Financial Accounting and F.

Management
9th Lecture (help taken from Web sites & M Y Khan PK Jain other books)
BY
Muhammad Sajeeruddin, FCMA

Capital Budgeting
The process in which a business determines whether projects such as building a new
plant or investing in a long-term venture are worth pursuing. Oftentimes, a
prospective project's lifetime cash inflows and outflows are assessed in order to
determine whether the returns generated meet a sufficient target benchmark.

The process of identifying, analyzing, and selecting investment projects whose returns
(Cash flows) are expected to extend beyond one year.

Silent Features
1. The Capital budgeting decisions determine the future destiny of the company.
An opportune investment decision can yield spectacular returns. On the other
hand an ill advised and incorrect investment decision can endanger the very
survival even of the large sized firms.
2. A capital expenditure decision has it affect over a long time span and
inevitably affects the company’s future cost structure.
3. Capital investment decisions, once made are not easily reversible without
much financial loss to the firm. It is because there conversion to other uses
may not be financially feasible.
4. Finally capital investment involves cost and the majority of the firms have
scarce capital resources. Thus underlines the need for thoughtful, wise and
correct investment decisions, as an incorrect decision would not only result in
losses but also prevent the firm from earning profits from other investment
which could not be undertaken for want of funds.

Capital Budgeting involves

 Generating investment project proposals consistent with the firm’s strategic
objectives.
 Estimating after tax incremental operating cash flows for the investment
projects.
 Evaluating projects incremental cash flows
 Selecting projects based on a value maximizing acceptance criterion
 Re evaluating implemented investment projects continually and performing
post audits for completed projects

Kinds
There are three major types of Capital Budgeting decisions
1. the accept reject decision
2. the mutually exclusive type decision
3. the capital rationing decision
 1. Accept reject decision
This is the fundamental decision in capital budgeting. If the project is accepted,
the firm invests in it if the proposal is rejected, the does not invest in it. All those
projects which yield a rate of return greater than a certain required rate of return or
cost of capital * are accepted and the rest are rejected.
*{The opportunity cost of an investment; that is, the rate of return that a company
would otherwise be able to earn at the same risk level as the investment that has been
selected. For example, when an investor purchases stock in a company, he/she expects
to see a return on that investment. Since the individual expects to get back more than
his/her initial investment, the cost of capital is equal to this return that the investor
receives, or the money that the company misses out on by selling its stock.}

2. Mutually exclusive Project decisions

Mutually exclusive projects are projects which compete with other projects in such a
way that the acceptance of one will exclude the acceptance of the other projects. The
alternatives are mutually exclusive and only one may be chosen. It acquire
significance when more than one proposal is acceptable under the accept reject
decision. Then some technique has to be used to determine the “best" one. The
acceptance of this best alternative automatically eliminates the other alternatives.

3. Capital Rationing Decisions.

In a situation where the firm has unlimited fund, capital budgeting becomes a very
simple process in that all independent investment proposals yielding return greater
than some pre determined level are accepted. But in real most of the firms have fixed
capital budget. Capital rationing refers to the situation in which the firm has more
acceptable investments, requiring a greater amount of finance than is available with
the firm. It is concerned with the selection the selection of a group of investment
proposals out of many investment proposals acceptable under the accept reject
decision. Ranking of the investment projects is employed in capital rationing. Project
can be ranked on the basis of some pre determined on the bases of some
predetermined criterion such as the rate of return. The project with thee highest return
is ranked first and the project with the lowest acceptable return last.

Capital Budgeting Evaluation Technique

Average Rate of Return (ARR)

Method of investment appraisal which determines return on investment by

totalling the Net Profit (over the years for which the money was invested) and
dividing that amount by the number of years.

The Average Rate of Return (ARR) method of evaluating proposed capital

expenditure is also known as the Accounting Rate Of Return Method. It is based
upon accounting information rather than cash flow. There is no unanimity regarding
the definition of the rate of return. There are a number of alternative methods for
calculating the ARR. The most common usage of the average rate of return (ARR)
expresses it as follows:

ARR = Average annual profits after taxes x 100

Average investment over the life of project

The average profits after taxes are determined by adding up the after-tax profits
expected for each year of the project’s life and dividing the result by the number of
years. In the case of annuity, the average after-tax profits are equal to any year’s
profits.

The average investment is determined by dividing the net investment by two. This
averaging process assumes that the firm is using straight line depreciation, in which
case the book value of the asset declines at a constant rate from its purchase price to
zero at the end of its depreciable life. This means, that on the average, firms will have
one-half of their initial purchase price in the books. Consequently, if the machine has
salvage value, then only the depreciable cost (cost-salvage value) of the machine
should be divided by two in order to ascertain the average net investment, as the
salvage money will be recovered only at the end of the life of the project. Therefore,
an amount equivalent to the salvage value remains tied up in the project throughout its
life time. Hence, no adjustment is required to the sum of salvage value to determine
the average investment. Likewise, if any additional net working capital is required tin
the initial year of the project life which is likely to be released only at the end of the
project’s life, the full amount of working capital should be taken in determining
relevant investment for the purpose of calculating ARR. Thus, the average investment
consists of the following:

Average Investment = Net working capital + Salvage value

+ 1/2 (Initial cost of machine
- Salvage value)

For instance, given the information:

Rs
Initial investment 11,000
(Purchase of machine)
Salvage value 1,000
Working capital 2,000
Service life 5 years

and that the straight line method of depreciation is adopted the average investment is:
Rs 1,000 + Rs 2,000 + 1/2 (Rs 11,000 – Rs 1,000) = Rs 8,000
Example- 1
Determine the average rate of return from the following data of two machines A and
B:

Machine A Machine B
Cost Rs 56,125 Rs 56,125
Annual estimated income after
depreciation and income tax:
1st Year 3,375 11,375
2nd Year 5,375 9,375
3rd Year 7,375 7,375
4th Year 9,375 5,375
5th Year 11,375 3,375
36,875 36,875

Estimated life in years 5 5

Estimated salvage value 3,000 3,000
Average income tax rate 55% 55%
Depreciation has been charged on straight line basis.

Solution

ARR = Average Income x 100

Average Investment

Average income of Machine A = Rs 36,875 = Rs 7,375

5
Average investment = Salvage value = 1/2 (Cost of machine
- Salvage value)
= Rs 3,000 + 1/2 (Rs 56,125 – Rs 3,000)
= Rs 29,562.50

ARR (for machine A and B) = Rs 7,375 x 100 = 24.9%

Rs 29,562.50

In addition to the above, there are other approaches to calculate the ARR. One
approach which is a variation of the above, involves using original rather than the
average cost of the project. In the case of this alternative approach the ARR for both
the machine would be 13.1% (Rs 7,375 + 56,125).
Accept-Reject Rule
According to the ARR as an accept-reject criterion, the actual ARR would be
compared with a pr-determined or a minimum rate of return or cut-off rate. A project
would qualify to be accepted if the actual ARR is higher than the minimum desired
ARR. Otherwise; it is liable to be rejected. Alternatively, the ranking method can be
used to select or reject proposals. Thus, the alternative proposals under consideration
may be arranged in the descending order of magnitude, starting with the proposal with
the highest ARR and ending with the proposal having the lowest ARR, projects
having higher ARR would be preferred to projects which have lower ARR.

Evaluation of ARR

In evaluation the ARR, as a criterion to select/reject investment projects, its merits

and drawbacks need to be considered. The most favourable attribute of the ARR
method is its easy calculation. What is required is only the figure of accounting profits
after taxes which should be easily obtainable. Moreover, it is simple to understand and
use. In contrast to this, the discounted flow techniques involve, as subsequently
shown, tedious calculations and are difficult to understand. Finally, the total benefits
associated with the project are taken into account while calculating the ARR. Some
methods, pay back for instance, do not use the entire stream of incomes.

The second principal shortcoming of ARR is that it does not take into account the
time value of money. That the timing of cash inflows and outflows is a major decision
variable in financial decision-making accordingly, benefits in the earlier years and
later years cannot be valued at par. To the extent that the ARR method treats these
benefits at par and fails to take account of the difference in the time value of money, it
suffers from a serous deficiency. Thus, in above Example, the ARR in case of both
machines A and B is the same, although machine B should be preferred since its
returns in the early years of its life are greater compared to that of machine. Clearly,
the ARR method of evaluating investment proposals fails to consider this.

Thirdly, the ARR criterion of measuring the worth of investment does not differentiate
between the size of the investment required for each project.
Pay Back Method
The pay back method (PB) is the second traditional method of capital budgeting. It
the simplest and, perhaps, the most widely employed, quantitative method for
appraising capital expenditure decisions. This method answers the question: How
many years will it take for the cash benefits to pay the original cost of and investment,
nor-morally disregarding salvage value? Cash benefits here represent CFAT ignoring
interest payment. Thus, PB measures the number of years required for the CFAT to
pay back the original outlay required in an investment proposal. There are two ways
of calculating the PB period. The first method can be applied when the cash flow
stream is in the nature of annuity for each year of the project’s life, i.e. CFAT are
uniform. In such a situation, the initial cost of the investment is divided by the
constant annual cash flow:

PB = Investment
Constant annual cash flow

For example, an investment of Rs 40,000 in a machine is expected to produce CFAT

of Rs 8,000 for 10 years, then,

PB = Rs 40,000 = 5 years
Rs 8,000

The second method is used when a project’s cash flows are not equal, but very from
year to year. In such a situation, PB is calculated by the process of cumulating cash
flow till the time when cumulative cash flows become equal to the original investment
outlay. Table below presents the calculations of pay back period for previous
Example-1

Year Annual CFAT Cumulative CFAT

A B A B
1 Rs 14,009 Rs 22,000 Rs 14,000 Rs 22,000
2 16,000 20,000 30,000 42,000
3 18,000 18,000 48,000 60,000
4 20,000 16,000 68,000 76,000
5 25,000* 17,000* 93,000 93,000
*CFAT in the fifth year includes Rs 3,000 salvage value also.
The initial investment of Rs 56,125 on machine A will be recovered between years 3
and 4.

The pay back period would be 3 years plus a fraction of a year. The sum of Rs 48,000
is recovered by the end of the third year. The balance Rs 8,125 in needed to be
recovered in the 4th year. In the fourth year CFAT is Rs 20,000. The pay back fraction
is, therefore, 0.406 or (Rs 8,125 /Rs 20,000). The pay back period would be 2 years
and a fraction of a year. As Rs 42,000is recovered by the end of the second year, the
balance of Rs 14,125 needs to be recovered in the third year. In the third year CFAT is
Rs 18,000. The pay back fraction is 0.785 or (Rs 14,125/Rs 18,000). Thus, the PB
period for machine B is 2.785 years.

Accept Reject Criterion

The pay back period can be used as a decision criterion to accept or reject investment
proposals. One applicator of this technique is to compare the actual pay back with a
pre-determined pay back, i.e. the pay back set up by the management in terms of the
maximum period during which the initial investment must be recovered. If the actual
pay back period is less than the pre-determined pay back, the project would be
accepted; if not, it would be rejected. Alternatively, the pay back can be used as a
ranking method. Then mutually exclusive projects are under consideration, they may
be ranked according to the lengthy of the ay back period. Thus, the project having the
shortest pay back may be assigned rank one, followed in that order so that the project
with the longest pay back would be ranked last. The term mutually exclusive refers to
proposals out of which only one can be accepted to the exclusion of others.
Obviously, projects with shorter pay back period will be selected.

Evaluation

The pay back method has certain merits. Its most outstanding merit is that it is easy to
calculate and simple to understand. Moreover, the pay back method is an
improvement over the ARR approach. Its superiority arises due to the fact that it is
based on cash flow analysis.
Thus, though the average cash flows for both the machines under the ARR method
were the same, the pay back method shows that the pay back period for machine B is
shorter than for machine A. The pay back period approach shows that machine B
should be preferred as it refunds the capital outlay earlier than machine A.

The pay back approach, however, suffers from serous limitations. Its major
shortcomings are as follows:

The first major shortcoming of the pay back method is that it completely ignores all
cash inflows after the pay back period. This could be very misleading in capital
budgeting evaluations. Table below reveals alternative projects with the same pay
period (3 years).

Project X Project Y
Total cost of the project Rs 15,000 Rs 15,000
Cash inflows (CFAT)
Year 1 5,000 4,000
6,000 5,000
2
4,000 6,000
3
0 6,000
4
0 3,000
5
0 3,000
6
Pay back period 3 years 3 years

Present Value (PV) Discounted Cash Flow (DCF): General Procedure

The present value or the discounted cash flow procedure recognizes the cash flow
steams at different time periods differ in value and can compared only when they are
expressed in terms of a common denominator, i.e. present values. It, thus, takes into
account the time value of money. In this method, all cash flows are expressed in terms
of their present values.

The present value of the cash flows in previous Example are illustrated in Table below

Calculations of Present Value of CFAT

 Machine A Machine B
PV Present PV Present
Year CFAT CFAT
factor Value factor Value
1 2 3 4 5 6 7
1 Rs 14,000 0.999 Rs 12,726 Rs 22,000 0.909 Rs 19,998
2 16.000 0.826 13,216 20,000 0.826 16,520
3 18,000 0.751 13,518 18,000 0.751 13,518
4 20,000 0.683 14,660 16,000 0.683 10,923
5 25,000 0.621 15,525 17,000* 0.621 10,557
69,649 71,523
*includes salvage value

The PV so determined is compared with the PV of cash outflows may be noted that
present values of cash inflows of both the machine are higher cash outflows, and,
therefore both are acceptable.

Net Present Value Method (NPV)

The first DCF/PV technique is the NPV. NPV may be defined as summation of the
present values of the cash proceeds (CFAT) in year minus the summation of present
values of the net cash outflows each year. Symbolically, the NPV for projects having
conventional cash flows would be:

NPV = ∑ CFt + Sn ++ W n - COo

t=1 (1 + K)t (1 + K)n

If cash outflow is also expected to occur at some time other than at initial investment
(non-conventional cash flows) the formula would be

n
CFt Sn + W n
NPV = ∑ (1 + K)t
+ (1 ++ K)n + - COo
t=1

The decision rule for a project under NPV is to accept the project if the NPV is
positive and reject if it is negative.
Symbolically,

(i) NPV > zero, accept

(ii) NPV < zero, reject
Zero NPV implies that the firm is indifferent between accepting or rejecting the
project. However, in practice it is rare if ever such a project will be accepted, as such
a situation simply implies that only the original investment has been recovered.

In Example we would accept the proposals of purchasing machines A and B as their

net present values are positives. The positive NPV of machine A is Rs 13,520 (Rs
69,645 – Rs 56,125) and that of B is Rs 15,396 (Rs 71,521 – Rs 56,125).

In this very example if we incorporate cash outflows of Rs 25,000 at the end of the
third year in respect of overhauling of the machine, we shall find the proposals to
purchase either of machines are unacceptable as their net present values are negative.
The negative NPV of machine A I s – Rs 6,255 (Rs 68,645 – Rs 74,900) and of
machine B is – Rs 3,379 (Rs 71,521 – Rs 74,900).

As a decision criterion, this method can also be used to make a choice between
mutually exclusive projects. On the basis of the NPV method, the various proposals
would be ranked in order of the net present values. The project with the highest NPV
would be assigned the first rank, followed by others in the descending order. If, in our
example, a choice is to be made between machine A and machine B on the basis of the
NPV method, machine B having larger NPV (Rs 15,396) would be preferred to
machine A (NPV being Rs 12,520).

Evaluation

The present value method including the NPV variation possesses several merits. The
first, and probably the most significant, advantage is that it explicitly recognizes the
time value of money. In Example for instance (Table ), the total cash inflows (CFAT)
pertaining to the two machines (A and B) are equal. But the present value as well as
the NPV are different. As can be seen from Table this primarily because of the
differences in the pattern of the cash streams.

The magnitude of CFAT in case of machine A is lower in the earlier

Present Value with Different Discount Rates

Discount rate Net Present value

Zero % Rs 5,000.00
4 3465.00
8 2,17950
10 1,614.00
12 1,093.50
16 168.00
20 626.50

discount rate.

Another shortcoming of the present value method is that it is an absolute measure.

Prima facie between tow projects, this method will favour the project which has
higher present value (or NPV). But it is likely that this project may also involve a
larger initial outlay. Thus, in case of projects involving different outlays, the present
value method may not give dependable results.

Finally, the present value method may also not give satisfactory results in the case of
two projects having different effective lives. In general, the project with a shorter
economic life would be preferable, other things being equal. It may be that a project
which has a higher present value may also have a larger economic life so that the
funds will remain invested for longer period, while that alternative proposal may have
shorter life but smaller present value. In such situations, the present value method
may not reflect the true worth of the alternative proposals.

Internal Rate of Return Method

The discount rate often used in capital budgeting that makes the net present value of
all cash flows from a particular project equal to zero. Generally speaking, the higher a
project's internal rate of return, the more desirable it is to undertake the project. As
such, IRR can be used to rank several prospective projects a firm is considering.
Assuming all other factors are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken first.

The second discounted cash flow (DCF) or time-adjusted method for appraising
capital investment decisions is the internal rate of return method (IRR). This
technique is also known as yield on investment, marginal efficiency of capital
marginal productivity of capital, rate of return, time-adjusted rate of return and so on.
Like the present value method, the IRR method also considers the time value of
money by discounting the cash streams. The basis of the discount factor, however, is
different in both cases. In the case of the present value method, the discount rate is the
required rate of return and being a pre-determined rate, usually the cost of capital, its
determinants are external to the proposal under consideration.

The IRR, on the other hand, is based on facts which are internal to the proposal. In
other words, while arriving at the required rate of return for finding out present values
the cash flows – inflows as well as outflows – are not considered. But the IRR
depends entirely on the initial outlay and the cash proceeds of the project which is
being evaluated for acceptance or rejection. It is, therefore, appropriately referred to
as internal rate of return.
The internal rate of return is usually the rate of return that a project earns. It is defined
as the discount rate r which equates the aggregate present value of the net cash
inflows (CFAT) with the aggregate present value of cash outflows of a project. In
other words it is that rate which gives the project NPV of zero.

Assuming conventional cash flows, mathematically, the IRR is represented by that

rate, r, such that
n

CO0 = ∑ CFt + Sn ++ Wn
t=1 (1 + r)t (1 + r)n

Zero = ∑ CFt + Sn ++ Wn - - C O0
t
t=1 (1 + r) (1 + r)n

For unconventional cash flows, the equation would be:

n
∑ CFt + Sn + W n
n
-∑ COt
t n
t=1 (1 + r) (1 + r) (1 + r)t
t=0

n
∑ CFt S
+n + Wn
n
-COt =
t n ∑
=Zero (1 + r) (1 + r) (1 + r) t
t=1
t=1
where r = The internal rate of return
CFt = Cash inflows at different time periods
S = Salvage value
Wn = Working capital adjustments
COt = Cash outlay at different time periods

Accept-Reject Decision

The use of the IRR, as a criterion to accept capital investment decisions involves a
comparison of the actual IRR with the required rate of return also known as the cut-
off rate or hurdle rate. The project would qualify to be accepted if the IRR (r) exceeds
the cut-off rate (k). If the IRR and the required rate of return are equal, the firm-is
indifferent as to whether to accept or reject the project.

Computation

Unlike the NPV method, calculating the value of IRR is more difficult. The procedure
will depend on whether the cash flows are annuity or mixed stream.

Annuities

The following steps are taken in determining IRR for an annuity:

(1) Determine the pay back period of the proposed investment.
(2) In Table A-4 (present value of an annuity) look for year that equal to or
closest to the life of the project.
(3) In the year row, find two PV values or discount factor (DF) closest to PB
period but one bigger and other smaller than it.
(4) From the top row of the table note interest rates (r) corresponding to these
PV values (DFr).
(5) Determine actual IRR by interpolation. This can be done either directly
using equation 5.13 or indirectly by finding present values or annuity
(Equation 5.14).

PB - DFr
IRR = r -
DFrL - DFrH
where PB = Pay back period
DFr = Discount factor for interest rate r.
 DFrL = Discount factor for lower interest rate
DFrH = Discount factor for higher interest rate
r = Either of the two interest rates used in the formula

Alternatively,

PBCO - PVCFAT
IRR = r - x ∆r
∆PV

where PVCO = Present value of cash outlay

PVCFAT = Present value of cash inflows (DF x annuity)
r = Either of the two interest rates used in the formula
∆ r = Different in interest rates
∆ PV = Difference in calculated present values of inflows
The computations are shown in Examples

Example

A project costs Rs 36,000 and is expected to generate cash inflows of Rs 11,200

annually for 5 years. Calculate the IRR of the project.

Solution

(1) The pay back period is 3.214 (Rs 36,000 + 11,200).

(2) According to Table A-4, discount factors closest to 3.214 for 5 years are
3.274 (16% rate of interest) and 3.199 (17% rate of interest). The actual
value of IRR which lies between 16% and 17% can, now, be determined
using equation 5.11 or 5.12.
Substituting the values in equation we get:

3.214 – 3.274
IRR = 16 -
3.274 – 3.199

= 16 - -0.06
0.075
 = 16 + 0.8 = 16.8%

Alternatively (starting with the higher rate)

3.214 – 3.199
IRR = 17 -
3.274 – 3.199

= 17 - -0.015
0.075

= 17 + 0.2 = 16.8%

Instead of using direct method, we may find the actual IRR by applying the
interpolation formula to present values of cash inflows and outflows (Equation). Here,
again, it is immaterial whether we start with lower or higher rate.

PVCFAT (16%) = Rs 11,200 x 3.274 = Rs 36,668.8

PVCFAT (17%) = Rs 11,200 x 3.199 = Rs 35,828.8

36,000 – 36,668.8
IRR = 16 - x 1
36,668.8 – 35,828.8

= 16 – (-6668.8 + 840)
= 16 + 0.8 = 16.8%

Alternatively (starting with the higher rate)

(PVCO - PVCFAT)
IRR = r - x ∆r
∆PV

36,000 – 36,668.8
RR = 16 - x 1
840

17 = - 0.20 = 16.8%

For a Mixed Stream of Cash Flows

Calculating the IRR for a mixed stream of cash flows is more tedious a mixed stream
of cash flows the inflows in various years are uneven unequal. One way simplify the
process is to use a “fake annuity” starting point.The following procedure is a useful
guide to calculation IRR.
(1) Calculate the average annual cash flow to get a “fake annuity”

(2) Determine “fake pay back period” dividing the initial outlay by the
average annual CFAT determined in step 1.

(3) Look for the factor, in Table-A-4, closest to the fake pay back value in the
same manner as in the case of annuity. The result be a rough
approximation of the IRR, based on the assumption that the mix stream is
an annuity (fake annuity).

(4) Adjust subjectively the IRR obtained in step 3 by comparing pattern of

average annual cash inflows (as per step 1) to the higher in the initial years
of the project’s life than the average stream adjust the IRR a few
percentage points upwards. The reason is obvious the greater recovery of
funds in the earlier years is likely to give higher yield rate (IRR).
Conversely, if in the early years the actual inflows are below the average,
adjust the IRR a few percentage point downward. If the average cash flows
pattern seem fairly close to actual pattern, no adjustment is to be made.

(5) Find out the present value of the mixed cash flows, taking the IRR as the
discount rate as estimated in step 4. (It may be noted here that Table A-3 is
to be used and not the Table A-4).

(6) Calculate the PV, using the discount rate. If the PV of CFAT equals the
initial outlay, i.e. NPV is zero, it is the IRR. Otherwise, repeat step 5. Stop
once two consecutive discount rates that cause the NPV to be positive and
negative, respectively have been calculated. Whichever of these two rates
causes the NPV to be closest to zero is the IRR to the nearest 1%.
 (7) The actual value can be ascertained by the method of interpolation as in
the case of an annuity.
Let us apply this procedure for determining the IRR of Example 5.4 of a
mixed stream of CFAT for machines A and B. The cash flows associated
with the machines are given in Table

Solution

(1) The sum of cash inflows of both the machines is Rs 93,000 which when
divided by the economic life of the machine (5 years), results in a “fake
annuity” of Rs 18,600.

(2) Dividing the initial outlay of Rs 56,125 by Rs 18600, we have “fake average
pay back period” of 3.017 years (Rs 56,125 + Rs 18,600).

(3) In Table A-4, the factor closet to 3.017 for 5 years is 2.991 for a rate of
20%.

(4) Since the actual cash flows in the earlier years are greater than the
average cash flows of Rs 18,600 in machine B, a subjective increase of
say, 2% is made. This makes an estimated rate of IRR 22% for machine B.
In the case of machine A since cash inflows in the initial years are smaller
than the average cash flows, a subjective decrease of, say, 2% is made.
This makes the estimated IRR rate 18% for machine A.

(5) Using the PV factors for 22% (Machine B) and 18% (Machine A) from
Table A-3 for years 1-5, the PVs are calculated in Table 5.16.

(6) Since the NPV is negative for both the machines, the discount rate should
be subsequently lowered. In the case of machine A the difference is of Rs
572 whereas in machine B the difference is Rs 1,221. Therefore,

Machine A Machine B
PV factor Total PV factor Total
Year CFAT CFAT
18% PV at 22% PV
1 2 3 4 5 6 7
1 Rs 14,000 0.847 Rs 11,858 Rs 22,000 0.909 18,040
2 16.000 0.718 11,488 20,000 0.826 13,440
 3 18,000 0.609 10,962 18,000 0.751 9,918
4 20,000 0.516 10,320 16,000 0.683 7,216
5 25,000 0.437 10,925 17,000 0.621 6,290
55,553 54,904
Less initial investment -56,125 -56,125
-572 -1,221

in the former case the discount rate is lowered by 1% (the new discount rate being
17%) whereas in the case of machine B this is lowered by 2% (the new discount rate
being 20%).

The calculations given in Table 5.17 show that the NPV at discount rate of 17% is Rs
853 (machine A).

Machine A Machine B
PV factor Total PV factor Total
Year CFAT CFAT
17% PV of 20% PV
1 2 3 4 5 6 7
1 Rs 14,000 0.855 Rs 11,970 Rs 22,000 0.833 18,326
2 16.000 0.731 11,696 20,000 0.694 13,880
3 18,000 0.624 11,232 18,000 0.579 10,422
4 20,000 0.534 10,680 16,000 0.484 7,712
5 25,000 0.456 11,400 17,000 0.442 6,834
PV of cash inflows 56,978 57,174
Less initial investment -56,125 -56,125
Net present value -853 -1,049

Therefore, higher discount rate should be tried. But our previous calculations suggest
that NPV for an IRR of 18% of this machine is Rs 572. Since 17% and 18% are
consecutive discount rates that give positive and negative net present values,
interpolation method can be applied to find the actual IRR which will be between
17% and 18%.

The interpolation method to find out the IRR can be employed according to Eq.

(PVCO - PVCFAT)
Thus, IRR = rL - x ∆r
∆PV
(i) For Machine A
 IRR = 17 + Rs 56,125 – Rs 56,978 x1
Rs 56,978 – Rs 55,553

= 17 + 853.0
1,425
= 17 + 0.6 = 17.6%

(ii) For Machine B

IRR = 20 + Rs 56,125 – Rs 56,174 x2

Rs 56,174 – Rs 54,904

= 20 + 1,049 x 2
1,425

= 20 + 0.9 = 20.9%