CA SUKESH BHATIA CLASSES

MOST IMPORTANT
REVISIONARY
NOTES OF
CAPITAL
BUDGETING
Specifically for Students of CA-IPC

2014
Written & Compiled by:-

By CA. SUKESH BHATIA

Contact No. – 09811270284, 09971086655
Email = casukeshbhatiaclasses@gmail.com

CA SUKESH BHATIA CLASSES, PH – 9811270284, 9971086655

1/27, Near Gurudwara, Lalita Park, Laxmi Nagar, Delhi-92
CHAPTER 4 - CAPITAL BUDGETING
Read this booklet with utmost care and take maximum benefit of this
booklet in exams.

Warmest Regards and Best Wishes

CA Sukesh Bhatia

Chapter of Capital Budgeting has been divided into 8 sections:-

Section 1:- Calculation of NPV, IRR (Internal Rate of Return), Pay Back
Period, Discounted Payback Period, Average Rate of
Return (ARR), Profitability Index Method (PI)
Section 2:- Savings per annum and Additional Cost per annum
Section 3:- Equal Annual Cost (EAC)
Section 4:- NPV-IRR Conflict
Section 5:- Reverse Calculation for NPV, Profitability Index Method,
Cost of Capital
Section 6:- Capital Rationing
Section 7:- Replacement Decisions
Section 8:- Leasing Decisions (It is now in CA FINAL)

Solutions with Presentation to some selected types of questions for

your help is as follows:-

Section 1:- Calculation of NPV, IRR (Internal Rate of Return), Pay

Back Period, Discounted Payback Period, Average Rate of
Return (ARR), Profitability Index Method (PI)

This section is normal as we have done by our examples. For practice

one question is given below.

Question 1:- PQR Company Ltd. is considering to select a machine out

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of two mutually exclusive machines. The company’s cost of capital is
12 per cent and corporate tax rate is 30 per cent. Other information
relating to both machines is as follows:
Machine – I Machine – II
Cost of Machine Rs. 10,00,000 Rs. 15,00,000
Expected Life 5 Yrs. 6 Yrs.
Annual Income Rs. 3,45,000 Rs. 4,55,000
(Before Tax and Depreciation)
Depreciation is to be charged on straight line basis.
You are required to calculate:
a) Payback period,
b) Discounted Payback period
c) NPV
d) IRR
e) Profitability Index
f) Advise as to which machine should be purchased

Section 2:- Savings per annum and Additional Cost per annum

This type of questions will have following characteristics and hence

you can identify these questions in exams:-

Characteristic 1:- If you shift/purchase from present system/machine

to new system/machine there will be some savings
as well as some additional costs per annum.

Question 2:- SS Limited is considering the purchase of a new

automatic machine which will carry out some operations which are at
present performed by manual labour. Machine 1 and Machine 2, two
alternative models are available in the market. The following details
are collected:
Machine 1 Machine 2

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1/27, Near Gurudwara, Lalita Park, Laxmi Nagar, Delhi-92
Cost of Machine Rs. 20 lacs Rs. 25 lacs

Life of Machine 5 years 5 years

Saving in wages per annum Rs. 7 lacs Rs. 9 lacs

Saving in scrap per annum Rs. 60,000 Rs. 1,00,000

Additional cost of material per annum Rs. 30,000 Rs. 90,000

Additional cost of labour per annum Rs. 40,000 Rs. 50,000

Additional cost of repairs per annum Rs. 45,000 Rs. 85,000

Depreciation will be charged on a straight line method. Corporate tax

rate is 30 percent and expected rate of return may be 12 percent.
You are required to evaluate the alternatives by calculating the:
a) Pay-back Period
b) Accounting (Average) Rate of Return

Answer 2:- Evaluation of both Machines:- (Figures in Rs.)

Particulars Machine 1 Machine 2

Annual savings:-
Direct wages 7,00,000 9,00,000
Scraps 60,000 1,00,000
Total Savings (A) 7,60,000 10,00,000
Annual
Additional
Costs:-
Indirect Material 30,000 90,000
Indirect Labour 40,000 50,000
Repairs 45,000 85,000
Total Cost (B) 1,15,000 2,25,000
Annual 6,45,000 7,75,000
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 Savings/EBDT (A-
B)
Less: 4,00,000 5,00,000
Depreciation
EBT 2,45,000 2,75,000
Less: Tax 73,500 82,500
EAT 1,71,500 1,92,500
Add: 4,00,000 5,00,000
Depreciation
CFAT per annum 5,71,500 6,92,500

Particulars Machine 1 Machine 2

Payback Period 20,00,000 25,00,000
Total Initial Capital Investment = =
5,71,500 6,92,500
=
CFAT per annum = 3.50 years = 3.61 years
Average Investment 20,00,000 25,00,000
Total Initial Capital Investment = =
2 2
= = 10,00,000 = 12,50,000
2
Average PAT 1,71,500 x 5 1,92,500 x 5
Total PAT of all years = =
5 5
=
No. of years
= 1,71,500 = 1,92,500

Average Rate of Return 1,71,500 1,92,500

Average PAT = x 100 = x 100
= x 100 10,00,000 12,50,000
Average Investment
= 17.15% = 15.40%

Question 3:- DL Services is in the business of providing home services

like plumbing, sewerage, line cleaning etc. There is a proposal before
the company to purchase a mechanized sewerage cleaning line for a

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1/27, Near Gurudwara, Lalita Park, Laxmi Nagar, Delhi-92
sum of Rs. 20 lacs. The life of the machine is 10 years. The present
system of the company is to use manual labour for the job. You are
provided the following information:-
 Cost of machine Rs. 20 lacs
 Depreciation 10% p.a. straight line.
 Operating cost Rs. 5 lacs p.a.
 Present system manual labour 200 persons
 Cost of manual labour Rs. 10,000 per person p.a.
 The company has an after tax cost of funds of 10% p.a.
 Tax = 35%

State whether it is advisable to purchase the machine.

Answer 3:- Evaluation of proposal

Particulars Machine
Annual savings:-
Savings in Manual Labour Cost p.a. 200 x 10,000 =
20,00,000
Total Savings (A) 20,00,000
Annual Additional Costs:-
Operating Cost p.a. 5,00,000
Total Cost (B) 5,00,000
Annual Savings/EBDT (A-B) 15,00,000
Less: Depreciation 2,00,000
EBT 13,00,000
Less: Tax 4,55,000
EAT 8,45,000
Add: Depreciation 2,00,000
CFAT per annum 10,45,000
Sum of PVF for 1-10 years @ 10% 6.145
PV of Cash Inflow 6.145 x 10,45,000 =
64,21,525
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 PV of Cash Outflow 20,00,000
NPV 44,21,525

Decision:- Machine is recommended as NPV is positive.

Section 3:- Equal Annual Cost (EAC)

This type of questions will have following characteristics and hence

you can identify these questions in exams:-

Characteristic 1:- Machines will be having IDENTICAL CAPACITY.

Characteristic 2:- Machines will be having UNEQUAL LIFES.
Characteristic 3:- These are real cash flows. (This line has no use in
exams. You can ignore this.)

Question 4:- A company has to make a choice between two machines

X and Y. The two machines are designed differently, but have
identical capacity and do exactly the same job. Machine ‘X’ costs
Rs. 5,50,000 and will last for three years. It costs Rs. 1,25,000 per
year to run. Machine ‘Y’ is an economy model costing Rs. 4,00,000,
but will last for two years and costs Rs. 1,50,000 per year to run.
These are real cash flows. The costs are forecasted in Rupees of
constant purchasing power. Opportunity cost of capital is 12%.
Ignore taxes. Which machine company should buy?

Answer 4 :- Statement showing Evaluation of 2 Machines

Machines X Y
Purchase Cost (in Rs.) 5,50,000 4,00,000
Life of Machines (in 3 2
Years)
Running/Operating 1,25,000 1,50,000
Cost of Machine per
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year (in Rs.)
Sum of PVF for 1-3 2.4019 ----
years @ 12%
Sum of PVF for 1-2 ---- 1.6901
years @ 12%
Present Value of 1,25,000 x 2.4019 = 1,50,000 x 1.6901 =
Running/Operating 3,00,237.50 2,53,515
Cost of Machines (in
Rs.)
Present Value of Cash 5,50,000 + 4,00,000 + 2,53,515 =
Outflow (in Rs.) 3,00,237.50 = 6,53,515
8,50,237.50
Equal Annual Cost 8,50,237.50 6,53,515
= 3,53,985.39 = 3,86,672.39
2.4019 1.6901
(EAC) (in Rs.)

The company should buy Machine X because its Equal Annual Cost
(EAC) is less than that of Machine Y.

Section 4:- NPV-IRR Conflict

This type of questions will have following characteristics and hence

you can identify these questions in exams:-

Characteristic 1:- There will be 2 machines. When we calculate NPV &

IRR of both machines results will be different. It means the machine
which has High NPV will have low IRR and machine which has Low
NPV will have High IRR. Hence, conflict arises when we give them
rankings. On the basis of NPV one Machine gets 1 st ranking but the
same Machine gets 2nd ranking if we do ranking on the basis of IRR.

Characteristic 2:- Machines/Projects may or may not have equal life.

Case A:- When both have unequal life.

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Question 5:- The cash flows of Projects P and J are as:-
T0 T1 T2 T3 T4 T5 T6

Project -40000 13000 8000 14000 12000 11000 15000

P

Project -20000 7000 13000 12000

J

Required:-
a) Estimate NPV of projects using 15% as hurdle rate.
b) Estimate IRR of projects.
c) Why there is a conflict in the project choice by using NPV and
IRR criterion ?
d) Which criterion you will use in such a situation ? Estimate the
value at that criterion. Make a project choice.

Answer 5:- Calculate NPV & IRR of both projects using Hurdle Rate as
Discounting Rate. It will give following results:-
Particulars Project P Project J
NPV Rs. 5,375 Rs. 3,806
Ranking on the basis Ist IInd
of NPV
IRR 20.15% 25.30%
Ranking on the basis IInd Ist
of IRR

Reason for Conflict:-

The reason for conflict in ranking between NPV & IRR is because of
the following reasons:-
a) Difference/Disparity in Amount Invested (Rs. 40,000 and Rs.
9|CA SUKESH BHATIA CLASSES, PH – 9811270284, 9971086655
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 20,000)
b) Differences in Project Lives (6 years and 3 years)
c) Variability of Cash Inflows of the Projects.

Resolving the Conflict-Project Choice to be made:-

If there is a conflict between NPV & IRR, the NPV criteria should
generally be preferred.
However in this case as both projects have different lives, we need to
Calculate Equal Annual Flows for a better decision.
NPV
Equal Annual Flows =
Sum of PVF @ 15% for Project Life Years

Project P Project J
Equal Annual Flows Rs. 5,375 Rs. 3,806
= Rs. 1,420 = Rs. 1,668
3.7845 2.2832

Project J should be preferred.

Case B:- When both have equal life.

Question 6:- The cash flows of Projects P and J are as:-

T0 T1 T2 T3 NPV IRR

Project P -10,000 2,000 4,000 12,000 4,139 26.5%

Project J -10,000 10,000 3,000 3,000 3,823 37.6%

(i) Why is there a conflict in Rankings?

(ii) Why should you recommend Project P inspite of lower IRR?

Answer 6:- Reason for Conflict:-

The reason for conflict in ranking between NPV & IRR is because of
the following reasons:-
a) Difference/Disparity in Amount Invested (Rs. 40,000 and Rs.

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 20,000). Now, the amount invested is same hence we cannot
mention this point in exams.
b) Differences in Project Lives (6 years and 3 years). Now, the lives
of projects are same hence we cannot mention this point in
exams.
c) Variability of Cash Inflows of the Projects. Project P has lower
initial cash flows and heavy later inflows. However, Project J has
heavy initial inflows in the lower inflows in the later periods.
This will distort the analysis under IRR. NPV is a technique which
takes into account, the variability of cash flows. Hence, NPV
should be preferred over IRR in case of conflict.

Project P is recommended as its NPV is higher.

Section 5:- Reverse Calculation for NPV, Profitability Index Method,

Cost of Capital

Question 7:- Annual cost of saving Rs. 96,000

Life of asset 5 years
Salvage value zero
IRR 15%
Profitability Index 1.05
Calculate :-
a) Cost of project
b) Payback period
c) NPV
d) Cost of capital

Answer 7:-

a) At IRR of 15%,

The PV of Cash Inflows = PV of Cash Outflow = Cost of the Project

Annual Cost savings = Rs. 96,000
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1/27, Near Gurudwara, Lalita Park, Laxmi Nagar, Delhi-92
Useful life = 5 years
Sum of PVF at 15% for 5 years = 3.353
Hence PV of cash inflows = 3.353 x 96,000 = 3,21,888
Hence cost of project = Rs. 3,21,888

Total Initial Capital Investment 3,21,888

b) Payback Period = =
CFAT per annum 96,000

= 3.353 years

PV of Cash Inflow
c) Profitability Index =
PV of Cash Outflow

PV of Cash Outflow
1.05 =
3,21,888

PV of Cash Outflow = 1.05 x 3,21,888 = 3,37,982.40

NPV = PV of Cash Inflow – PV of Cash Outflow

NPV = 3,37,982.40-3,21,888 = 16,094.40

d) 96,000 p.a. saving is an annuity.

Hence, PV of Cash Inflow = Sum of PVF x Annuity Amount

PV of Cash Inflow = Sum of PVF x 96,000
3,37,982.40 = Sum of PVF x 96,000
Sum of PVF = 3,37,982.40/96,000
Sum of PVF = 3.52
From the PV of Annuity Table, PVF rate = 13%.
Hence cost of capital = 13%

Note :- Present Value index method = Profitability Method

Note :- Notes of Capital Rationing and Replacement Decisions
already given in classroom. (Covered in only 3 pages).
Note :- It is just a coverage of Most Important Questions.
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