Capital Budgeting Definition

Capital budgeting is the process of evaluating and selecting long-term investments that are
in line with the goal of investors’ wealth maximization.

When a business makes a capital investment (assets such as equipment, building, land etc.)
it incurs a cash outlay in the expectation of future benefits. The expected benefits generally
extend beyond one year in the future. Out of different investment proposals available to a
business, it has to choose a proposal that provides the best return and the return equals to,
or greater than, that required by the investors.

In simple terms, Capital Budgeting involves:-

Evaluating investment project proposals that are strategic to business overall objectives;

Estimating and evaluating post-tax incremental cash flows for each of the investment
proposals; and Selection an investment proposal that maximizes the return to the investors.

However, Capital Budgeting excludes certain investment decisions, wherein, the benefits
of investment proposals cannot be directly quantified. For example, management may be
considering a proposal to build a recreation room for employees. The decision in this case
will be based on qualitative factors, such as management − employee relations, with less
consideration on direct financial returns.

However, most investment proposals considered by management will require quantitative

estimates of the benefits to be derived from accepting the project. A bad decision can be
detrimental to the value of the organisation over a long period of time.

Purpose of Capital Budgeting

The capital budgeting decisions are important, crucial and critical business decisions due to
following reasons:
(i) Substantial expenditure: Capital budgeting decisions involves the investment of
substantial amount of funds. It is therefore necessary for a firm to make such decisions
after a thoughtful consideration so as to result in the profitable use of its scarce resources.
The hasty and incorrect decisions would not only result into huge losses but may also
account for the failure of the firm.
(ii) Long time period: The capital budgeting decision has its effect over a long period of
time. These decisions not only affect the future benefits and costs of the firm but also
influence the rate and direction of growth of the firm.
(iii) Irreversibility: Most of the investment decisions are irreversible. Once they are taken,
the firm may not be in a position to reverse them back. This is because, as it is difficult to
find a buyer for the second-hand capital items.
(iv) Complex decision: The capital investment decision involves an assessment of future
events, which in fact is difficult to predict. Further it is quite difficult to estimate in
quantitative terms all the benefits or the costs relating to a particular investment decision.
Capital Budgeting Process
The extent to which the capital budgeting process needs to be formalised and systematic
procedures established depends on the size of the organisation; number of projects to be
considered; direct financial benefit of each project considered by itself; the composition of
the firm's existing assets and management's desire to change that composition; timing of
expenditures associated with the projects that are finally accepted.
(i) Planning: The capital budgeting process begins with the identification of potential
investment opportunities. The opportunity then enters the planning phase when the
potential effect on the firm's fortunes is assessed and the ability of the management of the
firm to exploit the opportunity is determined. Opportunities having little merit are rejected
and promising opportunities are advanced in the form of a proposal to enter the evaluation
phase.
(ii) Evaluation: This phase involves the determination of proposal and its investments,
inflows and outflows. Investment appraisal techniques, ranging from the simple payback
method and accounting rate of return to the more sophisticated discounted cash flow
techniques, are used to appraise the proposals. The technique selected should be the one
that enables the manager to make the best decision in the light of prevailing circumstances.
(iii) Selection: Considering the returns and risks associated with the individual projects as
well as the cost of capital to the organisation, the organisation will choose among projects
so as to maximise shareholders’ wealth.
(iv) Implementation: When the final selection has been made, the firm must acquire the
necessary funds, purchase the assets, and begin the implementation of the project.
(v) Control: The progress of the project is monitored with the aid of feedback reports.
These reports will include capital expenditure progress reports, performance reports
comparing actual performance against plans set and post completion audits.
(vi) Review: When a project terminates, or even before, the organisation should review the
entire project to explain its success or failure. This phase may have implication for firms
planning and evaluation procedures. Further, the review may produce ideas for new
proposals to be undertaken in the future.

Types of Capital Investment Decisions

There are many ways to classify the capital budgeting decision. Generally capital
investment decisions are classified in two ways. One way is to classify them on the basis of
firm’s existence. Another way is to classify them on the basis of decision situation.
On the basis of firm’s existence: The capital budgeting decisions are taken by both newly
incorporated firms as well as by existing firms. The new firms may be required to take
decision in respect of selection of a plant to be installed. The existing firm may be required
to take decisions to meet the requirement of new environment or to face the challenges of
competition. These decisions may be classified as follows:
(i) Replacement and Modernisation decisions: The replacement and modernisation
decisions aim at to improve operating efficiency and to reduce cost. Generally all types of
plant and machinery require replacement either because of the economic life of the plant or
machinery is over or because it has become technologically outdated. The former decision
is known as replacement decisions and latter is known as modernisation decisions. Both
replacement and modernisation decisions are called cost reduction decisions.
(ii) Expansion decisions: Existing successful firms may experience growth in demand of
their product line. If such firms experience shortage or delay in the delivery of their
products due to inadequate production facilities, they may consider proposal to add
capacity to existing product line.
(iii) Diversification decisions: These decisions require evaluation of proposals to diversify
into new product lines, new markets etc. for reducing the risk of failure by dealing in
different products or by operating in several markets.

On the basis of decision situation: The capital budgeting decisions on the basis of
decision situation are classified as follows:
(i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or
more alternative proposals are such that the acceptance of one proposal will exclude the
acceptance of the other alternative proposals. For instance, a firm may be considering
proposal to install a semi-automatic or highly automatic machine. If the firm installs a
semi-automatic machine it excludes the acceptance of proposal to install highly automatic
machine.
(ii) Accept-reject decisions: The accept-reject decisions occur when proposals are
independent and do not compete with each other. The firm may accept or reject a proposal
on the basis of a minimum return on the required investment. All those proposals which
give a higher return than certain desired rate of return are accepted and the rest are
rejected.
(iii) Contingent decisions: The contingent decisions are dependable proposals. The
investment in one proposal requires investment in one or more other proposals. For
example, if a company accepts a proposal to set up a factory in remote area it may have to
invest in infrastructure also e.g. building of roads, houses for employees etc.
Project Cash Flows

One of the most important tasks in capital budgeting is estimating future cash flows for a
project. The final decision we make at the end of the capital budgeting process is no better
than the accuracy of our cashflow estimates.
The estimation of costs and benefits are made with the help of inputs provided by
marketing, production, engineering, costing, purchase, taxation, and other departments.
The project cash flow stream consists of cash outflows and cash inflows. The costs are
denoted as cash outflows whereas the benefits are denoted as cash inflows.
An investment decision implies the choice of an objective, an appraisal technique and the
project’s life. The objective and technique must be related to definite period of time. The
life of the project may be determined by taking into consideration the following factors:
(i) Technological obsolescence;
(ii) Physical deterioration; and
(iii) A decline in demand for the output of the project.
No matter how good a company's maintenance policy, its technological forecasting ability
or its demand forecasting ability, uncertainty will always be present because of the
difficulty in predicting the duration of a project life.
Calculating Cash Flows: It is helpful to place project cash flows into three categories:-

a) Initial Cash Outflow: The initial cash out flow for a project is calculated as follows:-
Cost of New Asset(s)
+ Installation/Set-Up Costs
+ (-) Increase (Decrease) in Net Working Capital Level
- Net Proceeds from sale of Old Asset (If it is a replacement situation)
+(-) Taxes (tax saving) due to sale of Old Asset (If it is a replacement situation)
= Initial Cash Outflow

Interim Incremental Cash Flows: After making the initial cash outflow that is necessary
to begin implementing a project, the firm hopes to benefit from the future cash inflows
generated by
the project. It is calculated as follows:-
Net increase (decrease) in Operating Revenue
- (+) Net increase (decrease) in Operating Expenses excluding depreciation
= Net change in income before taxes
- (+) Net increase (decrease) in taxes
= Net change in income after taxes
+(-) Net increase (decrease) in tax depreciation charges
= Incremental net cash flow for the period
Terminal-Year Incremental Net Cash Flow: We now pay attention to the Net Cash Flow
in the terminal year of the project. For the purpose of Terminal Year we will first calculate
the incremental net cash flow for the period as calculated in point (b) above and further to
it we will make adjustments in order to arrive at Terminal-Year Incremental Net Cash flow
as follows:-
Incremental net cash flow for the period
+(-) Final salvage value (disposal costs) of asset
- (+) Taxes (tax saving) due to sale or disposal of asset
+ (-) Decreased (increased) level of Net Working Capital
= Terminal Year incremental net cash flow

Basic Principles for Measuring Project Cash Flows

For developing the project cash flows the following principles must be kept in mind:
1. Incremental Principle: The cash flows of a project must be measured in incremental
terms. To ascertain a project’s incremental cash flows, one has to look at what happens to
the cash flows of the firm 'with the project and without the project', and not before the
project and after the project as is sometimes done. The difference between the two reflects
the incremental cash flows attributable to the project.
Project cash flows for year t = Cash flow for the firm with the project for year t − Cash
flow for the firm without the project for year t.
2. Long Term Funds Principle: A project may be evaluated from various points of view:
total funds point of view, long-term funds point of view, and equity point of view. The
measurement of cash flows as well as the determination of the discount rate for evaluating
the cash flows depends on the point of view adopted. It is generally recommended that a
project may be evaluated from the point of view of long-term funds (which are provided by
equity stockholders, preference stock holders, debenture holders, and term lending
institutions) because the principal focus of such evaluation is normally on the profitability
of long-term funds.
3. Exclusion of Financing Costs Principle: When cash flows relating to long-term funds
are being defined, financing costs of long-term funds (interest on long-term debt and equity
dividend) should be excluded from the analysis. The question arises why? The weighted
average cost of capital used for evaluating the cash flows takes into account the cost of
long term funds. Put differently, the interest and dividend payments are reflected in the
weighted average cost of capital. Hence, if interest on long-term debt and dividend on
equity capital are deducted in defining the cash flows, the cost of long-term funds will be
counted twice.
The exclusion of financing costs principle means that:
(i) The interest on long-term debt (or interest) is ignored while computing profits and taxes
and;
(ii) The expected dividends are deemed irrelevant in cash flow analysis.
While dividends pose no difficulty as they come only from profit after taxes, interest needs
to be handled properly. Since interest is usually deducted in the process of arriving at profit
after tax, an amount equal to interest (1 − tax rate) should be added back to the figure of
profit after tax.
That is,
Profit before interest and tax (1 − tax rate)
= (Profit before tax + interest) (1 − tax rate)
= (Profit before tax) (1 − tax rate) + (interest) (1 − tax rate)
= Profit after tax + interest (1 − tax rate)
Thus, whether the tax rate is applied directly to the profit before interest and tax figure or
whether the tax − adjusted interest, which is simply interest (1 − tax rate), is added to profit
after tax, we get the same result.
Post−tax Principle: Tax payments like other payments must be properly deducted in
deriving the cash flows. That is, cash flows must be defined in post-tax terms.

ABC Ltd is evaluating the purchase of a new project with a depreciable base of RS.
1,00,000; expected economic life of 4 years and change in earnings before taxes and
depreciation of RS. 45,000 in year 1, RS. 30,000 in year 2, RS. 25,000 in year 3 and RS.
35,000 in year 4. Assume straight-line depreciation and a 20% tax rate. You are required to
compute relevant cash flows.

XYZ Ltd is considering a new investment project about which the following information is
available.
(i) The total outlay on the project will be RS. 100 lacs. This consists of RS. 60 lacs on
plant and equipment and RS. 40 lacs on gross working capital. The entire outlay will be
incurred at the beginning of the project.
(ii) The project will be financed with RS. 40 lacs of equity capital; RS. 30 lacs of long term
debt (in the form of debentures); RS. 20 lacs of short-term bank borrowings, and RS. 10
lacs of trade credit. This means that RS. 70 lacs of long term finds (equity + long term
debt) will be applied towards plant and equipment (RS. 60 lacs) and working capital
margin (RS. 10 lacs) – working capital margin is defined as the contribution of long term
funds towards working capital. The interest rate on debentures will be 15 percent and the
interest rate on short-term borrowings will be 18 percent.
(iii) The life of the project is expected to be 5 years and the plant and equipment would
fetch a salvage value of RS. 20 lacs. The liquidation value of working capital will be equal
to RS. 10 lacs.
(iv) The project will increase the revenues of the firm by RS. 80 lacs per year. The increase
in operating expenses on account of the project will be RS. 35.0 lacs per year. (This
includes all items of expenses other than depreciation, interest, and taxes). The effective
tax rate will be 50 percent.
(v) Plant and equipment will be depreciated at the rate of 331/3 percent per year as per the
written down value method. So, the depreciation charges will be:
RS. (in lacs)
First year 20.0
Second year 13.3
Third year 8.9
Fourth year 5.9
Fifth year 4.0
Given the above details, you are required to work out the post-tax, incremental cash flows
relating to long-term funds.

Capital Budgeting Techniques

In order to maximise the return to the shareholders of a company, it is important that the
best or most profitable investment projects are selected; as the results for making a bad
long-term investment decision can be both financially and strategically devastating,
particular care needs to be taken with investment project selection and evaluation. There
are number of techniques available for appraisal of investment proposals and can be
classified as presented below:
Payback Period: The payback period of an investment is the length of time required for the cumulative
total net cash flows from the investment to equal the total initial l cash outlays. At that point in time , the
investors has recovered the money invested in the project.

Decision :
PBP > Target = Accept
PBP < Target = Reject
PBP = Target = Indifferent
Advantages
 It is easy to compute.
 It is easy to understand as it provides a quick estimate of the time needed for the
organization to recoup the cash invested.
 The length of the payback period can also serve as an estimate of a project’s risk;
the longer the payback period, the riskier the project as long-term predictions are
less
 reliable. In some industries with high obsolescence risk like software industry or in
situations where an organization is short on cash, short payback periods often
become the determining factor for investments.
Limitations
 It ignores the time value of money. As long as the payback periods for two projects
are the same, the payback period technique considers them equal as investments,
even if one project generates most of its net cash inflows in the early years of the
project while the other project generates most of its net cash inflows in the latter
years of the payback period.
 A second limitation of this technique is its failure to consider an investment’s total
profitability; it only considers cash flows from the initiation of the project until its
payback period and ignores cash flows after the payback period.
 Lastly, use of the payback period technique may cause organizations to place too
much emphasis on short payback periods thereby ignoring the need to invest in
long-term projects that would enhance its competitive position.
Accounting (Book) Rate of Return (ARR): The accounting rate of return of an
investment measures the average annual net income of the project (incremental
income) as a percentage of the investment.

The numerator is the average annual net income generated by the project over its useful
life.
The denominator can be either the initial investment or the average investment over the
useful life of the project.
Some organizations prefer the initial investment because it is objectively determined
and is not influenced by either the choice of the depreciation method or the estimation
of the salvage value. Either of these amounts is used in practice but it is important that
the same method be used for all investments under consideration.

Decision :
Project ARR > Target = Accept
Project ARR < Target = Reject
Project ARR = Target = Indifferent
Advantages
 This technique uses readily available data that is routinely generated for
financial reports and does not require any special procedures to generate data.
 This method may also mirror the method used to evaluate performance on the
operating results of an investment and management performance. Using the
same procedure in both decision-making and performance evaluation ensures
consistency.
 Lastly, the calculation of the accounting rate of return method considers all net
incomes over the entire life of the project and provides a measure of the
investment’s profitability.
Limitations
 The accounting rate of return technique, like the payback period technique,
ignores the time value of money and considers the value of all cash flows to be
equal.
 The technique uses accounting numbers that are dependent on the
organization’s choice of accounting procedures, and different accounting
procedures, e.g., depreciation methods, can lead to substantially different
amounts for an investment’s net income and book values.
 The method uses net income rather than cash flows; while net income is a
useful measure of profitability, the net cash flow is a better measure of an
investment’s performance.
 Furthermore, inclusion of only the book value of the invested asset ignores the
fact that a project can require commitments of working capital and other outlays
that are not included in the book value of the project.
 Suppose a project requiring an investment of Rs. 1,000,000 yields profit after tax and
depreciation as follows:
Years Profit after tax and depreciation
Rs.
1. 50,000
2. 75,000
3. 125,000
4. 130,000
5. 80,000
Total 460,000
Suppose further that at the end of 5 years, the plant and machinery of the project can be
sold
for Rs. 80,000. In this case the rate of return can be calculated as follows:

(a) If Initial Investment is considered then,

This rate is compared with the rate expected on other projects, had the same funds been
invested alternatively in those projects. Sometimes, the management compares this rate
with the minimum rate (called-cut off rate) they may have in mind. For example,
management may decide that they will not undertake any project which has an average
annual yield after tax less than 20%. Any capital expenditure proposal which has an
average annual yield of less than 20% will be automatically rejected.

(b) If Average investment is considered, then,

Net Present Value Technique (NPV): The net present value technique is a discounted
cash flow method that considers the time value of money in evaluating capital investments.
An investment has cash flows throughout its life, and it is assumed that a rupee of cash
flow in the early years of an investment is worth more than a rupee of cash flow in a later
year.
The net present value method uses a specified discount rate to bring all subsequent net cash
inflows after the initial investment to their present values (the time of the initial investment
or year 0).
Determining Discount Rate
Theoretically, the discount rate or desired rate of return on an investment is the rate of
return the firm would have earned by investing the same funds in the best available
alternative investment that has the same risk. Determining the best alternative opportunity
available is difficult in practical terms so rather that using the true opportunity cost,
organizations often use an alternative measure for the desired rate of return. An
organization may establish a minimum rate of return that all capital projects must meet;
this minimum could be based on an industry average or the cost of other investment
opportunities. Many organizations choose to use the overall cost of capital as the desired
rate of return; the cost of capital is the cost that an organization has incurred in raising
funds or expects to incur in raising the funds needed for an investment.
The net present value of a project is the amount, in current rupees, the investment earns
after yielding the desired rate of return in each period.
Net present value = Present value of net cash flow - Total net initial investment
The steps to calculating net present value are:
1. Determine the net cash inflow in each year of the investment
2. Select the desired rate of return
3. Find the discount factor for each year based on the desired rate of return selected
4. Determine the present values of the net cash flows by multiplying the cash flows by the
discount factors
5. Total the amounts for all years in the life of the project
6. Lastly subtract the total net initial investment.

Decision :
NPV is +ve = Accept
NPV is –ve = Reject
NPV is 0= Indiffrent

Compute the net present value for a project with a net investment of Rs. 100,000 and the
following cash flows if the company’s cost of capital is 10%? Net cash flows for year one
is Rs. 55,000; for year two is Rs. 80,000 and for year three is Rs. 15,000.
ABC Ltd is a small company that is currently analyzing capital expenditure proposals for
the purchase of equipment; the company uses the net present value technique to evaluate
projects. The capital budget is limited to Rs.500,000 which ABC Ltd believes is the
maximum capital it can raise. The initial investment and projected net cash flows for each
project are shown below. The cost of capital of ABC Ltd is 12%. You are required to
compute the NPV of the different projects.
Project A Project B Project C Project D
Initial Investment 200,000 190,000 250,000 210,000
Project Cash Inflows
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000

Advantages
 NPV method takes into account the time value of money.
 The whole stream of cash flows is considered.
 The net present value can be seen as the addition to the wealth of share holders.
The criterion of NPV is thus in conformity with basic financial objectives.
 The NPV uses the discounted cash flows i.e., expresses cash flows in terms of
current rupees.
 The NPVs of different projects therefore can be compared. It implies that each
project can be evaluated independent of others on its own merit.
Limitations
 It involves difficult calculations.
 The application of this method necessitates forecasting cash flows and the discount
rate.
 Thus accuracy of NPV depends on accurate estimation of these two factors which
may be quite difficult in practice.

The ranking of projects depends on the discount rate. Let us consider two projects
involving an initial outlay of Rs. 25 lakhs each with following inflow:
(Rs.in lakhs)
1st year 2nd year
Project A 50.0 12.5
Project B 12.5 50.0
At discounted rate of 5% and 10% the NPV of Projects and their rankings at 5% and 10%
are as follows:
NPV @ 5% Rank NPV @ 10% Rank
Project A 33.94 I 30.78 I
Project B 32.25 II 27.66 II
The project ranking is same when the discount rate is changed from 5% to 10%. However,
the impact of the discounting becomes more severe for the later cash flows. Naturally,
higher the discount rate, higher would be the impact. In the case of project B the larger
cash flows come later in the project life, thus decreasing the present value to a larger
extent.

The decision under NPV method is based on absolute measure. It ignores the difference in
initial outflows, size of different proposals etc. while evaluating mutually exclusive
projects.
Sadaf Limited is planning its capital investment programme for next year. It has five
projects all of which give a positive NPV at the company cut-off rate of 15 percent, the
investment outflows and present values being as follows:
Project Investment NPV @ 15%
Rs.‘000 Rs.‘000
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3

The company is limited to a capital spending of Rs.120,000.

You are required to optimise the returns from a package of projects within the capital
spending limit. The projects are independent of each other and are divisible (i.e., part-
project is possible).

Desirability Factor/Profitability Index/Present Value Index Method (PI): In the above

illustration the students may have seen how with the help of discounted cash flow
technique, the two alternative proposals for capital expenditure can be compared. In certain
cases we have to compare a number of proposals each involving different amounts of cash
inflows.
One of the methods of comparing such proposals is to work out what is known as the
‘Desirability factor’, or ‘Profitability index’ or ‘Present Value Index Method’. In general
terms a project is acceptable if its profitability index value is greater than 1.
Mathematically:
The desirability factor is calculated as below:

Decision :
PI >1 = Accept
PI <1 = Reject
PI =1 = Indiffrent
Note : Profitability Method is used when projects are under capital rationing

Suppose we have three projects involving discounted cash outflow of Rs. 550,000, Rs.
75,000 and Rs. 100,20,000 respectively. Suppose further that the sum of discounted cash
inflows for these projects are Rs. 650,000, Rs. 95,000 and Rs. 10,030,000 respectively.
Calculate the desirability factors for the three projects.
Advantages
The method also uses the concept of time value of money and is a better project evaluation
technique than NPV.
Limitations
 Profitability index fails as a guide in resolving capital rationing where projects are
indivisible.
 Once a single large project with high NPV is selected, possibility of accepting
several small projects which together may have higher NPV than the single project
is excluded.
 Also situations may arise where a project with a lower profitability index selected
may generate cash flows in such a way that another project can be taken up one or
two years later, the total NPV in such case being more than the one with a project
with highest Profitability Index.
 The Profitability Index approach thus cannot be used indiscriminately but all other
type of alternatives of projects will have to be worked out.
NPV v/s PI:
 If we have to evaluate only project, we may either calculate NPV
or PI, both will give same result.
 If we have to evaluate two or more projects:

(i) We should apply NPV method if funds are not key factors,
i.e., our aim is maximization of profits.
(ii) We should apply PI method if funds are key factors, i.e.,
we want to maximize the rate of return on funds
employed.
Let’s have an example to understand this point. A person is offered
to two jobs and he can accept either. First job will give him Rs.350
per day of 7 hours (Rs.50.00 per hour). Second job will give him
Rs.380 per day of 8 hours (Rs.47.50 per hour), which job he should
accept? If time is key factor for him, i.e., if he wants to maximize
his earning per hour he should go for the first job. If time is
not key factor for him and he wants to maximize his total earnings,
he should go for the second job.
Let’s have another example. Suppose, a businessman has two capital expenditure proposals
before him. First will require on investment of Rs.40,000 initially and will result in cash
flows at present value amounting to Rs.60,000 (NPV = 20,000, PI = 1.50). Second will
require on investment of Rs.50,000 and will result in cash inflows at present value
amounting to Rs.72,000 (NPV = 22,000, PI = 1.44). If funds are key factor, he should go
for the first project, i.e., he should maximize the rate of return. If funds are not key factor,
i.e., he wants to maximize his profit, he should go for the second project
 

Internal Rate of Return Method (IRR) The internal rate of return method considers
the time value of money, the initial cash investment, and all cash flows from the
investment. But unlike the net present value method, the internal rate of return method
does not use the desired rate of return but estimates the discount rate that makes the present
value of subsequent net cash flows equal to the initial investment. This discount rate is
called IRR.
IRR Definition: Internal rate of return for an investment proposal is the discount rate
that equates the present value of the expected net cash flows with the initial cash outflow.
This IRR is then compared to a criterion rate of return that can be the organization’s
desired rate of return for evaluating capital investments.

Decision :
Project IRR > Target = Accept
Project IRR < Target = Reject
Project IRR = Target = Indifferent

Calculate the internal rate of return of an investment of Rs. 1, 36,000 which yields the
following cash inflows:
Year Cash Inflows (in Rs.)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
A company proposes to install machine involving a capital cost of Rs. 360,000. The life of
the machine is 5 years and its salvage value at the end of the life is nil. The machine will
produce the net operating income after depreciation of Rs. 68,000 per annum. The
company's tax rate is 45%.
You are required to calculate the internal rate of return of the proposal.

Multiple Internal Rate of Return: In cases where project cash flows change signs or
reverse during the life of a project e.g. an initial cash outflow is followed by cash inflows
and subsequently followed by a major cash outflow , there may be more than one IRR. The
following
graph of discount rate versus NPV may be used as an illustration;

In such situations if the cost of capital is less than the two IRR’s, a decision can be made
easily, however otherwise the IRR decision rule may turn out to be misleading as the
project should only be invested if the cost of capital is between IRR1 and IRR2.. To
understand the concept of multiple IRR it is necessary to understand the implicit
reinvestment assumption in both NPV and IRR techniques.

Advantages
 This method makes use of the concept of time value of money.
 All the cash flows in the project are considered.
 IRR is easier to use as instantaneous understanding of desirability can be
determined by comparing it with the cost of capital
 IRR technique helps in achieving the objective of minimization of shareholders
wealth.
Limitations
 The calculation process is tedious if there are more than one cash outflows
interspersed between the cash inflows, there can be multiple IRR, the interpretation
of which is difficult.
 The IRR approach creates a strange situation if we compare two projects with
different inflow/outflow patterns.
 It is assumed that under this method all the future cash inflows of a proposal are
reinvested at a rate equal to the IRR. It is ridiculous to imagine that the same firm
has a ability to reinvest the cash flows at a rate equal to IRR.
  If mutually exclusive projects are considered as investment options which have
considerably different cash outlays. A project with a larger fund commitment but
lower IRR contributes more in terms of absolute NPV and increases the
shareholders’ wealth. In such situation decisions based only on IRR criterion may
not be correct.

Comparison of Net Present Value and Internal Rate of Return Methods Similarity
 Both the net present value and the internal rate of return methods are discounted
cash flow methods which mean that they consider the time value of money.
 Both these techniques consider all cash flows over the expected useful life of the
investment.

Different conclusion in the following scenarios

There are circumstances/scenarios under which the net present value method and the
internal rate of return methods will reach different conclusions. Let’s discuss these
scenarios:-
Scenario 1 - Large initial investment
NPV: The net present value method will favour a project with a large initial investment
because the project is more likely to generate large net cash inflows.
IRR: Because the internal rate of return method uses percentages to evaluate the relative
profitability of an investment, the amount of the initial investment has no effect on the
outcome.
Conclusion: Therefore, the internal rate of return method is more appropriate in this
scenario.

Scenario 2 – Difference in the timing and amount of net cash inflows

NPV: The net present value method assumes that all net cash inflows from an investment
earn the desired rate of return used in the calculation. The desired rate of return used by the
net present value method is usually the organization’s weighted-average cost of capital, a
more conservative and more realistic expectation in most cases.
IRR: Differences in the timing and amount of net cash inflows affect a project’s internal
rate of return. This results from the fact that the internal rate of return method assumes that
all net cash inflows from a project earn the same rate of return as the project’s internal rate
of return.
Conclusion: In this scenario choosing NPV is a better choice.

Scenario 3 – Projects with long useful life

NPV: Both methods favour projects with long useful lives as long as a project earns
positive net cash inflow during the extended years. As long as the net cash inflow in a year
is positive, no matter how small, the net present value increases, and the projects
desirability improves.
IRR: Likewise, the internal rate of return method considers each additional useful year of
a project another year that its cumulative net cash inflow will earn a return equal to the
project’s internal rate of return.
Conclusion: Both NPV and IRR suitable.

Scenario 4 – Varying cost of capital

As an organization’s financial condition or operating environment changes, its cost of
capital could also change. A proper capital budgeting procedure should incorporate
changes in the organization’s cost of capital or desired rate of return in evaluating capital
investments.
NPV: The net present value method can accommodate different rates of return over the
years by using the appropriate discount rates for the net cash inflow of different periods.
IRR: The internal rate of return method calculates a single rate that reflects the return of
the project under consideration and cannot easily handle situations with varying desired
rates of return.
Conclusion: NPV is a better method in these circumstances.

Scenario 5 – Multiple Investments

NPV: The net present value method evaluates investment projects in cash amounts. The
net present values from multiple projects can be added to arrive at a single total net present
value for all investment.
IRR: The internal rate of return method evaluates investment projects in percentages or
rates. The percentages or rates of return on multiple projects cannot be added to determine
an overall rate of return. A combination of projects requires a recalculation of the internal
rate of return.
Conclusion: NPV is a better method in these circumstances.

Discounted Payback Period Method: Some accountants prefers to calculate payback

period after discounting the cash flow by a predetermined rate and the payback period so
calculated is called, ‘Discounted payback period’. One of the most popular economic
criteria for evaluating capital projects also is the payback period. Payback period is the
time required for cumulative cash inflows to recover the cash outflows of the project.
For example, a Rs. 30,000 cash outlay for a project with annual cash inflows of Rs. 6,000
would
have a payback of 5 years ( Rs. 30,000 / Rs. 6,000).
The problem with the Payback Period is that it ignores the time value of money. In order to
correct this, we can use discounted cash flows in calculating the payback period. Referring
back to our example, if we discount the cash inflows at 15% required rate of return we
have:
Year 1 - Rs. 6,000 x 0.870 = Rs. 5,220 Year 6 - Rs. 6,000 x 0.432 = Rs. 2,592
Year 2 - Rs. 6,000 x 0.756 = Rs. 4,536 Year 7 - Rs. 6,000 x 0.376 = Rs. 2,256
Year 3 - Rs. 6,000 x 0.658 = Rs. 3,948 Year 8 - Rs. 6,000 x 0.327 = Rs. 1,962
Year 4 - Rs. 6,000 x 0.572 = Rs. 3,432 Year 9 - Rs. 6,000 x 0.284 = Rs. 1,704
Year 5 - Rs. 6,000 x 0.497 = Rs. 2,982 Year 10 - Rs. 6,000 x 0.247 = Rs. 1,482
The cumulative total of discounted cash flows after ten years is Rs. 30,114. Therefore, our
discounted payback is approximately 10 years as opposed to 5 years under simple payback.
It should be noted that as the required rate of return increases, the distortion between
simple payback and discounted payback grows. Discounted Payback is more appropriate
way of measuring the payback period since it considers the time value of money.
The expected cash flows of three projects are given below. The cost of capital is 10 per
cent.
(a) Calculate the payback period, net present value, internal rate of return and accounting
rate of return of each project.
(b) Show the rankings of the projects by each of the four methods..

Period Project A Project B Project C

Question: Do the profitability index and the NPV criterion of evaluating investment
proposals lead to the same acceptance-rejection and ranking decisions? In what situations
will they give conflicting results?
Answer
In the most of the situations the Net Present Value Method (NPV) and Profitability Index
(PI) yield same accept or reject decision. In general items, under PI method a project is
acceptable if profitability index value is greater than 1 and rejected if it less than 1. Under
NPV method a project is acceptable if Net present value of a project is positive and
rejected if it is negative. Clearly a project offering a profitability index greater than 1 must
also offer a net present value which is positive. But a conflict may arise between two
methods if a choice between mutually exclusive projects has to be made. Consider the
following example:

According to NPV method, project A would be preferred, whereas according to

profitability index method project B would be preferred.
This is because Net present value gives ranking on the basis of absolute value of rupees,
whereas, profitability index gives ranking on the basis of ratio. Although PI method is
based on NPV, it is a better evaluation technique than NPV in a situation of capital
rationing.
Question 2 : Distinguish between Net Present Value and Internal Rate of Return.
Answer
NPV versus IRR: NPV and IRR methods differ in the sense that the results regarding the
choice of an asset under certain circumstances are mutually contradictory under two
methods.
In case of mutually exclusive investment projects, in certain situations, they may give
contradictory results such that if the NPV method finds one proposal acceptable, IRR
favours another. The different rankings given by the NPV and IRR methods could be due
to size disparity problem, time disparity problem and unequal expected lives.
The net present value is expressed in financial values whereas internal rate of return (IRR)
is expressed in percentage terms.
In the net present value cash flows are assumed to be re-invested at cost of capital rate. In
IRR reinvestment is assumed to be made at IRR rates.

Question 3: Write a short note on “Cut - off Rate”.

Answer
Cut - off Rate: It is the minimum rate which the management wishes to have from any
project. Usually this is based upon the cost of capital. The management gains only if a
project gives return of more than the cut - off rate. Therefore, the cut - off rate can be used
as the discount rate or the opportunity cost rate.
Summery

As long as the cost of capital is greater than the crossover rate, both the NPV and IRR
methods will lead to the same project selection. However, if the cost of capital is less than
the crossover rate the two methods lead to different project selections--a conflict exists. if r
is less than the crossover rate, a ranking conflict occurs.
COST COMPARISON OF FIXED ASSETS/ PROPOSALS WITH UNEQUAL LIVES (INCLUDING THE
FIXED ASSETS/PROPOSALS WITH UNEQUAL LIVES AND UNEQUAL OUTPUT PER PERIOD

Remember: In this type of situations, our assumption is that fixed

asset is required for infinite period i.e. when the life of the fixed asset
will we over, we will immediately again purchase that fixed asset.

There are three types of questions on the situations mentioned above:

I TYPE
There are two or more fixed assets. Similar details are given for all
of them. We have to select one fixed asset. In this type of situations,
we find equivalent annual cost of each fixed asset.

 If output per period is same, we take the decision of the basis

of equivalent annual cost of each fixed asset. We recommend
the fixed asset with lower equivalent annual cost.
 If output per period is not same, we calculate comparative
cost per unit and take decision on the basis of comparative
cost per unit. We recommend the fixed asset with lower
comparative cost per unit.

Q.: A firm is considering to install either of the two machines which

are mutually exclusive. The details of their purchase price and
operating costs are:
Year Machine X Machine Y
Purchase cost 0 Rs.10,000 Rs.8,000
Operating cost 1 Rs.2,000 Rs.2,500
Operating cost 2 Rs.2,000 Rs.2,500
Operating cost 3 Rs.2,000 Rs.2,500
Operating cost 4 Rs.2,500 Rs.3,800
Operating cost 5 Rs.2,500 Rs.3,800
Operating cost 6 Rs.2,500 Rs.3,800
Operating cost 7 Rs.3,000
Operating cost 8 Rs.3,000
Operating cost 9 Rs.3,000
Operating cost 10 Rs.3,000

Machine X will recover salvage value of Rs.1,500 in the year 10, while
Machine Y will recover Rs.1,000 in the year 6. Determine which
machine is cheaper at 10 per cent cost of capital, assuming that both
the machines operate at the same efficiency.
Answer
PV of cost of using X machine for 10 years and Y machine for 6 six years
Period X Y
0 10000x1 8000x1
1 2000x.909 2500x.909
2 2000x.826 2500x.826
3 2000x.751 2500x.751
 4 2500x.683 3800x.683
5 2500x.621 3800x.621
6 2500x.564 (3800-1000)x.564
7 3000x.513
8 3000x.467
9 3000x.424
10 (3000-1500)x.386
PV of net cost 24436 20751

Equivalent . Annual cost:

X machine :
24434/6.145
=3976 Y machine
: 20752/4.355
=4765
X is recommended because lower amount of Equivalent annual cost

Alternative way: Calculation of PV of cost of using each of two machines for 30

years
X Y
24434xPVF0 20752x PVF0
24434xPVF10 20752x PVF6
24434xPVF20 20752x PVF12
20752x PVF18
20752x PVF24
37506 44.923

PVF0 =1,PVF10 =0.386, PVF20 =0.149 , PVF6 =0.564

PVF12 =0.319 PVF18 =0.180 PVF24 =(.319x.319)

X recommended because lower amount of PV of cost for using for

same period of 30 years.

Q.: Company X is to choose between two machines A and B. The two

machines are designed differently, but have identical capacity and to
exactly the same job. Machine A cost Rs.1,50,000 and will last for 3
years. It costs Rs.40,000 per year to run. Machine B is an ‘economy’
model costing only Rs.1,00,000, but will last only for 2 years, and costs
Rs.60,000 per year to run. These are real cash flows. The costs are
forecasted in rupees of constant purchasing power. Ignore tax.
Opportunity cost of capital is 10 per cent. Which machine the company
X should buy?

Answer
Calculation of Equivalent Equivalent amount
amount
Machine A
150000+(40000x2.487) Rs.1,00,314
-----------------
2.487
 Machine B 100000+(60000x1.736) Rs.1,17,604
-----------------
1.736
A recommended because of lower EAC.

Q.: A manufacturing unit engaged in the productions of automobile

parts is considering a proposal of purchasing one of the two plants,
details given below :
Machine A Machine B
 60

Cost Rs.20,00,000 Rs.38,00,000

Installation charges Rs.4,00,000 Rs.2,00,000
Life 20 years 15 years
Scrap value after full life Rs.4,00,000 Rs.4,00,000
Output per minute 200 400

The annual cost of the two plants are to taken as follows

A B
Running hours per annum 2,500 2,500
Costs Rupees Rupees
Wages 1,00,000 1,40,000
Indirect material 4,80,000 6,00,000
Repairs 80,000 100000
Power 2,40,000 2,80,000
Fixed cost 60,000 60,000
Will it be advantageous to buy A or B? Substantiate your answer with the help of
comparative unit cost of the plants. Assume interest for capital as 10 per cent. Make
other relevant assumptions.

Note 10 per cent interest tables: 20 years 15 years

Present value of Re.1 0.1486 0.2394
Annuity of Re. 1
(Capital recovery factor with 10% interest) 0.1175 0.1315
Answer
A B
Machine Machine
Annual Output 2500 x 60 x 200 2500 x 60 x 400
= 3 crore units = 6 crore units

Annual Cost
Wages 1,00,000 1,40,000
Sundry Indirect Material 4,80,000 6,00,000
Repairs & Maintenance 80,000 1,00,000
Power & Steam 2,40,000 2,80,000
Fixed Costs 60,000 80,000
Dep. & Interest 2,75,015 5,13,408
Annual Total Cost 12,35,015 17,13,408
 61

Cost per unit 0.041167 0.0286

As the unit cost is less in proposed plant, it may be recommended that new plant is
advantageous to buy.

Zero Period cost of B Plant = 40,00,000 – (4,00,000 x 0.2394)

= 39,04,240

Equivalent annual cost

(i.e. Equivalent annual amount
of Depreciation & Interest) = 39,04,240 x Cap. Recover Factor
= 39,04,240 x 0.1315
= Rs.5,13,408

Zero Period cost of A Plant = 24,00,000 – 4,00,000 x 0.1486

= 23,40,560

Equivalent Annual Cost

(i.e. Equivalent annual amount
of Depreciation & Interest) = 23,40,560 x Cap. Recovery Factor
= 23,40,560 x 0.1175
= 2,75,015

Q.: A company is to select one of following two mechanical systems:

I : Cost of the system Rs.5,00,000; Life : Infinite; Annual Maintenance cost
Rs.50,000

II : Cost of the system Rs.1,00,000; Life : 15 years; Annual Maintenance cost

Rs.40,000
Advise. Assume cost of capital 10% Ignore tax.

Answer
I System :
PV of I system
500000 + 50000 [(1/1.10)1 +(1/1.10)2 + .......... Infinity ] 10,00,000
Equalized Annual cost
[10,00,000] / [(1/1.10) 1 + (1/1.10) 2 + …..[Infinity] 1,00,000

II System
PV of II system
= 100000 + 40000 [(1/1.10)1 + (1/1.10)2 + …..(1.1.10)15] 4,04,240
Equalized Annual cost =
 62

[404240] / [(1/1.10)1 +(1/1.10)2 + ….. (1/1.10)15] 53,148

II system is recommended.

COST COMPARISON OF FIXED ASSETS/ PROPOSALS WITH UNEQUAL LIVES

II TYPE

The question refers to only one fixed asset. It does not exist or we have no
information about existing project / proposal / fixed asset. We have to decide its
replacement period.

In this type of situations, we find equivalent annual cost of each proposed

replacement period. We recommend the replacement period that has minimum
equivalent annual cost.

Q.: The cost of new machine is Rs.10,000. Decide the replacement period using
following cost information:
Age of machine Annual repair cost Salvage value as year end
1 5,000 8,000
2 10,000 6,400
3 10,000 5,120
Assume that repairs are made at the end of each year only if machine is to be
retained and are not necessary if the machine is to be sold for salvage value. Cost of
capital 10 per cent. Tax Ignored.

Answer
Statement showing P.V. of Cost of Replacement after 1,2 or 3 years.

Replacement 1 Year 2 Years 3 Years

Cost - 10,000 - 10,000 - 10,000
Repair (End of year1 ) - - 5,000 x .909 -5,000 x .909
Repair (End of year 2) - - -10,000 x .826

Salvage Value +8,000 x .909 + 6,400 x .826 + 5,120 x .751

P.V. of Cost - 2,728 - 9,259 - 18,960

Equivalent Annual Cost = NPV of cost / Sum of PV factors

1 Year 2 Years 3 Years

Equivalent Annual Cost - 2728 9259 18960

.909 1.736 2.487

= Rs. 3001 = Rs. 5334 = Rs. 7624

 63

Replacement after 1 year is recommended as equivalent cost is least in the case.

Q: A company wishes to decide when to replace the vehicles that it operates in its
transport fleet. What should be replacement period, 3 years or 4 years?

The capital cost of a vehicle is Rs.6,000

Its estimate trade in value is:

If replaced after 3 years = Rs.1,000
If replaced after 4 years = Rs.700
Assume that corporation tax is 50 per cent and that there are taxable profits to
absorb any following deduction. Dep. is 100 per cent in the first year. Cost of capital
= 10 per cent
Operating costs (excluding depreciation) (Rupees)
Year Annual Tyres Fixed costs Fuel Total
repairs
1 290 - 900 2500 3690
2 840 250 900 2500 4490
3 1120 - 900 2500 4520
4 1340 250 900 2500 4990

Answer

DCF Analysis of 3 years and 4 years Replacement Proposals

Period PVF 3 years 4 years
CF PV CF PV
Investment 0 1 -6,000 -6,000 -6,000 -6,000
Tax savings 1 0.909 +3,000 +2,727 +3,000 +2,727
on depreciation
Operating cost less 1 0.909 -1,845 -1,677 -1,845 -1,677
tax savings
-----do------ 2 0.826 -2,245 -1,854 -2,245 -1,854
-----do------ 3 0.751 -2,260 -1,697 -2,260 -1,697
Sale of scrap less 3 0.751 +500 +376 --- ---
tax
Operating cost less 4 0.683 --- --- -2,495 -1,704
tax savings
Sale of scrap 4 0.683 --- --- +350 +239
 64

NPV -8,125 -9,966

3 years Replacement Proposal:

NPV = Rs.8,125 Equivalent annual cost: 8,125/2.4860 = Rs3,268

4 years Replacement Proposal:

NPV = Rs.9966 Equivalent annual cost: 9,966/3.1700 = Rs.3,144

4 years replacement proposal is recommended on account of its lower equivalent

annual cost.

COST COMPARISON OF FIXED ASSETS/ PROPOSALS WITH UNEQUAL LIVES

III TYPE

There is one existing machine. It is being used for quite some time. We want to
replace it with some other machine etc. We have to decide: when to replace.

In this case we divide all the cash flows in two parts (i) Repetitive cash flows and (ii)
Non repetitive cash flows. Repetitive cash flows are those cash flows which will be
repeating over infinite period. These cash flows are calculated assuming for a minute
that the existing machine does not exist i.e. these are calculated ignoring the
existing machine. Non repetitive cash flows are the cash flows which will be there
for limited period; these arise on account of existing machine.
Q.: Company Y is operating an elderly machine that is expected to produce a net
cash inflow of Rs.40,000 in the coming year and Rs.40,000 next year. Current
salvage value is Rs.80,000 and next year’s value is Rs.70,000. The machine can
be replaced now with a new machine, which costs Rs.1,50,000, but is much more
efficient and will provide a cash inflow of Rs.80,000 a year for 3 years. Company Y
wants to know whether it should replace the equipment now or wait a year with the
clear understanding that the new machine is the best of the available alternatives and
that it in turn be replaced at the optimal point. Ignore tax. Take opportunity cost of
capital as 10 per cent. Advise with reasons.
Answer

(Teaching note – not to be given in the exam) If you use the old machine for 1
year, the project is for total 4 years. If the replace the machine now, the total
project life is 3 years. This situation refers to projects with unequal lives.

Repetitive Cash flows

PV of cost of using new machine for 3 years:

-1,50,000 (investment) + 80,000 (Annual cash flow from operation) x 2.486 = 48,880
 65

Equalized annual NPV = 48,880 / 2.486 = 19,662

If we replace the machine now, our equalized annual net cash flow would be
Rs.19,962 from year one ( for ever)

If we replace the machine after 1 year, our equalized annual net cash flow would be
Rs.19,962 from year two ( for ever)

Non-Repetitive Cash flows

NPV of using the old machine for one year:

- 80,000 (forgone scrap) + 40,000 x 0.909 (cash inflow form operation) + 70,000 x
0.909 (sale of scrap after using the old machine for one year)
= 19,990

Equalized annual NPV = 19,990 / 0.909 = 21,991

Year Equalized NPV
Replace now Replace after 1 year
1 19,962 21,991
2 onwards 19,962 19,962
From the above table, we conclude that the machine should be replaced after 1 year.

Q.: S. Engineering Company is considering to replace or repair a particular machine,

which has just broken down. Last year this machine cost Rs.20,000 to run and
maintain. These costs have been increasing in real term in recent years with the age of
the machine. A further useful life of 5 years is expected, if immediate repairs of
Rs.19,000 are carried out. If the machine is not repaired it can be sold immediately to
realize about Rs.5,000 (ignore loss/gain on such disposal).

Alternatively, the company can buy a new machine for Rs.49,000 with an expected
life of 10 years with no salvage value after providing depreciation on straight line
basis. In this case, running and maintenance costs will reduce to Rs.14,000 each year
and are not expected to increase much in real terms for a few years at least. S.
Engineering Company regard a normal return of 10 per cent p.a. after tax as a
minimum requirement on any new investment. Considering capital budgeting
technique, which alternative will you choose? Take corporate tax rate of 50 per cent
and assume that depreciation on straight line basis will be accepted for tax purposes
also.

Answer:
PV of repair alternative:
Foregone sale of old machine -5,000 x 1.000
Repair -19,000 x 1.000
Tax Saving On Repair +9,500 x 0.909
 66

Annual Cost Less Tax Savings -10,000 x 3.791

---------------
-53,275
---------------
Equal. Annual Cost = 53275/3.791= 14,053

PV of Replace. Alternative
Net Investment -49,000 x 1.000
Running Cost (Net of Tax Savings) -7,000 x 6.145
Tax Saving on Dep. +2,450 x 6.145
--------------
-76,960
--------------
Equal. Annual cost = 76,960 /6.145 = 12,524

Q: A Co. is contemplating whether to replace an existing machine now or wait for a

year. A co. currently pays no taxes. The replacement machine costs Rs.90,000 now and
requires maintenance of Rs.10,000 at the end of every year for 8 years. At the end of
eight years it would have a salvage value of Rs.20000 and would be sold. The details
regarding the existing machine are as follows:
Year Maintenance (Rupees) Salvage (Rupees)
0 0 35,000
1 10,000 25,000

The opportunity cost of capital is 15%. Should the machine be replaced now or after
1 year.

Answer
Replacing the machine now :
Cost of machine -90,000 x 1.000
Annual maintenance cost for 8 years -10,000 x 4.487
Salvage value after 8 years +20,000 x 0.327
-------------
PV of cost of using the machine for 8 years 1,28,330
-------------
EA cost = 1,28,330 / 4.487 = Rs.28,600

II Using old machine for 1 year

Opportunity cost -35,000 x 1.00
Maintenance -10,000 x 0.870
Salvage +25,000 x 0.870
-------------
PV of cost of using old machine for 1 year 21,950
-------------
E A cost = 21,950 / 0.870 = 25,230
 67

Statement year EA cost under each of 2 alternatives

Year Replace now Wait for a year
1 28,600 25,230
nd
2 year onwards 28,600 28,600
Recommendation: Wait for a year

Q: A Co. is contemplating whether to replace an existing machine or to spend money

on overhauling it. A co. currently pays no taxes. The replacement machine costs
Rs.90,000 now and requires maintenance of Rs.10,000 at the end of every year for 8
years. At the end of eight years it would have a salvage value of Rs.20,000 and would
be sold. The existing machine requires increasing amounts of maintenance each year
and its salvage value falls each year as follows:
Year Maintenance (Rupees) Salvage (Rupees)
0 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0

The opportunity cost of capital is 15%. When should the machine replaced?

Answer
(A) New Machine (Repetitive cash - flows)
Cost of machine -90000 x 1.000
Annual maintenance cost for 8 years -10000 x 4.487
Salvage value after 8 years +20000 x 0.327
PV of cost of using the machine for 8 years 128330

EA cost = 128330 / 4.487 = 28600

Whenever we replace the machine, after replacement year after year the equivalent
annual cost would be Rs.28,600 (for infinite period)

(B) Other cash flows (NON-REPETITIVE CASH FLOWS)

PV of the cash flows associated with the use of old machine for one year:
Loss of salvage value - 40,000 x 1.000

Maintenance - 10,000 x 0.870

Salvage value + 25,000 x 0.810
26,950

E A cost = 26950 / .870 = 30977

PV of the cash flows associated with the use of old machine for 2 years:
-40,000 x 1.000
-10,000 x 0.870
- 20,000 x 0.756
+ 15,000 x 0.756
---------------
Jahanzaib Butt (Commerce Department)

PV of cost: 52,480

E A cost = 52,480 / 1.626 = 32,276

PV of the cash flows associated with the use of old machine for 3 years:
-40,000 x 1.000
-10,000 x 0.870
-20,000 x 0.756
-30,000 x 0.658
+10,000 x 0.658
----------------
PV of cost = 76,980

E A cost = 76,980 / 2.283 = 33,719

PV of the cash flows associated with the use of old machine for 4 years:
-40000 x 1
-10000 x 0.870
-20000 x 0.756
-30000 x 0.658
-40000 x 0.572
-----------------
PV of cost = 1,06,440

E A cost = 1,06,440 / 2.855 = 37,281

Statement showing EA cost under each of 5 alternatives

Year I II III IV V
1 28,600 30,977 32,276 33,719 37,281
2 28,600 28,600 32,276 33,719 37,281
3 28,600 28,600 28,600 33,719 37,281
4 28,600 28,600 28,600 28,600 37,281
5th year onwards 28,600 28,600 28,600 28,600 28,600

Alternative 1st is recommended.

Jahanzaib Butt (Commerce Department)

SENSITIVITY ANALYSIS

The five important determinants of NPV, besides some others, are:

(i) Selling price

(ii) sales quantity
(iii) cash cost
(iv) cost of capital, and
(v) Amount of investment.

Sensitivity analysis is a tool to measure the risk surrounding a capital expenditure

project. The analysis measures how responsive/sensitive the project’s NPV is to
change in the variables that determine NPV.

This analysis is carried on the projects reporting positive Net Present Values. It
requires the calculation of % change, in value of each determinant of the NPV that
may reduce the NPV to zero. These percentages are put in ascending order. The
item corresponding to minimum change is considered to be most sensitive / risky.
The concept of the sensitivity suggests that management should pay maximum
attention to this item as small adverse change in this item may result in big
unfavorable results. Sensitivity analysis therefore provides an indication of why a
project might fail.

Critics of this concept opine that the management should not pay maximum attention
towards most sensitive item, rather they should pay maximum attention towards the
item where there is highest probability of adverse change.

Q: Vanshu Ltd. is considering a project, the details are as follows. Cost of

project: Rs.2,00,000. Life of the project is 3 years. Scrap value is expected to be
Rs.5000. Annual expected sale 1000 units @ Rs.300. Unit variable cost Rs.200. Cost
of capital 16%. Ignore tax. Perform sensitivity Analysis.

Answer

(i) Cost of project: Let cost of project = x

- x + 1,00,000 ( 2.246 ) + 5,000(0.641) = 0

x = 2,27,805

% sensivity : (27805/2,00,000) x 100 = 13.90%

(ii) Sales volume :

Let sales volume = x

-2,00,000 + 100x(2.246) + 5000(0,641) = 0

x= 876

% Sensivity = (124/1000) x 100 = 12.40%

Jahanzaib Butt (Commerce Department)

(iii) Unit cost;

Let unit cost = x

-2,00,000 + (300 –x)(1000)(2.246) + 5000(0.641)

x= 212.38

% sensitivity = (12.38/200) x 100 = 6.19%

(iv) Selling price Let

selling price = x

- 2,00,000 + 1,000(x-200)(2.246) + 5,000(0.641) = 0

X = 287.62

% Sensitivity = (12.38/300) x 100 = 4.12%

(v)Discounting rate :

Average cash flow = (1,00,000 + 1,00,000 + 1,05,000) / 3 = 1,01,667

Fake payback period = 2,00,000 / 1,01,667 = 1.97

Approximate IRR = 24%

NPV at 24% = -2,00,000 + 1,00,000 x 1.981 + 5,000 x 0.524 = +720

NPV at 25% = -2,00,000 + 1,00,000 x 1.952 + 5,000 x 0.512 = -2,240

720
IRR = 24 + ----------------- x 1 = 24.24 %
720 – (-2240)

% Sensitivity = ( 8.24 / 16 ) x 100 = 51.50 %

Sensitivity Analysis

Factor affecting NPV % change leading to zero NPV

Selling price 4.12
Unit cost 6.19
Sales volume 12.40
Cost of project 13.90
Discounting rate 51.50

As per Sensitivity Analysis approach, the management should pay maximum attention
towards SP (as even a small decline of 4.12% will result in zero NPV i.e. a small
decline of slightly above 4.12% will make the project unviable), followed by unit cost,
then followed by sales volume, then by cost of project and then finally by discounting
rate.
Jahanzaib Butt (Commerce Department)

Q.: XYZ Ltd is considering a project. The following estimates are available:
Sales volume
I 20,000 Units
II 30,000 Units
III 30,000 Units
Initial cost of the project Rs.10,00,000
Selling price /unit Rs.60
Cost / unit Rs.40

You are required to measure the sensitivity of the project in relation to each of the
following parameters: (i) Sales price / unit (ii) unit cost (iii) sales Volume (iv) Initial
outlay (v) Project life. Ignore tax. Discount rate 10%.

Answer (i) Selling price Let selling price = x

- 10,00,000 + 20,000(x-40)(0.909) + 30,000(x-40)(0.826) + 30,000(x-40)

(0.751) = 0
x = Rs.55.26
% Sensitivity = (4.74/60) x 100 = 7.90%
(ii) Unit cost

Let unit cost = x

- 10,00,000 + 20,000(60-x)(0.909) + 30,000(60-x)(0.826) + 30,000(60-

x)(0.751) = 0

x = Rs.4.74

% Sensitivity = (4.74/40) x 100 = 11.85%

(iii) Sales volume
Let the sales volume of first year = 2x
Let the sales volume of second year = 3x
Let the sales volume of third year = 3x

- 10,00,000 + 2x(60-40)(0.909) + 3x(60-40)(0.826) + 3x(60-40)(0.751) = 0

x= 7,635 2x = 15,270

% Sensitivity = (4,730 / 20,000) x 100 = 23.65 %

(iv) Initial outlay
Let the initial outlay = x

- x + 20,000(60-40)(0.909) + 30,000(60-40)(0.826) + 30,000(60-40)(0.751) =

0

x= 13,09,800

% Sensitivity = (3,09,800 / 10,00,000) x 100 = 30.98 %

Jahanzaib Butt (Commerce Department)

(v) Life of project

NPV for 2 years NPV for 3 years

-10,00,000 -10,00,000
+ 4,00,000 x 0.909 + 4,00,000 x 0.909
+ 6,00,000 x 0.826 = -140,800 + 6,00,000 x 0.826
+ 6,00,000 x 0.751 = + 3,09,800

NPV increases by 4,50,600, when life of the project increases by 1 year

NPV increases by 1, when life of the project increases by 1/450600 year

NPV increases by 140800, when life of project increases by

(1/450600) x 140800 i.e. by 0.3125 year

Life of project for zero NPV = 2.3125 years

% Sensitivity = ( 0.6875 / 3 ) x 100 = 22.92%

Sensitivity Analysis

Factor affecting NPV % change leading to zero NPV

Selling price 7.90
Unit cost 11.85
Life of project 22.92
Sales volume 23.65
Cost of project 30.98

As per Sensitivity Analysis approach, the management should pay maximum attention
towards SP (as even a small decline of 7.90% will result in zero NPV i.e. a small
decline of slightly above 7.90% will make the project unviable), followed by unit cost,
then followed by life of project, then by sales volume and then finally by cost of
project.

Q : From th following details relating to a project, anlyze the sensitivity of the

project to changes in project cost, annual cash and cost of capital:

Initial cost = Rs. 1,20,000

Annual cash flow Rs. 45,000
Life of the project 4 years
Cost of capital = 10%

To which of the three factors, the project is most sensitive? (use annuity factors

:for 10% …3.169 and 11% … 3.109)factor

Answer
Jahanzaib Butt (Commerce Department)

(i) Cost of project: Let cost of project = x

- x + 45,000 (3.169) = 0

x = 142605

% sensitivity : (22605/1,20,000) x 100 = 18.8375%

(ii) Annual cash flows : Let annual cash flow = x

- 1,20,000 + x (3.169) = 0

x = 37,867

% sensitivity : [(45000-37867)/45000] x 100 = 15.8511%

(iii) Cost of capital :

Payback period = 120000/45000 = 2.667

Annuity at 10 % = 3.169

Annuity at 11 % = 3.109

RHS decreases by 0.060, LHS increases by 1%

RHS decreases by 1, LHS increases by 1/0.06 i.e 16.67%

RHS increase by 0.502, LHS increases by 16.67 x 0.502 i.e. 8.368%

Rough estimate is that annuity at 18.368 % for 4 years is 2.667

This is an indication that IRR is about 18%

NPV at 18% : -1,20,000 + 45000(2.69) = +1050

NPV at 20% : -1,20,000 + 45000( 2.589) = -3495

Jahanzaib Butt (Commerce Department)

1050

IRR = 18 + ----------------- x 2 = 18.46 %

1050 – (-3495)

% Sensitivity = ( 8.46 / 10 ) x 100 = 84.60 %

Annual cash flow is most sensitive factor. As per Sensitivity Analysis approach,
the management should pay maximum attention towards annual cash flow (as
even a small decline of 15.8511% will result in zero NPV i.e. a small decline of
slightly above 15.8511% will make the project unviable,