Financial Management

Topic – Capital Budgeting

Practice Numericals &

Introduction to Advanced Concepts
 Accept-Reject Proposal
Q) X Ltd. Has an option to buy either of the two
machines M and N. Choose the one from the
payback point of view –
Particulars M N
Estimated Life 4 years 5 years
Cost of Machine Rs. 9,000 Rs. 18,000
Estimated savings in scrap 500 800
Estimated savings in wages 6,000 8,000
Additional maintenance cost 800 1,000
Additional supervision cost 1,200 1,800
Statement showing Annual Cash Inflows
Particulars M N
Estimated Saving in Scrap 500 800
Estimated savings in wages 6,000 8,000
Total savings 6,500 8,800
Additional maintenance cost 800 1,000
Additional supervision cost 1,200 1,800
Total costs 2,000 2,800
Net cash flows (savings – costs) 4,500 6,000
Payback Period = Cost/Net Cash Flows 9,000/4,500 = 18,000/6,000=
2 years 3 years
Q2) Evaluate Machine I, II and III on payback method -
Particulars I (2years) II (3 years) III (3 years)
Capital cost (borrowings) 3,00,000 3,00,000 3,00,000
Sales 5,00,000 4,00,000 4,50,000
Scrap value 40,000 25,000 30,000
Cost of Production
Material 40,000 50,000 48,000
Labour 50,000 30,000 36,000
Factory overheads 60,000 50,000 58,000
(excluding dep)
Administration cost 20,000 10,000 15,000
Sales & Distr. Cost 10,000 10,000 10,000
Interest on capital @ 8% and tax rate is 50%
 Particulars I (2years) II (3 years) III (3 years)
Sales (A) 5,00,000 4,00,000 4,50,000
Outflows –
Material 40,000 50,000 48,000
Labour 50,000 30,000 36,000
Factory overheads (excluding 60,000 50,000 58,000
dep)
Administration cost 20,000 10,000 15,000
Sales & Distr. Cost 10,000 10,000 10,000
Costs (B) 1,80,000 1,50,000 1,67,000
Earnings before dep & int 3,20,000 2,50,000 2,83,000
-) Depreciation (C-SV/Life) 1,30,000 91,667 90,000
-) interest costs (8% of 3 lacs) 24,000 24,000 24,000
Earnings before tax (E-dep-int) 1,66,000 1,34,333 1,69,000
-) Tax @ 50% 83,000 67,166 84,500
EAT 83,000 67,166 84,500
 Particulars I (2years) II (3 years) III (3 years)

EAT 83,000 67,166 84,500

+) 1,30,000 91,667 90,000

Depreciation

Net cash 2,13,000 1,58,833 1,74,500

inflows

Pay back 3,00,000/2,13,000 = 3,000,000/1,58,833 300000/174500

period 1.408 years 1.89 years 1.72 years
(Cost/inflows)

Accept A which has lowest PBP

 Decision Tree Analysis
• It is a process of assigning probabilities of various
cash inflows at different years.

• Further the cash flows derived after probabilities

assignment are converted to their respective present
values.

• Then, the overall expected NPV is derived.

• Decision Rule is = + NPV accepted, - NPV rejected.

Q) The cost of new plant is Rs. 20,000. Useful life is 2 years. The
cash flows and their respective probabilities are –
1st YEAR Cash Prob.
inflows
Cash inflows 8,000 0.3
11,000 0.4
15,000 0.3
2nd YEAR (IF THE 1ST YEAR CASH INFLOW IS 8,000) 4,000 0.2
10,000 0.6
15,000 0.2
2nd YEAR (IF THE 1ST YEAR CASH INFLOW IS 11,000) 13,000 0.3
15,000 0.4
16,000 0.3
2nd YEAR (IF THE 1ST YEAR CASH INFLOW IS 15,000) 16,000 0.1
20,000 0.8
24,000 0.1
 Calculations of NPVs under Various Options
OPT. Year 1 PV1 = Year 2 PV2 = NPV
0.909 0.826 Year 1+2 –
20,000)

1 8,000 7,272 4,000 3,304 -9,424

8,000 7,272 10,000 8,260 -4468
8,000 7,272 15,000 12,390 -388
2 11,000 9,999 13,000 10,738 737
11,000 9,999 15,000 12,390 2,389
11,000 9,999 16,000 13,216 3,215
3 15,000 13,635 16,000 13,216 6,851
15,000 13,635 20,000 16,520 10,155
15,000 13,635 24,000 19,824 13,459
Decision Tree
Q) A proposal has investment of Rs. 80,000. It has an economic
life of 2 years having nil salvage value. Discount Rate is 10%.
1st YEAR Cash flows Probability

50,000 0.4

60,000 0.6

2nd YEAR (IF THE 1ST YEAR CASH FLOW IS 50,000) 24,000 0.2

32,000 0.3

44,000 0.5

2nd YEAR (IF THE 1ST YEAR CASH FLOW IS 60,000) 40,000 0.4

50,000 0.5

60,000 0.1
i) Construct a decision tree and compute an expected NPV of
the project.
ii) If the worst outcome arise, what will be the NPV.
iii) What shall be the best outcome.
iv) Should the project be accepted.
 Calculation of NPVs at different paths
Path PV Cash flow PV Cash flow TOTAL PV TOTAL PV NPV
Year 1 year 2 of Inflows of (inflows-
Outflows outflows)
1 50,000*0.909= 24,000*0.826= 65,274 80,000 -14,726
45,450 19,824
2 45,450 32,000*0.826= 71,882 80,000 -8,118
26,432
3 45,450 44,000*0.826= 81,794 80,000 1,794
36,344
4 60,000*0.909= 40,000*0.826= 87,580 80,000 7,580
54,540 33,040
5 54,540 50,000*0.826= 95,840 80,000 15,840
41,300
6 54,540 60,000*0.826= 1,04,100 80,000 24,100
49,560
 Statement Showing Expected NPV
Path NPV Joint Probability ENPV (NPV*JP)

1 -14,726 0.08 -1,178

2 -8,118 0.12 -974

3 1,794 0.20 359

4 7,580 0.24 1,819

5 15,840 0.30 4,752

6 24,100 0.06 1,446

6,224

Expected NPV is +ve, accept the proposal

 Conclusions
• In case of worst outcome – path 1, the ENPV is -1,178. The
expected probability is 0.08

• In case of best outcome – path 5, the ENPV is 4,752. The EP is

0.30.

• The project should be accepted due to overall positive ENPV =

Rs. 6,224.
Q) A Ltd. Has options of two projects I and II, having
respective investments of Rs. 8,50,000 and Rs.
8,25,000. The discounting rate is 6% and the
company uses Certainty equivalent approach.
Year M’s Cash CE (I) N’s Cash CE (II)
flows flows

1 4,50,000 0.8 4,50,000 0.9

2 5,00,000 0.7 4,50,000 0.8

3 5,00,000 0.5 5,00,000 0.7

 Project I
Year Cash CE (I) Certain PVF (6%) PV of
flows CFs inflows
1 4,50,000 0.8 3,60,000 0.943 3,39,480
2 5,00,000 0.7 3,50,000 0.890 3,11,500
3 5,00,000 0.5 2,50,000 0.840 2,10,000
PV of 8,60,980
inflows
PV (8,50,000)
outflows
NPV 10,980
 Project II
Year Cash CE (II) Certain PVF PV of
flows CFs (6%) inflows
1 4,50,000 0.9 4,05,000 0.943 3,81,915
2 4,50,000 0.8 3,60,000 0.890 3,20,400
3 5,00,000 0.7 3,50,000 0.840 2,94,000
PV of 9,96,315
inflows
PV 8,25,000
outflows
NPV 1,71,315