Practice Problem on Capital Budgeting

1. Initial Investment = Rs. 1,00,000

Expected future cash inflows Rs. 20,000, Rs. 40,000, Rs. 60,000, Rs. 70,000.
From the above compute Pay-back period.

Solution:

Calculation of Pay Back period.

Year Cash Inflows (Rs.) Cumulatige Cash Inflows (Rs.)
1 20,000 20,000
2 40,000 60,000
3 60,000 1,20,000
4 70,000 1,90,000

The initial investment is recovered between the 2nd and the 3rd year.

Balance of Unrecovered Initial Investment

∴ Pay back Preiod = 2 years  ×12
Cash Inflows during the year
Initial Investment − Cumulative
Cash Inflows at the end of 2 nd year
= 2 years  × 12
Cash Inflows in the 3rd year

1,00,000 − 60,000
= 2 years  ×12
60,000
40,000
= 2 years  ×12
60,000
= 2 years 8 months.

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 2. Victory Ltd. decided to purchase a machine to increase th installed capacity. The
company has four machines under consideration. The relevant details including
estimated yearly expenditure and sales are given below. All sales are for cash.
Corporate Tax Rate @ 33.99% (inclusive of Surcharge @ 10%, Deduction less @ 2% and
Secondary & Higher Education less @ 1%). Calculate Pay-back Period.

Particulars M1 M2 M3 M4
Initial Investment (Rs. lacs) 30.00 30.00 40.00 35.00
Estimated Annual Sales (Rs. lacs) 50.00 40.00 45.00 48.00
Cost of Production (Estd) (Rs. lacs) 18.00 14.00 16.70 21.00
Economic Life (yrs) 2 3 3 4
Scrap Values (Rs. lacs) 4.00 2.50 3.00 5.00

Solution:

Statement Showing Payback for four machines

Particulars M1 M2 M3 M4
(1)Initial Investment (Rs. lacs) 30.00 30.00 40.00 35.00
(2) Estd. Annual Cost of Production (Rs. Lacs) 50.00 40.00 45.00 48.00
(3)Estd. Cost of Production (Rs. lacs) 18.00 14.00 16.70 21.00
(4)Depreciation (Rs. lacs) 13.00 9.17 12.33 7.50

(5) Profit Before Tax (PBT) [2–3–4] 19.00 16.83 15.97 19.50
(6) Tax @ 33.99% (Rs. lacs) 6.4581 5.721 5.428 6.628
(7) Profit After Tax (PAT) [5–6] (Rs. lacs) 12.5419 11.109 10.542 12.872
(8) Net Cash Flow [7+4] 25.5419 20.279 22.872 20.372
M M M
M1 2 3 4

Pay back Period (Years)  30.00  30.00  40.00  35.00

25.5419 20.279 22.872 20.372
Initial Investment
= 1.17 = 1.48 = 1.74 = 1.72
Net Annual Cash Flow
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 Analysis : Machine 1 is more profitable, as it has the lowest payback period.

3. A project costing Rs. 10 lacs. EBITD (Earnings before Depreciation, Interest and
Taxes) during the first five years is expected to be Rs. 2,50,000; Rs. 3,00,000; Rs.
3,50,000; Rs. 4,00,000 and Rs. 5,00,000. Assume 33.99% tax and 30% depreciation
on WDV Method. Compute Accounting Rate of Return.

Computation of Project ARR :

Particulars Yr 1 Yr 2 Yr3 Yr 4 Yr 5 Average
Rs. Rs. Rs. Rs. Rs. Rs.
EBITD 2,50,000 3,00,000 3,50,000 4,00,000 5,00,000 3,60,000
Less : Depreciation 3,00,000 2,10,000 1,47,000 1,02,900 72,030 1,66,386
EBIT (50,000) 90,000 2,03,00 2,97,100 4,27,970 1,93,614
Less : Tax @ 33.99% — 13,596 69,000 1,00,984 1,45,467 65,809
(50,000) 76,404 1,34,000 1,96,116 2,82,503 1,27,805

Book Value of Investment :

Begining 10,00,000 7,00,000 4,90,000 3,43,000 2,40,100
End 7,00,000 4,90,000 3,43,000 2,40,100 1,68,070
Average 8,50,000 5,95,00 4,16,500 2,91,550 2,04,085 4,71,427
Average EBIT (1 − t) 1,27,805

ARR = Average Investment ×100 = 4,71,427 ×100

= 27.11%
Note : Unabsorbed depreciation of Yr. 1 is carried forward and set-off against profits of Yr. 2. Tax is
calculated on the balance of profits
= 33.99% (90,000 – 50,000)
= 13,596/-

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4. Z Ltd. has two projects under consideration A & B, each costing Rs. 60 lacs.
The projects are mutually exclusive. Life for project A is 4 years & project B is 3 years.
Salvage value NIL for both the projects. Tax Rate 33.99%. Cost of Capital is 15%. Compute
Net Present Value.

Net Cash Inflow (Rs. Lakhs)

At the end of the year Project A Project B P.V. @ 15%
1 60 100 0.870
2 110 130 0.756
3 120 50 0.685
4 50 — 0.572

Computation of Net Present Value of the Projects.

Project A (Rs. lakhs)
Yr. 1 Yr. 2 Yr. 3 Yr. 4
1. Net Cash Inflow 60.00 110.00 120.00 50.00

2. Depreciation 15.00 15.00 15.00 15.00

3. PBT (1–2) 45.00 95.00 105.00 35.00
4. Tax @ 33.99% 15.30 32.29 35.70 11.90
5. PAT (3–4) 29.70 62.71 69.30 23.10
6. Net Cash Flow 44.70 77.71 84.30 38.10
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 (PAT+Depn)
7. Discounting Factor 0.870 0.756 0.685 0.572
8. P.V. of Net Cash Flows 38.89 58.75 57.75 21.79
9. Total P.V. of Net Cash Flow = 177.18
10. P.V. of Cash outflow (Initial Investment) = 60.00
Net Present Value = 117.18

Project B
Yr. 1 Yr. 2 Yr. 3
1. Net Cash Inflow 100.00 130.00 50.00
2. Depreciation 20.00 20.00 20.00
3. PBT (1–2) 80.0 110.00 30.00
4. Tax @ 33.99% 27.19 37.39 10.20
5. PAT (3–4) 52.81 72.61 19.80
6. Next Cash Flow 72.81 92.61 39.80
(PAT+Dep.)
7. Discounting Factor 0.870 0.756 0.685
8. P.V. of Next Cash Flows 63.345 70.013 27.263
9. Total P.V. of Cash Inflows = 160.621
10. P.V. of Cash Outflows = 60.00
(Initial Investment)
Net Present Value = 100.621

5. As Project “A” has a higher Net Present Value, it has to be taken up.

Project Cost Rs. 1,10,000

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 Cash Inflows :
Year 1 Rs. 60,000
“ 2 Rs. 20,000
“ 3 Rs. 10,000
“ 4 Rs. 50,000

Calculate the Internal Rate of Return.

Solution:

Internal Rate of Return will be calculated by the trial and error method. The cash flow is not
uniform. To have an approximate idea about such rate, we can calculate the “Factor”. It
represent the same relationship of investment and cash inflows in case of payback calculation
:
F = I/C
Where F = Factor
I = Original investment
C = Average Cash inflow per annum
= 110,000 =
Factor for the project 3.14 35,000

The factor will be located from the table “P.V. of an Annuity of Rs. 1” representing number of
years corresponding to estimated useful life of the asset.
The approximate value of 3.14 is located against 10% in 4 years.
We will now apply 10% and 12% to get (+) NPV and (–) NPV [Which means IRR lies in
between]

Year Cash Inflows P.V. @ 10% DCFAT P.V. @ 12% DCFAT

(Rs.) (Rs.) (Rs.)
1 60,000 0.909 54,540 0.893 53,580
2 20,000 0.826 16,520 0.797 15,940
3 10,000 0.751 7,510 0.712 7,120
4 50,000 0.683 34,150 0.636 31,800

P.V. of Inflows 1,12,720 1,08,440

Less : Initial Investment 1,10,000 1,10,000
NPV 2,720 (1,560)

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Graphically,
For 2%, Difference = 4,280

10% 12%
NPV 2,720 (1560)
IRR may be calculated in two ways :
Forward Method : Taking 10%, (+) NPV
NPV at 10%
IRR = 10% + Total Difference × Difference in Rate

2720
= 10% + 4280 × 2%
= 10% + 1.27% = 11.27%
Backward Method : Taking 12%, (–) NPV
(1560)
IRR = 12% + 4280 × 2%
= 12% – 0.73% = 11.27%
The decision rule for the internal rate of retern is to invest in a project if its rate of returning greater
than its cost of capital.

6. From the following information compute Net Present Value of Project:

Original Investment Rs. 40,000

Life of the project 4 years
Cash Inflows Rs. 25,000 for 4 years
Cost of Capital 10% p.a.

Expected interest rates at which the cash inflows will be reinvested:

Year-end 1 2 3 4
% 8 8 8 8

Solution:

First of all, it is necessary to find out the total compounded sum which will be discounted
back to the present value.
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 Year Cash Inflows Rate of Int. (%) Yrs. of Compounding Total
(Rs.) Investment Factor Compounding
(Rs.) Sum (Rs.)
1 25,000 8 3 1.260 31,500
2 25,000 8 2 1.166 29,150
3 25,000 8 1 1.080 27,000
4 25,000 8 0 1.100 25,000
1,12,650

Present Value of the sum of compounded values by applying the discount rate @ 10%

Compounded Value of Cash Inflow

Present Value = (1  i)n
1,12,650
=
(1.10)n
= 1,12,650 × 0.683 = 76,940/-
[ 0.683 being the P.V. of Re. 1 receivable after 4 years ]

Decision: The present value of reinvested cash flows, i.e., Rs. 76,940 is greater than the original cash
outlay of Rs.40,000. The project should be accepted as per the terminal value criterion.

7. Initial investment Rs. 20 lacs. Expected annual cash flows Rs. 5 lacs for 10 years. Cost of
Capital @ 15%.

Calculate Profitability Index.

Solution:

Cumulative discounting factor @ 15% for 10 years = 5.019

∴ P.V. of outflows = 6.00 × 5.019 = Rs. 30.114 lacs.

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 P.V. of Inflows 30.114
∴ Profitability Index = P.V. of Outflows  20  1.51

Decision: The project should be accepted.

Discounted Payback Period

In Traditional Payback period, the time value of money is not considered. Under discounted payback
period, the expected future cash flows are discounted by applying the appropriate rate, i.e., the cost of
capital.
8.
Initial Investment Rs. 1,00,000
Cost of Capital @ 12% p.a.
Expected Cash Inflows
Yr. 1 Rs. 25,000
Yr. 2 Rs. 50,000
Yr. 3 Rs. 75,000
Yr. 4 Rs. 1,00,000
Yr. 5 Rs. 1,50,000
Calculate Discounted Payback Period.
Solution:
Year Cash Inflows Discounting Factor Discounted Cumulative
(Rs.) @ 12% Cash Flows (Rs.) DCF (Rs.)
1 25,000 0.8929 22,323 22,323
2 50,000 0.7972 39,860 62,183
3 75,000 0.7117 53,378 1,15,561
4 1,00,000 0.6355 63,550 1,79,111
5 1,50,000 0.5674 85,110 2,64,221

The recovery was made between 2nd and 3rd year.

Discounted Payback Period = 2 years + 1,00,000 − 62,183 ×12

1,15,561 − 62,183
37817 37817
= 2 years + ×12 = 2 years + ×12
1,15,561 − 62,183 53378

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 1
= 2 years 8 2 months.

9. Zenith Industrial Ltd. are thinking of investing in a project costing Rs. 20 lakhs. The
life of the project is five years and the estimated salvage value of the project is zero.
Straight line method of charging depreciation is followed. The tax rate is 50%. The
expected cash flows before tax are as follows:

Year 1 2 3 4 5
Estimated Cash flow before depreciation
and tax (Rs. lakhs) 4 6 8 8 10

You are required to determine the:

(i) Payback Period for the investment,
(ii) Average Rate of Return on the investment,
(iii) Net Present Value at 10% Cost of capital,
(iv) Benefit-Cost Ratio.

Solution:

Calculation of Annual Cash Inflow After Tax (Rs. lakhs)

Particulars 1 year 2 year 3 year 4 year 5 year

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 Cash inflow before depreciation and tax 4 6 8 8 10
Less : Depreciation 4 4 4 4 4
EBT – 2 4 4 6
Less : Tax @ 50% – 1 2 2 3
EAT – 1 2 2 3
Add : Depreciation 4 4 4 4 4
Cash inflow after tax 4 5 6 6 7
(i) Pay Back Period :
Year Cash inflow after tax Cumulative cash inflow after tax
1 4 4
2 5 9
3 6 15
4 6 21
5 7 28

Rs. 5 lacks
Pay Back Period = 3 years + ×12 Months = 3 years10 months
Rs. 6 lakhs
(ii) Average Rate of Return
Average return = Rs. 8 lakhs/5 years = Rs. 1.6 lakhs
Average investment = Rs. 20 lakhs/2 = Rs. 10 lakhs
1.6
Average rate of return = 10 ×100 = 16%
(iii) Net Present Value at 10% Cost of Capital (Rs. lakhs)
Year Cash inflow after tax Discount factor @ 20% Present Value
1 4 0.909 3.636
2 5 0.826 4.130
3 6 0.751 4.506
4 6 0.683 4.098
5 7 0.621 4.347
P.V. of cash inflows 20.717
Less : Initial investment 20.00
NPV 0.717

P. V. of cash inflow 20.717

(iv) Benefit-Cost Ratio    1.036
P.V. of cash outflow 20

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 10. The relevant information for two alternative systems of internal transportation are
given below

:
(Rs.
Million)
Particulars System 1 System 2
Initial investment 6 4
Annual operating 1
costs 0.9
Life 4 years 6 years
Salvage value at the end 2 1.5

Which system would you prefer if the cost of capital is 6%? Justify your
recommendation with appropriate analysis.

[Present value of annuity at 6% for 6 years = 4.917 and for 4 years = 3.465.
Present value of Rs. 1.00 at 6% at the end of 6the year 0.705 and that at the end
of 4th year 0.792].

Solution:

P.V. of Costs of Internal Transportation - System 1 (Rs. Million)

Initial investment (6×1.000) 6.000
Add : Annual operating cost (1×4.917) 4.917
10.410
Less : Salvage value at the end of 6 years (2×0.705) 1,410
P.V. cash outflow 9.507
P.V. of Costs of Internal Transportation - System 2 (Rs. Million)
Initial investment (4×1.000) 4.000
Add : Annual operating cost (0.9×3.465) 3.1185
7.1185
Less : Salvage value at the end of 6 years (1.5×0.792) 1,185
P.V. cash outflow 5.9305

Equivalent Annual Cost

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 = Rs.1.71
System 1 = 9.507 = Rs.1.93 Million System 2 = 5.9305 Million
4.917 3.465
Analysis : The equivalent annual cost of System 2 is less than System 1. Hence, System 2 is
suggested to take-up.

11. A company is considering which of two mutually exclusive projects is should

undertake. The Finance Director thinks that the project with the higher NPV
should be chosen whereas the managing Director think that the one with the
higher IRR should be undertaken especially as both projects have the same
initial outlay and length of life. The company anticipates a cost of capital of 10%
and the net after-tax cash flows of the projects are as follows:

Year 0 1 2 3 4 5
Cash Flows :
Project X (200) 35 80 90 75 20
Project Y (200) 218 10 10 4 3
Required:
(a) Calculate the NPV and IRR of each project.
(b) Sate, with reasons, which project you would recommend.
(c) Explain the inconsistency in the ranking of the two projects. The
discount factors are as follows:
Year 0 1 2 3 4 5
Discount Factors : (10%) 1 0.91 0.83 0.75 0.65 0.62
(20%) 1 0.83 0.69 0.58 0.48 0.41

Solution:

(a) Calculation of the NPV and IRR of each Project

NPV of Project X
Year Cash Discount Discounted Discount Discounted
Flows Factors Values Factors Values
@ 10% @ 20%
0 (200) 1.00 (200) 1.00 (200)
1 35 0.91 31.85 0.83 29.05
2 80 0.83 66.40 0.69 55.20
3 90 0.75 67.50 0.58 52.20

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 4 75 0.68 51.00 0.48 36.00
5 20 0.62 12.40 0.41 8.20
NPV + 29.15 – 19.35

IRR of Project X
At 20% NPV is – 19.35
At 10% NPV is + 29.15

IRR = 10 + 29.15 ×10 = 10 + 29.15 ×10 = 16.01%

29.15 + 19.35 48.50

NPV of Project Y
Year Cash Discount Discounted Discount Discounted
Flows Factors Values Factors Values
@ 10% @ 20%
0 (200) 1.00 (200) 1.00 (200)
1 218 0.91 198.38 0.83 180.94
2 10 0.83 8.30 0.69 6.90
3 10 0.75 7.50 0.58 5.80
4 4 0.68 2.72 0.48 1.92
5 3 0.62 1.86 0.41 1.23
NPV + 18.76 – 3.21
IRR of Project Y
At 20% NPV is – 3.21
At 10% NPV is + 18.76
18.76 18.76
IRR = 10 + ×10 = 10 + ×10 = 18.54%
18.76 + 3.21 21.97
(b) Both the projects are acceptable because they generate the positive NPV at the company’s
cost of Capital at 10%. However, the Company will have to select Project X because it has
a higher NPV. If the company follows IRR method, then Project Y should be selected
because of higher internal rate of return (IRR). But when NPV and IRR give contradictory

14
 results, a project with higher NPV is generally preferred because of higher return in
absolute terms. Hence, Project X should be selected.

(c) The inconsistency in the ranking of the projects arises because of the difference in the
pattern of cash flows. Project X’s major cash flows occur mainly in the middle three years,
whereas Y generates the major cash flows in the first itself.

12. Projects X and Y are analysed and you have determined the following
parameters. Advice the investor on the choice of a project:

Particulars Project X Project Y

Invest Rs. 7 cr. Rs. 5 cr.
Project life 8 years 10 years
Construction period 3 years 3 years
Cost of capital 15% 18%
N.P.V. @ 12% Rs. 3,700 Rs. 4,565
N.P.V. @ 18% Rs. 325 Rs. 325
I.R.R. 45% 32%
Rate of return 18% 25%
Payback 4 years 6 years
B.E.P. 45% 30%
Profitability index 1.76 1.35

(Rs. in lakhs)

Year Machine A Machine B

1 1.5 0.5
2 2.0 1.5
3 2.5 2.0

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 4 1.5 3.0
5 1.0 2.0

Indicate which machine would be profitable using the following methods of

ranking investment proposals:
i. Pay back method:
ii. Net present value method;
iii. Profitability index method; and
iv. Average rate of return method.

The discounting factors at 10% are—

Year 1 2 3 4 5
Discount factors .909 .826 .751 .683 .621

Solution
Initial Investment
(i) Payback Period (PB) 
Annual cash inflows

Calculation of Payback Period :

Machine A (Rs. lakhs)
Year Cash inflows Payback years required
Total Needed
1 1.50 1.50 1 year
2 2.00 2.00 1 year
1.50
3 2.50 1.50 ×12 = 7.2 months
2.50
Machine B (Rs. lakhs)
Year Cash inflows Payback years required
Total Needed
1 0.50 0.50 1 year
2 1.50 1.50 1 year
3 2.00 2.00 1year
4 3.00 1.00 (1/3 × 12) = 4 months

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 5.00
Payback period for Machine b = 3 years 4 months.
Rank: Machine-A, Machine-B - II machine A is more profitable.
(ii) Calculate of Net Present Value of cash inflows for Machine A & Machine B.

Years Cash Inflows Discount P. V. of cash inflows

Machine A Machine B Factor @ 10% Machine A Machine B
1. 1.5 0.5 .909 1.36 0.45
2. 2.0 1.5 .826 1.65 1.24
3. 2.5 2.0 .751 1.88 1.50
4. 1.50 3.0 .683 1.02 2.05
5. 1.0 2.0 .621 0.62 1.24
6.53 6.48
Total P.V. 6.53 6.48
Initial Investment 5.00 5.00
Net Present Value (NPV) 1.53 1.48
Rank: Machine-A - I, Machine-B - II
Since Machine A has greater NPV compared to Machine B, Machine A is more profitable.

(iii) Calculation of Profitability Index (Rs. lakhs)

Machine A Machine B

Profitability Index  Pr esent value of Cash Inflows 6.53  1.306 6.48  1.296
Present value of Cash Inflows 5.00 5.00
Rank I II
Machine A is more profitable.
Average annual earnings
(iv) Calculation of Average Rate of Return  ×100
Initial cost
(Rs. lakhs)

Machine A Machine B
Total Cash inflow 8.50 9.00
Less : Depreciation for 5 years 5.00 5.00
Net earning after tax and depreciation 3.50 4.00
Life of machine (yrs.) 5 5
Average earnings per year .70 0.80

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 Initial cost 5 5
0.70 0.80
ARR ×100  14% ×100  16%
5.00 5.00
Rank II I
Machine B is more profitable.

13. : Determine which of the following two mutually exclusive projects should be
selected it may are:
(i) One-off investments or (ii) It they can be repeated indefinitely:(Rs.)
Particulars Project A Project B

Investment 40,000 60,000

Life 4 years 7 years
Annual net cash inflows 15,000 16,000
Scrap value 5,000 3,000

Cost of capital is 15%. Ignore taxation. The Present Value of annuity for 4 years and 7
years at 15% are respectively 2.8550 and 4.1604 and the discounting factors at 4
years/7 years respectively 0.5718 and 0.3759.

Working Notes :
Compound present value of 3 years @ 10% = 2.486
P.V. of Running cost of Machine A for 3 years = Rs. 40,000×2.486 = Rs. 99,440
Compound present value of 2 years @ 10% = 1.735
P.V. of Running cost of Machine B for 2 years = Rs. 60,000×1.735 = Rs. 1,04,100
Statement showing evaluation of Machine A and B (Rs.)
Particulars Machine A Machine B
Cost of purchase 1,50,000 1,00,000
Add : P.V. of running cost for 3 years 99,440 1,04,100
2,49,440 2,04,100

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 P.V. of Cash outflow 2,49,440 2,04,100
2.486 1.753
Equivalent Present value of annual Cash outflow = 1,00,338 = 1,17,637

Analysis: Since the annual Cash outflow of Machine is highest, Machine A can be
purchased.

14. A particulars project has a four-year life with yearly projected net profit of
Rs.10,000 after charging yearly Depreciation of Rs.8,000 in order to write-off the
capital cost of Rs.32,000. Out of the Capital cost Rs.20,000 is payable
immediately (Year 0) and balance in the next year (which will be the Yea 1 for
evaluation). Stock amounting to Rs.6,000 (to be invested in Year 0) will be
required throughout the project and for Debtors a further sum of Rs.8,000 will
have to be invested in Year 1.

The working capital will be recouped in Year 5. It is expected that the

machinery will fetch a residual value of Rs.2,000 at the end of 4th year. Income
Tax is payable @ 40% and the Depreciation equals the taxation writing down
allowances of 25% per annum. Income Tax is paid after 9 months after the end
of the year when profit is made.

The residual value of Rs.2,000 will also bear Tax @ 40%. Although the project is
for 4 years, for computation of Tax and realisation of working capital, the
computation will be required up to 5 years.

Taking Discount factor of 10%, calculate NPV of the project and give your
comments regarding its acceptability.
(NPV Factors @ 10% - Year 1-0.9091; Yr. 2-0.8264; Yr. 3-0.7513; Yr. 4-0.6830; Yr. 5-
0.6209).

Solution:

Calculation of NPV of Project (Rs.)

Year
Particularsr 0 1 2 3 4 5
Capital Expenditure (20,000) (12,000) — — — —
Working Capital (6,000) (8,000) — — — —

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Net Profit — 10,000 10,000 10,000 10,000 10,000
Depreciation Add back — — 8,000 8,000 8,000 8,000
Tax — — (4,000) (4,000) (4,000) (4,800)
Salvage value — — — — 2,000 —
Recovery of working — — — — — 14,000
Capital
Net Cash inflow (26,000) (2,000) 14,000 14,000 16,000 9,200
Discount factor @ 10% 1.000 0.9091 0.8264 0.7513 0.6830 0.6209
Present Value (26,000) (1,819) 11,570 10,570 10,928 5,712

Suggestion: Since NPV is Rs.10,910; it is suggested to accept the proposal.

15. Following are the data on a capital project being evaluated by the Management of X Ltd.:

Project M

Annual cost saving Rs. 40,000

Useful life 4 years
I.R.R. 15%
Profitability Index (PI) 1.064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?
Salvage value 0

Find the missing values considering the following table of discount factor only :
Discount 15% 14% 13%
1 year 0.69 0.877 0.885
2 year 0.756 0.769 0.783
3 year 0.658 0.675 0.693

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 4 year 0.572 0.592 0.613

Calculation of Cost of Project i.e., Initial Cash Outlay of Project M

Annual cost saving = Rs. 40,000
Useful life = 4 years
I.R.R. = 15%
At 15% I.R.R., the total present value of cash inflows is equal to initial cash outlay.
Total present value of cash inflows @ 15% for 4 years is 2.855
= Rs. 40,000 × 2.885 = Rs. 1,14,200
∴ Project Cost is Rs. 1,14,200

Calculation of Payback period of Project M

1,14,000
Payback period = Cost of Project =
Annual Cost of Savings 40,000

= 2.855 years or 2 years 11 months

Calculation of Cost of Capital

Discounted Cash inflows

Profitability Index =
Cost of Project

Profitability Index = 1.064 given

Cost of Project = 1,14,200

Discounted Cash Inflows = 1.064 x 1,14,200 = 1,21,509

Cumulative Discount Factor for 4 years

= Present value of cash inflows  1,21,509 =3.038

Annual cost saving 40,000
Looking at present value table at discount compound discount factor for 4 years is 3.038 ∴
Cos of capital = 12%
Calculation Net Present Value of Project
N.P. V = Present Value of Total Cash Inflows - Cost of Project
= 1,21,509 – 1,14,200 = Rs. 7,309

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 16. Xpert Engineering Ltd. is considering buying one of the following two
mutually exclusive investment projects:
Project A: Buy a machine that requires an initial investment outlay of Rs.
1,00,000 and will generate the cash flows after tax (CFAT) of Rs.
30,000 per year for 5 years.
Project B: Buy a machine that requires an initial investment outlay of Rs.
1,25,000 and will generate ‘cash flows after tax’ (CFAT) of Rs. 27,000
per year for 8 years.
Which project should be undertaken? The company uses 10% cost of capital to
evaluate the projects.

Note: Present value of Re. 1 for eight years @10% - 0.9091, 0.8264, 0.7513, 0.6830,
0.6209, 0.5645, 0.5132, and 0.4665.

Solution:

Calculation of Net Present Value

Project A (Rs.)
Initial Investment (1,00,000×1.000) (1,00,000)
Cash Inflow After Tax (30,000×3.791) 1,13,730
NPV
Project B (Rs.)
Initial Investment (1,25,000×1.000) (1,25,000)
Cash Inflow After Tax (27,000×5.335) 1,44,045
NPV 19,045
Equivalent Annual NPV
Project A = 13,730/3.791 = Rs. 3.622 Project B = 19,045/5.335 = Rs. 3.570

Analysis
If it is one-time Project, Project B suggested, since its NPV is greater than Project
A
If a Project is to be replaced every time after the end of economic life of earlier
Project, then Project A is preferable, since its equivalent annual NPV is higher
than Project B.

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 17. XYZ Ltd., an infrastructure company is evaluating proposal to build, operate
and transfer a section of 35 kms. of road at a projcet cost of Rs. 200 crores to be
financed as follows:

Equity Share Capital Rs. 50 crores, loan at the rate of interest of 15% p.a. from
financial institutions Rs. 150 crores. The Project after completion will be opened to
traffic and a toll will be collected for a period of 15 years from the vehicles using
the road.

The company is also required to maintain the road during the above 15 years and
after the completion of that period, it will be handed over to the Highway
Authorities at zero value. It is estimated that the toll revenue will be Rs. 50 crores
per annum and the annual toll collection expenses including maintenance of the
roads will amount to 5% of the project cost.

The company considers to write off the total cost of the project in 15 years on a
straight line basis. For Corporate Income-tax purposes the company is allowed to
take depreciation @ 10% on WDV basis. The financial institutions are agreeable for
the repayment of the loan in 15 equal annual instalments–consisting of principal
and interest.

Solution:

Calculate Project IRR and Equity IRR. Ignore Corporate taxation. Explain the differences in
Project IRR and Equity IRR.

Road Project cost = Rs. 200 crores

Financed by :
Equity Share Capital = Rs. 50 crores
Term Loan from financial institutions @ 15% p.a. = Rs. 150 crores
Annual net cash inflows = Rs. 50 crores - 5% of Rs. 200 crores
= Rs. 40 crores
Maintenance of road = 15 years
Salvage value at the end of 15 years = NIL
Calculation of IRR
Rs. 200
Factor to be located = Original investment =crores = 5.000
Average annual cash inflow Rs. 40 crores
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The Present Value annuity factor appearing nearest to 5.092 for 15 years @ 18%
NPV at 18% (Rs. Crores)
P.V. of annual cash inflow (40×5.092) 203.68
Initial cash outlay 200.00
NPV 3.68
NPV at 19% (Rs. Crores)
P.V. of annual cash inflow (40×4.876) 195.04
Initial cash outlay 200.00
NPV (4.96)
Now, the IRR of the Project is acertained by method of interpolation as follows:

3.68 3.68
IRR = 18% + 3.68 − (−4.96) ×1% = 18% + 8.64 ×1% = 18% + 0.426% = 18.43%

18. An oil company proposes to install a pipeline for transport of crude from wells to
refinery. Investments and operating costs of the pipeline very for different sizes of
pipelines (diameter). The following details have been conducted:
(a) Pipeline diameter (in inches) 3 4 5 6 7
(b) Investment required (Rs. lakhs) 16 24 36 64 150
(c) Gross annual savings in operating
costs before depreciation
(Rs. lakhs) 5 8 15 30 50

The estimated life of the installation is 10 years. The oil company’s tax rate is 50%. There is no
salvage value and straight line rate of depreciation is followed.
Calculate the net savings after tax and cash flow generation and recommend therefrom, the
largest pipeline to be installed, if the company desires a 15% post-tax return. Also indicate
which pipeline will have the shortest payback. The annuity P.V. factor at 15% for 10 years is
5.019.

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Solutions

Determination of CFAT (Rs. Lakhs)

Pipeline Gross Savings Depreciation Tax adv. of Total cost
Diameter (inches) savings p.a. after tax depreciation savings/(CFAT)
(1) (2) (3) (4) (5) (6)
[(2)×50%] [(4)×50%] [(3)×5%]
3 5 2.5 1.6 0.8 3.3
4 8 4.0 2.4 1.2 5.2
5 15 7.5 3.6 1.8 9.3
6 30 15.0 6.4 3.2 18.2
7 50 25.0 15.0 7.5 32.5
Payback Period in Years
Inches Rs. lakhs Years
3 16/3.3 4.848
4 24/5.5 4.615
5 36/9.3 3.871
6 64/18.2 3.516
7 150/32.5 4.615
Therefore, Pipeline diameter of 6 inches has shortest payback period.
Determination of NPV (Rs. in lakhs)
Pipeline dia CFAT PV factor Total PV Cash NPV
(inches) for 10 years @ 15% 10 yrs. outflow
3 3.3 5.019 16.5627 16 0.5627
4 5.2 5.019 26.0988 24 2.0988
4 9.3 5.019 46.6767 36 10.6767
6 18.2 5.019 91.3458 64 27.3458
7 32.5 5.019 163.1175 150 13.1175

Suggestion: Pipeline of 6 inches’ diameter has highest NPV and it is recommended for installation.

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19. Indo Plastics Ltd. is a manufacturer of high quality plastic products. Rasik,
President, is considering computerising the company’s ordering, inventory and
billing procedures. He estimates that the annual savings from computerisation
include a reduction of 4 clerical employees with annual salaries of Rs. 50,000
each, Rs. 30,000 from reduced production delays caused by raw materials
inventory problems, Rs. 25,000 from lost sales due to inventory stock outs and
Rs. 18,000 associated with timely billing procedures.
The purchase price of the system in Rs. 2,50,000 and installation costs are Rs.
50,000. These outlays will be capitalised (depreciated) on a straight line basis to
a zero books salvage value which is also its market value at the end of five
years. Operation of the new system requires two computer specialists with
annual salaries of Rs. 80,000 per person. Also annual maintenance and
operating (cash) expenses of Rs. 22,000 are emstimated to be required. The
company’s tax rate is 40% and its required rate of return (cost of capital) for this
project is 12%

Your are required to—

(i) evaluate the project using NPV method;
(ii) evaluate the project using PI method;
(iii) calculate the Project’s payback period.
Note :
(a) Present value of annuity of Re. 1 at 12% rate of discount for 5 years is
3.605.
(b) Present value of Re. 1 at 12% rate of discount, received at the end of 5
years is 0.567.

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 Solution:

Determination of NPV (Rs.)

Cost 2,50,000
Installation expenses 50,000
Total net Cash Outlay 3,00,000

Project’s operating and terminal value cash flows over its 5-year life (Rs.)
Savings
Reduction in clerks salaries (4×50,000) 2,00,000
Reduction in projection delays 30,000
Reduction in lost sales 25,000
Gains due to timely production 18,000 2,73,000
Less : Expenses
Depreciation (3,00,000/5) 60,000
Add : People cost (80,000×2) 1,60,000
Maintenance cost 2,000 2,42,000
Profit before Tax 31,000
Less : Tax (40%) 12,400
Profit After Tax 18,600

Cash flow = Profit After Tax – Depreciation = 18,600 + 60,000 = Rs. 78,600
The cash flows are the same for the years 1 to 5.

(i) Evaluation of the Project by using Net Present Value (NPV) Method:
Years Cash flow PV of Annuity of Rs. 1 Total present value
After tax (Rs.) at 12% for five years (Rs.)
1 to 5 78,600 3.605 2,83,353
Less : Total Initial Cash Outlay 3,00,000
NPV (16,647)
Since NPV is negative, therefore, the project is unviable.

(ii) Evaluation fo the Project by using PI Method.

Profitability Index (PI) = PV of cash inflows/Initial outlay
= 2,83,353/3,00,000 = 0.945
Since PI is less than 1.0, the project is unviable.

(iii) Calculation of the Project’s Payback Period (Rs.)

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 Year Net cash flow Cumulative cash flow
1 78,600 78,600
2 78,600 1,57,200
3 78,600 2,35,800
4 78,600 3,14,400
5 78,600 3,93,00
Hence, the payback period is 3 years plus a fraction of the 4th year. The fraction of the year
can be calculated as under:
64,200 = 0.82
78,600
Therefore, the payback period is 3.82 years.

20. Five Projects M, N, O, P and Q are available to a company for consideratio. The
investment required for each project and the cash flows it yields are tabulated below.
Projects N and Q are mutually exclusive. Taking the cost of capital @ 10%, which
combination of projects should be taken up for a total capital outlay not exceeding Rs.
3 lakhs on the basis on NPV and Benefit-Cost Ratio (BCR)?

(Rs.)
Project Investment Cash flow p.a. No of years P.V. @ 10%
M 50,000 18,000 10 6.145
N 1,00,000 50,000 4 3.170
O 1,20,000 30,000 8 5.335
P 1,50,000 40,000 16 7.824
Q 2,00,000 30,000 25 9.077

Total Capital outlay < Rs. 3.00 lakhs

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 Solution :

Computation of Net Present Value and Benefit-Cost Ratio for 5 Projects (Rs.)
Project Investment Cash flow No. of years P.V. @ 10% P.V. NPV BCR (PV/
p.a. Investment)
M 50,000 18,000 10 6.145 1,10,610 60,160 2.212
N 1,00,000 50,000 4 3.170 1,58,500 58,500 1.585
O 1,20,000 30,000 8 5.335 1,60,050 40,050 1.334
P 1,50,000 40,000 16 7.824 3,12,960 1,62,960 2.086
Q 2,00,000 30,000 25 9.077 2,72,310 72,310 1.362

Statement showing Feasible Combination of Projects and their NPV, BCR

Feasible Combination Investment NPV Rank BCR Rank

of projects (Rs.) (Rs.)
(i) M, N and P 3,00,000 2,82,070 1 1.940 1

(ii) M, N and O 2,70,000 1,59,160 4 1.589 4

(iii) O & P 2,70,000 2,03,010 3 1.752 3

(iv) M&Q 2,50,000 1,32,920 5 1.532 5

(v) N&P 2,50,000 2,21,460 2 1.886 2

(vi) N&Q 3,00,000 1,30,810 6 1.436 6

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