Capital Budgeting

Method: ARR
Problem 1.
Determine the Average Rate of Return from the following data of two machines, A and B.
A (Rs.) B (Rs.)
Cost 56,125 56,125
Annual Estimated income after depreciation and income tax: NPAT
Year 1 3,375 11,375
Year 2 5,375 9,375
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
Estimated life in years of both machines is 5 years. Estimated Salvage Value of both the
machines is Rs. 3,000. Depreciation is charged on SLM basis. Calculate ARR of both the
machines.

Machine I
Step 1: Calculation of Average NPAT

(3375 + 5375 + 7375 + 9375 + 11375) / 5 = Rs. 7,375

Step 2: Calculation of Average Investment

Cost of Machine+Scrap Value

Average Investment =
2

= (56,125 + 3,000) / 2 = Rs. 29,563

Step 3: Calculation of ARR

Average NPAT
ARR = Average Investment x 100 = (7,375 / 29563) x 100 = 24.95%

Same answer for Machine II

Problem 2
A company is considering an investment proposal to install new machine at a cost of Rs. 50,000.
There is no salvage value at the end of estimated life of machine which is 5 years. Tax Rate is
35%. SLM of depreciation is being used. The estimated cash flows before depreciation and tax
are as follows:
Year CF (Rs.)
1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
Calculate ARR

Solution
Step 1: Calculation of Average NPAT
Year CF (Rs.) Depreciation NPBT Tax (35%) NPAT
1 10,000 10,000 0 0 0
2 10,692 10,000 692 242 450
3 12,769 10,000 2,769 969 1,800
4 13,462 10,000 3,462 1,212 2,250
5 20,385 10,000 10,385 3,635 6,750
Total 11,250
Average NPAT = 11,250/5 = Rs. 2,250

Calculation of Depreciation
Cost of the Machinery = Rs. 50,000
Salvage Value = Nil
Total Depreciation on Machinery = 50,000 – 0 = 50,000
For each year Depreciation = 50,000 / 5 = 10,000

Step 2: Calculation of Average Investment

Cost of Machine+Scrap Value

Average Investment =
2

= (50,000+0)/2 = Rs. 25,000

Step 3: Calculation of ARR

Average NPAT
ARR = Average Investment x 100 = (2250/25,000) x 100 = 9%
Problem No. 3
XYZ Company is considering investing in a project that requires an initial investment of Rs.
100,000 for some machinery. There will be net inflows (NPAT) of Rs. 20,000 for the first two
years, Rs. 10,000 in years three and four, and Rs. 30,000 in year five. Finally, the machine has a
salvage value of Rs. 25,000 at the end of 5th year. Compute ARR.

Average NPAT: Rs. 18,000

Average Investment = Rs. 62,500
ARR = 28.8%

Problem No.4
ABC Co. is planning to invest in a project which requires initial investment of Rs. 5,00,000.
There will be net inflows(NPAT) of Rs. 60,000, Rs. 60,000, Rs. 65,000, Rs. 65,000, and Rs.
50,000 in 1st, 2nd , 3rd, 4th and 5th year respectively. The machine has got a scrap value of Rs.
50,000 at the end of fifth year. Compute ARR.

Average NPAT: Rs. 60,000

Average Investment = Rs. 2,75,000
ARR = 21.82%

Problem No. 5
XYZ Company is considering investing in a project that requires an initial investment of
$100,000 for some machinery. There will be net inflows of $20,000 for the first two years,
$10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage
value of $25,000.

Problem No. 6
XYZ Company is looking to invest in some new machinery to replace its current malfunctioning
one. The new machine, which costs $420,000, would increase annual revenue by $200,000 and
annual expenses by $50,000. The machine is estimated to have a useful life of 12 years and zero
salvage value.
 Method: Pay Back Period

Problem No. 1 (When constant Cash inflow is given)

An investment of Rs. 40,000 in machine is expected to produce CFAT of Rs. 8,000 for 10 years.
Compute Payback period

Pay Back Period = Investment / Constant CFAT = 40,000 / 8,000 = 5 Years

Problem No. 2. (When uneven cash inflows are given)

A company is considering an investment proposal to install new machine at a cost of Rs. 50,000.
There is no salvage value at the end of estimated life of machine which is 5 years. Tax Rate is
35%. SLM of depreciation is being used. The estimated cash flows before depreciation and tax
are as follows:
Year CF (Rs.)
1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
Calculate Pay Back Period

Year CFBDT Depn. PBT Tax (35%) NPAT CFAT Cumulative

CFAT
1 10,000 10,000 0 0 0 10,000 10,000
2 10,692 10,000 692 242 450 10,450 20,450
3 12,769 10,000 2769 969 1800 11,800 32,250
4 13,462 10,000 3462 1212 2250 12,250 44,500
5 20,385 10,000 10,385 3635 6750 16,750 61,250

As investment amount is recovered between 4th and 5th year, the pay back period will be
calculated as:
4 + (5,500/16,750) = 4.32 Years
Problem No. 3
There are two projects “A” and “B”. Initial cost of investment in both the projects is Rs.
1,00,000. Project A generates constant cash inflow (after tax) of Rs. 20,000 each year. Project B
generates cash flow before depreciation and tax as Rs. 25,000, Rs. 15,000, Rs. 30,000, Rs.
40,000, Rs. 25,000, Rs. 35,000, Rs. 40,000, Rs. 45,000, Rs. 15,000 in 9 years respectively. Tax
rate is 20%. Depreciation each year is Rs. 5,000. Calculate Pay Back Period and suggest which
project is ideal one.

Project A: Pay back = 5 years

Project B:
Year CFAT Cumulative CFAT
1 21,000 21,000
2 13,000 34,000
3 25,000 59,000
4 33,000 92,000
5 21,000 1,13,000
6 29,000 1,42,000
7 33,000 1,75,000
8 37,000 2,12,000
9 13,000 2,25,000
Payback lies between 4th and 5th year
4 + (8,000/21,000 = 4.38 Years

Project B is ideal from the perspective of Payback Period.

Problem No. 4
A machine is to be installed with a cost of Rs. 2,00,000. The cash flow (after tax) generated
would be Rs. 20,000, Rs. 25,000, Rs. 30,000, Rs. 30,000, Rs. 35,000, Rs. 40,000, Rs. 50,000,
Rs. 60,000 in 1st, 2nd, 3rd, 4th, 5th, 6th, 7th and 8th year respectively. Calculate Pay Back Period.
 Discounted Payback Period
Problem No. 1
A machine is to be installed with a cost of Rs. 1,00,000. The cash flow (after tax) generated
would be Rs. 20,000, Rs. 25,000, Rs. 30,000, Rs. 30,000, Rs. 35,000, Rs. 40,000, Rs. 50,000,
Rs. 60,000 in 1st, 2nd, 3rd, 4th, 5th, 6th, 7th and 8th year respectively. PV Factor at 10% for the first
five years is 0.909, 0.826, 0.751, 0.683 and 0.621. Calculate Discounted Pay Back Period.

Year CFAT Discounting Factor PV CFAT Cum. PV CFAT

1 20,000 0.909 18,180 18,180
2 25,000 0.826 20,650 38,830
3 30,000 0.751 22,530 61,360
4 30,000 0.683 20,490 81,850
5 35,000 0.621 21,735 1,03,585
Payback period = 4.84 Years

Problem No. 2
Using the information given below, compute discounted Pay back period.
Initial Outlay Rs. 75,000. Estimated Life 5 years, NPAT at the end of 1st, 2nd, 3rd, 4th and 5th year
is Rs. 6,000, Rs. 14,000, Rs. 24,000, Rs. 16,000 and Nil. The cost of capital may be taken at
20%. Discounting factor (@ 20%) is as follows: 0.83, 0.69, 0.58, 0.48 and 0.40.

Year NPAT Depn. CFAT Discounting Factor PV Cum. PV

CFAT CFAT
1 6000 15000 21,000 0.83 17,430 17430
2 14000 15000 29,000 0.69 20,010 37440
3 24000 15000 39,000 0.58 22,620 60060
4 16000 15000 31,000 0.48 14880 74940
5 0 15000 15,000 0.40 6000 80940
Payback period= 4.01 Years

Problem No. 3
A project under consideration has the following expected cash flow: Rs. 15,000 is the Investment
incurred. Then for 5 years we will get money back as shown below:
Year 1 2 3 4 5
7,000 6,000 3,000 2,000 1,000
Assume that cost of capital is 10%. Find out discounted payback period.

Problem No. 4
The initial investment in a project is Rs. 50,000. Estimated life is 5 years. CFAT at the end of
first five years is Rs. 10,000, Rs. 15,000, Rs. 20,000, Rs. 25,000, Rs. 30,000. Discounting factor
to be considered at 20%. Calculate discounted Payback period.
 Net Present Value
Problem No. 1
A company is considering a project to install machinery with an initial outlay of Rs. 60,000. The
entire amount can be borrowed @ 12@ p.a.. The machinery can be used for 5 years. No salvage
value. Machinery is depreciated on SLM and tax rate is 30%.
Annual Sales are Rs. 1,00,000. Expenses excluding depreciation are Rs. 30,000. Based on NPV,
suggest whether project shall be accepted or not.

Annual Sales 1,00,000

Less: Expenses: 30,000
Less: Depreciation 12,000
Net Profit Before Tax 58,000
Less: Tax 17,400
Net Profit After Tax 40,600
Add: Depreciation 12,000
CFAT 52,600
DF 3.60
PV 1,89,360

NPV = PVCF – Initial Cost = 1,89,360-60,000 = Rs. 1,29,360

Calculation of Discounting Factor

1/ (1+r)t
1st Year: 1/(1+0.12) = 0.89
2nd Year: 1/(1+0.12)2 = 0.79
3rd Year: 0.714
4th Year: 0.635
5th Year: 0.567
Total: 3.60
Problem No. 2
The CFAT for two alternative investments, Tata and Bata are as follows:
Year Tata (Rs.) Bata (Rs.)
0 (2,00,000) (2,10,000)
1 50,000 80,000
2 80,000 60,000
3 1,00,000 80,000
4 80,000 60,000
5 60,000 80,000
Calculate the NPV using 11% discounting rate for both alternatives. Which alternative would
you choose?

Solution

Year Discounting Factor CFAT Tata PVCF CFAT Bata PVCF Bata
@11% (Rs.) Tata (Rs.)
1 0.901 50,000 45,050 80,000 72,080
2 0.812 80,000 64,960 60,000 48,720
3 0.731 1,00,000 73,100 80,000 58,480
4 0.659 80,000 52,720 60,000 39,540
5 0.593 60,000 35,580 80,000 47,440
PVCF 2,71,410 2,66,260
Less: Initial Investment 2,00,000 2,10,000
Net Present Value 71,410 56,260
Problem No. 3
C Ltd. is considering the following three investment proposals requiring a net cash outlay of Rs.
1,20,000, Rs. 1,70,000 and Rs. 2,40,000 respectively. The after tax cash inflows are tabulated
below:

Assume discounting rate of 12%. Based on NPV suggest, which alternative is better.
Year Project X Project Y Project Z
1 10,000 50,000 90,000
2 30,000 65,000 1,20,000
3 45,000 85,000 70,000
4 65,000 50,000 50,000
5 45,000 35,000 20,000
Problem No. 4
A company is considering an investment proposal to install new machine at a cost of Rs. 50,000.
There is no salvage value at the end of estimated life of machine which is 5 years. Tax Rate is
35%. SLM of depreciation is being used. The estimated cash flows before depreciation and tax
are as follows:
Year CF (Rs.)
1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
Based on NPV, suggest whether to invest in the project or not. Discounting factor: 10%

Year CFBDT Less: NPBT Tax NPAT CFAT Df PVCF

Dep 10%
1 10,000 10,000 0 0 0 10,000 0.909 9090
2 10,692 10,000 692 242 450 10,450 0.826 8632
3 12,769 10,000 2,769 969 1800 11,800 0.751 8862
4 13,462 10,000 3,462 1212 2250 12,250 0.683 8367
5 20,385 10,000 10,385 3635 6750 16,750 0.621 10,402
Total PVCF 45,353
Less: Initial Investment 50,000
Net Present Value (4,647)
Suggestion: It is suggested not to invest the above project as it generates negative NPV.

Problem No. 5
A company is considering an investment proposal to install new machine at a cost of Rs.
1,00,000. There is no salvage value at the end of estimated life of machine which is 5 years. Tax
Rate is 30%. SLM of depreciation is being used. The estimated cash flows before depreciation
and tax are as follows: Discounting factor 12%.
Year CF (Rs.)
1 20,000
2 21,000
3 25,000
4 26,000
5 40,000
Based on NPV, suggest whether to invest in the project or not.
 Profitability Index

Evaluate above 5 examples on the basis of PI.

1. PVCIF: 1,89,360
PVCOF (Initial Investment): 60,000
PI = 189360/60,000 = 3.156
 Miscellaneous Problems
Problem No. 1
The initial outlay for a project is Rs. 5 Million. PV Factor considered is 10%. Tax rate is 30%.
Depreciation is Rs. 0.5 Million each year.
Net Profit before Depreciation and Tax is as follows for first five years: Rs. 10,00,000, Rs.
15,00,000, Rs. 20,00,000, Rs. 10,00,000 and Rs. 25,00,000. The industry ROI is 20%.
Evaluate the project on the basis of ARR, NPV and PI. Also calculate Pay back period using non
discounting as well as discounting technique.

Problem No. 2
The Cost of Machinery is Rs. 10 Lakhs. Machinery will not generate scrap after its end of useful
life which is 5 years. Depreciation is calculated on SLM basis. Tax rate is 35%. NPAT is given
as follows for first five years: Rs. 3,00,000, Rs. 3,00,000, Rs. 4,00,000, Rs. 5,00,000 and Rs.
5,00,000. The industry ROI is 20%. Evaluate the project on the basis of ARR, NPV and PI. Also
calculate Pay-back period using non discounting as well as discounting technique. PV Factor
considered is 10%. Tax rate is 30%.

ARR: 80%
NPV: 12,30,900
PI: 2.23
PB: 2 Years
DPB: 2.294 Years

Problem No. 3
The Cash flow after tax for first 6 years of the project is Rs. 0.2 Million, 0.3 Million, 0.4 Million,
0.5 Million, 06 Million and 1 Million. The cost of project is Rs. 1.5 Million. Depreciation is on
SLM basis and there is no salvage at the end of 6 years. The industry ROI is 20%. Evaluate the
project on the basis of ARR, NPV and PI. Also calculate Pay-back period using non discounting
as well as discounting technique. PV Factor considered is 10%. Tax rate is 30%.

Problem No. 4
A company is considering an investment proposal to install new machine at a cost of Rs.
2,00,000. There is no salvage value at the end of estimated life of machine which is 5 years. Tax
Rate is 30%. SLM of depreciation is being used. The estimated cash flows before depreciation
and tax are as follows:
Year CF (Rs.)
1 40,000
2 42,000
3 50,000
4 53,000
5 82,000
a) Calculate ARR and evaluate the decision based on industry standard ROI of 20%.
b) Calculate NPV and evaluate the project.
c) Calculate PI and evaluate the project
d) Compute payback period using discounting as well as non discounting approach.
 IRR

Problem No. 1
Speedage Company Ltd. is considering a project which costs Rs. 5,00,000. The estimated
salvage value is zero. Tax rate is 55%. The company uses SLM for depreciation. CFBDT are as
follows for five years: (Rs.): 1,50,000, 2,50,000, 2,50,000, 2,00,000 and 1,50,000.
If the cost of capital is 12%, would you accept the project under IRR method?

Year CFBDT Depreciation CFBT Tax PAT CFAT

(55%)
1 1,50,00 1,00,000 50,000 27,500 22,500 1,22,500
0
2 2,50,00 1,00,000 1,50,000 82,500 67,500 1,67,500
0
3 2,50,00 1,00,000 1,50,000 82,500 67,500 1,67,500
0
4 2,00,00 1,00,000 1,00,000 55,000 45,000 1,45,000
0
5 1,50,00 1,00,000 50,000 27,500 22,500 1,22,500
0
Total CF 7,25,000
Average 1,45,000
CF
Fake Payback period = Initial Investment / Average CF = 5,00,000/1,45,000 = 3.45

At 14% At 12%
Year CFAT DF PV CF Year CFAT DF PV F
1 1,22,500 0.877 1,07,432 1 1,22,500 0.893 1,09,393
2 1,67,500 0.769 1,28,808 2 1,67,500 0.797 1,33,498
3 1,67,500 0.675 1,13,062 3 1,67,500 0.712 1,19,260
4 1,45,000 0.592 85,840 4 1,45,000 0.636 92,220
5 1,22,500 0519 63,577 5 1,22,500 0.567 69,457
4,98,720 5,23,827

IRR = LD + (PVCF LD – Initial Investment / PVCF LD – PVCF HD) (HD-LD)

12 + {(5,23,827-5,00,000)/(5,23,827 – 4,98,720)} (14-12) = 13.89%

Suggestion: The project shall be accepted as IRR > Cost of Capital

Problem No. 2
Chirag Ltd. is considering a project which costs Rs. 20,000. There is no salvage vale. Tax rate is
50%. The company uses WDV for depreciation @ 20%. CFBDT are as follows for five years:
(Rs.): 8,000, 8,000, 9,000, 9,000 and 7,500.
If the cost of capital is 18%, would you accept the project under IRR method?
Cost of Machine: 20,000
Depn @ 20% 4,000
WDV at the end of 1st year 16,000
Depn. @20% 3,200
WDV at the end of 2nd year 12, 800
Depn @ 20% 2,560
WDV at the end of 3rd year 10,240
Depn at @20% 2048
WDV at the end of 4th year 8192
Depreciation 8192
WDV at the end of 5th year 000

5th Year
CFBDT 7500
Less: Dep 8192
CFBT -692
Tax 0
CFAT -692
Add: Dep 8192
CFAT 7500

Fake Payback period: 20,000 /(30,404/5) = 3.29

Year CFAT Df 16% PVCF 16% DF 15% PVCF 15%

1 6000 0.862 5172 0.870 5220
2 5600 0.743 4161 0.756 4234
3 5780 0.641 3705 0.658 3803
4 5524 0.552 3049 0.572 3160
5 7500 0.476 3570 0.497 3728
19,657 20,145

IRR = LD + (PVCF LD – Initial Investment / PVCF LD – PVCF HD) (HD-LD)

= 15 + {(20145-20,000)} / {(20145-19657)} x (16-15) = 15.29%

Suggestion: As IRR < Cost of Capital, the project shall be rejected.

Problem No. 3
Calculate IRR for the following projects and decide which is the most profitable project
CFAT (Figures in Rs.)
Project X (Rs.) Project Y (Rs.) Project Z (Rs.)
Initial Cost 6,00,000 6,60,0000 7,20,000
Year
1 30,000 3,60,000 1,20,000
2 1,20,000 2,40,000 1,80,000
3 1,80,000 - 1,20,000
4 2,40,000 - 3,00,000
5 3,00,000 1,80,000 1,20,000
6 (60,000) 1,20,000 60,000

Project X: Total CFAT = 8,10,000, Average CFAT = 8,10,000/6 = 1,35,000

Fake Payback period = 6,00,000 / 1,35,000 = 4.45
Year CFAT DF 9% PVCF 9% DF 8% PVCF 8%
1 30,000 0.917 27,523 0.926 27,780
2 1,20,000 0.842 1,01,040 0.857 1,02,840
3 1,80,000 0.772 1,38,950 0.794 1,42,920
4 2,40,000 0.708 1,69,920 0.735 1,76,400
5 3,00,000 0.650 1,95,000 0.681 2,04,300
6 (60,000) 0.596 (35,760) 0.630 (37,800)
Total 5,96,760 6,16,440

IRR = LD + (PVCF LD – Initial Investment / PVCF LD – PVCF HD) (HD-LD)

8 + {(6,1,6440-6,00,000)/(6,16,440 – 5,96,760)} x (9-8) = 8.83%

Project Y : 13.2, Project Z: 7.08