Financial Management - Alaknanda Lonare

Capital Budgeting

1. A project requires initial investment of Rs. 40,000 and it will generate annual cash inflows of
Rs. 10,000 for 6 years. You are required to find out pay-back period.

Sol: PBP = Initial Investment / Constant Annual CIF

PBP = 4 years

2. From the following information you are required to calculate pay-back period: A project
requires initial investment of Rs. 40,000 and generate cash inflows of Rs. 16,000, Rs. 14,000,
Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth year respectively.
Sol:
Initial Investment = 40,000

Year CIF Cum CIF

1 16,000 16,000
2 14,000 30,000
3 8,000 38,000
4 6,000 44,000

PBP = 3 years + 2,000/6,000

PBP = 3.33 years

3. A machinery is costing Rs. 75,000; life of the machine is 5 years, depreciation is charged
using SLM and tax rate applicable to the company is 50%. Cash flows before depreciation
and taxes are given to you. Calculate Payback period.
Year 1 2 3 4 5
CIF 30,000 28,000 20,000 15,000 15,000
Sol: Initial Investment = 75,000, Life of Machine 5 years, Dep using SLM, Taxes @ 50%

Depn = (Cost of Machine – SV) / Life

Depn = 15,000

Year EBDITA Depreciation EBIT = EAT= CFAT = Cum

EBT EBT EAT + CFAT
*50% Dep
1 30,000 15,000 15,000 7,500 22,500 22,500
2 28,000 15,000 13,000 6,500 21,500 44,000
3 20,000 15,000 5,000 2,500 17,500 61,500
4 15,000 15,000 0 0 15,000 76,500
5 15,000 15,000 0 0 15,000 91,500
PBP = 3 years + 13,500 / 15,000
PBP = 3.9 years
Financial Management - Alaknanda Lonare

4. A project costs Rs.20,00,000 and yields annual profits of 300,000 after depreciation but
before taxes. Calculate Payback period if tax rate is 50% and depreciation is charged at
12.5%.
Sol:
Initial Investment = 20,00,000
Depreciation = 12.5%
Dep = 2,50,000
Taxes @ 50%

EBT = 3,00,000
(-) Taxes@50% = 1,50,000
EAT = 1,50,000
(+)Dep = 2,50,000
CFAT = 4,00,000

PBP = Initial Investment / CFAT

PBP = 20,00,000 / 4,00,000
PBP = 5 years

5. X ltd is considering the purchase of a new machine, which will carry out some operations at
present performed by laborers. Two alternative models, A and B are available for the
purpose. From the following information, prepare a profitability statement for submission to
the management and calculate Payback period.

Particulars Machine A Machine B

Estimated life in years 5 6

Cost of Machine 80,000 1,50,000
Estimated additional cost:
Indirect Material (per annum) 2,000 3,000
Maintenance (per month) 500 750
Supervision (per quarter) 3,000 4,500
Estimated savings in Scrap (per annum) 8,000 12,000

Estimated Savings in direct wages:

A. Workers not required 10 15
B. Wages per worker (per annum) 7,200 7,200

Depreciation is calculated under straight line method. Taxation may be taken at 50% of net
profit.
Sol:

Calculation of Depreciation:

Cost of Machine 80,000 1,50,000

Financial Management - Alaknanda Lonare

Life of Machine in
years 5 6

Dep = (Cost - SV) / Life 16000 25000

Particulars Machine A Machine B
Initial Investment 80,000 1,50,000

Calculation of Savings (A):

a. Savings in Scrap 8,000 12,000
b. Savings in direct wages 72,000 1,08,000
Total Savings (A) 80,000 1,20,000

Calculation of Add Cost (B):

a. Indirect Material 2,000 3,000
b. Maintenance 6,000 9,000
c. Supervision 12,000 18,000
Total Add Cost (B) 20,000 30,000

EBDITA = (A - B) 60,000 90,000

Less: Dep 16,000 25,000
EBIT = EBT 44,000 65,000
Taxes @ 50% 22000 32500
EAT 22,000 32,500
Add: Dep 16,000 25,000
CFAT 38,000 57,500

PBP = Initial
Investment/Annual CFAT 2.11 years 2.61 years
Machine A is recommended because it has lesser PBP as compared to Machine B
6. A project costs Rs.10,00,000 and has a scrap value of Rs.1,00,000. Its streams of income
before depreciation and taxes during first year through five years is 2,00,000; 2,40,000;
2,80,000; 3,20,000 and 4,00,000. Assume a 50% tax rate and depreciation on straight line
basis. Calculate the accounting rate of return for the project.
Sol:

Original Investment = 10,00,000; SV = 1,00,000; EBITDA is given; Taxes = 50%; Method

of Dep = SLM; ARR = ?

Dep = (Cost of Project – SV) / Life = 1,80,000

ARR = (Average Income / Average Investment) * 100

Calculation of Average Income:

Financial Management - Alaknanda Lonare

Year EBITDA Dep EBIT = EBT EAT = EBT*0.5

1 2,00,000 1,80,000 20,000 10,000
2 2,40,000 1,80,000 60,000 30,000
3 2,80,000 1,80,000 1,00,000 50,000
4 3,20,000 1,80,000 1,40,000 70,000
5 4,00,000 1,80,000 2,20,000 1,10,000

Average income = Total EAT/5

Average income = 54,000

Calculation of Average Investment:

Average Investment = (OI – SV)/2 +WC+SV

Average investment = (10,00,000 – 1,00,000) / 2 + 0 + 1,00,000
Average investment = 5,50,000

ARR = (Average Income / Average Investment) * 100

ARR = (54,000 / 5,50,000)*100
ARR = 9.8%

7. “A” limited company has under consideration following two projects:

Particulars Project X Project Y

Investment in Machines 10,00,000 15,00,000
Working Capital 5,00,000 5,00,000
Life of Machines 4 years 6 years
Scrap value of Machine 10% 10%
Tax Rate 50% 50%
Income before depreciation and taxes at the end of the year:

Year 1 2 3 4 5 6
X 8,00,000 8,00,000 8,00,000 8,00,000 - -
Y 15,00,000 9,00,000 15,00,000 8,00,000 6,00,000 3,00,000
Calculate ARR for the project and suggest which one is better?

Sol: ARR = (Average Income / Average Investment) * 100

Depreciation = (Cost of Project – SV) / Life

For Project X = Dep = 2,25,000

For Project Y = Dep = 2,25,000

Particulars Project X Project Y

Average EBITDA 8,00,000 9,33,333
Less: Depreciation 2,25,000 2,25,000
Financial Management - Alaknanda Lonare

EBIT = EBT 5,75,000 7,08,333

Taxes@ 50% 2,87,500 3,54,167
Average EAT = Average Income 2,87,500 3,54,167

Average Investment = (OI – SV)/2 +WC+SV 10,50,000 13,25,000

ARR = (Average Income / Average Investment) * 100 27.38% 26.73%

As in this case ARR of Project X is higher as compared to Project Y, therefore, Project X is
better than Project Y.

8. The company is considering investment of Rs. 1,00,000 in a project. The following are the
forecast for cash flows after tax, 1st year Rs. 10,000, 2nd year Rs. 40,000, 3rd year Rs.
60,000, 4th year Rs. 20,000 and 5th year Rs.5000. From the above information you are
required to calculate: (1) Pay-back Period (2) Discounted Pay-back Period if rate of
discounting is 10%.
Sol: Initial Investment = 1,00,000; CFATs are given for 5 years

(1) Pay-back Period

Year CFAT Cum CFAT

1 10,000 10,000
2 40,000 50,000
3 60,000 1,10,000
4 20,000 1,30,000
5 5,000 1,35,000

PBP = 2 years + 50,000/60,000

PBP = 2.83 years

(2) Discounted Pay-back Period if rate of discounting is 10%.

PVIF = 1/(1+r)^n

Year CFAT PVIF PVCIF Cum PVCIF

1 10,000 0.909 9,090 9,090
2 40,000 0.826 33,040 42,130
3 60,000 0.751 45,060 87,190
4 20,000 0.683 13,660 1,00,850
5 5,000 0.621 3,105 1,03,955

PBP = 3 years + 12,810/13,660

PBP = 3.94 years

9. The GE Company is considering an investment that will result in a $2,000 cash flow in one
year, a $3,000 cash flow in two years, and a $7,000 cash flow in three years What is the
Financial Management - Alaknanda Lonare

present value of this investment if all cash flows are to be discounted at an 8% rate? Should
GE Company management be willing to pay $10,000 for this investment?

Sol: NPV = PVCIF – PVCOF

PVCOF = $10,000

Calculation of PVCIF:

Year CFAT PVIF@8% PVCIF

1 2,000 0.926 1,852
2 3,000 0.857 2,571
3 7,000 0.794 5,558
Total PVCIF 9,981

NPV = PVCIF – PVCOF

NPV = 9,981 – 10,000
NPV = -19

As the NPV is negative therefore, GE Company management should not pay $10,000 for this
investment

10. A project cost Rs. 25,000 and it generates cash inflows through a period of five years Rs.
9,000, Rs. 8,000, Rs. 7,000, Rs. 6,000 and Rs. 5,000. If the required rate of return is assumed
to be 10%. Find out the Net Present Value and Profitability Index of the project.
Sol:

NPV = PVCIF – PVCOF

PVCOF = 25,000

Year CFAT PVIF PVCIF

1 9,000 0.909 8181.818
2 8,000 0.826 6611.57
3 7,000 0.751 5259.204
4 6,000 0.683 4098.081
5 5,000 0.621 3104.607
Total
PVCIF 27255.28
NPV = 27,255 – 25,000 = 2,255
PI = PVCIF / PVCOF
PI = 27,255 / 25,000
PI = 1.09
Financial Management - Alaknanda Lonare

11. A project costing Rs. 5,00,000 has a life of 10 years at the end of which its scrap value is
likely to be Rs. 50,000. The firm cut-off rate is 12%. The project is expected to yield an
annual profit after tax of Rs. 1,00,000; Depreciation being charged on straight line basis. At
12% P.A. the present value of the rupee received annually for 10 years is Rs. 5.65 and the
value of one rupee received at the end of 10th year is Re. 0.322. Ascertain the Net Present
Value of the project.

Sol: Cost of Project = 5,00,000; Life of project = 10 years; Scrap value = 50,000; r = 12%;
EAT = 1,00,000; PV of annuity factor for 1 rupee at 12% = 5.65; PV of 1 rupee at the end of
10th year (1/(1+0.12)10)= 0.322
NPV = ?

NPV = PVCIF – PVCOF

Dep using SLM = (cost of project – SV)/Life = 45,000;

PVCOF = 5,00,000

Calculation of PVCIF:
EAT = 1,00,000
(+) Depreciation = 45,000
CFAT = 1,45,000
 PV of annuity @ 12% = 5.65
PVCIF = 8,19,282
(+) PV of Scrap (50,000*0.322) = 16,099
Total PV of CFAT (PVCIF) = 8,35,381

NPV = PVCIF – PVCOF

NPV = 8,35,381 – 5,00,000

NPV = 3,35,381

OR
PVCIF can be calculated as below as well.
Year EAT Dep CFAT PV @12% PVCIF
145,00 12946
1 100000 45,000 0 0.893 4
145,00 11559
2 100000 45,000 0 0.797 3
145,00 10320
3 100000 45,000 0 0.712 8
4 100000 45,000 145,00 0.636 92150
Financial Management - Alaknanda Lonare

0
145,00
5 100000 45,000 0 0.567 82277
145,00
6 100000 45,000 0 0.507 73462
145,00
7 100000 45,000 0 0.452 65591
145,00
8 100000 45,000 0 0.404 58563
145,00
9 100000 45,000 0 0.361 52288
145,00
10 100000 45,000 0 0.322 46686
10* Scrap
* Value** 50,000 0.322 16099
83538
Total PVCIF 1

12. A project is under consideration of a firm. The initial outlay of the project is Rs. 10,000 and
it is expected to generate cash inflows of Rs. 4,000, Rs. 3,000, Rs. 5,000 and Rs. 2,000 in
four years to follow. Assuming 10% rate of discount, calculate the Net Present Value and
Benefit Cost Ratio of the project.

Sol: NPV = PVCIF – PVCOF and PI = PVCIF/PVCOF

PVOCF = 10,000

Calculation of PVCIF
PVIF @
Year CFAT 10% PVCIF
1 4,000 0.909 3636
2 3,000 0.826 2479
3 5,000 0.751 3757
4 2,000 0.683 1366

PVCIF 11238
PVCOF 10,000
NPV 1238

PI 1.12
Financial Management - Alaknanda Lonare

13. The cost of a project is Rs. 32,400. It is expected to generate cash inflows of Rs. 16,000, Rs.
14,000 and Rs. 12,000 through its three years’ life period. Calculate the Internal Rate of
Return of the Project.
Sol: PVCOF = 32,400; IRR =?

Calculation of PVCIF

Year CFAT Trial @10% PVCIF Trial @ 15% PVCIF

1 16,000 0.909 14,544 0.869 13,904
2 14,000 0.826 11,564 0.756 10,584
3 12,000 0.751 9,012 0.657 7,884
Total PVCIF 35,120 32,372
PVCOF 32,400 32,400
NPV 2,720 -28

Using Interpolation formula: IRR =

Lower Interest Rate + NPV of Lower Rate x (Higher Rate- Lower Rate)
NPV Lower Rate (-) NPV Higher Rate

IRR = 10 + 2,720 /(2720 –(-28)) * 5

IRR = 14.94%

14. There are two mutually exclusive projects under active consideration of a company. Both the
projects have a life of 5 years and have initial cash outlays of Rs. 1,00,000 each. The
company pays tax at 50% rate and the maximum required rate of the company has been given
as 10%. The straight line method of depreciation will be charged on the projects. The project
X is expected to generate a net cash inflow before depreciation and taxes of Rs. 40,000
throughout its life and project Y is expected to generate a net cash inflow before depreciation
and taxes of Rs. 60,000, 30,000, 20,000, 50,000 and 50,000 from one to five years
respectively. Compute: PBP, ARR, NPV, PI, and IRR. (HW)

15. The Alpha co. ltd. is considering the purchase of a new machine. Two alternative machine A
and B have been suggested, each having an initial cost of Rs. 4,00,000 and requiring Rs. 20,000
as additional working capital at the end of 1st year. Cash flows after taxes are expected to be as
follows:

Yea Machine A Machine B

r
1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
Financial Management - Alaknanda Lonare

4 2,40,000 1,20,000
5 1,60,000 80,000
The company has target of return on capital of 10% and on this basis, you are required to
compare the profitability of the machines and state which alternative you consider financially
preferable.

Sol:

NPV = PVCIF – PVCOF

Calculation of PVCOF = 4,00,000 + 20,000*[1/(1.10)1]

PVCOF = 4,18,181

Calculation of PVCIF

Machine Machine PVIF @ PVCIF for PVCIF for

Year
A B 10% Machine A Machine B
1 40,000 120,000 0.909 36364 109091
2 120,000 160,000 0.826 99174 132231
3 160,000 200,000 0.751 120210 150263
4 240,000 120,000 0.683 163923 81962
5 160,000 80,000 0.621 99347 49674
**5 20,000 20,000 0.621 12418 12418
** WC will be realized in last year
PVCIF 531437 535639
PVCOF 418,818 418,818
NPV 112619 116821

As the NPV of Machine B is higher therefore Machine b is recommended for investment.

16. M/s Pandey Ltd. is contemplating to purchase a machine A and B each costing Rs. 5,00,000.
Profits before depreciation are as follows:

Yea Machine Machine

r A B
1 1,50,000 50,000
2 2,00,000 1,50,000
3 2,50,000 2,00,000
4 1,50,000 3,00,000
5 1,00,000 2,00,000
Assuming a 10% discount rate indicate which of the machine would be profitable using NPV
method if depreciation is charged at 12% using written down value method and taxes at 30%.
Financial Management - Alaknanda Lonare

Calculation of Depreciation:
Financial Management - Alaknanda Lonare

Beginning Dep
Year Bal at the end of the year
amount @12%
1 500,000 60000 440,000
2 440,000 52800 387,200
3 387,200 46464 340,736
4 340,736 40888 299,848
5 299,848 35982 263,866

Calculation of NPV for Machine A:

EBITDA
Year Machine Tax@30 PVIF@10
A Dep EBT % EAT CFAT % PVCIF
1 150,000 60000 90,000 27000 63,000 123,000 0.909 111807
103,04
2 200,000
52800 147,200 44160 0 155,840 0.826 128724
142,47
3 250,000
46464 203,536 61061 5 188,939 0.751 141893
4 150,000 40888 109,112 32734 76,378 117,266 0.683 80093
5 100,000 35982 64,018 19205 44,813 80,795 0.621 50173
PVCIF 512691
PVCOF 500,000
NPV 12691

Calculation of NPV for Machine B:

EBITDA
Year
Machine B Dep EBT Tax@30% EAT CFAT PVIF@10% PVCIF
1 50,000 60000 -10,000 0 -10,000 50,000 0.909 45450
2 150,000 52800 97,200 29160 68,040 120,840 0.826 99814
3 200,000 46464 153,536 46061 107,475 153,939 0.751 115608
4 300,000 40888 259,112 77734 181,378 222,266 0.683 151808
5 200,000 35982 164,018 49205 114,813 150,795 0.621 93643
PVCIF 506324
PVCOF 500,000
NPV 6324
Financial Management - Alaknanda Lonare

17. Calculate the NPV of the following project requiring an initial cash outlay of Rs. 20,000 and
has no scrap value after 6 years. The net cash flows after taxes for each year of Rs. 6,000 for six
years. Assume the present value of an annuity of Re. 1 for 6 years at 8% p. a. interest is 4.623.
(HW)

18. After conducting a survey that cost Rs. 2,00,000, X ltd, decided to undertake a project for
placing a new product in the market. The company’s cut off rate is 12%. It was estimated that the
project would cost Rs.40,00,000 in plant and machinery in addition to working capital of
Rs.10,00,000. The scrap value of plant and machinery at the end of 5 years estimated at
5,00,000. After providing for depreciation on straight line basis, profit after tax was estimated as
follows:
Year 1 2 3 4 5
PAT 3,00,000 8,00,000 13,00,00 5,00,000 4,00,000
0
Ascertain, Net Present Value of the project if cost of capital is 12%.

Sol:

PVCOF = Cost of Machine + Survey Cost +WC

PVCOC = 40,00,000 + 2,00,000+10,00,000 = 42,00,000

Calculation of Depreciation = (Cost of Machine – SV) /Life

Depreciation = (40,00,000 – 5,00,000) / 5 = 7,00,000

Ye
PAT Dep CFAT PVIF PVCIF
ar
300,00 1,000,0 892,85
1 700000 0.893
0 00 7
800,00 1,500,0 1,195,7
2 700000 0.797
0 00 91
1,300,0 2,000,0 1,423,5
3 700000 0.712
00 00 60
500,00 1,200,0 762,62
4 700000 0.636
0 00 2
400,00 1,100,0 624,17
5 700000 0.567
0 00 0
1,000,0 567,42
5 Working Capital 0.567
00 7
500,00 283,71
5 Salvage Value 0.567
0 3
PVCI 5,750,1
F= 40
PVC 5,200,0
OF = 00
Financial Management - Alaknanda Lonare

550,14
NPV = PVCIF - PVCOF
0