UNIT 4: CAPITAL BUDGETING AND COST ANALYSIS

Content
4.0 Aims and Objectives
4.1 Introduction
4.2 A Review of Capital Budgeting Process and Tools
4.3 Traditional Methods
4.3.1 Pay Back Period Method
4.3.2 Time Adjusted Methods or Discounted Methods
4.4 Time Adjusted Methods or Discounted Methods
4.4.1 Net Present Value Methods
4.4.2 Internal Rate of Return Method
4.4.3 Profitability Index Method
4.5 Summary
4.6 Answers to Check Your Progress
4.7 Model Examination Question

4.0 AIMS AND OBJECTIVES

After completing this unit, you should be able to:

 implement the net present value decision rule
 administer of capital budgets
 explain why the internal rate of return and the net present value decision rules may rank
projects differently

4.1 INTRODUCTION

One of the most important decisions the management people taking in the organizations is long
term investment decisions associated with plant assets projects etc. Capital budgeting is the
process of making investment decisions in capital expenditures. A capital expenditure may be
defined as an expenditure the benefits of which are expected to be received over period of time
exceeding one year. The main characteristic of a capital expenditure is that the expenditure is

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incurred at one point of time where as benefits of the expenditure are realized at different points
of time in future. In simple language one can say that a capital expenditure is an expenditure
incurred for acquiring or improving plant assets, the benefits of which are expected to be
received over number of years in future. The following are some of the examples of capital
expenditure:
a. Cost of acquisition of plant assets such as land and buildings, plant and machinery etc.
b. Cost of addition, expansion, improvement or alteration in the plant assets.
c. Cost of replacement of plant assets
d. Research and development project costs etc.

Contrasts in purposes of cost analysis:

analysis: According to Charles T. Horngren “Capital budgeting is
long-term planning for making and financing proposed capital out lays”. It clear from the above
definition that capital budgeting expenditure involves non-flexible long-term commitment of
funds. Therefore capital expenditure decisions are also called long term investment decisions.
Managers of today’s corporate continually face the challenge of balancing long term and short-
term issues. An excessive focus on short run accounting income however may cause a
company to forego long run profitability. On the other hand a long-term decision is
systematically considered in terms of financial and no financial aspects. Finally the capital
budgeting decision should ultimately result in increase in capital value of the organization.

4.2- A REVIEW OF CAPITAL BUDGETING PROCESS AND TOOLS

Capital budgeting is complex process as it involves decisions relating to the investment of

current funds for the benefit to achieve in future and the future is always uncertain. However
the following procedure may be adopted in the process of capital budgeting:

a. Identify investment proposals: The capital budgeting process begins with the identification
of investment proposals. The proposal or the idea about the potential investment opportunities
may originate from the top management or may come from the rank and file worker of any
department or from any officer of the organization
b. Screening the proposals: The expenditure planning committee of the organization screens
the various proposals received from different departments. The committee views these

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proposals from various angles to ensure that there are in accordance with the corporate
strategies or selection criterion of the firm and also do not lead to departmental imbalances.
c. Evaluation of various proposals: Evaluating the profitability of various proposals by using
the appropriate capital budgeting tools. It should be noted that the various proposals may be
classified as I) independent proposals II) dependent proposals III) mutually exclusive
proposals.
d. Fixing priorities: After evaluating various proposals the unprofitable or uneconomic
proposals may be rejected straight away. But it may not be possible for the firm to invest
immediately in all the acceptable projects due to limited or scarce funds. Hence it is very
essential to rank the various proposals and to establish priorities after considering urgency, risk,
and profitability associated with each of the proposal.
e. Final approval and preparation of capital expenditure budget: Proposals meeting the
evaluation and other criteria are finally approved to be included in the capital expenditure
budget. However proposal involving smaller investments may be decided at the lower levels
for expeditious action. The capital expenditure budget lays down the amount of estimated
expenditure to incur on plant assets during the budget period.
f. Implementing the proposal: While implementing the project it is better to assign
responsibilities for completing the project within the given time frame and cost so as to avoid
unnecessary delays and cost over runs. Network techniques used in the project management
such as PERT and CPM can also be applied to control and monitor the implementation of the
projects.
g. Performance recipe: The last stage of in the process of capital budgeting is the evaluation of
the performance of the projects The evaluation is made through post completion audit by way
of comparison of actual expenditure on the project with the budgeted one and also by
comparing the actual return form the investment with anticipated return. The unfavorable
variances, if any should be looked into and the causes of the same are identified so that
corrective action may be taken in future.

Note:
Note: The above-mentioned process can also be expressed in the following manner
Stage1.Identification
Stage1.Identification Stage: The stage to distinguish which types of capital expenditure
projects are necessary to accomplish organization objectives.

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Stage2. Search Stage: The stage, which explores alternative capital investments that will
achieve organization objectives.
Stage3. Information-Acquisition stage: The stage, which considers the expected costs and the
expected benefits of alternative capital investments.
Stage4.
Stage4. Selection stage: The stage at which choosing the projects for implementation
Stage5. Financing stage: The stage which the funds needed for the projects are determined.
Stage6: Implementation and control stage: The stage at which projects get under way and
monitor their performances.
Methods of Capital Budgeting (or) evaluation of investment proposals

There are many methods of evaluating profitability of capital investment proposals. The various
commonly used methods are classified as follows:

4.3 TRADITIONAL METHODS

a. Pay Back Period method or Payout or Pay off method

b. Accounting Rate of Return method (ARR)
c.Net Present Value method (NPV method)
d. Internal Rate of Return method (IRR method)
e. Profitability Index method (PI method)

4.3.1 Pay Back Period Method

This method is based on the principle that every capital expenditure pays itself back within a
certain period out of the additional earnings generated from capital assets. Thus it measure the
period of time for the original cost of the project to be recovered from the additional earnings
of the project it self. (or)
It is the exact amount of time required for the firm to recover its initial investment in a project
as calculated from cash inflows.
The decision criterion: If the pay back period is less than the maximum acceptable pay back
period accept the project. If the pay back period is greater than the maximum acceptable pay
back period reject the project.

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Check your progress –1

1. What is pay back method? Explain

………………………………………………………………………………………………
………………………………………………………………………………………………

Steps: 1. Calculate annual net earnings (profits) before deprecation and after taxes. These are
called cash inflows.
Stpe: 2. Divide the initial outlay (cost) of the project by the annual cash inflows

Pay Back Period = Cash outlay of the project (or) Original cost of the asset
Annual Cash inflows
Note: If the annual cash inflows (profits before depreciation and after taxes) are unequal, the
pay back period can be found by adding up the cash inflows until the total cost is equal to the
initial cash outlay of the project or original cost of the asset.

Illustration 1.
1. (When cash inflows are equal)
A project costs $100,000 and yields annual cash inflow of $20,000 for 8 years. Calculate its
back period.

Solution:
Solution: We know that

Pay Back Period = Initial outlay of the project = $ 100,000 = 5 (years)

Annual cash inflows $ 20,000

Illustration 2.
2. (When cash inflows are unequal)
Determine the pay back period for a project which requires a cash outlay of $10,000 and
generates cash inflows of $ 2,000; $4,000; $3,000; 2,000 in the first, second, third, and fourth
years respectively.

Solution:
Total cash outlay =$10,000
Cash inflows for the first 3 years = $2,000 +$ 4,000 +$3,000 = $9,000

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 But we need another $1,000 to cover the initial cash outlay of the project since $9,000 is
already covered in the first 3 years as shown above. Therefore the rest of the balance (i.e.
$1,000) is to be recovered in 4th year.

In 4th year cash inflows = $2,000 = for 12 months

= $1,000 =?
= 6
Therefore the pay back period of the project is 3 years and 6 months

Illustration3. (When before tax cash inflows)

A project costs $500,000 and yields annually a profit of $80,000 after depreciation @12% per
year but before tax of 50%. Calculate the pay back of the project.

Solution:
Profit before taxes $80,000
Less: Taxes (50%of $80,000) 40,000
Profits after taxes 40,000
Add: depreciation (12%of $500,000) 60,000
Profit before depreciation but after taxes (cash inflows) 100,000

Therefore
Pay Back Period= Cost of the project = $500,000 = 5 (years)
Anal cash inflows $100,000

Illustration 4 (Selection of a project from two or more projects)

There are two projects X and Y. Each project requires an investment of $20,000. You are
required to rank these projects according to pay back period method. The information is as
follows:

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Years (net profit before depreciation and after taxes)
Project X Project Y
1 $1,000 $2,000
2 2,000 4,000
3 4,000 6,000
4 5,000 8,000
5 8,000 -----

Solution:
Since the both projects has unequal annual cash inflows their payback periods can be
calculated as follows
a. The pay back period for project X = (5 years)
($1,000+$2,000+$4,000+$5,000+$8,000)
b. The pay back period for project Y = (4 years)
($2,000+$4,000+$6,000+$8,000)

Therefore Project should be ranked I

Advantages of payback period method:
1. It is simple to understand and easy to calculate
2. Based towards liquidity
Disadvantages:
1. Ignores time value of money
2. Ignores cash inflows after the pay back period

4.3.2 Accounting Rate of Return Method (ARR)

This method takes into account the earnings expected form investment over the whole life of
the project. Under this method the accounting concept of profit (net profit after taxes and
depreciation) is used rather than cash inflows. The projects are ranked in the order of earnings
or rate of return. The following equations are used to calculate the accounting rate of return

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1. A RR = Average annual profits x100
Net investment in the project

Where
Average annual profits =Total profits
No. of years

Net investment in project =Total investment in project – scrap value

2. ARR = Average annual profits after depreciation and taxes x 100

Average investment

Where
Average investment = Total investment in the project –scrap value
2
Decision Criterion:
Criterion:
Accept a project if the ARR is more than the required rate of return, (or) in case of two or more
projects accept the project whose ARR is more.
Reject a project if the ARR is less than the required rate of return, (or) in case of two or more
projects reject the project whose ARR is less.

Illustration1 (Using first equation)

A project requires an investment of $500,000 and has a scrap value of $20,000 after 5 years. It
is expected to yield profits after depreciation and taxes during 5 years amounted to $40,000; $
60,000;$70,000; $50,000 and $20,000 Calculate its Accounting Rate of Return

Solution:
Solution:
Total profits =$40,000+$60,000+$70,000+$50,000+$20,000 =$240,000

Average profits = $240,000 = $48,000

5

Net investment in the project =$500,000 – $20,000 = $480,000

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Therefore
Accounting Rate of Return= Average annual profits x 100
Net investment in the project

= $48,000 x100
480,000
=10 %
Using the second equation:

ARR= Average annual profits after taxes and depreciation x100

Average investment

Where:
Average investment = net investment = $480,000 = $240,000
2 2

Therefore

ARR = $48,000 x100 = 20 %

$240,000

Note: It should be noted that the ARR is not the same using these two different equations

Illustration2:
Pioneer ltd. Plc is considering to purchase a machine, two machines are available E and F. the
cost of each machine is $60,000. Each machine has an expected life of 5 years. Net profits
before taxes and after depreciation during the expected life of the machines are given below:
Year Machine E Machine F
1 $15,000 $5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Total 85,000 90,000

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Assume tax rate as 50%.

Solution:
Year Machine E Machine F

PBT Tax PAT PBT Tax PAT

1 $15,000 $7,500 $7,500 $5,000 $2,500 $2,500

2 20,000 10,000 10,000 15,000 7,500 7,500
3 25,000 12,500 12,500 20,000 10,000 10,000
4 15,000 7,500 7,500 30,000 15,000 15,000
5 10,000 5,000 5,000 20,000 10,000 10,000
Total 85,000 42,500 42,500 90,000 45,000 45,000

Average profits= $42,500 = $8,500 $45,000 = $9,000

5 5

Average investment= $60,000 =$30,000 $60,000 = $30,000

2 2

ARR= $8,500 x100 =28.33% ARR= $9,000 x100 =30%

=30%
$30,000 $30,000

It is clear from the above that Machine F’s Accounting Rate of Return is more than that of
Machine E therefore it is advised to accept Machine F.

Advantages of ARR
a.Easy
a.Easy to understand and calculate
b. Entire earnings of the project is considered
c.Based
c.Based on accounting concept of profit

Disadvantages of ARR
a.Ignores
a.Ignores the time value of money

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 b. Does not take into account the cash flows, which are important than accounting
profits.

4.4 TIME ADJUSTED OR DISCOUNTED CASH FLOW METHODS

The traditional methods such as pay back period method, and accounting rate of return does not
recognize the time value of money. The modern corporate long-term investments decisions are
based on the time value of money and the risk associated with each of the project. According
to these modern techniques the money available today is more valuable than that of future
money on the grounds that future is uncertain and risky.

4.4.1 Net Present Value Method (NPV Method)

This method takes into account the time value of money and attempts to calculate the return on
investments by introducing the factor of time element. It recognizes the fact that a Birr earned
today is worth more than the same Birr earned tomorrow.

Decision Criterion
Accept a project if the net present value of cash inflows is greater than or equal to the present
value of cash out flow of the project.

Reject a project if the net present value of cash inflows is less than the present value of cash out
flow of the project.

Steps for the calculation of net present value technique

1. Determine the rate of interest/minimum-required rate of return/cutoff rate/discount rate

(usually it will be given in the problem)
2. Compute the present value of the total investment/outlay i.e. cash flows at the
determined rate. If the total investment is made in the project is made in initial year the
present value shall be the same as cost of investment.
3. Compute the present value of cash inflows (profits before depreciation and after taxes)
at the given discount rate.
4. Calculate the net present value of each project by subtracting the present value of cash
inflows (NPVCI) from present value of each out flow (PVCO)

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 NPV= NPVCI- PVCO
Note: In case of mutually exclusive projects rank the projects whose net present value of cash
inflows is more

Illustration: 1
From the following information calculate the present value of two projects and suggest which
project should be accepted assuming the discount rate as 10%.
Project X Project Y
Initial investment $20,000 $30,000
Estimated life 5 years 5 years
Scrap value $1,000 $2,000
The profits before and after taxes (cash inflows) are as follows:
Projects: 1st year 2nd year 3rd year4
year4th year 5 th
year
X $ 5,000 $10,000 $10,000 $3,000 $2,000
Y $20,000 $10,000 $5,000 $3,000 $2,000

Solution:
Net present value of project X
Year Cash inflows present value of $1.00 Present value of cashinflows
At 10% discount rate
1 $5,000 .909 $4,545
2 $10,000 .826 $8,260
3 $10,000 .751 $7,510
4 $3,000 .683 $2,049
5 $2,000 .621 $1,242
5(scrap) $1,000 .621 $ 621
Total $ 24,227

Therefore NPV= $24,227-$20,000 = $4,227

Net present value of project Y

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 Year Cash inflows Present value of $1.00 Present value of cashinflows
At 10% discount rate
1 $20,000 .909 $18,180
2 10,000 .826 $8,260
3 5,000 .751 3,755
4 3,000 .683 2,049
5 2,000 .621 1,242
5(scrap) 2,000 .621 1,242
Total $34,728
Therefore NPV= $34,728-30,000= $4,728

Note: It is clear from the above discussion the net present value of project is more than that of
X. Therefore Project Y should be accepted.
Advantages of NPV method:
method:
a. It recognizes the time value of money
b. Entire earnings of the of life of the project is considered
Disadvantages:
a. It is difficult to understand as compared to traditional techniques
b. It may not give good results if the projects are with unequal life and unequal investments.
c. It is not easy to determine appropriate discount rate.

4.4.2 Internal Rate of Return Method (IRR Method)

It takes into account the time value of money. Under this method internal rate of return is
calculate internally. Internal rate of return is defined as that rate of discount at which the present
value of cash inflows is equal to the present value of cash outflows.

Decision Criterion:
Accept a project if the internal rate of return is higher than required rate of return or cost of
capital

Reject a project if the internal rate of return is less than the required rate of return or cost of
capital.

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Steps to calculate internal rate of return
1. Determine the future net cash flows during the entire life of the project
2. Determine the rate of discount at which the value of cash inflows is equal to the
present value of cash outflows.
3. Apply the following formula:
IRR= A+ ( NA x (B-A)
NA- NB

Where A= lower rate of discount

B =Higher rate of discount
NA=Net Present Value at rate A
NB= Net Present Value at rate B
Illustration: 1
From the following information determine the internal rate of return
Initial investment $60,000
Life of the asset 4 years
Estimated cash inflows Ist year-$15,000; 2nd year-$20,000;3rd year-$30,000;4th year-$20,000.

Solution:
Year cash inflows 14% discount rate PVCI 15% discount rate PVCI
1 $15,000 .877 $13,155 .869 $13,035
2 20,000 .769 15,380 .756 15,120
3 30,000 .674 20,220 .657 19,710
4 20,000 .592 11,840.571
11,840.571 11,420
Total $60,595 Total $59,285

NPV at discount rate= $60,595-$60,000= $595

NPV at discount rate= $59,285-$60,000= -$715

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 We that IRR = A +( NA x (A-B)
NA-NB
Where
A= Lower rate of discount= 14%
B=Higher rate of discount=15%
NA= Net present value at rate A= $595
NB= Net present value at rate B= -$715

Substituting the values in the equation:

IRR = 14 +( $595 x (15-14)

$595-(-$915)

= 14+($595
14+($595 x1)
1310

=14+0.45
=14.45%
=14.45%
It should be noted here that the IRR is calculated directly by using the equation instead of
trial and error method which some authors follow to determine the same.

Profitability Index (PI Index): It is also time-adjusted method of evaluating investment

proposals. It is to be calculated by using the following equations:
Profitability Index = Present value of cash inflows
Initial cash outlay

(Or)

Present value of cash inflows

Present value of cash out flows
Decision criterion
Accept the if profitability index is more than 1; Reject a project if the profitability index is less
than 1.

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Illustration:1
The initial cash out lay of a project is $50,000 and it generates cash inflows of
$20,000;$15,000;$25,000;$10,000 for 4 years. Using the present value index method appraise
the profitability of the proposed investment assuming 10% discount rate
Solution:
Year Cash inflows Present value at 10% Present value of cash inflows
1 $20,000 .909 $18,180
2 15,000 .826 12,390
3 25,000 .751 18,775
4 10,000 .683 6,830
Total 56,175

Net present value of cash inflows=$56,175- $50,000 = $6,175

Profitability Index= Present value of cash inflows

Initial cash outlay

= $56,175
$50,000
= 1.1235
Since the profitability index is more than 1 the project can be accepted.
accepted.

Cheek your progress

1. Explain the following terms

a. Net present value method
b. Internal rate of return method
c. Profitability index method
2. Explain the advantage and disadvantage of the above three methods
………………………………………………………………………………………………
………………………………………………………………………………………………

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4.4.3 Capital Budgeting And Inflation

All the capital budgeting techniques discussed above that is traditional as well as modern
techniques do not consider the inflation effect in the evaluation to the projects. Inflation is the
common feature of every economy therefore the investment decisions made by the
organizations would influenced by the inflation rate prevailing in the economy. Inflation may
be defined as general increase in prices leading to a general decline in the real value of money.
There will be two impacts of inflation of discounted cash flow project as follows:
a.The
a.The discount rate given may include an allowance for general rate of inflation
b. The cash flows may be subject to inflation, possibly at different rates for different
flows (e.g. material, labor, sales. etc.)

Effect of inflation on the discount rate:

The discount rate used in investment appraisal reflects the finance providers required rate of
return (e.g. the rate of investment on loan raised, or share holders required return if financed by
the equator common stock. In times of inflation, the fund providers will require a return made
up of two elements
1. A return to compensate for inflation (to maintain purchasing power)
2. A real return on top of this for the use of their funds.

The required return that incorporates both of these elements is known as money return.
Therefore we now say money return= real rate +inflation rate.

Illustration:
An investor is prepared to invest $100 for 1 year. He requires a real return of 10% in addition
to an allowance for inflation currently running at 5%.

Just to compensate for inflation, his money need to increase by 5% to 100 x1.05 =$105. To
give a real return on top of this, it must be further increased by 10% to 105 x1.1= $115.5 Thus
his money meet increase overall by 1.05x1.1= 1.155 i.e. by 15.5 %

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 Discounted Cash flow analysis take place in either money or real terms

Project Appraisal under inflation

Discount money cash flows at money- discount real cash flows at real
Discount rates discount rates

To obtain real rate of return the following equation may be used:

1+ r = 1+m
1+i
Where
r= real discount rate 1+r = (1+0.155
(1+0.155))
m= money discount rate
i.= inflation rate r= 1.1-1= 10%

Illustration: 2
A company is considering a cost saving project. This involves purchasing a machine costing
$7,000, which will result an annual savings on wage costs of $1,000 and material costs of $400.
The following forecasts are made of the rates of inflation each year for next five years. Wage
costs 10% material costs 5%. General prices 6%. The cost of capital of the company in money
terms is 15%. Evaluate the project assuming that the machine has a life of 5 years and no scrap
value.

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Solution:
Step 1. Calculation of money cash savings:
Year Labor savings Material savings Total savings

1 $1,000x(1.1)= $1,100 $400x(1.05)=$420 $1,520

2 1,000x(1.1) 2= 1,210 400x(1.05) 2= 441 1,651
3 1,000x(1.1) 3= 1,331 400x(1.05) 3= 463 1,794
4 1,000x(1.1) 4= 1,464 400x(1.05) 4= 486 1,950
5 1,000x(1.1) 5= ,610 400x(1.05) 5= 510 2,120

Step 2. Evaluate the net present value

Year Cash flows present value factor 15% Present value of Cash flows

0 ($7,000) 1.000 ($7,000)

1 $1,520 0.870 $1,322
2 1.651 0.756 1,248
3 1,794 0.658 1,180
4 1,950 0.572 1,115
5 2,120 0.497 1,054
Total (1,081)

Since the net present value is negative the project not worthwhile

Note:
Note: The general rate of inflation has not been used in, and is irrelevant to this calculation.

Discounted cash flows and Taxation:

Taxation:
Taxation has two major effects on the discounted cash flow project appraisal
1. Project cash flows give raise to taxation- which it self has an impact on project
appraisal. There will be differences between the cash flows earned and the level of profits on
which the payment of taxation is based, particularly as regards to capital expenditure, but in
general cash receipts/payments will give rise to tax payable /relief. Tax relief on interest

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payments will reduce the effective rate of interest, which a firm pays on its borrowings and
hence the opportunity cost of capital.
Incorporating taxation into Discounted cash flow appraisals: the effects of taxation arte
complex and are influenced by many factors like 1) taxable profits and tax rate 2) accounting
period 3) capital allowances 4) losses available for set off etc.

Illustration:
JKL Corporation is considering manufacturing a new product. This requires machinery costing
$20,000 with a life of 4 years and terminal value of $5,000. Profits before depreciation the
project will be $8,000 per year. However, there will be cash flows that well differ from profits
by the build up of working capital during the first year of operations and its run down during
the 4th year amounting to $2,000.
Tax allowances on machine are 25% per year on reducing balance. At the end of the project’s
life a balancing charge or allowance will arise equal to the difference of scrap proceeds and the
tax written down value.
Tax payable one year after the end of accounting year on which it is based, at a rate of 30%.
The start of the project is also the start of the accounting year. The cost of capital is 15%.
Should the project be accepted?

Solution:
Year- Profit - working capital-
capital- machine-
machine-Tax-
Tax- net cash flows -P.Vfactor
-P.Vfactor PVCI
0 - - ($20,000) ($20,000) 1.000 ($20,000)
1 $8,000 ($2,000) --- $1,500 $7,500 0.870 $6,525
2 8,000 --- ---- ($1,275) 6,725 0.756 5,084
3 8,000 --- --- (1,556) 6,444 0.658 4,240
4 8,000 2,000 5,000 (1,767) 13,233 0.572 7,569
5 ---- ---- ---- (2,002) (2,002) 0.497 (995)
NPV = 2.423

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Since the net present value of cash inflows is positive the project is worthwhile.

Working

Year profit Capital allowances& Tax payable Tax at 30% in 1year

Balancing allowances
Written down value

0 --- $20,000 x25%=(5,000) (5,000) ---

1 $8,000 15,000x25%=(3,750) 4,250 (1,500)

2 8,000 11,250x25%= 2,813 5,187 1,275

3 8,000 8,437 x25%=(2,109) 5,89 1,556

4 8,000 6,328-5,000=(1,328)* 6,672 1,767

5 ---- ---- ----- 2,002
Note: * Balancing allowance =written down value- scrap proceeds
=(8,437- 2,109)= 5,000

Certainty Equivalent Coefficient

According to this method the estimated cash flows are reduced to a conservative level by
applying correction factor termed as ‘certainty equivalent’. In other words by applying this
coefficient factor we will be trying to say to what extent the cash inflows are certain to receive.
It can be calculated as follows:

Certainty Equivalent coefficient= Risk less cash flow

Risky cash flow

Example: A project is expected to generate a cash flow of $20,000. The project is risky but
management feels that it will get at least a cash flow of $12,000.

Therefore certainty equivalent coefficient= $12,000 = 0.6

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 $20,000

Illustration:
From the following data, state which project is better: using 5% discount rate.
Certainty coefficients
Year Project A Project B Project A Project B
0 ($10,000) ($10,000) -- ---
1 $4,000 $5,000 .90 .80
2 4,000 6,000 .80 .70
3 2,000 3,000 .60 .50

Solution:
Year Project A P.V.Factor Project B P.V.Factor
Cash inflows 5% cash inflows 5%
0 ($10,000) ($10,000) ($10,000) ($10,000)
1 4,000x.90 $, 3600 $, 3,427 5,000x.80 $4,000 $3,808
2 4000 x. 80 3,200 2,902 6,000x.70 4,200 3,809
3 2,000.60 1,200 1,037 3,000x.50 1,500 1,296
NPV -2,634 NPV -1,087

Strictly speaking both the projects should be rejected. In case if the organization is considering
to accept any one of the projects, Project B is better than A since it’s negative NPV is less as
compared to B.

4.5 SUMMARY

Income tax factors almost always play an important role in decision-making. Income taxes
make a major impact on the amounts of cash inflow and outflow and on their timing. Tax rules
in many countries are intricate and change often.

We can account for inflation inn several ways in capital budgeting. One correct approach is to
predict cash inflows and outflows in nominal terms and use a nominal discount rate a second

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correct approach is to predict cash inflows and outflows in real terms and use a real discount
rate. Both approaches are internally consistent.

The required rate of return should vary according to the friskiness’ of projects. The higher the
risk, the higher the required return.

Use caution when analyzing rankings based on percentages (.such as the internal rate of return)
to select the total set of investment projects. As a general rule, the net present value method is
preferred when selecting investment projects.

4.6 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 4.3

2. 1) Refer section 4.3
2) Refer section 4.3

4.7 MODEL EXAMINATION QUESTIONS

Capital Budgeting Problems

Exercise 1. A project costs $. 500,000 and yields annually profit of $. 80,000 after depreciation
@ 12%p.a.but before tax of 50%. Calculate the pay back period.

Solution:
$
Profit before tax 80,000
Less tax @ 50% 40,000
Profit after tax 40,000
Add back deprecation @ 12% on $ 500,000 60,000
Profit before deprecation but after tax or annual Cash Inflow 100,000

Pay back period= cost of the project

Annual cash flow

$500,000
100,000
= 5 years

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Exercise 2. There are two projects X and Y. Each project requires an investment ofRs.20,000.
You are required to rank these projects according to the pay back method from the following
information.
(Net profit before deprecation and after tax)
Years Project X Project Y
1st 1,000 2,000
2nd 2,000 4,000
3rd 4,000 6,000
4th 5,000 8,000
5th 8,000 —

Solution:
The pay back period for Project Xis5 year as ($. 1,000+2,000+4000+5,000+8,000)=$ 20,000.
While the pay-back period for project Y is 4 years as ($.2,000+4,000+6,000+8,000)=$.20,000.
Hence project Y should be preferred or ranked first.

Exercise 3. A project requires an investment of $. 500,000 and has a scrape value of $ 20,000
after five years it is expected to yield profits after depreciation and taxes during the five years
amounting to$.40,000, Rs.60,000,Rs.70,000 $ 50,000and $ 20,000.Calculate the average rate
of return on the investment.

Solution:
Total profit = $ 40,000+60,000+70,000+50,000+20,000
= $ 240,000
Average Profit = $.240,000 = $48,000
5
Net Investment in the project = $500,000-20,000(Scrape Value)
= $ 480,000
Average Rate of Return

= Average Annual profit * 100

Net Investment in the Project

= 48,000 * 100 = 10%

480,000

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Exercise 4. From the following information calculate the net present value of the two project
ad suggest which of the two project should be accepted assuming a discount rate of 10%.

Project X
Project Y
Initial Investment $ 20,000 $ 30,000
Estimated Life 5years 5years
Scrape Value $ 1,000 $. 2,000

The profit before deprecation and after taxes (cash flows) are as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
$ $ $ $ $
Project X 5,000 10,000 10,000 3,000 2,000

Project Y 20,000 10,000 5,000 3,000 2,000

Solution:

Calculation For Net Present Value Project X

Present value
Year Cash flows of $ 1 @ 10% Present Value
(discount factor) of Net Cash flows
Using preset value
tables
Present value
Year Cash flows of $1 @ 10% Present Value
(discount factor) of Net Cash flows
Using preset value
tables
$
= 24,227
Present Value of all cash inflows = 20,000
Less present value of initial investment
(because all the investment is to be made in the first year only, the
present value is the same as the cost of the initial investment)

Net Present Values =4,227

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Project Y
Present value
Year Cash flows of $ 1 @ 10% Present Value
(discount factor) of Net Cash flows
Using preset value
tables
1. 20,000 .909 18,180
2. 10,000 .826 8,260
3. 5,000 .751 3,755
4. 3,000 .683 2,049
5. 2,000 .621 1,242
6. 2,000 .621 1,242
(Scrape Value) 24,227

Total present Value of Cash Inflows = 34,728

Less Present of Initial investment = 30,000
Net Present Value = 4,728

We find that net present value of Project Y is higher than the net present value of project X and
hence it is suggested that project Y should be selected.

Exercise 5. The initial cash outlay of a project is $. 50,000andit generates cash inflows of $.
20,000, $.15,000 andRs.10,000 in four years. Using present value index method, appraise
profitability of the proposed investment assuming 10%rate of discount.

Solution:

Calculation of Present Values and Profitability Index

Year Cash Inflows Present Value Present Value
$ Factor @ 10% $
1. 20,000 .9.9 18,180
2. 15,000 .826 12,390
3. 25,000 .751 18,775
4 10,000 .683 6,830
56,175
Total Present Value =56,175
Less: Initial Outlay =50,000
Net Present Value =6,175

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 Profitability Index (gross) = Present Value of Cash Inflows
Initial Cash Outflow

= 56175 = 1.1235
50,000
As the P.I. is higher than 1,theproposal can be accepted.

Net Profitability Index = NPV

Initial Cash Outlay

= 6,175 = .1235
50,000
N.P.I. = 1.1235 – 1= 0.1235

As the profitability index is positive, the project can be accepted.

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