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This method is quite different from all the previous methods. The previous methods consider only cash inflows or revenues. But the Annual capital charge method is based on cost or Expenditure for the evaluation of a project. Procedure: The Annual capital charge must be calcuated as under: 1. Present value of initial cost and subsequent operatingcosts must be found out at the cost of capital given in the problem. 2. The total of all present values calculated in (one) above must be divided by Annuity present value factor for n years at the given rate of discount.
3. When the amount of step one is divided by the factor arrived at in the step two, we get Annual capital charge. It can be shown as under:
Present value of initial cost and subsequent costs Annual capital charge=------------------------------------------------------------------------------Annuity present value Factor ( for n years at r rate of Discount or interest) 4. When there are two or more projects, the project with Less annual capital charge must be selected for investment. Problem on Annual capital charge method: 1. For the completion of a project, there are two methods. The initial costs and subsequent costs of those two methods are given below: Initial Costs: A method = rs.1000000 B method = rs.800000 Subsequent costs: A method B method Year Rs. Rs. 1 ----100000 ---- 75000 2 ----125000 ---- 100000 3 ----150000 ---- 120000 4 ----175000 ---- 140000 5 ----200000 ---100000
6 7
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225000 200000
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Assuming the cost of capital at 12%, determine the method to be chosen for the completion of the project underAnnual capital charge method. Answer: Annual capital charge: A method B method Annuity discount factor: For 7years at 12% For 5years at 12% = 4.564 = 3.605 = 310010 rs. = 326728 rs.
[ Total Risk = Unsystematic Risk + Systematic Risk ] Graphically these two types of Risks can be shown as under:
-I I I I I I
systematic risks I X
No.of Assets.
1. Risk Adjusted Discount Rate method: under this method, the Normal discount Rate is increased to cover Risk also. It means that the Rate of discount includes two rates viz1. Risk free rate and 2. Risk premium rate. Risk Free rate is the rate at which the future cashflows should be discounted if there is no risk in the project. Risk Premium rate is the extra return expected by the investor for investing in a risky project. Thus Risk adjusted discount rate is a composite discount rate which takes into consideration both Time and Risk factors. For more risky,projects, a higher disocunt rate is used and for less risky projects, a low discount rate is used. Example: Suppose Risk free discount rate is 5% and Risk premium rate is 10%. Then the Risk adjusted discount rate is 15% [5%+10% = 15%]. At 15%, cashflows will be discounted to know the present values of cash flows. Evaluation: Though it is a simple method,Bias will creep in in determining the Risk adjusted discount rate. For the same risk, one investor may adjust 10% and another investor may adjust 15%.