-term capital loss and the AL. is entitled fo (ax shied In case block consists of a single asset (e.g. plant and machinery), no depreciation is to be charged in the terminal year in ‘which it is sold. The difference between the written down value (WDV) of the machine at the beginning of the year and its sale proceeds represents short- tem capital gain (when sale proceeds exceeds written down value/book vale of the machine) and short-term capital loss (in case the book value exceeds sale proceeds/salvage value). Such short-term capital gains (STCG) and losses (STCL) have been accorded special tax treatment, The STCL can be set off only against STCG or long-term capital gains. In case of inadequate/no profits, the STCL can be carried forward upto eight assessment years. To illustrate the implication of the tax provisions for capital budgeting, let us assume, a company buys a new machine for 210 lakh (forming a separate block). The machine is subject to 20 per cent depreciation on WDV basis. It is expected to have economic useful life of 5 years at the end of which its expected salvage value is %1 lakh. The depreciation in the first four years would be 2 lakh, €1.6 lakh, 1.28 lakh and €1.024 lakh, ortvely. The accumulated depreciation ‘would be 25.90 lakh. As a result, the WDV book value Yea'® machine at the beginning of year-5 would be %4,10 lakh. With no depreciation charged in i ne and sale proceeds of 21 lakh, there would be short-term capital loss of %3.10 lakh. This loss, Sal. Would yield tax shield, Assuming 30 per cent i rate and adequate STCG in year 5, the tax The ee:10 lakh * 0.30) %92,880. This amount would be reckoned as cash inflow in year 5, (i dag aX shield would be 292,880 in financial accownn also. It would consist of two components: Rag goeution in year 5, %B1,920 (0.20 * %4,09,600) and Gi) loss on sale of machine %2,27,680 81.920) aay €1:00.000 — €81,9200. The tax advantage on depreciation would be %24,576 (0.30 x 191920) and on loss %68,304 (0.30 X €2,27,680). The total (%24,576 + %68,304) is 292,880. Thus, the lo ire Ot Suffer any loss by not charging depreciation in the terminal year (as per income-tax irement),everal ansets (plants/machinery/equipments), depreciation 4, sold on ts closing balance (written de, Incase block consists of s ary 0 Vale te year in ahich the nnachine ere se valued The terminal loss ts allowed tbe carried fo cunning, of year of sales mand ie vein subsequent years (hough the asset does HOLE. Thy tay Charged ay depreciation eee a implies that the terminal loss would provide tax shield in the “ae y Fe flyatrate, conning with the present example, assuming the machine pure jig, U0 lakhs one of several machines, depreciation charged in year 9 would be on agi | (%4,00,000) — 81.00.00, sale value) at-20 per cent, that is B1,920. The terminal las de yg” Nrachine is €88,08,0000 ~ 861,920) 22,17,080. ‘This loss in terms of unabsorbed depreciany provide advantage in future ye In practice, as the block is likely to consist of several mack 2s for manufacturing fir, provision puts business firms at disadvantage as the tax advantage on terminal loss is a, 1 number of years and not in single year Net workingy Working Capital Effect Working capital constitutes another important i capital change] the cash flow stream which is directly related to an investment proposal. The 1s the difference | working capital is used here in net sense, that is, current assets minus cy between change} ghilities (net working capital). If an investment is expected to incre: incurrent assets aly that there will be an increase in current assets in the form of accounts re and change in Y curent liabilities 1 able, inventory and cash. But part of this increase in current assets will be offer an increase in current liabilities in the form of increased accounts and notes payabic Obviously, the sum equivalent to the difference between these additional current assets and cur rent liabilities will be needed to carry out the investment proposal. Sometimes, it may constnute a significant part of the total investment in a project. The increased working capital forms par of the initial cash outlay. The additional net working capital will, however, be returned to the firm the end of the project's life. Therefore, the recovery of working capital becomes part of the exh inflow stream in the terminal year. The initial investment in, and the subsequent recovery of, work ing capital do not balance out each other due to the time value of money. ‘The increase in the working capital may not only be in the zero time period, that is, at the time of initial investment. There can be continuous increase in the working capital as sales increase later years. This increase in working capital should be considered as cash outflow of the yea! which additional working capital is required Suppose, there is a project that requires an initial investment of 220,000 and has a useful le 5 years. The requirements of working capital are detailed in Table 9.5 in TABLE 9.5 Working Capital Requirements Particulars @ Initial investment 20,000 Sales %5,000 %10,000 Expenses 1,000 2,000 (b) Changes in inventory (decrease) 1,000 2,000 (c) Changes in receivables 1,000 2,000 (d) Changes in payables 1,500___2,000 (e) Change in net working capital (b + c - d) — 500 2,000Capital Budgeting 1: Principles and Techniques 9.15 sin the net working ¢: sin the net working capital are given in the last row of Table 9.5. The net working h outflows, while it has decreased in years tal is recovered, une han spats insrease iM Yeats Land 3 representing sans sowing cash flows as Working capt Myst all evenue-eXpansion capital inv im enn Proposals require additional working capital. phewise “suction capital investment projects release the existing amount of work- ng capital enhance the firm’s efficiency in such a way that the amount of inventory shard oF aecounts receivable can be reduced, Improved inventory control systems or improved and collection systems are some classic examples. From the point of view of evaluating an jqvement project, the amount of working capital so released should be seen as a cash inflow in cer time period (when the investment proposal is being considered), reducing the net cash svestment required for the project. In the terminating year of the project, it should be treated as ; cash outflow and adjusted against the cash inflow of that year mount invested in net working capital at the time of starting the project as gs in subsequent years is assumed to have been recovered fully by the terminal year. In reality, the fim would most probably recover less than 100 per cent primarily because of bad debts and inventory loss. Therefore, the working capital recovered would be less than 100 per cent (say, 95 percent), Accordingly, the cash inflow due to recovery of working capital in terminal year should te taken at less than 100 per cent amount. Morcover, for convenience, it is assumed that net ancously on termination of the project. In practice, however, it may take several months of the following year to recover it."° almost all cost-reduction ¢: ch proie Conventionally, the working capital is recovered inst Finally, tax considerations would not be involved when the net working capital recovered is less than 100 per cent!" because bad debt loss due to some uncollectible debtors and loss due to obsolete inventory are already reckoned in operating costs Determination of Relevant Cashflows The data requirement for capital budgeting are cash flows, that is, outflows and inflows. Their computation depends on the nature of the proposal. Capital projects can be categorised into, (0 single proposal, (ii) replacement situations and (iii) mutually exclusive Single Proposal The cash outflows, comprising cash outlays required to carry out the proposed capital expenditure are depicted in Format 9.1, while the computation of the cash inflows after taxes (CFAT) is shown in Format 9.2. The computation is illustrated in Example 9.2 and Example 9.3 FORMAT 9.1 Cash Outflows of New Project [Beginning of the Period at Zero Time (¢ = O)] (1) Cost of new project | (2) + Installation cost of plant and equipments | (3) & Working capital requirements |9.16 Financial Management FORMAT 9.2. Determination of Cash Inflows: Single Investmen it Proposal (t = | — Ny Years Particulars : 3 4 ~ Cash sales revenues ‘Less Cash operating cost Cash inflows before taxes (CFBT) Less Depreciation Taxable income Less Tax Eaming after taxes Plus. Depreciation Cash inflows after tax (CFAT) Plus: Salvage value (in mth year) Plus: Recovery of working capital (in nth year) Example 9.2 An iron ore company is considering investing in a new processing facility. The company extracts ore open pit mine. During a year, 1,00,000 tonnes of ore is extracted. If the output from the extraction pricey 's sold immediately upon removal of dirt, rocks and other impurities, a price of %1,000 per ton of be obtained. The company has estimated that its extraction costs amount to 70 per cent of the net rea value of the ore. As an alternative to selling all the ore at €1,000 per tonne, it is possible to process further 25 per cent the ourput, The additional cash cost of further processing would be %100 per ton. The proposed ore yield 80 per cent final output, and can be sold at %1,600 per ton. For additional processing, the company would have to instal equipment costing €100 lakh. The equipmex is subject to 20 per cent depreciation per annum on reducing balance (WDV) basis/method. It is expected have useful life of 5 years. Additional working capital requirement is estimated at %10 lakh. The compis'+ Cutoff rate for such investments is 15 per cent. Corporate tax rate is 35 per cent Assuming there is no other plant and machinery subject to 20 per cent depreciation, should the comps instal the equipment if (a) the expected salvage is 710 lakh, (b) there would be no salvage value atthe of year 5 and (©) for tax purposes, the firm would have sufficient short-term capital gains in year 5 Solution Financial Evaluation Whether to Instal Equipment for Further Processing of Iron Ore (A) Cash Outflows a % 1,00,00,000 Plus: Additional working capital 090.000 1.10,00.000 (B) Cash Inflows (CFAT) Particulars a 2 5 Revenue trom processing ——? _ — ((,600 » 20,000) - %1,000 2 25,000] £70,00.000 70.00.00 _ +70,00,000 70.00.00 7%Capital Budgeting 1 Principles and Techniques 9.17 (comes Tess: Processing costs Cash costs (100 \ 25,000 tons) 25,00,000 25,0000 25.00.00 25.00.00 Depreciation {working note 1) 20,00.000 16.00.00 10.24.00 Eamings before taxes 25,00,000 29,00,000 94,76,00 15 0.006 ss: Taxes (0.35) _875,000___10,15,000 12.16.600 15.75.00 Eamings after taxes (EAT) 16.25,000 18,85,000 20,93,000 —22,59,400 BH ‘Add: Depreciation _20,00,000___16,00,000 _12,80,000 10,24,000 ee FAT, 36,25,000 _34,85,000 __33,73,000 32,83,400 29.25.00 ‘Working Notes 1 Depreciation Schedule Year Depreciation base of equipment Depreciation @ 20% on WDV 1 1,00,00,000 20,00,000 2 80,00,000, 16,00,000, 3 64,00,000 12,80,000, 4 51,20,000 10,24,000, 5 40,96,000 Ni Tas the block consists ofa Single asset, no depreciation isto be charged inthe terminal year of the project. © @) Determination of NPV (Salvage Value = %10 lakh) Year CFAT PV factor (0.15) Total PV 1 % 36,25,000 0.870 2 31,53,750 2 '34,85,000 0.756 26,34,860 3 33,73,000, 0.658 22,19,434 4 32,83,400 0572 18,78,105 5 29,25,000 0.497 14.53.7285 Salvage value 10,00,000 0.497 4,97,000 Tax benefit on short-term capital loss 10,83,600b 0.497 5.38549 Recovery of working capital 10,00,000 0.497 497,000 Gross present value 7,28,72.223 Less: Cash outflows 1.10,00,000 Net present value (NPV) 18.72,223 (b) 0.35 (%40,96,000 — %10,00,000) = %10,83,600. Recommendation The company is advised to instal the equipment as it promises 4 positive NPV, ” Determination of NPV (Salvage Value = Zero) PV of operating OFAT (1 ~ 6 years) €1,13.99674 ‘Add PV of tax benett on short term capital 1s (°40,96,000 » 0.35 = 814,33,600 x 0.497, PV factor) Add: PV of recovery of working capital Total prsont valve “725.49.173 Less: Cash outfiows 1,10,00,000 a 15,49,173 Since the NPV is still positive, the company is advised to instal the equipment9.18 Financial Management SPREADSHEET SOLUTION 9.! Evaluation Whether (o Install 110 lakh) ae =< — ts rb nb one AO sot eae @ seas ere oe z 4 f 2 : 7 S open po wen "ob tc ects ovpd wou father procensng (ns) 75000, eens etcoan one tahe process) ‘ip rece capa wtp) rece esr eran ah eter pacssing 8) 10 sang coe peo a) Ma Soose ne) 1 1 Sepecmon ae Mt Suroevabe + ooo Dacron a 12 cos Eevee 100 0 te Sonny Spe tt 20 16 Total mcial cost ~11,000,000, ur pes, 7omao 700000 7am rang roo 25000 250000 25mm 25m 24m 2900000 1600000 1 e000 1 aee wg bere tares 2500900 250000 3200000 347 om, 875000 1 D100 1 127M 1 Dib 5 tases 1525000 1 335.000 2mm 2249.40 B Operaing CraT 3625000 340500 3.373000 325340 24 Sakage ve 2% Ter beret on shot-tarm capt oss x 2B Foease of Working Capital oI 2 spat 3625000 3486000 3373.00 By 1,889,767 58 2 x 31 oreage 32 Depreciation Sehedle 3 Deprecianon bate of equpment Yoo0o000 — .oons00 Ganon 5.120000 4. 2 Capen 2000000 1600000 1 zen) c24 oH 2% To1 Garton Shorter capt loss 2 ech Vane oequpmen coset 2B Swage vie 1a 3 Shan term capal oss we Mt 12 Tar Cento ht em capes . 6) " Mo W\ Stet (see {ee / — Enter the years in cells BI to ing with yea fer the input in cells B2 Rater ~82 in cell tte 6 with Year 0. Enter the input in cells B2 to BlZ —B3 in cell B15 for investmer Enter “SUM(BI4:1315) in cell B16 to calculate the nape Enter the formula =(Sb4*SB6%S17)-c$144¢§45) calculate revenue for all years, £3 8 equipment and_ working capital TesPe ‘otal initial investment os in cell C17 and copy the formula in cells DIT G18 to calculate the Processing cost. a . nd copy the formula «0 cell OM- Capital Budgeting 1: Principles and Techniques _9.19 peprecation is worked out in cells C33 to GM. For calculating depreciation enter =B2 in cell C33. Enter pe orl 2C33°SB10 in cell CB. Enter =C34-CM4 in cell B35 and copy it to cells £33 10 G33. Also copy ihe formuls in cell C34 (0 cells D34 to G34, The Depreciation figures are carried to cells C19 10 G19. This is a ce py entering =CH4 in cell C19 and itis copied in cells DI9 to G19 or : e earings before taxes, enter *C17-C18-C19 in cell C20 and copy the formula to cells B20 to eka e calculate taxes, enter = C20*SB$9 in cell C21 and copy to cells D21 to G21 o calculate eamings alter taxes, enter =C20-C21 in cell C22 and copy to cells D22 t0 G22 Jo calculate operating CFAT, enter =C22+C19 in cell C23 and copy to cells B23 to G23. salvage value is entered in cells G24 by entering =B11 Tax benefit on short-term capital loss is worked out in cells G37 to G40. Enter “G33 in cell G37 and =B1 in cell G38. Short-term capital loss is calculated in cell G39 by entering =G37-G38. Tax benefit on short-term capital loss i calculated in cell G40 by entering =G39"B9. This benefit is carried to cell G25 by entering =G40 in cell G28. Working capital released is entered in cell G26 by providing reference to cell B15 by entering =B15 in cell xs. Yearwise CFAT are calculated in row 27 by entering =sum(C23:C26) in cell C27 and copying it to cells DI? to G: NPV is calculated in cell B28 by entering =NPV(B12, C27-G27)+B16. (The difference in NPV is due to approximations) When Salvage Value is Zero Incase, the salvage value of the equipment is zero, only one change is required in spreadsheet. Enter 0 in cell B11 instead of 1,000,000. The spreadsheet will calculate the new NPV. Example 9.3 For the company in Example 9.2, assume there are other plants and machinery subject to 20 per cent depre- Cation (je. in the same block of assets). What course of action should the company choose? Solution @) Cash outflows would remain unchanged. ©) The annual depreciation will also remain the same for the first 4 yeas: In year 5, the depreciation = %30,96,000 (opening WDV of equipment, %40,96,000 — €10,00,000, salvage value) X 0.20 = %6,19,200 © The CFAT (operating) for years, 1-4 will not change. In year 5, it will be shown as below: Particulars CFAT (t = 5) Revenue from provessing %70,00,000 ess: Processing costs: Cash costs 25,00,000 Depreciation 6,19,200 before taxes 38,80,800 Less: Taxes (0.35) 13,58,280 Ear == 25,22,520 Sear 31,41,720 <=9.20 Financial Management Determination of NPV (Salvage we = 710 Iakhy Yeo: rar PV factor £36,25,000 0.870 2 34,85,000 0.756 3 33,73,000 0658 ‘ 22,80400 os7e s 31.41,720 0.497 Salvage value 10,00,000 0.497 Recovery of working capital 10,00,000 0.497 Gross present value Less: Cash outflows Net present value (NPV) Sin fact, the NPV of the equipment is likely to be hig £24.76 800. \¢. £30.96,000 ~ £619,200) in future year Recommendation The 1447 3e08 ner as tax advantage wil accrue on the eligible depecauy rs, company should instal the equipment. Determination of NPV (Salvage Value = 0) (0, For the first 4 years, depreciation amount (%40,96,000, opening WDV less zero salv will remain unchanged. In the fith year, depreciation = eas6o00 rage value) x 0.20 = %8,19,200, (1) Operating CFAT for years 1 - 4 wil remain unchanged. The CFAT for Sth year would be €32,11,720 as show below: Revenues trom processing ®70,00,000 Less: Processing costs (%25,00,000 + 88,19,200) 33,19.200 EBT Less: Taxes (0.35) eat ‘Adi: Depreciation rat (il) PV of operating CFAT (1 — 4 years) ‘Add: PV of operating CFAT (Sth year) (32,11,720 x 0.497) ‘Add: PY of recovery of working capital Toul PV 779,78.174 Less: Cash outiows 4.10.000006 NPV 979.178 “in ettect, NPV would be higher as tax ava tage will accrue on depreciation of €32.76,B00 in future years ‘Recommendation The decision does Replacement Situation In the the relevant cash outflows are ® Not change, as NPV is positive. case of replacement of after-tax incremental n existing machine (asset) by ne $ ash flows. IF a new machine: is inters' i Feplace an existing machine, the Proceeds so obtained from its sale reduce cash outtlows: Gua (© purchase the new machine and, henee, part of relevant cash flows The calculation of ater incremental cash outflows is, illustrated in, Format 9.4 and Forn ein the case of replacer preciatin AU 9.4 Which provide dep situationsroRMAT 7, cost of the new machine 4. + Installation Cost 4. ¢ Working Capital 4 gale proceeds of existing machine foRMAT 9.4 Depreciation Base of New Machine in a Replacement Situation 7, WOV of the existing machine 2, + Cost of the acquisition of new machine (including installation costs) 3, ~ Sale proceeds of existing machine The computation is illustrated in Example 9.4 Example 9.4 isin Paatipstres Led is considering the replacement of one of its moulding machines. The existing machine i 5 operating condition, but is smaller than required if the firm is to expand its operations. It is 4 years old, foe current salvage value of 82,00,000 and a remaining life of 6 years. The machine was initially purchased pe ti0 lakh and is being depreciated at 20 per cent on the basis of written down value method ‘The new machine will cost 715 lakh and will be subject to the same method as well as the same rate of depreciation. It is expected to have a useful life of 6 years, salvage value of €1,50,000 at the sixth year end The management anticipates that with the expanded operations, there will be a need of an additional net working capital of 1 lakh. The new machine will allow the firm to expand current operations and thereby Jheease annual revenues by %5,00,000; variable cost to volume ratio is 30 per cent. Fixed costs (excluding depreciation) are likely to remain unchanged, the corporte tax rate is 35 per cent. Its cost of capital is 10 per cent. The company has several machines in the block of 20 per cent depreciation. Should the company replace its existing machine? What course of action would you suggest, if there is no salvage value? Solution Financial Evaluation Whether to Replace Existing Machine (A) Cash Outflows (Incremental) Cost of the new machine ‘Add: Additional working captial Less: Sale value of existing machine ®)_Determination of Incremental CFAT (Operating) Year incremental Incremental Taxable Taxes EAT CFAT contribution? depreciation’ _income (0.35) _[Col4-Col.5] — [Col.6 + Col.3] 7 z 3 4 5 6 7 i %3,50,000 %2,60,000 780,000 31,500 758,500 %3,18,500 : 3,50,000 '2,08,000 1,42,000 49,700 92,300 3,00,300 ; 350,000, 1,66,400 1,893,600 64,260 1,19,340 2185,740 : 350,000 1133,120 2,416,880 75,908 1,40,972 2,74,092 4 350,000 1106496 2,49,504 85,226 1,58,278 264,774 x 3,50,000 35.197 _2,94,803 1,03,181 1,91,622 2,486,819 *7n.02.000 = f5,00,000 x 0.30, variable cost to value (V/V) ratio] = €8,50,000 orking note)—e ~ 9.22. Financial Management Notes a Incremental Depreciation (t= 1 ~ 6) Incremental asset cost base Depreciation (20% on Wow Year _ en no %2,60,000 : 10,40,000 2,08,000 + 8,32,000 1,66,400 : 6,65,600 1.33,120 4 5,32,480 1,06,496 a 4,25,984 85,197 ‘20 « (84, 25,984 ~ €1 50/000, salvage value) = 55,197 2@ Written Down Value (WDV) of Existng Machine at the Beginning of the Year § Initial cost of machine %10,00,000 Less: Depreciation @ 20% in year 1 2.00000 WDV at beginning of year 2 8,00,000 Less: Depreicaiton @ 20% on WOV 1.60.000 WOV at beginning of year 3 6.40000 Less: Depreciation @ 20% on WOV 12800 WV at beginning of year 4 12,000 Less: Depreciation @ 20% on WOV 1.02400 WDV at beginning of year 5 ~ 409,600 (i) Depreciation Base of New Machine WOV of existing machine - ‘Add: Cost of the new machine Less: Sale proceeds of existing machine Base for Incremental Depreciation Depreciation base of a new machine a. Less: Depreciation base of an existing machine © Determination of NPV (Salvage Value = 71,50 lakh) : ; ar CFAT PV factor (0.10) 6 Salvage value cone = ‘tenes tyson ns Gross present value £0,000 beeal Less: Cash outows Net present valueCapital Budgeting I: Principles and Techniques 9.23 fecommenation cae NPV is negative. the company should not replace the existing machine. However, Ree NP ie 10 pte atx adage wcrc the le deprecation of 21908 w Determination of NPV (Salvage Value fer) (p For the first S years, depreciation will remain unchanged. In the sixth year, it will be = %4,25.984 X 0.20 = %85,197. w Operating CFAT for years 1-5 will remain unchanged. ‘CFAT for year 6 would be: Incremental contribution #3,50,000 Less: Incremental depreciation 25.197 Taxable income — seme Less: Taxes (0.35) 92,681 EAT 1,72,122 ‘Add: Depreciation 85,197 FAT 257.319 (i) PV of operating CFAT (1 ~ 5 years) 11,03,785 ‘Add: PV of operating CFAT (6th year) (*2,57.319 x 0.564) 145,128 ‘Add: PV of working capital 56,400 ‘Total present value 73.05,313 Less: Cash outflows +14,00,000, NPV. (64.887), Recommendation since the NPV is negative, the existing machine should not be replaced. SPREADSHEET SOLUTION (See the excel sheet screen shot on next page) Enter the inputs in cells B1 to B11 Enter the years in row 16, starting with year 0. Enter —B1 in cell B17, =-B6 in cell B18 and =B3 in cell B19 for investment in equipment, working capital and salvage value of existing equipment respectively. Enter =SUM(B17:B19) in cell B20 to calculate the total initial investment, Enter the formula *$B7 in cell C21 and copy the formula in cells D21 to H21 to calculate incremental revenue for all years. Enter the formula =C21°SBB in cell C22 and copy the formula to cells D22 to H22 to calculate the incremental ‘atiable cost Depreciation is worked out in cells B38 to H42. For calculating depreciation, enter =B2*(1-B9)B4 in cell 338 Enter the formula 0.567) 20x (iv) Release of working capital (F70,000 x 0.567) 384% Total present value 431368 —~ Less: Cash outiows 25 — Nev 131558 — Advice: Proposal ¥ is recommended in view of its higher NPV Alternatively (Incremental Cashflow Approach) Incremental Cash Outflows Investment required in Proposal Y %3,20,000 Less: Investment required in Proposal X 2.0,000, 1.20000 Incremental CFAT and NPV =a (0) Incremental sales revenue (¥ ~ x) 70000 Less: Incremental cash expenses (Y ~ X) 20000 Incremental cash profit before taxes 50,000 Less: Taxes (0.35) 17500 Incremental CFAT (t= 1 - 5) 32500 (6) PV of annuity for 5 years (0.12) S608 Incremental present value 1762 i PV of Tax Savings Due to Incremental Depreciation ps Year Incremental depreciation Tax savings PVF Present value 1 % 20,000 @ 7,000 0.893 = 26,251 2 16,000 5,600 0797 4.463, 3 12,800 4,480 one 3,190 4 10,240 3.584 0.636 2279 16188 b {i PV of tax savings on incremental (Y — x) shor term capital loss (STCL) } (&1,02,400 - 261,440) x 0.35 x 0.567 3129 lv Tnermenil (YX) working capa 70,000 ~ 850,000) «0.567 airs Incremental present value 1,52.814 Less: Incremental cash outflows 120,000 Incremental NPV 32.814 Recommendation Proposal ¥ is better. Financial Evaluation of Proposals, Assuming Salvage Value of Machines X and Y (Incremental App*®) (a) Sum of PV of items (), (i) and (iv) (®1,17,162 + 816.1 (0) BV of incremental salvage value (€15,000 x 0.567) incremental STCL@ @ (%77,400 ~ %54,440) x 0.35 x 0.567 (6) PV of tax savings on i Incremental present value Less: Incremental cash outflows Incremental NPV Decision: Decision (superiority ofp items (i) (i) and (iv) when there is no salvag As a result of salvage value, the amount roposal Y) remains unchanged. 3° will Not change due to salvage value. Of short-term capital loss (STCL) will change 83 + 211,340)@ 11 4s 688 8808 5182Capital Budgeting I: Principles and Techniques 9.27 secTION| 3 | EVALUATION TECHNIQUES his section discusses the important evaluation techniques for ca nethods of apprtising tn investment proposal are anetho fonomie costs ind benefits pital budgeting. Included in the those which are objective, quantified and based on eC rhe methods of appraising capital expenditure Proposals can be classified into two broad c: egories: @D traditional, and QD time-adjusted. The latter are more popularly known as discounted cash flow (DCF) techniques as they take the time factor into account, The fist category includes (D average rite of return method and (i) pay back period method! () net present value method, Gi) internal rate and Gv) profitability index: ‘The second category includes of return method, (iii) net terminal value method, Traditional Technique Average Rate of Return Computation ‘The average rate of return (ARR) method of evaluating proposed capital expenditure is also known as the accounting rate of return method. It is based upon accounting information rather than cash flows. There is no unanimity regarding the definition of the rate of return, There are a number of alternative methods for calculating the ARR. The most common usage of the aver- age rate of return (ARR) expresses it as follows: ARR x 100 on ~ Average investment over the life of the project The average profits after taxes are determined by adding up the after-tax profits expected for each year of the project's life and dividing the result by the number of years. In the case of annu- iy, the average after-tax profits are equal to any year's profits The average investment is determined by dividing the net investment by two. ‘This avera Process assumes that the firm is using straight line depreciation, in which case the book value of the asset declines at a constant rate from its purchase price to zero at the end of its depreciable life. This means that, on the average, firms will have one-half of their initial purchase price in the books.'2 Consequently, if the machine has salvage value, then only the depreciable cost (cost-salvage value) of the machine should be divided by two in order to ascertain the average net investment, as the salvage money will be recovered only at the end of the life of the project. Therefore, an amount equivalent to the salvage value remains tied up in the project throughout its life time. Hence, no adjustment is required to the sum of salvage value to determine the average investment.'} Likewise, ifany additional net working capital is required in the initial year which is likely to be released only 4 the end of the project's life, the full amount of working capital should be taken in determining relevant investment for the purpose of calculating ARR. Thus, Average investment = Net working capital + Salvage value + 1/2 (nitial cost of machine ~ Salvage value) (9.2) For instance, given the information: initial investment (purchase of machine), 711,000, salvage “alue, 1,000, working capital, %2,000, service life (years) 5 and that the straight line method of geereciation is adopted, the average investment is: %1,000 + %2,000 + 1/2 11,000 = %1,000) = 000, ae9.28 Financial Management Example 9.6 chines, Aa Faxample 9 oe ow he lowing a of MASTS A ED Particul Machine A articular : a 756,125 ost ‘Annwval estimated income after ‘ation and income tax deprecation ae nore @ :: 5,375 = 3 7395 eo 4 9375 id 5 11,375 : 36,875 Estimated lite (years) 5 Estimated salvage value 3,000 Depreciation has been charged on straight line basis Solution 'ARR = (Average income/Average investment) X 100 (%36,875/5) = 87,375 Salvage value + 1/2(Cost of machine ~ Salvage value) = %3,000 + 1/2 (56,125 — %3,000) = 29,562.50 ARR (for machines A and B) = (@7,375/%29563.50) = 24.9 per cent In addition to the above, there are other approaches to calculate the average rat of return (ARR). One approach, which is a variation of the above, involves using original rather than the average cost of the project. In the case of this alternative approach, the ARR for both the machines would be 13.1 per ceat (27,375 + %56,125). Accept-reject Rule With the help of the ARR, the financial decision maker can decide wheter to accept of reject the investment proposal. As an accept-reject criterion, the actual ARK would be compared with a predetermined or a minimum required rate of retum or cutoff rte © projec would qualify to be accepted if the actual ARR is higher than the minimum desired ARR. Obe" weit is lable to be rejected. Alternatively, the ranking method can be used to select of SI proposals. Thus, the alternative proposals under consideration may be arranged in the descendint Cider of magnitude, starting with the proposal with the highest ARR and ending with the propost! having the lowest ARR. Obviously, projects having higher ARR would be preferred to proies® wah lower "Average income of Machines A and ‘Average investment Evaluation of ARR In evaluating the ARR, as a criterion to select/reject investment merits and drawbacks need to be considered. The most favourable attribute of the ARR & is its easy calculation. What is required is only the figure of accounting profits after taxes Woe should be easily obtainable. Moreover, it is simple to understand and use. In contrast (0 this. he dcoicied flow techniques involve tedious calculations and are difficult To understand. Finally e total benef a with the project are taken into account while calculating the ARS - thods, pay bad for instance, do not use the entire stream of incomes, eee method of evaluating investment proposals suffers from serious de! pr ips jortcoming of the ARR approach aries from the use of accounting income in flows. The cash flow approach is markedly superior to a aaa 2 eamit s for prove The earings calculations ignore the reinvestment potential of a projec’s benefits * flow takes into account this potential and, hence, the total benefits of the projet nstead ret eval pile he —_—Capital Budgeting |: Principles and Techniques 9.29 ¢ second principal shortcoming of ARR is th: 8 is that it does not take into account the time The timing of cash inflows aan ue of ieee pons is a major decision variable in financial decision is earlier years and later years cannot be valued at par. To the the ARR method treats these benefits at par and fails to take account of the differences in the value of money, it suffers from a serious deficiency. Thus, in Example 9.6, the ARR in case of hoxh machines, A and B is the same, although machine B should be preferred since its returns in ne early years of its life are greater. Clearly, the ARR method of evaluating investment proposals tails to consider this. Thirdly, the ARR criterion of measuring the worth of investment does not differentiate between he size of the investment required for each project. Competing investment proposals may have the same ARR, but may require different average investments, as shown in Table 9.6. The ARR method rn such a situation, will leave the firm in an indeterminate position. TABLE 9.6 Machines Average Annual Eamings ‘Average Investment ARR (per cent) 1 2 3 4 A %6,000 %30,000 20 B 2,000 10,000 20 c 4,000 20,000 20 Finally, this method does not take into consideration any benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by the new investment, The ‘new investment, from the point of view of correct financial decision making, should be measured in terms of incremental cash outflows due to new investments, that is, new investment minus sale proceeds of the existing equipment + tax adjustment. But the ARR method does not make any adjustment in this regard to determine the level of average investments. Investments in fixed assets are determined at their acquisition cost. For these reason, the ARR leaves much to be desired as a method for project selection. Pay Back Method Payback} Computation ‘The pay back method (PB) isthe second tational method of (oeriod) method] capital budgeting. It is the simplest and, perhaps, the most widely employed, is the exact} quantitative method for appraising capital expenditure decisions. po, sn avinitial amount of ime] This method answers the question: How many years will it take er required forall for the cash benefits to pay the original cost of an investment. J oyagy) fim to recover its] rmally disregarding salvage value? Cash benefits here wepresent Vis the — a I. Thus, the pay back method (PB) | cash outflow fora CFAT ignoring interest payment ina project fesee ee “ cae S| measures the number of years required for the CFAT to pay back nosed cash inflows the original outlay required in an investment propos There are two ways of calculating the PB period. ‘The fist T= 0) method can be applied when the cash flow stream is in the nature of ansmulty {0 panuity each year of the project's life, that is, CFAT are uniform. In such a situation, the J ream initial cost of the investment is divided by the constant annual cash flow: equal cash inflows.-! 9.30 Financial Management Investment DB = ; Constant annual cash flow (93) For example, an investment of 840,000 ina machine is expected to produce CFAT of 38,009 5 10 years, f PB = %40,000/88,000 = 5 years Mixed stream The second method is used when a project's cash flows are not uniform, (mix stream) but vary from year to year. In such a situation, PB is calculatey “a inflows exhibiting | rocess of cumulating cash flows till the time when cumulative cash flows bers a eitet ohas{ equal to the original investment outlay. Table 9.7 presents the caleulations of annuity. | back period for Example 9.6 is a series of eash TABLE 9.7 Calculation of Payback Period Year Annual CFAT Cumulative CAT A 8 A a %14,000 %22,000 14,000 2 16,000 20,000 30,000 3 18,000 18,000 48,000 4 20,000 16,000 68,000 5 25,000 17,000 * 93,000 93,000 * CFAT in the fifth year includes %3,000 salvage value also. ‘The initial investment of %56,125 on machine A will be recovered between years 3 and 4. ‘The pay back period would be,a fraction more than 3 years. The sum of €48,000 is recovered by the end of the third year. Thé balance %8,125 is needed to be recovered in the fourth yest In the fourth year CFAT is %20,000. The pay back fraction is, therefore, 0.406 (88,125/%20,000) The pay back period for machine A is 3.406 years. Similarly, for machine B the pay back period would be 2 years and a fraction of a year. As 42,000 is recovered by the end of the second year, the balance of %14,125 needs to be recovered in the third year. In the third year CFAT is £18,000. The pay back fraction is 0.785 (814,125/18,000). Thus, the PB period for machine B i 2.785 years. Accept-Reject Criterion The pay back period can be used as a decision criterion to accept or 1 invetument proposals. One application of this technique is to compare the actual pay back ats Predetermined pay back, that is, the pay back set up by the management in terms of the maxim investment must be recovered. If the actual pay back period is than the predetermined pay back, the project would be accepted; if not, it would be eejectet *” tematively, the pay back can be used as a ranking method. When mutually exclusive proie under consideration, they may be ranked according to the length of the pay back period. 7 IRe Project having the shonest pay back may be assigned rank one: followed in that ort the project with the longest pay back would be ranked last, Obviously, projects with shorter P* back period will be selected. Evaluation The pay back method has stand. Moreover, the pay back method arises due to the fact that it is based o1 under certain merits. It is easy to calculate and simple (© superior! is an improvement over the ARR approach: Its SPE ied n cash flow analysis. The results of Example 9-6 i __ Capital Budgeting |: Principles and Techniques 9.31 = 9.10 can be cited in suppor of this. Th in Table Thus, though the average cash flows for both the machines under the ARK methex! were the same, the pay hack metho! shows tha te eh te period for machine 1S is shorter than for machine A The pay back pera! ner ane eae Pa prchine B should be preferred as it refunds the 4 ae apital outlay earlic The pay back approach, however, suffers r than machine A from serious hr tations. Its major shortcomings are as follows The first major shortcoming of the pay back method is that it completely ignore nflow ater the pay back period. This can be very miste ‘ading in capital budgeting evalua vals altemative projects with the same pay back period (3 years) : 7 TABLE 9. Particulars Project X Project ¥ Total cost of the project % 15,000 ® 15,000 Cash inflows (CFAT) Year1 5,000 4,000 2 6,000 5,000 3 4,000 6,000 4 oO 6,000 5 oO 3,000 6 0 3,000 Pay back period (years) 3 3 In fact, the projects differs widely in respect of cash inflows generated after the pay back pence The cash flow for project X stops at the end of the third year, while that of Y continues up to the sixth year. Obviously, the firm would prefer project Y because it makes available to the firm cash inflows of 212,000, in years 4 through 6, whereas project X does not yield any cash inflow after the third year. Under the pay back method, however, both the projects would be given equal ranking which is apparently incorrect. Therefore, it cannot be regarded as a measure of profitability. is failure lies in the fact that it does not consider the total benefits accruing from the project. Another deficiency of the pay back method is that it does not measure correctly even the flows expected to be received within the pay back period as it does not differentiate between pro- as in terms of the timing or the magnitude of cash flows. It considers only the recovery penod. # 4 whole. This happens because it does not discount the future cash inflows but rather treats Tupee received in the second or third year as valuable as a rupee received in the first year. In other Words, to the extent the pay back method fails to consider the pattem of cash inflows, it ignores the time value of money. Table 9.9 shows that both the projects A and B have (i) the same cash outlays in the zero time Petiod; (i) the same total cash inflows of %15,000; and (iil) the same pay back penioa! of 3 years Sut project A would be acceptable to the firm because it retums cash earlier than project B, enabling Ato repay a loan or reinvest it and eam a return. A possible solution to this problem is provided by determining the pay back period of discounted cash flows. This is illustrated in the subsequent “ection of this chapter The discounted payback method still has significant drawbacks. ‘The major one is that the cubott Petiod is still arbitrarily set. As a result, there is a possibility that a project with positive NPV may ** Feiected because the cutoff is too short. Also, it does not ensure that a project accepted under “omer discounted payback period has necessarily the maximum NPV.LS > 9.32. Financial Management Projects — TABLE 9.9. Cashflows of ae = Particulars 715,000 "155 Total cost of the project inflows (CFAT) - 7 Cash ints ( ; : = i 5 ! 10,0 : k lox 7 consideration 1 cS : he pay back method is that it does not take into conside tO the erin Another flaw of the pay bac x ih cis ows are generated. AS a result, projects with le ry infra ee ye qe icra ee Profitable projects whey ee cash inflows in the earlier part of their lives Table s resem the 6 ai Sacre a Projects. On the basis of the pay back criterion, pron ae presents the comparison of two s be adiudged superior to project B. TABLE 9.10 _ : Particulars Sue “Oe SS a Total cost of the project 40,000 000 Cash bere (CFAT) 14,000 co ve 16,000 10,000 3 10,000 10,000 4 4,000 10,000 2 2,000 12,000 é 1,000 16,000 . Nil 17,000 Pay back period (years) 3 4 Since the cash inflows of the former amount to $45,000 after the expiry of the pay back period and the cash flows of the latter beyond the Pay back period are only 27,000, The above weaknesses notwithstanding, the pay back method can be gainfully employed under rear Sircumstances.4> In the first place, where the long-term outlook, say in excess of three yas, is extremely hazy, the pay back method may be useful. In a Politically unstable country, for BBlance, 4 quick return to recover the investment is the prima a es almost unexpected surprises Hikewise, this method may be suffering Very appropriate for firms su from liquidity crisis, A firm with limited liqui Xl assets and no ability to raise. additional furs Wt nevertheless wishes to undertake capital projects in the he might we PY pack as a selection enterion because it emphasises quick ree, $s original outlay 3 be Impairment of the already cxteal !duicity situation. Thirdly the method may 18) De beneficial in taking capital budgetin sis on sho '8 decisions for firms a emphasis on © earning performance rather th 2 Bey Beceem Hn its long-term ° rk period is a measure ofliqult Of investments rather than dian oo oP “Thun the pay bance Pld i 8 ‘ore appt tho) {Profitability measure to be maximised. It ate method can be used in conjunction with mot {me Ste Potential projects ta te fon ahoe met . ‘I methods such as popes Finally, the pay back peti ‘aking calculations in certain situations. For instance careful scrutiny with m Ore ‘Sophisticate Useful, apart from meas, uring liquidity,Capital Budgeting | Principles and Techniques 9.3% iremal ate of return can Be computed easy ftom the pay hack period The pay ack: methra! y good! aP h pproximation of the infernal nite of renim which otherwise requires a trial and error ipprs’ yelucke the discussion of the traditional method r To one methods of appraising capital investme sions, there are two mator drawbacks of these techniques. They do not consider the total henefit stems oF G) the magnitude and GH) the timing of cash flaws For these reasons. the ‘radiena ; g decision criteria. The two essential ingr Peawoeally sound apprnsal method, therefore, are that (D) it should be based! on a consideration ihe fotal cash stream, and Gi) it should consider the time value of money as refl Pe are unsabstatory as capvtal budget nagnitusle and the timing of expected ctsh flows in each period of a project's wed (also known as discounted cash flow) techniques satisfy these requirements and, 1 tha 4 provide & more objective basis for selecting and evaluating investment projects piscounted Cashflow (DCF)/Time-Adjusted (TA) Techniques vc distinguishing characteristics of the DCF capital budgeting techniques is that they “sweration the time value of money while evaluating the costs and benefits of a project. In one or another, all these methods requite cash flows to be discounted at @ certain rate ost of capital. The cost of capital (K) is the minimum discount rate eared on a projec exes the market value unchanged. The second commendable feature of these techniques is that they take into account all benefits and costs occurring during the entire life of the project. In the discussions that follow, we have attempted to discuss the DCF evaluation methods. First, se have explained the general procedure behind DCF. This is followed by a discussion of the first net present value (NPV). We have then covered the internal rate of return F technique, name IRR) method. The two variations of the NPV method, that is, terminal value and profitability index Pl) or benefit-cost ratio are also discussed. An attempt has also been made to compare the NPV method with IRR and the PI. Present Value (PV)/Discounted Cash Flow (DCF) General Procedure The present value or the discounted cash flow procedure recognises that cash flow streams at different time periods differ in value and can be compared only when they are ex- pressed in terms of a common denominator, that is, present values. It, thus, takes into account the time value of money. In this method, all cash flows are expressed in terms of their present values The procedure to determine present value is comprehensively covered in Chapter 2 The present value of the cash flows in Example 9.6 are illustrated in Table 9.11 TABLE 9.11 Calculations of Present Value of CFAT Machine A Machine 8 Year —GFAT PV Tactor (0.10) Present value CFAT PV factor (0.10) Present value 7 2 3 es cane) 4 14,000 0.909 312,726 22,000 0.909 219,998 2 16,000 0.826 13,216 20,000 0.826 16,520 3 18,000 0.751 13,518 18,000 0.751 13,518 : 20,000 0.683 14,660 16,000 0.683 10,928 5 25,000" 0.621 15,525 17,000" 0.621 10,557 69,645, 71,521 “Weludes salvage value.>» 9.34 Financial Management ih the PY of cash outflows. The present value, ' Se ao dioes ard Weta are sce chines are higher than © thereto Xs inflows of both the machin | 7 of Table 9.11) now can be used t determing the con a ere eee aa cdl on the basis of discounted present value of CEA yi! ne Pay back period. aie Col 4 of Table 9.11) used in the ‘simple pay bach Method a oe a counted pay ack period are 4.2 and 3.66 years for Machine relevant values of the ‘discot y ively B le 9.6. respectively in Examp! / ‘The first DCF/PV technique is the (NI Method The first NY = may be des as the st sal 8 of ca a Tn by in each year minus the summation of present values of the net ci SUtfOWs in ee, subtracting a year, symbolically, the NPV for projects having conventional cash flows Would jy The PV so determined is compar projects initial » Cf ce investment from = Y— + + - 00, the present Npv= G+Ky +KY (4) aa intons If cash outflow is also expected to occur at some time other than at initial investtnen, cash i : : discounted at] (non-conventional cash flows) the formula would be: the firm's cost of +W, 4 ©O, capital, = d+kyY +k" Sas+Ky 95) The decision rule for a project under NPV is to accept the project if the NPV is positive and reject if it is negative. Symbolically, (i) NPV > zero, accept, (i) NPV < zero, reject (9.6) Zero NPV implies that the firm is indifferent to accepting or rejecting the project. However, in prictice it is rare if ever such a project will be accepted, as such a situation simply. implies that only the original investment has been recovered™ In Example 9.6 we would accept the proposals of Purchasing machines A and B as theit net Present values are positive. The Positive NPV of machine A is 713,520 (R 69,645 — 256,125) and that of B is 715,396 71,521 — %56,125). In Example 9.6, if we incorporate cash outflows of %25,000 at the end of the third year in respect of overhauling of the machine, we shall find the proposals to purchase either of the machines ate Cone a 38 their net present values are negative. The Negative NPV of machine A is %6255 (68,645 — 374,900) and of machine B is %3,379 71,521 — 374,900). 4s a decision criterion, this method can also be used to make a choice between mutul exclusive projects. On the basis of the NPV method, the various proposals would be ranked it order of the net present values. The project with the highest NPV would be assigned the fist rank, followed by others in the descending order. If, in our example, a choice is to be made be rycen machine A and machine B on the basis of the NPV method, machine Is having larger NPY 315,396) would be preferred to machine A (NPV being 212,520), Evaluatie e : 7 fis and prota tn stan te NPV variation possesses sever met T money. In Example 9.6, for instance (Tal on the eat aPbeily recognises the time g tothe to machines (Wand B) se nee hae D, ihe total cash inflows (CFAT Cereal be LDL + Bi alu as well as the NPV is different. A¥ i ™ Tae ao ieee fale Of the differences in the pattern of the cash set as Metine Ais lower in the earlier years as comparedCapital Budgeting |: Principles and Techniques 9.35 e B while it is greater in the |, hine B whi a je latter years. Hex mac i Muse of Larger inflows in the first two years, ‘hee NPV of machine B ts larger than that of machine Ate . Vf H een aes oa A money is, thus, satisfied by this method egg ea 5 analy, it also fulfills the sceond attribute of eae eof sound method of appraisal in that it cc | benefits arising out of the proposal over its ee ihe to lifetime, till cae liscount rite can he built into the NPV calculations by altering, the denomi- nator, This feature becomes important as this rate normally changes hecause the longer the imme {pan, the lower is the value of money and the higher is the discount rate Fourthly. thi a 'S particularly useful for the selection of mutually exclusive projects. This ssed in detail in the latter part of the chapter, where it is shown that for mutu- s. the NPV method is the best decision-criterion 'sset selection is instrumental in achieving the objective of financial man- agement which is the maximisation of the shareholders’ wealth. The rationale behind this conten- rion is the effect on the market price of shares as a result of the acceptance of a proposal having present value exceeding the initial outlay or, as a variation having NPV greater than zero. The market price of the shares will be affected by the relative force of what the investors expect and what actual retum is earned on the funds. The discount rate that is used to convert benefits into present values is the minimum rate or the rate of interest is that when the present values of cash inflows is equal to the initial outlay or when the NPV = 0, the return on investment just equals the expected or required rate by investors. There would, therefore, be no change in the market price of shares. When the present value exceeds the outlay or the NPV > 0, the return would be higher than expected by the investors. It would, therefore, lead to an increase in share prices. The pres- ent value method is, thus, logically consistent with the goal of maximising shareholders’ wealth in tems of maximising the market price of the shares. In brief, the present value method is a theoretically correct technique for the selection of invest- ment projects. Nevertheless, it has certain limitations also. In the first place, it is difficult to calculate as well as understand and use in comparison with the pay back method or even the ARR method. This, of course, is a minor flaw. The second, and a more serious problem associated with the present value method, involves the calculation of the required rate of return to discount the cash flows. The discount rate is the m« important element used in the calculation of the present values because different discount rates wil give different present values. The relative desirability of a proposal will change with a change it the discount rate. For instance, for a proposal involving an initial outlay of %9,000, having annuit of 82,800 for 5 years, the net present values for different required rates of return are given in Tabl 9.12. ally exclusive Finally, this method of as TABLE 9.12 Net Present Value with Different Discount Rates Discount rate (per cent) Net present value 25,000.00 Ze , i 3,465.00 8 2,179.50 10 1,614.00 12 1,093.50 16 168.00 20 (626.50)6 Financial Management - : the calculatior of the discount rate 1; thus, obvious. But N Of the req The importance ' ih the Wired, serious problems. The cost of capital is generally the basis of the di ay ri : ee Cunt he cost of capital is very complicated. In fact, there is 4 difference ¢ he ¢ api F return presents : he calculation of aes itn he cle enact meno FCC A pola mea Mar peatcoming. of the present value metho i ASN. shortcoming : as higher pre i Another shoscont this method will favour the project which has higher present value oy ye" yetween two projects, ve a large i ja 7 ne Wey that this project may also involve @ larger initial outlay. Thus, in case of 5 ut itis " v0 oc Peeing diferent ouays, the present value method may Pot BE dependable resi i Finally, the present value method may also not give Sausi’e Fy F CE A tg having different effective lives. In general, the project with @ 8 horter economic life wey) preferable, ether things being equal. A project which has a higher present value may aly 5 larger economic life so that the funds will remain invested for a longer period, while the alters proposal may have shorter life but smaller present value. In such situations, the present value me, fay not reflect the true worth of the alternative proposals. Internal Rate of Return (IRR) Method The second discounted cash flow (DCF) oF time-adu method for appraising capital investment decisions is the intemal rate of return (IRR) method. technique is also known as yield on investment, marginal efficiency of capital, marginal produc of capital, rate of return, time-adjusted rate of return and so on. Like the present value method, & IRR method also considers the time value of money by discounting the cash streams. The bass the discount factor, however, is different in both cases. In the the discount rate is the required rate of return and bei e ¢ of the net present value meth ga predetermined rate, usually the ¢ capital, its determinants are external to the proposal under consideration. The IRR, on the ot hand, is based on facts which are intemal to the proposal. In other words, while arriving » required rate of return for finding out present values the cash flows—inflows as well as outlow— are not considered. But the IRR depends entirely on the initial outlay and the cash proceeds 0! project which is being evaluated for acceptance or rejection. It is, therefore, appropriately to as internal rate of return. Internal rate ofp, THe internal rate of return is usually the rate of return that a project em» ! return (IRR) defined as the discount rate (1) which equates the aggregate present value of is the discount} Cash inflows (CFAT) with the aggregate present value of cash outflows of 3 PO rate that equates, =" In a words, it is that rate which gives the project NPV of zero 1 present. suming conventional cash flows, mathe e esented values of cash} rate, r, such that : inflows with the initial investment 2 CK S, +W, associated with co,= 2 a 4 project, thereby causing NPV = 0 on Q+rY¥ (try Zero = § —S_, Sn + Wy ) + os) ier apy 6 For unconventional cash flows, the equation would by puld be: int 3 CO, oo Q4rk Geryr Gey mid + ry