UNITUNIT-II

INVESTMENT DECISIONS

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Capital Budgeting : Principles and Techniques

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CAPITAL BUDGETING I: Principles and Techniques

Nature of Capital Budgeting Data requirement: Identifying Relevant Cash Flows Evaluation Techniques Solved Problem Mini Case
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Nature
Capital Budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of shareholders (owners) wealth maximisation. Capital Expenditure is an outlay of funds that is expected to produce benefits over a period of time exceeding one year.

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Investment decisions are of two types

(1) Investment Decisions Affecting Revenues

It is more difficult to estimate revenues and costs of a new product line.

(2)

Investment Decisions Reducing Costs

Such types of decisions are subject to less risk as the potential cash saving can be estimated better from the past production and cost data.
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Capital Budgeting Decisions

Accept-reject Decision
Accept reject decision/approval is the evaluation of capital expenditure proposal to determine whether they meet the minimum acceptance criterion.

Mutually Exclusive Project Decisions

Mutually exclusive projects (decisions) are projects that compete with one another; the acceptance of one eliminates the others from further consideration.

Capital Rationing Decision

Capital rationing is the financial situation in which a firm has only fixed amount to allocate among competing capital expenditures.

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Data Requirement
The data requirement for capital budgeting are after tax cash outflows and cash inflows. Besides, they should be incremental in that they are directly attributable to the proposed investment project. The existing fixed costs, therefore, are ignored. In brief, incremental after-tax cash flows are the only relevant cashflows in the analysis of new investment projects.

Incremental Cash Flows

Incremental Cash Flows are the additional cash flows (outflows as well as inflows) expected to result from a proposed capital expenditure.

Relevant Cash Flow

Relevant Cash Flow is the incremental after-tax cash outflow (investment) and resulting subsequent inflows associated with a proposed capital expenditure.
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Table 1: Relevant and Irrelevant Outflows Relevant Cash Outflows 1. Variable labour expenses 2. Variable material expenses 3. Additional fixed overhead expenses 4. Cost of the investment 5. Marginal taxes Irrelevant Cash Outflows 1. Fixed overhead expense (existing) 2. Sunk costs

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Cash Flow Pattern

(1) Conventional Cash Flow Pattern Conventional cash flow pattern is an initial outflow followed by a series of inflows. (2) Non-Conventional Cash Flow Pattern Non-conventional cash flow pattern is a pattern in which an initial outflow is not followed by a series of inflows. Cash Flow Estimates: There are certain ingredients of cash flow streams. Tax Effect Effect on Other Projects Effect of Indirect Expenses Effect of Depreciation McGrawEffect Tata McGraw-Hill Publishing Company Limited, Financial Management of working capital

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Determination of Relevant
Cash flows
The data requirement for capital budgeting are cash flows, that is, outflows and inflows. Their computation depends on the nature of the proposal. The investment in new capital projects can be categorised into 1) 2) 3) Single proposal Re-placement proposal Mutually exclusive proposals

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Single Proposal
In the case of single/independent investment proposal, cash outflows primarily consist of (1) Purchase cost of the new plant and machinery (2) Its installation costs (3) Working capital requirement to support production and sales (in the case of revenue expanding proposals/release of working capital in cost reduction proposals. The cash inflows after taxes (CFAT) are computed by adding depreciation (D) to the projected earnings after taxes (EAT) from the proposal. In the terminal year of the project, apart from operating CFAT, the cash inflows include salvage value (if any, net of removal costs), recovery of working capital and tax advantage\taxes paid on short-term capital loss\gain on sale of machine.
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Format 1: Cash Outflows of New Project [Beginning of the Period at Zero Time (t = 0)] 1. Cost of new project 2. + Installation cost of plant and equipments 3. Working capital requirements Format 2: Determination of Cash Inflows: Single Investment Proposal (t = 1 N) Particulars 1 2 Years 3 4 .... N

Cash sales revenues Less: Cash operating cost Cash inflows before taxes (CFBT) Less: Depreciation Taxable income Less: Tax Earning after taxes Plus: Depreciation Cash inflows after tax (CFAT) Plus: Salvage value (in nth year) Plus: Recovery of working capital (in nth year)
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Example 1 An iron ore company is considering investing in a new processing facility. The company extracts ore from an open pit mine. During a year, 1,00,000 tonnes of ore is extracted. If the output from the extraction process is sold immediately upon removal of dirt, rocks and other impurities, a price of Rs 1,000 per ton of ore can be obtained. The company has estimated that its extraction costs amount to 70 per cent of the net realisable value of the ore. As an alternative to selling all the ore at Rs 1,000 per tonne, it is possible to process further 25 per cent of the output. The additional cash cost of further processing would be Rs 100 per ton. The proposed ore would yield 80 per cent final output, and can be sold at Rs 1,600 per ton. For additional processing, the company would have to instal equipment costing Rs.100 lakh. The equipment is subject to 25 per cent depreciation per annum on reducing balance (WDV -written down value ) basis/method. It is expected to have useful life of 5 years. Additional working capital requirement is estimated at Rs.10 lakh. The companys cut-off rate for such investments is 15 per cent. Corporate tax rate is 35 per cent. Assuming there is no other plant and machinery subject to 25 per cent depreciation, should the company instal the equipment if (a) the expected salvage is Rs 10 lakh and (b) there would be no salvage value at the end of year 5.
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Solution Financial Evaluation Whether to Instal Equipment for Further Processing of Iron Ore (A) Cost of equipment Plus: Additional working capital Cash Outflows Rs 1,00,00,000 10,00,000 1,10,00,000 (B) Particulars Revenue from processing [(Rs 1,600 20,000) Rs 1,000 25,000)] Less: Processing costs: Cash costs (Rs 100 25,000 tons) Depreciation (working note 1) Earnings before taxes Less: Taxes (0.35) Earnings after taxes (EAT) Add: Depreciation CFAT Cash Inflows (CFAT) Year 1 2 3 4 5

Rs 70,00,000 Rs 70,00,000

Rs 70,00,000 Rs 70,00,000 Rs 70,00,000

25,00,000 25,00,000 20,00,000 7,00,000 13,00,000 25,00,000 38,00,000

25,00,000 18,75,000 26,25,000 9,18,750 17,06,250 18,75,000 35,81,250

25,00,000 14,06,250 30,93,750 10,82,813 20,10,937 14,06,250 34,17,187

25,00,000 10,54,688 34,45,312 12,05,859 22,39,453 10,54,688 32,94,141

25,00,000 45,00,000 15,75,000 29,25,000 29,25,000

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Working Notes 1 Depreciation Schedule Year 1 2 3 4 5 Depreciation base of equipment Rs 1,00,00,000 75,00,000 56,25,000 42,18,750 31,64,062 Depreciation @ 25% on WDV Rs 25,00,000 18,75,000 14,06,250 10,54,688 Nil@

@As the block consists of a single asset, no depreciation is to be charged in the terminal year of the project.

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(C)(a) Determination of NPV (Salvage Value = Rs 10 lakh) Year CFAT PV factor (0.15) 0.870 0.756 0.658 0.572 0.497 0.497 0.497 0.497 Total PV

Rs 38,00,000 1 35,81,250 2 34,17,187 3 32,94,141 4 29,25,000 5 10,00,000 Salvage value 7,57,422 b Tax benefit on short-term capital loss 10,00,000 Recovery of working capital Gross present value Less: Cash outflows Net present value (NPV) (b) 0.35 (Rs 31,64,062 Rs 10,00,000) = Rs 7,57,422.

Rs 33,06,000 27,07,425 22,48,509 18,84,249 14,53,725 4,97,000 3,76,439 4,97,000 1,29,70,347 1,10,00,000 19,70,347

Recommendation: The company is advised to instal the equipment as it promises a positive NPV.
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(D) Determination of NPV (Salvage Value = Zero) PV of operating CFAT (1 5 years) Add: PV of tax benefit on short term capital loss (Rs 31,64,062 0.35 = Rs 11,07,4,22 0.497, PV factor) Add: PV of recovery of working capital Total present value Less: Cash outflows NPV Rs 115,99,908 5,50,389 4,97,000 1,26,47,297 1,10,00,000 16,47,297

Since the NPV is still positive, the company is advised to instal the equipment.

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Replacement Situation
In the case of replacement situation, the sale proceeds from the existing machine reduce the cash outflows required to purchase the new machine. The relevant cash outflows are incremental after-tax cash flows.

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Format 3: Cash Outflows in a Replacement Situation. 1. Cost of the new machine 2. + Installation Cost 3. Working Capital 4. Sale proceeds of existing machine 5. investment allowance 6. taxes paid/saved on sale of the asset

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Example 2 Royal Industries Ltd is considering the replacement of one of its moulding machines. The existing machine is in good operating condition, but is smaller than required if the firm is to expand its operations. It is 4 years old, has a current salvage value of Rs 2,00,000 and a remaining life of 6 years. The machine was initially purchased for Rs 10 lakh and is being depreciated at 25 per cent on the basis of written down value method. The new machine will cost Rs 15 lakh and will be subject to the same method as well as the same rate of depreciation. It is expected to have a useful life of 6 years, salvage value of Rs 1,50,000 at the sixth year end. The management anticipates that with the expanded operations, there will be a need of an additional net working capital of Rs 1 lakh. The new machine will allow the firm to expand current operations and thereby increase annual revenues by Rs 5,00,000; variable cost to volume ratio is 30 per cent. Fixed costs (excluding depreciation) are likely to remain unchanged. The corporate tax rate is 35 per cent. Its cost of capital is 10 per cent. The company has several machines in the block of 25 per cent depreciation. Should the company replace its existing machine? What course of action would you suggest, if there is no salvage value?

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Solution Financial Evaluation Whether to Replace Existing Machine (A) Cash Outflows (Incremental) Cost of the new machine Add: Additional working capital Less: Sale value of existing machine
(B) Year 1 1 2 3 4 5 6 Determination of Incremental CFAT (Operating) Incremental contribution(a) 2 Rs 3,50,000 3,50,000 3,50,000 3,50,000 3,50,000 3,50,000 Incremental depreciation(b) 3 Rs 3,25,000 2,43,750 1,82,813 1,37,109 1,02,832 39,624 Taxable income 4 Rs 25,000 1,06,250 1,67,187 2,12,891 2,47,168 3,10,376 Taxes (0.35) 5 Rs 8,750 37,188 58,515 74,512 86,509 1,08,632 EAT
[Col. 4-Col.5]

Rs 15,00,000 1,00,000 2,00,000 14,00,000

CFAT
[Col.6 + Col.3]

6 Rs 16,250 69,062 1,08,672 1,38,379 1,60,659 2,01,744

7 Rs 3,41,250 3,12,812 2,91,485 2,75,488 2,63,491 2,41,368

a Rs 5,00,000 [Rs 5,00,000 0.30, variable cost to value (V/V) ratio] = Rs 3,50,000 b (Working note)
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Working Note 1.Incremental Depreciation (t = 1 Year 1 2 3 4 5 6 c 0.25 (Rs 3,08,496 6) Depreciation (25% on WDV) Rs 3,25,000 2,43,750 1,82,813 1,37,109 1,02,832 39,624c Incremental asset cost base Rs 13,00,000 9,75,000 7,31,250 5,48,437 4,11,328 3,08,496

Rs 1,50,000, salvage value) = Rs 39,624

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2. (i) Written Down Value (WDV) of Existing Machine at the Beginning of the Year 5 Initial cost of machine Rs 10,00,000 Less: Depreciation @ 25% in year 1 2,50,000 7,50,000 WDV at beginning of year 2 1,87,500 Less: Depreciation @ 25% on WDV 5,62,500 WDV at beginning of year 3 1,40,625 Less: Depreciation @ 25% on WDV 4,21,875 WDV at beginning of year 4 1,05,469 Less: Depreciation @ 25% on WDV 3,16,406 WDV at beginning of year 5 (ii) Depreciation Base of New Machine WDV of existing machine 3,16,406 Add: Cost of the new machine 15,00,000 Less: Sale proceeds of existing machine 2,00,000 16,16,406 (iii) Base for Incremental Depreciation Depreciation base of a new machine 16,16,406 Less: Depreciation base of an existing machine 3,16,406 13,00,000
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(C) Determination of NPV (Salvage Value = Rs 1.50 lakh) Year 1 2 3 4 5 6 6 Salvage value 6 Recovery of working capital Gross present value Less: Cash outflows Net present value CFAT Rs 3,41,250 3,12,812 2,91,485 2,75,488 2,63,491 2,41,368 1,50,000 1,00,000 PV factor (0.10) 0.909 0.826 0.751 0.683 0.621 0.564 0.564 0.564 Total PV Rs 3,10,196 2,58,383 2,18,905 1,88,158 1,63,628 1,36,132 84,600 56,400 14,16,402 14,00,000 16,402

Recommendation: Since the NPV is positive, the company is advised to replace the existing machine. The NPV is likely to be higher as tax advantage will accrue on the eligible depreciation of Rs 1,18,872 (Rs 3,08,496 Rs 1,50,000 Rs 39,624) in the future years.
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Determination of NPV (Salvage Value = Zero) (i) For the first 5 years, depreciation will remain unchanged. In the sixth year, it will be = Rs 3,08,496 0.25 = Rs 77,124. (ii) Operating CFAT for years 1 5 will remain unchanged. CFAT for year 6 would be: Incremental contribution Less: Incremental depreciation Taxable income Less: Taxes (0.35) EAT Add: Depreciation CFAT (iii) PV of operating CFAT (1 5 years) Add: PV of operating CFAT (6th year) (Rs 2,54,493 0.564) Add: PV of working capital Total present value Less: Cash outflows NPV

Rs 3,50,000 77,124 2,72,876 95,507 1,77,369 77,124 2,54,493 11,39,270 1,43,534 56,400 13,39,204 14,00,000 (66,796)

Recommendation: Since the NPV is negative, the existing machine should not be replaced.
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Mutually Exclusive Proposals

In the case of mutually exclusive proposals, the selection of one proposal precludes the selection of the other(s). The computation of the cash outflows and cash inflows are on lines similar to the replacement situation.

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Example 3 A company is considering two mutually exclusive proposals, X and Y. Proposal X will require the purchase of machine X, for Rs 1,50,000 with no salvage value but an increase in the level of working capital to the tune of Rs 50,000 over its life. The project will generate additional sales of Rs 1,30,000 and require cash expenses of Rs 30,000 in each of the 5 years of its life. Proposal Y will require the purchase of machine Y for Rs 2,50,000 with no salvage value and additional working capital of Rs 70,000. The project is expected to generate additional sales of Rs 2,00,000 with cash expenses aggregating Rs 50,000. Both the machines are subject to written down value method of depreciation at the rate of 25 per cent. Assuming the company does not have any other asset in the block of 25 per cent; has 12 per cent cost of capital and is subject to 35 per cent tax, advise which machine it should purchase? What course of action would you suggest if Machine X and Machine Y have salvage values of Rs 10,000 and Rs 25,000 respectively?

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Solution Financial Evaluation of Proposals, X and Y Proposal X Cash outflows Cost price of machine Additional working capital Initial investment CFAT and NPV (i) Incremental sales revenue Less: Cash expenses Incremental cash profit before taxes Less: Taxes (0.35) CFAT (t = 1 5) () PV factor of annuity for 5 years (0.12) Present value Rs 1,50,000 50,000 2,00,000 1,30,000 30,000 1,00,000 35,000 65,000 3.605 2,34,325

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(ii) PV of Tax Savings Due to Depreciation Year 1 2 3 4 Depreciation Rs 37,500 28,125 21,094 15,820 Tax savings Rs 13,125 9,844 7,383 5,537 PVF Present value 0.893 0.797 0.712 0.636 Rs 11,721 7,846 5,257 3,522

28,346 9,419 28,350 3,00,440 2,00,000 1,00,440

(iii) PV of tax savings on short-term capital loss (STCL): (Rs 47,461 STCL 0.35 0.567) (iv) Release of working capital (Rs 50,000 0.567) Total present value Less: Cash outflows NPV

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Proposal Y Cash outflows Cost price of machine Additional working capital Initial investment CFAT and NPV (i) Incremental sales revenue Less: Cash expenses Incremental cash profits before taxes Less: Taxes (0.35) CFAT (t = 1 5) () PV factor of annuity for 5 years (0.12) Present value 2,50,000 70,000 3,20,000 2,00,000 50,000 1,50,000 52,500 97,500 3.605 3,51,488

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(ii) PV of Tax Savings Due to Depreciation Year 1 2 3 4 Depreciation Rs 62,500 46,875 35,156 26,367 Tax savings Rs 21,875 16,406 12,305 9,229 PVF 0.893 0.797 0.712 0.636 Present value Rs 19,534 13,076 8,761 5,869

47,240 15,698 39,690 4,54,116 3,20,000 1,34,116

(iii) PV of tax savings on short term capital loss (Rs 79,102 0.35 0.567) (iv) Release of working capital (Rs 70,000 0.567) Total present value Less: Cash outflows NPV Advice: Proposal Y is recommended in view of its higher NPV.

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Alternatively (Incremental Cashflow Approach) Incremental Cash Outflows Investment required in Proposal Y Less: Investment required in Proposal X Incremental CFAT and NPV (i) Incremental sales revenue (Y X) Less: Incremental cash expenses (Y X) Incremental cash profit before taxes Less: Taxes (0.35) Incremental CFAT (t = 1 5) () PV of annuity for 5 years (0.12) Incremental present value Rs 3,20,000 2,00,000 1,20,000 70,000 20,000 50,000 17,500 32,500 3.605 1,17,162

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(ii) PV of Tax Savings Due to Incremental Depreciation Year 1 2 3 4 Depreciation Rs 25,000 18,750 14,062 10,547 Tax savings Rs 8,750 6,562 4,922 3,691 PVF 0.893 0.797 0.712 0.636 Present value Rs 7,814 5,230 3,504 2,348 18,896

iii) PV of tax savings on incremental (Y X) short term capital loss (STCL): (Rs 79,102 Rs 47,461) 0.35 0.567 (iv) Incremental (Y X) working capital (Rs 70,000 0.567 Incremental present value Less: Incremental cash outflows Incremental NPV Recommendation: Proposal Y is better. Rs 50,000)

6,279 11,340 1,53,677 1,20,000 33,677

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Financial Evaluation of Proposals, Assuming Salvage Value of Machines X and Y (Incremental Approach) (a) Sum of PV of items (i), (ii) and (iv) (Rs 1,17,162 + Rs 18,896 + Rs 11,340)@ (b) PV of incremental salvage value (Rs 15,000 0.567) (c) PV of tax savings on incremental STCL@@ (Rs 54,102 Rs 37,461) 0.35 0.567 Incremental present value Less: Incremental cash outflows Incremental NPV Rs 1,47,398 8,505 3,302 1,59,205 1,20,000 39,205

Decision: Decision (superiority of proposal Y) remains unchanged. @ Items (i), (ii) and (iv) when there is no salvage will not change due to salvage value. @@ As a result of salvage value, the amount of short-term capital loss (STCL) will change.

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EVALUATION TECHNIQUES for CAPITAL BUDJECTING

(1) Traditional Techniques (i) Average rate of return method (ii) Pay back period method (2) Discounted Cash flow (DCF)/Time-Adjusted (TA) Techniques (i) Net present value method (ii) Internal rate of return method (iii) Profitability index

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Average Rate of Return Method

The ARR is obtained dividing annual average profits after taxes by average investments. Average investment = 1/2 (Initial cost of machine Salvage value) + Salvage value + net working capital. Annual average profits after taxes = Total expected after tax profits/Number of years The ARR is unsatisfactory method as it is based on accounting profits and ignores time value of money.

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Example 4 Determine the average rate of return from the following data of two machines, A and B. Particulars Cost Annual estimated income after depreciation and income tax: Year 1 2 3 4 5 Estimated life (years) Estimated salvage value Machine A Rs 56,125 Machine B Rs 56,125

3,375 5,375 7,375 9,375 11,375 36,875 5 3,000

11,375 9,375 7,375 5,375 3,375 36,875 5 3,000

Depreciation has been charged on straight line basis.

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Solution ARR = (Average income/Average investment) 100. Average income of Machines A and B =(Rs 36,875/5) = Rs 7,375. Average investment = Salvage value + 1/2 (Cost of machine Salvage value) = Rs 3,000 + 1/2 (Rs 56,125 Rs 3,000) = Rs 29,562.50. ARR (for machines A and B) = (Rs 7,375/Rs 29,562.50) 100 = 24.9 per cent.

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Pay Back Method

The pay back method measures the number of years required for the CFAT to pay back the initial capital investment outlay, ignoring interest payment. It is determined as follows (i) In the case of annuity CFAT: Initial investment/Annual CFAT. (ii) In the case of mixed CFAT: It is obtained by cumulating CFAT till the cumulative CFAT equal the initial investment. Original/initial Investment (outlay) is the relevant cash outflow for a proposed project at time zero (t = 0). Annuity is a stream of equal cash inflows. Mixed Stream is a series of cash inflows exhibiting any pattern other than that of an annuity. Although the pay back method is superior to the ARR method in that it is based on cash flows, it also ignores time value of money and disregards the total benefits associated with the investment proposal.
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Example 5 (i) In the case of annuity CFAT An investment of Rs 40,000 in a machine is expected to produce CFAT of Rs 8,000 for 10 years, PB = Rs 40,000/Rs 8,000 = 5 years

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(ii) In the case of mixed CFAT Table 2 presents the calculations of pay back period for Example 4. Table 2 Year 1 2 3 4 5
CFAT

Annual CFAT A Rs 14,000 16,000 18,000 20,000 25,000* B 22,000 20,000 18,000 16,000 17,000*

Cumulative CFAT A Rs 14,000 30,000 48,000 68,000 93,000 B Rs 22,000 42,000 60,000 76,000 93,000

in the fifth year includes Rs.3,000 salvage value also.

The

initial investment of Rs.56125

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The initial investment of Rs.56125 A will recover between 3 and 4 Pay back period=3+(56125-48000)/20000 period=3+(56125=3.406 years

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Discounted Cash flow (DCF)/TimeAdjusted (TA) Techniques

The DCF methods satisfy all the attributes of a good measure of appraisal as they consider the total benefits (CFAT) as well as the timing of benefits. The present value or the discounted cash flow procedure recognises that cash flow streams at different time periods differ in value and can be compared only when they are expressed in terms of a common denominator, that is, present values. It, thus, takes into account the time value of money. In this method, all cash flows are expressed in terms of their present values.

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The present value of the cash flows in Example 4 are illustrated in Table 3. Table 3: Calculations of Present Value of CFAT. Year Machine A CFAT PV factor (0.10) 2 Rs 14,000 16,000 18,000 20,000 25,000* 3 0.909 0.826 0.751 0.683 0.621 Present value 4 Machine B CFAT PV factor (0.10) 6 0.909 0.826 0.751 0.683 0.621 Present value 7 Rs 19,998 16,520 13,518 10,928 10,557 71,521

1 1 2 3 4 5

Rs 12,726 Rs 22,000 13,216 20,000 13,518 18,000 14,660 16,000 15,525 17,000* 69,645

*includes salvage value.

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Net Present Value (NPV) Method

The NPV may be described as the summation of the present values of (i) operating CFAT (CF) in each year and (ii) salvages value(S) and working capital(W) in the terminal year(n) minus the summation of present values of the cash outflows(CO) in each year. The present value is computed using cost of capital (k) as a discount rate. The decision rule for a project under NPV is to accept the project if the NPV is positive and reject if it is negative. Symbolically, (i) NPV > zero, accept, (ii) NPV < zero, reject Zero NPV implies that the firm is indifferent to accepting or rejecting the project. The project will be accepted in case the NPV is positive.

Net Present Value

t=1

CFt (1+k)t

Sn + Wn (1+k)n

t=0

COt (1+k)t

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Example 6 In Example 4 we would accept the proposals of purchasing machines A and B as their net present values are positive. The positive NPV of machine A is Rs 13,520 (Rs 69,645 Rs 56,125) and that of B is Rs 15,396 (Rs 71,521 Rs 56,125). In Example 4, if we incorporate cash outflows of Rs 25,000 at the end of the third year in respect of overhauling of the machine, we shall find the proposals to purchase either of the machines are unacceptable as their net present values are negative. The negative NPV of machine A is Rs 6,255 (Rs 69,645 Rs 74,900 (56125+25000*.751)) and of machine B is Rs 3,379 (Rs 71,521 Rs 74,900). As a decision criterion, this method can also be used to make a choice between mutually exclusive projects. On the basis of the NPV method, the various proposals would be ranked in order of the net present values. The project with the highest NPV would be assigned the first rank, followed by others in the descending order. If, in our example, a choice is to be made between machine A and machine B on the basis of the NPV method, machine B having larger NPV (Rs 15,396) would be preferred to machine A (NPV being Rs 13,520).
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Internal Rate of Return (IRR) Method

The IRR is defined as the discount rate (r) which equates the aggregate present value of the operating CFAT received each year and terminal cash flows (working capital recovery and salvage value) with aggregate present value of cash outflows of an investment proposal. r is found out from the relation

Zero

t=1

CFt (1+r)t

Sn + Wn (1+r)n when

IRR

t=0

COt (1+r)t the

The project will be accepted required rate of return. R > k

exceeds

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IRR for an Annuity

The following steps are taken in determining IRR for an annuity. Determine the pay back period of the proposed investment. In Table A-4 (present value of an annuity) look for the pay back period that is equal to or closest to the life of the project. In the year row, find two PV values or discount factor (DFr) closest to PB period but one bigger and other smaller than it. From the top row of the table, note interest rate (r) corresponding to these PV values (DFr).

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Determine actual IRR by interpolation. This can be done either directly using Equation 1 or indirectly by finding present values of annuity (Equation 2). IRR = r Where PB DFr DFrL - DFrH (Equation 1)

PB = Pay back period DFr = Discount factor for interest rate r. DFrL = Discount factor for lower interest rate DFrH = Discount factor for higher interest rate. r = Either of the two interest rates used in the formula PVco PVCFAT PV r (Equation 2)

Alternatively, IRR = r -

Where PVCO = Present value of cash outlay PVCFAT = Present value of cash inflows (DFr x annuity) r = Either of the two interest rates used in the formula r = Difference in interest rates PV = Difference in calculated present values of inflows

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Example 7 A project costs Rs 36,000 and is expected to generate cash inflows of Rs 11,200 annually for 5 years. Calculate the IRR of the project. Solution (1) The pay back period is 3.214 (Rs 36,000/Rs 11,200) (2) According to Table A-2, discount factors closest to 3.214 for 5 years are 3.274 (16 per cent rate of interest) and 3.199 (17 per cent rate of interest). The actual value of IRR which lies between 16 per cent and 17 per cent can, now, be determined using Equations 1 and 2. Substituting the values in Equation 1 we get: IRR =16- [(3.2143.274)/(3.274-3.199)] = 16.8 per cent. Alternatively (starting with the higher rate), IRR = 17 3.199)/(3.274-3.199)] = 16.8 per cent.
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Instead of using the direct method, we may find the actual IRR by applying the interpolation formula to the present values of cash inflows and outflows (Equation 2). Here, again, it is immaterial whether we start with the lower or the higher rate. PVCFAT (0.16) PVCFAT (0.17) = Rs 11,200 3.274 = Rs 36,668.8 = Rs 11,200 3.199 = Rs 35,828.8 IRR = 16 Alternatively (starting with the higher rate), IRR = r IRR = 17 36,000 36,668.8 36,668.8 35,828.8 1 = 16.8 %

(PVCO PVCFAT) PV 36,000 35,828.8 840

1 = 16.8 %

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Profitability Index (PI) or BenefitBenefitCost Ratio (B/C Ratio)

The profitability index/present value index measures the present value of returns per rupee invested. It is obtained dividing the present value of future cash inflows (both operating CFAT and terminal) by the present value of capital cash outflows. Profitability Index

Present value cash inflows Present value of cash outflows

The proposal will be worth accepting if the PI exceeds one.

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Example 8 When PI is greater than, equal to or less than 1, the net present value is greater than, equal to or less than zero respectively. In other words, the NPV will be positive when the PI is greater than 1; will be negative when the PI is less than one. Thus, the NPV and PI approaches give the same results regarding the investment proposals. The selection of projects with the PI method can also be done on the basis of ranking. The highest rank will be given to the project with the highest PI, followed by others in the same order. In Example 4 (Table 3) of machine A and B, the PI would be 1.24 for machine A and 1.27 for machine B: PI (Machine A) = PI (Machine B) = Rs 69,645 Rs 56,125 Rs 71,521 Rs 56,125 = 1.24 = 1.27

Since the PI for both the machines is greater than 1, both the machines are acceptable.

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SOLVED PROBLEM

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The Domanhill Colliery, an underground mine, owned by the public sector Coal India Ltd has been producing coal through manual operations for the last eight years. The past and projected revenues and cost data are summarised below Past and projected revenue and cost data (Rs crore) Year Sales revenue Direct labour cost Administrative expenses and selling expenses Fixed expenses (excluding depreciation) 15 17 22 25 31 49 51 68 68 75 83 91 98 Variable expenses

Past Data: 1 2 3 4 5 6 7 8 Projected Data: 9 10 11 12 13 309 342 375 408 441 62 69 76 82 88 52 58 63 69 75 89 97 106 115 124
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70 81 101 123 162 201 245 302

14 16 21 30 34 41 48 61

12 14 17 22 25 33 40 53

23 25 30 39 45 64 77 94

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With the liberalisation and opening up the coal sector to private firms, the Board of Directors of Coal India Ltd have decided to undertake a feasibility study for semi-mechanisation of Domanhill Colliery by introducing side dump and load (SDL) machine. With the introduction of the SDL machine, the following changes in the operating parameters are forecast:

 Increase in projected sales revenue by 25 per cent due to faster speed of work;  Decrease in direct labour cost by 5 per cent resulting from ban on new recruitments;  Fifteen per cent increase in administrative and selling expenses to support increased semi-mechanised production and sale;  10 per cent increase in fixed cost on account of setting up of additional maintenance facility;  Increase in variable expenses, 50 per cent, as a result of additional electricity consumption;  Loss in terms of disturbance charge due to opposition, strike and lockout: year 9, Rs 2 crore, year 10 Rs 0.80 crore and year 11, Rs 0.30 crore;  The semi-mechanisation would require acquisition of 20 machines at a cost of Rs 1 crore each. An additional Rs 2 crore would have to be spent on creation of additional facility like transformer, special cables and installation of the machines. The machines including the additional facility created would be depreciated over a five year period on the basis of written down value method @ 25 per cent. At the end of 5 years, they are expected to be sold at Rs 2 crore. The colliery does not have other machines in the block of 25 per cent.
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Assuming effective cost of capital of 8 per cent on World Bank loan to finance the project and 35 per cent tax, present a financial analysis of the feasibility of semi-automation of the Domanhill Colliery. As a financial consultant, what recommendation would you make to the Board of Directors of Coal India Ltd?

Solution Financial analysis for semi-mechanisation of Domanhill Colliery (using NPV method) Incremental cash outflows Cost of new machine (SDL) (20 Rs 1 crore) Additional cost of semi-mechanisation (Amount in crore of rupees) 20 2 22

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Incremental CFAT and NPV Particulars Incremental sales revenue (0.25 projected sales revenue) Add: Savings in direct labour cost (0.05 DLC) Less: Incremental administrative and selling expenses (0.15 ASE) Less: Incremental fixed costs (0.10 FC) Less: Increase in variable costs (0.50 VC) Less: Disruption charges Less: Depreciation Earnings before taxes Less: Taxes Earnings after taxes CFAT (operating) Salvage value Tax benefit on short-term capital loss (0.35 Rs 4.96)
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Year 1 77.25 3.10 7.8 6.8 44.5 2.0 5.5 13.75 4.81 8.94 14.44 2 85.5 3.45 8.70 7.5 48.5 0.8 4.12 19.33 6.77 12.56 16.68 3 93.75 3.8 9.45 8.3 53 0.3 3.1 23.4 8.19 15.21 18.31 4 102 4.1 10.35 9.1 57.5 2.32 26.83 9.4 17.43 19.75 5 110.25 4.4 11.25 9.8 62 Nil.@ 31.6 11.1 20.5 20.5 2.0 1.74
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Contd. (x) PV factor (0.08) Present value Total present value (t = 1 Less: Cash outflows Net present value 5) 0.926 13.37 0.857 0.794 0.735 10.76 12.08 12.81 0.681 16.51 65.53 22.00 43.53

@ No depreciation is charged in terminal year, as block ceases to exist. Recommendation: Since the NPV is positive, the proposal is financially viable.

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MINI CASE

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(Net Present Value) Choolah Chimney Ltd (CCL) is a leading manufacturer of items used in kitchens such as gas stoves, electric chimneys, ovens and so on. It has grown significantly under the CEO Vivek Razdans dynamic leadership. In line with his belief to enhance competitiveness by using research and development for launching innovative products in the market, the CCL has recently developed a zero Maintenance Electric Chimney (known as Zimney) which is ideally suited for Indian cooking. The research and development cost of Zimney amounts to Rs 20,00,000. To gauge the market prospects for Zimney, a market survey was conducted by Bazar Gyani, the V.P., Marketing, at an estimated cost of Rs 5,00,000. The results of the survey were very positive showing a significant demand for Zimney. The survey report also indicated that Zimney could capture 8 per cent of the current market size of 1,00,000 units of gas electric chimney. Considering the growth of satellite towns/cities and residential colonies, the market is expected to grow at 2 per cent annually. The VP, Marketing suggested to the CEO that a market penetration pricing strategy would be most suitable and Zimney should be priced at Rs 5,000 per unit in the initial year of the launch. The price could be raised in subsequent years by 5 per cent annually. The marketing and administrative costs are expected to be Rs 4,00,000 per year.

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The CCL is presently using 6 machines acquired 3 years ago at a cost of Rs 10,00,000 each, having a useful life of 7 years, with no salvage value. These machines are currently being used for manufacturing other types of chimneys. They could be sold for Rs 2,00,000 per machine with a removal cost of Rs 30,000 for each. The machine to manufacture Zimney is available in that market for Rs 1,00,00,000 with a useful life of 4 years and salvage value of Rs 10,00,000. It can produce other types of chimneys also. The new machine, being state of the art technology would improve the productivity of the workers as well reduce the unit variable cost of manufacture to Rs 600, which would increase by 5 per cent annually. Exhibit 1 summarises the labour cost with the existing machine and the new equipment. Category Existing Number Monthly salary Skilled labour Maintenance men Floor managers 20 2 3 Rs 4,000 6,000 8,000 New Machine/Equipment Number 15 1 2 Monthly salary Rs 4,000 6,000 8,000
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The maintenance costs currently amount to 1,00,000 per year (existing machine). They would total Rs 70,000 with the new equipment. The net working capital required to start production of Zimney would be Rs 60,00,000. The policy of CCL is to pay five months salary as compensation in case of layoff of employees. Required Should the CCL launch the Zimney. Assume the following: (i) Tax, 35 per cent (ii) Required rate of return, 14 per cent and (iii) Straight line depreciation for the tax purposes.
Solution Financial Evaluation of Proposal to launch Zimney (A) Incremental Cash Outflow (t = 0): 1. 2. 3. 4. 5. Cost of new machine Less sale proceeds of existing machinesa Less tax benefits on loss of sale of existing machinesb Cost of laying-off workersc Additional working capital Rs 1,00,00,000 (10,20,000) (8,42,999) 1,70,000 60,00,000 1,43,07,001

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a Sale proceeds of existing machines [(6 Rs 2,00,000, sale price 30,000, removal cost)] = Rs 10,20,000 b Tax benefits on loss of existing machine

(6 Rs

1. Book value of existing machine [(6 Rs 10,00,000) (3 Rs 8,57142, annual depreciation i.e. Rs 60,00,000 7)] = Rs 60,00,000 Rs 25,71,428 = Rs 34,28,571. 2. Loss on sale of existing machine [book value, Rs 34,28,571 Rs 10,20,000, sale proceeds] = Rs 24,08,571. 3. Tax benefit (Rs 24,08,571 (A) 0.35) = Rs 8,42,999. c Cost of lay-off: 1. Skilled labour 5 Rs 4,000 5 (months) 2. Floor manager = 1 Rs 8,000 5 3. Maintenance person = 1 Rs 6,000 5 = Rs 1,00,000 = = 40,000 30,000 1,70,000

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(B) Incremental Cash Inflows: (t = 1

4):

Year Particulars 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Sales revenuea Add savings in maintenance costb Add savings in labour costc Less variable costd Less incremental depreciatione EBT Less tax (0.35) EAT Add incremental depreciation CFAT Release of working capital Total 1 (Rs) 4,00,00,000 30,000 4,08,000 (52,00,000) (13,92,858) 3,38,45142 (1,18,45,799) 2,19,99,342 13,92,858 2,33,92,200 2,33,92,200 2 (Rs) 4,28,40,000 30,000 4,08,000 (55,40,800) (13,92,858) 3,63,44,342 (1,27,20,519) 2,36,23,822 13,92,858 2,50,16,680 2,50,16,680 3 (Rs) 4,58,81,640 30,000 4,08,000 (59,05,796) (13,92,858) 3,90,20,986 (1,36,57,346) 2,53,63,640 13,92,858 2,67,56,498 2,67,56,498 4 (Rs) 4,91,34,408 30,000 4,08,000 (62,96,663) (13,92,858) 4,18,82,887 (1,46,59,010) 2,72,23,876 13,92,858 2,86,16,734 60,00,000 3,46,16,734
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a Sales revenue :

Year 1 (0.08 1,00,000 Rs 5,000) 2 (0.08 1,02,000 Rs 5,250) 3 (0.08 1,04,040 Rs 5,512) 4 (0.08 1,06,120 Rs 5,787)

= = = =

Rs 4,00,00,000 4,28,40,000 4,58,81,640 4,91,34,408

b Savings in maintenance cost (Rs 1,00,000, existing c Savings in labour cost: 1 Existing:Skilled labour (20 Rs 4,000 12 months) Floor manager (3 Rs 8,000 12) Maintenance (2 Rs 6,000 12) 2 New: Skilled labour (15 Rs 4,000 12) Floor manager (2 Rs 8,000 12) Maintenance (1 Rs 6,000 12) d Variable cost and general administrative costs: Year 1 [(0.08 1,00,000 Rs 600) + Rs 4,00,000] 2 [(0.08 1,02,000 Rs 630) + Rs 4,00,000] 3 [(0.08 1,04,040 Rs 661) + Rs 4,00,000] 4 [(0.08 1,06,120 Rs 694) + Rs 4,00,000] e Incremental depreciation: 1. 2. = = = =

Rs 70,000 proposed) = Rs 30,000 Rs 9,60,000 2,88,000 1,44,000 Rs 13,92,000 7,20,000 1,92,000 9,84,000 72,000 4,08,000 Rs 52,00,000 55,40,000 59,05,796 62,96,663 Rs 22,50,000 8,57,142 13,92,858
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New equipment (Rs 1,00,00,000 Rs 10,00,000) 4 Existing (Book value, Rs 34,28,571 0) 4

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(C) Computation of NPV Year 1 2 3 4 Total Less Incremental cash outflow NPV Decision: The Chola Chimney should launch the Zimney Note: The research and development cost of Zimney (Rs 20,00,000) and expenses incurred on market survey (Rs 5,00,000) are sunk cost and, therefore, irrelevant for analysis. Incremental cash inflows Rs 2,33,92,200 2,50,16,680 2,67,56,498 3,46,16,734 PV factor (0.14) 0.877 0.769 0.675 0.592 Total PV Rs 2,05,14,959 1,92,37,826 1,80,60,636 2,04,93,106 7,83,06,527 1,43,07,001 6,39,99,526

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Table A-1 : The Present Value of One Rupee

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.789 0.773 0.758 0.743 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 5% 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614 0.585 0.557 0.530 0.505 0.481 6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592 0.558 0.527 0.497 0.469 0.442 0.417 7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 9-68

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Table A-1: The Present Value of One Rupee (Contd.)

Yea r 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 15% 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247 0.215 0.187 0.163 0.141 0.123 16% 0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227 0.195 0.168 0.145 0.125 0.108 17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.074 20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065

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Table A-2 : The Present Value of an Annuity of One Rupee

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 6.728 8.566 9.471 10.368 11.255 12.134 13.004 13.865 2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.326 8.162 8.983 9.787 10.575 11.348 12.106 12.849 3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 5% 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 6% 0.943 1.833 2.673 3.465 4.212 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.746 9.108 8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.560 9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606

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Table A-2: The Present Value of an Annuity of One Rupee (Contd.)

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 5.303 6.462 14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 15% 0.870 1.626 2.283 2.855 3.352 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 16% 0.862 1.605 2.246 2.798 3.274 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 4.793 4.910 5.008 5.092 9%1 0.850 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.487 4.611 4.715 4.802 4.876 20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675

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Format 1: Cash Outflows of New Project [Beginning of the Period at Zero Time (t = 0)] a) No salvage 1. Cost of new machine
2. + Installation cost 3. + Working capital requirements 4. tax saving due to investment allowance 50000 10000 40000 6250 (5000*25%)*50%

Format 2: Determination of Cash Inflows: Single Investment Proposal (t = 1 10) Particulars 1 Cash sales revenues 42000 Less: Cash operating cost 32000 Less: Depreciation 6000 Taxable income 4000 Less: Tax (50%) 2000 Earning after taxes 2000 Plus: Depreciation 6000
Cash inflows after tax (CFAT) 8000

2
32000

Years 3
32000

4
32000

.... .
..

10 42000
32000

42000 42000 42000 6000 6000 4000 4000 2000 2000 2000 2000 6000 6000
8000 8000

6000 4000 2000 2000 6000

8000

. .. .. ..

6000 4000 2000 2000 6000

8000

Plus: Recovery of working capital (in10th year)

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40000 48000
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