Capital Budgeting :

Principles and Techniques

CAPITAL BUDGETING I: Principles
and Techniques

Nature of Capital Budgeting

Data requirement: Identifying

Relevant Cash Flows

Evaluation Techniques

Solved Problem

Mini Case
Capital Budgeting is the process of
evaluating and selecting long-term
investments that are consistent with the
goal of shareholders (owners) wealth
maximization.
Capital Expenditure is an outlay of
funds that is expected to produce
benefits over a period of time exceeding
one year.
Such decisions are of paramount importance as they
affect the profitability of a firm, and are the major
determinants of its efficiency and competing power.
While an opportune investment decision can yield
spectacular returns, an ill-advised/incorrect decision
can endanger the very survival of a firm.
Capital expenditure decisions are beset with a number
of difficulties. The two major difficulties are:
(1) The benefits from long-term investments are
received in some future period which is uncertain.
Therefore, an element of risk is involved in
forecasting future sales revenues as well as the
associated costs of production and sales.
(2) It is not often possible to calculate in strict
quantitative terms all the benefits or the costs
relating to a specific investment decision.
 (1) Investment Decisions Affecting Revenues

It is more difficult to estimate revenues and costs

of a new product line.

(2) Investment Decisions Reducing Costs

Such types of decisions are subject to less risk as

the potential cash saving can be estimated better
from the past production and cost data.
Capital Budgeting Process includes four distinct but interrelated steps
used to evaluate and select long-term proposals: proposal generation,
evaluation, selection and follow up.

Accept-reject Decision
Accept reject decision/approval is the evaluation of capital expenditure
proposal to determine whether they meet the minimum acceptance
criterion.

Mutually Exclusive Project Decisions

Mutually exclusive projects (decisions) are projects that compete with one
another; the acceptance of one eliminates the others from further
consideration.
Capital Rationing Decision
Capital rationing is the financial situation in which a firm has only fixed
amount to allocate among competing capital expenditures.
The capital outlays and revenue benefits associated with such
decisions are measured in terms of cash flows after taxes. The cash
flow approach for measuring benefits is theoretically superior to the
accounting profit approach as it

(i) Avoids the ambiguities of the accounting profits concept,

(ii) Measures the total benefits and
(iii) Takes into account the time value of money.

The major difference between the cash flow and the accounting profit
approaches relates to the treatment of depreciation. While the
accounting approach considers depreciation in cost computation, it
is recognized, on the contrary, as a source of cash to the extent of tax
advantage in the cash flow approach.
 Treatment of Depreciation
For taxation purposes, depreciation is charged (on the basis of written down
value method) on a block of assets and not on an individual asset. A
block of assets is a group of assets (say, of plant and machinery)
in respect of which the same rate of depreciation is prescribed by the Income-
Tax Act.
Depreciation is charged on the year-end balance of the block which is equal to
the opening balance plus purchases made during the year (in the block
considered) minus sale proceeds of the assets during the year.
In case the entire block of assets is sold during the year (the block ceases to exist
at year-end), no depreciation is charged at the year-end. If the sale proceeds of
the block sold is higher than the opening balance, the
difference represents short-term capital gain which is subject to tax.
Where the sale proceeds are less than the opening balance, the firm
is entitled to tax shield on short-term capital loss. The adjustment related to the
payment of taxes/tax shield is made in terminal cash inflows of the project.
The data requirement for capital budgeting are after tax cash outflows and cash
inflows. Besides, they should be incremental in that they are directly attributable
to the proposed investment project. The existing fixed costs, therefore, are
ignored. In brief, incremental after-tax cash flows are the only relevant cash
flows in the analysis of new investment projects.

Incremental Cash Flows

Incremental Cash Flows are the additional cash flows (outflows as well
as inflows) expected to result from a proposed capital expenditure.

Relevant Cash Flow

Relevant Cash Flow is the incremental after-tax cash outflow

(investment) and resulting subsequent inflows associated with a
proposed capital expenditure.
Table 1: Relevant and Irrelevant Outflows

Relevant Cash Outflows Irrelevant Cash Outflows

1. Variable labour expenses 1. Fixed overhead expense
(existing)
2. Variable material expenses
2. Sunk costs
3. Additional fixed overhead
expenses
4. Cost of the investment
5. Marginal taxes
(1) Conventional Cash Flow Pattern

Conventional cash flow pattern is an initial outflow followed by a

series of inflows.
(2) Non-Conventional Cash Flow Pattern
Non-conventional cash flow pattern is a pattern in which an
initial outflow is not followed by a series of inflows.
Cash Flow Estimates: There are certain ingredients of cash flow
streams.
Tax Effect
Effect on Other Projects
Effect of Indirect Expenses
Effect of Depreciation
(1) Traditional Techniques
(i) Average rate of return method
(ii) Pay back period method
(2) Discounted Cashflow (DCF)/Time-Adjusted (TA)
Techniques
(i) Net present value method
(ii) Internal rate of return method
(iii) Profitability index
The ARR is obtained dividing annual average profits after
taxes by average investments.
Average investment = 1/2 (Initial cost of machine – Salvage
value) + Salvage value + net working
capital.
Annual average profits after taxes = Total expected after tax
profits/Number of years
The ARR is unsatisfactory method as it is based on
accounting profits and ignores time value of money.
Example
Determine the average rate of return from the following data of two
machines, A and B.
Particulars Machine A Machine B
Cost Rs 56,125 Rs 56,125
Annual estimated income
after depreciation and
income tax:
Year 1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
36,875 36,875
Estimated life (years) 5 5
Estimated salvage value 3,000 3,000

Depreciation has been charged on straight line basis.

Solution

ARR = (Average income/Average investment) × 100.

Average income of Machines A and B =(Rs 36,875/5) = Rs 7,375.

Average investment = Salvage value + 1/2 (Cost of machine – Salvage

value) = Rs 3,000 + 1/2 (Rs 56,125 – Rs 3,000) = Rs 29,562.50.

ARR (for machines A and B) = (Rs 7,375/Rs 29,562.50) × 100 = 24.9

per cent.
The pay back method measures the number of years required for the CFAT
to pay back the initial capital investment outlay, ignoring interest
payment. It is determined as follows
(i) In the case of annuity CFAT: Initial investment/Annual CFAT.
(ii) In the case of mixed CFAT: It is obtained by cumulating CFAT till the
cumulative CFAT equal the initial investment.
Original/initial Investment (outlay) is the relevant cash outflow for a
proposed project at time zero (t = 0).
Annuity is a stream of equal cash inflows.

Mixed Stream is a series of cash inflows exhibiting any pattern other than
that of an annuity.
Although the pay back method is superior to the ARR method in that
it is based on cash flows, it also ignores time value of money
and disregards the total benefits associated with the investment proposal.
Example 5

(i) In the case of annuity CFAT

An investment of Rs 40,000 in a machine is expected to

produce CFAT of Rs 8,000 for 10 years,

PB = Rs 40,000/Rs 8,000 = 5 years

(ii) In the case of mixed CFAT
Table 2 presents the calculations of pay back period for Example 4.
Table 2
Year Annual CFAT Cumulative CFAT
A B A B
1 Rs 14,000 Rs 22,000 Rs 14,000 Rs 22,000
2 16,000 20,000 30,000 42,000
3 18,000 18,000 48,000 60,000
4 20,000 16,000 68,000 76,000
5 25,000* 17,000* 93,000 93,000
* CFAT in the fifth year includes Rs.3,000 salvage value also.
The DCF methods satisfy all the attributes of a good measure of
appraisal as they consider the total benefits (CFAT) as well as the
timing of benefits.
The present value or the discounted cash flow procedure
recognises that cash flow streams at different time periods differ in
value and can be compared only when they are expressed in terms
of a common denominator, that is, present values. It, thus, takes into
account the time value of money. In this method, all cash flows are
expressed in terms of their present values.
The present value of the cash flows in Example 4 are illustrated in Table 3.
Table 3: Calculations of Present Value of CFAT.
Year Machine A Machine B
CFAT PV Present CFAT PV Present
factor value factor value
(0.10) (0.10)
1 2 3 4 5 6 7
1 Rs 14,000 0.909 Rs 12,726 Rs 22,000 0.909 Rs 19,998
2 16,000 0.826 13,216 20,000 0.826 16,520
3 18,000 0.751 13,518 18,000 0.751 13,518
4 20,000 0.683 14,660 16,000 0.683 10,928
5 25,000* 0.621 15,525 17,000* 0.621 10,557
69,645 71,521
*includes salvage value.
The NPV may be described as the summation of the present values of
(i) operating CFAT (CF) in each year and (ii) salvages value(S) and
working capital(W) in the terminal year(n) minus the summation
of present values of the cash outflows(CO) in each year. The present value
is computed using cost of capital (k) as a discount rate.
The decision rule for a project under NPV is to accept the project if the NPV
is positive and reject if it is negative. Symbolically,
(i) NPV > zero, accept, (ii) NPV < zero, reject
Zero NPV implies that the firm is indifferent to accepting or rejecting the
project.
The project will be accepted in case the NPV is positive.

n C Ct Sn + Wn n COt
Net Present
Value = ∑(1 + (1+k)n - ∑ (1+k)t
t= (1+k)t t=
1 1
Example
In the earlier Example we would accept the proposals of purchasing
machines A and B as their net present values are positive. The positive NPV
of machine A is Rs 13,520 (Rs 69,645 – Rs 56,125) and that of B is Rs 15,396
(Rs 71,521 – Rs 56,125).
In Example 4, if we incorporate cash outflows of Rs 25,000 at the end of the
third year in respect of overhauling of the machine, we shall find the
proposals to purchase either of the machines are unacceptable as their net
present values are negative. The negative NPV of machine A is Rs 6,255 (Rs
68,645 – Rs 74,900) and of machine B is Rs 3,379 (Rs 71,521 – Rs 74,900).
As a decision criterion, this method can also be used to make a choice
between mutually exclusive projects. On the basis of the NPV method, the
various proposals would be ranked in order of the net present values. The
project with the highest NPV would be assigned the first
rank, followed by others in the descending order. If, in our example, a
choice is to be made between machine A and machine B on the basis of the
NPV method, machine B having larger NPV (Rs 15,396) would be preferred
to machine A (NPV being Rs 12,520).
The IRR is defined as the discount rate (r) which equates the
aggregate present value of the operating CFTA received each year
and terminal cash flows (working capital recovery and salvage
value) with aggregate present value of cash outflows of an
investment proposal.

Internal Rate of CFt S n + Wn COt

= + -
n n
Return
∑ ∑
t= (1+r)t (1+r)n t= (1+r)t
1 1

The project will be accepted when IRR exceeds the

required rate of return.
 CALCULATION OF IRR

NPV at the smaller rate

Smaller Bigger Smaller
discount + X discount – discount
Sum of the absolute values of the
rate rate rate
NPV at the smaller and the bigger
discount rates
The profitability index/present value index measures the present
value of returns per rupee invested. It is obtained dividing
the present value of future cash inflows (both operating
CFAT and terminal) by the present value ofcapital cash outflows.

Profitability Present value cash inflows

Index = Present value of cash outflows

The proposal will be worth accepting if the PI exceeds one.

Example
When PI is greater than, equal to or less than 1, the net present value is
greater than, equal to or less than zero respectively. In other words, the
NPV will be positive when the PI is greater than 1; will be negative when
the PI is less than one. Thus, the NPV and PI approaches give the same
results regarding the investment proposals.
The selection of projects with the PI method can also be done on the basis
of ranking. The highest rank will be given to the project with the highest
PI, followed by others in the same order.
In Example 4 (Table 3) of machine A and B, the PI would be 1.22 for
machine A and 1.27 for machine B:
Rs 69,645
PI (Machine A) = = 1.24
Rs 56,125
Rs 71,521
PI (Machine B) = = 1.27
Rs 56,125
Since the PI for both the machines is greater than 1, both the machines
are acceptable.
The data requirement for capital budgeting are cash flows,
that is, outflows and inflows. Their computation depends on
the nature of the proposal. The investment in new capital
projects can be categorised into
1) Single proposal
2) Re-placement proposal
3) Mutually exclusive proposals
In the case of single/independent investment proposal, cash outflows
primarily consist of

(1) Purchase cost of the new plant and machinery

(2) Its installation costs
(3) Working capital requirement to support production and sales (in the
case of revenue expanding proposals/release of working capital in cost
reduction proposals.
The cash inflows after taxes (CFAT) are computed by adding depreciation
(D) to the projected earnings after taxes (EAT) from the proposal.
In the terminal year of the project, apart from operating CFAT, the
cash inflows include salvage value (if any, net of removal costs),
recovery of working capital and tax advantage\taxes paid on short-
term capital loss\gain on sale of machine (if the block ceases to
exist).
Format 1: Cash Outflows of New Project [Beginning of the Period at Zero
Time (t = 0)]
1. Cost of new project
2. + Installation cost of plant and equipments
3. ± Working capital requirements

Format 2: Determination of Cash Inflows: Single Investment Proposal

(t = 1 – N)
Particulars Years
1 2 3 4 .... N
Cash sales revenues
Less: Cash operating cost
Cash inflows before taxes (CFBT)
Less: Depreciation
Taxable income
Less: Tax
Earning after taxes
Plus: Depreciation
Cash inflows after tax (CFAT)
Plus: Salvage value (in nth year)
Plus: Recovery of working capital (in nth year)
Example 1
An iron ore company is considering investing in a new processing facility.
The company extracts ore from an open pit mine. During a year, 1,00,000
tonnes of ore is extracted. If the output from the extraction process is sold
immediately upon removal of dirt, rocks and other impurities, a price of Rs
1,000 per ton of ore can be obtained. The company has estimated that its
extraction costs amount to 70 per cent of the net realisable value of the ore.
As an alternative to selling all the ore at Rs 1,000 per tonne, it is possible to
process further 25 per cent of the output. The additional cash cost of further
processing would be Rs 100 per ton. The proposed ore would yield 80 per
cent final output, and can be sold at Rs 1,600 per ton.
For additional processing, the company would have to instal equipment
costing Rs.100 lakh. The equipment is subject to 25 per cent depreciation
per annum on reducing balance (WDV) basis/method. It is expected to have
useful life of 5 years. Additional working capital requirement is estimated at
Rs.10 lakh. The company’s cut-off rate for such investments is 15 per cent.
Corporate tax rate is 35 per cent.
Assuming there is no other plant and machinery subject to 25 per cent
depreciation, should the company instal the equipment if (a) the expected
salvage is Rs 10 lakh and (b) there would be no salvage value at the end of
year 5.
Solution
Financial Evaluation Whether to Instal Equipment for Further Processing of Iron Ore
(A) Cash Outflows
Cost of equipment Rs 1,00,00,000
Plus: Additional working capital 10,00,000
1,10,00,000

(B) Cash Inflows (CFAT)

Particulars Year
1 2 3 4 5
Revenue from processing
[(Rs 1,600 × 20,000) –
Rs 1,000 × 25,000)] Rs 70,00,000 Rs 70,00,000 Rs 70,00,000 Rs 70,00,000 Rs 70,00,000
Less: Processing costs:
Cash costs (Rs 100
× 25,000 tons) 25,00,000 25,00,000 25,00,000 25,00,000 25,00,000
Depreciation
(working note 1) 25,00,000 18,75,000 14,06,250 10,54,688 —
Earnings before taxes 20,00,000 26,25,000 30,93,750 34,45,312 45,00,000
Less: Taxes (0.35) 7,00,000 9,18,750 10,82,813 12,05,859 15,75,000
Earnings after taxes (EAT) 13,00,000 17,06,250 20,10,937 22,39,453 29,25,000
Add: Depreciation 25,00,000 18,75,000 14,06,250 10,54,688
CFAT 38,00,000 35,81,250 34,17,187 32,94,141 29,25,000
Working Notes
1 Depreciation Schedule
Year Depreciation base of equipment Depreciation @ 25% on
WDV
1 Rs 1,00,00,000 Rs 25,00,000
2 75,00,000 18,75,000
3 56,25,000 14,06,250
4 42,18,750 10,54,688
5 31,64,062 Nil@
@As the block consists of a single asset, no depreciation is to be charged
in the terminal year of the project.
(C)(a) Determination of NPV (Salvage Value = Rs 10 lakh)
Year CFAT PV Total PV
factor
(0.15)
1 Rs 38,00,00 0.870 Rs 33,06,00
2 0 0.756 0
3 35,81,250 0.658 27,07,425
4 34,17,187 0.572 22,48,509
5 32,94,141 0.497 18,84,249
Salvage value 29,25,000 0.497 14,53,725
Tax benefit on short-term capital 10,00,000 0.497 4,97,000
loss 7,57,422 b 0.497 3,76,439
Recovery of working capital 10,00,000 4,97,000
Gross present value 1,29,70,347
Less: Cash outflows 1,10,00,000
Net present value (NPV) 19,70,347
(b) 0.35 × (Rs 31,64,062 – Rs 10,00,000) = Rs 7,57,422.
Recommendation: The company is advised to instal the equipment as it
promises a positive NPV.
(D) Determination of NPV (Salvage Value = Zero)
PV of operating CFAT (1 – 5 years) Rs 1,15,78,421
Add: PV of tax benefit on short term capital loss
(Rs 31,64,062 × 0.35 = Rs 11,07,4,22 × 0.497, PV 5,50,389
factor) 4,97,000
Add: PV of recovery of working capital 1,26,25,810
Total present value 1,10,00,000
Less: Cash outflows
16,25,810
NPV
Since the NPV is still positive, the company is advised to instal the
equipment.
In the case of replacement
situation, the sale proceeds from
the existing machine reduce the
cash outflows required to purchase
the new machine. The relevant
CFAT are incremental after-tax
cash inflows.
Format 3: Cash Outflows in a Replacement
Situation.
1. Cost of the new machine
2. + Installation Cost
3. ± Working Capital
4. – Sale proceeds of existing machine

Format 4: Depreciation Base of New Machine in a

Replacement Situation.
1. WDV of the existing machine
2. + Cost of the acquisition of new machine
(including installation costs)
3. – Sale proceeds of existing machine
Example 2
Royal Industries Ltd is considering the replacement of one of its moulding
machines. The existing machine is in good operating condition, but is
smaller than required if the firm is to expand its operations. It is 4 years
old, has a current salvage value of Rs 2,00,000 and a remaining life of 6
years. The machine was initially purchased for Rs 10 lakh and is being
depreciated at 25 per cent on the basis of written down value method.
The new machine will cost Rs 15 lakh and will be subject to the same
method as well as the same rate of depreciation. It is expected to have a
useful life of 6 years, salvage value of Rs 1,50,000 at the sixth year end.
The management anticipates that with the expanded operations, there will
be a need of an additional net working capital of Rs 1 lakh. The new
machine will allow the firm to expand current operations and thereby
increase annual revenues by Rs 5,00,000; variable cost to volume ratio is
30 per cent. Fixed costs (excluding depreciation) are likely to remain
unchanged.
The corporate tax rate is 35 per cent. Its cost of capital is 10 per cent. The
company has several machines in the block of 25 per cent depreciation.
Should the company replace its existing machine? What course of action
would you suggest, if there is no salvage value?
Solution
Financial Evaluation Whether to Replace Existing Machine
(A) Cash Outflows (Incremental)
Cost of the new machine Rs 15,00,000
Add: Additional working capital 1,00,000
Less: Sale value of existing machine 2,00,000
14,00,000
(B) Determination of Incremental CFAT (Operating)
Year Incremental Incremental Taxable Taxes EAT CFAT
contribution(a) depreciation(b) income (0.35) [Col. 4- [Col.6 + Col.3]
Col.5]

1 2 3 4 5 6 7
1 Rs 3,50,000 Rs 3,25,000 Rs 25,00 Rs 8,75 Rs 16,25 Rs 3,41,25
2 3,50,000 2,43,750 0 0 0 0
3 3,50,000 1,82,813 1,06,250 37,188 69,062 3,12,812
4 3,50,000 1,37,109 1,67,187 58,515 1,08,672 2,91,485
5 3,50,000 1,02,832 2,12,891 74,512 1,38,379 2,75,488
6 3,50,000 39,624 2,47,168 86,509 1,60,659 2,63,491
3,10,376 1,08,63 2,01,744 2,41,368
2
a Rs 5,00,000 – [Rs 5,00,000 × 0.30, variable cost to value (V/V) ratio] = Rs 3,50,000
Working Note
1.Incremental Depreciation (t = 1 – 6)
Year Incremental asset cost base Depreciation (25% on WDV)
1 Rs 13,00,000 Rs 3,25,000
2 9,75,000 2,43,750
3 7,31,250 1,82,813
4 5,48,437 1,37,109
5 4,11,328 1,02,832
6 3,08,496 39,624c
c 0.25 × (Rs 3,08,496 – Rs 1,50,000, salvage value) = Rs 39,624
2. (i) Written Down Value (WDV) of Existing Machine at the Beginning of
the Year 5
Initial cost of machine Rs 10,00,00
Less: Depreciation @ 25% in year 1 0
WDV at beginning of year 2 2,50,000
Less: Depreciation @ 25% on WDV 7,50,000
WDV at beginning of year 3 1,87,500
Less: Depreciation @ 25% on WDV 5,62,500
WDV at beginning of year 4 1,40,625
Less: Depreciation @ 25% on WDV 4,21,875
WDV at beginning of year 5 1,05,469
3,16,406
(ii) Depreciation Base of New Machine
WDV of existing machine 3,16,406
Add: Cost of the new machine 15,00,000
Less: Sale proceeds of existing machine 2,00,000
16,16,406
(iii) Base for Incremental Depreciation
Depreciation base of a new machine 16,16,406
Less: Depreciation base of an existing machine 3,16,406
13,00,000
(C) Determination of NPV (Salvage Value = Rs 1.50 lakh)
Year CFAT PV factor Total PV
(0.10)
1 Rs 3,41,250 0.909 Rs 3,10,196
2 3,12,812 0.826 2,58,383
3 2,91,485 0.751 2,18,905
4 2,75,488 0.683 1,88,158
5 2,63,491 0.621 1,63,628
6 2,41,368 0.564 1,36,132
6 Salvage value 1,50,000 0.564 84,600
6 Recovery of working capital 1,00,000 0.564 56,400
Gross present value 14,16,402
Less: Cash outflows 14,00,000
Net present value 16,402
Recommendation: Since the NPV is positive, the company is advised to
replace the existing machine. The NPV is likely to be higher as tax
advantage will accrue on the eligible depreciation of Rs 1,18,872 (Rs
3,08,496 – Rs 1,50,000 – Rs 39,624) in the future years.
Determination of NPV (Salvage Value = Zero)
(i) For the first 5 years, depreciation will remain unchanged. In the sixth year,
it will be = Rs 3,08,496 × 0.25 = Rs 77,124.
(ii) Operating CFAT for years 1–5 will remain unchanged.
CFAT for year 6 would be:
Incremental contribution Rs 3,50,000
Less: Incremental depreciation 77,124
Taxable income 2,72,876
Less: Taxes (0.35) 95,507
EAT 1,77,369
Add: Depreciation 77,124
CFAT 2,54,493
(iii) PV of operating CFAT (1 – 5 years) 11,39,270
Add: PV of operating CFAT (6th year) (Rs 2,54,493 × 0.564) 1,43,534
Add: PV of working capital 56,400
Total present value 13,39,204
Less: Cash outflows 14,00,000
NPV (66,796)
Recommendation: Since the NPV is negative, the existing machine should not
be replaced.
In the case of mutually exclusive proposals,
the selection of one proposal precludes the
selection of the other(s). The computation of
the cash outflows and cash inflows are on
lines similar to the replacement situation.
Example 3

A company is considering two mutually exclusive proposals, X and Y.

Proposal X will require the purchase of machine X, for Rs 1,50,000 with no
salvage value but an increase in the level of working capital to the tune of
Rs 50,000 over its life. The project will generate additional sales of Rs
1,30,000 and require cash expenses of Rs 30,000 in each of the 5 years of
its life. Proposal Y will require the purchase of machine Y for Rs 2,50,000
with no salvage value and additional working capital of Rs 70,000. The
project is expected to generate additional sales of Rs 2,00,000 with cash
expenses aggregating Rs 50,000.
Both the machines are subject to written down value method of
depreciation at the rate of 25 per cent. Assuming the company does not
have any other asset in the block of 25 per cent; has 12 per cent cost of
capital and is subject to 35 per cent tax, advise which machine it should
purchase? What course of action would you suggest if Machine X and
Machine Y have salvage values of Rs 10,000 and Rs 25,000 respectively?
Solution
Financial Evaluation of Proposals, X and Y
Proposal X
Cash outflows
Cost price of machine Rs 1,50,000
Additional working capital 50,000
Initial investment 2,00,000
CFAT and NPV
(i) Incremental sales revenue 1,30,000
Less: Cash expenses 30,000
Incremental cash profit before taxes 1,00,000
Less: Taxes (0.35) 35,000
CFAT (t = 1 – 5) 65,000
(×) PV factor of annuity for 5 years (0.12) × 3.605
Present value 2,34,325
(ii) PV of Tax Savings Due to Depreciation
Year Depreciation Tax PVF Present value
savings
1 Rs 37,500 Rs 13,125 0.893 Rs 11,721
2 28,125 9,844 0.797 7,846
3 21,094 7,383 0.712 5,257
4 15,820 5,537 0.636 3,522 28,346
(iii) PV of tax savings on short-term capital loss (STCL):
(Rs 47,461 STCL × 0.35 × 0.567) 9,419
(iv) Release of working capital (Rs 50,000 × 0.567) 28,350
Total present value 3,00,44
Less: Cash outflows 0
NPV 2,00,00
0
1,00,44
0
Proposal Y
Cash outflows
Cost price of machine 2,50,000
Additional working capital 70,000
Initial investment 3,20,000
CFAT and NPV
(i) Incremental sales revenue 2,00,000
Less: Cash expenses 50,000
Incremental cash profits before taxes 1,50,000
Less: Taxes (0.35) 52,500
CFAT (t = 1 – 5) 97,500
(×) PV factor of annuity for 5 years (0.12) × 3.605
Present value 3,51,488
(ii) PV of Tax Savings Due to Depreciation
Year Depreciation Tax PVF Present
savings value
1 Rs 62,500 Rs 21,875 0.893 Rs 19,534
2 46,875 16,406 0.797 13,076
3 35,156 12,305 0.712 8,761
4 26,367 9,229 0.636 5,869 47,240
(iii) PV of tax savings on short term capital loss 15,698
(Rs 79,102 × 0.35 × 0.567)
(iv) Release of working capital (Rs 70,000 × 0.567)
Total present value 39,690
Less: Cash outflows 4,54,11
6
NPV
3,20,00
0
1,34,11
6
Advice: Proposal Y is recommended in view of its higher NPV.
Alternatively (Incremental Cashflow Approach)
Incremental Cash Outflows
Investment required in Proposal Y Rs 3,20,000
Less: Investment required in Proposal X 2,00,000
1,20,000
Incremental CFAT and NPV
(i) Incremental sales revenue (Y – X) 70,000
Less: Incremental cash expenses (Y – X) 20,000
Incremental cash profit before taxes 50,000
Less: Taxes (0.35) 17,500
Incremental CFAT (t = 1 – 5) 32,500
(×) PV of annuity for 5 years (0.12) × 3.605
Incremental present value 1,17,162
(ii) PV of Tax Savings Due to Incremental Depreciation
Year Depreciation Tax PVF Present
savings value
1 Rs 25,000 Rs 8,750 0.893 Rs 7,814 18,896
2 18,750 6,562 0.797 5,230
3 14,062 4,922 0.712 3,504
4 10,547 3,691 0.636 2,348
iii) PV of tax savings on incremental (Y – X) short term capital
loss (STCL): (Rs 79,102 – Rs 47,461) × 0.35 × 0.567 6,279
(iv) Incremental (Y – X) working capital (Rs 70,000 – Rs 50,000)
× 0.567
Incremental present value 11,340
Less: Incremental cash outflows 1,53,67
Incremental NPV 7
1,20,00
0
33,677
Recommendation: Proposal Y is better.
Financial Evaluation of Proposals, Assuming Salvage Value of Machines X
and Y
(Incremental Approach)
(a) Sum of PV of items (i), (ii) and (iv) (Rs 1,17,162 + Rs
18,896 + Rs 11,340)@ Rs 1,47,39
(b) PV of incremental salvage value (Rs 15,000 × 0.567) 8
(c) PV of tax savings on incremental STCL@@ (Rs 54,102 – 8,505
Rs 37,461) × 0.35 × 0.567
Incremental present value 3,302
Less: Incremental cash outflows 1,59,205
Incremental NPV 1,20,000
39,205
Decision: Decision (superiority of proposal Y) remains unchanged.
@ Items (i), (ii) and (iv) when there is no salvage will not change due to

salvage value.
@@ As a result of salvage value, the amount of short-term capital loss

(STCL) will change.