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Capital Budgeting- Numerical

Risk adjusted cut-off rate.

Question 1

Solution
The profitability of two investments can be compared based on their net present
values, cash inflows adjusted for risk premium.
Investment X Investment Y

Yea Discount Cash Present Value Discount Cash Present Value

r Factor 10 % Inflo Rs. Factor 10 % Inflo Rs.
+2%=12% w +8%=18% w
Rs. Rs.
1 0.893 60,00 53,580 0.847 85,00 71,995
0 0
2 0.797 45,00 35,865 0.718 55,00 39,490
0 0
3 0.712 35,00 24,920 0,609 40,00 24,360
0 0
4 0.635 30,00 30,000 0.516 40,00 20,640
0 0
133,41 156,48
5 5
Investment X
Net Present Value = 133,415-150,000
= Rs. 16585
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Investment Y
Net Present Value = 156,485-150,000
= Rs. 6,485
Project Y should be preferred because Y gives a higher NPV even at a
higher discount rate.
Question 2
Cash Flows
Year Project X Project Y
1 40000 50000
2 35000 40000
3 25000 30000
4 20000 30000

The company has a target return on capital at 10%. Risk premium rates are 2%
and 8%. for investments A and B. Which investment should be preferred?
Investment X Investment Y

Year Discount Cash Present Value Discount Cash Present Value

Factor 10 % Inflow Rs. Factor 10 % Inflow Rs.
+2%=12% Rs. +8%=18% Rs.
1 0.893 40000 0.847 50000
2 0.797 35000 0.718 40000
3 0.712 25000 0,609 30000
4 0.635 20000 0.516 30000

Investment X
Net Present Value =
=
Investment Y
Net Present Value =
=
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Question 3

Solution
Calculations of cashflows with uncertainty
Project A Project B

Yea Cash Certainty Certain Cash Certainty Certain Cash

r Inflows co- Cash Inflows co- inflow
efficient inflow efficient
1 35,000 0.8 28,000 25,000 0.9 22,500
2 30,000 0.7 21,000 35,000 0.8 28,000
3 20,000 0.9 18.000 20,000 0.7 14,000
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Project A Project B

Year Discount Cash Inflows Present Cash Present Value

Factor@ Value Inflows
10%
1 0.909 28,000 25,452 22.500 20,453
2 0.826 21,000 17,346 28.000 23,128
3 0.751 18.000 13,518 14.000 10,514
56.316 54,095

Project A
NPV= Rs 56,316- 50,000 = 6,316
Project B
NPV= Rs 54,096- 50,000 = 4,095
Project A is preferred as its NPV is higher than that of Project B
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Capital Budgeting- Numerical

Question 4
NZ ltd. is considering to take a new project. The management of the company
use Certainty Equivalent (CE) approach to evaluate such type of projects.
Following information is available for the project:

Year CFAT CE
1 115,000 0.90
2 115,000 0.85
3 115,000 0.75
4 115,000 0.70
5 115,000 0.65

Projects requires initial investment of 3,00,000. The Company’s cost of capital

is 12% and risk-free borrowing rate is 7%. Advise the company whether it
should take project or not?
Solution:

Since NPV is positive, project can be accepted.

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Sensitivity Technique
Question 5

Solution
Calculation of net present value of cash inflows at a discount rate of 15%.
(Annuity of Re 1 for 5 years)

For Project X

For Project Y
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Capital Budgeting- Numerical

The Net present values calculated above indicate that Project Y is riskier than
Project X. But during favourable conditions it is more profitable also.
Therefore, the choice will depend upon the investor’s attitude towards risk.

Probability Technique
Question 6
Two mutually exclusive investment proposals are being considered. The
following information is available.
Project A Project B
Cost 10,000 10,000
Year (Cash inflows Rs Probability Rs Probability
1 10,000 0.2 12,000 0.2
2 18,000 0.6 16,000 0.6
3 8000 0.2 14,000 0,2

Determine in which project should the investor in.

Solution

Step I: Calculation of NPV for the 2 products

Project A

Total Present Value : 11,941

Cost of Investment : 10,000
NPV : Rs.1,941
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Capital Budgeting- Numerical

Project B

Total Present Value : 11,233

Cost of Investment : 10,000
NPV :Rs.1,233

Question 7

X ltd. is considering starting a new project for which it has gathered

following data:
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Capital Budgeting- Numerical

Standard Deviation

Question 8

X ltd. is considering to start a new project for which it has gathered

following data:

NPV Probability
80,000 0.3
110,000 0.3
142,500 0.2

Compute the risk associated with the project i.e. standard deviation.
Solution:
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Capital Budgeting- Numerical

Question 9

Solution:

On the basis of information about standard deviation of project X & y, the

project X is better as it has lower standard deviation (i.e. risk). However, the
coefficient of variation for these projects may be found as follows:
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Capital Budgeting- Numerical

Question 10
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Capital Budgeting- Numerical

Question 11

Victoria Limited furnishes the following information from which you are
required to compute the PV and suggest which project to be selected.

Year Project AB Project XY

CFAT (Rs.) Probability CFAT (Rs.) Probability
1 8,000 0.1 22,000 0.2
2 9,000 0.2 21,000 0.2
3 12,000 0.3 17,000 0.2
4 13,000 0.2 15,000 0.2
5 18,000 0.2 12,000 0.2

Company’s Cost of Capital is 10%.

Question 11

HD Ltd furnishes the following information.

Investment Limit: Rs. 70 lakhs

Projects X Y Z
Initial Investment 12,00,000 10,00,000 15,00,000

Cash Flows
Year
1 5,00,000 5,00,000 4,00,000
2 5,00,000 4,00,000 5,00,000
3 5,00,000 5,00,000 6,00,000
4 5,00,000 3,00,000 10,00,000
Risk Index 1.80 1.00 0.60

and R is mutually exclusive. None of the projects can be delayed or undertaken

more than once. Suggest the most feasible combination.
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Capital Budgeting- Numerical

Question 12

Mohan Ltd is considering investment in one of the three mutually exclusive

projects: X, Y and Z.

The company’s cost of capital is 5% and the risk-free interest rate is 10%. The
income tax rate for the company is 34%. Mohan Ltd has gathered the following
basic cash flows and risk index data for each project:

Projects X Y Z
Initial 1,200,000 1,000,000 1,500,000
Investment
Cash Flows
Year
1 5,00,000 5,00,000 4,00,000
2 5,00,000 4,00,000 5,00,000
3 5,00,000 5,00,000 6,00,000
4 5,00,000 3,00,000 10,00,000
Risk Index 1.80 1.00 0.60

Determine the project in which Mohan should invest.

Question 13

PAM Ltd is considering two mutually exclusive projects viz., Project A and
Project B which require cash outflow of `30,00,000. The expected cash inflows
are as follows: -

Year Project A Project B

1 12,00,000 17,00,000
2 9,00,000 11,00,000
3 7,00,000 8,00,000
4 6,00,000 8,00,000

The company has a target return on capital of 10%.The risk premium for Project
A and Project B are 2% and 8% respectively. Which project should be accepted?
Why?

Question 14
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Capital Budgeting- Numerical

Zebra Ltd is considering two mutually exclusive projects. Investment outlay of

both the project is ` 2,50,000 and each is expected to have a life of 5 years.
under three possible situations their annual cash flows are as under

Situation Probabilities Situation Project Project Y

X (` in Lakhs)
(` in Lakhs)
Good 0.3 30 25
Normal 0.4 20 20
Worse 0.3 10 15

Which Project is riskier? Why?

Question 15

Steep Ltd. is considering the following projects.

Project Outlay (`) NPV

P 30,00,000 5,00,000
Q 20,00,000 9,00,000
R 18,00,000 8,00,000
S 16,00,000 7,00,000
T 14,00,000 6,00,000

The total fund available is `50,00,000. Determine optimal combination of

projects assuming that the projects are divisible.

Question 16
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Capital Budgeting- Numerical

Akshay Limited is considering new projects for investments. The two

alternative investment proposals are Project ‘Red’ and Project ‘Blue’ . The cost
of each project is estimated to be Rs 7,500,000

Year Red Blue

1 3,000,000 4,250,000
2 2,250,000 2,750,000
3 1.750,000 2,000,000
4 1,500,000 1,600,000

The current yield on government securities is 8 % and the risk premium for
Project Red is 5 % and Project Blue is 7 % . Which investment should be
preferred by Akshay Limited?

Discounting Year 1 Year 2 Year 3 Year 4

rate
13% 0.885 0.783 0.693 0.613
15% 0.870 0.756 0.658 0.572
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Capital Budgeting- Numerical

Fill in the blanks by choosing the correct option:

1. Co-efficient of Variation indicates that ________the co-efficient, the

riskier is the project.

(a) Higher
(b) Lower
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(c) zero

2. ________ ensures that lesser number of projects are selected by

imposing capital restrictions.

(a) Capital structure.

(b) Capital Budgeting
(c) Capital Rationing
(d) None of the above

3. ----------------- is a situation where a constraint or budget is placed on

the total size of capital expenditure during a particular period

(a) Capital budgeting.

(b) Capital rationing.
(c) Cost of capital
(d) Leverage

4. PI of a project is the ratio of present value of inflows to

(a) Initial cost

(b) PV of outflows
(c) Total cash inflows
(d) Total outflows

5. --------------------- is a schematic representation of several decisions

followed by different chances of occurrence.

(a) Sensitivity analysis

(b) Probability techniques
(c) Risk Adjusted Discounting Rate
(d) Decision Tree
B) State whether the following questions are True or False

1. In sensitivity analysis, the sensitivity of human factor is identified.

a. True
b. False

2. Capital rationing is caused by external factors only.

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a. True
b. False

3. Preference dividend is added to NPAT for calculation of EPS.

a. True
b. False

4. Capital budgeting deals with long-term decisions.

a. True
b. False

5. An estimation of the present value of cash for high-risk investments is

known as Risk adjusted discounting rate.

a. True
b. False