Afm All Amendments

ADVANCED CAPITAL BUDGETING DECISIONS
ADVANCED CAPITAL BUDGETING

DECISIONS
(1) BASICS
Question: 01
A manufacturing unit engaged in the production of automobile parts is considering a
proposal of purchasing one of the two plants, details of which are given below:
Particulars Plant A Plant B

Cost ₹ 20,00,000 ₹38,00,000
Installation charges ₹ 4,00,000 ₹ 2,00,000
Life 20 years 15 years
Scrap value after full life ₹ 4,00,000 ₹ 4,00,000
Output per minute (units) 200 400
The annual costs of the two plants are as follows:
Particulars Plant A Plant B

Running hours per annum 2,500 2,500
Costs: (In ₹) (In ₹)
Wages 1,00,000 1,40,000
Indirect materials 4,80,000 6,00,000
Repairs 80,000 1,00,000
Power 2,40,000 2,80,000
Fixed Costs 60,000 80,000
Will it be advantageous to buy Plant A or Plant B? Substantiate your answer with the
help of comparative unit cost of the plants. Assume interest on capital at 10 percent.
Make other relevant assumptions:
Note: 10 percent interest tables
20 Years 15 Years
Present value of ₹ 1 0.1486 0.2394
Annuity of ₹ 1 (capital recovery factor with 10% 0.1175 0.1315
interest)
Solution:
Working Notes:
Page 1
Calculation of Equivalent Annual Cost
Machine A Machine B
Cash Outlay ₹ 24,00,000 ₹ 40,00,000
Less:PV of Salvage Value
4,00,000 × 0.1486 ₹ 59,440
4,00,000 × 0.2394 ₹ 95,760
0.1175 2,75,016 0.1315
Annuity Factor ₹ 5,13,408
Computation of Cost Per Unit
Machine A Machine B
Annual Output (a) 2500 ×60 × 200 2500 × 60 ×400
= 3,00,00,000 = 6,00,00,000
Annual Cost (b) ₹ ₹
Wages 1,00,000 1,40,000
Indirect Material 4,80,000 6,00,000
Repairs 80,000 1,00,000
Powers 2,40,000 2,80,000
Fixed Cost 60,000 80,000
Equivalent Annual Cost 2,75,016 5,13,408
Total 12,35,016 17,13,408
Cost Per Unit (b)/(a)
0.041167 0.02860
Decision: As the unit cost is less in proposed Plant B, it may be recommended that it
is advantageous to acquire Plant B.
Question: 02
XYZ Ltd., an infrastructure company is evaluating a proposal to build, operate and
transfer a section of 35 kms. of road at a project cost of ₹ 200 crores to be financed as
follows:
Equity Shares Capital ₹ 50 crores, loans at the rate of interest of 15% p.a. from
financial institutions ₹ 150 crores. The Project after completion will be opened to traffic
and a toll will be collected for a period of 15 years from the vehicles using the road.
The company is also required to maintain the road during the above 15 years and after
the completion of that period, it will be handed over to the Highway authorities at zero
value. It is estimated that the toll revenue will be ₹ 50 crores per annum and the
annual toll collection expenses including maintenance of the roads will amount to 5%
of the project cost. The company considers to write off the total cost of the project in
15 years on a straight line basis. For Corporate Incometax purposes the company is
allowed to take depreciation @ 10% on WDV basis. The financial institutions are
agreeable for the repayment of the loan in 15 equal annual installments – consisting of
principal and interest.
Page 2
Calculate Project IRR and Equity IRR. Ignore Corporate taxation.
Explain the difference in Project IRR and Equity IRR.
Solution:
Computation of Project IRR
Project IRR is computed by using the following equation:
Where,
CO0 = Cash outflow at time zero
CFi = Net cash inflow at different points of time
N = Life of the project and
R = Rate of discount (IRR)
Now,
CO0 = ₹ 200 crores
CFi = ₹ 40 crores p.a. for 15 years
(Refer to working note (i))
Therefore,
₹ 40 Crore
₹ 200 Crore =
1+r 15
The value of IRR of the project:
1. An approximation of IRR is made on the basis of cash flow data. A rough

approximation may be made with reference to the payback period. The payback
₹200 Crores
period in the given case is 5 years i.e. . From the PVAF table the
₹40 Crores
closest figures are given in rate 18% (5.092) and the rate 19% (4.876). This
means the IRR of the project is expected to be between 18% and 19%.
2. The estimate of IRR cash inflow of the project for both these rates is as follows:
At 18% = ₹ 40 crores × PVAF (18%, 15 years)
= ₹ 40 crores × 5.092
= ₹203.68 crores
At 19% = ₹40 crores × PVAF (19%, 15 years)
Page 3
= ₹40 crores × 4.876
= ₹195.04 crores
3. The exact IRR by interpolating between 18% and 19% is worked out as follows:
₹203.68 crores −₹ 200 crores

IRR = 18% + × 1%
₹203.68 crores −₹195.04 crores
₹3.68 crores
= 18% + × 1%
₹8.64 crores
= 18% + 0.426%
= 18.43%
Therefore, the IRR of the project is 18.43%.
Working Notes:
(i) Net cash inflow of the project
Cash inflow ₹
Toll revenue 50 crores p.a. for 15 years
Cash outflow ₹
Toll collection expenses including maintenance 10 crores p.a. for 15 years
of the roads (5% of ₹ 200 crores)
Net cash inflow 40 crores p.a. for 15 years
Note: Since corporate taxes is not payable. The impact of depreciation need not
be considered.
Computation of Equity IRR
Equity IRRis computed by using the following equation:
Cash inflow at zero date from equity shareholders
Cash inflow available equity for shareholders

=
1+r n
Where,
r = Equity IRR
Page 4
n = Life of the project
Here, Cash inflow at zero date from equity shareholders = ₹ 50 crores
Cash inflow for equity shareholders = ₹ 14.35 crores p.a.
(Refer to working note)
Therefore:
₹ 14.35 Crores
₹ 50 crores =
(1+ r)15
The value of equity IRR of the project is calculated as follows:
1. An approximation of IRR is made on the basis of cash flow data. A rough

approximation may be made with reference to the payable period. The
₹ 50 Crores
payback period in the given case is3.484 .From the
₹ 14.35 Crores
PVAF table the closest figure may be about 25% and 30%. This means
the equity IRR of project must be between 25% and 30%.
2. The estimated NPV of the project at 25% = ₹ 14.35 crores × 3.859 = ₹

55.3766 crores. The estimated NPV of the project at 30% = ₹ 14.35
crores × 3.268 = ₹ 46.896 crores
3. IRR by using Interpolation Formula will be
55.377 − 50
= 25% + ×5%
55.3766 − 46.896
5.377
= 25% + ×5%
8.4806
= 25%+ 3.17% =28.17%
(ii) Equated annual installment (i.e. principal + interest) of loan from financial
institution:
Amount of loan from financial institution ₹ 150 crores
Rate of interest 15% p.a.
No. of years 15
Cumulative discount factor for 1-15 years 5.847
Hence, equated yearly installment will be ₹ 150 crores/5.847 i.e. ₹ 25.65 crores.
Page 5
(iii) Cash inflow available for equity shareholders
Net cash inflow of the project ₹ 40.00 crores
[Refer to working note (i)]
Equated yearly installment of the project ₹ 25.65 crores
[Refer to working note (ii)] ______________
Cash inflow available for equity shareholders ₹ 14.35 crores
Difference in Project IRR and Equity IRR:
The project IRR is 18.4% whereas Equity IRR is 28%. This is attributed to the
fact that XYZ Ltd. is earning 18.4% on the loan from financial institution but
paying only 15%. The difference between the return and cost of funds from
financial institution has enhanced equity IRR. The 3.4% (18.4% - 15%) earnings
on ₹ 150 crores goes to equity shareholders who have invested ₹ 50 crore i.e.
₹ 150 Crores
3.4% × = 10 2. % is added to the project IRR which gives equity
₹ 50 Crores
IRR of 28%.
Question: 03
ABC Chemicals is evaluating two alternative systems for waste disposal, System A and
System B, which have lives of 6 years and 4 years respectively. The initial investment
outlay and annual operating costs for the two systems are expected to be as follows:
System A System B
Initial Investment Outlay ₹ 5 million ₹ 4 million
Annual Operating Costs ₹ 1.5 million ₹ 1.6 million
Salvage value ₹ 1 million ₹ 0.5 million
If the hurdle rate is 15%, which system should ABC Chemicals choose?
The PVIF @ 15% for the six years are as below:
Year 1 2 3 4 5 6
PVIF 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
Solution:
PV of Total Cash Outflow under System A
Page 6
Initial Outlay 50,00,000

PV of Annual Operating Cost (1-6 years) 15,00,000 × 3.7845 56,76,750
Less: PV of Salvage Value ₹ 10,00,000 × 0.4323 (4,32,300)
1,02,44,450
PVAF (15%, 6) 3.7845
Equivalent Annual Cost (1,02,44,450/3.7845) 27,06,949
PV of Total Cash Outflow under System B
₹
Initial Outlay 40,00,000
PV of Annual Operating Cost (1-4 years) 16,00,000 × 45,68,000
2.855 (2,85,900)
Less: PV of Salvage Value ₹ 5,00,000 × 0.5718 82,82,100
2.855
PVAF (15%, 4) 29,00,911
Equivalent Annual Cost (82,82,100/2.855)
Since Equivalent Annual Cost (EAC) is least in case of system A hence same should be
opted.
Question: 04
DEF Ltd has been regularly paying a dividend of ₹19,20,000 per annum for several
years andit is expected that same dividend would continue at this level in near future.
There are 12,00,000 equity shares of ₹ 10 each and the share is traded at par.
The company has an opportunity to invest ₹ 8,00,000 in one year's time as well as
further ₹ 8,00,000 in two year's time in a project as it is estimated that the project will
generate cash inflow of ₹ 3,60,000 per annum in three year's time which will continue
for ever. This investment is possible if dividend is reduced for next two years.
Whether the company should accept the project? Also analyze the effect on the market
price of the share, if the company decides to accept the project.
Solution:
First we calculate cost of Equity (Ke)/PE Ratio
…………………………………….
∗ Assume these periods are the periods from which bike shall be kept in use. ♣ EAC is
used to bring Cash Flows occurring for different periods at one point of Time.
19,20,000
D1 =
12,00,000
P0 = 10
𝐷 ₹1.6
Ke = = = 16%
𝑃 10
10
P/E = = 6.25
1.6
Page 7
Now we shall compute NPV of the project
-8,00,000 -8,00,000 3,60,000 1

NPV = + 2 + ×
(1+0.16) (1+0.16) 0.16 (1+0.16)2
= -6,89,655 – 5,94,530 + 16,72,117
= 3,87,932
As NPV of the project is positive, the value of the firm will increase by ₹3,87,932 and
spread over the number of shares e.g. 12,00,000, the market price per share will
increase by 32 paisa.
(2) REPLACEMENT
Question: 05
A company has an old machine having book value zero – which can be sold for ₹
50,000. The company is thinking to choose one from following two alternatives:
(i) To incur additional cost of ₹ 10,00,000 to upgrade the old existing machine.
(ii) To replace old machine with a new machine costing ₹ 20,00,000 plus
installation cost ₹ 50,000.
Both above proposals envisage useful life to be five years with salvage value to be nil.
The expected after tax profits for the above three alternatives are as under :
Year Old existing Upgraded Machine New Machine

Machine (₹) (₹) (₹)
1 5,00,000 5,50,000 6,00,000
2 5,40,000 5,90,000 6,40,000
3 5,80,000 6,10,000 6,90,000
4 6,20,000 6,50,000 7,40,000
5 6,60,000 7,00,000 8,00,000
The tax rate is 40 per cent.
The company follows straight line method of depreciation. Assume cost of capital to be
15 per cent.
P.V.F. of 15%, 5 = 0.870, 0.756, 0.658, 0.572 and 0.497. You are required to advise
the company as to which alternative is to be adopted.
Solution:
(A) Cash Outflow ₹
Page 8
(i) In case machine is upgraded:

Up-gradation Cost 10,00,000
(ii) In case new machine installed:

Cost 20,00,000
Add: Installation Cost 50,000
Total Cost 20,50,000
Less: Disposal of old machine
₹ 50,000 – 40% tax 30,000
Total Cash Outflow 20,20,000
Working Note:
(iv) Depreciation – in case machine is upgraded
₹ 10,00,000 ÷ 5 = ₹ 2,00,000
(ii) Depreciation – in case new machine is installed
₹ 20,50,000 ÷ 5 = ₹ 4,10,000
(iii) Old existing machine – Book Value is zero. So, no depreciation.
(B) Cash Inflows after Taxes (CFAT)
Year Old Existing Upgraded Machine

Machine
(i) (ii) (iii) (iv) = (iv) – (i)
EAT/CFAT EAT DEP CFAT Incremental
₹ ₹ ₹ ₹ CFAT ₹
1 5,00,000 5,50,000 2,00,000 7,50,000 2,50,000
2 5,40,000 5,90,000 2,00,000 7,90,000 2,50,000
3 5,80,000 6,10,000 2,00,000 8,10,000 2,30,000
4 6,20,000 6,50,000 2,00,000 8,50,000 2,30,000
5 6,60,000 7,00,000 2,00,000 9,00,000 2,40,000
Cash Inflow after Taxes (CFAT)
Year Upgraded Machine

(vi) (vii) (viii) (ix)= (viii) – (i)
EAT DEP CFAT Incremental
₹ ₹ ₹ CFAT ₹
1 6,00,000 4,10,000 10,10,000 5,10,000
2 6,40,000 4,10,000 10,50,000 5,10,000
3 6,90,000 4,10,000 11,00,000 5,20,000
4 7,40,000 4,10,000 11,50,000 5,30,000
5 8,00,000 4,10,000 12,10,000 5,50,000
Page 9
P.V. AT 15% - 5 Years – on Incremental CFAT
Year Upgraded Machine New Machine

Incremental PVF Total Incremental PVF Total
CFAT P.V. CFAT PV
₹ ₹ ₹ ₹
1 2,50,000 0.870 2,17,500 5,10,000 0.870 4,43,700
2 2,50,000 0.756 1,89,000 5,10,000 0.756 3,85,560
3 2,30,000 0.658 1,51,340 5,20,000 0.658 3,42,160
4 2,30,000 0.572 1,31,560 5,30,000 0.572 3,03,160
5 2,40,000 0.497 1,19,280 5,50,000 0.497 2,73,350
Total P.V. of CFAT 8,08,680 17,47,930
Less: Cash Outflows 10,00,000 20,20,000*
N.P.V. = -1,91,320 - 2,72,070
*Acquisition Cost (including installation cost) ₹ 20,50,000
Less: Salvage Value of existing machine net of Tax ₹ 30,000
₹ 20,20,000
As the NPV in both the new (alternative) proposals is negative, the company
should continue with the existing old Machine.
Question: 06
A & Co. is contemplating whether to replace an existing machine or to spend money
on overhauling it. A & Co. currently pays no taxes. The replacement machine costs ₹
90,000 now and requires maintenance of ₹ 10,000 at the end of every year for eight
years. At the end of eight years it would have a salvage value of ₹ 20,000 and would be
sold. The existing machine requires increasing amounts of maintenance each year and
its salvage value falls each year as follows:
Year Maintenance Salvage

(₹) (₹)
Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for A & Co. is 15%.
Required:
When should the company replace the machine?
Page 10
(Notes: Present value of an annuity of Re. 1 per period for 8 years at interest rate of
15% : 4.4873; present value of Re. 1 to be received after 8 years at interest rate of 15%
: 0.3269).
Solution:
A & Co.
Equivalent cost of (EAC) of new machine
₹
(i) Cost of new machine now 90,000
Add: PV of annual repairs @ ₹ 10,000 per annum for 8 years
(₹ 10,000 × 4.4873) 44,873
1,34,873
Less: PV of salvage value at the end of 8 years 6,538

(₹ 20,000 × 0.3269)
1,28,335
Equivalent annual cost (EAC) (₹ 1,28,355/4.4873) 28,600
PV of cost of replacing the old machine in each of 4 years with new machine
Scenario Year Cash Flow PV @ 15% PV

₹ ₹
Replace Immediately 0 (28,600) 1.00 (28,600)
40,000 1.00 40,000
11,400
Replace in one year 1 (28,600) 0.870 (24,882)
1 (10,000) 0.870 (8,700)
1 25,000 0.870 21,750
(11,832)
Replace in two years 1 (10,000) 0.870 (8,700)
2 (28,600) 0.756 (21,622)
2 (20,000) 0.756 (15,120)
2 15,000 0.756 11,340
(34,102)
Replace in three years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)
3 (28,600) 0.658 (18,819)
3 (30,000) 0.658 (19,740)
3 10,000 0.658 6,580
(55,799)
Replace in 4 years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)
3 (30,000) 0.658 (19,740)
4 (28,600) 0.572 (16,359)
4 (40,000) 0.572 (22,880)
(82,799)
Page 11
Advice: The company should replace the old machine immediately because the PV of
cost of replacing the old machine with new machine is least.
Alternatively, optimal replacement period can also be computed using the

following table:
Scenario Year Cash flow PV @ 15% PV

Replace immediately 0 (40,000) 1 (40,000)
1 to 4 28,600 2.855 81,652
41,652
Replace after 1 year 1 10,000 0.870 8,696

1 (25,000) 0.870 (21,739)
2 to 4 28,600 1.985 56,783
43,739
Replace after 2 years 1 10,000 0.870
8,696
2 20,000 0.756
15,123
2 (15,000) 0.756
(11,342)
3 and 4 28,600 1.229
35,157
47,633
2 20,000 0.756 8,696
3 30,000 0.658 15,123
3 (10,000) 0.658 19,725
4 28,600 0.572 (6,575)
16,352
53,321
2 20,000 0.756 8,696
3 30,000 0.658 15,123
4 40,000 0.572 19,725
22,870
66,414
Question: 07
Company X is forced to choose between two machines A and B. The two machines are
designed differently but have identical capacity and do exactly the same job. Machine
A costs ₹1,50,000 and will last for 3 years. It costs ₹ 40,000 per year to run. Machine
B is an „economy‟ model costing only ₹ 1,00,000, but will last only for 2 years, and
costs ₹ 60,000 per year to run. These are real cash flows. The costs are forecasted in
rupees of constant purchasing power. Ignore tax. Opportunity cost of capital is 10 per
cent. Which machine company X should buy?
Solution:
Statement showing the evaluation of two machines
Page 12
Machines A B
Purchase cost (₹): (i) 1,50,000 1,00,000
Life of machines (years) 3 2
Running cost of machine per year (₹): (ii) 40,000 60,000
Cumulative present value factor for 1-3 years @ 10% (iii) 2.486 −
Cumulative present value factor for 1-2 years @ 10% (iv) − 1.735
Present value of running cost of machines (₹): (v) 99,440 1 1,04,100
[(iii)] × [(ii)] [(iv)] × [(ii)]
Cash outflow of machines (₹): (vi) = (i) + (v) 2,49,440 2,04,100
Equivalent present value of annual cash outflow 1,00,338 1,17,637
[(iii)] ÷ [(vi)] [(iv)] ÷ [(vi)]
Decision: Company X should buy machine A since its equivalent cash outflow is less
than machine B.
Question: 08
Company Y is operating an elderly machine that is expected to produce a net cash
inflow of ₹ 40,000 in the coming year and ₹ 40,000 next year. Current salvage value is
₹ 80,000 and next year‟s value is ₹ 70,000. The machine can be replaced now with a
new machine, which costs ₹ 1,50,000, but is much more efficient and will provide a
cash inflow of ₹ 80,000 a year for 3 years. Company Y wants to know whether it
should replace the equipment now or wait a year with the clear understanding that
the new machine is the best of the available alternatives and that it in turn be
replaced at the optimal point. Ignore tax. Take opportunity cost of capital as 10 per
cent. Advise with reasons.
Solution:
Statement showing present value of cash inflow of new machine when it replaces
elderly machine now
NPV of New Machine
PV of Cash Inflow (80,000 × 2.486) ₹ 1,98,880
Less: Purchase Cost of New Machine ₹ 1,50,000
₹ 48,880
Since NPV of New Machine is positive, it should be purchased.
Timing Decision
Replace Now
Current Realizable Value ₹ 80,000
NPV of New Machine ₹ 48,880
Page 13
Total NPV ₹ 1,28,880
Replace after 1 Year
Cash Inflow for Year 1 ₹ 40,000
Realizable Value of Old Machine ₹ 70,000
NPV of New Machine ₹ 48,880
Total NPV after 1 Year ₹ 1,58,880
PV of Total NPV (1,58,880/1.1) ₹ 1,44,436
Advise: Since Total NPV is higher in case of Replacement after one year Machine
should be replaced after 1 year.
Question: 09
A machine used on a production line must be replaced at least every four years. Costs
incurred to run the machine according to its age are:
Age of the Machine (years)

0 1 2 3 4
Purchase price (in ₹) 60,000
Maintenance (in ₹) 16,000 18,000 20,000 20,000
Repair (in ₹) 0 4,000 8,000 16,000
Scrap Value (in ₹) 32,000 24,000 16,000 8,000
Future replacement will be with identical machine with same cost. Revenue is
unaffected by the age of the machine. Ignoring inflation and tax, determine the
optimum replacement cycle. PV factors of the cost of capital of 15% for the respective
four years are 0.8696, 0.7561, 0.6575 and 0.5718.
Solution:
Working Notes
First of all, we shall calculate cash flows for each replacement cycle as follows:
One year replacement cycle ₹
Year Replacement Maintenance Residual Value Net Cash Flow

Cost & Repair
0 (60,000) - - (60,000)
1 - (16,000) 32,000 16,000
Page 14
Two years replacement cycle ₹

Cost & Repair
0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
2 - (22,000) 24,000 2,000
Three years replacement cycle ₹

Cost & Repair
0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
2 - (22,000) - (22,000)
3 - (28,000) 16,000 (12,000)
Four years replacement cycle ₹

Cost & Repair
0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
2 - (22,000) - (22,000)
3 - (28,000) - (28,000)
4 - (36,000) 8,000 (28,000)
Now we shall calculate NPV for each replacement cycles
1 Year 2 Years 3 Years 4 Years

Year PVF @ Cash PV Cash PV Cash PV Cash PV
15% Flows Flows Flows Flows
0 1 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000
1 0.8696 16,000 13,914 -16,000 -13,914 -16,000 -13,914 -16,000 -13,914
2 0.7561 - - 2,000 1,512 -22,000 -16,634 -22,000 -16,634
3 0.6575 - - - 0 -12,000 -7,890 -28,000 -18,410
4 0.5718 - - - 0 0 -28,000 -16,010
-46,086 -72,402 -98,438 -1,24,968
Replacement Cycle EAC (₹)

1 Year 46,086 52,997
0.8696
2 Years 72,402 44,536
1.6257
3 Years 98,438 43,114
2.2832
Page 15
4 Years 1,24,968 43,772

2.855
Since EAC is least in case of replacement cycle of 3 years hence machine should be
replaced after every three years.
Note: Alternatively, Answer can also be computed by excluding initial outflow as there
will be no change in final decision.
Question: 10
Trouble Free Solutions (TFS) is an authorized service center of a reputed domestic air
conditioner manufacturing company. All complaints/service related matters of Air
conditioner are attended by this service center. The service center employs a large
number of mechanics, each of whom is provided with a motor bike to attend the
complaints. Each mechanic travels approximately 40,000 kms per annum. TFS
decides to continue its present policy of always buying a new bike for its mechanics
but wonders whether the present policy of replacing the bike every three year is
optimal or not. It is of believe that as new models are entering into market on yearly
basis, it wishes to consider whether a replacement of either one year or two years
would be better option than present three year period. The fleet of bike is due for
replacement shortly in near future.
The purchase price of latest model bike is ₹ 55,000. Resale value of used bike at
current prices in market is as follows:
Period ₹
1 Year old 35,000
2 Year old 21,000
3 Year old 9,000
Running and Maintenance expenses (excluding depreciation) are as follows:
Year Road Taxes Insurance etc. Petrol Repair Maintenance

(₹) etc. (₹)
1 3,000 30,000
2 3,000 35,000
3 3,000 43,000
Using opportunity cost of capital as 10% you are required to determine optimal
replacement period of bike.
Solution:
In this question the effect of increasing running cost and decreasing resale value have
to be weighted upto against the purchase cost of bike. For this purpose, we shall
Page 16
compute Equivalent Annual Cost (EAC) of replacement in different years shall be

computed and compared.
Year Road Petrol Total PVF PV (₹) Cumulative PV of Net
Taxes etc. (₹) @10% PV (₹) Resale Outflow
(₹) (₹) Price (₹) (₹)
1 3,000 30,000 33,000 0.909 29,997 29,997 31,815 (1,818)
2 3,000 45,000 38,000 0.826 31,388 61,385 17,346 44,039
3 3,000 43,000 46,000 0.751 34,546 95,931 6,759 89,172
Computation of EACs
Year* Purchase Net Outflow Total PVAF EAC*

Price of (₹) Outflow @ 10% (₹)
Bike (₹) (₹)
1 55,000 (1,818) 53,182 0.909 58,506
2 55,000 44,039 99,039 1.735 57,083
3 55,000 89,172 1,44,172 2.486 57,993
Thus, from above table it is clear that EAC is least in case of 2 years, hence bike
should be replaced every two years.
Question: 11
A Company named Roby‟s cube decided to replace the existing Computer system of
their organization. Original cost of old system was ₹ 25,000 and it was installed 5
years ago. Current market value of old system is ₹ 5,000. Depreciation of the old
system was charged with life of 10 years with Estimated Salvage value as Nil.
Depreciation of the new system will be charged with life over 5 years Present cost of
the new system is ₹ 50,000. Estimated Salvage value of the new system is ₹1,000.
Estimated cost savings with new system is ₹ 5,000 per year. Increase in sales with
new system is assumed at 10% per year based on original total sales of ₹10,00,000.
Company follows straight line method of depreciation. Cost of capital of the company
is 10% whereas tax rate is 30%.
Solution:
Step I. Net cash outflow (assumed at current time) [Present values of cost]:
(a) (Book value of old system – market value of old system) × Tax Rate
= Tax payable/savings from sale
= [(₹ 25,000 – 5 × ₹ 2,500) – ₹ 5,000] × 0.30 = ₹ 7,500 × 0.30
= ₹ 2,250
(b) Cost of new system – [Tax payable/savings from sale + Market value of old
system] = Net cash outflow
Page 17
Or, ₹ 50,000 – [₹ 2,250 + ₹ 5,000] = ₹ 42,750
Step II. Estimated change in cash flows per year if replacement decision is
implemented.
Change in cash flow = [(Change in sales ± Change in operating costs) −Change in

depreciation)] (1tax rate) + Change in depreciation
= [₹1,00,000 × 0.1 + ₹5,000 – (₹49,000/5 – ₹25,000/10)] (1−0.30) + (₹ 49,000/5 –

₹25000/10)]
= ₹12,690
Step III. Present value of benefits = Present value of yearly cash flows + Present value
of estimated salvage of new system
= ₹12,690 × PVIFA (10%, 5) + ₹1,000 × PVIF (10%, 5)
= ₹48,723
Step IV. Net present value = Present value of benefits − Present value of costs
= ₹48,723 – ₹42,750
= ₹5,973
Step V. Decision rule: Since NPV is positive we should accept the proposal to replace
the machine.
Question: 12
X Ltd. is a taxi operator. Each taxi cost to company ₹4,00,000 and has a useful life of
3 years. The taxi‟s operating cost for each of 3 years and salvage value at the end of
year is as follows:
Year 1 Year 2 Year 3

Operating Cost ₹ 1,80,000 ₹ 2,10,000 ₹ 2,38,000
Resale Value ₹ 2,80,000 ₹ 2,30,000 ₹ 1,68,000
You are required to determine the optimal replacement period of taxi if cost of capital
of X Ltd. is 10%.
Solution:
NPV if taxi is kept for 1 Year
= – ₹ 4,00,000 − ₹ 1,80,000 (0.909) + ₹ 2,80,000 (0.909)
= – ₹ 3,09,100
Page 18
= – ₹4,00,000 – ₹1,80,000 × 0.909 + ₹ 20,000 × 0.826
= – ₹ 5,47,100
= – ₹4,00,000 – ₹1,80,000 × 0.909 – ₹2,10,000 × 0.826 – ₹70,000 × 0.751
= – ₹7,89,650
Since above NPV figures relate to different periods, there are not comparable. to make
them comparable we shall use concept of EAC as follows:
EAC of 1 year
3,09,100
= ₹3,40,044
0.909
EAC of 2 year
5,47,100
= ₹3,15,331
1,735
EAC of 3 year
7,89,650
= ₹3,17,639
2,486
Since lowest EAC incur if taxi for 2 year; Hence the optimum replacement cycle to
replace taxi in 2 years.
(3) RISK & UNCERTAINTY
(I) Probabilistic Approach
Question: 13
Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs ₹
36,000 and project B ₹ 30,000. You have been given below the net present value
probability distribution for each project.
Project A Project B
NPV Estimates (₹) Probability NPV Estimates (₹) Probability
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
Page 19
3,000 0.2 3,000 0.1
(i) Compute the expected net present values of projects A and B.
(ii) Compute the risk attached to each project i.e. standard deviation of each
probability distribution.
(iii) Compute the profitability index of each project.
(iv) Which project do you recommend? State with reasons.
Solution:
(i) Statement showing computation of expected net present value of

Projects A and B:
Project A Project B
NPV Probability Expected NPV Probability Expected

Estimate Value Estimate Value
(₹) (₹)
15,000 0.2 3,000 15,000 0.1 1,500
12,000 0.3 3,600 12,000 0.4 4,800
6,000 0.3 1,800 6,000 0.4 2,400
3,000 0.2 600 3,000 0.1 300
1.0 EV = 9,000 1.0
EV = 9,000
(ii) Computation of Standard deviation of each project
Project A
P X (X – EV) P (X - EV)²
0.2 15,000 6,000 72,00,000
0.3 12,000 3,000 27,00,000
0.3 6,000 - 3,000 27,00,000
0.2 3,000 - 6,000 72,00,000
Variance = 1,98,00,000
Standard Deviation of Project A = 1,98,00,000 = ₹ 4,450
Page 20
Project B
P X (X – EV) P (X − EV)²
0.1 15,000 6,000 36,00,000
0.4 12,000 3,000 36,00,000
0.4 6,000 - 3,000 36,00,000
0.1 3,000 - 6,000 36,00,000
Variance = 1,44,00,000
Standard Deviation of Project A = 1,44,00,000 = ₹ 3,795
(iii) Computation of profitability of each project
Profitability index = Discount cash inflow / Initial outlay
9,000 + 36,000 45,000

In case of Project A : PI = = = 1.25
36,000 36,000
9,000 + 30,000 39,000

In case of Project A : PI = = = 1.30
30,000 30,000
(iv) Measurement of risk is made by the possible variation of outcomes around the
expected value and the decision will be taken in view of the variation in the
expected value where two projects have the same expected value, the decision
will be the project which has smaller variation in expected value. In the
selection of one of the two projects A and B, Project B is preferable because the
possible profit which may occur is subject to less variation (or dispersion).
Much higher risk is lying with project A.
Question: 14
KLM Ltd., is considering taking up one of the two projects-Project-K and Project-So
Both the projects having same life require equal investment of ₹ 80 lakhs each. Both
are estimated to have almost the same yield. As the company is new to this type of
business, the cash flow arising from the projects cannot be estimated with certainty.
An attempt was therefore, made to use probability to analyze the pattern of cash flow
from other projects during the first year of operations. This pattern is likely to
continue during the life of these projects. The results of the analysis are as follows:
Project K Project S
Cash Flow (in ₹) Probability Cash Flow (in ₹) Probability
11 0.10 09 0.10
13 0.20 13 0.25
15 0.40 17 0.30
17 0.20 21 0.25
19 0.10 25 0.10
Page 21
Required:
(i) Calculate variance, standard deviation and co-efficient of variance for both the
projects.
(ii) Which of the two projects is riskier?
Solution:
Calculation of Variance and Standard Deviation
Project K
Expected Net Cash Flow
= (0.10 × 11) + (0.20 × 13) + (0.40 × 15) + (0.20 × 17) + (0.10 × 19)
= 1.1 + 2.6 + 6 + 3.4 + 1.9 = 15
2 2 2 2
σ2 = 0.10 11 – 15 + 0.20 13 – 15 + 0.40 15 – 15 + 0.20 17 – 15 + 0.10
2
19 – 15
= 1.6 + 0.8 + 0 + 0.8 + 1.6 = 4.8
σ = 4.8 = 2.19
Project S
Expected Net Cash Flow
= (0.10 × 9) + (0.25 × 13) + (0.30 × 17) + (0.25 × 21) + (0.10 × 25)
= 0.9 + 3.25 + 5.1 + 5.25 + 2.5 = 17
2 2 2 2
𝜎2 = 0.1 9 − 17 + 0.25 13 − 17 + 0.30 17 − 17 + 0.25 21 − 17 + 0.10
25 − 17 2
= 6.4 + 4 + 0 + 4 + 6.4 = 20.8
σ = 20.8 = 4.56
Calculation of Coefficient of Variation
Standard Deviation Mean

Coefficient of Variation =
Mean
Page 22
2.19
Project K = = 0.146
15
4.56
Project S = = 0.268
17
Project S is riskier as it has higher Coefficient of Variation.
Question: 15
Cyber Company is considering two mutually exclusive projects. Investment outlay of
both the projects is ₹ 5,00,000 and each is expected to have a life of 5 years. Under
three possible situations their annual cash flows and probabilities are as under:
Cash Flow (₹)

Situation Probabilities Project A Project B
Good 0.3 6,00,000 5,00,000
Normal 0.4 4,00,000 4,00,000
Worse 0.3 2,00,000 3,00,000
The cost of capital is 7 per cent, which project should be accepted? Explain with
workings.
Solution:
Project A
Expected Net Cash flow
(ENCF) = 0.3 (6,00,000) + 0.4 (4,00,000) + 0.3 (2,00,000) = 4,00,000
σ2 = 0.3 (6,00,000 – 4,00,000)2 + 0.4 (4,00,000 – 4,00,000)2 + 0.3 (2,00,000

– 4,00,000)2
σ = 24,00,00,00,000
σ = 1,54,919.33
Present Value of Expected Cash Inflows = 4,00,000 × 4.100 = 16,40,000
NPV = 16,40,000 – 5,00,000 = 11,40,000
Project B
ENCF = 0.3 (5,00,000) + 0.4 (4,00,000) + 0.3 (3,00,000) = 4,00,000
σ2 = 0.3 (5,00,000 – 4,00,000)2 + 0.4 (4,00,000 – 4,00,000)2 + 0.3 (3,00,000

–
Page 23
4,00,000)2
σ = 6,00,00,00,000
σ = 77,459.66
Present Value of Expected Cash Inflows = 4,00,000 × 4.100 = 16,40,000
NPV = 16,40,000 – 5,00,000 = 11,40,000
Recommendation: NPV in both projects being the same, the project should be
decided on the basis of standard deviation and hence project „B‟ should be accepted
having lower standard deviation, means less risky.
Question: 16
A company is considering Projects X and Y with following information:
Project Expected NPV (₹) Standard Deviation

X 1,22,000 90,000
Y 2,25,000 1,20,000
(i) Which project will you recommend based on the above data?
(ii) Explain whether your opinion will change, if you use coefficient of variation as a
measure of risk.
(iii) Which measure is more appropriate in this situation and why?
Solution:
(i) On the basis of standard deviation project X be chosen because it is less risky
than Project Y having higher standard deviation.
SD 90,000
(ii) CVx = = = 0.738
ENPV 1,22,000
1,20,000
CVx = = 0.533
2,25,000
On the basis of Co-efficient of Variation (C.V.) Project X appears to be riskier

and hence Y should be accepted.
(iii) However, the NPV method in such conflicting situation is best because the NPV
method is in compatibility of the objective of wealth maximization in terms of
time value.
Page 24
Question: 17
Possible net cash flows of Projects A and B at the end of first year and their
probabilities are given below. Discount rate is 10 per cent. For both the projects, initial
investment is ₹ 10,000. Calculate the expected net present value for each project.
State which project is preferable?
Possible Project A Project B

Event
Cash Flow (₹) Probability Cash Flow (₹) Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8 ,000 0.10
Solution:
Calculation of Expected Value for Project A and Project B
Project A Project B
Possible Cash Probability Expected Cash Probability Expected
Event Flow (₹) Value (₹) Flow (₹) Value (₹)
A 8,000 0.10 800 24,000 0.10 2,400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000
The Net Present Value for Project A is (0.909 × ₹ 12,000 – ₹ 10,000) = ₹ 908
The Net Present Value for Project B is (0.909 × ₹ 16,000 – ₹ 10,000) = ₹ 4,544.
Question: 18
Probabilities for net cash flows for 3 years of a project are as follows:

Cash Flow Probability Cash Flow Probability Cash Flow Probability
(₹) (₹) (₹)
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
Calculate the expected net present value of the project using 10 per cent discount rate
if the Initial Investment of the project is ₹ 10,000.
Page 25
Solution:
Calculation of Expected Value
Cash Probabi Expecte Cash Probabili Expecte Cash Probability Expect

Flow lity d Value Flow ty d Value Flow ed
(₹) (₹) (₹) (₹) (₹) Value
(₹)
2,000 0.1 200 2,000 0.2 400 2,000 0.3 600
4,000 0.2 800 4,000 0.3 1200 4,000 0.4 1,600
6,000 0.3 1,800 6,000 0.4 2400 6,000 0.2 1,200
8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800
ENCF 6,000 4,800 4,200
The present value of the expected value of cash flow at 10 per cent discount rate has
been determined as follows:
ENCF1 𝐸𝑁𝐶𝐹2 𝐸𝑁𝐶𝐹3

Present Value of cash flow = 1 + +
(1 + k) (1 + 𝑘)2 (1 + 𝑘)3
6,000 4,800 4,800

= + 2 +
(1.1) (1.1) (1.1)3
= (6,000 × 0.909) + (4,800 × 0.826) + (4,200 × 0.751)
= ₹12,573
Expected Net Present value = Present Value of cash flow − Initial Investment
= ₹12,573 – ₹10,000 = ₹2,573.
Question: 19
Calculate Variance and Standard Deviation of Project A and Project B on the basis of
following information:
Possible Event Project A Project B
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10
Solution:
Project A Project B
Page 26

A 8,000 0.10 800 24,000 0.10 2,400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000
Project A:
Variance (σ2)
= (8,000 – 12,000)2 × (0.1) + (10,000 – 12,000)2 × (0.2) + (12,000 – 12000)2 × (0.4) +

(14,000 – 12,000)2 × (0.2) + (16000 – 12,000)2 × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000
Standard Deviation (σ) = Variance (σ2 ) = 48,00,000 = 2,190.90
Project B:
Variance (σ2)
= (24,000 – 16,000)2 × (0.1) + (20,000 – 16,000)2 × (0.15) + (16,000 – 16,000)2 × (0.5)

+ (12,000 – 16,000)2 × (0.15) + (8,000 – 16,000)2 × (0.1)
= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000
Standard Deviation (σ) = Variance (σ2 ) = 1,76,00,000 = 4195.23
Question: 20
Calculate Coefficient of Variation of Project A and Project B based on the following
information:
Possible Event Project A Project B

A 10000 0.10 26,000 0.10
B 12,000 0.20 22,000 0.15
C 14,000 0.40 18,000 0.50
D 16,000 0.20 14,000 0.15
E 18,000 0.10 10,000 0.10
Solution:
Page 27
Project A Project B
A 10,000 0.10 1,000 26,000 0.10 2,600
B 12,000 0.20 2,400 22,000 0.15 3,300
C 14,000 0.40 5,600 18,000 0.50 9,000
D 16,000 0.20 3,200 14,000 0.15 2,100
E 18,000 0.10 1,800 10,000 0.10 1,000
ENCF 14,000 18,000
Project A:
Variance (σ2)
= (10,000 – 14,000)2 × (0.1) + (12,000 – 14,000)2 × (0.2) + (14,000 – 14000)2 × (0.4) +

(16,000 – 14,000)2 × (0.2) + (18000 – 14,000)2 × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000
Standard Deviation (σ) = Variance (σ2 ) = 48,00,000 = 2,190.90
Project B:
Variance(σ2)
= (26,000 – 18,000)2 × (0.1) + (22,000 – 18,000)2 × (0.15) + (18,000 – 18,000)2 × (0.5)

+ (14,000 – 18,000)2 × (0.15) + (10,000 – 18,000)2 × (0.1)
= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000
Standard Deviation (σ) = Variance (σ2 ) = 1,76,00,000= 4195.23
Projects Coefficient of variation Risk Expected Value

A 2,190.90 Less Less
= 0.1565
14,000
B 4,195.23 More More
= 0.2331
18,000
In project A, risk per rupee of cash flow is ₹ 0.16 while in project B, it is ₹ 0.23.
Therefore, Project A is better than Project B.
(II) Risk Adjusted Discounting Role
Question: 21
Determine the risk adjusted net present value of the following projects:
Page 28
X Y Z
Net cash outlays (₹) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (₹) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4
The Company selects the risk-adjusted rate of discount on the basis of the coefficient
of variation:
Coefficient of Variation Risk-Adjusted Rate of P.V. Factor 1 to 5 years

Return At risk adjusted rate of
discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
Solution:
Statement showing the determination of the risk adjusted net present value
Projects Net cash Coefficient Risk Annual PV Discounted Net

outlays of variation adjusted cash factor cash inflow present
discount inflow 1-5 Value
rate years
₹ ₹ ₹ ₹
(i) (ii) (iii) (iv) (v) (vi) (vii) = (v) × (viii) =
(vi) (vii) −(ii)
X 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180
Y 1,20,000 0.80 14% 42,000 3.433 1,44,186 24,186
Z 1,00,000 0.40 12% 30,000 3.605 1,08,150 8,150
Question: 22
New Projects Ltd. is evaluating 3 projects, P-I, P-II, P-III. Following information is
available in respect of these projects:
P-I P-II P-III

Cost ₹ 15,00,000 ₹ 11,00,000 ₹ 19,00,000
Inflow-Year 1 6,00,000 6,00,000 4,00,000
Year 2 6,00,000 4,00,000 6,00,000
Year 3 6,00,000 5,00,000 8,00,000
Year 4 6,00,000 2,00,000 12,00,000
Risk Index 1.80 1.00 0.60
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%.
The risk free interest rate is 10%.
Page 29
Required:
(i) Find out the risk-adjusted discount rate (RADR) for these projects.
(ii) Which project is the best?
Solution:
(i) The risk free rate of interest and risk factor for each of the projects are given.
The risk adjusted discount rate (RADR) for different projects can be found on
the basis of CAPM as follows:
Required Rate of Return = IRf + (ko − IRF ) Risk Factor
For P-I : RADR = 0.10 + (0.15 – 0.10 ) 1.80 = 19%
For P-II : RADR = 0.10 + (0.15 – 0.10 ) 1.00 = 15 %
For P-III : RADR = 0.10 + (0.15 – 0.10) 0.60 = 13 %
(ii) The three projects can now be evaluated at 19%, 15% and 13% discount rate as
follows:
Project P-I
Annual Inflows ₹ 6,00,000
PVAF (19%, 4) 2.639
PV of Inflows (₹ 6,00,000 × 2.639) ₹15,83,400
Less: Cost of Investment ₹15,00,000
Net Present Value ₹83,400

Project P-II
Year Cash Inflow (₹) PVF (15%,n) PV (₹)

1 6,00,000 0.870 5,22,000
2 4,00,000 0.756 3,02,400
3 5,00,000 0.658 3,29,000
4 2,00,000 0.572 1,14,400
Total Present Value 12,67,800
Less: Cost of 11,00,000
Investment
Net Present Value 1,67,800
Project P-III
Page 30
Year Cash Inflow (₹) PVF (15%,n) PV (₹)

1 4,00,000 0.885 3,54,000
2 6,00,000 0.783 4,69,800
3 8,00,000 0.693 5,54,400
4 12,00,000 0.613 7,35,600
Total Present Value 21,13,800
Less: Cost of 19,00,000
Investment
Project P-III has highest NPV. So, it should be accepted by the firm.
Question: 23
An enterprise is investing ₹ 100 lakhs in a project. The risk-free rate of return is 7%.
Risk premium expected by the Management is 7%. The life of the project is 5 years.
Following are the cash flows that are estimated over the life of the project:
Year Cash flows (₹ in lakhs)

1 25
2 60
3 75
4 80
5 65
Calculate Net Present Value of the project based on Risk free rate and also on the
basis of Risks adjusted discount rate.
Solution:
The Present Value of the Cash Flows for all the years by discounting the cash flow at
7% is calculated as below:
Year Cash flows (₹ in Discounting Present value of Cash

lakhs) Factor @ 7% Flows (₹ In Lakhs)
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of Present value of Cash flows 244.34
Less: Initial investment 100.00
Net Present Value (NPV) 144.34
Now, when the risk-free rate is 7% and the risk premium expected by the Management
is 7%, then risk adjusted discount rate is 7% + 7% = 14%.
Page 31
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as
below:
Year Cash flows (₹ in Discounting Present value of

lakhs) Factor @ 14% Cash Flows (₹ In
Lakhs)
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of Present value of Cash flows 199.79
Less: Initial investment 100.00
Net present value (NPV) 99.79
(III) Certainty Equivalent Approach
Question: 24
The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive
proposals, Projects M and N, which require cash outlays of ₹ 8,50,000 and ₹ 8,25,000
respectively. The certainty-equivalent (C.E) approach is used in incorporating risk in
capital budgeting decisions. The current yield on government bonds is 6% and this is
used as the risk free rate. The expected net cash flows and their certainty equivalents
are as follows:
Project M Project N
Year-end Cash Flow ₹ C.E. Cash Flow ₹ C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of ₹ 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943,
0.890 and 0.840 respectively.
Required:
(i) Which project should be accepted?
(ii) If risk adjusted discount rate method is used, which project would be appraised
with a higher rate and why?
Solution:
(i) Statement Showing the Net Present Value of Project M
Year Cash Flow C.E. Adjusted Cash Present Total Present
Page 32
end (₹) (a) flow value factor value (₹)

(b) (₹) (c) = (a) × at 6% (d) (e) = (c) × (d)
(b)
1 4,50,000 0.8 3,60,000 0.943 3,39,480
2 5,00,000 0.7 3,50,000 0.890 3,11,500
3 5,00,000 0.5 2,50,000 0.840 2,10,000
8,60,980
Less: Initial Investment 8,50,000
Net Present Value 10,980
Statement Showing the Net Present Value of Project N
Year Cash Flow C.E. Adjusted Cash Present Total Present

end (₹) (a) flow value factor value (₹)
(b) (₹) (c) = (a) × at 6% (d) (e) = (c) × (d)
(b)
1 4,50,000 0.9 4,05,000 0.943 3,81,915
2 5,00,000 0.8 3,60,000 0.890 3,20,400
3 5,00,000 0.7 3,50,000 0.840 2,94,000
9,96,315
Less: Initial Investment 8,25,000
Decision: Since the net present value of Project N is higher, so the project N
should be accepted.
(ii) Certainty - Equivalent (C.E.) Co-efficient of Project M (2.0) is lower than Project
N (2.4). This means Project M is riskier than Project N as "higher the riskiness
of a cash flow, the lower will be the CE factor". If risk adjusted discount rate
(RADR) method is used, Project M would be analyzed with a higher rate.
RADR is based on the premise that riskiness of a proposal may be taken care
of, by adjusting the discount rate. The cash flows from a more risky proposal
should be discounted at a relatively higher discount rate as compared to other
proposals whose cash flows are less risky. Any investor is basically risk averse.
However, he may be ready to take risk provided he is rewarded for undertaking
risk by higher returns. So, more risky the investment is, the greater would be
the expected return. The expected return is expressed in terms of discount rate
which is also the minimum required rate of return generated by a proposal if it
is to be accepted. Therefore, there is a positive correlation between risk of a
proposal and the discount rate.
Question: 25
If Investment proposal costs ₹ 45,00,000 and risk free rate is 5%, calculate net present
value under certainty equivalent technique.
Page 33
Year Expected cash flow (₹) Certainty Equivalent coefficient

1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
Solution:
10,00,000 × (0.90) 15,00,000 × (0.85) 20,00,000 × (0.82)

NPV = + +
(1.05) (1.05)2 (1.05)3
25,00,000 × (0.78)
+ − 45,00,000
(1.05)4
= ₹ 5,34,570
(IV) Decision Tree
Question: 26
A firm has an investment proposal, requiring an outlay of ₹ 80,000. The investment
proposal is expected to have two years economic life with no salvage value. In year 1,
there is a 0.4 probability that cash inflow after tax will be ₹ 50,000 and 0.6 probability
that cash inflow after tax will be ₹ 60,000. The probability assigned to cash inflow after
tax for the year 2 is as follows:
The cash inflow year 1 ₹ 50,000 ₹ 60,000

The cash inflow year 2 Probability Probability
₹ 24,000 0.2 ₹ 40,000 0.4
₹ 32,000 0.3 ₹ 50,000 0.5
₹ 44,000 0.5 ₹ 60,000 0.1
The firm uses a 10% discount rate for this type of investment.
Required:
(i) Construct a decision tree for the proposed investment project and calculate the
expected net present value (NPV).
(ii) What net present value will the project yield, if worst outcome is realized? What
is the probability of occurrence of this NPV?
(iii) What will be the best outcome and the probability of that occurrence?
(iv) Will the project be accepted?
(Note: 10% discount factor 1 year 0.909; 2 year 0.826)
Page 34
Solution:
(i) The decision tree diagram is presented in the chart, identifying various paths
and outcomes, and the computation of various paths/outcomes and NPV of
each path are presented in the following tables:
The Net Present Value (NPV) of each path at 10% discount rate is given below:
Path Year 1 Cash Flows Year 2 Cash Flows Total Cash Inflows NPV
(₹) (₹) Cash
Inflows (₹) (₹)
(PV) (₹)
1 50,000×.909 = 45,450 24,000×.826 = 19,824 65,274 80,00 (―) 14,726
0
2 45,450 32,000×.826 = 26,432 71,882 80,00 (―) 8,118
0
3 45,450 44,000×.826 = 36,344 81,794 80,00 1,794
0
4 60,000× .909 = 54,540 40,000×.826 = 33,040 87,580 80,00 7,580
0
5 54,540 50,000×.826 = 41,300 95,840 80,00 15,840
0
6 54,540 60,000×.826 = 49,560 1,04,100 80,00 24,100
0
Statement showing Expected Net Present Value

₹
z NPV (₹) Joint Probability Expected NPV
Page 35
1 ―14,726 0.08 ―1,178.08

2 ―8,118 0.12 ―974.16
3 1,794 0.20 358.80
4 7,580 0.24 1,819.20
5 15,840 0.30 4,752.00
6 24,100 0.06 1,446.00
6,223.76
(ii) If the worst outcome is realized the project will yield NPV of – ₹ 14,726. The
probability of occurrence of this NPV is 8% and a loss of ₹ 1,178 (path 1).
(iii) The best outcome will be path 6 when the NPV is at ₹ 24,100. The probability of
occurrence of this NPV is 6% and a expected profit of ₹ 1,446.
(iv) The project should be accepted because the expected NPV is positive at ₹
6,223.76 based on joint probability.
Question: 27
You own an unused Gold mine that will cost ₹10,00,000 to reopen. If you open the
mine, you expect to be able to extract 1,000 ounces of Gold a year for each of three
years. After that the deposit will be exhausted. The Gold price is currently ₹5,000 an
ounce, and each year the price is equally likely to rise or fall by ₹500 from its level at
the start of year. The extraction cost is ₹4,600 an ounce and the discount rate is 10
per cent.
Required:
(a) Should you open the mine now or delay one year in the hope of a rise in the
Gold price?
(b) What difference would it make to your decision if you could costlessly (but
irreversibly)shut down the mine at any stage? Show the value of abandonment
option.
Solution:
(a) (i) Assume we open the mine now at t = 0. Taking into account the distribution of
possible future price of gold over the next three years, we have
1,000 × [ 0.5 × 5,500 + 0.5 × 4,500 −4,600]

NPV = ₹ 10,00,000 +
1.10
1,000 + [ 0.5 2 (6,000 + 5,000 + 5,000 + 4,000 ) − 4,600]

+
(1.10)2
1,000+[ 0.5 3 (6,500+5,500+5,500+4,500+4,500+5,500+4,500+3,500)−4,600]

+
(1.10)3
Page 36
= − ₹5,260
Because the NPV is negative, we should not open the mine at t = 0. It does not
make sense to open the mine at any price less than or equal to ₹5,000 per
ounce.
(ii) Assume that we delay one year until t = 1, and open the mine if the price is ₹
5,500.
At that point:
1,000 × [ 0.5 ×₹ 6,000 + 0.5 × 5,000 −4,600]

NPV = (-) ₹10,00,000 + +
1.10
1,000 × [ 0.5 2 ×₹6,500 + ₹5,500 + ₹5,500 + ₹ 4,500) −₹4,600]

+
(1.10)2
= ₹ 12,38,167
If the price at t1 reaches ₹ 5,500, then expected price for all future periods is ₹
5,500.
NPV at t0 = ₹ 12,38,167/1.10 = ₹ 11,25,606
If the price rises to ₹ 5,500 at t = 1, we should open the mine at that time.
The expected NPV of this strategy is:
(0.50 × ₹ 11,25,606) + (0.50 × 0) = ₹ 5,62,803
As already stated mine should not be opened if the price is less than or equal to
₹ 5,000 per ounce.
If the price at t1 reaches ₹ 4,500, then expected price for all future periods is ₹
4,500. In that situation we should not open the mine.
(b) Suppose we open the mine at t = 0, when the price is ₹ 5,000. At t = 2, there is
a 0.25 probability that the price will be ₹ 4,000. Then since the price at t = 3
cannot rise above the extraction cost, the mine should be closed. If we open the
mine at t = 0, when the price was ₹ 5,000 with the closing option the NPV will
be:
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2 5,000−4,600 × 1,000
NPV = - ₹10,00,000 + 𝑡=1 1.10 t
0.125 × [1,900 + 900 + 900 + 900 – 100 − 100) × 1,000]

+
1.10 3
= ₹1,07,438
Therefore, the NPV with the abandonment option (i.e. savings) is ₹ 1,07,438.
The value of the abandonment option is:
0.125 × 1,000 × (100 +1100) / (1.10)3 = ₹ 1,12,697
The NPV of strategy (2), that to open the mine at t = 1, when price rises to ₹
5,500 per ounce, even without abandonment option, is higher than option 1.
Therefore, the strategy (2) is preferable.
Under strategy 2, the mine should be closed if the price reaches ₹ 4,500 at t =
3, because the expected profit is (₹ 4,500 – 4,600) × 1,000 = – ₹ 1,00,000.
The value of the abandonment option is: 0.125 × (1,00,000) / (1.10)4 = ₹ 8,538
Note: Students may also assume that the price of the gold remains at ₹ 5,000
to solve the question.
Question: 28
Ramesh owns a plot of land on which he intends to construct apartment units for sale.
No. of apartment units to be constructed may be either 10 or 15. Total construction
costs for these alternatives are estimated to be ₹ 600 lakhs or ₹ 1025 lakhs
respectively. Current market price for each apartment unit is ₹ 80 lakhs. The market
price after a year for apartment units will depend upon the conditions of market. If the
market is buoyant, each apartment unit will be sold for ₹ 91 lakhs, if it is sluggish, the
sale price for the same will be ₹ 75 lakhs. Determine the current value of vacant plot of
land. Should Ramesh start construction now or keep the land vacant? The yearly
rental per apartment unit is ₹ 7 lakh sand the risk free interest rate is 10% p.a.
Assume that the construction cost will remain unchanged.
Solution:
Presently 10 units apartments shall yield a profit of ₹ 200 lakh (₹ 800 lakhs – ₹ 600
lakhs) and 15 unit apartment will yield a profit of ₹ 175 lakh (₹ 1200 lakhs – ₹ 1025
lakhs). Thus 10 units apartment is the best alternative if Ramesh has to construct
now.
However, Ramesh waits for 1 year his pay-off will be as follows:
Page 38
Market Conditions
Buoyant Market Sluggish Market
10 units ₹ 91 lakhs × 10 – ₹ 600 lakhs ₹ 75 lakhs × 10 – ₹ 600 lakhs
apartments = ₹ 310 lakhs = ₹ 150 lakhs
15 units ₹ 91 lakhs × 15 – ₹ 1025 lakhs ₹ 75 lakhs × 15 – ₹ 1025

apartments = ₹ 340 lakhs lakhs = ₹ 100 lakhs
Thus if market conditions turnout to be buoyant the best alternative is 15 units

apartments and net pay-off will be ₹ 340 lakhs and if market turnout to be sluggish
the best alternative is the 10 units apartments and net pay-off shall be ₹ 150 lakhs.
To determine the value of vacant plot we shall use Binomial Model (Risk Neutral
Method) of option valuation as follows:
Alternatively student can calculate these values as follows (Sale Value + Rent):
If market is buoyant then possible outcome = ₹ 91 lakh + ₹ 7 lakh = ₹ 98 lakhs
If market is sluggish then possible outcome = ₹ 75 lakh + ₹ 7 lakh = ₹ 82 lakhs
Let p be the probability of buoyant condition then with the given risk-free rate of
interest of 10% the following condition should be satisfied:
p × ₹ 98 lakhs + 1−p × ₹82 lakhs

₹ 80 lakhs =
1.10
3
P= i.e. 0.375
8
Thus 1−p = 0.625
Expected cash flow next year
0.375 × ₹340 lakhs + 0.625 × ₹150 lakhs = ₹221.25 lakhs
Page 39
Present Value of expected cash flow:
₹221.25 lakhs (0.909) = ₹201.12 lakhs
Thus, the value of vacant plot is ₹201.12 lakhs
Since the current value of vacant land is more than profit from 10 units apartments
now (₹200 lakh) the land should be kept vacant.
Question: 29
Ram Chemical is in production Line of Chemicals and considering a proposal of
building new plant to produce pesticides. The Present Value (PV) of new proposal is
₹150 crores (After considering scrap value at the end of life of project). Since this is a
new product market, survey indicates following variation in Present Value (PV):
Condition Favorable in first year PV will increase 30% from original

estimate
Condition sluggish in first year
PV will decrease by 40% from original
Figures
In addition Rama Chemical has a option to abandon the project at the end of Year and
dispose it at ₹100 crores. If risk free rate of interest is 8%, what will be present value
of put option?
Solution:
Decision Tree showing pay off
Year 0 Year 1 Pay off
First of all we shall calculate probability of high demand (P) using risk neutral method
as follows:
8% = p × 30% + (1−p) × (-40%)
0.08 = 0.30 p − 0.40 + 0.40p
0.48
P= = 0.6857 say 0.686
0.70
Page 40
The value of abandonment option will be as follows:
Expected Payoff at Year 1
= p × 0 + [(1-p) ×10] = 0.686 × 0 + [0.314 × 10] = ₹ 3.14 crore
Since expected pay off at year 1 is 3.14 crore, present value of expected pay off will be:
3.14
= 2.907 crore.
1.08
This is the value of abandonment option (Put Option).
Question: 30
L & R Limited wishes to develop new virus-cleaner software. The cost of the
pilot project would be ₹2,40,000. Presently, the chances of the product being
successfully launched on a commercial scale are rated at 50% . In case it does
succeed. L&R can invest a sum of ₹20 lacs to market the product. Such an
effort can generate perpetually, an annual net afte r tax cash income of ₹4 lacs.
Even if the commercial launch fails, they can make an investment of a smaller
amount of ₹12 lacs with the hope of gaining perpetually a sum of ₹1 lac.
Evaluate the proposal, adopting decision tree approach. The discount rate i s
10% .
Solution:
Decision tree diagram is given below:
Evaluation
At Decision Point C: The choice is between investing ₹ 20 lacs for a perpetual benefit of
₹ 4 lacs and not to invest. The preferred choice is to invest, since the capitalized value
Page 41
of benefit of ₹ 4 lacs (at 10%) adjusted for the investment of ₹ 20 lacs, yields a net
benefit of ₹ 20 lacs.
At Decision Point D: The choice is between investing ₹ 12 lacs, for a similar perpetual
benefit of ₹1 lac. and not to invest. Here the invested amount is greater than
capitalized value of benefit at ₹ 10 lacs. There is a negative benefit of ₹ 2 lacs.
Therefore, it would not be prudent to invest.
At Outcome Point B: Evaluation of EMV is as under (₹ in lacs).
Outcome Amount (₹) Probability Result (₹)

Success 20.00 0.50 10.00
Failure 0.00 0.50 00.00
Net result 10.00
EMV at B is, therefore, ₹ 10 lacs.
At A: Decision is to be taken based on preferences between two alternatives. The first

is to test, by investing ₹ 2,40,000 and reap a benefit of ₹10 lacs. The second is not to
test, and thereby losing the opportunity of a possible gain.
The preferred choice is, therefore, investing a sum of ₹ 2,40,000 and undertaking the
test.
(4) SENSITIVITY ANALYSIS
Question: 31
From the following details relating to a project, analyze the sensitivity of the project to
changes in initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (₹) 1,20,000
Annual Cash Inflow (₹) 45,000
Project Life (Years) 4
Cost of Capital 10%
To which of the three factors, the project is most sensitive? (Use annuity factors: for
10% 3.169 and 11% 3.103).
Solution:
CALCULATION OF NPV
₹ PV of cash inflows (₹45,000 × 3.169) 1,42,605
Initial Project Cost 1,20,000
Page 42
NPV 22,605
If initial project cost is varied adversely by 10%*
NPV (Revised) (₹1,42,605 − ₹1,32,000) ₹10,605
Change in NPV (₹22,605 – ₹10,605)/₹22,605 i.e. 53.08 %
If annual cash inflow is varied adversely by 10%*
Revised annual inflow ₹40,500
NPV (Revised) (₹40,500 × 3.169) – (₹1,20,000) (+) ₹8,345
Change in NPV (₹22,605 – ₹8,345) /₹22,605 63.08 %
If cost of capital is varied adversely by 10%*
NPV (Revised) (₹45,000 × 3.103) – ₹1,20,000 (+) ₹19,635
Change in NPV (₹22,605 – ₹19,635) / ₹22,605 13.14 %
Conclusion: Project is most sensitive to „annual cash inflow‟.
*Note: Students may please note that they may assume any other percentage rate
other than 10 % say 15%, 20 % 25 % etc.
Question: 32
XYZ Ltd. is considering a project for which the following estimates are available:
₹
Initial Cost of the project 10,00,000
Sales price/unit 60
Cost/unit 40
Sales volumes
Year 1 20000 units
Year 2 30000 units
Year 3 30000 units
Discount rate is 10% p.a.
You are required to measure the sensitivity of the project in relation to each of the
following parameters:
(a) Sales Price/unit
(b) Unit cost
(c) Sales volume
Page 43
(d) Initial outlay and
(e) Project lifetime Taxation may be ignored.
Solution:
Calculation of NPV
20,000 × 20 30,000 × 20 20,000 × 20

= ₹10,00,000 + + +
1.1 1.21 1.331
= -10,00,000 + 3,63,636 + 4,95,868 + 4,50,789
= 13,10,293 – 10,00,000
= ₹3,10,293/-.
Measurement of sensitivity is as follows:
(a) Sales Price:-
Let the sale price/Unit be S so that the project would break even with 0 NPV.
20,000 × (S−40) 30,000 × (S−40) 30,000 × (S−40)

∴ ₹10,00,000 = + +
1.1 1.21 1.331
S − 40 = 10,00,000/65,514
S – 40 = ₹15.26
S = ₹ 55.26 which represents a fall of (60-55.26)/60
Or 0.079 or 7.9%
Alternative Method
10,00,000 × 20
= ₹15.26
13,10,293
S = ₹40 + ₹15.26
= ₹55.26
Alternative Solution
If sale Price decreased by say 10%, then NPV (at Sale Price of ₹60 – ₹6 = ₹54)
20,000 × 14 30,000 × 14 30,000 × 14

NPV = -10,00,000 + + +
1.1 1 1.1 2 1.1 3
Page 44
= -10,00,000 + 2,54,545 + 3,47,107 + 3,15,552
= -82,796
-3,10,293 – (-82,796)
NPV decrease (%) = × 100 = 126.68%
3,10,293
(b) Unit Cost :-
If sales price = ₹60 the cost price required to give a margin of ₹15.26 is (₹60 –
₹15.26) or ₹44.74 which would represent a rise of 11.85% i.e.,
(44.74-40)
× 100
40
If unit cost increased by say 10%. The new NPV will be as follows:
20,000 × 16 30,000 × 16 30,000 × 16

NPV = -10,00,000 + + +
1.1 1 1.1 2 1.1 3
= -10,00,000 + 2,90,909 + 3,96,694 + 3,60,631
= 48,234
-3,10,293 – (48,234)
NPV decrease (%) = × 100 = 84.46%
3,10,293
(c) Sales volume:-
The requisite percentage fall is:-
3,10,293/13,10,293 ×100 = 23.68%
If sale volume decreased by say 10%. The new NPV will be as follows:
18,000 × 20 27,000 × 20 27,000 × 20

NPV = -10,00,000 + + +
1.1 1 1.1 2 1.1 3
= -10,00,000 + 3,27,272 + 4,46,281 + 4,05,710
= 1,79,263
3,10,293 – 1,79,263
NPV decrease (%) = × 100 = 42.22%
3,10,293
Page 45
(d) Since PV of inflows remains at ₹13,10,293 the initial outlay must also be the
same.
∴ Percentage rise = 3,10,293/10,00,000 ×100 = 31.03%.
If initial outlay increased by say 10%. The new NPV will be as follows:
20,000 × 20 30,000 × 20 30,000 × 20

NPV = -11,00,000 + + +
1.1 1 1.1 2 1.1 3
= -11,00,000 + 3,63,636 + 4,95,868 + 4,50,789 = 2,10,293
3,10,293 – 2,10,293
NPV decrease (%) = × 100 = 32.22%
3,10,293
(e) Present value for 1st two years.
= − 10,00,000 + 4,00,000 × 0.909 + 6,00,000 × 0.826
= − 10,00,000 + 3,63,600 + 4,95,600
= − 10,00,000 + 8,59,200
= − 1,40,800
∴ The project needs to run for some part of the third year so that the present
value of return is ₹ 1,40,800. It can be computed as follows:
(i) 30,000 units × ₹20 × 0.751 = ₹ 4,50,600
(ii) Per day Production in (₹) assuming a year of 360 days
4,50,600
= × ₹ 1,252
360
₹1,40,800
(iii) Days needed to recover ₹1,40,800 = × ₹ 112
₹ 1,252
Thus, if the project runs for 2 years and 112 days then break even would be
(3 − 2.311)
achieved representing a fall of = × 100 = 22.97%
3
Question: 33
Red Ltd. is considering a project with the following Cash flows:
Years Cost of Plant Recurring Cost Savings

0 10,000
Page 46
1 4,000 12,000
2 5,000 14,000
The cost of capital is 9%. Measure the sensitivity of the project to changes in the levels
of plant value, running cost and savings (considering each factor at a time) such that
the NPV becomes zero. The P.V. factor at 9% are as under:
Year Factor
0 1
1 0.917
2 0.842
Which factor is the most sensitive to affect the acceptability of the project?
Solution:
P.V. of Cash Flows
Year 1 Running Cost ₹ 4,000 × 0.917 = (₹ 3,668)
Savings ₹ 12,000 × 0.917 = ₹ 11,004
Savings ₹ 14,000 × 0.842 = ₹ 11,788
₹ 14,914
Year 0 Less: P.V. of Cash Outflow ₹ 10,000 × 1 ₹ 10,000
NPV ₹ 4,914
Sensitivity Analysis
(i) Increase of Plant Value by ₹4,914
4,914
∴ × 100 = 49.14%
10,000
(ii) Increase of Running Cost by ₹ 4,914
4,914 4,914
= × 100 = 62.38%
3,668 + 4,210 7,878
Page 47
(iii) Fall in Saving by ₹ 4,914
4,914 4,914
= × 100 = 21.56%
11,004 + 11,788 22,792
Hence, savings factor is the most sensitive to affect the acceptability of the project as
in comparison of other two factors a slight % change in this fact shall more affect the
NPV than others.
P.V. of Cash Flows
Savings ₹ 12,000 × 0.917 = ₹ 11,004
Savings ₹ 14,000 × 0.842 = ₹ 11,788
₹ 14,914
Year 0 Less: P.V. of Cash Outflow ₹ 10,000 × 1 ₹ 10,000
NPV ₹ 4,914
Sensitivity Analysis
(i) If the initial project cost is varied adversely by say 10%*.
NPV (Revised) (₹ 4,914 – ₹ 1,000) = ₹ 3,914
₹ 4,914−₹ 3,917
Change in NPV = 20.35%
₹ 4,914
(ii) If Annual Running Cost is varied by say 10%*.
NPV (Revised) (₹ 4,914 – ₹ 400 × 0.917 – ₹ 500 × 0.843)
= ₹ 4,914 – ₹ 367 – ₹ 421= ₹ 4,126
₹ 4,914 − ₹ 4,126
₹ 4,914
(iii) If Saving is varied by say 10%*.
Page 48
NPV (Revised) (₹ 4,914 – ₹ 1,200 × 0.917 – ₹ 1,400 × 0.843)
= ₹ 4,914 – ₹ 1,100 – ₹ 1,180 = ₹ 2,634
₹ 4,914−₹ 2,634
₹ 4,914
Hence, savings factor is the most sensitive to affect the acceptability of the
project.
* Any percentage of variation other than 10% can also be assumed.
Question: 34
The Easygoing Company Limited is considering a new project with initial investment,
for a product “Survival”. It is estimated that IRR of the project is 16% having an
estimated life of 5 years.
Financial Manager has studied that project with sensitivity analysis and informed that
annual fixed cost sensitivity is 7.8416%, whereas cost of capital (discount rate)
sensitivity is 60%.
Other information available are:
Profit Volume Ratio (P/V) is 70%,
Variable cost ₹ 60/- per unit
Annual Cash Flow ₹ 57,500/-
Ignore Depreciation on initial investment and impact of taxation. Calculate
(i) Initial Investment of the Project
(ii) Net Present Value of the Project (iii) Annual Fixed Cost (iv) Estimated annual
unit of sales
(v) Break Even Units
Cumulative Discounting Factor for 5 years
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%

3.339 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127
Solution:
(i) Initial Investment
IRR = 16% (Given)
Page 49
At IRR, NPV shall be zero, therefore
Initial Cost of Investment = PVAF (16%,5) × Cash Flow (Annual)
= 3.274 × ₹ 57,500
= ₹ 1,88,255
(ii) Net Present Value (NPV)
16−X
Let Cost of Capital be X, then = 60% X = 10%
X
Thus NPV of the project
= Annual Cash Flow x PVAF (10%, 5) – Initial Investment
= ₹ 57,500 × 3.791 – ₹ 1,88,255
= ₹ 2,17,982.50 – ₹ 1,88,255 = ₹ 29,727.50
(iii) Annual Fixed Cost
Let change in the Fixed Cost which makes NPV zero is X. Then,
₹29,727.50 – 3.791X = 0
Thus X = ₹7,841.60
Let original Fixed Cost be Y then,
Y × 7.8416% = ₹7,841.60
Y = ₹1,00,000
Thus Fixed Cost is equal to ₹1,00,000
(iv) Estimated Annual Units of Sales
₹ 60
Selling Price per unit = = ₹ 200
100%-70%
Annual Cash Flow + Fixed Cost

= Sales Value
P/V Ratio
₹ 57,500 + ₹ 1,00,000
= ₹ 2,25,000
0.70
Page 50
₹ 2,25,000
Sales in Units = = 1,125 units
₹ 200
(v) Break Even Units
Fixed Cost 1,00,000

= = 714.285 units
Contribution Per Unit 140
Question: 35
Unnat Ltd. is considering investing ₹ 50,00,000 in a new machine. The expected life of
machine is five years and has no scrap value. It is expected that 2,00,000 units will be
produced and sold each year at a selling price of ₹ 30.00 per unit. It is expected that
the variable costs to be ₹ 16.50 per unit and fixed costs to be ₹ 10,00,000 per year.
The cost of capital of Unnat Ltd. is 12% and acceptable level of risk is 20%.
You are required to measure the sensitivity of the project‟s net present value to a
change in the following project variables:
(a) sale price;
(b) sales volume;
(c) variable cost;
(d) On further investigation it is found that there is a significant chance that the
expected sales volume of 2,00,000 units per year will not be achieved. The sales
manager of Unnat Ltd. suggests that sales volumes could depend on expected
economic states which could be assigned the following probabilities:
State of Economy Annual Sales (in Units) Probability

Poor 1,75,000 0.30
Normal 2,00,000 0.60
Good 2,25,000 0.10
Calculate expected net present value of the project and give your decision whether
company should accept the project or not.
Solution:
Calculation of NPV
= - ₹50,00,000 + [2,00,000 (₹30 – ₹16.50) – ₹10,00,000] PVIAF (12%,5)
= - ₹50,00,000 + [2,00,000 (₹13.50) – ₹10,00,000] 3.605
= - ₹50,00,000 + [₹27,00,000 – ₹10,00,000] 3.605
= - ₹50,00,000 + ₹61,28,500 = ₹11,28,500
Page 51
Measurement of Sensitivity Analysis
(a) Sales Price:-
Let the sale price/Unit be S so that the project would break even with 0 NPV.
∴ ₹50,00,000 = [2,00,000 (S – ₹16.50) – ₹10,00,000] PVIAF (12%,5)
₹50,00,000 = [2,00,000 S – ₹33,00,000 – ₹10,00,000] 3.605
₹50,00,000 = [2,00,000S – ₹43,00,000] 3.605
₹13,86,963 = 2,00,000S – ₹43,00,000
₹56,86,963 = 2,00,000S
S = ₹28.43 which represents a fall of (30 − 28.43)/30 or 0.0523 or 5.23%
(b) Sales volume:-
Let V be the sale volume so that the project would break even with 0 NPV.
∴ ₹50,00,000 = [V (₹30 – ₹16.50) – ₹10,00,000] PVIAF (12%,5)
₹50,00,000 = [V (₹13.50) – ₹10,00,000] PVIAF (12%,5)
₹50,00,000 = [₹13.50V – ₹10,00,000] 3.605
₹13,86,963 = ₹13.50V – ₹10,00,000
₹23,86,963 = ₹13.50V
V = 1,76,812 which represents a fall of (2,00,000 - 1,76,812)/2,00,000 or

0.1159 or 11.59%
(c) Variable Cost:
Let the variable cost be V so that the project would break even with 0 NPV.
₹50,00,000 = [2,00,000 (₹30 – V) – ₹10,00,000] PVIAF(12%,5)
₹50,00,000 = [₹60,00,000 – 2,00,000 V – ₹10,00,000] 3.605
₹50,00,000 = [₹50,00,000 – 2,00,000 V] 3.605
₹13,86,963 = ₹50,00,000 – 2,00,000 V
₹36,13,037 = 2,00,000V
V = ₹18.07 which represents a fall of (18.07 – 16.50)/16.50 or 0.0951 or 9.51%
Page 52
(d) Expected Net Present Value
(1,75,000 × 0.30) + (2,00,000 × 0.60) + (2,25,000 × 0.10) =1,95,000
NPV = [1,95,000 × ₹13.50 – ₹10,00,000] 3.605 – ₹50,00,000 = ₹8,85,163
Further NPV in worst and best cases will be as follows:
Worst Case:
[1,75,000 × ₹13.50 – ₹10,00,000] 3.605 – ₹50,00,000 = - ₹88,188
Best Case:
[2,25,000 × ₹13.50 – ₹10,00,000] 3.605 – ₹50,00,000 = ₹23,45,188
Thus, there are 30% chances that the rise will be a negative NPV and 70%
chances of positive NPV. Since acceptable level of risk of Unnat Ltd. is 20% and
there are 30% chances of negative NPV hence project should not be accepted.
Question: 36
X Ltd. is considering its new project with the following details:
Sr. No. Particulars Figures

1 Initial capital cost ₹ 400 Cr.
2 Annual unit sales 5 Cr.
3 Selling price per unit ₹ 100
4 Variable cost per unit ₹ 50
5 Fixed costs per year ₹ 50 Cr.
6 Discount Rate 6%
Required:
1. Calculate the NPV of the project.
2. Compute the impact on the project‟s NPV considering a 2.5 per cent adverse
variance in each variable. Which variable is having maximum effect?
Consider Life of the project as 3 years.
Solution:
1. Calculation of Net Cash Inflow per year
Particulars Amount (₹)

A Selling price per unit 100
B Variable cost per unit 50
C Contribution per unit (A − B) 50
D Number of units sold per year 5 Cr.
Page 53
E Total Contribution (C × D) ₹ 250 Cr.

F Fixed cost per year ₹ 50 Cr.
G Net cash inflow per year (E - F) ₹ 200 Cr.
Calculation of Net Present Value (NPV) of the Project
Year Year Cash Flow PV factor @ 6% Present Value (PV)

(₹ in Cr.) (₹ in Cr.)
0 (400.00) 1.000 (400.00)
1 200.00 0.943 188.60
2 200.00 0.890 178.00
3 200.00 0.840 168.00
Net Present Value 134.60
Here, NPV represent the most likely outcomes and not the actual outcomes. The
actual outcome can be lower or higher than the expected outcome.
2. Sensitivity Analysis considering 2.5 % Adverse Variance in each variable
Particulars Base Initial Selling Variable Fixed Units sold

capital cost Price per Cost Per Cost Per per year
increased Unit Unit Unit reduced
to ₹ 410 Reduced increased increased to 4.875
crore to ₹ 97.5 to ₹ 51.25 to ₹ crore
51.25
(₹) (₹) (₹) (₹) (₹) (₹)
A Selling price per 100 100 97.5 100 100 100
unit
B Variable cost per 50 50 50 51.25 50 50

unit
C Contribution per 50 50 47.5 48.75 50 50
unit (A - B)
(₹in Cr.) (₹in Cr.) (₹in Cr.) (₹in Cr.) (₹in Cr.) (₹in Cr.)
D Number of units 5 5 5 5 5 4.875
sold per year (units
in Crores)
E Total Contribution 250 250 237.5 243.75 250 243.75
(C × D)
F Fixed cost per year 50 50 50 50 51.25 50
G Net Cash Inflow per 200 200 187.5 193.75 198.75 193.75
year (E - F)
H PV of Net cash 534.60 534.60 501.19 517.89 531.26 517.89
Inflow per year (G ×
2.673)
I Initial capital cost 400 410 400 400 400 400
J NPV (H - I) 134.60 124.60 101.19 117.89 131.26 117.89
K Percentage - -7.43% -24.82% -12.41% -2.48% -12.41%
Change in NPV
The above table shows that by changing one variable at a time by 2.5% (adverse) while
keeping the others constant, the impact in percentage terms on the NPV of the project
Page 54
can be calculated. Thus, the change in selling price has the maximum effect on the
NPV by 24.82%.
(5) SCENARIO ANALYSIS
Question: 37
Skylark Airways is planning to acquire a light commercial aircraft for flying class
clients at an investment of ₹ 50,00,000. The expected cash flow after tax for the next
three years is as follows:
(₹)

CFAT Probability CFAT Probability CFAT Probability
14,00,000 0.1 15,00,000 0.1 18,00,000 0.2
18,00,000 0.2 20,00,000 0.3 25,00,000 0.5
25,00,000 0.4 32,00,000 0.4 35,00,000 0.2
40,00,000 0.3 45,00,000 0.2 48,00,000 0.1
The Company wishes to take into consideration all possible risk factors relating to
airline operations. The company wants to know:
(i) The expected NPV of this venture assuming independent probability

distribution with 6 per cent risk free rate of interest.
(ii) The possible deviation in the expected value.
(iii) How would standard deviation of the present value distribution help in Capital
Budgeting decisions?
Solution:
(i) Expected NPV
(₹ in lakhs)
Year I Year II Year III
CFAT P CF × P CFAT P CF × P CFAT P CF × P
14 0.1 1.4 15 0.1 1.5 18 0.2 3.6
18 0.2 3.6 20 0.3 6.0 25 0.5 12.5
25 0.4 10.0 32 0.4 12.8 35 0.2 7.0
40 0.3 12.0 45 0.2 9 48 0.1 4.8
𝑥 or 27.0 𝑥 or 29.3 𝑥 or CF 27.9
CF CF
NPV PV factor @ 6% Total PV

27 0.943 25.461
29.3 0.890 26.077
27.9 0.840 23.436
Page 55
PV of cash inflow 74.974

Less: Cash outflow 50.000
NPV 24.974
(ii) Possible deviation in the expected value
Year I
X −X X −X 2 P1 2
X −X X − X P1
14 – 27 -13 169 0.1 16.9
18 – 27 -9 81 0.2 16.2
25 – 27 -2 4 0.4 1.6
40 – 27 13 169 0.3 50.7
85.4
σ1 85.4 = 9,241
Year II
X −X X −X X −X 2 𝑷𝟐 X − X 2 𝑷𝟐
15-29.3 -14.3 204.49 0.1 20.449
20-29.3 -9.3 86.49 0.3 25.947
32-29.3 2.7 7.29 0.4 2.916
45-29.3 15.7 246.49 0.2 49.298
98.61
σ2 98.61 = 9.930
Year III
X −X X −X X –X 2 𝑷𝟑 X − X 2 𝑷𝟑
18-27.9 -9.9 98.01 0.2 19.602
25-27.9 -2.9 8.41 0.5 4.205
35-27.9 7.1 50.41 0.2 10.082
48-27.9 20.1 404.01 0.1 40.401
74.29
σ3 74.29 = 8.619
Standard deviation about the expected value:
85.4 98.61 74.29

σ + + = 14.3696
1.06 2 1.06 4 1.06 6
(iii) Standard deviation is a statistical measure of dispersion; it measures the

deviation from a central number i.e. the mean.
Page 56
In the context of capital budgeting decisions especially where we take up two or

more projects giving somewhat similar mean cash flows, by calculating
standard deviation in such cases, we can measure in each case the extent of
variation. It can then be used to identify which of the projects is least risky in
terms of variability of cash flows.
A project, which has a lower coefficient of variation will be preferred if sizes are
heterogeneous.
Besides this, if we assume that probability distribution is approximately normal

we are able to calculate the probability of a capital budgeting project generating
a net present value less than or more than a specified amount.
Question: 38
Project X and Project Y are under the evaluation of XY Co. The estimated cash flows
and their probabilities are as below:
Project X : Investment (year 0) ₹ 70 lakhs
Probability Weights 0.30 0.40 0.30

Years ₹ lakhs ₹ lakhs ₹ lakhs
1 30 50 65
2 30 40 55
3 30 40 45
Project Y: Investment (year 0) ₹ 80 lakhs.
Probability Weighted Annual cash flows through life

₹ lakhs
0.20 40
0.50 45
0.30 50
(a) Which project is better based on NPV, criterion with a discount rate of 10%?
(b) Compute the standard deviation of the present value distribution and analyze
the inherent risk of the projects.
Solution:
(a) Calculation of NPV of XY Co.:
Project X Cash flow PVF PV
Page 57
Year
1 (30 × 0.3) + (50 × 0.4) + (65 × 0.3) 48.5 0.909 44.09
2 (30 × 0.3) + (40 × 0.4) + (55 × 0.3) 41.5 0.826 34.28
3 (30 × 0.3) + (40 × 0.4) + (45 × 0.3) 38.5 0.751 28.91
107.28
NPV: (107.28 – 70.00) = (+) 37.28
Project Y (For 1-3 Years)
1-3 (40 × 0.2) + (45 × 0.5) + (50 × 0.3) 45.5 2.487 113.16
NPV (113.16 – 80.00) (+) 33.16
(b) Calculation of Standard deviation σ
As per Hiller‟s model
n -1
M = i=0 1 + r Mi
σ2 = n
i=0 1+r -2i σ2i
Hence
Project X
Year
1 30 − 48.5 2 0.30 + 50 − 48.5 2 0.40 + 65 − 48.5 2 0.30
= 185.25 = 13.61
2 30 − 41.5 2 0.30 + 40 − 41.5 2 0.40 + 55 − 41.5 2 0.30
= 95.25 = 9.76
3 30 − 38.5 2 0.30 + 40 − 38.5 2 0.40 + 45 − 38.5 2 0.30
= 35.25 = 5.94
Standard Deviation about the expected value
185.25 95.25 35.25

= 2 + 4 + 6
1+0.10 1+0.10 1−0.10
185.25 95.25 35.25

= + + = 153.10 + 65.06 + 19.90
1.21 1.4641 1.7716
Page 58
= 238.06 = 15.43
Project Y (For 1-3 Years)
40 − 45.5 2 0.20 + 45 − 45.5 2 0.50 + 50 − 45.5 2 0.30
= 12.25 = 3.50
Standard Deviation about the expected value
12.25 12.25 12.25

= 2 + 4 +
1+0.10 1+0.10 1−0.10 6
12.25 12.25 12.25

= + + = 10.12 + 8.37 + 6.91
1.21 1.4641 1.7716
= 25.4 = 5.03
Analysis: Project Y is less risky as its Standard Deviation is less than Project X.
Question: 39
Aeroflot airlines is planning to procure a light commercial aircraft for flying class
clients at an investment of ₹ 50 lakhs. The expected cash flow after tax for next three
years is as follows:
(₹ in lakh)
CFAT Probability CFAT Probability CFAT Probability
15 0.1 15 0.1 18 0.2
18 0.2 20 0.3 22 0.5
22 0.4 30 0.4 35 0.2
35 0.3 45 0.2 50 0.1
The company wishes to consider all possible risk factors relating to an airline.
The company wants to know-
(i) The expected NPV of this proposal assuming independent probability

distribution with 6per cent risk free rate of interest, and
(ii) The possible deviation on expected values.
Solution:
(i) Determination of expected CFAT
Page 59
₹ in lakh
Year-1 Year-2 Year -3
CFAT P1 Cash CFAT P2 Cash CFAT P3 Cash
flow flow flow
15 0.1 1.5 15 0.1 1.5 18 0.2 3.6
18 0.2 3.6 20 0.3 6 22 0.5 11
22 0.4 8.8 30 0.4 12 35 0.2 7
35 0.3 10.5 45 0.2 9 50 0.1 5
𝐶𝐹 124.4 𝐶𝐹 228.5 𝐶𝐹 326.6
₹
CFAT (₹ in lakh) PV factor @ 6% Total PV (₹ in lakh)
24.4 0.943 23.009
28.5 0.890 25.365
26.6 0.840 22.344
70.718
Less Cash flow 50.000
= NPV 20.718
(ii) Determination of Standard deviation for each year
Year 1
(CF1− 𝐶𝐹 1)2 (CF1− 𝐶𝐹 1)2 P1
(15−24.4)2 88.36 0.1 8.836
(18−24.4)2 40.96 0.2 8.192
(22−24.4)2 5.76 0.4 2.304
(35−24.4)2 112.36 0.3 33.708
53.04
𝜎= 53.04 = 7.282
Year 2
(CF2− 𝐶𝐹 2)2 (CF2− 𝐶𝐹 2)2 P2
(15−28.5)2 182.25 0.1 18.225
(20−28.5)2 72.25 0.3 21.675
(30−28.5)2 2.25 0.4 0.9
(45−28.5)2 272.25 0.2 54.45
95.25
𝜎= 95.25 = 9.76
Year 3
(CF3− 𝐶𝐹 3)2 (CF3− 𝐶𝐹 3)2 P3

(18−26.6)2 73.96 0.2 14.792
(22−26.6)2 21.16 0.5 10.58
(35−26.6)2 70.56 0.2 14.112
Page 60
(50−26.6)2 547.56 0.2 54.756

94.24
𝜎 = 94.25 = 9.70
Standard deviation of the expected Values
n σ2
t
t=1 1 + i 2t
53.04 95.25 94.24

𝜎= 2 + 4 +
1+0.06 1+0.06 1+0.06 6
𝜎 = 47.21 + 75.45 + 66.44 = 189.10 = 13.75

Question: 40
Following are the estimates of the net cash flows and probability of a new project of
M/s X Ltd.:
Year P = 0.3 P = 0.5 P = 0.2

Initial investment 0 4,00,000 4,00,000 4,00,000
Estimated net after tax cash inflows per year 1 to 5 1,00,000 1,10,000 1,20,000
Estimated salvage value (after tax) 5 20,000 50,000 60,000
Required rate of return from the project is 10%. Find:
(i) The expected NPV of the project.
(ii) The best case and the worst case NPVs.
(iii) The probability of occurrence of the worst case if the cash flows are perfectly
dependent overtime and independent overtime.
(iv) Standard deviation and coefficient of variation assuming that there are only
three streams of cash flow, which are represented by each column of the table
with the given probabilities.
(v) Coefficient of variation of X Ltd. on its average project which is in the range of
0.95 to1.0. If the coefficient of variation of the project is found to be less risky
than average, 100basis points are deducted from the Company‟s cost of Capital
Should the project be accepted by X Ltd?
Solution:
(i) Expected cash flows:-
Page 61
Year Net cash P.V. PV. @

flows 10%
0 (4,00,000 × 1) = (-)4,00,000 1.000 (-)4,00,000
1 to 4 (1,00,000 × 0.3 +1,10,000 × 0.5 + = 1,09,000 3.170 3,45,530
1,20,000 × 0.2)
5 [1,09,000 + (20,000 × 0.3 + 50,000 = 1,52,000 0.621 94,392
× 0.5 + 60,000 × 0.2)]
NPV= 39,922
(ii) ENPV of the worst case
1,00,000 × 3.790 = ₹ 3,79,000 (Students may have 3.791 also the values will
change accordingly)
20,000 × 0.621 = ₹ 12,420/-
ENPV = ( −) 4,00,000 + 3,79,000 + 12,420 = ( −) ₹ 8,580/-
ENPV of the best case
ENPV = ( −) 4,00,000 + 1,20,000 × 3.790 + 60,000 × 0.621 = ₹ 92,060/-.
(iii) (a) Required probability = 0.3
(b) Required probability = (0.3)5 = 0.00243
(iv) The base case NPV = (-) 4,00,000 + (1,10,000 × 3.79) + (50,000 × 0.621)
= ₹47,950/-
ENPV = 0.30 × (−) 8,580 + 0.5 × 47,950 + 92,060 × 0.20 = ₹ 39,813/-
Therefore,
σENPV =
0.3 −8,580 − 39,813 2 + 0.5 47,950 − 39,813 2 + 0.2 + 92,060 − 39,813 2
= ₹ 35,800/-
Therefore, CV = 35,800/39,813 = 0.90
(v) Risk adjusted out of cost of capital of X Ltd. = 10% - 1% = 9%.
NPV
Page 62
Year Expected net cash flow PV @ 9%

0 (-) 4,00,000 1.000 (-) 4,00,000
1 to 4 1,09,000 3.240 3,53,160
5 1,52,000 0.650 98,800
ENPV = 51,960
Therefore, the project should be accepted.
Question: 41
XY Ltd. has under its consideration a project with an initial investment of ₹ 1,00,000.
Three probable cash inflow scenarios with their probabilities of occurrence have been
estimated as below:
Annual cash inflow (₹) 20,000 30,000 40,000
Probability 0.1 0.7 0.2
The project life is 5 years and the desired rate of return is 20%. The estimated
terminal values for the project assets under the three probability alternatives,
respectively, are ₹ 0, 20,000 and 30,000.
You are required to:
(i) Find the probable NPV;
(ii) Find the worst-case NPV and the best-case NPV; and
(iii) State the probability occurrence of the worst case, if the cash flows are perfectly
positively correlated over time.
Solution:
The expected cash flows of the project are as follows:
Year Pr = 0.1 Pr = 0.7 Pr = 0.2 Total

₹ ₹ ₹ ₹
0 -10,000 -70,000 -20,000 -1,00,000
1 2,000 21,000 8,000 31,000
2 2,000 21,000 8,000 31,000
3 2,000 21,000 8,000 31,000
4 2,000 21,000 8,000 31,000
5 2,000 21,000 8,000 31,000
5 0 14,000 6,000 20,000
(i) NPV based on expected cash flows would be as follows:
Page 63
₹ 31,000 ₹ 31,000 ₹ 31,000 ₹ 31,000

= ₹1,00,000 + 1 + 2 + 3 + +
1+ 0.20 1 + 0.20 1 + 0.20 1 + 0.20 4
₹ 31,000 ₹ 20,000
+
1 + 0.20 5 1 + 0.20 5
= - ₹1,00,000 + ₹25,833.33 + ₹21,527.78 + ₹17,939.81 + ₹14,949.85 +
₹12,458.20 + ₹8,037.55
NPV = ₹746.52
(ii) For the worst case, the cash flows from the cash flow column farthest on the
left are used to calculate NPV
₹20,000 ₹20,000 ₹20,000 ₹20,000

= ₹100,000 + 1 + 2 + 3 + +
1+ 0.20 1+ 0.20 1+ 0.20 1+ 0.20 4
₹20,000
1+ 0.20 5
= - ₹100,000 + ₹16,666.67 + ₹13,888.89 + ₹11,574.07 + ₹9,645.06 +
₹8037.76
NPV = - ₹ 40,187.76
For the best case, the cash flows from the cash flow column farthest on the
right are used to calculated NPV
₹ 40,000 ₹40,000 ₹40,000 ₹ 40,000

= ₹ 100,000 + + + +
1+ 0.20 1 1+0.20 2 1+ 0.20 3 1+ 0.20 4
₹ 40,000 ₹30,000
+ +
1+ 0.20 5 1+ 0.20 5
= - ₹1,00,000 + ₹33,333.33 + ₹27,777.78 + ₹23,148.15 + ₹19,290.12 +

₹16,075.10 + ₹12,056.33
NPV = ₹31,680.81
(iii) If the cash flows are perfectly dependent, then the low cash flow in the first year
will mean a low cash flow in every year. Thus, the possibility of the worst case
occurring is the probability of getting ₹20,000 net cash flow in year 1 is 10%.
Question: 42
Jumble Consultancy Group has determined relative utilities of cash flows of two
forthcoming projects of its client company as follows:
Page 64
Cash Flow in ₹ -15,000 -10,000 -4,000 0 15,000 10,000 5,000 1,000

Utilities -100 -60 -3 0 40 30 20 10
The distribution of cash flows of project A and Project B are as follows:
Project A
Cash Flow (₹) -15,000 -10,000 15,000 10,000 5,000
Probability 0.10 0.20 0.40 0.20 0.10
Project B
Cash Flow (₹) -10,000 -4,000 15,000 5,000 10,000
Probability 0.10 0.15 0.40 0.25 0.10
Which project should be selected and why ?
Solution:
Evaluation of project utilizes of Project A and Project B
Project A
Cash Flow Probability Utility Utility Value
(in ₹)
-15,000 0.10 -100 -10
-10,000 0.20 -60 -12
15,000 0.40 40 16
10,000 0.20 30 6
5,000 0.10 20 2
2
Project B
Cash Flow Probability Utility Utility Value
(in ₹)
-10,000 0.10 -60 -6
-4,000 0.15 -3 -0.45
15,000 0.40 40 16
5,000 0.25 20 5
10,000 0.10 30 3
17.55
Project B should be selected as its expected utility is more.
Question: 43
XYZ Ltd. is considering a project “A” with an initial outlay of ₹ 14,00,000 and the
possible three cash inflow attached with the project as follows:
Particulars Year 1 Year 2 Year 3

Worst case 450 400 700
Page 65
Most likely 550 450 800

Best case 650 500 900
Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is
certain about the most likely result in first two years but uncertain about the third
year‟s cash flow, analyze what will be the NPV expecting worst scenario in the third
year.
Solution:
The possible outcomes will be as follows:
Year PVF @ Worst Case Most likely Best case

9% Cash PV Cash PV Cash PV
Flow Flow Flow
(₹ „000) (₹ „000) (₹ „000) (₹ „000) (₹ „000) (₹ „000)

0 1 (1,400) (1,400) (1,400) (1,400) (1,400) (1,400)
1 0.917 450 412.65 550 504.35 650 596.05
2 0.842 400 336.80 450 378.90 500 421.00
3 0.772 700 540.40 800 617.60 900 694.80
NPV -110.15 100.85 311.85
If XYZ Ltd. is certain about the most likely result in first two years but uncertain
about the third year‟s cash flow, then, NPV expecting worst case scenario is expected
in the third year will be as follows:
₹5,50,000 ₹ 4,50,000 ₹ 7,00,000

= - ₹14,00,000 + + +
(1+0.09) (1+0.09)2 (1+0.09)3
= − ₹ 14,00,000 + ₹ 5,04,587 + ₹ 3,78,756 + ₹ 5,40,528 = ₹ 23,871
(6) INFLATION IN CAPITAL BUDGETING
Question: 44
A firm has projected the following cash flows from a project under evaluation:
Year ₹ lakhs
0 (70)
1 30
2 40
3 30
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The above cash flows have been made at expected prices after recognizing inflation.
The firm‟s cost of capital is 10%. The expected annual rate of inflation is 5%.
Show how the viability of the project is to be evaluated.
Solution:
It is stated that the cash flows have been adjusted for inflation; hence they are
“nominal”. The cost of capital or discount rate is “real”. In order to be compatible, the
cash flows should be converted into “real flow”. This is done as below:
Year Nominal Adjusted Real cash PVF @ PV of cash

cash flows Inflation* factor flows 10% flows
0 (70) − (70) 1.000 (70)

1 30 0.952 28.56 0.909 25.96
2 40 0.907 36.28 0.826 29.97
3 30 0.864 25.92 0.751 19.47
Total 75.40
Less: Cash out flow 70.00
NPV (+) 5.40
* 1/1.05; 1/(1.05)2 ; 1/(1.05)3;
Advise: With positive NPV, the project is financially viable.
Alternatively, instead of converting cash flows into real terms, the discount rate can be
converted into nominal rate. Result will be the same.
An alternative solution is presented herewith
Alternative solution:
Year Nominal cash flows PVF @ 15.50% adjusted by the PV of cash

inflation factor i.e. 5%* flows
1 30 0.866 25.98
2 40 0.749 29.96
3 30 0.649 19.47
Cash inflow 75.41
Less: Cash out flow 70.00
Net present value 5.41
0.909 0.826 0.751

* = 0866, = 0.749, = 0.649
1.05 1.1025 1.1576
Advise: With positive NPV, the project is financially viable.
Page 67
Question: 45
Shashi Co. Ltd has projected the following cash flows from a project under evaluation:
Year 0 1 2 3
₹ (in lakhs) (72) 30 40 30
The above cash flows have been made at expected prices after recognizing inflation.
The firm‟s cost of capital is 10%. The expected annual rate of inflation is 5%. Show
how the viability of the project is to be evaluated. PVF at 10% for 1-3 years are 0.909,
0.826 and 0.751.
Solution:
Here the given cash flows have to be adjusted for inflation.
Alternatively, the discount rate can be converted into nominal rate, as follows:-
0.909 0.826 0.826

Year 1 = = 0866; Year 2 = or = 0.749
1.05 1.05 2 1.1025
0.751 0.751
Year 3 = 3 = = 0.649
1.05 1.1576
Year Nominal Cash Adjusted PVF as PV of Cash Flows

Flows (₹ in lakhs) above (₹ in lakhs)
1 30 0.866 25.98
2 40 0.749 29.96
3 30 0.649 19.47
Cash Inflow 75.41
Less: Cash Outflow 72.00
Net Present Value 3.41
With positive NPV, the project is financially viable.
Assumption: The cost of capital given in the question is “Real‟.
Nominal cost of capital = (1.10) (1.05) −1 = 0.155 =15.50%
DCF Analysis of the project

(₹ Lakhs)
Period PVF @15.50% CF PV
Page 68
Investment 0 1 -72 -72.00

Operation 1 0.866 30 + 25.98
---do--- 2 0.750 40 + 30.00
---do--- 3 0.649 30 + 19.47
NPV + 3.45
The proposal may be accepted as the NPV is positive.
Question: 46
KLM Ltd. requires ₹ 15,00,000 for a new project.
Useful life of project is 3 years.
Salvage value - NIL. Depreciation is ₹ 5,00,000 p.a.
Given below are projected revenues and costs (excluding depreciation) ignoring
inflation:
Year 1 2 3
Revenues in ₹ 10,00,000 13,00,000 14,00,000
Costs in ₹ 5,00,000 6,00,000 6,50,000
Applicable tax rate is 35%. Assume cost of capital to be 14% (after tax). The inflation
rates for revenues and costs are as under:
Year Revenues % Costs %

1 9 10
2 8 9
3 6 7
PVF at 14%, for 3 years =0.877, 0.769 and 0.675
Show amount to the nearest rupee in calculations.
You are required to calculate net present value of the project.
Solution:
(i) Inflation adjusted revenues
Year Revenues (₹) Revenues (Inflation Adjusted) (₹)

1 10,00,000 10,00,000(1.09) = 10,90,000
2 13,00,000 13,00,000(1.09) (1.08) = 15,30,360
3 14,00,000 14,00,000(1.09) (1.08)(1.06) = 17,46,965
(ii) Inflation adjusted Costs
Year Cost (₹) Cost (Inflation Adjusted) (₹)

1 5,00,000 5,00,000(1.10) = 5,50,000
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2 6,00,000 6,00,000(1.10)(1.09) = 7,19,400

3 6,50,000 6,50,000(1.10)(1.09)(1.07) = 8,33,905
(iii) Tax Benefit on Depreciation = ₹ 5,00,000 × 0.35 = ₹ 1,75,000
(iv) Net Profit after Tax
Year Revenues Cost Net Profit Tax (₹) Profit after

(Inflation (Inflation (₹) (4) = 35% of Tax (₹)
Adjusted) (₹) Adjusted) (₹) (3) = (1) – (2) (3) – (4)
(1) (2) (3)
1 10,90,000 5,50,000 5,40,000 1,89,000 3,51,000
2 15,30,360 7,19,400 8,10,960 2,83,836 5,27,124
3 17,46,965 8,33,905 9,13,060 3,19,571 5,93,489
(v) Present Value of Cash Inflows
Year Net Profit Tax Benefit Cash PVF @ 14% PV (₹)

after Tax on Inflow
(₹) Depreciation (₹)
(₹)
1 3,51,000 1,75,000 5,26,000 0.877 4,61,302
2 5,27,124 1,75,000 7,02,124 0.769 5,39,933
3 5,93,489 1,75,000 7,68,489 0.675 5,18,730
15,19,965
NPV = ₹ 15,19,965 – ₹ 15,00,000 = ₹ 19,965
Question: 47
Determine NPV of the project with the following information:
Initial Outlay of project ₹40,000
Annual revenues (Without inflation) ₹30,000
Annual costs excluding depreciation (Without inflation) ₹10,000
Useful life 4 years
Salvage value Nil
Tax Rate 50%
Cost of Capital (Including inflation premium of 10%) 12%
Solution:
Annual Cash Flow of project is
(₹ 30,000 – ₹ 10,000) (1 – 0.50) + ₹ 10,000 × 0.50 = ₹ 15,000
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It would be inconsistent to discount these real cash flows at 12% (nominal rate of
return).
There are two alternatives:
(i) Either to restate the cash flow in nominal term and discount at 12% or
(ii) Restate the discount rate in real terms and use this to discount the real cash
flows.
NPV using (i) approach
Since inflation rate is 10% a year, real cash flows may be stated in nominal cash flows
as follows:
Nominal Cash Flow = (1 + Inflation Rate) Real Cash Flows
Year Real Cash Flows Nominal Cash Flows

1 15,000 15,000 × 1.10 = 16,500
2 15,000 15,000 × (1.10)2 = 18,150
3 15,000 15,000 × (1.10)3 = 19,965
4 15,000 15,000 × (1.10)4 = 21,962
NPV using nominal discounting rate 12%
16,500 18,150 19,965 21,962

(1.12)
+ 2 + 3 + 4 − 40,000
(1.12) (1.12) (1.12)
= ₹14,732 + ₹14,469 + ₹14,211 + ₹13,957 – ₹40,000
= ₹17,369 (Approx)
NPV using (ii) approach
To compute NPV using (ii) approach, we shall need real discount rate, which shall be
computed as follows:
1+Nominal Discount Rate

Real Discount Rate = –1
1 + Inflation Rate
1+ 0.12
Real Discount Rate = – 1 = 0.0182 i.e. 1.8%
1+ 0.10
n
NPV = t=1 cft − I0
Where,
t = Time Period
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cft = Annual Cash Flow
I0 = Initial Outlay
Accordingly NPV of the project
15,000 15,000 15,000 15,000

+
(1.0182) (1.0182)2 + 3 + 4 − 40,000
(1.0182) (1.0182)
= ₹ 14,732 + ₹ 14,469 + ₹ 14,210 + ₹ 13,956 – ₹ 40,000
= ₹ 57,367 – ₹ 40,000 = ₹ 17,367(Approx)
NPV based on consideration that inflation rate for revenue and cost are different shall
be computed as follows:
n
N.P.V. = t=1 [{Rt (1 + ir) − Ct tΣr=1(1 + ic)} (1−T) + DtT] / (1+ k)t − I0
Rt→ revenues for the year „t‟ with no inflation.
ir→ annual inflation rate in revenues for „r th ‟ year.
Ct→ costs for year „t‟ with no inflation.
ic→ annual inflation rate of costs for year „r‟.
T → tax rate. Dt→ depreciation charge for year „t‟.
I0→ initial outlay.
k → cost of capital (with inflation premium).
Question: 48
XYZ Ltd. requires ₹ 8,00,000 for an unit. Useful life of project - 4 years. Salvage value -
Nil. Depreciation Charge ₹ 2,00,000 p.a. Expected revenues & costs (excluding
depreciation) ignoring inflation.
Year 1 2 3 4
Revenues ₹ 6,00,000 ₹ 7,00,000 ₹ 8,00,000 ₹ 8,00,000
Costs ₹ 3,00,000 ₹ 4,00,000 ₹ 4,00,000 ₹ 4,00,000
Tax Rate 60% cost of capital 10% (including inflation premium).
Calculate NPV of the project if inflation rates for revenues & costs are as follows:
Year Revenues Costs

1 10% 12%
2 9% 10%
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3 8% 9%
4 7% 8%
Solution:
Computation of Annual Cash Flow
(i) Inflation adjusted Revenues

1 6,00,000 6,00,000(1.10) = 6,60,000
2 7,00,000 7,00,000(1.10)(1.09) = 8,39,300
3 8,00,000 8,00,000(1.10)(1.09)(1.08) = 10,35,936
4 8,00,000 8,00,000(1.10)(1.09)(1.08)(1.07) = 11,08,452
(ii) Inflation adjusted Costs

1 3,00,000 3,00,000(1.12) = 3,36,000
2 4,00,000 4,00,000(1.12)(1.10) = 4,92,800
3 4,00,000 4,00,000(1.12)(1.10)(1.09) = 5,37,172
4 4,00,000 4,00,000(1.12)(1.10)(1.09)(1.08) = 5,80,124
(iii) Tax Benefit on Depreciation = ₹ 2,00,000 × 0.60 = `₹1,20,000
(iv) Net Profit after Tax
Year Revenues Costs Net Profit (₹) Tax (₹) (4) = Net after
(Inflation (Inflation (3) = (1) − (2) 60% of (3) Profit (₹)
Adjusted) Adjusted) (3) − (4)
(₹) (1) (₹)(2)
1 6,60,000 3,36,000 3,24,000 1,94,400 1,29,600
2 8,39,300 4,92,800 3,46,500 2,07,900 1,38,600
3 10,35,936 5,37,172 4,98,764 2,99,258 1,99,506
4 11,08,452 5,80,124 5,28,328 3,16,997 2,11,331
(iv) Present Value of Cash Inflows
Year Net after Tax Benefit Cash Outflow PVF @ 10% PV (₹)
Profit on (₹)
(₹) Depreciation
(₹)
1 1,29,600 1,20,000 2,49,600 0.909 2,26,886
2 1,38,600 1,20,000 2,58,600 0.826 2,13,604
3 1,99,506 1,20,000 3,19,506 0.751 2,39,949
4 2,11,331 1,20,000 3,31,331 0.683 2,26,299
9,06,738
NPV = ₹ 9,06,738 – ₹ 8,00,000 = ₹ 1,06,738
Page 73
(7) SIMULATION
Question: 49
Uncertainty associated with two aspects of the project: Annual Net Cash Flow & Life of
the project. NPV model for the project is
n Cft
t=1 –I
1+i t
Where i→ Risk free interest rate, I→ initial investment are parameters, CF = Annual
Cash Flow With i = 10%, I = ₹ 1,30,000, CFt & n stochastic exogenous variables with
the following distribution will be as under:
Annual Cash Flow Project Life

Value (₹) Probability Value (Year) Probability
10,000 0.02 3 0.05
15,000 0.03 4 0.10
20,000 0.15 5 0.30
25,000 0.15 6 0.25
30,000 0.30 7 0.15
35,000 0.20 8 0.10
40,000 0.15 9 0.03
10 0.02
Ten manual simulation runs are performed for the project. To perform this operation,
values are generated at random for the two exogenous variables viz., Annual Cash
Flow and Project Life. For this purpose, we take following steps
(1) set up correspondence between values of exogenous variables and random

numbers
(2) choose some random number generating device.
Solution:
Correspondence between Values of Exogenous Variables and two Digit Random
Numbers:

Value Probabili- Cumula- Tow Value Probabili Cumula- Two
(₹) ty tive Digit (Year) -ty tive Digit
Probability Random Probability Random
No. No.
10,000 0.02 0.02 00 – 01 3 0.05 0.05 00 – 04
15,000 0.03 0.05 02 – 04 4 0.10 0.15 05 – 14
20,000 0.15 0.20 05 – 19 5 0.30 0.45 15 – 44
25,000 0.15 0.35 20 – 34 6 0.25 0.70 45 – 69
7
30,000 0.30 0.65 35 – 64 0.15 0.85 70 – 84
8
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35,000 0.20 0.85 65 – 84 9 0.10 0.95 85 – 94

40,000 0.15 1.00 85 - 99 10 0.03 0.98 95 – 97
0.02 1.00 98 - 99
Random Number
53479 81115 98036 12217 59526

97344 70328 58116 91964 26240
66023 38277 74523 71118 84892
99776 75723 03172 43112 83086
30176 48979 92153 38416 42436
81874 83339 14988 99937 13213
19839 90630 71863 95053 55532
09337 33435 53869 52769 18801
31151 58295 40823 41330 21093
67619 52515 03037 81699 17106
For random numbers, we can begin from any-where taking at random from the table
and read any pair of adjacent columns, column/row wise. For the first simulation run
we need two digit random numbers (1) For Annual Cash Flow (2) For Project Life. The
numbers are 53 & 97 and corresponding value of Annual Cash Flow and Project Life
are ₹ 3,000 and 9 years respectively.
Simulation Results

Run Random Corres. Random Corres. PVAF @ NPV (1) ×
No. Value of No. Value of 10% (2) (2) –
Annual Project 1,30,000
Cash Flow Life
(1)
1 53 30,000 97 9 5.759 42,770
2 66 35,000 99 10 6.145 85,075
3 30 25,000 81 7 4.868 (8,300)
4 19 20,000 09 4 3.170 (66,600)
5 31 25,000 67 6 4.355 (21,125)
6 81 35,000 70 7 4.868 40,380
7 38 30,000 75 7 4.868 16,040
8 48 30,000 83 7 4.868 16,040
9 90 40,000 33 5 3.791 21,640
10 58 30,000 52 6 4.355 650
(8) ADJUSTED PRESENT VALUE
Question: 50
XYZ Ltd. is presently all equity financed. The directors of the company have been
evaluating investment is a project which will require ₹ 270 lakhs capital expenditure
Page 75
on new machinery. They expect the capital investment to provide annual cash flows of
₹42 lakhs indefinitely which is net of all tax adjustments. The discount rate which it
applies to such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take
advantage of tax benefits of debt, and propose to finance the new project with undated
perpetual debt secured on the company‟s assets. The company intends to issue
sufficient debt to cover the cost of capital expenditure and the after tax cost issue.
The current annual gross rate of interest required by the market on corporate undated
debt of similar risk is 10%. The after tax costs of issue are expected to be ₹ 10 lakh.
Company‟s tax rate is 30%.
Your are required to calculate:
(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and
(iii) explain the circumstances under which this adjusted discount rate may be used
to evaluate future investment.
Solution:
(i) Calculation of Adjusted Present Value of Investment (APV)
Adjusted PV = Base Case PV + PV of financing decisions associated with the

project
Base Case NPV for the project:
(-) ₹ 270 lakhs + (₹ 42 lakhs / 0.14) = (-) ₹ 270 lakhs + ₹ 300 lakhs
= ₹ 30
Issue costs = ₹ 10 lakhs
Thus, the amount to be raised = ₹ 270 lakhs + ₹ 10 lakhs
= ₹ 280 lakhs
Annual tax relief on interest payment = ₹ 280 × 0.1 × 0.3
= ₹ 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ₹ 8.4 lakhs / 0.1
= ₹ 84 lakhs
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Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= ₹ 30 lakhs – ₹ 10 lakhs + 84 lakhs
= ₹ 104 lakhs
(ii) Calculation of Adjusted Discount Rate (ADR)
Annual Income / Savings required to allow an NPV to zero
Let the annual income be x.
(-) ₹280 lakhs X (Annual Income / 0.14) = (-) ₹104 lakhs
Annual Income / 0.14 = (-) ₹ 104 + ₹ 280 lakhs
Therefore, Annual income = ₹ 176 × 0.14 = ₹ 24.64 lakhs
Adjusted discount rate = (₹ 24.64 lakhs / ₹ 280 lakhs) × 100
= 8.8%
(iii) Useable circumstances This ADR may be used to evaluate future investments
only if the business risk of the new venture is identical to the one being evaluated
here and the project is to be financed by the same method on the same terms.
The effect on the company‟s cost of capital of introducing debt into the capital
structure cannot be ignored.
MULTIPLE CHOICE QUESTIONS
1. The following information is available in case of an investment proposal: NPV

at discounting rate of 10% = ₹ 1250 and NPV at discounting rate of 11% =
₹ (-) 200. The IRR of the proposal is_________________
A. 11.86%
B. 10.86%
C. 9.87%
D. 11.96%
2. The Profitability Index of a project is 1.28 and its cost of investment is ₹

2,50,000. The NPV of the project is___________
A. ₹ 75,000
B. ₹ 80,000
Page 77
C. ₹ 70,000
D. ₹ 65,000
3. From the following information calculate the MIRR of the project. Initial Outlay
₹ 50,000, cost of capital 12% p.a., Life of the project 4 years, Aggregate future
value of cash flows ₹ 1,04,896.50.
A. 20.35%
B. 21.53%
C. 31.25%
D. 12.25%
4. The IRR of a project is 10%. If the annual cash flow after tax is ₹ 1,30,000 and
project duration is 4 years, what is the initial investment in the project?
A. ₹ 4,10,000
B. ₹ 4,12,100
C. ₹ 3,90,000
D. ₹ 4,05,000
5. The NPV of a 4-year project is ₹ 220 lakh and PVIFA at 12% for 4 years is
3.037. The Equivalent Annual Benefit of the project is ___________
A. ₹ 66.52 lakh
B. ₹ 94.74lakh
C. ₹ 66.96 lakh
D. ₹ 76.65 lakh
6. If the cash flows over the life of the project are perfectly correlated, the
Standard Deviation is determined using the formula ________
σ2
A. SD =
1+i 2
σ
B. SD =
1+i 2
Page 78
σ
C. SD =
1+i 2
σt
D. SD =
1+ i 2
7. Which of the following is/are not true regarding the risk adjusted investment
appraisal techniques?
i. In the certainty equivalent method, if there is high degree of correlation

between the cash flows over the entire project life the certainty equivalent
coefficient is taken as one for all the years.
ii. In sensitivity analysis, the impact of the changes in one or more variables
on the criterion of merit is studied.
iii. Simulation does not produce an optimal solution but the user of the
technique has to generate all possible combinations of conditions and
constraints to choose the optimal solution.
A. Only (ii) above.
B. Only (iii) above.
C. Both (i) and (ii) above
D. Both (i) and (iii) above
8. Coefficient of variation
A. Is an absolute measure of risk
B. Is a relative measure of risk
C. Is given by mean expected return by standard deviation
D. Is given by the product of mean expected return and standard deviation
9. If nominal discounting rate is 15%, inflation rate is 5%, then real discounting
rate will be ___________
A. 9.52%
B. 9.25%
C. 10.25%
D. 10.52%
Page 79
10. If project cost = ₹ 12,000, Annual cash flow = ₹ 4,500 Cost of capital = 14%, life
= 4 years, PVIFA (14%, 4) = 2.9137, then the sensitivity with respect to the
project cost is
A. 9.27%
B. 10.27%
C. 9.72%
D. 10.72%
11. The following information is available with respect to Project X NPV Estimate (₹
) 30,000 60,000 1,20,000 1,50,000 Probability 0.1 0.4 0.4 0.1 The expected
NPV will be _____________
A. ₹ 1,00,000
B. ₹ 75,000
C. ₹ 90,000
D. ₹ 1,20,000
12. If expected NPV = ₹ 1,20,000 and S.D = ₹ 30,000, then coefficient of variation
will be _____________
A. 25%
B. 20%
C. 30%
D. 50%
13. Given, expected value of profit without perfect information = ₹ 1,600 and
expected value of perfect information = ₹ 300, then expected value of profit with
perfect information will be ________
A. ₹ 1,300
B. ₹ 1,900
C. ₹ 950
D. None of the above
14. A project has a 10% discounted pay back of 2 years with annual after tax cash
inflows commencing from year end 2 to 4 of ₹ 400 lacs. How much would have
been the initial cash outlay which was fully made at the beginning of year 1?
Page 80
(A) ₹ 400 lacs
(B) ₹ 452 lacs
(C) ₹ 633.80 lacs
(D) ₹ 497.20 lacs
(Use p.v. factors only up to 3 decimal places.)
15. A project is expected to yield an after tax cash inflow at the end of year 2 of ₹
150 lacs and has a cost of capital of 10%. Inflation is expected at 3% p.a. While
computing the NPV of t the project, this cash flow will be taken as the following:
150
1.03
(A)
(1.1)2
150
(1.03)2
(B)
(1.1)2
150
(C)
(111.33%)2
150 (1.03)2
(D)
(1.11)2
16. Initial investment of a project is ₹ 25 lakh. Expected annual cash flows are ₹ 6.5
lakh for 10 years Cost of capital is 15%. The annuity factor for 15% for 10 years
is 5.019. The Profitability Index of the project will be
(A) 1.305
(B) 3.846
(C) 0.26
(D) 0.7663
17. Rate of inflation = 5.1%, β = 0.85, Risk premium = 2.295%, Market return
= 12%. The real rate of return will be
(A) 4.2%
(B) 11.70%
(C) 6%
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(D) 5.95%
18. Initial Investment ₹ 20 lakh. Expected annual cash flows ₹ 6 lakh for 10 years.
Cost of capital @ 15%. What is the Profitability Index? The cumulative
discounting factor @ 15% for 10 years = 5.019.
(A) 1.51
(B) 1.15
(C) 5.15
(D) 0.151
19. The interest rate in Germany is 11 per cent and the expected inflation rate is 5
per cent. The British interest rate is 9 per cent. How much is the expected
inflation rate in Britain?
(A) 3.0%
(B) 3.1%
(C) 4.5%
(D) 2.9%
20. A project had an equity beta of 1.2 and was going to be financed by a
combination of 30% debt and 70% equity (assume debt beta = 0). Hence, the
required rate of return of the project is (assume Rf = 10% and Rm =18%)
(A) 16.27%
(B) 17.26%
(C) 16.72%
(D) 12.76%
21. MAYANK Ltd. employs 12% as nominal required rate of return to evaluate its
new investment projects. In the recent meeting of the Board of Directors, it has
been decided to protect the interest of shareholders against purchasing power
loss due to inflation. The expected inflation rate in the economy is 5%. What is
the real discount rate?
(A) 6.67%
(B) 6%
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(C) 5%
(D) 6.5
22. Given for a project: Annual Cash inflow ₹ 80,000 Useful life 4 years Pay-Back
period 2.855 years What is the cost of the project?
(A) ₹ 2,28,500
(B) ₹ 2,28,400
(C) ₹ 2,28,600
(D) ₹ 2,28,700
23. Annual Cost Saving ₹ 4,00,000
Useful life 4 years
Cost of the Project ₹ 11,42,000
The Pay back period would be
(A) 2 years 8 months
(B) 2 years 11 months
(C) 3 years
(D) 1 year 10 months
24. There are 4 investments
X Y Z U
The standard deviation is 37,947 44,497 42,163 41,997
Expected net present value (₹) 90,000 1,06,000 1,00,000 90,000
Which investment has the highest risk?
(A) X
(B) Y
(C) X
(D) U
25. A company is considering four projects A, B, C and D with the following

information:
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Project A Project B Project C Project D

Expected NPV (₹) 60,000 80,000 70,000 90,000
Standard deviation (₹) 4,000 10,000 12,000 14,000
Which project will fit the requirement of low risk apatite?
(A) Project A
(B) Project B
(C) Project C
(D) Project D
26. The following information of a project are given below:
Expected cash flow (₹) Probability

6,000 0.20
16,000 0.80
If certainty equivalent coefficient is 0.7, what will be certain (Risk less) cash
flows of the project?
(A) ₹ 12,000
(B) ₹ 9,800
(C) ₹ 9,000
(D) ₹ 15,400
27. A company has ₹ 7 crore available for investment. It has evaluated its options
and has found that only four investment projects given below have positive
NPV. All these investments are divisible and get proportional NPVs.
Project Initial Investment (₹ NPV (₹ crore) PI

crore)
W 6.00 1.80 1.30
X 3.00 0.60 1.20
Y 2.00 0.50 1.25
Z 2.50 1.50 1.60
Which investment projects should be selected?
(A) Project W in full and X in part
(B) Project Z in full and W in part
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(C) Project W in full and Z in part
(D) Project Z and Y in full and X in part
28. Duhita Ltd. intends to buy an equipment. Quotes are obtained for two different
makes A and B as given below:
Cost (₹ Million) Estimate life (years)

A 4.5 10
B 6.00 15
Ignoring the operations and maintenance costs which will be almost the same
for A and B, which one would be chapter? The company's cost of capital is 10%
[Given: PVIFA (10%, 10 yrs.) = 6.1446 and PVIFA (10%, 15 years) = 7.6061]
(A) A will be cheaper
(B) B will be cheaper
(C) Cost will be the same
(D) They are not comparable and therefore nothing can be said about which
is cheaper.
29. Given for a project: Annual Cash inflow = ₹ 80,000, Useful life = 4 years
Undiscounted Pay-Back period = 2.855 years What is the cost of the project?
(A) ₹ 1,12,084
(B) ₹ 2,28,400
(C) ₹ 9,13,600
(D) None of the above
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DERIVATIVES AMENDMENT
DERIVATIVES
EXOTIC OPTIONS
Exotic options are the classes of option contracts with structure and features
different from plain vanilla options i.e. American and European style options.
Not only that Exotic options are different from these vanilla options in their
expiration dates also. As mentioned earlier an American option allows the
option buyer to exercise its right at any time on or before expiration date. On
the other hand European option can be exercised only at the expiry of maturity
period. Exotic option is some type of hybrid of American and European options
and hence falls somewhere in between these options.
Exotic Vs. Traditional Option
a. An exotic option can vary in terms of pay off and time of exercise.
b. These options are more complex than vanilla options.
c. Mostly Exotic options are traded in OTC market.
Types of Exotic Options
The most common types of Exotic options are as follows:
(a) Chooser Options: This option provides a right to the buyer of option after a
specified period of time to decide whether purchased option is a call option or
put option. It is to be noted that the decision can be made within a specified
period prior to the expiration of contracts.
(b) Compound Options: Also called split fee option or „option on option‟. As the
name suggests this option provides a right or choice not an obligation to buy
another option at specific price on the expiry of first maturity date. Thus, it can
be said in this option the underlying is an option. Further the payoff depends
on the strike price of second option.
(c) Barrier options: Though it is similar to plain vanilla call and put options,
but unique feature of this option is that contract will become activated only if
the price of the underlying reaches a certain price during a predetermined
period.
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(d) Binary Options: Also known as „Digital Option‟, this option contract
guarantees the pay-off based on the happening of a specific event. If the event
has occurred, the pay-off shall be predecided amount and if event it has not
occurred then there will be no pay-off.
(e) Asian Options: These are the option contracts whose pay off are determined
by the average of the prices of the underlying over a predetermined period
during the lifetime of the option.
(f) Bermuda Option: It is somewhat a compromise between a European and

American options. Contrary to American option where it can be exercised at
any point of time, the exercise of this option is restricted to certain dates or on
expiration like European option.
(g) Basket Options: In this type of contracts the value of option instead of one
underlying depends on the value of a portfolio i.e., a basket. Generally, this
value is computed based on the weighted average of underlying constituting
the basket.
(h) Spread Options: As the name suggests the payoff of these type of options
depend on difference between prices of two underlying.
(i) Look back options: Unlike other type of options whose exercise prices are
pre-decided, in this option on maturity date the holder of the option is given a
choice to choose a most favourable strike price depending on the minimum and
maximum price of an underlying achieved during the life time of option.
CREDIT DERIVATIVES
Credit Derivatives is summation of two terms, Credit + Derivatives. As we know

that derivative implies value deriving from an underlying, and this underlying
can be anything we discussed earlier i.e. stock, share, currency, interest etc.
Initially started in 1996, due to the need of the banking institutions to hedge
their exposure of lending portfolios today it is one of the popular structured
financial products.
Plainly speaking the financial products are subject to following two types of
risks:
(a) Market Risk: Due to adverse movement of the stock market, interest
rates and foreign exchange rates.
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(b) Credit Risk: Also called counter party or default risk, this risk involves
non-fulfillment of obligation by the counter party.
While, financial derivatives can be used to hedge the market risk, credit
derivatives emerged out to mitigate the credit risk. Accordingly, the credit
derivative is a mechanism whereby the risk is transferred from the risk averse
investor to those who wish to assume the risk.
Although there are number of credit derivative products but in this chapter, we
shall discuss two types of credit Derivatives „Collaterised Debt Obligation‟ and
„Credit Default Swap‟.
Collateralized Debt Obligations (CDOS)
While in securitization the securities issued by SPV are backed by the loans
and receivables the CDOs are backed by pool of bonds, asset backed securities,
REITs, and other CDOs. Accordingly, it covers both Collateralized Bond
Obligations (CBOs) and Collateralized Loan Obligations (CLOs).
Types of CDOs
The various types of CDOs are as follows:
(a) Cash Flow Collateralized Debt Obligations (Cash CDOs): Cash CDO is
CDO which is backed by cash market debt or securities which normally
have low risk weight. This structure mainly relies on the collateral‟s risk
weight and collateral‟s ability to generate sufficient cash to pay off the
securities issued by SPV.
(b) Synthetic Collateralized Debt Obligations: It is similar to Cash Flow

CDOs but with the difference that instead of transferring ownerships of
collateral to SPV (a separate legal entity), synthetic CDOs are structured
in such a manner that credit risk is transferred by the originator without
actual transfer of assets.
Normally the structure resembles the hedge funds where in the value of
portfolio of CDO is dependent upon the value of collateralized
instruments and market value of CDOs depends on the portfolio
manager‟s ability to generate adequate cash and meeting the cash flow
obligations (principal and interest) in timely manner.
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While in cash CDO the collateral assets are moved away from Balance
Sheet, in synthetic CDO there is no actual transfer of assets instead
economic effect is transferred.
This effect of transfer economic risk is achieved by creating provision for

Credit Default Swap (CDS) or by issue of Credit Linked Notes (CLN), a
form of liability.
Accordingly, this structure is mainly used to hedge the risk rather than
balance sheet funding. Further, for banks, this structure also allows the
customer‟s relations to be unaffected. This was started mainly by banks
who want to hedge the credit risk but not interested in taking
administrative burden of sale of assets through securitization.
Technically, speaking synthetic CDO obtain regulatory capital relief

benefits vis-à-vis cash CDOs. Further, they are more popular in
European market due to the reason of less legal documentation
requirements. Synthetic CDOs can also be categorized as follows:
(i) Unfunded: - It will be comprised only CDs.
(ii) Fully Funded: - It will be through issue of Credit Linked Notes

(CLN).
(iii) Partially Funded: - It will be partially through issue of CLN and

partially through CDs.
(c) Arbitrage CDOs: Basically, in Arbitrage CDOs, the issuer captures the
spread between the return realized collateral underlying the CDO and
cost of borrowing to purchase these collaterals. In addition to this issuer
also collects the fee for the management of CDOs. This arbitrage arises
due to acquisition of relatively high yielding securities with large spread
from open market.
Risks involved in CDOs
CDOs are structured products and just like other financial products are also
subject to various types of Risk.
The main types of risk associated with investment in CDOs are as follows:
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(a) Default Risk:- Also called „credit risk‟, it emanates from the default of
underlying party to the instruments. The prime sufferers of these types of
risks are equity or junior tranche in the waterfall.
(b) Interest Rate Risk:- Also called Basis risk and mainly arises due to
different basis of interest rates. For example, asset may be based on
floating interest rate but the liability may be based on fixed interest
rates. Though this type of risk is quite difficult to manage fully but
commonly used techniques such as swaps, caps, floors, collars etc. can
be used to mitigate the interest rate risk.
(c) Liquidity Risk:- Another major type of risk by which CDOs are affected
is liquidity risks as there may be mismatch in coupon receipts and
payments.
(d) Prepayment Risk:- This risk results from unscheduled or unexpected

repayment of principal amount underlying the security. Generally, this
risk arises in case assets are subject to fixed rate of interest and the
debtors have a call option. Since, in case of falling interest rates they
may pay back the money.
(e) Reinvestment Risk:- This risk is generic in nature as the CDO manager
may not find adequate opportunity to reinvest the proceeds when allowed
for substitutions.
(f) Foreign Exchange Risk:- Sometimes CDOs are comprised of debts and
loans from countries other than the country of issue. In such a case, in
addition to above mentioned risks, CDOs are also subject to the foreign
exchange rate risk.
Credit Default Swaps (CDSs)
It is a combination of following 3 words:
Credit : Loan given
Default : Non payment
Swap : Exchange of Liability or Risk
Accordingly, CDS can be defined as an insurance (not in stricter sense) against

the risk of default on a debt which may be debentures, bonds etc.
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Under this arrangement, one party (called buyer) needing protection against
the default pays a periodic premium to another party (called seller), who in
turn assumes the default risk. Hence, in case default takes place then there
will be settlement and in case no default takes place no cash flow will accrue to
the buyer alike option contract and agreement is terminated. Although it
resembles the options but since element of choice is not there it more
resembles the swap arrangements.
Amount of premium mainly depends on the price of underlying and especially

when the credit risk is more.
Main Features of CDS
The main features of CDS are as follows:
(a) CDS is a non-standardized private contract between the buyer and seller.
Therefore, it is covered in the category of Forward Contracts.
(b) They are normally not traded on any exchange and hence remains free
from the regulations of Governing Body.
(c) The International Swap and Derivative Association (ISAD) publishes the
guidelines and general rules used normally to carry out CDS contracts.
(d) CDS can be purchased from third party to protect itself from default of
borrowers.
(e) Similarly, an individual investor who is buying bonds from a company

can purchase CDS to protect his investment from insolvency of that
company. Thus, this increases the level of confidence of investor in
Bonds purchased.
(f) The cost or premium of CDS has a positive relationship with risk
attached with loans. Therefore, higher the risk attached to Bonds or
loans, higher will be premium or cost of CDS.
(g) If an investor buys a CDS without being exposed to credit risk of the
underlying bond issuer, it is called “naked CDS”.
Uses of Credit Default Swap
Following are the main purposes for which CDS can be used:
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(a) Hedging- Main purpose of using CDS is to neutralize or reduce a risk to

which CDS is exposed to. Thus, by buying CDS, risk can be passed on to
CDS seller or writer.
(b) Arbitrage- It involves buying a CDS and entering into an asset swap. For
example, a fixed coupon payment of a bond is swapped against a floating
interest stream.
(c) Speculation- CDS can also be used to make profit by exploiting price
changes. For example, a CDS writer assumed risk of default, will gain
from contract if credit risk does not materialize during the tenure of
contract or if compensation received exceeds potential payout.
Parties to CDS
In a CDS at least three parties are involved which are as follows:
i. The initial borrowers- It is also called a „reference entity‟, which are

owing a loan or bond obligation.
ii. Buyer- It is also called „investor‟ i.e. the buyer of protection. The buyer
will make regular payment to the seller for the protection from default or
credit event of reference entity.
iii. Seller- It is also called „writer‟ of the CDS and makes payment to buyer
in the event of credit event of reference entity. It receives a regular pay off
from the buyer of CDS.
Example:
Suppose BB Corp. buys CDS from SS Bank for the Bonds amounting $ 10
million of Danger Corp. In such case, the BB Corp. will become the buyer, SS
Bank becomes seller and Danger Corp. becomes the reference entity. BB Corp.
will make regular payment to SS Bank of the premium and if Danger Corp.
defaults on its debts, the BB Corp. will receive one time payment and CDS
contract is terminated.
Settlement of CDS
Broadly, following are main ways of settlement of CDS.
(i) Physical Settlement – This is the traditional method of settlement. It

involves the delivery of Bonds or debts of the reference entity by the
buyer to the seller and seller pays the buyer the par value.
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For example, as mentioned above suppose Danger Corp. defaults then SS

Bank will pay $ 10 Million to BB Corp. and BB Corp will deliver $10
Million face value of Bonds to SS Bank.
(ii) Cash Settlement- Under this arrangement seller pays the buyer the
difference between par value and the market price of a debt (whatever
may be the market value) of the reference entity. Continuing the above
example suppose, the market value of Bonds is 30%, as market is of
belief that bond holder will receive 30% of the money owed in case
company goes into liquidation. Thus, the SS Bank shall pay BB Corp. $
10 Million - $3 million (100% - 30%) = $ 7 Million.
To make Cash settlement even more transparent, the credit event

auction was developed. Credit event auction set a price for all market
participants that choose to cash settlement.
WEATHER DERIVATIVES
While there are some companies whose performance are completely unaffected
by weather but there are many companies whose performance is liable to be
adversely affected by the weather. For example, airline companies, juice
manufacturing companies etc. Especially farmers are highly exposed to
weather. To hedge this risk, instruments are required like instruments are
used to hedge foreign exchange and other financial risks. This led to rise of a
new class of financial instruments - Weather Derivatives- has been introduced
to enable businesses to manage their volumetric risk resulting from
unfavourable weather patterns. Just as traditional contingent claims, whose
payoffs depend upon the price of some fundamental, a weather derivative has
its underlying “asset”, a weather measure. “Weather”, of course, has several
dimensions: rainfall, temperature, humidity, wind speed, etc. There is a
fundamental difference between weather and traditional derivative contracts
concerning the hedge objective. The underlying of weather derivatives is
represented by a weather measure, which influences the trading volume of
goods. This, in turn, means that the primary objective of weather derivatives is
to hedge volume risk, rather than price risk, that results from a change in the
demand for goods due to a change in weather.
The first weather transaction was executed in 1997 in the Over the Counter
(OTC) market by Aquila Energy Company. The market was jump started during
the warm Midwest/Northeast El Nino winter of 1997-1998, when the unusual
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higher temperatures induced companies to protect themselves from significant

earnings decline. Since then, the market has rapidly expanded.
Weather derivatives represent an alternative tool to the usual insurance

contract by which firms and individuals can protect themselves against losing
out because of unforeseen weather events. Many factors differentiate weather
derivatives from insurance contracts. The main difference is due to the type of
coverage provided by the two instruments. Insurance provides protection to
extreme, low probability weather events, such as earthquakes, hurricanes and
floods, etc. Instead, derivatives can also be used to protect the holder from all
types of risks, including uncertainty in normal conditions that are much more
likely to occur. This is very important for industries closely related to weather
conditions for which less dramatic events can also generate huge losses.
Like other derivatives a Weather derivative is a contract between a buyer and a

seller wherein the seller of a weather derivative receives a premium from a
buyer with the understanding that the seller will provide a monetary amount in
case the buyer suffers any financial loss due to adverse weather conditions. In
case no adverse weather condition occurs, then the seller makes a profit
through the premium received.
Pricing a weather derivative is quite challenging as it cannot be stored and

following issues are involved: -
 Data:- The reliability of data is a big challenge as the availability of data

quite differs from one country to another and even agency to agency
within a country.
 Forecasting of weather:- Though various models can be used to make

short term and longterm predictions about evolving weather conditions
but it is difficult to predict the future weather behaviour as it is governed
by various dynamic factors. Generally, forecasts address seasonal levels
but not the daily levels of temperature.
 Temperature Modelling:- Temperature is one of the important

underlying for weather derivatives. The temperature normally remains
quite constant across different months in a year. Hence, there is no such
Model that can claim perfection and universality.
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ELECTRICITY DERIVATIVES
The purchase and sale of power in India takes place through state-owned
distribution companies which enter into Power Purchase Agreements (PPAs)
with power generators. Such long-term contracts (usually around 20-25 years)
are needed given the high capital and operational expenditure requirements of
these projects.
Since electricity spot prices in India, are generally volatile, due to smaller
market size and other various dynamic factors such as change in fuel supply
positions, weather conditions, transmission congestion, variation in RE
generation, and other physical attributes of production and distribution there
is a need for hedging instruments that reduces price risk exposures for market
participants i.e., generators, buyers and load serving entities.
As discussed earlier the derivative instruments can be used to hedge the risk of
price volatility derivative contracts linked with spot electricity prices as
underlying can help market participants to hedge from price risk variations.
This will help the buyer to pay a fixed price irrespective of variation in spot
electricity prices as variations are absorbed by derivative instruments.
Like other derivatives the vanilla forms of electricity derivatives are:
(i) forwards,
(ii) futures, and
(iii) swaps.
Not only that being traded either on the exchanges or over the counters, these
power contracts play the primary roles in offering future price discovery and
price certainty to generators, distributing companies and other buyers.
Electricity Forwards
Electricity Forward contracts represent the obligation to buy or sell a fixed

amount of electricity at a pre-specified contract price, known as the forward
price, at a certain time in the future (called maturity or expiration time). Like
financial and commodity forward contracts, electricity forwards are custom-
tailored supply contracts between a buyer and a seller, where the buyer is
obligated to take power and the seller is obligated to supply. The payoff of a
forward contract promising to deliver one unit of electricity at price F at a
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future time T is: Payoff of a Forward Contract = (ST - F); where ST is the
electricity spot price at time T.
Although the payoff function appears to be similar as pay-off in case of any

financial forwards, electricity forwards differ from other financial and
commodity forward contracts in the sense that the underlying electricity is a
different commodity at different times. The settlement price ST is usually
calculated based on the average price of electricity over the delivery period at
the maturity day “T”
Electricity Futures
Electricity Futures are contracts for the delivery of a certain quantity of

electricity at a specified price and a specified time in the future, sellers can sell
a proportion of their production in the future market, while consumers can buy
a specific amount of the power they need.
Like other financial futures contracts, Electricity futures contracts are

standardized contracts in terms of trading locations, transaction requirements
and settlement procedures. The apparent difference between the specifications
of electricity futures and those of forwards is the quantity of power to be
delivered. The delivery quantity specified in electricity futures contracts is often
significantly smaller than that in forward contracts.
Like difference between Financial Futures and Forwards discussed earlier the
electricity futures are exclusively traded on the organized exchanges and
electricity forwards are usually traded over the counter. As a result, the
electricity futures prices more transparent than forward prices being reflective
of higher market consensus. Similar to financial futures most electricity
futures contracts are settled by financial payments rather than physical
delivery resulting in lowering of the transaction costs. In addition, credit risks
and monitoring costs in trading futures are much lower than those in trading
forwards since exchanges implement strict margin requirements to ensure the
financial performance of all trading parties. The fact that the gains and losses
of Electricity Futures are paid out daily, as opposed to forward contract being
cumulated and paid out in a lump sum at maturity time thus reduces the
credit risks. Overall, as compared to Electricity Forwards, the advantages of
Electricity Futures lie in market consensus, price transparency, trading
liquidity, and reduced transaction and monitoring costs though there are
limitations of various basis risks associated with the rigidity in futures
specification and the limited transaction quantities specified in the contracts.
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Electricity Swap
Electricity Swaps are financial contracts that enable their holders to pay a fixed
price for underlying electricity, regardless of the floating electricity price, or vice
versa, over the contracted time. They are typically established for a fixed
quantity of power referenced to a variable spot price at either a generator‟s or a
consumer‟s location. Electricity Swaps are widely used in providing short-to-
medium term price certainty for up to a couple of years. Similar to financial
swaps, Electricity Swap can be considered as a strip of electricity forwards with
multiple settlement dates and identical forward prices for each settlement.
Another variant of Electricity Swap is Electricity Locational Basis Swaps

wherein a holder of an electricity swap agrees to either pay or receive the
difference between a specified futures contract price and another locational
spot price of interest for a fixed constant cash flow at the time of the
transaction. These swaps are used to lock-in a fixed price at a geographic
location that is different from the delivery point of a futures contract and hence
are effective financial instruments for hedging the risk-based on the price
difference between power prices at two different physical locations.
DERIVATIVE MISHAPS AND LESSONS
From the above discussion it can be seen that while Derivatives can be used for
hedging purpose, simultaneously they can also be used for speculation
purpose also. Due to this attribute of Financial Derivatives, legendary investor
Warren Buffet believes that the derivatives are financial weapons of mass
destruction. Though there may be many example/cases where derivatives have
proven very fatal for various organizations and even brought them to their
knees, but we shall keep our discussion limited to some of infamous cases
which are as follows:
Orange County’s Case
This case is based on Robert Citron, the treasurer of Orange County a

California municipality losing about $ 2 billion in 1994 having a fund of about
7.5 billion. In this case Treasurer Robert Citron despite the fact having no
background in trading of Financial Instrument he used derivative to speculate
in Interest rates using yield curve play strategy by arbitraging the difference
between long term and short-term rates that by leveraging the position of the
Fund which gone very well in the years 1992 and 1993 resulting in major
contributor in Income of the Orange County. Due to this reason Citron was
selected even though his opponent said the strategy followed was too risky. Not
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only that to increase his bet on the structure of interest rate yield curve, Citron
also used around $ 2.8 billion of Inverse Floaters (a Structured Note)
Since due to type of strategy followed by Citron in 1992 and 1993 Orange
County fund had been earning 300 to 400 basis points i.e. 3-4% above the
returns earned by similar funds operated in the State i.e. California, Orange
County Fund accepted funds from other municipalities as well. At one time
Orange County‟s Fund stood at almost $ 7.5 billion. Now Citron also leveraged
his position in the Repo market. This practice he followed many times
ultimately resulting in County‟s leveraged position threefold i.e. about $ 20
billion with $ 7.50 billion fund. Some of the municipalities realizing this over
leveraged position withdrew their funds.
However, this strategy turned sour with a shift in policy of Federal Reserve in
1994, when it made first of six consecutive interest rates rise in the beginning
of 1994. As a result, between February 1994 to May 1994 the County had to
produce $ 515 million in cash as Margin to cover its position. When further
interest rate rise caused the fund to have a series of huge margin calls from
their broker, the reserve of the County started dipping. When it could not meet
margin, the lenders started selling the collateral amounting to $ 10 Billion
sending a shock wave in Bond market and prices tumbled. Not only that other
bodies who invested their money with County started looking at ways to exit
and started withdrawing their money lacking credible assurance. As a result of
all this Citron admitted that the County had lost a fund of about $ 1.5 Billion
i.e., 20% of its value and he resigned on 3rd December 1994. Further Board of
County declared County as bankrupt on 6th December 1994, to prevent move
to investors to withdraw their money.
In 1996, Citron held guilty and sentence a year jail and fined $ 1,00,000.
Barings Bank’s Case
This is another infamous case of Derivative mishap. Perhaps after this mishap
the term „Operational Risk‟ gained importance in the world and especially in
context of banking business. Further to some extent it can be said that to some
extent due to this case the Basel Committee on Banking Supervision (BCBS)
introduced concept of Operational risk Capital requirements in Basel II
Guidelines.
This case can be considered as one of the best examples of risk that a firm
could face if arbitrageur switched to speculation.
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Nick Lesson, a Star trader of Barings Banks was carrying out low-risk arbitrage
between the Singapore stock Exchange and Osaka Market on Nikkei 225
Futures. This arbitrage involves long position at one exchange where price of
Future is bit lower and shortening position in same Futures on another
exchange where prices are quite higher.
Since in some of the trade Nick Leeson incurred huge losses and to cover up
these losses which can cost him his job, he started taking speculative long
position on Nikkei 225 Futures on both Exchange in anticipation of price rise
of same. Such action of Leeson exposed the Bank to two major risks „Market
Risk‟ and „Event Risk‟ which can result from unexpected major events though
may not be directly related to market.
Leeson in addition to being Floor‟s manager was also in charge of back office
i.e., settlement operations, which allowed him to influence the staff of back
office to hide losses due to trading positions taken by him. To hide these losses,
he used an old error account „8888‟. Not only that by hiding these losses, but
he was also able to show a substantial profit in 1994 for which he was
rewarded with a bonus of $ 7,20,000.
To some extent it can also be termed as an oversight by management when in

1994, Leeson asked for $ 354 million for margin call which he received without
any question, as management was of view that Leeson is using a risk-free
strategy.
In January 1995 guessing that both Singapore and Tokyo stock exchanges
would remain stable as neither going down or up Leeson built-up Future
positions on both exchanges with a total notional value of $ 7 Billion on Nikki
225. In addition to that he also started selling Futures on Long-Term and
Short-Term Japanese Government Bond. The main reason for this strategy was
that interest rate moves in opposite direction of the price of debt. This position
would be profit if there is a rise in interest rates on these Bonds. Unfortunately,
due to a big earthquake in Japan on 17 January 1995 both Japanese Stock
Market and Interest Rate plunged resulting in huge losses of $ 827 million ($
1.4 Billion) in both positions taken by Nick Leeson.
On 23rd February 1995, Nick left Singapore and on next day the management
of Barings Bank were informed about the situation. To meet the requirement of
funds for liquidation position on both exchanges the 233 years old bank
became bankrupt and in March 1995, ING a Dutch Bank purchased this Bank
for £1 only.
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Protector & Gamble (P&G) and Gibson Greetings’ Case
This is a dramatic example of activities of Banker Trust (BT) a banking

organization who in 1994 intentionally developed complex derivative structures
product and sold them to various clients including P&G and Gibson Greetings
leading to huge losses for these two companies. Further it also misled both
companies into thinking that the products have been structured to meet their
individual needs. The products sold to these two companies were inappropriate
because BT was aware of the risk appetite of these companies and other
clients. As a result, both the companies sued BT and it was forced to pay a
huge amount to them for settlement made out of court.
In 1999 this banking organization was taken over by Deutshe Bank.
This case supports the thumb rule that if a product is so complex and
complicated that it cannot be understood by the client it should not be offered
or sold to the same.
In this case BT sold Leveraged Swap products to the P&G. A Leveraged Swap
(also known Ratio Swap or Power Swap) is just like plain vanilla swap with the
difference that the receipt/payments are adjusted by a multiplying factor or
leverage factor. The result is that magnifying effect because of compounding
with interest rate movement.
The structure of the deal was such that P&G could make a profit if there is no
change in rates of returns on the two Bonds or if the rates of return did not
increase to the point where the spread has a positive value. Though the profit
to P&G was limited to 0.75% per 6 months, the potential loss was unlimited or
without celling because of the rise in rate of return on the Bonds.
In similar manner the Banker‟s Trust sold two swap products „Ratio Swap‟ and
„Basis Swap‟ to Gibson Greetings (an American manufacturer of cards and
wrapping papers) in 1992. Under this agreement Gibson in exchange of
receiving 5.5% from BT agreed to pay floating rate squared and then divided by
6. Though this swap was a good bet in a declining interest environment.
However, if interest LIBOR rises beyond a certain point, then it will give a loss
and it would increase exponentially. As a result of this swap agreement the
Gibson Greetings suffered a loss of $ 3 Million in February 1994, as interest
rates are increased because FRR tightened the monetary policy.
Further in April 1994, it suffered a loss of $ 16.7 Million at the same time P&G
suffered a loss of $ 106 million from the swap agreement.
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Both P&G and Gibson Greetings filed suit against BT and reached an out of
court settlement with both.
Lessons from Derivative Mishaps
Following are some of the important lessons can be learnt from the above-
mentioned case studies of Derivative Mishaps.
Don’t buy any derivative product that you don’t understand
This is an important lesson for non-financial corporation not to undertake a

trade or derivative product that they do not understand. As apparent in above
mentioned case of Orange County, treasurer Robert Citron speculated on
derivative instruments even though he has no financial background. Similar
things happened in BT‟s case where both P&G and Gibson Greetings were
misguided.
The best way to avoid such loss is to value the instrument in house because
outside persons can misguide the corporation about the potential dangers.
Due diligence before making Treasury Department as a Profit Centre
Though the main objective of establishing a Treasury Department is to reduce

financing costs and manage risk optimally. But it has been seen that though
initially Treasury Department made limited profits from treasury activities later
started taking more risks in anticipation of higher profit. As mentioned in case
study of Orange County the treasurer Citron with initial profit from yield curve
play strategy leveraged its position and led to bankruptcy. The best way to
avoid this situation is to avoid linking the treasurer‟s salary with the profit he
made for the organization.
Specify the Risk Limits
Proper monitoring is prerequisite for the trader to ensure that he/she should
switch from arbitrageur to speculator. Above mentioned Baring Bank‟s case is
a leading example for the bankruptcy of same bank as his positions remained
unmonitored and unquestionable by the management.
The best way to avoid the situation of overtrading is to limit the sizes positions
that can be taken by a trader, and it should be accurately reported from risk
perspective. The management should ensure that the limits specified should be
strictly obeyed and even daily reports of various positions taken by each trader
Page | 16
(though a star performer) should be obtained and scrutinized before the things
goes out of control.
Separation of Front, Middle and Back Offices
The three offices though are interlinked but they discharge separate functions.
Accordingly, there should be a firewall in the functioning of these offices i.e.
person of one office should not have the access to the functioning of other
office. Barings bank‟s case is a classic example where Nick Leeson carried out
manipulations in back office (which was under his control also) and hid the
losses in error account.
To ensure that these three offices work independently it is essential that role
and functions of each office should be clearly defined and followed.
Ensure that a hedger should not become a speculator
In most of the cases discussed above hedgers/arbitrageur have become

speculators and leveraged their position.
To avoid this situation, it is essential that clear cut risk limits should be
defined. Further before entering into any trading strategy proper risk analysis
should be carried out and if proposed strategy is crossing the limits of Risk
Appetite of the company it should be avoided.
Carry out Stress Test, Scenario Analysis etc.
As mentioned in above case of BT where Gibson Greetings was of belief that the
interest rates shall remain lower and to some extent ignored the possibility of
increasing of interest rates by 1%. But it happened and ultimately Gibson
Greetings faced a huge loss.
To counter this type of unpredictable situation it is necessary that VAR

analysis should always be followed by Scenario Analysis because as tendency a
human being normally can anticipate two to three scenarios. It will be better to
refer the data of at least 10 to 20 years to anticipate a Black Swan event.
Further even Simulation Test can be applied to analyze the results in various
possible situations.
Page | 17
Question – 01
ABC Ltd. is a pharmaceutical company possessing a patent of a drug called

„Aidrex‟, a medicine for aids patient. Being an approach drug ABC Ltd. holds
the right of production of drugs and its marketing. The period of patent is 15
years after which any other pharmaceutical company produce the drug with
same formula. It is estimated that company shall require to incur $ 12.5
million for development and market of the drug. As per a survey conducted the
expected present value of cash flows from the sale of drug during the period of
15 years shall be $ 16.7 million. Cash flow from the previous similar type of
drug have exhibited a variance of 26.8% of the present value of cash flows. The
current yield on Treasury Bonds of similar duration (15 years) is 7.8%.
Determine the value of the patent.
Given ln(1.336) =0.2897
e1.0005 = 0.3677 and e-1.17 = 0.3104
SOLUTION:
The given solution is like valuation of stock option wherein delay in

introduction of drug „Aidrex‟ shall cause the loss of cash flow which is like
payment of dividend.
To value the patent, we shall use Black Scholes Model for option pricing as
follows:
Inputs
S (Spot Price) = The Present Value of Cash flows = $16.7

million
E (Exercise Price) = Cost of Development Formula = $ 12.5 million
σ2(Variance of Cash flow) = 26.8% i.e. 0.27
R (Risk Free Rate of Return) = 7.8%
1
D (Expected cost of Delays) = = 0.0667 i.e. 6.67%
15
Value call option
C = Se-df – Ee–rt N(d2)
Page | 18
S 1
In + R-D + σ2 t
E 2
d1 =
σ t
d2 = d1 - σ t
Accordingly,
16.7 1
In + 0.078-0.0667 + 0.268 15
12.5 2
d1 =
0.268 15
0.2897 + 0.1453 15
D1 =
0.5177 × 3.8730
0.2897 + 2.1795
D1 =
2.005
2.4692
D1 = = 1.2315
2.005
d2 = 1.2315 – 2.005
d2 = -0.7735
N(d1) = 0.8910
N(d2) = 0.2196
Value of Patent
= 16.7 × e-0.0667×15 × 0.8910 – 12.5 × e-0.078×15 × 0.2196
= 16.7 × 0.3677 × 0.8910 – 12.5 × 0.3104 × 0.2196
= 5.471 – 0.852 = 4.619
Thus, the value of patents is $ 4.619 million
QUESTION – 02
IPL already in production of Fertilizer is considering a proposal of building a
new plant to produce pesticides. Suppose the PV of proposal is ₹ 100 crore
without the abandonment option. However, if market conditions for pesticide
turns out to be favorable the PV of proposal shall increase by 30%. On the
other hand, market conditions remain sluggish the PV of the proposal shall be
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reduced by 40%. In case company is not interested in continuation of the

project it can be disposed of for ₹ 80 crore.
If the risk-free rate of interest is 8% then what will be value of abandonment

option.
SOLUTION:
Decision Tree showing pay off
Year 0 Year 1 Pay off
130 0
100
60 80 - 60 = 20
First of all we shall calculate probability of high demand (P) using risk neutral
method as follows:
8% = p × 30% + (1-p) × (-40%)
0.08 = 0.30 p - 0.40 + 0.40p
0.48
P = = 0.686
0.70
The value of abandonment option will be as follows:
Expected Payoff at Year 1
= p × 0 + [(1-p) × 20]
= 0.686 × 0 + [0.314 × 20]
= ₹ 6.28 crore
Since expected pay off at year 1 is ₹ 6.28 crore. Present value of expected pay
off will be:
6.28
= ₹ 5.81 Crore.
1.08
This is the value of abandonment option (Put Option).
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QUESTION – 03
Suppose MIS Ltd. is considering installation of solar electricity generating plant
for light the staff quarters. The plant shall cost ₹ 2.50 crore and shall lead to
saving in electricity expenses at the current tariff by ₹ 21 lakh per year forever.
However, with change in Government in state, the rate of electricity is subject

to change. Accordingly, the saving in electricity can be of ₹ 12 lakh or ₹ 35
lakh per year and forever.
Assuming WACC of MIS Ltd. is 10% and risk-free rate of rate of return is 8%.
Decide whether MIS Ltd. should accept the project or wait and see.
SOLUTION:
Here we shall evaluate NPV in two possible situations:
(1) As on Today
At cost of Capital of 10%, the value of saving forever
₹ 21 lakhs
= = ₹ 2.1 crore
0.10
NPV = ₹ 2.1 crore − ₹ 2.5 crore = - ₹ 0.4 crore
Since NPV is negative, it does not worth to accept the project.
(2) After one Year
After one year these are two possible situations, either rate of electricity
decreases or increase.
(a) If price of electricity increases
₹ 35 lakhs
= = ₹ 3.50 crore
0.10
The position of the NPV will be as follows:
= ₹ 3.50 crore − ₹ 2.50 crore = ₹ 1 crore
And Rate of Return will be (3.5/2.5) - 1 = 0.40 is 40%
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(b) If the price of electricity decreases, then value of saving forever will
be
₹ 12 lakhs
= = ₹ 1.20 crore
0.10
The position of the NPV will be as follows:
= ₹ 1.20 crore − ₹ 2.5 crore = - ₹ 1.3 crore
and Rate of Return will be (1.2/2.5) - 1 = -0.52 i.e. – 52.00%
Diagrammatically it can be shown below
₹ 3.50 crore
₹ 2.5 crore
₹ 1.20 crore
Let prob. of price increase be p. Then using Risk Neutral Method, the risk-free
rate of return will be equal to expected saving as follows:
p × 0.40 + (1-p) (-0.52) = 0.08
0.40p − 0.52 + 0.52p = 0.08
0.92p = 0.60
p = 0.652
Hence, expected pay off = 0.652 × ₹ 1 crore + 0.348 × (-₹ 1.30 crore)
= ₹ 19.96 lakh.
PV of Pay off after one year = ₹ 19.96 lakh/ 1.08 = ₹ 18.48 lakh.
Thus, it shall be advisable to wait and see as NPV may turn out to be positive
after one year.
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BUSINESS VALUATION
BUSINESS VALUATION
GOING CONCERN AND NON-GOING CONCERN VALUATION
One of the basic accounting assumptions is that an enterprise is a going

concern and will continue in operation for the foreseeable future. Hence, it is
assumed that the enterprise has neither the intention nor the need to liquidate
or curtail materially the scale of its operations; if such an intention or need
exists, the financial statements may have to be prepared on a different basis
and, if so, the basis used needs to be disclosed.
The valuation of assets of a business entity is dependent on this assumption.

Traditionally, historical costing is followed in majority of the cases.
Non-Going Concern Valuation is also known as Liquidation Valuation because

it is the net value realized after disposing off all the assets and discharging all
the liabilities. Since an on-going firm could continue to earn the profit, which
contributes to its value in addition to its liquation value the Going Concern
Value is known as Total Value.
Generally, the going-concern value of a firm will be greater than its liquidation
value because when it is acquired as on basis the value of its assets and
considers the value of its future profitability, intangible assets, and goodwill
and hence the acquired firm can charge premium for the same.
Another reason for lower valuation on non-going concern is that liquation not
only implies the laying off its employees and, but it creates a feeling of bad
reputation among potential investors.
Thus, valuation based on non-going concern should be applied only when

investors are of view that the firm has no longer value as a going concern.
VALUATION OF DISTRESSED COMPANIES
Some firms are clearly exposed to possible distress, though the source of the
distress may vary across firms. For some firms, it is too much debt that creates
the potential for failure to make debt payments and its consequences
(bankruptcy, liquidation, and reorganization) whereas for other firms, distress
may arise from the inability to meet operating expenses.
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BUSINESS VALUATION
A company is said to be in distress when the company is unable to meet, or

has difficulty paying off, its financial obligations to its creditors, typically due to
high fixed costs, illiquid assets, or revenues being sensitive to economic
downturns. Such distress can lead to operational distress as increasing costs
of borrowings take a toll on the operations of the company as well.
Distressed companies are businesses that are likely to, or already have
defaulted on their debts. Although a company may not be making payments on
some, or all of its debt obligations, however there still may be some value
remaining on the instruments they hold. Just because a company cannot make
payments on its debt does not mean the company is entirely worthless.
Conventional methods are not usefully deployed when valuing companies in

distress as:
 Discounted cash flow valuation method required terminal value

calculation which is based upon an infinite life and ever-growing cash
flows. However, the assumption of perpetuity of cash flows may not be
relevant in case of distressed firm because of negative cash flows.
 A distressed firm generally has negative and declining revenues hence

expects to lose money for some more time in the future. For such firms,
estimating cash flows is difficult, since there is a high risk of bankruptcy.
For firms expected to fail, DCF does not work very well, since DCF values
a firm as a going concern – even if the firm is expected to survive,
projections have to be made until the cash flows turn positive, else the
DCF would yield a negative value for equity or firm.
 Discount rates used in conventional methods reflect companies which

are operationally as well as financially sound. They have to be adjusted
for the probabilities of failures of the companies to be used in case of
distressed companies.
Methods of valuation of distressed companies
The above-mentioned reasons warrant adjustments or amendments and

modifications to be made to the conventional methods to eliminate any issues
that may arise in the valuation of a distressed company.
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BUSINESS VALUATION
Modified Discounted Cash Flow Valuation
This method requires coming up with probability distributions for the cash
flows (across all possible outcomes) to estimate the expected cash flow in each
period. While computing this cash flow the likelihood of default should be
adjusted for. In conjunction with these cash flow estimates, discount rates are
also estimated:
 Using updated debt to equity ratios and unlevered beta to estimate the
cost of equity.
 Using updated measures of the default risk of the firm to estimate the
cost of debt.
However, in case of inability to estimate the entire distribution, probability of

distress shall be estimated for each period and used as the expected cash flow:
Expected cash flowt = Cash flowt * (1 - Probability of distresst)
DCF Valuation + Distress Value
A DCF valuation values a business as a going concern. However, DCF

valuations will understate the value of the firm if there is a possibility that the
firm will fail before it reaches stable growth, and the assets will be sold for a
value less than the present value of the expected cash flows (a distress sale
value).
Thus, the value of Distressed firm can be computing by following under-

mentioned steps:
(i) Value the business as a going concern by looking at the expected cash
flows it will have if it follows the path back to financial health.
(ii) Determine the probability of distress over the lifetime of the DCF
analysis.
(iii) Estimate the distress sale value as a percentage of book value or as a

percentage of DCF value of equity estimated as a going concern.
Accordingly following formula can be used to calculate the value of equity of a

distressed firm.
Value of Equity= DCF value of equity (1 - Probability of distress) + Distress sale

value of equity (Probability of distress)
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BUSINESS VALUATION
Adjusted Present Value Model
This approach is based on the logic of separating investment decision from

financing decision. Accordingly, first the value of firm is computed without debt
(the unlevered firm) and then effect of debt on firm value is adjusted in the
same:
Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected

Bankruptcy Cost from the Debt)
While the first part can be computed by discounting the free cash flows to the
firm at the unlevered cost of equity the second part reflects the present value of
the expected tax benefits from the use of debt. The expected bankruptcy cost
can be estimated as the difference between the unlevered firm value and the
distress sale value:
Expected Bankruptcy Costs = (Unlevered firm value - Distress Sale Value)*

Probability of Distress
Relative Valuation
Relative Valuation multiples such as Revenue and EBITDA multiples are used
more popular measures to value distressed firms than healthy firms because
multiples such as Price Earnings or Price to Book Value etc. often cannot even
be used for a distressed firm. Analysts who are aware of the possibility of
distress often consider them subjectively at the point when they compare the
multiple for the firm they are analyzing to the industry average. For example,
assume that the average telecom firm trades at 2 times revenues. So, adjust
this multiple down to 1.25 times revenues for a distressed telecom firm.
VALUATION OF START UPS
As discussed, earlier following are three most common globally accepted

methods of valuing a business:
(i) Earning/ Cash Flow Approach: In this approach, estimated cash flows
for the foreseeable future are discounted to present value and business is
valued accordingly.
(ii) Asset Approach: This approach is generally used when the business is
not a going concern viz. during liquidation, untimely losses etc. The
assets and liabilities are valued based on their current realizable value
and that is considered as value of the business.
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BUSINESS VALUATION
(iii) Market Approach: This approach assigns the value of a business based
on the value of comparable companies in same/ similar industries,
adjusted for their specific parameters.
One common feature in the above approaches is that it pre-supposes a

business that is established and generates cash flows using its assets.
On the contrary it is difficult to call Start-ups “established” in any sense or

assume that their cash flows (if not already spent on marketing) will remain
constant. Profitability seems to be a cursed word in the startup investor circles.
Like the valuation of startups is often required for bringing in investments

either by equity or debt. However, the most significant differentiating factor in
the valuation of a startup is that there is no historical data available based on
which future projections can be drawn.
The value rests entirely on its future growth potential, which, in many cases, is
based on an untested idea and may not have been based on an adequate
sampling of consumer behaviour or anticipated consumer behaviour. The
estimates of future growth are also often based upon assessments of the
competence, drive, and self-belief of, at times, very highly qualified and
intelligent managers and their capacity to convert a promising idea into
commercial success.
The major roadblock with startup valuation is the absence of past performance
indicators. There is no „past‟ track record, only a future whose narrative is
controlled based on the founders‟ skill. It can be equated as founders walking
in the dark and making the investors believe that they are wearing night vision
goggles. While this is exciting and fun for the founders, this is risky for the
investors.
This is why valuation of startups becomes critical and the role of a professional
comes in – it is a way of definitively helping investors navigate the dark using
facts, rather than fairy tales.
Why traditional methods cannot be applied?
Each of the commonly used methods discussed above pre-suppose an

established business – which is profitable, has established competitors and
generates cash using its assets.
• However, this is missing in new age startups whose value can lie majorly in
the concept and potential rather than numbers with a track record.
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BUSINESS VALUATION
The failure of each of the traditional methods in case of new age startups is
tabulated below:
Method Why does it fail in case of new age startups

Income A vast majority of startups operate under the assumption of not
approach generating positive cash flows in the foreseeable future. Off late,
this business model has been accepted and normalized by the
investor community as well. Since there are no or minimal
positive cash flows, it isn‟t easy to value the business correctly.
Asset There are two reasons why this approach does not work for new
approach age startups:
(i) Startups have negligible assets because a large chunk of
their assets are in the form of intellectual property and
other intangible assets. Valuing them correctly is a
challenge and arriving at a consensus with investors is
even more difficult.
(ii) Start ups are new, but usually operate under the going
concern assumption; hence their value should not be
limited to the realisable value of assets today.
Market New-age startups are disruptors. They generally function in a
approach market without established competitors. Their competition is
from other startups working in the same genre. The lack of
established competitors indicates that their numbers may be
skewed and not be comparable enough to form a base.
However, out of the three traditional approaches, we have seen
a few elements of the market approach being used for valuing
new-age startups, especially during advanced funding rounds.
Value Drivers for Startups
While every startup can be vastly different, we now take a look at a few key
value drivers and their impact on the valuation of a startup.
Drivers Impact on valuation

Product The uniqueness and readiness of the product or service
offered by significantly impact the company's valuation. A
company that is ready with a fully functional product (or
prototype) or service offering will attract higher value than
one whose offering is still an „idea‟. Further, market testing
and customer responses are key sub-drivers to gauge how
good the product is.
Management More than half of Indian unicorn startups have founders
from IIT or IIM. While it may seem unfair prima facie, it is a
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BUSINESS VALUATION
fact that if the founders are educated from elite schools and
colleges, the startup is looked upon more favourably by the
investors and stakeholders alike. Accordingly, it is
imperative to consider the credentials and balance of the
management. For instance, a team with engineers is not as
well balanced as a team comprising engineers, finance
professionals and MBA graduates. Keeping aside the
apparent subjectivity in evaluating the management, the
profile of the owners plays a crucial role in valuing the
startup.
Traction Traction is quantifiable evidence that the product or service
works and there is a demand for it. The better the traction,
the more valuable the startup will be.
The more revenue streams, the more valuable the company.
While revenues are not mandatory, their existence is a
better indicator than merely demonstrating traction and
makes the startup more valuable.
Revenue The more revenue streams, the more valuable the company.
While revenues are not mandatory, their existence is a
better indicator than merely demonstrating traction and
makes the startup more valuable.
Industry The industry‟s attractiveness plays a vital role in the value
attractiveness of a company. As good as the idea may be, to sustainably
scale, various factors like logistics, distribution channels
and customer base significantly impacts the startup value.
For example, a new-age startup in the tourism industry will
be less valuable, as innovative or unique as their offering is
if significant lockdowns are expected in the future.
Demand - If the industry is attractive, there will be more demand from
supply investors, making the industry‟s individual company more
valuable.
Competitiveness The lesser the competitors, the more valuable the startup
will be. There is no escaping the first-mover advantage in
any industry. While it is easier to convince investors about a
business that already exists (for example, it must have been
easier for Ola to convince investors when Uber was already
running successfully), it also casts an additional burden on
the startup to differentiate itself from the competition.
Methods for valuing startups
One key observation would be that most value drivers described above are
highly subjective. Hence, there is a need to provide standard methods using
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BUSINESS VALUATION
value drivers above in order to value the startup in a manner comparable to

others.
There are many innovative methods for valuing startups that try to reduce the
subjectivity in the valuation of startups that have come in recent times.
Let us take a look at the most common methods of valuing startups:
Berkus Approach
The Berkus Approach, created by American venture capitalist and angel

investor Dave Berkus, looks at valuing a startup enterprise based on a detailed
assessment of five key success factors:
(1) Basic value,
(2) Technology,
(3) Execution,
(4) Strategic relationships in its core market, and
(5) Production and consequent sales.
A detailed assessment is carried out evaluating how much value the five critical
success factors in quantitative measure add up to the total value of the
enterprise. Based on these numbers, the startup is valued.
This method caps pre-revenue valuations at $2 million and post-revenue

valuations at $2.5 million. Although it doesn‟t consider other market factor, the
limited scope is useful for businesses looking for an uncomplicated tool.
Cost-to-Duplicate Approach
The Cost-to-Duplicate Approach involves taking into account all costs and
expenses associated with the startup and its product development, including
the purchase of its physical assets. All such expenses are considered determine
the startup‟s fair market value based on all the expenses. This approach is
often criticized for not focusing on the future revenue projections or the assets
of the startup.
Comparable Transactions Method
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BUSINESS VALUATION
With the traditional market approach, this approach is lucrative for investors
because it is built on precedent. The question being answered is, “How much
were similar startups valued at?”
For instance, imagine XYZ Ltd., a logistics startup, was acquired for Rs 560
crores. It had 24 crore, active users. That‟s roughly Rs 23 per user.
Suppose you are valuing ABC Ltd, another logistics startup with 1.75 crore
users. ABC Ltd. has a valuation of about Rs 40 crores under this method.
With any comparison model, one needs to factor in ratios or multipliers for
anything that is a differentiating factor. Examples would be proprietary
technologies, intangibles, industry penetration, locational advantages, etc.
Depending on the same, the multiplier may be adjusted.
Scorecard Valuation Method
The Scorecard Method is another option for pre-revenue businesses. It also

works by comparing the startup to others already funded but with added
criteria.
First, we find the average pre-money valuation of comparable companies. Then,

we consider how the business stacks up according to the following qualities.
• Strength of the team: 0-30%
• Size of the opportunity: 0-25%
• Product or service: 0-15%
• Competitive environment: 0-10%
• Marketing, sales channels, and partnerships: 0-10%
• Need for additional investment: 0-5%
• Others: 0-5%
Then we assign each quality a comparison percentage. Essentially, it can be on

par (100%), below average (100%) for each quality compared to competitors/
industry.
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BUSINESS VALUATION
For example, the marketing team has a 150% score because it is thoroughly
trained and has tested a customer base that has positively responded. You‟d
multiply 10% by 150% to get a factor of .15.
This exercise is undertaken for each startup quality and the sum of all factors
is computed. Finally, that sum is multiplied by the average valuation in the
business sector to get a pre-revenue valuation.
First Chicago Method
This method combines a Discounted Cash Flow approach and a market

approach to give a fair estimate of startup value. It works out:
• Worst-case scenario
• Normal case scenario
• Best-case scenario
Valuation is done for each of these situations and multiplied with a probability
factor to arrive at a weighted average value.
Venture Capital Method
As the name suggests, venture capital firms have made this famous. Such
investors seek a return equal to some multiple of their initial investment or will
strive to achieve a specific internal rate of return based on the level of risk they
perceive in the venture.
The method incorporates this understanding and uses the relevant time frame
in discounting a future value attributable to the firm.
The post-money value is calculated by discounting the rate representing an

investor‟s expected or required rate of return.
The investor seeks a return based on some multiple of their initial investment.
For example, the investor may seek a return of 10x, 20x, 30x, etc., their
original investment at the time of exit.
New-age startups are disruptors in their own right and a necessary tool for
global innovation and progress. By their very nature, startups disrupt set
processes and industries to add value. In that process, they transcend
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BUSINESS VALUATION
traditional indicators of success like revenues, profitability, asset size, etc.

Accordingly, it is no mean feat to uncover the actual value of a startup.
While the traditional methods fall short, there is no shortage of new innovative
methods used to value startups based on their value drivers. However, the
valuation of a startup is much more than the application of ways – it is about
understanding the story of the future trajectory and communicating that
narrative using substantial numbers.
VALUATION OF DIGITAL PLATFORMS
A digital platform is a software based online infrastructure that facilitates

interactions and transactions between users. Principally platforms are built to
facilitate many to many interactions. A few illustrations based on the kind of
services provided are as under:
Category Descriptions
Marketplace Multiple buyers are matched to multiple suppliers.
For example: Booking.com connects guests to hotels, while

Uber links travelers to drivers, Amazon connects sellers and
buyers through its platform.
Search engine Multiple people looking for information are matched to
multiple sources of information. As a search request triggers
the system to actively seek out the desired information, it is
also called a search engine.
For example: Google, Bing, and Baidu

Repository Multiple suppliers „deposit‟ their materials into a type of
library, to be retrieved by users at a later moment.
For example: Spotify, YouTube, GitHub

Digital Multiple users to send messages and/or documents to a
communication variety of other people, or interact in real time via voice as
well as video.
For example: Whatsapp, Microsoft Teams, Telegram, Slack

etc are internet-based communication platforms.
Digital On a digital community platform, people who want to
community remain virtually connected for a longer period of time can
find each other and interact.
For example: Facebook lets one build one‟s own network of

friends, LinkedIn plays a similar role in the business
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BUSINESS VALUATION
context.
Payments On a digital payment platform, matching takes place
Platform between those owing money and those wanting to be paid.
For example: Paytm, GPay, are directed at online

consumers and facilities payments across vendors.
The principles of valuation for digital platform are largely like other types of
companies with certain nuances which are peculiar to the digital platform
industry.
Income Approach
As mentioned earlier, valuation methods under the Income Approach lay

emphasis on projected financial performance which takes into consideration
future revenues and costs using company specific revenue and cost drivers and
applicable capital expenditure and working capital cycles.
Backward working is required under the Top-Down Approach, which starts

with analysis of the total potential market for the Platform on a global or
domestic level. This is often referred to as Total Addressable Market („TAM‟).
The next step is to estimate the share in this target market, the company
estimates to gain in the future, and the time to reach such share. These are
often referred to as Serviceable Addressable Market („SAM‟) and Serviceable
Obtainable Market („SOM‟). The company then needs to estimate its business
plan to accomplish its objectives and the strategy. This would involve
estimating the manner in which the company will gain market share and
increase its revenues while optimizing cash or utilizing cash. The financial
forecast should take into consideration the types and features of the business
model of the platform. A digital repository which allows streaming of content
may earn revenue based on its subscribers while a payments solution platform
may earn revenues based on the number of transactions done using the same.
The direct operating costs for these types of platforms shall also be unique to
each type of platform or platform business.
It has often been seen in the digital platforms businesses that in order to create
market share companies and popularize the platform among end users,
companies have to resort to penetrative strategies by burning cash on books
and keeping lower margins. The cash requirement is expected to reduce with
time as profit margins become stable and the rate of reinvestment reduces.
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BUSINESS VALUATION
The Top-Down Approach can be ambitious for a company at a nascent stage as

estimating market size and market share poses its practical challenges. Under
the Bottom-Up Approach the Platform can estimate its earnings based on the
limited resources it has. A young Platform can estimate its revenue and costs
given its financial constraints. The promoters of such platform can deploy
appropriate strategies to target high margin sales and cost cutting
methodologies to generate more cash for the Platform. This is more in line to
making efficient capital budgeting decision, which will ultimately help to
forecast earnings and cash flows.
Under both the scenarios i.e Top-Down or Bottom-up, the value of a digital
platform will depend on the quality of the financial forecasts. In the digital
platform the growth and survival of an entity is highly dependent on its
promoters, investors and stakeholders creating products or services that fill or
meet a need in the market, and their capability to execute their products and
services efficiently by adapting to unexpected circumstances.
Discounting Rate
The discounting rate used should be based upon the type of cash flows being
discounted. The free cash flow to the Firm ('FCFF‟) should be discounted using
the Weighted Average Cost of Capital ('WACC‟) and the free cash flow to Equity
should be discounted at the Cost of Equity Capital („Ke‟).
CAPM can be used to calculate the Cost of Equity which is calculated as under:
R = rf + β (rm − rf)
Where R = expected rate of return
rf = risk free rate of return
β = Beta value of the stock
rm = market rate of return
Specific Considerations
(a) Beta measures the sensitivity of a stock or company to the market.

Practically, the beta of a company is estimated based on the sensitivity of
the share price of the stock, its comparable or the industry with respect
to the market. Due to the unique nature of each digital platform and
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BUSINESS VALUATION
scarcity of listed traded comparable, estimating beta becomes

challenging. One might need to draw a comparison between the general
diversified sector, the industry driving the revenue or international
comparable.
(b) The survival of such a digital platform is highly dependent upon the
quality of management, ability to adapt to change quickly, and foresee
opportunity.
Thus, there are certain specific risks of a digital platform that cannot be
estimated using CAPM with regard to only the industry or general sector beta.
A Company Specific Risk Premium („CSRP‟) or Alpha needs to be estimated and
added to determine the appropriate cost of equity used to discount the
estimated cash flows. The CSRP for nascent companies would be higher than
mature digital platforms with adequately large operations having a large
customer base.
Market Approach
The Market Approach values a company by drawing a comparison from similar

valued companies based on multiples like profit to earnings („P/E‟) ratio,
Enterprise Value to Earnings before Interest, Tax, Depreciation and
Amortization („EV/EBITDA‟) ratio, Price to Book Value ratio, Price to
Revenue/Sales Ratio. The selection of comparable to draw such comparison is
vital and parameters like the market capitalization, revenue, Profit margins,
capital structure etc. are used while making the selection.
However, in case of digital platform, such comparison becomes difficult due to

the following reasons:
• The listed comparables are scarce and even absent for many platforms.
• The underlying value specifically Profit and EBITDA may be negative for
certain digital platforms.
• Such digital platforms are capital-lite making their Book Value very low.
Due to the above complexity, the application of Market Approach for digital
platform, lays emphasis on revenue of a digital platform. Comparison is sought
on the manner the platform envisages its primary driver of revenue.
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BUSINESS VALUATION
Certain examples of the drivers of revenue that can be used as a basis are as
under:
Category of Digital Platform Drivers of Revenue

Market Place No of Booking made, No of registered
(Matching Supply and Demand) users, volume of Transactions
Payment No of active subscriber, No of merchants
(Matching Billing and Payments) registered on the platform, Compatibility
and speed of the operating system,
Security, Ease of Use
Community Number of users, subscription fees,
(Network of Contacts) platform for professionals
Communication Number of users, sponsored links,
(Network for Messaging) advertising revenue
Repository Number of readers and contributors,
(Supply Library) authenticity of data, duration of use,
quality and variety of data
Search Number of users, relevant search results,
(Machine Queries and Information) time taken per search
Two Search engines can be compared based on their total number of active
users and the average time taken to show relevant search results. The one with
more relevant search results in shorter time, shall be valued at a premium and
can be used as a base for comparison.
For a repository platform that seeks to draw subscription or advertising

revenue based on the number of times the content is viewed on its platform
and the duration of such visit, comparison can be drawn based upon the
number of users, the average number of views per user and the average
revenue per user.
Example: A Search engine platform Company valued at 100.00 Cr with a

subscriber base of 50 million users and content of 100,00 hours can be used to
draw a comparison while valuing a similar platform with fewer users however
having same or similar revenue parameters.
Cost Approach
The Cost Approach estimates the value based on the sum total of the cost to
build the same platform or similar platform with the same utility. Since, the
asset behind the digital platform is the code written, the numbers of hours
spent to write the code by the developers is the primary cost of the platform.
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BUSINESS VALUATION
However, this approach may not be most appropriate as it fails to take into
account the revenue generating capacity of the digital platform which may
create significantly higher value for the shareholders of the company versus the
cost spent on developing the platform.
The valuation of digital platform can be tricky based on the peculiarities as

mentioned above. However, the fundamentals of valuation remain the same.
The understanding of the business, the revenue model, the quality of
management, and the risk-reward parameters determine the value of the digital
platform.
VALUATION OF PROFESSIONAL/ CONSULTANCY FIRMS
The professional services firms can be defined as firms that provide

customized, knowledge-based services to clients such as Chartered
Accountants, Advocates, Management Consultancy firms etc. Even within
industry firms vary significantly due to the different nature of services each
firm provides.
Like any other business valuation understanding the present and projected
industry trends plays a significant role in determining an accurate valuation
amount but experts generally look at the firm‟s historical data to compare them
with industry Key Performance Indicators (KPIs) and benchmarks. Further,
generally valuation experts compare the company against its competitors. The
main source of information are Audited Annual Statements and Income Tax
Returns etc.
As mentioned earlier when using the income approach while historical data is
important, projected growth (Terminal Value) also impacts the overall value.
Although Valuation experts plan for future growth and compare it to the
projected trends after conversations with management but there is an inherent
risk associated with using future earnings potential, as results may or may not
materialize. Hence, this risk should be factored into the overall calculation.
In addition to analysis of financial statements and their comparison to industry

standards, normalization of net income and cash flows is another important
aspect. This step allows comparison of firms on equal footing. This step
involves adding back of non-cash items and specific items, which might not
apply to a new firm. Then these normalized cash flows are applied to the
chosen valuation method and used in calculating overall value.
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BUSINESS VALUATION
One commonly used method to analyse the extent that a firm meets
expectations in comparison to current industry benchmarks and KPIs. Since
professional services includes several different types of firms, KPIs can vary
greatly and hence it is equally important to look at specific indicators which
align with acquirer firm‟s goals.
To accurately value a professional services firm each piece of information

contributes importantly.
IMPACT OF ESG ON VALUATION
As per Wikipedia Environmental, Social, Governance (ESG) is a framework

designed to be embedded into an organization's strategy that considers the
needs and ways in which to generate value for all organizational stakeholders
(such as employees, customers and suppliers and financiers).
Illustrative list of contents included in these three factors are as follows:
Environmental Social Governance
Climate change Employee development Board Independence
Water Diversity & inclusion Board diversity
Waste generation Community development Anti-Corruption & Bribery
Emissions Health & Safety Tax transparency
Biodiversity Customer Ethical conduct
ESG is on the radar of several investors today. Focusing on ESG issues can
bring out risk and opportunities for the company‟s ability for sustainable value
creation. The key environmental aspects under consideration are climate
change and natural resource scarcity. It covers social issues like diversity and
inclusivity, labor practices, health & safety, and cyber security. There is greater
emphasis on governance aspect covering topics like board diversity and
independence, executive pay, and tax transparency.
There has been tremendous momentum in the whole ESG game plan and the
summary of key developments are captured as below:
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BUSINESS VALUATION
 Investment pace in ESG funds: ESG funds tapped in excess of $ 50

billion in 2020 and total assets with ESG focus crossed more than $35
trillion in the same period.
 Green bonds have been of significant focus: The green bonds market in
2020 crossed a major milestone of $ 1 trillion dollars.
 Sustainability taxonomy on the rise: Key regions have already defined

sustainability taxonomy for e.g. European Union (EU). Several other
countries / region are in process of introducing taxonomy related to
sustainability / ESG.
 Up next - Convergence of ESG framework: IFRS launched an important

work to develop single global reporting standard on ESG.
 SEBI - SEBI (Securities Exchange Board of India) in February 2023

proposed a regulatory framework on ESG disclosures by listed entities.
The ESG performance and linked ratings have begun to play an influencing
role for companies going to market to raise funds for future growth. The high
ESG focus from investors, lenders and financial institution in the recent times
has reached the tipping point and have started to impact the financing options
for companies. Companies with high ESG focus stand to get benefits in the
form of preferential / lower cost of debt or access to specialized financial
products like the Green, Social and Sustainability linked Bonds.
Traditional belief was that ESG was „good to have‟ in the area of business
ethics, sustainability, diversity and community. However with the heightened
interests from different stakeholders groups, directors realize that it is now
moving into the „must-to-have‟ territory. The business case for ESG generally
begins with operational efficiency and risk reduction as primary goals and then
extends to longer-term operational and organizational resiliency and
sustainability. Boards recognize the strong and direct link to build a profitable
business with a strong focus on environmental and social considerations. They
also know that focus on ESG issues requires robust governance practices
which will fortify their company‟s portfolio as a strong contender with investors
and shareholders.
Now question arises how the risks of ESG factors can be incorporated in the
Valuation of any business. As mentioned earlier the most popular technique of
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valuing any business is discounting of Future Cash Flows. Accordingly, the

impact of these risks can be incorporated either in discount rate or expected
cash flows.
Generally, management and investors are more interested in adjusting

discount rate by inclusion of risk premium in the same. Even though this
approach is more practical but the impact of ESG factors may not be that
much explicit. Hence adjustment of ESG factors in cash flows would be more
explicit.
Now let see how the impact of each factor can be incorporated in computation
of expected cash flows:
(i) E of ESG: The risk of this factor (Environment) can be incorporated by

carrying out 2-degree scenario analysis i.e. if temperature of the plant is
increased by 2 degrees. Similarly, adjustment in cash flows can be made
by considering carbon points.
(ii) S of ESG: The risk of this factor (Social) can be considered by adjusting
the impact of social measures cost on the revenue such as better labour
working conditions, CSR, and other welfare measures for the various
stakeholders.
(iii) G of ESG: The risk of this factor (Governance) can be considered by

adjusting the impact of poor governance on revenue in the form of
penalty, fines, taxes etc.
CASE STUDIES
A couple of real life case studies would help us to understand the Concepts
better –
Case Study 1
The application of ‘valuation’ in the context of the merger of Vodafone

with Idea Cellular Ltd:
The valuation methods deployed by the appointed CA firms for the merger were
as follows:
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BUSINESS VALUATION
(a) Market Value method: The share price observed on NSE (National Stock
Exchange) for a suitable time frame has been considered to arrive at the
valuation.
(b) Comparable companies‟ market multiple method: The stock market

valuations of comparable companies on the BSE and NSE were taken
into account.
(c) NAV method: The asset based approach was undertaken to arrive at the
net asset value of the merging entities as of 31st December 2016.
Surprisingly, the DCF method was not used for valuation purposes. The reason
stated was that the managements to both Vodafone and Idea had not provided
the projected (future) cash flows and other parameters necessary for
performing a DCF based valuation.
The final valuation done using methods a to c gave a basis to form a merger
based on the „Share Exchange‟ method.
Above information extracted from: „Valuation report‟ filed by Idea Cellular with
NSE
However, let‟s see how the markets have reacted to this news – the following
article published in The Hindu Business Line dated 20th March 2017 will give
a fair idea of the same:
“Idea Cellular slumped 9.6 per cent as traders said the implied deal price in a
planned merger with Vodafone PLC's Indian operations under-valued the
company shares. Although traders had initially reacted positively to the news,
doubts about Idea's valuations after the merger sent shares downward.
Idea Cellular Ltd fell as much as 14.57 per cent, reversing earlier gains of
14.25 per cent, after the telecom services provider said it would merge with
Vodafone Plc's Indian operations.”
Hence, we can conclude that the valuation methods, though technically

correct, may not elicit a positive impact amongst stockholders. That is because
there is something called as „perceived value‟ that‟s not quantifiable. It depends
upon a majority of factors like analyst interpretations, majority opinion etc.
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BUSINESS VALUATION
Case Study 2
Valuation model for the acquisition of ‘WhatsApp’ by Facebook
Facebook announced the takeover of WhatsApp for a staggering 21.8 billion

USD in 2015. The key characteristics of WhatsApp that influenced the deal
were –
(a) It is a free text-messaging service and with a $1 per year service fee, had
450 million users worldwide close to the valuation date.
(b) 70% of the above users were active users.
(c) An aggressive rate of user account increase of 1 million users a day

would lead to pipeline of 1 billion users just within a year‟s range.
The gross per-user value would thus, come to an average of USD 55, which
included a 4 billion payout as a sweetener for retaining WhatsApp employees
post takeover. The payback for Facebook will be eventually to monetize this
huge user base with recalibrated charges on international messaging arena.
Facebook believes that the future lies in international, cross-platform
communications.
Above information extracted from the official website of business news agency
„CNBC‟
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SECURITIZATION
SECURITIZATION
10. TOKENIZATION
Before we discuss the concept of Tokenization it is necessary to understand the

concept of Block-chain.
Block-chain, sometimes referred to as Distributed Ledger Technology (DLT) is a

shared, peer-topeer, and decentralized open ledger of transactions system with no
trusted third parties in between. This ledger database has every entry as
permanent as it is an append-only database which cannot be changed or altered.
All transactions are fully irreversible with any change in the transaction being
recorded as a new transaction. The decentralised network refers to the network
which is not controlled by any bank, corporation, or government. A block chain
generally uses a chain of blocks, with each block representing the digital
information stored in public database (“the chain”).
A simple analogy for understanding block-chain technology is a Google Doc. When

we create a document and share it with a group of people, the document is
distributed instead of copied or transferred. This creates a decentralized
distribution chain that gives everyone access to the document at the same time. No
one is locked out awaiting changes from another party, while all modifications to
the document are being recorded in real-time, making changes completely
transparent. Following figure represents the working of any Block-chain
transaction.
10.1 Applications of Block-chain
Some initiatives that are already existing in various fields like financial services,
healthcare, government, travel industry, economic forecasts etc. are discussed
below:
(a) Financial Services: Block-chain can be used to provide an automated trade

lifecycle in terms of the transaction log of any transaction of asset or property -
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SECURITIZATION
whether physical or digital such as laptops, smart phones, automobiles, real estate,
etc. from one person to another.
(b) Healthcare: Block-chain provides secure sharing of data in healthcare industry
by increasing the privacy, security, and interoperability of the data by eliminating
the interference of third party and avoiding the overhead costs.
(c) Government: At the government front, there are instances where the technical
decentralization is necessary but politically should be governed by governments
like land registration, vehicle registration and management, e-voting etc. Block-
chain improves the transparency and provides a better way to monitor and audit
the transactions in these systems.
(d) Travel Industry: Block-chain can be applied in money transactions and in

storing important documents like passports/other identification cards, reservations
and managing travel insurance, loyalty, and rewards thus, changing the working of
travel and hospitality industry.
(e) Economic Forecasts: Block-chain makes possible the financial and economic
forecasts based on decentralized prediction markets, decentralized voting, and
stock trading, thus enabling the organizations to plan and shape their businesses.
10.2 Risks associated with Block-chain Some of the risk associated with the use
block-chain technology are as follows:
10.2 Risks associated with Blockchain

Some of the risk associated with the use block-chain technology are as follows:
(i) With the use of block-chain, organizations need to consider risks with a wider
perspective as different members of a particular block-chain may have different risk
appetite/risk tolerances that may further lead to conflict when monitoring controls
are designed for a block-chain. There may be questions about who is responsible
for managing risks if no one party is in-charge, and how proper accountability is to
be achieved in a block-chain.
(ii) The reliability of financial transactions is dependent on the underlying
technology and if this underlying consensus mechanism has been tampered with, it
could render the financial information stored in the ledger to be inaccurate and
unreliable.
(iii) In the absence of any central authority to administer and enforce protocol
amendments, there could be a challenge in the development and maintenance of
process control activities and in such case, users of public block-chains find
difficult to obtain an understanding of the general IT controls implemented and the
effectiveness of these controls.
(iv) As block-chain involves humongous data getting updated frequently, risk

related to information overload could potentially challenge the level of monitoring
required. Furthermore, to find competent people to design and perform effective
monitoring controls may again prove to be difficult.
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SECURITIZATION
10.3 Meaning of Tokenization
Tokenization is a process of converting tangible and intangible assets into block-

chain tokens. Digitally representing anything has recently acquired a lot of traction.
It can be effective in conventional industries like real estate, artwork etc.
10.4 Tokenization and Securitization

Since tokenization of illiquid assets attempts to convert illiquid assets into a
product that is liquid and tradable and hence to some extent it resembles the
process of Securitization. Hence, following are some similarities between
Tokenization and Securitization:
(i) Liquidity: - First and foremost both Securitization and Tokenization inject
liquidity in the market for the assets which are otherwise illiquid assets.
(ii) Diversification: - Both help investors to diversify their portfolio thus
managing risk and optimizing returns.
(iii) Trading: - Both are tradable hence helps to generate wealth.

(iv) New Opportunities: - Both provide opportunities for financial institutions
and related agencies to earn income through collection of fees.
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FINANCIAL POLICY
FINANCIAL POLICY
1. ADVANCED ROLE OF CFO IN VARIOUS MATTERS INCLUDING VALUE

CREATION
Traditionally, the main role of CFO was concentrated to wealth maximization for
shareholders by taking care of financial health of an organization and overseeing and
implementing adequate financial controls. However, in recent time because of
globalization, growth in information and communications, pandemic situation etc.
their range of responsibilities has been drastically expanded, driven by complexity and
changing expectations.
Now a days in addition to fulfilling traditional role relating to governance, compliances

and controls, and business ethics as a part of the leadership of role CFOs are also
expected to contribute their support in strategic and operational decision making.
In post-pandemic time their role has been advanced in the following areas in addition
to traditional role:
a. Risk Management: Now a days the CFOs are expected to look after the overall
functioning of the framework of Risk Management system of an organization.
b. Supply Chain: Post pandemic supply chain management system has been posing
the challenge for the company to maintain the sustainable growth. Since CFOs are
care takers of finance of the company, considering the financial viability of the Supply
Chain Management their role has now become more critical.
c. Mergers, acquisitions, and Corporate Restructuring: Since in recent period to

maintain the growth and capture the market share there has been a spate of Mergers
and Acquisitions and hence the role of CFOs has become more crucial because these
are strategic decision and any error in them can lead to collapse of the whole
business.
d. Environmental, Social and Governance (ESG) Financing: With the evolving of the
concept of ESG their role has been shifted from traditional financing to sustainability
financing.
Thus, from above discussion it can be concluded that in today’s time CFOs are taking
a leadership role in Value Creation for the organization and that too on sustainable
basis for a longer period.
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STARTUP FINANCE
START-UP FINANCE
4. CONCEPT OF UNICORN
A Unicorn is a privately held start-up company which has achieved a valuation US$ 1
billion. This term was coined by venture capitalist Aileen Lee, first time in 2013.
Unicorn, a mythical animal represents the statistical rarity of successful ventures.
A start-up is referred as a Unicorn if it has following features:
(i) A privately held start-up.
(ii) Valuation of start-up reaches US$ 1 Billion.
(iii) Emphasis is on the rarity of success of such start-up.
(iv) Other common features are new ideas, disruptive innovation, consumer focus,
high on technology etc.
However, it is important to note that in case the valuation of any start-up slips below
US$ 1 billion it can lose its status of ‘Unicorn’. Hence a start-up may be Unicorn at
one point of time and may not be at another point of time.
In September 2011, InMobi, an ad-tech startup, became the first Unicorn of India.
SoftBank invested US$ 200 million in InMobi valuing the mobile advertising company
at over US$ 1 billion, making it India’s first unicorn. InMobi was founded in 2007 and
took four years to achieve the Unicorn status in 2011 In 2018, Udaan, a B2B e-
commerce marketplace, became the fastest growing startup by becoming a Unicorn in
just over two years’ time.
The names of various startups that became Unicorn during last decade is as follows:
Year of becoming Unicorn Unicorn Name

2011  Inmobi
2012  Flipkart
2013  Mu Sigma
2014  Ola
 Snapdeal
2015  Paytm
 Quikr
 Zomato
2016  Shopclues
 Hike
2017  ReNew
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STARTUP FINANCE
 BillDesk
 Byju’s
 Freshworks
 Oyo
2018  Paytm mall
 PhonePe
 Policy bazaar
 Rivigo
 Swiggy
 Udaan
 Bigbasket
 Delhivery
 Druva
2019  Dream 11
 Icertis
 Lenskart
 Ola Electric
 Cars 24
 Firstery
 Glance
 Nykaa
2020  Pine Labs
 POSTMAN
 Razorpay
 Unacademy
 Dailyhunt
 Zenoti
 Zerodha
 Acko
 Apna
 BharatPe
 Blackbuck
2021  Blinkit
 BrowserStack
 CarDekho
 Chargebee
 CoinDCX
 Coinswitch
 Cred
 Cult fit
 Digit
 Droom
 EaseMyTrip
 ERUDITIS
 GlobalBees
 The Good Glamm Group
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STARTUP FINANCE
 Groww
 Gupshup
 Infra.Market
 Innovaccer
 Licious
 Mamaearth
 MapMyIndia
 Meesho
 MENSA
 Mindtickle
 MobiKwik
 MPL
 Moglix
 NoBroker
 Of business
 PharmEasy
 Pristyn Care
 Rebel Foods
 ShareChat
 Slice
 Spinny
 UpGrad
 Urban Company
 Vedantu
 Zeta
 Zetwerk
 Amagi
 CredAvenue
 Darwinbox
 DealShare
 Elasticrun
2022  Fractal
 Games24×7
 Hasura
 Lead
 Leadsquared
India has now emerged as the 3rd largest ecosystem for startups globally, after US and
China, with over 59,000 DPIIT-recognized startups. As per data available on
InvestIndia.gov.in, as of 7th September 2022, India had 107 unicorns with a combined
valuation of US$ 340.79 billion. The next milestone for a Unicorn to achieve is to
become a Decacorn, i.e., a company which has attained a valuation of more than US$
10 billion. There should be no doubt that within a few years the Unicorns would be a
thing of the past and we would be talking about the Decacorns of India.
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STARTUP FINANCE
7. STARTUP INDIA INITIATIVE
Startup India scheme was initiated by the Government of India on 16 th of January,

2016. As per GSR Notification 127 (E) dated 19th February 2019, an entity shall be
considered as a Startup:
i. Upto a period of ten years from the date of incorporation/ registration, if it is

incorporated as a private limited company (as defined in the Companies Act,
2013) or registered as a partnership firm (registered under section 59 of the
Partnership Act, 1932) or a limited liability partnership (under the Limited
Liability Partnership Act, 2008) in India.
ii. Turnover of the entity for any of the financial years since incorporation/
registration has not exceeded one hundred crore rupees.
iii. Entity is working towards innovation, development or improvement of products

or processes or services, or if it is a scalable business model with a high
potential of employment generation or wealth creation.
Provided that an entity formed by splitting up or reconstruction of an existing

business shall not be considered a ‘Startup’.
What is a Startup to avail government schemes?
Up to 10 years from its date of incorporation / registration
Incorporated as either a Private Limited Company or a Registered Partnership Firm or

a Limited Liability Partnership in India
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STARTUP FINANCE
Turnover for any fiscal year has not exceeded INR 100 crore
Entity should not have been formed by splitting up or reconstructing a business

already in existence
Working towards innovation, development, deployment or commercialization of new

product, processes or services driven by technology or intellectual property
The start-ups story of India got a major boost with the launch of Startup India and
StandUp India programs in year 2016. It helped in creating widespread awareness in
general public about startups and gave a boost to the entrepreneurial mindset. By
setting up a SIDBI-run Electronic Development Fund (EDF), the Indian Government
became a Limited Partner (LP) in a fund for the first time ever. Easy finance options
such as Mudra Scheme, tax benefits such as 100% tax holiday under section 80-IAC
and exemption from angel taxation also provided the much-needed push to the young
Indian start-ups.
In January 2021, the Department for Promotion of Industry and Internal Trade (DPIIT)
created the Startup India Seed Fund Scheme (SISFS) with an outlay of INR 945 Crore
to provide financial assistance to start-ups for Proof of Concept, prototype
development, product trials, market entry, and commercialization. It will support an
estimated 3,600 entrepreneurs through 300 incubators in the next 4 years. A start-up,
recognized by DPIIT, incorporated not more than 2 years ago at the time of application
and having a business idea to develop a product or a service with a market fit, viable
commercialization, and scope of scaling, can apply for SISFS. A start-up can get seed
fund of as much as INR 50 Lakh under SISFS. The priority sectors for SISFS are social
impact, waste management, water management, financial inclusion, education,
agriculture, food processing, biotechnology, healthcare, energy, mobility, defence,
space, railways, oil and gas, and textiles.
Apart from the support from government, there are quite a few other reasons why
India became such a sustainable environment for start-ups to thrive in. Some of the
major reasons are:
Page 5
STARTUP FINANCE
(i) The Pool of Talent - Our country has a big pool of talent. There are millions of
students graduating from colleges and B-schools every year. Many of these students
use their knowledge and skills to begin their own ventures, and that has contributed
to the startup growth in India. In the past, much of this talent was attracted to only
the big companies, but now that is slowly changing.
(ii) Cost Effective Workforce - India is a young country with over 10 million people
joining the workforce every year. The workforce is also cost effective. So, compared to
some other countries, the cost of setting up and running a business is comparatively
lower.
(iii) Increasing use of the Internet - India has the world’s second-highest population,
and after the introduction of affordable telecom services, the usage of internet has
increased significantly. It has even reached the rural areas. India has the second-
largest internet user base after China, and companies as well as start-ups are
leveraging this easy access to the internet.
(iv) Technology - Technology has made the various processes of business very quick,
simple and efficient. There have been major developments in software and hardware
systems due to which data storage and recording has become an easy task. Indian
startups are now increasingly working in areas of artificial intelligence and blockchain
technologies which is adding to the growth of businesses.
(v) Variety of Funding Options Available - Earlier there were only some very
traditional methods available for acquiring funds for a new business model, which
included borrowing from the bank or borrowing from family and friends. However, this
concept has now changed. There are numerous options and opportunities available.
Start-up owners can approach angel investors, venture capitalists, seed funding stage
investors, etc. The easing of Foreign Direct Investment norms and opening up of
majority of sectors to 100% automatic route has also opened the floodgates for foreign
funding in the Indian start-up ecosystem.
8. SUCCESSION PLANNING IN BUSINESS
8.1 Meaning of Succession Planning
Succession planning is the process of identifying the critical positions within an

organization and developing action plans for individuals to assume those positions. A
succession plan identifies future need of people with the skills and potential to
perform leadership roles. Succession planning is an important priority for family
owned businesses as most of them are managed by a non-family leader even though
the ownership lies with the family. Taking a holistic view of current and future goals,
this type of preparation ensures that the right people are available for the right jobs
today and in the years to come. It can also provide a liquidity event, which enables the
Page 6
STARTUP FINANCE
transfer of ownership in a going concern to rising employees. Succession planning is a

good way for companies to ensure that businesses are fully prepared to promote and
advance all employees—not just those who are at the management or executive levels.
8.2 Why is there a need for succession planning?
 Risk mitigation – If existing leader quits, then searches can take six-nine
months for suitable candidate to close. Keeping an organization without leader
can invite disruption, uncertainty, conflict and endangers future
competitiveness.
 Cause removal – If the existing leader is culpable of gross negligence, fraud,

willful misconduct, or material breach while discharging duties and has been
barred from undertaking further activities by court, arbitral tribunal,
management, stakeholders or any other agency.
 Talent pipeline – Succession planning keep employees motivated and

determined as it can help them obtaining more visibility around career paths
expected, which would help in retaining the knowledge bank created by
company over a period of time and leverage upon the same.
 Conflict Resolution Mechanism – This planning is very helpful in promoting

open and transparent communication and settlement of conflicts.
 Aligning – In family owned business succession planning helps to align with

the culture, vision, direction and values of the business.
8.3 Business Succession Strategy
Step 1 – Evaluate key leadership positions:- To evaluate which roles are critical,
risk or impact assessment can be performed. Generally, these are such positions
which would bring transformation to the entire business or create strategic direction
for the organization.
Step 2 – Map competencies required for above positions:- In this step, one needs to
identify qualifications, behavioral and technical competencies required to perform the
role successfully.
Step 3 – Identify competencies of current workforce:- Identifying what are possible

internal options that can deliver results as expected in Step-2, and also if there is a
need for training and development of certain skills required. The organization should
also place weight on whether is there a need to search outside the organization.
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STARTUP FINANCE
Step 4 – Bridge Leader:- In family owned business appointment of an outsider as

‘bridge leaders’ will help to develop the business and prepare young family members
for leadership role.
8.4 Challenges
In context of Start-up following challenges are faced in implementing Succession

Planning.
(1) Founder mindset might be different than the corporate mindset – The way
founder’s brains are wired is different from the way that a traditional corporate
manager thinks, and this puts off seasoned corporate leaders from joining even
matured start-ups.
(2) Premature for startups to implement business succession - Certain startups are
at early growth stage and too much of processes would lead to growth slow-
down and hence they are not in a current stage for implementing business
succession planning.
(3) Founders are the face of startups – One cannot imagine a startup without a
founder who initiated the idea and executed it and in his/ her absence
succession planning can become difficult.
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ADVANCED CAPITAL BUDGETING DECISIONS

ADVANCED CAPITAL BUDGETING

Particulars Plant A Plant B

The annual costs of the two plants are as follows:

Particulars Plant A Plant B

Note: 10 percent interest tables

Calculation of Equivalent Annual Cost

Computation of Cost Per Unit

Calculate Project IRR and Equity IRR. Ignore Corporate taxation.

Explain the difference in Project IRR and Equity IRR.

Project IRR is computed by using the following equation:

CO0 = Cash outflow at time zero

CFi = Net cash inflow at different points of time

N = Life of the project and

R = Rate of discount (IRR)

CO0 = ₹ 200 crores

CFi = ₹ 40 crores p.a. for 15 years

(Refer to working note (i))

The value of IRR of the project:

1. An approximation of IRR is made on the basis of cash flow data. A rough

At 19% = ₹40 crores × PVAF (19%, 15 years)

= ₹40 crores × 4.876

₹203.68 crores −₹ 200 crores

Therefore, the IRR of the project is 18.43%.

(i) Net cash inflow of the project

Toll revenue 50 crores p.a. for 15 years

Toll collection expenses including maintenance 10 crores p.a. for 15 years

of the roads (5% of ₹ 200 crores)

Net cash inflow 40 crores p.a. for 15 years

Computation of Equity IRR

Equity IRRis computed by using the following equation:

Cash inflow at zero date from equity shareholders

Cash inflow available equity for shareholders

n = Life of the project

Here, Cash inflow at zero date from equity shareholders = ₹ 50 crores

Cash inflow for equity shareholders = ₹ 14.35 crores p.a.

(Refer to working note)

The value of equity IRR of the project is calculated as follows:

1. An approximation of IRR is made on the basis of cash flow data. A rough

2. The estimated NPV of the project at 25% = ₹ 14.35 crores × 3.859 = ₹

3. IRR by using Interpolation Formula will be

Amount of loan from financial institution ₹ 150 crores

Rate of interest 15% p.a.

Cumulative discount factor for 1-15 years 5.847

(iii) Cash inflow available for equity shareholders

Net cash inflow of the project ₹ 40.00 crores

[Refer to working note (i)]

Equated yearly installment of the project ₹ 25.65 crores

[Refer to working note (ii)] ______________

Cash inflow available for equity shareholders ₹ 14.35 crores

Difference in Project IRR and Equity IRR:

The PVIF @ 15% for the six years are as below:

Initial Outlay 50,00,000

PV of Total Cash Outflow under System B

Now we shall compute NPV of the project

-8,00,000 -8,00,000 3,60,000 1

= -6,89,655 – 5,94,530 + 16,72,117

Year Old existing Upgraded Machine New Machine

The tax rate is 40 per cent.

(A) Cash Outflow ₹

(i) In case machine is upgraded:

(ii) In case new machine installed:

(iv) Depreciation – in case machine is upgraded

(ii) Depreciation – in case new machine is installed