UNIT – V, MODULE - IV

CAPITAL BUDGETING TECHNIQUES (Solutions)

1. Computer Co Pvt. Ltd is considering purchasing a machine. Two

machine costing Rs 50000/- and earnings after taxes are expected to
be as under. There is no scrap value. A discounted rate of 10% is to
be used.

Year 1 2 3 4 5
Earnings 2,00,000 2,50,000 1,50,000 1,00,000 75,000
‘A’
Earnings 1,00,000 2,00,000 2,00,000 1,00,000 75,000
‘B’

Solution:

Project Year CFAT

Cumulative CFAT

A 1 2, 00,000
2, 00,000 2 years
 2 2, 50,000
4, 50,000

3 1, 50,000
6, 00,000 (50,000/1, 50,000)

4 1, 00,000
7, 00,000

5 75,000
7, 75,000

Payback period = Investment/yearly net cash inflator

Payback period for Project ‘A’ = 2 + (1/3) years

Project Year CFAT Cumulative CFAT

B 1 1,00,000 1,00,000
2 2,00,000 3,00,000 3 years
3 2,00,000 5,00,000
4 1,00,000 6,00,000
5 75,000 675,000
Payback period for Project B = 3 years

2. Following is a summary of financial data in respect of five

investment proposals.

Net
Initial annual life of
Outlay cash project
inflows
A 60,000 18,000 15
B 88,000 15,000 25
C 2150 1,000 5
D 20,500 3000 10
E 4,25,000 1,50,000 20

Rank these proposals according to (i) Payback period (ii) simple average
rate of return. The cost of capital being 6%.

Solution:

The payback period (P) = investment / annual net cash inflows

Calculation of payback period of different projects

 Project payback period rank
A 60,000 / 18,000=3.30 3
years
B 88,000 / 15,000=5.87 4
years
C 2150/1000=2.15years 1
D 20,500/3000=6.83 years 5
E 4,25,000/1,50,000=2.83 2
years

Simple average rate of return can be calculated by dividing the average

return per year of the project by its initial investment.

Project ARR Rankings

A (18,000 / 60,000) =0.30 3

B (15,000/ 88,000) = 0.17 4

C (1,000 / 2150) = 0.47 1

D (3,000 / 20,000) = 0.146 5

 E (150,000 / 4,25,000)=0.35 2

3. A management wants to judge whether project ‘X’ is worth taking up

or not. The data regard to this project (having) 10 years is given
below

Year 1 2 3 4 5 6 7 8 9 10
Net 700 980 10,80 11,10 940 760 570 400 200 200
benefi 0 0 0 0 0 0 0 0 0 0
t

If the initial outlay on the project is Rs 40,000 with a salvage value of Rs

10,000. Find out the NPV of the project, given the opportunity cost of
investment is 10%.

Solution:

Initial capital investment - Rs 40,000

Salvage value - Rs 10,000

Present value of investment - 40,000 - 10,000 (0.3855)

40,000 – 3855 = 36,145

Computation of PV of project X
 Year Net Benefit Discount Present
factor Value
1 7000 0.9091 6364
2 9800 0.8264 8182
3 10800 0.7513 8114
4 11,100 0.6830 7582
5 9400 0.6209 5836
6 7600 0.5645 4290
7 5700 0.5132 2926
8 4000 0.4665 1866
9 2000 0.4241 848
10 2000 0.3855 772

Gross value
46,780

Thus the NPV = Gross present value - Present value of investment

= 46780 - 36,145 = Rs 10,635

Hence the project under consideration

4. From the following cash flows calculate the NPV using 10%
discount rate/interest rate. The initial capital outlay is Rs 50000. Is
this project worth take-up?

Year CFAT PV factor (10%)

1 10,000 0.909
2 10,450 0.826
3 11,800 0.751
4 12,250 0.683
5 16,750 0.621

Solution

Calculation of Net Present Value of the project

Year CFAT PV factor Σ PV

(10%)
1 10,000 0.909 9090
2 10,450 0.826 8632
3 11,800 0.751 8862
4 12,250 0.683 8367
5 16,750 0.621 10,401
Total present value 45,352
 (Less) initial Out lay 50,000
It is not worth take-up as the Net PV are -4648
negative

5. Determine NPV / pay back from the following data of two machines
A&B

A B

1. Cost of machine Rs 26,125 Rs 26,125

2. Annual Income after the depreciation
& income tax
Year 1 Rs 3375 Rs 11,375
Year 2 Rs 5375 Rs 9375
Year 3 Rs 7375 Rs 7375
Year 4 Rs 9375 Rs 5375
Year 5 Rs 11375 Rs 3375
3. Estimated life(year) 05 05

Solution:

Calculation of present value of CFAT

 Machine A Machine B
Yea CFA PV(10 PV CFA PV(10% PV
r T %) T )
1 3375 0.909 3067.87 11,37 0.909 10339.87
5
2 5375 0.826 4439.75 9375 0.826 7743.75
3 7375 0.751 5538.62 7375 0.751 5538.62
4 9375 0.683 6403.12 5375 0.683 3671.12
5 1137 0.621 7063.87 3375 0.621 2095.87
5
2651 29386
0
Cost of machine 2612 26125
5
Net Present values of the 0385 03261
machines

Hence machine B can be consider for investment as the Machine B

(Rs. 3261/-) has more discounted cash compare to machine A (385/-).

6. Consider an initial investment of Rs20, 000 on project which yields

an annual cash inflows of Rs 10,000, Rs 8000, and Rs 6,000
 respectively during its three years life span what is the interval rate of
relation of project.

Solution:

IRR can be computed as follows

Trait NPV of investment Remark

discoun s
t rate
10 [(10000X0.9091) + (8000X0.8264)+ IRR is
percent (6000X0.7513)] – 20,000 = 20,210 – 20,000 = 210 greater
than
10%
12 [(10,000X 0.8929) +(8000X0.7972) + IRR is
Percent (6000X0.7118)] – 20,000 = 195774 – 20,000 = - between
422.6 10% and
12%
11 [(10,000X0.9009)+(8000X0.8116)+(6000X0.73120 IRR is
Percent ] – 20,000 = -11 between
10% and
11%
We can then go to find the value of NPV for different values of discount
rates between 10% and 12% (e.g 10.5%, 10.25%, 10.75% and so on)
until we get the NPV value of investment equals to Zero.

If the minimum acceptable Rate of Return is greater than discount rate,

we reject the project.

Problem for Practice by students

7. A company is considering an investment proposal to install a new

milling control at a cost of Rs 50,000. 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 is allowed for tax
purpose. The estimated cash flows before depreciation and tax
(CFBT) from the investment proposal are as follows.

Year CFBT
1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
Compute NPV at 10% percent discount value.

Solution:

Calculation of cash flows after taxes & depreciation

Year CFBT (50,000/5) (2 – 3) (0.35) (4 – 5) CFAT

Depreciation PBT Taxes EAT
1 2 3 4
1 10,000 10,000 Nil Nil Nil 10,000

2 10,692 10,000 692 242 450 10,450

3 12,769 10,000 2769 969 1800 11,800

4 13,462 10,000 3462 1212 2250 12,250

5 20,385 10,000 10385 3635 6750 16,750
11,250
61,250