Chapter 4

MARKET AND DEMAND ANALYSIS

1. We have to estimate the parameters a and b in the linear relationship
Yt = a + bT
Using the least squares method.
According to the least squares method the parameters are:
TYnTY
b=
T2nT2
a = Y bT
The parameters are calculated below:
Calculation in the Least Squares Method
T
Y
TY
1
2,000
2,000
2
2,200
4,400
3
2,100
6,300
4
2,300
9,200
5
2,500
12,500
6
3,200
19,200
7
3,600
25,200
8
4,000
32,000
9
3,900
35,100
10
4,000
40,000
11
4,200
46,200
12
4,300
51,600
13
4,900
63,700
14
5,300
74,200
T = 105
Y = 48,500
TY = 421,600
T = 7.5
Y = 3,464
TYnTY
b=
T2nT2
57,880
=

421,600 14 x 7.5 x 3,464

=

= 254

227.5
a = Y bT
= 3,464 254 (7.5)
= 1,559

1,015 14 x 7.5 x 7.5

T2
1
4
9
16
25
36
49
64
81
100
121
144
169
196
T 2 = 1,015

Thus linear regression is

Y = 1,559 + 254 T
2. In general, in exponential smoothing the forecast for t + 1 is
Ft + 1 = Ft + et
Where Ft + 1 = forecast for year )
= smoothing parameter
et = error in the forecast for year t = St = Ft
F1 is given to be 2100 and is given to be 0.3
The forecasts for periods 2 to 14 are calculated below:
Period t Data (St)
Forecast
Error
Forecast for t + 1
(Ft)
(et St =Ft)
(Ft + 1 = Ft + et)
1
2
3
4
5
6
7
8
9
10
11
12
13

2,000
2,200
2,100
2,300
2,500
3,200
3,600
4,000
3,900
4,000
4,200
4,300
4,900

2100.0
2070
2109.0
2111.7
2168.19
2267.7
2547.4
2863.2
3204.24
3413
3589.1
3772.4
3930.7

-100
130
-9
188.3
331.81
932.3
1052.6
1136.8
695.76
587.0
610.9
527.6
969.3

F2 = 2100 + 0.3 (-100) = 2070

F3 = 2070 + 0.3(130) = 2109
F4 = 2109 + 0.3 (-9) = 2111.7
F5 = 2111.7 + 0.3(188.3) = 2168.19
F6 = 2168.19 + 0.3(331.81) = 2267.7
F7 = 2267.7 + 0.3(9332.3) = 2547.4
F8 = 2547.4 + 0.3(1052.6) = 2863.2
F9 = 2863.2 + 0.3(1136.8) = 3204.24
F10 = 33204.24 + 0.3(695.76) = 3413.0
F11 = 3413.0 + 0.3(587) = 3589.1
F12 = 3589.1 + 0.3(610.9) = 3773.4
F13 = 3772.4 + 0.3(527.6) = 3930.7
F14 = 3930.7 + 0.3(969.3) = 4221.5

3. According to the moving average method

St + S t 1 ++ S t n +1
Ft + 1 =
n
where Ft + 1 = forecast for the next period
St = sales for the current period
n = period over which averaging is done
Given n = 3, the forecasts for the period 4 to 14 are given below:

Period t

Data (St)

1
2
3
4
5
6
7
8
9
10
11
12
13
14

2,000
2,200
2,100
2,300
2,500
3,200
3,600
4,000
3,900
4,000
4,200
4,300
4,900
5,300

Forecast
(Ft)

2100
2200
2300
2667
3100
3600
3833
3967
4033
4167
4467

Forecast for t + 1
Ft + 1 = (St+ S t 1 + S t 2)/ 3

F4 = (2000 + 2200 + 2100)/3 = 2100

F5 =(2200 + 2100 + 2300)/3= 2200
F6 = (2100 + 2300 + 2500)/3 = 2300
F7 = (2300 + 2500 + 3200)/3= 2667
F8 = (2500 + 3200 + 3600)/3 = 3100
F9 = (3200 + 3600 + 4000)/3 = 3600
F10 = (3600 + 4000 + 3900)/3 = 3833
F11 = (4000 + 3900 + 4000)/3 =3967
F12 =(3900 + 4000 + 4200)/3 = 4033
F13 = (4000 + 4200 + 4300)/3 = 4167
F14 = (4200 + 4300 + 4900) = 4467

4.
Q1 = 60
Q2 = 70
I1 = 1000
I2 = 1200

Q1 Q2

Income Elasticity of Demand E1 =

x
I2 - I1

E1 = Income Elasticity of Demand

Q1 = Quantity demanded in the base year
Q2 = Quantity demanded in the following year
I1 = Income level in base year
I2 = Income level in the following year
70 60
E1 =

1000 + 1200
x

1200 1000
22000

E1 =

= 0.846
26000

70 + 60

I1 + I2
Q2 Q1

5.
P1 = Rs.40
P2 = Rs.50
Q1 = 1,00,000
Q2 = 95,000

Q2 Q1

Price Elasticity of Demand = Ep =

P1 + P2
x

P2 P1

Q2 + Q1

P1 , Q1 = Price per unit and quantity demanded in the base year

P2, Q2 = Price per unit and quantity demanded in the following year
Ep = Price Elasticity of Demand
95000 - 100000
Ep =

40 + 50
x

50 - 40
- 45
Ep =

= - 0.0231
1950

95000 + 100000

Chapter 6
FINANCIAL ESTIMATES AND PROJECTIONS
1.
Projected Cash Flow Statement
Sources of Funds
Profit before interest and tax
Depreciation provision for the year
Secured term loan
Total (A)
Disposition of Funds
Capital expenditure
Increase in working capital
Repayment of term loan
Interest
Tax
Dividends
Total (B)
Opening cash balance
Net surplus (deficit) (A B)
Closing cash balance

(Rs. in million)

4.5
1.5
1.0
7.0

1.50
0.35
0.50
1.20
1.80
1.00
6.35
1.00
0.65
1.65

Projected Balance Sheet

Liabilities
Share capital
Reserves & surplus
Secured loans
Unsecured loans
Current liabilities
& provisions

5.00
4.50
4.50
3.00
6.30
1.05
24.35

(Rs. in million)
Assets
Fixed assets
11.00
Investments
.50
Current assets
12.85
* Cash
1.65
* Receivables 4.20
* Inventories 7.00
24.35

Working capital here is defined as :

(Current assets other than cash) (Current liabilities other than bank borrowings)
In this case inventories increase by 0.5 million, receivables increase by 0.2 million and current liabilities
and provisions increase by 0.35 million. So working capital increases by 0.35 million

2.

Projected Income Statement for the 1st Operating Year

Rs.
Sales
4,500
Cost of sales
3,000
Depreciation
319
Interest
1,044
Write off of Preliminary expenses
15
Net profit
122
Projected Cash Flow Statements
Construction period
Sources
Share capital
Term loan
Short-term bank borrowing
Profit before interest and tax
Depreciation
Write off preliminary expenses

1st Operating year

1800
3000

4800
Uses
Capital expenditure
Current assets (other than cash)
Interest
Preliminary expenses
Pre-operative expenses

3900
150
600
4650
Opening cash balance
0
Net surplus / deficit
150
Closing balance
150
Projected Balance Sheet
Liabilities
31/3/n+1 31/3/n+2 Assets
Share capital
1800
1800
Fixed assets (net)
Reserves & surplus
122
Secured loans :
Current assets
- Term loan
3000
3600
- Cash
- Short-term bank
1800
Other current assets
borrowing
Unsecured loans
Miscellaneous
expenditures & losses
Current liabilities and
- Preliminary
provisions
expenses
4800
7322

600
1800
1166
319
15
3900
2400
1044
3444
150
456
606
31/3/n+1
4500

31/3/n+2
4181

150

606
2400

150

135

4800

7322

Notes :
i.

Allocation of Pre-operative Expenses : Rs.

Type

Costs before
allocation
Land
120
Building
630
Plant & machinery
2700
Miscellaneous fixed assets
450
3900
ii.

19
97
415
69
600

Costs after
allocation
139
727
3115
519
4500

Depreciation Schedule :

Opening balance
Depreciation
Closing balance
iii.

Allocation

Land

Building

Plant & machinery

139
139

727
25
702

3115
252
2863

M.Fixed
assets
519
42
477

Total (Rs.)

Interest Schedule :
Interest on term loan of Rs.3600 @20%
= Rs.720
Interest on short term bank borrowings of Rs,1800 @ 18% = Rs.324
= Rs.1044

4500
319
4181

Chapter 7
THE TIME VALUE OF MONEY
1.

2.

Value five years hence of a deposit of Rs.1,000 at various interest rates is as

follows:
r

8%

FV5

=
=

1000 x FVIF (8%, 5 years)

1000 x 1.469 =
Rs.1469

10%

FV5

=
=

1000 x FVIF (10%, 5 years)

1000 x 1.611 =
Rs.1611

12%

FV5

=
=

1000 x FVIF (12%, 5 years)

1000 x 1.762 =
Rs.1762

15%

FV5

=
=

1000 x FVIF (15%, 5 years)

1000 x 2.011 =
Rs.2011

Rs.160,000 / Rs. 5,000 = 32 = 25

According to the Rule of 72 at 12 percent interest rate doubling takes place
approximately in 72 / 12 = 6 years
So Rs.5000 will grow to Rs.160,000 in approximately 5 x 6 years = 30 years

3.

In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 23 times the initial

deposit. Hence doubling takes place in 12 / 3 = 4 years.
According to the Rule of 69, the doubling period is:
0.35 + 69 / Interest rate
Equating this to 4 and solving for interest rate, we get
Interest rate = 18.9%.

4.

Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is
equivalent to saving Rs.2000 a year for 15 years and Rs.1000 a year for the
years 6 through 15.
Hence the savings will cumulate to:

2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)

=
2000 x 31.772 + 1000 x 15.937
=
Rs.79481.
5.

6.

Let A be the annual savings.

A x FVIFA (12%, 10 years) =
A x 17.549
=

1,000,000
1,000,000

So A = 1,000,000 / 17.549 =

Rs.56,983.

1,000 x FVIFA (r, 6 years)

10,000

FVIFA (r, 6 years)

10,000 / 1000 = 10

=
=

9.930
10.980

From the tables we find that

FVIFA (20%, 6 years)
FVIFA (24%, 6 years)

Using linear interpolation in the interval, we get:

20% + (10.000 9.930)
r=

x 4% = 20.3%
(10.980 9.930)

7.

1,000 x FVIF (r, 10 years)

FVIF (r,10 years)

=
=

From the tables we find that

FVIF (16%, 10 years) =
FVIF (18%, 10 years) =

5,000
5,000 / 1000 = 5

4.411
5.234

Using linear interpolation in the interval, we get:

(5.000 4.411) x 2%
r = 16% +

= 17.4%
(5.234 4.411)

8.

The present value of Rs.10,000 receivable after 8 years for various discount
rates (r ) are:
r = 10%
PV
= 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670
r = 12%

PV

= 10,000 x PVIF (r = 12%, 8 years)

= 10,000 x 0.404 = Rs.4,040

r = 15%
9.

PV

= 10,000 x PVIF (r = 15%, 8 years)

= 10,000 x 0.327 = Rs.3,270
Assuming that it is an ordinary annuity, the present value is:
2,000 x PVIFA (10%, 5years)
= 2,000 x 3.791 = Rs.7,582

10.

The present value of an annual pension of Rs.10,000 for 15 years when r = 15%
is:
10,000 x PVIFA (15%, 15 years)
= 10,000 x 5.847 = Rs.58,470
The alternative is to receive a lumpsum of Rs.50,000.
Obviously, Mr. Jingo will be better off with the annual pension amount of
Rs.10,000.

11.

The amount that can be withdrawn annually is:

100,000
100,000
A = ------------------ ------------ = ----------- = Rs.10,608
PVIFA (10%, 30 years)
9.427

12.

The present value of the income stream is:

1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)
+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)
= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.

13.

The present value of the income stream is:

2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)
= 2,000 x 3.791 + 3000/0.10 x 0.621
= Rs.26,212

14.

To earn an annual income of Rs.5,000 beginning from the end of 15 years from
now, if the deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000

is required at the end of 14 years. The amount that must be deposited to get this
sum is:
Rs.50,000 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165
15.

Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years)

PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00
From the tables we find that:
PVIFA (15%, 10 years)
PVIFA (18%, 10 years)

=
=

5.019
4.494

Using linear interpolation we get:

r = 15% +

5.019 5.00
---------------5.019 4.494

x 3%

= 15.1%
16.

PV (Stream A) = Rs.100 x PVIF (12%, 1 year) + Rs.200 x

PVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 x
PVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +
Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +
Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +
Rs.1,000 x PVIF (12%, 10 years)
= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712
+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507
+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361
+ Rs.1,000 x 0.322
= Rs.2590.9
Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs.2,851.1

17.

FV5

=
=
=
=

Rs.10,000 [1 + (0.16 / 4)]5x4

Rs.10,000 (1.04)20
Rs.10,000 x 2.191
Rs.21,910

18.

FV5

=
=

Rs.5,000 [1+( 0.12/4)] 5x4

Rs.5,000 (1.03)20

=
=

Rs.5,000 x 1.806
Rs.9,030

19.

Stated rate (%)

12
24
24
Frequency of compounding 6 times
4 times
12 times
Effective rate (%)
(1 + 0.12/6)6- 1 (1+0.24/4)4 1 (1 + 0.24/12)12-1
= 12.6
= 26.2
= 26.8
Difference between the
effective rate and stated
rate (%)
0.6
2.2
2.8
20.

Investment required at the end of 8th year to yield an income of Rs.12,000 per
year from the end of 9th year (beginning of 10th year) for ever:
Rs.12,000 x PVIFA(12%, )
= Rs.12,000 / 0.12 = Rs.100,000
To have a sum of Rs.100,000 at the end of 8th year , the amount to be deposited
now is:
Rs.100,000

Rs.100,000
=

PVIF(12%, 8 years)
21.

= Rs.40,388
2.476

The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of
Rs.5,000 now is:
Rs.5,000 x FVIF (r,10 years) = Rs.20,000
Rs.20,000
FVIF (r,10 years) =

= 4.000
Rs.5,000

From the tables we find that

FVIF (15%, 10 years) = 4.046
This means that the implied interest rate is nearly 15%.
I would choose Rs.20,000 for 10 years from now because I find a return of 15%
quite acceptable.
22.

FV10

= Rs.10,000 [1 + (0.10 / 2)]10x2

= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653

= Rs.26,530
If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in
terms of the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283
23.

A constant deposit at the beginning of each year represents an annuity due.

PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should
be

Rs.50,000
FVIFA(12%, 10 years) x (1.12)
Rs.50,000

= Rs.2544
17.549 x 1.12

24.

The discounted value of Rs.20,000 receivable at the beginning of each year from
2005 to 2009, evaluated as at the beginning of 2004 (or end of 2003) is:

Rs.20,000 x PVIFA (12%, 5 years)

Rs.20,000 x 3.605 = Rs.72,100.

The discounted value of Rs.72,100 evaluated at the end of 2000 is

Rs.72,100 x PVIF (12%, 3 years)

Rs.72,100 x 0.712 = Rs.51,335

If A is the amount deposited at the end of each year from 1995 to 2000 then
A x FVIFA (12%, 6 years) = Rs.51,335
A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115
= Rs.6326
25.

The discounted value of the annuity of Rs.2000 receivable for 30 years,

evaluated as at the end of 9th year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854
The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)
=
Rs.18,854 x 0.424
=
Rs.7,994

26.

of

30 percent of the pension amount is

0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate
12% is 1%, the discounted value of an annuity of Rs.180 receivable at the end of
each month for 180 months (15 years) is:
Rs.180 x PVIFA (1%, 180)

Rs.180 x

(1.01)180 - 1
---------------- = Rs.14,998
.01 (1.01)180

If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%
P x (1.01)60 =
P x 1.817
=

27.

Rs.14,998
Rs.14,998
Rs.14,998
------------ = Rs.8254
1.817

Rs.300 x PVIFA(r, 24 months) = Rs.6,000

PVIFA (4%,24) =

Rs.6000 / Rs.300

From the tables we find that:

PVIFA(1%,24)
=
PVIFA (2%, 24)
=

= 20

21.244
18.914

Using a linear interpolation

r = 1% +

21.244 20.000
---------------------21.244 18,914

x 1%

= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)12 1 ] x 100 = 20%
28.

The discounted value of the debentures to be redeemed between 8 to 10 years

evaluated at the end of the 5th year is:
Rs.10 million x PVIF (8%, 3 years)
+ Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)

= Rs.10 million (0.794 + 0.735 + 0.681)

= Rs.2.21 million
If A is the annual deposit to be made in the sinking fund for the years 1 to 5, then
A x FVIFA (8%, 5 years) = Rs.2.21 million
A x 5.867 = Rs.2.21 million
A = 5.867 = Rs.2.21 million
A = Rs.2.21 million / 5.867 = Rs.0.377 million
29.

Let `n be the number of years for which a sum of Rs.20,000 can be withdrawn
annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 5.000
From the tables we find that
PVIFA (10%, 7 years) =
4.868
PVIFA (10%, 8 years) =
5.335
Thus n is between 7 and 8. Using a linear interpolation we get

n=7+

30.

5.000 4.868
----------------5.335 4.868

Equated annual installment

x 1 = 7.3 years

= 500000 / PVIFA(14%,4)
= 500000 / 2.914
= Rs.171,585

Loan Amortisation Schedule

Year
1
2
3
4

Beginning
amount

Annual
installment

500000
398415
282608
150588

171585
171585
171585
171585

Interest

Principal
repaid

Remaining
balance

70000
55778
39565
21082

101585
115807
132020
150503

398415
282608
150588
85*

(*) rounding off error

31.

Define n as the maturity period of the loan. The value of n can be obtained
from the equation.
200,000 x PVIFA(13%, n) =
1,500,000
PVIFA (13%, n)
=
7.500
From the tables or otherwise it can be verified that PVIFA(13,30) = 7.500
Hence the maturity period of the loan is 30 years.

32.

Expected value of iron ore mined during year 1

=
Rs.300 million
Expected present value of the iron ore that can be mined over the next 15 years
assuming a price escalation of 6% per annum in the price per tonne of iron

= Rs.300 million x

1 (1 + g)n / (1 + i)n
-----------------------i-g

= Rs.300 million x

1 (1.06)15 / (1.16)15
0.16 0.06

= Rs.300 million x (0.74135 / 0.10)

= Rs.2224 million

Chapter 8
INVESTMENT CRITERIA
1.(a)

NPV of the project at a discount rate of 14%.

100,000
200,000
- 1,000,000 + ---------- + -----------(1.14)
(1.14)2
300,000
600,000
300,000
+ ----------- + ---------- + ---------(1.14)3
(1.14)4
(1.14)5

=
(b)

- 44837

NPV of the project at time varying discount rates

=

- 1,000,000
100,000
+
(1.12)
200,000
+
(1.12) (1.13)
300,000
+
(1.12) (1.13) (1.14)
600,000
+
(1.12) (1.13) (1.14) (1.15)
300,000
+
(1.12) (1.13) (1.14)(1.15)(1.16)

=
=

- 1,000,000 + 89286 + 158028 + 207931 + 361620 + 155871

- 27264

2.

Investment A
a)
b)
c)

Payback period
NPV

=
5 years
=
40000 x PVIFA (12%,10) 200 000
=
26000
IRR (r ) can be obtained by solving the equation:
40000 x PVIFA (r, 10)
=
200000
i.e., PVIFA (r, 10)
=
5.000
From the PVIFA tables we find that
PVIFA (15%,10)
PVIFA (16%,10)

=
=

5.019
4.883

Linear interporation in this range yields

d)

r =
=

15 + 1 x (0.019 / 0.136)
15.14%

BCR

=
=
=

Benefit Cost Ratio

PVB / I
226,000 / 200,000 = 1.13

Investment B
a)

Payback period

b)

NP V =

40,000 x PVIFA (12%,5)

+ 30,000 x PVIFA (12%,2) x PVIF (12%,5)
+ 20,000 x PVIFA (12%,3) x PVIF (12%,7)
- 300,000

(40,000 x 3.605) + (30,000 x 1.690 x 0.567)

+ (20,000 x 2.402 x 0.452) 300,000
- 105339

=
c)

9 years

IRR (r ) can be obtained by solving the equation

40,000 x PVIFA (r, 5) + 30,000 x PVIFA (r, 2) x PVIF (r,5) +
20,000 x PVIFA (r, 3) x PVIF (r, 7) = 300,000
Through the process of trial and error we find that
r = 1.37%

d)

BCR

PVB / I

194,661 / 300,000

= 0.65

Investment C
a)

Payback period lies between 2 years and 3 years. Linear interpolation in

this range provides an approximate payback period of 2.88 years.

b)

NPV

+ 80,000 x PVIF (12%,5) + 60,000 x PVIF (12%,6)

+ 40,000 x PVIFA (12%,4) x PVIF (12%,6)
- 210,000
111,371

c)

80.000 x PVIF (12%,1) + 60,000 x PVIF (12%,2)

+ 80,000 x PVIF (12%,3) + 60,000 x PVIF (12%,4)

IRR (r) is obtained by solving the equation

80,000 x PVIF (r,1) + 60,000 x PVIF (r,2) + 80,000 x PVIF (r,3)
+ 60,000 x PVIF (r,4) + 80,000 x PVIF (r,5) + 60,000 x PVIF (r,6)
+ 40000 x PVIFA (r,4) x PVIF (r,6) = 210000
Through the process of trial and error we get
r = 29.29%

d)

BCR

PVB / I =

321,371 / 210,000

1.53

Investment D
a)

Payback period lies between 8 years and 9 years. A linear interpolation

in this range provides an approximate payback period of 8.5 years.
8 + (1 x 100,000 / 200,000)

b)

NPV

200,000 x PVIF (12%,1)

+ 20,000 x PVIF (12%,2) + 200,000 x PVIF (12%,9)
+ 50,000 x PVIF (12%,10)
- 320,000
- 37,160

c)

IRR (r ) can be obtained by solving the equation

200,000 x PVIF (r,1) + 200,000 x PVIF (r,2)
+ 200,000 x PVIF (r,9) + 50,000 x PVIF (r,10)
=
320000
Through the process of trial and error we get r = 8.45%

d)

BCR

PVB / I

282,840 / 320,000

0.88

Comparative Table
Investment
a) Payback period
(in years)

2.88

8.5

b) NPV @ 12%

26000

-105339

111371

-37160

c) IRR (%)

15.14

1.37

29.29

8.45

d) BCR

1.13

0.65

1.53

0.88

Among the four alternative investments, the investment to be chosen is C

because it has the
a. Lowest payback period
b. Highest NPV
c. Highest IRR
d. Highest BCR
3.

IRR (r) can be calculated by solving the following equations for the value of r.
60000 x PVIFA (r,7) =
300,000
i.e., PVIFA (r,7)
=
5.000
Through a process of trial and error it can be verified that r = 9.20% p.a.

4.

The IRR (r) for the given cashflow stream can be obtained by solving the
following equation for the value of r.
-3000 + 9000 / (1+r) 3000 / (1+r) = 0
Simplifying the above equation we get
r = 1.61, -0.61; (or) 161%, (-)61%
Note : Given two changes in the signs of cashflow, we get two values for the
IRR of the cashflow stream. In such cases, the IRR rule breaks down.

5.

Define NCF as the minimum constant annual net cashflow that justifies the
purchase of the given equipment. The value of NCF can be obtained from the
equation
NCF x PVIFA (10%,8)
=
500000
NCF
=
500000 / 5.335
=
93271

6.

Define I as the initial investment that is justified in relation to a net annual cash
inflow of 25000 for 10 years at a discount rate of 12% per annum. The value
of I can be obtained from the following equation

25000 x PVIFA (12%,10)

i.e., I
7.

8.

PV of benefits (PVB) =
+
+
+
+
=
Investment
=
Benefit cost ratio
=

=
=

I
141256

25000 x PVIF (15%,1)

40000 x PVIF (15%,2)
50000 x PVIF (15%,3)
40000 x PVIF (15%,4)
30000 x PVIF (15%,5)
122646
100,000
1.23 [= (A) / (B)]

(A)
(B)

The NPVs of the three projects are as follows:

Project
Discount rate
0%
5%
10%
15%
25%
30%

9.
(a)

400
223
69
- 66
- 291
- 386

500
251
40
- 142
- 435
- 555

R
600
312
70
- 135
- 461
- 591

NPV profiles for Projects P and Q for selected discount rates are as follows:
Project
Discount rate (%)
0
5
10
15
20

b)

(i)

2950
1876
1075
471
11

500
208
- 28
- 222
- 382

The IRR (r ) of project P can be obtained by solving the following

equation for `r.
-1000 -1200 x PVIF (r,1) 600 x PVIF (r,2) 250 x PVIF (r,3)
+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5)
=
0
Through a process of trial and error we find that r = 20.13%

(ii)

The IRR (r') of project Q can be obtained by solving the following

equation for r'
-1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5)
=
0
Through a process of trial and error we find that r' = 9.34%.

c)

From (a) we find that at a cost of capital of 10%

NPV (P)
=
1075
NPV (Q)
=
- 28
Given that NPV (P), NPV (Q) and NPV (P) > 0, I would choose project P.
From (a) we find that at a cost of capital of 20%
NPV (P)
=
11
NPV (Q)
=
- 382
Again NPV (P) > NPV (Q); and NPV (P) > 0. I would choose project P.

d)

Project P
PV of investment-related costs
=
1000 x PVIF (12%,0)
+ 1200 x PVIF (12%,1) + 600 x PVIF (12%,2)
+ 250 x PVIF (12%,3)
=
2728
TV of cash inflows =
2000 x (1.12) + 4000 =
6240
The MIRR of the project P is given by the equation:
2728 =
6240 x PVIF (MIRR,5)
(1 + MIRR)5 =
2.2874
MIRR = 18%

(c)

10.
(a)

Project Q
PV of investment-related costs
=
1600
TV of cash inflows @ 15% p.a.
=
2772
The MIRR of project Q is given by the equation:
16000 (1 + MIRR)5 =
2772
MIRR
=
11.62%
Project A
NPV at a cost of capital of 12%
=
- 100 + 25 x PVIFA (12%,6)
=
Rs.2.79 million
IRR (r ) can be obtained by solving the following equation for r.
25 x PVIFA (r,6)
=
100
i.e., r = 12,98%

Project B
NPV at a cost of capital of 12%
=
- 50 + 13 x PVIFA (12%,6)
=
Rs.3.45 million
IRR (r') can be obtained by solving the equation
13 x PVIFA (r',6)
=
50
i.e.,
r' = 14.40% [determined through a process of trial and error]
(b)

Difference in capital outlays between projects A and B is Rs.50 million

Difference in net annual cash flow between projects A and B is Rs.12 million.
NPV of the differential project at 12%
=
-50 + 12 x PVIFA (12%,6)
=
Rs.3.15 million
IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6) =
50
i.e.,
r''
=
11.53%

11.
(a)

Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period of 2.63 years.
Project N
The pay back period lies between 1 and 2 years. Interpolating in this range we
get an approximate pay back period of 1.55 years.

(b)

Project M
Cost of capital
PV of cash flows up to the end of year 2
PV of cash flows up to the end of year 3
PV of cash flows up to the end of year 4

=
=
=
=

12% p.a
24.97
47.75
71.26

Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in
this range we get an approximate DPB of 3.1 years.
Project N
Cost of capital
PV of cash flows up to the end of year 1
PV of cash flows up to the end of year 2

=
=
=

12% per annum

33.93
51.47

DPB lies between 1 and 2 years. Interpolating in this range we get an

approximate DPB of 1.92 years.

(c)

Project M
Cost of capital
NPV

=
=

=
Project N
Cost of capital
NPV

12% per annum

- 50 + 11 x PVIFA (12%,1)
+ 19 x PVIF (12%,2) + 32 x PVIF (12%,3)
+ 37 x PVIF (12%,4)
Rs.21.26 million

= 12% per annum

= Rs.20.63 million

Since the two projects are independent and the NPV of each project is (+) ve,
both the projects can be accepted. This assumes that there is no capital
constraint.
(d)

Project M
Cost of capital
NPV

= 10% per annum

= Rs.25.02 million

Project N
Cost of capital
NPV

= 10% per annum

= Rs.23.08 million

Since the two projects are mutually exclusive, we need to choose the project
with the higher NPV i.e., choose project M.
Note : The MIRR can also be used as a criterion of merit for choosing between
the two projects because their initial outlays are equal.
(e)

Project M
Cost of capital =
NPV
=

15% per annum

16.13 million

Project N
Cost of capital:
NPV
=

15% per annum

Rs.17.23 million

Again the two projects are mutually exclusive. So we choose the project with the
higher NPV, i.e., choose project N.
(f)

Project M
Terminal value of the cash inflows: 114.47
MIRR of the project is given by the equation
50 (1 + MIRR)4
=
114.47
i.e., MIRR = 23.01%

Project N
Terminal value of the cash inflows: 115.41
MIRR of the project is given by the equation
50 ( 1+ MIRR)4
=
115.41
i.e., MIRR
=
23.26%
12.

The internal rate of return is the value of r in the equation

2,000
8000 =

1,000
-

10,000
+

2,000
+

(1+r)
(1+r)2
(1+r)3
At r = 18%, the right hand side is equal to 8099
At r = 20%, the right hand side is equal to 7726
Thus the solving value of r is :
8,099 8,000
18% +
x 2% = 18.5%
8,099 7,726

Year

(1+r)4

Unrecovered Investment Balance

Unrecovered
Interest for the
Cash flow at the
investment balance at
year Ft-1 (1+r) end of the year CFt
the beginning Ft-1

1
2
3
4

-8000
-7480
-9863.8
-1688.60

-1480
-1383.8
-1824.80
-312.39

2000
-1000
10000
2000

13.

Unrecovered
investment balance at
the end of the year Ft-1
(1+r) + CFt
-7480
-9863.8
-1688.60
0

Rs. in lakhs
Year
Investment
Depreciation
Income before
interest and tax
Interest
Income before tax
Tax
Income after tax

1
24.0
3.0
6.0

2
21.0
3.0
6.5

3
18.0
3.0
7.0

4
15.0
3.0
7.0

5
12.0
3.0
7.0

6
9.0
3.0
6.5

7
6.0
3.0
6.0

8
3.0
3.0
5.0

Sum
108
24.0
51.0

Average
13.500
3.000
6.375

2.5
3.5
3.5

2.5
4.0
1.0
3.0

2.5
4.5
2.5
2.0

2.5
4.5
2.5
2.0

2.5
4.5
2.5
2.0

2.5
4.0
2.2
1.8

2.5
3.5
1.9
1.6

2.5
2.5
1.4
1.1

20.0
31.0
14.0
17.0

2.500
3.875
1.750
2.125

Measures of Accounting Rate of Return

A.

Average income after tax

2.125
=

Initial investment

= 8.9%
24

B.

Average income after tax

2.125
=

Average investment
C.

= 15.7%
13.5

Average income after tax but before interest

2.125 + 2.5
=

= 19.3%

Initial investment
D.

24

Average income after tax but before interest

2.125 + 2.5
=

= 34.3%

Average investment

E.

13.5

Average income before interest and taxes

6.375
=

Initial investment
F.

= 26.6%
24

Average income before interest and taxes

6.375
=

Average investment
G.

= 47.2%
13.5

Total income after tax but before

Depreciation Initial investment

17.0 + 24.0 24.0

=

(Initial investment / 2) x Years

(24 / 2) x 8
= 17.0 / 96.0 = 17.7%

Chapter 9
PROJECT CASH FLOWS
1.
(a)

Project Cash Flows

Year

1. Plant & machinery

(150)

(Rs. in million)

3. Revenues

250

250

250

250

250

250

250

4. Costs (excluding depreciation & interest)

100

100

100

100

100

100

100

5. Depreciation

37.5

28.13 21.09 15.82 11.87 8.90

6.67

6. Profit before tax

112.5 121.87 128.91 134.18 138.13 141.1 143.33

7. Tax

33.75 36.56 38.67 40.25 41.44 42.33 43.0

8. Profit after tax

78.75 85.31 90.24 93.93 96.69 98.77 100.33

2. Working capital

(50)

9. Net salvage value of

plant & machinery

48

10. Recovery of working

capital
11. Initial outlay (=1+2)
12. Operating CF (= 8 + 5)
107.00
13. Terminal CF ( = 9 +10)

50

(200)
116.25 113.44 111.33 109.75 108.56 107.67

98

14.

NCF

(200) 116.25 113.44 111.33 109.75 108.56 107.67 205

(c)

IRR (r) of the project can be obtained by solving the following equation for r

-200 + 116.25 x PVIF (r,1) + 113.44 x PVIF (r,2)

+ 111.33 x PVIF (r,3) + 109.75 x PVIF (r,4) + 108.56 x PVIF (r,5)
+107.67 x PVIF (r,6) + 205 x PVIF (r,7)
=
0
Through a process of trial and error, we get r = 55.17%. The IRR of the
project is 55.17%.
2.

Post-tax Incremental Cash Flows

Year

(Rs. in million)
4

1. Capital equipment
(120)
2. Level of working capital
20
30
40
50
40
30
20
(ending)
3. Revenues
80
120
160
200
160
120
80
4. Raw material cost
24
36
48
60
48
36
24
5. Variable mfg cost.
8
12
16
20
16
12
8
6. Fixed operating & maint.
10
10
10
10
10
10
10
cost
7. Variable selling expenses
8
12
16
20
16
12
8
8. Incremental overheads
4
6
8
10
8
6
4
9. Loss of contribution
10
10
10
10
10
10
10
10.Bad debt loss
4
11. Depreciation
30
22.5 16.88 12.66 9.49 7.12 5.34
12. Profit before tax
-14
11.5 35.12 57.34 42.51 26.88 6.66
13. Tax
- 4.2
3.45 10.54 17.20 12.75 8.06 2.00
14. Profit after tax
- 9.8
8.05 24.58 40.14 29.76 18.82 4.66
15. Net salvage value of
capital equipments
25
16. Recovery of working
16
capital
17. Initial investment
(120)
18. Operating cash flow
20.2
30.55 41.46 52.80 39.25 25.94 14.00
(14 + 10+ 11)
19. Working capital
20 10
10
10
(10) (10) (10)
20. Terminal cash flow
41
21. Net cash flow
(17+18-19+20)

(b)

(140) 10.20

20.55 31.46 62.80 49.25 35.94 55.00

NPV of the net cash flow stream @ 15% per discount rate
=

-140 + 10.20 x PVIF(15%,1) + 20.55 x PVIF (15%,2)

+ 31.46 x PVIF (15%,3) + 62.80 x PVIF (15%,4) + 49.25 x PVIF

(15%,5)
+ 35.94 x PVIF (15%,6) + 55 x PVIF (15%,7)

3.
(a)

Rs.1.70 million

A.

Initial outlay (Time 0)

i.
ii.
iii
iv.

B.

Cost of new machine

Salvage value of old machine
Incremental working capital requirement
Total net investment (=i ii + iii)

Rs.

3,000,000
900,000
500,000
2,600,000

Operating cash flow (years 1 through 5)

Year

i. Post-tax savings in
manufacturing costs 455,000

455,000

455,000

455,000

455,000

ii. Incremental
depreciation

550,000

412,500

309,375

232,031

174,023

iii. Tax shield on

incremental dep.

165,000

123,750

92,813

69,609

52,207

iv. Operating cash

flow ( i + iii)

620,000

578,750

547,813

524,609

507,207

C.

Terminal cash flow (year 5)

i.
ii.
iii.
iv.

D.
Year
NCF

Salvage value of new machine

Salvage value of old machine
Recovery of incremental working capital
Terminal cash flow ( i ii + iii)

Rs.

1,500,000
200,000
500,000
1,800,000

Net cash flows associated with the replacement project (in Rs)
0
(2,600,000)

620000

578750

547813

524609

5
307207

(b)

NPV of the replacement project

=

4.

- 2600000 + 620000 x PVIF (14%,1)

+ 578750 x PVIF (14%,2)
+ 547813 x PVIF (14%,3)
+ 524609 x PVIF (14%,4)
+ 2307207 x PVIF (14%,5)
=
Rs.267849

Tax shield (savings) on depreciation (in Rs)

Year

Depreciation
charge (DC)

Tax shield
=0.4 x DC

PV of tax shield
@ 15% p.a.

25000

10000

8696

18750

7500

5671

14063

5625

3699

10547

4219

2412

7910

3164

1573
-------22051
--------

Present value of the tax savings on account of depreciation = Rs.22051

5.

A.

Initial outlay (at time 0)

i.
ii.
iii.

B.

Cost of new machine

Salvage value of the old machine
Net investment

Operating cash flow (years 1 through 5)

Rs.

400,000
90,000
310,000

Year

i. Depreciation
of old machine

18000

14400

11520

9216

7373

ii. Depreciation
of new machine

100000

75000

56250

42188

31641

iii. Incremental depreciation ( ii i)

82000

60600

44730

32972

24268

iv. Tax savings on incremental depreciation

( 0.35 x (iii))
28700

21210

15656

11540

8494

v. Operating cash flow

21210

15656

11540

8494

C.

Terminal cash flow (year 5)

i.
ii.
iii.

D.
Year
NCF

28700

Salvage value of new machine

Salvage value of old machine
Incremental salvage value of new
machine = Terminal cash flow

Rs.

15000

Net cash flows associated with the replacement proposal.

0
(310000)

1
28700

21210

15656

25000
10000

4
11540

5
23494

6.

Net Cash Flows Relating to Equity

(Rs. in million)

Particulars
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.

Equity funds
Revenues
Operating costs
Depreciation
Interest on working capital
advance
Interest on term loan
Profit before tax
Tax
Profit after tax
Preference dividend
Net salvage value of fixed assets
Net salvage value of current
assets
Repayment of term-loans
Redemption of preference capital
Repayment of short-term bank
borrowings
Retirement of trade creditors
Initial investment (1)
Operating cash flows (9-10+4)
Liquidation and retirement cash
flows (11+12-13-14-15-16)
Net cash flows (17+18+19)

Year
0
(100)

500
320
83.33
18.00

500
320
55.56
18.00

500
320
37.04
18.00

30.00
48.67
24.335
24.335

28.50
77.94
38.97
38.97

22.50
102.46
51.23
51.23

40

40

7.
8.
9.
10.
11.
12.
13.
14.
15.
16.

Fixed assets
Working capital margin
Revenues
Operating costs
Depreciation
Interest on working capital
advance
Interest on term loan
Profit before tax
Tax @ 50%
Profit after tax
Net salvage value of fixed assets
Net recovery of working capital
margin
Initial investment (1+2)
Operating cash inflow (9+5+7
(1-T) )
Terminal cash flow (11+12)
Net cash flow (13+14+15)

500
320
24.69
18.00
16.50
120.81
60.405
60.405

40

5
500
320
16.46
18.00
10.50
135.04
67.52
67.52

40

6
500
320
10.97
18.00
4.50
146.53
73.265
73.265
200
40

100
50
(100)

(100)

107.665
107.665

94.53
54.53

88.27
48.27

85.095
45.095

83.98
43.98

84.235
90

107.665

54.53

48.27

45.095

43.98

174.235

Net Cash Flows Relating to Long-term Funds

Particulars
Year
1.
2.
3.
4.
5.
6.

0
(250)
(50)

500
320
83.33
18.00

(Rs. in million)
4

500
320
24.69
18.00

500
320
16.46
18.00

500
320
10.97
18.00

500
320
55.56
18.00

500
320
37.04
18.00

30.00
48.67
24.335
24.335

28.50
77.94
38.97
38.97

22.50
102.46
51.23
51.23

16.50
120.81
60.405
60.405

10.50
135.04
67.52
67.52

4.50
146.53
73.265
73.265
80
50

122.665

108.78

99.52

93.345

89.23

86.845

122.665

108.78

99.52

93.345

89.23

130.00
216.485

(300)

(300)

Cash Flows Relating to Total Funds

(Rs. in million)
Year
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.

Total funds
Revenues
Operating costs
Depreciation
Interest on term loan
Interest on working capital
advance
Profit before tax
Tax
Profit after tax
Net salvalue of fixed assets
Net salvage value of current assets
Initial investment (1)
Operating cash inflow 9+4+6 (1-t)
+ 5(1-t)
Terminal cash flow (10+11)
Net cash flow (12+13+14)

0
(450)

500
320
83.33
30.00
18.00

500
320
55.56
28.50
18.00

500
320
37.04
22.50
18.00

500
320
24.69
16.50
18.00

500
320
16.46
10.50
18.00

500
320
10.97
4.50
18.00

48.67
24.34
24.34

77.94
38.97
38.97

102.46
51.23
51.23

120.81
60.41
60.41

135.04
67.52
67.52

146.53
73.265
73.265
80
200

131.67

117.78

108.52

102.35

98.23

95.485

131.67

117.78

108.52

102.35

98.23

280
375.485

(450)

(450)

Chapter 10
THE COST OF CAPITAL
1(a)

Define rD as the pre-tax cost of debt. Using the approximate yield formula, rD
can be calculated as follows:

rD

(b) After tax cost =

2.

WACC

9 + (100 92)/6
-------------------0.4 x100 + 0.6x92

0.1085 (or) 10.85%

0.4 x 13% x (1 0.35)

+ 0.6 x 18%
14.18%

=
4.

5.

12.60 x (1 0.35) = 8.19%

Define rp as the cost of preference capital. Using the approximate yield formula
rp can be calculated as follows:
rp

3.

14 + (100 108)/10
------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108

Cost of equity
=
(using SML equation)
Pre-tax cost of debt =
After-tax cost of debt =
Debt equity ratio
=
WACC
=
=

10% + 1.2 x 7% = 18.4%

14%
14% x (1 0.35) = 9.1%
2:3
2/5 x 9.1% + 3/5 x 18.4%
14.68%

Given
0.5 x 14% x (1 0.35) + 0.5 x rE = 12%
where rE is the cost of equity capital.
Therefore rE 14.9%
Using the SML equation we get
11% + 8% x = 14.9%
where denotes the beta of Azeezs equity.
Solving this equation we get = 0.4875.

(a) The cost of debt of 12% represents the historical interest rate at the time the debt
was originally issued. But we need to calculate the marginal cost of debt (cost
of raising new debt); and for this purpose we need to calculate the yield to
maturity of the debt as on the balance sheet date. The yield to maturity will not
be equal to 12% unless the book value of debt is equal to the market value of
debt on the balance sheet date.
(b) The cost of equity has been taken as D1/P0 ( = 6/100) whereas the cost of equity
is (D1/P0) + g where g represents the expected constant growth rate in dividend
per share.

7.

The book value and market values of the different sources of finance are
provided in the following table. The book value weights and the market value
weights are provided within parenthesis in the table.

Source
Equity
Debentures first series
Debentures second series
Bank loan
Total

Book value
800 (0.54)
300 (0.20)
200 (0.13)
200 (0.13)
1500 (1.00)

(Rs. in million)
Market value
2400 (0.78)
270 (0.09)
204 (0.06)
200 (0.07)
3074 (1.00)

8.

9.

(a)

Given
rD x (1 0.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pre-tax cost of debt.

(b)

Given
13% x (1 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.

Cost of equity =
D1/P0 + g
=
3.00 / 30.00 + 0.05
=
15%
(a) The first chunk of financing will comprise of Rs.5 million of retained
earnings costing 15 percent and Rs.25 million of debt costing 14 (1-.3) = 9.8
percent.
The second chunk of financing will comprise of Rs.5 million of additional
equity costing 15 percent and Rs.2.5 million of debt costing 15 (1-.3) = 10.5
percent.

(b) The marginal cost of capital in the first chunk will be :

5/7.5 x 15% + 2.5/7.5 x 9.8% = 13.27%
The marginal cost of capital in the second chunk will be
5/7.5 x 15% + 2.5/7.5 x 10.5% = 13.50%

Note : We have assumed that

(i) The net realisation per share will be Rs.25, after floatation costs, and
(ii) The planned investment of Rs.15 million is inclusive of floatation costs
10.

The cost of equity and retained earnings

rE
=
D1/PO + g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :
11 + (100-75)/10
rE
=
= 15.9%
0.6x75 + 0.4x100
The pre-tax cost of debentures, using the approximate formula, is :
13.5 + (100-80)/6
rD
=
= 19.1%
0.6x80 + 0.4x100
The post-tax cost of debentures is
19.1 (1-tax rate) = 19.1 (1 0.5)
= 9.6%
The post-tax cost of term loans is
12 (1-tax rate) = 12 (1 0.5)
= 6.0%
The average cost of capital using book value proportions is calculated below:
Source of capital

Equity capital
Preference capital
Retained earnings
Debentures
Term loans

Component Book value

Book value
cost
Rs. in million proportion
(1)
(2)
(3)
14.5%
100
0.28
15.9%
10
0.03
14.5%
120
0.33
9.6%
50
0.14
6.0%
80
0.22
360
Average cost
capital

Product of
(1) & (3)
4.06
0.48
4.79
1.34
1.32
11.99%

The average cost of capital using market value proportions is calculated below :

Source of capital

Equity capital
and retained earnings
Preference capital
Debentures
Term loans

Component
cost
(1)

Market value Market value Product of

Rs. in million
(2)
(3)
(1) & (3)

14.5%
15.9%
9.6%
6.0%

200
7.5
40
80
327.5

11.
(a)

WACC

=
=

0.62
0.02
0.12
0.24
Average cost
capital

1/3 x 13% x (1 0.3)

+ 2/3 x 20%
16.37%

(b)

Weighted average floatation cost

= 1/3 x 3% + 2/3 x 12%
= 9%

(c)

NPV of the proposal after taking into account the floatation costs
=
130 x PVIFA (16.37%, 8) 500 / (1 - 0.09)
=
Rs.8.51 million

8.99
0.32
1.15
1.44
11.90%

Chapter 11
RISK ANALYSIS OF SINGLE INVESTMENTS
1.
(a)

NPV of the project

(b)

NPVs under alternative scenarios:

=
=

-250 + 50 x PVIFA (13%,10)

Rs.21.31 million

Pessimistic

(Rs. in million)
Expected
Optimistic

Investment
Sales
Variable costs
Fixed costs
Depreciation
Pretax profit
Tax @ 28.57%
Profit after tax
Net cash flow
Cost of capital

300
150
97.5
30
30
- 7.5
- 2.14
- 5.36
24.64
14%

250
200
120
20
25
35
10
25
50
13%

200
275
154
15
20
86
24.57
61.43
81.43
12%

NPV

- 171.47

21.31

260.10

Assumptions: (1)

The useful life is assumed to be 10 years under all three

scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.

(2)

The investment is assumed to be depreciated at 10% per

annum; and it is also assumed that this method and rate of
depreciation are acceptable to the IT (income tax)
authorities.

(3)

The tax rate has been calculated from the given table i.e.
10 / 35 x 100 = 28.57%.

(4)

It is assumed that only loss on this project can be offset

against the taxable profit on other projects of the
company; and thus the company can claim a tax shield on
the loss in the same year.

(c)

2.
(a)

Accounting break even point (under expected scenario)

Fixed costs + depreciation
= Rs. 45 million
Contribution margin ratio
= 60 / 200 = 0.3
Break even level of sales
= 45 / 0.3 = Rs.150 million
Financial break even point (under expected scenario)
i.

Annual net cash flow

= 0.7143 [ 0.3 x sales 45 ] + 25

= 0.2143 sales 7.14

ii.

PV (net cash flows)

= [0.2143 sales 7.14 ] x PVIFA (13%,10)

= 1.1628 sales 38.74

iii.

Initial investment

= 200

iv.

Financial break even level

of sales

= 238.74 / 1.1628

Sensitivity of NPV with respect to quantity manufactured and sold:

(in Rs)
Pessimistic
Expected
Optimistic
Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV at a cost of
capital of 10% p.a
and useful life of
5 years

(b)

= Rs.205.31 million

30000
24000
16000
3000
2000
3000
1500
1500
3500

30000
42000
28000
3000
2000
9000
4500
4500
6500

30000
54000
36000
3000
2000
13000
6500
6500
8500

-16732

- 5360

2222

Sensitivity of NPV with respect to variations in unit price.

Initial investment
Sale revenue
Variable costs
Fixed costs

Pessimistic

Expected

Optimistic

30000
28000
28000
3000

30000
42000
28000
3000

30000
70000
28000
3000

Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV
(c)

2000
9000
4500
4500
6500
(-) 5360

2000
37000
18500
18500
20500
47711

Sensitivity of NPV with respect to variations in unit variable cost.

Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV
(d)

2000
-5000
-2500
-2500
- 500
- 31895

Pessimistic

Expected

Optimistic

30000
42000
56000
3000
2000
-11000
-5500
-5500
-3500
-43268

30000
42000
28000
3000
2000
9000
4500
4500
6500
- 5360

30000
42000
21000
3000
2000
16000
8000
8000
10000
7908

Accounting break-even point

i.
ii.
iii.

Fixed costs + depreciation

Contribution margin ratio
Break-even level of sales

= Rs.5000
= 10 / 30 = 0.3333
= 5000 / 0.3333
= Rs.15000

Financial break-even point

2.

i.
ii.

Annual cash flow

PV of annual cash flow

iii.
iv.

Initial investment
Break-even level of sales

= 0.5 x (0.3333 Sales 5000) = 2000

= (i) x PVIFA (10%,5)
= 0.6318 sales 1896
= 30000
= 31896 / 0.6318 = Rs.50484

Define At as the random variable denoting net cash flow in year t.

A1

=
=

4 x 0.4 + 5 x 0.5 + 6 x 0.1

4.7

A2

=
=

5 x 0.4 + 6 x 0.4 + 7 x 0.2

5.8

A3

=
=

3 x 0.3 + 4 x 0.5 + 5 x 0.2

3.9

NPV
12

=
=
=

4.7 / 1.1 +5.8 / (1.1)2 + 3.9 / (1.1)3 10

Rs.2.00 million
0.41

22
32

=
=

0.56
0.49

NPV =

12

22
+

(1.1)2

32
+

(1.1)4

(1.1)6

=
1.00
(NPV) = Rs.1.00 million
3.

Expected NPV
4
At
=
- 25,000
t=1 (1.08)t
=

12,000/(1.08) + 10,000 / (1.08)2 + 9,000 / (1.08)3

+ 8,000 / (1.08)4 25,000

[ 12,000 x .926 + 10,000 x .857 + 9,000 x .794 + 8,000 x .735]

- 25,000
7,708

Standard deviation of NPV

4
t

t=1 (1.08)t
=
=
=
4.

5,000 / (1.08) + 6,000 / (1.08)2 + 5,000 / (1,08)3 + 6,000 / (1.08)4

5,000 x .926 + 6,000 x .857 + 5000 x .794 + 6,000 x .735
18,152

Expected NPV
4
At
=
- 25,000
t=1 (1.06)t

. (1)

A1

=
=

2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3

3,100

A2

=
=

3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3

3,900

A3

=
=

4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2

4,900

A4

=
2,000 x 0.2 + 3,000 x 0.4 + 4,000 x 0.4
=
3,200
Substituting these values in (1) we get
Expected NPV = NPV
=

3,100 / (1.06)+ 3,900 / (1.06)2 + 4,900 / (1.06)3 + 3,200 / (1,06)4

- 10,000 = Rs.3,044

The variance of NPV is given by the expression

4 2t
2
(NPV) =
t=1 (1.06)2t
12

=
=

22

=
=

32

=
=

42

=
=

.. (2)

[(2,000 3,100)2 x 0.2 + (3,000 3,100)2 x 0.5

+ (4,000 3,100)2 x 0.3]
490,000
[(3,000 3,900)2 x 0.4 + (4,000 3,900)2 x 0.3
+ (5,000 3900)2 x 0.3]
690,000
[(4,000 4,900)2 x 0.3 + (5,000 4,900)2 x 0.5
+ (6,000 4,900)2 x 0.2]
490,000
[(2,000 3,200)2 x 0.2 + (3,000 3,200)2 x 0.4
+ (4,000 3200)2 x 0.4]
560,000

Substituting these values in (2) we get

490,000 / (1.06)2 + 690,000 / (1.06)4
+ 490,000 / (1.06)6 + 560,000 / (1.08)8
[ 490,000 x 0.890 + 690,000 x 0.792

+ 490,000 x 0.705 + 560,000 x 0.627 ]

= 1,679,150
NPV = 1,679,150 = Rs.1,296
NPV NPV
Prob (NPV < 0) = Prob.

0 - NPV
<

NPV

NPV

0 3044
= Prob Z <
1296
= Prob (Z < -2.35)
The required probability is given by the shaded area in the following normal
curve.
P (Z < - 2.35) =
=
=
=

0.5 P (-2.35 < Z < 0)

0.5 P (0 < Z < 2.35)
0.5 0.4906
0.0094

So the probability of NPV being negative is 0.0094

Prob (P1 > 1.2)

Prob (PV / I > 1.2)

Prob (NPV / I > 0.2)
Prob. (NPV > 0.2 x 10,000)
Prob (NPV > 2,000)

Prob (NPV >2,000)= Prob (Z > 2,000- 3,044 / 1,296)

Prob (Z > - 0.81)
The required probability is given by the shaded area of the following normal
curve:
P(Z > - 0.81) =
0.5 + P(-0.81 < Z < 0)
=
0.5 + P(0 < Z < 0.81)
=
0.5 + 0.2910
=
0.7910
So the probability of P1 > 1.2 as 0.7910
5.

Given values of variables other than Q, P and V, the net present value model of
Bidhan Corporation can be expressed as:

5
[Q(P V) 3,000 2,000] (0.5)+ 2,000
0
t=1
NPV = ---------------------------------------------------------- + ------- - 30,000
(1.1)t
(1.1)5
5
0.5 Q (P V) 500
t=1
=
------------------------------------ - 30,000
(1.1)t
[ 0.5Q (P V) 500] x PVIFA (10,5) 30,000
[0.5Q (P V) 500] x 3.791 30,000
1.8955Q (P V) 31,895.5

=
=
=

Exhibit 1 presents the correspondence between the values of exogenous

variables and the two digit random number. Exhibit 2 shows the results of the
simulation.
Exhibit 1
Correspondence between values of exogenous variables and
two digit random numbers
QUANTITY

Value

Prob

Cumulative
Prob.

800
1,000
1,200
1,400
1,600
1,800

0.10
0.10
0.20
0.30
0.20
0.10

0.10
0.20
0.40
0.70
0.90
1.00

PRICE
Two digit
random
numbers
00 to 09
10 to 19
20 to 39
40 to 69
70 to 89
90 to 99

Value

Prob

Cumulative
Prob.

20
30
40
50

0.40
0.40
0.10
0.10

0.40
0.80
0.90
1.00

VARIABLE COST
Two digit
random
numbers
00 to 39
40 to 79
80 to 89
90 to 99

Value

Prob

15
20
40

0.30
0.50
0.20

Cumulative
Prob.
0.30
0.80
1.00

Two digit
random
numbers
00 to 29
30 to 79
80 to 99

Exhibit 2
Simulation Results
Run

1
2
3
4
5
6
7
8
9
Run

10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
Run

QUANTITY (Q)
Random
CorresNumber
ponding
Value
03
800
32
1,200
61
1,400
48
1,400
32
1,200
31
1,200
22
1,200
46
1,400
57
1,400
QUANTITY (Q)
Random
CorresNumber
ponding
Value
92
1,800
25
1,200
64
1,400
14
1,000
05
800
07
800
34
1,200
79
1,600
55
1,400
57
1,400
53
1,400
36
1,200
32
1,200
49
1,400
21
1,200
08
.800
85
1,600
61
1,400
25
1,200
51
1,400
32
1,200
52
1,400
76
1,600
43
1,400
70
1,600
67
1,400
26
1,200
QUANTITY (Q)
Random
Corres-

PRICE (P)
Random
CorresNumber
ponding
value
38
20
69
30
30
20
60
30
19
20
88
40
78
30
11
20
20
20
PRICE (P)
Random
CorresNumber
ponding
value
77
30
65
30
04
20
51
30
39
20
90
50
63
30
91
50
54
30
12
20
78
30
79
30
22
20
93
50
84
40
70
30
63
30
68
30
81
40
76
30
47
30
61
30
18
20
04
20
11
20
35
20
63
30
PRICE (P)
Random
Corres-

VARIABLE COST (V)

Random
CorresNumber
ponding
value
17
15
24
15
03
15
83
40
11
15
30
20
41
20
52
20
15
15
VARIABLE COST (V)
Random
CorresNumber
ponding
value
38
20
36
20
83
40
72
20
81
40
40
20
67
20
99
40
64
20
19
15
22
15
96
40
75
20
88
40
35
20
27
15
69
20
16
15
39
20
38
20
46
20
58
20
41
20
49
20
59
20
26
15
22
15
VARIABLE COST (V)
Random
Corres-

NPV
1.8955 Q(P-V)-31,895.5

-24,314
2,224
-18,627
-58,433
-20,523
13,597
-9,150
-31,896
-18,627
NPV
1.8955 Q(P-V)-31,895.5

2,224
-9,150
-84,970
-12,941
-62,224
13,597
-9,150
-1,568
-5,359
-18,627
7,910
-54,642
-31,896
-5,359
13,597
-9,150
-1,568
7,910
13,597
-5,359
-9,150
-5,359
-31,896
-31,896
-31,896
-18,627
2,224
NPV
1.8955 Q(P-V)-31,895.5

Number
37
38
39
40
41
42
43
44
45
46
47
48
49
50

ponding
Value
1,600
1,800
.800
1,400
1,800
1,000
1,200
1,600
1,400
1,000
1,200
1,400
1,600
1,800

89
94
09
44
98
10
38
83
54
16
20
61
82
90

Expected NPV

Number
86
00
15
84
23
53
44
30
71
70
65
61
48
50

=
=
=
=

Variance of NPV

Number
59
25
29
21
79
77
31
10
52
19
87
70
97
43

ponding
value
20
15
15
15
20
20
20
15
20
15
40
20
40
20

28,761
-14,836
-24,314
34,447
-31,896
-12,941
-9,150
-16,732
-5,359
-3,463
-54,642
-5,359
-62,224
2,224

NPV
50
1/ 50 NPVi
i=1
1/50 (-7,20,961)
14,419
50
NPVi NPV)2
i=1

1/50

1/50 [27,474.047 x 106]

=
549.481 x 106

Standard deviation of NPV

6.

ponding
value
40
20
20
40
20
30
30
20
30
30
30
30
30
30

=
=

549.481 x 106
23,441

To carry out a sensitivity analysis, we have to define the range and the most
likely values of the variables in the NPV Model. These values are defined
below
Variable
I
k
F
D
T
N

Range
Rs.30,000 Rs.30,000
10% - 10%
Rs.3,000 Rs.3,000
Rs.2,000 Rs.2,000
0.5 0.5
55

Most likely value

Rs.30,000
10%
Rs.3,000
Rs.2,000
0.5
5

00
0
Can assume any one of the values 1,400*
800, 1,000, 1,200, 1,400, 1,600 and 1,800
P
Can assume any of the values 20, 30,
30**
40 and 50
V
Can assume any one of the values
20*
15,20 and 40
---------------------------------------------------------------------------------------* The most likely values in the case of Q, P and V are the values that
have the highest probability associated with them
S
Q

** In the case of price, 20 and 30 have the same probability of

occurrence viz., 0.4. We have chosen 30 as the most likely value
because the expected value of the distribution is closer to 30
Sensitivity Analysis with Reference to Q
The relationship between Q and NPV given the most likely values of other
variables is given by
5
[Q (30-20) 3,000 2,000] x 0.5 + 2,000
0
NPV =
+
- 30,000
t
t=1
(1.1)
(1.1)5

t=1

5Q - 500
- 30,000
t

(1.1)

The net present values for various values of Q are given in the following table:
Q
NPV

800
-16,732

1,000
-12,941

1,200
-9,150

1,400
-5,359

1,600
-1,568

1,800
2,224

Sensitivity analysis with reference to P

The relationship between P and NPV, given the most likely values of other
variables is defined as follows:

NPV

[1,400 (P-20) 3,000 2,000] x 0.5 + 2,000

0
+

t=1

(1.1)

- 30,000
(1.1)5

700 P 14,500

5
=
t=1

- 30,000
(1.1)t

The net present values for various values of P are given below :
P (Rs)
20
30
40
50
NPV(Rs)
-31,896
-5,359
21,179
47,716
8.

NPV
-5
(Rs.in lakhs)
PI
0.9

10

15

20

1.00

1.10

1.20

1.30

1.40

Prob.

0.03

0.10

0.40

0.30

0.15

0.02

6
Expected PI = PI = (PI)j P j
j=1
=
1.24
6
Standard deviation =
(PIj - PI) 2 P j
o f P1
j=1
= .01156
= .1075
The standard deviation of P1 is .1075 for the given investment with an expected
PI of 1.24. The maximum standard deviation of PI acceptable to the company
for an investment with an expected PI of 1.25 is 0.30.
Since the risk associated with the investment is much less than the maximum
risk acceptable to the company for the given level of expected PI, the company
should accept the investment.
9.

Investment A
Outlay
: Rs.10,000
Net cash flow
: Rs.3,000 for 6 years
Required rate of return
: 12%
NPV(A)

= 3,000 x PVIFA (12%, 6 years) 10,000

= 3,000 x 4.11 10,000 = Rs.2,333

Investment B
Outlay
: Rs.30,000
Net cash flow
: Rs.11,000 for 5 years
Required rate of return
: 14%

NPV(B)

10.

= 11,000 x PVIFA (14%, 5 years) 30,000

= Rs.7763

The NPVs of the two projects calculated at their risk adjusted discount rates are
as follows:
6
3,000
Project A:
NPV =

- 10,000 = Rs.2,333
t
t=1
(1.12)

Project B:

NPV

t=1

11,000
- 30,000 = Rs.7,763
t

(1.14)

PI and IRR for the two projects are as follows:

Project

PI
IRR

1.23
20%

1.26
24.3%

B is superior to A in terms of NPV, PI, and IRR. Hence the company must
choose B.

Chapter 12
RISK ANALYSIS OF SINGLE INVESTMENTS
2p = wi wj ij i j
2 p = w2121 + w2222 + w2323 + w2424 + w2525
+ 2 w1 w2 12 12 + 2 w1 w3 13 13 + 2 w1 w4 14 14 + 2 w1 w5 15
15 + 2 w2 w3 23 23 + 2 w2 w4 24 24 + 2 w2 w5 25 25 + 2 w3 w4
34 34 + 2 w3 w5 35 35 + 2 w4 w5 45 45

1.

= 0.12 x 82 + 0.22 x 92 + 0.32 x 102 + 0.32 x 162 + 0.12 x 122

+ 2 x 0.1 x 0.2 x 0.1 x 8 x 9 + 2 x 0.1 x 0.3 x 0.5 x 8 x 10
+ 2 x 0.1 x 0.3 x 0.2 x 8 x 16 + 2 x 0.1 x 0.1 x 0.3 x 8 x 12
+ 2 x 0.2 x 0.3 x 0.4 x 9 x 10 + 2 x 0.2 x 0.3 x 0.8 x 9 x 16
+ 2 x 0.2 x 0.1 x 0.2 x 9 x 12 + 2 x 0.3 x 0.3 x0.1 x 10 x 16
+ 2 x 0.3 x 0.1 x 0.6 x 10 x 12 + 2 x 0.3 x 0.1 x 0.1 x 16 x 12
= 66.448
p = (66.448)1/2 = 8.152
2.

(i) Since there are 3 securities, there are 3 variance terms and 3 covariance
terms. Note that if there are n securities the number of covariance terms are: 1 +
2 ++ (n + 1) = n (n 1)/2. In this problem all the variance terms are the same
(2A) all the covariance terms are the same (AB) and all the securities are
equally weighted (wA)
So,

2p = [3 w2A 2A + 2 x 3 AB]
2p = [3 w2A 2A + 6 wA wBAB]
1 2
1
1
=3x
x 2A + 6 x
x
x AB
3
3
3
1
2
=
2A +
AB
3
3
(ii) Since there are 9 securities, there are 9 variance terms and 36 covariance
terms. Note that if the number of securities is n, the number of covariance
terms is n(n 1)/2.
In this case all the variance terms are the same (2A), all the covariance terms are
1
the same (AB) and all the securities are equally weighted wA
9

So,

n(n-1)
p= 9 w A
2

wA wBAB

t 2x
2

1 2
1
1
2
= 9 x x A + 9(8) x x AB
9
9
9
1
72
=
2A +
AB
9
81
3. The beta for stock B is calculated below:
Period Return of Return on Deviation of
stock B,
market
return on
RB (%)
portfolio, stock B from
RM (%)
its mean
(RB - RB)

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

15
9
16
12
10
6
-15
4
-5
16
14
11
10
10
15
12
12
9
-4
8
-2
12
12
14
15
-6
12
2
10
8
9
7
12
9
9
10
22
37
13
10
180
200
RB = 180 RM = 200
RB = 9%
RM = 10%

6
7
1
-24
-14
5
1
6
3
-13
-11
3
6
3
1
0
3
0
13
4

Deviation
of return
on market
portfolio
from its
mean
(RM RM)

Product of
the
deviation
(RB RB)
(RM RM)

-1
2
-4
-6
6
1
0
2
-1
-2
2
4
-16
-8
-2
-3
-1
0
27
0

-6
14
-4
144
-84
5
0
12
-3
26
-22
12
-96
-24
-2
0
-3
0
351
0
(RB RB)
(RM RM)
= 320

Square of
the
deviation
of return
on market
portfolio,
from its
mean
(RM RM)2
1
4
16
36
36
1
0
4
1
4
4
16
256
64
4
9
1
0
729
0
(RB RB)2
= 1186

Beta of stock B is equal to:

Cov (RB, RM)
2M
Cov (RB, RM) =

(RB - RB) (RM RM)

=
n 1

= 16.84
19

(RM RM)2
M

320

1186
=

n 1

= 62.42
19

So the beta for stock B is:

16.84
= 0.270
62.42
4. According to the CAPM, the required rate of return is:
E(Ri) = Rf+ (E(RM Rf)i
Given a risk-free rate (Rf ) of 11 percent and the expected market risk premium
(E(RM Rf ) of 6 percent we get the following:
Project
Beta
Required rate(%)
Expected rate (%)
A
0.5
11 + 0.5 x 6 = 14
15
B
0.8
11 + 0.8 x 6 = 15.8
16
C
1.2
11 + 1.2 x 6 = 18.2
21
D
1.6
11 + 1.6 x 6 = 20.6
22
E
1.7
11 + 1.7 x 6 = 21.2
23
a. The expected return of all the 5 projects exceeds the required rate as per the CAPM.
So all of them should be accepted.
b. If the cost of capital of firm which is 16 percent is used as the hurdle rate, project A
will be rejected incorrectly.
5. The asset beta is linked to equity beta, debt-equity ratio, and tax rate as follows:
E
A =
[1 + D/E (1 T)]
The asset beta of A, B, and C is calculated below:

Firm

Asset Beta
1.25

= 0.49
[1 + (2.25) x 0.7]

1.25
B

= 0.48
[1 + (2.00) x 0.7]
1.10

= 0.45
[1 + (2.1) x 0.7]
0.49 + 0.48 + 0.45

Average of the asset betas of sample firms =

= 0.47
3

The equity beta of the cement project is

E = A [ 1 + D/E (1 T)]
= 0.47 [1 + 2 (1-0.3)] = 1.128
As per the CAPM model, the cost of equity of the proposed project is:
12% + (17% - 12%) x 1.128 = 17.64%
The post-tax cost of debt is:
16% (1 0.3) = 11.2%
The required rate of return for the project given a debt-equity ratio of 2:1 is:
1/3 x 17.64% + 2/3 x 11.2% = 13.35%
6.
A =

[1 + D/E (1 T)]
E = 1.25
D/E = 1.6

T = 0.3

So, Pariman Companys asset beta is:

1.25
= 0.59
[1 + 1.6 (0.7)]

7. (a) Asset beta for a petrochemicals project is:

A =

1.30
=

[1 + D/E ( 1 T)]

[1 + 1.5 (1 .4)]
= 0.68

The equity beta (systematic risk) for the petrochemicals project of Growmore,
when D/E = 1.25 and T = 0.4, is
0.68 [1 + 1.25 (1 .4)] = 1.19
(b) The cost of equity for the petrochemicals project is
12% + 1.19 (18% - 12%) = 19.14%
The cost of debt is
12% (1 0.4) = 7.2%
Given, a debt equity ratio of 1.25 the required return for the petrochemicals
project is
1
1.25
19.14% x
+ 7% x
= 12.4%
2.25
2.25

Chapter 13
SPECIAL DECISION SITUATIONS
1.

PV Cost
UAE =
PVIFAr,n
Cost of plastic emulsion painting
Cost of distemper painting
Discount rate
UAE of plastic emulsion painting
UAE of distemper painting

= Rs.3,00,000
Life = 7 years
= Rs. 1,80,000
Life = 3 years
= 10%
= Rs.3,00,000 / 4.868 = Rs.61,627
= Rs.1,80,000 / 2.487 = Rs.72,376

Since plastic emulsion painting has a lower UAE, it is preferable.

2.

Present value of the operating costs :

3,00,000
3,60,000
4,00,000
=
+
+
1.13
(1.13)2
(1.13)3

4,50,000
+

5,00,000
+

(1.13)4

(1.13)5

= Rs.1,372,013
Present value of salvage value = 3,00,000 / (1.13)5 = Rs.162,828
Present value of costs of internal transportation
= 1,500,000 1,372,013
system
162,828 = Rs.27,09,185
UAE of the internal transportation system = 27,09,185 / 3.517 = Rs.7,70,311
3.

Cost of standard overhaul

Cost of less costly overhaul
Cost of capital
UAE of standard overhaul
UAE of less costly overhaul

=
=
=
=
=

Rs.500,000
Rs.200,000
14%
500,000 / 3.889 = Rs.128,568
200,000 / 1.647 = Rs.121,433

Since the less costly overhaul has a lower UAE, it is the preferred alternative

4.

The details for the two alternatives are shown below :

Gunning plow
1.
2.
3.
4.
5.
6.
7.
8.

Initial outlay
Economic life
Annual operating and maintenance costs
Present value of the stream of operating
and maintenance costs at 12% discount rate
Salvage value
Present value of salvage value
Present value of total costs (1+4-6)
UAE of 7

Rs.2,500,000
12 years
Rs.250,000
Rs.1,548,500

Counter plow
Rs.1,500,000
9 years
Rs.320,000
Rs.1,704,960

Rs.800,000
Rs.500,000
Rs.205,600
Rs.180,500
Rs.3,842,900
Rs.3,024,460
Rs.3,842,900
Rs.3,024,460
PVIFA (12%,12) PVIFA (12%,9)
= 3,842,900
= 3,024,460
6.194
5.328
= Rs.620,423
= Rs.567,654

The Counter plow is a cheaper alternative

5.

The current value of different timing options is given below :

Time
0
1
2
3
4

Net Future Value

Rs. in million
10
15
19
23
26

Current Value
Rs. in million
10
13.395
15.143
16.376
16.536

The optimal timing of the project is year 4.

6.
Time
(t)

(1)
1
2
3
4
5

Calculation of UAE (OM) for Various Replacement Periods

Operating
and
maintenance
costs
(2)
20,000
25,000
35,000
50,000
70,000

Post-tax
operating &
maintenance
costs
(3)
12,000
15,000
21,000
30,000
42,000

PVIF
(12%,t)

(4)
0.893
0.797
0.712
0.636
0.567

Present Cumulative
value of
present
(3)
value
(5)
10,716
11,955
14,952
19,080
23,814

(6)
10,716
22,671
37,623
56,703
80,517

(Rupees)
PVIFA
UAE
(12%,t) (OM)

(7)
0.893
1.690
2.402
3.037
3.605

(8)
12,000
13,415
15,663
18,671
22,335

Calculation of UAE (IO) for Various Replacement Periods

Investment Outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.
80,000
0.893
89,586
80,000
1.690
47,337
80,000
2.402
33,306
80,000
3.037
26,342
80,000
3.605
22,191

Time (t)
1
2
3
4
5

Calculation of UAE (DTS) for Various Replacement Periods

Time
(t)

Depreciation
charge R.s.

Depreciation
tax shield

PVIF
(12%, t)

(1)
1
2
3
4
5

(2)
20,000
15,000
11,250
8,438
6,328

(3)
8,000
6,000
4,500
3,375
2,531

(4)
0.893
0.797
0.712
0.636
0.567

Time
(1)
1
2
3
4
5

PV of
depreciation
tax shield Rs..
(5)
7,144
4,782
3,204
2,147
1,435

Cumulative
present
value Rs..
(6)
7,144
11,926
15,130
17,277
18,712

PVIFA
(12%, t)
(7)
0.893
1.690
2.402
3.037
3.605

UAE of
depreciation
tax shield Rs..
(8)
8,000
7,057
6,299
5,689
5,191

Calculation of UAE (SV) for Various Replacement Periods

Salvage
PVIF
Present value of
PVIFA
UAE of salvage
value Rs.
(12%, t)
salvage value Rs.
(12%, t)
value Rs. (4) / (5)
(2)
(3)
(4)
(5)
(6)
60,000
0.893
53,580
0.893
60,000
45,000
0.797
35,865
1.690
21,222
32,000
0.712
22,784
2.402
9,485
22,000
0.636
13,992
3.037
4,607
15,000
0.567
8,505
3.605
2,359

Summary of Information Required to Determine the Economic Life

Replacement
UAE
UAE (IO)
UAE
UAE (SV)
UAE
UAE
period
(OM) Rs.
Rs.
(DTS) Rs.
Rs.
(CC) Rs. (TC) Rs.
(1)
(2)
(3)
(4)
(5)
(6)
(7)
1
12,000
89,586
8,000
60,000
21,586
33,586
2
13,415
47,337
7,057
21,222
19,058
32,473
3
15,663
33,306
6,299
9,485
17,522
33,185
4
18,671
26,342
5,689
4,607
16,046
34,717
5
22,335
22,191
5,190
2,359
14,642
36,977
OM
IO
DTS
SV
CC
TC

Operating and Maintenance Costs

Investment Outlay
Depreciation Tax Shield
Salvage Value
Capital Cost
Total Cost

UAE (CC) = UAE (IO) [UAE (DTS) + UAE (SV)]

UAE (TC) = UAE (OM) + UAE (CC)
7.

Calculation of UAE (OM) for Various Replacement periods

Time

O&M costs
Rs.

(1)
1
2
3
4
5

(2)
800,000
1,000,000
1,300,000
1,900,000
2,800,000

Time
1
2
3
4
5

Post-tax
O&M costs
Rs.
(3)
560,000
700,000
910,000
1,330,000
1,960,000

PVIF
(12%,t)
(4)
0.893
0.797
0.712
0.636
0.567

PV of posttax O&M
costs Rs.
(5)
500,080
557,900
647,920
845,880
1,111,320

Cumulative
present
value Rs.
(6)
500,080
1,057,980
1,705,9000
2,551,780
3,663,100

PVIFA
(12%, t)
(7)
0.893
1.690
2.402
3.037
3.605

UAE of
O&M
costs Rs.
(8)
560,000
626,024
710,200
840,230
1,016,117

Calculation of UAE (IO) for Various Replacement Periods

Investment outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.
4,000,000
0.893
4,479,283
4,000,000
1.690
2,366,864
4,000,000
2.402
1,665,279
4,000,000
3.037
1,317,089
4,000,000
3.605
1,109,570
Calculation of UAE (DTS) for Various Replacement Periods

Time
(t)

Depreciation
charge Rs.

1
2
3
4
5

1,000,000
750,000
562,500
421,875
316,406

Time
(1)
1
2
3
4
5

Depreciaton
tax shield
Rs.
300,000
225,000
168,750
126,563
94,922

PVIF
(12%, t)
0.893
0.797
0.712
0.636
0.567

PV of
depreciation
tax shield Rs.
267,940
179,325
120,150
80,494
53,821

Cumulative
present
value Rs.
267,900
447,225
567,375
647,869
701,690

PVIFA
(12%, t)
0.893
1.690
2.402
3.037
3.605

UAE of
depreciation
tax shield Rs.
300,000
264,630
236,209
213,325
194,643

Calculation of UAE (SV) for Various Replacement Peiods

Salvage
PVIF
Present value of
PVIFA
UAE of salvage
value Rs.
(12%, t)
salvage value Rs.
(12%, t)
value Rs. (4)/ (5)
(2)
(3)
(4)
(5)
(6)
2,800,000
0.893
267,900
0.893
2,800,000
2,000,000
0.797
1,594,000
1.690
943,195
1,400,000
0.712
996,80
2.402
414,988
1,000,000
0.636
636,000
3.037
209,417
800,000
0.567
453,600
3.605
125,825

Summary of Information Required to Determine the Economic Life

Replacement
UAE
UAE (IO)
UAE
UAE (SV)
UAE (CC) UAE (TC)
period
(OM)
Rs.
(DTS)
Rs.
Rs.
Rs.
Rs.
Rs.
1
560,000
4,479,283 300,000 2,800,000 (-)1,379,283 -819,283
2
626,024
2,366,864 264,630
943,195
1,159,039
1,785,063
3
710,200
1,665,279 236,209
414,988
1,014,082
1,724,282
4
840,230
1,317,089 213,325
209,417
894,347
1,734,577
5
1,016,117 1,109,570 194,643
125,825
789,102
1,805,219
The economic life of the well-drilling machine is 3 years
8. Adjusted cost of capital as per Modigliani Miller formula:
r* = r (1 TL)
r* = 0.16 (1 0.5 x 0.6)
= 0.16 x 0.7 = 0.112
Adjusted cost of capital as per Miles Ezzell formula:
1+r
r* = r LrDT
1 + rD
1 + 0.16
= 0.16 0.6 x 0.15 x 0.5 x
1 + 0.15
= 0.115
9.
a. Base case NPV = -12,000,000 + 3,000,000 x PVIFA (20%, b)
= -12,000,000 + 3,000,000 x 3,326
= - Rs.2,022,000
b. Adjusted NPV = Base case NPV Issue cost + Present value of tax shield.
Term loan = Rs.8 million
Equity finance = Rs.4 million
Issue cost of equity = 12%
Rs.4,000,000
Equity to be issued =
= Rs.4,545,455
0.88
Cost of equity issue = Rs.545,455

Year (t)

1
2
3
4
5
6

Computation of Tax Shield Associated with Debt Finance

Debt outstanding
Interest
Tax shield
Present value of
at the beginning
tax shield
Rs.
Rs.
Rs.
Rs.
8,000,000
1,440,000
432,000
366,102
8,000,000
1,440,000
432,000
310,256
7,000,000
1,260,000
378,000
230,062
6,000,000
1,080,000
324,000
167,116
5,000,000
900,000
270,000
118,019
4,000,000
720,000
216,000
80,013
1,271,568

Adjusted NPV = - Rs.2,022,000 Rs.545,455 + Rs.1,271,568

= - Rs.1,295,887
Adjusted NPV if issue cost alone is considered = Rs.2,567,455
Present Value of tax shield of debt finance
= Rs.1,271,568

10.
a.

b.

Year

1
2
3
4
5
6

Base Case NPV = - 8,000,000 + 2,000,000 x PVIFA (18%, 6)

= - 8,000,000 + 2,000,000 x 3,498
= - Rs.1,004,000
Adjusted NPV
= Base case NPV Issue cost + Present value of tax shield.
Term loan
= Rs.5 million
Equity finance
= Rs.3 million
Issue cost of equity = 10%
Rs.3,000,000
Hence, Equity to be issued =
= Rs.3,333,333
0.90
Cost of equity issue
= Rs.333,333
Computation of Tax Shield Associated with Debt Finance
Debt outstanding at the
Interest
Tax shield
Present value of tax
beginning
shield
Rs.5,000,000
5,000,000
4,000,000
3,00,000
2,000,000
1,000,000

Rs.750,000
750,000
600,000
450,000
300,000
150,000

Rs.300,000
300,000
240,000
180,000
120,000
60,000

Rs.260,869
226,843
157,804
102,916
59,66
25,940
843,033

Adjusted NPV = - 1004000 333333 + 834033 = - Rs.503,300

Adjusted NPV if issue cost of external
equity alone is adjusted for
= - Rs.1,004000 Rs.333333
= Rs.1337333
c. Present value of tax shield of debt finance = Rs.834,033
11. Adjusted cost of capital as per Modigliani Miller formula:
r* = r (1 TL)
r* = 0.19 x (1 0.5 x 0.5) = 0.1425 = 14.25%
Adjusted cost of capital as per Miles and Ezzell formula:
1+r
r* = r LrDT
1 + rD
1 + 0.19
= 0.19 0.5 x 0.16 x 0.5 x
1 + 0.16
= 0.149 = 14.9%
12.

S0 = Rs.46 , rh = 11 per cent , rf = 6 per cent

Hence the forecasted spot rates are :
Year
1
2
3
4
5

Forecasted spot exchange rate

Rs.46 (1.11 / 1.06)1 = Rs.48.17
Rs.46 (1.11 / 1.06)2 = Rs.50.44
Rs.46 (1.11 / 1.06)3 = Rs.52.82
Rs.46 (1.11 / 1.06)4 = Rs.55.31
Rs.46 (1.11 / 1.06)5 = Rs.57.92

The expected rupee cash flows for the project

Year
0
1
2
3
4
5

Cash flow in dollars Expected exchange

(million)
rate
-200
46
50
48.17
70
50.44
90
52.82
105
55.31
80
57.92

Cash flow in rupees

(million)
-9200
2408.5
3530.8
4753.8
5807.6
4633.6

Given a rupee discount rate of 20 per cent, the NPV in rupees is :

2408.5
NPV

-9200

+
(1.18)2

5807.6
+

3530.8
+
(1.18)3

4633.6
+

(1.18)5

4753.8

(1.18)6

= Rs.3406.2 million
The dollar NPV is :
3406.2 / 46 = 74.05 million dollars

(1.18)4

Chapter 14
SOCIAL COST BENEFIT ANALYSIS
1.

Social Costs and Benefits

Costs
1. Construction cost
2. Maintenance cost
Benefits
3. Savings in the operation
cost of existing ships
4. Increase in consumer
satisfaction

Nature

Economic
value (Rs
in million)

Oneshot
Annual

400

Annual

40

Explanation

Annual

3.6

The number of passenger hours

saved will be : (75,000 x 2 +
50,000 + 50,000 x 2) = 600000.
Multiplying this by Rs.6 gives
Rs.3.6 million

The IRR of the stream of social costs and benefits is the value of r in the
equation

400

50

t=1

40 + 3.6 3.0
=
(1+r)t

50

t=1

40.6
(1+r)t

The solving value r is about 10.1%

2.

Social Costs and Benefits

Costs
Decrease in customer satisfaction as reflected
in the opportunity cost of the extra time taken
by bus journey
800 x (2/3) x 250 x Rs.2
Benefits
1. Resale value of the diesel train (one time)
2. Avoidance of annual cash loss
Fare collection = 1000 x 250 x Rs.4
= Rs.1,000,000
Cash operating expenses = Rs.1,400,000

Rs.266,667

Rs.240,000
Rs.400,000

3.

The social costs and benefits of the project are estimated below:
Costs & Benefits

0
0
1-40
0

Economic
value
24
150
1
40

5. Labour cost

1-40

12

6. Decrease in the value of the timber

output

2-40

1-40

0.5

1-5
6-40
1

10
50
20

1.
2.
3.
4.

Time

Construction cost
Land development cost
Maintenance cost
Labour cost

Rs. in million
Explanation

This includes the cost of

transport and rehabilitation
The shadow price of labour
equals what others are willing
to pay.

Benefits
7. Savings in the cost of shipping the
agriculture produce
8. Income from cash crops
9. Income from the main crop
10. Increase in the value of timber output

Assuming that the life of the road is 40 years, the NPV of the stream of social costs and benefits
at a discount rate of 10 percent is:

NPV

40
= - 24 - 150 - 40 -
t=1
40
+
t=1

0.5

(1.1)t

= - Rs.9.93 million

t=1

1 + 12

(1.1)t

40

t=2

10
40

(1.1)t
t=6

50

4
(1.1)t
20

(1.1)t
(1.1)1

4.
Table 1
Social Costs Associated with the Initial Outlay
Rs. in million
Item

Financial
cost
0.30
12.0

Imported equipment
Indigeneous equipment
Transport

15.0
80.0
2.0

Engineering and know-how

fees
Pre-operative expenses
Bank charges
Working capital
requirement

6.0

Basis of
conversion
SCF = 1/1.5
T=0.50, L=0.25
R=0.25
CIF value
CIF value
T=0.65, L=0.25
R=0.10
SCF=1.5

6.0
3.7
25.0

SCF=1.0
SCF=0.02
SCF=0.8

Land
Buildings

150.0

Tradeable value
ab initio
0.20

6.0
0.074
20.0

6.0

3.0

3.0

1.3

0.5

0.2

7.3

3.5

3.2

9.0
60.0

9.0

104.274

Table 2
Conversion of Financial Costs into Social Costs
Rs. in million
Item
Indigeneous raw material
and stores
Labour
Salaries
Repairs and maintenance
Water, fuel, etc
Electricity (Rate portion)
Other overheads

Financial
cost
85

Basis of
conversion
SCF=0.8

Tradeable value
ab initio
68

7
5
1.2
6

SCF=0.5
SCF=0.8
SCF=1/1.5
T=0.5, L=0.25
R=0.25
T=0.71, L=0.13
R=0.16
SCF=1/1.5

3.5
4.0
0.8

5
10
119.2

6.667
82.967

1.5

1.5

3.55

0.65

0.8

6.55

2.15

2.3

As per table 1, the social cost of initial outlay is worked out as follows :

Rs. in million
104.274
4.867

Tradeable value ab initio

Social cost of the tradeable component
(7.3 / 1.5)
Social cost of labour component
1.75
(3.5 x 0.5)
Social cost of residual component
1.60
(3.2 x 0.5)
Total 112.491

As per Table 2, the annual social cost of operation is worked out as follows :
Tradeable value ab initio
Social cost of the tradeable component
( 6.55 x 1/1.5 )
Social cost of labour component
(2.15 x 0.5)
Social cost of residual component
(2.3 x 0.5)
Total

82.967
4.367
1.075
1.150
89.559

The annual CIF value of the output is Rs.110 million. Hence the annual social
net benefit will be : 110 89.559 = Rs.20.441 million
Working capital recovery will be Rs.20 million at the end of the 20th year.
Putting the above figures together the social flows associated with the project
would be as follows :
Year / s
0
1-19

Social flow (Rs. in million)

-112.491
20.441

Chapter 15
MULTIPLE PROJECTS AND CONSTRAINTS
1. The ranking of the projects on the dimensions of NPV, IRR, and BCR is given below
Project
NPV (Rs.)
Rank
IRR (%)
Rank
BCR
Rank
M
60,610
3
34.1
2
2.21
1
N
58,500
4
34.9
1
1.59
3
O
40,050
5
18.6
4
1.33
5
P
162,960
1
26.2
3
2.09
2
Q
72,310
2
14.5
5
1.36
4
2. The ranking of the projects on the dimensions of NPV and BCR is given below
Project
NPV (Rs.)
Rank
BCR
Rank
A
61,780
5
1.83
2
B
208,480
2
1.52
3
C
315,075
1
2.05
1
D
411,90
6
1.14
6
E
95,540
4
1.38
4
F
114,500
3
1.23
5
3. The two hypothetical projects are:

Initial outlay
Cash inflows
Year 1
Year 2
Year 3

A
B

A
10000

B
1000

5000
5000
5000

600
600
600

NPV @ 10%
2435
492

Rank
1
2

IRR
about 23%
above 35%

Rank
2
1

4. The two hypothetical 4-year projects for which BCR and IRR criteria give different
rankings are given below
Project
A
B
Investment outlay
20000
20000
Cash inflow
Year 1
2000
8000
Year 2
2000
8000
Year 3
2000
8000
Year 4
31500
8000

Project
A
B

NPV
4822
4296

Rank
1
2

IRR
19%
about 22%

Rank
2
1

5. The NPVs of the projects are as follows:

NPV (A) = 6000 x PVIFA(10%,5) + 5000 x PVIF(10%,5) 20,000 = Rs.5851
NPV (B) = 8000 x PVIFA(10%,8) 50,000 = - Rs.840
NPV (C) = 15,000 x PVIFA(10%,8) 75,000 = Rs.5025
NPV (D) = 15,000 x PVIFA(10%,12) 100,000 = Rs.6,995
NPV (E) = 25,000 x PVIFA (10%,7) + 50,000 x PVIF(10%,7)
150,000 = Rs.2,650
Since B and E have negative NPV, they are rejected. So we consider only A, C,
and D. Further C and D are mutually exclusive. The feasible combinations, their
outlays, and their NPVs are given below.
Combination
A
C
D
A&C
A&D

Outlay
(Rs.)
20,000
75,000
100,000
95,000
120,000

NPV
(Rs.)
5,851
5,025
6,995
10,876
12,846

The preferred combination is A & D.

6. The linear programming formulation of the capital budgeting problem under various
constraints is as follows:
Maximise 10 X1 + 15 X2 + 25 X3 + 40 X4 + 60 X5 + 100 X6
Subject to
15 X1 + 12 X2 + 8 X3 + 35 X4 + 100 X5
+ 50 X6 + SF1 = 150

Funds constraint for year 1

5 X1 + 13 X2 + 40 X3 + 25 X4 + 10 X5
+ 110 X6 200 + 1.08 SF1

Funds constraint for year 2

5 X1 + 6 X2 + 5 X3 + 10 X4 + 12 X5
+ 40 X6 60

Power constraint

15 X1 + 20 X2 + 30 X3 + 35 X4 + 40 X5
+ 60 X6 120

Managerial constraint

0 Xj 1 (j = 1,.8) and SF1 0

Rupees are expressed in 000s. Power units are also expressed in 000s.
7. Given the nature of the problem, in addition to the decision variables X1 through X10
for the original 10 projects, two more decision variables are required as follows:
X11
X12

is the decision variable to represent the delay of projects 8 by one year

is the decision variable for the composite project which represents the
combination of projects 4 and 5.
The integer linear programming formulation is as follows:
Maximise

55 X1 + 75 X2 + 50 X3 + 60 X4 + 105 X5 + 12 X6 + 60 X7 + 120 X8
+ 50 X9 + 40 X10 + 100 X11+ 178.2 X12

Subject to

75 X1 + 80 X2 + 75 X3 + 35 X4 + 80 X5 + 20 X6 + 70 X7 + 155 X8 +
55 X9 + 10 X10 + 109.3 X12 + SF1 = 400
40 X1 + 85 X2 + 8 X3 + 100 X4 + 160 X5 + 9 X6 + 5 X7 + 100 X8 + 20
X9 + 90 X10 + 155 X11+ 247 X12 + SF2 = 350 + SF1 (1 + r)
X3 + X7
X5 + X8 + X9 + X10
X2
X8
X4 + X5 + X12
X8 + X11
Xj = {0,1}
SFi 0

1
2
X6
X9
1
1
j = 1, 2.12
i = 1, 2

It has been assumed that surplus funds can be shifted from one period to the next
and they will earn a post-tax return of r percent.

8. Minimise [P1(3d1+ 2 d 2 + d 3) + P 2 (4 d 4 + 2 d 5 + d 6) + P 3 (d 7 d 7 )]
Subject to:
Economic Constraints
12 X1 + 14 X2 + 15 X3 + 16 X4 + 11 X5 + 23 X6 + 20 X7 65
Goal Constraints
1.2 X1 + 1.6 X2 + 0.6 X3 + 1.5 X4 + 0.5 X5

+ 0.9 X6 + 1.8 X7 + d 1 d 1 = 6

Net income for year 1

1.1 X1 + 1.2 X2 + 1.2 X3 + 1.6 X4 + 1.2 X5

+ 2.5 X6 + 2.0 X7 + d 2 d 2 = 8

Net income for year 2

1.6 X1 + 1.5 X2 + 2.0 X3 + 1.8 X4 + 1.5 X5

+ 4.0 X6 + 2.2 X7 + d 3 d 3 = 10

Net income for year 3

1.0 X1 + 1.2 X2 + 0.5 X3 + 1.8 X4 + 0.6 X5

+ 1.0 X6 + 2.0 X7 + d 4 d 4 = 6

Sales growth for year 1

1.5 X1 + 1.0 X2 + 1.2 X3 + 2.0 X4 + 1.4 X5

+ 3.0 X6 + 3.0 X7 + d 5 d 5 = 8

Sales growth for year 2

1.8 X1 + 1.2 X2 + 2.5 X3 + 2.2 X4 + 1.8 X5

+ 3.5 X6 + 3.5 X7 + d 6 d 6 = 10

Sales growth for year 3

4 X1 + 5 X2 + 6 X3 + 8 X4 + 4 X5

+ 9 X6 + 7 X7 + d 7 d 7 = 50
Xj 0

NPV

d i, d i 0

9. The BCRs of the projects are converted into NPVs as of now as follows
Project
1
2
3
4
5
6
7
8
9

Outlay (Rs.)
800,000
200,000
400,000
300,000
200,000
500,000
400,000
600,000
300,000

BCR
1.08
1.35
1.20
1.03
0.98
1.03
1.21
1.17
1.01

NPV (Rs.)
64,000
70,000
80,000
9,000
- 4,000
15,000/1.10 = 13,636
84,000/1.10 = 76,364
102,000/1.10 = 92,727
3,000/1.10 = 2,727

The integer linear programming formulation of the problem is as follows :

Maximise

64,000 X1 + 70,000 X2 + 80,000 X3 + 9,000 X4 + 13,636 X6

+ 76,364 X7 + 92,727 X8 + 2,727 X9

Subject to
800,000 X1 + 200,000 X2 + 400,000 X3 + 300,000 X4 + SF1 = 20,00,000
500,000 X6 + 400,000 X7 + 600,000 X8 + 300,000 X9 500,000 + SF1 (1.032)
Xj = {0,1}

j = 1, 2, 3, 4, 6, 7, 8, 9

Chapter 16
VALUATION OF REAL OPTIONS
1.

S = 100 , uS = 150, dS = 90
u = 1.5 , d = 0.9, r = 1.15 R = 1.15
E = 100
Cu = Max (uS E, 0) = Max (150 100,0) = 50
Cd = Max (dS E, 0) = Max (90 100,0) = 0
=

Cu Cd

50
=

= 0.833

(u-d)S

0.6 x 100

u Cd d C u

0 0.9 x 50

B =

=
(u-d)R

= - 65.22
0.6 x 1.15

C = S + B = 0.833 x 100 65.22 = 18.08

2.

S = 60 , dS = 45, d = 0.75, C = 5
r = 0.16, R = 1.16, E = 60
Cu = Max (uS E, 0) = Max (60u E, 0)
Cd = Max (dS E, 0) = Max (45 60, 0) = 0
=

Cu Cd

60u 60
=

u1
=

(u 0.75)60

(u-d)S
u Cd d C u

u 0.75

0.75 (60u 60)

B =

=
(u 0.75) 1.16

(u-d)R

45 (1 u)
=
1.16 (u 0.75)

C = S+B
(u 1) 60
5 =

45 (1 u)
+

u 0.75
1.16 (u 0.75)
Multiplying both the sides by u 0.75 we get
45
5(u 0.75) = (u 1) 60 +
(1 u)
1.16

Solving this equation for u we get

u = 1.077
So Betas equity can rise to
60 x 1.077 = Rs.64.62
3.

E
C0 = S0 N(d1) -

N (d2)
ert
S0 = 70, E = 72, r = 0.12, 0.3, t = 0.50
S0
ln

1
2

+ r+
E

d1 =

2
t

70
ln

+ (0.12 + 0.5 x .09) x 0.50

72

=
0.30 0.50
- 0.0282 + 0.0825
=

= 0.2560
0.2121

d2 = d1 -

t = 0.2560 0.30

N (d1) = 0.6010
N (d2) = 0.5175
E
=
ert

0.50 = 0.0439

72
= 67.81
e0.12x 0.50

C0 = S0 x 0.6010 67.81 x 0.5175

= 70 x 0.6010 67.81 x 0.5175 = Rs.6.98
4.

E
C0 = S0 N(d1) -

N (d2)
ert
E = 50, t = 0.25, S = 40, 0.40, r = 0.14

S0
ln

1
2

+ r+
E

d1 =

40
ln

+ (0.14 + 0.5 x 0.16) 0.25

50

d1 =
0.40 0.25
- 0.2231 + 0.055
=

= - 0.8405
0.20

d2 = d1 -

t = - 0.8405 0.40

N (d1) = 0.2003
N (d2) = 0.1491
E
=
rt
e

0.25 = -1.0405

50
= 48.28
0.14 x 0.25

C0 = S0 x 0.2003 48.28 x 0.1491

= 40 x 0.2003 48.28 x 0.1491 = 0.8135
5. The NPV of the proposal to make Comp-I is:
20
50
50
20 + 10
-100 +
+
+
+
1.20
(1.20)2 (1.20)3
(1.20)4
= -100 + 16.66 + 34.70 + 28.95 + 14.46
= - Rs.5.23 million
The present value of the cash inflows of Comp II proposal, four years from now
will be Rs.189.54 million (Two times the present value of the cash inflows of Comp-I).
So, we have
S0 = present value of the asset = 189.54 x e0.20 x 4 = Rs.85.17 million
E = exercise price = $ 200 million
= 0.30
t = 4 years
r = 12

Step 1 : Calculate d1 and d2

S0
2
ln
+ r+
t
E1
2
-0.854 + (0.12 + (.09/2)) 4
-0.194
d1 =
=
=
= -0.323
t
0.3 4
0.6
d2 = d1 -

= -0.323 0.60 = -0.923

Step 2 : Find N(d1) and N(d2)

N(d1) = 0.3733
N(d2) = 0.1780
Step 3 : Estimate the present value of the exercise price
E . e-rt = 200 / 1.6161 = Rs.123.76 million
Step 4 : Plug the numbers obtained in the previous steps in the Black-Scholes formula:
C0 = 85.17 x 0.3733 123.76 x 0.1780
= Rs.9.76
6. Presently a 9 unit building yields a profit of Rs.1.8 million (9 x 1.2 9) and a 15 unit
building yields a profit of Rs.1.0 million (15 x 1.2 17). Hence a 9 unit building is
the best alternative if the builder has to construct now.
However, if the builder waits for a year, his payoffs will be as follows:
Market Condition
Alternative
Buoyant (Apartment price:
Sluggish (Apartment price:
Rs.1.5 million)
Rs.1.1million)
9 unit building
1.5 x 9 9 = 4.5
1.1 x 9 9 = 0.9
15 unit building
1.5 x 15 17 = 5.5
1.1 x 15 17 = -0.5
Thus, if the market turns out to be buoyant the best alternative is the 15 unit
building (payoff: Rs.5.5 million) and if the market turns out to be sluggish the best
alternative is the 9 unit building (payoff: Rs.0.9 million).
Given the above information, we can apply the binomial method for valuing the
vacant land:
Step 1: Calculate the risk-neutral probabilities.

The binomial tree of apartment values is

Rs.1.60 million (1.6 + 0.1)
p
Rs.1.2 million
1- p

Rs.1.20 million (1.1 + 0.1)

Given a risk free rate of 10 percent, the risk-neutral probabilities must satisfy the
following conditions:
p x 1.6 + (1 p) x 120
1.2 million =
1.10
Solving this we get p = 0.3
Step 2: Calculate the expected cash flow next year
The expected cash flow next year is:
0.3 x 5.5 + 0.7 x 0.9 = Rs.2.28 million
Step 3: Compute the current value
2.28/ 1.10 = Rs.2.07 million
Since Rs.2.07 million is greater than Rs.1.80 million, the profit from
constructing a 9 unit building now, it is advisable to keep the vacant land. The value of
the vacant land is Rs.2.07 million.
7.
S0 = current value of the asset = value of the developed reserve discounted for
3 years (the development lag) at the dividend yield of 5% = $20 x 100/
(1.05)3 = $1727.6 million.
E = exercise price = development cost = $600 million
= standard deviation of ln (oil price) = 0.25
t = life of the option = 20 years
r = risk-free rate = 8%
y = dividend yield = net production revenue/ value of reserve = 5%
Given these inputs, the call option is valued as follows:
Step 1 : Calculate d1 and d2
S
2
ln
+ ry
t
E
2
d1 =
t

ln (1727.6/ 600) + [.08 - .05 + (.0625/ 2)] 20

=
0.25
d2 = d1 - t

20

= 2.0417 1.1180 = 0.9237

Step 2 : Find N(d1) and N(d2)

N(d1) = N(2.0417) = 0.9794
N(d2) = N(0.9237) = 0.8221
Step 3 : Estimate the present value of the exercise price
E / ert = 600 / e.08 x 20 = 600/ 4.9530 = $121.14 million
Step 4 : Plug the numbers obtained in the previous steps in the Black-Scholes formula:
C = $1727.6 million x 0.9794 - $121.14 million x 0.8221
= $1592.42 million

Chapter 21
PROJECT MANAGEMENT

1.
a. Cost variance: BCWP ACWP = 5,500,000 5,800,000
= Rs.300,000
b. Schedule variance in cost terms: BCWP BCWS = 5,500,000
6,00,000 = Rs.500,000
5,500,000
c. Cost performance index: BCWP/ ACWP =

= 0.948
5,800,000
5,500,000

d. Schedule performance index: BCWP/ BCWS =

= 0.916
6,000,000

BCTW
e. Estimated cost performance index:

10,000,000
=

(ACWP + ACC)

5,800,000 + 5,000,000
= 0.926

Chapter 22
NETWORK TECHNIQUES FOR PROJECT MANAGEMENT
2. The net work diagram with the earliest and latest occurrence times for each event is
shown in Exhibit 1.
Exhibit 1
Network for the Project

5
11 11

4 4

1
0 0

4
9 9

7
14 14

3
2 3
There are two critical paths: 1-2-4-5-7 and 1-2-4-7. The minimum time required
for completing the project is 14 weeks.

3. The time estimates for various activities are shown in Exhibit 2.

Exhibit 2
Time Estimates
Activity

Optimistic to

Most likely tm

Pessimistic tp

Average
to + 4 tm + tp
te =

1-2
1-3
1-4
1-7
2-4
2-6
2-7
3-4
4-5
5-6
3-7
6-7

4
3
5
2
6
3
5
3
2
1
2
1

6
7
6
4
10
4
9
7
4
3
5
2

10
12
9
6
20
7
15
12
5
6
8
6

(a) The network diagram with average time estimates is shown in Exhibit 3.

4
6 1/3
7 1/6
6 1/3
4
11
4 1/3
9 1/3
7 1/6
3 5/6
3 1/6
5
2 1/2

Exhibit 3
2
6 6

EOT LOT

4 9

11

6
3

17 17

21 21

6
24 24

7
6
3
7

10
5

1
0

4
0

(b) The critical path for the project is 1-2-4-5-6-7

(c) Exhibit 3 shows the event slacks.

7
26 26

Event
1
2
3
4
5
6
7

Exhibit 3
Event slacks
LOT
0
6 1/3
10 1/6
17 1/3
21 1/6
24 1/3
26 5/6

EOT
0
6 1/3
7 1/6
17 1/3
21 1/6
24 1/3
26 5/6

Slack = LOT EOT

0
0
3
0
0
0
0

Free Float
EOT(j) EOT(i) dij
0
0
11
22 5/6
0
13 2/3
11 1/6
3
14 2/3
0
0
0

Independent Float
EOT(j) LOT (i) dij
0
0
11
22 5/6
0
13 2/3
11 1/6
0
11 2/3
0
0
0

Exhibit 4 shows the activity floats

Exhibit 4
Activity Floats
Activity
(i j)
1-2
1-3
1-4
1-7
2-4
2-6
2-7
3-4
3-7
4-5
5-6
6-7

Duration
dij
6 1/3
7 1/6
6 1/3
4
11
4 1/3
9 1/3
7 1/6
5
3 5/6
3 1/6
2 1/2

Total Float
LOT(j) EOT(i) dij
0
3
11
22 5/6
0
13 2/3
11 1/6
3
14 2/3
0
0
0

(d) Standard deviation of the critical path duration = [Sum of the variances of activity
durations on the critical path]1/2
The variances of the activity durations on the critical path are shown in Exhibit 5.
Exhibit 5
Variances of Activity Durations on critical path
Activity
tp
to
tp to
2
=
6
1-2
10
4
1.00
1.00
2-4
12
6
1.00
1.00
4-5
5
2
0.50
0.25
5-6
6
1
0.83
0.69
6-7
6
1
0.83
0.69
The standard deviation of the duration of critical path is:

= (1.00 + 1.00 + 0.25 + 0.69 + 0.69)1/2

= (3.63)1/2
= 1.91 weeks.
(e) Let D = specified completion date
T = mean of the critical path duration
c = standard deviation of the critical path duration
T = sum of the mean values of the activity durations on the critical path
= 6 1/3 + 9 2/3 + 3 5/6 + 3 1/6 + 2
= 25
DT
Prob (D< 30) = Prob

30 25.5
<

= Prob [ Z < 2.356]

1.91

= 0.87
4.

(a) The net work diagram is given in Exhibit 6.

Exhibit 6
Network Diagram
6

10

12

12

(b) The all-normal critical paths are 1-2-4-6-7-9 and 1-3-4-6-7-9. For all-normal
network, the project duration is 34 weeks and the total direct cost is
Rs.66,000.
(c) The time-cost slope of the activities constituting the project is given in
Exhibit 7.

(1)
Activity
(1-2)
(2-4)
(1-3)
(3-4)
(4-7)
(3-5)
(4-6)
(6-7)
(7-9)
(5-9)

Time
in weeks
(2)
Normal
5
6
4
7
9
12
10
7
6
12

Exhibit 7
Time-Cost Slope of Activities
Cost (Rs.)
(3)
Crash
2
3
2
4
5
3
6
4
4
7

(4)
Normal
6,000
7,000
1,000
4,000
6,000
16,000
15,000
4,000
3,000
4,000

(5)
Crash
9,000
10,000
2,000
8,000
9,200
19,600
18,000
4,900
4,200
8,500

Cost to expedite per

week (Rs.)
(6)
[(5)-(4) (2)-(3)]
1,000
1,000
500
1333.35
800
400
750
300
600
900

Examining the time-cost slope of activities on the critical path, we find that
activity (6-7) has the lowest slope on both the critical paths. The project network after
crashing this activity is shown below in Exhibit 8.
Exhibit 8
6

10

12

12

As per Exhibit 8, the critical paths are (1-3-4-6-7-9) and (1-2-4-6-7-9) with a
length of 31 weeks and the total cost is Rs.66,900.
Looking at the time-cost slope of the activities on the critical paths (1-3-4-6-7-9)
and (1-2-4-6-7-9), we find that activities (1-3) and (7-9) have the least time-cost slopes
on the two critical paths respectively. The project net work after crashing these
activities is shown in Exhibit 9.

Exhibit 9
6

10

12

12

As per Exhibit 9, the critical path is (1-2-4-6-7-9) with a length of 29 weeks and
the total direct cost is Rs.(66,900 + 2,200) = Rs.69,100. Activity (4-6) has the least
time-cost slope on the critical path. Hence this is crashed the net work after crashing
(4-6) is shown in Exhibit 10.
Exhibit 10
6

12

12

As per Exhibit 10, the critical path is (1-3-5-9), with a length of 26 weeks, and
total direct costs of Rs.72,100. Looking at the time-cost slope of the non-crashed
activities on this path we find that activity (3-5) has the lowest slope. Hence it is
crashed. The project net work after such crashing is shown in Exhibit 11.

Exhibit 11

12

As per Exhibit 11, the critical path is (1-2-4-6-7-9), with a length of 25 weeks
and a total direct cost of Rs.75,700.
Looking at the time cost slope of the activities on this critical path, we find both
activities (1-2) and (2-4) have the same slope. We crash activity (2-4). The resulting
project network net work is given in Exhibit 12.
Exhibit 12
6

12

As per Exhibit 12, the critical path is (1-3-4-6-7-9), with a length of 23 weeks
and a total direct cost of Rs.78,700. Crashing activity (3-4), the only uncrashed activity
on this critical path, we get the net work shown in Exhibit 13.

Exhibit 13
6

12

As per Exhibit 13, the critical path is (1-2-4-6-7-9), with a length of 22 weeks
and a total direct cost of Rs.82,700. The only uncrashed activity on this critical path is
(1-2). Crashing this we get Exhibit 14.
Exhibit 14
6

12

As per Exhibit 14, the critical path is (1-3-4-6-7-9) with a duration of 20 weeks,
and a total direct cost of Rs.85,700. Since all activities on this path are crashed, there is
no possibility of further time reduction.
Exhibit 15 shows the time-cost relationship.

Exhibit 15
Project Duration and Total Cost
Exhibit

Activities Crashed

6
8
9
10
11
12
13
14

none
(6-7)
(6-7), (1-3) and (7-9)
(6-7), (1-3), (7-9) and (4-6)
(6-7), (1-3), (7-9), (4-6) and (3-5)
(6-7), (1-3), (7-9), (4-6), (3-5) and (2-4)
(6-7), (1-3), (7-9), (4-6), (3-5), (2-4) and (3-4)
(6-7), (1-3), (7-9), (4-6), (3-5), (2-4), (3-4) and
(1-2)

Project
duration
(in weeks)
34
31
29
26
25
23
22
20

Total
direct
cost (Rs.)
66,000
66,900
69,100
72,100
75,700
78,900
80,500
83,500

Total
indirect
cost (Rs.)
34,000
31,000
29,000
26,000
25,000
23,000
22,000
20,000

Total
cost (Rs.)
1,00,000
97,900
98,100
98,100
1,00,700
1,01,700
1,02,500
1,03,500

If the objective is to minimise the total cost of the project, the pattern to crashing
suggested by Exhibit 10 may appear as the best. However, it is possible to reduce the
cost further without increasing the project duration beyond 26 weeks by decrashing
some activities on the non-critical paths. To do so, begin with the activity which has the
highest time-cost slope and proceed in the order of decreasing time-cost slope.

Chapter 23
PROJECT REVIEW AND ADMINISTRATIVE PROJECTS
1.
1.
2.

3.

4.
5.
6.
7.

Calculation of Economic Rate of Return

Year
1
Cash flow
25
Present value at the 146.895
beginning of the year; 12
percent discount rate
Present value at the end 139.518
of the year, 12 percent
discount rate
Change in value during -7.377
the year (3 2)
Economic income
17.623
(1 + 4)
Economic rate of return
0.12
(5/2)
Economic depreciation
7.377

30
139.518

40
126.268

45
101.408

50
68.543

30
26.786

126.268

101.408

68.543

26.786

-13.250

-24.860

-32.865

-41.757

-26.786

16.750

15.140

12.135

8.243

3.214

0.12

0.12

0.12

0.12

0.12

13.250

24.860

32.865

41.757

26.786

2
30
122.412

3
40
97.929

4
45
73.446

5
50
48.963

6
30
24.480

97.929

73.446

48.963

24.480

-24.483

-24.483

-24.483

-24.483

-24.483

5.517
0.045

15.517
0.158

20.517
0.274

25.517
0.521

5.52
0.225

24.483

24.483

24.483

24.483

24.483

Calculation of Book Return on Investment

1.
2.

3.

4.
5.
6.
7.

Year
1
Cash flow
25
Book value at the 146.895
beginning of the year,
straight line depreciation
Book value at the end of 122.412
the year, straight line
depreciation
Change in book value -24.483
during the year (3 2
Book income (1 + 4)
0.517
Book
return
on
.004
investment (5/2)
Book depreciation
24.483

2.
SV = Rs.120 million

DV = Rs.175 million

30
PVCF

35
+

(1.12)

45
+

(1.12)2

50
+

(1.12)3

(1.12)4

30

25

= Rs.148.21 million
(1.12)5

(1.12)6

Since DV > PVCF > SV

it is advisable to sell it to the third party at Rs.175 million