ASC DEGREE COLLEGE

(Affiliated to Bangalore University and Approved by AICTE)

A-3, 1st Main Road, Rajajinagar Bangalore – 560 010
E-mail: ascdclg@[Link] Web: [Link]

SUBJECT FINANCIAL MANAGEMENT COURSE [Link] SEMESTER THIRD

MODULE 4 INVESTMENT DECISION

Investment Decision-Meaning and Definition of Capital Budgeting, Features, Significance –

Steps in Capital Budgeting Process. Techniques of Capital budgeting: Traditional Methods –
SYLLABUS Pay Back Period, and Accounting Rate of Return – DCF Methods: Net Present Value-
Internal Rate of Return under Trail & Error Method using Interpolation & Extrapolation and
Profitability Index- Illustrations.

MEANING OF CAPITAL BUDGETING

▪ Capital budgeting refers to the process of efficiently allocating long-term capital in different
long-term projects or fixed assets with an aim to maximize shareholders wealth in the future
period.
▪ Capital Budgeting is a process of long-range planning involving investment of funds in
long-term projects or fixed assets whose benefits are expected over series of years.
▪ Capital Budgeting is the estimation of long-term expenditure, income, cash inflow, cash
outflow, etc., related to major projects/fixed assets to be undertaken, to check whether they
have worth more than what they cost. For example: setting up of factories, installation of
machinery, creating additional capacity to manufacture etc.

DEFINITIONS OF CAPITAL BUDGETING

According to Charles T Horngren, “Capital budgeting is a long-term planning for making
and financing proposed capital outlays”.
According to Hampton John J, “Capital budgeting refers to firm's formal process for
acquisition and investment of capital”.
FEATURES OF CAPITAL BUDGETING
1. Investment in capital expenditure – It is long term investment which includes launching
a new product, improvisation, modernisation, expansion, developing R & D facility etc.
These activities need huge investment and are often consistent with wealth maximisation
goal.
2. Long term commitment of funds – Business makes long term investments in fixed assets,
intellectual property and so on. Investment is gradually recovered and converted back into
cash over three to five years. Funds are invested in current period to obtain future benefits.
3. Associated with risk and uncertainty – Capital budgeting decisions are associated with
future that is uncertain. Outcome of the project is not known. Hence it involves risk.
4. Strategic and expensive – Capital budgeting decisions are strategic in nature i.e., policies
that have long term impact on a business. Strategic decisions integrate organisational
resources with threats and opportunities. It equips organisation’s capabilities to face threats
and utilise opportunities arising in ever changing environment.
5. Irreversible decision - Capital budgeting is concerned with huge investment in long term
assets. it is very difficult to take back decision as if is difficult to find a market for such
assets.
6. It relates with investment of long-term funds in long-term projects/fixed assets/long-term
activities and generally involve huge funds.
7. It is undertaken to check whether the long-term projects/assets have worth more than what
they cost.

Page 1 of 19
 8. Capital budgeting decisions involve the exchange of current funds for the benefits to be
achieved in future.
9. The future benefits or cash flows are expected to be realized over a series of years and they
have a long-term effect or significant impact on the profitability of the company.
10. Capital budgeting decisions affect company's operations risks and returns for many years.
11. Capital budgeting decisions are irreversible and involve many complexities.
12. They have the effect of increasing the capacity, efficiency or economy of operation of
existing fixed assets.

SIGNIFICANCE or IMPORTANCE or ADVANTAGES OF CAPITAL BUDGETING

1) Capital budgeting decisions involve the investment of substantial amount of funds.
Therefore, it is necessary that the firm should carefully plan its investment program so that
funds are put to most profitable use.
2) Capital budgeting decisions have its effect over a long period of time. These decisions not
only affect the future benefits and costs of the firm, but also influence the rate and direction
of the growth of the firm.
3) Capital budgeting decisions are of irreversible in nature. Once they are taken, the firm may
not be in a position to reverse them back.
4) The capital investment decisions involve an assessment of future events, which in fact is
difficult to predict.
5) Capital budgeting decisions have a long-term effect on the profitability of a concern.
6) Capital budgeting is helpful for taking proper decisions on capital expenditure.
7) It facilitates proper adjustment of production facilities with the sales budget.
8) It provides the basis for long-term financial planning.
9) It avoids over investment and under investment in fixed assets.
10) It indicates proper timings for purchase of fixed assets.
11) It provides a sound policy for depreciation and replacement of fixed assets.
12) It serves as a means of controlling capital expenditure.
13) It furnishes essential information for cash budgeting.
14) A well-established capital budget would enable the management to decide in advance the
finances required and ensure their availability at the right time.
CAPITAL BUDGETING PROCESS or STEPS INVOLVED IN CAPITAL BUDGETING
PROCESS
1. Project Generation: It refers to the generation of investment proposals or projects. The first
step in capital budgeting is to compile investment proposals that may originate from different
levels within a firm. Proposals may be related to adding a new product to the existing product
line or may be related to reducing cost of output or upgradation of plant & machinery etc. It
involves the identification of potential investment opportunities after carrying out SWOT
analysis.
2. Project Screening – Once the proposals are received from all levels of organisation, the
finance department scrutinises each proposal in terms of cost, expected returns, alternative
investment, life of project etc. using capital budgeting techniques.
3. Project Evaluation: Once the investment proposal passes through preliminary screening
stage, they are now assessed in financial terms to determine if they maximise profits of the firm
in the long turn. In other words, it refers to the evaluation of the different investment proposals
in terms of their capital costs and expected returns. Using “Accept or Reject” criteria
organisations judge the desirability of the project.
Following are assessed in each investment proposal –

a) The benefit impact of investment proposal in the long run

b) The cost impact of an investment over time
Page 2 of 19
 c) The risk factors associated with the investment.
d) Cash inflows and Cash outflows of each proposal.
e) Selection and Appraisal of the projects using of Capital Budgeting Techniques
4. Project Selection: It refers to the selection or choosing of the most profitable or desirable
proposal or project from among the various investment proposals. It involves making choice
of the project so as to maximize the shareholders’ wealth.
5. Project Execution or Implementation: It refers to the implementation of the selected
project or proposal with adequate allocation funds. It involves the raising of funds, purchase of
required assets and deployment of assets to carry out the project.
6. Project Control: It involves monitoring the project with the help of feedback reports i.e.,
Capital Expenditure Progress Reports, Performance Reports etc. Systematic procedure should
be developed to review the performance of the project. Comparison of actual performance with
the estimated performance will ensure better control.
7. Project Review or Follow-up of the Project: It refers to the periodical assessment of the
results of the projects that have been implemented by comparing the actual results of the
projects with the estimated results. It involves reviewing the entire project to explain its success
or failure. It may have implication for planning and evaluation.
FACTORS INFLUENCING CAPITAL BUDGETING DECISIONS or DETERMINANTS
OF CAPITAL BUDGETING DECISIONS
1. Availability of funds – Investment’s decisions are influenced by availability of funds.
Funds are available in different sources like equity, debentures, preference capital etc.
Organisations should have the target of recovering cost of funds and hence investment
decisions are to be planned in such a way that it can raise cheaper source of funds.
2. Capital Structure – Capital structure is a combination of equity and debt. Equity capital
is less risky but does not enjoy leverage whereas, debt capital has the benefit of leverage
but has more risk. Hence, organisation should find optimal mix of equity and debt through
which they can recover their initial investment quickly.
3. Taxation Policy – If a company prefers to enjoy the benefit of concession in sales tax,
excise duty, subsidies, it has to choose the investment proposal judiciously. Organisation
should choose such investment proposals that reduces their tax burden and help to recover
investment at the earliest.
4. Government Policies – Industrial policy, foreign trade policy and finance policies of the
government will directly influence investment proposals of the company. Due to
liberalisation, globalisation and privatisation policies of government many Indian
industries have expanded globally. All these policies can influence investment decisions
like “make or buy”, “own or lease”, “continue or shutdown”, “retain or replace” etc.
5. Lending Policies of Financial Institutions – The policies regarding term loan,
documentation, prime lending rate (interest rate), money supply, security margin money,
general state of economy will have direct impact on flow of funds or lending policies. A
business firm seeking financial assistance from financial institutions have to carefully
analyse the impact of policies before making any decisions.
6. Immediate need of the Project – Some investment decisions like expansion,
diversification, R & D etc. may not yield immediate returns. Hence, business organisations
have to take proper care before analysing investment proposals.
7. Earnings – Earnings or Profitability of the proposed project is another important factor
that influence the investment decision. If the earning capacity of the project is not good
i.e., profits are below cut-off rate, it is not advisable to invest in such proposals. If the
project is economically viable and can be implemented.

Page 3 of 19
 8. Capital Return – It refers to payback of investment. The management, while taking an
investment decision has to assess as to how soon it will get back its investment. If a project
takes longer period to cover the invested capital, then such project may not be finalised.
9. Economic Value of the Project – Economic Value means life of the project That is how
long a project can expand cash inflows and outflows with initial investment to satisfy the
funds need of the project. As project progress, it may need additional funds which are to
be generated by running the activities.
10. Working Capital – There are two types of working capital requirement arise in the
concern viz., Permanent Working Capital and Variable or Temporary Working Capital.
The Permanent Working Capital requirements are met by long-term sources and Variable
or Temporary Working Capital requirements are met by short-term sources. Hence,
organisation must consider working capital requirement before finalising investment
proposal.
11. Accounting Practices – While making an investment decisions standard accounting
practices have to be evolved. Accounting policies are different for different types of
projects. The treatment of depreciation, valuation of stock differs from one organisation to
another. The knowledge of these helps business organisations in making investment
decisions.
12. Trends of Earnings – The profit or return on the investment are not constant for a business
firm. As the business risk is associated directly with the profitability, fluctuations in the
earnings are normally seen from the project. It is the duty of finance manager to consider
fluctuating cashflows for choosing best investment proposal.
CAPITAL BUDGETING METHODS or TECHNIQUES
I. Traditional or Non-Discounted Cashflow Methods or Techniques
1. Payback Period Method (PBP)
2. Payback Profitability Method or Post-Payback Profitability Method (PPM)
3. Average or Accounting Rate of Return Method (ARR) or Return on Investment Method.

II. Discounted Cashflow (DCF) Methods or Techniques / Time-Adjusted Methods or Techniques

1. Net Present Value Method (NPV)
2. Internal Rate of Return Method (IRR)
3. Profitability Index Method (PI) or Benefit Cost Ratio Method
I. TRADITIONAL or NON-DISCOUNTED CASHFLOW METHODS
1. PAYBACK PERIOD METHOD (PBP)
The term payback period refers to the period in which the project will generate the
necessary cash to recover the initial investment. It is a traditional and simple method of
evaluating the profitability of capital projects. It does not take the effect of time value of
money. It emphasises more on annual cash inflows, economic life of the project and the
original investments.
Cashflows or Cash inflows refers to profit before depreciation and after tax. (CFBDAT)
ACCEPT or REJECT CRITERIA
In case of independent project, during the process of valuation the company keeps cut off
rate and projects with PBP less than the cut off rate is accepted and vice versa. In case of
more than one project, project with higher PBP will be rejected.

Page 4 of 19
 MERITS
a. It is traditional and old method.
b. It involves simple calculation.
c. Selection or rejection of the project can be made easily.
d. The results obtained under this method is more reliable.
e. It is the best method for evaluating high risk projects.

DEMERITS
a. It is based on the principle of “Rule of Thumb.”
b. It does not recognise the importance of “Time value of money.”
c. It does not consider the profitability of economic life of the project (earnings till
payback period is only considered).
d. It does not recognise the pattern of cash flows and its timing.
e. Payback period concept does not reflect all the relevant dimensions of profitability.

FORMULA
(a) If the Annual Cashflows are Uniform or Equal
𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐨𝐟 𝐭𝐡𝐞 𝐏𝐫𝐨𝐣𝐞𝐜𝐭
Payback Period =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰 𝐨𝐟 𝐭𝐡𝐞 𝐏𝐫𝐨𝐣𝐞𝐜𝐭

(b) When Cashflows are not equal (Unequal Cashflows)

Payback Period =
𝐃𝐢𝐟𝐟𝐫𝐞𝐧𝐜𝐞𝐬 𝐛𝐞𝐭𝐰𝐞𝐞𝐧 𝐎𝐈 & 𝐂𝐂𝐈 𝐮𝐩𝐭𝐨 𝐜𝐨𝐦𝐩𝐥𝐞𝐭𝐞𝐝 𝐲𝐞𝐚𝐫
𝐂𝐨𝐦𝐩𝐥𝐞𝐭𝐞𝐝 𝐘𝐞𝐚𝐫 +
𝐂𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰 𝐚𝐟𝐭𝐞𝐫 𝐂𝐂𝐈
OI = Original Investment
CCI = Cumulative Cash inflow

𝐂𝐨𝐬𝐭 𝐨𝐟 𝐭𝐡𝐞 𝐀𝐬𝐬𝐞𝐭 − 𝐒𝐜𝐫𝐚𝐩 𝐯𝐚𝐥𝐮𝐞

Depreciation =
𝐄𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐝 𝐋𝐢𝐟𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐀𝐬𝐬𝐞𝐭

NOTE: All techniques under investment decisions require Cash inflows for calculation
purpose. Either Cash inflow Before Depreciation and After Tax (CFBDAT) or Cash
inflow After Depreciation and After Tax (CFADAT). This can be calculated with the
help of following format:
Particulars Amount
Cash inflow Before Depreciation and Before Tax (CFBDBT) xxx
Less: Depreciation xxx
Cash inflow After Depreciation and Before Tax (CFADBT) xxx
Less: Tax xxx
Cash inflow After Depreciation and After Tax (CFADAT) xxx
Add: Depreciation xxx
Cash inflow Before Depreciation and After Tax (CFBDAT) xxx

Alternatively,
CFBDBT Less: CFADBT Less: CFADAT Add: CFBDAT
Depreciation Tax Depreciation

Page 5 of 19
2. PAYBACK PROFITABILITY OR POST-PAYBACK PROFITABILITY METHOD (PPM)
Payback Profitability or Post-Payback Profitability Method (PPM) is an improvement of
payback period. This method was developed to remove the drawbacks of the payback period
method.
One of the major drawbacks of payback period method is that it does not consider the cash
inflows earned after payback period and as a result of this the true profitability of the investment
proposal cannot be judged. Therefore, in post payback profitability method the cash inflows
that would be generated or earned from a project during its economic life after recovering initial
investment is taken as a criterion for accepting or rejecting investment proposal or evaluating
the profitability of the project.
FORMULA
Particulars Amount (Rs.)
Total Cash inflow generated during the economic life of the asset or project XXX
Less: Original Investment XXX
Payback Profitability or Post-payback Profitability XXX
ACCEPT or REJECT CRITERIA
In case of independent project, if the proposal generates profits after recovering initial
investment during its economic life it should be accepted, if not rejected. In case of mutually
exclusive proposals after making comparison, whichever proposal yields high profits post
recovery of initial investment should be selected.
MERITS
a. It is based on simple calculations
b. Less time consuming.
c. It is easy to follow and even a non-finance executive can also understand the concept.
d. It takes into account the earnings of the project of entire life.
DEMERITS
a. It is also based on the principle “Rule of thumb.”
b. It doesn’t consider the impact of time value of money.
c. It ignores depreciation.
PROBLEMS ON PAYBACK PERIOD (PBP) METHOD
1. A Project requires an initial investment of Rs. 60,000 and yields an annual cash inflow of
Rs. 20,000 for 8 years. The Payback Period will be?
2. Calculate Payback Period.
Particular Project X Project Y
Purchase Price 1,00,000 1,68,000
Estimated Life in Years 8 Years 10 Years
Cash Inflow (Before Depreciation After Tax) 20,000 24,000
3. A Project involves a total initial expenditure of Rs. 4,00,000 and it is estimated to generate
future cash inflow of Rs. 60,000, Rs. 76,000, Rs. 50,000, Rs. 44,000, Rs. 72,000, Rs. 80,000,
Rs. 80,000, Rs. 56,000, Rs. 48,000, Rs, 48,000. Calculate Pay Back Period (PBP).
4. Calculate Payback Period.
Year Cash Inflow
1 6,20,000
2 6,20,000
3 6,20,000
4 6,20,000
5 14,48,000
Original Investment or Cost of the Machine is Rs. 20,00,000.
Page 6 of 19
5. A Company is considering an investment proposal to install a new machine. The machine
will cost Rs. 50,000 and will have a life of 5 years and no salvage value. The company’s tax
rate is 50%. The company uses Straight Line Method of depreciation. The estimated Net
Income Before Depreciation and Tax (EBDT) from the investment proposal is as follows:
Year Cash Inflow
1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Calculate Payback Period.
6. A Limited Company is considering investment in a project requiring a capital outlay of Rs.
2,00,000. Forecast for Annual Income After Depreciation but Before Tax (CFADBT) is as
follows:
Year CFADBT
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000
Depreciation may be taken as 20% on original cost and taxation at 50% of net income. You are
required to evaluate the project by the method of Payback Period.
7. Ganesh and Company is considering the purchase of a machine. Two Machines X and Y
each costing Rs. 50,000 is available. Earnings After Taxation (EAT) are expected to be as
under. Calculate Payback Period.
Year Machine X Machine Y
(Rs.) (Rs.)
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000

8. The Directors of Alpha Limited are contemplating the purchase of new machine, which has
been in operation in the factory for the last 5 years. Ignoring interest but considering tax at 50%
of net earnings, suggest which of the two alternatives should be preferred using Payback Period
Method. The following are the details.
Particulars Old Machine New Machine
Purchase Price Rs. 40,000 Rs. 60,000
Estimated Life of Machine 10 Years 10 Years
Machine Running Hours Per Annum 2000 2000
Units Per Hour 24 36
Wages Per Running Hour Rs. 3 Rs. 5.25
Power Per Annum Rs. 2,000 Rs. 4,500
Consumable Stores Per Annum Rs. 6,000 Rs. 7,500
All other charges Per Annum Rs. 8,000 Rs. 9,000
Material Cost Per Unit Rs. 0.50 Rs. 0.50
Selling Price Per Unit Rs. 1.25 Rs. 1.25
You may assume that the above information regarding sales and cost of sales will hold well
throughout the economic life of each of the machines.

Page 7 of 19
9. X Limited is considering the purchase of a new machine, which would carry out some
operations at present being performed by manual labour. Two alterative models under
consideration are A and B. Following is the information.
Particulars Machine ‘A’ Machine ‘B’
Cost of Machines 1,50,000 2,50,000
Expected Life in Years 5 6
Cost of Indirect Material P.A 6,000 8,000
Estimated Savings in Scarp P.A 10,000 15,000
Additional Cost of Maintenance P.A 19,000 27,000
Estimated Savings in Wages:
Employees not required 15 20
Wages Per Employees P.A Rs. 6,000 Rs. 6,000
Tax is to be regarded as 50% (Ignore Depreciation for Calculating Tax). Using Payback Period,
suggest which model should be purchased.

10. Bhagwan Electronics Ltd. is planning to introduce mechanization to replace the labour
force. Two alternatives are available, advise the management to select the machine under
Payback Period Method.
Particulars Machine X Machine Y
Cost of the Machine 50,000 40,000
Estimated life of the Machines 10 Years 8 Years
Estimated Scrap Savings per year 1,000 1,000
Estimated Cost of Materials P.A 2,000 3,000
Maintenance Cost P.A 2,500 3,100
Additional Cost of Supervision 1,500 2,000
Estimated savings in Wages 10,000 12,500
Depreciation will be taken on Straight line basis. Assume a tax rate of 50%.
3. AVERAGE or ACCOUNTING RATE OF RETURN METHOD (ARR) or RETURN
ON INVESTMENT METHOD.
Accounting Rate of Return means the average annual yield on the project. It is one of the
important methods of capital investment technique, which takes into account earnings over the
whole life of the project. It is also known as ‘Average Rate of Return Method’. Under this
method, various projects are ranked on the basis of rate of return.
This method divides the average profit by average investment to arrive at the ratio or return
that can be expected on the investment proposals. Profits earned on the amount of investment
proposal is expressed in terms of percentage, hence this method is also called as “Return on
Investment Method”.
ACCEPT or REJECT CRITERIA
In case of independent investment proposal, we have to compare ARR of the proposal with the
cut off rate. If ARR is more than or equal to cut off rate accept the project and vice versa. In
case of two or more projects, compare all the projects and projects having highest ARR should
be accepted.
MERITS
a. It is very easy to calculate and simple to understand.
b. This method takes into account the earnings over entire economic life of the project.
Therefore, provides a better comparison than payback period method.
c. This method recognises the concept of ‘net earnings’ i.e., earnings after tax and
depreciation, which is vital factor in evaluating investment proposal.
d. It can be readily calculated by using accounting data.
e. This method can be easily used for comparing and ranking the projects.
Page 8 of 19
 DEMERITS
a. It is based upon accounting profit and not cashflows.
b. This method ignores the time value of money.
c. It does not consider the length of life of the projects.
d. It is not consistent with the firm’s objective of maximising the market value of shares.
e. It ignores the fact that the profit earned can be reinvested.
Note: In ARR calculations, Cash flow means: Cash Flow After Depreciation and After Tax
(CFADAT)
FORMULA
Accounting Rate of Return (ARR)
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐈𝐧𝐜𝐨𝐦𝐞 𝐀𝐟𝐭𝐞𝐫 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐚𝐧𝐝 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱
ARR = 𝐗 𝟏𝟎𝟎
𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Or
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐈𝐧𝐜𝐨𝐦𝐞 𝐀𝐟𝐭𝐞𝐫 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐚𝐧𝐝 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱
ARR = 𝐗 𝟏𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

𝐓𝐨𝐭𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐚𝐧𝐝 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱

Average Annual Income =
𝐍𝐨.𝐨𝐟 𝐘𝐞𝐚𝐬 𝐨𝐫 𝐄𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐝 𝐋𝐢𝐟𝐞

𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 (−) 𝐒𝐜𝐚𝐫𝐩 𝐕𝐚𝐥𝐮𝐞

Average Investment =
𝟐
Or
𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 (−) 𝐒𝐜𝐚𝐫𝐩 𝐕𝐚𝐥𝐮𝐞
Average Investment = + (Additional Working Capital (+) Scrap Value)
𝟐

PROBLEMS ON ACCOUNTING RATE OF RETURN (ARR) METHOD

11. ‘X’ Ltd. has under consideration the following Two Projects. The details are as under.
Particulars Project ‘X’ Project ‘Y’
Investment in Machinery 10,00,000 15,00,000
Working Capital 5,00,000 5,00,000
Life of the Machinery 4 Years 6 Years
Scarp Value of Machinery 10% 10%
Tax Rate 50% 50%
Income Before Depreciation and Tax
Year Rs. Rs.
st
1 Year 8,00,000 15,00,000
2nd Year 8,00,000 9,00,000
rd
3 Year 8,00,000 15,00,000
4th Year 8,00,000 8,00,000
th
5 Year NIL 6,00,000
th
6 Year NIL 3,00,000
You are required to calculate the ARR and suggest which project is to be preferred.

12. Determine the Accounting Rate of Return (ARR) from the following 2 Machines ‘X’ and ‘Y’.
Particulars Machine ‘X’ Machine ‘Y’
Original Cost 56,125 56,125
Additional Investment in Working Capital 5,000 6,000
Estimated Life in Years 5 Years 5 Years
Estimated Salvage Value (SV) 3,000 3,000
Income Tax Rate 55% 55%

Page 9 of 19
Annual estimated Income after Depreciation and Tax
Year Machine ‘X’ (Rs.) Machine ‘Y’ (Rs.)
1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
Total 36,875 36,875
Depreciation charged on Straight-line basis.
13. A Project requires an initial investment of Rs. 6,00,000 and have scrap value of Rs. 30,000
after 5 years. Its Net Earnings After Taxes are.
Year 1 2 3 4 5
Rs. 50,000 70,000 80,000 60,000 10,000
14. Calculate ARR for Project ‘A’ & ‘B’ from the following.
Particulars Project ‘A’ Project ‘B’
Investment 20,000 30,000
Expected life 4 Years 5 Years
Projected Net Income (After Interest, Depreciation and Tax)
Year Project ‘A’ (Rs.) Project ‘B’ (Rs.)
1 2,000 3,000
2 1,500 3,000
3 1,500 3,000
4 1,000 1,000
5 - 1,000
If the required Rate of return is 12%, which project should be undertaken?
15. A limited is proposing to take up a project, which requires an investment of Rs. 1,20,000.
The Net Income Before Depreciation and Tax is estimated as follows:
Year Net Income Before Depreciation
and Tax (Rs.)
1 30,000
2 36,000
3 42,000
4 48,000
5 60,000
Depreciation is to be charged on Straight Line Basis. Tax rate is 50%. Calculate Accounting Rate of
Return (ARR).
16. Calculate the Accounting Rate of Return for Project ‘A’ and Project ‘B’ from the following:
Particulars Project ‘A’ Project ‘B’
Investments 2,00,000 3,00,000
Expected life 4 Years 5 Years
Projected Net Income (After Taxes)
1st Year 20,000 30,000
nd
2 Year 15,000 30,000
3rd Year 15,000 20,000
th
4 Year 10,000 10,000
5th Year ------ 10,000
If required Rate of Return is 12%, which Project should be undertaken?

Page 10 of 19
II. DISCOUNTED CASH FLOW (DCF) METHOD or TIME ADJUSTED METHOD
INTRODUCTION
Investment proposals are essentially current capital expenditure incurred at present in
anticipation of future returns. Hence, timing of expected future returns is important in
evaluating investment proposals. Thus, time value of money is an important concept.
Discounted Cashflow Technique (DCF) considers both magnitude and timing of expected
cashflows (returns) in each period of project’s life. So, Discounted Cash Flow (DCF) technique
is considered as best in evaluating investment proposals.
MEANING
Discounted Cash Flow (DCF) technique is evaluation method that estimates the value of an
investment based on its future cashflows. Present value of expected future cashflows are
calculated using discount rate and then present value of cashflows are used to evaluate
investment proposals.

TYPES
Different types of DCF techniques are;
1. Net Present Value Method (NPV)
2. Internal Rate of Return Method (IRR)
3. Profitability Index Method (PI) or Benefit Cost Ratio Method

1. NET PRESENT VALUE METHOD (NPV)

▪ Net Present Value (NPV) technique is one of the discounted cash flow techniques,
which takes into account the time value of money.
▪ It refers to the difference between the present value of all cash inflows and the present
value of cash outflows associated with the project over a period of time.
▪ The present value is ascertained using the firm’s overall cost of capital as the discount
rate.
▪ The cash flows to be received at different period of time will be discounted at a
particular discount rate (Rate of return /Interest rate /Capitalisation rate).
▪ The present values of cash flows are compared with the original investment. The
difference between the two will be used for accepting or rejecting the investment
proposal. If the difference yields Positive (+) Value, the proposal is selected for
investment. If the difference shows Negative (–) Value, the proposed project is rejected
for investment.
▪ It is considered as best method for evaluating investment proposals. It is widely used in
practice.
ACCEPT or REJECT CRITERIA
Project with positive NPV should be accepted and project with negative NPV will be
rejected. Symbolically, if NPV > 0 = Accept; if NPV < 0 = Reject.
NPV INTERPRETATION
▪ NPV may be interpreted as an immediate increase in firm’s wealth if the project is
accepted.
▪ NPV may also be interpreted as the amount, which the firm could raise at given
Required Rate of Return i.e., Cost of Capital.
MERITS
a. It recognises the time value of money.
b. It considers the cash flows of the entire life of the project.
c. It considers both profitability and risk of the projects.
d. It is consistent with the objective of maximising the welfare of shareholders or owners.
e. It estimates the present value of their cash flows by using a discount rate equal to the cost
of capital.

Page 11 of 19
 DEMERITS
a. It is difficult to use.
b. NPV method is based on discount rate. In a real-life situation, it is very difficult to
arrive at suitable discount rate and understand the concept of cost of capital.
c. It cannot give accurate decision if the amount of investment of two mutually exclusive
projects are not equal.
d. It may not give reliable answers when dealing with alternative projects under the
conditions of unequal lives of the project.
The present value of one rupee received after particular period of time at a particular rate
of discount is calculated using the following formula:
PV = 1
(1 + r)n
Where, PV = Present Value
r = Discount Rate or Interest Rate
n= No. of Years
Note: In NPV calculations, Cash flow means: Cash Flow Before Depreciation and After Tax
(CFBDAT)
FORMULA
Net Present Value (NPV)= Total Present Value of Cash Inflow (-) Original Investment
Or
Net Present Value (NPV)= Total Present Value of Cash Inflow (-) Total Present Value of
Cash Outflow
PROBLEMS ON NET PRESENT VALUE (NPV) METHOD
17. If discount factor or cost of capital is 8% and if Rs 1 is received after 5 years the present
value will be what?
18. ‘S’ Ltd. is planning to purchase a Machine. Two alternative Machines are selected for
evaluation and each costing Rs. 3,00,000. The Cash inflow are expected to be as follows.
The company’s expected Rate of return is 10%. Evaluate the profitability of Two Machines
Year Machine ‘X’ (Rs.) Machine ‘Y’ (Rs.)
1 20,000 40,000
2 65,000 1,10,000
3 90,000 1,20,000
4 1,50,000 1,40,000
5 1,75,000 2,00,000
by taking the Present Value at 10%.
19. From the following information calculate the NPV of two projects and suggest which of
the two projects should be accepted assuming a discount rate at 10%.
Particulars Project ‘X’ Project ‘Y’
Initial Investment 20,000 30,000
Expected life 5 Years 5 Years
Scrap Value 1,000 2,000
The Profit Before Depreciation and After Tax (Cashflows) are given as follows.
Year Project ‘X’ (Rs.) Project ‘Y’ (Rs.)
1 5,000 20,000
2 10,000 10,000
3 10,000 5,000
4 3,000 3,000
5 2,000 2,000
The PV factor at 10%. Discount rate are as follows.
Year 1 2 3 4 5
P.V Factor 0.909 0.826 0.751 0.683 0.621
Page 12 of 19
20. The company is evaluating two proposals for new investments. The details on the proposals
are as follows.
Particulars Proposal ‘A’ Proposal ‘B’
Net Cash outlay 40,000 50,000
Estimated life 4 Years 5 Years
Depreciation Method Straight Line Straight Line
Method Method
Corporate Income Tax Rate 50% 50%
Cut off rate 10% 10%
Earnings before Depreciation and Tax
Year Proposal ‘A’ Proposal ‘B’
1 12,000 14,000
2 14,000 16,000
3 16,000 18,000
4 22,000 22,000
5 - 20,000
Calculate:
(a) Payback Period
(b) Net Present Value (NPV)
Present Value of Rs. 1 @ 10%.
Year 1 2 3 4 5
P.V Factor @ 0.909 0.826 0.751 0.683 0.621
10%
21. No Project is acceptable unless the yield is 10%. Cah Inflows of a Project along with Cash
Outflows are given below:
Year Cash Outflow Cash Inflow
0 1,50,000 -
1 30,000 20,000
2 - 30,000
3 - 60,000
4 - 80,000
5 - 30,000
th
The salvage or scrap value at the end of 5 year is 40,000. Calculate NPV and ARR. PV factor
at 10% discount is as follows.
Year 1 2 3 4 5
P.V Factor @ 0.909 0.826 0.751 0.683 0.621
10%
2. INTERNAL RATE OF RETURN METHOD (IRR)
▪ Internal Rate of Return is the rate at which the sum of discounted or present value of
cash inflows equals to the sum of discounted or present value of cash outflows (initial
or original investment).
▪ The Internal Rate of Return of a project is the discount rate at which the Net Present
Value of the investment is equal to zero. (NPV= 0).
▪ It is called Internal Rate because it mainly depends on the cash outlay and the proceeds
or cash inflows associated with the project and not on any rate determined outside the
investment.
ACCEPT or REJECT CRITERIA
▪ Accept the project if the rate of return is higher than or equal to the minimum required
rate of return. The minimum required rate of return is also known as cut-off rate or
firm’s cost of capital.
Page 13 of 19
 ▪ A project shall be rejected if its IRR is lower than the cut-off rate.
▪ In case of independent project, Accept the project if the IRR is higher than or equal to
cut off rate and vice versa. While evaluating two or more projects, projects giving
higher rate or return would be preferred.
MERITS
a. It considers the time value of money.
b. Calculation of discount rate is not required for adopting IRR.
c. IRR attempts to find the maximum rate of interest at which funds invested in the project
could be repaid out of the cash inflows arising from the project.
d. It is not in conflict with the concept of maximising shareholders wealth.
e. It considers cash inflows throughout the life of the project.
DEMERITS
a. It involves tedious calculations and difficult to understand.
b. The results of NPV method and IRR method may differ when the projects under
evaluation differ in their size, life and timings of cash inflows.
c. IRR method assume cash inflows are reinvested at the discounting rate in new projects.
However, if ARR is not close to the IRR, the profitability is not justifiable.
d. NPV method is considered as more reliable than IRR method for ranking two or more
projects. IRR method is more suitable for independent projects.
Note: In IRR calculations, Cash flow means: Cash Flow Before Depreciation and After Tax
(CFBDAT)
TRIAL AND ERROR METHOD
The Trial and Error method in IRR is a manual or iterative approach used to find the rate of
return that makes the Net Present Value (NPV) of a project equal to zero.
𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
Factor =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰 𝐏𝐞𝐫 𝐘𝐞𝐚𝐫

FORMULA
𝐂−𝐎
Internal Rate of Return (IRR) = A + 𝑿(𝐁 − 𝐀)
𝐂−𝐃
Where,
A = Discount Factor of Lower Trial Rate or Lower Discount Rate
B = Discount Factor of Higher Trial Rate or Higher Discount Rate
C = Total Present Value of Cash inflow at Lower Trial Rate
D = Total Present Value of Cash inflow at Higher Trial Rate
O = Original or Initial Investment or Cash Outlay

COMPARISON OF NPV and IRR METHODS

NPV Method IRR Method
Similarities
1. Both are modern methods or techniques of evaluating investment proposals.
2. Both considers time value of money.
3. Both assumes that cash inflows can be reinvested in the new projects.
Differences
1. Discount rate is known. 1. Discount rate is to be calculated by trial a nd error
method.
2. NPV method results in the value that 2. IRR generates the rate of return that makes NPV
a project generates. =0

Page 14 of 19
3. It recognises the importance of market rate of 3. It does not consider market rate but prefers
interest or cost of capital. maximum rate of interest.
4. It is assumed cash inflows are re-invested at the 4. It is presumed cash inflows are to be reinvested at
cut-off rate or cost of capital. internal rate or return.

PROBLEMS ON INTERNAL RATE OF RETURN (IRR) METHOD

22. An equipment involves an initial investment of Rs. 6,000. The Annual Cash Flow is estimated at
Rs. 2,000 for five years. Calculate Internal Rate of Return (IRR).
23. A Company has to select one of the following projects:
Project ‘X’ (Rs.) Project ‘Y’ (Rs.)
Cost 11,000 10,000
Cash inflows
1st Year 6,000 1,000
nd
2 Year 2,000 1,000
3rd Year 1,000 2,000
th
4 Year 5,000 10,000
Using IRR Method, suggest which Project is preferable. Present Value Discount Factor Table:
Year Discount Factor Discount Factor Discount Factor
@10% @ 12% @ 15%
1 0.909 0.893 0.870
2 0.826 0.797 0.756
3 0.751 0.712 0.658
4 0.683 0.636 0.572

24. ABC Ltd is considering to invest in a project. Original Investment will be Rs. 2,00,000. Life of the
project will be for 5 years with no salvage value. The expected Net Cash Inflow After Depreciation
Before Tax (CIADBT) during the life of project will be as follows:
Year 1 2 3 4 5
CIADBT 85,000 1,00,000 80,000 80,000 40,000
The project will be depreciated at the rate of 20% on original cost. The company is subject to tax at the
rate of 30%. You are required to calculate:
(a) Net Present Value (NPV) if the cost of capital is 10%.
(b) Internal Rate of Return (IRR).
Present Value (PV) Factor:
Year PV Factor PV Factor @ PV Factor @
@10% 37% 40%
1 0.909 0.730 0.714
2 0.826 0.533 0.510
3 0.751 0.389 0.364
4 0.683 0.284 0.260
5 0.621 0.207 0.186

25. A Project is estimated to cost Rs. 16,200. It is expected to have a life of 3 years and generate Cash
Inflows of Rs. 8,000, Rs. 7,000 and Rs. 6,000.
Calculate Internal Rate of Return (IRR).
Present Value of Rs. 1 at varying Discount Rate for a period of 3 years.
Year PV Factor PV Factor PV Factor PV Factor
@13% @ 14% @ 15% @ 16%
1 0.885 0.877 0.870 0.862
2 0.783 0.769 0.765 0.743
3 0.693 0.675 0.657 0.641

Page 15 of 19
 3. PROFITABILITY INDEX (PI) METHOD or BENEFIT COST RATIO METHOD
Profitability Index (PI) represents the cost and benefits of investing in a particular investment
proposal in the form of a ratio. The ratio that is created by comparing the present value of future
cash flows from a proposal to the initial investment in the proposal. It is obtained by dividing the
total present value of future cash inflows expected to be generated from an investment by initial or
original investment of the proposal.
ACCEPT OR REJECT CRITERIA
In case of independent investment proposal if the PI > 1, then accept. If PI < 1, then reject. In case
of mutually exclusive project after making a comparison investment proposal with a highest PI
should be accepted (but it should be > 1).
MERITS
a. The time value of money is considered.
b. Considers cash flows generated from investment proposal throughout its entire life.
c. Indicates whether investment proposal increases or decreases the firm value.
d. Considers the risk involved in future cash flows with the help of cost of capital.
e. Ascertains the exact rate of return of the investment proposal.
DEMERITS
a. It is difficult to calculate profitability index if two projects having different useful life.
b. It is difficult to understand accurate estimate of cost of capital or discount rate.

FORMULA

𝐓𝐨𝐭𝐚𝐥 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬

Profitability Index (PI) =
𝐓𝐨𝐭𝐚𝐥 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐨𝐮𝐭𝐟𝐥𝐨𝐰𝐬 𝐨𝐫 𝐎𝐫𝐠𝐢𝐧𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Or
𝐓𝐨𝐭𝐚𝐥 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬
Profitability Index (PI) =
𝐎𝐫𝐠𝐢𝐧𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

PROBLEM ON PROFITABILITY INDEX (PI) METHOD

26. The initial cash outlay (original investment) of the project is Rs. 1,00,000 and it generates cash
inflows of Rs. 40,000, 30,000, 50,000 and 20,000. Assume a 10% Rate of Discount. Calculate
Profitability Index (PI).
Year 1 2 3 4
P.V Factor @ 0.909 0.826 0.751 0.683
10%

27. Beta Ltd. is considering the purchase of a new machine. Two alternative machines A and B are
suggested each costing Rs. 4,00,000. Earnings Before Depreciation and After Taxation (CFBDAT)
are expected to be as follows:

Year PV of Rs. 1 Cash Flow

@10% Machine ‘A’ Machine ‘B’
1 0.909 40,000 1,20,000
2 0.826 1,20,000 1,60,000
3 0.751 1,60,000 2,00,000
4 0.683 2,40,000 1,20,000
5 0.621 1,60,000 80,000
The cost target return on capital is 10%. You are required to compare the profitability of the machines
and state which alternative of the machines you consider financially preferable.

Page 16 of 19
ADVANCED PROBLEMS ON PBP, ARR, NPV, IRR AND PI METHODS
28.
Year Machine ‘A’ Machine ‘B’
1 - 10,00,000
2 5,00,000 14,00,000
3 20,00,000 16,00,000
4 14,00,000 17,00,000
5 6,00,000 8,00,000
The above Cash Inflow which is given is before depreciation and after tax. The companies cost
of capital is 16%. You are required to calculate the following.
a. Payback Period (PBP)
b. Net Present Value (NPV)
c. Profitability Index (PI)
d. Internal Rate of Return (IRR)
Present Value (PV) Factor:
Year PV Factor PV Factor @ PV Factor @
@16% 18% 20%
1 0.862 0.847 0.833
2 0.743 0.718 0.694
3 0.641 0.609 0.579
4 0.552 0.516 0.482
5 0.476 0.437 0.402
Original Investment for Machine ‘A’ = 25,00,000
Original Investment for Machine ‘B’ = 40,00,000
There is no salvage or scarp value.
29. XY limited can make either of 2 investments at the beginning of 2020. Assuming the rate of
return is 10% p.a. Evaluate the investment proposal by;
a. Payback Period (PBP) Method
b. Net Present Value (NPV) Method
c. Profitability Index (PI) Method
d. Accounting Rate of Return (ARR) Method

Particulars Project ‘X’ Project ‘Y’

Cost of Investment 25,000 30,000
Expected life 5 Years 6 Years
Net Income (After Depreciation and Tax)
2015 600 3800
2016 1000 4500
2017 2500 5000
2018 3000 4500
2019 3500 5500
2020 - 6000
Total 10,600 29,300
It is estimated that each of the alternative projects will require an additional working capital of Rs.
2000 which will be received back in full after the expiry of each project life. Depreciation is
provided under ‘Straight Line Method’.
Year 2015 2016 2017 2018 2019 2020
P.V Factor @ 0.909 0.826 0.751 0.683 0.621 0.564
10%
Page 17 of 19
30. RK Swamy Company ltd. is considering purchase of a machine in replacement of an old one.
Two machines ‘X’ and ‘Y’ are offered at prices of Rs. 22,50,000 and Rs. 30,00,000 respectively.
Further particulars of their machines are given below:
Particulars Machine ‘X’ Machine ‘Y’
Economic Life (in years) 5 Years 6 Years
Scarp Value at the end of economic life 2,00,000 2,50,000
Cash inflow Before Depreciation and After Tax
1st Year 5,00,000 6,00,000
2nd Year 7,50,000 8,00,000
3rd Year 10,00,000 10,00,000
4th Year 9,00,000 12,00,000
5th Year 8,50,000 10,50,000
6th Year - 9,50,000
Present Value factor at 12% as follows:
Year 1 2 3 4 5 6
P.V Factor @ 0.893 0.797 0.712 0.636 0.567 0.507
12%
You are required to calculate:
a. Payback Period (PBP)
b. Net Present Value (NPV)
Suggest which machine should be selected and why?
31. XYZ ltd is considering to invest in a project. The expected original investment in the project will
be Rs. 4,00,000, the life of the project will be 5 years with no salvage value. The expected ‘Net Cash
Inflow After Depreciation but Before Tax’ (CFADBT) during the life of the project will be:
Year 1 2 3 4 5
CFADBT 1,70,000 2,00,000 1,60,000 1,60,000 80,000

The project will be depreciated at the rate of 20% of original cost. The company is subject to 30%
tax rate. Present Value (PV) factor @ 10%. Calculate Payback Period (PBP), ARR and NPV.
32. A project needs an investment of Rs. 1,38,500. The cost of capital is 12%. The net cash inflow
are as follows:
Year Cash inflow
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Calculate NPV and IRR, where cost of capital is 10%.

33. A firm whose cost of capital is 10% and considering to invest in two projects ‘X’ and ‘Y’. The
details are as follows:
Particulars Project ‘X’ Project ‘Y’
Original Investment 70,000 70,000
Estimated life 5 Years 5 Years
Cash inflow
1st Year 10,000 60,000
2nd Year 20,000 40,000
3rd Year 30,000 20,000
4th Year 45,000 10,000
5th Year 60,000 10,000
Page 18 of 19
Calculate ARR and NPV for two Projects. Present Value at 10%.
Year 1 2 3 4 5
P.V Factor @ 10% 0.909 0.826 0.751 0.683 0.621

34. A company has to select one of the projects among 2 projects.

Particulars Project ‘A’ Project ‘B’
Cost 11,000 10,000
Cashflow (CFBDAT)
1st Year 6,000 1,000
nd
2 Year 2,000 1,000
3rd Year 1,000 2,000
th
4 Year 5,000 10,000
Discount factor at 10% and 12%.
Year 1 2 3 4
P.V Factor @ 10% 0.909 0.826 0.751 0.683
P.V Factor @ 12% 0.893 0.797 0.712 0.636
You are required to calculate NPV and IRR.

**********************

Page 19 of 19