CAPITAL BUDGETING MSC FINANCE BASIC SUMS:

ARR

ACCOUNTING RATE OF RETURN:

1. IS A TRADITONAL METHOD OF EVALUATING THE PROJECT
2. IT IS THE ONLY METHOD WHICH CONSIDERS NET PROFIT

The ARR is based on the accounting concept of return on investment or rate of return. The
ARR may be defined as the annualized net income earned on the average funds invested in a
project. In other words, the annual returns of a project are expressed as a percentage of the
net investment in the project.
Computation of ARR: symbolically,
ARR = Average Annual Profits (NPAT) * 100
Average Investment in the project

This clearly shows that the ARR Is a measure based on the accounting profit rather than the
cash flows and is very similar to the measure of rate of return on capital employed, which is
generally used to measure the overall profitability of the firm. The calculation of ARR may
be further discussed with the reference to annual profits and unequal annual profit is as
follows:
ARR = Annual Profit (NPAT) * 100
Average Investment in the project
Unequal profits: if the project is expected to generate unequal profits or uneven stream of
profits over different years, then the ARR May be calculated by finding out the average
annual profits that is by taking the average of the number of years profits and then comparing
it with average investments of the project as follows:
ARR = Average Annual Profits (NPAT) * 100
Average Investment in the project
where,
Average investment in the project = 1/2 (Initial cost + Installation expenses - Salvage
value) + salvage value.
The additional working capital: sometimes, the project may also require additional working
capital for its smooth operations. Do this additional working capital will be released back,
when the proposal will be scrapped and terminated, yet this amount of additional working
capital is blocked throughout the life of the project. So, this additional working capital entails
the investment of funds of the firm and should also be added to the average investment
calculated as above. The average investment in any proposal required to find out the ARR
may therefore, be calculated as follows:
Average investment = 1/2 (Initial cost + Installation expenses - Salvage value) + Salvage
value + Additional working capital

A project with an Initial outflow of ₹1,20,000 with ₹20,000 as Salvage and ₹20,000 as
additional working capital cost and is expected to generate an after tax profit of ₹18,000, then
the average investment and the ARR can be calculated as follows:

AVERAGE INVESTMENT = 1/2 (Initial cost + Installation expenses - Salvage value) +

Salvage value + Additional working capital

=½ (1,20,000 – 20,000) + 20,000 + 20,000

= 90,000
ARR = AVERAGE NPAT / AVERAGE INVESTMENT * 100
= 18,000 / 90,000 * 100 = 20.00%

A company is considering a new project for which the investment data as follows:
Capital outlay = Rs. 4,00,000
Depreciation = 10% p.a.
Forecasted annual income before charging depreciation, but after all other charges are as
follows:
Year Rs.
1 2,00,000
2 2,00,000
3 1,60,000
4 1,60,000
5 80,000

TAX RATE ASSUME AT 20%

Based on the available data, set out calculations, illustrating and comparing the following
methods of evaluating the return BASED ON ARR.

SOLUTION:
ARR = AVG NPAT / AVG INVESTMENT * 100
= 96,000 / 2,00,000 * 100
= 48%
AVG NPAT
Year PBDT DEP PBTTAX @ 20% NPAT
1 2,00,000 40,000 1,60,000 32,000 1,28,000
2 2,00,000 40,000 1,60,000 32,000 1,28,000
3 1,60,000 40,000 1,20,000 24,000 96,000
4 1,60,000 40,000 1,20,000 24,000 96,000
5 80,000 40,000 40,000 8,000 32,000
TOTAL NPAT 4,80,000
AVG NPAT = TOTAL NPAT / 5 96,000

AVG INVESTMENT =
1/2 (Initial cost + Installation expenses - Salvage value) + Salvage value + Additional
working capital
½ (4,00,000 + 0 – 0) + 0 + 0

= 2,00,000

Q.1. Northem Manufacturing Co. Ltd. wishes to purchase a machine. You have to advise the
directors from the following information supplied to you BASED ON PB PERIOD:
Particulars Machine A Machine B
Rs. Rs.

Initial outlay 10,000 10,000

Cash inflows
Year 1 1,000 3,000
Year 2 2,000 3,000
Year 3 3,500 3,000
Year 4 3,500 1,000
Year 5 3,000 -
Year 6 4,000 -

Q.2. M/S NIKUNJ WANTS PURCHASE A MACHINE WHOSE INITIAL OUTLAY IS

INR 1,50,000 AND THE CASH INFLOW OVER A PERIOD OF 5 YEARS IS
INR 45,000; 75,000; 90,000; 1,20,000; 65,000 RESPECTIEVELY FOR THE 5 YEARS
CALCULATE THE PBP.
Q.3. Machine Rambo costs Rs. 2,00,000 payable immediately. Machine Baaz costs Rs.
2,40,000 half payable immediately and half payable in one year’s time. The cash receipts
expected are as follows:
Year (at end) Machine Rambo Rs. Machine Baaz Rs.
1 40,000 -
2 1,20,000 1,20,000
3 80,000 1,20,000
4 60,000 1,60,000
5 40,000 -
At 6% opportunity cost, which machine should be selected on the basis of NPV method?

Q.4. A firm whose cost of capital is 10% is considering two mutually exclusive projects Red
and Brown, the details of which are:
Year Project Red Project Brown
Cost 0 Rs. 2,00,000 Rs. 2,00,000
Cash Inflows 1 20,000 1,00,000
2 40,000 80,000
3 60,000 40,000
4 90,000 20,000
5 1,20,000 20,000
Compute the Net Present Value at 10%, Profitability Index
Q.5. A company is considering a new project for which the investment data as follows:
Capital outlay = Rs. 4,00,000
Depreciation = 10% p.a.
Forecasted annual income before charging depreciation, but after all other charges are as
follows:
Year Rs.
1 2,00,000
2 2,00,000
3 1,60,000
4 1,60,000
5 80,000
TAX RATE @ 🡪 22%
On the basis of the available data, set out calculations, illustrating and comparing the
following methods of evaluating the return:
a. Payback method

Q.6. Company requires an initial investment of Rs. 1,20,000. The estimated net cash flows
are as follows:
Year Net cash flows (Rs.)
1 21,000
2 21,000
3 21,000
4 21,000
5 21,000
6 24,000
7 30,000
 8 45,000
9 30,000
10 12,000
Using 10% as the cost of capital (rate of Discount), determine the following:
(1) Pay – Back period (2) Net Present Value (3) Internal Rate of Return

Q.7. REX Ltd. has to replace one of machine for which it has following options:
a) Installation of equipment ‘A’ having cost of Rs. 1,50,000 which is expected to generate a
cash inflow of Rs. 40,000 p.a. for next 6 years.
b) Installation of equipment ‘B’ having a cost of Rs. 1,00,000 which is expected to generate a
cash inflow of Rs. 36,000 p.a. for next 4 years.
Which equipment should be preferred if the company adopts method of
(i) Payback period (ii) Internal Rate of Return.

CAPITAL RATIONING:
1. SELECTION OF PROJECT BASED ON VARIOUS METHODS BY GIVING
RANKINGS.

Q. 8. A LTD HAS THE A PROJECT WHOSE CAPITAL OUTLAY IS RS. 10,00,000 AND
THE FOLLOWING ARE THE INFORMATION AVAILABLE:

PROJECT OUTLAY NPV (RS) IRR

1 8,00,000 4,00,000 15.55%
2 9,50,000 3,15,000 12.67%
3 7,80,000 2,65,000 15.67%
4 8,75,000 4,25,000 17%
Find out the ranking of the proposals

Q. 9. A firm has capital budget constraint of Rs.30,00,000. The expected outlay and cash
flows of various projects is as follows:
Project Outlay (Rs. In lakhs) NPV (Rs. In lakhs)
A 18.0 7.5
B 15.0 6.0
C 12.0 5.0
D 7.5 3.6
E 6.0 3.0

Determine which possible combination the firm should select.

SELECT THE BEST PROJECT WITH NPV ONLY