Bosinp 8 CP 7

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

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

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

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

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

7.3 CAPITAL BUDGETING PROCESS

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

performance reports comparing actual performance against plans set and post
completion audits.
(vi) Review: When a project terminates, or even before, the organisation should
review the entire project to explain its success or failure. This phase may have
implication for firms planning and evaluation procedures. Further, the review
may produce ideas for new proposals to be undertaken in the future.
7.4 TYPES OF CAPITAL INVESTMENT DECISIONS

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

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

The capital budgeting decisions are taken by both newly incorporated firms as well
as by existing firms. The new firms may require decision making in respect of
selection of a plant to be installed. The existing firm may require taking decisions
to meet the requirement of new environment or to face the challenges of
competition. These decisions may be classified as follows:
(i) Replacement and Modernisation decisions: The replacement and
modernisation decisions aim at to improve operating efficiency and to reduce
cost. Generally, all types of plant and machinery require replacement either

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

7.4.3 Steps of Capital Budgeting Procedure

1. Estimation of Cash flows over the entire life for each of the projects under
consideration.
2. Evaluate each of the alternative using different decision criteria.
3. Determining the minimum required rate of return (i.e. WACC) to be used as
Discount rate.
Accordingly, this chapter is divided into two sections
1. Estimation of Cash Flows
2. Capital Budgeting Techniques
SECTION 1
7.5 ESTIMATION OF PROJECT CASH FLOWS

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

No matter how good a company's maintenance policy, technological or demand

forecasting abilities are, uncertainty will always be there.
Calculating Cash Flows : Before, we analyze how cash flow is computed in capital
budgeting decision, following items need consideration:
(a) Depreciation: As mentioned earlier depreciation is a non-cash item and
itself does not affect the cash flow. However, we must consider tax shield or benefit
from depreciation in our analysis. Since this benefit reduces cash outflow for taxes,
it is considered as cash inflow. To understand how depreciation acts as tax shield
let us consider following example:
Example -1
X Ltd. manufactures electronic motors fitted in desert coolers. It has an annual
turnover of ` 30 crore and cash expenses to generate this much of sale is ` 25 crore.
Suppose applicable tax rate is 30% and depreciation is ` 1.50 crore p.a. The table
below is showing Tax shield due to depreciation under two scenarios i.e. with and
without depreciation:
No Depreciation is Charged Depreciation is Charged
(` Crore) (` Crore)
Total Sales 30.00 30.00
Less: Cost of Goods Sold (25.00) (25.00)
5.00 5.00
Less: Depreciation - 1.50
Profit before tax 5.00 3.50
Tax @ 30% 1.50 1.05
Profit after Tax 3.50 2.45
Add: Depreciation* - 1.50
Cash Flow 3.50 3.95
* Being non- cash expenditure depreciation has been added back while calculating
the cash flow.
As we can see in the above table that due to depreciation under the second
scenario, a tax saving of ` 0.45 crore (` 1.50 – ` 1.05) was made. This is called tax
shield. The tax shield is considered while estimating cash flows.

(b) Opportunity Cost: Opportunity cost is foregoing of a benefit due to

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

(f) Additional Capital Investment: It is not necessary that capital investment

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

depends on the fact whether analysis is related to fresh project or modernization

of existing facilities or replacement of existing machined decision.
(i) New Project: If analysis is related to a fresh or completely a new project then
interim cash flow is calculated as follows:-
Amount Amount
Profit after Tax (PAT) xxx
Add: Non-Cash Expenses (e.g. xxx
Depreciation)
Add/ (less): Net decrease (increase) in xxx xxx
Working Capital
Interim net cash flow for the xxx
period
(ii) Similarly, interim cash flow in case of replacement decision shall be calculated as
follows:
Amount Amount
Net increase (decrease) in Operating xxx
Revenue
Add/ (less): Net decrease (increase) in operating xxx
expenses
Net change in income before taxes xxx
Add/ (less): Net decrease (increase) in taxes xxx
Net change in income after taxes xxx
Add/ (less): Net decrease (increase) in xxx
depreciation charges
Incremental net cash flow for the xxx
period
(c) Terminal-Year Incremental Net Cash Flow: We now pay attention to the
Net Cash Flow in the terminal year of the project. For the purpose of Terminal Year
we will first calculate the incremental net cash flow for the period as calculated in
point (b) above and further to it we will make adjustments in order to arrive at
Terminal-Year Incremental Net Cash flow as follows: -

Amount Amount
Final salvage value (disposal costs) of xxx

asset
Add: Interim Cash Flow xxx
Add/ (less): Tax savings (tax expenses) due to sale or xxx
disposal of asset (Including
Depreciation)
Add: Release of Net Working Capital xxx
Terminal Year incremental net cash xxx
flow
7.6 BASIC PRINCIPLES FOR MEASURING PROJECT

CASH FLOWS
For developing the project cash flows the following principles must be kept in mind:
7.6.1 Block of Assets and Depreciation
From above discussion it is clear that tax shield/ benefit from depreciation is
considered while calculating cash flows from the project. Taxable income is
calculated as per the provisions of Income Tax or similar Act of a country. The
treatment of deprecation is based on the concept of “Block of Assets”, which means
a group of assets falling within a particular class of assets. This class of assets can
be building, machinery, furniture etc. in respect of which depreciation is charged at
same rate. The treatment of tax depends on the fact whether block of asset consist
of one asset or several assets. To understand the concept of block of asset let us
discuss an example.
Example- 2
Suppose A Ltd. acquired new machinery for ` 1,00,000 depreciable at 20% as per
written down value (WDV) method. The machine has an expected life of 5 years
with salvage value of ` 10,000. The treatment of depreciation/ short term capital
loss in the 5 th year in two cases shall be as follows:
Depreciation for initial 4 years shall be common and WDV at the beginning of the
5th year shall be computed as follows:

`
Purchase Price of Machinery 1,00,000
Less: Depreciation @20% for year 1 20,000
WDV at the end of year 1 80,000
(i) Case 1: There is no other asset in the Block: When there is one asset in the
block and block shall cease to exist at the end of 5thyear no deprecation shall be
charged in this year and tax benefit/loss on Short Term Capital Loss/ Gain shall
be calculated as follows:
`
WDV at the beginning of year 5 40,960
Less: Sale value of Machine 10,000
Short Term Capital Loss 30,960
Tax Benefit on STCL @ 30% 9,288
(ii) Case 2: More than one asset exists in the Block: When more than one asset
exists in the block and deprecation shall be charged in the terminal year (5th year)
in which asset is sold. The WDV on which depreciation be charged shall be
calculated by deducting sale value from the WDV in the beginning of the year.
Tax benefit on Depreciation shall be calculated as follows:
`
WDV 30,960
Depreciation @20% 6,192
Tax Benefit on Depreciation @ 30% 1,858

Now suppose if in above two cases sale value of machine is ` 50,000, then no
depreciation shall be provided in case 2 and tax loss on Short Term Capital Gain in
Case 1 shall be computed as follows:
`
Short Term Capital Gain 9,040
Tax Loss on STCG @ 30% 2,712
7.6.2 Exclusion of Financing Costs Principle

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

Example- 3
Suppose XYZ Ltd.’s expected profit for the forthcoming 4 years is as follows:
Year 1 Year 2 Year 3 Year 4

Profit before Interest and Tax ` 10,000 ` 20,000 ` 40,000 ` 50,000
If interest payable is ` 5,000 and tax rate is 30% the profit after tax excluding
financing cost shall be as follows:
(`) (`) (`) (`)
Profit before Interest and Tax 10,000 20,000 40,000 50,000
Less: Interest (5,000) (5,000) (5,000) (5,000)
5,000 15,000 35,000 45,000
Less: Tax @ 30% (1,500) (4,500) (10,500) (13,500)
Profit after Tax (PAT) 3,500 10,500 24,500 31,500
Add: Interest (1- t) 3,500 3,500 3,500 3,500
PAT excluding financing cost 7,000 14,000 28,000 35,000
Alternatively

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

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

4. Less: Variable Cost xxx

5. Contribution [3-4] xxx
6. Less: Fixed Cost
(a) Fixed Cash Cost xxx
(b) Depreciation xxx
7. Earning Before Tax [5-6] xxx
8. Less: Tax xxx
9. Earning After Tax [7-8] xxx
10. Add: Depreciation xxx
11. Cash Inflow After Tax (CFAT) [9 +10] xxx
ILLUSTRATION 1
ABC Ltd is evaluating the purchase of a new machinery with a depreciable base of
` 1,00,000; expected economic life of 4 years and change in earnings before taxes
and depreciation of ` 45,000 in year 1, ` 30,000 in year 2, ` 25,000 in year 3 and
` 35,000 in year 4. Assume straight-line depreciation and a 20% tax rate. You are
required to COMPUTE relevant cash flows.
SOLUTION
Amount (in `)
Years
1 2 3 4
Earnings before tax and depreciation 45,000 30,000 25,000 35,000
Less: Depreciation (25,000) (25,000) (25,000) (25,000)
Earnings before tax 20,000 5,000 0 10,000
Less: Tax @20% (4,000) (1,000) 0 (2,000)
16,000 4,000 0 8,000
Add: Depreciation 25,000 25,000 25,000 25,000
Net Cash flow 41,000 29,000 25,000 33,000
Working Note:
Depreciation = ` 1,00,000  4 = ` 25,000

SECTION 2
7.7 CAPITAL BUDGETING TECHNIQUES

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

Techniques
Profitability Index (PI)
Time adjusted or
Discounted Cash Flows Internal Rate of Return (IRR)
Modified Internal Rate of

Return (MIRR)
Discounted Payback
Organizations may use any one or more of capital investment evaluation techniques;
some organizations use different methods for different types of projects while others
may use multiple methods for evaluating each project. These techniques have been
discussed below – net present value, profitability index, internal rate of return, modified
internal rate of return, payback period, and accounting (book) rate of return.

7.8 TRADITIONAL OR NON-DISCOUNTING

TECHNIQUES
These techniques of capital Budgeting does not discount the future cash flows.
There are two such techniques namely Payback Period and Accounting Rate of
Return
7.8.1 Payback Period
Time required to recover the initial cash-outflow is called pay-back period. The
payback period of an investment is the length of time required for the cumulative
total net cash flows from the investment to equal the total initial cash outlays. At
that point in time, the investor has recovered the money invested in the project.
Steps in Payback period technique : -
(a) The first steps in calculating the payback period is determining the total initial
capital investment (cash outflow) and
(b) The second step is calculating/estimating the annual expected after-tax cash
flows over the useful life of the investment.
1. When the cash inflows are uniform over the useful life of the project, the number
of years in the payback period can be calculated using the following equation:
Total initial capital investment

Payback period =
Annual expected after - tax net cash flow
Example- 4
Suppose a project costs ` 20,00,000 and yields annually a profit of ` 3,00,000 after
depreciation @ 12½% (straight line method) but before tax 50%. The first step
would be to calculate the cash inflow from this project. The cash inflow is ` 4,00,000
calculated as follows:
Particulars (`)
Profit before tax 3,00,000
Less: Tax @ 50% (1,50,000)
Profit after tax 1,50,000
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000

While calculating cash inflow, depreciation is added back to profit after tax since it
does not result in cash outflow. The cash generated from a project therefore is
equal to profit after tax plus depreciation. The payback period of the project shall
be:
` 20,00,000
Payback period = = 5 Years
4,00,000
Some Accountants calculate payback period after discounting the cash flows by a
predetermined rate and the payback period so calculated is called, ‘Discounted
payback period’ (discussed later on).
2. When the annual cash inflows are not uniform, the cumulative cash inflow
from operations must be calculated for each year. The payback period shall be
corresponding period when total of cumulative cash inflows is equal to the initial
capital investment. However, if exact sum does not match then the period in which
it lies should be identified. After that we need to compute the fraction of the year.
This method can be understood with the help of an example
Example- 5
Suppose XYZ Ltd. is analyzing a project requiring an initial cash outlay of ` 2,00,000
and expected to generate cash inflows as follows:
Year Annual Cash Inflows (`)

1 80,000
2 60,000
3 60,000
4 20,000
It’s payback period shall be computed by using cumulative cash flows as follows:
Year Annual Cash Inflows Cumulative Cash Inflows

(` ) (`)
1 80,000 80,000
2 60,000 1,40,000
3 60,000 2,00,000 ←
4 20,000 2,20,000
In 3 years total cash inflows equal to initial cash outlay. Hence, payback period is 3
years.

Suppose if in above example the initial outlay is ` 2,05,000 then payback period
shall be computed as follows:
Year Annual Cash Inflows Cumulative Cash

(`) Inflows (`)
1 80,000 80,000
2 60,000 1,40,000
3 60,000 2,00,000
4 20,000 2,20,000 ←
Payback period shall lie between 3 to 4 years. Since up to 3 years a sum of

` 2,00,000 shall be recovered balance of ` 5,000 shall be recovered in the part
(fraction) of 4th year, computation is as follows:
5,000 1
= year
20,000 4
Thus, total cash outlay of ` 205,000 shall be recovered in 3¼ years’ time.
Advantages of Payback period
➢ It is easy to compute.
➢ It is easy to understand as it provides a quick estimate of the time needed for
the organization to recoup the cash invested.
➢ The length of the payback period can also serve as an estimate of a project’s
risk; the longer the payback period, the riskier the project as long-term
predictions are less reliable. In some industries with high obsolescence risk like
software industry or in situations where an organization is short on cash, short
payback periods often become the determining factor for investments.
Limitations of Payback period
➢ It ignores the time value of money. As long as the payback periods for two
projects are the same, the payback period technique considers them equal as
investments, even if one project generates most of its net cash inflows in the
early years of the project while the other project generates most of its net cash
inflows in the latter years of the payback period.
➢ A second limitation of this technique is its failure to consider an investment’s
total profitability; it only considers cash inflows up-to the period in which initial
investment is fully recovered and ignores cash flows after the payback period.

➢ Payback technique places much emphasis on short payback periods thereby

ignoring long-term projects.
7.8.1.1 Payback Reciprocal
As the name indicates it is the reciprocal of payback period. A major drawback of
the payback period method of capital budgeting is that it does not indicate any cut
off period for the purpose of investment decision. It is, however, argued that the
reciprocal of the payback would be a close approximation of the Internal Rate of
Return (later discussed in detail) if the life of the project is at least twice the payback
period and the project generates equal amount of the annual cash inflows. In
practice, the payback reciprocal is a helpful tool for quick estimation of rate of
return of a project provided its life is at least twice the payback period.
The payback reciprocal can be calculated as follows:
Average annual cash in flow
Payback Reciprocal =
Initial investment
Example- 6
Suppose a project requires an initial investment of ` 20,000 and it would give
annual cash inflow of ` 4,000. The useful life of the project is estimated to be 5
years. In this example payback reciprocal will be:
` 4,000×100
=20%
` 20,000
The above payback reciprocal provides a reasonable approximation of the internal
rate of return, i.e. 19%.
7.8.2 Accounting (Book) Rate of Return (ARR) or Average Rate of Return
(ARR)
The accounting rate of return of an investment measures the average annual net
income of the project (incremental income) as a percentage of the investment.
Average annual net income
Accounting rate of return =
Investment
The numerator is the average annual net income generated by the project over its
useful life. The denominator can be either the initial investment (including
installation cost) or the average investment over the useful life of the project.
Average investment means the average amount of fund remained blocked during

the lifetime of the project under consideration. Further ARR can be calculated in a
number of ways as shown in the following example.
Example- 7
Suppose Times Ltd. is going to invest in a project a sum of ` 3,00,000 having a life
span of 3 years. Salvage value of machine is ` 90,000. The profit before depreciation
for each year is ` 1,50,000.
The Profit after Tax and value of Investment in the Beginning and at the End of each
year shall be as follows:
Year Profit Before Depreciation Profit after Value of Investment

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

(a) Version 1: Annual Basis
ProfitafterDepreciation
ARR =
Investmentinthebeginingof the year
Year
1 80,000
= 26.67%
3,00,000
2 80,000
= 34.78%
2,30,000
3 80,000
=50%
1,60,000
26.67%+34.78%+50.00%
Average ARR = =37.15%
3

(b) Version 2: Total Investment Basis

Average Annual Profit
ARR = ×100
Investment in the begining
(80,000+80,000+80,000) / 3
= ×100 = 26.67%
3,00,000
(c) Version 3: Average Investment Basis
Average Annual Profit
ARR = ×100
Average Investment
Average Investment = (`3,00,000 + ` 90,000)/2 = ` 1,95,000
Or, ½(Initial Investment – Salvage Value) + Salvage Value
= ½(` 3,00,000 –` 90,000) + ` 90,000 = ` 1,95,000
80,000
= ×100 = 41.03%
1,95,000
Further, it is important to note that project may also require additional working
capital during its life in addition to initial working capital. In such situation formula
for the calculation of average investment shall be modified as follows:
½(Initial Investment – Salvage Value) + Salvage Value+ Additional Working Capital
Continuing above example, suppose a sum of ` 45,000 is required as additional
working capital during the project life then average investment shall be:
= ½ (` 3,00,000 – ` 90,000) + ` 90,000 + ` 45,000 = ` 2,40,000 and
80,000
ARR = ×100 = 33.33%
2, 40,000
Some organizations prefer the initial investment because it is objectively
determined and is not influenced by either the choice of the depreciation method
or the estimation of the salvage value. Either of these amounts is used in practice
but it is important that the same method be used for all investments under
consideration.

Advantages of ARR
➢ This technique uses readily available data that is routinely generated for
financial reports and does not require any special procedures to generate data.
➢ This method may also mirror the method used to evaluate performance on the
operating results of an investment and management performance. Using the
same procedure in both decision-making and performance evaluation ensures
consistency.
➢ Calculation of the accounting rate of return method considers all net incomes
over the entire life of the project and provides a measure of the investment’s
profitability.
Limitations of ARR
➢ The accounting rate of return technique, like the payback period technique,
ignores the time value of money and considers the value of all cash flows to
be equal.
➢ The technique uses accounting numbers that are dependent on the
organization’s choice of accounting procedures, and different accounting
procedures, e.g., depreciation methods, can lead to substantially different
amounts for an investment’s net income and book values.
➢ The method uses net income rather than cash flows; while net income is a
useful measure of profitability, the net cash flow is a better measure of an
investment’s performance.
➢ Furthermore, inclusion of only the book value of the invested asset ignores the
fact that a project can require commitments of working capital and other
outlays that are not included in the book value of the project.
ILLUSTRATION 2
A project requiring an investment of ` 10,00,000 and it yields profit after tax and
depreciation which is as follows:
Years Profit after tax and depreciation (`)

1 50,000
2 75,000
3 1,25,000

4 1,30,000
5 80,000
Total 4,60,000
Suppose further that at the end of the 5 th year, the plant and machinery of the project
can be sold for ` 80,000. DETERMINE Average Rate of Return.
SOLUTION
In this case the rate of return can be calculated as follows:
Total Profit÷No. of years
× 100
Average investment / Initial Investment
(a) If Initial Investment is considered then,
= ` 4,60,000÷5years ×100 = ` 92,000 ×100 =9.2%

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

Discounting techniques consider time value of money and discount the cash flows
to their Present Value. These techniques are also known as Present Value
techniques. These are namely Net Present Value (NPV), Internal Rate of Return (IRR)

and Profitability Index (PI). First let us discuss about Determination of Discount rate
and it will be followed by the three techniques.
Determining Discount Rate
Theoretically, the discount rate or desired rate of return on an investment is the
rate of return the firm would have earned by investing the same funds in the best
available alternative investment that has the same risk. Determining the best
alternative opportunity available is difficult in practical terms so rather than using
the true opportunity cost, organizations often use an alternative measure for the
desired rate of return. An organization may establish a minimum rate of return that
all capital projects must meet; this minimum could be based on an industry average
or the cost of other investment opportunities. Many organizations choose to use
the overall cost of capital or Weighted Average Cost of Capital (WACC) that an
organization has incurred in raising funds or expects to incur in raising the funds
needed for an investment.
7.9.1 Net Present Value Technique (NPV)
The net present value technique is a discounted cash flow method that considers
the time value of money in evaluating capital investments. An investment has cash
flows throughout its life, and it is assumed that an amount of cash flow in the early
years of an investment is worth more than an amount of cash flow in a later year.
The net present value method uses a specified discount rate to bring all subsequent
cash inflows after the initial investment to their present values (the time of the
initial investment is year 0).
The net present value of a project is the amount, in current value of amount, the
investment earns after paying cost of capital in each period.
Net present value = Present value of net cash inflow - Total net initial investment
Since it might be possible that some additional investment may also be required
during the life time of the project then appropriate formula shall be:
Net present value = Present value of cash inflows - Present value of cash outflows
It can be expressed as below:
 C C C C 
NPV =  1 + 2 2 + 3 3 +......+ n n  -I
 (1+k) (1+k) (1+k) (1+k) 

n Ct
NPV =  -I
t =1 (1+k)t
Where,
C=Cash flow of various years
K = discount rate
N=Life of the project
I = Investment
Steps to calculating Net Present Value (NPV):
The steps to calculating net present value are: -
1. Determine the net cash inflow in each year of the investment
2. Select the desired rate of return or discounting rate or Weighted Average Cost
of Capital.
3. Find the discount factor for each year based on the desired rate of return
selected.
4. Determine the present values of the net cash flows by multiplying the cash flows
by respective discount factors of respective period called Present Value (PV) of
Cash flows
5. Total the amounts of all PVs of Cash Flows
Decision Rule:
If NPV ≥ 0 Accept the Proposal
If NPV ≤ 0 Reject the Proposal
The NPV method can be used to select between mutually exclusive projects; the
one with the higher NPV should be selected
ILLUSTRATION 3
COMPUTE the net present value for a project with a net investment of ` 1,00,000 and
net cash flows for year one is ` 55,000; for year two is ` 80,000 and for year three is
` 15,000. Further, the company’s cost of capital is 10%?
[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]

SOLUTION
Year Net Cash Flows PVIF @ 10% Discounted Cash Flows

(`) (`)
0 (1,00,000) 1.000 (1,00,000)
1 55,000 0.909 49,995
2 80,000 0.826 66,080
3 15,000 0.751 11,265
Net Present Value 27,340
Recommendation: Since the net present value of the project is positive, the
company should accept the project.
ILLUSTRATION 4
ABC Ltd is a small company that is currently analyzing capital expenditure proposals
for the purchase of equipment; the company uses the net present value technique to
evaluate projects. The capital budget is limited to ` 500,000 which ABC Ltd believes
is the maximum capital it can raise. The initial investment and projected net cash
flows for each project are shown below. The cost of capital of ABC Ltd is 12%. You
are required to COMPUTE the NPV of the different projects.
(Amount in ` )
Project A Project B Project C Project D

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

(`) (`) (`) (`)
0 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000)

1 0.893 44,650 35,720 66,975 66,975

2 0.797 39,850 39,850 59,775 59,775
3 0.712 35,600 49,840 42,720 42,720
4 0.636 31,800 47,700 50,880 25,440
5 0.567 28,350 42,525 56,700 11,340
Net Present Value (19,750) 25,635 27,050 (3,750)
Advantages of NPV
➢ NPV method takes into account the time value of money.
➢ The whole stream of cash flows is considered.
➢ The net present value can be seen as the addition to the wealth of shareholders.
The criterion of NPV is thus in conformity with basic financial objectives.
➢ The NPV uses the discounted cash flows i.e., expresses cash flows in terms of
current rupees. The NPVs of different projects therefore can be compared. It
implies that each project can be evaluated independent of others on its own
merit.
Limitations of NPV
➢ It involves difficult calculations.
➢ The application of this method necessitates forecasting cash flows and the
discount rate. Thus accuracy of NPV depends on accurate estimation of these
two factors which may be quite difficult in practice.
The decision under NPV method is based on absolute measure. It ignores the
difference in initial outflows, size of different proposals etc. while evaluating
mutually exclusive projects.
7.9.2 Profitability Index /Desirability Factor/Present Value Index
Method (PI)
The students may have seen how with the help of discounted cash flow technique,
the two alternative proposals for capital expenditure can be compared. In certain
cases we have to compare a number of proposals each involving different amounts
of cash inflows.
One of the methods of comparing such proposals is to work out what is known as
the ‘Desirability factor’, or ‘Profitability index’ or ‘Present Value Index Method’.

Mathematically:
The Profitability Index (PI) is calculated as below:
Sum of discounted cash in flows
Profitability Index (PI)=
Initial cash outlay or Total discounted cash outflow (as the case may)
Decision Rule:
If PI ≥ 1 Accept the Proposal

If PI ≤ 1 Reject the Proposal
In case of mutually exclusive projects; project with higher PI should be selected
ILLUSTRATION 5
Suppose we have three projects involving discounted cash outflow of ` 5,50,000,
` 75,000 and ` 1,00,20,000 respectively. Suppose further that the sum of discounted
cash inflows for these projects are ` 6,50,000, ` 95,000 and ` 1,00,30,000 respectively.
CALCULATE the desirability factors for the three projects.
SOLUTION
The desirability factors for the three projects would be as follows:
`6,50,000
1. =1.18
`5,50,000
`95,000
2. =1.27
`75,000
`1,00,30,000
3. =1.001
`1,00,20,000
It would be seen that in absolute terms project 3 gives the highest cash inflows yet
its desirability factor is low. This is because the outflow is also very high. The
Desirability/ Profitability Index factor helps us in ranking various projects .
Since PI is an extension of NPV it has same advantages and limitation.
Advantages of PI
➢ The method also uses the concept of time value of money.
➢ In the PI method, since the present value of cash inflows is divided by the present
value of cash outflow, it is a relative measure of a project’s profitability.

Limitations of PI
➢ Profitability index fails as a guide in resolving capital rationing where projects are
indivisible.
➢ Once a single large project with high NPV is selected, possibility of accepting
several small projects which together may have higher NPV than the single
project is excluded.
➢ Also situations may arise where a project with a lower profitability index selected
may generate cash flows in such a way that another project can be taken up one
or two years later, the total NPV in such case being more than the one with a
project with highest Profitability Index.
The Profitability Index approach thus cannot be used indiscriminately but all
other type of alternatives of projects will have to be worked out.
7.9.3 Internal Rate of Return Method (IRR)
The internal rate of return method considers the time value of money, the initial
cash investment, and all cash flows from the investment. But unlike the net present
value method, the internal rate of return method does not use the desired rate of
return but estimates the discount rate that makes the present value of subsequent
cash inflows equal to the initial investment. This discount rate is called IRR.
IRR Definition: Internal rate of return for an investment proposal is the discount
rate that equates the present value of the expected cash inflows with the
initial cash outflow.
This IRR is then compared to a criterion rate of return that can be the organization’s
desired rate of return for evaluating capital investments.
Calculation of IRR: The procedures for computing the internal rate of return vary
with the pattern of net cash flows over the useful life of an investment.
Scenario 1: For an investment with uniform cash flows over its life, the following
equation is used:
Step 1: Total initial investment =Annual cash inflow × Annuity discount factor of
the discount rate for the number of periods of the investment’s useful life
If A is the annuity discount factor, then
Total initial cash disbursements and commitments for the investment
A=
Annual (equal) cash inflows from the investment

Step 2: Once A is calculated, the interest rate corresponding to project’s life, the
value of A is searched in Present Value Annuity Factor (PVAF) table. If exact value
of ‘A’ is found the respective interest rate shall be IRR. However, it rarely happens
therefore we follow the method discussed below:
Step 1: Compute approximate payback period also called fake payback period.
Step 2: Locate this value in PVAF table corresponding to period of life of the project.
The value may be falling between two discounting rates.
Step 3: Discount cash flows using these two discounting rates.
Step 4: Use following Interpolation Formula:
NPV at LR
LR + ×(HR -LR)
NPV at LR - NPV at HR
Or
PV at LR - CI
LR+ ×(HR -LR)
PV at LR - PV at HR
Where,
LR = Lower Rate
HR = Higher Rate
CI = Capital Investment
ILLUSTRATION 6
A Ltd. is evaluating a project involving an outlay of ` 10,00,000 resulting in an annual
cash inflow of ` 2,50,000 for 6 years. Assuming salvage value of the project is zero;
DETERMINE the IRR of the project.
SOLUTION
First of all, we shall find an approximation of the payback period:
(`) 10,00,000
=4
(`) 2,50,000
Now we shall search this figure in the PVAF table corresponding to 6-year row.
The value 4 lies between values 4.111 and 3.998 correspondingly discounting rates
are 12% and 13% respectively.
NPV @ 12%

NPV12%= (10,00,000) + 4.111 × 2,50,000 = 27,750

NPV13%= (10,00,000) + 3.998 × 2,50,000 = -500
The internal rate of return is, thus, more than 12% but less than 13%. The exact rate
can be obtained by interpolation:
27,750
IRR =12%+ ×(13% -12%)
27,750 - (-500)
27,750
= 12% + = 12.978%
28,250
IRR = 12.978%
Scenario 2: When the cash inflows are not uniform over the life of the investment,
the determination of the discount rate can involve trial and error and interpolation
between discounting rates as mentioned above. However, IRR can also be found
out by using following procedure:
Step 1: Discount the cash flow at any random rate say 10%, 15% or 20% randomly.
Step 2: If resultant NPV is negative then discount cash flows again by lower
discounting rate to make NPV positive. Conversely, if resultant NPV is positive then
again discount cash flows by higher discounting rate to make NPV negative.
Step 3: Use following Interpolation Formula:
NPV at LR
=LR + ×(HR -LR)
Where
LR = Lower Rate
HR = Higher Rate
ILLUSTRATION 7
CALCULATE the internal rate of return of an investment of ` 1,36,000 which yields
the following cash inflows:
Year Cash Inflows (in ` )

1 30,000
2 40,000
3 60,000

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

at 10%
1 30,000 0.909 27,270
2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 30,000 0.683 20,490
5 20,000 0.621 12,420
Total present value 1,38,280
The present value at 10% comes to ` 1,38,280, which is more than the initial
investment. Therefore, a higher discount rate is suggested, say, 12%.
Year Cash Inflows (`) Discounting factor at 12% Present Value (`)
1 30,000 0.893 26,790
2 40,000 0.797 31,880
3 60,000 0.712 42,720
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Total present value 1,31,810
NPV at LR
IRR =LR + ×(HR -LR)
`2,280
=10+ ×(12- 10)
`2,280 - (-4,190)

`2,280
=10+ ×(12-10) = 10 + 0.704
`6, 470
IRR = 10.704%
ILLUSTRATION 8
A company proposes to install machine involving a capital cost of ` 3,60,000. The
life of the machine is 5 years and its salvage value at the end of the life is nil. The
machine will produce the net operating income after depreciation of ` 68,000 per
annum. The company's tax rate is 45%.
The Net Present Value factors for 5 years are as under:
Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13
You are required to COMPUTE the internal rate of return of the proposal.
SOLUTION
Computation of Cash inflow per annum (`)
Net operating income per annum 68,000
Less: Tax @ 45% (30,600)
Profit after tax 37,400
Add: Depreciation (` 3,60,000 / 5 years) 72,000
Cash inflow 1,09,400
The IRR of the investment can be found as follows:
NPV = −` 3,60,000 + ` 1,09,400 (PVAF5, r) = 0
`3,60,000
or PVAF5,r (Cumulative factor) = = 3.29
`1,09, 400
Computation of Internal Rate of Return

Discounting Rate 15% 16%
Cumulative factor 3.35 3.27
PV of Inflows 3,66,490 3,57,738
(` 1,09,4003.35) (` 1,09,4003.27)
Initial outlay (`) 3,60,000 3,60,000
NPV (`) 6,490 (2,262)

 6,490 
IRR = 15+   (16-15) =15+0.74 = 15.74%.
 6,490+2,262 
Acceptance Rule
The use of IRR, as a criterion to accept capital investment decision involves a
comparison of IRR with the required rate of return known as cut-off rate. The
project should the accepted if IRR is greater than cut-off rate. If IRR is equal to cut-
off rate the firm is indifferent. If IRR less than cut off rate the project is rejected.
Thus,
If IRR ≥ Cut-off Rate or WACC Accept the Proposal

If IRR ≤ Cut-off Rate or WACC Reject the Proposal
Internal Rate of Return (IRR) and Mutually Exclusive Projects

Projects are called mutually exclusive, when the selection of one precludes the
selection of others e.g. in case a company owns a piece of land which can be put
to use either for project S or L, such projects are mutually exclusive to each other
i.e. the selection of one project necessarily means the rejection of the other. Refer
to the figure below:
As long as the cost of capital is greater than the crossover rate of 7%, (1) NPVS is
larger than NPVL and (2) IRR S exceeds IRR L. Hence, if the cut- off rate or the cost of
capital is greater than 7%, both the methods shall lead to selection of project S.

However, if the cost of capital is less than 7%, the NPV method ranks Project L
higher, but the IRR method indicates that the Project S is better.
As can be seen above, mutually exclusive projects can create problem with the IRR
technique as IRR is expressed in percentage and does not take into account the scale
of investment or the quantum of money earned.
Let us consider another example of two mutually exclusive projects A and B with
the following details:
Example- 8
Cash flows
Year 0 Year 1 IRR NPV at 10%

Project A (` 1,00,000) `1,50,000 50% ` 36,360
Project B (` 5,00,000) ` 6,25,000 25% ` 68,180
Project A earns a return of 50% which is more than what Project B earns; however,
the NPV of Project B is more than of Project A. Acceptance of Project A means
rejection of Project B since the two Projects are mutually exclusive. Acceptance of
Project A also implies that the total investment will be ` 4,00,000 less had the
Project B been accepted, ` 4,00,000 being the difference between the initial
investment of the two projects. Assuming that the funds are freely available at 10%,
the total capital expenditure of the company should ideally be equal to sum total
of all outflows provided they earn more than 10% return along with the chosen
mutually exclusive project. Selection of Project A implies rejection of an opportunity
to earn an additional amount of ` 31,820 (` 68,180-` 36,360)for the shareholders,
thus reduction in the shareholders’ wealth.
In the above example the larger project had lower IRR, but maximises the
shareholders’ wealth. It is not safe to assume that a choice can be made between
mutually exclusive projects using IRR in cases where the larger project also happens
to have the higher IRR. Consider the following two Projects A and B with their
relevant cash flows:
Example- 9
Year Project A Project B

(`) (`)
0 (9,00,000) (8,00,000)
1 7,00,000 62,500
2 6,00,000 6,00,000

3 4,00,000 6,00,000
4 50,000 6,00,000
In this case Project A has the larger investment and also has a higher IRR as shown
below,
Year (`) r = 46% PV (`) (`) r = 35% PV (`)

0 (9,00,000) 1.0000 (9,00,000) (8,00,000) 1.0000 (8,00,000)
1 7,00,000 0.6849 4,79,430 62,500 0.7407 46,294
2 6,00,000 0.4691 2,81,460 6,00,000 0.5487 3,29,220
3 4,00,000 0.3213 1,28,520 6,00,000 0.4064 2,43,840
4 50,000 0.2201 11,005 6,00,000 0.3011 1,80,660
415 14
IRR of Project A = 46%
IRR of Project B = 35%
However, in case the relevant discounting factor is taken as 5%, the NPV of the two
projects provides a different picture as follows;
Project A Project B
Year (`) r= 5% PV (`) (`) r= 5% PV (`)
0 (9,00,000) 1.0 (9,00,000) (8,00,000) 1.0 (8,00,000)
1 7,00,000 0.9524 6,66,680 62,500 0.9524 59,525
2 6,00,000 0.9070 5,44,200 6,00,000 0.9070 5,44,200
3 4,00,000 0.8638 3,45,520 6,00,000 0.8638 5,18,280
4 50,000 0.8227 41,135 6,00,000 0.8227 4,93,620
6,97,535 8,15,625
As may be seen from the above, Project B should be the one to be selected even
though its IRR is lower than that of Project A. This decision shall need to be taken
in spite of the fact that Project A has a larger investment coupled with a higher IRR
as compared with Project B. This type of anomalous situation arises due to
reinvestment assumptions implicit in the two evaluation methods of NPV and
IRR.

7.9.4 Discounted Payback Period Method

This is similar to Payback period as discussed in 7.8.1 under the non-discounting
method except the cash flows are discounted at predetermined rate and the
payback period so calculated is called, ‘Discounted payback period’. One of the
most popular economic criteria for evaluating capital projects is the payback
period. Payback period is the time required for cumulative cash inflows to recover
the cash outflows of the project.
This is considered superior to simple payback period method because it takes into
account time value of money.
Example- 10
For example, a ` 30,000 cash outlay for a project with annual cash inflows of
` 6,000 would have a payback of 5 years (` 30,000 / ` 6,000).
The problem with the Payback Period is that it ignores the time value of money. In
order to correct this, we can use discounted cash flows in calculating the payback
period. Referring back to our example, if we discount the cash inflows at 15%
required rate of return, we have:
Year Cash Flow (`) PVF@15% PV (`) Cumulative PV (`)

1 6,000 0.870 5,220 5,220
2 6,000 0.756 4,536 9,756
3 6,000 0.658 3,948 13,704
4 6,000 0.572 3,432 17,136
5 6,000 0.497 2,982 20,118
6 6,000 0.432 2,592 22,710
7 6,000 0.376 2,256 24,966
8 6,000 0.327 1,962 26,928
9 6,000 0.284 1,704 28,632
10 6,000 0.247 1,482 30,114 ←
The cumulative total of discounted cash flows after ten years is ` 30,114. Therefore,
our discounted payback is approximately 10 years as opposed to 5 years under
simple payback. It should be noted that as the required rate of return increases,
the distortion between simple payback and discounted payback grows.

Discounted Payback is more appropriate way of measuring the payback period

since it considers the time value of money.
7.9.5 The Reinvestment Assumption
The Net Present Value technique assumes that all cash flows can be reinvested at
the discount rate used for calculating the NPV. This is a logical assumption since
the use of the NPV technique implies that all projects which provide a higher return
than the discounting factor are accepted.
In contrast, IRR technique assumes that all cash flows are reinvested at project ’s
IRR. This assumption means that projects with heavy cash flows in the early years
will be favoured by the IRR method vis-à-vis projects which have larger cash flows
in the later years. This implicit reinvestment assumption means that Projects like
A, with cash flows concentrated in the earlier years of life will be preferred by the
method relative to Projects such as B.
7.9.6 Multiple Internal Rate of Return
In cases where project cash flows change signs or reverse during the life of a project
e.g. an initial cash outflow is followed by cash inflows and subsequently followed
by a major cash outflow, there may be more than one IRR. The following graph of
discount rate versus NPV may be used as an illustration;
NPV
In such situations if the cost of capital is less than the two IRR’s, a decision can be
made easily, however otherwise the IRR decision rule may turn out to be misleading
as the project should only be invested if the cost of capital is between IRR 1and IRR2..
To understand the concept of multiple IRR it is necessary to understand the implicit
re-investment assumption in both NPV and IRR techniques.

Advantages of IRR
➢ This method makes use of the concept of time value of money.
➢ All the cash flows in the project are considered.
➢ IRR is easier to use as instantaneous understanding of desirability can be
determined by comparing it with the cost of capital
➢ IRR technique helps in achieving the objective of maximisation of
shareholder’s wealth.
Limitations of IRR
➢ The calculation process is tedious if there is more than one cash outflow
interspersed between the cash inflows; there can be multiple IRR, the
interpretation of which is difficult.
➢ The IRR approach creates a peculiar situation if we compare two projects with
different inflow/outflow patterns.
➢ It is assumed that under this method all the future cash inflows of a proposal are
reinvested at a rate equal to the IRR. It ignores a firm’s ability to re-invest in
portfolio of different rates.
➢ If mutually exclusive projects are considered as investment options which
have considerably different cash outlays. A project with a larger fund
commitment but lower IRR contributes more in terms of absolute NPV and
increases the shareholders’ wealth. In such situation decisions based only on
IRR criterion may not be correct.
7.9.7 Modified Internal Rate of Return (MIRR)
As mentioned earlier, there are several limitations attached with the concept of the
conventional Internal Rate of Return (IRR). The MIRR addresses some of these
deficiencies e.g., it eliminates multiple IRR rates; it addresses the reinvestment rate
issue and produces results which are consistent with the Net Present Value method.
This method is also called Terminal Value method.
Under this method, all cash flows, apart from the initial investment, are brought to
the terminal value using an appropriate discount rate (usually the Cost of Capital).
This results in a single stream of cash inflow in the terminal year. The MIRR is
obtained by assuming a single outflow in the zeroth year and the terminal
cash inflow as mentioned above. The discount rate which equates the present
value of the terminal cash inflow to the zeroth year outflow is called the MIRR.

The decision criterion of MIRR is same as IRR i.e. you accept an investment if MIRR is
larger than required rate of return and reject if it is lower than the required rate of return.
ILLUSTRATION 9
An investment of ` 1,36,000 yields the following cash inflows (profits before
depreciation but after tax). DETERMINE MIRR considering 8% as cost of capital.
Year `
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000
SOLUTION
Year 0 – Cash-outflow ` 1,36,000
The MIRR is calculated on the basis of investing the inflows at the cost of capital. The
table below shows the value of the inflows if they are immediately reinvested at 8%.
Year Cash flow @ 8% reinvestment rate factor `

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

to ` 1,36,000 in year 0 if the discount rate is 9%. Alternatively, we can compute

MIRR as follows:
2,13,587
Total return = = 1.5705
1,36,000
1
MIRR = 1.5705 - 1 = 9%.
5
7.9.8 Comparison of Net Present Value and Internal Rate of Return Methods
Similarity
➢ Both the net present value (NPV) and the internal rate of return (IRR) methods are
discounted cash flow methods which consider the time value of money.
➢ Both the techniques consider all cash flows over the expected useful life of the
investment.
7.9.9 Different conclusion in the following scenarios
There are circumstances/scenarios under which the net present value method and
the internal rate of return methods will reach different conclusions. Let’s discuss
these scenarios:-
Scenario 1 –Scale or Size Disparity
Being IRR a relative measure and NPV an absolute measure in case of disparity
in scale or size both may give contradicting ranking. This can be understood with
the help of following illustration:
ILLUSTRATION 10
Suppose there are two Project A and Project B are under consideration. The cash flows
associated with these projects are as follows:
Year Project A Project B
0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000
Assuming Cost of Capital equal to 10%, IDENTIFY which project should be accepted
as per NPV Method and IRR Method.

SOLUTION
Net Present Value (NPV) of Projects:
Year Cash Cash Present PV of PV of

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

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

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

(`) (`) 25%
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.800 40,000 1,12,000
2 60,000 1,90,000 0.640 38,400 1,21,600

3 40,000 1,00,000 0.512 20,480 51,200

(1,120) (15,200)
6, 450 6, 450
IRRA = 20%+ ×(25% -20%) =20% +  
× 5%  = 24.26%
6, 450 - (1,120)  7,570 
6,380 6,380
IRRB = 20%+ ×(25% -20%) =20% +  
×5%  = 21.48%
6,380 - (15,200)  21,580 
Overall Position
Project A Project B
NPV @ 10% 25,050 59,300
IRR 24.26% 21.48%
Thus there is contradiction in ranking by two methods.

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

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

SOLUTION
Net Present Value of Projects

Inflows Inflows Value Project X (`) Project Y (`)
Project X Project Y Factor @
(`) (`) 10%
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.909 1,81,800 45,450
2 1,00,000 1,00,000 0.826 82,600 82,600
3 50,000 3,00,000 0.751 37,550 2,25,300
51,950 53,350
Internal Rate of Returns of projects

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

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

Year Cash Present PV of Cash Present PV of

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

14,950
IRRX = 20%+ ×(25% -20%)
14,950 - (400)
= 20% +  14,950 × 5%  = 24.87%

 15,350 
16,500
IRRB =15%+ ×(20% -15%)
16,500 - (15,250)
=15% +  16,500 ×5%  = 17.60%

 31,750 
Overall Position
Project A Project B
NPV @ 10% 51,950 53,350
IRR 24.87% 17.60%

Scenario 3 – Disparity in life of Proposals (Unequal Lives)
Conflict in ranking may also arise if we are comparing two projects (especially
mutually exclusive) having unequal lives.

ILLUSTRATION 12
Suppose MVA Ltd. is considering two Project A and Project B for investment. The cash
flows associated with these projects are as follows:
Year Project A (`) Project B (`)

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

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

Let us discount cash flows using 50% discounting rate.

(`) (`) 50%
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)

1 7,50,000 2,00,000 0.667 5,00,250 1,33,400

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

Project B (`) Factor @ 15% Project B (`)
0 (5,00,000) 1.000 (5,00,000)
1 2,00,000 0.870 1,74,000
2 2,00,000 0.756 1,51,200
3 7,00,000 0.658 4,60,600
2,85,800
The internal rate can be obtained by interpolation:

2,85,800
IRRB =15%+ ×(50% -15%)
2,85,800 - (70,600)
= 15% +  2,85,800 ×35%  = 43.07%

 3,56, 400 
Overall Position
Project A Project B
NPV @ 12% (`) 1,69,750 (`) 3,36,400

IRR 50.00% 43.07%

7.10 SUMMARY OF DECISION CRITERIA OF

CAPITAL BUDGETING TECHNIQUES
Techniques For Independent Project For Mutually
Exclusive
Projects
Non- Pay Back (i) When Payback period ≤ Project with least
Discounted Maximum Acceptable Payback period
Payback period: should be
Accepted selected
(ii) When Payback period ≥
Maximum Acceptable
Payback period:
Rejected
Accounting (i) When ARR≥ Minimum Project with the
Rate of Acceptable Rate of maximum ARR
Return(ARR) Return: Accepted should be
(ii) When ARR ≤ Minimum selected.
Acceptable Rate of
Return: Rejected
Discounted Net Present (i) When NPV > 0: Project with the
Value (NPV) Accepted highest positive
(ii) When NPV < 0: Rejected NPV should be
selected
Profitability (i) When PI > 1: Accepted When Net Present
Index(PI) (ii) When PI<1:Rejected Value is same
project with
Highest PI should
be selected
Internal (i) When IRR >K: Accepted Project with the
Rate of (ii) When IRR <K: Rejected maximum IRR
Return (IRR) should be
selected

7.11 SPECIAL CASES

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

A (50,000) 15,400
B (40,000) 18,700
C (25,000) 10,100
D (30,000) 11,200
E (35,000) 19,300
The company is limited to a capital spending of ` 1,20,000.

You are required to ILLUSTRATE the returns from a package of projects within the capital
spending limit. The projects are independent of each other and are divisible (i.e., part-
project is possible).

SOLUTION
Computation of NPVs per ` 1 of Investment and Ranking of the Projects
Project Investment NPV @ 15% NPV per ` 1 Ranking

` '000 ` '000 invested
A (50) 15.4 0.31 5

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

` 000 ` 000
E (35) 19.3
B (40) 18.7
C (25) 10.1
D (20) 7.5 (2/3 of project total)
120 55.6
Thus Project A should be rejected and only two-third of Project D be undertaken. If

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

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

lower than C.
7.11.2 Projects with unequal lives
Sometimes firm may be faced with any of the following problems:
(i) Retaining an old asset or replace it with new one.

(ii) Choosing one proposal among two proposals (Mutually Exclusive).

Although, while evaluating the proposals in the above scenarios, do not pose any
special problem if they have same life period. But problem arises in case projects
have unequal lives. In such situations we can deal with the problem by following
any of the following method:
(i) Replacement Chain Method
(ii) Equivalent Annualized Criterion
These two methods can be understood with the help of following illustration.
ILLUSTRATION 14
R plc is considering modernizing its production facilities and it has two proposals under
consideration. The expected cash flows associated with these projects and their NPV as
per discounting rate of 12% and IRR is as follows:
Year Cash Flow

Project A (`) Project B (`)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000 0
5 11,00,000 0
6 10,00,000 0
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%
IDENTIFY which project should R plc accept?

SOLUTION
Although from NPV point of view Project A appears to be better but from IRR point of
view Project B appears to be better. Since, both projects have unequal lives, selection
on the basis of these two methods shall not be proper. In such situation we shall use
any of the following method:

(i) Replacement Chain (Common Life) Method: Since the life of the Project A
is 6 years and Project B is 3 years to equalize lives we can have second opportunity
of investing in project B after one time investing. The position of cash flows in such
situation shall be as follows:
NPV of extended life of 6 years of Project B shall be ` 8,82,403 and IRR of 25.20%.
Accordingly, with extended life NPV of Project B it appears to be more attractive.
(ii) Equivalent Annualized Criterion: The method discussed above has one
drawback when we have to compare two projects one has a life of 3 years and other
has 5 years. In such case the above method shall require analysis of a period of 15
years i.e. common multiple of these two values. The simple solution to this problem
is use of Equivalent Annualised Criterion involving following steps:
(a) Compute NPV using the WACC or discounting rate.
(b) Compute Present Value Annuity Factor (PVAF) of discounting factor used above
for the period of each project.
(c) Divide NPV computed under step (a) by PVAF as computed under step (b) and
compare the values.
Accordingly, for proposal under consideration:
Project A Project B
NPV @ 12% ` 6,49,094 ` 5,15,488
PVAF @12% 4.112 2.402
Equivalent Annualized Criterion ` 1,57,854 ` 2,14,608
Thus, Project B should be selected.

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

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

(10,000)1/ 2
Project B : (15,000 -10,000)1/ 2 = 2,500 = 50%

(10,000)1/ 2 5,000
Project C: (18,000 -10,000)1/ 3 = 2,667 = 53%

(10,000)1/ 2 5,000
Project D: (16,000 -10,000)1/ 3 = 2,000 = 40%

(10,000)1/ 2 5,000
Note: This net cash proceed includes recovery of investment also.

Therefore, net cash earnings are found by deducting initial investment.

(iii) IRR
Project A: The net cash proceeds in year 1 are just equal to

investment. Therefore, r = 0%.
Project B: This project produces an annuity of ` 7,500 for two years.
Therefore, the required PVAF is: 10,000/7,500 = 1.33.
This factor is found under 32% column. Therefore, r =
32%
Project C: Since cash flows are uneven, the trial and error method
will be followed. Using 20% rate of discount the NPV is
+ ` 1,389. At 30% rate of discount, the NPV is -` 633.
The true rate of return should be less than 30%. At 27%
rate of discount it is found that the NPV is -` 86 and at
26% +` 105. Through interpolation, we find r = 26.5%
Project D: In this case also by using the trial and error method, it
is found that at 37.6% rate of discount NPV becomes
almost zero.
Therefore, r = 37.6%.
(iv) NPV
Project A:
at 10% -10,000+10,000×0.909 = -910
at 30% -10,000+10,000×0.769 = -2,310
Project B:
at 10% -10,000+7,500(0.909+0.826) = +3,013
at 30% -10,000+7,500(0.769+0.592)= +208
Project C:
at 10% -10,000+2,000×0.909+4,000×0.826+12,000×0.751= +4,134
at 30% -10,000+2,000×0.769+4,000×0.592+12,000×0.455 =-633
Project D:
at 10% -10,000+10,000×0.909+3,000×(0.826+0.751) =+ 3,821
at 30% -10,000+10,000×0.769+3,000×(0.592+0.455) = + 831

The projects are ranked as follows according to the various methods:
Ranks
Projects PBP ARR IRR NPV NPV
(10%) (30%)
A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3
D 1 3 1 2 1
(b) Payback and ARR are theoretically unsound method for choosing between the
investment projects. Between the two time-adjusted (DCF) investment criteria,
NPV and IRR, NPV gives consistent results. If the projects are independent (and
there is no capital rationing), either IRR or NPV can be used since the same set
of projects will be accepted by any of the methods. In the present case, except
Project A all the three projects should be accepted if the discount rate is 10%.
Only Projects B and D should be undertaken if the discount rate is 30%.
If it is assumed that the projects are mutually exclusive, then under the
assumption of 30% discount rate, the choice is between B and D (A and C are
unprofitable). Both criteria IRR and NPV give the same results – D is the best.
Under the assumption of 10% discount rate, ranking according to IRR and NPV
conflict (except for Project A). If the IRR rule is followed, Project D should be
accepted. But the NPV rule tells that Project C is the best. The NPV rule generally
gives consistent results in conformity with the wealth maximization principle.
Therefore, Project C should be accepted following the NPV rule.
ILLUSTRATION 16
The expected cash flows of three projects are given below. The cost of capital is 10
per cent.
(a) CALCULATE the payback period, net present value, internal rate of return and
accounting rate of return of each project.
(b) IDENTIFY the rankings of the projects by each of the four methods.
(figures in ‘000)
Period Project A (`) Project B (`) Project C (`)

0 (5,000) (5,000) (5,000)

1 900 700 2,000

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

(`)
0 (5000) 1.000 (5,000)
1 700 0.909 636
2 800 0.826 661
3 900 0.751 676
4 1000 0.683 683
5 1100 0.621 683
6 1200 0.564 677
7 1300 0.513 667
8 1400 0.467 654
9 1500 0.424 636

10 1600 0.386 618

1591
NPVC is calculated as follows:
Year Cash flow (`) 10% discount factor Present value (`)
0 (5000) 1.000 (5,000)
1 2000 0.909 1,818
2 2000 0.826 1,652
3 2000 0.751 1,502
4 1000 0.683 683
655
Internal Rate of Return

Project A
NPV at 12% = (5,000) + 9005.650
= (5,000) + 5085= 85
NPV at 13% = (5,000) + 9005.426
= (5,000) + 4,883.40= -116.60
IRRA = 12+  85 
 85+116.60  ×(13-12) =12+0.42
 
IRRA = 12.42%.
Project B
IRRB
Year Cash 10% Present 16% Present

flow discount value discount value (`)
(`) factor (`) factor
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 700 0.909 636 0.862 603
2 800 0.826 661 0.743 595
3 900 0.751 676 0.641 577

4 1,000 0.683 683 0.552 552

5 1,100 0.621 683 0.476 524
6 1,200 0.564 677 0.410 493
7 1,300 0.513 667 0.354 460
8 1,400 0.467 654 0.305 427
9 1,500 0.424 636 0.263 394
10 1,600 0.386 618 0.227 363
1,591 (12)
Interpolating: IRRB= 10% + 1,591 × (16% -10%) = 10% + 5.94% = 15.94%
(1,591 + 12)
Project C
IRRC
Year Cash flow 15% Present 18% Present

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

5,000
ARRA: Average capital employed = = ` 2,500
2
(9,000 − 5,000)
Average accounting profit = = ` 400
10
(400 ×100)
ARRA = = 16 per cent
2,500

(11,500 − 5,000)
ARRB: Average accounting profit = = ` 650
10
(650 ×100)
ARRB = = 26 per cent
2,500
(7,000 − 5,000)
ARRC: Average accounting profit = = ` 500
4
(500 ×100)
ARRC = = 20 per cent
2,500
(b) Summary of Results
Project A B C
Payback (years) 5.5 5.4 2.5
NPV (`) 530.50 1,591 655
IRR (%) 12.42 15.94 16.52
ARR (%) 16 26 20
Comparison of Rankings
Method Payback NPV IRR ARR

1 C B C B
2 B C B C
3 A A A A
SUMMARY
 Capital budgeting is the process of evaluating and selecting long-term
investments that are in line with the goal of investor’s wealth maximization.
 The capital budgeting decisions are important, crucial and critical business
decisions due to substantial expenditure involved; long period for the recovery
of benefits; irreversibility of decisions and the complexity involved in capital
investment decisions.
 One of the most important tasks in capital budgeting is estimating future cash
flows for a project. The final decision we make at the end of the capital budgeting
process is no better than the accuracy of our cash-flow estimates.
 Tax payments like other payments must be properly deducted in deriving the

cash flows. That is, cash flows must be defined in post-tax terms.
 There are a number of capital budgeting techniques available for appraisal of
investment proposals and can be classified as traditional (non-discounted) and
time-adjusted (discounted).
 The most common traditional capital budgeting techniques are Payback Period
and Accounting (Book) Rate of Return.
Total initial capital investment
Payback period =
Annual expected after - tax net cash flow
Average Annual cash in flow

Payback Reciprocal =
Initial investment
 Accounting (Book) Rate of Return (ARR) or Average Rate of Return (ARR):
Average annual net income
Accounting rate of return =
Investment
 Net Present Value Technique (NPV):
Net present value = Present value of cash inflows - Present value of cash outflows
 C C2 C3 Cn 
NPV =  1 + 2
+ 3
+ ......+ -I
 (1+ k) (1+ k) (1+ k) (1+ k)n 
 Profitability Index /Desirability Factor/Present Value Index Method (PI):

Sum of discounted cash in flows
Profitability Index (PI) =
Initial cash outlay or Total discounted cash outflow (as the case may)
 Internal Rate of Return Method (IRR):

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

MCQs based Questions
1. A capital budgeting technique which does not require the computation of cost
of capital for decision making purposes is,

(a) Net Present Value method

(b) Internal Rate of Return method
(c) Modified Internal Rate of Return method
(d) Pay back
2. If two alternative proposals are such that the acceptance of one shall exclude the
possibility of the acceptance of another then such decision making will lead to,
(a) Mutually exclusive decisions
(b) Accept reject decisions
(c) Contingent decisions
(d) None of the above
3. In case a company considers a discounting factor higher than the cost of capital
for arriving at present values, the present values of cash inflows will be
(a) Less than those computed on the basis of cost of capital
(b) More than those computed on the basis of cost of capital
(c) Equal to those computed on the basis of the cost of capital
4. If the cut off rate of a project is greater than IRR, we may
(a) Accept the proposal
(b) Reject the proposal
(c) Be neutral about it
(d) Wait for the IRR to increase and match the cut off rate.
5. While evaluating capital investment proposals, time value of money is used in
which of the following techniques,
(a) Payback method
(b) Accounting rate of return
(c) Net present value

6. IRR would favour project proposals which have,

(a) Heavy cash inflows in the early stages of the project.
(b) Evenly distributed cash inflows throughout the project.
(c) Heavy cash inflows at the later stages of the project
(d) None of the above.
7. The reinvestment assumption in the case of the IRR technique assumes that,
(a) Cash flows can be reinvested at the projects IRR
(b) Cash flows can be reinvested at the weighted cost of capital
(c) Cash flows can be reinvested at the marginal cost of capital
8. Multiple IRRs are obtained when,
(a) Cash flows in the early stages of the project exceed cash flows during the
later stages.
(b) Cash flows reverse their signs during the project
(c) Cash flows are uneven
9. Depreciation is included as a cost in which of the following techniques,
(a) Accounting rate of return
(b) Net present value
(c) Internal rate of return
10. Management is considering a ` 1,00,000 investment in a project with a 5 year life
and no residual value. If the total income from the project is expected to be
` 60,000 and recognition is given to the effect of straight line depreciation on
the investment, the average rate of return is :
(a) 12%
(b) 24%

(c) 60%
(d) 75%
11. Assume cash outflow equals ` 1,20,000 followed by cash inflows of ` 25,000 per
year for 8 years and a cost of capital of 11%. What is the Net present value?
(a) (` 38,214)
(b) ` 9,653
(c) ` 8,653
(d) ` 38,214
12. What is the Internal rate of return for a project having cash flows of ` 40,000 per
year for 10 years and a cost of ` 2,26,009?
(a) 8%
(b) 9%
(c) 10%
(d) 12%
13. While evaluating investments, the release of working capital at the end of the
projects life should be considered as,
(a) Cash in flow
(b) Cash out flow
(c) Having no effect upon the capital budgeting decision
14. Capital rationing refers to a situation where,
(a) Funds are restricted and the management has to choose from amongst
available alternative investments.
(b) Funds are unlimited and the management has to decide how to allocate
them to suitable projects.
(c) Very few feasible investment proposals are available with the
management.

15. Capital budgeting is done for

(a) Evaluating short term investment decisions.
(b) Evaluating medium term investment decisions.
(c) Evaluating long term investment decisions.
Theoretical Questions
1. DISCUSS the various technique of capital budgeting.
2. DISCUSS NPV. How it is calculated?
3. DISCUSS in detail the ‘Capital Budgeting Process.
4. CLASSIFY various types of Capital Investment decisions known to you.
5. DESCRIBE the advantage and disadvantage of profitability of index.
6. DESCRIBE MIRR.
Practical Problems
1. Following data has been available for a capital project:
Annual cash inflows ` 1,00,000
Useful life 4 years
Salvage value 0
Internal rate of return 12%
Profitability index 1.064
You are required to CALCULATE the following for this project:

(i) Cost of project
(ii) Cost of capital
(iii) Net present value
(iv) Payback period
PV factors at different rates are given below:
Discount factor 12% 11% 10% 9%

1 year 0.893 0.901 0.909 0.917
2 year 0.797 0.812 0.826 0.842

3 year 0.712 0.731 0.751 0.772

4 year 0.636 0.659 0.683 0.708
2. Lockwood Limited wants to replace its old machine with a new automatic
machine. Two models A and B are available at the same cost of ` 5 lakhs each.
Salvage value of the old machine is ` 1 lakh. The utilities of the existing machine
can be used if the company purchases A. Additional cost of utilities to be
purchased in that case are ` 1 lakh. If the company purchases B then all the
existing utilities will have to be replaced with new utilities costing ` 2 lakhs. The
salvage value of the old utilities will be ` 0.20 lakhs. The earnings after taxation
are expected to be:
(cash in-flows of)

Year A B P.V. Factor
` ` @ 15%
1 1,00,000 2,00,000 0.870
2 1,50,000 2,10,000 0.756
3 1,80,000 1,80,000 0.658
4 2,00,000 1,70,000 0.572
5 1,70,000 40,000 0.497
Salvage Value at the end of 50,000 60,000
Year 5
The targeted return on capital is 15%. You are required to (i) COMPUTE, for the
two machines separately, net present value, discounted payback period and
desirability factor and (ii) STATE which of the machines is to be selected?
3. Hindlever Company is considering a new product line to supplement its range of
products. It is anticipated that the new product line will involve cash investments
of ` 7,00,000 at time 0 and ` 10,00,000 in year 1. After-tax cash inflows of
` 2,50,000 are expected in year 2, ` 3,00,000 in year 3, ` 3,50,000 in year 4 and
` 4,00,000 each year thereafter through year 10. Although the product line might
be viable after year 10, the company prefers to be conservative and end all
calculations at that time.
(a) If the required rate of return is 15 per cent, COMPUTE net present value of
the project? Is it acceptable?
(b) ANALYSE What would be the case if the required rate of return were 10
per cent?

(c) CALCULATE its internal rate of return?

(d) COMPUTE the project’s payback period?
4. Elite Cooker Company is evaluating three investment situations: (1) produce a
new line of aluminium skillets, (2) expand its existing cooker line to include
several new sizes, and (3) develop a new, higher-quality line of cookers. If only
the project in question is undertaken, the expected present values and the
amounts of investment required are:
Project Investment Present value of Future Cash-

required Flows
` `
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000
If projects 1 and 2 are jointly undertaken, there will be no economies; the
investments required and present values will simply be the sum of the parts.
With projects 1 and 3, economies are possible in investment because one of the
machines acquired can be used in both production processes. The total
investment required for projects 1 and 3 combined is ` 4,40,000. If projects 2
and 3 are undertaken, there are economies to be achieved in marketing and
producing the products but not in investment. The expected present value of
future cash flows for projects 2 and 3 is ` 6,20,000. If all three projects are
undertaken simultaneously, the economies noted will still hold. However, a
` 1,25,000 extension on the plant will be necessary, as space is not available for
all three projects. CALCULATE NPV of the projects and STATE which project or
projects should be chosen?
5. Cello Limited is considering buying a new machine which would have a useful
economic life of five years, a cost of ` 1,25,000 and a scrap value of ` 30,000,
with 80 per cent of the cost being payable at the start of the project and 20 per
cent at the end of the first year. The machine would produce 50,000 units per
annum of a new product with an estimated selling price of ` 3 per unit. Direct
costs would be ` 1.75 per unit and annual fixed costs, including depreciation
calculated on a straight- line basis, would be ` 40,000 per annum.

In the first year and the second year, special sales promotion expenditure, not
included in the above costs, would be incurred, amounting to ` 10,000 and
` 15,000 respectively.
CALCULATE NPV of the project for investment appraisal, assuming the
company’s cost of capital is 10 percent.
6. Ae Bee Cee Ltd. is planning to invest in machinery, for which it has to make a
choice between the two identical machines, in terms of Capacity, ‘X’ and ‘Y’.
Despite being designed differently, both machines do the same job. Further,
details regarding both the machines are given below:
Particulars Machine ‘X’ Machine ‘Y’
Purchase Cost of the Machine (`) 15,00,000 10,00,000
Life (years) 3 2
Running cost per year (`) 4,00,000 6,00,000
The opportunity cost of capital is 9%.

You are required to:
IDENTIFY the machine the company should buy?
The present value (PV) factors at 9% are:
Year t1 t2 t3
PVIF0.09.t 0.917 0.842 0.772
7. Alley Pvt. Ltd. is planning to invest in a machinery that would cost ` 1,00,000 at
the beginning of year 1. Net cash inflows from operations have been estimated
at ` 36,000 per annum for 3 years. The company has two options for smooth
functioning of the machinery- one is service, and another is replacement of parts.
If the company opts to service a part of the machinery at the end of year 1 at
` 20,000, in such a case, the scrap value at the end of year 3 will be ` 25,000.
However, if the company decides not to service the part, then it will have to be
replaced at the end of year 2 at ` 30,800. And in this case, the machinery will
work for the 4th year also and get operational cash inflow of ` 36,000 for the 4th
year. It will have to be scrapped at the end of year 4 at ` 18,000.
Assuming cost of capital at 10% and ignoring taxes, DETERMINE the purchase of
this machinery based on the net present value of its cash flows?
If the supplier gives a discount of ` 10,000 for purchase, what would be your
decision?

Note:
The PV factors at 10% are:
Year 0 1 2 3 4 5 6
PV Factor 1 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645
8. NavJeevani hospital is considering to purchase a machine for medical

projectional radiography which is priced at ` 2,00,000. The projected life of
the machine is 8 years and has an expected salvage value of ` 18,000 at the
end of 8 th year. The annual operating cost of the machine is ` 22,500. It is
expected to generate revenues of ` 1,20,000 per year for eight years.
Presently, the hospital is outsourcing the radiography work to its neighbour
Test Center and is earning commission income of ` 36,000 per annum, net of
taxes.
Required:
ANALYSE whether it would be profitable for the hospital to purchase the
machine? Give your recommendation under:
(i) Net Present Value method
(ii) Profitability Index method.
Consider tax @30%. PV factors at 10% are given below:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
9. XYZ Ltd. is planning to introduce a new product with a project life of 8 years.
Initial equipment cost will be ` 3.5 crores. Additional equipment costing
` 25,00,000 will be purchased at the end of the third year from the cash inflow
of this year. At the end of 8 years, the original equipment will have no resale
value, but additional equipment can be sold for ` 2,50,000. A working capital of
` 40,00,000 will be needed and it will be released at the end of eighth year. The
project will be financed with sufficient amount of equity capital.
The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4−5 6−8

Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000
A sales price of ` 240 per unit is expected and variable expenses will amount to
60% of sales revenue. Fixed cash operating costs will amount ` 36,00,000 per

year. The loss of any year will be set off from the profits of subsequent two years.
The company is subject to 30 per cent tax rate and considers 12 per cent to be
an appropriate after tax cost of capital for this project. The company follows
straight line method of depreciation.
Required:
CALCULATE the net present value of the project and advise the management to
take appropriate decision.
Note:
The PV factors at 12% are
Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404
10. A large profit making company is considering the installation of a machine to

process the waste produced by one of its existing manufacturing process to be
converted into a marketable product. At present, the waste is removed by a
contractor for disposal on payment by the company of ` 150 lakh per annum for
the next four years. The contract can be terminated upon installation of the
aforesaid machine on payment of a compensation of ` 90 lakh before the
processing operation starts. This compensation is not allowed as deduction for
tax purposes.
The machine required for carrying out the processing will cost ` 600 lakh to be
financed by a loan repayable in 4 equal instalments commencing from end of
the year- 1. The interest rate is 14% per annum. At the end of the 4th year, the
machine can be sold for ` 60 lakh and the cost of dismantling and removal will
be ` 45 lakh.
Sales and direct costs of the product emerging from waste processing for 4 years
are estimated as under:
(` In lakh)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210

Factory overheads 165 180 330 435

Depreciation (as per income tax rules) 150 114 84 63
Initial stock of materials required before commencement of the processing

operations is ` 60 lakh at the start of year 1. The stock levels of materials to be
maintained at the end of year 1, 2 and 3 will be ` 165 lakh and the stocks at the
end of year 4 will be nil. The storage of materials will utilise space which would
otherwise have been rented out for ` 30 lakh per annum. Labour costs include
wages of 40 workers, whose transfer to this process will reduce idle time
payments of ` 45 lakh in the year- 1 and ` 30 lakh in the year- 2. Factory
overheads include apportionment of general factory overheads except to the
extent of insurance charges of ` 90 lakh per annum payable on this venture. The
company’s tax rate is 30%.
Present value factors for four years are as under:
Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592
ADVISE the management on the desirability of installing the machine for

processing the waste. All calculations should form part of the answer.
ANSWERS/ SOLUTIONS
Answers to the MCQs based Questions
1. (d) 2. (a) 3. (a) 4. (b) 5. (c) 6. (a)
7. (a) 8. (b) 9. (a) 10. (b) 11. (c) 12. (d)
13. (a) 14. (a) 15. (c)
Answers to the Theoretical Questions

1. Please refer paragraph 7.7
2. Please refer paragraph 7.9.1
5. Please refer paragraph 7.9.2.
6. Please refer paragraph 7.12.

Answers to the Practical Problems

1. (i) Cost of the Project
At 12% internal rate of return (IRR), the sum of total cash inflows = cost of
the project i.e initial cash outlay
Annual cash inflows = ` 1,00,000
Useful life = 4 years
Considering the discount factor table @ 12%, cumulative present value of
cash inflows for 4 years is 3.038 (0.893 + 0.797 + 0.712 + 0.636)
Hence, Total Cash inflows for 4 years for the Project is
` 1,00,000 × 3.038 = ` 3,03,800
Hence, Cost of the Project = ` 3,03,800
(ii) Cost of Capital
Sum of Discounted Cash in flows
Profitability index =
Cost of the Project
Sum of Discounted Cash inflows
1.064 =
` 3,03,800
 Sum of Discounted Cash inflows = ` 3,23,243.20

Since, Annual Cash Inflows = ` 1,00,000
Hence, cumulative discount factor for 4 years = `3,23,243.20 = 3.232

`1,00,000
From the discount factor table, at discount rate of 9%, the cumulative
discount factor for 4 years is 3.239 (0.917 + 0.842 + 0.772 + 0.708)
Hence, Cost of Capital = 9% (approx.)
(iii) Net Present Value (NPV)
NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ` 3,23,243.20 – ` 3,03,800 = ` 19,443.20
Net Present Value = ` 19,443.20

(iv) Payback Period

Cost of the Project
Payback period = = `3,03,800 = 3.038 years
Annual Cash Inflows `1,00,000
2. Working:
Calculation of Cash-outflow at year zero
Particulars A (`) B (`)

Cost of Machine 5,00,000 5,00,000
Cost of Utilities 1,00,000 2,00,000
Salvage value of Old Machine (1,00,000) (1,00,000)
Salvage of value Old Utilities – (20,000)
Total Expenditure (Net) 5,00,000 5,80,000
(i) (a) Calculation of NPV
Machine A Machine B
Year NPV Cash Discounted Cash Discounted
Factor inflows value of inflows value of
@ 15% inflows inflows
0 1.000 (5,00,000) (5,00,000) (5,80,000) (5,80,000)
1 0.870 1,00,000 87,000 2,00,000 1,74,000
2 0.756 1,50,000 1,13,400 2,10,000 1,58,760
3 0.658 1,80,000 1,18,440 1,80,000 1,18,440
4 0.572 2,00,000 1,14,400 1,70,000 97,240
5 0.497 1,70,000 84,490 40,000 19,880
Salvage 0.497 50,000 24,850 60,000 29,820
5,42,580 5,98,140
Net Present Value 42,580 18,140
Since the Net present Value of both the machines is positive both
are acceptable.

(b) Discounted Pay-back Period (Amount in `)
Machine A Machine B
Year Discounted Cumulative Discounted Cumulative
cash Discounted cash Discounted
inflows cash inflows cash
inflows inflows
1 87,000 87,000 1,74,000 1,74,000
2 1,13,400 2,00,400 1,58,760 3,32,760
3 1,18,440 3,18,840 1,18,440 4,51,200
4 1,14,400 4,33,240 97,240 5,48,440
5 1,09,340* 5,42,580 49,700* 5,98,140
* Includes salvage value
Discounted Payback Period (For A and B):
 5,00,000 − 4,33,240 
Machine A = 4 years +   = 4.61 years
 1,09,340 
 5,80,000 − 5,48,440 
Machine B = 4 years +   = 4.63 years
 49,700 
(c) Desirability Factor or Profitability Index:
Sum of present value of net cash inflow
Profitability Index (PI) =
Initial cash outflow
` 5, 42,580 ` 5,98,140
Machine A = =1.08; Machine B = = 1.03
` 5,00,000 ` 5,80,000
(ii) Since the absolute surplus in the case of A is more than B and also the
desirability factor, it is better to choose A.
The discounted payback period in both the cases is almost same, also the
net present value is positive in both the cases but the desirability factor
(profitability index) is higher in the case of Machine A, it is therefore better
to choose Machine A.

3. (a) Computation of NPV at 15% discount rate
Year Cash flow Discount Factor Present value

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

(b) Computation of NPV if discount rate would be 10% discount rate
Year Cash flow Discount Factor Present

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

(c) Calculation of IRR:
IRR = LR+ NPVatLR

×(HR -LR)
NPVatLR-NPVatHR
` 2,51, 450
= 10% + ×(15%-10%)
` 2,51, 450-(-)1,18,200
= 10% + 3.4012 or 13.40%

(d) Computation of Pay-back period of the project:

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

Projects 1 and 3 should be chosen, as they provide the highest net present
value.
5. Calculation of Net Cash flows
Contribution = (3.00 – 1.75)50,000 = ` 62,500
Fixed costs = 40,000 – [(1,25,000 – 30,000)/5] = ` 21,000
Year Capital Contribution Fixed Adverts Net cash

(`) (`) costs (`) (`) flow (`)
0 (1,00,000) (1,00,000)
1 (25,000) 62,500 (21,000) (10,000) 6,500
2 62,500 (21,000) (15,000) 26,500
3 62,500 (21,000) 41,500
4 62,500 (21,000) 41,500
5 30,000 62,500 (21,000) 71,500
Calculation of Net Present Value
Year Net cash 10% discount Present

flow (`) factor value (`)
0 (1,00,000) 1.000 (1,00,000)
1 6,500 0.909 5,909
2 26,500 0.826 21,889
3 41,500 0.751 31,167
4 41,500 0.683 28,345
5 71,500 0.621 44,402
NPV 31,712
The net present value of the project is ` 31,712.
6. Statement Showing the Evaluation of Two Machines
Particulars Machine ‘X’ Machine ‘Y’
(i) Purchase Cost ` 15,00,000 ` 10,00,000
(ii) Life of Machine 3 years 2 years
(iii) Running Cost of Machine per year ` 4,00,000 ` 6,00,000

(iv) PVIFA 0.09, 3 2.531

PVIFA 0.09, 2 1.759
(v) PV of Running Cost of Machine ` 10,12,400 ` 10,55,400
{(iii)×(iv)}
(vi) Cash outflows of Machine {(i) + (v)} ` 25,12,400 ` 20,55,400
(vii) Equivalent PV of Annual Cash ` 9,92,651 ` 11,68,505
outflow (vi/iv)
Recommendation: Ae Bee Cee Ltd. should buy Machine ‘X’ since equivalent
annual cash outflow is less than that of Machine ‘Y’.
7. Option I: Purchase Machinery and Service Part at the end of Year 1.
Net Present value of cash flow @ 10% per annum discount rate.
20,000
NPV (in `) =−1,00,000 +
36,000 36,000 36,000 25,000
+ + − +
(1.1) (1.1)2 (1.1)3 (1.1) (1.1)3
= − 1,00,000 + 36,000 (0.9091 + 0.8264 + 0.7513) – (20,000 

0.9091) + (25,000  0.7513)
= − 1,00,000 + (36,000  2.4868) – 18,182 + 18,782.5
= − 1,00,000 + 89,524.8 – 18,182 + 18,782.5
NPV = − 9,874.7
Since, Net Present Value is negative; therefore, this option is not to be
considered.
If Supplier gives a discount of ` 10,000 then,
NPV (in `) = + 10,000 – 9,874.7 = + 125.3
In this case, Net Present Value is positive but very small; therefore, this option
may not be advisable.
Option II: Purchase Machinery and Replace Part at the end of Year 2.
NPV (in ` ) =−1,00,000 +

36,000 36,000 36,000 30,800 54,000
(1.1)
+ (1.1)2
+ (1.1)3
− (1.1)2
+ (1.1)4
= − 1,00,000+ 36,000 (0.9091 + 0.8264 + 0.7513) – (30,800 

0.8264) + (54,000  0.6830)
= − 1,00,000 + 36,000 (2.4868) – 25,453.12 + 36,882
= − 1,00,000 + 89,524.8 – 25,453.12 + 36,882

NPV = + 953.68
Net Present Value is positive, but very low as compared to the investment.
If the Supplier gives a discount of ` 10,000, then
NPV (in ` ) = 10,000 + 953.68 = 10,953.68
Decision: Option II is worth investing as the net present value is positive and
higher as compared to Option I.
8. Determination of Cash inflows
`
Sales Revenue 1,20,000
Less: Operating Cost 22,500
97,500
Less: Depreciation (` 2,00,000 – ` 18,000)/8 22,750
Net Income 74,750
Tax @ 30% 22,425
Earnings after Tax (EAT) 52,325
Add: Depreciation 22,750
Cash inflow after tax per annum 75,075
Less: Loss of Commission Income 36,000
Net Cash inflow after tax per annum 39,075
In 8th Year :
New Cash inflow after tax 39,075
Add: Salvage Value of Machine 18,000
Net Cash inflow in year 8 57,075
(i) Calculation of Net Present Value (NPV)
Year CFAT PV Factor Present Value of Cash

(`) @10% inflows (`)
1 to 7 39,075 4.867 1,90,178.03
8 57,075 0.467 26,654.03
2,16,832.06
Less: Cash Outflows 2,00,000.00
NPV 16,832.06

Sum of discounted cash in flows 2,16,832.06

(ii) Profitability Index= = =1.084
Present value of cash out flows 2,00,000
Advise: Since the net present value (NPV) is positive and profitability
index is also greater than 1, the hospital may purchase the machine.
9. Workings:
(a) Calculation of annual cash flows (` in lakh)
Year Sales VC FC Dep. Profit Tax PAT Dep. Cash

inflow
1 172.80 103.68 36 43.75 (10.63) − − 43.75 33.12
2 259.20 155.52 36 43.75 23.93 3.99* 19.94 43.75 63.69
3 624.00 374.40 36 43.75 169.85 50.955 118.895 43.75 162.645
4−5 648.00 388.80 36 48.25 174.95 52.485 122.465 48.25 170.715
6−8 432.00 259.20 36 48.25 88.55 26.565 61.985 48.25 110.235
(b) Calculation of Depreciation:
- On Initial equipment = ` 350 lakh =43.75 lakh

8 years
- On additional equipment = (` 25 −2.5) lakh = 4.5 lakh

5years
(c) *Calculation of tax in 2nd Year:
` in lakh
Profit for the year 23.93
Less: Set off of unabsorbed depreciation in 1 st year (10.63)
Taxable profit 13.30
Tax @30% 3.99

(d) Calculation of Initial cash outflow
` in lakh
Cost of New Equipment 350
Add: Working Capital 40
Outflow 390
Calculation of NPV (`in lakh)
Year Cash PV factor PV of cash- Remark

flows @12% flows
0 (390) 1.000 (390.00) Initial equipment cost
1 33.12 0.893 29.57
2 63.69 0.797 50.76
3 162.645 0.712 115.80
3 (25.00) 0.712 (17.80) Additional equipment cost
4 170.715 0.636 108.57
5 170.715 0.567 96.79
6 110.235 0.507 55.89
7 110.235 0.452 49.83
8 110.235 0.404 44.53
8 40.00 0.404 16.16 Release of working capital
8 2.50 0.404 1.01 Additional equipment
salvage value
Net Present Value 161.11
Advise: Since the project has a positive NPV, therefore, it should be accepted.
10. Statement of Operating Profit from processing of waste
(` in lakh)
Year 1 2 3 4
Sales :(A) 966 966 1,254 1,254

Material consumption 90 120 255 255
Wages 180 195 255 300

Other expenses 120 135 162 210

Factory overheads (insurance only) 90 90 90 90
Loss of rent on storage space (opportunity cost) 30 30 30 30
Interest @14% 84 63 42 21
Depreciation (as per income tax rules) 150 114 84 63
Total cost: (B) 744 747 918 969
Profit (C)=(A)-(B) 222 219 336 285
Tax (30%) 66.6 65.7 100.8 85.5
Profit after Tax (PAT) 155.4 153.3 235.2 199.5
Statement of Incremental Cash Flows

(` in lakh)
Year 0 1 2 3 4
Material stock (60) (105) - - 165
Compensation for contract (90) - - - -
Contract payment saved - 150 150 150 150
Tax on contract payment - (45) (45) (45) (45)
Incremental profit - 222 219 336 285
Depreciation added back - 150 114 84 63
Tax on profits - (66.6) (65.7) (100.8) (85.5)
Loan repayment - (150) (150) (150) (150)
Profit on sale of machinery - - - - 15
(net)
Total incremental cash flows (150) 155.4 222.3 274.2 397.5
Present value factor 1.00 0.877 0.769 0.674 0.592
Present value of cash flows (150) 136.28 170.95 184.81 235.32
Net present value 577.36

Advice: Since the net present value of cash flows is ` 577.36 lakh which is
positive the management should install the machine for processing the waste.
Notes:
1. Material stock increases are taken in cash flows.
2. Idle time wages have also been considered
3. Apportioned factory overheads are not relevant only insurance charges of
this project are relevant.
4. Interest calculated at 14% based on 4 equal instalments of loan repayment.
5. Sale of machinery- Net income after deducting removal expenses taken.
Tax on Capital gains ignored.
6. Saving in contract payment and income tax thereon considered in the cash
flows.

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CHAPTER 7

❑ State the objectives of capital investment decisions.

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

7.2 PURPOSE OF CAPITAL BUDGTETING

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7.3 CAPITAL BUDGETING PROCESS

© The Institute of Chartered Accountants of India

7.4 TYPES OF CAPITAL INVESTMENT DECISIONS

On the basis of firm’s

7.4.1 On the basis of firm’s existence

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

7.4.3 Steps of Capital Budgeting Procedure

7.5 ESTIMATION OF PROJECT CASH FLOWS

© The Institute of Chartered Accountants of India

No matter how good a company's maintenance policy, technological or demand

© The Institute of Chartered Accountants of India

(b) Opportunity Cost: Opportunity cost is foregoing of a benefit due to

© The Institute of Chartered Accountants of India

(f) Additional Capital Investment: It is not necessary that capital investment

© The Institute of Chartered Accountants of India

depends on the fact whether analysis is related to fresh project or modernization

© The Institute of Chartered Accountants of India

Final salvage value (disposal costs) of xxx

7.6 BASIC PRINCIPLES FOR MEASURING PROJECT

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© The Institute of Chartered Accountants of India

7.6.2 Exclusion of Financing Costs Principle

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Year 1 Year 2 Year 3 Year 4

Year 1 Year 2 Year 3 Year 4

7.6.3 Post−tax Principle

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4. Less: Variable Cost xxx

© The Institute of Chartered Accountants of India

7.7 CAPITAL BUDGETING TECHNIQUES

Capital Budgeting Net Present Value (NPV)

Modified Internal Rate of

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7.8 TRADITIONAL OR NON-DISCOUNTING

Total initial capital investment

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Year Annual Cash Inflows (`)

Year Annual Cash Inflows Cumulative Cash Inflows

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Year Annual Cash Inflows Cumulative Cash

Payback period shall lie between 3 to 4 years. Since up to 3 years a sum of

© The Institute of Chartered Accountants of India

➢ Payback technique places much emphasis on short payback periods thereby

© The Institute of Chartered Accountants of India

Year Profit Before Depreciation Profit after Value of Investment

The ARR can be computed by following methods as follows:

© The Institute of Chartered Accountants of India

(b) Version 2: Total Investment Basis

© The Institute of Chartered Accountants of India

Years Profit after tax and depreciation (`)

© The Institute of Chartered Accountants of India

= ` 4,60,000÷5years ×100 = ` 92,000 ×100 =9.2%