Financial Management

Module -4

INVESTMENT DECISIONS

Investment Decision: Introduction – Meaning and Definition of Capital

Budgeting – Features – Significance – Process – Techniques: Payback
Period, Accounting Rate of Return, Net Present Value, Internal Rate of
Return and profitability index Simple Problems.

The word Capital refers to be the total investment of a company of firm in

money, tangible, and intangible assets. Whereas budgeting defined by the
“Rowland and William” it may be said to be the art of building budgets.
Budgets are a blueprint of a plan and action expressed in quantities and
manners.

The examples of capital expenditure:

1. Purchase of fixed assets such as land and building, plant and machinery, good
will, etc.

2. The expenditure relating to addition, expansion, improvement and alteration

to the fixed assets.

3. The replacement of fixed assets.

4. Research and development project.

Definitions:

According to the definition of Charles T. Hrongreen, “capital budgeting is a

long-term planning for making and financing proposed capital outlays
(Investments).

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According to the definition of G.C. Philippatos, “capital budgeting is concerned

with the allocation of the firm’s source financial resources among the available
opportunities.

According to the definition of Richard and Green law, “capital budgeting is

acquiring inputs with long-term return”.

According to the definition of Lyrich, “capital budgeting consists in planning &

development of available capital for the purpose of maximizing the long-term
profitability of the concern”.

It is clearly explained in the above definitions that a firm’s scarce financial

resources are utilizing the available opportunities. The overall objectives of the
company from are to maximize the profits and minimize the expenditure of
cost.

Need for and Importance of Capital Budgeting

1. Huge investments: Capital budgeting requires huge investments of funds,

but the available funds are limited, therefore the firm before investing projects,
plan are controlling its capital expenditure.

2. Long-term: Capital expenditure is long-term in nature or permanent in

nature. Therefore, financial risks involved in the investment decision are more.
If higher risks are involved, it needs careful planning of capital budgeting.

3. Irreversible: The capital investment decisions are irreversible, are not

changed back. Once the decision is taken for purchasing a permanent asset, it is
very difficult to dispose of those assets without involving huge losses.

4. Long-term effect: Capital budgeting not only reduces the cost but also
increases the revenue in long-term and will bring significant changes in the
profit of the company by avoiding over or more investment or under

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investment. Over investments leads to be unable to utilize assets or over

utilization of fixed assets.

Therefore, before making the investment, it is required carefully planning and

analysis of the project thoroughly.

CAPITAL BUDGETING PROCESS

Capital budgeting is a difficult process to the investment of available funds. The

benefit will be attained only soon but, the future is uncertain. However, the
following steps followed for capital budgeting, then the process may be easier
are.

1. Identification of various investments proposals: The capital budgeting may

have various investment proposals. The proposal for the investment

opportunities may be defined from the top management or may be even from
the lower rank. The heads of various department analyse the various investment

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decisions and will select proposals submitted to the planning committee of

competent authority.

2. Screening or matching the proposals: The planning committee will analyse

the various proposals and screenings. The selected proposals are considered
with the available resources of the concern. Here resources referred as the
financial part of the proposal. This reduces the gap between the resources and
the investment cost.

3. Evaluation: After screening, the proposals are evaluated with the help of
various methods, such as payback period proposal, net discovered present value
method, accounting rate of return and risk analysis. Each method of evaluation
used in detail in the later part of this chapter. The proposals are evaluated by.

(a) Independent proposals

(b) Contingent of dependent proposals

(c) Partially exclusive proposals.

Independent proposals are not compared with other proposals and the same may
be accepted or rejected. Whereas higher proposals acceptance depends upon the
other one or more proposals. For example, the expansion of plant machinery
leads to constructing of new building, additional manpower etc. Mutually
exclusive projects are those which competed with other proposals and to
implement the proposals after considering the risk and return, market demand
etc.

4. Fixing property: After the evaluation, the planning committee will predict
which proposals will give more profit or economic consideration. If the projects
or proposals are not suitable for the concern’s financial condition, the projects
are rejected without considering other nature of the proposals.

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5. Final approval: The planning committee approves the final proposals, with
the help of the following:

(a) Profitability

(b) Economic constituents

(c) Financial violability

(d) Market conditions.

The planning committee prepares the cost estimation and submits to the
management.

6. Implementing: The competent authority spends the money and implements

the proposals. While implementing the proposals, assign responsibilities to the
proposals, assign responsibilities for completing it, within the time allotted and
reduce the cost for this purpose. The network techniques used such as PERT
and CPM. It helps the management for monitoring and containing the
implementation of the proposals.

7. Performance review of feedback: The final stage of capital budgeting is

actual results compared with the standard results. The adverse or unfavourable
results identified and removing the various difficulties of the project. This is
helpful for the future of the proposals.

KINDS OF CAPITAL BUDGETING DECISIONS

The overall objective of capital budgeting is to maximize the profitability. If a

firm concentrate return on investment, this objective can be achieved either by
increasing the revenues or reducing the costs. The increasing revenues can be
achieved by expansion or the size of operations by adding a new product line.
Reducing costs mean representing obsolete return on assets.

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METHODS OF CAPITAL BUDGETING OF EVALUATION

By matching the available resources and projects it can be invested. The funds
available are always living funds. There are many considerations taken for
investment decision process such as environment and economic conditions.

The methods of evaluations are classified as follows:

(A) Traditional methods (or non-discount methods)

(i) Pay-back Period Method (Years and months)

(ii) Post Pay-back Method (Years and months)

(iii) Accounting Rate of Return/ Average rate of return (%)

(B) Modern methods (or Discount methods)

(i) Net Present Value Method (Rupees)

(ii) Internal Rate of Return Method (%)

(iii) Profitability Index Method (>1)

(i) Pay-back period is the time required to recover the initial investment in a
project.

(It is one of the non-discounted cash flow methods of capital budgeting).

Pay-back period = Initial investment /

Annual cash inflows(PBDAT)

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Merits of Pay-back method:

The following are the important merits of the pay-back method:

1. It is easy to calculate and simple to understand.

2. Pay-back method provides further improvement over the accounting rate of

return.

3. Pay-back method reduces the possibility of loss on account of obsolescence.

Demerits:

1. It ignores the time value of money.

2. It ignores all cash inflows after the pay-back period.

3. It is one of the misleading evaluations of capital budgeting.

Accept /Reject criteria:

If the actual pay-back period is less than the predetermined pay-back period, the
project would be accepted. If not, it would be rejected.

Problems on Payback period: (PBDAT-Profits before depn after taxes)

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Formula:
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

1.A Project needs a total investment of Rs.4,00,000. The project promises a

total cash inflow of Rs. 20,000 for 30 years. Compute PBP.

Soln :

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
PBP:
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

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4,00,000
PBP : = 20 years
20,000

2. Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the
project is 5 years. Calculate the pay-back period.

Soln :

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
PBP :
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

30,000
PBP : = 3 years
10,000

3. A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000
after depreciation @ 12½% but before tax at 50%. Calculate the pay-back
period.

Profits under PBP should be in the format of PBDAT.

Profit 3,00,000(PADBT)

PBDAT

Soln: Profit after depreciation 3,00,000

Less: Tax 50% - 1,50,000

PAT 1,50,000

(20,00,000 x 12.5 %) 2,50,000

Cash in flow 4,00,000

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
PBP :
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

20,00,000
PBP : = 5 years
4,00,000

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4. A project costs Rs.5,00,000 and yields annually profit of Rs.80,000 after depn
at 12% pa but before taxes of 50%. Calculate PBP.

Soln : 5 years

5.From the following given below calculate PBP:

Original cost of Investment 5,00,000

Annual cash inflow after tax after depn 60,000

Annual Depreciation 40,000

Soln: Annual Cash inflows (PBDAT)=PATAD + Depreciation

=60,000 +40,000

=1,00,000

PBP =5,00,000 / 1,00,000 = 5 Years

6.Cost of a plant is Rs.2,00,000 and cash flows for the first three years are Rs.
20,000, Rs. 80,000 and Rs. 1,20,000. Express the payback period in terms of
years and months.

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Soln :PBP :
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

1,00,000
PBP :20,000 + 80,000 +
1,20,000

PBP =2 +0.833 years

PBP = 2.833 years

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Alternative method by using formula:

Years Cash in flows Cumulative Cash flows

1 20,000 20,000
2 80,000 1,00,000
3 1,20,000 2,20,000
PBP =2 years +OI – Cumulative cash flows of Second year

Cash flows of third year

PBP = 2 years +2,00,000 -1,00,000

1,20,000

PBP=2 years +0.833

PBP =2.833 years or 2 years 9 months 29 days.

7. A industry is considering investment in a project which costs Rs.6,00,000.

The cash flows are Rs.1,20,000, Rs.1,40,000, Rs.1,80,000, 2,00,000 &
Rs,2,50,000. Calculate PBP

PBP = 1,20,000+ 1,40,000 +1,80,000+1,60,000/2,00,000

PBP=3 + 0.8 years

PBP =3.8 years or 3 years 9 months 18 days

8. Evershine company is considering the purchase of machinery. Two

machinery, X and Y each costing Rs.5,00,000, are available.

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Cash inflows are expected to be as under:

Calculate PBP

Years Machine X Machine Y

2001 1,50,000 50,000
2002 2,00,000 1,50,000
2003 2,50,000 2,00,000
2004 1,50,000 3,00,000
2005 1,00,000 2,00,000
Soln : Machine X = 2.6 years

Machine Y =3.33 Years

Post Pay-back Profitability Method

One of the major limitations of pay-back period method is that it does not
consider the cash inflows earned after pay-back period and if the real
profitability of the project cannot be assessed. To improve over this method, it
can be made by considering the receivable after the pay-back period. These
returns are called post pay-back profits.

1.From the following particulars, compute:

1. Payback period.

2. Post pay-back period

(a) Cash outflow Rs. 1,00,000

Annual cash inflow Rs. 25,000
(After tax before depreciation)
Estimate Life 6 years
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(a) (i) Pay-back period= Initial investment/Annual cash inflows

= 1,00,000/25,000 = 4 Years

ii) Post payback period = Estimated life span of the asset – PBP

=6 years – 4 years

=2 years

Accounting Rate of Return or Average Rate of Return

Average rate of return means the average rate of return or profit taken for
considering the project evaluation. This method is one of the traditional
methods for evaluating the project proposals:

Merits:

1. It is easy to calculate and simple to understand.

2. It is based on accounting information rather than cash inflow.

3. It is not based on the time value of money.

4. It considers the total benefits associated with the project.

Demerits:

1. It ignores the time value of money.

2. It ignores the reinvestment potential of a project.

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3. Different methods are used for accounting profit. So, it leads to some
difficulties in the calculation of the project.

Accept/Reject criteria:

If the actual accounting rate of return is more than the predetermined required
rate of return, the project will be accepted. If not, it would be rejected.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡

Formula :ARR= 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

AAP = Profits after depn and taxes / No of years

Average Investment = Original Investment /2

Note = When scrap value and working capital is given:

The formula will be:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

Average Investment = + 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 +
2

𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

1.Initial Investment is Rs.12,00,000, scrap value is Rs.2,00,000, working life of

an asset 5 years, Additional working capital is Rs.1,00,000. Calculate Average
Investment.

Soln:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

Average Investment = + 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 +
2

𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

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12,00,000−2,00,000
Average Investment = + 1,00,000 + 2,00,000
2

Average Investment =5,00,000 + 1,00,000 + 2,00,000

AI= 8,00,000

2. Initial Investment is Rs.3,00,000 , scrap value is Rs.50,000 , working life of

an asset 5 years , Additional working capital is Rs.25,000 .Calculate Average
Investment .

Soln :2,00,000

3. Initial Investment is Rs.7,50,000, scrap value is Rs.1,00,000 , working life of

an asset 5 years , Additional working capital is Rs.50,000 .Calculate Average
Investment .

Soln :4,75,000

4. A Company is requiring a machine which requires an investment of

Rs.3,20,000. The net income before tax and depreciation is estimated as
follows.

Year Amount
1 1,60,000
2 60,000
3 1,08,000
4 1,12,000
5 96,000
Depreciation is to be charged on straight line basis. The tax rate is 55%.
Calculate ARR.

Profits in ARR Should be in the format of PADAT.

Notes:
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Depn value: OI-SV/Estimated life of an asset

=3,20,000 – Nil /5

=64,000 / year

Depn for 5 years = 64,000 x 5 = 3,20,000

Soln :

Caln of ARR

Year Profits (PBDBT)

1 1,60,000
2 60,000
3 1,08,000
4 1,12,000
5 96,000
Profit before Depn and Taxes 5,36,000
Less : Depreciation 3,20,000
Profit after depreciation before taxes 2,16,000
Less : Tax at 55%(2,16,000 x 55%) 1,18,800
Total Profit after depn after taxes 97,200

Average annual profit = total Profit / no of years = 97,200 /5 =19,440

Average Investment = Original Investment /2 =3,20,000/2 = 1,60,000

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡

ARR= 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

19,440
ARR= 𝑥 100 = ARR =12.15%
1,60,000

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5. A Company is requiring a machine which requires an investment of

Rs.1,60,000. The net income before tax and depreciation is estimated as
follows.

Year Amount
1 56,000
2 48,000
3 30,000
4 64,000
5 80,000
Depreciation is to be charged on straight line basis. Tax rate is 40%. Calculate
ARR

Soln :17.7%

6.From the following information calculate PBP and ARR

Project Original Cash in flow Economic life

Investment
A 25,000 3,000 10
B 3,000 1,000 5
C 12,000 2,000 8
D 20,000 4,000 10
E 40,000 8,000 2

PBP : A=8.33 years , B=3 years , C=6 years , D=5 years , E=5 years .

ARR: A=2.4% , B=13.33% , C=4.16% , D=4% , E=20% .

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𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
ARR= 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

300
ARR= 𝑥 100 =2.4
12,500

200
ARR= 𝑥 100=13.33
1500

250
ARR= 𝑥 100=4.16
6000

400
ARR= 𝑥 100=4%
10,000

4000
ARR= 𝑥 100=20%
20,000

7.A Company is planning to consider any one of the three alternatives A, B and
C , Calculate ARR

Alternatives Investment Cash in flows

0 1 2
A 5,000 0 6610
B 5,000 1080 3080
C 5,000 5750 0

A:132.2%

B:83.2%

C:115%

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8.Determine the ARR from the following details

Particulars Machine A Machine B

Original Cost 56,125 56,125
Additional working 5000 6000
capital
Life 5 yrs 5 yrs
Salvage value 3000 2000
Tax rate 55% 55%
Income after Tax &
Depn:
1st year 3375 11,375
2nd year 5375 8425
3rd year 7375 7635
4th year 9375 6455
5th year 11,375 5,355
Depreciation must be charged on diminishing balance method.

Soln: Machinery A :21.33%

Machinery B :22.38%

9.Determine the ARR from the following details

Particulars Machine X Machine Y

Original Cost 10 Lakhs 10 Lakhs
Additional working 5,00,000 5,00,000
capital
Life 4 yrs 6 yrs

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Salvage value 10% 10%

Tax rate 50% 50%
Income before Tax &
Depn:
1st year 8,00,000 15,00,000
2nd year 8,00,000 9,00,000
3rd year 8,00,000 15,00,000
4th year 8,00,000 8,00,000
5th year - 6,00,000
6th Year - 3,00,000
Depreciation must be charged on Fixed instalment method.

Soln :

Calculation of ARR

Particulars Project X Project y

1st year 8,00,000 15,00,000
2nd year 8,00,000 9,00,000
3rd year 8,00,000 15,00,000
4th year 8,00,000 8,00,000
5th year - 6,00,000
6th Year - 3,00,000
Profits BDBT 32,00,000 56,00,000
Less: Depn 9,00,000 9,00,000
PADBT 23,00,000 47,00,000
Less: Tax @ 50% 11,50,000 23,50,000
PADAT 11,50,000 23,50,000

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Depn = OI –SV / Estimated Life

Depn =10,00,000-10%/4=2,25,000/ year

4 years =9,00,000

Y=10,00,000-10%/6 =1,50,000/year

6 years = 9,00,000

Machine X =27.38% Machine Y = 37%

Net Present Value

The Net present value method is one of the modern methods for evaluating the
project proposals.

In this method cash inflows are considered with the time value of the money.
Net present value is described as the summation of the present value of cash
inflow and present value of cash outflow. Net present value is the difference
between the total present value of future cash inflows and the total present value
of future cash outflows.

Merits

1. It recognizes the time value of money.

2. It considers the total benefits arising out of the proposal.

3. It is the best method for the selection of mutually exclusive projects.

4. It helps to achieve the maximization of shareholders’ wealth.

Demerits

1. It is difficult to understand and calculate.

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2. It needs the discount factors for calculation of present values.

3. It is not suitable for the projects having different effective lives.

Accept/Reject criteria

If the present value of cash inflows is more than the present value of cash
outflows, it would be accepted. If not, it would be rejected.

Formula: Total present value of Cash inflow – Total PV of Cash outflow

Problem 1 :

A firm has initial investment of Rs.1,00,000 and cash inflows as shown below
Year Cash in flow

1 50,000
2 40,000
3 30,000
4 10,000

Find out NPV by using 10% discount rate.

1 1
PV Factor =(1+𝑅)𝑛 =(1+0.1)1

Soln :

Calculation of Net present value

Year Cash inflows PV factors @ PV of cash

10% inflow
1 50,000 0.909 45,450
2 40,000 0.826 33,040

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3 30,000 0.751 22,530

4 10,000 0.683 6,830
Total Present value of Cash inflows 1,07,850
Less :Cash out flow 1,00,000
Net present value 7,850

2.From the following information calculate NPV and suggest which of the two
projects should be accepted assuming discount rate at 10%

Particulars Project X Project Y

Initial Investment 40,000 60,000
Estimated life 5 years 5 years
Scrap value 2000 4000
The profits before depreciation and after taxes are as follows:

Year Project X Project Y

1 10,000 40,000
2 20,000 20,000
3 20,000 10,000
4 6,000 6,000
5 4,000 4,000
Soln :

Caln of NPV of Project X

Year Project X PV Factor PVCIF

1 10,000 0.909 9090
2 20,000 0.826 16.520
3 20,000 0.751 15,020

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4 6,000 0.683 4098

5 4,000 0.621 2484
5 2000 0.621 1242
Total value of CIF 48,454
Less : PVCOF 40,000
Net Present value 8,454

Caln of NPV of Project Y

Year Project Y PV Factor PVCIF

1 40,000 0.909 36,360
2 20,000 0.826 16,520
3 10,000 0.751 7,510
4 6,000 0.683 4098
5 4,000 0.621 2484
5 4000 0.621 2484
Total value of CIF 69,456
Less : PVCOF 60,000
Net Present value 9,456

3.Cash inflow and cash out flow of Narmada project is given below

Year Cash outflow Cash in flow

0 1,50,000 -
1 30,000 20,000
2 - 30,000
3 - 60,000
4 - 80,000

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5 - 30,000
The salvage value at the end of the 5th year is Rs. 40,000.

Calculate NPV

Discount factor to be taken at 10%.

Soln : Formula :PVCOF – PVCIF

Calculation of PVCOF

Year Cash out flow PV Factor PVCOF

0 1,50,000 1 1,50,000
1 30,000 0.909 27,270
Total Present value of Cash out flow 1,77,270

NPV = 8,860

4. A firms cost of capital is 10%. It is considering two mutually exclusive

projects X and Y. The details are given below

Cash flow Project X Project Y

0 1,40,000 1,40,000
1 20.000 1,20,000
2 40,000 80,000
3 60,000 40,000
4 90,000 20,000
5 1,20,000 20,000
Compute :

a)Pay back Period

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b)Net Present value

Soln:

PBP:

X =20,000+40,000+60,000+20,000/90,000

X= 3 years +0.22 Years

X: 3.22 Years

Y=1,20,000+20,000/80,000

Y: 1.25 Years

NPV:

X: 92,270

Y: 91,280

5.YES Company ltd is planning to invest in a project requiring a capital outlay

of Rs.2,00,000. Forecast of Annual income from the Project after
depreciation but before taxes are as follows:

Year 1 2 3 4 5

Income 1,00,000 1,00,000 80,000 80,000 50,000

The company’s tax rate is 40% and charges 20% depreciation on original cost.

You are required to ascertain a) PBP b) NPV using 15% Discount factor

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Soln : PBP =2 years NPV =1,05,630

Soln :

Particulars 1 2 3 4 5
PADBT 1,00,000 1,00,000 80,000 80,000 50,000
Less :Tax 40,000 40,000 32,000 32,000 20,000
PADAT 60,000 60,000 48,000 48,000 30,000
Add : Depn 40,000 40,000 40,000 40,000 40,000
PBDAT 1,00,000 1,00,000 88,000 88,000 70,000
0.870

0.756

0.658

0.572

0.497

6. A company has to choose one of the following two actually exclusive

machine.

Cash inflows

Year Machine X Machine Y

0 20,000 20,000

1 5,500 6,200

2 6,200 8,800

3 7,800 4,300

4 4,500 3,700

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5 3,000 2,000

Calculate NPV and interpret the results.

Soln : Machine X = 915

Machine Y= (97)

Years X Y Discount PVCIF of PVCIF of

Factors X Y
1
2
3
4
5

Profitability Index:

The profitability index is the relationship between net cash inflows and net cash
outflows. Projects having the highest profitability index will be ranked higher
and vice versa.

PI=Present value of cash inflows / Present value of cash out flow

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1.Rachi Enterprises can make either of two investments at the beginning of

2018. Assuming that the required rate of return is 10% p.a .evaluate the
investment proposals as under :

a) Payback Period

b) Return on Investment

c)Profitability Index

Particulars Project A Project B

Cost of Investment 4,40,000 5,56,000
Life 4 Years 5 Years
Scrap Value 5,000 9,000
Net Income after depreciation and tax

2018 1,10,000 -
2019 2,40,000 2,06,800
2020 1,70,000 2,06,800
2021 2,05,000 2,06,800
2022 - 2,06,800
It is estimated that each of the alternative projects will require an additional
working capital of Rs.1,04,000 which will be received back in full after the
expiry of Project life. Depreciation to be charged under SLM.

Soln : PBP

Project A =2.5 years

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Project B=2.68 years

Depn =OI – SV / Estimated Life = 5,56,000 – 1,13,000/5 =88,600

Year PADAT Depn PBDAT

1 - 88,600 88,600
2 2,06,800 88,600 2,95,400
3 2,06,800 88,600 2,95,400
4 2,06,800 88,600 2,95,400
5 2,06,800 88,600 2,95,400

PBP Project B =88,600 + 2,95,400 +1,72,000 /2,95,400

PBP =2 +0.58 years

PBP = 2.58 Years

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡

ARR for Project A = ARR= 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

Average Investment = + 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 +
2

𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

4,40,000−1,04,000
Average Investment = + 1,09,000 + 1,09,000
2

Average Investment = 1,68,000+1,09,000 + 1,09,000

Average Investment= 3,86,000

Average Annual Profit =1,10,000 + 2,40,000 + 1,70,000+2,05,000+1,09,000/4

Average Annual Profit =2,08,500

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2,08,500
ARR= 𝑥 100
3,86,000

ARR =54.01%

ARR for Project B = 53.61%

Profitability Index:

In question the profits given in the format of PADAT, which we have to convert
it into PBDAT

Depn = OI –SV/ Estimated life

Depn =4,40,000 -1,09,000/4 =3,31,000/4 =82,750

Year Cash in flow Depn PBDAT

1 1,10,000 82,750 1,92,750
2 2,40,000 82,750 3,22,750
3 1,70,000 82,750 2,52,750
4 2,05,000 82,750 2,87,750
4 1,09,000 1,09,000
Caln of PVCIF

Year PBDAT Disc Factor PVCIF

1 1,92,750 0.909 1,75,210
2 3,22,750 0.826 2,66,592
3 2,52,750 0.751 1,89,815
4 2,87,750 0.683 1,95,633
4 1,09,000 0.683 74,447
Total PVCIF 9,01,697

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PI = Total PVCIF / PVCOF

PI A =9,01,697/5,44,000 =1.65

PI B =4,10,707/6,60,000 =0.62

2. Beta ltd is considering the purchase of a new machine. Two alternative

machines A and B suggested each costing Rs. 4,00,000. Earnings are expected
to be as follows:

Year Machine A Machine B

1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000
The cost of capital is 10%, You are required to compare the Profitability of the
two machines and state the best out of two.

PI A =1.29

PI B = 1.30

Internal Rate of Return:

The internal rate of return is a metric used in financial analysis to estimate the
profitability of potential investments. The internal rate of return is a discount
rate that makes the net present value (NPV) of all cash flows equal to zero in a
discounted cash flow analysis.

It is also called as trial and error method.

IRR calculations rely on the same formula as NPV does.

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The formula to calculate IRR as follows:

𝑪−𝑶
IRR=A+ 𝑿 (𝑩 − 𝑨)
𝑪−𝑫

A=Discount factor at lower trail rate

B=Discount Factor at higher trail rate

C=Present value of Cash inflow at lower trail rate

D=Present value of Cash inflow at higher trail rate

O=Original Investment / Initial Cash outlay

1.A firm whose cost of capital is 10% considering two projects X and Y, the
details of which are as follows:

Particulars Machine X Machine Y

1 40,000 90,000
2 60,000 80,000
3 80,000 60,000
4 1,00,000 20,000
5 1,20,000 16,000
Original Investment is Rs.2,00,000 for both the projects. Compute the net
Present value at 10%, profitability Index and IRR for the two projects
separately, Project X by 20% and 29% and Project Y by 9% and 15% trail rates.

Soln: PV = 1/(1+r)n

10% = 0.1 20% 29% 9% 15%

0.909 0.833 0.775 0.917 0.870
0.826 0.694 0.601 0.842 0.750
0.751 0.579 0.466 0.772 0.658

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0.683 0.482 0.361 0.708 0.572

0.621 0.402 0.280 0.650 0.497

IRR Project X :

Year CIF Disc factor Disc factor PVCIF @ PVCIF @

@ 20% @ 29% 20%` 29%`
1 40,000 0.833 0.775 33,320 31,000
2 60,000 0.694 0.601 41,640 36,060
3 80,000 0.579 0.466 46,320 37,280
4 1,00,000 0.482 0.361 48,200 36,100
5 1,20,000 0.402 0.280 48,240 33,600
Total Present value of Cash in flows 2,17,720 1,74,040

𝑪−𝑶
IRR=A+ 𝑿 (𝑩 − 𝑨)
𝑪−𝑫

𝟐,𝟏𝟕,𝟕𝟐𝟎−𝟐,𝟎𝟎,𝟎𝟎𝟎
IRR=20+ 𝑿 (𝟐𝟗 − 𝟐𝟎)
𝟐,𝟏𝟕,𝟕𝟐𝟎−𝟏,𝟕𝟒,𝟎𝟒𝟎

𝟏𝟕,𝟕𝟐𝟎
IRR=20+ 𝑿 (𝟗)
𝟒𝟑,𝟔𝟖𝟎

IRR=20+𝟎. 𝟒𝟎𝟔 𝑿 (𝟗)

IRR=20+𝟑. 𝟔𝟓𝟒

IRR X =23.654%

Project Y: 14.28%

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2. AB Ltd is planning to invest Rs.6,00,000 on machinery whose life is only 4

years. the estimated net cash inflows are as follows. Calculate IRR

Year 1 2 3 4

CIF 1,50,000 2,00,000 3,00,000 2,00,000

Note :12% and 15% to be taken as trail rates.

Soln : IRR =14.520%

Year CIF PV @ PV @ PVCIF @ PVCIF @

12% 15% 12% 15%
1 1,50,000 0.893 0.870 1,33,950 1,30,500
2 2,00,000 0.797 0.756 1,59,400 1,51,200
3 3,00,000 0.712 0.658 2,13,600 1,97,400
4 2,00,000 0.636 0.572 1,27,200 1,14,400
Total PVCIF 6,34,150 5,93,500

𝐶−𝑂
IRR=A+ 𝑋 (𝐵 − 𝐴)
𝐶−𝐷

6,34,150−6,00,000
IRR=12+ 𝑋 (15 − 12)
6,34,150−5,93,500

34,150
IRR=12+ 𝑋 (15 − 12)
40,650

IRR=12+0.840 𝑋 (15 − 12)

IRR =12 +2.520

IRR =14.520%

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3. A Machine involves an initial investment of Rs. 12,000. The annual cash

inflows are estimated at Rs.4000 for 5 years. Calculate IRR by using 19% and
20%.

Factors @ 19% Factors @ 20%

0.840 0.833

0.706 0.694

0.593 0.579

0.499 0.482

0.419 0.402

Soln :19.851%

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