Finance Acharya Jatin Nagpal 3.

1 Advanced Capital Budgeting

1. Basics of Capital Budgeting Ex : Ef

- 10 20 30

Prob -
-
20 % 40 % 40
%
I) EXPECTED VALUE e
30
As
-

• Expected value (EV) =  CFi x Probabilityi

: 10XO 2004 t
- -

II) STANDARD DEVIATION (SD or σ) (Lower the better)

• SD =  P(x − x) [square root of “Average squared deviation”]

• Variance = Square of SD (σ2)

• Higher SD = Higher risk

III) COEFFICIENT OF VARIATION (CV) (Lower the better)

• CV = Standard Deviation
Expected NPV ( i.e. Avg return)

IV) NPV
• NPV = PVCI – PVCO
• Expected NPV =  NPVi x Probabilityi
• If conflict between NPV & CV  Chose NPV (as it is compatible with ‘wealth maximization’)

VI) IMPACT OF DEPRECIATION

Alternate 1 Lacs Alternate 2 (Preferred – Faster)

Ex: Sales 100 Sales 100
(-) Cost of goods 50 (-) Cost of goods 50
(-) Depreciation 20 50
(=) PBT 30 (-) Tax @ 30% 15
• PAT: PBT x (1 – 0.3) 21 35
%6
201X 30

(+) Depreciation 20 (+) Tax savings on Depn: 20 x 30%

(=) Cash flow 41 (=) Cash flow 41

Red
Grt I
(Sales VC-F() (1-tox)
of =
-

(1-tex) +
Dep
Deox bee + Tex
sawings
on

lie. Dep" X tex rate)

Finance Acharya Jatin Nagpal 3.2 Advanced Capital Budgeting
Crux: Method 1  CF = (Sales – VC – FC) x (1 – tax) + Depreciation
Method 2  CF = (Sales – VC - FC) x (1 – tax) + Tax savings on depreciation

Imp!! If tax rate = 0, then tax savings on depreciation will be zero. Then:
It,
 CF (if 0 tax) = Sales – VC – FC -live"
Top C
-
Sales >
-
5000 4500

Cast -
e
-
400 -

"Bottom live" n
zo
-
2. Sensitivity Analysis (SA) 50
%
• Analysing how change in 1 variable (sales, VC etc.) affects the project outcome (NPV, IRR etc.)

we a) Method 1 - Normal Method

·ge
• Reduce each variable by a certain % (generally 10%) & check its impact on NPV.
• Most sensitive Variable = Variable which reduces NPV by Highest %

b) Method 2 - NPV Breakeven method

• How much adverse movement is needed in a variable so that NPV becomes 0.
• Most sensitive variable = Variable in which lowest % change causes NPV to become negative.
Zerd .

Ex: Find sensitivity of following project w.r.t Sales & variable cost such that the NPV becomes Zero.
Particulars PV of Amount i) Let New fall be "ve"
Sales 100,000 ·
NPV =
/2 - 60000 -
10 ,
000) -

20
, 000

(-) Variable cost 60,000 ·

0 =
-90 000 ,

90o
= Contribution 40,000 .

(-) Fixed Cost 10,000

= Profit = CF 30,000 o
-1000 e
(-) Initial Investment 20,000 100000

= NPV 10,000 = 10
% in Sale
Ans: # Alternate 1 – Equation Method
(i) Sensitivity to sales (how much should sales decline for NPV to become 0)
• Let Sales be “x” ii) SD wet VC

• (x – 60,000 – 10,000) - 20,000 = 0 E 100000 -

VC-10000) -

20000 =
⑳
O
• x = 90,000
-
↓ -
C CPUC1] PVCO NPV
• Fall of  90,000 – 100,000 x 100 = - 10%
100,000 UC =
70 000
,

Increase 60000
ie
.
of: o

=
16 67 %
.
Finance Acharya Jatin Nagpal 3.3 Advanced Capital Budgeting
(ii) Sensitivity to Variable cost
• (100,000 – VC – 10,000) – 20,000 = 0
• VC = 70,000
• Increase of  70,000 – 60,000 x 100 = 16.67%
60,000

# Alternate 2 – Shortcut Method

(i) Sensitivity to sales
• NPV = 10,000
• So, if PV of sales falls by 10,000 then NPV will become 0.
• Hence, decline in Sales % = NPV x 100 = 10,000 x 100 = 10%
PV of Sales 100,000

(ii) Sensitivity to VC
• Similarly, if PV of VC increases by 10,000 then NPV will become 0.
• Increase in VC % = NPV x 100 = 10,000 x 100 = 16.67%
PV of VC 60,000

Summary:
# Sensitivity to: Shortcut Formula = NPV / PV of that item
NPV
1. Sales (or Sale price per unit)
PV of sales
NPV
2. Variable cost (or VC per unit)
PV of VC
NPV
3. Fixed Cost
PV of FC
NPV
4. Annual Cash flow
PV of Annual CF
NPV i.e. NPV
5. Initial Investment
PV of Initial Investment PVCO

Sales Volume (it affects both

NPV i.e. NPV
6. Revenue as well as VC. So, we will
PV of Contribution PVCI + PV of FC
take Contribution as base here.)

(i) Shortcut logic can be similarly applied for various “₹ figures” such as Running cost, Savings etc.
(ii) Shortcut cannot be used for used for non-monetary variables such as discount rate, project life etc.
Finance Acharya Jatin Nagpal 3.4 Advanced Capital Budgeting
3. Certainty Equivalent (C.E.) Approach
• C.E. CFs = How much certain CFs would you require to give up uncertain (risky) CFs.
• Example:

II) STEPS IN CE APPROACH

1. Get Certainty Equivalent CFs (C.E. CF)
C.E. CF = Normal CFs x C.E. Coefficient
2. Discount these “Certain CFs” at Risk-free risk.

• Theoretically, value as per C.E. Approach and Value as per RADR approach should be same.

4. Risk-Adjusted Discount Rate (RADR) (Covered in more detail in “Bonds”)

• RADR (or simply required return) = RF + Risk premium

• Higher risk = Higher required risk premium = Higher required return

II) NOMINAL VS REAL DISCOUNT RATE (K)

• Real discount rate = Does not include inflation
• Nominal discount rate (Includes inflation) = (1 + Real K) (1 + Inflation) -

III) RULE OF CONSISTENCY (informally – Rule of loyalty)

Cash flows Discount rate to be used
• Nominal cash flows Nominal discount rate
• Real cash flows Real discount rate

IV) CALCULATING RADR IF RISK INDEX IS GIVEN (Same as CAPM)

RADR = Rf + (Minimum Req. return – Rf) x Risk Index
CPN =
RF + (Rm -RF) X Beta
Finance Acharya Jatin Nagpal 3.5 Advanced Capital Budgeting

1. Probability – Perfectly dependent & Fully Independent

Find Prob. that Chintu will get
Bad class for entire 3 years if:

Case A: Class once allotted is

fixed for entire 3 years. · fully dependent
Case B: Classes are reshuffled
at the end of every year.
Lass
(fully Independent as

is
allotted in later year
PY's Hass)
not related to
.

Ans: Case A: Classes are Fixed. So, bad class in Y1 means bad class for entire 3 years.
Prob. of bad class for entire 3 years = Prob. of bad class in the 1st year = 40%

• Case B: Classes are reshuffled every year.

Prob. (Bad class for all 3 years) = Bad class in Y1 x Bad class in Y2 x Bad class in Y3
= 0.4 x 0.4 x 0.4 = 0.43 = 0.064 or 6.4%

Ex: Expected CFs of a project are as below:

Year Case 1 (Bad) – 40% chance Case 1 (Good) – 60% chance
Year 1 2L 4L
Year 2 2.5L 5L
Year 3 3L 7L
Find Prob. of bad CFs for entire 3 years if: (a) CFs are fully dependent
(b) CFs are independent of previous year’s CF
Ans: Case A: If CFs are fully dependent
 Prob (Bad CFs for entire 3 years) = Prob. (bad CF in Y1) = 0.4 or 40%

Case B: If CFs are independent of Previous year’s CF

 Prob (Bad CFs for entire 3 years) = Bad CF in Y1 x Bad CF in Y2 x Bad CF in Y3
= 0.4 x 0.4 x 0.4 = 0.43 = 0.064 or 6.4%

Prob of &
.

(i) bad
ofgetting
Yr1 , Good
oifn
in Ye2
again
Bad in
is in

if are

Prob Good X Prob Bad

(ii) Of Independent Prob Bad X
ever
fully Of in
.

YRI
↳ in 72Z Of in 423
=
0 4 x 0 6 X 0
. .
.

4 =
0 . 096 Of 9 6% .
Finance Acharya Jatin Nagpal 3.6 Advanced Capital Budgeting
2. SD & Variance of PVCI in case of a ‘Single year’ CF

I) BASE EXAMPLE
Ex: A project is expected to generate a CF of ₹150L after 3 years. SD of this CF is 20L.
Discount rate = 8%. Find: (i) PVCI (ii) SD of PVCI (iii) Variance of PVCI
Ans: PVCI = 150 / 1.083 = 119.17
⑧F

ii) SD of PVCI = 20 / 1.083 = 15.877

iii) Variance of PVCI = 15.8772 = 252.07

• Or variance of PVCI = = 𝟑×𝟐 = 𝟔 = 252.07

. . .

II) FORMULA
• SD of PVCI = SD of Year n
(1 + K)n

• Variance of PVCI = Variance of Year n

(1 + K)n x 2

3. SD & Variance when CFs of > 1 year are given (Hiller’s Model)

I) CASE 1 – When CFs are fully Independent (i.e. correlation = 0)

Study Mat
>
- Two

• Total Variance =  PV of Variance of all the years Ques

• Total Variance = Variance of Y1 + Variance of Y2 + Variance of Y3 + & so on…

of jecte
&V4 (1 + K)2 (1 + K)4 (1 + K)6

• SD = √ Total Variance

Ex: Calculate variance & SD of EV. Variance of each year CFs is as below. Discount rate = 6% p.a.
Year : 1 2 3
Variance of CF: 85.40 98.62 74.29
Ans: Variance of EV =  PV of Variance
= Variance of Year 1 + Variance of Year 2 + Variance of Year 3
(1 + K)2 (1 + K)4 (1 + K)6
Finance Acharya Jatin Nagpal 3.7 Advanced Capital Budgeting

= 85.40 + 98.62 + 74.29 = 206.493

1.062 1.064 1.066

• SD = √Total Variance = √206.493 = 14.369

>
II) CASE 2 – When CFs are fully Dependent (i.e. correlation = +1) -

• Total SD =  PV of SD of all the years hte

• Total SD = SD of Y1 + SD of Y2 + SD of Y3 + & so on…
(1 + K)1 (1 + K)2 (1 + K)3
• Imp!! If nothing is mentioned in ques, then assume CFs are “Independent”.

III) OTHER NAMES OF SD OF PVCI

• SD of Expected Value (EV) • SD of Present Value distribution
• Possible deviation in EV • SD of NPV

IV) NOTE FOR MCQ - WHICH ONE IS RISKIER?

• Fully dependent CFs (i.e. correlation = +1) or Independent CFs (correlation = 0).
Ans: Fully dependent (as higher the correlation, higher the risk).

4. Impact of Inflation on Actual return

Ex: Yuki incorporated purchased a machine in 1980 for ₹1L. Expected life of machine = 50 years.
Tax rate = 30%. Financial statements of Yuki Inc in 1980 and in 2025 are:
# Particulars Year 1980 Year 2025
Sales 10,000 15,00,000
(-) Expenses (8,000) (10,00,000)
= Profit 2,000 5,00,000
(+) Depreciation tax benefit: 2000 x 30% 600 600
= Cash Flow 2600 5,00,600

Analysis: Over time, goods get expensive due to inflation. But depreciation is charged on “Historical
cost” only. So, benefit of depreciation reduces over time due to inflation (i.e. lower CFs).
 Crux: Inflation reduces “Actual return” of investor.
Finance Acharya Jatin Nagpal 3.8 Advanced Capital Budgeting
5. Decision Tree
A diagrammatic way to represent the various paths along with the Prob. & outcome of that path.

Ex: There is a 40% chance that you will earn ₹5 Lacs in year 1 and 60% chance of earning ₹3 Lacs.
If you earned ₹5L in Y1 then you may earn ₹8L (70% Prob.) or ₹6L (30% Prob.) in Y2. Required:
(i) Draw decision tree for this scenario.
(ii) What is the probability that you will earn ₹8L in year 2?
Ans: (i) Decision Tree: a
· za 287

0 4 X0 3
.
.
=
0 . 12 B2 12 %
45
0 YLace 0 6 X0 45 &F %.
.

.
.
=
0 27.
G

i
0 .

55 Zac 0 6 . X 0 .
55 =
0 .
33 M

(ii) Prob. of earning ₹8L = Prob. (5L in Y1) x Prob. (8L in Y2)
(Joint prob.) = 0.4 x 0.7 = 0.28 or 28%

6. Other Points

I) PROFITABILITY INDEX (PI)

PI = PVCI / Initial Investment
or PI = (Initial Investment + NPV) / Initial Investment
 Note: Complete “Replacement decision” lecture is also available on Youtube. Search
Replacement decisions by Kriviii Eduspace to watch the complete video.

Finance Acharya Jatin Nagpal 3.9 Advanced Capital Budgeting

# Replacement Decisions – Master Chart

the
EAL is just
of
- "

aug
.
Lest pa .

-
a macrine /only
diff-
·
is that is

- in
cal a bit more

professional menuer)

1. When life is same = Incremental NPV approach

I) INCREMENTAL NPV (Use only if life of new machine = remaining life of existing machine)
Incremental NPV = Incremental PVCI (-) Incremental PVCO

cann
inflows
i) Inc. PVCI
* = (Δ Revenue – ΔCosts) (1 – tax) + Δ Depn x tax
LI
PVCI = Δ PAT + Δ Depreciation
or Inc. - C =

A PAT + DDept

ii) Inc. PVCO = MV of new machine – MV of old machine ± Tax paid / (savings)
• Tax paid / (Savings) = (MV – BV of old machine) x Tax %

Ex: Market price of new machine is ₹20,000. Old machine can be sold for ₹10,000. Tax rate is 30%. Find
Incremental Cash outflow if book value of existing machine is:
Case (i)  BV = ₹8,000 20 000 -
10 000 =
10 000
, , ,

Case (ii)  BV = ₹15,000

Finance Acharya Jatin Nagpal 3.10 Advanced Capital Budgeting
Ans: Case (i)  BV = ₹8,000
• Tax paid = (10,000 – 8,000) x 30% = 600
• Incremental Cash outflow = (20,000 – 10,000) + 600 = 10,600

Case (ii)  BV = ₹8,000

=> EI500S

• Tax paid = (10,000 – 15,000) x 30% = –1500 i.e. tax savings of 1500.
• Incremental Cash outflow = (20,000 – 10,000) - 1500 = 8,500

2. EAC / Equivalent NPV approach

I) EQUIVALENT NPV
• NPV cannot be compared directly if life of 2 projects is different.
• In such cases, we compare “Average earning p.a.” also known as “Equivalent NPV”.
• Equivalent NPV = NPV ÷ PVAF

Ex: Which of the following projects would you select if discount rate is 10% p.a.
Particulars Project A Project B
Total PV
of
NPV
lost
9,00,000 10,00,000
Life 5 years 10 years
Ans: Let Average Earning p.a. of project A be “a”. Then:
• a × PVAF(10%, 5) = NPV
• a= NPV = 9,00,000 = ₹ 2,37,417 p.a.
PVAF 3.7908
-
I
&
Eco Pot
Fo
"

Exan
only use "Equivalent NPV
# Equivalent NPV (Average earning p.a.) of project B:
C Do not mention
"ang
= NPV of project B = 10,00,000 = ₹ 1,62,745 p.a. "

erning pa in exam
.

PVAF(10%, 10) 6.1446

• Equivalent NPV (Average earning p.a.) of Project A > Project B. Hence, Project A is better.

II) EQUIVALENT ANNUAL COST (EAC) (Just like Eq. NPV)

• Here, we calculate “Average cost p.a.” to compare cost of different projects or machines.
• Equivalent Annual Cost (EAC) = PV of total costs
PVAF
Finance Acharya Jatin Nagpal 3.11 Advanced Capital Budgeting

flow flow case inflor

>
Total Cost
-

Or
PV
=
EDC
of
=

PVDF (10
%, 3) 85

# Calculating PV of total costs:

• Purchase price of machine xxx =
96 507,
-

(+) PV of operating costs (repair, maintenance etc.) xxx

- -

(-) PV of Salvage value (xxx)

= PV of total costs xxx

Notes:
• Informally, EAC = “True average cost p.a.” that co. incurs for operating a machine.
• EAC is also sometimes called as “Capital charge p.a.”

3. Applications of EAC

I) COMPARE 2 MACHINES WITH DIFFERENT LIFE

• Select the machine with the lowest EAC (or higher Equivalent NPV).

II) OPTIMUM REPLACEMENT CYCLE (ORC)

• Scenario  Same asset is purchased repeatedly after a set interval (ex: every 2 years, 3 years etc.)
• Optimum replacement cycle = Where average cost p.a. is lowest i.e. where EAC is lowest.

III) AVERAGE COST PER UNIT

Ex: Purchase price of new machine = ₹3 lacs. It will require maintenance of ₹2 lacs in year 2.
• It can produce 10,000 units p.a. for 3 years after which it will be sold for ₹40,000.
• Material and labour cost for each unit = ₹ 30.
• Find Selling price p.u. if co. wants to price its product on cost + 20% basis.
O & 2 3

I I 1

, 000
300
Repair
= 200000
40 000 (Resale)
Finance Acharya Jatin Nagpal 3.12 Advanced Capital Budgeting
• Discount rate = 10% p.a.
Ans: Step 1: Calculating Average cost p.a. of machinery using EAC
Purchase price 3,00,000
(+) PV of maintenance = 2L / 1.12 1,65,289
(-) PV of resale price = 40,000 / 1.13 (30,053)
Total = 4,35,236
(÷) PVAF (10%, 3) 2.4869
EAC = 1,75,011

# Step 2: Average cost per unit

• Average cost = Material + labour cost p.u. + EAC p.u.
= 30 + 1,75,011 = ₹ 47.5 p.u.
10,000

• Selling price per unit = 47.5 x 1.2 = ₹57 per unit

IV) REPLACE NOW OR LATER DECISIONS (When should a machine be replaced)

• Scenario – We want to replace the machine. But not sure whether we should replace now or after
1 year, 2 years or so on.

# Approach – Calculate Total PV of cost for the project

• Cost p.a. till machine is not replaced = Maintenance of existing machine etc.
• Cost p.a. once machine is replaced = EAC of new machine