Capital Budgeting | CMA Inter Syllabus
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Success of finance mainly depends on proper decision making in respect of investment of funds. In general decision-making means selecting the best alternatives among all available alternatives based on analysing the positive sides and negative sides of each alternative. In financial management, capital budgeting is decision making technique. Capital budgeting decision may be defined as firm’s decisions to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of year. On behalf of financial management, an effective decision should be taken on how and where the available fund be invested.
Successful operation of any business depends upon the investment of resources in such a way as to bring in benefits or best possible returns from any investment. An investment can be simply defined as an expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net inflow of cash or its equivalent in some future time period or periods. An appraisal of investment proposals is necessary to ensure that the investment of resources will bring in desired benefits in future. If the financial resources were in abundance, it would be possible to accept several investment proposals which satisfy the norms of approval or acceptability. Since resources are limited, a choice has to be made among the various investment proposals by evaluating their comparative merit. It is apparent that some techniques should be followed for making appraisal of investment proposals. Capital Budgeting is one of the appraising techniques of investment decisions. Capital budgeting is defined as the firm’s decision to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of years. It should be remembered that the investment proposal is common both for fixed assets and current assets. Mainly, the firm’s capital budgeting decisions will include addition, disposition, modification and replacement of fixed assets.
Some important definitions of capital budgeting are:
Charles. T. Horngren defined capital budgeting as ‘long-term planning for making and financing proposed capital out lay.’
According to Keller and Ferrara, ‘capital Budgeting represents the plans for the appropriation and expenditure for fixed asset during the budget period.’
Robert N. Anthony defined as ‘capital budget is essentially a list of what management believes to be worthwhile projects for the acquisition of new capital assets together with the estimated cost of each product.'
1.1 Nature of Capital Budgeting Decisions
The term capital budgeting is used interchangeably with capital expenditure decision, capital expenditure management, long-term investment decision, management of fixed assets and so on. Mainly, capital budgeting decisions related to fixed assets or long-term assets which by definition refer to assets which are in operation, and yield a return, over a period of time, usually, exceeding one year. They, therefore, involve a current outlay or series of outlays of cash resources in returnfor an anticipated flow of future benefits. In other words, the system of capital budgeting is employedto evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year. These benefits may be eitherin the form of increased revenues or reduced costs. Capital expenditure management,therefore, includes addition, disposition, modification and replacement of fixedassets. From the preceding discussion may be deduced the following basic features of capital budgeting: (i) potentially large anticipated benefits; (ii) a relatively highdegree of risk; and (iii) a relatively long time period between the initial outlay andthe anticipated returns.
1.2 Importance or Need of Capital Budgeting Decisions
An organisation has huge of fund to invest. As a finance manager, what you will do? You have to select the fund where you will invest your fund. Here, the capital budgeting decisions plays an important role. Capital budgeting is important because it creates accountability and measurability. Any organisation that seeks to invest its resources in a project without understanding the risks and returns involved would be held as irresponsible by its owners or shareholders. If this decision proves wrong, it may result huge loss forthe organisation. The selection of the most profitable project of capital investment is the key function of financial manager or finance team of any organisation. The decisions taken by the management in this area affect the operations of the firm for many years. Capital budgeting decisions may be generally needed for the following purpose:
| Expansion | Replacement | Diversification | Buy or Lease | Research & Development |
1.3 Significance of Capital Budgeting Decisions
The key function of the financial management is the selection of the most profitable portfolio of capital investment. It is the most important area of decision-making of the financial manager because any action taken by the manger in this area affects the working and the profitability of the firm for many years to come. Capital budgeting decisions are considered important for many reasons. Some of them are discussed below:
1.4 Process of Capital Budgeting
Capital budgeting process refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Basically, the firm may be confronted with three types of capital budgeting decisions: (i) the accept-reject decision; (ii) the mutually exclusive choice decision; and (iii) the capital rationing decision.
The major steps in the capital budgeting process are given below. These are (a) Generation of project; (b) Evaluation of the project; (c) Selection of the project and (d) Execution of the project. The capital budgeting process may include a few more steps. As each step is significant, they are usually taken by the top management. The Steps are discussed below:
a. Generation of Project: Depending upon the nature of the firm, investment proposals can emanate from a variety of Projects may be classified into five categories.
Investment proposals should be generated for the productive employment of firm’s funds. However, a sys- tematic procedure must be evolved for generating profitable proposals to keep the firm healthy.
b. Evaluation of the Project: The evaluation of the project may be done in two steps. First the costs and benefits of the project are estimated in terms of cash flows and secondly the desirability of the project is judged by an appropriate It is important that the project must be evaluated without any prejudice on the part of the individual. While selecting a criterion to judge the desirability of the project, due consideration must be given to the market value of the firm.
c. Selection of the Project: After evaluation of the project, the project with highest return should be selected. There is no hard and fast rule set for the purpose of selecting a project from many alternative projects. Normally the projects are screened at various levels. However, the final selection of the project vests with the top-level management.
d. Execution of Project: After selection of a project, the next step in capital budgeting process is to implement the Thus, the funds are appropriated for capital expenditures. The funds are spent in accordance with appropriations made in the capital budget funds for the purpose of project execution should be spent only after seeking format permission for the controller. The follow–up comparison of actual performance with original estimates ensures better control.
Thus, the top management should follow the above procedure before taking anycapital expenditure decision.
1.5 Capital Budgeting Decisions (Situation Decisions)
On the basis of situation decision, firm may be confronted with three types of capital budgeting decisions: (a) Accept-reject Decision; (b) Mutually Exclusive Project Decisions and (iii) Capital Rationing Decision. These are discussed below:
a. Accept-reject Decision
Business firm is confronted with alternative investment proposals. That means you have to take decision whether the project is accepted or rejected. So, accept-reject decision is a fundamental decision in capital budgeting. If the project is accepted, the firm would invest in it, if the proposal is rejected, the firm does not invest in it. In general, all those proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected. By applying this criterion, all independent projects are accepted. Under this decision criterion, all independent projects that satisfy the minimum investment criterion should be implemented.
b. Mutually Exclusive Project Decision
‘Mutually exclusive projects’ is used generally in the capital budgeting process where the firms choose a single project on the basis of certain parameters out of the set of the projects where acceptance of one project will lead to rejection of the other projects. In case of mutually exclusive projects, the project with highest net present value or the highest IRR or the lowest payback period is preferred and a decision to invest in that select project excluded all other projects from consideration even if they individually have positive NPV or higher IRR than hurdle rate or shorter payback period than the reference period.
c. Capital Rationing Decision
Capital rationing refers to the choice of investment proposals under financial constraints in terms of a given size of capital expenditure budget. The objective of capital rationing is to select the combination of projects would be the maximisation of the total NPV. It is concerned with the selection of a group of investment proposals out of many investment proposals acceptable under the accept-reject decision. Capital rationing employs ranking of the acceptable investment projects. The projects can be ranked on the basis of a predetermined criterion such as the rate of return. The projects are ranked in the descending order of the rate of return.
Capital budgeting is concerned with investment decisions which yield return over a period of time in future. As we know, capital budgeting decision mainly focuses on cash flows rather than profits. Capital budgeting involves identifying the cash in flows and cash out flows rather than accounting revenues and expenses flowing from the investment. So, capital budgeting involves in determination of cash flows.
Cash flows are the most important factor in a capital investment decision. Investment decision has to take place at present, not in future and therefore capital expenditure is a cash-flow concept, rather than a profit-based concept. That’s why computation of cash flow decides the success or failure of any investment decision.
To corroborate the same, we can mention about non-cash expenses like depreciation which are not included in capital budgeting (except to the extent they impact tax calculations for ‘after tax’ cash flows) because they are not cash transactions. Instead, the cash flow expenditures associated with the actual purchase and/or financing of a capital asset are included in the analysis.
Capital budgeting methods consider adjustments for the time value of money. Capital investments create cash flows that are often spread over several years into the future. This is the main reason of forecasting of cash flows. So, identification of forecasted cash flows is very important in capital budgeting decisions.
However, cash flow forecasting is the process of estimating the flow of cash in and out of a business over a specific period of time. An accurate cash flow forecast helps companies predict future cash positions.
Forecasting of cash flow is the responsibility of a business’s finance team. The best way to forecast cash flow for your business depends on business’s objectives, investor’s requirements, and the availability of information within the organization.
Financial analysis of long-term investment decisions basically involves estimating cost of the asset / project and benefits receivable thereon over the economic life of the asset or project for which investments are made. Estimating cost is relatively easier as it is made in the current period, but estimating benefits is very difficult as it relates to future period involving risk and uncertainty.
For estimating benefits, two alternatives are available: (i) Cash Inflow and (ii) Accounting Profit. The cash flow approach is considered as superior to accounting profit approach and cash flows are theoretically better measures of net economic benefits associated with the long-term investments. Moreover, as cost of investment is represented by cash outflows, benefit out of such investment is better represented through cash inflows. The difference between the two measures – cash flow and accounting profit – arises because of inclusion of some non-cash items, e.g., depreciation, in determining accounting profit. Moreover, accounting profit differs depending on accounting policies, procedures, methods (e.g., method of depreciation, method of inventory valuation) used.
Moreover, the cash flow approach takes cognizance of the time value of money. Usually, accrual concept is followed in determining accounting profit, e.g., revenue is recognized when the product is sold, not at the time when the cash is collected from such sale; similarly, revenue expenditure is recognized when it is incurred, not at the time actual payment is made. Thus, the cash flows as a measure of cost and benefit of an investment proposal is better to use for evaluating the financial viability of a proposal and for this purpose, the incremental cash flows are considered. For new investment decisions, all the cash flows are incremental but in case of investment decisions relating to replacement of old assets by the new ones, the incremental costs (cash outflows) and incremental benefits (cash inflows) are to be estimated.
The cash flows associated with a proposal may be classified into: (i) Initial Cash Flow, (ii) Subsequent Cash Flow and (iii) Terminal Cash Flow. These are discussed below:
i. Initial Cash Flow:
Any long-term investment decision will involve large amount of initial cash outlay. It reflects the cash spent for acquiring the asset, known as initial cash outflow. For estimating the initial cash outflow, the following aspects are taken into consideration.
| Initial Cash Outflow: |
| Cost of the new asset including installation, transportation and other incidental costs related to the asset |
| (±) Change in working capital requirement (Addition for increase, Subtraction for decrease) |
| (–) Salvage value of the old asset (in case of replacement of old asset) |
| (–) Tax savings for loss on sale of asset (if the block ceases to exist due to sale of old asset), or |
| (+) Tax payable for profit on sale of asset (if the block ceases to exist due to sale of old asset) |
ii. Subsequent Cash Flow
In conventional cash flow, cash outflow occurs at the initial period and a series of cash inflows occur in the subsequent periods. On the other hand, non-conventional cash flow involves intermittent cash outflows in the subsequent periods also for major repairing, additional working capital requirement, etc. Therefore, apart from estimating initial cash flow, subsequent cash flows are also required to be estimated. For estimating future cash inflows, i.e., cash inflows of the subsequent periods, the following aspects need to be considered.
Cash inflows are to be estimated on an after-tax basis.
Depreciation being a non-cash item is to be added back to the amount of profit after taxes.
Interest being financial charge will be excluded for estimating cash inflow for investment decisions (Interest Exclusion Principal). However, interest (on debt capital) is taken into consideration for determining weighted average cost of capital which is used for discounting the cash inflows to arrive at its present value.
Calculation of Net Cash Inflow after Taxes (CFAT)
| Particulars | Amount (₹) | Amount (₹) |
| Net Sales Revenue | xxx | |
| Lee: Cost of Goods sold | xxx | |
| Less: General Expenses (other than Interest) | xxx | |
| Less: Description | xxx | xxx |
| Profit before Interest and Teaxes (PBIT) or (EBIT) | xxx | |
| Less: Taxes | xxx | |
| Profit after Taxes (excluding Interest) [PAT] | xxx | |
| Add: Depreciation | xxx | |
|
Net Cash Inflow after Taxes [CFAT = EBIT (1 – t) + Depreciation [where, t is income tax rate] If PAT is taken from accounting records, which is arrived at after charging Interest, ‘Interest Net of Taxes’ is to be added back along with the amount of Depreciation, i.e., PAT after charging Interest |
xxx | |
| Add: Depreciation | xxx | |
| Add: Interest Net of Taxes (i.e., Total Interest – Tax on Interest) | xxx | |
| Net Cash Inflow after Taxes | xxx |
Illustration 1
From the following information calculate Net Cash Inflow after Taxes.
| Particulars | Amount (₹) | Amount (₹) |
| Net Sales Revenue | 10,00,000 | |
| Less: | ||
| Cost of Goods Sold | 5,00,000 | |
| Operating Expenses | 2,00,000 | |
| Depreciation | 1,00,000 | 8,00,000 |
| PBIT or EBIT | 2,00,000 | |
| Less: Interest | 50,000 | |
| PBT or EBT | 1,50,000 | |
| Less: Tax (30%) | 45,000 | |
| PAT | 1,05,000 |
Solution:
Relevant Cost Analysis for Projects
Relevant costs or revenues are those expected future costs or revenues that differ among alternative courses of action. It is a future cost/revenue that would arise as a direct consequence of the decision under review and it differs among the alternative courses of action. Any decision making relates to the future as nothing can be done to alter the past and the function of decision making is to select courses of action for the future.
Relevant cost analysis or relevant costing is used for various managerial decisions like:
In the context of investment decisions, incremental cash flows are considered as relevant. The sunk costs, which have already been incurred, or committed costs which are committed to be incurred in future, are considered as irrelevant, as it will have no impact on whatever decisions are taken. However, the opportunity costs, imputed costs, out of pocket costs, avoidable costs and differential costs are relevant.
Illustration 2
A company is considering replacement of one of its old machines, purchased three years ago at a cost of ₹ 5,00,000 with a life of 5 years. It follows straight line method of depreciation. Annual revenue from the sale of the product manufactured using the machine is ₹ 5,50,000 and the annual operating cost is ₹ 4,00,000. The current salvage value of the machine is ₹ 1,00,000. The cost of the new machine is ₹ 3,00,000 and its salvage value at the end of its life 2 years is nil. The annual operating cost of the new machine is estimated at ₹ 2,30,000 and the revenue is expected to be same as to that of the old machine.
Identify relevant costs and revenues if any form the above information.
Solution:
The foremost requirement for evaluation of any capital investment proposal is to estimate the future benefits accruing from the investment proposal. Theoretically, two alternative criteria are available to quantify the benefits: (i) accounting profit, and (ii) cash flows. Cash flow and profit are both important financial measures in any business organisation, but cash flow and profit are not the same things. It is critical to understand the difference between them to make key decisions regarding a business’s performance and financial health.
Cash flow refers to the net balance of cash moving into and out of a business at a specific point in time. Cash flow can be positive or negative. Positive cash flow indicates that a company has more money moving into it than out of it. Negative cash flow indicates that a company has more money moving out of it than into it. On the other hand, profit is typically defined as the balance that remains when all of a business’s operating expenses are subtracted from its revenues. Accounting profit is to be adjusted for non-cash expenditures to determine the actual cash inflow. The cash flow approach of measuring future benefits of a project is superior to the accounting approach as cash flows are theoretically better measures of the net economic benefits of costs associated with a proposed project.
However, changes in profits do not necessarily mean changes in cash flows. It is not difficult to find examples of firms in practice that experience cash shortages in spite of increasing profits. Cash flow and profit are not same in many reasons. The important reasons are:
We can explain differences between profit and cash flow.
Assume that a firm is entirely equity-financed, and it receives its revenues (REV) in cash and pays its expenses (EXP) and capital expenditures (CAPEX) also in cash. Further, assume that taxes do not exist. Under these circumstances, profit can be expressed in the following equation:
Profit = Revenues − Expenses – Depreciation
Profit = REV − EXP − DEP........................................................................................................................................... (1)
Cash flow can be shown in the following equation:
Cash flow = Revenues – Expenses – Capital Expenditure
Cash flow (CF) = REV – EXP – CAPEX.................................................................................................................... (2)
It may be noticed from Equations (1) and (2) that profit does not deduct capital expenditures as investment outlays are made. Instead, depreciation is charged on the capitalized value of investments. Cash flow, on the other hand, ignores depreciation since it is a non-cash item and includes cash paid for capital expenditures. In the accountant’s book, the net book value of capital expenditures will be equal to their capitalized value minus depreciation.
We can obtain the following definition of cash flows if we adjust Equation (2) for relationships given in Equation (1):
CF = (REV − EXP − DEP) + DEP − CAPEX
CF = Profit + DEP − CAPEX....................................................................................................................................... ( 3)
From Equation (3), it makes clear that even if revenues and expenses are expressed in terms of cash flow, still profit will not be equal to cash flows. It overstates cash inflows by excluding capital expenditures and understates them by including depreciation. Thus, profits do not focus on cash flows.
The objective of a firm is not to maximize profits or earnings per share, rather it is to maximize the shareholders’ wealth, which depends on the present value of cash flows available to them. In the absence of taxes and debt, Equation (3) provides the definition of profits available for distribution as cash dividends to shareholders. Profits fail to provide meaningful guidance for making financial decisions. Profits can be changed by affecting changes in the firm’s accounting policy without any effect on cash flows. For example, a change in the method of inventory valuation will change the accounting profit without a corresponding change in cash flows.
Here, we have assumed for simplicity an entirely equity-financed firm with no taxes. In the absence of taxes, depreciation is worthless since it has no impact on cash flows. When we compute after-tax cash flows then it requires a careful treatment of non-cash expense items such as depreciation. It is an allocation of cost of an asset and involves an accounting entry and does not require any cash outflow; the cash outflow occurs when the assets are acquired. Depreciation is calculated as per the income tax rules and is a deductible expense for computing taxes. So, it has no direct impact on cash flows, but it indirectly influences cash flow since it reduces the firm’s tax liability. Cash outflow for taxes saved is in fact an inflow of cash. The saving resulting from depreciation is called depreciation tax shield.
The capital budgeting appraisal methods or techniques for evaluation of investment proposals will help the company to decide the desirability of an investment proposal, depending upon their relative income generating capacity and rank them in order if their desirability. These methods provide the company a set of normal method should enable to measure the real worth of the investment proposal. Appraisal of investment proposals are based on objective, quantified and economic costs and benefits.
Characteristics of an Appraisal Method
The appraisal methods should possess several good characteristics, which are mentioned as under.
The methods of appraising capital expenditure proposals can be classified into two broad categories:
a. Traditional or Non-Discounted Cash Flow (Non-DCF) Techniques
b. Discounted Cash Flow (DCF) or Time-Adjusted Techniques
4.1 Non-discounted or Traditional Techniques
These methods are based on the principles to determine the desirability of an investment project on the basis of its useful life and expected returns. These methods depend upon the accounting information available from the books of accounts. These will not take into account the concept of ‘time value of money’ which is a signification factors to desirability of a project in terms of present value.
1. Payback Period (PBP) Method
The PBP method is the simplest way to budget for a new project. It measures the amount of time it will take to earn enough cash inflows from your project to recover what you invested.It is the most popular and widely recognized traditional methods of evaluating the investment proposals. It can be defined as the number of years to recover the original capital invested in a project. According to Weston and Brigham, the PBPis the number of years it takes for the firm to recover its original investment by net returns before depreciation, but after taxes:
a. When cash flows are uniform:
If the proposed project’s cash inflows are uniform the following formula can be used to calculate the payback period.
Payback period = Annual Cash Inflows / Initial Investment
b. When cash flows are not uniform
When the project’s cash inflows are not uniform, but vary from year to year payback period is calculated by the process of cumulating cash inflows till the time when cumulative cash flows become equal to the original investment outlay.
Advantages: The following are the advantages of the payback period method:
Disadvantages: However, the payback period method has certain disadvantages and limitations:
Accept-Reject Decision:
The payback period can be used as an accept or reject criterion as well as a method of ranking projects. The payback period is the number of years to recover the investment made in a project. If the payback period calculated for a project is less than the maximum payback period set-up by the company, it can be accepted. As a ranking method it gives the highest rank to a project which has the lowest payback period, and the lowest rank to a project with the highest payback period. Whenever a company faces the problem of choosing among two or more mutually exclusive projects, it can select a project on the basis of payback period, which has shorter period than the other projects.
With equal and unequal cash inflows
Illustration 3
Pioneer Ltd. is considering two mutually-exclusive projects. Both require an initial cash outlay of ₹ 10,000 each for machinery and have a life of 5 years. The company’s required rate of return is 10% and it pays tax at 50%. The projects will be depreciated on a straight-line basis. The net cash flows (before taxes) expected to be generated by the projects and the present value (PV) factor (at 10%) are as follows: (₹ in ‘000)
| 2017 (Year 1) | 2017 (Year 2) | 2017 (Year 3) | 2017 (Year 4) | 2017 (Year 5) | |
| Project 1 (₹) | 4,000 | 4,000 | 4,000 | 4,000 | 4,000 |
| Project 2 (₹) | 6,000 | 3,000 | 3,000 | 3,000 | 3,000 |
| PV factor (at 10%) | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
You are required to calculate the Payback Period of each project.
Solution:
2. Payback Reciprocal
It is the reciprocal of Payback Period, i.e., 1÷ Payback Period. Therefore,
Payback Reciprocal = Average Annual Net Cash Flow after Taxes / Inital Investment
Higher the payback reciprocal, better is the project.
The Payback Reciprocal is considered to be an approximation of the Internal Rate of Return, if-
Illustration 4
A project with an initial investment of ₹ 50 Lakh and life of 10 years, generates CFAT of ₹ 10 Lakh per annum. Calculate Payback Reciprocal of the project.
Solution:
3. Payback Profitability
As the profitability beyond the Payback Period is not taken into consideration in Payback Period method, the projects with higher Payback period are rejected though such projects with longer life may generate higher benefits after recovering its initial investment. In Payback Profitability method, the profitability beyond the payback period is considered and projects generating higher benefits after the recovery of initial investment are considered for selection.
Payback Profitability = Net Cash Inflow after Taxes after recovering the Initial Investment, i.e., Total Net Cash Inflow after Taxes – Initial Investment
4. Accounting or Average Rate of Return (ARR) Method
This technique uses the accounting information revealed by the financial statements to measure the profitability of an investment proposal. It can be determined by dividing the average income after taxes by the average investment. According to Solomon, Accounting Rate of Return can be calculated as the ratio of average net income to the initial investment.
On the basis of this method, the company can select all those projects whose ARR is higher than the minimum rate established by the company. It can reject the projects with an ARR lower than the expected rate of return.
Thi method also helps the management to rank the proposal on the basis of ARR.
|
Accounting Rate of Return (ARR) = Average Net Income / Original Investment OR, Accounting Rate of Return (ARR) = Average Net Income / Average Investment |
Advantages: The following are the advantages of ARR method:
Disadvantages: This method has the following limitations:
Accept-Reject Decision
With the help of the ARR, the financial decision maker can decide whether to accept or reject the investment proposal. As an accept-reject criterion, the actual ARR would be compared with a pre-determined or a minimum required rate of return or cut-off rate. A project would qualify to be accepted if the actual ARR is higher than the minimum desired ARR. Otherwise, it is liable to be rejected. Alternatively, the ranking method can be used to select or reject proposals. Thus, the alternative proposals under consideration may be arranged in the descending order of magnitude, starting with the proposal with the highest ARR and ending with the proposal having the lowest ARR. Obviously, projects having higher ARR would be preferred to projects with lower ARR.
Illustration 5
Determine the average rate of return from the following data of two machines, A and B. (₹ in “000)
| Particulars | Machine - A (₹) | Machine - B (₹) |
| Cost | 56,125 | 56,125 |
| Annual estimated income after depreciation and income tax: | ||
| Year 1 | 3,375 | 11,375 |
| Year 2 | 5,375 | 9,375 |
| Year 3 | 7,375 | 7,375 |
| Year 4 | 9,375 | 5,375 |
| Year 5 | 11,375 | 3,375 |
| Total | 36,875 | 36,875 |
| Estimated life (years) | 5 | 5 |
| Estimated salvage value | 3,000 | 3,000 |
Depreciation has been charged on straight line basis.
Solution:
4.2 Disounted Cash Flow Technique
The discounted cash flow methods provide a more objective basis for evaluating and selecting an investment project. These methods consider the magnitude and timing of cash flows in each period of a project’s life. Discounted cash flow methods enable us to isolate the differences in the timing of cash flows of the project by discounting them to know the present value. The present value can be analyses to determine the desirability of the project. These techniques adjust the cash flows over the life of a project for the time value of money.
The distinguishing characteristics of the discounted cash flow capital budgeting techniques is that they take into consideration the time value of money while evaluating the costs and benefits of a project. In one form or another, all these methods require cash flows to be discounted at a certain rate, that is, the cost of capital. The cost of capital (k) is the minimum discount rate earned on a project that leaves the market value unchanged. The second commendable feature of these techniques is that they take into account all benefits and costs occurring during the entire life of the project.
However, the popular discounted cash flows techniques are:
Present Value:
It is very important to have idea about present value for applying discounted cash flows techniques. The concept of present value has already been discussed in Time Value of Money chapter in detail. Present value states that an amount of money today is worth more than the same amount in the future. In other words, present value shows that money received in the future is not worth as much as an equal amount received today. The present value or the discounted cash flow procedure recognizes that cashflow streams at different time periods differ in value and can be compared only when they are expressed in terms of a common denominator, that is, present values. It, thus, takes into account the time value of money.
The value of a firm depends upon the net cash inflows generated by the firm assets and also on future returns. The amount of cash inflows and risk associated with the uncertainty of future returns forms the basis of valuation. To get the present value, cash inflows are to be discounted at the required rate of return i.e., minimum rate expected by the investor to account for their timing and risk. The cash inflows and outflows of an investment decision are to be compared at zero time period or at the same value by discounting them at required rate of return. The following formula can be used to discount the future inflows of a project to compare with its cash outflows.
| The present value (PV) formula is PV=FV/(1+i)n, where you divide the future value (FV) by a factor of 1 + i for each period between present and future dates. Here, i = PVIF/Rate of Discount and n = No. of Periods. |
1. Net Present Value (NPV) Method
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project. In other words, it is a method of calculating the present value of cash flows (inflows and outflows) of an investment proposal using the cost of capital as an appropriate discounting rate. According to Ezra Solomon, ‘it is a present value of the cast of the investment.’
This method correctly postulates that cash flows arising at time periods differ in value and are comparable
only with their equivalents i.e., present values.
Steps of computation of Net Present Value (NPV):
The formula for the net present value can be written as:
Net Present Value (NPV):
NPV = C1 / (1+k)1 + C2 / (1+k)2 + C3 / (1+k)3 + ……….. + Cn / (1+k)n - 1
Where,
C = Annual Cash inflows
Cn = Cash inflow in the year n k = Cost of Capital
I = Initial Investment
Or
Where,
Ct = Net cash inflow – outflows during a single period t.
i = Discount rate or return that could be earned in alternative investments.
t = Number of periods.
I = Initial Investment
Accept-Reject Decision:
If the NPV is positive or at least equal to zero, the project can be accepted. If it is negative, the proposal can be rejected. Among the various alternatives, the project which gives the highest positive NPV should be selected.
NPV is positive = A positive NPV indicates that the projected earnings generated by a project or investment. Cash inflows are generated at a rate higher than the minimum required by the firm.
NPV is zero = Cash inflows are generated at a rate equal to the minimum required.
NPV is negative = An investment with a negative NPV will result in a net loss. Cash inflows are generated at a rate lower than the minimum required by the firm.
The market value per share will increase if the project with positive NPV is selected.
| The accept/reject criterion under the NPV method is as follows: |
| If, NPV>Zero then, Accept |
| If, NPV<Zero then, Reject |
| If, NPV=0 then, May accept or reject |
Advantages: The following are the advantages of the net present value (NPV) methods:
Disadvantages: The following are the disadvantages of the net present value method:
Illustration 6
A project requires an initial investment of ₹ 2,25,000 and is expected to generate the following net cash inflows:
Year 1 (2018): ₹ 95,000; Year 2 (2019): ₹ 80,000; Year 3 (2020): ₹ 60,000; Year 4 (2021): ₹ 55,000. Compute net present value of the project if the minimum desired rate of return is 12%.
Solution:
Illustration 7
Parrot Ltd. is the manufacturer of a low-end consumer durable N. In order to modernize the manufacturing facility, Parrot Ltd. wants to buy a new machinery costing ₹ 10,00,000 at cash price. The annual cash flow before tax over the entire life span of the company is ₹ 3,00,000 p.a. The marginal rate of tax is 30% and cost of capital is 10% p.a. The scrap value at the end of the useful life of the machinery is negligible. The company is currently following a straight-line method of charging depreciation on machineries. Do you think the project is financially viable?
The company has an alternative to charge accelerated depreciation @ 30% of the depreciable amount each for the first three years and @ 10% for the fourth year. Does it change your suggestion?
Solution:
2. Profitability Index (PI) Method
Profitability index method measures the present value of benefits for every rupee investment. In other words, it involves the ratio that is created by comparing the ratio of the present value of future cash flows from a project to the initial investment in the project. This method is also known as ‘Benefit Cost Ratio’. According to Van Horne, the Profitability Index of a project is the ratio of the present value of future net cash inflows to the present value of cash outflows.
Actually, the profitability index is just a fraction. The profitability index is equal to the present value of future cash flows divided by the cost of the investment. Present value of future cash flows simply means the money that you expect to make from the investment. Initial investment refers to the money that the firm have to put down to make that money.
The formula for the net present value can be written as:
Profitability Index = Present value of the expected cash inflow / Present value of cash outflow or Initial Investment
Accept-Reject Decision:
If the Profitability Index (PI) is greater than or equal to one, the project should be accepted otherwise rejected. Specifically, if the PI is greater than 1, the project generates value and the company may want to proceed with the project. If the PI is less than 1, the project destroys value and the company should not proceed with the project. If the PI is equal to 1, the project breaks even and the company is indifferent between proceeding or not proceeding with the project.
So, the higher the profitability index, the more attractive the investment
| The accept/reject criterion under the PI method is as follows: |
| If, PI>1 then, Accept |
| If, PI>1 then, Reject |
| If, PI=0 then, May accept or reject |
Advantages: The advantages of this method are:
Disadvantages: However, this technique suffers from the following disadvantages:
Illustration 8
A project requires an initial investment of ₹ 225,000 and is expected to generate the following net cash inflows:
Year 1 (2018): ₹ 95,000; Year 2 (2019): ₹ 80,000; Year 3 (2020): ₹ 60,000; Year 4 (2021): ₹ 55,000. Compute profitability index of the project if the appropriate discount rate for this project is 12%.
Solution:
3. Internal Rate of Return (IRR) Method
Internal Rate of Return (IRR) is one such technique of capital budgeting. It is the rate of return at which the net present value of a project becomes zero. We call it ‘internal’ because it does not take any external factor (like infla- tion etc.) into consideration. IRR method follows discounted cash flow technique which takes into account the time value of money. The internal rate of return is the interest rate which equates the present value of expected future cash inflows with the initial capital outlay. In other words, it is the rate at which NPV is equal zero.
Whenever a project report is prepared, IRR is to be worked out in order to ascertain the viability of the project.
This is also an important guiding factor to financial institutions and investors.
For the computation of the internal rate of return, we use the same formula as NPV. To derive the IRR, we apply trial and error method to make the difference between the present value of expected future cash inflows with the initial investment zero.
IRR refers to that discount rate (i) such that
Present value of cash inflows = Present value of cash outflows
Or, Present value of cash inflows – present value of cash outflows = 0
Or, NPV = 0
Therefore, at IRR, NPV = 0 and PI = 1.
The formula for computation of IRR using NPV is written as under:
C = A1 / (1+r)1 + A2 / (1+r)2 + A3 / (1+r)3 + ……….. + An / (1+r)n
Where,
C = Initial Capital outlay
A1, A2, A3 etc. = Expected future cash inflows at the end of year 1,2,3 and so on.
r = Internal Rate of Return
n = Number of years of project
IRR = { Present value of the expected cash inflows / (1+i)n } + Initial Investment
Where,
i = Discount rate
n = No. of periods
In the above equation ‘r’ is to be solved in order to find out IRR.
Computation of IRR
The IRR is to be determined by trial-and-error method. The following steps can be used for its computation.
The rate at which the cost of investment and the present value of future cash flows match will be considered as the ideal rate of return. A project that can achieve this is a profitable project. In other words, at this rate the cash outflows and the present value of inflows are equal, making the project attractive.
Remember, the internal rate of return is using the interpolation technique to calculate it and it is very important to understand this concept so that you can get a better understanding of how IRR works. In order to find out the exact IRR between two near rates, the following formula is to be used.
IRR = L + { P1 – C0 / P1 – P2 } x D
Where, L = Lower rate of interest
P1 = Present value at lower rate of interest
P2 = Present value at higher rate of interest
C0 = Cash outlay
D = Difference in rate of interest
Illustration 9
Calculate IRR by using interpolation technique when initial investment is ₹ 56,000.
| 10% | ₹ 60,000 |
| 11% | ₹ 50,000 |
Solution:
Accept-Reject Decision:
If the internal rate of return exceeds the required rate of return, then the project will be accepted. If the project’s IRR is less than the required rate of return, it should be rejected. In case of ranking the proposals the technique of IRR is significantly used. The projects with highest rate of return will be ranked as first compared to the lowest rate of return projects.
| Thus, the IRR acceptance rules are - | |
| Accept if | IRR > k |
| Reject if | IRR < k |
| May accept or reject if | IRR = k |
| Where, ‘k’ is the cost of capital. | |
Advantages: The following are the advantages of the IRR method:
Limitation: The following are the limitations of the IRR:
Both NPV and IRR are sound analytical tools of capital budgeting.Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. By contrast, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.
Similarities:
Contrast, i.e., Points of Difference -
Recommendations -
The NPV method is generally considered to be superior theoretically because:
But IRR method is favoured by some analysts because:
4. Discounted Payback Period (DPBP) Method:
The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. Under this method the discounted cash inflows are calculated and where the discounted cash flows are equal to original investment then the period which is required is called discounting Payback period. While calculating discounting cash inflows the firm’s cost of capital has been used.
The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even. The point after that is when cash flows will be above the initial cost.
Procedure for computation of Discounted Payback Period
Step 1: Determine the Total Cash Outflow of the project. (Initial Investment)
Step 2: Determine the Cash Inflow after Taxes (CFAT) for each year.
Step 3: Determine the present value of net cash inflow after taxes (CFAT)
= CFAT of each year x PV Factor for that year.
Step 4: Determine the cumulative present value of CFAT of every year.
Step 5:
The formula for the DPBP can be written as
| DPBP = Total Investment / Discounted annual cash inflows |
| When the project’s cash inflows are not uniform, that means vary from year to year, payback period is calculated by the process of cumulating cash inflows till the time when cumulative cash flows become equal to the original investment outlay. If necessary, we have to use interpolation technique to find out the fraction of payback period. |
| DPBP = Year before the discounted below pay back period occurs + Cummulative cash flows in year before recovery / Discounted cash flow in year after recovery |
| [When cash flows are not uniform] |
Accept-Reject Decision:
The shorter a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost. A general rule to consider when using the discounted payback period is to accept projects that have a payback period that is shorter than the target timeframe. So, out of two projects, selection should be based on the period of discounting payback period (lesser payback period should be preferred.)
| The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even. While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted. |
Advantages: Following are the advantages of discounted payback period:
Disadvantages: Following are the disadvantages of discounted payback period:
Illustration 10
Assume a business that is considering a given project. Below are some selected data from the discounted cash flow model created by the company’s financial analysts:
A project requires an initial investment of ₹ 1,91,315 and is expected to generate the following net cash inflows:
Year 1 (2018): ₹ 95,000; Year 2 (2019): ₹ 80,000; Year 3 (2020): ₹ 60,000; Year 4 (2021): ₹ 55,000. Compute discounted payback period of the project if the appropriate discount rate for this project is 12%.
Solution:
Payback Period Vs. Discounted Payback Period
The payback period is the amount of time for a project to break even in cash collections in financial value of money. Alternatively, the discounted payback period reflects the amount of time necessary to break even in a project, based not only on what cash flows occur but when they occur and the prevailing rate of return in the market. The discounted payback period follows time value of money whereas payback period does not.
These two calculations, although similar, may not return the same result due to the discounting of cash flows. For example, projects with higher cash flows toward the end of a project’s life will experience greater discounting due to compound interest. For this reason, the payback period may return a positive figure, while the discounted payback period returns a negative figure.
5. Modified Net Present Value (MNPV)
One of the limitations of NPV method is that reinvestment rate in case of NPV is Cost of Capital (k). However, in case of MNPV, different reinvestment rates for the cash inflows over the life of the project may be used. Under this modified approach, terminal value of the cash inflows is calculated using such expected reinvestment rate (s). Thereafter, MNPV is determined with present value of such terminal value of the cash inflows and present value of the cash outflows using cost of capital (k) as the discounting factor.
Terminal value is the sum of the compounded value of cash inflows of different years at the end of the life of the project. If the life of the project is ‘n’ years, cash inflow of period ‘t’ is CFt and reinvestment rate is ‘r’, the terminal value will be ∑(CF )n-t.
6. Modified Internal Rate of Returns (MIRR)
The modified internal rate of return (MIRR) is a financial measure of an investment’s attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.
IRR assumes that interim positives cash flows are reinvested at the rate of returns as that of the project that gen- erated them. This is usually an unrealistic scenario. To overcome this draw back a new technique emerges. Under MIRR the earlier cash flows are reinvested at firm’s rate of return and finding out the terminal value. MIRR is the rate at which present value of terminal values equal to outflow (Investment).
The procedure for calculating MIRR is as follows:
| MIRR = (Future value of positive cash flows / present value of negative cash flows) ( 1 / n) -1. |
Advantages:
Disadvantages:
The disadvantage of MIRR is that it asks for two additional decisions, i.e., determination of financing rate and cost of capital.
Illustration 11
M Ltd. for a construction company and asked you to calculate the MIRR for two mutually exclusive projects to
determine which project should be selected.
Project X has a total life of 3 years with a cost of capital 12% and a financing cost 14%.
Project Y has a total life of 3 years with a cost of capital 15% and a financing cost 18%.
The expected cash flows of the projects are in the table below: (₹)
| Year | Project X | Project Y |
| 0 | -1,000 | -800 |
| 1 | -2,000 | -700 |
| 2 | 4,000 | 3,000 |
| 3 | 5,000 | 1,500 |
Solution:
7. Adjusted Net Present Value
For determining NPV, weighted average cost of capital is used as the discounting factor, based on the assumption that every project is financed by the same proportions of debt and equity as found in the capital structure of the firm. However, that may not be true. Moreover, tax advantages (savings in tax) due to use of borrowed fund is not usually considered in financial appraisal of investment proposals discussed so far. But impact of debt financing can be incorporated using Adjusted Present Value Method with an adjustment of tax aspects of debt financing with the Base Case NPV.
Base Case NPV is the NPV under the assumption that the project is all-equity financed.
Adjusted NPV = Base case NPV + NPV of Tax Shields arising out of financing decisions associated with the project.
Illustration 12
A firm is considering a project requiring ₹ 50 lakh of investment. Expected cash flow is ₹ 10 lakh per annum for 8 years. The rate of return required by the equity investors from the project is 15%. The firm is able to raise ₹ 24 lakh of debt finance carrying 14% interest for the project. The debt is repayable in equal annual installments over the eight-year period – the first to be paid at the end of the first year. The tax rate is 40%. You are required to calculate adjusted NPV. Assume equity cost is 5%.
Solution:
Conglomerates are companies that either partially or fully own a number of other companies. Here, conglomerate means large company. In case of investment in or by the large company environment, hurdle rate is an important criterion. Hurdle rate will guide us to make effective investment decision. A hurdle rate, which is also known as benchmark or cut-off rate or the minimum required rate of return or target rate that investors are expecting to receive on an investment. The rate is determined by assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return for similar investments, and other factors that could directly affect an investment.
In other words, before accepting and implementing a certain investment project, its internal rate of return (IRR) should be equal to or greater than the hurdle rate. Any potential investments must possess a return rate that is higher than the hurdle rate in order for it to be acceptable in the long run.
As we find in practical, most companies use their Weighted Average Cost of Capital (WACC) as a hurdle rate for investments. Generally, it is utilized to analyze a potential investment, taking the risks involved and the opportunity cost of foregoing other projects into consideration. One of the main advantages of a hurdle rate is its objectivity, which prevents management from accepting a project based on non-financial factors. Some projects get more attention due to popularity, while others involve the use of new and exciting technology. Another way of looking at the hurdle rate is that it’s the required rate of return investors demand from a company. Therefore, any project the company invests in must be equal to or ideally greater than its cost of capital.
In conglomerate environment, at present, the most common way to use the hurdle rate to evaluate an investment is using a discounted cash flow (DCF) technique. The DCF technique uses the concept of the time value of money (opportunity cost) to forecast all future cash flows and then discount them back to today’s value to provide the net present value.
NPV Vs. IRR
In case of mutually exclusive projects, financial appraisal using NPV & IRR methods may provide conflicting results. The reasons for such conflicts may be attributed to (i) Difference in timing / pattern of cash inflows of the alternative proposals (Time Disparity), (ii) difference in their amount of investment (Size Disparity) and (iii) difference in the life of the alternative proposals (Life Disparity).
a. Time Disparity:
Main source of conflict is the different re-investment rate assumption. Such conflicts may be resolved using modified version of NPV and IRR using expected / defined reinvestment rate applicable to the firm. For modified NPV and IRR, at first Terminal Value (TV) is calculated using the specified reinvestment rate.
TV = Σ CFt (1+r*)n-t
NPV* = { TV / (1+k)n } – I
IRR* = (TV ÷ I)1/n – 1
Where, r* = Reinvestment rate
NPV* & IRR* are the modified NPV and modified IRR
Illustration 13
The following information is available for two projects of a company.
| Particulars | Project I (₹ ) | Project II (₹ ) |
| Investment | 2,20,000 | 2,20,000 |
| Year 1 | 62,000 | 1,42,000 |
| Year 2 | 80,000 | 80,000 |
| Year 3 | 1,00,000 | 82,000 |
| Year 4 | 1,40,000 | 40,000 |
Cost of Capital is 10% . You are requested to advise to the company.
Solution:
b. Size Disparity:
Conflict may arise due to disparity in the size of initial investment /outlays. Such conflict may be resolved using incremental approach.
Steps:
Illustration 14
A and B are two mutually exclusive investments involving different outlays. The details are:
| Particulars | Project A | Project B |
| Initial Investment (₹) | 50,00,000 | 75,00,000 |
| Net Cash Inflow (₹) | 62,50,000 | 91,50,000 |
| IRR (%) | 25 | 22 |
| NPV (₹) | 6,81,250 | 8,17,350 |
Cost of capital (k) = 10%. Which method will be accepted?
Solution:
c. Life Disparity or Unequal Lives of the Projects:
In some cases, the mutually exclusive alternatives with different/ unequal lives may lead to conflict in ranking. To resolve such conflict, one approach is to compare the alternatives on the basis of their Equivalent Annual Benefit (EAB) or Equivalent Annual Cost (EAC) and select the alternative with the higher EAB or lower EAC.
EAB = NPV × Capital Recovery Factor or NPV ÷ PVIFAk,n
Capital Recovery Factor = The inverse of PVIFA = k (1 + k)n ÷ (1 + k)n – 1
EAC = PV of Cost ÷ PVIFAk,n
Another approach is to evaluate the alternatives over an equal time frame using the lowest common multiple (LCM) of the lives of the alternatives under consideration. This method is referred to as LCM method. For example, life of Proposal A is 3 Years and that of B is 5 years. Lowest common multiple period is 15 years, during which period, it may be assumed that Machine A will be replaced 5 times and Machine B will be replaced 3 times. Cash Flows are extended to this period and computations made. The final results would then be on equal platform i.e., equal years, and hence would be comparable.
Illustration 15
The follwoing information is obtained from the two projects:
| Particulars | P(₹ ) | Q(₹ ) |
| Initial Investment | 10,00,000 | 20,00,000 |
| Cash inflows | ||
| Year 1 | 8,00,000 | 8,00,000 |
| Year 2 | 7,00,000 | 9,00,000 |
| Year 3 | Nil | 7,00,000 |
| Year | Nil | 6,00,000 |
| Service Life | 2 Years | 4 Years |
| Required rate of return 10% |
Which project should be preferred?
Solution:
Capital Rationing
There may be situations where a firm has a number of independent projects that yield a positive NPV or having IRR more than it’s cut off rate, PI more than 1, i.e., the projects are financially viable, hence, acceptable. However, the most important resource in investment decisions, i.e., funds, are not sufficient enough to undertake all the projects. In such a case, the projects are selected in such a way so that NPV becomes maximum in order to maximize wealth of shareholders. Investment planning in such situation is Capital Rationing.
There are two possible situations of Capital Rationing
Different proposals may be classified into two categories: Divisible and Indivisible
In case of divisible projects, part acceptance of the project is possible. Indivisible projects are either to be accepted in its entirety or to be rejected, i.e., part acceptance is not possible. For divisible projects, PI approach help in selecting the proposals providing the highest NPV. For indivisible projects, through trial-and-error methods, best combination of the projects with the highest NPV may be ascertained.
For Divisible Projects
Rank the projects following PI and arrange them in descending order. Go on selecting the projects till the fund is available.
For Indivisible Projects
Determine all the feasible combinations of the projects and rank them according to total NPV of the combinations. Select the combination with the highest NPV.
Illustration 17
A limited company is considering investing a project requiring a capital outlay of ₹ 2,00,000. Forecast for annual income after depreciation but before tax is as follows:
| Year | (₹) |
| 1 | 1,00,000 |
| 2 | 1,00,000 |
| 3 | 80,000 |
| 4 | 80,000 |
| 5 | 40,000 |
Depreciation may be taken as 20% on original cost and taxation at 50% of net income.
You are required to evaluate the project according to each of the following methods:
Solution:
Illustration 18
A company has just installed a machine Model A for the manufacture of a new product at capital cost of ₹ 1,00,000. The annual operating costs are estimated at ₹ 50,000 (excluding depreciation) and these costs are estimated on the basis of an annual volume of 1,00,000 units of production. The fixed costs at this volume of 1,00,000 units of output will amount to ₹ 4,00,000 p.a. The selling price is ₹ 5 per unit of output. The machine has a five-year life with no residual value.
The company has now come across another machine called Super Model which is capable of giving, the same volume of production at an estimated annual operating cost of ₹ 30,000 exclusives of depreciation. The fixed costs will however, remain the same in value. This machine also will have a five-year life with no residual value. The capital cost of this machine is ₹ 1,50,000.
The company has an offer for the sale of the machine Model A (which has just been installed) at ₹ 50,000 and the cost of removal thereof will amount to ₹ 10,000. Ignore tax.
In view of the lower operating cost, the company is desirous of dismantling of the machine Model A and install- ing the Super Model Machine. Assume that Model A has not yet started commercial production and that the time lag in the removal thereof and the installation of the Super Model machine is not material.
The cost of capital is 14% and the P.V. Factors for each of the five years respectively are 0.877, 0.769, 0.675, 0.592 and 0.519.
State whether the company should replace Model A machine by installing the Super Model machine. Will there be any change in your decision if the Model A machine has not been installed and the company is in the process of consideration of selection of either of the two models of the machine? Present suitable statement to illustrate your answer.
Solution:
Illustration 19
A chemical company is considering replacing an existing machine with one costing ₹ 65,000. The existing machine was originally purchased two years ago for ₹ 28,000 and is being depreciated by the straight-line method over its seven-year life period. It can currently be sold for ₹ 30,000 with no removal costs. The new machine would cost ₹ 10,000 to install and would be depreciate over five years. The management believes that the new machine would have a salvage value of ₹ 5,000 at the end of year 5. The management also estimates an increase in net working capital requirement of ₹ 10,000 as a result of expanded operations with the new machine. The firm is taxed at a rate of 55% on normal income and 30% on capital gains. The company’s expected after-tax profits for next 5 years with existing machine and with new machine are given as follows:
| Expected after-tax profits (₹ ) | ||
| Year | With existing machine | With new machine |
| 1 | 2,00,000 | 2,16,000 |
| 2 | 1,50,000 | 1,50,000 |
| 3 | 1,80,000 | 2,00,000 |
| 4 | 2,10,000 | 2,40,000 |
| 5 | 2,20,000 | 2,30,000 |
Solution:
Illustration 20:
A project costing ₹ 5,60,000 is expected to produce annual net cash benefits (CFAT) of ₹ 80,000 over a period of 15 year. Estimate the internal rate of return (IRR). Also, find the payback period and obtain the IRR from it. How do you compare this IRR with the one directly estimated?
Solution:
IRR determination through PB period:
The reciprocal of the Payback period is a good approximation of the IRR if,
Comparison: The two IRRs are different. But the IRR which is directly estimated is correct as at this rate of discount, NPV of cash flow stream of the project would be zero. The NPV cannot be zero at 14.28%. The IRR through the Payback period is only an approximate measure.
Illustration 21
A plastic manufacturer has under consideration the proposal of production of high-quality plastic glasses. The necessary equipment to manufacture the glasses would cost ₹ 1 lakh and would last 5 year The tax relevant rate of depreciation is 20% on written down value. There is no other asset in this block. The expected salvage value is ₹ 10,000. The glasses can be sold at ₹ 4 each. Regardless of the level of production, the manufacturer will incur cash cost of ₹ 25,000 each year if the project is undertaken. The overhead costs allocated to this new line would be ₹ 5,000. The variable costs are estimated at ₹ 2 per glass. The manufacturer estimates it will sell about 75,000 glasses per year; the tax rate is 35%. Should the proposed equipment be purchased? Assume 20% cost of capital and additional working requirement, ₹ 50,000.
Solution:
Illustration 22
Modern Enterprises Ltd. is considering the purchase of a new computer system for its research and development division, which would cost ₹ 35 lakh. The operation and maintenance costs (excluding depreciation) are expected to be ₹ 7 lakh per annum. It is estimated that the useful life of the system would be 6 years, at the end of which the disposal value is expected to be ₹ 1 lakh.
The tangible benefits expected from the system in the form of reduction in design and draftsmanship costs would be ₹ 12 lakh per annum. The disposal of used drawing office equipment and furniture initially is anticipated to net ₹ 9 lakh.
As capital expenditure in research and development, the proposal would attract a 100% write-off for tax purposes. The gains arising from disposal of used assets may be considered tax free. The effective tax rate is 35%. The average cost of capital of the company is 12%.
After appropriate analysis of cash flows, advise the company of the financial viability of the proposal. Ignore tax on salvage value.
Solution:
Illustration 23
A textile company is considering two mutually exclusive investment proposals. Their expected cashflow streams (CFAT) are given as follows:
| Year | Proposal X (₹ in thousand) | Proposal Y (₹ in thousand) |
| 0 | (500) | (700) |
| 1 | 145 | 100 |
| 2 | 145 | 110 |
| 3 | 145 | 130 |
| 4 | 145 | 150 |
| 5 | 145 | 160 |
| 6 | 145 | 150 |
| 7 | 120 | |
| 8 | 120 | |
| 9 | 110 | |
| 10 | 100 |
The company employs the risk-adjusted method of evaluating risky projects and selects the appropriate required rate of return as follows:
| Project Payback | Required rate of return (percentage) |
| Less than 1 year | 8 |
| 1 to 5 years | 10 |
| 5 to 10 years | 12 |
| Over 10 years | 15 |
Which proposal should be acceptable to the company?
Solution:
Illustration 24
XYZ Ltd. is considering two mutually-exclusive projects. Both require an initial cash outlay of ₹ 100,00,000 each for machinery and have a life of 5 year. The company’s required rate of return is 10% and it pays tax at 50%. The projects will be depreciated on a straight-line basis. The net cash flows (before taxes) expected to be generated by the projects and the present value (PV) factor (at 10%) are as follows:
| Year (₹ in ‘000) | |||||
| 1 | 2 | 3 | 4 | 5 | |
| Project 1 | 4,000 | 4,000 | 4,000 | 4,000 | 4,000 |
| Project 2 | 6,000 | 3,000 | 3,000 | 5,000 | 5,000 |
| PV factor (at 10%) | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
You are required to calculate
Solution:
Illustration 25
A machine costing ₹ 110 lakh has a life of 10 years, at the end of which its scrap value is likely to be ₹ 10 lakh. The firm’s cut-off rate is 12 %. The machine is expected to yield an annual profit after tax of ₹ 10 lakh, depreciation being reckoned on straight line basis for tax purposes. At 12%, the PV of the rupee received annually for 10 years is 5.650, and the value of one rupee received at the end of the tenth year is 0.322. Ascertain the NPV of the project.
Solution:
Illustration 26
A company has to replace one of its machines, which has become unserviceable. Two options are available to the company:
If machine LM is chosen, it will be replaced at the end of 6 years by another LM machine.
The pattern of maintenance, running costs and prices as under:
| Particulars | EM(₹ ) | LM(₹ ) |
| Purchase price | 20,00,000 | 14,00,000 |
| Scarp value at the end of life | 3,00,000 | 3,00,000 |
| Overhauling is due at the end of | 8th Year | 4th Year |
| Overhauling cost | 4,00,000 | 2,00,000 |
| Annual repairing expenses | 2,00,000 | 2,80,000 |
Cost of capital is 14%.
You are required to recommend which of the machines should be purchased.
Given, Present Value Interest Factor, PVIF (14%)
| Year | 4 | 6 | 8 | 12 |
| PV Factor | 0.5921 | 0.4556 | 0.3506 | 0.2076 |
Present Value Interest Factor for an Annuity, PVIFA (14%)
| Year | 1 to 6 Years | 1 to 12 Years |
| PV Factor | 3.8899 | 5.6600 |
Solution:
Illustration 27
Electronics Pvt. Ltd. is considering a proposal to replace one of its machines. In this connection, the following information is available.
The existing machine was purchased 3 years ago for ₹ 20 Lakh. It was depreciated 20 % per annum on reducing balance basis. It has remaining useful life of 5 years, but its annual maintenance cost is expected to increase by
₹ 1 Lakh form the sixth year of its installation. Its present realizable value is ₹ 12 Lakh. The company has several machines, having 20% depreciation.
The new machine costs ₹ 30 Lakh and is subject to the same rate of depreciation. On sale after 5 years, it is expected to realize ₹ 18 Lakh. With the new machine, the annual operating costs (excluding depreciation) are expected to decrease by ₹ 2 Lakh. In addition, the machine would increase productivity on account of which net revenues would increase by ₹ 3 Lakh annually. The tax rate applicable to the company is 40% and the cost of capital is 10%.
Is the proposal financially viable? Advise the company on the basis of NPV of the proposal.
PV Factors (10%)
| Year | 1 | 2 | 3 | 4 | 5 |
| PV Factor | 0.909 | 0.826 | 0.751 | 0.683 | 0.620 |
Solution:
Illuatration 28
A manufacturing company has an old machine having no book value which can be sold for ₹ 100,000. The company is thinking to choose one of the following two alternatives:
The above two alternatives envisage useful life to be 5 years. The expected after-tax profits for three alternatives are as under:
| Year | Old Existing Machine (₹ ) | Upgraded Machine (₹ ) | New Machine (₹ ) |
| 1 | 10,00,000 | 11,00,000 | 12,00,000 |
| 2 | 10,80,000 | 11,80,000 | 12,80,000 |
| 3 | 11,60,000 | 12,20,000 | 13,80,000 |
| 4 | 12,40,000 | 13,00,000 | 14,80,000 |
| 5 | 13,20,000 | 14,00,000 | 16,00,000 |
The tax rate is 40%. The company follows straight line depreciation and the cost of capital is to be taken 15%. You are required to advice the company as to which alternative is to be adopted.
Present value of One Rupee.
| Year/Rate | 1 | 2 | 3 | 4 | 5 |
| 15% | 0.870 | 0.756 | 0.658 | 0.572 | 0.497 |
Solution:
Illustration 29
Vedika Ltd., with a limited investment funds of ₹ 6,00,000 is evaluating the desirability of 5 (five) investment proposals. Their profiles are summarized below:
| Project Investment (₹ ) | Annual Cash flow (after tax) (₹ ) | Life (in years) | |
| M | 1,00,000 | 36,000 | 10 |
| N | 2,00,000 | 1,00,000 | 4 |
| O | 2,40,000 | 60,000 | 8 |
| P | 3,00,000 | 80,000 | 16 |
| Q | 4,00,000 | 60,000 | 25 |
Project N and Q are mutually exclusive. The cost of funds is 10%.
Find out the feasible combination of projects and rank them on the basis of Net Present Value (NPV).
PVIFA
| Year | 10 | 4 | 8 | 16 | 25 |
| PVIFA at 10% | 6.145 | 3.170 | 5.335 | 7.824 | 9.077 |
Solution:
Illustration 30
Vedavyas Ltd. is considering two manually exclusive projects M and project N. The Finance Director thinks that the project with the higher NPV should be chosen, whereas the Managing Director thinks that the one with the higher IRR should be undertaken, especially as both projects have the same initial outlay and length of life. The company anticipates a cost of 10% and the net after-tax cash flow of the projects are as follows:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cash Flows (₹) | (₹) | (₹) | (₹) | (₹) | (₹) | (₹) |
| Projact M | (4,00,000) | 70,000 | 1,60,000 | 1,80,000 | 1,50,000 | 40,000 |
| Project N | (4,00,000) | 4,36,000 | 20,000 | 20,000 | 8,000 | 6,000 |
You are required to:
Present value table is given:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| PVIF at 10% | 1000 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| PVIF at 20% | 1000 | 0.833 | 0.694 | 0.579 | 0.482 | 0.402 |
Solution:
Illustration 31
Information of two projects is given below:
| Project | A | B |
| Cash Inflows (₹ ‘000) Year-end | ||
| 1 | 50 | 282 |
| 2 | 300 | 250 |
| 3 | 360 | 180 |
| 4 | 208 | NIL |
| Initial Investment – beginning of year 1 | 535 | 540 |
Evaluate which project is better under each of the following criteria taking discount rate as 10% p.a.
Solution:
Illustration 32
Lokesh Ltd. is considering buying a machine costing ₹ 15,00,000 which yields the following annual income:
| End of year | 1 | 2 | 3 | 4 | 5 |
| Annual Income after Depreciation but before tax | 3,50,000 | 3,72,000 | 3,10,000 | 1,75,000 | 1,10,000 |
| PV Factor at 12% of ₹ 1 | 0.893 | 0.797 | 0.712 | 0.636 | 0.567 |
Corporate tax rate applicable is 30%. Depreciation is on straight line basis for 5 year There is no scrap value. Normal rate of return is 12%. Round off calculations to the nearest rupee and calculate:
Solution:
Illustration 33
Robin Ltd. is examining two manually exclusive investment proposals. The management uses Net Present Value method to evaluate new investment proposals. Depreciation is charged using Straight line Method. Other details relating to these proposals are:
| Particulars | Proposal X | Proposal Y |
| Annual Profit before tax (₹) | 13,00,000 | 24,50,000 |
| Cost of the Project (₹) | 90,00,000 | 1,80,00,000 |
| Salvage value (₹) | 1,20,000 | 1,50,000 |
| Working Life | 4 Years | 5 Years |
| Cost of Capital | 10% | 10% |
| Corporate Tax Rate | 30% | 30% |
The present value of ₹ 1 at 10% discount rates at the end of first, second, third, fourth and fifth year are 0.9091; 0.8264; 0.7513; 0.683; and 0.6209 respectively.
You are required to advise the company on which proposal should be taken up by it.
Solution:
Illustration 34
ABC Ltd. wishes to evaluate two mutually exclusive proposals to acquire a machine. Machines M and N are being considered, each costing ₹ 2,00,000 and having an estimated life of 5 years and 4 years respectively. Both have nil salvage value. The anticipated cash flows after adjustment of taxes for M and N are given below:
| End of Year | Machine M (₹ ) | Machine N (₹ ) |
| 1 | 70,000 | 1,00,000 |
| 2 | 60,000 | 90,000 |
| 3 | 60,000 | 80,000 |
| 4 | 50,000 | 40,000 |
| 5 | 90,000 | NIL |
Find the accounting rate of return and net present value for both the machines and advise ABC Ltd., which machine should be bought. The required rate of return is 10% p.a.
Present Value factor for 10%.
| End of Year | 1 | 2 | 3 | 4 | 5 |
| 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
Solution:
Illustration 35
FB Chemical Ltd. has three potential projects, all with an initial cost of ₹ 20,00,000 and estimated life of five year The capital budget for the year will only allow the company to accept one of the three projects.
Given the discount rates and the future cash flows of each project, which project should the company accept?
Project 1 has an annual cash flow of ₹ 5,00,000 and discount rate of 6%.
Project 2 has an annual cash flow of ₹ 6,00,000 and discount rate of 9%.
Project 3 has the following cash inflows and discount rate of 15%
| Year | 1 | 2 | 3 | 4 | 5 |
| Cash inflows ₹ | 10,00,000 | 8,00,000 | 6,00,000 | 2,00,000 | 1,00,000 |
Solution:
Illustration 36
P Ltd. has four potential projects all with an initial cost of ₹ 15,00,000. The capital budget for the year will only allow the company to take up only one of the three projects. Given the discount rates and the future cash flows of each project, which project should they accept?
| Project | Annual Net Cash Flows per year for five years (₹ ) | Discount Rates |
| A | 3,50,000 | 4% |
| B | 4,00,000 | 8% |
| C | 5,00,000 | 10% |
Solution:
Solved Case 1
A company is considering an investment proposal to install new milling controls at a cost of ₹ 50,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume the firm uses straight line depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax (CFBT) from the investment proposal are as follows:
| Year | CFBT (₹ ) |
| 1 | 10,000 |
| 2 | 10,692 |
| 3 | 12,769 |
| 4 | 13,462 |
| 5 | 20,385 |
Compute the following:
Solution:
Solved Case 2
The H Ltd is considering investment in a new product. The information for one year is given as follows:
| Particulars | (₹) |
| (a) Sales | 1,00,000 |
| (b) Manufacturing cost of sales (including ₹ 10,000 of depreciation) | 40,000 |
| (c) Selling and administrative expenses (directly associated with the product) | 20,000 |
| (d) Decrease in contribution of other products | 2,000 |
| (e) Increase in accounts receivable | 7,000 |
| (f) Increase in inventories | 10,000 |
| (g) Increase in current liabilities | 15,000 |
| (h) Income taxes associated with product income | 6,000 |
You are required to compute the relevant cash flows of the year to be considered in evaluating this investment proposal.
Solution:
A. Theoretical Questions:
1. Capital Budgeting is a part of:
Answer: a. Investment Decision
2. Capital Budgeting deals with:
Answer: a. Long-term Decision
3. Which of the following is not used in Capital Budgeting?
Answer: c. Net Assets Method
4. Capital Budgeting Decisions are:
Answer: b. Irreversible
5. Which of the following is not incorporated in Capital Budgeting?
Answer: d. Rate of Cash Discount
6. Which of the following is not a capital budgeting decision?
Answer: d. Inventory Level
7. A sound Capital Budgeting technique is based on:
Answer: a. Cash Flows
8. Which of the following is not a relevant cost in Capital Budgeting?
Answer: d. Both (a) and (c) above.
9. Capital Budgeting Decisions are based on:
Answer: b. Incremental Cash Flows
10. Which of the following does not effect cash flows proposal?
Answer: d. Method of Project Financing
11. Cash Inflows from a project include:
Answer: d. Both (a) and (b)
12. Which of the following is not true with reference capital budgeting?
Answer: c. Existing investment in a project is not treated as sunk cost
13. Which of the following is not followed in capital budgeting?
Answer: c. Accursal Principle
14. Depreciation is incorporated in cash flows because it:
Answer: c. Reduces Tax liability
15. Which of the following is not true for capital budgeting?
Answer: b. Opportunity costs are excluded
16. Which of the following is not applied in capital budgeting?
Answer: c. All accrued costs and revenues be incorporated
17. Evaluation of Capital Budgeting proposals is based on Cash Flows because:
Answer: c. Cash is more important than profit
18. Which of the following is not included in incremental A flows?
Answer: b. Sunk Costs
19. A proposal is not a Capital Budgeting proposal if it:
Answer: c. brings short-term benefits only
20. In Capital Budgeting, Sunk cost is excluded because it is:
Answer: b. not incremental
21. Savings in respect of a cost is treated in capital budgeting as:
Answer: a. An Inflow
22. ignores the time value of
Answer: b. ARR
23. The discounted cash flows techniques are:
Answer: d. All of the above
24. If the NPV is positive or at least equal to zero, the project can be .
Answer: d. accepted
25. The following information is given for a project:
Annual cash inflow ₹ 8,00,000
Useful life 4 years
Payback period 2.855 years
The cost of the project would be -
Answer: b. ₹ 22,84,000
26. Initial investment ₹ 20 Expected annual cash flows ₹ 6 Lakh for 10 years. Cost of capital @15%. Profitability Index (PI) is -
[ Cumulative discounting factor @ 15% for 10 years = 5.019)
Answer: a. 1.51
27. Annual Cost Saving ₹ 4,00,000; Useful life 4 years; Cost of the Project ₹ 11,42,000. The Payback period would be -
Answer: b. 2 years 11 months
28. A project has a 10% discounted payback of 2 years with annual after-tax cash inflows commencing from year end 2 to 4 of ₹ 400 lakh. How much would have been the initial cash outlay which was fully made at the beginning of year 1?
Answer: c. ₹ 452 lakh
B. Fill in the Blanks
1. Discuss the basic concept of capital budgeting.
Answer:
2. Discuss the nature of capital
Answer:
3. State the need of capital budgeting
Answer:
4. Discuss the significance of capital budgeting.
Answer:
5. Evaluate the process of capital budgeting.
Answer:
6. Distinguish between Cash flow and Profit of the firm.
Answer:
7. What is mutually exclusive project decision? Explain.
Answer:
8. Write a note on the traditional capital budgeting techniques (non-discounted).
Answer:
9. Write a note on the modern capital budgeting techniques (discounted).
Answer:
10. Make differences between NPV and IRR method.
Answer:
1. Why is it important to evaluate capital budgeting projects on the basis of after-tax cash incremental flows? Why we not use accounting data instead of cash flow?
Answer:
2. What are the components of net cash outlay in the capital budgeting decision? At what time is such an outlay incurred in the case of conventional cash flows?
Answer:
3. How should working capital and sunk costs be treated in analysing investment opportunities? Explain with suitable examples.
Answer:
4. Explain clearly the concept of block of assets vis-a-vis depreciation in the context of replacement situations of capital budgeting.
Answer:
5. Suppose a firm is considering replacing an old machine with a new one. The firm does not anticipate that any new revenues will be created by the replacement since demand for the product generation by both the machines is the However, in the CFAT work sheet used in evaluating the proposal, the analyst shows positive CFBT in the operating cash flow section. What creates operating CFBT in this situation?
Answer:
6. It is said that only cash costs are relevant for capital budgeting decision. However, depreciation which is a non-cash cost is a prominent part of cash flow analysis for such an investment How do you explain this paradox?
Answer:
7. What is payback period? Also, discuss the utility of the Payback period in determining the internal rate of return.
Answer:
8. What are the critical factors to be observed while making replacement investment decision?
Answer:
9. What does the profitability index signify? What is the criterion for judging the worth of investments in the capital budgeting technique based on the profitability index?
Answer:
10. Do the profitability index and the NPV criterion of evaluating investment proposals lead to the same acceptance-rejection and ranking decisions?
Answer:
11. Discuss the advantages and disadvantages of all the evaluation techniques of capital budgeting.
Answer:
B. Numerical Questions:
1. One project of XYZ Ltd. is doing poorly and is being considered for replacement. Three mutually exclusive projects A, B and C have been proposed. The projects are expected to require ₹ 2,00,000 each, and have an estimated life of 5 years, 4 years and 3 years, respectively, and have no salvage value. The company’s required rate of return is 10%. The anticipated cash inflows after taxes (CFAT) for the three projects are as follows:
| Year | CFAT | ||
| A (₹ ) | B (₹ ) | C (₹ ) | |
| 1 | 50,000 | 80,000 | 1,00,000 |
| 2 | 50,000 | 80,000 | 1,00,000 |
| 3 | 50,000 | 80,000 | 10,000 |
| 4 | 50,000 | 30,000 | -- |
| 5 | 1,90,000 | -- | -- |
Answer:
2. Royal Industries is considering the replacement of one of its moulding machines. The existing machine is in good operating condition, but is smaller than required if the firm is to expand its operations. The old machine is 5 years old, has a current salvage value of ₹ 30,000 and a remaining depreciable life of 10 years. The machine was originally purchased for ₹ 75,000 and is being depreciated at ₹ 5,000 per year for tax purposes.
The new machine will cost ₹ 1,50,000 and will be depreciated on a straight line basis over 10 years, with no salvage value. The management anticipates that, with the expanded operations, there will be need of an additional net working capital of ₹ 30,000. The new machine will allow the firm to expand current operations, and thereby increase annual revenues of ₹ 40,000, and variable operating costs from ₹ 2,00,000 to ₹ 2,10,000. The company’s tax rate is 35% and its cost of capital is 10%.
Should the company replace its existing machine? Assume that the loss on sale of existing machine can be claimed as short-term capital loss in the current year itself.
Answer:
3. Arvind Mills Ltd. is considering two mutually exclusive investment proposals for its expansion programme. Proposal A requires an initial investment of ₹ 7,50,000 and yearly cash operating costs of ₹ 50,000. Proposal B requires an initial investment of ₹ 5,00,000 and yearly cash operating costs of ₹ 1,00,000. The life of the equipment used in both the investment proposals will be 12 years, with no salvage value; depreciation is on the straight-line basis for tax purposes. The anticipated increase in revenues is ₹ 1,50,000 per year in both the investment proposals. The firm’s tax rate is 35% and its cost of capital is 15%. Which investment proposal should be undertaken by the company?
Answer:
4. Initial investment is ₹ 100 lakh is same for both the projects A & B. The net cash inflows after taxes for project A is ₹ 25 lakh per annum for 5 years and those for project B over its life of 5 years are ₹ 20 lakh, ₹ 25 lakh, ₹ 30 lakh, ₹ 30 lakh and ₹ 20 lakh respectively. Find out payback period of both the projects.
Answer:
5. Z has two projects under consideration A & B, each costing ₹ 60 lakh. The projects are mutually exclusive. Life for project A is 4 years & project B is 3 years. Salvage value NIL for both the projects. Tax Rate 33.99%. Cost of Capital is 15%.
Cash Inflows (₹ in Lakh)
| At the end of the year | Project A | Project B | Project @ 15% |
| 1 | 60 | 100 | 0.970 |
| 2 | 110 | 130 | 0.756 |
| 3 | 120 | 50 | 0.685 |
| 4 | 50 | - | 0.572 |
Which project will be accepted by the company?
Answer:
Unsolved Case(s)
1. The cost of a project is ₹ 50,000 and it generates cash inflows of ₹ 20,000, ₹ 15,000, ₹ 25,000, and ₹ 10,000 over four years.
Required: Using the present value index method, appraise the profitability of the proposed investment, assuming a 10% rate of discount, charged semi-annually.
Answer:
2. The cost of a plant is ₹ 50,000. It has an estimated life of 5 years after which it would be disposed of (scrap value is nil). Profit Before Depreciation, Interest and Taxes (PBIT) is estimated to be ₹ 17,500 a. Calculate the yearly cash flow from the plant when tax rate is 30%.
Answer:
3.Oxford Ltd. has decided to diversify its production and wanted to invest its surplus funds on the most profitable project. It has only two projects under consideration – ‘X’ and ‘Y’. The cost of project ‘X’ is ₹ 100 lacs and that of ‘Y’ is ₹ 10 lacs. Both projects are expected to have a life of 8 years only and at the end of this period ‘X’ will have a salvage value of ₹ 4 lacs and ‘B’ ₹ 14 lacs. The running expenses of ‘X’ will be ₹ 35 lacs per year and that of ‘Y’ ₹ 20 lacs per In either case, the company expects a rate of return of 10%. The company’s tax rate is 50%. Depreciation is charged on straight line basis. Which project is profitable?
Answer:
4. A firm is considering an introduction of a new product which will have a life of five Two alternatives of promoting the product have been identified:
Option 1: This involves hiring many agents. An immediate investment of ₹ 5,00,000 is required to promote the product. This will result in a net cash inflow of ₹ 3,00,000 at the end of each year for the next five years. However, agents need to pay ₹ 50,000 per year. After the contract is terminated, the agent has to pay a lump sum of ₹ 1,00,000 at the end of the fifth year.
Option 2: Under this alternative, the firm will not employ agents but will sell directly to the customers. The initial cost of advertising is ₹ 2,50,000. This earns cash at the end of each year ₹ 1,50,000. However, this alternative comes with a sales administration fee of ₹ 50,000. The firm also proposes to allocate fixed costs worth ₹ 20,000 per year to this product if this alternative is pursued.
Required:
Answer:
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