88868074 Capital Budgeting Solved Problems | Net Present Value | Internal Rate Of Return

FINANCIAL MANAGEMENT

Solved Problems

SOLVED PROBLEMS – CAPITAL BUDGETING
Problem 1 The cost of a plant is Rs. 5,00,000. It has an estimated life of 5 years after which it would be disposed off (scrap value nil). Profit before depreciation, interest and taxes (PBIT) is estimated to be Rs. 1,75,000 p.a. Find out the yearly cash flow from the plant. Tax rate 30%. Solution Annual depreciation charge (Rs. 5,00,000/5) Profit before depreciation, interest and taxes - Depreciation Profit before tax Tax @ 30% Profit after Tax + depreciation (added back) Therefore, cash flow 1,00,000 1,75,000 1,00,000 75,000 22,500 52,500 1,00,000 1,52,500

Problem 2 A cosmetic company is considering to introduce a new lotion. The manufacturing equipment will cost Rs. 5,60,000. The expected life of the equipment is 8 years. The company is thinking of selling the lotion in a single standard pack of 50 grams at Rs. 12 each pack. It is estimated that variable cost per pack would be Rs. 6 and annual fixed cost Rs. 4,50,000. Fixed cost includes (straight line) depreciation of Rs. 70,000 and allocated overheads of Rs. 30,000. The company expects to sell 1,00,000 packs of the lotion each year. Assume that tax is 45% and straight line depreciation is allowed for tax purpose. Calculate the cash flows. Solution Initial cash outflow Cost of equipments Subsequent cash flows Units sold Sales @ Rs. 12/- Variable cost @ Rs. 6/- Fixed cost (4,50,000 – 30,000 – 70,000) - Depreciation Profit before tax Tax @ 45% Profit after tax Depreciation (added back) Cash flow

Rs. 5,60,000 1,00,000 Rs. 12,00,000 6,00,000 3,50,000 70,000 1,80,000 81,000 99,000 70,000 1,69,000

There is no terminal cash inflow. It may be noted that the allocated overheads of Rs. 30,000 gave been ignored as they are irrelevant. Problem 3 Rushi Ahuja 1

FINANCIAL MANAGEMENT

Solved Problems

ABC and Co. is considering a proposal to replace one of its plants costing Rs. 60,000 and having a written down value of Rs. 24,000. The remaining economic life of the plant is 4 years after which it will have no salvage value. However, if sold today, it has a salvage value of Rs. 20,000. The new machine costing Rs. 1,30,000 is also expected to have a life of 4 years with a scrap value of Rs. 18,000. The new machine, due to its technological superiority, is expected to contribute additional annual benefit (before depreciation and tax) of Rs. 60,000. Find out the cash flows associated with this decision given that the tax rate applicable to the firm is 40%. (The capital gain or loss may be taken as not subject to tax). Solution (Amount in Rs.) 1,30,000 20,000 1,10,000

1.

Initial cash outflow: Cost of new machine - Scrap value of old machine Subsequent cash inflows (annual) Incremental benefit - Incremental depreciation Dep. On new machine Dep. On old machine Profit before tax - Tax @ 40% Profit after tax + Depreciation (added back) Annual cash inflow

2.

60,000 28,000 6,000

22,000 38,000 15,200 22,800 22,000 44,800

The amount of depreciation of Rs. 28,000 on the new machine is ascertained as follows: (Rs. 1,30,000Rs. 18,000)/4 = Rs. 28,000. It may be noted that in the given situation, the benefits are given in the incremental form i.e., the additional benefits contributed by the proposal. Therefore, only the incremental depreciation of Rs. 22,000 has been deduced to find out the taxable profits. The same amount of depreciation has been added back to find out the incremental annual cash inflows. Terminal cash inflow: There will be an additional cash inflow of Rs. 18,000 at the end of 4 th year when the new machine will be scrapped away. Therefore, total inflow of the last year would be Rs. 62,800 (i.e. Rs. 44,800 + Rs. 18,000). Problem 4 XYZ is interested in assessing the cash flows associated with the replacement of an old machine by a new machine. The old machine bought a few years ago has a book value of Rs. 90,000 and it can be sold for Rs. 90,000. It has a remaining life of five years after which its salvage value is expected to be nil. It is being depreciated annually at the rate of 20 per cent (written down value methd). The new machine costs Rs. 4,00,000. It is expected to fetch Rs. 2,50,000 after five years when it will no longer be required. It will be depreciated annually at the rate of 33 1/3 per cent (written down value method). The new machine is expected to bring a saving of Rs. 1,00,000 in manufacturing costs. Investment in working capital would remain unaffected. The tax rate applicable to the firm is 50 percent. Find out the relevant cash flow for this replacement decision. (Tax on capital gain / loss to be ignored). Rushi Ahuja 2

50.4 18.3 -7.3 18.3 -15. ‘000) Savings in costs (A) Depreciation on new machine .2 30.1 40.) 4. Problem 5 A firm is currently using a machine which was purchased two years ago for Rs.5 47. 59.2 Yr. 50.Depreciation on old machine Therefore.40.5 9.2 Yr. So. The average tax on income as well as on capital gains / losses is 40%.3 69. 1.7 34. in the last year the total cash inflow will be Rs.000 Solved Problems Subsequent annual cash flows: (Amount Rs.e.000. The increase in working capital will be Rs.3 107. The cost of installation will amount to Rs.1 47.000 The firm use Straight Line Method of depreciation.3 7.9 30. Rs.000.09.00.9 Yr. (iii) Rs.9 14.9 59..5 25. 80.8 52.000 90.5 87.7 115. Rushi Ahuja 3 .000 1. 60.4 Terminal cash flow: There will be a cash inflow of Rs. 3.8 12.4 100 39.8 73.000 30. Calculate the incremental cash flows assuming sale value of existing machine: (i) Rs.6 Yr.5 12.FINANCIAL MANAGEMENT Solution Initial cash flows: Cost of new machine .9 81.3 11.5 100 26.7 74.1 26.000 30.000 New Machine Rs.6 40.000 3.10. and (iv) Rs. (ii) Rs.000 60.000. 70.Salvage value of old machine Amt.50.3 65.2 100 88.000 30. 2. 2. 10. 30.000. 30.1 100 133.2 26.000 30.400). The expected cash inflows before depreciation and taxes for both the machines are as follows: Year 1 2 3 4 5 Existing Machine Rs.000 at the end of 5th year when the new machine will be scrapped away.000.000 70. 20.8 34.4 74.000 90.000.000 and has a remaining useful life of 5 years.6 -7.50.3 100 59. It is considering to replace the machine with a new one which will cost Rs. (Rs.000.000 + Rs.00.400 (i.5 18. incremental depreciation (B) Net incremental saving (A – B) Less: Incremental Tax @ 50% Incremental Profit Depreciation (added back) Net cash flow Yr.0 115.

Incremental depreciation Profit before tax .Scrap value Tax liability / saving Cash outflow Calculate of tax paid / saved: Book value of old plant .Tax at 40% Profit after tax Depreciation (added back) Net cash inflow 50.000 60.000 Rs. incremental depreciation = = = = = (Rs.02.000 1.000 50.000 1.000 20.000 Yr.000 10.000 4. 70.000 30.000 Subsequent Cash inflows (Annual) (Amount Rs.000 (20.000 10.000 30.40.000 30. 10.000 20.000 20.000 40.000 30.000 1. 70.000 20.00 at the end of 5th year in the form of working capital released.000 10.40.000 30. 1.4 90.000 20.000 Yr.000 20.000 50.000 20.000 Scrap 1. 10.000 50.000 1.000 Rs.000 1.20.1 Cash inflows On new machine On old machine Incremental cash inflow .000 50. 30.000/7 Rs.000 32.000 12.000 80. 70.000 50.000 44.000 Yr.000 20.40.02.000 70.000 10.000 20.000 10. ‘000) Yr.00.) Cost of new machine + Installation cost + Additional working capital . 20.000 – 1.000 26.000 20.000 24.000 20.000 4.000 50.000 6.000 30.000 -8.000 60.000 + Rs.000 1.000 The amount of incremental depreciation has been calculated as follows: Depreciation of new machine Depreciation on old machine Therefore.2 60. Problem 6 A firm whose cost of capital is 10% is considering two mutually exclusive projects X and Y.000 30.000 Yr.000 30.000 4.10.000 20.32.000 80.000 16.000 10.FINANCIAL MANAGEMENT Solution Solved Problems (Figures in Rs.000 12.14.5 1.000 20.000 Project Y Rs.000 Rushi Ahuja 4 Cost .000 50.000 20.000 12.000 20.3 70.000 20.40.000 8.000 50.000 30.000 Terminal cash flow: There will be a terminal cash flow of Rs.000 60.000 40.40.000 30.000 1.000 20.000 – – Values 1.40.000)/5 Rs.000) -8.000 20.Scrap value Profit / Loss Tax @ 40% on capital gain / loss Different 1. the details of which are: Year 0 Project X Rs.000 90. 20.

000 30.659 1.000 20.121 against 5 years is 2.291 Total PV (Rs.477 0.000 10.830 37. 70.000 = 2.000 60.621 Total PV (Rs.) 10.826 0. In the case of Project Y.460 70. the PV factor closest to 2.400 12.121 = Rs.488 0. since CF in the initial years are considerably smaller than the average cash flows.FINANCIAL MANAGEMENT Cash inflows 1 2 3 4 5 10.785 18.000 60.370 68. 33.689 at 25%.143 at 37% and Project Y.692 is 2.) X Y 10.683 0. 370 (i.909 0.520 33.260 6.000 45.000 10. CF in the initial years are considerably larger than the average cash flows.210 1. the PV Factor closest to 2.000 20000 45.373 0.000 50.000 30.735 6.781 0. and Internal Rate of Return of the two projects. the IRR is likely to be much higher than 25%.000 10.040 22. So.565 Since the NPV is Rs. 70. Project X may be tried at 27% and 28% and the Project Y may be tried at 36% and 37%.000 20.000 20.370 – 70.000 46.787 0.000 Solved Problems Compute the Net Present Value at 10%.) 27% 28% 7.090 45.135 36.000 20. Profitability Index.000 = 2. In the case of Project X.000 50.16.000 45.303 0.000 60.200 14. the IRR is likely to be much smaller than 37%.000 PV Factor 27% 28% 0. 26.e.620 0.310 17.550 70. Solution Calculation of NPV: Year 1 2 3 4 5 Total PV Less cash outflow NPV PI = (PV of inflows / PV of outflows) CF (Rs. Project X Year 1 2 3 4 5 CP (Rs.610 0.180 17.000) only.810 12.384 0.450 16.020 30.552 Calculation of IRR: Payback value Project X Project Y = Initial cash outlays / average cash inflows = Rs.280 16.06.870 7.000 30.550 1. at 27%.) X Y 9.135 1. the IRR is 27% approx. Rs.692 The PVAF table indicates that for Project X.751 0.000 10.000 40.000 / Rs.000 / Rs.530 15.n) 0. Rushi Ahuja 5 .000 70.000 PVF (10%.000 40. 70.640 14.

000.000 B – Rs.000 20. payable immediately.380 32. 20.389 0. -60.000 .750 36.207 Total PV (Rs.713 PV(A) -1.292 0.000 – With 7% cost of capital.873 .000 -60.) 50. 1.000 20.960 61. half payable immediately and half payable in one year’s time.000 20.840 2.000 10.541 0.284 0. The cash receipts expected are as follows: Year (at the end) 1 2 3 4 5 A Rs.000 PV Factor 27% 28% 0.640 7. which machine should be selected? Solution The NPV of both the machines may be found as follows: Year 0 1 2 3 4 5 CF(A) Rs. 36.659 27% Project Y Rs.510 Since the NPV @ 37% is Rs.e.000 60.n) 1.260 PV(B) -60. 60.380 48. 1.000 80.320 7.640 21.040 6 Rushi Ahuja .000 60.890 14.000 40.000 CF(B) Rs.) 27% 28% 36. 510 (i.000 10.420 70.000 30.130 1. -1.6 Machine A costs Rs.000 60. the IRR is likely to be slightly more than 37%.FINANCIAL MANAGEMENT Solved Problems Project Y Year 1 2 3 4 5 CP (Rs.150 2.700 52.000 PVF (7%.000 60.00.00. 46.398 0.070 71.000 20.500 21.816 .000 60.550 1.510 – 70.000 80.000 -56. Machine B costs Rs.640 22.735 0.215 0.000) only.000 40.000 40.920 2.763 .000. 70.100 52.780 2.000 18.935 .00. The results of the above calculations may be summarized as follows: Project X Rs.533 0.000 30.730 0.522 37% BPV PI IRR Problem 5.20.

The cash flows at the present level of operations under the two alternatives are as follows: 0 -25 -40 1 10 2 5 14 3 20 16 4 14 17 5 14 15 Machine A Machine B The company’s cost of capital is 10%. You are required to make these calculation and in the light thereof to advise the finance manager about the proposed investment. however.62 15. Net Present Value.91 2 .00 12.n) 1.62 NPV Total PV (Rs.15 11. Problem 7 A company is considering the replacement of its existing machine which is obsolete and unable to meet the rapidly rising demand for its product.00 1 .68 5 .780 46.30 12.58 0 1.00 9. Payback period.00 0.35 13.FINANCIAL MANAGEMENT Net Present Value 40.91 0.83 3 .68 9. 2.62 Rushi Ahuja 7 . The company is faced with two alternatives: (i) to buy Machine A which is similar to the existing machine or (ii) to go in for Machine B which is more expensive and has much greater capacity. Discounted Payback period At the end of his calculations.75 0.75 4 . and 4. Note: Present values of Rs. Profitability Index.280 Solved Problems The Machine B has a higher NPV and it should be selected.52 11. in lacs) Machine A Machine B -25 -40 10 5 14 20 16 14 17 14 15 PVF(10%. in lacs) Machine A Machine B -25.00 9. 1 at 10% discount rate are as follow: Year PV Solution Calculation of Net Present Value Year 0 1 2 3 4 5 CF (Rs.56 8.10 4. The finance manager tries to evaluate the machines by calculating the following: 1.00 -40.83 0. the finance manager is unable to make up his mind as to which machine to recommend. 3.68 0.

52 11. in lakhs) 37.62 15.35 53. NPV 2.28 11.494 Machine B 13. Net present value Thus pay back =3+ Machine A -25.00 19. in Lacs) Cash inflows Machine A Machine B 0 -25 -40 1 10 2 5 14 3 20 16 4 14 17 5 14 15 In both cases. in lakhs) 53.68 9.00 -40.00 9.629 years Outflow In 3 years.28 37.35 1.00 1.339 Solved Problems PV of Cash inflow PV of Cash outflow = = Calculation of Pay Back Period (Rs.72 19.15 11.FINANCIAL MANAGEMENT Calculation of Profitability Index: Machine A (Rs.339 Choice B A Rushi Ahuja 8 1.35 25.52 5.00 32.494 Machine B (Rs.56 8.56 = 3. Payback were Unrecouped oputflow In 4th year.15 32. Year Cumulative cash inflows Machine A Machine B 10 5 24 25 40 39 57 53 72 Calculation of Discounted Payback Period (Rs.15 20.15 5.85 9.614 years =3+ Conclusion Machine A 12.00 9.58 1.56 7.28 11.00 12.30 Cumulative present value Machine A Machine B 9. Profitability index .52 = 3. the Payback Period is 3 years.85 9.10 4.72 7. in lacs) Year 0 1 2 3 4 5 Present value Machine A Machine B -25.10 4.67 44.00 1.58 Machine B -40.58 40.72 28.

41 4.354 PV (30.10 2. (22.552 0.629 years Indifferent A Solved Problems Because of rising demand of Company’s product.50 12.000 0 7 Rs.614 years 3 years 3.552 Net present value PV Rs.00. AXE and BXE.50.683 Cash flows Rs.53 Cash flows Rs.641 7.50.12 5. (22.81 6.00 BXE PFV (16%.29 6.000 7. lacs 6.57 4.862 0.50 0. lacs 4. 30.46 (ii) Calculation of IRR: Both the proposals have positive NPV at 16%.00. The initial capital outlay and annual cash inflows are as under: Initial capital outlay Salvage value at the end of the life Economic life (years) After tax annual cash inflows AXE Rs.410 0.30 5.50) 5.50) 1.n) 1.000 10. the NPV of these proposals may be found @ 21% as under: Year Discount Factor @21% 0.95 4.862 12.00 7050 BXE Total PVs Rs.000 0. (b) Internal rate of return Solution (i) NPV of the two proposals (Figures in Rs. Machine B should be the choice as it has higher capacity and its NPV is also higher.50 10.000 12. 22.000 0 4 Rs. 5. In order to calculate IRR.50 AXE PVs Rs.00.50 12.000 7.00.000 12.743 0.000 10.00 7.14 2.50.00) 4. (a) Net present value of cash flows.n) Rs.00) 5.000 Year 1 2 3 4 5 6 7 The company’s cost of capital is 16% Calculate for each project.51 CF (30.000 7.000 6. Payable period 4.83 4.826 0.90 5.000 12. lacs 5. lacs) Year 0 1 2 3 4 5 6 7 AXE CF PFV (16%.00 0.00.000 BXE Rs.476 0.743 10.13 1 2 Rushi Ahuja 9 .00 12.00 0. Discounted payback 3 years 3. Problem 8 A company proposes to undertake one of two mutually exclusive projects namely.FINANCIAL MANAGEMENT 3.000 8.50.641 0.00. lacs 4.50 7.50.00 8.50 0.00.50. 6.95 8.17 9.

has decided to diversity its production and wants to invest its surplus funds on the most profitable project.44 30.467 1.00.800 Analysis: Under the NPV analysis of Projects. It may be interpreted as that the company will be able to earn 10% on its investments. 56.23.56 Solved Problems Project AXE: As the NPV of the proposal AXE at 21% discount rate is Rs.53.800 177.564 0.335 170. The running expenses of “A” will be Rs. 20 lacs per year.386 0.00. the IRR may be taken as slightly lower than 21%.000 5.25. The cost of project “A” is Rs.00 7.83 3.00 -.8) Present value of salvage value PV of total cash inflow Less: Initial investment Net present value Project A Rs.000 4. Project BXE: As the NPV of the proposal BXE @21% discount rate is negative Rs.64 3.50 22.10 29. Depreciation is charged on straight line basis. a and B.19 2. the IRR may be taken as slightly more than 21%. Problem 9 XYZ Ltd. 14 lacs. 4 lacs and “B” Rs.000 only.50 10.83 4.8) Present value of net cash inflow Salvage value PVF(10%. Hence. 35 lacs per year and that of “B” Rs. Which project should be company take up? Solution In this case.800 119.000 .50 5.62 22. Project B is suggested for implementation.000 22. 12.25.50 0.800 Project B Rs.319 0. is considering two different investment proposals.12 7.00. 10.467 6.72.00.00. 10 lacs.FINANCIAL MANAGEMENT 3 4 5 6 7 Present value Less: Initial outlay NPV 0. In either case the company expects a rate of return of 10%.23.00. 100 lacs and that of “B” is Rs.263 10.000 19.800 150.000 5. The cost of capital is also to be taken at 10%.000 only. 15.335 117.000 12.00. it is given that the company expects a rate of return of 10%. The details are as under: Rushi Ahuja 10 . It has under consideration only two projects – “A” and “B”. Project B is having higher NPV.000 .86.000 14.000 32.37.00.23 5.00 4.000 27. Problem 10 Bright Metals Ltd.000 17.00. Computation of NPV of the projects Particulars Profit after Tax (10% of cost of Project) Add: Depreciation Net cash inflow (annual) PVAF(10%.50 12.50 12.800 100. The company’s tax rate is 50%.00.467 0.00 8. Both projects are expected to have a life of 8 years only and at the end of this period “A” will have a salvage value of Rs.

000 12.144 2 4. Solution Evaluation of investment proposal (net present value method) Cash inflows (Rs.78% Project B NPV @ 12% Rs. 17% and 18%.FINANCIAL MANAGEMENT Solved Problems Investment cost Estimated income Year 1 Year 2 Year 3 Proposal A Rs.000 0.064 NPV is more in proposal B and therefore.) A B A B 0 -9.500 12.572 7. Calculation of Internal Rate of Return In case of Proposal A.204 8. for B the same should be tried at. -172 Interpolation between 17% and 18% IRR = 17% + 176 / 176+172 = 17.893 3.000 8.51% Year Problem 11 Precision Instruments is considering two mutually exclusive Projects X and Y: Following details are made available to you: (Rs. Similarly. in lacs) Project X Project Y Rushi Ahuja 11 .000 0.000 1.000 1 4.000 0.000 4. 122 NPV @ 15% Rs.) PVF (12%.n) Present value (Rs.000. 9500 and Rs. say.000 8.376 3 4.000 Suggest the most attractive proposal on the basis of the NPV method considering that the future incomes are discounted at 12%. the discount factor should be raised from 12% and tested at. it should be accepted. 14% and 15%. 9.712 3.188 6.797 3. Project A NPV @ 12% Rs. Also find out the IRR of the two proposals. 20. 176 NPV @ 18% Rs.000 8. 20.500 -20.500 Proposal B Rs. -35 Interpolation between 14% and 15% IRR = 14% + 122 / 122+35 = 14.000 -9.544 Net present value (NPV) 464 2.500 -20.500 4. The purpose is to find out at which point the present value of inflows are equal to Rs.000 4. 2064 NPV @ 17% Rs.000 8. 464 NPV @ 14% Rs. say.

n) Y 500 400 200 100 100 0.00 700.85 181.40 143.20 307.50 Internal Rate of Return (IRR): Project X Year 1 2 3 4 5 Total PV Less: Initial cash outflow Net present value CFX 100 200 300 450 600 PV factor at 27% 28% .20 330.787 . in lacs) Year 1 2 3 4 5 Total PV Less: Initial cash outflow Net present value CF X 100 200 300 450 600 PVF (10%.50 165.621 Present value X Y 90.909 0.90 454.826 0.60 62.303 .40 225.70 + 14.00 146.683 0.205 = 27.373 .70 78.65 700.620 .384 .10 172.488 .70 700.00 122.00 (14.30 150. The firm’s cost of capital is 10% required.610 .50 700.10 124.30 372.70 / 3.FINANCIAL MANAGEMENT Project cost Cash inflows: Year 1 Year 2 Year 3 Year 4 Year 5 700 100 200 300 450 600 700 500 400 200 100 100 Solved Problems Assume no residual values at the end of the fifth year.21% Project Y Rushi Ahuja 12 .35 68.35) IRR = 27 + 3.781 .80 703.60 685.00 3.751 0.00 461.80 167. in respect of each of the two projects: (i) Net present value.10 1065.35 365.70 174.35 x 1 = 27 + 0.477 .291 Present Value 27% 28% 78. using 10% discounting (ii) Internal rate of return: (iii) Profitability index Solution Net present value (NPV) (Rs.

000 = 1.659 You are required to calculate: a) The payback of each project b) The average rate of return for each project c) The net present value and profitability index for each project d) The Internal rate of returns for each project Rushi Ahuja 13 . The projects will be depreciated on a straight line basis.725 . 6.00 5. 10. is considering two mutually exclusive projects.389 .000 2 4.284 . 700 lacs Rs.000 4 4.35 lacs Project X = Rs. 700 lacs Problem 12 Pioneer Steels Ltd.00 77.000 5.276 .00 x 1 = 37 + 0.065.10 700.63% Profitability Index Total Present Value of cash inflow @ 10% PI = Initial cash outlay Rs.50 213.381 .80 76.20 28.50 lacs Project X = Rs.000 2.10 + 3.200 Present Value 27% 28% 365.000 3 4.522 = 1.000 5 4.00) IRR = 37 + 5. The company’s required rate of return is 10% and pays tax at a 50% rate.70 705.00 (3. The net cash flow expected to be generated by the projects are as follows: Year Project 1 Project 2 1 Rs. 4.000 3.207 .40 27.000 5.00 700.20 210. Both require an initial cash outlay of Rs.10 / 5. 1.FINANCIAL MANAGEMENT Solved Problems Year 1 2 3 4 5 Total PV Less: Initial cash outflow Net present value CFY 500 400 200 100 100 PV factor at 27% 28% . 1.000 each and have a life of five years.60 20.00 362.10 697.533 .70 20.525 .000 Rs.161.730 .63 = 37.

000 3.500 / 3.Rs.000 3. 10.000 .000 1.000 Calculation of payback period Calculation of accounting rate of return Average cost Average profit after tax Rate of return Project 1 3 years + 1. 3.000 PAT Rs.000 Project 2: 1 2 3 4 5 Rs.000 CF Rs.000 3.500 2.065 1.826 . 2.000 Rs.500 12.000 x 3.791 Rs.502 2.500 Rs.500 8. 2. 3.000 Rs.000 500 – 1. 2.000 1. 4.000 2.100 22% Calculation of NPV (cost of capital 10%) Project 1: Annuity of cash inflows for 5 years PVAF (10%.000 1.000 2.000 3.000 1. CF Rs.000 3.000 1. 4. 5.000 2. 4. 4.500 1.751 .000 PBT Rs.000 Rs.000 4.000 12.000 1.FINANCIAL MANAGEMENT Which project should be accepted and why? Solution Solved Problems Calculation of cash inflows: In the question it has been mentioned that the depreciation will be provided on straight line basis.000 Tax Rs.000 2.000 15. It appears that the net cash flows given in the question are the profits before depreciation and tax.000 4.500 = 3 3/7 years Rs.000 2.000 4.000 / 3. 11.000 5.000 15.000 2.000 3.000 2.000 2.000 3.000 1. 2. 5.500 Rs. 1. 3.000 4.000 1.000 5.000 Rs.373 Project 2: Year 0 1 2 3 4 Cash flow .000 = 3 1/3 years Rs. 10.000 9.000 2.500 PVF (10%.373 10. 1. 2.000 3.n) 1. 1.683 PV Rs. 1.000 500 – 1.500 Rs.000 Dep.391 Rushi Ahuja 14 .000 1.909 . 6.000 2.000 4.000 3.000 20% Project 2 3 years + 1.000 1.000 Cum.500 1.000 3.000 2.636 2. These are to be adjusted to find out the cash flows as follows: Project 1: Year 1 2 3 4 5 PBD Rs.500 3.500 2.000 6.000 2.5y) PV of Annuity (3.000 2.000 2.000 Rs.000 6.000 2.000 – 3.791) Less cash outflow Net present value = = = = = Rs. Rs.

420 1.000 x 3.000 . So. The exact IRR may be ascertained as follows: Project 1: In this case.24% Rushi Ahuja 15 .282 1.000 3.731 .743 . 3. the IRR for both the projects are more than 10%.333 in 5 years raw may be found between 15% and 16% column.000 Rs.641 .000 (3.000 3. 5y)) – 10.534 PV .000 3.333 In the PVAF table. 11.373 / Rs.n) 1.500 2. the IRR falls between 15% and 16%. the value of 3. the cash inflows Rs. 11. NPV is The exact IRR may be found by interpolating between 15% and 16% 56 IRR = 15% + (56+178) Project 2: As the Project 2 is having higher NPV and the inflows are scattered.767 = 1.00 (3.274) – 10.000 2.137 PI = Rs.n) 1.552 PV .Rs.869 = 15.000  3.621 Net present value 2. So.173 1. both projects were found to be having positive NPV.177 Calculation of Internal Rate of Return The IRR of a Project is the rate at which the NPV of the project comes to zero.862 . NPV is = = = = = = (3.828 1.000 x PVAF(15%.855 . 56 (3.FINANCIAL MANAGEMENT 5 3.932 PVF (17%. 11. the NPV may be found at 16% and 17% Year 0 1 2 3 4 CF .000 x 3. 10.248 1.Rs.5y) = = are equal for 5 years. therefore.767 Solved Problems Calculation of profitability index PI = PV of inflows / PV of outflows Project 1 Project 2 PI = Rs.767 / Rs. – 178 at 16%. 5y)) – 10. 10.000 Rs.000 3. In the above calculation of NPV (at 10%).000 x PVAF(r. At 15%.000 .000 4.000 = PVAF(r. the situation can be presented like this: Rs.624 .352) – 10.Rs. 10. 10.858 1.448 1.500 .000 x PVAF(16%. 10.000 = 1.5) 10.500 PVF(16%.

53.000 PVF(10%.000 17. the IRR is = 16% + 186 / 186 + 39 = 16.000 5.34 Rushi Ahuja 16 .000 Project Y Rs.621 Net present value PV (X) Rs.000 5.826 .522 9. The capacity of a particular machine. 27. 38.564 12.000 9.315 13. The Chief Accountant.908 PV (Y) Rs.751 .000 4.909 . The possibilities exist either of acquiring a similar machine (Project X) or of purchasing a more expensive machine with greater capacity (Project Y).016 11.000 = 1.694 11. – 27.000 .130 16. the demand for which at current price is in excess of its ability to produce.000 15.562 8.596 Project X Rs.476 1. – 40. – 40.000 14.000 14.000 17. – 40.000 15.908 / Rs. 40.000 Calculation of Profitability Index PI Project X Project Y = = = PV of Inflows / PV of Outflows Rs. In deciding between the two alternatives the Managing Director favors the ‘pay back method’.000 CF (Y) Rs.596 -39 Solved Problems Now.000 10. The company’s opportunity cost of capital is 10%.090 11. The relevant cashflows are: Year 0 1 2 3 4 5 Solution: Calculation of NPV Year 0 1 2 3 4 5 CF (X) Rs.611 9.666 186 . he finds himself still uncertain about which project to recommended. after tax.000 14. – 27. however. – 27.000 14.000 16. now due for replacement.000 10.000 22. The cash flows under each alternative have been estimated and given below.000 16.683 .500 .456 1.000 = 1.000 14.44 Rs. thinks that a more specific method should be used and he has calculated for each project: i) ii) iii) The Net Present Value The Profitability Index The Discounted Pay Back Period Having made these calculations. however.FINANCIAL MANAGEMENT 5 3.000 22.83% Problem 13 A company is manufacturing a consumer product.000 14. is the limiting factor on production.596 / Rs.n) 1. You are required to make these calculations and to discuss their relevance to the decision to be taken.

56 years 40. The initial expenditure on advertising will be Rs.000 at the end of the fifth year. 9.000. the agents will have to be paid a lump sum of Rs. On termination of the contract.596 27. 1.000 per year to this product if this alternative is pursued.908 53. the agents will have to be paid Rs.214 44.214 – 20. the firm will not employ agents but will sell directly to the consumers.652 32. 4. Two alternatives of promoting the product have been identified: Alternative 1: This will involve employing a number of agents.281 39. b) Calculate the internal rate of return for alternative 2.00. This will bring in cash at the end of each year of Rs. This will produce net annual cash inflows of Rs.670 = 3.000 – 32.000 at the end of the each of the subsequent five years. 3.090 Rs.63 years 3 years + Problem 14 A firm is considering the introduction of a new product which will have a life of five years.50.00.130 20.654 20. Required: a) Advise the management as to the method of promotion to be adopted. An immediate expenditure of Rs.000.00.000 each year. However. You may assume that the firm’s cost of capital is 20%. 2. However. 1. Alternative 2 Under this alternative. Rushi Ahuja 17 .000 – 20.670 / 44.000. 50. 20.FINANCIAL MANAGEMENT Solved Problems Calculation of Discounted Payback Period Year 1 2 3 4 5 Payback Period 3 years + Cumulative Discounted PV Project X Project Y Rs.000 will be required to advertise the product.652 / 30. The firm also proposes to allocate fixed costs worth Rs. 5.670 30.50. 50.652 = 3. this alternative will involve out-of-pocket costs for sales administration to the extent of Rs.281 – 32.

50. -1.50.5Y) = = Rs.00. 1.483) – 2.000 Rs.000 x 2.000 2.FINANCIAL MANAGEMENT Solved Problems Solution Calculation of NPV Alternative 1 Outflows: Initial expenditure Inflows: Annual Cash inflow Less Payment to agent Net cash inflow PVAF (20%.000 1.532) – 2.99.000 Rs.402 40. 2.50.5Y) 2.700) = 28.00.000 Rs. 1.200 + 1.200 Rs. – 5.50.200 (1.100 – 2.00. the value of 2.5 For 5 years in the PVAF table.00.550 Alternative 2 Outflows: Initial expenditure Inflows: Annual Cash inflow Less out of pocket expenses Net inflow PVAF (20%.700 The exact IRR may be found by interpolating between 28% and 29% as follows: IRR = 28% + 3.000 = PVAF(r.5y) Present value of inflows (2.200 -40. At At 28% NPV 29% NPV = = = = (1.200 / (3.47. To agents) PVF (20%.000 2.000  1.5y) Present Value Net present value Rs.00.80.991 x 1.000 x 2.000 Rs. Rushi Ahuja 18 .000 .000 2.65% Note: The allocated fixed costs in case of Alternative 2 have been ignored because these do not involve any incremental cash outflow.750 1.50.791 7.5 may be traced between 28% and 29%.000 x 2. 3.50.000 2.100 Calculation of internal rate of return for alternative 2: Rs.50.000 50.00.991 2.000 x PVAF(r.000) Net present value (2.50.00. – 2.000 50.000.07. 3.791) Outflow: at the end of year 5 (Pyt.5y) Present value of inflows (2.100 49. 2.000) Rs.99.50.

Ignore income tax saving on additional depreciation as well as on loss due to sale of existing machine. The old machine.000 an has a book value of Rs. Ltd. Cash inflow at the end of year 5 Salvage value of new 4. 19. 10. The life of the old machine will be 5 years at the end of which it will have a scrap value of Rs. it will mean a saving in variable costs to the extent of Rs.00.500 Rs.00.000.00. and the scrap value of the new machines is Rs.00.000 2.00.72. 20. Cash Outflows: Cost of new machine .13.00.000 4. if the additional depreciation (on new machine) and gain on sale of old machine is also subject to same tax at the rate of 40%. Advise P. of sold today.000.e.000 is available. PVF(12%. the firm need not replace the old machine with the new machine. PVAF(12%. it will have no salvage value if sold at the end of 5th year.000.00.000 Rs. the additional depreciation and capital gain on sale of old machine is also subject to same tax rate @ 40%. The rate of income tax is 40% and P Ltd’s policy is not to make an investment if the yield is less than 12% per annum. 4.FINANCIAL MANAGEMENT Solved Problems Problem 15 P.2. has a machine having an additional life of 5 years which costs Rs. 7. 1. then the position would be as follows: Rushi Ahuja 19 .Scrap value of old 2. 3. 2. Calculation of NPV Cash outflow at year 0 Cash inflow: 4.100 1.000x.00. 20. Will it make any difference.80.20. A new machine costing Rs.00.000x3. 7.14.000 15.e.605 (i.567 (i. 2.00. Ltd. will realize Rs.00. Capital gain is tax free.000 Rs.00.5y)) Net present value Rs. However. in case.000 As the NPV of the new machine is negative.000 Rs.5y)) : 2.400 . Cash inflow (annual) Net savings in variable costs . Solution 1.Tax @ 40% Net benefit 3.20.000 1.00. whether or not the old machine should be replaced. – 19.000 per annum. Though its capacity is the same as that of the old machine.00.00.

000 1.000 5.00. The machine was bought five years back.00.Tax @ 40% Net benefit + Depreciation added back Cash inflows (annual) 3.60.020 1.00.Additional depreciation Savings before tax . 6 lacs and has useful life of five years. 10 lacs to Rs.000 2.00.000 Rs.76.120. 6 lacs for it.681.000/5) Additional depreciation 3.000 80.000) 2.64. Cash Outflows: Cost of new machine . The company does not expect to realize any return from scrapping the old machine at the end of 10 years but if it is sold at present to another company in the industry.70. The old machine had a cost of Rs.FINANCIAL MANAGEMENT Solved Problems 1.000 Rs.000x. 10 lacs and a useful life of ten years. It has an estimated salvage value of Rs. 2 lacs a year.5y)) Net present value Rs.79. 20.100 2. Cash inflow at the end of year 5 Salvage value of new 4.00. 3.79.24.00. National Bottling Company would receive Rs. Calculation of NPV Cash outflow at year 0 Cash inflow : 5. however.e.00. PVF(12%.000 1. the firm may replace the old machine.000 1.605 (i. PVAF(12%. 17. when the assumption regarding taxability of depreciation and capital gains / loss is charged.Scrap value of old .567 (i.5y)) : 3.000 2.00.Tax saving on capital loss 40% of (4.000 4. Operating efficiencies with the new machine will also produce savings of Rs. 20 lacs.60.000-1.89. The new machine has a purchase price of Rs.000 – 3.60. 12 lacs.40.000 It may be noted that the proposal is not acceptable in one set of assumptions.000x3.000)/5 Depreciation on old machine (4. The new machine will have a greater capacity and annual sales are expected to increase from Rs. 7. Depreciation is on a straight-line basis over a ten year life.993 and present value interest factor at the end of five years is 0.000 Rs.20.80. The cost of capital is 8% and a 50% tax rate is applicable to both revenue and capital gains. Problem 16 National Bottling Company is contemplating to replace one of its bottling machines with a new more efficient machine. The depreciation (additional) on new machine has been calculated as follows: Depreciation on new machine (20.24. Should the company replace the old machine? Solution Rushi Ahuja 20 .80.000 2. Cash inflows (Annual) Net savings in variable costs .e.000 2.120 As the NPV of the new machine is Rs. The present value interest factor for an annuity for five years at 8% is 3. – 17.00.000 18.000 Rs. the proposal becomes acceptable.00.40. 2.

000 10.000 50.000 6.000 14. The firm may go for replacement of the existing machine.Incremental depreciation (3.00.000 1.690 Rs. 20.000 65.000 2. 2.000 .000 Proposal II Rs. The following tw mutually exclusive proposals are being considered: Plant Building Installation Working capital required Annual earnings (before depreciation) Sales promotion expenses Scrap value of plant Disposable value of building Proposal I Rs. Ignore taxation.890 The replacement decision has a NPV of Rs.000 10.00. Which proposal be accepted given that the cost of capital of the firm is 8%.681) Net present value (13.30. 4. Sales promotion expenses of Proposal II are required to be incurred at the end of year? These expenses have not been considered to find out the Annual earnings (given above).00.60.00.00.000 Life of the Project is 10 years.000 15. (It may be noted that there is no tax benefit of depreciation in this case).000 15. 2. Solution In this case.993) Cash inflow (terminal) Scrap value at the end of 5 th year PVF (8%.00.60.36.200 – 14.36.00.000 Rs.FINANCIAL MANAGEMENT Cash outflows: Cost of new machine .000 50.000 14.000 30.00.000 Rs.000 15.000 x . the Annual earnings before depreciation are given for the proposals.200 3.000 x 3.Disposal value of existing machine +50% Tax on Profit on sale (6.993 Rs.000 60.000 – 5.000 70.30.50.000 70. in considering to enhance its production capacity. The two proposals may be evaluated as follows: Rushi Ahuja 21 .681 1.00.00. these earning may be considered as cash flows also. 2.00. 3.5y) Present value of cash inflows (3. 13.00.5y) Present value (2.000 3.17. 3.00.000 95.000 70.40.000) Net profit after tax (incremental) Less tax @ 50% Profit after tax Cash flow (PAT + Depreciation) PVAF (8%. Problem 17 Central Gas Ltd.17.000 – 1.50.690 + 1.000) Net outflow Cash inflows (Annual) Incremental Sales Savings in expenses .890.000 50.000 3.00.000 1.000 2.000) Solved Problems Rs. As the tax is to be ignored.

000 7 years Project B Rs.000 60.A Proj.409 24. if the cash flows from Project B are for 8 years instead of 7 years (Rs.A Prof.000 6.820 68.395 64.000 6.000 Proposal II Rs.000 50.595 Rs. 6.487 4. -22.280 30.415 Proposal II has higher NPV and so. -27.7) Present value . 2.000 6. 17%. 3.000 4.700 41.69.01. 18%. 65. Rate % 15 16 Cash flow (Rs.240 28. 41.000 6.000 .000 .000 7.10.960 29.000 10.B Prof. and iii) Will it make any difference in project selection as per IRR.000 Proposal I Rs.855) – 6.40.37.710 Rs.80.00.) Prof.000 1.000 7 years i) Calculate NPV of the proposals at different discount rates of 15%.000 PVAF 7 yrs 4.000 15.9415 4.000 1.PV of outflows Net present value Rs. 64.B(8y) 24. 4. 4.00.408 Rushi Ahuja 22 .000 2. it may be accepted by the firm.450 (12.820 Rs.00. 7.09.040 8 yrs 4.69.000 65.10.370 3.2)) Present value of inflows (Annual) Present value of Terminal Inflows Release of working capital Sale value of plant Disposable value of building PVF(8%.FINANCIAL MANAGEMENT Solved Problems Proposal I Initial cash outflow Cost of plant Installation expenses Cost of building Working capital required Total outflow Present value of annual inflows: Profit before depreciation PVAF(8%.11.670 Rs. Cash flows (Rs.000 50.000 7. 50. 70.700 Rs.370 Proposal II Rs.B 6.463 Rs.700 – – 4.000 3. Problem 18 The cash flows from two mutually exclusive Projects A and B are as under: Years 0 1-7 (annual) Project life Project A Rs.) Proj. 16%.69. ii) Advise on the project on the basis of IRR method.Present value of sales promotion exp (15000 x PVF(8%. 19% and 20%.000 per year). Solution Computation of present value of cash inflows of different projects Dis. 6.463 Rs.10) Present value of terminal inflows Calculation of net present value PV of annual inflows + PV of terminal inflows Total .000 90.120 31. 95.V.000 15.24.000 10.000 30.000 2.80.160 4.24.670 5.000 7.710 Rs.344 P.

22. the IRR must be between 19% to 20%.235 and Rs. 26.59% Project B (8 years): Since outflow of Rs.942 25.000 = 17% + Rs.859 Solved Problems Calculation of NPV Dis. the IRR must be between 17% to 18%.235 – 21.000 is falling between Rs.872 22.83%) as against Project A (IRR = 19.837 23.240 23.39%).000 7.83% Conclusion: As per the NPV technique.678 26.630 27.812 3. interpolating the difference of Rs.000 7.960 24.532 872 235 -370 PV of inflows (B) Rs. 29. So.684 = 17% Rs. if the life of the Project B extends to 8 years.454 and Rs. the Project B becomes unviable even at 18%. 819 between 19% and 20%.120 28. then as per the IRR method. the IRR comes to 19. 27. interpolating the difference of Rs.000 7.684. Rs.684 25. 770 between 17% and 18%.280 454 -216 -1.678 – 27.859 = 19% Rs. interpolating the difference of Rs.960 2.235 21.532 22.784 25.235 NPV (B) Rs.235 – 22.207 4. 605 between 19% and 20%.942 25.954 3. However.872 22. 2.765 Calculation of IRR Project A: Since outflow of Rs.240 1.000 6.078 3.532 22.120 1.556 27. 22.000 7. 22.000 = 19% + Rs. 27.058 -1. 27.000 is falling between Rs.000 6.454 – 26.859.922 3. Problem 19 Rushi Ahuja 23 .630.39% against the IRR of 17.119 28. the IRR comes to 19.83%.630 = 19% Rs. 2.280 27.235 29. the Project A is acceptable even if the discount rate is as high as 19%.59% of Project B. 22. So. Rs.605 4.000 = 19% + Rs.454 26. 27. So.39%. 678 = 19. 26. 819 Rs.59%. Rate 15% 16% 17% 18% 19% 20% PV of inflows (A) Rs. 27. 235 = 19.706 3. 770 Rs. 24.000 3. 21.630 NPV (A) Rs. Rs. 605 Rs. 27.000 is falling between Rs. whereas. the Project A is acceptable and is having an IRR of 19. 27.39% Project B: Since outflow of Rs.000 6.235 21. As per IRR technique.454 26. 454 = 17.678 – 26.678 and Rs.454 – 27.FINANCIAL MANAGEMENT 17 18 19 20 6. the IRR must be between 19% to 20%. the Project B becomes acceptable (IRR = 19. 27. the IRR comes to 17.

There is no investment tax credit in effect.000 Annual inflow Annual labour savings .000 10. 20.000 Depreciation on new machine = 20. You are required to – i) Identify all the relevant cash flows for this replacement decision. 2.000 but could be sold for Rs.00. The company is subject to a 50% tax fate on regular income as well as on capital gains. iii) Find out whether this is an attractive project.FINANCIAL MANAGEMENT Solved Problems AP Udyog is considering a new automatic blender. 30. Solution i) Tax on the sale of the old machine: Sale price Book value Profit on sale Tax on sale (Rs.000 ii) 1.000 a year. 12. 1.000x. 40.Increased earnings before tax Increased earnings before tax Increased tax Increased earnings after tax + Depreciation Increased after-tax cash flow (Annual) v) Calculation of present value at 8% discount rate: Cash flow Rs.000 iii) iv) Year 1-10 H outflow .000 Rushi Ahuja 24 Cash flow Rs. 10.000 20.000 / 10 = Rs.000 30.000 / 10 = Rs.000 8.000 2.000 25.000).50) After-tax cash receipts from sale of old machine Sale Price After tax cash receipt Cash outflow to replace old machine with new: Cost of new machine After-tax receipt from sale of old machine Net cash flow to replace old machine with new Depreciation on new machine = 1. The new blender would last fir 10 years and would be depreciated to zero over the 10 year period.000 8.100 Rs. It would reduce labour expense by Rs. The old blender has a book value of Rs. ii) Compute the present value.0.000 Rs.00. Net Present Value and Profitability Index.000 2.000 PVAF(8%.000 75. 12. The new blender would cost Rs. 10.000 25.000 10.000 5.710 Present value Rs. 30.000 (the original cost was Rs.10y) 6. The old blender would also last for 10 more years and would be depreciated to zero over the same 10 year period. Their cost of capital is 8%. 67.000 4. 75. 10.000.

Working Note: The tax on profit on sale has been deducted from the sale price of old machine on the assumption that the tax liability arises on that day itself.000 = 0.100 / 75.100 Rs. 67. this assumption seems to be logical.895 Rs. in view of the advance tax payments. the project is not an attractive project. Moreover. -7.FINANCIAL MANAGEMENT PV of cash inflow NPV of the Project Profitability Index = 67. Rushi Ahuja 25 .900 Solved Problems iii) Since the Net present value is negative and Profitability Index is less than one.

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