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ABFM MODULE - B Since at mes, processing of term Current assets are those which The gap between these assets
Chapter 7: SOURCES OF FINANCE loans takes me, promoters also are created and ex nguished in and the said liabili es is the
AND go in for bridge finance which is a an opera onal cycle. working capital gap which can be
temporary funding to fill the me An opera onal cycle is the me financed by a bank.
FINANCIAL STRATEGIES (PART-I)
gap between the fund
or period in which cash, a er However, the bankers will always
requirement and the actual going through various forms is insist on the borrower to provide
What we will study? release by the long-term lenders.
converted back into cash. his contribu on towards the gap.
*What are the various sources of Term finance is provided by banks
For example, with cash you buy The quantum of working capital
funds? and financial ins tu ons. raw materials that are converted finance varies from me to me
*All about Equity Capital? There is a norm called debt equity into finished goods through work based on the level of business
ra o which means how much in process and later when the ac vi es and the gap.
ideally promoters should finished goods are sold, they are It also depends on how you
INTRODUCTION:
contribute as equity and how converted into debtors or manage and minimize the gap.
All businesses need finance. much they should borrow for long receivables and upon realisa on
Basically, finance is required for term. or debt collec on, the cash comes Financial strategies are those
establishing businesses and also back into the business. permuta ons and combina ons
This depends on various factors which a business adopts or avails
for running them subsequently.
but the general and safe norm is Clearly, you need funds for all
to sa sfy its funds requirements,
The finance to start the business if equity is Rs. 100, one can safely these ac vi es and func ons whether these are long-term or
is generally provided by the borrow up to Rs. 200. before you realise profits.
short-term.
persons who moot the idea of
The en re requirement of long- Like in any business, and
business. These persons are Strategies are so worked out as to
term funds will depend on the depending on the maximise the advantages and
known as owners or promoters.
size and capital requirement of creditworthiness of the business minimise the cost of funds.
Since the owners are going to the project. en ty and the established norms,
stay with the project, their credit is generally available for A clean finance is the costliest,
The finance required for running because the lender who has no
finance is long term finance. procuring goods.
a business is called working assets to fall upon in case of a
However, if the project is too big capital finance and is based on Therefore, to that extent, fewer
default and runs higher risks
and the promoters do not have the gap between the current funds are required. which he would cover by charging
enough money, normally long- assets and current liabili es.
higher rate of interest.
term borrowing is preferred.

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Equity is a clean finance and Therefore, now a day, most large It was at the me of arrival of 5. All subscribers to the Equity
although it appears to be cheap, borrowers go for a regular ra ng corporates, that the term Equity Shares are governed by a
the cost of servicing is very high exercise to avail the best deals. got coined. common document called
because the equity shareholders Equity means a quality of being Memorandum and Ar cles of
will expect good returns over the Associa on.
EQUITY CAPITAL: fair or impar al, something that
years in the form of dividend, is fair and just. 6. All subsequent transferees of
which is always distributed a er Capital generally means the
Equity capital has the following such shares also have to abide by
the company pays its taxes. amount invested for establishing the above document.
a business, which is owned by the features as well as advantages:
They also expect increase in the 7. The Equity Shareholder can exit
market price of shares. promoter. 1. It is divided into units called
Equity Shares. at will by following the prescribed
The other examples of clean In accoun ng terms, it means the rules.
finance are preference shares and amount remaining a er selling all 2. Each unit has the same value
8. If the company is listed on a
unsecured debentures, the issue the assets and paying off all the called nominal value.
liabili es. stock exchange, the liquidity of
of which is fairly regulated. 3. Equity holder has two types of the Equity Shares increases since
The other sources of finance are It also represents the money the financial rights; the right to the holder can sell it to anyone
borrowings for long term as well owner brought in at the me of income (dividend) and the right through the exchange.
as short term purposes by se ng up the business and the to retaining surplus assets in case
profits he earned but did not take of liquida on. Addi onally, they 9. Equity Shares can be priced by
offering security such as fixed and the issuer at the nominal value or
current assets. away over a period of me. also have vo ng rights (except in
case of Differen al Vo ng Right at a premium or discount subject
The rate of interest a corporate Over a period of me, as business to extant regula ons and
developed, various forms of shares), whenever so required by
pay depends on how strong is its the governing act viz. Companies guidelines.
balance sheet, performance, organisa ons or en es evolved
with the arrival of corporates. Act, 2013. 10. Also, subject to extant
profitability, track record of past regula ons and guidelines, Equity
servicing and repayment, and last A corporate has hordes of 4. Anyone can buy or subscribe to
any number of Equity Shares Capital can be enhanced,
but not the least, the ra ng the investors who come from various
subject the terms and condi ons reduced, subdivided, bought back
business gets from a reputed and walks of life and who may neither or issued free of cost.
approved credit ra ng agency. know one another nor may be prescribed in the Ar cles of
related to each other. Associa on of the Company. 11. Equity Shareholder can also
pledge and borrow against the

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shares because an equity share is than cash to promoters of a Paid up capital is the amount of Board decides, subject to the
a marketable and valuable company or other people. money a company has received regula ons.
security. Subscribed Share Capital: from shareholders in exchange of
shares.
It is the por on of the issued
Some other terms related to the share capital that is subscribed to However, even a er subscrip on,
some may skip or delay the actual ABFM MODULE - B
equity capital are: by the public, i.e., applied for and
allo ed by the company. payment and, in such case, the Chapter 7: SOURCES OF FINANCE
Authorised Capital or Nominal paid-up capital can s ll be lesser AND
Capital: It also includes the face value of than the subscribed capital.
the company's shares issued for FINANCIAL STRATEGIES (PART-II)
This represents the maximum Calls in Arrears:
considera on other than cash.
amount of capital that the
company is authorised to issue, It is possible that all the Are a part of the called up or
What we will study?
subscribed capital, which the
which can be in any instalments shareholders, who have been
company can follow up and *All about Internal Accruals?
as the Board decides. called upon to subscribe to the
capital, may not respond and righ ully collect when the *All about Preference Capital?
This is prescribed by the shareholders fail to pay the full or
therefore the actual subscribed
Memorandum and Ar cles of part amount.
Associa on of the company and capital may be less than the
INTERNAL ACCRUALS:
in case of any change, the called up one. Unpaid Share Capital:
As a measure of financial
company has to go to the Called-up Share Capital: Is, as the name suggests, the
prudence, no company can or
shareholders as prescribed in the This is that part of the Issued amount finally determined as
would like to distribute the en re
Act. Capital that the company has unpaid for which the
earnings a er tax to the
management can take suitable
Issued Share Capital: called up from the shareholders. shareholders.
decision.
The part of authorised capital, The call can be one or more There are also dividend
which is issued to public for subject to the extant regula ons Forfeited Shares:
distribu on rules, which the
subscrip on. and need of funds by the Are that part of the subscribed regulators want the management
company. capital which is not fully paid as to follow.
This includes shares issued for
cash and for considera on other Paid up Share Capital: required and as a final resort, the
As a result, part of the Profit a er
company forfeits the amount so
Tax (PAT) is retained in the
that it can be reissued as the

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company, which usually reflected These reserves such as dividend  Internal accruals are readily shareholders par cularly the
in the general reserve. equalisa on reserve, redemp on available. minority shareholders.
These retained profits are reserve fund and other  Internal accruals are as liquid as  The company cannot build a
internal accruals of the company. mandatory reserves under certain the form in which these remain good dividend track record
statutory provisions, cannot be invested. resul ng into lesser interest by
These arise out of the cash profits u lised as free or general inves ng public.
 The use or availing of internal
i.e. (1) PAT, (2) non-cash profits reserves un l transferred to free accruals does not change the  Safety cover provided by the
charged to the Profit & Loss reserves a er the expiry period ownership structure or results in retained earnings is reduced by
account, in the form of provisions or before fulfilment of the laid the dilu on of control. the use of it.
or reserves and (3) deprecia on down condi ons.  There is no cost of raising these
charged to the Profit & Loss
Internal accruals or the ploughed funds. PREFERENCE CAPITAL:
account.
back profits belong to the equity
If the company has preference This is that part of the capital,
holders and become equity if Disadvantages:
shares on which dividend is which provides lesser risk to the
these are converted in to bonus
cashed out, the same will reduce  Just because internal accruals investor compared to that, which
shares for which regula ons exist.
the retained earnings. are readily and easily available, is taken by the equity investors.
Let's now see what advantages there is tendency of
Deprecia on is part of internal As the name suggests, the holder
and limita ons internal accruals indiscriminate applica on of
accruals as it results in increasing gets a preference with respect to
represent. retained earnings.
the cash balance available to the dividend as well as payment is
 The cost of these funds in case of liquida on, which is one
company even though it does not
reality is higher because these of the major monetary
affect the general reserves and, Advantages:
represent undeclared dividend. considera ons for any investor.
therefore, cannot be used for
 There is no restric on on the These funds, therefore, belong to
declaring dividend and issue of It is a quasi-risk capital because it
use of internal accruals, except as the equity shareholders and they
bonus shares. is not as safe as secured debts,
men oned above. expect reasonable return on
Internal accruals can also include  These can be used for long which get payment priority over
these.
other reserves, which are created preference shares in case of
term as well as short term  Retained earnings are
out of current profits but post purposes. liquida on of a company.
depriva on of dividend and over-
tax.  Internal accruals do not have use of such earnings may hurt the
any cost for use or servicing.

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Host regula ons with regard to dividend is guaranteed. In other dividend on preference shares  The recurring cost in the form
the issue of preference shares words, if in a year the company has not been paid for two years of dividend is fixed and known
exist. does not have enough profits to or more, such shareholders get a beforehand unlike dividend on
If equity is a common stock, declare dividend, it is right to vote on all company equity shares.
accumulated to the credit of the resolu ons.  The current owners do not
preference share is preferred
stock. shareholders and paid when, in a have to dilute their equity
subsequent year, the holding and hence they retain the
distributable surplus is available. Why companies raise preference
present level of control over
Let's now see what are the main  Redeemable Preference Shares capital and the reasons are not
management.
are those which get repaid as per far away to find:
features of the preference capital:  It is a part of the net worth of
the terms of issue. Under the  It is a good source of funds for the company and hence it helps is
 It is a stock which is preferred
current provisions of the very long period up to 20 years. improving the debt equity ra o.
over equity shares with regards
Companies Act, 2013, companies  In case of infrastructure  Absence of vo ng rights, unless
to the payment of dividend and
are prohibited from issuing companies, the period can even the company skips dividend for
repayment in case of liquida on.
Preference Shares which are not be more than 20 years. two or more years, gives a
 Unlike equity capital, the
redeemable. All the preference  Mostly such securi es are comfort to the management who
dividend rate of preference share
shares are required to be privately placed and hence the generally does not like
is fixed just like debentures.
redeemed within a period not cost of raising such funds is not interference.
 Generally speaking, the
exceeding 20 years. Redemp on high.  No security is provided to the
preference shares are en tled to
has to be made out of profits or  Private placement (or non- preference shareholder unlike in
dividend if distributable profits
out of the proceeds of fresh share public offering) is a funding round case of debentures.
are available and hence dividend
issue for such redemp on of securi es, which are sold not
distribu on is not obligatory like However, there are certain
purpose. However, in case of through a public offering, but
equity capital. drawbacks, from the point of
banks, perpetual debt rather through a private offering,
 Like equity capital, preference view of the management and the
instruments can be issued. mostly to a small number of
shares are paid dividend, out of equity shareholders, which are
 Preference shareholders have a chosen investors.
post-tax profits and hence the enumerated below:
limited right to par cipate in  There is no compulsion to pay
dividend on preference shares is
vo ng only on some of the dividend unless cumula ve  Possibility of management
not a tax-deduc ble expense.
resolu ons as specified in the preference shares are issued. interference in case of non-
 There are cumula ve
Companies Act, 2013. Where
preference shares where the

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payment of dividends for more DEBENTURES: borrower company promising to In case of so called, Zero-Coupon
than 2 years. pay, at fixed future date, a certain bonds also, a fixed rate of
Sec on 2(30) of the Companies
 Dividend paid is a non- Act, 2013 defines "debenture" amount to the holder. interest, payable at the me of
deduc ble expenditure which which includes debenture stock, Agreement or deed: If debentures redemp on, is involved as these
increases the real cost of funding. are issued at a discount to their
bonds or any other instrument of are issued to more than 500
 Equity shareholders feel side- a company evidencing a debt, persons, Trustees are required to redemp on value.
lined when the preference for whether cons tu ng a charge on be appointed to look a er Call op ons with the issuer: The
dividend payout is given to the assets of the company or not. interest of the debenture holders. company issuing debentures can
preference shareholders. incorporate an op on like call
In other words, it is a wri en Regula ons: Sec on 71 of the
 In case of liquida on, these op on where it can repay the
instrument acknowledging debt companies Act, 2013 contains
shareholders get prior charge principal before due date at a
by the company promising provisions rela ng to issue of
over the residual assets fixed price. This is called call
repayment at a certain future debentures covering the points
compared to the equity op on.
date. such as manner, procedures,
shareholders.
conver bility, vo ng rights, Put op on with the investor: The
This is another form of long-term
borrowing targeted at various redemp on, crea ng reserves, company issuing debentures can
prospectus or invita on, trust etc. incorporate an op on like put
individuals or ins tu ons that
subscribe to the issue and pay to Fixed tenure: Loans are repaid in op on where the investor has the
ABFM MODULE - B
the company. instalments over a period of me. op on to demand redemp on
Chapter 7: SOURCES OF FINANCE before due date at a fixed price.
AND The terms of issue like tenure, On the other hand, debentures
rate of interest, denomina on, are repaid on a fixed date on This is called put op on.
FINANCIAL STRATEGIES (PART-III)
minimum subscrip on, total issue expiry of the term. No vo ng rights: Sec on 71(2) of
size etc. all form part of the issue Repayment on maturity is also the Companies Act, 2013
What we will study? document. called redemp on. prohibits giving any vo ng rights
to a debenture holder.
*All about Debentures? Perpetual bonds are also
The following are the main permi ed to be issued.
features of debentures: Fixed rate of interest: The rate of Stake in the company: In case of
An instrument: Debenture is an interest is also prefixed. conver ble (wholly or partly)
instrument issued by the debentures, which are permi ed

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to be issued, the debenture the investors, the companies nego ated cost of servicing and With regard to management
holder gets an equity stake in the issue partly or fully conver ble redemp on period beforehand, freedom equity is the least
company a er conversion in the debentures so that at a future some of which are not available preferable.
equity followed by vo ng rights. date, upon conversion, the in Ins tu onal Long Terms where
debentures holders can be the company does not have as
The ra o of conversion as well as
the price at which shares will be growth par cipants and also have much bargaining power.
vo ng rights.
valued is indicated in the offer Disadvantages are that once
document. Based on nego ability: The issued, no nego a on of terms is
debenture is a debt instruments possible, ra ng requirement may
ABFM MODULE - B
and mostly transferable by way of create some unan cipated
Types of debentures: a registered transfer form. problems, statutory requirement Chapter 7: SOURCES OF FINANCE
Based on tenure: There are of crea ng reserve funds and AND
However, in case of bearer
debentures specifying investment thereof and finally FINANCIAL STRATEGIES (PART-IV)
debentures the transfer takes
redemp on with call op ons, put place by mere delivery. you deal with numerous investors
op ons, or with fixed tenure as against one lender in case of
under this kind. Such debentures are rare due to Long-Term Loan. What we will study?
concerns such as money
Perpetual bonds with call op on, Conclusions: If we summarise the *What is Alterna ve Financing
laundering and benami
are also permi ed to be issued. long-term funding, we find that Strategy?
transac ons.
as we move from equity to *What is Private Equity (PE)?
Based on security: Many a mes,
debentures, we find reduc on in
to offer lower rate of interest and *What is Foreign Direct
Advantages and disadvantages: cost of raising funds; control
a sense of security to the Investment (FDI)?
Advantages emanate from the dilu on is only in the case of
investor’s, secured debentures
features of debentures such low equity issue except when loan or
are issued providing first or
cost of raising of funds, known debentures are converted, the ALTERNATIVE FINANCING
second charge over the fixed
and fixed future interest liability, dilu on follows. STRATEGIES IN THE CONTEXT OF
assets of the company and
appoin ng trustees if the number known date of redemp on The issuer incurs lowest risk while REGULATORY REQUIREMENTS:
liability facilita ng planning of issuing equity which increases as
of holders exceeds 500. Financing is considered to be an
fund management, no dilu on of he moves to other long-term
Based on Conver bility: To important part of any business
owners' equity and management sources of financing.
provide addi onal incen ve to study.
powers, flexibility to provide

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It relates to money, the most out with guidelines to regulate SEBI had come out with a capital gains rather than short
valuable asset and also the most ac vi es directly, indirectly or consulta on paper on crowd term regular reimbursements.
liquid. It is also subject to great remotely connected with finical funding but later decided not to Private equi es are generally less
risk. advice including lending. pursue it. liquid than publicly traded stocks
Whoever deals with it, whether a A businessman has a number of and are thought of as a long-term
lender or borrower, has to be not alterna ves available today who Private Equity (PE): investment.
only extra careful but also has to looks for finances. Pra has tried to categories types
be brought under supervision and Private equity industry has
However, since these are not emerged as a poten al source of of private equity ac vi es in
some desired control. within the banking or NBFC terms of the stages of corporate
capital for the corporate sector
Therefore, there have been sector, they do not and cannot today. development, where PE financing
various regulatory efforts by replicate ac vi es carried on by is called for.
statutory authori es, the major banks and NBFCs. Lerner has broadly defined
Seed Financing: Providing small
being Reserve Bank of India. private equity organiza on as
These cater to funds partnerships specializing in sums of capital necessary to
The en re banking sector has requirements which are tailor venture capital, leveraged develop a business idea.
been regulated by Banking made for SMEs, start-ups, reality buyouts (LBOS), mezzanine Start-up financing: Providing
Companies Act, 1949 (changed to sectors etc. investments, build-ups, distressed capital required for product
Banking Regula on Act, 1949
Some of these are crowd funding, debt and other related development and ini al
from March 1, 1966), which has peer to peer lending, Alternate investments. marke ng ac vi es.
been always evolving.
Finance Funds, mutual funds, The European Venture Capital First-stage: Financing the
We have also guidelines issued by angel investors, venture capital
Associa on defines private equity commercializa on and
RBI for those Companies engaged funds, boot strapping, Real Estate as the provision of equity capital produc on of products.
in financing ac vi es which are Investment Trusts (RIETs), by financial investors - over the
non-banking. Infrastructure Investment Trusts( Second-stage: Providing working
medium or long-term to non-
InvIT) etc. capital funding and required
These are known as non-banking quoted companies with high financing for young firms during
financing companies that are also All these deal with all sorts of growth poten al. growth period.
regulated by RBI. finance from micro to long term
It is also called 'pa ent capital' as Third-stage: Financing the
Since most of these are in the to extra-long term as well as it seeks to profit from long term
equity. expansion of growth of
corporate sector, SEBI also comes companies.

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Bridge financing: Last financing Foreign Exchange Management conver ble are considered as ABFM MODULE - B
round prior to an ini al public Act (FEMA) 1999. debt.
Chapter 7: SOURCES OF FINANCE
offering of a company. Foreign investment is freely As such, the guidelines applicable AND
PIPE deals: A private investment permi ed in almost all sectors. for External Commercial FINANCIAL STRATEGIES
in public equity, o en called a Foreign Direct Investments (FDI) Borrowing (ECB), viz. eligible
PIPE deal, involves the selling of borrowers, recognised lenders, (PART-V)
can be made under two routes-
publicly traded common shares or Automa c Route and amount and maturity, end use
some form of preferred stock or s pula ons, etc. will apply to
Government Route. What we will study?
conver ble security to private such issues.
investors. Under the Automa c Route, the *What is Term Loan?
foreign investor or the Indian A foreign investor can invest in an
Leveraged Buyout (LBO): It entails Indian company which is a small-
company does not require any
the purchase of a company by a approval from RBI or Government scale industrial unit provided it is TERM LOANS:
small group of investors, of India for the investment. not engaged in any ac vity which
This is another major source of
especially buyout specialists, is prohibited under the FDI policy.
Under the Government Route, long-term finance by which a
largely financed by debt. Such investments are subject to a
prior approval of the Government company can obtain term loans
Management Buyout (MBO): It is of India, Ministry of Finance, limit of 24% of paid-up capital of from banks or financial
a subset of LBO whereby the Indian company/ Small-scale ins tu ons.
Foreign Investment Promo on
incumbent management is Board (FIPB) is required. industries (SSI) Unit.
While banks also give working
included in the buying group and
Indian companies can freely issue The policy and procedures in capital finance, the Financial
key execu ves perform an respect of FDI in India is available
equity shares / conver ble Ins tu ons are allowed to give
important role in the LBO in the Manual on Inves ng in
debentures and preference only such loans, which are
transac ons.
shares subject to valua on norms India, 'Foreign Direct Investment, repayable over the years as per
prescribed under FEMA Policy & Procedures'. the terms and condi ons of the
Foreign Direct Investment (FDI): Regula ons. sanc on.

Foreign Investment in India is Issue of other types of preference This source is different from
governed by the FDI policy shares such as non-conver ble, equity and rela vely, cheaper to
announced by the Government of op onally conver ble or par ally service.
India and the provisions of the

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The equity forms are either a generally granted for short terms Short to medium term loans are Some mes, the rela onship with
permanent source where to long terms. preferred for other tangible borrower and future business
repayment is not there or a very Short-term loans are repaid assets such computers, opportunity are also taken into
long period like 20 years is within a year. peripherals, furniture, account while determining the
available for repayment in the renova ons etc. rate of interest.
case of preference shares or Long term is period from 5 to 10
years and medium term is a range Loans are also granted for Penal, addi onal or higher rates
capital.
from 1 to 5 years. housing and so furnishing. are generally provided for delays
Term loans can be for long to beyond the agreed repayment
This is the period within which Interest: Term loans carry a fixed
medium terms stretching to and predetermined rate of period.
about ten years. the loans are to be fully repaid.
interest. In case moratorium is granted for
Term loan may not be as costly a Loans granted for housing are repayment of principal, interest is
generally for long period ranging The rate to be charged is
source of finance as taking nego ated and depends upon required to be paid as per the
working capital finance because from 5 years to 30 years. schedule.
factors such as period, risk, ra ng
rates are determined based on Purpose: Term loans are granted of the borrower or Whether the interest is paid
medium to long term prospects to acquire assets like land, creditworthiness as well as the separately or is embedded in EMI,
of the project where cyclical buildings, plant and machinery to purpose. the interest keeps reducing
movements in the business establish a factory or set up a depending on the outstanding
fortune are more or less evened project which are tangible and Interest is payable either monthly
or quarterly and some mes it is principal amount due.
out. have a long useful life.
embedded into the equal Repayment: Loans are generally
Generally, term loans are For the reasons such as long monthly instalment (EMI) which repaid over the granted period
resorted to finance se ng up or gesta on period, slow start to combine both interest and and generally in instalments,
expansion of the projects. cash genera on cycle and longer principal. which are monthly, quarterly, half
life, a longer period is granted for yearly or yearly.
In certain regulated sectors, there
repayment.
The main features of Term Loans are floor and ceiling rates of In some specific but me bound
are described below: If the project is already running interest prescribed. acquisi on of assets, there is
and loan is taken for capacity recovery by bullet payment in
Period: All loans, except demand build up, a shorter period up to 5 Rates also depend on the market
loans, are term loans and are condi ons and compe on. one shot.
years will suffice as cash flows are
already there.

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Moratorium is granted for Security: Uncertainty over a long In cases where the term loan is properly serviced by the
principal repayments where period obviously enhances risk for crea on of fixed assets by the borrower due to temporary
projects are large and cash percep on and so also insecurity borrower, the loan amount is liquidity constraints.
genera ons are likely to take in the mind of the lender. arrived at by the debt / equity Due to these liquidity constraints,
me. ra o, as decided by the lender.
Even otherwise, no lender can or the cash credit account remains
In cases like EMI, the financial will lend without securing the Appraisal: The appraisal process generally overdrawn.
burden is evenly spread out term loan by crea ng charge over of a term loan by the lender To mi gate these temporary
though the interest component the primary assets, i.e., the assets depends on the size and
liquidity problems, the bank
gradually goes down. purchased through the term loan. complexity of the project agrees to provide a short-term
From every instalment, the Some mes collateral securi es financed. loan under the head Working
accrued interest is carved out first are also obtained which generally However, no term loan is granted Capital Term Loan. The bank fixes
and only the remaining amount is comprise of personal assets of without examining the economic the instalments for repayment.
appor oned towards principal. the promoters, especially to keep viability and technical feasibility. WCTL was more relevant in pre-
the promoters highly commi ed.
Currency: In many large projects, liberaliza on era when the credit
the import component of assets Tangible securi es are always Working Capital Term Loan was restricted and the concept of
is quite large where the loans are preferred. (WCTL): MPBF (Tondon commi ee) was
granted in foreign currency to strictly implemented.
A proper and independent This is not a type of normal term
facilitate proper requirement, valua on is carried out by the Banks were required to ensure
since the quota ons are foreign loan given by any bank or
lender. Titles to the mortgaged Financial Ins tu on. It is a term the required current ra o,
currency denominated and by the assets and liquidity or sale ability depending upon whether they
me the actual import takes loan against the current assets.
are also examined. have used 1st (1:1) or 2nd (1:1.33)
place the INR element may be a It is used in the banking industry
Amount of loan: In case of method of lending in assessing
different amount. when a working capital loan, the working capital requirements.
purchase of exis ng assets, the
Repayments are also done in given by a bank, is not being
lender carries out an independent
foreign currency where the
valua on and a er providing a
borrower buys the foreign margin to cover value fluctua on
exchange from the market at the
and borrower's margin or
then prevailing rate. contribu on, the loan amount is
determined.

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Marketability of such shares is ABFM MODULE - B
generally poor and these give no Chapter 8: FINANCIAL AND
return to the lender except a seat OPERATING
on the board which helps the
LEVERAGES (PART-I)
bank to be er monitor the
running of the project or business
of the borrower. What we will study?
*What is Leverage?
Moratorium:
It takes me for any project to INTRODUCTION:
start genera ng cash flows, We use a lever to enhance the
posi ve cash flows and profits. impact or force to push or move
Bigger the project, longer the an object.
me.
Some mes, it is op onal for the Therefore, ll such me the
Conversion: lender to convert. borrower starts genera ng
Many mes, the loan quality required cash flows, the lenders
Conversion of loan into equity is give me to start the repayment.
deteriorates and the borrower
generally not a planned ac on This grace period is called
except when the banks and the expresses inability to pay interest
or instalments of repayment. moratorium.
borrower agree upfront to
Moratorium is generally for the The simplest example of a lever is
convert loans into equity at a In such a scenario, le with no
principal repayment and interest the see-saw which has a long bar
later stage. be er op on, the loan is
is required to be paid as and with a fulcrum and two children
In such a case, at the expiry of the restructured and as a part of the
when due. sit on the bar, one on each side of
agreed term, the loan is scheme, conversion of full or a
the fulcrum.
converted into the equity of the part of the outstanding is done It is mutual to agree for the
into equity of the borrower at an moratorium for the interest A light-weight child can li a
borrower. The valua on
agreed price. payments. heavier child on the other side if
mechanism is pre-agreed.
his distance from the fulcrum is

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more than the distance of the (-) Interest (xx) ABFM MODULE - B Degree of Opera ng Leverage
heavier child. EARNING xxx % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓
(DOL) =% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐚𝐥𝐞𝐬
Chapter 8: FINANCIAL AND
BEFORE TAX
This property of lever prompted OPERATING
[EBT]
Galileo to say, "Give me a point of (-) Tax (xx) LEVERAGES (PART-II)
support and I can li the earth". EARNING xxx In other words, we are measuring
Same principle is applied in AFTER TAX the impact of Fixed Cost.
business. [EAT] What we will study?
*Types of Leverage?
EARNING PER = DOL =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
𝐄𝐁𝐈𝐓
SHARE [EPS] 𝐄𝐀𝐓 *What is DOL, DFL, DCL?
𝐍𝐨 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬
Example 1: [EBIT 50% = EPS 50%]
2. Financial Leverage:
Par culars Scenario Scenario TYPES OF LEVERAGE:
1 2 Taking advantage of financial
1. Opera ng Leverage.
When you apply it to the EBIT 1,00,000 1,50,000 structure of business i.e., Fixed
Tax@50% 50,000 75,000 2. Finanacial Leverage. Cost of finance = interest.
opera ons, it is called opera ng
PAT 50,000 75,000
leverage and when you apply it to 3. Combined Leverage. We can measure the financial
No. of 10,000 10,000
the finance func ons, it amounts shares leverage using degree of leverage
to financial leverage. EPS 5 7.5 i.e., Degree of Financial Leverage
1. Opera ng Leverage:
Example 2: [EBIT 50% = EPS (DFL).
Profitability Statement:
62.5%] Taking advantage of opera ons of
PARTICULARs ₹ By increasing the EBIT by a
business i.e., Opera ng Fixed
Sales xxx Par culars Scenario Scenario certain %, we want to increase
1 2 Cost.
(-) Variable (xx) EPS by a greater %.
Cost EBIT 1,00,000 1,50,000 We can measure the opera ng
Interest 20,000 20,000 Degree of Financial Leverage
CONTRIBUTIO xxx leverage using degree of leverage % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐏𝐒
N EBT 80,000 1,30,000 (DFL) =% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓
i.e., Degree of Opera ng Leverage
(-) Fixed Cost (xx) Tax @ 50% 40,000 65,000
(DOL). In other words, we are measuring
EARNING xxx PAT 40,000 65,000
BEFORE No of 10,000 10,000 By increasing the SALES by a the impact of Interest Cost.
INTEREST & shares certain %, we want to increase 𝐄𝐁𝐈𝐓
EPS 4 6.5 DFL = 𝐄𝐁𝐓
TAX [EBIT] EBIT by a greater %.

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3. Combined Leverage: Summary: ABFM MODULE - B Degree of Opera ng Leverage
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
Taking advantage of opera ons Degree DOL= DOL Chapter 8: FINANCIAL AND (DOL) = 𝐄𝐁𝐈𝐓
and financial structure of of % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓= OPERATING 𝟐𝟎,𝟎𝟎𝟎
Opera % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐚𝐥𝐞𝐬𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 = = 4 mes
business. 𝐄𝐁𝐈𝐓 LEVERAGES (PART-III) 𝟓,𝟎𝟎𝟎
ng
We can measure the combined Leverag
leverage using degree of leverage e (DOL) Example 2:
What we will study?
i.e., Degree of Combined Degree DFL DFL
of = 𝐄𝐁𝐈𝐓 *How to calculate DOL? A Company ABC Ltd produces and
Leverage (DCL). =
Financi % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐏𝐒 𝐄𝐁𝐓 sells 20,000 shirts. The selling
By increasing the Sales by a al % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓
price per shirt is Rs. 500. Variable
certain %, we want to increase Leverag Example 1: cost is Rs. 200 per shirt and fixed
EPS by a greater %. e (DFL) opera ng cost is Rs. 40,00,000.
Calculate Degree of Opera ng
Degree DCL DCL =
Degree of Combined Leverage of = 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 Leverage when, a company sells
% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐏𝐒
(DCL) =% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐚𝐥𝐞𝐬 Combin % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐏𝐒 𝐄𝐁𝐓 1000 units of product X at Rs. 50
% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐚𝐥𝐞𝐬 Calculate degree of opera ng
ed having variable cost of Rs. 30 per
In other words, we are measuring leverage.
Leverag unit and fixed cost of Rs. 15,000.
the impact of Interest Cost and e (DCL) Solu on:
fixed cost.
Par culars Rs.
Solu on:
DCL =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 Sales Revenue 1,00,00,000
𝐄𝐁𝐓
Par culars Product (20,000 x 500)
X (Rs.) Less: Variable 40,00,000
Sales (50 x 1000 units) 50,000 Cost (20,000 x
Formula:
Less: Variable Cost (30 (30,000) 200)
DOL =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
x 1000 units) Contribu on 60,00,000
𝐄𝐁𝐈𝐓
𝐄𝐁𝐈𝐓 Contribu on 20,000 Less: Fixed Cost 40,00,000
DFL = 𝐄𝐁𝐓
Less: Fixed Cost (15,000) EBIT 20,00,000
DCL = DOL * DFL =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
* Profit (EBIT) 5,000
𝐄𝐁𝐈𝐓
𝐄𝐁𝐈𝐓 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 Degree of Opera ng Leverage =
𝐄𝐁𝐓
= 𝐄𝐁𝐓 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐄𝐁𝐈𝐓
DCL =
𝐄𝐁𝐓

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=
𝟔𝟎,𝟎𝟎,𝟎𝟎𝟎
= 3 mes Calculate the degree of opera ng DOL C Ltd =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
=
𝟏,𝟓𝟎,𝟎𝟎𝟎 Selling Price 40 20
𝟐𝟎,𝟎𝟎,𝟎𝟎𝟎 𝐄𝐁𝐈𝐓 𝟓𝟎,𝟎𝟎𝟎
leverage for each of the four p.u.
= 3 mes Variable 20 12
Companies A Ltd, B Ltd, C Ltd and
D Ltd from the following price DOL D Ltd =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
=
𝟏,𝟎𝟎,𝟎𝟎𝟎 Cost p.u.
Illustra on 3: 𝐄𝐁𝐈𝐓 𝟏,𝟎𝟎,𝟎𝟎𝟎 Fixed Cost 15,000 5,000
and cost data: = 1 mes Now calculate DOL and Break-
Company even point for Product A and
A Ltd (Rs.) B Ltd (Rs.) C Ltd (Rs.) D Ltd (Rs.) Product B?
Sale price 20 32 50 70 Break-Even Analysis:
Variable cost 6 16 20 50 Solu on:
Par culars Product Product
per unit A B Say we sell total 1000 units:
Fixed opera ng 60,000 40,000 1,00,000 Nil (Rs.) (Rs.)
cost Par culars Product A Product B
(Rs.) (Rs.)
Selling Price p.u. 40 20
Total Selling cost 40*1000= 40,000 20*1000=20,000
Company Variable Cost p.u. 20 12
A Ltd B Ltd C Ltd D Ltd Total Variable Cost 20*1000= (20,000) 12*1000=(12,000)
Sale(units) 5,000 5,000 5,000 5,000 Contribu on 20,000 8,000
Seles revenue (Units x sale 1,00,000 1,00,000 2,50,000 3,50,000 Fixed Cost (15,000) (5,000)
price per unit) Profit (EBIT) 5000 3000
DOL 20000/5000 = 4 8000/3000 = 2.67
Less: Variable cost (Unit x (30,000) (80,000) (1,00,000) (2,50,000)
variable cost per unit)
Contribu on 70,000 80,000 1,50,000 1,00,000 Break-even Point ABFM MODULE - B
𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭
Less: Fixed opera on costs (60,000) (40,000) (1,00,000) Nil (0) = 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 Chapter 8: FINANCIAL AND
OPERATING
𝟏𝟓𝟎𝟎𝟎
EBIT 10,000 40,000 50,000 1,00,000 Break-even Point for A = =
𝟐𝟎 LEVERAGES (PART-IV)
750 units
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝟕𝟎,𝟎𝟎𝟎 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝟖𝟎,𝟎𝟎𝟎 𝟓𝟎𝟎𝟎
DOL A Ltd = = = DOL B Ltd = = = Break-even Point for A = =
𝐄𝐁𝐈𝐓 𝟏𝟎,𝟎𝟎𝟎 𝐄𝐁𝐈𝐓 𝟒𝟎,𝟎𝟎𝟎 𝟖 What we will study?
7 mes 2 mes 625 units.
*How to calculate DFL?

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Example 1:  Variable cost (50% of Sales) = Degree of Financial Leverage Income Tax Applicable
50% of 24,00,000 (DFL) =
𝐄𝐁𝐈𝐓 𝟐,𝟎𝟎,𝟎𝟎𝟎
= 𝟏,𝟎𝟎,𝟎𝟎𝟎 = 2 mes 40%
A firm's details are as under: 𝐄𝐁𝐓
= 12,00,000 Calculate its Degree of Financial
 Sales (@100 per unit) Rs.
Leverage?
24,00,000.  It has borrowed Rs. 10,00,000 Example 2:
 Variable Cost 50%. @ 10% p.a.
The following informa on is
So, Interest = 10% of SOLUTION:
 Fixed Cost Rs. 10,00,000. related to XYZ Company Ltd. for
10,00,000 = 1,00,000 the year ended 31st March, 2022:  Equity share capital (of Rs. 10
 It has borrowed Rs. 10,00,000
each) = Rs. 50 lakhs
@ 10% p.a. and its equity share Equity share capital (of Rs. 10
capital is Rs. 10,00,000 (Rs. 100  its equity share capital is Rs. each) Rs. 50 lakhs So, Number of shares =
𝟓𝟎,𝟎𝟎,𝟎𝟎𝟎
each). 10,00,000 (Rs. 100 each) 12% Bonds of Rs. 1,000 each = 5,00,000
𝟏𝟎
 Consider tax @ 50%. So, Number of shares = Rs. 37 lakhs
 12% Bonds of Rs. 1,000 each
𝟏𝟎,𝟎𝟎,𝟎𝟎𝟎
Calculate its Degree of Financial = 10,000 Sales = Rs. 37 lakhs
𝟏𝟎𝟎
Leverage. Rs. 84 lakhs
So, Interest on Bond = 12% of
SOLUTION: Fixed cost (excluding interest) 37,00,000 = 4,44,000
Rs. 6.96 lakhs
Sales 24,00,000  Contribu on = Sales × P/V
Less: Variable cost (50% of Sales) 12,00,000 Profit-volume Ra o ra o = 84 Lac * 27.55% =
Contribu on 12,00,000 27.55% 23,14,200
Less: Fixed cost 10,00,000
Par culars Amount (Rs.)
EBIT 2,00,000
Sales 84,00,000
Less: Interest 1,00,000 Contribu on (Sales × P/V ra o) 23,14,200
EBT 1,00,000 Less: Fixed cost (excluding Interest) (6,96,000)
Less: Tax (50%) 50,000 EBIT 16,18,200
EAT 50,000 Less: Interest on debentures (4,44,0000)
No. of equity shares 10,000 (12% Rs.37 lakhs)
EPS 5 EBT 11,74,200
Less: Tax (40%) 4,69,680
𝐄𝐀𝐓 𝟓𝟎,𝟎𝟎𝟎
EAT 7,04,520
EPS = = =5 No. of equity shares 5,00,000
𝐍𝐨 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞 𝟏𝟎,𝟎𝟎𝟎

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Degree of Combined Leverage: SOLUTION 1: point is 2,000 units, if the items
are sold for ₹ 14 per unit.
EPS = 𝐍𝐨
𝐄𝐀𝐓 𝟕,𝟎𝟒,𝟓𝟐𝟎
= 𝟓,𝟎𝟎,𝟎𝟎𝟎 = DTL: Degree of Total Leverage. Statement of Profit (Amt in
𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞
Rs.) The Cost Accoun ng department
1.41 DCL: Degree of Combined
Sales 10,00,000 has currently iden fied variable
Leverage. Less: Variable Cost 7,00,000
Degree of Financial Leverage cost of Rs. 9 per unit.
𝐄𝐁𝐈𝐓 Contribu on 3,00,000
(DFL) = Calculate the degree of opera ng
𝐄𝐁𝐓
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
Less: Fixed Cost 2,00,000
𝟏𝟔,𝟏𝟖,𝟐𝟎𝟎 DCL = EBIT 1,00,000 leverage for sales volume of 2,500
= 𝟏𝟏,𝟕𝟒,𝟐𝟎𝟎 = 1.38 mes 𝐄𝐁𝐓
Less: Interest @ 50,000 units and 3,000 units.
10% on 5,00,000
Earnings before tax 50,000 What do you infer from the
Formula:
(EBT) degree of opera ng leverage at
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
DOL = 𝐄𝐁𝐈𝐓
the sales volumes of 2,500 units
DFL =
𝐄𝐁𝐈𝐓 and 3,000 units and their
ABFM MODULE - B 𝐄𝐁𝐓 Opera ng Leverage =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝟑,𝟎𝟎,𝟎𝟎𝟎 difference if any?
Chapter 8: FINANCIAL AND = =𝟑
𝐄𝐁𝐈𝐓 𝟏,𝟎𝟎,𝟎𝟎𝟎
OPERATING 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
DCL = DOL * DFL = 𝐄𝐁𝐈𝐓
* SOLUTION 2:
LEVERAGES (PART-V) 𝐄𝐁𝐈𝐓 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐄𝐁𝐈𝐓
= Financial Leverage = 𝐄𝐁𝐓
= Par culars 2,500 3,000
𝐄𝐁𝐓 𝐄𝐁𝐓
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
𝟏,𝟎𝟎,𝟎𝟎𝟎
=𝟐 Units Units
DCL = 𝟓𝟎,𝟎𝟎𝟎
Sales @ Rs. 14 35,000 42,000
𝐄𝐁𝐓
per unit
What we will study?
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 Variable cost 22,500 27,000
*How to calculate DCL or DTL? Example 1: Combined Leverage: = 𝐄𝐁𝐓 @ Rs.9 per unit
=
𝟑,𝟎𝟎,𝟎𝟎𝟎
=𝟔 Contribu on 12,500 15,000
A firm has sales of Rs. 10,00,000, 𝟓𝟎,𝟎𝟎𝟎
Fixed cost Rs. 10,000 10,000
variable cost of Rs. 7,00,000 and
[2,000 x (14-9)]
fixed costs of Rs. 2,00,000 and EBIT 2,500 5,000
debt of Rs. 5,00,000 at 10% rate Example 2:
of interest. Z Ltd. has es mated that for a Break-even Point
What are the opera ng, financial new product, the break-even 𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭
= 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
and combined leverages?

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𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭
2000 = 𝟓 PROJECT A PROJECT C PROJECT B
Fixed Cost = 2000*5 = 10000 ₹ 20,00,000 ₹ 60,00,000 ₹ 40,00,000
Degree of Opera ng Leverage =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
𝐄𝐁𝐈𝐓

Degree of Opera ng Leverage

𝟏𝟐𝟓𝟎𝟎
(2500 unit) = 𝟐𝟓𝟎𝟎
=5

Degree of Opera ng Leverage

𝟏𝟓𝟎𝟎𝟎
(3000 unit) = =3
𝟓𝟎𝟎𝟎
CAPITAL INVESTMENT DECISIONS:
The Investment decision is
ABFM MODULE - B concerned with the selec on of
assets in which funds will be
Chapter 9: CAPITAL INVESTMENT EVALUATION TECHNIQUES
invested by a firm.
DECISIONS
Where to invest the Money?
(PART-I)
The Investment of funds has
to be made a er NON – DISCOUNTING DISCOUNTED
What we will study?
CAREFUL ASSESSMENT
*How to make capital investment
decision?
Of various projects Through PAY BACK PERIOD NET PRESENT VALUE (NPV)
*What are the methods available
to evaluate your investment
ACCOUNTING RATE OF
decision? CAPITALBUDGETING
PROITABILITY INDEX (PI)
RETURN (ARR)
*How to calculate Payback Capital Budge ng refers to the
period? INTERNAL RATE RETURN
PROCESS of making decision (IRR)
regarding capital investment in
fixed assets such as machinery, MODIFIED IRR
land, building etc.

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PAY BACK PERIOD: So, buy Machine A because you In 4th year we need only 6,00,000
will get your money back sooner - 4,40,000 = 1,60,000 ₹
How soon can we get our CASH BACK?
than Machine B.
₹1000 In 4th year the actual cash inflow
is = 2,00,000
1 2 3 4 5 6 7
PAY BACK PERIOD: When cash So, the ques on is in how much
inflow is NOT same every year me you will earn ₹ 1,60,000 if
200 200 200 200 200 200 200 you earn total ₹ 2,00,000 in a
If cash inflow of every year is not
year.
No. of years to recover = MACHINE A MACHINE B the same, we have to add up Net
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 Ini al 20,00,000 Cash Inflows from the first year ll 𝟏𝟔𝟎,𝟎𝟎𝟎
Payback Period = 3 years + 𝟐𝟎𝟎,𝟎𝟎𝟎
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰
Investment = the total is equal to the amount
Ini al Investment =
𝟏𝟎𝟎
= 5 years 15,00,000 invested ini ally. (Cumula ve = 3 years + 0.8 =
𝟐𝟎
Cash inflow (per 5,50,000 cash flow is calculated) 3.8 years
year) =5,00,000
Ques 3. An Industry is considering
PAY BACK PERIOD: When cash investment in a project which
inflow is same every year cost ₹ 6,00,000 and Cash Inflows
Ques 1. Ini al Investment = Sol 2: are ₹ 120,000, ₹ 140,000,
30,00,000, Annual cash inflow = ₹ 180,000, ₹ 2,00,000, ₹ 2,50,000. ABFM MODULE - B
Calculate the payback period of
5,00,000 for 10 years. Calculate Now calculate the Payback Chapter 9: CAPITAL INVESTMENT
each machine:
the payback period? Period? DECISIONS
MACHINE A
Sol 1: Sol: (PART-II)
MACHINE B
Pay back Period = 𝟏𝟓,𝟎𝟎,𝟎𝟎𝟎 Ini al Investment: ₹ 6,00,000
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 =
𝟓,𝟎𝟎,𝟎𝟎𝟎
𝐀𝐧𝐧𝐮𝐚𝐥 𝐜𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰 𝟐𝟎,𝟎𝟎,𝟎𝟎𝟎 Years Cash Cumula ve What we will study?
=
= 𝟓,𝟓𝟎,𝟎𝟎𝟎 flows Cash
*How to calculate Cash Inflow
𝟑𝟎,𝟎𝟎,𝟎𝟎𝟎
= 6 years = 3 years = 1 1,20,000 1,20,000
A er Tax (CFAT)?
𝟓,𝟎𝟎,𝟎𝟎𝟎
3.6 years 2 1,40,000 2,60,000
3 1,80,000 4,40,000 *How to calculate Payback
4 2,00,000 6,40,000 Period?
Ques 2. Suggest the management
5 2,50,000
using Payback Period which
machine they should buy?

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Calcula on of Cash Inflow a er years and change in earnings Numerical based on Payback
Tax (CFAT): before taxes and deprecia on of period:
Example 2:
Rs. 45,000 in 2021, Rs. 30,000 in Example 1: Suppose a project
Par culars (Rs.) Suppose ABC Ltd. is analyzing a
Sales value XXX year 2022, Rs. 25,000 in year 2023
costs Rs. 20,00,000 and yields project requiring an ini al cash
Less: Variable Cost (XX) and Rs. 35,000 in year 2024.
annually a profit of Rs. 3,00,000 outlay of Rs. 2,00,000 and is
Contribu on XXX Assume straight-line deprecia on a er deprecia on (@ 10%
expected to generate cash inflows
Less: Fixed Cost (XX) and a 20% tax rate. (straight line method) but before as follows:
(a) Fixed Cash Cost tax at 50%.
You are required to compute net
(b) Deprecia on
cash flows. Solu on: The cash inflow is
Earning Before Tax XXX Year Annual Cash Inflows
calculated as follows:
(EBT) (Rs.)
Less: Tax (XX) SOLUTION 1: 1 80,000
Earning A er Tax (EAT) XXX 2 60,000
Deprecia on = 1,00,000 and life Par culars (Rs.)
Add: Deprecia on XXX 3 60,000
Profit before
Cash Inflow A er Tax XXX of machine = 4 years. 4 20,000
deprecia on and tax
(CFAT) So, Deprecia on in each year = Profit before tax [EBT] 3,00,000
EXAPLE 1: 𝟏,𝟎𝟎,𝟎𝟎𝟎
Less: Tax @ 50% 1,50,000
= 25,000. It’s payback period shall be
𝟒
XYZ Ltd is evalua ng the purchase Profit a er tax [EAT] 1,50,000 computed by using cumula ve
of a new machinery with a Add: Deprecia on 2,00,000 cash flows as follows:
depreciable base of Rs. 1,00,000 Amount in (Rs.) wri en off
and expected economic life of 4 Total cash inflow 3,50,000 Year Annual Cumula ve
Cash Cash Inflows
Year Inflows (Rs.)
2021 2022 2023 2024 The payback period of the project (Rs.)
Earnings before 45,000 30,000 25,000 35,000 shall be: 1 80,000 80,000
deprecia on and tax Payback period =
𝐑𝐬.𝟐𝟎,𝟎𝟎,𝟎𝟎𝟎
= 2 60,000 1,40,000
(EBIDT) or (EBDT) 𝐑𝐬.𝟑,𝟓𝟎,𝟎𝟎𝟎 3 60,000 2,00,000
Less: Deprecia on (25,000) (25,000) (25,000) (25,000) 5.71 Years 4 20,000 2,20,000
EBT 20,000 5,000 0 10,000 While calcula ng cash inflow,
Less: Tax @20% (4,000) (1,000) 0 (2,000) deprecia on is added back to In 3rd year, cumula ve cash
EAT 16,000 4,000 0 8,000 profit a er tax since it does not inflows equal to ini al cash
Add: Deprecia on 25,000 25,000 25,000 25,000 result in cash ou low.
Net Cash flow 41,000 29,000 25,000 33,000

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outlay i.e., Rs. 2,00,000. Hence, ABFM MODULE - B Example: Example:
payback period is 3 years.
Chapter 9: CAPITAL INVESTMENT If you will get ₹1000 a er 2 years If rate of interest is 15% then find
Suppose if in above example, the DECISIONS and rate of interest 10% then find the present value factor (PVF) for
ini al outlay is Rs. 2,05,000 then: the present value of this 0 year (same year), 1 year, 2
(PART-III)
cashflow? years, 3 years.
Payback period shall lie between
3 to 4 years. Solu on: r=
𝟏𝟓
= 0.15
What we will study? 𝟏𝟎𝟎
Since up to 3 years, a sum of Rs. F = 1000 & r=
𝟏𝟎
= 0.1 & 𝟏
*How to calculate Discounted 𝟏𝟎𝟎 PVF for year zero = (𝟏 =
2,00,000 shall be recovered and 𝒓)𝟎
balance of Rs. 5,000 shall be Payback Period? n =2 𝟏
= =1
𝟏
(𝟏 𝟎.𝟏𝟓)𝟎 𝟏
recovered in the part (frac on) of F = P * (𝟏 + 𝐫)𝐧
𝟏
4th year, computa on is as PVF for year one = =
Payback Period: 1000 = 𝐏 ∗ (𝟏 + 𝟎. 𝟏)𝟐 (𝟏 𝒓)𝟏
follows: 𝟏 𝟏
= = 0.870
Example: 1000 = 𝐏 ∗ (𝟏. 𝟏)𝟐 (𝟏 𝟎.𝟏𝟓)𝟏 𝟏.𝟏𝟓
Part of 4th year =
𝟏
𝐁𝐚𝐥𝐚𝐧𝐜𝐞 𝐜𝐚𝐬𝐡 𝐨𝐮𝐭𝐥𝐚𝐲 𝟓,𝟎𝟎𝟎
= 𝟐𝟎,𝟎𝟎𝟎 = Rs. 30,000 cash outlay for a 1000 = 𝐏 ∗ 1.21 PVF for year two = =
𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰 𝐢𝐧 𝟒𝒕𝒉 𝐘𝐞𝐚𝐫 (𝟏 𝒓)𝟐
project with annual cash inflows 𝟏𝟎𝟎𝟎 𝟏 𝟏
𝟎. 𝟐𝟓 𝒚𝒆𝒂𝒓 P= = 826.45 ₹ = 𝟏.𝟑𝟐𝟐𝟓 = 0.756
of Rs. 6,000. What will be 𝟏.𝟐𝟏 (𝟏 𝟎.𝟏𝟓)𝟐
payback period? PVF or PVIF for 2 years: 𝟏
PVF for year three = (𝟏 𝒓)𝟑
=
Thus, total cash outlay of Rs. Solu on: 𝟏 𝟏 𝟏
PVF = 𝒏 = 𝟐 = = 𝟏
𝟑 =
𝟏
= 0.658
2,05,000 shall be recovered in 𝟑𝟎𝟎𝟎𝟎
(𝟏 𝒓) (𝟏 𝟎.𝟏) 𝟏.𝟐𝟏 (𝟏 𝟎.𝟏𝟓) 𝟏.𝟓𝟐𝟎𝟗
3.25 years' me. Payback Period = = 5 years 0.826
𝟔𝟎𝟎𝟎

Discoun ng: So, PVF for 3 years:

Discounted Payback Period:
𝟏 𝟏 𝟏
Discoun ng is the process by PVIF = = = =
(𝟏 𝒓)𝒏 (𝟏 𝟎.𝟏)𝟑 𝟏.𝟑𝟑𝟏 The problem with the Payback
which a cash flow, which is
0.751 so 1000*0.751 = ₹751 Period is that it ignores the me
expected to occur in future, is
So, PVF for 4 years: value of money.
converted to its present value.
𝟏 𝟏 𝟏 In order to correct this, we can
i.e, conver ng future value into PVIF = = = =
(𝟏 𝒓)𝒏 (𝟏 𝟎.𝟏)𝟒 𝟏.𝟒𝟔𝟒𝟏 use discounted cash flows in
present value is called 0.683 so 1000*0.683 = ₹683 calcula ng the payback period.
discoun ng.
Referring back to our example, if
F = P * (𝟏 + 𝐫)𝐧
we discount the cash inflows at

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15% required rate of return, we If the NPV is equal to 0, then the Further, the company's cost of
have: project will neither add value nor capital is 10%.
are you likely to lose.
Year Cash Flow PVF@15% PV (Rs.) Cumula ve [PVIF @ 10% for three years are
(Rs.) PV (Rs.) Posi ve NPV means project can 0.909, 0.826 and 0.751]
1 6,000 0.870 5,220 5,220 be given go ahead and the
2 6,000 0.756 4,536 9,756 nega ve is red signal. SOLUTION:
3 6,000 0.658 3,948 13,704 Net present value (NPV) =
Year Net Cash PVIF @ Discounted
4 6,000 0.572 3,432 17,136
Present value of net cash inflow - Flows 10% Cash Flows
5 6,000 0.497 2,982 20,118
Total net ini al investment. (Rs) (Rs.)
6 6,000 0.432 2,592 22,710
0 (100000) 1.000 (100000)
7 6,000 0.376 2,256 24,966
8 6,000 0.327 1,962 26,928 1 55000 0.909 49995
Decision Rule:
9 6,000 0284 1,704 28,632 2 80000 0.826 66080
If NPV ≥ 0 Accept the Proposal
10 6,000 0.247 1,482 30,114 3 15000 0.751 11265
If NPV ≤0 Reject the Proposal Net Present Value 27340
*How to calculte NPV?
The cumula ve total of Since the net present value of the
discounted cash flows a er ten project is posi ve, the company
The NPV method can be used to
years is Rs. 30,114, discounted Net Present Value (NPV): should accept the project.
select between mutually
payback is approximately 10 The meaning of NPV: A bird in exclusive projects:
years as opposed to 5 years under hand is be er than two in the
The one with the higher NPV
simple payback. bush! A rupee now is more
should be selected. Example 2:
valuable than the same rupee a
year later. Example 1: XYZ Ltd. is analysing capital
ABFM MODULE - B Compute the net present value expenditure proposals for the
This is what the present value
Chapter 9: CAPITAL INVESTMENT means. for a project with a net ini al purchase of equipment, the
DECISIONS investment of Rs. 1,00,000. company uses the net present
Net present value used in terms value technique to evaluate
(PART-IV) of cash flow means the present The net cash flow for year one is
projects.
value of all future cash flows. Rs. 55,000; for year two is Rs.
80,000 and for year three is Rs. The capital budget is limited to
Cash flows mean net flow; Rs. 5,00,000 which XYZ Ltd.
15,000.
difference between the inflow believes is the maximum capital it
What we will study? and ou lows. can raise.

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The ini al investment and Project 2 (Rs.) PV factor PV
projected net cash flows for each Ini al Investment 190000 1.000 (190000)
project are shown below. Year 1 40000 0.893 35720
The cost of capital of XYZ Ltd is 2 50000 0.797 39850
12%. 3 70000 0.712 49840
You are required to compute the 4 75000 0.636 47700
NPV of the different projects. 5 75000 0.567 42525
[PVIF @ 12% for 5 years are Net Present Value 26635
0.893, 0.797, 0.712, 0.636, 0.567]

Project 3 (Rs.) PV factor PV

Project1(Rs.) Project Project 3(Rs) Project 4 (Rs)
Ini al Investment 250000 1.000 (250000)
2(Rs)
Year 1 75000 0.893 66975
Ini al Investment 200000 190000 250000 210000
2 75000 0.797 59775
Year 1 50000 40000 75000 75000
2 50000 50000 75000 75000 3 60000 0.712 42720
3 50000 70000 60000 60000 4 80000 0.636 50880
4 50000 75000 80000 40000 5 100000 0.567 56700
5 50000 75000 100000 20000 Net Present Value 27050

SOLUTION: Project 4 (Rs.) PV factor PV

Calcula on of net present value: Ini al Investment 210000 1.000 (210000)
Project 1 (Rs.) PV factor PV Year 1 75000 0.893 66975
Ini al Investment 200000 1.000 (200000) 2 75000 0.797 59775
Year 1 50000 0.893 44650 3 60000 0.712 42720
2 50000 0.797 39850 4 40000 0.636 25440
3 50000 0.712 35600 5 20000 0.567 11340
4 50000 0.636 31800 Net Present Value (3750)
5 50000 0.567 28350
Net Present Value (19750) We can accept project 2 and If we need to select only one
project 3 because NPV is posi ve. project then we will select Project
3 because its' NPV is very high.

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ABFM MODULE - B Average Investment = Solu on: Year ARR
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐒𝐜𝐫𝐚𝐩 𝐕𝐚𝐥𝐮𝐞 1 𝟖𝟎𝟎𝟎𝟎
× 𝟏𝟎𝟎 = 26.67%
Chapter 9: CAPITAL INVESTMENT 𝟐 Depreca on per year = 𝟑𝟎𝟎𝟎𝟎𝟎
DECISIONS 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐌𝐚𝐜𝐡𝐢𝐧𝐞 𝐒𝐚𝐥𝐯𝐚𝐠𝐞 𝐕𝐚𝐥𝐮𝐞 2 𝟖𝟎𝟎𝟎𝟎
× 𝟏𝟎𝟎 = 34.78%
𝐋𝐢𝐟𝐞 𝐨𝐟 𝐌𝐚𝐜𝐡𝐢𝐧𝐞(𝐲𝐞𝐚𝐫) 𝟐𝟑𝟎𝟎𝟎𝟎
(PART-V) 3 𝟖𝟎𝟎𝟎𝟎
× 𝟏𝟎𝟎 = 50%
Version 1: Annual Basis: Depreca on per year = 𝟏𝟔𝟎𝟎𝟎𝟎
𝟑,𝟎𝟎,𝟎𝟎𝟎 𝟗𝟎,𝟎𝟎𝟎 𝟐,𝟏𝟎,𝟎𝟎𝟎
𝐀𝐑𝐑 = =
𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝟑 𝟑
= 70,000/- Version 2: Total Investment Basis:
𝐈𝐧𝐯𝐞𝐭𝐦𝐞𝐧𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐛𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐨𝐟 𝐭𝐡𝐞 𝐲𝐞𝐚𝐫
× 𝟏𝟎𝟎 𝐀𝐑𝐑
What we will study? Year Profit Deprec Profit 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
=
*How to calculate ARR? Before ia on a er 𝐈𝐧𝐯𝐞𝐭𝐦𝐞𝐧𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐛𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐨𝐟 𝐭𝐡𝐞 𝐲𝐞𝐚𝐫

Version 2: Total Investment Basis: Deprecia (Rs.) Deprecia × 𝟏𝟎𝟎

on (Rs.) on (Rs.) 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 =
𝐀𝐑𝐑
1 1,50,000 70,000 80,000 𝟖𝟎𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 = 80,000
=
𝐈𝐧𝐯𝐞𝐭𝐦𝐞𝐧𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐛𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐨𝐟 𝐭𝐡𝐞 𝐲𝐞𝐚𝐫 2 1,50,000 70,000 80,000 𝟑
Accoun ng Rate of Return (ARR): × 𝟏𝟎𝟎 3 1,50,000 70,000 80,000
ARR = 𝐀𝐑𝐑 =
𝟖𝟎,𝟎𝟎𝟎
× 𝟏𝟎𝟎 = 26.67%
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐍𝐞𝐭 𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐚𝐟𝐭𝐞𝐫 𝐓𝐚𝐱𝐞𝐬 𝟑,𝟎𝟎,𝟎𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 Version 3: Average Investment Value of Investment In (Rs.)
× 100% Basis: Beginning Deprecia End
on (Rs.) Version 3: Average Investment
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
𝐀𝐑𝐑 = × 100 3,00,000 70,000 2,30,000 Basis:
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
ARR =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐫𝐨𝐟𝐢𝐭
× 100% 2,30,000 70,000 1,60,000 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐀𝐑𝐑 = × 100
1,60,000 70,000 90,000 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Average profit made yearly = Example 1:
𝐓𝐨𝐭𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
𝐍𝐨. 𝐨𝐟 𝐘𝐞𝐚𝐫𝐬 Suppose A Ltd. is going to invest Version 1: Annual Basis: 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 =
in a project a sum of Rs. 3,00,000 𝟖𝟎𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎
Where, Yearly Profit = Profit a er 𝐀𝐑𝐑 = 80,000
having a life span of 3 years. 𝟑
Deprecia on and Tax 𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧
Salvage value of machine is Rs. =
𝐈𝐧𝐯𝐞𝐭𝐦𝐞𝐧𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐛𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐨𝐟 𝐭𝐡𝐞 𝐲𝐞𝐚𝐫Average Investment =
Average Investment = 90,000. The profit before × 𝟏𝟎𝟎 𝟑,𝟎𝟎,𝟎𝟎𝟎 𝟗𝟎,𝟎𝟎𝟎
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐒𝐜𝐫𝐚𝐩 = 1,95,000
+ Scrap deprecia on for each year is Rs. 𝟐
𝟐
Value 1,50,000. Calculate ARR?

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Average Investment = Determine the Accoun ng Rate of Determine the accoun ng or Machine A:
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐒𝐚𝐥𝐯𝐚𝐠𝐞 𝐕𝐚𝐥𝐮𝐞
+ Return. average rate of return from the 𝟑𝟔,𝟖𝟕𝟓
𝟐 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 =
following date of two machine A 𝟓
Salvage Value = 7,375
& B:
= Solu on: 𝟓𝟔,𝟏𝟐𝟓 𝟑𝟎𝟎𝟎
𝟑,𝟎𝟎,𝟎𝟎𝟎 𝟗𝟎,𝟎𝟎𝟎 Machine Machine Average Investment =
𝟐
+ 90,000 Version 2: Total Investment Basis: A B 𝟓𝟗,𝟏𝟐𝟓
𝟐

𝟐,𝟏𝟎,𝟎𝟎𝟎 = = 29,562.50
= + 90,000 𝐀𝐑𝐑 Cost 56,125 56,125 𝟐
𝟐
=
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 Es mated life in 5 5 𝐀𝐑𝐑 =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
× 100
= 1,05,000 𝐈𝐧𝐯𝐞𝐭𝐦𝐞𝐧𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐛𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐨𝐟 𝐭𝐡𝐞 𝐲𝐞𝐚𝐫
year 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
× 𝟏𝟎𝟎
+ 90000 = 1,95,000 Es mated 3000 2000 𝟕𝟑𝟕𝟓
𝐀𝐑𝐑 = × 100 = 24.95%
𝟖𝟎,𝟎𝟎𝟎 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 = Salvage Value 𝟐𝟗𝟓𝟔𝟐.𝟓
ARR = × 100 = 41.03% 𝟒,𝟔𝟎,𝟎𝟎𝟎
𝟏,𝟗𝟓,𝟎𝟎𝟎 = 92,000 Tax rate 25% 25% Machine B:
𝟓
𝟑𝟔,𝟖𝟕𝟓
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 = 𝟓
EXAMPLE 2: 𝟗𝟐,𝟎𝟎𝟎 Annual es mated income a er
𝐀𝐑𝐑 = × 𝟏𝟎𝟎 = 9.2% = 7,375
𝟏𝟎,𝟎𝟎,𝟎𝟎𝟎 Deprecia on and Tax:
A project, requiring an 𝟓𝟔,𝟏𝟐𝟓 𝟐𝟎𝟎𝟎
Year Income A Income B Average Investment =
investment of Rs. 10,00,000, 𝟐
𝟓𝟖,𝟏𝟐𝟓
yields profit a er tax and Version 3: Average Investment 1 3,375 11,375 = = 29,062.50
𝟐
deprecia on which is as follows: Basis: 2 5,375 9,375
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
3 7,375 7,375 𝐀𝐑𝐑 = 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
× 100
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
Years Profit a er tax and 𝐀𝐑𝐑 = × 100 4 9,375 5,375
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
deprecia on (Rs) 5 11,375 3,375 𝐀𝐑𝐑 =
𝟕𝟑𝟕𝟓
× 100 = 25.38%
𝟐𝟗𝟎𝟔𝟐.𝟓
1 5000 36,875 36,875
2 75000 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 =
3 125000 𝟒,𝟔𝟎,𝟎𝟎𝟎 Example 4:
4 130000 𝟓
= 92,000 Deprecia on has been charged on
5 80000 straight-line method. Determine the average rate of
Average Investment =
Total 460000 𝟏𝟎,𝟎𝟎,𝟎𝟎𝟎 𝟖𝟎,𝟎𝟎𝟎 return from the following two
𝟐
= 5,40,000 machine A:
𝟗𝟐,𝟎𝟎𝟎 Solu on:
Suppose further that at the end ARR = 𝟓,𝟒𝟎,𝟎𝟎𝟎 × 100 = 17.04% Machine A
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
of the 5th year, the plant and 𝐀𝐑𝐑 = 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
× 100 Cost 56,125
Example 3: Es mated life in 5
machinery of the project can be
sold for Rs. 80,000. year

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Es mated Salvage 3000 Deprecia on has been charged on ABFM MODULE - B Solu on:
Value straight line method.
Chapter 9: CAPITAL INVESTMENT 𝑪𝟎 = 1,00,000 𝑪𝟏 = 55000
Tax rate 25%
Solu on: DECISIONS 𝑪𝟐 = 80000 𝑪𝟑 = 15000
Depreca on per year = (PART-VI)
Annual es mated income before 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐌𝐚𝐜𝐡𝐢𝐧𝐞 𝐒𝐚𝐥𝐯𝐚𝐠𝐞 𝐕𝐚𝐥𝐮𝐞
𝑪𝟏 𝑪𝟐 𝑪𝟑
Deprecia on and Tax: 𝐋𝐢𝐟𝐞 𝐨𝐟 𝐌𝐚𝐜𝐡𝐢𝐧𝐞(𝐲𝐞𝐚𝐫) NPV = + + +
(𝟏 𝒓)𝟏 (𝟏 𝒓)𝟐 (𝟏 𝒓)𝟑
Year Income A Depreca on per year = − 𝑪𝟎
1 15,125 𝟓𝟔,𝟏𝟐𝟓 𝟑,𝟎𝟎𝟎
=
𝟓𝟑,𝟏𝟐𝟓
= 10,625/- What we will study? 𝟓𝟓𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎 𝟏𝟓𝟎𝟎𝟎
2 17,792 𝟓 𝟓 NPV = + +
(𝟏 𝟎.𝟏)𝟏 (𝟏 𝟎.𝟏)𝟐 (𝟏 𝟎.𝟏)𝟑
3 20,458 *How to calculate Profitability - 1,00,000
4 23,125 Index (PI)? 𝟓𝟓𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎 𝟏𝟓𝟎𝟎𝟎
5 25,792 NPV = + + -
(𝟏.𝟏)𝟏 (𝟏.𝟏)𝟐 (𝟏.𝟏)𝟑
36,875 1,00,000
Calcula ng of earnings a er Deposit tax: 𝟓𝟓𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎 𝟏𝟓𝟎𝟎𝟎
NPV = + + -
𝟏.𝟏 𝟏.𝟐𝟏 𝟏.𝟑𝟑𝟏
EBDT Deprecia on EADBT TAX PADT 1,00,000
1 15,125 10,625 4500 1125 3375 NPV:
NPV = 50,000 + 66,116 + 11,270 -
2 17,792 10,625 7167 1792 5575 𝐂𝟏 𝐂𝟐 𝐂𝟑
NPV = + + + 1,00,000
3 20,452 10,625 2458 2458 7375 (𝟏 𝐫)𝟏 (𝟏 𝐫)𝟐 (𝟏 𝐫)𝟑
𝐂𝟒
4 23,125 10,625 3125 3125 9375 (𝟏 𝐫)𝟒
.... − 𝐂𝟎 NPV =1,27,386 - 1,00,000 =
5 25,792 10,625 3792 3792 11375 ₹27,386
Total 36,875
Example 1:
Profitability Index:
Machine A: 𝐀𝐑𝐑 =
𝟕𝟑𝟕𝟓
× 100 = 24.95% Compute the net present value
𝟐𝟗𝟓𝟔𝟐.𝟓 (NPV) for a project with a net This is an index that either
𝟑𝟔,𝟖𝟕𝟓
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 = ini al investment of Rs. 1,00,000. explains or represents the
𝟓
= 7,375 The net cash flow for year one is rela onship between the cost
𝟓𝟔,𝟏𝟐𝟓 𝟑𝟎𝟎𝟎 Rs. 55,000, for year two is Rs. and the benefit of a project
Average Investment = proposal.
𝟓𝟗,𝟏𝟐𝟓
𝟐 80,000 and for year three is Rs.
= 𝟐
= 29,562.50 15,000. It is also called value investment
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 Further, the company's cost of ra o or profit investment ra o.
𝐀𝐑𝐑 = × 100
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 capital is 10%.

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PI is calculated by dividing the discounted cash inflows for these NPV = (𝟏
𝐂𝟏
+ (𝟏
𝐂𝟐
+ (𝟏
𝐂𝟑
+ SOLUTION:
𝐫)𝟏 𝐫)𝟐 𝐫)𝟑
present value of future expected projects are Rs. 6,50,000, Rs. 𝐂𝟒 𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒

cash flows by the ini al 95,000 and Rs. 1,00,30,000 .... − 𝐂𝟎 (𝟏 𝒓)𝟏 (𝟏 𝒓)𝟐 (𝟏 𝒓)𝟑 (𝟏 𝒓)𝟒
....
(𝟏 𝐫)𝟒 PI =
𝑪𝟎
investment amount in the respec vely. 𝐏𝐕 𝐨𝐟 𝐚𝐥𝐥 𝐟𝐮𝐭𝐮𝐫𝐞 𝐜𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰
PI = = 𝑪𝟎 = 1,00,000 𝑪𝟏 = 40000 𝑪𝟐 =
project. 𝐈𝐧𝐭𝐢𝐚𝐥 𝐜𝐚𝐬𝐡 𝐨𝐮𝐭𝐥𝐚𝐲
Calculate the respec ve 𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒
.... 30000 𝑪𝟑 = 50000 𝑪𝟒 = 20000
Higher the Index be er is Profitability Index (PI) for the (𝟏 𝒓)𝟏 (𝟏 𝒓)𝟐 (𝟏 𝒓)𝟑 (𝟏 𝒓)𝟒

profitability of the project. three projects. 𝑪𝟎 PV of all future cash inflow =

𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒
Anything below 1 indicates that + + +
(𝟏 𝒓)𝟏 (𝟏 𝒓)𝟐 (𝟏 𝒓)𝟑 (𝟏 𝒓)𝟒
the project is unprofitable. Previous Example 1:
SOLUTION: = (𝟏
𝟒𝟎𝟎𝟎𝟎
+ (𝟏
𝟑𝟎𝟎𝟎𝟎
+ (𝟏
𝟓𝟎𝟎𝟎𝟎
+
𝑪𝟏 𝑪𝟐 𝑪𝟑 𝟎.𝟏)𝟏 𝟎.𝟏)𝟐 𝟎.𝟏)𝟑
The respec ve Profitability Index NPV = (𝟏 𝒓)𝟏
+ (𝟏 𝒓)𝟐
+ (𝟏 𝒓)𝟑
+ 𝟐𝟎𝟎𝟎𝟎
(𝟏 𝟎.𝟏)𝟒
Profitability Index (PI) for the three projects would be as − 𝑪𝟎
follows: =
𝟒𝟎𝟎𝟎𝟎
+
𝟑𝟎𝟎𝟎𝟎
+
𝟓𝟎𝟎𝟎𝟎
+
𝟐𝟎𝟎𝟎𝟎
=
𝐒𝐮𝐦 𝐨𝐟 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰 NPV = 50,000 + 66,116 + 11,270 - (𝟏.𝟏)𝟏 (𝟏.𝟏)𝟐 (𝟏.𝟏)𝟑 (𝟏.𝟏)𝟒
𝐈𝐧𝐭𝐢𝐚𝐥 𝐜𝐚𝐬𝐡 𝐨𝐮𝐭𝐥𝐚𝐲
PI =
𝟔,𝟓𝟎,𝟎𝟎𝟎
= 1.18 1,00,000 𝟒𝟎𝟎𝟎𝟎 𝟑𝟎𝟎𝟎𝟎 𝟓𝟎𝟎𝟎𝟎 𝟐𝟎𝟎𝟎𝟎
𝐏𝐕 𝐨𝐟 𝐜𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰 𝟓,𝟓𝟎,𝟎𝟎𝟎 = + + + 𝟏.𝟒𝟔𝟒𝟏
= NPV = 1,27,386 - 1,00,000 𝟏.𝟏 𝟏.𝟐𝟏 𝟏.𝟑𝟑𝟏
𝐈𝐧𝐭𝐢𝐚𝐥 𝐜𝐚𝐬𝐡 𝐨𝐮𝐭𝐥𝐚𝐲 𝐑𝐬.𝟗𝟓,𝟎𝟎𝟎
PI = 𝐑𝐒.𝟕𝟓,𝟎𝟎𝟎 = 1.27 = 36,363.64 + 24,793.39 +
𝟏,𝟐𝟕,𝟑𝟖𝟔
PI = 𝟏,𝟎𝟎,𝟎𝟎𝟎
= 1.27 37,565.74 + 13,660.27=
𝐑𝐬.𝟏𝟎𝟎𝟑𝟎𝟎𝟎𝟎
Profitability Index (PI) PI = = 1.001 1,12,383.04
𝐑𝐒.𝟏𝟎𝟎𝟐𝟎𝟎𝟎𝟎
𝐒𝐮𝐦 𝐨𝐟 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰
= Example 3:
𝐓𝐨𝐭𝐚𝐥 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐨𝐮𝐭𝐟𝐥𝐨𝐰
It can be seen that in absolute 𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒
....
The ini al cash outlay of a project (𝟏 𝒓)𝟏 (𝟏 𝒓)𝟐 (𝟏 𝒓)𝟑 (𝟏 𝒓)𝟒
terms, project 3 gives the highest PI =
𝐏𝐕 𝐨𝐟 𝐜𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰 is Rs 1,00,000 and it can generate 𝑪𝟎
= 𝐓𝐨𝐭𝐚𝐥 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐨𝐮𝐭𝐟𝐥𝐨𝐰 cash inflows yet its Profitability 𝟏,𝟏𝟐,𝟑𝟖𝟑.𝟎𝟒
cash inflow of Rs 40,000, Rs = = 1.1238
index is low. This is because the 𝟏,𝟎𝟎,𝟎𝟎𝟎
30,000, Rs 50,000 and Rs 20,000
ou low is also very high. The
in year 1 through 4.
Example 2: Profitability index factor helps us
in ranking various projects. Assume a 10 % rate of discount.
Suppose we have three projects
Calculate PI?
involving discounted cash ou low
of Rs. 5,50,000, Rs. 75,000 and Rs. Profitability Index:
1,00,20,000 respec vely. Suppose
further that the sum of

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ABFM MODULE - B Now NPV = 0 So, 𝑪𝟎 =
𝑪𝟏 The following is the decision rule Let us, to begin with, try r = 14%.
(𝟏 𝒓)𝟏
that should be used for IRR:
Chapter 9: CAPITAL INVESTMENT + (𝟏
𝑪𝟐
+ (𝟏
𝑪𝟑
+ (𝟏
𝑪𝟒 This makes the le -hand side
𝒓)𝟐 𝒓)𝟑 𝒓)𝟒
DECISIONS Accept: If the IRR is greater than equal to:
Or the cost of capital.
(PART-VII) 𝟔𝟎𝟎𝟎𝟎
+
𝟔𝟎𝟎𝟎𝟎
+
𝟖𝟎𝟎𝟎𝟎
+
𝟗𝟎𝟎𝟎𝟎
=
(𝟏.𝟏𝟒)𝟏 (𝟏.𝟏𝟒)𝟐 (𝟏.𝟏𝟒)𝟑 (𝟏.𝟏𝟒)𝟒
NPV = 0 => ∑𝐓𝐭 𝟏
𝑪𝒕
− 𝐂𝟎 = Reject: If the IRR is less than the
(𝟏 𝐈𝐑𝐑)𝐭 2,06,085
cost of capital.
What we will study? 0
This value is slightly higher than
*How to calculate IRR? Where: our target value, 2,00,000.
Example 1:
𝑪𝒕 = Net cash inflow during the So, we increase the value of from
period t. The following example will 14% to 15%.
Internal Rate of return (IRR): illustrate the calcula ons
𝐂𝟎 = Total ini al investment costs. (In general, a higher r decreases
In the context of investment, an involved in arriving at the IRR.
IRR the internal rate of return. and a lower r increases the le -
Internal Rate of Return means an Following are the cash flows of
hand side value).
annual rate of growth in T= the number of me periods. the project of XYZ Ltd.
investment a business is going to The le hand side becomes:
However, the formula is such that Year 0 1 2 3 4
generate. 𝟔𝟎𝟎𝟎𝟎 𝟔𝟎𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎
+ (𝟏.𝟏𝟓)𝟐 + (𝟏.𝟏𝟓)𝟑 + (𝟏.𝟏𝟒𝟓)𝟒 =
𝟗𝟎𝟎𝟎𝟎
the resultant IRR will not be Cash (200 600 600 800 900 (𝟏.𝟏𝟓)𝟏
The concept of calcula ng NPV generated easily and therefore Flow 000) 00 00 00 00 2,01,601
and IRR is the same. permuta ons and combina ons
This value is s ll slightly higher
However, while calcula ng IRR, through excel sheet on trial and
than our target value, 200,000.
the NPV is set to zero. error basis will give you the The IRR is the value of r which
result, which finally can be tested sa sfies the following equa on: So, we increase the value of r
The formula and calcula on used by simple calcula ons. from 15% to 16%.
𝟔𝟎𝟎𝟎𝟎 𝟔𝟎𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎
to determine this figure are as 200000 = + + +
(𝟏 𝒓)𝟏 (𝟏 𝒓)² (𝟏 𝒓)³ The le -hand side becomes:
follows: If this rate of return is higher than 𝟗𝟎𝟎𝟎𝟎
basic or required RR(RRR), then (𝟏 𝒓)𝟒 𝟔𝟎𝟎𝟎𝟎 𝟔𝟎𝟎𝟎𝟎 𝟖𝟎𝟎𝟎𝟎 𝟗𝟎𝟎𝟎𝟎
NPV =
𝑪𝟏
+
𝑪𝟐
+
𝑪𝟑
+ + (𝟏.𝟏𝟔)𝟐 + (𝟏.𝟏𝟔)𝟑 + (𝟏.𝟏𝟔)𝟒 =
𝒓)𝟏 𝒓)𝟐 𝒓)𝟑 only the investment is worth. (𝟏.𝟏𝟔)𝟏
(𝟏 (𝟏 (𝟏 The calcula on of r involves a 1,97,272
𝑪𝟒
(𝟏 𝒓)𝟒
.... − 𝑪𝟎 RRR is equivalent to the cost of process of trial and error.
funds. Since this value is now less than
We try different values of r ll we 200,000, we conclude that the
find that the right-hand side of value of r lies between 15%and
the above equa on is equal to 16%.
2,00,000.

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If a single point es mate of r is ABFM MODULE - B compounded terminal value (TV) Example 1:
needed, the following of the inflows.
Chapter 9: CAPITAL INVESTMENT Consider the following cash flow
interpola on procedure is to be DECISIONS Then an appropriate rate of for a project.
used: discount for this compounded
(PART-VIII) Find out the MIRR for the project.
1. Determine the net present terminal value is found out so
The project's cost of the capital is
value of the two closest rates of that this discounted terminal
value is equal to the total present 10%. [Company expect 15%
return. What we will study? return].
value of the cost of the project
NPV @ 15 percent = 1,601 *How to calculate MIRR? (PVC). This discount rate is called Year 0 1 2 3
NPV@ 16 percent = (2,728) MIRR.
Cash Flow (100) 10 60 80
2. Find the sum of the absolute
values of the net present values
obtained in step 1:
1,601 + 2,728 = 4,329
0 1 2 3
Defini on and explana on of
3. Calculate the ra o of the net
MIRR:
present value at the smaller
discount rate, iden fied in step 1, MIRR: Modified internal Rate of -100 10 60 80
to the sum obtained in step 2: Return TV = FV1 + FV2 + FV3
𝟏𝟔𝟎𝟏
= 0.37 Under this approach, any = PV1 (1+r)𝒏𝟏 + PV2 (1+r)𝒏𝟐 + PV3
𝟒𝟑𝟐𝟗
nega ve cash flow in any period, (1+r)𝒏𝟑
4. Add the number obtained in r = 10 %
during the life of the project, is
step 3 to the smaller discount = 10 (1.1)𝟐 + 60 (1.1)𝟏 + 80 (1.1)𝟎
treated as the cost of the project r is cost of the capital.
rate:
and added to the ini al cost of
Step 1: Find the present value of
15 +0.37 = 15.37% the project by discoun ng at the
cost (PVC):
When done in this manner, the cost of the capital.
PVC = 100 TV = 10*1.21 + 60*1.1 + 80*1 =
internal rate of return that is This is called the Present Value of
Step 2: Calculate the terminal 12.1+66+80 = = 158.10
determined is an approxima on Costs (PVC).
of the actual internal rate of value (TV) i.e., future value of
Also, the project inflows are
return that is extremely near to each cash inflows expected from
compounded at the cost of
being accurate. the project:
capital to arrive at the total

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Step 3: Obtain the MIRR by MIRR = 16.5% (> 15% so accept TV = PV1 (1+r)𝒏𝟏 + PV2 (1+r)𝒏𝟐 +
solving the following equa on: it). PV3 (1+r)𝒏𝟑 + PV4 (1+r)𝒏𝟒
ABFM MODULE - B
PVC = => 100 =
𝟏𝟓𝟖.𝟏𝟎 How to calculate nth root? + PV5 (1+r)𝒏𝟓
( ) (𝟏 𝒓)𝟑 Chapter 10: CAPTIAL BUDGETING
or Step 1: √ -> 12 mes. = 40(1.15)𝟒 + 120(1.15)³ + FOR INTERNATIONAL
Step 2: - 1 [subtract 1]. 160(1.15)² + 200(1.15) + 240
PV of Cash ou lows = PV of PROJECT INVESTMENT DECISIONS
Terminal Value of cash inflow Step 3: ÷ power(n) [here n =3] = 40 * 1.7490 + 120 * 1.5208 + (PART-I)
160 * 1.3225 + 240
FV = PV * (𝟏 + 𝐫)𝐧 => PV = Step 4: +1 [add 1]
𝐅𝐕 = 69.96 + 182.51 +211.60 +230 +
(𝟏 𝐫)𝐧 Step 5: x = -> 12 mes. [mul ply What we will study?
240 = 934.07
𝟏𝟓𝟖.𝟏𝟎 then equal] *What is Capital Asset Pricing
100 =
(𝟏 𝒓)𝟑 Model (CAPM)?
Example 2:
(𝟏 + 𝒓)𝟑 =
𝟏𝟓𝟖.𝟏𝟎
= 1.581 => 1+r = Step 3:
𝟏𝟎𝟎 The calcula on of MIRR can be *What is Arbitrage Pricing Theory
𝟏
illustrated through the following Obtain the MIRR by solving the (APT)?
(𝟏. 𝟓𝟖𝟏) 𝟑

example. Square Limited is following equa on:

(1+r) = 1.165 => r = 1.165 - 1 =
evalua ng a project which has PVC = => 379.13 =
0.165 => 16.5% ( ) Capital Asset Pricing Model
the following ini al investment 𝟗𝟑𝟒.𝟎𝟕 (CAPM):
and cash inflows: (𝟏 𝒎𝒊𝒓𝒓)𝟔
The term CAPM describes the
Year 0 1 2 3 4 5 6
Cash Flow -240 -160 40 120 160 200 240 rela onship between the risk and
𝟗𝟑𝟒.𝟎𝟕
(𝟏 + 𝒓)𝟔 = 𝟑𝟕𝟗.𝟏𝟑 = 2.464 the returns or specifically,
between the systemic risk and
The cost of capital for Square Ltd 𝟏𝟔𝟎
PVC = 240 + 𝟏.𝟏𝟓 = 379.13 [PV (𝟏 + 𝒓)𝟔 = 2.463 => 1+r =
𝟏 expected returns.
is 15%. 𝐅𝐕 (𝟐. 𝟒𝟔𝟑) 𝟔
= ]
(𝟏 𝐫)𝐧 The returns are always based on
Solu on: 1+r = 1.162
Step 2: the risk and the me value of
Step 1: r = 0.162 => 16.2% money.
Calculate the terminal value (TV)
Find the present value of cost
i.e., future value of each cash For pricing of a par cular security
(PVC):
inflows expected from the Conclusion: As the MIRR is higher or investment product, one has to
project: than the cost of capital, the undertake quite a few analyses.
TV = FV1 + FV2 + FV3 + FV4 + FV5 project is acceptable.

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CAPM is one such method. Cost of Equity (𝑹𝒆 ) = Risk-Free Market Risk Premium (𝑹𝒎 − 𝑹𝒇 annually. Calculate the cost of
Rate + Levered Beta × Market Risk or mrp): equity?
This is generally done for risky
assets, so that the price paid is Premium
The difference between the
appropriated to generate Cost of Equity (𝐑 𝐞) = 𝐑 𝐟 + ßL × expected return on an investment Solution 1:
expected returns. (𝐑 𝐦 – 𝐑 𝐟 ) and the risk-free rate is known as
the market risk premium. 𝐑 𝐟 = 4% , ßL = 1.1,
Basically, one would like to find Where:
𝐑 𝐦 – 𝐑 𝐟 = 7% - 3% = 4%
out risk free return over a me. 𝐑 𝐟 = risk-free rate
Cost of Equity (𝐑 𝐞) = 𝐑 𝐟 + ßL ×
A beta is generated, which is a ßL= levered beta Beta (ß): (𝐑 𝐦 – 𝐑 𝐟 )
measure of vola lity or the
𝐑 𝐦 = expected return on The S&P 500 index has 𝐑 𝐞 = 4% + 1.1 x (7% – 3%)
systemic risk compared to the
the market tradi onally been used as a
market as a whole. 𝐑 𝐞 = 8.4%
stand-in for the market when
A security beta is calculated by 𝐑 𝐦 − 𝐑 𝐟 = Market Risk calcula ng beta, which is a
dividing the product of the co- Premium (mrp) measure of the co-variance
Example 2: The investor is all set
variance of the security's returns between the rate of return on a
to buy stocks worth Rs. 455.
and the market returns. company's stock and the return
Risk-Free Rate (𝐑 𝐟 ): Annual returns from such an
If it was possible to accurately on the overall market (systema c
The expected rate of return on an investment are expected to be
forecast future cash flows, this risk). around 9%. Beta factor, in this
investment in a security
type of deriva ve method would Example 1: An investor is case, is 0.8. Risk-free rate is 5%.
considered to have no inherent
not be necessary. considering buying stocks priced This investor expects the market
risks is referred to as the risk-free
However, that not being the case, rate. at Rs. 367, which offer annual to increase in value by 8% within
an investor would like to depend returns of 4%. If beta factor of 1.1 this next year. Calculate 𝑲𝒆 .
The actual risk-free rate that is is associated with this par cular
on such pricing method.
used in CAPM shi s depending stock, one can calculate the
on the yields that are currently expected dividend earnings by Solution 2:
Calcula on of CAPM: available for the selected security. considering the risk-free premium 𝑹𝒇 = 9% , ßL = 0.8,
as 3% and investor expecta on of 𝑹𝒎 – 𝑹𝒇 =8% - 5% = 3%
Cost of Equity (𝑹𝒆 ) or (𝑲𝒆 ).
market apprecia on by 7%
Cost of Equity (𝑹𝒆 ) = 𝑹𝒇 + ßL ×
(𝑹𝒎 – 𝑹𝒇 )

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𝑹𝒆 = 9% + 0.8 x (8% – 5%) Expected Return E(x) = 𝑹𝒇 + ß𝟏 Expected return
𝑹𝒆 = 11.4% * 𝐑𝐏𝟏 + ß𝟐 * 𝐑𝐏𝟐 + ß𝟑 * 𝐑𝐏𝟑 = 3% + (0.6 × 4%) + (0.8 × 2%) + (- ABFM MODULE - B
RP = 𝑹𝒎 – 𝑹𝒇 0.7 × 5%) + (1.3 × 9%) Chapter 10: CAPTIAL BUDGETING
Example 3: = 3% + (2.4%) + (1.6%) + (-3.5%) + FOR INTERNATIONAL
Arbitrage Pricing Theory (APT):
(11.7%) = 15.2% PROJECT INVESTMENT DECISIONS
This is an alterna ve method to The following 4 factors have been
(PART-II)
CAPM. iden fied as explaining a stock's
return and sensi vity to each Example 4:
While CAPM takes into account
factor and the risk premium What we will study?
security returns and market Let’s consider our asset as a
associated with each factor have
returns, this method or theory commodity stock called GOLD *How to calculate risk adjusted
been calculated: (RP means Risk
goes beyond it, thinking that 123. The stock has two risk discount rate?
Premium)
market some mes misprices factors associated with it –
*If Spot rate of USD is given then
securi es. *Gross domes c product (GDP) inflation and the price of the U.S
how to calculate future rate of
growth: ß = 0.6, RP = 4% Dollar currency.
APT, therefore, tries to take USD?
advantages of any or many * Infla on rate: ß = 0.8, RP = 2% 𝑹𝒇 (Risk free rate) = 2%
arbitrage opportuni es or * Gold prices: ß= -0.7, RP = 5% Inflation – Risk Premium = 2%, ISSUES INVOLVED IN EVALUATION
deriva ves in the market or the
* Sensex index return: ß= 1.3, RP Beta = 0.2 OF OVERSEAS PROJECTS:
economy.
= 9% U.S Dollar – Risk Premium =10%,
It uses the linear rela onship While the methods of evalua on
* The risk-free rate is 3% Beta = 0.5 of overseas projects are the same
between the asset's expected
return and a number of as for the domes c projects, the
macroeconomic factors or following issues are involved:
Solu on 3: Solu on 3:
variables that affect or capture
Using the APT formula, the E(x) = Rf + β1 *(RP1) + β2 *(RP2) +
the systemic risk. GDP, Domes c
expected return is calculated as: …+ βn *(RP n) Calcula on of Risk Adjusted
Infla on Rate, Stock Indices, Gold
Discount rate:
Prices, risk free rate of interest Expected Return E(x) = 𝑹𝒇 + ß𝟏 E(x) = 2% + 0.2 * (2%) + 0.5 *
are such factors. * 𝐑𝐏𝟏 + ß𝟐 * 𝐑𝐏𝟐 + ß𝟑 * 𝐑𝐏𝟑 + ß𝟒 (10%) Arriving at an appropriate
* 𝐑𝐏𝟒 + discount rate is essen al for
= 2% + 0.4% + 5% = 7.4%

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applying the discoun ng methods Solu on: 𝒓𝒂 = 0.0888 => The method applied for this will
of project evalua on. 𝒓𝒂 = 0.0888*100 = 8.88% be clear from the following
The formula used is, (𝟏 + 𝒓𝒂 ) =
While the risk-free interest rate or So, the risk-adjusted discount Illustra on:
𝟏 + 𝒓𝒇 × 𝟏 + 𝒓𝒑
discount rate is readily available rate, applicable for cash flows in Example:
Where, 𝒓𝒂 is the risk-adjusted
in both India and the foreign US$, will be 8.88% The following data is provided:
discount rate.
country, we have to arrive at the
relevant risk-adjusted discount 𝒓𝒇 is the risk-free discount * The no onal risk-free interest
rate. rate and Es ma ng the exchange rate in rate in USA is 4%
future years of the project's life: * The no onal risk-free interest
𝒓𝒑 is the risk premium
While evalua on of a domes c rate in India is 7%
The method applied for this will Applying this formula to the
project is same as cash flows are * Current Spot rate of 1 US$ is Rs.
be clear from the following rupee discount rates, we calculate
in rupees and the discounted 80
Illustra on: the risk premium, required by the
value is also calculated in rupees.
company, as under: * We have to calculate the
ILLUSTRATION:
But, in case of an overseas es mated spot rate of US$ at the
(𝟏 + 𝟎. 𝟏𝟐) = (𝟏 + 𝟎. 𝟎𝟕) ×
* The following data is provided: project, the cash flows are in
𝟏 + 𝒓𝒑 or, end of each of the years of the
* The risk-free discount rate in foreign currency. project life.
𝟏. 𝟏𝟐
USA is 4% 𝟏 + 𝒓𝒑 = = 𝟏. 𝟎𝟒𝟔𝟕 So, before discoun ng, we will
𝟏. 𝟎𝟕
have to convert these cash flows
* The risk-free discount rate in Solu on:
Applying the same formula and in to rupees at the prevailing
India is 7%
using the value of 𝒓𝒑 , as arrived exchange rate, to arrive at the The formula used is, 𝐒𝐭 = 𝐒𝟎 ×
* The risk-adjusted discount rate, above, we can calculate the risk present value. (𝟏 𝐫𝐡 ) 𝐭
required by the company in India adjusted discount rate for US$, as (𝟏 𝐫𝐟 )
is 12% This is because our ini al
under: Where, 𝑺𝒕 is the spot rate of US$
investment in the project is
We have to calculate the risk- (𝟏 + 𝒓𝒂 ) = 𝟏 + 𝒓𝒇 × 𝟏 + valued at the present spot rate. at me t,
adjusted discount rate in USA, 𝒓𝒑 or, 𝑺𝟎 is the spot rate today.
which will be acceptable to the
company. (𝟏 + 𝒓𝒂 ) = (𝟏 + 𝟎. 𝟎𝟒) 𝒓𝒉 is the no onal risk-free
× 𝟏. 𝟎𝟒𝟔𝟕 = 𝟏. 𝟎𝟖𝟖𝟖 interest rate in India,

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𝒓𝒇 is the risk-free interest rate ABFM MODULE - B applying the actual/es mated We have to calculate the PV of
in Foreign Country Chapter 10: CAPTIAL BUDGETING spot rate at the me of the cash the cash inflows of the project
FOR INTERNATIONAL PROJECT flow. which has a useful life of 4 years,
(USA in this case)
INVESTMENT DECISIONS These cash flows are then using the Home Currency
approach.
(PART-III) discounted using the domes c
Applying this formula, we risk-adjusted discount rate.
calculate the es mated spot rate
Solu on:
for 1 US$, as under:
This approach will be clear from We have to first calculate the
For first year: What we will study?
the following Illustra on: es mated spot rate for 1 US$, for
𝐒𝟏 = 𝟖𝟎 ×
(𝟏 𝟎.𝟎𝟕)
or *What are the two approaches year 1 , 2 , 3 and 4 as under:
(𝟏 𝟎.𝟎𝟒) ILLUSTRATION:
for foreign project evalua on?
(𝟏 𝟎.𝟎𝟕)
( 𝟏.𝟎𝟕)
𝐒𝟏 = 𝟖𝟎 × (𝟏.𝟎𝟒) = 𝟖𝟎 × The following data is provided: 𝐒𝟏 = 𝟖𝟎 × (𝟏 or
1. Home Currency Approach. 𝟎.𝟎𝟒)

𝟏. 𝟎𝟐𝟖𝟖 = 𝐑𝐬. 𝟖𝟐. 𝟑𝟏𝟎  The cash flows of the project ( 𝟏. 𝟎𝟕)
2. Foreign Currency Approach. 𝐒𝟏 = 𝟖𝟎 ×
are as under (in US$, lakh): (𝟏. 𝟎𝟒)
 Ini al investment 100 = 𝟖𝟎 × 𝟏. 𝟎𝟐𝟖𝟖
For second year:
APPROACHES FOR EVALUATION  First year net cash inflow 30 = 𝐑𝐬. 𝟖𝟐. 𝟑𝟏𝟎
𝐒𝟐 = 𝟖𝟎 × (𝟏. 𝟎𝟐𝟖𝟖)𝟐 = 𝟖𝟎 × OF OVERSEAS PROJECT:  Second year net cash inflow 40
𝟏. 𝟎𝟓𝟖𝟓 = 𝟖𝟒. 𝟔𝟖𝟐𝟎
There are, basically, two  Third year net cash inflow 50
For second year:
approaches for foreign project  Fourth year net cash inflow 50
 The risk-adjusted rupee 𝐒𝟐 = 𝟖𝟎 × (𝟏. 𝟎𝟐𝟖𝟖)𝟐 = 𝟖𝟎 ×
For third year: evalua on, viz.
discount rate, required by the 𝟏. 𝟎𝟓𝟖𝟓 = 𝟖𝟒. 𝟔𝟖𝟐
𝐒𝟑 = 𝟖𝟎 × (𝟏. 𝟎𝟐𝟖𝟖)𝟑 = 𝟖𝟎 × 1. Home Currency Approach.
company which is envisaging
𝟏. 𝟎𝟖𝟖𝟗 = 𝟖𝟕. 𝟏𝟏𝟑𝟎 2. Foreign Currency Approach. project in USA, is 12%
For third year:
 The no onal risk-free interest
rate in USA is 4% 𝐒𝟑 = 𝟖𝟎 × (𝟏. 𝟎𝟐𝟖𝟖)𝟑 = 𝟖𝟎 ×
For fourth year: Home Currency Approach: 𝟏. 𝟎𝟖𝟖𝟗 = 𝟖𝟕. 𝟏𝟏𝟑
 The no onal risk-free interest
𝐒𝟒 = 𝟖𝟎 × (𝟏. 𝟎𝟐𝟖𝟖)𝟒 = 𝟖𝟎 × Under this approach, all the cash rate in India is 7%
𝟏. 𝟏𝟐𝟎𝟑 = 𝟖𝟗. 𝟔𝟐𝟓𝟎 flows of the project are converted  Current Spot rate of 1 US$ is Rs.
in to home currency (rupee) by 80

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For fourth year: So, the Present Value of all the Step 3. Convert ini al investment So, the pay-back period is 𝟐 +
cash inflows of the project is Rs. in foreign currency in to home 𝟐𝟏𝟒𝟒
= 2.49 years or, 2 years and
𝐒𝟒 = 𝟖𝟎 × (𝟏. 𝟎𝟐𝟖𝟖)𝟒 = 𝟖𝟎 × 𝟒𝟑𝟓𝟔
10,852. currency by using actual present
𝟏. 𝟏𝟐𝟎𝟑 = 𝟖𝟗. 𝟔𝟐𝟓 5.88 months.
EVALUATION METHODS: spot rate.
Internal Rate of Return Method
We will not go into the details of Step 4. Find out the period during
Therefore, the cash inflows, (IRR):
the methods as these are already which the cash inflows in home
converted in to rupees, will be, currency are equal to the ini al Step 1. Es mate the spot rate for
discussed in the previous chapter.
Cash Inflow US $ Cash investment in home currency. each year of the project's life by
($) Rates Inflow (₹) We will only illustrate how the using the formula, 𝑺𝒕 = 𝑺𝟎 ×
This is the pay-back period.
(a) (b) (a)*(b) Home Currency approach and the (𝟏 𝒓𝒉 )
𝒕

30 82.310 2469 Foreign Currency approach are 𝟏 𝒓𝒇

40 84.682 3378 applied to these methods. In the example given in above, Step 2. Convert foreign currency
50 87.113 4356
For this, we will use the same the cash flows in home currency cash inflows in to home currency
50 89.625 4481
project, which is men oned in are calculated as under: inflows, by using the spot rates
These cash inflows will have to be the previous illustra ons. arrived at in step 1
Ini al investment 8,000
discounted by the rupee risk- Step 3. Convert ini al investment
adjusted discount rate to arrive at in foreign currency in to home
their Present Value (PV). Evalua on methods using Home
Cash Flow Rs. In Cumula ve currency by using actual present
Currency Approach: Lakh flow
So, spot rate
Pay-back period method: First year 2,469 2,469
𝟐𝟒𝟔𝟗 𝟑𝟑𝟖𝟕 cash inflow
𝐏𝐕 = + Step 1. Es mate the spot rate for
𝟏. 𝟏𝟐 (𝟏. 𝟏𝟐)𝟐 Second year 3,387 5,856 Step 4. By trial and error, find that
𝟒𝟑𝟓𝟔 𝟒𝟒𝟖𝟏 each year of the project's life by cash inflow
+ + discount rate which makes the PV
(𝟏. 𝟏𝟐)𝟑 (𝟏. 𝟏𝟐)𝟒 using the formula, 𝑺𝒕 = 𝑺𝟎 × Third year 4,356 10,212
𝒕 cash inflow of cash inflows equal to the ini al
𝟐𝟒𝟔𝟗 𝟑𝟑𝟖𝟕 (𝟏 𝒓𝒉 )
𝐏𝐕 = + 𝟏 𝒓𝒇 Fourth year 4,481 investment.
𝟏. 𝟏𝟐 𝟏. 𝟐𝟓𝟒𝟒 cash inflow
𝟒𝟑𝟓𝟔 𝟒𝟒𝟖𝟏 Step 2. Convert foreign currency
+ +
𝟏. 𝟒𝟎𝟒𝟗 𝟏. 𝟓𝟕𝟑𝟓 cash inflows in to home currency
𝐏𝐕 = 𝟐𝟐𝟎𝟒 + 𝟐𝟕𝟎𝟎 + 𝟑𝟏𝟎𝟎 inflows, by using the spot rates
+ 𝟐𝟖𝟒𝟖 = 𝟏𝟎, 𝟖𝟓𝟐 arrived at in step 1.

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ILLUSTRATION: NPV method: Profitability Index Method: 𝐏𝐕
𝐏𝐈 =
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
In the example given above, the Step 1. Es mate the spot rate for Step 1. Es mate the spot rate for 𝟏𝟎, 𝟖𝟓𝟐
cash flows in home currency are each year of the project's life by each year of the project's life by = = 𝟏. 𝟑𝟓𝟔
𝟖𝟎𝟎𝟎
calculated as under: using the formula, 𝑺𝒕 = 𝑺𝟎 × using the formula, 𝑺𝒕 = 𝑺𝟎 ×
𝒕 𝒕
(𝟏 𝒓𝒉 ) (𝟏 𝒓𝒉 )
Ini al investment
𝟏 𝒓𝒇 𝟏 𝒓𝒇
Rs. 8,000 lakh
Step 2. Convert foreign currency Step 2. Convert foreign currency ABFM MODULE - B
First year cash inflow
cash inflows in to home currency cash inflows in to home currency Chapter 10: CAPTIAL BUDGETING
Rs. 2469 lakh
inflows, by using the spot rates inflows, by using the spot rates FOR INTERNATIONAL
Second year cash inflow arrived at in step 1. arrived at in step 1.
PROJECT INVESTMENT DECISIONS
Rs. 3387 lakh
Step 3. Convert ini al investment Step 3. Convert ini al investment (PART-IV)
Third year Fourth year cash in foreign currency in to home in foreign currency in to home
inflow Rs. 4356 lakh currency by using actual present currency by using actual present
Fourth year cash inflow spot rate. spot rate.
Rs. 4481 lakh Step 4. Discount the cash inflows Step 4. Discount the cash inflows What we will study?
using the domes c risk-adjusted using the domes c risk-adjusted *All about Foreign Currency
discount rate and find their PV. discount rate and find their PV. Approach?
So, use the following formula to
calculate IRR (r) of the project: Step 5. Calculate NPV by Step 5. Calculate PI by dividing PV *How to calculate Payback
subtrac ng ini al investment by the investment. Period, NPV, PI, IRR using foreign
𝟐𝟒𝟔𝟗 𝟑𝟑𝟖𝟕
𝟖𝟎𝟎𝟎 = + from the PV. currency approach?
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐
𝟒𝟑𝟓𝟔 𝟒𝟒𝟖𝟏 ILLUSTRATION: ILLUSTRATION:
+ +
(𝟏 + 𝐫)𝟑 (𝟏 + 𝐫)𝟒 In the example given above, the
In the example given above, the Foreign Currency Approach:
By trial and error, the rate is PV of the cash flows in home PV of the cash flows in home Under this approach, the cash
about 27%. currency is calculated as Rs. currency is calculated as Rs flows of the project remain in the
10,852 lakhs.
10,852 lakh. So, foreign currency only and are not
So, NPV is 10,852 - 8000 = Rs. converted in to home currency
2,852 lakhs. (rupee).

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These cash flows are then  Current Spot rate of 1 US$ is Rs. adjusted discount rate for US$, as So, the Present Value of all the
discounted, using the risk- 80 under: cash inflows of the project is US$
adjusted discount rate of the 135.55 lakh.
We are required to calculate the (𝟏 + 𝒓𝒂 ) = 𝟏 + 𝒓𝒇 × 𝟏 + 𝒓𝒑
foreign currency. Applying the spot rate given, this
PV of the cash inflows of the or,
The present value of the project, which has a useful life of is equal to
(𝟏 + 𝒓𝒂 ) = (𝟏 + 𝟎. 𝟎𝟒)
discounted cash flow, thus 4, using the Foreign Currency 80 × 135.55$ =
× 𝟏. 𝟎𝟒𝟔𝟕 = 𝟏. 𝟎𝟖𝟖𝟖
arrived, is converted in to home approach. 10,844₹
currency by applying the present So, the risk-adjusted discount
Solu on: We will have to first Note: NPV and PI need
spot rate. rate, applicable for cash flows in
calculate the risk-adjusted US$, will be 8.88% or say, 8.9%. conversion into home currency
discount rate for US$, which will while payback period, IRR use
be acceptable to the company. Now, we will discount the cash
This approach will be clear from foreign currency directly.
inflows in US$, using this risk-
the following Illustra on:
adjusted discount rate for US$, to
ILLUSTRATION: Applying the formula, given in the arrive at the present value of the Evalua on methods using Foreign
The following data is provided: earlier paragraph, we calculate cash inflows Currency Approach:
the risk premium, required by the 𝟑𝟎 𝟒𝟎
 The cash flows of the project company, as under: 𝐏𝐕 = + Pay-back period method:
𝟏. 𝟎𝟖𝟗 (𝟏. 𝟎𝟖𝟗)𝟐
are as under (in US$, lakh): Step 1. Find out the period during
Formula: (𝟏 + 𝐫𝐚 ) = 𝟓𝟎
 Ini al investment 100 +
which the cash inflows in foreign
(𝟏 + 𝐫𝐟 ) × 𝟏 + 𝐫𝐩 (𝟏. 𝟎𝟖𝟗)𝟑
 First year net cash inflow 30 𝟓𝟎 currency are equal to the ini al
 Second year net cash inflow 40 (𝟏 + 𝟎. 𝟏𝟐) = (𝟏 + 𝟎. 𝟎𝟕) × (𝟏 + +
(𝟏. 𝟎𝟖𝟗)𝟒 investment in foreign currency.
 Third year net cash inflow 50 𝐫𝐩 ) or This is the pay-back period.
𝟑𝟎 𝟒𝟎
 Fourth year net cash inflow 50 𝟏. 𝟏𝟐 𝐏𝐕 = +
𝟏. 𝟎𝟖𝟗 𝟏. 𝟏𝟖𝟓𝟗
𝟏 + 𝐫𝐩 = = 𝟏. 𝟎𝟒𝟔𝟕 ILLUSTRATION:
 The risk-free discount rate in 𝟏. 𝟎𝟕 𝟓𝟎 𝟓𝟎
+ + In the example given above, the
USA is 4% 𝟏. 𝟐𝟗𝟏𝟓 𝟏. 𝟒𝟎𝟔𝟒
 The risk-free discount rate in cash flows in foreign currency are
PV = 𝟐𝟕. 𝟓𝟓 +
India is 7% Applying the same formula and calculated as under:
𝟑𝟑. 𝟕𝟑 + 𝟑𝟖. 𝟕𝟐 + 𝟑𝟓. 𝟓𝟓 =
using the value of 𝒓𝒑 , as arrived
 The risk-adjusted discount rate, 𝟏𝟑𝟓. 𝟓𝟓 $
required by the company, in above, we can calculate the risk
India, is 12%

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Ini al investment 100 Step 2. By trial and error, find out NPV method: ILLUSTRATION:
that rate of discount which makes
Step 1. First, calculate the risk- In the example given above, the
Cash Flow $ in Cumula ve PV of cash inflows in foreign adjusted discount rate for foreign risk-adjusted discount rate,
Lakh flow currency, equal to ini al currency, which will be applicable for cash flows in US$,
First year 30 30 investment in foreign currency.
acceptable to the company, by is calculated to be 8.88% or say,
cash inflow This is the IRR of the project. using the formula; 8.9% .
Second year 40 70 Step 3. If the rate calculated in The PV, of the cash inflows,
(𝟏 + 𝒓𝒂 ) = 𝟏 + 𝒓𝒇 × 𝟏 + 𝒓𝒑
cash inflow step 2 is more than that in step 1,
discounted by 8.9% is:
the proposal is acceptable. Step 2. Discount the cash inflows
Third year 50 120 in foreign currency, using this risk- 𝟑𝟎 𝟒𝟎
𝐏𝐕 = +
cash inflow adjusted discount rate for foreign 𝟏. 𝟎𝟖𝟗 (𝟏. 𝟎𝟖𝟗)𝟐
ILLUSTRATION: currency, to arrive at the present 𝟓𝟎
Fourth year 50 +
(𝟏. 𝟎𝟖𝟗)𝟑
cash inflow In the example given above, the value of the cash inflows in
𝟓𝟎
risk-adjusted discount rate, foreign currency. +
(𝟏. 𝟎𝟖𝟗)𝟒
applicable for cash flows in US$, Step 3. Convert the figure, arrived
So, the pay-back period is 𝟐 + is calculated to be 8.88% or say,
𝟑𝟎
at Step 2 to home currency by
= 2.6 years or 8.9% . mul plying it by the present spot PV= 𝟐𝟕. 𝟓𝟓 + 𝟑𝟑. 𝟕𝟑 +
𝟓𝟎
rate. 𝟑𝟖. 𝟕𝟐 + 𝟑𝟓. 𝟓𝟓 =
2 years and 7.2 months. For finding IRR (r), use the
𝐔𝐒$ 𝟏𝟑𝟓. 𝟓𝟓 𝐥𝐚𝐤𝐡.
formula: Step 4. Convert the ini al
investment to home currency by Applying the spot rate given, this
𝟑𝟎 𝟒𝟎
Internal Rate of Return Method 𝟏𝟎𝟎 = + mul plying it by the present spot is equal to
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐
(IRR): rate
𝟓𝟎 𝟓𝟎 80 × 135.55 = Rs. 10,844 lakhs.
+ +
Step 1. First, calculate the risk- (𝟏 + 𝐫)𝟑 (𝟏 + 𝐫)𝟒 Step 5. Calculate NPV by The ini al investment is 100 × 80
adjusted discount rate for foreign subtrac ng ini al investment = Rs. 8000 lakhs.
currency, which will be from the PV
acceptable to the company, by By trial and error, the value of r So, the NPV is 10,844 - 8000 = Rs.
using the formula; can be found, which will be about 2,844 lakhs.
35%.
(𝟏 + 𝐫𝐚 ) = (𝟏 + 𝐫𝐟 ) × 𝟏 + 𝐫𝐩

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Profitability Index Method (PI): ILLUSTRATION: ABFM MODULE - B To explain the sensi vity analysis
Chapter 11: ADJUSTMENT OF due to such varia ons, let's take a
Step 1. First, calculate the risk- In the example given above, the
adjusted discount rate for foreign risk-adjusted discount rate, RISK UNCERTAINTY IN CAPITAL simple example of a project to be
currency, which will be applicable for cash flows in US$, implemented.
BUDGETING DECISION (PART-I)
acceptable to the company, by is calculated to be 8.88% or say, Table A below gives brief but
using the formula; 8.9% . important details of a PET Tube
What we will study? manufacturing project.
(𝟏 + 𝒓𝒂 ) = 𝟏 + 𝒓𝒇 × 𝟏 + 𝒓𝒑 The PV, of the cash inflows,
discounted by 8.9% is: *What is Sensi vity Analysis? Table A
Step 2. Discount the cash inflows
𝟑𝟎 𝟒𝟎 Rs. in Lakhs
in foreign currency, using this risk- 𝐏𝐕 = +
adjusted discount rate for foreign 𝟏. 𝟎𝟖𝟗 (𝟏. 𝟎𝟖𝟗)𝟐 Year 0 Year 1-
currency, to arrive at the present 𝟓𝟎
SENSITIVITY ANALYSIS: 10
+
value of the cash inflows in
(𝟏. 𝟎𝟖𝟗)𝟑 Investment (40,000)
𝟓𝟎 The uncertainty of future Sales 36,000
foreign currency. +
(𝟏. 𝟎𝟖𝟗)𝟒 movements of certain variables Variable (-) 24,000
Step 3. Convert the figure, arrived can move either way, that puts all Costs
PV = 27.55 + 33.73 + 38.72 + 35.55
at Step 2 to home currency by our present es mates and the Fixed Costs (-) 2,000
= US$ 135.55 lakh. Deprecia on (-) 4,000
mul plying it by the present spot project or investments to
Applying the spot rate given, this @10% of
rate. jeopardy. We need to safeguard
is equal to 80 × 135.55 = Rs. project cost
Step 4. Convert the ini al against this. (40000)
10,844 lakh.
investment to home currency by The variables and important Profit before 6,000
mul plying it by the present spot The ini al investment is 100 × 80 components of capital budget are Tax (PBT)
rate = Rs. 8000 lakh. Tax @ 33.33% (-) 2,000
cost, revenue and net profits.
Profit a er 4,000
Step 5. Divide the figure of step 3 Taking all possible variables into Tax (PAT)
by the figure of step 4 to arrive at 𝐏𝐕 account will be a difficult task, Deprecia on (+) 4,000
𝐏𝐈 = Net cash flow 8,000
the PI. 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 making calcula ons complex.
𝟏𝟎, 𝟖𝟓𝟐
= = 𝟏. 𝟑𝟓𝟔 Sensi vity analysis aims to assess
𝟖𝟎𝟎𝟎 On a total investment of Rs.
the impact of changes in each of
these important variables on our 40,000 lakhs, targeted sales are
projec ons or es mates. Rs. 36,000 lakhs. The PAT (Profit

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a er Tax) is Rs. 4,000 lakhs Method 2:
resul ng into net cash flow from
Given Annuity factor: 12% = 5.65
opera ons at Rs. 8,000 lakhs.
PV = 8000*5.65 = 45200
Considering discoun ng rate of
12% and project term as NPV = PV - I = 45202 - 40000 =
5202.
10 years, the Net Present Value
(NPV) works out to This is a normal scenario without We can, therefore, say that the Case 1: If Investment cost goes up
ge ng in to risk arising out of sensi vity analysis is a good to 48000:
Rs. 5,200 lakhs. uncertainty. method of assessing the risk, Rs. in Lakhs
Net Present Value (NPV) enabling us to find out how
Now if we consider the best and Year 0 Year 1-10
calcula on: robust or weak the project is. Investment (48,000)
the worst scenarios in the case of
Method 1: investment, sales, variable cost If we find such impact and Sales 36,000
and fixed cost; the results give iden fy the vulnerable aspects, Variable Costs (-) 24,000
𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎
𝐏𝐕 = + (𝟏.𝟏𝟐)𝟐 + (𝟏.𝟏𝟐)𝟑 + Fixed Costs (-) 2,000
𝟏.𝟏𝟐 you surprises. we can change our plan or make
𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 Deprecia on (-) 4,800
+ (𝟏.𝟏𝟐)𝟓 + (𝟏.𝟏𝟐)𝟔 + (𝟏.𝟏𝟐)𝟕 + amendments to contain the risk. @10% of
(𝟏.𝟏𝟐)𝟒 To calculate the impact of
𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎
+ (𝟏.𝟏𝟐)𝟗 + (𝟏.𝟏𝟐)𝟏𝟎 changes in one variable, we This method can thus be project cost
(𝟏.𝟏𝟐)𝟖
presume that the other variables employed to evaluate the budget (48000)
PV =
𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 Profit before 5,200
+ + + remain constant. and the project to a higher
𝟏.𝟏𝟐 𝟏.𝟐𝟓𝟒𝟒 𝟏.𝟒𝟎𝟒𝟗 Tax (PBT)
𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎
+ 𝟏.𝟕𝟔𝟐𝟑 + 𝟏.𝟗𝟕𝟑𝟖 + 𝟐.𝟐𝟏𝟎𝟕 + degree of risk management.
𝟏.𝟓𝟕𝟑𝟓 The Table B below shows that in Tax @ 33.33% (-) 1,733
𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 𝟖𝟎𝟎𝟎 the worst scenario, if the The limita on of this method is Profit a er Tax 3,467
+ +
𝟐.𝟒𝟕𝟓𝟗 𝟐.𝟕𝟕𝟑𝟏 𝟑.𝟏𝟎𝟓𝟖
investment cost goes up to Rs. that it only shows the NPV and (PAT)
only one variable is changed at a Deprecia on (+) 4,800
48,000 lakhs, the NPV nose dives
Net cash flow 8,267
PV = 7142.86 + 6377.55 + 5694.36 to -1300 (nega ve). me.
Method 2:
+ 5084.21 + 4539.52 + 4053.10 + Similarly, if the sales fall to Rs. To an extent this method is also
3618.76 + 3231.15 + 2884.86 + Given Annuity factor: 12% = 5.65
30,000 Lakhs, the NPV falls to - subjec ve because it depends on
2575.83 = 45202.20 2340(nega ve). the percep on of the decision PV = 8267*5.65 = 46708
NPV = PV - I = 45202 - 40000 = maker of the analyst. NPV = PV - I = 46708 - 48000 = -
5202. 1292 = - 1300.

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ABFM MODULE - B ILLUSTRATION 1: shall have the maximum Calcula on of Net Present Value
Chapter 11: ADJUSTMENT OF effect? (NPV) of the Project
A Ltd. is considering its new
RISK UNCERTAINTY IN CAPITAL project with the following details: Consider Life of the project as 3 Year Year PV Present
BUDGETING DECISION (PART-II) years. Cash factor Value
Sr. No Par culars Figure
Flow @ 6% (PV)
1 Ini al capital Rs. 400 (Rs. in (Rs. in
What we will study? cost Cr. SOLUTION: Cr.) Cr)
2 Annual unit 5 Cr. 0 1.000 (400.00)
*How to Solve Sensi vity Analysis NPV Calcula on: (400.00)
sales
Numerical? 1 0.943 188.60
Calcula on of Net Cash Inflow per
3 Selling price Rs. 100 200.00
per unit year
2 0.890 178.00
Steps involved in Sensi vity 4 Variable cost Rs. 50 200.00
Analysis: Par culars Amount 3 0.840 168.00
per unit
(Rs.) 200.00
The steps that need to be taken in 5 Fixed costs Rs. 50 Cr. A Selling price per 100 Net Present Value 134.60
order to perform a sensi vity per year unit
analysis are as follows: 6 Discount Rate 6% B Variable cost per 50
unit Method 2:
1. Iden fying the factors that C Contribu on per 50 If PVIFA for 6% is 2.673:
have an impact on the NPV (or Calculate: unit (A−B)
IRR) of the project. D Number of units 5 Cr. PV = 200 * 2.673 = 534.6
1. Calculate the Net Present Value sold per year
2. Developing a mathema cal NPV = PV - I = 534.6 - 400 =
(NPV) of the project. E Total Rs.
understanding of the connec ons 134.60
Contribu on (C × 250 Cr.
between the different variables. Assume that the tax rate is
D) In this case, NPV represents the
zero. F Fixed cost per Rs. 50
3. Conduc ng an analysis to outcomes that are most likely to
2. Compute the impact on the year Cr.
determine how the changes in occur rather than the events that
project's NPV considering a G Net cash inflow Rs.
each of the variables will affect actually occur.
per year (E−F) 200 Cr.
the net present value (or internal 2.5% adverse variance in each It's possible that the real
rate of return) of the project. variable. Which variable conclusion will be lower than
projected, or it could end up
being higher.

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Sensi vity Analysis considering accoun ng for 24.82% of the total
2.5 % Adverse in each variable: change.
Par culars Base Selling Variable Fixed Units
The table that follows Factors that can affect the NPV price per cost Per Cost per sold per
demonstrates how to determine are: unit unit year year
increased increased increased reduced
the impact on the NPV of the
Par culars Base New to to to to 4.875
project in terms of percentages Ini al capital cost increase by 2.5% Rs. 400 Cr. Rs. 410 Cr. Rs.97.5 Rs.51.25 Rs.51.25 crore
by adjus ng one variable at a Annual unit sales decreases by 2.5% 5 Cr. 4.875 Cr. crore
me by 2.5 % (in a nega ve Selling price per unit decreases by 2.5% Rs. 100 Rs. 97.50 (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
direc on) while maintaining the Variable cost per unit increases by 2.5% Rs. 50 A Selling
Rs. 51.25
price 100 97.5 100 100 100
other variables in their original Fixed costs per year increases by 2.5% Rs. 50 Cr. per
[Link]
51.25 Cr.
states. B Variable cost 50 50 51.25 50 50
Case 1: Ini al capital cost increase per unit
As a result, it is clear that the C Contribu on 50 47.5 48.75 50 50
change in selling price has the by 2.5% to 410 Cr:
per unit
greatest impact on the NPV, (A−B)
Par culars Base Ini al Capital cost D Number of 5 5 5 5 4.875
increased to Rs. 410 crore. units sold
A Selling price per unit 100 100 per year
B Variable cost per unit 50 50 (units in
C Contribu on per unit (A−B) 50 50 Crores)
D Number of units sold per year 5 5 E Total 250 237.5 243.75 250 243.75
(units in Crores) contribu on
E Total contribu on (C×D) 250 250 (C×D)
F Fixed cost per year 50 50 F Fixed cost 50 50 50 51.25 50
G Net Cash Inflow per year (E−F) 200 200 per year
PV of Net cash inflow per year 534.6 G Net Cash 200 187.5 193.75 198.75 193.75
H (G×2.673) 0 534.60 Inflow per
I Ini al capital cost 400 410 (E−F)
J NPV (H−I) 134.6 124.60 H PV of Net 534.6 501.19 517.89 531.26 517.89
0 cash inflow 0
K Percentage Change NPV -7.43% per year
(G×2.673)

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I Ini al capital 400 400 400 400 400 (Rs.) % change in NPV =
𝟏𝟎𝟔𝟎𝟓 𝟐𝟐𝟔𝟎𝟓
𝟐𝟐𝟔𝟎𝟓
cost
PV of cash on flows (Rs. 1,42,605 *100 =
𝟏𝟐𝟎𝟎𝟎
*100 =-53.09%
J NPV (H−I) 134.6 101.19 117.89 131.26 117.89
45000×3.169) 𝟐𝟐𝟔𝟎𝟓
K Percentage -24.82% -12.41% -2.48% -12.41%
Ini al Project Cost (1,20,000)
Change NPV
NPV 22,605 ₹ 2. NPV when annual cash inflow
decreases to 40500:

Three factors, the project is most (If annual cash inflow is varied
sensi ve to are: (if the variable is adversely by 10%)
ABFM MODULE - B
adversely affected by 10%?) (Rs.)
Chapter 11: ADJUSTMENT OF PV of cash on flows (Rs. 1,28,345
RISK UNCERTAINTY IN CAPITAL Base +10% -10%
Amt 40500×3.169)
BUDGETING DECISION (PART-III) Ini al Project Cost (1,20,000)
Ini al 1,20 1,32, 1,08,
NPV 8,345 ₹
project cost ,000 000 000
Annual cash 450 4950 4050
What we will study? inflow 00 0 0
Ini al Project Cost (Rs.) 1,20,000 % change in NPV =
𝟖𝟑𝟒𝟓 𝟐𝟐𝟔𝟎𝟓
*How to Solve SENSITIVITY Cost of 10% 11% 9%
Annual Cash Inflow (Rs.) 45,000 𝟐𝟐𝟔𝟎𝟓
ANALYSIS Numerical 2? capital *100 =
𝟏𝟒𝟐𝟔𝟎
*100 = - 63.08%
Project Life (years) 4 𝟐𝟐𝟔𝟎𝟓
Cost of Capital 10%
1. NPV when Ini al project cost
ILLUSTRATION 2 3. NPV when cost of capital
Iden fy which of the three increases to 1,32,000:
Analyze how sensi ve a project is increases to 11%:
factors, the project is most (If ini al project cost is varied
to changes in ini al project cost, sensi ve to, if the variable is (If cost of capital is varied
adversely by 10%)
annual cash inflow, and cost of adversely affected by 10%? adversely by 10%)
capital using the following (Rs.)
(Use annuity factors: 10% = 3.169 PV of cash on flows (Rs. 1,42,605 (Rs.)
informa on regarding the
and 11% = 3.103). 45000×3.169) PV of cash on flows 1,39,635
project:
Ini al Project Cost (1,32,000) (Rs. 45000×3.103)
Solu on: Ini al Project Cost (1,20,000)
NPV 10,605 ₹
Calcula on of NPV through NPV 19,605 ₹
Sensi vity Analysis:

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% change in NPV =
𝟏𝟗𝟔𝟎𝟓 𝟐𝟐𝟔𝟎𝟓 Table C
𝟐𝟐𝟔𝟎𝟓
*100 =
𝟑𝟎𝟎𝟎
*100 = - 13.14% (Rs. in lakhs)
𝟐𝟐𝟔𝟎𝟓

Conclusion: Project is most Pessimis c Expected Op mis c

Scenario Scenario Scenario
sensi ve to annual cash inflow.
Investment 48,000 40,000 36,000
Sales 30,000 36,000 42,000
Variable Costs 21,000(70%) 24,000 (66.67%) 27,300 (65%)
Fixed Costs 2,600 2,000 1,600
ABFM MODULE - B This method is an extension of or Deprecia on 4,800 4,000 3,600
a step forward compared to the Pre-Tax profit 1,600 6,000 9,500
Chapter 11: ADJUSTMENT OF
sensi vity analysis where only Tax 540 2,000 3,160
RISK UNCERTAINTY IN CAPITAL Profit a er Tax 1,060 4,000 6,340
BUDGETING DECISION one variable was changed at a
Annual Cash flow from 5,860 8,000 9,940
me. In this method, one plans
(PART-IV) opera ons
for say, three scenarios namely, Net present value (14,900) 5,200 10,080
normal or the expected, Cash Flow X PVIFA(5.65)
op mis c and the pessimis c (12%, 10 year)
scenario.
What we will study?
In the normal scenario, all the However, someone may ask, will
*What is SCENARIO ANALYSIS?
variables show expected values all the variables move in the
and the best values are taken for same direc on at the same me? (Rs.‘000)
SCENARIO ANALYSIS: the op mis c scenario. The answer may not be in
Par culars Year 1 Year 2 Year 3
It is in the pessimis c scenario affirma ve. Worst case 450 400 700
the worst values are placed. ILLUSTRATION 3 Most likely 550 450 800
Best case 650 500 900
Thus, all the variables move in XYZ Ltd. is considering a project
the same direc ons at the same "A" with an ini al outlay of Rs.
me. Determine the net present value
14,00,000 and the possible three
of each scenario based on the
To explain the analysis in figures, cash inflow a ached with the
assump on that the cost of
the following table is presented. project as follows:
capital is 9%.

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If XYZ Ltd is sure about the most 0 1 (1,400) (1,400) ABFM MODULE - B Higher volume of produc ons will
likely result in the first two years 1 0.917 650 596.05 generally reduce the cost of
Chapter 12: DECISION MAKING
but uncertain about the cash flow 2 0.842 500 421.00 produc on due to economy of
3 0.772 900 694.80 (PART-I)
in the third year, then analyze scale, but incremental cost due to
what the NPV will be assuming NPV 311.85 up scaling the facili es may again
the worst-case scenario in the What we will study? change the cost structure.
third year. If XYZ Ltd. is certain about the
*What is COST-VOLUME-PROFIT Higher volume in sales may
SOLUTION: The possible most likely result in first two (CVP) ANALYSIS? accompany with dispropor onate
outcomes will be as follows: years but uncertain about the increase in marke ng cost, some
third year's cash flow, then, NPV, of which will be for brand
Worst Case: expec ng worst case scenario in building and the rest may
Year PVF @ 9 Cash PV the third year, will be as follows: DECISION MAKING USING COST- commensurate with the sales
% Flow VOLUME-PROFIT (CVP) ANALYSIS:
Par culars Year Year Year volumes.
0 1 (1,400) (1,400)
1 2 3 In prac cal terms, the cost,
1 0.917 450 412.65 While pricing will have direct
Worst case 450 400 700
2 0.842 400 336.80 volume and the price are the impact on profitability, it in fact
Most likely 550 450 800
3 0.772 700 540.40 Best case 650 500 900 important ingredients of any determines the breakeven point.
profit analysis.
NPV -110.15 Higher the sales realisa on,
Solu on: Cost has two main components earlier the breakeven point.
namely, fixed and variable.
Most likely: 𝟏 Volume will also have direct
𝐑𝐬. 𝟓, 𝟓𝟎, 𝟎𝟎𝟎 × The fixed cost per unit will go
Year PVF @ 9 Cash PV (𝟏. 𝟎𝟗) impact on absolute profits, which
% Flow 𝟏 down if volume of produc on or too will be a determining factor in
+ 𝐑𝐬. 𝟒, 𝟓𝟎, 𝟎𝟎𝟎 ×
0 1 (1,400) (1,400) (𝟏. 𝟎𝟗)𝟐 sales increases. calcula ng the breakeven point.
1 0.917 550 504.35 𝟏
+ 𝐑𝐬. 𝟕, 𝟎𝟎, 𝟎𝟎𝟎 × Variable cost generally varies An investor will have many
2 0.842 450 378.90 (𝟏. 𝟎𝟗)𝟑
with volume but here too the constraints and criteria while
3 0.772 800 617.60 − (𝐑𝐬. 𝟏𝟒, 𝟎𝟎, 𝟎𝟎𝟎) +
variance will depend on the taking a decision to invest.
NPV 100.85 = 𝐑𝐬. 𝟓, 𝟎𝟒, 𝟓𝟖𝟕 +
Best Case: product mix and the processes
𝐑𝐬. 𝟑, 𝟕𝟖, 𝟓𝟕𝟔 + 𝐑𝐬. 𝟓, 𝟒𝟎, 𝟓𝟐𝟖 − Some important points affec ng
adopted.
Year PVF @ 9 Cash PV (𝐑𝐬. 𝟏𝟒, 𝟎𝟎, 𝟎𝟎𝟎) = 𝐑𝐬. 𝟐𝟑, 𝟖𝟕𝟏. investment decisions due to cost,
% Flow volume and price, which

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ul mately determine profits and F: A speciality product, on the promo on measures, what Example 1: A company
the breakeven point, are noted other hand, can be launched with should be the addi onal sales manufactures cycles for both
below. high price and good margins but volume to meet these costs? adults and children. Given below
A : When we introduce a new may need brand building and *Whether the sales staff should is informa on about cycles made
huge R&D expenditure. for children –
product in the market, we cannot be paid on the basis of fixed
expect high volumes and We can go on giving dozens of salary, commission or, a
therefore the cos ng will be such examples to emphasise the combina on of both?
higher. point that cost, volume and price
*What will happen to the
B : In the aforesaid scenario, we remain the most important and financial results of the
will have to keep the price constant factors affec ng the organisa on, if there is
affordable or prac cally low to profits, breakeven point, and fluctua on in the sales, price,
a ract new set of buyers, which payback period and ul mately output or costs?
the decision-making process for
will delay the breakeven point.
any project investment.
C : In case of a consumer products
having large market, we will have Any change in any one or more of Par culars Tradi onal CVP Analysis Ac vity Based CVP
these factors will need reworking Analysis
to plan for big volumes which will
and reanalysis of the decision- Monthly Demand 10,000 units 10,000 units
require large capital investment.
making process. and Produc on
D: In the aforesaid scenario, to Selling Price Rs. 8,000 per unit Rs. 8,000 per unit
In addi on to being helpful in Variable Cost per unit Rs. 7,500 per unit Rs. 7,500 per unit
carve out a reasonable market
share, huge adver sement and decision making for project Fixed Cost p.m. Rs. 10,00,000 p.m. Rs. 8,00,000 p.m.
implementa on, the CVP analysis (as iden fied under
brand building expenses will have
helps in answering various each cost system)
to be incurred affec ng the cost
and profitability. financial ques ons like:
*How the profits will be affected In the context of a tradi onal CVP A er conduc ng an analysis using
E: Moreover, building large
if we reduce the selling price and study, fixed costs are defined as ac vity-based cos ng, it was
capacity will need huge
increase the volume? costs that do not change in determined that the monthly
investment delaying the payback
propor on to the amount of fixed costs that do not change,
period. *If the fixed costs undergo a
product or service being based on factors such as volume
change due to adver sing
purchased.
campaign or other sales

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or any other cost driver, are Rs. the fixed cost altogether. You are more inventory storage space, the cost of each set-up affect the
8,00,000 per month. required to which will result in an addi onal machine’s overall flexibility?
According to the findings of the (i) Determine the break-even expense of Rs. 50,000 per month Explain.
analysis, a milling machine is point and profit per month using for the business. Solu on:
u lised to cut metal into steer both the classic (tradi onal) CVP (i) (a) Break-even point (units per
support. method and the Ac vity Based Analyse the impact on BEP (units month) and profit per month
The produc on of these steer CVP method. per month) and PPM (earnings under classical(tradi onal) CVP
supports occurs in batches of 25 (ii) As the manager of the plant, it per month). analysis:
units. is in your best interest to limit the
(iii) When should the cost of
A er comple ng a batch amount of mes that the labour be included in the overall
machine needs to be set up so
intended for the children’s cycle, es mate of how much a set-up
the following batch would be that it can operate at full will cost? Explain.
intended for the adult cycles. capacity.
(iv) How shall the number of set-
As a result, there would be a Imagine for a moment that the ups on the milling machine and
change in the set-up following the milling machine has the capability
Selling Price per unit Rs. 8,000
comple on of each batch. If of producing different types of Variable Cost per unit Rs. 7,500
cycles, such as adult cycles, sports Contribu on per unit (S - VC) Rs. 500
10,000 children’s bicycles need to
be manufactured, the needed cycles, and so on at any me. Fixed Cost per month Rs. 10,00,000
Break-even Point (per month in units) 2,000 units
number of set-ups is equal to As a result, you suggest that the 𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭 𝐩.𝐦. 𝐑𝐬.𝟏𝟎,𝟎𝟎,𝟎𝟎𝟎
10,000 steer support divided by batch size of the children’s steer = =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩.𝐮. 𝐑𝐬.𝟓𝟎𝟎 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
25 each batch. This results in a support be increased to 50 Monthly Demand (units) 10,000 units
total of 400 set-ups. individual units in a single batch. Profit per month = Rs. 40,00,000
{Monthly demand (units) × Contribu on per unit}
Each set-up costs Rs. 500, which The current number of set-ups,
− Fixed Cost per month
includes charges for items such as 400 (10,000 units divided by 25 = (10,000 x Rs. 500 per unit) − Rs.
changing the oil and purchasing units), will be reduced to 200 10,00,000
jigs, among other things. (10,000 units divided by 50 units).
In the past, the standard CVP The fabrica on of larger batches
analysis combined this cost with will necessitate the leasing of

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(b) Break-even point (units per Total expense inset up of 400 fact that there are 400 set-ups
month) and PPM (profit per batches = 400*500 = 2,00,000. being conducted each month.
month) under Ac vity Based CVP This would provide management
method. (ii) Break-even point (units per
with addi onal data to work with month) and profit per month
Number of units produced per in order to enhance the under Ac vity Based CVP
batch is 25. Therefore, number of func oning of the opera ons. analysis: Batch size increased
𝟏𝟎,𝟎𝟎𝟎 𝐮𝐧𝐢𝐭𝐬
set-ups will be 𝟐𝟓 𝐮𝐧𝐢𝐭𝐬
= 400 from 25 to 50 units; monthly
per month. set-ups reduce from 400 to 200
per month.
Selling Price per unit Rs. 8,000
Variable Cost per unit Rs. 7,500 Selling Price per unit Rs. 8,000
Contribu on per unit Rs. 500 Variable Cost per unit Rs. 7,500
Fixed Cost per month (per Ac vity Based method) Rs. 8,00,000 Contribu on per unit Rs. 500
Total expense in set up of 400 batches Rs. 2,00,000 Fixed Cost per month (per Ac vity Based method) Rs.
Break-even Point (per month in units) 2,000 units Addi onal cost p.m. for inventory storage = Rs. 50,000 8,50,000
{𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭 𝐩. 𝐦. +(𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐞𝐭𝐮𝐩𝐬 × 𝐜𝐨𝐬𝐭 𝐩𝐞𝐫 𝐬𝐞𝐭𝐮𝐩)
= Total expense in set up of 200 batches = 200*500 Rs.
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩. 𝐮.
𝐑𝐬. 𝟖, 𝟎𝟎, 𝟎𝟎𝟎 + (𝟒𝟎𝟎 × 𝐑𝐬. 𝟓𝟎𝟎 𝐩𝐞𝐫𝐬𝐞𝐭𝐮𝐩) 1,00,000
=
𝐑𝐬. 𝟓𝟎𝟎 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 Break-even Point (per month in units) 1,900
𝐑𝐬. 𝟏𝟎, 𝟎𝟎, 𝟎𝟎𝟎 {𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭 𝐩. 𝐦. +(𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐞𝐭𝐮𝐩𝐬 × 𝐜𝐨𝐬𝐭 𝐩𝐞𝐫 𝐬𝐞𝐭𝐮𝐩) units
= =
𝐑𝐬. 𝟓𝟎𝟎 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩. 𝐮.
Monthly Demand (units) 10,000 units 𝐑𝐬. 𝟖, 𝟓𝟎, 𝟎𝟎𝟎 + (𝟐𝟎𝟎 × 𝐑𝐬. 𝟓𝟎𝟎 𝐩𝐞𝐫 𝐬𝐞𝐭𝐮𝐩)
=
Profit per month = Rs. 40,00,000 𝐑𝐬. 𝟓𝟎𝟎 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
{Monthly demand (units) × Contribu on per unit} − 𝐑𝐬. 𝟗, 𝟓𝟎, 𝟎𝟎𝟎
=
(Fixed Cost per month +Set-up cost per month) 𝐑𝐬. 𝟓𝟎𝟎 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
= (10,000 x Rs. 500 per unit) − (Rs. 8,00,000 Monthly Demand (units) 10,000
+Rs.200,000) = Rs. 50,00,000− Rs. units
10,00,00 Profit per month = Rs.
{Monthly demand (units) × Contribu on per unit} − (Fixed Cost 40,50,000
per month +Set-up cost per month)
= (10,000 x Rs. 500 per unit) − (Rs. 8,50,000 +Rs.1,00,000)
Despite the fact that the BEP either method, the Ac vity-Based
= Rs. 50,00,000− Rs. 9,50,00
units and the earnings each method has brought to light the
month are iden cal when using

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where opera ons are profitable permanent labour is used for Reduced set-up costs result in
has come down from 2,000 to setup, who are otherwise fully increased adaptability to alter the
1,900. engaged in the produc on milling machine’s produc on
This decrease is a ributable to process, addi onal labour batches to accommodate
supplies are unavailable in the different types of cycles.
the savings in the overall set-up
costs that were achieved as a short term, and no further
Analysis:
over me work is possible.
result of there being fewer set- ABFM MODULE - B
A conclusion can be drawn that
ups. (iv) How shall the number of set-
the capacity of the machine can Chapter 12: DECISION MAKING
(iii) Inclusion of labour cost in the ups on the milling machine and
be enhanced if the batch size is
the cost of each set-up affect the (PART-II)
increased. cost of set-up would depend on
their availability: machine’s overall flexibility?
The me that has been saved as a Explain.
result of the reduc on in set-ups (a) The cost of hiring temporary What we will study?
labour or the cost of outsourcing (iv) Setup affects a machine’s
from 400 per month to 200 per *What is Relevant Cost Concept?
produc on efficiency.
month is now available to be opera ons necessary for set-up
employed in the produc on of would be included in the total Reduced number of set-ups or
parts for other cycles. cost of se ng up. reduced set-up me can help DECISION MAKING USING
increase the machine’s RELEVANT COST CONCEPTS:
As a result of there being fewer (b) The cost of permanent labour
used for set-up who are u lisa on. In decision-making, one of the
set-ups, the monthly
expenditures associated with the otherwise idle would not be This also provides the other ways is to classify the costs
set-ups will go down. included in set-up costs because organisa on with the freedom to according to whether they are
the salaries given to them have to alter the batches produced by the relevant or not to a par cular
Even a er taking into account the
be incurred even otherwise: this milling machine to meet the decision.
rise in the cost of storing the
cost is a sunk cost. A sunk cost is needs of both children’s and This concept is called Relevant
goods, profits have gone up by
money that has already been adults’ bicycles. Cost Concept and is valid and
Rs. 50,000 per month (40,50,000
spent and cannot be recovered. applicable for not only while
− 40,00,000). Setup expenses are another issue
(c) The opportunity cost of labour that affects the flexibility of planning an investment, but also
As a direct result of this, the
must be taken into account, in produc on. while running a business, on the
number of units per month
addi on to the hourly labour premises that decision-making is
required to reach the point (BEP)
rate, in situa ons where

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a constant process and cost is an will remain the same, irrespec ve business decision is made while Opportunity cost thus does not
integral part of it. of the decision. the unavoidable costs will have to require the payment of cash or its
Why we call it a Relevant Cost is So, the costs of petrol and diesel be incurred irrespec ve of the equivalent.
because the cost is not a fixed or are relevant costs, while the costs outcome of the decision. It is a poten al benefit or income
one me concept but a concept of road tax and insurance are In our above example, the road that is given up as a result of
relevant at a given me for a irrelevant cost. tax and insurance costs are selec ng an alterna ve over
given situa on. In this example, the costs of road unavoidable costs while the cost another.
of petrol and diesel are the
It varies in total from one tax and insurance are called It may be noted that opportunity
alterna ve to another. “Sunk Costs” as these are made avoidable costs. cost, as a part of decision making,
In fact, every business decision even before the decision-making The relevant cost concept helps will arise only when use of scares
process starts. the decision-making process by resources is involved.
has its cost whether known,
unknown, direct or indirect. Sunk cost does not mean that it is discarding the irrelevant cost data
a wrongly incurred expenditure and thus, make the decision-
Let’s now discuss in more detail making process less complicated. For example:
various cost elements. or has no benefit.
While using the concept of If the forging machine in an
In our above example, road tax
Relevant costs are those future Relevant costs, it is worthwhile to engineering workshop is being
costs, which will be affected by a and insurance costs have to be u lised at only 60% of its capacity
examine the so called
decision whereas, irrelevant costs incurred and have their benefits. for exis ng products, the decision
“Opportunity Costs”.
are those which are not affected The only point is that these are to add another product, which
by the decision. irrelevant to the decision of When you conceive a project, you uses 10% of the poten al
had an alterna ve use available
To give a simple example, if one making a choice of using which of capacity of the forging plant, no
the cars. or was in mind, which could have opportunity cost is involved as we
owns both, a diesel and a petrol given you some X return.
car, and he has to undertake a Relevant costs are also are not sacrificing any produc on
When you use the resources for of exis ng products.
long journey, the decision about categorised as Avoidable costs,
using diesel or petrol car will take while the irrelevant costs are another project, you will lose that However, if it is being used, say at
into account the costs of petrol categorised under Unavoidable opportunity and poten al 95% of its capacity, adding the
income. That lost income is the
and diesel but not the cost of costs. item to the produc on line will
road tax and insurance, as these opportunity cost. result in some sacrifice of the
This is because avoidable costs
costs are already incurred and are incurred only if a specific quan ty of produc on of exis ng

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items, and, therefore, will involve and each case of management the decision of whether to sell or
an opportunity cost. decision will need special and not.
specific study and analysis.
Relevant cost analysis plays a
significant role in decision- Material Inventory Units Required Sale price per unit
making. A Nil 50 Rs. 10 p.u
B 150 @ Rs. 15 p.u 200 Rs. 17 p.u Inventory units
can be sold at Rs. 13
Some of the important areas of Let us check out some relevant C 90 @ Rs. 30 p.u 100 Rs. 23
decision making, which involve cost examples:
the Relevant Cost Concept, are as Example 1: The ABC Company Material A: With zero inventories, = Rs. 13 × 150 + Rs. 17 × 50 = Rs.
under: plans to launch a self-care portal, they will buy all 50 units at Rs. 10. 1,950 + Rs. 850
1. Add or drop a product line or which will result in a reduc on of Hence, relevant costs = 50 units × = Rs. 2800
segment. five posi ons within the Rs. 10 = Rs. 500
company’s customer support
2. Make or buy decision. Material B: We assume that if the
department. Material C:
3. Se ng price of a product. order of buyer X is not accepted,
In this case, the cost that is the units in inventory will have to Rs. 30 per unit is not relevant
4. Accep ng or rejec ng special significant and relevant is the since the current price is Rs. 23.
be sold at the discounted selling
orders. payment for the five personnel Therefore,
price of Rs. 13/unit, as there are
5. Heavy discount offers from posi ons. not many buyers in the market Relevant cost of Material C = 100
suppliers. Example 2: A business has for this product. units x Rs. 23 = Rs. 2,300
6. Import Subs tutes. received orders from buyer X for Our purchase price of Rs. 15/unit
3 materials A, B and C. It already has no meaning.
7. Raw material mix. Example of Make or Buy Decision
has some old inventory of
8. Sale and Deals. As there are only 150 units in the using Relevant Cost Concept:
products B and C, as specified in
inventory, we will have to
9. Outsourcing an ac vity or the following table. A company that specialises in the
purchase 50 units @ 17/unit from
service. produc on of completed items
We have to arrive at the relevant the market to fulfil the order.
needs to have certain
To conclude, the relevant cost cost of each material for making
Hence, relevant cost of material B components.
concept is a very wide concept

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It must choose between Thus, the company is able to Item Cost per Unit (Rs.) Total cost for 50,000 units
manufacturing the components reach the conclusion with the Direct Materials 2 1,00,000
in-house or obtaining them from help of relevant cost analysis that Direct Labour 2 1,00,000
a third party. purchasing the part is a more Overhead Costs 1 50,000
Special Tools 40,000
financially sound choice.
Naturally, the one with the Total Cost = 2,90,000
lowest cost is the one to choose. For example: The ABC Company is
In the case of a make or buy in the business of producing auto
According to the above When it comes to making that
parts, some of which require very
decision, some examples of illustra on, it will cost ABC Rs. decision, having the appropriate
associated costs are direct precise pieces of machinery.
2,50,000 to buy from a supplier. cost analysis form is of the
materials, direct labour, and The company needs a total of utmost importance
And it will cost Rs. 2,90,000 to
other overhead expenses. 50,000 individual units of spare
make the same internally. For example: The company Amol
Let’s say a business needs a parts each year.
Therefore, ABC should con nue makes cheese worth Rs. 10,000
component for a machine. When purchasing from a supplier, outsourcing. per month. Maintenance cost for
They have the op on of procuring the unit price is Rs. 5 (five machinery is Rs. 3,000, Rs. 2,000
the part from a third party or rupees). Total expense = 50,000 * for material, Rs. 2,500 for labour,
5 = 2,50,000/-. Example of Con nue Produc on and Rs. 2,500 for miscellaneous
producing it in-house at the
or Close Business Unit decision, costs.
factory. However, the iden cal
using Relevant Cost Concept:
component can also be Overall expenses amount to Rs.
In the event that the business
manufactured by the company The ques on of whether or not to 10,000 for an income of the same
chooses to outsource certain
itself. con nue opera ons or to shut amount at Rs. 10,000. So, the
func ons, it will need to free up
down individual business units, company might think of
some space that can be rented The following costs are incurred
inevitably arises at some point in discon nuing the cheese unit.
out. by the company when the goods
the life of every company. Amol might con nue with cheese
are produced internally:
If the management decides to
In this case, the management produc on if the expenses are
outsource work it can generate Direct materials = Rs. 2/unit. &
needs to assess whether or not lower, like Rs. 7,500/-.
addi onal cash from rented Direct labour = Rs. 2/unit
the units produced are genera ng
premises. Overhead costs = Rs. 1/unit & the desired income and whether
Special tools = Rs. 40,000 or not the maintenance cost of
the plant and machinery is high. ABFM MODULE - B

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Chapter 12: DECISION MAKING It has been widely used to help The material and labour cost of In the ac vity of assembly, the
the management in taking each pack, ll it reaches the main cost cons tuent (cost
(PART-III)
important decisions like pricing, assembly line, is Rs. 50,000 and driver) is the labour, which is paid
outsourcing etc. Rs. 80,000 respec vely. on hourly basis.
What we will study? The method is used for cos ng of Total cost incurred by assembly In this case, the rate of the cost
*All about decision-making using products, service or even a line, during the year, is Rs. driver is total assembly
𝐜𝐨𝐬𝐭
𝐥𝐚𝐛𝐨𝐮𝐫
Ac vity Based Cos ng (ABC)? customer who is being serviced, 20,00,000, u lising 20,000 labour 𝟐𝟎,𝟎𝟎,𝟎𝟎𝟎
hours used = = Rs. 100
all are termed as objects under hours. 𝟐𝟎,𝟎𝟎𝟎

this method. per labour hour.

Assembly of a 2 wheeler takes, on
The method is named a er an average, 20 labour hours while So, the assembly cost allocated to
ac vity, which is the focus of the the assembly of a 3 wheeler takes each 2-wheeler is Rs. 20×100 =
process. 30 labour hours. 2000 and for 3-wheeler, it is Rs.
30×100 =3000.
DECISION MAKING USING ABC method of cos ng is based We have to find the cost of each
on the fact that the products and 2-wheeler and 3-wheeler using So, the total cost of each 2-
ACTIVITY BASED COSTING (ABC):
services, provided by a company the ABC cos ng method. wheeler is Rs. 52,000 and that of
Prior to the emergence of ABC, each 3 wheelers, Rs. 83,000.
to its customers, involves various Solu on: Direct cost of material
companies typically calculated
such ac vi es which are not
profitability using the alloca on and labour for each pack is
exclusively related to one product known, viz.
method. What is Cost Driver?
or service.
This alloca on method involved Rs. 50,000 and Rs. 80,000 This is any factor that causes a
To clarify further the concept of
alloca ng costs to a product or respec vely. change in the cost of ac vity.
ABC, let us take a simple
customer using metrics such as The issue is how to allocate the These are further classified into
example:
the total number of units cost of assembly, an ac vity Resource Cost Driver and Ac vity
produced, accounts, customers, Example 1: Company SW Ltd.
which is applied to both types of Cost Driver.
or transac ons. purchases CKD (Completely products.
Knocked Down) packs of 2 A Resource Cost Driver measures
Ac vity Based Cos ng (ABC) is For this, we use the term, ‘cost the quan ty of resources
wheelers and 3 wheelers and
used for es ma ng the cost, driver of the ac vity’, i.e. the consumed by an ac vity and the
assembles them to sell in the
which in turn is used for decision- most prominent cons tuent of Ac vity Cost Driver is a measure
market.
making. the cost of the ac vity.

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of produc on, marke ng, hours, and the quan ty of Unemployment insurance Rs. 1,500 total number of purchase orders
research etc. purchase orders. Total Rs. 4,500 in the given case.
Measuring units can be number The following are the company’s Assume that the total number of
of units produced, number of overhead costs, as shown in the Differen ate which overheads are labour hours be 1,000 hours,
sales personnel, number of general ledger: driven by direct machine hours? machine hours be 250 hours and
research projects, number of Machine maintenance Rs. 500 total purchase orders be 100
hours spent on project etc. Equipment deprecia on Rs. 750 orders.
Electricity Rs. 1,250
In the tradi onal approach, we So, Cost driver rate would be
Total Rs. 2,500
allocate the overheads based on
the volume of produc on unlike
in ABC system where the
alloca on is ac vity based Differen ate which overheads are
calculated on the basis of cost General Ledger Amount (Rs.) driven by no of purchase order?
Payroll taxes 1,000 Cost Driver Rate (Rs.)
drivers of the ac vi es. 𝐑𝐬. 𝟒, 𝟓𝟎𝟎 Rs. 4.50 per
Machine 500 Purchasing Dept, labour Rs. 4,000
𝐀𝐜𝐭𝐢𝐯𝐢𝐭𝐲 𝐜𝐨𝐬𝐭 𝐝𝐫𝐢𝐯𝐞𝐫 𝐫𝐚𝐭𝐞 maintenance 𝟏, 𝟎𝟎𝟎 labour hour
𝐓𝐨𝐭𝐚𝐥 𝐜𝐨𝐬𝐭 𝐨𝐟 𝐚𝐜𝐭𝐢𝐯𝐢𝐭𝐲 Purchasing Dept, 4,000 𝐑𝐬. 𝟐, 𝟓𝟎𝟎 Rs. 10 per
= Purchasing Dept. Supplies Rs. 250 𝟐𝟓𝟎 machine hour
𝐀𝐜𝐭𝐢𝐯𝐢𝐭𝐲 𝐝𝐫𝐢𝐯𝐞𝐫 labour
Fringe benefits 2,000 𝐑𝐬. 𝟒, 𝟐𝟓𝟎 Rs. 42.50 per
Purchasing Dept. 250 𝟏𝟎𝟎 purchase order
Total Rs. 4,250
Example 2: Let’s say that the Supplies
management of a company that Equipment 750
manufactures certain electronic deprecia on
Overhead rate is calculated by the
Electricity 1,250
devices has taken a decision to formula: ABFM MODULE - B
Unemployment 1,500
install an ABC system.
insurance Chapter 12: DECISION MAKING
The management comes to the Total 11,250 𝐓𝐨𝐭𝐚𝐥 𝐜𝐨𝐬𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐚𝐜𝐭𝐢𝐯𝐢𝐭𝐲 𝐩𝐨𝐨𝐥
Differen ate which overheads are (PART-IV)
conclusion that there should only 𝐁𝐚𝐬𝐞

be three cost drivers for all driven by direct labour hours? Base being the total number of
overhead expenses, and those Payroll taxes Rs. 1,000 labour hours, machine hours and
What we will study?
are direct labour hours, machine Fringe benefits Rs. 2,000

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*Ac vity Based Cos ng (ABC) manufacturing three products X, Electricity Number of Machine Number of 6 3 2
Method based Numerical? Y and Z. opera ons Machine
3. Data on Cost Drivers was as opera ons
The budgeted costs and
follows:
produc on for the year ending
31st March are as follows: X Y Z You are requested to: Prepare a
Example 3: XYZ Ltd. is a For complete statement for management,
mul product company, produc on: showing the product costs of
X Y Z Batches of material 10 5 15 each product using the ABC
Produc on quan ty (Units) 4,000 3,000 16,00 Per unit of approach.
Resources per Unit: produc on:
Solu on:
- Direct Materials (Kg.) 4 6 3
- Direct Labour (Minutes) 30 45 60 X Y Z Total

Quan ty (units) 4,000 3,000 1,600 -----

The budgeted direct labour rate
Material Weight per unit (Kg.) 4 6 3 -----
was Rs. 10 per hour, and the
1. Budgeted overheads were Total material weight 16,000 18,000 4,800 38,800
budgeted material cost was Rs. 2 analysed into the following: Machine opera ons per unit 6 3 2 -----
per kg. Total opera ons 24,000 9,000 3,200 36,200
Produc on overheads were Total batches of Material 10 5 15 30
budgeted at Rs. 99,450 and were
absorbed to products using the (Rs.) Material handling rate per kg. =
direct labour hour rate. Material handling 29,100 𝐑𝐬.𝟐𝟗,𝟏𝟎𝟎
Kg = Rs. 0.75 per Kg 𝐑𝐬.𝟑𝟏,𝟐𝟎𝟎
𝟑𝟖,𝟖𝟎𝟎 Storage rate per batch =
Storage costs 31,200 𝟑𝟎 𝐛𝐚𝐭𝐜𝐡𝐞𝐬
XYZ Ltd. followed the Absorp on = Rs. 1,040 per batch.
Electricity 39,150 Electricity rate per machine
Cos ng System.
opera ons =
XYZ Ltd. is now considering to 2. The cost drivers iden fied were 𝐑𝐬.𝟑𝟗,𝟏𝟓𝟎
= = Rs. 1.081 per
adopt an Ac vity Based Cos ng as follows: 𝟑𝟔,𝟐𝟎𝟎

system. machine opera ons Unit Cost:

Material Weight of material
The following addi onal handling handled X(Rs.) Y(Rs.) Z(Rs.)
informa on is made available for Storage Number of batches of Direct cost:
this purpose. costs material Direct Labour 5 7.5 10

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Direct Material 8 12 6
Produc on Overhead:
Material Handling 3 4.5 2.25
Electricity 6.49 3.24 2.16
Storage 2.60 1.73 9.75
Total Unit cost 25.09 28.97 30.16
No of units 4000 3000 1600
Total cost 1,00,360 86,910 48,256

Details: Storage price per unit = 𝟏𝟎𝟒𝟎𝟎 𝟓𝟐𝟎𝟎 𝟏𝟓𝟔𝟎𝟎

X Y Z 𝟒𝟎𝟎𝟎 𝟑𝟎𝟎𝟎 𝟏𝟔𝟎𝟎
Direct Labour (10₹/Hour) 30 min 45 min 60 min 2.60 1.73 9.75
5 7.5 10

X Y Z
Direct Material (2₹/Kg) 4 Kg 6 Kg 3 Kg
8 12 6

X Y Z
Material Handling (0.75₹/Kg) 4 Kg 6 Kg 3 Kg
3 4.5 2.25

X Y Z
Electricity (Rs. 1.081/machine opera ons) 6 3 2
6.49 3.24 2.16

X Y Z
Storage (1,040 ₹/batch) 10 5 15
Storage price total 10400 5200 15600
No of units 4000 3000 1600

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