13 - Advanced Capital Bud Class Notes

Chapter 13
ADVANCED CAPITAL
BUDGETING
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ADVANCED CAPITAL BUDGETING 13.2
BASICS OF INVESTMENT DECISION

INTRODUCTION
• Long term investment decision regarding capital assets (i.e. machine,
project, etc) is also termed as Capital Budgeting or, Investment
decision).
Balance Sheet of a Company

Liabilities ₹ Assets ₹
(Sources of fund) (Application of fund)
Equity xxx Machine xxx
Preference xxx +
Debt xxx Working Capital xxx
xxx xxx
Capital Employed Invest or not (?)

% cost is WACC Capital Budgeting
• Capital budgeting decision depends upon various factors. Some

factors are:
(i) Outflow in the project (Machine & Working capital)
(ii) Inflow from project
(iii) Required return of a project [i.e. Return based on Risk or
Cost of capital-WACC ]
(I) OUTFLOW IN THE PROJECT:

• Cost of machine and value of working capital is outflow of project.
• Sometimes company pays value of machine in instalment. In this
case calculate present value of all payment to calculate PV of
Outflow in the project.

13.3 AFM | SFM CLASS NOTES
(II) INFLOW FROM PROJECT:

(A) ANNUAL CASH INFLOWS (ACIF) OR CFAT
Method-1: ACIF = [EAT + Depreciation]
(₹) Example
EBDT xxx 60,000
Less: Dep xxx 50,000
EBT xxx 10,000
Less: Tax xxx 3,000
EAT xxx 7,000
Add: Dep xxx 50,000
ACIF/CFAT xxx 57,000
Method-2: ACIF= [EBDT x (1-t)] +Tax saving on Depreciation

(₹) Example
EBDT xxx 60,000
Less: Tax xxx 18,000
xxx 42,000
Add: Tax saving on Dep xxx 15,000
(50,000 x30%)
ACIF/CFAT xxx 57,000
Method-3: ACIF/CFAT = EBDT – Correct Tax

In our example:
ACIF = 60,000 – 3000 = 57,000
To calculate it, we must

have to follow Method-1
(B) INFLOW FROM SALVAGE:

• Scrap value realisable from machine at end of life of project is
known as salvage.
• If sale value is higher than WDV of machine then short term
capital gain arises or vice versa.

• Inflow from salvage [At end of life]

= Sale value – Tax on STCG or,
Sale value + Tax saving on STCL
Where, STCG/LTCG is calculated as follows:

Sale value xxx
Less: WDV in book xxx
STCG/STCL xxx
STCG = Short term capital gain

STCL = Short term capital loss
Tax on STCG = (STCG x Tax rate)
Tax saving on STCL = (STCL x Tax rate)
(C) INFLOW FROM WORKING CAPITAL:

• Realisable value of working capital is inflow at end of the life.
• If question is silent, assume realisable value at end of life is
equal to value of working capital at beginning.
(III) REQUIRED RETURN OF THE PROJECT:

• Required return is fair expected return of a project
calculated using risk factor.
• High risk  High required return
Low risk  Low required return
Calculation of RR:
(i) Risk factor (β) of project is given
RR = RF + βproject (Rm – RF)
(ii) If risk factor of similar risk industry (i.e. proxy entity) is

given:
Assume, proxy entity risk as project risk and use same formula
RR = RF + βproxy (Rm – RF)

(iii) If risk factor is not given:

Assume, cost of capital (WACC) as fair expected return of the
project (i.e. required return)
CONCEPT: PROJECT EVALUATION TECHNIQUE
Project Evaluation
Technique
Time value adjusted Time value not adjusted

technique technique
NPV (Net present value) Payback period
PI (Profitability Index)
IRR (Internal Rate of Return) Payback reciprocal
MIRR (Modified Internal ARR (Accounting
Rate of Return) rate of return or,
Modified NPV Average rate of
return)
Discounted Payback Period
(1) NET PRESENT VALUE (NPV):

• Difference between PV of inflows and PV of outflows is known as
NPV.
• NPV = [PV of inflows – PV of outflows]
Where,
• PV of outflows = Cost of machine + Value of working capital
• PV of inflows:
0 year 1 year 2 year n year
ACIF ACIF ACIF

PV +SV
of + WC
Inflow
Discount @ RR (Requited Return)

Where, SV = Salvage Value; WC = Working Capital
Note: For NPV always use RR as discount rate.

Decision:
(i) [NPV = +Ve]  Accept the project
(ii) [NPV = -Ve]  Reject the project
(iii) [NPV = zero]  Accept the project
[Because project still provides that
return which is required by investor]
(2) PROFITABILITY INDEX OR, PRESENT VALUE INDEX OR,

DESIRABILITY FACTOR OR, BENEFIT TO COST RATIO:
𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬
PI = [𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰𝐬]
Decision:
(i) If PI > 1  Accept the project
(ii) If PI < 1  Reject the project
(iii) If PI = 1  Accept the project
(3) IRR [INTERNAL RATE OF RETURN]:
• Annual compounded return calculated using cash flows of project
is known as Internal rate of return (IRR).
• For calculation of IRR, we have to use interpolation technique
studied in Time Value of Money.
ACIF ACIF ACIF

PV +SV
of + WC
Inflow
Discount @ R%
Must be IRR is that discount rate Use Interpolation

equal to where PV of inflows is Technique studied
Outflow equal to PV of Outflow in TVM Chapter

Decision:
(i) If IRR > RR  Accept the project
(ii) If IRR < RR  Reject the project
(iii) If IRR = RR  Accept the project
COMPARISON AMONG NPV, PI & IRR VS. RR

NPV PI IRR Vs. RR Decision
+Ve >1 IRR > RR Accept
-Ve <1 IRR < RR Reject
Zero =1 IRR = RR Accept
COMPARISON BETWEEN IRR & RR

(a) RR (Required Return):
• Fair expected return based on risk factor is known as RR.
• PV of inflows calculated using RR may be or may not be equal to
PV of outflow. [i.e. NPV  +Ve / -Ve / Zero]
(b) IRR (Internal Rate of Return):

• Annual compounded return expected from project calculated
using expected cash flows is known as IRR.
• PV of inflows calculated using IRR should be equal to PV of
outflow. [i.e. NPV = 0]
(4) MODIFIED INTERNAL RATE OF RETURN (MIRR):

• IRR is Annual compounded return based on cash flows of project.
However, investor can earn compounded return only when they re-
invest intermediate period cash flows at IRR rate itself.
• When intermediate period inflows are re-invested at a rate other
than IRR, then actual return changes and that changed return is
also termed as MIRR.
• If question is silent on re-investment rate then use cost of capital
as re-investment rate.

Example:
0 year 1 year 2 year 3 year
(500) 300 250 200

Outflow Inflow Inflow Inflow
Calculate “return of project” if intermediate period cash flows

are re-invested at 12% p.a.
In other words, calculate MIRR, using 12% reinvestment rate.
Calculation:
(500) 300 250 200

280
@12 % p.a.
376.32
856.32
It Means
(500) 856.32
@ R% [MIRR]
500 x (1 + R) 3 = 856.32
1
856.32 3
(1 + R) = [ ]
500
R = 19.64% (i.e. MIRR)
Decision:
(i) If MIRR > RR  Accept the project
(ii) If MIRR < RR  Reject the project
(iii) If MIRR = RR  Accept the project

(5) MODIFIED NPV:

• Net present value calculated using reinvested cash flows is also
termed as modified NPV.
• Reinvested cash flow is future value of intermediate period cash
inflows when these are reinvested at a rate other than cost of
capital.
0 Year 1 year 2 year 3 Year 4 year
(Outflow) ACIF ACIF ACIF ACIF + Sal. + WC
FV
Reinvest at specified rate Reinvested

cash inflow
Reinvested cash flows
PV of reinvested cash inflow =
( 1+RR)4
Modified NPV = [PV of re-invested cash inflows – Outflows]
Decision:
(i) MNPV = +Ve  Accept the project
(ii) MNPV = -Ve  Reject the project
(iii) MNPV = 0  Accept the project
(6) PAYBACK PERIOD:

• Time period during which outflow of project would be received
from future inflows.
• It ignores time value of money.
Example-1:
0 year 1 year 2 year 3 year 4 year
(500) 200 200 200 200

Outflow Inflow Inflow Inflow Inflow

As annual inflows are same we can directly calculate payback

period as follows:
500
Payback period = = 2.5 years
200
It means, initial investment will be recovered in 2.5 years ignoring

time value.
In other words, Break even period is 2.5 years.
Example-2:
(500) 200 250 300 200

Outflow Inflow Inflow Inflow Inflow
In this example, we can calculate payback period as follows:

Recovery in 2y = 200 + 250 = 450
Total amount to be recovered = 500
Balance to be recovered in year 3 = 50
₹ 300 recovery  12 months (in year 3)
12
₹ 50 recovery  ( x 50)
300
= 2 months
Payback period = 2 years and 2 months
Second Alternative:
Recovery in 2y = ₹ 450
Recovery in 3y = ₹ 750
Required Recovery = ₹ 500
1y
Difference =?
2Y (?) 3y
450 500 750

Difference =50
Difference = 300
300  1 year
1
50  (300 x 50) = 0.1667 year [i.e. 2 months]
Payback period = 2 year + 2 months
Decision: Shorter payback period  Better project

Note: Use payback period as evaluation technique when life of
project is unknown.
(7) Discounted Payback period:

• It is same as payback period. However, it considers time value also.
• Discounted payback period provides more accurate decision than
payback period.
Example-3: [Same as example-2 above]
0 year 1 year 2 year 3 year 4 Year
(500) 200 250 300 200

181.82
@10%
206.61
@10%
225.40
@10%
136.60 @10%
Recovery in 2y = 181.82 + 206.61 = 388.43

Total amount to be recovered = 500
Balance to be recovered in year 3 = 111.57
₹ 225.40 recovery  12 months (in year 3)
12
₹ 111.57 recovery  ( x 111.57)
225.40
= 5.93 months (i.e. 6m)
Discounted Payback period = 2 years and 6 months
Decision: Shorter discounted payback period  Better project

(8) Payback reciprocal:
1
Payback reciprocal = [ ]
Payback period
Example:
Payback period = 4 years (assumed)
1
Payback reciprocal = = 0.25 (i.e. 25%)
4
It means, on an average there is 25% annual recovery of outflow

during payback period.
(9) ARR (ACCOUNTING RATE OF RETURN OR, AVERAGE RATE OF

RETURN):
• ARR provides simple percentage earning (i.e. simple return, not
compounded return) of project.
• It ignores time value of money. In other words, it ignores
compounding effect.
Example:
(1000) 80 120 100 (EAT-3) +

Outflow EAT-1 EAT-2 200 (Salvage)
Method-1:
80+120+100
Average Annual EAT = = 100
3
Investment (Net of Salvage) = 1000 – 200 = 800
100
ARR (Annual %) = x 100 = 12.5%
800

Method-2:
Average annual EAT = 100
1000+200
Average value of project = = 600
2
100
ARR (Annual %) = x 100 = 16.67%
600
Note: Both methods are acceptable and used by Institute.
Formula:
Average annual EAT
(1) ARR = [ x 100]
Outflow net of salvage
Or,
Average annual EAT
(2) ARR = [ x 100]
Average value of project
Where,
Initial cost + Salvage
Average value of project = [ ]
2
COMPARISON BETWEEN IRR & ARR:

IRR  Annual compounded return of project
ARR  Annual simple average return of project
For same example above we can calculate IRR also.

Calculation:
For IRR, we nee1d cash inflows.
Cash inflows = EAT + Depreciation
Cost − Salvage 1000 − 200
Depreciation = =
Life 3
= 266.67 (i.e. 267)
ACIF (Year-1) = 80 + 267 = 347
ACIF (Year-2) = 120 + 267 = 387
ACIF (Year-3) = 100 + 267 = 367

347 387 367

+200
PV
of
Inflow
Discount @ R%
= 1000
Assume, R = 15%
347 387 567
PV = + +( 1+ 0.15)3 = 967.17
( 1+ 0.15)1 ( 1+ 0.15)2
Assume, R = 13%
347 387 567
PV = + +( 1+ 0.13)3 = 1003.12
( 1+ 0.13)1 ( 1+ 0.13)2
Almost equal to 1000.
Hence, we can say,
IRR is almost 13%.
Comparison:
ARR  12.5% or, 16.67%
IRR  13% (Normally falls between above two rates)
Decision:
(i) If ARR > RR  Accept the project
(ii) If ARR < RR  Reject the project
(iii) If ARR = RR  Accept the project
RR = Required return based on Risk factor.

CONCEPT: EFFECT OF INFLATION ON INVESTMENT

DECISIONS:
(i) Real Cash Flows:
• Cash flows in which inflations is excluded.
• In other words, real cash flows are cash flows in terms of current
purchasing power.
(ii) Money Cash Flows (or, Nominal cash flows)

• Cash flows in which inflation is included.
(iii) Real interest rate (or, Real cost of capital)

• Interest rate or cost of capital in which inflation is excluded.
(iv) Money rate (or, Money cost of Capital)

• Interest rate or cost of capital in which inflation is included.
 Conversion of real cash flows into money cash flows or vice versa:
(i) Money cash flows = Real Cash flows x (1 + inflation rate) n
[When there is no Depreciation]
Money cash flows
(ii) Real cash Flows =
(1 + Inflation Rate)n
Example:
Present value =  1,000
Real rate = 4% p.a. ; Inflation rate = 5% p.a.
0 Year 1y end 2y end
PV Real Cash flow Real Cash flow

1000 = 1000 x (1+0.04) = 1000 x (1+0.04) 2
= 1040 = 1081.60
Money Cash flow Money Cash flow

= 1040 x (1+0.05) = 1081.60 x (1+0.05)2
= 1092 = 1192.46

 Conversion of Real rate into Money rate or, vice versa:

Fisher’s Formula
(i) (1 + Real rate) x (1 + Inflation rate) = (1 + Money rate)
Money Rate
Inflation
Real Rate (Risk Adjusted)
Explanation:
From same example above [Using 2nd year cash flows]:
0y 1y 2y
PV = 1000 MCF = 1192.46

@MR% (?)
1000 x (1 + MR)2 = 1192.46

Or, (1 + MR) 1192.46
=[ ]
1000
∴ MR = [1.092 – 1] = 0.092 i.e., 9.2%
We, can calculate it directly using fisher’s formula as follows:

(1 + MR) = (1 + RR) x (1 + Inflation)
(1 + MR) = (1 + 0.04) x (1 + 0.05)
∴MR = 1.092 – 1 =0.092 i.e., 9.2%

CONCEPT: EFFECT OF INFLATION ON DEPRECIATION:

• As depreciation is calculated on historical cost, inflation does not
affect depreciation amount.
• Hence, we can calculate money cash flows as follows when there is
depreciation.
• Method - 1
Amount (₹)
Money EBDT [Real EBDT x (1 + Inflation) n] xxx
Less: Depreciation xxx
Money EBT xxx
Less: Tax xxx
Money EAT xxx
Add: Depreciation (Without Inflation) xxx
Money cash inflows xxx
• Method - 2
Amount (₹)
Money EBDT [Real EBDT x (1 + Inflation) n] xxx
Less: Tax xxx
xxx
Add: Tax Saving on Depreciation xxx
Money cash Flows xxx
CONCEPT: NPV WHEN THERE IS INFLATION:

Method-1: Use real cash flows with real cost of capital to calculate PV
and then NPV
Method-2: Use money cash flows with money cost of capital as discount
rate to calculate PV and then NPV
Note: NPV calculated using both methods remain same when there is no
information of depreciation.

QUESTION- 1A
Interpretation:
If question is silent, assume expected cash inflows are nominal cash
inflows or, money cash inflows.
It means, Annual cash inflows of ₹5,00,000 are nominal cash inflows.
(i) Nominal cash flows (2y end) = ₹5,00,000

₹5,00,000 ₹5,00,000
Real cash flows (2y end) = =
(1+inflation)2 (1+0.05)2
(ii) Present value of 2nd year inflow:

Method-1: Discount nominal cash flows by using nominal discount rate.
(1 + Real rate) x (1 + Inflation rate) = (1 + Nominal rate)
or, (1 + 0.10) x (1 + 0.05) = (1 + Nominal rate)
∴ Nominal rate = 0.155 [i.e. 15.5%]
2y
PV = ? ₹5,00,000
@ 15.5%
₹5,00,000
PV =
(1+0.155)2
Method-2: Discount real inflows by using real discount rate.

2y
₹5,00,000
PV = ?
@ 10% (1+0.05)2
₹5,00,000 1
PV = x
(1+0.05)2 (1+0.10)2
Disclaimer:
CMA Institute solution is not correct as it discounted 2nd year Cash
flows but discount factor used for first year.

QUESTION – 1B
40,000−0
Annual Depreciation = = 10,000
4
Calculation of Nominal cash flows:
Year – 1 Year – 2 Year – 3 Year – 4
Revenue with 30,000 x 30,000 x 30,000 x 30,000 x
inf. (1 +0.10)1 (1 +0.10)2 (1 +0.10)3 (1 +0.10)4
= 33,000 = 36,300 = 39,930 = 43,923
Less: Annual 10,000 x 10,000 x 10,000 x 10,000 x

cost with inf. (1+ 0.10) (1+ 0.10)2 (1+ 0.10)3 (1+ 0.10)4
= 11,000 = 12,100 = 13,310 = 14,641
Nominal EBDT 22,000 24,200 26,620 29,282
Less: Dep 10,000 10,000 10,000 10,000
EBT 12,000 14,200 16,620 19,282
Less: -Tax 50% 6,000 7,100 8,310 9,641

EAT 6,000 7,100 8,310 9,641
Add: Dep 10,000 10,000 10,000 10,000
Nominal CF (A) 16,000 17,100 18,310 19,641
PVF @ 12% (B) 0.893 0.797 0.712 0.635
Note (Not for Exam):

In Nov-19 paper, it is not mentioned whether Cost of capital is inflation
included or not. But PV factors are given at 12%. Given discount factor
indirectly hints that given cost of capital is nominal rate.
Disclaimer: In SM-2023, ICAI adjusted Inflation on Depreciation also
which is not correct. However, in same question, in Nov 2019 Suggested,
ICAI provided correct solution as above.
PV of inflows = 𝚺 (𝐀 × 𝐁) = 52,945.46
NPV =  52,945.46 – 40,000 =  12,945.46
Advice:- Yes, it is beneficial to accept project as NPV is positive.

QUESTION – 1C
Year – 1 Year – 2 Year – 3 Year - 4
Revenue after 6,00,000 x 7,00,000 x 8,00,000 x 8,00,000 x
inflation (1 + 0.10)1 (1 + 0.10) x (1 + 0.10) x (1 + 0.10) x
(1 + 0.09) (1 + 0.09) x (1 + 0.09) x
(1 + 0.08) (1 + 0.08) x
(1 + 0.07)
= 6,60,000 = 8,39,300 = 10,35,936 = 11,08,452
Less: - Cost with 3,00,000x 4,00,000 x 4,00,000 x 4,00,000 x

inflation (1+ 12)1 (1 + 0.12) x (1 + 0.12) x (1 + 0.12) x
(1 + 0.10) (1 + 0.10) x (1 + 0.10) x
(1 + 0.09) (1 + 0.09) x
(1 + 0.08)
= 3,36,000 = 4,92,800 = 5,37,172 = 5,80,124
Nominal EBDT 3,24,000 3,46,500 4,98,764 5,28,328
Less: Tax @60% 1,94,400 2,07,900 2,99,258 3,16,997
1,29,600 1,38,600 1,99,506 2,11,331
Add: Tax saving 1,20,000 1,20,000 1,20,000 1,20,000
on dep.(2,00,000
x 60%)
Nominal CF (A) 2,49,600 2,58,600 3,19,506 3,31,331
PVIF (B) 0.909 0.826 0.751 0.683
PV of Inflows = 𝚺 (𝐀 × 𝐁) =  9,06,738
NPV =  9,06,738 – 8,00,000 =  1,06,738

QUESTION – 1D
Calculation of Depreciation: ( in ‘000)
Year 1 2 3 4 5
Opening 4,000.00 3,000,00 2,250.00 1,687.50 -
(-) Dep 1,000.00 750.00 5,62.50 421.88 -
Closing 3,000.00 2,250.00 1,687.50 1,265.63 -
TS on Dep 300.00 225.00 168.75 126.56
Inflow from Salvage:

( in ‘000)
Sale Value 0
Less: WDV 1,265.63
STCL (At end of 4 Year) 1265.63
Tax STCL (1,265.63 X 0.30) at end of 5Y 379.68
Cash outflow in Working Capital: ( in ‘000)

Year 0 1 2 3 4 5
Sales (Nominal) 2617.50 5634.51 1,5815.73 1088.72 -
WC Required 261.75 563.45 1581.57 108.87 - -
@10% of sale
Increase in WC - 301.70 1018.12 -1472.71 -108.87
Calculation of Nominal Sales

Year 1 2 3 4
Sales revenue 2500 5140 13780 906
Inflated sale (by 4.7%) 2617.50 5634.52 15815.74 1088.72
Inflated costs have been calculated accordingly by inflating 4.7%

Saving in wage cost & saving in material cost are inflows.
( in ‘000’)
Year 1 2 3 4 5
Sales Revenue 2617.50 5634.52 15815.74 1088.72 -
Less: Costs 1047.00 2192.42 5738.66 4205.86 -
Net Revenue 1570.50 3442.10 10077.08 (3117.14) -
Less: tax payable - (471.16) (1032.64) (3023.12) 935.14*
Capital All. (Dep) - 300.00 225.00 168.76 126.56
Tax sav on STCL - - - - 379.68
After tax cash 1570.50 3270.94 9269.44 -5971.50 506.26
flow
Less: Working (301.72) (1018.12) 1472.70 108.87 -
Capital
Project cash flow 1268.78 2252.82 10742.14 (5862.63) 506.26

Discount factor 0.893 0.797 0.712 0.636 0.567
12%
Present Value of 1133.02 1795.50 7648.40 (3728.63) 287.05
Cash inflow
( in ‘000’)
P.V of Future Cash Flow 7135.34
Less: Initial Investment (4000.00)**
Less: Working Capital (261.76)
NPV 2873.58
The net present value is ₹ 2873.58. So the investment is financially

acceptable.
Note: * In above solution institute ignored Tax saving on 4th year loss.
However, it is appropriate to consider tax saving in 5th year. In
such case project cash inflow in 5th year would be 1,441.38
thousand.
** Initial research cost of  400 thousand can also be considered as
outflow in calculation of NPV (which institute ignored).
CONCEPT: RISK ADJUSTED NPV USING CERTAINTY

EQUIVALENT APPROCH AND RADR:
Risk Adjusted NPV
Certainty Equivalent Approach RADR Method (Risk adjustment

discount rate)
Use certain cash Inflows (i.e. Use Risky cash Inflows and RADR
Risk free cash inflows) with Risk to calculate NPV
free Rate as discount rate to In other words:
calculate NPV Inflows  Risky Cash flows
In other words: DR  Risk Adjusted
Inflows  Risk free RADR = CAPM return
DR  Risk free rate RADR = Rf + 𝜷(Rm - Rf)
Risk Free cash Inflows
= [Risky Inflows x C.E. Factor] ∴ (Rm - Rf) = Mkt. risk premium
𝛽(Rm - Rf)= Risk Premium
∴ C.E. Factor = Certainty
Equivalent factor (Estimated
from past Experience)
Example:
0Y 1Y 2Y nY
(100,000) 50,000 60,000 40,000

Risky Risky Risky
80% certain 70% certain 50% certain
RFCIF RFCIF RFCIF

= 50,000 x 80% = 60,000 x 70% = 40,000 x 50%
= 40,000 = 42,000 = 20,000

Calculation of PV and NPV:

(i) RADR METHOD
50,000 60,000 40,000
PV
Discount @ RADR
Risk Adjusted NPV = PV of Inflow – PV of Outflow
(II) CERTAINTY EQUIVALENT APPROACH
40,000 42,000 20,000
PV
Discount @ RF
Risk Adjusted NPV = PV of Inflow – PV of Outflow
QUESTION –2A
Year Project – Y Project – x
Cash flow Risk free cash Cash flow Risk free cash
(Risky) flows (Risky) flows
1 1,80,000 1,80,000 x 0.80 1,80,000 1,80,000 x 0.90
= 1,44,000 = 1,62,000
2 2,00,000 2,00,000 x 0.7 1,80,000 1,80,000 x 0.80
= 1,40,000 = 1,44,000
3 2,00,000 2,00,000 x 0.5 2,00,000 2,00,000 x 0.70
= 1,00,000 = 1,40,000
PV of inflows (y) @ 8% p.a.

= (1,44,000 x 0.926) + (1,40,000 x 0.857) + (1,00,000 x 0.794)
= 3,32,724

PV of inflows (X) @ 8% p.a.

= (1,62,000 x 0.926) + (1,44,000 x 0.857) + (1,40,000 x 0.794)
= 3,84,580
NPV (Y) = 3,32,724 – 3,30,000 = 2,724

NPV (X) = 3,84,580 – 3,40,000 = 44,580
Advise:- Project – x is more beneficial as NPV is higher.
(ii) Since the certainty-equivalent (C.E.) factor of project X is

lower than project Y, the project X is riskier than project Y.
Therefore, if risk adjusted discount rate method is used the
project X would be analysed with a higher rate.
QUESTION – 2B
A B C
CV 0.40 0.80 1.20
RADR 12% 14% 16%
(a) Annual Inflow 30,000 42,000 70,000
(b) PVIFA (RADAR, 5) 3.605 3.433 3.274
(c) PV of Inflow (a x b) 1,08,150 1,44,186 2,29,180
Less: - Outflow 1,00,000 1,20,000 2,10,000
NPV 8,150 24,186 19,180

QUESTION – 2C
Interpretation (Not for Exam):
Risk Index = Risk factor = Beta
Return of firm  Market return
(i) Risk Adjusted discount rate:

RADR = Rf + 𝛽(Rm - Rf)
Where, 𝛽 = Risk Index
Rm = firm return
RADR (P – I) = 10 + 1.80(15 – 10) = 19%
RADR (P – II) = 10 + 1.00(15 – 10) = 15%
RADR (P – III) = 10 + 0.60(15 – 10) = 13%
(ii) Selection of Project:

P – I:
PV of inflow = 6,00,000 x PVIFA (19%,4)
= 6,00,000 x 2.639 = 15,83,400
NPV = 15,83,400 – 15,00,000 = 83,400
P – II:
PV of inflows = (6,00,000 x 0.870) + (4,00,000 x 0.756)
@15% + (5,00,000 x 0.658) + (2,00,000 x 0.572)
= 12,67,800
NPV = 12,67,800 – 11,00,000 = 1,67,800
P – III:
PV of inflows = (4,00,000 x 0.885) + (6,00,000 x 0.783)
@13% + (8,00,000 x 0.693) + (12,00,000 x 0.613)
= 21,13,800
NPV = 21,13,800 – 19,00,000 = 2,13,800
Advise:- NPV of P-III is higher. Hence project- III should be selected.

QUESTION – 2D [ICAI Solution]

(i) Statement showing the Net Present Value of the Project
Year Cash C.E. Adjusted Applicable PV ()
end Flow () (b) Cash Flow () PVIF
(e) = (c) × (d)
(a) (c) = (a) × (b) (d)
1 1,40,000 0.8 112,000 0.943 1,05,616
2 1,30,000 0.7 91,000 0.890 80,990
3 1,20,000 0.6 72,000 0.840 60,480
4 1,15,000 0.4 46,000 0.735* 33,810
5 80,000 0.3 24,000 0.681** 16,344
Total PV of Cash Flows 2,97,240
Less: Initial Investment 3,00,000
Net Present Value -2760
Decision: Since the net present value of the Project is negative, it
should not be accepted.
Disclaimer: ICAI solution is not appropriate for 4th & 5th Year.
NS Opinion:
* in 4th year PVIF should be 0.778 [.926 × .840] so PV will be 35,788.
** in 5th year PVIF should be 0.720 [.857 × .840] so PV will be 17,280.
In such case NPV would be 154.
(ii) In Certainty Equivalent approach we incorporate risk to adjust the cash

flows of a proposal so as to reflect the risk element and also adjust
future cash flows rather than discount rates. But the procedure for
reducing the forecasts of cash flows is implicit and likely to be
inconsistent from one investment to another. Therefore, it is not
popular.

CONCEPT: STATISTICAL TECHINIQUES TO ANALYSE RISK:

(A) EXPECTED NPV:
• Average calculated using probability as weight is known as
Expected value. Expected Value = ⅀[value x prob.]
• Similarly, Expected NPV can be calculated using any one of the
following two methods.
Methods - 1: [Year wise]
0Y 1Y 2Y nY
CIF1 (P1) CIF1 (P1) CIF1 (P1)

Exp CIF Exp CIF Exp CIF
PV Of
Exp CIF
Where, Discount @ CC (RR)
CIF1; CIF2; CIF3 = Cash Inflows – 1, 2 & 3 Respectively
P1 = Probability of CIF 1
Exp CIF = Expected cash Inflows
= ⅀(Different CIF x prob.]
CC = Cost of Capital
Expected NPV = [PV of ECIF – PV of outflow]
Method – 2: [Cash Stream Wise]

0Y 1Y 2Y nY
NPV1 (P1) CIF1 (P1) CIF1 (P1) CIF1 (P1)

Exp NPV
Exp NPV = Expected NPV = ⅀(Different NPV x prob.]

Note:-
• We can use second method only when probability of every year
under each cash stream remains same (i.e. P1 of every year is same,
P2 of every year is same. Otherwise, we can use method – 1 only.
• Method – 1 can be used in all situations.
• If we can use method -2 and method -1 in same question then
answers remain same hence, we can use anyone method.
(B) Standard deviation of project (SD/𝝈):

• standard deviation measures overall risk of project which depends
upon volatility (i.e., Fluctuation) of Cash flows:
• High volatility  High SD (High Risk)
Low Volatility  Low SD (Low Risk)
• Formulae to calculate SD:

SD (𝝈) = √∑[ (𝒙 − 𝒙̅ )𝟐 × 𝒑𝒓𝒐𝒃.
For more refer portfolio management.
• Similarly, we can calculate SD project using anyone of following two
techniques.
Method – 1: [Year wise]

0Y 1Y 2Y nY

𝛔𝐘𝐞𝐚𝐫−𝟏 𝛔𝐘𝐞𝐚𝐫−𝟐 𝛔𝐘𝐞𝐚𝐫−𝐧
PV
Discount @ CC
SD of Project

Case – (i) Cashflows of one year is dependent on other years (i.e., Cash
flows are correlated (i.e., r = 1)
𝜎 project =
√[𝜎 𝑦1 × PVIF(RR, 1)] + [𝜎 𝑦2 × PVIF(RR, 2)] +. . . . +[𝜎 𝑦𝑛 × PVIF(RR, n)]
Case – (ii) Cash flows are independent(i.e., Correlation zero: r = 0)

𝝈 project =
√[𝜎 𝑦1 × PVIF(RR, 1)] 2 + [𝜎 𝑦2 × PVIF(RR, 2)] 2 +. . . . +[𝜎 𝑦𝑛 × PVIF(RR, n)] 2
Note: we can link this formulae with 𝜎 portfolio formulae when r =1 and r =0
Method–2: [Cash stream wise ]

0Y 1Y 2Y nY

NPV of project
SD of project = √∑[ (𝐍𝐏𝐕 − 𝐍𝐏𝐕
̅̅̅̅̅̅̅)𝟐 × 𝐩𝐫𝐨𝐛.
Note: -
• We can use method - 2 only, when every year probability of CIF1 is
same, similarly every year probability of CIF 2 is also same and so on..
• It is possible in case of dependent cash flows only,
• SD calculated in Method – 2 and case – (i) of Method – 1 remain
same. (i.e., Answer remains same) because volatility of cash flows
and volatility of NPV remains same.

(C) COEFFICIENT OF VARIATION (CV)  Mini SD

𝛔
CV =[ ]
𝐍𝐏𝐕
• Coefficient of variation is risk per unit of NPV.

• It is useful when both NPV and SD move in same direction.
[i.e., High NPV  High SD]
[Low NPV  Low SD]
Example:
A B
NPV 10,000 12,000
SD 5,000 5,500
SD for 1 NPV 5,000 5500
= =
10,000 12,000
[coefficient of variation]
= 0.50 = 0.46
• Project – B is comparatively Low risky even though SD is high.

• Project – B is less risky.
QUESTION – 3A
(i) Expected NPV (X):
= (3,000 x 0.10) + (6,000 x 0.40) + (12,000 x 0.40) + (15,000 x 0.10)
= 9,000
Expected NPV (Y):

= (3,000 x 0.20) + (6,000 x 0.30) + (12,000 x 0.30) + (15,000 x 0.20)
= 9,000

(ii) SD of Project:  in (000) / (000) 2
𝐍𝐏𝐕𝐗 𝐍𝐏𝐕 𝐱 (𝐍𝐏𝐕 - (𝐍𝐏𝐕 - 𝐍𝐏𝐕𝐘 𝐍𝐏𝐕𝐘 (𝐍𝐏𝐕 - (𝐍𝐏𝐕 -
𝐍𝐏𝐕𝐱 ) 𝐍𝐏𝐕𝐱 )2 𝐍𝐏𝐕𝐘 ) 𝐍𝐏𝐕𝐘 )2
3 9 -6 36 3 9 -6 36
6 9 -3 9 6 9 -3 9
12 9 3 9 12 9 3 9
15 9 6 36 15 9 6 36
̅̅̅̅̅̅)2 × Probablity
σx = √∑(NPV − NPV
= √(36 × 0.10) + (9 × 0.40) + (9 × 0.40) + (36 × 0.10)

= √14.40 = 3.795 thousand.
σY = √(36 × 0.20) + (9 × 0.30) + (9 × 0.30) + (36 × 0.20)

= √19.80 = 4.450 thousand.
(iii) Risky project:

X Y
NPV 9,000 9,000
SD (σ) 3,795 4,450
Project Y is more risky.
(iv) Profitability Index:
PV of Inflows NPV+PV of Outflow
PI = = [ ]
PV of outflows PV of outflow
9,000+30,000
PI (x) = = 1.30
30,000
9,000+36,000
PI (Y) = = 1.25
36,000

QUESTION – 3B
0Y 1Y 2Y 3Y 4Y 5Y
1 (0.30) 1 (0.30) 1 (0.30) 1 (0.30) 1+0.2 (0.30)

1.1 (0.50) 1.1 (0.50) 1.1 (0.50) 1.1 (0.50) 1.1+0.5(0.50)
1.20(0.20) 1.20(0.20) 1.20(0.20) 1.20(0.20) 1.20+0.6(0.20)
(i) Expected NPV of Project:

NPV1 when annual cash inflows will be 1 Lakh and salvage will be 0.20
Lakhs.
NPV1 = 1 x PVIFA (10%, 5) + 0.20 x PVIF (10%,5) – 4
= (1 x 3.791) + (0.20 x 0.621) – 4
= (3.9152 Lakh – 4)
= - 0.0848 Lakh  (prob of this NPV is 0.30)
NPV2 = (1.10 x 3.791) + (0.50 x 0.621) – 4

= 4.4806 – 4 = 0.4806 Lakh (prob = 0.50)
NPV3 = (1.20 x 3.791) + (0.60 x 0.621) – 4

= 4.9218 – 4 = 0.9218 Lakh (prob = 0.20)
Expected NPV = (- 0.0848 x 0.30) + (0.4806 x 0.50) + (0.9218x0.20)

= 0.3992 Lakh
(ii) Best case NPV:

[when best outcome will realise then annual inflow will be 1.20 Lakh &
Salvage will be 0.60 Lakh]
In this case NPV = 0.9218 Lakh (Calculated above)
Worst case NPV:

[when worst outcome will realise then annual inflow will be 1Lakh &
Salvage will be 0.20 Lakh]
In this case NPV = - 0.0848 Lakh (Calculated above)

(iii) Probability of worst case NPV:
When cashflows are dependent : Prob = 0.30
When cashflows are independent.
Prob = 0.30 x 0.30 x 0.30 x 0.30 x 0.30 = 0.00243
(iv) Standard Deviation:  in Lakh / (Lakh)

𝐍𝐏𝐕 ̅̅̅̅̅̅
𝐍𝐏𝐕 (𝐍𝐏𝐕 - ̅̅̅̅̅̅
𝐍𝐏𝐕) 𝐍𝐏𝐕)2
(𝐍𝐏𝐕 - ̅̅̅̅̅̅
- 0.0848 0.3992 - 0.484 0.2343
0.4806 0.3992 0.0814 0.0066
0.9218 0.3992 0.5226 0.2731
2
σx =√∑(NPV − NPV
̅̅̅̅̅̅) × Probablity
= √(0.2343 × 0.30) + (0.0066 × 0.50) + (0.2731 × 0.20)

= √0.12821 = 0.3581 Lakh
Coefficient of variation
SD 0.3581
= = = 0.897 (i.e., 0.90)
NPV 0.3992
(v) Acceptance of project in revised condition:

CV of similar project = 0.95 to 1
CV of given Project = 0.90
As given project is less risky than similar project, new CC should be 10%
- 1% = 9%
In this case, New NPV should be
NPV1 = 1 x PVIFA (9%, 5) + 0.20 x PVIFA (9%,5) – 4
= (1 x 3.890) + (0.20 x 0.650) – 4 = 0.02
NPV2 = (1.10 x 3.890) + (0.50 x 0.650) – 4 = 0.604
NPV3 = (1.2 x 3.890) + (0.60 x 0.650) – 4 = 1.058
Exp NPV = (0.02 x 0.30) + (0.604 x 0.50) + (1.058 x 0.20)
= 0.5196 Lakh

QUESTION – 3C
(i) Project x is more beneficial as SD is Low. [i.e., Low risk project]
(ii) Coefficient of variation based on decision.
X Y
SD 90,000 1,20,000
CV = = 0.74 = 0.53
NPV 1,22,000 2,25,000
As CV of Project Y is lesser, than project x. We can say project Y

is more beneficial.
(iii) CV provides risk in comparison to NPV which is more appropriate.

[i.e., CV based decision is more appropriate]
QUESTION – 3D
Interpretation (Not for Exam):
As life of project is not given. We can’t calculate NPV
Hence, calculate desired value (variance, SD etc.) using cash flows:
𝐂𝐅𝐊 𝐂𝐅𝐊 DK DK2 𝐂𝐅𝐒 𝐂𝐅𝐒 DS DS2

11 15 -4 16 9 17 -8 64
13 15 -2 4 13 17 -4 16
15 15 0 0 17 17 0 0
17 15 2 4 21 17 4 16
19 15 4 16 25 17 8 64
𝐂𝐅𝐊 = Σ (CF x Prob)

= (11 x0.10) + (13 x0.20) + (15 x 0.40) + (17 x 0.20) + (19x 0.10)
= 15 Lakh
𝐂𝐅𝐒 = Σ (CF x Prob)

= (9 x 0.10) + (13 x 0.25) + (17 x 0.30) + (21 x0.25) + (25 x0.10)
= 17 Lakh

Requirement:
(i) Variance:
σK 2 = (16 x 0.10) + (4 x 0.20) + (0 x 0.40) + (4 x 0.20) + (16 x 0.10)
= 4.8
σS 2 = (64 x 0.10) + (16 x0.25) + (0 x0.30) + (16 x0.25) + (64 x 0.10)

= 20.8
Standard Deviation:
σ𝐾 = √4.8 = 2.19
σ𝑆 = √20.8 = 4.5
Coefficient of variation
Project – K Project – S
Mean CF 15 17
SD (σ) 2.19 4.56
Coefficient of 2.19 4.56
= 0.146 = 0.268
variation (CV) 15 17
(ii) Risk project:

Project – S is more risky as coefficient of variation is higher.

CONCEPT: PROBABILITY OF RANGE OF NPV:

• As we studied in Derivative chapter, probability of range of data can
be calculated using Normal distribution table.
• For detail discussion on Normal distribution table refer derivative
chapter. Concept: Just before Black Scholes Model.
Rough Discussion:
-∞ Mean +∞
𝑥 − 𝑥̅
Z= | |  It indicates no. of standard deviation from Mean.
𝜎
Prob. Of this area

[S. Normal distribution Table]
Prob. Of this area

[i.e., One tail table]
Z
-∞ Mean 𝑥̅ x +∞
QUESTION – 4A
̅̅̅̅̅̅
𝐍𝐏𝐕 = 40
σ = 20
(i) Probability of NPV zero or less:
Z
Probability =?
-∞ 0 40 +∞
0 − 40 NPV ̅̅̅̅̅̅
𝐍𝐏𝐕
Z= | |= |−2| = 2
20

Using standard normal dist. Table

Probability of [Z = 2] = 0.4772
Hence, probability of NPV being zero of less.
= 0.50 – 0.4772 = 0.00228 (i.e., 2.28%)
(ii) Probability of NPV higher than 𝝈 (i.e., + ve):

= Total Prob (- ∞ to + ∞) – 0.0228
= 1 – 0.0228 = 0.9772 (i.e., 97.72%)
(iii) Probability of NPV in range 25 to 45:
Z1 Z2
25 40 45
NPV ̅̅̅̅̅̅
𝐍𝐏𝐕 NPV
25 − 40 −15
Z1 = | | = | 20 | = 0.75
20
45 − 40 5
Z2 = | | = |20| = 0.25
20
Prob of (Z = 0.75) = 0.2734

Prob of (Z = 0.25) = 0.0987
Probability of NPV from 25 to 45

= (0.2734 + 0.0987)
= 0.3721 (i.e., 37.21%)

QUESTION – 4B
1Y 2Y
60,000 (.20) 50,000 (.20)

70,000 (.50) 60,000 (.50)
80,000 (.30) 70,000 (.30)
Expected CIF Year-1 = (60,000 × .20) + (70,000 × .50) +

(80,000 ×.30) = 71,000
Expected CIF Year-2 = (50,000 × .20) + (60,000 × .50) +

(70,000 ×.30) = 61,000
PV of expected CIF@10% = (71,000 × 0.909) + (61,000 × 0.826)

= 1,14,925
NPV = (1,14,925 – 100,000) = 14,925
Standard Deviation:
Year -1 Year -2
CIF (CIF − CIF ) (CIF − CIF) CIF CIF (CIF − CIF ) (CIF − CIF)
2 2
CIF
60 71 -11 121 50 61 -11 121
70 71 -1 1 60 61 -1 1
80 71 9 81 70 61 9 81
CIF = 71,000 calculated above

CIF = 61,000 calculated above
𝜎1
= √(121 × .20) + (1 × .50) + (81 × .30) = 7000
𝜎2 = 7000 (Because of same deviation & probability

σproject = 7000 × PVIF (10%,1) + 7000 × PVIF (10%,2)
= (7000 × .909) + (7000 × .826) = 12,145

CONCEPT: CAPITAL BUDGETING BASED ON UTILITIES

 Utility  satisfaction
 Sometimes question provides information of utilities of different
cash flows with their probabilities.
 In this case, we have to take decision on the basis of “expected
utilities”.
Expected Utilities = ∑(𝐮𝐭𝐢𝐥𝐢𝐭𝐢𝐞𝐬 × 𝐩𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬)
Decision : High expected utilities project  Best
QUESTION – 5A
(i) Expected utilities of project – A:
Cash Flows Utilities Probability
- 15,000 - 100 0.10
- 10,000 - 60 0.20
15,000 40 0.40
10,000 30 0.20
5,000 20 0.10
Expected utilities = Σ (utilities x probability)

= (-100 x 0.10) + (-60 x 0.20) + (40 x 0.40)
+(30 x 0.20) + (20 x 0.10) = 2
(ii) Expected utilities of project – B:

Cash Flows Utilities Probability Avg. utilities
- 10,000 - 60 0.10 -6
- 4,000 -3 0.15 - 0.45
15,000 40 0.40 16
5,000 20 0.25 5
10,000 30 0.10 3
Expected Utilities 17.55
Advice:- Project – B is better than A. Hence select project – B.

QUESTION – 5B
Existing Operation New Project
Return 14% 18%
SD (σ) 20% 32%
Investment 75% 25%
Correlation (Existing, New) = 0.25

To take decision we have to calculate utility of following two
alternatives.
Alternative – 1: 100% investment in existing operation.
Alternative – 2: 75% investment in existing & 25% in New.
(i) Utilities of Alternative – 1:

= 100R - σ2 = (100 x 14) – (20)2 = 1000
(ii) Utilities of Alternative – 2:

RAlt -2 = (RE WE) + (RN WN)
= (14 x 0.75) + (18 x 0.25) = 15%
𝛔𝐀𝐥𝐭−𝟐 = √(σE WE )2 + (σN WN )2 + 2(σE WE )(σN WN ) × 𝑟𝐸,𝑁

=√(20 × 0.75)2 + (32 × 0.25)2 + 2(20 × 0.75)(32 × 0.25) × 0.25
=√349 = 18.68%
Utilities = 100R - σ2 = (100 x 15) – (18.68)2 = 1151
Advice: As utility increases when new project is accepted. Hence, go for

new projects.

CONCEPT: DECISION TREE APPROCH IN CAPITAL BUDGETING

• Decision tree is a graphic display of the relationship between a present
decision and future events, future decision, and their consequences.
1 Decision node
X
2 2&3 Chance node
Y
Z X, Y & Z Possible node
1
3
• For Example:
Year – 1 Year – 2
Inflow Prob. Inflow Prob.
10,000 0.60 8,000 0.20
15,000 0.30
20,000 0.50
20,000 0.40 15,000 0.40
25,000 0.30
30,000 0.30
Decision tree:
Year 1 Year 2 Joint Prob.

8,000 (.20) .12
10,000 15,000 (.30) .18

0.60
20,000 (.50) .30
D 15,000 (.40) .16

20,000
0.40 25,000 (.30) .12
30,000 (.30) .12

1.00
Now we can calculate expected NPV using any one of following two
methods.
Method – 1: Branch wise:
Branch – 1 NPV = Using inflows: 10,000 (1Y) and 8,000 in (2Y)
And so on…. Upto Branch – 6
Expected NPV = ∑6i= 1 (NPVi × Joint probability)
Method – 2: Year wise:
Expected CIF (Year – 1) Average of 10,000 and 20,000 using
respective probability.
Expected CIF (Year – 2) Average of all 6 cash inflows using joint
probability.
Important Note:-
 Must verify total probability of all possibility while calculating
average. Total probability  Always “1”
 In both methods NPV remains same.
QUESTION- 6A
(a) Decision tree:
Year 1 Year 2 Joint Prob.
12,000 (.20) .08
25,000 16,000 (.30) .12

0.40
22,000 (.50) .20
20,000 (.40) .24

30,000
0.60 25,000 (.50) .30
30,000 (.10) .06

1.00
(b) Worst case NPV:
When worst outcome will realize, first year CIF should be 25,000 &
second year CIF should be 12,000.
NPV = PV of inflows @ 10% – PV of outflow
= (25,000 x 0.909) + (12,000 x 0.826) – 40,000
= 32,637 – 40,000 = -7,363
Probability of this NPV = 0.08 (calculated above)
(c) Best case NPV:

In this case, first year inflows should be 30,000 and second year inflows
should be 30,000.
NPV = (30,000 x 0.909) + (30,000 x 0.826) – 40,000 = 12,050
(d) Advice:
NPV1 = -7363
NPV2 = (25000 x 0.909) + (16000 x 0.826) – 40000 = -4059
NPV3 = (25000 x 0.909) + (22000 x 0.826) – 40000 = 897
NPV4 = (30000 x 0.909) + (20000 x 0.826) – 40000 = 3790
NPV5 = (30000 x 0.909) + (25000 x 0.826) – 40000 = 7920
NPV6 = 12050 (Calculated above)
Expected NPV = (-7363 x 0.08) + (-4059 x 0.12) + (897 x 0.20) +
(3790 x 0.24) + (7920 x 0.30) + (12050 x 0.06)
= 3112
Advice: Beneficial to invest in project.

QUESTION-6B
A
D
Evaluation
At Decision Point C: The choice is between investing ₹ 20 lacs for a
perpetual benefit of ₹ 4 lacs and not to invest. The preferred choice is
to invest, since the capitalized value of benefit of ₹ 4 lacs (at 10%)
adjusted for the investment of ₹ 20 lacs, yields a net benefit of ₹ 20
lacs.
At Decision Point D: The choice is between investing ₹ 12 lacs, for a

similar perpetual benefit of ₹ 1 lac. and not to invest. Here the invested
amount is greater than capitalized value of benefit at ₹ 10 lacs. There is
a negative benefit of ₹ 2 lacs. Therefore, it would not be prudent to
invest.
At Outcome Point B: Evaluation of EMV is as under (₹ in lacs).
Outcome Amount (₹) Probability Result (₹)
Success 20.00 0.50 10
Failure 0.00 0.50 00.00
Net Result 10.00
EMV at B is, therefore, ₹10 lacs.
At Decision Point A: Decision is to be taken based on preferences
between two alternatives. The first is to test, by investing ₹ 2,40,000
and reap a benefit of ₹ 10 lacs. The second is not to test, and thereby
losing the opportunity of a possible gain.
The preferred choice is, therefore, investing a sum of ₹ 2,40,000 and
undertaking the test.

QUESTION-6C [Nov-2000-old-8 Marks]

Big Oil is wondering whether to drill for oil in Westchester Country. The
prospectus are as follows:
Depth of Total Cost Cumulative PV of Oil (If found)
Well Feet Millions of Probability of Millions of Dollars
Dollars Finding Oil
2,000 4 0.5 10
4,000 5 0.6 9
6,000 6 0.7 8
Draw a decision tree showing the successive drilling decisions to be made
by Big Oil. How deep should it be prepared to drill?
[CMA-RTP-June-2012] [CMA-Compendium]
Ans: 1.8 Mill
SOLUTION
Cost
4 mill 2000 ft
1 mill 2000 ft
1 mill 2000 ft
Decision tree:
(4 mill) Not F. (1 mill) Not F. (1 mill) Not F.

D1 D2 D3
Drill 0.50 Drill 0.80 Drill 0.75
2000 ft further further
2000 ft 2000 ft
Note:
Decision at D 1 depends upon decision at D 2 and decision at D 2
depends upon decision at D 3.
Hence, first take decision at D 3 then at D2 and then at D1.
Calculation of probability:
(i) Probability of finding oil up to 4000 ft after 2000 ft
Assume, prob = 𝑥
prob. of not finding oil up to 2000 ft.
Cumulative prob. of prob. of finding oil up to 2000 ft +

[ ]=
finding oil up to 4000 ft. (𝑥 x 0.50)
or, 0.60 = 0.50 + (𝑥 x 0.50)

0.60−0.50
or, 𝑥 = = 0.20
0.50
Probability of not finding oil up to 4000 ft after 2000 ft
= (1 - 0.20) = 0.80
(ii) Probability of finding oil up to 6000 ft after 4000 ft

Assume, prob = 𝑥
Cumulative prob. of cumulative prob. of finding oil up to
[ ]=
finding oil up to 6000 ft. 4000 ft + (𝑥 x 0.80 x 0.50)
or, 0.70 = 0.60 + (𝑥 x 0.40)

0.70−0.60
or, 𝑥 = = 0.25
0.40
Probability of not finding oil = 1 – 0.25 = 0.75
Decision at D 3:
Outflow = 1 mill
Expected PV of inflow = (8 mill x 0.25) + (0 mill x 0.75) = 2 mill
NPV = 2 – 1 = 1 mill
Advice: Drill up to 6000 ft if oil not find up to 4000 ft.
Decision at D 2:
Outflow = 1 mill
Expected PV of inflow = (9 mill x 0.20) + (1 mill x 0.80) = 2.6 mill

NPV = 2.6 – 1 = 1.6 mill

Advice: Drill up to 4000 ft if oil not find up to 2000 ft.
Decision at D 1:
Outflow = 4 mill
Expected PV of inflow = (10 mill x 0.50) + (1.6 mill x 0.50) =5.8mill
NPV = 5.8 – 4 = 1.8 mill
Final Advice: Drill up to 2000 ft. If not find oil, further drill up to
4000 ft. If gain not find oil then drill up to 6000 ft.
CONCEPT: SENSITIVITY ANALYSIS OR, WHAT IF ANALYSIS

• Under sensitivity analysis, we calculate sensitivity of NPV in relation
to change in each factor assuming other factor remains same.
Following are same factors which affects NPV.
 Sale price (SP);  Sale value (SV)
 Unit cost (UC);  Discount rate (DR)
 Life of project;  Initial Investment
• For Example:
NPV = [ (SP – UC) x SV] x PVIFA(DR, Life) – Outflow
[] [ ] [] [] [] [] []
[] increase []  decrease
Now, we have to find that factor which affects NPV more [i.e., Find
Most sensitive Factor]
Following are two methods to find most sensitive factor which

affects NPV more:

Methods – 1:
Calculate % change of each factor where NPV becomes zero (i.e. 100%
down). In same example above, assume following situations:
Factor % change in each factor where NPV will be Zero
SP 5% Decrease
UC 8% Increase
SV 10% Decrease
DR 20% Increase
Life 40% Decrease
Outflow 50% Increase
Here, sale price is most sensitive factor and outflow is least sensitive
factor.
Reason: SP affects NPV 20 times, Outflows affects NPV only 2 times.
Methods – 2:
Calculate change in NPV assuming any fixed % change in each factor
(like 10%, 20%, etc..)
Factor % change in Factor % Change in NPV

(Assumed) (Calculated)
SP 10%  200% 
UC 10%  125% 
SV 10%  100% 
DR 10%  50% 
Life 10%  25% 
Outflow 10%  20% 
In this result also, sale price is most sensitive as it affects NPV 20
times and outflow is lest sensitive as it affects NPV only 2 times.
Note:- we can use any one method according to available information.

QUESTION-7A
1. Calculation of Net Cash Inflow per year
Particulars Amount (₹)
A Selling price per unit 100
B Variable cost per unit 50
C Contribution per unit (A-B) 50
D No. of units sold per year 5 Cr.
E Total Contribution (C x D) ₹250 Cr.
F Fixed cost per year ₹50 Cr.
G Net cash inflow per year (E-F) ₹200 Cr.
Calculation of Net Present Value (NPV) of the project

Year Year Cash Flow PV factor @6% Present Value (PV)
(₹ in Cr.) (₹ in Cr.)
0 (400.00) 1.000 (400.00)
1 200.00 0.943 188.60
2 200.00 0.890 178.00
3 200.00 0.840 168.00
Net Present Value 134.60
Here, NPV represent the most likely outcomes and not the actual
outcomes. The actual outcome can be lower or higher than the expected
outcome.
2. Sensitivity Analysis considering 2.5 % Adverse Variance in each

variable
(a) SP: 100 – 2.5% = 97.5
NPV = [[(97.5 – 50) × 5] – 50] × 2.673 - 400 = 101.1875
134.60 −101.1875
% decrease in NPV = × 100 = 24.82%
134.60
(b) VC: 50 + 2.5% = 51.25

NPV = [[(100 – 51.25) × 5] – 50] × 2.673 - 400 = 117.8938

134.60 −117.8938
% decrease in NPV = × 100 = 12.41%
134.60
(c) Sales Unit: 5 - 2.5% = 4.875

NPV = [[(100 – 50) × 4.875] – 50] × 2.673 - 400 = 117.8938
134.60 −117.8938
% decrease in NPV = × 100 = 12.41%
134.60
(d) Fixed Cost: 50 + 2.5% = 51.25

NPV = [[(100 – 50) × 5] – 51.25] × 2.673 - 400 = 131.2588
134.60 −131.2588
% decrease in NPV = × 100 = 2.48%
134.60
(e) Discount rate: 6% + 2.5% = 6.15%

NPV = [[(100 – 50) × 5] – 50] × 2.666 - 400 = 133.20
134.60 −133.20
% decrease in NPV = × 100 = 1.04%
134.60
(f) Outflow: 400 + 2.5% = 410

NPV = [[(100 – 50) × 5] – 50] × 2.673 - 410 = 124.60
134.60 −124.60
% decrease in NPV = × 100 = 7.43%
134.60
Hence, SP is more sensitive.

Or, NPV is more sensitive with respect to SP.

QUESTION- 7B
Interpretation (Not for exam)
Given PVF @10% and 11% indirectly hints to assume 10% change in
each factor to analyze sensitivity.
NPV of project:
= 45000 x PVIFA(10%,4) – 1,20,000
= 45000 x 3.169 – 1,20,000 = 22,605
Sensitivity analysis:
(i) Initial project cost:
Assume, increase in project cost = 10%
New project cost = 1,20,000 x 110% = 1,32,000
New NPV = (45,000 x 3.169) – 1,32,000
= 10,605
22605−10605
% decrease in NPV = x 100
22605
= 53.09%
(ii) Annual inflow:

Assume, decrease in inflow = 10%
New annual inflow = 45000 – 10% = 40,500
New NPV = (40500 x 3.169) – 1,20,000
= 8344.50
22605−8344.50
% decrease in NPV = = 63.09%
22605
(iii) Cost of capital:

Assume, increase in CC = 10%
New CC = 10% + (10 x 10%) = 11%
New NPV = 45000 x PVIFA(11%,4) – 1,20,000
= 19,590

22605−19590
% decrease in NPV = x 100 = 13.34%
22605
Summary:
Factors % change in factor % change in NPV
Outflow 10% () 53.09% ()
Inflow 10% () 63.09% ()
CC 10% () 13.34% ()
Advice:
Inflow affects NPV more. Hence, inflow is most sensitive factor.
QUESTION- 7C
Calculation of NPV:
NPV = [(SP – UC) x SV] x PVIF @ 10% - Outflow
= (60 - 40) x 20000 x 0.909 + (60 - 40) x 30000 x 0.826 +(60
- 40) x 30000 x 0.751 – 10,00,000
= (60 – 40) x [(20000 x 0.909) + (30000 x 0.826) + (30000 x
To save 0.751)] – 10,00,000
time in next
= (60 – 40) x 65490 – 10,00,000
calculated
= 13,09,800 – 10,00,000 = 3,09,800
Sensitivity analysis:
(a) Sales price/unit:
Assume, sale price = 𝑥 [where NPV = 0]
NPV [i.e. 0] = (𝑥 – 40) x 65490 – 10,00,000
10,00,000
or, (𝑥 – 40) = = 15.27
65490
∴ 𝑥 = 15.27 + 40 = 55.27
60−55.27
% decrease in sales price = x 100 = 7.88%
60
(b) Unit cost:
Assume, unit cost = 𝑥 [where NPV = 0]

NPV [i.e. 0] = (60 - 𝑥) x 65490 – 10,00,000

10,00,000
or, (60 - 𝑥) = = 15.27
65490
∴ 𝑥 = 60 - 15.27 = 44.73
44.73−40
% increase in unit cost = x 100 = 11.825%
40
(c) Sales Volume:
Assume, year-1 SV = 𝑥 ; year-2 and 3 SV = 1.5 𝑥 [where NPV = 0]
NPV = (60 - 40) x [(𝑥 x 0.909) + (1.5 𝑥 x 0.826) + (1.5 𝑥 x

0.751)] - 10,00,000
or, 0 = [20 x 3.2745𝑥] – 10,00,000
10,00,000
∴𝑥 = = 15,270
65.49
Sales Vol. (Year-1) = 15270

Sales Vol. (Year-2 & 3) = 15270 x 1.5 = 22905
20000−15270
% decrease in SV (Year-1) = x 100 = 23.65%
20000
30000−22905
% decrease in SV (Year-2&3) = x 100 = 23.65%
30000
(d) Initial Outflow:
Assume, outflow = 𝑥 [where NPV = 0]
NPV [i.e. 0] = 13,09,800 - 𝑥
∴ 𝑥 = 13,09,800
13,09,800−10,00,000
% increase in initial outflow = x 100 = 30.98%
10,00,000

(e) Project life time:

We know, discounted payback period is that time period where NPV = 0.
Year Inflow PVIF @10% PV Cumulative PV
1 20 x 20000 0.909 3,63,600 3,63,600
= 4,00,000
2 20 x 30000 0.826 4,95,600 8,59,200
= 6,00,000
3 6,00,000 0.751 4,50,600 13,09,800
Recovery in 2 years = 8,59,200

Desired recovery = 10,00,000
Balance to be recovered in year-3 = 1000000 – 859200 = 1,40,800
₹ 4,50,600 recovery = 1 year

1 year
₹ 1,40,800 recovery = x 140800 = 0.31 years
450600
Discounted payback period = 2 + 0.31y = 2.31 years
3−2.31
% decrease in life = x100 = 23%
3
Summary:
Factors % change in factor where NPV is zero
(a) SP 7.88% ()
(b) UC 11.825% ()
(c) SV 23.65% ()
(d) Outflow 13.09% ()
(e) Life 23% ()
As sales price affect NPV more, sales price is most sensitive factor.

QUESTION- 7D
• IRR = 16% [Where NPV is 0]
• Sensitivity of CC = 60% [i.e. if CC is increased by 60% then NPV will
be zero]
Assume, CC = 𝑥
𝑥 + (𝑥 x 60%) = IRR
or, 1.60 𝑥 = 16%
∴ 𝑥 = 10%
• Sensitivity of fixed cost = 7.8416% [It means, if fixed cost will
increase by 7.8416% then NPV will be zero].
• P/V ratio = 70%; Variable cost ratio = 30%; Variable cost = 60
60
Sale price = = ₹200 per unit
30%
• Annual cash inflows = 57,500
Requirement:
(i) Initial investment:
PV of inflow @RR = Outflow
or, 57,500 x PVIFA(16%,5) = Outflow
∴ Outflow = 57500 x 3.274 = 1,88,255
(ii) NPV:
= PV of inflows @CC – Outflow
= 57500 x PVIFA(10%,5) – 188255
= (57500 x 3.791) – 188255 = 29,727.5
(iii) Annual fixed cost:

• As other factor remains same in sensitivity analysis, we can say
change in fixed cost is equal to change in inflow.
• Assume, inflow = 𝑥 [Where NPV = 0]
NPV = 𝑥 x PVIFA(10%,5) – 188255
or, 0 = 𝑥 x 3.791 – 188255
188255
∴𝑥 = = 49,658
3.791

Inflow where (NPV = 0) = 49658

Decrease in inflow = 57500 – 49658 = 7842
It must be equal to increase in fixed cost = 7842
Given, sensitivity factor = 7.8416%
∴ Existing FC x 7.8416% = 7842
7842
∴ Existing fixed cost = = 1,00,005
7.8416%
(iv) Annual Sales Unit:

Contribution = Inflow + Fixed cost
= 57500 + 100005 = 1,57,505
Contribution per unit = Sale price – VC = 200 -60 = ₹140
157505
No. of units = = 1125
140
(v) Break Even Unit:

At BEP, FC = Contribution of BEP unit
or, 1,00,005 = (BEP unit x 140)
1,00,005
∴ BEP unit = = 715 unit
140
CONCEPT: SCENARIO ANALYSIS

Scenario analysis examine the risk of investment, to analyse the impact
of alternative combinations of variables on the project’s NPV (or IRR).
This analysis brings in the probabilities of changes in key variables and
also allows us to change more than one variable at a time.
This analysis begins with the base case or most likely set of values for
the input variables. Then, go for worst case scenario (low unit sales, low
sale price, high variable cost, etc.) and best case scenario (high unit
sales, high sale price, low variable cost, etc.).
Alternatively, scenario analysis is possible where some factors are
changed positively and some factors are changed negatively.

QUESTION- 8A
The possible outcomes will be as follows:
Year PVF Worst Case Most Likely Best case
@9% Cash PV Cash PV Cash PV
Flow Flow Flow
( ‘000) ( ‘000) ( ‘000) ( ‘000) ( ‘000) ( ‘000)
0 1 (1,400) (1,400) (1,400) (1,400) (1,400) (1,400)
1 0.917 450 412.65 550 504.35 650 596.05
2 0.842 400 336.80 450 378.90 500 421.00
3 0.772 700 540.40 800 617.60 900 694.80
NPV -110.15 100.85 311.85
If XYZ Ltd. is certain about the most likely result in first two years but
uncertain about the third year’s cash flow, then, NPV expecting worst
case scenario is expected in the third year will be as follows:
 5,50,000  4,50,000  4,50,000
= -  14,00,000 + + +
(1 +0.09) (1+0.09)2 (1+0.09)3
= -  14,00,000 +  5,04,587 +  3,78,756 +  5,40,528 =  23,871
QUESTION-8B
If the project with the highest EV of profit were chosen, this would be
project C.
Outcome Probability Project-A Project-B Project-C
EV EV EV
I (Worst) 0.2 10,000 14,000 18,000
II (Most likely) 0.5 42,500 37,500 50,000
III (Best) 0.3 39,000 42,000 33,000
1.0 91,500 93,500 1,01,000
A table of regrets can be compiled, as follows, showing the amount of
profit that might be foregone for each project, depending on whether
the outcome is I, II or III.

Outcome Project
A B C
I (Worst) 90,000 – 50,000 90,000 – 70,000 90,000 – 90,000
= 40,000 = 20,000 =0
II 1,00,000 - 85,000 1,00,000 - 1,00,000 –
(Most likely) = 15,000 75,000 = 25,000 1,00,000 = 0
III (Best) 1,40,000 - 1,40,000 – 1,40,000 –
1,30,000 = 10,000 1,40,000 = 0 1,10,000 = 30,000
Analysis: The maximum regret is 40,000 with project A, 25,000 with B

and 30,000 with C. The lowest of these three maximum regrets is 25,000
with B, and so project B would be selected if the minimax regret rule is
used.
Note: The minimax regret rule aims to minimize the regret from making
the wrong decision. Regret is the opportunity lost through making the
wrong decision.
CONCEPT: SIMULATION TECHINIQUE IN CAPITAL BUDGETING

• Simulation is a technique to forecast happening of uncertain variable
(also termed as exogenous variable) on trail & error basis.
• To forecast happening of variable we use probability of outcomes
with random number. Random no. is that number which is generated
randomly on trial & error basis.
0 1 2 0 1 2 0 1 2
……………….. ……………….. ………………..
7 8 9 7 8 9 7 8 9
Random no.
Trail run – 1: 1 0 5 105
Trail run – 2: 0 2 3 023
Trail run – 3: 8 0 5 805
and so on……..
 Above random no. are three digit random no.

 We find 5 digits random no. table in examination if random no. are
not given question.
In this situation, select desired digit (i.e., 2 digit or 3 digit) from
starting and ignore remaining digit.
Example: - Table random no. :  53479

But we need 2 digit random number.
Hence, use “53” and ignore 479.
Steps to forecast happening of variables:

(1) Calculate cumulative probability
(2) Calculate Range of random no. on the basis of probabilities
(3) Link the random no. of each trail run with outcomes on the basis of
Range. It gives forecasted outcomes.
How to use random no. tables

XXXXX XXXXX XXXXX XXX
XXXXX XXXXX XXXXX XXX
(i) For First trail run  Randomly select any no. from table and use
first few digit number according to requirement and ignore
remaining digits.
(ii) For second trail run  Either proceed row wise or column wise in
sequence

QUESTION- 9A
Calculation of range of random no.
CF Prob. Cum. Range Life Prob. Cum. Range

Outcomes Prob. of Outcomes Prob. of
rand. R.N.
10,000 0.02 0.02 00-01 3 0.05 0.05 00-04
15,000 0.03 0.05 02-04 4 0.10 0.15 05-14
20,000 0.15 0.20 05-19 5 0.30 0.45 15-44
25,000 0.15 0.35 20-34 6 0.25 0.70 45-69
30,000 0.30 0.65 35-64 7 0.15 0.85 70-84
35,000 0.20 0.85 65-84 8 0.10 0.95 85-94
40,000 0.15 1.00 85-99 9 0.03 0.98 95-97
10 0.02 1.00 98-99
Forecast of cash flows and life for 10 trial run

We need 20 random no. (i.e. 10 for cash inflows and 10 for project life).
From table we are selecting no. column wise:
(53,97), (66,99), (30,81), (19,09), (31,67), (81,70), (38,75), (48,83),
(90,33), (58,52)
Assumed, first two random no. are for 1 st trial run and so on…
It means: 53  For inflow; 97  For life
Trial run Random No. Cash inflow Random Life

(Forecasted) (Forecasted)
1 53 30,000 97 9
2 66 35,000 99 10
3 30 25,000 81 7
4 19 20,000 09 4
5 31 25,000 67 6
6 81 35,000 70 7
7 38 30,000 75 7
8 48 30,000 83 7

9 90 40,000 33 5
10 58 30,000 52 6
Simulated NPV:
Trial run NPV = Inflow x PVIFA @10% - Outflow
1 30,000 x PVIFA (10%,9) – 1,30,000
= (30,000) x 5.759) – 1,30,000 = 42,770
2 35,000 x PVIFA (10%,10) – 1,30,000
= (30,000) x 6.145) – 1,30,000 = 85,075
3 25,000 x PVIFA (10%,7) – 1,30,000
= (25,000) x 4.868) – 1,30,000 = -8300
4 20,000 x PVIFA (10%,4) – 1,30,000
= (20,000 x 3.170) – 1,30,000 = -66,600
5 25,000 x PVIFA (10%,6) – 1,30,000
= (25,000 x 4.355) – 1,30,000 = -21,125
6 35,000 x PVIFA (10%,7) – 1,30,000
= (35,000 x 4.868) – 1,30,000 = 40,380
7 30,000 x PVIFA (10%,7) – 1,30,000
= (30,000 x 4.868) – 1,30,000 = 16,040
8 30,000 x PVIFA (10%,7) – 1,30,000
= (30,000 x 4.868) – 1,30,000 = 16,040
9 40,000 x PVIFA (10%,5) – 1,30,000
= (40,000 x 3.791) – 1,30,000 = 21,640
10 30,000 x PVIFA (10%,6) – 1,30,000
= (30,000 x 4.355) – 1,30,000 = 650

QUESTION- 9B
Formation of range of random no.
Original Cost Life
Value Prob. Cum. Prob. Range Life Prob. Cum. Prob. Range
60,000 0.30 0.30 00-29 5 0.40 0.40 00-39
70,000 0.60 0.90 30-89 6 0.40 0.80 40-79
90,000 0.10 1.00 90-99 7 0.20 1.00 80-99
For cash inflows
Value Prob. Cum. Prob. Range
10,000 0.10 0.10 00-09
15,000 0.30 0.40 10-39
20,000 0.40 0.80 40-79
25,000 0.20 1.00 80-99
Forecast of cash flows and life for 10 trial run
T. run Original cost Life Inflow
R.N. Value R.N. Life R.N. Value
1 09 60,000 24 5 07 10,000
2 84 70,000 38 5 48 20,000
3 41 70,000 73 6 57 20,000
4 92 90,000 07 5 64 20,000
5 65 70,000 04 5 72 20,000
Calculation of NPV:
Trial run NPV = Inflow x PVIFA @6% - Outflow
1 10,000 x PVIFA (6%,5) – 60,000
= (10,000) x 4.212) – 60,000 = -17,880
2 20,000 x PVIFA (6%,5) – 70,000
= (20,000) x 4.212) – 70,000 = 14,240
3 20,000 x PVIFA (6%,6) – 70,000
= (20,000) x 4.917) – 70,000 = 28,340
4 20,000 x PVIFA (6%,5) – 90,000
= (20,000) x 4.212) – 90,000 = -5760

5 20,000 x PVIFA (6%,5) – 70,000

= (20,000) x 4.212) – 70,000 = 14,240
CONCEPT: REAL OPTOIN IN CAPITAL BUDGETING

The traditional analytical methods usually under estimate investment
opportunity because they ignore management’s flexibility to after
decision. It assumes project should be initiated immediately and operate
it continuously until the end of its expected useful life.
Real option gives flexibility in decision-making which improves estimates

of project value and cash flows. It relies on option pricing theory to
Evaluate project.
All concepts of option theories/pricing studied in Derivative chapter are

applicable in this chapter also. In this chapter underlying of option is a
project/machine.
Option in Capital Budgeting
Call option Put option
Long Call Short Call Long Put Short Put
Right to invest Promise to sell Right to sell at Promise to buy

at some future if counter party some future if counter party
date at a wants to buy. date at a wants to sell.
certain price. certain price.
Valuation of Real option:

All concepts of valuation are same. Usually we use following two methods
to value option:
(A) Binomial Model

(i) Risk Neutral Method

(ii) Risk less hedge portfolio method
(B) Black sholes Method

 Sometimes it becomes difficult to identify certain inputs required to
use above methods. Hence keep following in mind.
(i) Cost of Project at which we can buy project at some future date
 Strike Price of Call
(ii) Value of abandonment or sale price of project at some future date

 strike price of put
(iii) PV of Cash flows  Spot price of project
(iv) Dividend Yield (Expected benefit/cost to delay)  1/Life
 Value of call = [EDSP × N(d1 )] – [PV of strike × N(d2 )]
Value of Put = [PV of strike – EDSP] + call premium

Or, [PV of strike × (1 - N(d2 ))] - [EDSP × (1- N(d1 ))]
SP σ2
Ln ( )+ [(Rf −Dy)+ ] ×T
K 2
𝑑1 =
σ × √T
𝑑2 = 𝑑1 - σ × √T
N(d1 ) = Cumulative probability of Area – ∞ to 𝑑1
N(d2 ) = Cumulative probability of Area – ∞ to 𝑑2
SP
EDSP = [eDy.t ]

QUESTION- 10A
(i) Start construction now:
(a) Construct 10 units Apartments:
Current market value (10 x 80) 800 lakhs
Less: Construction cost 600 lakhs
Net profit 200 lakhs
(b) Construct 15 units Apartments:

Current market value (15 x 80) 1200 lakhs
Less: Construction cost 1025 lakhs
Net profit 175 lakhs
10 Apartment is best if construct now.
(ii) Construct after 1 year:

Market Condition
Buoyant Sluggish
10 units Apart. (91 x 10) – 600 = 310 (75 x 10) – 600 = 150
15 units Apart. (91 x 15) -1025 = 340 (75 x 15) – 1025 = 100
Selection 15 units Apart. 10 units Apart.
Determination of value of vacant plot:
(91 + 7) = 98
80
(75 + 7) = 82
R−d 1.10−1.025
Prob. of attaining value 98 = = = 0.375
U−d 1.225−1.025
Prob. of attaining value 82 = 1 – 0.375 = 0.625

Expected cash flows = (340 x 0.375) + (150 x 0.625)

= ₹221.25 lakhs
₹ 221.25
PV of expected cash flows = = ₹201.12 lakhs
(1+0.10)
Since the current value of vacant land is more than profit from 10
units Apartment now, the land should be kept vacant.
QUESTION- 10B
0y 1y
Payoff
195 Cr. 0
150 Cr.
90 Cr. 10
Strike price = 100 Cr

R−d (1+0.08)−(1−0.40)
Prob. of attaining value 195Cr. = = = 0.6857
U−d (1+0.30)−(1−0.40)
Prob. of attaining value 90Cr. = 1 – 0.6857 = 0.3143
Expected value of payoff = (0 x 0.6857) + (10 x 0.3143) = 3.143
3.143
Value of put option = = 2.91 Cr.
(1+0.08)
Question – 10 C
The given solution is like valuation of stock option wherein delay in
introduction of drug ‘Aidrex’ shall cause the loss of cashflow which is like
payment of dividend.
To value the patent, we shall use Black Scholes Model for option pricing
as follows:

Inputs
S (Spot Price) = The Present Value of Cashflows = $ 16.7 million
E (Exercise Price) = Cost of Development Formula = $ 12.5 million
2 = 26.8% (i.e., 0.27)
𝜎
R (Risk Free rate of Return) = 7.8%
1
D (Expected Cost of Delays) = = 0.0667 (i.e., 6.67%)
15
Value Call Option

C = Se-df – Ee-rt N(d2)
1
In (S/E)+ [R−D+( )σ2 ] t
2
d1 =
σ √t
d2 = d1 - σ √t
Accordingly,
1
In (16.7/12.5)+ [0.078−0.0667+( )(0.268)] 15
d1 =
2
√0.268 √15
0.2897+(0.1453)15 0.2897+2.1795 2.4692
= = = = 1.2315
0.5177 ×3.8730 2.005 2.005
d2 = 1.2315 – 2.005 = - 0.7735

N(d1) = 0.8910
N(d2) = 0.2196
Value of Patent
− 0.0667 ×15
= 16.7 x e × 0.8910 – 12.5 x e− 0.078 ×15 × 0.2196
= 16.7 x 0.3677 x 0.08910 x – 12.5 x 0.3104 x 0.2196
= 5.471 – 0.852 = 4.619
Thus, The Value of Patents is $ 4.619 Million.

Question – 10D
Decision Tree showing pay off
Year 0 Year 1 Pay
off
130 0
100
60 80-60 = 20
First of all we shall calculate probability of high demand (P) using risk
neutral method as follows:
8% = p x 30% + (1-p) x (-40%)
0.08 = 0.30 p - 0.40 + 0.40p
0.48
p= = 0.686
0.70
The value of abandonment option will be as follows:

Expected Payoff at Year 1
= p x 0 + [(1-p) x 20]
= 0.686 x 0 + [0.314 x 20]
= ₹ 6.28 crore
Since expected pay off at year 1 is ₹ 6.28 crore. Present value of
expected pay off will be:
6.28
= = ₹ 5.81 crore
1.08
This is the value of abandonment option (Put Option).

CONCEPT: BASE CASE NPV AND ADJUSTED NPV

• Normally, we use cost of capital as discount rate to evaluate project
on the assumption that every project is financed by same proportion
of debt and equity. However, it may not be true. Moreover, tax
advantages (i.e. Tax saving on interest) due to use of borrowed fund
is not usually considered in evaluation of project. But impact of debt
financing can be incorporated using adjusted present value method
with an adjustment of tax saving on debt financing with Base Case
NPV.
• Base case NPV  NPV under the assumption that the project is
financed by equity only (All equity financed company).
• Adjusted NPV:
Adjusted NPV = Base case NPV
+ PV of tax saving on interest of debt.
Where,
PV of Tax saving on interest of debt can be calculated as follows:
Tax saving on int (TSI) = (Interest x Tax rate)
Case-I: Fixed interest debt of definite life:

TSI TSI TSI
PV
(?)
Discount @ Kd

Case-II: Debt with indefinite life

PV of tax saving on interest = Debt amount x Tax rate
Verification:
0 year 1 year 2 year 3 year n year
TSI TSI TSI
PV
(?)
Discount @ Kd
(Borrowing
TSI Int x TR
PV of Tax saving on int = =
BR BR
(Debt Amt x BR) x TR
=
BR
= (Debt Amt x TR)
Note:
• If borrowing amount vary time to time to maintain proportion
of debt with equity market value then we have to use cost of
capital [not borrowing rate (K d)] as discount rate because Tax
saving becomes uncertain.
• We can accept project with -ve base case NPV.
Acceptable Adjusted NPV = 0

QUESTION – 11A
0Y 1Y 2Y 3Y
(1,000) 85 L 85 L 85 L
CC = 10%
Kd = 8% - 1% = 7%
(a) Base case NPV:

85 L 85
PV of Inflow = [ CC ] = = 850 Lakh
0.10
Base case NPV = PV of Inflow – Outflow

= 850 – 1000 = -  150 Lakh
Adjusted NPV = Base case NPV + PV of tax saving on interest on debt

= - 150 L + (Debt Amount x TR)
= - 150 L + (400 x 0.35) = -  10 Lakh
(b) Adjusted NPV in revised condition:

As borrowing amount will change, use cost of capital to calculate pv
of tax saving.
Tax saving on int = Int. amount x TR

= (900 x 7%) x 35% = 9.8 Lakh [perpetual]
9.8 L
PV of tax saving = [0.10 (CC) ] = 98 Lakh
Adjusted NPV = Base case NPV + PV of tax saving

= - 150 L + 98 Lakh = -  52 Lakh
(b) Reason behind difference:

Due to different discount rate adjusted NPV is changed.

QUESTION-11B
(i) Net Present Value (All Equity Financed) – Base NPV
Particulars Period USD PVF PV (USD
Lakhs @12% Lakhs)
Initial Investment 0 (250.00) 1.000 (250.000)
EBIDTA 1 to 20 33.00 7.469 246.477
Tax 1 to 20 (9.90) 7.469 (73.943)
Depreciation 1 to 10 (25.00)
Tax saving on dep 1 to 10 7.50 5.650 42.375
NPV (35.091)
(ii) Present Value of Impact of Financing by Debt

Particulars Period USD Lakhs PVF @8% PV (USD
Lakhs)
Loan 0 150.00 1.00 150.000
Interest 1 to 15 (9.00) 8.559 (77.031)
Tax saving on Interest 1 to 15 2.70 8.559 23.109
Repayment of Principal 15 (150.00) 0.315 (47.250)
NPV 48.828
Adjusted Present Value of the Project
= Base NPV + PV of Impact of Financing
= - US$ 35.091 + US $ 48.828 lakh
= US$ 13.737 lakh
Advise: Since APV is positive, TL Ltd. should accept the project.
Alternatively, if instead of PV of overall impact of Financing the PV of

impact of tax shield on Interest is considered then APV shall be computed
as follows:
= Base NPV + PV of Tax Shield on Interest
= - US$ 35.091 + US $ 23.109 lakh
= - US$ 11.982 lakh
Advise: Since APV is negative, TL Ltd. should not accept the project.

CONCEPT: REPLACEMENT DECISION

• Selling old machine and buying new machine in place of old machine is
known as replacement decision.
• Evaluation of replacement decision is based on “change in cash flows”.
• Evaluation:
(i) Initial incremental outflow [or, replacement cost]
Cost of new machine xxx
Less: Realisation from old machine net of capital gain tax xxx
xxx
Note: Purchase cost of old machine is irrelevant for decision
making [i.e. Sunk cost].
(ii) Annual incremental cash inflows:

Method-1 :
Annual cash Annual cash

inflows - inflows
[New machine] [Old machine]
[ ] [ ]
Method-2:
Particulars ₹
Increase in sale xxx
Decrease in operating cost xxx
Or,
Increase in operating cost (xxx)
Incremental EBDT xxx
Less: Increase in Dep. (xxx)
Incremental EBT xxx
Less: Tax xxx
Incremental EAT xxx
Add: Increase in Dep xxx
Incremental annual cash inflows xxx

Second alternative of Method-2:

Particulars ₹
Incremental EBDT xxx
Less: Tax (xxx)
xxx
Add: Tax saving on increase in Dep. xxx
Annual cash inflows xxx
(iii) Incremental inflows from salvage (At end of life)
Inflow net of Inflow net of

= capital gain tax - capital gain tax
on New machine on Old machine
[ ] [ ]
Where,
Inflow = Net sale value – Tax on STCG
Or, Net sale value + Tax saving on STCL
STCL = Short term capital loss
(iv) Calculation of incremental NPV

= PV of incremental inflow – Initial incremental outflow
Decision:
Incremental NPV = +ve  Replace old machine
Incremental NPV = -ve  Do not replace old machine
Incremental NPV = 0  Indifference
Note:
Similarly, we can calculate “PI”, payback period also for
incremental cash flows, using same concept studied earlier.

Question – 12 A
Step I: Net cash outflow (assumed at current time) [Present values of
cost]:
a. (Book value of old system – market value of old system) × Tax Rate
= Tax payable/savings from sale
= [(₹ 25,000 – 5 × ₹ 2,500) – ₹ 5,000] × 0.30 = ₹ 7,500 × 0.30
= ₹ 2,250
b. Cost of new system – [Tax payable/savings from sale

+ Market value of old system] =Net cash outflow
Or, ₹ 50,000 – [₹ 2,250 + ₹ 5,000] = ₹42,750
Step II: Estimated change in cash flows per year if replacement

decision is implemented.
Change in cash flow = [(Change in sales ± Change in operating costs)

-Change in depreciation)] (1- tax rate) + Change in depreciation
= [₹ 1,00,000 × 0.1 + ₹ 5,000 – (₹ 49,000/5 – ₹ 25,000/10)] (1-0.30)
+ (₹ 49,000/5 – ₹ 25000/10)] = ₹ 12,690
Step III: Present value of benefits = Present value of yearly cash flows
+ Present value of estimated salvage of new system
= ₹ 12,690 × PVIFA (10%, 5) + ₹ 1,000 × PVIF (10%, 5)
= ₹ 48,723
Step IV: Net present value = Present value of benefits

- Present value of costs
= ₹ 48,723 – ₹ 42,750 = ₹ 5,973
Step V: Decision rule: Since NPV is positive we should accept the

proposal to replace the machine.

QUESTION – 12B
Machine – R Machine – S
Cost 2,00,000 2,50,000
Life 5 Year 5 Year
Salavage NIL NIL
Production 1,50,000 units Same
Sale valuen 9,00,000 Same
Operating cost 2,00,000 1,80,000
Fixed cost (1,50,000 x 3) 4,50,000 same
(i) Replacement decision:

(a)
Sale value of Machine - R 1,00,000
Less:- Removal Cost 30,000
70,000
Initial incremental outflow = [2,50,000 – 70,000] = 1,80,000

[i.e., Replacement cost]
(b) Incremental Inflow

Particulars  (1 to 5y)
Decrease in sale NIL
Decrease in Opreating cost 20,000
Decrease in Fixed cost NIL
Incremental EBDT 20,000
[or, Incremental Inflow] Because tax = NIL
(c) Incremental Inflow from salvage = NIL
(d) PV of incremental inflow and NPV:

(1,80,000) 20,000 20,000 20,000 20,000 20,000
PV of inflow = 20,000 x PVIFA (14%,5)

= 20,000 x 3.432 = 68,640
NPV = 68,640 – 1,80,000 = - 1,11,360
Advice: Replacement is not beneficial work on machine R
(ii) Advice, if machine – R has not been installed:

In this case, Machine – R and Machine – S becomes mutually exclusive.
Annual Cash Inflows:

Machine – R Machine – S
Sale Value 9,00,000 9,00,000
Less:- Operating Cost 2,00,000 1,80,000
Less:- Fixed Cost 4,50,000 4,50,000
EBDT 2,50,000 2,70,000
(or, cash Inflows)  Because of no tax
PV of inflows (R) = 2,50,000 x PVIFA (14%,5)

= 2,50,000 x 3.432 = 8,58,000
NPV (R) = 8,58,000 – 2,00,000 = 6,58,000
PV of inflows (S) = 2,70,000 x 3.432

= 9,26,640
NPV (S) = 9,26,640 - 2,50,000 = 6,76,640
Advice: - Install Machine – S, If Machine – R has not been installed.

QUESTION – 12C (Good Question)
3 years ago Now 1y 2y 3y 4y 5y
(20L) Sale (Old) (1 L) (1 L) (1 L)

 = 12 L  
Dep @20% WDV  Old exp. Sale
New (Buy) (New)
= 30 L = 18 L
(i) Initial incremental Outflow:

(a) WDV as today [Old Machine]
Particulars 
Cost 20,00,000
Less:- Dep (year – 1) 4,00,000
16,00,000
Less:- Dep (year – 2) 3,20,000
12,80,000
Less:- Dep (year – 3) 2,56,000
WDV at end of 3Year 10,24,000
(b)
Particulars 
Cost of new Machine 30,00,000
Less:- Sale Value 12,00,000
Incremental Outflow(Initial) 18,00,000
(ii) Tax saving on incremental Dep:

Difference in value of machine
= 30,00,000 – 10,24,000 = 19,76,000

Depreciation on this value is incremental depreciation.
Particulars 1 2 3 4 5
Opening value 19,76,000 15,80,800 12,64,640 10,11,712 8,09,370
Less:- Dep @20% 3,95,200 3,16,160 2,52,928 2,02,342 1,61,874
Closing value 15,80,800 12,64,640 10,11,712 8,09,372 6,47,496

Tax sav on dep.@40% 1,58,080 1,26,464 1,01,171 80,937 64,750
PVF @10% 0.909 0.826 0.751 0.683 0.621
PV of tax saving on dep.

= Σ (Tax saving on dep x PVIF) = 4,19,623
(iii) Annual incremental cash flows excluding depreciation:

Increase in Rev. 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Decrease in oper. cost 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Additional maintencence - - 1,00,000 1,00,000 1,00,000

cost saving
Incremental EBDT 5,00,000 5,00,000 6,00,000 6,00,000 6,00,000

Less:- Tax @ 40% 2,00,000 2,00,000 2,40,000 2,40,000 2,40,000
Net cash flow excl. dep. 3,00,000 3,00,000 3,60,000 3,60,000 3,60,000
Add:- Salvage - - - - 18,00,000
Total inflow 3,00,000 3,00,000 3,60,000 3,60,000 21,60,000

PVIF @10% 0.909 0.826 0.751 0.683 0.621
(iv) NPV:
Particulars 
PV of inflows 23,78,100
Add:- PV of tax saving on depreciation 4,19,623
Total PV of inflows 27,97,723
Less:- Initial Outflow 18,00,000
NPV 9,97,723
As incremental NPV is positive, it is beneficial to replace old machine.

Note:- Ignored capital gain tax because question informed there are
several machines in same block of assets.
Disclaimer:
• When old machine will be sold, company will save additional
maintenance cost of  1,00,000 from 3 rd year end. Hence it is
inflow, but institute assumed outflow which is not correct.
• Increase in revenue is in additional to decrease is in operating
cost (according to question). Hence, we have to consider both
saving. But institute ignored 2,00,000 saving which is not
correct.
QUESTION – 12D
Cost of new machine = 26,00,000 + 9,000 + 6,000 = 26,15,000
Outflow in WC = 17,000
26,15,000
Annual Depreciation = = 3,26,875
8
Particulars Amount
Sale value of Old Machine 12,500
Less:- Dismantling cost 4,500
Net sale value 8,000
Less:- WDV in books 76,000
STCL (68,000)
Tax saving on STCL = 68,000 x 35% = 23,800

Total Inflow = 8,000 + 23,800 = 31,800
Incremental initial outflow:

Cost of Machine 26,15,000
Working capital 17,000
26,32,000
Less:- Inflow from old M. 31,800
Net Outflow 26,00,200

Annual Cash Inflows:

Particulars  (1 to 8y)
EBT 3,15,000
Less:- Tax @35% 1,10,250
EAT 2,04,750
Add:- Depreciation 3,26,875
Annual Cash Inflow 5,31,625
 Inflow at 8y end from WC = 17,000

 PV of inflows @13%
= 5,31,625 x PVIFA (13%, 8)
= 5,31,625 x 4.80 = 25,51,800
 PV of inflows from W.C.

= 17,000 x 0.376
= 6,392
 NPV = PV of Inflows – PV of Outflows

= (25,51,800 + 6,392) – 26,00,200
= - 42,008

CONCEPT: PROJECT WITH UNEQUAL LIFE

• Cash flows/ NPV of unequal life projects can’t be compared.
Hence, calculate equivalent annual equal cash flows (or, equivalent
annual equal NPV) first and then take decision.
• Calculation of annual equal cash flows:
PV of 𝑥 𝑥 𝑥 𝑥
cash
൦ ൪
flows
or, NPV
Assumed, equivalent annual equal cash flows/ NPV = 𝑥

PV of 𝑥 = PV of cash flows/NPV
𝑥 x PVIFA (RR, n) = PV of cash flows/NPV
PV of cash flows/NPV
𝑥 = [ ]
PVIFA (RR, n)
QUESTION – 12E
This question is simply unequal life project question. Nothing link with
Replacement.
(i) Annual equal Outflow of machine EM (12y):

Particulars Amount Period PVF/PVIFA@14% PV
Purchase Price 10,00,000 0y 1 10,00,000
Overhauling 2,00,000 8y 0.3506 70,120
Annual repair 1,00,000 1 – 12Y 5.6600 5,66,000
Scrap (1,50,000) 12y 0.2076 (31,140)
PV of net outflow 16,04,980
Assume, Annual equal outflow = x

X x PVIFA (14%, 12) = 16,04,980
16,04,980
∴x= = 2,83,565
5.6600
(ii) Annual equal Cash Outflow of machine LM (6y):
Particulars Amount Period PVF/PVIFA@14% PV
Purchase Price 7,00,000 0y 1 7,00,000
Overhauling 1,00,000 4y 0.5921 59,210
Annual repair 1,40,000 1 – 6Y 3.8890 5,44,460
Scrap (1,50,000) 6y 0.4556 (68,340)
PV of net outflow 12,35,330
12,35,330 12,35,330
Annual Equal outflow = = = 3,17,647
PVIFA (14%,6) 3.8890
(iii) Advice: since annual outflow of machine EM is lesser, it is beneficial

to go for machine EM.
CONCEPT: REPLACEMENT AT OPTIMAL POINT & OPTIMAL

REPLACEMENT CYCLE:
QUESTION – 13A
(i) New Machine:
0Y 1Y 2Y 3Y 4Y 8Y
(90,000) (10,000) (10,000) (10,000) (10,000) (10,000)

20,000
Calculation of equivalent annual equal outflow [i.e., Annual outflow to

work on new Machine]
PV of Outflow
= 90,000 + 10,000 x PVIFA (15%,8) – 20,000 x PVIF (15%,8)
= 90,000 + (10,000 x 4.4873) – (20,000 x 0.3269)
= 1,28,335
Assume, Annual equal cash outflow = x

X x PVIFA (15%, 8) = 1,28,335
1,28,335
∴x= = 28,600
4.4873
Interpretation (Note for exam):
0Y 1Y 2Y 3Y 4Y 8Y
(28,600 (28,600 (28,600 (28,600 (28,600)

) ) ) )
This cashflows and above timeline cash flows are same.
(ii) Annual cost to work on old machine:

year 1 2 3 4
Maintenance 10,000 20,000 30,000 40,000
Decrease in 40,000 - 15,000 40,000 - 15,000 40,000 - 15,000 40,000 - 15,000
salvage = 15,000 = 15,000 = 15,000 = 15,000

Opportunity 40,000 x 15% 25,000 x 15% 15,000 x 15% 10,000 x 15%
Loss of int = 6,000 = 3750 = 2250 = 1500
Total cost to 31,000 33,750 37,250 51,500
work on old
m. (Annual )
Advice:- Annual equivalent outflow when work on new machine is 28,600

which is lesser than outflow of old machine from first year itself.
Analysis (Not for exam):

• Suppose, annual equal outflow of new machine is 32,000. In this
case, old machine cost is lesser is first year. Hence replace
machine at end of 1 st year.

QUESTION – 13B
Calculation of cash flows and NPV for each replacement cycle [i.e.,
Replacement every year, Replacement in every 2 years, Replacement in
every 3 years etc.]
(i) 1 year replacement cycle:

Particulars 0 1
Replacement cost (60,000) -
[Purchase cost]
Maintenance (16,000)
Salvage 32,000
(60,000) 16,000
PVF@15% 1 0.8696
NPV = - 60,000 + (16,000 X 0.8696)

= - 46,086
(ii) 2 years replacement cycle:

Particulars 0 1 2
Purchase price (60,000) -
Maintenance (16,000) (18,000)
Repair 0 (4,000)
Salvage 24,000
Net cash flows (60,000) (16,000) 2,000
PVF@15% 1 0.8696 0.7561
NPV = - (60,000 x 1) - (16,000 X 0.8696) + (2,000 x 0.7561)

= - 72,402

(iii) 3 years replacement cycle:

Particulars 0 1 2 3
Purchase price (60,000) -
Maintenance (16,000) (18,000) (20,000)
Repair 0 (4,000) (8,000)
Salvage 16,000
Net cash flows (60,000) (16,000) (22,000) (12,000)
PVF@15% 1 0.8696 0.7561 0.6575
NPV = - (60,000 x 1) - (16,000 X 0.8696) - (22,000 x 0.7561)

- (12,000 x 0.6575)
= - 98,438
(iv) 4 years replacement cycle:

Purchase (60,000) -
price
Maintenance (16,000) (18,000) (20,000) (20,000)
Repair 0 (4,000) (8,000) (16,000)
Salvage 8,000
Net cash f. (60,000) (16,000) (22,000) (28,000) (28,000)
PVF@15% 1 0.8696 0.7561 0.6575 0.5718
NPV = - (60,000 x 1) - (16,000 X 0.8696) - (22,000 x 0.7561)

- (28,000 x 0.6575) - (28,000 x 0.5718)
= - 1,24,968
Interpretation (Not for exam):

Above NPV are not comparable as these are of different time period.
In this case we have to calculate equivalent annual equal NPV.

 Calculation of equivalent annual equal NPV:
Assume, Equivalent equal NPV = x
X x PVIFA (15%, n) = NPV
NPV
∴x=
PVIFA
Replacement cycle 1 year 2 Years 3 Years 4 Years

NPV - 46,086 - 72,402 - 98,438 - 1,24,968
Annual equal NPV
NPV − 46,086 − 72,402 − 98,438 − 1,24,968
(x) = [ ] ( ) ( ) ( ) ( )
PVIFA 0.8696 1.6257 2.2832 2.855
= - 52,997 = - 44,536 = - 43,114 = - 43,772
Equivalent annual equal NPV in 3 years replacement cycle is lowest.

Hence, optimum replacement cycle should be 3 years (i.e., replace old
machine in every 3 years instead of 4 years)
QUESTION-13C
Ri = Rf + β(Rm – Rf )
0.14 = Rf + 0.04
Rf = 0.10 or 10 percent
(Sale Price−Variable Cost)
NPV0 = Quantity X – Initial Investment
Risk Free Rate
= [6000 X (10-6)/0.10] - ₹ 1,00,000 = ₹ 1,40,000
[8,000𝑋(11 − 5)/0.10 − 100000]
NPV1 = = ₹ 3,45,454
1.10
[5,000 (9 − 7.50)/0.10 − 1,00,000]
NPV2 =  = - ₹ 20,661
(1.10)2
It is better to defer the investment by 1 year and not by 2 years

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Chapter 13

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

BASICS OF INVESTMENT DECISION

Balance Sheet of a Company

Capital Employed Invest or not (?)

• Capital budgeting decision depends upon various factors. Some

(I) OUTFLOW IN THE PROJECT:

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

(II) INFLOW FROM PROJECT:

Method-2: ACIF= [EBDT x (1-t)] +Tax saving on Depreciation

Method-3: ACIF/CFAT = EBDT – Correct Tax

To calculate it, we must

(B) INFLOW FROM SALVAGE:

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

• Inflow from salvage [At end of life]

Where, STCG/LTCG is calculated as follows:

STCG = Short term capital gain

(C) INFLOW FROM WORKING CAPITAL:

(III) REQUIRED RETURN OF THE PROJECT:

(ii) If risk factor of similar risk industry (i.e. proxy entity) is

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

(iii) If risk factor is not given:

CONCEPT: PROJECT EVALUATION TECHNIQUE

Time value adjusted Time value not adjusted

(1) NET PRESENT VALUE (NPV):

ACIF ACIF ACIF

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

Where, SV = Salvage Value; WC = Working Capital

Note: For NPV always use RR as discount rate.

(2) PROFITABILITY INDEX OR, PRESENT VALUE INDEX OR,

ACIF ACIF ACIF

Must be IRR is that discount rate Use Interpolation

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COMPARISON AMONG NPV, PI & IRR VS. RR

COMPARISON BETWEEN IRR & RR

(b) IRR (Internal Rate of Return):

(4) MODIFIED INTERNAL RATE OF RETURN (MIRR):

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0 year 1 year 2 year 3 year

(500) 300 250 200

Calculate “return of project” if intermediate period cash flows

(500) 300 250 200

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(5) MODIFIED NPV:

(Outflow) ACIF ACIF ACIF ACIF + Sal. + WC

Reinvest at specified rate Reinvested

Modified NPV = [PV of re-invested cash inflows – Outflows]

(6) PAYBACK PERIOD:

(500) 200 200 200 200

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As annual inflows are same we can directly calculate payback

It means, initial investment will be recovered in 2.5 years ignoring

(500) 200 250 300 200

In this example, we can calculate payback period as follows:

450 500 750

Decision: Shorter payback period  Better project

(7) Discounted Payback period:

0 year 1 year 2 year 3 year 4 Year

(500) 200 250 300 200