Module 2

Capital Budgeting

Meaning of Investment Decision / Capital Budgeting

The term capital budgeting is a combination of two terms, namely, capital and budgeting. Capital
refers to the long term investment in business. Budgeting refers to planning for long term capital
requirements. Thus capital budgeting refers to the selection of proposals or projects for making
long term investment.

Capital budgeting simply refers to investment decisions. It is the planning of capital expenditure.
It is the process of allocating the resources of the organization in the long term projects to
generate profits. Capital budgeting is a process of long range planning involving investments of
funds in long term activities whose benefits are expected over a series of years. In short, capital
budgeting is the process of making investment decisions.

Features (Nature) of Capital Budgeting / Investment Decision

Capital budgeting decisions are not repetitive like working capital decisions. They are tailor-
made to the requirements of each situation. As such, capital budgeting has its own features. The
nature of capital budgeting may be understood from the following features:

1. Funds are invested in long term activities.

2. It involves large outlays.

3. Current funds are exchanged for future benefits.

4. The benefits are expected over a number of years in future.

5. It involves a high degree of risk.

6. Capital budgeting decision is irreversible. Hence, it requires careful consideration.

7. Gestation period is long. Gestation period is the period between the initial outlay and
anticipated return.

Role and Importance of Capital Budgeting/Investment Decision

Proper planning and utmost care is needed while making capital budgeting decisions. The
capital budgeting decisions are important, crucial and critical because of the following reasons:

1. Huge investment: Capital budgeting decisions involve huge investment in permanent assets
Hence it requires careful planning and appraisal. A mistake in capital budgeting can prove fatal
to the enterprise.
2. Long term implications: Capital budgeting decisions have long term effects on the future
profitability and cost structure of the firm. A right decision may bring amazing returns, while a
wrong decision may endanger the survival of the firm.

3. Irreversible decision: Capital budgeting decisions once made cannot be reversed easily. It is
not possible to abandon the project once the funds have been invested in it.

4. Risk: Long term commitment of funds involves greater risk and uncertainty. The longer is the
period of project, the greater may be the risk and uncertainty.

5. Growth: The capital budgeting decisions affect the rate and direction of growth of a firm

6. Impact on firm's competitive strength: The capital budgeting decisions affect the capacity
and strength of a firm to face competition. It is so because the capital investment decisions affect
the future profits and costs of the firm. This will ultimately affect the firm's competitive strength.

7. Most difficult decision: Capital budgeting decisions are very difficult to make. This is due to
(a) uncertainty of future; (b) decisions are based on future years' cash inflows, and (c) more risk.
Moreover, the benefits and costs are affected by economic, political and technological forces.
Therefore, such decisions are not so simple to be taken.

8. Cost control: In capital budgeting there is a regular comparison of budgeted and actual
expenditures. Thus cost control is facilitated through capital budgeting.

9. Wealth maximization: The basic objective of financial management is to maximize the

wealth of the shareholders. Capital budgeting helps to achieve this basic objective.

10. Economic and social consequence because of large size: There is an ever increasing trend
towards the creation of larger business units by amalgamation and globalization. Hence, if the
investment decisions are bad, the economic and social consequences would be very serious.

Steps in Capital Budgeting (Capital Budgeting Process)

Capital budgeting is a complex process. It is a six-step process (six 'P's of capital budgeting). The
following steps are involved in capital budgeting

1. Project generation: The capital budgeting process begins with generation or identification of
investment proposals. This involves a continuous search for investment opportunities which are
compatible with the firm's objectives.

2. Project screening: Each proposal is then subject to a preliminary screening process in order
to assess whether it is technically feasible, resources required are available , and the expected
return are adequate to compensate for the risks involved.
3. Project evaluation: After screening of project ideas or investment proposals the next step is
to evaluate the profitability of each proposal. This involves two steps: (a) estimation of costs and
benefits in terms of cash flows, and (b) selecting an appropriate criterion to judge the desirability
of the projects.

4. Project selection: After evaluation the next step is to select and approve the best proposal or
proposals.

5. Project execution and implementation: After the selection of projects (or finalisation of
proposal), funds are allocated for them and a capital budget is prepared.

6. Performance review: After the start of the implementation of a project, its progress must be
reviewed at periodical intervals. The follow-up or review is made by comparing actual
performance with the budget estimates. This helps to take corrective action.

Factors Affecting Capital Budgeting Decisions

1. Availability of fund

2. Utilization of funds

3. Urgency of the project

4. Expectation of future earnings

5. Intangible factors

6. Risk and uncertainty

7. Minimum rate of return on investment.

Approaches to Capital Budgeting Decisions

There are three approaches to capital budgeting decisions. They are:

1. Disaster approach: In many cases, the capital expenditure decisions are taken by
management only when a disaster occurs, e.g., a plant breaks down. Thus, this approach is a
situation of management by crisis.

2. Passive approach: Under this approach, the emphasis is only on present needs. It is a
situation of "manage as we go". This is an improvement over the first approach.

3. Dynamic approach: This is the most modern and effective approach to capital budgeting In
this approach, the emphasis is on long range planning. In this case the capital budgeting
decisions are taken on the basis of market research, technological changes etc. Thus, under this
approach the capital expenditures are the results of advance planning.
Limitations of Capital Budgeting

1. The benefits from investments are received in future. These are uncertain. Therefore, an
element of risk is involved.

2. Some factors affecting investment proposals cannot be expressed in money value.

3. It is difficult to estimate the period for which investment is to be made and income will
generate.

4. It is not easy to estimate the rate of return because future is uncertain.

5. It is difficult to estimate the cost of capital.

Information Required for Capital Budgeting/Investment Decision

The following data or information is required before using any technique of capital budgeting

1. Cash flows: In capital budgeting decisions, the cost and benefit of a project are measured in
terms of cash flows. Cash flow may be cash outflow or inflow. Costs are referred to as cash
outflows and benefits (from the project) are denoted as cash inflows.

Types of Cash Flows: There are three types of cash flows. They are:

(a) Initial cash flow (Initial investment): It is the investment required for beginning a new
project. It is the outlay of total cash outflows that takes place in the initial period (zero time
period). It will be a large amount. It includes: (a) cost of new asset, including insurance, freight,
installation charges etc. (b) opportunity cost of the assets (c) increase in working capital or
additional working capital (increase in fixed assets leads to an increase in the amount of current
assets required for increase the production).

(b) Net annual cash inflows or operating cash flows: The initial investment is expected to
generate a series of cash inflows in the form of benefits or returns (i.e., profits) from the project.

These cash inflows are called net annual cash inflows or simply cash flows. These may be same
every year throughout the life of the project or may vary from year to year.

(c) Terminal cash inflows: It is the cash inflows for the last or terminal year of the project. It
occurs in two ways: (a) the estimated salvage or scrap value realizable at the end of the life of the
project (termination) and (b) the working capital which was invested in the beginning will no
longer be required as the project is being terminated.

2. Required rate of return: The expected rate of return from a proposal is required in order to
(a) adjust the future cash flows of a project for time value of money, and (b) thereafter,
determining the profitability of the proposal or project. An investment proposal is accepted when
the retum from it is more than the required rate of return. This required rate of return is also
called cost of capital or cut-off rate or hurdle rate.

3. Other information: (a) Economic life of the project (b) available funds (c) risk of
obsolescence ete

Investment Evaluation Criteria or Methods (Methods or Techniques of Capital Budgeting)

There are a number of appraisal criteria (or evaluation methods) to judge the profitability of
capital projects More than 30 criteria have been proposed to guide investment decision making.
The more important and popular of these can be classified into two broad categories as follows:

1. Non- discounting Techniques or Traditional Methods

(a) Urgency Method

(b) Pay Back Method

(c) Average Rate of Return Method

2 Discounting Criteria or Modern Methods

(a) Discounted Pay Back Method

(b) Net Present Value Method

(c) Benefit Cost Ratio

(d) Internal Rate of Return

(e) Modified Internal Rate of Return

(f) Net Terminal Value method

Traditional Methods

Traditional methods do not take into consideration the time value of money. Important traditional
methods may be discussed as follows:

Urgency Method

Urgency is a criterion used to justify the acceptance of capital projects on the basis of emergency
requirements or under crisis conditions. Under this method, urgency or degree of necessity plays
an important role and the project that cannot be postponed is undertaken first. In short, the most
urgent project is taken up first.
Pay Back Method (Pay Back Period or PBP)

This is one of the commonly used techniques of evaluating capital expenditure proposals. It is a
cash based technique. It uses qualitative approach to evaluate capital budgeting. Pay back period
is the length of time or period required to recover the initial cost (investment) of the project. It is
the expected number of years during which the original investment is recovered. It is the break
even point of the project, where the accumulated returns (cash inflows) equal investment (cash
outflow). Pay back method is also called 'pay-out' or 'pay-off period' or 'recoupment period or
'replacement period'. Some companies use a 'target payback' approach. In this case companies
specify a maximum payback period that projects must meet in order to be accepted.

The payback period can be calculated in two different situations as follows:

1. When annual cash inflows are equal: When cash inflows or benefits generated by a project
per year are equal or constant (i.e., even cash inflows), the payback period is computed by
dividing the initial investment or cash outlay by the net annual cash inflows. It is expressed as
follows: Pay back period = Original cost of project (cash outlay) or I Annual net cash inflow (net
earnings) For example, if a project involves a cash outlay of Rs.5,00,000 and generates cash
inflow of Rs.1,00,000 annually for 7 years Payback 1,00,000 = 5 years

The whole cost of the original investment, i.e., Rs. 5,00,000 is recovered with 5 years.

2. When annual cash inflows are unequal: When cash inflows in different years are unequal
(uneven) the computation of payback period is not so easy as in the case of even cash inflows.

In such a case, payback period is calculated in the form of cumulative cash inflows. It is
ascertained by cumulating cash inflows till the time when the cumulative cash inflows become
equal to initial investment. For example, if the cost of the project is Rs. 1,00,000 and the cash
inflows are: Ist year Rs. 10,000, second year Rs. 15,000, 3rd year Rs. 25,000, 4th year Rs.
30,000, and 5th year Rs. 30,000. Pay back period to recover original investment of Rs, 1,00,000
comes to 4 years and 8 months (Rs. 80,000 is recovered in 4 years and to recover the balance Rs.
20,000, 8 months are required).

20,000/30,000 = 2/3 years or 8 months

Pay back period can also be calculated by the following formula:

Pay back period = E+ B/C

where, E= No. of years immediately preceding the year of final recovery

B= Balance amount still to be recovered.

C=Cash inflow during the year of final recovery.

Under payback method the cash inflow (benefit or return) means the operating profit before
depreciation and amortization of intangible assets but after tax.

Decision Rule (or Selection Criterion): According to the pay back criterion, the shorter the pay
back, the better the project. This means a project having shorter pay back period is chosen.

Suitability of Payback Method

Payback method is an appropriate method under the following circumstances:

(a) When the cost of the project is comparatively small

(b) When the project is likely to be completed in short period

(c) When only limited funds are available

(d) When the cash earning capacity of the company is low

(e) When there is chance of obsolescence due to technological development.

Average Rate of Return Method/Accounting Rate of Return Method (ARR)

ARR method is a simple technique of averaging returns over investments. The ARR represents
the ratio of the average annual profits to the average investment in the project. It is based on
accounting profits and not cash flows. This method is also known as Accounting Rate of Return
method or Return on Investment method or unadjusted rate of return method. Under this method
average annual profit (after tax) is expressed as percentage of investment. ARR is found out by
dividing average income by the average investment. ARR is calculated with the help of the
following formula:

ARR= Average income or return / Average investment

The average return is computed by adding all the earnings and dividing them by project's life.
Under ARR method the cash inflow (i.e, return) means the earnings and dividing them by
project's life. Average investment is found in two alternative ways as follows

Average Investment = (Original Investment + Scrap Value)/2

or

(Original Investment - Scrap Value)/2 + Scrap Value

The amount of scrap value is first deducted and then added back. It is deducted to find out the
annual amount of depreciation. However, this amount is blocked throughout the life of the
project and is released only at the end of its economic life. That is why it is added back to find
out the average investment.
Sometimes, the project may also require additional working capital for its smooth operation. This
additional working capital will be blocked throughout the life of the project. Hence it is added to
the average investment. Thus in this case average investment is ascertained as follows:

= (Original Investment - Scrap Value)/ 2 +Scrap Value + Additional Working Capital

Decision Rule (or Selection Criterion): The higher the average rate of return, the better the
project. If the projects are mutually exclusive, the project with the highest rate of return is
selected. If the calculated ARR is equal to or more than the company's target rate of return, the
project will be accepted. If the calculated ARR is less than the company's target rate of return,
the project is totally rejected.

Discounted Cash Flow Techniques (Time adjusted cash flow techniques)

Features of Present Value Methods

1. All present value methods are based on discounted cash flows. Both cash inflows and cash
outflows are discounted to ascertain their present value.

2. These use cash flows and not accounting concept of profit. That is cash inflow after tax but
before depreciation are taken.

3. They take into consideration the interest factor by recognising the value of earlier cash flows
compared to later cash flows.

4. They consider the entire cash flows of a project throughout its economic life.

Important discounted techniques are discounted pay back period method, net present value
method, profitability index method, internal rate of return method, net terminal value method etc.

Discounted Pay back Period

A major shortcoming of the conventional pay back period method is that it does not take inty
account the time value of money. To overcome this limitation the discounted pay back pering
method is suggested. In this modified method, cash flows are first converted into their present
values (by applying suitable discounting factors) and then added to ascertain the period of time
required to recover the initial outlay on the project.

Net Present Value Method (NPV)

NPV method involves discounting future cash flows to present values. Under this method, the
present value of all cash inflows (stream of benefits) is compared against the present value of all
cash outflows (cash outlays or cost of investment). The difference between the present value of
cash inflows and present value of cash outflow is called the net present value In other words, the
cash outflow (i.e., initial investment whose present value is the same) is deducted from the sum
of the present values of future cash inflows (returns or benefits). The balance amount is the NPV
The NPV may be either positive or negative. If the NPV is positive, it means that the actual rate
of return is more than the discount rate. A negative NPV indicates that the project is not even
covering the cost of capital. It means that the actual rate of return is less than the discount rate.

The discount rate for obtaining the present value is some desired rate of return which may be
equal to the cost of capital. If the discount rate represents the company's cost of capital, then the
NPV represents the returns to the company's shareholders over and above the cost of capital. As
a result, we may say that a positive NPV contributes to the wealth of the shareholders. NPV
method is also known as investor's method.

Computation Procedure of NPV

The following steps are involved in the computation of NPV:

(a) Determination of minimum rate of return: To discount the cash flows a minimum rate of
interest should be selected. This is generally the firm's cost of capital (i.e., the minimum rate of
return an investor expects from the firm to earn on the proposed investment).

(b) Computation of PV of cash inflows and outflows: With the help of the minimum rate of
return, the present value of cash inflows (return or benefit) and the present value of cash
outflows (cost or amount of investment) should be computed. As investment in the project is
made at the beginning of the period, its cost (cash outflows) itself is the present value.

The present values of cash flows for different years may be calculated with the help of the
following formula:

Note: In practice, the present values are not computed with the help of above formula. For this
"Present Value Table" is used. The formula for computation of present value is as follows:

PV = Cash inflow x discount factor of the concerned period.

(c) Computation of NPV: The difference between total present value of cash inflows and total
present value of cash outflows should be found out. The resulting amount is the net present value
(NPV).

Decision Rule (or Selection Criterion): In the case of mutually exclusive or alternative project,
(where only one project is to be selected) accept a project that has the highest positive NPV. In
the case of independent investment, accept a project if its NPV is positive. If the NPV is
negative, reject it.

Alternative method: If the cash inflows are equal, the present values can be found easily by
using annuity table. An annuity is a series of equal and consecutive cash flows. The present value
(PV) of an annuity is calculated as follows:
Annual net cash flow x Annuity factor

The alternative method is the short cut method. This method can be used only when the cash
inflows are uniform over the different years.

Benefit Cost Ratio (Profitability Index Method)

Two projects having different investment outlay cannot be compared by net present value
method because it indicates the NPV in absolute terms. In such a situation, benefit cost ratio
should be applied. It is the ratio of benefits (cash inflows) to cost (cash outflow). It is the ratio of
present value of cash inflows to the present value of cash outflows. Thus it measures the present
value of returns. Benefit cost is also called profitability index or present value index. It is
particularly useful to compare the projects having different investment outlays.

Benefit cost ratio is computed as follows:

Benefit cost ratio = Present value of cash inflows/ Present value of cash outflows

Profitability index method may also be expressed as follows:

NPV/ PV of cash outflows (i.e., investment)

Then it is called Net Present Value Index (NPVI) or Excess Present Value Index (EPVI). Thus,
NPVI or EPVI is the ratio of NPV to the initial cash outflow of the project.

An important feature of PI is that it can also explain the NPV position of an investment, that is if
PI is equal to one then NPV will be equal to zero. If it is greater than one, then NPV will be
positive. If it is less than one, then NPV will be negative. PI is particularly useful for appraising
the projects on the basis of their profitability. This is because the present value of a project is
compared against its investment.

Decision Rule (or Selection Criterion): Under PI method the decision rule is "accept the
project if its PI is more than one and reject the project if PI is less than one". In the case of
mutually exclusive projects, the project with higher PI is to be selected. Higher the profitability
index better is the project.

Internal Rate of Return (IRR)

In IRR we try discounting at different discount rates until we reach the discount rate at which the
present value of cash inflows is equal to the present value of cash outflow (investment). Thus
internal rate of return is the rate of return at which total present value of future cash inflow is
equal to initial investment. In other words, it is the rate at which NPV is zero. This rate is called
the internal rate because it exclusively depends on the initial outlay and cash proceeds associated
with the project and not on any other rate outside the investment.
Calculation of IRR

(a) When cash flows are equal

If the cash inflows are uniform or equal, the calculation of IRR is simple. This can be explained
with the help of an example:

Example

A project cost Rs. 6,000 and is expected to generate cash inflow of Rs. 2,000 over its life of 5
years.

In this case IRR may be calculated by taking the following steps:

Step 1: First of all a rough approximation may be made with reference to PV factor (or payback
period). This is calculated by the following formula:

P.V factor = Initial Investment/ Annual Cash Inflow

= 6,000/ 2,000

=3

The P.V factor in the given example is 3.

Step 2: Search for a value nearest to P.V factor (3) in the 5^{\circ} year row of cumulative
present value table (Table II). The rate given in the column of the P.V factor will be the IRR.
But, usually, the same P.V factor as calculated by the above formula (i.e.,3 in this example) is
not available in the cumulative present value table. We shall get closest rates from the table. In
the given example, one rate is 18% (3.127 present value of Re.l in the 5th year row). The other
closest rate is 20% (2.9000 present value of Re.1 in the 5th year row). This implies that IRR is
more than 18% but less than 20%. In other worlds, IRR is expected to lie in between 18% and
20%.

Step 3: In order to make a precise estimation of the IRR, find out the present values of the
project for both these rates. It is calculated as follows:

P.V at 18% = Rs 2000*3.127 = Rs 6254

P.V at 20% = Rs 2000*2.9000 = Rs 5800

Step 4: Find out the exact IRR by interpolation. The interpolation should be made between two
closest discount rates having a positive NPV and a negative NPV. The interpolation formula is as
follows:
Interpolation formula:

Where,

L= Lower discount rate

H= Higher discount rate

P1 = Present value at lower rate

P2 = Present value at higher rate.

Q= Net cash outlay.

(b) When cash flows are unequal:

When cash inflows are uneven, the IRR is calculated by Trial and Error Method. In this method,
present values of cash inflows are computed at different rates. In the last, the rate at which the
total P.V of cash inflows is equal to the cost of the project is treated as the IRR. The following
steps are required:

1. Calculate average cash inflow and establish first trial rate: It is difficult to decide the rate
at which the trial should be commenced. However, the first trial rate can be calculated on the
basis of average annual cash inflow. To get the first trail rate, the following formula may be
used:

P.V factor = Initial Investment/ Average annual cash inflows

Now, search for a value nearest to PV factor (as calculated above) in the row of year of life in the
cumulative present value table (Table II). The rate given in the column against this value will be
the first trail rate. The present value of cash inflows of all the years will be computed at this rate
using the present value table (Table II).

Alternatively, various discounting rates are applied to the net cash flows until the rate is found
that reduces NPV to zero. Usually cut-off rate is at the starting point. If it is not given, first rate is
computed as follows:

(Average earning p.a./ Investments) x 100

2. Try the second trial rate: The total of the present value of cash inflows for all years
calculated by first trial rate will be compared with the cost of the project.

If the NPV at the first rate comes positive, a higher rate should be tried. If the NPV comes
negative, a lower rate should be tried. This exercise is done till the NPV comes to zero
3. Compute actual IRR: It is tedious to find the discount rate where NPV becomes zero. Hence
interpolation will be applied after arriving at a range between which the IRR lies. It should be
noted that we should not try to interpolate between a range of more than 5%.

Decision Rule (or Acceptance Criterion): The calculated internal rate of return is compared
with the desired minimum rate of return (cut-off rate). If IRR is equal to or greater than the
desired minimum rate of return, then the project is accepted. If it is less than the desired
minimum rate of return, then the project is rejected.

Problems
1. A project involves a cash outlay of Rs 5, 00,000 and generates cash inflow of Rs 1, 00,000
annually for 7 years. Calculate payback period?

Ans.

Payback = 5, 00,000 / 1, 00,000 = 5 Years

The whole cost of the original investment i.e. Rs 5, 00,000 is recovered with 5 years.

2. The cost of the project is ₹ 1, 00,000 and the cash inflows are: 1st year 10,000, second year
15,000, 3rd year 25,000, 4th year 30,000, and 5th year 30,000. Compute payback period?

Ans. Payback period to recover original investment of 1, 00,000 comes to 4 years and 8 months
(80,000 is recovered in 4 years and to recover the balance 20,000, 8 months are required).

20,000/30000= 2/3 years or 8 months

Thus, payback period can be calculated by the following formula:

Payback period = Year before full recovery + (Unrecovered amount + Cash flows during the
year)

Important Note: Under payback method the cash inflow (benefit or return) means the operating
profit before depreciation and amortization of intangible assets but after tax.

Decision Rule (or Selection Criterion): According to the pay back criterion, the shorter the pay
back, the better the project. This means a project having shorter payback period is chosen.

3. For each of the following projects, compute (a) payback period, and (b) post pay back
profitability.

Project A
Initial outlay 1,00,000
Annual cash inflows (after tax but before 20,000
depreciation)
Estimated life 8 years

Project B
Initial outlay 1,00,000
Annual cash inflows (after tax but before
depreciation):
First 3 years 30,000
Next 5 years 10,000
Estimated life 8 years.

Ans.

Project A
Initial Investment 1,00,000
Payback period 5 years
Annual cash inflows 20,000
Post pay back profitability Total cash inflows in life – Initial cost
1,60,000 – 1,00,000 = 60,000
Or 20,000 * (8-5) = 60,000
Note: Total cash inflows in life 20,000 * 8 = 1,60,000

Cash inflows are not equal. Therefore, payback period is calculated as follows:

First year cash inflow = 30,000

Second year cash inflow = 30,000

Third year cash inflow = 30,000

Fourth year cash inflow = 10,000

Thus, payback period is 4 years.

Post pay back profitability = Total cash inflows in life - Initial cost = 1, 40,000-1, 00,000 =
40,000

Note: Total cash inflows in life = (30,000 x 3) + (10,000×5) = 1, 40,000

4.

Projects
X Y
Capital cost 40,000 60,000
Earnings after 1st year 5,000 8,000
depreciation
2nd year 7,000 10,000
3rd year 6,000 7,000
4th year 6,000 5,000

Calculate ARR of projects X and Y.

Ans.

The average earnings of Project X = 24,000 / 4 = 6,000

The average investment = (Cost at the beginning + Cost at the end of the life) / 2

(40,000+ 0) / 2 =20,000

Therefore, ARR = (6,000 / 20,000) ×100 = 30%

Similarly,

Average earnings of Project Y = 30,000 / 4 = 7,500

Average investment = (60,000+0) / 2 = ₹30,000

Therefore, ARR = (7,500 / 30,000) ×100=25%

On the basis of ARR, project X will be selected as its ARR is higher than that of project Y the
projects are mutually exclusive).

5. The following information relate to two projects A and B. The required rate of return is 15%.
Initial outlay for both projects is 1, 00,000. Calculate the NPV of the two projects and say which
project t is better?

Cash inflows over the five years are:

Years 1 2 3 4 5
Project A 30,000 40,000 40,000 30,000 30,000
Project B 20,000 30,000 50,000 40,000 30,000
Ans.

Project A
YRS Investment & Cash Discount Factor at Present value(Rs)
flow(Rs) 15%
0 -1,00,000 1,00,000
1 +30,000 0.870 +26,100
2 +40,000 0.756 +30,240
3 +40,000 .658 +26,320
4 +30,000 0.572 +17,160
5 +30,000 0.497 +14,910
+1,70,000 +1,14,730
PV of cash outflow -1,00,000
NPV 14,730

Project B
YRS Investment & Cash Discount Factor at Present value(Rs)
flow(Rs) 15%
0 -1,00,000 1,00,000
1 +20,000 0.870 +17,400
2 +30,000 0.756 +22,680
3 +50,000 .658 +32,900
4 +40,000 0.572 +22,880
5 +30,000 0.497 +14,910
+1,70,000 +1,10,770
PV of cash outflow -1,00,000
NPV 10,770

It is presumed that life of both the project is 5 years. Entire investment of ₹ 1, 00,000 is done in
one year of construction period.

In the above case, project A is better because the NPV is higher.

Alternative method: If the cash inflows are equal, the present values can be found easily by
using annuity table. An annuity is a series of equal and consecutive cash flows. The present value
(PV) of an annuity is calculated as follows:

Annual net cash flow x Annuity factor

For example, a project is expected to produce net cash flows of 10,000 per year for each of the
next four years. The discount rate is 10%. In this case, the annuity factor @ 10% against the 4
year is 3.17 (as per annuity table). The present value is 31,700 (i.e., 10,000 x 3.17). According to
the first method (the method followed in example 5) also, we shall get the same present value as
follows

Year Cash Flows (Rs) D.F @ 10% PV(Rs)

1 10,000 0.909 9,090
2 10,000 0.826 8,260
3 10,000 0.751 7,510
4 10,000 0.683 6,830
3.169( or 3.17) 31,690(or 31,700)
The alternative method is the short cut method. This method can be used only when the cash
inflows are uniform over the different years.

6. Projects X and Y are having initial investment of 50,000 and 1, 00,000 respectively. Their
present values of cash inflows are 60,000 and 1, 12,000.

Calculate Profitability Index.

Ans.

Project X (Rs) Project Y (RS)

Present value of investment( -50,000 -1,00,000
cost)
Present value of cash +60,000 +1,12,000
inflows(benefits)
NPV +10,000 +12,000
PI 60,000/50,000 = 1.20 1,12,000/1,00,000=1.12
Or 10,000/50,000 = 0.2 12,000/1,00,000=0.12

As profitability index of project X is more than that of project Y, it can be concluded that project
X is better than project Y.

According to the absolute figure of net present value, project Y appears better than project X.
But in fact project X is better because in project X, an investment of ₹ 50,000 provides an NPV
of 10,000 whereas in project Y an investment of twice that amount provides a net present value
of 12,000 only.

7. A project cost 6,000 and is expected to generate cash inflow of 2,000 over its life of 5 years.

Compute IRR?

Ans.

Step 1: First of all a rough approximation may be made with reference to PV factor (or payback
period). This is calculated by the following formula:

P.V. factor = Initial Investment / Annual Cash Inflow = 6000/2000 = 3

The P.V. factor in the given case is 3.

Step 2: Search for a value nearest to P.V factor (3) in the 5th year row of cumulative present
value table (Table II). The rate given in the column of the P.V factor will be the IRR. But,
usually, the same P.V factor as calculated by the above formula (i.e., 3 in this example) is not
available in the cumulative present value table. We shall get closest rates from the table. In the
given example one rate is 18% (3.127 present value of 1 in the 5th year row). The other closest
rate is 20% (2.9000 present value of 1 in the 5th year row). This implies that IRR is more than
18% but less than 20%. In other worlds, IRR is expected to lie in between 18% and 20%.

Step 3: In order to make a precise estimation of the IRR, find out the present values of the
project for both these rates. It is calculated as follows:

P.V. at 18% = 2,000 x 3.127 = 6,254

P.V. at 20% = 2,000 x 2.9000 = 5,800

Step 4: Find out the exact IRR by interpolation. The interpolation should be made between two
closest discount rates having a positive NPV and a negative NPV. The interpolation formula is as
follows:

Interpolation formula:

where,

L= Lower discount rate

H= Higher discount rate

P1 = Present value at lower rate

P2 = value at higher rate.

Q = Net cash outlay.

In the given example, the actual IRR will be:

18% + ((6254-6000)/(6254-5800)) * (20% - 18%)

= 18% + (254/454) *2

=18% +1.12%

=19.12%

Alternatively,

= 18% + ((3.127-3.00)/ (3.127-2.900)) * (20-18)

=19.12%
In the alternative method, step 3 can be avoided.

(b) When cash flows are unequal

When cash inflows are uneven, the IRR is calculated by Trial and Error Method. In this method,
present values of cash inflows are computed at different rates. In the last, the rate at which the
total PV of cash inflows is equal to the cost of the project is treated as the IRR. The following
steps are required:

1. Calculate average cash inflow and establish first trial rate: It is difficult to decide the rate
at which the trial should be commenced. However, the first trial rate can be calculated on the
basis of average annual cash inflow. To get the first trail rate, the following formula may be
used:

P.V factor = Initial Investment / Average annual cash inflows

Now, search for a value nearest to PV factor (as calculated above) in the row of year of life in the
cumulative present value table (Table II). The rate given in the column against this value will be
the first trail rate. The present value of cash inflows of all the years will be computed at this rate
using the present value table (Table II).

Alternatively, various discounting rates are applied to the net cash flows until the rate is found
that reduces NPV to zero. Usually cut-off rate is at the starting point. If it is not given, first rate is
computed as follows:

(Average earning p.a. / Investments) ×100

2. Try the second trial rate: The total of the present value of cash inflows for all years
calculated by first trial rate will be compared with the cost of the project.

If the NPV at the first rate comes positive, a higher rate should be tried. If the NPV comes
negative, a lower rate should be tried. This exercise is done till the NPV comes to zero 3.
Compute actual IRR: It is tedious to find the discount rate where NPV becomes zero. Hence
interpolation will be applied after arriving at a range between which the IRR lies. It should be
noted that we should not try to interpolate between a range of more than 5%.

8. From the following information, calculate IRR:

Cost : 22,000
Cash inflows:
Year
1 12,000
2 4,000
3 2,000
4 10,000

Ans.

Average cash inflow (12,000+4,000+2,000+10,000) / 4 = 7,000

PV Factor= 22,000 / 7,000 = 3.14

The closest present value to 3.14 from Annuity Table (Table II) is 3.170 at 10%. Thus the first
trial rate is 10%. At this rate, the present values (Table 1) may be calculated as follows

Year Cash inflow(Rs) Dis. Factor 10% PV(Rs)

1 12,000 0.909 10,908
2 4,000 0.826 3,304
3 2,000 0.751 1,502
4 10,000 0.683 6,830
Total 22,544
Cost of the project 22,000
NPV +544

Since the NPV is positive, Let us try a higher rate, say 12%

Year Cash inflow(Rs) Dis. Factor 10% PV(Rs)

1 12,000 0.909 10,716
2 4,000 0.826 3,188
3 2,000 0.751 1,424
4 10,000 0.683 6,360
Total 21,688
Cost of the project 22,000
NPV -312

Thus, IRR lies in between 10% and 12%. The actual IRR can be interpolated as follows:

IRR = 10 + ((22,544-22000)/(22,544-21,688)) * (12-10)

= 10 + (544/856)*2

=10+1.27

=11.27%
Or

Lower rate + ((positive NPV)/(Positive NPV + Negative NPV)) * (Higher rate – Lower rate)

= 10 + (544/(544+312)) * (12-10) = 11.27%

Alternatively, IRR can also be calculated from the higher rate as follows:

12-((22,000-21,688)/(22,544-21,688)) * (12-10)

=12-(312/856)*2

=12-0.73

=11.27%

Decision Rule (or Acceptance Criterion): The calculated internal rate of return is compared
with the desired minimum rate of return (cut-off rate). If IRR is equal to or greater than the
desired minimum rate of return, then the project is accepted. If it is less than the desired
minimum rate of return, then the project is rejected.

9. Compute the ARR from the following data of two machines A & B

Machine A Machine B

Original cost 56,125 56,125

Addl. Investment in 5,000 6,000

net working capital

Estimated life in 5 5
years

Estimated salvage 3,000 3,000

values

Average income-tax 55% 55%

rate

Annual estimated
income after
depreciation and 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

Depreciation has been charged on straight line basis.

Ans.

ARR = (Average Earnings/Average Investment) *100

Average Income = Total Income/ Number of Years

Machine A = 36875/5= Rs 7375

Machine B = 36875/5 = Rs 7375

Average Investment = (Original Investment – scrap Value)/2 + Addl. Net working Capital
+Scrap Value

Machine A = (56125-3000)/2 + 5000+ 3000

= 26562.50 + 8000

= 34562.50

Machine B = (56125-3000)/2 + 6000+ 3000

=26562.50 + 9000 = 35562.50

ARR of Machine A = (7375/34562.50) * 100 = 21.34%

ARR of Machine B = (7375/35562.50) * 100 = 20.74%

10. A project with an initial investment of Rs 1, 00,000 generates cash inflows of 50,000, 40,000
and 30,000 with life of 3 years. What will be the IRR?

Ans.

Step 1: For this, first trial rate will be calculated as follows:

= Initial Investment / Average Annual Cash Inflows

= 1, 00,000 / [(50000+40000+30000) / 3]

= 100000/40000 = 2.5

In the row of 3rd year of the cumulative present value table (Table II), the rate of return at this
P. V actor is approximately 10%. Therefore, total present value of cash inflows of different years
at this rate will be compared with the cost of the investment:-

Verification of First Trial Rate of Return

Year Cash Inflows PV factor @10% PV

1 50000 0.909 45450

2 40000 0.826 33040

3 30000 0.751 22530

Total Present Value 101020

Step II: As the total present value of cash inflows (1,01,020) is more than the cost of

investment (1,00,000); hence, the next trial rate will be higher than this, i.e., 12% and

total present value at this rate will be as follows:

Verification of Second Trial Rate of Return

Year Cash Inflows PV factor @10% PV

1 50000 0.893 44650

2 40000 0.797 31880

3 30000 0.712 21360

Total Present Value 97890

Step III: At this rate (12%) the total present value of cash inflows (97,890) is less than the

cost of investment (1,00,000). Therefore, the IRR will be lower than this. The actual IRR will be
calculated by interpolation as follows:-

IRR= 10 + [(1, 01,020-1, 00,000) / (1, 01,020-97,890)] x (12-10) =10+0.65=10.65%

11. A Ltd is considering the purchase of a new machine. Two alternative machines (A & B)
have been suggested each costing Rs 400000. Earnings after taxation are expected to be as
follows.

Cash Flows

Year Machine A Machine B

1 40000 120000

2 120000 160000

3 160000 200000

4 240000 120000

5 160000 80000

The company has a target of return on capital @ 10% and on this basis you are required to
compare the profitability of machines and state which alternative you consider financially
preferable.

Note:

Year 1 2 3 4 5

PV of Rs 0.91 0.83 0.75 0.68 0.62

1 @ 10%
Ans. The profitability of the machines can be compared on the basis of NPV of cash inflows as
follows

Machine A Machine B

Year Discount Cash Inflow Present Cash Present

Factor @ Value Inflow Value
10%

1 0.91 40000 36400 120000 109200

2 0.83 120000 99600 160000 132800

3 0.75 160000 120000 200000 150000

4 0.68 240000 163200 120000 81600

5 0.62 160000 99200 80000 49600

518400 523200

Cost 400000 400000

Net Present Value 118400 123200

The NPV is higher in case of Machine B and hence Machine B is preferable. If the costs of
Machines are different, the decision will be taken on the basis of profitability Index