Vipul’s™ Financial Mana, Bement. 52 Chapter 2 Capital Budgeting i ing - Decision making for Capital Expendi | Expenditure and Capital Budgeting ‘ l enditure . es Planning and Control - Features of Capital Budgeting Decisions _ Qualitative Influences on Capital Expenditure Decisions - Assumptions for Cope Expenditure Proposals ~ Capital Budgeting Evaluation Techniques — Entry barriers ~ Solyeg Problems — Questions for Self-Practice. Capit Capital Expenditure Introduction: Definitions: (1) “The term capital budgeting generally refers to acquiring inputs with long. run returns.” - Richards & Greenlaw “Capital budgeting is long-term planning for making and_ financing proposed capital outlay.” - Charles T. Horngreen “Capital budgeting consists of planning, the development of available | capital for the purpose of maximising the long term profitability (return on investment) of the firm.” ~R.M. Lynch “Capital budgeting is concerned with the allocation of the firm's scarce financial resources among the available market opportunities. The consideration of investment opportunities involve the comparison of # expected future streams of earnings from a project, with the immediate subsequent streams of expenditures for it.” ~G. C. Philiphat “Capital budget is essentially a list of what management believes tole worthwhile projects for the acquisition of new capital assets together wil the estimated cost of each product.” ~ Robert N. Antho Capital budgeting means a decision relating to planning for ap ree (e.g. purchase of a new machine or setting up of @ factory) ® Capital bud a money should be invested in the long-te™ POO ee proposals ee : ae involves a financial analysis of the various # Lt cut obinere garding a capital expenditure and to select /choose vos ie eee alternatives. Capital budgeting technique is enka likely to expenditure decisions which involve current out ays Pot 'Y to produce benefits over a period of time, usually exceedin’ (2 3 4) 6b2 . The term capital budgeting is used interchangeably with capital nditure decisions and long-term investment decisions. Capital geting is a decision making process for making investment decisions pital expenditures or fixed assets. Capital budgeting is also known reezing of Capital” in Fixed Assets. apital expenditure includes all those expenditure which are cted to produce benefits to the firm over more than one year, and passes both tangible and intangible assets. But mainly it includes diture on tangible fixed assets. Capital expenditure involves a investments for long-term in the fixed assets. Activities of Financial Management: e three broad activities of financial management are: Financial analysis, planning and control, i | management of the firm’s asset structure, and management of the firm’s financial structure. All these activities are related to the balance sheet of the firm. Financial Analysis, Planning and Control Management Balance Sheet of the Firm’s Long-term Financing Fixed Assets Asset Structure Structure Short-term Financing Current Assets Fig. 2.1: Indicating Key Activities of Financial Management Financial Analysis, Planning and Control: It is concerned with - Assessing the financial performance and condition of the firm, Forecasting and planning the financial future of the firm, Estimating the financing needs of the firm, and Instituting appropriate systems of control to ensure that the actions of managers are in agreement with the goals of the firm. Comprehensive as they are, these functions have reference to the ince sheet, the profit and loss account, and other statements. Management of the Firm’s Asset Structure: Value is created mostly on: the asset side of the balance sheet. gement of the firm’s asset structure involves; Determining the capital budget; Managing the liquid resources; Establishing the credit policy; and Controlling the level of inventories.54 vid (iii) Management of t! The management o: (a) Establishing the debt-equil (b) Determining the dividend policy; (&) Choosing the specific instruments of financing, and (d) Negotiating and developing relationships with various suppliers of capital. On going through the Fig. 2.1 it can be observed that one of the key activity of financial management is management of the firm’s asset structure which includes determination of the capital budget. Therefore decisions pertaining to capital expenditures form a very important aspect of financial management. The decision-maker has to keep a big picture in mind at all times as a guideline for effectively allocating corporate financial resources. Role of Financial Management Vipul’s™ Financial Management . Wi (Ar he Firm’s Financial Structure: ¢ the financing side of the balance sheet involves, ty ratio or financial leverage; ; Mobilisation of Funds Deployment of Funds (Financing Decisions) (Investment Decisions) L (1) Share Capital (1) Fixed Assets (2) Reserves and Surplus (Capital Budgeting) (3) Borrowing (2) Net Current Assets (Capital Structure, (Working Capital Management) Cost of capital, (3) Investments Dividend Policy) (Treasury Mana; ement) Fig. 2.2: Role of Financial Management ; The above Fig. 2.2 indicates that the role of financial management ® not only mobilisation of funds from different sources but it involve taking decisions about deployment of funds in the right avenues W! by will help to earn returns to the firm. The investment decisions taken ‘s the firm in case of deployment of funds in the fixed assets is termed capital budgeting. For planning and have fon identified: contrsh punpieeh IMeRata aaa (1) Operating (2) Administrative (3) Strategic (1) Operating capital budgeting sion ma Lower level Managementapital Budgeting Administrative capital budgeting ) Strategic capital budgeting Strategic Investments. e.g. Acquisition of a new business; expansion in the new line of business. Capital Expenditure jects: Fig. 2.3: Levels of. Decision-making for Classification of Capital Expenditure Pro’ { (1) Replacement (1) Strategic Projects. (2) Expansion in the new line of business. (3) Expansion in the existing line of business. (4) General Replacement projects. (S) Statutory required and welfare projects. (2) Modernisation (3) Expansion (4) New Project 6) R&D (6) Diversification (7) Cost Reduction Fig. 2.4: Classification of Capital Expenditure Projects Capital expenditure projects can be classified in teplacement, modernization, expansion, diversification, new project, cost reduction, Statutory projects, etc. Statutory projects are like starting a waste Tecycling plant in case of a chemical plant. ae A business organisation is influenced by its environment, both internal as well as external environment. Capital budgeting system of an Organisation is influenced by the strategic planning which in turn has to be in line with the overall corporate/organisational strategy. The corporate strategy is based on the mission an organisation aims to achieve. It is the responsibility of the top management to design the Corporate strategy taking into consideration the external environmental factors which pose opportunities and threats. The strategic planning is done considering the strengths and_ Weaknesses from the internal environmental factors. The planning for pital expenditure depends upon such strategic planning which takes Mto consideration what the organisation wants to do in the long run. The decision in the investment in the assets, ie. whether it is °Perating or administrative or strategic capital expenditure decisions, depends upon the size of investment as explained in Fig. 2.3. As Mdicated in Fig. 2.5 the planning for capital expenditure is “Top-down”56 row Vipul’s™ Financial Management . ll (64 | for the capital expenditure is always sanctioneq whereas the approva! core the controle ales “Bottom-up”, b the Top Management. There External Factors Technology Compton larkets Corporate ree : Government Management Opportunities Policies Strengths Weaknesses Market Scope Competence Growth Image} Strategic Planning Capital Budgeting System Nature of Investment Origination Development Evaluation Authorisation Control Operating Top-down management Bottom-up Fig. 2.5 Capital Expenditure Planning and Control Model f Five Phases of Capital Expenditure Planning and Control: (Refer Fig 2.5) (1) Proposal Origination: Identification or origination of investmert opportunities. Potential investment proposals originates ina variety of ways such as acquisition or additions to existing production ea marketing facilities. Ideas can be generated from productiol managers, marketing analysts, etc. Large companies mainl project analysis divisions which continuously search for new ident projects and ventures. A potential proposal will be considered ® if it attracts additional cash flows. “l (2) Development of Forecasts: Development of forecasts of benefits ee costs. Widely used methods are ARR, NPV and IRR. The bet perme from the project is estimated. While calculating 5 nie; as oo flows are considered which differs from the accor ise Prolit, While computing the cash flows non-cash expenditir gy depreciation is added b, ack i i “ forecasting involves: to accounting profit. C al| Budgeting row 57 valuation of Net Benefits: Evaluation of the net benefits. Benefits ould exceed its cost adjusted for time, value and risk. Discounted fash flow (DCF) and Pay back techniques are used. Accept/reject ecision involves the evaluation of capital expenditure proposal in der to determine whether they meet the minimum acceptance el. The projects under consideration may be: ) Independent projects. ) Mutually exclusive projects. uthorisation: Authorisation for Progressing and pees capital penditure after considering: fa) Business risk. ) Capital rationing. ‘ontrol: Control of capital projects. Review and feedback. capital budgeting decisions the following questions have to be ered: capital expenditure over the next 1, 3, 5, 10 or 15 years is ipated, how much additional capital ~ fixed and/or working — will uired? How will the company’s Balance-Sheet and Profit and Loss unt look like after the anticipated period? selecting a suitable criterion, the following TWO fundamental iples must be kept in view: The bigger the better principle” which means that, other things being qual, bigger benefits are preferable to small ones. The bird in hand principle” which means that, other things being ual, early benefits are preferable to later benefits as:other things ire seldom equal. | any event, these principles themselves can hardly be used as . Means have to be found for taking both of them in a single tick, Features of Capital Expenditure Decisions: Purchase of capital equipments are non-repetitive, purchases Occurring once in ten years or SO. It involves large investment over a long duration entailing careful budgeting. Capital expenditure involves committing major pale v to get Uncertain returns in the future.“i wr Vipul’s™ Financial Managemen (4) The top most level in the organisation is involved in expenditure decision-making. (5) From accounting point of view, capital expenditure is cons; ip a fixed asset, to be depreciated over the period of its economig ed iy (6) Capital equipment buying involves project Seneration, evaluation, project selection and project execution. (7) Since the size of the expenditure is huge it requires methods to evaluate the benefits of the expenditures, (8) Since the equipment is custom-built, sufficient lead time should given to the suppliers of the equipment for fabri manufacturing and assembling. (9) The new equipment should be compatible with the environmental conditions. j (10) In view of the major expenditure involved there are several } influencing factors, arising out of social, Political, economic, aap technological, _ religious, regional, ethnic, natural, _ financial, regulatory and global considerations, all of which cannot be quantified. (11) Commitment of large amount of funds since the decisions involves Re purchase of capital assets. | (2) Long term implications since the investments are made for long | duration. ee (13) Number of variables are involved in capital budgeting. (14) Uncertainties and risk factors since the time duration is quite long. (15) Irreversible decisions since the decisions are non repetitive and even if the asset is sold it will be sold at a loss. Qualitative Influences on Capital expenditure Decisions: (1) Intuition. (2) Vision. (3) Superstition. (4) Politics. (5) Sponsorship. (6) Intangible Benefits. Capital Investment Decisions: R fi is Capital Investment Decisions involves the outlay of current tio | capital assets which determine the t future earnings of the organ al Capital investment decisions have several alternatives in W™" of company can invest in with each alternative having its own! eal specialities, costs, revenues, duration, risk, etc. A capital inves ving decision involves a largely irreversible commitment of resourcesinal Budgeting ~ ere 59 , reaching effects on the ae profitability and is subject to a at degree of risk. The investment and production function of a firm covers a series of vities associated with the identification of opportunities which erate a return on the investiengs This function involves decisions ting to issues like: if Jeska ‘ ‘ What plants to be built? dary, Tebnenria te Where should the plant be located?’ What process to be used? ae How plants to be equipped? What products to be manufactured? With what capacity the : process should carry on?’ What new product lines to venture into? | How diversification is to be carried out? Selection of profitable investment project i is the most important long- mm planning decision of a finance manager. The various , types of vestment projects that the firm undertakes are: ,_, Purchase of a new machinery, Expansion of product lines, or strengthening of distribution facilities in markets now being served. ) Replacement of worn out or less epagauchiNe exstngs assets. ) Mergers - Acquisition. » ~,,., ‘oposal Origination: The characteristics of projects, which differentiates, them sbi other tivities or undertakings in an. rere: usually centre around four mes. thet Projects are clearly goalie ~ = usually with very anecifd objectives. Projects involve co-ordinating a nite of inter- related activities 4 often across functional boundaries. . Projects are of finite duration ~ they will start aad finish, Projects are all in some way unique, The search for promising project ideas is the first step in Paoishine Successful business venture. ‘The idea of a project may.come to the id when one is seriously trying to overcome certain problems. A wide ay of sources should be tapped to Adeaity good prviest ideas. Some the sources are: ts} ) Analysis of the existing industries in eats their profitability and ‘apacity utilisation provides information: for the potential investment.Vipul’s™ Financial Manage, 60 (2) Examination of the inputs and outputs af various industri outputs of one industry becomes the inputs required w] acquired at a lower cost. eng ti (3) Examination of import and export statistics in underst 1 possibilities of manufacturing import substitution good; possibilities of export promotion goods. 4 (4) Studying the governmental guidelines and the pla rec which provides useful pointers towards investment opps indicating the potential demand for goods/services various sectors. ; (5) All-India financial institutions and state level financial i conduct studies, prepare feasibility reports and offer s the potential entrepreneurs and thereby help in id promising investment opportunities. (6) Investigation of the locally available materials, reso’ infrastructural facilities. : (7) Changing economic and social trends and identificati business opportunities with changing consumer prefe: s (8) A study of new products or new processes and te Oo) existing products which is developed by research laborato be examined for profitable Commercialisation. i (9) Taking clues from consumption patterns abroad for f of products or supply of services which are exte abroad. (10) Exploring the possibilities of reviving sick units which is by marginal efforts and shorter gestation periods. (11) Identifying unfulfilled psychological needs of the consun (12) Attending trade fairs and exhibitions helps to know products and developments. \ i (13) Stimulating creativity for generating new product ideas. — Economic Evaluation: Economic evaluation is re quired to eliminate those ideas (a) Timing of cash outflows. (b) Working capital required for the Project. (c) Repayment of loan to be considered as outflows.10! Budgeting Ly YY él (d) Subsidies and grants received from government towards the capital expenditure of projects. {e) Tax incentives available in calculating cash outflows. ({f) Tax impact on the sale of capital assets. (g) Depreciation amount allowed to be deducted as a business expense. (h) Incremental cash flows in case of replacement decisions. (i) Scrap value of the project at the end of its terminal life. (j) Return of the initial working capital at the end of the project. (k) Allocated overheads which would be incurred, irrespective of whether the projects are undertaken or not. (l) Tax benefits in the form of “TAX HOLIDAYS”. n Discounted Techniques Discounted Techniques Average or Internal Accounting Rate of Rate of Retum Return Fig. 2.6: Capital Budgeting Techniques Discount factor or the cost of capital: Discounting of the future cash flows to find out the current value of money that are estimated to be received at future dates. Deciding the technique for evaluation of the project: Capital budgeting techniques are classified as Non-Discounted and Discounted techniques as indicated in Fig. 2.6. ital Expenditure Control: The project on approved will be implemented. Its progress should be tored with the help of feedback reports which will include: Critical path analysis. Capital expenditure progress reports. Performance reports which involves comparing the actual performance against planned targets. Post completion audits. The movement project is launched, control becomes an important cern. Control involves a regular monitoring, of performance against Bets to check for adverse variances and to motivate the project Tsonnel to strive for achieving for project objectives.62 Vipul’s™ Financial Ma Post Audit: 4 Post-audit or post-completion audit is an audit of a pro been commissioned. Such an audit compares actual perfo the planned performance. Regular post-audit of capital projects helps in: 4 (1) providing a documented record which may be improving the future decision making. (2) discovering systematic biases in judgements. (@) serves as a training ground for executiv experience and exposure. (4) drawing lessons from decisions. es requirin Past experience and impro (5) providing valuable experience to the members of the team who are being groomed to shoulder higher respor The most appropriate time to conduct Post-audit is when’ th : Operations analyzing. Post-audit work must not be assigne Sponsoring group as it has a Possibility of a natural bias fav or project. try Barriers that result in Positive Economies of Scale. ) Product Differentiation. Cost Advantage. eting Reach. hnological Edge. ent Policy. eting Evaluation Techniques: ‘ ly used methods of evaluating and ranking tal Investment Decisions are as follows: on Method. of Urgency Method. Period Method. NPV projects: & Rate of Retum Method/Average Rate 4 t Value Method. 7 ent Value Method. Value Index Method / Profitability Index it Cost Ratio Method. ; ral Rate of Return Method. Discounted Pay Back Period Method.ital Budgeting 63 41) Terminal Value Method. ppraisal of Capital Expenditure Proposals/Capital Investment Decisions Traditional or Unsophisticated Time Adjusted or Sophisticated Payback method (1) NPV method Payback Profitability Method (2) Profitability Index or Benefit - Cost Average Rate of Return method or Ratio ‘Accounting Rate of Return method (3) Discounted Pay | Back . Period Method (4) IRR method (5) Net Terminal Value method Fig. 2.7: Methods of Appraisal of Capital Expenditure Proposals sumptions for Capital Expenditure Proposals: While evaluating the relative profitability of the acceptable estment proposals, it is assumed that; fia ay (i) All the alternative investment proposals are riskless or carry an equal amount of risk; H ‘ (ii) Cash inflows are net of corporate income-taxes; (iii) Investment outlays are made at the beginning of the year and cash inflows are received at the end of the year. F ik Costs: i : Sunk costs are the part cash outflows which have already been urred and therefore have no effect on the cash flows relevant to the trent decision. Proforma of Calculation of Cash Inflows 7 a i All Expenses Excluding Depreciation lings Before Depreciation and Tax (EBDT) : Depreciation lings Before Tax (EBT) i Income Tax @ __% ings After Tax (EAT) t: Depreciation sh Inflows te: For ARR method use profit/earnings after tax. For all other methods in capital budgeting except ARR use cash inflows,is ree Vipul’s™ Financial Management - nl (ay Methods of Evaluation: (1) Payback Period Method: Two situations: " (i) Where the cash inflows are in the nature of a series of unify amounts ie. the annual cash inflows are evenly spread over the economic life of the project. Initial investment Payback Period = Annual Cash Inflows (ii) Where the net cash inflows are in the nature of a series of uneven amounts i.e. the annual cash inflows differ from year to year oye, the life span of the project total cumulative cash flows are considered. Net cash outlay Annual cash inflows Cumulative net cash infl equire unt Annual net inflow x12 months) Payback period = xxx years + (II) ARR Method: _ Average Net Profit After Tax OEARR = Original Investment x 100 (2) ARR= Average Net Profit After Tax x 100 Average Investment a Net Profit can be NPBT before Depreciation or NPAT before Depreciation. or NPAT after Depreciation. [Average Antyual Profita = feel pen of all years lo. of years Investment can be Original Investment or Average _ (tt cost of machine - Salvage value) Additional Net Salvage Investment 2 ‘)s Working Capital + Value Note: Average Investment = C 2 Ms AWC +SV where, OI + Original/Opening Investment in Machine SV > Salvage value AWC ~ Additional Working Capital _ Incremental Earnings or Profit (3) ARR=""Treremental Investment — * 100 (i) Consideration of old and new machines which are alternative. Net Profit after Tax Machine B - Net PAT of Machi ~ Purchase Price of new Machine — Sale Proceeds of si aaa ‘adpital Budgeting or" 65 i) Consideration of 2 projects (Machinery) to be purchased. Net PAT Machine B - Net PAT Machine A = Investment in Machine B - Investment in Machine A III) Present Value Method: (1) Present Value Method. (2) Net Present Value Method. (3) Profitability Index Method. (1) Present Value (PV) Method: PV >C Accept the proposal PV zero Accept NPV 1 accept (NPV +ve) PI <1 Reject (NPV -ve) PI = 1 Indifferent (NPV zero) Benefit - Cost Ratio (B/C): _ Discounted Inflows ~ Discounted Outflows If=>1 accept; < 1 Reject Greater than 1 Accept Less than 1 Reject Benefits should exceed its cost adjusted for time value and risk. Illustration: x 100 PI=—_ wae" Vipul’s™ Financial Management - | 66 vv iv P (BAR) Ee The best Project is the one which adds the most among available alternatives to the shareholders wealth. Therefore NPV technique ig superior and project A should be accepted. (IV) Internal rate of return (IRR) method: Also known as, (a) Yield on Investment, (b). Marginal efficiency of Capital, (c) Marginal Productivity of Capital, (da) Rate of Return on Investment, (e) Time Adjusted Rate of Return. IRR is the Rate at which CFAT = C ie. when NPV = Zero |r (ris IRR) Under FRR: Condition: If" NPV > Zero Interest rate higher than the rate selected would be tried. NPV < Zero Lower rate would be used. () IRR =r+ (Fg P¥ey x Ar Where, r_ = Lower rate of discount tH = Higher rate of discount PVcrat = PV of Cash Inflows PVc =Pvofcash outlays APV = Difference in PV Ar = Difference in rates of interest OR PVDi - PVc (2) |IRR =D; + PVD; - PVD; * (D2 - Di) Rate of Return (3) IRR= whenNPV 4 (ee where it is +ve Raliares Difference in PV. ,. Difference in os) rate of return a ROR NPV +ve f é ie. LR.R= py peas Co x Difference — : . Tate of return, (4) Applying the Interpolation Technique: “, PV of Cash Inflows at Di- eee PV of IRR = Di + Py of Cash Inflows at D> pyres Cogent Out sh Inflows at D2 * (D2— Di)al Budgeting LV iV iv) 67 PVD; -PVOI PVD; — PVD, * (D2 Ds) tual IRR may be interpolated as follows: PV of CFAT at D; ~ PV of cash outlays IRR = DU of noua R= D1 + Py of CFAT at D; ~PV of CFAT at Dy * (D2~ Ds) there CFAT means cash inflows after tax. Fake’ Payback period or ‘Factor’ is determined as follows: Cash Outlays ° Average Annual Cash Inflow Initial outlay Original Investment ake Average payback = Fake Annuity ° Average Annual CFAT ie. IRR =D, + TE esti a Sum of Cash Inflows CFAT (including salvage a 'uity = Economic Life of the Machine °F No. of years ocate the factor closest to the Fake payback in the Annuity factor e (Table B) along the line of economic life of the Machine. Actual flows in earlier years is more.than average cash flows take higher. erest Rate. Actual cash ‘flows in earlier years is less than average cash take lower Interest Rate. Depreciation: SL = Straight line method of Depreciation OC = Original cost including installation charges. SV = Salvage value AL = Asset life Investment allowance: To the extent of tax savings the initial cash itflows associated with the proposal is reduced. Sales Credit side item AmountX (100%-Tax%) Inflow Savings | Debitside item Amount X Tax __% Inflow Gain i Capital Budgeting depends upon: (1) Net capital expenditure required. (2) Future cash flows. (3) Choice of horizon. (1) Net capital outlay: Bunt of capital required at present Additional working capital Deferred expenses (payable at a future date)& row Vipul’s™ Financial Management - jj (Ba, Less: Scrap value of existing (old) Machinery. wv % ae value of new machinery at the end of its effective life. Recovery of working capital at the end of the project (2) Future cash flows: (a) Net cash inflows (b) Cash outflows (expenses) (c) Cash flow (savings) (3) Choice of Horizon: Economic life of the assets. Formulae to Determine Discount Factor: If discounting factor Table is not given: r =Rate n =No. of years 10 E.g.@10% =799=-1 1 1st year = @+-= 0.909 1 5th year = @s-D5 = 0.621 Calculator Tricks: 1+1x = where x will be any percentage value for which you require the Discout! Factor Eg. 1+1,1 =Year 1 value = Year 2 value = Year 3 value = Year 4 value = Year 5 value and so on Or Calculator Tricks: Eg. 1+1x xx Year} value _ = Year 2 value ith. Year 3 value = Year 4 value = Year 5 Value and so onBudgeting row 69 tional Techniques: Y BACK PERIOD pay back period is also one of the derivative of the cash flows. It mple technique and does not employ the discounted cash flow gues. It simply measures the time within which the initial ment of the project would or can be recovered based on the cash ils generated by the project. ation on pay back period ject has an initial outlay of Rs. 100 lakhs and it is expected that t would generate cash accruals as per the following: AMOUNT Rs. IN LAKHS 10 25 30 35 30 25 25 25 E 20 required to estimate the pay back period of the project. ay be seen from the above figures that the company will generate ccruals of Rs. 100 lakhs by the end of the fourth year. Thus the *t would pay back the initial investment within a period of four e can be cases where the pay back period may not be in exact er of years. In these kinds of situations the extrapolation can be find out the fraction of years within which the project will e cash accruals to repay the project's initial outlay. ges of the pay back period method: e method is fairly simple and does not involve any lengthy ations as are required to be done in the case of the NPV iques. 1e method can be employed by a layman. e method is also an indicator of the period within which the initial estment would be recovered. Lower the payback period more active would be the project as the higher payback period would ate that the project will take a long time in generating cash cruals to meet the initial outlay. mitations of the payback criteria, however are very serious: s to consider the time value of money. Cash inflows, in the k calculation, are simply added without suitable discounting. violates the most basic principle of financial analysis whichi ‘70 roe vipul’s™ Financial Management . Tr i i t points of time urring at different po! a Can, oi ier suitable compounding /discoung, : 8. back period. This leads eee beyond the pay’ : (2) It ignores cash ae rele cts, which generate substantia] aa wee mie years. To illustrate, consider the cash flows of inflow: two projects, A and B: CASH FLOW OF A CASH FLOW OFB Ss. As. (7,00,000) (1,00,000) stipulates that cas! added or subtracte lonnano The payback criteria prefers A, which has payback Period of 3 years, in comparison to B, which has a payback period of 4 years, even though B has very substantial cash inflows in years 5 and 6. (3) Since the payback period is a measure of projects’ capital recovery, it may divert attention from profitability. Payback has harshly, but not unfairly, been described as the “fish-bait test” since effectively it concentrates on the recovery of the bait (the capital outlay) paying no attention to the size of the fish (the ultimate profitability). (4) Though it measures a Project’s liquidity, liquidity position of the firm as a whole, whi The method, of course, suffers from the vari it does not indicate the ich is more important. ious disadvantages yet it ae 's for the sake of the simplicity pay back period i indi in itself and one can use the method of simplicity Pi is an indicator in itself (B) Pay Back Reciprocal: This is a variant of the Pay back period method. The pay back period but it does not show any faa post in terms of Period i.e. in yeals reciprocal aims to show the mi a measure of Profitability. Pay back project profitability. The higher im rather than Period as a measure Project and vice-versa, * teciprocal the more profitable is : Pay Back Reciprocal = Set ig Pay Back Period " a Cost of Inve. S| Net Cash Flow Pes Tam — Net Cash Flow Per A, ui Cost of Investm, = ent71 al Budgeting Pay Back Profitability: is is a modification of pay back period method. It considers total cash flows remaining after recovering cost of investment. The = of the project is based on the profitability after the pay-off F mbit = xpected Life of the oa geek Profitability 5 Nabe aah Hari le aes Pay Back Period e real profitability of an investment depends on the number of it will continue to operate after the pay-back period. Average Rate of Return Method: The Average Rate of Return (ARR) method is also known as ecounting Rate of Return Method” or “Financial Statement Method” Return on Investment Method” or “Unadjusted Rate of Return thod.” It attempts to measure the rate of return on investment on the is of the accounting information contained in the financial ements. Normally, a minimum (cut-off) rate’ of return is determined fixed by the firms which constitutes the accept/reject criterion. ects expected to give a return below this rate are rejected, otherwise pted. In case of several alternative investment proposals, projects higher ARR would be preferred to those having lower ARR. There are two possible interpretations of investment: The original cost of investment, and Average investment. Average investment takes into consideration that the original estment in an asset diminishes from year to year over its life because fecovering capital cost by way of depreciation charges assuming that straight line method is used for charging depreciation. In this case average investment over the lifetime of the asset is half the eciable part plus the whole of the non-depreciable part (i.e. scrap ie) of the cost of asset. Rs. 1,00,000 “Ayears Rs, 20,000 Straight Line Method P value (at the end of 4 years) ciation 1,00,000= 20.000 +20,000 = Rs. 60,000 erage Investment = uation: a . Ttis easy to understand and simple to calculate. is method does not take into account the time value of money, i.e. it does not discount the future cash inflows.es Vipul’s™ Financial Management . fn (ty 2 i ntiate the alternative jny, ss mefiod oes vie —a of investments. estmeny proposals in terms of their magni , i i Discounted Cash Flow (DCF) Techniques (Time Adjuste Techniques): , The payback period and accounting rate of return techniques i from a major weakness and that is, both these methods ignore the time value of money. It is well-known fact that the amount received in fy is less valuable than it is today. “A Bird in Hand is Worth Two in a Bush” This fall in value is mainly due to future uncertainties ang inflationary pressures. In order to ascertain the time value of money, the discounted cash flow techniques were evolved. Concepts of Compounding and Discounting: The concept of DCF becomes easier to understand once the concepts of compounding and discounting are known: f Compounding refers to the addition of interest to the principal at periodic intervals. This helps in establishing a new value for sub sequent computations. This process is continued till the end of the final year. Compounding is done using the formula: where, A = Principal + Interest P = The Principal amount i = rate of interest and n= number of years. Discounting is just the o Pposite of compounding. Here, one computes the present value whi ich is to be received at a future period. Discounting is done using the formula:Compounding Discounting A (1+ i)r A = 100 (1 +0.1)5 PGs = 100 (1.1)5 _ 161.051 = 100 x 1.61051 = +015 A =Rs. 161.051 161.051 * 1.61051 P =Rs. 100 Future Values at rl 2.9: Present Values of a Future Re. 1 at 10 percent Discount Rate he entire cash inflows i.e. profit after tax plus depreciation from the are discounted to the present value using an appropriate t rate. The DCF technique considers the time value of money or that money earns money by compounding method. This method care of the differences in times at which revenues are generated an investment and the present value concept is used in the tion of investments. In this method, normally the cost of capital, portunity cost is taken as the rate of discount. DCF techniques include NPV PI IRR * Present Value (Present Value Index (Internal Rate of Return Method) Method) Method) Fig. 2.10: Discounted Cash Flow (DCF) Methods ent Value Method.Vipul’s™ Financial Managemeng - Mg 74 (2) Net Present Value (NPV) Method. ; (3) Profitability Index (PI) or Benefit Cost Ratio Method or id Value Index Method. oy (4) Internal Rate of Return (IRR) Method. i : (5) Discounted Pay Back Period Method. ye (A) Net Present Value Method (NPV): rae Here, the cash inflows and outflows are discounted using a it discount factor. This helps in determining the present value of the il flows. The discount factor is the rate that is acceptable to they! management. The sum of the present value of the cash inflows is then} jsit subtracted from the present value of the cost of the project. If the cash ql inflows exceed the cash outflows, the project is accepted, if not the} 2 yx project is rejected. sie Advantages of NPV: eR (a) The analysis is based on the entire economic life of the project. et (b) It recognises the time value of money. : ie (c) This method can be applied even in cases where the inflows at the uneven. (d) If facilitates comparison between two projects in case of projects involving same investments. Disadvantages of NPV: (a) Itis difficult to determine the appropriate discount rate. (b) It involves lot of calculations. (c) It has limited use when projects with unequal investments are! , be compared. (B) Internal Rate of Return Method (IRR): IRR is the interest rate at which the present value of future © inflows equates the capital outlay of the project. The IRR is det using “trial and error method”. The present value of cash flows determined using an arbitrarily selected rate. The sum of present vi so obtained is compared to the initial investment, If the present V 4 higher than the initial investment, a higher rate of discount facl® ; selected and the present values are calculated again on the other the present value is lower than the initial tices a lower a discount factor is selected and the eee ‘ ‘ ‘ TOCeSS i continues until the equality is wee, is repeated again. This P! IRR is the discount rate when, Present Value of Cash Iifisuis =P Net Present Value = Zero Profitability Index = 1 resent Value of Cash Outflow?tal Budgeting 75 Discounted Cash Inflows Discounted Cash Outflows ~ s in Calculating IRR using Trial and Error Method: ‘compute the Fake Payback period. Locate the fake payback period across the line of the life of the project in Annuity Factor Table. Use the present value factors between which fake payback period lies in the Annuity Factor Table. ising the present value factors discount the cash inflows. Determine the net present value at the above present value factors. IRR will lie between a negative and positive NPV. If both the NPV’s are negative use a lower discount factor and if both the NPV’s are positive use a higher discount factor. The IRR is computed using the interpolation technique. Advantages of IRR: a) It considers the time value of money. b) It considers the cash flows over the entire life of the project. Disadvantages of IRR: yi fa) It involves elaborate calculations. (b) This method is not useful where two mutually exclusive projects are to be compared. tinction between Net Present Value and Internal Rate of Return: NPV IRR | 4) The cash flows. are (1) Under IRR no discount verted into their present values| rate’ is given and it has to be Using a discount rate which is selected such that the present value erally taken to be the firm’s cost] of capital outlay exactly equals the pital. present value of net cash inflows. 2) Proposals resulting in the} (2) The best investment is the Balive net present values are| one that secures the highest rate of ted being unprofitable. yield while equating the capital outlay with the present value of the net cash flows. Terminal Value or Net Terminal Value Method: The Terminal Value (TV) approach is based on the assumption that tating income or cash inflow of each year is reinvested in another ét at a certain rate of return from the moment of its receipt until the Pity of the projects economic life. Obviously, there will be no Avestment of cash inflows received at the end of the last year. The “Pounded values of cash inflows over the projects lifetime are76 Vipul’s™ Financial Management f determined on the basis of compounding factor which can be obta, from the “Compounded Value Table” or by calculating Usin, following formula: 8 Compounded Value of Cash Inflow = C(1 + i)® where, C =Cash Inflow i = Rate of Interest n =Number of years for Investment The total sum of compounded cash inflows for different years treated to have been received at the termination of the project and discounted back to the present values on the basis of the given di rate or cost of capital. The present value of the total compounded sum of cash inflows then compared with the present value of the cash outflows. If the pi value of the sum of total compounded reinvested cash inflows is great than the present value of cash outflows or investment outlays, tl proposed project is accepted otherwise rejected. The firm would bi indifferent if both the values are equal. Evaluation: (1) The NTV approach is similar to the NPV method except that the former involves compounding of cash inflows whereas the la involves discounting. (2) This method is mathematically easier than the IRR method andi makes the process of evaluating the real worth of alternati investment projects simple. (3) This method is easier to understand for business executives who att not trained in accountancy or economics, since the compout technique is more appealing than the discounting technique. (D) Discounted Pay Back Period: . In this method the net present values are added cumulatively fro P the start of the project until the sum becomes positive. The turning ih when the NPV becomes positive is the discounted pay back period an | project. The discounted pay back period is defined as the time W! ie \ invested capital has been returned together with the interest cost ° 1 funds associated with it. Here the rate of discount used to arrive * present values of the net cash flows is thi e cost of capital. ’ Advantages: "7} ae ort qa) at method takes into consideration the time value of ™ J pecmbining Pay back period with discounted cash flow (2) It considers requirement to make some return on investme®™ (3) Ithelps in the judgement of Project risks.77 is method is not useful for assessing profitability of the whole project. gj e traditional method, and ounted pay back method. Net Cash Flows (Rs.) PV of Re. 1 at 10% 0.909 0.826 0.751 0.683 - 0.621 ‘Cumulative Net Cash Flows. (Rs) 4,000 7,000 11,000 i 3,000) 2.75 Back Period =2+\4 000)" ~ years ounted Pay Back Method: PV Factor at 10% PV of Net Cash Flows Cumulative NPV 4,000 oat » discounted pay back period lies between 3rd and 4th year. By dlation the pay back period is \ Ps) = 3.65 years78 Vipul’s™ Financial Management. Ny Assumptions: ) The cash outflow representing the amount invested ; project including the amount invested in working capital ke place in one instalment at the beginning of the first year, @) Each year’s cash inflow is received in one lumpsum at the end y each year. The above assumptions are made purely for convenience af calculations because it would be impractical to discount cash flows for each day of the year. (E) Profitability Index (PI) or Benefit Cost (B/C) Ratio: It is the relation between present value of future net cash flows ang the initial cash outlay. In case of mutually exclusive investmen, proposals, the acceptance criterion is; higher the index, the more profitable is the proposal and vice versa. Gross Present Value of Cash Inflows Bh relent Value of Cash Outflows Profitability index is an extension of present value method. PI vie expresses the relative profitability. PI is to be used only when: (1) Initial investment is not same. (2) When all the projects show positive net present value. When NPV is negative PI is not to be considered. In case of a single project or when the initial cash outlay is same the accept-reject decision under both NPV and PI will be the same. When the firm has unlimited when one has to choose betwee: involve different initial outlay ther method. On the other hand, in cases of capi be more useful as the PI method i funds available for investment and nN mutually exclusive projects thit ~ n the NPV method is better than MI} machines are available — |, information, advise the ma be more profitable unde: (ii) Profitabili achine A and Machine B. From the follo agement which of the two alternatives and r the (j 5 yi od Index Method (i) Net Present Value Meth initial outlay Net cash flows pa Estimated life The cost of capit.79 a Machine A Machine B Net Cash Flows | PV of Cash Flows | NetCash Flows | PVof Cash Flows (Rs) Rs. Rs) (Rs) 15,000 10,000 9,090 15,000 10,000 8,260 15,000 10,000 7,510 oe 10,000 6,830 oe 10,000 6,210 a 10,000 5,640 43,540 37,500 6,040 et Present Value PV of Cash Flows bility Index’ =Tritial Cash Outlay Machine B 143540 * 37,500 estment in Machine B is more profitable according to NPV d; whereas according to profitability index, it would be Machine hen the supply of capital is in abundance for investment purpose, ine B, which shows a greater NPV should be selected. Whereas there is capital rationing Machine A whose PI is greater than that achine B should be selected because it will maximise the benefits in On to scarce financial resources. SOLVED PROBLEMS Payback Period tion 1: mosa Company Ltd. has invested in a machine at cost of Rs. 9,00,000. Following details are 4 staff @ salary of Rs. 20000. 1 staff @ salary of Rs. 40000. Rs. 40000 Rs. 10000 Rs, 15000. Culate: . Payback period. Ignore Taxation and Depreciation. on: Particulars 4 staff @ Rs. 20,000 Igs in Maintenanceoo VEE Vipul’s™ Financial Managemen, _ i Savings in wastage Additional costs: Additional staff required 1 staff @ Rs. 40,000 Additional electricity bill : Total Additional expenses: .Net Cash Inflows! ((1) - (2)) } Net savings - iS Original Investment Payback period = Average Annual Cash Inflows Oa = 200000 Aas 75,000 st Illustration 2: tp vf Calculate Payback period from the following information of Safer Ltd. is Investment Rs. 1 Lakh Estimated Life 10 yrs. i Tax rate 50% Ett Year |_ Profit Before Depreciation | Depreciation | Profit After Depreciation vigil (Rs) (Rs) | (Rs.) et 1 40,000 10,000 30,000 I ie 2 60,000 10,000 50,000 25,000 3 50,000 40,000 40,000 20,00 |i 4 50,000 10,000 40,000 20,000 ha Solution: Year PAT + Depreciation = Cashflow Cumulative Cash ow (Rs.) (Rs.) (Rs.) (Rs.) 1 15,000 10,000 25,000 25,000 2 25,000 10,000 35,000 60, 3 20,000 10,000 30,000 z 4 20,000 10,000 30,000 1,20,000 Payback period = 3 yrs. + 0.33 = 3.33 yrs. or 3 yrs. and 4 months Tyr. 30,000 12 mths 30,000 [7] * 10,000 * 40,000 = 0.33 = 4 mths Illustration 3: If the net cash outlay of an investment yrs. are Rs. 9,000; Rs. 12,000; Rs. 8,000; payback period for Victor Ltd, Solution: Project is Rs. 30,000 and the annual cash inflows "6 ; Rs. 4,000 and Rs. 5,000 respectively. Calculate t e aE s AG Computation of Pa Annual Net Cash Inflows ayback Period 4 Year Fa AF. ln Ono =,sdgeting rod al period =3yrs. +3 mths = 3 yrs. and 3 mths, 4,000 12 mths 1,000 * =3 mths. yijustration 4: Co. Ltd. is considering Excel Trading Co. Ltd. is consi the purchase of a Machine ‘on programme. There are three types of machines in Fgh for Pe iach fsmmated savings in scrap per year, Fsimated savings in direct wages per year. Kk | Cost of Indirect Materials per year, 6 savings in Indirect Materials per annum. Additional Cost of Maintenance per year, Additional Cost of Supervision. simated Lite of Machine (Yrs. Taxation at 40 % of Profit ’ You are required to advise the management which type of machine should be purchased on the basis of Payback Period? Solution: Profitabilit Particulars Estimated savings in scrap Estimated savings in direct wages Expected savings in Indirect Materials J (1) ‘Ad. Cost of Indirect Materials 49d. Cost of Maintenance Add. Cost of Supervision Gla Additional Cost ) Net savings before depreciation 1+) Depreciation Net savings ater depreciation Fil. Tax @ 40% Net Savings atter Taxation ) Depreciation Met hrrwal Cash Inflows iginal Investment Payback Period “Annual Net Cash Inflows sazording 10 the payback periods, the On the basis of profitability statement and ace yee. it has a lesser payback pe Management is advised to purchase Machine B; sinc®= 82 Vipul’s™ Financial Management - } (BAR) Illustration 5: Jugnu Company Ltd. is proposing to expand its production. It can go in for a Standard Machine Costing Rs. 50,000 or an Assembled machine costing Rs. 50,000. The life of both these Machines is 5 years. The annual sales and costs are as below: Particulars Standard Assembled (Rs.) (Rs.) | Sales 50,000 50,000 Materials 15,000 15,000 Labour 7,000 6,000 Variable Overheads 7,000 6,000 Compute the comparative profitability of the proposals under the Payback period. Also calculate the Payback Profitability. Ignore Taxation and Depreciation. | Solution: Statement of Cash Inflows Particulars Standard Assembled (Rs) (Rs) Sales 50,000 50,000 Less: Cost: Materials 15,000 15,000 Labour 7,000 6,000 Variable Overheads 7,000 6,000 Cash Inflows 21,000 23,000 x Initial Investment Payback Perlod = “snnual Cash Inflows : Standard Assembled _ 50,000 ~ 50,000 | 21,000 = 33,000 | = 2.381 yrs. = 2.174 yrs. | Payback profitability = Annual cash Inflows x ew i a erio Standard | Assembled = 21,000 x (52.381) = 23,000 x (6=2.178) = Rs. 55,000 = Rs. 65,000 The above analysis shows that the Assembled machi 5 aca uied ainses (alr the Payback patiod i ehorter, line should be acquired since: (b) The Payback profitability is higher. Illustration 6: Alpha Ltd. is producing articles Mostly on hand fat i “ice i machine. There are two alternative models P and Q eh Considering to replace it wie profitability showing the pay-back period from the following Nome Prepare Particulars : Estimated life of machine Cost of Machine Estimated savings in scrap Estimated savings in direct wages Additional cost of Maintenancepil Budertne ' Tow 83 tion: Lsecheiagrth ee aS golutt Statement showing Annual Cash Inflows 5 avings in sorap i : a savings in direct wages ‘fn 0h y savings (1) 5 ‘ea Cost of Maintenance aciional cost ‘of Supervision Total Additional Cost (2) net Cash Inflow. 1-2 Original Investment Payback Period = onal Average Cash Inflows Based on Payback Period, Machine P has a shorter pay-back period, hence it should be preferred to Machine Q. ohah Payback Profitability = Annual Cash Inflows x (Estimated Life - Machine P Based on Payback Profitability, Machine Q would be preferred as the payback profitability is higher than Machine P. Illustration 7: F From the following details of Omega Particulars back Period and Payback Profit. Sales Vatiable Cost Fixed Cost !nvestment Life 10 years, Tax @ 50% Solution: Sales’ (Variable cost (Fated Cost "Dereon (ioe = Rs. 1000) : Per * Tax Par 250% ty Depreciation Sesh ini ™ Financial Management - | 84 vipul’s™ Fina! ! (Bary Original Investment Payback period = Fnnual Average Cash Inflows 40,000 _ ="2,000 ~ [sys] Annual Average Payback profitability = Cash Inflows = 2,000 x (10-5) = Illustration 8: Charlie Company Ltd. wishes to buy a machine costing Rs. 2,00,000. The life of this maching is 10 years and its scrap value would be Rs. 5,000. The following details are provided: Average Annual NPBT Tax Rate Depreciation (already charged) Calculate: (i) Payback Period. (ii) Payback Profitability (ili) A. R.R. [Accounting Rate of Return Method] Estimated Payback Life ~ Period SLM basis Solution: Statement of Annual Cash Inflows Particulars Annual NPBT Less: Tax @ 35% NPAT Add: Depreciation already charged Cost _ Scrap value 2,00,0007_5,000 10 years Annual Cash Inflow + Initial Investment i Payback Period = @ y Annual Average Cash Inflow _2,00,000 "32,500 = 6-154 years (ii) Payback Profitability = Annual Cash | Inflow x (Estimated life — i = 8250 (08.184 led life - Payback period) = Rs. 1,25,000 (+) Scray Payback Profitability d ied FE (iii) Accounting Rate of Return =—Annual PAT eth Investment * 100 ~ 13,000 ~ 1,02,500 * 100 Average Investment = 12.68% (approx.)ogi —— rrr 85 ¥ Additional Net original ivestment Scrap ‘at + Ween Scrap Capital at (202000=5000) i+ 5000 97/500 + 5,000 zfs. 1,02,900. illustration 9: The Directors of Delta India Ltd. are Considering the purchase of a machine to teplace a rathine which has been in operation for the last 5 years. The details relating to the available aherrative machines are as follows: Particulars Purchase price Power per year Consumable stores per year | Other charges per year Wages per running hour Seling price per unit | Material cost per unit Esimated life of machine | Machine running hrs. per year | Unts of output per hour Tax at 40 % of Net Profit i the entire economic life Assuming that the above sales and cost of sales hold good for fe et of the machines, suggest which of the two altematives should be preferred; using Average Rate of Return (ARR). Depreciation has to be charged according to Straight Line Method. Solution: Particulars, Annual Sales (Hrs. ish. $P p, uw) Rs, 625 8: Cost of Sales Direct Matera 2,000 hrs, x 24 units x Rs. 2.50 ages 2,000 hrs, x RS. 15 Power Consumable Stores Other charges Depreciation Ris, 2,00,000 + 10 yrs. hPRy ‘a <—_Annual PAT __ ~ Average Investment 05. = 30.000 499 *73.0,000 Ce) ne = 30% 100 3roew Vipul’s™ Financial Management . 1 (ear, 86 =e Since the ARR of the New machine is higher as compared to old machine, hence Noy j ; machine should be preferred. | Illustration 10: waa RE Determine the (a) Pay back period and (b) A.R.R. from the following information of a Propose4 fl i roject. aaa Particulars Cost E Annual Profits after Tax and Depreciation Year1 Z 3 4 5 Estimated life Syears Estimated scrap value Rs. 20,000 Solution: _(1) Computation of Pay Back Period: Year PAT Depreciation’ Cash Inflows Cumulative Cash Inflows | (Rs) (Rs) (Rs) (Rs) 1 30,000 1,00,000 1,30,000 1,30,000 2 50,000 1,00,000 1,50,000 2,80,000 3 70,000 1,00,000 1,70,000 4 90,000 1,00,000 1,90,000 6,40,000 5 1,10,000 1,00,000 2,30,0008 8,70,000. Total 3,50,000 5.00,000 8,70,000 @ including scrap value Rs. 20,000 at the end of 5th year. , a - Original Investment - Salvage Depreciation Estimated Life in Years __5,20,000 - 20,000 oy 5 = Rs. 1,00,000 per year Pay Back Period = 3 years + (222000 45.000 = 3.368 years (ARR = x 100 (i) Average Annual PAT = Toa Profit Ater Tax No. of Years ~ 350,000 “5 =Rs.70,000 (ii) Average Investment ay ee inal Investment ~ Sora Value Additional a ) + Net Working 4. we 5,20,000 - 20,000 Capital falue A ( 2 et) +Nil + 20,000 = 250,000 + 20,00087 ital Budgeting = Rs. 2,70,000 70,000, Z ARR = 3795999 * 100 = 25.93% (approx.) pe: NPV ustration 11: A plant is offered for Rs. 1,00,000. Its estimated life is 20 years. During that period it is ated that the net cash flow of the plant will be at the rate of Rs. 10,000 p.a. and the rate of est to be taken is 8% p.a. Is it worthwhile to accept the offer? lution: Itis first to ascertain present value of net cash flows using the annuity table: Statement of Profitability Particulars Net Present Value Since the NPV is negative the offer must be rejected. stration 12: Accompany is considering a project with an initial outlay of Rs. 60,000 comprising of machinery Rs. 50,000 and balance towards working capital exclusively for this project Rs. 10,000. The ‘amount can be borrowed at a rate of 12% p.a. The machinery can be used for 5 years, at the ‘of which there is no salvage value. It can be assumed that the machinery is depreciated on basis for Tax purposes, the tax rate being 30%, Evaluate whether the project is viable under NPV method, Also calculate the Payback __ Period for the project given the following annual sales and expenses. nual sales (Rs.) es excluding depreciation (Rs.) Briefly note your reservations to the decision. lution: b 1,00,000 Particulars expenses Excluding Depreciation Before Depreciation and Tax (PBD&T) Original Cost = ‘Average Annual Cash Inflows . 50,000 = 52,000 PapsekPeied = [OB aa Tanne] ginal Cost - Salvage Value Depreciation p.a. = Orin aeaad Life Payback Period88 Vipul's™ Financial Management. in rm 50,000 ae 8 = Rs. 10,000 NPV Years l CFAT | PVF @ 12% 1105 52,000 3.605 5 "10,000 0.567 Gross PV of Cash Inflows (-) PV of Cash Outows Machinery 50,000 Working Capital 10,000 Net Present Value (NP' “Recovery of Working Capital Recommendations: Since the NPV is positive the proposal is acceptable, Illustration 13: Gati Company Ltd. is considering the following three investment proposals requiring a net cas) Outlay of Rs. 1,20,000; Rs. 1,70,000 and Rs. 2,40,000 respectively. The after cash inflows a tabulated below. Rank these projects in order of their profitability according to the Profitability Index Method Assume that the firm's cost of capital is 15%. ‘vue Atter Tax Cash Inflows J Project X Project Y ProjectZ | (Rs) | (Rs) (Rs) i 10,000 50,000 0,000 i 2 30,000 65,000 1,20,000 0.756 3 45,000 85,000 70,000 0.658 4 65,000 50,000 50,000 0.572 5 45,000 35,000 20,000 0.497 Solution: Project X Year | PVF at 15% | (Rs.) 7 0870 8,700 |” 50,000 2 756 30,000 22,680 | 65,000 3 0.658 45,000 28.610 | 85.000 4 os72 65,000 37,180 | 50,000 5 0.497 45,000 22.385 | 35,000 Total PV 1,20,535, Less: Cash outlay 120.000 NPV 535 Ranking es | Pr Index PV of Cash iniows | PV of Cash Outtiows| 120535 * 1,20,000pital Budgeting he re 89 stration 14: ; for two it ; alternative investments Tata and Bata are: Tne cash flow streams Calculate the (i) Pay back period, (ii a Benefit cost ratio using 11% discount ae inten eae a . . you choose? (-) PV of Cash Outflows Net Present Value ) BIC Ratio = Benefit _PV of Cash Inflows; = "Cost = PV of Cash Outlows Tata Bata 271410 266,260 = 200000 | ~ 210.000 213531 4 ard AAns.: Choose TATA based on PB, NPV and 1 2 Ratio.90 we Vipul's™ Financial Management. (uy / Type: Internal Rate of Return (IRR) Illustration 15: r ich costs Fs, 5,00,000) Ta ; Ltd. is considering a project whicl : Rs. 5,00,000. The esting. | / ae ere tate is 55%. The company uses straight ne Gepreclaion and ef _ proposed project has cash inflaws before depreciation and tax. (CFBDT) as follows: Cash Inflows (Rs. Year end 7,50,000 , 2'50,000 3 2,50,000 4 2,00,000 5 1,50,000 It the cost of capital is 12%, would you recommend the acceptance of the project nde Internal Rate of Return Method? Solution: Year | CFBDT Dep. Net Tax @ 55% | Net Earnings ~ Tax Earnings | _ = EAT Rs) (Rs) (Rs) (Rs) (Rs) 1 1,50,000 1,00,000 50,000 27,500 22,500 2 2,50,000 1,00,000 | 1,50,000 82,500 67,500 3 2,50,000 1,00,000 | 1,50,000 82,500 67,500, 4 2,00,000 1,00,000 | 1,00,000 55,000 45,000 5 1,50,000 1,00,000, 50,000 27,500 22,500. Total CFAT Fake Payback Period Cash Outlays * Average Annual Cash Inflows As per Annuity Table the PV Factors closest to 3.448 agai at 12% 3.605 igainst 5 years are at 14% 3.433 Year | CFAT_] PV Factor @ 12% | PVoICFAT ALT p ~ (Rs (Rs) 1 | 1,22,500 0883 7,00,392 2 | 11675500 0.797 ‘aarp 3 | 1167;500 o7i2 1,19,260.00 4 | 145,000 0.636 92,220.00 5 | 122500 0.567 69,457.50 Total PV of CFAT 5:23,827 50 PV of CFAT Dy; = ~ PV of cash IRR = sh outa Ot+ PV of CFATD,— PV of CFAT D, Ss (D2- Ds) = 10% + 523827.50 ~ 5,00,000 5.23,627.50 = 498,799 * (14% ~ 1294) 2 =12%+ 2 3,827.50 5,107.50 * 2%ter 91 ingari Ltd. is currently under examination of a project which Yield the following returns over a cof time: The cost of the machinery to be installed works out to Rs. 20,000 and the machine is to be ciated at 20% on Written Down Value (WDV) basis. Income Tax Rate is 50%. If the average taising capital is 18%, would you recommend accepting the project under IRR Method. tion: ssuming that the scrap value will be zero at the end of 5th year, therefore the entire remaining ciable value of the asset in the 5th year will be charged as depreciation. Fake Payback Period = Fverage Annual Cash Inf &' 20,000 Oe = ate 807 = 3.289 As per Annuity Table the PV Factors closest to 3.289 across the line of Sth year are; PVF Discount Rate F 3.352 5,172.00 3,570.00 PV OFATD:=PVOl = D1 + BY GFAT Di PV OFAT De 20,144 - 20,000 ~ 15%) = 10g 4 20144 = 20,000 = 15% + Forgas 1997 * 1"92 IRR Since the IRR is lower than the average cost of raising capital therefore the p should be rejected. Illustration 17: ji jects and decide which is the most profitable Calculate the IRR for the following projects an Goch tiara (CEA Project, Particulars Initial Cost End of Year { TOTAL [= Solution: Project X Initial Outlay Fake Payback Period * Average Annual Cash Inflows 6,00,000 - i (Goa net 6 yrs. As per Annuity Table across the line of 6th year: PVF Discount Rate 4.623 8% 4.355 10% Year | CFAT PVF @ 8% PVF @ 10% (Rs.) 1 30,000 a 0 2 1,20,000 0.857 nee 3 1,80,000 0.794 0751 4 2,40,000 0.735 0.683 5 3,00,000 0.681 0621 6 (60,000) 0.630 0564 Total CFAT s 6.16, , 8.16440 ~6,00,000 IRR (Project X} = BY ,00, Pee 08 ear OK 16,440 = Be + 38 499 * 2% Project y a Anitial Outlay Average Annual Cash Inflows Fake Payback Periodrw 93 all r Annuity Table eee line of 6th year, Discount Rate NPV at both 8% and 10% will be positive, Since IRR willbe between a negative and a postive NPV: therfore using 12% and 14% discount factors; IRR using Trial and Error Method. - 3,60,000 2,40,000 1,80,000 1,20,000 Total CFAT IRR (Project Y) =12%+ pie pn 15,660 = 12% +57 240 IRR (Project Y) = 13.14% (approximately) Project Z Initial Outlay__. Fake Payback Period = Jverage Annual Cash Inflows -720,000__ 4g bes ie ‘9,00,000" (emai) As per Annuity Table across the line of 6th year, PVF Discount Rate 4.917 revi [rages [em 1,11,120 x (14% - 12%) ee. TAgoo= TAO - 6%) IRR (Project Z) = 6% +7.43,700-7,7 a 94 Se Summary: Since the IRR of Project Y is higher than Project X and Project Z, hence Project y isty most profitable project. Illustration 18: ; A company is considering the two mutually exclusive projects. The finance director conse that the project with higher NPV should be chosen; whereas the Managing Director thinks that on with higher rate of return should be considered. Both the projects have got an useful life of 5 yeas and the cost of capital is 10%. The initial outlay is Rs. 2 lakhs. The future cash inflow from Project X and Y are as under: eS SEN a YS Year Project X Project Y PV Factor PV Factor it (Rs) (Rs) @ 10% @ 20% 2 1 35,000 1,18,000 0.91 0.83 Pn 2 80,000 60,000 0.83 0.69 ‘pt 3 90,000 40,000 0.75 0.58 a 4 75,000 14,000 0.68 0.48 5 20,000 13,000 0.62 0.41 i You are required to evaluate the projects and explain the inconsistency, if any, inte } — ranking of the projects. wha) Solution: & (a) Pay Back Period Method: . | Cash Inflows | Cumulative Cash Inflows | Cash Inflows fa) (Rs.) Rs) { 7 35,000 35,000 | RA Ty 2 80,000 1,15,000 60,000 i 3 90,000 2,05,000 40,000 i 4 75,000 2,80,000 14,000 \4 5 20,000 3,00,000 18.000 Uy Pay Back Period - 2,00,000 - 1,15,000 - (2,00,000 — 1,15,000' =2yean+ (ena) ~2 yea (2000 780 = 2.944 years or 40,000 2 years and 11.33 months or = 2.55 years or years and 6.6 months or =2 =2 Accept: Project Y b) ARR:Tow 95 Average Annual Profit After Tax ARR="~~ Original Investment ___* 100 (Based on Original Investment) 4,00,000 5 = Foon * 100= [10%] Average Annual Profit After Tax ARR = Average Investment By (Based on Average Investment) Accept: Project X Net Present Value: PV Factor @ 10% PV of Cash Inflows ey RY foe Te) R ; 8060 f : 204,760 Less: PV of Cash Outflows 00. 2,00,000 Net Present Value| 29.150 | 4760] Accept: Project X Inflows: Profitability Index = PV of Cash. = PV of Cash Outflows Accept: Project X nal Rate of Return (IRR):9% oa 4 75.00 0.68 5 20,000, 062 PV of Cash Intiows Less: PV of Cash Outfiows Net Present Value PVcratp, — PVcash outieys IRR =Di+ x (D2- Di) PVorato, — PVcretp, 2,29.150 - 2,00,000 men ey & = 10% + 2,29,150 ~ 1,80,650 * (20 ~ 10) 29,150 = 10% + 46509 * 10 = 16.01% (approx, ] Project ¥ Year Cash Inflows PV Factor PV Cash PV Factor @ 10% Inflows @ 10% @ 20% (Rs) __ (Rs) 1,18,000 0.91 1,07,380 083 60,000 0.83 49,800 0.69 40,000 075 30,000 058 14,000 0.68 9,520 0.48 13,000 0.62 041 PV of Cash Inflows Less: PV of Cash Outtlows Net Present Value 2.04.760 - 2.00.000 * 2,08,760— 1,74,599 * 20-10) =10%+ 5700. x10 30,170 = (11.58% (approx nmr IRR = 10%ital Budgeting Cos! of investment (Rs.) =a Espected life (no salvage) ne ieee ‘acted net income (afer depreciation, Interest and taxes) Year... \ 1 2 3 i 4 j 5 fa) Pay Back Period: we [PAT | Depreciation] 40,000 jf 00,000 — 1,60, iod eS (290000 — 160,000 Pay Back Peri =3years + 20,000 = 3.67 years or 3 years and 8 months 2, 80,000 — 2,40,000 Pay Back Period = 3 years + ( 80,000 = 3.5 years OF 3 years and 6 months Based on pay back period Project is recommended b) Discounted Pay Back Period: gince it has a shorter pay back period. 210 _ Pay Back Period naeunalarean = 4,73 yearsVipul’s™ Financial Management - II (BAR) 98 (iQ : Year | PVFactor@ 10% | Cash Inflows | PV Cash Inflows | Cumulative PV Cash inflows 's.) (Re) (es) | (Rs.) o 1.000 (2.80000) (2,80,000) {2:80,000) 1 0.909 80,000 72,720 (2,07,280) 2 0.826 80,000 66,080 (1,41,200) 3 0.751 80,000 60,080 (81,120) 4 0.683 80,000 54,640 (26,480) 5 621 80,000 49,680 23,200 Pay Back Period =4 years + GR = 4,53 years Based on discounted pay back period Project Q is recommended, since it has a shorter pay back period, Profitability Index: PV Factor @ 10% Project P [_ProectQ__ crat__[ PVGFAT (Rs) (fs) j 1 0.909 50,000 45,450 ce 0.826 50,000 41,300 3 0.751 60,000 45,060 4 0.683 60,000 40,980 5 0.621 60,000. 37,260, Present Value of Cash Inflows Less: PV of Cash Outlays Net Present Value ss PV Cash Inflows Profitability Index = BV Cash Outows (d) Internal Rate of Return (IRR): 7 Initial Outlay Fake Pay Back Period = 77-726 annual Cash Inflows (iP “(a 3.571 ae) As per Annuity table across the line of 5th year, But since IRR will lie between a positive and negative NPV: ; discount factors; IRR will be computed as follows: negative NPV; therefore using 10% and 12%Total CFAT 2.10,050 — 2,00,000 IRR(P) = 10% +9 10.050 = 1,99,400 * (12% - 10%) 10, = 10 +Fggp *2= 11.88% (approx) Q Fake Pay Back Period = 280000 =35 As per Annuity table across the line of 5th yea CFAT PVAnnuity | PVCFAT @ 12% PVCFAT @ 14% Rs.) Factor @ 12% ) 80,000 3.605 2,88,400 2,74,640 2,88,400 - 2,80,000 IRR(Q) = 12%+ SE ene x (14% - 12%) = 13.22% (approx.) . Based on IRR Project Q is recommended, since it has a higher IRR as compared to Project P. llustration 20: Caravan Corporation is venturing in a new project. Initial investment for the project is Rs. 20 . The rate of depreciation 25% on WDV basis. The rate of discount is 10%, Tax rate is 40%. culate: (i) ARR (ii) Discounted pay back eal = «. 2,81,250.00 2,10,937.50 6,32,812.50 7/52,812.50 Depreciation @ 25% on WDV Basis(-) Depreciation Year 1 WDV end of Year 1 (-) Depreciation Year 2 WDV end of Year 2 (-) Depreciation Year 3 WDV end of Year 3 (+) Depreciation Year 4 WDV end of Year 4 (-) Depreciation Year 5 WDV end of Year 5 (i) | ARR: (a) Based on Original Investment Average Annual NPAT «100 =" Original Investment 15,00,000 5 ="papasa0 * 1° (b) Based on Average Investment _ Average Annual NPAT 100 =" Average Investment * 15,00,000 = x 100 = (i) : Years | CFAT PVF @ 10% PVofCFAT | Cumulative PVCFAT | | 2005 6,20,000.00 0.909 5,63,580.00 5,63,580.00 | = 2006 6,75,000.00 0.826 5,57,550.00 11,21,130.00 2007 7,01,250.00 0.751 5,26,638.75 16,47,768.75 2008 7,50,937.50 0.683 5,12,890.31 21,60,659.06 | * 2009 752,812.50 0.621 4,67,496.56 26,28,15562 | | Gross PV of CI] 26,28, 155.62 \ Less: Cost of Project 20,00,000.00 r Discounted PB Profi/NPV 6,28, 155.62 1 Discounted Payback Period =3+ £20,00,000 — 16,47,768.75 ; 5,12,890.31 r 2g 4 352.281.25 i 5,12,890.31 i Pesca een cke =3+0.687 | iscou a eri = 3.687 years (appro: i Illustration 21: {approx.) | The details of a capital investment project are given below: Initial investment for plant and machinery = * Additional investment in working capital Sales (units) per year for years 1 to 5 Selling price per unit Variable cost per unit Fixed overheads (excluding depreciation) per Year for years 1 to 5 to, pital Budgeting row lol inery 25% on W.D.V. Method ery W.D.V. at the end of year 5 Rate of depreciation on plant and machi Salvage value of plant and machin. Applicable tax rate Time horizon fe 40% Post-tax cut off rate "i 3 art Calculate NPV and Discounted pay back period. Discount Factor pizk : ; ok : : 0.2621 Bae : [ 02603 [0.1859 [0.1928 Solution: z Particulars Rs. Cos ) Depreciation Year 125% WDV iets DV Year 1 end |-__75,00,000 | ) Depreciation Year 2 25% WDV | hag 18,75,000 DV Year 2 end ih [56.25.00 | Depreciation Year 3 25% WDV } 14,068,250 DV Year 3 end 42,18,750 +) Depreciation Year 4 25% WDV *10,54,688 DV Year 4 end : a OF rn 31,64,062 ) Depreciation Year 5 KS 7,91,016 DV Year 5 end (Scrap Value] 23,73,046 Particulars Per Unit Total for 1,00,000 Units Sales 120 ) Variable Cost ot AP 60 ) Fixed Overheads 15,00,000 Poft Before Depreciation and Tax (PBD8” . ieee. alba | am 127500 ers 30,93,750 | 94,45,912 | snoo| roars | rare | 250 | 20, 14,06,250 Profit Before Depreciation & Tax (PBD&T) ) Depreciation Prolt Before Tax (PBT) )Tax @ 40% Profit ter Tax (PAT) ) Depreciation ash Fi Working Capital Recovery 23 el rer ae s fp Goat te Pant end Mechiny 1,00,00,000.00102 Vipul’s™ Financial Management . jj (iy Assumption: sla. Outflow towards working capital is incurred at the beginning of first year, Discounted Payback Period a Years Cash Inflow PVF @ 12% PV of oe il 37,00,000 0.8929 39.0379000 2 34,50,000 0.7972 27,50,340. y 5 32,62,500 07118 2,22,247.5 4 31,21,875 0.6355 1983,951.56 5 30,16,406 0.5674 17,11,508.76. 4,00,00,000 - 83,76,317.50 Discounted Payback Period =3+ (ee aeanst SS 983,951.56 = 3,818 years (approx.) Illustration 22: TVS is considering a purchase of a machine. X and Y are the 2 machines available, From the following information, suggest which of the two is recommended under: (a) ARR and _(b) Profitability Index Methods. Machine X(Rs.) | Machine Y (Rs, Cost 4,00,000 5,60,000 Life Syears T years Profit After Tax Year. 1 12,000 10,000 2 12,000 40,000 3 42,000 40,000 4 24,000 20,000 5 12,000 10,000 6 s 10,000 7 = 10,000 (i) Profit is calculated after deducting straight line depreciation and tax. (ii) The cost of capital is 10%. {iii) The PVF's at 10% for years ending 1,2,3,4,5,6 and 7 are 0.909, 0826, 0.751, 0.683 0.621, 0.564 and 0.513 respectively, (iv) — Depreciation for both machines X and Y = Rs. 80,000 per annum. respectively. Solution: Machine X Machine yen PAT + Depreciation = Cash Inflows PAT + Depreciation = Cash Inflows. 7 72,000 80,000 $2,000 10,000 00 2 412,000 80,000 82,000 40,000 3 42,000 80,000 | 1,22,000 40,000 4 24,000 20,000 | 1/0400 20,000 5 12,000 80,000 82,000 10,000 ri i] rc 10,000 ‘ Total_| _1,02,000 | I Ta | ARR ‘Average Annual NPAT (a) (Original Investment) = wal NPAT Original Investment * 100 eepital Budgeting : row 103 scommendation: i Based on ARR (original Investment) Machine X is recommended since the ARR is greater. V of Cost Inflows commendation: Since the PI is less than 1 therefore both the Machines is to be rejected. But if one of them as to be selected then it should be Machine X since the PI is greater in this case. Mlustration 23: A choice is to be made between two competing projects which require an equal investment of Rs. 50,000 and are expected to generate net cash flows as under. Particulars | Project!_| End of year 1 End of year2 End of year 3 End of year 4 End of year 5 End of year 6 Tax Rate Calculate: (2) Pay Back Period. (b) Average Ratio of Return. (C) Pay Back Profitability.ie reo Vipul’s™ Financial Managem, ni = 8,333 _ Total Profit ~ No. of years Project | = Bee = Rs. 3,000 p.a. Average NPAT p.a. Project I a roc 25,000 ~ Average Annual Net Profit After Tax (2) ARR (Original investment) Original Investment ml _ Average Annual PAT ARR (Average Investment) = Average Investment * (3) Payback Profitability = Total Cash Inflow = Cost of Asset Prsieotl = 68,000 ~ 50,000 = Rs. 18,000 Project = 77,000 ~ 50,000 = Rs. 27,000| Budgeting rr 105 tration 24: Onward Technology has short listed two projects A and B for final consideration. It wants up only one project of the two and not both, The investment required for proj { . project A is Rs. 190 le that for project Bis Rs. 400 Lakhs. The other details related to Project A and B are ROJECT A est Profit After Tax 6" Il 60 Mi 14 ROJECT B Year | i Depreciation 78° 64 Profit After Tax, 82 92 54 186 he cost of capital of company is 14% and the present value of Re. 1 at the end of first, second d year @ 14% rate is 0.8772, 0.7695 and 0.6750 respectively using Net Present Value d, which project would you recommend. . at will be your answer under Pay Back Period Method? ition: i i PV Method: Project A PBT | Tax | PAT | Cash Inflows (PAT+Dep.) | PVF @ 14% | PV of Cash Inflows 78 22 56 80 0.8772 70.176 82 22 60 80 0.7695 61.560 60.750 192.486 190.000 2.486, 0.6750 PV of Cash Inflows | | Less: PV of Cash Outflows NPV of Cash Inflows. [PVF @ 14% | PV of Cash inflows | 0.8772 140.352 120.042 162.000 422.394 400.000 22.394 100 26 74 90 Project B Cash Inflows (PAT + Dep, 160 PAT. 82 92 156 196 240 PV of Cash Inflows Less: PV of Cash Outllows NPV of Cash Inflows in Project A. roject B is recommended since NPV is greater tha B i é ’y Back Period rts AN Rs. 190 Lacs [ Cumutative Cash intiows | PAT | Depreciation | 20 % -90_. 2 250 74 Pay Back Period = 2years+( 55% 12) : =fo sare and 4 months or 2.33 or 2 years and 120 Pay Back Periodwo Vipul’s™ Financial Management. oS fi <} 106 Project B: Investment Rs. 400 Lacs Cash Inflows (PAT + Dep Cumul 160 a eeiog te bo oe oa 196. 54 i a 2) Pay Back Period = 2years +549 * i 2 years and 4.2 months or 2.35 years or Pay Back Period =| 2 years 4 months and 6 days or 2 years and 126 days Project A will be selected since the payback period is lesser than Project B. Illustration 25: The Company has short-listed the following three machines for its expansion lative Particulars: Machine | Machine I initial Cost Rs. 1,85,000| Rs. 1,76,000 wit Estimated life in years 8 years 12 years Scrap value at the end of the life Rs. 5,000 Rs. 8,000 be Yearly profit before tax and depreciation Rs. 45,000 Rs. 40,000. You may assume that the company follows straight line method for depreciation. The Income Tax rate is to be assumed at 30%. Mi You are required to prepare a comparative statement of: ‘ (a) Pay back period. (b) Surplus life Profitability. (c) Pay back profitability index. You are also required to prepare a score-sheet to select any one of the above machines. Solution: oa _ Original Cost - Salvage Value Depreciation (SLM) =" Estimated Life (in years) Machine | = 18500-8000 = 22,500 Machine w= 4289008000 44,009 Machine =228500= 15.000. 91999 Type: Cash Inflows are Constant (1) Payback Period =-———Costof Asset_ Constant Annual Cash Inflowspital Budgeting wy rer Jee g)suplus life (Pay back) Profitability: 2... Constant Annual | Estimated Pay ck [ Cash Inflows ™ \ Lite of Asset Pare | + Scrap Value Machine! = [38,250 x (8 ~ 4.83)] + 5,000 = Rs. 1,21,000 + 5,000 = Rs, 1,286,000 Machine ll = [82,200 x (12 -5.46)] + 8,000 we = Rs. 2,10,400 + 8,000 = Rs, 2,18,400 Machine Ill = [44,800 x (10 ~5.02)] + 15,000 = Rs. 2,23,000 + 15,000 = Rs. 2,38,000 (3) Payback Profitability Index = we Sesh nous + Sra Value Alternatively, ; Bs oack Profiabiity inde a eae Folie + Gost Asset , _ (38,250 x 8) +5000 | 3:14,000 Machinel = 7,85,000 = 785,000. (32,200 x 12) +8000 _ 394400 4 0,.4 176,000 ~1,76,000.="""" ; (44,800 x 10) + 15,000 _ 463,000 _, 0. Machine lll = 2,25,000 = 525,000 2.05:1 Machine ll = Payback Period (Select Machine | since Payback period is lower) Suplus Lite Profitability (Select Machine Ii since Payback Profits is greater) we Payback Profitability Index (Select Payback Profitability Index is greater stration 26: Kaira Ltd. is considering evaluating an investment propo: Sas below: i Cash flows after tax before d predition s Machine I since 2.0541 (Oct. 18) al of Rs. 7,00,000 with expected cash ‘Cumulative PV of Cash Inflows (Rs,