INVESTMENT DECISIONS: CAPITAL BUDGETING

1. Finance is lifeblood of a modern business enterprise. Adequate

availability of Finance from right source at a right point of time ensures
smooth functioning of the Production and Marketing activities. Thus
Finance, Production and Marketing are 3 important activities of a
business firm.

2. Finance required to conduct the business activities of a Company form of

Organisation, incorporated under the Indian Companies Act, 1956 is
termed as Corporate Finance.

3. Corporate Finance or Financial Management of a Company deals with

managerial activity concerned with planning, raising, investing and
monitoring of funds so as to achieve the financial objectives of a
Corporate Firm and intended to result in maximisation of Shareholders
wealth.

4. Importance of Financial Management and objectives of Corporate

Finance: Every type of business organisation be it small or large requires
finance throughout its life time right from its journey from “Cradle to
Grave”. Finance is rightly treated as the life blood of modern business
considering its importance in various financial activities of the Company
which finally result in achieving the objective of maximisation of
shareholders wealth.
Finance is required for conducting feasibility study and payment of
consultant’s fees, promoting a company, purchasing fixed assets, meeting
working capital needs of the company (such as payment of supplier’s
dues, payment of wages, salaries), undertaking investment decisions,
payment of taxes and dues, ensuring payment of dividends, timely
repayment of loans, modernisation or expansion plans, providing
donations under Corporate Social Responsibilities etc. The demand for
effective management of funds of the Company is ever growing to ensure
shareholders maximisation of wealth. Investing Decision, Financing
decision and Dividend policy are crucial aspects Financial Management
has to engage with. Thus, Financial Management practised by corporate
 firms for attaining effectiveness in financial activities is referred as
Corporate Finance.

5. Profit maximisation and Wealth Maximisation are different in the sense

Profits earned are merely absolute figures and are subject to variations
under difficult situations and does not have potential to absorb business
risk. Wealth Maximisation is considered crucial since they ensure effective
utilisation of resources, projecting Cash inflows / Outflows and keeps
abreast with market changes to take effective and timely decisions to
avoid risks and losses for the Company. While Profit maximisation
increases profit of the organisation and measure the organisational
effectiveness, Wealth Maximisation increases the wealth of the
Shareholders and measures the financial stability of the organisation and
has long term objectives in mind. It increases EPS of Shareholders and
considers time value of money unlike Profit maximisation. Finally, it is the
Finance Manager who has to take Finance decisions and take into
consideration risk and returns before accepting the proposal.

6. Financial Management starts when financial accounting ends. Financial

Accounting is based on accrual principle of accounting of funds, Financial
Management is based on actuarial accounting recognising revenue and
payment on current basis.

7. The functions of Finance in a firm may be divided into three major

decisions that the firm must make:
a. The Investment Decision: Capital Budgeting
b. The Financing Decision: Tapping source of Finance e.g Issue of Shares,
Debentures etc
c. The Dividend Decision : Dividend and Retaining Earnings.

8. Capital Budgeting is defined as the firm’s decision to invest its current

funds most efficiently in long term activities in anticipation of an expected
flow of future benefits over a series of years. Capital expenditure
decisions is also known as Capital Budgeting.

9. Since resources are limited, a choice has to be made among the various
investment proposals by evaluating their comparative merit for which
 some technique need to be followed for making appraisal of investment
proposals.

10.Capital Budgeting decisions are generally needed for purpose of (a)

Expansion (b) Replacement (c) Diversification (d) Buy or Lease (e)
Research and Development.

11.The need of Capital Budgeting Decision arises due to various reasons:

a. Crucial Decisions: Capital Budgeting decisions are crucial, affecting all
the departments of the firm. So, Capital Budgeting decisions are to be
taken very carefully.
b. Long-run Decisions: The implications of Capital Budgeting decisions
extend to a longer period with uncertain future involving risk. The
consequences of a wrong decision will be disastrous for the survival of
the firm.
c. Large amount of funds: Capital Budgeting decisions involve spending
large amount of funds. As such proper care should be exercised to see
that these funds are invested in productive purchases.
d. Rigid: Capital Budgeting decisions cannot be altered easily to suit the
purpose. Because of this reason, when once funds are committed in a
project, they are to be continued till the end, loss or profit no matter.

12. Process of Capital Budgeting process: The major steps in the Capital
Budgeting process, which are usually taken by Top Management cover (a)
Generation of project (b) Evaluation of the project (c) Selection of the
project and (d) Execution of the project.

13. The Evaluation of the project will involve Estimation of Cash Flows ( i.e
Cash Outflows and Cash Inflows ) and Selection of Evaluation
Technique.

14.The Methods of selection of Evaluation/ Appraisal Technique for

Investment criterion covers
a. Traditional Method (Technique which recognise Pay back of Capital
employed) i.e Pay Back Period Method, Pay Back Reciprocal, Pay Back
Profitability.
 b. Traditional Method (Technique which considers Accounting of profit
based on financial statement) i.e Accounting or Average Rate of
Return Method/ Return on Investment method/ Financial Statement
method.
c. Time Adjusted or Discounted Cash Flow Technique (DCF) deals with
Time value of Money
1. Net Present Value Method
2. Profitability Index Method / Discounted Benefit Cost Ratio
3. Internal Rate of Return Method
4. Discounted Pay Back Period
d. Probability Technique for Measurement of Cash Flows
1. Probability Method
2. Standard Deviation Method
3. Co-efficient of Variation Method
4. Decision Tree Analysis

15. Pay Back period is a simple Technique which measures the time within
which the initial investment of the project would or can be recovered
based on the cash accrual generated by the project.
If Average Annual Cash Inflow are equal then Payback period = Original/
Initial investment/ Cash Outlay Divided by Average Annual Cash Inflow
will provide the Pay Back period. For example, If Original investment is
₹ 10,000/- and Average Annual Cash inflow is ₹ 2,000/- then Pay back
period = 10,000/2,000= 5 years. It means, it will take 5 years to recover
the original investment with ₹ 2,000/- equal cash inflow every year.
However, if Cash flows are unequal, cumulative Cash inflow is to be
calculated till they become equal to the initial Cash Outflow/ Original
investment to arrive at Pay Back Period. For example, if original
investment is ₹ 10,000/- and Cash inflow for 1st year is ₹ 3,000/-, 2nd Year
₹ 5,000/- & 3rd Year ₹ 6,000/- then Cumulative Cash Inflow for 1st
year, 2nd Year, 3rd year is ₹ 3,000, ₹ 8,000 & ₹ 14,000/- So the payback
period considering cumulative cash inflow falls between 2nd & 3rd year.
Since ₹ 8,000/- is already received up to 2nd year, balance ₹ 2,000/- is to
be received and considered out of ₹ 6,000/- in 3rd year i.e.,
=2000/6000=1/3rd year = 1/3*12= 4 months. Thus, payback period will
be 2 years and 1/3rd year or 2 years and 4 months.
 Under Pay Back period, we consider Average Annual Cash Flows
considering liquidity of cash flow. It means, Depreciation deducted to
compute Tax is added back since Depreciation is a non cash expense and
a notional charge to get benefit of tax on reduced profit . In short, Profit
After tax/ Earnings after Tax + Depreciation = Cash Flow.
Under Written Down value method of Depreciation, the entire remaining
depreciable value of the asset will be charged as Depreciation in the last
year.

16. Pay Back Reciprocal aims to show return rather than period as a
measure of project profitability. Higher the Pay Back Reciprocal more
profitable is the project and vice versa.

17. Pay Back Profitability = Average Annual Cash Inflows (*) multiplied by
(Estimated life – Pay Back period) + Scrap.

It is the Profitability/ Annual Cash flows beyond the pay back period up
to the estimated life of the project

18. Accounting Rate of Return (ARR) = Average Annual Profit after Tax
(Depreciation not added) Divided by Original/ Average Investment
multiplied by 100.
Average Investment = (Original Investment – Scrap) / 2 + Additional net
working Capital + Scrap value.
In ARR, to arrive at Profit After Tax, the profit is reduced by Depreciation
and Tax is computed on reduced profit (to the extent of depreciation)
and Depreciation is not added thereafter being net Accounting profit (
after Dep. & Tax). It is expressed as a %age.

19. The Concept of Discounted Cash Flow ( DCF) can be understood with
concepts of Compounding and Discounting. To convert Present Value into
Future Value, Compounding is required and in order to convert the Future
Value into Present value, Discounting is required. Say A= Future Value &
P= Present/ Principal value. i = rate of interest, n= no. of years
Compounding A = P (1 + i) raised to n and
Discounting P = A/ (1 + i) raised to n
20. Time value of Money: It is well known fact that the amount received in
future is less valuable than it is today. “A Bird in Hand is Worth Two in a
Bush”. This fall in value of Money is mainly due to future uncertainties
and inflationary pressures. In order to ascertain the, Time value of Money
Discounted Cash Flow Techniques are to be used. Time value of money
represents the difference between value of money receivable at present
and value of money receivable in future. Present value is today’s value of
tomorrows money.

21. Concept of Compounding and Discounting: Compounding refers to the

addition of interest to the principal at periodic intervals. This helps in
establishing a new value for subsequent computations unlike the Simple
rate of interest on same Principal amount. The process of computing
interest applies interest on interest and is continued till the end of the
final year.

22. Compounding is done using the formula:

A (Future value) = P (Present value) (1 + i) raised to n where i is rate of
interest and n is number of years, A is Principal + Interest, P= Principal
Amount.
Discounting is just the opposite of compounding. Here one computes the
present value which is to be received at a future period. Discounting is
done using the formula.
P (Present Value) = A (Future value)/ (1 + i) raised to n.

Present Value (P) ---------------→COMPOUNDING-------------------

→FUTURE VALUE=A

FUTURE VALUE = A ---------------→DISCOUNTING -------------------

→PRESENT VALUE (P)

To convert Present Value into Future Value, Compounding is required and

in order to convert the Future Value into Present Value Discounting is
required. For e.g P=100, i= 10 %, n = 5 yrs
 Compounding Discounting
A= P ( 1 + i) raised to n=5 P= A/(1+i) raised to n=5
= 100 ( 1 + 0.10) raised to n =5 = 161.051/(1+0.1) raised to n=5
= 100 (1.1) raised to n=5 =161.051/1.61051
= 100 * 1.61051 = ₹ 100
A= ₹161.051
It means , the present value of ₹ 161.051 compounded @ 10 % for 5 years
will be ₹ 100/- TODAY. In simple terms it means
YEAR PRINCIPAL/PRESENT INTEREST ( @ COMPOUNDING
VALUE ( Say ₹ 100) 10 % ) ₹ ₹

1 100 10 110
2 110 11 121
3 121 12.1 133.10
4 133.1 13.31 146.41
5 146.41 14.64 161.05
Alternatively, it means Present value of Re 1 at end of 5th Year
compounded @ 10 % is 1*100/161.05= 0.6209= Re 0.621 TODAY. ( Refer
P V Table – Value of Future ₹ 1 Today)

Present value of a Future Re 1 at 10 % Discount rate for 5 years

Present value Future Future Future Future Future
value value value value value
t 1 Re 1 t 2 Re 1 t 3 Re 1 t 4 Re 1 t 5 Re 1
1/ ( 1+0.1) <………
raised to 1=
0.909
1/ ( 1+0.1) <………
raised to 2=
0.826
1/ ( 1+0.1) <………
raised to 3
=0.751
1/ ( 1+0.1) <………
raised to 4
=0.683
1/ ( 1+0.1) <………
raised to 5
=0.621
 Annuity is a series of equal amount of Cash Flows over a specified/
certain period of time e.g LIC (premium payments), Loan Payment, how
much to save presently to get certain amount at a later date etc whereas
Perpetuity is the stream of regular cash flows for an indefinite period.

23. Net Present Value =

Present Value of Cash Inflows (Profit after tax and adding back
depreciation) Less Present Value of Cash Outflows.
Project with higher NPV should be accepted. As stated, Present Value is
today’s value of tomorrows money.
The Cash flows calculated is Cash Flows after Tax (CFAT) is arrived by
adding back Depreciation to Profit after Tax / Earnings after Tax.
EAT/PAT + DEPRECIATION = CFAT. When CFAT is discounted to Present
Value, it will give PV of Cash Inflows.

24.Profitability Index (PI) or Benefit Cost ( B/C) Ratio = PV of Cash Inflows/

PV of Cash Outflows.
If PI is less than 1 , the proposal is rejected and if PI is Higher than 1,it
will be accepted.

25.Internal Rate of Return Method (IRR):

IRR is the interest rate at which the present value of future cash inflows
equates the capital outlay ( present value of the project). The IRR is
determined using “Trial and Error Method”. The present value of cash
flows is determined using an arbitrarily selected rate. The sum of present
values so obtained is compared to the initial investment. If the present
value is higher than the initial investment, a higher rate of discount factor
is selected and the present values are calculated again on the other hand,
if the present value is lower than the initial investment, a lower rate of
discount factor is selected and the process is repeated again. This process
continues until the equality is attained.

IRR is the discount rate when Present Value of Cash Inflows = Present
Value of Cash Outflows, Net Present Value = Zero, Profitability Index=1
i.e Discounted Cash Inflows Divided by Discounted Cash Outflows= 1.
 Steps in calculating IRR using Trial and Error Method:
1. Compute the Fake Payback period = Original / Initial investment/ Cash
Outlay Divided by Average Annual Cash Inflows ( after Tax )or CFAT(
adding back Dep. If any)
2. Locate the Fake payback period across the line of the life of the project
in Annuity Factor Table.
3. Use the Present value factors between which fake payback period lies
in the Annuity Factor Table.
4. Using the Present value factors discount the cash inflows ( CFAT)(
adding back Dep. If any)
5. Determine the net present value at the above present value factors.
6. IRR will lie between a negative and positive NPV. If both the NPV’s are
negative use a lower discount factor and if both the NPV’s are positive
use a higher discount factor.
7. The IRR is computed using the Interpolation technique.
a. Fake Pay Back period= Cash Outlays/ average Annual Cash Inflows
b. From Annuity Table ascertain PV factors (D1 & D2) closest to the
Fake Payback period.
c. IRR= D1 + (PV of CFAT D1 – PV of Cash Outlays) / (PV of CFAT D1 –
PV of CFAT D2) * ( D2- D1). (CFAT= EAT + Depreciation)
d. If IRR is higher than the Cost of Capital, one should accept the
proposal and vice versa.

26. Distinction between NET present Value and Internal rate of return.
a. Under NPV the Cash Flows are converted into their present values by
using a discount rate which is generally taken to be the firm’s cost of
capital.
Under IRR no discount rate is given and it has to be selected such that
the present value of capital outlay exactly equals the present value of
net cash inflows.
b. Under NPV, Proposals resulting in the negative net present values are
rejected being unprofitable. Under IRR, the best investment is the one
that secures the highest rate of yield while equating the capital outlay
with the present value of the net cash flows.
27. Discounted Pay Back Period is defined as the time when the invested
capital has been returned together with the interest cost of the funds
associated with it. At the start of investment, Cash Outlay, PV discount
factor will be with negative outlay/investment.

28. Cost of Capital is the benchmark the organisation uses to evaluate the
investment proposals. The Cost of Capital is the return the organisation
must earn on its investment to meet its investor’s return requirements. If
the Organisation earns returns more than its Cost of Capital from a
proposed investment, the investment is desirable as surplus earned
enhances shareholders wealth. The desired rate of return is the weighted
average Cost of Capital (Cost of Debt and Cost of equity) and is called as
the cut off rate or discount rate or hurdle rate.

29. Sensitivity Analysis is a way of analysing change in the projects NPV or

IRR for a given change in any “variable” such as expected sales volume,
selling price, material costs, labour costs etc. It indicates how sensitive
a projects NPV or IRR is to changes in particular variables. The more
sensitive the NPV, the more critical the variable. It is used to analyse
the risk in short term decision opportunities. Thus, Sensitivity analysis
helps in focussing more attention on critical variables.

Sensitivity with Annual Cash flow = NPV/ Annual Cash Flow

Sensitivity with Project cost = NPV / Project Cost

The lesser of the above is more sensitive than the other.

30.Probability Technique for measurement of Cash Flow

a. Probability Method: Sensitivity Analysis fails to show the changes of
variability of cash flow. Probability assignment give some definite
measure of possibility of different cash flows. For e.g if the probability
of occurrence of cash flow of ₹ 40,000 is 0.6. It means the probable
cash flow is ₹ 24,000. If the probability is 1, it means it is certain to take
place. If probability is 0, it means it is not likely to occur at all. Thus,
probability varies from 0 to 1.
 b. Standard Deviation Method: Probability assignment takes into
account the risk in terms of variability in cash flows. However, it does
not indicate the extent of variability or the extent of risk in cash flow
estimates. Under this method, we calculate the dispersion of cash
flows which indicates the degree of risk. It is the difference between
the possible cash flows and their estimates. The project which has
higher standard deviation is considered riskier. The project which has
smaller standard deviation is considered less risky.
c. Co-efficient of Variation Method: Standard Deviation is an absolute
measure of variability. It cannot be used for comparison of 2 projects
when their sizes are different. Co-efficient of variation is a relative
measure of dispersion. It indicates that higher the co-efficient , the
risker is the project. Co-efficient of Variation = Standard deviation/
Expected Cash Flow. Select the project which has lesser co-efficient
of variation.
d. Decision Tree Analysis: It is a quantitative technique used to evaluate
risky proposals. A Decision tree is a pictorial representation in a tree
form which indicates the magnitude of probability and inter
relationship of possible decisions.
Under Decision tree approach it is possible to see a large number of
decisions arising out of the main decision. This is known as Decision
Tree because just as several branches come out of the main trunk of a
tree, in the same way major decision brings out a number of sub-
decisions.

31. Capital Rationing:

a. The difference between NPV and PI is that NPV attempts to analysing
the value of the firm in absolute terms while PI considers value of Firm
in relative terms.
b. Under Capital Rationing the objective is to select the combination of
investment proposals that provide the highest net present values,
subject to the budget constraint for the period.
c. Capital rationing refers to a situation where a firm is constrained, for
self-imposed or external reasons, to obtain necessary funds to invest
in all profitable investment projects. Such Constraints which lead to a
decision to keep capital expenditures within a ceiling during a specified
 period of time may arise due to self- imposed restrictions or market
conditions.
d. In Capital rationing the projects will be ranked, using the PI method in
descending order of profitability. Thereafter the projects will be
selected in descending order of profitability until the entire funds are
exhausted.

32. Mutually Exclusive decisions:

Two or more capital projects are said to be mutually exclusive when
the acceptance of one of them results in automatic rejection of all
others. This type of decision arises when a choice is to be made
between two or more competing projects. In the case of mutually
exclusive decisions, the result given by IRR and NPV may be either
identical or different.

PROBLEMS ON CAPITAL BUDGETING

1. Mimosa Company Ltd has invested in a machine at cost of ₹ 9,00,000.

Following details are estimated:
Retrenchment of Staff: 4 Staff @ salary of ₹ 20,000.
Additional Staff required: 1 Staff @ salary of ₹ 40,000.
Savings in wastage: ₹ 40,000
Savings in Maintenance: ₹10,000
Additional electricity Bill: ₹ 15,000
Calculate Pay Back Period. Ignore Taxation and Depreciation.
2. Calculate Pay Back period from the following information of Safer Ltd.
Investment: ₹ 1 Lakh, estimated life 10 years, Tax Rate 50 %.
Year Profit before Depreciation Profit after Tax @ 50
Depreciation Depreciation %
₹ ₹ ₹ ₹
1 40,000 10,000 30,000 15,000
2 60,000 10,000 50,000 25,000
3 50,000 10,000 40,000 20,000
4 50,000 10,000 40,000 20,000
3. If the net cash outlay of an investment project is ₹ 30,000 and the
annual cash inflows for 5 years are
 ₹ 9,000; ₹ 12,000; ₹ 8,000; ₹ 4,000 and ₹ 5,000 respectively. Calculate
the Pay Back period for Victor Ltd.
4. Excel Trading Co. Ltd is considering the purchase of a New Machine for
the immediate expansion programme. There are three types of
machines in the market for this purpose. Their details are as follows:
Particulars Machine Machine Machine
A B C
₹ ₹ ₹
Cost of Machine 17,500 12,500 9,000
Estimated savings in Scrap per year 400 750 250
Estimated savings in direct wages 2,750 6,000 2,250
per year
Additional Cost of indirect - 400 -
Materials per year
Expected savings in indirect 100 - 250
Materials per annum
Additional cost of Maintenance per 750 550 500
year
Additional Cost of supervision - 800 -
Estimated Life of Machine ( Yrs) 10 6 5
Taxation at 40 % of profit
You are required to advise the Management which type of machine
should be purchased on the basis of Pay Back period.
5. Jugnu Company Ltd is proposing to expand its production. It can go in for
a Standard Machine costing ₹ 50,000 or an Assembled machine costing ₹
50,000. The life of both these machines is 5 years.
The annual sales and costs are as under:
Particulars Standard Assembled
₹ ₹
Sales 50,000 50,000
Materials 15,000 15,000
Labour 7,000 6,000
Variable Overheads 7,000 6,000
Compute the comparative profitability of the proposals under the pay
back period. Also calculate the Pay back profitability. Ignore taxation and
Depreciation.
6. Alpha Ltd is procuring articles mostly on hand labour and is considering
to replace it by a new machine. There are two alternative models P and
 Q of the new machine. Prepare a statement of profitability showing the
pay-back period from the following information.
Particulars Machine P Machine Q
Estimated life of Machine 4 years 5 years
₹ ₹
Cost of Machine 9,000 18,000
Estimated savings in scrap 500 800
Estimated savings in direct 6,000 8,000
wages
Additional cost of 800 1,000
Maintenance
Additional cost of 1,200 1,800
supervision
Ignore Taxation and Depreciation. Also calculate the Pay Back
Profitability.
7. From the following details of Omega Ltd, calculate Pay Back Period and
Pay Back Profitability
Particulars ₹
Sales 8,000
Variable Cost 3,000
Fixed Cost 2,000 (excluding depreciation)
Investment 10,000
Life 10 years. Tax @ 50 %.
8. Charlie Company Ltd wishes to buy a machine costing ₹ 2,00,000. The
life of this machine is 10 years and its scrap value would be ₹ 5,000.
The following details are provided:
Average Annual NPBT ₹ 20,000
Tax Rate 35%
Depreciation (already charged) SLM basis
Calculate:
a. Pay Back Period b. Pay Back Profitability c. A.R.R. (Accounting Rate of
Return Method)
9. The Directors of Delta India Ltd are considering the purchase of a
machine to replace a machine which has been in operation for the last 5
years. The details relating to the available alternative machines are as
follows:
Particulars Old Machine New Machine
₹ ₹
 Purchase Price 2,00,000 3,00,000
Power per year 10,000 22,500
Consumable Stores per 30,000 37,500
year
Other charges per year 40,000 45,000
Wages per running hour 15 26.25
Selling price per unit 6.25 6.25
Material Cost per Unit 2.50 2.50
Estimated life of 10 years 10 years
Machine
Machine running hrs per 2,000 hrs 2,000 hrs
year
Units of output per hour 24 units 36 units
Assuming that the above sales and cost of sales hold good for the entire
economic life of the machines, suggest which of the two alternatives
should be preferred using Average Rate of Return ( ARR). Depreciation
has to be charged according to Straight Line Method.
10.Determine the (a) Pay Back period and (b) A.R.R from the following
information of a proposed project.
Particulars ₹
Annual Profits after Tax and 5,20,000
Depreciation
Year 1 30,000
Year 2 50,000
Year 3 70,000
Year 4 90,000
Year 5 1,10,000
TOTAL 3,50,000
Estimated life: 5 years and Estimated Scrap Value: ₹ 20,000
11.Gati Company Ltd is considering the following three investment proposals
requiring a net cash outlay of ₹ 1,20,000; ₹ 1,70,000 and ₹ 2,40,000
respectively. After cash inflows are tabulated below.
Rank these projects in order of their profitability according to the
Profitability Index Method. Assume that the firms cost of capital is 15 %.
Year After Tax Cash Inflows PV of Re 1 at 15
% Discounting
factor
Project X Project Y Project
Z
 ₹ ₹ ₹
1 10,000 50,000 90,000 0.870
2 30,000 65,000 1,20,000 0.756
3 45,000 85,000 70,000 0.658
4 65,000 50,000 50,000 0.572
5 45,000 35,000 20,000 0.497

12.The Cash Flow streams for two alternative investments Tata and Bata
are:
Year Tata Bata
₹ ₹
0 (2,00,000) (2,10,000)
1 50,000 80,000
2 80,000 60,000
3 1,00,000 80,000
4 80,000 60,000
5 60,000 80,000
Calculate (i) Pay Back Period (ii) Net present value using 11 % discount
rate and (iii) Benefit Cost ration using 11 % discount rate, for the two
alternatives. Which would you choose? Why? (PV discounted factor @ 11
% for 5 years is .901;.812;.731;.659 & .593)
13.Speed age Company Ltd is considering a project which costs Rs 5,00,000.
The estimated salvage value is zero. Tax rate is 55 %. The company uses
straight line depreciation and the proposed project has cash inflows
before depreciation and tax (CFBDT) as follows:
Year end Cash Inflows (₹)
1 1,50,000
2 2,50,000
3 2,50,000
4 2,00,000
5 1,50,000
If the Cost of Capital is 12 %, would you recommend the acceptance of
the project under Internal Rate of Return Method? PV factor @ 12 % are
0.893;0.797;0.712;0.636 & 0.567 for first 5 years and @ 14 % are
0.877;0.769;0.675;0.592 & 0.519 for first 5 years.
14.Chingari Ltd is currently under examination of a project which yield the
following returns over a period of time:
Year end Gross Yield (Rs)
1 8,000
2 8,000
3 9,000
4 9,000
5 7,500
The Cost of the machinery to be installed works out to Rs 20,000 and the
machine is to be depreciated at 20 % on Written Down Value ( WDV) basis.
Income Tax Rate is 50 % . If the average cost of raising capital is 18 %,
would you recommend accepting the project under IRR Method. PV
Factor @ 15 % are .870;.756;.658;.572;.497 for first 5 years and @ 16 %
are .862;.743;.641;.552; & .476 for first 5 years.
15.Calculate IRR for the following projects and decide which is the most
profitable project.
Cash inflows ( CFAT)
Particulars Project X Project Y Project Z
₹ ₹ ₹
Initial Cost 6,00,000 6,60,000 7,20,000
End of Year
1 30,000 3,60,000 1,20,000
2 1,20,000 2,40,000 1,80,000
3 1,80,000 - 1,20,000
4 2,40,000 - 3,00,000
5 3,00,000 1,80,000 1,20,000
6 (60,000) 1,20,000 60,000
TOTAL 8,10,000 9,00,000 9,00,000
Use Discount rate for Project as follows to calculate IRR:
Project X – 8 % & 10 %, Project Y – 12% & 14 %, Project Z – 6 % & 8 %
PV factor @ 6 % for first 6 Yrs are .943;.890;.840,.792,.747 & .705
PV factor @ 8 % for first 6 Yrs are .926;.857;.794;.735;.681 & .630
PV factor @ 10 % for first 6 Yrs are .909;.826;.751;.683;.621 & .564
PV factor @ 12 % for first 6 Yrs are .893;.797;.712;.636;.567 & .507
PV factor @ 14 % for first 6 Yrs are .877;.769;.675;.592;.519 & .456
16.A Company is considering the two mutually exclusive projects. The
Finance Director considers that the project with higher NPV should be
chosen; whereas the Managing Director thinks that one with higher rate
of return should be considered. Both the projects have got a useful life of
5 years and the cost of capital is 10 %. The initial outlay is Rs 2 Lakhs.
The future cash inflow (Before Depreciation) from Project X and Y are as
under: No tax is applicable.
Year Project X Project Y PV Factor @ PV Factor @
( ₹) ( ₹) 10 % 20 %
1 35,000 1,18,000 0.91 0.83
2 80,000 60,000 0.83 0.69
3 90,000 40,000 0.75 0.58
4 75,000 14,000 0.68 0.48
5 20,000 13,000 0.62 0.41
You are required to evaluate the projects and explain the inconsistency, if
any in the ranking of the projects using Pay Back Period Method, ARR, Net
present Value Method, Profitability Index & IRR.
17.A Company can make either of two investments at period t5. Assuming a
required rate of return of 10 %, determine for each project: a. Pay Back
Period b. Discounted Pay Back period c Profitability Index and d. Internal
Rate of Return. You may assume straight line depreciation.

P Q
Cost of Investment (Rs) 2,00,000 2,80,000
Estimated Life ( No salvage) 5 Years 5 Years
Projected net income ( after Depreciation,
interest and taxes)
YEAR ₹ ₹
1 10,000 24,000
2 10,000 24,000
3 20,000 24,000
4 20,000 24,000
5 20,000 24,000
( PV factor @ 10 % are .909;.826;.751;.683 & .621 for first 5 Years; @ 12
% are .893;.797;.712;.636 & .567; As per Annuity Table across the line of
5th year PVF is 3.605 & 3.433 at 12 % & 14 % Discount Rate. For Project
P use 10 % & 12 % P V Factor and for Project Q use 12 % & 14 % Discount
Rate )
 18.Caravan Corporation is venturing in a new project. Initial investment for
the project is Rs 20 lakh. The rate of depreciation 25 % on WDV basis. The
rate of discount is 10 % , Tax rate is 40 %. Calculate a. ARR b. Discounted
Pay Back Period c. Discounted Pay Back profitability.
Year 2005 2006 2007 2008 2009
Earnings Before Tax 2 5 7 9 2
( ₹ in lakhs)
PV Factor @ 10 % 0.909 0.826 0.751 0.683 0.621
19.The details of a capital investment project are given below:
Initial investment for Plant and Machinery ₹ 100 lakh
Additional investment in working capital( outflow at ₹ 40 Lakh
th
beginning and recovery at end of the 5 year)
Sales ( Units) per year for years 1 to 5 ₹ 1 lakh
Selling price per unit ₹ 120
Variable Cost per unit ₹ 60
Fixed Overheads ( excluding depreciation ) per year ₹ 15 lakh
for years 1 to 5
Rate of Depreciation on plant and Machinery 25 % on
W D V method
Salvage value of plant and Machinery = WDV at the
end of year 5
Applicable Tax rate 40 %
Time horizon 5 years
Post- tax cut off rate 12 %
Calculate NPV and Discounted Pay Back period
Discoun 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr
t Factor
@ 12 % 1.00 0.892 0.797 0.711 0.635 0.567 0.506 0.452
0 9 2 8 5 4 6 3
@ 25 % 1.00 0.800 0.640 0.512 0.409 0.327 0.262 0.209
0 0 0 0 6 7 1 7
@ 40 % 1.00 0.714 0.510 0.364 0.260 0.185 0.132 0.094
0 3 2 4 3 9 8 9
20.TYPE: CAPITAL RATIONING .Indica Chemicals Ltd is considering the
following projects:
Project Outlay ₹ NPV ₹
A 1,60,000 65,000
B 1,40,000 50,000
 C 1,20,000 45,000
D 80,000 30,000
E 70,000 32,000
Projects B & C are mutually exclusive so are Projects D & E. Capital
Budget constraint is ₹ 3,00,000. Choose the feasible combination that
has the highest NPV. Give reason.
21.Tango Ltd is considering the following projects:
Project Outlay ₹ NPV ₹
A 15,00,000 5,00,000
B 10,00,000 4,50,000
C 9,00,000 4,00,000
D 8,00,000 3,50,000
E 7,00,000 2,50,000
Select the most profitable project considering Capital Budget Constraint
is of Rs 25,00,000.
22.Total available fund for capital expenditure in a year in a firm is
estimated at Rs 2 Lakhs. The mutually exclusive investment proposals
along with profitability index are given below:
Project A B C D E F G
Initial 25 35 25 80 20 40 20
Outlay (
₹’000)
PI 0.94 1.16 1.14 1.25 1.05 1.09 1.19
Which of the above projects should be accepted?
23.The following investment proposals are competing for selection. The PI
of each of these proposals is also given.
Proposal P Q R S
Initial Outlay 25 35 40 30
(Rs’000)
PI 1.13 1.11 1.15 1.08
If the budgeted fund is ₹ 60,000, select the most profitable projects.
24.Jack and Jill furnish the following information. Investment limit: ₹
7,00,00,000
Project Initial Outlay NPV
₹ ₹
M 340 26.7
N 280 36.7
O 300 38.8
 P 320 70.6
Rank them on PI and select them. Also determine the aggregate NPV for
the selected projects. All projects are DIVISIBLE i.e size of investment can
be reduced, if necessary, in relation to the availability of funds. None of
the projects can be delayed or undertaken more than once.
25.Humpty and Dumpty Ltd. Furnishes the following information:
Investment Ltd is ₹ 70 Lakh.
Project Initial Outlay NPV
( ₹) (₹)
P 50 20
Q 10 9
R 35 7.2
S 32 6.4
Q and R are mutually exclusive. None of the projects can be delayed or
undertaken more than once. Suggest the most feasible combination.
26.TVS is considering a purchase of machine .X and Y are the 2 machines
available. From the following information, suggest which of the two is
recommended under a. ARR b. Profitability Index method
Machine X (₹) Machine Y ( ₹)
Cost 4,00,000 5,60,000
Life 5 Years 7 Years
Profit after Tax
Year 1 12,000 10,000
Year 2 12,000 40,000
Year 3 42,000 40,000
Year 4 24,000 20,000
Year 5 12,000 10,000
Year 6 - 10,000
Year 7 - 10,000
(i) Profit is calculated after deducting straight line depreciation and
tax.
(ii) The Cost of capital is 10 %.
(iii) The PVF’s at 10 % for years ending 1,2,3,4,5,6 and 7 are
0.909,0.826,0.751,0.683,0.621,0.564 and 0.513 respectively.
(iv) Depreciation for both the Machines is ₹ 80,000 p.a.
27.A Company is contemplating to purchase a machine. Two Machines A and
B are available, each costing ₹ 5 Lakhs. In comparing the Profitability of
the machines, a discounting of 10 % is to be used and machine is to be
 written off in 5 years by straight line method of depreciation. Cash inflows
after tax are expected as follows:
Year Machine A Machine B
( ₹ in lakhs) ( ₹ in lakhs)
1 1.5 0.5
2 2.0 1.5
3 2.5 2.0
4 1.5 3.0
5 1.0 2.0
Indicate which Machine would be profitable considering NPV Method .
The discounting factors at 10 % are 0.909;.826;0.751;0.683;0.621
(NPV/PI-MCOM APRIL 2017)

28.Bajaj Motors Ltd provides you the following information:

Purchase price of each equipment ₹ 14,00,000; Working Capital ₹
6,00,000( To be considered as outflow at beginning of year and recovered
at end of 5th year ),Life of Machine 5 years, Estimated salvage value ₹
4,00,000;Method of Depreciation – SLM.
Tax rate 40 %;Cost of Capital 10 %. Earnings before depreciation and tax
Year Equipment A Equipment B P V Factor
₹ ₹ @ 10 %
1 7,00,000 2,00,000 0.9091
2 7,00,000 3,00,000 .8264
3 7,00,000 5,00,000 .7513
4 7,00,000 6,00,000 .6830
5 7,00,000 28,00,000 .6209
Calculate NPV and select the most profitable equipment ( WORKING CAP GIVEN-
MCOM OCT 2016)
29.Panther claw productions Ltd wants to introduce a new product with
estimated Life of 5 years. The Manufacturing equipment will cost ₹
2,50,000 with the scrap value of ₹ 15,000 at the end of 5 years. The
working capital requirement is ₹ 20,000 which will be released after 5
years. The Annual Cash Inflow and PV factor @ 10 % are:

Year PV Factor ₹
1 0.9091 1,25,000
2 .8264 1,50,000
3 .7513 1,87,500
 4 .6830 1,80,000
5 .6209 1,12,500
Depreciation to be charged under Straight Line Method Tax applicable @
40 % . Evaluate the proposal under NPV METHOD( Working Capital
requirement given)- MCOM APRIL 2016
30.Jaslok Hospital is considering to purchase a Diagnostic Equipment costing
₹ 80,000. The projected life of the equipment is 8 years, and it has an
expected salvage value of ₹ 6,000 at the end of 8 years. The Annual
operating cost of the equipment is ₹ 7,500. It is expected to generate sales
of ₹ 40,000 per year for 8 years. Presently the Hospital is outsourcing the
diagnostic work and is earning commission income of ₹ 12,000 p.a, net of
taxes which will be discontinued if hospital purchases Diagnostic
Equipment . Tax rate is 40 % . Whether it would be profitable for the
Hospital to purchase the equipment?. Give your recommendation under
New Present Value method. PV Factors at 10 % are given below:

Year PV Factor @ 10 %
1 0.909
2 .826
3 .751
4 .683
5 .621
6 .564
7 .513
8 .467
( Evaluation of Outsourcing V/s Purchase of equipment ) MCOM OCT
2015
31.Konak Ltd is considering two mutually exclusive project investments,
either ₹ 195 Lakhs in Fully Automatic Machine or ₹ 150 Lakhs in Semi-
Automatic Machine. Both the Machines have scrap value at the end of
eight years to their respective WDV. You are given the present value of ₹
1 @ 10 % rate of 8 years and estimated profit before depreciation and
Income Tax as follows:
Year PV of ₹ Fully Automatic Semi-Automatic
1 Machine ( ₹ in Machine ( ₹ in
Lakhs) Lakhs)
1 0.909 36 23
2 0.826 38 24
 3 0.751 40 25
4 0.683 42 26
5 0.621 44 27
6 0.564 46 28
7 0.513 47 29
8 0.467 48 30
The Company provides Depreciation on Machinery @ 10 % on WDV
basis and pays income tax @ 40 %. You are required to calculate NPV of
each machine @ 10 % and suggest which Machine to be purchased. (
Scrap value is WDV after 8 yrs- MCOM April 2014, Oct 2006)
32 Cash inflows of a certain project along with cash outflows are given
below: ( OUTFLOWS FOR 2 YEARS)
YEAR OUTFLOWS INFLOWS
₹ ₹
0 150000 -
1 30000 20000
2 - 30000
3 - 60000
4 - 80000
5 - 30000
Salvage value ₹ 40,000 at the end of 5 years. The cost of capital is 10 %.
The PV of ₹ 1 @ 10 % p.a is given below:
Year 1 2 3 4 5
PV Factor 0.90909 0.82645 0.75131 0.68301 0.62093
Calculate net present value on the basis of discounted cash flows @ 10 %
discounting factor. Offer your comments whether the project should be
accepted or not.
 PROBLEMS WITH SOLUTIONS – LATEST UNIVERSITY PAPERS
1. A limited company is considering the purchase of a new machine which
will replace some operations. There are two alternatives A and B. From
the following information, prepare a profitability statement and work
out the payback period for each. Also calculate the net present value of
both the alternatives if the cost of capital is 8 percent.

Particulars Model A Model B

Cost of the Machine in Rs 5,00,000 6,00,000
Estimated life in years 5 6
Additional Cost in Indirect Materials in Rs 8,000 9,000
Estimated savings in scrap in Rs 50,000 60,000
Additional cost of maintenance in Rs 15,000 20,000
Estimated savings in Direct wages
Employees not required 15 20
Wages per employee p.a in Rs 10,000 p.a 8,000 pa

Tax rate is 40 %. Suggest which machine should be preferred

SOLUTION
PARTICULARS MODEL A MODEL B
Estimated savings in scrap 50000 60000
Estimated savings in wages 150000 160000
Total savings A 200000 220000
Additional cost
Indirect materials 8000 9000
Cost of maintenance 15000 20000
Additional Cost B 23000 29000
177000 191000
Less Depreciation 100000 100000
NBT 77000 91000
Tax 30800 36400
NPAT 46200 54600
Add Depreciation 100000 100000
Annual Cash Inflow C 146200 154600
Payback= Invest/ Cash inflow
Cash Outflow 500000 600000
Pay Back period 3.42 3.9
Calculation of NPV discounting rate 8 % 5 years 6 years
PVAF for 8 % 3.99 4.62
Present value of Cash Inflow D 583338 714252
Net Present value 83338 114252

As per Pay Back period Model A is to be selected and as per NPV method
Model B is to be selected
2. PQR Ltd is considering a project for which the following estimates are
available.

Initial cost of the Project Rs 5 Lacs

Sales price/ Unit Rs 75
Cost per unit Rs 45
No. of units sold pa 5,000
Life of the project 5 years
Cost of Capital 10 %
Calculate the sensitivity of the project with project cost, annual cash
flow and state which if the most sensitive?
SOLUTION
Sales price per unit 75
Cost per unit 45
Profit 30 Per unit
No.of units 5000
Total profit 150000
Add Depreciation 100000
Annual Cash inflow 250000
Present Value of cash inflow @ 10 % for 5 3.7908
years
947700
Cash Outflow 500000
Net present value 447700
Sensitivity with Annual Cash flow NPV/ Annual
Cash inflow
447700/947700 0.47
Sensitivity with Project cost NPV/ Project
cost
 447700/500000 0.90
Annual cash inflow is more sensitive than
project cost

3. In a Capital rationing situation ( investment limit is Rs 50 lakh. Suggest

the most desirable feasible combination on the basis of the following
data ( indicate justification ) ( Rs Lakh)
Projects Initial Outlay NPV
A 29 12
B 21 9
C 10 8
D 20 6
Project B and C are mutually exclusive.
SOLUTION

Combination of projects Total Outlay NPV

A&B 50 21
A&C 39 17
A&D 49 18
B&D 41 15
C&D 30 14

A & B combination gives highest NPV of Rs 21 Lakh. Therefore undertaking

Projects A & B the wealth can be maximised.

4. XYZ Ltd is considering the new project.

Initial cost of the project is Rs 5,00,000 and Discount rate is 11 %
Cash flow for the 6 years are as follows:

Year Cash flow PVF

1 100000 0.9009
2 110000 0.8116
3 120000 0.7312
4 130000 0.6587
5 140000 0.5934
 6 150000 0.5346

Calculate NPV , Profitability index and discounted Pay Back period

SOLUTION
CALCULATION OF NPV
PARTICULARS CASH FLOW PVF PV
INITIAL COST -5,00,000 1 -5,00,000
YEAR 1 1,00,000 0.9009 90,090
YEAR 2 1,10,000 0.8116 89,276
YEAR 3 1,20,000 0.7312 87,744
YEAR 4 1,30,000 0.6587 85,651
YEAR 5 1,40,000 0.5934 83,076
YEAR 6 1,50,000 0.5346 80,190
NPV 16,007

CALCULATION OF PROFITABILITY INDEX

PROFITABILITY INDEX = PV OF CASH INFLOW/ PV OF CASH OUTFLOW
= 5,16,000/5,00,000=1.032
CALCULATION OF DISCOUNTED PAY BACK PERIOD
YEAR PV CUMMULATIVE
1 90,090 90,090
2 89,276 1,79,366
3 87,744 2,67,110
4 85,651 3,52,741
5 83,076 4,35,817
6 80,190 5,16,007

Discounted pay back period :

Year before full recovery + ( initial cost – Cummulative cash flow of year
before full recovery / Cash flow of year of recovery.
= 5+ ( 5,00,000-4,35,817)/80,190= 5.8