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PROBLEMS ON PROJECT CASH FLOWS

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.

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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

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Solution is as follows:

Statement of project cash flows


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

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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

Cash flows relating to long term funds:


 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.

Cash flows relating to total resources:


 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

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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

Net cash flows relating to Long-term Funds


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

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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.

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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?

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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

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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

Net cash flows relating to Total Funds


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

Calculation of cash inflows for the replacement project


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

Calculation of cash inflows for the replacement project


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

Calculation of cash inflows for the replacement project


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

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


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

Years Cash flows PV @ 12% PV of 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

MIRR  1.176  1  0.176 or 17.60%

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

MIRR 1.104 1  0.104 or 10.40%

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

Project B if more profitable since, it’s NPV is greater than Project A

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

Project B has to be selected since its NPV is greater than Project A


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

MIRR  1.192  1  0.192 or 19.20%

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

MIRR  1.234 1  0.234 or 23.40%

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

MIRR 1.162 1  0.162 or 16.20%

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:

Projects Investment NPV


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

From the above analysis it is clear that

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:

Underlying variable Pessimistic Expected Optimistic


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

Calculation of Tax Rate:


tax paid 10
Tax rate  x 100  x 100  28.57%
PBT 35

NPV when underlying variable investment changes

Particulars Pessimistic Optimistic


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

Particulars Pessimistic Optimistic


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

Particulars (life 5 years) Amount


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

Determination of NPV for underlying variable [quantity manufactured and sold]

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?

Determination of NPV for expected values:


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

Determination of NPV under two investment situations

Particulars Amount Amount


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

NPV P NPV NPV  NPV NPV  NPV  NPV  NPV  xP


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.

Cash flow for year 1


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

Cash flow for year 2


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

Cash flow for year 3


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  5.800.826  3.900.751 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   0.410.826  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?

Cash flow for year 1


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

Cash flow for year 2


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

Cash flow for year 3


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

Cash flow for year 4


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  3,9000.890  4,9000.839  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  10,0000.857   9,0000.794  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)

NPV P NPV NPV  NPV NPV  NPV  NPV  NPV  xP


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

NPV  PV of inf low  outflow


1.19  PV of inf low  5
PV of inf low 1.19  5  6.19

PV of inf low 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

8. The possible cash inflows for a project ‘A’ are as follows:


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

UAE for Machine A



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

UAE for Distemper Pa int s


PV of cos t 1,80,000
PV of cos t 1,80,000
UAE  
PVIFA10%, 3 yrs 2.487
UAE  72,376

plastic emulsion is better than Distemper since its UAE it less.

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.

UAE for System M UAE for System M


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

UAE for Gunning Plow


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

UAE for Coulter Plow


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

1. Parimala Company is considering a project requiring Rs. 5 million of investment. It is


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.

Initial investment = Rs. 50,00,000


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

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
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

Years Opening Interest Tax saving PVIF PV of


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.

Initial investment = Rs. 1,50,00,000


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

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

Years Opening Interest Tax saving PVIF PV of


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.

Initial investment = Rs. 80,00,000


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

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 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

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

Years Opening Interest Tax saving PVIF PV of


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 (TC) = UAE (OM) + UAE (CC)


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

UAE = Uniform Annual Equivalents


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

Calculation of UAE of Initial Investment


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

Calculation of UAE for Depreciation Tax shield

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

Calculation of UAE of Total Cost (TC)


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

2 53.66 355.03 67.42 118.84 168.77 222.43


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

Calculation of UAE for Depreciation Tax shield


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

Calculation of UAE of Salvage Value


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

Calculation of UAE of Total Cost (TC)


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

Calculation of UAE of Initial Investment


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

Calculation of UAE for Depreciation Tax shield


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

Calculation of UAE of Total Cost (TC)


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

C21 High Annual


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

Project should be taken since its NPV is positive of Rs. 2,513.19*

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%.

Solution is as follows: 45,000


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

Project should be taken since its NPV is positive of Rs. 31,061.20*

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

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