Managem!

:rlt Accounting

&.110 .

,,~ 45 Rs &5 and R:;... 65 l\.'SjJCCtlvcly.

The eost per unir of A, .B and C was "-". , .

. • .... differentvnriancesto exolnin tbe dlfference hetv r c~n Ihe budgetoo and

COITIJlmc we tlJ " ............ " w ~.,~~., r

actual p.mfil_

Chapter 9

P4(1ifrus., .M, Com.., (ICE) Mti)! J 9')71 I ~\ns : (' I' Sales margin l: or PI'ofit V , Total ~ Rs. 5,(51)[F), A ; lb. 5.500(1''); B , Rl;, P5ij(,\): C : iil.s. 1.30tl(F); , . \' llfi·ilJ·"~ "800'· {F)' A : :; OOO(F); B : 3,:5(1!}tA}. C : J,JVO(FJi

(2) S:lles Ilf1iClC : u. , ......... " ,. ..' .

. S ·1 I .f • ·,,-,.,t·1I1 • Rs lSO/Ii'"t.; A : SIlO(F); B ; 750(F). C • I.oOO(A),

0) II eS\·i}ume" ••• _ • , \'1 .. _. », • ". . '.

(.f) s~ tes 1Il~1Il " : 'm'o1~1 : R!;.. 217"(A), A ; oi 18ff}; 8· :' 5jJ(t). C , .1,118(.\);

(5) SIl.Ii!~ q UJllri!if}, 'If ; To'ral : Rs.. 47i(F); A : Rs. Sl(f): .B : J 77{ f); C : .21 StYli

·1,·

Capita] Budgeting

. ' Caprlal BUclg:eting refersto the Jong -term pbnoin,g [OJ" [I] Investmen.t in proje~ls and {ked ,a!lsets and (2) Methods offhlililCln,g the approved p.roj~'C[s. It "'·~,'lIlICJII:u.Uli me meihoos of mol,lilisation of J(}.[Ig~Ie._1'I1l IhIlds and their deployment In "".""",,,,:-,":",.G""''''~ pI oj eeta However most of the experts 011 FinaIlc.i af Man~genlC:[l! give mlJ'Il111t:J:1I;.tS to the project selection, aspecr (If capItal Bllidgetillg.

Capital BuJgeting is considered as the process of making ill\o'~stn14rnt decisions on Ci'lpLrnJ t:Xpelilditttrc, Capital e~Jl'!lnd.iture IS tnt; e;,:pcll{ijtllre fue "benefits of which are t'Xpt'Ctealo be recei V€d o ver 11. period e.,-,ceeding 'one year. The moo! importam chaJ'ac~~Tisrlc of(;apital expenditure is Eli .. ! the ~ndj~!T<: i~ Jru:[Iffflj at one pohu cf'tirne wl:tel'e.ts Ille benefits uf'th e ~xp~ndita.re are re.aJifi'fd ~! d1fferel1tpoints of time in I'i.Jtufe.

The folIm''''ing are some of the examples of cap:ital ¢:X!l'f'nrliutrc !'eJati flg ro Mam~wmeJ1[S of firms have to take decisions.

(.a) &pansion of aeti vities- In tlit exbling lines by increasing outpU11h rough adili tlenal machines or plants; 0, by entering: intu ]1f".iatcd lines of'aeti "jQ', (oj Div~r.sifica[jon or llcth'i[ies through new pmducrs. 1lE!\V methods new markets etc.,

. ,'dod.ernrSatfQll. of existing Machfuery;

I!:'Jlttl)K.ejpJ,;t.CCJt"I~lll orwom-ou t equlprnent ;

Research and deveLopment expendlrur« w:hieh m3)-' result in fong term rettff'ns etc.

orC:Jpit'dl Dudgeff~g

are several definj~j OIlS emphllsisiJ]g di (fere.l1t aspects of Clip ita I

Budgeting L~ the process of decldiJ:lg ",1lctner 01' not to C(I!rnTI1~ io prn.1jeot~ whose Costs Imd' berg diM lITe spread ova several tim!:

Herold Bierman J1".. and T R. Dyckman Bud,getillgis th e f lin 's fomlfnl PI·OCE.'SS for the a~q!Jj~lti on !hnd

. Qf c~pitrl l", Hampton, Juhn .J.

(!i) 1"0 fix prl [)riHe~ .aJl]omg [he various plTIjects and ensure MI()<w-up action, (6'110 obfaill perl[)dica~ n:porn Oil variances beh!.1CC'll budgated and actual (l:)(a:!cIHIi~uro and rrlal-: t:f[urts 11) el i lllin1!lt~ Illc eauses for such 'ladafll:l.-"'!i: ' (-r) Th measure ~lu: performaace of un-·goillg_proj ccts

(!If Til prevent cost OVCH .. u't~ On the projects', I '

CIlliltrul'm'~i' c~ld~,;d,e)lpc[1.I1jrore ~hMUgh capita:1 '8)1:p~IHrliWr~ bLll(J~d PrqMlfl1io,rl Ojcapit.11 apt:lu/liNFe luulg!!l: '['110;: f!nt ~I~p in III ~ process .u.. .. J .. arion ofC'apii.1I.1 cxpenditun; [jY~lgCL ~1 should sp!:dfy 11Ll' status L~I OJl OIL the begilm in:!! of tne bud get period. new pmjllcts to be started .. 1.,,, ri'>1"Ic1('1 and those which ~r,nllld. b~ 'Olllp'eted wlrhm the current blldgd amount HHoned [0 each of lhl.!" projects ~md Ult SOurce of finance also be df;ll'ly stated,

limpeT Ar,~tll(jri!;Qli(j1l y!cllpiraf eJ:p(!lIdtlmf!: In all bi~ firrns a sep .• rare expendrtur-e' COllllmr[1~e is set up h', apl~Hwe and S811C.;'IIl UVJI1EY ,IFlJ ~Kiii~I\l'iJ'lse imP[~'l1~!lrraf Lon 0 f capita I pro ject~ The Cfll1lJ11 lrree f'I"": L~ ~ i ~'!II Y re\'j~~\ ~ project to ~n~llre Iha1 (:3) The proi C>t=1 corui m.JO::~ to be cs ~~10tl as v .. il~ tl j:

'(h) fund~ are availeble a~ bmiget~rl; (c) wheiherbcuer or 11 !OC!lU'l' i', c of funds have iI~i5CI1 sinc« rh~ approval of the budget. r.1QIl~:' !~ SpC!11 fl'l '-,"".It, l1ln .. I"<'i only nftcr obtain mg. sj}£!cHk ~ LI thol i~:'I~LO'il rrorn tne COin III rttee

(3) !?t.'L·fmlfflg {ffu/('omml nfl-.\pemlifU,'": \\ :"th ElI~ (.bJe;:,(L\-~ fit I)l~,'''' I.u

~r;;.endrllil'~ C'n each pf"L)j~r,l, the n,llnwii1g ~~rl,~~~;i'.He j~ r(lll(l~' :\;1:

l,l) A ~El'~<lLC 'Im:lcct sll~d- I~ linin! i'IL7i! t',l C"tii pr 'i~d f' 'll)l, j' -, VlllJmn" w eutcr e.\p~I~t:lihLr~ ~~nJn:ii~lg ~II rlir"':ef~tli ~~a~.·~ e)1 I'-,~ P,"\Jjt>:L T.,<! ~~p~![Jiwf'.: fIl<L} }-.~: anxlysed unrlcr rl'" ~ lcrnerus L'I- ~'" i e., materia L labour and overh cads,

( b) Proj ecr numberand dera i ls are 5tL IlP I ted (0 nl l rha cxecuti yes G(lI1C~meJ WJlO Jl1m.' to analyse the expemC'~ iucurred properly and enter in lheI)f:~pecth'e project sheers,

(c) Eutrles in lim project sheets are to 00 based un authernlc r~I:ONS or vouehers, I ike i nvo i ces, bills, CT~,

(d} The tup m~nil~elltcm is to be periodically inforn:L.ed ofthe progre~~ and any devladcns in of KfDe.w:Hrn rre ,

(e) Any 'eosrover-rens' !mve to' be sp~cifucany sancuoned by HLC eapitai expenditure oommiltce,

{f) C~p[~:ill.woik:.in.pTOgrusS[~ separately maint~il1ed ill flJll~rtctat books and ilcan be comparedwich the ~o:sl:l! ~nOiwn in pfojec~. sheets,

(")l~~l(llmliloR '(}/11!I'/o.rmrlllt'.f! (J/lfll' p.rojet:l: 'Post Co.mp!etiolll AudLr' LS eenductcd to ascertain the !01,,1 expenditure hicurred, bLld~"ted expenditure anti tile variance. Th~: ~l.itli. has 10 be ~OIJdUcL~tl byindependsnt experts different from those who are responsi ble for the pm_ ec t. rh'e aud h ~lwukl give ;"I de~:liI e II j In of C~lI~~~ for 811_\ eX.C~S.S expend i t u re "n, 1 III ~ spec Iii C I1(;HOnS rcspons i b:.;; lor

9.4 Management AccOunti

[t. Such audit helps ill developing 'cllpilal expenditure policy' on'~I)1(nd~ it pro vides suitable guide!in~ for implementation of flrture projects. es and

An uytr8llcbeck is rnsde by the 'capir:'1 expenditure oomm i (tee' to seeW.ileLll rhe ac tlJa.l.revenu~ from the project are m conformity wIth lihe prOjected line E::r iitrt, ~il&C6il1l.nhtee can galli' Y.iJlu:ilbJe ezperience in dealing Wlth fu(;ure prOj5 Or fr-OlU !'Il: "check on ~e\'eIlu~' of t'{)mpreted projects, . ~

J m(J urtanee of Cap,ibd Budg"e"lin;g

• C~piklJ. ~il.dgetillg' is !he !llmt vita ~ activity wh ich call 'make or m~t' a t.iJ'tI.l'S fulure fjnmlclal.healtltlL The following are the reasons for its importance..

(0 Hug"£'! fIrtlf}UiUOf iIi W!.S.iIlU!1J. t: Capital expenditure decisions Can CQ!lilllJ' the fhrn for bilge invesnnen, over a period of'time. A wrong deciSiOllca: resulrin heavy loss,

(l) P.ernuulelJI aTl'd Irl"(!Wtrsiblc' cOnlmilm(!IIf of f_l4mf!i: Cap,ital e1l(Pelllciih.lr, decisiolls result in comrnitrnent of am as (In long term basis, Once II pmJec~ is taked up. Mit investment is made, it.is not-usually pmsible to fC1i(:r;e the decision. The reversal will be uUh.c ~OBt-f:lHle.avy loss. .:

(3) l-iJng-lerm impllcr ,(J.n p1WjlJ{(/Jiflty: The capirnJ espendince decis;iof[s wlll £hapctlie future revenue streams illIdi tJle pmmabiiity of opera~jOlls,

(4). Growth WNlE:tptlJJSim.i.' JSU.~in~$5 firms grow. e:.pand, divc~[fpl1d acq~ sta tore ill. the r ll,dus(j'Y thro ugh their capital budge ting aeti vities, 1110= success of III ob ilisaiion an d dep f"l'Olflll or funds detenn i nes the futur~ cfa finn.

(5) COIl over I'litiS.' [hul metical ously implemented, deJay ill completi{l!lof pl"Oject~ will .mtomatically r~;;uJI 1" e;';Ct~5S costs ami heavy losses (6)Alterlttltll1tS: Limlred fud1d~ at tile disposal of a finn have to be deployed in the mast profitable of the alternati.ve projects. The elimination precess is a di fficu:!t one,

P') MrdflJl'liclty of !'r1,jllbJf!:..~: Large number of'factors an'c~t the dccis tons 001 c-apilal expenditure, They make the 'capua I expenditure d~cisio!ls' llie most difflcu rt to make,

(8") Trip Mal!'(1geml'lIt AcliJ,'if}': Ihe metamol1ll1lc impact of capital ex_petldilLL"-e decL,tol1s uutomatically ~llrustS chem On the lop management. Oilly si:1!ior managerial personnelcan tllk.e these decisions and bear ruponsibiWy for them.

factors influencing (!apitlllc.£penditm-e decisions

Then: arc mall)' factors, both t1nanejitl and non fillancial wlJ1.ch inf!u~nGc the capiral expenditure decisions. The followillg are some (lfth~ jmportanr factors,

(1) AV(lilalJNlry of !Hnrki: This 3~~ lite crucial factor affecting all capital e~pendit~m.: decisions. i-imorewr atlrnC tive some projeClS may hoe, ~ C<lIUlOl[ be taken up if.th ey sre 100 big for a firm to mob-i] i~~ the nee<led funds

FiJ.mre 1!IJ;mi"f1~';'1 ; VI,;I)' prtl_i~'t:1 h:J~ !O ~sllil III cash inll m~ s in future. 'UlI': e ... lt"!~[ III' the rcn.'1ll.!o.-.; illllidJ'larcLl 1:-. tile illus,l si!,ln.iliuJIIl lactor which aUh:l~ th~ choice o[!! p!-Il.ic~l_

Lq:1I1 ClllnpUIJ .. kuu: Whet! Sl!llUl!1.r)" i,;nmpulsiull arises, ~O!'il lind pmlil J&:un.~jJCI1l!9~mS have In he secondary.For ~,'):alnrh:. waste (jJ~[ltl;;a':pht111~ l'1::I\"(: [,i be inSll;llJcd Ell' :>!I.ts~)' ~tl\lir'litm~Oi<ll laws in must ufthe ceuntries i n the world. p.lIrtk 1Iiarly in industries Hkc leather lind chcm i t.:~ls.

Dq:rt!lt iJfulwertaJnfj' 01' riJlk: The level (iforisk iinvvh'ed in !l. pruj-~~t ls .' ~[eul for dedJin.g its d~sirnhi lity.

Urg"em:y: ll'rojccl~ v.'hi~h are In be immediately l.!Iken lip f{!1'!.1 firm's survival hi! He' lu be [n.:at~t:J diITcr~nlly linm up. iona I projl'CIS_

Re.fl!Qrdr (Jml iJewdopml!lU projects: Pnl<ic~l." which ITIl:Y n:$Llll ill 'jn v entlon vrn~w produeis ur method. s, el(: .• aft' a son of'ilWIl"SlmCnl wish ltope' _. fhll'}, "'''Y fll"\W!! su,,'Cc:;sf1.ll or not Mul 'I-l: &. lJo is a must ill most of ih~ [rulustrie:>, parli,t:ularly in ~t."Cht'lul[lg)' ba"L~ indus!ri:e_'I.. Oluu/en!l!flr:'Il: If o~slllL:\~ rmu::inillery i1ntl phllu e;><!s! jill ~ finn. IJIl~if ~eflll,cem~n'~ OOt'Oll.e!l u (,,{Impuls'ioll.

Compi!li(.(r~-~· At!tlw'til!.~: When cQmpetl[ur_~ r~l'fllrm certain activities, tl!Jc~' !lUi)' corapel u Ikm tu undertake simi I ar :acliVll Ue.~ W wi thsrand oolllr-&i:ei.on.

{IJ) Int{l~gi:M~ 1:'IKlOT5;' FInTl'~ prestige, \~Qi'kt=r"!i' s<l.I~C)'. ~~X"ial we 1111f!<' etc .• [nfh,lent~ caphal expenditure which may be j,b."Iill,..'tl ~'itin{llior!p.!.1 !dd~'r~.

1}-pes ml:ll pit:al.expendi.ure

C1pitai i:"x:p~tdilLlI'\!' can he divided into lWO catcgoriee depending 011 the .Dcnl!llt e",pec[cQ. [I'"om (he e. ·pelltHtl.lfe_

(1) Capit.irlexptuuIIIlITi! whldl im.'nose'S rf!I'etlIlII!: I[ is 'h~ expenditure ,\tLkh Jel-Clw! adcli~!(lml': inConl~ In Ituurc_ II 111!)' be by tak mg 141 prncueu on u r new pt.'(id.ucts or c~anding tnt: existing producticn facilities to increase production, Irt botllt eases purchasot.: of lixed assets becomes neL-e~r.a"'I,

. (1:) Capllar it.rpertdilure ",Ilk.." reduces costs; F.xpe:ndtltil'e whlciireduces :ff.U:' ~G5t or present products or processes or- operetiens can rncresse ~he _" ... ,_",fuaililily of existlng operations .. It may be done by purchase of impro"ed ~c~,iil~ M:d t:Quipnu:nt cr ieols.

Itl the fmmer case 1m: risk is higher because the finn has ro enter into new #,itivttiCs or produce new prOOlK'l5, The liI!~ is less r.isl.;,~' because the tintl is already . jp the line MId oQlSt reduction is n-.ore feasible because of 1I.to;: knOW11 cperations

"Q!lSsltrlCjali~m of ell,pitld uperu:!il:ure prGpUsalll

Illves.till(!!1r ,Flfopos.als nil iicll are usua Hy considered U}' fi n'llS can he classified " to rile f~jHowiJtg !hree types.

. '.(d) lIu/t!penikn11'I'opostr/.f: . ~liese are proposals ...... hi'='h ~I\: rm~ im~tmn~tt:U, • ,l b~· acceptance or ~~je~tiOl1 of a proposal has l10 effect (Ill 11;1;; acceptance Of

_Q_g_=- --------------M~~-j"~~£S~~m~~!~lI~~~tc~ .

()~nfjJl~

There are a .large number or methods i n practice ~n over the wQ,rrJ ~ Sphel€ rnf capitalexpendsure dllci~iol1~_ Which e~el' me~ood is Sielec~t.'1.It iI8lit~~~

(l ) Provide' a basis fCif d lstlngu i~hing between aceeptable ilml nflrl.8c~~Pt~b'~ rIOJe~ls;

(:2) Rank dirr~rent propos(:Ils ~n orde~ of prior~~.

0) Have ~lJJilllMi1:' approach to c.]lO(l!!e from a:rllollg the IIhem~ti1o'e~ aYOlilab!e; (4) Adop~ 'Oiler-Jon' which can aS$ess any kind of project; (5) Be logic!!! hy reecgni 5~ng tf:i,~ tilliL!:! vahtC (I,r Ilwrney and: the i m,pm~~II~e or

returns, -

Th'llfoUDwing is Ih~ popular elassification of various methods or ~~pit"'l budge~illg :

(A) 11rudt!1m.a.allmel1md's:

(I) 'ay~ period method

(2) ~mIJ11Dve:[JI]el1'll ]ntradi~iQ.nallllppmach to p!ly~ba1::k perj,od method. (3) A!:OOUfltin,g rate of retum or average rate of R'mmlif:le~lOd

(is) NOD Traditio!U! I Method ... (or) ID tS('ollnfcd Cas!] 'flow m~t'h{lds Ole Ii' l'flcthod~):

(4) Nel Present Value (N.P,v.) Mi1Llilocl~

(5) Pr. ~fi lai:lil iry Index (or) Excess Prl.:".'Ienl va tue Index Method (r~ 1, Met,hod.)

(li) Imemal m!:e efrenirn (I.R..R_, method Each of'thc above mC'[lIud's is E:1'lP !aim:.d be!uw:

CAjiJrrndith:m8J1 Mc-lilJ,ooS

Wilest: m~thocl:s, gt'.nC'r~ 111' ignore "l'ime ",alue of 1lI1o.ncy· and !reM incomes ~Sl[lll .. m:cl fun) ifft'rtlll flUutc peri~ al ike, These mctll~ have been t!Ol\liliunJ lly used in business ~mln.

,( I), r·.i\V -8ACK PER.lOD M El'HOD

'Pily-bi3~k p!lrIDd' is II~SO called • P"ay-oul perlcd' Or 'Pay--cff period t 'PJYback period' :illlb.c t[IIlS ~p.::i11 in ",,11 lch a ,proj~~ • Plly~ tor JlsdC through Sllrp I~~s caSl:1 flews. It is Ih~ period ~'o'ithil'l wb lch ilJ,wstment in fixed assets, or projects ean be recovered, It is 'rne time r'cqu.urcd for ih.Il 'Saving.:; i~] costs' er 'net ,ash inflows' from a, project to i:tjui\1 tho iIiYiJS~llL~llt m.adc IJtereJII, Thus, p.tI::r--ooc.k period i5 ih~ period oftime fO.~U1C oosl.ofa projcclliO be recoveree from tnc-additignal cilrning:"1 o:flh~ p.r(J'j~~t LI:sc;~~

I~(lr example, 'if., p,rojec l rot.'Iuires milial LI'!"'eslmen L 0 f I~s 1,00,00 0 a rtd il is !.slimal(:d to gellern~e aJlJ1WlJ llet ca~h ~11.tlow of Rs, ;;!O',OOO f{!lr 8 years, [hI: ~~!t'b.i!~k period is S yelrs beeanse it lru::es!i years to recoup Rs. I ,m1,0{1© M the rate of ns. .20,000 per year.

is '[JOG

_ ~ '-'eo.t5+-'-'_·-ycafs

-; 30;000

~) 11

J) II ignores pmt.p;tly.bach period returns. T.hus mllny lug.hll' profirabkpr'Qjec&:s m~j' be ignm"fd.

It is nll~ concerned with the le.ngt~l 0 f (! rmj&;l',S i We time. ])~rti!,;I,!larJj' ~nef (l::ly-tlackperioo. An prnjct:b which have IOn..I'l~T geSlatiClIl periods bUL very 'on£ periods or prol"iirab le (Iper,,~ tOil I}U ignored by this method, Id;:ompi6h::Jy igllO:rC:il '"f.Urrnc valli~' 0 f moncy. It treats tile eash ~iIlHow~ ~n dlC firsl year and !he last year a~ nke. rhus, tlLe jJ'i~et'~t a$p~l ami the rj~k 3ipect whkh make eash iJ:! fl~ in~hed nstam f1ilM1E: less desrrnb le than

!fl,ll tmnledia:~e cash iiIlflo'Wl'l 111m notreiognJstld. un thismethod.

{4) It docs nol make use of CQSt of C~Plbl l;thkh i~ bigh ljl relevant for inve:':IJIl eri[ "nal~is ill tim SEn~ it represents the cast of rulllrJS ttl be invested,

(5) S1Jmdr.Lrd pili)' back pertod or • Norm' for p.ilY baek is difficuhto de!enn rne becau~ it ~s a subje>cti~'e d'ecisiml.

(6)Thc meliloo treats each prnje~~ in ioolatloll where !IS in practice mVel>rtrnent in di fl:llmiit lI~sets is ilIte<nr;elaroo.

(7J f'ay~b~cki :periiorl ~e!ilro.d d.oes}lo,t ,PlyaslireprofitahiJ,ity of projec1~ at ~IJ bee::ni5il: it is co:nce:mru wilh II s.non p~~il]dl of'a project'll ~.ift: time,

CMdmrfO'n: In spito!: several cll:l11N;rLls Or short com il'lg:~. pa:(·back p~lod is !lie 1'J],(lS1 fit:quclitly used crite.rion for project analysis, His IIITrliculiarly used by mllltiJlat i Dnal ecaipanles 10 !lSis.eS~ proj ects i 1'1 d~vlld'{jp.i ng countries

The follow~ng are the reasons for its popn!arly.

( I} Most of the gffi'I,~'i ng bus lness uu il.s ~\1, ten take up n,~1;\' in".e~tTIlent proW'Qf>als are u~lIlaUy no~ well I:ndlJw~d \~'jth funds, The buill ill liquid jly [JI!\:I erenee (If pay-back period method attracts sue h. f U1HS, (2) 11~ foc!:Is OIl 'reoo\le.ry onnYC~l;menr ls l!lore sYI~ti.tJle fonhe d)'wmk m:lfk_cl~ 1LI:Ld uncertajn investment clirnaee.

P) TiJI.;: '~p.;.;~tl' Of' haste' which is the characteristic Qnh~ mud..mJ business world prefers short term ventures which are the preferred proieers under pay-back P~! [ud merhod,

(Z) 1m prov~melll(j in trad itkll:lallljJpflll9.~h tapll} -bacl.;. period I11'etilOO

[!i~ popularity f.lfpi!~ -back l)eriOl' rlle~hod has pr(@Clted efforts ro eliminate some iJf its nlajor ~ruw backs. The [ollownng are JOJIi~ of (he more popll~8r rmprovcme:nJl:S lei tradltiona I pay-back period COI1CleJJL

fa) POJt plly~bm:/; pwTrtfJtJUif)' ltletholl: A serieus Jimimt ian (I f 'pay-b~.ck ~ri(,'!d is [h8J~ it ignores tile post pay-beck returns of projects. Torectify the defee!, post lP<!iy-b<lC:k profiloilbii ti)' und uu index arc used ~y some rmH!;,

PO~[ pay&llmck: pmfit-abilily is computed by aseertaini rig the IImount of nN cash In I'IO\~S est i mated i n ca~ h (J f Un:Y~lll~, u ncr U1C p.;;lj'-v,lck perjrld They me s~n'o\ 11 05 11 percentage of ~h~ i nvestmems [n the' proje~l

Po~t P!y • back proji~ x ''''''.

Pflq p1.l}'-iTack: pro fllabi lit~ !!ld~, = , eI'"

ill illal [nvest inent

pay- back recipro-cai

(0i)1 l!IHl.djU~'ed rsre (If return

t) r ~ ~·bn~g'l:'m~·m ~cr"u- L'

'-! I~ IfJl~

Projects wilh higher ina!::>: aft: pr<.':fcrflb~.c whc:n !w(lor mere p'roje~

, . '. b'" _l ' .... ve

mere tess Sll!TJ uar p.l!;lI" . ac,.; peneu .

. (bJ P~'l''; Pr1:1~~~C1l p:j'~l)d m~rllf)~f ', He~ thelengm of the PO~t~y-~'k period '~:Ith. posnhvccasll .lnfioW'll i5lhe Cri~e.rI.M. ]t ~:S' also called' :;urpl'u:s .I i fe o pay·back' method, Pf'jJje~t& with longer post l13y-lback perjods with sign[fi~~ elit:n. cash (lows ale preferredl.

(c) Pa,.bac. Reciprocal nUff/Jod (of) ·,ul,Mlju:.:.tced rait! !if fejl:jl'll 1Jj{!111O,t1J.

Pa_y&back redproc~J m..eI!h,Q!tj 'S emplll'yed tl;I estimate Lbe rate oheturn Qf rilCQ~ gctiie'fa~ed by 1:1 project Sudl rate (If tctumC<ln be USNI A.'> a criter! On to faak different projects and chooi!letb.e ones wirth_highest rate of return .

. Annoo.I, cash inilow ------xHm 1'lIIvesttnent

This m.elihcodi can be emplo~d '(mJ.y wken the follQwingtwu t.::ondil:ioll'l ar'e

IDl1iltoo: . -

M ArulUJil cash inHows are unifurml1l_1VO!il'gl:lout a p:roj ecrs lIre time.

(b) 'the projeat under cofuldefilthm has: a long lire, p.rd'ernhly at 1~1l~-t' twice me pay.b,a .. 1;: pe[~odJ.

(d) DisCdsm(ed h~'Jttc.k melluxd: lhe mo.r;~ serious limitatioll ofp~j·.~ period m~thod i~ Ihat il i:gnOrCiS time value of money by !ttating eash inflows. in different fmme )'emll atib. 10 circunwent the linm:[t'lltLon and to make p,ay-Jbatk period method more effec!L\!e,nhe dj_s,.c:(Hilnting concept Is 'infused" in«J the Ir.1ciiliof[.11 pay-bad::pernorl rnetiilQIl,

I n this method, the efiri[ll1l:teil future n~t cash-inflow'S !Ire discounted at a~ apl)ropdal:e rate (!J511a1.l~ cost of capItal rate) to flnd their present values, The d iscollnted ca,slJ flows ~re used 10 a.'I-C~ain~ay·b;1ck periOd,

The discnunted pay"back cO!ll1ept. has .rndic.aHy changed the pay.back ~J'C~p~ becaase .Lt is now far superior-tOo other D,C.F. methods, The discounted raY back penod me~hod retains all l:he IrndltlQ.mJ ad\i'.i!I.!1t~ge!i <!lid eHm inares tile gl~ILng draW' back of pilly-back coaecpt,

(3) ACCOUNTING RATtE Of RETURN MiETHOD (OR)

AViERA<;t: RATE OF R.E'flfRN MiETHOD (ry.R.R.)

This methodlnkes int~ acOO1.mt ilie tQtaI earnings expec~edfiom en inve.s!m.Cfl1

- _._ __, - - - 'I

proposal over .ils fill I .~ife lime. The meth.roEs t\e~ld AQCOL.Hl!.~g tale of re-ttIm

meoth.od. because it ases the IIct:)olm~.ing comiepl of prom ie"i.ncome ~:fter depreciati,(lU lind tax as the criteriQ~fu.rcakul .. tilJi!'l of return. ]t should be noted ti13t pay-back period metJlOd and also !he diseeunted clI~h flow methods make L1S!.l of'tas.h inflows' of projec1~. wherees A..R.R. utdhod is based 011 '!'Imfi!' ..

II

Ori.ghl:~1 ~Il ve8tmeLlI. - Sc~p va lu . e o( the asset f Projeq

2 . .

OrigioaJ investmelll "'" Sc:rapvah,w ~fthe

. a=l Qr pr-ojec::!

2

O.ri,jllll'li ~

Ih,,~s.mel1t - va!llle Additto<naJ

~. met ""zyking + Scrnp

. . 2 C3pilal Yalue

. . A1le~li\!'e (iv) ebove is more' ~?glcal OlJ.l,d popular method of a:.cei!ai .

average In'l'cstcm8nt, fm th~fo~.~~'i'I'~:;'''' n:asons: I1II!,g

CO . , . . . .,. ..... ,

.'. ..' .t line m.~~ofd:p.ru:~tiol1>~.,;.~.ag~ iJ1vestm~ fQr'

'1 ~e. I {)fl~eam(!S5~ .~fl'!s ong~ cos~J.es.s"scrRp~lue.

t •. ) '] h~ WO\l'k~llgC~~I~] needeJ W operate. ~h;e' a'sllei::w.1H ar:Wa~.s~.e- tied.u '

d'ru~1g the ruJ. ]d.e tune of the asset. ' . I , ,':; "R:

(3) ~esc.rap Mllie l£,.rOOuccrl init~it~]y ec asc:e.naitll depreciation rere, Billt the scrap ~a!l!Il~ is ~hs~,] only ~ th~·~J1d. ty~n,g up the'~moun:r ,off scrap \l'ahre throl1ghChUt the i1fe· tLme of'the asset,

It should be noted ~hat.C(l.mp!ltalion OfliCCOilllting rate-of'return is 11 difficult process due tn th~ allermmve methods a\la~~ab]e. Which~ver method is adop~ed, by a fmIl, the $line method sh.o!ilJd be ctmSistent;y used so that ,aU the i!lVe:l:lFr}~m proposals art assessed On an llnifo[Ill basis.

Ad"',!lDU!g~ 'of A~oun:Ii!lg RaW (If Retum I"IIllf'llh.oo

(I) Whell the. metbJlrl 'OF Clll~uJ~iilg is d-eci~d, it is easy touaderstand and

operaee. .

(2) The .metlioou.sc$ the entire lI'arnings Man mvestmest proPOS.lt 1l111~ke the pay-beck period method,

(.l) lt give~ a clear picture ofth.e proflt.ahmtYQfa project

(4) As t.D:t basis for ~c nwthQd'is accounting concept ,C![ proftt, ~t can be r~a~11y cllkul~ted frDJll the deta 1IVailabt!.::in the firm '5 l!(;'t,;ollfLling records. {5} [1:1.15 me .. thoJ.lS.base<:l. on 'N.·,et e. arnlnas"] "" .,.,F»; ......... after ~:".. dati

. .. _ ~ g~"r" ... ""';;LJ.Jj.II.I,I-tr" '§.L !;.;.oJ lh'.rTecl2lJL~Dn

. and ~a:>i., ,1Inhkeother. m:~ethods. It provides l'I1!110rf' comprehensive

comparattve assessment of proj eels. " ..

D~dv~I:U:ages

(I) l.ile pay-back. peried me'tli.od, ~ method also 19nores the time value of liIlon(l)~ and tr_eats. all incomes received, whether in the first year or tast

yea!' a!ik.e. '

(2) ~eliabHity .or.A,R.n. method is affec~ed due tothe various concepts of m\l'Gf.tnn.cnL.Dlffe!';~lt rates can be Ob~l'IlIled, lI~ing different iLl~ci]lre~:atiOOli of'!lhe meal'l!!1g Gf !nve:strllcnt',

(il) Avem_gle investment

(iij) Avemge investment

9.1:'

tJ) By cOlisidedng p~fila:s the erlterion " 'c~~hfl ow' aspect of pl"(ljects is nut proper~ assessed.

(4) [tis n,(:iwsefulloa~es~ projects wtiel'G investment i>madc ii'l two or more

jlliSffi~lmeliltS. at dd'ferl'll1il tm~.e~.

RU~ to !he oomplkatiolls i.n c"lculMil]~ '[!lv(J;!:itmenf and o!Jler shorl.l::orn lngs, . . .. (lr~.".eragt rare ofreIDIJITI l'il-l1:thod ~~ nOlv~TY popular i.Ll modern capital

"'

W::'Mi'i N.c)il1'rnd.itiomd MelJlods (Qr) Mod.em .Methoos (1I:r}1 DiscOll !I~ed Cash 1I!.ow M.clhods (_D.('..R)

ll!les~ ffii1:thClds, togeiher, are called present value methgdti or time adjusted

~~ •. f'mlrl' nl)·,:J .18. They arebased Ulpon the 1'WllIi'l~.e of' Disoounkd ClIsn flow (DE, F,), . . basic d:~,.rect of trailition.alll1e-!hods, j}'OltLllle pO'int ofview of ill.v~stl]l.em

rxriiijldV~il~ Is that they neg~ecl the <Tin'le value '!If money'. The dl;lCQU1l1ted cash teeM [que rectifi.e;s,1he d.efe;c! Ol[ tra4it~orillJlmeth04~ by bril1.€jin:g ill! the .1ii!i~'lIlIli~ cash floW'S· wiilie common paramek;r of''pl'es~ntyallle'. The pre$et"l~ value are !~pre:~izyWYb~~tnlni' popuiar in capital e.xrenditnre deci $(Olt~ due

scientific: bas~LS .ijd 'acCllIllLcy.

. f~atl[fI~ ~f[lJlilJ~tV3h!f~ mcthoos ,'.'

(1) The basicf.eakl!l~ of all the pre~ent value methods is that they are based on di.&tounted cash f1o~vs., J30th cash inflows and cash mrr [lows are

diseounted ('0 asc.ertail!l 111-ei.r present vahA~.

(2) They use cash flows and not the i!~nt]lltlflg COflC€p1t of proflt. Thus.cash inflows after t;lX.,.beftlre deprec lation are taken as the revenues.

(3) -riley take into account the i.n~ert:S;tfa~tor by reoogn;s[ngthe value of earlier eash t10W3 compared to later cam. flows.

(4) They consider the eneire cash tlo,,",'s of an ilwesliJ',en:t proposal throughout

its economic. tife.

Mo]lIr stf,pS in disC~'I(I,nt¢d ~3sh flow nu~th(J{.I~

The f.oUowing an: Ule' 1U1l.io-r steps in aH me present value methoos

(3.) Esbmat~d casJ:.! inflows and outnows., after til:>:', but before depreciation, re'lI~in~ to the plo}ect un-der censideration should be ascc[(ainrd.. They must b,e for th.e 'l:ull economic hfeof Ill.:: project cOl'1ce.r:ned.

(b) Both th~ cash inflows and ourftows shoulJ be discounted at .. p:redeterm~~ dis.counting [ate. U:;u~Hy, the dlscOlIIlting We is the cost OfC3pitai rare of [he flrm, I8l1t it can be any Dther rate also. Disooufltin,g facwrs can be obtl'Lin'edfi'om prese[llr value tables. They ~ .also be cak:ul.·nec:! by using the fol'lowiDg [O\rmub:

I ~. -.

I -; 1

r ~ Discounting rule II => No. OfY£3J"S

9, I (,

F elf C.\::JII IjJ I..:.

di sroun tin~ lilc~{lr at 1 U% rn~(;' for a p..:riOt.l o f .:! ~ ears

(h,lI~ Jll'" .1126

. !l16 means 'that !ill) R:s;, I ,000 feteh ... ble OIfiet' 2 y~ali'lO is ~L!a~ to It~. !l16 to.nal'.

Or. R s, 1126 i iiv!.~led IOO~)'!lit I'll% \\ ill briny Rs, URI[! IIfl.~r ~ .YI:~I"S, '

(~) TI1~' totul of di~'UI.macJ cash innuw!o! I}; CtlmpaB~'tI ""~Ih Ih~ ll~ta! ijf t!t~ di~t'l)lmh.~d cush uul ntlU~

Th"'F~' !.In: chr~;! ~lnflU n nnl pr~;\il;;'nl ndu~ nH:I.i1otl.H],f t'llpi:1l.11 hmlg,111 bilk': whkh arc L:"~pl~ln'i.:d bd~n,;

(4) Net I'~~~m 'Vtt11H: (N'V~ "'h~hod

Nea pms~J'It value m~thod ls 11m: iI!I.f 11:tL! dlseeunted t-as.h I~r:m ,mthods Inf C.:!ililit:!iJ budgc!iog. !ll'lL'IIXI~ise-s .'hc' dill!!: va[uc (lrt'!llOn~) .an~'that ,c<liSl11.lhrws arisin~. a~ di m.'l"~nl POCrrlOO:' (l,r li.lth! dmh in vs [UI::' 3m:1mc' ~\m com~Me lm~(l~~, ih~iT alllilii~'at~>Jll :prt'S!l.:nl,~lucs ar.c .IOUiTld, TIu: Llell. ~nl~'alu~ of all il"lilows and QltUlolII'S of c.Bsl1iX"ClIlmng during IJlii~ C'nljJ,~ me or a proj.e~1 is dele"nill~(j b~ dis~(luntin~ IhC"5C' nows IJ}' [h~ Hrm's cO!:l (I r '~J).iI(l1 or same mf~'f pre- dCh:FmineJ rate,

The Ibllowin~ ill~ ~h~ sU~"PS in ~h(~ 111:1 presem va !uc mcshod:

~:I J .A ppmpriilli: d ~SCOL.n [illi!! nile has [0 be d~c:nnin~'tI, II is the mi nimum roqulred rate 01 f"!l[liLm and is catted "CLlI-OU m~e' Of ·dt'i.C®W11 'rate'. TIJ~ rate is g~JI~; ... J1~ based QU eosr or cap] wI whidl is ~lIitabr.y ad] usted for lhe riskand ImccE1111llly L~h'tlhd in the pn:l:f~'C1. Sl.lch o.4dWtll'l 1(1 ~Q5i of capi 1:11 is called '.Risk return' ,

(b) fr'l'!~nI valu~ (Of cash oLJI flows shoLl!Id b~ fomlQ ""'Llh I.h~' help I."Iflh.e dIS0()~lfItu.ng.:r.are. 1t·lihe.ffi~i.F;e mv~!Jmmt is made lIiiHlallj". there I~,no :oo~1llI to disCO\l,iII it. "The 1I11l0UI1t of in\'e·S!un~f:l1 itself is [he present value of eash (llIl !lows.. However any investments to be' 1'11;!cl~ ar some fsture pounts of lime ere !:.o be di~courUed t@ find theIr presem value,

I [ shQuld ~~ rillll~l1b~rnd Ih~t~liY \vorking capitaJ should be ~aket1J as c1l:SlL 011 tn~}\\ ,in th.~ ye~;r ifl wi! lell ~'()mn~erria~prl[)olu:c!;i,Q!' aClmJ~~y stens OIl 1.l"I~ rroJm:jJ,

~ c 1 Present ''"llTllle of estiml'liLed eash iilt10V.'S should also 'Dt: c()li:tpl.l~ed. The e'ils.h 'H~ws sh.ould be UU~ 'lTI~t easn I!o~\'s 11 !t~r ~~X, betore depreclil~io;n, "The ~rcllfl value of the :project ~~S, 10 be 'taken liS <I cash innow in !h~ lasl >"C>!I. 8imHa.r,~~' worKing e.mp.Uallodoc:di up [Ill UK: p:rOJIll~t has 10 be 3ssumellJ ill:> ·llll~ocked' allh.e end of FLlud ;·~a[ •• hllls sho\\'j ng il all a cash il"ll:lo\'" for Ih~ I'in~~ YCllir.

(I:.n Nl.:'i IJI\o,:i~~m ~iliu.o: U-i f: '\I' I i.~ Ill'~ ,L1i rrel~n~"l;' h~~ ",~O:rI Lin~ I 'H,~~!;:rn \ ill U~ .... j' cash hrnfitr~~;s, and {11(;, nresem \'<l!illle O<{ CW;1l (JUL~ ews.

Nil''!.: ~ ]1.\" ohOlsh in UO'o,\'lO - p, V. of "II~~II}UI How"5

11.1'

(5) rrofil!lbilitylnd~,,"~~:l.Hor) E)(~(~~ Pr~:ye!ilt \lillu~ hule:t Method .:....i:;

The pmfilllbjlity .!ndlJ1!x is also called 'Benefits Ci:lsl{fl/q Ratin'.

~ ough ~is is IlrC31~d as 11 scjlllm~e method d ue to the. impol1tance 0 r n;~lIlts obtalned by lis Ilsages;, It IS on ly a reflnementcf'rse t'H",V_ melhQd. H sho",~ ~

relatlenship betweell P: V of cash ilrflows and P. v_ of c!l5!l] (ll,!mDW~, .

F'ffl'm.~lu,:

fm(jtlb.ilHy lndex (p. t)

(o:r) ~~.el'lt ~1ITI:tl :raLio (B I C)

~ \f,ilI!J.l: of rUU!f~ ~b, il!tl:Qt\'~ .!'res~nt VlI!W': of I1I1:ure cash [].~tllO!\vs

A~Qt'~ 011" rej'~t '~lI"i~eriQIlI

I rIhe P. L or B1C ~s mllTe th~!1I 'I' project is act~riable_ Projectswhll PJ. ones!; t11..il1l'L T <lIe to' iJe rejected mn ~jght.

".

Acoept when P:] ,> rn

Rejcect when. PI <I

"fheprofitalJility lllde10l methH is espcciaHy sruU!Jbleto liiirika large mOWint >[I] investment propOWl15 ,simL.lltm~ou::sly. B8500 ,onlhc fJ" projects. tarlDE:'. rank~ jwt J Hkcsturle:nrrrs au gU\!~ .mmkl; b~!!l. o:n the marks 6~'1!in~d in an 'e'xmn. ., E)W11plc: Project A - P. V. of ca:ihout .lIo'W'5 R:;., ~ ,00,000 P. 'II. O'f cash. in Ft()!,1,'5 R5.1;w.0Cl0. Pm~B - P:V. of =l;) o:utfiIrJI.vs Rs, 40,001 P:v. oftaShirJ~ ~5S.ooo Under the N_P. V_ method. N.P. V; m Poojed A. - ! ,20,(H'}{l- 1.00,000 = Rs, 20,000 and ,projoct B - 55,000 - 40.000 =Rs, J S,OO(J_ .A looks to be bener,

Um:l~r r. L method,

1.2{1,OOO

P_I- of A = 1,00,000 =12

35,000

P.L (Ira = 110,000 -1.375

P'JIoj eel; FI' wfIh .htgher prnf~abiljty llldex is detil!i!.eJy ~ter lhan proj ecr A.

Merttt.5 and Demerits

r.~- Mell-.od rO~s.esses,~lI ~he merlts <md de~t',erits afN.P. V. method because P.~- is a reflllefilelll0fNJ";V, liIlIeUlOd. However it is,mort: us~.fi.ll ,ill f~ two or mere p.roj0c:I;s,

Thus, ]':1 is mQre suit<lble' for oomparative assessmem of!projects wheFe~~

N.f: V, ;15 i'Ii.lpprtJp:rfuk to decidle II!JOU~ a particular project. '

~fi) JlD~N'.mdl Rate otl".Rf,1um (IRa) M~oo:

l[l!emlli rate 'o:f return is 'tha~. rate of retum at which !he presem Vl'Ih.t~ of c~sh ~nt1o'!\':> and ,cash outflOW!i·llfe e'ilu~l·. Thus, a:~ tR. R. 'me mtaJ of d.bs.cm,lllt~d cash ill1f1ows equals the' WIl'II of discounted cash outflows, lR.R, diS'CounL:> th.e loml cash nows. to the leve I of" zero,

Cash Inflows

At UtR, "".'~ Il.. fl - I

'-"'ISI~ OLIt ows

It l"'-I+r

R'" Caslil inflows

r. ~ of return 00. the investml.:D1. OJUt.)

. 6,000 .. 5.00Q = l+ f

5.;000 r' +' 5,)l!ilI!1l - 6,0CKl

;<;,000:;= 6,®{lIO - :5000 1.000

1,000 r= 5{iOO

It is easy l~ compute thr. 1- R..R, fore a single year. Ho"yey~r, the: same m~d1od

call be applied to dl;lt~rroFnC' UtR. . .'

. (II~) Wlhen cash f1ows:ln: O(lnvtnE~onal i.e., investnlCDI is fu1ty initial, follow&!

by futu&ecash i"tlo,ws'

R Rl RJ Rn

] '" ____j_ -II- --- + -----r. ,_ .. + -. --~

(I +r) U + r)! (H r) (I +r)

(b" \llhelll eash ~O"3 are IJIIC-Qn~'~ti[)n:'l~ i.e, CDSI'! outflows as well as·illHoWli am aver 11 series of future' pe'fIOOll.

- [ R 'R R] [, ]1 l2 III]

. ~ --.~- ~ = 10 +-.-.- + --r ---'·---.-Ii

(! +~)~. flH)l ... ," (i.Ht (1 +r) (I+r) (lu)'.

twc:r,e ~ • Cash o.utflows at di:lierJl11t times

R ~ Futuro CO)sh iniio'oVS at diHiererlt times

r = :ita.te of:rret'Jrn yield by the hn",enment {rn.:R)

ln the ab!:we equMi.Qns, l ani! It <we .he kJlown ·factats. So, ~ us the nnly redo! l1l be found. [4j)w~.ver it ,is cumbersoJTle to rtgld the l_R.R. with_duo: ~Ip of lie aoo.o,re fumlula because of t: je lengthy and CDmpHcated ealcul atmns m v o~ ... ed, It is '.tllltomary ttl use the prcsenr \'aluel.llble'S and asccrtam UU{. wIth the

htll~ oftttbu!ar 1'31 ues,

The ebove precess ~h(luJd be replaced t~J'lthe p, V. of cash inflows and P.V, of omfl OWlS II~ more Or less equal. The rateat y,'l1i~h this is achieved j s tcmlcd 'li1lern~ r rate (I f return'. (See T IIIlS!'i"lltioo No I 8).

ofI.rtR MethoD

{U Like 1I111he otlte~ D.er, basedrnetheds, LR.R. atso takes into eccouerthe time valae of meneyand can be appJied where dle cash ~ nfiows am even ur unequal,

(2) It also considers the profilabiJitYQhpmjccto",e:r its entire economlc life and thus the lruc: profitability of <I projeCct cen be assessed,

m Coot of C1Ipf!E11 or pre-determined cut·ofr.ril~~ ls nol 01 pre-requisite for ~ippl0tlg DtJt method, Hence it is benel"tl18n th~ N.P,Vam:il P.l. nwthoo~ in all t1msc' sjtufftioos where datcl1llining cost or Gapitill is diffi:cllll..

(4) !, R.R. pruv.idtt.S fur rBnking of various propesals because it is it percentage return.

(5) J! Jlm~id.e.s fur m;aximis:ing profnabi liny.

Dfllwrits

(' l [t is U cClmplIcatc;d method! and mdylttad te cumberscme c'lllJ~1l1[1tiQn5,

(2) TIle underlying as~Ltmptiofi of I.R.R. tI!lal~he earnings are relnvesred al J.R,R, for the remaining life oflh't proj ect dS nol ..I j lIs(L!labt~. a ssumptlo n, From this point ohJew, N.P.V and PJ, which ~55lHllC reinvesnncnt iii CoS! of cmpi!al rate are better,

(3) The rtl~tJJts obtalned through NI"V or PI mejirods m::t;i differ from thm obt~i!'led III rough l.R.R, dep~f1ding on the slze, life and rirnlngs of the cash flCi!\'i~,

C'OIllV:iltlso:n of lR It \,>,1«11 N.P. V. alit! 'r.~" ~lethods Difjerm.u:'e!J,·

(I) CoSI of capital or cut-off'ratc is determined ill advance ill NfiV ;MId Fit 1.11 I.R.R., rhe'disoolllnting rme is the 'unknQ\NIlfaocwr'

(2) NfV und .rl ~trjvc to Me~rtain lIte lliIlm,mt which C'-(l~ be il'lv ested i n .~ proj~ct wh k:hcan 'earn the !l:(!tI ifed rate of retu Ill. IRR ascertains tru: ml!lxim I,Irn interesr tljat can be pa1di (Jut of returns £rom 1.11 e prlJje~!,

(J) T1le lIIlIdefJying a.sSIlIllP! len 'of the D.C.f. rnet!llll:l~ is that the cash infl'owi> can be retl'lves:too. HmV>Il\l£F NPV and P[ IIS~liImC lhe re inYCl;tliient .at cos, o.fcaptl<l.! mte ()rlflecl!~-oJlra~c, U,Jt 3SSUIiIl.eS re-Lnveslmem at th~ lR.R. Me, 'rhe forme r is mO'I\epraJ;:tie~ I an d j usriflable thsnlhe later,

Gencrully, NPV and Pl arc considered to be more fj:Ji~b~e for cQm];)~ra.iye analys i ~ of proj eets than the UUt method,

v

J

I

'.I.l2

CAPH'AlI... RA'fIONJ NG Capi~!l1 rationIng refers 10 ~ situation wheec a lim ~ ~~ nnl In OIllosiUon to ;n~A \

irn el ~ pmfuable proj~cC5 due lo the oonsl:m.tlnt.!i on .w,a rlatril II)' {If funds. '

))ilTereIH methods of C··~I)ita I blll:lgectin.g evatuate investmeat ProllO.li!ll~ 3I'iIJ uHika:lie Ihc,aoccp1:.flbihlyofproj~~s, forexai11.ple, Ol~per 'N.P. V.' methOO, Projtc~ with poo:;Jiti",r.: N .1", V, are acceptable, 'Under ~p, r I'l1c~h~l. projec'~~ whh fro h.t,lDm'~y Index. or mose ~ium 'I' are aeeeptable, However, I'll e problem is ~ihac the fLlrnb !:IvauJable .m[lrY rul'I be sufflelent to take up and impf.cntl:.n~ iI~ ~~ht: fLCu:pllllble Projetl5 at a gu\!en time or durl rig II ftmdlget per,iQd.. . -.

ltis possible Iii ~t the Top M;alililg~ment of a COLl:Il).111_Y ru~ysel !illlins on the ([llui amll'Ul't'l ofin.vcs:tm'llnt during Si b"udgct period as '" rarHrf capital CKPeJJ.d iture ood,gct Su~h decision may UI.Ke UliltO il(COUrU Ihe gro~h Me! expansion plall~ or t!H~ linn. Ifl'll 'I:!Iipa~i[y of the firm to raise fllJlds fi'ulii c~.pital .in<lrk~1 or Ic:ndin,g irultlfut~~Js, etc.

~ben ·C~pi~~ ~tiQflifl~' sinllatioQ ,ma!ewIai!s~s, !t is characterised by (<!J limited <I\'3l1abii Lt)· of ful'Ldls (b) Pro~rabJe iJ~ye.stmellll.,proje~ Of pmp05a1~ wll ich ,~re a I~e-ady "ss.e~sed and round suitab le lind (c} 'The IQta.! inVcs-tm~~l needed En finance all tie selected pl'o}ec~s exceeds true fund.; ava ~bb]e.

OlJjill!i:Hv~ olthe method o.f dcaliil:r: with a.,pl hllirblioil ~ilg

In vestment prolrQ!la~s wh r ch are accept.llhre ~r~ far more limn what can be taken lip wf!ll the availah I e funds, So the objective mils •. 00 to select OJ choose or decide upon a 'oomLinalioll' of'mvestment propuaafs which pmvid'l.;sthe highest net present value.

The ro!lowmgare essemia: ro achieve theabove objective ofma7<in)tsing the ne<1 presem value,

(iI) All thr projects which are evaluated must b~ 'Ranked' accordin,gm their Profltability lndex (pJ.} or Ir.nCIDllI Rate ofR~lurn t1,R,R.), (b)1 Projects II'll.lSl be selected as ,per Ill!: rankin,g ltn.illl~e a"<lllable funds are t:xJJ.t'lu:;I~Q, III case oHnr.: IlOHrginal cases, ~JJc decbion must be based 0Jl tfit: principle (I f n1~ximi5iil!j the net p(e£~m villuc.

IDFAl.ING wnu IUSK A.ND UNCERfAWNf¥ ~N CAPITA.J.. iHUllGETlNG

JIIlrodu~ti~,m

C~pita~ bu dgeti!),g mcth ods \\!h lc 11 ,~j~alyse investment l)mpO:S-l! ~s - both Tr-dilitilIDl'l ~ OO:lnudsa.rtd d iscountedi c<lsh flow melJlod~ -~re based 011 !he assumption that the 1::11.5:11 nows PJ~iCled [(It each proposal will matenalise III future, The estimated or foreeasted cash flows, are Ihe found~liolll for each and every method of in\~e!:rQ1 en ~ ~n~ Iys ls, HOWEver there L~ ample risk .111d uncertainly auachcd !.00 the p.re-diC!~<d c.J~h flows.

Fllciol"S [n1'1 uendng e.s~ i mated fu ~ u I'e eash !lows

~ n, Demand fertbc product, 0) Prodaetien and 5~Hin~ costs; (3) S~Hingrficc&~ (.:I) Prof~t rapaciLY; (5) Investrnuu n~'Cdetf; (6) Sal vage value; (i') Eeoaom i c Uti: of .be pruj eet; (g) Depreciation rates: (9) RHI£5 of Taxation; ( 10) Compel ilion, etc,

9.24

. ... Mllrn<tg~Il1~1lt Ace .

method stnves to adjust the discmlnt rates r I h Ollntl1l

to . r, ,. . '. " .~~. n ves urn W 0 are 03' _

fI S" ma) no! prefer a risky pro; ect mspj Ic of II slightly h'gII. SlcaJ Iy IWel"$t

The method is used! by man'-' allaj"sts bee f'" e.r feI1Ui].

• . J J waliSC (I' 'IS slmpllclt"

(2) ( eriamtyequlv!1Jellt methad· Here the c:....,.... J'

, ',. . . - 'ue IOreG!lsc<;;u cas.h flow . •

as ccrtam or 'nskIess' cash nows. ThE! method d. . sare deemed

f1mnjs to <Ii more oo!iservafi".~ leveJ with rhe IwJ .. orce., !.ICes. m.e predicted ca.sa

'em . rv ' .. a (;Ol"1!'el::llD!l fact '

~I:!n·l ~q nlWLIelJt cocffidCf(~'. The risk free Or cetal . h f1 or c.allei;l

year is taken ,lIS 'I' ilitd depBllding (In the risk . I~ cas . Q~ of each future

ooffi ' .. ,'. peIceprJ.OJJ., cel1aJnty e.· '

e icients are !ls..~ rgned for ea.ch year's CIiIsh f ' .1' 1.. • qUI 'rr.l.fellt A~" .. ..•. .,. O~ w llr" IS aJ.ways Jess lha ' , i"L>o.je.iSIIU!1l( This m.ethOO also ]$ snnp!e am! easy tn 'J . !IJ I.

cash floVl'S '>\1uch are, ill fac~ !lllc~rtaJin to 111~ "a ,11... ' lItlP eml:n~- it red uces 111£

, . ' . "r;." "lVm ntnre rea IS nc

This method JS also arbitrary and slIhje(..'five TIl. "

co.efiicielllS cannot be cOIl1"II!:eci m· ,.""~ ~ .. 't' t: •.. e certmnty equi v,aJell!

. .'f'.' ~'J ",C·len.111(; malUler

Tills method also is p()p;;tr~r due [0 118 simplicity. '

(b) 'Qllfl1ltitntil!l? TedmttjlUJS

T,hese methods .are based on Matherllatic:8 or Sta.tis~icllJ ... , . .

genera !ly cons ideITd as .more rcliab [~ !be fuUo ,.. ~pnnclpJes and ·;tIt tedm [q ues, . . ". \0\ lJ1g al e tiC more well tn()Wm

0) SernifMty A na/y~h'· Generally "singie c f". [ . h . .

ttl e fUlure periOd w hid! may prove to' be WL"OIj'g. S ~~~~e o::~. fJoA\\S IS. n.mde fus flo ,. - , ' . " ,~enS"l'l'ltv nalvsis: c· I

O\~~ 8Je "'-Ssumed to be 'Sens1~i'Ve' L nd d''''''_. , . .' v v . '. ~S'I

k' d 1 uer h rerent ell CUmslallce' So t[

In S of cash flo", forecasts are made, 'ope irnistl c", 'most Jikel\ ' lind' " .. c ' . m,e The ,1InlOlIJli[S reflect the pcn:;~)rion ofLhe pe s . _,' . Y . pessrthIS1ic, may be slIbjecti,'e. . r Oll~ preu,lCtmg the cash tlu\~'s al]d

The: Jevel of v ariations between tille three kinds of fol'ttas1S . ",.

degree of risl., . , In u I!:ates Itlc

[F N.r. Vs IU.lder !Il!i: three sltuatiocs d.iffer wide]t! u I'mnl'· th tln . .

hl"!icx A"~ f· . J. .""t' les at ]8 nsk IS

'" .. "~d:rn\~ rnn.gt 0 votnatlon Signifies j('lw~:r ie'r'eI of risk. .

(2) rrobab~ity AssigmllCJIf M~l'llod.

'flrooobifity' is [he ... reJa(]vefreque.n:-cy with m.·h1ct an event .. . , ..,.,

h means tho r'd il ".,-. .. . may occur in .L"nwe.

, . '. E. f"''''l ]Q,O ... 0] happening ofan event '0' mb~lJir." . .

IS nOd at 'lIt i.rkely to h.a;· . d' I ' .,_~ ... . ,pi....~ means an event . I,~. I. . ppel1 an pro ~bduy unpiles that rlie event is certain to

rase p ace. Re,m~en ·0' alld 'J' d om, t I..~L .,' - ..-

_ . I ' • ... ~ 1 :eJ en pmVduIll ty values C'all be essigncd to

even!.!;: 11 ~IlSlt1V!ry analySIS, 1l1ree kinds, ofcasl; flows arc gtven but til· f"k· I 'Ir d of each of (he.tll material is ing Or rhe probabi litv of each 'f" . '. :e I re I 00

PI) ... .. .. ";1. 0 . liltrn IS Ignored,

. ro abJll l) fact?r IS a~lgned to each ca<;lll1ow "rl:dJcrIo:n m ,,~ 1-1l. '

cash flows a_ro m u rt I' .~ , .•. " . ' . . ,..- . a"",. tie pred Ictet!

tp le,-, WIllI resv€ctlve pwbablllN factors asS!""' ~d ..... ft·.

Ihe u"'" 'ii" [h _, f . , .~, .. [J~., .. ¢rca el,

, .~".' It~e 0 ... 0' a~Gelt;Iln!ll.g pre~ent values can be fuHowea: .

Asslgmng pmbllbiHties can b~ objectlve ba$e{! all a I b f

observations by iJldepem:ient ana lysis OWr a p~riod f r I r a,!l'e nUI~ eL: 0 "

!m!iua new ·n. ...... ..' u Ime. ' t lC prOject I S ~

. "J pe. oU.Jl:c.'tJ'I't aSSJg:tl."Il'lent 1.5. no t pos$ii:!fe [n~' ~~ ... ,~~~~ . I, .. (.

pmbabH '~y . . , ' . . I ,. . "~,, ~~.,~:s snuJec ,vee

. . , I .. aSSIgmnem. IS U,l1aYOHilOliOlC. P~SOJl a I j u,dg~me')f takes the I ~ce of

'~rge J] umber of (lb~erv~ tUJJl s. p .

.'

S!l1Il1diird Ue\'ialion Method

"robllbili.ty assignment method does not provide a precise value indicating

i . of cash Hows and the amollnt or risk involved Standard deviation

IhnerllQtl o~'e:r{;Omes Ulls limitation. It may be defined as 'The Square root of deviatl oes cal culated from tim mean'. lt is 01 measure of dispersion. This call be IISed to compare tho variabililY ofrl(lssihle cash flo' .... s (lfd lfferent from the ~r rcspecti lIC mean Or expected va lues,

.projects with larg-er ~t~mi~rd deviatlon are more risky and vice versa,

Wl,il (lodliclcl'lUlif V~u'iatton Metlmd

Coel1icient of variation provides a re lative measure of dispersion where as ·~M~~;taJjldi:lJFd deviatien' is an absolute measure of dispersion. If" [he projects nave slID1C cost but different streams of net casb inflows, relative measure i.e.,

-."~tlt1,,,e'm ofvari.atiol1 can be C(l.1upl.1ted' to jucl;ge rile relative risk involved.

Formula

. . Standard deviati Oil .

GDdficien~ of variation" M. .1.. ti. x .100

ean c8Su J.LOW

Whert coefficient cfverietion is more, risk iI1vo'lved is also higher.mel vice \'E\r5lI,

(5) Dedsloll Tree Analysis

In t1,o,]cm industry and rrade, invesnnent decislons have generally become eemplex, iJ'lvolving J 'sequence of decisions' over a period oftime. When a series ofd.edsiom; chronologically are involved, decision tree analysis is the appropriate r.;clm[qUt'. The sequential decisions ean be handled b~' plotting decision trees.

A decision tree is a gr<!ph ic representaticn oflbe rc i.ali"o[J.Ship between 11. present dedsioll and future events.future decisions and !lleir consequences. TIle seqlleJlce l'lf events i~ mapped om overtime i n a formae resemh ling branches of a tree and knee the name "Decision TrN: Analysis" is user,! for (he method.

Th« foilowing are the lI.'t;ua{ steps in (he method:

(1) [dLmtLf.lcarioo of[laej)wpos.al orproblem (2)C[€8Hlefinition offhe proposal (3) Asce.rrainiIlg d ifl'ereflt altemativcccurses of· action possiblt:; (4) P1o~ingthe . dec:.ision tree on graph paper, fndicatmg 'Decision points', 'Chan-ce Events' and . Ofiler relevant rM.a (; J Fo-recasting the cash flows of different !lIllem~ti ves, with ·'pamk;l,IIa, empha~i~ ou most ~ibl:r ahernatives; (6) Evaluating results, di~ing weak: altemarives and rdcnlliying prn.fitable altemadves,

This: method provides tremendous flexibility butjudgemenl and experience are ~eiltial for successfill usage of !tie decision tr~e 311aIYlli!>.

COil d I!ISifi n ~ R is!:: ami tlIw·ertainl:y 1m: fin inberelU parto[ Cflpital expend iture decision, Hmv0ver. ilLlaly:sing'lliec""uses fur risk, theeXle-llt of risk lind the possible ~oors.e of ac.tion to dl;:;i'll with ~!I1Ce:ttaOllty are all necc.ssaJ)' to mmim ise their impact on tile investtflenr decisions.

Specifw lechn ique 10 be llsed depen,d:;s OTirhe ~im.linstllnc~ and the cxpcrJen~e ofthe anal)'l'it. Ulti mattlly it isrne cffidency (If the a.lla lyS! and hi~ jlldgeillent which tfi.1l mitig;!(c i'he d16cts of Disk 8J1d lLl1Cel1aillty an capital budgeting d~(~LSLOIll::;,

fa

-, 9,l6

ILLlISTRATIUNS

(1) PAY·hAle,", PruUQIJ ME'mo:o

In [I~tl1llilll:O 'I

A project eosts ftll_ ~ 5,60.Q(W and yield!; anntl:llly a prom oUs, :2. 7O,4()O <lfit)" depreeiation of ~ 2% p,:!_ ~1!It before t~l; m 25%.

Calculate p.ly"back peri(l~.

S!;lJ:!.Iti~m~

Inil.illl jT"i'\I.l!s.m~l1t Annual ~~S2J [~flo", R:!L 1$.>60,000

c ,~, 1,9'0;000

l5.l;O,OOO

J,90.000

1.11 iti.[hl. inw,,'tnlel'iiI.1 ~i~elll) AnniITl.[ cash ~Ilflm'" (W.NJ.)

4}~ ":f!U: ('Il/c#iaritf!f of il!!r:jlf(il cash iffjlow:

Aunual rmfil ~ft~r d~p='~1rlln ~~fm.: tax L=. ra~ CIJ 25%

2:m,400

oHM

lJ12,1I1l() 1,&7.200 3_9'0 .. 000

'\llImal ]m)Ht, Iltl~r deprecratron ~1If.1 M~

jdd· D~flr<!'~i~lion fI V.rI,Oti)fl > 1 ~~.")

A rmnal c ~'5h mHLH\

,iii (I~tl"llliil.lll (Asc.c:r LII n in g II!;:H 11 ~Il Him)

Lovdeen enterprises is rtfJl~id~fillg an investment proposal whh the fQII(I\II.in~ details:

(I ) C(',st of m~~h[n~ as. J,(]O,OOO

(3) Annual maclune JlO~ 5,000 lind estimated machine hom rare Rs, ~O.

Pundl,lction e"!o(p~fed per 11 our 10 Ul1J.its, Overheads areto be absorted on mach ille hom rute b.:tSIS lC'x{:cpl d~prec[at ion},

(4} Ml.'[te'r~al cest rt.e_ I per unit and wages at an aVfr~ge of'Rs, 400 pel' hour, (5) The forec~s~ for avera.ge se II Lng price is R3. ~ {I per aalt,

(6} Jacometax Illlly be taken II~ 50~

(7) The roll1p~nl 11.1:0, ~!:I 'standard pay-back period' of 3 years for acceprlng

in vestment [,rnj!:c[s

A:>I:Cr1aiJt the pay-back period dud [;ivt:: your tcconnneuuarion

9,:0

Ini~~l ~lIves[rl'lent Almll<!1 c~~h b~I1.:ow

I~ iti ifl ·iJl\ .. ~slllleLn gh 1."H Anllual e.as:il il1l1{]w (\\'. N'.I.)

ss, l.OO.GOO R:!'.90.(lO(l

". J"lI)'-b~ perri ~tI 90_000

~i'[I'IJllJit!l~df1lrUiJ The project s.hoLlI.r! IlO! be ~Ied bec~ure i~s P-!t)'-b.a,;k.pe:riml 01 1 JJ ~!~ltrS i ~ 1I10.l'O Hum I.he' ~~amlilD!l p8),-bil1;;k. pe1"i~kl, of 1 )'~~t"!:,

~.~. f,'; I: g't1JiIIlICIlI Sfrt1K'.iIl!; ,4jjNlwi.m:sir infl'(I<It!~

,

Aflll~:i! OLltjl'llll ~ 5.000 tLCHU'S at 10 L~li~s ~I!r bmLr ('ml oj fJ.rf1put

)J)I.I.OOO

(Al (I:lJ

O~-A)

~·ul1il~ Rs

50.000 1!..OO_OOO I.oO.()OO 30.1100

3 • .80_UM ~j)OWU

~o-:)O 60.000

5~,OOO"1 $,000" 40 S,ooo" 20

3.00_000 + 1.(1

mlill~f'!I,lmn 3 (i'ilIst [l'!liy-h:;t[k pOl r.1~bility)

I:ivDlu~le Ehe following lWO pmjcc1 ~ an ~}'-I:P~ck peri cd crlrcrion and Oil po~t .po<l)'-back pwli[ahiUty c:riterion:

'SlIIl"".!lper ;..~nUDI profit W~~rc I~'l il-a.~ at .50~

['wIll arUM dCj7l'r,--::i ;JLLOl1 and taK De-PI ecianool

Projec(X R.:,'.

Original. inVeSlmtl;]:I1 Milual cash in no Wi) Ei.;Oflomic li~!; 0 [project

35,cal IS,oon

Rs 1~00J 7.500 j }'caf~

Snllllilm: n) DvafuotiOll fm PtlJ""lmcJc pf!riod crill!l'i()1t.

Origin:!1 ilweruncnt Annual .:a~fl ii'lfl~w

jJ j

mwo

15,GOO = 203 3 YC1US

I II

i

I

15..000

7,500 = '2 years

. ConclUS10II: ProjllCt Y is better than project X because of its lower p:1y-bw:k pe~i'lld.

(2) .Evaluation on pbSl=piiy,bm:-k prt:JjllfJM1iIy ,uiu!I'I'olt

Posl fay-tJ.ack peried Eoollumic life of project - Pay-~k period

Pr()jc:c~ X: 7 year~- 2.33 years =. 4.67 yean

Pwj-ect Y : J years - 2 ye(I!T~ I )'COlf

C~dUSrlJl.l: 0JI i1r&!.hioliill p21y-b~ckpi:.rio.d, basis, pr~jc1l:l Y is ~Iightll' b~~r. H{)wc\'eJr

the.re LS VIIS. difference between the 1"1'0 projc:ct5 illp~t.-p;ty-b:rck period. .

_PrQJ~d X i~ heuer, trkinll pO:St..~a}'-Dru:.k period also ~ criterion for decislou a~ proJects.

Ulu~ratiGu 4 (pI1oject.s witil equal pay-back poCrioo)

Es,h of the [ollowing pmje-,ts requires a cash 'outl1lY of Rs. 10.000 You are rcq~lI'C~ to suggest which project SllOlJld be accepted if the standard pay-back peried IS 5 years,

Ctuh inflows
J Yem- Pj'ojectX Pm/eel f Project Z
&. .R1;: &.
2.5Oll 4,0ill0 1.00{I
2 2,5«) J,1XlO 2,0CKl
3 2,500 2,1)00 3,000
4 ~,500 um 4,000
5 ~.soo {MadrfL~. B.Com., MUTCh 1987; M.Colrl'., Sep. 19851

'X?-i

2

C(J;s/J
rJJjffJI11 C(Jsn in}1r)'U'
Rs Rs. !?s .. Ra Rs ks.
2.500 2,500 4.1)0(1 -l.OOO ],000 1,(1(10
2.S{)O },OOO 1.000 1,[100 UJOO lOOO
2.500 150(1 ;2,000 9,000 3.000 6,000
1,500 10.000 1.000 10,000 4,000 IO.!,'!(IO
2.500 12,500
1 MOO w:ooo 11),000
_-
4 yc=<Il"S ~ years 4 }'e;lU O~lu'j'~'Sil.!l!: \Vhen stilld.tl1(I~iI) .. b~ck period is 5- ~~r:s. IIIl (he three PfOJcods ~T~ e£ill~Ui acceptable undcr b"~ditj0n~1 p'iIY'"llack pertot method.

H"OI~\I~\.C''- when twO or more p'Qjccl~ hs v e Ille same ~1I).-oo.ck. period, the Pf(Jj =«

with higher ioiti al cash i.tti1o~ sllmdd 'I:;.;!, pI'e(err~d •

I'roject Y is hctte:rtll11l'l X and Z ~<lL13e jl has bigh~r';llmulm".~ easn inflow !lIllie

etta 01' c",.;:h (If the Ii rst 3 )'~1lP.;,

:milstr~tioD 5lCllwllUlation IIfcas:ldnfloWIl)

Jaaaki Products Ltd, has two projects under eonsidennion ""hick are mutually.exclu~iw. The eosr of tach o[1herr. j~ Rs. 1.011.001 Both projecis lIla.\'!;:' to be d~preciat¢d on straigln line: basis ilild the tax rule may be &:ak.en as 50'%, Detemllne wbkh p'roll:1c~ is better [In. ~he pay-back ~rj cd criterion:

relIt CMn;,V'···· 4
Project A Project 8'
R.~. ,&,
1 8O,COO 2-OIOCKl
2 6O,ot.XI 4O,0fJ{I
3 40.000 60,000
4 2O.,(I(K) 80,000
5 10,000 ].,00,000
·- PI OJ em . A' ts bencr beruuse (If 1.)\O,..c1 p~~"h,al. peril'J uf.2 . .l) }'c~rs M pmj~cL '[I' with ~1l}""~J.cl; period (II l.2 ye.'~~.

~U:.cI'lllitiv~ meilUli1 or ,]st~ r~~.illing :~,ay-lIl~ck 11~l"io cl

S rflt(lm~llt shllill'.log r~y·b~ ck ~~~riod

1~"~-;;- ~'~ctA ---;';;;'ct iJ

i_Rs IU..

-i----

In i1 i~1 in\r,es!;I1R~ll [,00,000 l.OO.OOll

C:1S.11 liltlo<"," in !:;.! yenr 50.000 20.000

SO!IlIJOIt:

W.N.l

is;.:fIt~1I1CJI:L shon' ill.~ a.D.nll~~. ~~~ b iu.nll'~'s ~f Pt~j~d i\.

-;:::-:::::-- __ .::,1

2 Ii~,

Casl~ inflew befOfC dc'jJJ"C~i~1;Q!l'1II1d 'I::L~

Less: Dep:recj~~[Qn (1.00.00(1 + 5)

oo.noo 20,Otm 6ll,QOO JO,OOO

50.1)00 8.0.000
4>0,000 3D.OfJO
1(1,000 ~(f,O(I<l
W,(lOO
0
40.00[1
---
lO,(..oO
]0.000
-- -
o
B3~5 3.2 }'eHr:·: Net Qlsln J.nJl()ws

1 I~

Ca;;h illllowbeiQu-e depreciatien

---~ -- _ __,__-----'---"=

Ilh,I~[".iltiQn 6 tMe~rl~lil1iflg pr~nt3bilUy Imli.c:lsb Il'In{!<w~)

Al~CTLry Ltd- is c~l~sjd~J~!1g the purchase of a o~...,. machine whi~ll \\OlLld I:~ny OU[ some op;t'rn~ i 01l~ ll~ 1)liC.SCi1l perf()Fl"ncd by matILl31 ] ~tJ{I!.lr, The l we . aH,enl:tti~ rncdels under CoUIl:>i{temhol1 are -D~Illrn::r and 'Shylock'-

The follmv:ingi.nfoLllli'1.1 Lon from ""bicl:i a prof'itabililY ssuement i$ to be prepJTec! fmr sul .... mission IQ ~h.e board or directors is a vu LI:ilil~:

Add Dcpreel ;.rio.~

Sh)'lodr 5,O!U)fl(J l2 30.00a

DmlUel 3.00,000

10 20,(0} 24,(l(XI 14.(1(10 12,.OO(l

C ()sl of iuachine (R.<;,) E&timau;i:I Hfc{ifl yc~r:;)

E~jmatoo S,3.\"in~s~n scrap p.a, tR:;.)

AdditioIl ~1 coot of supe:rvisiml per ilrull.1:m (Rs.) Additlcuul cost ofmaint:enam:e peL' annum (Rs.) Cosr of'l ndirec~ material pel' aneum (Rti,)

32,000 22,OIXl i61)11(J

,C(f j (1rJ/IhrN~'~ Cas

irlj1rfil' c~fh i'rfl~ I' inflml

Ill' J{I'Jl\'

--~~-r----~~~

SQ;

40.000 30.00(1 20,000 HI,OOO

emh (11'014' .its

2(1.0(10 3~.OOO 40.000 50.000 UO.oOO

20,000 50,000 '9(1,000

1,4(1,(1()0 2,0(1,000

Estimoted ,~(1II!iIlgS in 1I'~!~i!'~:

WagC"s pe.r w.o!'ker per ennem (R.!:;,) 1,2.OCD 1,200

\M:;l~~rB nm r~quircd (Number) l.'lO 200

Therate of 1811;1L;on j rlay b.: ~eg~.rded as 50% (I f prall L. Which model call b~

recommended for pUrchllSe'? Give re~~O'I1$ for )" our answer,

IM:l1drlil. M.co~u •• OCJ'. J 969; S{!P' i 91)2; SI!p. 1993 J

:2 J 4 5

Siltution:

SU!.tem en ~ showi,gg promall.trity iill~ pl),-b.!!ck p@dl}[I lJ:f mach. ~f~ .'l/ocMncs

, --
p(lrIIC1l'cr~ l),;mI!i~' Shyl{1Ck
& R.~ ~, &
CoS! of ml11:11ill~ ;'00,001} 5.00.o{H)
E.5limal~ lHi; in yt~r5 10 12
St1~i'/18~ IhrfJ~gh macfJine.~·
Sa.yi.ngs.in scrap 20.00) J(),OOO
Saving,s.i:fil ~ ],2ilG x LSI) 1.110.000 1.20011:200 2.40,0000
Tm~1 S:lVLIl,!1S 2,00,000 2,7~OOO
Less .4ddit'i=! r:OSfS.
SUpelVillID.Il lol,O@O n,OOll
Mai:n'~Dn[J~ ~4,[)OO 22,00(]
rnd ircct ma.terifl!~ 12,00G 16,000
[{ltml ,.ddiHolla] ~-Q~ 50000 -
7(10rl(j
1[lrum~ bdi:N"~ depr~i:atiot\ and lax ,[.50,000 2,O(l,OOi
LUf [).cpr«[~' ion 3,00.000 5,00.000
W JV.O["1I1 12 41.6!!i'
L:W,OOO I.~&'m
Less: riiX at 50'% 60,000 79',161
60,000 7~JC:Ii'
Add· Deprecfal ion JO,Ooo ~Ui67
Amlllai cash [nnDW5 ~ j,f[,~M [lIvestm.e.llJ Pny-D.ack period' AntlLJal

c!!Sh 'n.l'h:!\'!.'5

5,00,00\}

1,2(1,834 .12 ~:m

3.00,000 9Ci.{)OO

C"Qfdciff!ffOm M",d-el '!J.iimscl' 15·~mcndod~~us~ ~f~t!; i[l\ver pay-had: ~riod CI.f .1.3) y~~ oom~ 10 IOOOO[ 'Slr)olmJ{' wf.lo~ paY"bad: perioo is h[gher at 4.12~.

(2) ACCOUNTING RA.TE OF IRI!:TU-RN M['fHOD(OR) AVERAGE RATE or RETIl.lIRN METHOD{Af{R}

Ulllstf!li!10fl 7

A c~rnp<UlJ b cons[dering1nve~nmeJ]l or Rs. 10,00,000 III a pmjec t, Th,e

fuiLo-wlllg ars th.!!:: moom~ forecasts, <lfl:er depreciation and tax;

~ st year 1= Rs. 1,00,000 4til year profll Rs.2,oo.ooa

2nd year profit R.~. 3,00.,000 5th ~ar pHlim Rs. 2,00,000

.ltd yeill" protil, Rs.4,OO.,Om.J'

Calcalate ~.~ llC1:oUll'lting rete of return {1I) on Qri.ginaJ mvestment meHIOd' (b) 0:11 lI",erage invesrment method

.. "

,\ Ilnu~ I ,H ~ril.l!l': il~l ~~rllir\ll;:; ,;1 O~)

:l1li OliginfIJ~ i 11 Y~:»lTIcn1

An:n11~1 ;n ernr~ net camii\,llS Ori£,ill~] i n" ~~ti1lC11t ~iw[1

• J.i:s ~.OtH~OO ~WN_J) Rs. H),OO,OOO

2,00,001) .. 100 _

'" 10,00,000)<· 20%

AR.R-

A"'~r.tg.c 811lUlilnel enrn in[!..S aft~r der-retiatLon and tB:( silent I rI be w.kl::fJ i 0 AR~ 1ll~1.'lOd Sinc~ Iheearnil'lgs gh~i1 arealile.r der~L~lh,m and l~'!.II(} ~dJLlstml:'nt I~

l1~edcd.

(b) CtIlcu{ull(lfj of Acro~lllJng raM 1J/"i:lUHf oni"A~efilC~ fnN!SlmtNll m.~1I0(}

AIlf]Il~IAVCW!l~ D.t:~ dIIIIings x 100

A ~!:ruge "il'!Y!!~lmi:nt

A..R·R.

Ori~in~1 S",f1IP Additi(lnal

in~'1:strn~nt - va~u~ ·Scrap

.. net \'lurking + Y~I!J.(:

.2 tapil~l

Aumml ~~er"t~ ~t eaming~ .. R:;.. 2.00.000 (W.N. I)

IO,Orl.OOIJ - (I 0 " I)

.. ~ +" = j{~. 5_00.~JlJ

1

. A.R.R

fr~.r'I)~ ,UJ,fn::

l'll_N.l.: A."cmg~ mlilll:al ~ ~I eamll'lg£

E.ami.ng;; of.th~ ~·ca..!! ~

-\,OQ 1)00.;.. J .{lIJ,DOO .~ 4,00,000 + 2,00,000 + ~

:- S

[0,00,00(1 5

= R~. 2,00.00[1

lllustrati C)ll.lil

J ane and Coo. proposes 10 take up 3 P!'L"lj~ct which needs an in¥estmtlll of R~_ 2.40 .0000_ The tie! inoom.z befon: depreclat i Oil ,u1{11ax ls e5hrn~tNI as fo llows

for the cnsu ins 5 yellr5.

bJ{;.'OJnL· Rf, 6(},000

:2

72.000 ,~.{J{XI

4 %.000

, 5~.2(~OOO

income tax rate may,lm assumed as 50~ al'l!d d ".'

maig.iu lillt ba.~is, . . ~p~cmtlOlII]s 10 he pm"jdedo~

COlJookrle ttle lIccounling ,rare Of"~(um.

SolILlUun:

"

J

A,t:c:tmfittl!l! ,me of r:~Uffl' (lUll)

A!'1Jll1a1 ,~v.et1!gc ,M! eltmin~g;5

Origjnal iJW~:>1lr]lO:lli x l 00

(a)

(OT,

I. "l-" ,

(b)

OrjgM1~1

r n vcstrneru

.... 'fl(O!: Fornmla "b' ts rnnrc ~,id~jy 1Jse;j.

j~' A.nnnal,~vt'rog..: ri:L"oi I!arJlings Ie ,R~. 'Q,Jfm l \,VN 2}

On1!fn~J .I rm;~tlll..:-ni = R,;. 2,.Jj),O()1}

19.2oo

:tii1;:ooJ x WO = g'~ ~

.. AR R.

2.40.1)00-0

: 2 +0i Il

'= J,20,000

i9JOD

= 1.20..000 j( i 00 = Ui%

.'. A.RJt

tIl, r I ~

!lD'iI .. ~lli.:: Ijota; C9%Li I'at'un Cor rl~,c,U me' ~fk [. ~ll.~prrdj[ltfin Jlnd ±~~

6,001)+ 12,000 + U!lootl+ 24,000+ 36..000 5

~ani:m LId., is cOrJ;s,ideriing expanskm of us produc~ r(m fucjl ullc;s,. ]t has (AlHect"d, dct.llils about two models ora rllllqjlinc.Mode] 'N costs R~. 5,4f1,aOO ~Ild 11M an eeonomic Ii fe of6 years Yohere as mooel • B' <costs R~. lAO,OOa 3TId has a life on years.

The forlowing are tile estimates Qfs.a[~ and costs per year.

Mac/lblfi!A

R1>,

Mur:hll1e B

R£.

Costs'

4O,(M 8.O,OOn 50,00;,

2.S{I,.ooo 2,5{I.OQO

Depree i.lllioo is 10 00 charged on stragghl~mJ.: basis, T ax rute may be taken ar J(j'I}'c

Calculare the a~~rage rare of return en the basls of orlgii1al lrwesrment for beth mach lnes, \'I,lhich machine do you recommend?

So~'utill'[l~

M~tCfials Labour

4QtOO 20,00) !iO,OOO

Ovemea.r:!~ (excluding depl'eeiarlrm) Sa~~s

Machine t\ ;

QJ6. Marmgemrllt AccOUmi

'C.(jjjcl'u.5i~ 0 ~ Mild~ille 'Er wh [.c:h ~i ~es ){I% return en i~ "~~1IllCHl is fir ~

machine 'A'\1!ltoso return is Gnly u,<! B%, er II'I..an

Mll~lIin~ B is recemmended because of il'~ high~ !:dum !l:nd rO'w~r In'M ,"_

• '~~"JJel]~

Wo#;rr~ J!o.t~'

St~1i1tfU ~I'tD'Wliig mmpllJf3~1'it'~ WDru~' or m ~thlll~~,

Illjljil:JillV~Cllt

h(:}"~ti1iC I!f~Qrm~cbirte Ann!!~1 sales

Le5S: M'Diteria]s Lalxllli OC\'erheBds

MO,~m 6-~

40,000 8{l,()(I(I

~, 1 O,{IOI1 ~(),OOO

~,4o.000

~ 1,40,000 ,

40,000 20,flOO 50,OIl!)

2,5(1,1/00

50,000 15,000

3S,OOO

1,1Q,00!!!

---

80,000

~

42,000

5,;W,OOO 6

Uh:l~~nllimJl 10

Vighnesh Ltd, fu rnishes the foUowing details abeut Ihe t:x bting machine being used fur preductlon and the proposed new machine,

Eh')f)k value

OrigillJI cosl Estimated !ife inyears

Existing machine Rs.2,00,000

New machine

Rs. :l ,00,000

10

Rl;, 3,67,500

Eslmmted CDS[ of output 1'1,.<1, lb . .2,5{lJlOO

(iJlc!ud ~g deprec i~tion)

Tax!'iilte 50"..11

Estil'llBl:ed sales va !ue p_a.. ]ts, 3,00.000

YQU are 'e\j;i.lired to ascel:1aan for botlllihe !llll.c.l'1ines

(a) AocOUIJIJI'ung rate of rerum on ori,ginalinves,tmenl (h) Aocoul1ti.rI.g rate o:f return OIl lIvr.ltage in\o\~strllem

(c) rnC1tll:lel'lt;l1, rate of eO!rning~ on incremental investment..

Rl;, 4,:50,000

9,.37

l' ru rifflbllUy ~ll'~eml:'J:iJ ,~{ m ~chin~,!; £~~ing Rs

1,61.500 &2.S00 41,250

41,250

N~~t' nrachfPU!' l/,f

J,ml,OOO 2,50.000

:'ill.(!OO 25,000

25.,000

YI3II1~'P'~-

Co~[ d 9ales p .. a. (LndLI,ding d.c=p.reci ~H~l'I)

r:at~ [}f·lli:l.ll!lt OJ] t\Ilin,tl81 ~v~riige ll.~l e(lrJlings x 100 Ori!lill~~im·~s.lm.clll

~1(WO 2,01::1,000

4l,250 )1'100' 1& l},75% ,WO,OOO

1.2.5%

(Ill ""cDun1 i Ilg rare IJI return (I'll ~V(."11J!!.c ~n"estmeJl':

Alllllrul :l".crll$~ a~ ~ikng.~ )< 100 A ~'~r'l~ inY~l1Ll~ll!

Original i[l\'~~'ment

:2

(c) Incr~ntent~ me' of earnings om: im:rcl'illmt~~ in\ll!l:S(l!1IL.dllt:. .,

IJlo;)j'ell1~!11:al earnilll!];!i B~I1I!ings ~[l1ew il'l"dlilMl - Th!rnLns:o {If (ll~ 11I~elU11~ 41.2S.O- - 25.(1,00 as. Hi,250

Iru:;re:lllen\~l iL'lW$tm.Hlt • ("'0';>1 ~fil~"'" lll~cnin ~ Book v8111~ @f L!;(isti~l,! mach lne = J_OO,oon 2.00,000 ~ Rs, 1.01),000

Note,' 1[ is :J,.l;~ml\~ ttl ut eKisli.llg lllaehill~ f~a~ises i~ boo~ V~hl.e in ease H l~ ~Ill~ccd.

O!~ginai cos L

"I

Esrill1.Ql!!:d rife in yenrs

5" r~.2o,OOO 40.000 4m1

X

Rs. 60;000 81Ji,00ll IJlJ;JlOO

tR.Q,P,OO

E;;';pecl!Cd so1J\l.ll_g8 "{alull!

Adcit[icnJaJ workil1i!l. cspi~~ i needed OJ11 ,~,:YeJage lac ome llil'l r;H~

E:;;tim~too !Ilcomell bt:fore depl1ecL8 tion and lax:

1 sl year 2nd Ye.";iJ' 3rdycrrr 4th year

,)

t\t;cot[lllnng ml~ (.IfrcmrJ1 l"lJll!\'\!r~g~ in\'~~1:m~n

A ~·!;"r;.I!l~ Ilnll ~J !let ~~rll in~

::q - ~- I :-: JOO ,., \I\."'1"J.\l~ II'lV~S!J1li!:n L

o'r~grllnl _ Sellip

r n ~·~.:;lnJcnt value II d.lJilicmaJ

- + n~11) .. ~rldn8

~Jli.81 -

.:.l,(lO'IO(I- 2H.orKl

-~-..;_.- +40,Ollll:l+ 20.Ov,1

~ Rs, 1 ,50.000 V10,OOO - 40 {I.OO

Z --' - + ]O.rllIO j- 4n,O{l~

!il.s. 1,50,IlOtl

JS,400

= ~)(100 '-"1/.

I ;V.OOl ~ .. )_o' ••

rr~I~G: CnlcultliJbR o.f jji .... J':"t1E~ llimiml ruN /!:/i,flllfJg:.· ..

~:1J[flip&S b~fur,e d~Jlrccllltioo mull !~X I!r'c II'IIlire' IJ]ili'llt~c ~mOLln! of de;pl'CcilLLfun y~J; !M fomnwiillg Ii"I'Clhnd can he ~JnptC"lV i!f'.CI.:rt~i n ~1lO":\i'J;: annual' nd ~~rmrlj.!:s

Ma'l:JI[ll~ 1ls.2,OQ,~ S ~ 3O,-M!I

6iJ,OOCH ®f,,cKlO + 1,00,000 + 1,2n',OQO + 1,400,000 ~

( 2 .• 00,000 - 20.000)

,pl:pfJXlatioo p~r illUIum 5 .

y ; A\IIimIg~ linl':llla~ eammgs b~fu~e deprecillHoo and. tali:

I,1lCt,OO(J ". ~.Q;QOO' + l ,(;(1,000 + 40,000 + 1,80,00(1 5

(2.00,000- <w,OOOJ

Depn:Cj~1 ilm PCI'.iliMlliJll - 5

~, j~I,' _" ~t ,

[{s,

J6,OOO - 64.000 2~,6(1Qi

38,4(Nl

gl},OOO 31,00(1

,'II,U()i'

AIl rndu9tdlili~[ is oftered two Qllli!1·mIOr investment with Ihe foHowiilg cash m~ deeision criterion Is a pay-Il<ld{ pef[od on years. Option A Rs.

j nvesuneut req Llircd Ann.'Uill cash f1ows~ V~r ~

Yenr2

Year 3

YeN 4

AdvLce Ihe incli;lstti.lli se

(a.) U~C pay-back method

(lI) Return Oil investmeut 111e[J 100

MOO

4,@ 3,(101} Z.oofl' 2:GIOO

Oprior B Its.

2.5f1(l 2,500 2,500 2500

9.40

(3) mWOlimED CA.S._H rtow MlF.THODS

, ...... ~~1r'H 11.'."'"'' prfsttll value radVr.'l

SiillI.lltw.m

(ti) i':!l1"'liac.k pe,i.od methed

Stl"lle'DlUII silowillg c!!rn'~ I~·~v,,~ ~R~h ilnlluw~

llii'id p~rI6i:1 of iii\'~Hmellt opti~JU

I :2 J 4

I
(1+. ~}s • '" 1),621
l.olt1:S I
~ i+. ~Z}! = fl7'H
1.1544 n ... ";u .. '" LJ

pNs~nt vmlucfacwr.: at Hl% P"i'l,[o:r a pe~ loti of j years.

CO-$Ii CwmrJabiiJi!
r'!flrr,l! caslrinjlo'.l! itif!lJw
R£. Rs. lb.
4,000 4,000 2.500
),00fl 1,000' 2.,:500
2,0CHl 9,00(1 2,500
2,000 IUiOO 2,~OO II .. Nil of year-;

.. 1),909

8,000

" . 1,000 ..

.. ~+ -- 1f,e~ts

2,~O

I (1+.11

Ul

COiidiBlon: BMI'I prujeet~ are wi!httlJ tl'te decision criterion of J ~3rs P<L~' Both opti@rt!i can be M.c=.n up j f Ih~ ate not mlJ:[Uaily .c~~l usive. If the options are mlltl.l~Uy exe lusive, optioo A i~ better D-=USC of low!!1 ~~l·biid

period of 2, 5 yt"alS Q(lmplrrcti W pmp>OSR! [lv.·[th 2.,S y~ru'S [If pay-b~d; period,

NoIt~ ,Iii t!te !l~~~e of details U'te cas!1. .1l0 .... ~ are ~:s.sun1cd ~5l!Jtltf t:t~. befell e d~r~~I;i~

(h) [tP.lUM 1m ifl W!!£tpI£Mi rlI~/wd .

Nole:

In Ihc absence of d~ails abeui dq:;rl,!ld8~il;l'n. iax, :ocmp "..~II!l~. ~.~ .• It is ~s.surn-.d ~~l 1M QL~. HIll'W!> gi~'~n are aURUm net eamlugs ~r depreciation and laX

Annual A 1i"rnge Dt t CII11lin.f,.." ~ 10rl origimu investmsm

:. Reram on i[l~mc.nt

.. 0,7~1

I 1,4MI

R.5&,00CI

'WOO + 3.000 + 2,000+ 2.OC1Jl

4 = R.~, 2.0 1~~

In prob lem~\';nc~~ the P.V. f~c[(lr i 5 Il~l given, ~t csn be calculated f()~ rLny ral~ f~r an~ 1i&a\f14llmOI;r. of y~~1"$ w:i1Jl Ih~ llC1Jl oHhc 300.'C m.dl!(K1

N(l'l PFe-S!Ii.'Dt value method (t"iIT'i'')1

IIlustm,H'ol! 14

,A ·projee1: ~qulil'\'is Inve;bl'ICll! of Rs, 1.00,000 inil ~~HY. [t is eMinmLed to prolo'id\.:

1 nei tas.b innow~ oUts. 40.000 f{l~ a pcnod on years.

The QUllIp::my's COSl of c:ii.pit~~ is 10%, . .

.A5'!:~rt:.'li!ltne !let lJrf;.SCm \lallll: of the project. R(:ference to afll1l1ll), IllbJf,;

uoo~ present ~~lllIe ofRe.1 for 8 ye~r.;~.t 10% p.~., interest ls Rs. 5.335,

2,7~O x HID

8,000 .

~ h 7,000

2,:500 + 2.500 + 2,500 ... 2,500

- 4 1ts,2,500

34.31%

2.500

- 7.000 jot 100 ~ 35. r 1%

C(![J1cJ~Qlliom Optittn 'W is bener 'bee:llkS~ of higher ~<!nlrn lJif J 5. 7 ~ % ,tornp;:tcd !O oplion 'N WLth lewer r~l.um at 34,37%.

NOIe: RdYrll an iliy.c~ImMt illtl)1l ~J~D b~ CORljlUled OIl av~mse i!'l .... s.~I .... ent,

. ~i •. ~

5 H5

~ ItS . .., 0.01)1)

,

Nf)(i!: rile above mc[!ioo C~11 be- applled \\'hen ,~n'!lulli ~as~ jJlf"lo,'iII's 9rc e:l;pec,ted !(I twc sru i toun for i11r years.

Illustrntton ]:)

All inVes,tmellll Q[Rs. W,OOO (!laving scrop vallie afRs. SaO) yields rile f(lJ]Q~ returns:

Years Yields

Rs.

] 4,000

2 4,000,

,3 3,O:XI

4 3,0(~)

5 2',0iJ0

rr,c C'(}s;L of cafli~j is [OO/<l. t S the in vestment desirilbk? [)i.s.cus~ it aCl;ordill,g 10 net present value method assuming rhe p, \", factors for Ist, 2nd, J~d, 4fh and 5lh years- ,9[}9 .. 82,6.,75 t. .683, .62 i n:;spe-criveJy,

fM(uJf'(I._~,lJ.C(Jm., S~p. 1988/

Solll1ion:

. .. I ~

2 3

"' :)

4.000 .. ~ 4,omJ .1,000 3.0(l() 2,500

,(incL~ding :scrll,~ ~·fillJe) Prc.~e.l'1t value 0 r fwm:c cash im flows

Less: Initjal [lWC:>1.JJ1~I;IL

({or) presenr value of ('1Isl1 omll.ows) Net present v~luc =

.9W ,1l2.6 .151 J1J13 .621

.3.6J41 3.304 2.253 2,(149 1.552

12,794 ro,I)()O R,s,2-794

C~I'i.~lu~j,on: 1'b~ lnvesuuenr Is Lk'~rrllble because D r [W.l~iI i~ net present value of Rs;. 2.794 onthe iln-eslmem MRs, 10.000.

IIt(Jft!: Scrap value has to be lidded to Ihe cas!! larlow cfthe last year [If [he mvestment,

projects M and N which are mutually exclusive are heing under .;gj(:loolnon. Both ofthmn require en investmeat of Rs. ! ,00,0-00 each The net

inflows are estimated as Illntic.r: _

Year M N

Rs. Rs..

10,,000 30,(100

2 4OjOCJO 50.000

3 30,000 80.001

4 00,000 4U,OOO

s OO,OOf.)' oo,Ol)i;i'

The compaIlY'S: targeted rate of'retum on iirJveSl:me~ is ! :%. 'You lire rct~uired , the projects on tile basis of their present values, usmg ( I) NPV method "''1J~.'lIIrLoU· (2) Profitability dnd,eK. method.

present va.luts of Re. I ar l 2% mrere5t for five years are given below:

ISlye1!lf: 0,893; 2nd year: 0.797; Jrd year: 0 112; 4th year; 0..636; 5fuycaf; n"567.

sm~tilln;

-
!'.VDfR~.l l'~()j.ect .. If Pto..lf.l:tl,1
j;ftaf ar JZ'Up,a. C.7~k Presen! Ca.;.h Pre .. '''l
i"j!(}W,~ value trijim"s value
J ] .1 4(2.: 3) 5 6(2;0; .S)
!U. N., Rs. RJ
I 0.89.3 IO.OO() 8.930 30.00(1 2{.,7OO
2 0,797 'W,DI10 3USO 50,VOO 39.8:50
1 '0.112 JOA)O(l 21,360 IW,OOO 56,~}60
4 1].6.3& (.0,00(1 311.l60 40,000 25.440
5 0.567 90.000 S [,(]J'O &0.000 34,O2~
-- .----
Presern vnl Lie ['J r c,;l~h inflmvs 1,51,360 l,83,()(YO PrQje>':! .\oi R~. 1.51.360 1.00,00(1

Project N R,s, 1,83,0(;0 1.00.000

8J,06()

Pfisem value of cash inll{l\','S {ASS: lnitial in\~-st~l~~'

Nei present value '

---.

Rs "l,J(,O

l).~4 M~:n~ge'me-Ilt ACC!ll.lI.fIHIl~

i r(}\\,,=~·cl·.sr~~ they are 'mutu~liy mJu~jl'~, j:IJQjeCl :N' should M'~a~~r1~

of U5 hJgller NPV of Rs, ,n,Clc60 Ctllfi'rparcdto HIm (I.fIJ'TOJcct M Rs. 51,36[1. Y:~

f2) f'rojilufliti.ry ilftkx fmlJjlJd (p l)

eon(.I'~.si.on:' Both pmjoct:; iIJ'~aocepUibk; si~ 'nh-e .p.r, is J1lo.~e .han. l ,

However,. ~iJj('.t:: me}' are .nl.l.!~II!y exclusive, 'pr1)jm 'N' wii!h higbee- r:L of l8lratii s.il(iI!JJf..cl bC'~n up aro.tl rroj~t "!lot' witl'l liJwcr j',I. of. 1.5 {36, may bc. rej~.

fD) Iaternel .Rate ,~r .Return nlil~~tJt!)d (mR)

IU'usU·<1itiun ~"

A. PI'OJect costs Rs. 80,000 and is estimated (.0 generate cash iofi.ow of Rs, 20:QOO fora per,1t;Jd!oif5}'Glml. Ascertam tJ.'lt: irlh::!"Jui rat.eofrelU1Il (]RR). S'-o]IlMn~

Wilen e~ti.m"'tQd. 'c~ i.nfl(lW~ ~f ~~rojec[ ace ufl~furm, Ul:.R. can !J,e c..!I.IG!!!ai.Id by locating fuctllr in .A:IlI:l!l~!y T~Jjle 11

. I

factor to be tocated = F = C

Peesent value of cash infl.o,w5 PCC5"alt value (~f eash oumO\!o'S (i~j~ ial inve.slmetH)

,Proj'l.'Ct M Rs, 1,51.360

1.00,000 l51JOO ~,(Io,OOO

cUIJ6

Proj~N R~ l.,&3.060

LQo,oo() ULl,r.NSO

~.

UQ06

F • f~cm~ to be JOGllted = Orig:iJ1al In¥ClItrn.r:m C D C!i:;1i flC!w per year

, f'~ 80,000= 4

2~MmO

hclor ell' 4 s:lioulcl be located iii !Iilr:tuily rn:bJe U in [h~ lnne on ye~ Ute db~mmtiil,g percenl'lll!!C LS SC!\Il1e w!te.re ~S% and 6%

R~. J.Si'9] presem vatu'll of aJlflULly {I'{ Re. I. Is ,So/i,.

Rs .•. .2i' 2: present val ue ~'hnn.l,d.y oUte. ! l~ 6%

Sinec ].993 Is \'~I}' near ro (-....._

LR.R. m,Ll' 00 taken as; 8%.

Ne:dam & Co." is eonslderlng ,1 project .... 1ltch requires irlvestmet"iI of ! ,50,000, Th.ecosA (If capital is 12%. The oe[ es~umt1~c<l:;h inflows a!"<': as fellows:

~ .-----~,-~--~~~~~--,-

fear Mrimafed casts i!ljlO"liJS

R,f.

IIO,OOJ
.2 5O.,OCO
3 50,000.
4 4fJ'{!OD
5 3(m)l) Cakul!l.te the itU.e.m.a~rate· of rerum and decide wh.~[hcr the proj:~[ 'Cian be up for impl ementation,

, ' gin.c~ ~~. tlDWS given Me !.lot Ulliform. (he [,EtR sliould be !A1I(;~I&ed D)' tIk 16 y! lfta e.rr.u~ riWtbQd.-H!lJw.~v*r.tO' gm M .:'I"jJpr(i;,;lmat~ idea abourme I.R.R, rate.

Where

= Clrigin 1llll'l·e~~meD.1

c A~g~ cash inflow per year

of(l.O;)O .... 50.000 ~ :'l (lJIDO + 40,000 + 3{1.0()(l

.A"BJ1Ij!J~ C$l.l lnfklw p~r year 5

Rs.42.oo0

. . - 1.,50,OOi) _ -a -71 .. f ------ - J,)

42,000 '.

l..oC:filiilg filctur J..5'1' 1 ill ruUl.Lijzy taNt, II In the line fur.5 }'C<m. J: . .fim j epresents 12~ and 3/H3 ~roij3GI!I[S 14%, Thesetwo ~'re ~he ne~r~1 r[lte~ fur facro~ J 571. SQ. l.R.R, - , ~rust be oomew.hcrc betw~~m. lhese twn J13k~.

E"~~ct ~:alC\!h!~ioll 0fI.R.R, r~q,llirGS tn,M pue.sCllt values :>lJ{mM Doe found, ~llig these ~mte.s 3 di~!JJ"]ti.ll:!lr:tlk<:!:. Reftn::o.c:e!u P.V. rBb[~~ ~mv[dc !hc f()IIowil'lg

Ui:l;wunril!'g f:act(l'.rs:

3"dYf!r1r .fIJq~Qr 5-t}j'yeo.p
.712 .06J.ci .5fJ"]
.675 ,59".2 ,519 ]2% .893 .197

14% .S17 _169

'"

S~;Ue'm~lll .~hl)win;g pre.ll!lM l'lIll1eS of ptuj@"l:;t

Yea,. 'ash i;iflow D .. E at 11% PV.oU2% D. F. at 14% pv. as N%
Rj R.~ R_~
J 4(1,000 0.&93 35.710 o.&n 3).08.0
l 30.000 0.797 39,&50 11769 38,4:50
3 :)0,000 0712 35,600 0.615 33,750
~ 40,000 0,(;36 25.440 0.592 23,6&1)
S 30,000 0.561 17,010 0.519 lS,5'i'lJ
1,53,620 !.4{1,:5)0
Inilial imoesonell l.50"OOO J .50,000
N ej present Vlli u 3,620 ----=u76 N.P. V, II;t 12% .

I R R = 12% -+ . x 0, fferenec in rnte

,. N.P, V, at 12% - N.P. V. a1 1111% . . <

3,620

= 12%+ ;.;:2

3.62·0+ 3.470

'''Me: SineeN1?V at 14% i,.; II negati'iicfigu:rc. it ts add,:"IOl1O NPV D112% Le., 3,030'+ 3,47(1 If it is 8 pasiti ve fiflu~., il. :mm.ddl be subjractcd,

(E) Di$coulited pay-back m:dhod

[IIu:!ltra~j 0 n 19

Calculate discounted pay-hack period from the details given below.

~(p5-'r 0 r project Rs. 6,00, [lOO; Life of the project:) years; An nual cash in f!,)\,

R~. 1,00.000; Cut o,~ff..;..· T"",il_te--,,-I ~=-':..:"'~c.... _. ...,

r ... ar . f)is(:or.mling faClOf'

.909

2 J

., ..

.826

.751 I

.68., i

~5_-,- __ ----,,:::::621 __ ....",.-.,-1

,,'\-Iatka.f, M:Com., {ICE) May 19941

I

Cm"r Ul./lDIIlS Disc()1Jmi,~~ Presestvalu»
Fat;lm" at JO%p.[j. of 'cash m17QLl'S
1 s 4{2:d)
/t.\'. FI:.~
1,00.000 0.9\()9 LSUWO
1.00.000 O.8~6 I.M,~O()
2,O~OOO 1J.7~ I LjO.2C1U
2.00,0(11) o W!J Uil.600
1J)(J,(M1(J 0.6'1 1',1~,200 J J

5

9.47

2

C,1In1"Jati'Ve cas!' lI!f"J1I &

(.'~inftDlI' &.

LBL800 3,41,(1'00 4.97,200 6.3J.,ROO 7.5&,O()O

1.81.1100 1,65,200 [,50,200 1.36,000 1,24,201l

J 4 5

6,00.000

102800

3 vears + --.- vears = 3 7~ ~'Q3r~

'" 13MOO • . ~ ,. c

Dlu.straUp!I. 20:

/!rWlil Ltd. ~s considering the purchase of a new rn achine which wi1l cany out some operarioas ptrfmm~d, by labour. A and B are nJlelfl~~ive models Frolll the followil1g inf(lnua' ion, you arc required to prep:m: 11 PIO fitabi lity statement, and work-OLJuhe Fay-bad period, present values. net present value and profitd1:>ilil)

irIdE']c

Machim: A J MJ,_l!!!l(' B

hstimllttd lite, (years) 6

Co.s<t ofmac 11 lne (Rs.) 1.50.CiO.l

Co-sr nf'indlrcct materials (Rs.) 6,000

E~tilbr{'d savillg in scrap (R.s.J lltOOO

Additional ~VS[ LJ f maintenance (Rs.) 19.001

l,5o.C(IQ &00:) 15,000 2i',OOD

lis{imGlfd ~'(H'ilfg f~t w~;rC!S

Err!)}1 oyecs not required (number) 1 50 ~))U

'i'-':lges per i.:lllployee (Rs.} 600 bOO

A:S5ume tax rate At 5(l% and cost of c;apita~ 10%. ''Which model would ycu recommend?

IM(Jdras, M.Com... April1987J

SrJI!;!il'ioll : ru

M anagernent AC~Ollming

tfa('Mri~ A UI1('hill<' ~ -

--~ I---

~_-:- __ ~ -+_&_. _. _","-_.R:..~ _+-~R;=' _ _j Jb-

Coli! DfIlmcl:ti.llc ~ ,jo,OOO 2,so.OOIl

ESlimaled hfe , ,~ Ii y~s

E:r/'~lI!11ed ,fff'o';ngs:

In ~rnp

InwBg~s

TCital 5n"II1,~

u~~ /jdditimra/OO3ls: hldj~G~ ma:le.r.i.alis, MajJ]lClll!IlJ:c'

H},OOO lS,OOO
15111<600 OO,O()fl 200" CloOO ~,2(1,OOU
I,®(I,O(]JQI 1.35.000
6,000 11,.000
19,000 25.,000 27,0(110 J 5,(Il00
1:5,000' ~ ,O[l_OOiJ
1,~O,O~U .2,50,000
j l.Q,QOO 6 .i.i.&:!.Z
45,000 ss.m
22,500 29.167
- - --
22,SOO 29,H:i1
JO,()OO 41,6{,7
52,.500 7O,8J 1 l~ilj:L1 [n".~st.ill~nt A rmual c~:;~h ln [low

Mru:hilllt A

1050,000 ,UOO

Co'ne ~us,~on:

M~'h i ne • A' ,is b~r~lI5C'; of l,mw~r pay-llack peri od of ;L~6 ya.rs ~1,m1p:art.:tl Lu I.b~l I)'f maehlnc '0.' of.3 .. B y~.~

[l] ('"lndrItlQ[~ ojpf'tWnl wd{,j~-~

Srll~!ll~nt sh,o'willl!: I'l rts:ellt V3J ~ es

- ~ L ----r-
~ h1L'lrrm' 1 I rac/IIIII' R
- r=~-' ---+- ~ ;.,:.._
lear /)j.'1(;mmJ/llt;J(JCiOr'S Cw;h "'N.'~·~rlt ('a.l'Jj "I"L'W~'rr
rrl IfI%p.tJ_ mjlow l'ull'~'~ mfln' .... 11(r~rr~.I'
t{~ R.7 Rs fh
, 9~ SHOO 47.n2 7O,IIH , 0·1,38.11
I
~ ,826 51,500 43J~S 70,.1134 ~&,501:i
j .751 52,500 19,42S 70,834 H,!%
4 .6111 '2,500 H.Sjl 7ll,.HI 11\)!I{]
:s .621 52.5[10 3'2.rm 7o.s34 ~'.911~
.:\ _564 - - 70,SJ~ 39,95(1
--- _ .. _-
Pr~l'l1t wlu.d {If cash inflaows 1,9A,975 },OOI,~ i 1 N(Jie': DJsC'o.1,lOLlilg fact{l'T"l; ilt HflO p.il. ere {jb~~in«l froll1lile prescnl "9Iu~ taM!:~. The)' I.

can niSI) be c~kul~te-d by U~ii\~Um r(lrTmd~ ~

(41 Ni!llUl"dltnllM[lm!J

M~cnill~ A.

Rs

lJ~~1 \·.tI~~ otcash Lnntm'~ 1,<):s...'.l7~

(~U J~~st:lll ... aiul: cf tiL~h (lutnuw~ (i'W~~Lm~Lln 1,50,orHi

M~~lliJ1~ ~ [( ;

H~8,4L 1 z.sD,()t10

58,411

Con~ 11I5ioll:

M~~1Ii1l(: 'A,' i~ bc:tl~r ~ausc fir rrull1'rLhlll~l~l~ IIj~l!r N I] v., ~(Olj1P~mcl L{l tt\(

ill~~~illlent. (Tllis can be tI~m{jm;'IT;u1.ed bencr ~ILcla rM: ~.I. method)

(SJ i'rofil.fj~IUt}! /lltle.f

1'. V. [ljf c:ru;b Inn4l\\'s I]. V. of eash mil n~~\'! s

p, V. ef C~~ i~flollolS

P. V. of ciiSh o1!Ul1tml!l {lD.V-~-5I;l11entl

MadlillC A ~ ,911,975 I.SO,Il(DO

M~chille [l 3,Ql!,41l 2.50.000

.'. P.I.l:lfm~cbln~ A =

1.s18,~75 1,50,000

M&,4~ I;

= l.2JJ6 2,5'0,000

Con ~tlf~iOIl: MiLthioe • A' is better bl!:!;;IWSJ,l oflh~ hi ~lIer protll.8bili.~' ir~I~\ of ~,3165, ~mP"lrnd to Ihllt IJF machine 'G' of [.HJ6

I

I, '"'iI' .. ' .'_ ._Q __ ~_[) ~ ~ M_a~n_a.:=_g,-e_m~nt Acc(1un!ihg

~ Tile€! ry Q u.csHmlls

I

(A) $lIoN rillM1Wo!!'T Qu~.dWm

L Wb~[ i~ 'C~pi!ill BlIdJ!t'Lmg'?

3, Wh aL i s 'e:Il!lit~1 ElqICndjlmc"1'

4. WIHlt is !he imJlor!an~~ ()rC~pil;1] nlJ!:lg~liJllg7

5 f:.'!:pl~iI11l1~ IITU;l;In!Il.S ~f' f'~X·b~ck· p~riOO. 6 WhaL ls Accoumjllg mil: of rc:lurnl

1. VllJal. dlJ ~111 lIQt!I~rSt:.!nd 'by 'NetPrI;5~n~ V~hm'?

1l: \Vh;u is ~~ces5;~rlt ".alu~ Index or prof:it8~nily J 11(I~x? q E::tlll~in'~ iscountedPay .. llacIC.

J 0 B~In.g oul the ~ i~ni[,cm~.vcof 'Ctllsh"Fao~,v.~:' . II E~ r I~I[L' 'VIlf)'ing discount r-.ll<!:';',

12. Rrjdl~' describe 'a=r1.JtinLy E:quh'81~nl method". 13, lkscr1~~' s ~"si[i"'ily Arm]ysis-

1 ~ WnOit i~ dec,) on he..:: 1\ n~ ii:;_i<~

l 5 ~""h M ls ·C~pjtlll RaHcm i 11;!; '';I

(tIJ L.Jj{{! A nswe« {"lfit'SrlO1iS :

, Wll'l' i~ (~pj,~ 113 ud~di[I,{' \VII~L arc Lt~ obj~"li, .~~

. 2. Wha[ is Capital [~~T.dlm:~ Butl(ll.'1'? How ;~ 11 prt"r.lr~d·.j l V r~~LI UfJ you umkr~l~ nd b .... "C~pi ~~I B\ildg~liJl& PrLI~~~~' ~

l'IHllT]cr:o[~ the I'T'.:lJ<Jf steps m: .. (}lv~d [f] Capieal Dud£~.iilg

/,'daurtu, .1 j~1,C~m.. (ICF) lkr.. 20(W 4 ,. "pin ill ~h~ rJl~r~~1 51~gC5 ir)\'ohd in the - invcstme Il! appraisal process'. f,1jfd!'.Js e . 1 M£(N,,,, 0<1 •. 1001j S V"'h~LI 8r~ "h~ f11J::!(l!1; I~'hicll lnflucnce eepiral expenditure declsions?

6 Dcl'ini: ·C~pit~11:J udgetin,g·, Wh~1 is ntsimfOOriallre? Wh~[ are the d i rr~relll methods 01 cUJlil~~1 [l;udgetiflg !!,PPf8i5ilJ1

Ij~/{J:dms.lJ>Com. AprIJZf)IJll 7 l',};,pl~il1J Ih~ ~~rio-~s rnetheds ofB\'i1I~a!il1lgca:(:IiuL~ c:o;r~lldi~urc'

Ij~'lildro5.IJ.Com. o« 1(J()~: ,8.l.')I1~ (OM) ()~ )'fHMJ ~ CI i I icll.lJy examine ~ arious methods of i:".=uri.llf!. r~m~1I on clLJIir.a I 111'\-~1 rncnt,

Cilpltal Bud,getfpg

~~--~~~---------------------------------------.~

9, Briefly cxpr~ill th~ important m.e1.llods of Rallkill'l:_l ~n'fl::;':I:rI1~n! pru.po~l~.

ItlJ4trro~, I M;Cmn. oa. 1M21 lO. Wh.at h PDy-:baek f"I=flOd"l WIl;,' ~ h,q hmillllfQn:>?

f~tJlIrm;, B. Cl;Im; fOil!) April .NHJOj II, Elt;pl~in' Pa,' ba.J: ~d me1bGtI'. WhllJ[ arc the ililv;u1lm@~.s end (liSllt:hl~~lB.~·e~ (] r this !D!:Lhg~;J'?

iMlldm.~, B£onl. oa. ,]()fJJ; 8. CtJm. (ICE) NflJ' lOr}ll IJ2_ Bridly desenbe I.h~ il'llpm~CilJ]e.J1.[~ ever the Trad luona I apprsaeh ro • raj blcl pcr~QoI;I mdli.{I~ '.

i 3. Wtial is 'A.coolnUin,g R~le of t-teim:n Method-? H~\\, ~Jjch rate is-computed? Wh~t arc the pros and cons {If Ehc melhodi?

~4. fu:pl~ii'llli~ pru>eJ11. \'aJue' rl1ei:hods o:fC!puti!~ R1!dg¢l !Hg in Il~'ili I. L'i. ri'fI'L{lln th~ 8(h'an!:;:Jg~ aJld dr~~d\lInm.!l~5ofNPVand JR.R,

1.~fjJdJ'fJs. 8.(;.[}m. (ICE) ~.f1lJl ~'(J(}JI 16.. H(Io\~ do YOUI d istifi€,LJisll I.R_ It method fl':'I'D lJ~h~ p~~e:il. vuhre 1'I:Iiclhoib~

.17. IF...xr!~im, InC' rn~tling&n{l m~lh[)li (]f'CI!.pil:!Ll Ratiooing'_

U!. Discuss ilie ITI':illllns. of' R~~;I.;' Bnd '11nOC:Mi nly' in thi: ton I",·'d 0 f ~fI~t.a1 Rut!s~un~ I 'ii, E"pl~i~ I'rnhkm~ in deciston m~kill:!l under uncertain sittl~Li(ln

j'l1"d!tJj, J.,~t, Com <XI. zoo 11 :w Eh(:ll:ai.n tbc ~~lrjlll~sToclmiQIi~~ u~'iiI tor incorporaung risk r~llOJin d'OJ:j~;(m nia~in~ pmc~~~.

jt.If1(lrm·, I M. Com. Aprlf ;WM I 21 E~'alml~~ s.cnsitMt} analysis as II mclhOod ofassessjll@. risk .

IMQr!ros. 1 M, C£im. (iCE) ~!{It .10031

22. ni~!J~.hi:; lJS!!:fu 111e.~s ofQu:ln!i.~tillC l'i.:cimlqllC;> in dci!Jill.ll with ri::ik and uncertamty in C~pil~1 Bud,,"-'li~Il;.

2.:1. F.:o::~llll.n ~h~ 'Gcncral1cc'hmqucs'lIScful in dealing wid! ·Rtsk' ill tll.p;ilaJBu.dgeling, 2~, W~at is m~~!it by 'Dedsio.n Tree'? PoilU OO! the m:l~'II![3ge.~ uf '[)e(-i.sim'l Tree Anal}sii-