DIPLOMA IN ISLAMIC BANKING EXAMINATION

Management Accounting & Financial Management (204)

Capital Budgeting
August-2014
Class-5
K S Omar Faruk ACA1

Capital Budgeting – Meaning

Capital expenditure budget or capital budgeting is a process of making decision regarding investments in
fixed assets which are not meant for sale such as land, building, machinery or furniture. The word investment
refers to the expenditure which is required to be made in connection with the acquisition and the
development of long-term facilities including fixed assets. It refers to a process by which management
selects those investment proposals which are worthwhile for investing available funds. For this purpose,
management is to decide whether or not to acquire, or add or replace fixed assets in the light of overall
objectives of the firm.

Capital Budgeting – definition

According to Prof. R.M. Lynch “Capital budgeting consists in planning, the development of available capital
for the purpose of maximizing the long-term profitability [ROI-Return on Investment] of the firm”.
"Capital budgeting is long term planning for making and financing proposed capital outlays".
T.Horngreen "Capital budgeting is concerned with allocation of the firm's scarce financial resources among
the available market opportunities. The consideration of investment opportunities involves the comparison of
the expected future streams of earnings from a project with immediate and subsequent streams of
expenditure for it".

Capital Budgeting – Nature

Nature of Capital Budgeting can be explained in brief as under:
a) Capital expenditure plans involve a huge investment in fixed assets.
b) Capital expenditure once approved represents long term investment that cannot be reversed or
withdrawn without sustaining loss.
c) Preparation of capital budget plans involves forecasting, of several years profits in advance in order to
judge the profitability of projects.
d) In view of the investment of large amount for a fairly long period of time, any error in the evaluation
of investment projects, may lead to serious consequences; financially and otherwise and may adversely
affect the other future plans of the organisations.
Many formal methods are used in capital budgeting, including the techniques such as
 Accounting rate of return
 Payback period
 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annuity
 Real options valuation

1
Member, the Institute of Chartered Accountants of Bangladesh
AVP, Financial Administration Division, IBBL, HO
Former;
Faculty Member, Islami Bank Training and Research Academy
Company Secretary, Al-Arafah Islami Bank Ltd.
Director (Finance and Accounts), the Dhaka Jute Mills Ltd.
Web: www.ksomar.hpage.com, Email: ksfaruk@gmail.com

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Problems and Difficulties in Capital Budgeting
Capital Budgeting may also be defined as "The decision making process by which a firm evaluates the
purchase of major fixed assets. It involves firm's decision to invest its current funds for addition, disposition,
modification and replacement of fixed assets.
"Capital budgeting is concerned with allocation of the firm's scarce financial resources among the available
market opportunities. The consideration of investment opportunities involves the comparison of the expected
future streams of earnings from a project with immediate and subsequent streams of expenditure for it". The
problems in capital budgeting decisions may be as follows:
a) Future uncertainty: Capital budgeting decisions involve long term commitments. However there is lot
of uncertainty in the long term. The uncertainty may be with reference to cost of the project, future expected
returns, future competition, legal provisions, political situation etc.
b) Time Element: The implications of a Capital Budgeting decision are scattered over a long period. The
cost and the benefits of a decision may occur at different points of time. The cost of a project is incurred
immediately. However, the investment is recovered over a number of years. The future benefits have to be
adjusted to make them comparable with the cost. Longer the time period involved, greater would be the
uncertainty.
c) Difficulty in Quantification of impact: The finance manager may face difficulties in measuring the
cost and benefits of projects in quantitative terms.

Assumptions in capital budgeting:

The capital budgeting decision process is a multi-faced and analytical process. A number of assumptions are
required to be made. These assumptions constitute a general set of conditions within which the financial
aspects of different proposals are to be evaluated. Some of these assumptions are:
 Certainty with respect to cost and benefits: It is very difficult to estimate the cost and benefits of a
proposal beyond 2-3 years in future. However, for a capital budgeting decision, It is assumed that the
estimates of cost and benefits are reasonably accurate and certain.
 Profit motive: Another assumption is that the capital budgeting decisions are taken with a primary
motive of increasing the profit of the firm. No other motive or goal influences the decision of the
finance manager
 No Capital Rationing: The Capital Budgeting decisions in the present chapter assume that there is no
scarcity of capital. It assumes that a proposal will be accepted or rejected on the strength of its merits
alone. The proposal will not be considered in combination with other proposals to consider the
maximum utilization of available funds.

What Is Time Value?

If you're like most people, you would choose to receive the Tk. 10,000 now. After all, three years is a long
time to wait. Why would any rational person defer payment into the future when he or she could have the
same amount of money now?
A Tk.100 bill has the same value as a Tk. 100 bill one year from now, doesn't it? Actually, although the bill
is the same, you can do much more with the money if you have it now: over time you can earn more
interest/profit on your money.
By receiving Tk. 10,000 today, you are poised to increase the future value of your money by investing and
gaining interest/profit over a period of time. For option B, you don't have time on your side, and the payment
received in three years would be your future value. To illustrate, we have provided a timeline:

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If you are choosing option A, your future value will be Tk. 10,000 plus any interest acquired over the three
years. The future value for option B, on the other hand, would only be Tk. 10,000. But stay tuned to find out
how to calculate exactly how much more option A is worth, compared to option B.
Future Value Basics
If you choose option A and invest the total amount at a simple annual rate of 4.5%, the future value of your
investment at the end of the first year is Tk.10,450, which of course is calculated by multiplying the principal
amount of Tk.10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:
Future value of investment at end of first year:
= (Tk.10,000 x 0.045) + Tk.10,000
= Tk.10,450
If the Tk. 10,450 left in your investment account at the end of the first year is left untouched and you
invested it at 4.5% for another year, how much would you have? To calculate this, you would take the
Tk.10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have Tk.10,920:
Future value of investment at end of second
year:
= Tk.10,450 x (1+0.045)
= Tk.10,920.25
After three years it will be

This calculation shows us that we don't need to calculate the future value after the first year, then the second
year, then the third year, and so on. If you know how many years you would like to hold a present amount of
money in an investment, the future value of that amount is calculated by the following equation:

Present Value Basis

If Tk.10,000 were to be received in a year, the present value of the amount would not be Tk.10,000 because
you do not have it in your hand now, in the present. To find the present value of the future Tk.10,000, we
need to find out how much we would have to invest today in order to receive that Tk.10,000 in the future.
To calculate present value, or the amount that we would have to invest today, you must subtract the
accumulated interest from the Tk.10,000. To achieve this, we can discount the future payment amount
(Tk.10,000) by the interest rate for the period. Here we can calculate today's present value of the Tk.10,000
expected from a three-year investment earning 4.5% as follows;

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So the present value of a future payment of Tk.10,000 is worth Tk.8,762.97 today if interest rates are 4.5%
per year. In other words, choosing option B is like taking Tk.8,762.97 now and then investing it for three
years.
Conclusion
These calculations demonstrate that time literally is money - the value of the money you have now is not the
same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of
money so that you can distinguish between the worth of investments that offer you returns at different times
Discounted cash flow (DCF)
The DCF is a cash flow summary that has been adjusted to reflect the time value of money. It is an important
criterion in evaluating or comparing investments or purchases; other things being equal, the purchase or
investment associated with the larger DCF is the better decision. Almost every manager trained in finance
will ask to see cash flows on a discounted and non-discounted basis.

DCF makes use of the Present Value concept, the idea that money you have now should be valued more than
an identical amount you would receive in the future, Why? The money you have now you could (in
principle) invests now, and gain return or interest, between now and the future time. Money you will not
have until some future time cannot be used now. Therefore, the future money’s value is Discounted in
financial evaluation, to reflect its lesser value.

What that future money is worth today is called its Present Value, and what it will be worth when it finally
arrives in the future is called not surprisingly its Future Value. Just how much present value should be
discounted from future value is determined by two things: the amount of time between now and future
payment, and an interest rate. (For rough estimates, think of the interest rate as the return rate we would
expect if we had the money now and invested it). For a future payment coming in one year:

Now consider two competing investments in computer equipment. Each calls for an initial cash outlay of Tk.
100 million, and each returns a total a Tk. 200 m over the next 5 years making net gain of Tk. 100 m. But the
timing of the returns is different, as shown in the table below (Case A and Case B), and therefore the present
value of each year’s return is different. The sum of each investment’s present values is called the Discounted
Cash flow, or DCF. Using a 10% interest rate again, we find:

Amount in million Taka

Case A Case A Case B Case B
Timing
Net Cash Flow Present Value Net Cash Flow Present Value
Now -Tk. 100.00 -Tk. 100.00 -Tk. 100.00 -Tk. 100.00
Year 1 +Tk. 60.00 +Tk. 54.54 +Tk. 20.00 +Tk. 18.18
Year 2 +Tk. 60.00 +Tk. 49.59 +Tk. 20.00 +Tk. 16.52
Year 3 +Tk. 40.00 +Tk. 30.05 +Tk. 40.00 +Tk. 30.05
Year 4 +Tk. 20.00 +Tk. 13.70 +Tk. 60.00 +Tk. 41.10
Year 5 +Tk. 20.00 +Tk. 12.42 +Tk. 60.00 +Tk. 37.27
Total Tk. 100.00 NPV=Tk. 60.30 Tk. 100.00 NPV=Tk. 43.12
Comparing the two investments, you can see that the early large returns in Case A lead to a better total net
present value (NPV) than the later large returns in Case B. Note especially the Total line for each present
value column in the table. This total is the net present value (NPV) of each "cash flow stream." When
choosing alternative investments or actions, other things being equal, the one with the higher NPV is the
better investment.

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DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which
makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes
in the value of a company. Instead of trying to project the cash flows to infinity, a terminal value approach is
often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done
because it is harder to come to a realistic estimate of the cash flows as time goes on.

Payback Period
The payback period is the amount of time needed for an investment to generate cash flows to recover its
initial costs. i.e. The length of time required to recover the cost of an investment.
Calculated as:

All other things being equal, the better investment is the one with the shorter payback period.

For example, if a project cost Tk. 100,000 and was expected to return Tk. 20,000 annually, the payback
period would be Tk. 100,000 / Tk. 20,000, or five years.
There are two main problems with the payback period method:
1) It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.
2) It ignores the time value of money.
Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or
discounted cash flow are generally preferred.
The payback period method has some serious shortcomings though. It is calculated by simply adding up the
future cash flows. There is no discounting of cash flows, so the time value of money is ignored. Without
discounting the future cash flows, your project will look much more attractive than it really is. Not only will
the project look more attractive, but since there is no required rate of return used, the risk level of the project
is never captured. This means that a very risky project is treated the same as a low risk project. The biggest
shortcoming with the payback method is that there is no economic rationale for determining the correct
cutoff period. An arbitrary cutoff period must be chosen, so you need to decide whether 2 years is
acceptable, or 4 years, or 5, etc. The payback period also tends to bias the user toward short term
investments as it ignores cash flows beyond the cutoff. A project that takes a few years to get up to speed
and then creates phenomenal returns would be rejected strictly on its cash flow profile.
With all of the shortcomings of the payback period method, it is easy to see why you should put very little
weight on the analysis results other than as a very general guide when looking at two fairly comparable
projects. If payback period is a valuation metric that your organization tends to look at, you can and should
perform a discounted payback period analysis where you determine your discount rate and discount the
future cash flows before performing the payback analysis. This would eliminate the some of the
shortcomings mentioned above, but very few individuals ever perform such an analysis in practice. Use the
discounted payback method only as a quick and dirty valuation method to value a project on the “back of an
envelope” and as just another valuation metric in conjunction with the others mentioned here. Do not base
your accept/reject decision upon it.

Example of Payback period:

Cash flow
Year
Investment -A Investment -B
0 (500,000.00) (500,000.00)
1 250,000.00 75,000.00
2 250,000.00 100,000.00
3 100,000.00 125,000.00
4 250,000.00
5 250,000.00

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The payback pariod for investment A is 2 years, while investment B requires 3.80 years. In the latter case,
we recover Tk. 300,000.00 in the first 3 years. we need for another Tk. 200,000.00 to recover the Taka 5 lac
Investment. Since the fourth year has a total inflow of Tk. 2.50 lac, Tk. 2.00 lac represent 0.8 (2.00/2.50) if
that value. Thus, the payback period for Investment B is 3.8 Years.

Net present value

Net present value (NPV) is a standard method for the financial appraisal of long-term projects. Used for
capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in
present value (PV) terms, once financing charges are met.
Net present value(NPV) of a project is found by subtracting the initial investment from the present value of
the cash inflows of that project discounted at a rate equal to the firm’s cost of capital.
NPV= Present value of cash flows-Initial Investment
Formula
Each cash inflow/outflow is discounted back to its PV. Then they are summed. Therefore PV:
_
CFO

Where
t - the time of the cash flow
N - the total time of the project
r - the discount rate (the rate of return that could be earned on an investment in the
financial markets with similar risk.)
Ct - the net cash flow (the amount of cash) at time t (for educational purposes, C0
is commonly placed to the left of the sum to emphasize its role as the initial
investment.)
The Discount Rate
The rate used to discount future cash flows to their present values is a key variable of this process. A firm's
weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use
higher discount rates to adjust for risk for riskier projects. A variable discount rate with higher rates applied
to cash flows occurring further along the time span might be used to reflect the yield curve premium for
long-term debt.

In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the
higher NPV should be selected. The following sums up the NPVs in various situations.
If... It means... Then...
NPV the investment would
the project may be accepted
>0 add value to the firm
the investment would
NPV
subtract value from the the project should be rejected
<0
firm
We should be indifferent in the decision whether to accept or reject the
the investment would
NPV project. This project adds no monetary value. Decision should be based on
neither gain nor lose
=0 other criteria, e.g. strategic positioning or other factors not explicitly
value for the firm
included in the calculation.
However, NPV = 0 does not mean that a project is only expected to break even, in the sense of undiscounted
profit or loss (earnings). It will show net total positive cash flow and earnings over its life.

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Example-1
X corporation must decide whether to introduce a new product line. The new product will have startup costs,
operational costs, and incoming cash flows over six years. This project will have an immediate (t=0) cash
outflow of Tk. 100,000 (which might include machinery, and employee training costs). Other cash outflows
for years 1-6 are expected to be Tk. 5,000 per year. Cash inflows are expected to be Tk. 30,000 per year for
years 1-6. All cash flows are after-tax, and there are no cash flows expected after year 6. The required rate of
return is 10%. The present value (PV) can be calculated for each year:
T=0 -Tk. 100,000/ 1.100 = -Tk. 100,000 PV.
T=1 (Tk. 30,000 - Tk. 5,000) / 1.101 = Tk. 22,725 PV.
T=2 (Tk. 30,000 - Tk. 5,000) / 1.102 = Tk. 20,650 PV.
T=3 (Tk. 30,000 - Tk. 5,000) / 1.103 = Tk. 18,775 PV.
T=4 (Tk. 30,000 - Tk. 5,000) / 1.104 = Tk. 17,075 PV.
T=5 (Tk. 30,000 - Tk. 5,000) / 1.105 = Tk. 15,525 PV.
T=6 (Tk. 30,000 - Tk. 5,000) / 1.106 = Tk. 14,100 PV.
The sum of all these present values is the net present value, which equals Tk. 8,850. Since the NPV is
greater than zero, the corporation should invest in the project.

Example-2
Cash flow
Year
Investment -A Investment -B
0 (500,000.00) (500,000.00)
1 250,000 X .909 = 227,250 75,000 X .909 = 68,175
2 250,000 X .826 = 206,500 100,000 X .826 = 82,600
3 100,000 X .751 = 72,100 125,000 X .751 = 93,875
4 250,000 X .683 = 170,750
5 250,000 X .621 = 155,250
PV of inflows = 508,850 PV of inflows = 570,650
PV of outflows 500,000 PV of outflows 500,000.00
NPV = 8,850.00 NPV = 70,650.00
Selection: Higher net present value: Investment B

Benefit-Cost Ration
The ratio of total present benefits ( B ) to total present costs ( C ), sometimes used in cost-benefit analysis
with the assumption that a project is worthwhile if and only if B / C is greater than 1, but this ratio leads to
ambiguity.
A Benefit-Cost Ratio (BCR) is an indicator, used in the formal discipline of cost-benefit analysis, that
attempts to summarize the overall value for money of a project or proposal. A BCR is the ratio of the
benefits of a project or proposal, expressed in monetary terms, relative to its costs, also expressed in
monetary terms. All benefits and costs should be expressed in discounted present values.

Prior to erecting a new plant or taking on a new project, prudent managers will conduct a cost-benefit
analysis as a means of evaluating all of the potential costs and revenues that may be generated if the
project is completed. The outcome of the analysis will determine whether the project is financially feasible,
or if another project should be pursued.
It is some times called profitability index.

PV of cash inflows
BCR =
Initial Investment

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Decision rules:
Should we expect to earn at least Accept the
If the NPV is: Benefits vs. Costs
our minimum rate of return? investment?
Positive Benefits > Costs Yes, more than Accept
Zero Benefits = Costs Exactly equal to Indifferent
Negative Benefits < Costs No, less than Reject

Notice that, if the NPV is positive, it says that the company expects to receive benefits that are large enough
to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that
adequately compensates the company for the risk found in the cash flow estimates. If the NPV is negative,
the benefits are not large enough to cover all three of the above, and therefore the project should be rejected.

Example-2
Cash flow
Year
Investment -A Investment -B
0 (500,000.00) (500,000.00)
1 250,000 X .909 = 227,250 75,000 X .909 = 68,175
2 250,000 X .826 = 206,500 100,000 X .826 = 82,600
3 100,000 X .751 = 72,100 125,000 X .751 = 93,875
4 250,000 X .683 = 170,750
5 250,000 X .621 = 155,250
PV of inflows = 508,850 PV of inflows = 570,650
PV of outflows 500,000 PV of outflows 500,000.00

Investment -A Investment -B
508,850 570,650
BCR = = 1.018 = 1.142
500,000 500,000
Decision: BCR is higher for investment B than investment A, so, Investment B is accepted.

Internal Rate of Return (IRR)

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero.
It is a commonly used measure of investment efficiency.
The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in
an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the
project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR
higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision
rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV.
In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is
unique if one or more years of net investment (negative cash flow) are followed by years of net revenues.
But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation
generally cannot be solved analytically but only via iterations.
One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual
profitability of an investment. However, this is not the case because intermediate cash flows are almost never
reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower.
Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used.
Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV
although they should be used in concert. In a budget-constrained environment, efficiency measures should be

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used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate
investments in terms of percentage rates of return than dollars of NPV.
Calculation of IRR with the help of Trial and error method
IRR can also be calculated by Trial and error method if the data satisfy the following conditions
 outflow take place one time
 inflows are constant as per interval and amount
 Time period involve is significant so that the other methods become complicated

for example in a case there is a project with initial investment of Tk.100 (year 0) and annual cash inflows of
Tk.20 at the end of each year till 10th year now here one want to calculate the IRR. IRR is the rate with
which if all the cash inflows are discounted then the resultant figure will be equal to initial investment so
here we use Trail and error method in this method one formula for aggression is used That is as below

Here as we will calculate IRR at lower rate that will be in positive and NPV at Higher rate will negative and
as we will put this value in NPV at lower rate - NPV at Higher rate the Minus sign will become positive as
NPV at Higher rate also contain negative sign with it so the 2nd important thing is to guess higher rate and
lower rate like in the case given above suppose 10% as lower rate and 20% as higher rate NPV@10% will be
22.89 and NPV@20% will be -16.15 and at last if we apply the formula above we will get 15% that is IRR
of the project

Now if all the inflows are discounted @15% the resultant figure will be 100 as the Present value factor
@15% for 10years is 5.0 and 20*5 = Tk.100 this method is also called Hit and Trail Method

Equivalent annuity method

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present
value of the annuity factor. It is often used when assessing only the costs of specific projects that have the
same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per
year of owning and operating an asset over its entire lifespan.
It is often used when comparing investment projects of unequal lifespans. For example if project A has an
expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to
simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.
The use of the EAC method implies that the project will be replaced by an identical project.
Alternatively the chained method can be used with the NPV method under the assumption that the projects
will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and
4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three
repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent
answers.
The assumption of the same cash flows for each link in the chain is essentially an assumption of
zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations
Real options analysis
Real options analysis has become important since the 1970s as option pricing models have gotten more
sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with
the promised cash flows known. But managers will have many choices of how to increase future cash
inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not
simply accept or reject them. Real options analysis try to value the choices - the option value - that the
managers will have in the future and adds these values to the NPV.

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Example:
A company is considering an investment proposal to install new milling controls at a cost of Tk. 50,000.00.
The facility has a 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 purpose. The estimated cash flow before
depreciation and tax from the investment proposal are as follows:
Year CTBT

1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
Compute; (i) Payback period, (ii) IRR (iii) NPV at 10% discount rate (iv) Profitability index at 10% discount rate.
Solutions:
Year CFBT Depreciation Profits BT Taxes (.35) EAT CFAT
1 10,000 10,000 0 0 0 10,000
2 10,692 10,000 692 242 450 10,450
3 12,769 10,000 2769 696 1800 11,800
4 13,462 10,000 3462 1212 2250 12,250
5 20,385 10,000 10385 3635 6750 16,750

(i) Payback period

Year CFAT Cumulative CFAT
1 10,000 10,000
2 10,450 20,450
3 11,800 32,250
4 12,250 44,500
5 16,750 61,250
The recovery of the investment falls between the fourth and fifth years. Therefore, the PB is 4 years plus a fraction of
the fifth year. The fractional value = Tk. 5,500/ Tk. 16750 = 0.328. Thus, the PB 4.328 years.
(ii)
Average Income
X 100
Average Rate of Return(ARR) = Average Investment

2,250
X 100 = 9 %
Average Rate of Return(ARR) = 25000

(iii) Internal Rate of Return

Year CFAT PVf@.06 Total PV PVf@.07 Total PV
1 10,000 0.943 9,430 0.935 9350
2 10,450 0.890 9,300 0.873 9123
3 11,800 0.840 9,912 0.816 9629
4 12,250 0.792 9,702 0.763 9347
5 16,750 0.747 12,512 0.713 11942
Total PV 50,866 49391
Initial outlay 50,000 50,000
NPV 866 (609)

NPVa
X a-b
Internal Rate of Return (IRR) = A+ NPVa-NPVb

866
X 1= 6.58
Internal Rate of Return (IRR) = 6+ 1475

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 (iv) Net present Value (NPV)
Year CFAT PVf@.10 Total PV
1 10,000 0.909 9,090
2 10,450 0.826 8,632
3 11,800 0.751 8,862
4 12,250 0.683 8,367
5 16,750 0.621 10,401
Total PV 45,352
Initial outlay 50,000
NPV (4648)
(v)
PV of cash inflow
Profitability Index = PV of cash inflow
45,352
= 0.907
Profitability Index = 50,000

Year Question
October-2011
(a) What is meant by Internal Rate of Return?
(b) The Alif company has two investment opportunities, Zim and Mim. The relevant cash flows of each
opportunity are given below:
Initial Investment ( Io) Zim___ Mim___
Tk. 80,000 Tk. 50,000
Year Annual cash inflows afterTaxes (ACFt)
1 Tk. 15,000 Tk.15,000
2 20,000 15,000
3 25,000 15,000
4 30,000 15,000
5 35,000 15,000
Alif’s cost of capital is 15% and has set a maximum payback period of 3 years for each alternative.
i) Calculate payback period, net present value (NPV) and internal rate of return (IRR) of each
investment alternative.
ii) Which alternative should the company accept? Explain your views if the investment opportunities: Zim
and Mim are either of mutually exclusive or independent with each other.

April-2011
Why is net present value method theoretically superior to internal rate of return method?
A company is contemplating to purchase a machine. Two machines A and B are available, each costing
Tk.5, 00,000. In comparing the desirability of the machines, a discounted rate of 10% is to be used and
machine is to be written-off in five years by using straight line method of depreciation with zero
residual value. Expected annual net cash inflows after taxes of two machines are as follows:
Year Machine A Machine B
1 Tk. 1,50,000 Tk.50,000
2 1,50,000 1,50,000
3 1,50,000 2,00,000
4 1,50,000 3,00,000
5 1,50,000 2,00,000
Determine the Payback period, Net present value (NPV) and Internal rate of return (IRR) of the two
investment proposals and pass your comment on the feasibility of the investment in machine to be
purchased.

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November 2012
A company plans to replace one of its line of business at a cost of Tk. 13,00,000. The old line was installed 20
years ago at a cost of Tk. 3,50,000. It was being depreciated toward a Tk.50,000 salvage value using straight-
line depreciation over 30 years and can be sold now for Tk.20,000. The new line will be depreciated by the
straight-line method over 10 years toward a Tk.3,00,000 salvage value. Installation of the new line allows
revenues to increase by Tk.5,00,000 per year while operating cost remain constant. Net working capital would
increase by Tk.50,000. Assume that the marginal cost of capital of the company is 10 percent and the
company is in 40 percent tax bracket. Should the existing line be replaced?

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