

Chapter: 8
Capital Budgeting
MEANING OF CAPITAL BUDEGETING
• Capital budgeting is a process of planning capital expenditure which is to be made to maximize the
long-term profitability of the organization.
• It refers to planning for capital assets.
• The capital budgeting decision means a decision as the whether or not money should be invested in
long-term projects such as installing a machinery or creating additional capacities to manufacture a
part which at present may be purchased from outside.

The process of convertible future sums into their present equivalents is known as “discounting”, which is
used to determine the present value of future cashflows

INVESTMENT APPRAISAL TECHNIQUES

Traditional Techniques
a) Payback Period Method
b) Accounting Rate of Return Method

Discounted Cashflow Techniques

a) Net Present Value Method
b) Internal Rate of Return Method
c) Profitability Index Method
d) Discounted Payback Period Method
e) Terminal Value Method

PAYBACK PERIOD METHOD

Payback period represents the time period required for complete recovery of the initial investment in the
project. It is the period within which the total cash inflows from the project equals the cost of investment in
the project. The lower the payback period, the better it is, since initial investment is recouped faster.

Illustration: 1
Suppose a project with an initial investment of Rs. 100 crores, yields a profit of Rs. 20 crores, after writing off
depreciation of Rs. 5 crores per annum. The Payback period of the project is:

CFAT per annum = PAT + Depreciation = Rs. 20 + Rs. 5 crores = Rs. 25 crores.
Payback period = Initial Investment / CFAT per annum = 100 / 25 = 4 years.

Steps used in computation of Simple Payback Period

Step: 1 Determine the Initial Investment (Cash Outflow) of the Project.

Step: 2 Determine the CFAT (Cash Inflow) from the project for various years.

Step: 3 Compute Payback Period

Case 1 In case of uniform CFAT per annum
Payback Period = Initial Investment / CFAT per annum
Case 2 In case of differential CFAT for various years
a) Compute cumulative CFAT at the end of every year.
b) Determine the year in which cumulative CFAT exceeds initial investment.
c) Payback Period = Time at which the cumulative CFAT = Initial Investment.

|KIMS_The Platform to Perform| 85 FM_Capital Budgeting_JM


(which is calculated on time proportion basis. Refer Illustration: 2)
Step: 4 Accept the project, if Payback Period is less than maximum or benchmark period; else
reject the project.

Illustration: 2
The initial outlay for a project is Rs. 25 crore. The project analyst expects the following annual cash flows
which will be generated uniformly over the year:

Year: 0 1 2 3 4 5 6 7
Cash flow (Rs. Crore): (25) 7 6 6 5 4 4 8

You are required to compute the pay back period for the above project. If the cut-off period decided by the
management is 5 years, should the project be accepted?

Year Cash flows (Rs. Cr) Cumulative flows

1 7 7
2 6 13
3 6 19
4 5 24
5 4 28
6 4 32
7 8 40

Evident from the table above, Rs. 25 crores in total would be collected in the 5th year.

Payback Period is
(25 - 24)
4 years + x 12 months = 4years 3months
(28 - 24)

Since, the payback period is less than the cut-off period decided by the management, the project should be
accepted.

Illustration: 3
A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 12.5%
(straight line method) but before tax @ 50%. Compute the payback period.

[Answer: 5 years]

Illustration: 4
Initial investment is Project X and Project Y is Rs. 1,00,000 each. Following is the cash inflow from the two
projects over a period of five years. Which project should be selected. Use payback period method.

Year Project X Project Y

1 20,000 25,000
2 20,000 25,000
3 30,000 50,000
4 30,000 20,000
5 50,000 10,000

[Answer: Project X – 4 years, Project Y – 3 years]

DISCOUNTED PAYBACK PERIOD METHOD

|KIMS_The Platform to Perform| 86 FM_Capital Budgeting_JM


When the payback period is computed after discounting the cash flows by a pre-determined rate (cut-off
rate), it is called as the “Discounted Payback Period”.

Steps in computation of Discounted PP

Step 1 Determine the total cash outflow of the project. (Initial Investment)
Step 2 Determine the cash inflow after taxes (CFAT) for each year.
Step 3 Determine the PV factor for each year and compute discounted CFAT (DCFAT) for each year.
DCFAT = CFAT for each year x PVIF
Step 4 Determine the cumulative DCFAT at the end of every year.
Step 5 Determine the year in which cumulative DCFAT exceeds the initial investment (Step 1).
Step 6 Compute Discounted Payback Period as the time at which cumulative CFAT = Initial Investment.
This is calculated on “time proportion basis”.
Step 7 Accept if DPP is less than maximum or benchmark period; else reject the project.

Illustration: 5
The initial outlay for a project is Rs. 25 crore. The project analyst expects the following annual cash flows
which will be generated uniformly over the year:
Year: 0 1 2 3 4 5 6 7
Cash flow (Rs. Crore): (25) 7 6 6 5 4 4 8

You are required to compute the discounted pay back period for the above project, assuming cost of capital
to be 12%.

Year Cashflows Discounting Discounted Cashflows Cumulative Discounted

(Rs. Crores) Factor @12% (Rs. Crores) Cashflows (Rs. Crores)
0 (25) 1.000 (25.000) (25.000)
1 7 0.893 6.251 (18.749)
2 6 0.797 4.782 (13.967)
3 6 0.712 4.272 (9.695)
4 5 0.636 3.180 (6.515)
5 4 0.567 2.268 (4.247)
6 4 0.507 2.028 (2.219)
7 8 0.452 3.616 1.397

Discounted payback period = 6 + 2.219 ÷ 3.616 = 6.61 years

PACKBACK RECIPROCAL
It is the reciprocal of payback period. It is expressed in percentage and computed as:

Average Annual Cash Inflows (CFAT p.a.)

Payback Reciprocal =
Initial Investment

The Payback Reciprocal is considered to be an approximation of the Internal Rate of Return (IRR), if:
a) The life of the project is at least twice the payback period;
b) The project generates equal amount of the annual cash inflows; and
c) The project doesn’t require additional outflow during project life.

Illustration: 6
A project with initial investment of Rs. 50,00,000 and life of 10 years, generates CFAT of Rs. 10,00,000 per
annum.
Payback Period = 50,00,000 ÷ 10,00,000 = 5 years
Payback Reciprocal = (1 ÷ 5) x 100 = 20%

ACCOUNTING OR AVERAGE RATE OF RETURN METHOD

Accounting or Average Rate of Return (ARR) means the average annual yield on the project. In this
method, Profit after Taxes (PAT) is used for evaluation, instead of CFAT.

|KIMS_The Platform to Perform| 87 FM_Capital Budgeting_JM


Steps in computation of ARR
Step 1 Determine the average investment of the project.
* Average Investment = (Initial Investment + Salvage Value) ÷ 2
Step 2 Determine the Profits after Tax (PAT) for each year.
PAT = CFAT – Depreciation
Step 3 Determine the total PAT for N years, where N = Project Life.
Step 4 Compute Average PAT per annum = Total PAT for all years ÷ N years.
Step 5 ARR = Average PAT per annum ÷ Average Investment = Step 4 ÷ Step 1.

[* NOTE:
We assume that depreciation is on Straight Line Basis, where Book Value declines at constant rate from
purchase price to zero.
Again,
Average Investment = Net Working Capital + Salvage Value + ½ (Initial Investment – Salvage Value)
If Net Working Capital = 0, the above equation reduces to: ½ (Initial Investment + Salvage Value)]

Illustration: 7
A machine is available for purchase at a cost of Rs. 80,000.
We expect it to have life of five years and to have a scrap value of Rs. 10,000 at the end of the five year
period. We have estimated that it will generate additional profits over its life as follows:

Year 1 2 3 4 5
Amount (Rs.) 20,000 40,000 30,000 15,000 5,000

These estimates are of profits before depreciation. You are required to calculate the accounting rate of
return of the project.

Total profit before depreciation over five years of machine life = Rs. 1,10,000
Average profit per annum = Rs. 1,10,000 / 5 years = Rs. 22,000
Total depreciation over five years = Rs. 80,000 – Rs. 10,000= Rs. 70,000
Average depreciation per annum = Rs. 70,000 / 5 years = Rs. 14,000
Avg. annual profit after depreciation = Rs. 22,000 – Rs. 14,000= Rs. 8,000

Original investment required = Rs. 80,000

Salvage Value = Rs. 10,000
Average Investment = Rs. 90,000 / 2 = Rs. 45,000
Accounting rate of return = (Rs. 8,000 / Rs. 45,000) = 17.78%

Illustration: 8
Compute the accounting rate of return for the project given:

Year Book value of Fixed Profit after

Investment (Rs.) tax (Rs.)
1 90,000 20,000
2 80,000 22,000
3 70,000 24,000
4 60,000 26,000
5 50,000 28,000

Average Profit after Tax Rs. 24,000

ARR = = = 34.29%
Average book value of Investment Rs. 70,0 00

NET PRESENT VALUE METHOD (NPV) OR DISCOUNTED CASH FLOW TECHNIQUE (DCF)
The Net Present Value of an investment proposal is defined as the sum of the present value of all future
cash inflows less the sum of the present value of all cash outflows associated with the proposal.

|KIMS_The Platform to Perform| 88 FM_Capital Budgeting_JM


Thus NPV = Discounted Cash Inflows – Discounted Cash Outflows

In simple terms:

FV1 FV2 FV3 FV4 FVn

NPV = + + + +...... + - CO0
( 1 + K) ( 1 + K) ( 1 + K) ( 1 + K) ( 1 + K)
1 2 3 4 n

n
FVi
NPV = ∑ − CO0
( 1 + K)
i
i=1

Where, K = Cut-off rate or discounting rate

FV = Future cash inflows arising at different points of time, I, 2, 3, …., n
CO0 = Initial cash outflow, which pertains to time 0, hence not discounted

Procedure for computation of NPV

Step 1 Determine the total cash outflow of the project

and the time periods in which they occur.
Step 2 Compute the total discounted cash outflow = Outflow X PVIF
Step 3 Determine the total cash inflows of the project and the time periods in which they arise.
Step 4 Compute the total discounted cash inflows = Inflow X PVIF
Step 5 Compute NPV = Discounted Cash Inflows – Discounted Cash Outflows (Step 4 – Step 2)
Step 6 Accept Project if NPV is positive, else reject.

Decision making or Acceptance Rule

If Decision
NPV > 0 Accept the Project. Surplus over and above the cut-off rate is obtained.
NPV = 0 Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be
accepted or rejected. This constitutes an Indifference Point.
NPV < 0 Reject the Project. The Project does not provide returns even equivalent to the cut-off rate.

Cash Outflows
Generally cash outflows consist of (a) Initial Investment which occurs at time t = 0 and (b) Special payment
and outflows, e.g. working capital outflow which arises in the year of commercial production, tax paid on
capital gain made by sale of old asset, if any; and installation charges at time t = 0 or extra outflows during
the life of the project.

Cash Inflows
Cash Inflows = CFAT = PAT + Depreciation. OR
Cash Inflows = PBD (1 – tax rate) + Tax Shield on Depreciation.
Also, specific cash inflows like salvage value of new assets and recovery of working capital at the end of the
project, tax savings on loss due to sale of old asset, should be carefully considered. The general assumption
is that all cash inflows occur at the end of each year.

Discounting Cash Inflows and Outflows

Each item of cash inflow and outflow is discounted to ascertain its present value. For this purpose, the
discounting rate is generally taken as the Cost of Capital since the project must earn at least what is paid out
on the funds blocked in the project. The present value tables (PVIF tables) are used to calculate the present
value of various cash flows. In case of uniform inflows per annum, annuity tables (PVIFA tables) may be
used.
Use of Discounting Rate
Instead of using PVIF tables, the relevant discount factor can be computed as:

|KIMS_The Platform to Perform| 89 FM_Capital Budgeting_JM


1
DF =
(1 + k)
n

, where, k =cost of capital

n =year in which inflow or outflow takes place
DF =Discounting Factor
For example;
PV factor at 10% after one year = 1 ÷ (1.10)1 = 0.9091
PV factor at 10% at the end of 2 years = 1 ÷ (1.10)2 = 0.8264 and so on.

NOTE:
The NPV method will give valid results only if money can be immediately reinvested at a rate of return equal
to the firm’s cost of capital.

Illustration: 9
A company is considering which of two mutually exclusive projects it should undertake. The Finance Director
thinks that the project with higher NPV should be chosen whereas the Managing Director thinks 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 project are as
follows:
Year 0 1 2 3 4 5
Project X (200,000) 35,000 80,000 90,000 75,000 20,000
Project Y (200,000) 218,000 10,000 10,000 4,000 3,000

Calculate the NPV of each project taking 10% as discounting rate.

Year PVIF 10% Project X Project Y
CFAT DCFAT CFAT DCFAT
0 1.00 (200,000) (200,000) (200,000) (200,000)
1 0.91 35,000 31,850 218,000 198,380
2 0.83 80,000 66,400 10,000 8,300
3 0.75 90,000 67,500 10,000 7,500
4 0.68 75,000 51,000 4,000 2,720
5 0.62 20,000 12,400 3,000 1,860
29,150 18,760

As per NPV criterion Project X should be selected which gives better NPV than Project Y.

INTERNAL RATE OF RETURN METHOD (IRR)

Internal Rate of Return (IRR) is the rate at which the sum total of Discounted Cash Inflows equals the
Discounted Cash Outflows. The Internal Rate of Return of a project is the discount rate which makes Net
Present Value of the project equal to zero.

IRR refers to that discount rate K, such that;

FV1 FV2 FV3 FV4 FVn

NPV = + + + +...... + - CO0 = 0
( 1 + K) ( 1 + K) ( 1 + K) ( 1 + K) ( 1 + K)
At IRR, NPV = 0
1 2 3 4 n

and Profitability
n
FVi
NPV = ∑ − CO0 = 0 Index = 1
i=1 ( 1 + K )
i
The discount
rate, i.e., cost of
capital is assumed to be known in the determination of Net Present Value, while in the internal rate of return
calculation, the NPV is set equal to zero and the discount rate which satisfies the condition is determined.

|KIMS_The Platform to Perform| 90 FM_Capital Budgeting_JM


Interpretation
IRR can be interpreted in two ways:
a) IRR represents the rate of return on the unrecovered investment balance in the project.
b) IRR is the rate of return earned on the initial investment made by the project.

Of these, the first view seems to be more realistic, since it may not always be possible for an enterprise to
reinvest immediate cash flows at a rate equal to IRR.

Decision Making or Acceptance Rule

If Decision
IRR > K0 Accept the Project. Surplus over and above the cut-off rate is obtained.
IRR = K0 Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be
accepted or rejected. This constitutes an Indifference Point.
IRR < K0 Reject the Project. The Project does not provide returns even equivalent to the cut-off rate.

Procedure for computation of IRR

Step 1 Determine the total cash outflow of the project and time periods in which they occur.
Step 2 Determine the total cash inflows of the project and the time periods in which they arise.
Step 3 Compute the NPV at an arbitrary discount rate, say 10%.
Step 4 Choose another discount rate and compute NPV. The second discount rate is chosen in such a way
that one of the NPV’s is negative and the other is positive. Suppose, NPV is positive at 10%,
choose a higher discount rate so as to get a negative NPV. In case NPV is negative at 10%,
choose a lower rate.
Step 5 Compute the change in NPV over the two selected discount rates.
Step 6 On proportionate basis, compute the discount rate at which NPV is zero.

Illustration: 10
Taking data from Illustration: 9 calculate the IRR for each project.

Year PVIF Project X Project Y

10% 20% CFAT DCFAT DCFAT CFAT DCFAT DCFAT
10% 20% 10% 20%
0 1.00 1.00 (200,000) (200,000) (200,000) (200,000) (200,000) (200,000)
1 0.91 0.83 35,000 31,850 29,050 218,000 198,380 180,940
2 0.83 0.69 80,000 66,400 55,200 10,000 8,300 6,900
3 0.75 0.58 90,000 67,500 52.200 10,000 7,500 5,800
4 0.68 0.48 75,000 51,000 36,000 4,000 2,720 1,920
5 0.62 0.41 20,000 12,400 8,200 3,000 1,860 1,230
29,150 (19,350) 18,760 (3,210)
Since NPV is positive for both the projects at 10% discounting rate, we arbitrary choose a higher discounting
rate for negative NPV, let say 20%. By interpolation method or on proportionate basis, IRR calculated is:

IRR of Project X:

k − 10 0 − 29,150
= = 0.601 ∴ k = 10 + 6.01 = 16.01%
20 − 10 −19, 350 − 29,150

IRR of Project Y:
k − 10 0 − 18, 760
= = 0.854 ∴ k = 10 + 8.54 = 18.54%
20 − 10 −3, 210 − 18, 760
CONFLICT BETWEEN CHOICE OF
IRR AND NPV METHODS

Causes of Conflict
Generally, the higher the NPV, higher will be the IRR. However, NPV and IRR may give conflicting result in
the evaluation of different projects.

|KIMS_The Platform to Perform| 91 FM_Capital Budgeting_JM


a) Initial Investment Disparity – i.e., different project sizes.
b) Project Life Disparity – i.e., difference in project lives.
c) Outflows Pattern – i.e., when cash outflows arise at different points of time during the project life,
rather than as initial investment (t = 0) only.
d) Cash Flow Disparity – i.e., when there is huge difference between initial CFAT and later years’
CFAT. A project with heavy initial CFAT then compared to later years will have higher IRR and vice-
versa.

Superiority of NPV
In case of conflicting decisions based on NPV and IRR, the NPV method must prevail. Decisions are based
on NPV sue to the superiority of NPV, as given from the following points:
a) NPV represents the surplus from the project whereas IRR represents the point of no surplus-no
deficit.
b) NPV consider cost of capital as constant. Under IRR, the discount rate is determined by reverse
working, by setting NPV = 0.
c) NPV aids decision-making by itself, i.e., projects with positive NPV are accepted. IRR by itself does
not aid decision-making. For example, a project with IRR = 18% will be accepted if K 0 < 18%.
However, the project will be rejected if K0 = 21% (say > 18%).
d) NPV method considers the timing differences in cash flows at the appropriate discount rate. IRR is
greatly affected by the volatility or variance in cash flow patterns.
e) IRR presumes that intermediate cash inflows will be reinvested at the rate (IRR); whereas in the
case of NPV method, intermediate cash inflows are presumed to be reinvested at the cut-off rate.
The later presumption, viz., reinvestment at the cut-off rate, is more realistic than reinvestment at
IRR.

Illustration: 11
Taking data from Illustration 9 and 10, state with reasons which project would you recommend?

NPV – IRR conflict

Particulars Project X Project Y
NPV at 10% Rs. 29,150 Rs. 18,760
Rank based on NPV I II
Internal Rate of Return 16.01% 18.54%
Rank based on IRR II I

In case of NPV – IRR conflict, NPV should be preferred for decision making since it gives the net benefit in
absolute terms. Hence Project X will be preferred.

NOTE:
Inconsistency in ranking between NPV and IRR arises because:
a) Cash flow patterns of projects are different, Project Y has heavy initial cash inflows and hence has
higher IRR.

Illustration: 12
The cash flows of Project C and D with other details are given below:
Year 0 1 2 3 NPV at 10% IRR
Project C (10,000) 2,000 4,000 12,000 4,139 26.5%
Project D (10,000) 10,000 3,000 3,000 3,823 37.6%

Year PVIF at
10% 14% 15% 30% 40%
1 0.9090 0.8772 0.8696 0.7692 0.7143
2 0.8264 0.7695 0.7561 0.5917 0.5102
3 0.7513 0.6750 0.6575 0.4552 0.3644

|KIMS_The Platform to Perform| 92 FM_Capital Budgeting_JM


a) Compare and rank the projects at different discounting rates based on NPV.
b) Why there is conflict in rankings?
c) Which project do you recommend?

Comparison and Ranking of Projects at different discounting rates based on NPV

Discounting Rate 0% 10% 14% 15% 30% 40%

NPV of Project C 8,000 4,139 2,932 2,653 (633) (2,157)
NPV of Project D 6,000 3,823 3,106 2,937 833 (233)
Preference C C D D D NA

The conflict in project ranking between NPV and IRR is due to the variability of cash flows. Project C has
lower initial cash flows and heavy later inflows. However, Project D has heavy initial inflows and lower
inflows in the later period. This will distort the analysis under IRR. NPV is a realistic technique which takes
into account, the variability of cash flows. Hence, NPV should be preferred over IRR in case of conflict.
We are informed that the company’s cost of capital of 10%, NPV is higher for Project C. Hence, it should be
preferred over Project D.

PROFITABILITY INDEX METHOD

When different investment proposals each involving different initial investments and cash inflows are to be
compared, the technique of Profitability Index (PI) is used.

Profitability Index (PI) or Desirability Factor or Benefit Cost Ratio (BCR) is:

Total Discounted Cash Inflows

Total Discounted Cash Outflows

PI represents the amount obtained at the end of the project life, for every rupee invested in the project at the
initial stage. The higher the PI, the better it is, since the greater is the return for every rupee of investment in
the project.

Decision Making or Acceptance Rule

If Decision
PI > 1 Accept the Project. Surplus over and above the cut-off rate is obtained.
PI = 1 Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be
accepted or rejected. This constitutes an Indifference Point.
PI < 1 Reject the Project. The Project does not provide returns even equivalent to the cut-off rate.

CONFLICT BETWEEN THE CHOICE OF PI AND NPV METHODS

Acceptance – Rejection Decision

• Both NPV and PI techniques recognize the time value of money.
• The discount rate used in NPV and PI methods are the same.
• Both NPV and PI use the same factors, i.e., Discounted Cash Inflows (A) and Discounted Cash
Outflows (B), in the computation. NPV = A – B whereas PI = A ÷ B.
• When NPV > 0, PI will always be greater than 1. Also when NPV < 0, PI will be less than 1.
• Hence, for a given project, NPV and PI method give the same Accept or Reject Decision.
Ranking Criteria
However, if one project is to be selected out of two mutually exclusive projects, the NPV and PI method may
give conflicting ranking criteria.

Example:
Project P Q
Discounted Cash Inflows Rs. 10,00,000 Rs. 5,00,000

|KIMS_The Platform to Perform| 93 FM_Capital Budgeting_JM


Less: Discounted Cash Outflows Rs. 5,00,000 Rs. 2,00,000
Net Present Value Rs. 5,00,000 Rs. 3,00,000
Profitability Index 2.00 2.50

Project P has a better ranking based on NPV while project Q will be preferred if PI were to be used for
decision-making. Thus, there is a conflict in ranking, between NPV and PI methods. This is because NPV
gives the ranking in terms of absolute value of rupees, whereas PI gives ranking for every rupee of
investment, i.e., in terms of ratio.

Decision-making
Generally the NPV method should be preferred since NPV indicates the economic contribution or surplus of
the project in absolute terms. However, in capital rationing situations, for deciding between mutually
exclusive projects, PI is a better evaluation technique.

PROJECT LIFE DISPARITY SITUATIONS – DIFFERENTIAL PROJECT LIVES

In case of evaluation based on NPV method, comparison of two projects is possible only if initial investment
and project lives are the same. If project lives are different, e.g., Machine A operates for 6 years whereas
Machine B operates for 8 years, the decisions can be obtained by any of the following methods:

Equivalent Annual Flows Method

Here, the cash flows are converted into an equivalent annual annuity called EAB, i.e., Equivalent Annual
Benefit (in case of net inflow) or EAC, i.e., Equivalent Annual Cost (in case of net outflow).

Step 1 Compute the Initial Investment of each alternative.

Step 2 Determine the project lives of each alternatives.
Step 3 Determine the annuity factor relating to the project life of each alternative.
Step 4 Compute Equivalent Annual Investment.
(EAI) = Initial Investment ÷ Relevant Annuity Factor
Step 5 Compute CFAT per annum or Cash Outflows per annum, for each alternative.
Step 6 Compute EAB = CFAT per annum – EAI
Compute EAC = Cash outflows per annum + EAI
Step 7 Select project with maximum EAB or minimum EAC, as the case may be.

Illustration: 13
The cash flows of two mutually exclusive projects are as under:
Year 0 1 2 3 4 5 6
Project P (40,000) 13,000 8,000 14,000 12,000 11,000 15,000
Project J (20,000) 7,000 13,000 12,000 - - -
a) Estimate the net present value of the projects P and J using 15% as the hurdle rate.
b) Estimate the internal rate of return of the projects P and J.
c) Why is there conflict in the project by using NPV and IRR criteria?
d) Which criterion will you use in such a situation? Estimate the value at that criterion. Make a project
choice.
Calculation of NPV at 15% hurdle rate

Project P Project J
Year PVIF 15%
CFAT DCFAT CFAT DCFAT
0 1.0000 (40,000) (40,000) (20,000) (20,000)
1 0.8696 13,000 11,305 7,000 6,087
2 0.7561 8,000 6,049 13,000 9,829
3 0.6575 14,000 9,205 12,000 7,890
4 0.5718 12,000 6,862
5 0.4972 11,000 5,469

|KIMS_The Platform to Perform| 94 FM_Capital Budgeting_JM


6 0.4323 15,000 6,485
5,375 3,806

Computation of IRR
Since both the projects yield a positive NPV at 15%, a higher discount rate is used to determine a negative
NPV. IRR hence calculated by interpolation method is 20.15% for Project P and 25.30% for Project J.
(Students are advised to calculate the IRR)

NPV – IRR conflict

Particulars Project P Project J
NPV at 15% Rs. 5,375 Rs. 3,806
Rank based on NPV I II
Internal Rate of Return 20.15% 25.30%
Rank based on IRR II I
Project Life 6 years 3 years
Initial Investment Rs. 40,000 Rs. 20,000

The difference or conflict in ranking between NPV and IRR is attributed to:
a) Disparity in Initial Investment
b) Difference in Project Lives
c) Non uniform cash inflows of the project

Resolving the conflict and Project choice

In case of conflict between NPV and IRR, the NPV criterion is generally preferred. Hence Project P, whose
NPV is Rs. 5,375, will be preferred in the above case. However, in this case, Project P and J have
differential lives and hence, Equivalent Annual Flows Method will be better criteria for project
ranking.

Equivalent Annual Flows from the Project = NPV ÷ PVIFA at 15% for the relevant project life
For Project P: EAF = 5,375 ÷ 3.7845 = Rs. 1,420
For Project J: EAF = 3,806 ÷ 2.2832 = Rs. 1,668
Hence, Project J should be preferred in the above situation, based on Equivalent Annual Flow
criteria.

Terminal Value Method / Modified Net Present Value Method

Under this method it is assumed that each cash flow is reinvested in another project at a predetermined rate
of interest. It is also assumed that each cash inflow is reinvested elsewhere immediately until the termination
of the project. If the present value of the sum total of the compounded reinvested cash flows is greater than
the present value of the outflows the proposed project is accepted otherwise not.

Step 1 Find Terminal Value

Terminal Value = Future value of the immediate cash flows invested at different rates.
n

∑ CF ( 1 + r )
n −1
TV = t
t=1

Where, TV = Terminal Value

CFt = Cash Inflow in year t
r = Re-investment rate
n = Life of the project

Step 2 Find Modified NPV

TV
Modified NPV = − I0
( 1+k )
n

|KIMS_The Platform to Perform| 95 FM_Capital Budgeting_JM


Where, k = Cost of Capital
I0 = Initial Investment

Illustration: 14

Original outlay Rs. 8,000

Life of the project 3 years
Cash inflows Rs, 4,000 p.a. for 3 years
Cost of Capital 10%
Expected interest rates at which the cash inflows will be re-invested:
Year end 1 2 3
% 8 8 8

First of all, it is necessary to find out total compounded sum which will be discounted back to the present
value.

Rate of Total
Cash Inflow Years of Compounding
Year Interest Compounding
(Rs.) Investment Factor
(%) Sum (Rs.)
1 4,000 8 2 1.166 4,664
2 4,000 8 1 1.080 4,320
3 4,000 8 0 1.000 4,000
12,984

Now, we have to find out the present value of Rs. 12,984 by applying the discount rate (cost of capital) of
10%. (PVIF at 10% for 3 years = 0.7513)

Modified NPV = Total Compounding Sum x PVIF – I0

= (Rs. 12,984 x 0.7513) – Rs. 8,000
= Rs. 9,755 – Rs. 8000
= Rs. 1,755

Since Modified NPV is positive, the project would be accepted under the terminal value criterion.

CAPITAL RATIONING – Advance Level

Generally, a firm fixes up the maximum amount that can be invested in capital projects during a given period
of time. The firm then tries to select a combination of investment proposals, which will be within the specific
limits providing maximum profitability, and put them n descending order according to their rate of return.
Such a situation is then considered to be capital rationing.

Situations of Capital Rationing

Situation I

|KIMS_The Platform to Perform| 96 FM_Capital Budgeting_JM


Projects are Divisible

Step 1 Calculate the profitability index of each project

Step 2 Rank the projects on the basis of the profitability index calculated in Step: 1.
Step 3 Choose the optimal combination of the projects.

Illustration: 15

Project Required Initial NPV at the appropriate

Investment (Rs.) cost of capital (Rs.)
A 1,00,000 20,000
B 3,00,000 35,000
C 50,000 16,000
D 2,00,000 25,000
E 1,00,000 30,000

Total funds available is Rs. 3,00,000. Determine the optimal combination of projects assuming that the
projects are divisible.

NPV at the
Required Initial Profitability
Project appropriate cost Rank
Outlay (Rs.) Index
of capital (Rs.)
A 1,00,000 20,000 0.2 3
B 3,00,000 35,000 0.117 5
C 50,000 16,000 0.32 1
D 2,00,000 25,000 0.125 4
E 1,00,000 30,000 0.3 2

Rank of Investment Project Initial Investment (Rs.) Cumulative

1 C 50,000 50,000
2 E 1,00,000 1,50,000
3 A 1,00,000 2,50,000
4 D (50,000÷200,000) 1/4th 50,000 3,00,000

Thus, the optimal combination of projects is C, E, A and 1/4th of D.

Situation II
Projects are Indivisible

Step 1 Construct a table showing the feasible combinations of the project (whose aggregate of initial outlay
does not exceed the fund available for investment).
Step 2 Choose the combination whose aggregate NPV is maximum and consider it as the optimal project
mix.

Illustration: 16

Using the same data as used in previous illustration, determine the optimal project mix on the basis of the
assumption that the projects are indivisible.

Feasible Combinations Aggregate of NPVs (Rs.)

A, C 36,000
A, D 45,000
A, E 50,000
C, D 41,000

|KIMS_The Platform to Perform| 97 FM_Capital Budgeting_JM


C, E 46,000
D, E 55,000
A, C, E 66,000

By a careful inspection of the feasible combinations constructed in the above table, we can conclude that the
optimal project mix is A, C, E because the aggregate of their NPV’s is maximum.

LEASE DECISIONS – Advance Level

Leasing is the general contract between the owner and user of the asset over a specific period of time. The
asset is purchased initially by the lessor and leased to the user which pays a specified rent at periodic
intervals.

From the lessee’s point of view, leasing has the attraction of eliminating immediate cash outflow, and the
lease rentals are also tax deductible expenses.

Buying has the advantages of depreciation allowance and interest on borrowed capital being tax deductible.

Evaluation of the two alternatives is to be made in order to take decision.

Illustration: 17

K Limited has decided to go in for a new model of a Car. The cost of the vehicle is Rs. 40,00,000. The
company has two alternatives:
a) Taking the Car on Finance Lease; or
b) Borrowing and Purchasing the Car.

J Limited is willing to provide the car on financial lease to K Limited for 5 years at an annual rental of Rs.
8,75,000, payable at the end of the year.

The vehicle is expected to have a useful life of 5 years, and it will fetch a net salvage value of Rs. 10,00,000
at the end of year five. The depreciation rate for tax purposes is 40% on written down value basis. The
applicable tax rate for the company is 35%. The applicable before tax borrowing rate for the company is
13.8462%.

What is the advantage of leasing for K Limited?

Rate of discount 1 2 3 4 5
0.138462 0.8784 0.7715 0.6777 0.5953 0.5229
0.09 0.9174 0.8417 0.7722 0.7084 0.6499

Analysis of Lease Option

Company’s cost of borrowing before tax = 13.8462%
Cost of Capital (after tax) = 13.8462 x 0.65 = 9% approx
Annual Lease Rental = Rs. 8,75,000
Less: Tax saved @ 35% = Rs. 3,06,250
Cash outflow net of taxes = Rs. 5,68,750
PV of cash outflows = Cash outflow p.a. x PVIFA
= Rs. 5,68,750 x 3.8896
= Rs. 22,12,210

|KIMS_The Platform to Perform| 98 FM_Capital Budgeting_JM


Analysis of Loan Option

Computation of Depreciation per year (in Rs. Lakhs)

Year 1 2 3 4 5
Opening Balance 40.00 24.00 14.40 8.64 5.18
Less: Dep. @40% 16.00 9.60 5.76 3.46 2.07
Closing Balance 24.00 14.40 8.64 5.18 3.11

Computation of loan amounts repaid (presumed to be repaid in 5 years equally) (in Rs. Lakhs)
Annual repayment of loan = 40.00 ÷ 5 = 8.00
Year 1 2 3 4 5
Opening Balance 40.00 32.00 24.00 16.00 8.00
Less: Repayments 8.00 8.00 8.00 8.00 8.00
Closing Balance 32.00 24.00 16.00 8.00 0.00

Total Cash Outflows of Loan Option (Rs. Lakhs)

Year 1 2 3 4 5
Principal Repayment 8.00 8.00 8.00 8.00 8.00
Interest @9% on Opening Balance 3.60 2.88 2.16 1.44 0.72
Less: Tax saved on depreciation @ 35% (5.60) (3.36) (2.02) (1.21) (0.72)
Less: Salvage Value (10.00 – 3.11)x0.65 + 3.11 - - - - (7.59)
Outflows 6.00 7.52 8.14 8.23 0.41
PVIF 9% 0.9714 0.8417 0.7722 0.7084 0.6499
Discounted Cash outflows 5.50 6.33 6.29 5.83 0.27

Total Discounted Cash Outflows = Rs. 24,22,000

Thus, net advantage of lease option = Rs. 24,22,000 – Rs. 22,12,210

= Rs. 2,09,790

Exercise
1. A company is considering an investment proposal to install new milling controls at a cost of Rs.
50,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume
the firm uses straight line depreciation and the same is allowed for tax purposes. The estimated cash
flows before depreciation and tax (CFBT) from the investment proposal are as follows:
Year : 1 2 3 4 5
CFBT (Rs.) : 10,000 10,692 12,769 13,462 20,385

Compute the following:

a) Pay back period

|KIMS_The Platform to Perform| 99 FM_Capital Budgeting_JM


b) Average rate of return
c) Internal rate of return
d) Net present value at 10% discount rate
e) Profitability index at 10% discount rate

[Answer: 4.328 years, 9%, 6.6%, (Rs. 4,648), 0.907]

2. A company is contemplating to purchase a machine. Two machines A and B are available, each
costing Rs. 5,00,000. In comparing the profitability of the machines, a discounting rate of 10% is to be
used and machines to be written off in five years by straight line method of depreciation with nil residual
value. Cash inflows after tax are expected as follows:

Year Machine A Machine B

1 1,50,000 50,000
2 2,00,000 1,50,000
3 2,50,000 2,00,000
4 1,50,000 3,00,000
5 1,00,000 2,00,000

Indicate which machine would be profitable using the following methods of ranking investment
proposals:
a) Pay Back Method
b) Net Present Value Method
c) Profitability Index Method
d) Average Rate of Return Method

[Answer: a) 2 years 7.2 months, 3 years 4 month, b) Rs. 1.5401 lakhs, Rs. 1.4876 lakhs, c) 1.308,
1.298, d) 28%, 32%]

3. Oasis Plastics Limited is a manufacturer of high quality plastic products. Bania, President, is
considering computerizing the company’s ordering, inventory and billing procedures. He estimates that
the annual savings from computerization include a reduction of 4 clerical employees with annual salaries
of Rs. 50000 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 is Rs. 2,50,000 and installation costs are Rs. 50,000. These outlays
will be capitalized (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 operation (cash) expenses
of Rs. 22,000 are estimated to be required. The company’s tax rate is 40% and its required rate of return
(cost of capital) for the project is 12%.

You are required to:

a) Evaluate the project using NPV method.
b) Evaluate the project using PI method.
c) Evaluate the Project’s Payback Period.

[Answer: NPV = (Rs. 16,663), PI = 0.944, PBP = 3.817 years]

4. A company has to make a choice between two projects namely A and B. The initial capital outlay of
two projects are Rs. 1,35,000 and Rs. 2,40,000 respectively for A and B. There will be no scrap value at
the end of the life of both the projects. The opportunity cost of capital is 16%. The annual incomes are as
under:

Year Project A Project B Discounting Factor @16%

1 - 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476

|KIMS_The Platform to Perform| 100 FM_Capital Budgeting_JM


You are required to calculate for each project:
a) Discounted Payback Period
b) Profitability Index
c) Net Present Value

[Answer: a) 3.606 years, 4.187 years; b) 1.4315, 1.1451; c) Rs. 58,254, Rs. 34,812]

5. M/s. M & Co. wants to replace its old machine with a new automatic machine. Two models Bye-Bye
and K&K are available at the same cost of Rs. 5,00,000 each. Salvage value of the old machine is Rs.
1,00,000. The utilities of the existing machine can be used if the company purchases Bye-Bye.
Additional cost of utilities to be purchased in that case are Rs. 1,00,000. If the company purchases K&K
then all the existing utilities will have to be replaced with new utilities costing Rs. 2,00,000. The salvage
value of the old utilities will be Rs. 20,000. The cash flows after taxation are expected to be:

Year Cash Inflows of PV factor

@ 15%
Bye-Bye (Rs.) K&K (Rs.)
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
Salvage value at the end of year 5 50,000 60,000

The targeted return on capital is 15%. You are required to:

a) Compute, for the two machines separately, net present value, discounted pay back period and
desirability factor, and
b) Advise which of the machines is to be selected.

[Answer: NPV = Rs. 44,000, Rs. 20,000; DPBP = 4.6 years, 4.6 years; DF = 1.088, 1.034]

6. A particular 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 Year 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 realization 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.

[Answer: NPV = Rs. 10,910; Accept the proposal]

7. K Limited has the following expectations from its project:

Rs. In Lakhs
Year 0 1 2 3 4 5
Total (2,910.24) 1,439.49 1,355.16 1,272.67 1,248.59 2,673.20
To finance its project the company borrowed Rs. 1,000 lakhs @ 12%. The balance was invested through
equity. The cost of equity is 14%. The marginal tax rate applicable to the company is 35%. The company
expects to reinvest the intermediate cash flows @6% in government securities.
You are required to compute the company’s modified NPV and suggest whether the project should be
accepted.
[Answer: Modified NPV = Rs. 2,145.22 lakhs, the company should accept this project]

|KIMS_The Platform to Perform| 101 FM_Capital Budgeting_JM


8. Om Limited has Rs. 10,00,000 allocated for capital budgeting purpose. The following proposals and
associated profitability indices have been determined:
Project 1 2 3 4 5 6
Project Costs (Rs. Lakh) 3.00 1.50 3.50 4.50 2.00 4.00
Profitability Index 1.22 0.95 1.20 1.18 1.20 1.05
Which of the above investments should be undertaken? Assume that projects are indivisible and there is
no alternative use of money allocated for capital budgeting.
[Answer: Mix of projects 3, 4 and 5]

9. Beta Limited is considering 5 capital projects for the years 1, 2, 3 and 4. The company is financed
entirely by equity and its cost of capital is 12%. The expected cash flows of the projects are as follows:

Project Year 1 Year 2 Year 3 Year 4

A (70) 35 35 20
B (40) (30) 45 55
C (50) (60) 70 80
D - (90) 55 65
E (60) 20 40 50

All projects are divisible. None of the projects can be delayed or undertaken more than once. Calculate
which project the company should undertake if the capital available for investment is limited to Rs.
110000 in year 1 and with no limitation in subsequent years?
[Answer: Either D or Combination of E, B and C]

10. In a capital rationing situation (investment limit Rs. 25 lakhs), suggest the most desirable and
feasible combination on the basis of the following data (indicate justification):

Project Initial Outlay NPV

A 15,00,000 6,00,000
B 10,00,000 4,50,000
C 7,50,000 3,60,000
D 6,00,000 3,00,000

Projects B and C are mutually exclusive.

[Answer: Project A and B]

11. Five projects M, N, O, P, and Q are available to a company for consideration. The investment
required for each project and 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 of NPV and Benefit- Cost Ratio?

Project Investment Cash flow p.a. No. of years PV @ 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
[Answer: Projects M, N & P combines to give maximum NPV of Rs. 2,82,070 and maximum BCR
of 1.940]
12. A company is evaluating three projects 1, 2 and 3. Investments required and expected present
values of cash inflows from each of the projects are as below:

Year Investments (Rs.) PV of Inflows (Rs.)

1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000

a) If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and
present values will simply be the sum of the parts.

|KIMS_The Platform to Perform| 102 FM_Capital Budgeting_JM


b) With projects 1 and 3, economies are possible in investment because one of the machines costing
Rs. 30,000 can be used for both of the projects.
c) If projects 2 and 3 are undertaken, there are economies to be achieved in marketing and production
but not in investment. The expected present value of costs saved is Rs. 35,000.
d) If all three projects are undertaken simultaneously, the economies noted will still hold. However, an
extension of plant capacity will be necessary at additional investment of Rs. 1,25,000.
Which projects should be chosen?
[Answer: Combination of 2 and 3]

13. S Limited a highly profitable company is engaged in the manufacture of power intensive products.
As part of its diversification plans, the company proposes to put up a Windmill to generate electricity.
The details of the scheme are as follows:

a) Cost of windmill – Rs. 300 lakhs

b) Cost of land – Rs. 15 lakhs
c) Subsidy from state Government to be received at the end of first year of installation – Rs. 15
lakhs.
d) Cost of electricity will be Rs. 2.25 per unit in year 1. This will increase by Re. 0.25 per unit
every year till year 7. After that it will increase by Re. 0.50 per unit.
e) Maintenance costs will be Rs. 4 lakhs in year 1 and the same will increase by Rs. 2 lakhs
every year.
f) Estimated life is 10 years.
g) Cost of capital is 15%.
h) Residual value of the windmill will be nil. However, land value will go up to Rs. 60 lakhs at
the end of 10 years.
i) Depreciation will be 100% of the cost of the Windmill in year 1 and the same will be allowed
for tax purposes.
j) As windmills are expected to work based on wind velocity, the efficiency is expected to be
an average 30%. Gross electricity generated at this level will be 25 lakhs units per annum. 4% of
this electricity generated will be committed free to the State Electricity Board as per the agreement.
k) Tax rate is 50%

From the above information you are required to calculate the net present value. (Ignore tax on capital
profits.)

Year 1 2 3 4 5 6 7 8 9 10
At 15% 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25
[Answer: Rs. 8.26 lakhs]

14. K Limited is considering a new project for manufacture of pocket video games involving a capital
expenditure of Rs. 600 lakh and working capital of Rs. 150 lakh. The capacity of the plant is for an
annual production of 12 lakh units and capacity utilization during the 6 year working life of the project is
expected to be as indicated below:

Year : 1 2 3 4–6
Capacity Utilization (%) : 33.33 66.67 90 100

The average price per unit of the product is expected to be Rs. 200 netting a contribution of 40%. The
annual fixed costs, excluding depreciation, are estimated to be Rs. 480 lakh per annum from the third
year onwards; for the first and second year, it would be Rs. 240 lakh and Rs. 360 lakh respectively. The
average rate of depreciation for tax purposes is 33.33 % on the capital assets. The rate of income tax
may be taken as 35%. Cost of capital is 15%.
At the end of the third year, an additional investment of Rs. 100 lakh would be required for working
capital.

Terminal value for the fixed assets may be taken at 10% and for the current assets at 100%. For the
purpose of your calculations, the recent amendments to the tax laws with regard to balancing charge
may be neglected.
[Answer: NPV = Rs. 273 lakh]

|KIMS_The Platform to Perform| 103 FM_Capital Budgeting_JM


15. Run Away Limited is considering the manufacture of a new product. They have prepared the
following estimate of profit in the first year of manufacture:
(Rs.)
Sales, 9,000 units @ Rs. 32 2,88,000
Cost of goods sold:
Labour 40,000 hours @ Rs. 3.50 per hour 1,40,000
Materials and other variable costs 65,000
Depreciation 45,000
2,50,000
Less: Closing stock 25,000 2,25,000
Net Profit 63,000

The product is expected to have a life of four years. Annual sales volume is expected to be constant
over the period at 9,000 units. Production which was estimated at 10,000 units in the first year would be
only 9,000 units each in year two and three and 8,000 units in year four. Debtors at the end of each year
would be 20% of sales during the year, creditors would be 10% of materials and other variable costs. If
sales differed from the forecast level, stocks would be adjusted in proportion.
Depreciation relates to machinery which would be purchased especially for the manufacture of the new
product and is calculated on the straight line basis assuming that the machinery would last for four years
and have no terminal scrap value. Fixed costs are included in labour cost.

There is high level of confidence concerning the accuracy of all the above estimates except the annual
sales volume. Cost of capital is 20% per annum. You may assume that debtors are realized and
creditors are paid in the following year. No changes in the prices of inputs and outputs are expected over
the next four years.
You are required to show whether the manufacture of the new product is worthwhile. Ignore taxes.
[Answer: NPV = Rs. 58,398]

16. A plastic manufacturing company is considering replacing an older machine which was fully
depreciated for tax purposes with a new machine costing Rs. 40,000. The new machine will be
depreciated over its eight-year life. It is estimated that the new machine will reduce labour costs by Rs.
8,000 per year. The management believes that there will be no change in other expenses and revenues
of the firm due to the machine. The company requires an after-tax return on investment of 10%. Its rate
of tax is 35%. The company’s income statement for the current year is given for other information.

Income statement for the current year:

(Rs.)
Sales 5,00,000
Costs:
Materials 1,50,000
Labour 2,00,000
Factory and administrative 40,000
Depreciation 40,000 4,30,000
Net income before taxes 70,000
Less: Taxes (0.35) (24,500)
Earnings after taxes 45,500

Should the company buy the new machine? You may assume the company follows straight line method
of depreciation and the same is allowed for tax purposes.
[Answer: Differential NPV = (Rs. 2,922)]

17. A company is currently considering modernization of a machine originally costing Rs. 50,000
(current book value zero). However, it is in good working condition and can be sold for Rs. 25,000. Two
choices are available. One is to rehabilitate the existing machine at a total cost of Rs. 1,80,000; and the
other is to replace the existing machine with a new machine costing Rs. 2,10,000 and requiring Rs.
30,000 to install. The rehabilitated machine as well as the new machine would have a six year life and
no salvage value. The projected after-tax profits under the various alternatives are:

(Rs.)
Years Expected after-tax profits

|KIMS_The Platform to Perform| 104 FM_Capital Budgeting_JM


Existing machine Rehabilitated machine New machine
1 2,00,000 2,20,000 2,40,000
2 2,50,000 2,90,000 3,10,000
3 3,10,000 3,50,000 3,50,000
4 3,60,000 4,00,000 4,10,000
5 4,10,000 4,50,000 4,30,000
6 5,00,000 5,40,000 5,10,000

The firm is taxed at 35%. The company uses straight line depreciation method and the same is allowed
for tax purposes. Ignore block assets concept. The cost of capital is 12%.

Advise the company whether it should rehabilitate the existing machine or should replace it with the new
machine. Also, state the situation in which the company would like to continue with the existing machine.
[Answer: Incremental NPV for Rehab machine = Rs. 89,980; new machine = Rs. 1,00,960]

18. A company is considering the proposal of taking up a new project which requires an investment of
Rs. 400 lakhs on machinery and other assets. The project is expected to yield the following earnings
before depreciation and taxes over the next five years: Rs. In lakhs: 160, 160, 180, 180 and 150
respectively.
The cost of raising the additional capital is 12% and the assets have to be depreciated at 20% on WDV
basis. The salvage value at the end of 5 yrs period may be taken as zero. Income tax applicable is 50%.
Calculate the NPV and IRR of the project.

19. A Limited is considering investing in a project. The expected investment in the project is Rs.
2,00,000. Life of the project is 5 years with no salvage value. The expected net cash inflows after
depreciation but before taxes are in Rs. 85,000; 100,000; 80,000; 80,000 and 40,000 respectively.
Depreciation is 20% on original cost. Applicable tax rate is 30%.
Calculate payback period, ARR, NPV and IRR of the project.

20. A company wants to invest in a machinery costing Rs. 50,000 at the beginning of year 1. It is
estimated that net cash inflows from operation is Rs. 18,000 per annum for 3 years, if the company opts
to service a part of the machinery at the end of year 1 at Rs. 10,000 and the salvage value at the end of
year 3 will be Rs. 12,500. However, if the company decides not to service the part, it will have to be
replaced at the end of year 2 at Rs. 15,400. But in this case, the machinery will work for the 4 th year with
Rs. 18,000 as cash inflow. It will have to be scrapped at the end of year 4 at Rs. 9,000. Opportunity cost
of capital is 10%. Ignore taxation. Will you recommend the purchase of this machine based on NPV? If
the supplier gives you Rs. 5,000 discount, what would be your decision? [1, 0.9091, 0.8264, 0.7513,
0.6830, 0.6209, 0.5644]

21. Following are the date on a capital project being evaluated by X limited.
Annual cost saving Rs. 40,000
Useful life of the project 4 years
IRR 15%
Profitability Index 1.064
Net Present Value ??
Cost of Capital ??
Cost of Project ??
Payback Period ??
Salvage Value 0
Find the missing values.
22. Company X is forced to choose between two machines A and B. The two machines are designed
differently, but have identical capacity and do exactly the same job. Machine A costs Rs. 1,50,000 and
will last for 3 years. It costs Rs. 40,000 per year to run. Machine B is an “economy” model costing Rs.
1,00,000, but will last only for 2 years, and costs Rs. 60,000 per year to run. These are real cash inflows.
Ignore tax. Opportunity cost of capital is 10%. Which machine should company X buy?

23. Company X is operating an elderly machine that is expected to produce a net cash inflow of Rs.
40,000 in the coming year and Rs. 40,000 next year. Current salvage value is Rs. 80,000 and next
year’s value is Rs. 70,000. The machine can be replaced now with a new machine, which costs Rs.

|KIMS_The Platform to Perform| 105 FM_Capital Budgeting_JM


150,000, but is more efficient and will provide a cash inflow of Rs. 80,000 a year for 3 years. Company
wants to know whether it should replace the equipment now or wait a year with the clear understanding
that the new machine is the best of the available alternatives and that it in turn be replaced at the optimal
point. Ignore tax. Take cost of capital 10%. Advise with reasons.

24. PQ limited has decided to purchase a car worth Rs. 40,00,000, have two alternatives:
a) Taking the car on financial lease; or
b) Borrowing and purchasing the car.
LM limited is willing to provide the car on lease for 5 years at an annual rental of Rs. 8.75 lakhs, payable
at the end of the year. The vehicle is expected to have useful life of 5 years, with salvage value of Rs.
10,00,000. Depreciation @ 40% on WDV method. Applicable tax rate is 35%. Applicable before tax
borrowing rate is 13.8462%. Find net advantage of leasing.

25. A company is thinking of replacing its existing machine by a new machine which would cost Rs. 60
lakhs. The company’s current production is 80,000 units and is expected to increase to 100,000 units, if
the new machine is bought. The selling price remain unchanged at Rs. 200 per unit. The following is the
cost of producing one unit of product using both existing and new machine:

Existing machine New machine Difference

Materials 75.00 63.75 (11.25)
Wages and Salaries 51.25 37.50 (13.75)
Supervision 20.00 25.00 5.00
Repairs 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.00 4.75
Allocated corporate OHS 10.00 12.50 2.50

The existing machine has an accounting book value of Rs. 100,000, and it has been fully depreciated for
tax purposes. It is estimated that machine will be useful for 5 years. The supplier of the new machine
has offered to accept the old machine for Rs. 2,50,000. However, the market price of old machine today
is Rs. 1,50,000 and it is expected to be Rs. 35,000 after 5 years. The new machine has a life of 5 years
and a salvage value of Rs. 2,50,000 at the end of its economic life. Assume corporate income tax rate at
40% and depreciation is charged on straight line basis for income tax purposes. Further assume that
book profit is treated as ordinary income for tax purposes. The opportunity cost of capital is 15%.

Required:
a) Estimate NPV of the replacement decision.
b) Estimate the IRR of the replacement decision.
c) Should company go ahead with the replacement decision? Suggest.

|KIMS_The Platform to Perform| 106 FM_Capital Budgeting_JM