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Project Evaluation
Chapter 4
MARKET AND DEMAND ANALYSIS
1. We have to estimate the parameters a and b in the linear relationship
Yt = a + bT
Using the least squares method.
According to the least squares method the parameters are:
∑TY–nTY
b=
∑T2–nT2
a = Y – bT
The parameters are calculated below:
Calculation in the Least Squares Method
T
Y
TY
1
2,000
2,000
2
2,200
4,400
3
2,100
6,300
4
2,300
9,200
5
2,500
12,500
6
3,200
19,200
7
3,600
25,200
8
4,000
32,000
9
3,900
35,100
10
4,000
40,000
11
4,200
46,200
12
4,300
51,600
13
4,900
63,700
14
5,300
74,200
∑ T = 105
∑ Y = 48,500
∑ TY = 421,600
T = 7.5
Y = 3,464
∑TY–nTY
b=
∑T2–nT2
T2
1
4
9
16
25
36
49
64
81
100
121
144
169
196
2
∑ T = 1,015
421,600 – 14 x 7.5 x 3,464
=
1,015 – 14 x 7.5 x 7.5
57,880
=
= 254
227.5
a = Y – bT
= 3,464 – 254 (7.5)
= 1,559
Thus linear regression is
Y = 1,559 + 254 T
2. In general, in exponential smoothing the forecast for t + 1 is
Ft + 1 = Ft + α et
Where Ft + 1 = forecast for year )
α = smoothing parameter
et = error in the forecast for year t = St = Ft
F1 is given to be 2100 and α is given to be 0.3
The forecasts for periods 2 to 14 are calculated below:
1
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Period t
Data (St)
Forecast
(Ft)
Error
(et St =Ft)
Forecast for t + 1
(Ft + 1 = Ft + α et)
1
2
3
4
5
6
7
8
9
10
11
12
13
2,000
2,200
2,100
2,300
2,500
3,200
3,600
4,000
3,900
4,000
4,200
4,300
4,900
2100.0
2070
2109.0
2111.7
2168.19
2267.7
2547.4
2863.2
3204.24
3413
3589.1
3772.4
3930.7
100
130
9
188.3
331.81
932.3
1052.6
1136.8
695.76
587.0
610.9
527.6
969.3
F2 = 2100 + 0.3 (100) = 2070
F3 = 2070 + 0.3(130) = 2109
F4 = 2109 + 0.3 (9) = 2111.7
F5 = 2111.7 + 0.3(188.3) = 2168.19
F6 = 2168.19 + 0.3(331.81) = 2267.7
F7 = 2267.7 + 0.3(9332.3) = 2547.4
F8 = 2547.4 + 0.3(1052.6) = 2863.2
F9 = 2863.2 + 0.3(1136.8) = 3204.24
F10 = 33204.24 + 0.3(695.76) = 3413.0
F11 = 3413.0 + 0.3(587) = 3589.1
F12 = 3589.1 + 0.3(610.9) = 3773.4
F13 = 3772.4 + 0.3(527.6) = 3930.7
F14 = 3930.7 + 0.3(969.3) = 4221.5
3. According to the moving average method
St + S t – 1 +…+ S t – n +1
Ft + 1 =
n
where Ft + 1 = forecast for the next period
St = sales for the current period
n = period over which averaging is done
Given n = 3, the forecasts for the period 4 to 14 are given below:
Period t
Data (St)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
2,000
2,200
2,100
2,300
2,500
3,200
3,600
4,000
3,900
4,000
4,200
4,300
4,900
5,300
Forecast
(Ft)
2100
2200
2300
2667
3100
3600
3833
3967
4033
4167
4467
Forecast for t + 1
Ft + 1 = (St+ S t – 1 + S t – 2)/ 3
F4 = (2000 + 2200 + 2100)/3 = 2100
F5 =(2200 + 2100 + 2300)/3= 2200
F6 = (2100 + 2300 + 2500)/3 = 2300
F7 = (2300 + 2500 + 3200)/3= 2667
F8 = (2500 + 3200 + 3600)/3 = 3100
F9 = (3200 + 3600 + 4000)/3 = 3600
F10 = (3600 + 4000 + 3900)/3 = 3833
F11 = (4000 + 3900 + 4000)/3 =3967
F12 =(3900 + 4000 + 4200)/3 = 4033
F13 = (4000 + 4200 + 4300)/3 = 4167
F14 = (4200 + 4300 + 4900) = 4467
4.
Q1 = 60
Q2 = 70
I1 = 1000
I2 = 1200
2
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Income Elasticity of Demand E1 =
Q1 – Q2
x
I2  I1
E1 = Income Elasticity of Demand
Q1 = Quantity demanded in the base year
Q2 = Quantity demanded in the following year
I1 = Income level in base year
I2 = Income level in the following year
70 – 60
E1 =
I1 + I2
Q2 – Q1
1000 + 1200
x
1200 – 1000
70 + 60
22000
E1 =
= 0.846
26000
5.
P1 = Rs.40
P2 = Rs.50
Q1 = 1,00,000
Q2 = 95,000
Price Elasticity of Demand = Ep =
Q2 – Q1
P2 –P1
x
P1 + P2
Q2 + Q1
P1 , Q1 = Price per unit and quantity demanded in the base year
P2, Q2 = Price per unit and quantity demanded in the following year
Ep = Price Elasticity of Demand
95000  100000
Ep =
40 + 50
x
50  40
95000 + 100000
 45
Ep =
3
=  0.0231
1950
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Chapter 6
1.
FINANCIAL ESTIMATES AND PROJECTIONS
Projected Cash Flow Statement
Sources of Funds
Profit before interest and tax
Depreciation provision for the year
Secured term loan
Total (A)
Disposition of Funds
Capital expenditure
Increase in working capital∗
Repayment of term loan
Interest
Tax
Dividends
Total (B)
Opening cash balance
Net surplus (deficit) (A – B)
Closing cash balance
5.00
4.50
4.50
3.00
6.30
1.05
24.35
4.5
1.5
1.0
7.0
1.50
0.35
0.50
1.20
1.80
1.00
6.35
1.00
0.65
1.65
Projected Balance Sheet
Liabilities
Share capital
Reserves & surplus
Secured loans
Unsecured loans
Current liabilities
& provisions
(Rs. in million)
(Rs. in million)
Assets
Fixed assets
11.00
Investments
.50
Current assets
12.85
* Cash
1.65
* Receivables 4.20
* Inventories 7.00
24.35
2.
Projected Income Statement for the 1st Operating Year
Rs.
Sales
4,500
Cost of sales
3,000
Depreciation
319
Interest
1,044
Write off of Preliminary expenses
15
Net profit
122
Projected Cash Flow Statements
Construction period
Sources
Share capital
1800
Term loan
3000
Shortterm bank borrowing
1st Operating year
600
1800
∗
Working capital here is defined as :
(Current assets other than cash) – (Current liabilities other than bank borrowings)
In this case inventories increase by 0.5 million, receivables increase by 0.2 million and current liabilities and provisions
increase by 0.35 million. So working capital increases by 0.35 million
4
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Profit before interest and tax
Depreciation
Write off preliminary expenses
Uses
Capital expenditure
Current assets (other than cash)
Interest
Preliminary expenses
Preoperative expenses
Opening cash balance
Net surplus / deficit
Closing balance
Projected Balance Sheet
Liabilities
Share capital
Reserves & surplus
Secured loans :
 Term loan
Shortterm bank
borrowing
Unsecured loans
Current liabilities
provisions
31/3/n+1
1800

4800
1166
319
15
3900
3900
150
600
4650
0
150
150
2400
1044
3444
150
456
606
31/3/n+2
1800
122
3000
3600
1800


and
4800
7322
Assets
Fixed assets (net)
31/3/n+1
4500
31/3/n+2
4181
Current assets
 Cash
Other current assets
150
606
2400
Miscellaneous
expenditures & losses
Preliminary 150
expenses
4800
Notes :
i.
Allocation of Preoperative Expenses: Rs.
Type
Costs before
allocation
Land
120
Building
630
Plant & machinery
2700
Miscellaneous fixed assets
450
3900
ii.
iii.
5
Depreciation Schedule:
Land Building
Opening balance 139
727
Depreciation
25
Closing balance 139
702
Allocation
Plant & machinery
3115
252
2863
19
97
415
69
600
135
7322
Costs after
allocation
139
727
3115
519
4500
M. Fixed assets
519
42
477
Total (Rs.)
4500
319
4181
Interest Schedule:
Interest on term loan of Rs.3600 @20%
= Rs.720
Interest on short term bank borrowings of Rs,1800 @ 18% = Rs.324
= Rs.1044
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Chapter 7
1.
2.
THE TIME VALUE OF MONEY
Value five years hence of a deposit of Rs.1,000 at various interest rates is as follows:
r
=
8%
FV5
=
=
1000 x FVIF (8%, 5 years)
1000 x 1.469 =
Rs.1469
r
=
10%
FV5
=
=
1000 x FVIF (10%, 5 years)
1000 x 1.611 =
Rs.1611
r
=
12%
FV5
=
=
1000 x FVIF (12%, 5 years)
1000 x 1.762 =
Rs.1762
r
=
15%
FV5
=
=
1000 x FVIF (15%, 5 years)
1000 x 2.011 =
Rs.2011
Rs.160,000 / Rs. 5,000 = 32 = 25
According to the Rule of 72 at 12 percent interest rate doubling takes place
approximately in 72 / 12 = 6 years
So Rs.5000 will grow to Rs.160,000 in approximately 5 x 6 years = 30 years
3.
In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 23 times the initial
Hence doubling takes place in 12 / 3 = 4 years.
deposit.
According to the Rule of 69, the doubling period is:
0.35 + 69 / Interest rate
Equating this to 4 and solving for interest rate, we get
Interest rate = 18.9%.
4.
Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is equivalent to
saving Rs.2000 a year for 15 years and Rs.1000 a year for the years 6 through 15.
Hence the savings will cumulate to:
2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)
=
2000 x 31.772 + 1000 x 15.937
=
Rs.79481.
5.
6.
6
Let A be the annual savings.
A x FVIFA (12%, 10 years) =
A x 17.549
=
1,000,000
1,000,000
So A = 1,000,000 / 17.549 =
Rs.56,983.
1,000 x FVIFA (r, 6 years)
=
10,000
FVIFA (r, 6 years)
=
10,000 / 1000 = 10
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
From the tables we find that
FVIFA (20%, 6 years)
FVIFA (24%, 6 years)
=
=
9.930
10.980
Using linear interpolation in the interval, we get:
20% + (10.000 – 9.930)
r=
x 4% = 20.3%
(10.980 – 9.930)
7.
1,000 x FVIF (r, 10 years)
FVIF (r,10 years)
=
=
From the tables we find that
FVIF (16%, 10 years) =
FVIF (18%, 10 years) =
5,000
5,000 / 1000 = 5
4.411
5.234
Using linear interpolation in the interval, we get:
(5.000 – 4.411) x 2%
r = 16% +
= 17.4%
(5.234 – 4.411)
8.
9.
The present value of Rs.10,000 receivable after 8 years for various discount rates (r ) are:
r = 10%
PV
= 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670
r = 12%
PV
r = 15%
PV
= 10,000 x PVIF (r = 12%, 8 years)
= 10,000 x 0.404 = Rs.4,040
= 10,000 x PVIF (r = 15%, 8 years)
= 10,000 x 0.327 = Rs.3,270
Assuming that it is an ordinary annuity, the present value is:
2,000 x PVIFA (10%, 5years)
= 2,000 x 3.791 = Rs.7,582
10.
The present value of an annual pension of Rs.10,000 for 15 years when r = 15% is:
10,000 x PVIFA (15%, 15 years)
= 10,000 x 5.847 = Rs.58,470
The alternative is to receive a lumpsum of Rs.50,000.
Obviously, Mr. Jingo will be better off with the annual pension amount of Rs.10,000.
11.
7
The amount that can be withdrawn annually is:
100,000
100,000
A =   =  = Rs.10,608
PVIFA (10%, 30 years)
9.427
By M. Iftikhar Mubbashir
Problems’ Solutions
12.
Project Evaluation
The present value of the income stream is:
1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)
+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)
= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.
13.
The present value of the income stream is:
2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)
= 2,000 x 3.791 + 3000/0.10 x 0.621
= Rs.26,212
14.
To earn an annual income of Rs.5,000 beginning from the end of 15 years from now, if the
deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000
is required at the end of 14 years. The amount that must be deposited to get this
Rs.50,000 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165
15.
Rs.20,000 = Rs.4,000 x PVIFA (r, 10 years)
PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00
From the tables we find that:
PVIFA (15%, 10 years)
PVIFA (18%, 10 years)
=
=
5.019
4.494
Using linear interpolation we get:
r = 15% +
5.019 – 5.00
5.019 – 4.494
x 3%
= 15.1%
16.
PV (Stream A) = Rs.100 x PVIF (12%, 1 year) + Rs.200 x
PVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 x
PVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +
Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +
Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +
Rs.1,000 x PVIF (12%, 10 years)
= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712
+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507
+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361
+ Rs.1,000 x 0.322
= Rs.2590.9
Similarly,
PV (Stream B) = Rs.3,625.2
8
By M. Iftikhar Mubbashir
sum is:
Problems’ Solutions
Project Evaluation
PV (Stream C) = Rs.2,851.1
17.
FV5
=
=
=
=
Rs.10,000 [1 + (0.16 / 4)]5x4
Rs.10,000 (1.04)20
Rs.10,000 x 2.191
Rs.21,910
18.
FV5
=
=
=
=
Rs.5,000 [1+( 0.12/4)] 5x4
Rs.5,000 (1.03)20
Rs.5,000 x 1.806
Rs.9,030
19.
A
B
C
Stated rate (%)
12
24
24
Frequency of compounding 6 times
4 times
12 times
6
4
Effective rate (%)
(1 + 0.12/6)  1 (1+0.24/4) –1 (1 + 0.24/12)121
= 12.6
= 26.2
= 26.8
Difference between the
effective rate and stated
rate (%)
0.6
2.2
2.8
20.
Investment required at the end of 8th year to yield an income of Rs.12,000 per year from
the end of 9th year (beginning of 10th year) for ever:
Rs.12,000 x PVIFA(12%, ∞ )
= Rs.12,000 / 0.12 = Rs.100,000
To have a sum of Rs.100,000 at the end of 8th year , the amount to be deposited
Rs.100,000
Rs.100,000
=
PVIF(12%, 8 years)
21.
now is:
= Rs.40,388
2.476
The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of Rs.5,000 now is:
Rs.5,000 x FVIF (r,10 years) = Rs.20,000
Rs.20,000
FVIF (r,10 years) =
= 4.000
Rs.5,000
From the tables we find that
FVIF (15%, 10 years) = 4.046
This means that the implied interest rate is nearly 15%.
I would choose Rs.20,000 for 10 years from now because I find a return of 15% quite
acceptable.
22.
9
FV10
= Rs.10,000 [1 + (0.10 / 2)]10x2
= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653
= Rs.26,530
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in terms of
the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283
23.
A constant deposit at the beginning of each year represents an annuity due.
PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should be
A
=
Rs.50,000
FVIFA(12%, 10 years) x (1.12)
Rs.50,000
=
= Rs.2544
17.549 x 1.12
24.
The discounted value of Rs.20,000 receivable at the beginning of each year from 2005 to
2009, evaluated as at the beginning of 2004 (or end of 2003) is:
=
Rs.20,000 x PVIFA (12%, 5 years)
Rs.20,000 x 3.605 = Rs.72,100.
The discounted value of Rs.72,100 evaluated at the end of 2000 is
=
Rs.72,100 x PVIF (12%, 3 years)
Rs.72,100 x 0.712 = Rs.51,335
If A is the amount deposited at the end of each year from 1995 to 2000 then
A x FVIFA (12%, 6 years) = Rs.51,335
A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115
= Rs.6326
25.
The discounted value of the annuity of Rs.2000 receivable for 30 years, evaluated as at the
end of 9th year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854
The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)
=
Rs.18,854 x 0.424
=
Rs.7,994
26.
30 percent of the pension amount is
0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate of
12% is 1%, the discounted value of an annuity of Rs.180 receivable at the end of each
month for 180 months (15 years) is:
Rs.180 x PVIFA (1%, 180)
Rs.180 x
10
(1.01)180  1
 = Rs.14,998
.01 (1.01)180
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%
P x (1.01)60 =
P x 1.817
=
P
27.
=
Rs.14,998
Rs.14,998
Rs.14,998
 = Rs.8254
1.817
Rs.300 x PVIFA(r, 24 months) = Rs.6,000
PVIFA (4%,24) =
Rs.6000 / Rs.300
From the tables we find that:
PVIFA(1%,24)
=
PVIFA (2%, 24)
=
= 20
21.244
18.914
Using a linear interpolation
r = 1% +
21.244 – 20.000
21.244 – 18,914
x 1%
= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)12 – 1 ] x 100 = 20%
28.
The discounted value of the debentures to be redeemed between 8 to 10 years evaluated at
the end of the 5th year is:
Rs.10 million x PVIF (8%, 3 years)
+ Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)
= Rs.10 million (0.794 + 0.735 + 0.681)
= Rs.2.21 million
If A is the annual deposit to be made in the sinking fund for the years 1 to 5, then
A x FVIFA (8%, 5 years) = Rs.2.21 million
A x 5.867 = Rs.2.21 million
A = 5.867 = Rs.2.21 million
A = Rs.2.21 million / 5.867 = Rs.0.377 million
29.
Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 5.000
From the tables we find that
PVIFA (10%, 7 years) =
4.868
PVIFA (10%, 8 years) =
5.335
Thus n is between 7 and 8. Using a linear interpolation we get
11
By M. Iftikhar Mubbashir
Problems’ Solutions
n=7+
30.
Project Evaluation
5.000 – 4.868
 x 1 = 7.3 years
5.335 – 4.868
Equated annual installment
= 500000 / PVIFA(14%,4)
= 500000 / 2.914
= Rs.171,585
Loan Amortization Schedule
Year
1
2
3
4
Beginning
amount
500000
398415
282608
150588
Annual
installment
171585
171585
171585
171585
Interest
70000
55778
39565
21082
Principal
repaid
101585
115807
132020
150503
Remaining
balance
398415
282608
150588
85*
(*) rounding off error
31.
Define n as the maturity period of the loan. The value of n can be obtained from the
equation.
200,000 x PVIFA(13%, n) =
1,500,000
PVIFA (13%, n)
=
7.500
From the tables or otherwise it can be verified that PVIFA(13,30) = 7.500
Hence the maturity period of the loan is 30 years.
32.
Expected value of iron ore mined during year 1
=
Rs.300 million
Expected present value of the iron ore that can be mined over the next 15 years
a price escalation of 6% per annum in the price per ton of iron
= Rs.300 million x
1 – (1 + g)n / (1 + i)n
ig
= Rs.300 million x
1 – (1.06)15 / (1.16)15
0.16 – 0.06
= Rs.300 million x (0.74135 / 0.10)
= Rs.2224 million
12
By M. Iftikhar Mubbashir
assuming
Problems’ Solutions
Project Evaluation
Chapter 8
1.(a)
INVESTMENT CRITERIA
NPV of the project at a discount rate of 14%.
=
100,000
200,000
 1,000,000 +  + (1.14)
(1.14)2
300,000
600,000
300,000
+  +  + (1.14)3
(1.14)4
(1.14)5
=
(b)
 44837
NPV of the project at time varying discount rates
=
 1,000,000
100,000
+
(1.12)
200,000
+
(1.12) (1.13)
300,000
+
(1.12) (1.13) (1.14)
600,000
+
(1.12) (1.13) (1.14) (1.15)
300,000
+
(1.12) (1.13) (1.14)(1.15)(1.16)
=
=
2.
 1,000,000 + 89286 + 158028 + 207931 + 361620 + 155871
 27264
Investment A
a)
Payback period
b)
NPV
c)
=
5 years
=
40000 x PVIFA (12%,10) – 200 000
=
26000
IRR (r ) can be obtained by solving the equation:
40000 x PVIFA (r, 10)
=
200000
i.e., PVIFA (r, 10)
=
5.000
From the PVIFA tables we find that
PVIFA (15%,10)
13
=
5.019
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
PVIFA (16%,10)
=
4.883
Linear interpolation in this range yields
d)
r =
=
15 + 1 x (0.019 / 0.136)
15.14%
BCR
=
=
=
Benefit Cost Ratio
PVB / I
226,000 / 200,000 = 1.13
Investment B
a)
Payback period
b)
9 years
NP V =
40,000 x PVIFA (12%,5)
+ 30,000 x PVIFA (12%,2) x PVIF (12%,5)
+ 20,000 x PVIFA (12%,3) x PVIF (12%,7)
 300,000
=
(40,000 x 3.605) + (30,000 x 1.690 x 0.567)
+ (20,000 x 2.402 x 0.452) – 300,000
 105339
=
c)
=
IRR (r ) can be obtained by solving the equation
40,000 x PVIFA (r, 5) + 30,000 x PVIFA (r, 2) x PVIF (r,5) +
20,000 x PVIFA (r, 3) x PVIF (r, 7) = 300,000
Through the process of trial and error we find that
r = 1.37%
d)
BCR
=
=
PVB / I
194,661 / 300,000
= 0.65
Investment C
a)
Payback period lies between 2 years and 3 years. Linear interpolation in
This range provides an approximate payback period of 2.88 years.
b)
c)
NPV
=
80.000 x PVIF (12%,1) + 60,000 x PVIF (12%,2)
+ 80,000 x PVIF (12%,3) + 60,000 x PVIF (12%,4)
=
+ 80,000 x PVIF (12%,5) + 60,000 x PVIF (12%,6)
+ 40,000 x PVIFA (12%,4) x PVIF (12%,6)
 210,000
111,371
IRR (r) is obtained by solving the equation
80,000 x PVIF (r,1) + 60,000 x PVIF (r,2) + 80,000 x PVIF (r,3)
+ 60,000 x PVIF (r,4) + 80,000 x PVIF (r,5) + 60,000 x PVIF (r,6)
+ 40000 x PVIFA (r,4) x PVIF (r,6) = 210000
Through the process of trial and error we get
r = 29.29%
14
By M. Iftikhar Mubbashir
Problems’ Solutions
d)
Project Evaluation
BCR =
PVB / I =
321,371 / 210,000
=
1.53
Investment D
a)
Payback period lies between 8 years and 9 years. A linear interpolation in this range
provides an approximate payback period of 8.5 years.
8 + (1 x 100,000 / 200,000)
b)
NPV
=
=
c)
200,000 x PVIF (12%,1)
+ 20,000 x PVIF (12%,2) + 200,000 x PVIF (12%,9)
+ 50,000 x PVIF (12%,10)
 320,000
 37,160
IRR (r ) can be obtained by solving the equation
200,000 x PVIF (r,1) + 200,000 x PVIF (r,2)
+ 200,000 x PVIF (r,9) + 50,000 x PVIF (r,10)
=
320000
Through the process of trial and error we get r = 8.45%
d)
BCR =
PVB / I
Comparative Table
Investment
a) Payback period (in years)
b) NPV @ 12%
c) IRR (%)
d) BCR
=
A
5
26000
15.14
1.13
282,840 / 320,000
B
9
105339
1.37
0.65
=
0.88
C
2.88
111371
29.29
1.53
D
8.5
37160
8.45
0.88
Among the four alternative investments, the investment to be chosen is ‘C’ because it has
the
a. Lowest payback period
b. Highest NPV
c. Highest IRR
d. Highest BCR
3.
IRR (r) can be calculated by solving the following equations for the value of r.
60000 x PVIFA (r,7) =
300,000
i.e., PVIFA (r,7)
=
5.000
Through a process of trial and error it can be verified that r = 9.20% p.a.
4.
The IRR (r) for the given cash flow stream can be obtained by solving the following
equation for the value of r.
3000 + 9000 / (1+r) – 3000 / (1+r) = 0
Simplifying the above equation we get
r = 1.61, 0.61; (or) 161%, ()61%
Note: Given two changes in the signs of cash flow, we get two values for the IRR of the
cash flow stream. In such cases, the IRR rule breaks down.
5.
15
Define NCF as the minimum constant annual net cash flow that justifies the purchase of the
given equipment. The value of NCF can be obtained from the equation
NCF x PVIFA (10%,8)
=
500000
By M. Iftikhar Mubbashir
Problems’ Solutions
NCF
Project Evaluation
=
=
500000 / 5.335
93271
6.
Define I as the initial investment that is justified in relation to a net annual cash inflow of
25000 for 10 years at a discount rate of 12% per annum. The value of I can be obtained
from the following equation
25000 x PVIFA (12%,10)
=
I
i.e., I
=
141256
7.
PV of benefits (PVB) =
+
+
+
+
=
Investment
=
Benefit cost ratio
=
8.
25000 x PVIF (15%,1)
40000 x PVIF (15%,2)
50000 x PVIF (15%,3)
40000 x PVIF (15%,4)
30000 x PVIF (15%,5)
122646
100,000
1.23 [= (A) / (B)]
The NPV’s of the three projects are as follows:
Project
P
Q
Discount rate
0%
400
500
5%
223
251
10%
69
40
15%
 66
 142
25%
 291
 435
30%
 386
 555
(A)
(B)
R
600
312
70
 135
 461
 591
9.
(a)
NPV profiles for Projects P and Q for selected discount rates are as follows:
Project
P
Q
Discount rate (%)
0
2950
500
5
1876
208
10
1075
 28
15
471
 222
20
11
 382
b)
(i)
The IRR (r ) of project P can be obtained by solving the following
equation for `r’.
1000 1200 x PVIF (r,1) – 600 x PVIF (r,2) – 250 x PVIF (r,3)
+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5)
=
0
Through a process of trial and error we find that r = 20.13%
(ii)
The IRR (r') of project Q can be obtained by solving the following equation for r'
1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5)
=
0
Through a process of trial and error we find that r' = 9.34%.
16
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
c)
From (a) we find that at a cost of capital of 10%
NPV (P)
=
1075
NPV (Q)
=
 28
Given that NPV (P), NPV (Q) and NPV (P) > 0, I would choose project P.
From (a) we find that at a cost of capital of 20%
NPV (P)
=
11
NPV (Q)
=
 382
Again NPV (P) > NPV (Q); and NPV (P) > 0. I would choose project P.
d)
Project P
PV of investmentrelated costs
=
1000 x PVIF (12%,0)
+ 1200 x PVIF (12%,1) + 600 x PVIF (12%,2)
+ 250 x PVIF (12%,3)
=
2728
TV of cash inflows =
2000 x (1.12) + 4000 =
6240
The MIRR of the project P is given by the equation:
2728 =
6240 x PVIF (MIRR,5)
(1 + MIRR)5 =
2.2874
MIRR = 18%
(c)
10.
(a)
Project Q
PV of investmentrelated costs
=
1600
TV of cash inflows @ 15% p.a.
=
2772
The MIRR of project Q is given by the equation:
16000 (1 + MIRR)5 =
2772
MIRR
=
11.62%
Project A
NPV at a cost of capital of 12%
=
 100 + 25 x PVIFA (12%,6)
=
Rs.2.79 million
IRR (r ) can be obtained by solving the following equation for r.
25 x PVIFA (r,6)
=
100
i.e., r = 12,98%
Project B
NPV at a cost of capital of 12%
=
 50 + 13 x PVIFA (12%,6)
=
Rs.3.45 million
IRR (r') can be obtained by solving the equation
13 x PVIFA (r',6)
=
50
i.e.,
r' = 14.40% [determined through a process of trial and error]
(b)
17
Difference in capital outlays between projects A and B is Rs.50 million
Difference in net annual cash flow between projects A and B is Rs.12 million.
NPV of the differential project at 12%
=
50 + 12 x PVIFA (12%,6)
=
Rs.3.15 million
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6) =
50
i.e.,
r''
=
11.53%
11.
(a)
Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period of 2.63 years.
Project N
The pay back period lies between 1 and 2 years. Interpolating in this range we
get an approximate pay back period of 1.55 years.
(b)
Project M
Cost of capital
PV of cash flows up to the end of year 2
PV of cash flows up to the end of year 3
PV of cash flows up to the end of year 4
=
=
=
=
12% p.a
24.97
47.75
71.26
Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in this range
we get an approximate DPB of 3.1 years.
Project N
Cost of capital
PV of cash flows up to the end of year 1
PV of cash flows up to the end of year 2
=
=
=
12% per annum
33.93
51.47
DPB lies between 1 and 2 years. Interpolating in this range we get an approximate DPB of
1.92 years.
(c)
Project M
Cost of capital
NPV
=
=
=
Project N
Cost of capital
NPV
12% per annum
 50 + 11 x PVIFA (12%,1)
+ 19 x PVIF (12%,2) + 32 x PVIF (12%,3)
+ 37 x PVIF (12%,4)
Rs.21.26 million
= 12% per annum
= Rs.20.63 million
Since the two projects are independent and the NPV of each project is (+) ve, both the
projects can be accepted. This assumes that there is no capital constraint.
(d)
18
Project M
Cost of capital
NPV
= 10% per annum
= Rs.25.02 million
Project N
Cost of capital
NPV
= 10% per annum
= Rs.23.08 million
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Since the two projects are mutually exclusive, we need to choose the project with the higher
NPV i.e., choose project M.
Note : The MIRR can also be used as a criterion of merit for choosing between the two
projects because their initial outlays are equal.
(e)
Project M
Cost of capital =
NPV
=
15% per annum
16.13 million
Project N
Cost of capital:
NPV
=
15% per annum
Rs.17.23 million
Again the two projects are mutually exclusive. So we choose the project with the higher
NPV, i.e., choose project N.
(f)
Project M
Terminal value of the cash inflows: 114.47
MIRR of the project is given by the equation
50 (1 + MIRR)4
=
114.47
i.e., MIRR = 23.01%
Project N
Terminal value of the cash inflows: 115.41
MIRR of the project is given by the equation
50 ( 1+ MIRR)4
=
115.41
i.e., MIRR
=
23.26%
12.
The internal rate of return is the value of r in the equation
2,000
1,000
10,000
2,000
8000 =
+
+
(1+r)
(1+r)2
(1+r)3
(1+r)4
At r = 18%, the right hand side is equal to 8099
At r = 20%, the right hand side is equal to 7726
Thus the solving value of r is:
8,099 – 8,000
18% +
x 2% = 18.5%
8,099 – 7,726
Unrecovered Investment Balance
Year
Unrecovered
Interest for the
Cash flow at the
investment balance at
year Ft1 (1+r) end of the year CFt
the beginning Ft1
1
2
3
4
19
8000
7480
9863.8
1688.60
1480
1383.8
1824.80
312.39
2000
1000
10000
2000
Unrecovered
investment balance at
the end of the year Ft1
(1+r) + CFt
7480
9863.8
1688.60
0
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
13.
Rs. in lakhs
Year
Investment
Depreciation
Income before
interest and tax
Interest
Income before tax
Tax
Income after tax
1
24.0
3.0
6.0
2
21.0
3.0
6.5
3
18.0
3.0
7.0
4
15.0
3.0
7.0
5
12.0
3.0
7.0
6
9.0
3.0
6.5
7
6.0
3.0
6.0
8
3.0
3.0
5.0
Sum
108
24.0
51.0
Average
13.500
3.000
6.375
2.5
3.5
3.5
2.5
4.0
1.0
3.0
2.5
4.5
2.5
2.0
2.5
4.5
2.5
2.0
2.5
4.5
2.5
2.0
2.5
4.0
2.2
1.8
2.5
3.5
1.9
1.6
2.5
2.5
1.4
1.1
20.0
31.0
14.0
17.0
2.500
3.875
1.750
2.125
Measures of Accounting Rate of Return
A.
Average income after tax
2.125
=
Initial investment
B.
= 8.9%
24
Average income after tax
2.125
=
Average investment
C.
= 15.7%
13.5
Average income after tax but before interest
2.125 + 2.5
=
= 19.3%
Initial investment
D.
24
Average income after tax but before interest
2.125 + 2.5
=
= 34.3%
Average investment
E.
13.5
Average income before interest and taxes
6.375
=
Initial investment
F.
= 26.6%
24
Average income before interest and taxes
6.375
=
Average investment
G.
= 47.2%
13.5
Total income after tax but before
Depreciation – Initial investment
17.0 + 24.0 – 24.0
=
(Initial investment / 2) x Years
20
(24 / 2) x 8
= 17.0 / 96.0 = 17.7%
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Chapter 9
1.
(a)
PROJECT CASH FLOWS
Project Cash Flows
Year
0
1. Plant & machinery
(150)
(Rs. in million)
1
2
3
4
5
6
7
3. Revenues
250
250
250
250
250
250
250
4. Costs (excluding depreciation & interest)
100
100
100
100
100
100
100
5. Depreciation
37.5
28.13 21.09 15.82 11.87 8.90
6.67
6. Profit before tax
112.5 121.87 128.91 134.18 138.13 141.1 143.33
7. Tax
33.75 36.56 38.67 40.25 41.44 42.33 43.0
8. Profit after tax
78.75 85.31 90.24 93.93 96.69 98.77 100.33
2. Working capital
(50)
9. Net salvage value of
plant & machinery
48
10. Recovery of working
capital
11. Initial outlay (=1+2)
12. Operating CF (= 8 + 5)
50
(200)
116.25 113.44 111.33 109.75 108.56 107.67 107.00
13. Terminal CF ( = 9 +10)
98
14.
NCF
(200) 116.25 113.44 111.33 109.75 108.56 107.67 205
(c)
IRR (r) of the project can be obtained by solving the following equation for r
200 + 116.25 x PVIF (r,1) + 113.44 x PVIF (r,2)
+ 111.33 x PVIF (r,3) + 109.75 x PVIF (r,4) + 108.56 x PVIF (r,5)
+107.67 x PVIF (r,6) + 205 x PVIF (r,7)
=
0
Through a process of trial and error, we get r = 55.17%. The IRR of the project is
55.17%.
21
By M. Iftikhar Mubbashir
Problems’ Solutions
2.
Project Evaluation
Posttax Incremental Cash Flows
Year
0
1
2
3
(Rs. in million)
4
5
6
7
1. Capital equipment
(120)
2. Level of working capital
20
30
40
50
40
30
20
(ending)
3. Revenues
80
120
160
200
160
120
80
4. Raw material cost
24
36
48
60
48
36 24
5. Variable mfg cost.
8
12
16
20
16
12
8
6. Fixed operating & maint.
10
10
10
10
10
10
10
cost
7. Variable selling expenses
8
12
16
20
16
12
8
8. Incremental overheads
4
6
8
10
8
6
4
9. Loss of contribution
10
10
10
10
10
10 10
10.Bad debt loss
4
11. Depreciation
30
22.5 16.88 12.66 9.49 7.12 5.34
12. Profit before tax
14
11.5 35.12 57.34 42.51 26.88 6.66
13. Tax
 4.2
3.45 10.54 17.20 12.75 8.06 2.00
14. Profit after tax
 9.8
8.05 24.58 40.14 29.76 18.82 4.66
15. Net salvage value of
capital equipments
25
16. Recovery of working
16
capital
17. Initial investment
(120)
18. Operating cash flow
20.2
30.55 41.46 52.80 39.25 25.94 14.00
(14 + 10+ 11)
19. ∆ Working capital
20 10
10
10
(10) (10) (10)
20. Terminal cash flow
41
21. Net cash flow
(17+1819+20)
(b)
3.
(a)
20.55 31.46 62.80 49.25 35.94 55.00
NPV of the net cash flow stream @ 15% per discount rate
=
140 + 10.20 x PVIF(15%,1) + 20.55 x PVIF (15%,2)
+ 31.46 x PVIF (15%,3) + 62.80 x PVIF (15%,4) + 49.25 x PVIF
(15%,5)
+ 35.94 x PVIF (15%,6) + 55 x PVIF (15%,7)
=
Rs.1.70 million
A.
Initial outlay (Time 0)
i.
ii.
iii
iv.
22
(140) 10.20
Cost of new machine
Salvage value of old machine
Incremental working capital requirement
Total net investment (=i – ii + iii)
Rs.
3,000,000
900,000
500,000
2,600,000
By M. Iftikhar Mubbashir
Problems’ Solutions
B.
Project Evaluation
Operating cash flow (years 1 through 5)
Year
1
2
3
4
5
i. Posttax savings in
manufacturing costs 455,000
455,000
455,000
455,000
455,000
ii. Incremental
depreciation
550,000
412,500
309,375
232,031
174,023
iii. Tax shield on
incremental dep.
165,000
123,750
92,813
69,609
52,207
iv. Operating cash
flow ( i + iii)
620,000
578,750
547,813
524,609
507,207
C.
Terminal cash flow (year 5)
i.
ii.
iii.
iv.
D.
Year
NCF
Salvage value of new machine
Salvage value of old machine
Recovery of incremental working capital
Terminal cash flow ( i – ii + iii)
Rs.
1,500,000
200,000
500,000
1,800,000
Net cash flows associated with the replacement project (in Rs)
0
(2,600,000)
1
2
3
4
620000
578750
547813
524609
(b)
NPV of the replacement project
=
 2600000 + 620000 x PVIF (14%,1)
+ 578750 x PVIF (14%,2)
+ 547813 x PVIF (14%,3)
+ 524609 x PVIF (14%,4)
+ 2307207 x PVIF (14%,5)
=
Rs.267849
4.
Tax shield (savings) on depreciation (in Rs)
Year
Depreciation
charge (DC)
Tax shield
=0.4 x DC
PV of tax shield
@ 15% p.a.
1
2
3
4
5
25000
18750
14063
10547
7910
10000
7500
5625
4219
3164
8696
5671
3699
2412
1573
22051
5
307207
Present value of the tax savings on account of depreciation = Rs.22051
23
By M. Iftikhar Mubbashir
Problems’ Solutions
5.
A.
Project Evaluation
Initial outlay (at time 0)
i.
ii.
iii.
B.
Cost of new machine
Salvage value of the old machine
Net investment
1
2
3
4
5
i. Depreciation
of old machine
18000
14400
11520
9216
7373
ii. Depreciation
of new machine
100000
75000
56250
42188
31641
iii. Incremental depreciation ( ii – i)
82000
60600
44730
32972
24268
iv. Tax savings on incremental depreciation
( 0.35 x (iii))
28700
21210
15656
11540
8494
v. Operating cash flow
21210
15656
11540
8494
C.
D.
Year
NCF
6.
Particulars
28700
Terminal cash flow (year 5)
i.
ii.
iii.
Salvage value of new machine
Salvage value of old machine
Incremental salvage value of new
machine = Terminal cash flow
Rs.
25000
10000
15000
Net cash flows associated with the replacement proposal.
0
(310000)
1
28700
2
3
4
21210
15656
5
11540
23494
Net Cash Flows Relating to Equity
Equity funds
Revenues
Operating costs
Depreciation
Interest on working capital
advance
6. Interest on term loan
7. Profit before tax
8. Tax
9. Profit after tax
10. Preference dividend
11. Net salvage value of fixed assets
12. Net salvage value of current
24
400,000
90,000
310,000
Operating cash flow (years 1 through 5)
Year
1.
2.
3.
4.
5.
Rs.
(Rs. in million)
Year
0
(100)
1
2
3
500
320
83.33
18.00
500
320
55.56
18.00
500
320
37.04
18.00
30.00
48.67
24.335
24.335
28.50
77.94
38.97
38.97
22.50
102.46
51.23
51.23

40
40
4
500
320
24.69
18.00
16.50
120.81
60.405
60.405
40
5
500
320
16.46
18.00
10.50
135.04
67.52
67.52
40
By M. Iftikhar Mubbashir
6
500
320
10.97
18.00
4.50
146.53
73.265
73.265
200
40
Problems’ Solutions
Project Evaluation
assets
13. Repayment of termloans
14. Redemption of preference capital
15. Repayment of shortterm bank
borrowings
16. Retirement of trade creditors
17. Initial investment (1)
18. Operating cash flows (910+4)
19. Liquidation and retirement cash
flows (11+1213141516)
20. Net cash flows (17+18+19)
100
50
(100)
(100)
107.665
107.665
94.53
54.53
88.27
48.27
85.095
45.095
83.98
43.98
84.235
90
107.665
54.53
48.27
45.095
43.98
174.235
Net Cash Flows Relating to Longterm Funds
Particulars
Year
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
Fixed assets
Working capital margin
Revenues
Operating costs
Depreciation
Interest on working capital
advance
Interest on term loan
Profit before tax
Tax @ 50%
Profit after tax
Net salvage value of fixed assets
Net recovery of working capital
margin
Initial investment (1+2)
Operating cash inflow (9+5+7
(1T) )
Terminal cash flow (11+12)
Net cash flow (13+14+15)
0
(250)
(50)
1
500
320
83.33
18.00
2
3
500
320
55.56
18.00
500
320
37.04
18.00
30.00
48.67
24.335
24.335
28.50
77.94
38.97
38.97
22.50
102.46
51.23
51.23
122.665
108.78
122.665
108.78
(Rs. in million)
4
5
500
320
24.69
18.00
6
500
320
16.46
18.00
500
320
10.97
18.00
16.50
120.81
60.405
60.405
10.50
135.04
67.52
67.52
4.50
146.53
73.265
73.265
80
50
99.52
93.345
89.23
86.845
99.52
93.345
89.23
130.00
216.485
(300)
(300)
Cash Flows Relating to Total Funds
(Rs. in million)
Year
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
25
Total funds
Revenues
Operating costs
Depreciation
Interest on term loan
Interest on working capital
advance
Profit before tax
Tax
Profit after tax
Net salvalue of fixed assets
Net salvage value of current assets
Initial investment (1)
Operating cash inflow 9+4+6 (1t)
+ 5(1t)
Terminal cash flow (10+11)
Net cash flow (12+13+14)
0
(450)
1
2
3
4
5
6
500
320
83.33
30.00
18.00
500
320
55.56
28.50
18.00
500
320
37.04
22.50
18.00
500
320
24.69
16.50
18.00
500
320
16.46
10.50
18.00
500
320
10.97
4.50
18.00
48.67
24.34
24.34
77.94
38.97
38.97
102.46
51.23
51.23
120.81
60.41
60.41
135.04
67.52
67.52
146.53
73.265
73.265
80
200
131.67
117.78
108.52
102.35
98.23
95.485
131.67
117.78
108.52
102.35
98.23
280
375.485
(450)
(450)
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Chapter 11
RISK ANALYSIS OF SINGLE INVESTMENTS
1.
(a)
NPV of the project
(b)
NPVs under alternative scenarios:
=
=
250 + 50 x PVIFA (13%,10)
Rs.21.31 million
Pessimistic
(Rs. in million)
Expected
Optimistic
Investment
Sales
Variable costs
Fixed costs
Depreciation
Pretax profit
Tax @ 28.57%
Profit after tax
Net cash flow
Cost of capital
300
150
97.5
30
30
 7.5
 2.14
 5.36
24.64
14%
250
200
120
20
25
35
10
25
50
13%
200
275
154
15
20
86
24.57
61.43
81.43
12%
NPV
 171.47
21.31
260.10
Assumptions: (1)
The useful life is assumed to be 10 years under all three
scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.
(c)
26
(2)
The investment is assumed to be depreciated at 10% per annum; and
it is also assumed that this method and rate of depreciation are
acceptable to the IT (income tax) authorities.
(3)
The tax rate has been calculated from the given table i.e. 10 / 35 x
100 = 28.57%.
(4)
It is assumed that only loss on this project can be offset against the
taxable profit on other projects of the company; and thus the
company can claim a tax shield on the loss in the same year.
Accounting break even point (under ‘expected’ scenario)
Fixed costs + depreciation
= Rs. 45 million
Contribution margin ratio
= 60 / 200 = 0.3
Break even level of sales
= 45 / 0.3 = Rs.150 million
Financial break even point (under ‘expected’ scenario)
i.
Annual net cash flow
= 0.7143 [ 0.3 x sales – 45 ] + 25
= 0.2143 sales – 7.14
ii.
PV (net cash flows)
= [0.2143 sales – 7.14 ] x PVIFA (13%,10)
= 1.1628 sales – 38.74
iii.
Initial investment
= 200
By M. Iftikhar Mubbashir
Problems’ Solutions
iv.
2.
(a)
Financial break even level of sales
27
30000
42000
28000
3000
2000
9000
4500
4500
6500
30000
54000
36000
3000
2000
13000
6500
6500
8500
16732
 5360
2222
(in Rs)
30000
28000
28000
3000
2000
5000
2500
2500
 500
 31895
30000
42000
28000
3000
2000
9000
4500
4500
6500
() 5360
30000
70000
28000
3000
2000
37000
18500
18500
20500
47711
Sensitivity of NPV with respect to variations in unit variable cost.
Pessimistic Expected
Optimistic
Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV
(d)
30000
24000
16000
3000
2000
3000
1500
1500
3500
= Rs.205.31 million
Sensitivity of NPV with respect to variations in unit price.
Pessimistic Expected
Optimistic
Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV
(c)
= 238.74 / 1.1628
Sensitivity of NPV with respect to quantity manufactured and sold:
Pessimistic Expected
Optimistic
Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV at a cost of
capital of 10% p.a
and useful life of
5 years
(b)
Project Evaluation
30000
42000
56000
3000
2000
11000
5500
5500
3500
43268
Accounting breakeven point
i.
Fixed costs + depreciation
ii.
Contribution margin ratio
30000
42000
28000
3000
2000
9000
4500
4500
6500
 5360
30000
42000
21000
3000
2000
16000
8000
8000
10000
7908
= Rs.5000
= 10 / 30 = 0.3333
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
iii.
Breakeven level of sales
Financial breakeven point
i.
Annual cash flow
ii.
PV of annual cash flow
iii.
iv.
2.
= 5000 / 0.3333 = Rs.15000
= 0.5 x (0.3333 Sales – 5000) = 2000
= (i) x PVIFA (10%,5)
= 0.6318 sales – 1896
= 30000
= 31896 / 0.6318 = Rs.50484
Initial investment
Breakeven level of sales
Define At as the random variable denoting net cash flow in year t.
A1
=
=
4 x 0.4 + 5 x 0.5 + 6 x 0.1
4.7
A2
=
=
5 x 0.4 + 6 x 0.4 + 7 x 0.2
5.8
A3
=
=
3 x 0.3 + 4 x 0.5 + 5 x 0.2
3.9
NPV
σ12
=
=
=
4.7 / 1.1 +5.8 / (1.1)2 + 3.9 / (1.1)3 – 10
Rs.2.00 million
0.41
σ22
σ32
=
=
0.56
0.49
σ2 NPV =
σ12
(1.1)2
σ22
+
(1.1)4
σ32
+
(1.1)6
=
1.00
σ (NPV) = Rs.1.00 million
3.
Expected NPV
4
At
= ∑
 25,000
t=1 (1.08)t
=
12,000/(1.08) + 10,000 / (1.08)2 + 9,000 / (1.08)3
+ 8,000 / (1.08)4 – 25,000
=
[ 12,000 x .926 + 10,000 x .857 + 9,000 x .794 + 8,000 x .735]
 25,000
7,708
=
Standard deviation of NPV
σt
∑
t=1 (1.08)t
4
=
28
5,000 / (1.08) + 6,000 / (1.08)2 + 5,000 / (1,08)3 + 6,000 / (1.08)4
By M. Iftikhar Mubbashir
Problems’ Solutions
=
=
4.
Project Evaluation
5,000 x .926 + 6,000 x .857 + 5000 x .794 + 6,000 x .735
18,152
Expected NPV
4
At
= ∑
 25,000
t
t=1 (1.06)
A1
=
2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3
=
3,100
A2
=
=
3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3
3,900
A3
=
=
4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2
4,900
…. (1)
=
2,000 x 0.2 + 3,000 x 0.4 + 4,000 x 0.4
=
3,200
Substituting these values in (1) we get
A4
Expected NPV = NPV
=
3,100 / (1.06)+ 3,900 / (1.06)2 + 4,900 / (1.06)3 + 3,200 / (1,06)4
 10,000 = Rs.3,044
The variance of NPV is given by the expression
4 σ2t
σ2 (NPV) = ∑
t=1 (1.06)2t
σ12
=
=
σ22
=
=
σ32
=
=
σ42
=
=
…….. (2)
[(2,000 – 3,100)2 x 0.2 + (3,000 – 3,100)2 x 0.5
+ (4,000 – 3,100)2 x 0.3]
490,000
[(3,000 – 3,900)2 x 0.4 + (4,000 – 3,900)2 x 0.3
+ (5,000 – 3900)2 x 0.3]
690,000
[(4,000 – 4,900)2 x 0.3 + (5,000 – 4,900)2 x 0.5
+ (6,000 – 4,900)2 x 0.2]
490,000
[(2,000 – 3,200)2 x 0.2 + (3,000 – 3,200)2 x 0.4
+ (4,000 – 3200)2 x 0.4]
560,000
Substituting these values in (2) we get
490,000 / (1.06)2 + 690,000 / (1.06)4
+ 490,000 / (1.06)6 + 560,000 / (1.08)8
[ 490,000 x 0.890 + 690,000 x 0.792
+ 490,000 x 0.705 + 560,000 x 0.627 ]
= 1,679,150
29
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
σ NPV = 1,679,150 = Rs.1,296
NPV – NPV
Prob (NPV < 0) = Prob.
0  NPV
<
σ NPV
σ NPV
0 – 3044
= Prob
Z<
1296
= Prob (Z < 2.35)
The required probability is given by the shaded area in the following normal
P (Z <  2.35) =
=
=
=
curve.
0.5 – P (2.35 < Z < 0)
0.5 – P (0 < Z < 2.35)
0.5 – 0.4906
0.0094
So the probability of NPV being negative is 0.0094
Prob (P1 > 1.2)
Prob (PV / I > 1.2)
Prob (NPV / I > 0.2)
Prob. (NPV > 0.2 x 10,000)
Prob (NPV > 2,000)
Prob (NPV >2,000)= Prob (Z > 2,000 3,044 / 1,296)
Prob (Z >  0.81)
The required probability is given by the shaded area of the following normal
curve:
P(Z >  0.81) =
0.5 + P(0.81 < Z < 0)
=
0.5 + P(0 < Z < 0.81)
=
0.5 + 0.2910
=
0.7910
So the probability of P1 > 1.2 as 0.7910
5.
Given values of variables other than Q, P and V, the net present value model of Bidhan
Corporation can be expressed as:
5
∑ [Q(P – V) – 3,000 – 2,000] (0.5)+ 2,000
0
t=1
NPV =  +   30,000
(1.1)t
(1.1)5
5
∑
t=1
30
0.5 Q (P – V) – 500
  30,000
(1.1)t
By M. Iftikhar Mubbashir
Problems’ Solutions
=
=
=
Project Evaluation
[ 0.5Q (P – V) – 500] x PVIFA (10,5) – 30,000
[0.5Q (P – V) – 500] x 3.791 – 30,000
1.8955Q (P – V) – 31,895.5
Exhibit 1 presents the correspondence between the values of exogenous variables and the
two digit random number. Exhibit 2 shows the results of the simulation.
Exhibit 1
Correspondence between values of exogenous variables and two digit random numbers
QUANTITY
PRICE
Value
Prob
Cumulative
Prob.
800
1,000
1,200
1,400
1,600
1,800
0.10
0.10
0.20
0.30
0.20
0.10
0.10
0.20
0.40
0.70
0.90
1.00
Two
digit
random
numbers
00 to 09
10 to 19
20 to 39
40 to 69
70 to 89
90 to 99
VARIABLE COST
Value
Prob
Cumulative
Prob.
20
30
40
50
0.40
0.40
0.10
0.10
0.40
0.80
0.90
1.00
Two digit
random
numbers
00 to 39
40 to 79
80 to 89
90 to 99
Value
Prob
15
20
40
0.30
0.50
0.20
Cumul
ative
Prob.
0.30
0.80
1.00
Two
digit
random
numbers
00 to 29
30 to 79
80 to 99
Exhibit 2
Simulation Results
Run
1
2
3
4
5
6
7
8
9
Run
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
31
QUANTITY (Q)
Random CorresNumber ponding
Value
03
800
32
1,200
61
1,400
48
1,400
32
1,200
31
1,200
22
1,200
46
1,400
57
1,400
QUANTITY (Q)
Random CorresNumber ponding
Value
92
1,800
25
1,200
64
1,400
14
1,000
05
800
07
800
34
1,200
79
1,600
55
1,400
57
1,400
53
1,400
36
1,200
32
1,200
49
1,400
21
1,200
08
.800
85
1,600
61
1,400
PRICE (P)
Random
Number
38
69
30
60
19
88
78
11
20
PRICE (P)
Random
Number
77
65
04
51
39
90
63
91
54
12
78
79
22
93
84
70
63
68
Corresponding
value
20
30
20
30
20
40
30
20
20
Corresponding
value
30
30
20
30
20
50
30
50
30
20
30
30
20
50
40
30
30
30
VARIABLE COST (V)
NPV
Random
Corres1.8955 Q(PV)31,895.5
Number
ponding
value
17
15
24,314
24
15
2,224
03
15
18,627
83
40
58,433
11
15
20,523
30
20
13,597
41
20
9,150
52
20
31,896
15
15
18,627
VARIABLE COST (V)
NPV
Random
Corres1.8955 Q(PV)31,895.5
Number
ponding
value
38
20
2,224
36
20
9,150
83
40
84,970
72
20
12,941
81
40
62,224
40
20
13,597
67
20
9,150
99
40
1,568
64
20
5,359
19
15
18,627
22
15
7,910
96
40
54,642
75
20
31,896
88
40
5,359
35
20
13,597
27
15
9,150
69
20
1,568
16
15
7,910
By M. Iftikhar Mubbashir
Problems’ Solutions
28
29
30
31
32
33
34
35
36
Run
37
38
39
40
41
42
43
44
45
46
47
48
49
50
Project Evaluation
25
1,200
51
1,400
32
1,200
52
1,400
76
1,600
43
1,400
70
1,600
67
1,400
26
1,200
QUANTITY (Q)
Random
CorresNumber
ponding
Value
89
1,600
94
1,800
09
.800
44
1,400
98
1,800
10
1,000
38
1,200
83
1,600
54
1,400
16
1,000
20
1,200
61
1,400
82
1,600
90
1,800
81
76
47
61
18
04
11
35
63
PRICE (P)
Random
Number
Expected NPV
=
86
00
15
84
23
53
44
30
71
70
65
61
48
50
=
=
=
Variance of NPV
13,597
5,359
9,150
5,359
31,896
31,896
31,896
18,627
2,224
NPV
1.8955 Q(PV)31,895.5
28,761
14,836
24,314
34,447
31,896
12,941
9,150
16,732
5,359
3,463
54,642
5,359
62,224
2,224
NPV
50
1/ 50 ∑ NPVi
i=1
1/50 (7,20,961)
14,419
50
∑ (NPVi – NPV)2
i=1
1/50
=
1/50 [27,474.047 x 106]
=
549.481 x 106
=
=
549.481 x 106
23,441
To carry out a sensitivity analysis, we have to define the range and the most likely values of
the variables in the NPV Model. These values are defined below
Variable
I
k
F
D
T
N
S
32
Corresponding
value
40
20
20
40
20
30
30
20
30
30
30
30
30
30
39
20
38
20
46
20
58
20
41
20
49
20
59
20
26
15
22
15
VARIABLE COST (V)
Random
CorresNumber
ponding
value
59
20
25
15
29
15
21
15
79
20
77
20
31
20
10
15
52
20
19
15
87
40
70
20
97
40
43
20
=
Standard deviation of NPV
6.
40
30
30
30
20
20
20
20
30
Range
Rs.30,000 – Rs.30,000
10%  10%
Rs.3,000 – Rs.3,000
Rs.2,000 – Rs.2,000
0.5 – 0.5
5–5
0–0
Most likely value
Rs.30,000
10%
Rs.3,000
Rs.2,000
0.5
5
0
By M. Iftikhar Mubbashir
Problems’ Solutions
Q
P
V
Project Evaluation
Can assume any one of the values 1,400*
800, 1,000, 1,200, 1,400, 1,600 and 1,800
Can assume any of the values 20, 30,
30**
40 and 50
Can assume any one of the values
20*
15,20 and 40
* The most likely values in the case of Q, P and V are the values that
have the highest probability associated with them
** In the case of price, 20 and 30 have the same probability of
occurrence viz., 0.4. We have chosen 30 as the most likely value
because the expected value of the distribution is closer to 30
Sensitivity Analysis with Reference to Q
The relationship between Q and NPV given the most likely values of other variables is
given by
5
[Q (3020) – 3,000 – 2,000] x 0.5 + 2,000
0
NPV = ∑
+
 30,000
t
5
t=1
(1.1)
(1.1)
=
5
∑
t=1
5Q  500
 30,000
t
(1.1)
The net present values for various values of Q are given in the following table:
Q
NPV
800
16,732
1,000
12,941
1,200
9,150
1,400
5,359
1,600
1,568
1,800
2,224
Sensitivity analysis with reference to P
The relationship between P and NPV, given the most likely values of other variables is
defined as follows:
NPV
5
= ∑
t=1
[1,400 (P20) – 3,000 – 2,000] x 0.5 + 2,000
0
+
(1.1)t
5
= ∑
t=1
(1.1)5
 30,000
700 P – 14,500
 30,000
(1.1)t
The net present values for various values of P are given below :
P (Rs)
20
30
40
50
NPV(Rs)
31,896
5,359
21,179
47,716
8.
33
NPV
5
(Rs.in lakhs)
PI
0.9
0
5
10
15
20
1.00
1.10
1.20
1.30
1.40
Prob.
0.03
0.10
0.40
0.30
0.15
0.02
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
6
Expected PI = PI = ∑ (PI)j P j
j=1
=
1.24
6
Standard deviation =
∑ (PIj  PI) 2 P j
o f P1
j=1
= √ .01156
= .1075
The standard deviation of P1 is .1075 for the given investment with an expected PI of
1.24. The maximum standard deviation of PI acceptable to the company for an investment with
an expected PI of 1.25 is 0.30.
Since the risk associated with the investment is much less than the maximum
risk acceptable to the company for the given level of expected PI, the company
should accept the investment.
9.
Investment A
Outlay
: Rs.10,000
Net cash flow
: Rs.3,000 for 6 years
Required rate of return
: 12%
NPV(A)
= 3,000 x PVIFA (12%, 6 years) – 10,000
= 3,000 x 4.11 – 10,000 = Rs.2,333
Investment B
Outlay
: Rs.30,000
Net cash flow
: Rs.11,000 for 5 years
Required rate of return
: 14%
NPV(B)
= 11,000 x PVIFA (14%, 5 years) – 30,000
= Rs.7763
10.
The NPVs of the two projects calculated at their risk adjusted discount rates are
follows:
6
3,000
Project A:
NPV =
∑
 10,000 = Rs.2,333
t
t=1
(1.12)
Project B:
NPV
=
5
∑
t=1
as
11,000
 30,000 = Rs.7,763
(1.14)
t
PI and IRR for the two projects are as follows:
Project
A
B
PI
IRR
1.23
20%
1.26
24.3%
B is superior to A in terms of NPV, PI, and IRR. Hence the company must choose B.
34
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Chapter 13
1.
SPECIAL DECISION SITUATIONS
PV Cost
UAE =
PVIFAr,n
Cost of plastic emulsion painting
Cost of distemper painting
Discount rate
UAE of plastic emulsion painting
UAE of distemper painting
= Rs.3,00,000
Life = 7 years
= Rs. 1,80,000
Life = 3 years
= 10%
= Rs.3,00,000 / 4.868 = Rs.61,627
= Rs.1,80,000 / 2.487 = Rs.72,376
Since plastic emulsion painting has a lower UAE, it is preferable.
2.
Present value of the operating costs :
3,00,000
3,60,000
4,00,000
4,50,000
=
+
+
+
+
1.13
(1.13)2
(1.13)3
(1.13)4
5,00,000
(1.13)5
= Rs.1,372,013
Present value of salvage value = 3,00,000 / (1.13)5 = Rs.162,828
Present value of costs of internal transportation
= 1,500,000 –1,372,013
system
– 162,828 = Rs.27,09,185
UAE of the internal transportation system = 27,09,185 / 3.517 = Rs.7,70,311
3.
Cost of standard overhaul
Cost of less costly overhaul
Cost of capital
UAE of standard overhaul
UAE of less costly overhaul
=
=
=
=
=
Rs.500,000
Rs.200,000
14%
500,000 / 3.889 = Rs.128,568
200,000 / 1.647 = Rs.121,433
Since the less costly overhaul has a lower UAE, it is the preferred alternative
4.
The details for the two alternatives are shown below :
Gunning plow
1.
2.
3.
4.
5.
6.
7.
8.
Initial outlay
Economic life
Annual operating and maintenance costs
Present value of the stream of operating
and maintenance costs at 12% discount rate
Salvage value
Present value of salvage value
Present value of total costs (1+46)
UAE of 7
Rs.2,500,000
12 years
Rs.250,000
Rs.1,548,500
Counter plow
Rs.1,500,000
9 years
Rs.320,000
Rs.1,704,960
Rs.800,000
Rs.500,000
Rs.205,600
Rs.180,500
Rs.3,842,900
Rs.3,024,460
Rs.3,024,460
Rs.3,842,900
PVIFA (12%,12) PVIFA (12%,9)
= 3,024,460
= 3,842,900
5.328
6.194
= Rs.567,654
= Rs.620,423
The Counter plow is a cheaper alternative
35
By M. Iftikhar Mubbashir
Problems’ Solutions
5.
Project Evaluation
The current value of different timing options is given below :
Time
0
1
2
3
4
Net Future Value
Rs. in million
10
15
19
23
26
Current Value
Rs. in million
10
13.395
15.143
16.376
16.536
The optimal timing of the project is year 4.
6.
Time
(t)
(1)
1
2
3
4
5
Calculation of UAE (OM) for Various Replacement Periods
(Rupees)
UAE
PVIF
Present Cumulative PVIFA
Posttax
Operating
(12%,t) (OM)
present
operating & (12%,t) value of
and
(3)
value
maintenance maintenance
costs
costs
(2)
(3)
(4)
(5)
(6)
(7)
(8)
20,000
12,000
0.893
10,716
10,716
0.893 12,000
25,000
15,000
0.797
11,955
22,671
1.690 13,415
35,000
21,000
0.712
14,952
37,623
2.402 15,663
50,000
30,000
0.636
19,080
56,703
3.037 18,671
70,000
42,000
0.567
23,814
80,517
3.605 22,335
Calculation of UAE (IO) for Various Replacement Periods
Time (t)
Investment Outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.
1
80,000
0.893
89,586
2
80,000
1.690
47,337
3
80,000
2.402
33,306
4
80,000
3.037
26,342
5
80,000
3.605
22,191
Calculation of UAE (DTS) for Various Replacement Periods
Time
(t)
Depreciation
charge R.s.
Depreciation
tax shield
PVIF
(12%, t)
PV of
depreciation
tax shield Rs..
Cumulative
present
value Rs..
PVIFA
(12%, t)
UAE of
depreciation
tax shield Rs.
(1)
1
2
3
4
5
(2)
20,000
15,000
11,250
8,438
6,328
(3)
8,000
6,000
4,500
3,375
2,531
(4)
0.893
0.797
0.712
0.636
0.567
(5)
7,144
4,782
3,204
2,147
1,435
(6)
7,144
11,926
15,130
17,277
18,712
(7)
0.893
1.690
2.402
3.037
3.605
(8)
8,000
7,057
6,299
5,689
5,191
Time
(1)
1
2
3
36
Calculation of UAE (SV) for Various Replacement Periods
Salvage
PVIF
Present value of
PVIFA
UAE of salvage
(12%, t)
(12%, t)
value Rs. (4) / (5)
value Rs.
salvage value Rs.
(2)
(3)
(4)
(5)
(6)
60,000
0.893
53,580
0.893
60,000
45,000
0.797
35,865
1.690
21,222
32,000
0.712
22,784
2.402
9,485
By M. Iftikhar Mubbashir
Problems’ Solutions
4
5
22,000
15,000
Project Evaluation
0.636
0.567
13,992
8,505
3.037
3.605
Summary of Information Required to Determine the Economic Life
Replacement
UAE
UAE (IO)
UAE
UAE (SV)
period
(OM) Rs.
Rs.
(DTS) Rs.
Rs.
(1)
(2)
(3)
(4)
(5)
1
12,000
89,586
8,000
60,000
2
13,415
47,337
7,057
21,222
3
15,663
33,306
6,299
9,485
4
18,671
26,342
5,689
4,607
5
22,335
22,191
5,190
2,359
4,607
2,359
UAE
(CC) Rs.
(6)
21,586
19,058
17,522
16,046
14,642
UAE
(TC) Rs.
(7)
33,586
32,473
33,185
34,717
36,977
OM Operating and Maintenance Costs
IO
Investment Outlay
DTS Depreciation Tax Shield
SV
Salvage Value
CC
Capital Cost
TC
Total Cost
UAE (CC) = UAE (IO) – [UAE (DTS) + UAE (SV)]
UAE (TC) = UAE (OM) + UAE (CC)
7.
Calculation of UAE (OM) for Various Replacement periods
Time
O&M costs
Rs.
(1)
1
2
3
4
5
(2)
800,000
1,000,000
1,300,000
1,900,000
2,800,000
Posttax
O&M costs
Rs.
(3)
560,000
700,000
910,000
1,330,000
1,960,000
PVIF
(12%,t)
(4)
0.893
0.797
0.712
0.636
0.567
PV of posttax O&M
costs Rs.
(5)
500,080
557,900
647,920
845,880
1,111,320
Calculation of UAE (IO) for Various Replacement Periods
Time
Investment outlay Rs. PVIFA (12%, t)
1
4,000,000
0.893
2
4,000,000
1.690
3
4,000,000
2.402
4
4,000,000
3.037
5
4,000,000
3.605
Cumulative
present
value Rs.
(6)
500,080
1,057,980
1,705,9000
2,551,780
3,663,100
PVIFA
(12%, t)
(7)
0.893
1.690
2.402
3.037
3.605
UAE of
O&M
costs Rs.
(8)
560,000
626,024
710,200
840,230
1,016,117
UAE of investment outlay Rs.
4,479,283
2,366,864
1,665,279
1,317,089
1,109,570
Calculation of UAE (DTS) for Various Replacement Periods
37
Time
(t)
Depreciation
charge Rs.
1
2
3
4
5
1,000,000
750,000
562,500
421,875
316,406
Depreciaton
tax shield
Rs.
300,000
225,000
168,750
126,563
94,922
PVIF
(12%, t)
0.893
0.797
0.712
0.636
0.567
PV of
depreciation
tax shield Rs.
267,940
179,325
120,150
80,494
53,821
Cumulative
present
value Rs.
267,900
447,225
567,375
647,869
701,690
PVIFA
(12%, t)
0.893
1.690
2.402
3.037
3.605
UAE of
depreciation
tax shield Rs.
300,000
264,630
236,209
213,325
194,643
By M. Iftikhar Mubbashir
Problems’ Solutions
Calculation of UAE (SV) for Various Replacement Periods
Time
Salvage
PVIF
Present value of
(12%, t)
value Rs.
salvage value Rs.
(1)
(2)
(3)
(4)
1
2,800,000
0.893
267,900
2
2,000,000
0.797
1,594,000
3
1,400,000
0.712
996,80
4
1,000,000
0.636
636,000
5
800,000
0.567
453,600
Project Evaluation
PVIFA
(12%, t)
(5)
0.893
1.690
2.402
3.037
3.605
UAE of salvage
value Rs. (4)/ (5)
(6)
2,800,000
943,195
414,988
209,417
125,825
Summary of Information Required Determining the Economic Life
UAE (CC)
UAE (SV)
UAE (IO)
UAE
Replacement
UAE
Rs.
(DTS)
period
(OM)
Rs.
Rs.
Rs.
Rs.
1
560,000
4,479,283 300,000 2,800,000 ()1,379,283
2
626,024
2,366,864 264,630
943,195
1,159,039
3
710,200
1,665,279 236,209
414,988
1,014,082
4
840,230
1,317,089 213,325
209,417
894,347
5
1,016,117 1,109,570 194,643
125,825
789,102
The economic life of the welldrilling machine is 3 years
UAE (TC)
Rs.
819,283
1,785,063
1,724,282
1,734,577
1,805,219
8. Adjusted cost of capital as per Modigliani – Miller formula:
r* = r (1 – TL)
r* = 0.16 (1 – 0.5 x 0.6)
= 0.16 x 0.7 = 0.112
Adjusted cost of capital as per Miles – Ezzell formula:
1+r
r* = r – LrDT
1 + rD
1 + 0.16
= 0.16 – 0.6 x 0.15 x 0.5 x
1 + 0.15
= 0.115
9.
a. Base case NPV = 12,000,000 + 3,000,000 x PVIFA (20%, b)
= 12,000,000 + 3,000,000 x 3,326
=  Rs.2,022,000
b. Adjusted NPV = Base case NPV – Issue cost + Present value of tax shield.
Term loan = Rs.8 million
Equity finance = Rs.4 million
Issue cost of equity = 12%
Rs.4,000,000
Equity to be issued =
= Rs.4,545,455
0.88
Cost of equity issue = Rs.545,455
38
By M. Iftikhar Mubbashir
Problems’ Solutions
Computation of Tax Shield Associated with Debt Finance
Interest
Year (t) Debt outstanding
at the beginning
Rs.
Rs.
1
8,000,000
1,440,000
2
8,000,000
1,440,000
3
7,000,000
1,260,000
4
6,000,000
1,080,000
5
5,000,000
900,000
6
4,000,000
720,000
Project Evaluation
Present value of
tax shield
Rs.
366,102
310,256
230,062
167,116
118,019
80,013
1,271,568
Tax shield
Rs.
432,000
432,000
378,000
324,000
270,000
216,000
Adjusted NPV =  Rs.2,022,000 – Rs.545,455 + Rs.1,271,568
=  Rs.1,295,887
Adjusted NPV if issue cost alone is considered = Rs.2,567,455
Present Value of tax shield of debt finance
= Rs.1,271,568
10.
a.
b.
Base Case NPV =  8,000,000 + 2,000,000 x PVIFA (18%, 6)
=  8,000,000 + 2,000,000 x 3,498
=  Rs.1,004,000
Adjusted NPV
= Base case NPV – Issue cost + Present value of tax shield.
Term loan
= Rs.5 million
Equity finance
= Rs.3 million
Issue cost of equity = 10%
Rs.3,000,000
Hence, Equity to be issued =
= Rs.3,333,333
0.90
Cost of equity issue
= Rs.333,333
Computation of Tax Shield Associated with Debt Finance
Year
Debt outstanding at the
Interest
Tax shield
beginning
1
Rs.5,000,000
Rs.750,000 Rs.300,000
2
5,000,000
750,000
300,000
3
4,000,000
600,000
240,000
4
3,00,000
450,000
180,000
5
2,000,000
300,000
120,000
6
1,000,000
150,000
60,000
Present value of tax
shield
Rs.260,869
226,843
157,804
102,916
59,66
25,940
843,033
Adjusted NPV =  1004000 – 333333 + 834033 =  Rs.503,300
Adjusted NPV if issue cost of external
equity alone is adjusted for
=  Rs.1,004000 – Rs.333333
= Rs.1337333
c. Present value of tax shield of debt finance = Rs.834,033
11. Adjusted cost of capital as per Modigliani – Miller formula:
r* = r (1 – TL)
r* = 0.19 x (1 – 0.5 x 0.5) = 0.1425 = 14.25%
39
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Adjusted cost of capital as per Miles and Ezzell formula:
1+r
r* = r – LrDT
1 + rD
1 + 0.19
= 0.19 – 0.5 x 0.16 x 0.5 x
1 + 0.16
= 0.149 = 14.9%
12.
S0 = Rs.46 , rh = 11 per cent , rf = 6 per cent
Hence the forecasted spot rates are :
Year
Forecasted spot exchange rate
1
Rs.46 (1.11 / 1.06)1 = Rs.48.17
2
Rs.46 (1.11 / 1.06)2 = Rs.50.44
3
Rs.46 (1.11 / 1.06)3 = Rs.52.82
4
Rs.46 (1.11 / 1.06)4 = Rs.55.31
5
Rs.46 (1.11 / 1.06)5 = Rs.57.92
The expected rupee cash flows for the project
Year
0
1
2
3
4
5
Cash flow in dollars Expected exchange
(million)
rate
200
46
50
48.17
70
50.44
90
52.82
105
55.31
80
57.92
Cash flow in rupees
(million)
9200
2408.5
3530.8
4753.8
5807.6
4633.6
Given a rupee discount rate of 20 per cent, the NPV in rupees is :
2408.5
3530.8
4753.8
NPV =
9200 +
+
+
(1.18)2
(1.18)3
(1.18)4
5807.6
+
(1.18)5
4633.6
+
(1.18)6
= Rs.3406.2 million
The dollar NPV is :
3406.2 / 46 = 74.05 million dollars
40
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
Chapter 14
1.
SOCIAL COST BENEFIT ANALYSIS
Social Costs and Benefits
Nature Economic
value (Rs
in million)
Costs
1. Construction cost
2. Maintenance cost
Benefits
3. Savings in the operation
cost of existing ships
4. Increase in consumer
satisfaction
Oneshot
Annual
400
Annual
40
Annual
Explanation
3
3.6
The number of passenger hours
saved will be : (75,000 x 2 +
50,000 + 50,000 x 2) = 600000.
Multiplying this by Rs.6 gives
Rs.3.6 million
The IRR of the stream of social costs and benefits is the value of r in the
equation
50
40 + 3.6 – 3.0
50
40.6
400 =
Σ
=
Σ
t=1
(1+r)t
t=1
(1+r)t
The solving value r is about 10.1%
2.
3.
1.
2.
3.
4.
Social Costs and Benefits
Costs
Decrease in customer satisfaction as reflected
in the opportunity cost of the extra time taken
by bus journey
800 x (2/3) x 250 x Rs.2
Rs.266,667
Benefits
1. Resale value of the diesel train (one time)
Rs.240,000
2. Avoidance of annual cash loss
Rs.400,000
Fare collection = 1000 x 250 x Rs.4
= Rs.1,000,000
Cash operating expenses = Rs.1,400,000
The social costs and benefits of the project are estimated below:
(Rs. in million)
Costs & Benefits
Time
Economic
Explanation
value
Construction cost
0
24
Land development cost
0
150
Maintenance cost
140
1
This includes the cost of
Labour cost
0
40
5. Labour cost
140
12
6. Decrease in the value of the timber
240
4
41
transport and rehabilitation
The shadow price of labour
equals what others are willing
to pay.
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
output
Benefits
7. Savings in the cost of shipping the
agriculture produce
8. Income from cash crops
9. Income from the main crop
10. Increase in the value of timber output
140
0.5
15
640
1
10
50
20
Assuming that the life of the road is 40 years, the NPV of the stream of social costs and benefits at
a discount rate of 10 percent is:
40
1 + 12
40
4
NPV =  24  150  40  Σ
Σ
t=1
(1.1)t
t=2 (1.1)t
40
+ Σ
t=1
0.5
+
(1.1)t
5
Σ
t=1
10
40
+ Σ
(1.1)t
t=6
20
+
(1.1)t
(1.1)1
=  Rs.9.93 million
Table 1
Social Costs Associated with the Initial Outlay
4.
Item
Financial
cost
0.30
12.0
Imported equipment
Indigeneous equipment
Transport
15.0
80.0
2.0
Engineering and knowhow
fees
Preoperative expenses
Bank charges
Working capital
requirement
6.0
Basis of
conversion
SCF = 1/1.5
T=0.50, L=0.25
R=0.25
CIF value
CIF value
T=0.65, L=0.25
R=0.10
SCF=1.5
6.0
3.7
25.0
SCF=1.0
SCF=0.02
SCF=0.8
Land
Buildings
150.0
Table 2
Indigeneous raw material
and stores
Labour
Salaries
Repairs and maintenance
Water, fuel, etc
Electricity (Rate portion)
Other overheads
Tradeable value
ab initio
0.20
6.0
0.074
20.0
Rs. in million
T
L
R
6.0
3.0
3.0
1.3
0.5
0.2
7.3
3.5
3.2
9.0
60.0
9.0
104.274
(Rs. in million)
Conversion of Financial Costs into Social Costs
Item
42
50
Financial
cost
85
Basis of
conversion
SCF=0.8
Tradeable value
ab initio
68
7
5
1.2
6
SCF=0.5
SCF=0.8
SCF=1/1.5
T=0.5, L=0.25
R=0.25
T=0.71, L=0.13
R=0.16
SCF=1/1.5
3.5
4.0
0.8
5
10
119.2
6.667
82.967
T
L
R
3
1.5
1.5
3.55
0.65
0.8
6.55
2.15
2.3
By M. Iftikhar Mubbashir
Problems’ Solutions
Project Evaluation
As per table 1, the social cost of initial outlay is worked out as follows :
Rs. in million
Tradeable value ab initio
104.274
Social cost of the tradeable component
4.867
(7.3 / 1.5)
Social cost of labour component
1.75
(3.5 x 0.5)
Social cost of residual component
1.60
(3.2 x 0.5)
Total 112.491
As per Table 2, the annual social cost of operation is worked out as follows :
Tradeable value ab initio
Social cost of the tradeable component
( 6.55 x 1/1.5 )
Social cost of labor component
(2.15 x 0.5)
Social cost of residual component
(2.3 x 0.5)
Total
82.967
4.367
1.075
1.150
89.559
The annual CIF value of the output is Rs.110 million. Hence the annual social
net benefit will be : 110 – 89.559 = Rs.20.441 million
Working capital recovery will be Rs.20 million at the end of the 20th year.
Putting the above figures together the social flows associated with the project
would be as follows :
Year / ’s
0
119
43
Social flow (Rs. in million)
112.491
20.441
By M. Iftikhar Mubbashir
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