Unit- V

Problems and Solutions on Capital Budgeting

Cash inflows: Cash inflows mean receipt of Cash or flow of cash into the organisation. Cash Inflows are
also known as Profits after taxes but before depreciation.
Calculation of Cash Inflows:
Particulars Amount in Rs.
Profits Before Depreciation and Taxes Xxxxxx
Less: Depreciation Xxxx
-------
Profits after Depreciation Xxxxxx
Less: Income-tax (Normally in Xxxxx
Percentage) Xxxxxxx
Profits after Depreciation and Income- Xxxx
tax Xxxxxx
Add: Depreciation ------------
Cash Inflows
Cash Inflows are two types:
1) Annuity Cash Inflows: If Cash inflows are even every year they are called Annuity Cash Inflows.
2) Mixed Stream: If Cash Inflows are Unequal in every year such Cash Inflows are called Mixed
Stream Cash Inflows
Problem: 1
A machine costs Rs.1,00,000. And has no scrap value. It is depreciated on straight line basis. Find out Cash
Inflows when the rate of Income Tax is 50%. Life of the asset is 5 years
Year 1 2 3 4 5
Profits 80,0000 60,000 1,00,000 40,000 40,000
Before
Depreciation
and Income-
tax (Rs.)

Solution:
Profits after
depreciation
Profits before Profits after
Depreciation Income-tax and income-
Year depreciation and Depreciation CIF(Rs.)
(Rs.) (@50%) tax (Rs.)/
income- tax (Rs.) (Rs.)
Accounting
profit
1 80,000 20,000 60,000 30,000 30,000 50,000
2 60,000 20,000 40,000 20,000 20,000 40,000
3 1,00,000 20,000 80,000 40,000 40,000 60,000
4 40,000 20,000 20,000 10,000 10,000 30,000
5 40,000 20,000 20,000 10,000 10,000 30,000
Depreciation= (Cost of Investment + Installation Charges – Scrap Value) / Life of the asset
Rs.1,00,000 + 0 + 0)/ 5 Years = Rs.1,00,000/ 5 Years = Rs.20,000
Cash Inflow = Accounting Profit + Depreciation
Accounting Profit = CIF- Depreciation
 A) Traditional Methods
i) Pay Back Period Method
ii) ii) Accounting/Average Rate of Return Method.
When Cash Inflows are Annuity:

Problem: 2
A project Requires an initial outlay (Cost of Asset) of Rs.20,000 with a useful life of 5 years. The projected
cash inflows for 5 years are as follows. Calculate a) Pay Back period. b) ARR
Year 1 2 3 4 5
CIF(Rs.) 8,000 8,000 8,000 8,000 8,000
Solution:
a) The Cash inflows are Annuity. Hence the Pay-back period is calculated as follows:
Pay Back Period (PBP) = Cash outlay ÷ Annual cash inflow
= Rs.20,000 ÷ Rs.8,000= 2.5years
b) Calculation of Accounting Rate of Return/ Average Rate of Return (A R R)
Note: For calculating Accounting profit/ Profit after depreciation and income tax is required. It is
calculated as follows:
Accounting Profit= CIF- Depreciation
Calculation of depreciation:
Depreciation= (Cost of the asset + Installation Charges – Scrap )÷ Life of the asset
= Rs.20,000÷ 5years= Rs.4,000
Therefore, Accounting profits in each year = Rs.8,000-Rs.4,000= Rs.4,000
ARR= (Average profits after taxes÷ Average investment) × 100
Average profits after taxes= total accounting profits÷ no of years
Here average Pat are Rs.4,000 as they are in annuity
Average Investment= (Investment-Scrap value) ÷ 2
={ (Rs.20,000-Rs.0) ÷ 2} * 100 = Rs.10,000
= (Rs.4,000÷ Rs.10,000) × 100= 40%
(OR) Alternatively ARR can also be calculated as follows:
ARR= Average Pat÷ (Original investment) × 100
= (Rs.4,000÷ Rs.20,000) × 100= 20%

Problem:3
A machine costs Rs.60,000 with an economic life of 6 years. The annual cash inflows are expected to be
Rs.25,000 for 6 years. The machine has no scrap value and is depreciated under straight line method.
Calculate a) PBP b) ARR.
Solution:
a) The Cash inflows are Annuity. Hence the Payback period is calculated as follows:
Pay Back Period= Cash outlay÷ Annual cash inflow
= Rs.60,000 ÷ Rs.25,000= 2.4years
b) Calculation of Accounting Rate of Return:
Note: For calculating Accounting profit/ Profit after Depreciation and Income Tax is required. It is
calculated as follows:
Accounting Profit= CIF- Depreciation
Calculation of depreciation:
Depreciation= Cost of the asset÷ Life of the asset
= Rs.60,000÷ 6years= Rs.10,000
Therefore, Accounting profits in each year = Rs.25,000-Rs.10,000= Rs.15,000
ARR= (Average profits after taxes÷ Average investment) × 100
Average profits after taxes= total accounting profits÷ no of years
Here average Pat are Rs.15,000 as they are in annuity
Average Investment= (Investment-Scrap value) ÷ 2
= (Rs.60,000-Rs.0) ÷ 2= Rs.30,000
= (Rs.15,000÷ Rs.30,000) × 100= 50%
(OR) Alternatively ARR can also be calculated as follows
ARR= Average Pat÷ (Original investment) × 100=
= (Rs.15,000÷ Rs.60,000) × 100= 25%
i) Pay Back Period Method
ii) Accounting/Average Rate of Return Method.
When Cash Inflows are Mixed Stream:

Problem: 4
A project requires an initial investment of Rs.20,000 with useful life of 5 years. The projected
Cash inflows are as follows: Find out a) PBP b) ARR
Year 1 2 3 4 5
CIF(Rs.) 6,000 8,000 6,000 5,000 7,000
Solution:
a) Calculation of Pay Back Period: To calculate Pay-back period Cumulative Cash inflows are
required. THEY ARE CALCULATED AS FOLLOWS:

Year 1 2 3 4 5
CIF(Rs.) 6,000 8,000 6,000 5,000 7,000
Cumulative CIF(Rs.) 6,000 14,000 20,000 25,000 32,000

Pay Back period is calculated as follows:

It has taken 3 years to completely recover the initial investment. Hence Pay Back period is 3 Years.
b) Calculation ARR:
To calculate ARR Account Profits are Required.
Account profits= CIF-Depreciation
It is Calculated as follows:
Depreciation= {(Cost of the asset+ Installation Charges)- scrap value} ÷ Life of Asset
= Rs.20,000÷ 5 Years= Rs.4,000

Year 1 2 3 4 5 Total
CIF (Rs.) 6,000 8,000 6,000 5,000 7,000 32,000

Depreciation
4,000 4,000 4,000 4,000 4,000 20,000
(Rs.)

Profits after
Depreciation and 2,000 4,000 2,000 1,000 3,000 12,000
Taxes (Rs.)

ARR= (Average profits after taxes÷ Average investment) × 100

Average Profits after Taxes= Total Profits after taxes÷ No. of years
= Rs.12,000÷ 5 Years= Rs.2,400
Average Investment= (Investment-Scrap value) ÷ 2
= Rs.20,000÷ 2= Rs.10,000
ARR= Rs.2,400÷ Rs.10,000) × 100= 24%
Problem: 5
A project requires an initial investment of Rs.20,000 with a useful life of 5 years. The projected cash
inflows are as follows. Calculate PBP
Year 1 2 3 4 5
CIF(Rs.) 7,000 9,000 8,000 6,000 10,000
Calculation of Payback period:
Year 1 2 3 4 5
CIF(Rs.) 7,000 9,000 8,000 6,000 10,000
Cumulative 7,000 16,000 24,000 30,000 40,000
CIF(Rs.)
Pay Back period= 2nd Year +{(Rs.20,000- Rs.16000)} ÷ Rs.8,000 = 2.5 Years
Problem: 6
A machine costs Rs.1,00,000. And has no scrap value. It is depreciated on straight line basis. Find out
Payback period and ARR when the rate of Depreciation is 20%
Year 1 2 3 4 5
CIF(Rs.) 50,000 40,000 60,000 30,000 30,000

Solution:
a) Calculation of Payback period:
Year 1 2 3 4 5
CIF(Rs.) 50,000 40,000 60,000 30,000 30,000
Cumulative CIF(Rs.) 50,000 90,000 1,50,000 1,80,000 2,10,000

2 Years+ {(Rs.1,00,000- Rs.90,000)} ÷ Rs.60,000

= 2 Years+( Rs.10,000÷ Rs.60,000)
= 2.17 Years
b) Calculation of ARR:
For Calculating ARR Accounting Profits are required.
They are calculated as follows:
Year 1 2 3 4 5 Total
CIF(Rs.) 50,000 40,000 60,000 30,000 30,000 2,10,000

Depreciation(Rs.) 20,000 20,000 20,000 20,000 20,000 1,00,000

Profits after
Depreciation and
30,000 20,000 40,000 10,000 10,000 1,10,000
Taxes (Rs.) (CIF-
Dep.)
ARR= (Average profits after taxes÷ Average investment) × 100
Average Profits after taxes= Rs.1,10,000÷ 5 Years= Rs.22,000
Average Investment= Rs1,00,000÷ 2= Rs.50,000
ARR= (Rs.22,000÷ Rs50,000)× 100= 44% (Or) (Rs.22,000÷ Rs.1,00,000)× 100= 22%
B) Discounted Cashflow Methods
Discounted Cashflow methods include 1) Net Present Value Method (NPV), 2) Profitability Index
Method(PI), and 3) Internal Rate of Return Method(IRR).
a) Cash inflows are Annuity:
Problem: 7
A limited company is considering an investment in a project requiring a capital outlay of Rs.2,00,000. The
projected cash inflows are as follows.
Calculate a) NPV and b) PI taking cost of capital as 10%
Year 1 2 3 4 5
CIF(Rs.) 60,000 60,000 60,000 60,000 60,000
Solution:
Note: T
he cash inflows are annuity. Hence Present value of CIF is to be found out by using Annuity Table.
a) NPV= Total PV of CIF- Total PV of COF
= (Rs.60,000× 3.791)- (Rs.2,00,000× 1.00)
= Rs.2,27,460- Rs.2,00,000= Rs.27,460.
b) Profitability index= Total OV of CIF---- Total PV of COF(Investment)
= Rs.2,27,460÷ Rs.2,00,000= 1.14 Times
Problem: 8
A project requires an initial investment of Rs.1,00,000 at a cost of capital of 20%. The annual CIFs
generated by the project during its economic life of 5 years are Rs.30,000 each. Calculate IRR.
Solution:
Cash inflows are annuity. IRR is to be calculated through trial and error method.
1) CIF(Rs.) 2) Cost 3) PV 4) PV of
of Factor CIF(Rs.)(1×3)
Capital
30,000 20% 2.991 89,730
30,000 15% 3.352 1,00,560
30,000 16% 3.274 98,220
Considering PV of CIF at 15%(rl) and 16% (rh) IRR may be calculated as follows:
IRR= r1+ {(PV of CIF @rl – PV of COF) ÷ (PV of CIF @rl- PV of CIF @rh) × (rh-rl)}
IRR= 15%+ {(1,00,560-1,00,000) ÷ (1,00,560-98,220) × (16%-15%)}
IRR= 15%+ {560÷ 2,340× 1}
IRR= 15%+ 0.239
= 15.239% (or) 15.24%
Problem: 9
A limited company is considering Investment In a project requiring a capital outlay of Rs.2,00,000. The
projected annual cash inflows are as follows.
Year 1 2 3 4 5
CIF(Rs.) 50,000 60,000 70,000 60,000 50,000
Calculate a) NPV b) PI taking cost of capital as 10%.
Solution:
Year CIF(Rs.) PV factor PV of CIF
@10% @10%
1 50,000 0.909 45,450
2 60,000 0.826 49,560
3 70,000 0.751 52,570
4 60,000 0.683 40980
5 50,000 0.621 31,050
Total 2,19,610

Net Present value= PV of CIF- PV of COF

Rs.2,19,610- Rs.2,00,000
= Rs.19,610
Profitability Index= Total PV of CIF÷ Total PV of COF
= Rs.2,19,610÷ Rs.2,00,000 = 1.09 times
Problem: 10
Calculate NPV taking cost of capital as 10%.
Year COF(Rs.) CIF(Rs.)
0 1,00,000 --
1 20,000 30,000
2 40,000
3 50,000
4 40,000
5 30,000
5(Scrap) 10,000
Solution:
Year CIF(Rs.) PV factor PV of CIF
@10% @10%
1 30,000 0.909 27,270
2 40,000 0.826 33,040
3 50,000 0.751 37,550
4 40,000 0.683 27,320
5 30,000 0.621 18,630
6 10,000 0.621 6,210
Total 1,50,020
Less: PV of
COF 1,18,180
1st year
1,00,000
+20,000×.909) 31,840
18,180 ----------

Net Present
Value
Profitability Index= Total PV of CIF÷ Total PV of COF
= Rs.1,50,020 ÷ Rs.1,18,180
= 1.26 times
Problem: 11
Determine IRR from the following data when the initial investment is Rs.2,50,000
Year 1 2 3 4 5 6
CIF(Rs.) 40,000 60,000 75,000 85,000 70,000 50,000
Solution:
Year CIF(Rs.) PV PV of PV PV of
factor CIF factor CIF
@10% @10% @15% @15%
1 40,000 0.909 36,360 0.869 34,760
2 60,000 0.826 49,560 0.756 45,360
3 75,000 0.751 56,325 0.657 49,275
4 85,000 0.683 58,055 0.572 48,620
5 70,000 0.621 43,470 0.497 34,790
6 50,000 0.564 28,200 0.432 21,600
Total 2,71’970 2,34,405
Less:
PV of 2,50,000 2,50,000
COF 21,970 -15,595
----------
----

IRR= rl+ {NPV f CIF@ rl÷ (NPV of CIF @ rl-NPV of CIF @rh} × rh-rl
IRR= 10%+ {21,970÷ (21,970- (-)15,595)} × 15%-10%
IRR= 10%+ {21,970÷ (21,970+ 15,595)} × 5%
IRR= 10%+ 2.92%= 12.92%