Payback period

Delhi Machinery Manufacturing company wants to replace the manual operations by new
machine. There are two alternative models „X‟ and „Y‟ of the new machine. Using payback
period, suggest the most profitable investment. Ignore Taxation.

Machine X Machine Y
Initial investment (Rs) 9,000 18,000
Estimated life of the machine (years) 4 5
Estimated savings in the cost (Rs) 500 800
Estimated savings in the wages (Rs) 6,000 8,000
Additional cost of maintenance (Rs) 800 1,000
Additional cost of supervision (Rs) 1,200 1,800

Solution:

Machine X Machine Y
Estimated savings in the cost (Rs) 500 800
Estimated savings in the wages (Rs) 6,000 8,000
A 6,500 8,800
Less: Additional cost of maintenance (Rs) 800 1,000
Less: Additional cost of supervision (Rs) 1,200 1,800
B 2,000 2,800
(A-B) NET INFLOW 4,500 6,000

Initial investment (Rs) OUTFLOW 9,000 18,000

Payback period (Cash outflow/cash inflow) 9000/4500 18000/6000

2 years 3 years

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 1

 Accounting/Average Rate of Return (ARR)

ARR= Average Annual Profit (after tax) * 100

Average investment in the project

Average investment =1/2 (initial cost + installation expenses – salvage value) + salvage value
+ additional working capital
Example:
ABC Ltd. Takes a project costing Rs 1,20,000 with the expected life of 5-years and the
salvage value of Rs 20,000. Then the average investment of the proposal is:
Solution:

Average investment =1/2 (1,20,000 – 20,000) + 20,000

= 50000+20000

=Rs 70,000

Example:
Purchase price of a small printer Rs 22,000
Salvage value Rs 2,000
Working capital Rs 4,000
Service life 5 years
Straight line method of depreciation is adopted. If the average income is Rs 32,000 and
company‟s cut-off rate is 80%. State whether the project is acceptable.
Solution:
Average investment =1/2 (initial cost + installation expenses – salvage value) + salvage value
+ additional working capital
=1/2 (22,000-2,000) + 2,000 + 4,000
= 10,000 + 6,000
= 16,000
ARR= Average Annual Profit (after tax) * 100
Average investment in the project
=32000/16000*100
= 200%

Accept/Reject decision

Since the cut-off rate of the company is 80% a project would be accepted when its average
rate of return is greater than 80%, otherwise it would be rejected. In this case the ARR is
200%. The Printer should be accepted.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 2

 Net Present Value (NPV)

Net Present Value (NPV) = Present value of inflows – Cash outflows

Decision Rule: Accept the proposal if the NPV is positive and reject the proposal if NPV is
negative

Example:

Following mutually exclusive projects are being considered by ABC Ltd.

Project A Project B
PV of cash inflows Rs 20,000 Rs 8,000
Initial Cash outlays 15,000 5,000
NPV 5,000 3,000
Profitability Index 1.33 1.6

Which project should be preferred and why?

Solution:

The Project A is having higher NPV of Rs 5,000 and therefore as per NPV method, it should
be preferred. However, as per Profitability Index method, Project B should be selected as it is
having higher PI of 1.6 against 1.33 of project A.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 3

Example:
Vikram Automotive components Ltd., manufactures all components of its final product. ABC
Ltd., has offered to provide one of the main assemblies needed at what appears to be a very
attractive price. However, Vikram Automotive components Ltd is hesitant in buying from
ABC because quite a lot of its own special purpose equipment will become redundant and
have to sold at a considerable loss.

The following information is the summary of the available information:

i. ABC will supply the sub-assembly in any quantity needed at Rs 225 per
unit. The forecasted value of the demand is 10,000 units per year for the
next 6 years.
ii. The current manufacturing costs of Vikram Automotive Components Ltd
to produce 10,000 sub-assemblies per year are as follows:
Materials Rs 4,50,000
Direct Labour Rs 9,00,000
Variable overheads Rs 4,50,000
Fixed overheads Rs 10,00,000
Rs 28,00,000
It is expected that the material prices will raise by 25% and labour rates by
10% after 3 years. Overhead rates are not expected to increase.
iii. In case of purchase from outside, all variable manufacturing costs can be
avoided. Of the fixed overheads Rs 1,00,000 cannot be avoided as it
related to the in-house plant administrative costs that were being allocated
to the sub-assemblies. Depreciation charges on the special purpose
equipment used only to manufacture sub-assemblies are Rs 4,00,000. The
equipment has a current book value of Rs 54,00,000 and would be
depreciated on straight line basis. It can currently be sold for Rs 9,00,000.
The equipment would have no resale value after 6 years.
iv. The company is subject to 35% tax. The minimum required rate of return
for profits of this type is considered to be 15%.
Use NPV analysis, determine whether it would be profitable to switchover from
making sub-assemblies to buying the same from outside.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 4

Solution:
Make decision

Particulars Years (1-3) Years (4-6)

Material 4,50,000 5,62,500
(25% of 4,50,000
i.e., 1,12500)
Direct Labour 9,00,000 9,90,000
(10% of 9,00,000
i.e.,90,000)
Variable Overheads 4,50,000 4,50,000
Depreciation/Fixed overheads 9,00,000 9,00,000
(54,00,000/6 years) (54,00,000/6 years)
Total Manufacturing costs 27,00,000 29,02,500
Less: Tax (35%) 9,45,000 10,15,875
Effective manufacturing cost 17,55,000 18,86,625
Less: Depreciation 9,00,000 9,00,000
Effective cash outflows/cost 8,55,000 9,86,625
Multiplied by PV Annuity factor at 15% 2.283 (3rd year) 2.283
Total Present Value of cash costs 19,51,965 22,52,465
42,04,429

Buying costs

Year (1-6)
10,000 units * INR 225 each 22,50,000
Less: Tax (35%) 7,87,500
Effective cash cost 14,62,500
Multiplied by PV Annuity factor for 6 years 3.784
at 15%
Total Present value of cash cost 55,34,100
Less: Sale value of old equipment 9,00,000
46,34,100

Balance of depreciation which can be claimed next years.

Advisable to MAKE.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 5

 Net Present Value (NPV)

Net Present Value (NPV) = Present value of inflows – Cash outflows

Example:

A Company is contemplating the introduction of a new machine. From the following

information given to you, determine the profitability of project, assuming 10% as the cost of
capital.

Year 0 1 2 3 4 5
Cash out
flows
Rs 40,000 - - Rs 30,000 - -
(at the
year-end)
Net Cash
inflows
- Rs 20,000 Rs 20,000 - Rs 40,000 Rs 80,000
(at the
year-end)

Solution:

Determination of NPV
Year Cash flows PV factor at 0.10 Total PV
0 Rs (40,000) 1.000 Rs (40,000)
1 Rs 20,000 0.909 Rs 18,180
2 Rs 20,000 0.826 Rs 16,520
3 Rs (30,000) 0.751 Rs (22,530)
4 Rs 40,000 0.683 Rs 27,320
5 Rs 80,000 0.621 Rs 49,680
NPV
Rs 49,170

Net Present Value (NPV) = Present value of inflows – Cash outflows

1,11,700-62,530=49,170

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 6

Example:

ABC Ltd considering to install a machine, either X or Y which are mutually exclusive. The
details of their purchase price and operating costs are:

Year Machine „X` (Rs) Machine „Y (Rs)

0 10,000 8,000
Purchase 1 2,000 2,500
cost 2 2,000 2,500
3 2,000 2,500
4 2,500 3,800
5 2,500 3,800
6 2,500 3,800
Operating 7 3,000
costs 8 3,000
9 3,000
10 3,000

Machine „X‟ will recover a salvage value of Rs 1,500 in the year 10 while machine „Y‟ will
recover Rs 1,000 in the year 6. Determine which is cheaper at the 10% cost of capital,
assuming that both the machines operate at the same efficiency.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 7

Solution:
Machine „X` (Rs) Machine „Y (Rs)
Year PV adjusted PV adjusted
Cost PV factor Cost PV factor
cost cost
0 10,000 1.000 10,000 8,000 1.000 8,000
Purchase cost 1 2,000 0.909 1,818 2,500 0.909 2,272.50
2 2,000 0.826 1,652 2,500 0.826 2,065.00
3 2,000 0.751 1,502 2,500 0.751 1,877.50
4 2,500 0.683 1,707.50 3,800 0.683 2,595.40
5 2,500 0.621 1,552.50 3,800 0.621 2,359.80
Operating costs 6 2,500 0.564 1,410.00 3,800 0.564 2,143.20
7 3,000 0.513 1,539.00
8 3,000 0.467 1,401.00
9 3,000 0.424 1,272.00
10 3,000 0.386 1,158.00
TOTAL COST 25,012.00 21,313.40
Less: Salvage
1,500 0.386 579.00 1000 0.564 564.00
value
24,433.00 20,749.40
Divided by the annuity PV factor for 10 % corresponding to the
life of the project /6.1446 /4.3553
(capital recovery factor )
Equivalent Annual Cost 3,976.50 4,764.20

Machine „X‟ would be cheaper to buy due to lower equivalent annual cost.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 8

Example:

A company is considering three methods of attracting customers to expand its business: (a)
advertisement campaign, (b) display of neon signs (c) direct delivery service. The initial
outlays for each alternative are:

A Rs 1.00,000 advertisement campaign

B Rs 1,50,000 display of neon signs
C Rs 1,50,000 direct delivery service

If A is carried out, but not B, it has an NPV of Rs 1,25,000. If B is done, not A, B has an
NPV of Rs 45,000. However, if both are done, their NPVs are Rs 2,00,000. The NPV of the
delivery system, C, is Rs 90,000. Its NPV is not dependent on whether A or B is adopted, and
the NPV of A or B does not depend on whether C is adopted. Which of the investments
should be made by the company:

(i) If the firm has no budget constraint,

(ii) If the budgeted amount is only Rs 2,50,000

Solution:

Mode of attracting
Initial outlay Expected NPV
customers
A- Advertisement campaign Rs 1.00,000 Rs 1,25,000
B- Display of neon signs Rs 1,50,000 Rs 45,000
2,50,000 Rs 2,00,000
C -Direct delivery service Rs 1,50,000 Rs 90,000

(i) If the firm has no budget constraint,

The firm should adopt (A+B) and C modes of attracting customers.
(ii) If the budgeted amount is only Rs 2,50,000
The firm should adopt (A) and (C) as the NPV from this combination is the
maximum.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 9

 Profitability Index (PI)

Profitability Index = PV of Inflows

PV of Outflows

Decision rule: Accept the project if its PI is more than 1 and reject the proposal if the PI is
less than 1.

Example:

A firm is evaluating a proposal which requires a cash outlay of Rs 40,000 at present and Rs
20,000 at the end of the third year from now. It is expected to generate cash inflows of Rs
20,000, Rs 40,000 and Rs 20,000 at the end of the 1st year, 2nd year and 4th year respectively.

Given the rate of discount of 10% the calculation of PI has been presented

Solution:

Year Cash flows PV factor at 0.10 Total PV

0 Rs (40,000) 1.000 Rs (40,000)
1 Rs 20,000 0.909 Rs 18,180
2 Rs 40,000 0.826 Rs 33,040
3 Rs (20,000) 0.751 Rs (15,020)
4 Rs 20,000 0.683 Rs 13,660

Present value of cash outflows = 40,000 + 15,020 = 55,020

Present values of cash inflows = 18,180 + 33,040 + 13,660 = 64,880

Profitability Index = PV of Inflows

PV of Outflows

Profitability Index = 64,880

55,020

= 1.18

In present worth terms, for every Re 1 invested, the project/proposal is expected to give an
inflow of Re 1.18. So, it can be accepted.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 10

 Internal Rate of Return (IRR)

Example:

XYZ Ltd has to replace one of its machines for which it has following options:

a) Installation of equipment “Best” having cost of Rs 75,000 which is expected to

generate a cash inflow of Rs. 20,000 per annum for next 6 years.
b) Installation of equipment “Better” having a cost of Rs 50,000 which is expected to
generate a cash inflow of Rs. 18,000 per annum for the next 4 years.

Which equipment should be preffered if the company adopts method of (i) payback period
(ii) IRR.

Solution:

Payback period

Payback period of equipment “Best” is: Rs 75,000 / 20,000 = 3.75 years

Payback period of equipment “Better” is: Rs 50,000 / 18,000 = 2.778 years

So, the equipment “Better”, having lower payback period of 2.778 years may be preferred.

IRR

Equipment “best”

Initital outlay = Rs 75,000

Inflows = Rs 20,000 per year for 6 years

PVAF (%,6)= 3.75

In the PVAF Table, the values nearest to 3.75 in the 6th year row are found in 15% (3.784)
and 16% (3.685) column. No, the IRR may be found by interpolating between 15% and 16%
as follows:

IRR = 15%+ 3.784-3.750 *1

3.784-3.685

= 15% + .34 = 15.34%

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 11

Equipment “Better”

Initital outlay = Rs 50,000

Inflows = Rs 18,000 per year for 4 years

PVAF (%,4)= 2.778

In the PVAF Table, the values nearest to 2.778 in the 4th year row are found in 16% (2.798)
and 17% (2.743) column. No, the IRR may be found by interpolating between 16% and 17%
as follows:

IRR = 16%+ 2.798-2.778 *1

2.798-2.743

= 16.36%

The equipment “Better”, having IRR of 16.36% may be preferred over the equipment
“Best”.

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 12

Example:

Calculate the NPV and PI, when the initial investment on a proposal of purchase of a
machine is Rs 1,00,000. The cash inflows from year 1 to 4 are Rs 25,000, Rs 40,000, Rs
40,000 and Rs 50,000 respectively. Findout if the machine is acceptable by NPV and PI
technique. The cost of capital is 12%.

Solution:

The firm has a cost of capital of 12%

Initial investment 1,00,000

Year Cash flows PV factor at 0.12 Total PV

1 25,000 0.893 22,325
2 40,000 0.797 31,880
3 40,000 0.712 28,480
4 50,000 0.636 31,800
1,14,485

PI > 1 Accept the proposal 1,14,485

1,00,000

= 1.145 by PI method

NPV > 0 Accept the proposal cash inflows of Rs 1,14,485 – Rs 1,00,000

= Rs 14,485
The proposal can be accepted by both NPV and PI method

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 13

Calculation of IRR
Example:
A company is evaluating the following project:
Cost 10,000
Cash inflows Year 1 Rs 1,000
Cash inflows Year 2 Rs 1,000
Cash inflows Year 3 Rs 2,000
Cash inflows Year 4 Rs 10,000
Compute the IRR and comment on the opportunity cost is 14%

Solution:

IRR =
Cost =
Calculate IRR
A project costs Rs 36 lakhs and generates 11,20,000 every year for 5 years.

Solution:

Dr. M Anil Kumar, Assistant Professor, SMS, CBIT Page 14