Assume you are the finance manager of X Ltd. and the marketing head have come up with proposals.

He wants to comment on the pros and cons of either of these proposals. Proposal 1: First he is proposing to go into construction of roads which requires an investment of 8 crs. The expected cash flows for next 5 years is Year Cash Flow (in cr.) 1 1 2 2.3 3 3 4 4.1 5 5

After end of 5 years machine would not fetch any value. Proposal 2: we can enter into an EPC Construction business which would require initial cash outlay of Rs. 4 cr. & it would provide a profitability of the following for the next 4 years Year Profitability (in crs.) 1 2 2 2 3 3 4 1.4

After 4th year the machine can be sold off for 50 lakhs. The depreciation for the 4 years is Year Depreciation (in lakhs) 1 30 2 20 3 10 4 10

Assume there are no working capital changes; please provide comments. Please assume the cost of capital for additional capital is fixed at 14 per cent.

PROPOSAL 1:
NET PRESENT VALUE YEAR 0 1 2 3 4 5 NET PRESENT VALUE CASH FLOW -2 1 2.3 3 4.1 5 DISCOUNTING FACTOR (14%) 1 0.8771 0.7694 0.6749 0.5920 0.5193 PRESENT VALUE (CF * DF) -2 0.8771 1.7697 2.0249 2.4275 2.5968 7.6962

DISCOUNTED PAYBACK PERIOD Money left to be recovered = 2 crs. 0.8771 crs. = 1.1229 crs. In the next year we recover 1.7697. So, if to recover 1 rupee it would take 1/1.7697, how much time would it take to recover 1.1229? i.e. 1.1229 * 1/1.7697 = 0.634 (in years) In years 0.634 years In months 7.608 months In days 231.41 days INTERNAL RATE OF RETURN CALCULATION

Cash Year Flows 0 -8.00 1 1.00 2 2.30 3 3.00 4 4.10 5 5.00 NET PRESENT VALUE

DF (14%) 1.00 1 0.8772 2 0.7695 3 0.6750 4 0.5921 5 0.5194

Present Value (14%) -8.00 0.87719 1.76978 2.02491 2.42753 2.59684 1.69626

DF (18%) 1 1 0.8475 2 0.7182 3 0.6086 4 0.5158 5 0.4371

Present Value (18%) -8.00 0.84746 1.65182 1.82589 2.11473 2.18555 0.62545

Initial Discounting Factor 14% Assumed Discounting Factor (for IRR) 18% Change in NPV due to change in Discount percentage by 4% is - 1.0708

If the NPV falls 1.0708, the percentage increase that has to be considered over and above the change in percentage assumed for finding out the IRR
Therefore, the Internal Rate of Return is -

2.34%
20.34%

PROPOSAL 2:
NET PRESENT VALUE & IRR
Present Value (14%) -4.00 2.0175 1.6928 2.0924 1.1842 2.9869 Present Value (18%) -4.00 1.9492 1.5800 1.8868 1.0316 2.4475

Cash Year Flows 0 -4.00 1 2.30 2 2.20 3 3.10 4 2.00 NET PRESENT VALUE

DF (14%) 1.00 1 0.8772 2 0.7695 3 0.6750 4 0.5921

DF (18%) 1 1 0.8475 2 0.7182 3 0.6086 4 0.5158

Initial Discounting Factor 14% Assumed Discounting Factor (for IRR) 18% Change in NPV due to change in Discount percentage by 4% is - 0.5395

If the NPV falls 1.0708, the percentage increase that has to be considered over and above the change in percentage assumed for finding out the IRR
Therefore, the Internal Rate of Return is -

18.15%
36.15%

DISCOUNTED PAYBACK PERIOD Money left to be recovered = 4 crs. (2.0175+1.6928) crs. = 0.2896 crs. In the next year we recover 2.0924. So, if to recover 1 rupee it would take 1/2.0924, how much time would it take to recover 0.2896? i.e. 0.2896 *1/ 2.0924 = 2.138 (in years) In years 2.138 years In months 25.656 months In days 780.37 days COMMENT -