Chapter XVIII

Capital Expenditure Decisions

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After'r'e'sdlng1;thls chapter ,·:yoO. w!II.i:)e· -conversant-wtth • .' . . Na·(ti~~>dftJi~·:Inv~~t~e~t,. o'r::¢~pi taiif:Xpendit~e Pecisiop.

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• Other steps. of Project Management like Fea:5j,!;ility:;S'tudy, Implementation and Performance Apprrusal

• Introduction to Network Tedhriiq~es.for P;oj~ct'pla~ning and' Control . ': . .'

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Principles underlying Me~urement ofCostsand B~ncfits. , «: .. :.

Preparing Cash Flow Projections for Projects .... . ';"',;/

Assessing the Financial Viability: of Projects using' the various ':Appr~.is~ Criteria.

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• Shri Shakti LPG Ltd, a Hyderabad based company, up facilities to import and market liquified petroleum gas, at an estimated cost of Rs.I03.50 crores.

• Tara Metaliks has set up a new Mini Blast Furnace with associated systems for manufacture of foundry grade pig iron.

• Lupin Chemicals Ltd has set up a project to manufacture 'RIFAMPICIN', an anti-TB drug, at an estimated cost of Rs.8250 lakhs.

The above items, which appeared in newspapers are typical examples of capital expendituredecisions, also referred to as capital b~dgeting or investment decisions. Such a decision may be defined as the company's decision (0 invest its current funds most efficiently in long-term assets in anticipation of an expected flow of benefits over a series of years. Capital expenditure decisions occupy a very important place in corporate finance for the following reason~:

• Once the decision is taken, it has far-reaching consequences which extend over a considerably long period, which influences the risk complexion of the firm.

• These decisions involve huge amounts of money.

These decisions are irreversible once taken . These are among the 1I10s.t difficult to make when the. compan.y is faced with various. potentially viable investment opportunities.

While capital expenditure decisions are extremely important. managers lind it extremely diflicult to analyze the pres and cons and arrive at a decision.because:

Measuring costs and benefits of an investment proposal whether it be a mini-steel plant or a library is difficult because all costs and benefits cannot be expressed in tangible terms.

The benefits of capital expenditure are expected 10 occur for a number of years in the future which is highly uncertain.

Because the costs and benefits occur at different points of time, for a proper analysis of the viability of the investment proposal, all these have to be brought to a ccm:i'1on time-frame. Hence time value of money becomes very relevant here.

The investment decision starts with idcnti Iication of 'investment opportunities and culminates In performance review after the project is implemented and operations are stabilized.


Identification of appropriate investment opportunities is a complicated exercise primarily because of the innumerable investment opportunities available to a promoter. To identify such investment opportunities that are prima facie feasible and promising, the promoter has to:

Scan the various sources that can throw up promising investment opportunities;

Understand the governmental regulatory framework and policies that have a bearing on the different investments; and

Appraise the potential investments in relation to his organization'S strengths and weaknesses.



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Potential Sources for Project Ideas

The sources Ihal can be lapped for identifying promising investment opportunities are numerous and an aucmnt has been made here to describe some of the important sources.

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Market Characteristics of Different Industries The supply and demand conditions prevailing in the different industries can be analyzed 10 identify such industries which have unfulfilled demand. Such industries can be subjected to a further scrutiny to examine the present level of capai.ity utilization, the profitability of the existing units, and the new projects under implementation. Some instances of projects which have successfully capitalized on such unfulfilled demand are presented below:

• When Food Specialities Ltd., introduced 'Maggi' noodles in the market in the early eighties and the product gained a high degree of consumer acceptance, it became evident that ~ huze unsatisfied demand exists for fast foods. We have seen a number of new entrants in this industry. since then.


• The market for spark plugs was virtually a monopoly of MrCO until the Modi group recognized the supply-demand imbalance and promoted a new company for manufacturing spark-plugs.

• Perceiving the popularity of 'Surf in the premium detergents market, Karsan Bhai Patel saw an opportunity to sell detergents to the lower strata of the market. and launched 'Nirrna'.

Product Profiles of Various Industries

A study of the end-products (including by-products) of the various industries can throw up new project ideas. The following examples are relevant in this regard:

• The natural gas emitted during the off-shore oil drilling operations was burnt off for lack of any productive use, until it was recognized that this gas can be an important input in manufacturing fertilizers. The HB] pipeline is supplying gas to gas based fertilizer plants.

• Mini-steel plants in the country were started with the intention of using the steel scrap which was invariably discarded as waste.

An analysis of the inputs required for the variousindustries can also help in the identification of new projects.

• Linear Alkyl Benzene (LAB), an important input in manufacturing detergents was in short-supply a few years ago. Perceiving the need for this raw material, SPIC floated a new project for manufacturing LAB and many others have followed suit.

In many industries dominated by large firms, small firms can concentrate on producing components

or other specialized parts for the larger firms. Ford Motors. for example. at one time produced thcir own car window frames but found it more suitable to contract this workout as they could not benefit from the economics open to the specialist firm. In the Indian context, we have the examples of Ashok Leyland and Maruti Udyog which depend upon a large network of ancillary units for manufacturing specific components or parts.

Imports and Exports

The government is keen on promoting export-oriented industries and import-substitution industries. Therefore the promoter might find it advantageous to analyze the trends in exports and imports over the last live to six years, to identify potential investment opportunities. Two examples and a potential idea are given here:

• Cold-rolled coils and many other steel derivatives worth Rs.1500 crores are imported by India every year. Is~at Profiles India Ltd, identified an opportunity to produce these items indigenously and their project has beendoing extremely well.

ATV group of companies, mainly engaged in cardamom exports, found an export market for cut flowers and tissue culture plants and have successfully commissioned an export-oriented project for this purpose.

While examining the end-products of a particular industry, it may be also worthwhile 10 analyze whether one can improve upon the product or find new uses for the existing product. For example Sinter Plast Containers recognized that the storage tanks made of low density polythene are functionally better suited than the conventional storage tanks for storinz water and chemicals. This improved version has ~indeed gained considerable acceptance in the market.

Emerging Technologies

Analyzing the commercial viability of some of the ~ndigeneously developed technologies or adapting the Imported technologies to suit the local requirements can result in identification of potential investment opportunities. The Technology Development and Infrastructure Corporation of India (TDICI) set up by the ICICI and similar venture capital windows promoted by the other financial institutions can provide useful ideas in this regard. The success story of Xerox Corporation in the United States is in fact based un the successful exploitation of a new technology.

• Xeroxography was invented in 1938 by Carlson but he could not sell the technology to business firms successfully. Even IBM was not convinced that it is a promising idea. Xerox Corporation adopted the idea in 1960, and launched photo-copiers with astounding success.

Hindusran Computers Ltd. Hewlett Packard (HCL-HP) has launched a new compu~r system


Finane al Managoment

cased on Intel Corporations Pentium 586 chip. TIle Pentium 586 processor which is said to be 10 times faster than the norm' I processor was launched internationally only a month before HCL-HP launched its new system in India.

Social and Economic Trends

An entrepreneur who is quick to spot changes in the social and economic status of the popuiation can identify new opportunities for investment. For instance, there has been a perceptible increase in the demand for ready-made garments, and garment 'units which have spoiled this change rather early have successfully exploited the opportunity. Likewise, the middle-income group are becoming less averse to buying goods on credit and recognizing this trend, many finance companies arc launching innovative consumerfinancing schemes.

Consumption Patterns in Foreign Countries An analysis of the consumption patterns abroad can provide clues for launching new projects. To give an example. Brooke Bond and Food Specialities promoted projects for manufacturing granulated coffee in India after recognizing a shift in the consumption pattern abroad from powdered instant coffee to granulated coffee.

Revival of Sick Units

A sick unit presents a potential investment opportunity to an e-ntrepreneur who has the capability of turning it around.

• Nutrine confectioneries tookover an ailing biscuit manufacturing unit in Andhra Pradesh and turned it around. Likewise Gujarat Narmada Auto took over Girnar Scooters as a part of its diversification strategy and successfully revitalized the unit. (However, subsequently Gujarat Narmada Auto became sick and was 'closed down).

• SPIC took over the loss-making caustic soda plant of Kothari Industrial Corporation Limited and at the same time promoted a downstream petrochemical unit to effectively utilize the chlorine which results as a by-product in the process of manufacturing caustic soda. The downstream unit will manufacture polyglycol and polyol which are imported at present.

• Baroda Fibres and Chemicals Company's attempt to takeover Calico Mills. the one time flagship company of the Sarabhai Group, a sick unit referred to BIFR, with the hope of turning it around.

Backward r- and Forward Integration

Many units find an opportunity to use their own output to make other products. The advantage is that the output can be captively consumed to make better value-added products.

Dccpak Fertilizers and Chemicals has been the only producer of ammonia in the private sector. Since ammonia prices arc administered by the government, the company was not able to maintain its profitability. It has therefore decided to set up a new project to manufacture ammonia-based fertilizers and thereby improve its profit potential.

Chance Factors

Sometimes investment opportunities are identified by sheer chance like the following instance:

• Satya Prakash Mathur hit upon the idea of making domestic mixers when his wife complained that their imported mixer had succumbed to Indian conditions. He designed and manufactured 'Sumect' mixers to cater 10 Indian kitchens.

Regulatory Framework and Policies An entrepreneur scouting for suitable investment opportunities must familiarize himself with those economic legislations, governmental guidelines and policies that have a bearing on the identification and implementation of projects. Some of the legislations to be studied in this regard are the Industries (Development and Regulation) Act, Income Tax Act and the Foreign Exchange Regulation Act. Besides these legislations. the Industrial policy statements, the guidelines governing foreign collaboration and investment, the incentives and subsidy schemes of the government. and the fiscal policy of the government also influence the choice of projects.

TIle entrepreneur will also do well to look for distinct shifts in the priorities of the government in the recent years and assess the implications of such shifts for investments in different industries because other things being equal, a project which is in line with the governmental priorities is a better bet than a project which is not.

• Shri Shakti LPG Ltd's plans to market LPG follows the government's decision to privatize LPG Marketing. Other pri vate companies that may follow suit are Essar and Reliance.

Now that the Indian economy is opening up and is on the way to globalization, foreign companies are also on the look out for investment opportunities in India.

• CRA Exploration Pvt. Ltd,anAustralian mining company has recently submitted a proposal to expiore the potential for diamonds in Kurnool and Ananthapur districts of Andhra Pradesh.

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TIle list of promising investment opportunities identified from various sources is first subjected to an analysis within the governmental regulatory framework to obtain a set of feasible investment opportunities that merit further consideration. Since it will be a tedious



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task to undertake a detailed appraisal of each ofthese opportunities the list has to be further narrowed d iwn by evaluating the investments against certain specific criteria and selecting only those investments that arc prima facie desirable. TIlC criteria that arc typically applied for the preliminary evaluation arc,'

• Compatibility with the Promoter.

• Compatibility with Governmental Priorities.

• Availability of Raw Materials and Utilities.

• Size of the Potential Market.

• Reasonableness of Cost.

• Risk Inherent in the Project.

These criteria arc briefly examined here:

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Compatibility with the Promoter

Any entrepreneur promoting a new project must ensure that the physical. financial, and human resources available at his disposal arc adequate to meet the requirements of the project under review. Many diversification projects have failed because of the incompatibility between the promoter's strengths and the project requirements. An example in this regard can be the unsuccessful attempt made by Brooke Bond to enter the two-wheeler automobile market by taking over Karnataka Scooters Limited. Similarly. Bush's entry into the Color TV market was not entirely successful and it has taken a decision to come back to the business it knows best - audio systems. though it still plans to manufacture Black & White TV sets.


Compatibility with Governmental Priorities

It is preferable that the project under review does not run counter to the governmental priorities. Besides it is also necessary to ensure that the promoter does not violate any governmental guidelines andlor legislations that have a bearing on the choice of investment. For example. a medium-scale unit cannot embark on a

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project for manufa<:~l,I£~h-p-mvrler.because.-iLisa

proOticlEs..~Yeci.l'eMhe~~mall-sc~ .sec.IQr. Likewise.. a pr~~~ .. c(?lJ>or.~~~ promoter cannot undertake .an activity included in Schedule A of theIndustrial Policy Resoliifion of 1951C


Availability of Inputs

The importance of this factor cannot be over-emphasized because business history is replete with . instances of project failures on account of


non-availability or scarcity of critical inputs. The

various inputs. the availability of which needs to be verified. include raw materials. utilities. the technology involved etc. Apart from availability of inputs. the COSLC; involv~ in obtaining these inputs must also be examined

C3p,tal Exponditure Decisions

because adverse variation In input costs can significantly affect the viability of the project. For example. the successive revaluations in the exchange value of yen over the last few;' . aI'S resulted in a sharp increase in the input costs of Maruti Udyog because it was importing auto-components in large numbers from Japan.

Size of the Potential Market

The size of the present domestic am! export markets, the projected increase in consumption. the competitors' ~1)rofiIc5 and their market shares. the barriers to the entry of new units. the availability of substitute-products. and the pace of technological development in the industry concerned are some of the important factors to be assessed while subjecting the project to a preliminary evaluation.

Reasonableness of Cost

The cost structure of the product must be examined to see whether the desired profit margin can be attained with a competitive price. A break down of the product cost in terms of raw materials cost. labor cost. factory overheads. selling and distribution overheads. and after sales service costs is often helpful for this analysis.

Acceptability of Risk Level

The risk characterizing the project must be carefully assessed taking into account the different sources of risk like technological changes. availability of substitutes. competitive forces and cyclical effects.


Once a project opportunity is conceived and it is considered acceptable after preliminary screening. a detailed feasibility study has to be undertaken covering all marketing. technical. financial and economic aspects of the project. The study in the form of a Detailed Project Report (DPR) will contain fairly specific estimates of project cost. means of financing. schedules of implementation. estimates of profit.ability based on projected sales and production COSL". estimates of cost and benefit streams in terms of cash flows. debt servicing capability of the project I and social profitability. The ultimate decision whether to go in for the project or not and how to finance it is undertaken after this study which discloses whether the project is technically feasible. economically viable and financially sound.


The implementation of a project i.e .. translating the investment proposal into a concrete project is a highly complicated, time consuming. tension-fraught and risky affair. The various stages of implementation arc:

.Debt servicing capability refers to the ability ot the project to generate sufficient cash flows to repay the debt taken to finance the project. This includes the principal along with the interest component.


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Preparation of blueprints and designs for project and plant engineering, selection of machineries and equipment.

Negotiating for project finance with various financial institutioos, entering into technical knowhow agrccmaJls if necessary, entering into contracts for constructioo of buildings, supply of machinery, marketing of the company's products etc.

Actual construction of buildings and other civil works, erection and installation/of machinery and equipment.

Training of engineers, technicians, workers etc.

Commissioning of plant and triai run.

• Commercial Production.

Project Delays

It is quite common for projects in India to be inordinately delayed due to a horde of reasons like wrong target date setting, mistake in tender specifications due to which a lot of equipment cannot be fitted and goes waste, delay in arrival of materials, unskilled labor etc. which lead to huge cost overruns and subsequent revision of project cost and the search for. additional financing over and above the finance already sanctioned, which can in no way meet the cost overruns .:

• The project of Ready Foods Limited to promote a 100% - EOU (Export Oriented Unit) which will process and freeze fruits, vegetables, delicacies etc, for export was originally appraised by IDBI in November, 1991 and the project cost was estimated to be Rs.5710 lakhs. There was a cost escalation of about Rs.650 lakhs due to delay in project implementation, which raised the project cost to Rs.6360 lakhs in March, 1993. The company had to raised Rs.6360 lakhs, which it proposed to do by issue of equity shares to the public and by taking loans together amounting to Rs.5465 lakhs, the balance of Rs.895 lakhs to be brought in by the promoters as their contribution.

For expeditious implementation or' projects, it is helpful if

The projeets are formulated adequately so that. all aspects of. the project are .covered and. targets are set on time.

Specific responsibilities are assigned to project managers for completing the project within the defined time- frame.

Network techniques like PERT (Program Evaluation Review Technique) and CPM (Critical Path Method) are used. These are ideal tools for project planning and control developed in the late 19505. While CPM was developed for construction projects, PERT was developed for Research and Development projects. Both PERT and CPM present various activities of a project

in the form of a network. A project may be sr-:it into various activities which have precedence relationships among them. This means that an activity in the project may require some other activities in the project to be completed before it can be started. Certain other activities can be carried on in tandem. When these activities are set out in the form of a network, it is called a network technique and this establishes the logical relationships between activities and also helps to analyze various project characteristics.

A simple network for the setting up of a plant can be shown as follows:


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Purchase Machinery


Figure 18.1

The above network has been designed using the major activities in setting up a plant. Actually, each major activity has to be split up into several activities like calling for quotations, entering into contracts for building, machinery, finance etc., installation of electricity, water supply etc.

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Once the project has been implemented, the trial run successful, and commercial production started, a review of the actual performance with' the performance projected in the feasibility study is required. This is an integral and vital part of project management because:

I. It throws light on how realistic were the assumptions underlying the project

2. It is a valuable tool for decision making in future.


. The appraisal of a project includes the following types

of appraisal: .

• Market Appraisal.


,\echnical Appraisal. Financial Appraisal. Economic Appraisal.

Market Appraisal

The market appraisal is attempted to answer two important questions:



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What is the size of the total market for the •

,proposed product or service?

What will be the project's share of the total

market? •



Answers to both these questions are equally important because a dominant position in a rapidly shrinking market is certainly not a better proposition than a meagre share of a large market. To answer these questions, thd market analyst compiles and analyzes the data relating to the following aspects2:

Past and present consumption trends Present and prospective supply position Level of imports and exports

Structure of competition

Price and cross-elasticity of demand3 Consumer requirements, and Production constraints.


Based on the available data, the market analyst estimates the future demand using an appropriate forecasting technique or a combination of forecasting techniques.



Technical Appraisal

As the name suggests, this appraisal is done to ensure that all technical aspects related to the successful commissioning of the project have been taken care of. The important issues considered in this appraisal are:

• Availability of the required quality and quantity of raw materials and other inputs;


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Availability of utilities like power, water etc.:

Appropriateness of the plant design and layout; The proposed technology vis-a-vis the alternative state-of-the-art technologies available;

Optimality of the scale of operations;

Capital Exponditure Decisions

The technical specifications of the plant and machinery in relation to the proposed technology; and

Assembly line balancing.

Financial Appraisal

The financial appraisal looks at return and risk characterising the project and examines whether the risk adjusted return exceeds the cost of financing the project. For this purpose, the financial analyst compiles data on the cost of project, mhns of financing, and projected revenues and costs. Based on this data, he works out the net cash flows expected from the project and appraises these cashflows in terms of various criteria of merit like payback, IRR, etc.

Economic Appraisal

In addition to financial appraisal, most of the projects sponsored by government ,authorities are subjected to a social cost benefit analysis (otherwise known as economic appraisal) to adjudge whether the project is desirable from the social point of view. Some 01 the issues considered in this analysis are:

Impact of the project on the distribution cf income in the society.

Impact of the project on the level of savings and investment in the society and

Contribution of the project desirable objectives like employment etc .

towards socially self-sufficiency,

For the successful implementation of a project, each step of the capital budgeting process is equally important. As students of Corp-vue Finance, while we must be aware of all the aspect!' 0- _ roject Management, we must be thoroughly proficient in how to appraise a project in relation to its financial aspects. This is discussed in detail in the next section.




The financial appraisal of a project Can be viewed as a two-step procedure:


Step 1

Define the stream of cash flows (both inflows and outflows} associated with the project.

Step 2

Appraise the cash flow stream to determine whether the project is financially viable or not.

2 3

The list is only illustrative and not exhaustive,

Price-elasticity of demand for a product refers to the responsiveness of the quantity demanded to a given change in its price. Cross-elasticity of demand on the other hand refers to the responsiveness of the quantity demanded of a product to a given change in the price of a related product. Cross-elasticity of demand needs to be analyzed for a product which has a close substitute or complementary product. For instance, tea and coHee being substitutes, an increase in the price of tea can result in an increase in the demand for coHee, and vice-versa. Likewise a steep hike in the price of petrol can have an adverse impact on the demand for cars in general. large cars in particular, and may have some impact eva" on tt:edemand, for __ ,lyres.,



Financial Management



This section covers tbcse two steps in greater detail. TIle first part of this section deals with the principles underlying measurement of cash flows and the second part discusses the criteria employed for appraising the financial viability. Bill before we discuss these aspects, we should be aware or the two important assumptions that underlie our discussions: (a) The cash flows occur only once a year, (b) The risk characterising the project is similar to the risk complexion of the on-going projects of the firm. While Ibe first assumption is made "to simplify the calculations. the second assumption is made for the sake of expository convenience.



The important principles underlying measurement of costs (outflows) and inflows (benefits) are as follows:

• Since the net cash flows relevant from the firm's point of view are what accrue to the firm after paying tax. cas_li Hows for the purpose of appraisal. must be defi~ irl pOSt-lax leI M.=-

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• <!1sua!ly the net cash flows are defined from the point 'Of view oftbe suppliers of longrterm fu.nds4 (Ce .• suppliers of' equity capital plus long-term loans).

*. Interest on long-term loans must Dot be jncluded fo~ de'terminin the net cash flows. The rationale f his principle is as fol ows: mce the net cash flows are defined from the point" of view of suppliers of long-term funds. the post-tax cost of long-term funds will be used as the interest rate for discounting. The post-tax cost of long-term funds obviously includes the post-tax cost of long-term debt. Therefore if interest on long-term debt is considered for the purpose of determining the net cash flows. there will be an error of double-counting.

• The cash flows must be m~asl:lre6 in inerement-al terms. In other words. the increments in the present levels oi costs and benefits that occur on account of the adoptioll of (he project are alone reJCvant for the purpose of determmmg the net cashflows,

Some implications of this principle are as follows:

• If the proposed project has a beneficial or detrimental impact on say, the other produ_g_lines


of the firm, then such imp"'". must be quantified and considered for ascertaining the net cash flows.

Sunk costs mus~ ignored. For eg:- the cost of existmg land must be ignored because money has already bee!"! sunk in it and no additional or incremental money is spent on it for the purposes of this project.

0W0rtunity costs .associated wilh tbe utjlizaljoo of the resources available with the firm must be constQered even though such utilization does not entail explicit cash outflows. Eg: While the sunk cost of land is ignored. its opportunity cost i.e., the income it would have generated if it had been utilized for some other purpose or project must be considered.

The/share of the existing overhead costs whichjs to be borne by the end product(s) of tbe propg§ed

project must be ignored.,

The application of these principles in the measurement of the cash flows of a project are illustrated by the following examples:




Example 1

Anand, a chemical engineer with 15 years of experience. and Prakash, a pharmacy graduate with 18 years of experience, are evaluating a pharmaceutical formulation. They have estimated the total outlay on the project to be as follows:

._-;>Plant & Machinery : LR.~;~~~

.....;~orking Capital ·Rs.2A lakh3".

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The proposed scheme of financing is as f6110~s:

~;~~W!X~~C~} Rs.16 1akhsl

L.D.< Tcrrt! L~.m=- Rs.26 lakhs.J


.:lfrade-Credit Rs. ·8 lakhs

Working Capital Advance R'~.l if lakhs

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The project has an expected life of 10 years. Plant &


Machinery will be depreciated at the rate of 33 1/3 (

percent per annum as per the written down value method. The expected annual sales would be Rs.80 lakhs, and the ·~ost of sales «(ficlpding. depreciationbut excluding in~~est)-is· expected to beRs_:50,lakhs per year. The tax rate of the company wilfbe 50 percent, Term-loan will carry 14 percent interest and will be repayable in 5 equal arinual installments, beginning from the end of the first year. Working capital advance will carry an interest rate Bf Jfpercent and. thanks to the 'rollover' phenomenon: will 'have an indefinite m~turity. ,

Define the cash flows for the first three years from the

long-term funds point ot;:'1ew: ,-- """ ----

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4 Cash flows can also be defined either exclusively from the point of view of equity shareholders or from the view point of~the suppliers at both ionq-term and snort-term runds. Suppliers at snort-termtunds will include commercial banks which provide short- term loans and trade-creditors.



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Table 18.1

Net Cash Flows Relating to Long-term Funds (Rs. in takhs)


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w.;riI~ on wor1dng ~ ' ..

advatice-'" '," '. '.

Profit be foce tax·

Capital E xpenditur e Decisions

the cashflows are defined over a specified lime horizon, a notional salvage value is taken into account in the final year of the time horizon.

The following example illustrates this point:

Example 2

- A capital project involves the following outlays: (Rs. in lakhs)

CJ:l(){~ (1:20.-1

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Plant and machinery ~orking Capital

The proposed scheme of financing is as follows: (Rs. in lakhs)

Equity 100

I Long-term loans ' . ~

~~a!~~~~iit Banks \~~

r C!!f)

The project has a life of 10 years. Plant and machinery are depreciated at the rate of 15 percent per annum as per the written down value method. The expected annual net sales is Rs.350 la~s. Cost of sales (including depreciation, but excludinginterest), is expected to be Rs.190 lakhs a year. The tax rate of the company is 60 perceni/At the end of 10 years plant and machinery will ~etCn a value equal to their book-value' and the investment in working capital will be fully recovered.I The long-term loan carries an inter_est o~i!.i-pen:ent pc(f' annum. It is repayable in eight equal annual installments starting from the end of the third year. Short-term advance from commercial banks will be maintainedat Rs.6_Q_.lakhs; and will carry interest at lS'percent per annum. It will be fully liquidated after 10years. Tr.ade credit will also be maintained uniformly~at-Rs.3:6 i~khs and w~ll befullypaid bac]; at the end Of thetenth year,

Calculate the cash flow stream from the iong-term funds point of view.


The net cash flows are defined .in the Table 18.2 in the next page.

Explanatory Notes:

Net salvage value of fixed assets will be equal to the salvage value of fixed assets less any income tax that may be payable on the excess of the salvage value over the book value. Likewise there will be a tax. shield on the loss, if any, incurred at the time of disposing off the fixed assets. According to tax laws, the net salvage value of any individual item of plant and machinery has lost its significance and therefore for our purposes, we will ignore the impact of tax on the salvage value. In other words, we will take only the gross salvage value into consideration.


G. TIIlf-

H. L K.

Pro!i1 aher,lax

Estimating the salva~e valu~s 01 capital equipment is indeed a complicated task given ihe absence 01 a secondary market lor used capital equiprnents and the numerous factors that influence the estimation of salvage value which are difficult to predict.

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Explanatory Notes:

The investment outlay has, to be considered from the point of view of the suppliers of long-term funds. In the given example, we find that Rs.18 lakhs out of the investment of Rs.24 lakhs in current assets is financed by "''1ay of trade-credit and working capital advance. The difference of Rs.6 lakhs is called the working-capital margin i.e., the contribution of the suppliers of long-term funds towards" working capital. Therefore, the investment outlay relevant from the long .. term funds point of view will be equal to investment in plant and machinery + working capital margin = Rs.42 lakhs.

Since depreciation is a non-cash charge which has to be added to the profit after tax, this charge must be disclosed separately in the cash flow statement and not clubbed with. other operating costs. Further. the depreciation charge to be considered here will be the tax-relevant charge. In other words, the depreciation must be computed in accordance with the method and rate(s) prescribed by the Income-tax Act, 1961.

While interest on long-term debt must be excluded for •

reasons discussed earlier, iQlerest on short-term hank QQrrQwjngs must be included in the cash flow statement.

In the example discussed above, we have defined the cashflows only over the first three years of the project's

life. But in practice cash flows are defined over the entire project life or over a specified time horizon (if

the project life is too long). If the cashflows are defined over the entire life of the project, then the estimated salvage value'' of the investment in plant and machinery

and the working capital must be considered for determining the net cash flow in the terminal year. If



Financial Management


(Rs, in takhs)
8 9 10 }
:.~~ ': ~ ~..; , . -:'.
350.00 " , , 350.00 350.00 SSO.OQ )
179.82 181.34 162.84 183.75
10.18 8.66 ," , 7.36 .. 6E' )
160.00 100.00 . "161).00
10.80 10.80 "10.80 ~j
149.20 U920 14920 "'
69.52 89.52 89.52 )
59.68 59.68 59.68 Tallie IH.2

Cash Flows Relating to Long-Term Funds

6 .





"'-'\51':' i">' ::~.,

350.00""350.00' ">, 350.00 350.00

A. ' 'Investment

: :f~~'; ',', 204.00 ~ ::'t " ~ ..

B. ~'i~s ;'~ ,: :

C. Cost of sales r- :':,i '

103.00, 167.05

D. Depreclaiion .,: "",;' erE!£. ,22-?,~. ,':" ' 19.51 '

E, I'i(,r~ before Into rest and taxes ,,;':':.,", " 'i ,160.09;" ;,,'160,01:>:; -: 160.00' .:

q " F. Interaston STbal)kbo,ITO~.·::;,;j~i";),,),,,,·10.eO:·> .J.0.8~ :".-:'10.80.

149.20, i4920,', .. 149.20"

69.5Z 63.52 69.52'


G. ' Profit belora taxe,~: ... ..

H. Tax

Profit 8~.er lax ,


59.68 . . 59.68


Net salvage value ~ rlX~,.


170,49 .' 173.42

350.00;"., 350.00 ' 175.91 '"" 17B.02


16.58 14.li9 11.98
160.00 160.00 160.00
10.80 10.80 10.80
,149.20 149.20 14920
89.52 89.52 89.52
59.68 59.68 59.68 K Nelsalvage of current asselS· L;R~ti'Km16nt~trade'~t~~'·:.',,·, ';.: ..... ".

~:'.·::~~~:~:'·~~,~~}S':~<.';'·'·.:~·'-~:-·;-· --'.,-,.:,...:.-,.,.--"'-.'"c':'-'-.,._.,'-------------;__-------+__._-¥

·.,:'-AtftDtJ tK.(~··,··i;-·'·;;··'::·(204.00) :' 86.68' ' :62.63 <,'.:'19.19 7626 73.n 71.66 69.86 68.34 67.04


The depreciation rate assumed in this problem is not indicative of the current rates in force. (The depreciation rates currently applicable to plant and machinery under the Income Tax Act are 25%, 40%. and 100%).

In working out the cash flows. deduction available for a new project under Section 80 I of the Income Tax. Act has been ignored.

Our examples have so far been focused on estimating cashflows for a new project. The following example illustrates estimation of cash flows for a replacement project:

Example 3

Sandals Inc. is considering the purchase of a new leather cutting machine to replace n existing machine thathas a book ~alcued(Rs:':OOO d can be 's~~ B2r_X~.1 ,sob.] The estimated salvage value of the 010 rrtachme III four years would be zero, a~d if is depreciated.on a straight-line bask. Thenew machine wil] reduce costs (before tax) by Rs.7,OOO per Year •. i.e., B.s.7.000c,alih savings. overtheold ~a<:hi9~. 'Th~ new machine, has a four year life, costs Rs, I~\.QOO and can be sold for an expected amoun~ of ,~s~2,09Q at the end-of the fourth year. Assuming straight-line depreciation, and a 40% tax 'rate. define the cash flows associated with th~ investm"ent. Assume that the straight li~- method of depreciation' is used for tax purposes,


Table 18.3

Cash Flows Associated with Replacement Decision (in As.)


Year 0 2 3 4
1. Net investment in !.I2.500)
new machine 'r
2. Savings in costs 7~ 7.000 7,000 7,000
3. inae,mental UsO 2.250 2,250 2,250
, depr~ciation .
4. Pre-tax pTOfi_~, ~760 4,750 4.750 4.750
5. Tax~s- ,1.9QO 1.900 1.900 1.900
6. Post-tax profits 2.~0 2.850 2.850 2,850
7. Initial flow (= (1)) (12.500)
8. Operating How (=(6) + 5,100 5.100 ~.100 .5.1QO
9. TetminaJ flow (2.00~ ~
10. Net cash How -, .. ----
(=(7) + (8) + (9)) _f!:pooi') _~~_c=~Q~ __ 5~~~ [) )

Working Notes:

Computation of depreciation:

Existing leather-cutting machine

Rs.3.000/4 =<' Rs.7S0 IA:r annum

New leather-cutting machine

Rs.12,OOO/4 = R$.3.00Q per annum

Incremental depreciation = Rs.2 .. 250 per annum.


'-- /


J, =i

" -i I


.c::,_ r I







, ;

, '
J Capual Expondituro Decisions



The cut-off period is chosen rather arbitrarily and applied uniformly for evaluating projects regardless of their life spans. Consequently the firm may accept too many short-lived projects and too iew long-lived ones.

Having defined the costs and the benefits associated with a project, we arc now ready to examine whether the project is financially desirable or not A number of criteria have been evolved for evaluating the financial desirability of a project These criteria can be classified as follows:

Evaiualio.1 Criteria

NorI·Discounling Cnteria

DiscoooUng Cnteria

Payback AccounUng Nel

Period Rale of Present

Relurn Vaiue

(ARR) (NPy)

Benelil Inlern,,:

Cost Rate of

Ralio Return


Annual Capital Charge

Pay back Period

The payback period measures the length of time required to recover the initial outlay in the project. For example, if a project with a life of 5 years involves an initial outlay of Rs.20 lakhs and is expected to generate a constant annual inflow of Rs.8 lakhs, the payback period of the project = 20/3 = 2.5 years. On the other hand if the project is expected to generate annual inflows of, say RsA lakhs, Rs.6 lakhs, Rs.1O lakhs, Rs.12 lakhs and Rs.14 lakhs over the 5 year period the pay back period will be equal to 3 years because the sum of the cash inflows over the first three years is equal to the initial outlay.

In order to use the/payback period as a decision rule for accepting or rejecting the projects, the firm has to decide upon an appropriate cut-off period. Projects with pay back periods less than or equal to the cut-off period will be accepted and others will be rejected. The payback period is a widely used investment appraisal criterion for the following reasons:

• • It is simple in both concept and application;

• H helps in weeding out risky projects by favoring only those projects which generate substantial.

inflows In earlier years. '"

The pay back period criterion however suffers from the following serious shortcomings:

It fails to consider the time value of money, the . importance of which has already been discussed ..,at length.

6 n=3+(4-3}x 2.500-2.402 =3.15

(3.037 - 2.402)

Since the application of the pay back criterion IC:Jcs to discrimination against projects which generate substantial cash inflows in later years, the criterion cannot be considered as a measure of profitability.

To incorporate the time value of money in the calculation of pay back period some firms compute what is called the "discounted pay back period". In other words, these firms discount the cash flows before they compute the pay back period. For instance if a project involves an initial outlay of Rs.1O lakhs, and is expected to generate a net annual inflow of RsA lakhs for the next 4 years, the discounted pay back will be that value of 'n' for which

4xPVIFA (l2,n) = 10 .. (I)

Assuming the cost of funds to be 12 percent. Equation (I) can be re-written as

PVIFA (12, n) = 2.5

From PVIFA Tables, we find that PVIFA (12,3) ::: 2.402

PVIFA (12,4) == 3.037

Therefore, 'n' lies between 3 and 4 years and is approximately equal to 3.15 years6.We find the discounted pay back period is longer than the undiscounted pay back period which will be 2.5 years in this case.

Evaluating the discounted pay back period as an appraisal criterion, we find it to be a whisker better than the undiscounted pay back period. It considers the time value of money and thereby does not give an equal weight to all flows before the cut-off date. But it still suffers from the other shortcomings of the pay back period. This criterion also depends on the choice of an arbitrary cut-off date and ignores all cash flows after that date. In practice, companies do not give much importance to the pay back period as an appraisal criteria.

Accounting Rate of A~turn

The accounting rate of return or the book rate of return is typically defined as follows:

Accounting 'Rate of Return .(ARR) .::: Average Profit After Tax/Average book value 'of the investment

To use it as an appraisal criterion, the ARR of a project is compared with the ARR of the firm as a whole or


Financial Management

against SOIl1C external yard-stick like the average rate of return for the industry as a whole. To illustrate the computation of ARR consider a project with the following data:


,', .:'.'

Investment (Rsr<:,i1.·;:;--- :." Saies RevafYJe :(R;;:i/; OpcratinQ e>:pe rses . .<, (exduding Depreciaiion) (Ra.) ,

,,-'·'·:i. ·.60000:' 60000 :}~4oooo

.";" 'Il~).t.{~!~-\_~·:'·::. ': -:'("':?f:?~;"~_;

;)1).;,30000· 30000' .: 30000

Depreclalion (Rs.)

..... : ;

30000 + 20000 + 10000.

A vcrage annual income/ =


= 20000 Average net book value of investment

(90000 + 0) 2

= 45000

= (20000) x 100 (45000)


Accounting rate of return

= 44 percent

TIle firm will accept the project if its target average rate of return is lower than 44 percent.

As an investment appraisal criterion, ARR has the following merits:

• Like pay back criterion, ARR is simple both in concept and application. It appeals to the busi ncssmen who find the concept of rate of return familiar and easy to work with rather than absolute quantities.

• It considers the returns over the entire life of the project and therefore serves as a measure of profitability (unlike the pay back period which is only a measure of capital recovery).

This criterion however suffers from several serious defects. First, this criterion ignores the time value of money. Put differently, it gives no allowance for the fact that immediate receipts are more valuable than distant flows and as a result gives too much weight to the more distant flows. Second, the ARR depends on accounting income and not on the cash flows. Since cash flows and accounting income are often different and investment appraisal emphasises cash flows, a profitability measure based on accounting income cannot be used as a reliable investment appraisal criterion. Finally the firm using ARR as an appraisal criterion must decide on a yard-stick for judging a project and this decision is often arbitrary. Often firms use their current book-return as the yard-stick for comparison. In such cases if the current book return of a firm tends to be unusually high or low, then the firm can end upon rejecting good projects or accepting bad projects.

Net Present Value (N~

Wc have already discussed the concept of present value and the method of computing the present value in the lesson on time value of money. The net present value is equal to the present value of future cash flows and any immediate cash out now. In the case of a project, the immediate cash now will he investment (cash outflow) and the net present value will be therefore equal to the present value of future cash inflows minus the initial investment. The follo~'ing example illustrates this point.


Example 4

Consider the project described in Example 3. Compute the net present value of the project. if the cost of funds to the firm is 12 percent.


The net cash flows of the project and their present values are as follows:

Rs.-12500 + (4554 + 4065 + -3631 + 4516)

= Rs, (-12500 + 16766)·


The decision rule based on the-Nl'V criterion is obvious.

A project will be accepted if its NPV is positive and rejected if its NPV is negative. Rarely in real life situations, wc encounter a project with NPV exactly equal to zero. If it happens, theoretically speaking the decision-maker is supposed to be indifferent between accepting or rejecting the project. BUI in practice, NPV in the neighborhood of zero calls for a close review of the projections made in respect of such parameters that are critical to the viability of the project because even minor adverse variations can mar the viability-of such marginally viable projects.

Net present value =





The NPV is a conceptually sound criterion of investment appraisal because it takes into account the time value of money and considers the cash flow stream in its entirety. Since net present value represents the contribution to the wealth of the shareholders, maximizing NPV is congruent with the objective of investment decision making viz., maximization of shareholders' wealth. The only problem in applying this criterion appears to be the difficulty in comprehending the concept per se. Most non-financial executives and businessmen find 'Return on Capital Employed' or 'Average Rate of Return ' easy to interpret compared to absolute values like the NPV.



L~,~, , ;

Benefit-Cost Ratio (8CR)

The benefit COSl ratio (or the Profitability Index) is defined as follows:




BCR = Benefit-Cost Ratio

PV = Present Value of future cash flows

and I = Initial Investment

A variant of the benefit-cost ratio is the net benefit-cost ratio (NBCR) which is defined as:

= . I
== I
= PV _I
I ;.-'
::: BCR - The BCR and NBCR for the project described In example 4, will be:



::: 16766/12500
= 1.34
= 4266112500
= 0.34 The decision-rules based on the BCR (or alternatively the NBCR) criterion will be as follows:

/ )


If -

Decision Rule

BCR > 1 (NBCR > 0) Accept the project BCR < 1 (NBCR < 0) Reject the project Since the BCR measures the present value per rupee of outlay, it is considered to be a useful criterion for ranking a set of projects in the order of decreasingly efficient use of capital. But there are two serious limitations inhibiting the use of this criterion. First, it provides no means for aggregating several smaller projects into a package that can be compared with a large project. Second, when the investment outlay is spread over more than one period, this criterion cannot be used. The following example illustrates the first limitation.

Example 5

Zeta Limited 'is considering 4 projects - A, B, C, and D with the following characteristics:

Initial investment Annual Net Cash Flow
(Year 0) (YealS 1 tl 5)
A (20) 7I.
B (4.5) 1I.
C (7) 2!J
0 (8) 3.5 The funds available for investment are limited to Rs.20 lakhs and the cost of funds to the firm is 14 percent. Rank the 4 projects in terms of the NPV and OCR criteria. Which project(s) will you recommend given the limited supply of funds?

Capita' Expondrturu Decisions


The NPVs of the 4 projects arc as follows:


Projed ,'_' .~~W~,(~l$;~,~l":l'::'" ,:,-,;~,~~ ,:;

A',7.5)(!'VIF~c:Sf,..20 ~(7I. x3,43~~O ;';5.75/~· u;~,] .

. " .-,,' ;:. .,;..;,~~,\.': ~':.~ ::,'. . -. .~. ~

B (lI.i<3A~~'4I."O,65'" ' :",",rv" .. ";

:,:'1;,); :,~;r I,)j%~!i,dr'::<:: , ' . :.:.\"i.;(~'·{?,\ "1./', ;'.

c ,(2~ x 3A:n.~<7" .. ·].58;1(i," "', ',r{'t,.,,~",,~I;lI·l III' ,~" .~,.

',,!~:, ..... ¥. ~: "f. ;:'<f~Jo~~)-~ft.;/w. p,".:4,. . . ,~}:".~ v .' . (:~ft .~:. ~rj') ~ ~'.:.' . ~ p:~rr .

D (35' x3'~~~ff~:lri3i1~':;;:" r}~~~A~~:;ic;.,::;;\~»u"itf!; '.

111e OCR of the 4 projects are as follows:

Based on the NPV and BCR criteria, all 4 projects are acceptable because NPV is positive and BCR is greater than one for each project. But all 4 projects cannot be taken by the firm because of the limited availability of funds. Either Zeta has to accept project A or a package consisting of projects, B, C and 0 but not both. The decision wili depend upon which option maximizes the shareholders' wealth. In this sort of a decision-making situation, the BCR becomes inapplicable because there is no way by which we can aggregate the !BCRs of projects B, C and D. On the other hand NPVs of projects B, C, and D can be aggregated and compared with the NPV of project A to arrive at a decision.

Internai Rate of Return

The internal rate of return is that rate of interest at which the net present value of a project is equal to zero, or in other words, it is the rate which equates the present value of the cash inflows to the present value of the cash outflows. While under NPV method the rate of discounting is known (the firm's cost of capital) under IRR this rate which makes NPV zero has to be found out. To illustrate this concept, lei us consider the following example.

Example 6

A'project has the following pattern of cash flows:

Cash flow (As. in lakhs)


o 1 2 3

(10) 5


3.08 . -1.20

What is the IRR of this project?


To determine the IRR, we have to compute the NPV of the project for different rates of interest until we



Finanei'!l Management

find that rate of interest at which the NPY of the project is equal to zero or sufficiently close LV zero. To reduce the number of iterations involved in this trial and error process, we can use the following short-cut procedure:

Step 1

Find the average annual net cash flow based on the given future net cash tlows. In our example, the average annual net cash flow will be equal to:

(5 + 5 + 3.08 -t- 1.20)/4 = 3.57

Step 2

Divide the initial outlay by the average annual net cash flow i.e., 10/3.57 = 2.801

Step 3

From the PVIFA table find that interest rate at which the present value of an annuity of Re. i will be nearly equal to 2.801 in 4 years i.e., the duration of the project. In our case, this rate of interest will be equal to 15%.

We use 15% as the initial value for starting the trial and error process and keep trying at successively higher rates of interest until we get an interest rate at which the NPV is marginally above zero and an interest rate at which the NPV is marginally below zero. Now we know that IRR lies between the two rates of interest and using a linear approximation, we can. determine the approximate value of the IRR. In the case of our project,

the NPV at r


! 5% will be equal to:

-10 + (5 x 0.870) + (5 x 0.756) + (3.08 x 0.658) + (1.2 x 0.572) 0.84

NPV at r

= 16% will be equal to: -10+ (5 x 0.862)

+ (5 x 0.743) + (3.08 x 0.641) + (1.2 x 0.552)

= 0.66

NPV at r

= 18% will be equal to:

-10 + (5 x 0.848) + (5 x 0.719) + (3.08 x 0.609) + (1.20 x 0.516)

= 0.33

;;: 20% will be equal 'to:

-10 + (5 x 0.833) + (5 x 0.694) + (3.08 x 0.579)

+ (1.20 x 0.482) = 0

We find that at r = 20%, the NPV is zero and therefore the IRR of the project is 20%.

NPV at r

To use IRR as an appraisal criterion, we require information.on the cost of capital or funds employed in the project. If we define IRR as 'r' and cost of funds employed as 'k', then the decision rule based on IRR will be: Accept the project if 'r ' is greater than k and reject the project if r is less than k. (If r = k, it is a

matter of indifference). .



IRR is a popular method of investment appraisal and has a number of merits:

• It takes into account the time value of money.

• It considers the cash flow stream over the entire investment horizon.

Like ARR, it makes sense to businessmen who prefer to think in terms of rate of return on capital employed.

This criterion however suffers from the following


• IRR is uniquely defined only for a project whose cash tlow pattern is characterized by cash outflowis) followed by cash inflows (such projects are called simpie investments). If the cash flow stream has one or more cash outflows interspersed with cash inflows, there can be multiple internal rates of return. This point can be clarified with the help of the following table where four projects with different patterns of cash flows are given:

(As. in. lakhs)

Projed ':' '.: "" ::., - Cash Flow Stream (As.) .. :;!,;., .,.: ,: .. -. ··,"::.:·i· .Ye_a2O, 0'" ,Year j . :-Ye,arO' 2·-?':··Yea'-5r?:::.:,:.;.'~.';.rf~.~1;5i~~.~_;.:.,.J.·I ./;::'.>,

.- O' -10 -10 15 15 15' s:

.'C'.:,:,·:;·;;/ -10 5 '-10 .. , 20. .'.20.<.:,

O' -10 15 :, 10'. -5 20 .

• Projects A and B are simple investments and therefore will have unique IRR values. But projects C and D can have multiple internal rates of return because their cash inflows and outflows are interspersed. For such projects IRR cannot be a meaningful criterion of appraisal.

• The IRR criterion can be misleading when the decision-maker has to choose between mutually exclusive projects that differ significantly in terms of outlays.

Inspite of these defects, IRR is still the best criterion today to appraise a project financially. Financial Institutions insist that projects having substantial outlay specially in the medium and large scale sectors must show th~ compuiation of IRRin the Detailed Project' Report, which they appraise before sanctioning financial assistance.



'\ j



Annual Capital Charge

This appraisal criterion is used for evaluating mutually exclusive projects or alternatives which provide similar service but have differing patterns of costs and often unequal life spans, e.g., choosing between fork-lift transportation and conveyor-belt transportation.

The steps involved in computing the annual capital charge are as follows:




"--",.J t __ ",\ , I ;

Step I

Determine the present value of the initial investment and operating costs using the cost of capital (k) as the discount rate.

Step 2

Divide the present value by PVIFA (k.n) where n represents the life span of the project. The quotient is defined as the annual capital charge/or the equivalent annual cost.

Once the annual capital charge for the various alternatives are defined. the alternative which has the minimum annual capital charge is selected.

Example 7

Hindustan Forge Limited is evaluating two alternative systems: A and B, for internal transportation. While the two systems serve the same purpose, system A has a life of 7 ycars and system B has a life of 5 years. The initial outlay and operating costs (in Rs.) associated with these systems are as follows:


.>Year. .. ,

.,., ".1 ..


.. ' ':: 1,25,O~·"", .

. :,.3 "

.. tso,OOQ: .' .

. "1.75.(01)""


. 6 .'. '.

.. '. :·:'·;',.?!lO,ooo<,.,: :'. •... :, ',~ .2,25.000,::, .• ,,'



Calculate the annuai capital charge associated with these two systems, if the cost of capital is 12 percent.

(You can assume that the net salvage values of the two systems at the end of their economic lives will be zero.)

Capuat E xpenduuro Decisions


Present value of costs associated with system A

= Rs.l0.oo.000 4- (100000 x 0.893)

+ (l25000x0.797) + (150000xO,712) + (175000 x 0.636) + (200000 x 0.567) + (225000 x 0.507) + (200000 x 0.452)

= Rs.17_~24,900

Annual capital charge associated wit.h system A 17.24,900



PVIFA(12.7) 1724900 4.564 Rs.3.77,936


Present value of costs associated with system B

= Rs.800000 + (75000 x 0.893)

+ (IOOOOOxO.797) +(1200(,'0 xO.712) + (140000 x 0.636) + (100000 x ti.567)

= Rs.t 1,77,855


capital charge associated 11.77.855 PVIFA(l2.5)

with system B 11.77.855 3.605



= Rs.3,26,728

Since the annual capital charge associated with system B is lower than that of system A. svstern B

is preferred. .

A wide variety of measures are used in practice for appraising investments. But whatever method is used, the appraisal must be carried out in explicit. well-defined. preferably standardized terms and

.should be based on sound economic logic.

\ .P q._. ~

,_, ,,:l:':. ;



_}.- 6.
-. 12.
r'i, 17.
,j.. 18. ~ 19.


Self-Evaluation Exercises

Section 1

State whether the following statements are True (T) or False (F),

As per our definition, an investment in finished goods inventory can be classified as a project.

The definition of a 'project' is synonymous with the definition of 'capita! expenditure.' in accounting. Capital expenditure decisions are by and large not irreversible,

Identification of suitable investment opportunities is the least important step of capital budgeting, Adequate formulation of a project is ~. pre-requisite for its successful implementation,

PERT and CPM arc -the two l'!::.t-work techniques widely used in the technical appraisal of projects;P-:~ Data on cross-elasticity of demand for a product can help the market analyst to examine the degree of competition from substitutes and near-substitutes.

One of the issues examined in the economic appraisal of a project is the appropriateness of the proposed technology from the social point of view.

The objective of investment decision-making is congruent with the goal of financial management. Maximization of shareholder's wealth cannot be an objective of investment decision-making because this goal is not as inclusive as the goal of profit maximization.

Risk and Return are inversely related.r-

Cost and Return are inversely related. -r:

The focus of the financial appraisal of projects is on the trade-off between risk and return.

Preliminary screening of project ideas is required primarily for eliminating ideas which are prima facie, not promising.

In investment appraisal, the principal focus is usually on the profitability of long-term funds.r

The costs and benefits associated with a project are measured in terms of cash flows because cash flows represent the flow of purchasing power. -j.

While incremental overhead costs must be considered in defining the operating cash flows of a project, allocated overhead costs must be ignored. "

Assuming that investment is measured by the long-term funds committed to a project, the post-tax operating

cash flow is defined as: r '

Profit after' interest on long-term borrowings (I - tax rate) + Depreciation + other non-cash charges.

The terminal cash flow of a project is defined as: Net salvage value of fixed assets + Net recovery of working capital margin, r






/ "'j • J


\ ,j

, J

20. While it is convenient to assume that the sale value of fixed assets (in the terminal year of the investment horizon) will be equal to the depreciated book value at that point of time, the assumption is unreal istic because depreciation charge has no relationship with the decline in market price.

21. The Benefit-Cost Ratio is a non-discounting criterion of investments appraisal.

22. The pay back period is a measure of a project's capital recovery, not profitability. Therefore, it is a sensible creation when a firm is pressed with problems ofliquidity,

23. The ARR of a project is based on accounting profits revealed by the projected profitability statement.")

Like the pay back criterion, the ARR does not take into account the time value of money and gives no weightage to the benefits occurring in the dist~nt future. y

25. The discounted pay back period takes into account the time value of money and considers the cash-flow


stream in its entirety. "

26. TIle net present value criterion squares neatly with the financial objective of shareholder's wealth maximization. T'

27. The problem with the net present value criterion is that the ranking of projects based on this criterion is influenced hy the discount rate, ,.,


'_'--, i r=.
x 28.
» 30.
" 32,
) ;J. 33.
. ¥:-' 34 .
,_i ,j



. \


. _/

Capital Expondituro Docisions

While the PV is an absolute measure, NPV is a measure of the fate or return on the initial investment. F 111e BCR criterion is useful for ranking projects correctly in the order of decreasingly efficient use of capital. . -r-

111c IRR may not be uniquely defined if the cash flow stream of a project has more than one change in sign. _po 111e internal rate of return will be equal to the cost of capital if and only if the NPV of a project is greater than zero. F

If a project involves an initial cash outflow followed by subsequent cash inflows, it mayor may not have a uniquely defined IRR .. F;'

As the cost of capital decreases, the NPV of a project increases. rt:

NPV and IRR of a project will never be in conflict. .r

Section II

Zeta corporation has recently started a project, for which it needs a mixer. A new mixer which suits the requirements of "Zeta" is available for Rs.30 lakh. Mixer which Zeta is presently using is 2 years old & it was purchased for Rs.15 lakh at that time, its salvage value is equal to book value. Depreciation applicable to both the mixers. is 20% WDV. Deterinine the cash flow associated with the replacement of mixer, with the help of the following i~formlition:

a. new mixer can be sold for Rs.20 lakhs after three years.


existing mixer has nil salvage value after three years.

2 .


c. operating expenses are reduced by RsA lakhs if new mixer is used.

d. tax rate is 40%. '. ~ \.~

The lift used by Austin Manufacturing was bought 3 years ago for Rs®lakhs, & its. salvage value after three years will be Rs.3 lakhs, depreciation applicable to the lift is 15% WDV method, If a new lift which costs Rs.20 lakhs is used then the savings in operations will be Rs.3 lakh p.a. Tne salvage value of the new lift after three years is Rs.14 lakhs & depreciation applicable is 15% WDV. Calculate the cash flows related to the proposal if tax rate is 50%.

Astra limited purchased a new machine costing Rs.Z lakh having salvage value cf Rs.80,OOO after expiration of its life span of 3 years. Net present value of machine is Rs.l,IO,OOO. Findout the profit after tax if it is constant, when depreciation is 25% WDV, tax is 50% & cost of capital is 12%.

Exide industries wants to launch a new product "Signon". Capital expenditure for the product will be RS.25 lakhs & working capital margin Rs.7 !akh. Short-term bank borrowings of Rs.20 lakh available at 15% are also needed. Calculate cash flows related to this product with the help of the following additional information:



= RsAO lakh

Manufacturing cost = Rs.12 lakh

(excluding depreciation but includes I lakh allocated cost)

Selling and distribution costs = Rs.7 lakhs.

Deprecintiol1 Tax

Salvage value


= 50%

= Rs.7 lakh after Syears.

5. Graf enterprises wants to purchase a new machine as a replacement. The new machine costs Rs.1 lakh,

\-D';\J.oP its salvage value after three years will be Rs.75,OOO. The existing machine has a book value of RS.25,OOO

t() ".. \ ~~ & salvage value of Rs.35,Opo. The tax rate for the firm is 50%. Find IRR of proposal if depreciation on

t;d>l both is 30%, WDV.Tfiei1ew machine is likely to have an operating cost of RsAO,OOO., -----

6. Cyclone corporation is considering a proposal to replace one of its machines. The following information is available:

a. New machine costs Rs.14 lakh & it will be depreciated @ 30% WDV. After 3 years it is expected !o fetch Rs.1O lakh, with this machine the revenue will increase by Rs.3 lakhs p.a.


Financial Managoment


Existing machine was bought for Rs. IO lakh two years ago and depreciated @ 20%. WOY. If this machine is used in future, depreciation applicable will be 30%. lis prcr cnt salvage value is equal to book value and after three years it is expected to be Rs.1 lakh,

Tax rate is 50%.



Define cash flows associated with the replacement proposal.

The cash flow streams associated with three alternatives are given below. Calculate payback period and NPY at 10%.

60,000' 60,000

60,000 60,000

, .J

, 1


8. Calculate the IRR of a project having an investment of Rs.3,SO,ooo and annual return of Rs.80,00Q for :tve years.

9. A project has an initial outlay of Rs.lO,OOO and results in inflow of .Rs.18,OOO in the next year. In second year of its operation, due to upgradation .of technology there is an outflow of Rs.6,OOO. Find IRR.

10. As finance manager of Zircon Limited calculate the minimum cash inflow required so that the investment is profitable, if the initial outflow is Rs.8 lakh and life of the investment is four years. Make suitable assumptions.

11. . Calculate the BCR for the following project

... ,."..... ..i

Cash flow


. (2;00,000) 40,000 }~,bOO 7b~()(){) 1,20,000

'-._ r

Calculate the appropriate cost of a Chilling plant providing inflow of Rs.2 lakh per year for four years.

13. Cash flows of two projects are as follows:

'. Yeai··.{;:i. ,

'0.' .' .' .. : .. .': .:.:".~.: ","

... ~·~·;:i·~: r

(SOOO)<' (7000) .. '
2,SOO· .. 3,SOO . :~-' '

1 }~.r' .. ...

2: ;~:>t> "': ,3,000 2,000

3 '~.; ". . 2.000 4 oon

------='-----'--. _.,.:C --~"="""~-""-_-~-'-:-' -.---- .. - - ;~-c.=,=~=."""~.""'

/ ~;:!.;;~!;.~.:.' ~p,;, ;"r both at drscount rates 10 &. 20 percent.

~ A new software for accounting costs Rs.20 lakhs and has a useful lifespan of four years. The operational cost is estimated to be Rs.I.5 lakh per annum, it is expected to reduce the clerical costs by Rs.4.5 lakh per annum & other costs by Rs.80,ooo per annum. Calculate the NPY if depreciation is SO% WDY &

tax rate is 30%. . ....

. ,Zet~ Corporation is considering the proposal to replace one of its .. achines. The following information .

\ is available:

.a, The existing machine was bought five years ago for Rs.10 lakhs and it was depreciated at 22.S percent per year under the WDY method. The machine has a remaining life of five years after which its salvage value is expected to be Rs.30,OOO. Its present salvage value is Rs.5 lakhs. The machine will b~ depreciated al 331/~ % per annum for the next 5.years.

. _/

" .. /


Capital EXp'lndituro Docisions

l'i1('. new machine costs Rs.20 lakhs and its WDV depreciation rate is 331/3 percent per annum. A{i,~r five years it is expected to fetch Rs. I 0 lakhs. The installation of this rnachin.: .will increase the annual revenue by Rs.3 lakhs and decrease the total cost, (excluding depreciation and interest on long-term borrowing) by Rs.80,OOO.

Compute the cash flows associated with the proposal. Ignore taxes.

16. is considering investing in a new product. The following annual infonnation is available.


*Collected after a year with a bad debt loss of 2percent.

The capital equipment costs Rs.30 lakhs and is depreciated at 331;3 percent per annum (written down value method). Working capital investment of Rs.20 lakhs is required.

A long-term debt carrying 14 percent interest rate will increase by Rs.20 lakhs and a short-term bank borrowing carrying 18 percent interest rate will increase by Rs.lO lakhs. The corporate tax rate is 50 percent.

Compute the cash flow for four years.

17. The projected profit after tax, depreciation, interest on long-term loans, and loan repayment installments for a newly formed company are given below:

Rs. in lakhs



3.':,::, 4. 5:' 6. 7.


9,.'- 10.

20.0' 5.0 ~,~:; " .: '"""'::''7.2;,', 6.0
32.0 5.0 ',6.3 .: •... 6.0
32.0 5.0 . '. 5.4 J 6.0
36:0 5.0 '.'.4.5 6.0
40.0 5.0 3.6 6.0
36.0 5.0 '.' 2.7 6.0
32.0 5.0 .. , 1;~;,: 6.0,\.
30.0 5.0 0.9 6.0 Calculate the debt service coverage for each year and for the total period.

Naveen Enterprises is considering two mutually exclusive projects with the following cash flow streams:

Year Project A Project B

t- ._~Rs. Rs.

.. _------

- 3,00,000 - 3,00,000

60,000 ' 1,30,000

1,00,000 80,000 60,000



2 1,00,000
.,.- . 3 1,20,000
4 1.50,000 a.

, j


If the cost of capital to the linn is 12 percent, rank the two projects in terms (i) discounted pay back period: and (ii) net present value. Which criterion will you use for selecting a project? Why?

If the cost of capital is 16 percent, and you have 10 choose a project based on the NPV criterion, which project will you choose? Is your choice different from the one chosen in (a)? If so, why?



Financial Managomenl


Tastcwcll Bakery has purchased a new kneading machine for Rs.1 U,OOO. The machine has an estimated life or 10 years, a zero salvage value, and an IRR of 15%. The firm follows the straight line method of depreciation. If the cash llows arc evenly distributed and the tax rate is 40%, what is the annual pre-tax net profit on the machine? (Assume straight line depreciation is 'acceptable for tax purposes).

A project has the following pattern of cash flows:

..: -,4000 "1500 800

a. Calculate <fhe IRR of the project?

b. Can this investment be classified as a simple investment? Give reason for your answer.

21. If an equipment costs Rs.IO lakhs and lasts for 10 years, what should be the minimum annual net cash inflow before it is worthwhile to purchase the equipment? Assume that the cost of capital is 12

percent. ,

How much can be paid for a machine which brings in an annual cash inflow of Rs.35,OOO for 8 years? Assume that the discount rate is 14 percent.

Senior executives of Laxmi Rice Mill Ltd., have been considering the proposal to replace the existing coal-fired furnace in the paddy-boiling section by a new cyclone type husk-fired furnace. The capital cost of the new furnace is expected to be Rs, I lakh, It wiil have an useful life of 10 years at the end of which period its residual value will be negligible. The present -furnace has a netboolcvallleorRs.15.000 and can be used for another 10 years with only minor repairs. If scrapped now, the present furnace can fetch Rs.IO,OOO but it cannot fetch any amount if scrapped after ten more years of use.


/ , }

~\ - )

The basic advantage of the new furnace is that it docs not depend on coal whose supplies are becoming increasingly erratic in recent years. On a conservative estimate, the new furnace will result in a saving of Rs.25,000 per annum on account of eliminated coal cost. However. the cost of electricity and other operating expenses arc likely to go up by Rs.8,000 per annum and Rs.4.000 per annum respectively.

The husk which results as a by-product during the normal milling operations at 3.000 M.T of paddy milled per year is considered adequate for operating the new furnace. On the average. for every M.T of paddy milled. the husk content will be 20%. At present. the husk resulting during the milling operations is sold at a price of Rs.50 per M.T. Once the new furnace is installed. the husk will be diverted for own use. 'White Ash' which constitutes about 5% of the husk burnt in the new furnace, will be collected in a separate ash-pitas it has considerable demand in the refractory industry. It can be sold very easily at a price of Rs.1 ,500 per M.T.

The new furnace will require a motor of 15 HP, whose COSl is not included in Rs.1 lakh, the capital cost of the furnace. A 15 HP motor is lying idle with the polishing section of the Mill which can fetch an amount of Rs.3,000 on sale. It has a net book value of Rs.5,000. The motor can be used for the new furnace. At the end of ten years it can be scrapped at zero residual value.

The company follows straight line depreciation which is assumed 10 be acceptable for tax purpose as well. Applicable tax rate is 40%.



Formulate the incremental net after-tax cash flows associated with the replacement project. (Ignore lax on capital gain and tax shield on capital Joss)

Also calculate the project's IRR.





/ -, /

, )

-, , , /

Capital Exponditure Docisions

Calculate the lR ~ for a project with the following pattern of cash llowx:


Cash Flow (Rs.) -1600 10000 -10000

e I 2

Comment on the valuc(s) obtained by you.

Saranath Machine Tools Limited is evaluating two mutually exclusive projects with the following



The cost of capital for the firm is 14 percent.

a. Rank the two projects in terms of

(i) Nr\j (ii) BCR and (iii) I~R.

b. Is there a conflict in ranking? If so, what is the reason for such conflict?

c. How will you resolve this conflict?

The standard overhaul of an equipment costs Rs.3,50,OOO. Such overhaul is required every 25 years. A less costly overhaul can be done for Rs.25000. This is required every two years. Which should be chosen? Why'! Assume a cost of capital of 12 percent.

The initial outlay on an internal transportation system would be Rs. I 6,00,000. 'The operating costs would be as follows:


The salvage value at the end of five years would be Rs.3,50,OOO. What is the annual capital charge if the cost of capital is 14 percent?


B.' .. C.

D .. ., E.

IF. G. H; "

I' . J;, .


I. F 12. T 23. T 34. F

2. F 13. T

Section I
3. F 4. r- 5. T 6. F 7. T ,X. F 9. T 10. F II. F
14. T 15, T 16. T 17. T lIt F 19. T 20. T 21. F 22. T
25. F 26. T 27. T 28. F 29. T 30. T :ll. F 32. F 33. T .,~',\ )

24. F

. ..

Incremental tax .:. : .. : ....

Inc~riinenlal PAT::\.:{;;:',::-: .. ·' .'

.;- _:-



". }

.. .. _

/ \

-, ;

Working Notes:

W.D.V Calculation for Old Mixers and New Mixers

Old Mixer

2. 3.

Dep;~i~ti6~:i~' .': . Closing w.h V·" .

', 4.915

New Mixer



19.2 3.84 15.36



1. 2. 3.

Opening"'N.D.Y',::;~:~;i;:;/ . Depreciation ".;",.:/>;~'(::' ClosingW.DY'·:;::· .


. '/ ..


24 4.8 ' 19.2

2. Year


, ~ ..



A. B. C. D. E. F. G. H.

Net investment in new.hammer- .' Savings in operating cost Incremental depreciation Incremental PBT

Incremental Tax

Incremental PAT

Incremental salvage value Initial flow

(11 )


.~ ,/

3 1.62 1.38 0.69 0.69

3 1.38 1.62 0.81 0.81

3 L617 1.383 0.6915 0.6915

'-. _/

'-. __ .;r'


J r-·'.

Capital Expenditure Decisions




(2.0) ..



"' .. ' .....

Depreciation ';


Net.salvage value ' ..

Initial flow Operating flow .v Terminal flow

Net cash flow



".,,' ."

.. ;':\\.:'i:p+O.2s1

'<:. '0.8

. (P+(081)






(2.0) .P+O.5 P+0.375 (P+1.081) __ 1.1

----+ ---+ +

(\,\2)0 (1.12) (1.12)2 (1.12)3

- 2 + (P + 0.5) PVIF (12,1) + (P + 0.375) PVIF (12,2) + (P + 1.081) PVIF(l2,3) = I. I

- 2 + (P + 0.5) x 0.893 + (P + 0.375) 0.797 + (P + 1.081) 0.712 = l.l

- 2 + 0.4465 + 0.298 + 0.769 + 2.402P :: 1.1

- 0.4865 + 2.402 P :::: 1.1

P :::: 0.660 = 0.660 x 1,00,000 :::: Rs.66,00,OOO

Year .' 0 2 3 .4 5
~ ...
A. Investment .... ·(25)
B. Working capital margin .(7) \, _o'

. ;49 40 40 '40" 40
.... , .. .'._; ,0':< ····1 ~ 11 :",:,. 11 11
.e •. .; .•••. _. ,.:
>··7···· 7 7 7 7
5 4 3.2 2.56' 2.04
3 3 3 3 3
14 15 15.8 16.44 16.95
7 7.5 7.9 8.22 8.47
375 C., ..• Sales Revenue ..

D:," ; .: Manufacturing Cost (Incremental) E; .. Selling & Distribution (Incremental)·'"

F. Depreciation

G. Interest on short-term bank borrowings

H. P.B.T

I. Tax @50%

Financial Managcmcnl

Year '.









.' ',-

K.. Net salvage value

L. ' .' InitiaI"flow

M. Operating flow

N. Termi~'aJ flow

O. Net cash flow· ..'

.... : ..

, )= r:

. ' ., ....

.... :... . 7

.7.5',·: '"

J 1.5



I 1.1



10.52 14.00


Assumptions : Tax. Rate

Salvage value after 5 years Depreciation

Depreciation on W.D.V Basis

= 50%

= Rs.7 lakhs

= 20% W.D.V.

2 3
20 ]6
4 3.2
16 12.8 . ,0:"': ... .,

. (65,OOot.'

A;;:": ·";'~(irivestiTienl.in new machine 'B~;(n;~$~~ings on operating costs

. C. }"::: Incremental depreciation

D .. ' .:. Incremental PBT'

E. ··Tax

F.. Incremental PAT G'- Net salvage value H. :~:; Initial flow

I. Operating. flow

1. . .... Terminal flow K. . Net cash flow

40,000 22,500 17,500

8,750 8,750

.. (65,000~': .. :."



i·.:~·2 .

:'-.~' -.

40,000 15,750 24,250 12,125' 12,125 .



40,000.0 11,025.0 28,975.0 14,487.5 14,487.5 75,000.0

25.512.5 75,006.0 1,00,512.5

I.R.R Determination

" . '~-.

(65,000) .




r: -.


. Net cash flow PVIF at K = 40% Presentvalue

N~P.V PVIF.at 44%



rV,:,,, .. )::.: ....


(65,000) I (65,000) 8115.3 1 (65,000) 3694.425

-, ;",

-, ~. ' ... '. "

,_ .>."



= 44 + __ ~3-'69_4-'-.4_2 __ x 4 3694.24 - (- 238.15)

= 44 + 3.75

lRR = 47.75%


... ,';' . -

~ . _',

.:. ,',

27,875 0.510 .14,216:25

0.482 13,435.75


1,00.512.5 0.364 36,586.55

0.334 33,511.75

0.308 ..30,951.85

. './






~ .•

,) S ,~

J r:
c '\
/" .. ~
\ .. l
. )
\1 /
(" '.
. )
~l J
r \
\: )
/ -,
\ J
\. )
/ "
. )
'1; Capital Expenditure Docisions


Opening W.D.V Depreciation', .. ' Closing W.D:V

New Machines

~ ~.: .


Opening WaD.V ";



Closi W.D.V



a. Net investment
b. Increase in revenue
c. Incremental depreciation'
d. Incremental P.B.T
e. Tax (50%)
f. Incremental PAT .. ." ~ .
g. Incremental salvage value.".'
h. Initial flow
i. Operating flow
j. Terminal flow
. :-~ '.
k. Net cash flow . {'7 .. 6).·'~ '::~<; ~fi~~~:~}:·~~:·~·~~~~~;~~/·/:'·.~·~{·~ ~ I'j~};~~!'~L .

'J:,~.:3 .... :,.; 2.28', .

, O?~; 0.36



,'" . 3

. 1.596 10404

" .-

3 1.118 1..882 ., 0.941

', 0.941

.. i}'. 9

'0.702 ~~>. 0.702 ."







·2.298/(~~,~ .r /, ·11.059

Depreciation on W.D.V Basis a.

Old Machine

New Machine

. ,;

1 ~ . ]4.0

. 4.2"



t·· ..

. ~~~~.>-:

3 6.86

.. ~


_,. ':":,"

.. [


Projects ..



Payback period . .' . N.P.V (Rs) (r'~ 10%)

6.6,6:ye#S· . (i99:,~)


}.4:years '(]3,660)

c =

.~ ,.1i

~"" (,

- 400,000 + 60,000 x PVIFA(lo.8)J"- \.. ~~

Ib' v-.

- 450,000 + 60,090 ~"lVIFA(IO.51 + 50,000 x, PVIF(lo.6)

w~~ . ~

+ 40,000 x PVIF(lo.7) + 90,000 PVIF(IO.8)~"l, , .. :.f.tJ

~ - 350,000 + PVIF(lo.l} J.... 240,000 + 30,000 PVIF(lO.2}

+ 200,000 PVIF(IO.8} ~


\J.;._ '1,;'f;J

For N.P.V ~A =

B =

Financial Management

8. Investment

= Rs.350,OOO

l.R.R is given by 'r ' in the equation 80,000 PVIFA(r.5) = 35,000 PVIFA(r.5) = 4.375

Now at r and at r

= 5% value is 4.329 = 4% value is 4.452

= 4 +

4.452 - 4.329 0.077

x 0.123

:. l.R.R

4.452 - 4.375 = 4 + I x _..:__ __ -


= 4 + 0.626. = 4.626%


. )

9. I.R.R is given by the equation

10,000 .l. 18,000 _ 6,000 = 0

(I+r)o' (I+r)1 (l+r)2

__ 18,000 6,000

~ 10,000

I+r (l+r)2

__ [18,000 (I + r) - 6,000]


( I . _,2 +i)

~ 10,000 (I + r)2 - 18,000(1 + r) + 6,000 = 0 ~ 5(1 + r)2 - 9 (I + r) + 3 = 0

- b± ...Jb2-4 ac

I + r



9 ± '-'81- 60 = ---1-:0--

9± 4.58



+ r = 1.358 or 0.442

r = 35.8% or -55.8%


since 'r' cannot be negative r = 35.8%

10. Let A be the minimum inflow then 4 A

L --. = 800,000 1=1 (l + r)'


= discount rate = 10%

! -,

let r Then


~ PVIFA(lO.4) = 800,000 800,000 PVIFA( 10.4)






= Rs.252,365.93

Capitat Expenditure Decisions

11. LCI discount rate = 10% then

_40_,OOO_ + 35,000 + 70,000 + 1,20,000

(1.1) (1.1)2 (1.1)] (1.1)4

B.C. R = __:___:__~~c...__~_!_-___;,-----~


36363.63 + 28925.62 + 52592.036 + 81961.61 200,000


, )
.- J
~ -,
-, _;
, j
j B.C.R = 0.999 ;; I.

12. Inllow = Rs.2 lakh

= 2 x PVIFA(r.4) = Appropriate cost let r = 10%

2 x PVIFA(r. 4) = COSt = 2 x 3.170

= Rs.6.34 lakh

For Project A at r = 10%

N 5,000 2,500 3,000 2,000

.P.V = - -- + -- + -- + --

(1.1)0 (1.1)1 (1.1)2 (J.1)3

= -5,000 + 2272.72 + 2479.33 + 1502.62 :.: 1254.67

For A at r = 20%


= -5 000 + 2,500 + 3,O~ + 2,000

, (1.2)1 (1.2)2 (1.2)3

= -5,000 + 2083.33 + 2083.33 + 1157.40 = 324.06

For 8 at r = 10%


7000 3500 2000 4,000


(1.1 )0 (1.1) 1 ( 1.1)2 ( i.1 )3

= -7,000 + 3181.81 + 1652.89 + 3005.25 = 839.95

For 8 at r = 20%


= -7000 + 3,500 + 2,000 + 4,000

P .2) (1.2/ (1.2)3

= - 7,000 + 2916.66 + 1388.88 + 2314.81

NPV = -379.645




, ,

".'~ ~,


, -'


Net savings

Depreciation PBT

10 (6.2)

s.s 5 (1.2)

2.5 I.3

1.25 ,2.55


Financial Management

NPV = - 6.788 Working Note



Depreciation, ' .' , 'VXD.V;:~:-·::~ .


Savings due to the package

Rs. in lakhs 4.5



Clerical costs Other costs


5.3 Additional operating costs = (1.5)


Net Savings

Discount Rate = 10% (assumed)



Cash Flows of the Replacement Project


r, J -, ./

'\ )

, --j

\ j


Capi '.II Expenditure Decisions

Working Notes:


* TI,e depreciation on the old machine was charged at the rate of 22.5% for five years, and then it has been increased 10 33{9'0.

2. Depreciation on the new machine*:

) )

-_ ;

-, )

-, )
/ )
-, '" The depreciation rate on the new machine is 33t %. Net investment in the new machine:

Cost of the new machine

Present salvage value of the old machine

Rs. in lakhs 20.0



Net incremental salvage value:

Salvage value of the new machine after five years Salvage value of the old machine after another 5 years

Rs. in lakhs 10.0




As we have not taken into consideration the taxes, incremental profit alter taxes, the incremental profit before taxes are same.

16. Assumptions

. .

I. The Project is financed as follows:


Long term debt (14%)

Short term bank borrowings (18%) Trade Creditors

Rs, in lakhs 15





Long term funds are utilized as follows:

Investment in capital equipment Working capital margin

(25% of increase in working capital requirement)

Rs. in lakhs 30

5 35


Financial Managomonl

2. Entire Capital Outlay is incurred in the year O.

3. 4. 5. 6.

Life of the Project is equal to 4 years.

The net salvage value of the project is equal to book value at the end of the 4 years. The Corporate taxes are ')0%.

The increase in Working Capital at the end of year recovered at the end of year 5, (less Bad debt losses)

I, on account of increase in receivables will be

Term loan will be repaid at the end of 4 years.

Shon term bank borrowings and trade credit. will be maintained at Rs.l 0 lakhs and Rs.5 lakhs respectively throughout the 4 year period. and liquidated at the end of 4 years.

TIle operating flow is calculated as follows:

= Profit after tax + Depreciation + Interest on term loans (I - tax rate)

Depredation :

7. 8.

Net Cash Flows of the Project

·.:.2~,~:_: .. ~~O~~~.t~~:J/


1(1~7.· Il:~§':];:5'3:'~~:!):';; :':;5~93:' .

. . >:/:. ~,:~;,,::;}~,

Terminal flow relating to recovery of increase in receivables = Increase in receivables - bad debt losses + Tax Shield on bad debt losses

= 32.0 - 0.64 + 0.5 (0.64) 32.0 - 0.64 + 0.32

= Rs.31.68 lakhs


/; · )

· ."

-, )


· )



\ ")

Capital Expenditure Decisions


Debt Service Coverage Rate =

PAT+ Dj + Ii 1+ LRI


" )

Debt Service Coverage Ratio for the total period 10


'l , J

i~1 (PATj+Di+li)

10 (Ii + LRIi)




= l02~6 ==


18. a. i.


I :

..' '",-. ',

~~" 3;


I Y.~ar.·'-':- .. __ ~"--",·,"", .. ~C:.:as=h..:F~I..::;.ow.;.;..:;.s_ .. __ -'--,"'":..:....

'. grojeCl'A


. /

. \ J

"\ ;

Thediscounted-pay back period. indicates the length of time required to recover the initial cash outlay. taking into consideration the time value of money.

fayback period for Project A

In the first three years. capital recovered = 2.IS.720 and in the fourth year .it has, to recover Rs.SI.2S0. and assuming that the cash flows are uniform every month, it will take about ! I months @ Rs,7950 per month. or the discounted pay back period is approximately 4 years.

Discounted payback period for Project B

In case of Project B. the discounted cash flows generated during the first four years are not sufficient to recover the initial capital outlay, therefore. the discounted pay back period for Project B is more than 4 years. provided there are cash inflows after 4 years.

As the discounted pay back period of Project A is less than Project B. the decision maker ~iIt prefer Project A over Project B.

u. NPV of Project A

_ 3 00 000 60.000 1,00,000 1,20,000 1,50,000

- - " + r+ ., + ] + I

(1.12) (I.'i2)- (1.I2)· (1.12),

== - 3.00,000 + 6O.000(O.S93} + 1,00,000(0.797) + 1.20,OOO(0.712} + 1,50,OOO(0.636}

== 3.00,000 + 53,580 + 79.700 + 85,440 + 95,400

::: 3,00,000 + 3,14,120 = Rs.14,120


Financial Management


NPY of Project 13

1.30.000 1.00.000 80.0()0 60.000

= - 3.00.000 + + -+---+--

(1.12)' (l.i2)2 (1.12)3 (1.12)4

= - 3.00.000 + 1.30.000(0.893) + 1,00,000(0.797) + 80.000(0.712) + 60.000(0.636) = - 3.00,000 + 1.16.090 + 79.700 + 56.960 + 38.160

:: - 3.00.000 + 2.90.910 = Rs.(9090)

If NPV criteria is adopted for choosing a project. Project A will be selected. as the NPV of Project B is negative.

Between discounted pay back period and NPV techniques for selecting the projects. it is better to choose the latter than the former. because NPV represents the contribution to the wealth of stockholders following the taking up a particular project. whereas discounted pay back period only indicates the number of years to . recover the original cash outlay. However, there is one similarity between discounted pay back period and

NPV. Both take into consideration the time value of money. .

NPV of Project A, if the cost of capital is 16%

P :: 3 00 000 60,000. 1.00.000 1,20,000 1.50.000

N V -., + (1.I6)i T (1.16)2 + (1.16)3 + (1.16)4

= - 3,00.000 + 60,000 (0.862) + 1.00,000 (0.743) + 1,20,000 (0.641) + 1,50,000 (O~552)

'\ )

:: - 3,OO,(XX) + 51,720 + 74,300 + 76.920 + 82,800 :: (14,260)

Project B

3 00 000 J .30,000 1,00,000 80,000 60,000

= -.,. + I + 2 + ~+ 4

(1.16) (1.16) (1.16)-' (1.16)

== - 3,(xJJXXJ + 1,3UJXXl (0.862) + (1.00,(XX) x 0.743) + 80,000 (0.641) + 60.000 (0.552)

== - 3,00,000 + J .12,060 + 74,300 + 51,280 + 33,120

= - 3,00.000 + 2,70.760 = - 29.240

= NPV = Rs.{29,240)

If the cost of capital of the company is 16%, neither of the projects is acceptable, because NPV for both A and B is negative.

The choice is different, from what we have chosen if the cost of capital is 12%. The reason is that. as the discount rate increases, NPV decreases, as a result in the above case at a discount of 12% Project A is accepted. But when the discount rate is increased to 16%, the NPV of Project A has become negative, and therefore it is rejected.

19. Cost of the machine = Rs.IO,OOO

Estimated life

:: 10 years, Salvage value = 0

Straight line method of J,:::pi·cdatioil I:> f01!owecJ

D ., 10,000 - 0 R I 000

. . epreCH1IJOn per year = 10 :: S..




Let the PAT, per year be Rs.x for 10 years, then the cash flows associated with the project may be

tabulated as follows:

., ; ..»

\ '_oj

It is given that IRR of the Project is 15%, which means, at a discount rate of 15%. the NPV of the project is zero.

~(~;~) = R,. ro.ooo



/1 r=--

Capital ~xpendlture Deci.uons

As th:. net cash now from year I to year 10 is same, we can usc the PVIF annuity tables, instead of PVIF values from fear 1 to year 10.

PVIFA (15%.10) = 5.019


= Rs.IO,OOO = 10,000

= 4981

4981 = 5.019

= RS.992.43 or Rs.992 (Approximately)

lr\eref~re, PAT per year from year i to 10 is Rs.992.oo. Tax rate is 40%. If the profit before tax is Rs.loo and tax rate is 40%, the profit after tax will be Rs.60.

If PAT is Rs.60 PBT is ns.ioo

If PAT is Rs.992 PBT ?

-_ 992 x 100 R I 653 ( . I)

60 = s., approximate y .

5.019x + 5019 5.019 x

.. (x + iOOO) 5.01Y

., x

Therefore, the annual pre-tax net profit on the machine is Rs.1653.



• J

lRR is a rate of return,' where the net present value of the project is zero.

1500 800 750 ~ 3523 .

. 4000 = ---+---+ +---

(l+r)1 (l+r)2 (I+r)3 (l+r)4 (i+r)S.


1500 (PVIFt4%,I) + 800 (PVIFI4%,2) + 750 (PVIF)4%.3) - 800 (PVIFt4%.4) + 3523 (PVIFl4'h.s)

1500 (0.877) + 800 (0.770) + 750 (0.675) - 800 (0.592) + 3523 (0.519) 1315 + 616 + 506 - 473 + 1828


As the required value is higher, try a iower rate, say 12%.

4000 = 1500 (PVIFI2%.I) + 800 (PVIFI2%,2) + 750 ( PVlh2%,3) - 800 (PVIFI2%,4) + 3523 (PVIFr2%,s)

4000 = 1500 (0.893) -+- 800 (0.797) + 750 (0.712) - 800 (0.636) + 3523 (0.567)

= 1340 + 637 + 534 - 508 + 1997

4000 = 4000

At 12%, the value is equal to required value; «.'0' :., .. :;. , ,.,,,.,~,':

IRR of the project is 12%.

b. This investment cannot be classified as simple investment. because this project has more' than one cash outflow. interspersed with cash inflows. in other words, there is more than one sign change.

Let r =
4000 =
4000 =
4000 = 21. Cost of equipment Rs.IO lakhs, and it lasts 10 years.

, ,Co~t of Capital =12%

We are required to. find annual net cash inflows.

The annual cash inflows should be such that the present value of these cash flows should be at least equal to the initial investment.

, .

Let C be the annual cash inflows, then

10 C

L = 10,00,000

1=1(1- 12}1

As the annual cash inflow is same throughout the 10 year period, we can use present value annuity (PVIFA) tables.


Financial Management

PVIFAI2%,10 C x 5,650

C = 10,00,000 5,650

::: 5.650

= 10.00,000

== Rs.I ,76.991 (approximately)


Annual cash inflow Discount rate

== Rs.35,OOO for 8 years == 14%

We are required to find, how much we can pay for this machine.

The maximum amount we can pay for this machine, is the present value of future cash inflows. Let the initial outlay be equal to I, then

8 11

= Rs.35,OOO x 1: [_1_

! ~ 14

(=1 ._

I = Rs.35,OOO x PVIFAI40/0,8

I = Rs.35,OOO x 4.639

\ J


Rs, I ,62,365

, )

23. a,

Incremental Cash Flows of replacing the Old Furnace

... L)

·"i" .,

7.iliitial flow . ,,'


:-."~ ~.':';'>. ';; is; .: .'




IRR of the Project

Net cash outflow in year 0 ::: Rs.93,OOO

Net· cash inflow from year I to year 10 = Rs.20,400

As annual cash inflow is a constant amount, we can use PVIF annuity tables Let "r" be the IRR, then


93,000 = 1:-'-,

1=1 (I + r)

93,000 = 20,400 x PVIFAr%,10

PVIFA 93,000 4 56

r%,10 = 20,400 = .

We have to locate this value (4.56) in the PVIFA tables in the row corresponding to 10 years.

PVIFAI5%,10 = 5.019


= 4.494

i.e, IRR lies in between 15% and 18% and the exact value is found out by interpolation. = 15% + (18% - 15%) [5.019-4.56]

5,019 - 4.494

Capital Expendituro Decisions

= 15% + 3 [~:~~~] = 15% + 3(0.87)

= 15% + 2.62 = 17.62% Working Notes:


,r'\ -, r

~ Less: Present salvage value of old furnace incremental investment

Rs. 1,00,000 3,000 1,03,000 10,000 93,000



Cost of new furnace

I. Add: Salvage value ')f 15 HP motor

II. Net Savings on the-installation of new furnace:

Savings on eliminated coal cost Cash' received on Sale of White Ash

20 5

(3000 x T 00 x 100 x 15(0)

Rs. 25,000



Less: Additional Costs:

- Increase in Electricity Costs

- Other maintenance costs

- Loss of contribution of husk

(3000 x 0.2 x 50) Net Savings

III. ' Incremental depreciation from year 1 to year i 0:

Depreciation on new furnace per year




28,000 , 10,000


(1,00,000 - 01 I 0)

Add: depreciation of .15 HP motor (5,000/10)




. ,/

Less: depreciation of old furnace (15,000/)0)

10,500 1.500


9,000 As the straight line method of depreciation is adopted, the incremental depreciation charges will remain same for all the ten years.

Similarly, the net savings per year will remain same in all the years.

Net salvage value is zero. because both new and old furnace have negligible salvage value, as such terminal flow is zero.


IRR is the value of "r" which satisfies the following equation:


_ (1600) + 10,000 _ 10,000 = 0 (1 + r)O (1 + r/ (1 + r)2

(1 + r)O is equal to one because anything tb the power 0 is equal to 1.

r. 10,000:. 10,000 = ],600 (I+r) (I+d

Multiplying both the sides by (1 + r)2



Rnanclal Management

10,000 2 10000 2 2

= --x (I +r) ---2 X (I +r) = 1600 (I +r)

(I+r) (1+r)

10,000 (I + r) - 10,000 = 1600 (I + r)2

10,000 + IO,OOOr - 10,000 = 1600 (I + r2 + 2r) 10,OOOr = 1600 + 1600 r2 + 3200r

10,OOOr - 3200r - 1600 = 1600 r2

6,800r - 1600 = 1600 r2

6,800r - 16OOr2 = 160{)

Dividing both the sides of the equation by 16<J'O

4.25r - (- = 1

r2 - 4.25r+ 1

= 0

or By applying the formula for obtaining roots of quadratic equation: ax2+ bx + c = 0

-b ± --.lb2 - 4ac


Formula: x =

Where, a

= II, b = - 4.25, C = 1

-(-4.25 ± ...J(4.25)2 - 4 (I) (I)


+ 4.25 ± -./18.06 - 4

= 2xl = 2



=! = 4 or _0.5_0 = 0.25

2 2


+4.25±3.75 2

:. r

i.e., IRR are 400% and 25%

In case of projects where the cash flow stream has mere than one change of sign, there will be more than one rate of return. In this problem as there is more than one change of sign, two IRR are obtained. In such cases, it is difficult to choose a particular project. especially in case of mutuaily exclusive projects. This is known as multiple rates of return.

25. Project A

, '\

Initial cash outlay for Project A

Annual Cash inflows from years 1 to 10 Cost of capital of the finn

NPV = -4,OO,~ +~ i,OO,~

(1.14) 1=1 (1.14)

NPV = 1,00,000 (PVIFA14%,lO) - 4,00,000 = (1,00,000 x 5.216) - 4.00,000

= 5,21,600 - 4,00,000 = Rs.l,2I,600

= Rs.4,OO,OOO = Rs.l,OO,OOO = 14%

, \ ,j

BCR of Project A: 10

E 1.00,000

1=1 (1.14)1 4,00,000



1,00,000 x PVIFA14%.lO 4.00,000

'. _ _/

1,00,000 x 5.216 4,00,000

IRR of Project A:


= 5,21,600 = 1.30 4,00,000



E 1,00:000 1=1

= ----=----



Capital Expendituro Docisions


:= (1.00.000) (I'V IFAr.IO) := 4,00,000 = 4



We have to locate the value of 4 in PVIFA tables, in the row corresponding to 10 years.

PVIFA74%,IO := 3.682 PVIFA20%,IO = 4.193

As the value 4 lies in between these two, the IRR of the Project is in between 20% and 24%. The exact IRR, can be found OL!t by interpolation.

[ 4.193 -4.0 ] 20.0% + 4.0%


= 20% + 4.0[g:~;n

= 20.0 + 1.51 := 21.51 %f/

, \ , /

Project 3
NPV -16,00,000 1: 3,00,000
a. = o + ,
(1.14) 1=1 (1.14)'
= -16,00,000 + 3,00,000 (PVIFAI4%,JO)
:= -16,00,000 + 3,00,000 (5.216)
-16,00,000 + 15,64,800
NPV = Rs.(35,2oo) \





1: 3,00,000

1=1 (1.l4)1


3,00,000 (5.216) 16,00,000


3,00,000 [PVIFA 14%.10] 16,00,000

15,M,800 := 0.978 16.00,000

".c-- \



\ . /

c. IRR
1: 3,00,000
16,00,000 1=1
(I + r)'
16,00,000 = 3,00,000 (PVIFAr%,IO)
PVIFAr%,lo 16,00,000 = 5.34
3,00,000 Locate 5.34 in PVIFA tables in the row corresponding to year 10. PVIFAI2%,10 = 5.650 PVIFAI4%,10 = 5.216

The value 5.34, therefore, lies in between 12% and 14% and the exact percentage is found by interpolation.

IR [5.650._ 5.340]

R = 12.0% + (14.0 - 12.0) 5.650-'5.216


= 12.0 + 2.0 0,434J = 12.0 + 2.0(0.71)

= 12.0 + 1.42 = 13.42%0'

The above res.ults of Project A and Project B are tabulated as under:


Project A Project B

Rs.l,2l,600 Rs.(35,200)

1.300 0.978

21.51% 13.42%


Financial Management

From the above table we can notice that in all the three criteria. Project A is acceptable and Project B'~ has to be rejected because. in case of Project A. NPV is positive. BCR is more than I and IRR is greater than the firm's cost of capital. whereas for Project B. NPV is negative. nCR is less than one and IRR is less than the firm's cost of capital.

In this case, there is no conflict in ranking. In all the three methods, the Project A is preferred over Project B. Normally, there will be conflict in ranking by NPV and IRR,



I. 2.

When the life of the Projects differ;

When the initial cash outlays are different; When the timings of the cash flows differ.




Annual Capital charge of standard overhaul

3,50,000 = 3,50,000 = Rs.44,626 (Approximately)

PVIFA (12%.25) 7.843


Annual capital charge of less costly overhaul

25,000 _ 25,000

PVIFA (12%.2) - 1.690


. )


= Rs.14,793 (Approximately)

As the annual capital charge of the second alternative is less, it is better to choose the less costly overhaul.

27. Present value of the costs of the internal transportation system are:


[16,00.000 x PVIFA(!4%.O) + 3,00,000 x PV!F(l4%.1) + 3,70,000 x PVIF(l4%.2)

+ 4,50,000 PVIF(14%.3) + 5,00,000 x PVIF(14%.4) + 5,50,000 PVIF(14%,5) - 3,50,000 PVIF(l4%,5)]

[16,00,000 + 3,00,000(0.877) + 3,70,000(0.770) + 4,50,000(0.675)

+ 5,00,000(0.592) + 5,50,000(0.519) - 3,50,000(0.456))

[16,00,000 + 2,63,100 + 2,84,900 + 3,03,750 + 2,96,000 + 2,85,450 - 1,59,600) 30,33,200 - 1,59,600






Annual Capital Charge



PVIFA (14%,5) 28,73,600



= Rs~8,37 ,052

'- _/



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