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 review the entire project to
explain its success or failure. This phase may have implication for firms planning and evaluation
procedures. Further, the review may produce ideas for new proposals to be undertaken in the future.
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
An investment decision implies the choice of an
objective, an appraisal technique and the project’s life.
The objective and technique must be related to definite
period of time. The life of the project may be determined
by taking into consideration the following factors:
(i) Technological obsolescence;
(ii) Physical deterioration; and
(iii) A decline in demand for the output of the project.
Estimation Of Project Cash Flows
Before, we analyze how cash flow is computed in capital budgeting decision following items
needs consideration:
 Depreciation: As mentioned earlier depreciation is a non-cash item and itself does not
affect the cash flow. However, we must consider tax shield or benefit from depreciation in
our analysis. Since this benefit reduces cash outflow for taxes it is considered as cash
inflow.
 Opportunity Cost : Sometimes, managers of a project may overlook some of the cost of
the project which is not paid in cash directly i.e. opportunity cost.
Incidential Impact: Alternative cash inflow foregone due to acceptance of any project should
be considered as opportunity cost and should be included in our analysis.
 Sunk Cost : Sunk cost is an outlay that has already incurred and hence should be excluded
from capital budgeting analysis.
 Working Capital : Every big project requires working capital because, for every business,
investment in working capital is must. Therefore, while evaluating the projects initial
working capital requirement should be treated as cash outflow and at the end of the project
its release should be treated as cash inflow.
 Allocated Overheads : Allocated overheads are charged on the basis of some rational basis
such as machine hour, labour hour, direct material consumption etc. Since, expenditures
already incurred are allocated to new proposal; they should not be considered as cash flows.
 Additional Capital Investment : It is not necessary that capital investment shall be
required in the beginning of the project. It can also be required during the continuance of
the project. In such cases it shall be treated as cash outflows.
Categories of Cash Flows
It is helpful to place project cash flows into three categories:-

(a) Initial Cash Outflow: The initial cash out flow for a project depends upon
the type of capital investment decision as follows:-
 If decision is related to investment in a fresh proposal or an expansion decision
 If decision is related to replacement decision

(b) Interim Cash Flows: After making the initial cash outflow that is necessary
to begin implementing a project, the firm hopes to get benefit from the future
cash inflows generated by the project. As mentioned earlier calculation of cash
flows depends on the fact whether analysis is related to fresh project or
modernization of existing facilities or replacement of existing machined decision.

(c) Terminal-Year Incremental Net Cash Flow: For the purpose of Terminal
Year, first incremental net cash flow is being calculated for the period and further
to it adjustments to be made in order to arrive at Terminal-Year Incremental Net
Cash flow.
BASIC PRINCIPLES FOR MEASURING
PROJECT CASH FLOWS
 Exclusion of Financing Costs Principle
The exclusion of financing costs principle means that:
(i) The interest on long-term debt (or interest) is
ignored while computing profits and taxes and;
(ii) The expected dividends are deemed irrelevant in
cash flow analysis.
 Post-tax Principle

Tax payments like other payments must be properly

deducted in deriving the cash flows. That is, cash flows
must be defined in post-tax terms.
 Statement Showing the Calculation of Cash
Inflow after Tax (CFAT)
Sl. no. (Rs.)
1Total Sales Units xxx
2Selling Price per unit xxx
3Total Sales [1 × 2] xxx
4Less: Variable Cost xxx
5Contribution [3 - 4] xxx
6Less: Fixed Cost
(a) Fixed Cash Cost xxx
(b) Depreciation xxx
7Earning Before Tax [6 - 7] xxx
8Less: Tax xxx
9Earning After Tax [7-8] xxx
10Add: Depreciation xxx
11Cash Inflow After Tax (CFAT) [9 +10] xxx
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 for 8 years 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)

 UnevenCash 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 0.00
evaluate such non- -100.00
0% 50% 100% 150% 200% 250% 300% 350%

conventional investment -200.00 NPV

can yield multiple internal -300.00
rates of return because of -400.00
more than one change of -500.00
signs in 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%

NPV -750.00 -200.00 0.00 61.22 62.50 37.04 0.00 -41.32 -83.33 -124.26 -163.27 -200.00 -234.38
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.
 The projects may have different expected lives.
 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)
 Profitability index 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 dividing cash
outlay by the annual cash inflow. That is:
Initial Investment C0
Payback = =
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
cash flows occurring after the payback period.
3 DISCOUNTED PAYBACK ILLUSTRATED
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 if it were depreciated constantly.
Average income
ARR =
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) Find out the discounted payback period, if the cost of capital is 9%

Year 1 2 3
PV (9%) 0.9174 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 and reject if it is lower than the
required rate of return.
Illustration
 A projecthas 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 Exclusive
Techniques For Independent Project Projects
  Pay Back (i) When Payback period ≤ Project with least Payback
  Maximum Acceptable period should be selected
  Payback period: Accepted
Non- (ii) When Payback period ≥
Discounte Maximum Acceptable
d Payback period: Rejected

Accounting (i) When ARR ≥ Minimum Project with the maximum ARR
Rate of Return Acceptable Rate of Return: should be selected.
(ARR)
Accepted
(ii) When ARR ≤ Minimum
Acceptable Rate of Return:
Rejected
Discounted Net Present
Value (NPV)
(i) When NPV > 0: Accepted Project with the highest positive
NPV should be selected
(ii) When NPV < 0: Rejected
Profitability (i) When PI > 1: Accepted When Net Present Value is same
Index(PI) project with highest PI should
(ii) When PI < 1: Rejected be selected

Internal Rate of (i) When IRR > K: Accepted Project with the maximum IRR
Return (IRR) should be selected
(ii) When IRR < K: Rejected
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%.
 What is IRR of the Project?
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. The cash receipts are as follows:
Year (at end) Machine A Machine B
1 20000 -
2 60000 60000
3 40000 60000
4 30000 80000
5 20000 -
At 7% opportunity cost, which machine should be selected on
the basis of NPV.
Year 1 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 the IRR for both the equipment is between 15%-
18%)
Year 1 2 3 4
PV (11%) 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
14% 0.8772 0.7695 0.6750 0.5921 0.5194 0.4556
Illustration
 A firm has several projects on hand. These projects have varying
size, annual cash flows, lives as given below:
  Project Project Project Project Project
A B C D E
Initial outlay 100 120 135 165 200
Expected annual cash 30 45 55 70 90
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 methods.
Period Project A (Rs.) Project B (Rs.) Project C (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  
Illustration
Perfect Inc., A U.S. based Pharmaceutical Company has received an offer
from Aidsecure Ltd., a company engaged in manufacturing of drugs to
cure dengue, to setup a manufacturing unit in Baddi (H.P.), India a joint
venture.
As per the joint venture Agreement, Perfect Inc. will receive 55% share of
revenue plus a royalty @ 60 paisa per bottle (.6 Rupee). The initial
investment will be Rs.200 crores for machinery and factory and initial
working capital of Rs.50 crores shall be required. The scrap value of
machinery and factory is estimated at the end of 5 year to be Rs.5 crores.
The machinery is depreciable @ 20% on the value of net of salvage value
using Straight Line Method.
As per GOI directions, it is estimated that the price per bottle will be
Rs.7.50 and the production will be 24 crores bottle per year. The price in
addition to inflation of respective years shall be increased by Rs. 1 each
year. The production cost shall be 40% of the revenues.
The applicable tax rate in India is 35%.
Class Test
 A company has to make a choice between two projects namely A and
B. The initial capital outlay of two Projects are Rs. 1,35,000 and Rs.
2,40,000 respectively for A and B. There will be no scrap value at
the end of the life of both the projects. The opportunity Cost of
Capital of the company is 16%. The annual incomes are as under:

Year Project A Project B PVF (16%)

1 -3000 60000 0.862
2 0 84000 0.743
3 132000 96000 0.641
4 84000 102000 0.552
5 84000 90000 0.476

You are required to calculate for each project:

  Discounted payback period
  Profitability index
  Net present value.
Illustration
The Management of a Company has two alternative proposals under
consideration. Project A requires a capital outlay of Rs. 12,00,000
and project ‘B” requires Rs. 18,00,000. Both are estimated to
provide a cash flow for five years:

Project A Rs. 4,00,000 per year and Project B Rs. 5,80,000 per
year. The cost of capital is 10%. Show which of the two projects is
preferable from the view point of

(i) Net present value method,

(ii) Present value index method (PI method)
(iii) Internal rate of return method.

The present values of Re. 1 of 10%, 18% and 20% to be received

annually for 5 years being 3.791, 3.127 and 2.991 respectively.