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1. Naveen enterprises is considering a capital project about which the following information is

available:

a. The investment outlay on the project will be Rs. 100 million. This consists of Rs. 80

million on plant and machinery and Rs. 20 million on net working capital. The entire

outlay will be incurred at the beginning of the project.

b. The project will be financed with Rs. 45 million of equity capital, Rs. 5 million of

preference capital, and Rs. 50 million of debt capital. Preference capital will carry a

dividend rate of 15 per cent; debt capital will carry an interest rate of 15 per cent.

c. The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will

fetch a net salvage value of Rs. 30 million whereas net working capital will be liquidated

at its book value.

d. The project is expected to increase the revenues of the firm by Rs. 120 million per year.

The increase in costs on account of the project is expected to be Rs. 80 million per year.

The effective tax rate will be 30 per cent.

e. Plant and machinery will be depreciated at the rate of 15 per cent per year as per the

written down value method. Hence, the depreciation charges will be:

i. First year : Rs. 12 million

ii. Second year : Rs. 10.20 million

iii. Third year : Rs. 8.67 million

iv. Fourth year : Rs. 7.37 million

v. Fifth year : Rs. 6.26 million

From the above information prepare the project cash flows.

Solution is as follows:

Statement of project cash flows

(Rs. in million)

Particulars 0 1 2 3 4 5

Initial investment ----- ----- ----- ----- -----

a. Fixed assets (80)

b. Working capital (20)

Operating cash flows

a. Revenues 120.00 120.00 120.00 120.00 120.00

b. Operating cost 80.00 80.00 80.00 80.00 80.00

c. Depreciation 12.00 10.20 8.67 7.37 6.26

d. Profit before tax (a-(b+c)) 28.00 29.80 31.33 32.63 33.74

e. Tax (d x 30%) 8.40 8.94 9.40 9.79 10.12

f. Profit after tax (d-e) 19.60 20.86 21.93 22.84 23.62

Terminal cash flows

a. Salvage of fixed assets 30.00

b. Recovery of WC 20.00

Initial investment (100)

Operating cash flows (f+c) ----- 31.60 31.06 30.60 30.21 29.88

Terminal cash flows ----- 50.00

Net cash flows (100) 31.60 31.06 30.60 31.21 79.88

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2. Naveen Company is considering capital project. Data is given below. Investment outlay is Rs. 80

million on plant and machinery and Rs. 20 million on working capital. All incurred in beginning of

the year. Life of project is 5 years. At end of 5 years salvage value fetches Rs. 30 million. The

sales revenue will increase by Rs. 120 million per year and costs (other than depreciation) will

increase by Rs. 80 million. Tax rate is 30% and depreciation charges from year 1 to 5 are Rs. 20,

R. 15, Rs. 11.15, Rs. 8.44 and Rs. 6.33 million respectively. Find cash flows per year.

Solution is as follows:

Statement of project cash flows

(Rs. in million)

Particulars 0 1 2 3 4 5

Initial investment ----- ----- ----- ----- -----

a. Fixed assets (80)

b. Working capital (20)

Operating cash flows

a. Revenues 120.00 120.00 120.00 120.00 120.00

b. Operating cost 80.00 80.00 80.00 80.00 80.00

c. Depreciation 20.00 15.00 11.15 8.44 6.33

d. Profit before tax (a-(b+c)) 20.00 25.00 28.85 31.36 33.67

e. Tax (d x 30%) 6.00 7.50 8.67 9.41 10.10

f. Profit after tax (d-e) 14.00 17.50 20.18 21.95 23.57

Terminal cash flows

a. Salvage of fixed 30.00

assets 20.00

b. Recovery of WC

Initial investment (100)

Operating cash flows (f+c) ----- 34.00 32.50 31.33 30.39 29.90

Terminal cash flows ----- 50.00

Net cash flows (100) 34.44 32.50 31.33 30.39 79.90

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3. India Pharma Ltd is engaged in the manufacture of pharmaceuticals. The company was

established in 1998 and has registered a steady growth in sales since then. Presently the

company manufactures 16 products and has an annual turnover of Rs. 2,200 million. The

company is considering the manufacture of a new antibiotic preparation, K-cin, for which the

following information has been gathered:

a. K-cin is expected to have a product life cycle of five years and thereafter it would be

withdrawn from the market. The sales from this preparation are expected to be as

follows: Rs. 100 million, Rs. 150 million, Rs. 200 million, Rs. 150 million and Rs. 100

million.

b. The capital equipment required for manufacturing K-cin is Rs. 100 million and it will be

depreciated at the rate of 15 per cent per year as per the WDV method for tax

purposes. The expected net salvage value after five years is Rs. 20 million.

c. The net working capital requirement for the project is expected to be 20 per cent of

sales. At the end of 5 years, the net working capital is expected to be liquidated at par,

barring an estimated loss of Rs. 5 million on account of bad debt. The bad debt loss will

be a tax deductable expense.

d. The account of the firm has provided the following cost estimated for K-cin:

i. Raw material cost : 30 per cent of sales

ii. Variable labour cost : 20 per cent of sales

iii. Fixed annual operating cost : Rs. 5 million

iv. Overhead allocation : 10 per cent of sales

(while the project is charged an overhead allocation, it is not likely to have any

effect on overhead expenses as such)

e. The manufacture of K-cin would also require some of the common facilities of the firm.

The use of these facilities would call for reduction in sales and would entail a reduction

of Rs. 15 million of contribution margin.

f. The tax rate applicable to the firm is 30 per cent.

Calculate the project cash flows for a period of 5 years.

3|Page

Solution is as follows:

Statement of Project Cash Flows

(Rs. in millions)

Particulars 0 1 2 3 4 5

Initial investment:

a. Fixed Assets (100)

b. Working capital (20) 30.00 40.00 30.00 20.00 00.00

Operating cash flows:

a. Revenues 100.00 150.00 200.00 150.00 100.00

b. Raw material cost 30.00 45.00 60.00 45.00 30.00

c. Labour cost 20.00 30.00 40.00 30.00 20.00

d. Fixed cost 5.00 5.00 5.00 5.00 5.00

e. Opportunity cost 15.00 15.00 15.00 15.00 15.00

f. Depreciation 15.00 12.75 10.84 9.21 7.83

g. Bad debt loss 5.00

h. Profit before tax 15.00 42.25 69.16 45.79 17.17

i. Tax 4.50 12.68 20.75 13.74 5.15

j. Profit after tax 10.50 29.58 48.41 32.05 12.02

Terminal cash flows:

a. Salvage value 20.00

b. Recovery of WC 15.00

1. Initial investment (120.00)

2. Operating cash flows 25.50 42.33 59.25 41.26 24.85

3. Net working capital 10.00 10.00 -10.00 -10.00

4. Terminal cash flows 35.00

-120.00 15.50 32.33 69.75 51.26 59.85

Net cash flows (1+2-3+4)

4. A Crystal glass is considering an expansion project which would require investment in plant and

machinery worth Rs. 18 lakhs. The working capital required for the project is expected to be Rs.

1,20,000 which can be realized at the book value at the end of 7 years. The plant and machinery

will have a salvage value of Rs. 75,000 at the end of the 7 years of expected life of the asset. The

expected sales of the asset are given below. The management feels that raw materials would

cost 40 per cent of sales and labour would cost 25 per cent of sales throughout the life of the

asset. Overhead will account for 5 per cent of sales for first three years and 10 per cent for the

remaining life of the asset. The firm charges depreciation at 25 per cent on WDV method and

tax rate at 35 per cent. The average cost of capital of the company is 12 per cent. Calculate NPV

of the project after estimating its cash flows and suggest whether the company should go in for

expansion or not?

(Rs. In 000’s)

Years 1 2 3 4 5 6 7

Sales 986 1246 1684 2586 3284 1860 1462

4|Page

Solution is as follows:

Particulars 0 1 2 3 4 5 6 7

Initial investment

a. Fixed assets (1800)

b. Working capital (120)

Operating cash flows:

a. Sales 986.00 1246.00 1684.00 2586.00 3284.00 1860.00 1462.00

b. Raw materials 394.40 498.40 673.60 1034.40 1313.60 744.00 584.80

c. Labour 246.50 311.50 421.00 646.50 821.00 465.00 365.50

d. Overheads 49.30 62.30 84.20 258.60 328.40 186.00 146.20

e. Depreciation 450.00 337.50 253.13 189.84 142.38 106.79 80.09

f. Profit before tax (154) 36.30 252.07 456.66 678.62 358.21 285.41

g. Tax ---- 12.71 88.22 159.83 237.52 125.37 99.89

h. Profit after tax (154) 23.59 163.85 296.83 441.10 232.84 185.52

Terminal value:

a. Salvage value of FA 75.00

b. Recovery of WC 120.00

Initial investment (1920)

Operating cash flows 296.00 361.09 353.69 486.67 583.48 339.63 265.61

Terminal cash flows 195.00

Net cash flows (1920) 296.00 361.69 353.69 486.67 583.48 339.63 460.61

PV of rupee at 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452

Present value of inflows 261.65 288.27 251.83 309.56 330.83 172.19 208.20

Net present value:

Initial investment 1800.00

PV of cash inflows 1822.53

Net present value 2.53

The company has to go for expansion as it is yielding positive NPV

5|Page

5. Magnum technologies limited is evaluating an electronics project for which the following

information has been assemble:

a. The total outlay on the project is expected to be Rs. 50 million. This consists of Rs. 30

million of fixed assets and Rs.20 million of current assets.

b. The total outlay of Rs. 50 million is proposed to be financed as follows: Rs. 15 million of

equity, Rs. 20 million of term loans, Rs. 10 million of bank finance for working capital,

and Rs. 5 million of trade credit.

c. The term loan is repayable in five equal annual installments of Rs. 4 million each. The

first installment will be due at the end of the first year and the last installment at the

end of the fifth year. The levels of bank finance for working capital and trade credit will

remain at Rs. 10 million and Rs. 5 million till they are paid back or retired at the end of

five years.

d. The interest rates on the term loan and bank finance for working capital will be 10 per

cent and 12 per cent respectively.

e. The expected revenues from the project will be Rs. 60 million per year. The operating

costs, excluding depreciation will be Rs. 42 million. The depreciation rate on the fixed

assets will be charged at 15 per cent on WDV method.

f. The net salvage value of fixed assets and current assets at the end of year 5 will be Rs. 5

million and Rs. 20 million respectively.

g. The tax rate applicable to the firm is 30 per cent.

Calculate cash flows relating to equity, long term funds and relating to total resources.

Solution is as follows:

Cash flow relating to equity funds:

Initial investment: Equity funds committed to the project

Operating cash flows: profit after tax – preference dividend + depreciation + other non

cash charges

Liquidation and retirement cash flows: net salvage value of fixed assets + net salvage

value of current assets – repayment of term loans – repayment of preference capital –

repayment of working capital advances – retirement of trade credit

Initial investment: fixed assets + working capital margin

Operating cash flows: profit after tax + depreciation + other non-cash charges + interest

on long-term borrowings (1-t)

Terminal cash flows: salvage value of fixed assets + recovery of working capital margin.

Initial investment: fixed assets + gross working capital

Operating cash flows: profit after tax + depreciation + other non-cash charges + interest

on long-term borrowings (1-t) + interest on short term borrowings (1-t)

Terminal cash flows: salvage value of fixed assets + salvage value of current assets

Working note: *calculation of interest on term loan:interest on loan will be calculated on the

opening balance

6|Page

Net cash flows relating to equity

Particulars 0 1 2 3 4 5

1. Fixed assets (15.00)

2. Revenues 60.00 60.00 60.00 60.00 60.00

3. Operating costs 42.00 42.00 42.00 42.00 42.00

4. Depreciation 4.50 3.83 3.25 2.76 2.35

5. Interest on WC advance 1.20 1.20 1.20 1.20 1.20

6. Interest on Term loan* 2.00 1.60 1.20 0.80 0.40

7. Profit before tax 10.30 11.38 12.35 13.24 14.05

8. Tax 3.09 3.41 3.70 3.97 4.22

9. Profit after tax 7.21 7.96 8.64 9.27 9.84

10. Salvage value of FA 5.00

11. Salvage value of CA 20.00

12. Repayment of term loans (4.00) (4.00) (4.00) (4.00) (4.00)

13. Repayment of short-term loans (10.00)

14. Retirement of trade credit (5.00)

1. Initial investment (15.00)

2. Operating cash flows(9+4) 11.71 11.79 11.90 12.03 12.18

3. Retirement and liquidation cash (4.00) (4.00) (4.00) (4.00) 6.00

flows (10+11-12-13-14)

Net cash flows (1+2+3) (15.00) 7.71 7.79 7.90 8.03 18.18

Particulars 0 1 2 3 4 5

1. Fixed assets (30.00)

2. Current Assets (5.00)

3. Revenues 60.00 60.00 60.00 60.00 60.00

4. Operating costs 42.00 42.00 42.00 42.00 42.00

5. Depreciation 4.50 3.83 3.25 2.76 2.35

6. Interest on WC advance 1.20 1.20 1.20 1.20 1.20

7. Interest on Term loan* 2.00 1.60 1.20 0.80 0.40

8. Profit before tax 10.30 11.38 12.35 13.24 14.05

9. Tax 3.09 3.41 3.70 3.97 4.22

10. Profit after tax 7.21 7.96 8.64 9.27 9.84

11. Salvage value of FA 5.00

12. Salvage value of CA 5.00

1. Initial investment (35.00)

2. Operating cash 13.11 12.91 12.73 12.59 12.47

flows(9+4+7(1-t)

3. Terminal cash flows (11+12) 10.00

Net cash flows (1+2+3) (35.00) 13.11 12.91 12.73 12.59 22.47

7|Page

Net cash flows relating to Long-term Funds

Particulars 0 1 2 3 4 5

1. Fixed assets (30.00)

2. Current Assets (20.00)

3. Revenues 60.00 60.00 60.00 60.00 60.00

4. Operating costs 42.00 42.00 42.00 42.00 42.00

5. Depreciation 4.50 3.83 3.25 2.76 2.35

6. Interest on WC advance 1.20 1.20 1.20 1.20 1.20

7. Interest on Term loan* 2.00 1.60 1.20 0.80 0.40

8. Profit before tax 10.30 11.38 12.35 13.24 14.05

9. Tax 3.09 3.41 3.70 3.97 4.22

10. Profit after tax 7.21 7.96 8.64 9.27 9.84

11. Salvage value of FA 5.00

12. Salvage value of CA 20.00

4. Initial investment (50.00)

5. Operating cash 13.95 13.75 13.57 13.43 13.31

flows(9+4+7(1-t)+6(1-t))

6. Terminal cash flows (11+12) 25.00

Net cash flows (1+2+3) (50.00) 13.95 13.75 13.57 13.43 38.31

6. Futura Limited is considering a capital project about which the following information is

available:

a. The investment outlay on the project will be Rs. 200 million. This consists of Rs. 150

million on the plant and machinery and Rs. 50 million on net working capital. The entire

outlay will be incurred in the beginning.

b. The life of the project is expected to be 7 years. At the end of 7 years, fixed assets will

fetch a net salvage value of Rs. 48 million whereas net working capital will be liquidated

at its book value.

c. The project is expected to increase the revenues of the firm by Rs. 250 million per year.

The increase in costs on account of the project is expected to the Rs. 100 million per

year.

d. Plant and machinery will be depreciated at the rate of 25 per cent as per the WDV

method.

i. Estimate the post-tax cash flows of the project.

ii. Calculate the IRR of the project.

8|Page

Solution is as follows:

Statement of project cash flows

Particulars 0 1 2 3 4 5 6 7

Initial investment

a. Fixed assets (150)

b. Working capital (50)

Operating cash flows:

a. Revenue 250.00 250.00 250.00 250.00 250.00 250.00 250.00

b. Operating cost 100.00 100.00 100.00 100.00 100.00 100.00 100.00

c. Depreciation 37.50 28.13 21.09 15.82 11.87 8.90 6.67

d. Profit before tax 112.50 121.88 128.91 134.18 138.13 141.10 143.33

e. Tax 56.25 60.94 64.46 67.09 69.07 70.55 71.67

f. Profit after tax 56.25 60.94 64.45 67.09 69.06 70.55 71.66

Terminal value:

c. Salvage value of FA 48.00

d. Recovery of WC 50.00

Initial investment (200)

Operating cash flows 93.75 89.07 85.54 82.91 80.93 79.45 78.33

Terminal cash flows 98.00

Net cash flows (200) 93.75 89.07 85.54 82.91 80.93 79.45 176.33

7. Modern pharma is considering the manufacture of a new drug, Floxin, for which the following

information has been gathered:

a. Floxin is expected to have a product life cycle of seven years and after that it would be

withdrawn from the market. The sales from this drug are expected to be as follows:

i. Rs. 80 millions, Rs. 120 million, Rs. 160 millions, Rs. 200 million, Rs. 160 million,

Rs. 120 million and Rs. 80 million.

b. The capital equipment required for manufacturing Floxin is Rs. 120 million and it will be

depreciated at the rate of 25 per cent per year as per the WDV method for tax

purposes. The expected net salvage value after seven years is Rs. 25 million.

c. The working capital requirement for the project is expected to be 25 per cent of sales.

Working capital level is adjusted to be at the beginning of the year. At the end of 7

years, working capital is expected to be liquidated at par, barring an estimated loss of

Rs. 4 million on account of bad debts which of course will be a tax deductible expense.

d. The accountant of the firm has provided the following estimates for the cost of Floxin:

i. Raw material cost : 30 per cent of sales

ii. Variable manufacturing cost : 10 per cent of sales

iii. Fixed annual operating cost : Rs. 10 million

iv. Variable selling expenses : 10 per cent of sales

v. Overhead allocation : 10 per cent of sales

1. The incremental overheads attributable to the new product are

however expected to be only 5 per cent of sales.

vi. The manufacture of Floxin will cut into the sales of an existing product thereby

reducing its contribution margin by Rs. 10 million per year.

vii. The tax rate for the firm is 30 per cent.

1. Estimate the post-tax incremental cash flows

2. What is the NPV if cost of capital is 15 per cent?

9|Page

Solution is as follows:

Particulars 0 1 2 3 4 5 6 7

Initial Investment

1. Capital investment (120)

2. Level of working (20) (30) (40) (50) (40) (30) (20) ----

capital

Operating cash flows:

1. Revenues 80.00 120.00 160.00 200.00 160.00 120.00 80.00

2. Raw material cost 24.00 36.00 48.00 60.00 48.00 36.00 24.00

3. Variable Manu. Cost 8.00 12.00 16.00 20.00 16.00 12.00 8.00

4. Fixed cost 10.00 10.00 10.00 10.00 10.00 10.00 10.00

5. Variable sel exp 8.00 12.00 16.00 20.00 16.00 12.00 8.00

6. Opportunity cost 10.00 10.00 10.00 10.00 10.00 10.00 10.00

7. Depreciation 30.00 22.50 16.88 12.66 9.49 7.12 5.34

8. Bad debt loss ---- ---- ---- ---- ---- ---- 4.00

9. Profit before tax -10.00 17.50 43.12 67.34 50.51 32.88 10.66

10. Tax ---- 5.25 12.94 20.20 15.15 9.86 3.20

11. Profit after tax -10.00 12.25 30.18 47.14 35.36 23.02 7.46

Terminal values

1. Salvage value of FA 25.00

2. Recovery of WC 16.00

Initial investment 140.00

Operating cash flows 20.00 34.75 47.06 59.80 44.85 30.14 16.80

Net working capital 10.00 10.00 10.00 -10.00 -10.00 -10.00 ----

Terminal cash flows 41.00

Net cash flows 140.00 30.00 44.75 57.06 49.80 34.85 20.14 57.80

PV @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 0.432 0.376

PV of cash inflows 140.00 26.100 33.83 37.55 28.49 17.32 8.70 21.73

PV of cash inflows = 173.72

Initial investment = 140.00

NPV = 33.72

10 | P a g e

8. Supreme industries is evaluating a project for which the following information has been

assembled:

a. The total outlay of the project is expected to be Rs. 450 million. This consists of Rs. 250

million of fixed assets and Rs. 200 million of gross current assets.

b. The proposed scheme of financing is as follows: Rs. 100 million of equity, Rs. 200 million

of term loans, Rs. 100 million of working capital advance, and Rs. 50 million of trade

credit.

c. The term loan is repayable in 10 equal semi-annual instalments of Rs. 20 million each.

The first instalment will be due after 18 months. The interest rate on the term loan will

be 15 per cent.

d. The levels of working capital advance and trade credit will remain at Rs. 100 million and

Rs. 50 million respectively till they are paid back or retired at the end of 6 years. The

working capital advance will carry an interest rate of 18 per cent.

e. The expected revenues for the project will be Rs. 500 million per year. The operating

costs are expected to be Rs. 320 million per year. The depreciation rate on the fixed

assets will be 33.33 per cent as per the WDV method.

f. The net salvage value of fixed assets and current assets at the end of the year 6 (the

project life is expected to be 6 years) will be Rs. 80 million and Rs. 200 million

respectively.

g. The tax rate applicable to the firm is 50 per cent.

Determine the cash flows from the point of view of (i) equity funds, (ii) long-term funds,

and (iii) total funds.

Net cash flows relating to equity

Particulars 0 1 2 3 4 5 6

1. Fixed assets (100.00)

2. Revenues 500.00 500.00 500.00 500.00 500.00 500.00

3. Operating costs 320.00 320.00 320.00 320.00 320.00 320.00

4. Depreciation 150.00 100.00 66.67 44.44 29.63 19.75

5. Interest on WC advance 18.00 18.00 18.00 18.00 18.00 18.00

6. Interest on Term loan* 30.00 28.50 22.50 16.50 10.50 4.50

7. Profit before tax (18) 33.50 72.83 101.06 121.87 137.75

8. Tax ---- 16.75 36.42 50.53 60.94 68.88

9. Profit after tax (18) 16.75 36.41 50.53 60.93 68.87

10. Salvage value of FA 80.00

11. Salvage value of CA 200.00

12. Repayment of term loans (40.00) (40.00) (40.00) (40.00) (40.00)

13. Repayment of WC loans (100.00)

14. Retirement of trade credit (50.00)

1. Initial investment (100.00)

2. Operating cash flows(9+4) 132.00 116.75 103.08 94.97 90.56 88.62

3. Retirement and liquidation (40.00) (40.00) (40.00) (40.00) 90.00

cash flows(10+11-12-13-14

Net cash flows (1+2+3) (100.00) 132.00 76.75 63.08 54.97 50.56 178.62

11 | P a g e

Net cash flows relating to Long-term Funds

Particulars 0 1 2 3 4 5 6

1. Fixed assets 250.00

2. Current Assets 150.00

3. Revenues 500.00 500.00 500.00 500.00 500.00 500.00

4. Operating costs 320.00 320.00 320.00 320.00 320.00 320.00

5. Depreciation 150.00 100.00 66.67 44.44 29.63 19.75

6. Interest on WC advance 18.00 18.00 18.00 18.00 18.00 18.00

7. Interest on Term loan* 30.00 28.50 22.50 16.50 10.50 4.50

8. Profit before tax (18) 33.50 72.83 101.06 121.87 137.75

9. Tax ---- 16.75 36.42 50.53 60.94 68.88

10. Profit after tax (18) 16.75 36.41 50.53 60.93 68.87

11. Salvage value of FA 80.00

12. Salvage value of CA 200.00

1. Initial investment 400.00

2. Operating cash 147.00 131.00 114.33 103.22 95.81 90.87

flows9+4+7(1-t)

3. Terminal cash flows 280.00

(11+12)

Net cash flows (1+2+3) 400.00 147.00 131.00 114.33 103.22 95.81 377.87

Particulars 0 1 2 3 4 5 6

1. Fixed assets 250.00

2. Current Assets 200.00

3. Revenues 500.00 500.00 500.00 500.00 500.00 500.00

4. Operating costs 320.00 320.00 320.00 320.00 320.00 320.00

5. Depreciation 150.00 100.00 66.67 44.44 29.63 19.75

6. Interest on WC advance 18.00 18.00 18.00 18.00 18.00 18.00

7. Interest on Term loan* 30.00 28.50 22.50 16.50 10.50 4.50

8. Profit before tax (18) 33.50 72.83 101.06 121.87 137.75

9. Tax ---- 16.75 36.42 50.53 60.94 68.88

10. Profit after tax (18) 16.75 36.41 50.53 60.93 68.87

11. Salvage value of FA 80.00

12. Salvage value of CA 200.00

1. Initial investment 450.00

2. Operating cash flows 156.00 140.00 123.33 112.22 104.81 99.87

(9+4+7(1-t)+6(1-t))

3. Terminal cash flows 280.00

(11+12)

Net cash flows (1+2+3) 450.00 156.00 140.00 123.33 112.22 104.81 379.87

12 | P a g e

Problems on Replacement cash flows

1. OZS Enterprises is considering a project proposal for replacement on an old machine by new

machine. The old machine bought a few years ago has a book value of Rs. 4,00,000 and it

can be sold to realize a post tax salvage value of Rs. 5,00,000. It has a remaining life of five

years after which its net salvage value is expected to be Rs. 1,60,000. It is being depreciated

annually at a rate of 25 per cent under the WDV method. Working capital for the old

machine is Rs. 4,00,000. The new machine costs Rs. 16,00,000. it is expected to fetch a net

salvage value of Rs. 8,00,000 after 5 years, when it will be no longer required. The

depreciation rate applicable to it is 25 per cent under the WDV method. The net working

capital required for the machine is Rs. 5,00,000. The new machine is expected to bring a

saving of Rs. 3,00,000 annually in manufacturing costs. Tax rate applicable to firm is 40 per

cent. Given the above information advice the firm based on incremental after tax cash flow.

Solution is as follows:

Working Note:

Calculation of depreciation as Written Down Value (MDV) method:

Old Machine New Machine

Years Inc. dept

Opening Dept Closing Opening Dept Closing

1 7 (5-3)

value 2 3 value 3 value 4 5 value 6

1 4,00,000 1,00,000 3,00,000 16,00,000 4,00,000 12,00,000 3,00,000

2 3,00,000 75,000 2,25,000 12,00,000 3,00,000 9,00,000 2,25,000

3 2,25,000 56,250 1,68,750 9,00,000 2,25,000 6,75,000 1,68,750

4 1,68,750 42,188 1,26,562 6,75,000 1,68,750 5,06,250 1,26,562

5 1,26,562 31,641 94,921 5,06,250 1,26,563 3,76,687 94,921

Particulars 0 1 2 3 4 5

Initial investment:

Cost of new asset 16,00,000

(+)Inc WC 1,00,000

(-)SV of old asset 5,00,000

Total Initial investment 12,00,000 ----- ----- ----- ----- -----

Operating cash flows:

Incremental Dept 3,00,000 2,25,000 1,68,750 1,26,562 94,921

Post tax savings Inc Dept 1,20,000 90,000 67,500 50,625 37,968

Saving in Manf cost 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000

Post tax savings in MC 1,80,000 1,80,000 1,80,000 1,80,000 1,80,000

Total savings ----- 3,00,000 2,70,000 2,47,500 2,30,625 2,17,968

Terminal cash flows:

SV of New fixed assets 8,00,000

(+)Recovery of WC 1,00,000

(-) SV of old assets 1,60,000

Total terminal cash flows ----- ----- ----- ----- ----- 7,40,000

Net cash flows 12,00,000 3,00,000 2,70,000 2,47,500 2,30,625 9,57,968

13 | P a g e

2. Teja International is determining the cash flow for a project involving replacement of an old

machine by a new machine. The old machine bought a few years ago has a book value of Rs.

8,00,000 and it can be sold to realize a post-tax salvage value of Rs. 9,00,000. It has a

remaining life of five years after which its net salvage value is expected to be Rs. 2,00,000. It

is being depreciated annually at a rate of 25 per cent under the WDV method. The working

capital associated with this machine is Rs.5,00,000.

The new machine costs Rs. 30,00,000. It is expected to fetch a new salvage value of

Rs. 15,00,000 after five years. The depreciated rate applicable to it is 25 per cent under the

WDV method. The net working capital required for the new machine is Rs. 15,60,000 and is

expected to bring a saving of Rs. 6,50,000 annually in manufacturing costs. The tax rate

applicable to the firm is 30 per cent.

a. Estimate the cash flow associated with the replacement project.

b. What is the NPV of the replacement project if cost of capital is 14 per cent?

Solution is as follows:

Working Note:

Calculation of depreciation as Written Down Value (MDV) method:

Old Machine New Machine

Years Inc. dept

Opening Dept Closing Opening Dept Closing

1 7 (5-3)

value 2 3 value 3 value 4 5 value 6

1 8,00,000 2,00,000 6,00,000 30,00,000 7,50,000 22,50,000 5,50,000

2 6,00,000 1,50,000 4,50,000 22,50,000 5,62,500 16,87,500 4,12,500

3 4,50,000 1,12,500 3,37,500 16,87,500 4,21,875 12,65,625 3,09,375

4 3,37,300 84,375 2,53,125 12,65,625 3,16,406 9,49,219 2,32,031

5 2,53,125 63,281 1,89,844 9,49,219 2,37,305 7,11,914 1,74,024

Particulars 0 1 2 3 4 5

Initial investment:

Cost of new asset 30,00,000

(+)Inc WC 1,00,000

(-)SV of old asset 9,00,000

Total Initial investment 22,00,000 ----- ----- ----- ----- -----

Operating cash flows:

Incremental Dept 5,50,000 4,12,500 3,09,375 2,32,031 1,74,024

Post tax savings Inc Dept 1,65,000 1,23,750 92,813 69,609 52,207

Saving in Manf cost 6,50,000 6,50,000 6,50,000 6,50,000 6,50,000

Post tax savings in MC 4,55,000 4,55,000 4,55,000 4,55,000 4,55,000

Total savings ----- 6,20,000 5,78,750 5,47,813 5,24,609 5,07,207

Terminal cash flows:

SV of New fixed assets 15,00,000

(+)Recovery of WC 1,00,000

(-) SV of old assets 2,00,000

Total terminal cash flows ----- ----- ----- ----- ----- 14,00,000

Net cash flows 22,00,000 6,20,000 5,78,750 5,47,813 5,24,609 19,07,207

PV@14% 0.877 0.769 0.675 0.592 0.519

PV of cash flows 22,00,000 5,43,740 4,45,059 3,69,774 3,10,569 9,89,840

14 | P a g e

3. Mahima enterprises considering replacing old machinery by a new machine. The old

machine bought few years ago has a book value of Rs. 90,000 and it can be sold for Rs.

9,000. It has a remaining life of five years after which its net salvage value is expected to be

Rs.10,000. It is being depreciated annually at the rate of 20 per cent as per the WDV

method.

The new machine costs Rs. 4,00,000. It is expected to fetch a net salvage value of Rs.

25,000 after 5 years. It will be depreciated annually at the rate of 25 per cent as per the

WDV method. Investment in working capital will not change with the new machine. The tax

rate for the firm is 35 per cent. Estimate the cash flow associated with the replacement

proposal, assuming other costs remain unchanged and savings of Rs. 1,50,000.

Solution is as follows:

Working Note:

Calculation of depreciation as Written Down Value (MDV) method:

Old Machine New Machine

Years Inc. dept

Opening Dept Closing Opening Dept Closing

1 7 (5-3)

value 2 3 value 3 value 4 5 value 6

1 90,000 18,000 72,000 4,00,000 80,000 3,20,000 62,000

2 72,000 14,400 57,600 3,20,000 64,000 2,56,000 49,600

3 57,600 11,520 46,080 2,56,000 51,200 2,04,800 39,680

4 46,080 9,216 36,864 2,04,800 40,960 1,63,840 31,744

5 36,864 7,373 29,491 1,63,840 32,768 1,31,072 25,395

Particulars 0 1 2 3 4 5

Initial investment:

Cost of new asset 4,00,000

(+)Inc WC -----

(-)SV of old asset 25,000

Total Initial investment 3,75,000 ----- ----- ----- ----- -----

Operating cash flows:

Incremental Dept 62,600 49,600 39,680 31,744 25,395

Post tax savings Inc Dept 21,910 17,360 13,888 11,110 8,888

Saving in Manf cost 1,50,000 1,50,000 1,50,000 1,50,000 1,50,000

Post tax savings in MC 97,500 97,500 97,500 97,500 97,500

Total savings ----- 1,19,410 1,14,860 1,11,388 1,08,610 1,06,388

Terminal cash flows:

SV of New fixed assets 25,000

(+)Recovery of WC -----

(-) SV of old assets 10,000

Total terminal cash flows ----- ----- ----- ----- ----- 15,000

Net cash flows 3,75,000 1,19,410 1,14,860 1,11,388 1,08,610 1,21,388

15 | P a g e

PROBLEMS ON FINANCIAL ANALYSIS

1. Sulabh International is evaluating a project whose expected cash flows are as follows:

Year 0 1 2 3 4 5

Cash flows 10,00,000 1,00,000 2,00,000 3,00,000 6,00,000 3,00,000

a. What is the NPV of the project if the discount rate is 14 per cent for the entire period?

b. What is the NPV of the project if the discount rate is 12 per cent for 1st year and rises every

year by 1 per cent?

Solution is as follows:

a. NPV of the project if discount rate if 14 per cent.

NPV = Present value of cash inflows – Initial Investment

NPV = (-) 45,100

*Calculation of PV of cash inflows:

Years Inflows PV of rupee PV of inflows

1 1,00,000 0.877 87,700

2 2,00,000 0.769 1,53,800

3 3,00,000 0.675 2,02,500

4 6,00,000 0.592 3,55,200

5 3,00,000 0.519 1,55,700

Total inflows 9,54,900

Less: Initial investment -10,00,000

NPV -45,100

NPV = Present value of cash inflows – Initial Investment

NPV = (-) 1,17,300

*Calculation of PV of cash inflows:

Years Inflows PV of rupee PV of inflows

1 1,00,000 0.877 87,700

2 2,00,000 0.756 1,51,200

3 3,00,000 0.641 1,92,300

4 6,00,000 0.534 3,20,400

5 3,00,000 0.437 1,31,100

Total inflows 8,82,700

Less: Initial investment -10,00,000

NPV -1,17,300

In both the cases project NPV is of negative value. So, the project is not feasible.

16 | P a g e

2. What is the IRR of an investment which involves a current outlay of Rs. 3,00,000 and results in

annual cash inflow of Rs. 60,000 for 7 years.

Solution is as follows:

Steps in calculating IRR

a. Calculation of PBP

Initial Investment

PBP

Average Annual cash inf lows

3,00,000

PBP 5 years

60,000

b. By referring table – 4 (PVIFA), PBP of 5 falls in between 8% and 10% in 7th year row. Since

it is of annuity cash flows, PV of 8% and 10% can be calculated as follows:

PV @ LDF (8%) = 60,000 x 5.206 = 3,12,360

PV @ HDF (10%) = 60,000 x 4.868 = 2,92,080

c. IRR as follows:

IRR LDF

PV @ LDF Initial Investment x HDF LDF

PV @ LDF PV @ HDF

3,12,360 3,00,000

IRR 8 x 10 8

3,12,360 2,92,080

12,360

IRR 8 x2

20,280

IRR 8 1.219 9.219%

3. What is the NPV of following cash flow stream at 12% discount rate?

Years 0 1 2

Cash flow (3,000) 9,000 (3,000)

Solution is as follows:

Note: cash flows should not be converted into present value for negative cash flows

1 9,000 0.893 8,037

2 -3,000 --- -3,000

Total cash flows 5,037

Less: initial investment 3,000

NPB 2,037

17 | P a g e

4. The cash flows of a project are given below:

Years 0 1 2 3 4

Cash flow -8,000 2,000 -1,000 10,000 2,000

Calculate IRR for this project. Also calculate the un-recovered investment balance at the end of

each year.

a. Calculation of PBP

Initial Investment

PBP

Average Annual cash inf lows

8,000

PBP 2.462 years

3,250

b. By referring table – 4 (PVIFA), PBP of 2.462 falls in between 16% and 20% in 4th year row. Since

it is of annuity cash flows, PV of 16% and 20% can be calculated as follows:

PV@LDF = (2,000 x 0.862) + (-1,000) + (10,000 x 0.641) + (2,000 x 552) = Rs. 8,239

PV@HDF = (2,000 x 0.833) + (-1,000) + (10,000 x 0.579) + (2,000 x 482) = Rs. 7,420

c. IRR as follows:

IRR LDF

PV @ LDF Initial Investment x HDF LDF

PV @ LDF PV @ HDF

8,239 8,000

IRR 16 x 20 16

8,239 7,420

239

IRR 16 x2

819

IRR 16 0.584 16.584%

d. Unrecovered Investment Balance

Years Unrecovered Interest for Cash flow at the Unrecovered

balance at the the year end of the year balance at the

beginning end of the year

1 8000 1,327 2,000 7,327

2 7,327 1,215 -1,000 9,542

3 9,542 1,582 10,000 1,124

4 1,124 186 2,000 (690)

18 | P a g e

5. Phoenix Company is considering two mutually exclusive investments, project ‘P’ and project ‘Q’.

The expected cash flows of these projects are as follows:

Years 0 1 2 3 4 5

Cash flow (project P) (1,000) (1,200) (600) (250) 2,000 4,000

Cash flow (project Q) (1,600) 200 400 600 800 100

a. Construct the NPV profiles for projects P and Q.

b. What is the IRR of each project?

c. Which project would you choose if the cost of capital is 10 per cent?

d. What is each project MIRR if the cost of capital is 12 per cent?

Solution is as follows:

a. NPV

Project A = PV of cash inflows – Initial Investment

PV of cash flows = (2,000 x 0.683) + (4,000 x 0.621) = Rs. 3,850

Initial Investment = (1,000) + (1,200 x 0.909) + (600 x 0.826) + (250 x 751) = Rs. 2,775

NPV = 3,850 – 2,775 = 1,075

Project B = PV of cash inflows – Initial Investment

PV of inflow= (200 x 0.909) + (400 x 0.826) + (600 x 0.751) + (800 x 0.683) + (100 x 0.621) = 1,571

Initial Investment = 1,600

NPV = 1,600 – 1,571 = 29

b. Calculation of IRR

PROJECT – A

a. Calculation of PBP

2,775

PBP 0.925 years

3,000

b. By referring table – 4 (PVIFA), PBP of 2.3125 falls exactly at 8%. So, IRR of the project is

8%.

PROJECT – B

a. Calculation of PBP

1,600

PBP 3.810 years

420

b. By referring table – 4 (PVIFA), PBP of 3.810 falls between 9% and 11%. Since its

cash flows are of single value, need to determine PV at 9% and 11% by referring

table 3 (single amount).

Years Inflows PV@9% PV@11% PV of LDF PV of HDF

1 200 0.917 0.901 183 180

2 400 0.842 0.812 337 325

3 600 0.772 0.731 463 439

4 800 0.708 0.659 566 527

5 100 0.650 0.593 65 59

1,614 1,530

IRR as follows:

19 | P a g e

IRR LDF

PV @ LDF Initial Investment x HDF LDF

PV @ LDF PV @ HDF

1,614 1,600

IRR 9 x 11 9

1,614 1,530

14

IRR 9 x 2

84

IRR 9 0.33 9.33%

c. Among both the projects, project A is more profitable since its NPV is greater.

d. MIRR is as follows:

Project A

TV

PVC

1 MIRR n

PVC 2,775

TV 2,000 x 1.120 4,000 x 1 2,240 4,000 6,240

6,240

2,775

1 MIRR 5

1 MIRR 5 6,240

2,775

1 MIRR 5 2.249

1 MIRR 2.249 5

1

Project B

TV

PVC

1 MIRR n

PVC 1,600

TV 200 x 1.574 400 x 1.405 600 x 1.254 800 x 1.120 100 x 1

TV 315 562 752 896 100 2,625

2,625

1,600

1 MIRR 5

1 MIRR 5 2,625

1,600

1 MIRR 5 1.641

1 MIRR 1.641 5

1

20 | P a g e

6. The Alpha company limited is considering setting of two projects A and B. The investment

outlays and cash inflows from the projects are expected as below:

Years 0 1 2 3 4 5

Project A 4,00,000 40,000 1,20,000 1,60,000 2,40,000 1,60,000

Project B 4,50,000 1,20,000 1,60,000 2,00,000 1,20,000 80,000

The company has a target of return on capital of 10 per cent and on this basis, you are required

to compare the profitability of the projects and state which alternative you consider financially

more profitable.

Solution is as follows:

To select the project based upon more profitable one, NPV of both the project has to be

calculated.

NPV of Project A

Years Inflows PV@10% PV of cashflows

1 40,000 0.909 36,360

2 1,20,000 0.826 99,120

3 1,60,000 0.751 1,20,160

4 2,40,000 0.683 1,63,920

5 1,60,000 0.621 99,360

PV of cash flows 5,19,370

Less: initial investment 4,00,000

Net Present Value 1,19,370

NPV of Project B

Years Inflows PV@10% PV of cashflows

1 1,20,000 0.909 1,09,080

2 1,60,000 0.826 1,32,160

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

4 1,20,000 0.683 81,960

5 80,000 0.621 49,680

PV of cash flows 5,23,080

Less: initial investment 4,50,000

Net Present Value 73,080

7. Your company is considering two projects, M and N, each of which requires an initial outlay of

Rs. 50 million. The expected cash inflows from these projects are as follows:

Year 1 2 3 4

Project A 11 million 9 million 32 million 37 million

Project B 38 million 22 million 18 million 10 million

If the projects are mutually exclusive and cost of capital is 10 per cent, which project should the

firm invest in? If the projects are mutually exclusive and cost of capital is 14 per cent. What is

the MIRR of each project?

21 | P a g e

Solution is as follows:

On the basis of NPV projects has to be selected:

NPV of Project A

Years Inflows PV@10% PV of cashflows

1 11 0.909 10

2 9 0.826 7

3 32 0.751 24

4 37 0.683 25

PV of cash flows 66

Less: initial investment 50

Net Present Value 16

NPV of Project B

Years Inflows PV@10% PV of cashflows

1 38 0.909 35

2 22 0.826 18

3 18 0.751 14

4 10 0.683 7

PV of cash flows 74

Less: initial investment 50

Net Present Value 24

e. MIRR is as follows:

Project A

TV

PVC

1 MIRR n

PVC 50

TV 11 x 1.482 9 x 1.300 32 x 1.140 37 x 1

TV 16 12 36 37 101

101

50

1 MIRR 5

1 MIRR 4 101

50

1 MIRR 2.02

4

1 MIRR 2.02 4

1

22 | P a g e

Project B

TV

PVC

1 MIRR n

PVC 50

TV 38 x 1.482 22 x 1.300 18 x 1.140 10 x 1

TV 56 29 21 10 116

116

50

1 MIRR 4

1 MIRR 4 116

50

1 MIRR 2.32

5

1 MIRR 2.32 5

1

8. Calculate MIRR for Pentagon limited from the following cash flow stream. Cost of capital 15 per

cent:

Years 0 1 2 3 4 5 6

Cash flows (millions) -120 -80 20 60 80 100 120

Solution is as follows:

TV

PVC

1 MIRR n

PVC [120 [ 80 x 0.870] 120 69.60 189.60

TV 20 x 1.749 60 x 1.521 80 x 1.322 100 x 1.150 120

TV 34.98 91.26 105.76 115 120 467

467

189.60

1 MIRR 6

1 MIRR 6 467

189.60

1 MIRR 2.463

5

1 MIRR 2.463 6

1

23 | P a g e

9. The cash flow stream of a project is given below:

Year 0 1 2 3 4

Cash flows -8,000 2,000 -1,000 10,000 2,000

Calculate the IRR for the project. Define the unrecovered investment balance at the end of each

year.

a. Calculation of PBP

8,000

PBP 2.462 years

3,250

b. By referring table – 4 (PVIFA), PBP of 2.462 falls between 20% and 24%. Since its

cash flows are of single value, need to determine PV at 20% and 24% by referring

table 3 (single amount).

Years Inflows PV@16% PV@20% PV of LDF PV of HDF

1 2,000 0.862 0.833 1,724 1,666

2 -1,000 0.743 0.694 -1,000 -1,000

3 10,000 0.641 0.579 6,410 5,790

4 2,000 0.552 0.482 1,104 964

8,238 7,420

IRR as follows:

IRR LDF

PV @ LDF Initial Investment x HDF LDF

PV @ LDF PV @ HDF

8,238 8,000

IRR 16 x 20 16

8,238 7,420

238

IRR 16 x4

818

IRR 16 1.164 17.164%

Unrecovered Investment Balance

Years Unrecovered Interest for Cash flow at the Unrecovered

balance at the the year end of the year balance at the

beginning end of the year

1 8,000 1,373 2,000 7,373

2 7,373 1,266 -1,000 9,639

3 9,639 1,654 10,000 1,293

4 1,293 222 2,000 (485)

24 | P a g e

10. Consider a set of five projects:

Project M N O P Q

Initial outlay 50,000 1,00,000 1,20,000 1,50,000 2,00,000

Cash flows 18,000 50,000 30,000 40,000 30,000

Project life 10 4 8 16 25

Rank the five projects on the dimensions of NPV and BCR. The discount rate is 10 per cent.

Solution is as follows: as the cash flows are given only for one year, it can be assumed as

annuity cash flows:

Net Present Value:

Project M

NPV = PV of cash inflows – Initial Investment

NPV = [18,000 x 6.145] – 50,000 = 1,10,610 – 50,000 = 60,610 Rank – 3

Project N

NPV = [50,000 x 3.170] – 1,00,000 = 1,58,500 – 1,00,000 = 58,500 Rank – 4

Project O

NPV = [30,000 x 5.335] – 1,20,000 = 1,60,050 – 1,20,000 = 40,050 Rank – 5

Project P

NPV = [40,000 x 7.824] – 1,50,000 = 3,12,960 – 1,50,000 = 1,62,960 Rank – 1

Project Q

NPV = [30,000 x 9.077] – 2,00,000 = 2,72,310 – 2,00,000 = 72,310 Rank – 2

BCR (PI)

PI = PV of cash inflows / Initial investment

Project M = 1,10,610 / 50,000 = 2.21 Rank – 1

Project N = 1,58,500 / 1,00,000 = 1.585 Rank – 3

Project O = 1,60,050 / 1,20,000 = 1.334 Rank – 4

Project P = 3,12,960 / 1,50,000 = 2.0864 Rank – 2

Project Q = 2,72,310 / 2,00,000 = 1.362 Rank – 5

25 | P a g e

11. MB Ltd., has a capital budget constraint of Rs.30,00,000. From the following projects under

review, project B and C are mutually exclusive. Other projects are independent. After carefully

examining the following information, advice the company.

Project A B C D E

Outlay 18,00,000 15,00,000 12,00,000 7,50,000 6,00,000

NPV (rs) 7,50,000 6,00,000 5,00,000 3,60,000 3,00,000

Solution is as follows:

A 18,00,000 7,50,000

B 15,00,000 6,00,000

C 12,00,000 5,00,000

D 7,50,000 3,60,000

E 6,00,000 3,00,000

A&C 30,00,000 12,50,000

A&D 25,50,000 11,10,000

A&E 24,00,000 10,50,000

B&D 22,50,000 9,60,000

B&E 21,00,000 9,00,000

C&D 19,50,000 8,60,000

C&E 18,00,000 8,00,000

D&E 13,50,000 6,60,000

B, D & E 28,50,000 12,60,000

C, D & E 25,50,000 11,60,000

26 | P a g e

12. Five projects A, B, C, D and E are available to a company. The details are tabulated:

Project A B C D E

Outlay 20,000 50,000 75,000 1,00,000 1,50,000

Annual Cash inflow 6,000 8,000 15,000 15,000 25,000

Life in years 5 10 8 12 7

Salvage value 5,000 ---- ---- 15,000 50,000

Project B is a prerequisite for project E and project C and D are mutually exclusive. Otherwise

the projects are independent. If the cost of capital of the firm is 10 per cent, which project

should be chosen at the following budget levels: Rs. 2,00,000 and Rs. 2,50,000? Assume that the

decision criterion in the NPV. Use feasible combination approach.

Solution is as follows:

Based upon NPV of the project, the feasible combination can be known. So, we need to

determine NPV of all the given projects. The cash flows of the projects are given only for one

year. It can be assumed as annuity values.

Project A B C D E

a. Initial Investment 20,000 50,000 75,000 1,00,000 1,50,000

b. Annual Cash inflow 6,000 8,000 15,000 15,000 25,000

c. Life in years 5 10 8 12 7

d. Salvage value 5,000 ----- ----- 15,000 50,000

e. PVIFA 3.791 6.145 5.335 6.814 4.868

f. PV of cash inflows [b x e] 22,746 49,160 80,025 1,02,210 1,21,700

g. PVIF 0.621 0.386 0.467 0.319 0.513

h. PV of salvage value [d x g] 3,105 ----- ----- 4,785 25,650

i. Total cash flows [f + h] 25,851 49,160 80,025 1,06,995 1,47,350

NPV [i – a] 5,851 -840 5,025 6,995 -2,650

Ranking II IV III I V

Feasible combination for Rs. 2,00,000

a. Let us select project ‘D’ which has I rank. Its initial investment is Rs. 1,00,000.

Now we will be left out with Rs. 1,00,000 (2,00,000 – 1,00,000)

b. Now we select Project ‘A’ which has II rank. Its initial investment is Rs. 20,000.

Now we will be left out with Rs. 80,000 (1,00,000 – 20,000)

c. We can’t select Project ‘C’, because ‘C’ and ‘D’ are mutually exclusive and we

have already selected ‘D’

d. ‘B’ and ‘E’ can’t be selected because they are complimentary, i.e., we should

select both; but it is impossible to select since its outlay exceeds 80,000

[50,000 + 1,50,000]

Therefore for investment of Rs. 2,00,000 budget level; project ‘A’ & ‘D’ should be

selected

Feasible combination for Rs. 2,50,000

Similarly for investment of Rs. 2,50,000 budget level also projects ‘A’ & ‘D’ should be

selected

27 | P a g e

13. A company is considering two mutually exclusive investments, projects X and Y. the expected

cash flows of these projects are as follows:

Years 0 1 2 3 4 5

Project X (5,000) -2,500 300 2,000 5,000 6,000

Project Y (2,500) 800 1,000 2,000 2,000 1,500

Which project should it chose if the cost of capital is 15 per cent and 45 per cent?

Solution is as follows:

Based upon NPV, the projects has to be selected

Project X Project Y

Years

Inflows PV @ 15% PV of inflows Inflows PV @ 15% PV of inflows

1 -2,500 0.870 -2,175 800 0.870 696

2 300 0.756 227 1,000 0.756 756

3 2,000 0.658 1,316 2,000 0.658 1,316

4 5,000 0.572 2,860 2,000 0.572 1,144

5 6,000 0.497 2,982 1,500 0.497 746

PV of cash inflows 5,210 PV of cash inflows 4,658

Less: initial investment 5,000 Less: Initial investment 2,500

NPV 210 NPV 2,158

If cost of capital is 15%, Project ‘Y’ is to be choosed since its NPV is more than Project ‘X’

Project X Project Y

Years

Inflows PV @ 45% PV of inflows Inflows PV @ 45% PV of inflows

1 -2,500 0.690 -1,725 800 0.690 552

2 300 0.476 143 1,000 0.476 476

3 2,000 0.328 656 2,000 0.328 656

4 5,000 0.226 1,130 2,000 0.226 452

5 6,000 0.156 936 1,500 0.156 234

PV of cash inflows 1,140 PV of cash inflows 2,370

Less: initial investment 5,000 Less: Initial investment 2,500

NPV -3,860 NPV -130

Both the project are having Negative NPV they should not be considered for investment

28 | P a g e

SENSITIVITY ANALYSIS

14. Prepare a sensitivity analysis statement from the following information pertaining to a project:

Particulars Rs in million (years 10)

Investment (250)

Sales 200

Variable costs (60 % of sales) 120

Fixed costs 20

Depreciation 25

Pre-tax profits 35

Taxes 10

Profit after taxes 25

Cash flow from operations 50

Net cash flow 50

What is the NPV of the project assuming a cost of capital of 13 per cent? The range of values of

the underlying variables can be taken as shown under:

Investment 300 250 200

Variable cost (% of sales) 65 60 56

Solution is as follows:

Calculation of NPV for Expected

NPV = PV of inflow – PV of outflow

NPV = CF [PVIFA] – Co

NPV = [50 x 5.426] – 250 = 21.30 Millions

tax paid 10

Tax rate x 100 x 100 28.57%

PBT 35

Investment [300] [200]

a. Sales 200 200

b. Less: variable cost 120 120

c. Contribution 80 80

d. Less: Fixed Cost 20 20

e. EBIT 60 60

f. Less: Depreciation (cost / life) 30 20

g. PBT 30 40

h. Less: Tax 8.571 11.428

i. PAT 21.429 28.572

j. Add: Depreciation 30 20

k. Cash flows 51.429 48.572

NPV when investment is Rs. 300 = [51.429 x 5.426] – 300 = -20.79

NPV when investment is Rs. 200 = [48.572 x 5.4260 – 200 = 63.55

29 | P a g e

When the underlying variable is Variable Cost as a % of sales

Variable cost 65% of sales 56% of sales

Investment [250] [250]

a. Sales 200 200

b. Less: variable cost 130 112

c. Contribution 70 88

d. Less: Fixed Cost 20 20

e. EBIT 50 68

f. Less: Depreciation (cost/life) 25 25

g. PBT 25 43

h. Less: Tax (28.57%) 7.143 12.285

i. PAT 17.857 30.715

j. Add: Depreciation 25 25

k. Cash flows 42.857 55.715

NPV when investment is Rs. 300 = [42.857 x 5.426] – 250 = -17.46

NPV when investment is Rs. 200 = [55.715 x 5.426] – 250 = 52.31

15. Ajeet Corporation is considering the risk characteristics of a certain project. The firm has

identified that the following factors, with their respective expected values, have a bearing on

the NPV of this project:

Particulars Amount

Initial investment 30,000

Cost of capital 10%

Units produced and sold 1,400

Price per unit 30

Variable cost per unit 20

Fixed costs 3,000

Depreciation 2,000

Tax rate 50%

Life of the project 5 years

Net salvage value Nil

Assume that the following underlying variables can take the values as shown below:

Underlying variable Pessimistic Optimistic

Units produced and sold 800 1,800

Variable cost (% of sales) 15 40

Price per unit 20 50

Calculate the sensitivity of the net present value to variations in the above underlying variables.

Solution is as follows:

NPV is to be calculated initially for Expected values and then for underlying variables

30 | P a g e

Determination of NPV for expected value

a. Sales revenue (1,400 x 30) 42,000

b. Less: Variable cost (1,400 x 20) 28,000

c. Contribution 14,000

d. Less: fixed cost 3,000

e. PBDT 11,000

f. Less: Depreciation 2,000

g. PBT 9,000

h. Less: Tax (50%) 4,500

i. PAT 4,500

j. Add: depreciation 2,000

k. Cash flows 6,500

NPV = PV of cash inflow – Initial Investment

NPV = [6,500 x 3.791] – 30,000 -5,358.50

Amount Amount

Particulars (life 5 years) (pessimistic) (optimistic)

800 units 1,800 units

a. Sales revenue (price Rs. 30 each) 24,000 54,000

b. Less: Variable cost (cost Rs. 20 each) 16,000 36,000

c. Contribution 8,000 18,000

d. Less: fixed cost 3,000 3,000

e. PBDT 5,000 15,000

f. Less: Depreciation 2,000 2,000

g. PBT 3,000 13,000

h. Less: Tax (50%) 1,500 6,500

i. PAT 1,500 6,500

j. Add: depreciation 2,000 2,000

k. Cash flows 3,500 8,500

NPV = PV of cash inflow – Initial Investment

NPV = [3,500 x 3.791] – 30,000 -16,731.50

NPV = [8,500 x 3.791] – 30,000 2,223.50

31 | P a g e

Determination of NPV for underlying variable [changes in price per unit]

Amount Amount

Particulars (life 5 years) (pessimistic) (optimistic)

Price Rs. 20/unit Price Rs. 50/unit

a. Sales revenue (units 1,400) 28,000 70,000

b. Less: Variable cost (cost Rs. 20 each) 28,000 28,000

c. Contribution 00,000 42,000

d. Less: fixed cost 3,000 3,000

e. PBDT -3,000 39,000

f. Less: Depreciation -2,000 2,000

g. PBT -5,000 37,000

h. Less: Tax (50%)* 2,500* 18,500

i. PAT -2,500 18,500

j. Add: depreciation 2,000 2,000

k. Cash flows -500 20,500

NPV = PV of cash inflow – Initial Investment

NPV = [-500 x 3.791] – 30,000 -31,895.50

NPV = [20,500 x 3.791] – 30,000 47,715.50

*calculation of Tax: as discussed earlier, on expenditure tax saving will be equal to the

percentage of tax paid (50%). 50% of PBT [5,000 x 50%] = Rs. 2,500

Determination of NPV for underlying variable [changes in variable cost per unit]

Amount Amount

Particulars (life 5 years) (pessimistic) (optimistic)

VC Rs. 15/unit VC Rs. 40/unit

a. Sales revenue (1,400 x 30) 42,000 42,000

b. Less: Variable cost 21,000 -56,000

c. Contribution 21,000 -14,000

d. Less: fixed cost 3,000 -3,000

e. PBDT 18,000 -17,000

f. Less: Depreciation 2,000 -2,000

g. PBT 16,000 -19,000

h. Less: Tax (50%)* 8,000 9,500*

i. PAT 8,000 -9,500

j. Add: depreciation 2,000 2,000

k. Cash flows 10,000 -7,500

NPV = PV of cash inflow – Initial Investment

NPV = [10,000 x 3.791] – 30,000 7,910

NPV = [-7,500 x 3.791] – 30,000 -58,432.50

*calculation of Tax: as discussed earlier, on expenditure tax saving will be equal to the

percentage of tax paid (50%). 50% of PBT [19,000 x 50%] = Rs. 9,500

32 | P a g e

16. Following information is given about revenue and cost for a company `XYZ`

Particulars Year ‘0’ Year ‘1 to 10’

Investments 20,000

Sales ---- 18,000

rd

Variable costs (2/3 of sales) 12,000

Fixed costs ----- 1,000

Depreciation (10% fixed) 2,000

a. Assuming that the cost of capital is 12 per cent and tax rate at 33.33 per cent, calculate the

NPV.

b. Calculate the effect of variation in investment. Assume investment under two situations; (a)

Rs. 24,000, and (b) Rs. 18,000

c. Assuming equal probability of all the three investment amounts, what is the risk of the

project in term of standard deviation of NPV?

Particulars Amount

Sales 18,000

Less: variable cost 12,000

Contribution 6,000

Less: fixed cost 1,000

PBDT 5,000

Less: Depreciation 2,000

PBT 3,000

Less: tax 1,000

PAT 2,000

Add: depreciation 2,000

Inflows 4,000

PVIFA [12%, 10 years] 5.65

NPV = PV of inflows – Initial investment

PV of inflows = [inflows x PVIFA] 22,600

Less: Initial Investment 20,000

NPV 2,600

Investment 24,000 18,000

Sales 18,000 18,000

Less: variable cost 12,000 12,000

Contribution 6,000 6,000

Less: fixed cost 1,000 1,000

PBDT 5,000 5,000

Less: Depreciation [cost / life] 2,400 1,800

PBT 2,600 3,200

Less: Tax 867 1,067

PAT 1,733 2,133

33 | P a g e

Add: depreciation 2,400 1,800

Inflows 4,133 3,933

PVIFA [12%, 10 years] 5.65 5.65

NPV = PV of inflows – Initial investment

PV of inflows = [inflows x PVIFA] 23,354 22,224

Less: Initial Investment 24,000 18,000

NPV -646 4,224

Determination of SD of NPV having equal probability of all the three investment amounts

2 2

(NPVxP)

2,600 1/3 867 540 2,91,600 97,200

-646 1/3 -215 -2,706 73,22,436 24,40,812

4,224 1/3 1,408 2,164 46,82,896 15,60,965

2,060 40,98,977

SD NPV NPV 2

SD 40,98,977

SD 2,024.59

34 | P a g e

SCENARIO ANALYSIS

1. Mitsubishi Corporation has a project to be evaluated under three different scenarios. It wants to

manufacture a component used in the manufacture of machinery. In all the scenarios, the initial

investment is Rs. 80,00,000. The unit selling price is Rs. 1,500, Rs. 1,000 and Rs. 3,000 in three

scenarios. The demand is 4,000 units, 7,000 units and 3,000 units and the variable costs are Rs.

50, Rs. 60 and Rs. 70 per unit under three scenarios. Fixed costs are Rs. 5,00,000 and

depreciation is Rs. 3,00,000. The tax rate is 50 per cent.

What is the NPV under the three scenarios if the life of the asset is 5 years and the discount rate

is 24 per cent.

Solution is as follows:

Particulars Scenario 1 Scenario 2 Scenario 3

Initial investment 80,00,000 80,00,000 80,00,000

SP price unit 1,500 1,000 3,000

Demand (units) 4,000 7,000 3,000

VC per unit 50 60 70

Statement showing the NPV of three scenarios

Sales 60,00,000.00 70,00,000.00 90,00,000.00

Less: variable cost 75,000.00 60,000.00 2,10,000.00

Contribution 59,25,000.00 69,40,000.00 87,90,000.00

Less: fixed cost 5,00,000.00 5,00,000.00 5,00,000.00

PBDT 54,25,000.00 64,40,000.00 82,90,000.00

Less: depreciation 3,00,000.00 3,00,000.00 3,00,000.00

PBT 51,25,000.00 61,40,000.00 79,90,000.00

Less: tax [50%] 25,62,500.00 30,70,000.00 39,95,000.00

PAT 25,62,500.00 30,70,000.00 39,95,000.00

Add: depreciation 3,00,000.00 3,00,000.00 3,00,000.00

Cash inflows 28,62,500.00 33,70,000.00 42,95,000.00

PVIFA[24%, 5 years] 2.745.00 2.745 2.745

PV of cash inflows 78,57,562.50 92,50,650.00 1,17,89,775.00

Less: initial investment 80,00,000.00 80,00,000.00 80,00,000.00

NPV -1,42,437.50 12,50,650.00 37,89,775.00

35 | P a g e

PROBLEMS ON HILLIER MODEL

1. A project involving an outlay of Rs. 10 million has the following benefits associated with it.

Given that the cash flows are independent and the risk free rate is 10 per cent, determine

the expected NPV and the standard deviation of NPV:

Year 1 Year 2 Year 3

CF (million) Prob. CF (million) Prob. CF (million) Prob.

4 0.4 5 0.4 3 0.3

5 0.5 6 0.4 4 0.5

6 0.1 7 0.2 5 0.2

Solution is as follows:

Determination of expected cash flows and expected for all the years. Determine NPV of the

whole project taking year wise cash flows.

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

4 0.4 1.60 -0.70 0.49 0.196

5 0.5 2.50 0.30 0.09 0.045

6 0.1 0.60 1.30 1.69 0.169

4.70 0.41

SD CF CF xP

2

0.41 0.64

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

5 0.40 2.00 -0.80 0.64 0.256

6 0.40 2.40 0.20 0.04 0.016

7 0.20 1.40 1.20 1.44 0.288

5.80 0.56

SD CF CF xP

2

0.56 0.75

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

3 0.30 0.90 -0.90 0.81 0.243

4 0.50 2.00 0.10 0.01 0.005

5 0.20 1.00 1.10 1.21 0.242

3.90 0.49

SD CF CF xP

2

0.49 0.70

36 | P a g e

Summary of all the three year variables

Year Expected CF 2

1 4.70 0.64 0.41

2 5.80 0.75 0.56

3 3.90 0.70 0.49

Calculation of NPV

n

CFt

NPV Initial Investment

t 1 1 r t

NPV CF1 PVIF10%,1 yr CF1 PVIF10%, 2 yr CF1 PVIF10%, 3 yr Initial investment

NPV 4.70 0.909 5.800.826 3.900.751 10

NPV [4.272 4.791 2.929] 10

NPV 1.992 million

Determination of NPV

n

t2

NPV

t 1 1 r 2 xt

NPV t 2 PVIF 2 x1 t 2 PVIF 2 x 2 t 2 PVIF 2 x 3

NPV 0.410.826 0.56 0.683 0.49 0.564

NPV 0.339 0.382 0.276

NPV 0.997

NPV 0.998

37 | P a g e

2. Ujwal lamps Company is considering an investment project which has life of four years. The

cost of the project is Rs. 10,000 and the possible cash flows are as follows:

Year 1 Year 2 Year 3 Year 4

CF (mn) Prob. CF (mn) Prob. CF (mn) Prob. CF (mn) Prob.

2,000 0.2 3,000 0.4 4,000 0.3 2,000 0.2

3,000 0.5 4,000 0.3 5,000 0.5 3,000 0.4

4,000 0.3 5,000 0.3 6,000 0.2 4,000 0.4

The cash flows of various years are independent and the risk-free discount rate (post tax) is 6

per cent.

a. What is the expected NPV?

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

2,000 0.20 400 -1,100 12,10,000 2,42,000

3,000 0.50 1,500 100 10,000 5,000

4,000 0.30 1,200 900 8,10,000 2,43,000

3,100 4,90,000

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

3,000 0.40 1,200 -900 8,10,000 3,24,000

4,000 0.30 1,200 100 10,000 3,000

5,000 0.30 1,500 1,100 12,10,000 3,63,000

3,900 6,90,000

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

4,000 0.30 1,200 -900 8,10,000 2,43,000

5,000 0.50 2,500 100 10,000 5,000

6,000 0.20 1,200 1,100 12,10,000 2,42,000

4,900 4,90,000

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

2,000 0.20 400 -1,200 14,40,000 2,88,000

3,000 0.40 1,200 -200 40,000 16,000

4,000 0.40 1,600 800 6,40,000 2,56,000

3,200 5,60,000

38 | P a g e

Summary of all the three year variables

Year Expected CF 2

1 3,100 4,90,000

2 3,900 6,90,000

3 4,900 4,90,000

4 3,200 5,60,000

Calculation of NPV

n

CFt

NPV Initial Investment

t 1 1 r t

NPV CF1 PVIF6%,1 yr CF1 PVIF6%, 2 yr CF1 PVIF6%, 3 yr CF1 PVIF6%, 4 yr II

NPV 3,100 0.943 3,9000.890 4,9000.839 3,200 0.792 10,000

NPV [2,923 3,471 4,111 2,534] 10,000

NPV 3,039 million

Determination of NPV

n

t2

NPV

t 1 1 r 2 xt

NPV t 2 PVIF 2 x1 t 2 PVIF 2 x 2 t 2 PVIF 2 x 3 t 2 PVIF 2 x 4

NPV 4,90,000 0.890 6,90,000 0.792 4,90,000 0.705 5,60,000 0.627

NPV 4,36,100 5,46,480 3,45,450 3,51,120

NPV 16,79,150

NPV 1,295.82

39 | P a g e

3. Janakiram is considering an investment which requires a current outlay of Rs. 25,000. The

expected value and standard deviation of cash flows are:

Year Expected value Standard deviation

1 12,000 5,000

2 10,000 6,000

3 9,000 5,000

4 8,000 6,000

The cash flows are perfectly correlated. Calculate the expected net present value and standard

deviation of net present value of this investment, if the risk-free interest rate is 8 per cent.

Calculation of NPV

n

CFt

NPV Initial Investment

t 1 1 r t

NPV CF1 PVIF8%,1 yr CF1 PVIF8%, 2 yr CF1 PVIF8%, 3 yr CF1 PVIF8%, 4 yr II

NPV 12,000 0.926 10,0000.857 9,0000.794 8,000 0.735 25,000

NPV [11,112 8,570 7,146 5,880] 25,000

NPV 7,708

Determination of NPV

n

t

NPV

t 1 1 r t

NPV 1 PVIF8%,1 yr 2 PVIF8%, 2 yr 3 PVIF8%, 3 yr 4 PVIF8%, 4 yr

NPV 5,000 0.926 6,000 0.857 5,000 0.794 6,000 0.735

NPV 4,630 5,142 3,970 4,410

NPV 18,152

40 | P a g e

4. A company is evaluating two projects. The probability distribution as also the likely NPVs for

each of these projects is furnished below:

Project A Prob Project B Prob

4,000 0.2 4,000 0.15

8,000 0.3 8,000 0.35

11,000 0.3 11,000 0.35

14,250 0.2 14,000 0.15

Determine:

a. Expected NPV of the two projects.

b. Risk attached to each of these projects.

c. Which project would you prefer and why?

Solution is as follows:

Project A

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

4,000 0.20 800 -5,350 2,86,22,500 57,24,500

8,000 0.30 2,400 -1,350 18,22,500 5,46,750

11,000 0.30 3,300 1,650 27,22,500 8,16,750

14,250 0.20 2,850 4,900 2,40,10,000 48,02,000

9,350 1,18,90,000

2

SD CF CF xP 1,18,90,000 3,448.19 is risk

Project B

CF P CF CF CF CF CF CF CF xP

2 2

(CFxP)

4,000 0.15 600 -5,350 2,86,22,500 42,93,375

8,000 0.35 2,800 -1,350 18,22,500 6,37,875

11,000 0.35 3,850 1,650 27,22,500 9,52,875

14,000 0.15 2,100 4,650 2,16,22,500 32,43,375

9,350 91,27,500

2

SD CF CF xP 91,27,500 3,021.17 is risk

Project ‘B’ should be preferred since it has less risk when compared to Project ‘A’

41 | P a g e

5. Kejriwal Company is considering two mutually exclusive investment A and B. investment A

requires an outlay of Rs. 10,000 and generates a net cash flow of Rs. 3,000 for six years.

Investment B requires an outlay of Rs. 30,000 and generates a net cash flow of Rs. 11,000

for five years. The required rates of return on these investments are 12 per cent (for A) and

14 per cent (for B). Which of these two the firm chose?

Solution is as follows:

Based upon NPV the projects have to be chosen.

NPV PV of cashinf low Initial investment

PV of cash inf low Net cash flows PVIFA6 yrs,12%

PROJECT A

NPV [3,000 x 4.111] 10,000

NPV 2,333

PROJECT B

NPV [11,000 x 3.433] 30,000

NPV 7,763

42 | P a g e

6. After carefully assessing the risk preference of its management, Star Shipping Company has

determined the maximum standard deviation of profitability acceptable for a particular

expected value of profitability index. The maximum risk profiles are:

Expected profitability index 0.1 1.05 1.10 1.1 1.20 1.25

Maximum standard deviation 0.0 0.03 0.08 0.16 0.25 0.30

The company is considering an investment proposal involving an outlay of rupees 5

million. The distribution of NPV of this is as follows:

NPV in RS. Million -0.5 0 0.5 1.0 1.5 1.2

Probability 0.02 0.03 0.1 0.40 0.30 0.15

Should the company accept the investment proposal?

Solution is as follows:

Based upon PI and SD of the existing project, the company can decide about accept or reject

decision. It means that we should find out PI and SD of the company. To find PI, first we

should find out Average NPV (mean of NPV)

2 2

(NPVxP)

-0.50 0.02 -0.01 -1.69 2.8561 0.057122

0.00 0.03 0.00 -1.19 1.4161 0.042483

0.50 0.10 0.05 -0.69 0.4761 0.04761

1.00 0.40 0.40 -0.19 0.0361 0.01444

1.50 0.30 0.45 0.31 0.0961 0.02883

2.00 0.15 0.30 0.81 0.6561 0.098415

1.19 0.2889

SD CF CF xP

2

0.2889 0.54 is risk

1.19 PV of inf low 5

PV of inf low 1.19 5 6.19

PI 1.238

II 5.00

Since the expected PI has risk more than the maximum standard deviation profile. It spite of

having 1.238 of PI which is in the limit of Expected PI, its risk is more than the Maximum SD.

So, the company should not accept the investment proposal.

43 | P a g e

7. Mr. Venkat is considering two mutually exclusive projects ‘Q’ and ‘R’. from the following

information you are required to calculate NPV for each possible outcome assuming 16% cost

of capital and suggest which project is risky.

Possible situation Project ‘Q’ Project ‘R’

Initial cash outlay 65,000 65,000

Cash inflow estimates (for 5 yrs):

Pessimistic 20,000 10,000

Most likely 25,000 25,000

Optimistic 35,000 45,000

Solution is as follows:

Possible Project ‘Q’ – cash outlay – Rs. 65,000 Project ‘R’ – cash outlay – Rs. 65,000

outcome Annual PVIFA Present NPV Annual PVIFA Present NPV

cash @16% value cash @16% value

inflow For inflow For

5yrs 5yrs

Pessimistic 20,000 3.274 65,480 480 10,000 3.274 32,740 -32,260

Most likely 25,000 3.274 81,850 16,850 25,000 3.274 81,850 16,850

Optimistic 35,000 3.274 1,14,590 49,590 45,000 3.274 1,47,330 82,330

Project ‘R’ is risky, because there is a possibility of suffering from loss if the possible

outcome is pessimistic

Year 1 2 3 4 5

Cash inflows 5,000 6,000 7,000 8,000 9,000

Probability 0.10 0.20 0.30 0.20 0.20

You are required to calculate total Expected Monetary Value (EMV)

Solution is as follows:

Year Cash inflows Probability EMV

1 5,000 0.10 500

2 6,000 0.20 1,200

3 7,000 0.30 2,100

4 8,000 0.20 1,600

5 9,000 0.20 1,800

Total Expected Monetary Value 7,200

44 | P a g e

9. The following information is available with regard to a project, whose economic lie is three

years and cost is Rs. 1,00,000.

Possible Year 1 Year 2 Year 3

situation Cash probability Cash probability Cash probability

inflow inflow inflow

Pessimistic 2,000 0.20 2,000 0.40 2,000 0.25

Most likely 5,000 0.60 5,000 0.50 5,000 0.35

Optimistic 7,000 0.20 7,000 0.10 7,000 0.40

You are required to EMV and Present value of EMV assuming 10% cost of capital

Solution is as follows:

Expected Monetary Value

Year 1 Year 2 Year 3

CF’s Pro. EMV’s CF’s Pro. EMV’s CF’s Pro. EMV’s

2,000 0.20 400 2,000 0.40 800 2,000 0.25 500

5,000 0.60 3,000 5,000 0.50 2,500 5,000 0.35 1,750

7,000 0.20 1,400 7,000 0.10 700 7,000 0.40 2,800

Total EMV 4,800 Total EMV 4,000 Total EMV 4,050

Year 1

Years EMV PV @ 10% PV of EMV

1 4,800 0.909 4,363.20

2 4,000 0.826 3,304.00

3 4,050 0.751 3,041.55

Total Present Value of EMV 10,708.75

45 | P a g e

SPECIAL DECISION SITUATIONS

1. Alpha limited is considering two machines, A and B. though designed differently, they serve

the same functions. Machine A, a standard model with Rs. 75,000, lasts for 5 years. Its

annual operating cost will be Rs. 12,000. Machine B, an economy model, costs Rs. 50,000,

but lasts for only 3 years. Its annual operating costs will be Rs. 15,000.

Assuming a discount rate of 12 per cent, how should Alpha limited choose between the

two machines?

Solution is as follows:

Based upon less amount of regular cash flow, the company can select the best machine.

First we need to determine the Uniform Annual Equivalents (UAE) of the machine. It

means that one time expenditure of the machine will be of single amount concept where

the regular expenditure of the machine will be of annuity concept. Sum of these cash

flows is known as total cash outlay and it should be divided by PVIFA as we need to

determine UAE which means regular cash outflow based upon annuity concept.

PV of cos t

UAE

PVIFA

PV of cos t Initial cos t annual operating cos t

Initial cos t is of sin gle amount concept where as annual operating cos t is of annuity concept

UAE for Machine A

PV of cos t Initial cos t annual operating cos t PVIFA5 yrs,12%

PV of cos t 75,000 12,000 x 3.605

PV of cos t 75,000 43,260 1,18,260

PV of cos t 1,18,260

UAE 32,804

PVIFA 3.605

PV of cos t Initial cos t annual operating cos t PVIFA3 yrs,12%

PV of cos t 50,000 15,000 x 2.402

PV of cos t 50,000 36,030 86,030

PV of cos t 86,030

UAE 35,816

PVIFA 2.402

Machine ‘A’ is preferred since its Uniform Annual Equivalent (UAE) is less than that of

Machine ‘B’

46 | P a g e

2. Plastic emulsion painting for a building costs Rs. 3,00,000 and has a life of 7 years.

Distemper painting costs Rs. 1,80,000 and has a life of 3 years. How does UAE of plastic

emulsion painting, compare with that of distemper painting? Assume a discount rate of 10

per cent.

Solution is as follows:

PV of cos t

UAE

PVIFA

PV of cos t Initial cos t annual operating cos t

Initial cos t is of sin gle amount concept where as annual operating cos t is of annuity concept

UAE for PLastic Emulsion

Company' s PV cos t is given in total ( Initial cos t annaul operating cos t )

PV of cos t 3,00,000

PV of cos t 3,00,000

UAE

PVIFA10%, 7 yrs 4.868

UAE 61,627

PV of cos t 1,80,000

PV of cos t 1,80,000

UAE

PVIFA10%, 3 yrs 2.487

UAE 72,376

47 | P a g e

3. A firm is evaluating two alternative systems for sewage water treatment. System M has life

of 7 years and system N has a life of 5 years. The initial outlay and operating cost associated

with these systems are as follows:

Years 0 1 2 3 4 5 6 7

System M 10 1.00 1.25 1.50 1.75 2.00 2.25 2.00

System N 8 0.75 1.00 1.20 1.40 1.00

Assume that the discount rate is 10%. Which out of the two systems would you

recommend and on what basis.

Solution is as follows:

In the above given question cash outflows are of single amount concept. But UAE will be

always of annuity concept.

Years Cash PV @ PV of cash Cash PV @ PV of cash

outflows 10% outflows outflows 10% outflows

0 10.00 1.000 10.000 8.00 1.000 8.00

1 1.00 0.909 0.909 0.75 0.909 0.682

2 1.25 0.826 1.033 1.00 0.826 0.826

3 1.50 0.751 1.127 1.20 0.751 0.901

4 1.75 0.683 1.195 1.40 0.683 0.956

5 2.00 0.621 1.242 1.00 0.621 0.621

6 2.25 0.564 1.269

7 2.00 0.513 1.026

PV of Cash outflow 17.801 PV of Cash outflow 11.986

PV of cos t 17,801 PV of cos t 11.986

UAE UAE

PVIFA10%, 7 yrs 4.868 PVIFA10%, 5 yrs 3.791

UAE 3.657 UAE 3.162

System ‘N’ is better than system ‘M’ since, UAE of ‘N’ is less than that of ‘M’

48 | P a g e

4. The initial outlay on an internal transport system would be Rs.15,00,000. The operating

costs are expected to be as follows:

Year Operating cost

1 3,00,000

2 3,60,000

3 4,00,000

4 4,50,000

5 5,00,000

The estimated salvage at the end of 5 years is Rs. 3,00,000. What is the UAE if the cost of

capital is 13 per cent?

Solution is as follows

In the above given question, scrap value should be subtracted at present value for the

total PV of cash outflows at the end of its life.

Years Cash outflow PV @ 13% PV of cash ourflows

0 15,00,000 1.000 15,00,000

1 3,00,000 0.885 2,65,500

2 3,60,000 0.783 2,81,880

3 4,00,000 0.693 2,77,200

4 4,50,000 0.613 2,75,850

5 5,00,000 0.543 2,71,500

5 [SV] [3,00,000] 0.543 [1,62,900]

Present value of cash outflows 27,09,030

PV of cos t 27,09,030

UAE

PVIFA13%, 5 yrs 3.517

UAE 7,70,267

49 | P a g e

5. Shimla municipality is considering two different snowplows. The gunning plow has an

economic life of 12 years, whereas the coulter plow has an economic life of 9 years. The

gunning plow cost Rs. 2.5 millions and is expected to have a salvage value of 0.8 million at

the end of 12 years. The coulter plow cost Rs. 1.5 millions and is expected to have a salvage

value of 0.5 million after 9 years. The operating and maintenance cost for the gunning plow

are expected to be Rs. 0.25 million per year and the same cost for the coulter plow are

expected to be Rs. 0.32 million per year. The plows have identical capacity. Whichever plow

is chosen, Shimla municipality would continue to replace it with essentially the same

machine indefinitely. If the discount rate is 12 per cent, which plow should be selected?

Solution is as follows:

UAE is to be determined for both the options

Initial cost = Rs. 2.50 millions

Annual operating cost = Rs. 0.25 million per year

Salvage value = Rs. 0.80 millions

Life is 12 years

Annuity concept has to be follows since annual cash out flow are given only for one year.

UAE

Initial investment Annaul operating cos t x PVIFA 12 yrs , 12% PV ofScrap value

PVIFA12 yrs,12%

UAE

2.50 0.25 x 6.194 0.80 x 0.257

6.194

UAE

2.50 1.55 0.21 3.84

6.194 6.194

UAE 0.62 millions

Initial cost = Rs. 1.50 millions

Annual operating cost = Rs. 0.32 million per year

Salvage value = Rs. 0.50 millions

Life is 9 years

Annuity concept has to be follows since annual cash out flow are given only for one year.

UAE

Initial investment Annaul operating cos t x PVIFA 9 yrs , 12% PV ofScrap value

PVIFA9 yrs,12%

UAE

1.50 0.32 x 5.328 0.50 x 0.361

5.328

UAE

1.50 1.705 0.181 3.024

5.328 5.328

UAE 0.57 millions

Coulter Plow should be selected since its UAE is less than that of Gunning Plow.

50 | P a g e

ADJUSTED NET PRESENT VALUES (ANPV)

ANPV = Base Case NPV – Issue cost + PV of tax shield

expected to generate a net cash flow of Rs. 1 million per year for 8 years. The opportunity

cost of capital is 15 per cent; this reflects the return required by equity investors, assuming

that the project is entirely financed by equity. The cost of issuing equity is 5 per cent. The

project enables the firm to raise Rs. 2.4 million of debt finance. The debt finance will carry

14 per cent interest and will be repaid in equal annual instalments over an eight year period

– the first instalment will be paid at the end of the first year. The tax rate applicable to the

firm is 40 per cent.

What is the base case NPV?

What is the adjusted NPV?

Solution is as follows:

Adjusted NPV = Base case NPV – Issue cost + Tax benefit on interest paid on debt.

Debt capital = Rs. 24,00,000 at 14% rate on interest

Installment amount of Debt capital = Rs. 3,00,000 (24,00,000 / 8)

Equity capital = Rs. 26,00,000 [50,00,000 – 24,00,000]

Cost of issue = 5% [floatation cost]

Annual cash inflow = Rs. 10,00,000 per year

Life of the project = 8 years

Cost of capital = 15%

Step 1: We need to determine the NPV for the above given project which is also

known as Base Case NPV.

NPV = Inflows [PVIFA8 yrs, 15%] – Initial Investment

NPV = [10,00,000 x 4.487] – 50,00,000

NPV = 44,87,000 – 50,00 000

Base Case NPV = -5,13,000

It is the cost which is incurred by the company for raising the capital. The capital what

they raise is after such floating cost. For instance, in the given question floatation cost is

5% and the capital what they have is 95%. So, we need to determine the floatation cost

of 5%.

Equity capital

Issue cos t x fc

1 fc

26,00,000

Issue cos t x 0.05

1 0.05

Issue cos t 1,36,842

51 | P a g e

Step 3: Calculation of PV of Tax shield on debt-financing

Balance [14%] [40%] [14%] tax shield

1 24,00,000 3,36,000 1,34,400 0.877 1,17,868

2 21,00,000 2,94,000 1,17,600 0.769 90,434

3 18,00,000 2,52,000 1,00,800 0.675 68,040

4 15,00,000 2,10,000 84,000 0.592 49,728

5 12,00,000 1,68,000 67,200 0.519 34,877

6 9,00,000 1,26,000 50,400 0.455 22,932

7 6,00,000 84,000 33,600 0.399 13,406

8 3,00,000 42,000 16,800 0.351 5,897

PV of tax benefit on debt capital 4,03,182

Adjusted NPV = Base case NPV – Issue cost + Tax benefit on interest paid on debt.

Adjusted NPV = -5,13,000 – 1,36,842 + 4,03,182

Adjusted NPV = -2,46,660

2. Growmore fertilizers limited are considering a capital project requiring an outlay of Rs. 15

million. It is expected to generate a net cash inflow of Rs. 3.75 million for 6 years. The

opportunity cost of capital is 18 per cent. Grow more fertilizers can raise a term loan of Rs.

10 million for the project. The term loan will carry an interest rate of 16 per cent and would

be repayable in 5 equal annual installments; the first installment is due at the end of second

year. The balance amount required for the project can be raised by issuing equity capital.

The issue cost is expected to be 8 per cent. The tax rate for the company is 50 per cent.

a. What is the base case NPV?

b. What is Adjusted Net Present Value (ANPV)?

Solution is as follows:

Adjusted NPV = Base case NPV – Issue cost + Tax benefit on interest paid on debt.

Debt capital = Rs. 1,00,00,000 at 16% rate on interest

Installment amount of Debt capital = Rs. 20,00,000 (1,00,00,000 / 5)

Equity capital = Rs. 50,00,000 [1,50,00,000 – 1,00,00,000]

Cost of issue = 8% [floatation cost]

Annual cash inflow = Rs. 37,50,000 per year

Life of the project = 6 years

Cost of capital = 18%

Step 1: We need to determine the NPV for the above given project which is also known as

Base Case NPV.

NPV = Inflows [PVIFA6 yrs, 18%] – Initial Investment

NPV = [37,50,000 x 3.498] – 1,50,00,000

NPV = 1,31,17,500 – 1,50,00 000

Base Case NPV = -18,82,500

52 | P a g e

Step 2: Calculation of Issue cost

It is the cost which is incurred by the company for raising the capital. The capital what they

raise is after such floating cost. For instance, in the given question floatation cost is 8% and

the capital what they have is 92%. So, we need to determine the floatation cost of 8%.

Equity capital

Issue cos t x fc

1 fc

50,00,000

Issue cos t x 0.08

1 0.08

Issue cos t 4,34,783

balance [16%] [50%] [16%] tax shield

1 1,00,00,000 16,00,000 8,00,000 0.862 6,89,600

2 1,00,00,000 16,00,000 8,00,000 0.743 5,94,400

3 80,00,000 12,80,000 6,40,000 0.641 4,10,240

4 60,00,000 9,60,000 4,80,000 0.552 2,64,960

5 40,00,000 6,40,000 3,20,000 0.476 1,52,320

6 20,00,000 3,20,000 1,60,000 0.410 65,600

PV of tax benefit on debt capital 21,77,120

Adjusted NPV = Base case NPV – Issue cost + Tax benefit on interest paid on debt.

Adjusted NPV = -18,82,500 – 4,34,783 + 21,77,120

Adjusted NPV = -1,40,163

3. Nikhil Electronics Limited is evaluating a capital project requiring an outlay of Rs. 8 million. It

is expected to generate a net cash inflow of Rs. 2 million for 6 years. The opportunity cost of

capital is 18 per cent. Nikhil Electronics Limited can raise a term loan of Rs. 5 million for the

project. The term loan will carry an interest rate of 15 per cent and would be repayable in 5

equal installments and first installment falling due at the end of the second year. The

balance amount required for the project can be raised by issuing equity capital. The issue

cost is expected to be 10 per cent. The tax rate for the company is 40 per cent.

a. What is the base case NPV?

b. What is the adjusted NPV?

Solution is as follows:

Adjusted NPV = Base case NPV – Issue cost + Tax benefit on interest paid on debt.

Debt capital = Rs. 50,00,000 at 15% rate on interest

Installment amount of Debt capital = Rs. 10,00,000 (50,00,000 / 5)

53 | P a g e

Equity capital = Rs. 30,00,000 [80,00,000 – 50,00,000]

Cost of issue = 10% [floatation cost]

Annual cash inflow = Rs. 20,00,000 per year

Life of the project = 6 years

Cost of capital = 18%

Step 1: We need to determine the NPV for the above given project which is also known as

Base Case NPV.

NPV = Inflows [PVIFA6 yrs, 18%] – Initial Investment

NPV = [20,00,000 x 3.498] – 80,00,000

NPV = 69,96,000 – 80,00 000

Base Case NPV = -10,04,000

It is the cost which is incurred by the company for raising the capital. The capital what they

raise is after such floating cost. For instance, in the given question floatation cost is 8% and

the capital what they have is 90%. So, we need to determine the floatation cost of 10%.

Equity capital

Issue cos t x fc

1 fc

30,00,000

Issue cos t x 0.10

1 0.10

Issue cos t 3,33,333

Balance [15%] [40%] [15%] tax shield

1 50,00,000 7,50,000 3,00,000 0.870 2,61,000

2 50,00,000 7,50,000 3,00,000 0.756 2,26,800

3 40,00,000 6,00,000 2,40,000 0.658 1,57,920

4 30,00,000 4,50,000 1,80,000 0.572 1,02,960

5 20,00,000 3,00,000 1,20,000 0.497 59,640

6 10,00,000 1,50,000 60,000 0.432 25,920

PV of tax benefit on debt capital 8,34,240

Adjusted NPV = Base case NPV – Issue cost + Tax benefit on interest paid on debt.

Adjusted NPV = -10,04,000 – 3,33,333 + 8,34,240

Adjusted NPV = -5,03,093

54 | P a g e

ECONOMIC LIFE DETERMINATION

UAE (CC) = UAE (IO) – [UAE (DTS) + UAE (SV)]

TC = Total Cost

OM = Operating & Maintenance Cost

CC = Capital Cost

IO = Initial Outlay

DTS = Depreciation Tax Shield

SV = Salvage Value

Note: while determining the economic life of the machine, we need to come across some

important points.

a. First we should determine the UAE of operating and maintaining cost, assuming that

machine can be used for one year, two years, three years and so on. If it is used only for

one year it will of single amount concept and if it is used for more than one year it is of

annuity concept. When we follow annuity concept we need to accumulate the costs.

b. Secondly, we should know the UAE of Investment outlay. It is also of single and annuity

concept for one year and more than one year. Even if it is for one or more than one year,

investment amount should not be accumulated.

c. Thirdly, we should know the UAE of depreciation tax shield. It is also of single and annuity

concept. If it is for more than one year it should be accumulated.

d. After knowing depreciation tax shield, we should determine UAE of scrap value. The

amount should not be accumulated for any of the year.

e. Finally, we should determine the economic life of the asset.

55 | P a g e

1. Modern plastics ltd., is considering a machine to produce plastic products. It required an

initial outlay of Rs. 0.6 million and will be depreciated at the rate of 33.33 per cent per

annum as per the WDV method. The expected operating and maintenance cost and salvage

value for the next 8 years, which represents the maximum physical life of the machine, are

shown below:

(Rs. ‘000)

Year

1 2 3 4 5 6 7 8

Operating and maintenance cost 80 100 130 180 240 300 360 450

Salvage value 400 252 180 100 80 60 50 40

The cost of capital appropriate for the machine is 12 per cent and the tax rate for the

company is 40 per cent.

You are required to determine the economic life of the machine

Solution is as follows:

Calculation of UAE of Operating and Maintaining cost (OM) (in 000’s)

Particulars 1 2 3 4 5 6 7 8

a. O & M cost 80 100 130 180 240 300 360 450

b. Tax (40%) 32 40 52 72 96 120 144 180

c. Post tax of OM 48 60 78 108 144 180 216 270

d. PVIF (12%) 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

e. PV of OM 42.86 47.82 55.54 68.69 81.65 91.26 97.63 109.08

f. Cumulative PV 42.86 90.68 146.22 214.91 296.56 387.82 485.45 594.53

g. PVIFA12%, 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968

h. UAE (f/g) 48.00 53.66 60.87 70.76 82.26 94.34 106.37 119.67

Particulars 1 2 3 4 5 6 7 8

a. Cash outlay 600 600 600 600 600 600 600 600

b. PVIFA12%, 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968

c. UAE (a/b) 671.89 355.03 249.79 197.56 166.44 145.95 131.46 120.77

Particulars 1 2 3 4 5 6 7 8

a. Depreciation 200.00 133.33 88.89 59.26 39.51 26.34 17.56 11.71

b. Post tax savings 80.00 53.33 35.55 23.70 15.80 10.53 7.02 4.68

c. PVIF (12%) 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

d. PV of Dept tax svg 71.44 42.50 25.31 15.07 8.96 5.34 3.17 1.89

e. Cumulative of PV 71.44 113.94 139.25 154.32 163.28 168.62 171.79 173.68

f. PVIFA12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968

g. UAE (e/f) 80.00 67.42 57.97 50.81 45.29 41.02 37.64 34.96

56 | P a g e

Calculation of UAE of Salvage Value

Particulars 1 2 3 4 5 6 7 8

a. Salvage value 400 252 180 100 80 60 50 40

b. PVIF 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

c. PV of SV 357.20 200.84 128.16 63.60 45.36 30.42 22.60 16.16

d. PVIFA12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968

e. UAE (c x d) 400.00 118.84 53.36 20.94 12.58 7.40 4.95 3.25

Time UAE (OM) UAE(II) UAE (DTS) UAE (SV) UAE (CC) UAE (TC)

1 2 3 4 5 6 (3-[4+5]) 7 (2+6)

1 48.00 671.89 80.00 400.00 191.89 239.89

3 60.87 249.79 57.97 53.36 138.46 199.33

4 70.76 197.56 50.81 20.94 125.81 196.57

5 82.26 166.44 45.29 12.58 108.57 190.83

6 94.34 145.95 41.02 7.40 97.53 191.87

7 106.37 131.46 37.64 4.95 88.87 195.24

8 119.67 120.77 34.96 3.25 82.56 202.23

Economic life of the asset is 5 years since its UAE is less

2. Zenith Company sews garments for retail stores. The firm is evaluating a new sewing

machine costing Rs. 80,000. The machine has a physical life of five years. The depreciation

rate applicable to it is 25 per cent as per the WDV method. The estimated operating and

maintenance cost and salvage are as follows:

Year Operating and maintenance cost Salvage value

1 20,000 60,000

2 25,000 45,000

3 35,000 32,000

4 50,000 22,000

5 70,000 15,000

Zeniths cost of capital is 12 per cent and its tax rate if 40 per cent. What is the economic life of

the sewing machine which minimizes the UAE cost of buying and operating the machine?

Solution is as follows:

Calculation of UAE of Operating and Maintaining cost (OM)

Particulars 1 2 3 4 5

a. O & M cost 20,000 25,000 35,000 50,000 70,000

b. Tax (40%) 8,000 10,000 14,000 20,000 28,000

c. Post tax of OM 12,000 15,000 21,000 30,000 42,000

d. PVIF (12%) 0.893 0.797 0.712 0.636 0.567

e. PV of OM 10,716 11,955 14,952 19,080 23,814

f. Cumulative PV 10,716 22,671 37,623 56,703 80,517

g. PVIFA12%, 0.893 1.690 2.402 3.037 3.605

h. UAE (f/g) 12,000 13,415 15,663 18,671 22,335

57 | P a g e

Calculation of UAE of Initial Investment

Particulars 1 2 3 4 5

a. Cash outlay 80,000 80,000 80,000 80,000 80,000

b. PVIFA12%, 0.893 1.690 2.402 3.037 3.605

c. UAE (a/b) 89,586 47,337 33,306 26,342 22,191

Particulars 1 2 3 4 5

a. Depreciation 20,000 15,000 11,250 8,438 6,328

b. Post tax savings 8,000 6,000 4,500 3,375 2,531

c. PVIF (12%) 0.893 0.797 0.712 0.636 0.567

d. PV of Dept tax svg 7,144 4,782 3,204 2,147 1,435

e. Cumulative of PV 7,144 11,926 15,130 17,277 18,712

f. PVIFA12% 0.893 1.690 2.402 3.037 3.605

g. UAE (e/f) 8,000 7,057 6,299 5,689 5,191

Particulars 1 2 3 4 5

a. Salvage val 60,000 45,000 32,000 22,000 15,000

b. PVIFA 0.893 0.797 0.712 0.636 0.567

c. PV of SV 53,580 35,865 22,784 13,992 8,505

d. PVIFA12% 0.893 1.690 2.402 3.037 3.605

e. UAE (c x d) 60,000 21,222 9,485 4,607 2,359

Time UAE (OM) UAE(II) UAE (DTS) UAE (SV) UAE (CC) UAE (TC)

1 2 3 4 5 6 (3-[4+6]) 7 (2+6)

1 12,000 89,586 8,000 60,000 21,586 33,586

2 13,415 47,337 7,057 21,222 19,058 32,473

3 15,663 33,306 6,299 9,485 17,522 33,185

4 18,671 26,342 5,689 4,607 16,046 34,717

5 22,335 22,191 5,191 2,359 14,641 36,976

Economic life of the asset is 2 years since its UAE is less

58 | P a g e

3. Sushant Well Dwillers evaluating a new well drilling machine costing Rs. 4 million. Estimates

of operating and maintenance cost and salvage value are as follows:

Operating and

Year Salvage value

maintenance cost

1 8,00,000 28,00,000

2 10,00,000 20,00,000

3 13,00,000 14,00,000

4 19,00,000 10,00,000

5 28,00,000 8,00,000

Sushanth has a cost of capital of 12 per cent and a tax rate of 30 per cent. For

tax purpose, Sushanth is allowed to depreciate the machine at a rate of 25 per cent as

per the WDV method.

Determine the economic life for the well drilling machine that minimizes the

uniform annual equivalents cost of buying and operating the machine.

Solution is as follows:

Calculation of UAE of Operating and Maintaining cost (OM)

Particulars 1 2 3 4 5

a. O & M cost 8,00,000 10,00,000 13,00,000 19,00,000 28,00,000

b. Tax (30%) 2,40,000 3,00,000 3,90,000 5,70,000 8,40,000

c. Post tax of OM 5,60,000 7,00,000 9,10,000 13,30,000 19,60,000

d. PVIF (12%) 0.893 0.797 0.712 0.636 0.567

e. PV of OM 5,00,080 5,57,900 6,47,920 8,45,880 11,11,320

f. Cumulative PV 5,00,080 10,57,980 17,05,900 25,52,780 36,63,100

g. PVIFA12%, 0.893 1.690 2.402 3.037 3.605

h. UAE (f/g) 5,60,000 6,26,024 7,10,200 8,40,560 10,16,117

Particulars 1 2 3 4 5

a. Cash outlay 40,00,000 40,00,000 40,00,000 40,00,000 40,00,000

b. PVIFA12%, 0.893 1.690 2.402 3.037 3.605

c. UAE (a/b) 44,79,283 23,66,864 16,65,279 13,17,089 11,09,570

Particulars 1 2 3 4 5

a. Depreciation 10,00,000 7,50,000 5,62,500 4,21,875 3,16,406

b. Post tax savings 3,00,000 2,25,000 1,68,750 1,26,562 94,922

c. PVIF (12%) 0.893 0.797 0.712 0.636 0.567

d. PV of Dept tax svg 2,67,900 1,79,325 1,20,150 80,493 53,821

e. Cumulative of PV 2,67,900 4,47,225 5,67,375 6,47,868 7,01,689

f. PVIFA12% 0.893 1.690 2.402 3.037 3.605

g. UAE (e/f) 3,00,000 2,64,630 2,36,209 2,13,325 1,94,643

59 | P a g e

Calculation of UAE of Salvage Value

Particulars 1 2 3 4 5

a. Salvage val 28,00,000 20,00,000 14,00,000 10,00,000 8,00,000

b. PVIFA 0.893 0.797 0.712 0.636 0.567

c. PV of SV 25,00,400 15,94,000 9,96,800 6,36,000 4,53,600

d. PVIFA12% 0.893 1.690 2.402 3.037 3.605

e. UAE (c x d) 28,00,000 9,43,195 4,14,988 2,09,417 1,25,825

Time UAE (OM) UAE(II) UAE (DTS) UAE (SV) UAE (CC) UAE (TC)

1 2 3 4 5 6 (3-[4+6]) 7 (2+6)

1 5,60,000 44,79,283 3,00,000 28,00,000 13,79,283 19,39,283

2 6,26,024 23,66,864 2,64,630 9,43,195 11,59,039 17,85,063

3 7,10,200 16,65,279 2,36,209 4,14,988 10,14,082 17,24,282

4 8,40,560 13,17,089 2,13,325 2,09,417 8,94,347 17,34,907

5 10,16,117 11,09,570 1,94,643 1,25,825 7,89,102 18,05,219

Economic life of the asset is 3 years since its UAE is less

60 | P a g e

DECISION TREE ANALYSIS

1. The scientists at Spectrum have come up with an electric moped. The firm is ready for the

pilot production and test marketing. This will cost Rs. 20 million and take six months.

Management believes that there is a 70 per cent chance that the pilot production and test

marketing will be successful. In the case of success, Spectrum can build a plant costing Rs.

150 million. The plant will generate an annual cash inflow of Rs. 30 million for 20 years is the

demand in high or an annual cash inflow of Rs. 20 million if the demand is low. High demand

has a probability of 0.6; low demand has a probability of 0.4. What is the optimal course of

action using decision tree analysis? Assume cost of capital of 12 per cent.

Solution is as follows:

Initially we should draw decision tree to know the feasibility of the project

Demand cash flow

0.60 30 million

D21Invest

C2

D11 carry out pilot -Rs. 150 mn C22 low Annual

Production and C11Success demand cash flow

D2

Market test 0.70 0.40 20 million

Rs. 20 million D22Stop

C1

C12Failure D31 Stop

D1 D3

0.30

D12 do nothing

From the above diagram we need to determine the optimal course of action:

Step 1: determine the PV of chance point C2 that comes first as we proceed from leftward.

EMV (C2) = 0.60 [30 x PVIFA20 yrs, 12%] + 0.40 [20 x PVIFA20 yrs, 12%]

EMV (C2) = 0.60 [30 x 7.469] + 0.40 [20 x 7.469]

EMV (C2) = 134.44 + 59.75

EMV (C2) = 194.19 million

Step 2: determine the EMV for investment of 150 mn at the last decision point (D2)

Value = 194.19 – 150

Value = 44.19 million

Step 3: determine the EMV for the success rate of 0.70 (C1)

EMV = [44.19 x 0.70] + [0 x 0.30]

EMV = 30.93 million

Step 4: determine the NPV for carrying out pilot production for Rs. 20 mn (D1)

Value = 30.93 – 20

Value = 10.93 million

61 | P a g e

2. X ltd is considering the purchase of a new plant requiring a cash outlay of Rs. 20,000. The

plant is expected to have a useful life of 2 years without any salvage value. The cash flows

and their associates probabilities for the two years are as follows:

Options Cash flow (Rs) Probability

I 8,000 0.3

1st year

ii 11,000 0.4

iii 15,000 0.3

nd st

2 year: if cash flow in 1 are Rs. 8,000, Rs. 11,000 and Rs. 15,000

Options Cash flow probability Cash flow probability Cash flow probability

i 4,000 0.2 13,000 0.3 16,000 0.1

ii 10,000 0.6 15,000 0.4 20,000 0.8

iii 15,000 0.2 16,000 0.3 24,000 0.1

Presuming that 10 per cent of the cost of capital, plot the above data in the form of a decision

tree and suggest, whether the project should be taken up or not.

Solution is as follows:

cash outlay: Rs. 20,000 and cost of capital is 10%

4,000

0.20

C1

8,000 10,000

0.30 0.60

15,000

0.20

13,000

0.30

D 11,000 15,000

C2

0.40 0.40

16,000

0.30

16,000

0.10

15,000 20,000

C3

0.30 0.80

24,000

0.10

62 | P a g e

PV@10% PV@10% PV of PV of Total NPV JP Net NPV

Sl CF1 CF2 P1 P2 II

1st yr 2nd yr CF1 CF2 PV [9-10] [1x2] [11x12]

.No 1 2 3 4 (10)

5 6 [1x5]7 [2x6] 8 [7+8] 9 11 12 13

8,000 4,000 0.30 0.20 0.909 0.826 7,272 3,304 10,576 20,000 -9,424 0.06 -565.44

1 8,000 10,000 0.30 0.60 0.909 0.826 7,272 8,260 15,532 20,000 -4,468 0.18 -804.24

8,000 15,000 0.30 0.20 0.909 0.826 7,272 12,390 19,662 20,000 -338 0.06 -20.28

11,000 13,000 0.40 0.30 0.909 0.826 9,999 10,738 20,737 20,000 737 0.12 88.44

2 11,000 15,000 0.40 0.40 0.909 0.826 9,999 12,390 22,389 20,000 2,389 0.16 383.24

11,000 16,000 0.40 0.30 0.909 0.826 9,999 13,216 23,215 20,000 3,215 0.12 385.80

15,000 16,000 0.30 0.10 0.909 0.826 13,635 13,216 26,850 20,000 6,850 0.03 205.50

3 15,000 20,000 0.30 0.80 0.909 0.826 13,635 16,520 30,155 20,000 10,155 0.24 2,437.20

15,000 24,000 0.30 0.10 0.909 0.826 13,635 19,824 33,459 20,000 13,459 0.03 403.77

NPV 2,513.99*

63 | P a g e

3. Dream Well Company Limited has an investment proposal that requires an investment

outlay of Rs. 2,50,000. The following information is available:

Options Cash flow (Rs) Probability

A 1,00,000 0.20

1st year

B 1,25,000 0.40

C 1,80,000 0.40

nd

2 year

Options Cash flow probability Cash flow Probability Cash flow probability

A 45,000 0.20 1,40,000 0.20 1,90,000 0.30

B 1,20,000 0.30 1,80,000 0.60 2,10,000 0.30

C 1,80,000 0.50 1,90,000 0.20 2,60,000 0.40

You are required to advise the company regarding the financial feasibility of the project

using decision tree approach. Company’s cost of capital is 10%.

0.20

C1

1,00,000 1,20,000

0.20 0.30

1,80,000

0.50

1,40,000

0.20

D 1,25,000 1,80,000

C2

0.40 0.60

1,90,000

0.20

1,90,000

0.30

1,80,000 2,10,000

C3

0.40 0.30

2,60,000

0.40

64 | P a g e

PV@10% PV@10% PV of PV of Total JP Net NPV

Sl CF1 CF2 P1 P2 II NPV

1st yr 2nd yr CF1 CF2 PV [3x4] [11x12]

.No 1 2 3 4 (10) [9-10] 11

5 6 [1x5]7 [2x6] 8 [7+8] 9 12 13

1,00,000 45,000 0.20 0.20 0.909 0.826 90,900 37,170 1,28,070 2,50,000 -1,21,930 0.04 -4,877.20

1 1,00,000 1,20,000 0.20 0.30 0.909 0.826 90,900 99,120 1,90,020 2,50,000 -59,980 0.06 -3,598.80

1,00,000 1,80,000 0.20 0.50 0.909 0.826 90,900 1,48,680 2,39,580 2,50,000 -10,420 0.10 -1,042.00

1,20,000 1,40,000 0.40 0.20 0.909 0.826 1,09,080 1,15,640 2,24,720 2,50,000 -25,280 0.08 -2,022.40

2 1,20,000 1,80,000 0.40 0.60 0.909 0.826 1,09,080 1,48,680 2,57,760 2,50,000 7,760 0.24 1,862.40

1,20,000 1,90,000 0.40 0.20 0.909 0.826 1,09,080 1,56,940 2,66,020 2,50,000 16,020 0.08 1,281.60

1,80,000 1,90,000 0.40 0.30 0.909 0.826 1,63,620 1,56,940 3,20,560 2,50,000 70,560 0.12 8,467.20

3 1,80,000 2,10,000 0.40 0.30 0.909 0.826 1,63,620 1,73,460 3,37,080 2,50,000 87,080 0.12 10,449.60

1,80,000 2,60,000 0.40 0.40 0.909 0.826 1,63,620 2,14,760 3,78,380 2,50,000 1,28,380 0.16 20,540.80

NPV 31,061.20*

65 | P a g e

4. Mr. A an MBA student with entrepreneurship specialization is considering a new project,

whose cost is Rs. 20,00,000. He has estimated the projects NCF’s over its 2 year life as

follows:

CF’s Year 1 Probability Year 2 Probability

9,00,000 0.60

NCF’s 11,00,000 0.40

12,00,000 0.40

17,00,000 0.50

NCF’s 13,00,000 0.60

21,00,000 0.50

Mr. A’s expected rate of return is 14%. Evaluate the project using decision tree analysis tree

approach and suggest whether the project should be started or not.

Solution is as follows:

9,00,000

C1 0.60

11,00,000 12,00,000

0.40 0.40

D 17,00,000

13,00,000 C2 0.50

0.60 21,00,000

0.50

PV@14% PV@14%

CF1 CF2 P1 P2

Sl .No 1st yr 2nd yr

1 2 3 4

5 6

11,00,000 9,00,000 0.40 0.60 0.877 0.769

1

11,00,000 12,00,000 0.40 0.40 0.877 0.769

13,00,000 17,00,000 0.60 0.50 0.877 0.769

2

13,00,000 21,00,000 0.60 0.50 0.877 0.769

PV of Net NPV

PV of CF2 Total PV II NPV JP [3x4]

CF1 [11x12]

[2x6] 8 [7+8] 9 (10) [9-10] 11 12

[1x5] 7 13

9,64,700 6,92,100 16,56,800 20,00,000 -3,43,200 0.24 -82,368

9,64,700 9,22,800 18,87,500 20,00,000 -1,12,500 0.16 --18,000

11,40,100 13,07,300 24,47,400 20,00,000 4,47,400 0.30 1,34,220

11,40,100 16,14,900 27,55,000 20,00,000 7,55,000 0.30 2,26,500

NPV 2,60,352

66 | P a g e

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