Chapter 13

Investment Decision (NPV, IRR) with

Replacement Analysis
MEANING & CONCEPT
Capital budgeting is the estimation of expenditure, income, cash inflow and outflow etc. related to
major projects to be undertaken, to check whether they have worth more than what they cost.
According to C.T. Horngren, “Capital Budgeting is long term planning for making and financing
proposed capital outlay.”
In Capital budgeting, we are concerned with evaluation of feasible alternative projects available
for employment of Capital. Capital budgeting is an investment decision technique to check the
viability of a project.
Thus, capital budgeting decisions are decisions as to whether or not money should be invested in
long term projects.

TECHNIQUES OF INVESTMENT DECISION (CAPITAL

BUDGETING )
The method of appraising an investment proposal can be grouped into:
Investment Appraisal methods

Traditional Method Modern & Discounted Cash Flow Method

Pay Back Accounting Rate Net Present Internal Rate Profitability

Period of Return (ARR) Value (NPV) of Return (IRR) Index (PI)

PAY BACK PERIOD

It is one of the simplest method to calculate the period within which the entire cost of project will
be completely recovered. It is the period within which the total cash inflows from the project
equals the cost of the project. Cash flow means profit after tax but before depreciation. In other
words it represents the number of years within which the investment is expected to “pay for itself”.
Initial Investment
Pay back period =
Annual cash flow
Where, Annual cash flow = profit after tax + Depreciation.

15.1
15.2  Accounting and Finance for Engineers

According to this method, the period of time necessary to recover its capital cost is computed –
the best project would be that which has the shortest pay back period.
MERITS
(a) It is very simple and easy to understand.
(b) It is particularly suitable in case of industries where the risk of technological obsolescence is very high.
(c) Projects bringing cash inflows in later years are ignored because they are conceived to be risky.
(d) Liquidity dimension is considered in selection criteria.
(e) Risk is associated with future cash flow because of uncertainty regarding their materializing.
Such risks are minimized by this method.
DEMERITS
(a) Time value of money is ignored.
(b) Cut-off period is chosen arbitrarily.
(c) Projects yielding high cash flows towards the end of life are rejected.
(d) It stresses on capital recovery rather than profitability.
(e) It is inadequate for evaluating two projects with uneven cash flows.

ACCEPT/REJECT CRITERION

(a) If projects are mutually exclusive, select the project which has the least pay back period.
(b) In respect of other projects, select the project which have payback period less than or equal
to the standard payback stipulated by the management.

ILLUSTRATION 15.1
The initial outlay for a project is ` 25 crore. The project analyst expects the following annual cash
flows which will be generated uniformly over the years:
Year 0 1 2 3 4 5 6 7
Cash flow (` in Crore) (25) 7 6 6 5 4 4 8
Compute the pay back period for the above project. If the cut-off period decided by the
management is 5 years, should the project be accepted?

SOLUTION

Year Net Cash Flows ` in crores Cumulative Net Flows

0 (25) (25)
1 7 (18)
2 6 (12)
3 6 (6)
4 5 (1)
5 4 3
6 4 7
7 8 15
 Capital Budgeting for Decision Making 15.3

From the above table it is clear that pay-back period is between 4th and 5th years.
The firm needed ` 1 crore to recover its investment in the 5th year. However, it earned ` 4 crores in
the 5th year. Assuming the cash flows to be evenly distributed, the firm must have taken 3 months
[ i.e. ` 1 crore ÷ ` 4 crores ] to recover ` 1 crore in the 5th year. Hence, the pay-back period is 4
years and 3 months.
Since, the pay-back period is less than the cut-off period decided by the management, the project
should be accepted.
ILLUSTRATION 15.2
A Project costs ` 20,00,000 and yields annually a profit of ` 3,00,000 after depreciation @ 12 ½%
[straight line method] but before tax @ 50% .Compute the payback period.

SOLUTION
Annual cash flow = Profit after tax + Depreciation
= ` 3,00,000 × [ 1 – 0.50 ] + 12½% of ` 20,00,000 = 4,00,000
` 20,00,000
 Pay back period = Initial Investment = = 5 years
Annual Cash Flow ` 4,00,000

ACCOUNTING/AVERAGE RATE OF RETURN (ARR)

Accounting or Average rate of return means the average annual yield on the project. Under this
method profit after tax and depreciation as percentage of total investment is considered. ARR
measures the profitability of Investment (project) using information taken from financial statement.
Average Pr ofit after tax
ARR =
Average Investment.
Where, Average Investment = [Book value of the Investment in the beginning + Book value of
Investment at the end of the life of the project or Investment]  2
MERITS
(a) It is very simple and easy to understand.
(b) It includes income from the project throughout its life.

DEMERITS
(a) It is based upon crude average of profits of the future years, ignoring the effect of fluctuations
of profits every year.
(b) It ignores time value of money.
ACCEPT/REJECT CRITERION
(a) When ARR more the minimum rate fixed by the management is accepted.
(b) If actual ARR is less than the cut rate (minimum rate specified by the management) then the
project is rejected.
15.4  Accounting and Finance for Engineers

ILLUSTRATION 15.3

Year Book Value of Fixed Investment (`) Profit After Tax (`)
1 90,000 20,000
2 80,000 22,000
3 70,000 24,000
4 60,000 26,000
5 50,000 28,000
Compute the accounting rate of return for the above project.

SOLUTION
Average Profit After Tax ` 24,000
Accounting Rate of Return = = = 34.29%
Average Book Value of Investment ` 70,000

DISCOUNTED CASH FLOW (DCF) TECHNIQUE

Investments are essentially current capital expenditure incurred at present in anticipation of
getting return in future. So, it involves some difference in timing between investment and return.
We understand that value of money changes with respect to time which is termed as time-value
of money. Same amount of money received today and receivable after 5 years do not result
receiving of same value. Delay in receipt mean receipt of lesser value. Therefore amount of
investment made today can not be directly compared with amount of return receivable after 10
years. So in order to compare with today’s investment future return need to be converted to its
present value. Hence, the technique that discounts (or reduces) the future amounts into their
present values at a specified time value (discount rate) is called as Discounted Cash Flow
techniques. These techniques take into account both the magnitude and timing of expected future
cash flows in each period of a project’s life.

MEANING OF DISCOUNTING
Discounting means reducing the values of future cash flows or returns to make it directly comparable
to the value at present. It is the basic operation of any DCF method. The problem is that a rupee today
is worth more than the same rupee in a year’s time regardless of inflation, because the rupee one was
invested can grow to a larger soon in the future. The rate at which the future cash flows are reduced to
their present values is termed as discount rate. Discount rate otherwise called as the time value of
money is normally set as rate of interest or rate of cost of capital.

NET PRESENT VALUE (NPV) METHOD

The best method for the evaluation of an investment proposal is the net present value method or
discounted cash flow technique. This method takes into account the time value for money. The
net present value of an investment proposal may be defined as the sum of the present values of
all the future cash inflows less the sum of the present values of all the cash outflows associated
with the proposal. Under the NPV method, the cash flows are converted into present values by
 Capital Budgeting for Decision Making 15.5

using a discount rate which is usually taken to represents the firms cost of capital. Proposals
resulting in negative net present values are rejected being unprofitable.
NVP = Present value of future Cash inflows - Initial investment.
Or,
C1 C2 C3
NPV = + + – C0
(1 + r ) (1 + r) (1 + r)3
2

Where,
C0 = Initial Investment
C1 to C3 = Cash flows in 1st, 2nd, 3rd years
r = Rate of cost of capital or discounting rate
Net Cash Flow = profit after tax but before depreciation.
Thus, under NPV method the decision criteria should be as follows:
(i) If NPV > 0, the projects will be accepted.
(ii) If NPV < 0, the project will be rejected.
(iii) If NPV = 0, Indifference as to acceptance or rejection.
In case of calculation following NPV or IRR Method investment made at present is compared with
the Net cash flows receivable in future. For this comparison the future cash flows are converted to
their present value which is called as discounting. For the purpose of discounting, the future net
cash flows are multiplied by some fraction figure which is basically the present value of `1 in
future year normally given in form of a table which is called present value table. Present value for
10 years of few frequently required discounting rate (r) is given in the following table:
Present Value Table
(Present value of ` 1 payable or receivable Annually for N years)
Year 8% 10% 12% 14% 15% 20%
01 0.92593 0.90909 0.89286 0.87719 0.86957 0.83333
02 0.85734 0.82654 0.79719 0.76947 0.75614 0.69444
03 0.79383 0.75131 0.71178 0.67497 0.65752 0.57870
04 0.73503 0.68301 0.63552 0.59208 0.57175 0.48225
05 0.68058 0.62092 0.56743 0.51937 0.49718 0.40188
06 0.63017 0.56447 0.50663 0.45559 0.43233 0.33490
07 0.58349 0.51361 0.45305 0.39964 0.37594 0.27908
08 0.54027 0.46651 0.40388 0.35056 0.32690 0.23257
09 0.50025 0.42410 0.36061 0.30874 0.28426 0.19381
10 0.46319 0.38554 0.32197 0.26974 0.24718 0.16151

MERITS
(a) It considers the time value of money.
(b) The entire stream of cash flows is taken into consideration.
(c) It takes care of not only the capital recovery but also profitability.

DEMERITS
(a) It involves difficult calculations.
15.6  Accounting and Finance for Engineers

(b) Its application requires forecasting cash flows and the discount rate. Accuracy of NPV
depends upon the accuracy of these estimates, which are quite difficult to estimate.
(c) The ranking of projects depends on the discount rate.

INTERNAL RATE OF RETURN (IRR)

IRR is that rate at which the sum totals of cash inflows after discounting equals to the discounted
cash outflows. The internal rate of return of a project is the discount rate which makes net present
value of the project equal to zero. Under internal rate of return method, no specific discount rate is
given and it has to be selected such that the present value of capital outlay exactly equal the
present value of net cash flows.
According to this method, the internal rate of return should be compared with a required rate of
return known as the cut-off or hurdle rate. If the IRR is not less than required rate, a project is
profitable; otherwise it should be rejected. Normally this cut-off rate is considered equivalent to
the rate of cost of capital.
Thus, under IRR method the decision criteria should be as follows :
(i) If IRR > cost of capital  accept the project.
(ii) If IRR < cost of capital  reject the project.
(iii) If IRR = cost of capital  indifference as to acceptance or rejection.
In general, the NPV and IRR methods lead to the same acceptance or rejection decision when a
single project is involved because –
(a) For discount rates greater than the internal rate of return the net present value of the project
is negative.
(b) For required rate greater than internal rate of return, a project would be rejected under either method.
Thus, project acceptable under NPV are as acceptable under IRR because NPV will be positive if
and only if the IRR is greater than the cost of capital.
MERITS
(a) It considers time value of money.
(b) All the cash flows in the project are considered.
(c) IRR is easy to use, as immediate understanding of desirability can be determined by
comparing it with the cost of capital.
(d) It helps in achieving the object of maximization of shareholders wealth.
DEMERITS
(a) The calculation process is tedious.
(b) Cash outflows interspersed between the cash inflows can give multiple IRRs, the interpretation of
which is difficult.
(c) It creates a peculiar situation if we compare two projects with different inflow/outflow patterns.
(d) It is assumed that all the future cash inflows of a proposal are reinvested at a rate equal to the
IRR which is quite ridiculous.
(e) If mutually exclusive projects are considered as investment options, which have considerably
different cash outlays, a project with a larger fund commitment but lower IRR contributes
 Capital Budgeting for Decision Making 15.7

more in terms of absolute NPV and increases the shareholders’ wealth, in such, situation,
decisions based only on IRR criterion may not be correct.

DIFFERENTIATION BETWEEN NET PRESENT VALUE (NPV)

METHOD AND INTERNAL RATE OF RATE (IRR) METHOD
Difference between NPV and IRR methods are as under –
1. NPV is calculated by using required rate of return as the discount rate. Under the IRR method
rate of return which equates the sum of discounted cash inflows with the sum of cash
outflows is ascertained.
2. If the NPV is zero or positive the project is accepted. If IRR is more than the cut-off rate, the
project is accepted, otherwise it is rejected.
3. The basic assumption behind discounting is that the cash inflow can be reinvested at the
discounting rate in the new projects. Keeping in view this assumption, NPV method is more
realistic than IRR in ranking two or more projects.
4. In case of mutually exclusive projects the two methods may indicate contradictory decisions. From
the point of view of maximization of shareholders wealth, it is better to follow the NPV method.

PROFITABLE INDEX (PI) OR BENEFIT COST RATIO

(BCR) OR DESIRABILITY FACTOR
Profitability Index is the ratio of the present value of cash inflows to initial cash outlay. The
discount factor based on the required rate of return is use to discount the cash inflows.
Present value of Net Cash Flows
Profitability Index (PI) =
Initial Cash outlay
X Y
Present value of Net Cash Flows 37,305 43,560
Initial outlay 32,000 37,500
Profitability Index 1  17 1 16
As long as PI is equal or greater than unity, an investment proposal is acceptable. In case of mutually
exclusive projects the acceptance criterion is: higher the index more profitable is the proposal.
Thus, under PI method the decision criteria should be as follows:
(i) If PI > 1 => project accepted
(ii) If PI < 1 => project Rejected
(iii) If PI = 1 => Management may accept the project because, the sum of present value of cash
inflow is equal to the sum of present value of cash outflow.
MERITS
(a) It considers time value of money.
(b) It is a better evaluation technique than NPV.
15.8  Accounting and Finance for Engineers

DEMERITS
It fails as guide in resolving capital rationing where projects are indivisible.
ILLUSTRATION 15.4
A project cost ` 25,000 and is expected to generate Cash in flows as:
Year Cash in flows(`)
1 10,000
2 8,000
3 9,000
4 6,000
5 7,000
The Cost of Capital is 12%.The present value factors are:
Year PV Factor at 12%
1 0.893
2 0.797
3 0.712
4 0.636
5 0.567
Compute the NPV of the project.

SOLUTION

Year Cash flows (`) PV Factor at 12% PV of cash flow

(a) (b) (c) d=b×c
1 10,000 0.893 8,930
2 8,000 0.797 6,376
3 9,000 0.712 6,408
4 6,000 0.636 3,816
5 7,000 0.567 3,969
29,499
Sum of the present value of Cash inflows 29,499
Less sum of the PV of cash out flow 25,000
NPV 4,499
The Project generates a positive NPV of ` 4,499.
Therefore, project should be accepted.

ILLUSTRATION 15.5
A company is planning to purchase a machine. Two machines A and B are available, each
costing ` 5 lakhs. In comparing the profitability of the machines, a discounting rate of 10% is to be
used and machines to be written off in five years by straight line method of depreciation with nil
residual value. Cash inflows after tax are expected as flows:
(` In lakhs)
Year Machine A Machine B
1 1.5 0.5
 Capital Budgeting for Decision Making 15.9

2 2.0 1.5
3 2.5 2.0
4 1.5 3.0
5 1.0 2.0
Indicate which machine would be profitable using the following methods of ranking investment
proposals :
(i) Pay back period method
(ii) Net present value method
(iii) Profitability index method. and
(iv) Average rate of return method.

SOLUTION
(i) Pay Back Period Method
(` in lakhs)
Machine A Machine B
Year
Cash Flow Cumulative Cash Flows Cash Flow Cumulative Cash Flows
1 1.5 1.5 0.5 0.5
2 2.0 3.5 1.5 2.0
3 2.5 6.0 2.0 4.0
4 1.5 7.5 3.0 7.0
5 1.0 8.5 2.0 9.0
 Payback period of machine A = 2 + ` 5 lakhs – ` 3.5 lakhs = 2.6 years or 2 years 7 months
` 2.5 lakhs
 Payback period of machine B = 3 + ` 5 lakhs – ` 4 lakhs = 3.33 years or 3 years 4 months
` 3 lakhs
Comment : Machine A is more profitable.
(ii) Net Present Value Method
Machine A (` in lakhs)
Discount Factors Discounted
Years CF
@ 10% Cash Flows
0 (5.0) 1.0000 (5.0000)
1 1.5 0.9091 1.3637
2 2.0 0.8264 1.6528
3 2.5 0.7513 1.8783
4 1.5 0.6830 1.0245
5 1.0 0.6209 0.6209
NPV 1.5401
Machine B (` in lakhs)
Discount Factors Discounted
Years CF
@ 10% Cash Flows
0 (5.0) 1.0000 (5.0000)
1 0.5 0.9091 0.4546
2 1.5 0.8264 1.2396
15.10  Accounting and Finance for Engineers

3 2.0 0.7513 1.5026

4 3.0 0.6830 2.0490
5 2.0 0.6209 1.2418
NPV 1.4876
Comment : Machine A is more profitable.
(iii) Profitability Index = Present value of inflows
Present value of outflows
 Profitability Index of Machine A = ` 5 lakhs + ` 1.5401 lakhs = 1.308
` 5 lakhs
 Profitability Index of Machine B = ` 5 lakhs + ` 1.4876 lakhs = 1.298
` 5 lakhs
Comment: Machine A is more profitable.

(iv) Average Rate of Return Method

Machine A
Average return = ( ` 8.5 lakhs – ` 5 lakhs) ÷ 5 years = ` 0.7 lakh
Average investment = ( ` 5 lakhs + 0) ÷ 2 = ` 2.5 lakhs
Average rate of return = 0.7 ×100 = 28%
2.5
Machine B
Average return = ( ` 9 lakhs – ` 5 lakhs) ÷ 5 years = ` 0.8 lakh
Average investment= ( ` 5 lakhs + 0) ÷ 2 = ` 2.5 lakhs
Average rate of return = 0.8 × 100 = 32%
2.5
Comment : Machine B is more profitable.

ILLUSTRATION 15.6
Project X requires an initial investment of `10,00,000 whereas Project Y requires an initial investment
of `12,00,000. Project X gives a Cash Flow After Tax (CFAT) of `2,50,000 p.a. over its estimated
economic life of 6 years, whereas Project Y gives a CFAT of `2,00,000 p.a. for 10 years.
(i) Compute the payback period of each project.
(ii) Which project should be accepted under this method?

SOLUTION
Initial Investment
(i) Payback period (i.e., PBP) =
Constant CFAT p.a.
` 10,00,000
For Project X, PBP = = 4 years
` 2,50,000 per year
` 12,00,000
For Project Y, PBP = = 6 years.
` 2,00,000 per year
(ii) As project X has shorter payback period, Project X should be accepted.
 Capital Budgeting for Decision Making 15.11

ILLUSTRATION 15.7
A project requires an investment of `1,00,000 with a life of 10 years which yields an expected
annual net cash inflow of `25,000. Compute the pay back period.

SOLUTION
Cost of the investment (projects)
Pay Back Period (P.B.P.) =
Annual Net Cash Inflow
` 1,00,000
= = 4 years
` 25,000

ILLUSTRATION 15.8
Doll & Co. invests `20,00,000 in a project. Its estimated life is 7 years. The additional net working
capital requirement is `1,50,000 for the entire period. The estimated earnings after taxes (EAT)
are as follows:

Year 1 2 3 4 5 6 7
EAT (` in lakhs) 2.0 2.3 1.9 2.5 3.0 2.2 4.0
Compute the ARR.

SOLUTION

 2 + 2.3 + 1.9 + 2.5 + 3 + 2.2 + 4 

Average EAT = `   lakhs
 7 
= 2.55714 lakhs. i.e., `2,55,714.
Average EAT
ARR =  100
Average investment
` 2,55,714
= × 100 = 11.89% (approx.)
` 21,50,000

ILLUSTRATION 15.9
Cat Ltd. wants to purchase a machine. Two machines A and B are available in the market. The
cost of each machine is `1,00,000. Their expected lives are 5 years. Net profits before tax during
the expected life of the machines are:

Machines
Years
A (`) B (`)
I 10,000 7,000
II 15,000 13,000
III 13,000 15,000
15.12  Accounting and Finance for Engineers

IV 20,000 25,000
V 17,000 20,000
Total 75,000 80,000
Note : The average rate of tax is 50%.
From the above information, ascertain which one is more profitable.
SOLUTION
Comparative Profitability Statement
Machine A Machine B
Cost Price `1,00,000 `1,00,000
Estimated Life (Years) 5 5
Total Net Profit `75,000 `80,000
Average Annual Profit (before tax) `15,000 `16,000
(75,000 ÷ 5) (80,000 ÷ 5)
Average Annual Profit (after tax) `7,500 `8,000
Average Investment `50,000 `50,000
(1,00,000) (1,00,000)
2 2
 Average Annual Profit after tax 
ARR   15% 16%
 Average investment 
Hence, Machine B is more profitable since it gives the higher return.
Average Annual Profit after tax is determined by adding the after-tax expected profits for each
year of the life of the project and dividing the same by the number of years.

ILLUSTRATION 15.10
Calculate the pay back period from the following particulars using (i) the traditional method, and
(ii) the discounted pay back method.
Cost of the Project `40,000
Life 5 years
Cost of Capital 10%

Years (`) P. V. of `1 at 10%

1 7,000 0.909
2 7,000 0.826
3 7,000 0.751
4 7,000 0.683
5 7,000 0.621
6 8,000 0.564
7 10,000 0.513
 Capital Budgeting for Decision Making 15.13

8 15,000 0.467
9 10,000 0.424
10 4,000 0.386

SOLUTION
(i) Pay Back Period (under traditional method)
N.C.F. Cumulative N.C.F.
Year
` `
1 7,000 7,000
2 7,000 14,000
3 7,000 21,000
4 7,000 28,000
5 7,000 35,000
→ Time required to cover the original investment of `40,000 
6 8,000 43,000
7 10,000 53,000
8 15,000 68,000
9 10,000 78,000
10 4,000 82,000
 5,000 
Therefore, the pay back period is 5 +   years or 5 + .62 = 5.62 years
 8,000 
(ii) Discounted Pay Back Period
Cumulative
N.C.F P.V. Factor P.V. of N.C.F.
Years N.P.V.
(`) (`) (`)
(`)
0 -40,000 1.000 -40,000 -40,000
1 7,000 0.909 6,363 -38,637
2 7,000 0.826 5,782 -27,855
3 7,000 0.751 5,267 -22,598
4 7,000 0.683 4,781 -17,817
5 7,000 0.621 4,347 -13,470
6 8,000 0.564 4,512 -8,958
7 10,000 0.513 5,130 -3,828
8 15,000 0.467 7,005 3,177

Thus, the discounted pay back period lies between 7 th and 8th year from the beginning of the
project. Using simple interpolation, the pay back period is calculated as:
15.14  Accounting and Finance for Engineers

 ` 3,828 
=  
 ` 3,828 + ` 3,177 
= 7 + .55
= 7.55 years

ILLUSTRATION 15.11
From the particulars given below calculate the ‘Internal Rate of Return (IRR)’ :
(i) Net after tax inflows over the four years of the project life :
`
End of Year 1 5,000
2 8,000
3 10,000
4 4,000
(ii) Initial outlay : `20,000. No realizable scrap value at the end of project life.
(iii) Present value of `1 receivable at the end of year, 1, 2, 3 and 4
Year 1 Year 2 Year 3 Year 4
At 12% 0.892 0.797 0.712 0.636
13% 0.885 0.783 0.693 0.613
14% 0.877 0.770 0.675 0.592
15% 0.867 0.756 0.658 0.572
16% 0.862 0.743 0.641 0.552

SOLUTION
Assuming the given net after-tax inflows are CFAT, the ‘IRR’ has been calculated as follows :
CFAT PV factor PV of CFAT (`)
Year
(`) @13% @14% @ 13% @ 14%
1 5,000 0.885 0.877 4,425 4,385
2 8,000 0.783 0.770 6,264 6,160
3 10,000 6.693 0.675 6,930 6,750
4 4,000 0.613 0.592 2,452 2,368
Total PV of CFAT 20,071 19,663
Using the method of interpolation,
 20,071-20,000  71
IRR =  13 + × 1 % = 13 + = 13 + 0.17 = 13.17% (approx.)
 20,071-19,663  408

ILLUSTRATION 15.12
CINTHOL company is considering an investing an investment proposal to purchase a machine
costing ` 2,50,000. The machine has a life expectancy of 5 years and no salvage value. The
company’s tax rate is 40%. The firm straight line method for providing depreciation. The estimated
cash flows before tax after depreciation (CFBT) from the machine are as follows:
Year CFBT (`)
 Capital Budgeting for Decision Making 15.15

1 60,000
2 70,000
3 90,000
4 1,00,000
5 1,50,000
Year 1 2 3 4 5
P.V. Factor at 10% 0.909 0.826 0.751 0.683 0.621
Calculate : (i) Pay Back period,
(ii) Average Rate of Return,
(iii) NPV and
(iv) Profitability Index.

SOLUTION
Calculation of Cash Inflows
CFBT Cash flows after Tax and
CFAT
Year (before Tax (40%) Depreciation before Depreciation Cash
(after dep.)
dep.) Inflows
(`) (`) (`) (`) (`)
1 60,000 24,000 36,000 50,000 86,000
2 70,000 28,000 42,000 50,000 92,000
3 90,000 36,000 54,000 50,00 1,04,000
4 1,00,000 40,000 60,000 50,000 1,10,000
5 1,50,000 60,000 90,000 50,000 1,40,000
(i) Calculation of Pay-back Period
`
Cash outlay of the project 2,50,000
Total cash inflows for the first 2 years 1,78,000
Balance of cash outlay left to be paid-back in the 3rd year 72,000
Cash inflow for the 3rd
year 1,04,000
So, the pay-back period is between 2nd and 3rd year, i.e.;
72,000
2 years +
1,04,000
= 2.692 years
(ii) Calculation of Average Rate of Return
Average Annual Profits (After Dep. and Tax)
Average Rate of Return =  100
Net Investment in the Project
15.16  Accounting and Finance for Engineers

36,000 + 42,000 + 54,000 + 60,000 + 90,000

Average Annual Profits =
5
= `56,400
56,400
Average Rate of Return =  100
2,50,000
= 22.56%
(iii) Calculation of Net Present Value at 10% Discount Rate
Year Cash Inflows P.V. Factor at 10% Present Value
(`) (`)
1 86,000 0.909 78,174
2 92,000 0.826 75,992
3 1,04,000 0.751 78,104
4 1,10,000 0.683 75,130
5 1,40,000 0.621 86,940
3,94,340
Net Present Value = Present Value of Cash Inflows – Present Value of Cash Outflows
= Present Value of Cash Inflows – Cost of Investment
= `3,94,340 – 2,50,000 = `1,44,340
(iv) Calculation of Profitability Index
Present Value of Cash Inflows
(Gross) Profitability Index =
Cost of Investment
3,94,340
= = 1.577
2,50,000
Net Present Value of Cash Inflows
(Net) Profitability Index =
Cost of investment
1,44,340
= = 0.577
2,50,000

ILLUSTRATION 15.13
G. K. enterprise can make either of two investments at the beginning of 2010. Assuming required
rate of return of 10% p.a. evaluate the investment proposals as under :
(a) Payback Period (c) Profitability index
(b) Net present value (d) Internal rate of return
The forecast particulars are given below:
Proposal A Proposal B
Cost of investment `20,000 `28,000
Life 4 years 5 years
Scrap Value Nil Nil

Net Income (After depreciation and tax) : ` `

 Capital Budgeting for Decision Making 15.17

End of 2010 500 Nil

End of 2011 2,000 3,400
End of 2012 3,500 3,400
End of 2013 2,500 3,400
End of 2014 — 3,400
It is estimated that each of the alternative projects will require an additional net working capital of
`2,000 which will be received back in full after the expiry of each project life. Depreciation is
provided under the straight line method. The present value of `1 to be received at the end of each
year, at 10% p.a. and 14% p.a. is given below:
Year 1 2 3 4 5
P.V. at 10% .91 .83 .75 .68 .62
P.V. at 14% .88 .77 .67 .59 .52

SOLUTION
Calculation of Cash Inflows
Proposal A (`20,000 + 2000) Proposal B (`28,000 + 2000)
Net
Net Depreciatio Cash
Year Income Depreciation Cash Inflow
Income n Inflow
` ` ` ` ` `
2010 500 5,000 5,500 — 5,600 5,600
2011 2,000 5,000 7,000 3,400 5,600 9,000
2012 3,500 5,000 8,500 3,400 5,600 9,000
2013 2,500 5,000 9,500 3,400 5,600 9,000
2014 — — (7,500 + 2000 W.C.) 3,400 5,600 11,000
(9,000
+2000
W.C.)
Total 8,500 20,000 30,500 13,600 28,000 43,600
(a) Pay back Period
Proposal A
Cash inflows for first 3 years = ` 5,500 + 7,000 + 8,500 = ` 21,000
Cash inflows for 4th year = ` 9,500
22,000 − 21,000
Payback period = 3 years +  12 = 3 years and 1.26 months.
9,500
Proposal B
Cash inflows for first 3 years = ` 5,600 + 9,000 + 9,000 = 23,600
Cash inflows for 4th year = ` 9, 000
30,000 – 23,600
Payback period = 3 years + × 12 = 3 years and 8.53 months
9,000
(b) Net Present Value (NPV)
Proposal A Proposal B
P.V. Factor Cash Inflow Present value Cash Inflow Present Value
Year
at 10% (`) (`) (`) (`)
2010 0.91 5,500 5,005 5,600 5,096
15.18  Accounting and Finance for Engineers

2011 0.83 7,000 5,810 9,000 7,470

2012 0.75 8,500 6,375 9,000 6,750
2013 0.68 9,500 6,460 9,000 6,120
2014 0.62 — — 11,000 6,820
Total P.V. 23,650 Total P.V. 32,256
Less : Investment 22,000 Less : 30,000
Investment
1,650 2,256
(c) Profitability Index (PI)
Proposal A Proposal B
Gross Profitability Index 23,650 32,256
= 1.075 = 1.0752
22,000 30,000
Net Profitability Index 1,650 2,256
= 0.075 = 0.0752
22,000 30,000
(d) Internal Rate of Return (IRR)
Net present value at 10% as calculated in (b) above is + 1,650 and + 2,256 for proposals A
and B respectively, so we apply higher rate of discount (14%).
PV Factor
Year Proposal A Proposal B
at 14%
Cash Inflows Present Value Cash Inflows Present Value
(`) (`) (`) (`)
2010 0.88 5,500 4,840 5,600 4,928
2011 0.77 7,000 5,390 9,000 6,930
2012 0.67 8,500 5,695 9,000 6,030
2013 0.59 9,500 5,605 9,000 5,310
2014 0.52 — — 11,000 5,720
Total P.V 21,530 28,918
Less : Cost of Investment NPV 22,000 30,000
( -470) (-1082)
Proposal A Proposal B
Cost of NCF Cost of Capital NCF
Capital
10% 23,650 10% 32,256
IRR 22,000 IRR 30,000
14% 21,530 14% 28,918
IRR – 10 22,000 – 23,650 IRR – 10 30,000 – 32,256
= =
14 – 10 21,530 – 23,650 14 – 10 28,918 – 32,256
IRR – 10 1,650 IRR – 10 2,256
or, = or, =
4 2,120 4 3,338
 IRR = 13.11%  IRR = 12.70%

ILLUSTRATION 15.14
 Capital Budgeting for Decision Making 15.19

Godrej Co. is thinking of investing in a project costing `20 lakhs. The life of the project is five years
and the estimated salvage value of project is zero. Straight line method of charging depreciation
is followed. The tax rate is 50%. The expected cash flows before tax are as follows:
Year 1 2 3 4 5
Estimated Cash flow before depreciation and tax (` lakhs) 4 6 8 8 10
You are required to determine the: (i) Payback Period for the investment, (ii) Average Rate of
Return on the investment, (iii) Net Present Value at 20% Cost of Capital, (iv) Profitability Index.
SOLUTION
Calculation of Annual Cash inflow After Tax
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Cash inflow before depreciation 4 6 8 8 10
and tax
Less: Depreciation 4 4 4 4 4
EBT - 2 4 4 6
Less: Tax @ 50% - 1 2 2 3
EAT - 1 2 2 3
Add: Depreciation 4 4 4 4 4
Cash inflow after tax 4 5 6 6 7
(i) Pay Back Period
Year Cash inflow after tax Cumulative Cash inflow after tax
1 4 4
2 5 9
3 6 15
4 6 21
5 7 28
` 5 lakhs
Pay Back Period = 3 years + × 12 = 3 years 10 months
` 6 lakhs
(ii) Average Rate of Return (ARR)
Average return = (` 28 lakhs – ` 20 lakhs) ÷ 5 years = ` 1.6 lakhs
Average investment = ` 20 lakhs ÷ 2 = ` 10 lakhs
Average Return
Average rate of return = × 100 = (1.6 / 10) × 100
Average Investment
(iii) Net Present Value (NPV)
(` in lakhs)
Years CF Discount Factors @ 20% Discounted Cash Flows
0 (20) 1.0000 (20.0000)
1 4 0.8333 3.3332
2 5 0.6944 3.4720
15.20  Accounting and Finance for Engineers

3 6 0.5787 3.4722
4 6 0.4823 2.8938
5 7 0.4019 2.8133
NPV (4.0155)
As discounted not cash flows is negative, the project is not accepted.
Present value of inflows ` 20 lakhs − ` 4.0155 lakhs
(iv) Profitability Index = = = 0.80
Present value of outflows ` 20 lakhs

ILLUSTRATION 15.15
Dove company has to make a choice between two projects namely A and B. The initial capital
outlay of two Projects are `1,35,000 and `2,40,000 respectively for A and B. There will be no scrap
value at the end of the life of both the projects. The opportunity Cost of Capital of the company is
16%. The annual incomes are as under:
Year Project A Project B Discounting factor @ 16%
1 - 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476
You are required to calculate for each project :
(i) Discounted payback period
(ii) Profitability index
(iii) Net present value

SOLUTION
Computation of cumulative present values of project cash inflows
Project Project
Year Project A Project B
A B Discounting
factor @ PV of Cumulative PV of Cumulative
16% cash PV cash PV
Inflows Inflows
(d) = (f) =
(a) (b) (c) (e)=(d) (g)= (f)
(a)×(c) (b)×(c)
1 - 60,000 0.862 - - 51,720 51,720
2 30,000 84,000 0.743 22,290 22,290 62,412 1,14,132
3 1,32,000 96,000 0.641 84,612 1,06,902 61,536 1,75,668
4 84,000 1,02,000 0.552 46,368 1,53,270 56,304 2,31,972
5 84,000 90,000 0.476 39,984 1,93,254 42,840 2,74,812
(i) Discounted payback period
Project A
Cost of Project A = `1,35,000
Amount received by year 3 = `1.06,902
 Capital Budgeting for Decision Making 15.21

Amount recovered by year 4 = `1,53,270

 Discounted payback period lies between 3 and 4 year.
Exact amount to be recovered in year 4 = `1,35,000 – `1,06,902 = `28,098
Actual amount recovered in year 4 = `46,368
` 28,098
 Actual discounted payback period =3+ = 3.606 years
` 46,368
Project B
Cost of Project B = `2,40,000
Amount recovered by year 4 = `2,31,972
Amount recovered by year 5 = `2,74,812
 Discounted payback period lies between 4 and 5 years.
Exact amount to be recovered in year 5 = `2,40,000 – `2,31,972 = `8,028
Actual amount recovered in year 4 = `56,304
` 8,028
 Actual discounted payback period =4+ = 4.142 years
` 56,304
(ii) Profitability Index
Present value of cash inflow
Profitability index =
Initial investment
` 1,93,254
 Profitability Index for project A = = 1.4315
` 1,35,000
` 2,74,812
 Profitability Index for project B = = 1.1451
` 2,40,000
(iii) Net Present Value
Net Present Value = Present value of cash inflows – Initial investment
Net Present value for Project A = `1,93,254 – `1,35,000 = `58,254
Net Present value for Project B = `2,74,812 – `2,40,000 = `34,812

ILLUSTRATION 15.16

Z Ltd. is thinking of investing in a project costing ` 20 lakhs. The life of the project is 5 years and
the estimated salvage value of the project is zero. Straight line method of charging depreciation is
followed. The tax rate is 50%. The expected cash flows before tax are :

Year 1 2 3 4 5

Estimated cash flow before depreciation and tax (` in lakhs) 4 6 8 8 10

You are required to determine the: (i) Pay back period for the investment; (ii) Average Rate of
Return on the Return on the Investment; (iii) Net Present Value at 10% Cost of Capital; (iv)
Benefit Cost Ratio; (v) Internal Rate of Return.
SOLUTION
(i) Pack Back Period
Computation of Annual Cash Flows (after tax)
Years Cash Depreciation Profit Tax Profit Net Cash Cumulative
15.22  Accounting and Finance for Engineers

Flow  ` 20,00,000  before @ 50% after Inflow Cash

 5 years 
(before   Tax Tax Inflow
Dep. and
Tax)
Col(1) (2) (3) (4) (5) (6) (7)=(3)+(6) (8)
` ` ` `
1 4,00,000 4,00,000 – – – 4,00,000 4,00,000
2 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000 9,00,000
3 8,00,000 4,00,000 4,00,000 2,00,000 2,00,000 6,00,000 15,00,000
4 8,00,000 4,00,000 4,00,000 2,00,000 2,00,000 6,00,000 21,00,000
5 10,00,000 4,00,000 6,00,000 3,00,000 3,00,000 7,00,000 28,00,000
8,00,000

In 3rd year cumulative cash flows are ` 15,00,000 and in 4th year ` 21,00,000 i.e., pay back period
lies in between 2nd and 3rd year as the initial investment of ` 2,00,000 lies in between item.
` 5,00,000 (i.e.,, ` 20,00,000 – ` 15,00,000)
Thus, the Pay-back Period will be = 3 years +
` 6,00,000 ( ` 21,00,000 – ` 15,00,000)
= 3 years + .83 years
= 3.83 years
(ii) Average Rate of Return (ARR)
Average Annual Profit (After tax)
ARR = × 100
Average Investments
` 8,00,000
= where, Average Annual Profit = = ` 1,60,000
5

Average Investment = ` 20,00,000 = ` 10,00,000

2
Average Rate of Return (ARR) = ` 1,60,000 × 100
` 10,00,000
= 16%
(iii) Net Present Value (at 10% cost of Capital)
Cash Inflow
Discount PV of NCF
Years (after Tax)
Factor at 10%
` `
1 4,00,000 0.9091 3,63,640
2 5,00,000 0.8264 4,13,200
3 6,00,000 0.7513 4,50,780
4 6,00,000 0.6830 4,09,800
5 7,00,000 0.6209 4,34,630
20,72,050
Less: Initial Investment 20,00,000
Net Present Value 72,050
 Capital Budgeting for Decision Making 15.23

(iv) Benefit Cost Ratio, i.e., Profitability Index (PI)

PI = PV of NCF
Initial Cash Outlay

= ` 20,72,050
` 20,00,000
= 1.036
(v) Internal Rate of Return (IRR)
10% discount rate has already been calculated above which presents a reasonable amount
of positive figure. Now it may be suggested that the rate must lie in between 11% and 12%
i.e., Trial and Error method should be followed as there were unequal Cash flows.

Profitability Statement
Discount Rate at 11% Discount Rate at 12%
Cash Inflows PV of NCF PV of NCF
Years PV on Re. 1 PV of Re. 1
` ` `
1 4,00,000 0.901 3,60,400 0.893 3,57,200
2 5,00,000 0.812 4,06,000 0.797 3,98,500
3 6,00,000 0.731 4,38,600 0.712 4,27,200
4 6,00,000 0.659 3,95,400 0.636 3,81,600
5 7,00,000 0.593 4,15,100 0.567 3,96,900
20,15,500 19,61,400
Thus, from the above statement it becomes clear that the actual rate will be in between 11% and
12% which may be found out with the help of the following:
Discount Rate PV of NCF
11% 20,15,500
12% 19,61,400
1% 54,100

 Actual Rate = 11% +

(`
15,500 i.e., ` 20,15,500 – ` 20,00,000 )
× 1%(12% – 11%)
` 54,100
= 11% + 0.286%
= 11.286% or 11.29% (i.e., at this rate Initial Investment and PV of NCF will be
equal or NPV will be zero)

ILLUSTRATION 15.17
NICCO company has an investment opportunity costing `40,000 with the following expected net
cash flow (i.e., after tax and before depreciation):
Net Cash Flow
Years
(`)
1 7,000
2 7,000
3 7,000
15.24  Accounting and Finance for Engineers

4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 4,000
Using 10% as the cost of capital (rate of discount) determine the following :
(i) Pay-Back period; (ii) Net present Value at 10% discounting factor; (iii) Profitability index at 10%
discounting factor; (iv) Internal Rate of Return with the help of 10% discounting factor and 15%
discounting factor.

SOLUTION
(a) Pay Back Period
Net Cash Flow
Years
`
1 7,000
2 7,000
3 7,000
4 7,000
5 7,000
35,000
From the above it is clear that `35,000 is recovered in 5 years and balance `5,000 (`40,000 –
` 5,000 5
`35,000) to be recovered in = years or .62 years. Then the Pay Back period is 5.62
` 8,000 8
years.)
(b) Net Present Value
Net Cash Flow P.V. of N.C.F.
Years P.V. Factor at 10%
(`) (`)
1 7,000 0.909 6,363
2 7,000 0.826 5,782
3 7,000 0.751 5,257
4 7,000 0.683 4,781
5 7,000 0.621 4,347
6 8,000 0.564 4,512
7 10,000 0.513 5,130
8 15,000 0.467 7,005
9 10,000 0.424 4,240
10 4,000 0.386 1,544
 Capital Budgeting for Decision Making 15.25

Present value of cash inflows 48,961

Less : Initial Outlay 40,000
Net Present Value 8,961
(c) Profitability Index (PI)
P.V. of N.C.F. ` 48,961
PI = = = 1.22
Initial Cash Outlay ` 40,000

(d) Internal Rate of Return (IRR)

10% discount rate has already been calculated above. Now, at 15% discount rate, NPV is calculated:
Net Cash Flow P.V. of N.C.F.
Years P.V. Factor at 15%
(`) (`)
1 7,000 0.897 6,090
2 7,000 0.756 5,292
3 7,000 0.658 4,606
4 7,000 0.572 4,004
5 7,000 0.497 3,479
6 8,000 0.432 3,456
7 10,000 0.376 3,760
8 15,000 0.327 4,905
9 10,000 0.284 2,840
10 4,000 0.247 988
Present Value of Cash in flows 39,420
Less: Initial Outlay 40,000
Net Present Value (–)580
From the above data, it became clear that the NPV at 10% discount rate is positive which is in
excess of `8,961. But at 15% discount rate, the NPV is found to be negative. So the IRR will
be slightly less than 15%. As per simple interpolation technique, the exact rate can be
determined which is calculated as:
IRR – 10 40,000 – 48,961
=
15 – 10 39,420 – 48,961
IRR – 10 8961
or , =
5 9541
 IRR = 14.7%

ILLUSTRATION 15.18
Calculate the ‘Pay Back Period’, Average Rate of Return’ and ‘Net Present Value’ for a project
which requires an initial outlay of `10,000 and generates year ending cash flows of `6,000; `3,000;
15.26  Accounting and Finance for Engineers

`2,000, `5,000 and `5,000 from the end of the first year to the end of the fifth year. The required
rate of return is 10% and pays tax at 50% rate. The project has a life of five years and is
depreciated on straight line basis:

Years Discounting Factor at 10%

1 .909
2 .826
3 .751
4 .683
5 .621

SOLUTION
It is assumed that year ending cash flow represents the cash flow before depreciation and tax.
Pay Back Period
Statement of Cash Flow
Cash Flow Cash Flow
Profit Profit
before Tax @ (Profit after tax
Depreciation before After
Years Depreciation 50% and
tax tax
and tax Depreciation)
(`) (`) (`) (`) (`) (`)
1 6,000 2,000 4,000 2,000 2,000 4,000
2 3,000 2,000 1,000 500 500 2,500
3 2,000 2,000 — — — 2,000
4 5,000 2,000 3,000 1,500 1,500 3,500
5 5,000 2,000 3,000 1,500 1,500 3,500
21,000 5,500 5,500 15,500
4,200 11,100 31,000
Pay Back Period = `4,000 + `2,500 + `2,000 = `8,500 for 3 years.
(since there is unequal cash inflow)
Balance (`10,000 – `8,500) = `1,500
` 1,500 3
 For the year = =
` 3,500 7
3 24
So, Pay Back Period is = 3 + = or 3.43 years
7 7
Average Rate of Return (ARR)
Average Annual Profit after tax
ARR =  100
Average investment
` 1,100
= × 100
(` 10,000  2)
= 22%
 Capital Budgeting for Decision Making 15.27

Net Present Value (NPV)

Cash Flow P.V. of N.C.F.
Years Discount Factor
(`) (`)
1 4,000 .909 3,636
2 2,500 .826 2,065
3 2,000 .751 1,502
4 3,500 .683 2,391
5 3,500 .621 2,174
11,768
Less : Initial Outlay 10,000
Net Present Value 1,768

ILLUSTRATION 15.18
Graphite Ltd. wishes to invest in either of two investments at the beginning of the next year. The
required rate of return is 10% p.a. Evaluate the investment proposals and advise under —
(i) Discounted payback period Method
(ii) Payback profitability Method
(iii) Profitability index Method
(iv) NPV Method.
Proposal AA Proposal BB
Cost of investment (`) 2,00,000 2,80,000
Effective life (years) 4 5
Scrap value NIL NIL
Estimated Earnings after taxes :
Year ` `
1 5,000 NIL
2 20,000 34,000
3 35,000 34,000
4 25,000 34,000
5 NIL 34,000
Additional working capital required 20,000 20,000
Method of depreciation Straight line Straight line
The P.V. of `1 @ 10% p.a. at the end of each year is as follows:
Year : 1 2 3 4 5
P.V. factor : 0.91 0.83 0.75 0.68 0.62

SOLUTION

Depreciation p.a.: Proposal AA `50,000; Proposal BB `56,000

P.V. P.V. of P.V. P.V. of
Year EAT CFAT EAT CFAT
factor CFAT factor CFAT
1 5,000 55,000 0.91 50,050 NIL 56,000 0.91 50,960
2 20,000 70,000 0.83 58,100 34,000 90,000 0.83 74,700
3 35,000 85,000 0.75 63,750 34,000 90,000 0.75 67,500
15.28  Accounting and Finance for Engineers

4 25,000 75,000+ 0.68 64,600 34,000 90,000 0.68 61,200

20,000
5 NIL NIL 34,000 90,000 + 0.62 68,200
20,000
Total P.V. of CFAT 2,36,500 322,560
(i) Computation of Discounted Payback period
Proposal AA Proposal BB
Year
P.V. of CFAT Cumulative P.V. P.V. of CFAT Cumulative P.V.
1 50,050 50,050 50,960 50,960
2 58,100 1,08,150 74,700 1,25,660
3 63,750 1,71,900 67,500 1,93,160
4 64,600 2,36,500 61,200 2,54,360
5 NIL 68,200 3,22,560
Discounted Payback period
 2,20,000-1,71,900 
For Proposal AA =  3 + × 1 years = 3.94 years.
 64,600-13,600 
 3,00,000-2,54,360 
For proposal BB =  4 + × 1 years = 4.82 years
 68,200-12,400 
Recommendation: Proposal AA should be accepted.
Note: Recovery of working capital is not considered in calculating the discounted period.
Recovery of working capital
For proposal AA = `20,000 × 0.68 = `13,600
For proposal BB = `20,000 × 0.62 = `12,400
(ii) Computation of payback profitability :
Proposal AA Proposal BB
(`) (`)
Total CFAT during the life of the project 2,85,000 4,16,000
Add: Recovery of working capital 20,000 20,000
Total cash inflows 3,05,000 4,36,000
Less: Total investment 2,20,000 3,00,000
Payback profitability 85,000 1,36,000
Recommendation : Proposal BB should be selected.
P.V. of cash in flows
(iii) Profitability Index (P.I) =
P.V. of cash outflows
` 2,36,500
For Proposal AA = = 1.075
` 2,20,000
` 3,22,560
For Proposal BB = = 1.0752
` 3,00,000
Recommendation: Both are almost same. But proposal BB should be selected as it is
slightly higher than proposal A, with respect to P.I.
(iv) Computation of NPV :
Proposal AA (`) Proposal BB (`)
Total P.V. of cash inflows 2,36,500 3,22,560
Less: P.V. of cash outflows 2,20,000 3,00,000
 Capital Budgeting for Decision Making 15.29

NPV 16,500 22,500

Recommendation : Under NPV method proposal BB should be selected.

ILLUSTRATOION15.20
The expected cash flows of a project are as follows:
Year Cash flow
0 – 1,00,000
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
The cost of capital is 12%. Calculate the following:
(i) Net present value
(ii) Benefit – cost ratio
(iii)Internal rate of return.

Solution:
Statement showing calculation of net present value
Year Cash flow Discounting Factor P.V. of cash
12% outflow
1 20,000 0.893 17,860
2 30,000 0.797 23,910
3 40,000 0.712 28,480
4 50,000 0.636 31,800
5 30,000 0.567 17,010
1,19,060
(i) Net present value = 1,19,060 –1,00,000
= ` 19,060/-
1,19, 060
(ii) Benefit – Cost Ratio = = 1.906
1, 00, 000

PV of cash PV of
Year Cash D.F. 14% D.F. 16% DF 20% PV deep
outflow CDF
1 20,000 0.877 17,540 0.862 17,240 0.833 16,660
2 30,000 0.769 23,070 0.743 22,290 0.694 20,820
3 40,000 0.675 27,000 0.641 25,640 0.579 23,160
4 50,000 0.592 29,600 0.552 27,600 0.482 24,100
5 30,000 0.519 15,570 0.476 14,280 0.437 13,110
NPV 12,780 7,050 (2,150)
15.30  Accounting and Finance for Engineers

Diff. in disconnection rate

 IRR= lower disconnection + × NPVat lower rate
Diff. in NPV
20% – 16%
=16%+ × 7, 050
7, 050 + 2,150
= 16%+ 4% × 0.766
= 19.065%
Illustration 15.21
ABC Ltd. need your help in the selection of profitable projects out of the details given
below:
Projects Cash outlay Annual Cash Life of the
(Rs.) inflow (Rs.) project (in
years)
A 3,00,000 1,10,000 5
B 2,50,000 56,000 7
C 5,00,000 1,00,000 10
D 4,00,000 90,000 12
E 1,50,000 30,000 8
Company’s required rate of return is 14%. Advise the management about the
profitable project with the budget for capital expenditure of Rs. 8,00,000.
Given Annuity factor @ 14%
For 5 years 3.433
For 7 years 4.288
For 8 years 4.639
For 10 years 5.217
For 12 years 5.660
Solution
(a) Project A = A(P/A, I,n) – I
= (1,10,000×3.433) – 3,00,000
= 3,77,630 –3,00,000
= 77,630
77,630
 Per year profitability = = 15,526
5
15,526
 Percentage of profitability = ×100 = 5.175%
3,00,000
Project B =A(P/A, I,n) – I
= (56,000 × 4.288) – 2,50,000
= (56,000×4.288) – 2,50,000
= 2,40,128 – 2,50,000
= (9872) (Rejected)
 Capital Budgeting for Decision Making 15.31

Project C = A(P/A, i,n.) – I

= (100000 × 5.217) – 5,00,000
= 5,21,700 – 5,00,000
= 21,700
21,700
 Per year profitability = = 2,170
10
2170
 Percentage of profitability = ×100 = 0.434%
5,00,000
Project D = A (P/A, I,n) – I
= (90,000 × 5.660) – 4,00,000
= 5,09,400 – 4,00,000
= 1,09,400
1,09,400
 Per year profitability = = 9,117
12
9,117
 Percentage of profitability =  100 = 2.279%
4,00,000
Project E = A (P/A, i,n) – I
= (30,000 × 4.639) – 1,50,000
= 139170 – 150000 = (10,830) (Rejected).
As the excess return over 14% of the project A is 5.175% i.e. more than the project C & D. Which are
0.434% and 2.279% respectively.
So the project A is more profitable.

ILLUSTRATION 15.20
A company has an investment opportunity costing ` 40,000 with following expected net cash flow
(i.e. after taxes and before depreciation).
Net Cash Flow
Year
(`)
1 7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 4,000
Using 10% as the cost of capital, determine the following :
(a) Pay-back period.
(b) Net present value at 10% discount factor.
15.32  Accounting and Finance for Engineers

(c) Profitability Index at 10% discount factor.

(d) Internal rate of return with the help of 10%.
Discounting factor and 15% discounting factor
Present value of 1
Year 15% Discount factor
10% Discounting factor
1 0.909 0.870
2 0.826 0.756
3 0.751 0.658
4 0.683 0.572
5 0.621 0.497
6 0.564 10.432
7 0.513 0.376
8 0.467 0.327
9 0.424 0.284
10 0.386 0.247

SOLUTION
(a) Statement Showing Calculation of Pay-back Period
Cash in flow Calculation Capital yet to recover Pay back period
Year cash in flow required
A B C = 40,000 – B
0 “ 40,000
1 7,000 7,000 33,000 1 year
2 7,000 14,000 26,000 1 year
3 7,000 21,000 19,000 1 year
4 7,000 28,000 12,000 1 year
5 7,000 35,000 5,000 5,000/8,000 * 1 year
6 8,000 43,000 0.62 year
7 10,000 53,000 Nil as Capital as fully Nil
8 15,000 68,000 Recovered Nil
9 10,000 78,000 Nil
10 4,000 82,000 Nil
Pay back period required 5.62 years
(b) Statement showing calculation NPV and Profit profitability index
Present value of Present value of
Year Cash flow DF @ 10%
Cash outflow cash inflow
0 (40,000) 1 40,000
1 7,000 0.909 6,363
2 7,000 0.826 5,782
3 7,000 0.751 5,257
 Capital Budgeting for Decision Making 15.33

4 7,000 0.683 4,781

5 7,000 0.621 4.347
6 8,000 0.564 4,512
7 10,000 0.513 5,130
8 15,000 0.467 7,005
9 10,000 0.424 4,240
10 4,000 0.386 1,544
Present Value (PV) of cash flows 40,000 48,961
Net Present Value i.e.;
[PV of cash inflow / PV of cash outflow] `8,961
[`48,961 – `40,000]
Profitability index i.e.;
[PV of cash inflow / PV of cash outflow] 1.22
[`48,961 / `40,000]
(c) Statement showing calculation of Internal rate of return
Step 1 Step 2
Year Cash flow Discounting @ 10% Discount @ 15%
DF PV DF PV
0 (40,000) 1 (40,000) 1 (40,000)
1 7,000 0.909 6,363 0.870 6,090
2 7,000 0.826 5,782 0.756 5,292
3 7,000 0.751 5,257 0.658 4,606
4 7,000 0.683 4,781 0.572 4,004
5 7,000 0.621 4,347 0.497 3,479
6 8,000 0.564 4,512 0.432 3,456
7 10,000 0.513 5,130 0.376 3,760
8 15,000 0.467 7,005 0.327 4,905
9 10,000 0.424 4,240 0.284 2,840
10 4,000 0.386 1,544 0.247 988
Net Present Value 8,961 (580)
Step 1. Initially we have discounted the cash flows arbitrarily at 10% rate of interest.
Step 2. Since the NPV at 10% discounting rate was positive therefore we chose a higher
discounting rate i.e.; 10%
Step 3. Since the NPV at 10% discounting rate is positive and at 15% discounting rate is
negative therefore the IRR lies in between 10% to 15% which can be calculated
through interpolation technique as under :
15.34  Accounting and Finance for Engineers

Difference in Discounting Rate

IRR = Lower discounting rate + * NPV at Lower Rate
Difference in NPV

IRR = 10% + 15% – 10% * 8,961

580 + 8,961
IRR = 10% + 4.70% = 14.70%

Illustration 15.22
A company is planning to expand its present business activity. It has two alternatives for
the expansion programme and corresponding cash flows are tabulated below. Each
alternative has a life of five years and a negligible salvage value. The minimum attractive
rate of return for the company is 12%. Suggest the best alternative of the company.

Initial Investments Yearly Revenue

Particulars
(`) (`)
Alternative 1 5,00,000 1,70,000
Alternative 2 8,00,000 2,70,000
Solution

Alternative – 1
Year Cash inflow P.V (12%) P.V of CIF
1 1,70,000 0.893 1,51,810
2 1,70,000 0.797 1,35,490
3 1,70,000 0.712 1,21,040
4 1,70,000 0.635 1,07,950
5 1,70,000 0.567 96,462
6,12,752
 NPV = 6,12,752 – 5,00,000 = ` 1,12,752

Alternative – 1
Year Cash inflow P.V (12%) P.V of CIF
1 2,70,000 0.893 2,41,110
2 2,70,000 0.797 2,15,190
3 2,70,000 0.712 1,92,240
4 2,70,000 0.635 1,71,450
5 2,70,000 0.567 1,53,090
9,73,080

Net present value of alternative 2 is ` 1,73,080 more than alternative 1 i.

1,12,752
 Capital Budgeting for Decision Making 15.35

So we will accept alternative – 2

Provided the Company has no short supply of capital.

ILLUSTRATION 15.22
A firm whose cost of capital is 10% is considering two mutually exclusive projects X and Y, the
details of which are –
Project X Project Y
(`) (`)
Investment 70,000 70,000
Cash Flow
Year 1 10,000 50,000
2 20,000 40,000
3 30,000 20,000
4 45,000 10,000
5 60,000 10,000
Total Cash Flows 1,65,000 1,30,000

Compute the net present value at 10%. Profitability index and Internal Rate of Return for the two project.

Discounting Factor
Year 10% 15% 20% 25% 30% 35% 40%
1 0.909 0.870 0.833 0.800 0.769 0.741 0.714
2 0.826 0.756 0.694 0.640 0.592 0.549 0.510
3 0.751 0.658 0.579 0.512 0.455 0.406 0.364
4 0.683 0.572 0.482 0.410 0.350 0.301 0.260
5 0.621 0.497 0.402 0.328 0.269 0.223 0.186

SOLUTION
1. Statement showing calculation of NPV and Profitability index of Project X
Present value of Present value of cash
Year Cash flow DF @ 10%
cash outflow inflow
0 (70,000) 1 70,000
1 10,000 0.909 9,090
15.36  Accounting and Finance for Engineers

2 20,000 0.826 16,520

3 30,000 0.751 22,530
4 45,000 0.683 30,735
5 60,000 0.621 37,260
Present Value (PV) of cash flows 70,000 1,16,135
Net Present Value i.e.;
[PV of cash inflow – PV of cash outflow] `46,135
[`1,16,135 – `70,000]
Profitability index i.e.;
[PV of cash inflow / PV of cash outflow] 1.659
[`1,16,135 / `70,000]

2. Statement showing calculation of NPV and Profitability index of Project Y

Present value of Present value of
Year Cash flow DF @ 10%
cash outflow cash inflow
0 (70,000) 1 70,000
1 50,000 0.909 45,450
2 40,000 0.826 33,040
3 20,000 0.751 15,020
4 10,000 0.683 6,830
5 10,000 0.621 6,210
Present Value (PV) of cash flows 70,000 1,06,550
Net Present Value i.e.;
[PV of cash inflow – PV of cash outflow] `36,550
[`1,06,550 – `70,000]
Profitability index i.e.;
[PV of cash inflow / PV of cash outflow] 1.522
[`1,06,550 / `70,000]

3. Statement showing calculation of Internal rate of return of Project X

Step 1 Step 2 Step 3 Step 4
Cash Discounting @ Discounting @ Discounting @ Discounting @
Year
flow 15% 20% 30% 25%
DF PV DF PV DF PV DF PV
0 (70,000) 1 (70,000) 1 (70,000) 1 (70,000) 1 (70,000)
 Capital Budgeting for Decision Making 15.37

1 10,000 0.870 8,700 0.833 8,330 0.769 7,690 0.800 8,000

2 20,000 0.756 15,120 0.694 13,880 0.592 11,840 0.640 12,800
3 30,000 0.658 19,740 0.579 17,370 0.455 13,650 0.512 15,360
4 45,000 0.572 25,740 0.482 21,690 0.350 15,750 0.410 18,450
5 60,000 0.497 29,820 0.402 24,120 0.269 16,140 0.328 19,680
Net Present Value 29,120 15,390 (4,930) 4,290

Step 1. Initially we have discounted the cash flows arbitrarily at 10% rate of interest since
NPV at 10% is positive.
Step 2. Since the NPV at 15% discounting rate was positive therefore we chose a higher
discounting rate i.e.; 20%
Step 3. Since the NPV at 20% discounting rate was positive therefore we chose a higher
discounting rate i.e.; 30%
Step 4. Since the NPV at 30% discounting rate was negative therefore we chose a lower
discounting rate i.e.; 25%
Step 5. Since the NPV at 25% discounting rate is positive and at 30% discounting rate is
negative therefore the IRR lies in between 25% to 30% which can be calculated
through interpolation technique as under :
Difference in discounting rate
IRR = Lower discounting rate + * NPV at lower rate
Difference in NPV

IRR = 25% + 30% – 25% * 4,290

4,930 + 4,290
IRR = 25% + 2.326% = 27.326%

4. Statement showing calculation of Internal rate of return of Project Y

Step 1 Step 2 Step 3 Step 4
Cash Discounting @ Discounting @ Discounting @ Discounting @
Year
flow 15% 20% 30% 25%
DF PV DF PV DF PV DF PV
0 (70,000) 1 (70,000) 1 (70,000) 1 (70,000) 1 (70,000)
1 50,000 0.870 43,500 0.800 40,000 0.714 35,700 0.741 37,050
2 40,000 0.756 30,240 0.640 25,600 0.510 20,400 0.549 21,960
3 20,000 0.658 13,160 0.512 10,240 0.364 7,280 0.406 8,120
4 10,000 0.572 5,720 0.410 4,100 0.260 2,600 0.301 3,010
5 10,000 0.497 4,970 0.328 3,280 0.186 1,860 0.223 2,230
Net Present Value 27,590 13,220 (2,160) 2,370

Step 1. Initially we have discounted the cash flows arbitrarily at 15% rate of interest since
NPV at 10% is positive.
15.38  Accounting and Finance for Engineers

Step 2. Since the NPV at 15% discounting rate was positive therefore we chose a higher
discounting rate i.e; 25%
Step 3. Since the NPV at 25% discounting rate was positive therefore we chose a higher
discounting rate i.e; 40%
Step 4. Since the NPV at 40% discounting rate was negative therefore we chose a lower
discounting rate i.e; 35%
Step 5. Since the NPV at 35% discounting rate is positive and at 40% discounting rate is
negative therefore the IRR lies in between 35% to 40% which can be calculated
through interpolation technique as under :
Difference in discounting rate
IRR = Lower discounting rate + * NPV at lower rate
Difference in NPV

IRR = 35% + 40% – 35% * 2,370

2,160 + 2,370
IRR = 35% + 2.62% = 37.62%

ILLUSTRATION 15.22
CLOUDY Co. LTD. desires to invest in a project which requires an initial investment of
`50,00,000. The useful life of the project is 10 years with a salvage value of `5,00,000 and will be
depreciated on straight line method. The profit before charging depreciation is `10,00,000 p.a.
The income tax rate is 35%.
Compute the internal rate of return.

SOLUTION

Initial Investment – Salvage Value ` (50,000,000 – 5,00,000)

= 10,00,000
Useful life of the profit 10
Profit before tax 4,50,000
5,50,000
Less : Tax @ 35% 1,92,500
Profit after tax 3,57,500
Add : Depreciation 4,50,000
CFAT p.a. (t = 1 to 10) 8,07,500
Recovery of salvage value (t = 10) 5,00,000
CFAT PV factor Present Value of CFAT
Year
(`) @ 10% @ 11% @ 10% @ 11%
 Capital Budgeting for Decision Making 15.39

1 to 10 8,07,500 6,145 5.889 49,62,087.50 47,55,367.50

10 5,00,000 0.386 0.352 1,93,000.00 1,76,000.00

Total PV of CFAT 51,55,087.50 49,31,367.50

By the method of interpolation.
 51,55,087.50 – 50,00,000) 
IRR =  10 + × 1 % = 10.69% (approx.)
 51,55,087.50 – 49,31,367.50 

ILLUSTRATION 15.23
A company is contemplating to purchase a machine. Two machines A and B are available each
costing ` 5 lakhs. In comparing the profitability of the machines, a discount rate of 10% is to be
used and the machine is to be written – off in 5 years by straight line method a depreciation with
nil residual value.
Cash flow after tax expected as:
Years Machine A Machine B
` `
1 1,50,000 50,000
2 2,00,000 1,50,000
3 2,50,000 2,00,000
4 1,50,000 3,00,000
5 1,00,000 2,00,000
Indicate which machine would be profitable using the following methods of rank investments
proposals:
(i) Pay Back Method; (ii) Net Present Value Method; (iii) Profitability Index Method and (iv)
Average Rate of Return Method.
The discounting factors at 10% are:
Year 1 2 3 4 5
Discounting factor 0.990 0.826 0.751 0.683 0.621

SOLUTION
15.40  Accounting and Finance for Engineers

(i) Pay Back Period

Computation of Annual Cash Flow
Machine A Machine B
Annual Cumulative Annual Cash Cumulative
Year
Years Cash Flow Cash Flow Flow Cash Flow
` ` ` `
1 1,50,000 1,50,000 1 50,000 50,000
2 2,00,000 3,50,000 2 1,50,000 2,00,000
3 2,50,000 6,00,000 3 2,00,000 4,00,000
4 1,50,000 7,50,000 4 3,00,000 7,00,000
5 1,00,000 8,50,000 5 2,00,000 9,00,000
For Machine A
In 2nd year cumulative cash flows are ` 3,50,000, and in 3rd year ` 6,00,000, i.e., pay back

period lies in- between 2nd and 3rd as the initial investment of ` 5,00,000 lies in between them.

Thus, the Pay Back Period will be = 2 years + 1,50,000

` 2,50,000
= 2 years + .6 years
= 2.6 years.
For Machine B
In 3rd year cumulative cash flows are ` 4,00,000 in the 4th year ` 7,00,000, i.e., pay back period lies

in between 3rd and 4th year as the initial investment of ` 5,00,000 lies in-between them.

Thus, the Pay Back Period will be = 3 years + 1,00,000

` 3,00,000
= 3 years + .33 years
= 3.33 years.
Rank : Machine A = First
Machine B = Second
Hence, Machine A should be purchased as its pay back period is less than the pay back
period of Machine B.
(ii) Net Present Value Method
Computation of Net Present Value of Machine A and Machine B
Annual Annual Discount
Cash Flow Discount PV of NCF Cash Flow PV of NCF
Year Factor at
Factor 10%
` ` ` 10% `
1 1,50,000 0.909 1,36,350 50,000 0.909 45,450
2 2,00,000 0.826 1,65,200 1,50,000 0.826 1,23,900
 Capital Budgeting for Decision Making 15.41

3 2,50,000 0.751 1,87,750 2,00,000 0.751 1,50,200

4 1,50,000 0.683 1,02,450 3,00,000 0.683 2,04,900
5 1,00,000 0.621 62,100 2,00,000 0.621 1,24,200
6,53,850 6,48,650
Less : Initial Investment 5,00,000 Less : Initial Investment 5,00,000
Net Present Value 1,53,850 1,48,650
Since , Machine A has more NPV in comparison with Machine B, Machine A is
recommended.
 Rank : Machine A = first
Machine B = Second
(iii) Profitability index Method
Machine A = PI = PV of NCF = ` 6,53,850 = 1.31; Rank = First
Initial Cash Outlay ` 5,00,000
PV of NCF ` 6,48,650
Machine B = PI = = = 1.30; Rank = Second
Initial Cash Outlay ` 5,00,000
 Machine A is profitable to purchase.
(iv) Average Rate of Return (ARR)
Average Annual Profit after tax
ARR = × 100
Average Investment
Machine A Machine B
` `
Average Annual Profit 8,50,000 9,00,000
Less: Depn. For 5 5,00,000 5,00,000
years
(` 1,00,000 × 5)
Profit after Depreciation 3,50,000 4,00,000
 Average Profit 3,50,000 4,00,000 = ` 80,000
= ` 70,000 5
5
Average Investment ` 5,00,000  2 = ` 2,50,000 ` 5,00,000  2 = ` 2,50,000
 PI ` 70,000 × 100 80,000 × 100
` 2,50,000 ` 2,50,000
= 28% = 32%
Hence, Machine B is more profitable.
Rank : Machine B = First
Machine A= Second
Illustration 15.24
(a) The following table summarizes a cash flow stream of an investment project:
15.42  Accounting and Finance for Engineers

Year Net cash flow

0 – 65000
1 162500
2 162500
3 162500
.
.
.
8 162500
If the firm’s rate of interest is 15%, compute the NPV of this project. Moreover, will this project
be acceptable?
(b)The project cash flow of an investment proposal is given below:
End of Year Net cash flow
0 –50000
1 20400
2 25200
3 45750
Evaluate the economic viability of this project for i= 10% under NPV

Solution
(a)
Year CIF P.V (15%) P.V of CIF
1 1,62,500 0.869 1,41,213
2 1,62,500 0.756 1,22,850
3 1,62,500 0.657 1,06,762
4 1,62,500 0.572 92,950
5 1,62,500 0.497 80,763
6 1,62,500 0.432 70,200
7 1,62,500 0.376 61,100
8 1,62,500 0.327 53,138
7,28,976
 NPV = 7,28,976 – 65,000
= 6,63,976
 The Project will be acceptable be come NPV is positive i.e ` 6,63,976
(b)
 Capital Budgeting for Decision Making 15.43

Year CIF P.V (10%) P.V of CIF

1 20,400 0.909 18,544
2 25,200 0.826 20,815
3 45,750 0.751 34,358
73,717

 NPV = 73,717 – 50,000 = 23,717

 The NPV of that Project is 23,717, so we will accept the project.

ILLUSTRATION 15.24
CHANDRA LTD. is confronted with two mutually exclusive investment opportunities having
following cash flows :
Proposal A : Initial outlay of `1,00,000 with net inflows of `25,000 at the end of first year and
`1,25,000 at the end of second year.
Proposal B : Initial outlay of `1,00.670 with net inflows of `95,000 at the end of first year and
`45,000 at the end of second year.
Rank the two investment opportunities in order of preference by the P.V. method and the IRR
method. Assume cost of capital to be 10%.
Discuss with reasons which of the two methods you would rely upon in arriving at your final
choice in the present case.
The relevant P.V. factors are given below :
Ko 10% 24% 25% 26% 27% 28% 29% 30%
Year 1 0.909 0.806 0.800 0.794 0.787 0.781 0.775 0.769
Year 2 0.826 0.650 0.640 0.630 0.620 0.610 0.601 0.592

SOLUTION
Statement showing the Computation of NPV
PV Factor CFAT (`) P.V. of CFAT (`)
Year
@ 10% A B A B
1 0.909 25,000 95,000 22,725 86,355
2 0.826 1,25,000 45,000 1,03,250 37,170
Total P.V. of CFAT 1,25,975 1,23,525
Less : P.V. of cash outflows 1,00,000 1,00,670
(Net Present Value) NPV 25,975 22,855
Proposal A :
Statement showing the Computation of IRR
15.44  Accounting and Finance for Engineers

CFAT P.V. Factor P.V. of CFAT (`)

Year
(2) @ 26% @ 24% @ 25% @ 26% @ 24% @ 25%
1 25,000 0.794 0.806 0.800 19,850 20,150 20,000
2 1,25,000 0.630 0.650 0.640 78,750 81,250 80,000
Total PV of CFAT 98,600 1,01,400 1,00,000
IRR of Proposal A is 25%
 Capital Budgeting for Decision Making 15.45

Proposal B :
Statement showing the Computation of IRR
CFAT P.V. Factor P.V. of CFAT (`)
Year
` @ 30% @ 29% @ 30% @ 29%
1 95,000 0.769 0.775 73,055 73,625
2 45,000 0.592 0.601 26,640 27,045
Total P.V. of CFAT 99,695 1,00,670
IRR of Proposal B is 29%
Profitability Ranking
Proposal A Proposal B
(i) NPV Method 1st 2nd
(ii) IRR Method 2nd 1st
Comment: Here, Proposal A and Proposal B are mutually exclusive projects i.e., only one project
will be accepted by the company. In such a situation, decision should be taken on the basis of
NPV method. The IRR method assumes that the cash flows generated from the projects are re-
invested at internal rate of return whereas NPV method assumes the investment of the cash flows
at the rate of cost of capital. Thus the NPV method is superior to IRR method in the sense that
the former assumes the cost of capital rate for re-investment purpose which is uniform and can be
applied for all investment projects. But the IRR may vary widely from project to project.
Thus the company should accept Proposal A.

ILLUSTRATION 15.25
MR. REX, an investor facing two mutually exclusive investment proposals having life span of four
years each furnishes the following information :
Project A Project B
` `
Initial Investment needed 80,000 24,000
Net after tax inflows expected
at the end of year 1 28,000 9,800
2 28,000 9,800
3 28,000 9,800
4 28,000 9,800
You are asked to rank the two proposals by the IRR method and the P.V. method assuming cost
of capital to be 10%. Explain the reasons for contradiction in ranking, if any and state with reason
which of the two methods the investor should rely upon in making the final choice.
15.46  Accounting and Finance for Engineers

SOLUTION
Computation of NPV @ 10%
Proposal A Proposal B
CFAT p.a. for 4 years `28,000 `9,800
P.V. of an annuity for 4 years @ 10% 3.170 3.170
Total P.V. of CFAT `28,000 × 3.170 `9,800 × 3.170
`88,760 `31,066
Less : Initial Investment `80,000 `24,000
NPV `8,760 `7,066
Computation of IRR:
Step 1 : Find out the P.V. of an annuity of `1 for 4 years
Initial Investment ` 80,000
Proposal A = =
cons tan t CFAT p.a. ` 28,000
= 2.8571 (nearest to 15% in the P.V. of an Annuity table)
Initial Investment ` 24,000
Proposal B = =
cons tan t CFAT p.a. ` 9,800
= 2.45 (nearest to 2% in the P.v. of an Annuity table)
Proposal A :
Year CFAT P.V. Factor P.V. of CFAT (`)
@ 14% @ 15% @ 14% @ 15%
1 to 4 28,000 2.914 2.855 81,592 79,940
 24,441 – 24,000 
IRR =  22 + × 1 % = 22.98%
 24,441 – 23,990 
Profitability Ranking
Proposal A Proposal B
NPV Method 1st 2nd
IRR Method 2nd 1st
Comment: Here, Proposal A and Proposal B are mutually exclusive proposals i.e., only one
proposal will be accepted by the company. In such a situation, decision should be taken on the
basis of NPV method. The IRR method assumes that the cash flows generated from the projects
are re-invested at internal rate of return whereas NPV method assumes that the cash flows are
invested at the rate of cost of capital. Thus the NPV method is superior to IRR method in the
sense that the former (NPV method) assumes the cost of capital rate for re-investment purpose
which is uniform and can be applied for all investment projects. But the IRR may vary widely from
project to project.
Thus, the company should accept Proposal A.
Note: In case of ‘Accept-Reject decision’. IRR method should be applied.
 Capital Budgeting for Decision Making 15.47

Replacement of Assets
Replacement analysis is a systematic assessment, by a business, of the need to replace its existing
asset/assets (that is asset/assets in service), and taking appropriate decisions thereon, with the objective of
maintaining/improving its financial performance.
Every business is continuously confronted with an ever-changing business environment. This necessitates
ongoing review of its own working and, if need be, working out a mid-course correction. It also uses a
variety of assets necessary for its business activities. Maintaining a high level of efficiency in all its
branches is the hallmark of a successful business. This in turn, necessitates a systematic periodical
replacement of its old and aging assets. A business entity which ignores this basic need is competed out of
the market. A well considered and scheduled replacement of its assets in service minimizes compulsory and
unpredictable shut down episodes and equips the business in maintaining a high level efficient
performance.
It is self evident that a well managed business would not resort to replacing its assets at random. Each
decision to this effect should be backed by a well articulated analysis of the facts and the expected outcome
of the proposed action. Analysts have developed a set of principles and steps to be followed in their
implementation to ensure that the decision arrived at is rational and optimal.
Replacement analysis is an integral part of business management for the reason that in almost all non-
routine cases, a choice has to be made between available alternatives. It also remains a basic principle in all
such decision making exercises that the selected alternative should be that which offers the best
combination of investment and outcome. If, for example, an alternative necessitating a higher investment
yields additional MAAR-adjusted PW, it should be a preferred choice. It means that the management
should choose that alternative which maximizes overall profitability in the sense that it has the greatest
positive equivalent worth at interest rate > MAAR.
Thus, replacement analysis covers the choice between a variety of alternative options derived from sound
economic reasoning.
Forms of Replacement
Emerging from the above questions, a replacement decision may take any of the following forms.
(a) Retirement of an existing asset and acquiring another one in its place. There is true replacement in
real sense of the term. Moreover, the capacity and life of the new asset need not be the same as those
of the retiring asset. In such a case, the existing asset may be retained as a back up.
(b) The existing asset(s) may be supplemented with an additional asset similar or dissimilar to the
existing asset(s).
(c) The decision to replace/augment an existing asset may be postponed for a specified time, or
indefinitely, noting the fact that, by very nature of things, every asset has to be replaced sooner or
later.
It is noteworthy that replacement analysis may also throw up a result favouring non-replacement of an
existing asset. This means that non-replacement of an existing asset is always an option and in some cases
may even be a preferred one.
Also, it should be noted that replacement is not the same thing as expansion.

Illustration :
National Bottling Company is contemplating to replace one of its bottling machines with
a new and more efficient machine. The old machine has a book value of ` 5 lakhs and
remaining useful life of 5 years. The company does not expect to realize and return from
15.48  Accounting and Finance for Engineers

scraping the old machine after 5th year but if it is sold to another company in the industry
right now, National Bottling Company would receive ` 6 lakhs for it.
The new machine has a purchase price of ` 20 lakhs and has an estimated salvage value of
` 2 lakhs after 5 years.
The new machine will have a greater capacity and annual sales are expected to increase
from ` 10 lakhs to 12 lakhs. Operating efficiencies with the new machine will also
produce saving of ` 2 lakhs a year. Tax rate is 40%. Suggest whether machine should be
replaced or not. Assume cost of capital is 10%. Discounting factor at 10% rate of interest
is as under :
Year 0 1 2 3 4 5
Discounting factor (DF) 1 0.909 0.826 0.751 0.683 0.621
Solution
Statement showing net present value of replacement
Increase
Saving in
Dep of Dep of Cange in Change Change Change in Present
Yr operation DF
M2 M1 in Dep income in PBT in PAT cash flow value
cost
(Sales)
F=D+E- G=F
A1 B1 C=A-B D E H=G+C I J=H*I
C (1-0.4)
0 (14,40,000)2 1 (14,40,000)
1 3,60,000 1,00,000 2,60,000 2,00,000 2,00,000 1,40,000 84,000 3,44,000 0.909 3,12,696
2 3,60,000 1,00,000 2,60,000 2,00,000 2,00,000 1,40,000 84,000 3,44,000 0.826 2,84,144
3 3,60,000 1,00,000 2,60,000 2,00,000 2,00,000 1,40,000 84,000 3,44,000 0.751 2,58,344
4 3,60,000 1,00,000 2,60,000 2,00,000 2,00,000 1,40,000 84,000 3,44,000 0.683 2,34,952
5 3,60,000 1,00,000 2,60,000 2,00,000 2,00,000 1,40,000 84,000 5,44,0003 0.621 3,37,824
Net present value (12,040)
Conclusion : Since the new present value of the replacement project is negative i.e.
(12,040), therefore the machine should not be replaced.
Working 1 : Statement showing calculation of depreciation of old and new machine
Depreciation of machine 1 (Old machine) :
= (Book value – scrap value) / Remaining life of the machine
= ` 1,00,000 (i.e. ` 5,00,000/5)
Depreciation of machine 2 (New machine) :
= (Cost of machine – Scrap value) / life of machine
= ` 3,60,000 [i.e. ` 20,00,000 – 2,00,000) /5]
Working 2 : Cash outflow at the beginning of the project due to replacement
Particulars Calculation Details Amount
New machine purchased 20,00,000
Realisation on old machine sold 60,00,000
 Capital Budgeting for Decision Making 15.49

Less : Tax on profit on sale of old (6,00,000 – 5,00,000)*40% (40,000) (5,60,000)

machine
Cash outflow 14,40,000

Working 3 : Cash outflow at the beginning of the project due to replacement

Particulars Details Amount
New machine scrap sold 2,00,000
Cash from operation
Profit after tax 84,000
Add : Change in Depreciation 2,60,000 3,44,000
Cash inflow in the last year 5,44,000
Illustration :
Tufan Ltd. is interested in assessing the cash flows associated with replacement of old
machine with new machine. The old machine has written down value of ` 60,000 and this
can be sold for ` 90,000 immediately. It has remaining life of 5 years after which its value
will be nil.
The new machine costing ` 4,00,000 is expected to bring ` 2,50,000 after 5 years.
Depreciation rate on new machine is 1/3rd on WDV method. New machine will save
manufacturing cost ` 10,000 p.a. If investment in working capital will be unaffected and
tax rate is 30%, should the old machine be replaced with the new machine. Assume cost
of capital is 12%. Discounting factor @ 12% rate of interest is as under :
Year 0 1 2 3 4 5
Discounting factor (DF) 1 0.893 0.797 0.712 0.636 0.567
Solution
Statement showing net present value of replacement
Saving
Dep of Dep of Cange Change Change Change in Present
in Mfg. DF
Yr MII M1 in Dep in PBT in PAT cash flow Value
cost
A1 B1 C=A-B D E=D-C H I = G*H
0 (3,19,000)2 1 (3,19,000)
1 1,33,333 12,000 1,21,333 10,000 (1,11,333) (77,933) 43,400 0.893 38,756
2 88,889 1,00,000 2,60,000 2,00,000 2,00,000 1,40,000 84,000 3,44,000 0.826
3 3,60,000 12,000 76,889 10,000 (66,889) (46,822) 30,067 0.797 23,963
4 39,506 12,000 27,506 10,000 (17,506) (12,254) 15,252 0.636 9,700
5 26,338 12,000 14,338 10,000 (4,338) (3,037) 2,02,1033 0.567 1,14,592
Net present value (1,16,910)

Conclusion : Since the net present value of the replacement project is negative i.e. (`
1,16,910) therefore the machine should not be replaced.
Working 1 : Statement showing calculation of depreciation new machine.
15.50  Accounting and Finance for Engineers

Year New Machine (Machine II) Amount

Opening balance 4,00,000
1st Year
Less : Depreciation (1,33,333)
WDV 2,66,667
2nd year
Less : Depreciation (88,889)
WDV 1,77,778
3rd year
Less : Depreciation (59,259)
4th year WDV 1,18,519
Less : Depreciation (39,506)
WDV 79,013
5th year Less : Depreciation (26,338)
WDV 52,675
Depreciation on old machine (Machine I) = (Book value-Scrap value)/Remaining life of
asset
= (60,000 – 0)/5 = ` 12,000
Working 2 : Cash outflow at the beginning of the project due to replacement
Particular Calculation Details Amount
New machine 4,00,000
purchased
Less: Realisation on 90,000
sale of old machine
Less: Tax on profit on (90,000-60,000)*30% (9,000) (81,000)
sale of old machine
Cash outflow of first year 3,19,000
Working 3 : Cash inflow in the last year due to replacement is
Particular Calculation Details Amount
Realisation from sale
of new machinery
New machine scrap 2,50,000
sold
Less : Tax on profit of 30%*(2,50,000-52,675) (59,198) 1,90,802
sale of machine
Cash from operation
Profit after tax (3,037)
Add : Change in 14,338 11,301
Depreciation
Cash inflow of last year
Exercise :
 Capital Budgeting for Decision Making 15.51

N company is contemplating to replace one of its machines (which is purchased 5 years

ago) with a new and more efficient machine. The old machine has a original value of ` 20
lakhs and remaining useful life of 5 years. The company does not expect to realize any
return from scraping the old machine after 5 year but if it is sold to another company in
the industry right now, N company would received ` 18 lakhs for it.
The new machine has a purchase price ` 50 lakhs and has an estimated salvage value of `
5 lakhs after 5 years.
The new machine will have a greater capacity and annual gross income are expected to
increase by ` 5 lacs. Operating efficiencies with the new machine will also produce saving
of ` 5 lakhs a year. Tax rate is 40%. Assume cost of capital is 12%.
Illustration 33
A cigarette manufacture proposes to replace his cigarette making machine which produce
at the rate of 1,200 cigarettes per minute, by the latest type of high – speed machines, to
operate at the rate of 2,000 cigarettes per minute. The existing machines cost ` 6,000 each
ten years ago. New and Old machine have an estimated total effective life of 20 years
each. The depreciation provisions is by the “straight line” method, the residual value of
each machine being `1,000. The price of the new machine is ` 10,000. The present
exchange value of the existing Machine is ` 1,500.
The new machine will occupy 80% of the effective floor space of the old machine, the
cost of which is ` 50 per year.
The following details are also available.
Old Machine New Machine
` `
Annual operating hours 1,500 1,500
Operator’s annual wages 550 500
Annual repairs 150 190
Annual power cost 50 110
Any probable loss on the old machine is to be included in the estimated cost of the new
machine :
(a) Tabulate a comparative cost estimate for one year for an old and a new machine.
(b) Calculate change in cost per 1,00,000 units.
Solution :
Working 1
Calculation of depreciation on Old machinery
= (Original cost-Scrap value) / Life of the asset = (6,000 – 1,000) / 20 = ` 250
Calculation of written down value of Machinery as on date of sale
Original Cost – Depreciation for 10 years = WDV after 10 years
` 6,000 – (250* 19) = ` 3,500
15.52  Accounting and Finance for Engineers

Calculation of loss on sale

= WDV of assets sold – realizable value = ` 2,000 i.e. (` 3,500 – ` 1,500)
Calculation of depreciation on new assets
Cost of new asset – Scrap value) / Life of the asset
= (Cost of purchase + loss on sale of old asset – Scrap value) / Life of the assets
= (10,000 + 2,000 – 1,000) / 20 = ` 550
Statement showing change in cost details on replacement
Particulars Cost on old machinery Cost on new machinery
Depreciation 250 550
Wages 550 500
Repairs 150 190
Power 50 110
Rent 50 40 (80% of ` 50)
Total 1,050 1,390
Operating hours 1,500 1,500
Cost per operating
0.70(i.e. 1,050/1,500) 0.927(1,390/1,500)
hours
Cost per minute 0.0117 (i.e. 0.70/60) 0.0154 (i.e. 0.927/60)
Production per minute 1,200 units 2,000 units
Cost of production of 0.97 (i.e. 0.0117/1,200* 0.77 (i.e.
1,00,000 units 1,00,000) 0.0154/2,000*1,00,000)
Change in total cost
0.20 (` 0.97 – 0.77)
per 1,00,000 units
Illustration
A company is using a machine, the original cost of which was ` 3,60,000. The Machine is
two years old and has a remaining useful life of 10 years. The company does not except
to realize any return from scrapping the old machine in 10 years but if it is sold now to
another firm in the industry it would receive `1,00,000. The straight line method of
depreciation is in effect.
The management is contemplating in replacing it with a newer and more efficient
machine which cost ` 4,20,000 and has a estimated salvaged value of ` 20,000 after its
useful life of 10 years. The new machine will have greater capacity and annual revenues
are expected to go up by ` 40,000 per year. The operating efficiency of the new machine
will also product an expected savings of ` 50,000 a year. The company’s tax rate is 55%.
Additionally, if the new machine is purchased, inventories will increase by ` 20,000
during the life of the project. Determine the economic desirability of the purchase of the
machine, assuming the cost of capital to be 12%.
Solution
 Capital Budgeting for Decision Making 15.53

Statement showing calculation of economic desirability of the purchase of the

machine
Dep of Dep of Saving in Increase
Cange Change Change Change in
Yr of Old new operation in DF PV
in Dep in PBT in PAT cash flow
machine machine cost revenue
C=A- F=D+E- G=F
A1 B1 D E H=G+C I J=H*I
B C (1-t)
0 (2,30,000))2 1 (2,30,000)
1 30,000 40,000 10,000 50,000 40,000 40,000 36,000 46,000 0.893 41,078
2 30,000 40,000 10,000 50,000 40,000 80,000 36,000 46,000 0.797 36,663
3 30,000 40,000 10,000 50,000 40,000 80,000 36,000 46,000 0.712 32,752
4 30,000 40,000 10,000 50,000 40,000 80,000 36,000 46,000 0.636 29,256
5 30,000 40,000 10,000 50,000 40,000 80,000 36,000 46,000 0.567 26,082
6 30,000 40,000 10,000 50,000 40,000 80,000 36,000 46,000 0.507 23,322
7 30,000 40,000 10,000 50,000 40,000 80,000 36,000 46,000 0.452 20,792
8 30,000 40,000 10,000 50,000 40,000 80,000 36,000 45,000 0.404 18,584
9 30,000 40,000 10,000 50,000 40,000 80,000 36,000 46,000 0.361 16,067
10 30,000 40,000 10,000 50,000 40,000 80,000 36,000 86,0003 0.322 27,692
Net present value 42,288

Working 1 : Calculation of Depreciation

Depreciation of old machinery = (Original cost – Scrap value) / life of asset = (3,60,000 –
Nil / 12 = 30,000
Depreciation of new machinery = (Original cost – Scrap value) / life of asset = (4,20,000
– 20,000) / 10 = 40,000
Working 2 : Cash flow in the year of replacement
Particulars Calculation Amount
New machine purchased 4,20,000
Less : Realisation on old machinery (1,00,000)
sold
Less : Tax shield due to loss on sale (WDV-Sale value)*
(1,10,000)
of old plant (3,00,000 – 1,00,000)*55%
Add : Additional investment in stock 20,000
Total 2,30,000
Working 3 : Cash inflow in the last year due to replacement is
Particulars Details Amount
New machinery scrap sold 20,000
Increase in Inventories 20,000
Cash from Operation
Profit after tax 36,000
Add : Change in Depreciation 10,000 46,000
15.54  Accounting and Finance for Engineers

Cash inflow in the last year 86,000

Illustration
An existing company has a machine which has been in operation for 2 years, its
remaining estimated useful life is 10 years, with no salvage value at the end. Its current
market value is ` 1,00,000. The management is considering a proposal to purchase an
improved model of a similar machine, which gives increased output. The relevant
particulars are as follows :
Particulars Existing Machine New Machine
Purchase price ` 2,40,000 4,00,000
Estimated life 12 years 10 years
Salvage value Nil Nil
Annual operating hours 2,000 2,000
Selling price per unit ` 10 ` 10
Output per hour 15 units 30 units
Material cost per unit `2 `2
Labour cost per hour ` 20 ` 40
Consumable stores per year ` 2,000 ` 5,000
Repairs and maintenance per year ` 9,000 ` 6,000
Working capital ` 25,000 ` 40,000
The company follows the straight line method of depreciation and is subject to 50% tax.
Should the existing machine be replaced? Assume that the company’s required rate of
return is 15%.
Solution
Calculation of Output p.a. :
Existing machine=2,000 hours×15 units per hour = 30,000 units
New machine=2,000 hours×15 units per hour = 60,000 units
Calculation of Sales Revenue p.a. :
Existing machine=30,000 hours×10 units per hour = ` 3,00,000
New machine=60,000 hours×10 units per hour ` 6,00,000
Initial Cash Outlay (`)
Cost of new machine 4,00,000
Less : Sale proceeds of old machine 1,00,000
3,00,000
Add : Additional working capital requirement 15,000
3,15,000
Less : Tax Savings on loss on sale of old machine 50% of (` 2,00,000 – ` 50,000
1,00,000)
Initial net cash outflow 2,65,000
Calculation of Cash Inflow Operations p.a.
 Capital Budgeting for Decision Making 15.55

Existing New Machine Different

Particulars
Machine 60,000 units 30,000 units
Sales revenue (A) 3,00,000 6,00,000 3,00,000
Less : Expenses
Material cost 60,000 1,20,000 60,000
Labour cost 40,000 80,000 40,000
Consumable stores 2,000 5,000 3,000
Repairs and Maintenance 9,000 6,000 (3,000)
Depreciation 20,000 40,000 20,000
Total (B) 1,31,000 2,51,000 1,20,000
Profit Before Taxes(A)-(B) 1,69,000 3,49,000 1,80,000
Less : Tax @ 50% 84,500 1,74,500 90,000
Profit After Tax 84,500 1,74,500 90,000
Net Cash Flow (PAT+Dep) 1,04,500 2,14,500 1,10,000
NPV = `1,10,000 × PVIFA (15%, 10) + ` 15,000 × PVIF(15%, 10) – `2,65,000
= (`1,10,000 × 5.019) + (`15,000 × 0.247) – ` 2,65,000 = ` 2,90,795
Existing machine should be replaced with the new one, since the NPV is positive.
Debt Repayment
Money, when lent (or borrowed), earns an interest income to be paid by the debtor and received by the
lender. By implication, the sum of money payable by the debtor differs from the original sum of
money that was borrowed by him. It gets inflated. The sum so payable by the debtor in the ‘time value
of the originally received sum by him’. It is self evident that, given the original borrowed sum, its time
value (that is, the equivalent payable amount) would depend upon several things like.
(i) The rate of interest,
(ii) The time-distance between raising of loan and its repayment, and
(iii) The periodicity of the compounding of interest.
For example, let the sum borrowed by a debtor be represented by PV (present value), and let it carry
an interest rate of I per cent p.a., compounded annually, then at the end of N years, the time value of
PV would increase to PV (1+i)N.
Correspondingly, three years earlier, the time value of a payable loan amount of PV today was PV
(1+i)3.

Real Option
Real option is an alternative or choice that becomes available with a business investment opportunity. Real
options can include opportunities to expand or close one project if certain conditions arise. It is referred to
as “real’ because they usually involve tangible assets such as capital equipment, rather than financial
instruments. Taking into account real options can greatly affect the valuation of potential investments.
Oftentimes, however, valuation methods, such as NPV, do not include the benefits that real options
provide.
This kind of option is not a derivative instrument, but an actual option (in the sense of ‘choice”) that a
business may gain by undertaking certain endeavors. For example, by investing in a particular project, a
15.56  Accounting and Finance for Engineers

company may have the real option of expanding, downsizing or abandoning other projects in the future.
Other examples of real options may be opportunities for R&D, M&A and licensing.
The following are the advantages of Real Option
(1) Real option provide a strategic way of dealing with real life uncertainty faced by a big business
projects.
(2) It helps in taking risk optimal project planning, designing and implementation of business projects.
(3) Real option provide a fesible and economical implementation channel for the methods currently in use
for project evaluation including cost benefit analysis.
(4) It provides the platforms towards incorporation of technological and managerial innovation.
(5) Real options act as a major help in implementing greater flexibility into the business sector as a whole.

EXERCISE

PROBLEM 1
A project cost `6,00,000 and yields annually a profit of `90,000 after depreciation at 12.5% p.a.
before tax at 50%. Calculate the pay-back period. [Ans. 5 years]
PROBLEM 2
Calculate the pay-back periods of the following projects each requiring a cash outlay of `1,00,000.
Suggest which projects are acceptable if the standard pay-back period is 5 years –
Year Project A Project B Project C
1 30,000 30,000 10,000
2 30,000 40,000 20,000
3 30,000 20,000 30,000
4 30,000 10,000 40,000
5 30,000 5,000 —
[Ans. Project A = 3.333 years; Project B = 4 years; Project C = 4 years; All the three
projects are acceptable]

PROBLEM 3
A project costs `25,000 and has a scrap value of `5,000 after 5 years. The net profits before
depreciation and taxes for the five years period are expected to be `5,000, `7,000, `8,000 and
`10,000. You are required to calculate the accounting rate of return (on average investments)
assuming 50% rate of tax and depreciation on straight line method. [Ans. 16%]

PROBLEM 4
Following is the relevant data for two machines A and B.
 Capital Budgeting for Decision Making 15.57

Particulars A B
Capital Outlay `2,000 `2,400
Net Cash Flow
1st year `1,000 `800
2nd year `1,000 `800
3rd year — `2,000
Find out which of the two is a better investment showing necessary workings.
[Ans. Machine B is a better investment though according to Pay-back method machine A
looks to be better investment].

PROBLEM 5
X Ltd., having cost of capital 10%, is considering two mutually exclusive projects X and Y, the
details of which are:
Cost of investment ` 70,000 –both in Project X and Project Y.
Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5
Project X(`) 10,000 20,000 30,000 45,000 60,000

Project Y(`) 50,000 40,000 20,000 10,000 10,000

Compute the NPV at 10% Profitability Index, and IRR for the two projects.
Ans.
Project X Project Y
PI 1.659 1.522
NPV ` 46,130 ` 36,550
IRR 27% 37%

PROBLEM 6
The Tamil Nadu Fertizers Ltd. is considering a Proposal for the investment of `5 lakhs on product
development which is expected to generate net cash inflows for 6 years as under:
Years Net Cash Flows (` in thousands)
1 Nil
2 100
3 160
4 240
5 300
6 600
The company’s cost of capital is 15% Advise the company on the desirability or otherwise of
accepting the proposal. [Ans. NPV = `226.40 (‘000); Proposal is acceptable.]

PROBLEM 8
15.58  Accounting and Finance for Engineers

XYZ Ltd. is considering purchase of a machine in replacement of an old one. Two models viz.
MOLIN and SKODA are offered at prices of `22.50 lakhs and `30 lakhs respectively. Further
particulars regarding these models are given below:
Particulars Molin Skoda
Economic life (years) 5 6
Scrap value at the end of the economic life (` in lakhs) 2 2.50
After tax annual cash inflows: (` in lakhs) Year
1 5.00 6.00
2 7.50 8.00
3 10.00 10.00
4 9.00 12.00
5 8.50 10.50
6 - 9.50
Evaluate the two proposals under : (a) Pay back period and (b) Net Present Value method. Which
model will you recommend and why?
[Ans. (a) 3 years; 3 ½ years; (b) `6.74 lakhs; `8.523 lakhs; Skoda is recommended]

PROBLEM 9
Precision instruments is considering two mutually exclusive X and Y. Following details are made
available to you : (` in lakhs)
Project X Project Y
Project cost 700 700
Cash inflows : Year 1 100 500
Year 2 200 400
Year 3 300 200
Year 4 450 100
Year 5 600 100
Total 1,650 1,300
Assume no residual values at the end of the fifth year. The firm’s cost of capital is 10%. Required,
in respect each of the two projects:
(i) Net present value, using 10% discounting
(ii) Internal rate of return
(iii) Profitability index.
[Ans. NPV : `461.35 lakhs; `365.50 lakhs; IRR : IRR : 27.21%; 37.63%; PI : 1.659, 1.522]
PROBLEM 10
A company proposes to undertake one of the two mutually exclusive projects namely, AXE and
BXE The initial capital outlay and annual cash inflows are as under :
Particulars AXE BXE
Initial Capital outlay (`) 22,50,000 30,00,000
Salvage value at the end of the life 0 0
Economic life (years) 4 7
After tax annual cash inflows
Year
` lakhs ` lakhs
1 6.00 5.00
2 12.50 7.50
 Capital Budgeting for Decision Making 15.59

3 10.00 7.50
4 7.50 12.50
5 – 12.50
6 – 10.00
7 – 8.00
The company’s cost of capital is 16%. Required :
(i) Calculate for each project. (a) Net present value of cash flows. (b) Internal rate of return
(ii) Recommend, with reasons, which of the two projects should be undertaken by the Company.
[Ans. NPV: `2.51 lakhs; `4.46 lakhs; IRR : 21.23%; 20.73%; Project BXE is preferred]

PROBLEM 11
A Ltd. is considering the question of taking up a new project which requires an investment of `200
lakhs on machinery and other assets. The projects is expected to yield the following gross profits
(before depreciation and tax) over the next five years:
Year Gross profit (` lakhs)
1 80
2 80
3 90
4 90
5 75
The cost of raising the additional capital is 12% and the assets have to be depreciated at 20% on
written down value basis. The scrap value at the end of the five-year period may be taken as
zero. Income-tax applicable to the company is 50%.
Calculate the Net Present Value of the project and advise the management whether the project
has to be implemented. Also calculate the Internal Rate of Return of the project.
[Ans. NPV : `19.31 lakhs; IRR : 15.6%]

PRESENT VALUE TABLE

n/r 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091

2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264

3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513

4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830

5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209
15.60  Accounting and Finance for Engineers

6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645

7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132

8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665

9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241

10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855

11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3506

12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186

13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897

14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633

15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394

16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176

17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978

18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799

19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635

20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486

21 0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.2415 0.1987 0.1637 0.1351
22 0.8034 0.6468 0.5219 0.4220 0.3418 0.2775 0.2257 0.1839 0.1502 0.1228
23 0.7954 0.6342 0.5067 0.4057 0.3256 0.2618 0.2109 0.1703 0.1378 0.1117
24 0.7876 0.6217 0.4919 0.3901 0.3101 0.2470 0.1971 0.1577 0.1264 0.1015
25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923

30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573

40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221

50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085

60 0.5504 0.3048 0.1697 0.0951 0.0535 0.0303 0.0173 0.0099 0.0057 0.0033

n/r 12% 14% 15% 16% 18% 20% 24% 28% 32% 36%

1 0.8929 0.8772 0.8696 0.8621 0.8475 0.8333 0.8065 0.7813 0.7576 0.7353

2 0.7972 0.7695 0.7561 0.7432 0.7182 0.6944 0.6504 0.6104 0.5739 0.5407
 Capital Budgeting for Decision Making 15.61

3 0.7118 0.6750 0.6575 0.6407 0.6086 0.5787 0.5245 0.4768 0.4348 0.3975

4 0.6355 0.5921 0.5718 0.5523 0.5158 0.4823 0.4230 0.3725 0.3294 0.2923

5 0.5674 0.5194 0.4972 0.4761 0.4371 0.4019 0.3411 0.2910 0.2495 0.2149

6 0.5066 0.4556 0.4323 0.4104 0.3704 0.3349 0.2751 0.2274 0.1890 0.1580

7 0.4523 0.3996 0.3759 0.3538 0.3139 0.2791 0.2218 0.1776 0.1432 0.1162

8 0.4039 0.3506 0.3269 0.3050 0.2660 0.2326 0.1789 0.1388 0.1085 0.0854

9 0.3606 0.3075 0.2843 0.2630 0.2255 0.1938 0.1443 0.1084 0.0822 0.0628

10 0.3220 0.2697 0.2472 0.2267 0.1911 0.1615 0.1164 0.0847 0.0623 0.0462

11 0.2875 0.2366 0.2149 0.1954 0.1619 0.1346 0.0938 0.0662 0.0472 0.0340

12 0.2567 0.2076 0.1869 0.1685 0.1372 0.1122 0.0757 0.0517 0.0357 0.0250

13 0.2292 0.1821 0.1625 0.1452 0.1163 0.0935 0.0610 0.0404 0.0271 0.0184

14 0.2046 0.1597 0.1413 0.1252 0.0985 0.0779 0.0492 0.0316 0.0205 0.0135

15 0.1827 0.1401 0.1229 0.1079 0.0835 0.0649 0.0397 0.0247 0.0155 0.0099

16 0.1631 0.1229 0.1069 0.0930 0.0708 0.0541 0.0320 0.0193 0.0118 0.0073

17 0.1456 0.1078 0.0929 0.0802 0.0600 0.0451 0.0258 0.0150 0.0089 0.0054

18 0.1300 0.0946 0.0808 0.0691 0.0508 0.0376 0.0208 0.0118 0.0068 0.0039

19 0.1161 0.0829 0.0703 0.0596 0.0431 0.0313 0.0168 0.0092 0.0051 0.0029

20 0.1037 0.0728 0.0611 0.0514 0.0365 0.0261 0.0135 0.0072 0.0039 0.0021

21 0.0926 0.0638 0.0531 0.0443 0.0309 0.0217 0.0109 0.0056 0.0029 0.0016

22 0,0826 0.0560 0.0462 0.0382 0.0262 0.0181 0.0088 0.0044 0.0022 0.0012

23 0.0738 0.0491 0.0402 0.0329 0.0222 0.0151 0.0071 0.0034 0.0017 0.0008

24 0.0659 0.0431 0.0349 0.0284 0.0188 0.0126 0.0057 0.0027 0.0013 0.0006

25 0.0588 0.0378 0.0304 0.0245 0.0160 0.0105 0.0046 0.0021 0.0010 0.0005

30 0.0334 0.0196 0.0151 0.0116 0.0070 0.0042 0.0016 0.0006 0.0002

40 0.0107 0.0053 0.0037 0.0026 0.0013 0.0007 0.0002

50 0.0035 0.0014 0.0009 0.0006 0.0003 0.0001

15.62  Accounting and Finance for Engineers

60 0.0011 0.0004 0.0002 0.0001