CMA Module 3 - MBA I Sem - Financial Statements Preparation, Analysis and Interpretation (Useful For MBA 1st & BBA 1st)
CMA Module 3 - MBA I Sem - Financial Statements Preparation, Analysis and Interpretation (Useful For MBA 1st & BBA 1st)
CMA Module 3 - MBA I Sem - Financial Statements Preparation, Analysis and Interpretation (Useful For MBA 1st & BBA 1st)
CMA
Cost &
MANAGEMENT
ACCOUNTING
Presented by:
DR. LOKESH AGARWAL (Associate Professor)
Arya Group Of Colleges, Kukas, Jaipur
MODULE -3
CONTENT
Financial Statements preparation, analysis
and Interpretation:
Income statement
Comparative and common size statements
Analysis techniques- Ratio Analysis
Cash flow Statement analysis as per AS3 and
Fund flow statement analysis
FINANCIAL STATEMENT
Financial analysis is a process of selecting,
evaluating, and interpreting financial data, along
with other pertinent information, in order to
formulate an assessment of a company’s present and
future financial condition and performance.
ANALYSIS INTERPRETATION
Ratio Analysis
Balance Sheet
Trend Analysis
BUSINESS ACTIVITY
OWN Outside
CAPITAL Investment
BORROWED Investment
/ DEBT in Own
CAPITAL Business
Operational
Activities
Trading Account
Trading A/c for the year ended ……………….
Particulars Amount Particulars Amount
To Opening Stock By Sales
To Purchase (i) Credit Sales
(i) Credit Purchase (ii) Cash Sales
(ii) Cash Purchase Less: Sales Return
Less: Purchase Return
To Wages By Closing Stock
To Customs and import duty
To Carriage inward
To Royalty
To Manufacturing Expenses
TOTAL TOTAL
Questions:
1. From the following balances taken from the books of Simmi and Vimmi
Ltd. for the year ending March 31, 2020, prepare Trading Account.
(Rs.)
Closing Stock 2,50,000
Net sales during the year 40,00,000
Net purchases during the year 15,00,000
Opening stock 15,00,000
Direct expenses 80,000
Trading A/c of Simmi and Vimmi Ltd. For the year ended 31st March 2020
Particulars Amount Particulars Amount
To Opening Stock 1500000 By Sales a/c 4000000
To Purchase a/c 1500000 By Closing Stock 250000
To Direct Expenses a/c 80000
To Gross Profit transferred
to P&L A/c 1170000
4250000 4250000
Questions:
2. From the following balances extracted from the books of M/s Ahuja
and Nanda Prepare Trading A/c:
Particulars Amount (in
Rs)
Opening Stock 25000
Credit Purchases 750000
Cash Purchases 300000
Credit Sales 1200000
Cash Sales 400000
Commission Received 10000
Wages 100000
Salaries 140000
Rent 15000
Closing stock 30000
Sales return 50000
Purchases return 10000
Answer:
Trading A/c of M/s Ahuja and Nandu Ltd. For the year ended 31st March 2020
Particulars Amount Particulars Amount
To Opening Stock 25000 By Sales
To Purchase (i) Credit Sales 1200000
(i) Credit Purchase 750000 (ii) Cash Sales 400000
(ii) Cash Purchase 300000 1600000
1050000 Less: Sales Ret. 50000 1550000
Less: Purchase Ret. 10000 1040000
To Wages 100000 By Closing Stock 30000
To Gross Profit transferred
to P&L A/c 415000
1580000 1580000
Profit and Loss A/c of M/s Ahuja and Nandu Ltd. For the year ended 31st March 2020
Particulars Amount Particulars Amount
To Salary 140000 By Balance b/d (Gross Profit) 415000
To Rent 15000 By Commission 10000
Profit and Loss A/c for the year ended 31st March 2020
Particulars Amount Particulars Amount
To Sundry Expenses 600 By Balance b/d (Gross Profit) 15950
To Rent & Taxes 1350
Step 1
Firstly, specify absolute figures of assets and liabilities relating to the current and
previous accounting periods for analysis in Column I and Column II of the
comparative balance sheet.
Step 2
Find out the absolute change (increase or decrease) in the items mentioned in the
balance sheet in Column III of the comparative balance sheet.
Absolute Change = Current Year figure – Previous Year Figure
Step 3
Finally, calculate the percentage change in the assets and liabilities by assuming
previous year as the base year. It is mentioned in Column V of the comparative
balance sheet.
Percentage Change = Absolute Increase or Decrease x 100
.
Step 1
Firstly, specify absolute figures such as cost of goods sold, net sales, selling
expenses, office expenses, etc. relating to the current and previous accounting
periods for analysis in Column I and Column II of the comparative Income
Statement.
Step 2
Find out the absolute change (increase or decrease) in the items mentioned in the
Income Statement in Column III of the comparative Income Statement.
Absolute Change = Current Year figure – Previous Year Figure
Step 3
Finally, calculate the percentage change in the Income Statement items by assuming
previous year as the base year. It is mentioned in Column V of the comparative
balance sheet.
Percentage Change = Absolute Increase or Decrease x 100
.
From the following profit and loss account of Priyanshu Ltd., for the
year ending 31-3-2019 and 31-3-2020. You are required to prepare a
comparative profit and Loss Account and interpret the results:
Particulars 31-3-2019 31-3-2020
Net Revenue from Operation 240000 300000
Cost of Revenue from Operation 150000 187500
Manufacturing Overheads 9000 12000
Administrative Overheads 33000 45000
Selling and Distribution Expenses 27000 21000
Non Operation Income 1500 1500
Non Operating Expenses 3000 1500
Priyanshu Ltd.
Comparative Profit and Loss Account
For the year ending 31-3-2020
Particulars Note For the For the Absolute Percentage
year ending year ending Change (Inc/dec)
2018-19 2019-20 (Inc/Dec)
A B C=B–A D= C / A X 100
The income statement of Megha Ltd. are given for the year ending
31st December 2018 and 2019. Rearrange the figures in a
comparative form and study the profitability of the concern:
Particulars 2018 2019
Net Sales 350000 450000
Expenses:
Salaries 35000 36000
Audit Fees 40000 45000
Interest on Bank Loans 12500 15000
Step 1
Firstly, specify absolute figures of assets and liabilities relating to the
current and previous accounting periods for analysis in Column I and
Column II of the comparative balance sheet.
Step 2
Each item on the asset side is taken as the percentage of total assets.
Similarly, each item on the liability side is taken as a percentage of total
liabilities by using following formula:
Percentage Change = Individual Assets or Individual Liabilities x 100
Total of Balance Sheet
Note: Specify the percentages as calculated above in Column III and IV year
wise of the Common Size Balance Sheet.
Namira Ltd.
Common Size Balance Sheet
(as on 31st March 2020 In (Rs.)
Step 1
Firstly, specify absolute figures such as cost of goods sold, net sales,
selling expenses, office expenses, etc. relating to the current and
previous accounting periods for analysis in Column I and Column II
of the comparative Income Statement.
Step 2
Each item of the income statement is taken as the percentage of total sales
by using following formula:
Percentage Change = Individual item of Income Statement x 100
Net Sales
Note: Specify the percentages as calculated above in Column III and IV year
wise of the Common Size Balance Sheet.
Ravi Limited
Common Size Income Statement
For the year ending 31-3-2020
Particulars Note Rs. (In lakhs) Percentage
I. Revenue from Operation (Net Sales) 1600 100.00
II. Other Income (Non-OP) 40 2.50
III. TOTAL REVENUE 1640 102.50
IV. Expenses:
Cost of Operating Revenue 1000 62.50
Other Expenses (Non-operating) 40 2.50
Interest 200 12.50
TOTAL EXPENSES 1240 77.50
V. Net Profit before tax(III – IV) 400 25.00
Less: Provision for Tax 200 12.50
VI. Net Profit after tax 200 12.50
Less: Dividends 140 8.75
60 3.75
Add: Capital Profit 20 1.25
Increase in Retained Earnings 80 5.00
RATIO ANALYSIS
With the help and study of some key financial ratios, we can look at the
financial health of a organization. Ratio analysis can also be used as a
diagnostic tool to find the sources of financial trouble at a company.
RATIOS
Example:
Current Assets (CA) : 400000 Rs.
Current Liabilities (CL) : 200000 Rs.
Now we can express the relation between CA and CL as follows:
As a simple Ratio =2:1
As a multiplication system = CA is double from the CL or CL is Half of the CA
As a percentage = CA is 200% of CL or CL is 50% of CA
Classification of Ratios
A. BASED ON SALES
Gross Profit
Net Profit
Inventory Turnover Operation Profit
Debt-Equity Ratio
Debtors Turnover Operating Ratio
Proprietary Ratio
Creditors Turnover
Fixed Assets Ratio
Current Ratio Assets Turnover B. BASED ON CAPITAL
Solvency Ratio EMPLOYED
Quick Ratio Fixed Assets Turnover
Capital Gearing Ratio Return on Equity
Current Assets Turnover
Debt Service Ratio
Capital Turnover Return on Total Assets
Networth Turnover Return on Capital
Employed
C. BASED ON EARNINGS
ON SHARE
LIQUIDITY RATIO OR SHORT TERM SOLVENCY RATIOS:
Liquidity is the ease with which assets may be converted into cash without loss.
Liquidity Ratios:
1) Current Ratio
2) Quick or Liquid Ratio
1) Current Ratio:
Meaning: Relationship between current assets and current liabilities.
Objective: to measure the ability of the concern to meet its short term
obligations and to depict the short term financial soundness of a concern.
Components of Current Ratios:
Current Assets .
Current Liabilities
Ideal Ratio= 2:1
Answer:
Current Ratio: 80000 / 40000 = 2:1
(i) When building for Rs. 30000 is purchased, current assets would decrease by
30000 because cash is the part of CA, hence new current ratio will be:
(80000 – 30000) / 40000 = 1.25 : 1
(ii) Machinery is the part of Non-current Assets and Long term bank loan is also
Non-current liabilities. So both will not affect current assets and current
liabilities hence current ration will remain the same.
Example 2:
The current assets and current liabilities of Sagrika Ltd. as on 31st march, 2020 were
Rs. 80000 and Rs. 40000. Calculate the effect of the following transactions
individually and totally on the current ration of Sagrika Ltd.
(i) Purchase of building for Rs. 30000 to be paid in cash.
(ii) Purchase of a machinery for Rs. 10000 to be financed through a long-term bank
loan.
(iii) Payment of final dividend of Rs. 10000 and payment of dividend tax Rs. 1000.
(iv) Purchase of tradable goods for Rs. 5000 on credit.
Answer:
Current Ratio: 80000 / 40000 = 2:1
(iii) Payment of final dividend of Rs. 10000 and payment of dividend tax Rs. 1000
will decrease current assets and current liabilities by Rs. 10000; hence
Current Ratio: (80000 – 11000) / (40000 – 11000) = 2.38 : 1
(iv) Purchase of tradable goods for Rs. 5000 on credit would increase both current
assets and current liabilities by Rs. 5000; hence
Current Ratio: (80000 + 5000) / (40000 + 5000) = 1.89:1
Shefali Ltd. Balance Sheet as on 31st March 2020
Particulars Note 2019-20
I. Equity and Liabilities
(1) Shareholders Fund
(a) Share Capital 200000
(b) Reserves and Surplus 20000
(2) Non Current Liabilities
(a) 10% Debentures 80000
(3) Current Liabilities
(a) Trade Payables 50000
(b) Short term Provisions (Taxation) 10000
Total 360000
II. Assets:
(1)Non-Current Assets
(a)Fixed Assets 250000
(2) Current Assets
(a) Inventories 40000
(b) Trade Receivables 30000
(c) Cash and Cash Equivalents:
Cash 25000
Bank 10000
(d) Other Current Assets (Prepaid Expenses) 5000
Total 360000
The following figures are extracted from the Balance Sheet of Megha
Limited as at 31st March 2019 and 2020:
Items 2019 2020
Inventories 30000 40000
Debtors 10000 15000
Cash at Bank 8000 5000
Creditors 12000 25000
Bills Payable 5000 4000
Bank Overdraft 5000 10000
Provision for Taxes 2000 1000
Answer:
CAPITAL STRUCTURE
FINANCE
INVESTMENT (OUTSIDE)
DEBENTURES
(Fixed Cost Capital)
Leverage or Capital Structure Ratios are calculated to judge the long term financial
position of the firm. These ratios reveal the funds provided by owners and outsiders.
Liquidity Ratios:
1) Debt-equity Ratio
2) Proprietary Ratio
3) Fixed Assets Ratio
4) Solvency Ratio
1) Debt-Equity Ratio
_____Debt______
Equity
Proprietor’s Fund
Total Assets
Proprietors’ Fund:
Equity Share Capital + Preference Share Capital+Reserve and
Surplus - Fictitious Assets
Balance Sheet
as on 31st March 2020 In (Rs.)
Particulars Note 2019-20
I. Equity and Liabilities
(1) Shareholders Fund
(a) Share Capital 100000
(b) Reserves and Surplus 50000
(2) Non Current Liabilities
(a) Long-term Borrowings (10% Debentures) 200000
(3) Current Liabilities
(a) Creditors 30000
(b) Bills Payable 20000
Total 400000
II. Assets:
(1)Non-Current Assets
(a)Fixed Assets 270000
(2) Current Assets
(a) Inventories 80000
(b) Trade Receivables 30000
(c) Cash and Cash Equivalents 20000
Total 400000
ANSWER:
1. Current Ratio:Current Assets / Current Liabilities
130000 / 50000 = 2.6 : 1
Current Assets: Cash + Trade Receivables + Inventories
20000 + 30000 + 80000 = 130000
Current Liabilities: Creditors + Bills Payable
30000 + 20000 = 50000
Activity ratios are computed to evaluate the efficiency with which the firm manages
and utilises its assets. These ratios are also called turnover ratios because they
indicate the rapidity with which assets are being converted or turned over into sales.
1) Inventory Ratio
_____Cost of Revenue from Operation______
Average Stock
Calculate the Stock Turnover Ratio from the information given below:
Opening Stock 20000 Revenue from Operation (Sales) 75000
Purchase 40000 Closing Stock 15000
Carriage Inward 5000
Solution:
STR : _____Cost of Revenue from Operation______
Average Stock
Calculate the Stock Turnover Ratio from the information given below:
Opening Stock 20000 Revenue from Operation (Sales) 400000
Closing Stock 30000 Gross Profit 30% of Sales
Solution:
STR : _____Cost of Revenue from Operation______
Average Stock
Net Credit Revenue from Operation: Gross Credit Revenue from Operation –
Revenue from Operation Return (Sales Return)
Average Receivables: (Opening Debtors and B/R) + (Closing Debtors and B/R)
2
Average Payables: (Opening Creditors and B/P) + (Closing Creditors and B/P)
2
or 160 / 8 = 20:1
3) Dividend Pay-out Ratio
Dividend Per Share (DPS) __ X 100
Earning per Share (EPS)
Cash flow statement is a statement setting out the flow of cash under
different heads of sources and their utilizations to determine the
requirements of cash during the given period and to prepare for its
adequate provision.
-Institute of Cost Accountants of India
Cash and Cash Equivalents
As stated earlier, cash flow statement shows inflows and outflows of
cash and cash equivalents from various activities of an enterprise
during a particular period.
As per AS-3,
‘Cash’ comprises cash in hand and demand deposits with banks.
‘Cash equivalents’ means short-term highly liquid investments that
are readily convertible into known amounts of cash and which are
subject to an insignificant risk of changes in value.
(Note: An investment normally qualifies as cash equivalents only when it has
a short maturity, of say, three months or less from the date of acquisition.
Investments in shares are excluded from cash equivalents unless they are in
substantial cash equivalents. For example, preference shares of a company
acquired shortly before their specific redemption date, provided there is only
insignificant risk of failure of the company to repay the amount at maturity.
Similarly, short-term marketable securities which can be readily converted
into cash are treated as cash equivalents and is liquidable immediately
without considerable change in value.)
Cash Flows:
‘Cash Flows’ implies movement of cash in and out due to
some non-cash items. Receipt of cash from a non-cash item
is termed as cash inflow while cash payment in respect of
such items as cash outflow. For example, purchase of
machinery by paying cash is cash outflow while sale
proceeds received from sale of machinery is cash inflow.
Other examples of cash flows include collection of cash from
trade receivables, payment to trade payables, payment to
employees, receipt of dividend, interest payments, etc. Cash
management includes the investment of excess cash in cash
equivalents. Hence, purchase of marketable securities or
short-term investment which constitutes cash equivalents is
not considered while preparing cash flow statement.
Classification of Activities for the Preparation of
Cash Flow Statement
1. Cash Flows From Operating Activities:
Cash flows from operating activities are primarily derived from the main activities of the
enterprise. They generally result from the transactions and other events that enter into the
determination of net profit or loss. Examples of cash flows from operating activities are:
The net position is shown in case of operating cash flows. An enterprise may hold securities and
loans for dealing or for trading purposes. In either case they represent Inventory specifically
held for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading
securities are classified as operating activities. Similarly, cash advances and loans made by
financial enterprises are usually classified as operating activities since they relate to main
activity of that enterprise.
2. Cash from Investing Activities:
As per AS-3, investing activities are the acquisition and disposal of long-term
assets and other investments not included in cash equivalents. Examples of
cash flows arising from investing activities are:
Cash Outflows from investing activities
Cash payments to acquire fixed assets including intangibles and capitalised
research and development.
Cash payments to acquire shares, warrants or debt instruments of other
enterprises other than the instruments those held for trading purposes.
Cash advances and loans made to third party (other than advances and loans
made by a financial enterprise wherein it is operating activities).
Cash Inflows from Investing Activities
Cash receipt from disposal of fixed assets including intangibles.
Cash receipt from the repayment of advances or loans made to third parties
(except in case of financial enterprise).
Cash receipt from disposal of shares, warrants or debt instruments of other
enterprises except those held for trading purposes.
Interest received in cash from loans and advances.
Dividend received from investments in other enterprises.
3. Cash from Financing Activities:
Financing activities relate to long-term funds or capital of an enterprise.
Examples of financing activities are:
Example: If a company by investing Rs. 800000 gets net annual income of Rs.
200000 before depreciation but after taxes continuously for 10 years, compute the
payback period.
Solution: P = I/C
P = 800000 / 200000 = 4 years.
Example:
Mohan Ltd wants to buy a new machine on the condition that its costs can be recovered in five
years by the savings therefrom. You are given the following information:
Cost of the machine Rs. 600000; Annual sales revenue generated by the new machine Rs.
800000; Variable Cost 60% of sales; Annual fixed cost other than depreciation Rs. 40000; Life
of the machine is 8 years; Taxation to be charged @ 50% of profits. Advise the management
whether the machine should be acquired or not.
Solution: Profitability Statement
Particulars Rs. Rs.
Sales Revenue 800000
Less: Variable Cost (60% of sales) 480000
Fixed Cost 40000 520000
Profit before Tax and Depreciation 280000
Less: Depreciation (600000 / 8) 75000
Profit before Tax 205000
Less: Income Tax (@ 50%) 102500
Profit after Tax 102500
Add: Depreciation 75000
Net Cash Inflow 177500
Payback Period = I / C
600000 / 177500 = 3.38 years.
(ii) When annual cash inflows are unequal:
Example: XYZ Ltd. Evaluates an investment proposal which costs Rs. 40000 and
yields (CFAT) cash flow after tax of Rs. 8000, 12000, 15000, 20000, 21000 and 24000
in the years 1 to 6 respectively.
Solution:
Year Annual CFAT Cumulative CFAT
1 8000 8000
2 12000 20000
3 15000 35000
4 20000 55000
5 21000 76000
6 24000 100000
Solution:
Year Annual CFAT Cumulative CFAT
1 5000 5000
2 10000 15000
3 15000 30000
4 25000 55000
5 21000 76000
6 24000 100000
Example: Ravi Ltd. Is considering the purchase of a machine. Two machines A and B are
available at the cost of Rs 60000 each. Scrap value of both the machines are 12000 and 15000
respectively. Earnings after taxes but before depreciation are expected as follows:
Year Cash Inflow of machine A Cash Inflow of machine B
1 25000 10000
2 20000 15000
3 15000 25000
4 10000 20000
5 10000 20000
Evaluate the two alternatives by using: (i) Pay-back Period Method; and (ii) Post pay-back
period profitability Method.
Solution (i):
Payback period of machine A: 25000+20000+15000 = 3 years.
Payback period of machine B: 10000+15000+25000 (3 years.) + [10000/20000 x 12] = 3.6 Years.
Solution (ii):
Post payback period profitability of machine A: (80000 + 12000) – 60000 = 32000
Post payback period profitability of machine B: (90000 + 15000) – 60000 = 45000
(2) Accounting Rate of Return on Average Investment (ARR):
ARR = Average Annual Income after Tax & Depreciation X 100
Average Investment
Here
Average Investment = Initial Investment + Scrap Value
2
Example:
ABC Ltd. Is contemplating an investment of Rs. 100000 in a new plant, which
will provide a salvage value of Rs. 8000 at the end of its economic life of 5
years. The profits after depreciating and tax for 5 years are estimated as 5000,
7500, 12500, 13000 and 8000 respectively. Calculate ARR.
Solution:
ARR = Average Annual Income after Tax & Depreciation X 100
Average Investment
= 9200 / 54000 x 100 =17.04%
Average Annual Profits: (5000+7500+12500+13000+8000) / 5 = 9200
Average Investment: (100000 + 8000) / 2 = 54000
Example:
Calculate the average rate of return for Project X and Y from the following:
Project X Project Y
Investment 40000 60000
Expected Life 4 years 5 years
Salvage Value 4000 8000
Projected net Income after tax and depreciation:
Years 1 2 3 4 5
Project X 4000 3000 3000 2000 -
Project Y 6000 6000 4000 2000 2000
If the required rate of return is 12% which project should be selected?
Solution:
ARR = Average Annual Income after Tax & Depreciation
X 100
Average Investment
Project X:
Average Annual Profits: (4000+3000+3000+2000) / 4 = 3000
Average Investment: (40000 + 4000) / 2 = 22000
ARR = 3000 / 22000 x 100 = 13.64% (Project X should be selected)
Project Y:
Average Annual Profits: (6000+6000+4000+2000+2000) / 5 = 4000
Average Investment: (60000 + 8000) / 2 = 34000
ARR = 4000 / 34000 x 100 = 11.76%
Example:
A Project costs Rs 25000 and has a scrap value of Rs 5000 after 5 years. The net profit before
depreciation and taxes for the five years period are expected to be 5000, 6000, 7000, 8000 and
10000. You are required to calculate the average rate of return assuming 30% rate of tax and
depreciation on straight line method.
Solution:
ARR = Average Annual Income after Tax & Depreciation X 100
Average Investment
Years 1 2 3 4 5
Profit before Depreciation and tax 5000 6000 7000 8000 10000
Less: Depreciation 4000 4000 4000 4000 4000
Profit before tax 1000 2000 3000 4000 6000
Less: Income Tax @ 30% 300 600 900 1200 1800
Profit after Depreciation and tax 700 1400 2100 2800 4200
Add: Depreciation 4000 4000 4000 4000 4000
Profit after tax 25000
Depreciation: – 5000
& before Depreciation
/ 5 = 4000 Rs. 4700 5400 6100 6800 8200
Average Annual Profits: (700+1400+2100+2800+4200) / 5 = 2240
Average Investment: (25000 + 5000) / 2 = 15000
ARR = 2240 / 15000 x 100 = 14.93%
Example:
A project involves a net cash inflow of Rs. 3 lacs a year for three years and the cost of capital is 8%. Find
the present value of cash inflows.
Solution:
PV = C1 + C2 + C3 _
(1 + r) (1 + r)2 (1 + r)3
Years 1 2 3 4 5
Project A 7000 12000 12000 5000 4000
Project B 22000 12000 7000 5000 4000
Year Cash Inflow Cash Inflow P.V. Factor at Present Value Present Value
of Project A of Project B 10% of Project A of Project B
1 7000 22000 0.909 6363 19998
2 12000 12000 0.826 9912 9912
3 12000 7000 0.751 9012 5257
4 5000 5000 0.683 3415 3415
5 4000 4000 0.621 2484 2484
(Scrap) 2000 3000 0.621 1242 1863
TOTAL PRESENT VALUE 32428 42929
Net Present Value: Present Value of Cash Inflow – Initial Investment
Project A: 32428 – 30000 = 2428
Project B: 42929 – 40000 = 2929
Decision: Project B will be chosen because its NPV is greater.
Example:
No project is acceptable unless yield is 10%. Cash inflows of a certain project along with cash
outflows are given below:
The salvage value at the end of 5th year is Rs. 40000. Calculate the net present value of the
project if discount factor at 10% for 5 year is 0.909, 0.826, 0.751, 0.683 and 0.621 respectively.
P.T.O.
Solution: Calculation of present value of cash Inflow
NPV: Total Present Value of Cash Inflow – Total Present Value of Cash Outflow
186130 – 177270 = 8860
PROFITABILITY INDEX OR BENEFIT-COST RATIO:
PVI OR PI: Present Value of Cash Inflows / Present Value of Cash Outflow
Decision Rule: If the result is one or more then the project is accepted and if it is less
than 1, the project is rejected.
Example:
While using the figures of last example compute profitability index.
Calculation of IRR:
(a) When the annual cash inflows are equal:
Step 1: Calculate Present Value Factor = Initial Investment / Annual Cash Inflow
Step 2: Once PV factor is known, it is located in the Annuity Table on the line
which represents number of years corresponding to economic life of the
project. If accurate PV factor is not available then IRR will be in between
two factors and nearest factor is take as internal rate of return. It can be
computed by the following formula:
PV at LDR – PV at HDR
Here:
IRR = Internal Rate of Return
LDR = Lower Discount Rate
HDR = Higher Discount Rate
I = Initial Investment
(b) When the annual cash inflows are unequal: In this case PV Factor will be calculated on
the basis of average cash inflow. Rest steps will be same as point (a).
Example (When Annual Cash Inflows are equal):
Determine the internal rate of return using annuity method from the following data:
Initial Investment Rs. 10000
Annual Cash Inflow for 5 years is 2637.83 in every year.
Solution:
10177 – 9874
IRR = 11.17%
Example:
The following is a summary of financial data in respect of five investment proposals:
Proposal Initial Outlay Net annual cash flow Life in years
A 60000 18000 15
B 88000 15000 25
C 2000 1000 5
D 20000 3000 10
E 42000 15000 20
Rank these proposals according to:
(i) Pay-back Period Method,
(ii) Average Rate of Return Method,
(iii) Net Present Value Method, and
The cost of capital being 6%.
SOLUTION:
(i) Ranking according to Pay Back Method:
Propo Initial Life Net Present Present Value Net Present Ranking
sal Outlay in annual Value of Total Cash Value
years cash Factor Flow
Inflow at 6%
A 60000 15 18000 9.712 174816 114816 2
B 88000 25 15000 12.783 191745 103745 3
C 2000 5 1000 4.212 4212 2212 4
D 20000 10 3000 7.360 22080 2080 5
E 42000 20 15000 11.470 172050 130050 1
(3) Discounted pay-back period:
In this method all cash inflows are discounted with a discounted rate
equal to cost of capital. With the help of discounted cash inflows pay
back period is completed.
Example: Sagrika Limited is considering a project with an initial capital outlay of Rs.
50000. Its cash inflows are as follows:
Year 1 2 3 4 5
Cash Inflow 20000 15000 15000 10000 10000
The expected rate of return on the capital invested is 10% p.a. Calculate the
discounted pay back period of the project.
Solution: