Investment Decisions, Project Planning

and Control/Capital Budgeting

❑ Introduction;

❑ Initial cash outflows;

❑ Annual cash inflows;

❑ Terminal cash inflows;

❑ Replacement Decision;

❑ Incremental Initial cash outflows;

❑ Incremental Annual cash inflows;

❑ Incremental Terminal cash inflows;

❑ Practice Questions;
❑ Introduction;

❑ Net present value method;

❑ Profitability Index or Benefit Cost Ratio method;

❑ Payback period method;

❑ Payback Reciprocal;

❑ Payback Profitability;

❑ Discounted payback period method;

❑ Internal rate of return method;

❑ Modified Internal rate of return;

❑ Modified NPV;

❑ Average or Accounting rate of return method;

❑ Adjusted Present value;

 INVESTMENT DECISION (CASH FLOWS)

INTRODUCTION
Investment decision is a function of financial manager to achieve the objective of profit maximization and wealth
maximization.

Here investment decision means long term investment decision.

There are various methods of taking investment decision, but while taking investment decision the financial manager
estimates the three types of cash flows related to the potential investment:
(1) How much initial cash outflows will be?
(2) how much annual cash inflows will be?
(3) How much terminal cash inflows will be?
 INITIAL CASH OUTFLOWS (YEAR 0)

It indicates the cash outflows without which production cannot be started;

Particulars `
Purchase cost of machine/Plant/Equipment X
+ Installation cost X
+ Working capital introduced X
- Subsidy received X
Initial cash outflows xx
 INVESTMENT DECISION (CASH FLOWS)
INITIAL CASH OUTFLOWS

Q. A firm is considering purchasing a new machine which will cost ` 1, 20,000. The cost of installation
will amount to ` 25,000. The working capital requirements will be ` 15,000. Calculate initial cash
outflows.

Ans: 1,60,000;
 Ans: INITIAL CASH OUTFLOWS (YEAR 0)

Particulars `
Purchase cost of machine/Plant/Equipment 1,20,000
+ Installation cost 25,000
+ Working capital introduced 15,000
Initial cash outflows 1,60,000
 ANNUAL CASH INFLOWS (YEARS 1 - 10)
Particulars `
Sales X
- Variable cost X
- Fixed cost excluding depreciation X
Earnings before depreciation and tax (EBDT) X
- Depreciation X
EBT X
- Tax X
EAT X
+ Depreciation X
Annual cash inflows xx
 INVESTMENT DECISION (CASH FLOWS)
ANNUAL CASH INFLOWS
Q. ABC Ltd is evaluating the purchase of a new project with a cost of ` 1,00,000; expected economic
life of 4 years and earnings before taxes and depreciation of ` 45,000 in year 1, ` 30,000 in year 2, `
25,000 in year 3 and ` 35,000 in year 4.
Assume straight-line depreciation and a 20% tax rate. You are required to compute annual cash
inflows.
Ans: 41,000. 29,000. 25,000. 33,000.
 Ans: ANNUAL CASH INFLOWS (YEARS 1 - 4)
Particulars 1 2 3 4
Earnings before depreciation 45,000 30,000 25,000 35,000
and tax (EBDT)
- Depreciation 25,000 25,000 25,000 25,000

EBT 20,000 5,000 0 10,000

- Tax (20%) 4,000 1,000 0 2,000
EAT 16,000 4,000 0 8,000
+ Depreciation 25,000 25,000 25,000 25,000
Annual cash inflows 41,000 29,000 25,000 33,000
 TERMINAL YEAR CASH INFLOWS (YEAR 10)

It indicates the additional cash inflows to be generated in last year of the project, which are
not generated each year.
Particulars `
Scrap value of asset X
+ Working capital released (Assumed) X
Terminal year cash inflows xx
 INVESTMENT DECISION (CASH FLOWS)
TERMINAL CASH INFLOWS
Q. From the following information finds out initial, subsequent annual and terminal cash flows:
Cost of machine ` 5,25,000
Salvage value ` 30,000
Installation cost ` 5,000
Life 5 years
Expected annual sales 10,000 units
Sale price per unit ` 40
Variable cost per unit ` 16
Tax rate 50%
Ans: initial cash outflows = 5, 30,000; annual cash inflows = 1, 70,000; terminal year cash inflows =
30,000;
 Ans: INITIAL CASH OUTFLOWS (YEAR 0)

Particulars `
Purchase cost of machine/Plant/Equipment 5,25,000
+ Installation cost 5,000
Initial cash outflows 5,30,000
 ANNUAL CASH INFLOWS (YEARS 1 - 5)
Particulars `
Sales 4,00,000
- Variable cost 1,60,000
Earnings before depreciation and tax (EBDT) 2,40,000
- Depreciation 1,00,000

EBT 1,40,000
- Tax (50%) 70,000
EAT 70,000
+ Depreciation 1,00,000
Annual cash inflows 1,70,000
 TERMINAL YEAR CASH INFLOWS (YEAR 5)

Particulars `
Scrap value of asset 30,000
Terminal year cash inflows 30,000
1. When organization is already using a machine and wants to remove it by installing a new
machine, this decision is known as replacement decision.
2. In replacement decision, all cash flows are calculated on incremental basis.
 Incremental Initial cash outflows (Year 0)
Particulars `
Purchase cost of new machine X
+ Increase in Working capital X
+ Installation cost X
- Subsidy received X
- Sale value of old machine X
+ tax paid on capital gain on sale of old machine X
- Tax saving on capital loss on sale of old machine X
Xx
Note: If question specify that capital gain or capital loss is not subject to tax, then tax paid on
capital gain or tax saving on capital loss should be ignored.
Q. SARAWAGI & CO. is considering a proposal to replace one of its plants costing ` 60,000
and having a written down value of ` 24,000. The remaining economic life of the plant is 4
years after which it will have no salvage value. However, if sold today, it has a salvage value
of ` 20,000. The new machine costing ` 1, 30,000 are also expected to have a life of 4 years
with a scrap value of ` 18,000. Find out the incremental initial cash outflows flows (Relevant
cash outflows) associated with this decision given that the tax rate applicable to the firm is
40%.
 Incremental Annual cash inflows (Year 1-5)
Particulars `
Increase in sales X
- Increase in variable cost X
- Increase in fixed cost excluding depreciation X
+ saving in cost X
Cash flows before tax (EBDT) Xx
- Increase in Depreciation X
EBT Xx
- Tax X
EAT Xx
+ Increase in Depreciation X
Incremental Annual cash inflows xx
Q. P. ltd. has a machine having an additional life of 5 years which costs ` 2, 00,000 and has a
book value of ` 80,000. A new machine costing ` 4, 00,000 is available. Though its capacity is
the same as that of the old machine, it will mean a saving in variable cost to the extent of `
1, 40,000 per annum. The life of the machine will be 5 years at the end of which it will have
a scrap value of ` 40,000. The rate of income tax is 46%. The old machine, if sold today, will
realize ` 20,000; it will have no salvage value if sold at the end of 5th year. Calculate
incremental annual cash inflows (Relevant cash inflows).
 Incremental Terminal year cash inflows (Year 5)
Particulars `
Increase in Working capital released X
+ Incremental scrap value X
xx
Q. A chemical company is considering replacing an existing machine with one costing
`65,000. The existing machine was originally purchased two years ago for `28,000 and is
being depreciated by the straight-line method over its seven-year life period. It can
currently be sold for `30,000 with no removal costs. The new machine would cost `10,000 to
install and would be depreciate over five years. The management believes that the new
machine would have a salvage value of `5,000 at the end of year 5. The management also
estimates an increase in net working capital requirement of `10,000 as a result of expanded
operations with the new machine. The firm is taxed at a rate of 50%. The company’s
expected after-tax profits for next 5 years with existing machine and with new machine are
given as follows:
Expected after-tax profits
Year With existing machine (`) With new machine (`)
1 2,00,000 2,16,000
2 1,50,000 1,50,000
3 1,80,000 2,00,000
4 2,10,000 2,40,000
5 2,20,000 2,30,000

Calculate all Relevant cash flows.

PAYBACK PROFITABILITY
MODIFIED NPV
▪ Inflows and outflows should be compared, when all
values are at Present values.
NPV Present value of cash inflows – Initial cash outflows

Selection criteria:
NPV Decision
+ Accepted
- Rejected
0 Indifference

▪ If there are two or more alternatives, then the option

with higher NPV should be selected.

▪ If no method of investment decision is given in

question then NPV should be used.
 Present value of cash inflows
Year Cash inflows PVIF@R Present value (PV)
1 X X Xx
2 X X Xx
3 X X Xx
4 X X Xx
5 X + X = XX X Xx
Total Present value of cash inflows Xxx
PVIF = Present value interest factor

PVIF = 1/(1+𝒌)𝒏

K = Cost of capital rate

𝒏 = Number of periods
R = Rate of interest or cost of capital rate or discount rate or hurdle rate or target rate of return
or WACC or Opportunity cost or Minimum required rate of return or cut-off rate
Q. Z ltd. has two projects under consideration A & B, each costing ` 60 lacs. The projects are mutually
exclusive. Life for project A is 4 years & Project B is 3 years. Salvage value Nil for both the projects.
Tax rate 33.99%. cost of capital is 15%.
Cash flows before tax
(` lacs)
At the end of the year Project A Project B P.V. @ 15%
1 60 100 .870
2 110 130 .756
3 120 50 .685
4 50 - .572
Calculate NPV of both the projects.
▪ It is also known as Present value Index (PVI) or Desirability factor or Cost-benefit ratio.
PI Present value of cash inflows
----------------------------------------
Initial cash outflows

PI Decision
More than 1 Accept
Less than 1 Reject
1 Indifference
If there are various options, then the option with highest PI should be selected.
Q. Initial investment ` 20 lacs. Expected annual cash flows ` 6 lacs for 10 years. Cost of capital @ 15%.
Calculate Profitability Index.
▪ This method does not consider the concept of Time value of money.

▪ In this method no discounting is used.

▪ In this method PVF are irrelevant.

▪ It indicates the period in which the initial cash outflows are recovered back in the form of
cash inflows.
 Situation I When cash inflows of each year is equal
Payback period Initial cash outflows
----------------------------
Annual cash inflows

Payback period Decision

Less than life Accept
More than life Reject
Equal to life Indifference
If there are various options, then the option with lowest payback period should be selected.
Q. Rama ltd is considering two mutually exclusive machines to meet the rapidly rising demand for its
product. The cash flows after taxes under the two alternatives are as follows:

Year 0 1-5 (` In lakhs)

Machine A -25 10
Machine B -40 14
Calculate payback period for both the machines and advise the company which machine should be bought.
Specify the reason also for your advice.
 Situation II When cash inflows of each year is not equal
Statement of cumulative cash inflows
Year Cash inflows Cumulative cash inflows
1
2
3
4
Q. ABHISHEK limited is evaluating a proposal to install a new machine costing ` 50,000 with a life of 5
years and no salvage value. Following cash flows before depreciation and taxes have been calculated:
1 2 3 4 5
Cash flows 10,000 12000 13000 15000 20000
The firm provides depreciation as per straight line method and is subjected to tax at 40%. Find out the
Payback period.
Statement of cumulative present value of cash inflows
Year Present value of Cash inflows Cumulative PV of cash inflows
1
2
3
4
Decision criteria will be same as in payback period.
Q. A product is currently manufactured on a machine that is not fully depreciated for tax purposes and
has a book value of ` 70,000. It was purchased for ` 2,10,000 twenty years ago. The cost of the
product are as follows:
Unit cost
Direct costs 28
Indirect labour 14
Other variable overheads 10.50
Fixed overheads 17.50
70
10,000 units are normally produced. It is expected that the old machine can be used, indefinitely into
the future, after suitable repairs, estimated to cost ` 75,000 annually, are carried out.
A manufacture of machinery is offering a new machine with the latest technology at ` 4, 20,000 before
trading off the old plant for ` 1,05,000. The projected cost of the product (per unit) will then be:

Direct costs 14
Indirect labour 21
Other variable overheads 7
Fixed overheads 22.75
64.75
The fixed overheads are allocation from other departments plus the depreciation of plant and machinery.
The old machine can be sold for ` 50,000 in the open market. The new machine is expected to last for
10 years at the end of which, its salvage value will be ` 20,000. Rate of corporate tax is 50%. For tax
purposes, the cost of new machine and that of the old one may be depreciated in 10 years. The minimum
rate of return expected is 10%.
It is also anticipated that in future the demand for the products will stay at 10,000 units. The present
value of an annuity of ` 1 for 9 years @ 10% discount factors = 5.759. The present value of ` 1 received
at the end of 10th year @ 10% discount factor is = 0.386.

(1) Advise whether the new machine can be purchased (NPV Method).
(2) Calculate Discounted payback period.
▪ This method consider the concept of Time value of money.

▪ In this method discounting is used.

▪ In this method PVF are relevant.

▪ It indicates the available rate of return from the project.

 Situation I When cash inflows of each year is equal
Step: 1
PVIFA @ IRR Initial cash outflows
----------------------------
Annual cash inflows

Step: 2
IRR PVIFA @ Low rate – PVIFA @ IRR
Low rate + ---------------------------------------------------- x Difference in rates
PVIFA @ Low rate – PVIFA @ High rate
Decision criteria: IRR > Cost of capital rate = Accept
IRR < Cost of capital rate = Reject
If there are various proposals, then the proposal with higher IRR should be selected.
Q. Complex ltd. an infrastructure company is evaluating a proposal to build, operate and transfer a
section of 20 kms. road at a project cost of ` 400 crores to be financed as follows:
Equity share capital ` 100 crores, loans at the rate of interest of 15% p.a. from financial institutions `
300 crores. The project after completion will be opened to traffic and a toll will be collected for a period
of 15 years from the vehicles using the road. The company is also required to maintain the road during
the above 15 years and after the completion of that period, it will be handed over to the highway
authorities at zero value. It is estimated that the toll revenue will be ` 100 crores per annum and the
annual toll collection expenses including maintenance of the roads will amount to 5% of the project cost.
The company considers to write off the total cost of the project in 15 years on a straight-line basis. For
corporate income-tax purposes the company is allowed to take depreciation @ 10% on WDV basis. The
financial institutions are agreeable for the repayment of the loan in 15 equal annual instalments –
consisting of principal and interest.
Calculate Project IRR and equity IRR. Ignore corporate taxation.
 Situation II When cash inflows of each year is not equal
The cost of capital rate at which NPV will be equal to Zero, this rate is known as IRR.
Step: 1. Assume a discount rate.
Fake payback period/Fake PVIFA @ IRR Initial cash outflows
--------------------------------------
Average Annual cash inflows
Average annual cash inflows Total cash inflows
-------------------------
Life
This fake PVIFA @ IRR should be find out in PVIFA table.
Step: 2. Calculate NPV @ this assumed discount rate.
Step: 3. Assume another discount rate.
If NPV in step 2 is positive = Higher rate
If NPV in step 2 is positive = Lower rate
Step: 4. calculate NPV @ this another assumed discount rate.
Step: 5. When we have one positive and one negative NPV then:
IRR NPV @ Low rate – NPV @ IRR
Low rate + ---------------------------------------------------- x Difference in rates
NPV @ Low rate – NPV @ High rate
Q. Calculate the Internal rate of return.

Project cost 1,10,000

Cash inflows:
Year 1 60,000
Year 2 20,000
Year 3 10,000
Year 4 50,000
In this method, it is assumed that cash inflows of each year are
reinvested at cost of capital rate.

Year Cash inflows FVIF @ K Future value

1 X Xx Xx
2 X Xx Xx
3 X Xx Xx
4 X Xx Xx
5 X Xx Xx
Future value Xxx
FV = Present value x (1+MIRR)𝒏

FVIF = (1+MIRR)𝒏

FVIF should be find out in FVIF table to calculate MIRR.

Q. An investment of ` 1, 36,000 yields the following cash inflows (profits before depreciation but after
tax). Determine MIRR considering 8% as cost of capital.
Year `
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1. It is also known as Accounting rate of return or annual rate of return or rate of return on
original investment.
2. It is a part of non-discounting technique.
3. There is no relevancy of PVIF.
4. It ignores the time value of money concept.
5. This method is based on EAT instead of cash flows.
 X 100

Average EAT Total EAT

------------
Life
Average investment Initial cash outflows + Scrap value
----------------------------------------------
2
Note: If question requires rate of return on original investment, then 1st formula should be
used. In other cases any formula may be used.
Q. A ltd. is considering the purchase of a machine which will perform some operations which are at
present performed by workers. Machines X and Y are alternative models. The following details are
available:
Machine X (`) Machine Y (`)
Cost of machine 1,50,000 2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance p.a. 7,000 11,000
Estimated cost of indirect material p.a. 6,000 8,000
Estimated savings in scrap p.a. 10,000 15,000
Estimated cost of supervision p.a. 12,000 16,000
Estimated savings in wages p.a. 90,000 1,20,000
Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the alternatives
according to:
(1) average rate of return method, and
(2) Present value index method assuming cost of capital being 10%.
(The present value of ` 1.00 @ 10% p.a. for 5 years is 3.79 and for 6 years is 4.354).
 PAYBACK RECIPROCAL
1. It is the reciprocal of payback period, i.e. 1 ÷ Payback period
2. Payback Reciprocal = Average annual CFAT p.a./Initial Investment
3. Higher the payback reciprocal, better is the project.
4. The payback reciprocal is considered to be an approximation of the IRR if:
A. The life of the project is at least twice the payback period and
B. The project generates equal amount of the annual cash inflows.
Q. A project with an initial investment of ` 50 lakh and life of 10 years, generates CFAT of ` 10 lakh
per annum. Calculate Payback reciprocal.
 PAYBACK PROFITABILTY
As the profitability beyond the payback period is not taken into consideration in payback
period method, the projects with higher payback period are rejected though such projects
with longer life may generate higher profits after recovering its initial investment.
In payback profitability method, the profitability beyond the payback period is considered and
projects generating higher benefits after the recovery of initial investment are considered for
selection.
Payback profitability = Total net cash inflows after taxes – Initial investment
Q. A project with an initial investment of ` 50 lakh and life of 10 years, generates CFAT of ` 10 lakh
per annum. Calculate Payback reciprocal.
Modified
In this method, it is assumed that cash inflows of each year are
reinvested at different rate than cost of capital rate.
NPV Year Cash inflows FVIF @ re- Future value
investment rate
1 X Xx Xx
2 X Xx Xx
3 X Xx Xx
4 X Xx Xx
5 X Xx Xx
Future value Xxx
Modified PV of CI = Future value ÷ (1+𝐂𝐨𝐬𝐭 𝐨𝐟 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐫𝐚𝐭𝐞)𝒏

Modified NPV = Modified PV of CI – ICO

Q. Calculate Modified NPV.
Project I Project II
` `
Investment 2,20,000 2,20,000
Year 1 62,000 1,42,000
Year 2 80,000 80,000
Year 3 1,00,000 82,000
Year 4 1,40,000 40,000
Cost of capital rate is 10% and re-investment rate may be considered as 14%.
ADJUSTED
NPV
Step – 1 Calculate Base case NPV.

Base Case NPV is the NPV under the assumption that the project is all
equity financed.

Base case NPV = PV of CI – ICO

Step – 2 Adjusted NPV = Base case NPV – Issue cost + PV of tax saving
on interest
Q. A firm is considering a project requiring ` 50 lakh of investment. Expected cash flow is ` 10 lakh per
annum for 8 years. The rate of return required by the equity investors from the project is 15%. The
firm is able to raise ` 24 lakh of debt finance carrying 14% interest for the project. The debt is
repayable in instalment over the eight-year period. The tax rate is 40%. The cost of equity issue is 5%.
Calculate Adjusted NPV.
 Equal annual cash outflows
1. Two or more machines.
2. Life of machines will be unequal.
3. Cash outflows are given.
4. Cash inflows are not given.
 Statement of Equal annual cash outflows/Equal annual cost
Particulars Machine A Machine B
Purchase cost of machine Xx Xx
+ Present value of running cost Xx Xx
Total present value of cash Xxx Xxx
outflows
÷
PVIFA @ K for life
EAC Xx Xx
The option with lower EAC should be selected.
Q. Cost of Machine I - ` 75,000, life – 5 years, annual operating cost ` 12,000
Cost of Machine II - ` 50,000, life – 3 years, annual operating cost ` 20,000
Cost of capital 12%
Advise which machine should be selected on the basis of Equal annual cost (EAC).
 Equal annual NPV
1. Two or more machines.
2. Life of machines will be unequal.
3. Cash outflows are given.
4. Cash inflows are also given.
EANPV NPV
---------------
PVIFA @ K
The option with higher EANPV should be selected.
Q. Calculate Equal Annual Benefit (EAB) from the following data:
P Q
Investment (`) 50,00,000 50,00,000
Cash inflows (`)
Year 1 75,00,000 20,00,000
Year 2 20,00,000
Year 3 70,00,000
K = 12%;
❑ When organization has limited
funds and there are various
projects for investment, in such
situation the organization has
to select the projects, which
will generate maximum NPV.
❑ Project may be accepted in ❑ Project may not be accepted in
part; part;
 Capital rationing in case of divisible projects
Step: 1. Calculate NPV of all the projects.
Step: 2. Eliminate the project which has negative NPV.
Step: 3. Prepare a statement of Ranking as follows:
Projects NPV ICO Ratio of NPV to ICO Ranking
A X X X 1
B X X X 2
C X X X 3
Step: 4. Allotment of funds on the basis of Ranking:
A = xx
B = xx
C = xx
Step: 5. Calculate total NPV.
 Capital rationing in case of Indivisible projects
Step: 1. Calculate NPV of all the projects.
Step: 2. Eliminate the project which has negative NPV.
Step: 3. Check the maximum number of projects that can be taken up with
amount available for investment.
Step: 4. Write NPV in decreasing order with the project name.
NPV in decreasing order Project
X X
X X
X X
Step: 5. Prepare a statement of combination of projects.
Combination ICO Availability Feasibility NPV
Xxx Xx Xx Yes/No xx
The first combination with feasibility Yes should be selected.
Q. X ltd. has a capital budget of ` 1.5 crore for the year. From the following information relating to six
independent proposals, select the projects if (i) the projects are divisible and (ii) the projects are
indivisible.
Proposal Investments (`) NPV (`)
A 70,00,000 30,00,000
B 25,00,000 16,00,000
C 50,00,000 20,00,000
D 20,00,000 10,00,000
E 55,00,000 45,00,000
F 75,00,000 - 25,00,000