Capital Budgeting Math

Problem: The Azad Int Ltd.
is contemplating to invest in a new project that would require procurement of a

machine costing Tk.25,50,000; and a working capital of Tk.1,00,000. The project is expected provide benefits
for five years. The expected profit before depreciation and tax from the project is as below:
Year Profit before Tax and Depreciation

1st year 8,50,000
2nd year 7,00,000
3rd year 6,50,000
4th year 6,00,000
5th year 4,50,000
(The policy of the company is to depreciate fixed assets on straight line basis over the period of the asset.
Salvage value of the machine is expected to be Tk.50,000. Assume a 40% tax rate and cost of capital of 10%)
Required: Determine the acceptability of the project on the basis of (i) Payback period; (ii) ARR; (iii)
NPV; (iv) IRR; (v) Profitability Index.
(The present values of Tk1 for five years at 10% are 0.9091; 0.8264; 0.7513; 0.6830; 0.6209)
Solution:
Depreciation = Cost – Salvage value/No. of year in lifetime = (25,50,000 – 50,000)/5 = 5,00,000.
Total Investment = 25,50,000 (Machine price) + 1,00,000 (Working capital) = 26,50,000.
Statement of cash inflow:
Particulars 1st year 2nd year 3rd year 4th year 5th year
Profit before Tax & Depreciation 8,50,000 7,00,000 6,50,000 6,00,000 4,50,000
Less Depreciation 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000
Profit before Tax 3,50,000 2,00,000 1,50,000 1,00,000 (50,000)
Less Tax @40% 1,40,000 80,000 60,000 40,000 -
Profit after Tax 2,10,000 1,20,000 90,000 60,000 (50,000)
Add depreciation 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000
Cash before Terminal cash inflow 7,10,000 6,20,000 5,90,000 5,60,000 4,50,000
Add Salvage value at 5th year - - - - 50,000
Add working Capital - - - - 1,00,000
7,10,000 6,20,000 5,90,000 5,60,000 6,00,000
Required 1: (Pay Back Period (PBP)):
Year Cash inflow Cumulative cash inflow

1 7,10,000 7,10,000
2 6,20,000 13,30,000
3 5,90,000 19,20,000
4 5,60,000 24,80,000
5 6,00,000 30,80,000
PBP = 4 + (Total investment – 4th year cumulative cash inflow)/5th year cash inflow
= 4 + (26,50,000 – 24,80,000)/6,00,000 = 4.28 years
Required 2: Average rate of return:

ARR= (Average annual profit / Average investment)*100
=[{(2,10,000+1,20,000+90,000+60,000-50,000)/5}/(26,50,000+50,000)/2]*100=(86,000/13,50,000)*100
= 6.37%
Required 3: Net Present Value (NPV) calculation:

Year Cash flow Discount Present value
factor@10%
1 7,10,000 0.9091 6,45,467
2 6,20,000 0.8264 5,12,368
3 5,90,000 0.7513 4,43,267
4 5,60,000 0.6830 3,82,480
5 6,00,000 0.6209 3,72,540
Present Value of cash =23,56,116
Less, investment =(26,50,000)
Net Present Value (NPV) (293884)
Required 4: Internal Rate of Return (IRR):
Since the NPV at 10% discounting rate is negative; Let us take lower discounting rate 5%
Therefore,
Present Value = {7,10,000/(1+0.05)+(620000)/(1+0.05) +5,90,000/(1+0.05)

+5,60,000/(1+0.05) +6,00,000/(1+0.05) } – 26,50,000 (total investment)
= (6,76,190.48 + 5,62,358.28 + 5,09,664.18 + 4,60,713.39 + 4,70,115.70) - 26,50,000 (total investment)
= 26,77,488 – 26,50,000 (total investment)
= 27,488.
IRR= A+C/C-D(B-A)
=5% +27,488/27,488-(-2,93,884)*(10%-5%) Here,

=5% + 27,488/321372 * 5% A= Lower discounting rate
=5% +0.0855*5% B= Higher discounting rate
=0.05+0.0042 = 0.0542 = 5.42% C=NPV of lower discounting rate
D= NPV of higher discounting rate
Required 5: Calculation of Profitability Index (PI)
PI = PV of cash inflow/PV of investment cost

= 23,56,116/26,50,000 = 0.889 = 0.89 (Approximated)
Ans:
i) Pay Back Period 4.28 years
ii) ARR = 6.37%
iii) NPV = (-2,93,884)
iv) PI = 0.89
Comments: Out of 5 years project life, the investment will return within 4.28 years, ARR is 6.37% which is
lower than cost of capital, PI is less than 1 and NPV value negative, So the project is not acceptable.
Problem: A large size company is considering to invest in a new project that costs Tk.4,00,000. The
estimated salvage value is zero; tax rate is 35%. The company uses straight line depreciation and the proposed
project has cash flows before tax (CBFT) as below:
Year Profit before Tax and Depreciation
1st year 1,00,000
2nd year 1,00,000
3rd year 1,50,000
4th year 1,50,000
5th year 2,50,000
Required: Determine the following: (i) Payback period; (ii) ARR; (iii) NPV at 15%; (iv) Profitability
Index.
(The PV at 15% are 0.870; 0.756; 0.658; 0.572; 0.497)
Solution:
Depreciation = Cost – Salvage value/No. of year in lifetime = 4,00,000-0/5 = 80,000.
Statement of cash inflow:

Particulars 1st year 2nd year 3rd year 4th year 5th year
Profit before Tax & Depreciation 1,00,000 1,00,000 1,50,000 1,50,000 2,50,000
Less Depreciation 80,000 80,000 80,000 80,000 80,000
Profit before Tax 20,000 20,000 70,000 70,000 1,70,000
Less Tax @35% 7,000 7,000 24,500 24,500 59,500
Profit after Tax 13,000 13,000 45,500 45,500 1,10,500
Add depreciation 80,000 80,000 80,000 80,000 80,000
Cash inflow 93,000 93,000 1,25,500 1,25,500 1,90,500
Required 1: (Pay Back Period (PBP)):

Year Cash inflow Cumulative cash inflow
1 93,000 93,000
2 93,000 1,86,000
3 1,25,500 3,11,500
4 1,25,500 4,37,000
5 1,90,500 6,27,500
PBP = 3 + (Total investment – 3rd year cumulative cash inflow)/4th year cash inflow
= 4 + (4,00,000 – 3,11,500)/1,25,500 = 3.71 years
Required 2: Average rate of return:
ARR= (Average annual profit / Average investment)*100

=[{(13,000+13,000+45,500+45,500+1,10,500)/5}/(4,00,000)/2]*100=(45,500/2,00,000)*100
= 22.75%
Required 3: Net Present Value (NPV) calculation:

Year Cash flow Discount Present value
factor@10%
1 93,000 0.870 80,910
2 93,000 0.756 70,308
3 1,25,500 0.658 82,579
4 1,25,500 0.572 71,786
5 1,90,500 0.497 94,679
Present Value of cash =4,00,262
Less, investment =(4,00,000)
Net Present Value (NPV) 262
Required 4: Calculation of Profitability Index (PI)

PI = PV of cash inflow/PV of investment cost
= 4,00,262/4,00,000 = 1.000655
Ans:
i) Pay Back Period 3.71 years
ii) ARR = 22.75%
iii) NPV = 262
iv) PI = 1.000655
Comments: Out of 5 years project life, the investment will return within 3.71 years, ARR is 22.75% which is
higher than cost of capital, PI is greater than 1 and NPV value negative, So the project is viable.

Capital Budgeting Math

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Problem: The Azad Int Ltd.

is contemplating to invest in a new project that would require procurement of a

Year Profit before Tax and Depreciation

Depreciation = Cost – Salvage value/No. of year in lifetime = (25,50,000 – 50,000)/5 = 5,00,000.

Total Investment = 25,50,000 (Machine price) + 1,00,000 (Working capital) = 26,50,000.

Statement of cash inflow:

Required 1: (Pay Back Period (PBP)):

Year Cash inflow Cumulative cash inflow

Required 2: Average rate of return:

Required 3: Net Present Value (NPV) calculation:

Present Value = {7,10,000/(1+0.05)+(620000)/(1+0.05) +5,90,000/(1+0.05)

=5% +27,488/27,488-(-2,93,884)*(10%-5%) Here,

Required 5: Calculation of Profitability Index (PI)

PI = PV of cash inflow/PV of investment cost

Statement of cash inflow:

Required 1: (Pay Back Period (PBP)):

Required 2: Average rate of return:

ARR= (Average annual profit / Average investment)*100

Required 3: Net Present Value (NPV) calculation:

Required 4: Calculation of Profitability Index (PI)

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