MBAFM/BI/BE-6214

Financial Management
January-May: 2023

Dr. Shambhu Nath Singh

Associate Professor (Economics & Management)
Department of Banking, Economics & Finance,
Bundelkhand University, Jhansi
 Syllabus: Financial Management
 Unit I: Nature of Financial Management: Concepts and
Objectives of Financial Management; Approaches of
Financial Management.
 Unit II: Time Value of Money, Valuation of Securities, Risk
and Return, Beta Estimation, Cost of Capital.
 Unit III: Investment Analysis: Capital Budgeting Decisions,
Determining Cash Flow for Investment Analysis, Complex
Investment Decision and Risk Analysis in Capital Budgeting
 Unit IV: Capital Structure: Instruments of Long and short
term sources of funds, Capital Structure Theories, Leverages
Analysis, Dividend Theories and Policies
 Unit V: Working Capital Management Concepts and its
Types, Estimation of Working Capital, Determinants of
Working Capital, Credit Policy, Receivable Management,
Cash Management, Marketable Securities, Inventory
Management;
 Unit-3 Capital Budgeting Decision
Capital Budgeting: Nature of Investment
Decisions,
Tools and Techniques of Capital Budgeting,
Payback Period, Accounting Rate of Return,
Net Present Value, Internal Rate of Return,
Profitability Index,
NPV and IRR Comparison,
Capital Rationing and Complex Investment
Decision, and
Risk Analysis in Capital Budgeting;
 Capital Budgeting Decision
Capital budgeting is the process of
making investment decisions in capital
expenditure.
It is a process of long-term investment
decision of funds in which benefits are
expected over series of years.
For example- setting up of factories,
plant, machinery, and land and building
etc.
Need & Importance of Capital Budgeting
 Capital budgeting means planning for capital assets. Capital
budgeting decisions are vital to any organization as they
include the decisions as to-
1. Whether or not funds should be invested in long-term
project such as setting of an industry, purchase of plant &
machinery etc
2. To decide the replacement of permanent assets such as
building and equipments
 The need, significance or importance of capital budgeting
arises mainly due to the followings-
1. Large investments
2. Long term commitment of the funds
3. Irreversible in nature
4. Long term effect on profitability
5. Difficulties of investment decisions
 Capital Budgeting Process
 Capital budgeting is a complex process as it involve
decisions relating to the investment of current funds for
the benefit to the achieved in future and the future is
always uncertain. However the following procedure may
be adopted in the process of capital budgeting-
1. Identification of investment proposals
2. Screening the proposals
3. Evaluation of various proposals
4. Fixing priorities
5. Final approval and preparation of capital expenditure
budget
6. Implementing proposal
7. Performance Review
Tools & Techniques of Capital Budgeting
At each point of time, a business firm has a
number of proposals regarding various projects
in which it can invest funds, but the funds
available with the firm are always limited and
it is not possible to invest funds in all proposals
at a time.
Hence it is vary essential to select from
amongst the various competing proposals,
those which will give the highest benefits.
 There are many methods of evaluation
profitability of capital investment proposals.
Tools & Techniques of Capital Budgeting
Capital Budgeting Methods are divided into two
parts-
1. Unsophisticated or Traditional or Non discounted
Method: It may further divided in two parts-
a) Payback period
b) Accounting Rate of Return
2. Sophisticated or Time Adjusted or Discounted Cash
flow Method: It may further divided in four parts-
a) Net Present Value
b) Internal Rate of Return
c) Profitability Index
d) Terminal Value Method
 1- Pay Back Period
It can be defined as the number of years required to
recover the cost of the investment. It can be
calculated as follows-

Net earnings (profits) before depreciation and after

taxes are called cash inflows.
 Question 1
Calculate the Payback period from the following-
Particulars Project A Project B Project C
Initial Cash outflows ₹ 4, 00, 000 ₹ 3, 50, ₹ 2, 80,
000 000
Annual cash inflows ₹ 1, 00, 000 ₹ 1, 00, ₹ 1, 00,
after tax 000 000
Life of the project 5 5 5

(Ans: Project A-4 years; Project B-3.5 years and Project

C-2.8 years)
 Question 2
ABC limited provides you the following information-
Purchasing price of machine=₹ 1, 90, 000; instalment
expenses=₹ 10, 000; useful life of machine=5 years; salvage
value at the end of the useful life= nil; tax rate=30%.
You are required to calculate-
1. If earnings before depreciation and tax= ₹ 1, 00, 000 per
annum (Ans:2.439 years)
2. If earnings before tax=₹ 1, 00, 000 per annum (Ans:1.818
years)
3. If earnings after tax =₹ 1, 00, 000 (Ans:1.429 years)
4. If annual revenues are ₹ 4, 00, 000 and annual cash expenses
are ₹ 3, 00, 000 per annum (Ans:2.439 years)
 Solution of Question-2 (1)
Total investment= purchasing price+ instalment expenses
Total investment= ₹ 1, 90, 000+₹ 10, 000= ₹ 2,00, 000
Since the total life of the machine=5 years,
hence depreciation will be-

1-Given that Earnings before depreciation and tax= ₹ 1,00, 000

Earning after depreciation and before tax-
= ₹ 1,00, 000 - ₹ 40, 000= ₹ 60, 000
Earning after depreciation and after tax-
= ₹ 60, 000- ₹ 18, 000= ₹ 42, 000
Earning after tax but before depreciaiton-
=₹ 42, 000+ ₹ 40, 000= ₹ 82, 000
It is also known as cash inflow.
 Solution of Question-2 (2)
Total initial investment= ₹ 2, 00, 000; depreciation=40,000
Given that Earnings before tax= ₹ 1,00, 000
Therefore Earning after tax-
=₹ 1,00, 000- ₹ 30, 000= ₹ 70, 000
Earning after tax but before depreciaiton-
=₹ 70, 000+ ₹ 40, 000 = ₹ 1,10, 000
It is also known as cash inflow.
 Solution of Question-2 (3)
Total initial investment= ₹ 2,00, 000; depreciation=40,000
Given that Earnings after tax= ₹ 1,00, 000
Therefore earnings after tax but before depreciaiton-
=₹ 1,00, 000+ ₹ 40, 000= ₹ 1,40, 000
It is also known as cash inflow.

Solution 2 (4): as we know that annual revenue minus annual

expenses is equal to operating profit that is earnings before
depreciation and tax. Hence-
Operating profit=₹ 4,00, 000- ₹ 3,00, 000= ₹ 1,00, 000
It will become same as in first case of this question. Hence
answer and other calculation will be same.
 Question 3
A project cost is ₹1, 00, 000 and yields annual cash
inflows of ₹20, 000 for 8 years. Calculate its payback
period. (Ans: 5 years)

Solution: Given that initial investment= ₹ 1,00, 000 and

Cash-inflow=₹20, 000 per year
 Question 4
A project cost is ₹5, 00, 000 and yields annually profit of ₹80,
000 after depreciation 12% per annum but before tax of 50%.
Calculate payback period. (Ans: 5 years)
Solution: Given that initial investment= ₹ 5, 00, 000;
depreciation=12% of ₹ 5,00, 000 that is ₹ 60, 000 and profit
after depreciation but before tax is ₹ 80, 000. Hence, profit after
depreciation and tax will be-
=₹ 80, 000- ₹ 40, 000= ₹ 40, 000
By adding depreciation to get profit after tax but before
depreciation (Cash-inflow) =₹ 40, 000+ ₹ 60, 000= ₹ 1,00, 000
 Question 5
The initial investment of ₹ 20,000 and annual cash inflows for 5
years are ₹6, 000; ₹8, 000; ₹5, 000; ₹4, 000 and ₹4, 000
respectively. Calculate the payback period. (Ans: 3.25 years)
Solution: Given that initial investment= ₹ 20, 000; and
cashinflows are-
Years Year-1 Year-2 Year-3 Year-4 Year-5
Cashinflows ₹6, 000 ₹8, 000 ₹5, 000 ₹4, 000 ₹4, 000
Cumulative ₹6, 000 ₹14, 000 ₹19, 000 +₹1, 000
In year 4 cashinlow requir to cover the initial investment=₹1,
000 only. Hence
 2-Accounting/Average Rate of Return
The ARR (also known as return on investment or return
on capital employment) method employ the normal
accounting technique to measure the increase in profit
expected to result from an investment, the formula is
given by-
𝐀𝐑𝐑
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐚𝐧𝐝 𝐓𝐚𝐱𝐞𝐬
=
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
∗ 𝟏𝟎𝟎

𝐚𝐧𝐝, 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 + 𝐒𝐚𝐥𝐯𝐚𝐠𝐞 𝐕𝐚𝐥𝐮𝐞
=
𝟐

The value realised from the disposal of an asset is

known as salvage value. ARR method can be used as
accept or reject criteria. This method will accept all
projects, which have ARR greater than the minimum
rate.
 Question 6
Calculate the ARR for project A and B from the following information-
Particulars Project A Project B
Initial investment ₹20, 000 ₹30, 000
Expected life (no salvage value) 4 years 5 years
Project Net income (after interest, depreciation and taxes)
years 1 2 3 4 5
Project A ₹2, 000 ₹1, 500 ₹1, 500 ₹1, 000 --
Project B ₹3, 000 ₹3, 000 ₹2, 000 ₹1, 000 ₹1, 000
If the required rate of return is 12%. Which project should be undertaken?
(Ans: Project A should be undertaken)
 Solution of Question-6
Particulars Project A Project B
Total profit (after int.; ₹ 6, 000 ₹ 10, 000
dep.& tax)
Average annual 6000/4= ₹1, 10000/5=₹2,
profit=TP/no.of years 500 000
Net investment on ₹ 20, 000 ₹ 30, 000
project
𝐀𝐑𝐑 𝐀𝐑𝐑 𝐀𝐑𝐑
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐚𝐧𝐧𝐮𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭 𝟏, 𝟓𝟎𝟎 ∗ 𝟏𝟎𝟎 𝟐, 𝟎𝟎𝟎 ∗ 𝟏𝟎𝟎
= = =
𝐧𝐞𝐭 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝟐𝟎, 𝟎𝟎𝟎 𝟑𝟎, 𝟎𝟎𝟎
∗ 𝟏𝟎𝟎
--- ARR=7.5% ARR=6.66%
ARR on average 𝐀𝐑𝐑 𝐀𝐑𝐑
investment 𝟏, 𝟓𝟎𝟎 ∗ 𝟏𝟎𝟎 𝟐, 𝟎𝟎𝟎 ∗ 𝟏𝟎𝟎
= =
𝟐𝟎, 𝟎𝟎𝟎/𝟐 𝟑𝟎, 𝟎𝟎𝟎/𝟐
--- ARR=15% ARR=13.33%
Since both projects have ARR more than the
required rate of return based on average
investment. Hence, both may be selected. However,
if we have to select only one, hence we go for
higher ARR that is project A.
 3-Net Present Value
NPV is the difference between discounted cash inflows
over year and initial investment.

𝐍𝐏𝐕 = 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐂𝐚𝐬𝐡𝐟𝐥𝐨𝐰 𝐨𝐯𝐞𝐫 𝐲𝐞𝐚𝐫

− 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝐧
𝐂. 𝐅𝐭
𝐍𝐏𝐕 = − 𝐂𝟎
(𝟏 + 𝐫)𝐭
𝐭=𝟏

Where CFt= Net cash inflow in time period t

r=rate of discount; C0=Initial Cash out lay and n=life of
the project
The, NPV method is the process of calculating the
present value of cash flows (inflows and outflows) of an
investment proposal, using opportunity cost of capital
as appropriate discounting rate, and finding out the
NPV by subtracting out the present value of cash
outflows from the present value of cash inflows. Thus,
𝐍𝐏𝐕 > 𝟏 𝐨𝐫 𝐏𝐨𝐬𝐢𝐭𝐢𝐯𝐞; 𝐒𝐞𝐥𝐞𝐜𝐭 𝐭𝐡𝐞 𝐩𝐫𝐨𝐣𝐞𝐜𝐭
𝐍𝐏𝐕 = 𝟎 𝐨𝐫 𝐙𝐞𝐫𝐨;
𝐢𝐧𝐝𝐢𝐟𝐟𝐞𝐫𝐞𝐧𝐭 𝐬𝐢𝐭𝐮𝐚𝐭𝐢𝐨𝐧 𝐞𝐢𝐭𝐡𝐞𝐫 𝐒𝐞𝐥𝐞𝐜𝐭 𝐨𝐫 𝐫𝐞𝐣𝐞𝐜𝐭 𝐭𝐡𝐞 𝐩𝐫𝐨𝐣𝐞𝐜𝐭
𝐍𝐏𝐕 < 𝟏 𝐨𝐫 𝐍𝐞𝐠𝐚𝐭𝐢𝐯𝐞; 𝐑𝐞𝐣𝐞𝐜𝐭 𝐭𝐡𝐞 𝐩𝐫𝐨𝐣𝐞𝐜𝐭
 Question 7
From the following information, calculate NPV of two projects and
suggest which of the two projects should be accepted assuming
discounting rate of 10%-
Particulars Project A Project B
Initial investment ₹ 20, 000 ₹ 30, 000
Estimated life 5 years 5 years
Scrap value ₹ 1, 000 ₹ 2, 000
Cash flows (profit before depreciation after taxes) are as follows-
Years 1 2 3 4 5
Project A ₹ 5, 000 ₹ 10, 000 ₹ 10, 000 ₹ 3, 000 ₹ 2, 000
Project B ₹ 20, 000 ₹ 10, 000 ₹ 5, 000 ₹ 3, 000 ₹ 2, 000
 Solution of Question-7
we know that net present value is-
𝐧
𝐂. 𝐅𝐭
𝐍𝐏𝐕 = − 𝐂𝟎
(𝟏 + 𝐫)𝐭
𝐭=𝟏
𝐍𝐏𝐕 𝐨𝐟 𝐩𝐫𝐨𝐣𝐞𝐜𝐭 𝐀
𝟓, 𝟎𝟎𝟎 𝟏𝟎, 𝟎𝟎𝟎 𝟏𝟎, 𝟎𝟎𝟎 𝟑, 𝟎𝟎𝟎 𝟐, 𝟎𝟎𝟎
= + + + +
(𝟏. 𝟏𝟎) (𝟏. 𝟏𝟎)𝟐 (𝟏. 𝟏𝟎)𝟑 (𝟏. 𝟏𝟎)𝟒 (𝟏. 𝟏𝟎)𝟓
𝟏, 𝟎𝟎𝟎
+ − 𝟐𝟎, 𝟎𝟎𝟎
(𝟏. 𝟏𝟎)𝟓
𝐍𝐏𝐕 𝐨𝐟 𝐏𝐫𝐨𝐣𝐞𝐜𝐭 𝐀 = ₹ 𝟒, 𝟐𝟐𝟕
𝐍𝐏𝐕 𝐨𝐟 𝐩𝐫𝐨𝐣𝐞𝐜𝐭 𝐁
𝟐𝟎, 𝟎𝟎𝟎 𝟏𝟎, 𝟎𝟎𝟎 𝟓, 𝟎𝟎𝟎 𝟑, 𝟎𝟎𝟎 𝟐, 𝟎𝟎𝟎
= + + + +
(𝟏. 𝟏𝟎) (𝟏. 𝟏𝟎)𝟐 (𝟏. 𝟏𝟎)𝟑 (𝟏. 𝟏𝟎)𝟒 (𝟏. 𝟏𝟎)𝟓
𝟐, 𝟎𝟎𝟎
+ − 𝟑𝟎, 𝟎𝟎𝟎
(𝟏. 𝟏𝟎)𝟓
𝐍𝐏𝐕 𝐨𝐟 𝐏𝐫𝐨𝐣𝐞𝐜𝐭 𝐁 = ₹ 𝟒, 𝟕𝟐𝟖
Here we can see that the NPV of project B is higher than
project A. Hence, it is suggested that project B should be
selected.
 Question 8
ABC ltd is considering the purchase of the two
machines. The related details are given as follows-
Particulars Machine X Machine Y
Life of the machine 3 years 3 years
Initial investment ₹ 1, 00, 000 ₹ 1, 00, 000
Year 1 ₹ 80, 000 ₹ 20, 000
Cash Year 2 ₹ 60, 000 ₹ 70, 000
inflows Year 3 ₹ 40, 000 ₹ 1, 00, 000
Estimate the profitability of these two machines by
using Pay back methods and NPV methods
assuming the discount rate is 10%.
 Solution of Question-8
we know that net present value is-
𝐧
𝐭
𝐭 𝟎
𝐭=𝟏

𝟐 𝟑

𝟐 𝟑

Since the NPV of machine X is greater than the machine Y. Hence,

machine X should be selected on the basis of NPV.

On the basis of PBP machine X should be seleced.

 Question 9
Cash inflows and cash outflows of a project are given below-
Years 0 1 2 3 4 5
Cash ₹ 15, ₹ 3, 000 --- --- --- ---
outflows 000
Cash inflows --- ₹ 2, 000 ₹ 3, ₹ 6, ₹ 8, 000 ₹ 3, 000
000 000
The salvage value at the end of the 5th year is ₹ 4, 000. The cost of
capital is 10%. Is the investment is desirable? Discuss it on the
basis of NPV.
 Solution of Question-9
we know that net present value is-

Since NPV of the given project is positive. Hence,

the investment in this would be desirable.
 4-Internal Rate of Return
It may be defined as the rate at which the value of
NPV is zero, or it is the discount rate at which the
aggregate present value of net cash inflows is
equal to the aggregate present value of cash out
flows. It is also known as yield on investment or
marginal productivity of capital or marginal
efficiency of capital. Since NPV=0; therefore-
𝐧
𝐂. 𝐅𝐭
= 𝐂𝟎
(𝟏 + 𝐫)𝐭
𝐭=𝟏

Where symbols have their usual meanings

Using the NPV formula, find two values of r for
which one NPV is positive and the other r for
which NPV is negative and use the following to
find the appropriate IRR-
𝐏𝐨𝐬𝐢𝐭𝐢𝐯𝐞 𝐍𝐏𝐕 𝐚𝐭 @ 𝐫𝐋
𝐈𝐑𝐑 = 𝐫𝐋 % + ∗ (𝐫𝐇 − 𝐫𝐋 )
𝐏𝐕 @ 𝐫𝐋 − 𝐏𝐕 @ 𝐫𝐇
NPV method is the most superior investment
criteria as it always consistent with the wealth
maximization principle.
 Question 10 and its Solution
A company has to select one of the following two projects-
Particulars costs CI in year 1 CI in year CI in year CI in year
2 3 4
Project A ₹ 11,000 ₹ 6,000 ₹ 2,000 ₹ 1,000 ₹ 5,000
Project B ₹ 10,000 ₹ 1,000 ₹ 1,000 ₹ 2,000 ₹ 10,000
Using IRR method, suggest which project is preferable? (Ans: IRR for
Project A=11.33% and IRR for project B=10.24%)
Solution: For Project A
As we know that the rate at which net present value is zero, will be the
𝐧 𝐂.𝐅𝐭
IRR. Let us suppose r=10% then 𝐭=𝟏 (𝟏+𝐫)𝐭 𝟎

𝟐 𝟑 𝟒
 Question 10 and its Solution

Similarly, we will the IRR for project B; then we will compare

the IRR of project A and B. Finally, the project, which has
higher the IRR, will be selected for the investment.
 Question 10 and its Solution
𝐧 𝐂.𝐅𝐭
For Project B: Let us suppose r=10% then 𝐭=𝟏 (𝟏+𝐫)𝐭 𝟎

𝟐 𝟑 𝟒

𝟐 𝟑 𝟒

𝐇 𝐋
𝐋
𝐋 𝐇 𝐋
𝐋 𝐇
 Question 11 and its Solution
Calculate the IRR from the following cash flows-
Years 0 1 2 3 4 5
CFATs (₹) -₹90,000 ₹20,000 ₹25,000 ₹27,000 ₹30,000 ₹35,000
(Ans: IRR=14.44%)
Solution: As we know that the rate at which net present value is zero, will
𝐂.𝐅
be the IRR. Let us suppose r=10% then 𝐍𝐏𝐕 = ∑𝐧 𝐭
𝐭=𝟏 (𝟏+𝐫)𝐭 − 𝐂𝟎

𝟐𝟎, 𝟎𝟎𝟎 𝟐𝟓, 𝟎𝟎𝟎 𝟐𝟕, 𝟎𝟎𝟎 𝟑𝟎, 𝟎𝟎𝟎 𝟑𝟓, 𝟎𝟎𝟎
𝐍𝐏𝐕 = + + + + − 𝟗𝟎, 𝟎𝟎𝟎
(𝟏. 𝟏𝟎) (𝟏. 𝟏𝟎)𝟐 (𝟏. 𝟏𝟎)𝟑 (𝟏. 𝟏𝟎)𝟒 (𝟏. 𝟏𝟎)𝟓
𝐍𝐏𝐕 = ₹ 𝟏𝟏, 𝟑𝟓𝟎 𝐢. 𝐞. 𝐏𝐎𝐒𝐈𝐓𝐈𝐕𝐄
Since we find positive NPV at r=10%, then we need to find next Negative NPV which
we could be found at r=15%, hence
𝟐𝟎, 𝟎𝟎𝟎 𝟐𝟓, 𝟎𝟎𝟎 𝟐𝟕, 𝟎𝟎𝟎 𝟑𝟎, 𝟎𝟎𝟎 𝟑𝟓, 𝟎𝟎𝟎
𝐍𝐏𝐕 = + + + + − 𝟗𝟎, 𝟎𝟎𝟎
(𝟏. 𝟏𝟓) (𝟏. 𝟏𝟓)𝟐 (𝟏. 𝟏𝟓)𝟑 (𝟏. 𝟏𝟓)𝟒 (𝟏. 𝟏𝟓)𝟓
𝐍𝐏𝐕 𝐨𝐟 𝐏𝐫𝐨𝐣𝐞𝐜𝐭 𝐀 = ₹ − 𝟏𝟑𝟗𝟖 𝐢. 𝐞. 𝐍𝐄𝐆𝐀𝐓𝐈𝐕𝐄
𝐡𝐞𝐧𝐜𝐞 𝐫𝐇 = 𝟏𝟓% 𝐚𝐧𝐝 𝐫𝐋 = 𝟏𝟎%
𝐏𝐨𝐬𝐢𝐭𝐢𝐯𝐞 𝐍𝐏𝐕 𝐚𝐭 @ 𝐫𝐋
𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐈𝐑𝐑 = 𝐫𝐋 % + ∗ (𝐫𝐇 % − 𝐫𝐋 %)
𝐏𝐕 @ 𝐫𝐋 − 𝐏𝐕 @ 𝐫𝐇
+𝟏𝟏, 𝟑𝟓𝟎
𝐈𝐑𝐑 = 𝟏𝟎% + ∗ (𝟏𝟓 − 𝟏𝟎) = 𝟏𝟒. 𝟒𝟓%
+𝟏𝟏𝟑𝟓𝟎 − (−𝟏𝟑𝟗𝟖)
 5-Profitability Index
It is the present value of anticipated future cash inflows divided by
the initial outlay. Thus-

It is also known as cash benefit ratio or desirability ratio method.

Question 12: The initial out lay of a project is ₹ 50,000 and it

generates cash inflows of ₹ 20,000; ₹ 15,000; ₹ 25,000 and ₹ 10,000
in four years. Using profitability index, appraise profitability of the
proposed investment assuming 10% rate of discount.
 Solution of Question-12
As we know that, the PV of the given cashinflows may be
calculated by-

Since PI of the given cashinflows with outflow is greater than 1,

hence the project may be selected.
 Question 13 and its Solution
The following mutually exclusive projects can be considered-
Particulars Project A Project B
PV of cash inflows ₹ 20,000 ₹ 8,000
Initial investment ₹ 15,000 ₹ 5,000
Which project should be selected by NPV and PI methods?
Solution:

Particulars Project A Project B

PV of cash inflows ₹ 20,000 ₹ 8,000
Initial investment ₹ 15,000 ₹ 5,000
Net Present Value ₹ 5,000 ₹ 3,000
Profitability Index 1.33 1.66
Analysis: Based on NPV, the project A should be selected while based
on PI, the project B should be selected. So as per availability of funds
or requirement, the financial manager can take the decision.
 6-Terminal Value Method
Under this method, it is assumed that each cash inflows are
reinvested in another project at a predetermined rate of interest. It
is also assumed that each cash inflows are reinvested
immediately until the termination of the project. The present value
of total of the compounded reinvested cash inflows-

Question 14: Initial outlay= ₹ 8,000; life of the project 3 years;

cash inflows=₹ 4,000 per annum for 3 years; cost of capital=10%;
expected interest rate at which cash inflows will be
reinvested=8% for each year. Analyse the project whether it
should be accepted or not?
 Solution of Question-14
Solution 14: The steps of terminal value method may be as follows-

The present value of total of the compounded reinvested cash inflows-

Since the present value of total of the compounded reinvested cash

inflows is greater than the initial outlay i.e. ; hence the
project may be accepted.
 Question-15 & its Solution
Question 15: The following information is related to a project –
Initial outlay=₹20, 000; life of the project 4 years; cash inflows ₹ 10, 000 for 4
years per annum and cost of capital=12%. The expected rate of interest at
which cash inflows will reinvest-
End of the year 1 2 3 4
R% 7% 7% 9% 9%
You are required to analyse the feasibility of the project using terminal value
method.

Solution 15: The steps of terminal value method may be as follows-

𝐂𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐞𝐝 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬 = 𝟏𝟎, 𝟎𝟎𝟎 ∗ (𝟏. 𝟎𝟕)𝟑 + 𝟏𝟎, 𝟎𝟎𝟎 ∗ (𝟏. 𝟎𝟕)𝟐 +
𝟏𝟎, 𝟎𝟎𝟎 ∗ (𝟏. 𝟎𝟗)𝟏 + 𝟏𝟎, 𝟎𝟎𝟎
𝐂𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐞𝐝 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬 = ₹𝟒𝟒, 𝟓𝟗𝟗

The present value of total of the compounded reinvested cash inflows-

𝐂𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐞𝐝 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬 ₹𝟒𝟒, 𝟓𝟗𝟗
= = = ₹𝟐𝟖, 𝟑𝟒𝟑
(𝟏 + 𝐫%)𝐧 (𝟏. 𝟏𝟐)𝟒
Since the present value of total of the compounded reinvested cash inflows
is greater than the initial outlay i.e. ₹𝟐𝟖, 𝟑𝟒𝟑 > ₹20,000; hence the project
may be accepted.
 Question-16 & its Solution
Question 16: Cost of investment=₹ 20,000; economic life 5 years; cash
inflows =₹ 8,000 each for 5 years; cost of capital may be taken 10%; cash
inflows will reinvest at the following expected rate of return-
End of the year 1 2 3 4 5
R% 6% 6% 8% 8% 8%
Using terminal value method, evaluate the proposal.

Solution 16: The steps of terminal value method may be as follows-

𝐂𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐞𝐝 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬 = 𝟖, 𝟎𝟎𝟎 ∗ (𝟏. 𝟎𝟔)𝟒 + 𝟖, 𝟎𝟎𝟎 ∗ (𝟏. 𝟎𝟔)𝟑 +
𝟖, 𝟎𝟎𝟎 ∗ (𝟏. 𝟎𝟖)𝟐 + 𝟖, 𝟎𝟎𝟎 ∗ (𝟏. 𝟎𝟖)𝟏 + 𝟖, 𝟎𝟎𝟎
𝐂𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐞𝐝 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬 = ₹𝟒𝟓, 𝟓𝟗𝟗

The present value of total of the compounded reinvested cash inflows-

𝐂𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐞𝐝 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬 ₹𝟒𝟓, 𝟓𝟗𝟗
= = = ₹𝟐𝟖, 𝟑𝟏𝟑
(𝟏 + 𝐫%)𝐧 (𝟏. 𝟏𝟎)𝟓
Since the present value of total of the compounded reinvested cash
inflows is greater than the initial outlay i.e. ₹𝟐𝟖, 𝟑𝟏𝟑 > ₹𝟐𝟎, 𝟎𝟎𝟎; hence the
project may be accepted.
 Capital Rationing
Capital rationing situation is said to be exist, if –
1. Limited funds are available for investment
2. More than one financially viable project,
which is not mutually exclusive, is under
consideration.
Capital rationing is a process whereby limited
funds available are allocated amongst the
financially viable projects, which are not mutually
exclusive under consideration to maximize the
wealth of shareholders.
 Risk Analysis in Capital Budgeting
Risk is associated with the variability of future returns of a project.
The greater is the variability of expected return, greater will the
risk of the project. The most common measures of risk are
standard deviation and coefficient of variation. Risk measurement
is the process of measuring risk and developing strategies to
manage it. The important techniques for risk analysis are as
follows-
1. Standard Deviation and Coefficient of Variation
2. Projected Beta
3. Probability Analysis
4. Sensitivity Analysis
5. Simulation
 1- Standard Deviation and Coefficient of Variation
It is a statistical technique used in capital budgeting decision to
determine the variation from the mean of cash inflows of the
projects. Lesser the standard deviation of cash inflows means less
risk and uncertainty of the project.
Risk is measured by the possible variation of outcomes around the
expected value. If the cash outflows and life of the projects are the
same, then standard deviation is used for the selection. However, if
life of the project and their cash outflows differ, then selection of
the project is done by coefficient of variation instead of standard
deviation. The basic assumption under this method is that
probability distribution of cash flows is approximately normal. If
higher the CV, more risky the project;

∑(𝐑−𝐑)𝟐
𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧 = ; 𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞 = 𝛔𝟐
𝐍
𝛔
𝐂𝐨𝐞𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐭 𝐨𝐟 𝐕𝐚𝐫𝐢𝐚𝐭𝐢𝐨𝐧 = ∗ 𝟏𝟎𝟎
𝐗
 2- Projected Beta
Risk is defined as the variability of returns. It is divided into two
categories i.e. business risk and financial risk. The first one is
concerned with operating leverage while second is concerned with
financial leverage. Another source of beta is revenue cycle of the
firm. It is an expression of market sensitivity of the project.
Situation Revenue Operating Financial Projected
Cycle leverage leverage beta
First High High High β˃1
Second Average Average Average β=1
Third Low Low Low β˂1
 3- Probability Analysis
The most crucial information for capital budgeting decision is a
forecasting of future cash flows. The whole theory of probability
is based on the following three axioms-
1. The value of probability lies between 0 to 1;
2. The value of probability of entire sample space is one.
3. If A and B are two mutually exclusive events, then the
probability of occurrence of either A or B is given by-
 4-Sensitivity Analysis & 5-Simulation
Sensitivity Analysis: It is the way of analysing change in project’s
NPV (or IRR) for a given change in the variables. It indicates how
sensitive a project NPV (or IRR) is to changes in particular
variable. The following three steps involved in the use of this
method-
1. Identify all the variables
2. Define the variables
3. Analyse the impact of variables.
Simulation: In this method, the interaction among the variables
and the probabilities of changes in the variables are considered.
It is based on random numbers and probability distribution. It is
very useful technique in risk analysis like production,
scheduling, inventory problem, investment problems, queuing
problems and work force decisions etc
 Unit 3 is over.
Thank You so much....

Dr. Shambhu Nath Singh