Ch.

10: Determining Cash Flows for Investment Analysis

CHAPTER 10
DTERMINING CASH FLOWS FOR INVESTMENT ANALYSIS
Problem 1
Assumption: (1) It is assumed that the given annual cash inflows are after-tax. (2) ARR is calculated as average cash
profit divided by original investment. Alternatively, average investment (original investment/2) can be used for
calculation.
10%
35%

Required rate
Tax rate
Projects

Outlay
Annual inflows
Life
PVAF @10%
PV of NCF
NPV
IRR
PB (years)
ARR

-500,000 -120,000
-92,000 -5,750 -40,000
125,000
12,000
15,000
2,000
6,000
8
15
20
5
10
5.3349
7.6061
8.5136 3.7908
6.1446
666,865.8 91,273.0 127,703.5 7,581.6 36,867.4
166,865.8 -28,727.0 35,703.5 1,831.6 -3,132.6
18.6%
5.6%
15.4% 21.8%
8.1%
4.00
10.00
6.13
2.88
6.67
25.0%
10.0%
16.3% 34.8%
15.0%
Rank

Project
A
B
C
D
E

NPV

IRR
1
5
2
3
4

PB
2
5
3
1
4

ARR
2
5
3
1
4

2
5
3
1
4

Problem 2
Cost of capital
Tax rate
Cost of project X
Life of project X
Straight line depreciation
Cost of project Y
Life of project Y
Straight line depreciation
PROJECT X
Year
BT cash flows
AT cash flows (T =
35%)
Add: DTS (Dep. T =
4,000 .35 )
NCF
PVF
PV (Rs)
NPV (Rs)
PI

10%
43%
20,000
5
4,000
15,000
5
3,000

0
-20,000

-20,000
1.000
-20,000
-1,855
0.91

1
4,200
2,730

2
4,800
3,120

3
7,000
4,550

4
8,000
5,200

5
2,000
1,300

1,400

1,400

1,400

1,400

1,400

4,130
0.909
3,755

4,520
0.826
3,736

5,950
0.751
4,470

6,600
0.683
4,508

2,700
0.621
1,676

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

IRR
Accumulated cash
flows
Payback (years)

6.29%
-20000

-15870

-11350

-5400

1200

3900

PROJECT Y
Year
BT cash flows
AT cash flows (T =
35%)
Add: DTS (Dep. T =
3,000 .35 )
NCF
PVF
PV (Rs)
NPV (Rs)
PI
IRR
Cumulative cash flows
Payback (years)

-15,000

4,200

4,500

4,000

5,000

1,000

2,730
1,050

2,925
1,050

2,600
1,050

3,250
1,050

650
1,050

3,780
0.909
3,436

3,975
0.826
3,285

3,650
0.751
2,742

4,300
0.683
2,937

1,700
0.621
1,056

-11220

-7245

-3595

705
4

2405

-15,000
1.000
-15,000
-1,544
0.90
5.59%
-15000

Both projects have negative NPV and IRR less than the cost of capital. They should be rejected.
Problem 3
Required rate of return (RRR)
Tax rate
Outlay M:
Life (years)
S L depreciation: 100,000/5
Salvage value (SV)
Outlay N:
Life (years)
SV
S L depreciation: 140,000/5

10%
35%
100,000
5
20,000
0
140,000
5
20,000
28,000

PROJECT M
Year
Book value (BV)
SL depreciation
Earnings before depreciation & tax
Less: dep.
Earnings before tax
Tax at 35%
Earnings after tax (EAT)
Plus: dep.
Plus: SV
NCF
PVF
PV (Rs)
NPV (Rs)
IRR

0
100,000

1
80,000
20,000
25,000
20,000
5,000
1750
3,250
20,000

2
60,000
20,000
25,000
20,000
5,000
1750
3,250
20,000

3
40,000
20,000
25,000
20,000
5,000
1750
3,250
20,000

4
20,000
20,000
25,000
20,000
5,000
1750
3,250
20,000

-100,000
1.000
-100,000
-11,864
5.24%

23,250
0.909
21,136

23,250
0.826
19,215

23,250
0.751
17,468

23,250
0.683
15,880

5
0
20,000
25,000
20,000
5,000
1750
3,250
20,000
0
23,250
0.621
14,436

Ch. 10: Determining Cash Flows for Investment Analysis

Cumulative NCF
Payback (years)

-100,000
4 1/2

-76,750

-53,500

-30,250

-7,000

16,250

Project N
Year
Book value
S L depreciation
Earnings before depreciation &
taxes
Less: dep.
Earnings before taxes
Tax
Earnings after tax
Plus: dep.
After-tax salvage
NCF
PVF
PV (Rs)
NPV (Rs)
IRR
Cum. NCF
Payback

140,000

112,000
28,000
40,000

84,000
28,000
40,000

56,000
28,000
40,000

28,000
28,000
40,000

0
28,000
40,000

28,000
12,000
4,200
7,800
28,000

28,000
12,000
4,200
7,800
28,000

28,000
12,000
4,200
7,800
28,000

28,000
12,000
4,200
7,800
28,000

35,800
0.909
32,545

35,800
0.826
29,587

35,800
0.751
26,897

35,800
0.683
24,452

28,000
12,000
4,200
7,800
28,000
13,000
48,800
0.621
30,301

-104,200

-68,400

-32,600

3,200

52,000

-140,000
1.000
-140,000
3,782
11.0%
-140,000
4

* After-tax salvage: 20,000 - .35(20,000 0) = Rs 13,000.

Problem 4
Year
O
P
Q
(P - Q)

IRR NPV, 12%

-50,000 25,270 25,270 25,270 0.24

-25,000 5,000 5,000 25,570 0.15
-28,000 12,670 12,670 12,670 0.17
3,000 -7,670 -7,670 12,900

10,694.3
1,650.5
2,431.2
(780.7)

Project O has the highest NPV; hence it should be preferred over other projects. Between projects P and Q, Q is better
with higher NPV. The incremental cash flow analysis also shows that P losses NPV when compared with Q.
Problem 5
Year
A
B
(A - B)

-6,000

8,000
2,000 2,000
-8,000 12,000 4,000
-6,000 16,000 -10,000 -2,000

NPV, 10%

IRR

4,428.2 65.6%
5,649.9 78.1%
(1,221.6)

Both absolute and incremental analyses reveal that B is a better project than A.
Problem 6
Year
Cash flow

7,000 7,000 7,000 7,000 -25,000

Problem 7
RRR
Tax rate
Purchase price
Installation
Total cost

NPV, 10%

IRR

7,332.6 -4.5%

10%
40%
40,000
8,000
48,000

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Plus: WC
Less: SV, old
Initial outlay
SV, new (4 yrs)
SV, old (4 yrs)
Differential SV after 4 years
BV, old
Life (years), new
Life (years), old
SL dep., new
SL dep., old
Differential dep.
Diff. DTS (depreciation tax
shield): 8,000 0.40
Year
Initial outlay
BT cash flows
AT cash flows: 16,000 (1-.4)
DTS
Differential SV
NCF
NPV
IRR

10,000
20,000 no tax assumed
38,000
14,000
4,000
10,000 no tax assumed
16,000
4
4
12,000
4,000
8,000
3,200

-38,000
16,000 16,000 16,000 16,000
9,600 9,600 9,600 9,600
3,200 3,200 3,200 3,200
10,000
-38,000 12,800 12,800 12,800 22,800
9,404.4
20%

Problem 8
Investment
Required rate
Tax rate
Investment period
Building
Merchandise
Working capital
Total investment

300,000
15%
30%
13
140,000
100,000
60,000
300,000

Annual receipts
Less: Costs
Less: SL dep. on build.
(140,000/13)

390,000
300,000
10,769

Pre-tax savings
Tax @ 30%

79,231
23,769

Post-tax savings
Add: Dep.
Less: Loss of salary
(no tax on salary
assumed)
NCF (annuity)

55,462
10,769
36,000

Post-tax SV: 50,000

(1 0.3)
Release of WC and
merchandise

35,000

30,231

160,000

Ch. 10: Determining Cash Flows for Investment Analysis

Year-end CF

195,000

PVAF, 15%, 13
PVF, 15%, 13
PV of annuity
PV of year-end CF
NPV

5.5831
0.1625
168,781
31,688
-99,531

Problem 9
BV, old
Life, old (years)
Cost, new
Life, new (years)
SV, new
Savings, new
WDV dep. rate
Tax rate
Required rate

64,000
6
80,000
6
0
16,000
25%
35%
10%

Situation I
SV, old (now)
SV, (after 6 years)
BV, old
Dep. base, new
Diff. dep. base (80,000-64,000)

0
0
64,000
80,000
16,000

Year
Depreciated value
WDV dep.
Investment
Savings
Less: depreciation*
Taxable savings
Less: Tax @ 35%
Post-tax savings
Add: depreciation*
After-tax SV (old) lost
NCF
PVF
PV
NPV

16,000

12,000
4,000

9,000
3,000

6,750
2,250

5,063
1,688

3,797
1,266

2,848
949

16,000
4,000
12,000
4,200
7,800
4,000

16,000
3,000
13,000
4,550
8,450
3,000

16,000
2,250
13,750
4,813
8,938
2,250

16,000
1,688
14,313
5,009
9,303
1,688

16,000
1,266
14,734
5,157
9,577
1,266

11,800
0.909
10,727

11,450
0.826
9,463

11,188
0.751
8,405

10,991
0.683
7,507

10,843
0.621
6,733

16,000
3,797
12,203
4,271
7,932
3,797
0
11,729
0.564
6,621

-80,000

-80,000
1.000
-80,000
-30,545

* New machine has zero salvage value. Its book value of Rs 2,848 at the end of 6th year will be treated as loss and will save taxes. This
amount has been added to the sixth year's depreciation.
Situation II
SV, old (now)
BV, old
After-tax SV, old: 16,000 - .35(16,000-64,000)
SV, old (after 6 years)
Cost of new
Less: After-tax SV, old
Net cost of new
Diff. dep. Base (80,000-64,000)

16000
64,000
32,800
0
80,000
32,800
47,200
16,000

Assumption given in the problem

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Year
Depreciated value
WDV depreciation
Investment
Savings
Less: depreciation*
Taxable savings
Less: Tax
Post-tax savings
Add: depreciation*
After-tax SV (old) lost
NCF
PVF
PV
NPV

16,000

12,000
4,000

9,000
3,000

6,750
2,250

5,063
1,688

3,797
1,266

2,848
949

16,000
4,000
12,000
4,200
7,800
4,000

16,000
3,000
13,000
4,550
8,450
3,000

16,000
2,250
13,750
4,813
8,938
2,250

16,000
1,688
14,313
5,009
9,303
1,688

16,000
1,266
14,734
5,157
9,577
1,266

11,800
0.909
10,727

11,450
0.826
9,463

11,188
0.751
8,405

10,991
0.683
7,507

10,843
0.621
6,733

16,000
3,797
12,203
4,271
7,932
3,797
0
11,729
0.564
6,621

-47,200

-47,200
1.000
-47,200
2,255

* New machine has zero salvage value. Its book value of Rs 2,848 at the end of 6th year will be treated as loss and will save taxes. This
amount has been added to the sixth years depreciation.
Situation III
SV, old (now)
BV, old
After-tax SV, old: 16,000 - .35(16,000-64,000)
SV, (after 6 years)
BV, old (after six years): 64,000 (1-0.25)6
After-tax SV, old: 2,000 - .35(2,000-11,391)
Cost of new
Less: After-tax SV, old
Net cost of new
Diff. dep. base (80,000-64,000)
Year
Depreciated value
WDV depreciation
Investment
Savings
Less: depreciation*
Taxable savings
Less: Tax
Post-tax savings
Add: depreciation*
After-tax SV (old) lost
NCF
PVF
PV
NPV

16000
64,000
32,800
2,000
11391
5,287
80,000
32,800
47,200
16,000

0
16,000

Assumption given in the problem

1
12,000
4,000

2
9,000
3,000

3
6,750
2,250

4
5,063
1,688

5
3,797
1,266

6
2,848
949

16,000
4,000
12,000
4,200
7,800
4,000

16,000
3,000
13,000
4,550
8,450
3,000

16,000
2,250
13,750
4,813
8,938
2,250

16,000
1,688
14,313
5,009
9,303
1,688

16,000
1,266
14,734
5,157
9,577
1,266

11,800
0.909
10,727

11,450
0.826
9,463

11,188
0.751
8,405

10,991
0.683
7,507

10,843
0.621
6,733

16,000
3,797
12,203
4,271
7,932
3,797
-5,287
6,442
0.564
3,636

-47,200

-47,200
1.000
-47,200
-729

* New machine has zero salvage value. Its book value of Rs 2,848 at the end of 6th year will be treated as loss and will save taxes. This
amount has been added to the sixth year's depreciation.

Ch. 10: Determining Cash Flows for Investment Analysis

Problem 10
Old Machine:
BV
Current MV
After-tax SV: 20,000-.35(20,000-0)
SV after 8 years
Remaining life (years)

0
20,000
13,000
0
8

New Machines (Vs Old):

Cost
SV after 8 years
BV after 8 years
After-tax SV: SV-.35(SV-BV)
Life (years)
Dep. rate (WDV)
Tax rate
Cost of capital
Increase in sales
Cost savings
Gross savings
After-tax savings (T = 35%)
Diff. dep. base: Cost, new BV, old
New investment: cost After-tax
SV, old (Rs 13,000)

I
102,500
12,500
10,262
11,717
8
0.25
0.35
0.11
12,500
12,500
25,000
16,250
102,500
89,500

II
175,000
25,000
17,520
22,382
8
0.25
0.35
0.11
12,500
30,000
42,500
27,625
175,000
162,000

New machine I (Vs Old):

Years
Diff. dep. Base
Depreciation
Dep. Tax shield
After-tax savings
SV
NCF
PVF
PV (Rs)
NPV (Rs)
IRR

102,500

76,875
25,625
8,969
16,250

-89,500
1.000
-89,500
23,040
18.1%

25,219
0.901
22,720

New machine II (Vs Old) :

Years
Diff. dep. Base

175,000

131,25
0
43,750

98,438

73,828

55,371

41,528

31,146

23,360

17,520

32,813

24,609

18,457

13,843

10,382

7,787

5,840

15,313
27,625

11,484
27,625

8,613
27,625

6,460
27,625

4,845
27,625

3,634
27,625

2,725
27,625

2,044
27,625
22,382

42,938
0.901
38,682

39,109
0.812
31,742

36,238
0.731
26,497

34,085
0.659
22,453

32,470
0.593
19,269

31,259
0.535
16,712

30,350
0.482
14,618

52,051
0.434
22,586

Depreciation
Dep. Tax shield
After-tax savings
SV
NCF
PVF
PV (Rs)

57,656 43,242 32,432 24,324 18,243 13,682 10,262

19,219 14,414 10,811 8,108 6,081 4,561 3,421
6,727 5,045 3,784 2,838 2,128 1,596 1,197
16,250 16,250 16,250 16,250 16,250 16,250 16,250
11,717
22,977 21,295 20,034 19,088 18,378 17,846 29,164
0.812 0.731 0.659 0.593 0.535 0.482 0.434
18,648 15,571 13,197 11,328 9,826 8,596 12,655

-162,000
1.000
-162,000

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

NPV (Rs)
IRR

30,561
16.20%

The company should go for the new machine costing Rs 175,000 since it has higher NPV. NPV is consistent with
shareholder wealth maximisation.
Problem 11
The block of assets method of depreciation in India requires adjustment of salvage value in the depreciable base. Thus,
if an asset has no salvage value, it can be depreciated for ever (infinity) if the firm keeps the positive balance in the
block of assets. If it has a salvage value, the balance of the block will be reduced for the amount of salvage value less
depreciation tax shield lost on this amount.
Old Machine:
Depreciated BV
0
Exchange value
40,000
Current MV
30,000
SV after 10 years
6,000
Remaining life (years)
10
New Machine:
Cost
360,000
SV after 10 years.
40,000
Life (years)
10
WDV dep. rate
25%
Required rate
12%
Tax rate
50%
Old

Differenc
e
Profit before tax 373,000 449,000
76,000
Add: dep.
2,000 36,000
34,000
Add: allocated
120,000 130,000
10,000
overhead
PBDT
495,000 615,000 120,000
Tax @ 50%
247,500 307,500
60,000
PBDAT
247,500 307,500
60,000

Years

New

10

320,000

240,000

180,000

135,000

101,250

75,938

56,953

42,715

32,036

24,027

18,020

Dep.

80,000

60,000

45,000

33,750

25,313

18,984

14,238

10,679

8,009

6,007

DTS

40,000

30,000

22,500

16,875

12,656

9,492

7,119

5,339

4,005

9,091

60,000

60,000

60,000

60,000

60,000

60,000

60,000

60,000

60,000

60,000

100,000

90,000

82,500

76,875

72,656

69,492

67,119

65,339

64,005

69,091

New block

PBDAT
CFO
Investment

-320,000

SV

40,000

Lost DTS on SV

13,514
95,578

NCF

-320,000

100,000

90,000

82,500

76,875

72,656

69,492

67,119

65,339

PVF

1.000

0.893

0.797

0.712

0.636

0.567

0.507

0.452

0.404

0.361

0.322

-320,000

89,286

71,747

58,722

48,855

41,227

35,207

30,361

26,389

23,081

30,774

PV (Rs)
NPV (Rs)

135,649

IRR

22.45%

64,005

Last year DTS includes depreciation on the remaining book value: BV (d T)/(k + d) = 18.020 (0.25 0.50)/(0.12
+ 0.25) = Rs .6,088.

Ch. 10: Determining Cash Flows for Investment Analysis

Note: Exchange value is higher than the current market value. Hence, the relevant salvage value of the old machine is
Rs 40,000.
Problem 12
Old Machine:
Original cost (Rs)
Original life (yrs)
Remaining life (yrs)
Depreciation rate
BV after 5 years
BV after 12 years
Current MV
New Machine:
Cost
Installation
Total cost
Working capital
Gross outlay
Life (years)
Depreciation rate
SV (Rs)
BV after 7 years

129,000
12
7
25%
30,612
4,086
40,000
175,000
25,000
200,000
25,000
225,000
7
0.25
18,000
23,360

Cost of capital
Tax rate

Diff. dep. base

Differential dep.

(1-0.25)^7*175,000

12%
35%

Increase in sales
After-tax revenue: 70,000(1.35)
Gross outlay
Less: SV, old
Net outlay
Diff. Dep. Base: 200,000 40,000
Year

(1-0.25)^5*129,000
(1-0.25)^12*129,000

70,000
45,500
225,000
40,000
185,000
160,000

160,000

120,000
40,000

90,000
30,000

67,500
22,500

50,625
16,875

37,969
12,656

28,477
9,492

21,357
7,119

DTS*

14,000

10,500

7,875

5,906

4,430

3,322

7,542

After-tax revenue
SV
DTS lost on SV**

45,500

45,500

45,500

45,500

45,500

45,500

45,500
18,000
-4,257
25,000

WC released
Net outlay

-185,000

NCF
PVF
PV (Rs)
NPV
IRR

-185,000
1.000
-185,000
78,014
24.0%

59,500
0.893
53,125

56,000
0.797
44,643

53,375
0.712
37,991

51,406
0.636
32,670

49,930
0.567
28,331

48,822
0.507
24,735

* Last year DTS includes DTS on remaining book value: 21,357 (.25 .35)/(.12 + .25) = Rs 5,051.
** DTS lost on SV: 18,000 (.25 .35)/(.25 + .12) = -4,257.

91,786
0.452
41,519

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 13
Purchase price
Life (years)
SV (Rs)
Maintenance cost
SL dep.
Tax rate
Cost of capital

175,000
5
21,000
3,500
35,000
0.50
0.10
0

Outlay
Tax saved on depreciation
After-tax SV
NCF
PVF
PV (Rs)
NPV (Rs)

17,500 17,500 17,500 17,500

10,500
-175,000 17,500 17,500 17,500 28,000
1.0000 0.9091 0.8264 0.7513 0.6209
-175,000 15,909 14,463 13,148 17,386
-102,142

17,500
10,500
27,500
0.6209
23,905

-175,000

* Tax payable on book profit. After-tax SV = 21,000 0.50(21,000 0)

0
1
2
3
4
5
0 -42,000 -42,000 -42,000 -42,000 -42,000
0 -21,000 -21,000 -21,000 -21,000 -21,000
1.0000 0.9091 0.8264 0.7513 0.6209 0.6209
0 -19,091 -17,355 -15,778 -14,343 -13,039
-79,607

Hiring option:
Hire charges (Rs)
After-tax hire charges (Rs)
PVF
PV (Rs)
NPV (Rs)

Maintenance cost being common in both options is ignored in calculating cash flows.
Hiring option is cheaper.
Problem 14
Cost of capital
Tax rate
Dep. Rate
Project P

Investment

0.18
0.50
0.25
0

250,000

187,500

140,625

105,469

79,102

59,326

62,500

46,875

35,156

26,367

19,775
45,000

33,750

Depreciation
Additional investment

Depreciation
Total depreciation

62,500

46,875

35,156

26,367

19,775

10

44,495

33,371

25,028

18,771

14,078

14,832

11,124

8,343

6,257

4,693

25,313

18,984

14,238

10,679

11,250

8,438

6,328

4,746

3,560

26,082

19,561

14,671

11,003

8,252

Before-tax cash flows

90,000

90,000

90,000

90,000

90,000

90,000

90,000

90,000

90,000

90,000

After-tax cash flows

45,000

45,000

45,000

45,000

45,000

45,000

45,000

45,000

45,000

45,000

31,250

23,438

17,578

13,184

9,888

13,041

9,781

7,335

5,502

11,323*

DTS
Investment
Working capital

-250,000

-45,000

-50,000

Salvage value

30,000

Lost DTS on SV

-8,721#

WC released
NCF

50,000
-300,000

76,250

68,438

62,578

58,184

10

9,888

58,041

54,781

52,335

50,502

127,602

Ch. 10: Determining Cash Flows for Investment Analysis

PVF
PV

1.000

0.847

0.718

0.609

0.516

0.437

0.370

0.314

0.266

0.225

0.191

-300,000

64,619

49,151

38,087

30,010

4,322

21,500

17,197

13,923

11,386

24,380

NPV

-25,425

IRR

15.5%

* Includes DTS on the remaining book value: Rs (14,078 + 10,679) (.25 .50)/(.25 + .18) = Rs 7,197.
# Lost DTS on VS: Rs 30,000 (.25 .50)/(.25 + .18) = Rs 8,721.

11

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 15
100,000
5
20,000
0
40,000
0.50
0.18

Cost
Life (years)
Straight line dep. (Rs)
Savage value
Savings
Tax rate
Cost of capital
Year
Investment
After-tax savings
Tax saved on dep.
Salvage value
NCF
PVF
PV (Rs)
NPV (Rs)
IRR

20,000
10,000

20,000
10,000

20,000
10,000

20,000
10,000

30,000
0.8475
25,424

30,000
0.7182
21,546

30,000
0.6086
18,259

30,000
0.5158
15,474

20,000
10,000
0
30,000
0.4371
13,113

-100,000

-100,000
1.0000
-100,000
-6,185
15.2%

Here we ignore the effect of specific financing. The cost of capital, which assumes a target capital structure, is used as
the discount rate.
Problem 16
Project cost (Rs)
Cost savings (Rs)
Period (years)
Tax rate
Required rate
Straight line dep. (Rs)
Salvage value
Year
Investment (Rs)
After-tax cost savings (Rs)
Tax saved on dep. (Rs)
Salvage value (Rs)
NCF (Rs)
PVF
PV (Rs)
NPV (Rs)
IRR

50,000
30,000
5
0.5
0.12
10,000
0
0

15,000
5,000

15,000
5,000

15,000
5,000

15,000
5,000

20,000
0.8929
17,857

20,000
0.7972
15,944

20,000
0.7118
14,236

20,000
0.6355
12,710

15,000
5,000
0
20,000
0.5674
11,349

-50,000

-50,000
1.0000
-50,000
22,096
28.65%

Here we ignore the effect of specific financing. The cost of capital, which assumes a target capital structure, is used as
the discount rate.
Problem 17

Old
Capacity (units)

New
3

12

(Rs 000)
New Old
1

Ch. 10: Determining Cash Flows for Investment Analysis

Selling price
Revenue
Cost of production:
Materials
Labour
Variable overheads
Fixed overheads
Per unit production cost
Total production cost
Profit
Original cost of machine (Rs)
Current book value
Exchange (salvage) value
After-tax salvage value: 100,000-.5(100,000 200,000)
Tax saved on book loss
Net outlay (Rs): 500,000 - 150,000
Salvage value after 10 years
After-tax salvage value: 50,000 - .5(50,000 0)
Remaining life (years)
Straight line dep.
Working capital
Tax rate
Required rate of return

200
600

180
720

-20
120

40
60
30

38
40
15
2
95
380
340
500

2
20
15
-2
35
10
110

130
390
210
300
200
100
150
50

10
20

350
50
25
10
50
25
0.5
0.15

30

(Rs 000)
Year
Cost of machine
Working capital
Tax saved on SV
Revenue
Cost savings
Increase in profits
After-tax profits
Dep. tax shield
After-tax SV
Release of WC
NCF
PVF
PV (Rs)
NPV (Rs)
IRR

-200
-25
50

-200

120
10
130
65
15

-175
1.000
-175
65.0
20.2%

120
10
130
65
15

120
10
130
65
15

120
10
130
65
15

120
10
130
65
15

120
10
130
65
15

120
10
130
65
15

120
10
130
65
15

120
10
130
65
15

10

120
10
130
65
15
25
25
-120
80
80
80
80
80
80
80
80
130
0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247
-104
60
53
46
40
35
30
26
23
32

Problem 18
Initial cost (Rs)
200,000
Life (years)
5
Cash inflow (Rs)
70,000
Cost of capital (real)
10.0%
Inflation
5.0%
Nominal cost of capital: [(1.10)(1.05) - 1] 15.5%

13

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Assumptions: (1) It is assumed that both cash flows and the cost of capital are in real terms. (2) Nominal cash flows are
calculated as follows: Real cash flows (1 + inflation rate)n.
Year
Cash flows (real)
Nominal cash flows

0
1
2
3
4
5
Dis. rate NPV
-200,000 70,000 70,000 70,000 70,000 70,000
0.1000 65,355
-200,000 73,500 77,175 81,034 85,085 89,340
0.1550 65,355

It may be noticed that NPV is the same in both situations. The real cash flows are discounted at the nominal cost of
capital, and real cash flows at the real cost of capital.
Problem 19
Discount rate
Tax rate
General inflation rate
Year
Cost
Volume
Price
Cost per unit
Revenue
Total cost
Profit
Less: dep.
PBT
Tax
PAT
Add: dep.
NCF
PVF at 20%
PV at 20%
NPV
IRR

20%
35%
10%
0
-500,000
20%
10%
15%

-500,000
1.000
-500,000
-99,155
11.6%

10,000
20
10
200,000
100,000
100,000
100,000
0
0
0
100,000
100,000
0.833
83,333

12,000
22.00
11.50
264,000
138,000
126,000
100,000
26,000
9,100
16,900
100,000
116,900
0.694
81,181

14,400
24.20
13.23
348,480
190,440
158,040
100,000
58,040
20,314
37,726
100,000
137,726
0.579
79,703

17,280
26.62
15.21
459,994
262,807
197,186
100,000
97,186
34,015
63,171
100,000
163,171
0.482
78,690

20,736
29.28
17.49
607,192
362,674
244,518
100,000
144,518
50,581
93,936
100,000
193,936
0.402
77,939

Price increases at general inflation rate while cost increases by a higher rate of inflation. It is assumed that the cost of
capital is market determined; hence, it is in nominal terms.
Problem 20
Cash outlay
Life of project (years)
Sales growth: 2-7 years
Increase in expenses
Initial working capital
WC to sales
WDV dep. rate
Tax rate
Opportunity cost of capital
Salvage value: 0.20 6,000,000 (1.10)7

6,000,000
7
10%
10%
500,000
25%
25%
35%
21%
2,338,461

14

Ch. 10: Determining Cash Flows for Investment Analysis

Nominal Cash Flows

Year
0
1
2
3
4
5
6
7
Cash outlay
-6,000,000
Sales
1,200,000 2,000,000 2,200,000 2,420,000 2,662,000 2,928,200 3,221,020
Op. expenses
600,000
660,000
726,000
798,600
878,460
966,306 1,062,937
PBDIT
600,000 1,340,000 1,474,000 1,621,400 1,783,540 1,961,894 2,158,083
Depreciation
1,500,000 1,125,000
843,750
632,813
474,609
355,957
266,968
Profit/loss
-900,000
215,000
630,250
988,588 1,308,931 1,605,937 1,891,116
Loss carried forward
-900,000 -685,000
-54,750
0
0
0
Unrecovered loss
-900,000 -685,000
-54,750
0
0
0
0
Taxable profit
0
0
0
933,838 1,308,931 1,605,937 1,891,116
Tax
0
0
0
326,843
458,126
562,078
661,890
PAT
0
215,000
630,250
661,744
850,805 1,043,859 1,229,225
Add : depreciation
1,500,000 1,125,000
843,750
632,813
474,609
355,957
266,968
Funds from operation
1,500,000 1,340,000 1,474,000 1,294,557 1,325,414 1,399,816 1,496,193
Initial working capital
-500,000
Change in WC
-300,000 -200,000
-50,000
-55,000
-60,500
-66,550
-73,205
Release of WC
1,305,255
Salvage value
2,338,461
NCF
-6,500,000 1,200,000 1,140,000 1,424,000 1,239,557 1,264,914 1,333,266 5,066,703
PVF, 21%
1.000
0.826
0.683
0.564
0.467
0.386
0.319
0.263
PV
-6,500,000
991,736
778,635
803,811
578,262
487,679
424,820 1,334,221
NPV
-1,100,836
IRR
15.7%
Theoretically, the answer should not change if the analysis is made in terms of real terms. The real cash flows would be
discounted at the real cost of capital. However, since flows like deprecation tax shields are always in nominal terms, it
is difficult to use real cash flow analysis.

15

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

CASES
Case 10.1: Hind Petrochemicals Company
This case brings out a number of issues in calculating the relevant cash flows, the discount rate, NPV and IRR. The
important points are: (1) relevant depreciation for tax purposes, (2) irrelevance of allocated overheads, (3) sunk cost
(part of survey cost), (4) release of working capital, (5) tax shield treatment of depreciation and salvage value as per the
Indian tax system, and (6) ignoring the financing effect in calculating the cash flows.

Cost of refinery
Cost of machinery
Total capital investment
Working capital
Total cash outlay

(Rs mn.)
1,550
5,950
7,500
300
7,800

Discount rate

15%

Cash flows
0
Sales
Less: Wages and salaries
Selling and distribution costs
Materials and consumables
Depreciation (WDV)
Corporate office costs
Survey costs
Total expenses
Profit (loss) before tax
Less: tax @ 35%
Profit after tax
Plus: depreciation
CFO
Cash outlay
Working capital released
Salvage value
Book value
Lost DTS on (SV -BV)
Net cash flows
NPV at 15%
IRR
Cumulative casf flows
Payback (years)

1
5,730
1,450
760
180
1,875
100
15
4,380
1,350
473
878
1,875
2,753

2
5,930
1,500
770
270
1,406
100
4,046
1,884
659
1,224
1,406
2,631

3
5,870
1,850
1,080
290
1,055
100
4,375
1,495
523
972
1,055
2,027

4
3,790
1,030
530
200
791
100
2,651
1,139
399
740
791
1,531

(Rs mn.)
5
4,500
1,210
650
230
593
100
2,783
1,717
601
1,116
593
1,709
300
3,600
1,780
-430
5,179

-7,800

-7,800
1,365
22%

2,753

2,631

2,027

1,531

-7,800

-5,048

-2,417

-390

1,141
3.25

6,320

Note: (1) Only Rs 15 million of survey cost is rlevant. (2) All corporate office costs are not relevant for the
project; Rs 100 million costs relate to the project. (3) Interest is a financing cost. Free cash flows are calculated,
ignoring the interest ch

16

Ch. 10: Determining Cash Flows for Investment Analysis

Case 10.2: Pure Drinks Company

Like Hind Petrochemicals case, this case high lights the relevant cash flows. It introduces the concept of opportunity
cost of using existing facilities. Further, it also introduces the adjustment of inflation.

Inflation rate assumed zero

Number of sachets
Price
Variable costs:
Material
Labour
Overhead
Fixed costs (Rs million)
Allocated fixed costs (Rs million)
Working capital ratio
Tax rate
Real discount rate
Inflation rate
Nominal discount rate
Tax rate

900,000
(Rs)
65.0
15.0
6.5
3.5
5.0
0.5
6.8
26%
35%
8.65%
0%
8.65%
35%

Cost of processing facilities (Rs million)

Life (years)
SL depreciation
Salvage value (Rs million)

200
5
40
100

Current building opportunity cost (Rs mn)

Building opportunity cost after 5 years(Rs mn)
PV of building cost after 5 years: 200/(1.0865)5

100
200
132

17

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

0
Revenue
Variable costs
Material
Labour
Overhead
Total
Fixed costs
Total cost
EBDIT
Depreciation
EBIT
Less: Tax
Post-tax earnings
Plus: depreciation
Cash flow from operations
Change in working capital
Free cash flows
Cost of processing facilities
Cost of building
Salvage value
Less: Tax on (SV - BV)
Net cash flows
NPV
NPV if WC ratio is 30%

-15.21
-15.21
-200
-132

-347.30
-125.84
-126.63

1
58.50

2
58.50

3
58.50

4
58.50

(Rs lakh)
5
58.50

5.85
3.15
4.50
13.5
0.50
14.00
44.50
40.00
4.50
1.58
2.93
40.00
42.93
0.00
42.93

5.85
3.15
4.50
13.5
0.50
14.00
44.50
40.00
4.50
1.58
2.93
40.00
42.93
0.00
42.93

5.85
3.15
4.50
13.5
0.50
14.00
44.50
40.00
4.50
1.58
2.93
40.00
42.93
0.00
42.93

5.85
3.15
4.50
13.5
0.50
14.00
44.50
40.00
4.50
1.58
2.93
40.00
42.93
0.00
42.93

5.85
3.15
4.50
13.5
0.50
14.00
44.50
40.00
4.50
1.58
2.93
40.00
42.93
15.21
58.14

42.93

100
-35
123.14

42.93

42.93

42.93

Note: (1) Rs 5 million survey cost is sunl cost. Hence, it is ignored. (2) The corporate office fixed costs are
irrelevant for the project.
Inflation adjustment:
Number of sachets
Price
Variable costs:
Material
Labour
Overhead
Fixed costs (Rs million)
Working capital ratio
Tax rate
Real discount rate
General inflation rate
Nominal discount rate
Tax rate
Cost of processing facilities
Life
SL depreciation
Salvage value
Current building opportunity cost (Rs mn)
Building opportunity cost after 5 years(Rs mn)
PV of building cost after 5 years: 200/(1.13)5

900,000
(Rs) Inflation
65.0
4%
6.5
3.5
5.0
0.5
26%
35%
8.65%

3%
5%
5%

4%
13%
35%
200
5
40
100
100
200
109

18

Ch. 10: Determining Cash Flows for Investment Analysis

1
60.84

2
63.27

3
65.80

4
68.44

(Rs lakh)
5
71.17

Revenue
Variable costs
Material
6.03
6.21
6.39
6.58
6.78
Labour
3.31
3.47
3.65
3.83
4.02
Overhead
4.73
4.96
5.21
5.47
5.74
Total
14.1
14.6
15.2
15.9
16.5
Fixed costs
0.52
0.54
0.56
0.58
0.61
Total cost
14.58
15.18
15.81
16.47
17.15
EBDIT
46.26
48.09
49.99
51.97
54.02
Depreciation
40.00
40.00
40.00
40.00
40.00
EBIT
6.26
8.09
9.99
11.97
14.02
Less: Tax
2.19
2.83
3.50
4.19
4.91
Post-tax earnings
4.07
5.26
6.50
7.78
9.11
Plus: depreciation
40.00
40.00
40.00
40.00
40.00
Cash flow from operations
44.07
45.26
46.50
47.78
49.11
Change in working capital
-15.82
-0.63
-0.66
-0.68
-0.71
18.51
Free cash flows
-15.82
43.44
44.60
45.81
47.07
67.62
Cost of processing facilities
-200
Cost of building
-109
Salvage value
100
Less: Tax on (SV - BV)
-35
Net cash flows
-324.39
43.44
44.60
45.81
47.07 132.62
NPV
-118.40
NPV if WC ratio 30%
-199.59
Note: (1) Rs 5 million survey cost is sunl cost. Hence, it is ignored. (2) The corporate office fixed costs are
irrelevant for the project.

19