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Week 2
1. Following are the expected nominal cash flow of project A, requiring an initial outlay of Rs.
1,00,000.00
Year 1 2 3 4
Cash Flow Rs. 30,000 Rs. 60,000 Rs. 40,000 Rs. 10,000
If the cost of capital of the company is static economy is 8%, and the inflation rate is 5% .Can the project
be accepted ?
Sol 1:
Working Note 1:
1
= 7, 392.67
Conclusion: As NPV computed to yield a positive value, the project should be accepted.
2) Following are the expected nominal cash flow of project XYZ , requiring an initial outlay of Rs.
500,000
Year 1 2 3 4
Cash Flow Rs. 30,000 Rs. 60,000 Rs. 40,000 Rs. 10,000
If the cost of capital of the company is static economy is 9%, and the deflation rate is 5 % .Can the project
be accepted ?
Sol 2:
Working Note 1:
Working Note 2:
= (371, 572.58)
2
In practice, expected value: 140,000 but in real: 128, 427.42
Conclusion: As NPV computed to yield a negative value, the project should be rejected.
4) Following are the cash flows for the project having a life of 5 years – Rs. 20,000, Rs. 80,000, Rs.
60,000, Rs. 50,000 and Rs. 40,000. Capital outlay is Rs. 1,50,000.
Based on past experiences (Business Cycle), the company sees the cost of capital for the project period as
follows-
● For the year 1 and 2 – 15%
● For the year 3- 16%
● For the year 4 and 5 – 14%
Ascertain the NPV of the project and the Profitability Index
Sol:
Working Note:
= 15, 646.54
165,646.54
= 150,000 = 1.104
3
Conclusion: As NPV computed to yield a positive value and PI is greater than 1, the project should be
accepted.
5 ) Following are the cash flows for the project having a life of 5 years – Rs. 220,000, Rs. 180,000, Rs.
260,000, Rs. 250,000 and Rs. 240,000. Capital outlay is Rs. 850,000.
Based on past experiences (Business Cycle), the company sees the cost of capital for the project period as
follows-
● For the year 1 and 2 – 12%
● For the year 3- 14%
● For the year 4 and 5 – 16%
Ascertain the NPV of the project and the Profitability Index
Sol:
Working Note:
= (52, 825.47)
797,174.53
= 850,000 = 0.938
4
Conclusion: As NPV computed to yield a negative value and PI is less than 1, the project should be
accepted.
Notes:
● For non-cash items, fixed cost must not be deducted to obtain net profit. Hence in this case,
Contribution = Profit.
● If dismantling cost is mentioned instead of scrape, in the working note table, it has to be taken as
cash outflow instead of cash inflow which is taken for scrape.
8) Forward planning Limited is considering whether to invest in a project which would entail immediate
expenditure on capital equipment of Rs. 40 000. Expected from sales from the projects are as follows.
0.10 2000
0.25 6000
0.40 8000
0.15 10000
0.10 14000
Once sales are established at a certain volume in the first year, they will continue at the same volume in
subsequent years.
The unit selling price will be Rs. 10, the unit variable cost Rs. 6 and the additional fixed cost will be Rs.
20000 (all cash items) the project would have a life of 6 years after which the equipment would be sold as
scrap which would fetch Rs. 3000.
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You are required to find – (1) expected value of NPV of the project (2) minimum volume of sales per
annum required to justify the project.
Cost of capital of the company is 10%. Discount factor of Re.1 per annum for 6 years at 10% is 4.355 and
the discount factor of Re. 1 at the end of 6th year at 10% is 0.5645
Sol:
Working Note 1:
Working Note 3:
6
N P V = 50, 469.50 − 40, 000 = 10, 469.50
50,469.50
PI = 40,0000 = 1.26
9) Backward planning Limited is considering whether to invest in a project which would entail immediate
expenditure on capital equipment of Rs. 80 000. Expected from sales from the projects are as follows.
(Homework)
0.10 2000
0.25 6000
0.40 18000
0.15 10000
0.10 14000
Once sales are established at a certain volume in the first year, they will continue at the same volume in
subsequent years.
The unit selling price will be Rs. 12, the unit variable cost Rs. 6 and the additional fixed cost will be Rs.
20000 (all cash items) the project would have a life of 6 years after which the equipment would be sold as
scrap which would fetch Rs. 8000.
You are required to find – (1) expected value of NPV of the project (2) minimum volume of sales per
annum required to justify the project.
Cost of capital of the company is 10%. Discount factor of Re.1 per annum for 6 years at 10% is 4.355 and
the discount factor of Re. 1 at the end of 6th year at 10% is 0.5645
Solution:
Working Note 1:
7
Working Note 2: Marginal Cost Statement
Working Note 3:
Year Cash Flow Discount Rate Expected Cash Flow If dismantling cost
was mentioned
0 (80,000.00)
instead of
1-5 50,800 4.355 221234 scraping
6 8,000 0.5645 4516 (4,516.00)
Total Expected Cash Flow (Discounted Cash Inflow) 225750 216,718.00
225,750
PI = 80,0000
= 2.82
Week 2
RISK EVALUATION IN CAPITAL BUDGETING
10. Two mutually exclusive investment proposals are being considered. The following information is
available
Salvage value 0 0
8
Advice for selecting the proposal if the cost of capital is 10%. The probabilities of cash inflow of each
year for the projects are---
Project A Project B
Solution:
Project A
D = Cash Flow inflow - E = Square of
A B C=AxB Total Expected Inflow (Z) (Deviation(D)) F=ExB
Expected
Cash Flow Cash Flow
inflow in '000 Probability Inflow in '000 Square of Variance
(A) (B) (C) Deviation in '000 (D) Deviation (E) (F)
10 0.2 2 (2.00) 4 0.8
12 0.6 7.2 0.00 0 0
14 0.2 2.8 2.00 4 0.8
Total Expected Inflow (Z) 12 Total Variance (Y) 1.6
Variance 1.6
Standard
Deviation 1.265
Project B
D = Cash Flow inflow - E = Square of
A B C=AxB Total Expected Inflow (Z) (Deviation(D)) F=ExB
Expected
Cash Flow Cash Flow
inflow in '000 Probability Inflow in '000 Square of Variance
(A) (B) (C) Deviation in '000 (D) Deviation (E) (F)
11 0.2 2.2 (1.00) 1 0.2
12 0.6 7.2 0.00 0 0
13 0.2 2.6 1.00 1 0.2
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Total Expected Inflow (Z) 12 Total Variance (Y) 0.4
Variance 0.4
Standard
Deviation 0.632
Conclusion: As standard deviation and variance of Project B is less than Project A, Project B is accepted
as it is less riskier compared to Project A.
11. Two mutually exclusive investment proposals are being considered. The following information is
available (Homework)
Salvage value 0 0
Advice for selecting the proposal if the cost of capital is 10%. The probabilities of cash inflow of each
year for the projects are---
Project A Project B
Solution:
The working notes are exactly the same as that of Q10. Only difference is that Project B involves higher
cost than Project A. At expense of higher cost, the risk involvement is less for Project B in contrast to
Project A which costs lower than it. The difference in cost between project A and project B is 20,000 i.e.
cost of Project B involves additional cost of 40% of Project A. As the difference in cost is not by very big
margin, it is better to accept Project B. Hence, Project B is accepted.
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Evaluation of projects ---Expected NPV and risk attached to the project
12) A company is considering two mutually exclusive projects X and Y. Project X costs Rs.30,000 and
project Y costs Rs.36,000. The NPV probability distribution for each project is given below:
Project X Project Y
2.Compute the risk attached to each project i.e., Standard Deviation of each probability distribution.
Solution:
Part 1 and 2:
Project X
D = Cash Flow inflow - E = Square of
A B C=AxB Total Expected Inflow (Z) (Deviation(D)) F=ExB
Expected
NPV in '000 Probability NPV in '000 Square of
(A) (B) (C) Deviation in '000 (D) Deviation (E) Variance (F)
3 0.1 0.3 (6.00) 36 3.6
6 0.4 2.4 (3.00) 9 3.6
12 0.4 4.8 3.00 9 3.6
15 0.1 1.5 6.00 36 3.6
Total Expected NPV (Z) 9 Total Variance (Y) 14.4
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Project Y
D = Cash Flow inflow - E = Square of
A B C=AxB Total Expected Inflow (Z) (Deviation(D)) F=ExB
Expected
NPV in '000 Probability NPV in '000 Square of
(A) (B) (C) Deviation in '000 (D) Deviation (E) Variance (F)
3 0.2 0.6 (6.00) 36 7.2
6 0.3 1.8 (3.00) 9 2.7
12 0.3 3.6 3.00 9 2.7
15 0.2 3 6.00 36 7.2
Total Expected NPV (Z) 9 Total Variance (Y) 19.8
Part 3:
Project X is having lower variance and standard deviation compared to Project Y. Therefore, Project Y is
more risky than Project X.
Part 4:
(30000 + 9000)
P I f or P roject X = 30000
= 1.3
(36000 + 9000)
P I f or P roject Y = 36000
= 1.25
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RISK EVALUATION OF CAPITAL BUDGETING USING RISK ADJUSTED
DISCOUNT RATE
14) The Global Manufacturing company Ltd., is considering an investment in one of the two mutually
exclusive proposals –Project X and Project Y, which require cash outlays of Rs.3,40,000 and Rs.3,30,000
respectively. The certainly equivalent (C.E) approach is used in incorporating risk in capital budgeting
decisions. The current yield on government bond is 8% and this be used as the riskless rate. The expected
net cash flows and their certainly-equivalents are as follows-
Project X Project Y
Year end Cash flow Rs. C.E Cash flow Rs. C.E
Required-(a) which project should be accepted? (b) If risk adjusted discount rate method is used, which
project would be analyzed with a higher rate?
Solution:
Project X
Certainty Discount Discounted
Cash Flow Equivalent Certainty Equivalent Cash rate @ 8% Cash Flow
Year (A) '000 (B) Factor (C) Flow '000 (D) (E) (F)
1 180 0.8 144 0.926 133.333
2 200 0.7 140 0.857 120.027
3 200 0.5 100 0.794 79.383
Total Cash Flow Inflow or Present Value 332.744
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Project Y
Certainty Discount Discounted
Cash Flow Equivalent Certainty Equivalent Cash rate @ 8% Cash Flow
Year (A) '000 (B) Factor (C) Flow '000 (D) (E) (F)
1 180 0.9 162 0.926 150.000
2 180 0.8 144 0.857 123.457
3 200 0.7 140 0.794 111.137
Total Cash Flow Inflow or Present Value 384.593
b) Project X has lower certainty equivalent factor than Project Y. Therefore, Project X is more risky.
Hence, it should be analysed with higher discount rate as per RADR method.
15) The Textile Manufacturing company Ltd., is considering an investment in one of the two mutually
exclusive proposals –Project M and Project N, which require cash outlays of Rs.8,50,000 and Rs.8,25,000
respectively. The certainly equivalent (C.E) approach is used in incorporating risk in capital budgeting
decisions. The current yield on government bond is 6% and this be used as the riskless rate. The expected
net cash flows and their certainly-equivalents are as follows-
Project M Project N
Year end Cash flow Rs. C.E Cash flow Rs. C.E
Required-(a) which project should be accepted? (b) If risk adjusted discount rate method is used, which
project would be analyzed with a higher rate?
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Solution:
Project M
Certainty Discount Discounted
Cash Flow Equivalent Certainty Equivalent Cash rate @ 6% Cash Flow
Year (A) '000 (B) Factor (C) Flow '000 (D) (E) (F)
1 450 0.8 360 0.943 339.623
2 500 0.7 350 0.890 311.499
3 500 0.5 250 0.840 209.905
Total Cash Flow Inflow or Present Value 861.026
Project N
Certainty Discount Discounted
Cash Flow Equivalent Certainty Equivalent Cash rate @ 6% Cash Flow
Year (A) '000 (B) Factor (C) Flow '000 (D) (E) (F)
1 450 0.9 405 0.943 382.075
2 450 0.8 360 0.890 320.399
3 500 0.7 350 0.840 293.867
Total Cash Flow Inflow or Present Value 996.341
b) Project M has lower certainty equivalent factors in all three years compared to Project N. Hence,
Project M is more risky than Project N. Therefore Project M is to be analysed using higher discount rate if
the company makes use of RADR method.
16 ) Determine the risk adjusted net present value of the following Projects-
Particulars X Y Z
Net Cash Outlays (Rs.) 2,10,000 1,20,000 1,00,000
Project Life 5 years 5 years 5 years
Annual Cash Inflow (Rs.) 70,000 42,000 30,000
Coefficient of Variation 1.2 0.8 0.4
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The Company selects the risk adjusted rate of discount on the basis of the coefficient of variation-
Coefficient of variation Risk-Adjusted rate of P.V. Factor 1 to 5 years at risk adjusted rate of
return discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.854
More than 2.0 26% 2.689
Solution:
Project X
Year (A) Cash Flow (B) Discount Factor (C) Discounted Cash Flow (D)
0 (210,000.00)
1-5 70000 3.274 229180
NPV 19,180.00
Project Y
Year (A) Cash Flow (B) Discount Factor (C) Discounted Cash Flow (D)
0 (120,000.00)
1-5 42,000 3.433 144186
NPV 24,186.00
Project X
Year (A) Cash Flow (B) Discount Factor (C) Discounted Cash Flow (D)
0 (100,000.00)
1-5 30,000 3.605 108150
NPV 8,150.00
Project Y has the highest NPV compared to all projects. Therefore Project Y is accepted.
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