Resource Person:

Dr. Binoy Mathew

M.Com,MBA,LLB,PGDCA,CELI,DPC,Ph.D
Associate Professor
Dept. of MBA
Visvesvaraya Technological University
Centre for Post Graduate Studies,
Bangalore Region,
VIAT, Muddenahalli, Chikkaballapur-562101
E-Mail:binoykm@yahoo.com

Subject: Financial Management

Lesson: Module-IV
Session: 1
Investment Decision
Capital investments are funds invested in a firm or enterprise for the purposes of furthering
its business objectives. Capital investment may also refer to a firm's acquisition of capital
assets or fixed assets such as manufacturing plants and machinery that are expected to be
productive over many years. Sources of capital investment are manifold and can include
equity investors, banks, financial institutions, venture capital and angel investors. While
capital investment is usually earmarked for capital or long-life assets, a portion may also be
used for working capital purposes.

The investment decision relates to the selection of assets in which funds will be
invested by a firm.

The assets which can be acquired are of two broad groups:

(i) long- term assets (Capital budgeting),

(ii) short- term or current assets (working capital management).

Capital Budgeting(CB)
Capital budgeting decisions are of paramount importance in financial decision making.
Capital budgeting is the process of evaluating and selecting long-term investments that are
consistent with the goal of shareholders wealth maximization. Capital expenditure is an
outlay of funds that is expected to produce benefits over a period of time exceeding one year.
The system of capital budgeting is employed to evaluate expenditure devisions which
involve current outlays but are likely to produce benefits over a period of tome longer than
one year. These benefits may be either in the form of increased revenues or reduced costs.
Basic Features

The following are the basic features of capital budgeting:

Long term consequences

Large initial outlays followed by small periodic inflows

It may be difficult or expensive to reverse them

Information gap and inexperience

Strategic and risky nature

Inflexibility

Capital budgeting is perhaps the most crucial financial decision of a firm.

How a firm finances its investments (the capital structure decision) and

How it manages its short-term operations (the working capital decision) are definitely
issues of concern.

But how it allocates its capital (the capital budgeting decision) really reflects its
strategy and its business.

That is why the process of capital budgeting is also referred to as strategic asset
allocation.
Importance of Capital Budgeting (CB)

1. Capital budgeting decisions affect the profitability of a firm

2. Capital budgeting decision has its effect over a long time span and inevitably affects
the companys future cost structure.
3. Capital investment decisions, once made are not easily reversible without much
financial loss to the firm because there may be no market for second-hand plant and
equipment and their conversion to other uses may not be financially viable
4. Capital investment involves costs and the majority of the firms have scarce capital
resources. This underlines the need for thoughtful, wise and correct investment
decisions, as an incorrect decision would not only result in losses but also prevent the
firm from earning profits from other investments which could not be undertaken for
want of funds.
Difficulties
1. The benefits from investments are received in some future period.
2. Cost incurred and benefits received from the capital budgeting decisions occur in
different time periods.

3. It is not often possible to calculate in strict quantitative terms all the benefits or the
costs relating to a particular investment decision.
BASIC TYPES OF CB DECISIONS
CB decisions can be of two types:
(i) Investment decisions expand revenues: Such investment decisions are expected to
bring in additional revenue, thereby raising the size of the firms total revenue and
(ii) Investment decisions reducing costs: such decisions, by reducing costs, add to the
total earnings of the firm. A classic example of such investment decisions are the
replacement proposals when an asset wears out or becomes outdated.
Steps involved in CB process
(1) Project generation: the investment proposal may fall into on the following categories:
Proposal to add new product to the product line
To expand production capacity in existing product lines
To reduce the costs of the output of the existing products without altering the scale of
production
(2) Project Evaluation
It involves two steps, namely,
(i) Estimation of costs and benefits of different capital budgeting proposals
(ii) Setting up of appropriate criteria to judge the profitability of the project
While evaluating the various investment proposals, the following points must be noted:
(i) The costs and benefits of various proposals should be estimated in terms of cash
flows
(ii) While estimating the cash flows, particularly the cash inflows of different
proposals, the risk associated with the proposals should be properly taken into
consideration
(iii) While estimating the costs and benefits of proposals, the time value of money
should be taken into consideration
(iv) The evaluation of the projects should be done by a group of experts who are
impartial
(v) Proper care should be taken while deciding upon the selection criteria. The
selection criteria should be consistent with the concerns objective of maximizing its
market value.
3

(3) Project Selection: selection of the most profitable or desirable proposals

(4)Project execution: implementation of the selected projects with adequate allocation of
funds.
(5)Follow up of the project: periodical assessment of the results of the projects by comparing
the actual results of the projects with the estimated results.
Types of capital budgeting decisions
1. Independent projects/proposals: Independent projects are projects whose cash flows
are unrelated/independent of one another; the acceptance of one does not eliminate the
others from further consideration.
2. Mutually exclusive projects: Mutually exclusive projects are projects that compete
with one another; the acceptance of one eliminates the others from further
consideration.
3. Capital rationing: Capital rationing is the financial situation in which a firm has only
fixed amount to allocate among competing capital expenditures. In other words,
capital rationing refers to a situation in which a firm has more acceptable investments
than it can finance. It is concerned with the selection of a group of investment
proposals out of many investment proposals acceptable under the accept-reject
decision.
Steps in Project Selection under Capital Rationing
(i)
(ii)

Identification of the acceptable projects,

Selection of the combination of projects.

The acceptability of projects can be based either on profitability index or IRR.

Types of Capital rationing
(i) Soft rationing and
(ii) Hard rationing.
While hard rationing refers to the situation when a business firm cannot raise required
finances to execute all potential available profitable investment projects, the soft rationing is
internal to the firms in that different divisions/units of a firm are allocated a fixed amount of
capital budget each year.
Cash Flow
Capital budgeting is concerned with investment decisions which yield return over a period of
time in future. The foremost requirement for evaluation of any capital investment proposal is
to estimate the future benefits accruing from the investment proposal.

Relevant cash flow: is the incremental after tax cash outflow and resulting
subsequent inflows associated with a proposed capital expenditure
4

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

Variable labour expenses

Variable material expenses
Additional fixed overhead expenses
Cost of the investment
Marginal taxes
Irrelevant Cash Outflows

Fixed overhead expenses (existing)

Sunk costs
Cash flow pattern

Conventional cash flow pattern is an initial outflow followed by only a series of

inflows. Most of the capital expenditure decisions display this pattern of cash flow

Non-conventional cash flow pattern is a pattern in which an initial outflow is not

followed by only a series of inflows. Alternating inflows and outflows and an inflow
followed by outflows are examples of non-conventional cash flow patterns.
Cash Flow Estimates

1) Tax effect: Special consideration needs to be given to tax effects on cash flows if the
firm is incurring losses and, therefore, paying no taxes. The tax laws permit carrying
losses forward to be set off against future income.
2) Effect on other projects: Cash flow effects of the project under consideration, if it is
not economically independent, on other existing projects of the firm must be taken
into consideration.
3) Effect of indirect expenses: another factor which merits special consideration in
estimating cash flows is the effect of overheads. The indirect expenses/overheads are
allocated to the different products on the basis of wages paid, materials used, floor
space occupied or some other similar common factor.
4) Working capital effect: Working capital constitutes another important ingredient of
the cash flow stream which is directly related to an investment proposal. If an
investment is expected to increase sales, it is likely that there will be an increase in
current assets in the form of accounts receivable, inventory and cash.
5) Effect of depreciation: Depreciation, although a non-cash item of cost, is deductible
expenditure in determining taxable inome
Effect of Depreciation
5

Block of assets: are assets which fall in the same class and in respect of which the
same depreciation rate is applicable irrespective of their nature.

If an asset falling in a block is sold out, there is no capital gain or terminal

depreciation or balancing charge.

The sale proceeds of the asset are reduced from the WDV of the block.

Capital gain/loss can arise in the following situations:

(i)When the sale proceeds exceeds the WDV of the whole block;
(ii) When the entire block is sold out; and
(iii) In case of per cent depreciable assets
In case block consists of a single asset, no depreciation is to be charged in the
terminal year in which it is sold
Implication of Tax Provision
Illustration: A company buys a new machine for Rs.10,00,000 (forming a separate block).
The machine is subject to 20% depreciation on WDC basis. It is expected to have economic
useful life of 5 years at the end of which its expected salvage value is Rs. 1,00,000

Depreciation in the first 4 years would be, Rs. 2,00,000, Rs. 1,60,000, Rs. 1,28,000,
and Rs. 1,02,400 respectively.

The accumulated depreciation would be Rs. 5,90,400

As result, the WDV/book value of the machine at the beginning of year 5 would be
Rs.4,09,600.

No depreciation is charged in the 5th year and there is a salvage value of Rs.1,00,000,
there would be short-term capital loss of Rs. 3,09,600.

This loss, in turn, would yield tax shield.

Assuming 30% tax, the tax shield is Rs. 92,880

This amount will be treated as cash inflow in year 5

Effect in Financial Accounting

Depreciation in year 5=409600x.20=81920

Loss on sale of machine=409600-81920-100000=227680

Tax benefit on depreciation and loss=(81920+227680)0.30=92880

6

Thus, the firm does not suffer any loss by not charging depreciation in the terminal
year
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.
Capital projects can be categorized into: (i) single proposal, (ii) replacement situations and
(iii) mutually exclusive.
-

Single proposal cash outflow of new project

Cost of new project
+ Installation cost of plant and equipments
+/- Working capital requirements
Determination of Cash Inflows
Cash sales revenues
Less: cash operating cost
Cash inflows before taxes (CFBT)
Less: Depreciation
Taxable income
Less: Tax
Earnings after taxes
Plus: Depreciation
Cash inflows after tax (CFAT)
Plus: Salvage value in the terminal year
Plus: Recovery of working capital in the terminal year
Replacement Situation
Cash outflows in a replacement situation
Cost of the new machine
+ installation cost
+/- working capital
7

 sale proceeds of existing machine

Depreciation base of new machine in a replacement situation
WDV of the existing machine
+ Cost of the acquisition of new machine (including installation costs)
Sale proceeds of existing machine

Base for incremental depreciation

Depreciation base of a new machine
Less: depreciation base of an existing machine
Investment Appraisal Techniques
Non-discounted methods

(i)

Pay-back period method: Pay-back period is the time period required to get back the
original investment.
When mutually exclusive projects are under consideration, they may be
ranked according to the length of the payback period.
Advantages

1) Easy to understand and simple to operate

2) It takes into account the liquidity of the projects
3) It is quite useful in evaluating projects, which involves high uncertainty
4) As this method considers the cash flows from the projects during the payback period,
the estimates of cash flow made under this method should be more reliable and results
would be more accurate

Disadvantages
1) It is based on the principle of rule of thumb
2) It does not recognize the importance of time value of money
3) It does not consider the profitability of the project earnings after the payback period
4) It is a measure of projects recovery of capital cost, and not a measure of the
profitability of the project.
In case of Even Cash Flows (Uniform) Pay back period is calculated as follows:
8

Pay back period = Initial investment

Annual cash flow
Example, if a project requires Rs. 20,000 as initial investment and it will generate an annual
cash inflow of Rs. 5,000 for ten year, the pay-back period will be 4 years. 20000/5000
From the above information calculate payback period
Original cost of investment Rs. 6,00,000
Annual cash inflow after tax Rs. 60,000
Annual depreciation Rs. 40,000
Annual cash inflow= Annual cash inflow after tax + Annual depreciation
= 60000 + 40000 = 1,00,000
Payback period=60000/100000= 6 Years
Illustration: ABC Ltd. is considering the purchase of a new machine, which would carry out
some operations at present being performed by labour. Two alternative models under
consideration are X and Y. Following is the information:
X
150000
5
6000
10000
19000

Y
250000
6
8000
15000
27000

X X XX
10,000
90,000
1,00,000
6,000
19,000
25,000
75,000
37,500
37,500

Y
15,000
1,20,000
1,35,000
8,000
27,000
35,000
1,00,000
50,000
50,000

Cost of machine
Expected life in years
Cost of indirect materials per annum
Estimated savings in scrap per annum
Additional cost of maintenance per annum
Estimated savings in wages:
Employees not required(Nos.)
150
200
Wages per employee per annum
600
600
Tax is to be regarded as 50% (ignore depreciation for calculating tax). Using payback period
suggest which machine should be purchased.
Ans. Calculation of annual cash inflow
Savings in scrap
Estimated savings in wages
Total savings
Cost of indirect material
Additional maintenance
Total expenditure
EBT
Less: Tax
Annual cash inflow

Payback period
X= 150000/37500=4 Years
Y=250000/50000=5 Years
Illustration (uneven cash flow)
A company is considering an investment proposal to install a new machine. The
project will cost Rs. 50,000 and will have a life of 5 years and no salvage value. The
companys tax rate is 50%. The company uses straight-line method of depreciation.
The estimated net income before depreciation and tax from the proposed investment is
as follows:
Year
PBDT

1
10000

2
11000

3
14000

4
15000

5
25000

Calculation of payback period

Year

PBDT

Dep.

PBT

1
10000 10000 0
2
11000
10000 1000
3
14000 10000 4000
4
15000 10000 5000
5
25000 10000 15000
Payback period=4 years +(5000/17500)

Tax

PAT

Cash
inflow

0
500
2000
2500
7500

0
500
2000
2500
7500

10000
10500
12000
12500
17500

Cumulative
cash
inflow
10000
20500
32500
45000
62500

=4.29 Years

Uneven cash inflows

Example, if a project requires an initial investment of Rs. 20,000 and the annual cash inflows
for 5 years are Rs. 6,000, Rs. 8,000, Rs.5,000, Rs. 4,000 and Rs. 4,000 respectively. Calculate
the payback period.
Year
Cash inflow
1
6000
2
8000
3
5000
4
4000
5
4000
Payback period=3 years+1000/4000 =3.25years

Cumulative cash inflow

6000
14000
19000
23000
27000

10

Illustration: A limited company is considering investment in a project requiring a capital

outlay of Rs. 2,00,000. The companys tax rate is 50%. Forecast for annual income after
depreciation but before tax is as follows:
Year
1
2
3
4
5

Income after Dep. before Tax (Rs.)

1,00,000
1,00,000
80,000
80,000
40,000
Depreciation= 2,00,000/5=40,000

Year
1
2
3
4
5

EBT

TAX

EAT

Depr.

Cash
Inflow
1,00,000
50,000
50,000
40,000
90,000
1,00,000
50,000
50,000
40,000
90,000
80,000
40,000
40,000
40,000
80,000
80,000
40,000
40,000
40,000
80,000
40,000
20,000
20,000
40,000
60,000
Pay back period= 2 years+(20,000/80,000) = 2 years 3 months

Cumulative
Cash Inflow
90,000
1,80,000
2,60,000
2,40,000
4,00,000

2. Accounting Rate of Return Method

Accounting Rate of Return method / Average rate of return method/Return on
investment /return on capital method
ARR is based upon accounting information rather than cash flows. There is no unanimity
regarding the definition of the rate of return. There are a number of alternative methods for
calculating the ARR.
ARR = Average Annual Profit after Tax x 100
Average investment
Average annual profit after tax = Total profit
No. of years
Average investment = Initial investment + Salvage value
2
Example, A project requires an investment of Rs.5,00,000 and has a scrap value of Rs.
20,000 after five years. It is expected to yield profits after taxes during the five years are
as follows:
Year

Rs.

11

40,000

60,000

70,000

50,000

20,000 calculate ARR

ARR=Average Annual Income/Average Investment

Average annual income=PAT/No.of years
=24000/5=48000
Average investment= 500000-20000/2=240000
ARR= 48000/240000x100= 20%
Illustration: ABC Ltd. is proposing to take up a project, which requires an investment of Rs.
1,20,000. The net income before depreciation and tax is estimated as follows:
Year

Rs.

30,000

36,000

42,000

48,000

60,000

Depreciation is to be charged on straight-line basis. Tax rate is 50%. Calculate ARR

Average Annual Income=
Profit before depreciation and tax=216000
Less: total depreciation

=12000

Total profit before tax

=96000

Less: tax @50%

=48000

Total profit after tax

=48000

Average annual income=48000/5=9600

Average investment=120000/2=60000

12

ARR=9600/60000 x100=16%
If any additional net working capital is required in the initial year which is likely to be
released only at the end of the projects life, the full amount of working capital should be
taken in determining relevant investment for the purpose of calculating ARR.
Average Investment = Initial investment-scrap value/2+Net working capital + scrap
value
Initial investment Rs. 7,50,000, scrap value Rs.1,00,000, working life 5 years,
additional working capital requirement Rs. 50,000. calculate average investment.
Average investment=750000-100000/2 + 50000 + 100000
=475000
Advantages
1) It is easy to understand and simple to operate
2) Takes into account the earnings or profits over the entire economic life of the projects
3) Takes into account the depreciation charges of the project in the computation of the
earnings of the project.
4) Makes it clear that no profit will arise till the payback period is over. This helps a
company in deciding when it should start paying dividend
Disadvantages
1) It ignores time value of money
2) It does not consider the length of life of the projects
3) It is not consistent with the firms objective of maximizing the market value of shares.

Discounted Cash Flow (DCF) Method

DCF/Time Adjusted Techniques
This method is an improvement on the pay-back period method. It takes into account both
the interest factor as well as the return after the pay-back period.
DCF method involves three stages:

Calculation of cash flows, inflows and outflows

Discounting the cash flows so calculated by a discount factor

13

Aggregating of discounted cash inflows and comparing the total with the discounted
cash outflows.

Net present value method (NPV)

The term NPV refers to the excess of present value of cash inflows over the present values of
cash outflows.
The present values of cash inflows and outflows are calculated at the rate of return acceptable
to the management.
Usually the rate of discount factor is the weighted average cost of capital.
Merits
1) This method takes into account the cash inflows of a project over its entire economic
life.
2) It takes into account the time factor while evaluating the profitability of the
investment proposal
3) As it takes the time factor into consideration, it provides for uncertainty and risk
4) This method is more scientific and dependable
Demerits
1) It is a complicated method, in the sense that it involves a good amount of calculations
2) This method does not correspond to the accounting concepts, while recording costs
and revenues.
3) It is not suitable for ranking the projects requiring different capital outlay
4) It assumes that intermediate cash inflows are re-invested at the firms cost of capital,
which is not always correct.
Illustration: A company is considering an investment proposal which requires an initial
investment of Rs. 1,40,000. the cost of capital of the company is 10%. The cash inflow
expected from the investment proposal is given below:
Year

Rs.

20000

40000

60000

90000

14

120000 compute NPV

NPV calculation
YEAR

CASH FLOW

1
2
3
4
5

20000
40000
60000
90000
120000
Total PV
Less: Initial
Investment

PV
FACTOR@10%
0.909
0.826
0.751
0.683
0.621

PV OF
CASHFLOW
18180
33040
45060
61470
74520
232270
140000

NPV

92270

Illustration: A company is considering the purchase of a machinery, which costs Rs.

8,00,000 and which has an estimated life of 10 years. The machine will generate additional
Rs.1,00,000 per year. The cost of the machine is depreciated on a straight-line basis and has
no salvage value. The company has a cost of capital of 12% and a corporate tax rate of 40%.
Calculate:
(i) Annual cash inflow (ii) NPV and (iii) Payback period

Calculation of annual cash inflow

Rs
Additional Revenue
Less: Depreciation

100000
80000

Annual PBT
Less: Tax

20000
8000

Annual PAT
Add: Depreciation

12000
80000

Annual Cash inflow

92000

15

Calculation of NPV
NPV= Annual Cash inflow x PV Annuity@12% for 10 years
= 92000 x 5.650

=519800

Less: Initial investment

=800000

NPV

=(280200)

Payback period= 800000/92000=8.7 Years

Illustration: The following information is available pertaining to ABC Ltd:
Initial investment Rs. 10,00,000
Required rate of return 10%.
Cash flows in various years:
Year
1
2
3
4
5
Cash inflows
1 lakh
4 lakh
6 lakh
6 lakh
2 lakh
i)
Calculate Payback period ignoring the interest factor
ii)
Calculate payback period taking into account the interest factor
Year

Cash inflow

Cumulative cash
inflow
100000
500000
1100000
1700000
1900000

1
100000
2
400000
3
600000
4
600000
5
200000
Payback period=2 years +500000/600000
=2.83 years
Discounted Payback period
Year

Cash inflow

PV factor

PV

1
2
3
4
5

100000
400000
600000
600000
200000

0.909
0.826
0.751
0.683
0.621

90900
330400
450600
409800
124200

Cumulative
PV
90900
421300
871900
1281700
1405900

Discounted payback period=3 years +128100/409800=3.31 years

Illustration: Cash inflows of a project along with outflows are given below: Salvage value
Rs.40000. calculate NPV.PV factor 10%.
16

Year
0
1
2
3
4
5

Cash Outflows
150000
30000

Cash Inflows
20000
30000
60000
80000
30000

Calculation of PV of Cash outflow

Year
0
1

Cash outflow
150000
30000

PV factor
1
0.909
Total PV of cash
outflow

PV
150000
27270
177270

Calculation of NPV
Year
1
2
3
4
5
5

Cash inflow
20000
30000
60000
80000
30000
40000

PV factor
0.909
0.826
0.751
0.683
0.621
0.621
Total PV
Less: PV of outflow
NPV

PV
18180
24780
45060
54640
18630
24840
186130
177270
8860

Internal Rate of Return (IRR)

IRR is the discount rate at which the NPV is zero. It is usually the rate of return that a project
earns. It is defined as the discount rate which equates the aggregate present value of the net
cash inflows with the aggregate present value of cash outflows of a project.
It is that rate at which the sum of discounted cash inflows equals the sum of discounted cash
outflows.
This method is also known as yield on investment, marginal efficiency of capital, marginal
productivity of capital.
NPV Vs IRR
1) Like the NPV method, IRR method also considers the time value of money by
discounting the cash streams.

17

2) In the case of NPV method, the discount rate is required rate of return and being
predetermined rate, usually the cost of capital, its determinants are external to the
proposal under consideration.
3) The IRR, on the other hand, is based on the facts, which are internal to the proposal.
Merits
1) It considers the time value of money
2) Calculation of cost of capital is not a prerequisite for adopting IRR
3) IRR attempts to find the maximum rate of interest at which funds invested in the
projects could be repaid out of the cash inflows arising from the project
4) It is not in conflict with the concept of maximizing the welfare of the equity
shareholders
5) It considers cash inflows throughout the life of the project
Demerits
1) Computation of IRR is tedious and difficult to understand
2) Both NPV and IRR assume that the cash can be reinvested at the discounting rate in
new projects.
3) However, reinvestment of funds at the cut off rate is more appropriate that at the IRR.
4) Hence, NPV method is more reliable than IRR for ranking two or more projects
5) It may give the results, which are inconsistent with NPV. This is especially true in
case of mutually exclusive projects
6) IRR = Lower Discount rate + (PV of cash inflows at lower rate Initial investment) /
(PV of cash inflows at lower rate - PV of cash inflows at higher rate) x Difference in
discount rates
IRR Calculations
Example, A project is estimated to cost Rs. 16,300. it is expected to have a life of 3 years and
generate cash inflows of Rs. 8,000, Rs. 7,000 and Rs. 6,000. Calculate IRR
YEAR

CASH
INFLOW

PV @14%

1
2
3

8000
7000
6000

.877
.769
.675

PV OF
CASH
INFLOW
7016
5383
4050
16449

PV@15%
.870
.756
.658

PV OF
CASH
INFLOW
6960
5292
3948
16200
18

IRR = LR + (HPV-I)

X(HR-LR)

(HPV-LPV)
= 14 + (16449-16300)

X1

(16449-16200)
= 14 + 149

X1

249
= 14.60%
Modified IRR (MIRR): The source of conflict between IRR and NPV method of appraising
the project is the assumption of reinvestment rate of the cash flows implied in the DCF
techniques.
To overcome the drawback of the IRR method and to make it consistent with the NPV rule, a
modified method is developed known as MIRR.
MIRR
The method works as follows:
1) Find out the terminal values of all the cash flows assuming the reinvestment rate at
cost of capital
2) The total of terminal value is treated as single cash inflow at the end of the project
3) With only two cash flows (initial investment and terminal value at the end of the
project) recomputed the IRR. This new IRR is the modified IRR.
Profitability Index method
It is the ratio of the present value of cash inflows, at the required rate of return, to the initial
cash outflow of the investment.
The PI approach measures the present value of returns per rupee invested, while the
NPV is based on the difference between the present value of future cash inflows and the
present value of cash outlays.

PI = Total PV of cash inflows

Initial cash outflow
This method is also known as the B/C ratio because the numerator measures benefits and the
denominator costs.

19

Illustration: Beta Ltd.is considering the purchase of a new machine. Two alternative
machines A and B are suggested each costing Rs.1,00,000. Assume 10% rate of discount.
Calculate PI. Earnings after taxation are expected to be as follows:
YEARS
A
B

1
40000
60000

YEAR

CF-A

1
2
3
4

40000
30000
50000
20000

2
30000
30000

3
50000
30000

PV@10% PV OF
CF
0.909
36360
0.826
24780
0.751
37550
0.683
13660
TOTAL
112350
PV

CF-B
60000
30000
30000
20000

4
20000
20000
PV OF
CF
54540
24780
22530
13660
115510

PI = Total PV of cash inflows

Initial Investment
Machine A = 112350/100000 =1.1235
Machine B = 115510/100000 = 1.1551
Illustration: Mohan Ltd. has Rs. 200000 to invest. The following proposals are under
consideration. The cost of capital for the company is estimated to be 15%.
Project
A
B
C
D
E

Initial outlay
100000
70000
30000
50000
50000

Annual cash flow

25000
20000
6000
15000
12000

Life of project
10
8
20
10
20

Rank the above projects on the basis of NPV and PI.

Calculation of NPV
project
A
B
C
D

Cash
inflow
25000
20000
6000
15000

PV factor

Total PV

5.019
4.487
6.259
5.019

125475
89740
37554
75285

Initial
investment
100000
70000
30000
50000

NPV

Rank

25475
19740
7554
25285

1
4
5
2
20

12000

6.259

75108

50000

25108

CALCULATION OF PI
PROJECT

TOTAL PV OF CF

A
B
C
D
E

125475
89740
37554
75285
75108

INITIAL
INVESTMENT
100000
70000
30000
50000
50000

PI

RANK

1.255
1.282
1.252
1.506
1.502

4
3
5
1
2

Illustration: A company is considering an investment proposal to install new milling controls

at a cost of Rs. 50,000. The facility has life expectancy of 5 years and no salvage value. The
tax rate is 35%. Assume the firm uses straight line depreciation and the same is allowed for
tax purposes. The estimated cash flows before depreciation and tax from the investment
proposal are as follows:
year
CFBT

1
10000

2
10692

3
12769

4
13462

5
20385

Compute: (i)Payback period,(ii)ARR, (iii)NPV(discount factor 10%), (iv)IRR and (v)PI at

10% discount factor.(source:Financial Management, M.Y.Khan & P.K. Jain, 6th Edition, page
9.47)
Determination of CFAT
Year
1
2
3
4
5

CFBT
10000
10692
12769
13462
20385

Depr.
10000
10000
10000
10000
10000

PBT
0
692
2769
3462
10385

Tax
0
242
969
1212
3635

EAT
0
450
1800
2250
6750
11250

CFAT
10000
10450
11800
12250
16750
61250

Payback period
year
CFAT
1
10000
2
10450
3
11800
4
12250
5
16750
Payback period=4 years+5500/16750=4.328

Cumulative CFAT
10000
20450
32250
44500
61250

ARR=11250/5

21

50000/2
=2250/25000x100= 9%
NPV
Year
1
2
3
4
5

CFAT
10000
10450
11800
12250
16750

PV Factor@10%
0.909
0.826
0.751
0.683
0.621
Total PV
Initial investment
NPV

Total PV
9090
8632
8862
8367
10401
45352
50000
(4648)

IRR
year
1
2
3
4
5

CFAT
10000
10450
11800
12250
16750

IRR = LR + (HPV-I)

X(HR-LR)

PV@6%
0.943
0.890
0.840
0.792
0.747

Total PV@6%
9430
9300
9912
9702
12512
50856
50000
856

(HPV-LPV)
=6+ (50856-50000) x (10-6)
(50856-45352)
=6+856 x4
5504
=6+0.622= 6.62%
PI = Total PV of cash inflows
Initial Investment
=45352/50000=0.907
Inflation and Capital Budgeting
22

The capital budgeting results would be unrealistic if the impact of inflation is not correctly
factored in the analysis.
The cash flow estimates will not reflect the real purchasing power.
Therefore, cash flows should be adjusted to accommodate the inflation factor so that the CB
decisions reflect the true picture.
Real Cash Flows
Real cash flows are cash flows discounted/deflated to reflect effect of inflation on nominal
cash flows.
In case of inflation real cash flows are substantially lower than nominal cash flows.
This is due to the fact that increased income (as depreciation charges do not change) is
subject to higher amount of taxes.

23