Capital Budgeting

Week 2

FIXING DISCOUNTING RATE, STATIC ECONOMY AND INFLATION

1. Following are the expected nominal cash flow of project A, requiring an initial outlay of Rs.
1,00,000.00

Year 1 2 3 4

Cash Flow Rs. 30,000 Rs. 60,000 Rs. 40,000 Rs. 10,000

If the cost of capital of the company is static economy is 8%, and the inflation rate is 5% .Can the project
be accepted ?

Sol 1:

Working Note 1:

Discount Rate = Cost of Capital + Inf lation Rate

= 8% + 5%
= 13%
Working Note 2:

Year Cash Flow Discount Rate @ 13% Expected Cash Flow

0 (100,000.00)
1 30000 0.8849557522 26548.67257
2 60000 0.7831466834 46988.801
3 40000 0.6930501623 27722.00649
4 10000 0.6133187277 6133.187277
Total Expected Cash Flow (Discounted Cash Inflow) 107392.6673

Given initial cash outlay or cash outf low = 100, 000

N et P resent V alue(N P V ) = Discounted Cash Inf low − Cash Outf low

= 107, 392.67 − 100, 000

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 = 7, 392.67

In practice, expected value: 140,000 but in real: 107,393.

Conclusion: ​As NPV computed to yield a positive value, the project should be accepted.

STATIC ECONOMY & DEFLATION

2) Following are the expected nominal cash flow of project XYZ , requiring an initial outlay of Rs.
500,000

Year 1 2 3 4

Cash Flow Rs. 30,000 Rs. 60,000 Rs. 40,000 Rs. 10,000

If the cost of capital of the company is static economy is 9%, and the deflation rate is 5 % .Can the project
be accepted ?

Sol 2:
Working Note 1:

Discount Rate = Cost of Capital − Def lation Rate

= 9% − 5%
= 4%

Working Note 2:

Year Cash Flow Discount Rate @ 13% Expected Cash Flow

0 (500,000.00)
1 30000 0.9615384615 28846.15385
2 60000 0.924556213 55473.37278
3 40000 0.8889963587 35559.85435
4 10000 0.854804191 8548.04191
Total Expected Cash Flow (Discounted Cash Inflow) 128427.4229

Given initial cash outlay or cash outf low = 500, 000

N et P resent V alue(N P V ) = Discounted Cash inf low − Cash Outf low

= 128, 427.42 − 500, 000

= (371, 572.58)

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In practice, expected value: 140,000 but in real: 128, 427.42

Conclusion: ​As NPV computed to yield a negative value, the project should be rejected.

DIFFERENT COST OF CAPITAL THRO THE LIFE OF PROJECT

4) Following are the cash flows for the project having a life of 5 years – Rs. 20,000, Rs. 80,000, Rs.
60,000, Rs. 50,000 and Rs. 40,000. Capital outlay is Rs. 1,50,000.
Based on past experiences (Business Cycle), the company sees the cost of capital for the project period as
follows-
● For the year 1 and 2 – 15%
● For the year 3- 16%
● For the year 4 and 5 – 14%
Ascertain the NPV of the project and the Profitability Index

Sol:

Working Note:

Year Cash Flow Discount Rate @ 13% Expected Cash Flow

0 (150,000.00)
1 20000 0.8696 17391.30
2 80000 0.7561 60491.49
3 60000 0.6518 39110.88
4 50000 0.5718 28589.82
5 40000 0.5016 20063.03
Total Expected Cash Flow (Discounted Cash Inflow) 165646.54

Given initial cash outlay or cash outf low = 150, 000

N et P resent V alue(N P V ) = Discounted Cash inf low − Cash Outf low

= 165, 646.54 − 150, 000

= 15, 646.54

In practice, expected value: 250,000 but in real: 165, 646.54

(Discounted Cash Inf low)
P robability Index (P I) = (Outf low)

165,646.54
= 150,000 = 1.104

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Conclusion: ​As NPV computed to yield a positive value and PI is greater than 1, the project should be
accepted.

5 ) Following are the cash flows for the project having a life of 5 years – Rs. 220,000, Rs. 180,000, Rs.
260,000, Rs. 250,000 and Rs. 240,000. Capital outlay is Rs. 850,000.
Based on past experiences (Business Cycle), the company sees the cost of capital for the project period as
follows-
● For the year 1 and 2 – 12%
● For the year 3- 14%
● For the year 4 and 5 – 16%
Ascertain the NPV of the project and the Profitability Index

Sol:

Working Note:

Year Cash Flow Discount Rate @ 13% Expected Cash Flow

0 (850,000.00)
1 220000 0.8929 196428.57
2 180000 0.7972 143494.90
3 260000 0.6993 181816.15
4 250000 0.6028 150709.67
5 240000 0.5197 124725.25
Total Expected Cash Flow (Discounted Cash Inflow) 797174.53

Given initial cash outlay or cash outf low = 850, 000

N et P resent V alue(N P V ) = Discounted Cash inf low − Cash Outf low

= 797, 174.53 − 850, 000

= (52, 825.47)

In practice, expected value: 1,150,000 but in real: 797, 174.53

(Discounted Cash Inf low)
P robability Index (P I) = (Outf low)

797,174.53
= 850,000 = 0.938

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Conclusion: ​As NPV computed to yield a negative value and PI is less than 1, the project should be
accepted.

Notes:

EBITDA - Earnings Before Interest, Tax, Depreciation and Amortization

Less: Depreciation and Amortization

EBIT - Earnings Before Interest and Tax xxx

Less: Interest xxx

EBT - Earnings Before Tax xxx

Less: Tax xxx

EAT/PAT - Earnings After Tax/Profit After Tax

● For non-cash items, fixed cost must not be deducted to obtain net profit. Hence in this case,
Contribution = Profit.

● If dismantling cost is mentioned instead of scrape, in the working note table, it has to be taken as
cash outflow instead of cash inflow which is taken for scrape.

CAPITAL BUDGETING & PROFIT VOLUME RATIO (CONTRIBUTION MARGIN)

8) Forward planning Limited is considering whether to invest in a project which would entail immediate
expenditure on capital equipment of Rs. 40 000. Expected from sales from the projects are as follows.

Probability Sales Volume

0.10 2000

0.25 6000

0.40 8000

0.15 10000

0.10 14000

Once sales are established at a certain volume in the first year, they will continue at the same volume in
subsequent years.

The unit selling price will be Rs. 10, the unit variable cost Rs. 6 and the additional fixed cost will be Rs.
20000 (all cash items) the project would have a life of 6 years after which the equipment would be sold as
scrap which would fetch Rs. 3000.

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You are required to find – (1) expected value of NPV of the project (2) minimum volume of sales per
annum required to justify the project.

Cost of capital of the company is 10%. Discount factor of Re.1 per annum for 6 years at 10% is 4.355 and
the discount factor of Re. 1 at the end of 6​th​ year at 10% is 0.5645

Sol:
Working Note 1:

Probability Sales Volume Probable Sales

0.1 2000 200
0.25 6000 1500
0.4 8000 3200
0.15 10000 1500
0.1 14000 1400
Total volume of probable sales 7800

Working Note 2: Marginal Cost Statement

Selling price per unit 10

Variable cost per unit 6
Contribution margin per unit 4
Contribution margin probable sales 31200 If non-cash
Fixed Cost 20000 items
Net Profit(Minimum volume of sales) 11200 31200

Working Note 3:

Year Cash Flow Discount Rate Expected Cash Flow

0 (40,000.00)
1-5(Annuity If dismantling cost was
method is mentioned instead of
applied) 11,200 4.355 48776 scraping
6 3,000 0.5645 1693.5 (1,693.50)
Total Expected Cash Flow (Discounted Cash
Inflow) 50469.5 47,082.50

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 N P V = 50, 469.50 − 40, 000 = 10, 469.50
50,469.50
PI = 40,0000 = 1.26

9) Backward planning Limited is considering whether to invest in a project which would entail immediate
expenditure on capital equipment of Rs. 80 000. Expected from sales from the projects are as follows.
(Homework)

Probability Sales Volume

0.10 2000

0.25 6000

0.40 18000

0.15 10000

0.10 14000

Once sales are established at a certain volume in the first year, they will continue at the same volume in
subsequent years.

The unit selling price will be Rs. 12, the unit variable cost Rs. 6 and the additional fixed cost will be Rs.
20000 (all cash items) the project would have a life of 6 years after which the equipment would be sold as
scrap which would fetch Rs. 8000.

You are required to find – (1) expected value of NPV of the project (2) minimum volume of sales per
annum required to justify the project.

Cost of capital of the company is 10%. Discount factor of Re.1 per annum for 6 years at 10% is 4.355 and
the discount factor of Re. 1 at the end of 6​th​ year at 10% is 0.5645

Solution:

Working Note 1:

Probability Sales Volume Probable Sales

0.1 2000 200
0.25 6000 1500
0.4 18000 7200
0.15 10000 1500
0.1 14000 1400
Total volume of probable sales 11800

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Working Note 2: Marginal Cost Statement

Selling price per unit 12

Variable cost per unit 6
Contribution margin per unit 6

Contribution margin probable sales 70800

Fixed Cost 20000 If non-cash items
Net Profit 50800 70800

Working Note 3:

Year Cash Flow Discount Rate Expected Cash Flow If dismantling cost
was mentioned
0 (80,000.00)
instead of
1-5 50,800 4.355 221234 scraping
6 8,000 0.5645 4516 (4,516.00)
Total Expected Cash Flow (Discounted Cash Inflow) 225750 216,718.00

N P V = 225, 750 − 80, 000 = 145, 750

225,750
PI = 80,0000
= 2.82

Week 2
RISK EVALUATION IN CAPITAL BUDGETING

Note: Salvage value = Scrap value. Risk is measured by standard deviation.

10. Two mutually exclusive investment proposals are being considered. The following information is
available

Particulars Project A Project B

Cost 20,000 20,000

Life 2 years 2 years

Cash flow each year 12,000 12,000

Salvage value 0 0

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Advice for selecting the proposal if the cost of capital is 10%. The probabilities of cash inflow of each
year for the projects are---

Project A Project B

Possible inflow Probability Possible inflow Probability

Rs.10,000 0.2 Rs.11,000 0.2

Rs.12,000 0.6 Rs.12,000 0.6

Rs.14,000 0.2 Rs.13,000 0.2

Solution:

Project A
D = Cash Flow inflow - E = Square of
A B C=AxB Total Expected Inflow (Z) (Deviation(D)) F=ExB
Expected
Cash Flow Cash Flow
inflow in '000 Probability Inflow in '000 Square of Variance
(A) (B) (C) Deviation in '000 (D) Deviation (E) (F)
10 0.2 2 (2.00) 4 0.8
12 0.6 7.2 0.00 0 0
14 0.2 2.8 2.00 4 0.8
Total Expected Inflow (Z) 12 Total Variance (Y) 1.6

Variance 1.6
Standard
Deviation 1.265

Project B
D = Cash Flow inflow - E = Square of
A B C=AxB Total Expected Inflow (Z) (Deviation(D)) F=ExB
Expected
Cash Flow Cash Flow
inflow in '000 Probability Inflow in '000 Square of Variance
(A) (B) (C) Deviation in '000 (D) Deviation (E) (F)
11 0.2 2.2 (1.00) 1 0.2
12 0.6 7.2 0.00 0 0
13 0.2 2.6 1.00 1 0.2

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Total Expected Inflow (Z) 12 Total Variance (Y) 0.4

Variance 0.4
Standard
Deviation 0.632

Conclusion: As standard deviation and variance of Project B is less than Project A, Project B is accepted
as it is less riskier compared to Project A.

11. Two mutually exclusive investment proposals are being considered. The following information is
available ​(Homework)

Particulars Project A Project B

Cost 50,000 70,000

Life 2 years 2 years

Cash flow each year 12,000 12,000

Salvage value 0 0

Advice for selecting the proposal if the cost of capital is 10%. The probabilities of cash inflow of each
year for the projects are---

Project A Project B

Possible inflow Probability Possible inflow Probability

Rs.10,000 0.2 Rs.11,000 0.2

Rs.12,000 0.6 Rs.12,000 0.6

Rs.14,000 0.2 Rs.13,000 0.2

Solution:

The working notes are exactly the same as that of Q10. Only difference is that Project B involves higher
cost than Project A. At expense of higher cost, the risk involvement is less for Project B in contrast to
Project A which costs lower than it. The difference in cost between project A and project B is 20,000 i.e.
cost of Project B involves additional cost of 40% of Project A. As the difference in cost is not by very big
margin, it is better to accept Project B. Hence, Project B is accepted.

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Evaluation of projects ---Expected NPV and risk attached to the project

12) A company is considering two mutually exclusive projects X and Y. Project X costs Rs.30,000 and
project Y costs Rs.36,000. The NPV probability distribution for each project is given below:

Project X Project Y

NPV Estimate (Rs.) Probability NPV Estimate (Rs.) Probability

3,000 0.1 3,000 0.2

6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2

1.Compute the expected Net Present Value of projects X and Y.

2.Compute the risk attached to each project i.e., Standard Deviation of each probability distribution.

3.Which project is more risky and why?

4.Compute the probability index of each project

Solution:

Part 1 and 2:

Project X
D = Cash Flow inflow - E = Square of
A B C=AxB Total Expected Inflow (Z) (Deviation(D)) F=ExB
Expected
NPV in '000 Probability NPV in '000 Square of
(A) (B) (C) Deviation in '000 (D) Deviation (E) Variance (F)
3 0.1 0.3 (6.00) 36 3.6
6 0.4 2.4 (3.00) 9 3.6
12 0.4 4.8 3.00 9 3.6
15 0.1 1.5 6.00 36 3.6
Total Expected NPV (Z) 9 Total Variance (Y) 14.4

Variance 14.4 Project X Cost 30000

Standard
Deviation 3.795

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 Project Y
D = Cash Flow inflow - E = Square of
A B C=AxB Total Expected Inflow (Z) (Deviation(D)) F=ExB
Expected
NPV in '000 Probability NPV in '000 Square of
(A) (B) (C) Deviation in '000 (D) Deviation (E) Variance (F)
3 0.2 0.6 (6.00) 36 7.2
6 0.3 1.8 (3.00) 9 2.7
12 0.3 3.6 3.00 9 2.7
15 0.2 3 6.00 36 7.2
Total Expected NPV (Z) 9 Total Variance (Y) 19.8

Variance 19.8 Project Y Cost 36000

Standard
Deviation 4.450

Part 3:

Project X is having lower variance and standard deviation compared to Project Y. Therefore, Project Y is
more risky than Project X.

Part 4:
(30000 + 9000)
P I f or P roject X = 30000
= 1.3
(36000 + 9000)
P I f or P roject Y = 36000
= 1.25

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 RISK EVALUATION OF CAPITAL BUDGETING USING RISK ADJUSTED
DISCOUNT RATE

14) The Global Manufacturing company Ltd., is considering an investment in one of the two mutually
exclusive proposals –Project X and Project Y, which require cash outlays of Rs.3,40,000 and Rs.3,30,000
respectively. The certainly equivalent (C.E) approach is used in incorporating risk in capital budgeting
decisions. The current yield on government bond is 8% and this be used as the riskless rate. The expected
net cash flows and their certainly-equivalents are as follows-

Project X Project Y

Year end Cash flow Rs. C.E Cash flow Rs. C.E

1 1,80,000 0.8 1,80,000 0.9

2 2,00,000 0.7 1,80,000 0.8

3 2,00,000 0.5 2,00,000 0.7

Required-(a) which project should be accepted? (b) If risk adjusted discount rate method is used, which
project would be analyzed with a higher rate?

Solution:

Project X
Certainty Discount Discounted
Cash Flow Equivalent Certainty Equivalent Cash rate @ 8% Cash Flow
Year (A) '000 (B) Factor (C) Flow '000 (D) (E) (F)
1 180 0.8 144 0.926 133.333
2 200 0.7 140 0.857 120.027
3 200 0.5 100 0.794 79.383
Total Cash Flow Inflow or Present Value 332.744

N P V = 332, 744 − 340, 000 = (7, 256)

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 Project Y
Certainty Discount Discounted
Cash Flow Equivalent Certainty Equivalent Cash rate @ 8% Cash Flow
Year (A) '000 (B) Factor (C) Flow '000 (D) (E) (F)
1 180 0.9 162 0.926 150.000
2 180 0.8 144 0.857 123.457
3 200 0.7 140 0.794 111.137
Total Cash Flow Inflow or Present Value 384.593

N P V = 384, 593 − 330, 000 = 54, 593

a) Project Y should be accepted as it has positive NPV.

b) Project X has lower certainty equivalent factor than Project Y. Therefore, Project X is more risky.
Hence, it should be analysed with higher discount rate as per RADR method.

15) The Textile Manufacturing company Ltd., is considering an investment in one of the two mutually
exclusive proposals –Project M and Project N, which require cash outlays of Rs.8,50,000 and Rs.8,25,000
respectively. The certainly equivalent (C.E) approach is used in incorporating risk in capital budgeting
decisions. The current yield on government bond is 6% and this be used as the riskless rate. The expected
net cash flows and their certainly-equivalents are as follows-

Project M Project N

Year end Cash flow Rs. C.E Cash flow Rs. C.E

1 4,50,000 0.8 4,50,000 0.9

2 5,00,000 0.7 4,50,000 0.8

3 5,00,000 0.5 5,00,000 0.7

Required-(a) which project should be accepted? (b) If risk adjusted discount rate method is used, which
project would be analyzed with a higher rate?

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Solution:

Project M
Certainty Discount Discounted
Cash Flow Equivalent Certainty Equivalent Cash rate @ 6% Cash Flow
Year (A) '000 (B) Factor (C) Flow '000 (D) (E) (F)
1 450 0.8 360 0.943 339.623
2 500 0.7 350 0.890 311.499
3 500 0.5 250 0.840 209.905
Total Cash Flow Inflow or Present Value 861.026

N P V = 861, 026 − 850, 000 = 11, 026

Project N
Certainty Discount Discounted
Cash Flow Equivalent Certainty Equivalent Cash rate @ 6% Cash Flow
Year (A) '000 (B) Factor (C) Flow '000 (D) (E) (F)
1 450 0.9 405 0.943 382.075
2 450 0.8 360 0.890 320.399
3 500 0.7 350 0.840 293.867
Total Cash Flow Inflow or Present Value 996.341

N P V = 996, 341 − 825, 000 = 171, 341

a) Project N should be accepted as its NPV is higher.

b) Project M has lower certainty equivalent factors in all three years compared to Project N. Hence,
Project M is more risky than Project N. Therefore Project M is to be analysed using higher discount rate if
the company makes use of RADR method.

16 ) Determine the risk adjusted net present value of the following Projects-

Particulars X Y Z
Net Cash Outlays (Rs.) 2,10,000 1,20,000 1,00,000
Project Life 5 years 5 years 5 years
Annual Cash Inflow (Rs.) 70,000 42,000 30,000
Coefficient of Variation 1.2 0.8 0.4

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The Company selects the risk adjusted rate of discount on the basis of the coefficient of variation-

Coefficient of variation Risk-Adjusted rate of P.V. Factor 1 to 5 years at risk adjusted rate of
return discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.854
More than 2.0 26% 2.689
Solution:

Project X
Year (A) Cash Flow (B) Discount Factor (C) Discounted Cash Flow (D)
0 (210,000.00)
1-5 70000 3.274 229180

NPV 19,180.00

Project Y
Year (A) Cash Flow (B) Discount Factor (C) Discounted Cash Flow (D)
0 (120,000.00)
1-5 42,000 3.433 144186

NPV 24,186.00

Project X
Year (A) Cash Flow (B) Discount Factor (C) Discounted Cash Flow (D)
0 (100,000.00)
1-5 30,000 3.605 108150

NPV 8,150.00

Project Y has the highest NPV compared to all projects. Therefore Project Y is accepted.

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