Reading Unit II

DELHI SCHOOL OF ECONOMICS
DEPARTMENT OF ECONOMICS
Minutes of Meeting
Subject: B.A. (Prog) Economics Discipline, Sixth Semester (CBCS)
Course: Basic Computational Techniques for Data Analysis: Skill-Enhancement Elective
Courses (SEC) - Credit: 4
Date: 29th December, 2021
Venue: Online
Convener: Prof. Rohini Somanathan
The course meeting was attended by following teachers:

1. Prof. Rohini Somanathan - Convenor
2. Dr Devesh Birwal- Co-Convenor
3. Dr Renu Kumari Verma – Motilal Nehru College Evening
4. Dr Enakshi Sinha Ray Chaudhary – Rajdhani college
5. Dr Appala Naidu – ARSD College
6. Dr Promila Sehrawat- Aditi Mahavidyalaya
7. Loveleen Gupta- Bharti College
8. Abhinav Parashar – Sri Aurobindo College Evening
9. Shweta nanda- ARSD College
10. Ajay Gupta- Shyamlal College Evening
11. Rakesh Kumar – ARSD College
12. Akanksha Saini – Kamla Nehru College
13. Akshay Garg- PGDAV College
14. Bhavna Seth – Dyal Sigh College
15. Swarup Santra-Satyawati College
16. Suneyana Sharma – Ram Lal Anand College
17. Kapil Dev Yadav- LSR
18. Vickey Mahariya – Maharaja Agrasen College
19. Dushyant Tyagi-Zakir Hussain Delhi College Evening
20. Abhishek Jaiswal- SPM College
21. Arun Kumar-DCAC
22. Md Irfan Alam-Shivaji College
23. Manvi Jain- IP College for Women
24. Sharad Ranjan-ZHCCE
25. Komal Garg
26. Nimisha Chauhan
27. Sumit Singh
28. Nidhi Gupta
Decisions:
1. No changes were made to the reading list of set of topics covered.
2. For project work and internal assessment, the R programme can be used instead of
excel.
Purpose / Objective of the paper:
The main purpose of this Skill Enhancement Course (SEC) in Economics is to provide B.A.
Program students with hands-on experience in developing skills in statistical techniques
involving computer applications. The course would enable students to become familiar with
different data sources relating to various aspects of the economy, with estimation of simple
relationship between economic variables, and with interpretation of the estimation results.
This course is an extension of the previous semester’s course SEC: Data Analysis, which is a
perquisite for taking this course. This course develops computational skills based on the
knowledge of Statistics developed in the previous semester. Along with the previous semester’s
SEC papers (i.e. ‘Understanding the Economic Survey and the Union Budget’, ‘Research
Methodology’ and ‘Data Analysis’), this course aims to equip students with the ability to
undertake basic research projects pertaining to the Indian economy, which in turn, would prove
helpful in a variety of professions.
Course outline:
Unit -1
Introduction to MS Excel: Spreadsheet basics and inputting of data, word processing and
presentation of data using graphs and tables.
Unit - II
a) Review of concepts (i) Measures of Central Tendency - Mean, Median and Mode;
Arithmetic Mean, Geometric Mean and Harmonic Mean; (ii) Measures of Dispersion –
Standard Deviation and Variance; (iii) Skewness; (iv) Kurtosis.
b) Introduction to calculation of financial formulae, net present value (NPA), internal rate
of return, future value, Equated monthly instalment (EMI), computed growth rate.
c) Using spreadsheet to perform the above mathematical/statistical/financial functions.
Unit III
a) Review of the concept of Correlation and Rank Correlation.
b) Introduction to simple Ordinary Least Squares (OLS) in two variable case (one
dependent and one explanatory variable); Testing of hypotheses related to regression
coefficients; Goodness of fit (𝑅 ); Reporting the estimation results.
c) Using of MS Excel/GRETL (Free ware) for above.
Unit IV
Introduction to economic and business data sets available in the public domain, such as from
the NSE, BSE, RBI, MOSPI, etc.
Any of these datasets may be used for demonstrating the statistical concepts studied in the
course
Unit V
Preparation of a project report based on data available in the public domain, using concepts
studied in units II and III.
References:
1. Spreadsheet-Microsoft office/Open office manual.
2. GRETL-Manual.
3. P.H. Karmel and M. Polasek (1978), Applied Statistics for Economists, 4th edition,
Pitman.
4. M.R. Spiegel, L.J. Stephens and N. Kumar (2010), Statistics, 4th edition, Schaum
Series, McGraw Hill
Marking scheme:
1. Internal assessment of 25 marks, comprising:
(a) 5 marks for attendance,
(b) 10 marks for written test,
(c) 10 marks for computer based test
2. End Semester assessment of 75 marks, comprising: (a) 25 marks for project based on
Unit V, to be submitted before the final exam, and (b) 50 marks for a written final exam,
which will include one compulsory question based on interpreting computer output
related to OLS. Questions in the final exam will be based on only Unit 1 to IV.
The Mean, Median,
Mode, and Other
Measures of
Central Tendency
INDEX, OR SUBSCRIPT, NOTATION

Let the symbol Xj (read ‘‘X sub j’’) denote any of the N values X1 , X2 , X3 , . . . , XN assumed by a
variable X. The letter j in Xj , which can stand for any of the numbers 1, 2, 3, . . . , N is called a subscript,
or index. Clearly any letter other than j, such as i, k, p, q, or s, could have been used as well.
SUMMATION NOTATION
P
The symbol Nj¼1 Xj is used to denote the sum of all the Xj ’s from j ¼ 1 to j ¼ N; by definition,
X
N
Xj ¼ X1 þ X2 þ X3 þ þ XN
j¼1
P P P P
When no confusion can result, we often denote this sum simply by X, Xj , or j Xj . The symbol
is the Greek capital letter sigma, denoting sum.
X
N
EXAMPLE 1. Xj Yj ¼ X1 Y1 þ X2 Y2 þ X3 Y3 þ þ XN YN
j¼1
X
N X
N
EXAMPLE 2. aXj ¼ aX1 þ aX2 þ þ aXN ¼ aðX1 þ X2 þ þ XN Þ ¼ a Xj
j¼1 j¼1
P P
where a is a constant. More simply, aX ¼ a X.
P P P P
EXAMPLE 3. If a, b, and c are any constants, then ðaX þ bY cZÞ ¼ a Xþb Yc Z. See Problem 3.3.
61
Copyright © 2008, 1999, 1988, 1961 by The McGraw-Hill Companies, Inc. Click here for terms of use.
62 MEASURES OF CENTRAL TENDENCY [CHAP. 3
AVERAGES, OR MEASURES OF CENTRAL TENDENCY

An average is a value that is typical, or representative, of a set of data. Since such typical values tend
to lie centrally within a set of data arranged according to magnitude, averages are also called measures of
central tendency.
Several types of averages can be defined, the most common being the arithmetic mean, the median,
the mode, the geometric mean, and the harmonic mean. Each has advantages and disadvantages, depend-
ing on the data and the intended purpose.
THE ARITHMETIC MEAN

The arithmetic mean, or briefly the mean, of a set of N numbers X1 , X2 , X3 , . . . , XN is denoted by X
(read ‘‘X bar’’) and is defined as
X
N
Xj P
X þ X2 þ X3 þ þ XN X
X ¼ 1
j¼1
¼ ¼ ð1Þ
N N N
EXAMPLE 4. The arithmetic mean of the numbers 8, 3, 5, 12, and 10 is

8 þ 3 þ 5 þ 12 þ 10 38
X ¼ ¼ ¼ 7:6
5 5
If the numbers X1 , X2 , . . . , XK occur f1 , f2 , . . . , fK times, respectively (i.e., occur with frequencies
f1 , f2 , . . . , fK ), the arithmetic mean is
XK
fj Xj P P
f X þ f X þ þ f X fX fX
X ¼
j¼1
1 1 2 2 K K
¼ K ¼ P ¼ ð2Þ
f1 þ f2 þ þ fK X f N
fj
P j¼1
where N ¼ f is the total frequency (i.e., the total number of cases).
EXAMPLE 5. If 5, 8, 6, and 2 occur with frequencies 3, 2, 4, and 1, respectively, the arithmetic mean is
ð3Þð5Þ þ ð2Þð8Þ þ ð4Þð6Þ þ ð1Þð2Þ 15 þ 16 þ 24 þ 2
X ¼ ¼ ¼ 5:7
3þ2þ4þ1 10
THE WEIGHTED ARITHMETIC MEAN

Sometimes we associate with the numbers X1 , X2 , . . . , XK certain weighting factors (or weights)
w1 , w2 , . . . , wK , depending on the significance or importance attached to the numbers. In this case,
P
w1 X1 þ w2 X2 þ þ wK Xk wX
X¼ ¼ P ð3Þ
w1 þ w2 þ þ wK w
is called the weighted arithmetic mean. Note the similarity to equation (2), which can be considered a
weighted arithmetic mean with weights f1 , f2 , . . . , fK .
EXAMPLE 6. If a final examination in a course is weighted 3 times as much as a quiz and a student has a final
examination grade of 85 and quiz grades of 70 and 90, the mean grade is
ð1Þð70Þ þ ð1Þð90Þ þ ð3Þð85Þ 415
X ¼ ¼ ¼ 83
1þ1þ3 5
CHAP. 3] MEASURES OF CENTRAL TENDENCY 63
PROPERTIES OF THE ARITHMETIC MEAN

1. The algebraic sum of the deviations of a set of numbers from their arithmetic mean is zero.
EXAMPLE 7. The deviations of the numbers 8, 3, 5, 12, and 10 from their arithmetic mean 7.6 are 8 7:6, 3 7:6,
5 7:6, 12 7:6, and 10 7:6, or 0.4, 4:6, 2:6, 4.4, and 2.4, with algebraic sum 0:4 4:6 2:6 þ 4:4 þ 2:4 ¼ 0.
2. The sum of the squares of the deviations of a set of numbers Xj from any number a is a minimum if
and only if a ¼ X (see Problem 4.27).
3. If f1 numbers have mean m1 , f2 numbers have mean m2 , . . . , fK numbers have mean mK , then the
mean of all the numbers is
f m þ f2 m 2 þ þ fK m K
X ¼ 1 1 ð4Þ
f1 þ f2 þ þ fK
that is, a weighted arithmetic mean of all the means (see Problem 3.12).
4. If A is any guessed or assumed arithmetic mean (which may be any number) and if dj ¼ Xj A are the
deviations of Xj from A, then equations (1) and (2) become, respectively,
X
N
dj P
d
X ¼ A þ
j¼1
¼Aþ ð5Þ
N N
X
K
f j dj P
fd
X ¼ A þ
j¼1
¼Aþ ð6Þ
X
K N
fj
j¼1
P P
where N ¼ K j¼1 fj ¼ f . Note that formulas (5) and (6) are summarized in the equation
X ¼ A þ d (see Problem 3.18).
THE ARITHMETIC MEAN COMPUTED FROM GROUPED DATA

When data are presented in a frequency distribution, all values falling within a given class interval
are considerd to be coincident with the class mark, or midpoint, of the interval. Formulas (2) and (6) are
valid for such grouped data if we interpret Xj as the class mark, fj as its corresponding class frequency, A
as any guessed or assumed class mark, and dj ¼ Xj A as the deviations of Xj from A.
Computations using formulas (2) and (6) are sometimes called the long and short methods, respec-
tively (see Problems 3.15 and 3.20).
If class intervals all have equal size c, the deviations dj ¼ Xj A can all be expressed as cuj , where uj
can be positive or negative integers or zero (i.e., 0, 1, 2, 3, . . .), and formula (6) becomes
0 1
X
K
B fj uj C P
@ j¼1 A fu
X ¼ A þ ¼Aþ c ð7Þ
N N
which is equivalent to the equation X ¼ A þ c u (see Problem 3.21). This is called the coding method for
computing the mean. It is a very short method and should always be used for grouped data where the
class-interval sizes are equal (see Problems 3.22 and 3.23). Note that in the coding method the values of
the variable X are transformed into the values of the variable u according to X ¼ A þ cu.
THE MEDIAN
The median of a set of numbers arranged in order of magnitude (i.e., in an array) is either the middle
value or the arithmetic mean of the two middle values.
EXAMPLE 8. The set of numbers 3, 4, 4, 5, 6, 8, 8, 8, and 10 has median 6.
EXAMPLE 9. The set of numbers 5, 5, 7, 9, 11, 12, 15, and 18 has median 12 ð9 þ 11Þ ¼ 10.
For grouped data, the median, obtained by interpolation, is given by

0 P 1
N
ð f Þ1
B C
Median ¼ L1 þ @ 2 Ac ð8Þ
fmedian
where L1 ¼ lower class boundary of the median class (i.e., the class containing the median)
P N ¼ number of items in the data (i.e., total frequency)
ð f Þ1 ¼ sum of frequencies of all classes lower than the median class
fmedian ¼ frequency of the median class
c ¼ size of the median class interval
Geometrically the median is the value of X (abscissa) corresponding to the vertical line which divides
a histogram into two parts having equal areas. This value of X is sometimes denoted by X. ~
THE MODE
The mode of a set of numbers is that value which occurs with the greatest frequency; that is, it is the
most common value. The mode may not exist, and even if it does exist it may not be unique.
EXAMPLE 10. The set 2, 2, 5, 7, 9, 9, 9, 10, 10, 11, 12, and 18 has mode 9.
EXAMPLE 11. The set 3, 5, 8, 10, 12, 15, and 16 has no mode.
EXAMPLE 12. The set 2, 3, 4, 4, 4, 5, 5, 7, 7, 7, and 9 has two modes, 4 and 7, and is called bimodal.
A distribution having only one mode is called unimodal.

In the case of grouped data where a frequency curve has been constructed to fit the data, the mode
will be the value (or values) of X corresponding to the maximum point (or points) on the curve.
This value of X is sometimes denoted by X. ^
From a frequency distribution or histogram the mode can be obtained from the formula

1
Mode ¼ L1 þ c ð9Þ
1 þ 2
where L1 ¼ lower class boundary of the modal class (i.e., the class containing the mode)
1 ¼ excess of modal frequency over frequency of next-lower class
2 ¼ excess of modal frequency over frequency of next-higher class
c ¼ size of the modal class interval
THE EMPIRICAL RELATION BETWEEN THE MEAN, MEDIAN, AND MODE

For unimodal frequency curves that are moderately skewed (asymmetrical), we have the empirical
relation
Mean mode ¼ 3ðmean medianÞ ð10Þ
Figures 3-1 and 3-2 show the relative positions of the mean, median, and mode for frequency curves
skewed to the right and left, respectively. For symmetrical curves, the mean, mode, and median all
coincide.
0
* * *
0 Mode Median Mean
Fig. 3-1 Relative positions of mode, median, and mean for a right-skewed frequency curve.
0
* * *
0 Mean Median Mode
Fig. 3-2 Relative positions of mode, median, and mean for a left-skewed frequency curve.
THE GEOMETRIC MEAN G

The geometric mean G of a set of N positive numbers X1 , X2 , X3 , . . . , XN is the Nth root of the
product of the numbers:
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
G ¼ N X1 X2 X3 XN ð11Þ
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi pffiffiffiffiffi
EXAMPLE 13. The geometric mean of the numbers 2, 4, and 8 is G ¼ 3 ð2Þð4Þð8Þ ¼ 3 64 ¼ 4.
We can compute G by logarithms (see Problem 3.35) or by using a calculator. For the geometric
mean from grouped data, see Problems 3.36 and 3.91.
THE HARMONIC MEAN H

The harmonic mean H of a set of N numbers X1 , X2 , X3 , . . . , XN is the reciprocal of the arithmetic
mean of the reciprocals of the numbers:
1 N
H¼ ¼ ð12Þ
1 XN
1 P 1
N j¼1 Xj X
In practice it may be easier to remember that

P1
1
¼ X¼ 1P1 ð13Þ
H N N X
EXAMPLE 14. The harmonic mean of the numbers 2, 4, and 8 is

3 3
H¼1 ¼ 7 ¼ 3:43
2 þ 1
4 þ 1
8 8
For the harmonic mean from grouped data, see Problems 3.99 and 3.100.
THE RELATION BETWEEN THE ARITHMETIC, GEOMETRIC, AND HARMONIC MEANS

The geometric mean of a set of positive numbers X1 , X2 , . . . , XN is less than or equal to their
arithmetic mean but is greater than or equal to their harmonic mean. In symbols,
H G X ð14Þ
The equality signs hold only if all the numbers X1 , X2 , . . . , XN are identical.
EXAMPLE 15. The set 2, 4, 8 has arithmetic mean 4.67, geometric mean 4, and harmonic mean 3.43.
THE ROOT MEAN SQUARE
ffiffiffiffiffiffi square (RMS), or quadratic mean, of a set of numbers X1 , X2 , . . . , XN is sometimes

The rootpmean
denoted by X 2 and is defined by
X
N
sffi Xj2 rP
ffiffiffiffiffiffiffiffiffiffiffiffi
pffiffiffiffiffiffi j¼1 X2
RMS ¼ X 2 ¼ ¼ ð15Þ
N N
This type of average is frequently used in physical applications.
EXAMPLE 16. The RMS of the set 1, 3, 4, 5, and 7 is

rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
12 þ 32 þ 42 þ 52 þ 72 pffiffiffiffiffi
¼ 20 ¼ 4:47
5
QUARTILES, DECILES, AND PERCENTILES

If a set of data is arranged in order of magnitude, the middle value (or arithmetic mean of the two
middle values) that divides the set into two equal parts is the median. By extending this idea, we can
think of those values which divide the set into four equal parts. These values, denoted by Q1 , Q2 , and Q3 ,
are called the first, second, and third quartiles, respectively, the value Q2 being equal to the median.
Similarly, the values that divide the data into 10 equal parts are called deciles and are denoted by D1 ,
D2 , . . . , D9 , while the values dividing the data into 100 equal parts are called percentiles and are denoted
by P1 , P2 , . . . , P99 . The fifth decile and the 50th percentile correspond to the median. The 25th and 75th
percentiles correspond to the first and third quartiles, respectively.
Collectively, quartiles, deciles, percentiles, and other values obtained by equal subdivisions of
the data are called quantiles. For computations of these from grouped data, see Problems 3.44 to 3.46.
EXAMPLE 17. Use EXCEL to find Q1, Q2, Q3, D9, and P95 for the following sample of test scores:
88 45 53 86 33 86 85 30 89 53 41 96 56 38 62
71 51 86 68 29 28 47 33 37 25 36 33 94 73 46
42 34 79 72 88 99 82 62 57 42 28 55 67 62 60
96 61 57 75 93 34 75 53 32 28 73 51 69 91 35
To find the first quartile, put the data in the first 60 rows of column A of the EXCEL worksheet.
Then give the command ¼PERCENTILE(A1:A60,0.25). EXCEL returns the value 37.75. We find
that 15 out of the 60 values are less than 37.75 or 25% of the scores are less than 37.75. Similarly,
we find ¼PERCENTILE(A1:A60,0.5) gives 57, ¼PERCENTILE(A1:A60,0.75) gives 76,
¼PERCENTILE(A1:A60,0.9) gives 89.2, and ¼PERCENTILE(A1:A60,0.95) gives 94.1. EXCEL
gives quartiles, deciles, and percentiles all expressed as percentiles.
An algorithm that is often used to find quartiles, deciles, and percentiles by hand is described as
follows. The data in example 17 is first sorted and the result is:
test scores
25 28 28 28 29 30 32 33 33 33 34 34 35 36 37
38 41 42 42 45 46 47 51 51 53 53 53 55 56 57
57 60 61 62 62 62 67 68 69 71 72 73 73 75 75
79 82 85 86 86 86 88 88 89 91 93 94 96 96 99
Suppose we wish to find the first quartile (25th percentile). Calculate i ¼ np/100 ¼ 60(25)/100 ¼ 15.
Since 15 is a whole number, go to the 15th and 16th numbers in the sorted array and average the 15th
and 16th numbers. That is average 37 and 38 to get 37.5 as the first quartile (Q1 ¼ 37.5). To find the 93rd
percentile, calculate np/100 ¼ 60(93)/100 to get 55.8. Since this number is not a whole number, always
round it up to get 56. The 56th number in the sorted array is 93 and P93 ¼ 93. The EXCEL command
¼PERCENTILE(A1:A60,0.93) gives 92.74. Note that EXCEL does not give the same values for the
percentiles, but the values are close. As the data set becomes larger, the values tend to equal each other.
SOFTWARE AND MEASURES OF CENTRAL TENDENCY

All the software packages utilized in this book give the descriptive statistics discussed in this section.
The output for all five packages is now given for the test scores in Example 17.
EXCEL
If the pull-down ‘‘Tools ) Data Analysis ) Descriptive Statistics’’ is given, the measures of central
tendency median, mean, and mode as well as several measures of dispersion are obtained:
Mean 59.16667
Standard Error 2.867425
Median 57
Mode 28
Standard Deviation 22.21098
Sample Variance 493.3277
Kurtosis 1.24413
Skewness 0.167175
Range 74
Minimum 25
Maximum 99
Sum 3550
Count 60
MINITAB
If the pull-down ‘‘Stat ) Basic Statistics ) Display Descriptive Statistics’’ is given, the following
output is obtained:
Descriptive Statistics: testscore

Variable N N* Mean SE Mean St Dev Minimum Q1 Median Q3
testscore 60 0 59.17 2.87 22.21 25.00 37.25 57.00 78.00
Variable Maximum
testscore 99.00
SPSS
If the pull-down ‘‘Analyze ) Descriptive Statistics ) Descriptives’’ is given, the following output is
obtained:
Descriptive Statistics
N Minimum Maximum Mean Std. Deviation
Testscore 60 25.00 99.00 59.1667 22.21098

Valid N (listwise) 60
SAS
If the pull-down ‘‘Solutions ) Analysis ) Analyst’’ is given and the data are read in as a file, the
pull-down ‘‘Statistics ) Descriptive ) Summary Statistics’’ gives the following output:
The MEANS Procedure

Analysis Variable : Testscr
Mean Std Dev N Minimum Maximum
ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff
59.1666667 22.2109811 60 25.0000000 99.0000000
ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff
STATISTIX
If the pull-down ‘‘Statistics ) Summary Statistics ) Descriptive Statistics’’ is given in the software
package STATISTIX, the following output is obtained:
Statistix 8.0
Descriptive Staistics
Testscore
N 60
Mean 59.167
SD 22.211
Minimum 25.000
1st Quarti 37.250
3rd Quarti 78.000
Maximum 99.000
The Standard Deviation
and Other Measures
of Dispersion
DISPERSION, OR VARIATION
The degree to which numerical data tend to spread about an average value is called the dispersion,
or variation, of the data. Various measures of this dispersion (or variation) are available, the most
common being the range, mean deviation, semi-interquartile range, 10–90 percentile range, and standard
deviation.
THE RANGE
The range of a set of numbers is the difference between the largest and smallest numbers in the set.
EXAMPLE 1. The range of the set 2, 3, 3, 5, 5, 5, 8, 10, 12 is 12 2 ¼ 10. Sometimes the range is given by simply
quoting the smallest and largest numbers; in the above set, for instance, the range could be indicated as 2 to 12,
or 2–12.
THE MEAN DEVIATION

The mean deviation, or average deviation, of a set of N numbers X1 , X2 , . . . , XN is abbreviated MD
and is defined by
X
N

jXj Xj P

jX Xj
Mean deviation ðMDÞ ¼
j¼1
¼
¼ jX Xj ð1Þ
N N
is the absolute value of the deviation of Xj
where X is the arithmetic mean of the numbers and jXj Xj
(The absolute value of a number is the number without the associated sign and is indicated by
from X.
two vertical lines placed around the number; thus j 4j ¼ 4, j þ 3j ¼ 3, j6j ¼ 6, and j 0:84j ¼ 0:84.)
95
96 THE STANDARD DEVIATION AND OTHER MEASURES OF DISPERSION [CHAP. 4
EXAMPLE 2. Find the mean deviation of the set 2, 3, 6, 8, 11.
Arithmetic mean ðXÞ ¼ 2 þ 3 þ 6 þ 8 þ 11 ¼ 6

5
j2 6j þ j3 6j þ j6 6j þ j8 6j þ j11 6j j 4j þ j 3j þ j0j þ j2j þ j5j 4 þ 3 þ 0 þ 2 þ 5
MD ¼ ¼ ¼ ¼ 2:8
5 5 5
If X1 , X2 , . . . , XK occur with frequencies f1 , f2 , . . . ; fK , respectively, the mean deviation can be

written as
X
K

fj jXj Xj P

f jX Xj
MD ¼
j¼1
¼
¼ jX Xj ð2Þ
N N
P P
where N ¼ K j¼1 fj ¼ f . This form is useful for grouped data, where the Xj ’s represent class marks
and the fj ’s are the corresponding class frequencies.
Occasionally the mean deviation is defined in terms of absolute deviationsPNfrom the median or other
average instead of from the mean. An interesting property of the sum j¼1 jXj aj is that it is a
minimum when a is the median (i.e., the mean deviation about the median is a minimum).
Note that it would be more appropriate to use the terminology mean absolute deviation than mean
deviation.
THE SEMI-INTERQUARTILE RANGE

The semi-interquartile range, or quartile deviation, of a set of data is denoted by Q and is defined by
Q3 Q1
Q¼ ð3Þ
2
where Q1 and Q3 are the first and third quartiles for the data (see Problems 4.6 and 4.7). The interquartile
range Q3 Q1 is sometimes used, but the semi-interquartile range is more common as a measure of
dispersion.
THE 10–90 PERCENTILE RANGE

The 10–90 percentile range of a set of data is defined by
1090 percentile range ¼ P90 P10 ð4Þ
where P10 and P90 are the 10th and 90th percentiles for the data (see Problem 4.8). The semi-10–90
percentile range, 12 ðP90 P10 Þ, can also be used but is not commonly employed.
THE STANDARD DEVIATION

The standard deviation of a set of N numbers X1 , X2 , . . . , XN is denoted by s and is defined by
X
N
sffi 2
ðXj XÞ sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi rffiffiffiffiffiffiffiffiffiffiffiffi
P P 2 qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
ðX XÞ 2 x
s¼
j¼1
¼ ¼ 2
¼ ðX XÞ ð5Þ
N N N
Thus s is the root mean
where x represents the deviations of each of the numbers Xj from the mean X.
square (RMS) of the deviations from the mean, or, as it is sometimes called, the root-mean-square
deviation.
CHAP. 4] THE STANDARD DEVIATION AND OTHER MEASURES OF DISPERSION 97
If X1 , X2 , . . . , XK occur with frequencies f1 , f2 , . . . , fK , respectively, the standard deviation can be

written
X
K
sffi 2
fj ðXj XÞ ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi rP
rP ffiffiffiffiffiffiffiffiffiffiffiffiffiffi qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
f ðX XÞ 2 fx2
s¼
j¼1
¼ ¼ ¼ ðX XÞ 2 ð6Þ
N N N
P P
where N ¼ K j¼1 fj ¼ f . In this form it is useful for grouped data.
Sometimes the standard deviation of a sample’s data is defined with ðN 1Þ replacing N in the
denominators of the expressions in equations (5) and (6) because the resulting value represents a better
estimate of the standard deviation of a population from which the sample is taken. For large values of N
(certainly N > 30), there is practically no difference betwen the two definitions. Also, when the better
estimate is needed we can always obtain
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
ffi it by multiplying the standard deviation computed according to
the first definition by N=ðN 1Þ. Hence we shall adhere to the form (5) and (6).
THE VARIANCE
The variance of a set of data is defined as the square of the standard deviation and is thus given by s2
in equations (5) and (6).
When it is necessary to distinguish the standard deviation of a population from the standard
deviation of a sample drawn from this population, we often use the symbol s for the latter and
(lowercase Greek sigma) for the former. Thus s2 and 2 would represent the sample variance and
population variance, respectively.
SHORT METHODS FOR COMPUTING THE STANDARD DEVIATION

Equations (5) and (6) can be written, respectively, in the equivalent forms
0 N 1
XN X 2
sffi sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
P 2 P 2ffi qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2
Xj B XC
j
@ j¼1 A X X
¼ X 2 X 2
j¼1
s¼ ¼ ð7Þ
N N N N
0 1
X
K X
K 2
sffi fj Xj2 B fj Xj C sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
@ j¼1 A P P qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
fX 2 fX 2
¼ X 2 X 2
j¼1
s¼ ¼ ð8Þ
N N N N
where X 2 denotes the mean of the squares of the various values of X, while X 2 denotes the square of the
mean of the various values of X (see Problems 4.12 to 4.14).
If dj ¼ Xj A are the deviations of Xj from some arbitrary constant A, results (7) and (8) become,
respectively,
0 N 1
X N X 2
sffi 2
dj B dj C sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
@ j¼1 A P 2 P 2 qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
d d
¼ d 2 d2
j¼1
s¼ ¼ ð9Þ
N N N N
0 1
X
K X
K 2
sffi sP
ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
fj dj2 B f j dj C P 2ffi qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
@ j¼1 A fd 2 fd
¼ d 2 d2
j¼1
s¼ ¼ ð10Þ
N N N N
(See Problems 4.15 and 4.17.)
When data are grouped into a frequency distribution whose class intervals have equal size c, we have
dj ¼ cuj or Xj ¼ A þ cuj and result (10) becomes
0 K 1
X K X 2
sffi 2
f j uj B f j uj C sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
P 2 P 2 qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
j¼1 @ j¼1 A fu fu
s¼c ¼c ¼ c u2 u2 ð11Þ
N N N N
This last formula provides a very short method for computing the standard deviation and should always
be used for grouped data when the class-interval sizes are equal. It is called the coding method and
is exactly analogous to that used in Chapter 3 for computing the arithmetic mean of grouped data.
(See Problems 4.16 to 4.19.)
PROPERTIES OF THE STANDARD DEVIATION

1. The standard deviation can be defined as
X
N
sffi ðXj aÞ2
j¼1
s¼
N
where a is an average besides the arithmetic mean. Of all such standard deviations, the minimum
is that for which a ¼ X, because of Property 2 in Chapter 3. This property provides an
important reason for defining the standard deviation as above. For a proof of this property,
see Problem 4.27.
2. For normal distributions (see Chapter 7), it turns out that (as shown in Fig. 4-1):
(a) 68.27% of the cases are included between X s and X þ s (i.e., one standard deviation on
either side of the mean).
(b) 95.45% of the cases are included between X 2s and X þ 2s (i.e., two standard deviations
on either side of the mean).
(c) 99.73% of the cases are included between X 3s and X þ 3s (i.e., three standard deviations on
either side of the mean).
For moderately skewed distributions, the above percentages may hold approximately
(see Problem 4.24).
3. Suppose that two sets consisting of N1 and N2 numbers (or two frequency distributions with
total frequencies N1 and N2 ) have variances given by s21 and s22 , respectively, and have the same
mean X. Then the combined, or pooled, variance of both sets (or both frequency distributions)
is given by
N1 s21 þ N2 s22
s2 ¼ ð12Þ
N1 þ N2
Note that this is a weighted arithmetic mean of the variances. This result can be generalized to three
or more sets.
4. Chebyshev’s theorem states that for k41, there is at least ð1 ð1=k2 ÞÞ 100% of the probability
distribution for any variable within k standard deviations of the mean. In particular, when k ¼ 2,
there is at least ð1 ð1=22 ÞÞ 100% or 75% of the data in the interval ð x 2S, x þ 2SÞ, when
k ¼ 3 there is at least ð1 ð1=32 ÞÞ 100% or 89% of the data in the interval ð x 3S, x þ 3SÞ,
and when k ¼ 4 there is at least ð1 ð1=42 ÞÞ 100% or 93.75% of the data in the interval
x 4S, x þ 4SÞ.
ð
* *
Mean + SD Mean − SD
* *
Mean − 2SD Mean + 2SD
* *
Mean − 3SD Mean + 3SD
Fig. 4-1 Illustration of the empirical rule.
CHARLIER’S CHECK
Charlier’s check in computations of the mean and standard deviation by the coding method makes
use of the identities
P P P P
f ðu þ 1Þ ¼ fu þ f ¼ fu þ N
P P P P P P 2 P
f ðu þ 1Þ2 ¼ f ðu2 þ 2u þ 1Þ ¼ fu2 þ 2 fu þ f ¼ fu þ 2 fu þ N
(See Problem 4.20.)

SHEPPARD’S CORRECTION FOR VARIANCE

The computation of the standard deviation is somewhat in error as a result of grouping the data into
classes (grouping error). To adjust for grouping error, we use the formula
c2
Corrected variance ¼ variance from grouped data ð13Þ
12
where c is the class-interval size. The correction c2 =12 (which is subtracted) is called Sheppard’s correc-
tion. It is used for distributions of continuous variables where the ‘‘tails’’ go gradually to zero in both
directions.
Statisticians differ as to when and whether Sheppard’s correction should be applied. It should
certainly not be applied before one examines the situation thoroughly, for it often tends to overcorrect,
thus replacing an old error with a new one. In this book, unless otherwise indicated, we shall not be using
Sheppard’s correction.
EMPIRICAL RELATIONS BETWEEN MEASURES OF DISPERSION

For moderately skewed distributions, we have the empirical formulas
Mean deviation ¼ 45 ðstandard deviationÞ
Semi-interquartile range ¼ 23 ðstandard deviationÞ
These are consequences of the fact that for the normal distribution we find that the mean
deviation and semi-interquartile range are equal, respectively, to 0.7979 and 0.6745 times the standard
deviation.
ABSOLUTE AND RELATIVE DISPERSION; COEFFICIENT OF VARIATION

The actual variation, or dispersion, as determined from the standard deviation or other measure
of dispersion is called the absolute dispersion. However, a variation (or dispersion) of 10 inches
(in) in measuring a distance of 1000 feet (ft) is quite different in effect from the same variation
of 10 in in a distance of 20 ft. A measure of this effect is supplied by the relative dispersion, which
is defined by
absolute dispersion
Relative dispersion ¼ ð14Þ
average
If the absolute dispersion is the standard deviation s and if the average is the mean X, then the
relative dispersion is called the coefficient of variation, or coefficient of dispersion; it is denoted by V and
is given by
s
Coefficient of variation ðVÞ ¼ (15)
X
and is generally expressed as a percentage. Other possibilities also occur (see Problem 4.30).
Note that the coefficient of variation is independent of the units used. For this reason, it is useful in
comparing distributions where the units may be different. A disadvantage of the coefficient of variation
is that it fails to be useful when X is close to zero.
STANDARDIZED VARIABLE; STANDARD SCORES

The variable that measures the deviation from the mean in units of the standard deviation is called a
standardized variable, is a dimensionless quantity (i.e., is independent of the units used), and is given by
X X
z¼ ð16Þ
s
If the deviations from the mean are given in units of the standard deviation, they are said to be
expressed in standard units, or standard scores. These are of great value in the comparison of distributions
(see Problem 4.31).
SOFTWARE AND MEASURES OF DISPERSION

The statistical software gives a variety of measures for dispersion. The dispersion measures are
usually given in descriptive statistics. EXCEL allows for the computation of all the measures discussed
in this book. MINITAB and EXCEL are discussed here and outputs of other packages are given in the
solved problems.
EXAMPLE 3.
(a) EXCEL provides calculations for several measures of dispersion. The following example illus-
trates several. A survey was taken at a large company and the question asked was how many
e-mails do you send per week? The results for 75 employees are shown in A1:E15 of an EXCEL
worksheet.
32 113 70 60 84
114 31 58 86 102
113 79 86 24 40
44 42 54 71 25
42 116 68 30 63
121 74 77 77 100
51 31 61 28 26
47 54 74 57 35
77 80 125 105 61
102 45 115 36 52
58 24 24 39 40
95 99 54 35 31
77 29 69 58 32
49 118 44 95 65
71 65 74 122 99
The range is given by ¼MAX(A1:E15)-MIN(A1:E15) or 125 24 ¼ 101. The mean deviation

or average deviation is given by ¼AVEDEV(A1:E15) or 24.42. The semi-interquartile range
is given by the expression ¼(PERCENTILE(A1:E15,0.75)-PERCENTILE(A1:E15,0.25))/2
or 22. The 10–90 percentile range is given by PERCENTILE(A1:E15,0.9)-PERCENTILE
(A1:E15,0.1) or 82.6.
The standard deviation and variance is given by ¼STDEV(A1:E15) or 29.2563, and
¼VAR(A1:E15) or 855.932 for samples and ¼STDEVP(A1:E15) or 29.0606 and
¼VARP(A1:E15) or 844.52 for populations.
(b)
Fig. 4-2 Dialog box for MINITAB.
The dialog box in Fig. 4-2 shows MINITAB choices for measures of dispersion and measures
of central tendency. Output is as follows:
Descriptive Statistics: e-mails

Variable StDev Variance CoefVar Minimum Q1 Q3 Maximum Range IQR
e-mails 29.26 855.93 44.56 24.00 40.00 86.00 125.00 101.00 46.00
Solved Problems
THE RANGE
4.1 Find the range of the sets (a) 12, 6, 7, 3, 15, 10, 18, 5 and (b) 9, 3, 8, 8, 9, 8, 9, 18.
SOLUTION
In both cases, range ¼ largest number smallest number ¼ 18 3 ¼ 15. However, as seen from the
arrays of sets (a) and (b),
(a) 3, 5, 6, 7, 10, 12, 15, 18 (b) 3, 8, 8, 8, 9, 9, 9, 18
there is much more variation, or dispersion, in (a) than in (b). In fact, (b) consists mainly of 8’s and 9’s.
Since the range indicates no difference between the sets, it is not a very good measure of dispersion in
this case. Where extreme values are present, the range is generally a poor measure of dispersion.
An improvement is achieved by throwing out the extreme cases, 3 and 18. Then for set (a) the range is
ð15 5Þ ¼ 10, while for set (b) the range is ð9 8Þ ¼ 1, clearly showing that (a) has greater dispersion than
(b). However, this is not the way the range is defined. The semi-interquartile range and the 10–90 percentile
range were designed to improve on the range by eliminating extreme cases.
4.2 Find the range of heights of the students at XYZ University as given in Table 2.1.
Moments, Skewness,
and Kurtosis
MOMENTS
If X1 , X2 ; . . . ; XN are the N values assumed by the variable X, we define the quantity
X
N
Xjr P
X1r þ X2r þ þ XNr j¼1 Xr
Xr ¼ ¼ ¼ ð1Þ
N N N

called the rth moment. The first moment with r ¼ 1 is the arithmetic mean X.

The rth moment about the mean X is defined as
X
N
r
ðXj XÞ P
r
ðX XÞ
mr ¼
j¼1
¼ r
¼ ðX XÞ ð2Þ
N N
If r ¼ 1, then m1 ¼ 0 (see Problem 3.16). If r ¼ 2, then m2 ¼ s2 , the variance.
The rth moment about any origin A is defined as
X
N
ðXj AÞr P P r
j¼1 ðX AÞr d
mr0 ¼ ¼ ¼ ¼ ðX AÞr ð3Þ
N N N
where d ¼ X A are the deviations of X from A. If A ¼ 0, equation (3) reduces to equation (1). For this
reason, equation (1) is often called the rth moment about zero.
MOMENTS FOR GROUPED DATA

If X1 , X2 ; . . . , XK occur with frequencies f1 , f2 ; . . . , fK , respectively, the above moments are given by
X
K
fj Xjr P
f X r þ f2 X2r þ þ fK XKr j¼1 fX r
Xr ¼ 1 1 ¼ ¼ ð4Þ
N N N
123
124 MOMENTS, SKEWNESS, AND KURTOSIS [CHAP. 5
X
K
r
fj ðXj XÞ P
r
f ðX XÞ
mr ¼
j¼1
¼ r
¼ ðX XÞ ð5Þ
N N
X
K
fj ðXj AÞr P
j¼1 f ðX AÞr
mr0 ¼ ¼ ¼ ðX AÞr ð6Þ
N N
PK P
where N ¼ j¼1 fj ¼ f . The formulas are suitable for calculating moments from grouped data.
RELATIONS BETWEEN MOMENTS

The following relations exist between moments about the mean mr and moments about an arbitrary
origin mr0 :
m2 ¼ m20 m10 2
m3 ¼ m30 3m10 m20 þ 2m10 3 ð7Þ
m4 ¼ m40 4m10 m30 þ 6m10 2 m20 3m10 4
etc. (see Problem 5.5). Note that m10 ¼ X A.
COMPUTATION OF MOMENTS FOR GROUPED DATA

The coding method given in previous chapters for computing the mean and standard deviation can
also be used to provide a short method for computing moments. This method uses the fact that
Xj ¼ A þ cuj (or briefly, X ¼ A þ cu), so that from equation (6) we have
P r
0 fu
mr ¼ c r
¼ c r ur ð8Þ
N
which can be used to find mr by applying equations (7).
CHARLIER’S CHECK AND SHEPPARD’S CORRECTIONS

Charlier’s check in computing moments by the coding method uses the identities:
P P
f ðu þ 1Þ ¼ fu þ N
P P P
f ðu þ 1Þ2 ¼ fu2 þ 2 fu þ N
P P P P ð9Þ
f ðu þ 1Þ3 ¼ fu3 þ 3 fu2 þ 3 fu þ N
P P P P P
f ðu þ 1Þ4 ¼ fu4 þ 4 fu3 þ 6 fu2 þ 4 fu þ N
Sheppard’s corrections for moments are as follows:
1 2
Corrected m2 ¼ m2 12 c Corrected m4 ¼ m4 12 c2 m2 þ 240
7 4
c
The moments m1 and m3 need no correction.
MOMENTS IN DIMENSIONLESS FORM

To avoid particular units, we can define the dimensionless moments about the mean as
m mr mr
ar ¼ rr ¼ pffiffiffiffiffiffi ¼ pffiffiffiffiffiffi ð10Þ
s ( m2 )r mr2
pffiffiffiffiffiffi
where s ¼ m2 is the standard deviation. Since m1 ¼ 0 and m2 ¼ s2 , we have a1 ¼ 0 and a2 ¼ 1.
CHAP. 5] MOMENTS, SKEWNESS, AND KURTOSIS 125
SKEWNESS
Skewness is the degree of asymmetry, or departure from symmetry, of a distribution. If the frequency
curve (smoothed frequency polygon) of a distribution has a longer tail to the right of the central
maximum than to the left, the distribution is said to be skewed to the right, or to have positive skewness.
If the reverse is true, it is said to be skewed to the left, or to have negative skewness.
For skewed distributions, the mean tends to lie on the same side of the mode as the longer tail
(see Figs. 3-1 and 3-2). Thus a measure of the asymmetry is supplied by the difference: mean–mode.
This can be made dimensionless if we divide it by a measure of dispersion, such as the standard deviation,
leading to the definition
mean mode X mode
Skewness ¼ ¼ ð11Þ
standard deviation s
To avoid using the mode, we can employ the empirical formula (10) of Chapter 3 and define
3ðmean medianÞ 3ðX medianÞ

Skewness ¼ ¼ ð12Þ
standard deviation s
Equations (11) and (12) are called, respectively, Pearson’s first and second coefficients of skewness.
Other measures of skewness, defined in terms of quartiles and percentiles, are as follows:
ðQ3 Q2 Þ ðQ2 Q1 Þ Q3 2Q2 þ Q1

Quartile coefficient of skewness ¼ ¼ ð13Þ
Q3 Q1 Q3 Q1
ðP90 P50 Þ ðP50 P10 Þ P90 2P50 þ P10
1090 percentile coefficient of skewness ¼ ¼ ð14Þ
P90 P10 P90 P10
An important measure of skewness uses the third moment about the mean expressed in dimension-
less form and is given by
m3 m m3
Moment coefficient of skewness ¼ a3 ¼ ¼ pffiffiffiffiffi3ffi 3 ¼ pffiffiffiffiffiffi ð15Þ
s3 ( m2 ) m23
Another measure of skewness is sometimes given by b1 ¼ a23 . For perfectly symmetrical curves,
such as the normal curve, a3 and b1 are zero.
KURTOSIS
Kurtosis is the degree of peakedness of a distribution, usually taken relative to a normal distribution.
A distribution having a relatively high peak is called leptokurtic, while one which is flat-topped is called
platykurtic. A normal distribution, which is not very peaked or very flat-topped, is called mesokurtic.
One measure of kurtosis uses the fourth moment about the mean expressed in dimensionless form
and is given by
m m
Moment coefficient of kurtosis ¼ a4 ¼ 44 ¼ 42 ð16Þ
s m2
which is often denoted by b2 . For the normal distribution, b2 ¼ a4 ¼ 3. For this reason, the kurtosis is
sometimes defined by ðb2 3Þ, which is positive for a leptokurtic distribution, negative for a platykurtic
distribution, and zero for the normal distribution.
Another measure of kurtosis is based on both quartiles and percentiles and is given by
Q
¼ ð17Þ
P90 P10
where Q ¼ 12 ðQ3 Q1 Þ is the semi-interquartile range. We refer to (the lowercase Greek letter kappa)
as the percentile coefficient of kurtosis; for the normal distribution, has the value 0.263.
POPULATION MOMENTS, SKEWNESS, AND KURTOSIS

When it is necessary to distinguish a sample’s moments, measures of skewness, and measures of
kurtosis from those corresponding to a population of which the sample is a part, it is often the custom to
use Latin symbols for the former and Greek symbols for the latter. Thus if the sample’s moments are
denoted by mr and mr0 , the corresponding Greek symbols would be r and r0 ( is the Greek letter mu).
Subscripts are always denoted by Latin symbols.
Similarly, if the sample’s measures of skewness and kurtosis are denoted by a3 and a4 , respectively,
the population’s skewness and kurtosis would be 3 and 4 ( is the Greek letter alpha).
We already know from Chapter 4 that the standard deviation of a sample and of a population are
denoted by s and , respectively.
SOFTWARE COMPUTATION OF SKEWNESS AND KURTOSIS

The software that we have discussed in the text so far may be used to compute skewness and kurtosis
measures for sample data. The data in Table 5.1 samples of size 50 from a normal distribution,
a skewed-right distribution, a skewed-left distribution, and a uniform distribution.
The normal data are female height measurements, the skewed-right data are age at marriage for
females, the skewed-left data are obituary data that give the age at death for females, and the uniform
data are the amount of cola put into a 12 ounce container by a soft drinks machine. The distribution of
Table 5.1
Normal Skewed-right Skewed-left Uniform
67 69 31 40 102 87 12.1 11.6

70 62 43 24 55 104 12.1 11.6
63 67 30 29 70 75 12.4 12.0
65 59 30 24 95 80 12.1 11.6
68 66 38 27 73 66 12.1 11.6
60 65 26 35 79 93 12.2 11.7
70 63 29 33 60 90 12.2 12.3
64 65 55 75 73 84 12.2 11.7
69 60 46 38 89 73 11.9 11.7
61 67 26 34 85 98 12.2 11.7
66 64 29 85 72 79 12.3 11.8
65 68 57 29 92 35 12.3 12.5
71 61 34 40 76 71 11.7 11.8
62 69 34 41 93 90 12.3 11.8
66 65 36 35 76 71 12.3 11.8
68 62 40 26 97 63 12.4 11.9
64 67 28 34 10 58 12.4 11.9
67 70 26 19 70 82 12.1 11.9
62 64 66 23 85 72 12.4 12.2
66 63 63 28 25 93 12.4 11.9
65 68 30 26 83 44 12.5 12.0
63 64 33 31 58 65 11.8 11.9
66 65 24 25 10 77 12.5 12.0
65 61 35 22 92 81 12.5 12.0
63 66 34 28 82 77 12.5 12.0
the four sets of sample data is shown in Fig. 5-1. The distributions of the four samples are illustrated by
dotplots.
Dotplot of Height, Wedage, Obitage, Cola-fill

Height
60 62 64 66 68 70
Wedage
18 27 36 45 54 63 72 81
Obitage
14 28 42 56 70 84 98
Cola-fill
11.6 11.8 12.0 12.2 12.4

Fig. 5-1 MINITAB plot of four distributions: normal, right-skewed, left-skewed, and uniform.
The variable Height is the height of 50 adult females, the variable Wedage is the age at the wedding
of 50 females, the variable Obitage is the age at death of 50 females, and the variable Cola-fill is the
amount of cola put into 12 ounce containers. Each sample is of size 50. Using the terminology that we
have learned in this chapter: the height distribution is mesokurtic, the cola-fill distribution is platykurtic,
the wedage distribution is skewed to the right, and the obitage distribution is skewed to the left.
EXAMPLE 1. If MINITAB is used to find skewness and kurtosis values for the four variables, the following results
are obtained by using the pull-down menu ‘‘Stat ) Basic statistics ) Display descriptive statistics.’’
Descriptive Statistics: Height, Wedage, Obitage, Cola-fill

Variable N N* Mean StDev Skewness Kurtosis
Height 50 0 65.120 2.911 0.02 0.61
Wedage 50 0 35.48 13.51 1.98 4.10
Obitage 50 0 74.20 20.70 1.50 2.64
Cola-fill 50 0 12.056 0.284 0.02 1.19
The skewness values for the uniform and normal distributions are seen to be near 0. The skewness measure is
positive for a distribution that is skewed to the right and negative for a distribution that is skewed to the left.
EXAMPLE 2. Use EXCEL to find the skewness and kurtosis values for the data in Fig. 5-1. If the variable
names are entered into A1:D1 and the sample data are entered into A2:D51 and any open cell is used to
enter ¼SKEW(A2:A51) the value 0.0203 is returned. The function ¼SKEW(B2:B51) returns 1.9774,
the function ¼SKEW(C2:C51) returns 1.4986, and ¼SKEW(D2:D51) returns 0.0156. The kurtosis values are
obtained by ¼KURT(A2:A51) which gives 0.6083, ¼KURT(B2:B51) which gives 4.0985, ¼KURT(C2:C51)
which gives 2.6368, and ¼KURT(D2:D51) which gives 1.1889. It can be seen that MINITAB and EXCEL give
the same values for kurtosis and skewness.
EXAMPLE 3. When STATISTIX is used to analyze the data shown in Fig. 5-1, the pull-down ‘‘Statistics )
Summary Statistics ) Descriptive Statistics’’ gives the dialog box in Fig. 5-2.
Fig. 5-2 Dialogue box for STATISTIX.

Note that N, Mean, SD, Skew, and Kurtosis are checked as the statistics to report. The STATISTIX
output is as follows.
Variable N Mean SD Skew Kurtosis
Cola 50 12.056 0.2837 0.0151 1.1910
Height 50 65.120 2.9112 0.0197 0.6668
Obitage 50 74.200 20.696 1.4533 2.2628
Wedage 50 35.480 13.511 1.9176 3.5823
Since the numerical values differ slightly from MINITAB and EXCEL, it is obvious that slightly
different measures of skewness and kurtosis are used by the software.
EXAMPLE 4. The SPSS pull-down menu ‘‘Analyze ) Descriptive Statistics ) Descriptives’’ gives the dialog box in
Fig. 5-3 and the routines Mean, Std. deviation, Kurtosis, and Skewness are chosen. SPSS gives the same measures of
skewness and kurtosis as EXCEL and MINITAB.
Fig. 5-3 Dialogue box for SPSS.

The following SPSS output is given.

N Mean Std. Skewness Kurtosis

Statistic Statistic Statistic Statistic Std. Error Statistic Std. Error
Height 50 65.1200 2.91120 .020 .337 .608 .662

Wedage 50 35.4800 13.51075 1.977 .337 4.098 .662
Obitage 50 74.2000 20.69605 1.499 .337 2.637 .662
Colafill 50 12.0560 .28368 .016 .337 1.189 .662
Valid N 50
(listwise)
EXAMPLE 5. When SAS is used to compute the skewness and kurtosis values, the following output results.
It is basically the same as that given by EXCEL, MINITAB, and SPSS.
The MEANS Procedure

Variable Mean Std Dev N Skewness Kurtosis
fffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff
Height 65.1200000 2.9112029 50 0.0203232 0.6083437
Wedage 35.4800000 13.5107516 50 1.9774237 4.0984607
Obitage 74.2000000 20.6960511 50 1.4986145 2.6368045
Cola_fill 12.0560000 0.2836785 50 0.0156088 1.1889600
fffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff
Solved Problems
MOMENTS
5.1 Find the (a) first, (b) second, (c) third, and (d ) fourth moments of the set 2, 3, 7, 8, 10.
SOLUTION
(a) The first moment, or arithmetic mean, is
P
X 2 þ 3 þ 7 þ 8 þ 10 30
X¼ ¼ ¼ ¼6
N 5 5
(b) The second moment is
P
X 2 22 þ 32 þ 72 þ 82 þ 102 226
X2 ¼ ¼ ¼ ¼ 45:2
N 5 5
(c) The third moment is
P
X 3 23 þ 33 þ 73 þ 83 þ 103 1890
X3 ¼ ¼ ¼ ¼ 378
N 5 5
(d) The fourth moment is
P
X 4 24 þ 34 þ 74 þ 84 þ 104 16,594
X4 ¼ ¼ ¼ ¼ 3318:8
N 5 5
6. FINANCIAL MANAGEMENT
Syllabus
Financial Management: Investment-need, Appraisal and criteria, Financial analysis tech-
niques-Simple pay back period, Return on investment, Net present value, Internal rate of
return, Cash flows, Risk and sensitivity analysis; Financing options, Energy performance
contracts and role of ESCOs.
6.1 Introduction
In the process of energy management, at some stage, investment would be required for reduc-
ing the energy consumption of a process or utility. Investment would be required for modifica-
tions/retrofitting and for incorporating new technology. It would be prudent to adopt a system-
atic approach for merit rating of the different investment options vis-à-vis the anticipated sav-
ings. It is essential to identify the benefits of the proposed measure with reference to not only
energy savings but also other associated benefits such as increased productivity, improved prod-
uct quality etc.
The cost involved in the proposed measure should be captured in totality viz.
• Direct project cost
• Additional operations and maintenance cost
• Training of personnel on new technology etc.
Based on the above, the investment analysis can be carried out by the techniques explained
in the later section of the chapter.
6.2 Investment Need, Appraisal and Criteria

To persuade your organization to commit itself to a program of investment in energy efficien-
cy, you need to demonstrate:
• The size of the energy problem it currently faces
• The technical and good housekeeping measure available to reduce waste
• The predicted return on any investment
• The real returns achieved on particular measures over time.
The need for investments in energy conservation can arise under following circumstances
• For new equipment, process improvements etc.
• To provide staff training
• To implement or upgrade the energy information system
Criteria
Any investment has to be seen as an addition and not as a substitute for having effective man-
agement practices for controlling energy consumption throughout your organization.
Spending money on technical improvements for energy management cannot compensate for
inadequate attention to gaining control over energy consumption. Therefore, before you make
any investments, it is important to ensure that
Bureau of Energy Efficiency 130

6. Financial Management
• You are getting the best performance from existing plant and equipment
• Your energy charges are set at the lowest possible tariffs
• You are consuming the best energy forms - fuels or electricity - as efficiently as possi-
ble
• Good housekeeping practices are being regularly practiced.
When listing investment opportunities, the following criteria need to be considered:
• The energy consumption per unit of production of a plant or process
• The current state of repair and energy efficiency of the building design, plant and ser-
vices, including controls
• The quality of the indoor environment - not just room temperatures but indoor air qual-
ity and air change rates, drafts, under and overheating including glare, etc.
• The effect of any proposed measure on staff attitudes and behaviour.
Energy Proposals Vs Other Competitive Proposals

One of the most difficult problems which many energy managers face is justifying why their
organization should invest money in increasing its energy efficiency, especially when there are
other, seemingly more important priorities for the use of its capital.
• Organization typically give priority to investing in what they see as their core or profit-
making activities in preference to energy efficiency
• Even when they do invest in saving energy, they tend to demand faster rates of return
than they require from other kinds of investment.
Investment Appraisal
Energy manager has to identify how cost savings arising from energy management could be
redeployed within his organization to the maximum effect. To do this, he has to work out how
benefits of increased energy efficiency can be best sold to top management as,
• Reducing operating /production costs
• Increasing employee comfort and well-being
• Improving cost-effectiveness and/or profits
• Protecting under-funded core activities
• Enhancing the quality of service or customer care delivered
• Protecting the environment
6.3 Financial Analysis

In most respects, investment in energy efficiency is no different from any other area of finan-
cial management. So when your organization first decides to invest in increasing its energy effi-
ciency it should apply exactly the same criteria to reducing its energy consumption as it applies
to all its other investments. It should not require a faster or slower rate of return on investment
in energy efficiency than it demands elsewhere.
The basic criteria for financial investment appraisal include:
• Simple Payback - a measure of how long it will be before the investment makes money,
and how long the financing term needs to be
• Return on Investment (ROI) and Internal Rate of Return (IRR) - measure that allow

comparison with other investment options

• Net Present Value (NPV) and Cash Flow - measures that allow financial planning of
the project and provide the company with all the information needed to incorporate
energy efficiency projects into the corporate financial system.
Initially, when you can identify no or low cost investment opportunities, this principle
should not be difficult to maintain. However, if your organization decides to fund a rolling pro-
gram of such investments, then over time it will become increasingly difficult for you to iden-
tify opportunities, which conform to the principle. Before you'll reach this position, you need
to renegotiate the basis on which investment decisions are made.
It may require particular thoroughness to ensure that all the costs and benefits arising are
taken into account. As an approximate appraisal, simple payback (the total cost of the measure
divided by the annual savings arising from it expressed as years required for the original invest-
ment to be returned) is a useful tool.
As the process becomes more sophisticated, financial criteria such as Discounted Cash
Flow, Internal Rate of Return and Net Present Value may be used. If you do not possess suffi-
cient financial expertise to calculate these yourself, you will need to ensure that you have
access, either within your own staff or elsewhere within the organization, to people who can
employ them on your behalf.
There are two quite separate grounds for arguing that, at least long after their payback peri-
ods. Such measure does not need to be written off using fast discounting rates but can be regard-
ed as adding to the long term value of the assets. For this reason, short term payback can be an
inadequate yardstick for assessin long after their payback periods. Such measure does not need
to be written off using fast discounting rates but can be regarded as adding to the long term
value of the assets. For this reason, short term payback can be an inadequate yardstick for
assessing longer term benefits. To assess the real gains from investing in saving energy, you
should use investment appraisal techniques, which accurately reflect the longevity of the returns
on particular types of technical measures.
Protecting Energy Investment
It is essential to keep a careful watch on your organization's maintenance policy and practices
in order to protect any investment already made in reducing your organization's energy con-
sumption. There is a clear dependence relationship between energy efficiency and maintenance.
This operates at two levels:
• Initially, improving energy efficiency is most cost-effectively done in existing facilities

through normal maintenance procedures
• Subsequently, unless maintenance is regularly undertaken, savings from installed tech-
nical measure, whether in new-build or existing facilities, may not be realized.
6.4 Financial Analysis Techniques
In this chapter, investment analysis tools relevant to energy management projects will be
discussed.
6.4.1 Simple Pay Back Period:

Simple Payback Period (SPP) represents, as a first approximation; the time (number of years)
required to recover the initial investment (First Cost), considering only the Net Annual Saving:

The simple payback period is usually calculated as follows:
Examples
First cos t
Simple payback period =
Yearly benefits − Yearly cos ts
Simple payback period for a continuous Deodorizer that costs Rs.60 lakhs to purchase and
install, Rs.1.5 lakhs per year on an average to operate and maintain and is expected to save Rs.
20 lakhs by reducing steam consumption (as compared to batch deodorizers), may be calculat-
ed as follows:
According to the payback criterion, the shorter the payback period, the more desirable the pro-
60
Simple payback period = = 3 years 3 months
20 − 1.5
ject.
Advantages
A widely used investment criterion, the payback period seems to offer the following advantages:
• It is simple, both in concept and application. Obviously a shorter payback generally indi-
cates a more attractive investment. It does not use tedious calculations.
• It favours projects, which generate substantial cash inflows in earlier years, and dis-
criminates against projects, which bring substantial cash inflows in later years but not in
earlier years.
Limitations
• It fails to consider the time value of money. Cash inflows, in the payback calculation, are
simply added without suitable discounting. This violates the most basic principle of
financial analysis, which stipulates that cash flows occurring at different points of time
can be added or subtracted only after suitable compounding/discounting.
• It ignores cash flows beyond the payback period. This leads to discrimination against
projects that generate substantial cash inflows in later years.
To illustrate, consider the cash flows of two projects, A and B:
The payback criterion prefers A, which has a payback period of 3 years, in comparison to B,
which has a payback period of 4 years, even though B has very substantial cash inflows in years

5 and 6.
• It is a measure of a project's capital recovery, not profitability.
• Despite its limitations, the simple payback period has advantages in that it may be use-
ful for evaluating an investment.
Time Value of Money

A project usually entails an investment for the initial cost of installation, called the capital cost,
and a series of annual costs and/or cost savings (i.e. operating, energy, maintenance, etc.)
throughout the life of the project. To assess project feasibility, all these present and future cash
flows must be equated to a common basis. The problem with equating cash flows which occur
at different times is that the value of money changes with time. The method by which these var-
ious cash flows are related is called discounting, or the present value concept.
For example, if money can be deposited in the bank at 10% interest, then a Rs.100 deposit
will be worth Rs.110 in one year's time. Thus the Rs.110 in one year is a future value equiva-
lent to the Rs.100 present value.
In the same manner, Rs.100 received one year from now is only worth Rs.90.91 in today's
money (i.e. Rs.90.91 plus 10% interest equals Rs.100). Thus Rs.90.91 represents the present
value of Rs.100 cash flow occurring one year in the future. If the interest rate were something
different than 10%, then the equivalent present value would also change. The relationship
between present and future value is determined as follows:
Future Value (FV) = NPV (1 + i)n or NPV = FV / (1+i)n
Where
FV = Future value of the cash flow
NPV= Net Present Value of the cash flow
i = Interest or discount rate
n = Number of years in the future
6.4.2 Return on Investment (ROI)

ROI expresses the "annual return" from the project as a percentage of capital cost. The annual
return takes into account the cash flows over the project life and the discount rate by convert-
ing the total present value of ongoing cash flows to an equivalent annual amount over the life
of the project, which can then be compared to the capital cost. ROI does not require similar pro-
ject life or capital cost for comparison.
This is a broad indicator of the annual return expected from initial capital investment,
expressed as a percentage:
Annual Net Cash Flow

ROI = --------------------------------- x 100
Capital Cost
ROI must always be higher than cost of money (interest rate); the greater the return on invest-
ment better is the investment.

Limitations
• It does not take into account the time value of money.
• It does not account for the variable nature of annual net cash inflows.
6.4.3 Net Present Value

The net present value (NPV) of a project is equal to the sum of the present values of all the cash
flows associated with it. Symbolically,
Where NPV = Net Present Value

CFt = Cash flow occurring at the end of year 't' (t=0,1,….n)
n = life of the project
k = Discount rate
The discount rate (k) employed for evaluating the present value of the expected future cash
flows should reflect the risk of the project.
Example
To illustrate the calculation of net present value, consider a project, which has the following
cash flow stream:
The cost of capital, κ, for the firm is 10 per cent. The net present value of the proposal is:
The net present value represents the net benefit over and above the compensation for time and
risk.
Hence the decision rule associated with the net present value criterion is: "Accept the project
if the net present value is positive and reject the project if the net present value is negative".

Advantages
The net present value criterion has considerable merits.
• It takes into account the time value of money.
• It considers the cash flow stream in its project life.
6.4.4 Internal Rate of Return

This method calculates the rate of return that the investment is expected to yield. The internal
rate of return (IRR) method expresses each investment alternative in terms of a rate of return (a
compound interest rate). The expected rate of return is the interest rate for which total dis-
counted benefits become just equal to total discounted costs (i.e net present benefits or net annu-
al benefits are equal to zero, or for which the benefit / cost ratio equals one). The criterion for
selection among alternatives is to choose the investment with the highest rate of return.
The rate of return is usually calculated by a process of trial and error, whereby the net cash
flow is computed for various discount rates until its value is reduced to zero.
The internal rate of return (IRR) of a project is the discount rate, which makes its net pre-
sent value (NPV) equal to zero. It is the discount rate in the equation:
where CFt = cash flow at the end of year "t"

k = discount rate
n = life of the project.
CFt value will be negative if it is expenditure and positive if it is savings.

In the net present value calculation we assume that the discount rate (cost of capital) is known
and determine the net present value of the project. In the internal rate of return calculation, we
set the net present value equal to zero and determine the discount rate (internal rate of return),
which satisfies this condition.
To illustrate the calculation of internal rate of return, consider the cash flows of a project:
The internal rate of return is the value of " κ " which satisfies the following equation:
The calculation of "k" involves a process of trial and error. We try different values of "k" till
we find that the right-hand side of the above equation is equal to 100,000. Let us, to begin with,
try k = 15 per cent. This makes the right-hand side equal to:

30,000 30,000 40,000 45,000

------------ + ------------- + --------------- + --------------- = 100, 802
(1.15) (1.15)2 (1.15)3 (1.15)4
This value is slightly higher than our target value, 100,000. So we increase the value of k from
15 per cent to 16 per cent. (In general, a higher k lowers and a smaller k increases the right-
hand side value). The right-hand side becomes:
30,000 30,000 40,000 45,000
------------ + ------------- + --------------- + --------------- = 98, 641
(1.16) (1.16)2 (1.16)3 (1.16)4
Since this value is now less than 100,000, we conclude that the value of k lies between 15
per cent and 16 per cent. For most of the purposes this indication suffices.
Advantages
A popular discounted cash flow method, the internal rate of return criterion has several advan-
tages:
• It takes into account the time value of money.
• It considers the cash flow stream in its entirety.
• It makes sense to businessmen who prefer to think in terms of rate of return and find an
absolute quantity, like net present value, somewhat difficult to work with.
Limitations
• The internal rate of return figure cannot distinguish between lending and borrowing and
hence a high internal rate of return need not necessarily be a desirable feature.
Example
Calculate the internal rate of return for an economizer that will cost Rs.500,000, will last 10
years, and will result in fuel savings of Rs.150,000 each year.
Find the i that will equate the following:
Rs.500,000 = 150,000 x PV (A = 10 years, i = ?)
To do this, calculate the net present value (NPV) for various i values, selected by visual inspec-
tion;
NPV 25% = Rs.150,000 x 3.571 - Rs.500,000
= Rs.35,650
NPV 30% = Rs.150,000 x 3.092 - Rs. 500,000

= -Rs. 36,200
For i = 25 per cent, net present value is positive; i = 30 per cent, net present value is negative.
Thus, for some discount rate between 25 and 30 per cent, present value benefits are equated to
present value costs. To find the rate more exactly, one can interpolate between the two rates as
follows:
i = 0.25 + (0.30-0.25) x 35650 / (35650 + 36200)
= 0.275, or 27.5 percent

Cash Flows
Generally there are two kinds of cash flow; the initial investment as one or more installments,
and the savings arising from the investment. This over simplifies the reality of energy manage-
ment investment.
There are usually other cash flows related to a project. These include the following:
• Capital costs are the costs associated with the design, planning, installation and com-
missioning of the project; these are usually one-time costs unaffected by inflation or dis-
count rate factors, although, as in the example, installments paid over a period of time
will have time costs associated with them.
• Annual cash flows, such as annual savings accruing from a project, occur each year over
the life of the project; these include taxes, insurance, equipment leases, energy costs, ser-
vicing, maintenance, operating labour, and so on. Increases in any of these costs repre-
sent negative cash flows, whereas decreases in the cost represent positive cash flows.
Factors that need to be considered in calculating annual cash flows are:-
• Taxes, using the marginal tax rate applied to positive (i.e. increasing taxes) or negative
(i.e. decreasing taxes) cash flows.
• Asset depreciation, the depreciation of plant assets over their life; depreciation is a
"paper expense allocation" rather than a real cash flow, and therefore is not included
directly in the life cycle cost. However, depreciation is "real expense" in terms of tax
calculations, and therefore does have an impact on the tax calculation noted above. For
example, if a Rs.10,00,000 asset is depreciated at 20% and the marginal tax rate is 40%,
the depreciation would be Rs.200,000 and the tax cash flow would be Rs.80,000 and it
is this later amount that would show up in the costing calculation.
• Intermittent cash flows occur sporadically rather than annually during the life of the pro-
ject, relining a boiler once every five years would be an example.
6.5 Sensitivity and Risk Analysis

Many of the cash flows in the project are based on assumptions that have an element of uncer-
tainty. The present day cash flows, such as capital cost, energy cost savings, maintenance costs,
etc can usually be estimated fairly accurately. Even though these costs can be predicted with
some certainty, it should always be remembered that they are only estimates. Cash flows in
future years normally contain inflation components which are often "guess-timates" at best. The
project life itself is an estimate that can vary significantly.
Sensitivity analysis is an assessment of risk. Because of the uncertainty in assigning values
to the analysis, it is recommended that a sensitivity analysis be carried out - particularly on pro-
jects where the feasibility is marginal. How sensitive is the project's feasibility to changes in the
input parameters? What if one or more of the factors in the analysis is not as favourable as pre-
dicted? How much would it have to vary before the project becomes unviable? What is the prob-
ability of this happening?
Suppose, for example, that a feasible project is based on an energy cost saving that escalates
at 10% per year, but a sensitivity analysis shows the break-even is at 9% (i.e. the project
becomes unviable if the inflation of energy cost falls below 9%). There is a high degree of risk
associated with this project - much greater than if the break-even value was at 2%.

Many of the computer spreadsheet programs have built-in "what if" functions that make sensi-
tivity analysis easy. If carried out manually, the sensitivity analysis can become laborious -
reworking the analysis many times with various changes in the parameters.
Sensitivity analysis is undertaken to identify those parameters that are both uncertain and
for which the project decision, taken through the NPV or IRR, is sensitive. Switching values
showing the change in a variable required for the project decision to change from acceptance to
rejection are presented for key variables and can be compared with post evaluation results for
similar projects. For large projects and those close to the cut-off rate, a quantitative risk analy-
sis incorporating different ranges for key variables and the likelihood of their occurring simul-
taneously is recommended. Sensitivity and risk analysis should lead to improved project design,
with actions mitigating against major sources of uncertainty being outlined
The various micro and macro factors that are considered for the sensitivity analysis are list-
ed below.
Micro factors
• Operating expenses (various expenses items)
• Capital structure
• Costs of debt, equity
• Changing of the forms of finance e.g. leasing
• Changing the project duration
Macro factors
Macro economic variables are the variable that affects the operation of the industry of which the
firm operates. They cannot be changed by the firm's management.
Macro economic variables, which affect projects, include among others:
• Changes in interest rates
• Changes in the tax rates
• Changes in the accounting standards e.g. methods of calculating depreciation
• Changes in depreciation rates
• Extension of various government subsidized projects e.g. rural electrification
• General employment trends e.g. if the government changes the salary scales
• Imposition of regulations on environmental and safety issues in the industry
• Energy Price change
• Technology changes
The sensitivity analysis will bring changes in various items in the analysis of financial state-
ments or the projects, which in turn might lead to different conclusions regarding the imple-
mentation of projects.
6.6 Financing Options

There are various options for financing in-house energy management
1. From a central budget
2. From a specific departmental or section budget such as engineering
3. By obtaining a bank loan
4. By raising money from stock market

5. By awarding the project to Energy Service Company (ESCO)

6. By retaining a proportion of the savings achieved.
Self-Financing Energy Management

One way to make energy management self-financing is to split savings to provide identifiable
returns to each interested party. This has the following benefits:
• Assigning a proportion of energy savings to your energy management budget means you
have a direct financial incentive to identify and quantify savings arising from your own
activities.
• Separately identified returns will help the constituent parts of your organization under-
standing whether they are each getting good value for money through their support for
energy management.
• If operated successfully, splitting the savings will improve motivation and commitment
to energy management throughout the organization since staff at all levels will see a
financial return for their effort or support.
• But the main benefit is on the independence and longevity of the energy management
function.
Ensuring Continuity
After implementation of energy savings, your organization ought to be able to make consider-
able savings at little cost (except for the funding needed for energy management staff). The
important question is what should happen to these savings?
If part of these easily achieved savings is not returned to your budget as energy manager,
then your access to self-generated investments funds to support future activities will be lost.
And later in the program, it is likely to be much harder for you to make savings.
However, if, an energy manager, has access to a proportion of the revenue savings arising
from staff's activities, then these can be reinvested in:
• Further energy efficiency measures
• Activities necessary to create the right climate for successful energy management which
do not, of themselves, directly generate savings
• Maintaining or up-grading the management information system.
Energy Performance Contracting and Role of ESCOS

If the project is to be financed externally, one of the attractive options for many organizations
is the use of energy performance contracts delivered by energy service companies, or ESCOs.
ESCOs are usually companies that provide a complete energy project service, from assess-
ment to design to construction or installation, along with engineering and project management
services, and financing. In one way or another, the contract involves the capitalization of all of
the services and goods purchased, and repayment out of the energy savings that result from the
project.
In performance contracting, an end-user (such as an industry, institution, or utility), seeking
to improve its energy efficiency, contracts with ESCO for energy efficiency services and financ-
ing.
In some contracts, the ESCOs provide a guarantee for the savings that will be realized, and
absorbs the cost if real savings fall short of this level. Typically, there will be a risk manage-

ment cost involved in the contract in these situations. Insurance is sometimes attached, at a cost,
to protect the ESCO in the event of a savings shortfall.
Energy efficiency projects generate incremental cost savings as opposed to incremental rev-
enues from the sale of outputs. The energy
cost savings can be turned into incremental
cash flows to the lender or ESCO based on
the commitment of the energy user (and in
some cases, a utility) to pay for the savings.
What are performance contracts?

Performance contracting represents one of
the ways to address several of the most fre-
quently mentioned barriers to investment.
Performance contracting through an ESCO
transfers the technology and management
risks away from the end-user to the ESCO.
For energy users reluctant to invest in
energy efficiency, a performance contract
can be a powerful incentive to implement a
project. Performance contracting also mini-
mizes or eliminates the up-front cash outlay
required by the end-user. Payments are
made over time as the energy savings are
realized.
Figure 6.1 ESCO Role

QUESTIONS
1. Why fresh investments are needed for energy conservation in industry?
2. Name at least three selling points to top management for investing in energy efficien-
cy over other competitive projects.
3. Cost of an heat exchanger is Rs.1.00 lakhs .Calculate simple pay back period consid-
ering annual saving potential of Rs.60,000/- and annual operating cost of
Rs.15,000/- .
4. What is the main draw back of simple pay back method?
5. Calculate simple pay back period for a boiler that cost Rs.75.00 lakhs to purchase
and Rs.5 lakhs per year on an average to operate and maintain and is expected to
annually save Rs.30 lakhs.
6. What are the advantages of simple pay back method?
7. A project entails an investment for initial cost of installation and series of annual
costs and/or cost savings through out the life of project.. Recommend a suitable
financial analysis techniques and explain.
8. What do you understand by the term " present value of money"?
9. What do you understand by the term " discounting"?
10. ROI stands for
(a) return on investment (b) rotating on investment (c) realization on investment (d)
reality only investment?
11. Define ROI .
12. Investment for an energy proposal is Rs.10.00 lakhs. Annual savings for the first
three years is 150,000, 200,000 & 300,000. Considering cost of capital as 10%, what
is the net present value of the proposal?
13. What are the advantages of net present value?
14. Internal rate of return of a project is the discount rate which makes its net present
value equal to zero. Explain
15. What are the advantages of discounted cash flow method?
16. What is the main limitation of discounted cash flow method?
17. What is the objective of carrying out sensitivity analysis?
18. Name at least three financing options for energy management.
19. What is role of an ESCO?
20. What is performance contracting?
REFERENCES
1. Financial Management, Tata Mc-Graw Hill - Prasanna Chandra.

CHAPTER 7
INVESTMENT DECISIONS
LEARNING OUTCOMES
 State the objectives of capital investment decisions.

 Discuss the importance and purpose of Capital budgeting for
a business entity.
 Calculate cash flows in capital budgeting decisions and try to
explain the basic principles for measuring the same.
 Discuss the various investment evaluation techniques like
Pay-back, Net Present Value (NPV), Profitability Index (PI),
Internal Rate of Return (IRR), Modified Internal Rate of Return
(MIRR) and Accounting Rate of Return (ARR).
 Apply the concepts of the various investment evaluation
techniques for capital investment decision making.
 Discuss the advantages and disadvantages of the above-
mentioned techniques.
© The Institute of Chartered Accountants of India

7.2 FINANCIAL MANAGEMENT
7.1 INTRODUCTION
7
In the first chapter we have discussed the three important functions of financial
management which were Investment Decisions, Financing Decisions and Dividend
Decisions. So far we have studied Financing decisions in previous chapters. In this
chapter we will discuss the second important decision area of financial
management which is Investment Decision. Investment decision is concerned with
optimum utilization of fund to maximize the wealth of the organization and in turn
the wealth of its shareholders. Investment decision is very crucial for an
organization to fulfill its objectives; in fact, it generates revenue and ensures long
term existence of the organization. Even the entities which exist not for profit are
also required to make investment decision though not to earn profit but to fulfill
its mission.
As we have seen in the financing decision chapters that each rupee of capital raised
by an entity bears some cost, commonly known as cost of capital. It is necessary
that each rupee raised is to be invested in a very prudent manner. It requires a
proper planning for capital, and it is done through a proper budgeting. A proper

INVESTMENT DECISIONS 7.3
budgeting requires all the characteristics of budget. Due to this feature, investment
decisions are very popularly known as Capital Budgeting, which means applying
the principles of budgeting for capital investment.
In simple terms, Capital Budgeting involves: -
 Identification of investment projects that are strategic to business’ overall
objectives;
 Estimating and evaluating post-tax incremental cash flows for each of the
investment proposals; and
 Selection of an investment proposal that maximizes the return to the
investors.
7.2 PURPOSE OF CAPITAL BUDGTETING

The capital budgeting decisions are important, crucial and critical business
decisions due to following reasons:
(i) Substantial expenditure: Investment decisions are related with fulfillment of
long term objectives and existence of an organization. To invest in a project or
projects, a substantial capital investment is required. Based on size of capital and
timing of cash flows, sources of finance are selected. Due to huge capital
investments and associated costs, it is therefore necessary for an entity to make
such decisions after a thorough study and planning.
(ii) Long time period: The capital budgeting decision has its effect over a long
period of time. These decisions not only affect the future benefits and costs of
the firm but also influence the rate and direction of growth of the firm.
(iii) Irreversibility: Most of the investment decisions are irreversible. Once the
decision implemented it is very difficult and reasonably and economically not
possible to reverse the decision. The reason may be upfront payment of amount,
contractual obligations, technological impossibilities etc.
(iv) Complex decisions: The capital investment decision involves an assessment of
future events, which in fact is difficult to predict. Further it is quite difficult to
estimate in quantitative terms all the benefits or the costs relating to a particular
investment decision.

7.3 CAPITAL BUDGETING PROCESS

The extent to which the capital budgeting process needs to be formalised and
systematic procedures established depends on the size of the organisation;
number of projects to be considered; direct financial benefit of each project
considered by itself; the composition of the firm's existing assets and
management's desire to change that composition; timing of expenditures
associated with the projects that are finally accepted.
(i) Planning: The capital budgeting process begins with the identification of
potential investment opportunities. The opportunity then enters the planning
phase when the potential effect on the firm's fortunes is assessed and the ability
of the management of the firm to exploit the opportunity is determined.
Opportunities having little merit are rejected and promising opportunities are
advanced in the form of a proposal to enter the evaluation phase.
(ii) Evaluation: This phase involves the determination of proposal and its
investments, inflows and outflows. Investment appraisal techniques, ranging
from the simple payback method and accounting rate of return to the more
sophisticated discounted cash flow techniques, are used to appraise the
proposals. The technique selected should be the one that enables the manager
to make the best decision in the light of prevailing circumstances.
(iii) Selection: Considering the returns and risks associated with the individual
projects as well as the cost of capital to the organisation, the organisation will
choose among projects so as to maximise shareholders’ wealth.
(iv) Implementation: When the final selection has been made, the firm must acquire
the necessary funds, purchase the assets, and begin the implementation of the
project.
(v) Control: The progress of the project is monitored with the aid of feedback
reports. These reports will include capital expenditure progress reports,
performance reports comparing actual performance against plans set and post
completion audits.
(vi) Review: When a project terminates, or even before, the organisation should
review the entire project to explain its success or failure. This phase may have
implication for firms planning and evaluation procedures. Further, the review
may produce ideas for new proposals to be undertaken in the future.

7.4 TYPES OF CAPITAL INVESTMENT DECISIONS

There are many ways to classify the capital budgeting decision. Generally capital
investment decisions are classified in two ways. One way is to classify them on the
basis of firm’s existence. Another way is to classify them on the basis of decision
situation.
Replacement and
Modernisation decisions
On the basis of firm’s

Expansion decisions
Types of Capital Investment
existence
Diversification decisions
Decisions
Mutualy exclusive
decisions
On the basis of
Accept-Reject decisions
decision situation
Contingent decisions
7.4.1 On the basis of firm’s existence

The capital budgeting decisions are taken by both newly incorporated firms as well
as by existing firms. The new firms may require taking decision in respect of
selection of a plant to be installed. The existing firm may require taking decisions
to meet the requirement of new environment or to face the challenges of
competition. These decisions may be classified as follows:
(i) Replacement and Modernisation decisions: The replacement and
modernisation decisions aim at to improve operating efficiency and to reduce
cost. Generally, all types of plant and machinery require replacement either
because of the economic life of the plant or machinery is over or because it has
become technologically outdated. The former decision is known as replacement
decisions and latter is known as modernisation decisions. Both replacement and
modernisation decisions are called cost reduction decisions.

(ii) Expansion decisions: Existing successful firms may experience growth in

demand of their product line. If such firms experience shortage or delay in the
delivery of their products due to inadequate production facilities, they may
consider proposal to add capacity to existing product line.
(iii) Diversification decisions: These decisions require evaluation of proposals to
diversify into new product lines, new markets etc. for reducing the risk of failure
by dealing in different products or by operating in several markets.
Both expansion and diversification decisions are called revenue expansion
decisions.
7.4.2 On the basis of decision situation
The capital budgeting decisions on the basis of decision situation are classified as
follows:
(i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if
two or more alternative proposals are such that the acceptance of one proposal
will exclude the acceptance of the other alternative proposals. For instance, a
firm may be considering proposal to install a semi-automatic or highly automatic
machine. If the firm installs a semi-automatic machine it excludes the acceptance
of proposal to install highly automatic machine.
(ii) Accept-reject decisions: The accept-reject decisions occur when proposals are
independent and do not compete with each other. The firm may accept or reject
a proposal on the basis of a minimum return on the required investment. All
those proposals which give a higher return than certain desired rate of return
are accepted and the rest are rejected.
(iii) Contingent decisions: The contingent decisions are dependable proposals. The
investment in one proposal requires investment in one or more other proposals.
For example, if a company accepts a proposal to set up a factory in remote area
it may have to invest in infrastructure also e.g. building of roads, houses for
employees etc.
7.4.3 Steps of Capital Budgeting Procedure
1. Estimation of Cash flows over the entire life for each of the projects under
consideration.
2. Evaluate each of the alternative using different decision criteria.

3. Determining the minimum required rate of return (i.e. WACC) to be used as

Discount rate.
Accordingly, this chapter is divided into two sections
1. Estimation of Cash Flows
2. Capital Budgeting Techniques
SECTION 1
7.5 ESTIMATION OF PROJECT CASH FLOWS

Capital Budgeting analysis considers only incremental cash flows from an
investment likely to result due to acceptance of any project. Therefore, one of the
most important tasks in capital budgeting is estimating future cash flows for a
project. Though one of the techniques Accounting Rate of Return (ARR) evaluates
profitability of a project on the basis of accounting profit but accounting profit has
its limitations. Timing of cash flow may not match with the period of profit. Further,
non-cash item like depreciation has no immediate cash outflow.
The cash flows are estimated on the basis of input provided by various
departments.
The project cash flow stream consists of cash outflows and cash inflows. The costs
are denoted as cash outflows whereas the benefits are denoted as cash inflows.
An investment decision implies the choice of an objective, an appraisal technique
and the project’s life. The objective and technique must be related to definite
period of time. The life of the project may be determined by taking into
consideration the following factors:
(i) Technological obsolescence;
(ii) Physical deterioration; and
(iii) A decline in demand for the output of the project.
No matter how good a company's maintenance policy, its technological or demand
forecasting abilities are, uncertainty always be there.
Calculating Cash Flows: Before, we analyze how cash flow is computed in capital
budgeting decision, following items need consideration:

(a) Depreciation: As mentioned earlier depreciation is a non-cash item and

itself does not affect the cash flow. However, we must consider tax shield or benefit
from depreciation in our analysis. Since this benefit reduces cash outflow for taxes,
it is considered as cash inflow. To understand how depreciation acts as tax shield
let us consider following example:
Example
X Ltd. manufactures electronic motors fitted in desert coolers. It has an annual
turnover of `30 crore and cash expenses to generate this much of sale is `25 crore.
Suppose applicable tax rate is 30% and depreciation is `1.50 crore p.a. The table
below is showing Tax shield due to depreciation under two scenarios i.e. with and
without depreciation:
No Depreciation Depreciation is
is Charged Charged
(` Crore) (` Crore)
Total Sales 30.00 30.00
Less: Cost of Goods Sold (25.00) (25.00)
5.00 5.00
Less: Depreciation - 1.50
Profit before tax 5.00 3.50
Tax @ 30% 1.50 1.05
Profit after Tax 3.50 2.45
Add: Depreciation* - 1.50
Cash Flow 3.50 3.95
* Being non- cash expenditure depreciation has been added back while calculating
the cash flow.
As we can see in the above table that due to depreciation under the second
scenario, a tax saving of `0.45 crore (`1.50 – `1.05) was made. This is called tax
shield. The tax shield is considered while estimating cash flows.
(b) Opportunity Cost: Opportunity cost is foregoing of a benefit due to
choosing of an alternative investment option. For example, if a company owns a
piece of land acquired 10 years ago for `1 crore can be sold for `10 crore. If the
company uses this piece of land for a project then its sale value i.e. `10 crore forms

the part of initial outlay as by using the land the company has foregone `10 crore
which could be earned by selling it. This opportunity cost can occur both at the
time of initial outlay and during the tenure of the project.
Opportunity costs are considered for estimation of cash outflows.
(c) Sunk Cost: Sunk cost is an outlay of cash that has already been incurred
and cannot be reversed in present. Therefore, these costs do not have any impact
on decision making, hence should be excluded from capital budgeting analysis. For
example, if a company has paid a sum of `1,00,000 for consultancy fees to a firm
to prepare a Project Report for analysing a particular project. The consultancy fee
is irrelevant and not considered for estimating cash flows as it has already been
paid and shall not affect our decision whether project should be undertaken or not.
(d) Working Capital: Every big project requires working capital because, for
every business, investment in working capital is must. Therefore, while evaluating
the projects initial working capital requirement should be treated as cash
outflow and at the end of the project its release should be treated as cash inflow.
It is important to note that no depreciation is provided on working capital though
it might be possible that at the time of its release its value might have been
reduced. Further there may be also a possibility that additional working capital
may be required during the life of the project. In such cases the additional working
capital required is treated as cash outflow at that period of time. Similarly, any
reduction in working capital shall be treated as cash inflow. It may be noted that, if
nothing has been specifically mentioned for the release of working capital it is
assumed that full amount has been realized at the end of the project. However,
adjustment on account of increase or decrease in working capital needs to be
incorporated.
(e) Allocated Overheads: As discussed in subject of Cost and Management
Accounting, allocated overheads are charged on the basis of some rational basis
such as machine hour, labour hour, direct material consumption etc. Since,
expenditures already incurred are allocated to new proposal; they should not be
considered as cash flows. However, it is expected that overhead cost shall increase
due to acceptance of any proposal then incremental overhead cost shall be treated
as cash outflow.
(f) Additional Capital Investment: It is not necessary that capital investment
shall be required in the beginning of the project. It can also be required during the
continuance of the project. In such cases it shall be treated as cash outflows.

Categories of Cash Flows: It is helpful to place project cash flows into three
categories:-
(a) Initial Cash Outflow: The initial cash out flow for a project depends upon
the type of capital investment decision as follows:-
(i) If decision is related to investment in a fresh proposal or an expansion decision
then initial cash outflow shall be calculated as follows:
Amount Amount
Cost of new Asset(s) xxx
Add: Installation/Set-Up Costs xxx
Add: Investment in Working Capital xxx xxx
Initial Cash Outflow xxx
(ii) If decision is related to replacement decision then initial cash outflow shall be
calculated as follows:
Amount Amount
Cost of new Asset(s) xxx
Add: Add: Installation/Set-Up Costs xxx
Add/(less): Increase (Decrease) in net Working xxx
Capital level
Less: Net Proceeds from sale of old assets (xxx)
(If it is a replacement situation)
Add/(less): Tax expense (saving/ loss) due to sale xxx xxx
of Old Asset
(If it is a replacement situation)
Initial Cash Outflow xxx
(b) Interim Cash Flows: After making the initial cash outflow that is necessary to
begin implementing a project, the firm hopes to get benefit from the future cash
inflows generated by the project. As mentioned earlier calculation of cash flows
depends on the fact whether analysis is related to fresh project or modernization
of existing facilities or replacement of existing machined decision.
(i) New Project: If analysis is related to a fresh or completely a new project then
interim cash flow is calculated as follows:-

Amount Amount
Profit after Tax (PAT) xxx
Add: Non-Cash Expenses (e.g. xxx
Depreciation)
Add/ (less): Net decrease (increase) in xxx xxx
Working Capital
Interim net cash flow for the xxx
period
(ii) Similarly interim cash flow in case of replacement decision shall be calculated as
follows:
Amount Amount
Net increase (decrease) in Operating xxx
Revenue
Add/ (less): Net decrease (increase) in operating xxx
expenses
Net change in income before taxes xxx
Add/ (less): Net decrease (increase) in taxes xxx
Net change in income after taxes xxx
Add/ (less): Net decrease (increase) in xxx
depreciation charges
Incremental net cash flow for the xxx
period
(c) Terminal-Year Incremental Net Cash Flow: We now pay attention to the
Net Cash Flow in the terminal year of the project. For the purpose of Terminal Year
we will first calculate the incremental net cash flow for the period as calculated in
point (b) above and further to it we will make adjustments in order to arrive at
Terminal-Year Incremental Net Cash flow as follows: -
Amount Amount
Final salvage value (disposal costs) of xxx

asset
Add: Interim Cash Flow xxx

Add/ (less): Tax savings (tax expenses) due to sale or xxx

disposal of asset (Including
Depreciation)
Add: Release of Net Working Capital xxx
Terminal Year incremental net cash xxx
flow
7.6 BASIC PRINCIPLES FOR MEASURING PROJECT

CASH FLOWS
For developing the project cash flows the following principles must be kept in mind:
7.6.1 Block of Assets and Depreciation
From above discussion it is clear that tax shield/ benefit from depreciation is
considered while calculating cash flows from the project. Taxable income is
calculated as per the provisions of Income Tax or similar Act of a country. The
treatment of deprecation is based on the concept of “Block of Assets”, which means
a group of assets falling within a particular class of assets. This class of assets can
be building, machinery, furniture etc. in respect of which depreciation is charged at
same rate. The treatment of tax depends on the fact whether block of asset consist
of one asset or several assets. To understand the concept of block of asset let us
discuss an example.
Example
Suppose A Ltd. acquired new machinery for `1,00,000 depreciable at 20% as per
Written Down Value (WDV) method. The machine has an expected life of 5 years
with salvage value of `10,000. The treatment of Depreciation/ Short Term Capital
Loss in the 5th year in two cases shall be as follows:
Depreciation for initial 4 years shall be common and WDV at the beginning of the
5th year shall be computed as follows:
`
Purchase Price of Machinery 1,00,000
Less: Depreciation @20% for year 1 20,000
WDV at the end of year 1 80,000


(i) Case 1: There is no other asset in the Block: When there is one asset in the
block and block shall cease to exist at the end of 5th year no deprecation shall be
charged in this year and tax benefit/loss on Short Term Capital Loss/ Gain shall
be calculated as follows:
`
WDV at the beginning of year 5 40,960
Less: Sale value of Machine 10,000
Short Term Capital Loss 30,960
Tax Benefit on STCL @ 30% 9,288
(ii) Case 2: More than one asset exists in the Block: When more than one asset
exists in the block and deprecation shall be charged in the terminal year (5th year)
in which asset is sold. The WDV on which depreciation be charged shall be
calculated by deducting sale value from the WDV in the beginning of the year.
Tax benefit on Depreciation shall be calculated as follows:
`
WDV 30,960
Depreciation @20% 6,192
Tax Benefit on Depreciation @ 30% 1,858
Now suppose if in above two cases sale value of machine is ` 50,000, then no
depreciation shall be provided in case 2 and tax loss on Short Term Capital Gain in
Case 1 shall be computed as follows:
`


Short Term Capital Gain 9,040
Tax Loss on STCG @ 30% 2,712
7.6.2 Exclusion of Financing Costs Principle

When cash flows relating to long-term funds are being defined, financing costs of
long-term funds (interest on long-term debt and equity dividend) should be
excluded from the analysis. The interest and dividend payments are reflected in
the weighted average cost of capital. Hence, if interest on long-term debt and
dividend on equity capital are deducted in defining the cash flows, the cost of long-
term funds will be counted twice.
The exclusion of financing costs principle means that:
(i) The interest on long-term debt (or interest) is ignored while computing profits
and taxes and;
(ii) The expected dividends are deemed irrelevant in cash flow analysis.
While dividends pose no difficulty as they come only from profit after taxes, interest
needs to be handled properly. Since interest is usually deducted in the process of
arriving at profit after tax, an amount equal to ‘Interest (1 − Tax rate)’ should be
added back to the figure of Profit after Tax as shown below:
Profit Before Interest and Tax × (1 − Tax rate)
= (Profit Before Tax + Interest) (1 − Tax rate)
= (Profit Before Tax) (1 − Tax rate) + (Interest) (1 − Tax rate)
= Profit After Tax + Interest (1 − Tax rate)
Thus, whether the tax rate is applied directly to the profit before interest and tax
figure or whether the tax − adjusted interest, which is simply interest (1 − tax rate),
is added to profit after tax, we get the same result.
Example
Suppose XYZ Ltd.’s expected profit for the forthcoming 4 years is as follows:
Year 1 Year 2 Year 3 Year 4
Profit before Interest and Tax `10,000 `20,000 `40,000 `50,000
If interest payable is `5,000 and tax rate is 30% the profit after tax excluding
financing cost shall be as follows:


(`) (`) (`) (`)
Profit before Interest and Tax 10,000 20,000 40,000 50,000
Less: Interest (5,000) (5,000) (5,000) (5,000)
5,000 15,000 35,000 45,000
Less: Tax @ 30% (1,500) (4,500) (10,500) 13,500
Profit after Tax (PAT) 3,500 10,500 24,500 31,500
Add: Interest (1- t) 3,500 3,500 3,500 3,500
PAT excluding financing cost 7,000 14,000 28,000 35,000
Alternatively

(`) (`) (`) (`)
Profit before Interest and Tax 10,000 20,000 40,000 50,000
Less: Tax @ 30% 3,000 6,000 12,000 15,000
PAT excluding financing cost 7,000 14,000 28,000 35,000
7.6.3 Post−tax Principle

Tax payments like other payments must be properly deducted in deriving the cash
flows. That is, cash flows must be defined in post-tax terms. It is always better to
avoid using Pre Tax Cash Flows and using Pre-Tax Discounting Rate.
STATEMENT SHOWING THE CALCULATION OF CASH INFLOW AFTER TAX (CFAT)
Sl. No. (`)
1 Total Sales Units xxx
2 Selling Price per unit xxx
3. Total Sales [1 × 2] xxx
4. Less: Variable Cost xxx
5. Contribution [3-4] xxx
6. Less: Fixed Cost
(a) Fixed Cash Cost xxx
(b) Depreciation xxx

7. Earning Before Tax [6-7] xxx

8. Less: Tax xxx
9. Earning After Tax [7-8] xxx
10. Add: Depreciation xxx
11. Cash Inflow After Tax (CFAT) [9 +10] xxx
ILLUSTRATION 1
ABC Ltd is evaluating the purchase of a new machinery with a depreciable base of
`1,00,000; expected economic life of 4 years and change in earnings before taxes and
depreciation of `45,000 in year 1, `30,000 in year 2, `25,000 in year 3 and `35,000
in year 4. Assume straight-line depreciation and a 20% tax rate. You are required to
COMPUTE relevant cash flows.
SOLUTION
Amount (in `)
Years
1 2 3 4
Earnings before tax and depreciation 45,000 30,000 25,000 35,000
Less: Depreciation (25,000) (25,000) (25,000) (25,000)
Earnings before tax 20,000 5,000 0 10,000
Less: Tax @20% (4,000) (1,000) 0 (2,000)
16,000 4,000 0 8,000
Add: Depreciation 25,000 25,000 25,000 25,000
Net Cash flow 41,000 29,000 25,000 33,000
Working Note:
Depreciation = `1, 00,000÷4 = `25,000

SECTION 2
7.7 CAPITAL BUDGETING TECHNIQUES

7
In order to maximise the return to the shareholders of a company, it is important
that the best or most profitable investment projects are selected. Results of making
a bad long-term investment decision can be devastating in both financial and
strategic terms. Care required for investment project selection and evaluation.
There are a number of techniques available for appraisal of investment proposals
and can be classified as presented below:
Traditional or Non Payback Period

Discounting
Accounting Rate of
Return (ARR)
Net Present Value
Capital Budgeting (NPV)
Techniques
Profitability Index (PI)
Time adjusted or
Internal Rate of Return
Discounted Cash
(IRR)
Flows
Modified Internal Rate
of Return (MIRR)
Discounted Payback
Organizations may use any one or more of capital investment evaluation techniques;
some organizations use different methods for different types of projects while others
may use multiple methods for evaluating each project. These techniques have been
discussed below – net present value, profitability index, internal rate of return, modified
internal rate of return, payback period, and accounting (book) rate of return.
7.8 TRADITIONAL OR NON-DISCOUNTING

TECHNIQUES
These techniques of capital Budgeting does not discount the future cash flows.
There are two such techniques namely Payback Period and Accounting Rate of
Return

7.8.1 Payback Period

Time required to recover the initial cash-outflow is called pay-back period. The
payback period of an investment is the length of time required for the cumulative
total net cash flows from the investment to equal the total initial cash outlays. At
that point in time, the investor has recovered the money invested in the project.
Steps in Payback period technique: -
(a) The first steps in calculating the payback period is determining the total initial
capital investment (cash outflow) and
(b) The second step is calculating/estimating the annual expected after-tax cash
flows over the useful life of the investment.
1. When the cash inflows are uniform over the useful life of the project, the number
of years in the payback period can be calculated using the following equation:
Total initial capital investment
Payback period =
Annual expected after - tax net cash flow
Example: Suppose a project costs `20,00,000 and yields annually a profit of

`3,00,000 after depreciation @ 12½% (straight line method) but before tax 50%.
The first step would be to calculate the cash inflow from this project. The cash
inflow is `4,00,000 calculated as follows:
Particulars (`)
Profit before tax 3,00,000
Less: Tax @ 50% (1,50,000)
Profit after tax 1,50,000
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000
While calculating cash inflow, depreciation is added back to profit after tax since it
does not result in cash outflow. The cash generated from a project therefore is
equal to profit after tax plus depreciation. The payback period of the project shall
be:
` 20,00,000
Payback period = = 5 Years
4,00,000

Some Accountants calculate payback period after discounting the cash flows by a
predetermined rate and the payback period so calculated is called, ‘Discounted
payback period’ (discussed later on).
2. When the annual cash inflows are not uniform, the cumulative cash inflow
from operations must be calculated for each year. The payback period shall be
corresponding period when total of cumulative cash inflows is equal to the initial
capital investment. However, if exact sum does not match then the period in which
it lies should be identified. After that we need to compute the fraction of the year.
This method can be understood with the help of an example
Example
Suppose XYZ Ltd. is analyzing a project requiring an initial cash outlay of `2,00,000
and expected to generate cash inflows as follows:
Year Annual Cash Inflows

1 80,000
2 60,000
3 60,000
4 20,000
It’s payback period shall be computed by using cumulative cash flows as follows:
Year Annual Cash Inflows Cumulative Cash Inflows
1 80,000 80,000
2 60,000 1,40,000
3 60,000 2,00,000 ←
4 20,000 2,20,000
In 3 years total cash inflows equal to initial cash outlay. Hence, payback period is 3
years.
Suppose if in above example the initial outlay is `2,05,000 then payback period
shall be computed as follows:
Year Annual Cash Inflows Cumulative Cash

Inflows
1 80,000 80,000
2 60,000 1,40,000

3 60,000 2,00,000
4 20,000 2,20,000 ←
Payback period shall lie between 3 to 4 years. Since up to 3 years a sum of `2,00,000
shall be recovered balance of `5,000 shall be recovered in the part (fraction) of 4th
year, computation is as follows:
5,000 1
= year
20,000 4
Thus, total cash outlay of ` 205,000 shall be recovered in 3¼ years’ time.
Advantages of Payback period
 It is easy to compute.
 It is easy to understand as it provides a quick estimate of the time needed for
the organization to recoup the cash invested.
 The length of the payback period can also serve as an estimate of a project’s
risk; the longer the payback period, the riskier the project as long-term
predictions are less reliable. In some industries with high obsolescence risk like
software industry or in situations where an organization is short on cash, short
payback periods often become the determining factor for investments.
Limitations of Payback period
 It ignores the time value of money. As long as the payback periods for two
projects are the same, the payback period technique considers them equal as
investments, even if one project generates most of its net cash inflows in the
early years of the project while the other project generates most of its net cash
inflows in the latter years of the payback period.
 A second limitation of this technique is its failure to consider an investment’s
total profitability; it only considers cash inflows upto the period in which initial
investment is fully recovered and ignores cash flows after the payback period.
 Payback technique places much emphasis on short payback periods thereby
ignoring long-term projects.
7.8.1.1 Payback Reciprocal
As the name indicates it is the reciprocal of payback period. A major drawback of
the payback period method of capital budgeting is that it does not indicate any cut
off period for the purpose of investment decision. It is, however, argued that the

reciprocal of the payback would be a close approximation of the Internal Rate of

Return (later discussed in detail) if the life of the project is at least twice the payback
period and the project generates equal amount of the annual cash inflows. In
practice, the payback reciprocal is a helpful tool for quick estimation of rate of
return of a project provided its life is at least twice the payback period.
The payback reciprocal can be calculated as follows:
Average annual cash in flow
Payback Reciprocal =
Initial investment
Example
Suppose a project requires an initial investment of `20,000 and it would give annual
cash inflow of `4,000. The useful life of the project is estimated to be 5 years. In
this example payback reciprocal will be:
` 4,000×100
=20%
` 20,000
The above payback reciprocal provides a reasonable approximation of the internal
rate of return, i.e. 19%.
7.8.2 Accounting (Book) Rate of Return (ARR) or Average Rate of Return
(ARR)
The accounting rate of return of an investment measures the average annual net
income of the project (incremental income) as a percentage of the investment.
Average annual net income
Accounting rate of return =
Investment
The numerator is the average annual net income generated by the project over its
useful life. The denominator can be either the initial investment (including
installation cost) or the average investment over the useful life of the project.
Average investment means the average amount of fund remained blocked during
the lifetime of the project under consideration. Further ARR can be calculated in a
number of ways as shown in the following example.
Example
Suppose Times Ltd. is going to invest in a project a sum of ` 3,00,000 having a life
span of 3 years. Salvage value of machine is `90,000. The profit before depreciation
for each year is `1,50,000.

The Profit after Tax and value of Investment in the Beginning and at the End of each
year shall be as follows:
Year Profit Depreciation Profit Value of Investment

Before after Dep. in
Depreciation (`) (`) (`)
(`)
Beginning End
1 1,50,000 70,000 80,000 3,00,000 2,30,000
2 1,50,000 70,000 80,000 2,30,000 1,60,000
3 1,50,000 70,000 80,000 1,60,000 90,000
The ARR can be computed by following methods as follows:

(a) Version 1: Annual Basis
Profit afterDepreciation
ARR =
Investmentinthebeginingof the year
Year
1 80,000
= 26.67%
3,00,000
2 80,000
= 34.78%
2,30,000
3 80,000
=50%
1,60,000
26.67%+34.78%+50.00%
Average ARR = = 37.15%
3
(b) Version 2: Total Investment Basis
Average AnnualProfit
ARR = ×100
Investmentinthebegining
(80,000+80,000+80,000) / 3
= ×100 = 26.67%
3,00,000

(c) Version 3: Average Investment Basis

Average AnnualProfit
ARR = ×100
AverageInvestment
Average Investment = (`3,00,000 + ` 90,000)/2 = `1,95,000
Or, ½(Initial Investment – Salvage Value) + Salvage Value
= ½(`3,00,000 –`90,000) + `90,000 = ` 1,95,000
80,000
= ×100 = 41.03%
1,95,000
Further, it is important to note that project may also require additional working
capital during its life in addition to initial working capital. In such situation formula
for the calculation of average investment shall be modified as follows:
½(Initial Investment – Salvage Value) + Salvage Value+ Additional Working Capital
Continuing above example, suppose a sum of `45,000 is required as additional
working capital during the project life then average investment shall be:
= ½ (`3,00,000 – `90,000) + `90,000 + `45,000 = `2,40,000 and
80,000
ARR = ×100 = 33.33%
2, 40,000
Some organizations prefer the initial investment because it is objectively
determined and is not influenced by either the choice of the depreciation method
or the estimation of the salvage value. Either of these amounts is used in practice
but it is important that the same method be used for all investments under
consideration.
Advantages of ARR
 This technique uses readily available data that is routinely generated for
financial reports and does not require any special procedures to generate data.
 This method may also mirror the method used to evaluate performance on the
operating results of an investment and management performance. Using the
same procedure in both decision-making and performance evaluation ensures
consistency.

 Calculation of the accounting rate of return method considers all net incomes
over the entire life of the project and provides a measure of the investment’s
profitability.
Limitations of ARR
 The accounting rate of return technique, like the payback period technique,
ignores the time value of money and considers the value of all cash flows to
be equal.
 The technique uses accounting numbers that are dependent on the
organization’s choice of accounting procedures, and different accounting
procedures, e.g., depreciation methods, can lead to substantially different
amounts for an investment’s net income and book values.
 The method uses net income rather than cash flows; while net income is a
useful measure of profitability, the net cash flow is a better measure of an
investment’s performance.
 Furthermore, inclusion of only the book value of the invested asset ignores the
fact that a project can require commitments of working capital and other
outlays that are not included in the book value of the project.
ILLUSTRATION 2
A project requiring an investment of `10,00,000 and it yields profit after tax and
depreciation which is as follows:
Years Profit after tax and depreciation (`)

1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
th
Suppose further that at the end of the 5 year, the plant and machinery of the project
can be sold for ` 80,000. DETERMINE Average Rate of Return.
SOLUTION
In this case the rate of return can be calculated as follows:

Total Profit÷No. of years

× 100
Average investment / Initial Investment
(a) If Initial Investment is considered then,

` 4,60,000÷5 years `92,000
= ×100 = ×100 =9.2%
`10,00,000 `10,00,000
This rate is compared with the rate expected on other projects, had the same
funds been invested alternatively in those projects. Sometimes, the management
compares this rate with the minimum rate (called-cut off rate). For example,
management may decide that they will not undertake any project which has an
average annual yield after tax less than 20%. Any capital expenditure proposal
which has an average annual yield of less than 20% will be automatically rejected.
(b) If Average investment is considered, then,
92,000 92,000
= × 100 = × 100 = 17.04%
Average investment 5, 40,000
Where,
Average Investment= ½ (Initial investment – Salvage value) + Salvage value
= ½ (10,00,000 – 80,000) + 80,000
= 4,60,000 + 80,000 = 5,40,000
7.9 DISCOUNTING TECHNIQUES

Discounting techniques consider time value of money and discount the cash flows
to their Present Value. These techniques are also known as Present Value
techniques. These are namely Net Present Value (NPV), Internal Rate of Return (IRR)
and Profitability Index (PI). First let us discuss about Determination of Discount rate
and it will be followed by the three techniques.
Determining Discount Rate
Theoretically, the discount rate or desired rate of return on an investment is the
rate of return the firm would have earned by investing the same funds in the best
available alternative investment that has the same risk. Determining the best
alternative opportunity available is difficult in practical terms so rather than using
the true opportunity cost, organizations often use an alternative measure for the
desired rate of return. An organization may establish a minimum rate of return that
all capital projects must meet; this minimum could be based on an industry average

or the cost of other investment opportunities. Many organizations choose to use

the overall cost of capital or Weighted Average Cost of Capital (WACC) that an
organization has incurred in raising funds or expects to incur in raising the funds
needed for an investment.
7.9.1 Net Present Value Technique (NPV)
The net present value technique is a discounted cash flow method that considers
the time value of money in evaluating capital investments. An investment has cash
flows throughout its life, and it is assumed that an amount of cash flow in the early
years of an investment is worth more than an amount of cash flow in a later year.
The net present value method uses a specified discount rate to bring all subsequent
cash inflows after the initial investment to their present values (the time of the
initial investment is year 0).
The net present value of a project is the amount, in current value of amount, the
investment earns after paying cost of capital in each period.
Net present value = Present value of net cash inflow - Total net initial investment
Since it might be possible that some additional investment may also be required
during the life time of the project then appropriate formula shall be:
Net present value = Present value of cash inflows - Present value of cash outflows
It can be expressed as below:
 C C2 C3 Cn 
NPV =  1 + + +......+  -I
 (1+k) (1+k) (1+k)
2 3
(1+k)n 
n Ct
NPV = ∑ -I
t =1 (1+k)t
Where,
C=Cash flow of various years

K = discount rate
N=Life of the project
I = Investment

Steps to calculating Net Present Value (NPV):

The steps to calculating net present value are: -
1. Determine the net cash inflow in each year of the investment
2. Select the desired rate of return or discounting rate or Weighted Average Cost
of Capital.
3. Find the discount factor for each year based on the desired rate of return
selected.
4. Determine the present values of the net cash flows by multiplying the cash flows
by respective discount factors of respective period called Present Value (PV) of
Cash flows
5. Total the amounts of all PVs of Cash Flows
Decision Rule:
If NPV ≥ 0 Accept the Proposal
If NPV ≤ 0 Reject the Proposal
The NPV method can be used to select between mutually exclusive projects; the
one with the higher NPV should be selected
ILLUSTRATION 3
COMPUTE the net present value for a project with a net investment of `1,00,000 and
net cash flows year one is `55,000; for year two is `80,000 and for year three is
` 15,000. Further, the company’s cost of capital is 10%?
[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]
SOLUTION
Year Net Cash Flows PVIF @ 10% Discounted Cash Flows
0 (1,00,000) 1.000 (1,00,000)
1 55,000 0.909 49,995
2 80,000 0.826 66,080
3 15,000 0.751 11,265
Net Present Value 27,340

Recommendation: Since the net present value of the project is positive, the
company should accept the project.
ILLUSTRATION 4
ABC Ltd is a small company that is currently analyzing capital expenditure proposals
for the purchase of equipment; the company uses the net present value technique to
evaluate projects. The capital budget is limited to ` 500,000 which ABC Ltd believes
is the maximum capital it can raise. The initial investment and projected net cash
flows for each project are shown below. The cost of capital of ABC Ltd is 12%. You
are required to COMPUTE the NPV of the different projects.
Project A Project B Project C Project D

Initial Investment 200,000 190,000 250,000 210,000
Project Cash Inflows
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000
SOLUTION
Calculation of net present value:
Period PV factor Project A Project B Project C Project D

0 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000)
1 0.893 44,650 35,720 66,975 66,975
2 0.797 39,850 39,850 59,775 59,775
3 0.712 35,600 49,840 42,720 42,720
4 0.636 31,800 47,700 50,880 25,440
5 0.567 28,350 42,525 56,700 11,340
Net Present Value (19,750) 25,635 27,050 (3,750)
Advantages of NPV
 NPV method takes into account the time value of money.
 The whole stream of cash flows is considered.

 The net present value can be seen as the addition to the wealth of shareholders.
The criterion of NPV is thus in conformity with basic financial objectives.
 The NPV uses the discounted cash flows i.e., expresses cash flows in terms of
current rupees. The NPVs of different projects therefore can be compared. It
implies that each project can be evaluated independent of others on its own
merit.
Limitations of NPV
 It involves difficult calculations.
 The application of this method necessitates forecasting cash flows and the
discount rate. Thus accuracy of NPV depends on accurate estimation of these
two factors which may be quite difficult in practice.
The decision under NPV method is based on absolute measure. It ignores the
difference in initial outflows, size of different proposals etc. while evaluating
mutually exclusive projects.
7.9.2 Profitability Index /Desirability Factor/Present Value Index
Method (PI)
The students may have seen how with the help of discounted cash flow technique,
the two alternative proposals for capital expenditure can be compared. In certain
cases we have to compare a number of proposals each involving different
amounts of cash inflows.
One of the methods of comparing such proposals is to work out what is known as
the ‘Desirability factor’, or ‘Profitability index’ or ‘Present Value Index Method’.
Mathematically:
The Profitability Index (PI) is calculated as below:
Sum of discounted cash in flows
Profitability Index (PI)=
Initial cash outlay or Total discounted cash outflow (as the case may)
Decision Rule:
If PI ≥ 1 Accept the Proposal
If PI ≤ 1 Reject the Proposal
In case of mutually exclusive projects; project with higher PI should be selected

ILLUSTRATION 5
Suppose we have three projects involving discounted cash outflow of `5,50,000, `
75,000 and `1,00,20,000 respectively. Suppose further that the sum of discounted
cash inflows for these projects are `6,50,000, `95,000 and `1,00,30,000 respectively.
CALCULATE the desirability factors for the three projects.
SOLUTION
The desirability factors for the three projects would be as follows:
`6,50,000
1. =1.18
`5,50,000
`95,000
2. = 1.27
`75,000
`1,00,30,000
3. =1.001
`1,00,20,000
It would be seen that in absolute terms project 3 gives the highest cash inflows yet
its desirability factor is low. This is because the outflow is also very high. The
Desirability/ Profitability Index factor helps us in ranking various projects.
Since PI is an extension of NPV it has same advantages and limitation.
Advantages of PI
 The method also uses the concept of time value of money and is a better project
evaluation technique than NPV.
 In the PI method, since the present value of cash inflows is divided by the present
value of cash outflow, it is a relative measure of a project’s profitability.
Limitations of PI
 Profitability index fails as a guide in resolving capital rationing where projects are
indivisible.
 Once a single large project with high NPV is selected, possibility of accepting
several small projects which together may have higher NPV than the single
project is excluded.
 Also situations may arise where a project with a lower profitability index selected
may generate cash flows in such a way that another project can be taken up one
or two years later, the total NPV in such case being more than the one with a
project with highest Profitability Index.

The Profitability Index approach thus cannot be used indiscriminately but all
other type of alternatives of projects will have to be worked out.
7.9.3 Internal Rate of Return Method (IRR)
The internal rate of return method considers the time value of money, the initial
cash investment, and all cash flows from the investment. But unlike the net present
value method, the internal rate of return method does not use the desired rate of
return but estimates the discount rate that makes the present value of subsequent
cash inflows equal to the initial investment. This discount rate is called IRR.
IRR Definition: Internal rate of return for an investment proposal is the discount
rate that equates the present value of the expected cash inflows with the initial cash
outflow.
This IRR is then compared to a criterion rate of return that can be the organization’s
desired rate of return for evaluating capital investments.
Calculation of IRR: The procedures for computing the internal rate of return vary
with the pattern of net cash flows over the useful life of an investment.
Scenario 1: For an investment with uniform cash flows over its life, the following
equation is used:
Step 1: Total initial investment =Annual cash inflow × Annuity discount factor of
the discount rate for the number of periods of the investment’s useful life
If A is the annuity discount factor, then
Total initial cash disbursements and commitments for the investment
A=
Annual (equal) cash inflows from the investment
Step 2: Once A has been calculated, the discount rate is the interest rate that has
the same discounting factor as A in the annuity table along the row for the number
of periods of the useful life of the investment. If exact value of ‘A’ could be found
in Present Value Annuity Factor (PVAF) table corresponding to the period of the
project the respective discounting factor or rate shall be IRR. However, it rarely
happens therefore we follow the method discussed below:
Step 1: Compute approximate payback period also called fake payback period.
Step 2: Locate this value in PVAF table corresponding to period of life of the project.
The value may be falling between two discounting rates.
Step 3: Discount cash flows using these two discounting rates.

Step 4: Use following Interpolation Formula:

NPV at LR
LR + ×(HR -LR)
NPV at LR - NPV at HR
Where,
LR = Lower Rate
HR = Higher Rate
ILLUSTRATION 6
A Ltd. is evaluating a project involving an outlay of `10,00,000 resulting in an annual
cash inflow of ` 2,50,000 for 6 years. Assuming salvage value of the project is zero;
DETERMINE the IRR of the project.
SOLUTION
First of all we shall find an approximation of the payback period:
10,00,000
=4
2,50,000
Now we shall search this figure in the PVAF table corresponding to 6-year row.
The value 4 lies between values 4.111 and 3.998 correspondingly discounting rates
12% and 13% respectively.
NPV @ 12%
NPV12%= (10,00,000) + 4.111 × 2,50,000 = 27,750
NPV13%= (10,00,000) + 3.998 × 2,50,000 = -500
The internal rate of return is, thus, more than 12% but less than 13%. The exact rate
can be obtained by interpolation:
27,750
IRR =12%+ ×(13% -12%)
27,750 - (500)
27,750
= 12% + = 12.98%
28,250
IRR = 12.98%
Scenario 2: When the cash inflows are not uniform over the life of the investment,
the determination of the discount rate can involve trial and error and interpolation

between discounting rates as mentioned above. However, IRR can also be found
out by using following procedure:
Step 1: Discount the cash flow at any random rate say 10%, 15% or 20% randomly.
Step 2: If resultant NPV is negative then discount cash flows again by lower
discounting rate to make NPV positive. Conversely, if resultant NPV is positive then
again discount cash flows by higher discounting rate to make NPV negative.
Step 3: Use following Interpolation Formula:
NPV at LR
=LR + ×(HR -LR)
Where
LR = Lower Rate
HR = Higher Rate
ILLUSTRATION 7
CALCULATE the internal rate of return of an investment of `1,36,000 which yields the
following cash inflows:
Year Cash Inflows (in ` )

1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
SOLUTION
Let us discount cash flows by 10%.
Year Cash Inflows (`) Discounting factor at Present Value (`)

10%
1 30,000 0.909 27,270
2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 30,000 0.683 20,490

5 20,000 0.621 12,420

Total present value 1,38,280
The present value at 10% comes to `1,38,280, which is more than the initial
investment. Therefore, a higher discount rate is suggested, say, 12%.
Year Cash Inflows (`) Discounting factor at Present Value (`)

12%
1 30,000 0.893 26,790
2 40,000 0.797 31,880
3 60,000 0.712 42,720
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Total present value 1,31,810
  `1,38,280 - `1,36,000  
IRR = 10+  `1,38,280 - `1,31,810   × 2
  
 2,280 
= 10 +  ×2  = 10 + 0.70
 6, 470 
IRR = 10.70%
ILLUSTRATION 8
A company proposes to install machine involving a capital cost of `3,60,000. The life
of the machine is 5 years and its salvage value at the end of the life is nil. The
machine will produce the net operating income after depreciation of `68,000 per
annum. The company's tax rate is 45%.
The Net Present Value factors for 5 years are as under:
Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13
You are required to CALCULATE the internal rate of return of the proposal.

SOLUTION
Computation of Cash inflow per annum (` )
Net operating income per annum 68,000

Less: Tax @ 45% (30,600)
Profit after tax 37,400
Add: Depreciation (` 3,60,000 / 5 years) 72,000
Cash inflow 1,09,400
The IRR of the investment can be found as follows:

NPV = −`3,60,000 + `1,09,400 (PVAF5, r) = 0
`3,60,000
or PVAF5,r (Cumulative factor) = = 3.29
`1,09, 400
Computation of Internal Rate of Return
Discounting Rate 15% 16%
Cumulative factor 3.35 3.27
PV of Inflows 3,66,490 3,57,738
(`1,09,400×3.35) (`1,09,400×3.27)
Initial outlay (`) 3,60,000 3,60,000
NPV (`) 6,490 (2,262)
 6, 490 
IRR = 15+   =15+0.74 = 15.74%.
 6, 490+2,262 
Acceptance Rule
The use of IRR, as a criterion to accept capital investment decision involves a
comparison of IRR with the required rate of return known as cut off rate. The project
should the accepted if IRR is greater than cut-off rate. If IRR is equal to cut off rate
the firm is indifferent. If IRR less than cut off rate the project is rejected. Thus,
If IRR ≥ Cut-off Rate or WACC Accept the Proposal
If IRR ≤ Cut-off Rate or WACC Reject the Proposal

Internal Rate of Return and Mutually Exclusive Projects

Projects are called mutually exclusive, when the selection of one precludes the
selection of others e.g. in case a company owns a piece of land which can be put
to use for either of the two different projects S or L, then such projects are mutually
exclusive to each other i.e. the selection of one project necessarily means the
rejection of the other. Refer to the figure below:
As long as the cost of capital is greater than the crossover rate of 7%, then (1) NPVS
is larger than NPVL and (2) IRRS exceeds IRRL. Hence, if the cut off rate or the cost
of capital is greater than 7%, both the methods shall lead to selection of project S.
However, if the cost of capital is less than 7%, the NPV method ranks Project L
higher, but the IRR method indicates that the Project S is better.
As can be seen from the above discussion, mutually exclusive projects can create
problems with the IRR technique because IRR is expressed as a percentage and does
not take into account the scale of investment or the quantum of money earned.
Let us consider another example of two mutually exclusive projects A and B with
the following details,
Cash flows
Year 0 Year 1 IRR NPV (10%)

Project A (` 1,00,000) `1,50,000 50% ` 36,360
Project B (` 5,00,000) ` 6,25,000 25% ` 68,180

Project A earns a return of 50% which is more than what Project B earns; however,
the NPV of Project B is greater than that of Project A. Acceptance of Project A
means that Project B must be rejected since the two Projects are mutually exclusive.
Acceptance of Project A also implies that the total investment will be `4,00,000 less
than if Project B had been accepted, `4,00,000 being the difference between the
initial investment of the two projects. Assuming that the funds are freely available
at 10%, the total capital expenditure of the company should be ideally equal to the
sum total of all outflows provided they earn more than 10% along with the chosen
project from amongst the mutually exclusive. Hence, in case the smaller of the two
Projects i.e. Project A is selected, the implication will be of rejecting the investment
of additional funds required by the larger investment. This shall lead to a reduction
in the shareholders’ wealth and thus, such an action shall be against the very basic
tenets of Financial Management.
In the above mentioned example the larger of the two projects had the lower IRR,
but nevertheless provided for the wealth maximising choice. However, it is not safe
to assume that a choice can be made between mutually exclusive projects using
IRR in cases where the larger project also happens to have the higher IRR. Consider
the following two Projects A and B with their relevant cash flows;
Year A B
(`) (`)
0 (9,00,000) (8,00,000)
1 7,00,000 62,500
2 6,00,000 6,00,000
3 4,00,000 6,00,000
4 50,000 6,00,000
In this case Project A is the larger investment and also has a higher IRR as shown
below,
Year (`) r = 46% PV (`) (`) r = 35% PV (`)

0 (9,00,000) 1.0000 (9,00,000) (8,00,000) 1.0000 (8,00,000)
1 7,00,000 0.6849 4,79,430 62,500 0.7407 46,294
2 6,00,000 0.4691 2,81,460 6,00,000 0.5487 3,29,220
3 4,00,000 0.3213 1,28,520 6,00,000 0.4064 2,43,840

4 50,000 0.2201 11,005 6,00,000 0.3011 1,80,660

(415) 14
IRR of Project A = 46%
IRR of Project B = 35%
However, in case the relevant discounting factor is taken as 5%, the NPV of the two
projects provides a different picture as follows;
Project A Project B
Year (`) r= 5% PV (`) (`) r= 5% PV (`)
0 (9,00,000) 1.0 (9,00,000) (8,00,000) 1.0 (8,00,000)
1 7,00,000 0.9524 6,66,680 62,500 0.9524 59,525
2 6,00,000 0.9070 5,44,200 6,00,000 0.9070 5,44,200
3 4,00,000 0.8638 3,45,520 6,00,000 0.8638 5,18,280
4 50,000 0.8227 41,135 6,00,000 0.8227 4,93,620
NPV 6,97,535 8,15,625
As may be seen from the above, Project B should be the one to be selected even
though its IRR is lower than that of Project A. This decision shall need to be taken
in spite of the fact that Project A has a larger investment coupled with a higher IRR
as compared with Project B. This type of an anomalous situation arises because of
the reinvestment assumptions implicit in the two evaluation methods of NPV and
IRR.
7.9.4 Discounted Payback Period Method
Some accountants prefer to calculate payback period after discounting the cash
flow by a predetermined rate and the payback period so calculated is called,
‘Discounted payback period’. One of the most popular economic criteria for
evaluating capital projects also is the payback period. Payback period is the time
required for cumulative cash inflows to recover the cash outflows of the project.
This is considered superior to simple payback period method because it takes into
account time value of money.
For example, a `30,000 cash outlay for a project with annual cash inflows of `6,000
would have a payback of 5 years (`30,000 / `6,000).

The problem with the Payback Period is that it ignores the time value of money. In
order to correct this, we can use discounted cash flows in calculating the payback
period. Referring back to our example, if we discount the cash inflows at 15%
required rate of return we have:
Year Cash Flow PVF@15% PV Cumulative PV

1 6,000 0.870 5,220 5,220
2 6,000 0.756 4,536 9,756
3 6,000 0.658 3,948 13,704
4 6,000 0.572 3,432 17,136
5 6,000 0.497 2,982 20,118
6 6,000 0.432 2,592 22,710
7 6,000 0.376 2,256 24,966
8 6,000 0.327 1,962 26,928
9 6,000 0.284 1,704 28,632
10 6,000 0.247 1,482 30,114 ←
The cumulative total of discounted cash flows after ten years is `30,114. Therefore,
our discounted payback is approximately 10 years as opposed to 5 years under
simple payback. It should be noted that as the required rate of return increases, the
distortion between simple payback and discounted payback grows. Discounted
Payback is more appropriate way of measuring the payback period since it
considers the time value of money.
7.9.5 The Reinvestment Assumption
The Net Present Value technique assumes that all cash flows can be reinvested at
the discount rate used for calculating the NPV. This is a logical assumption since
the use of the NPV technique implies that all projects which provide a higher return
than the discounting factor are accepted.
In contrast, IRR technique assumes that all cash flows are reinvested at the projects
IRR. This assumption means that projects with heavy cash flows in the early years
will be favoured by the IRR method vis-à-vis projects which have got heavy cash
flows in the later years. This implicit reinvestment assumption means that Projects
like A, with cash flows concentrated in the earlier years of life will be preferred by
the method relative to Projects such as B.

7.9.6 Multiple Internal Rate of Return

In cases where project cash flows change signs or reverse during the life of a project
e.g. an initial cash outflow is followed by cash inflows and subsequently followed
by a major cash outflow, there may be more than one IRR. The following graph of
discount rate versus NPV may be used as an illustration;
In such situations if the cost of capital is less than the two IRR’s, a decision can be
made easily, however otherwise the IRR decision rule may turn out to be misleading
as the project should only be invested if the cost of capital is between IRR1 and
IRR2.. To understand the concept of multiple IRR it is necessary to understand the
implicit re-investment assumption in both NPV and IRR techniques.
Advantages of IRR
 This method makes use of the concept of time value of money.
 All the cash flows in the project are considered.
 IRR is easier to use as instantaneous understanding of desirability can be
determined by comparing it with the cost of capital
 IRR technique helps in achieving the objective of maximisation of shareholder’s
wealth.
Limitations of IRR
 The calculation process is tedious if there are more than one cash outflows
interspersed between the cash inflows, there can be multiple IRR, the
interpretation of which is difficult.

 The IRR approach creates a peculiar situation if we compare two projects with
different inflow/outflow patterns.
 It is assumed that under this method all the future cash inflows of a proposal are
reinvested at a rate equal to the IRR. It is ridiculous to imagine that the same
firm has a ability to reinvest the cash flows at a rate equal to IRR.
 If mutually exclusive projects are considered as investment options which
have considerably different cash outlays. A project with a larger fund
commitment but lower IRR contributes more in terms of absolute NPV and
increases the shareholders’ wealth. In such situation decisions based only on
IRR criterion may not be correct.
7.9.7 Modified Internal Rate of Return (MIRR)
As mentioned earlier, there are several limitations attached with the concept of the
conventional Internal Rate of Return. The MIRR addresses some of these
deficiencies e.g., it eliminates multiple IRR rates; it addresses the reinvestment rate
issue and produces results which are consistent with the Net Present Value method.
This method is also called Terminal Value method.
Under this method, all cash flows, apart from the initial investment, are brought to
the terminal value using an appropriate discount rate (usually the Cost of Capital).
This results in a single stream of cash inflow in the terminal year. The MIRR is
obtained by assuming a single outflow in the zeroth year and the terminal
cash inflow as mentioned above. The discount rate which equates the present
value of the terminal cash inflow to the zeroth year outflow is called the MIRR.
The decision criterion of MIRR is same as IRR i.e. you accept an investment if MIRR is
larger than required rate of return and reject if it is lower than the required rate of return.
ILLUSTRATION 9
An investment of `1,36,000 yields the following cash inflows (profits before
depreciation but after tax). DETERMINE MIRR considering 8% as cost of capital.
Year `
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000

SOLUTION
Year- 0 , Cashflow-`1,36,000
The MIRR is calculated on the basis of investing the inflows at the cost of capital. The
table below shows the value of the inflows if they are immediately reinvested at 8%.
Year Cash flow @ 8% reinvestment rate `

factor
1 30,000 1.3605* 40,815
2 40,000 1.2597 50,388
3 60,000 1.1664 69,984
4 30,000 1.0800 32,400
5 20,000 1.0000 20,000
2,13,587
* Investment of ` 1 at the end of the year 1 is reinvested for 4 years (at the end of
5 years) shall become 1(1.08)4= 1.3605. Similarly, reinvestment rate factor for
remaining years shall be calculated. Please note investment at the end of 5th year
shall be reinvested for zero year hence reinvestment rate factor shall be 1.00.
The total cash outflow in year 0 (`1,36,000) is compared with the possible inflow at
1,36,000
year 5 and the resulting figure of = 0.6367 is the discount factor in year
2,13,587
5. By looking at the year 5 row in the present value tables, you will see that this
gives a return of 9%. This means that the `2,13,587 received in year 5 is equivalent
to `1,36,000 in year 0 if the discount rate is 9%. Alternatively, we can compute
MIRR as follows:
2,13,587
Total return = = 1.5705
1,36,000
1
MIRR = 1.5705 - 1 = 9%.
5
7.9.8 Comparison of Net Present Value and Internal Rate of Return

Methods
Similarity
 Both the net present value and the internal rate of return methods are discounted
cash flow methods which mean that they consider the time value of money.

 Both the techniques consider all cash flows over the expected useful life of the
investment.
7.9.9 Different conclusion in the following scenarios
There are circumstances/scenarios under which the net present value method and
the internal rate of return methods will reach different conclusions. Let’s discuss
these scenarios:-
Scenario 1 –Scale or Size Disparity
Being IRR a relative measure and NPV an absolute measure in case of disparity in
scale or size both may give contradicting ranking. This can be understood with the
help of following illustration:
ILLUSTRATION 10
Suppose there are two Project A and Project B are under consideration. The cash flows
associated with these projects are as follows:
Year Project A Project B

0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000
Assuming Cost of Capital equal to 10% IDENTIFY which project should be accepted
as per NPV Method and IRR Method.
SOLUTION
Net Present Value of Projects
Year Cash Cash Present PV of PV of

Inflows Inflows Value Project A Project B
Project A Project B Factor @ (`) (`)
(`) (`) 10%
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.909 45,450 1,27,260
2 60,000 1,90,000 0.826 49,560 1,56,940
3 40,000 1,00,000 0.751 30,040 75,100
25,050 59,300

Internal Rate of Returns of projects

Since by discounting cash flows at 10% we are getting values very far from zero.
Therefore, let us discount cash flows using 20% discounting rate.

(`) (`) 20%
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.833 41,650 1,16,620
2 60,000 1,90,000 0.694 41,640 1,31,860
3 40,000 1,00,000 0.579 23,160 57,900
6,450 6,380
Since by discounting cash flows at 20% we are getting values far from zero.

(`) (`) 25%
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.800 40,000 1,12,000
2 60,000 1,90,000 0.640 38,400 1,21,600
3 40,000 1,00,000 0.512 20,480 51,200
(1,120) (15,200)
6, 450  6, 450 
IRRA = 20%+ ×(25% -20%) =20% +  × 5%  = 24.26%
6, 450 - (1,120)  7,570 
6,380
IRRB = 20%+ ×(25% -20%)
6,380 - (15,200)
 6,380 
= 20% +  ×5%  = 21.48%
 21,580 

Overall Position
Project A Project B
NPV @ 10% 25,050 59,300
IRR 24.26% 21.48%
Thus there is contradiction in ranking by two methods.

Scenario 2 – Time Disparity in Cash Flows
It might be possible that overall cash flows may be more or less same in the projects
but there may be disparity in their flows i.e. larger part of cash inflows may be
occurred in the beginning or end of the project. In such situation there may be
difference in the ranking of projects as per two methods.
ILLUSTRATION 11
Suppose ABC Ltd. is considering two Project X and Project Y for investment. The cash
flows associated with these projects are as follows:
Year Project X Project Y

0 (2,50,000) (3,00,000)
1 2,00,000 50,000
2 1,00,000 1,00,000
3 50,000 3,00,000
Assuming Cost of Capital be 10%, IDENTIFY which project should be accepted as per
NPV Method and IRR Method.
SOLUTION

Inflows Inflows Value Project X (`) Project Y (`)
Project X Project Y Factor @
(`) (`) 10%
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.909 1,81,800 45,450

2 1,00,000 1,00,000 0.826 82,600 82,600

3 50,000 3,00,000 0.751 37,550 2,25,300
51,950 53,350

Since by discounting cash flows at 10% we are getting values far from zero.

Inflows Inflows Value Project X Project Y (`)
Project X Project Y Factor @ (`)
(`) (`) 20%
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.833 1,66,600 41,650
2 1,00,000 1,00,000 0.694 69,400 69,400
3 50,000 3,00,000 0.579 28,950 1,73,700
14,950 (15,250)
Since by discounting cash flows at 20% we are getting value of Project X is positive
and value of Project Y is negative. Therefore, let us discount cash flows of Project
X using 25% discounting rate and Project Y using discount rate of 1
Year Cash Present PV of Cash Present PV of

Inflows Value Project X Inflows Value Project Y
Project X Factor (`) Project Y Factor (`)
(`) @ 25% (`) @ 15%
0 (2,50,000) 1.000 (2,50,000) (3,00,000) 1.000 (3,00,000)
1 2,00,000 0.800 1,60,000 50,000 0.870 43,500
2 1,00,000 0.640 64,000 1,00,000 0.756 75,600
3 50,000 0.512 25,600 3,00,000 0.658 1,97,400
(400) 16,500

The internal rate can be obtained by interpolation:

14,950
IRRX = 20%+ ×(25% -20%)
14,950 - (400)
14,950
= 20% +  
× 5%  = 24.87%
 15,350 
16,500
IRRB =15%+ ×(20% -15%)
16,500 - (15,250)
16,500
=15% +  
×5%  = 17.60%
 31,750 
Overall Position
Project A Project B
NPV @ 10% 51,950 53,350
IRR 24.87% 17.60%

Scenario 3 – Disparity in life of Proposals (Unequal Lives)
Conflict in ranking may also arise if we are comparing two projects (especially
mutually exclusive) having unequal lives.
ILLUSTRATION 12
Suppose MVA Ltd. is considering two Project A and Project B for investment. The cash
flows associated with these projects are as follows:
Year Project A Project B

0 (5,00,000) (5,00,000)
1 7,50,000 2,00,000
2 0 2,00,000
3 0 7,00,000
Assuming Cost of Capital equal to 12%, ANALYSE which project should be accepted
as per NPV Method and IRR Method?

SOLUTION

(`) (`) 12%
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)
1 7,50,000 2,00,000 0.893 6,69,750 1,78,600
2 0 2,00,000 0.797 0 1,59,400
3 0 7,00,000 0.712 0 4,98,400
1,69,750 3,36,400

Let us discount cash flows using 50% discounting rate.

(`) (`) 50%
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)
1 7,50,000 2,00,000 0.667 5,00,250 1,33,400
2 0 2,00,000 0.444 0 88,800
3 0 7,00,000 0.296 0 2,07,200
250 (70,600)
Since, IRR of project A shall be 50% as NPV is very small. Further, by discounting
cash flows at 50% we are getting NPV of Project B negative, let us discount cash
flows of Project B using 15% discounting rate.
Year Cash Inflows Present Value PV of
Project B (`) Factor @ 15% Project B (`)
0 (5,00,000) 1.000 (5,00,000)
1 2,00,000 0.870 1,74,000
2 2,00,000 0.756 1,51,200

3 7,00,000 0.658 4,60,600

2,85,800
The internal rate can be obtained by interpolation:

2,85,800
IRRB =15%+ ×(50% -15%)
2,85,800 - (70,600)
2,85,800
= 15% +  
×35%  = 43.07%
 3,56, 400 
Overall Position
Project A Project B
NPV @ 10% 1,69,750 3,36,400
IRR 50.00% 43.07%
7.10 SUMMARY OF DECISION CRITERIA OF

CAPITAL BUDGETING TECHNIQUES
Techniques For Independent Project For Mutually
Exclusive
Projects
Non- Pay Back (i) When Payback period ≤ Project with least
Discounted Maximum Acceptable Payback period
Payback period: Accepted should be
(ii) When Payback period ≥ selected
Maximum Acceptable
Payback period: Rejected
Accounting (i) When ARR≥ Minimum Project with the
Rate of Acceptable Rate of Return: maximum ARR
Return(ARR) Accepted should be
(ii) When ARR ≤ Minimum selected.
Acceptable Rate of Return:
Rejected

Discounted Net Present (i) When NPV > 0: Accepted Project with the
Value (NPV) (ii) When NPV < 0: Rejected highest positive
NPV should be
selected
Profitability (i) When PI > 1: Accepted When Net Present
Index(PI) (ii) When PI<1:Rejected Value is same
project with
Highest PI should
be selected
Internal (i) When IRR >K: Accepted Project with the
Rate of (ii) When IRR <K: Rejected maximum IRR
Return (IRR) should be
selected
7.11 SPECIAL CASES

7.11.1 Capital Budgeting under Capital Rationing
As discussed earlier, if project has positive NPV it should be accepted with an
objective of maximisation of wealth of shareholders. However, there may be a
situation due to resource (capital) constraints (rationing) a firm may have to select
some projects among various projects, all having positive NPVs. Broadly two
scenarios may influence the method of evaluation to be adopted.
(i) If projects are independent of each other and are divisible in nature: In such
situation NPV Rule should be modified and accordingly projects should be
ranked on the basis of ‘NPV per rupee of Capital ’method.
(ii) If projects are not divisible: In such situation projects shall be ranked on the basis
of absolute NPV and should be mixed up to the point available resources are
exhausted.
ILLUSTRATION 13
Shiva Limited is planning its capital investment programme for next year. It has five
projects all of which give a positive NPV at the company cut-off rate of 15 percent,
the investment outflows and present values being as follows:

Project Investment NPV @ 15%

`000 `000
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3
The company is limited to a capital spending of `1,20,000.

You are required to ILLUSTRATE the returns from a package of projects within the capital
spending limit. The projects are independent of each other and are divisible (i.e., part-
project is possible).
SOLUTION
Computation of NPVs per ` 1 of Investment and Ranking of the Projects
Project Investment NPV @ 15% NPV per `1 Ranking
`'000 `'000 invested
A (50) 15.4 0.31 5

B (40) 18.7 0.47 2
C (25) 10.1 0.40 3
D (30) 11.2 0.37 4
E (35) 19.3 0.55 1
Building up of a Programme of Projects based on their Rankings
Project Investment NPV @ 15%

`000 `000
E (35) 19.3
B (40) 18.7
C (25) 10.1
D (20) 7.5 (2/3 of project total)
120 55.6

Thus Project A should be rejected and only two-third of Project D be undertaken. If

the projects are not divisible then other combinations can be examined as:
Investment NPV @ 15%

` 000 `000
E+B+C 100 48.1
E+B+D 105 49.2
In this case E + B + D would be preferable as it provides a higher NPV despite D ranking

lower than C.
7.11.2 Projects with unequal lives
Sometimes firm may be faced with any of the following problems:
(i) Retaining an old asset or replace it with new one.
(ii) Choosing one proposal among two proposals (Mutually Exclusive).
Although, while evaluating the proposals the above scenarios do not pose any
special problem if they have same life period. But problem arises in case projects
have unequal lives. In such situations we can deal with the problem by following
any of the following method:
(i) Replacement Chain Method
(ii) Equivalent Annualized Criterion
These two methods can be understood with the help of following illustration.
ILLUSTRATION 14
R plc is considering modernizing its production facilities and it has two proposals under
consideration. The expected cash flows associated with these projects and their NPV as
per discounting rate of 12% and IRR is as follows:
Year Cash Flow

Project A (`) Project B (`)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000

4 12,00,000 0
5 11,00,000 0
6 10,00,000 0
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%
IDENTIFY which project should R plc accept?

SOLUTION
Although from NPV point of view Project A appears to be better but from IRR point of
view Project B appears to be better. Since, both projects have unequal lives selection
on the basis of these two methods shall not be proper. In such situation we shall use
any of the following method:
(i) Replacement Chain (Common Life) Method: Since the life of the Project A
is 6 years and Project B is 3 years to equalize lives we can have second opportunity
of investing in project B after one time investing. The position of cash flows in such
situation shall be as follows:
NPV of extended life of 6 years of Project B shall be `8,82,403 and IRR of 25.20%.
Accordingly, with extended life NPV of Project B it appears to be more attractive.
(ii) Equivalent Annualized Criterion: The method discussed above has one
drawback when we have to compare two projects one has a life of 3 years and other
has 5 years. In such case the above method shall require analysis of a period of 15
years i.e. common multiple of these two values. The simple solution to this problem
is use of Equivalent Annualised Criterion involving following steps:
(a) Compute NPV using the WACC or discounting rate.
(b) Compute Present Value Annuity Factor (PVAF) of discounting factor used above
for the period of each project.
(c) Divide NPV computed under step (a) by PVAF as computed under step (b) and
compare the values.

Accordingly, for proposal under consideration:
Project A Project B
NPV @ 12% ` 6,49,094 `5,15,488
PVAF @12% 4.112 2.402
Equivalent Annualized Criterion `1,57,854 `2,14,608
Thus, Project B should be selected.

ILLUSTRATION 15
Alpha Company is considering the following investment projects:
Cash Flows (`)

Projects C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +7,500 +7,500
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000
(a) ANALYSE the rank the projects according to each of the following methods: (i)
Payback, (ii) ARR, (iii) IRR and (iv) NPV, assuming discount rates of 10 and 30 per
cent.
(b) Assuming the projects are independent, which one should be accepted? If the
projects are mutually exclusive, IDENTIFY which project is the best?
SOLUTION
(a) (i) Payback Period
Project A : 10,000/10,000 = 1 year
Project B: 10,000/7,500 = 1 1/3 years.
10,000 − 6,000 1
Project C: 2 years + = 2 years
12,000 3
Project D: 1 year.
(ii) ARR
(10,000 -10,000)1/ 2
Project A : =0
(10,000)1/ 2

(15,000 -10,000)1/ 2 2,500

Project B : = = 50%
(10,000)1/ 2 5,000
(18,000 -10,000)1/ 3 2,667

Project C: = = 53%
(10,000)1/ 2 5,000
(16,000 -10,000)1/ 3 2,000
Project D: = = 40%
(10,000)1/ 2 5,000
Note: This net cash proceed includes recovery of investment also.

Therefore, net cash earnings are found by deducting initial investment.
(iii) IRR
Project A: The net cash proceeds in year 1 are just equal to

investment. Therefore, r = 0%.
Project B: This project produces an annuity of `7,500 for two years.
Therefore, the required PVAF is: 10,000/7,500 = 1.33.
This factor is found under 32% column. Therefore, r =
32%
Project C: Since cash flows are uneven, the trial and error method
will be followed. Using 20% rate of discount the NPV is
+ `1,389. At 30% rate of discount, the NPV is -`633. The
true rate of return should be less than 30%. At 27% rate
of discount it is found that the NPV is -`86 and at 26%
+`105. Through interpolation, we find r = 26.5%
Project D: In this case also by using the trial and error method, it
is found that at 37.6% rate of discount NPV becomes
almost zero.
Therefore, r = 37.6%.
(iv) NPV
Project A:
at 10% -10,000+10,000×0.909 = -910
at 30% -10,000+10,000×0.769 = -2,310
Project B:
at 10% -10,000+7,500(0.909+0.826) = 3,013
at 30% -10,000+7,500(0.769+0.592)= +208

Project C:
at 10% -10,000+2,000×0.909+4,000×0.826+12,000×0.751= +4,134
at 30% -10,000+2,000×0.769+4,000×0.592+12,000×0.455 =-633
Project D:
at 10% -10,000+10,000×0.909+3,000×(0.826+0.751) =+ 3,821
at 30% -10,000+10,000×0.769+3,000×(0.592+0.455) = + 831
The projects are ranked as follows according to the various methods:
Ranks
Projects PBP ARR IRR NPV NPV
(10%) (30%)
A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3
D 1 3 1 2 1
(b) Payback and ARR are theoretically unsound method for choosing between the
investment projects. Between the two time-adjusted (DCF) investment criteria,
NPV and IRR, NPV gives consistent results. If the projects are independent (and
there is no capital rationing), either IRR or NPV can be used since the same set
of projects will be accepted by any of the methods. In the present case, except
Project A all the three projects should be accepted if the discount rate is 10%.
Only Projects B and D should be undertaken if the discount rate is 30%.
If it is assumed that the projects are mutually exclusive, then under the assumption
of 30% discount rate, the choice is between B and D (A and C are unprofitable).
Both criteria IRR and NPV give the same results – D is the best. Under the
assumption of 10% discount rate, ranking according to IRR and NPV conflict
(except for Project A). If the IRR rule is followed, Project D should be accepted.
But the NPV rule tells that Project C is the best. The NPV rule generally gives
consistent results in conformity with the wealth maximization principle. Therefore,
Project C should be accepted following the NPV rule.
ILLUSTRATION 16
The expected cash flows of three projects are given below. The cost of capital is 10
per cent.

(a) CALCULATE the payback period, net present value, internal rate of return and
accounting rate of return of each project.
(b) IDENTIFY the rankings of the projects by each of the four methods.
(figures in ‘000)
Period Project A (`) Project B (`) Project C (` )

0 (5,000) (5,000) (5,000)
1 900 700 2,000
2 900 800 2,000
3 900 900 2,000
4 900 1,000 1,000
5 900 1,100
6 900 1,200
7 900 1,300
8 900 1,400
9 900 1,500
10 900 1,600
SOLUTION
(a) Payback Period Method:
A = 5 + (500/900) = 5.56 years
B = 5 + (500/1,200) = 5.42 years
C = 2 + (1,000/2,000) = 2.5 years
Net Present Value Method:
NPVA = (− 5,000) + (900×6.145) = (5,000) + 5,530.5 = `530.5
NPVB is calculated as follows:
Year Cash flow (`) 10% discount factor Present value (`)
0 (5000) 1.000 (5,000)
1 700 0.909 636
2 800 0.826 661

3 900 0.751 676

4 1000 0.683 683
5 1100 0.621 683
6 1200 0.564 677
7 1300 0.513 667
8 1400 0.467 654
9 1500 0.424 636
10 1600 0.386 618
1591
NPVC is calculated as follows:
Year Cash flow (`) 10% discount factor Present value (`)
0 (5000) 1.000 (5,000)
1 2000 0.909 1,818
2 2000 0.826 1,652
3 2000 0.751 1,502
4 1000 0.683 683
655
Internal Rate of Return

NPV at 12% = (5,000) + 900×5.650
= (5,000) + 5085= 85
NPV at 13% = (5,000) + 900×5.426
= (5,000) + 4,883.40= -116.60
 85 
IRRA = 12+   ×(13-12) =12+0.42
 85+116.60 
IRRA = 12.42%.

IRRB
Year Cash 10% Present 20% Present

flow discount value discount value (`)
(`) factor (`) factor
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 700 0.909 636 0.833 583
2 800 0.826 661 0.694 555
3 900 0.751 676 0.579 521
4 1,000 0.683 683 0.482 482
5 1,100 0.621 683 0.402 442
6 1,200 0.564 677 0.335 402
7 1,300 0.513 667 0.279 363
8 1,400 0.467 654 0.233 326
9 1,500 0.424 636 0.194 291
10 1,600 0.386 618 0.162 259
1,591 (776)
1,591
Interpolating: IRRB= 10% + × (20% -10%) = 10% + 6.72% = 16.72%
(1,591 + 776)
IRRC
Year Cash flow 15% Present 18% Present

(`) discount value discount value (`)
factor (`) factor
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 2,000 0.870 1,740 0.847 1,694
2 2,000 0.756 1,512 0.718 1,436
3 2,000 0.658 1,316 0.609 1,218
4 1,000 0.572 572 0.516 516
140 (136)
140
Interpolating: IRRC = 15% + × (18% -15%) = 15% + 1.52% = 16.52%
(140 + 136)

Accounting Rate of Return:

5,000
ARRA: Average capital employed = = ` 2,500
2
(9,000 − 5,000)
Average accounting profit = = ` 400
10
(400 ×100)
ARRA = = 16 per cent
2,500
(11,500 − 5,000)
ARRB: Average accounting profit = = ` 650
10
(650 ×100)
ARRB = = 26 per cent
2,500
(7,000 − 5,000)
ARRC: Average accounting profit = = ` 500
4
(500 ×100)
ARRC = = 20 per cent
2,500
(b) Summary of Results
Project A B C
Payback (years) 5.5 5.4 2.5
ARR (%) 16 26 20
IRR (%) 12.42 16.72 16.52
NPV (`) 530.50 1,591 655
Comparison of Rankings
Method Payback ARR IRR NPV

1 C B B B
2 B C C C
3 A A A A

SUMMARY
♦ Capital budgeting is the process of evaluating and selecting long-term
investments that are in line with the goal of investor’s wealth maximization.
♦ The capital budgeting decisions are important, crucial and critical business
decisions due to substantial expenditure involved; long period for the recovery of
benefits; irreversibility of decisions and the complexity involved in capital
investment decisions.
♦ One of the most important tasks in capital budgeting is estimating future cash
flows for a project. The final decision we make at the end of the capital budgeting
process is no better than the accuracy of our cash-flow estimates.
♦ Tax payments like other payments must be properly deducted in deriving the cash
flows. That is, cash flows must be defined in post-tax terms.
♦ There are a number of capital budgeting techniques available for appraisal of
investment proposals and can be classified as traditional (non-discounted) and
time-adjusted (discounted).
♦ The most common traditional capital budgeting techniques are Payback Period
and Accounting (Book) Rate of Return.
Total initial capital investment
Payback period =
Annual expected after - tax net cash flow
Average Annual cash in flow

Payback Reciprocal =
Initial investment
♦ Accounting (Book) Rate of Return (ARR) or Average Rate of Return (ARR):
Average annual net income
Accounting rate of return =
Investment
♦ Net Present Value Technique (NPV):
Net present value = Present value of cash inflows - Present value of cash outflows
 C C2 C3 Cn 
NPV =  1 + + + ......+ -I
 (1+ k) (1+ k) (1+ k)
2 3
(1+ k)n 
♦ Profitability Index /Desirability Factor/Present Value Index Method (PI):

Sum of discounted cash in flows
Profitability Index (PI) =
Initial cash outlay or Total discounted cash outflow (as the case may)

♦ Internal Rate of Return Method (IRR):

NPV at LR
LR + ×(HR -LR)
♦ Modified Internal Rate of Return (MIRR): All cash flows, apart from the initial
investment, are brought to the terminal value using an appropriate discount rate
(usually the Cost of Capital).
TEST YOUR KNOWLEDGE

MCQs based Questions
1. A capital budgeting technique which does not require the computation of cost
of capital for decision making purposes is,
(a) Net Present Value method
(b) Internal Rate of Return method
(c) Modified Internal Rate of Return method
(d) Pay back
2. If two alternative proposals are such that the acceptance of one shall exclude the
possibility of the acceptance of another then such decision making will lead to,
(a) Mutually exclusive decisions
(b) Accept reject decisions
(c) Contingent decisions
(d) None of the above
3. In case a company considers a discounting factor higher than the cost of capital
for arriving at present values, the present values of cash inflows will be
(a) Less than those computed on the basis of cost of capital
(b) More than those computed on the basis of cost of capital
(c) Equal to those computed on the basis of the cost of capital
4. The pay back technique is specially useful during times
(a) When the value of money is turbulent
(b) When there is no inflation

(c) When the economy is growing at a steady rate coupled with minimal
inflation.
5. While evaluating capital investment proposals, time value of money is used in
which of the following techniques,
(a) Payback method
(b) Accounting rate of return
(c) Net present value
6. IRR would favour project proposals which have,
(a) Heavy cash inflows in the early stages of the project.
(b) Evenly distributed cash inflows throughout the project.
(c) Heavy cash inflows at the later stages of the project
(d) None of the above.
7. The reinvestment assumption in the case of the IRR technique assumes that,
(a) Cash flows can be reinvested at the projects IRR
(b) Cash flows can be reinvested at the weighted cost of capital
(c) Cash flows can be reinvested at the marginal cost of capital
8. Multiple IRRs are obtained when,
(a) Cash flows in the early stages of the project exceed cash flows during the
later stages.
(b) Cash flows reverse their signs during the project
(c) Cash flows are uneven
9. Depreciation is included as a cost in which of the following techniques,
(a) Accounting rate of return
(b) Net present value

(c) Internal rate of return

10. Management is considering a ` 1,00,000 investment in a project with a 5 year life
and no residual value . If the total income from the project is expected to be `
60,000 and recognition is given to the effect of straight line depreciation on the
investment, the average rate of return is :
(a) 12%
(b) 24%
(c) 60%
(d) 75%
11. Assume cash outflow equals ` 1,20,000 followed by cash inflows of ` 25,000 per
year for 8 years and a cost of capital of 11%. What is the Net present value?
(a) (` 38,214)
(b) ` 9,653
(c) ` 8,653
(d) ` 38,214
12. What is the Internal rate of return for a project having cash flows of ` 40,000 per
year for 10 years and a cost of ` 2,26,009?
(a) 8%
(b) 9%
(c) 10%
(d) 12%
13. While evaluating investments, the release of working capital at the end of the
projects life should be considered as,
(a) Cash in flow
(b) Cash out flow
(c) Having no effect upon the capital budgeting decision

14. Capital rationing refers to a situation where,

(a) Funds are restricted and the management has to choose from amongst
available alternative investments.
(b) Funds are unlimited and the management has to decide how to allocate
them to suitable projects.
(c) Very few feasible investment proposals are available with the
management.
15. Capital budgeting is done for
(a) Evaluating short term investment decisions.
(b) Evaluating medium term investment decisions.
(c) Evaluating long term investment decisions.
Theoretical Questions
1. DISCUSS the various technique of capital budgeting.
2. DISCUSS NPV. How it is calculated?
3. DISCUSS in detail the ‘Capital Budgeting Process.
4. CLASSIFY various types of Capital Investment decisions known to you.
5. DESCRIBE the advantage and disadvantage of profitability of index.
6. DESCRIBE MIRR.
Practical Problems
1. Lockwood Limited wants to replace its old machine with a new automatic
machine. Two models A and B are available at the same cost of `5 lakhs each.
Salvage value of the old machine is `1 lakh. The utilities of the existing machine
can be used if the company purchases A. Additional cost of utilities to be
purchased in that case are `1 lakh. If the company purchases B then all the existing
utilities will have to be replaced with new utilities costing `2 lakhs. The salvage
value of the old utilities will be `0.20 lakhs. The earnings after taxation are
expected to be:

(cash in-flows of)

Year A B P.V. Factor
` ` @ 15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
Salvage Value at the end of 50,000 60,000
Year 5
The targeted return on capital is 15%. You are required to (i) COMPUTE, for the
two machines separately, net present value, discounted payback period and
desirability factor and (ii) ADVICE which of the machines is to be selected?
2. Hindlever Company is considering a new product line to supplement its range of
products. It is anticipated that the new product line will involve cash investments
of `7,00,000 at time 0 and `10,00,000 in year 1. After-tax cash inflows of `2,50,000
are expected in year 2, `3,00,000 in year 3, `3,50,000 in year 4 and `4,00,000 each
year thereafter through year 10. Although the product line might be viable after
year 10, the company prefers to be conservative and end all calculations at that
time.
(a) If the required rate of return is 15 per cent, COMPUTE net present value of
the project? Is it acceptable?
(b) ANALYSE What would be the case if the required rate of return were 10
per cent?
(c) CALCULATE its internal rate of return?
(d) COMPUTE the project’s payback period?
3. Elite Cooker Company is evaluating three investment situations: (1) produce a new
line of aluminium skillets, (2) expand its existing cooker line to include several new
sizes, and (3) develop a new, higher-quality line of cookers. If only the project in
question is undertaken, the expected present values and the amounts of
investment required are:

Project Investment Present value of Future Cash-

required Flows
` `
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000
If projects 1 and 2 are jointly undertaken, there will be no economies; the

investments required and present values will simply be the sum of the parts. With
projects 1 and 3, economies are possible in investment because one of the
machines acquired can be used in both production processes. The total
investment required for projects 1 and 3 combined is `4,40,000. If projects 2 and
3 are undertaken, there are economies to be achieved in marketing and producing
the products but not in investment. The expected present value of future cash
flows for projects 2 and 3 is `6,20,000. If all three projects are undertaken
simultaneously, the economies noted will still hold. However, a `1,25,000
extension on the plant will be necessary, as space is not available for all three
projects. ANALYSE which project or projects should be chosen?
4. Cello Limited is considering buying a new machine which would have a useful
economic life of five years, a cost of `1,25,000 and a scrap value of `30,000, with
80 per cent of the cost being payable at the start of the project and 20 per cent
at the end of the first year. The machine would produce 50,000 units per annum
of a new product with an estimated selling price of `3 per unit. Direct costs
would be `1.75 per unit and annual fixed costs, including depreciation calculated
on a straight- line basis, would be `40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not
included in the above costs, would be incurred, amounting to `10,000 and
`15,000 respectively.
ANALYSE the project using the NPV method of investment appraisal, assuming
the company’s cost of capital to be 10 percent.

ANSWERS/SOLUTIONS
Answers to the MCQs based Questions
1. (d) 2. (a) 3. (a) 4. (a) 5. (c) 6. (a)
7. (a) 8. (b) 9. (a) 10. (b) 11. (c) 12. (d)
13. (a) 14. (a) 15. (c)
Answers to the Theoretical Questions

1. Please refer paragraph 7.7
2. Please refer paragraph 7.9.1
5. Please refer paragraph 7.9.2.
6. Please refer paragraph 7.12.
Answers to the Practical Problems
1. (i) Expenditure at year zero (` in lakhs)
Particulars A B
Cost of Machine 5.00 5.00
Cost of Utilities 1.00 2.00
Salvage of Old Machine (1.00) (1.00)
Salvage of Old Utilities – (0.20)
Total Expenditure (Net) 5.00 5.80
(ii) Discounted Value of Cash inflows

(ìn lakhs)
Machine A Machine B
Year NPV Cash Discounted Cash Discounted
Factor inflows value of Flows value of
@ 15% inflows inflows
0 1.00 (5.00) (5.00) (5.80) (5.80)
1 0.87 1.00 0.87 2.00 1.74

2 0.76 1.50 1.14 2.10 1.60

3 0.66 1.80 1.19 1.80 1.19
4 0.57 2.00 1.14 1.70 0.97
5 0.50 1.70 0.85 0.40 0.20
Salvage 0.50 0.50 0.25 0.60 0.30
5.44 6.00
Net Present (+)0.44 (+)0.20
Value
Since the Net present Value of both the machines is positive both are acceptable.
(iii) Discounted Pay-back Period (` in lakhs)
Machine A Machine B
Year Discounted cash Cumulative Discounted Cumulative
inflows Discounted cash inflows Discounted
cash inflows cash
inflows
1 0.87 0.87 1.74 1.74
2 1.14 2.01 1.60 3.34
3 1.19 3.20 1.19 4.53
4 1.14 4.34 0.97 5.50
5 1.10* 5.44 0.50 6.00
* Includes salvage value

Discounted Payback Period (For A and B):
 0.66 
Machine A = 4 years +   = 4.6 years
 1.10 
 0.30 
Machine B = 4 years +   = 4.6 years
 0.50 
Sum of present value of net cash inflow
Profitability Index (PI) =
Initial cash outlay
` 5.44 lakhs ` 6.00 lakhs

Machine A = =1.088 Machine B = = 1.034
`c5.00 lakhs ` 5.80 * lakhs

*[Cost of Machine B = Purchase cost + Incremental cost (Additional utilities cost

less recoverable value of utilities)] = [5,00,000+(2,00,000-1,00,000-20,000)]
(iv) Since the absolute surplus in the case of A is more than B and also the desirability
factor, it is better to choose A.
The discounted payback period in both the cases is same, also the net present
value is positive in both the cases but the desirability factor (profitability index)
is higher in the case of Machine A, it is therefore better to choose Machine A.
2. (a)
Year Cash flow Discount Factor Present value

(15%)
(`) (`)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.870 (8,70,000)
2 2,50,000 0.756 1,89,000
3 3,00,000 0.658 1,97,400
4 3,50,000 0.572 2,00,200
5−10 4,00,000 2.163 8,65,200
Net Present Value (1,18,200)
As the net present value is negative, the project is unacceptable.

(b) Similarly, NPV at 10% discount rate can be computed as follows:
Year Cash flow Discount Factor Present

(10%) value
(`) (`)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.909 (9,09,000)
2 2,50,000 0.826 2,06,500
3 3,00,000 0.751 2,25,300
4 3,50,000 0.683 2,39,050
5−10 4,00,000 2.974 11,89,600
Net Present Value 2,51,450
Since NPV = `2,51,450 is positive, hence the project would be acceptable.

NPVatLR
(c) IRR = LR + ×(HR -LR)
NPVatLR -NPV atHR
` 2,51, 450 ×(15% -10%)

= 10% +
` 2,51, 450 -(-)1,18,200
= 10% + 3.4012 or 13.40%

(d) Payback Period = 6 years:
−`7,00,000−`10,00,000 + `2,50,000 + `3,00,000 + `3,50,000 + `4,00,000 +
`4,00,000 = 0
3.
Project Investment Present value of Net
Required Future Cash Present
Flows value
` ` `
1 2,00,000 2,90,000 90,000
2 1,15,000 1,85,000 70,000
3 2,70,000 4,00,000 1,30,000
1 and 2 3,15,000 4,75,000 1,60,000
1 and 3 4,40,000 6,90,000 2,50,000
2 and 3 3,85,000 6,20,000 2,35,000
1, 2 and 3 6,80,000* 9,10,000 2,30,000
(Refer Working note)
Working Note:
(i) Total Investment required if all the three projects are undertaken
simultaneously:
(`)
Project 1& 3 4,40,000
Project 2 1,15,000
Plant extension cost 1,25,000
Total 6,80,000

(ii) Total of Present value of Cash flows if all the three projects are undertaken
simultaneously:
(`)
Project 2& 3 6,20,000
Project 1 2,90,000
Total 9,10,000
Advise: Projects 1 and 3 should be chosen, as they provide the highest net
present value.
4. Calculation of Net Cash flows
Contribution = (3.00 – 1.75)×50,000 = ` 62,500
Fixed costs = 40,000 – [(1,25,000 – 30,000)/5] = ` 21,000
Year Capital (`) Contribution Fixed costs Adverts (`) Net cash
(`) (`) flow (`)
0 (1,00,000) (1,00,000)
1 (25,000) 62,500 (21,000) (10,000) 6,500
2 62,500 (21,000) (15,000) 26,500
3 62,500 (21,000) 41,500
4 62,500 (21,000) 41,500
5 30,000 62,500 (21,000) 71,500
Calculation of Net Present Value
Year Net cash 10% discount Present

flow (`) factor value (`)
0 (1,00,000) 1.000 (1,00,000)
1 6,500 0.909 5,909
2 26,500 0.826 21,889
3 41,500 0.751 31,167
4 41,500 0.683 28,345
5 71,500 0.621 44,402
31,712
The net present value of the project is ` 31,712.

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DELHI SCHOOL OF ECONOMICS

The course meeting was attended by following teachers:

INDEX, OR SUBSCRIPT, NOTATION

AVERAGES, OR MEASURES OF CENTRAL TENDENCY

THE ARITHMETIC MEAN

EXAMPLE 4. The arithmetic mean of the numbers 8, 3, 5, 12, and 10 is

THE WEIGHTED ARITHMETIC MEAN

PROPERTIES OF THE ARITHMETIC MEAN

THE ARITHMETIC MEAN COMPUTED FROM GROUPED DATA

EXAMPLE 8. The set of numbers 3, 4, 4, 5, 6, 8, 8, 8, and 10 has median 6.

For grouped data, the median, obtained by interpolation, is given by

A distribution having only one mode is called unimodal.

THE EMPIRICAL RELATION BETWEEN THE MEAN, MEDIAN, AND MODE

THE GEOMETRIC MEAN G

THE HARMONIC MEAN H

In practice it may be easier to remember that

EXAMPLE 14. The harmonic mean of the numbers 2, 4, and 8 is

THE RELATION BETWEEN THE ARITHMETIC, GEOMETRIC, AND HARMONIC MEANS

THE ROOT MEAN SQUARE

ffiffiffiffiffiffi square (RMS), or quadratic mean, of a set of numbers X1 , X2 , . . . , XN is sometimes

EXAMPLE 16. The RMS of the set 1, 3, 4, 5, and 7 is

QUARTILES, DECILES, AND PERCENTILES

SOFTWARE AND MEASURES OF CENTRAL TENDENCY

Descriptive Statistics: testscore

N Minimum Maximum Mean Std. Deviation

Testscore 60 25.00 99.00 59.1667 22.21098

The MEANS Procedure

THE MEAN DEVIATION

EXAMPLE 2. Find the mean deviation of the set 2, 3, 6, 8, 11.

Arithmetic mean ðXÞ ¼ 2 þ 3 þ 6 þ 8 þ 11 ¼ 6

If X1 , X2 , . . . , XK occur with frequencies f1 , f2 , . . . ; fK , respectively, the mean deviation can be

THE SEMI-INTERQUARTILE RANGE

THE 10–90 PERCENTILE RANGE

THE STANDARD DEVIATION

If X1 , X2 , . . . , XK occur with frequencies f1 , f2 , . . . , fK , respectively, the standard deviation can be

SHORT METHODS FOR COMPUTING THE STANDARD DEVIATION

PROPERTIES OF THE STANDARD DEVIATION

Fig. 4-1 Illustration of the empirical rule.

(See Problem 4.20.)

SHEPPARD’S CORRECTION FOR VARIANCE

EMPIRICAL RELATIONS BETWEEN MEASURES OF DISPERSION

Mean deviation ¼ 45 ðstandard deviationÞ

Semi-interquartile range ¼ 23 ðstandard deviationÞ

ABSOLUTE AND RELATIVE DISPERSION; COEFFICIENT OF VARIATION

STANDARDIZED VARIABLE; STANDARD SCORES

SOFTWARE AND MEASURES OF DISPERSION

The range is given by ¼MAX(A1:E15)-MIN(A1:E15) or 125 24 ¼ 101. The mean deviation

Fig. 4-2 Dialog box for MINITAB.

Descriptive Statistics: e-mails

(a) 3, 5, 6, 7, 10, 12, 15, 18 (b) 3, 8, 8, 8, 9, 9, 9, 18

MOMENTS FOR GROUPED DATA

RELATIONS BETWEEN MOMENTS

COMPUTATION OF MOMENTS FOR GROUPED DATA

CHARLIER’S CHECK AND SHEPPARD’S CORRECTIONS

MOMENTS IN DIMENSIONLESS FORM

3ðmean medianÞ 3ðX medianÞ

ðQ3 Q2 Þ ðQ2 Q1 Þ Q3 2Q2 þ Q1

POPULATION MOMENTS, SKEWNESS, AND KURTOSIS

SOFTWARE COMPUTATION OF SKEWNESS AND KURTOSIS

Normal Skewed-right Skewed-left Uniform

67 69 31 40 102 87 12.1 11.6

Dotplot of Height, Wedage, Obitage, Cola-fill

11.6 11.8 12.0 12.2 12.4

Descriptive Statistics: Height, Wedage, Obitage, Cola-ﬁll