After conducting a survey that cost Rs.2,00,000, X Ltd.

, decided to undertake a project for placing a new p

the market. The company’s cut-off rate is 12 per cent. It was estimated that the project would cost Rs.40,0
plant and machinery in addition to working capital of Rs.10,00,000. The scrap value of plant and machine
end of 5 years was estimated at Rs.5,00,000. After providing for depreciation on straight-line basis, profit
1 were estimated as follows:
Year 1 2 3
PAT 3,00,000 8,00,000 13,00,000
(Rs.)

Ascertain the net present value of the projects with 12 cost of capital.
Solution:

Working Note 1 Calculation of Cash outflows Rs

Cost of Equipment 40,00,000
Add: Survey Cost 2,00,000
Additional Working Capital 10,00,000
52,00,000
Calculation of NPV
Year PAT (Rs.) CFAT (Rs.) DF 12%

1 3,00,000 10,40,000 0.89

2 8,00,000 15,40,000 0.8

3 13,00,000 20,40,000 0.71

4 5,00,000 12,40,000 0.64

5 4,00,000 11,40,000 0.57
PV of cash inflows

Add: PV of working capital 10,00,000 × 0.567

 Add: PV of Scrap value 5,00,000 × 0.567

Total PV of Cash inflows

Less: PV of cash outflows

NPV

Working notes 2: Depreciation: Original cost + Survey cost – Scrap value ÷ Life of machinery
= (40,00,000 + 2,00,000 – 5,00,000)/5 = Rs. 7,40,000
Depreciation should be added to PAT of every year to get CFAT
ake a project for placing a new product on
at the project would cost Rs.40,00,000 in
crap value of plant and machinery at the
tion on straight-line basis, profits after tax

4 5
5,00,000 4,00,000

Present
Values
(Rs.)
9,28,720
12,27,380

14,52,480

7,88,640
6,46,380
50,43,600

5,67,000
 2,83,500

58,94,100

52,00,000

6,94,000

e ÷ Life of machinery
 A firm has two investment opportunities, each costing Rs.1,00,000 and
2 eachhaving an expected profit as shown below:
Year 1 2 3 4
Project 50,000 40,000 30,000 10,000
X (Rs.)
Project 20,000 40,000 50,000 60,000
Y (Rs.)

After giving due consideration to the risk criteria in each project the
management has decided that project A should be evaluated at a 10 per
cent cost of capital and project B, a risky project with a 15 per cent cost
of capital.

Compare the NPV and suggest the course of action for the management
if
a) Both the projects are independent,
b) Both are mutually exclusive

Solution:
Calculation of NPV
Year CFAT (Rs.) DF % PVs (Rs.)
Project Project 10 15 Project Project
A B A B
1 50,000 20,000 0.91 0.78 45,450 17,400
2 40,000 40,000 0.83 0.76 33,040 30,240
3 30,000 50,000 0.75 0.66 22,530 32,850
4 10,000 60,000 0.68 0.57 6,830 34,320
Present Value of cash inflows 1,07,850 1,14,810
Less: Cash outflows 1,00,000 1,00,000
Netindependent,
a) If both the projects are Present Values (NPV)
accept 7,850 as14,810
both the projects, NPV
of both projects are positive.
b) If both the projects are mutually exclusive, accept project B as its
NPV is higher than that of Project A.
 X Ltd., is considering the purchase of a new machine, which will carry out some
operations at present performed by labour. Two alternative models A and B are
available for the purpose. From the following information prepare a profitability
3 statement for submission to management and calculate PBP.
Machine A Machine B
Rs. Rs.
Estimated life (Years) 5 6
Cost of Machine (Rs.) 80,000 1, 50,000
Estimated additional cost (Rs.)
Indirect material (p.a) 2,000 3,000
Maintenance (p.m) 500 750
Supervision (per quarter) 3,000 4,500
Estimated savings in scrap (p.a.) 8,000 12,000
Estimated savings in direct wages
a. workers not required 10 15
b. wages per worker p.a. 7,200 7,200

Depreciation is calculated under straight-line method. Taxation may be taken at

50 per cent of net profit (net savings).

Solution: Profitability Statement

Particulars Machine A (Rs.) Machine B
(Rs.)
Estimated savings p.a.
Scrap 8,000 12,000
Direct Wages: A - 10x7,200 ; B – 15 72,000 1,08,000
x 7,200
Total savings 80,000 1, 20,000
Additional costs
Indirect material 2,000 3,000
Maintenance: A – 500 x 12 ; B – 750 6,000 9,000
x 12
Supervision: A – 3,000 x 4 ; B – 12,000 18,000
4500 x 4
Total cost 20,000 30,000
Net savings (EBDT) (Savings – 60,000 90,000
cost)
Less: Depreciation 16,000 25,000
EBT 44,000 65,000
Less: Taxes at 50 per cent 22,000 32,500
EAT 22,000 32,500
Add: Depreciation 16,000 25,000
Annual cash inflow (CFAT) 38,000 57,500
PBP = Initial investment  Constant Annual cash inflows
Machine X =Rs.80,000 ÷ 38,000 = 2.1 Years
Machine Y =Rs.1,50,000 ÷ 57,500 = 2.61 Years
Depreciation: Machine X=Rs.80,000/6=Rs. 16,000; Machine
Y=Rs.1,50,000/5=Rs. 25,000
 The following two projects A and B require an investment of Rs. 2, 00,000 each. The income
4 after
taxes for these projects is as follows:
Year Project Project
A (in B (in
Rs.) Rs.)
1 80,000 20,000
2 80,000 40,000
3 40,000 40,000
4 20,000 40,000
5 ------- 60,000
6 ----- 60,000
Using the following criteria, determine which of the project is preferable:
(i) 8 years pay back; (ii) Average Rate of Return
iii) Present value approach if the company’s cost of capital is 10 per cent
Solution:
Note 1: Depreciation = Initial cost – Salvage value ÷ Life period
Project A: (Rs.2,00,000 – 0) ÷ 4 = Rs.50,000; Project B: (Rs.2,00,000 – 0) ÷ 6 = Rs.33,333
Calculation of Cash inflows
Year Project A Project B
EAT Cash Cumulat EAT Cash Cumulat
inflow ive inflow ive
(Rs.) (Rs.) CFAT (Rs.) (Rs.) CFAT
(Rs.) (Rs.)
1 80,000 1,30,000 1,30,000 20,000 53,333 53,333
2 80,000 1,30,000 2,60,000 40,000 73,333 1,26,666
3 40,000 90,000 3,50,000 40,000 73,333 1,99,999
4 20,000 70,000 4,20,000 40,000 73,333 2,73,332
5 ------- -------- -------- 60,000 93,333 3,66,665
6 ------- -------- -------- 60,000 93,333 4,59,998
i) Initial investment = 2, 00,000
PBP: Project A
= 3 years

Decision: Based on 8 years pay back both the projects should be

selected Project A should be selected since their PBP is less than the 8
years pay back period which is to considered as standard pay back
period. But Project A’ should be selected because its pay back period is
less than the Project B.
 ii) Computation of Average Rate of Return = (Annual Avg. IAT ÷
Average investment) 100
Annual Average Income (AAI)= Total EAT ÷ No. of years
Project A: 2,20,000 ÷ 4 = Rs.55,000;
Average Investment = 2,00,000 ÷ 2 = Rs.1,00,000
Average rate of return = (55,000 / 1,00,000)100 = 55 per cent
Project B: AAI = 2,60,000 ÷ 6 = Rs. 36,667
Average investment = 2,00,000 ÷ 2 = Rs. 1,00,000
Average rate of return = (36,667 / 1,00,000)100 = 36.67 per cent
Decision: Project A should be selected since its ARR is greater than the Project B.
c) Computation of Net Present Value (NPV)
Year CFAT (in Rs.) DF PV’s (in Rs.)
Project Project 10 % Project Project
A B A B
1 1,30,000 53,333 0.91 1,18,170 48,480
2 1,30,000 73,333 0.83 1,07,380 60,573
3 90,000 73,333 0.75 67,590 55,073
4 70,000 73,333 0.68 48,181 50,086
5 -------- 93,333 0.62 -------- 57,960
6 -------- 93,333 0.56 ------ 52,640
Present Value of cash 3,41,321 3,24,812
inflows
Less: Cash outflows 2,00,000 2,00,000
Net Present Values 1,41,321 1,24,812
(NPV)

Decision: Based on the NPV both the Projects A and B

eligible to accept. However, Project A is preferable since its
NPV is more than that of Project B.
= Rs.33,333
 A company is considering an investment proposal to install a new machine. The project will cost Rs. 50,00
have life and no salvage value. Tax rate is 50 per cent, the company follows straight-line method of deprec
5 net income before depreciation and tax is as follows:
Year 1 2 3
NIBDT 10,000 11,000 14,000
(Rs.)
Evaluate the project using:

(a) PBP (b) ARR (c) NPV at 10 per cent and (d) PI at 10 per cent

Solution: Calculation of CFAT (Rs.)

Year EBDT EBT (Rs.) EAT (Rs.)

(Rs.) (EBDT-Dep.) (EBT-Tax)

1 10,000 - -
2 11,000 1,000 500
3 14,000 4,000 2,000
4 15,000 5,000 2,500
5 25,000 15,000 7,500

Note: Depreciation = (Original cost – Salvage value) ÷ Life period

= (Rs. 50,000 – 0) ÷5 = Rs. 10,000
(a) Calculation of Pay back period:
Pay Back Period = 4+ (5,000 / 17,500) = 4.29 years

b) Computation of ARR: (Annual Average Income After Tax ÷ Average

Investment) × 100
Annual Average Income = 12,500÷5 =
Rs. 2,500
Average Investment = 50,000÷2 =
Rs.25,000
ARR = (2,500÷25,000)100 = 10 per cent
c) Computation of Net Present Value (NPV)
Year CFAT DF 10 % PVs (Rs.)
(Rs.)
1 10,000 0.91 9,090
 2 10,500 0.83 8,673
3 12,000 0.75 9,012
4 12,500 0.68 8,538
5 17,500 0.62 10,868
Present Value of cash inflows 46,181

Less: Cash outflows 50,000

Net Present Value (-) 3,819
d) Computation of Profitability Index (PI): PV of cash inflows ÷ Initial
investment
= Rs. 46,181 ÷ 50,000 = 0.92 paise

PI indicates that for every one rupee of investment the project will generate only 0.92
paise, in other words the project will incur a loss of 0.08 paise for every one rupee of
investment.
. The project will cost Rs. 50,000 and will
s straight-line method of depreciation. The

4 5
15,000 25,000

CFAT Cumulat
(Rs.) ive
(EAT+D CFAT
ep.) (Rs.)
10,000 10,000
10,500 20,500
12,000 32,500
12,500 45,000
17,500 62,500