Capital Budgeting

31-03-2010
 Problem 2
 An iron ore company is considering investing in
a new processing facility. The company extracts
ore from an open pit mine. During the year
1,00,000 tonnes of ore is extracted. If the
output from the extraction process is sold
immediately upon removal of dirt, rocks and
other impurities a price of Rs. 1000 per ton of
ore can be obtained. The company has
estimated that its extraction costs amounts to
70 per cent of the net realizable value of the
ore.
 Problem 2 continued…
 As an alternative to selling all the ore at Rs.
1000 per tonne, it is possible to process further
25 per cent of the output. The additional cost of
further processing would be Rs. 100 per ton.
The proposed ore would yield 80 per cent final
out put and can be sold at Rs.1600 per ton.
 For additional processing, the company would
have to install equipment costing Rs.100 lakh.
The equipment is subject to 25 per cent
depreciation per annum on reducing balance
method. It is expected to have useful life of 5
years. Additional working capital requirement is
estimated as Rs. 10 lakhs. The company’s cut-
off rate of such investment is 15 %. Corporate
tax rate is 35 per cent.
 Problem 2 continued…
 Assuming there is no other plant and
machinery subject to 25%
depreciation, should the company
install the equipment if a. the
expected salvage is Rs. 10 lakh and
b. there would be no salvage value
at the end of 5 years.
 Average Rate of Return
 (Average Annual profits after taxes/
Average investment over the life of the
project)* 100
 Average Investment = Net working
capital+ Salvage value+ ½ (Initial cost of
machine – Salvage value)
 Decision: Actual ARR compared with
predetermined or minimum required Rate
of Return/ cut off rate – Higher actual
accepted, Lower actual rejected
 Evaluation of ARR
 Merits:
 Easy to calculate
 Simple to understand and use
 Drawbacks:
 Use of accounting income instead of cash
flows
 Does not consider time value of money
 Does not differentiate between the size of
investment required for each project
 Does not consider the benefit that arise
from the sale of the equipment being
replaced
 Pay Back Method
 Annuity from the project
 PBP = Investment/ Annuity flow
 Mixed Stream
 PBP is calculated by cumulating cash
flow till time when cumulative cash
flows are equal to initial investment
 PBP Method – Acceptance
Rejection Decision
 Project that gives the earliest return
must be accepted (Mutually exclusive
projects)
 Ranking can be done to see which
ones are feasible
 Evaluation of PBP
 Merits:
 Easy to calculate and understand
 Superior to ARR as based on cash flow analysis
 Drawbacks:
 Completely ignores all cash flows after the pay
back period
 Does not measure cash flow in terms of time
and magnitude (No PV)
 Full life of the project not considered
 When to gainfully employ PBP
method?
 When long-term outlook is hazy
 Firms suffering from liquidity crisis
 Projects abroad with country risk and
political risk
 PBP can be used as a constraint to
be satisfied rather than a profitability
measure to be maximised
 Determine the average rate of return from the
following data of two machines, A and B.
Particulars Machine A Machine B
Cost Rs.56,125 Rs.56,125
Annual estimated income after

depreciation and income tax:

Year 1 3375 11375

2 5375 9375
3 7375 7375
4 9375 5375
5 11375 3375
Estimated life (years) 5

Estimated salvage value 3000 3000

 Calculate the Pay Back Period for the
following data:
 The constant annual cash flow from a
project costing Rs. 4,00,000 is Rs.
12000. Another project costing Rs.
5,00,000 provides Rs. 25,000 annual
cash flow. Calculate the Pay back period
and suggest the project to be selected.
 Calculate the PBP from the
following information:
Year Project A (CFAT) Project B (CFAT)

1Rs. 15000 Rs. 34000

2Rs. 25000 Rs. 33000

3Rs. 28000 Rs. 28000

4Rs. 32000 Rs. 32000

5Rs. 36000 Rs. 30000

 Net Present Value Method (Discount factor
10 per cent)
Year Project A (CFAT) Project B (CFAT)

1Rs. 15000 Rs. 34000

2Rs. 25000 Rs. 33000

3Rs. 28000 Rs. 28000

4Rs. 32000 Rs. 32000

5Rs. 36000 Rs. 30000

Initial cost Rs.100000 Rs. 110000

 NPV Method
 Traditional cash flow:
 Summation of the present value of
the cash inflows – Initial cash
outflow
 Non-traditional cash flow:
 Summation of the present value of
the cash inflows – Summation of the
present value of the cash outflows
 Decision Rule under NPV method
 NPV > 0, Accept the project
 NPV < 0, Reject the project
 NPV = 0, The firm is indifferent to
the project
 Evaluation of NPV
 Recognizes explicitly time value of
money
 Considers total benefits arising out of
the proposal during its life time
 A changing discounting factor can be
built into the NPV method
 Helps to achieve shareholder wealth
maximization
 Theoretically correct technique
 NPV Drawbacks
 Difficult to calculate, understand and use
in comparison to PBP method
 Calculation of the required rate of return
to discount the cash flows (general basis
is cost of capital: Controversy in its
calculation)
 Absolute measure – Prima facie between
two projects, one with high NPV will be
selected. When the initial outlay
drastically differ there is no justifiable
reflection of the alternative proposals.