Projects Solutions

Download as doc, pdf, or txt
Download as doc, pdf, or txt
You are on page 1of 81

Chapter 4

MARKET AND DEMAND ANALYSIS

1. We have to estimate the parameters a and b in the linear relationship


Yt = a + bT
Using the least squares method.
According to the least squares method the parameters are:

∑TY–nTY
b=
∑T2–nT2

a = Y – bT
The parameters are calculated below:
Calculation in the Least Squares Method
T Y TY T2
1 2,000 2,000 1
2 2,200 4,400 4
3 2,100 6,300 9
4 2,300 9,200 16
5 2,500 12,500 25
6 3,200 19,200 36
7 3,600 25,200 49
8 4,000 32,000 64
9 3,900 35,100 81
10 4,000 40,000 100
11 4,200 46,200 121
12 4,300 51,600 144
13 4,900 63,700 169
14 5,300 74,200 196
∑ T = 105 ∑ Y = 48,500 ∑ TY = 421,600 ∑ T 2 = 1,015
T = 7.5 Y = 3,464

∑TY–nTY 421,600 – 14 x 7.5 x 3,464


b= =
∑T2–nT2 1,015 – 14 x 7.5 x 7.5

57,880
= = 254
227.5
a = Y – bT
= 3,464 – 254 (7.5)
= 1,559
Thus linear regression is
Y = 1,559 + 254 T
2. In general, in exponential smoothing the forecast for t + 1 is
Ft + 1 = Ft + α et

Where Ft + 1 = forecast for year ) α = smoothing parameter


et = error in the forecast for year t = St = Ft
F1 is given to be 2100 and α is given to be 0.3
The forecasts for periods 2 to 14 are calculated below:
Period Data (St) Forecast Error Forecast for t + 1
t (Ft) (et St =Ft) (Ft + 1 = Ft + α et)

1 2,000 2100.0 -100 F2 = 2100 + 0.3 (-100) = 2070


2 2,200 2070 130 F3 = 2070 + 0.3(130) = 2109
3 2,100 2109.0 -9 F4 = 2109 + 0.3 (-9) = 2111.7
4 2,300 2111.7 188.3 F5 = 2111.7 + 0.3(188.3) = 2168.19
5 2,500 2168.19 331.81 F6 = 2168.19 + 0.3(331.81) = 2267.7
6 3,200 2267.7 932.3 F7 = 2267.7 + 0.3(9332.3) = 2547.4
7 3,600 2547.4 1052.6 F8 = 2547.4 + 0.3(1052.6) = 2863.2
8 4,000 2863.2 1136.8 F9 = 2863.2 + 0.3(1136.8) = 3204.24
9 3,900 3204.24 695.76 F10 = 33204.24 + 0.3(695.76) = 3413.0
10 4,000 3413 587.0 F11 = 3413.0 + 0.3(587) = 3589.1
11 4,200 3589.1 610.9 F12 = 3589.1 + 0.3(610.9) = 3773.4
12 4,300 3772.4 527.6 F13 = 3772.4 + 0.3(527.6) = 3930.7
13 4,900 3930.7 969.3 F14 = 3930.7 + 0.3(969.3) = 4221.5

3. According to the moving average method


St + S t – 1 +…+ S t – n +1
Ft + 1 =
n
where Ft + 1 = forecast for the next period
St = sales for the current period
n = period over which averaging is done

Given n = 3, the forecasts for the period 4 to 14 are given below:


Period Data (St) Forecast Forecast for t + 1
t (Ft) Ft + 1 = (St+ S t – 1 + S t – 2)/ 3

1 2,000
2 2,200
3 2,100 F4 = (2000 + 2200 + 2100)/3 = 2100
4 2,300 2100 F5 =(2200 + 2100 + 2300)/3= 2200
5 2,500 2200 F6 = (2100 + 2300 + 2500)/3 = 2300
6 3,200 2300 F7 = (2300 + 2500 + 3200)/3= 2667
7 3,600 2667 F8 = (2500 + 3200 + 3600)/3 = 3100
8 4,000 3100 F9 = (3200 + 3600 + 4000)/3 = 3600
9 3,900 3600 F10 = (3600 + 4000 + 3900)/3 = 3833
10 4,000 3833 F11 = (4000 + 3900 + 4000)/3 =3967
11 4,200 3967 F12 =(3900 + 4000 + 4200)/3 = 4033
12 4,300 4033 F13 = (4000 + 4200 + 4300)/3 = 4167
13 4,900 4167 F14 = (4200 + 4300 + 4900) = 4467
14 5,300 4467

4.
Q1 = 60
Q2 = 70
I1 = 1000
I2 = 1200
Q1 – Q2 I1 + I2
Income Elasticity of Demand E1 = x
I2 - I1 Q2 – Q1
E1 = Income Elasticity of Demand
Q1 = Quantity demanded in the base year
Q2 = Quantity demanded in the following year
I1 = Income level in base year
I2 = Income level in the following year

70 – 60 1000 + 1200
E1 = x
1200 – 1000 70 + 60

22000
E1 = = 0.846
26000
5.
P1 = Rs.40
P2 = Rs.50
Q1 = 1,00,000
Q2 = 95,000
Q2 – Q1 P1 + P2
Price Elasticity of Demand = Ep = x
P2 –P1 Q2 + Q1
P1 , Q1 = Price per unit and quantity demanded in the base year
P2, Q2 = Price per unit and quantity demanded in the following year
Ep = Price Elasticity of Demand

95000 - 100000 40 + 50
Ep = x
50 - 40 95000 + 100000

- 45
Ep = = - 0.0231
1950
Chapter 6

FINANCIAL ESTIMATES AND PROJECTIONS

1.
Projected Cash Flow Statement (Rs. in million)

Sources of Funds
Profit before interest and tax 4.5
Depreciation provision for the year 1.5
Secured term loan 1.0
Total (A) 7.0

Disposition of Funds
Capital expenditure 1.50
Increase in working capital 0.35
Repayment of term loan 0.50
Interest 1.20
Tax 1.80
Dividends 1.00
Total (B) 6.35

Opening cash balance 1.00


Net surplus (deficit) (A – B) 0.65
Closing cash balance 1.65

Projected Balance Sheet

(Rs. in million)
Liabilities Assets
Share capital 5.00 Fixed assets 11.00
Reserves & surplus 4.50 Investments .50
Secured loans 4.50 Current assets 12.85
Unsecured loans 3.00 * Cash 1.65
Current liabilities 6.30 * Receivables 4.20
& provisions 1.05 * Inventories 7.00
24.35 24.35

2. Projected Income Statement for the 1st Operating Year



Working capital here is defined as :
(Current assets other than cash) – (Current liabilities other than bank borrowings)
In this case inventories increase by 0.5 million, receivables increase by 0.2 million and current liabilities
and provisions increase by 0.35 million. So working capital increases by 0.35 million
Rs.
Sales 4,500
Cost of sales 3,000
Depreciation 319
Interest 1,044
Write off of Preliminary expenses 15
Net profit 122

Projected Cash Flow Statements


Construction period 1st Operating year
Sources
Share capital 1800 -
Term loan 3000 600
Short-term bank borrowing 1800
Profit before interest and tax 1166
Depreciation 319
Write off preliminary expenses 15
4800 3900
Uses
Capital expenditure 3900 -
Current assets (other than cash) - 2400
Interest - 1044
Preliminary expenses 150 -
Pre-operative expenses 600 -
4650 3444
Opening cash balance 0 150
Net surplus / deficit 150 456
Closing balance 150 606
Projected Balance Sheet
Liabilities 31/3/n+1 31/3/n+2 Assets 31/3/n+1 31/3/n+2
Share capital 1800 1800 Fixed assets (net) 4500 4181
Reserves & surplus - 122
Secured loans : Current assets
- Term loan 3000 3600 - Cash 150 606
- Short-term bank 1800 Other current assets 2400
borrowing
Unsecured loans - - Miscellaneous
expenditures & losses
Current liabilities and - Preliminary 150 135
provisions expenses
4800 7322 4800 7322
Notes :
i. Allocation of Pre-operative Expenses : Rs.

Type Costs before Allocation Costs after


allocation allocation
Land 120 19 139
Building 630 97 727
Plant & machinery 2700 415 3115
Miscellaneous fixed assets 450 69 519
3900 600 4500

ii. Depreciation Schedule :

Lan Building Plant & machinery M.Fixed Total (Rs.)


d assets
Opening balance 139 727 3115 519 4500
Depreciation - 25 252 42 319
Closing balance 139 702 2863 477 4181

iii. Interest Schedule :


Interest on term loan of Rs.3600 @20% = Rs.720
Interest on short term bank borrowings of Rs,1800 @ 18% = Rs.324
= Rs.1044
Chapter 7

THE TIME VALUE OF MONEY

1. Value five years hence of a deposit of Rs.1,000 at various interest rates is as


follows:

r = 8% FV5 = 1000 x FVIF (8%, 5 years)


= 1000 x 1.469 = Rs.1469

r = 10% FV5 = 1000 x FVIF (10%, 5 years)


= 1000 x 1.611 = Rs.1611

r = 12% FV5 = 1000 x FVIF (12%, 5 years)


= 1000 x 1.762 = Rs.1762

r = 15% FV5 = 1000 x FVIF (15%, 5 years)


= 1000 x 2.011 = Rs.2011

2. Rs.160,000 / Rs. 5,000 = 32 = 25

According to the Rule of 72 at 12 percent interest rate doubling takes place


approximately in 72 / 12 = 6 years

So Rs.5000 will grow to Rs.160,000 in approximately 5 x 6 years = 30 years

3. In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 2 3 times the initial


deposit. Hence doubling takes place in 12 / 3 = 4 years.

According to the Rule of 69, the doubling period is:

0.35 + 69 / Interest rate

Equating this to 4 and solving for interest rate, we get

Interest rate = 18.9%.

4. Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is
equivalent to saving Rs.2000 a year for 15 years and Rs.1000 a year for the
years 6 through 15.

Hence the savings will cumulate to:

2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)


= 2000 x 31.772 + 1000 x 15.937 = Rs.79481.

5. Let A be the annual savings.

A x FVIFA (12%, 10 years) = 1,000,000


A x 17.549 = 1,000,000

So A = 1,000,000 / 17.549 = Rs.56,983.

6. 1,000 x FVIFA (r, 6 years) = 10,000

FVIFA (r, 6 years) = 10,000 / 1000 = 10

From the tables we find that

FVIFA (20%, 6 years) = 9.930


FVIFA (24%, 6 years) = 10.980

Using linear interpolation in the interval, we get:

20% + (10.000 – 9.930)


r= x 4% = 20.3%
(10.980 – 9.930)

7. 1,000 x FVIF (r, 10 years) = 5,000


FVIF (r,10 years) = 5,000 / 1000 = 5

From the tables we find that


FVIF (16%, 10 years) = 4.411
FVIF (18%, 10 years) = 5.234

Using linear interpolation in the interval, we get:

(5.000 – 4.411) x 2%
r = 16% + = 17.4%
(5.234 – 4.411)

8. The present value of Rs.10,000 receivable after 8 years for various discount
rates (r ) are:
r = 10% PV = 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670

r = 12% PV = 10,000 x PVIF (r = 12%, 8 years)


= 10,000 x 0.404 = Rs.4,040
r = 15% PV = 10,000 x PVIF (r = 15%, 8 years)
= 10,000 x 0.327 = Rs.3,270
9. Assuming that it is an ordinary annuity, the present value is:

2,000 x PVIFA (10%, 5years)


= 2,000 x 3.791 = Rs.7,582

10. The present value of an annual pension of Rs.10,000 for 15 years when r = 15%
is:

10,000 x PVIFA (15%, 15 years)


= 10,000 x 5.847 = Rs.58,470

The alternative is to receive a lumpsum of Rs.50,000.

Obviously, Mr. Jingo will be better off with the annual pension amount of
Rs.10,000.

11. The amount that can be withdrawn annually is:


100,000 100,000
A = ------------------ ------------ = ----------- = Rs.10,608
PVIFA (10%, 30 years) 9.427

12. The present value of the income stream is:

1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)


+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)

= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.

13. The present value of the income stream is:

2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)


= 2,000 x 3.791 + 3000/0.10 x 0.621
= Rs.26,212

14. To earn an annual income of Rs.5,000 beginning from the end of 15 years from
now, if the deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000

is required at the end of 14 years. The amount that must be deposited to get this
sum is:
Rs.50,000 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165

15. Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years)


PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00

From the tables we find that:

PVIFA (15%, 10 years) = 5.019


PVIFA (18%, 10 years) = 4.494

Using linear interpolation we get:

5.019 – 5.00
r = 15% + ---------------- x 3%
5.019 – 4.494
= 15.1%

16. PV (Stream A) = Rs.100 x PVIF (12%, 1 year) + Rs.200 x


PVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 x
PVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +
Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +
Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +
Rs.1,000 x PVIF (12%, 10 years)

= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712


+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507
+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361
+ Rs.1,000 x 0.322

= Rs.2590.9

Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs.2,851.1

17. FV5 = Rs.10,000 [1 + (0.16 / 4)]5x4


= Rs.10,000 (1.04)20
= Rs.10,000 x 2.191
= Rs.21,910

18. FV5 = Rs.5,000 [1+( 0.12/4)] 5x4


= Rs.5,000 (1.03)20
= Rs.5,000 x 1.806
= Rs.9,030
19. A B C

Stated rate (%) 12 24 24


Frequency of compounding 6 times 4 times 12 times
Effective rate (%) (1 + 0.12/6)6- 1 (1+0.24/4)4 –1 (1 + 0.24/12)12-1
= 12.6 = 26.2 = 26.8
Difference between the
effective rate and stated
rate (%) 0.6 2.2 2.8

20. Investment required at the end of 8 th year to yield an income of Rs.12,000 per
year from the end of 9th year (beginning of 10th year) for ever:

Rs.12,000 x PVIFA(12%, ∞ )
= Rs.12,000 / 0.12 = Rs.100,000

To have a sum of Rs.100,000 at the end of 8 th year , the amount to be deposited


now is:

Rs.100,000 Rs.100,000
= = Rs.40,388
PVIF(12%, 8 years) 2.476

21. The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of
Rs.5,000 now is:

Rs.5,000 x FVIF (r,10 years) = Rs.20,000

Rs.20,000
FVIF (r,10 years) = = 4.000
Rs.5,000

From the tables we find that


FVIF (15%, 10 years) = 4.046
This means that the implied interest rate is nearly 15%.
I would choose Rs.20,000 for 10 years from now because I find a return of 15%
quite acceptable.

22. FV10 = Rs.10,000 [1 + (0.10 / 2)]10x2


= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653
= Rs.26,530
If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in
terms of the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283

23. A constant deposit at the beginning of each year represents an annuity due.

PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)

To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should
be

Rs.50,000
A = FVIFA(12%, 10 years) x (1.12)

Rs.50,000
= = Rs.2544
17.549 x 1.12

24. The discounted value of Rs.20,000 receivable at the beginning of each year from
2005 to 2009, evaluated as at the beginning of 2004 (or end of 2003) is:

Rs.20,000 x PVIFA (12%, 5 years)


= Rs.20,000 x 3.605 = Rs.72,100.

The discounted value of Rs.72,100 evaluated at the end of 2000 is

Rs.72,100 x PVIF (12%, 3 years)


= Rs.72,100 x 0.712 = Rs.51,335

If A is the amount deposited at the end of each year from 1995 to 2000 then
A x FVIFA (12%, 6 years) = Rs.51,335
A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115 = Rs.6326

25. The discounted value of the annuity of Rs.2000 receivable for 30 years,
evaluated as at the end of 9th year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854
The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)
= Rs.18,854 x 0.424
= Rs.7,994
26. 30 percent of the pension amount is
0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate
of 12% is 1%, the discounted value of an annuity of Rs.180 receivable at the end of
each month for 180 months (15 years) is:
Rs.180 x PVIFA (1%, 180)

(1.01)180 - 1
Rs.180 x ---------------- = Rs.14,998
.01 (1.01)180
If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%

P x (1.01)60 = Rs.14,998
P x 1.817 = Rs.14,998

Rs.14,998
P = ------------ = Rs.8254
1.817

27. Rs.300 x PVIFA(r, 24 months) = Rs.6,000

PVIFA (4%,24) = Rs.6000 / Rs.300 = 20

From the tables we find that:


PVIFA(1%,24) = 21.244
PVIFA (2%, 24) = 18.914

Using a linear interpolation

21.244 – 20.000
r = 1% + ---------------------- x 1%
21.244 – 18,914

= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)12 – 1 ] x 100 = 20%

28. The discounted value of the debentures to be redeemed between 8 to 10 years


evaluated at the end of the 5th year is:
Rs.10 million x PVIF (8%, 3 years)
+ Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)
= Rs.10 million (0.794 + 0.735 + 0.681)
= Rs.2.21 million
If A is the annual deposit to be made in the sinking fund for the years 1 to 5, then
A x FVIFA (8%, 5 years) = Rs.2.21 million
A x 5.867 = Rs.2.21 million
A = 5.867 = Rs.2.21 million
A = Rs.2.21 million / 5.867 = Rs.0.377 million

29. Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn
annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 5.000
From the tables we find that
PVIFA (10%, 7 years) = 4.868
PVIFA (10%, 8 years) = 5.335
Thus n is between 7 and 8. Using a linear interpolation we get

5.000 – 4.868
n=7+ ----------------- x 1 = 7.3 years
5.335 – 4.868

30. Equated annual installment = 500000 / PVIFA(14%,4)


= 500000 / 2.914
= Rs.171,585

Loan Amortisation Schedule

Beginning Annual Principal Remaining


Year amount installment Interest repaid balance
1 500000 171585 70000 101585 398415
2 398415 171585 55778 115807282608
3 282608 171585 39565 132020 150588
4 150588 171585 21082 150503 85*

(*) rounding off error

31. Define n as the maturity period of the loan. The value of n can be obtained
from the equation.
200,000 x PVIFA(13%, n) = 1,500,000
PVIFA (13%, n) = 7.500
From the tables or otherwise it can be verified that PVIFA(13,30) = 7.500
Hence the maturity period of the loan is 30 years.

32. Expected value of iron ore mined during year 1 = Rs.300 million
Expected present value of the iron ore that can be mined over the next 15 years
assuming a price escalation of 6% per annum in the price per tonne of iron
1 – (1 + g)n / (1 + i)n
= Rs.300 million x ------------------------
i-g

= Rs.300 million x 1 – (1.06)15 / (1.16)15


0.16 – 0.06

= Rs.300 million x (0.74135 / 0.10)


= Rs.2224 million

Chapter 8

INVESTMENT CRITERIA
1.(a) NPV of the project at a discount rate of 14%.

100,000 200,000
= - 1,000,000 + ---------- + ------------
(1.14) (1.14)2

300,000 600,000 300,000


+ ----------- + ---------- + ----------
(1.14)3 (1.14)4 (1.14)5

= - 44837

(b) NPV of the project at time varying discount rates

= - 1,000,000

100,000
+
(1.12)

200,000
+
(1.12) (1.13)

300,000
+
(1.12) (1.13) (1.14)

600,000
+
(1.12) (1.13) (1.14) (1.15)

300,000
+
(1.12) (1.13) (1.14)(1.15)(1.16)

= - 1,000,000 + 89286 + 158028 + 207931 + 361620 + 155871


= - 27264

2. Investment A

a) Payback period = 5 years


b) NPV = 40000 x PVIFA (12%,10) – 200 000
= 26000
c) IRR (r ) can be obtained by solving the equation:
40000 x PVIFA (r, 10) = 200000
i.e., PVIFA (r, 10) = 5.000

From the PVIFA tables we find that

PVIFA (15%,10) = 5.019


PVIFA (16%,10) = 4.883

Linear interporation in this range yields

r = 15 + 1 x (0.019 / 0.136)
= 15.14%

d) BCR = Benefit Cost Ratio


= PVB / I
= 226,000 / 200,000 = 1.13

Investment B

a) Payback period = 9 years

b) NP V = 40,000 x PVIFA (12%,5)


+ 30,000 x PVIFA (12%,2) x PVIF (12%,5)
+ 20,000 x PVIFA (12%,3) x PVIF (12%,7)
- 300,000

= (40,000 x 3.605) + (30,000 x 1.690 x 0.567)


+ (20,000 x 2.402 x 0.452) – 300,000
= - 105339

c) IRR (r ) can be obtained by solving the equation


40,000 x PVIFA (r, 5) + 30,000 x PVIFA (r, 2) x PVIF (r,5) +
20,000 x PVIFA (r, 3) x PVIF (r, 7) = 300,000

Through the process of trial and error we find that


r = 1.37%

d) BCR = PVB / I
= 194,661 / 300,000 = 0.65

Investment C
a) Payback period lies between 2 years and 3 years. Linear interpolation in
this range provides an approximate payback period of 2.88 years.

b) NPV = 80.000 x PVIF (12%,1) + 60,000 x PVIF (12%,2)


+ 80,000 x PVIF (12%,3) + 60,000 x PVIF (12%,4)

+ 80,000 x PVIF (12%,5) + 60,000 x PVIF (12%,6)


+ 40,000 x PVIFA (12%,4) x PVIF (12%,6)
- 210,000
= 111,371

c) IRR (r) is obtained by solving the equation


80,000 x PVIF (r,1) + 60,000 x PVIF (r,2) + 80,000 x PVIF (r,3)
+ 60,000 x PVIF (r,4) + 80,000 x PVIF (r,5) + 60,000 x PVIF (r,6)
+ 40000 x PVIFA (r,4) x PVIF (r,6) = 210000

Through the process of trial and error we get


r = 29.29%

d) BCR = PVB / I = 321,371 / 210,000 = 1.53

Investment D

a) Payback period lies between 8 years and 9 years. A linear interpolation


in this range provides an approximate payback period of 8.5 years.
8 + (1 x 100,000 / 200,000)

b) NPV = 200,000 x PVIF (12%,1)


+ 20,000 x PVIF (12%,2) + 200,000 x PVIF (12%,9)
+ 50,000 x PVIF (12%,10)
- 320,000
= - 37,160

c) IRR (r ) can be obtained by solving the equation


200,000 x PVIF (r,1) + 200,000 x PVIF (r,2)
+ 200,000 x PVIF (r,9) + 50,000 x PVIF (r,10)
= 320000
Through the process of trial and error we get r = 8.45%

d) BCR = PVB / I = 282,840 / 320,000 = 0.88


Comparative Table

Investment A B C D
a) Payback period
(in years) 5 9 2.88 8.5

b) NPV @ 12% 26000 -105339 111371 -37160

c) IRR (%) 15.14 1.37 29.29 8.45

d) BCR 1.13 0.65 1.53 0.88

Among the four alternative investments, the investment to be chosen is ‘C’


because it has the a. Lowest payback period
b. Highest NPV
c. Highest IRR
d. Highest BCR

3. IRR (r) can be calculated by solving the following equations for the value of r.
60000 x PVIFA (r,7) = 300,000
i.e., PVIFA (r,7) = 5.000

Through a process of trial and error it can be verified that r = 9.20% p.a.

4. The IRR (r) for the given cashflow stream can be obtained by solving the
following equation for the value of r.
-3000 + 9000 / (1+r) – 3000 / (1+r) = 0
Simplifying the above equation we get
r = 1.61, -0.61; (or) 161%, (-)61%

Note : Given two changes in the signs of cashflow, we get two values for the
IRR of the cashflow stream. In such cases, the IRR rule breaks down.

5. Define NCF as the minimum constant annual net cashflow that justifies the
purchase of the given equipment. The value of NCF can be obtained from the
equation
NCF x PVIFA (10%,8) = 500000
NCF = 500000 / 5.335
= 93271

6. Define I as the initial investment that is justified in relation to a net annual cash
inflow of 25000 for 10 years at a discount rate of 12% per annum. The value
of I can be obtained from the following equation
25000 x PVIFA (12%,10) = I
i.e., I = 141256

7. PV of benefits (PVB) = 25000 x PVIF (15%,1)


+ 40000 x PVIF (15%,2)
+ 50000 x PVIF (15%,3)
+ 40000 x PVIF (15%,4)
+ 30000 x PVIF (15%,5)
= 122646 (A)
Investment = 100,000 (B)
Benefit cost ratio = 1.23 [= (A) / (B)]

8. The NPV’s of the three projects are as follows:

Project
P Q R
Discount rate
0% 400 500 600
5% 223 251 312
10% 69 40 70
15% - 66 - 142 - 135
25% - 291 - 435 - 461
30% - 386 - 555 - 591

9. NPV profiles for Projects P and Q for selected discount rates are as follows:
(a)
Project
P Q
Discount rate (%)
0 2950 500
5 1876 208
10 1075 - 28
15 471 - 222
20 11 - 382

b) (i) The IRR (r ) of project P can be obtained by solving the following


equation for `r’.

-1000 -1200 x PVIF (r,1) – 600 x PVIF (r,2) – 250 x PVIF (r,3)
+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5) = 0

Through a process of trial and error we find that r = 20.13%

(ii) The IRR (r') of project Q can be obtained by solving the following
equation for r'
-1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5) = 0
Through a process of trial and error we find that r' = 9.34%.

c) From (a) we find that at a cost of capital of 10%


NPV (P) = 1075
NPV (Q) = - 28
Given that NPV (P), NPV (Q) and NPV (P) > 0, I would choose project P.
From (a) we find that at a cost of capital of 20%
NPV (P) = 11
NPV (Q) = - 382
Again NPV (P) > NPV (Q); and NPV (P) > 0. I would choose project P.

d) Project P
PV of investment-related costs
= 1000 x PVIF (12%,0)
+ 1200 x PVIF (12%,1) + 600 x PVIF (12%,2)
+ 250 x PVIF (12%,3)
= 2728
TV of cash inflows = 2000 x (1.12) + 4000 = 6240
The MIRR of the project P is given by the equation:
2728 = 6240 x PVIF (MIRR,5)
(1 + MIRR)5 = 2.2874
MIRR = 18%

(c) Project Q
PV of investment-related costs = 1600
TV of cash inflows @ 15% p.a. = 2772
The MIRR of project Q is given by the equation:
16000 (1 + MIRR)5 = 2772
MIRR = 11.62%
10.
(a) Project A
NPV at a cost of capital of 12%
= - 100 + 25 x PVIFA (12%,6)
= Rs.2.79 million

IRR (r ) can be obtained by solving the following equation for r.


25 x PVIFA (r,6) = 100
i.e., r = 12,98%

Project B
NPV at a cost of capital of 12%
= - 50 + 13 x PVIFA (12%,6)
= Rs.3.45 million
IRR (r') can be obtained by solving the equation
13 x PVIFA (r',6) = 50
i.e., r' = 14.40% [determined through a process of trial and error]

(b) Difference in capital outlays between projects A and B is Rs.50 million


Difference in net annual cash flow between projects A and B is Rs.12 million.
NPV of the differential project at 12%
= -50 + 12 x PVIFA (12%,6)
= Rs.3.15 million

IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6) = 50
i.e., r'' = 11.53%

11.
(a) Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period of 2.63 years.

Project N
The pay back period lies between 1 and 2 years. Interpolating in this range we
get an approximate pay back period of 1.55 years.

(b) Project M
Cost of capital = 12% p.a
PV of cash flows up to the end of year 2 = 24.97
PV of cash flows up to the end of year 3 = 47.75
PV of cash flows up to the end of year 4 = 71.26

Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in
this range we get an approximate DPB of 3.1 years.

Project N
Cost of capital = 12% per annum
PV of cash flows up to the end of year 1 = 33.93
PV of cash flows up to the end of year 2 = 51.47

DPB lies between 1 and 2 years. Interpolating in this range we get an


approximate DPB of 1.92 years.
(c) Project M
Cost of capital = 12% per annum
NPV = - 50 + 11 x PVIFA (12%,1)
+ 19 x PVIF (12%,2) + 32 x PVIF (12%,3)
+ 37 x PVIF (12%,4)
= Rs.21.26 million
Project N
Cost of capital = 12% per annum
NPV = Rs.20.63 million

Since the two projects are independent and the NPV of each project is (+) ve,
both the projects can be accepted. This assumes that there is no capital
constraint.

(d) Project M
Cost of capital = 10% per annum
NPV = Rs.25.02 million

Project N
Cost of capital = 10% per annum
NPV = Rs.23.08 million

Since the two projects are mutually exclusive, we need to choose the project
with the higher NPV i.e., choose project M.

Note : The MIRR can also be used as a criterion of merit for choosing between
the two projects because their initial outlays are equal.

(e) Project M
Cost of capital = 15% per annum
NPV = 16.13 million

Project N
Cost of capital: 15% per annum
NPV = Rs.17.23 million

Again the two projects are mutually exclusive. So we choose the project with the
higher NPV, i.e., choose project N.

(f) Project M
Terminal value of the cash inflows: 114.47
MIRR of the project is given by the equation
50 (1 + MIRR)4 = 114.47
i.e., MIRR = 23.01%
Project N
Terminal value of the cash inflows: 115.41
MIRR of the project is given by the equation
50 ( 1+ MIRR)4 = 115.41
i.e., MIRR = 23.26%
12. The internal rate of return is the value of r in the equation

2,000 1,000 10,000 2,000


8000 = - + +
(1+r) (1+r)2 (1+r)3 (1+r)4
At r = 18%, the right hand side is equal to 8099
At r = 20%, the right hand side is equal to 7726
Thus the solving value of r is :
8,099 – 8,000
18% + x 2% = 18.5%
8,099 – 7,726

Unrecovered Investment Balance


Year Unrecovered Interest for the Cash flow at the Unrecovered
investment balance at year Ft-1 (1+r) end of the year investment balance at
the beginning Ft-1 CFt the end of the year Ft-1
(1+r) + CFt
1 -8000 -1480 2000 -7480
2 -7480 -1383.8 -1000 -9863.8
3 -9863.8 -1824.80 10000 -1688.60
4 -1688.60 -312.39 2000 0

13. Rs. in lakhs


Year 1 2 3 4 5 6 7 8 Sum Average
Investment 24.0 21.0 18.0 15.0 12.0 9.0 6.0 3.0 108 13.500
Depreciation 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 24.0 3.000
Income before 6.0 6.5 7.0 7.0 7.0 6.5 6.0 5.0 51.0 6.375
interest and tax
Interest 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 20.0 2.500
Income before tax 3.5 4.0 4.5 4.5 4.5 4.0 3.5 2.5 31.0 3.875
Tax - 1.0 2.5 2.5 2.5 2.2 1.9 1.4 14.0 1.750
Income after tax 3.5 3.0 2.0 2.0 2.0 1.8 1.6 1.1 17.0 2.125

Measures of Accounting Rate of Return

A. Average income after tax 2.125


= = 8.9%
Initial investment 24

B. Average income after tax 2.125


= = 15.7%
Average investment 13.5

C. Average income after tax but before interest 2.125 + 2.5


= = 19.3%
Initial investment 24

D. Average income after tax but before interest 2.125 + 2.5


= = 34.3%
Average investment 13.5

E. Average income before interest and taxes 6.375


= = 26.6%
Initial investment 24

F. Average income before interest and taxes 6.375


= = 47.2%
Average investment 13.5

G. Total income after tax but before


Depreciation – Initial investment 17.0 + 24.0 – 24.0
=
(Initial investment / 2) x Years (24 / 2) x 8

= 17.0 / 96.0 = 17.7%

Chapter 9

PROJECT CASH FLOWS

1.
(a) Project Cash Flows (Rs. in million)

Year 0 1 2 3 4 5 6 7

1. Plant & machinery (150)

2. Working capital (50)

3. Revenues 250 250 250 250 250 250 250

4. Costs (excluding de-


preciation & interest) 100 100 100 100 100 100 100

5. Depreciation 37.5 28.13 21.09 15.82 11.87 8.90 6.67

6. Profit before tax 112.5 121.87 128.91 134.18 138.13 141.1 143.33

7. Tax 33.75 36.56 38.67 40.25 41.44 42.33 43.0

8. Profit after tax 78.75 85.31 90.24 93.93 96.69 98.77 100.33

9. Net salvage value of


plant & machinery 48

10. Recovery of working 50


capital

11. Initial outlay (=1+2) (200)

12. Operating CF (= 8 + 5) 116.25 113.44 111.33 109.75 108.56 107.67


107.00

13. Terminal CF ( = 9 +10) 98

14. NCF (200) 116.25 113.44 111.33 109.75 108.56 107.67 205

(c) IRR (r) of the project can be obtained by solving the following equation for r

-200 + 116.25 x PVIF (r,1) + 113.44 x PVIF (r,2)


+ 111.33 x PVIF (r,3) + 109.75 x PVIF (r,4) + 108.56 x PVIF (r,5)
+107.67 x PVIF (r,6) + 205 x PVIF (r,7) = 0
Through a process of trial and error, we get r = 55.17%. The IRR of the
project is 55.17%.

2. Post-tax Incremental Cash Flows (Rs. in million)

Year 0 1 2 3 4 5 6 7

1. Capital equipment (120)


2. Level of working capital 20 30 40 50 40 30 20
(ending)
3. Revenues 80 120 160 200 160 120 80
4. Raw material cost 24 36 48 60 48 36 24
5. Variable mfg cost. 8 12 16 20 16 12 8
6. Fixed operating & maint. 10 10 10 10 10 10 10
cost
7. Variable selling expenses 8 12 16 20 16 12 8
8. Incremental overheads 4 6 8 10 8 6 4
9. Loss of contribution 10 10 10 10 10 10 10
10.Bad debt loss 4
11. Depreciation 30 22.5 16.88 12.66 9.49 7.12 5.34
12. Profit before tax -14 11.5 35.12 57.34 42.51 26.88 6.66
13. Tax - 4.2 3.45 10.54 17.20 12.75 8.06 2.00
14. Profit after tax - 9.8 8.05 24.58 40.14 29.76 18.82 4.66
15. Net salvage value of
capital equipments 25
16. Recovery of working 16
capital
17. Initial investment (120)
18. Operating cash flow 20.2 30.55 41.46 52.80 39.25 25.94 14.00
(14 + 10+ 11)
19.  Working capital 20 10 10 10 (10) (10) (10)
20. Terminal cash flow 41

21. Net cash flow (140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00
(17+18-19+20)

(b) NPV of the net cash flow stream @ 15% per discount rate

= -140 + 10.20 x PVIF(15%,1) + 20.55 x PVIF (15%,2)


+ 31.46 x PVIF (15%,3) + 62.80 x PVIF (15%,4) + 49.25 x PVIF
(15%,5)
+ 35.94 x PVIF (15%,6) + 55 x PVIF (15%,7)
= Rs.1.70 million

3.
(a) A. Initial outlay (Time 0)

i. Cost of new machine Rs. 3,000,000


ii. Salvage value of old machine 900,000
iii Incremental working capital requirement 500,000
iv. Total net investment (=i – ii + iii) 2,600,000

B. Operating cash flow (years 1 through 5)

Year 1 2 3 4 5

i. Post-tax savings in
manufacturing costs 455,000 455,000 455,000 455,000 455,000

ii. Incremental
depreciation 550,000 412,500 309,375 232,031 174,023

iii. Tax shield on


incremental dep. 165,000 123,750 92,813 69,609 52,207

iv. Operating cash


flow ( i + iii) 620,000 578,750 547,813 524,609 507,207

C. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 1,500,000


ii. Salvage value of old machine 200,000
iii. Recovery of incremental working capital 500,000
iv. Terminal cash flow ( i – ii + iii) 1,800,000

D. Net cash flows associated with the replacement project (in Rs)

Year 0 1 2 3 4 5

NCF (2,600,000) 620000 578750 547813 524609 307207

(b) NPV of the replacement project

= - 2600000 + 620000 x PVIF (14%,1)


+ 578750 x PVIF (14%,2)
+ 547813 x PVIF (14%,3)
+ 524609 x PVIF (14%,4)
+ 2307207 x PVIF (14%,5)
= Rs.267849

4. Tax shield (savings) on depreciation (in Rs)

Depreciation Tax shield PV of tax shield


Year charge (DC) =0.4 x DC @ 15% p.a.

1 25000 10000 8696

2 18750 7500 5671

3 14063 5625 3699

4 10547 4219 2412

5 7910 3164 1573


--------
22051
--------

Present value of the tax savings on account of depreciation = Rs.22051

5. A. Initial outlay (at time 0)

i. Cost of new machine Rs. 400,000


ii. Salvage value of the old machine 90,000
iii. Net investment 310,000

B. Operating cash flow (years 1 through 5)

Year 1 2 3 4 5

i. Depreciation
of old machine 18000 14400 11520 9216 7373

ii. Depreciation
of new machine 100000 75000 56250 42188 31641

iii. Incremental depre-


ciation ( ii – i) 82000 60600 44730 32972 24268

iv. Tax savings on inc-


remental depreciation
( 0.35 x (iii)) 28700 21210 15656 11540 8494

v. Operating cash flow 28700 21210 15656 11540 8494

C. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 25000


ii. Salvage value of old machine 10000
iii. Incremental salvage value of new
machine = Terminal cash flow 15000

D. Net cash flows associated with the replacement proposal.

Year 0 1 2 3 4 5

NCF (310000) 28700 21210 15656 11540 23494

6. Net Cash Flows Relating to Equity


(Rs. in million)
Particulars Year
0 1 2 3 4 5 6
1. Equity funds (100)
2. Revenues 500 500 500 500 500 500
3. Operating costs 320 320 320 320 320 320
4. Depreciation 83.33 55.56 37.04 24.69 16.46 10.97
5. Interest on working capital 18.00 18.00 18.00 18.00 18.00 18.00
advance
6. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.50
7. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.53
8. Tax 24.335 38.97 51.23 60.405 67.52 73.265
9. Profit after tax 24.335 38.97 51.23 60.405 67.52 73.265
10. Preference dividend
11. Net salvage value of fixed assets 200
12. Net salvage value of current - 40 40 40 40 40
assets
13. Repayment of term-loans
14. Redemption of preference capital
15. Repayment of short-term bank 100
borrowings
16. Retirement of trade creditors 50
17. Initial investment (1) (100)
18. Operating cash flows (9-10+4) 107.665 94.53 88.27 85.095 83.98 84.235
19. Liquidation and retirement cash 107.665 54.53 48.27 45.095 43.98 90
flows (11+12-13-14-15-16)
20. Net cash flows (17+18+19) (100) 107.665 54.53 48.27 45.095 43.98 174.235

Net Cash Flows Relating to Long-term Funds (Rs. in million)


Particulars Year
0 1 2 3 4 5 6
1. Fixed assets (250)
2. Working capital margin (50)
3. Revenues 500 500 500 500 500 500
4. Operating costs 320 320 320 320 320 320
5. Depreciation 83.33 55.56 37.04 24.69 16.46 10.97
6. Interest on working capital 18.00 18.00 18.00 18.00 18.00 18.00
advance
7. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.50
8. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.53
9. Tax @ 50% 24.335 38.97 51.23 60.405 67.52 73.265
10. Profit after tax 24.335 38.97 51.23 60.405 67.52 73.265
11. Net salvage value of fixed assets 80
12. Net recovery of working capital 50
margin
13. Initial investment (1+2) (300)
14. Operating cash inflow (9+5+7 122.665 108.78 99.52 93.345 89.23 86.845
(1-T) )
15. Terminal cash flow (11+12) 130.00
16. Net cash flow (13+14+15) (300) 122.665 108.78 99.52 93.345 89.23 216.485
Cash Flows Relating to Total Funds
(Rs. in million)
Year
0 1 2 3 4 5 6
1. Total funds (450)
2. Revenues 500 500 500 500 500 500
3. Operating costs 320 320 320 320 320 320
4. Depreciation 83.33 55.56 37.04 24.69 16.46 10.97
5. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.50
6. Interest on working capital 18.00 18.00 18.00 18.00 18.00 18.00
advance
7. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.53
8. Tax 24.34 38.97 51.23 60.41 67.52 73.265
9. Profit after tax 24.34 38.97 51.23 60.41 67.52 73.265
10. Net salvalue of fixed assets 80
11. Net salvage value of current assets 200
12. Initial investment (1) (450)
13. Operating cash inflow 9+4+6 (1-t) 131.67 117.78 108.52 102.35 98.23 95.485
+ 5(1-t)
14. Terminal cash flow (10+11) 280
15. Net cash flow (12+13+14) (450) 131.67 117.78 108.52 102.35 98.23 375.485

Chapter 10

THE COST OF CAPITAL


1(a) Define rD as the pre-tax cost of debt. Using the approximate yield formula, rD
can be calculated as follows:

14 + (100 – 108)/10
rD = ------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108

(b) After tax cost = 12.60 x (1 – 0.35) = 8.19%

2. Define rp as the cost of preference capital. Using the approximate yield formula
rp can be calculated as follows:

9 + (100 – 92)/6
rp = --------------------
0.4 x100 + 0.6x92

= 0.1085 (or) 10.85%

3. WACC = 0.4 x 13% x (1 – 0.35)


+ 0.6 x 18%
= 14.18%

4. Cost of equity = 10% + 1.2 x 7% = 18.4%


(using SML equation)
Pre-tax cost of debt = 14%
After-tax cost of debt = 14% x (1 – 0.35) = 9.1%
Debt equity ratio = 2:3
WACC = 2/5 x 9.1% + 3/5 x 18.4%
= 14.68%

5. Given
0.5 x 14% x (1 – 0.35) + 0.5 x rE = 12%

where rE is the cost of equity capital.


Therefore rE – 14.9%
Using the SML equation we get
11% + 8% x β = 14.9%
where β denotes the beta of Azeez’s equity.
Solving this equation we get β = 0.4875.

6 (a) The cost of debt of 12% represents the historical interest rate at the time the debt
was originally issued. But we need to calculate the marginal cost of debt (cost
of raising new debt); and for this purpose we need to calculate the yield to
maturity of the debt as on the balance sheet date. The yield to maturity will not
be equal to 12% unless the book value of debt is equal to the market value of
debt on the balance sheet date.

(b) The cost of equity has been taken as D1/P0 ( = 6/100) whereas the cost of equity
is (D1/P0) + g where g represents the expected constant growth rate in dividend
per share.

7. The book value and market values of the different sources of finance are
provided in the following table. The book value weights and the market value
weights are provided within parenthesis in the table.

(Rs. in million)
Source Book value Market value
Equity 800 (0.54) 2400 (0.78)
Debentures – first series 300 (0.20) 270 (0.09)
Debentures – second series 200 (0.13) 204 (0.06)
Bank loan 200 (0.13) 200 (0.07)
Total 1500 (1.00) 3074 (1.00)

8.
(a) Given
rD x (1 – 0.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pre-tax cost of debt.

(b) Given
13% x (1 – 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.

9. Cost of equity = D1/P0 + g


= 3.00 / 30.00 + 0.05
= 15%
(a) The first chunk of financing will comprise of Rs.5 million of retained
earnings costing 15 percent and Rs.25 million of debt costing 14 (1-.3) = 9.8
percent.
The second chunk of financing will comprise of Rs.5 million of additional
equity costing 15 percent and Rs.2.5 million of debt costing 15 (1-.3) = 10.5
percent.

(b) The marginal cost of capital in the first chunk will be :


5/7.5 x 15% + 2.5/7.5 x 9.8% = 13.27%
The marginal cost of capital in the second chunk will be :
5/7.5 x 15% + 2.5/7.5 x 10.5% = 13.50%

Note : We have assumed that


(i) The net realisation per share will be Rs.25, after floatation costs, and
(ii) The planned investment of Rs.15 million is inclusive of floatation costs

10. The cost of equity and retained earnings


rE = D1/PO + g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :
11 + (100-75)/10
rE = = 15.9%
0.6x75 + 0.4x100
The pre-tax cost of debentures, using the approximate formula, is :
13.5 + (100-80)/6
rD = = 19.1%
0.6x80 + 0.4x100

The post-tax cost of debentures is


19.1 (1-tax rate) = 19.1 (1 – 0.5)
= 9.6%
The post-tax cost of term loans is
12 (1-tax rate) = 12 (1 – 0.5)
= 6.0%

The average cost of capital using book value proportions is calculated below:

Source of capital Component Book value Book value Product of


cost Rs. in million proportion (1) & (3)
(1) (2) (3)
Equity capital 14.5% 100 0.28 4.06
Preference capital 15.9% 10 0.03 0.48
Retained earnings 14.5% 120 0.33 4.79
Debentures 9.6% 50 0.14 1.34
Term loans 6.0% 80 0.22 1.32
360 Average cost 11.99%
capital

The average cost of capital using market value proportions is calculated below :

Source of capital Component Market value Market value Product of


cost Rs. in million
(1) (2) (3) (1) & (3)
Equity capital
and retained earnings 14.5% 200 0.62 8.99
Preference capital 15.9% 7.5 0.02 0.32
Debentures 9.6% 40 0.12 1.15
Term loans 6.0% 80 0.24 1.44

327.5 Average cost 11.90%


capital

11.
(a) WACC = 1/3 x 13% x (1 – 0.3)
+ 2/3 x 20%
= 16.37%

(b) Weighted average floatation cost


= 1/3 x 3% + 2/3 x 12%
= 9%

(c) NPV of the proposal after taking into account the floatation costs
= 130 x PVIFA (16.37%, 8) – 500 / (1 - 0.09)
= Rs.8.51 million

Chapter 11

RISK ANALYSIS OF SINGLE INVESTMENTS


1.
(a) NPV of the project = -250 + 50 x PVIFA (13%,10)
= Rs.21.31 million

(b) NPVs under alternative scenarios:


(Rs. in million)
Pessimistic Expected Optimistic

Investment 300 250 200


Sales 150 200 275
Variable costs 97.5 120 154
Fixed costs 30 20 15
Depreciation 30 25 20
Pretax profit - 7.5 35 86
Tax @ 28.57% - 2.14 10 24.57
Profit after tax - 5.36 25 61.43
Net cash flow 24.64 50 81.43
Cost of capital 14% 13% 12%

NPV - 171.47 21.31 260.10

Assumptions: (1) The useful life is assumed to be 10 years under all three
scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.

(2) The investment is assumed to be depreciated at 10% per


annum; and it is also assumed that this method and rate of
depreciation are acceptable to the IT (income tax)
authorities.

(3) The tax rate has been calculated from the given table i.e.
10 / 35 x 100 = 28.57%.

(4) It is assumed that only loss on this project can be offset


against the taxable profit on other projects of the
company; and thus the company can claim a tax shield on
the loss in the same year.

(c) Accounting break even point (under ‘expected’ scenario)


Fixed costs + depreciation = Rs. 45 million
Contribution margin ratio = 60 / 200 = 0.3
Break even level of sales = 45 / 0.3 = Rs.150 million
Financial break even point (under ‘expected’ scenario)

i. Annual net cash flow = 0.7143 [ 0.3 x sales – 45 ] + 25


= 0.2143 sales – 7.14

ii. PV (net cash flows) = [0.2143 sales – 7.14 ] x PVIFA (13%,10)


= 1.1628 sales – 38.74

iii. Initial investment = 200

iv. Financial break even level


of sales = 238.74 / 1.1628 = Rs.205.31 million

2.
(a) Sensitivity of NPV with respect to quantity manufactured and sold:
(in Rs)
Pessimistic Expected Optimistic

Initial investment 30000 30000 30000


Sale revenue 24000 42000 54000
Variable costs 16000 28000 36000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax 3000 9000 13000
Tax 1500 4500 6500
Profit after tax 1500 4500 6500
Net cash flow 3500 6500 8500
NPV at a cost of
capital of 10% p.a
and useful life of
5 years -16732 - 5360 2222

(b) Sensitivity of NPV with respect to variations in unit price.

Pessimistic Expected Optimistic

Initial investment 30000 30000 30000


Sale revenue 28000 42000 70000
Variable costs 28000 28000 28000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax -5000 9000 37000
Tax -2500 4500 18500
Profit after tax -2500 4500 18500
Net cash flow - 500 6500 20500
NPV - 31895 (-) 5360 47711

(c) Sensitivity of NPV with respect to variations in unit variable cost.

Pessimistic Expected Optimistic

Initial investment 30000 30000 30000


Sale revenue 42000 42000 42000
Variable costs 56000 28000 21000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax -11000 9000 16000
Tax -5500 4500 8000
Profit after tax -5500 4500 8000
Net cash flow -3500 6500 10000
NPV -43268 - 5360 7908

(d) Accounting break-even point

i. Fixed costs + depreciation = Rs.5000


ii. Contribution margin ratio = 10 / 30 = 0.3333
iii. Break-even level of sales = 5000 / 0.3333
= Rs.15000

Financial break-even point

i. Annual cash flow = 0.5 x (0.3333 Sales – 5000) = 2000


ii. PV of annual cash flow = (i) x PVIFA (10%,5)
= 0.6318 sales – 1896
iii. Initial investment = 30000
iv. Break-even level of sales = 31896 / 0.6318 = Rs.50484

2. Define At as the random variable denoting net cash flow in year t.

A1 = 4 x 0.4 + 5 x 0.5 + 6 x 0.1


= 4.7

A2 = 5 x 0.4 + 6 x 0.4 + 7 x 0.2


= 5.8

A3 = 3 x 0.3 + 4 x 0.5 + 5 x 0.2


= 3.9
NPV = 4.7 / 1.1 +5.8 / (1.1)2 + 3.9 / (1.1)3 – 10
= Rs.2.00 million
12 = 0.41

22 = 0.56
32 = 0.49

12 22 32


 NPV =
2
+ +
2 4
(1.1) (1.1) (1.1)6

= 1.00
 (NPV) = Rs.1.00 million

3. Expected NPV
4 At
=  - 25,000
t=1 (1.08)t

= 12,000/(1.08) + 10,000 / (1.08)2 + 9,000 / (1.08)3


+ 8,000 / (1.08)4 – 25,000

= [ 12,000 x .926 + 10,000 x .857 + 9,000 x .794 + 8,000 x .735]


- 25,000
= 7,708

Standard deviation of NPV


4 t

t=1 (1.08)t

= 5,000 / (1.08) + 6,000 / (1.08)2 + 5,000 / (1,08)3 + 6,000 / (1.08)4


= 5,000 x .926 + 6,000 x .857 + 5000 x .794 + 6,000 x .735
= 18,152

4. Expected NPV
4 At
=  - 25,000 …. (1)
t=1 (1.06)t
A1 = 2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3
= 3,100
A2 = 3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3
= 3,900

A3 = 4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2


= 4,900

A4 = 2,000 x 0.2 + 3,000 x 0.4 + 4,000 x 0.4


= 3,200
Substituting these values in (1) we get

Expected NPV = NPV

= 3,100 / (1.06)+ 3,900 / (1.06)2 + 4,900 / (1.06)3 + 3,200 / (1,06)4


- 10,000 = Rs.3,044

The variance of NPV is given by the expression


4 2t
 (NPV) = 
2
…….. (2)
t=1 (1.06)2t

12 = [(2,000 – 3,100)2 x 0.2 + (3,000 – 3,100)2 x 0.5


+ (4,000 – 3,100)2 x 0.3]
= 490,000

22 = [(3,000 – 3,900)2 x 0.4 + (4,000 – 3,900)2 x 0.3


+ (5,000 – 3900)2 x 0.3]
= 690,000

32 = [(4,000 – 4,900)2 x 0.3 + (5,000 – 4,900)2 x 0.5


+ (6,000 – 4,900)2 x 0.2]
= 490,000

42 = [(2,000 – 3,200)2 x 0.2 + (3,000 – 3,200)2 x 0.4


+ (4,000 – 3200)2 x 0.4]
= 560,000

Substituting these values in (2) we get


490,000 / (1.06)2 + 690,000 / (1.06)4
+ 490,000 / (1.06)6 + 560,000 / (1.08)8
[ 490,000 x 0.890 + 690,000 x 0.792
+ 490,000 x 0.705 + 560,000 x 0.627 ]
= 1,679,150
NPV = 1,679,150 = Rs.1,296
NPV – NPV 0 - NPV
Prob (NPV < 0) = Prob. <
NPV NPV

0 – 3044
= Prob Z<
1296

= Prob (Z < -2.35)

The required probability is given by the shaded area in the following normal
curve.

P (Z < - 2.35) = 0.5 – P (-2.35 < Z < 0)


= 0.5 – P (0 < Z < 2.35)
= 0.5 – 0.4906
= 0.0094

So the probability of NPV being negative is 0.0094

Prob (P1 > 1.2) Prob (PV / I > 1.2)


Prob (NPV / I > 0.2)
Prob. (NPV > 0.2 x 10,000)
Prob (NPV > 2,000)

Prob (NPV >2,000)= Prob (Z > 2,000- 3,044 / 1,296)


Prob (Z > - 0.81)

The required probability is given by the shaded area of the following normal
curve:
P(Z > - 0.81) = 0.5 + P(-0.81 < Z < 0)
= 0.5 + P(0 < Z < 0.81)
= 0.5 + 0.2910
= 0.7910

So the probability of P1 > 1.2 as 0.7910

5. Given values of variables other than Q, P and V, the net present value model of
Bidhan Corporation can be expressed as:
5
 [Q(P – V) – 3,000 – 2,000] (0.5)+ 2,000 0
t=1
NPV = ---------------------------------------------------------- + ------- - 30,000
(1.1)t (1.1)5
5
 0.5 Q (P – V) – 500
t=1
= ------------------------------------ - 30,000
(1.1)t

= [ 0.5Q (P – V) – 500] x PVIFA (10,5) – 30,000


= [0.5Q (P – V) – 500] x 3.791 – 30,000
= 1.8955Q (P – V) – 31,895.5

Exhibit 1 presents the correspondence between the values of exogenous


variables and the two digit random number. Exhibit 2 shows the results of the
simulation.

Exhibit 1
Correspondence between values of exogenous variables and
two digit random numbers

QUANTITY PRICE VARIABLE COST


Two digit Two digit Two digit
Cumulative random Cumulative random Cumu- random
Value Prob Prob. numbers Value Prob Prob. numbers Value Prob lative numbers
Prob.
800 0.10 0.10 00 to 09 20 0.40 0.40 00 to 39 15 0.30 0.30 00 to 29
1,000 0.10 0.20 10 to 19 30 0.40 0.80 40 to 79 20 0.50 0.80 30 to 79
1,200 0.20 0.40 20 to 39 40 0.10 0.90 80 to 89 40 0.20 1.00 80 to 99
1,400 0.30 0.70 40 to 69 50 0.10 1.00 90 to 99
1,600 0.20 0.90 70 to 89
1,800 0.10 1.00 90 to 99

Exhibit 2
Simulation Results

QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV


Run Rando Corres- Random Corres- Random Corres- 1.8955 Q(P-V)-31,895.5
m ponding Number ponding Number ponding
Number Value value value
1 03 800 38 20 17 15 -24,314
2 32 1,200 69 30 24 15 2,224
3 61 1,400 30 20 03 15 -18,627
4 48 1,400 60 30 83 40 -58,433
5 32 1,200 19 20 11 15 -20,523
6 31 1,200 88 40 30 20 13,597
7 22 1,200 78 30 41 20 -9,150
8 46 1,400 11 20 52 20 -31,896
9 57 1,400 20 20 15 15 -18,627
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Run Rando Corres- Random Corres- Random Corres- 1.8955 Q(P-V)-31,895.5
m ponding Number ponding Number ponding
Number Value value value
10 92 1,800 77 30 38 20 2,224
11 25 1,200 65 30 36 20 -9,150
12 64 1,400 04 20 83 40 -84,970
13 14 1,000 51 30 72 20 -12,941
14 05 800 39 20 81 40 -62,224
15 07 800 90 50 40 20 13,597
16 34 1,200 63 30 67 20 -9,150
17 79 1,600 91 50 99 40 -1,568
18 55 1,400 54 30 64 20 -5,359
19 57 1,400 12 20 19 15 -18,627
20 53 1,400 78 30 22 15 7,910
21 36 1,200 79 30 96 40 -54,642
22 32 1,200 22 20 75 20 -31,896
23 49 1,400 93 50 88 40 -5,359
24 21 1,200 84 40 35 20 13,597
25 08 .800 70 30 27 15 -9,150
26 85 1,600 63 30 69 20 -1,568
27 61 1,400 68 30 16 15 7,910
28 25 1,200 81 40 39 20 13,597
29 51 1,400 76 30 38 20 -5,359
30 32 1,200 47 30 46 20 -9,150
31 52 1,400 61 30 58 20 -5,359
32 76 1,600 18 20 41 20 -31,896
33 43 1,400 04 20 49 20 -31,896
34 70 1,600 11 20 59 20 -31,896
35 67 1,400 35 20 26 15 -18,627
36 26 1,200 63 30 22 15 2,224
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Run Random Corres- Random Corres- Random Corres- 1.8955 Q(P-V)-31,895.5
Number ponding Number ponding Number ponding
Value value value
37 89 1,600 86 40 59 20 28,761
38 94 1,800 00 20 25 15 -14,836
39 09 .800 15 20 29 15 -24,314
40 44 1,400 84 40 21 15 34,447
41 98 1,800 23 20 79 20 -31,896
42 10 1,000 53 30 77 20 -12,941
43 38 1,200 44 30 31 20 -9,150
44 83 1,600 30 20 10 15 -16,732
45 54 1,400 71 30 52 20 -5,359
46 16 1,000 70 30 19 15 -3,463
47 20 1,200 65 30 87 40 -54,642
48 61 1,400 61 30 70 20 -5,359
49 82 1,600 48 30 97 40 -62,224
50 90 1,800 50 30 43 20 2,224

Expected NPV = NPV


50
= 1/ 50 NPVi
i=1
= 1/50 (-7,20,961)
= 14,419

50
Variance of NPV = 1/50 NPVi – NPV)2
i=1

= 1/50 [27,474.047 x 106]


= 549.481 x 106

Standard deviation of NPV = 549.481 x 106


= 23,441

6. To carry out a sensitivity analysis, we have to define the range and the most
likely values of the variables in the NPV Model. These values are defined
below

Variable Range Most likely value

I Rs.30,000 – Rs.30,000 Rs.30,000


k 10% - 10% 10%
F Rs.3,000 – Rs.3,000 Rs.3,000
D Rs.2,000 – Rs.2,000 Rs.2,000
T 0.5 – 0.5 0.5
N 5–5 5
S 0–0 0
Q Can assume any one of the values - 1,400*
800, 1,000, 1,200, 1,400, 1,600 and 1,800
P Can assume any of the values 20, 30, 30**
40 and 50
V Can assume any one of the values 20*
15,20 and 40
----------------------------------------------------------------------------------------
* The most likely values in the case of Q, P and V are the values that
have the highest probability associated with them

** In the case of price, 20 and 30 have the same probability of


occurrence viz., 0.4. We have chosen 30 as the most likely value
because the expected value of the distribution is closer to 30

Sensitivity Analysis with Reference to Q

The relationship between Q and NPV given the most likely values of other
variables is given by
5 [Q (30-20) – 3,000 – 2,000] x 0.5 + 2,000 0
NPV =  + - 30,000
t=1 (1.1)t (1.1)5

5 5Q - 500
=  - 30,000
t=1 (1.1)t

The net present values for various values of Q are given in the following table:

Q 800 1,000 1,200 1,400 1,600 1,800


NPV -16,732 -12,941 -9,150 -5,359 -1,568 2,224

Sensitivity analysis with reference to P

The relationship between P and NPV, given the most likely values of other
variables is defined as follows:

5 [1,400 (P-20) – 3,000 – 2,000] x 0.5 + 2,000 0


NPV =  + - 30,000
t=1 (1.1)t (1.1)5

5 700 P – 14,500
=  - 30,000
t=1 (1.1)t

The net present values for various values of P are given below :
P (Rs) 20 30 40 50
NPV(Rs) -31,896 -5,359 21,179 47,716

8. NPV -5 0 5 10 15 20
(Rs.in lakhs)
PI 0.9 1.00 1.10 1.20 1.30 1.40

Prob. 0.02 0.03 0.10 0.40 0.30 0.15

6
Expected PI = PI =  (PI)j P j
j=1
= 1.24

6
Standard deviation =  (PIj - PI) 2 P j
o f P1 j=1
=  .01156
= .1075
The standard deviation of P1 is .1075 for the given investment with an expected
PI of 1.24. The maximum standard deviation of PI acceptable to the company
for an investment with an expected PI of 1.25 is 0.30.

Since the risk associated with the investment is much less than the maximum
risk acceptable to the company for the given level of expected PI, the company
should accept the investment.

9. Investment A
Outlay : Rs.10,000
Net cash flow : Rs.3,000 for 6 years
Required rate of return : 12%

NPV(A) = 3,000 x PVIFA (12%, 6 years) – 10,000


= 3,000 x 4.11 – 10,000 = Rs.2,333

Investment B
Outlay : Rs.30,000
Net cash flow : Rs.11,000 for 5 years
Required rate of return : 14%
NPV(B) = 11,000 x PVIFA (14%, 5 years) – 30,000
= Rs.7763

10. The NPVs of the two projects calculated at their risk adjusted discount rates are
as follows:
6 3,000
Project A: NPV =  - 10,000 = Rs.2,333
t=1 (1.12)t

5 11,000
Project B: NPV =  - 30,000 = Rs.7,763
t=1 (1.14)t

PI and IRR for the two projects are as follows:

Project A B

PI 1.23 1.26
IRR 20% 24.3%

B is superior to A in terms of NPV, PI, and IRR. Hence the company must
choose B.

Chapter 12

RISK ANALYSIS OF SINGLE INVESTMENTS

1. 2p = wi wj ij i j


2 p = w2121 + w2222 + w2323 + w2424 + w2525
+ 2 w1 w2 12 12 + 2 w1 w3 13 13 + 2 w1 w4 14 14 + 2 w1 w5 15
15 + 2 w2 w3 23 23 + 2 w2 w4 24 24 + 2 w2 w5 25 25 + 2 w3 w4
34 34 + 2 w3 w5 35 35 + 2 w4 w5 45 45

= 0.12 x 82 + 0.22 x 92 + 0.32 x 102 + 0.32 x 162 + 0.12 x 122


+ 2 x 0.1 x 0.2 x 0.1 x 8 x 9 + 2 x 0.1 x 0.3 x 0.5 x 8 x 10
+ 2 x 0.1 x 0.3 x –0.2 x 8 x 16 + 2 x 0.1 x 0.1 x 0.3 x 8 x 12
+ 2 x 0.2 x 0.3 x 0.4 x 9 x 10 + 2 x 0.2 x 0.3 x 0.8 x 9 x 16
+ 2 x 0.2 x 0.1 x 0.2 x 9 x 12 + 2 x 0.3 x 0.3 x0.1 x 10 x 16
+ 2 x 0.3 x 0.1 x 0.6 x 10 x 12 + 2 x 0.3 x 0.1 x 0.1 x 16 x 12
= 66.448
p = (66.448)1/2 = 8.152

2. (i) Since there are 3 securities, there are 3 variance terms and 3 covariance
terms. Note that if there are n securities the number of covariance terms are: 1 +
2 +…+ (n + 1) = n (n –1)/2. In this problem all the variance terms are the same
(2A) all the covariance terms are the same (AB) and all the securities are equally
weighted (wA)
So,
2p = [3 w2A 2A + 2 x 3 AB]
2p = [3 w2A 2A + 6 wA wBAB]
1 2 1 1
=3x x 2A + 6 x x x AB
3 3 3
1 2
= 2A + AB
3 3
(ii) Since there are 9 securities, there are 9 variance terms and 36 covariance
terms. Note that if the number of securities is n, the number of covariance
terms is n(n – 1)/2.
In this case all the variance terms are the same (2A), all the covariance terms are 
1
the same (AB) and all the securities are equally weighted wA
9

So,
n(n-1)
2p = 9 w2A 2A t 2 x wA wBAB
2

1 2 1 1
= 9 x x 2A + 9(8) x x AB
9 9 9
1 72
= 2A + AB
9 81

3. The beta for stock B is calculated below:


Period Return of Return on Deviation of Deviation Product of Square of
stock B, market return on of return the the
RB (%) portfolio, stock B on market deviation deviation
RM (%) from its portfolio (RB – RB) of return
mean from its (RM – RM) on market
(RB - RB) mean portfolio,
(RM – RM) from its
mean
(RM – RM)2
1 15 9 6 -1 -6 1
2 16 12 7 2 14 4
3 10 6 1 -4 -4 16
4 -15 4 -24 -6 144 36
5 -5 16 -14 6 -84 36
6 14 11 5 1 5 1
7 10 10 1 0 0 0
8 15 12 6 2 12 4
9 12 9 3 -1 -3 1
10 -4 8 -13 -2 26 4
11 -2 12 -11 2 -22 4
12 12 14 3 4 12 16
13 15 -6 6 -16 -96 256
14 12 2 3 -8 -24 64
15 10 8 1 -2 -2 4
16 9 7 0 -3 0 9
17 12 9 3 -1 -3 1
18 9 10 0 0 0 0
19 22 37 13 27 351 729
20 13 10 4 0 0 0
180 200 Σ(RB – RB) Σ(RB – RB)2
Σ RB = 180 ΣRM = 200 (RM – RM) = 1186
RB = 9% RM = 10% = 320

Beta of stock B is equal to:

Cov (RB, RM)

2M
Σ (RB - RB) (RM – RM) 320
Cov (RB, RM) = = = 16.84
n –1 19

Σ (RM – RM)2 1186


M =
2
= = 62.42
n –1 19

So the beta for stock B is:


16.84
= 0.270
62.42

4. According to the CAPM, the required rate of return is:


E(Ri) = Rf+ (E(RM – Rf)i

Given a risk-free rate (Rf ) of 11 percent and the expected market risk premium
(E(RM – Rf ) of 6 percent we get the following:
Project Beta Required rate(%) Expected rate (%)
A 0.5 11 + 0.5 x 6 = 14 15
B 0.8 11 + 0.8 x 6 = 15.8 16
C 1.2 11 + 1.2 x 6 = 18.2 21
D 1.6 11 + 1.6 x 6 = 20.6 22
E 1.7 11 + 1.7 x 6 = 21.2 23

a. The expected return of all the 5 projects exceeds the required rate as per the CAPM.
So all of them should be accepted.
b. If the cost of capital of firm which is 16 percent is used as the hurdle rate, project A
will be rejected incorrectly.

5. The asset beta is linked to equity beta, debt-equity ratio, and tax rate as follows:
E
A =
[1 + D/E (1 –T)]

The asset beta of A, B, and C is calculated below:

Firm Asset Beta


1.25
A = 0.49
[1 + (2.25) x 0.7]
1.25
B = 0.48
[1 + (2.00) x 0.7]

1.10
C = 0.45
[1 + (2.1) x 0.7]

0.49 + 0.48 + 0.45


Average of the asset betas of sample firms = = 0.47
3
The equity beta of the cement project is
E = A [ 1 + D/E (1 – T)]
= 0.47 [1 + 2 (1-0.3)] = 1.128

As per the CAPM model, the cost of equity of the proposed project is:
12% + (17% - 12%) x 1.128 = 17.64%

The post-tax cost of debt is:


16% (1 – 0.3) = 11.2%

The required rate of return for the project given a debt-equity ratio of 2:1 is:
1/3 x 17.64% + 2/3 x 11.2% = 13.35%

6. E
A =
[1 + D/E (1 –T)]
E = 1.25 D/E = 1.6 T = 0.3

So, Pariman Company’s asset beta is:


1.25
= 0.59
[1 + 1.6 (0.7)]

7. (a) Asset beta for a petrochemicals project is:

E 1.30
A = =
[1 + D/E ( 1 –T)] [1 + 1.5 (1 –.4)]
= 0.68

The equity beta (systematic risk) for the petrochemicals project of Growmore,
when D/E = 1.25 and T = 0.4, is
0.68 [1 + 1.25 (1 – .4)] = 1.19

(b) The cost of equity for the petrochemicals project is


12% + 1.19 (18% - 12%) = 19.14%
The cost of debt is
12% (1 – 0.4) = 7.2%
Given, a debt – equity ratio of 1.25 the required return for the petrochemicals
project is
1 1.25
19.14% x + 7% x = 12.4%
2.25 2.25

Chapter 13

SPECIAL DECISION SITUATIONS

1. PV Cost
UAE =
PVIFAr,n

Cost of plastic emulsion painting = Rs.3,00,000 Life = 7 years


Cost of distemper painting = Rs. 1,80,000 Life = 3 years
Discount rate = 10%
UAE of plastic emulsion painting = Rs.3,00,000 / 4.868 = Rs.61,627
UAE of distemper painting = Rs.1,80,000 / 2.487 = Rs.72,376

Since plastic emulsion painting has a lower UAE, it is preferable.

2. Present value of the operating costs :


3,00,000 3,60,000 4,00,000 4,50,000 5,00,000
= + + + +
1.13 (1.13)2 (1.13)3 (1.13)4 (1.13)5

= Rs.1,372,013
Present value of salvage value = 3,00,000 / (1.13)5 = Rs.162,828
Present value of costs of internal transportation = 1,500,000 –1,372,013
system – 162,828 = Rs.27,09,185
UAE of the internal transportation system = 27,09,185 / 3.517 = Rs.7,70,311

3. Cost of standard overhaul = Rs.500,000


Cost of less costly overhaul = Rs.200,000
Cost of capital = 14%
UAE of standard overhaul = 500,000 / 3.889 = Rs.128,568
UAE of less costly overhaul = 200,000 / 1.647 = Rs.121,433

Since the less costly overhaul has a lower UAE, it is the preferred alternative

4. The details for the two alternatives are shown below :

Gunning plow Counter plow

1. Initial outlay Rs.2,500,000 Rs.1,500,000


2. Economic life 12 years 9 years
3. Annual operating and maintenance costs Rs.250,000 Rs.320,000
4. Present value of the stream of operating Rs.1,548,500 Rs.1,704,960
and maintenance costs at 12% discount rate
5. Salvage value Rs.800,000 Rs.500,000
6. Present value of salvage value Rs.205,600 Rs.180,500
7. Present value of total costs (1+4-6) Rs.3,842,900 Rs.3,024,460
8. UAE of 7 Rs.3,842,900 Rs.3,024,460
PVIFA (12%,12) PVIFA (12%,9)
= 3,842,900 = 3,024,460
6.194 5.328
= Rs.620,423 = Rs.567,654

The Counter plow is a cheaper alternative

5. The current value of different timing options is given below :

Time Net Future Value Current Value


Rs. in million Rs. in million
0 10 10
1 15 13.395
2 19 15.143
3 23 16.376
4 26 16.536

The optimal timing of the project is year 4.

6. Calculation of UAE (OM) for Various Replacement Periods


(Rupees)
Time Operating Post-tax PVIF Present Cumulative PVIFA UAE
(t) and operating & (12%,t) value present (12%,t) (OM)
maintenance maintenance of (3) value
costs costs
(1) (2) (3) (4) (5) (6) (7) (8)
1 20,000 12,000 0.893 10,716 10,716 0.893 12,000
2 25,000 15,000 0.797 11,955 22,671 1.690 13,415
3 35,000 21,000 0.712 14,952 37,623 2.402 15,663
4 50,000 30,000 0.636 19,080 56,703 3.037 18,671
5 70,000 42,000 0.567 23,814 80,517 3.605 22,335
Calculation of UAE (IO) for Various Replacement Periods
Time (t) Investment Outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.
1 80,000 0.893 89,586
2 80,000 1.690 47,337
3 80,000 2.402 33,306
4 80,000 3.037 26,342
5 80,000 3.605 22,191

Calculation of UAE (DTS) for Various Replacement Periods


Time Depreciation Depreciation PVIF PV of Cumulative PVIFA UAE of
(t) charge R.s. tax shield (12%, t) depreciation present (12%, t) depreciation
tax shield value Rs.. tax shield Rs..
Rs..
(1) (2) (3) (4) (5) (6) (7) (8)
1 20,000 8,000 0.893 7,144 7,144 0.893 8,000
2 15,000 6,000 0.797 4,782 11,926 1.690 7,057
3 11,250 4,500 0.712 3,204 15,130 2.402 6,299
4 8,438 3,375 0.636 2,147 17,277 3.037 5,689
5 6,328 2,531 0.567 1,435 18,712 3.605 5,191

Calculation of UAE (SV) for Various Replacement Periods


Time Salvage PVIF Present value of PVIFA UAE of salvage
value Rs. (12%, t) salvage value Rs. (12%, t) value Rs. (4) / (5)
(1) (2) (3) (4) (5) (6)
1 60,000 0.893 53,580 0.893 60,000
2 45,000 0.797 35,865 1.690 21,222
3 32,000 0.712 22,784 2.402 9,485
4 22,000 0.636 13,992 3.037 4,607
5 15,000 0.567 8,505 3.605 2,359

Summary of Information Required to Determine the Economic Life


Replacement UAE UAE (IO) UAE UAE (SV) UAE UAE
period (OM) Rs. Rs. (DTS) Rs. (CC) Rs. (TC) Rs.
Rs.
(1) (2) (3) (4) (5) (6) (7)
1 12,000 89,586 8,000 60,000 21,586 33,586
2 13,415 47,337 7,057 21,222 19,058 32,473
3 15,663 33,306 6,299 9,485 17,522 33,185
4 18,671 26,342 5,689 4,607 16,046 34,717
5 22,335 22,191 5,190 2,359 14,642 36,977

OM - Operating and Maintenance Costs


IO - Investment Outlay
DTS - Depreciation Tax Shield
SV - Salvage Value
CC - Capital Cost
TC - Total Cost
UAE (CC) = UAE (IO) – [UAE (DTS) + UAE (SV)]
UAE (TC) = UAE (OM) + UAE (CC)
7. Calculation of UAE (OM) for Various Replacement periods
Time O&M costs Post-tax PVIF PV of post- Cumulative PVIFA UAE of
Rs. O&M costs (12%,t) tax O&M present (12%, t) O&M
Rs. costs Rs. value Rs. costs Rs.
(1) (2) (3) (4) (5) (6) (7) (8)
1 800,000 560,000 0.893 500,080 500,080 0.893 560,000
2 1,000,000 700,000 0.797 557,900 1,057,980 1.690 626,024
3 1,300,000 910,000 0.712 647,920 1,705,9000 2.402 710,200
4 1,900,000 1,330,000 0.636 845,880 2,551,780 3.037 840,230
5 2,800,000 1,960,000 0.567 1,111,320 3,663,100 3.605 1,016,117

Calculation of UAE (IO) for Various Replacement Periods


Time Investment outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.
1 4,000,000 0.893 4,479,283
2 4,000,000 1.690 2,366,864
3 4,000,000 2.402 1,665,279
4 4,000,000 3.037 1,317,089
5 4,000,000 3.605 1,109,570

Calculation of UAE (DTS) for Various Replacement Periods


Time Depreciation Depreciaton PVIF PV of Cumulative PVIFA UAE of
(t) charge Rs. tax shield (12%, t) depreciation present (12%, t) depreciation
Rs. tax shield Rs. value Rs. tax shield Rs.
1 1,000,000 300,000 0.893 267,940 267,900 0.893 300,000
2 750,000 225,000 0.797 179,325 447,225 1.690 264,630
3 562,500 168,750 0.712 120,150 567,375 2.402 236,209
4 421,875 126,563 0.636 80,494 647,869 3.037 213,325
5 316,406 94,922 0.567 53,821 701,690 3.605 194,643

Calculation of UAE (SV) for Various Replacement Peiods


Time Salvage PVIF Present value of PVIFA UAE of salvage
value Rs. (12%, t) salvage value Rs. (12%, t) value Rs. (4)/ (5)
(1) (2) (3) (4) (5) (6)
1 2,800,000 0.893 267,900 0.893 2,800,000
2 2,000,000 0.797 1,594,000 1.690 943,195
3 1,400,000 0.712 996,80 2.402 414,988
4 1,000,000 0.636 636,000 3.037 209,417
5 800,000 0.567 453,600 3.605 125,825

Summary of Information Required to Determine the Economic Life


Replacement UAE UAE (IO) UAE UAE (SV) UAE (CC) UAE (TC)
period (OM) Rs. (DTS)
Rs. Rs. Rs. Rs. Rs.
1 560,000 4,479,283 300,000 2,800,000 (-)1,379,283 -819,283
2 626,024 2,366,864 264,630 943,195 1,159,039 1,785,063
3 710,200 1,665,279 236,209 414,988 1,014,082 1,724,282
4 840,230 1,317,089 213,325 209,417 894,347 1,734,577
5 1,016,117 1,109,570 194,643 125,825 789,102 1,805,219
The economic life of the well-drilling machine is 3 years

8. Adjusted cost of capital as per Modigliani – Miller formula:


r* = r (1 – TL)
r* = 0.16 (1 – 0.5 x 0.6)
= 0.16 x 0.7 = 0.112
Adjusted cost of capital as per Miles – Ezzell formula:
1+r
*
r = r – LrDT
1 + rD
1 + 0.16
= 0.16 – 0.6 x 0.15 x 0.5 x
1 + 0.15
= 0.115

9.
a. Base case NPV = -12,000,000 + 3,000,000 x PVIFA (20%, b)
= -12,000,000 + 3,000,000 x 3,326
= - Rs.2,022,000

b. Adjusted NPV = Base case NPV – Issue cost + Present value of tax shield.
Term loan = Rs.8 million Equity finance = Rs.4 million
Issue cost of equity = 12%
Rs.4,000,000
Equity to be issued = = Rs.4,545,455
0.88
Cost of equity issue = Rs.545,455

Computation of Tax Shield Associated with Debt Finance


Year (t) Debt outstanding Interest Tax shield Present value of
at the beginning tax shield
Rs. Rs. Rs. Rs.
1 8,000,000 1,440,000 432,000 366,102
2 8,000,000 1,440,000 432,000 310,256
3 7,000,000 1,260,000 378,000 230,062
4 6,000,000 1,080,000 324,000 167,116
5 5,000,000 900,000 270,000 118,019
6 4,000,000 720,000 216,000 80,013
1,271,568

Adjusted NPV = - Rs.2,022,000 – Rs.545,455 + Rs.1,271,568


= - Rs.1,295,887
Adjusted NPV if issue cost alone is considered = Rs.2,567,455
Present Value of tax shield of debt finance = Rs.1,271,568

10.
a. Base Case NPV = - 8,000,000 + 2,000,000 x PVIFA (18%, 6)
= - 8,000,000 + 2,000,000 x 3,498
= - Rs.1,004,000

b. Adjusted NPV = Base case NPV – Issue cost + Present value of tax shield.
Term loan = Rs.5 million
Equity finance = Rs.3 million
Issue cost of equity = 10%
Rs.3,000,000
Hence, Equity to be issued = = Rs.3,333,333
0.90
Cost of equity issue = Rs.333,333

Computation of Tax Shield Associated with Debt Finance


Year Debt outstanding at the Interest Tax shield Present value of tax
beginning shield

1 Rs.5,000,000 Rs.750,000 Rs.300,000 Rs.260,869


2 5,000,000 750,000 300,000 226,843
3 4,000,000 600,000 240,000 157,804
4 3,00,000 450,000 180,000 102,916
5 2,000,000 300,000 120,000 59,66
6 1,000,000 150,000 60,000 25,940
843,033

Adjusted NPV = - 1004000 – 333333 + 834033 = - Rs.503,300


Adjusted NPV if issue cost of external
equity alone is adjusted for = - Rs.1,004000 – Rs.333333
= Rs.1337333

c. Present value of tax shield of debt finance = Rs.834,033

11. Adjusted cost of capital as per Modigliani – Miller formula:


r* = r (1 – TL)
r* = 0.19 x (1 – 0.5 x 0.5) = 0.1425 = 14.25%

Adjusted cost of capital as per Miles and Ezzell formula:


1+r
*
r = r – LrDT
1 + rD
1 + 0.19
= 0.19 – 0.5 x 0.16 x 0.5 x
1 + 0.16
= 0.149 = 14.9%

12. S0 = Rs.46 , rh = 11 per cent , rf = 6 per cent


Hence the forecasted spot rates are :

Year Forecasted spot exchange rate


1 Rs.46 (1.11 / 1.06)1 = Rs.48.17
2 Rs.46 (1.11 / 1.06)2 = Rs.50.44
3 Rs.46 (1.11 / 1.06)3 = Rs.52.82
4 Rs.46 (1.11 / 1.06)4 = Rs.55.31
5 Rs.46 (1.11 / 1.06)5 = Rs.57.92

The expected rupee cash flows for the project

Year Cash flow in dollars Expected exchange Cash flow in rupees


(million) rate (million)
0 -200 46 -9200
1 50 48.17 2408.5
2 70 50.44 3530.8
3 90 52.82 4753.8
4 105 55.31 5807.6
5 80 57.92 4633.6

Given a rupee discount rate of 20 per cent, the NPV in rupees is :

2408.5 3530.8 4753.8


NPV = -9200 + + +
(1.18)2 (1.18)3 (1.18)4
5807.6 4633.6
+ +
(1.18)5 (1.18)6

= Rs.3406.2 million

The dollar NPV is :


3406.2 / 46 = 74.05 million dollars

Chapter 14

SOCIAL COST BENEFIT ANALYSIS


1. Social Costs and Benefits

Nature Economic Explanation


value (Rs
in million)
Costs
1. Construction cost One- 400
shot
2. Maintenance cost Annual 3
Benefits
3. Savings in the operation Annual 40
cost of existing ships
4. Increase in consumer Annual 3.6 The number of passenger hours
satisfaction saved will be : (75,000 x 2 +
50,000 + 50,000 x 2) = 600000.
Multiplying this by Rs.6 gives
Rs.3.6 million

The IRR of the stream of social costs and benefits is the value of r in the
equation

50 40 + 3.6 – 3.0 50 40.6


400 =  = 
t
t=1 (1+r) t=1 (1+r)t

The solving value r is about 10.1%

2. Social Costs and Benefits


Costs
Decrease in customer satisfaction as reflected Rs.266,667
in the opportunity cost of the extra time taken
by bus journey
800 x (2/3) x 250 x Rs.2

Benefits
1. Resale value of the diesel train (one time) Rs.240,000
2. Avoidance of annual cash loss Rs.400,000
Fare collection = 1000 x 250 x Rs.4
= Rs.1,000,000
Cash operating expenses = Rs.1,400,000
3. The social costs and benefits of the project are estimated below:
Rs. in
million
Costs & Benefits Time Economic Explanation
value
1. Construction cost 0 24
2. Land development cost 0 150
3. Maintenance cost 1-40 1
4. Labour cost 0 40 This includes the cost of
transport and rehabilitation
5. Labour cost 1-40 12 The shadow price of labour
equals what others are willing
to pay.
6. Decrease in the value of the timber 2-40 4
output
Benefits
7. Savings in the cost of shipping the 1-40 0.5
agriculture produce
8. Income from cash crops 1-5 10
9. Income from the main crop 6-40 50
10. Increase in the value of timber output 1 20

Assuming that the life of the road is 40 years, the NPV of the stream of social costs and benefits
at a discount rate of 10 percent is:

40 1 + 12 40 4
NPV = - 24 - 150 - 40 -  - 
t=1 (1.1)t t=2 (1.1)t

40 0.5 5 10 40 50 20
+     
t=1 (1.1)t t=1 (1.1)t t=6 (1.1)t (1.1)1
= - Rs.9.93 million
4.
Table 1
Social Costs Associated with the Initial Outlay

Rs. in
million
Item Financia Basis of Tradeable value T L R
l cost conversion ab initio
Land 0.30 SCF = 1/1.5 0.20
Buildings 12.0 T=0.50, L=0.25 6.0 3.0 3.0
R=0.25
Imported equipment 15.0 CIF value 9.0
Indigeneous equipment 80.0 CIF value 60.0
Transport 2.0 T=0.65, L=0.25 1.3 0.5 0.2
R=0.10
Engineering and know-how 6.0 SCF=1.5 9.0
fees
Pre-operative expenses 6.0 SCF=1.0 6.0
Bank charges 3.7 SCF=0.02 0.074
Working capital 25.0 SCF=0.8 20.0
requirement
150.0 104.274 7.3 3.5 3.2

Table 2
Conversion of Financial Costs into Social Costs
Rs. in
million
Item Financia Basis of Tradeable value T L R
l cost conversion ab initio
Indigeneous raw material 85 SCF=0.8 68
and stores
Labour 7 SCF=0.5 3.5
Salaries 5 SCF=0.8 4.0
Repairs and maintenance 1.2 SCF=1/1.5 0.8
Water, fuel, etc 6 T=0.5, L=0.25 3 1.5 1.5
R=0.25
Electricity (Rate portion) 5 T=0.71, L=0.13 3.55 0.65 0.8
R=0.16
Other overheads 10 SCF=1/1.5 6.667
119.2 82.967 6.55 2.15 2.3

As per table 1, the social cost of initial outlay is worked out as follows :
Rs. in million
Tradeable value ab initio 104.274
Social cost of the tradeable component 4.867
(7.3 / 1.5)
Social cost of labour component 1.75
(3.5 x 0.5)
Social cost of residual component 1.60
(3.2 x 0.5)
Total 112.491

As per Table 2, the annual social cost of operation is worked out as follows :

Tradeable value ab initio 82.967


Social cost of the tradeable component 4.367
( 6.55 x 1/1.5 )
Social cost of labour component 1.075
(2.15 x 0.5)
Social cost of residual component 1.150
(2.3 x 0.5)
Total 89.559

The annual CIF value of the output is Rs.110 million. Hence the annual social
net benefit will be : 110 – 89.559 = Rs.20.441 million
Working capital recovery will be Rs.20 million at the end of the 20th year.

Putting the above figures together the social flows associated with the project
would be as follows :

Year / ’s Social flow (Rs. in million)


0 -112.491
1-19 20.441
Chapter 15

MULTIPLE PROJECTS AND CONSTRAINTS

1. The ranking of the projects on the dimensions of NPV, IRR, and BCR is given below
Project NPV (Rs.) Rank IRR (%) Rank BCR Rank
M 60,610 3 34.1 2 2.21 1
N 58,500 4 34.9 1 1.59 3
O 40,050 5 18.6 4 1.33 5
P 162,960 1 26.2 3 2.09 2
Q 72,310 2 14.5 5 1.36 4

2. The ranking of the projects on the dimensions of NPV and BCR is given below
Project NPV (Rs.) Rank BCR Rank
A 61,780 5 1.83 2
B 208,480 2 1.52 3
C 315,075 1 2.05 1
D 411,90 6 1.14 6
E 95,540 4 1.38 4
F 114,500 3 1.23 5

3. The two hypothetical projects are:

A B
Initial outlay 10000 1000
Cash inflows
Year 1 5000 600
Year 2 5000 600
Year 3 5000 600

NPV @ 10% Rank IRR Rank


A 2435 1 about 23% 2
B 492 2 above 35% 1

4. The two hypothetical 4-year projects for which BCR and IRR criteria give different
rankings are given below
Project A B
Investment outlay 20000 20000
Cash inflow
Year 1 2000 8000
Year 2 2000 8000
Year 3 2000 8000
Year 4 31500 8000
Project NPV Rank IRR Rank
A 4822 1 19% 2
B 4296 2 about 22% 1

5. The NPVs of the projects are as follows:


NPV (A) = 6000 x PVIFA(10%,5) + 5000 x PVIF(10%,5) – 20,000 = Rs.5851
NPV (B) = 8000 x PVIFA(10%,8) – 50,000 = - Rs.840
NPV (C) = 15,000 x PVIFA(10%,8) – 75,000 = Rs.5025
NPV (D) = 15,000 x PVIFA(10%,12) – 100,000 = Rs.6,995
NPV (E) = 25,000 x PVIFA (10%,7) + 50,000 x PVIF(10%,7)
– 150,000 = Rs.2,650

Since B and E have negative NPV, they are rejected. So we consider only A, C,
and D. Further C and D are mutually exclusive. The feasible combinations, their
outlays, and their NPVs are given below.

Combination Outlay NPV


(Rs.) (Rs.)
A 20,000 5,851
C 75,000 5,025
D 100,000 6,995
A& C 95,000 10,876
A&D 120,000 12,846

The preferred combination is A & D.

6. The linear programming formulation of the capital budgeting problem under various
constraints is as follows:
Maximise 10 X1 + 15 X2 + 25 X3 + 40 X4 + 60 X5 + 100 X6
Subject to
15 X1 + 12 X2 + 8 X3 + 35 X4 + 100 X5
+ 50 X6 + SF1 = 150 Funds constraint for year 1

5 X1 + 13 X2 + 40 X3 + 25 X4 + 10 X5
+ 110 X6 ≤ 200 + 1.08 SF1 Funds constraint for year 2

5 X1 + 6 X2 + 5 X3 + 10 X4 + 12 X5
+ 40 X6 ≤ 60 Power constraint

15 X1 + 20 X2 + 30 X3 + 35 X4 + 40 X5
+ 60 X6 ≤ 120 Managerial constraint
0 ≤ Xj ≤ 1 (j = 1,….8) and SF1 ≥ 0
Rupees are expressed in ’000s. Power units are also expressed in ’000s.

7. Given the nature of the problem, in addition to the decision variables X1 through X10
for the original 10 projects, two more decision variables are required as follows:

X11 is the decision variable to represent the delay of projects 8 by one year
X12 is the decision variable for the composite project which represents the
combination of projects 4 and 5.
The integer linear programming formulation is as follows:

Maximise 55 X1 + 75 X2 + 50 X3 + 60 X4 + 105 X5 + 12 X6 + 60 X7 + 120 X8


+ 50 X9 + 40 X10 + 100 X11+ 178.2 X12
Subject to 75 X1 + 80 X2 + 75 X3 + 35 X4 + 80 X5 + 20 X6 + 70 X7 + 155 X8 +
55 X9 + 10 X10 + 109.3 X12 + SF1 = 400

40 X1 + 85 X2 + 8 X3 + 100 X4 + 160 X5 + 9 X6 + 5 X7 + 100 X8 + 20


X9 + 90 X10 + 155 X11+ 247 X12 + SF2 = 350 + SF1 (1 + r)

X3 + X7 ≥1
X5 + X8 + X9 + X10 ≥2
X2 ≤ X6
X8 ≤ X9
X4 + X5 + X12 ≤1
X8 + X11 ≤1

Xj = {0,1} j = 1, 2….12
SFi ≥ 0 i = 1, 2

It has been assumed that surplus funds can be shifted from one period to the next
and they will earn a post-tax return of r percent.
– – – – – – – +
8. Minimise [P1(3d1+ 2 d 2 + d 3) + P 2 (4 d 4 + 2 d 5 + d 6) + P 3 (d 7 – d 7 )]

Subject to:
Economic Constraints
12 X1 + 14 X2 + 15 X3 + 16 X4 + 11 X5 + 23 X6 + 20 X7 ≤ 65

Goal Constraints

1.2 X1 + 1.6 X2 + 0.6 X3 + 1.5 X4 + 0.5 X5


– +
+ 0.9 X6 + 1.8 X7 + d 1 – d 1 = 6 Net income for year 1
1.1 X1 + 1.2 X2 + 1.2 X3 + 1.6 X4 + 1.2 X5
– +
+ 2.5 X6 + 2.0 X7 + d 2 – d 2 = 8 Net income for year 2

1.6 X1 + 1.5 X2 + 2.0 X3 + 1.8 X4 + 1.5 X5


– +
+ 4.0 X6 + 2.2 X7 + d 3 – d 3 = 10 Net income for year 3

1.0 X1 + 1.2 X2 + 0.5 X3 + 1.8 X4 + 0.6 X5


– +
+ 1.0 X6 + 2.0 X7 + d 4 – d 4 = 6 Sales growth for year 1

1.5 X1 + 1.0 X2 + 1.2 X3 + 2.0 X4 + 1.4 X5


– +
+ 3.0 X6 + 3.0 X7 + d 5 – d 5 = 8 Sales growth for year 2

1.8 X1 + 1.2 X2 + 2.5 X3 + 2.2 X4 + 1.8 X5


– +
+ 3.5 X6 + 3.5 X7 + d 6 – d 6 = 10 Sales growth for year 3

4 X1 + 5 X2 + 6 X3 + 8 X4 + 4 X5
– +
+ 9 X6 + 7 X7 + d 7 – d 7 = 50 NPV
– +
Xj  0 d i, d i  0

9. The BCRs of the projects are converted into NPVs as of now as follows

Project Outlay (Rs.) BCR NPV (Rs.)


1 800,000 1.08 64,000
2 200,000 1.35 70,000
3 400,000 1.20 80,000
4 300,000 1.03 9,000
5 200,000 0.98 - 4,000
6 500,000 1.03 15,000/1.10 = 13,636
7 400,000 1.21 84,000/1.10 = 76,364
8 600,000 1.17 102,000/1.10 = 92,727
9 300,000 1.01 3,000/1.10 = 2,727

The integer linear programming formulation of the problem is as follows :

Maximise 64,000 X1 + 70,000 X2 + 80,000 X3 + 9,000 X4 + 13,636 X6


+ 76,364 X7 + 92,727 X8 + 2,727 X9
Subject to
800,000 X1 + 200,000 X2 + 400,000 X3 + 300,000 X4 + SF1 = 20,00,000
500,000 X6 + 400,000 X7 + 600,000 X8 + 300,000 X9 ≤ 500,000 + SF1 (1.032)

Xj = {0,1} j = 1, 2, 3, 4, 6, 7, 8, 9

Chapter 22

NETWORK TECHNIQUES FOR PROJECT MANAGEMENT


2. The net work diagram with the earliest and latest occurrence times for each event is
shown in Exhibit 1.

Exhibit 1
Network for the Project

2 1 5
4 4 11 11

4 5
2 3

1 3 4 5 7
0 0 9 9 14 14

2 6

3
2 3

There are two critical paths: 1-2-4-5-7 and 1-2-4-7. The minimum time required
for completing the project is 14 weeks.

3. The time estimates for various activities are shown in Exhibit 2.

Exhibit 2
Time Estimates

Activity Optimistic to Most likely tm Pessimistic tp Average


to + 4 tm + tp
te =
6
1-2 4 6 10 6 1/3
1-3 3 7 12 7 1/6
1-4 5 6 9 6 1/3
1-7 2 4 6 4
2-4 6 10 20 11
2-6 3 4 7 4 1/3
2-7 5 9 15 9 1/3
3-4 3 7 12 7 1/6
4-5 2 4 5 3 5/6
5-6 1 3 6 3 1/6
3-7 2 5 8 5
6-7 1 2 6 2 1/2

(a) The network diagram with average time estimates is shown in Exhibit 3.

Exhibit 3

2
6⅓ 6⅓ EOT LOT

11 4⅓ 9⅓

6⅓

3⅚ 3⅙
4 5 6
17 ⅓ 17⅓ 21 ⅓ 21 ⅓ 24 ⅓ 24 ⅓

7⅙
6⅓

3
7⅙ 10 ⅙ 2½

7⅙

1 4 7
0 0 26 ⅚ 26 ⅚

(b) The critical path for the project is 1-2-4-5-6-7


(c) Exhibit 3 shows the event slacks.

Exhibit 3
Event slacks
Event LOT EOT Slack = LOT – EOT
1 0 0 0
2 6 1/3 6 1/3 0
3 10 1/6 7 1/6 3
4 17 1/3 17 1/3 0
5 21 1/6 21 1/6 0
6 24 1/3 24 1/3 0
7 26 5/6 26 5/6 0

Exhibit 4 shows the activity floats

Exhibit 4
Activity Floats
Activity Duration Total Float Free Float Independent Float
(i –j) dij LOT(j) – EOT(i) – dij EOT(j) – EOT(i) – dij EOT(j) – LOT (i) – dij
1-2 6 1/3 0 0 0
1-3 7 1/6 3 0 0
1-4 6 1/3 11 11 11
1-7 4 22 5/6 22 5/6 22 5/6
2-4 11 0 0 0
2-6 4 1/3 13 2/3 13 2/3 13 2/3
2-7 9 1/3 11 1/6 11 1/6 11 1/6
3-4 7 1/6 3 3 0
3-7 5 14 2/3 14 2/3 11 2/3
4-5 3 5/6 0 0 0
5-6 3 1/6 0 0 0
6-7 2 1/2 0 0 0

(d) Standard deviation of the critical path duration = [Sum of the variances of activity
durations on the critical path]1/2
The variances of the activity durations on the critical path are shown in Exhibit 5.

Exhibit 5
Variances of Activity Durations on critical path
Activity tp to tp – to 2
 =
6
1-2 10 4 1.00 1.00
2-4 12 6 1.00 1.00
4-5 5 2 0.50 0.25
5-6 6 1 0.83 0.69
6-7 6 1 0.83 0.69
The standard deviation of the duration of critical path is:
= (1.00 + 1.00 + 0.25 + 0.69 + 0.69)1/2
= (3.63)1/2
= 1.91 weeks.
(e) Let D = specified completion date
T = mean of the critical path duration
c = standard deviation of the critical path duration

T = sum of the mean values of the activity durations on the critical path
= 6 1/3 + 9 2/3 + 3 5/6 + 3 1/6 + 2 ½
= 25 ½

D–T 30 – 25.5
Prob (D< 30) = Prob < = Prob [ Z < 2.356]
c 1.91

= 0.87

4. (a) The net work diagram is given in Exhibit 6.

Exhibit 6
Network Diagram

10 7

2 6 4 9 7

5 7 6

1 4 3 12 5 12 9

(b) The all-normal critical paths are 1-2-4-6-7-9 and 1-3-4-6-7-9. For all-normal
network, the project duration is 34 weeks and the total direct cost is
Rs.66,000.
(c) The time-cost slope of the activities constituting the project is given in
Exhibit 7.
Exhibit 7
Time-Cost Slope of Activities
Time Cost (Rs.) Cost to expedite per
in weeks week (Rs.)
(1) (2) (3) (4) (5) (6)
Activity Normal Crash Normal Crash [(5)-(4) (2)-(3)]
(1-2) 5 2 6,000 9,000 1,000
(2-4) 6 3 7,000 10,000 1,000
(1-3) 4 2 1,000 2,000 500
(3-4) 7 4 4,000 8,000 1333.35
(4-7) 9 5 6,000 9,200 800
(3-5) 12 3 16,000 19,600 400
(4-6) 10 6 15,000 18,000 750
(6-7) 7 4 4,000 4,900 300
(7-9) 6 4 3,000 4,200 600
(5-9) 12 7 4,000 8,500 900

Examining the time-cost slope of activities on the critical path, we find that
activity (6-7) has the lowest slope on both the critical paths. The project network after
crashing this activity is shown below in Exhibit 8.

Exhibit 8
6

10 4

2 6 4 9 7

5 7 6

1 4 3 12 5 12 9

As per Exhibit 8, the critical paths are (1-3-4-6-7-9) and (1-2-4-6-7-9) with a
length of 31 weeks and the total cost is Rs.66,900.
Looking at the time-cost slope of the activities on the critical paths (1-3-4-6-7-9)
and (1-2-4-6-7-9), we find that activities (1-3) and (7-9) have the least time-cost slopes
on the two critical paths respectively. The project net work after crashing these
activities is shown in Exhibit 9.

Exhibit 9
6
10 4

2 6 4 9 7

5 7 4

1 2 3 12 5 12 9

As per Exhibit 9, the critical path is (1-2-4-6-7-9) with a length of 29 weeks and
the total direct cost is Rs.(66,900 + 2,200) = Rs.69,100. Activity (4-6) has the least
time-cost slope on the critical path. Hence this is crashed the net work after crashing
(4-6) is shown in Exhibit 10.

Exhibit 10
6

6 4

2 6 4 9 7

5 7 4

1 2 3 12 5 12 9

As per Exhibit 10, the critical path is (1-3-5-9), with a length of 26 weeks, and
total direct costs of Rs.72,100. Looking at the time-cost slope of the non-crashed
activities on this path we find that activity (3-5) has the lowest slope. Hence it is
crashed. The project net work after such crashing is shown in Exhibit 11.

Exhibit 11
6

6 4

2 6 4 9 7

5 7

1 2 3 3 5 12 9

As per Exhibit 11, the critical path is (1-2-4-6-7-9), with a length of 25 weeks
and a total direct cost of Rs.75,700.
Looking at the time cost slope of the activities on this critical path, we find both
activities (1-2) and (2-4) have the same slope. We crash activity (2-4). The resulting
project network net work is given in Exhibit 12.

Exhibit 12

6 4

2 3 4 9 7

5 7

1 2 3 3 5 12 9

As per Exhibit 12, the critical path is (1-3-4-6-7-9), with a length of 23 weeks
and a total direct cost of Rs.78,700. Crashing activity (3-4), the only uncrashed activity
on this critical path, we get the net work shown in Exhibit 13.
Exhibit 13
6
6 4

2 3 4 9 7

5 4 4

1 2 3 3 5 12 9

As per Exhibit 13, the critical path is (1-2-4-6-7-9), with a length of 22 weeks
and a total direct cost of Rs.82,700. The only uncrashed activity on this critical path is
(1-2). Crashing this we get Exhibit 14.

Exhibit 14

6 4

2 3 4 9 7

2 4 4

1 2 3 3 5 12 9

As per Exhibit 14, the critical path is (1-3-4-6-7-9) with a duration of 20 weeks,
and a total direct cost of Rs.85,700. Since all activities on this path are crashed, there is
no possibility of further time reduction.
Exhibit 15 shows the time-cost relationship.

Exhibit 15
Project Duration and Total Cost
Exhibit Activities Crashed Project Total Total Total cost
duration direct indirect (Rs.)
(in weeks) cost cost
(Rs.) (Rs.)
6 none 34 66,000 34,000 1,00,000
8 (6-7) 31 66,900 31,000 97,900
9 (6-7), (1-3) and (7-9) 29 69,100 29,000 98,100
10 (6-7), (1-3), (7-9) and (4-6) 26 72,100 26,000 98,100
11 (6-7), (1-3), (7-9), (4-6) and (3-5) 25 75,700 25,000 1,00,700
12 (6-7), (1-3), (7-9), (4-6), (3-5) and (2-4) 23 78,900 23,000 1,01,700
13 (6-7), (1-3), (7-9), (4-6), (3-5), (2-4) and (3-4) 22 80,500 22,000 1,02,500
14 (6-7), (1-3), (7-9), (4-6), (3-5), (2-4), (3-4) and 20 83,500 20,000 1,03,500
(1-2)

If the objective is to minimise the total cost of the project, the pattern to crashing
suggested by Exhibit 10 may appear as the best. However, it is possible to reduce the
cost further without increasing the project duration beyond 26 weeks by decrashing
some activities on the non-critical paths. To do so, begin with the activity which has the
highest time-cost slope and proceed in the order of decreasing time-cost slope.

You might also like