Unit III MODELS AND PROBLEMS TO BE WORKED OUT IN THE CLASS

25 Jan Pay back Period

1. A project costs Rs.1,00,000 and yields an annual cash flow of Rs.20,000 or 8 years.
T.B – Calculate its pay back period.
P.N0 – 8.7 1,00,000
8.8 Solution = = 5 Years
Rs. 20,000

2. Determine the payback period for a project which requires a cash outlay of Rs.10,000
and generates cash inflows of Rs.2000, Rs.4000, Rs.3000 and Rs.2000 in the first,
second, third and fourth year respectively.
Cumulative Cash Inflows
Year Cash Inflows (Rs.) (Rs.)
1 2,000 2,000
2 4,000 6,000
3 3,000 9,000
4 2,000 11,000
The above calculation shows that in 3 years Rs. 9,000 has been recovered Rs. 1,000, is
balance out of cash outflow. In the 4th year the cash inflow is Rs. 2,000. It means the pay-back
period is three to four years, calculated as follows
Pay-back period = 3 years+1000/2000×12 months = 3
years 6 months.

3. A project cost Rs.5,00,000 and yields annually a profit o Rs.80,000 after depreciation
@12% but before tax of 50%. Calculate its pay back period.

Profit after depreciation 80,000

40,000

Tax 50%
40,000
Add depreciation
1
5,00,000 12% 2% 60,000

Cash in flow 1,00,000

Solution
Investment

Pay-back period = Cash flow

5,00,000

= 1,00,000 = 5 years.

4. There are two projects X and Y. Each project requires an investment of Rs.20,000. You
 are required to rank these projects according to the pay back method from the
following information:
Net profit before depreciation and after tax
Year ProjectX Project Y
1 1000 2000
2 2000 4000
3 4000 6000
4 5000 8000
5 8000 -

T.B. – P.N 1. X Ltd. Is producing articles mostly by manual labour and is considering to replace it by
8.8 a new machine. There are two alternative models M and N of the new machine.
Prepare a statement of profitability showing the pay back period from the following
information:

Machine M Machine N
Estimated life of machine 4 years 5 years
Cost of machine Rs.90,000 Rs.1,80,000
Estimated savings in scrap 5,000 8,000
Estimated savings in direct wages 60,000 80,000
Additional cost of maintenance 8,000 10,000
Additional cost of supervision 12,000 18,000
Profitability Statement

8.11 Machine M (Rs.) Machine N(Rs.)

Estimated savings per annum:
Scrap 5000 8000
direct wages 60000 80000
total savings (a) 65000 88000
Additional cost p.a
Maintenance 8000 10000
Supervision 12000 18000
Total Additional cost b 20000 28000
Net savings or annual cash inflows (a- 45000 60000
b)

8.12 Pay back period = initial outlay 90,000/45000 180,000/60000

Annual Cash Inflow =2 Years =3 Years
Improvements in traditional approach
2. For each of the following projects compute (i) pay back period (ii) post-back
profitability and (iii) post – back profitability index:

(a) Initial Outlay Rs.50,000

Annual cash inflow (After tax but before depreciation) - Rs.10,000
Estimated life - 8 years
(b) Initial Outlay Rs.50,000
Annual cash inflow (After tax but before depreciation)
First 3 years - Rs.15,000
Next 5 years – Rs.5000
Estimated life - 8 years
Salvage – Rs.8000

Pay back period = Initial investment = 50000 = 5 Years

Annual cash inflows 10000

Post pay-back profitability

=Cash inflow (Estimated life – Pay-back period)
=10,000 (8–5)
=Rs. 30,000
Post pay-back profitability index
30,000
= 50,000 × 100 = 60%
(b) Cash inflows are equal, therefore pay back period is calculated as follows:

Cash Inflows Cumulative Cash Inflows

Year (Rs.) (Rs.)
1 15,000 15,000
2 15,000 30,000
3 15,000 45,000
4 5,000 50,000

(ii) Post pay-back profitability.

= Cash inflow (estimated life – pay-back period)
= 5,000 (8–4)
= 5000×4 = 20,000
(iii) Post pay-back profitability index
20,000 ×100=40%
50,000

1. Calculate discounted pay-back period from the information given below:

Cost of Project – Rs.6,00,000
 Life of the project – 5 years
Annual Cash inflow – Rs.2,00,000
Cut off rate 10%

Year Inflow (Rs) PV @10 discount Present value Cumulative present

factor (Rs.) value (Rs)
1 200000 0.909 181800 181800
2 200000 0.826 165200 347000
3 200000 0.751 150200 497200
4 200000 0.683 136600 633800
5 200000 0.621 124200 758000
The above calculation shows that in 3 years Rs. 497200 has been recovered and in 4th year
the cumulative present value is Rs.633800. It means the discount pay-back period is three to
four years, calculated as follows
Pay-back period = 3 years + 102800 / 136600
= 3 years 9 months.

30 Jan Average Rate of Return Method

2 Feb Net present value method

1. From the following information calculate the net present value of the two projects and
suggest which of the two projects should be accepted assuming a discount rate of 10%
Project X Project Y
Initial investment Rs. 20,000 Rs.30,000
Estimated Life 5 years 5 years
Scrap value Rs.1,000 Rs.2,000

The profits before depreciation and after taxes (cash flow) are as follows:

Year 1 year 2 year 3 year 4 year 5

Rs. Rs. Rs. Rs. Rs.

Project X 5,000 10,000 10,000 3,000 2,000

Project Y 20,000 10,000 5,000 3,000 2,000

Solution

Cash
Inflows Present Present Value of Net Cash
Value of
Rs. Inflow
Project X Project Y Project X
Year Rs. Rs. 1 @ 10% Rs. Project Y Rs.
1 5,000 20,000 0.909 4,545 18,180
2 10,000 10,000 0.826 8,260 8,260
3 10,000 5,000 0.751 7,510 3,755
4 3,000 3,000 0.683 2,049 2,049
 5 2,000 2,000 0.621 1,242 1,242
Scrap Value 1,000 2,000 0.621 621 1,245
Total present value
Initial investments 24,227 34,728
20,000 30,000
Net present value 4,227 4,728
Project Y should be selected as net present value of project Y is higher

2. No project is acceptable unless the yield is 10%. Cash inflows of a certain project
alongwith cash outflows are given below:
Years outflows inflows
Rs. Rs.
0 1,50,000 –
1 30,000 20,000
2 30,000
3 60,000
4 80,000
5 30,000

The salvage value at the end of the 5th year is Rs.40, 000. Calculate net present value.

Internal rate of return method

3 Feb 1. Initial Outlay Rs.60,000
T.B. –P.N Estimated life - 4 years
Estimated Annual cash inflow
1st year - Rs.15,000
6.27 2nd year – Rs.20,000
3rd year – Rs.30,000
4th year – Rs.20,000
Calculate Internal rate of return.
Year Annual PVF@10 PV PVF@ PV PVF@ PV PVF PV
cash (Rs.) 12 (Rs. 14 (Rs. @15 (Rs.
Inflow
(Rs)
1 15000 0.909 13635 .892 133 .877 1315 .869 1303
80 5 5
2 20000 0.826 16525 .797 159 .769 1538 .756 1512
40 0 0
3 30000 0.751 22530 .711 213 .675 2022 .657 1971
30 0 0
4 20000 0.683 13660 .635 127 .592 1184 .571 1142
00 0 0
66345 633 6059 5928
50 5 5

7 Feb Profitability Index

1. The initial cash outlay of a project is Rs.50,000 and it generates cash inflow o
 Rs.20,000; Rs.15,000; Rs.25,000 and Rs.10,000 in our years. Using present value
index method, appraise profitability of the proposed Investment assuming 10% rate of
discount.

Year Inflow (Rs) PV @10 discount Present value

factor (Rs.)
1 20000 0.909 18180
2 15000 0.826 12390
3 25000 0.751 18775
4 10000 0.683 6830

Total present value = 56175

Less: initial outlay = 50000
NPV = 6175

Profitability Index (gross) = present value of cash inflow

Initial cash outlay
=56175
50000
=1.1235
As the Profitability Index is higher than 1, the proposal can be accepted.

Net Profitability Index = NPV/ Initial cash outlay = 6175 / 50000 = .1235

2. A company is considering an investment proposal involving an initial cash outlay of

Rs.20,00,000. The proposal has an expected life of 7 years and zero salvage value. At a
required rate of return of 12% , the proposal has a profitability index of 1.182.
Calculate the annual cash inflows. The present value of an annuity of Re.1 for 7 years
at 12% discount is 4.5638.

ABC Ltd, belongs to a risk class or which the appropriate capitalisation rate is 10%. It
currently has outstanding 5000 shares selling at Rs.100 each. The firm is contemplating the
declaration of dividend of Rs.6 per share at the end of the current financial year. The company
expects to have a net income of Rs.50,000 and has a proposal for making new investments of
Rs.1,00,000. Show that under the MM hypothesis, the payment of dividend does not effect the
value of the firm.