Chapter 2

CAPITAL BUDGETING DECISIONS

Q1. A plastic company is considering two mutually exclusive investment proposals for its
expansion programme. Proposal X requires purchase of a new machine costing Rs. 16 lakh and
causes yearly cash operating costs of Rs. 1,00,000. Proposal Y requires an initial investment
of Rs. 10 lakh (cost of a machine) and yearly cash operating costs of Rs. 2,20,000. The life of
both machines used is 8 years with no salvage value; depreciation is on straight-line method
and the same is assumed to be accepted for tax purposes. The corporate firm’s effective tax
rate is 35 per cent. Determine relevant cash outflows and cash inflows after taxes.

Solution:
(i) Proposal X is more costly. It requires additional investment of Rs. 6,00,000 vis-à-vis
Proposal Y.
(ii) Proposal X yields more cash cost savings (EBT) of Rs. 1,20,000 (Rs. 2,20,000 -
Rs1, 00,000)
(iii) Proposal X causes higher depreciation (Rs 16 lakh/8 years) i.e., Rs 2,00,000 as
compared to Rs. 1,25,000(Rs. 10 lakh/8years) in case of Proposal Y.
In more concrete terms, cash outflows and inflows are as follows:
Cash outflows:
Incremental investment in more costly machine:
Machine X Rs 16,00,000
Machine Y 10,00,000 Rs 6,00,000

Cash inflows after taxes:

Cash operating cost (Y machine) Rs. 2,20,000
Less cash operating cost (X machine) 1,00,000
Cash operating savings 1,20,000
Less incremental depreciation:
Machine X Rs. 2,00,000
Machine Y 1,25,000 75,000
Cost savings before taxes (EBT) 45,000
Less taxes (Rs. 45,000 × 0.35) 15,750
Earnings after taxes 29,250
Add back incremental depreciation 75,000 1,04,250

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Q2. Determine modified IRR from following data:

Cost of new machine Rs 56,125

Cash inflows after taxes:
Year 1 14,000
2 16,000
3 18,000
4 20,000
5 25,000
Cost of capital is 10%

Solution:
______________________________________________________________________
Year CFAT Compounded factor at 10% for n – 1years Compounded sum
________________________________________________________________________________________________________
1 Rs 14,000 1.464 (for 4 years) Rs 20,496
2 16,000 1.331 (for 3 years) 21,296
3 18,000 1.210 (for 2 years) 21,780
4 20,000 1.110 (for 1 year) 22,200
5 25,000 No compounding 25,000
Total compounded sum at year-end 5 1,10,772
______________________________________________________________________________________________________
Note: Cost of capital is 10 per cent (Compounded factors are as per Table A-1.)
Rs 1,10,772
Rs 56,125 = --------------------
(1 + MIRR)5

1. Dividing the compound sum/terminal value (Rs 1,10,772) by the initial outlay (Rs
56,125), we have growth factor (1.9737).
2. In Table A-1, the factors closet to 1.9737 for 5 years are 1.925 (at 14%) and 2.011
(at 15%).
3. The MIRR would be between 14% and 15% as shown below.
Rs 56,125 compounds at 15% for 5 years = Rs 1,12,867
Rs 56,125 compounds at 14% for 5 years = 1,08,041
Difference of 1 per cent 4,826

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Based on interpolation:

Rs 1,10,772 - Rs 1,08,041 = Rs 2,731

MIRR = 14% + -------------------------------------------------- x 1 = 14.57 per cent
Rs 4,826

Q3. The Domanhill Colliery, an underground mine, owned by the public sector Coal
India Ltd. has been producing coal through manual operations for the last eight years.
The past and projected revenues and cost data re summarized in Exhibit 1.

Exhibit 1: Past and projected revenue and cost data (Rs. crore)

Year Sales Direct Administrative Fixed expenses Variable

revenue labour and selling (excluding) expenses
cost expenses depreciation
Past data
1 70 14 12 15 23
2 81 16 14 17 25
3 101 21 17 22 30
4 123 30 22 25 39
5 162 34 25 31 45
6 201 41 33 49 64
7 245 48 40 51 77
8 302 61 53 68 94
Projected Data
9 333.8 62 52 68 89
10 369.6 69 58 75 97
11 405.4 76 63 83 06
12 440.8 82 69 91 115
13 476.2 88 75 98 124

With the liberalisation and opening up of coal sector to private firms, the Board
of Directors of Coal India Ltd. have decided to undertake a feasibility study for semi-
mechanization of Domanhill Colliery by introducing side dump and load (SDL)
machine. With the introduction of the SDL machine, the following changes in the
operating parameters are forecasted:

- Increase in projected sales revenue with manual production by 25 per cent

due to faster speed of work;
- Decrease in direct labour by 5 per cent resulting from ban on new
recruitments;

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 - 15 per cent increase in administrative and selling expenses to support
increased semi-mechanized production and sales;
- 10 per cent increase in fixed cost on account of setting up of additional
maintenance facility;
- Increase in variable expenses; 50 per cent, as a result of additional electricity
consumption;
- Loss in terms of disturbance charge due to opposition, strike and lock-out;
year 9, Rs 2 crore, year 10 Rs 0.80 crore and year 11, Rs 0.30 crore;
- The semi-mechanization would require acquisition of 20 machines at a cost
of Rs 1 crore each. An additional Rs 2 crore would have to be spent on
creation of additional facility like transformer, special cables, and installation
of the machines. The machines including the additional facility created would
be depreciated over a five-year period on the basis of written down value
method @ 25 per cent. At the end of 5 years, they are expected to be sold at
Rs 2 crore. The colliery does not have other machines in the block of 25 per
cent.

Assuming effective (tax adjusted) cost of capital of 8 per cent on World Bank
loan to finance the project and 35 per cent tax, present a financial analysis of the
feasibility of semi-automation of the Domanhill Colliery. As a financial consultant,
what recommendation would you make to the Board of Directors of Coal India Ltd.?

Solution:

Finance analysis for semi-mechanization of Downhill Colliery (using NPV method)

(Amount in crore of rupees)
Incremental cash outflows:
Cost of new machine (SDL) (20 x Rs 1 crore) 20
Additional cost of semi-mechanization 2
22

Incremental CFAT and NPV

Particulars Year
1 2 3 4 5
Incremental sales revenue 83.45 92.4 101.35 110.2 119.05
(0.25 x Projected sales revenue)
Add savings in direct labour cost 3.10 3.45 3.8 4.1 4.4
(0.05 x DLC)
Less incremental administrative and 7.8 8.70 9.45 10.35 11.25
selling expenses, ASE (0.15 x ASE)
Less incremental fixed costs 6.8 7.5 8.3 9.1 9.8

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(0.10 x FC)
Less increase in variable costs 44.5 48.5 53 57.5 62
(0.50 x VC)
Less disruption charges 2.0 0.8 0.3 - -
@
Less depreciation 5.5 4.13 3.09 2.32 Nil
Earnings before taxes 19.95 26.22 31.01 35.03 40.4
Less taxes 6.98 9.18 10.85 12.26 14.14
Earnings after taxes 12.97 17.04 20.16 22.77 26.26
CFAT (operating) 18.47 21.17 23.25 25.09 26.26
Salvage value 2.0
Tax benefit on short-term capital loss 1.74
(0.35 x Rs 4.96)
(x) PV factor (0.08) 0.926 0.857 0.794 0.735 0.681
Present value 17.10 18.15 18.46 18.44 20.43
Gross present value 92.57
Less cash outflows 22.00
Net present value 70.57
@ No depreciation is charged in terminal year, as block ceases to exist.

Recommendation: Since NPV is positive, the proposal is financially viable.

Q.4 An iron ore company is considering investing in a new processing facility. The
company extracts ore from an open pit mine. During a year, 1,00,000 tons of ore is
extracted. If the output from the extraction process is sold immediately upon removal
of dirt, rocks and other impurities, a price of Rs 1,000 per ton of ore can be obtained.
The company has estimated that its extraction costs amount to 70 per cent of the net
realizable value of the ore.
As an alternative to selling all the ore at Rs 1,000 per ton, it is possible to process further
25 per cent of the output. The additional cash cost of further processing would be Rs
100 per ton. The proposed ore would yield 80 per cent final output, and can be sold at
Rs 1,600 per ton.
For additional processing, the company would have to install equipment costing
Rs 100 lakh. The equipment is subject to 25 per cent depreciation per annum on
reducing balance (WDV) basis/method. It is expected to have useful life of 5 years.
Additional working capital requirement is estimated at Rs 10 lakh. The company’s cost
of capital for such investments is 15 per cent. Corporate tax rate is 35 per cent.
Assuming there is no other plant and machinery subject to 25 per cent
depreciation, should the company install the equipment if the expected salvage is Rs 10
lakh at the end of 5 years.

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 Solution:
Financial evaluation whether to install equipment for further processing of iron ore or
not
(a) Cash outflows:
Cost of equipment Rs 1,00,00,000
Plus additional working capital 10,00,000
1,10,00,000

Working note – 1
1. Depreciation schedule
Year Depreciation base of equipment Depreciation @25% on WDV
1 Rs 1,00,00,000 Rs 25,00,000
2 75,00,000 18,75,000
3 56,25,000 14,06,250
4 42,18,750 10,54,688
5 31,64,062 Nil*
* As the block consists of single asset, no depreciation is to be charged in the terminal
year of the project.
(b) CFATP
(Amount in Rs)
Particulars Year
1 2 3 4 5
Incremental revenue
[(1,600 x 20,000) –
Rs 1,000 x 25,000)] 70,00,000 70,00,000 70,00,000 70,00,000 70,00,000
Less incremental costs:
Procession costs
(Rs 100 x 25,000 (tons)
25,00,000 25,00,000 25,00,000 25,00,000 25,00,000
Depreciation
(working note 1) 25,00,000 18,75,000 14,06,250 10,54,688 ___--___
Earnings before taxes 20,00,000 26,25,000 30,93,750 34,45,312 45,00,000
Less taxes (0.35) 7,00,000 9,18,750 10,82,813 12,05,859 15,75,000
Earnings after taxes (EAT) 13,00,000 17,06,250 20,10,937 22,39,453 29,25,000
Add: depreciation 25,00,000 18,75,000 14,06,250 10,54,688 ____--__
CFAT 38,00,000 35,81,250 34,17,187 32,94,141 29,25,000
(c) Determination of NPV (Salvage value = Rs 10 lakh)

Year CFAT PV factor Total PV

(0.15)
1 Rs 38,00,000 0.870 Rs 33,06,000
2 35,81,250 0.756 26,85,938
3 34,17,187 0.658 22,48,509
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4 32,94,141 0.572 18,84,249
5 29,25,000 0.497 14,53,725
Salvage value 10,00,000 0.497 4,97,000
Tax benefit on short-term capital loss 7,57,422* 0.497 3,76,439
Recovery of working capital 10,00,000 0.497 4,97,000
Total present value 1,29,48,860
Less cash outflows 1,10,00,000
Net present value (NPV) 19,48,860
0.35 x (Rs 31,64,062 – Rs 10,00,000) = Rs 7,57,422

Recommendation: The company is advised to install the equipment as it promises a

positive NPV.

Q.5 Royal Industries is considering the replacement of one of its moulding machines.
The existing machine is in good operating condition but is smaller than required if the
firm is to expand its operations. It is 4 years old, has a current salvage value of Rs
2,00,000 and a remaining life of 6 years. The machine was initially purchased for Rs 10
lakh and is being depreciated at 25 per cent on the basis of written down value method.
The new machine will cost Rs 15 lakh and will be subject to the same method as
well as the same rate of depreciation. It is expected to have useful life of 6 years, salvage
value of Rs 1,50,000 at the sixth-year end. The management anticipates that with the
expanded operations, there will be need of an additional net working capital of Rs 1
lakh.
The new machine will allow the firm to expand current operations and thereby
increase annual revenues by Rs 5,00,000; variable cost to volume ratio is 30 per cent.
Fixed costs (excluding depreciation) are likely to remain unchanged.
The corporate tax rate is 35 per cent. Its cost of capital is 10 per cent. The
company has several machines in the block of 25 per cent depreciation.
Should the company replace its existing machine? What course of action would
you suggest, if there is no salvage value.
Working note:
(1) (i) WDV of existing machine in the beginning of the year 5
Initial cost of machine Rs 10,00,000
Less depreciation @ 25% in year 1 2,50,000
WDV at beginning of year 2 7,50,000
Less depreciation @ 25% on WDV 1,87,500
WDV at beginning of year 3 5,62,500
Less depreciation@ 25% on WDV 1,40,625
WDV at beginning of year 4 4,21,875
Less depreciation@ 25% on WDV 1,05,469
WDV at beginning of year 5 3,16,406

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 (ii) Depreciation base of new machine 3,16,406
WDV of existing machine 15,00,000
Add cost of the new machine (2,00,000)
Less sale proceeds of existing machine 16,16,406

(iii) Base for incremental depreciation 16,16,406

Depreciation base of a new machine 3,16,406
Less: depreciation base of an existing machine 13,00,000
**Working note

(2) Incremental depreciation (t = 1 – 6)

Year Incremental asset cost base Depreciation (25% on WDV)
1 Rs 13,00,000 Rs 3,25,000
2 9,75,000 2,43,750
3 7,31,250 1,82,813
4 5,48,437 1,37,109
5 4,11,328 1,02,832
6 3,08,496 39,624*
* 0.25 (Rs 3,08,496 – Rs 1,50,000 salvage value) = Rs 39,624

Solution:
Financial evaluation whether to replace existing machine

(a) Cash outflows (incremental)

Cost of the new machine Rs 15,00,000
Add additional working capital 1,00,000
Less sale value of existing machine (2,00,000)
14,00,000
(b) Determination of incremental CFAT (operating)

Incremental Incremental Taxable Taxes (0.35) EAT CFAT

Year contribution* depreciation** income (Col.4-Col.5) (Col.6+Col.3)
1 Rs 3,50,000 Rs 3,25,000 Rs 25,000 Rs 8,750 Rs 16,250 Rs 3,41,250
2 3,50,000 2,43,750 1,06,250 37,188 69,062 3,12,812
3 3,50,000 1,82,813 1,67,187 58,515 1,08,672 2,91,485
4 3,50,000 1,37,109 2,12,891 74,512 1,38,379 2,75,488
5 3,50,000 1,02,832 2,47,168 86,509 1,60,659 2,63,491
6 3,50,000 39,624 3,10,376 1,08,632 2,01,744 2,41,368

= Rs 5,00,000 – (Rs 5,00,000 x 0.30, variable cost to volume (V/V) ratio)

= Rs 3,50,000

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(c) Determination of NPV (Salvage value = Rs 1.50 lakh)

Year CFAT PV factor Total PV

1 Rs 3,41,250 0.909 Rs 3,10,196
2 3,12,812 0.826 2,58,383
3 2,91,485 0.751 2,18,905
4 2,75,488 0.683 1,88,158
5 2,63,491 0.621 1,63,628
6 2,41,368 0.564 1,36,132
6 Salvage value 1,50,000 0.564 84,600
6 Recovery of working capital 1,00,000 0.564 56,400
Gross present value 14,16,402
Less cash outflows (14,00,000)
Net present value 16,402

(d) Recommendation: Since the NPV is positive, the company is advised to replace the
existing machine. The NPV is likely to be higher as tax advantage will accrue on the
unabsorbed depreciation of Rs 1,18,872 (Rs 3,08,496 - Rs 1,50,000 –
Rs 39,624) in future years.

Determination of NPV (Salvage value = Zero)

(i) No change in depreciation in the first 5 years
In sixth year, it will be Rs 77,124 = Rs 3,08,496 × 0.25
(ii) No change in operating CFAT for years 1 – 5
CFAT for 6th year would be:
Incremental contribution Rs 3,50,000
Less: incremental depreciation 77,124
Taxable income 2,72,876
Less: taxes (0.35) 95,507
EAT 1,77,369
Add depreciation 77,124
CFAT 2,54,493
(iii) PV of operating CFAT (1-5 years) 11,39,270
Add PV of operating CFAT (6th Year) (Rs 2,54,493 × 1,43,534
0.564)
Add PV of working capital 56,400
Total present value 13,39,204
Less cash outflows (14,00,000)
NPV (60,796)

Recommendation: Since the NPV is negative, the existing machine should not be
replaced.
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Q.6 A job which is presently done entirely by manual methods has a labour cost of Rs.
46,000 a year. It is proposed to install a machine to do the job, which involves an
investment of Rs 80,000 and an annual operating cost of Rs 10,000. Assume that the
machine can be written off in five years on straight line depreciation basis for tax
purposes. Salvage value at the end of its economic life is zero. The tax rate is 35 per
cent and its cost of capital is 15 per cent. Advise to the company.

Solution:

Determination of CFAT and NPV

Cost savings (Lower running expenses Rs 46,000 – 10,000) Rs 36,000
Less depreciation (Rs 80,000/5 years) 16,000
Net cost savings 20,000
Less taxes (0.35) 7,000
Earnings after taxes (EAT) 13,000
CFAT (EAT + Depreciation) 29,000
(X) PV factor at 15% for t = 1-5 years X 3.352
Total PV 97,208
Less cash outflows (80,000)
Net present value 17,208
Recommendation: The proposal should be accepted as it has positive NPV.

Q.7 An existing company has a machine which has been in operation for 2 years; its
remaining estimated useful life is 4 years, with no salvage value at the end. Its current
market value is Rs 1,00,000.
The management is considering a proposal to purchase an improved model of
similar machine, which gives increased output. The relevant particulars are as follows:
Particulars Existing New machine
machine
Purchase price (Rs) 2,40,000 4,00,000
Estimated life (years) 6 4
Salvage value Nil Nil
Annual operating hours 2,000 2,000
Selling price per unit (Rs) 10 10
Output per hour (units) 15 30
Material cost per unit (Rs) 2 2
Labour cost per hour (Rs) 20 40
Consumable stores per year (Rs) 2,000 5,000
Repairs and maintenance per year (Rs) 9,000 6,000
Working capital (Rs) 25,000 40,000

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The company follows the declining balance method of depreciation @ 25 per cent and
is subject to 35 per cent tax. Should the existing machine be replaced? Assume that the
company’s required rate of return is 15 per cent and the company has several assets in
the 25 per cent block.

Solution:

Cash outflows
Purchase price of new machine Rs 4,00,000
Add additional working capital 15,000
Less sale value of old machine (1,00,000)
3,15,000

Incremental cash inflows before taxes

Particulars Existing New machine Difference
machine (Col 3-Col 2)
1 2 3 4
1. Annual operating hours 2,000 2,000 --
2. (x) Output per hour (units) (x) 15 (x) 30 15
3. Total output (units) 30,000 60,000 30,000
4. (x) Selling price per unit (Rs) x 10 (x) 10 --
5. Total sales revenue (Rs) 3,00,000 6,00,000 3,00,000
Less: expenses
Material cost 60,000 1,20,000 60,000
Labour cost 40,000 80,000 40,000
Consumable stores 2,000 5,000 3,000
Repairs and maintenance 9,000 6,000 (3,000)
6. Total expenses 1,11,000 2,11,000 1,00,000
7. Cashflows before taxes 1,89,000 3,89,000 2,00,000

Working Notes:
Depreciation base of new machine
WDV of existing machine
(Rs 2,40,000 – Rs 60,000 – Rs 45,000) Rs 1,35,000
Add cost of new machine 4,00,000
Less sale value of old machine 1,00,000
4,35,000
Base for incremental depreciation:
(Rs 4,35,000 – Rs 1,35,000, WDV of existing machine) = Rs 3,00,000.

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 Determination of CFAT and NPV
Particulars Years
1 2 3 4
Incremental cashflows before taxes Rs 2,00,000 Rs 2,00,000 Rs 2,00,000 Rs 2,00,000
Less incremental depreciation 75,000 56,250 42,187 31,641
Earnings before depreciation 1,25,000 1,43,750 1,57,813 1,68,359
Less taxes 43,750 50,312 55,235 58,926
EAT 81,250 93,438 1,02,578 1,09,433
CFAT (EAT + Depreciation) 1,56,250 1,49,688 1,44,765 1,41,074
Release of working capital x PV 15,000
factor (at 0.15) 0.870 0.756 0.658 0.572
PV 1,35,937 1,13,164 95,255 89,274
Gross PV (t = 1 – 4) 4,33,630
Less cash outflows (3,15,000)
NPV 1,18,630

Recommendation: As the NPV of incremental CFAT is positive, the existing machine

should be replaced. (In fact, NPV will be higher as tax advantage will accrue on
unabsorbed depreciation of Rs 1,25,563 – Rs 31,641 = Rs 93,922 in future years).

Q8. The capital budgeting department of a company has suggested 3 investment

proposals. The after-tax cash flows for each are tabulated below. If the cost of capital is
12 per cent, rank them on the basis of the profitability index.
After-tax cash flows
Year Project A Project B Project C
0 Rs 20,000 Rs 60,000 Rs 36,000
1 5,600 12,000 13,000
2 6,000 20,000 13,000
3 8,000 24,000 13,000
4 8,000 32,000 13,000
Solution:
Determination of present value
Year CFAT PV factor Total PV
A B C at 12% A B C
1 Rs 5,600 Rs 12,000 Rs 13,000 0.893 Rs 5,001 Rs 10,716 Rs 11,609
2 6,000 20,000 13,000 0.797 4,782 15,940 10,361
3 8,000 24,000 13,000 0.712 5,696 17,088 9,256
4 8,000 32,000 13,000 0.636 5,088 20,352 8,268
Gross present value 20,567 64,096 39,494

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Profitability index = PV of cash inflows/PV of cash outflows
PI(A) = Rs 20,567/Rs 20,000 = 1.028
PI(B) = Rs 64,096/Rs 60,000 = 1.068
PI(C) = Rs 39,494/Rs 36,000 = 1.097
The projects in descending order of profitability are: C, B and A.

Q.9 (Indivisible Project) A company working against a self-imposed capital

budgeting constraint of Rs 70 crore is trying to decide which of the following
investment proposals should be undertaken by it. All these investment proposals
are indivisible as well as independent. The list of investments along with the
investment required and the NPV of the projected cash flows are given as below:
Project Initial investment (Rs NPV (Rs crore)
crore)
A 10 6
B 24 18
C 32 20
D 22 30
E 18 20
Which investment projects should be acquired by the company?

Solution:
NPV from investments D, E and B is Rs 68 crore with Rs 64 crore utilised leaving
Rs 6 crore to be invested in some other investment outlet. No other investment
package would yield an NPV higher than this amount. The company is advised
to invest in D, E and B projects.
Trial and error process is an integral part of selecting optimal investment
packages/set in capital rationing situation.

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 Q.10 Sound Limited has a financial resource constraint of a maximum of Rs 65
lakh in the current year. It has evaluated a large number of investment projects but
has discarded all except those listed below. All the listed investment proposals are
independent. The selected list of investments provide investment outlays, gross
present value, NPV and present value index.

Project Investment NPV Gross present Present value

outlay value index
A Rs 21,85,000 Rs 15,07,500 Rs 36,92,500 1.69
B 19,10,000 10,70,000 29,80,000 1.56
C 15,50,000 2,15,000 17,65,000 1.14
D 13,00,000 2,75,000 15,75,000 1.21
E 11,45,000 15,80,000 27,25,000 2.38
F 9,40,000 4,25,000 13,65,000 1.45
G 6,75,000 6,20,000 12,95,000 1.92
H 5,35,000 3,90,000 9,25,000 1.73
I 4,65,000 6,10,000 10,75,000 2.31
J 4,30,000 4,77,500 9,07,500 2.11
K 4,10,000 2,95,000 7,05,000 1.72
L 3,50,000 3,05,000 6,55,000 1.87
M 2,75,000 1,07,500 3,82,500 1.39
N 2,45,000 2,05,000 4,50,000 1.84
O 1,90,000 3,00,000 4,90,000 2.58
1,26,05,000 83,82,500 2,09,87,500
Which investments should be acquired by Sound Limited?

Solution:
First, we should arrange the investment projects in descending order of present value
(PI) index. The optimal investment portfolio/set will be one which yields the maximum
NPV. The investment projects are accordingly listed below.
Project PI Investment outlays of NPV of
Project Cumulative Project Cumulative
O 2.58 Rs 1,90,000 Rs 1,90,000 Rs 3,00,000 Rs 3,00,000
E 2.38 11,45,000 13,35,000 15,80,000 18,80,000
I 2.31 4,65,000 18,00,000 6,10,000 24,90,000
J 2.11 4,30,000 22,30,000 4,77,500 29,67,500
G 1.92 6,75,000 29,05,000 6,20,000 35,87,500
L 1.87 3,50,000 32,55,000 3,05,000 38,92,500
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Delhi in Semester II - 2020-21 and is not intended for wider circulation.
 N 1.84 2,45,000 35,00,000 2,05,000 40,97,500
H 1.73 5,35,000 40,35,000 3,90,000 44,87,500
K 1.72 4,10,000 44,45,000 2,95,000 47,82,500
A 1.69 21,85,000 66,30,000 1
15,07,500 —
B 1.56 19,10,000 63,55,000 10,70,000 58,52,5002
F 1.45 9,40,000 4,25,000
M 1.39 2,75,000 1,07,500
D 1.21 13,00,000 2,75,000
C 1.14 15,50,000 2,15,000
1 Not feasible at this stage; cumulative investment outlays exceed Rs 65 lakh.
2 Investment outlay as well as NPV consist of projects (from O to H) plus project B.

In case the company is guided simply by the PI index, then it selects the first nine
projects (numbered from O through K) plus project B. This investment package yields
an NPV of Rs 58,52,500.
Project Investment outlays of NPV of
Project (s) Cumulative Project (s) Cumulative
O–H — Rs 40,35,000 — Rs 44,87,500
A Rs 21,85,000 62,20,000 Rs 15,07,500 59,95,000
M 2,75,000 64,95,000 1,07,500 61,02,500
Such a substitution exercise involves a trial and error approach. Thus, the optimal
investment package consists of 10 projects (O, E, I, J, G, L, N, H, A and M) requiring
a total investment outlay of Rs 64.95 lakh, yielding a total NPV of Rs 61,02,500.

Q.11 ABC Ltd is considering to install a machine, either X or Y which are mutually
exclusive. The details of their purchase price and operating costs are:
Year Machine X Machine Y
Purchase cost 0 Rs 10,000 Rs 8,000
Operating costs 1 2,000 2,500
2 2,000 2,500
3 2,000 2,500
4 2,500 3,800
5 2,500 3,800
6 2,500 3,800
7 3,000
8 3,000
9 3,000
10 3,000

This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
Machine X will recover a salvage value of Rs 1,500 in the year 10 while machine Y
will recover Rs 1,000 in the year 6. Determine which is cheaper at the 10 per cent cost
of capital, assuming that both the machines operate at the same efficiency? Assumption:
Firm is not to pay taxes.

Solution:
Equivalent annual cost (EAC)
Particulars Year Cost Machine X PV adjusted
PV factor cost
Purchase cost 0 Rs 10,000 1.000 10,000
Operating cost 1 2,000 0.909 1,818
2 2,000 0.826 1,652
3 2,000 0.751 1,502
4 2,500 0.683 1,707
5 2,500 0.621 1,552
6 2,500 0.564 1,410
7 3,000 0.513 1,539
8 3,000 0.467 1,401
9 3,000 0.424 1,272
10 3,000 0.386 1,158
Total cost 25,012
Less salvage value (1,500) 0.386 (579)
Effective cost 24,433
Divided by annuity PV factor for 10 per cent corresponding to
the life of the project (capital recovery factor) ÷ 6.1446
Equivalent annual cost 3,976.50

Equivalent annual cost (EAC)

Particulars Year Cost Machine Y PV adjusted
PV factor cost
Purchase cost 0 Rs 8,000 1.000 8,000
Operating cost 1 2,500 0.909 2,272.50
2 2,500 0.826 2,065
3 2,500 0.751 1,877.50
4 3,800 0.683 2,595.40
5 3,800 0.621 2,359,80
6 3,800 0.564 2,143.20
Total cost 21,313.40
Less salvage value (1,000) 0.564 (564)
Effective cost 20,749.40

This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
 Divided by annuity PV factor for 10 per cent corresponding to
the life of the project (capital recovery factor) ÷ 4.3553
Equivalent annual cost 4,764.20

Machine X would be cheaper to buy due to lower equivalent annual cost.

Q12. An educational institute is planning to install air conditioners for its new computer
centre. It has received proposals from 2 manufacturers. The first proposal is for the
installation of 6 window air conditioners @ Rs 25,000 each. The other is for the
installation of split air conditioners of an equal capacity costing Rs 2,00,000. The useful
life of window air conditioners is 6 years and that of split air conditioners is 10 years.
The cash operating costs associated with each proposal are given below

Year Proposal 1 Proposal 2

1 Rs 20,000 Rs 18,000
2 20,000 18,000
3 20,000 18,000
4 25,000 22,000
5 25,000 22,000
6 25,000 22,000
7 26,000
8 26,000
9 26,000
10 26,000
The salvage value of the window air conditioners at the end of 6 years is expected to be
Rs 10,000 and that of the split air conditioners Rs 15,000. Advise the educational
institute which proposal should be selected by it if its opportunity cost of funds is 10
per cent.

Solution:

Equivalent Annual Cost

Proposal 1
Particulars Year Cost PV factor (at 10%) PV
Purchase cost 0 Rs 1,50,000 1.000 Rs 1,50,000
Operating costs 1 20,000 0.909 18,180
2 20,000 0.826 16,520
3 20,000 0.751 15,020
4 25,000 0.683 17,075
5 25,000 0.621 15,525
6 25,000 0.564 14,100
Salvage value 6 (10,000) 0.564 (5,640)
This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
 Total PV Rs 2,40,780
Equivalent Annual Cost (EAC) = (Total present value of the project / PV of annuity
corresponding to the life of the project at the given cost of capital.
Rs 2,40,780/4.355 = Rs 55,288.17

Proposal 2
Particulars Year Cost PV factor (at 10%) PV
Purchase cost 0 Rs 2,00,000 1.000 Rs 2,00,000
Operating costs 1 18,000 0.909 16,362
2 18,000 0.826 14,868
3 18,000 0.751 13,518
4 22,000 0.683 15,026
5 22,000 0.621 13,662
6 22,000 0.564 12,408
7 26,000 0.513 13,338
8 26,000 0.467 12,142
9 26,000 0.424 11,024
10 26,000 0.386 10,036
Salvage value 10 (15,000) 0.386 (5,790)
Total PV Rs 3,38,174
Equivalent Annual Cost (EAC) = Rs 3,32,384/6.145 = Rs 55,032.38

Recommendation: The educational institution should go for split air conditioners as

their equivalent annual cost is lower.

This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
 Table A-1 : The Present Value of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.789 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.227 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
21 0.811 0.660 0.538 0.439 0.359 0.294 0.242 0.199 0.164 0.135
22 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123
23 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112
24 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057
35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022
45 0.639 0.410 0.264 0.171 0.111 0.073 0.048 0.031 0.021 0.014
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009

(Contd.)

This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
 Table A-1: The Present Value of One Rupee (Contd.)
Year 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
21 0.112 0.093 0.077 0.064 0.053 0.044 0.037 0.031 0.026 0.022
22 0.101 0.083 0.068 0.056 0.046 0.038 0.032 0.026 0.022 0.018
23 0.091 0.074 0.060 0.049 0.040 0.033 0.027 0.022 0.018 0.015
24 0.082 0.066 0.053 0.043 0.035 0.028 0.023 0.019 0.015 0.013
25 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010
30 0.044 0.033 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.004
35 0.026 0.019 0.014 0.010 0.008 0.006 0.004 0.003 0.002 0.002
40 0.015 0.011 0.008 0.005 0.004 0.003 0.002 0.001 0.001 0.001
45 0.009 0.006 0.004 0.003 0.002 0.001 0.001 0.001 0.000 0.000
50 0.005 0.003 0.002 0.001 0.001 0.001 0.000 0.000 0.000 0.000

This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
Table A-2 : The Present Value of an Annuity of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 6.728 7.326 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.746 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.560 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.352 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649
22 19.661 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883
24 21.244 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985
25 22.023 19.524 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.397 19.601 17.292 15.373 13.765 12.409 11.258 10.274 9.427
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644
40 32.835 27.356 23.115 19.793 17.159 15.046 12.332 11.925 10.757 9.779
45 36.095 29.490 24.519 20.720 17.774 15.456 13.606 12.108 10.881 9.863
50 39.197 31.424 25.730 21.482 18.256 15.762 13.801 12.234 10.962 9.915

(Contd.)
This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
 Table A-2: The Present Value of an Annuity of One Rupee (Contd.)
Year 11% 12% 13% 14% 15% 16% 17% 18% 9%1 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.850 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.487 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 5.303 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.669 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.585 5.316 5.070 4.843
20 7.963 7.469 7.024 6.623 6.259 5.929 5.628 5.353 5.101 4.870
21 8.075 7.562 7.102 6.687 6.312 5.973 5.665 5.384 5.127 4.891
22 8.176 7.645 7.170 6.743 6.359 6.011 5.696 5.410 5.149 4.909
23 8.266 7.718 7.230 6.792 6.399 6.044 6.723 5.432 5.167 4.925
24 8.348 7.784 7.283 6.835 6.434 6.073 5.747 5.451 5.182 4.937
25 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
30 8.694 8.055 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979
35 8.855 8.176 7.586 7.070 6.617 6.215 5.858 5.539 5.251 4.992
40 8.951 8.244 7.634 7.105 6.642 6.233 5.871 5.548 5.258 4.997
45 9.008 8.283 7.661 7.123 6.654 6.242 5.877 5.552 5.261 4.999
50 9.042 8.305 7.675 7.133 6.661 6.246 5.880 5.554 5.262 4.999

This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
 Present Value table assuming uniform cash flows throughout the year
Years 1% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00%
1 0.994 0.989 0.984 0.979 0.974 0.969 0.964 0.959 0.955
2 0.989 0.979 0.969 0.960 0.951 0.942 0.933 0.924 0.915
3 0.984 0.970 0.955 0.942 0.928 0.915 0.902 0.890 0.878
4 0.979 0.960 0.941 0.924 0.907 0.890 0.874 0.858 0.843
5 0.975 0.951 0.928 0.907 0.886 0.865 0.846 0.827 0.810
6 0.970 0.942 0.915 0.890 0.865 0.842 0.820 0.798 0.778
7 0.965 0.933 0.902 0.873 0.845 0.819 0.794 0.771 0.748
8 0.960 0.924 0.889 0.857 0.826 0.797 0.770 0.744 0.720
9 0.956 0.915 0.876 0.841 0.808 0.776 0.747 0.719 0.693
10 0.951 0.906 0.864 0.826 0.790 0.756 0.725 0.695 0.668
11 0.946 0.897 0.852 0.811 0.772 0.736 0.703 0.672 0.644
12 0.942 0.889 0.840 0.796 0.755 0.718 0.683 0.651 0.621
13 0.937 0.880 0.829 0.782 0.739 0.700 0.663 0.630 0.599
14 0.933 0.872 0.817 0.768 0.723 0.682 0.644 0.610 0.579
15 0.928 0.864 0.806 0.755 0.708 0.665 0.626 0.591 0.559
16 0.924 0.856 0.795 0.742 0.693 0.649 0.609 0.573 0.541
17 0.919 0.848 0.785 0.729 0.678 0.633 0.593 0.556 0.523
18 0.915 0.840 0.774 0.716 0.664 0.618 0.577 0.539 0.506
19 0.910 0.832 0.764 0.704 0.651 0.603 0.561 0.524 0.490
20 0.906 0.825 0.754 0.692 0.637 0.589 0.546 0.509 0.475

This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
 Present Value table assuming uniform cash flows throughout the year
10.00% 11.00% 12.00% 13.00% 14.00% 15.00% 16.00% 17.00% 18.00% 19.00% 20.00%

0.950 0.945 0.941 0.937 0.932 0.928 0.924 0.919 0.915 0.911 0.907
0.907 0.899 0891 0.883 0.875 0.867 0.860 0.853 0.845 0.838 0.832
0.866 0.855 0.844 0.833 0.822 0.812 0.802 0.792 0.783 0.773 0.764
0.828 0.814 0.800 0.787 0.774 0.762 0.749 0.738 0.726 0.715 0.705
0.792 0.776 0.760 0.744 0.730 0.715 0.702 0.688 0.675 0.663 0.651
0.759 0.740 0.722 0.705 0.689 0.673 0.658 0.643 0.630 0.616 0.603
0.727 0.706 0.687 0.669 0.651 0.634 0.618 0.603 0.588 0.574 0.561
0.697 0.675 0.654 0.635 0.616 0.599 0.582 0.566 0.550 0.536 0.522
0.669 0.646 0.624 0.603 0.584 0.566 0.548 0.532 0.516 0.502 0.488
0.642 0.618 0.595 0.574 0.554 0.536 0.518 0.501 0.485 0.470 0.456
0.617 0.592 0.569 0.547 0.527 0.508 0.490 0.473 0.457 0.442 0.428
0.593 0.568 0.544 0.522 0.501 0.482 0.464 0.447 0.431 0.417 0.403
0.571 0.545 0.521 0.498 0.478 0.458 0.440 0.424 0.408 0.393 0.380
0.550 0.523 0.499 0.476 0.456 0.436 0.418 0.402 0.386 0.372 0.359
0.530 0.503 0.479 0.456 0.435 0.416 0.398 0.382 0.367 0.352 0.339
0.511 0.484 0.459 0.437 0.416 0.397 0.380 0.363 0.348 0.335 0.322
0.493 0.466 0.441 0.419 0.398 0.380 0.362 0.346 0.332 0.318 0.306
0.476 0.449 0.424 0.402 0.382 0.363 0.346 0.331 0.316 0.303 0.291
0.460 0.433 0.409 0.386 0.366 0.348 0.331 0.316 0.302 0.289 0.278
0.445 0.418 0.394 0.372 0.352 0.334 0.318 0.303 0.289 0.277 0.265

This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.