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    Financial Management Session 10

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    vaidehirajput03
    Here are the steps to solve this problem: 1) Calculate the NPV for each project: Project A: NPV = $50,000 - $40,000 = $10,000 Project B: NPV = $60,000 - $50,000 = $10,000 2) Calculate the Profitability Index (PI) for each project using Formula 2: Project A PI = 1 + (NPV/Initial Investment) = 1 + ($10,000/$40,000) = 1.25 Project B PI = 1 + (NPV/Initial Investment) = 1 + ($10,000/$50,000) = 1.20

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    Financial Management Session 10

    Uploaded by

    vaidehirajput03
    53 views20 pages
    Here are the steps to solve this problem: 1) Calculate the NPV for each project: Project A: NPV = $50,000 - $40,000 = $10,000 Project B: NPV = $60,000 - $50,000 = $10,000 2) Calculate the Profitability Index (PI) for each project using Formula 2: Project A PI = 1 + (NPV/Initial Investment) = 1 + ($10,000/$40,000) = 1.25 Project B PI = 1 + (NPV/Initial Investment) = 1 + ($10,000/$50,000) = 1.20

    Original Title

    Financial Management Session 10 (1)

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    Here are the steps to solve this problem: 1) Calculate the NPV for each project: Project A: NPV = $50,000 - $40,000 = $10,000 Project B: NPV = $60,000 - $50,000 = $10,000 2) Calculate the Profitability Index (PI) for each project using Formula 2: Project A PI = 1 + (NPV/Initial Investment) = 1 + ($10,000/$40,000) = 1.25 Project B PI = 1 + (NPV/Initial Investment) = 1 + ($10,000/$50,000) = 1.20

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    53 views20 pages

    Financial Management Session 10

    Uploaded by

    vaidehirajput03
    Here are the steps to solve this problem: 1) Calculate the NPV for each project: Project A: NPV = $50,000 - $40,000 = $10,000 Project B: NPV = $60,000 - $50,000 = $10,000 2) Calculate the Profitability Index (PI) for each project using Formula 2: Project A PI = 1 + (NPV/Initial Investment) = 1 + ($10,000/$40,000) = 1.25 Project B PI = 1 + (NPV/Initial Investment) = 1 + ($10,000/$50,000) = 1.20

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 20

    Capital Budgeting

    Session 10
    Question 4.
    • A company is considering a proposal to install a new machine at a cost of Rs. 50,000.
    The machine has a life expectancy of 5 years and no salvage value. The tax rate is
    35% p.a. Assume the firm uses straight line depreciation and the same is allowed for
    tax purposes. The estimated cash flows before depreciation and tax (CFBT) from the
    investment are as follows:

    Year CFBT (Rs.)


    1 10,000
    2 10,692
    3 12,769
    4 13,462
    5 20,365

    • Compute the NPV @ 10% to determine whether the company must make the
    investment or not.
    Solution
    • 1. Calculate the depreciation using SLM

    50,000 / 5 = Rs. 10,000 per year of useful life

    • 2. Arrive at the CFAT (Cash flow before depreciation and after tax)

    Year (1) CFBT (2) Depreciation (3) PBT (4) = Tax @ 35% EAT (6) = CFAT (7) =
    (2-3) (5) (4-5) (6 +3)
    1 10,000 10,000 - - - 10,000
    2 10,692 10,000 692 242 450 10,450
    3 12,769 10,000 2,769 969 1,800 11,800
    4 13,462 10,000 3,462 1,212 2,250 12,250
    5 20,365 10,000 10,365 3,627.75 6,737.25 16,737.25
    Year CFAT PVIF @ 10% PV of CF
    1 10,000 0.909 9,090
    2 10,450 0.826 8,632
    3 11,800 0.751 8,862
    4 12,250 0.683 8,367
    5 16,737.25 0.621 10,393.83

    Total PV of Cash flow = 45,344.83

    NPV = 45,344.83 - 50,000 = Rs. - 4,655.17

    Since NPV is negative, the investment proposal to install a new milling control may be rejected.
    Question 5.
    • EM Private Ltd. Is evaluating two mutually exclusive proposals for new capital investment. The
    following information about the proposal is available. Advise the company which project would
    be financially viable using NPV method.

    Project A (Rs.) Project B(Rs.) Depreciation using SLM, Cut off


    Net cash outlay 80,000 1,00,000 discount rate is 10% and Corporate Tax
    rate @50%
    Salvage - -
    Earnings before depreciation and tax is
    Estimated Life 4 years 5 years as follows

    Year Project A Project B


    1 24,000 28,000
    2 28,000 32,000
    3 32,000 36,000
    4 44,000 44,000
    5 40,000
    Solution
    • Depreciation for Project A - Using SLM - 80,000/4 = Rs. 20,000

    • Calcuation of CFAT
    Year CFBT Depreciation EBT Tax@50% EAT CFAT
    1 24,000 20,000 4,000 2,000 2,000 22,000
    2 28,000 20,000 8,000 4,000 4,000 24,000
    3 32,000 20,000 12,000 6,000 6,000 26,000
    4 44,000 20,000 24,000 12,000 12,000 32,000

    Year CFAT PVIF@10% PV of CFAT


    1 22,000 0.909 19,998
    PV of CF = Rs. 81,204
    2 24,000 0.826 19,824
    3 26,000 0.751 19,526 NPV = 81,204 - 80,000 = Rs. 1,204

    4 32,000 0.683 21,856


    Solution contd...
    • Depreciation for Project A - Using SLM - 1,00,000/5 = Rs. 20,000

    • Calcuation of CFAT Year CFBT Depreciation EBT Tax@50% EAT CFAT


    1 28,000 20,000 8,000 4,000 4,000 24,000
    2 32,000 20,000 12,000 6,000 6,000 26,000
    3 36,000 20,000 16,000 8,000 8,000 28,000
    4 44,000 20,000 24,000 12,000 12,000 32,000
    5 40,000 20,000 20,000 10,000 10,000 30,000

    Year CFAT PVIF@10% PV of CFAT


    1 24,000 0.909 21,816
    PV of CF = Rs. 1,04,806
    2 26,000 0.826 21,476
    3 28,000 0.751 21,028 NPV = 1,04,806-1,00,000 = Rs. 4,806

    4 32,000 0.683 21,856 Owing to higher NPV, Proposal B must be


    5 30,000 0.621 18,630 chosen for investment.
    Method #2
    Profitability Index
    Profitability index

    • The profitability index (PI) is a measure of a project's or


    investment's attractiveness.

    • The Profitability Index is calculated by dividing the present value of


    future expected cash flows by the initial investment amount in the
    project.

    • A PI greater than 1.0 is deemed as a good investment, with higher


    values corresponding to more attractive projects.
    Importance of PI

    • Profitability index, also known as profit investment ratio and value


    investment ratio, is the ratio of payoff to investment of a proposed
    project.

    • It is a useful tool for ranking projects because it allows you to


    quantify the amount of value created per unit of investment.

    • PI greater than one indicates that present value of future cash


    inflows from the investment is more than the initial investment,
    thereby indicating that it will earn profits.
    Advantages of using PI
    • The profitability index indicates whether an investment would create or destroy
    company value.

    • It takes into consideration the time value of money and the risk of future cash
    flows through the cost of capital.

    • It is useful for ranking and choosing between projects when capital is rationed.

    • It measures the ratio between the present value of future cash flows and the
    initial investment. It presents a parallel between the costs and profits of a
    certain project.

    • It is an investment tool that is easy to understand.

    • It ascertains the exact rate of return of the project.

    • It will take into consideration all cash flows from a project.


    Demerits of PI

    • The information generated is based on estimates instead of


    facts.
    • The tool ignores what is called the “sunk cost.”
    • It can be difficult to estimate opportunity costs.
    • It is difficult to understand interest rate or discount rate.
    • It is difficult to calculate profitability index if two projects
    having different useful life.
    Calculation of PI
    • In order to determine which project to pursue, the best formula to use is the Present value
    Index.

    • PI may be computed using either of the following formulae:

    • Formula 1:

    • PI = PV of inflows/PV of outflows.

    • Formula 2:

    • PI = 1+ (Net Present Value / Initial Investment Required)


    Interpretation
    Example 1

    • Calculate the Profitability index of the


    project at 10% cost of capital

    • Advice Jade Ltd. whether the project must


    be accepted or rejected, based on the PI.
    Solution

    Jade Ltd. may


    accept the proposal
    since PI is greater
    than 1.
    Question 1

    • PQR Ltd. is considering an investment proposal costing $ 30,000.


    Calculate the PI (using formula 2) and determine whether it is worth
    investing at 10% cost of capital. The cash flows are are follows:
    Solution

    Year Cashflow (in ‘000 $) PV factor at 10% PV of Cashflow


    1 5 0.909 4.545
    2 10 0.826 8.260
    3 15 0.751 11.265
    4 20 0.683 13.66
    5 25 0.621 15.525
    Total 53.255

    Investment = 30,000
    NPV = 53,255 - 30,000 = $ 23,255

    Profitability Index = 1 + (NPV/Initial Investment)


    PI = 1 + (23,255/30,000)
    PI = 1+0.77 = 1.77

    The Project may be accepted owing to PI greater than 1.


    Question 2

    • From the following data, compute the number of dollars returned for
    every dollar invested. Recommend which is the best investment
    proposal.

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