MODULE 04

Value Analysis and value Engineering: Cost Value, Exchange Value, Use Value, Esteem
Value - Aims, Advantages and Application areas of Value Engineering - Value Engineering
Procedure

Capital Budgeting: Time value of money - Net Present Value Method - Benefit Cost Ratio –
Internal Rate of Return -– Payback – Accounting Rate of Return.

VALUE ANALYSIS (VA)

A systematic approach to reduce cost of an existing product or service without affecting its
quality, performance, reliability, or appearance.

Focus: Eliminate unnecessary cost.

Also known as: Value Assurance, Value Management.

Key Features of VA:

• Cost reduction without quality loss – maintains function and efficiency.
• Applied to existing products/services – after production or launch.
• Team-oriented process – experts from design, marketing, production, etc.
• Systematic approach – identify function → analyze cost → find alternatives → evaluate
→ implement.
• Function-based thinking – focus on what the product does (function), not how it looks.

Example: A pen’s function = “to write,” not “to look fancy.” So, VA would focus on cheaper ways to
make it write well without fancy materials.

Uses of VA:
• Reduce product cost.
• Balance cost and performance.
• Avoid over-design.
• Motivate employees to suggest improvements.
• Ensure customer satisfaction.

Example: Tata Nano – redesigned using VA → reduced cost but kept essential functions (safe,
small, efficient).
Value Engineering (VE)
A technique applied at the design stage of a product to build value from the beginning by
selecting cost-effective materials, designs, and processes.

Focus: Prevent unnecessary costs (before production).

Example: Boeing 777 Aircraft

During design, engineers used VE to select lightweight materials and optimize parts. Result is
Reduced fuel consumption, cost savings, and maintained safety.

Key Features of VE:

• Applied at the design/planning stage → unlike VA, VE is proactive.
• Function and cost focus – ensure each part performs its function at lowest cost.
• Cost prevention – reduces cost before it occurs, unlike VA which reduces existing
costs.
• Multidisciplinary team – engineers, designers, and cost experts collaborate.
• Creative problem-solving – brainstorming for better designs/materials.

Aims of VE:
• Simplify the product design.
• Use cheaper/better materials.
• Improve product design.
• Reduce cost and increase profits.

Aspect Value Analysis (VA) Value Engineering (VE)

Stage applied Existing products (after production) Design stage (before production)
Main goal Cost reduction without quality loss Cost prevention from the beginning
Focus Improve existing design Plan efficient design
Process type Corrective (fixes later) Preventive (avoids extra cost)
Example Tata Nano Delhi Metro, Boeing 777

Think?
If you are designing a new smartphone, how could VE help you prevent extra costs while
keeping features?
If the phone is already made and too expensive, how could VA help?
Types of Value
Type of Value Meaning Example
Actual cost of making a product (materials, Making a smartphone may cost
Cost Value
labor, overhead). ₹8,000.
Functional utility of the product – what it does
Use Value A fan → provides air circulation.
for the user.
Exchange Price a customer is willing to pay in the
Selling price of the fan = ₹1,500.
Value market.
iPhone → prestige and style
Esteem Value Emotional/brand value attached to the product.
factor.

Think of a pair of shoes:

1. Cost Value → ₹1,000 to make (materials, labor)
2. Exchange Value → You sell it for ₹2,000 in the market
3. Use Value → Protects your feet, comfortable to walk
4. Esteem Value → Branded shoes make you feel stylish and respected

Advantages of Value Engineering

• Cost Reduction – Eliminates unnecessary costs without affecting quality or performance.
• Efficient Resource Use – Avoids waste of materials and processes.
• Encourages Creativity & Innovation – Promotes new ideas and alternative solutions.
• Improves Value – Achieves better function-to-cost ratio.
• Customer Satisfaction – Higher quality at lower or same cost.
• Time & Maintenance Savings – Speeds up production and reduces long-term
maintenance.

Applications of Value Engineering

• Manufacturing – Choosing economical components while maintaining performance.
• Construction – Cost-effective materials, simplified structures.
• Automobile & Aerospace – Lightweight and durable materials to cut cost and improve
efficiency.
• Public Infrastructure – Roads, bridges, metro systems, airports → large-scale projects
completed within budget.
• General Engineering Projects – Smarter design and planning for better outcomes.

Example:
Delhi Metro → cost-effective, high-quality, completed on time.
Automobiles → lightweight body panels reduce cost and fuel use.
VALUE ENGINEERING PROCEDURE (JOB PLAN)
A systematic process to identify unnecessary costs and suggest better alternatives.
Phases of VE Job Plan
1. Information Phase
Collect complete data about design, cost, materials, production, and user needs.
Example: For a chair → type of material (wood, plastic, metal), manufacturing cost, durability,
seating comfort.

2. Function Analysis Phase

Focus on what the product does (function), not what it is. Expressed as verb + noun (e.g.,
“support weight,” “provide comfort”).

Analyse Functions:
Basic Function → Essential purpose (chair: “support weight”).
Secondary Function → Additional features (chair: “enhance appearance”).

3. Creative Phase (Idea Generation)

Brainstorming stage. Generate many alternative ideas without criticism.
Example: Suggest plastic instead of wood, reduce design complexity, use efficient machines.

4. Evaluation Phase
Analyze and compare ideas from the creative stage. Criteria: cost, safety, effectiveness, ease of
implementation.
Example: Check if plastic is strong, safe, durable, and cheaper than wood.

5. Development Phase
Turn selected ideas into detailed proposals with cost estimates, technical drawings, and
performance data.
Example: Plan full chair production with plastic, machinery needed, expected durability.
CAPITAL BUDGETING
Capital budgeting is the process of making long-term investment decisions in fixed assets
(capital expenditure), allocating current and future funds with the expectation of returns in the
future.

Also called: Investment Decision Making, Capital Acquisition Planning, Capital Expenditure
Analysis.

Definitions:
Capital budgeting involves the planning of expenditures for assets, the returns from which will be
realized in future time periods. – Milton H. Spencer

Capital budgeting is long term planning for making and financing proposed capital outlay. –
Charles T. Horngren

Capital Budgeting Process (Steps)

1. Generation of Ideas
• Identify potential investment opportunities.
• Sources: planning body, employees, external suggestions.
• Example: A company considers buying new machinery to improve production efficiency.
2. Analysis of Proposed Projects
• Evaluate projects on basis of future cash flows and profitability.
• Example: Check if the new machinery will increase production and profits enough to
cover its cost.
3. Implementation of Capital Budget
Select and prioritize profitable projects based on:
- Available resources
- Timing of cash flows
- Company objectives
Example: Decide whether to buy machinery now or later depending on cash availability and
production needs.
4. Performance Review
• Compare actual results vs projected results.
• Analyze mismatches and improve future decisions.
• Example: If production doesn’t increase as expected, analyze why and adjust future
investment decisions.

Objectives of Capital Budgeting

• To identify profitable capital expenditures.
• To evaluate whether replacing old assets gives better returns.
• To decide selection/rejection of projects.
• To estimate finance required for projects.
• To assess sources of finance.
• To compare proposals and select the best project.
Importance of Capital Budgeting
• Determines long-term growth of firm.
• Influences risk profile of firm.
• Involves large capital expenditure.
• Decisions are irreversible – once investment is made, it cannot be easily recovered.

Types of Investment Projects

Type Meaning Example
Expansion & Expansion = enlarge existing capacity; A steel plant expanding vs
Diversification Diversification = invest in new product entering cement business
A bakery replacing its manual
Replacement & Replace/upgrade to improve efficiency and
dough mixer with an
Modernisation reduce cost
automated industrial mixer.
Mutually Exclusive Projects serve same purpose; choosing Selecting one type of power
Investments one excludes others plant design over another
Independent Projects serve different purposes; can be A textile firm investing in both
Investments taken together spinning and dyeing
Contingent Building a factory → requires
One project depends on another
Investments housing colony for workers

Sound Investment Evaluation

Sound Investment Evaluation is the process of assessing investment projects carefully to ensure
they are profitable, feasible, and aligned with company objectives before committing funds.

→ It ensures that money is invested in projects that maximize returns and minimize risks.
→ Basically, it helps the company decide which project to accept or reject.
Characteristics
• Should maximize shareholder’s wealth.
• Must consider all cash flows.
• Should give a clear decision rule (accept/reject).
• Should help in ranking projects based on profitability.

Example: Imagine you have ₹10,000 to invest in either a bike, a laptop, or a small business.
Sound evaluation helps you figure out which option gives the best returns and fits your needs,
instead of just choosing randomly.
CAPITAL BUDGETING PROCESS
Capital Budgeting is a multi-step process that helps firms evaluate, select, implement, and review
long-term investments.
1. Origination of Investment Proposals
First step: conception of a profit-making idea.
Ideas may originate from:
• Top management (long-term strategy)
• Periodic review of company performance (earnings, costs, procedures, product line).

Purpose: to identify opportunities for growth, cost reduction, or diversification.

Example: A company considers opening a new production plant to increase output.

2. Evaluation of Projects (Capital Appraisal)

Involves estimating:
Costs → cash outflows.
Benefits → cash inflows.
Select an appropriate criterion to judge project desirability.

Examples of Evaluation Criteria:

1. Payback Period → How long it takes to recover investment
2. Net Present Value (NPV) → Present value of cash inflows minus outflows
3. Internal Rate of Return (IRR) → Rate of return that makes NPV zero
Example: Estimating whether a new machine will pay for itself in 3 years.

3. Screening and Selection of Projects

Capital expenditure requests must be screened by the Budget Committee.
Projects categorized into:

→ Most essential projects – must be accepted.

→ Desirable projects – should be accepted.
→ Deferrable projects – can be postponed.

Selection based on:

- Cost and availability of capital.
- Expected returns from alternative opportunities.

Example: Choosing between expanding an existing plant (essential) vs starting a new product
line (desirable).

4. Project Execution
After approval, funds are allocated for capital expenditure. Project execution committee
ensures:
→ Funds are spent as per budget.
→ Work is carried out efficiently and within schedule.

Example: Ordering machinery, hiring staff, and starting production according to the plan.
5. Follow-Up (Performance Review)
Continuous monitoring during and after project completion. Compare actual performance vs
projected estimates.

Benefits of follow-up:
- Improves accuracy of future forecasting.
- Forces managers to be realistic and careful.
- Enhances project accountability and efficiency.

Example: Checking whether a new production plant actually increases output and profits as
projected.

Time Value of Money (TVM)

The time value of money means that a certain amount of money has different values at different
times. A rupee today is worth more than a rupee received in the future because today’s money
can be invested to earn returns.

Why Important?
• Money can earn interest.
• Future cash flows must be discounted to compare fairly.
• Used in investment decisions, capital budgeting, loans, and savings.

Concepts:
FV
Present Value (PV): Current value of a future sum, PV=
(1+r )n

Future Value (FV): Value of money after compounding, FV=PV×(1+r )n

r: Interest/discount rate.
n: Number of periods (years, months).

Example:
Suppose you invest ₹1,000 today at 10% annual interest for 2 years.

Future Value:
2
FV=1000×(1+0.10) =1000×1.21=₹ 1210
So, ₹1,000 today becomes ₹1,210 in 2 years.

Present Value:
If you expect to receive ₹1,210 after 2 years, its present value at 10% is:

1210 1210
PV= 2
= =₹ 1000
(1+0.10) 1.21
CAPITAL BUDGETING TECHNIQUES (INVESTMENT APPRAISAL METHODS)
Capital budgeting helps firms decide which long-term projects to invest in. It can be broadly
divided into:
1. Traditional Techniques (Non-Discounted Cash Flow Methods)
Do not consider the time value of money. Useful for short-term projects and liquidity analysis.

Methods:
1. Payback Period Method (PBP) (Imp)
2. Post Payback Profitability Method
3. Average Rate of Return (ARR) Method

2. Modern Techniques (Discounted Cash Flow Methods)

Consider the time value of money. More accurate for long-term projects.

Methods:
1. Net Present Value (NPV) (Imp)
2. Benefit-Cost Ratio (Profitability Index)
3. Internal Rate of Return (IRR) (Imp)
4. Net Terminal Value (NTV)

1. Payback Method (PBP)

The payback period is the time required to recover the original investment from the project’s cash
inflows. In simple words: How many years (or months) will it take to get back the money I put into
a project?

Formula (if inflows are equal):

Initial Investment (cash outlay)

PBP=
Annual CashInflows (cash inflow)

Imagine you invest money in two businesses:

Business A gives your money back in 2 years
Business B gives it back in 5 years
Which is safer or better? → Business A, because you recover your investment faster.

Decision Rule:
Shorter PBP = Better project (because investment is recovered faster).

Shorter Payback Period = Less risk = Better Project

Case 1: Equal Cash Inflows
Example: A project involves a cash outlay of 5,00,000 and generates cash inflow of 1,00,000
annually for 7 years. Calculate payback period.

500000
PBP= =5 years
100000

Whole Investment is recovered in 5 years.

Imagine:
Suppose you open a restaurant by investing ₹5,00,000. Every year, after expenses, you earn
₹1,00,000 net profit.

It will take 5 years just to get back your money. After that, any profit is actual earnings.

Case 2: Unequal Cash Inflows

Here, add cash inflows year by year until the investment is recovered.

Example: Investment = ₹1,00,000 : Inflows: Year 1 = 10,000, Year 2 = 15,000, Year 3 = 25,000,
Year 4 = 30,000, Year 5 = 30,000

After 4 years = 80,000 recovered, Still need = 20,000 = 20,000

5th year inflow = 30,000 → only 20,000 needed,
Fraction of Year 5 = (20,000 ÷ 30,000) × 12 = 8 months

PBP = 4 years 8 months

Advantages:
• Simple and easy to use
• Useful for cash flow planning
• Considers liquidity and reduces risk of obsolescence

Limitations:
• Ignores time value of money
• Ignores inflows after payback period
• Does not measure profitability, only recovery
2. Post Payback Profitability Method
The Payback Period (PBP) tells us how fast we recover our investment. But Problem is PBP
ignores cash inflows after the payback point.

Example: Two projects may have the same payback period, but one gives much higher returns
after recovery.

The Post Payback Profitability (PPP) method solves this by considering all cash inflows
during the project’s life, not just until break-even.

Formula: If inflows are unequal:

Post Payback Profitability = Total Cash Inflows − Initial Investment

Or, if inflows are equal:

Post Payback Profitability=Annual Inflow×(Project Life−PBP)

Example:
Project A
Investment = ₹1,00,000, Annual inflows = ₹20,000, Life = 8 years

Step 1: Find Payback Period (PBP)

100000
PBP= =5 years
20000

Step 2: Calculate Post PBP Profit

After 5 years, investment is recovered. Project continues for 8 years → Extra 3 years.

Post PBP Profit=20000×(8−5)=₹ 60000

So, Project A earns ₹60,000 after recovery.

Project B
Investment = ₹1,00,000, Inflows = ₹30,000 (first 3 years), ₹10,000 (next 5 years), Life = 8 years

Step 1: Find PBP

Year 1: 30,000, Year 2: 60,000, Year 3: 90,000, Year 4: +10,000 = 1,00,000 → PBP = 4 years

Step 2: Post PBP Profit

Total inflows in 8 years=(30000×3)+(10000×5)=90000+50000=140000

Post PBP Profit=140000−100000=₹ 40000

So, Project B earns ₹40,000 after recovery.

3. Average Rate / Accounting Rate of Return Method (ARR)
ARR is a method to check how profitable an investment (project) is, expressed as a
percentage of the money you invested.
It uses accounting profits (after depreciation and tax), not cash inflows.
Formula:
Average Annual Proft
ARR= ×100
Average Investment
Steps:
1. Calculate average profit (Total profits ÷ Life of project)

Initial Investment +Scrap Value

2. Find Average Investment: (+Working Capital if required)
2
3. Apply to the formula.

Scrap Value (Salvage Value or Residual Value)

It is the expected value of an asset at the end of its useful life. In simple words → when a
project finishes or when machinery becomes too old, you can sell it as scrap (or second-hand).
That money you get back is the scrap value.

Suppose you buy a machine for ₹1,00,000. You use it for 5 years. At the end, you sell it as old
junk for ₹10,000.
That ₹10,000 = Scrap Value.

Example:

Project X
Investment = ₹40,000, Earnings (4 years, after Depreciation) = ₹5,000, 7,000, 6,000, 6,000

Average profit = ₹24,000 / 4 = ₹6,000

Avg Investment = (40,000 + 0)/2 = ₹20,000

6000
ARR= ×100 = 30 %
20000

Project Y
Investment = ₹60,000, Earnings (4 years) = ₹8,000, 10,000, 7,000, 5,000

Avg profit = ₹30,000 / 4 = ₹7,500

Avg Investment = (60,000 + 0)/2 = ₹30,000

7500
ARR= ×100=25 %
30000

Decision: Project X is better (30% ARR vs 25%).

Advantages of ARR:
• Simple and easy
• Considers profitability
• Useful for comparing different projects

Limitations of ARR:
• Ignores time value of money
• Uses accounting profits, not cash inflows
• Ignores reinvestment opportunities

Modern Techniques (Discounted Cash Flow Methods)

Consider the time value of money. More accurate for long-term projects.

Methods:
• Net Present Value (NPV) (Imp)
• Benefit-Cost Ratio (Profitability Index) (Imp)
• Internal Rate of Return (IRR) (Imp)
• Net Terminal Value (NTV)
1. Net Present Value (NPV) Method
NPV is the difference between the Present Value (PV) of Cash Inflows and the Present Value
of Cash Outflows (Investment).

It uses the time value of money (i.e., ₹1 today is worth more than ₹1 in future).

NPV = PV of Cash Inflows - PV of Cash Outflows

Steps in NPV Calculation

1. Decide Discount Rate (r): Usually equal to the cost of capital or minimum required rate of
return.
C1 C2 Cn
2. Find PV of Cash Inflows: Present Value = 1
+ 2
+....+
(1+r ) (1+r ) (1+r )n

(C1 Is Cash In Flow Of Year 1, C2 Is Cash In Flow Of Year 2...)

If Discount Factor Given:

Present Value = Cash Inflow of Each Yr × Discount Factor (DF) of Each Year

Then take sum of that.

3. Subtract PV of Outflows (Investment): Since Investment is made at Year 0 →

Investment (cash outflow) at Year 0 need not be discounted because it is already at
present value.
4. Decision Rule:
If NPV > 0 → Accept project (profitable, increases shareholder wealth).
If NPV < 0 → Reject project.

→ If projects are mutually exclusive, select the one with higher positive NPV.
→ NPV considers both magnitude and timing of cash flows.

What is DF (Discount Factor)?

DF brings future money back to today’s value.

1
Discount Factor=
(1+r )n
where:
r = discount rate (e.g., 10%, 15%)
n = year number

Example: If discount rate = 15%

Year 1:
1 1
DF= = =0.870
(1+0.15) 1.15
1

Year 2:
1 1
DF= = =0.756
(1+0.15) 1.3225
2
Example 1: Unequal Cash Inflows
Each of the following projects requires an initial investment of ₹1,00,000. The cash inflows of
Project A are ₹30,000, ₹40,000, ₹40,000, ₹30,000, and ₹30,000. In case of Project B, the cash
inflows are ₹20,000, ₹30,000, ₹50,000, ₹40,000, and ₹30,000.
On the basis of the NPV method, which project is better if the discount rate is 15%?

Answer:

Find The Discount Factor At 15% For Each Year First, Then Calculate Present Values.

PROJECT A PROJECT B
Investment / Discount Present Investment / Discount Present
Year
Cash Flow (A) Factor @15% Value (A) Cash Flow (B) Factor @15% Value (B)
1 +30,000 0.870 +26,100 +20,000 0.870 +17,400
2 +40,000 0.756 +30,240 +30,000 0.756 +22,680
3 +40,000 0.658 +26,320 +50,000 0.658 +32,900
4 +30,000 0.572 +17,160 +40,000 0.572 +22,880
5 +30,000 0.497 +14,910 +30,000 0.497 +14,910
Total PV of Cash Inflows ₹1,14,730 ₹1,10,770
PV of Cash Outflows ₹1,00,000 ₹1,00,000
Net Present Value (NPV) ₹14,730 ₹10,770

NPV(A) > NPV(B), hence select Project A.

Example 2: Equal Cash Inflows (Using Annuity Factor)

Investment = ₹10,000 per year for 4 years. Discount Rate = 10%. Annuity Factor (4 years @
10%) = 3.17

Normally, you’d do this:

10000 10000 10000 10000
PV= + + +
(1+0.10) (1+0.10) (1+0.10) (1+0.10)4
1 2 3

If you calculate, you’ll get something like:

Year 1: ₹9,090.91, Year 2: ₹8,264.46, Year 3: ₹7,513.15, Year 4: ₹6,830.13

Total ≈ ₹31,698 ≈ ₹31,700

Shortcut with Annuity Factor

We normally use the Annuity Factor (AF) when cash flows are equal every year.

1−(1+r )−n
AF= ​ or can Use Table
r

For 4 years, 10%, the annuity factor is already given: 3.17. AF for 10%, 4 years = 3.170 (from annuity table).

PV = CashFlow × AF (STUDY THIS ONLY)

PV=10000×3.17=31700

Total ≈ ₹31,700
Example 3: Model Question Paper Question
Suppose the initial investment of a project is Rs. 3000 (Crores) and the cost of capital or the
opportunity cost of capital is 10 percent. Calculate NPV of the project based on the cash flows
given below. (In Crores) (5 Marks)

Year 1 2 3 4 5
Cash Flow 1000 900 800 700 600

Solution

Step 1: Find PV of Cash Inflows

r=0.10

C1 C2 C3 C4 C5
PV= 1
+ 2
+ 3
+ 4
+ +..., ie:
(1+r ) (1+r ) (1+r ) (1+r ) (1+r )5

1000 1000
PV 1= 1
= ≈909.09
(1+0.1) 1.1

900 900
PV 2= = ≈743.80
(1+0.1) 1.21
2

800 800
PV 3 = = ≈601.95
(1+0.1) 1.331
3

700 700
PV 4 = = ≈478.07
(1+0.1) 1.4641
4

600 600
PV 5 = 5
= ≈372.67
(1+0.1) 1.61051

Total PV of Cash Inflows:

PV inflows =909.09+743.80+601.95+478.07+372.67≈3105.58

Step 2: Subtract PV of Cash Outflows

NPV=PV inflows −PV outflows

NPV=3105.58−3000=105.58 Crores

Step 3: Decision
NPV > 0 → NPV≈105.58 Crores → Accept Project . The project is profitable and increases
shareholder wealth.
Advantages of NPV Method
• Considers time value of money.
• Takes into account entire cash flow stream.
• Focuses on shareholder wealth maximization.
• Works well for mutually exclusive projects.
• Suitable even when inflows are unequal.
• NPV helps achieve optimal capital budgeting decisions.

Disadvantages of NPV Method

• Requires correct discount rate (difficult to estimate).
• Different discount rates → different NPVs → confusion.
• Not directly useful when projects have different lifespans or investment sizes.
• More complex calculations than traditional methods.
• It may fail when projects have different project durations (need Equivalent Annual
NPV).

2. Profitability Index (PI) / Benefit-Cost Ratio Method

NPV (Net Present Value) is total inflows minus total investment. But if two projects need
different investment amounts, NPV alone can be misleading.

Example: If Project X gives you ₹10,000 profit on ₹50,000 investment, and Project Y gives
₹12,000 profit on ₹1,00,000 investment — which is actually better?

Y gives more total profit, but X gives more profit per rupee invested. That’s what the Profitability
Index (PI) helps us find.

Formula:
Present Value of Cash Inflows
Profitability Index =
Present Value of Cash Outflows

or

NPV
Profitability Index = 1 +
PV of Outflows (Investment)

If PI = 1 → NPV = 0
If PI > 1 → Project Profitable
If PI < 1 → Project Not Profitable

→ Accept project if PI > 1

→ Reject project if PI < 1

For mutually exclusive projects, select project with higher PI

Example 1:
Project X and Y are having initial investments of ₹50,000 and ₹1,00,000 respectively. Their
present value of cash inflows is ₹60,000 and ₹1,12,000. Calculate the Profitability Index
(PI).

Solution
Particulars Project X (₹) Project Y (₹)
Present Value of Investment (Cost) 50,000 1,00,000
Present Value of Cash Inflows (Benefits) 60,000 1,12,000
Net Present Value (NPV) 10,000 12,000

We know: NPV = PV of Cash Inflows - PV of Cash Outflows

Present Value of CashInflows

PI=
Present Value of Investment (Outflows)

60000
PI X = =1.20
50000

112000
PIY = =1.12
100000

Alternative Method
NPV
PI=1+
Investment

10000
PIX =1+ =1.20
50000

12000
PI Y =1+ =1.12
100000

• As the Profitability Index (PI) of Project X (1.20) is greater than that of Project Y (1.12),
➡️Project X is better than Project Y.
• Although the absolute NPV of Project Y (₹12,000) is higher than that of Project X
(₹10,000),
• Project X provides a higher return per rupee invested. Thus, Project X is more
efficient and more profitable.
Example 2:
A company is considering two projects A and B. Evaluate the projects using the Profitability
Index (PI) method.

Particulars Project A (₹) Project B (₹)

Capital Outlay 50,000 50,000
Cash Flows (₹)
Year 1 24,000 10,000
Year 2 16,000 12,000
Year 3 10,000 18,000
Year 4 Nil 24,000
Year 5 12,000 8,000
Year 6 6,000 4,000

The cost of capital is 10%, and the P.V. factors for various years are: 0.909, 0.826, 0.751, 0.683,
0.621, and 0.564 respectively.

Solution
Present Value of Cash Inflows
Profitability Index =
Present Value of Cash Outflows

Project A
Year Cash Inflow (₹) P.V. Factor Present Value (₹)
1 24,000 0.909 21,816
2 16,000 0.826 13,216
3 10,000 0.751 7,510
4 Nil 0.683 —
5 12,000 0.621 7,452
6 6,000 0.564 3,384
Total 53,378

53,378
Profitability Index of Project A= =1.07
50,000
Project B
Year Cash Inflow (₹) P.V. Factor Present Value (₹)
1 10,000 0.909 9,090
2 12,000 0.826 9,912
3 18,000 0.751 13,518
4 24,000 0.683 16,392
5 8,000 0.621 4,968
6 4,000 0.564 2,256
Total 56,136

56,136
Profitability Index of Project B= =1.12 , Project B is better.
50,000

• Profitability Index (PI) of both projects is greater than 1, so both are profitable.
• However, since Project B (PI = 1.12) > Project A (PI = 1.07), ➡️Project B is more
profitable than Project A.

Advantages of PI Method
• Scientific and logical approach.
• Considers time value of money.
• Useful in case of capital rationing.
• Helps compare projects with different investment sizes.
• Reflects return per rupee invested.
• PI is useful when capital is rationed (limited budget situations).

Limitations
• Not aligned with accounting principles.
• Difficult to calculate and understand compared to simple methods.
• Estimating effective project life is not easy.
• PI may not give correct ranking when project lives differ unless converted to Equivalent
Annual PI.
• Not useful when many small projects must be aggregated vs. one large project.

Relationship between PI and NPV

PI > 1 ⟺ NPV > 0
PI = 1 ⟺ NPV = 0
PI < 1 ⟺ NPV < 0
2. Internal Rate Of Return (IRR)
Internal Rate of Return (IRR) is the discount rate at which:

Total Present Value (PV) of future cash inflows = Initial Investment

This means:

• IRR is the real rate of return the project earns.

• At IRR, NPV becomes zero.
• IRR uses only the project's own cash flows (no external rate needed).
• IRR is also called:
- marginal rate of return
- time-adjusted rate of return

Why do we search for a rate?

Because cash inflows come in future years, we convert them into present value using discount
factors.

→ Different discount rates give different present values.

→ So we try different rates until: PV of inflows = investment

That rate is IRR.

Two cases in IRR calculation

1. Equal yearly cash inflows (annuity case)
2. Unequal yearly cash inflows (general case)

1. When Cash Inflows Are Equal

Step 1: Calculate PV Factor
InitialInvestment
PV Factor =
Annual CashInflow

This PV Factor tells us:

“How many years of inflow (at some rate) are required to recover the investment?”

Example: Given that Initial Investment = 6000, Annual Inflow = 2000 (constant), Duration: 5
Years
Then,

PV Factor = 6,000 / 2,000, = 3

This 3 is the target value we want to match using the PV annuity table.
Step 2: Search PV Factor in Annuity Table
Go to the row for number of years (5 years). - (Given in question)
Look across the columns for different discount rates.

Find the closest value to 3. From table (values are standard):

At 18% → 3.127
At 20% → 2.900

Explanation:
3.127 is slightly more than 3
2.900 is slightly less than 3

→ IRR lies between 18% and 20%.

Step 3: Compute Present Value at Both Rates

To check accuracy, multiply:

PV = Annual Cash Inflow × PV Factor at that rate

At 18%: PV = 2,000 × 3.127 = 6,254

At 20%: PV = 2,000 × 2.900 = 5,800

Investment = 6,000. (Given in question)

Now compare:

At 18% → PV = 6,254 (higher than cost → NPV positive)

At 20% → PV = 5,800 (lower than cost → NPV negative)

This confirms IRR is between 18% and 20%.

Step 4: Apply Interpolation

Interpolation gives a more accurate value between the two known discount rates.
Using formula:

IRR=L+
( P1−Q
P1−P2)×(H−L)

Where values come from:

L = lower discount rate = 18%
H = higher rate = 20%
P1 = PV at lower rate = 6,254
P2 = PV at higher rate = 5,800
Q = Investment = 6,000

Substitute:
IRR = 18 + [(6,254 − 6,000) / (6,254 − 5,800)] × (20 – 18)
IRR = 18 + (254 / 454) × 2
IRR = 18 + 1.12
IRR = 19.12% - This is the final IRR.
2. When Cash Inflows Are Unequal
This uses trial and error because no single PV factor works.

Step A: Find Average Cash Inflow

To get a rough starting rate:

Total CashInflows
Average Cash Inflow =
Number of Years

Example: Given that Initial Investment = 22,000, Cash Inflows are: 12,000; 4,000; 2,000;
10,000 & No of Year = 4

Average Cash Inflow = (12,000 + 4,000 + 2,000 + 10,000) / 4

= 7,000

Step B: Calculate PV Factor

InitialInvestment
PV Factor =
Average CashInflow

PV Factor = 22,000 / 7,000

= 3.14

This PV factor (3.14) guides us to find the first trial rate.

Step C: Locate 3.14 in Annuity Table

Go to 4-year row: Closest value is:

3.170 at 10%

So the first trial rate = 10%.

Step D: Compute PV at 10%

We now use the PV Table (not annuity table).

Discount factors at 10%:

Year 1 → 0.909
Year 2 → 0.826
Year 3 → 0.751
Year 4 → 0.683

These come from standard PV tables.

Now multiply:
1: 12,000 × 0.909 = 10,908
2: 4,000 × 0.826 = 3,304
3: 2,000 × 0.751 = 1,502
4: 10,000 × 0.683 = 6,830

Total PV = 22,544 , Investment = 22,000

NPV = +544 (positive) Since NPV is positive → So we now try higher rate. (we need a range)
Step E: So Compute PV at 12%
Discount factors at 12%:

Year 1 → 0.893
Year 2 → 0.797
Year 3 → 0.712
Year 4 → 0.636

Multiply:
1: 12,000 × 0.893 = 10,716
2: 4,000 × 0.797 = 3,188
3: 2,000 × 0.712 = 1,424
4: 10,000 × 0.636 = 6,360

Total PV = 21,688

NPV = 21,688 – 22,000 = −312 (negative)

So IRR lies between 10% and 12%.

Step F: Interpolate
Use same formula:

IRR=L+
( P1−Q
P1−P2)×(H−L)

IRR = 10 + [(22,544 – 22,000) / (22,544 – 21,688)] × (12 – 10)

IRR = 10 + (544 / 856) × 2
IRR = 10 + 1.27

IRR = 11.27%

Advantages of IRR
• Considers all project cash flows.
• Fully accounts for the time value of money.
• Cost of capital is not required to calculate IRR.
• Shows true earning capacity of the project.
• Useful when comparing projects with different risks.
• IRR considers all years of cash flows and provides a long-term return.

Disadvantages of IRR
• Calculation is time-consuming.
• Irregular cash flows can produce multiple IRRs.
• May sometimes give unrealistic or negative rates.
• Difficult for small firms to use without tables/calculators.
• Not suitable when cash flows change sign multiple times.
• IRR cannot be used reliably when cash flows change signs more than once (multiple
IRRs).
• IRR assumes cash flows are reinvested at IRR itself (unrealistic).
ANNUITY TABLE
PRESENT VALUE TABLE (PV TABLE)

Note: Both Tables (For Using In Exam) are provided in the Notes/materials Download Folder
3. Net Terminal Value (NTV) Method
In NTV, each annual cash inflow is reinvested at a given reinvestment rate until the project ends.
Then, the total compounded sum is discounted back (using cost of capital) to find the present
value.

NTV = Present Value – Project Cost

Compare this present value with initial investment.

→ If NTV > 0 → Accept the project

→ If NTV < 0 → Reject the project

Difference from NPV:

NPV: Discounts inflows year by year.
NTV: Compounds inflows till the end, then discounts back once.

In one line: NPV discounts → NTV compounds.

Advantages
• Simple and easy to understand.
• Avoids direct influence of cost of capital on intermediate reinvestments.
• Useful in cash budgeting.
Limitations
• Difficult to estimate future reinvestment rates.
• Not suitable for mutually exclusive projects comparison.

Example: Project Data:

Initial cost = ₹20,000, Life = 5 years, Annual inflow = ₹5,000, Cost of capital = 10%,
Reinvestment rates: 8%, 8%, 9%, 6%, 5%

Step 1: Compound inflows till year 5

Year Inflow (₹) Rate or % (r) Compound Factor Compounded Sum (₹)
1 5,000 8 1.360 6,800
2 5,000 8 1.260 6,300
3 5,000 9 1.186 5,930
4 5,000 6 1.060 5,300
5 5,000 5 1.000 5,000
Total Compounded Sum 29,330

Compound Factor = (1 + r)n

Step 2: Discount Compounded Sum

PV factor at 10% for 5 years = 0.621 (This comes from the Present Value Table.)

So:
Present Value = 29,330 × 0.621
Present Value = ₹18,215
Step 3: Calculate NTV

NTV = Present Value – Project Cost

NTV = 18,215 − 20,000 = −1,785

Interpretation: NTV is negative (–1,785).

Decision: Reject the project.

MODEL QUESTIONS
1. What is esteem value? (3 Marks)
2. Write a short note on time value of money. (3 Marks)
3. Examine the procedures of value engineering. (5 Marks)
4. Examine the application areas of value engineering.(3 Marks)
5. Point out any three merits of NPV method. (3 Marks)

6. Suppose the initial investment of a project is Rs. 3000 (Crores) and the cost of capital or
the opportunity cost of capital is 10 percent. Calculate NPV of the project based on the
cash flows given below. (In Crores) (5 Marks)

Year 1 2 3 4 5
Cash Flow 1000 900 800 700 600