Professional Documents
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In case the product does not come out or comes out but
proves to be unprofitable, the company will have to
bear the burden of fixed-cost unless it decides to write
off the investment completely. A wrong decision,
therefore, can provide disastrous for the long-term
survival of the firm. Similarly, inadequate investment in
assets would make it difficult for the firm to run the
business in the long run just as an unwanted expansion
results in unnecessary heavy operating costs to the firm.
situation.
Solution
(a) Cash required for the purchase of the Rs. 15,000
new machine
Less: Cash realised on sale of the old
machine 6,000
Net Cash Outflow 9,000
(b) Cash required for purchase of the new Rs. 15,000
machine
Less: Cash realised on sale of the old Rs. 8,000
machine
Rs. 7,000
Add: Income tax liability on profit made
on sale of machinery (2000 x 50/1000) 1,000
Net cash Outflow 8,000
(c) Cash required for purchase of the new Rs. 15,000
machine
Less: Cash realised on sale of the old 12,000
machine
3,000
Add: Income Tax Liability (6000x50/100) 3000
Capital Gains tax liability (2000x30/100) 600
3,600
Net Cash Outflow
6,600
(b) Cash required for purchase of the new Rs. 15,000
16
machine
Less: Cash realised on sale of the old 4,000
machine 11,000
Solution
ESTIMATION OF CASH REQUIREMENT FOR
REPLACEMENT
Cost of the new machine Rs.70000
Add: Installation charges 10,000
Additional working capital required 5,000
Additional tax liability ;
Income tax 5,000x50/1 00 2,500
Capital gains tax
87,500
Less: Amount realized on sale of old machine 25,000
Investment allowance [70,000 x 20/100] 14,000 39,000
Net Cash outflow 48,500
Cut-off point
The cut off point refers to the point below which a
project would not be accepted. For example, if 10% is
the desired rate of return, the cut-off rate is 10%. The
cut-off point may also be in terms of period. For
example, if the management desires that the investment
in the project should be recouped in three years, the
period of three years would be taken as the cut-off
period. A project, incapable of generating necessary
cash to pay for the initial investment in the project
within three years, will not be accepted.
Solution
Initial Investment
Pay-back period = Annual Cash Inflow
Rs.20,000
= Rs. 5,000
= Rs.5,000 X 100
Rs.20,000 = 25%
Machine M Machine N
Estimated life of machine 4 years 5 years
Cost of machine Rs.9,000 Rs. 1 8,000
Estimated saving in scrap 500 800
Estimated savings in direct wages 6,000 8,000
Additional cost of maintenance 800 1,000
Additional cost of supervision 1,200 1,800
Ignore taxation
Solution:
STATEMENT SHOWING ANNUAL CASH
INFLOWS
Machine M Machine N
Estimated saving in scrap Rs. 500 Rs. 800
Estimated savings in direct wages 6,000 8,000
Total Savings (i) 6,500 8,800
Additional cost of maintenance 800 1,000
Additional cost of supervision 1,200 1,800
Total Additional costs (ii) 2,000 2,800
Net Cash Inflow (i) - (ii) 4.500 6,000
Pay-back period =
Original Investment
Annual Average Cash Inflow Machine M
9,000
= 4,500
= 2 years
Illustration 5:
Machine
1 2 3
(Rs.) (Rs.) (Rs.)
Capital Cost 3,00,000 3,00,000 3,00,000
Sales (at standard prices) 5,00,000 4,00,000 4,50,000
Net Cost of Production:
Direct Material 40,000 50,000 48,000
Direct Labour 50,000 30,000 36,000
Factory Overheads 60,000 50,000 58,000
Administrative Costs 20,000 10,000 15,000
Selling and Distribution 10,000 10,000 10,000
Costs
Solution
Machine
1 2 3
(Rs.) (Rs.) (Rs.)
Capital Cost 3,00,000 3,00,000 3,00,000
Sales (i) 5,00,000 4,00,000 4,50,000
Cost of Production 1,50,000 1,30,000 1,42,000
Administrative Costs 20,000 10,000 15,000
Selling and Distribution 10,000 10,000 10,000
Costs
Total Cost (ii) 1,80,000 1,50,000 1,67,000
34
Notes:
(i) It has been presumed that interest on borrowings
will have to be paid throughout the economic life of the
assets.
(ii) Factory overheads do not include depreciation.
(iii) No borrowings will be required for working capital.
Merits
The pay-back method has the following merits:
1. The method is very useful in evaluation of those
projects which involve high uncertainty. Political
instability, rapid technological development of
cheap substitutes, etc., are some of the reasons
35
Demerits
Example:
Initial Investment Project A Project B
Cash Inflows; Rs. 1 0,000 Rs. 10,000
Year 1
2 4,000 3,000
3 4,000 3,000
4 2,000 3,000
5 ------ 3,000
Pay-back period 3yrs. 3.33 yrs.
In the above ease Project A has a shorter payback period
and therefore it should be preferred over B. But his may
not be rational decision since project B continues to
give return after the pay-back period which fact has
been completely ignored. As a matter of fact, on the
whole Project B is more profitable as compared to
Project A.
Suitability
In spite the above limitations, ,the pay-back method can
profitability be used in each of the following cases:
Solution
The Alpha Company
STATEMENT SHOWING THE PROFITABILITY OF
THE TWO MACHINES
Year Discount Machine A Machine B
Factor
Cash Present Cash Present
Inflow Value Rs. Inflow Value Rs.
Rs. Rs.
1 0.91 40,000 36,400 1,20,000 1,09,200
2 0.83 1,20,000 99,600 1,60,000 1,32,800
3 0.75 1,60,000 1,20,000 2,00,000 1,50,000
4 0.68 2,40,000 1,63,200 1,20,000 81,600
5 0.62 1,60,000 99,200 80,000 49,600
Total Present Value 5,18,400 5,23,200
of Cash Inflows
Total Present Value
of Cash Outflows
(Rs. 4,00,000 +
20,000 x 0.91) 4,18,200 4,18,200
Net Present Value 1,00,200 1,05,000
44
Solution
PAY-BACK PERIOD METHOD
Project I Project II
Cash Cum. Cash Cum. Cash-
inflows Cash- inflows inflows
inflows
End of year 1 Rs. 25,000 Rs. 25,000 Rs. 10,000 Rs. 10,000
End of year 2 15,000 40,000 12,000 22,000
End of year 3 10,000 50,000 18,000 40,000
End of year 4 Nil 50,000 25,000 65,000
End of year 5 12,000 62,000 8,000 73,000
End of year 6 6,000 68,000 4,000 77,000
Solution
SAVING PER ANNUM OF INSTALLING LARGE
PLANT
Saving in Direct labour (both shifts) Rs. 1,80,000
Savings in Overhead costs (-) 30,000
Savings per annum of using large plant 1,50,000
Present value of recurring annual savings of
Rs. 1,50,000 per year, at 10 per cent
opportunity rate = 1,50,000 x 6,1446 Rs. 9,21,690
Cost of Large Plant Rs. 30,00,000
Cost of Small Plant Rs. 22,93,500
Additional outlay for large plant Rs. 7,06,500
1,20,000 X100
Present Value Index for Project A =1,00,000
= 120%
51
15,000 X 100
Present Value Index for Project B =10,000
Solution
53,461 X 100
Project I = 50,000 = 107% (approx.)
56,819 X 100
Project II = 50,000 = 114% (approx.)
Solution
STATEMENT RANKING OF PROJECTS ON THE
BASIS OF PROFITABILITY INDEX
Project Amount Rs. Profitability Rank
Index
1 3,00,000 1.22 1
2 1,50,000 0.95 5
3 3,50,000 1,20 2
4 4,50,000 1.18 3
5 2,00,000 1.20 2
6 4,00,000 1.05 4
Since projects are indivisible and there is no alternative
53
Cash Inflows
Cash Outflows =1
Where
I = Cash Outflow i.e., initial investment
R = Cash Inflow
r = Rate of return yielded by the Investment (or IRR)
Thus:
800=l,000/l+r
or 800 r +800 =1,000
or 800 r = 200
or r = 200/800 = .25 or 25%
55
where
I = Cash Outflow (or outflow) at different time
periods.
R = Cash Inflows at different time periods.
r = Rate of return yielded by the Investment (or
IRR).
Accept/Reject criterion
Solution
The annual cash flow is uniform at Rs.2,000 for five
years. Hence, the 'Factor' or the 'Pay-back' is 3,
calculated as follows:
I
F = C
where
F = Factor to be located
I = Initial Investment
C = Cash Inflow per year
6,000
F =Rs. 2,000 =3
After applying the first trial rate the second trial rate is
determined when the total present value of cash inflows
is greater or less than the total present value of cash
outflows. In case the total present value of cash inflows
is less than the total present value of cash outflows, the
second trial taken will be lower than the first rate. In
case the present total value of cash inflows exceeds the
present total value of cash outflows, a trial higher than
first trial rate will be used. This process will continue
till the two flows more or less set off each other. This
will be the 'internal rates of return'.
60
Solution
The cash inflows are not uniform and hence the Internal
Rate of Return will have to be calculated by the Trial
and Error Method. In order to have an approximate idea
about such rate it will be better to find out the "Factor".
The factor reflects the same relationships of investment
and 'cash inflows' as in case of pay-back calculations:
Thus.
I
F= C
where
F = Factor to be located
I = Original Investment
C = Average cash flow per year
61
11,000
F= Rs. 3,000 = 3.14
Project A:
Year Cash Inflows Discounting Present value
Factor at 10%
1 Rs. 6000 0.893 Rs. 5454
2 2000 0.826 1652
3 1000 0.751 751
4 5000 0.683 3415
Total Present value 11272
11,272-11,000 X 2
= 100% + 11,272-10,844
272 X 2
= 100% + 428 = 11.3%
63
= 10 + 272 x 2
272+156
= 10+1.3= 11.3%
Project B
67 x 5
= 10 + 67+1,338
67 x 5
= 10 + 1,405
Solution
projects.
Both NPV and IRR will give the same result (i.e.,
acceptance or rejection) regarding an investments
proposal in following cases:
Project A B
Present value of cash Rs. Rs.
Inflows 5,454 (8,800 x.909) 7,999
(6,000 x .909) 5,000 7,500
Initial Investment 454 499
NPV IRR
Method
Project
Internal Rate of A B
Return 20% 17.33%
71
Project A B B-A
Cash Outlays Rs. 5,000 Rs. 7,500 Rs. 2,500
Cash Inflows Rs. 6,000 Rs. 8,800 Rs. 2,800
IRR for Incremental cash
inflows
Merits
The merits of discounted cash flow method are as
follows:
72
Demerits
The following are the demerits of discounted cash flow
method:
(i) The method is difficult to understand and work out
as compared to other methods of ranking capital
investment proposals.
(ii) The method takes into account only the cash
inflows on account of a capital investment decisions. As
a matter of fact the profitability or otherwise of a capital
investment proposal can be judged only when the net
73
Original investment
(iv) (a) 2
Accept/reject criterion
Old New
Machine Machine
Purchase price 40,000 60,000
Estimated life of machine 10 years 10 years
Machine running hours per annum 2,000 2,000
Units per hour 24 36
Wages per running hour 3 5.25
Power per annum 2,000 4,500
Consumable stores per annum 6,000 7,500
All other charges per annum 8,000 9,000
Material cost per unit 0.50 0.50
Selling price per unit 1.25 1.25
Solution:
PROFITABILITY STATEMENT
Old New
Machine Machine
Cost of the Machine 40,000 60,000
(Rs.) 10 10
Life of Machine (yrs.) 48,000 72,000
Output (Units) 60,000 90,000
Sales Value (Rs.)
Less: Cost of Sales: 36,000
Direct Material 24,000 10,500
Wages 6,000 4,500
Power 2,000 7,500
Consumable stores 6,000 9,000
Other charges 8,000
Depredation 4,000 50,000 6,000 73,500
Profit before tax 10,000 16,500
Tax at 50% 5,000 8,250
Profit after tax 5,000 8,250
Solution
Average Earnings X 100
ARR = Average Investment
Total Income
Average Income = Number of years
Rs. 36,875
Machine A = 5 = Rs. 7,375
Rs.36,875
Machine B = 5 = Rs. 7,375
Add.Net Scrap
+ Working Capital + Value
Rs.7,375 X 100
ARR for Machine A = 34,562,50
= 21.34%
Rs.7,375 X 100
ARR for Machine B = 35,562.50
= 20.74%
Existing New
Machine Machine
Initial cost Rs. 25,000 Rs. 50,000
Machine hours per annum 2,000 2,000
Wages per running hour 1.25 1.25
Power per hour 0.50 2.00
Indirect material per annum 3,000 5,000
Other expenses per annum 12,000 15,000
Cost of materials per unit 1 1
Number of units produced per hour 12 18
Selling price per unit 2 2
Interest to be paid at 10% on fresh capital invested.
81
Solution
STATEMENT OF PROFIT
Existing New
Machine Machine
Production per annum 24,000 36,000
(Units) Rs. 2 Rs. 2
Selling price per unit Rs. 48,000 Rs. 72,000
Cost of Sales: Rs. 24,000 Rs. 36,000
Materials 2,500 2,500
Wages 1,000 4,000
Power 3,000 5,000
Indirect Materials 12,000 15,000
Other Expenses 2,500 5,000
Depreciation -- 3,750
Interest 45,000 71,250
Rs.3,000 Rs. 750
Total profit Re. 1.87 Re. 1.98
Cost per unit Re. 0.13 Re. 0.02
Profit per unit
Working Notes:
Interest has been calculated as follows:
Investment in New Machine Rs.50,000
Less: Sale value of the old machine
(Rs. 25,000 -Dep. Rs. 12,500
on fixed instalment basis) Rs. 12,500
Interest at 10% p.a. on Rs. 37,500 =
Rs.3,750 Rs. 37,500
Solution
PROTABILITY OF NEW PRODUCT
Sales (8,000 units x Rs.9) Rs.72,000
Less: Cost of Production; Rs.
Materials Cost (8,000 x Rs.3) 24,000
Direct Labour (8,000 x Rs.2) 16,000
Indirect Expenses 12,000
Depreciation (8,000 hrs. x Re.l) 8,000 60,000
12,000
Extra cost for Part 'A' payable to
Cuttak Firm 7,000
5,000
Average investment in the new project 20,000
Rate of return at 25% cut-off rate 5,000
Rate of return at 30% cut-off rate 6,000
The proposal may be accepted at cut-off rate of 25%.
However, it is not acceptable at cut-off rate at 30%.
Advantages
Disadvantages
Age of machine
(years)
0 1 2 3 4
Rs. Rs. Rs. Rs. Rs.
Purchase price 3,000
Maintenance 800 900 1,000 1,000
Repairs 200 400 800
Net realisable value 1,600 1,200 800 400
Solution
In a similar manner:
Comprehensive Illustrations
89
Year Rs.
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000
Solution
(a) Pay-back Method
STATEMENT NET CASH INFLOW
40,000 X 100
Rate of return = 2,00,000
= 20%
3,08,130
= 2,00,000 =1.541 or 154%
2,00,000
F = 80,000 = 2.5
93