For purposes of investment appraisal, the cashflow is the incremental

cash receipts less the incremental cash expenditures solely attributable to

the investment in question. The future costs and revenues associated
with each investment alternative are –

a. Capital costs,
b. Operating costs,
c. Revenue,
d. Depreciation, and
e. Residual value
 The life of the project may be determined by taking into
consideration the following factors like

a. Technological obsolescence,
b. Physical deterioration
c. A decline in demand for the output of the project etc.
Investment Appraisal Techniques,

Payback Period Method

The payback period is usually expressed in years, which it
takes the cash inflows from a capital investment project to
equal the cash outflows. The method recognizes the recovery
of original capital invested in a project. At payback period the
cash inflows from a project will be equal to the project's cash
outflows. This method specifies the recovery time, by
accumulation of the cash inflows (inclusive of depreciation)
year by year until the cash inflows equal to the amount of the
original investment. The length of time this process takes
gives the 'payback period' for the project. In simple terms it
can be defined as the number of years required to recover the
cost of the investment
Illustration 12.1

The project involves a total initial expenditure of Rs. 2, 00,000

and it is estimated to generate future cash inflow of Rs. 30,000, Rs.
38,000, Rs. 25,000, Rs. 22,000, Rs. 36,000, Rs. 40,000, Rs. 40,000,
Rs.28,000 Rs. 24,000 and Rs. 24,000 in its last year.
Solution
Calculation of Payback Period
Years Cash inflows Cumulative cash inflows
1 30,000 30,000
2 38,000 68,000
3 25,000 93,000
4 22,000 1,15000
5 36,000 1,51,000
6 40,000 1,91,000
7 40,000 2,31,000
8 28,000 2,59,000
9 24,000 2,83,000
10 24,000 3,07,000
In six years, Rs. 1, 91,000 are recovered.
:.Pay term = 6 years + Rs. 9,000/Rs.40,000 * 12 months = 6 years 3 months
Illustration 12.2

Initial Project X (1,00,000) Project Y (1,00,000)

investment Cash Total cash Cash inflows Total cash
inflows inflows inflows
Year 1 20,000 20,000 25,000 25,000
Year 2 20,000 40,000 25,000 50,000
Year3 30,000 70,000 50,000 1,00,000
Year 4 30,000 1,00,000 20,000 1,20,000
Year5 50,000 1,50,000 10,000 1,30,000

Analysis : In this example, Project Y would be selected as its payback

period of 3 years is shorter" than the 4 years payback period of Project X.
Accounting Rate of Return Method
The accounting rate of return is also known as 'return on investment' or
'return on capital employed' method employing the normal accounting
technique to measure the increase in profit expected to result from an
investment by expressing the net accounting profit arising from the
investment as a percentage of that capital investment. The method does not
take into consideration all the years involved in the life of the project. In
this method, most often the following formula is applied to arrive at the
accounting rate of return.

Accounting Rate of Return = Average Annual Profit After Tax /

Average or Initial Investment * 100

Average Investment = Initial Investment + salvage Value / 2

Illustration12.4
Consider the following investment opportunity:
A machine is available for purchase at a cost of Rs. 80,000.

We expect it to have a life of five years and to have a scrap value of Rs. 10,000 at the end of the five year period. We have
estimated that it will generate additional profits over its life as follows:

These estimates are of profits before depreciation. You are required to calculate the return on capital employed.

Year 1 2 3 4 5
Amount (Rs.) 20,000 40,000 30,000 15,000 5,000
Solution

Total profit before depreciation over the life of the machine = Rs. 1, 10,000
.: Average profit p.a. = Rs. 1,10,000 /5 years = Rs. 22,000
Total depreciation over the life of the machine (Rs. 80,000 - Rs. 10,000)
= Rs. 70,000
.,Average depreciation p.a. = Rs. 70,000/5 years = Rs. 14,000
:.Average annual profit after depreciation = Rs. 22,000 - Rs. 14,000= Rs.
8,000
Original investment required = Rs. 80,000
..Accounting rate of return = (Rs. 8,000/Rs. 80,000) X 100 = 10%
Average investment = (Rs. 80,000 + Rs. 10,000)/2 = Rs.45,000
Accounting rate of return = (Rs. 8,000/Rs. 45,000) X 100 =
17.78%
Net Present Value Method
The objective of the firm is to create wealth by using existing and
future resources to produce goods and services. To create wealth, inflows
must exceed the present value of all anticipated cash outflows. Net present
value is obtained by discounting all cash outflows and inflows attributable
to a capital investment project by a chosen percentage e.g. ,the entity’s
weighted average cost of capital. The method discounts the net cash flows
from the investment by the minimum required rate of return, and deducts
the initial investment to give the yield from the funds invested. If yield is
positive the project is acceptable. If it is negative the project in unable to
pay for itself and is thus unacceptable.
 The exercise involved in calculating the present value is known as
‘discounting and the factors by which we have multiplied the cash flows
are known as the ‘discount factors’. The discount factor is given by the
following expression:

1 / (1 + r) n
Where, r = Rate of interest p.a.
n = number of years over which we are discounting.
Illustration 12.5
A firm can invest Rs. 10,000 in a project with a life of three years.
The projected cash inflows are: Year 1 - Rs. 4,000, Year 2 - Rs. 5,000 and
Year 3 - Rs. 4,000.
The cost of capital is 10%p.a. should the investment be made?

Solution
Firstly the discount factors can be calculated based on Re. 1received
in with 'r' rate of interest in 3 year

1 / (1 + r) n
Year 1 = 1 / 1+ 10 / 100) = 1 / (1.10) = 0.909
Year 2 = 1 / 1+ 10 / 100)2 = 1/ (1.10)2 = 0.826
Year 3 = 1 / 1+ 10 / 100)3 = 1/ (1.10)3 = 0.751
In this chapter, the tables given at the end of the book are used wherever possible. Obviously where a particular year or rate of interest is not given in the tables, it will be necessary to
resort to the basic discounting formula.

Analysis-Since the net present value is positive, investment in the project can be made.

Year Cash flow (Rs.) Discount factor Present value (Rs.)

0 (10,000) 1,000 (10,000)

1 4,000 0.909 3,636
2 5,000 0.826 4,130
3 4,000 0.751 3,004
NPV = 770
Internal Rate of Return Method

Internal rate of return (IRR) is a percentage discount rate used in

capital investment appraisals which brings the cost of a project and its
future cash inflows into equality. It is the rate of return which equates the
present value of anticipated net cash flows with the initial outlay. The IRR
is also defined as the rate at which the net present value is zero. The rate
for computing IRR depends on bank lending rate or opportunity cost of
funds to invest which is often called as personal discounting rate or
accounting rate. The test of profitability of a project is the relationship
between the IRR (%) of the project and the minimum acceptable rate of
return (%).The IRR can be stated in form of a ratio as shown below:

Cash Inflows / Cash Outflows = 1

P.V. of Cash Inflows - P.V. of Cash Outflows = Zero
 The IRR is to be obtained by trial and error method to ascertain the
discount rate at which the present values of total cash inflows will be equal
to the present values of total cash outflows. If the cash inflow is not
uniform, then IRR will have to be calculated by trial and error method. In
order to have an approximate idea about such discounting rate, it will be
better to find out the, actor: The factor reflects the same relationship of
investment and cash inflows as in case of payback calculations

F = I/C
Where, F = Factor to be located
I = Original Investment
C = Average cash inflow per year
Illustration 12.6
A company has to select one of the following two projects:

Using the internal rate of return method, suggest which project is preferable.

Particulars Project A Project B

Cost 11,000 10,000
Cash inflows
Year 1 6,000 1,000
Year 2 2,000 1,000
Year 3 1,000 2,000
Year 4 5,000 10,000
Solution

Factor in case of Project A = 11,000/ 3,500 = 3.14

Factor in case of Project B = 10,000/ 3,500 = 2.86

The factor thus calculated will be located in table given at the end of
the book on the line representing number of years corresponding to
estimated useful life of the asset. This would give the expected rate of
return to be applied for discounting the cash inflows in finding the internal
rate of return.

In case of Project A, the rate comes to 10%while in case of Project B

it comes to 15%.
Project A

The present value at 10% comes to Rs. 11,272. The initial investment is Rs. 11,000. Internal rate of return may be taken approximately at 10%.

Year Cash inflows Discounting factor at Present value

(Rs.) 10% (Rs.)
1 6,000 0.909 5,454

2 2,000 0.826 1,652

3 1,000 0.751 751

4 5,000 0.683 3,415

Total present value 11,272

In case more exactness is required another trial rate which is slightly higher than 10 % ( since at this rate the present value is more than initial investment) may be taken. Taking a rate of 12%, the following results would emerge:

The internal rate of return is thus more than 10%but less than 12%.The exact rate may be calculated as follows:
P.V. required = 11,000
PV. at 10% = 11,272
PV. at 12% = 10,844
Actual IRR = 10 + 272 / 272-(-156)* 2 = 11.27%

Year Cash inflows (Rs.) Discounting factor at 12% Present value (Rs.)
1 6,000 0.893 5,358
2 2,000 0.797 1,594
3 1,000 0.712 712
4 5,000 0.636 3,180
Total present value 10,844
Project B

Since present value at 15%comes only to Rs. 8,662, a lower rate of discount should be taken. Taking a rate of 10% the following will be the result.

Year Cash inflows (Rs.) Discounting factor Present value

at 15% (Rs.)
1 1,000 0.870 870
2 1,000 0.756 756
3 2,000 0.658 1,316
4 10,000 0.572 5,720
Total present value 8,662
 Year Cash inflows Discounting factor at Present value
(Rs.) 10% (Rs.)
1 6,000 0.909 909
2 2,000 0.826 826
3 1,000 0.751 1,502
4 5,000 0.683 6,830
Total present value 10,067

The present value at 10%comes to Rs. 10,067 which is more or less

equal to the initial investment. Hence, the internal rate of return may be
taken as 10%.
 In order to have more exactness to internal rate of return, can be
interpolated as done in case of Project 'A'

P.V. required 10,000

PV. at 10% 10,067
PV. at 15% 8,662
Actual IRR = 10 + 67 / 67 - (-1,338) X 5 = 10.24%

Analysis - Thus, internal rate of return in case of Project A is higher as

compared to Project B. Hence, Project A is preferable.
Profitability Index Method
It is a method of assessing capital expenditure opportunities in the
profitability index. The profitability index (PI) is the present value of an
anticipated future cash inflows divided by the initial outlay. The only
difference between the net present value method and profitability index
method is that when using the NPV technique the initial outlay is deducted
from the present value of anticipated cash inflows, whereas with the
profitability index approach the initial outlay is used as a divisor. In
general terms, a project is acceptable if its profitability index value is
greater than l. Clearly, a project offering a profitability index greater than 1
must also offer a net present value which is positive. When more than one
project proposals are evaluated, for selection of one among them, the
project with higher profitability index will be selected.

Mathematically, PI (profitability index) can be expressed as follows:

Profitability Index (PI) = Present Value of Cash Inflows / Present Value of
Cash Outlay
This method is also called 'cost-benefit ratio' or 'desirability ratio' method.
lIIustration12.8
The following mutually exclusively projects can be considered: (Rs.)

Analysis - According to the NPV method, Project A would be preferred, whereas according to profitability index Project B would be preferred. Although PI method is based on NPV, it is a better evaluation technique than NPV in a situation of
capital rationing. For example two projects may have the same NPV of Rs. 10,000 but Project A requires initial outlay of Rs. 1,00,000 whereas B only Rs.50,000. Project B would be preferred as per the yard stick of PI method.

Particulars Project A Project B

PV of cash inflows (i) 20,000 8,000
Initial cash outlay (ii) 15,000 5,000
Net present value 5,000 3,000
Profitability Index (i)/ (ii) 1.33 1.60
Capital Rationing

Capital rationing is a situation where a constraint or budget ceiling is

placed on the total size of capital expenditures during a particular period.
Often firms draw up their capital budget under the assumption that the
availability of financial resources is limited. Capital rationing refers to the
selection of the investment proposals in a situation of constraint on
availability of capital funds, to maximize the wealth of the company by
selecting those projects which will maximize overall NPV of the concern.
In capital rationing situation a company may have to forego some of the
projects whose IRR is above the overall cost of the firm due to ceiling on
budget allocation for the projects which are eligible for capital investment.
Situations of Capital Rationing
Capital rationing decisions can be studied under the following
situations:
Situation I- Projects are Divisible and Constraint is a Single Period One
The following are the steps to be adopted for solving the problem
under this situation:

a. Calculate the profitability index of each project.

b. Rank the projects on the basis of the profitability index calculated
in (a) above.
c. Choose the optimal combination of the projects.
Illustration 12.11

Total fund available is Rs. 3, 00,000. Determine the optimal combination of projects assuming that the projects are divisible.

Project Required initial investment NPV at the appropriate cost

of capital
A 1,00,000 20,000
B 3,00,000 35,000
C 50,000 16,000
D 2,00,000 25,000
E 1,00,000 30,000
 Solution

Project Required initial NPV at the appropriate Profitability Rank

outlay (Rs.) cost of capital (Rs.) index [(3) /
(2)]

(1) (2) (3) (4) (5)

A 1,00,000 20,000 0.2 3
B 3,00,000 35,000 0.117 5
C 50,000 16,000 0.32 1
D 2,00,000 25,000 0.125 4
E 1,00,000 30,000 0.3 2
Rank of Investment Project Required initial (Rs.)
1 C 50,000
2 E 1,00,000
3 A 1,00,000
4 1 / 4th of D 50,000*
Total 3,00,000
Illustration 12.12
Using the same data as used in the previous illustration, determine the optimal
project mix on the basis of the assumption that the projects are indivisible.

Solution
Feasible Combinations Aggregate of NPVs (Rs.)
A,C 36,000
A,D 45,000
A,E 50,000
C,D 41,000
C,E 46,000
D,E 55,000
A,C,E 66,000
By a careful inspection of the feasible combinations constructed in
the above table, we can conclude that the optimal project mix is A, C and E
because the aggregate of their NPVs is maximum.