JII

, ,untc-d , ·,1,h I 1,,\\ C11t~n t1

'\II'' I

' · , i.Pcn,,t 1PH \

•
r , •"'",nlt1h'
' R nr t,t Rc t\1 111 {.,, RI{ l
\ ,'"'\~
• • ') ,,, in the fnll rw. Ill ~ p,,µc, th,H Ih , ,
, ,, , l nc P H''-l nl ",tltw u 1tcrwn I fl1( rno , 1J,tl1tl
:\ .,. ,, .• ,,,1, 1.mn~ ,m 11n c, tnw nt 11rn tl't I It, , v 1.• ri 1 II
" , ,... •1,1 'v l un c; 1c; tc 1H ..... rrh rhc <,h1 '< 11 v of ,nu
,~ 1'i"" ,,, .... IH,l,h.-, , · ,, ca lt h
\; 1I ·\ \ '
1
'

, ~T PRESENT VALUE METHOD

:bi . ;,rc~cnt ,,ih1c _1 ~ PV) method' ' the clt1, , 1c Ctonotnr l. mt.' thnd nl c-.,t111.1 1mg rhc mvc,frn 111
JI-- ll ,, l'lll' ,,1 the di, cmmtr d cash fl ov. (OCF ) techni que, t' \p l11.. 11 1., re·," rri1i; 111 r 1}u 1rrnc
, 1 n~~--nr, It c0 rrcc tl~ po, tulatcs th at ca, h fl ow, .ir1 , m g .11 d1ffcrl'n f 11111, peri nd i; litter n
~J :u"' l ('mp,1I able onl y when their equi, alent1.- pre,ent \ ._1IUL' '- .1r,· fo11 n d nur r'he follnv.,
n ~ ,rt' tnH-.Jved in the calc ul ati on of NPV:
" ' I

• ~a, h fl<''-' " of the investment project should be fo rcca"ted h,,._ed on rl', tl1 , 11l J'i,umrr," n"
• \rprornat~ di ,counl rat e should be identified to di ~count thr for~,.:.i\l ed 1..,1',h lln w'i f h
arntC'pn:ite di, count rate is the finn 's opportunity cost of capiI nl wh1C h 1, equ ,tl to rh,· rrq 111re 1
~;e 0f return ex pected by investors on in vestments of cqui vaknl ri ~~.
• r-,,ent , al ue of cash fl ows should be calcul ated using 0pportun i1y co.; t nl Lap 1t,rl I th·
.., •..;count rate .

I., , d pre\ent value should be found out by substracting prc~ent valul' (I f cd~h 011tt lo',\;, 11 11111
pi-c ~ nt value of cash in nows. The project should be acceptec.J if NPV ,, pP, 1t1 v1: ( 1 c /\i f> \ . 0
..r· "'' con,1der an exa mple.
,, o//l/l/l///
1
/ /////// /l////////// //// //////////////l /l/ //////l//// ////l//////l//// /// ///// ///////2;,;;7/;;x
LSTRATION 11.1 Assume that Project X costs Rs 2.500 now and is ex pected to ge nc.: ra tr 'rear c.: ml
~ ,rJlov. ~ of Rs 900. Rs 800. Rs 700. Rs 600 and Rs 500 in year, I th ro u!! h ~ The opponunll )
• 1~ ('Jp1tJI may be assum~d to be IO per cent.
n~ r.~1 pre~l'nt \·alut' fo r Projec t X can be calculated by referring to the presc nl \ alu~ r:1hk , l',1hl •
!ltt c"1d of the hook). The calculati ons are shown below:
,. R~ 900 Rs ~00 Rs 700 R~ 600 R-, '100 ] lh ,_ ,oo
\P\ C: - -- T ---- + ----c-3 + - - - - 1 + ~
~ d - ti I 0) cI + 0. I 0) 2
t I - 0. 10) ( I - 0. 1OJ fI r O I())
"-P\ - K~ Yo<>, P\ ' r 1 0 ,o) + R~ 800t PV F:: o ,o> -·- R,; 700(P\'I ·, o 10)
· R tOO( P\' h O w) , Rs 500(P\ ' Fi o 10> - R~ 2 500
\:P\ {R) ':100 , O I.JO':) I 1-b 800 x 0.826 -, R, 700,.. 0 71 I • R, 600 , ll hS \
V ,oo , 0 6201 R, 2,500
412 Investment Decisions

Th e fo rmula for the net present value can be written as follows:

NPV - - -1-
c e,,
- + c .1 ell - ] -
+ .. · + - -
- [ ( I +k)+( l + k )2 ( l+k ) 3 ( l+k ) 11 Co
n C1
or NPV =L - Co
I= ] (I + k)I 01
w here C 1, C: ... represent net cash inflows in year 1, 2 ... , k is t~e opportunity cost of capital, C .
initial cost of the investment and n is the expected life of the mvestment. It should be noted h01st~
. . · t atth
cost of capital, k, 1s assumed to be known and 1s constant. e
.
Why is NPV Important?

A que sti on may be raised: why should a financial manager invest Rs 2,500 in Project X? Project
X should be undertaken if it is best for the company's shareholders; they would like their shares to
be as valuable as possible. Let us assume that the total market value of a hypothetical companyis
R s 10,000, which includes Rs 2,500 cash that can be invested in Project X. Thu s the value of the
co mpan y's other assets must be Rs 7,500. The company has to decide whether it should spend
cas h and accept Project X or to keep the cash and reject Project X. Clearly Project Xis desirable
since its PV (Rs 2,725) is greater than the Rs 2,500 cash. If Project Xis accepted, the total market
value of the firm will be: Rs 7,500 + PV of Project X = Rs 7,500 + Rs 2,725 = Rs 10,225: that is.
an increase by Rs 225. The company's total market value would remain only Rs 10,000 if Project
X is rejected.
Why should the PV of Project X reflect in the company's market value? To answer this question,
let us assume that a new company X with Project X as the only asset is formed. What is the value of
the company? We know from our earlier discussion in Chapter 8 that the market value of a compa·
ny's shares is equal to the present value of the expected dividends. Since Project Xis the only asset
of Company X, the expected dividends would be equal to the forecasted cash flows from Proje~t X.
In vestors would discount the forecasted dividends at a rate of return expected .on securities eqm~a-
lent in risk to company X. The rate used by investors to discount dividends is exactly the rate w~ich
we should use to discount cash flows of Project X. The calculation of the PV of Project X15 a
replication of the process which shareholders wiU be following in valuing the shares of company X.
Once we find out the value of Project X, as a separate venture we can add it to the value of 0th er
assets to find out the portfolio value. '
The difficult part in the calculation of the PV of an investment project is the precise measu~ernent
of the discount rate. Funds available with a company can either be invested in projects or given~o
shareholders. Shareholders can invest funds distributed t th . f' . ts Therefore, t _e
. . h . · o em m mancia1 asse • QbVJ·
d iscount rate 1s t e .opportunity cost of investing in proJec . cap1·tal rn·irkets. k as
• ts rat her th an m l . •

ously, the opportunity cost concept makes sense whe f' . l f equivalent flS
compared to the project. n mancia assets are o
An alternate interpretation of the positive t . . . h tit represents
th e max imum amount a fir Id b . ne present value of an mvestment is t a . ginvest·
m wou e teady to pay fo h . h . f rnaktn .a
me nt , or the amount at which th f _r ~urc asmg t e opportumty o . hout betJlei
e irm would be w11lmg to sell the right to invest wit
►
Analysis of Capital Budgeting Decisions 413

prete d to represent the amo unt

.-:ii.111 ,·i.tll~ " or~c- ~)ff. T he net pre~ent valu e (Rs 225) can also be inter
;I:-' f1r111 1..·t)l! ld _r~n ~e at ~he req_mred ra~e of return
(10 %) , in addition to the initi al cas h outl ay
by the end of the projects' life to have
, ~~ 2.5(){)) . w dt~tr ~butc 1_mme diatel y to its share hold ers and
1
t is illus trate d by the calcul ati ons show n in
i'-n,.i ,~tY :1ll th~ capit al rai sed at1<l return on it. The poin
rJ1I,' 1l . l .

f.lble 11.1 INTERPRETATION OF NPV

.-lmo w1t Retu rn on Total Amo unt Repa ymen t
Ours ra11di11g in Outstanding Outstanding from Cash at Bala nce
the Begi1111i11,g Amo unt at 10% Flows the End Outs tanding
Rs Rs Rs Rs Rs
) ;·Jr

2,725 .00 272.5 0 2,997 .50 900 2,097 .50

2.097 .50 209.7 5 2,307.25 800 1.507 .25
150.73 1,657.98 700 957.9 8
1.507. 25
95.80 1,053.78 600 453.78
- 957 .9 8
45 .38 499.16 500 (0.84 )*
;; --1-53.7 8
-
,:. ~:~:-.Jinf l1ff l'TTOf.
that the firm choo ses to rece ive the cas h
C1kulatio ns in Tab le 11 .1 are base d on the assumption
. Any pattern of cash receipts, such that
~en-:>iir resulting fro m the inve stme nt in the year it is made
::i;:> net present \'alu e is equa l to Rs 225, can be
selected. Thus , if the firm raise s Rs 2,50 0 (the initial
,'u:l.1~) inste ad of Rs 2,72 5 (init ial outla y plus
net present value) at 10 per cent rate of return , at th e
h~r with interest, it woul d be left wi th Rs
crj c,f fi ft h year after havi ng paid the princ ipal sum toget
at 10 per cent di scou nt rate is Rs 225 . It
_:o3. \\ hose p resent valu e at the begi nnin g of the first year
the rate of raising mon ey is less than
.
>h . ,uld be noted that the gain to share hold ers would be more if
IJ per cen t.

Acceptance Rule
method is to acce pt the in ves tment proje-c t
It shoul d be c lear that the acce ptan ce rule using the NPV
if it~ net pre sent value is positi ve (NPV > O) and
to reject it if the net pre~e nt valu e is ne~ative
\P\ ' < 0). Positi ve NP Vs cont ribut e to the net weal
th of the sharehold ers wh1c h should result 111 the
value w~ ll result o~l y if the proje ct gene r-
in"'re a~ed pri ce of a fi rm 's share . The positi ve net prese nt if
Jt~~ cas h infl ows at a rate hi gher than the
opportunity cost of cap1t al. A P:OJec t may be acce pted
fl ows at a rate _1u st equa l to the oppo rtu-
\P\' :::: 0. A zero NPY impl ie s th at proje ct gene rates cash
nn~ cos t of capit a l. Thu s. the NPY acce ptan ce rules
are:
• Acce pt if NP V > O
• Re1ec l if ?\ PY < O
• \fa~ i.H.:CCp l if NPV = 0

-- --- -
1
d .
J: eflllf::
Der i ,·ioll Mncmi ll nn. 1975 . p. 73 .
· ·
•Hl:rrn an H. LmJ Sm idt , S .. The Capi to l Bu
414 investment Decisions

The ~ P V m eth od can be used to select between mutually exclusi ve projects· th

hi ghe r NP V s hould be selec ted. Using the NPV method, projects would be rank~d ~ one With~
. f irst
present ,·a1ues : t h at 1s, . rank will
. be given
. toth e proJect
. . h h 1g
wit °
. hest positi ve net n rd er of n1:1
~nd so o n . present Vq!Ut

Evaluation of the NPV Method

>J PV is the true m easure of an in vestment 's profitability. The NPV method , therefore pro .d
. . . . · ' vi es the
m o st ac ceptable m vestment rule . Ftrst, it recogrnses the time value of money-a rupee rec .
tod ay is w orth m o re than a rupee received tomorrow. Second, it uses all cash flows occurrin eived
0
the entire life of the project in calculating its worth. The NPV method relies on estimateJ "er
f:i1ows and the di. scount rate rather than any arb1trary
. . b. .
assumpt10ns, or su ~ect1ve consideraf
casn

Third. the di scounting process facilitates measuring cash flows in terms of present values; th~~~s.
in te m1s of current rupee. Therefore, the NPVs of projects can be added. For example, NPV(A:
B) = 1\TPV (A ) + NPV (B ). This is called the value-additivity principle, and it implies that if we
know the NPV s of separate projects, the value of the firm will increase by the sum of their NPVs.
\Ve can also say that if we know values of separate assets, the firm's value can simply be found by
adding their values. The value-additivity is an important property of an investment criterion be-
cau se it means that each project can be evaluated, independent of others, on its own merit. Founh,
the NPV method is always consistent with the objective of maximising the shareholders' wealth.
T his is the greatest virtue of the method.
The N PV method is easy to use if forecasted cash flows and the discount rate are known. In
practice, it is quite difficult to obtain the estimates of cash flows due to uncertainty and to precisely
measure the discount rate. Further, caution needs to be applied in using the NPV method when
a lternati ve projec ts with unequal li ves, or under funds constraint are evaluated. These problems are
discussed in detail in a later chapter.
It should be noted that the ranking of investment projects as per the NPV rule is not independent
of the di scount rates . 1 Let us consider two projects-A and B-both costing Rs 50 eac h. ProjectA
retu n1S Rs 100 after one year and Rs 25 after two years. on the others hand, Project B returns Rs30
after one year and ~s 100_ after two years. At discount rates of 5 per cent and 1O per cent, the NPV
of proj ects and the ir rankmg are as follows :
NPVat5% Rank NPVat 10% Rank
Proj ect A 67.92 II 61.57 I
Project B 69 .27 I 59.91 II
I t can be seen th at the project. ranking
. . c h ange d frorn 5 ptt
is reversed when th e d"1scount rate 1s
ce nt to IO per cent. The reason hes m _the cash ~ow patterns. The impact of the di scounting bee~
mo re severe for the cas h fl_ow occ.urn~g later m the life of the project· the higher the discount.-
the higher would b~ th e d1 scountmg i_mpact. In the case of Project B' the larger cash fl ows cor1'
. n th e life. Thelf present value will decline as th d . .'
Iater 1 e iscount rate mcreases .

. and S midt. op. cit., p. 3 I.

1. Bi e rm a n
 or,r, 419
A, 111ly1ilo of C11pl1n1H, " 1(101/11 ~; (),1<:11il

HAI EOF nETURN METHOD

iNl l HNJ\l k ..
/ low fl•dwi c,·,, . wl · ·I
. Il l., I 1,I 1,; li
,
1nlh1·1 d1."- l'll llll kd l '1t ;-1 /i L

,i ,'I 11,1I
,., t,
1 ,, 11 •111111 ( II{ I~)
, ,
11w tlh
1d
•
1d
t'u
is 111
s li I
,
l11 w s. 1 ( )1h vr re 1·1n,"1 1,.~l•d 111 di ·sn ih,· 11 ,( . lf<f>' "I L.11 j( H 1
/::
11 tli.· 111 :1,~111 111d1· :111d 11111111 g • .. ' ' '
Ii11H ; ;1dju ~1<.:d r:tl 1,;
,q1 1I ' I 1
cl I 1v 11·1~1/ lll vnp 1lu l. !'Ilk 111' i'l'H1rn o vc.: n ·o s t,
i111pl i; lo 1111dc rs 1;111d in
~11 11 11
···: •;.,1,l ,, 11 ;111 ill\ l· ~111 w 111. "'." ,' ~ cn 111 I 1'111~· of' rdu111 is q11i11 • s
S\l l'll : l lw l' t\ll V<.' pl ul ltH
ti , \ .-,n.d 1\· 111111 .111d d JW I l>:1<.: k
0,000 will1 II h:1111,; ;111d wo11/
pll ,'-1 11 l{ s I
1 1
1w 1",, I 1'1dll 'd . : \ SS \lll ll' I 11111 )' dll dv
\ _1l_ ,, .· ,I( .t I l lh '
llf 1v t11 rn Oil y ou r i11v
~s111ll·n1 wo uld h1,; :
·, ~i¼l .,ik r , 11-·
1 ) 1'. 11. Th <.' ll'l lt' rnl t'
,•:·· •
\ 1 1 •'
It). ~{I () I 0.0 00 I 0, HOO
1.0 8 0 .08 (If' H%
I 0,000
I 0 ,00 () I 0,0 00
i11v <.:s ln1 c 111
1 i11 fu11trL' (R s 10, HOO) wo uld c o11...; i,..; 1 ot' y<>11r
n1,, .11 1h11111 t "lt 1,l t ~ 1 11 1 \\'l l\ll d l,h1:1i1
00 0) :
. ~-' 11 1.11ll() ) l' lus 1,·111111 ,,11 y,rnr i11 v1..· s111w111 (0 .0~ ;:,., R,..; 10.
I 0, HOO
10. 00 0 t i .mn . io.xoo nr 10 .00 0
(I .OH)
ak L: S lh <.: dis <.; OUllt<.: d
\Ir yo ur inv c.:s1111 i: 111 (8 pl.! r .,;1..•111) 111
\ ,111 ,,h., 1.' I'\ 1.' 1h:11 lhc._• l'!ll l' ur
11 1.l \
1\ .' lltr n
(l~ s 10,000).
) (R s I 0.HOO ) l!(t llll l lo YlH II' it1V t!Sl lll<.: lll
U' l\'~l 'lll) u lul' \,r \\\I t' 1.· ash i11fhn \l ) 1ha l g<.: 11 1.! ral l.!s a
the rai l' "'f n:t urn (r) 011 1111 i11v L:sl111~11t (C0
\\ 1· ,.111 1h' " dc.· , c h,p a r,,
nn ula flH '
d l ( ·1) as fol lm vs :
,.n) ,' 1·.1~1111 ,,\\ :11'tcr ,,tK ' p,..- rin Co
( '1
,. - Co
C 1 (2)
,. = --
Co

<' 1 - I I ,.
Co
C1
( I I ,. )
L:s inv csl mc nt ou tla y
te nf t\.'t lll' ll l..' :tll he dl' fitl l'd as tha l rat e wh kh l'q uat n is
Fi\,in l-\.1u.11 i,,11 t,~) till' ra u11 ~ 1x· rio d . Th is als1., impli ~s tha t thl! rat e of re. tur
t~ \.'.ci vt.· d uft l'r I
'' 11 h 1h~· p1\ ·scn1 \':l lul ' 1.,f inf lnw is n11 c ma y lw 1d.crrt.:1. I tn as II1c .rnte ma rar e o t re tum .
th '' 111' ~1.·(.'lln t r:111.- ,, hk ·h m:lkl'S N I'\ ' = <>. '['h ernnl rat e o f
l' nf l'l.'turn ~)fa long-t erm ass et. Th e inr
ln,·rt· 1~ 'h' s:u isf.11.:t ,Jn \\': I\' ,,r t.k m.:: p1. vVc shall sec that alt ho ug h it is a ve ry fre qu e ntly use d
fin in~ lrn c rut
ah k l.:O
~·rum tlR R) is tlw tK· ~t a,,;,il of invL'st mL'nl wo rth .~
t.·s it he :1 mi sk ad ing llll'asm·c
' \'il.:,'pt in ti n :HH,'l.' . Vl.'I m tim l'ti ll a sso c iat ed
on the ou tla y an d pro ce ed s
s,, hc t.::\USl.' it dcpL'nds so kl y
liHt' rnal r..ll l' ,) f t\'.Curn is l.'n lkd invl'Stm c nl. It c;in bL' de te rm
ine d by
I ~mv rat e dl.'lt.'l'lllincd outsidt.' the
rn,
I '' 1th th,· itWt.'Slnh.'nt :m d l"h) . . .,
,
~,•h u,,. h , h,t .
h,,,·m~ l'q n :\lt t''ll ( ('It' r:
:-- I t

I . d . I .1 rn1s. f1)r lhc firs t tiIT i c .

c:-:11111.: 111 w :1s c tttl ' ws,sc.:- 111 I i r ll rm nl 1c
l" 1"t' \) r lR R. t'l, r : , , r;11 :,: 111 ~ ,·:1p it:1I in
ss. 19 51. nnd his urt ick .
11\\
i .- 11 1
n. J, K·I. C,1 piw l h'11 dg c•ti1 1.t.! . C,, lum h ia U nin~rsi1 y Pre t· Co pir al.
~' .k,d D,· .111 ~ c•t· . P en g em e111 <1. f Cm po ra1
>'
1,'nh ,11. ·~ k .l~ ltn n~ th e P r,,d ui: ti vit y
' ·' ll.'.l ln . R. . .tnd t\l~ , r~ . ~ . Jl1 i11 c'ip l
C':1pit:1I. F . l hi. ). r,, ,· M a m1
l,r
'.'' •!( C't' 1/'' ' l'c l f<' f- 'i 11,111n
c
-, l\k G rnw Hil l , 199 1.
p. 8 .
 .. I

'
\' '
\ f
l)
--\ \\ ~ d '
1.t ,',\\\ h." \\, ~h "\' \t t\\~\\
H\<' \\(~ (~\\ ~\th,n ,s th
..h ft~'i\-'\~'\"' t"~\t n\ r satn( as th,, lH )r us
t\ ~ 'N \' \' ,\~th\, \ th<' ed fnr th e NPV mcth Odwi~
f\ \'~~m , ;\\ \\ t , ~ t\''"''~ t\'\t\\h~t m tt ' ,l t'l"tu11
- ,, h, k u, t\w tRR mt'.'th1. , . A. is assmncd to
x\ th t' v. ,htC' ,-,r r has to be know!\ andi~
be determined at whkhth
c

l't'" ' , ;,\n" ,,f ,, n, \~,\\

\~h,,n \4) ,'~\\\ ht' foun
..h ~'\.'\'\mt \~t~ h ' ,'\ \\\ \\' d 1.mt hy trial and <.
H lt' th t \' f\' ~t't\ 'rror . The approa1.:h is
t'\.l~'-'h'<l ,-~\~" \nt1 t v~,h\t' l.)f \'~\sh
in tl to selcclt.
,,,\ ls
tti"'' "· l.."n th ~ 0th" r \,~
h,,,,,t th ~\t\ tht' pt~ s~m ,)aht
,) ws. If the ~akulate
<' 0f ,·ash outflows,
~t present value o[~
m1.t. ~, h(~htx \'~\\\\'t' sh a lower rate should~
th ,m thr P ~ ~' 1\t ,·,\h
,,mn,"''$.
\t' ,,f T
hi~ pt'\,~c~~ will be
,f
<,old ~ tried the
p re se nt value of inflo ws
is higM
~ '\' \) "'~~ .'( 'l\'
l1\,' t\,\\,,,, U\* Hlu~t r~n rept'ated unless the
net present va\1
(\' t\\ f\\ ,0n c.'~p\:\tt\~ the pt,h.'e
durc to ~ ak ul at e the
interno\ rate a
• . .
• 5
' "
4
• h ' f Pf// '/7/7//l//l//)/J///JJ/II
/I/I / / -
 Analyols ol Capital Budgeting Decisions 417

l>ijf'erellCl!
-
pV rcq11m.:d
200
pY al lowe r rat e, 15 u1,1 16,2 00
257
py al hi gher rate, 16% l ~.941

r = 15% + ( I 6rfn - I 5'Yr1) ;~~

::: 15% + 0.80 % = 15.8 %

------- -
///// ///// ///// ///// ///// ///// ///// ///// //ffe///ffea
'flillll/l////l/f/l/f/l/////////////////1////l//l// ///// ////f ///// ///// f////
Level cash Flows
a project that produces level or equal cash
Aneasy procedure can be followed to calculate the JRR for
stment would cost Rs 20,000 and provide
nows each period. To illustrate, let us assume that an inve
rtunity cost of' capital is IO per cent, what is
anannual cash inflow of Rs 5,430 for 6 years. If the oppo
investmen t's NPV? The Rs 5,43 0 is an annuity for 6 years. The NPV can be found as follows :
the
= Rs 3.64 8
= - Rs 20,0 00 + Rs 5,43 0(PV AF6 . 0.IO) = - Rs 20,0 00 + Rs 5,43 0 x
4 .355
NPV
How much is the project's IRR?
The IRR of the investment can be found out as follo
ws:
NPV = - Rs 20,000 + Rs 5,43 0(PV AFn ,. ) = 0
Rs 20,000 = Rs 5,430(PVAF<,,,.)
. Rs 20,0 00
PVA F6,.
·
=---
Rs 5,43 0
= 3.683
project's internal rate of relu rn. Looking up
The rate which gives a PVAF of 3.683 for 6 years is the
6 year row, we find it approximately unde r
PVAF in Table D (given at the end of the book) across the
IRR which equates the present value of the
the 16 per cent column. Thus, 16 per cent is the projec.:t's
outlay (Rs 20,0 00) with the constant annual cash inflows (Rs 5,430 per year) for 6 years .
initial cash

NPV Profile and IRR

as th~ discount rate increases. and for dis-
We repeat to emphasise that NPV of a project de~lines
coun t rates higher than the project's IRR, NPV
will_ be negative. NPV profile of the proj ec t (in the
Table 1.1.2 and Figure I l . l.
above example) at various discount rates is shown m
-- - - - - -- - - -
Table 11.2 PROJECT'S NPV PROFILE - - - - - - - -
- - --ount - (,%
-- Rate NPV
Disc I'2 .5R O
0 7 ,5() I
5 ~ .(V ~8
10 550
15 0
16 l,IJ42
20 - J.97LI
25 -- -- -- -- --
 Decisions
418 Inve stment

Acceptance Rule
.. the IRR me thod, is to ac-
. . . her than l SO(XJ, - - - - - - - -
Thc acc: cpt -or-rcJ cct ruJe , usi ng
12500
ccp l the project if its inte rna· l rate of return JS h1g . 1·
( . k) · Note tha · t k 1.s a so /000 0
cap ita 1 ' > > 750 0
ihe opp ortunity cost of . f . l • or the cutoff, or hur -
. a.. SO(XJ
known as the req uired rate o re urn , of Z 2.500
if its inte ~naJ rate ..
die rate. The projec t sha ll be rejecte d () . ·-· --·.
t of c_apitaJ. (r < k). I()
return is lower than the opp ortunity cos - 250 0 J .5 __
- .5000 ...__ _ _ _ _ _ _
iffe ren t 1f the mte :na l
The deci sio n maker may remain ind Discount Rate ( %)
nity cos t of cap ital .
rate of return is eq ual to the opportu
Thus the IRR accept ance rules are:
Figure 11.1 NP V Profile
• Accept if r > k
• Reject if r < k
• Ma y accept if r = k om es cle ar if we plot NP V s and dis cou
nt rate s for the
The reason ing for the acc ept anc e rule bec
is less
le 1 .2 on a gra ph like Fig . 11 . I. It can be see n tha t if the dis cou nt rate
projec t given in Tab J
jec t has a zero
t IRR , then the pro jec t has pos itiv e NPV; if it is equal to IRR, the pro
tha n 16 per cen of the
than IRR , the pro jec t has neg ativ e NP V Th us, wh en we com par e IRR
NPV; and if it is gre ater project 's
ortu nity cos t of cap ital , we are in fact trying to ascertain wh eth er the
project with the opp e the same
or not. In cas e of ind epe nde nt pro jects, IRR and NP V rul es wiJJ giv
NPV is pos itive
funds.
res ult s if the firm has no shortage of

Evaluation of fRR Method

•ash
the JRR me tho d rec ogn ises the time value of m oney, an d 1·t cons1·d ers a/l c
Like .the. NPV. me tho d, . .. . 11 · th
.
ove r the entire life of the pro 3ec t to
. calculate its ra te o f retu rn. I t gen era y gives e
now s occ urri,ng ,.
NP V me tho d. It 1s consi·ste nt wit · h the the sha reh old ers , wea Jth
same. acc ept anc e rule as the th
., . . .. rule can how eve r giv e misl d' .
whe n e
max 1m1 sat1on ob1ect 1ve . IRR ea mg and mc ons iste nt res ults
t doe s not dec line ;ith d' '
NP V of a projec
ort~ ~t r~tes .. It also fails . tod ind ica te . a
correc t choice
tua lly exc lus ive pro iect s und e/~: h IRR
between mu am s1tuat1ons Th ese an oth er pit fal ls of t e
- J
s chapter. ·
me thod are elabora ted late r on in thi
d, the valu e add itiv i r· .
Un like in the case of the NP V me tho 1 Thu s fo p ty_ P mc
iple doe s not hol d when 1he IRR
method i~ used- JR Rs of pro jec ts do not add .
, ' r ro3 ects A , d B , IRR (A) + IRR (B) need
the following example: an
not be equal to IRR (A + B). Consider
Project C0 c, NP Vat 10% IR R%
A I 00 + l 20 + 9. /
+ 168 20. 0
B - 150 + 2. 7
- 250 + 288 12. 0
A + IJ + 11 .8

It c:an b~ ~ en fro rn th e excJ mple

thc.tt NPVs of projei.: ts add : -- 15.2

r c,pe land . ·1.1 ~. and WL:s l 1 111 , 1.1 ·'. , Fin am·ial n,,,m:vand Co, por a, /:J
0
.
11cy A
"
, I
' , _,dd isu r1 - ,1YVL!S cy, f 98J . f'· JJ.
 Analysic; of (,1;1pllal IJUif~llt ttJ IJq1;1~1111 ,~ ~I Q

NPV (A) + NPV( 8) = NPV(A + 8 ) =9. 1 I 2 '7 l l H, wtill,·

IRR(A ) + IRR (B) -f. IRR( A + 8 ) = 2{Wh I l 2'1', f J,; '/,'i/,,

CJ PROFITABILITY INDEX

another time-adjusted method of evaluating the in vestment propwm lii Hi I l1c br:1wfIt ~ o ~t ( H/f ')
::~o or profitability index (Pl). It is the ratio of the pre.vent value oj ,·w,h 111/fo w,, ot ,1,,, ,., 1111/1, 1 1
,/

,areofretum, to the initial cash outflow of the inve.vtment. ft rnay be 1!,f ' J'iPi w 1icl , m~t t,~111 v, ~1111ply
gross minus one. The formula to calculate benefit-emit rati o or profitabi11ty mdcJ. II} /Hj foJl11 w11
PV of cash inflows PV( C,J ~ C,
PI= - -- -- ~ - - \-. , ( '11
Initial· cash outlay c,, - ~
1- 1
(J I k)' ' ,
(1)

t/J/IIII///////JlJ/)l/llJJJ/JJJ//(/7(/(/////J//#////////Jll/JJJ//(///l(/l///ll//l/////l/l////////////////l//////ll/$/,f//~
ILLUSTRATION 11.3 The m1tial cash outlay of a proJect rn RH·1()(),000 arnJ it '- 1111 icucrufc <.. 1111'1 111f 1(,w
of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year I thr(Jugh 4, A ~f;LWlC a J() per <;c r11 ,at e; of
discount. The PV of cash inflows at l Oper cent discount rate iw
PY= Rs 40p()()(PVF1.o.10) + Rs 30P()O(PVP2. o.10) + R~ 50/'J(J')(J'VF1, ,J 10) ·I f<l} 2') JHX)WVl ',i.o 111)
= Rs 40,000 x 0.909 + Rs 30,000 x 0.826 + Rs 50,000 ..< 0.75 I+ kn 20.000 / (),C,W~
NPV = Rs 112,350 - R.11 100.000 s.. f<s1 12: 1, 0
Rs I , 12 350
PI = - -- - = I.I 235 .
R~ 1,00,000
'/////////(/f/l////////////////////ffe///////////ffe//////////////////////~///(//////////////////&/$L$/ff/////////////#&.

Acceptance Rule

The following are the Pl acceptance rules:

• Accept if Pl> 1
• Reject if Pl < l
• May accept if Pl= 1
When PI is greater than one, then the project will have po"iti ve net J}rc1}Cnt valut; ,

Evaluation of Pl Method
Like the NPV and IRR rules, PI is a conceptually sound method of apprai'iin~ in vcNtrn~nt prt>jc<:fH.
It recognises the time value of motlC'y. It is a variation of the NPV method, and rt qu ir~lt th~ ,mrn,;
computations as the NPV method . In the Pl method, since the prtfCnt value o1 caJfh infJowi-i ij
I divided by the initial cash outflow, it is a relative mea~ure of' a proj~t'ff profitability.

□ PAYBACK

!he payback (PB) is one of the most popular and wideJy recugnir~cJ tratJiliunal meU1otfo of ~v,,li m1
ing investment proposal ~. It is defined as the number c,f' yearn requi-rc<l to f«,uver the, OdJ$irlltl C1iNh
- . - -- .._---..U!,cc11.1on pnnc1pJe.

ILLUSTRATIVE PROBLEMS

i;::.~•, 11. 1.1

A company is considering the following investment projects:
Cash Flows (Rs)
~,: ... ts
'".I t ~ C C C c·
j -
I
•- 1 - 10.000 + l OJ)()()
-- - 10,000 + 7,500
~
...,
+ 7,500
.... - 10.000 + 2,000 + 4,000 + 12,()(XJ
'
....,, 10~000 + 10,000 + 3,000 + 3,()(XJ
 ~
.
_ ~.

''l

442 Investment Decisions

(aJ Rank the project according to each of the fo ll owi ng methods : ( i ) Payback. (ii) ARR ..
(iv) NPV, ass umin g di scoun t rates of l O and 30 per cent. · ' <111) ~
Assumin g the projects are independent. which one sho uld be accep ted? If the projects ar ~
. e lllutua11
sive, which project is the best? Ye~

Solution
( a) ( i J Payback
Proj ect A I 0,000/10.000 = l yr.
1
Project B I 0 ,000/7,500 = I /
1
yrs.

Proj ec t C 2 yrs - - - - - = 2 'I

10,000 - 6.000
+- 1 yrs.
12,000 ·
Project D I yr.
(i i ; ARR
( I 0 ,000 - I 0,000) I / 2 =0
Proj ect A
( I 0.000) I / 2
( 15 .000 - I 0 ,000) I / 2 = 2,.500 = SO%
Project B
( I 0.000 ) I / 2 5 .000
( 18,000 - I ODOO) I / 3 = 2.667 = 53 %
Project C
( I 0,000) I / 2 5 DOO
( 16,000- I0,000 ) 1/ 3 2.000
Project D - -- - - --- = - - = 40%
)I / 2
( I 0.000 5.000
Note : The net cash proceeds include reco very of in vestm ent also. Therefore . ne t cas h earnin gs are found by
deducting initial investment.
(iii) IRR
Project A The net cash proceeds in year I are just equal to investment.
Therefore, r = 0%.
Project B This project produces an annuity of Rs 7,500 for two years.
Therefore, the required PVAF is : 10,000/7.500 = 1.33 .
Looking in Table D across 2 year row, this factor
is found under 32% co lumn . Therefore r = 32 %.
Project C Since cash flows are uneven , the trial a~d error method will
have to be followed : Let us try 20% rate of discount. The
NPV is+ Rs 1,389. A higher rate should be tried. At 30%
rate of discount, the NPV is - Rs 633. The true rate of return
should be less than 30%. At 27 % rate of discount we find
~hat the NPV is - Rs 86 and at 26 % + Rs J05 . Through
mterpolation, we find r = 26.S %.
Project D
I~ this case also we use the trial and error method, and
fm d that at 37.6% rate of discoutnt NPV becomes almost
zero. Therefore, ,- = 37.6%.

r 'J 1l '') ( - 7- r •
442 Investment Decisions - - - -
. .. ·h o f' ilte l'l1ll11wi11 p; 111 c'1 1tod,"l ; ( /) P11v lind . (Ii i /\l{I
~~J
~ ~1c f' I() nnd JO prr ,:cnl. <, 1///11111(
(a) Rank the projec_t acc_ord 111g
(iv) NPV, ass umtt~g d1 scoL'. nl '.".l~s
(h) Assumin g the proJcc:ts arc md ~pc m Lil •
t
l wltid1 pm· sh,111ld he :tlT l' l'l cd '/ II !lw p1,,j, •t·t•1 i,,,.
ll1 111 1
111llyr
•1~

sivc, which project is the best! 11!1,

Solution
(a) (i) Payback I 0.()00/ I ()J)OO = I yr.
Project A
I 0,000/7, .')00 = I 'I , yrs .
Project 13
I O,000 - (l,( )()() :- 2 1/ y f ,"l ,

Project C
2 yrs + - 12~)0() 1 •

I yr.
Project D
(ii) ARR
( I 0,000 - I 0 ,0~0) I / ~ :::: o
Project A ( I 0,000) I / 2
( 15,000 - I 0,000) I / 2 -· 2,5 00 . :,i W¼,
Project B ( I 0.000) I / 2 5 ,000
n s.ooo - ,0.00~.1 == 2t,r,1 :.-: 51 ,y,,
Project C ( I 0,000) l / 2 5 J>OO
(16,000 - IC~.00~~~ / J ::: 2.000 == tl <V7r ,
Project D ( I 0.000) I / 2 5,000

Note: The net cash proceeds include recovery o l' inws1111 c nt also . 'f'h L' rc l'11rc. rw t L·1 1.. , 1i ~·111·11 i11 g.-. nrc found ~

deducting initial investmen t.

(iii) IRR
The nel cas h proceeds in ycur I urcjm:t <.!quul to i11vc.,11 111c111 .
Project A
Therefore, r = 0%.
Project B This project produces an annuity ol' Rs 7,)00 fort wo y1·,11·s.
Therefore, the required PV/\1:' is : I 0,0()()/7, :<;()0 - I .1J .
Looking in 'fohl e D acro ss 2 yc11 r rnw, th is fm.: 1< ,r
is found under 32'¼1co lu111n . Tlu:n;f'o1·1,; , r = _ 12rYr1.
Project C Since cas h fl ows arc u11 evc 11 , the trial :ind erro r 111r11t rn l wi ll
have tu be f'ollowcd . Let us lry 20 % rntc pf' di sl.· 011111. Tl1r
NPV is+ Rs 1,3 89 . A hi ghc1· rak should he tri t.:d . /\ t IO 'Y.·
11
rate of dis<.:ounl, the N PV is Hs (,1 .L The t I'll <.; rn l l' Ill' , c t 111'
should he l•·s" 1
tr'. /\ t .....t. ~7110,1 rntc 1>f• d1• sc.:n 1111f we , ..111 I
"'· " lli ..·1,1 1- () 0'
~hat the N_PV is - Rs 86 und ._ 1t 26'½, 1 fh I 0) . Th n 111 1: h
1111.crpolat1<rn , we f'ind,. - ..
'J (i) c:"1.
) / () ,

, , f 1H.: fr .rnl uncl crrn r mc thlld . 11 11d

Proj ec t D .. thi
In s cnsc •ti s<J we. use
• ..
. ,,I.··Il e Pl · d1·sc p11fnl Nl'V h t·1 ·0 111 L'S 11 l1l1PSI
· ·(, ry,
1111<.J lhal HI 17
I.cm . There fore ,. - ·17 ( 01
' • • ) / ( I.
 ,,nrnys1s or Gnp 11111 t iuago11ng u0c1s1ons 44J

:\t I n•·i, 1tU>oo + 1n.ooo x O.Qo 9 == _ Q 10

,\l Jtl' ';. I0,l)()() I- 10,()()() X 0.769= - 2,J 10
nt I 01•;, 10.000 ·I 7.500 (0 .QQ() + 0.826) = + 3,013
nt 30•~· 10.0 00 + 7.50 0 (0 .769 + 0.59 2) = + 208
r 12.000
nt HV i• I 0,()()0 + 2,000 X 0.Q09 + 4,000 x 0.826
, 0.75 I = + -t. D4
1
:\l ·"'0 ·;. I 0.00() + 2.000 X 0.769 = + 4.000
~ 0.59 2 + 12.000 X 0.455 = - 63:°'
nt I 0 , · I 0.()()0 + 10.000 x 0.909 + lOO
1 O
'< (0.~26 + 0.75 l) = + 3.82 1
al .i0% 10,000 + 10,()()() X 0.769 + 3,00 0
X t0 ..592 + 0.4555) = + 83 1.
ng to the var ious met hod s :
;">:; :•t\'_t-\:1:- :m' rank.c·d :\:- f~l ll l,ws HLTordi ----------------
- - - - - - -ub
Ra
IRR NPV-10% NP V-3 0%
PR AR R
r ,~·c'i.'(
4 4
4 4
~ 2
"I 2 2 3
,.... ·- 3
3 ,,
·'"' I
3 l 4,

~ _,, 1
'"
P.1~
- --
~,ll' l .md .-\R R nre th\.'O rc ti c nlly uns oun d met hod s for cho osin g betw ee n the inv estm
ent pro jec ts.
res ults . If
estm ent crit eria . NPV and IRR . NPV giv es con sist e nt
r: .·rn 11,f I \\\ ' timt :'-ad j ustl 'd (DC F) inv
no cap ital rati onin g). e ithe r IRR or NP V ca n be
use d s ince th e
•._. ;-1'<~1.-,·r~ :m.· indl 'l't'n dt'n t (an d thl'r e is
A all the
will be 3cc ep ted by uny of the met hod s. In the pres ent case . exc e pt Pro ject
.l-.!- ·:· ~~! t)i' prnj t'\.'tS be und erta ken
uld ht- act' t'pt ed if the disc oun t rate is l 0%. Onl y proj ec ts B and D sho uld
· ~_,_, f!\:ic\.'lS sho
· :..\ • Ji >\.'t'Unt rnte is 30ci'. oun t rate . the
the pro jer ts arr mut uall y exc l usiv e, then und er the assu mpt ion of 30% disc
;:· "t .1~~un1t' that sam e res ults -D i s
B nnd D ~A nnd Car e unp rofi tabl e) . Both criteria IRR and NPV give the
,--:. :: ,~, !~ bcl \\t't. 'n flic t (ex cep t for
assu mpt io n of 10% disc oun t rate , rank ings acc ord ing to IRR and NPV con
-~: ('\·:-t. l·ndt'r the that pro ject C is the
w thl' IRR ru te. Pro ject D sho uld be acc epted. But the NPV rul e tells
?: ·:,',·i -\ ). If\\ t' foll o sati on prin cipl e .
lts in con form ity with the wea lth m ax imi
;-< Th~· \'PY rule gen e rall y gin~ s co ns.is tent resu
ing the NPV rule.
-' '\,,ul d. Ulfreforc. nc~ept pro jec t C fo llow
be low :
C and Din Pro blem l l . l are repr odu ced
P'POBLEJJ 11.2. The cas h flow s of pro ject s
Cash Flows (Rs)
CJ NP Vat /0% IRR
C,
_!!ojecr c,
+ 12.000 +4, 134 26 .5%
+2.000 +4.000
C - 10.000 +3, 000 +3,8 2 1 37 .6%
l) + 10,0 00 +3 ,000
10.000
- \\'h,. , 1I . s..,
,,) 1ere n c0 nfl1· ct o f ran k ing .
·cc·t c in spit e of a low e r rate of return ?
,. \'.·h,• ,1 1" ul J ~ ou reco mm e nd p1.01.
·~
 2

Investment Decisions , 1 ch of• lhc, rO

- -·- llowing' methods: (i) •Payha ck. {ii) A.RR , Uii ) l~Q<
44 f 10 per ccn1. . . .
. . ·1ccording lo c. .
the
RankNPV, . .arc
ng• discn
Jll'U,. Jccl . Irates
. uni c•11cndc which. one'
oln1,IO""' , ·I10 uld he accepted'/ If lhc pro.1cc ts are n1u1ua11.1 '' ·
( u) (iv) .mgassunu •ojects me
(h) Assum th~ P'. . . . the best'!
sivc. which proJec t is
Solution
(a) (i) Payback
Project A I 0.000/10,000 = I yr.
Project Il
10,00017,500 = I 'IJ yrs.
Project C 2 I 0,000 - 6.000 = 2 'I· yrs.
1
yrs+ 12,000
Project D I yr.
(ii) ARR

Project A (l0,000 - 10,000)1/2 = O .

(l 0,000) l /2

(15,000 - 10,000 )1/2 _ ~

Project B == 50%
(10,000) I /2 - 5,000
Project C
(18.00 0- 10.000)1/3 == '!:.!'!!!._ == %
(10,000) l/2 5,000 53
Project D

· ~00;00
c 5,0QQ cc 40%
0)1;2c ~
deducting initial investment.
Nore: The net cash proceeds include recovery of investment also. There
fore, net cash earnings are fouo O
Uii ) IRR
Project A d

Project B The netore,

Theref 0%. ds in Year I are just equal to investmen1.
cashr :::::Procee

Projec t C
This project Produces an annuity of Rs 7 500 for two years.
Theref ore, lhe required PVA.p is: 10,000;7,50
Looking •n TabJe D across 2 e .
~ 0 1.33.

is found uncte. 320, Y arrow , this factor

3? a
Since cash no, . io cotun1 · ere ore, r :::: _ ro.
n Th f
Ws are uneven th . ·11
have to be foll d L ' e tr1a] anct error
. metho d w1
. owe . et us t1·y 2001
Npy 1s +. Rs J '38 9· Ah'tgher r t,. mh rate of discou . nt. The
rate of discount, lhc Npy is a CS _OU!d be tned. At 30%
1 he less u1 -111 ]()u 633. 1'he true rate of return
should ' Yn _ At· -·)7Rs0

. _11 hc Npy
lh;. . ~ . o6
is _ I\.S u unc.1. -. ?fo ra1e of discou nt we find
Jin1crro
I laL1on , We finct . at 10-6% + R.s 105. Throuoh
In t 11' s L: asc nlso w.c Li se .I ::: 26•~ 501 . C

. ,, , lhe 1 •·,
, "" t h,11at l 7 " '" .
1 " " I and c,·,·o,· I d d
1.cr,1. 'l'hcrc •rorL:• " .' _•1tc nr d'1sc()t1t111 Npy b llle110 · an
1
• ' · . 7. 0'1, ,. ecomes almos t

10 ?0 -7- 1"' 0 0, rJ
- _o ) j 'l"l '
444 Investment Decisions

Solution . , o and 40 per cent. The NPV for each f

(a) Supp ose the disco unt rate as 0 ' 10 ' 15 3
given below : -- -- -- -- -- -- -- -~ IP1V__ __ __ __ _
o the Pr .
OJeq1
I
NPV ---
Discount Rate (%) C D
8,000 6,000
0
10 4,134 3,821
15 2,660 2,942
30 -634 831
40 - 2,164 - 238
It is noticeable that for proje ct C, the larger cash flows occu
. . r later in its life. At the lower disco
proje ct C's NPV will be highe r than that of proje ct D. As disco . . . unt ra1.;
unt rates start mcre asmg , project C's NPV 7
however, fall at a faster rate simply because its large st cash
flows come late in li:e when the compoun:
effects of timings are most significant. Till the disco unt rate reach
es 12 per cent, proje ct Chas higher NPV ~
project D. After this break -even discount rate, proje ct D has
highe r NPV as well as higher IRR. Thusfu
ranki ngs of the projects have differed because of the differ ence
in time- patte rns of cash flows.
(b) If the oppor tunity cost of capital is 10%, proje ct C shoul
d be unde rtake n becau se the finn will beric~
by addit ional Rs 313 (i.e. Rs 4,134 - Rs 3,821). This can be bette
r appre ciate d if we calcu late the profitabilit
of the incre menta l inves tment (C - D). ·

Cash Flows (Rs)

Project
c, C .
2
C NPV at 10% IRR
1
C-D O - 8,000 + 1,000 + 9,000 + 313 12.5%
The incremental proje ct C- D involves an outla f R 8 000
and Rs 9,000 in years 2 and . At O% O ·
3 1 0
ortuni Y s • _m year 1 and produ ces cash inflows Rs Ii
12.5%. What does this imply? It im r pph t~ coS t of capit al, the NPV is posit ive, Rs 313. The IRR
additional wealth. · p ies t at project C has all the bene fits of proje ct D as well
as~
PROBLEM 11.3 An investment proiect hast ·
NPV at 30 per cent disco Rs 1 woW mternal rat O f
• J
unt rate is + es · tmen
return , 20 and 50 per cent. The mves
000
per cent, (b) 10 per cent, and (c) 60 per ce •·t D• ould the ProJe · b
ct ~ acce·p table if the disco unt rate 15· ·•(a)
Solution n . raw NPV . ra h . .
g P to Justif y your answ er.

The inves tment in question has featur fb

and borrowing. It can be seen from th es O oth lending
positi ve if discount rate lies within e graph th at NPV is
20 r-- -:- -:- --- --- -- -- ---
cent range. Therefore, the investme t per h
cent and
50 per NPV
40 .
at per cent disco unt rate ( : . NPVn >s ould be accep .
ted
0
10 and 60 per cent( :. NPV < 0). ) a nd rejected at
PROBLEM 11.4 A company is co .d .
. . nsi enng .
propo sal, mvolvmg an initial cash outla an investment
The proposal has an expected life of Y:ar~f Rs 45 lakh. l 000
- ________________ _
vage value . At a required rate of r t 7 and zero sal
.. ,.,..__ _
propo sal has a profitab1hty index eofurn of 12 Per cent, the-
1 182 O - ~ ::---- ?..- - 1 - - + -
. · Calculate th 10 0 30 40
e annua l h.
cas inflow-- - r q
'/r.J'lO- 7 - )o
 Analysis of Capital Bud .
geting Decisions 445
7 A
I
PI = I= ) ( l + 0.12) 7
45 == l.182
Ax 4 564
. == 45 X l.182
. A= 53.19/4.564 == Rs l l
BLEM 1/.5 An equipment A has a cost of Rs .65 lakh
75 00
pRO h·titute equipment B would cost Rs 50 000 and ' 0 and net cash flow of Rs 20 000
,\ ,Ul'~ • ' generate n t h
'111L·. ,,uircd rate of retu rn of both equipments , per year fo .·
is e cas flow of Rs 14
fLl1 · 11 per cent. C l 1 '000 per year for
. rs~x years.
six .
\V Ill. • ctluipmcnt should be accepted and why?. a cu ate the IRR and NPV fo.1 eac h . years.
l 11 equipm ent.
soiution
£q11 ip111e11 t A:
NPV = 20,000 x PVAF 6,0. l l - 75,000 = 20,00 0x4 231-
IRR = 20 .000 x PVAF .r = 75.000 .
7 84
S,000= ,620-75,000= Rs9,62
6 0
PVAF 0.,. = 75 ,000 / 20 .000 = 3. 75
Fromthe present value of an annuity table, we find:
PVAF6.0.15 = 3.784
PVAF6 . 0.16 = 3.685
Therefore.

= r = O.15 + 0 .01 3. 7 84 - 3. 75 ]
1i
IRR --- --
[ 3.784 - 3.685
= 0.15 + 0.0034 = 0 1534 or 15.34%
.
Equipm ent B:
NPV = 14.000 x PVAF 50,000 = 14,000 x 4.231 - 50,000 = 59,234- 50,000
6
. o.l
1
- = Rs 9,234
IRR= 14 ,000 x PVAF6.r = 50,000
PVAF6.,. = 3.571
From the present value of an annuity table, we find :
PYAF6. 0.17 == 3.5 89
PVAF6 , 0.1s == 3.498
Therefore ,
3.589 - 3.571 ] == O.l7 + Q.002 == 0.172or 17.20%
IRR= r = 0.17 + 0.01 [ 3 .589 _ 3 ·498
· ent A
d with equipment B. Therefore equipm
E . IRR as compare
qu1pment A has a hioher NPV but lower d
sho ld 1·11 be maximised.
e th
u be preferred since the wealth of e s harehol es w

REVIEW QUESTIONS

I Wh . . . ·gnificant for a firm? in practice? What are the reasons for its
. at 1s capital budgeting? Why is it si . d method is popu 1ar
2· Desp·He its
· weaknesses, the
Popu1 pay back peno . •t limitations? .
.
3 anty'? . rate of return? What. ate ts evaluating the investm
ds of . s.
ent proJect
. How do you calcul ate the accounting . -adjusted rne th o
4· ExP\ain
· · O f the urne
the merits and demerits ' ) Q) ') Q) _, / @ QQ) ~ J _, 5 .J