Handout Five-Capital Budgeting

Techniques
Chapter Thirteen
P-1: Pespsi, Inc., has two investment proposals, which have the following characteristics:
Project A Project B
Period Cost Profit After Tax Net Cash Flow Cost PAT Net Cash Flow
0 Rs. 9,000 Rs. 12,000
1 Rs. 1,000 Rs. 5,000 Rs. 1,000 Rs. 5,000
2 1,000 4,000 1,000 5,000
3 1,000 3,000 4,000 8,000
For each project, compute its payback period, its net present value, and its profitability index
using a discount rate of 15 percent. Solve Project B in same way & also solve P-2. Refer book.
Answer1:Payback period is the time which tells in how many years, months and days
company would receive its invested amount.
Year Outflow Inflows Amount received Remaining amount
0 Rs. -9,000
1 Rs. 5,000 Rs. 5,000 Rs. 4,000
2 Rs. 4,000 Rs. 9,000 Rs. 0
Payback period (Project A) is two years.

Year Cash Flows PV Discount Factor PV Cash Flows

0 Rs. -9,000 1 Rs. -9,000
1 Rs. 5,000 0.870 Rs. 4,350
2 Rs. 4,000 0.756 Rs. 3,024
3 Rs. 3,000 0.658 Rs. 1,974
Net Present Value (Project A) (PVInflows – PVOutflows) Rs. 348
P-3: The following are exercises on internal rates of return:
A. An investment of Rs. 1,000 today will return Rs. 2,000 at the end of 10 years. What is its
internal rate of return?
B. An investment of Rs. 1,000 will return Rs. 500 at the end of each of the next 3 years. What
is its internal rate of return?
C. An investment of Rs. 1,000 today will return Rs. 900 at the end of 1 year, Rs. 500 at the end
of 2 years, and Rs. 100 at the end of 3 years. What is its internal rate of return?
D. An investment of Rs. 1,000 will return Rs. 130 per year forever. What is its internal rate of
return?
Answer3:
Internal rate of return or IRR is the rate where outflows and inflows become equal.
A. This rate is found by trial and error method (By assuming different rates).
1. Assume rate 10%

2. Assume rate 8%

3. Assume rate 7.18%

With the help of trial and error, we found that equation becomes equal at the rate of 7.18%. It
means 7.18% is our IRR.
P-3: The following are exercises on internal rates of return:
A. An investment of Rs. 1,000 today will return Rs. 2,000 at the end of 10 years. What is its
internal rate of return?
B. An investment of Rs. 1,000 will return Rs. 500 at the end of each of the next 3 years. What
is its internal rate of return?
C. An investment of Rs. 1,000 today will return Rs. 900 at the end of 1 year, Rs. 500 at the end
of 2 years, and Rs. 100 at the end of 3 years. What is its internal rate of return? Solve Part
C. Refer Part B
D. An investment of Rs. 1,000 will return Rs. 130 per year forever. What is its internal rate of
return?
Answer3:
Internal rate of return or IRR is the rate where outflows and inflows become equal.
B. This rate is found by trial and error method (By assuming different rates).
1. Assume rate 10%

2. Assume rate 12%

3. Assume rate 23.37%

With the help of trial and error, we found that equation becomes equal at the rate of 23.37%.
It means 23.37% is our IRR.
P-4: Two mutually exclusive projects have projected cash flows as follows:
End of Year
0 1 2 3 4
Project A Rs. -2,000 Rs. 1,000 Rs. 1,000 Rs. 1,000 Rs. 1,000
Project B -2,000 0 0 0 6,000

A. Determine the internal rate of return for each project.

B. Determine the net present value for each project at discount rates of 0, 5, 10, 20, 30, and
35 percent.
C. Plot a graph of the net present value of each project at the different discount rates.
D. Which project would you select? Why? What assumptions are inherent in your decision?

4500 Rates NPV(A) NPV(B)

Solve Part A and B. Refer P-1 to P-3. 4000 0 2000 4000
3500 5 1546 2936
3000 10 1170 2098
Part C, plot NPVs on y-axis 2500 Rates
NPV(A) 15 855 1431
2000
and rates on x-axis. Draw the graph. 1500
NPV(B) 20 589 894
1000 25 362 458
500 30 166 101
Answer4: 0 35 -3 -194
0 5 10 15 20 25 30 35
-500
D.
The project selection decision is made on the basis of NPV because it provides results in
rupee amount which would be added in the company’s wealth. So, select a project which has
high NPV.
Solve P-5. Refer P-1 to P-3.
MACRS property class rates for 3, 5, 7 and 10 years are given below.

Solve Part C, plot NPVs on y-axis and rates on x-axis. Draw the graph.

Solve P-6 and P-7. Refer P-1 to P-5.

Use the data of P-6 and P-7 of Handout Four (Previous Handout). The relevant cash flows have
already been calculated, you just have to discount them with given required rate of return and
decide about project selection.

Solve P-8.
Capital rationing means company has limited funds to invest. The company has Rs. 1 billion or
1000 millions to invest. Select maximum projects where you can utilize Rs. 1000 million efficiently.
First focus on high profitability index (PI) projects but remember selection should also be based on
both better PI and utilization of funds.
Solve P-9. Refer P-8 of Handout Four (Previous Handout).
Select project which has low present value cost.

Solve P-10. Refer P-1 to P-9.

Solve Part A of P-11. Refer P-1 to P-10.

Answer11:

B.
∆ Change project means subtract small scale project’s cash flows (both outflows and inflows) from large
scale project. For example
Large project’s out flow is Rs. 50 millions and small project’s out flow Rs. 15 millions.
So, ∆ project's out flow = 50 – 15 = Rs. 35 millions

Similarly large project’s inflows are Rs. 8 millions each year for 20 years and small project's inflows are Rs.
3.4 millions each year for 20 years.

So, ∆ project's inflows = 8 – 3.4 = Rs. 4.6 millions each year for 20 years.

Now a new project is developed, calculate NPV of IRR of ∆ change project.

C.
Develop NPV profile means plot NPVs on y-axis and rates on x-axis (Refer P-4). Draw a graph and check
where project A intersects project B. Remember at the point where project A intersects project B is called
crossover rate and also check whether IRR of ∆ project is equal to crossover rate or not.
Solve P-12, P-13 and P-14. Refer P-1 to P-11.

Answer15:
A.
Outflows of project A and B are Rs. 10 millions
Incremental cash flows are 0 at zero period (t=0 or today)

Inflow of project A is Rs. 12 million at the end of year 1 (t=1)

Inflows of project B are Rs. 1.75 millions each year for 20 years

Incremental cash flow at years 1 (t=1) = 1.75 – 12 = -10.25

Incremental cash flows from year 2 to year 20 = 1.75 – 0 = 1.75 each year for next 19 years.

Solve Part C and D of P-15. Refer P-1 to P-14.

P-16: Air Blue Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will
cost Rs. 100 million, and will produce net cash flows of Rs. 30 million per year. Plane B has a life of 10
years, will cost Rs. 132 million, and will produce net cash flows of Rs. 25 million per year. Air Blue plans to
serve the route for only 10 years. Inflation in operating costs, airplane costs, and fares is expected to be
zero, and the company’s cost of capital is 12%. By how much would the value of the company increase if
it accepted the better project (plane)? What is the equivalent annual annuity (EAA)for each plane?
Answer16: Repeat outflow and inflows of the project (short life) twice in order to equalize the project
(long life) and calculate the required things. With same procedure, solve P-17 and P-18.
Years 0 1 2 3 4 5 6 7 8 9 10
Plane A Rs. (100) Rs. 30 30 30 30 30 30 30 30 30 30
(100)
Plane B Rs. (132) Rs. 25 25 25 25 25 25 25 25 25 25

PV inflows Plane A = 169.51, PV outflows Plane A = 156.74, NPV = 169.51 – 156.74 = 12.77
PV Inflows Plane B = 141.30, PV outflows Plane B = 132.00, NPV = 141.30 – 132.00 = 9.30

Solve P-19. Refer previous problems

For MIRR use this formula:

P-20: The TCS Courier Company recently purchased a new delivery truck. The new
truck cost Rs. 22,500, and it is expected to generate net after-tax operating cash
flows, including depreciation, of Rs. 6,250 per year. The truck has a 5-year expected
life. The expected salvage values after tax adjustments for the truck are given below.
The company’s cost of capital is 10%. Solve P-21. Refer previous problems.
Year Annual Operating Cash Flows Salvage Value
0 Rs. -22,500 Rs. 22,500
1 6,250 17,500
2 6,250 14,000
3 6,250 11,000
4 6,250 5,000
5 6,250 0
A. Should the firm operate the truck until the end of its 5-year physical life? If not, then what
is its optimal economic life? Solve year 4 and 5. Refer following procedure.
B. Would the introduction of salvage values, in addition to operating cash flows, ever reduce
the expected NPV and/or IRR of a project? Refer Book or Google

Answer20:
A.
 Thank YOU
Questions &
Lynn Connaway
connawal@oclc.org

Suggestions
abdul.aziz@fuuast.gov.pk
abdulaziz2004@gmail.com

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