TYBAF Financial Management SEM V

CHAPTER NO.2 CAPITAL BUDGETING

❖ Methods of Capital Budgeting

1. Pay Back Period :-
Under this Method the no. of years taken to recover the original investment is calculated. This period
is called as Pay Back Period.

When Cash Inflow is Constant:-

When Cash Inflow is Fluctuable:-

Note: - Lower the payback period better option.

2. Pay Back Profitability :-
Under this method the total cash Inflows over the life of the assets. This Compare with Outflow.
Thus,
Pay Back Profitability = Total Inflow – Total Outflow
Note:- Higher the Pay Back Profitability better the option.

3. Accounting Rate of Return :-

Under this method the business profit is converted into the % of earnings over the Investment.

ARR =

ARR =

Average Investment =

Note: - Higher the ARR better the Option.

4. Net Present Value :-

Under this method the future cash inflows are discounted to calculate the present Value of Future
cash Inflow. Thus, Considering the Time Value of Money future inflow gets converted into Present
Value of Inflow which is compared with Present Value of Cash Outflow to determine the Profit &
Loss.
NOTE: - NPV – Positive – Accepted
NPV – Negative – Rejected

5. Profitability Index Method / Benefit Cost Method :-

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TYBAF Financial Management SEM V

Note :- PI – If more than 1 time – Accepted

PI – If more than 1 time – Rejected
6. Rate of Return / Internal Rate of Return/ Yield to Investment/ Marginal Efficiency of Capital
:-
IRR is the rate of Discounting where NP value is Zero.
Total Present Value / Cash Inflow = Outflow
Note: - Higher IRR – Accepted
Lower IRR – Rejected

7. Discounted Pay Back Period:-

It is same as Pay Back Period Method but Pay back is calculated on the basis of Present Value.

❖ Cash Outflow :-
The Scrape value of assets at the end of the life (New Machine) is considered as a cash inflow.
If any Working Capital involved at the beginning of the project, it gets realized at the end of the
project. It considered as a Cash Inflow.
NOTE:-
Working Capital is realized only if provided in the problem.
Format of Capital Budgeting:-

Sales
(-)Variable Cost
Contribution
(-) Fixed Cost__
EBDT
(-) Depreciation
EBT
(-) Tax_______
EAT
(+)Depreciation
Cash Inflow

Illustration 1:
Mimosa company ltd. has invested in a machine at cost of Rs. 9,00,000. Following details are estimated:
Retrenchment in staff 4 staff @ salary of Rs. 20,000.
Additional staff required 1 staff @ salary of Rs. 40,000.
Savings in wastage Rs. 40,000
Saving in maintenance Rs. 10,000
Additional electricity bill Rs. 15,000
Calculate: Payback period. Ignore taxation and depreciation.
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TYBAF Financial Management SEM V
Illustration 2:
Calculate payback period from the following information of safer Ltd.
Investment Rs. 1 Lakh
Estimated life 10 Yrs.
Tax rate 50%

Year Profit Before Depreciation Depreciation Profit After Depreciation Tax @ 50%
(Rs) (Rs) (Rs)

1 40,000 10,000 30,000 15,000

2 60,000 10,000 50,000 25,000
3 50,000 10,000 40,000 20,000
4 50,000 10,000 40,000 20,000

Illustration 3:
If the net cash outlay of an investment project is Rs. 30,000 and the annual cash inflow for 5 yrs. are Rs.
9000; Rs.12000; Rs.8000; Rs.4000 and Rs.5000 respectively. Calculate the payback period for victor Ltd
Illustration 4: Excel trading Co. Ltd. is considering the purchase of a new machine for the immediate
expansion programme. There are three types of machines in the market for this purpose. Their details are as
follows:

Particulars Machine A Machine B Machine C

Rs. Rs. Rs.

Cost of machine 17,500 12,500 9,000

Estimated saving in scrap 400 750 250
Estimated saving in direct wages per year 2,750 6,000 2,250
Additional cost of indirect materials per year. - 400 -
Expected saving in indirect material per annum. 100 - 250
Additional cost of maintenance per year. 750 550 500
Additional cost of supervision. - 800 -
Estimated life of Machine (yrs). 10 6 5

Taxation at 40% of profit

You are required to advise the management which type of machine should be purchased on the basis of
payback period

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TYBAF Financial Management SEM V
Illustration 5:
Jugnu company ltd. is proposing to expand its production. It can go in for a standard machine costing Rs.
50,000 or an assembled machine costing Rs. 50,000. The life of both these machine is 5 years. The annual
sales and cost are as below:

Standard Assembled
(Rs) (Rs)
Sales 50,000 50,000
Materials 15,000 15,000
Labour 7,000 6,000
Variable overheads 7,000 6,000
Compute the comparative profitability of the proposals under the payback period. Also calculate the
payback profitability. Ignore taxation and depreciation.
Illustration 6:
Alpha Ltd. is producing articles mostly on hand labour and is considering to replace it by a new machine.
There are two alternative models P and Q of the new machine. Prepare a statement of profitability showing
the pay-back period from the following information:

Machine P Machine Q
Estimated life of Machine 4 years 5 years
Rs. Rs.
Cost of machine 9,000 18,000
Estimated saving in scrap 500 800
Estimated saving in direct wages 6,000 8,000
Additional cost of maintenance per year. 800 1,000
Additional cost of supervision. 1,200 1,800
Ignore taxation and depreciation. Also calculate the payback profitability
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llustration 7: From the following details of omega Ltd. calculate payback period and payback profitability.
Sales 8,000
Variable cost 3,000
Fixed cost 2,000
Investment 10,000
Life 10 years. Tax @50%.
Illustration 8: Charlie company Ltd. wishes to buy a machine costing Rs. 2,00,000. The life of this machine
is 10 years and its scrap value would be Rs.5000.
The following details are provided:
Average annual NPBT Rs. 20,000
Tax rate 35%
Depreciation ( already charged) SLM basis
i. Payback period.
ii. Payback profitability
iii. A. R. R. [Accounting Rate of Return Method]
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TYBAF Financial Management SEM V
Illustration 9: The directors of delta India Ltd. are considering the purchase of a machine to replace a
machine which has been in operation for the last 5 years. The details relating to the available alternative
machine are as follows:

Old machine New machine

Rs. Rs.
Purchase price 2,00,000 3,00,000
Power per year 10,000 22,500
Consumable stores per year 30,000 37,500
Other charges per year 40,000 45,000
Wages per running hour 15 26.25
Selling price per unit 6.25 6.25
Material cost per unit 2.50 2.50
Estimated life of machine 10yrs. 10yrs.
Machine running hrs. per year 2,000 hrs. 2,000 hrs.
Units of output per hour 24 units 36 units
Tax at 40% of net profit
Assuming that the above sales and cost of sales hold good for the entire economic life of the machines,
suggest which of the two alternatives should be preferred; using Average Rate of Return (ARR).
Depreciation has to be charged according to straight line method.

Illustration 10: Determine the (1) pay back period and (2) A.R.R. from the following information of a
proposed project of Aaj Tak Ltd.

Rs.
Cost 5,20,000
Annual Profit After Tax And Depreciation
Year 1
30,000
2
50,000
3
70,000
4
90,000
5
1,10,000
Total
3,50,000
Estimated life= 5 years
Estimated scrap value= Rs. 20,000.

PART II CAPITAL RAITIONING

Q.1 Venture Ltd has 30 lakh available for investment in capital projects. It has the option of making
investment in proportion A ,B ,C and D Each projects is entirely independent from each other and having
useful life of 5 years. The expected present value of cash flow from the project is as follow:-

Projects Initial Outlay Present Value of cash Flow

A 800000 1000000
B 1500000 1900000
C 700000 1140000
D 1300000 2000000
From the above data given please explain that which of the above investment should be undertaken.
Assuming that the cost of capital is 12% and risk free interest rate is 10% per annum.
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Q.2 The total budget for the company is Rs.20lacs The project have been ranked in order of profitability

Project Cost (In Lac) Profitability Index

M 6 1.50
N 5 1.25
O 7 1.20
P 2 1.15
Q 5 1.10
R 13 1.40
Calculate :-

1. Cash inflow for each of the project

2. Net present value for each of the project

Which project should be undertaken by the company in order to maximize the Net Present Value under
capital rationing assuming that the each project is indivisible?

Q.3 RDS Ltd furnishes the following:-

Investment limit is up to 70 lacs Project Initial Outlay(in Lac) NPV (In Lac)
P 50 20
Q and R mutually exclusive none of Q 10 9
projects can be delayed or undertaken R 35 7.2
more than more. Suggest more feasible S 32 6.4
combination.

Q.4 Jack and Jill Ltd furnishes that

following information Project Initial Outlay (Rs in Lac) NPV( Rs in Lac)
Investment Limit: - Rs.70000000 M 340 26.7
N 280 36.7
Rank them on PI and select them. Also O 300 38.8
determine the aggregate NPV for the P 320 70.6
selected projects. All projects are
divisible. I.e. size of the investment can be reduced if necessary in relation to the availability of funds, none
of the project can be delayed and undertaken more than once.

Q.5 The following investment proposals are competing for selection. The PI of each of these proposals
given

Proposal P Q R S
Initial Outlay 25 35 40 30
PI 1.13 1.11 1.15 1.08
If a budgeted fund is Rs.60000 select the most profitable projects.

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TYBAF Financial Management SEM V
PART III Capital Budgeting (Uncertainty)
Illustration 1: (Risk Adjusted Discounted Rate)

Calculate NPV using PADR for an investment project having following cash inflow

Year 1 2 3 4 5
CFAT 80000 70000 85000 60000 50000
Investment Rs.200000 Risk free rate of Return is 7% Risk Adjusted Rate is 10%

Illustration 2: (Risk Adjusted Discounted Rate) MNL Ltd is considering investment in one of the three
mutually exclusive project : AB ,BC and CD The company cost of capital is 15% and risk free interest rate
is 10%.The income tax rate for the company is 34% MNL has gathered following three basic cash flow

Projects Ab BC CD
Initial Investment 1200000 1000000 1500000
Cash Inflow
Year 1 500000 500000 400000
Year 2 500000 400000 500000
Year 3 500000 500000 600000
Year 4 500000 300000 1000000
Risk Index 1.80 1.00 0.60
Using risk adjusted discount rate determine the risk adjusted NPV for each of the project.
Illustration 3: (Certainty Equivalent)

If the risky cash flow is Rs.80000 Calculate the Certainty Equivalent Coefficient in the following situations
if the risk free cash flow is:

Situation 1 : Rs.52000

Situation 2 : Rs. 18000

Calculate your inferences

Illustration 4: (CertaintyCoefficient)

From the following data of Shatabdi Ltd find out which project is better using Certainty Coefficient
Approach

Year CFAT Certainty Coefficient CFAT Certainty Coefficient

1 60000 0.9 50000 0.8
2 50000 0.8 60000 0.7
3 20000 0.6 30000 0.5
4 50000 0.5 20000 0.4
Each of the project require a cash outflow of Rs.100000 Risk Free Discount rate is 12% for both of the
project

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TYBAF Financial Management SEM V
Illustration 5: A project Costing Rs.100000
has the following estimated cash flow and certainty equivalent coefficient as follow
If risk free discount rate is 10% Calculate
Year 1 2 3 4
NPV(Certainty Equivalent)
Cash Inflow 70000 80000 50000 60000
Illustration 6: (Sensitivity Analysis) CE Coefficient 0.8 0.6 0.7 0.67

A company has two mutually exclusive projects. The management has developed the following estimates of
the annual cash flow for each project having a life of 10 years and 12% discount Rate

Particulars Project X Project Y

Net Investment 100000 100000

Annual CFAT:-

Pessimistic 12000 15000

Most Likely 17000 17000

Optimistic 20000 19000

Calculate NPV using sensitivity Analysis. Comment

Illustration 7: (Decision Tree)

Arangetram Ltd has following estimates of cash inflow with different investment proposal. The company
wants to use a decision tree to get the picture of project cash inflow. The life of the project is 2 years. The
total investment of the project is Rs.200000 and the company prefer to discount the inflow at 10% discount
factor. Tree for investment proposals: In the first Year:

Events Cash Inflow Probability

1 125000 0.4
2 150000 0.6

In the second year if cash inflow in the 1st year are:

Rs. 125000 Rs. 150000
Cash Inflow Probability Cash Inflow Probability
60000 0.2 100000 0.2
80000 0.6 125000 0.5
110000 0.2 150000 0.3

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