CHAPTER 8

Capital Budgeting Decisions

Learning Objectives:
After studying this chapter, you will be able to
Appreciate vital significance of capital budgeting decisions for business firms.
Know the reasons why such decisions are difficult decisions.
Develop relevant data (in terms of cash outflows and cash inflows) to evaluate proposed capital budgeting
proposal.
Learn various methods of appraising such decisions and reasons of superiority of discounted cash flows, (DCF),
methods (in particular NPV method) to the traditional methods (accounting rate of return and pay back period).
Have insight regarding the concepts of cost of capital and time value of money (a rupee received today (referred
to as time zero period) is worth more than a rupee received infutureyears(year1,2…nthyear)).

INTRODUCTION
There is a paramount significance of long-term investment decisions (more popularly
referred to as capital budgeting decisions) for business enterprises as substantial investments are
needed for their acquisition and execution. They have their effects over a long time span; above
all, the firm’s future cost structure is also affected. For instance, if a company d
the purchase of a new plant, it is committing itself to a sizeable amount of recurring fixed costs
in terms of salaries of additional work force, insurance, rent of the newly acquired space, and so
on.
However, if the investment in future turns out to be unsuccessful, the firm is likely to
bear the burden of fixed costs (explained in Chapter 6) in years to come unless it writes off the
investment completely. You will appreciate that the latter option is difficult proposition in the
Indian context. This apart, abandoning of the investment project may entail substantial financial
losses to the firm (you will agree the sale value of plant is likely to be much lower than its
acquisition costs). It is apparent, therefore, that capital budgeting decisions have a marked
bearing on profitability of a business firm.
From the above, it is not incorrect to infer that incorrect/unsound investment decisions
have inherent threats of endangering the survival even of the well-run business firms. A few

8.1
wrong decisions are likely to be enough recipe for their liquidation / bankruptcy. In contrast,
correct and sound investment decisions can fetch spectacular returns and thus can be
instrumental in changing the fortunes of even the weak and marginal firms.
Given such a vital significance of capital budgeting decisions, it will be useful for you to
know theoretically correct and sound conceptual framework of proposals both in terms of data
requirement and evaluation techniques. The objective of this chapter is to provide the subject
matter on these aspects and certain other/allied aspects which have a bearing on capital
budgeting decisions.

NATURE OF CAPITAL BUDGETING DECISIONS

Capital budgeting decisions are long-term investment decisions as they relate to the
purchase of long-term assets. Being so, they involve current cash outlays (outflows) in
expectation of future benefits (measured in terms of cash inflows), likely to accrue over a period
of time longer than one year. Since the time span involved is longer than one year, such
decisions are also aptly referred to as capital expenditure decisions.
Current investment (known as investment made in time zero (0) period) can provide
benefits in future years (referred to as time period t1, t2 and so on) either in terms of increased
revenues or reduced costs. Viewed from this perspective, these decisions can either be revenue
expanding investment decisions or cost reduction investment decisions.
From the above, it is imperative that the correct forecasts of cash inflows the project is
likely to yield over its economic useful life (in future years) is very important for capital
budgeting decisions. However, it is not easy to come as the future is uncertain. Therefore, there
is an element of risk involved in such decisions. For instance, a project which is expected to
provide benefits for 8 years, requires 8-year forecast; an incorrect forecast may entail heavy
financial losses. There are a large number of factors, which affect the estimate of future
revenues. Included in the list are price, substitutes available, advertising and promotion,
possibility of a new technology, shift in consumer preference, changes in economic and
government policies. Evidently, capital budgeting decisions are beset with a number of
difficulties. In general, revenue expanding investment decisions are more risky (as they are based
on external factors more) than cost reduction investment proposals.

8.2
 RELEVANT DATA
Capital budgeting decisions require data relating to their costs and benefits which can be
conveniently, wholly and exclusively identified with proposed investment decision. In other
words, the data which do not affect the present decision either in terms of investment outlays,
operating costs or benefits (revenues) are irrelevant. For instance, cost of land which is lying
vacant in factory premises and cannot be let out as a policy decision to outside party would not
constitute relevant investment outlay for setting up a new plant to produce a new product. (It is
useful for you to recapitulate that this framework is in tune with incremental analysis approach
suggested in Chapter 6 for decision – making).
Likewise, the existing factory and administrative overheads (for instance, salary of
factory manager and chief executive, property taxes, store expenses, etc.) are to be excluded as
they are not incremental for setting up a new plant; for the same reason only the incremental
benefits and revenues accruing from the proposed decision are to be considered. In the case of
capital budgeting decision related to replacement of the existing machine, only the incremental
sales revenues (and not the total sales revenue) should be considered. For instance, if the existing
sales revenue from the existing machine is Rs. 15 million per year; it is estimated that with the
new machine the sales revenues are likely to be Rs. 25 million; the relevant data (in terms of
benefits) will be Rs. 10 million (incremental sales revenue of Rs. 10 million over the existing
sales revenue). The reason is very simple; the firm was already having sales revenue of Rs. 15
million; on account of the proposed investment decision, it is to be benefited only by Rs. 10
million and not by Rs. 25 million.
The list of costs and benefits which ‘should be’ and which ‘should not be’
account obviously cannot be exhaustive; it will vary from one firm to another in the industry and
may vary within the same firm over a period of time. In operational terms, only incremental
costs and benefits of the proposed capital budgeting decision should be taken into account.
It is important for you to remember that both costs and benefits (revenues) from a capital
budgeting proposal should be measured on cash flow basis and not on the basis of accounting
profits. The major reasons for preference of cash flow approach are as follows:
(i) It avoids the ambiguities of the accounting profit approach; you will recall that there are
various assumptions involved in arriving at net income figure. Accordingly, there may be
varying net income estimates. In contrast, there is only one estimate of cash flows.

8.3
(ii) Cash flow approach is more readily comprehensible to the owner/chief executive than
accounting profits. For instance, he understands better that a project in which he is required
to invest Rs. 10 lakh in time zero period is expected to yield him, say Rs. 3 lakh in year 1,
Rs. 5 lakh in year 2 and so on. Obviously, accounting profit figure is not as crystal clear.
(iii) It takes cognisance of the time value of money1 i.e., a rupee received in year 1 is worth more
than a rupee receive in year 2; similarly a rupee obtained in year 2 carries more worth than a
rupee received in year 3 and so on as cash received in earlier years have reinvestment
opportunity to earn more (for instance, assume that you are an owner and you are to decide
whether to invest in Project A which is expected to yield Rs. 10 lakh at year-end 1 or to
invest in Project B which is expected to yield Rs. 10 lakh at year-end 2; both these projects
are identical in all other respects. In which project, you will invest? Evidently, your
preference will be for Project A).
(iv) Above all, cash flow approach is concerned with finding out whether future cash inflows
(duly adjusted for time value) are sufficiently large to warrant the initial investment2.
However, it is important for you to bear in mind that like the accounting approach the
cash flow approach also requires the cash inflows after taxes. Obviously, cash inflows before
taxes are not the benefits available to the business enterprise, its relevant receipts / returns are
cash inflows after taxes.
In sum, it can be said that incremental cash flows after taxes, identifiable due to the
proposed capital budgeting decision, constitute the relevant data for its evaluation. Their
computation depends on the nature of the proposal. From the computation perspective, such
decisions can be categorised into (i) single proposal, (ii) replacement proposal and (iii) mutually
exclusive proposals.

Single Proposal
Cash Outflows: The cash outflows required to carry out an independent investment proposal are
listed in Format 8.1. The broad principle in this regard is that these cash flows consist of all
investment outlays required to carry out a capital budgeting proposal.

1
Please refer to Appendix 8-A for details.
2
However, it is not to suggest that accounting approach is of no utility. In fact, such an approach is the only basis to
determine taxable liability.

8.4
Format 8.1: Cash outflows of a capital budgeting proposal at beginning of the period (t =
0).
Cost of plant and equipment
Plus cost of additional land and building.
Plus installation cost of plant and equipment
Plus training cost (if required)
Plus working capital requirements.
While the first four items are self-explanatory, a word of explanation is required for
working capital effect. You, as an experienced business executive, will appreciate that a new
investment project requires investment outlays/cash outflows not only in terms of purchase of
long-term assets (like plant and machinery) but also in terms of working capital to support the
additional activity on account of a new machine. For instance, in the case of revenue expanding
investment proposal, the purchase of a new machine is obviously likely to increase production
and sales. Evidently, to support additional production and sales, there will be an increase in
current assets (CA) in the form of debtors, larger inventory and perhaps larger amount of cash
also.
However, the investment in working capital is not equivalent to the investment in current
assets (debtors, inventory and cash); it is partly offset by increase in creditors (current liabilities).
You will be wondering, why? The reason is as the firm sells goods on credit (which causes
increase in debtors and hence working capital); the firm also purchases raw materials on credit
(which causes increase in creditors (current liability) and thus reduces working capital). Hence,
in the context of capital budgeting decisions, the working capital is used in a net sense (that is,
current assets minus current liabilities).
This increased working capital, then, forms part of the initial cash outflows / outlays. It
may be noted that this net working capital is released / recovered in the terminal year of the
project. In operational terms, the net working capital in considered as cash outflows (at t = 0) and
a part of cash inflows in the terminal year of the capital investment project.
Cash inflows: As stated earlier, cash inflows will consists of cash inflows after taxes (CFAT).
For better exposition the computation procedure of CFAT for revenue expanding investment
proposal is shown in Format 8.2 and of cost reduction investment proposals in Format 8.3.

8.5
 Format 8.2: Cash inflows after taxes in revenue expanding investment proposals
(t = 1–n)
Particulars Years
1 2 3 4 … N
Sales revenue
Less Costs :
Operating costs
Depreciation (D)
Earnings before taxes (EBT)
Less taxes
Earnings after taxes (EAT)
Add back depreciation
Cash inflows after taxes (EAT + D)
Plus salvage value (in nth year)
Plus recovery of net working capital (in nth year)
Notes:
(i) Depreciation is deducted first so that the taxable income can be determined; it is added
back as it does not constitute cash outflow (depreciation is a non-cash expense; please
refer to chapter 3).
(ii) Depreciation is determined by the tax laws applicable to industry groups and the nature of
assets. According to income tax rules in India (at present), depreciation is charged not on
an individual asset but on a block of assets; assets having the same rate of depreciation
form one block. Further, depreciation is to be charged on written down value method; most
of the plant and equipments are subject to 25 per cent rate of depreciation.
(iii) Operating costs include variable costs and incremental fixed costs only; in other words,
apportionment of the existing fixed costs are to be excluded as per the principles of the
incremental analysis.

8.6
 Format 8.3: CFAT in cost reduction investment proposal (t = 1- n).
Particulars Years
1 2 3 4 … n
Operating costs (existing)
Less expected operating costs with new machine
Less depreciation with new machine
Net cost savings / (Earnings before taxes)*
Less Taxes
Earnings after taxes (EAT)
Add back depreciation (D)
CFAT (EAT + D)
Plus salvage value, if any in (nth year)
Plus (Minus) working capital in (nth year)**
* In operational terms, cost savings imply increased profits on which the firm is to pay taxes.
** While revenue expanding capital budgeting decisions normally require additional working
capital, cost reduction investment proposals reduce the requirement of working capital. In other
words, the latter type of proposals release working capital. As a result, the initial cash outflows
required at t = 0 period gets reduced by the amount of working capital so “freed” and cash
inflows in terminal year are adjusted lower by an equivalent amount.
In view of the above, Format 8.1 showing determination of cash outflows requires
adjustment in respect of working capital. While the amount of working capital is added in the
case of revenue expanding investment proposals (as shown in Format 8.1), the amount of
working capital released is to be subtracted in the case of cost reduction investment proposals.

Replacement Proposals
Like single proposals, cash outflows are required to buy a new machine in the case of
replacement proposals also. However, in the case of replacement of an existing machine by a
new machine, the sale proceeds so obtained from its sale reduce cash outflows required to
purchase a new machine. Format 8.4 shows determination of cash outflows in a replacement
situation.

8.7
Format 8.4 : Cash outflows in a replacement situation
Cost of new machine
Plus installation cost
Plus increase in working capital required
(less decrease in case working capital is released)
Less sale proceeds of existing machine
Like cash outflows, it is important for you to remember some notable points related to
determination of CFAT in the case of replacement proposals. These points pertain both to
revenues and costs; only incremental sales revenues and incremental costs are to be reckoned;
likewise, only incremental depreciation is to be considered.

Mutually Exclusive Proposals

In the case of mutually exclusive proposals, the selection of one proposal implies the
rejection of other proposal(s). The procedure of determining cash outflows and cash inflows are
on lines of Formats 8.1 and 8.2 in the case of revenue expanding investment proposals and on the
basis of Format 8.3 in the case of cost reduction investment proposal (with suitable modification;
refer to Example 8.1).

Example 8.1:
A plastic company is considering two mutually exclusive investment proposals for its
expansion programme. Proposal X requires purchase of a new machine costing Rs. 16 lakh and
causes yearly cash operating costs of Rs. 1,00,000. Proposal Y requires an initial investment of
Rs. 10 lakh (cost of a machine) and yearly cash operating costs of Rs. 2,20,000. The life of both
machines used is 8 years with no salvage value; depreciation is on straight-line method and the
same is assumed to be accepted fortaxpurposes.Thecorporatefirm’seffectivetaxratei
cent. Determine relevant cash outflows and cash inflows after taxes.

Solution:
(i) Proposal X is more costly. It requires additional investment of Rs. 6,00,000 vis-à-vis
Proposal Y.
(ii) Proposal X yields more cash cost savings (EBT) of Rs. 1,20,000 (Rs. 2,20,000 - Rs1,
00,000)

8.8
 (iii) Proposal X causes higher depreciation (Rs 16 lakh/8 years) i.e., Rs 2,00,000 as
compared to Rs. 1,25,000(Rs. 10 lakh/8years) in case of Proposal Y.
In more concrete terms, cash outflows and inflows are as follows:
Cash outflows:
Incremental investment in more costly machine:
Machine X Rs 16,00,000
Machine Y 10,00,000 Rs 6,00,000

Cash inflows after taxes:

Cash operating cost (Y machine) Rs. 2,20,000
Less cash operating cost (X machine) 1,00,000
Cash operating savings 1,20,000
Less incremental depreciation:
Machine X Rs. 2,00,000
Machine Y 1,25,000 75,000
Cost savings before taxes (EBT) 45,000
Less taxes (Rs. 45,000 × 0.35) 15,750
Earnings after taxes 29,250
Add back incremental depreciation 75,000 1,04,250

While Example 8.1 focused on relevant data for cost reduction investment proposals, the
objective of Example 8.2 is to help you to identity relevant data in the case of revenue expanding
investment proposals.

Example 8.2:
A corporate firm is considering an investment in a new product. The information related
to expected revenues and costs for year 1 is as follows:

Sales Rs. 5,00,000

Manufacturing cost of sales (including Rs 50,000 depreciation) 2,00,000
Decrease in contribution of existing products 20,000
Selling and administrative costs (on account of introduction of a new product) 1,00,000
Existing fixed costs apportioned 25,000
Income tax rate is 35 per cent
From the above information, you are required to compute the relevant cash inflows after taxes
likely to be generated by the new product in year 1.

8.9
Solution:
Determination of CFAT
Sales Rs. 5,00,000
Less incremental costs:
Manufacturing cost of sales (cash) 1,50,000
Depreciation 50,000
Decrease in contribution of existing products 20,000
Selling and administrative costs 1,00,000
Incremental earnings before taxes 1,80,000
Less taxes (Rs 1,80,000 × 0.35) 63,000
Earnings after taxes 1,17,000
Add back depreciation 50,000
(CFAT (in year 1) 1,67,000

Note: (Apportioned fixed costs are not incremental costs and hence ignored)
Examples 8.1 and 8.2 are useful as they help in identifying relevant data (and determination of
CFAT) to evaluate capital budgeting investment proposals. But these examples were
inconclusive as far as the decision regarding acceptance or rejection of an investment proposal is
concerned. For the purpose of decision-making, we require additional data related to cost of
financing investments. Cost of financing investments is referred to as cost of capital. This
constitutes the subject matter of the next section.

Cost of Capital
Cost of Debt: Let us suppose that a corporate firm requires investment of Rs 100 lakh to finance
a new investment proposal/project; this proposal is to be funded by long-term debt carrying
interest of 13 per cent. What is the cost of financing of this project? You will think that the cost
of debt is 13 per cent. Accordingly, 13 per cent is the cost of financing. But this is not true. The
reason is that interest is a deductible item of expense to arrive at taxable income. In operational
terms, there is a tax savings on payment of interest. Therefore, after tax cost of debt will be
lower to the extent of tax savings.

8.10
 You will be wondering why we should have tax-adjusted cost of debt. The reason is that
returns from the project (cash inflows) are measured on after tax basis. Obviously, the costs (cost
of funds) should also be computed on after tax basis. This, then, constitutes the rationale of
having after-tax cost of debt. This apart, the effective cost of debt is not 13 per cent. Example 8.3
reinforces the reason of lower cost of debt.

Example 8.3:
The following is the income statement of a firm having no interest cost
Table 8.1: Income statement (with no interest costs)
Sales revenue Rs 200 lakh
Less operating costs (i.e., cost of goods sold, administrative
expenses and selling expenses) 150
Operating profit 50
Less interest Nil
Earnings before taxes 50
Less taxes (Rs 50 lakh × 0.35 tax rate, assumed) 17.5
Earnings after tax (EAT) 32.5
This firm now borrows Rs 100 lakh at 13 per cant rate of interest. As a result, its interest costs
will be Rs 13 lakh. Income statement, with interest costs is shown in Table 8.2.

Table 8.2: Income statement (with interest costs)

Sales revenue Rs. 200 lakh
Less operating costs 150
Less interest cost 13
Earning before taxes 37
Less taxes (Rs 37 lakh × 0.35) 12.95
Earnings after taxes (EAT) 24.05

Every data input is the same in both the income statements except that interest cost is
included in the income statement shown in Table 8.2 Inclusion of interest of Rs 13 lakh has,
however decreased EAT by Rs. 8.45 lakh (Rs. 32.5 lakh –Rs. 24.05 lakh) and not by Rs 13 lakh.
(equivalent to interest payment). Does it not mean then that effective cost of interest is Rs. 8.45

8.11
lakh only (and not Rs. 13 lakh) of Rs. 100 lakh debt? In percentage terms, it is 8.45 per cent. (Rs.
8.45 lakh/Rs.100 lakh). In symbolic terms, cost of debt (kd),
kd = ki(1-t) (8.1)
= 13% (1-0.35) = 8.45 per cent.
Where ki = Interest rate
t = Corporate tax rate

Cost of preference shares: Like debt, preference shares are also paid a specified (pre-fixed) rate
of dividend. Suppose, Rs. 100 lakh required to finance the project are now to be raised through
issue of 14 per cent preference shares. What is the cost of preference shares? Your answer will
be 14 per cent; this is a correct answer. The reason is that dividends paid to preference
shareholders are not eligible items as a source of deduction to determine taxable income (like
interest payment on debt). Obviously, there is no tax advantage accruing to the corporate firm on
preference dividend payments (as was the case in respect of interest payment); on the contrary as
per the present income-tax rules in India, the corporate firms are to pay taxes on dividend
payments (say, at the rate of 10 per cent).
Evidently the cost of preference shares (kp) will be 15.4 per cent consisting of 14 per cent
dividends paid plus 10 per cent (of Rs. 14, i.e. Rs. 1.4).
Symbolically,
D p (1  Dt )
kp = (8.2)
P0 (1  f )
Where Dp = Dividend payable on preference share
Dt = Tax on preference dividend payment
Po = Issue price of preference shares.
f = Floatation cost incurred on issue of preference shares
Cost of Equity Capital: At the outset, it is worth mentioning that cost of equity capital is the
most difficult and controversial cost to measure. The reason is that equity capital is not subject to
a pre-specified rate of dividend (as is the case with preference shares). You may be aware that
the payment of equity dividend is at the complete discretion of the company management. Even
if the company has earned substantial profits, the corporate management cannot be compelled to
pay dividends. Viewed from this perspective, you may be tempted to infer that equity capital
does not carry any cost. But this is not true.

8.12
 Equity capital, like any other source of finance, does carry cost. How much? The answer
is not easy to come. To get an answer let us try to understand the conceptual framework of its
determination. For the purpose, assume yourself as a potential investor in equity shares of a
typical corporate firm. Are you not expecting returns on your investments made in equity shares
of such a corporate firm? Obviously, your answer will be in the affirmative. The rate of return
expected by you, then, constitutes the cost of equity from the perspective of a corporate firm.
This, then, raises another question what is the quantum of expected return? As per sound
tenets of finance, it is equivalent to the risk free rate of return plus risk premium.
Will you be satisfied with 8-10 per cent return on equity investment? Your answer is
likely to be in the negative; this rate of return can be easily earned by investing in public
provident fund, Indira-Vikas Patra, Long-term deposit with commercial banks and so on (with
virtually full safety of investments). Obviously, you will like to be compensated for extra risk
you are assuming by investing in equity shares of a corporate enterprise. You know that a
corporate firm is subject to business risk. This apart, there is a variability in the rates of return
available to equity-holders (as they are the last claimants on dividends as well as repayment of
capital in the event of liquidation of a company), known as financial risk. As a compensation to
the higher risk exposure, equity-holders expect a higher return and, therefore, higher cost is
associated with them. In brief, cost of equity (ke)3 is
ke = rf +b+ f (8.3)
Where rf =Risk free rate of return
b =Business risk premium
f =Financial risk premium
Thus, the cost of equity is likely to be around 14-15 per cent for a typical corporate firm
(consisting 10 per cent risk free rate of return plus 4-5 per cent risk premium to compensate for
business and financial risk).
Besides, like preference dividend payment, equity dividend payments are also subject to
additional dividend payment tax. This further increases the cost of equity. It is very apparent
from the above that the cost of equity is relatively costly source of finance. This premise is in
the marked contrast to the popular belief that equity capital does not carry cost.

3
This is outside the scope of this volume to discuss various other valuation models and methods to determine ke.

8.13
Cost of Retained Earnings: Retained earnings are the funds, which belong to equity-owners.
Had the earnings not been retained, they would have been distributed among equity-holders in
the form of dividends? What the equity-holders would have earned on these dividends (by
investing in a similar risk class) constitutes cost of retained earnings (kr). In operational terms,
the kr is virtually equivalent to the cost of equity; the kr is likely to be marginally lower than the
ke as the issue of equity shares involves flotation costs (consisting of advertisement, fees of the
merchant banker, underwriting commission, brokerage fees, and so on) and dividend payment
tax. Evidently there are no such costs in the case of retained earnings.
It is very apparent from the preceding discussion that all the above four major sources of
finance have different costs. In general, debt is relatively the cheapest source of finance and
equity the most costly one. If it is so, what is the cost of capital? Is it equivalent to cost of debt or
cost of equity? Let us dwell more on this aspect.
Suppose a project in question (Rs. 100 lakh investment) is to be financed by debt. Please
recollect, the cost of debt is 8.45 per cent. Assume further, the expected internal rate of return (to
be discussed subsequently) of this project is 10 per cent. Will you accept the project? Your
answer may be that the project is worth accepting as it yields return higher than its cost.
Assume further, after 6 months another investment project is placed for consideration; it
promises potential return of 14 per cent. But it is now required to be financed by equity (and not
debt); the firm may like to go for debt as it is the cheaper source of finance; but lender may not
agree to lend to a firm which has already debt dominated capital structure as it increases the
finance risk of lenders; (please refer to the subject matter related to capital structure/debt-equity
ratio in chapter 4). Equity capital (assume) carries 15 per cent cost. The proposal will be rejected
as it promises 14 per cent return vis-à-vis 15 per cent cost.
Do you subscribe to the view that the firm is following right policy in the above two
cases? The firm is not following a right policy as such a policy will not be able to maximise
wealth (measured in net present value, discussed later in this chapter) in the long-run. This apart,
it is not fair and equitable to pass on the entire advantage of a cheap source of finance (say debt)
to one project only which happens to be financed from that source at that point of time.
Likewise, it is not justifiable to pass on the burden of the most costly source of finance (say
equity) to the investment project which happens to be financed from that source. This apart,
when you have raised equity funds now, you have created the possibility of raising debt in

8.14
 future; in operational terms, more costly source of finance today opens the plausibility of raising
funds which are cheaper in future. The reverse, for the same reason, also holds true. If you have
raised debt today, perhaps, you may have no option but to go for equity in future.
From the preceding discussion, it is hoped that you will be convinced that cost of capital
should not consist of single source; it should be weighted average cost of all long-term sources
of finance (Example 8.4).

Example 8.4:
Determine the weighted average cost of capital (k0) of a corporate firm from the
following data:
Source Amount Cost (in percentage)
Equity Rs 40 lakh 16%
12% Debt 35 lakh 8
13% Preference shares 15 lakh 14
Retained earnings 10 lakh 15

Solution:
Table 8.3: Determination of Weighted Average Cost of Capital (k0)
Source Amount Cost (in %) Total cost (Amount × Cost)
Equity Rs. 40,00,000 16 Rs. 6,40,000
12% Debt 35,00,000 8 2,80,000
13% Preference shares 15,00,000 14 2,10,000
Retained earnings 10,00,000 15 1,50,000
100,00,000 12,80,000

Total cos t
k0   100 (8.4)
Total amount
Rs12,80,000
=  100  12.8 per cent
Rs.100,00,000
Thefirm’scostofcapitalis12.8percent.

8.15
 Evaluation Techniques/Methods

Another vital aspect in capital budgeting decision relates to the choice of an appropriate
evaluation technique/method. The methods of evaluation can be segregated into two broad
categories: (i) traditional and (ii) time-adjusted. Included in the first category are (a) average rate
of return and (b) pay back method. The second category comprises (a) net present value, (b)
internal rate of return and (c) present value index.
In general, the traditional techniques are less satisfactory because they ignore two basic
financial principles: (i) they ignore time value of money (in simple words, they ignore the fact
that earlier are the receipts of cash flows, CFAT, better they are and (ii) they do not take into
account total benefits (the bigger the better). You will appreciate these limitations once you have
learnt these techniques.

Traditional Techniques
Average Rate of Return (ARR): Also known as accounting rate of return is computed (as per the
name) dividing average annual earnings after tax (EAT) by average investment, symbolically,
Average EAT
ARR=  100 (8.5)
Average Investment

While average EAT are determined dividing total EAT from the investment project
during its entire economic useful life by number of years, average investment is determined as
per Equation 8.6.

Average investment = Net working capital + Salvage value + ½ (Initial investment -Salvage
value) (8.6)
The rationale for Equation 8.6 is that an amount equivalent to net working capital and
salvage value remains invested in the project throughout its life-time and, hence, are not to be
averaged Whereas, depreciable cost of the asset (initial investment-salvage value) needs to be
averaged. The project is accepted if the computed ARR is higher than the required ARR;
otherwise, it is rejected.

8.16
 Example 8.5
Determine the ARR from the following data related to two machines X and Y:
Particulars Machine X Machine Y
Cost of machine Rs. 5,00,000 Rs. 5,00,000
Net working capital (NWC) required Rs. 25,000 Rs. 25,000
Annual estimated earnings after taxes
Year 1 30,000 1,25,000
2 50,000 1,00,000
3 70,000 70,000
4 1,00,000 50,000
5 1,25,000 30,000
Estimated economic useful life (years) 5 5
Estimated salvage value Rs. 50,000 Rs. 50,000

The company uses straight-line method of depreciation.

Solution

Average EAT Rs 75,0001

ARR (of machine X and Y) = × × 100 = 25 per cent
2
Average investment Rs 3,00,000

1. Average EAT (of machines X and Y): Total EAT in 5 years, Rs 3,75,000/ 5 years = Rs
75,000
2. Average investment (of machines X and Y): Rs. 50,000 (salvage value) + Rs. 25,000
(net working capital) + 0.5 (Rs. 5,00,000-Rs.50,000) = Rs. 3,00,000

It is apparent that the firm will be indifferent between the two proposed investments as
they yield identical ARR of 25 per cent. But if you glance at the pattern of returns, you will find
that it will be more profitable to invest in machine Y as it yields more profits in earlier years
compared to Machine X. Evidently, ARR is a crude method of evaluating capital budgeting
proposal.

8.17
Pay Back Method: This method indicates the time period required to recover the initial
investment outlays of the capital budgeting proposal. In other words, this method measures the
number of years required by cash benefits (measured in terms of CFAT) to return back the initial
investments made in the proposal. The earlier is the sum received, the better it is as per the pay
back method.
Its computation is very simple when CFAT are uniform (referred to as annuity) in all the
years of economic useful life of the project. For instance, if an investment of Rs. 5,00,000 in a
machine is expected to yield CFAT of Rs. 1,25,000 for 6 years, the pay back period is 4 years
(Rs.5,00,000/Rs.1,25,000).
In the case of non-annuity (referred to as mixed stream of CFAT), the pay back (PB)
period is calculated by cumulating CFAT till such time this cumulative total (of CFAT) becomes
equal to original investment outlay. Consider Example 8.6.

Example 8.6
The firm has 3 investment proposals under consideration having identical investment
requirement of Rs. 10 lakh. The expected CFAT from these 3 proposals is as under:
Proposals
Year A B C
1 Rs 1,00,000 Rs 4,00,000 Rs 6,00,000
2 2,00,000 3,00,000 2,50,000
3 3,00,000 2,00,000 1,00,000
4 4,00,000 1,00,000 1,00,000
5 5,00,000 6,00,000 -
6 2,00,000 2,00,000 -

8.18
 Solution:
Table 8.4 provides cumulative CFAT to determine the PB period.
Table 8.4: Determination of pay back period
Year Annual CFAT Cumulative CFAT
A B C A B C
1 Rs. 1,00,000 Rs.4,00,000 Rs. 6,00,000 Rs. 1,00,000 Rs.4,00,000 Rs. 6,00,000
2 2,00,000 3,00,000 2,50,000 3,00,000 7,00,000 8,50,000
3 3,00,000 2,00,000 1,00,000 6,00,000 9,00,000 9,50,000
4 4,00,000 1,00,000 1,00,000 10,00,000 10,00,000 10,50,000
5 5,00,000 6,00,000 - 15,00,000 16,00,000 -
6 2,00,000 2,00,000 - 17,00,000 18,00,000 -
Pay back period (in years) 4 4 3.5*
* The pay back period is 3.5 years. Rs. 9,50,000 is recovered by the end of the third year. The
remaining sum of Rs. 50,000 is needed to be recovered is the fourth year. In the fourth year,
CFAT is Rs. 1,00,000. The pay back fraction is (Rs.50,000/Rs.1,00,000) = 0.5 year.
As per the PB method, perhaps proposal C will be accepted as it has the minimum PB
period. Do you think it is a right decision? Certainly not, the reason is that proposals A and B
(though have higher PB period of 6 months), generate substantial CFAT in years 5 and 6.
Whereas there are no CFAT from proposal C after 4th year. Evidently, the PB does not reckon
the CFAT earned subsequent to the PB period. Clearly, the PB method is not an ideal method as
it does not take into account total benefits of the project.
Modifying example 8.6, assume there are two proposals A and B only. Both the
proposals have identical pay back period of 4 years. Are both the proposals equally good from
the point of view of business firm? Certainly not. Proposal B is better than proposal A. It not
only provides more CFAT, vis-à-vis, proposal B, (within the PB period of 4 years) but also
provides more CFAT in year 5; clearly, the PB method has serious limitations in that it is neither
a true measure of profitability (as it ignores the CFAT received in years subsequent to the PB
period) nor a true measure of time value of money (in Example 8.6 a rupee received in year 4 is
reckoned as valuable as a rupee received in year 1, which is not true).
For these reasons, therefore, it can be inferred that the traditional methods are apparently
unsatisfactory. The discounted cash flow (DCF) methods tend to overcome these limitations.

8.19
Discounted cashflow (DCF) Methods
Net Present Value (NPV) Method: This method requires that all the CFAT associated with a
proposed investment project should be discounted at a pre-determined weighted average cost of
capital (k0). From the summation of present value (PV) of CFAT so arrived at, deduction is made
of the PV of cash outflows (normally incurred in time zero period). Symbolically,
n CFATt Sn + Wn
NPV=+ - CO0 (8.7)
t = 1 (1 + k0)t (1 + k0)n

where Sn = Salvage value (say of machine) in terminal year (nth year).

Wn = Recovery of working capital in terminal year.
CO0 = Investment outlays at time zero period.
k0 = Weighted average cost of capital.
The rationale of discounting is that CFAT received in various years (1 through n), clearly
heterogeneous in nature (as they pertain to different periods) are made homogenous. As a result
of this discounting procedure, the PV of CFAT so obtained is the PV at time zero period.
If the PV of CFAT exceeds the PV of CO, the project is said to have positive NPV and is
worth accepting; in case, the NPV is negative (i.e., the PV of CFAT is less than PV of CO), the
project is liable to be rejected.

Example 8.7:
Determine the NPV of two capital budgeting proposals, as per example 8.5 (relating to
purchase of Machine X and Machine Y), assuming the firm’s overall cost of capital i
cent. All other data remain unchanged.

Solution:
While Table 8.5 provides determination of NPV is respect of machine X, the NPV of machine Y
is shown in Table 8.6.

8.20
 Table 8.5 : Determination of NPV in respect of Machine X
Year EAT Depreciation CFAT PV factor at Total PV
(Col.2 + Col.3) 13 per cent (Col.4 x Col.5)
1 2 3 4 5 6
1 Rs 30,000 Rs. 90,000 Rs. 1,20,000 0.885 Rs. 1,06,200
2 50,000 90,000 1,40,000 0.783 1,09,620
3 70,000 90,000 1,60,000 0.693 1,10,880
4 1,00,000 90,000 1,90,000 0.613 1,16,470
5 1,25,000 90,000 2,15,000 0.543 1,16,745
5 50,000 (Salvage value) 50,000 0.543 27,150
5 25,000 (NWC recovered) 25,000 0.543 13,575
Gross present value 6,00,640
Less cash outflows / Investment outlays 5,25,000
Net present value 75,640
Notes: (i) (Rs 5,00,000 – Rs 50,000) / 5 years = Rs 90,000
(ii) PV factors are as per Table A-1. This table shows PV of Re 1 received in different
years at different rates of discount (k0).
(iii) Assumptions: (a) CFATs are assumed to have been received at the year-end. (b)
Salvage value as well as working capital is recovered at the end of year 5.

Table 8.6 : Determination of NPV in respect of Machine Y

Year EAT Depreciation CFAT PV factor at Total PV
(Col.2 + Col.3) 13 per cent (Col.4 x Col.5)
1 2 3 4 5 6
1 Rs 1,25,000 Rs. 90,000 Rs. 2,15,000 0.885 Rs 1,90,275
2 1,00,000 90,000 1,90,000 0.783 1,48,770

8.21
3 70,000 90,000 1,60,000 0.693 1,10,880
4 50,000 90,000 1,40,000 0.613 85,820
5 30,000 90,000 1,20,000 0.543 65,160
5 50,000 (Salvage 50,000 0.543 27,150
value)
5 25,000 (NWC recovered) 25,000 0.543 13,575
Gross present value 6,41,630
Less cash outflows / Investment outlays 5,25,000
Net present value 1,16,630

Since the NPV is positive in respect of both the machines, if they are independent
proposals, both machines are worth purchasing. Assume proposals X and Y are mutually
exclusive in nature, proposal Y would be preferred as it promises higher NPV.

Internal Rate of Return (IRR) Method : The IRR method indicates the expected rate of return
likely to be provided by the capital budgeting proposal. To help you to understand its method of
computation, let us take a very simple example. Suppose, a project requires cash outflows of Rs
10 lakh (in time zero period), and is expected to yield Rs 11 lakh CFAT at the end of year 1.
Obviously, the IRR is 10 per cent (The present value of Rs 11 lakh received at the year-end 1 is
Rs 10 lakh i.e., Rs 11 lakh × PV factor at 10 per cent for a rupee received at year-end 1 is 0.909;
if the project is expected to yield Rs 12.1 lakh CFAT at year-end 2 (with no CFAT at year-end
1), the IRR will still be 10 per cent; (the PV of Rs 12.1 lakh received at year-end 2 is Rs 10 lakh
i.e., 12.1 × 0.826, PV factor of 1 rupee received at year-end 2 at 10 per cent).
The above process of computing is illustrated so that you can comprehend the definition
of IRR. The IRR is the discount rate that discounts CFAT (likely to accrue in future years, 1, 2,
…n)insuchamannersothatthe
ateaggreg
present value of CFATs is equal to the present value
of initial cash outflows.
Symbolically,
n
CFATt S n  Wn
CO 0  
t  1 (1  r)
t

(1  r) n
(8.8)

r = Internal rate of return (IRR).

8.22
 The investment proposal is worth accepting if IRR exceeds the cost of capital (k0); if the
k0 is higher than IRR, the proposed investment project is worth rejecting.
The IRR was 10 per cent in the two very simple situations described earlier.
Rs 11 lakh
Rs10 lakh 
 1 r  1
Rs 12.1 lakh
Rs 10 lakh 
 1 r  2
when r = 10%, the two sides of equation tally. In practice, the CFAT do not normally accrue in
one single year; they are spread over among several years; therefore, the computation of IRR is
not as simple as projected above. The procedure of its computation is described in the following
paragraphs.
When CFAT are uniform, the steps needed to determined IRR are:
(i) Determine the pay back period of the proposed investment project.
(ii) In the present value table of annuity (Table A-2), search for the pay back period that is equal
to or closest to the life of the project.
(iii) In case the annuity value is not equal to the PB period (which is the most likely to be the
case), it is suggested that the two closest values should be selected : one should be higher than
the PB period and another lower than the PB period.
(iv) From the top row of Table A-2, note the interest rates corresponding to these pay back
period values; they represent the range of IRR. Consider Example 8.8.

Example 8.8:
Machine X requires initial investment of Rs 3,00,000; it is expected to generate CFAT of
Rs 75,000 each year for next 6 years. Determine IRR

Solution :
(i) Pay back period = Rs 3,00,000/ Rs. 75,000 = 4 years
(ii) Correspondingto 6 year’s lifeof thefactor
project,
closestthe
to the pay back period
(4) is 3.998.

8.23
 (iii) The IRR is 13 per cent approximately.
(iv) The precise value of IRR can be determined with the help of interpolation. For the
purpose, the two identified values (as per Table A-2) will be as follows :

At 12 per cent 4.111

At 13 per cent 3.998

Evidently 1 per cent difference represents PV factor difference of 0.113. It is apparent

that the value of IRR will be between 12-13 per cent range. Adjustment can be made in either of
the values.
0.111
12 %   12.98 per cent
0.113
0.002
13 %   12.98 per cent
0.113
In the case of a mixed stream of CFAT
(i) the ‘fake annuity’ can be determined (which will be equivalent to the average
likely to be generated by the project).
(ii)Basedonthe‘fakeannuity’thePBperiodisrequiredtobedetermined(whicho
be fake pay back period).
(iii) Table A-2 is to be searched to identify two closest values (one higher than PB period and
another lower than the PB period) corresponding to the life of the project.
(iv) It is important to note that the fake annuity is the only starting point of the exercise towards
determination of IRR. In case, the CFAT in the initial years of the project’s life a
the average CFAT (as per fake annuity), obviously, the IRR is likely to be higher (it is based
sheer on common sense). Likewise, the reverse will hold true; i.e., if the CFAT are higher in the
latter years, the IRR tends to be lower than the one suggested by step (iii). Consider Example
8.9.

8.24
 Example 8.9:
Machine Y requires an investment of Rs 4,00,000. As a result of this investment, the
following CFAT are likely to accrue in next 5 years.
Year CFAT
1 Rs 1,25,000
2 1,25,000
3 1,50,000
4 1,50,000
5 2,00,000
Determine IRR.
Solution :
(i) Fake annuity = Total CFAT / 5 years = Rs 7,50,000/5 years = Rs 1,50,000.
(ii) Fake pay back period = Rs 4,00,000 / Rs 1,50,000 = 2.667.
(iii) The PB factors closest to 2.667 against 5 years as per Table A-2 are 2.689 (25 per cent)
and 2.635 (at 26 per cent).
(iv) Since the initial CFAT are lower than the fake CFAT, the IRR tends to be lower than 26
per cent. Let us try to determine PV at 25 per cent and 24 per cent (Table 8.7).
Table 8.7: Determination of PV at discount rates 25 and 24
PV factor at (%) Total PV at (%)
Year CFAT
25 24 25 24
1 Rs 1,25,000 0.800 0.806 Rs 1,00,000 Rs 1,00,750
2 1,25,000 0.640 0.650 80,000 81,250
3 1,50,000 0.512 0.524 76,800 78600
4 1,50,000 0.410 0.423 61,500 63,450
5 2,00,000 0.328 0.341 65,600 68,200
Total present value 3,83,900 3,92,250

The value of IRR tends to be lower than 24 per cent (as summarization of PV at 24 per
cent is less than Rs. 4,00,000); in operational terms, future CFAT should be discounted at a rate
lower than 24 per cent (There is a inverse relationship between PV and discount rate; to have

8.25
 higher PV total at Rs 4,00,000, evidently the discount rate should be lower). You may further
note that 1 per cent difference (between 25-24 per cent) is Rs. 8,350; we should try PV at 23 per
cent (Table 8.8).

Table 8.8: Determination of PV at discount rate 23

Year CFAT PV Factor at 23% Total PV at 23%
1 Rs 1,25,000 0.813 1,01,625
2 1,25,000 0.661 82,625
3 1,50,000 0.537 80,550
4 1,50,000 0.437 65,550
5 2,00,000 0.355 71,000
Total present value 401,350

(i) It is very apparent that IRR will be between the range of 23 and 24 per cent (Further, it is
also very evident that the determination of IRR is essentially based on trial and error
process; fake annuity is a useful concept as a starting point to determine IRR). By
interpolation, we determine the value of IRR.
One per cent difference is (Rs 4,01,350 – Rs 3,92,250) = Rs 9100. Therefore,
Rs 7,750 *
IRR  24%   23.15% ; * (Rs 4,00,000 – Rs 3,92,250)
Rs 9,100

Rs 1,350 * *
 23%   23.15% ; ** (Rs 4,01,350 – Rs 4,00,000)
Rs 9,100
Present value (Profitability) index :
The present value (PV) index method is variant of the NPV method. It is determined
dividing PV of CFAT by initial cash outflows. Symbolically,

PV of CFAT
PV Index  (8.9)
PV of CO

8.26
 If the PV index exceeds one4, the proposal is worth accepting; otherwise, it merits
rejection. (Consider Example 8.10).

Example 8.10:
From the facts contained in Example 8.9, determine PV index, assuming cost of capital of
15 per cent.

Solution:
Table 8.9: Determination of PV index at 15 per cent
Year CFAT PV factor at 15% Total PV at 15%
1 Rs 1,25,000 0.870 Rs 1,08,750
2 1,25,000 0.756 94,500
3 1,50,000 0.658 98,700
4 1,50,000 0.572 85,800
5 2,00,000 0.497 99,400
Total present value 4,87,150
PV index = Rs 4,87,150 / Rs 4,00,000 = 1.218.

In the discussions that follow, you will be convinced that the NPV method should be
preferred, vis-à-vis, other DCF methods related to capital budgeting projects.
In the case of independent investment proposals, all the DCF methods provide consistent
results in terms of their acceptance or rejection. The reason why these methods lead to the same
results can be traced to their decision criteria. According to the NPV method, the investment
proposal is accepted if it promises positive NPV. In the case of IRR, the proposal is accepted if
IRR exceeds the overall cost of capital (k0). As per the PV index, the value of PV must be higher
than one to gain acceptance of the proposed capital budgeting proposal.
The proposals which emerge to have positive NPVs will be those having IRRs higher
than k0 and PV indices greater than one. (Refer to Example 8.10, NPV is positive at Rs 87,150 5;

4
PV index can also be measured in percentages; in that case its value should be more than 100 for the investment
project to be accepted.

8.27
 PV is 1.218; IRR is 23.15% > k0 15%). In other words, the negative NPVs will be associated
with IRRs lower than k0 and PV indices of less than one. (Assume in Example 8.10, cost of
capital is 25 per cent, the NPV is negative Rs 16,100 (Rs 4,00,000 – Rs 3,83,900, PV at 25%);
the PV index is 0.959 (Rs 3,83,900 / Rs 4,00,000) which is less than one and IRR will remain
unchanged at 23.15 per cent (as only at this rate PV of CFAT will be equal to Rs 4,00,000); IRR
is less than 25%). Thus, all the three methods lead to identical results with respect to the accept –
reject decision.
However, these methods may provide conflicting results in the case of mutually exclusive
new capital budgeting projects. Consider data provided in Example 8.11.

Example 8.11:
X and Y are two mutually exclusive capital budgeting projects, involving different outlays. The
required rate of return (k) is 10 per cent; the other details are contained in Table 8.10.
Table 8.10: NPV, IRR and PV index of projects X and Y
Particulars Project X Project Y Difference (Y - X)
Cash outlays Rs 2,50,000 Rs 3,75,000 Rs 1,25,000
CFAT at the year end 1 3,12,500 4,61,250 1,48,750
Determined Values :
IRR 25 per cent 23 per cent 19 per cent
(Rank 1) (Rank 2)
Gross present value 2,84,062.50 4,19,276.25 1,35,213.75
Net present value 34,062.50 44,276.25 10,213.75
(Rank 2) (Rank 1)
Present value index 1.136 1.118 1.081
(Rank 1) (Rank 2)

It is apparent that NPV method ranks the projects differently from IRR and PV index
methods. Project X has a higher IRR (25 per cent) and PV index (1.136) than project Y, the
respective figures being 23 per cent and 1.118. In contrast, Project Y has higher NPV (Rs
44,276.25) than project X (Rs 34,062.50). In such situations of conflict rankings, it is important

5
(Rs 4,87,150 – Rs 4,00,000)

8.28
to know which method yields better results. The answer should be related to the objective of
financial decision-making. In the current academic literature the maximisation of shareholde
wealth (also known as net present worth maximisation) is almost universally accepted as an
appropriate operational decision criterion for financial management decisions.
The IRR and PI methods clearly are incompatible with this objective; they are more
concerned with the rate of earnings on total investments rather than the total earnings on the
investment. It should be recognized that rate of return is only a means to the end (wealth
maximisation) and not an end in itself. The recommendation of NPV method is consistent with
the goal of maximizing shareholders’ wealth of the firm. This is because the pro
largest NPV will cause the shareholders’ wealth to increase more than will b
of the other projects.
In hypothetical Example 8.11 project Y fetches NPV of Rs 44,276.25 compared to a
much smaller sum of Rs 34,062.50 from project X. (Will you not like to go for project Y, as it
brings more NPV, though at lower rate?) The superiority of project Y gets evidenced further
when we calculate the IRR and PI values of differential cash flows. The IRR of differential cash
outlays of Project Y is 19 per cent as against cost of capital of 10 per cent; obviously it will be
profitable for the firm to procure additional funds at 10 per cent and earn 19 per cent. Thus, it
may be concluded that Project Y is better albeit its lower values of IRR and PI. It is so because it
offers the benefits offered by Project X (Rs. 34.062.50) plus additional return of Rs 10,213.75)
on additional investment of Rs 1,25,000.
From the above follows, on extending analysis under IRR and PV index methods based
on differential cash flows, these methods also can be made to give results similar to the NPV
method. Undoubtedly, the logic is true. However, it requires additional computation, whereas the
NPV method provides the correct answer in the first instance itself. Clearly, the NPV emerges
as a superior technique of evaluation.
The superiority of NPV method is also apparent in situations when the pattern of cash
inflows (CFAT) generated of the two mutually exclusive capital budgeting proposals differ, their
identical initial investments notwithstanding. Consider facts contained in Example 8.12 assuming
10 per cent as the cost of capital.

8.29
 Example 8.12
X and Y are two mutually exclusive investment proposals relating to acquisition of new machine
having the following pattern of cash flows during its 4-year economic useful life with no salvage
value. Determine NPV, IRR and PV index.
Year Project X Project Y
0 (Cash outflows) Rs 5,25,000 Rs 5,25,000
1 (Cash inflows, CFAT) 3,00,000 75,000
2 2,25,000 1,50,000
3 1,50,000 2,25,000
4 75,000 4,00,000

Solution:
Table 8.11: Determined values of NPV, IRR and PV index of projects X and Y.
IRR 20% (Rank 1) 17 per cent (Rank 2)
Gross present value Rs 6,22,425 Rs 6,34,250
NPV 97,425 (Rank 2) 1,09,250 (Rank 1)
PV index 1.186 (Rank 2) 1.208 (Rank 1)

Again, we are faced with conflict rankings. The IRR approach recommends Project X,
whereas the other approaches recommend Project Y. Consistent with the objective of NPV
maximisation, Project Y should be preferred. The PV technique incidentally happens to be in line
with NPV. However, it may not be always true and, therefore, it is always safe to count on the
ranking provided by the NPV method in preference to others.
The conflict between the NPV and IRR methods mainly may be ascribed to the different
re-investment rate assumptions of intermediate cash inflows accruing from projects. The IRR
method assumes that the cash flows generated from the projects are subject to reinvestment at the
same rate of IRR, whereas the reinvestment rate under the NPV method is cost of capital. The
assumption of the NPV method is considered to be conceptually superior to that of IRR. In the
IRR method, there will be as many rates of reinvestments as there are investment proposals
under consideration. In operational terms, it implies that the firm will reinvest CFAT generated
from one project (say of Rs 10 lakh) at 25 per cent (assuming this to be IRR of that project)
whereas cash generated from another project, Y (say of identical sum of Rs 10 lakh) will be

8.30
subject to reinvestment at 18 per cent if this happens to be its value of IRR. There cannot be
anything, perhaps more impractical and illogical than to assume two different rates of
reinvestment in the same firm as if the money has different colours. In what way is cash of Rs 10
lakh from Project X better than that from Project Y? Cash is cash whether it accrues from project
X or Y and in that way from any other project.
Moreover, in the situation of very high value of IRR (say 40 per cent), having project life
of 8 years, it may not always be possible, in practice, to have such profitable projects which can
bring yield of 40 per cent on all intermediate cash flows for the remaining years of project life,
i.e., 7 years (cash inflows at year-end 1, say of Rs. 5 lakh), should have an investment outlet of
having potentials of providing 40 per cent return for 7 years, year-end 2 cash inflows for 6 years,
and so on). In other words, the IRR assumption may lack practical realism. There is no reason to
believe that a firm can find investment opportunities at required value of IRR. In contrast, the
NPV method has the virtue of having single and uniform rate (cost of capital) which can
uniformally and consistently be applied to all new investment proposals. This apart, cost of
capital represents an opportunity cost of funds and thus conforms to the reality. The reinvestment
rate in the NPV method is clearly more realistic and reasonable as it assumes that cash inflows
are reinvested at the same rate as the market cost of capital.
However, the IRR can be modified assuming the cost of capital to be the re-investment
rate. The intermediate cash inflows can be compounded by using the cost of capital. The
compounded sum so arrived at can be used as the basis of determining IRR. This modified
approach again overcomes the limitation of IRR. It may be noted that IRR approach, time and
again, is required to be modified to give results consistent with the NPV which provides correct
answers in the very first instance and therefore is superior to IRR.

Above all, IRR also suffers from computational problems. The calculation of IRR
involves a trial and error approach. In contrast, the calculation of the NPV is relatively simple
and does not pose any special problems.
From the above, it is very apparent that the NPV method is the best evaluation technique
for appraising capital budgeting proposals. Therefore, it is suggested that you should adopt this
method to evaluate proposed investment projects.

8.31
8.32
 Summary of Key points

Capital budgeting decisions relate to the investment proposals pertaining to long-term (fixed)
assets, such as buying of a new machine. Being so, they involve current investment outlays,
followed by a series of anticipated future benefits (over the economic life of the projects).
Such decisions have been appropriately referred to as strategic decisions for manifold
reasons. The major ones are: (i) they require substantial investments; (ii) they are financially
irreversible decisions as they cause substantial losses in the case of their abandonment; (iii)
firm may commit for a sizeable fixed costs; (iv) they have a marked bearing on its
profitability, efficiency and competing positions in the industry.
In broad terms, capital budgeting decisions can be categorized into (i) revenue expanding and
(ii) cost reducing.
The incremental cash outflows, cash inflows after taxes (CFAT) and weighted average cost
of capital (k0) constitute relevant data for evaluating capital budgeting decisions.
The cash flow approach is preferred to the accounting profit approach for appraising capital
budgeting proposals. The major reasons for its superiority are : (i) it avoids the ambiguities of
the accounting profit concept, (ii) it reckons time value of money (the earlier CFAT are
received, the better it is) and (iii) it measures the total benefits over the economic useful life
of the proposal.
Format 8.1 shows the major items of cash outflows.
Format 8.1 : Cash outflows (at time zero period).
Cost of new machine
+ Installation cost
+ Cost of training
+ Working capital requirement (- release of working capital)
- Sale proceeds of existing machine (in the case of replacement decision).

While Format 8.2 shows the major constituents of cash inflows (both operating and
terminating) in the case of revenue expanding investment proposals, the subject matter of
Format 8.3 is concerned with cost reduction investment proposals.

8.33
 Format 8.2: Cash inflows after taxes (revenue expanding proposals)
Years
Particulars
1 2 3 4 … n
Sales revenues
Less cash operating costs
Less depreciation
Earnings before taxes (EBT)
Less taxes
Earnings after taxes (EAT)
Add back depreciation
Cash inflows after taxes (CFAT)
Add salvage value (in nth year)
Add recovery of net working capital (in nth year)

Format 8.3: CFAT (Cost reduction proposals)

Years
Particulars
1 2 3 4 … n
Cash operating costs (old machine)
Less cash operating cost (new machine)
Cash operating savings
Less incremental depreciation due to new machine
Net cost savings / Earnings before taxes
Less taxes
Earnings after taxes (EAT)
Add incremental depreciation (D)
CFAT (EAT + Dep.)
Add salvage value (in nth year)

Format 8.4 outlines procedure of determining the overall cost of capital.

8.34
 Format 8.4 : Determination of overall cost of capital (k0).
Source of fund Cost of specific Amount Total cost
source (%) (Col. 2 × Col.3)
1 2 3 4
Equity share capital
Preference share capital
Long-term loans
(specify each loan separately)
Retained earnings
Notes : k0 = (Total cost / Total amount) x 100
Cost of equity (ke) = Risk free rate of return + Risk premium
Cost of debt (kd) = ki(1 - t), where ki is interest rate; t is tax rate.
Cost of preference shares (kp) = DP /P0 (1-f), where DP is divided payable on preference shares;
P0 (1-f) is sale proceeds obtained from preference shares.
Cost of retained earnings is equal to cost of existing equity. Issue of additional equity capital
causes flotation costs. In that case cost of retained earnings will be marginally lower than that of
equity.

In general, equity is relatively the most costly source of finance. Debt is relatively the
cheaper source of finance as the payment of interest on debt is tax deductible.
The discounted cash flow (DCF) techniques (net present value, internal rate of return, present
value index) are theoretically superior to the traditional techniques (namely, average /
accounting rate of return and pay back method). The reason is the DCF techniques satisfy the
requirements of a theoretically sound method in that they reckon the total benefits as well as
the timing of such benefits.
While Format 8.5 show the computation of traditional techniques, the computation procedure
of the DCF techniques is covered in Format 8.6.

8.35
Format 8.5 : Computation procedure under traditional techniques
Average rate of return (ARR) :
Annual average profits after taxes / Average investments (8.1)
Average investments = Salvage value + Net working capital + 0.5(Initial cost – Salvage value) (8.2)
Pay back method :
In the case of equal CFAT (annuity) = Initial investment / Annual CFAT (8.3)
In the case of mixed stream of CFAT : It is calculated by cumulating CFAT till such time these
cash inflows became equal to the initial cash outflows (8.4)

Format 8.6 : Computation procedure under DCF methods.

Net present value (NPV) method :
Gross present value of CFAT
Less present value of CO
Net present value
Internal rate of return (IRR) method :
In the case of annuity :
(i) the pay back period of the proposed investment proposal is determined;
(ii) the two present value factors which are close to the pay back period are identified
from the present value of annuity (Table A-2);
(iii) from the top row of this table, the interest rates corresponding to these pay back
periods represent the range of IRR;
(iv) by interpolation, the value of IRR can be determined.

In the case of mixed stream of CFAT : (i) The fake annuity of CFAT is determined;
(ii)basedonthe‘fake’annuity,thePB period
is determined;
(iii) as per step (ii) above;
(iv) as per step (iii) above;
(v) in case, the CFAT in the initial years of the project life are higher than the average CFAT
shown as per fake annuity, the IRR is likely to be higher than the one shown as per step (iv) or
vice versa; (vi) a trial-and-error process is to be followed by trying a few per centage lower /
higher as in warranted by the situation.

8.36
Present value index (PI) method :
Present value of CFAT / CO (8.5)
The investment proposal is accepted if NPV is positive (under the NPV method); if IRR is
higher than K0 (as per the IRR method); if PV index exceeds one (in the case of PV index
method).
In the case of independent investment proposals, all the DCF methods provide consistent
results in terms of acceptance or rejection of capital budgeting proposals. However, in the
case of mutually exclusive proposals, they may provide conflicting rankings. In such
situations, the NPV emerges as the best evaluation technique for it is consistent with the
goal of maximisation of shareholders’ wealth. This apart, it has the virtue
required rate of return which can uniformally and consistently be applied to all investment
projects as far as the reinvestment of intermediate CFAT is concerned. The IRR is logically
deficient in both these respects.
However, in practice, the IRR is more popular with executives as experienced by the
author in his interaction with them in the large number of management development
programmes. It needs to pave the way for the NPV as it is theoretically / conceptually far
superior to the IRR. Alternatively, the IRR should be determined on the basis of a modified
approach. The modified approach is based on the more rational premise, that is, the
intermediate CFAT are reinvested at the overall cost of capital and not at the rate of IRR.

8.37
 APPENDIX 8-A
TIME VALUE OF MONEY
The objective of this appendix is to provide you a synoptic profile of time value of
money/mathematics of finance so that you can comprehend DCF methods of capital budgeting
decisions better. For your easy understanding, the subject-matter has been explained with the
help of simple examples/illustrations.
Suppose you are offered a choice to have Rs 1,00,000 today (technically referred to as
time (t) zero period)) or Rs 1,00,000 after one year (year – end 1), which choice will you
exercise? Obviously, you will opt for the first choice of receiving Rs 1,00,000 today. The reason
is very simple; Rs 1,00,000 today will compound to more than Rs 1 lakh after one year on
account of reinvestment opportunity for funds. Let us suppose, that you can deposit this sum of
Rs 1 lakh with commercial bank for one year at 10 per cent rate of interest. Rs 1 lakh sum will
compound to Rs 1,10,000 at the year-end 1 [Rs 1,00,000 (1 + 0.1)].
As a logical corollary of the above follows that there is a time value of money, i.e. a
rupee received today is worth more than a rupee received in future. In other words, value of a
rupee received in future is less than a value of a rupee received today. For this reason, there is a
preference for current receipts to future receipts. Viewed from the business perspective, the
future cash inflows are less valuable than the present cash inflows.
Given 10 per cent as a compound rate of interest, you will be indifferent if the choice is
to receive Rs 1,00,000 (at t = 0) or Rs 1,10,000 at year-end 1 (at t = 1). Let us extend this
example further. You are now given an option to have Rs 1,00,000 at t = 0 or to have Rs
1,20,000 at year-end 2. Are you indifferent between the two options ? No, you will prefer to
receive Rs 1,00,000 today as this sum can be compounded to Rs 1,21,000 at year-end 2 as shown
by Equation 8A.1.
P (1 + i)n = A (8A.1)
Where P is the principal sum invested to day;
i = interest rate;
n = number of years;
Rs. 1,00,000 (1 + 0.1)2 = Rs 1,21,000
Suppose, your option was to provide you Rs 1,25,000 at year-end 2 or Rs 1,00,000 at t =
0. Obviously, you should prefer the option of receiving money at year – end 2 (as Rs 1 lakh will

8.38
compound to Rs 1,21,000 only at year – end 2 @ 10 per cent compound rate of interest as shown
above). In operational terms, the present value (at t = 0) of Rs 1,25,000 received at year – end 2
is more than Rs 1,00,000.
You will be interested in knowing how present value of the future sum is determined. The
process is simple. The present value (PV) is simply the reverse of compounding. Being so, the
equation 8A.1 (p (1 + i)n = A) which is used for compounding the sum can be readily
transformed into a PV formula. Now P is the sum to be determined given other values, value of P
is given by equation 8A.2.
A
P (8A.2)
(1  i) n
where P = Present value of the future sum (say CFAT) to be received
A = Future sum (say CFAT) to be received.
i = Interest rate
n = Number of years.
Accordingly,
Rs 1,25,000 Rs 1,25,000
P   Rs 1,03,305.79
(1  0.1) 2 1.21
In simple terms, the PV (at t = 0) of Rs 1,25,000 (received at year-end 2) is Rs
1,03,305.79. Evidently, it is greater than Rs 1,00,000.
It is important for you to note that the PV is just the reciprocal of compounding value. Let
us illustrate, Re 1 compounds (at the interest rate of 10 per cent to Rs 1.10 at year-end 1, Rs 1.21
at year-end 2, Rs. 1.331 at year-end 3 and so on. The PV of these compounded sums (in terms of
rupee one) is shown in Table 8A-1.

Table 8A-1: Present value of one rupee received in years 1, 2, 3.

Year–end Compounded sum of one rupee Present value of one rupee
1 Rs. 1.10 1/1.10 = Rs 0.909
2 1.21 1/1.21 = 0.826
3 1.331 1/1.31 = 0.751

8.39
 The value Re 0.909 implies that the PV of one rupee received at year-end 1 is Re 0.909
(at t = 0); likewise, the PV of 1 rupee received at year–end 2 and year-end 3 are Re 0.826 and Re
0.751 respectively.
You will be happy to learn that you are not to compute the PV of one rupee (as shown in
the last column of Table 8A-1). The present values (more popularly known as the present value
interest factor, PVIF) are readily available for various ranges of interest rates (i) and time period
(n). Table A-1 (provided at the end of this chapter) contains the PVIF for interest rates (also
known as discount rates) upto 30 per cent for a period upto 50 years.
Since Table A-1 enumerates the PVIF for the various combination of i and n, the PV of
the future sums (CFAT) can be readily determined multiplying future sum with the appropriate
PVIF.
Symbolically
PV = Future sum, A (×) PVIF (8A.3)
There is an immense use of the PVIF (as shown by the present value table A-1) in the
capital budgeting decisions as such decisions involve the current cash outflows in expectations of
future benefits (measured in terms of CFAT) during its useful life. Since, CFAT are available to
the firm in several future years (1, 2, 3, …. n), they certainly cannot
ed asbe add
they have
different values (Rs 1 lakh received at year-end 3 has not the same value as Rs 1 lakh received at
year – end 1). There is a need to determine the PV of all these future cash flows (CFAT) at time
zero period so that the benefits can then be compared with cash outflows (investment outlays)
made at time zero period. Consider Example 8A-1.

Example 8A-1:
A firm is contemplating to buy a machine for Rs 25,00,000; it is expected to generate cash
inflows after taxes (CFAT) in subsequent 5 years as follows :
Year 1 Rs 6,00,000
Year 2 8,00,000
Year 3 11,00,000
Year 4 9,00,000
Year 5 8,00,000

(i) Determine the present value, assume 10 per cent as cost of capital (ii) determine the
NPV.

8.40
 Solution :
Table 8A-2 : Determination of present value and net present value.
Year – end CFAT PVIF at 10 per cent as Total PV
per Table A-1 (CFAT × PVIF)
1 Rs 6,00,000 0.909 Rs 5,45,400
2 8,00,000 0.826 6,60,800
3 11,00,000 0.751 8,26,100
4 9,00,000 0.683 6,14,700
5 8,00,000 0.621 4,96,800
(i) Total present value (GPV) 31,43,800
Less cost of machine/cash outflows 25,00,000
(ii) Net present value (NPV) 6,43,800

Will the GPV / NPV decrease / increase if the cost of capital is higher than 10 per cent
(say 12 per cent) ? Obviously, it will decrease. It is obvious that the higher interest/discount rate
will obviously cause the lower PV. It is very apparent from the perusal of equation 8A.2; the
discount rate is denominator; higher is the denominator, lower is the PV. As a result the PVIFs
(at 12 per cent) are lower than the PVIFs (at 10 per cent) as shown in Table 8A-3.

Table 8A-3 : PVIF at 12 per cent and 10 per cent (for t = 1 – 5 years)
Year–end 1 2 3 4 5
PVIF (at 0.12) 0.893 0.797 0.797 0.636 0.567
PVIF (at 0.10) 0.909 0.826 0.751 0.683 0.621

You will be convinced that higher is the interest rate/discount rate/cost of capital, lower is
the PVIF. Likewise, cash inflows received in more distant years will have the lower PVIF than
the cash inflows received relatively in earlier years (due to reinvestment opportunity of existing
funds). This is very apparent from the various PVIFs contained in Table 8A-3. For these simple
common-sense based reasons, the PVIFs shown in Table A-1 (present value of Re 1) are in
decreasing order both row-wise and column-wise.

8.41
 In the case of equal cash inflows (known as annuity) to be received in future, the
determination of PV/NPV becomes a very simple exercise. Consider Example 8.A-2.
Example 8A-2
A company is contemplating to invest Rs 25 lakh in buying a new machine. It is expected
to provide CFAT of Rs 8 lakh per year for next 5 years. Assuming cost of capital of 13%,
determine the NPV.
Table 8A-4: NPV at 13 per cent cost of capital/discount rate
Year – end CFAT PVIF at 0.13 Total PV
1 Rs 8,00,000 0.885 Rs 7,08,000
2 8,00,000 0.783 6,26,400
3 8,00,000 0.693 5,54,400
4 8,00,000 0.613 4,90,400
5 8,00,000 0.543 4,34,400
Gross present value (GPV) 3.517 28,13,600
Less cash outflows 25,00,000
Net present value (NPV) 3,13,600

Table 8A-4 contains the long way of determining the PV of annuity cash flows. There is
a potential of reducing calculations to a marked extent; Rs 8,00,000 is a common factor; each
time PVIF is to be multiplied by the uniform sum of Rs 8 lakh. Instead of this exercise of
multiplication repeated each time (5 times in Table 8.4); only one multiplication exercise can be
adequate enough to provide PV of annuity of Rs 8 lakh (for a period of 5 years). The following
paragraph provides explanation for the same.
The sum of PVIFs at 0.13 for 5 years is 3.517. It implies that one rupee received at the
end of each of next 5 years will have PV of 3.517. Therefore, total present value of Rs 8 lakh
received at the end of each year for next 5 years will be Rs 28,13,600 (Rs 8 lakh x 3.517 PVIF of
annuity of Re 1 for 5 years at 0.13). The answer is the same.
Again, it will be gratifying for you to know that ready-made calculations are available in
Table A-2 in this regard (present value of annuity of Re 1, given at the end of this chapter). This
table presents the sum of the present values of an annuity (PVIFA) for the wide range of interest
rate, i (from 1 per cent to 30 per cent) and the number of years, n (from year 1 to 50). In view of

8.42
the function PVIFA serves, it can also be referred to as annuity discount factor (ADF); let us
interpret 3.517 in the sense of ADF. It implies the discounted value (present value) of one rupee
received at the end of each year for the next 5 years is Rs 3.517.
Since, such calculations are readily available in Table A-2 (please find on your own ADF
of Re 1 for 5 years at 13% from Table A-2; it will be 3.517), the NPV of future annuity CFAT
can be more easily computed. Let us determine PV/NPV of Example 8A-2 as per Table A-2.

Table 8A-5 : Determination of NPV (s per annuity table).

Year-end CFAT PVIF at 0.13 Total PV
1-5 Rs 8,00,000 3.517 Rs 28,13,600
Less cash outflows 25,00,000
Net present value (NPV) 3,13,600
Note: Annuity table can be used only when cash inflows are uniform in all the years.

Apart from the capital budgeting decisions, there are other important business
applications of the present value tables. Let us discuss the major ones with the help of examples.

Example 8A-3 (Determination of equated annual instalment of loan repayment)

A corporate firm borrows from a financial institution Rs 200 lakh at 13 per cent rate of
interest to be paid in 6 equal year-end instalments. Determine the amount of instalment.

Solution:
The problem relates to loan amortisation. From Table A-2 (PV of annuity), we find that PV of
one rupee received each year for next 6 years at 13 per cent rate of interest is 3.998 (please try to
search this value on your own).
In the present context, the value of 3.998 is to be interpreted differently, i.e., if the firm
borrows Rs. 3.998 today (at t = 0), it is required to repay Re 1 each year for the next 6 years. This
interpretation provides better comprehension and helps us to determine equated instalment. Let
us make use of simple mathematics.
If the sum borrowed today is Rs 3.998, the instalment required to be paid is Re 1.
Therefore, if the sum borrowed is Re 1, the instalment required will be Rs 1/3.998.

8.43
 Hence, if the sum borrowed is Rs 200 lakh, the instalment required will be (Rs 1/3.998 x
Rs 200 lakh) = Rs. 50,02,501.25.

Having understood the procedure, equated instalment can be computed as per equation
8.4 for any combination of i and n.

Amount borrowed (8A.4)

PVIFAi, n

Example 8A-4 (Determination of lease rent)

A leasing company is contemplating to buy a machine at Rs 25 lakh to be leased
out. The machine can be leased out for its economic useful 1ife of 5 years. The leasing company
wants to earn 20 per cent return. Determine the lease amount, assuming lease amounts are
payable at the end of each year for the next 5 years.

Solution:
The problem relates to the determination of lease rent. Table A-2 will again be found
useful in this context also. This table provides PVIFA for 5 years at 20 per cent is 2.991. In
operational terms, it implies that if the leasing company is to invest Rs 2.991 today, it will
require lease rent of Re 1 to be received in each of next 5 years. Therefore, to recover Rs 25 lakh
investment, the lease rent will obviously be (Rs 25 lakh/ 2.991) i.e., Rs 8,35,840.86.
This is as per equation 8A.4
Amount to be invested

PVIFA (at 20 per cent for 5 years)
Rs 25,00,000
  Rs 8,35,840.86
2.991

8.44
Example 8A-5 (Determination of PV of future cash inflows)
A business executive is on the verge of retirement. He has been offered two options by
his employer (a) Rs 22,00,000 lump sum, (b) Rs 3,60,000 per year for next 12 years. Assuming
11 per cent compound rate of interest, which is a better option for the business executive ?

Solution:
Business executive will go for the option in which he has higher present value. In option
one, he gets Rs 22,00,000 (at time zero period itself). In option two, he will determine the PV of
annuity cash inflows of Rs 3,60,000 (each year) to be received for a period of next 12 years at 11
per cent rate of interest. It will be :
Rs 3,60,000 Annuity x PVIFA at 11% for 12 years
= Rs 3,60,000 x 6.492 (Table A-2) = Rs. 23,37,120
Since the PV of annuity cash inflows is higher, the executive is advised to go for option
two.

Example 8A-6 (Determination of one time deposit to receive a specified sum in future
years)
A retired person desires to have Rs, 1,20,000 each year for next 10 years. How much
sum he should deposit now with bank which promises 10 per cent compound rate of interest to
receive Rs 1,20,000 ?

Solution:
You can find out from Table A-2 that the PV of Re 1 received for next 10 years at 10 per
cent rate of interest is 6.145. It implies, that the commercial bank requires deposit of Rs 6.145 in
order to enable the bank to pay Re 1 each year for next 10 years. Hence to pay Rs 1,20,000 each
year, amount required will be :
Rs 1,20,000 x 6.145 = Rs 7,37,400.
A retired person should deposit Rs 7,37,400 today to receive annual sum of Rs 1,20,000
for next 10 years.

8.45
 Example 8A-7 (Whether to buy debenture at the market price or not)
A debenture (with face value of Rs 100) has 4 more years to run for maturity. The
company pays rate of interest of 10 per cent on debenture. The current rate of interest on similar
debentures in the market is 11 per cent. Will you advise the investor to buy this debenture if it is
available in the market at Rs 95 ?

Solution:
The problem, in a way is similar to the capital budgeting decision. Should investor invest
Rs 95 at time zero period to have future cash streams of Rs 10 (for 3 years) and Rs 110 (at 4 th
year-end), given 11 per cent as his cost of funds ? For the purpose, net present value of cash
stream is to be determined.

Table 8A-6: Net present value of investment in debenture

Year CFAT PVIF at 0.11 Total PV
1–3 Rs 10 2.444 (Table A-2) Rs 24.44
4 110 0.659 (Table A-1) 72.49
Total present value 96.93
Less investment / cash outflows 95.00
Net present value (NPV) 1.93

Since NPV is positive, the investor is advised to buy debenture at the prevailing market
price of Rs 95.

8.46
 OBJECTIVE TYPE QUESTIONS

8.1 Indicate whether the following statements are true or false :

(i) Capital budgeting decisions are primarily based on estimated revenues and costs.
(ii) Internal rate of return (IRR) is the best method of evaluating long-term investment
proposals.
(iii) In general, debt is more costly than equity as a source of finance.
(iv) Retained earnings do not carry any cost.
(v) In the case of independent investment proposals, both net present value (NPV) and IRR
provide the same acceptance and rejection decision.
(vi) Reinvestment rate of intermediate cash inflows is assumed to be the same for all the
investment proposals under IRR method.
(vii) More distant are cash inflows, less is their present value to the business firm.
(viii) Annuity tables can always be used to determine present value of future cash inflows.
(ix) Higher is the cost of capital (discount rate), higher is the present value of cash flows.
(x) Pay back method is similar to the DCF methods.

(Answers : (i) True, (ii) False, (iii) False, (iv) True, (v) True, (vi) False, (vii) True, (viii) False,
(ix) False, (x) False.)

8.2 Fill in the blanks with right choice.

(i) _________________________ is the best method of evaluating long-term investment
proposals. (internal rate of return / NPV / Pay back).
(ii) Cost of capital is ___________________ (interest rate / cost of equity / neither of the
two).
(iii) ____________________ indicates the number of years required to recover initial
investment (pay back method / Net-present value method).
(iv) In actual business world, cash inflows accruing in different years from a capital
budgeting proposals are normally _____________________ (equal / unequal).
(v) Capital expenditure items normally are of __________________(larger / smaller) sums
as compared to revenue expense items.

Answers : (i) NPV, (ii) Neither of the two, (iii) pay back, (iv) unequal, (v) larger.

8.47
8.48
 EXERCISES

8.1 Why are capital budgeting decisions so important ?

8.2 Is depreciation included in the computation of CFAT ?
8.3 Why is it important to evaluate replacement proposals based on incremental after-tax
cash inflows ?
8.4 For capital budgeting decisions, only cash costs are relevant. Then, why depreciation
which is a non-cash cost forms an important part of analysis ? How do you explain this
paradox ?
8.5 Under what circumstances, the NPV and IRR methods may lead to (a) comparable
recommendations and (b) give conflicting ranking ? In the latter situation, which method
should be used and why ?
8.6 What is the terminal cash flow ? Name its constituents.

NUMERICAL EXERCISES

8.7 Avon Limited is considering two mutually exclusive proposals, A and B.

Proposal A requires the initial investment in terms of purchase of a new machine of Rs. 7,00,000
with no salvage value; the proposed investment requires an additional investment of Rs 3,00,000
in working capital (to support additional production / sales) over its life. The project is expected
to generate additional sales revenue of Rs. 6,00,000 and is estimated to require additional cash
expenses of Rs. 2,00,000 in each of its 5-year life. The machine will be depreciated on straight-
line method and it is assumed that the same is accepted for tax purposes.
Proposal B requires machine costing Rs. 8,00,000 (with salvage value of Rs. 1,00,000 at
the end of its economic useful life of 5 years). It is estimated that the firm will require additional
working capital of Rs. 2,00,000 to support operations from this machine. The machine is subject
to straight-line method of depreciation. The earnings before depreciation and taxes during its 5-
year life are estimated as follows :

8.49
 Year 1 Rs. 3,50,000
2 4,00,000
3 4,50,000
4 5,00,000
5 4,00,000
The corporate tax rate is 35 per cent; its cost of capital is 12 per cent.
Your are required to calculate pay back period, internal rate of return and net present
value of both the projects. Which project will you advise the company should opt for and why?

8.8 A company is considering buying a machine. The machine is expected to execute

operations which are presently done by manual methods (having annual labour costs of Rs.
2,50,000). The machine is estimated to cost Rs. 5,00,000 with an annual operating costs of Rs.
50,000. Assume that the machine can be written off in 5 years on straight-line basis for tax
purposes. Salvage value at the end of its economic life is zero. Corporate tax rate is 35 per cent
and the required rate of return for such proposals is 15 per cent. Advise the company whether it
should replace its manual operations.

8.9 Supreme Industries Ltd. is considering the replacement of one of its moulding machines.
This machine has the current book value of Rs 1,00,000. A review of its conditions reveals that it
can be used for an additional 5 years. This machine can currently be sold for Rs 40,000, net of
removal costs. However, it will have no salvage value after 5 years.
The new machine will cost Rs 3,00,000 and will be depreciated on a straight-line basis
during its anticipated economic useful life of 5 years and the same is accepted for tax purposes; it
is expected to have no salvage value at the end of 5th year.
The management anticipates that with the expanded operations, there will be requirement
of additional working capital of Rs 50,000. Due to expanded current operations, sales revenues
are to increase by Rs 1,20,000; variable costs by Rs 30,000 and total cash fixed cost by Rs
10,000. The corporate tax rate is 35 per cent and its cost of capital is 14 per cent.
Should the firm replace its existing machine? Assume that the loss on sale of existing
machine can be claimed as short-term capital loss in the current year itself.
8.10 Royal Industries is investigating the feasibility of manufacturing one of the components
hitherto purchased from an outside supplier at Rs 60 per unit.

8.50
 The machine needed to make this component can be purchased for Rs 6,00,000 and is
expected to have no salvage value at the end of its 6 year economic useful life. To support the
additional level of activity, there will be need of additional working capital of Rs 1,00,000.
Additional cash fixed costs are estimated to increase by Rs 60,000 per year; the estimated
variable cost is Rs 20 per unit. The company is subject to a 35 per cent tax rate and 15 per cent is
its cost of capital. The machine is subject to straight-line method of depreciation and the same is
accepted for tax purposes.
Advise the company whether it should manufacture the component on its own or buy it
from the outside, assuming that it requires 10,000 components per year for next 6 years.

Solution to Numerical Exercises

8.7 Determination of cash outflows (at t = 0) of Proposals A and B

Particulars Proposal A Proposal B

Cost of new machine Rs 7,00,000 Rs 8,00,000
Working capital 3,00,000 2,00,000
Total cash outflows 10,00,000 10,00,000

(ii) Determination of cash inflows after taxes (CFAT)

(a) Proposal A:
Incremental sales revenue Rs.6,00,000
Less cash expenses 2,00,000
Less depreciation (Rs. 7,00,000/5 years) 1,40,000
Earnings before taxes 2,60,000
Less taxes (at the rate of 35%) 91,000
Earnings after taxes (EAT) 1,69,000
Add depreciation 1,40,000
Cash inflows after taxes (t = 1 - 4 years) 3,09,000
CFAT in 5th year: CFAT in 4th year (operating) Rs 3,09,000
Add recovery of working capital 3,00,000 6,09,000

8.51
(b) Proposal B:
Year EBDT* Depreciation EBT** Taxes EAT CFAT
(EAT + Dep.)
1 2 3 4 5 6 7
1 Rs 3,50,000 Rs 1,40,000@ Rs 2,10,000 Rs 73,500 Rs 1,36,500 Rs 2,76,500
2 4,00,000 1,40,000 2,60,000 91,000 1,69,000 3,09,000
3 4,50,000 1,40,000 3,10,000 1,08,500 2,01,500 3,41,500
4 5,00,000 1,40,000 3,60,000 1,26,000 2,34,000 3,74,000
5 4,00,000 1,40,000 2,60,000 91,000 1,69,000 3,09,000
5 Recovery of working capital (Rs 2,00,000) + Salvage value (Rs 1,00,000) 3,00,000
* EBDT = Earnings before depreciation and taxes
** EBT = Earnings before taxes
@ = (Rs. 8,00,000 Cost of machine –Rs. 1,00,000 Salvage value)/ 5 Years

(iii) Determination of pay back period (proposals A and B)

Year Proposal A Proposal B
CFAT Cumulative CFAT CFAT Cumulative CFAT
1 Rs.3,09,000 Rs. 3,09,000 Rs. 2,76,500 Rs. 2,76,500
2 3,09,000 6,18,000 3,09,000 5,85,500
3 3,09,000 9,27,000 3,41,500 9,27,000
4 3,09,000 12,36,000 3,74,000 13,01,000
5 6,09,000 Not required* 6,09,000 Not required*
* Only Rs 10,00,000 is required to be recovered.
Proposal A: The pay back period is 3 years plus a fraction of 4th year. The fraction value will be
equal to 0.236 i.e. (Rs. 73,000/Rs.3,09,000)= The pay back period is 3.236 years.
Proposal B: The pay back period is 3 years plus a fraction of 4th year. The fraction value will be
equal to 0.195 i.e. (Rs. 73,000/ Rs.3,74,000). The pay back period is 3.195 years.

8.52
 (iv) Determination of net present value (Proposals A and B)
Year CFAT PVIF at 12 Total present value
per cent
Proposal A Proposal B Proposal A Proposal B
1 Rs. 3.09,000 Rs.2,76,500 0.893 Rs. 2,75,937 Rs 2,46,915
2 3,09,000 3,09,000 0.797 2,46,273 2,46,273
3 3,09,000 3,41,500 0.712 2,20,008 2,43,148
4 3,09,000 3,74,000 0.636 1,96,524 2,37,864
5 6,09,000 6,09,000 0.567 3,45,303 3,45,303
Gross present value 12,84,045 13,19,503
Less cash outflows 10,00,000 10,00,000
Net present value 2,84,045 3,19,503

(v) Determination of internal rate of return (proposals A and B)

Proposal A:
Average CFAT= (Rs. 18,45,000/ 5 years)= Rs. 3,69,000 (fake annuity)
Fake PB period = (Rs. 10,00,000/Rs. 3,69,000)= 2.710
Factors closest to take PB period (as per Table A-2) corresponding to 5 years (life of the
proposal) are 2.745 (at 24 per cent) and 2.689 (at 25 per cent). Since the actual cash flow stream
is substantially lower than average CFAT, the lower discount rates of 22 and 21 per cent are tried
to determine IRR.

PV of CFAT at 22 and 21 per cent discount rates

Year CFAT PVIF at (%) Total PV at (%)
22 21 22 21
1-4 Rs. 3,09,000 2.494 2.540(Table A-2) Rs. 7,70,646 Rs. 7,84,860
5 6,09,000 0.370 0.386 (Table A-1) 2,16,195 2,35,074
Total present value 9,86,841 10,19,934

8.53
 IRR is 21% + (Rs. 19,934/Rs. 33,093 i.e., Rs. 10,19,934 - Rs. 9,86,841)= 21.6% app.
Proposal B
Average CFAT/fake annuity = (Rs. 19,10,000/5years)= Rs. 3,82,000 Fake PB period = (Rs.
10,00,000/Rs. 3,82,000)= 2.6178
Factors closest to the fake PB period (as per Table A-2) corresponding to 5 years (life of
the proposal) are 2.635 (at 26%) and 2.583 (At 25%). Since actual cash flow stream is
substantially lower than the average CFAT, the lower discount rates of 23 and 22 are tried to
determine IRR. PV of CFAT at 23 and 22 per cent discount rates
PV of CFAT at 23 and 22 per cent discount rates
Year CFAT PVIF at (%) Total PV at (%)
23 22 23 22
1 Rs. 2,76,500 0.813 0.820 Rs.2,24,795 Rs.2,26,730
2 3,09,000 0.661 0.672 2,04,249 2,07,648
3 3,41,500 0.537 0.551 1,83,386 1,88,167
4 3,74,000 0.437 0.451 1,63,438 1,68,674
5 6,09,000 0.355 0.370 2,16,195 2,25,330
Total present value 9,92,063 10,16,549

IRR is 22% + (Rs. 16,549/ Rs. 24,486) = 22.68%

The company is advised to go for proposal B as it has higher net present value.

8.8 Financial analysis whether to buy a new machine (using NPV method)
(i) Cash outflows:
Cost of new machine Rs. 5,00,000
(ii) Determination of CFAT:
Existing labour cost 2,50,000
Less costs with new machine:
Operating costs Rs. 50,000
Depreciation (Rs.5,00,000/ 5 years) 1,00,000 1,50,000
Savings in costs/Earnings before taxes 1,00,000
Less taxes (35%) 35,000
Earnings after taxes 65,000
Add depreciation 1,00,000
CFAT 1,65,000

8.54
 (iii) Determination of NPV
Years CFAT PVIFA at 15% Total PV
1-5 Rs. 1,65,000 3.352 Rs. 5,53,080
Less cash outflows 5,00,000
Net present value 53,080
Recommendation: The company is advised to replace its manual operations.

8.9 Financial Analysis whether to replace the existing machine, using NPV method
(i) Incremental Cash outflows:
Cost of new machine Rs 3,00,000
Add additional working capital required 50,000
Less sale value of existing machine (40,000)
Less tax advantage on loss of machine:
Current book value Rs 1,00,000
Sale value 40,000
Loss 60,000
Tax advantage (Rs 60,000 × 0.35) (21,000)
Net cash outflows 2,89,000

(ii) Incremental cash inflows after taxes (CFAT)

Particulars Amount
Incremental sales revenue Rs 1,20,000
Less incremental costs:
Variable costs Rs 30,000
Fixed costs 10,000
Depreciation
New machine (Rs 3,00,000/5 years) Rs 60,000
Existing machine (Rs 1,00,000/5 years) 20,000 40,000 80,000
Earnings before taxes 40,000
Less taxes (0.35) 14,000
Earnings after taxes 26,000
Add back incremental depreciation 40,000
CFAT (t = 1 – 4) 66,000
CFAT (t = 5th year) Rs 66,000 + Rs 50,000 working capital recovered 1,16,000

8.55
 (iii) Determination of net present value
Year CFAT PVIFA (at 0.14) Total PV
1–4 Rs 66,000 2.914 (Table A-2) Rs 1,92,324
5 1,16,000 0.519 (Table A-1) 60,204
Total present value 2,52,528
Less cash outflows 2,89,000
Net present value (NPV) (36,472)

(iv) Recommendation: Since NPV is negative, the company is advised not to replace the
existing machine.

8.10 Financial analysis whether to make the components or continue to buy from outside;
(using NPV method)
(i) Cash outflows
Cost of machine Rs 6,00,000
Add working capital required 1,00,000
7,00,000
(ii) Determination of cash inflows after taxes
Particulars Amount
Buy costs (10,000 components × Rs 60) Rs 6,00,000
Less manufacturing costs:
Variable costs (10,000 components × Rs 20) Rs 2,00,000
Fixed costs 60,000
Depreciation (Rs 6,00,000/6 years) 1,00,000 3,60,000
Cost savings/Earnings before taxes 2,40,000
Less taxes (0.35) 84,000
Earnings after taxes 1,56,000
Add depreciation 1,00,000
CFAT (t = 1 – 5) 2,56,000
CFAT (t = 6)
CFAT (operating) Rs 2,56,000

8.56
 Add release of working capital 1,00,000 3,56,000
(iii) Determination of net present value (NPV)
Year CFAT PVIF at (0.15) Total PV
1–5 Rs 2,56,000 3.352 (Table A-2) Rs 8,58,112
6 3,56,000 0.432 (Table A-1) 1,53,792
Total present value 10,11,904
Less cash outflows 7,00,000
Net present value 3,11,904

(iv) Recommendation: The company is advised to start manufacturing the components on its
own, as NPV is positive.

8.57
8.58
Table A-1 : The Present Value of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.789 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.227 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
21 0.811 0.660 0.538 0.439 0.359 0.294 0.242 0.199 0.164 0.135
22 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123
23 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112
24 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057
35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022
45 0.639 0.410 0.264 0.171 0.111 0.073 0.048 0.031 0.021 0.014
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009

8.59
Table A-1: The Present Value of One Rupee (Contd.)
Year 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
21 0.112 0.093 0.077 0.064 0.053 0.044 0.037 0.031 0.026 0.022
22 0.101 0.083 0.068 0.056 0.046 0.038 0.032 0.026 0.022 0.018
23 0.091 0.074 0.060 0.049 0.040 0.033 0.027 0.022 0.018 0.015
24 0.082 0.066 0.053 0.043 0.035 0.028 0.023 0.019 0.015 0.013
25 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010
30 0.044 0.033 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.004
35 0.026 0.019 0.014 0.010 0.008 0.006 0.004 0.003 0.002 0.002
40 0.015 0.011 0.008 0.005 0.004 0.003 0.002 0.001 0.001 0.001
45 0.009 0.006 0.004 0.003 0.002 0.001 0.001 0.001 0.000 0.000
50 0.005 0.003 0.002 0.001 0.001 0.001 0.000 0.000 0.000 0.000

8.60
Table A-1 The Present Value of One Rupee (contd.)
Year 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 0.826 0.820 0.813 0.806 0.800 0.794 0.787 0.781 0.775 0.769
2 0.683 0.672 0.661 0.650 0.640 0.630 0.620 0.610 0.601 0.592
3 0.564 0.551 0.537 0.524 0.512 0.500 0.488 0.477 0.466 0.455
4 0.467 0.451 0.437 0.423 0.410 0.397 0.384 0.373 0.361 0.350
5 0.386 0.370 0.355 0.341 0.328 0.315 0.303 0.291 0.280 0.269
6 0.319 0.303 0.289 0.275 0.262 0.250 0.238 0.227 0.217 0.207
7 0.263 0.249 0.235 0.222 0.210 0.198 0.188 0.178 0.168 0.159
8 0.218 0.204 0.191 0.179 0.168 0.157 0.148 0.139 0.130 0.123
9 0.180 0.167 0.155 0.144 0.134 0.125 0.116 0.108 0.101 0.094
10 0.149 0.137 0.126 0.116 0.107 0.099 0.092 0.085 0.078 0.073
11 0.123 0.112 0.103 0.094 0.086 0.079 0.072 0.066 0.061 0.056
12 0.102 0.092 0.083 0.076 0.069 0.062 0.057 0.052 0.047 0.043
13 0.084 0.075 0.068 0.061 0.055 0.050 0.045 0.040 0.037 0.033
14 0.069 0.062 0.055 0.049 0.044 0.039 0.035 0.032 0.028 0.025
15 0.057 0.051 0.045 0.040 0.035 0.031 0.028 0.025 0.022 0.020
16 0.047 0.042 0.036 0.032 0.028 0.025 0.022 0.019 0.017 0.015
17 0.039 0.034 0.030 0.026 0.023 0.020 0.017 0.015 0.013 0.012
18 0.032 0.028 0.024 0.021 0.018 0.016 0.014 0.012 0.010 0.009
19 0.027 0.023 0.020 0.017 0.014 0.012 0.011 0.009 0.008 0.007
20 0.022 0.019 0.016 0.014 0.012 0.010 0.008 0.007 0.006 0.005
21 0.018 0.015 0.013 0.011 0.009 0.008 0.007 0.006 0.005 0.004
22 0.015 0.013 0.011 0.009 0.007 0.006 0.005 0.004 0.004 0.003
23 0.012 0.010 0.009 0.007 0.006 0.005 0.004 0.003 0.003 0.002
24 0.010 0.008 0.007 0.006 0.005 0.004 0.003 0.003 0.002 0.002
25 0.009 0.007 0.006 0.005 0.004 0.003 0.003 0.002 0.002 0.001
30 0.003 0.003 0.002 0.002 0.001 0.001 0.001 0.001 0.000 0.000
35 0.001 0.001 0.001 0.001 0.000 0.000 0.000 0.000 0.000 0.000
40 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
45 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
50 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

8.61
Table A-2 : The Present Value of an Annuity of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 6.728 7.326 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.746 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.560 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.352 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649
22 19.661 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883
24 21.244 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985
25 22.023 19.524 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.397 19.601 17.292 15.373 13.765 12.409 11.258 10.274 9.427
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644
40 32.835 27.356 23.115 19.793 17.159 15.046 12.332 11.925 10.757 9.779
45 36.095 29.490 24.519 20.720 17.774 15.456 13.606 12.108 10.881 9.863
50 39.197 31.424 25.730 21.482 18.256 15.762 13.801 12.234 10.962 9.915

8.62
Table A-2: The Present Value of an Annuity of One Rupee (Contd.)
Year 11% 12% 13% 14% 15% 16% 17% 18% 9%1 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.850 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.487 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 5.303 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.669 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.585 5.316 5.070 4.843
20 7.963 7.469 7.024 6.623 6.259 5.929 5.628 5.353 5.101 4.870
21 8.075 7.562 7.102 6.687 6.312 5.973 5.665 5.384 5.127 4.891
22 8.176 7.645 7.170 6.743 6.359 6.011 5.696 5.410 5.149 4.909
23 8.266 7.718 7.230 6.792 6.399 6.044 6.723 5.432 5.167 4.925
24 8.348 7.784 7.283 6.835 6.434 6.073 5.747 5.451 5.182 4.937
25 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
30 8.694 8.055 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979
35 8.855 8.176 7.586 7.070 6.617 6.215 5.858 5.539 5.251 4.992
40 8.951 8.244 7.634 7.105 6.642 6.233 5.871 5.548 5.258 4.997
45 9.008 8.283 7.661 7.123 6.654 6.242 5.877 5.552 5.261 4.999
50 9.042 8.305 7.675 7.133 6.661 6.246 5.880 5.554 5.262 4.999

8.63
Year 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 0.826 0.820 0.813 0.806 0.800 0.794 0.787 0.781 0.775 0.769
2 1.509 1.492 1.474 1.457 1.440 1.424 1.407 1.392 1.376 1.361
3 2.074 2.042 2.011 1.981 1.952 1.923 1.896 1.868 1.842 1.816
4 2.540 2.494 2.448 2.404 2.362 2.320 2.280 2.241 2.203 2.166
5 2.926 2.864 2.803 2.745 2.689 2.635 2.583 2.532 2.483 2.436
6 3.245 3.167 3.092 3.020 2.951 2.885 2.821 2.759 2.700 2.643
7 3.508 3.416 3.327 3.242 3.161 3.083 3.009 2.937 2.868 2.802
8 3.726 3.619 3.518 3.421 3.329 3.241 3.156 3.076 2.999 2.925
9 3.905 3.786 3.673 3.566 3.463 3.366 3.273 3.184 3.100 3.019
10 4.054 3.923 3.799 3.682 3.570 3.465 3.364 3.269 3.178 3.092
11 4.177 4.035 4.902 3.776 3.656 3.544 3.437 3.335 3.239 3.147
12 4.278 4.127 3.985 3.851 3.752 3.606 3.493 3.387 3.286 3.190
13 4.362 4.203 4.053 3.912 3.780 3.656 3.538 3.427 3.322 3.223
14 4.432 4.265 4.108 3.962 3.824 3.695 3.573 3.459 3.351 3.249
15 4.489 4.315 4.153 4.001 3.859 3.726 3.601 3.483 3.373 3.268
16 4.536 4.357 4.189 4.033 3.887 3.751 3.623 3.503 3.390 3.283
17 4.576 4.391 4.219 4.059 3.910 3.771 3.640 3.518 3.403 3.295
18 4.608 4.419 4.243 4.080 3.928 3.786 3.654 3.529 3.413 3.304
19 4.635 4.442 4.263 4.097 3.942 3.799 3.664 3.539 3.421 3.311
20 4.657 4.460 4.279 4.110 3.954 3.808 3.673 3.546 3.427 3.316
21 4.675 4.476 4.292 4.121 3.963 3.816 3.679 3.551 3.432 3.320
22 4.690 4.488 4.302 4.130 3.970 3.822 3.684 3.556 3.436 3.323
23 4.703 4.499 4.311 4.137 3.976 3.827 3.689 3.559 3.438 3.325
24 4.713 4.507 4.318 4.143 3.981 3.831 3.692 3.562 3.441 3.327
25 4.721 4.514 4.323 4.147 3.985 3.834 3.694 3.564 3.442 3.329
30 4.746 4.534 4.339 4.160 3.995 3.842 3.701 3.569 3.447 3.332
35 4.756 4.541 4.345 4.164 3.998 3.845 3.703 3.571 3.448 3.333
40 4.760 4.544 4.347 4.166 3.999 3.846 3.703 3.571 3.448 3.333
45 4.761 4.545 4.347 4.166 4.000 3.846 3.704 3.571 3.448 3.333
50 4.762 4.545 4.348 4.167 4.000 3.846 3.704 3.571 3.448 3.333

8.64