The Basics of Capital Budgeting

Should we
build this
plant?
 What is Capital Budgeting
• Process of evaluating and selecting long-term
investments that are consistent with the goal
of wealth maximization.
• It pertains to the fixed/long-term assets.
• Long-term assets are they assets which are in
operation and yield a return over a period of
time (exceeding one year)
• Hence, they involve current outlay and a
series of anticipated cash flows of future
benefits.
• These benefits may be increase in revenues or
decrease in costs.
 Involves
• Addition
• Modification
• Replacement of fixed assets
 Features of Capital Budgeting
• Potentially large anticipated benefits
• Relatively high degree of risk
• Long time period between the initial outlay and the
anticipated returns
• Decisions affect the profitability of the firm
• Irrevocable decisions
• Strategic in nature
• Involves huge cost and firms have scarce capital
resources
 Difficulties
• Benefits received in some future period and
future is uncertain
• Costs incurred and benefits received are in
different time periods and are not logically
comparable because of time value of money
• All benefits cannot be measured in
quantitative terms
 Rationale
• Efficiency
• Either by increased revenues or decreased
costs
• Hence capital budgeting decisions can be of
two types: those which expand revenues and
those which reduce costs
 Types of Capital Budgeting Decisions
• Accept-Reject Decision: Projects are independent
of each other. Projects having greater return than
the required rate of return are accepted and
others are rejected.
• Mutually Exclusive Projects: Acceptance of one
will exclude the acceptance of the other projects.
• Capital Rationing Decision: firm has only fixed
amount to allocate among competing capital
expenditures.
 Other Related Concepts
• Cash flows vs accounting profits
 Exclusion of non cash expenses e.g.
depreciation
 Avoids accounting ambiguities like inventory
valuation
 Considers time value of money
Accounting profits are useful for performance
measures but not for decision criteria.
 Relevant Cash Flows
• Incremental cash flows: only differences due to
the decision need to be considered.
• Only those cash flows which are directly
attributable to the investment are taken into
account.
• Hence, fixed overhead costs are not considered;
but if there is any increase in them due to the
new proposal, they must be considered.
 Sunk Costs
• Are cash outflows that have already been
made and therefore have no effect on the
cash flows relevant to a current decision.
• Example: expenditure incurred on Research.
 Cash Flow Pattern
• Conventional Cash Flows:
- + + + +
• Non Conventional Cash Flows
- + + _ +
 Evaluation Techniques

Evaluation Techniques

Traditional Techniques Time-Adjusted or Discounted Methods

Net Terminal Profitability

Average Rate of Return (ARR) Pay-Back Period Method NPV Method IRR Method Value Index
 1. Average Rate of Return (ARR)
• Also known as accounting rate of return method
• Based on accounting information rather than
cash flows
• ARR = Average annual profits after taxes
__________________________ * 100
Average Investment
• Average Investment = Net working capital
+ Salvage Value
+ ½ (Initial cost – Salvage)
 Illustrations…
1. Determine the average rate of return from the following
data of two machines A and B.
Particulars Machine A Machine B
Cost 56,125 56,125
Annual estimated income
after depreciation and
tax
Year 1 3,375 11,375
Year 2 5,375 9,375
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
Salvage 3,000 3,000
 Particulars Machine A Machine B

Cost 56,125 56,125

Annual estimated income

after depreciation and tax

Year 1 3,375 11,375

Year 2 5,375 9,375
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
Salvage 3,000 3,000
Average Income

Average Investment

ARR
 Particulars Machine A Machine B

Cost 56,125 56,125

Annual estimated income

after depreciation and tax

Year 1 3,375 11,375

Year 2 5,375 9,375
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
Salvage 3,000 3,000
Average Income 7,375 7,375

Average Investment 29,562.50 29,562.50

ARR 24.9 24.9

 Accept - Reject Rule
• If ARR > Required rate of Return => Accept
• If ARR < Required rate of Return => Reject
 Merits and Demerits of ARR
Merits Demerits
Easy to calculate Uses accounting profit instead of cash
flows
Simple to understand Ignores time value of money
Total Benefits of the project is taken into Does not differentiate between the size of
account investments required for each project
Does not consider any benefits that
accrue to the firm from the sale of old
equipment which is replaced by new
equipment
 Illustration…
• A company is considering an investment
proposal to install new machinery at a cost of
Rs 50,000. The machine has a expected life of
5 years and no salvage value. Tax rate is 35 %.
Assume the firm uses straight line method of
depreciation, compute the ARR given the
following CFBT:
YEAR CFBT

1 10,000

2 10,692

3 12,769

4 13,462

5 20,385
YEAR CFBT DEPRECIATION PBT TAXES EAT

1 10,000

2 10,692

3 12,769

4 13,462

5 20,385
YEAR CFBT DEPRECIATION PBT TAXES EAT

1 10,000 10,000 - - -

2 10,692 10,000 692 242 450

3 12,769 10,000 2,769 969 1,800

4 13,462 10,000 3,462 1,212 2,250

5 20,385 10,000 10,385 3,635 6,750

Average 11,250
Income
• ARR = 2250 / 25000 = 9%
 Pay-Back Period Method
• Exact amount of time required for a firm to
recover its initial investment in a project as
calculated from cash inflows.
• Pay-Back Period = Investment / outlay
Constant annual cash flow
 Illustration…
• An investment of Rs. 40,000 in a machine is
expected to produce CFAT of Rs. 8000 for 10
years.
• Pay back period is 5 years.
• Project with shortest pay back period is
superior than others.
 Merits and Demerits of Pay-back period
method
Merits Demerits

Simple to understand Does not consider the cash flows earned a

fter the pay-back
period

Easy to calculate Ignores time value of money

Reduces the loss through obsolescence

Suited to a firm which has shortage of

cost or whose liquidity position is not
good
 Suitability
• For firms who lay more emphasis on short-run
earning performance rather than long-term
growth.
• It is a measure of liquidity rather than
profitability.
• It is used to calculate IRR.
 Steps to Calculate CFAT
Particulars 1 2 3 4 5

Sales Revenues

Less Operating
Expenses

CFBT

Less Depreciation

PBT

Less Tax

EAT

Add Depreciation

CFAT
 Practice Questions
1. A project cost Rs. 5,00,000 and yields
annually a profit of Rs 80,000 after
depreciation @ 12% but before tax of 50%.
Calculate the pay back period.
 Particulars Amount

Sales Revenues -

Less Operating Expenses -

CFBT -

Less Depreciation -

PBT 80,000

Less Tax 40,000

EAT 40,000

Add Depreciation 60,000

CFAT 1,00,000

Pay back period 5,00,000 / 1,00,000 = 5 years

 Practice Question…
2. X Ltd is producing articles mostly by manual
labour and is considering to replace it by a
new machine. There are two alternative
models M and N of the new machine.
Compute the payback period on the basis of
the given information:
 Particulars Machine M Machine N

Cost of machine 90,000 1,80,000

Estimated life of machine 4 5

Estimated Savings in Scrap 5,000 8,000

Estimated Savings in direct 60,000 80,000

wages
Additional cost of 8,000 10,000
maintenance
Additional cost of 12,000 18,000
supervision
 Particulars M N

Savings 65,000 88,000

Additional cost 20,000 28,000

Net Savings 45,000 60,000

Cost 90,000 1,80,000

Pay-Back Period 2 3
Discounted Cash Flows or Time
Adjusted Techniques
 Net Present Value Method (NPV)
• Two Basic limitation of Traditional Methods:
1. Not consider total cash flow stream
2. Not consider time value of Money

DCF methods takes into account of these two

drawbacks.
 General Procedure
• Cash flows at different periods differ in value
and can be compared only when they are
expressed in terms of a common denominator,
which is present values.
• Hence, all cash flows are expressed in terms of
their present values.
• Present value of cash flows is compared with
present values of cash outflows.
 What is NPV ???
• Net Present Value is the summation of present
values of cash proceeds (CFAT) in each year
minus the summation of present values of the
net cash outflows in each year.
• If NPV > 0; Accept the project
• If NPV < 0; Reject the project
• If NPV = 0; Indifference
 Same Illustration…
• A company is considering an investment
proposal to install new machinery at a cost of
Rs 50,000. The machine has a expected life of
5 years and no salvage value. Tax rate is 35 %.
Assume the firm uses straight line method of
depreciation, compute the ARR given the
following CFBT:
YEAR CFBT

1 10,000

2 10,692

3 12,769

4 13,462

5 20,385
 Particulars 1 2 3 4 5

CFBT 10,000 10,692 12,769 13,462 20,385

Less
Depreciation
PBT

Less Tax

EAT

Add
Depreciation
CFAT

PVF (10%)

Present Values

Total PV of Cash flows =

Less Initial Outlay =
NPV =
 Particulars 1 2 3 4 5

CFBT 10,000 10,692 12,769 13,462 20,385

Less 10,000 10,000 10,000 10,000 10,000

Depreciation
PBT - 692 2,769 3,462 10,385

Less Tax - 242 969 1,212 3,635

EAT - 450 1,800 2,250 6,750

Add 10,000 10,000 10,000 10,000 10,000

Depreciation
CFAT 10,000 10,450 11,800 12,250 16,750

PVF (10%) 0.909 0.826 0.751 0.683 0.621

Present Values 9,090 8,632 8,862 8,367 10,401

Total PV of Cash flows = 45,352

Less Initial Outlay = 50,000
NPV = (4,648)
3. A company is considering investment in a
project that costs Rs. 2,00,000. The project
has an expected life of 5 years and zero
salvage value. The company uses straight line
method of depreciation. The company’s tax
rate is 40%. The estimated earnings before
depreciation and before tax from the project
are as follows: (Assume 10% as discount rate)
…
Calculate net present value…
YEAR CFBT

1 70,000

2 80,000

3 1,20,000

4 90,000

5 60,000
 Particulars 1 2 3 4 5

CFBT

Less
Depreciation
PBT

Less Tax

EAT

Add
Depreciation
CFAT

PVF (10%)

Present Values

Total PV of Cash flows =

Less Initial Outlay =
NPV =
 Particulars 1 2 3 4 5

CFBT 70,000 80,000 1,20,000 90,000 60,000

Less 40,000 40,000 40,000 40,000 40,000

Depreciation
PBT 30,000 40,000 80,000 50,000 20,000

Less Tax @ 40% 12,000 16,000 32,000 20,000 8,000

EAT 18,000 24,000 48,000 30,000 12,000

Add 40,000 40,000 40,000 40,000 40,000

Depreciation
CFAT 58,000 64,000 88,000 70,000 52,000

PVF (10%) 0.909 0.826 0.751 0.683 0.621

Present Values 52,722 52,864 66,088 47,810 32,292

Total PV of Cash flows = 5,51,776

Less Initial Outlay = 2,00,000
NPV = 51,776
 Merits and Demerits of NPV
Merits Demerits

Considers time value of money Difficult to calculate and understand

Considers the total benefits of project Decision changes with the difference in
over the life time cost of capital

Useful for selection of mutually exclusive It is an absolute method; In case of

projects projects of different outlays, the present
value method may not give good results

Doesn’t give satisfactory result, if the lives

of the project are different. Project having
higher NPV may have longer period which
would result in blockage of huge funds
 Profitability Index
• Also known as Benefit-cost Ratio (B/C Ratio)
• Measures the present value of returns per
rupee invested
• Overcomes the shortcoming of NPV method
of not being relative
• PI = Present value of cash inflows
Present value of cash outflows
Also known as Present value index
 Accept-Reject Rule
• The PI of 1.18 implies that for every Re. 1
invested, the proposal is expected to give a
return of Rs. 1.18.
• If PI > 1; Accept
• If PI < 1; Reject
• PI = 1; Indifferent
 Illustration…
• Solve the earlier example (Slide 41)
 Similarities b/w PI and NPV
• Both would give the same results when
evaluating independent projects.
• Both are based on time value of money
 Differences b/w PI and NPV
• NPV is absolute measure; while PI is relative
measure.
• Would give contradictory results if cash
outflows are different for two projects.
Project A Project B

Cost 1,00,000 80,000

PV of Cash inflows 1,20,000 1,00,000

NPV 20,000 20,000

PI 1.20 1.25
 Internal Rate of Return (IRR) Method

• Rate of return that a project earns.

• Defined as the discount rate which equates
the aggregate present values of cash inflows
with the initial investment associated with a
project.
• Rate which gives the project NPV = 0.
 Calculation Procedure for IRR
• Case 1 When Future cash flows are equal
(Annuities)
1. Determine the pay-back period
2. In table A4, look for the pay back period that is
equal to or closest to the life of the project
3. In the year row, find two PV closest to PB period-
one bigger and other smaller
4. Note the interest rate corresponding to these
values
5. Determine IRR by interpolation
• IRR = L + A (H-L)
(A – B)
Where L = Lower Discount Rate
H= Higher Discount Rate
A= NPV at lower discount rate
B= NPV at higher discount rate

• IRR = H – B (H – L )
(A – B)
 Illustration…
• A project costs Rs. 36,000 and is expected to
generate cash inflows of Rs. 11,200 annually
for 5 years. Calculate IRR of the project.
 Steps Calculation

Determine the 36,000 / 11,200 = 3.214

pay back period

In A4, look for Discount factor closest to 3.214 for 5 years are 3.274 @ 16% and
payback period 3.199 @ 17%
equal to or closest
to life of the
project

Calculate the NPV NPV @ 16% = 668.8

at both these NPV @ 17 % = -171.2
rates

Interpolate 16 + 668.8 (17-16) 17 - (-171.2) (17-16)

668.8- (-171.2) 668.8 – (-171.2)

 16.8%  16.8 %
• Case 2 : When future cash flows are not equal
1. Calculate “fake annuity” by taking average
annual cash inflows.
2. Determine fake payback period.
 Illustration…
Year CFAT
1 14,000
2 16,000
3 18,000
4 20,000
5 25,000
Total 93,000
Initial Outlay 56,125

Fake Annuity = 93,000 / 5 = 18,600

Fake Payback Period = 56,125 / 18,600 = 3.017

Year CFAT PVF @ 19% PVF @ 20 %

1 14,000

2 16,000

3 18,000

4 20,000

5 25,000

Total
Year CFAT PVF @ 19% PVF @ 20 %

1 14,000 .840 .833

11760 11662
2 16,000 .706 .694

11296 11104
3 18,000 .593 .579

10674 10422
4 20,000 .499 .482

9980 9640
5 25,000 .419 .402

10475 10050
Total

54185 52878
 Year CFAT PVF @ 17% PVF @ 18 %

1 14,000

2 16,000

3 18,000

4 20,000

5 25,000

Total

Initial Cash Outlay

NPV
 Year CFAT PVF @ 17% PVF @ 18 %

1 14,000 .855 .847

11970 11858
2 16,000 .731 .718
11696 11488
3 18,000 .624 .609
11232 10962
4 20,000 .534 .516
10680 10320
5 25,000 .456 .437
11400 10925
Total
56,978 55,553
Initial Cash Outlay
56,125 56,125
NPV
853 -572
Calculate the NPV NPV @ 17% = 853
at both these NPV @ 18 % = -572
rates

Interpolate 17 + 853 (18-17) 18 + (-572) (18-17)

853- (-572) 853 – (-572)

 17.598 %  17.598 %
 Accept-Reject Rule
• IRR is compared with required rate of return
or cut-off rate or hurdle rate.
• If IRR ( r ) > cut-off rate, Accept
• If IRR ( r ) < cut-off rate, Reject
• If IRR ( r ) = cut-off rate, Indifferent
 Practice Questions
• A company is considering an investment
proposal to install new machinery at a cost of
Rs 50,000. The machine has a expected life of
5 years and no salvage value. Tax rate is 35 %.
Assume the firm uses straight line method of
depreciation, compute the IRR given the
following CFBT:
YEAR CFBT

1 10,000

2 10,692

3 12,769

4 13,462

5 20,385
Year CFBT DEPN PBT TAX EAT DEPN CFAT

1 10,000

2 10,692

3 12,769

4 13,462

5 20,385

TOTAL

AVERAGE (ANNUITY)  TOTAL / 5

Fake Payback Period
Year CFBT DEPN PBT TAX EAT DEPN CFAT

1 10,000 10,000 - - - 10,000 10,000

2 10,692 10,000 692 242 450 10,000 10,450

3 12,769 10,000 2,769 969 1,800 10,000 11,800

4 13,462 10,000 3,462 1,212 2,250 10,000 12,250

5 20,385 10,000 10,385 3,635 6,750 10,000 16,750

TOTAL 61,250

AVERAGE (ANNUITY)  TOTAL / 5 12,250

Fake Payback Period (50,000 / 12,250) 4.0816
 Year CFAT PVF @ 6% PVF @ 7 % PVF @ 8%

1 10,000

2 10,450

3 11,800

4 12,250

5 16,750

Total

Initial Cash
Outlay

NPV
 Year CFAT PVF @ 6% PVF @ 7 % PVF @ 8%

1 10,000 .943 .935

9,430 9,350 .926 9260
2 10,450 .890 .873
9,300 9,123 .857 8955.65
3 11,800 .840 .816
9,912 9,629 .794 9369.2
4 12,250 .792 .763
9,702 9,347 .735 9003.75
5 16,750 .747 .713
12,512 11,942 .681 11406.75
Total
50,856 49,391 47995.35
Initial Cash
Outlay
50,000 50,000 50,000
NPV
856 (609) (2004.65)
Calculate the NPV NPV @ 6% = 856
at both these NPV @ 7 % = - 609
rates

Interpolate 6 + 856 (7-6) 7 + (-609) (7-6)

856- (-609) 856 – (-609)

 6.58 %  6.58 %
 Merits and Demerits
Merits Demerits

Considers time value of money Difficult to calculate

Considers total cash inflows and outflows Produces multiple rates leading to
confusion

Easy to understand IRR than NPV Inconsistent results while evaluating

mutually exclusive projects

Provides a rate of return indicative of the

profitability of the project itself
 Question
• A company is considering the following
project:
Particulars Amount
Cost 10,000
Cash inflows
Year 1 1,000
2 1,000
3 2,000
4 10,000
Compute the IRR on the project if the opportunity cost is 14%.
 Cases where NPV & IRR would give
identical results
• In case of conventional investment projects
• In case of independent projects
 Conflicting NPV and IRR Ranking
• In case of mutually exclusive projects
1. Size – disparity problem
2. Time – disparity problem
3. Unequal expected lives
 Size – Disparity Problem
• Where cash outlays of the two projects are
different.
Particulars Project A Project B

Cash outlays 5,000 7,500

Cash inflows at the end of 6,250 9,150

year 1
Present Values @ 10% 5681.25 8317.35

NPV 681.25 817.35

IRR 25 22
 Time – Disparity Problem
• Difference on the basis of pattern of cash
flows generated; initial investment may be the
same.
Year Project A Project B
0 1,05,000 1,05,000
1 60,000 15,000
2 45,000 30,000
3 30,000 45,000
4 15,000 75,000
IRR 20 16
NPV 23,970 25,455
 Unequal expected lives
Project A Project B
Life 1 5
Cash outlay 20,000 20,000
Inflows at the end of 24,000 40,200
project life
IRR 20 15
NPV 1,816 4,900
 Equal Annual NPV (EANPV)
• Determined by dividing the NPV of cash flows
of the project by the annuity factor
corresponding to the life of the project at a
given cost of capital.

EANPV = NPV of the project

PVAF
 Particulars Project A Project B

Initial outlay 1,00,000 1,25,000

Annual inflows 30,000 27,000

Life 5 8

Assume 10 % cost of capital, which project should the firm select?

 Particulars Project A Project B

CFAT 30,000 27,000

PVAF (10 %) 3.791 5.335

Present Value 1,13,730 1,44,045

NPV 13,730 19,045

EANPV 13,730 / 3.791 19,045 / 5.335

 3,621.74  3,569.82
 Terminal Value Method
• Assumes that each cash inflow is reinvested in
another asset at a certain rate of return from
the moment it is received until the
termination of the project.
• If PV of compounded reinvested cash inflows >
PV of outflows; Accept
• If PV of compounded reinvested cash inflows <
PV of outflows; Reject
0 1 2 3 4
***
***
***
***

NPV ***
 Illustration…
Particulars
Original Outlay 10,000
Life of the project 5
Cash inflows (Annuity) 4,000
Cost of capital 10%
Expected interest rates at which cash
flows can be invested
Year 1 6
2 6
3 8
4 8
5 8
Year Cash inflows Rate of Years for Compounding Total
interest investment factor Compounded
sums
Year Cash inflows Rate of Years for Compounding Total
interest investment factor Compounded
sums

1 4,000 6 4 1.262 5,048

2 4,000 6 3 1.191 4,764

3 4,000 8 2 1.166 4,664

4 4,000 8 1 1.080 4,320

5 4,000 8 0 1.000 4,000

Total 22,796

Present Value 14,156.3

 22,796 *
0.621
Net Terminal 4,156.3
Value  Accept
 Question for Practice
• Analyze the feasibility of the project using terminal
value method:
Particulars Amount
Initial Outlay 20,000
Life of the project 4 years
Annual Cash inflows 10,000
Cost of capital 12%
Expected interest rates at which cash
inflows will be reinvested
1 7%
2 7%
3 9%
4 9%
Year Cash inflows Rate of Years for Compounding Total
interest investment factor Compounded
sums

1 10,000 7 3 1.225 12,250

2 10,000 7 2 1.145 11,450

3 10,000 9 1 1.090 10,900

4 10,000 9 0 1.000 10,000

Total 44,600

Present Value 28,366

 44,600*
0.636

Net Terminal 8,366

Value  Accept
 Discounted Pay Back Period
• A combination of payback period and DCF.
• Cash flows of the project are discounted to
find their present values.
 Capital Rationing
• Refers to the choice of investment proposals
under financial constraints in terms of a given
size of capital expenditure budget.
• Objective is to select combination of projects
that lead to maximization of total NPV.
• It involves two stages:
1. Identification of acceptable projects
2. Selection of the combination of projects
• Capital Rationing occurs when a company has
more amounts of capital budgeting projects
with positive net present values than it has
money to invest in them. Therefore, some
projects that should be accepted are excluded
because financial capital is limited
 Internal and External Capital Rationing

• Internal capital rationing: A situation where

the firm has imposed limit on the funds
allocated for fresh investment.
• External capital rationing: a situation where
the firm is willing to undertake the financially
viable proposals but is unable to do so
because of limited funds or capital market
conditions.
 Divisible and Indivisible Projects
• If a project can be accepted or rejected in its
entirety, project is indivisible.
• If a project can be accepted in parts, it is
divisible project.
 Methods
1. Feasible Set Approach (based on NPV)
2. Analysis based on IRR
3. Profitability Index Method
 Illustration…
• ABC ltd has a capital budget of Rs. 20,00,000.
it has the following 6 proposals for which
necessary information is provided as:
Proposal Outlay NPV IRR

A 7,00,000 3,00,000 20.0%

B 2,50,000 1,60,000 17.0%

C 5,00,000 2,00,000 19.0%

D 2,00,000 1,00,000 17.5%

E 5,50,000 4,50,000 18.0%

F 7,50,000 (2,50,000) 12.0%

Proposal Outlay NPV Inflow PI IRR

A 7,00,000 3,00,000 10,00,000 1.428 20.0%

B 2,50,000 1,60,000 4,10,000 1.640 17.0%

C 5,00,000 2,00,000 7,00,000 1.400 19.0%

D 2,00,000 1,00,000 3,00,000 1.500 17.5%

E 5,50,000 4,50,000 10,00,000 1.818 18.0%

F 7,50,000 (2,50,000) 5,00,000 .667 12.0%

Proposal Outlay NPV Inflow PI IRR

A 7,00,000 3,00,000 - II 10,00,000 1.428 – IV 20.0% - I

B 2,50,000 1,60,000 - IV 4,10,000 1.640 – II 17.0%

C 5,00,000 2,00,000 - III 7,00,000 1.400 19.0% – II

D 2,00,000 1,00,000 3,00,000 1.500 – III 17.5% - IV

E 5,50,000 4,50,000 - I 10,00,000 1.818 - I 18.0% – III

F 7,50,000 (2,50,000) 5,00,000 .667 12.0%

Total NPV 11,10,000 10,10,000 10,50,000

 When the projects are divisible
• Feasibility Set Approach
Proposal Outlay Cumulative NPV
Outlay
E 5,50,000 5,50,000 4,50,000

A 7,00,000 12,50,000 3,00,000

C 5,00,000 17,50,000 2,00,000

B 2,50,000 20,00,000 1,60,000

Total 11,10,000
• Analysis based on IRR
Proposal Outlay Cumulative NPV
Outlay

A 7,00,000 7,00,000 3,00,000

C 5,00,000 12,00,000 2,00,000

E 5,50,000 17,50,000 4,50,000

D 2,00,000 19,50,000 1,00,000

B 50,000 20,00,000 32,000

Total 10,82,000
• Analysis based on PI
Proposal Outlay Cumulative NPV
Outlay

E 5,50,000 5,50,000 4,50,000

B 2,50,000 8,00,000 1,60,000

D 2,00,000 10,00,000 1,00,000

A 7,00,000 17,00,000 3,00,000

C 3,00,000 20,00,000 1,20,000

Total 11,30,000
 Replacement Decisions
• An existing asset is being replaced by a new
asset.
• It is assumed that the life of the new asset is
equal to the remaining life of the old asset.
• Incremental cash flows need to be
ascertained.
 Different types of cash flows
Initial Outflows

●
Cost of new project
Add Additional working capital
Less Salvage value of old machine (after Tax)

Subsequent Annual Inflows

●
Operating Cash flows from the new project
Less operating cash flows from the old

Terminal Inflows
 Illustration…
• Abc ltd whose required rate of return is 10% is
considering to replace one of its plants by a
new plant. Relevant data is as follows:
Particulars Existing Plant Proposed Plant
Present book value 24,000 54,000
Remaining life 6 6
Depreciation per annum 4,000 9,000
Salvage Value (current) 20,000 -
PBTD 8,000 15,000
Evaluate the proposal given the tax rate as 40%.
 Incremental Cash outflows
Cost of the proposed plant 54,000
Less Current scrap value of existing plant 20,000
Net cash outflow 34,000

Subsequent Cash flows

Existing Plant Proposed Plant Incremental
Profit before 8,000 15,000 7,000
depreciation
Less Depreciation 4,000 9,000 5,000
PBT 4,000 6,000 2,000
Less Tax @ 40% 1,600 2,400 800
PAT 2,400 3,600 1,200
Add Depreciation 4,000 9,000 5,000
CFAT 6,400 12,600 6,200
Evaluation
Present Value of CFAT 6,200 * PVAF (10%, 6)
 27,001

NPV 27,001 – 34,000

 (6,999)

Hence Reject the project