Budgeting

Cash budget(problem 1) 8Marks

• Using the information below, prepare a cash
budget showing expected cash receipts and
disbursements for the month of june and
balance expected on June 30th 1999.
• Budgeted cash balance June 1,1999 Rs
1,20,000. Sales for June Rs 16,00,000,half
collected in the month of sale,40% in next
month, 10% in third month.
• Customer receivables as of June 1 Rs 1,40,000
from April sales, Rs 9,00,000 from May Sales.
• Merchandise purchases for June Rs 10,00,000.
40% payment in the month of purchase, 60%
paid in next month. Wages due in June Rs
1,76,000.
• Three years insurance policy due for renewal
Rs 4,000 to be paid in cash
• Other expenses for june, payable in June Rs
88,000.
• Depreciation for the month of June Rs 4,000
• Accrued taxes for June, payable in December
Rs 12,000
• Fixed Deposit receipts due June 15 Rs 3,50,000
plus Rs 20,000 interest.
 Solution-cash
Particulars
budget for month of June1999
Rs
Opening balance 1,20,000
Add: Estimated Cash Receipts:
Cash sales (16,00,000 X 50%) 8,00,000
Cash recd from debtors (40% sales of May and customer 5,00,000
receivable of April) (i.e.,9,00,000 x 40% + Rs 1,40,000)
Fixed Deposits 3,70,000
Total Receipts(A) 17,90,000
Less: Estimated cash payments:
Payment to creditors (10,00,000 x 40%) 4,00,000
Payment of wages 1,76,000
Payment of insurance premium 4,000
Payment of other expenses 88,000
Total Payments(B) 6,68,000
Closing Balance (A-B) 11,22,000
 2) Illustration 2 (8 marks)
• ABC company Ltd has given the following
particulars. You are required to prepare a cash
budget for the three months ending
31.12.1999.
Months Sales (RS) Materials (Rs) Wages (Rs) Overheads (RS)
August 20,000 10,200 3,800 1,900
September 21,000 10,000 3,800 2.100
October 23,000 9,800 4,000 2,300
November 25,000 10,000 4,200 2,400
December 30,000 10,800 4,500 2,500
• Credit terms are:
• Sales/ Debtors – 10% sales are on cash basis,
50% of the credit sales are collected next
month and the balance in the following
month.
• Creditors – Materials 2 month
• - wages 1/5 month
• - overheads ½ month
• (iii) cash balance 0n 1-10-1999 is expected to be 8,000
• (iv) a machinery will be installed in August 1999 at a
cost of Rs 1,00,000. The monthly instalment of Rs 5,000
is payable from October onwards.
(v) Dividend at 10% on preference share capital of Rs
3,00,000 will be paid on 1st Dec 1999
(vi) Advance to be received for sale of vehicle Rs 20,000 in
December.
(vii) Income tax (advance) to be paid in December Rs
5,000
 Solution
(i) calculation of cash collected from debtors
Month Credit sales Collection in Collection in Collection in
(90% of total October November December
sales
August 18,000 9,000 - -
September 18,900 9,450 9,450 -
October 20,700 - 10,350 10,350
November 22,500 - - 11,250

18,450 19,800 21,600

 (ii) Calculation of amount paid to
creditors:
August purchases payable in October= Rs10,200
September purchases payable in November =
Rs 10,000
October purchases payable in December=
Rs 9,800
(iii) Calculation of payment towards wages:

• Payable in October = (3,800 x 1/5) + (4,000 x

4/5) = Rs 3,960
• Payable in November = (4,000 x 1/5) + (4,200
x 4/5) = Rs 4.160
• Payable in December = (4,200 x 1/5) + (4,500 x
4/5) = Rs 4,440
(iv) Calculation of payment of overheads:

Payable in October = (2,100 x1/2) + (2,300 x ½) =

Rs2,200
Payable in November = (2,300 x ½) + (2,400x ½ )
= Rs 2,350
Payable in December = (2,400 x ½) + (2,500 x ½)
= Rs 2,450
 Cash budget for three months ending
Particulars Oct (Rs) Nov(Rs) Dec (RS)
Opening balance 31.12.1999
8,000 7,390 8,180
Add: Cash receipts:
Cash sales(10% 0f total sales) 2,300 2,500 3,000
Cash collected from debtors 18,450 19,800 21,600
Advance from sale of vehicle - - 20,000
Total Receipts(A) 28,750 29,690 52,780
Less : cash payments
Payment to creditors 10,200 10,000 9,800
Payment to wages 3,960 4,160 4,440
Payment of overheads 2,200 2,350 2,450
Payment of monthly instal on machine 5,000 5,000 5,000
Payment of preference dividend(10%) - - 30,000
Payment of advance income tax - - 5,000
Total payments (B) 21,360 21,510 56,690
Closing Balance (A-B) 7,390 8,180 (-)3,910
 3) Prepare a cash budget for 6
months from January
Months Total Sales Materials Wages Production Selling &
OHS Dist OHs
January 20,000 20,000 4,000 3,200 800
February 22,000 14,000 4,400 3,300 900
March 24,000 14,000 4,600 3,300 800
April 26,000 12,000 4,600 3,400 900
May 28,000 12,000 4,800 3,500 900
June 30,000 16,000 4,800 3,600 1,000
Cash balance on 1st January was Rs 10,000. A
new machine is to be installed at Rs 30,000 on
credit, to be repaid by two equal instalments
in March and April.
Sales commission at 5% on total sales is to be
paid within the month following actual sales.
Rs 10,000 being the amount of 2nd call may be
received in March. Share premium amounting
to Rs 2,000 is also obtained with 2nd call.
• Period of credit allowed by suppliers – 2
months
• Period of credit allowed to customers – 1
month
• Delay in payment of overheads- 1 month
• Delay in payment of wages – ½ month
• Assume cash sales to be 50% of the total sales.
Particulars Jan (RS) Feb(Rs) March (R April (Rs) May(Rs) June(Rs)
Opening cash bal 10,000 18,000 29,800 20,000 6,100 8,800
Add: Receipts:
Cash sales 10,000 11,000 12,000 13,000 14,000 15,000
Cash from Debtor - 10,000 11,000 12,000 13,000 14,000
Share 2nd call - - 10,000 - - -
Share premium - - 2,000 - - -
Total receipts(A) 20,000 39,000 64,800 45,000 33,100 37,800
Payments:
Materials - - 20,000 14,000 14,000 12,000
Wages 2,000 4,200 4,500 4,600 4,700 4,800
Production OHs - 3,200 3,300 3,300 3,400 3,500
Sell & Dist OHs - 800 900 800 900 900
Sales commission - 1,000 1,100 1,200 1.300 1,400
Machinery - 15,000 15,000 - -
instalment
Total Payments(B) 2,000 9,200 44,800 38,900 24,300 22,600
Closing bal (A-B) 18,000 29,800 20,000 6,100 8,800 15,200
 Sales budget
Illustration 1
• Shri Ram Company Ltd manufactures two
products X and Y. Its sales department has
three divisions: East, West , North. Preliminary
sales budget for the year ending 31st
December 1999 based on the assessments of
the divisional managers were:
• Product X : East- 3,00,000 units: West –
6,00,000 units and North-1,50,000 units.
• Sales price = X : Rs 5 and Y: Rs 4 in all areas
• Arrangements are made for the extensive
advertising of products X and Y and it is estimated
that East division sales will increase by 1,50,000
units. Arrangements are also made to advertise and
distribute product Y in the northern area in the
second half of 1999 when sales are expected to be
6,00,000 units.
• Since the estimated sales of the west division
represented an unsatisfactory target, it is agreed to
increase both estimated by 20%.
• Prepare a sales budget for the year to 31st Dec 1999
 Solution
Divisions Product X Value Product Value Total (Rs)
Qty Price (Rs) Y Qty Pric (Rs)
(Rs) e
(Rs)
East 4,50,000 5 22,50,000 5,50,000 4 22,00,000 44,50,000

West 7,20,000 5 36,00,000 6,00,000 4 24,00,000 60,00,000

North 1,50,000 5 7,50,000 6,00,000 4 24,00,000 31,50,000

13,20,000 66,00,000 17,50,000 70,00,000 136,00,000

 Illustration 2
• An estimate shows that there is a market for
10,00,000 units of divide 80% of the market.
Among other companies producing bell,
Ranjini Ltd., should get 15% of the total
market. 60% of Ranjini’s sales will probably be
evenly divided between the first and last
calender quarters of the year, with twice as
many sales being made in the second quarter
as in the third.
• The bell for Rs 60 an unit with manufacturing costs as
follows:
• The costs is worked out with reference to normal
working capacity for the production which is 1,50,000
bells a year.
• Direct material Rs 30, Direct labour cost Rs 15.
• Variable overhead cost Rs 5, Fixed overhead Rs 2,00,000,
prepare a sales budget for the year showing cost of
production and G.P by calender quarters. Assume no
change in the inventory levels during the year.
 Solution
• Sales of Ranjini Ltd., should be 15% of
10,00,000 ie 1,50,000.
• 60% of 1,50,000 ie 90,000 bells evenly divided
between first and last calender quarter.
• Ist quarter – Rs 45,000
• 2nd quarter – Rs 45,00
• 2nd quarter:
• Balance 1,50,000- 90,000 = 60,000 x 2/3=
40,000
• 3rd quarter = 60,000x 1/3 = 20,000
 Production budget
Illustration 1
• From the following particulars, prepare a
production budget of Arun sales corporation
for the year ended June 30, 1987
Product Sales (units) as per Estimated stock Estimated stock
sales budget (units),July 1,1986 (units), June 30
1987

A 1,50,000 14,000 15,000

B 1,00,000 5,000 4,500

C 70,000 8,000 8,000

 Solution
Production Budget of Arun
Product A Product B Product C Total
Budgeted Sales 1,50,000 1,00,000 70,000 3,20,000
Add: Desired closing 15,000 4,500 8,000 27,500
stock
Total requirement 1,65,000 1,04,500 78,000 3.47,500
Less: Opening stk 14,000 5,000 8,000 27,000

Production (units to 1,51,000 99,500 70,000 3,20,500

be produced)
 Illustration 2
• A company manufactures two products A and
B. A Forecast for the number of units to be
sold in the four months of the year is given :
 Product A (units) Product B (units)
January 3,000 6,000
February 3,400 6,000
March 4,200 5,200
April 5,000 4,400
• It is anticipated that (i) there will be no work-
in progress at the end of any month and (ii)
finished units equal to half the sales for the
next month will be in stock at the end of each
month (including previous December)
• Prepare for the three months endings March
31, a production budget for each month.
 Production budget for the first quarter
ending March
Product A Feb March Product B Feb March
Jan (units) (Units) (units) Jan (units) (units)
(units)
Budgeted sales 3,000 3,400 4,200 6,000 6,000 5,200
Add: Clo. stk 1,700 2,100 2,500 3,000 2,600 2,200
Total 4,700 5,500 6,700 9,000 8,600 7,400
requirement
Less: Op. stk 1,500 1,700 2,100 3,000 3,000 2,600
Budgeted 3,200 3,800 4,600 6,000 5,600 4,800
production
(units to be
produced)
 Flexible budget(8 marks)
Illustration 1
• A factory is currently working at 50% capacity
and produces 10,000 units at a cost of Rs 180
per unit as per details below:
• Materials Rs 100
Labour Rs 30
Factory OHs Rs 30 (Rs 12 fixed)
Administration OHs Rs 20 (Rs 10 fixed
Total Rs 180
• The current selling price is Rs 200 per unit. At
60% working, material cost per unit increases
by 2% and selling price per unit falls by 2%.
• At 80% working, materials cost per unit
increases by 5% and selling price per unit falls
by 5%.
• Estimate profits of the factory at 60% and 80%
working and offer your comments.
 Important note:
• Variable cost per unit remain constant at all
capacity levels
• Fixed cost remain constant in total but change
in per unit
 Working notes
• Given that at 50% working capacity the factory
produces 10,000
• At 60% how much the factory produces?
• 50 - 10,000
• 60 - ?
• By cross multiplying
• 10,000 X60/50 =12,000 units
• Therefore at 60% capacity the factory produces
12,000 units
• Similarly at 80% capacity we can find out
• 50 - 10,000
• 80 - ?
• 10,000 X80 /50 = 16,000 units
• Therefore at 80% capacity the factory
produces 16,000 units
 Working note 2
• Calculation of selling price at 60 % capacity
• Given that at 60% capacity the selling price falls by
2%
• Selling price at 60%
• If Rs 200 - 100%
• ? - 98%
• Cross multiplying
• 98 X 200/100 = 196
• Therefore the S.P at 60% capacity is Rs 196
• Calculation of SP at 80%
• Given that at 80% capacity the S.P falls by 5%
• So Rs 200 - 100%
• ? - 95 %
• Cross multiplying
• 95 x200/100 =190
• Therefore the SP at 80% capacity is Rs 190
 Solution:
Flexible budget showing Profit at 50%, 60% and 80% level of activity

Particulars 50% 60% 80%

(10,000) Total (12,000) Total (16,000) Total
Per unit Per per unit
unit
Variable Cost:
Material cost 100 10,00,000 102 12,24,000 105 16,80,000
Labour cost 30 3,00,000 30 3,60,000 30 4,80,000
Factory OHs 18 1,80,000 18 2,16,000 18 2,88,000
Admin OHs 10 1,00,000 10 1,20,000 10 1,60,000
Total Variable 158 15,80,000 160 19,20,000 163 26,08,000
Costs (A)
 Cont….
Fixed Costs:
Factory OHS 12 1,20,000 10 1,20,000 7.50 1,20,000
Admin OHs 10 1,00,000 8.33 1,00,000 6.25 1,00,000
Total Fixed 22 2,20,000 18.33 2,20,000 13.75 2,20,000
Costs (B)
Total cost of 180 18,00,000 178.33 21,40,000 176.75 28,28,000
production
(A+B)= C
Estimated profit 20 2,00,000 17.67 2,12,000 13.25 2,12,000
B/F (D-C)
Sales (D) 200 20,00,000 196 23,52,000 190 30,40,000
 Illustration 2
• The expenses budgeted for production of
5,000 units in a factory are furnished below:
• Materials Per unit Rs 40
• Labour Per unit Rs 30
• Direct Expenses Per unit Rs 20
• Factory expenses (30% fixed) Per unit Rs 30
• Selling and Dist exps(15% fixed) Per unit Rs 20
• Administration Exps (100% fixed) Per unit Rs 5
• Prepare a flexible budget for production of (i)
4,000 units and (ii) 7,000 units and also
calculate the cost per unit at those levels of
production.
 Solution
Flexible budget
Output (units) 5,000 4,000 7,000
Amount Per unit Amount Per unit Amount
Per unit
Variable costs:
Materials 40 2,00,000 40 1,60,000 40 2,80,000
Labour 30 1,50,000 30 1,20,000 30 2,10,000
Direct Expenses 20 1,00,000 20 80,000 0 1,40,000
Factory 21 1,05,000 21 84,000 21 1,47,000
Expenses(70%)
Selling & Dist. 17 85,000 17 68,000 17 1,19,000
Expenses (85%)
Total variable 128 6,40,000 128 5,12,000 128 8,96,000
costs (A)
 Cont…
Fixed costs:
Factory exps 9.00 45,000 11.25 45,000 6.53 45,000
(30%)
Selling & Dist 3.00 15,000 3.75 15,000 2.14 15,000
expenses (15%)
Administration 5.00 25,000 6.25 25,000 3.57 25,000
exps (100%)
Total Fixed 17.00 85,000 21.25 85,000 12.14 85,000
costs(B)
Total cost of 145 7,25,000 149.25 5,97,000 140.14 9,81,000
production (A+B)
 Important note
Variable cost is constant per unit , but varies in
total. Fixed cost is constant in total but, varies
per unit.
 Capital budgeting
• Fixed assets refers to those assets which are
acquired for own use and not for resale Eg:-
land, building, machinery etc.
• It is a challenging task before the management
to take judicious decisions regarding capital
expenditure i.e investments in fixed, so that
the amount is not unnecessarily locked up in
capital assets.
• A capital asset, once acquired, cannot be
disposed off except at a substantial loss.
• If the capital asset is purchased on a long-term
credit basis, a continuing liability is incurred
over a period of time and will affect the
financial obligations of the company adversely.
• It therefore requires a long range planning
while taking decisions regarding investments in
fixed assets
• Such a process of making decision regarding capital
expenditure is termed as Capital budgeting (or)
investment Decision making.
• Capital budgeting refers to the planned and pre-
decided allocation of funds available to the business
enterprise to long-term assets so as to achieve the
maximum profitability of the resources.
• It helps to decide whether or not money should be
invested in long term projects
 Definition of capital budgeting
• “It is the process of generating, evaluating,
selecting and following up on capital
expenditure alternatives”
• “It is the process of deciding whether or not to
commit resources in projects whose costs and
benefits are spread over several time periods.”
 Features of capital budgeting
1.It entails heavy investment of funds.
2. Capital expenditure once approved cannot be
reversed or withdrawn
3. Preparation of capital budget plans involves
forecasting of several years profit in advance.
4. There is greater uncertainty of the results.
Need and importance of capital budgeting

1. Heavy investments
2. Long-term commitment of funds
3. Irreversible decisions
4. Long-term impact of profitability
5. Most difficult to make
6. Wealth maximization of shareholders
7. Cash forecast
 Methods of capital budgeting
1. Traditional methods
a) Traditional Pay-back method
b) Modern Pay-back method
c) Average rate of return method
2. Discounted cash flow method/time adjusted
methods /present value methods
a) Net present value method
b) Profitability Index method
c) Internal Rate of return method
 Pay Back method
• It is a traditional method
• It does not consider the time value of money
• It is also known as payout or pay off method
• It is used to ascertain the period within which cost
incurred on a capital project and earnings there
from are equated.
• Pay back period = Initial investment/annual
cash inflow
• Cash inflow means profit before depreciation
but after tax because depreciation does not
involve cash outflow, whereas tax involves
cash outflow
 Merits of payback method
• It is simple
• It saves cost
• It emphasis the liquidity and solvency of the
firm
• The lender can know the period by which the
loan shall be repaid
 Demerits of payback method
• It ignores the time value of money
• It does not take into account the cost of
capital
• Quick recovery of cash is given more
importance
 Average Rate of Return Method(ARR)

• This method is known as Total Income Method

or Return on Investment method.
• It takes into account the total earnings
expected from the investment over its life.
• It also takes into account the residual value of
the asset.
• It is based on accounting information rather
than cash flow.
 ARR Method (continued….)
• If initial investment is taken into account in the
calculation, it is called ROI
• ARR (ROI) = Annual average net earnings or
savings /original investment X100
• Here Annual average net earnings means Average
of the earnings after depreciation and tax over the
whole of the economic life of the projects.
• Investment means capital cost of the equipment
minus any salvage value.
• If average investment (capital) is being
considered for the purpose of calculation, it is
called ARR.
• The formula is Annual average net
earnings/average investmentX100
• The amount of average investment is
calculated using one of the following formulas:
(i) Average investment = Original Investment/2
(ii) Average investment = Original investment –
scrap value/2
(iii) Average investment = original
investment+scrap value of the Asset/2
(iv) Average investment= original investment-
scrap value/2 + additional working capital+
scrap value
• As this method employs profitability as a
criterion for evaluation, projects are selected
based on the size of ARR in case of mutually
exclusive projects.
• However, the selection of independent project
be done if the ARR of a project is higher than
the minimum rate of return expected from all
its investment projects
• ARR> Predetermined or minimum rate of
return = Accept
• ARR< Predetermined or minimum rate of
return = Reject
 Merits of ARR Method
• It is easy to understand and easy to apply
• It places emphasis on profitability of the
project rather than liquidity
• It takes into account the earnings arising out
of a project throughout its life
 Demerits of ARR method
• It takes into account only accounting profit
and not the cash inflows which are very
important for the evaluation of a project.
• It considers only the rate of return and not the
length of project.
• It is inapplicable if any of the investment are
made after the beginning of the project.
 Problems (Illustration 1)
• ABC chemical company is considering two
alternative methods of processing a chemical
product for future commercial use. Equipment
costs for both methods will be evenly
depreciated over a 20 year period.
Initial cost Annual income
Equipment A Rs 12,00,000 Rs 90,000
Equipment B Rs 15,00,000 Rs 1,35,000
• If they are ranked by the average rate of
return method, which equipment is
preferable?
Solution: ARR= Annual net earnings/ avg
investment
Avg investment= Original investment-scrap
value/2 + additional working capital +scrap
value
 Solution
• A = 12,00,000-0/2+0+0= Rs6,00,000
• B = 15,00,000-0/2+0+0 = Rs7,50,000
• Therefore ARR of A =
Rs90,000/6,00,000X100=15%
• ARR of B = Rs1,35,000/7,50,000X100= 18%
• The average rate of return of equipment B is
higher than that of equipment A. Hence
equipment B is more preferable.
 Illustration 2
• X Ltd is considering the purchase of a
machine. Two machines A and B are available.
The cost of each machine is Rs 75,000. Each
machine has an expected life of 5 years.
Netsprofits before tax (after depreciation )
during the expected life of the machine are
given below:
Year Machine A(RS) Machine B(Rs)

1 18,000 6,000
2 21,000 16,000
3 28,000 22,000
4 20,000 28,000
5 13,000 25,000
Total 1,00,000 97,000
• Following the method of return on
investment, ascertain which of the
alternatives will be more profitable. The
average rate of tax may be taken as 50%.
 Solution:
Computation of profit after Tax

Year Machine A Machine B

Profit Tax @50% Profits Profits Tax @50% Profit
before (Rs) after before (Rs) after
tax(RS) tax(Rs) tax(Rs) tax(Rs)
1 18,000 9,000 9,000 6,000 3,000 3,000
2 21,000 10,500 10,500 16,000 8,000 8,000
3 28,000 14,000 14,000 22,000 11,000 11,000
4 20,000 10,000 10,000 28,000 14,000 14,000
5 13,000 6,500 6,500 25,000 12,500 12,500
50,000 48,500
• Annual average net earnings:
Machine A= Rs50,000/5=Rs 10,000
Machine B= Rs48,500/5= Rs 9,500
Average investment= Investment-scrap
value/2+additional working capital +scrap
value
Machine A 75,000-0/2+0+0= Rs37,500
Machine B 75,000-0/2+0+0 = Rs37,500
(i) Average rate of return on original investment
= Annual average net earnings/original
investmentX100
Machine A: Rs10,000/75,000X100 = 13.33%
Machine B: Rs9,700/75,000X100 = 12.93%
(ii) Average rate of return on average investment
= Annual average net earnings/average
investment X100
Machine A Rs 10,000/Rs 37,500 X100= 26.67%
Machine B Rs 9,700/Rs37,500x100 = 25.87%
Since Machine A gives higher ARR, it should be
purchased.
 Illustration 3
• Determine the average rate of return from the
following data of two machines A & B
Machine A Machine B
Cost Rs 56,125 Rs 56,125
Annual estimated income
after depreciation and
income tax:
First year 3,375 11.375
Second year 5,375 9,375
Third year 7,375 7,375
Fourth year 9,375 5,375
Fifth year 11,375 3,375
Total 36,875 36,875
Estimated life in years 5 5
Estimated salvage value 3,000 3,000
Average income tax rate 55% 55%
Additional working capital Rs 5,000 Rs 6,000
 Solution:
ARR= Annual average net earnings/average
investment X100
Annual Average net earnings= Total income/No of
Years
Machine A = Rs36,875/5 = Rs 7,375
Machine B = Rs 36,875/5 =Rs 7,375
Average investment = original investment – scrap
value/2 + additional working capital+ scrape
value
• Machine A = 56,125-3,000/2+5,000+3,000=
Rs 34,562.50
• Machine B = 56,125-3,000/2+6,000+3,000=
Rs 35,562.50
• ARR of machine A = 7,375/34,562.50X100 =
21.34%
• ARR of Machine B = 7,375/35,562.50 x 100 =
20.74%
 Pay back method
illustration 1
• A project costs Rs 2,50,000 and yields an
annual cash inflow of Rs 50,000 for 7 years.
Calculate its pay-back period.
Solution:
Pay-back period = Initial investment/ annual

cash inflow
= 2,50,000/50,000
= 5 years
 Illustration 2
• Calculate the pay-back period for a project
which requires a cash outlay of Rs 2,00,000
and generates cash inflows of Rs 80,000, Rs
40,000, Rs 70,000, Rs 30,000 and Rs 10,000 in
the first, second, third, fourth and fifth year
repectively.
 Solution :
statement showing cumulative cash inflows

Year Cash inflows(Rs) Cumulative cash

inflows (Rs)
1 80,000 80,000
2 40,000 1,20,000
3 70,000 1,90,000
4 30,000 2,20,000
5 10,000 2,30,000
• Initial investment is Rs 2,00,000. Rs 1,90,000 is
recovered in the first 3 years. The balance of
Rs 10,000 is to be recovered in the 4th year.
The time taken for recovery of this amount
(Rs10,000) is:
• For recovery of 30,000 in the fourth year, time
required :12 months.
• For recovery of 10,000 in the fourth year,
• Time required : 10,000/ 30,000 x 12 = 4
months
• Therefore Pay-back period = 3 years and 4
months.
 Illustration 3
• A project costs Rs 20,00,000 and yields
annually a profit of Rs 3,00,000 after
depreciation at 10% p.a but before tax of 50%.
Calculate the pay-back period.
 Solution :
Statement showing annual Cash inflow
Rs
Annual profit after depreciation before tax 3,00,000
Less: Tax at 50% 1,50,000
Annual profit, after depreciation and tax 1,50,000
Add : Depreciation (20,00,000 x10%) 2,00,000
Annual cash inflow 3,50,000
• Therefore pay-back period = initial
investment/annual cash inflow
• which is 20,00,000/3,50,000 = 5.7 years
 Illustration 4
• The Manekshaw company Ltd, is considering
two projects. Each requires an investment of
Rs 1,00,000. The net Cash inflows for
investment in the two projects X &Y are as
follows:
• You are required to rank these projects
according to pay back method
Year X(Rs) Y(Rs)
1 20,000 20,000
2 35,000 22,000
3 35,000 22,000
4 20,000 18,000
5 25,000 18,000
 Solution
• Project X
Year Cash inflows (Rs) Cumulative cash
inflows(Rs)
1 20,000 20,000
2 35,000 55,000
3 35,000 90,000
4 20,000 1,10,000
5 25,000 1,35,000
• The above table reveals that in three years Rs
90,000 has been recovered.
• Rs 10,000 is left.
• In fourth year, the cash inflow is Rs 20,000
• It means the pay back period is between three
to four years:
• Pay back period = 3 years + 10,000/20,000=3.5

years
 Project Y
• Statement showing Cumulative cash inflows
Year Cash Inflows(Rs) Cumulative Cash
inflow(Rs)
1 20,000 20,000
2 22,000 42,000
3 22,000 64,000
4 18,000 82,000
5 18,000 1,00,000
• The above table reveals that in five years, the
initial investment of Rs1,00,000 is recovered.
So, the payback period for the project for
Project Y is 5 years
• Project X is preferable as it has a shorter
payback period.
 Illustration 5
• One of the two machines A and B is to be
purchased. From the following information,
find out which of the two will be more
profitable. The average rate of tax may be
taken at 50%:
 Machine A Machine B
Cost of each machine Rs 50,000 Rs 80,000
Working life 4 years 6 years
Earnings before tax Rs Rs
Year 1 10,000 8,000
2 15,000 14,000
3 20,000 25,000
4 15,000 30,000
5 - 18,000
6 - 13,000
 Solution
Machine A- statement showing net cash inflows

Year Earnings Tax @50% Earnings Depreciati Net cash Cumulative

(1) before tax (3) Rs after tax on (5) Rs inflows cash
(2) Rs (4) = (2) – (3) (6)= (4)+(5) inflows (7)

1 10,000 5,000 5,000 12,500 17,500 17,500

2 15,000 7,500 7,500 12,500 20,000 37,500
3 20,000 10,000 10,000 12,500 22,500 60,000
4 15,000 7,500 7,500 12,500 20,000 80,000
 Working note:
• Depreciation = Cost of machine/ Estimated life
in years= 50,000/4= 12,500
• Payback period =2 years +12,500/22,500= 2.55
years
• Post pay-back profitability= total earnings-
Cost of machine
• Which is = 80,000-50,000= 30,000
 Machine B
statement showing net Cash inflows
Year (1) Earnings Tax @ Earnings Depreciati Net cash Cumulative
before tax 50% (3) after tax on (5) inflows cash
(2) Rs Rs (4)=(2)- (3) (6)= (4)+(5) inflows (7)
1 8,000 4,000 4,000 13,333 17,333 17,333
2 14,000 7,000 7,000 13,333 20,333 37,666
3 25,000 12,500 12,500 13,333 25,833 63,499
4 30,000 15,000 15,000 13,333 28,333 91,832
5 18,000 9,000 9,000 13,333 22,333 1,14,165
6 13,000 6,500 6,500 13,333 19,833 1,33,998
 Working note:
• Depreciation = cost of machine/ estimated
life= 80,000/ 6 years =Rs 13,333
• There fore pay back period = 3 years +
16,501/28,333 = 3.58 years
• Post pay back profitability = total earnings –
cost of machine = 1,33,998 -80,000 = Rs
53,998
 Comments
• From the view point of pay-back period alone.
Machine A having a shorter pay-back should
be recommended.
• But if we consider the full servicable life of the
machine, Machine B is preferable because it
gives surplus of Rs 53,998 in 6 years, while
Machine A gives a surplus of only Rs 30,000 in
4 years.
 Discounted Pay-back method
Illustration 6
• Calculate discounted pay-back period from the
details given below:
• Cost of project Rs 6,00,000; life of the project
5 years: annual cash inflow Rs 2,00,000; Cut
off rate 10%
• Year 1 2 3 4 5
• Discounting 0.909 0.826 0.751 0.683 0.621
factor
 Solution
statement showing Present value of cash inflows

Year (1) Cash inflows (rs) (2) Discounting factor Present value of
at 10% p.a (3) cash inflows (rs)
(4) = (2) x (3)
1 2,00,000 0.909 1,81,800
2 2,00,000 0.826 1,65,200
3 2,00,000 0.751 1,50,200
4 2,00,000 0.683 1,36,600
5 2,00,000 0.621 1,24,200
 Statement showing discounted pay-
bank period
year Cash inflows (Rs) Cumulative cash inflows
(Rs)
1 1,81,800 1,81,800
2 1,65,200 3,47,000
3 1,50,200 4,97,200
4 1,36,600 6,33,800
5 1,24,200 7,58,000
• The above table reveals that in 3 years Rs
4,97,200 has been recovered.
• Rs 1,02,800 is left out of initial investment.
• In the 4th year , the cash inflow is Rs 1,36,600.
• Therefore, discounted pay-back = 3 years
+1,02,800/1,36,600 years
• = 3.75 years
 NET PRESENT VALUE METHOD
• It is also known as Excess present value or Net
gain method
• In this method, the cash inflows and cash
outflows associated with each project are
calculated.
• Cash inflows are calculated by adding
depreciation to profit after tax of each project.
• Cash outflows means the investment made in
fixed assets at various points of time,
• In addition to investment made in fixed assets,
each project, at its commencement, involves
commitment of funds in working capital.
• The commitment of funds on account of
working capital is taken as cash outflows, in
the year project starts production and as cash
inflows at the end of the life of the project.
• The scrap value is also taken as cash inflow at the
end of the life of the project.
• After determining the amount of cash inflows and
cash outflows, they are multiplied by the relevant
‘cut-off’ factor or ‘discount factor’ to find their
present values.
• The present value of the cash inflows expected
during the entire expected life of the asset is then
compared with the present value of the cash
outflow/investment
• The difference between the present value of
cash inflows and the present value of cash
outflows is known as Net Present Value (NPV)
• NPV=sigma PV of all cash inflows-Sigma PV of all
cash outflows
• If the present value is positive of zero, the
project should be accepted
• If the present value is negative the project should
be rejected
 merits
• It considers the time value of money
• It considers income over the entire life of the
project
• It is useful for its simplicity
• It attempts to maximize the profits by
favouring more profitable investment projects
 Demerits
• It leads to confusing and contradictory
answers
• It is troublesome to find the present value
• There are many difficulties in forecasting sales
and costs
 Net Present Value Method
Illustration
• A project costing Rs 110 lakhs has a life of 10 years
at the end of which its scrap value is likely to be Rs
10 lakhs, The firm’s cut-off rate is 12%. The project
is expected to yield an annual profit after tax of Rs
10 lakhs, depreciation being reckoned on straight
line basis. At 12% p.a., the present value of the
rupee received annually for 10 years is Rs 5,650 and
the value of one rupee received at the end of the
10th year is 0.322. Ascertain the net present value.
 Solution
computation of Net Present Value
Rs
(i) Annual Profit after tax 10,00,000
Add: Depreciation = cost – scrap value/ estimated life in years 10,00,000
= Rs 1,10,00,000 – 10,00,000/ 10 years
Profit after tax before Depreciation 20,00,000
(ii) PV factor (Annuity for 10 years at 12%) 5.650
(iii) Total present value (20,00,000x 5.650) 1,13,00,000
Add: Addition PV in the 10th year (10,00,000 x 0.322) 3,22,000
Total present value 1,16,22,000
Less: project cost 1,10,00,000
Net Present Value 6,22,000
 Note:
• The above method can be adopted only when
annual cash inflows are expected to be
uniform for all years.
 Illustration 2
No project is acceptable unless the yield is 10%. Cash inflows and
outflows are given below.(8 marks)

Year Outflows Inflows

0 1,50,000 -
1 30,000 20,000
2 - 30,000
3 - 60,000
4 - 80,000
5 - 30,000
6 - 40,000
 Statement showing Net present value
Year Cash inflows Rs Discount factor at 10 % Present value
1 20,000 0.909 18,180
2 30,000 0.826 24,780
3 60,000 0.751 45,060
4 80,000 0.683 54,640
5 70,000 0.621 43,470
Total present 1,86,130
value
Less: Cash 1,50,000
outflow at the
beginning
Cash outflow at 27,270 1,77,270
the end of 1st
year (30,000 x
0.909)
Net Present value 8,860
 Conclusion
• Since the net present value is positive, the
project is acceptable.
 Internal Rate of Return Method(IRR)
• This is also a time adjusted rate of return or
discounted cash flow method
• It indicates the rate at which discounted cash
inflows are equal to discounted cash outflow
• In the NPV method the required rate of return is
predetermined on the basis of cost of capital or
opportunity cost of capital
• This predetermined rate may give a positive or
negative NPV.
• But in IRR method the discounting rate is
calculated by the process of trial and error or by
picking a rate which equalizes the inflows and
outflows.
• The discounting rate is termed as ‘Internal Rate
of Return’
• IRR is the rate of interest at which present value
of cash inflows and each outflows are equal.
• It can be calculated according to two methods
(i) When cash inflows/savings are even for all
years
• IRR is ascertained with the help of Annuity Table II
showing the present value of Rs 1received
annually over ‘n’ years by adopting two steps
• (i) the factor to be located in the relevant Annuity
table is calculated by using the simple equation
• F=I/C , where F= factor to be located
• I = original investment
• C= Annual cash inflows
• (ii) the calculated factor is located in the
Annuity Table on the line representing the
number of years corresponding the estimated
useful life of the asset and the relevant
percentage of the discount which represents
the rate of return.
 Illustration
• A project costs 1,25,000 and is estimated to
generate Cash inflow of Rs 25,000 for a period
of 6 years. Ascertain IRR
• Solution:
• When estimated cash inflows of a project are
uniform, IRR can be computed by locating
factor in Annuity Table II
• Factor to be located = F=I/C
• Where F= Factor to be located
• I = Original Investment
• C= Cash inflows per year
• F= 1,25,000/25,000 = 5
• Factor of 5 should be located in annuity table
II in the line of 6 years
• The discounting percentage is somewhere
between 5% and 6%
• Rs 5.076 present value of annuity of Re 1 is 5%
• Rs 4.917 present value of annuity of Re1 is 6%
• Since 4.917 is very near to 5
• IRR may be taken as 6%
(ii) Where cash inflows/savings are not even

• The factor is located using the formula

• F=I/C
• Where F = factor to be locate
• I = original investment
• C= Average cash inflows per year
 Illustration 2
• Initial investment = Rs 2,40,000
• Life of the asset = 4 years
• Estimated net annual cash flows:
• Year 1 = Rs 60,000
• Year 2 = Rs 80,000
• Year 3 = Rs 1,20,000
• Year 4 = Rs 80,000
• You are required to calculate IRR
• F= I/C
• F= factor
• I = original investment
• C = Average cash inflow per year
• Average cash inflow = Rs3,40,000/4 years=
85,000
• F= 2,40,000/85,000 = 2.8235
• Closest present values to 2.8235 fro Annuity
Table II for 4 years are 2.914 at 14% and 2.855
at 15%
• Thus IRR can be either 14% or 15%
 Important problems for exam- 8 marks

• Final accounts problem

• Cost sheet
• Marginal costing problem
• Cash flow/Fund Flow problem
• Cash budget/ Flexible Budget
• Pay back period method/NPV
method/Discounted Pay back method/ARR
method
 Important questions- 8 marks
• Accounting concepts/ conventions and
principles
• Difference between Financial/Cost/
Management accounting
• Cost concepts
• Types of costs
• Marginal costing/CVP analysis
• Factors affecting working capital requirements
• Capital budgeting and its importance
• What is ratio analysis?
• Different types of budgets.