Capital

Budgeting
Investment Decision
 The investment decisions of a firm are
generally known as the capital budgeting, or
capital expenditure decisions.
 The firm’s investment decisions would generally
include expansion, acquisition,
modernisation and replacement of the long-
term assets. Sale of a division or business
(divestment) is also as an investment decision.
 Decisions like the change in the methods of
sales distribution, or an advertisement
campaign or a research and development
programme have long-term implications for
the firm’s expenditures and benefits, and
therefore, they should also be evaluated as
investment decisions.
Investment Decision
 Investment decision is concerned with optimum
utilization of fund to maximize the wealth of the
organization and in turn the wealth of its
shareholders.
 Investment decision is very crucial for an organization
to fulfill its objectives; in fact, it generates revenue
and ensures long term existence of the organization.
 In simple terms, Capital Budgeting involves: -

 Identification of investment projects that are

strategic to business overall objectives;
 Estimating and evaluating post-tax incremental cash
flows for each of the investment proposals; and
 Selection an investment proposal that maximizes the
return to the investors.
Purpose of Capital
Budgeting
The capital budgeting decisions are important, crucial and critical business
decisions due to following reasons:
 Substantial expenditure : Investment decisions are related with
fulfillment of long term objectives and existence of an organization. To
invest in a project or projects, a substantial capital investment is required.
Based on size of capital and timing of cash flows, sources of finance are
selected. Due to huge capital investments and associated costs, it is
therefore necessary for an entity to make such decisions after a thorough
study and planning.
 Long time period : The capital budgeting decision has its effect over a
long period of time. These decisions not only affect the future benefits and
costs of the firm but also influence the rate and direction of growth of the
firm.
 Irreversibility :Most of the investment decisions are irreversible. Once the
decision implemented it is very difficult and reasonably and economically
not possible to reverse the decision. The reason may be upfront payment of
amount, contractual obligations, technological impossibilities etc.
 Complex decision : The capital investment decision involves an
assessment of future events, which in fact is difficult to predict. Further it is
quite difficult to estimate in quantitative terms all the benefits or the costs
relating to a particular investment decision.
 Capital Budgeting Process
The extent to which the capital budgeting process needs to be formalised and
systematic procedures established depends on the size of the organisation; number of
projects to be considered; direct financial benefit of each project considered by itself;
the composition of the firm’s existing assets and management’s desire to change that
composition; timing of expenditures associated with the projects that are finally
accepted.
 Planning :The capital budgeting process begins with the identification of potential
investment opportunities. The opportunity then enters the planning phase when the
potential effect on the firm’s fortunes is assessed and the ability of the
management of the firm to exploit the opportunity is determined.
 Evaluation : This phase involves the determination of proposal and its
investments, inflows and outflows. Investment appraisal techniques, ranging from
the simple payback method to the more sophisticated discounted cash flow
techniques, are used to appraise the proposals. The technique selected should be
the one that enables the manager to make the best decision in the light of
prevailing circumstances.
 Selection : Considering the returns and risks associated with the individual
projects as well as the cost of capital to the organisation, the organisation will
choose among projects so as to maximise shareholders’ wealth.
 Implementation : When the final selection has been made, the firm must acquire
the necessary funds, purchase the assets, and begin the implementation of the
project.
 Control : The progress of the project is monitored with the aid of feedback reports.
These reports will include capital expenditure progress reports, performance reports
comparing actual performance against plans set and post completion audits.
 Review : When a project terminates, or even before, the organisation should
Types of Capital Investment Decisions
 There are many ways to classify the capital
budgeting decision. Generally capital investment
decisions are classified in two ways.  
Steps of Capital Budgeting Procedure
 Estimation of Cash flows over the entire
life for each of the projects under
consideration.
 Determining the minimum required rate of
return (i.e. WACC) to be used as Discount
rate.
 Evaluate each of the alternative using
different decision criteria.
Estimation Of Project Cash Flows

Cash flows Cash flows

Financing
are are on an
costs are
incrementa after-tax
ignored.
l. basis.
Net
Terminal
working
Cash Flow
Capital
Cost: Included and
excluded
 Sunk cost
 Opportunity cost
 Question Overhead Allocation
 Incidental Effect
Illustration
 ABC Ltd is evaluating the purchase of a
new project with an initial investment of
Rs.1,00,000; expected economic life of
the project is 4 years. The project will
provide an earnings before taxes and
depreciation of Rs.45,000 in year 1,
Rs.30,000 in year 2, Rs.25,000 in year 3
and Rs.35,000 in year 4. Assume straight-
line depreciation and a 35% tax rate. You
are required to compute relevant cash
flows.
Investment Decision
Rule
 It should maximise the shareholders’ wealth.
 It should consider all cash flows to determine the true
profitability of the project.
 It should provide for an objective and unambiguous way of
separating good projects from bad projects.
 It should help ranking of projects according to their true
profitability.
 It should recognise the fact that bigger cash flows are
preferable to smaller ones and early cash flows are
preferable to later ones.
 It should help to choose among mutually exclusive projects
that project which maximises the shareholders’ wealth.
 It should be a criterion which is applicable to any
conceivable investment project independent of others.
Capital Budgeting Techniques
1. Discounted Cash Flow (DCF) Criteria
   Net Present Value (NPV)
   Internal Rate of Return (IRR)
   Profitability Index (PI)
   Discounted Payback Period (DPB)
 Modified IRR

2. Non-discounted Cash Flow Criteria

   Payback Period (PB)
   Accounting Rate of Return (ARR)
Payback Period
 The payback period of an investment is the length
of time required for the cumulative total net cash
flows from the investment to equal the total initial
cash outlays. At that point in time, the investor
has recovered the money invested in the project.
 Steps in Payback period technique: -

(a) The first steps in calculating the payback period

is determining the total initial capital investment
and
(b) The second step is calculating/estimating the
annual expected after-tax net cash flows over the
useful life of the investment.
Advantages of Payback period
 It is easy to compute.
 It is easy to understand as it provides a quick
estimate of the time needed for the organization
to recoup the cash invested.
 The length of the payback period can also serve
as an estimate of a project’s risk; the longer the
payback period, the riskier the project as long-
term predictions are less reliable.
 In some industries with high obsolescence risk
like software industry or in situations where an
organization is short on cash, short payback
periods often become the determining factor for
investments.
Limitations of Payback period
 It ignores the time value of money. As long as the payback
periods for two projects are the same, the payback period
technique considers them equal as investments, even if one
project generates most of its net cash inflows in the early
years of the project while the other project generates most
of its net cash inflows in the latter years of the payback
period.
 A second limitation of this technique is its failure to consider
an investment’s total profitability; it only considers cash
flows from the initiation of the project till its payback period
is being reached, and ignores cash flows after the payback
period.
 Lastly, use of the payback period technique may cause
organizations to place too much emphasis on short payback
periods thereby ignoring the need to invest in long-term
projects that would enhance its competitive position.
Illustration
 Suppose a project costs Rs.20,00,000 and
yields annually a profit of Rs.3,00,000 after
depreciation @ 12½% (straight line
method) but before tax 50%.
Find out the payback period of the Project.
 Illustration
Suppose XYZ Ltd. is analyzing a project requiring an initial cash
outlay of Rs.2,00,000 and expected to generate cash inflows as
follows:

Year Annual Cash Inflows

1 80,000
2 60,000
3 60,000
4 20,000
Net Present Value Technique (NPV)
 The net present value technique is a
discounted cash flow method that
considers the time value of money in
evaluating capital investments. An
investment has cash flows throughout its
life, and it is assumed that a ngultrum of
cash flow in the early years of an
investment is worth more than a ngultrum
of cash flow in a later year.
Net Present Value Technique (NPV)
 Cash flows of the investment project should
be forecasted based on realistic
assumptions.
 Appropriate discount rate should be
identified to discount the forecasted cash
flows. The appropriate discount rate is the
project’s opportunity cost of capital.
 Present value of cash flows should be
calculated using the opportunity cost of
capital as the discount rate.
 The project should be accepted if NPV is
positive (i.e., NPV > 0).
Net Present Value Technique (NPV)

 Net present value should be found out by

subtracting present value of cash outflows
from present value of cash inflows. The
formula for the net present value can be
written as follows:
 C1 C2 C3 Cn 
NPV      n 
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3

n
Ct
NPV    C0
t 1 (1  k )
t
 Net Present Value Technique (NPV)

 Accept the project when NPV is positive

NPV > 0
 Reject the project when NPV is negative
NPV < 0
  May accept the project when NPV is zero
NPV = 0
 The NPV method can be used to select
between mutually exclusive projects; the one
with the higher NPV should be selected.
Evaluation of NPV
 NPV is most acceptable investment rule for
the following reasons:
 Time value
 Measure of true profitability
 Value-additivity
 Shareholder value
 Limitations:
 Involved cash flow estimation
 Discount rate difficult to determine
 Mutually exclusive projects
 Ranking of projects
Internal Rate of Return (IRR)
 The internal rate of return (IRR) is the rate
that equates the investment outlay with the
present value of cash inflow received after
one period. This also implies that the rate of
return is the discount rate which makes NPV
= 0. C1 C2 C3 Cn
C0    
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) n
n
Ct
C0  
t 1 (1  r )t
n
Ct
 t 1 (1  r ) t
 C0  0
Internal Rate of Return (IRR)

 Uneven Cash Flows:

Calculating IRR by Trial and Error
The approach is to select any discount rate to
compute the present value of cash inflows. If
the calculated present value of the expected
cash inflow is lower than the present value of
cash outflows, a lower rate should be tried. On
the other hand, a higher value should be tried if
the present value of inflows is higher than the
present value of outflows. This process will be
repeated unless the net present value becomes
zero.
NPV Profile and IRR
A B C D E F G H
1 NPV Profile
Discount
2 Cash Flow rate NPV
3 -20000 0% 12,580
IR
4 5430 5% 7,561
R
5 5430 10% 3,649
6 5430 15% 550
7 5430 16% 0
8 5430 20% (1,942)
9 5430 25% (3,974)
Figure 8.1 NPV Profile
Internal Rate of Return (IRR)

 Accept the project when r > k.

 Reject the project when r < k.
 May accept the project when r = k.
 In case of independent projects, IRR and
NPV rules will give the same results if the
firm has no shortage of funds.
Evaluation of IRR
 IRR method has following merits:
 Time value
 Profitability measure
 Acceptance rule
 Shareholder value
 IRR method may suffer from:
 Multiplerates
 Mutually exclusive projects
 Value additivity
Conventional and Non-conventional
Cash Flows
A conventional investment has cash flows
the pattern of an initial cash outlay followed
by cash inflows. Conventional projects have
only one change in the sign of cash flows;
for example, the initial outflow followed by
inflows, i.e., – + + +.
 A non-conventional investment, on the
other hand, has cash outflows mingled with
cash inflows throughout the life of the
project. Non-conventional investments have
more than one change in the signs of cash
flows; for example, – + + + – ++ – +.
 Problem of Multiple IRR
 A project may have both NPV
lending and borrowing 200.00
features together. IRR
100.00
method, when used to
evaluate such non- 0.00
0% 100% 200% 300% 400%
conventional investment -100.00

can yield multiple -200.00 NPV

internal rates of return -300.00
because of more than -400.00
one change of signs in -500.00
cash flows.
C0 -1000 -600.00

C1 4000 -700.00

C2 -3750 -800.00

Df
(%) 0% 25% 50% 75% 100% 125% 150% 175% 200% 225% 250% 275% 300%
- - - -
- 124.2 163.2 200.0 234.3
NPV -750.00 200.00 0.00 61.22 62.50 37.04 0.00 -41.32 -83.33 6 7 0 8
NPV vs. IRR

 Conventional Independent
Projects:
In case of conventional
investments, which are
economically independent of each
other, NPV and IRR methods result
in same accept-or-reject decision if
the firm is not constrained for
funds in accepting all profitable
projects.
Case of Ranking Mutually Exclusive
Projects
 Investment projects are said to be mutually
exclusive when only one investment could
be accepted and others would have to be
excluded.
 Two independent projects may also be
mutually exclusive if a financial constraint
is imposed.
 The NPV and IRR rules give conflicting
ranking to the projects under the following
conditions:
 The cash flow pattern of the projects may
differ. That is, the cash flows of one project
may increase over time, while those of others
may decrease or vice-versa.
 The cash outlays of the projects may differ.

 Timing of Cash Flows

Cash Flows (Rs) NPV

Project C0 C1 C2 C3 at 9% IRR
M – 1,680 1,400 700 140 301 23%
N – 1,680 140 840 1,510 321 17%
 Scale of Investment
Cash Flow (Rs) NPV
Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%
Project Life Span

Cash Flows (Rs)

Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR
X – 10,000 12,000 – – – – 908 20%
Y – 10,000 0 0 0 0 20,120 2,495 15%
Profitability Index (PI)
 Profitabilityindex is the ratio of the present
value of cash inflows, at the required rate
of return, to the initial cash outflow of the
investment.
 Profitability Index (PI)
 The following are the PI acceptance rules:
 Accept the project when PI is greater than
one. PI > 1
 Reject the project when PI is less than one.
PI < 1
 May accept the project when PI is equal to
one. PI = 1
 The project with positive NPV will have PI
greater than one. PI less than means that the
project’s NPV is negative.
Evaluation of Profitability Index (PI)
 It recognises the time value of money.
 It is consistent with the shareholder value
maximisation principle. A project with PI
greater than one will have positive NPV and
if accepted, it will increase shareholders’
wealth.
 In the PI method, since the present value of
cash inflows is divided by the initial cash
outflow, it is a relative measure of a
project’s profitability.
 Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the
discount rate. In practice, estimation of cash
flows and discount rate pose problems.
 NPV Versus PI
 A conflict may arise between the two methods if a choice between
mutually exclusive projects has to be made. Follow NPV method.
 In case of capital Rationing follow PI to rank a project.

Project C0 C1 C2 C3 NPV PI IRR

A -60 30 30 30 14.61 1.24 23.38%
B -25 10 20 10 8.13 1.33 27.42%
C -35 25 10 20 11.02 1.31 28.37%
D -35 20 20 15 10.98 1.31 27.97%

The net present value (NPV) rule should be modified while

choosing among projects under capital constraint. The
objective should be to maximize NPV per rupee of capital
rather than to maximize NPV. Projects should be ranked by
their profitability index, and top-ranked projects should be
undertaken until funds are exhausted.
Payback Period
 Payback is the number of years required
to recover the original cash outlay
invested in a project.
 If the project generates constant annual
cash inflows, the payback period can be
computed by Initial
dividing cash outlay
Investment C0
by the
Payback
annual cash= inflow. That is: =
Annual Cash Inflow C

 Unequal cash flows In case of unequal

cash inflows, the payback period can be
found out by adding up the cash inflows
until the total is equal to the initial cash
outlay.
Payback Period
 The project would be accepted if its
payback period is less than the maximum
or standard payback period set by
management.
 As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest
ranking to the project with highest
payback period.
Evaluation of Payback
 Certain virtues:
 Simplicity
 Cost effective
 Short-term effects
 Risk shield
 Liquidity
 Serious limitations:
 Cash flows after payback ignored
 Cash flow patterns
 Inconsistent with shareholder value
Payback Reciprocal and the
Rate of Return
 The reciprocal of payback will be a close
approximation of the internal rate of return
if the following two conditions are satisfied:

 The life of the project is large or at least

twice the payback period.
 The project generates equal annual cash
inflows.
 Discounted Payback Period
 The discounted payback period is the
number of periods taken in recovering the
investment outlay on the present value
basis.
 The discounted payback period still fails to
consider the 3 cash flows occurring after the
DISCOUNTED PAYBACK ILLUSTRATED
payback period. Cash Flows
(Rs) Simple Discounted NPV at
C0 C1 C2 C3 C4 PB PB 10%
P -4,000 3,000 1,000 1,000 1,000 2 yrs – –
PV of cash flows -4,000 2,727 826 751 683 2.6 yrs 987
Q -4,000 0 4,000 1,000 2,000 2 yrs – –
PV of cash flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421
Accounting Rate of Return
Method
 The accounting rate of return is the ratio of
the average after-tax profit divided by the
average investment. The average
investment would be equal to half of the
original investment
Averageifincome
it were depreciated
ARR =
constantly. Average investment

A variation of the ARR method is to divide

average earnings after taxes by the original
cost of the project instead of the average
cost.
Accounting Rate of Return
Method
 This method will accept all those projects
whose ARR is higher than the minimum rate
established by the management and reject
those projects which have ARR less than the
minimum rate.
 This method would rank a project as number
one if it has highest ARR and lowest rank
would be assigned to the project with lowest
ARR.
Evaluation of ARR Method
 The ARR method may claim some merits
 Simplicity
 Accounting data
 Accounting profitability
 Serious shortcoming
 Time value ignored
 Arbitrary cut-off
 Cash Flows ignored
Illustration
A firm has the following information about a
Project. Income Statement
C1 C2 C3
Cash revenue 16000 14000 12000
Cash Expenses 8000 7000 6000
EBDIT 8000 7000 6000
Depreciation 4000 4000 4000
EBIT 4000 3000 2000
Tax (35%) 1200 900 600
EBIT (1-t) 2800 2100 1400

The initial investment of the project is estimated to be

Rs.12000.
(a) Calculate the Project’s ARR
(b) Calculate the Payback period of the Project.
(c)
Year out the discounted
Find 1 payback2period, if the 3
cost of
PV (9%) is 9% 0.9174
capital 0.8417 0.7722
Modified Internal rate of Return (MIRR)
 
There are several limitations attached with the concept of the
conventional Internal Rate of Return. The MIRR addresses
some of these deficiencies
e.g., it eliminates multiple IRR rates; it addresses the
reinvestment rate issue and produces results which are
consistent with the Net Present Value method.
This method is also called Terminal Value method.
Under this method, all cash flows, apart from the initial
investment, are brought to the terminal value using an
appropriate discount rate (usually the Cost of Capital). This
results in a single stream of cash inflow in the terminal year.
The MIRR is obtained by assuming a single outflow in the 0 th
year and the terminal cash inflow as mentioned above.
The discount rate which equates the present value of the
terminal cash inflow to the 0th year outflow is called the MIRR.
Present value of Outflow , PV
The decision criterion of MIRR is same as IRR i.e. you accept
an investment if MIRR is larger than required rate of return
Illustration
A project has an initial outflow of
Rs.20000 and the expected cash inflows
over next 3 years are Rs.7000, Rs. 10000
and Rs.8000. The required rate of return
is 10%. What is MIRR of the Project?
 
Summery 
For Mutually
Techniques For Independent Exclusive Projects
Project
  Pay Back (i) When Payback period Project with least Payback
  ≤ Maximum period should be selected
 
Acceptable Payback
Non- period: Accepted
Discoun (ii) When Payback period
ted ≥ Maximum
Acceptable Payback
period: Rejected
Accounting (i) When ARR ≥ Project with the maximum
Rate of Minimum Acceptable ARR should be selected.
Return (ARR)
Rate of Return:
Accepted
(ii) When ARR ≤
Minimum Acceptable
Rate of Return:
Rejected
Discoun Net Present (i) When NPV > 0: Project with the highest
Value (NPV) positive NPV should be
ted Accepted selected
(ii) When NPV < 0:
Rejected
Profitability (i) When PI > 1: When Net Present Value is
Index(PI) same project with highest
Accepted PI should be selected
(ii) When PI < 1:
Popularity and usage of capital budgeting methods
 In terms of consistency with owners’
wealth maximization, NPV and IRR are
preferred over other methods.
 Larger companies tend to prefer NPV and
IRR over the payback period method.
 The payback period is still used, despite its
failings.
 The NPV is the estimated added value
from investing in the project; therefore,
this added value should be reflected in the
company’s stock price.
Illustration
A firm is evaluating a proposal costing
Rs.1,60,000 and expected to generate cash
inflows of Rs.40,000, Rs.60,000, Rs.50,000
and Rs.80,000 at the end of each year for
next four years. There is no salvage value
thereafter.
 Will you accept the project on the basis of
NPV, if the discount rate is 13%.
 Whether you change your decision, if the
discount rate is 16%.
Illustration
 Machine A cost Rs. 1,00,000 payable
immediately. Machine B costs Rs. 1, 20,000 half
payable immediately and half payable in 1
year’s time.
Year (at The cash
end) receipts
Machine A are Machine
as follows:
B
1 20000 -
2 60000 60000
3 40000 60000
4 30000 80000
5 20000 -

At 7% opportunity cost, which machine should be

selected
Year on the
1 basis of NPV.
2 3 4 5
PV
(7%) 0.9346 0.8734 0.8163 0.7629 0.7130
 Illustration
 Equipment A has a cost of Rs. 50000 and net
cash flows of Rs. 18500 per year for four years.
A substitute equipment B would cost Rs. 75000
and generate net cash flow of Rs.25000,
30000, 33000, 20000 each year from year 1 to
4. The required rate of return for both the
equipment is 11%. Calculate the NPV & IRR for
the equipment. Which equipment should be
accepted and why?
(Assume
Year the IRR
1 for both2 the equipment
3 is 4
between
PV (11%) 15%-18%)
0.9009 0.8116 0.7312 0.6587
PV (15%) 0.8696 0.7561 0.6575 0.5718
PV (18%) 0.8475 0.7182 0.6086 0.5158
 Illustration
Sumitra Electronics is evaluating a capital project
requiring an outlay of Rs.1250 million. It is
expected to generate a net cash inflow of Rs.320
million per year for 6 years. The opportunity cost
of capital is 14 percent.
Will you accept or reject the project.
year 1 2 3 4 5 6
0.519 0.455
14% 0.8772 0.7695 0.6750 0.5921 4 6
Illustration
 A firm has several projects on hand. These projects have
varying size, annual cash flows, lives as given below:
  Projec Projec Projec Projec Projec
tA tB tC tD tE
Initial outlay 100 120 135 165 200
Expected annual 30 45 55 70 90
cash inflow
Management's
discount rate 12% 13% 15% 18% 20%
Life of the Project 5 5 6 6 4
 If the firm faces a capital constraint of Rs 500 lacs which
of the project would be accepted under
a) NPV criterion
b) PI criterion.
c) What would be the addition to the NPV in each case?
Assume that projects can be implemented in parts.
Illustration
Pharmaco, Inc., is a company that manufactures and
distributes pharmaceuticals. It is considering buying the
rights to make and sell a new drug created by another
company, the drug development laboratory R&D Ltd.,
which develops new drugs but generally lets others
manufacture and distribute them.
R&D Ltd. will sell the rights to the product to Pharmaco for
Rs.1 billion. The net after-tax cash flow generated by the
drug is expected to be Rs.150 million in Year 1 and to
grow at 20% per year for the following four years, at
which point (in Year 5) the remaining value (or terminal
value) of the drug is expected to be Rs.500 million.
Suppose the risk-free rate of return is 4% and Pharmaco
has determined that 8% is the appropriate opportunity
cost of funds for this project. Pharmaco needs to decide
whether to go ahead and purchase the rights to the new
drug.
Case
GSPC is a fast growing profitable company. The company is situated in
Western India. Its sales are expected to grow about three times from Rs.360
million in 2014 to Rs.1, 100 million in 2015. The company is considering of
commissioning a 35 km pipeline between two areas to carry gas to a state
electricity board. The project will cost Rs.500 million. The pipeline will have
a capacity of 2.5 MMSCM. The company will enter into a contract with the
state electricity board (SEB) to supply gas. The revenue from the sale to SEB
is expected to be Rs.240 million per annum. The pipeline will also be used
for transportation of LNG to other users in the area. This is expected to
bring additional revenue of Rs. 160 million per annum. The company
management considers the useful life of the pipeline to be 20 years. The
financial manager estimates cash profit to sales ratio of 20 per cent per
annum for the first 12 years of the project's operations and 17 per cent per
annum for the remaining life of the project. The project has no salvage
value. The project being in a backward area is exempt from paying any
taxes. The company requires a rate of return of 15 per cent from the project.
Discussion Questions
1. What is the project's payback?
2. Compute project's NPV and IRR.
3. Should the project be accepted? Why?
Case
Calmex is situated in North India. It specializes in manufacturing overhead
water tanks. The management of Calmex has identified a niche market in
certain Southern cities that need a particular size of water tank, not currently
manufactured by the company. The company is therefore thinking of producing
a new type of overhead water tank. The survey of the company's marketing
department reveals that the company could sell 120,000 tanks each year for
six years at a price of Rs.1500 each. The company's current facilities cannot be
used to manufacture the new-size tanks. Therefore, it will have to buy new
machinery. A manufacturer has offered two options to the company. The first
option is that the company could buy four small machines with the capacity of
manufacturing 30,000 tanks each at Rs.115 million each. The machine
operation and manufacturing cost of each tank will be Rs.535. Alternatively,
Calmex can buy a larger machine with a capacity of 120,000 units per annum
for Rs.500 million. The machine operation and manufacturing costs of each
tank will be Rs.450. The company has a required rate of return of 12 per cent.
Assume that the company does not pay any taxes.
Discussion Questions:
1. Which option should the company accept? Use the most suitable method of
evaluation to give your recommendation and explicitly state your assumptions.
2. Why do you think that the method chosen by you is the most suitable
method in evaluating the proposed investment? Give the computation of the
alternative methods.
Case
Aman Limited is a leading manufacturer of automotive components. . It supplies to the original
equipment manufacturers as well as the replacement market. Its projects typically have a short life as it
introduces new models periodically.
You have recently joined Aman Limited as a financial analyst reporting to Ravi Sharma, the CFO of the
company. He has provided you the following information about three projects, A, B, and C that are being
considered by the Executive Committee of Sona Limited:
• Project A is an extension of an existing line. Its cash flow will decrease over time.
• Project B involves a new product. Building its market will take some time and hence its cash flow will
increase over time.
• Project C is concerned with sponsoring a pavilion at a Trade Fair. It will entail a cost initially which will
be followed by a huge benefit for one year. However, in the year following that a substantial cost will be
incurred to raze the pavilion. The expected net cash flows of the three projects are as follows.
Year Project A Project B Project C
0 -15000 -15000 -15000
1 11000 3500 42000
2 7000 8000 -4000
3 4800 13000 -
Ravi Sharma believes that all the three projects have risk characteristics similar to the average risk of the
firm and hence the firm's cost of capital, viz. 12 percent, will apply to them.
You are asked to evaluate the projects.
•What is payback period and discounted payback period? Find the payback periods and the discounted
payback periods of Projects A and B.
•What is the net present value (NPV)? What are the properties of NPV? Calculate the NPVs of projects A,
B and C.
•What is internal rate of return (IRR)? What are the problems with IRR? Calculate the IRR of Projects A, B
and C.
 Illustration
 A company is considering a proposal of installing a
drying equipment. The equipment would involve a cash
outlay of Rs.6,00,000 and working capital of Rs.80,000.
the expected life of the project is 6 years without
salvage value. Assume that company is allowed to
charge depreciation on straight line basis for tax
purpose and the tax rate is 35%. The estimated before
tax cash flows are given below:
Rs. '000
Before-tax Cash Flow
Year 1 2 3 4 5 6
  210 180 160 150 120 100
 If the company’s opportunity cost of capital is 12%,
calculate the after tax cash flows and NPV of the project.
Illustration
 The expected cash flows of three projects are given
below. The cost of capital is 10 per cent.
(a) Calculate the payback period, net present value,
internal rate of return and accounting rate of return of
each project.
(b) Show the rankings of the projects by each of the four
Period Project A (Rs.)
methods.
Project B Project C
(Rs.) (Rs.)
0 (5,000) (5,000) (5,000)
1 900 700 2,000
2 900 800 2,000
3 900 900 2,000
4 900 1,000 1,000
5 900 1,100  
6 900 1,200  
7 900 1,300  
8 900 1,400  
9 900 1,500  
10 900 1,600