BA4202: FINANCIAL MANAGEMENT: UNIT-II

Capital Budgeting – Solved Problems for Revision

Solution to Problem 1: PAY BACK PERIOD METHOD

Project 1: (Uniform Cash Flow)
Pay Back Period = Total Investment / Annual Cash Flow = 2,00,000 / 50,000 = 4 years.

Project II: (Uneven Cash Flow)

Year Cash Flow Cumulative Cash Flow Pay Back Period =
1 60,000 60,000
2 yrs + (2,00,000 – 1,30,000) / 75,000
2 70,000 1,30,000
3 75,000 2,05,000 2 yrs + (70,000 / 75,000) = 2 + 0.933
4 45,000 2,50,000
2.933 years
5 0

Project III: (Uneven Cash Flow)

Year Cash Flow Cumulative Cash Flow Pay Back Period =
1 35,000 35,000
3 yrs + (2,00,000 – 1,65,000) / 50,000
2 45,000 80,000
3 85,000 1,65,000 3 yrs + (35,000 / 50,000) = 3 + 0.70
4 50,000 2,15,000
3.70 years
5 35,000 2,50,000

Pay-Back Period of Project-I: 4.00 years

Pay-Back Period of Project-II: 2.93 years
Pay-Back Period of Project-III: 3.70 years

Since the Project II has the LOWEST Payback period among the three, it is profitable to invest in
Project II under Pay back method.

Solution: Pay Back Period Method

Yr. PBDT Depn** PBT Tax @ 50% PAT Cash Cumulative
Inflow C.I.
1 20,000 18,000 2,000 1,000 1,000 19,000 19,000
2 24,000 18,000 6,000 3,000 3,000 21,000 40,000
3 30,000 18,000 12,000 6,000 6,000 24,000 64,000
4 26,000 18,000 8,000 4,000 4,000 22,000 86,000
5 22,000 18,000 4,000 2,000 2,000 20,000 1,06,000

Pay Back Period

= 4 yrs + {(1,00,000 – 86,000) / 20,000} = 4 + (14,000/20,000) = 4 + 0.7 = 4.7 years
 Solution: Accounting Rate of Return Method
Yr. PBDT Depn** PBT Tax @ 50% PAT
1 20,000 18,000 2,000 1,000 1,000
2 24,000 18,000 6,000 3,000 3,000
3 30,000 18,000 12,000 6,000 6,000
4 26,000 18,000 8,000 4,000 4,000
5 22,000 18,000 4,000 2,000 2,000
TOTAL PROFITS IN 5 YEARS 16,000

Average Investment = ( Invt at the beginning + Invt at the end ) / 2

= (1,00,000 + 0) / 2 = 50,000

Average Return = Total Profits / Life of the Project = 16,000 / 5 = 3,200

Accounting Rate of Return = Average Return / Average Investment x 100

= 3,200 / 50,000 x 100 = 6.4%

Solution: Net Present Value Method

Note: Since no discount factor (cost of capital) is not given in the problem, 10% is taken as the
Discount Factor for the calculation of Present Values.

Year Discount Machine X Machine Y

Factor @ 10% Cash Inflows Present Value Cash Inflows Present Value
1 0.9091 5,500 5,000 6,200 5,636
2 0.8264 6,200 5,124 8,800 7,272
3 0.7513 7,800 5,860 4,300 3,231
4 0.6830 4,500 3,074 3,700 2,527
5 0.6209 3,000 1,863 2,000 1,242
Total Present Value 20,920 19,908
Less: Investment 20,000 20,000
Net Present Value 920 -92

Machine X has a positive NPV of ₹920, while Machine Y has a negative NPV of ₹92. The one
with higher positive NPV (Machine X) is to be chosen for investment.
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Solution to Problem 4: Internal Rate of Return

To find out IRR, we shall try applying 10% discount factor first, and keep increasing the DF
gradually till we get NEGATIVE NPV.
Year Cash Inflows DF @ 10% Present Value DF @ 12% Present Value DF @ 13% Present Value
1 25,000 0.9091 22,727 0.8929 22,321 0.8850 22,124
2 35,000 0.8264 28,926 0.7972 27,902 0.7831 27,410
3 50,000 0.7513 37,566 0.7118 35,589 0.6931 34,653
4 40,000 0.6830 27,321 0.6355 25,421 0.6133 24,533
5 25,000 0.6209 15,523 0.5674 14,186 0.5576 13,939
Total Present Value 1,32,062 1,25,419 1,22,658
Less: Investment 1,25,000 1,25,000 1,25,000
Net Present Value 7,062 419 -2,342

At 12% Discount Factor, NPV is +419.

At 13% Discount Factor, NPV is -2,342.

IRR is the rate at which NPV is exactly “zero”; hence, it lies in between 12% and 13%. We
calculate the exact IRR by using the following formula:

IRR = LDF + { (HDF – LDF) x (NPV at LDF / Difference between TPV of LDF and HDF)
Note: For the computation of IRR, we take into account the data pertaining to two DF nearer to each
other. Here, we ignore the working for 10% DF, but take into account 12% and 13%.

Here:
LDF = Lower Discount Factor (i.e. 12)
HDF = Higher Discount Factor (i.e. 13)
NPV at LDF = Net Present Value at Lower Discount Factor (i.e. 419)
Difference between TPV of LDF and HDF
= Total Present Value at LDF – Total Present Value at HDF = 1,25,419 – 1,22,658 = 2,760

IRR = 12 + { (13 – 12) x (419 / 2,760) = 12 + (1 x 0.1517) = 12 + 0.1517 = 12.1517

Hence, the Internal Rate of Return of the given Project is 12.1517.

Since it is much lower than the cost of capital (15%), the project is NOT acceptable.

Note: For acceptance under IRR method, the IRR must be more than the Cost of Capital.
5

Solution: Net Present Value Method

Project A Project B
Year DF @ 10%
Cash Inflows Present Value Cash Inflows Present Value
1 0.9091 60,000 54,545 40,000 36,364
2 0.8264 50,000 41,322 50,000 41,322
3 0.7513 50,000 37,566 60,000 45,079
4 0.6830 40,000 27,321 90,000 61,471
5 0.6209 30,000 18,628 1,00,000 62,092
Total Present Value 1,79,382 2,46,328
Less: Investment 2,00,000 3,00,000
Net Present Value -20,618 -53,672

Since both the projects are yielding Negative NPVs, both are to be rejected.

Solution: Internal Rate of Return Method

Year Cash Inflows DF @ 10% Present Value DF @ 8% Present Value DF @ 5% Present Value
1 60,000 0.9091 54,545 0.9259 55,556 0.9524 57,143
2 50,000 0.8264 41,322 0.8573 42,867 0.9070 45,351
3 50,000 0.7513 37,566 0.7938 39,692 0.8638 43,192
4 40,000 0.6830 27,321 0.7350 29,401 0.8227 32,908
5 30,000 0.6209 18,628 0.6806 20,417 0.7835 23,506
Total Present Value 1,79,382 1,87,933 2,02,100
Less: Investment 2,00,000 2,00,000 2,00,000
Net Present Value -20,618 -12,067 2,100

We get Negative NPV at 8% DF, while we get Positive NPV at 5%.

IRR = LDF + { (HDF – LDF) x (NPV at LDF / Difference between TPV of LDF and HDF)

Here:
LDF = Lower Discount Factor (i.e. 5)
HDF = Higher Discount Factor (i.e. 8)
NPV at LDF = Net Present Value at Lower Discount Factor (i.e. 2,100)
Difference between TPV of LDF and HDF
= Total Present Value at LDF – Total Present Value at HDF = 2,02,100 – 1,87,933 = 14,167

IRR = 5 + { (8 – 5) x (2,100 / 14,167) = 5 + (3 x 0.148235) = 5 + 0.4447 = 5.4447

Hence, the Internal Rate of Return for the Project A is 5.4447%.

Since it is much lower than the cost of capital (10%), the project is rejected under IRR
method.
Similar working can be made for Project B.
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Solution to Problem 6

Note: Cost of Capital (i.e. Discount Factor) is not directly given in this problem.
Cost of Capital (DF) = Risk less Discount Rate + Risk Premium

For Project I = CoC = 5% + 5% = 10% (used as Discount Factor for discounting Cash Flows)

For Project II = CoC = 5% + 10% = 15% (used as Discount Factor for discounting Cash Flows)

Project I
Year DF @ 10% Since NPV is
Cash Inflows Present Value
1 0.9091 7,000 6,364 Negative,
2 0.8264 7,000 5,785 Project I cannot
3 0.7513 6,000 4,508 be considered
Total Present Value 16,657 for investment.
Less: Investment 20,000
Net Present Value -3,343

Project II
Year DF @ 15% Since NPV is
Cash Inflows Present Value
1 0.8696 8,000 6,957 Negative,
2 0.7561 9,000 6,805 Project II also
3 0.6575 5,000 3,288 cannot be
Total Present Value 17,049 considered for
Less: Investment 20,000
investment.
Net Present Value -2,951

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 Solution to Problem 7: Net Present Value Method
Project
Year DF @ 10%
Cash Flows Present Value
Cash Outflows
0 1.0000 1,75,000 1,75,000
1 0.9091 5,50,000 5,00,000
Total Present Value of Cash Outflows 6,75,000
Cash Inflows
1 0.9091 35,000 31,818
2 0.8264 45,000 37,190
3 0.7513 65,000 48,835
4 0.6830 85,000 58,056
5 0.6209 50,000 31,046
5** 0.6209 50,000 31,046
Total Present Value of Cash Inflows 2,37,992
Less: Total PV of Cash Outflows 6,75,000
Net Present Value -4,37,008
** Salvage (₹50,000 received at the end of 5th year)
Since the NPV is Negative, the Project is to be rejected.

Note: Investment in this project happens in Year 0 and year 1. Hence, the respective DF are
applied to calculate “Total Present Value of Cash Outflows”.
Salvage received at the end of the 5th year is to be treated as “Cash Inflow” in the 5th year
and is to be discounted accordingly.

Solution to Problem 8: Accounting Rate of Return Method

Proposal I Proposal II
Automatic Ordinary
Estimated Sales per annum 1,50,000 1,50,000
Less: Costs (Mat + Lab + OH) 86,000 1,30,000
Net Profit per annum 64,000 20,000
Less: Depreciation
(Cost / Estimated Life) 40,000 7,500
Profit after Depn before Tax 24,000 12,500
Less: Tax (assumed at 50%) 12,000 6,250
Profit After Tax 12,000 6,250
 Proposal I (Automatic Machine):
Average Investment = (Invt at the beginning + Invt at the end) / 2
= (2,20,000 + 0) / 2 = 1,10,000

Accounting Rate of Return = Average Return / Average Investment x 100

= (12,000 / 1,10,000) x 100 = 10.91%

Proposal II (Ordinary Machine):

Average Investment = (Invt at the beginning + Invt at the end) / 2
= (60,000 + 0) / 2 = 30,000

Accounting Rate of Return = Average Return / Average Investment x 100

= (6,250 / 30,000) x 100 = 20.83%

Since the ARR of Ordinary machine (20.83%) is better than that of Automatic machine
(10.91%), it is profitable to buy “Ordinary Machine” under Accounting Rate of Return
method.

Note: Since Tax Rate is not given, the same is assumed at 50% in this calculation.

Solution (a)
Using a constant discount factor throughout life:
Year DF used Cash Flow DF @ 14% Present Value
1 14% 1,00,000 0.8772 87,719
2 14% 2,00,000 0.7695 1,53,894
3 14% 3,00,000 0.6750 2,02,491
4 14% 6,00,000 0.5921 3,55,248
5 14% 3,00,000 0.5194 1,55,811
Total Present Value 9,55,163
Less: Initial Cash Outlay 10,00,000
Net Present Value -44,837

Hence, the NPV is (-) 44,837 when 14% discount factor is used throughout the life of the
project.
 Solution (b)
Using variable discount factors (12% in the first year, and increasing it by 1% each year)
Year DF used Cash Flow Discount Factor Present Value
1 12% 1,00,000 0.8929 89,286
2 13% 2,00,000 0.7901 1,58,028
3 14% 3,00,000 0.6931 2,07,931
4 15% 6,00,000 0.6027 3,61,620
5 16% 3,00,000 0.5196 1,55,871
Total Present Value 9,72,735
Less: Initial Cash Outlay 10,00,000
Net Present Value -27,265

Hence, the NPV is (-) 27,265 when variable discount factors are used during the life of the
project.
 Comprehensive Problem on Capital Budgeting

Solution to Comprehensive Problem:

Computation of “Profit After Tax” and “Cash Inflows” for the Life of the Project
Year PBT Tax @ 50% PAT Depn (20% of OC) Cash Inflow
1 9,000 4,500 4,500 60,000 64,500
2 80,000 40,000 40,000 60,000 1,00,000
3 70,000 35,000 35,000 60,000 95,000
4 60,000 30,000 30,000 60,000 90,000
5 50,000 25,000 25,000 60,000 85,000

Pay Back Period:

Year Cash Inflow Cumulative C.I.

1 64,500 64,500
2 1,00,000 1,64,500
3 95,000 2,59,500
4 90,000 3,49,500
5 85,000 4,34,500

Pay Back Period

= 3 yrs + (3,00,000 – 2,59,500) / 90,000
= 3 yrs + (40,500 / 90,000)
= 3 yrs + 0.45 = 3.45 years

Hence, PBP is 3.45 years.

Accounting Rate of Return Method:

Average Investment = (Invt at the beginning + Invt at the end) / 2 = (3,00,000 + 0 ) / 2 = 1,50,000

Average Return = (4,500 + 40,000 + 35,000 + 30,000 + 25,000) / 5 = 1,34,500 / 5 = 26,900

Accounting Rate of Return = Average Return / Average Investment x 100

= 26,900 / 1,50,000 x 100 = 17.93% Hence, ARR is 17.93%

Net Present Value Method:

Year Cash Inflow DF @ 10% Present Value

1 64,500 0.9091 58,636
2 1,00,000 0.8264 82,645
3 95,000 0.7513 71,375
4 90,000 0.6830 61,471
5 85,000 0.6209 52,778
Total Present Value 3,26,905
Less: Investment 3,00,000
Net Present Value 26,905

Net Present Value of the Project is ₹26,905.

Net Present Value Index Method (or) Profitability Index Method:

NPV Index or PI = Total Present Value of Cash Inflows / Total Present Value of Cash Outflows

= Total Present Value of Cash Inflows / Investment = 3,26,905 / 3,00,000 = 1.09

NPV Index or Profitability Index is 1.09.

Internal Rate of Return Method:

Year Cash Inflow DF @ 10% Present Value DF @ 12% Present Value DF @ 14% Present Value
1 64,500 0.9091 58,636 0.8929 57,589 0.8772 56,579
2 1,00,000 0.8264 82,645 0.7972 79,719 0.7695 76,947
3 95,000 0.7513 71,375 0.7118 67,619 0.6750 64,122
4 90,000 0.6830 61,471 0.6355 57,197 0.5921 53,287
5 85,000 0.6209 52,778 0.5674 48,231 0.5194 44,146
Total Present Value 3,26,905 3,10,356 2,95,082
Less: Investment 3,00,000 3,00,000 3,00,000
Net Present Value 26,905 10,356 -4,918

IRR = LDF + { (HDF – LDF) x (NPV at LDF / Difference between TPV of LDF and HDF)

Here:

LDF = Lower Discount Factor (i.e. 12)

HDF = Higher Discount Factor (i.e. 14)

NPV at LDF = Net Present Value at Lower Discount Factor (i.e. 10,356)

Difference between TPV of LDF and HDF

= Total Present Value at LDF – Total Present Value at HDF = 3,10,356 – 2,95,082 = 15,274.

IRR = 12 + { (14 – 12) x (10,356 / 15,274) = 12 + ( 2 x 0.677989) = 12 + 1.355978 = 13.3559%

Hence, the Internal Rate of Return is 13.3559%.