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FM Unit 4 Investment Decision Problems

Financial Management - 5th sem - B.Com - Bangalore University

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Lavin Bhawnani
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260 views5 pages

FM Unit 4 Investment Decision Problems

Financial Management - 5th sem - B.Com - Bangalore University

Uploaded by

Lavin Bhawnani
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Unit 4 : INVESTMENT DECISION

Methods of Appraisal of Capital Budgeting

OR

Methods of Investment Evaluation

A. Traditional Methods
i) Pay Back Period (PBP)
ii) Post Pay Back Period (Post PBP)
iii) Accounting Rate of Return (ARR)

B. Modern Methods or Discounted Cash Flow Methods


i) Net Present Value Method (NPV)
ii) Profitability Index Method
iii) Internal Rate of Return (IRR)

SIX MARKS PROBLEMS

Method – 1. Pay Back Period Method

Formula :

Payback Period = Original Investment of the Project


Annual Cash Flow of the Project

PBP = No. of years before recovery of initial investment + Amount to be recovered


Total Cash Flow during Payback Year

Solution :
Calculation of PBP for Machine Easy

YEAR CIF (CASH IN FLOW) CCF


(CUMULATIVE
CASH FLOW)
1 30,000 30,000
2 40,000 70,000 (40,000 + 30,000)
3 60,000 1,30,000 (60,000+70,000)
4 70,000 2,00,000
5 50,000 2,50,000

Initial investment 2,00,000

Less: 4th year 2,00,000

Balance Nil
4 + 0 = 4 years
Hence, Payback Period for Machine Easy is 4 years

Calculation for Machine Quick

YEAR CIF (CASH IN FLOW) CCF


(CUMULATIVE
CASH FLOW)
1 40,000 40000
2 50,000 90,000
3 60,000 1,50,000
4 60,000 2,10,000
5 50,000 2,60,000

PBP = No. of years before recovery of initial investment + Amount to be recovered


Total Cash Flow during Payback Year

PBP = 3 + 50,000
60,000

PBP = 3 + 0.8

PBP = 3.8 years

Hence, Payback Period for Machine Quick is 3.8 years

Conclusion : Machine Quick should be selected for purchase as it has lowest Pay Back Period.
2.

Solution:

Calculation of PBP for Machine A

YEAR CIF (CASH IN FLOW) CCF


(CUMULATIVE
CASH FLOW)
1 1,80,000 1,80,000
2 2,40,000 4,20,000
3 3,00,000 7,20,000
4 1,80,000 9,00,000
5 1,20,000 10,20,000

PBP = No. of years before recovery of initial investment + Amount to be recovered


Cash Flow during Payback Year

PBP = 2 + 1,80,000
3,00,000

PBP = 2 + 0.60

PBP = 2.60 years

Hence, Payback Period for Machine A is 2.60 years


Calculation of PBP for Machine A

YEAR CIF (CASH IN FLOW) CCF


(CUMULATIVE
CASH FLOW)
1 2,60,000 2,60,000
2 1,80,000 4,40,000
3 2,40,000 6,80,000
4 3,60,000 10,40,000
5 2,40,000 12,80,000

PBP = No. of years before recovery of initial investment + Amount to be recovered


Cash Flow during Payback Year

PBP = 2 + 1,60,000
2,40,000

PBP = 2 + 0.6

PBP = 2.67 years

Hence, Payback Period for Machine B is 2.67 years

Type 2 – Post Pay Back Period

1. From the following data of Rajiv & Co. for Machine A & B each costing Rs.50,000 each. Find the
Post payback profitability. Advise which machine is more suitable for investment.
Year Cash Flows
A B
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000

Solution:
Machine A

Total Cash Flow of Machine A during life = 85,000

Less: Initial Investment = 50,000

----------------------------------------------------------------------

Post Payback Profitability = 35,000


Machine B

Total Cash Flow of Machine A during life = 90,000

Less: Initial Investment = 50,000

----------------------------------------------------------------------

Post Payback Profitability = 40,000

Conclusion : Machine B is more suitable for investment because its Post Payback
Profitability is higher.

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