Chapter –7-

Practical Capital Budgeting

After studying this chapter you should be able to:

1. Understand the mechanics of MIRR

2. You should be able to deal with situations that really exist in the market.
3. You should be able to deal with situations of capital Rationing using the Linear
Programming Approach and the Solver on Excel worksheet.
4. Handle risk in project Appraisal.
5. Understand the Basic Concept of EVA, CVA and MVA

Chapter –7 Page - 1 -
 7.1 INTRODUCTION
We have till now worked on the various methods of appraising a project but we all know
that when it comes to practice many of these will fail, and even if they work, there will be
practical difficulties. No project will start at time zero, if two project are comparable they
may not be having the same life and we know that if two projects do not have equal life’s
they are not comparable, they both may be having different cash outlays which adds to
the complication, timing of these projects can also be a problem, one project can start
now and the other even if appraised and selected will at least need 1 year in installation,
nobody can claim with 100% certainty that there will be a inflow of X amount, so we
need to incorporate for the risk.
So lets explore how to deal with these difficulties.

7.2 MODIFIED INTERNAL RATE OF RETURN

Reinvestment assumption, NPV and IRR rules assume to rely on a implicit assumption
that cash flow generated during the life time of the project are reinvested at the same rate
which many times does not hold true. If you take out loan to build an office building,
you pay the bank one rate.
When your tenants start to make rental payments, you stick those rentals in a money
market fund and get an entirely different rate.1

Illustration 1
Lets take the question that we have earlier discussed where a Project had a outlay of Rs.
100,000 and a inflow of

Year Cash flow

1 Rs. 30,000
2 30,000
3 40,000
4 45,000

When we solved this we found that the IRR is working out to 15.4% and if the cost of
capital is 12% the project is certainly acceptable. This decision relies on the assumption
that the reinvestment rate is 15.4%. Lets say that we want the reinvestment rate to be
10% and then we want to find out as to the worthiness of the project. Then we have to
calculate the Modified internal rate of return. For doing so we have to find out the
terminal value assuming that these cash flows will be reinvested at 10% and then driving
at a rate of return which equates the two sides.
Let us work out that if the reinvestment is at the IRR i.e 15.4% what is the terminal value
and the rate of return.

1
Nossiter Josh, Using Microsoft Excel 97, Que Publications, 1996

Chapter –7 Page - 2 -
 46,410

39,960

46,160

45,000

0 1 2 3 4
30,000 30,000 40,000 45,000

TV = CI * CVF3years15.4%+C1*CVF2years 15.4% + C1*CVF1year 15.4%

Terminal value = 30,000*1.547+30,000*1.332+40,000*1.154+45,000*1=177,530

Present value of Rs. 177,530= 177,530*0.564 =Rs. 100,000

We have generated present value and the Compounded value at 15.4% by using the table
on excel sheet to generate values, which is provided on the C.D. First we found the future
value in the 4th year of all the inflows and then we arrived at the PV of the terminal value.

177,530
4 − 1 = 0.15429 or 15.4%
100,000

Now let us see what if the reinvestment rate is different from the IRR, we are assuming
that the reinvestment can be done at the rate of 10%

39,930

36,300

44,000

45,000

0 1 2 3 4
30,000 30,000 40,000 45,000

TV = CI * CVF3years10%+C1*CVF2years 10% + C1**CVF1year 10%

Chapter –7 Page - 3 -
Terminal value = 30,000*1.331+30,000*1.21+40,000*1.1+45,000*1=165,230.
Now let us see what is the average annual rate of return.

165,230
4 − 1 = 0.1337 or 13.37%
100,000

When we calculate the average annual return with a reinvestment rate different from IRR,
it is referred to as MIRR.

The same can be done using the excel sheet

MIRR(VALUES,FINANCE_RATE,REINVEST_RATE)
Where VALUES is the range of cash flows, FINANCE_RATE is the required rate of
return, and REINVEST_RATE is the rate at which the cash flows are to be reinvested.
To calculate the MIRR in your Supreme Shoe worksheet, enter =MIRR(B1:B5,B6,B8)
into B9. Exactly as we calculated above, the answer is 0.13376. In this example we have
used the same rate for the required return and the reinvestment rate. This is normally the
appropriate assumption to make (it is the same assumption that is implicit within NPV
calculation). But if you have other information, which suggests a different rate, then that
different rate should be used.

Exhibit 7.1

7.3 PROJECT WITH UNEQUAL LIVES

If two projects are having unequal lives they are incomparable and as we have just seen
in the previous chapter there may be a conflict in decision when we use NPV or IRR
technique. This problem can be resolved if we make their life equal that is to say if one
project has a life of 2 years and the other 3 years, if we have to compare them we have to
take the least common multiple (LCM) i.e. 6 years and then select either of the two.

Illustration 2

We have to compare between two machines, X and Y, Machine X can be purchased for
Rs. 30,000 and needs and annual maintenance and operating expenditure of Rs. 12,000
for 3 years. Machine Y has a cost of Rs. 22,500 and involve an operating expenditure of

Chapter –7 Page - 4 -
Rs. 15,000 for 2 years. If the discounting rate is 14%, which machinery should be
selected?

C0 C1 C2 C3 NPV at
14%
X 30,000 12,000 12,000 12,000 57,859.58
Y 22,500 15,000 15,000 - 47,199.91

While deciding upon which projects to choose since we have only information related to
cost we would select the machinery which has the least cost in terms of the present value.
As we can see machine Y has a lower cost so it can be selected. But what we are
forgetting is that machine X has a longer life so in order to compare them we have to
assume that we will reinstall machinery Y at the end of second year and then it will again
have a life of 2 years. Let us see what happens if we make the life of both machinery 6
years.

C0 C1 C2 C3 C4 C5 C6 NPV
X 30,000 12,000 12,000 42,000 12,000 12,000 12,000 96,913.1
Y 22,500 15,000 37,500 15,000 37,500 15,000 15,000 111,464.8

Now we see that project X has a less cost and if we select project X and continue the
business for 6 years we will save Rs. 14,551.64 but let us consider that one project has a
life of 7 years and the other project has a life of 9 years then we would have been forced
to generate cash flows for 63 years in order to arrive to a solution. Don’t worry, why
don’t we calculate cost per year and look at the solution. So, a simple approach will be to
find the annual equivalent cost per year and then to compare the annual cost of both the
projects.

C0 C1 C2 C3 NPV at
14%
X 30,000 12,000 12,000 12,000 57,859.58
AEV 24,918 24,918 24,918
Y 22,500 15,000 15,000 - 47,199.91
AEV 28,658 28,658

AEV = NPV at 14%

PVAF 14%n

AEV for project X = 57,859.58/2.322 = Rs. 24,918

AEV for project Y = 47,199.91/1.647= Rs. 28,658
So, now we can see that project X has a lesser AEV and so it should be selected.
Arriving at AEV is the same as arriving at annual equivalent installment for a loan, as
discussed in the concept Time value of money?

7.4 AEV FOR PERPETUITIES

Chapter –7 Page - 5 -
If machine X and Y are assumed to be replaced for an indefinite period then the NPV of
cost of machine X can be arrived as 24,918/0.14 = Rs. 177,985.71 and for machine Y =
28,658/0.14=Rs. 204,700. In this manner also we see that selecting machine X is a better
option and during their lives we will save Rs. 26,715 if we select machine X instead of Y.

7.5 TIMING OF PROJECTS

Many a times there is a situation where a same project can be undertaken now or it can be
undertaken one year down the line and the inflows and outflows are different. In order to
solve this kind of a problem we simply need to arrive at the PV in terms of revenue and
expenditure.

Illustration 3
Consider a project, which can be undertaken in this manner.

Project C0 C1 C2 C3
Undertaken at
Period
0 -120 170
1 -140 210
2 -160 250

Discounting Rate = 10%

If the project is undertaken now, NPV will be = -120 +(170*0.909) = 34.53
If the project is undertaken one year down the line = (-140 *0.909) + (210* 0.826) =46.2
If the project is undertaken after 2 years = (-160*0.826) + (250 *0.751) = 55.59

Now from this analysis we find that undertaking the project at the end of 2 years will
result into more addition to the wealth of shareholders then undertaking it at in other
period.

7.6 REPLACEMENT DECISIONS AND AEV

We have discussed in the previous chapter how decisions should be taken when there is
replacement situation. Same kind of situation can also be solved using the AEV
approach. Let us assume that old machinery was working and had a remaining life of 4
years. It is expected to generate cash flows of Rs. 4,000 each year. Management had an
option to replace that machinery with new machinery which has a cost of Rs. 15,000 and
which will generate cash flows of Rs. 5,000 for 6 years. Now our problem is that the life
of the machineries are different, cost are different and cash inflows are different. The
problem can be further complicated if we consider the resale value of the old machinery,
the depreciation tax shield that we will be loosing and the tax related aspects. The other
approach towards the same problem can be to find out the NPV and then to arrive at
AEV.

Chapter –7 Page - 6 -
 C0 C1 C2 C3 C4 C5 C6 NPV
New -15,000 5,000 5,000 5,000 5,000 5,000 5,000 6,775
Old 0 4,000 4,000 4,000 4,000 12,680
AEV (N) 1,556 1,556 1,556 1,556 1,556 1,556
AEV (O) 4,000 4,000 4,000 4,000

Now from this analysis this is very clear that since the old machinery is generating a
higher annual equivalent value it should not be replaced2.

7.7 Method of financing and Project Appraisal

Method of financing a project is crucial as each medium of finance has it own unique
cost, manager should focus on the cheapest source of finance so as to reduce the, overall
cost of capital and there by increasing the Net Present Value.
Let us work out a problem where the company has the option to get the project financed
through various means.

Illustration 4

ILC Plant started its operation in the year 1984; presently it is the most successful plant in
Rajasthan, with net profit after tax of Rs. 24 lakh per annum.
It is planning to expand its operations since the demand of its product is more than its
supply, it wants to purchase a new automatic conveyor belt plant costing Rs. 1.5 crore.
The expected life of the plant is 10 years and the Cash flow is expected to be Rs.
3,150,000 lakh per annum.

The present debt equity ratio of the company is 3:1.

If only debt is raised to finance the project the cost of fund will go up to 20%. (Before
adjusting for taxes)
If the same structure is maintained the cost of debt is likely to be 19% and the cost of
equity will be app. 12%.
If only equity is raised then cost of equity will go up to 13%.

Depreciation method adopted is straight-line method.

Tax rate may be assumed to be 35%.

Solution

2
Brealey R A & Myers S C, Principles of Corporate Finance, 6 th Edition, Tata McGraw Hill, 2002, Page
139.

Chapter –7 Page - 7 -
Exhibit 7.2

From cell number B1 to B7, we have determined the cash flow and cell no. D8 to D10
gives us the present cash flow using the cost of capital in cell no. B8 to B10.
PV has been calculate using the function =PV(B8,B$2,-$B$7) .
What we see is that PV is maximum when discount rate is least 12.26%

7.8 OPTIMAL CAPITAL BUDGET WITHOUT CAPITAL

RATIONING
We have seen in the previous chapter that a firm’s weighted average cost of capital will
increase as the amount of capital requirement increases. We can make use of this fact to
determine exactly what a firm’s optimal capital budget should be in the absence of capital
rationing. Briefly, we rank all project by their IRR and compare this ranking to the
marginal weighted average cost of capital schedule.

Illustration 5

Exhibit 7.3

Project Cost Cumulative Cost IRR

A 450,000.00 450,000.00 15.00%
B 440,000.00 890,000.00 16.00%
C 410,000.00 1,300,000.00 16.50%
D 390,000.00 1,690,000.00 15.50%
E 270,000.00 1,960,000.00 11.50%
F 200,000.00 2,160,000.00 13.80%
G 160,000.00 2,320,000.00 12.00%
H 70,000.00 2,390,000.00 9.00%

Chapter –7 Page - 8 -
A company had no capital constraint and it had to decide which projects should it choose.
As we know that the project with higher IRR should be chosen we need to sought and list
the projects in the descending order starting from the project with highest IRR for doing
so select the Project from A to H then go to Sort option in Data Menu, click Descending
and then Ok.

Exhibit 7.3

Project Cost Cumulative Cost IRR

C 410,000.00 410,000.00 16.50%
B 440,000.00 850,000.00 16.00%
D 390,000.00 1,240,000.00 15.50%
A 450,000.00 1,690,000.00 15.00%
F 200,000.00 1,890,000.00 13.80%
G 160,000.00 2,050,000.00 12.00%
E 270,000.00 2,320,000.00 11.50%
H 70,000.00 2,390,000.00 9.00%

Now lets say if we want to add the IRR of the project to the marginal weighted average
cost of capital chart that we created in chapter 4 we need to add the new data to our
existing worksheet, then go to Tools – Chart Wizard and select the type of chart you want
to create.

Graph from Exhibit 7.3

MCC and IRR

20

15

10

As we see that the MCC is increasing, IRR is falling and the optimal capital budget is the
point at which they intersect.

7.9 INVESTMENT DECISIONS UNDER CAPITAL

RATIONING
Under normal circumstances when capital is not a constraint we should select projects
with positive NPV. But when we have many projects at hand and capital is a constraint
we need to select only those, which results into maximum NPV per rupee of initial outlay

Chapter –7 Page - 9 -
that is to say, we are talking of profitability index method. This is referred to as a
situation of capital rationing. Let us explore the advantage & limitation of PI method.

Illustration 6

Inflows and outflows of Project A, B and C are given below:

Capital constraint 2,500.
Exhibit 7.4

A -2,500 1,500 1,250 1,000

B -1,250 500 1,000 500
C -1,250 500 750 750
PV factor @10% 1.00 0.91 0.83 0.75
PV of A -2500.00 1363.64 1033.06 751.31
PV of B -1250.00 454.55 826.45 375.66
PV of C -1250.00 454.55 619.83 563.49
NPV-A 648.01 Ranking 1
NPV-B 406.65 Ranking 2
NPV-C 387.87 Ranking 3
IRR-A 25.35% Ranking 3
IRR-B 27.42% Ranking 1
IRR-C 25.70% Ranking 2
P.I.-A 1.26 Ranking 3
P.I.-B 1.33 Ranking 1
P.I.-C 1.31 Ranking 2

If we use NPV method as a selection criterion we should select project A but that will
absorb the entire Rs 2,500 rupee and produce the wealth of Rs. 648. On the other hand if
we select project B and C that will also absorb Rs. 2,500 but the net addition to our
wealth will be Rs. 794.50 so we can clearly see that adopting the Profitability index
method will give us the correct result but this will hold true only if the decision has a
capital constraint for one year only and all the projects are starting at one time, they are
having equal lives and there are no other limiting factors attached. Lets expand previous
example and we will add one other project D which has a outflow of Rs. -4000 at the end
of first year followed by inflows of Rs. 3,000 and Rs. 2,000 at the end of second and third
year.

Capital constraint for the second year is also Rs. 2,500.

Chapter –7 Page - 10 -
Exhibit 7.5
A -2,500 1,500 1,250 1,000
B -1,250 500 1,000 500
C -1,250 500 750 750
D 0 -4,000 3,000 2,000
PV factor @10% 1.00 0.91 0.83 0.75
PV of A -2500.00 1363.64 1033.06 751.31
PV of B -1250.00 454.55 826.45 375.66
PV of C -1250.00 454.55 619.83 563.49
PV of D 0.00 -3636.36 2479.34 1502.63
NPV-A 648.01 Ranking 1
NPV-B 406.65 Ranking 2
NPV-C 387.87 Ranking 3
NPV-D 345.60 Ranking 4
IRR-A 25.35% Ranking 3
IRR-B 27.42% Ranking 1
IRR-C 25.70% Ranking 2
IRR-D 17.54% Ranking 4
P.I.-A 1.26 Ranking 3
P.I.-B 1.33 Ranking 1
P.I.-C 1.31 Ranking 2
P.I.-D 1.10 Ranking 4

The PI rule of selecting any project will also fail if the projects are indivisible. As we
have just discussed if project B and C are selected they will generate more profits then
selecting project A alone. Now since we have project D also in consideration we can also
look at the possibility of selecting project A in first year and project D in second year or
project B and C in the first year and project D in the second year. Since capital constraint
in the second year is also Rs.2,500 which means that the management of the company
cannot arrange for more than this amount in first and second year. Project A and B will
generate at the end of first year Rs. 1,000 and we have Rs. 2,500 which means that we
cannot undertake project D as it involves a outlay of Rs. 4,000 and we have only Rs.
3,500 but if we undertake in the first year project A then at the end of first year it will
generate Rs. 1,500 and we already have Rs. 2500. Now lets look at the total wealth
addition if we undertake project A and D, NPV (A) +NPV (D) =Rs. 993.613 which is
higher than the NPV generated by project B and C. So we have just seen that when there
are multiple constraints attached we cannot restrict ourselves to any of these methods.
The only way out is the programming approach.

Chapter –7 Page - 11 -
7.10 PROGRAMMING APPROACH TO CAPITAL
RATIONING
Large a firm’s capital budget is a serious problem that confronts financial managers.
Capital rationing is arbitrary limiting the amount of capital available for investment
purposes. This solution is, irrational and contrary to the goal of the firm wealth
maximization as they have projects with positive worth yet they plan to undertake few.
In order to maximize shareholder wealth, the firm must accept all positive NPV projects,
but due to capital constraints they are restricted. Remember that a positive NPV project
is one, which will cover the cost of financing (the weighted average cost of capital). In
effect, a positive NPV project is self-liquidating, so there should be no problem raising
the required funds to make the investment. No matter how much we raise as long as
positive NPV projects exist, a firm should continue to invest until cost of investing is less
than the benefits to be gained.
But since there is a capital constraint we have to choose those projects from which we get
maximum benefits.

Illustration 7

Capital constraint Rs. 20,000 in first and second year. All projects are mutually exclusive
and they are indivisible.

Exhibit 7.6 (All figures are in thousand)

A -20 60 10
B -10 10 40
C -10 10 30
D 0 -80 120
PV factor @10% 1 0.909 0.826
PV of A -20 54.545 8.264
PV of B -10 9.091 33.058
PV of C -10 9.091 24.793
PV of D 0 -72.727 99.174
NPV-A 42.81 Ranking 1
NPV-B 32.15 Ranking 2
NPV-C 23.88 Ranking 4
NPV – D 26.45 Ranking 3
IRR-A 215.83% Ranking 1
IRR-B 156.16% Ranking 2
IRR-C 130.28% Ranking 3
IRR-D 50.00% Ranking 4

Chapter –7 Page - 12 -
 P.I.-A 3.14 Ranking 3
P.I.-B 4.21 Ranking 1
P.I.-C 3.39 Ranking 2
P.I.-D 1.36 Ranking 4

(We are assuming that the student is aware of linear programming model, which is a part
of Quantitative Technique in the first term at all management school).

Since our objective is to maximize NPV, we will write the equation as:
(NPV of the projects have been rounded up)
Maximize NPV = 42xA +32xB+24xC+26xD ………………………………………….. Eq. 7.1
20xA +10xB+10xC+0xD  20
-60xA -10xB -10xC +80xD  20
0 xA  1 0 xB  1

Layman approach of solving a problem is to substitute the values of x at random but that
will take a lot of time. The other approach can be the linear programming approach,
which we learn in the paper of Quantitative techniques or we can also use solver which is
a in-built operation in excel worksheets.

NOTE:
(If the solver is not loaded on the excel sheet ask the system administrator to do so.)

Enter the equation 7.1, on the excel sheet in the manner as shown in the Exhibit below,
we have also written one row which is denoted by the word SOLUTION on which we
have written all zero, there is one column which says TOTAL in this column enter the
following function =SUMPRODUCT(B2:E2,$B$5:$E$5), this function simply shows
that whatever project is selected the sum cannot exceed the constraint, as entered in the
next column named as Availability.

Now go to cell F4 and go to TOOLS and then to SOLVER, we have to select cell no F4
because we want to Maximize profits/NPV.

The worksheet should look like this:

Chapter –7 Page - 13 -
Now since we want to maximize the NPV we will click on the word Max in the solver
parameters. In the column labeled as “By changing cells” enter cells B5 to E5 because the
results as to the selection of the project will appear in row 5. In the column “Subject to
constraints” we will enter that the projects should be selected in totality and they cannot
be selected in parts as they are indivisible, so the first condition we will enter will be that
from cell no. B5 to E5 has to be a integer, for doing so go to Add and select cell no. B5 to
E5 and in the next column of constraints enter integer. The second condition is that in
one year we cannot invest more than Rs. 20,000, which means cell no. F2 and F3 should
be less than or equal to G2 and G3. After doing so go to “Options” and click on assume
linear model and assume non-negativity. Finally click on the word Solve. Your
worksheet should resemble as given below:

Chapter –7 Page - 14 -
When we click on the word solve the result will display that project A and D should be
selected in totality and the NPV generated will be 68. In the row marked as solution the
zero has been turned into one, which means that A & D should be selected for maximum
profit operating.

Exhibit 7.7

We can also select the projects in part by changing the first constraint where we enter that
the project should be integer by inserting a new condition stating that B5 to E5 should be
less than equal to 1.

After entering this constraint we will press the button solve and the result will be that
project B should be selected in full, A half and D two third and the NPV will be 72.5.

Chapter –7 Page - 15 -
Alternative Approach for dealing with problem on Capital Rationing.

Illustration 8

There are 8 projects their cost and NPVs are given to us and the capital constraint is of
Rs. 4 lakh. All projects have positive NPVs.

Exhibit 7.8

We will assume that each project is indivisible and so it cannot be selected in parts for
which in column D we have entered one against each project. We have used the sum
product formula as discussed in the previous question in cell no. C11 and B11. We can
also use an array formula. An array formula is one, which operates on each element in a
range, but without specifying each element separately. Array formulas are therefore
easier to write and save space. We want to calculate the total cost of the accepted projects
in B10, we want to write a formula which multiplies the costs in column B by the
corresponding 0 or 1 as in column D and keeps a running total of the results. So the
array formula would be =SUM(B2:B9*D2:D9). Now if you will simply click the enter
button you will see # VALUE to make excel understand this formula we need to press the
enter key after holding shift and control key.

Now go to Tools and select Solver and enter the parameters as shown in the exhibit
below, Go to Options and click on Assume linear model and Assume non-negativity.
Finally click on the word Solve. Your worksheet resemble as given below:

Chapter –7 Page - 16 -
The result returned to us by Solver will be that project A, E and F should be selected in
Full if the Constraint is Rs. 4 lakh and NPV will be Rs.111,000.

Exhibit 7.8

7. 11 TESTING PROJECTS FOR ITS SENSITIVITY

Now lets see how variables can change the project selection by using the
sensitivity/scenario analysis in a more detail manner.

Illustration 9

Lets put our self in the shoes of Mr. Finance manager of a company which is planning to
launch a television with a flat screen and internet browsing facility known as Cinetel Ltd.,
it also has the inbuilt facility known as DTH (direct to home) so we do not need the Cable
connection, and there are many other features, it requires a investment of Rs. 4,000 lakh
and will have a life of 5 years estimated demand and prices are given, in the exhibit
below the profitability, cash flow and net present value are arrived after careful study of

Chapter –7 Page - 17 -
the market. Finance manager has also developed a model for the same and wants to test
the project for its sensitivity. Expected sales in the first year 15,000 units, which will
grow at the rate of 10%each year.

1. What if the market size falls to 10,000 units in the first year growth rate still
continuing at 10%?
2. What if the company cannot sell products at the desired price because a
competitor is selling at Rs.18,000 and so the company has to sell at the same
price?
3. What if the variable cost moves up to Rs.14,000 Per unit.
4. What if the fixed cost doubles for all the 5 years.

The finance manager has calculated the Net Present Value as given in Exhibit 7.9
Exhibit 7.9
Cash Outflow 400,000,000.00 Net cash Flow 28,672,347.58
Life in years 5
Discounting rate 0.10
1 2 3 4 5
Annual Demand of
Television 15,000.0 16,500.0 18,150.0 19,965.0 21,961.5
Unit selling price 20,000.0 20,000.0 20,000.0 20,000.0 20,000.0
Revenue 300,000,000.0 330,000,000.0 363,000,000.0 399,300,000.0 439,230,000.0
Variable cost per unit 12,500.0 12,500.0 12,500.0 12,500.0 12,500.0
Variable cost 187,500,000.0 206,250,000.0 226,875,000.0 249,562,500.0 274,518,750.0
Fixed cost 4,000,000.0 4,000,000.0 4,000,000.0 4,000,000.0 4,000,000.0
Less-Depreciation 80,000,000.0 80,000,000.0 80,000,000.0 80,000,000.0 80,000,000.0
P.B.T 28,500,000.0 39,750,000.0 52,125,000.0 65,737,500.0 80,711,250.0
Less- TAX 9,975,000.0 13,912,500.0 18,243,750.0 23,008,125.0 28,248,937.5
Net Profit 18,525,000.0 25,837,500.0 33,881,250.0 42,729,375.0 52,462,312.5
Add- Depreciation 80,000,000.0 80,000,000.0 80,000,000.0 80,000,000.0 80,000,000.0
Cash Flow 98,525,000.0 105,837,500.0 113,881,250.0 122,729,375.0 132,462,312.5
Present Value of
Cash Flow 428,672,347.58

Solution

One easy way is to change the value of each component individually and test the result
the other approach can be to use Goal seek, lets see that till what extent can the demand
go down and still we are able to get positive results. But do remember that goal seek can
change values of only one cell to get the desired result, so we have to resort to Scenario
and observe the consequences. For creating scenarios refer to chapter 1.

Chapter –7 Page - 18 -
Exhibit 7.10

The result from the scenario summary sheet can be summarized as follows:
When the demand moves down the net present value turns out to be the negative figure of
(95,481,220.23.) On other counts also like a change in price movement of Variable cost
and Fixed cost, the NPV is negative.
Under normal situations the NPV is positive but the margins are very low. Sensitivity
analysis falls down to expressing cash flows in terms of variables and calculating its
effect on the present value. One drawback of sensitivity analysis is that it always gives
ambiguous result like we do not know what is optimistic and what is pessimistic. When
to be optimistic and what will be the level of optimism. Another problem with sensitivity
analysis is that the underline variables are likely to be interrelated and so it does not make
much sense to look at effects in isolation of an increase or decrease in market share.

7.12 HANDLING RISK

Risk can be defined in many ways but from the point of view of project appraisal risk it is
simply a possibility of some bad outcome. In the current context risk may be defined as

Chapter –7 Page - 19 -
the possibility of decrease in NPV of a project because of increase in prices of crude oil
in the global market.

The risk of driving a car too fast is getting a penalty ticket or, worse still, getting into an
accident. Merriam-Webster’s Collegiate Dictionary, in fact, defines the verb to risk as
“to expose to hazard or danger.” Thus risk is perceived almost entirely in negative terms.

In finance, our definition of risk is both different and broader. Risk, as we see it, refers to
the likelihood that we will receive a return on an investment that is different from the
return we expect to make. Thus, risk includes not only the bad outcomes (returns that are
lower than expected), but also good outcomes (returns that are higher than expected).

Much of this can be viewed as an attempt to come up with a model that best measures the
danger in any investment, and then attempts to convert this into the opportunity that we
would need to compensate for the danger. In finance terms, we term the danger to be
“risk” and the opportunity to be “expected return.”

When analyzing the risk of a firm, we can measure it from the viewpoint of the firm’s
managers or we can argue that the firm’s equity is owned by its shareholder’s who might
perceive the risk in a different manner than the firm’s managers.

Risk in an investment has to be perceived through the eyes of investors in the firm. Since
firms often have thousands of investors, often with very different perspectives, it can be
asserted that risk has to be measured from the perspective of not just any investor in the
stock, but of the marginal investor, defined to be the investor most likely to be trading on
the stock at any given point in time. The objective in corporate finance is the
maximization of firm value and stock price. If we want to stay true to this objective, we
have to consider the viewpoint of those who set the stock prices, and they are the
marginal investors.

7.12.1 Risk and Expected Return

To demonstrate how risk is viewed in finance, risk analysis is presented here in three
steps: first, defining risk in terms of the distribution of actual returns around and expected
return; second, differentiating between risk that is specific to one or a few investments
and risk that affects a much wider cross section of investments (in a market where the
marginal investor is well diversified, it is only the latter risk, called market risk, that will
be rewarded); and third, simulation models for measuring this market risk and the
expected returns that go with it.

Investors who buy assets expect to earn returns over the time horizon that they hold the
asset. Their actual returns over this holding period may be very different from the
expected returns, and it is the difference between actual and expected returns that is a
source of risk. For example, assume that you are an investor with a one-year time
horizon buying a one-year Government scrutiny (or any other default-free one-year bond)
with a 5 percent expected return. At the end of the one-year holding period, the actual

Chapter –7 Page - 20 -
return on this investment will be 5 percent, which is equal to the expected return. The
return distribution for this investment is shown in Figure below. This is a riskless
investment with a probability of 1.

Probability = 1

The actual return

is always equal
to the expected
return.

Expected Return

Low Risk investment

High-Risk investment

When probability cannot be assigned to occurrence of an event we call it as uncertainty,

which is non-quantifiable, and so a project should not be adjusted for any uncertainty.

7.12.2 Probability Distribution of Return on a Risk-Free Investment

To provide a contrast to the riskless investment, consider an investor who buys stock in a
firm, say HLL. This investor, having done his research, may conclude that he can make
an expected return of 30 percent on HLL over one-year holding period. The actual return
over this period will almost certainly not be equal to 30 percent; it might be much greater
or much lower.

Chapter –7 Page - 21 -
7.12.3 Return Distribution for Risky Investment

In addition to the expected return, an investor now has to consider the following. First,
note that the actual returns, in this case, are different from the expected return. The
spread of the actual returns around the expected return is measured by the variance or
standard deviation of the distribution; the greater the deviation of the actual returns from
the expected return, the greater the variance, Second, the bias toward positive or negative
returns is represented by the skewness of the distribution. To be more precise, in a
positively skewed distribution mean is maximum and the mode least, the median lies
between the two whereas in the negatively skewed distribution the value of mode is
maximum and mean least.

In the special case where the distribution of returns is normal, investors do not have to
worry about skewness, since there is no skewness.

Lets take an example of firm X and Y to calculate standard deviation and variance. The
word return is defined from investor’s perspective as

Price at end of year n – Price at beginning of year n

Return in year n = + Dividend in year n
Price at beginning of year n

For Firm X and Y the returns are calculated on an average basis and expressed in
percentage terms incorporating for price appreciation and dividend:

Arithmetic Average or Arithmetic Mean = X1+X2+X3……………

Standard Deviation =
x 2

N −1
x = (X – X) it denotes deviation from the mean.

Variance =
(X − X ) 2

N −1

We can also use the built in function on Excel spreadsheet to calculate Variance and
Standard Deviation.

Exhibit 7.11

Year Firm X Firm Y (Rx-AVGx)2 (Ry-AVGy)2

1991 5.00% 4.00% 2.56% 4.17%
1992 -16.00% 34.00% 13.70% 0.92%

Chapter –7 Page - 22 -
 1993 7.80% 4.00% 1.75% 4.17%
1994 5.70% -50.00% 2.34% 55.38%
1995 -30.90% 67.50% 26.95% 18.56%
1996 39.00% 71.87% 3.24% 22.52%
1997 78.00% 21.00% 32.48% 0.12%
1998 68.00% -61.89% 22.08% 74.49%
1999 -34.00% 40.00% 30.26% 2.43%
2000 23.00% 34.00% 0.04% 0.92%
2001 67.54% 35.98% 21.65% 1.34%
2002 39.00% 71.00% 3.24% 21.70%
2003 21.00% 45.98% 0.00% 4.65%
Sum 273.14% 317.44% 160.28% 211.35%
Average 21.01% 24.42%
Variance 13.36% 17.61%
St. Dev 0.37 0.42

Based on this calculation we can conclude that the average return of firm Y is higher than
X and so is the risk which is measured by the standard deviation of the company.

While evaluating a project the stand alone risk is most important because this is easier to
calculate than the market risk and the corporate risk. Decision-making becomes simpler
if we compare the project risk with the corporate risk. Although, in majority of the cases
all the risk are highly correlated and so we can conclude that if the economy does well so
will the firm and the project. When we are absolutely certain about an occurrence of an
event the probability associated with it is one and so there is no risk attached with it. But
in real life nothing can be predicted with certainty and there is always a probability
attached so we need to calculate the most likely result.

7.12.4 Probability Distribution

Probability distributions provide a more quantitative insight into an asset’s risk. The
probability of a given outcome is its chance of occurring. If an outcome has an 80
percent probability of occurrence, the given outcome would be expected to occur 8 out of
10 times. If an outcome has a probability of 100 percent, it is certain to occur. Outcomes
having a probability of zero will never occur.

A probability distribution is a model that relates probabilities to the associated outcomes.

Illustration 10

ABC Ltd. past estimates indicate that the probabilities of the pessimistic, most likely, and
optimistic outcomes are 25%, 50%, 25%, respectively. The sum of these probabilities
must equal 100%; that is, they must be based on all the alternatives considered.

The expected values for ABC Ltd. assets A and B are presented in table below. Column
1 gives the probabilities (or Pri.) and column 2 gives the R or returns. The expected value
for each asset’s return is 15%.

Chapter –7 Page - 23 -
 Expected values of returns for Assets A and B

Possible Probability Returns Weighted value

Outcomes (1) (2) (1 * 2)=(3)
Assets A
Pessimistic 0.25 13% 3.25%
Most likely 0.50 15% 7.50%
Optimistic 0.25 17% 4.25%
Total 1.00 Expected return E x 15.00%
Asset B
Pessimistic 0.25 7% 1.75%
Most likely 0.50 15% 7.50%
Optimistic 0.25 23% 5.75%
Total 1.00 Expected return E x 15.00%

The calculation of the standard deviation of the returns for Assets A and B

Asset A
R Ex R - E x (R - E x )2 Pri (R - E x ) * Pri
1 13% 15% -2% 4% 0.25 1%
2 15 15 0 0 0.50 0
3 17 15 2 4 0.25 1
3
 Asset A =  (x
i =1
1 − Ex) 2 * Pr1 = 2% = 1.41 %

Asset B
R Ex R - Ex (R - E x )2 Pri (R - E x ) * Pri
1 7% 15% -8% 64% 0.25 16%
2 15 15 0 0 0.50 0
3 23 15 8 64 0.25 16
3
 Asset B =  (k
i =1
1 − k ) 2 * Pr1 = 32 % = 5.66 %

The standard deviation for asset A is 1.41%, and the standard deviation for asset B is
5.66%. The higher risk of asset B is clearly reflected in its higher standard deviation.

Higher the standard deviation of a project, greater the risk.

A normal probability distribution is depicted by a “Bell-Shaped” curve. The symmetry of

the curve means that half the probability is associated with the values to the left of the
peak and half with values to the right.

Chapter –7 Page - 24 -
 68.26%

95.46%

99.74%

 3  2  1 X  1  2  3

Note:

• The area under the normal curve always equals 1.0, or 100 percent. Thus, the areas
under any pair of normal curves drawn on the same scale, whether they are peaked or
flat, must be equal.
• Half of the area under a normal curve is to the left of the mean, indicating that there is
a 50 percent probability that the actual outcome will be less than the mean, and half if
the right of mean, indicating a 50 percent probability that it will be greater than the
mean.
• Of the area under the curve, 68.26 percent is within  1  of the mean, indicating that
the probability is 68.26 percent that the actual outcome will be within the range
Mean, -1 to Mean + 1.
95 percent of all outcomes will lie between  2 from the expected value, and 99
percent of all outcomes will lie between  3 from the expected value.
• For a normal distribution, the lager the value of , the greater the probability that the
actual outcome will vary widely from, and hence perhaps be far below, the expected,
or most likely, outcome, outcome. Since the probability of having the actual result
turn out to be far below the expected result is one definition of risk, and since 
measures, this probability, we can use  as measure of risk.

If we assume that the probability distribution of returns for the ABC Ltd. is normal,
68% of the possible outcomes would have a return ranging from13.59% to 16.41% for
asset A and from 9.34% to 20.66% for asset B.
95% of the possible return outcomes would range from 12.18% to 17.82% for asset A
and from 3.68% to 26.32% for asset B.
99% of the possible return outcomes would range from 10.77% to 19.23% for asset A
and from (1.98%) to 31.98% for asset B.
The greater risk of asset B is clearly reflected by its much wider range of possible returns
for each level of confidence (68%, 95%, etc).

7.12.5 Coefficient of Variation

Chapter –7 Page - 25 -
The coefficient variation, CV, is a measure of relative dispersion that is useful in
comparing the risk of assets with differing expected returns. Expression for the
coefficient of variation:


CV =
Expected Return

The higher the coefficient of variation, the greater the risk.

When the standard deviation and the expected returns for assets A and B are substituted
into equation above, the coefficients of variation for A and B are 0.094(1.41% /15%) and
0.37 (5.66% / 15%), respectively. Asset B has the higher coefficient of variation and is
therefore, more risky than asset A which we already know from the standard deviation.
Because both assets have the same expected return, the coefficient of variation has not
provided any new information.

The real utility of the coefficient of variation comes in comparing the risk of assets that
have different expected returns.

The coefficient of variation shows the risk per unit of return, and it provides a more
meaningful basis for comparison when the expected returns of two alternatives are not
the same.

Illustration 11

A firm wants to select the less risky of two alternatives assets X and Y. The expected
return, standard deviation, and coefficient of variation for each of these assets’ returns are

Statistics Assets X Assets Y

(1) Expected return 12% 20%
(2) Standard deviation 9% 10%
(3) Coefficient of variation (2) /(1) 0.75 0.50

Based solely on their standard deviations, the firm would prefer asset X, which has a
lower standard deviation than asset Y (9% versus 10%). However, management would
be making a serious error in choosing asset X over asset Y, because the relative
dispersion-the risk-of the assets is reflected in the coefficient of variation which is lower
for Y than for X (0.50 versus 0.75).

Clearly, the use of the coefficient of variation to compare asset risk is effective because it
also considers the relative size, or expected return, of the assets.

Chapter –7 Page - 26 -
 Project X
 = 9%
X =12%

12%

Project Y
 = 10%
X =20%

20%

Project Y is less risky although it has a higher Standard deviation.

Illustration 12

A company is planning to start a project in the year 2004 which will terminate in the year
2008. The investments would be: Building Rs. 12,000, Equipments Rs. 8,000, sales are
expected to be 17,000 units and will be sold at Rs. 5 per unit, working capital
requirement would be 10% of the sales, variable cost is expected to be Rs. 3 per unit and
fixed cost Rs. 10,000 because of inflation fixed cost will go up by 1% each year, variable
cost by 2% each year and sales price by 4% each year. The policy of the company has
been to discount the project at 12%. At the end of the life of the project building will
fetch Rs. 7,500 and equipments at Rs. 2, 000. The company depreciates using straight-
line method. (The solution is on the CD-ROM with the file name simulation if there is a
problem in installation refer to instruction on page 168)

Chapter –7 Page - 27 -
Solution

Exhibit - Simulation 7.1

Input Data
Building cost 12,000.00 Market value of building in 2008 7,500.00
Equipment cost 8,000.00 Market value of equipment in 2008 2,000.00
Net Operating WC / Sales 0.10 Tax rate 0.40
First year sales (in units) 17,000.00 WACC 0.12
Growth rate in units sold 0.00 Inflation: growth in sales price 0.04
Sales price per unit 5.00 Inflation: growth in VC per unit 0.02
Variable cost per unit 3.00 Inflation: growth in fixed costs 0.01
Fixed costs 10,000.00
NPV 35,992.29

Depreciation Schedule Years

1 2 3 4
Building Depreciation 3,000.00 3,000.00 3,000.00 3,000.00
Depreciated value of Building 9,000.00 6,000.00 3,000.00 0.00

Equipment Depreciation 2,000.00 2,000.00 2,000.00 2,000.00

Depreciated value of Equipment 6,000.00 4,000.00 2,000.00 0.00

Net Salvage Values in 2008

Building Equipment Total
Estimated Market Value in 2008 7,500.00 2,000.00
Book Value in 2008 0.00 0.00
Expected Gain or Loss 7,500.00 2,000.00
Taxes paid or tax credit 3,000.00 800.00
Net cash flow from salvage 4,500.00 1,200.00 5,700.00

Projected Net Cash Year

0 1 2 3 4
Building -12,000.00
Equipment -8,000.00
Units sold 17,000.00 17,000.00 17,000.00 17,000.00
Sales price 5.00 5.20 5.41 5.62
Sales revenue 85,000.00 88,400.00 91,936.00 95,613.44
Variable costs 51,000.00 52,020.00 53,060.40 54,121.61
Fixed operating costs 10,000.00 10,100.00 10,201.00 10,303.01
Depreciation (building) 3,000.00 3,000.00 3,000.00 3,000.00
Depreciation (equipment) 2,000.00 2,000.00 2,000.00 2,000.00
EBIT 19,000.00 21,280.00 23,674.60 26,188.82
Taxes (40%) 7,600.00 8,512.00 9,469.84 10,475.53

Chapter –7 Page - 28 -
NOPAT 11,400.00 12,768.00 14,204.76 15,713.29
Add back depreciation 5,000.00 5,000.00 5,000.00 5,000.00
Operating cash flow 16,400.00 17,768.00 19,204.76 20,713.29

Cash Flows Due to Net Operating Working Capital

NOWC-10% of sales 8,500.00 8,840.00 9,193.60 9,561.34 0.00
Change in NOWC -8,500.00 -340.00 -353.60 -367.74 9,561.34

Net salvage cash flow: Building 4,500.00

Net salvage cash flow: Equipment 1,200.00
Total salvage cash flows 5,700.00
Net Cash Flow -28,500.00 16,060.00 17,414.40 18,837.02 35,974.64

Appraisal of the Proposed Project

Net Present Value (at 12%) 35,992.29

IRR 0.55968

Using Scenario Manager to analyze Risk

Three situations are created namely Best Scenario, Worst case and Base case in which we
assumed that if the sales in terms of quantity move up by 25% what is the NPV and if it
moves down by 25% what will be the NPV. The results are summarized below:

Exhibit - Simulation 7.2

Scenario Summary
Current Values: Best Scenario Base Case Worst Case
Changing Cells:
$D$5 17,000.00 21,250.00 17,000.00 12,750.00
Result Cells:
$H$52 35,974.64 44,588.75 35,974.64 27,360.53
Notes: Current Values column represents values of changing cells at
Time Scenario Summary Report was created. Changing cells for each
Scenarios are highlighted in gray.

The probability of occurrence of best case is 10%, for worst case 30% and for base case
60% so the standard deviation of project can be calculated as:

Scenario Probability NPV

Best Case 10% 44,588.75
Base Case 60% 35,974.64
Worst Case 30% 27,360.53

n
Expected NPV =  P ( NPV )
i =1
i i

Chapter –7 Page - 29 -
(0.1*44,588.75) + (0.6*35,974.64) + (0.3*27,360.53) = 34,251.8

n
Standard Deviation NPV =  P ( NPV
i =1
i i − Expected NPV ) 2

0.1(44,588 .75 - 34,251.8) 2 + 0.6 (35,974.64 - 34,251.8) 2 + 0.3(27,360 .53 - 34,251.8) 2

= 90.9

Coefficient of Variation = NPV

E(NPV)

= 90.9
34,251.8

= 0.002

The project Coefficient of Variation (CV) can be compared with the Coefficient of
Variation of company in order to get the relative riskiness of the project. If the existing
CV of the company is greater than 0.002 then there is no risk in selecting the project.
Scenario analysis provides useful information about a project stand-alone risk, and so it
has limited application, because there are infinite numbers of possibilities.

7.13 SENSITIVITY GRAPH

By changing three variables we want to check the sensitivity of the project. The three
variables are sales price, variable cost and sales quantity, we want to see the change in
NPV because of change in any of the three variables by 25% change in both directions.

Change Unit Sales VC Sales Price

(0.25) 12,750.00 2.25 3.75

0 17,000.00 3.00 5
0.25 21,250.00 3.75 6.25

The results can be obtained by using scenario manager, which are as follows.
NPV-VC NPV-Unit NPV-Sales
Sales Price
(0.25) 59,867.54 27,360.53 (4,095.00)
0 35,992.29 35,992.29 35,992.29
25% 42,040.68 44,588.75 76,059.00

The graph depicting the relationship indicates the sensitivity of the project, with regards
to change in variables.

Exhibit - Simulation 7.2

Chapter –7 Page - 30 -
 Sensitivity

100,000.00

50,000.00 NPV-VC
NPV

NPV-Unit Sales
0.00 NPV-Sales Price
(0.25) 0 25%
-50,000.00
Percentage change

When there is no change in any of the variable the present value is Rs.35,992.29 with the
change in variables the NPV is changing.
The graph indicates that the project is most sensitive to the Sales price.
The steeper the slope the more sensitive the NPV is to the change in the variable.

7.14 MONTE CARLO SIMULATION

Monte Carlo simulation is similar to scenario analysis but it uses different values of key
inputs as input. Unlike scenario analysis, Monte Carlo simulation draws the input values
from a specified probability distribution and then computes the NPV. It repeats this
process hundred, or even thousands, of times. It then averages the NPVs from each
repetition.
Monte Carlo simulation is considerably more complex but software packages have made
it simple. Many packages are available in the market and few are add-ins for excel which
greatly enhance the ability to use simulation. Two prominent simulation add-ins are
@RISK, developed by Palisade Corporation and Crystal Ball, developed by
Decisioneering.
In a simulation exercise the computer generates random numbers for a variable like sales,
price and so on. Then those values are combined and NPV of the project is calculated and
stored in the memory. A second random variable is taken and the result is recorded, this
can be done for thousand of times.
Finally the mean and the standard distribution of the random generated result is
determined, the mean is used as the project expected NPV and the standard deviation and
Coefficient of Variation is used to measure the risk.

NOTE before proceeding further you have to install an Add-In file on your computer.
This Add-In is developed by Professor Roger Myerson at Northwestern University and
the file can download from his website.
http://www.kellogg.nwu.edu/faculty/myerson/ftp/addins.htm

All working of Monte Carlo simulation is on a separate Excel file with the name of
“Simulation” on the CD ROM (And on the website of Taxmann).

Chapter –7 Page - 31 -
The software is a free ware and I am thankful to Professor Roger Myerson for the
wonderful software.
Please read the instructions carefully for successfully installing the component.
The file is also provided on the CD-ROM the name of the file is ‘Simtools.xla’, the xla
word indicates that it is an Add-In.

When you will open the excel file ‘Simulation of chapter-7’, the computer will prompt a
box as shown below:

Click ‘Yes’ to proceed further even after doing so if there is some problem in any of the
cells it means that the programme is not correctly installed.

The file copy should be placed in the excel library or else it may not work.
The library is normally located at c:\\Programme Files\Microsoft Office\Office\Library.
After doing so open a worksheet and click on Tools on the Menu Bar and click on Add-
Ins.

Screen shot –1

Chapter –7 Page - 32 -
This will open a dialog box as shown below. If you are unable to see the word
Simulation Tools it means that the downloaded file simtools.xla is either corrupt or is not
located in the correct folder.

Screen shot -2

After we have installed Simulation Tools few more statistical functions will be added.
The explanation of these new functions is given on the website of Professor Roger
Myerson.

We want to simulate the variable sales price per unit and see its resultant effect on the
NPV. Since the company is newly incorporated and our best guess is that the selling
price per unit will be Rs. 5 per unit with the standard deviation of 0.4. As a student of
statistics we already know that there are 68% chances for the actual price to be within one
standard deviation that is to say share price will vary in the range of 4.6 to 5.4. Another
way of expressing can be that the probability of actual price not being within this range is
32%. We can do away with this by increasing the range to 3 standard deviations.

Let us understand the function Rand. This function generates a sequence of random
observations from a uniform distribution between 0 and 1. Click on any cell and type
=RAND(), this will generate a random number between 0 and 1, now if we want 100
random numbers we simply have to copy this cell to other cells. We also have one more
information regarding the share price, which give us the mean and standard deviation so
we will use the RAND function with a small modification.

Exhibit - Simulation 7.1 (Continued from Row-60)

Chapter –7 Page - 33 -
In the column probability we will write Rand() because we want to generate random
variables with uniform distribution. In the original worksheet we had mentioned the sales
price to be Rs. 5 and the entire worksheet was dependent on the input variables. Now, we
simply need to relate the new simulated sales price as an input variable and the results
will automatically change. When we press F9 key new set of results will generate
because excel will change the random variables.
Before proceeding further make a duplicate copy of the model from cell no. A1 to H57,
and copy it just below the simulated sales price.

In the input cell make a change by relating it with the simulated sales price.
Create a new worksheet and make three columns and relate it with the revised simulated

Exhibit - Simulation 7.4

Finally select an area where you want the simulated result, by simply selecting the area,
including cells A2 to C2 drag it down to as many cells as you want. After doing so just go
to Tools – SimTools - Simulation Table.

Chapter –7 Page - 34 -
This table gives us the various possible values of sales and the resultant NPV, with the
mean of Rs.5 and standard deviation of 0.4.

There is also an alternative method for generating random values, without installing
simtools software, go to Tools – Data analysis and click on Random number Generation.

Screen shot -3

Screen shot -4

Chapter –7 Page - 35 -
Random number will be generated in a new worksheet, which can be used as inputs for
selling price and the new NPV for each sales price can then be calculated.

This method is simply to apply if we want to check the simulation for one variable only,
but when variables are more than one and there is interrelationship between them then we
have to use the former method.

Now let us assume that management of the company want to simulate for one more
variable that is variable cost, which is expected to move in the range of Rs.2.5 to Rs.5.

Before proceeding further for simulation with more than 1 variable lets make a copy of
the existing file.

The function, which will solve the above problem, is TRIANINV.

Which will use random numbers between 2.5 to 5.

Exhibit - Simulation 7.5

Chapter –7 Page - 36 -
The variable cost in our model should be then related to the simulated variable cost.
Insert a new worksheet and perform the simulation in the same manner as we performed
earlier.

Exhibit - Simulation 7.6

Trial Sales Variable

Number Price Cost NPV
SimTable 5.14 3.13 40,550.70
- 4.78 3.90 28,932.58
0.00 5.25 4.21 43,855.80
0.00 5.38 3.59 48,029.20
0.00 4.59 4.09 22,747.28
0.00 5.04 4.17 37,279.24
0.00 4.95 2.73 34,546.48
0.00 4.98 3.49 35,309.94
0.00 5.37 3.00 47,996.73
0.00 4.68 3.78 25,853.89
0.00 4.60 4.05 23,034.93
0.00 4.45 3.61 18,414.06
0.00 4.80 3.12 29,719.08
0.00 4.22 4.11 10,974.60
0.00 5.11 3.99 39,532.84
0.00 5.01 2.71 36,421.80
0.01 5.01 4.44 36,304.46
0.01 5.04 3.94 37,376.54
0.01 5.21 3.44 42,726.80

On the CD the cells selected for performing simulation are 3,000.

Each time we open the worksheet and perform calculation the NPV is going to change, so
the result as displayed in the text may not exactly resemble with the figures on the CD.

Chapter –7 Page - 37 -
7.14-1 SUMMARY OF SIMULATION

Exhibit - Simulation 7.7

Simulation Summary
Sales Variable Cost NPV
Mean 5.01 3.49 36,173.07
Standard deviation 0.40 0.54 12,804.91
Maximum 6.43 4.98 81,696.48
Minimum 3.35 2.53 -17,025.77
Probability of NPV > 0 99.7%
Coefficient of Variation 0.35

The results indicate that even in adverse circumstances there is a 99.7% probability for
the project to generate positive NPV.

Monte Carlo simulation is the best method to judge the riskiness of the project. The only
limitation that it has is that of the assumption of mean and standard deviation of any
variable, which is subjective in nature. If we have projects of the same nature we can
reduce this subjective assumption and use the data of the like project.

7.15 RISK ADJUSTED DISCOUNT RATE

Mangers often resort to increase in the discounting rate and dealing with situations of
risk, which they refer to as risk adjusted discount rate. If the base rate or discounting rate
that the company uses is 12% and if the managers faces some kind of a risk in the market
he adds a risk premium to the base rate

Risk adjusted discount rate = Weighted average cost of capital + Risk premium

The need for the risk adjusted discount rate usually arise because evaluators fail to assign
bad outcomes their probability so the managers tend to discount the whole project by
adding a risk premium.

Illustration 13

Project A will produce one cash flow of 1 lakh and the discounting rate used is 10%. The
project involve initial investment of Rs.75,000 so technically the NPV will work out to
100,000 / (1+0.1)1 = Rs.90,909. But now the manager feels that the project is not running
as per his expectation and so likely outcome for project A may vary from Rs.120,000 to
Rs. 60,000. The probability associated are given below

Chapter –7 Page - 38 -
Exhibit 7.12
Possibility of Cashflow Probability of cashflow Probability * Cashflow
120,000 0.25 30,000
100,000 0.4 40,000
60,000 0.35 21,000
91,000

Now the NPV is 91,000 / (1+0.1)1 = Rs.82,727

Now even after incorporating for risk we know that the project is worth selecting.
If after incorporating for risk the project present value is Rs.82,727 and initially the
forecast of cash inflow was 1 lakh, we can determine the rate at which 1 lakh should be
discounted to give us a PV of Rs.82,727 which is working out to 20.87%.
If the discounting rate / base rate of the company is 10% it needs to add 10.87% more to
get the risk adjusted discount rate.3
There can also be one more way to deal with the same kind of a problem, which is called
as the certainty equivalent approach.

7.16 CERTAINTY EQUIVALENT

Risky cash flows should be discounted with risk adjusted discounted rate and risk free
cash flows should be discounted with risk free rate. In a sense we are adjusting for risk in
a project through the cash flows rather than in the discount rate, which we are referring to
as certainty equivalent. To adjust for risk with Certainty Equivalent Approach, we need
to multiply the Cash flow with the Certainty Equivalent Coefficient; the net result will be
the same.

Certainty Equivalent Coefficient = Riskless Cash flow

Risky cash flow

The Certainty Equivalent Coefficient will always vary between 0 and 1 and will generally
decrease with time because of increase in Risk.4

Illustration 14

Consider a project A with a cash flow of Rs.100 in 2 years, discounting rate being 10%,
Project B also has the same life but it is a risk free project and so the discounting rate is
6%

Exhibit 7.13

Project A

3
Myers, Capital Budgeting and Risk, Tata McGraw-Hill, 2002, 6th Ed., Page 221 and Damodaran Aswath,
Corporate Theory and Practice, John Wiley & Sons, 2002, 2nd Ed., Page 188
4
Pandey I.M, Financial Management, 8th Edition, Vikas Publication, 2001, Page 579.

Chapter –7 Page - 39 -
 Year Cash flow Discounting rate PV
I 100 0.91 90.91
II 100 0.83 82.64
173.55
Project B
Year Cash flow Discounting rate PV
I 96.36 0.94 90.91
II 92.86 0.89 82.64
173.55

In project A the cash flows are 100 and the PV of the cash flow is Rs. 173.55. Project B
also has a PV of Rs.173.55 but the cash flows are different which primarily indicates that
the investors is willing to sacrifice 100 – 96.36 = Rs.3.64 in the first year for the
uncertainty and to eliminate uncertainty in the second year he is willing to sacrifice
Rs.7.15. The second cash flow is riskier than the first cash flow simply because it is
exposed to 2 years of risk.

C CEQ
PV = =
1 + RADR 1 + Rf

So just remember that certainty equivalent cash flow will be less than cash flow and so
the risk free return will always be less than risk adjusted discount rate. Also note that
whether it is one year project or a 100 year project the discounting rate used should
remain the same and the notion that long live project should be discounting at long rate
should not be considered because the discount rate compensates for risk borne per period
which we have just proved because the certainty equivalent cash flow is going down with
the increase in period.

The certainty – equivalent approach recognizes risk in capital budgeting analysis by

adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash
flows. On the other hand, the risk-adjusted discount rate adjusts for risk by adjusting the
discount rate. It has been suggested that the certainty equivalent approach is theoretically
a superior technique over the Risk adjusted discount approach because it can measure
risk more accurately.5

7.16 THE DECISION TREE APPROACH

5
Robicheck, A. and Myers, S., Optimal Financing Decisions, Prentice – Hall, 1965, Page 82

Chapter –7 Page - 40 -
 Illustration 15

Consider a project with an outflow of Rs 600

Period 0 Period 1 Period 2

50% • 600

500
• 400
•
50%
50% • 300

-600 70%
•
50%
• 200
400 30%

In this example there are two possible outcomes, each with a 50% probability of
occurrence. Similarly, in the second period there are four possible outcomes, each with
an associated conditional probability. We say that the probabilities in the second period
(and any succeeding periods) are conditional because they depend on which event occurs
in the first period.

Once the conditional probability distributions have been defined for each period, we next
determine the joint probability of following each potential path. The joint probability is
the probability of following each branch along a given path. The probability is
determined by taking the product of the conditional probabilities along the path.

For the third step in the analysis, we calculate the NPV for each branch of the tree. This
“branch NPV” has a probability of occurrence equal to the joint probability for the
branch. Note that the risk-free rate of return should be used as the discount rate because
we are using the full probability distribution. Finally, we calculate the expected NPV
from the branch NPVs and the joint probabilities. In this case, the expected NPV is:

Joint Probability and NPV of Each Branch of the Decision Tree

Chapter –7 Page - 41 -
Joint Probability NPV
0.5*0.5 = 0.25 -600+500*.909+600*0.826 = 350.1
0.5*0.5 = 0.25 -600+500*.909+400*0.826 = 184.9
0.5*0.7 =0.35 -600+400*.909+300*0.826 = 11.4
0.5*0.3 = 0.15 -600+400*.909+200*0.826 = -71.2

Project NPV

= 350.1*0.25+184.9*0.25+11.4*0.35-71.2*0.15 = 127.06

The decision tree methodology is an extremely useful method of dealing with risk,
because it forces the decision maker to quantify all of the potential outcomes and their
probabilities. Unfortunately, this methodology is not well-suited to spreadsheets because
of its inherently nature

7.17 EVA, CVA and MVA

EVA6 is a term used by consulting firm Stern – Stewart, which has done much to
popularize and implement this measure. It asks what are earnings after deducting charge
for the Cost of Capital; EVA is an attempt to measure the true economic profit.

There are two concepts for evaluating business income-Accounting concept and
Economic concept.
According to accounting concept income is measured by deducting expenses incurred
from income earned during the period. According to economic concept, business income
is considered to be the maximum amount, which the business is capable of distributing to
its shareholders while still remaining in the same position at the end of the period as it
was at the beginning. Accounting concept do not take into account opportunity cost &
risk adjusted return on capital employed in the business.

In order to overcome limitations of accounting based measures of financial performance,

stern Stewart & co. adopted and modified concept of economic income in 1990 and
named it as Economic Value Added (EVA).

EVA measures whether the Operating Profit is sufficient enough to cover cost of capital.
Shareholders must earn sufficient returns for the risk they have taken in investing their
money in company’s capital. The return generated by the company for shareholders has
to be more than the cost of capital to justify risk taken by shareholders.

If a company’s EVA is negative, the firm is destroying shareholders wealth even though
it may be reporting a positive & growing EPS or ROE.

6
EVA is a registered trademark of Stern & Stewart. Developed by Bennett Stewart

Chapter –7 Page - 42 -
According to Business Standard-KPMG study based on 1997-98 results major
shareholder value generating companies were IOC, VSNL, Hindustan Lever, GAIL, ITC.
Whereas worst value destroyers are Essar Shipping, BSES, Flex Industries, Videocon
International.

EVA measures how much net operating profit NOPAT (net operating profit after taxes)
exceeds the capital charge (WACC * INVESTED CAPITAL)

EVA = NOPAT – (WACC * INVESTED CAPITAL)

Since ROIC = NOPAT / INVESTED CAPITAL

EVA can also be expressed as

EVA = (ROIC - WACC) * INVESTED CAPITAL

7.17.1 How To Improve EVA

Grow the business by taking on new investments that promise to earn more than the cost
of capital.

Improve efficiency thereby increasing operating profit without increasing the existing
capital.

From the existing business, capital is withdrawn or unprofitable assets are sold so as to
give a greater return than the cost of capital.

7.17.2 Weakness In EVA

EVA is biased in favour of large, low return investments. Large companies that earn
returns only slightly above cost of capital can have bigger EVA than small businesses
earning much higher return.

For example Company A has an Capital employed of Rs. 1,000 with NOPAT of 12%
whereas WACC is 10%. EVA will be (1,000*12%)-(1,000*10%)= Rs.20
Whereas company B with capital employed of Rs. 100 with NOPAT of 15% with WACC
of 10% will have EVA of (100*15%)-(100*10%)=Rs.5.
Thus even though Company B has higher rate of return than company A, it has lower
EVA as compared to Company A.
From the company perspective EVA is useful because it focuses attention on the
management of capital as well as the management of profit.
Many companies in India have adopted the concept of EVA and in their balance sheet
they report the EVA, but please remember that EVA depends on current level of
earnings, so it rewards manager who undertake projects with quick payback and penalize
those who undertake long gestation projects. Think of a project which involves huge
amount of investment in the beginning years because a research is carried on for
developing a product although using the present value approach the project may be

Chapter –7 Page - 43 -
worthy but the treatment of expenditure will largely affect the EVA, so we can conclude
that applying EVA requires a major changes in Accounting and financial statements.

7.17.3 CVA7 (Cash Value Added)

It is a Net Present Value model that periodizes the Net Present Value calculation and
classifies investments into two categories, Strategic and Non –strategic investments.
Strategic Investments are those which objective is to create new value for the
shareholders, such as expansion, while Non-strategic Investments are the ones made to
maintain the value that the strategic investments create. A strategic Investment is
followed by several Non-strategic investments. What we believe in our company, to be a
value creating cash outlay is what we then should define as a Strategic Investment.

The strategic investments form the capital base in the CVA model because the
shareholders’ financial requirements should be derived from a company’s ventures, not
chairs and tables. That means that all other investments with the purpose of maintaining
the original value of the venture must be considered as “costs”, such as buying new chairs
and tables. For more reading on CVA refer “CVA, Cash Value Added – a new method
for measuring financial performance” or “Cash Value Added – a framework for Value
Based Management”, by Erik Ottosson and Fredrik Weissenrieder.
The CVA discussed above should not be confused with the Boston consulting group
CVA.

7.17.4 MVA (Market Value Added)

The goal of a company’s Value Based Management (and shareholder value) process is to
make the shareholders as wealthy as possible, but how is that measured? Bennett Stewart
and his company Stern & Stewart have introduced a measure called Market Value Added.
Bennett Stewart writes “shareholders wealth is maximized only be maximizing the
difference between the firm’s total value and the total capital that investors have
committed to it”. We call this difference Market Value Added, or MVA

MVA = Total Value – Total Capital Employed

The total value is the market values of debt and market value of equity. The total capital
is the adjusted total assets from the balance sheet. It is adjusted according to the EVA
concept.

MVA

Total Total
Value Capital
7 (Market
CVA is a registered trademark of Anelda AB. Developed by Erik Ottosson and Fredrik Weissenrieder.
Value)

Chapter –7 Page - 44 -
7.18 THE POST-AUDIT
An important aspect of the capital budgeting process is the post-audit, which involves (1)
comparing actual results with those predicted by the project’s sponsors and (2) explaining
why any differences occurred. For example, many firms require that the operating
divisions send a monthly report for the first six months after a project goes into operation,
and a quarterly report thereafter, until the project’s results are up to expectations. From
then on, reports on the operation are reviewed on a regular basis like those of other
operations.

1) Improve Forecasts
When decision makers are forced to compare their projections to actual outcomes, there
is a tendency for estimates to improve. Conscious or unconscious biases are observed
and eliminated: new forecasting methods are sought as the need for them becomes
apparent; and people simply tend to do everything better, including forecasting, if they
know that their actions are being monitored.

2) Improve Operations
Businesses are run by people, and people can perform at higher or lower levels of
efficiency. When a divisional team has made a forecast about an investment, its members
are, in a sense, putting their reputations on the line. If sales are below expectations, sales
team will strive to improve operations and to bring results into line with forecasts.

3) Identify termination opportunities

Although the decision to undertake a project may be the correct one based on information
at hand, things don’t always turn out as expected. If initial operating results indicate that
a project is not likely to achieve its expected profitability, it may be best for the firm to
terminate rather than continue the project. Furthermore most projects, at some point in
their lives, lose their economic viability and should be terminated. Both the post-audit
and a continuing review of ongoing operations help identify the optimal point for the
termination of a project.

Projects sometimes fail to meet expectations for reasons beyond the control of the
operating executives and for reasons that no one could realistically be expected to
anticipate. It is often difficult to separate benefits of one investment from the system,
few projects are stand alone and cost and benefits are easily identifiable but cost savings
that results from the use of computer may be hard to measure. It is also sometimes
difficult to assign credit or blame an executive for the wrong decisions made because of
the simple fact that he has moved out before the results were known.

Chapter –7 Page - 45 -
 Practice Questions in Finance

Illustration 1

Capital Pipelines is being formed to build and operate a gas pipeline in the Country. The
pipeline is estimated to cost Rs.140 crore and is expected to earn (EBIT) Rs. 19.6 crore
per year forever. (Assume no taxes will be paid and all earnings will be distributed as
dividends and interest.)

a. Assume that, if the plant is financed entirely with common stock, stockholders will
require a 14 percent rate of return. What will be the total market value of Capital
pipelines if only common stock is issued in financing the pipeline?
b. Assuming perfect capital markets and no costs of bankruptcy, what will be the total
value of Capital pipelines if Rs. 60 crore in bonds is issued at an interest rate of 10
percent as part of the financing package?
c. Given that bonds are issued as in b, calculate the rate of return required by
stockholders on Capital pipelines common stock.
d. Assuming that the pipeline will be built, how should it be financed?

Solution
Total earnings
a. Total value =
Required rate of return

Rs. 19.6 crore

=
0.14
= 140 crore

b. Rs. 140 crore as per a, because total value of the firm’s securities is not affected by
the financing decision under these assumptions.

c. Total value = stock value + bond value

If total value is Rs. 140 crore and Rs. 60 crore in bonds are issued, then the stock
value must be

Stock value = Rs. 140 crore– Rs. 60 crore

= Rs. 80 crore
Dividends to stockholders = Earnings – Interest
= Rs. 19.6 crore – 10% of Rs. 60 crore
= Rs. 19.6 crore – Rs. 6 crore
= Rs. 13.6 crore

ke = Rs. 13.6 crore / Rs. 80 crore

= 17%

Chapter –7 Page - 46 -
d. The stockholders should be indifferent to the financing methods under the
assumptions stated.

Illustration 2

The law firm of M & M is small and has the resources to take on only one of four cases.
The cash flows for each of the four legal projects and their net present values discounted
at the rate of 10 percent per period are given below:

Cash flow
0 1 2 Net present
value
Project A -7 11 12.1 13
Project B -1 22 -12.1 9
Project C -5 44 -24.2 15
Project D -1 11 0 9

Which is the best project?

Solution

In mutual exclusivity, the cost of adopting one of the projects is the loss of the others.
Hence, computation of the cash flows relative to the best alternative should provide an
equally valid calculation. The best alternative to projects A, B and D is project C. The
best alternative to project C is project A. The appropriate cash flow calculation subtracts
the cash flows of the best alternative and is described with the pair wise project
comparisons below (concept of opportunity cost)

Cash flow
0 1 2 Net present
value
Project A (less C) -2 -33 36.3 -2
Project B (less C) 4 -22 12.1 -6
Project C (less A) 2 33 -36.3 2
Project D (less C) 4 -33 24.2 -6

Only project C has a positive net present value. Thus, selecting the project with the
largest positive net present value, as in the first set of NPV calculations, is equivalent to
picking the only positive value project, when cash flows are computed relative to the best
alternative.

Illustration 3

Two types of machines, denoted A and B, can be placed only in the same corner of a
factory. Machine A, the old technology, has a life of two periods. Machine B costs more

Chapter –7 Page - 47 -
to purchase but works faster. However, machine B wears out more quickly and has a life
of only one period. The delivery and setup of each machine takes place one period after
initially paying for it. Immediately upon the setup of either machine, positive cash flows
starts. The cash flows from each machine and the net present values of their cash flows
at a discount rate of 10 percent are as follows:

Cash flow
0 1 2 Net present
value
Machine A -0.8 1.1 1.21 1.2
Machine B -1.9 3.30 1.1

It appears that machine A is a better choice. Is this true?

Solution

Cash flow
0 1 2 Net present
value
Machine A -0.8 1.1 1.21 1.2
Machine B -1.9 3.3 1.1
Second Machine B repurchased -1.9 3.3 1.0
Sum of the two B Machines -1.9 1.4 3.3 2.1

Over the life of machine A, one could have adopted machine B, use it to the end of its
useful life, purchased a second machine B, and let it live out is useful life as well. In this
case, machine B has a higher NPV.

Illustration 4

Sola Company is into business since last 15 years. Sola Insulation Materials is
considering a Rs. 270,000 outlay for a new cutter that will reduce costs. The cutter will
last twenty years and will have a zero liquidation value at the end of the twenty years.
Non-depreciation cost reductions resulting from the new cutter are forecast at 3 percent
of the current Rs. 20 lakh per year. Sola’s annual revenues of Rs. 40 lakh will remain
unaffected. The cutter will be depreciated over twelve years on a straight-line basis; this
depreciation will be added to a current depreciation allowance for the firm of Rs. 500,000
per year on existing plant and equipment. The firm’s tax rate is 30 per cent. Sola’s cost
of capital is 15 per cent.

Compute the net present value, internal rate of return, payback period, and accounting
rate of return for this project. Should the project be adopted?

Solution

Chapter –7 Page - 48 -
Incremental investment is Rs. 270,000. Annual depreciation in years 1 to 12 = Rs.
270,000 / 12 years = Rs. 22,500, Cost reduction = 0.97 * 2,000,000 = 1,940,000.

Years 1 to 12
Firm cash flow Firm cash flow Change in cash
w/o investment with investment flow
Annual revenues (R) Rs. 4,000,000 Rs. 4,000,000 Rs. 0
Annual expenses other
than depreciation (E) Rs. 2,000,000 Rs. 1,940,000 -Rs. 60,000
R–E Rs. 2,000,000 Rs. 2,060,000 Rs. 60,000
Less: Depreciation 500,000 522,500 22,500
Taxable income Rs. 1,500,000 Rs. 1,537,500 Rs. 37,500
(TI)
Tax @ 30% of TI 450,000 461,250 11,250
PAT 1,050,000 1,076,250 26,250
Depreciation 500,000 522,500 22,500
Net cash flow (PAT + Rs. 1,550,000 Rs. 1,598,750 Rs. 48,750
Depreciation) or (R-
E-tax)

Years 13 to 20
Firm cash flow Firm cash flow Change in cash
w/o investment with investment flow
Annual revenues (R) Rs. 4,000,000 Rs. 4,000,000 Rs. 0
Annual expenses other
than depreciation (E) Rs. 2,000,000 Rs. 1,940,000 -Rs. 60,000
R–E Rs. 2,000,000 Rs. 2,060,000 Rs. 60,000
Less: Depreciation 500,000 500,000 0
Taxable income Rs. 1,500,000 Rs. 1,560,500 Rs. 60,000
(TI)
Tax @ 30% of TI 450,000 468,000 18,000
Net cash flow Rs. 1,550,000 Rs. 1,592,000 Rs. 42,000
(R-E-tax)

Life of asset: 20 years

Price of asset: Rs. 270,000
Effective tax rate: 30%
Discount rate: 15%

Summary
Date Added cash flow
Now -Rs. 270,000
Years 1-12 48,750
Years 13-20 42,000

b.

Chapter –7 Page - 49 -
Net present value:

NPV at 15% = 48,750 (PVAF, 15%, 12) + 42,000 [(PVAF, 15%, 20) -(PVAF, 15%, 12)]
– 270,000
= 48,750(5.4206) + 42,000 (0.83) – 270,000
= 29,114 > 0; therefore accept

The IRR solution to:

0 = 48,750 (PVAF, r, 12) + 42,000 (PVAF, r,8) (PVF, r, 12) – 270,000

Using interpolation;

NPV at 16% = 48,750 (5.1971) + 42,000 (4.3436)(0.1685)-270,000 = 14,098

NPV at 18% = 48,750 (4.7932) + 42,000 (4.0776)(0.1372) – 270,000
=12,835

Using interpolation;

 Rs.14,098 
R =   2% + 16% =17.05%
 Rs.14,098 + Rs.12,835 

Since the internal rate of return (r ) of 17.05% exceeds the discount rate of 15%, the
project should be accepted.

Payback period:

Payback period = Rs. 270,000 = 5.54 years

Rs. 48,750

Accounting rate of return (ARR):

ARR = Average Accounting Income

Average income

Accounting income = R-E-Depreciation –Tax. From part a, accounting income is Rs.

26,250 in years 1 to 12 and is Rs. 42,000 in years 13 to 20. The average accounting
income is therefore Rs. 32,550 (Rs. 651,000 total profit over the 20 years/20 years). The
average investment is Rs. 270,000/2 = Rs. 135,000. Therefore,

ARR = Rs. 32,550 = 24.11%

Rs. 135,000

Illustration 5

Chapter –7 Page - 50 -
Suppose we own a concession stand that sells French Fries, peanuts and Popcorn at Priya
Theatre. We have 3 years left in the contract and we do not expect it to be renewed.

There are four different proposals to reduce the lines and increase profits:
▪ The first proposal is to renovate by adding another window.
▪ The second is to update the equipment at the existing windows.

These two renovation projects are not mutually exclusive; we could take on both projects.
The third and fourth proposals involve abandoning the existing stand.

• The third proposal is to build a new stand.

• The fourth proposal is to rent a larger stand in a Priya theatre. This option would
require a Rs. 1,000 up-front investment for new signs and equipment installation.
We have decided that a 15% discount rate is appropriate for this type of
investment. The incremental cash flows associated with each of the proposals are
as follows:

INCREMENTAL CASH FLOWS

PROJECT OUTFLOW YEAR 1 YEAR 2 YEAR 3

Add a new -Rs. 75,000 Rs. 44,000 Rs. 44,000 Rs. 44,000
window

Update -50,000 23,000 23,000 23,000

existing
equipment

Build a new -125,000 70,000 70,000 70,000

stand

Rent a larger -1,000 12,000 13,000 14,000

stand

Using the internal rate of return (IRR) rule, which proposal(s) is recommended?
Using the net present value (NPV) rule, which proposal(s) is recommended?

Solution

PROJECT Add a new window Present Value Factor Present Value

OUTFLOW -75,000.00 1.00 -75,000.00
YEAR 1 44,000.00 0.87 38,280.00
YEAR 2 44,000.00 0.76 33,264.00

Chapter –7 Page - 51 -
 YEAR 3 44,000.00 0.66 28,952.00
NPV 25,496.00
PROJECT Update existing equipment
OUTFLOW -50,000.00 1.00 -50,000.00
YEAR 1 23,000.00 0.87 20,010.00
YEAR 2 23,000.00 0.76 17,388.00
YEAR 3 23,000.00 0.66 15,134.00
NPV 2,532.00
PROJECT Build a new stand
OUTFLOW -125,000.00 1.00 -125,000.00
YEAR 1 70,000.00 0.87 60,900.00
YEAR 2 70,000.00 0.76 52,920.00
YEAR 3 70,000.00 0.66 46,060.00
NPV 34,880.00
PROJECT Rent a larger stand
OUTFLOW -1,000.00 1.00 -1,000.00
YEAR 1 12,000.00 0.87 10,440.00
YEAR 2 13,000.00 0.76 9,828.00
YEAR 3 14,000.00 0.66 9,212.00
NPV 28,480.00

IRR can be calculated manually or on excel sheet. The results are summarized below:

SOLUTION
Project IRR NPV
Add a new window 34.6% Rs. 25,496
Update existing equipment 18.0% Rs. 2,532
Build a new stand 31.2% Rs. 34,880
Rent a larger stand 1208% Rs. 28,480

Result, as per NPV building a new stand is better but if we look at the results given by
IRR method, rented a largest stand is superior with misleading returns of 1208%. This is
a typical problem of misleading results by the IRR method. Since the flaws of IRR
method are already discussed in the chapter we can straightaway conclude that the results
of NPV are superior to IRR.

Illustration 6

Bala Company has to choose between two machines, which do the same job but have
different lives. The two machines have the following costs:
Year Machine A Machine B
0 Rs. 40,000 Rs. 50,000
1 10,000 8,000
2 10,000 8,000
3 10,000 + replace 8,000

Chapter –7 Page - 52 -
 4 8000 + replace
These costs are expressed in real terms and discounting rate is 6%

Solution

Present value of cost for Machine A can be calculated as (All figure are in thousand)

PVA = Rs.66.73.

PVB = Rs.77.72

Equivalent annual cost can be calculated as.

PVA = EACA [PVAF 6%, 3yrs.]

66.73 = EACA [2.673]
EACA = Rs.26.96, or Rs.24,960 per year.

PVB = EACB [PVAF 6%, 4 yrs]

77.72 = EACB [3.465]
EACB = Rs.22.43, or Rs.22,430 per year

Conclusion: Machine B is cheaper, considering the Equivalent Annual Cost.

Illustration 7

As a result of improvements in product engineering, United Automation is able to sell

one of its two milling machines. Both machines perform the same function but differ in
age. The newer machine could be sold today for Rs. 50,000. Its operating costs are Rs.
20,000 a year, but in five years the machine will require a Rs. 20,000 for overhaul.
Thereafter, operating costs will be Rs. 30,000 until the machine is finally sold in year 10
for Rs. 5,000.

The older machine could be sold today for Rs. 25,000. If it is kept, it will need an
immediate Rs. 20,000 overhaul. Thereafter operating costs will be Rs. 30,000 a year
until the machine is finally sold in year 5 for Rs. 5,000.

Chapter –7 Page - 53 -
Both machines are fully depreciated for tax purposes. The company pays tax at 35
percent. Cash flows have been forecasted in real terms. The real cost of capital is 12
percent.

Which machine should United Automation sell?

Solution

Since the life of both machines is not equal, we must calculate the equivalent annual cost
of two choices. (All cash flows are in thousands).

a) Sell the new machine: If we sell the new machine, we receive the cash flow from the
sale, pay taxes on the gain, and must pay the costs associated with keeping the old
machine, after 5 years sell old machine and pay taxes. The present value of this is:

30 30 30 30 30 5 0.35(5 − 0)
PV1 = 50 − 0.35(50 − 0) − 20 − − 2
− 3
− 4
− 5
+ 5
−
1.12 1.12 1.12 1.12 1.12 1.12 1.12 5

PV1= -93.8

Over the course of 5 years, the Equivalent Annual Cost (EAC) can be
found by:

--PV1 = EAC1 [PVAF 5 yrs. 12%]

-93.80 = EAC1 [3.605]
-EAC1 = -26.02, or an annual cost of Rs.26, 020

a) Sell the old machine: If we sell the old machine, we receive the cash flow
from the sale, pay taxes on the gain, and must pay the costs associated with
keeping the new machine. The present value of this is:

Over the course of 10 years, the Equivalent Annual Cost can be found by:

Chapter –7 Page - 54 -
 ----PV2 = EAC2 [PVAF 10 yrs. 12%]
-127.51 = EAC2 [5.650]
--EAC2 = -22.57, or an annual cost of Rs.22, 570.

Thus, the cheapest thing to do is to sell the old machine: this choice has
the lowest equivalent annual cost.

Illustration 8

Amit Inc. has a number of copiers that were bought four years ago for Rs. 20,000.
Currently maintenance costs is Rs. 2,000 a year, but the maintenance agreement expires
at the end of two years and thereafter the annual maintenance charge will rise to Rs.
8,000. The machines have a current resale value of Rs. 16,000, but at the end of year 2
their value will fall to Rs. 10,000. By the end of year 6 the machines will be valueless
and would be scrapped.

Amit is considering replacing the copiers with new machines, which would do the same
job. These machines cost Rs. 25,000 and the company can take out an eight-year
maintenance contract for Rs. 2,000 a year. The machines have no value by the end of the
eight years and would be scrapped.

Both machines are depreciated by using SLM, and the tax rate is 35 percent.

Assume that the inflation rate is zero. The cost of capital is 10%.

When should Amit Inc. replace its copiers?

Solution

Total life of old machinery is 10 yrs. So the annual depreciation is Rs. 2,000 per year, the
machinery has the remaining useful life of 6 yrs.

The current copier net cost cash flows can be calculated as follows:

Before-
Tax Present
Cash After Tax Cash Net Cash PV Factor Value of
Year Flow Depreciation Flow Flow at 10% Cash Flow
1 -2 2 =-2*0.65+0.35*2 -0.6 0.91 -0.55
2 -2 2 =-2*0.65+0.35*2 -0.6 0.83 -0.50
3 -8 2 =-8*0.65+0.35*2 -4.5 0.75 -3.38
4 -8 2 =-8*0.65+0.35*2 -4.5 0.68 -3.07
5 -8 2 =-8*0.65+0.35*2 -4.5 0.62 -2.79
6 -8 2 =-8*0.65+0.35*2 -4.5 0.56 -2.54
-12.83

Chapter –7 Page - 55 -
Using the annuity factor for 6 years at 10 percent (4.355), we find an equivalent annual
cost works out to:

-12.8301/ 4.355 = 2.95

Which means that if the equivalent annual cost of the new machine is less than 2.95 per
year then we should replace the old machinery.

The new copier will have net annual cash flows as follows:

Before-
Present
Tax PV Value of
Cash After Tax Cash Net Cash Factor at Cash
Year Flow Depreciation Flow Flow 10% Flow
0 -25 -25.00
1 -2 3.125 = -2*0.65+3.125*0.35 -0.206 0.91 -0.19
2 -2 3.125 = -2*0.65+3.125*0.35 -0.206 0.83 -0.17
3 -2 3.125 = -2*0.65+3.125*0.35 -0.206 0.75 -0.15
4 -2 3.125 = -2*0.65+3.125*0.35 -0.206 0.68 -0.14
5 -2 3.125 = -2*0.65+3.125*0.35 -0.206 0.62 -0.13
6 -2 3.125 = -2*0.65+3.125*0.35 -0.206 0.56 -0.12
7 -2 3.125 = -2*0.65+3.125*0.35 -0.206 0.51 -0.11
8 -2 3.125 = -2*0.65+3.125*0.35 -0.206 0.47 -0.10
-26.10

New machine cash flows have a present value of –26.10 or 26,100. The decision to
replace must, take into account the resale value of the machine, as well as the associated
tax on the gain (or loss).

So the three situation of selling the copier can be calculated as:

a) If we replace now, the book (depreciated) value of the existing copier is Rs.12,000
(20,000- (4*2,000)) and hence the present value of the cash flow is:

-26,100 + 16,000 - 0.35 (16,000 – 12,000) = -11,500

Using the annuity factor for 8 yrs 10 percent (5.335), we calculate the equivalent
annual cost to be 11,500/5.335 = 2,155.5

b) If we replace in 2 years, the book (depreciated) value of the existing copier will be
Rs.8,000 (20,000- (6*2,000)) and hence the present value of the cash flow is:

-26100 +10,000 – (0.35 (10,000 – 8,000)) – 545.45 – 495.87 = -17841.32

Chapter –7 Page - 56 -
 Using the annuity factor for 8 yrs 10 percent (5.335), we calculate the equivalent
annual cost to be 8,258.68/5.335 = 3,344.2

c) If we replace the old machinery in the 6th year, the book (depreciated) value of the
existing copier is zero and it has no resale value. Hence the present value of the cash
flow is:

-12.83 -26.10 = -38.93 or -38,930.

Using the annuity factor for 14 yrs 10 percent (7.367), we calculate the equivalent
annual cost to be 38,930 / 7.367 = 5284.3

a) Equivalent Annual Cost = 2,155.5

b) Equivalent Annual Cost = 3,344.2

c) Equivalent Annual Cost = 5,284.3

So it can be concluded that the machinery should be sold immediately.

Illustration 9

An petrol company is drilling a series of new wells on the perimeter of a producing oil
field. About 20 percent of the new wells will be dry holes. Even if a new well strikes
petrol, there is still uncertainty about the amount of petrol produces; 40 percent of new
wells, which strike petrol, produce only 1,000 barrels a day; 60 percent produce 5,000
barrels per day.

Forecast the annual cash revenues from a new well. Use a future petrol Price of Rs. 15
per barrel.

Solution

Expected daily production = 0.2(0) + 0.8(.4 x 1,000 + 0 .6 x 5,000) = 2,720 barrels.

Expected annual revenues = 2,720 x 365 x Rs.18 = Rs.179 lakh.

Illustration 10

A project has the following forecasted cash flows:

C0 C1 C2 C3
-100 +40 +60 +50

The estimated project beta is 1.5. The market return rm is 16 percent, and the risk-free
rate rf is 7 percent.

Chapter –7 Page - 57 -
a. Estimate the opportunity cost of capital and the project’s PV (using the same rate
to discount each cash flow).
b. What are the certainty-equivalent cash flows in each year?
c. What is the ratio of the certainty-equivalent cash flow to the expected cash flow in
each year?

Solution

a. Using the CAPM, we find the cost of capital to be:

r = 0.07 + 1.5 (0.16 - 0.07) = 0.205.

And, therefore:

b.

CEQ1 = 40 (1.07 / 1.205) = 35.5

CEQ2 = 60 (1.07 / 1.205)2 = 47.3
3
CEQ3 = 50 (1.07) / 1.205) = 35.0

c.

a1 = 35.5 / 40 = 0.89
a2 = 47.3 / 60 = 0.79

a3 = 35.0 / 50 = 0.70

Illustration 11

Determine the risk adjusted net present value of the following projects.
A B C
Net cash outlays (Rs.) 170,000 210,000 300,000
Project life 5 years 5 Years 5 Years
Annual Cash inflow (Rs.) 50,000 70,000 100,000
Coefficient of variation 0.4 0.8 1.2

Chapter –7 Page - 58 -
The management of the company selects the risk-adjusted rate of discount on the basis of
the coefficient of variation:

Coefficient of Risk adjusted rate of Present value factor 1 to 5 years at

variation discount risk adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689

Solution:

Statement showing the determination of the risk adjusted net present value
Projects Net C.V. RADR Annual P.V. factor Discoun NPV
Cash Cash 1-5 years ted Cash
Outlays Inflows at RADR Inflow
(i) (ii) (iii) (iv) (v) (vi) (vii) (viii)=(vii)-(ii)
A 1,70,000 0.4 12% 50,000 3.605 1,80,250 10,250
B 2,10,000 0.8 14% 70,000 3.433 2,40,310 30,310
C 3,00,000 1.2 16% 1,00,000 3.274 3,27,400 27,400

Project B is the best amongst the three projects under consideration.

Illustration 12

A company is examining three mutually exclusive investment proposals. The

management of the company uses certainty equivalents coefficient (CEC) to evaluate
new investment proposals from the following information, advise the company which
project should be taken by it.

Year Project A C.E.C. Project B C.E.C Project C C.E.C

Rs. Rs. Rs.
0 (-) 10,000 1 (-) 10,000 1 (-) 10,000 1
1 3,500 0.7 5,000 0.8 3,000 0.9
2 3,500 0.6 4,000 0.5 2,500 0.8
3 3,500 0.5 4,000 0.4 5,000 0.7
4 3,500 0.4 3,000 0.3 6,000 0.5
5 3,500 0.3 3,000 0.2 5,000 0.4

Risk free rate of return is 10%.

Solution:

Chapter –7 Page - 59 -
Project A
Year Project A C.E.C. Certain CFAT D.F. at 10% PV
Rs.
0 -10,000 1 -10000 1.00 -10000
1 3,500 0.7 2450 0.91 2227.273
2 3,500 0.6 2100 0.83 1735.537
3 3,500 0.5 1750 0.75 1314.801
4 3,500 0.4 1400 0.68 956.2188
5 3,500 0.3 1050 0.62 651.9674
NPV -3114.2

Project B
Year Project B C.E.C Certain CFAT D.F. at 10% PV
Rs.
0 -10,000 1 -10000 1.00 -10000
1 5,000 0.8 4000 0.91 3636.364
2 4,000 0.5 2000 0.83 1652.893
3 4,000 0.4 1600 0.75 1202.104
4 3,000 0.3 900 0.68 614.7121
5 3,000 0.2 600 0.62 372.5528
NPV -2521.38

Project C
Year Project C C.E.C Certain CFAT D.F. at 10% PV
Rs.
0 -10,000 1 -10000 1.00 -10000
1 3,000 0.9 2700 0.91 2454.545
2 2,500 0.8 2000 0.83 1652.893
3 5,000 0.7 3500 0.75 2629.602
4 6,000 0.5 3000 0.68 2049.04
5 5,000 0.4 2000 0.62 1241.843
NPV 27.92283

The project C has positive NPV project A and B should not be selected.

Web Based Exercise.

For more on EVA refer to web link www.sternstewart.com or www.financeadvisor.com

Summary:

It really helps us to know the powerful concept of Present Value and its use in our daily
life, but this is not the whole story, good investment decision depend on a sensible
criterion and sensible forecast, as it is said that no equipment can work faster than the
person operating it.
Up till now we have virtually discussed all the concepts of Capital Budgeting and related
aspects, which can cause a problem in dealing with situations in practice.

Chapter –7 Page - 60 -
We also learnt how to deal with complicated situations where multiple constraints exist,
and how do deal with risk in projects.
The most commonly used discounting rate is the WACC, strictly speaking this formula
only works if the new project is a ‘zerox’ of the firm, which normally does not happen so
the company can use the WACC as a method of benchmark but it should take due care
and adjust the discount rate for difference in change in risk.
Please remember that we have just discussed the essentials of value added methods
namely EVA, CVA and MVA, and these methods should be applied only after a
thorough understanding on the subject.

Words of wisdom “Anything you try to fix will take longer and cost more than you
thought.”

Take calculated risk. That is quite different from being rash.

Problem set

Q1)
Why is modified internal rate of return a superior approach to IRR?

Q2)
If projects have unequal life which method of appraisal is best suited?

Q3)
How do we evaluate projects if they start at different periods?

Q4)
What is capital rationing? And what method of appraisal fits in this situation?

Q5)
How do we define the relationship between IRR and MIRR?

Chapter –7 Page - 61 -
Q6)
What are the various methods of handling risk?

Q7)
What is Certainty Equivalent Approach and how is it different from risk adjusted
discount rate?

Q8)
The Chief Financial Officer of XYZ Co. has determined that the firm’s capital investment
budget will be Rs. 30 lakh for the upcoming year. This amount is not sufficient to cover
all of the positive NPV projects that are available to the firm. You have been asked to
choose which investments, of those listed in the table below, should be made.

Project name Cost NPV

A 200,000 84,000
B 700,000 26,000
C 300,000 23,000
D 550,000 82,000
E 100,000 20,000
F 85,000 90,000
G 790,000 18,000
H 810,000 95,000
I 480,000 50,000
J 820,000 54,000
K 730,000 56,000
L 910,000 90,000
M 970,000 70,000

Which method in your opinion is best suited for appraisal?

Differentiate between various discounted methods of appraisal and there limitation?
Develop a solver model assuming that the projects are indivisible?

Q9)
Calculate the IRR of the following project:

C0 C1 C2 C3
-3,000 +3,560 +4,500 -5,600

Q10)
Consider the following two mutually exclusive projects:

Project C0 C1 C2 C3
A -100 +70 +70 0
B -100 0 0 +160

Chapter –7 Page - 62 -
Which is more superior A or B?

Q11)
A company known as Zed Ltd. wants to know the sensitivity with regards to its
discounting rate, and also wants to know that at what discounting rate it moves into the
negativity zone.
The project involves a initial investment of 6,000 lakh and the unit selling price will be
22,000 which will move up by 10% each year, the variable cost is estimated to be 15,000
and it will move up by 10% each year, the rise in selling price is primarily to offset the
increase in variable cost.
The company also estimates that the unit sold in the first year will be 20,000 which will
move up by 20% each year, but in the 9 and 10 year the growth rate will slow down to
5 %. Fixed cost is estimated to be 40 lakh, and plant will have a useful life of 10 years
and it will be depreciated according to the straight line method.
1. Calculate the present value of the project?
2. Also find the impact if the variable cost moves up by 15% each year?

Chapter –7 Page - 63 -
 SITUATION BASED CASE STUDY
ZED TRAINING CENTER, DELHI.

We are talking of a leading Institute of India, which stood under top 10 institutes as on
July 2002, and is a leading institute in training and development. The institute was
considering procuring LCD and Computers to facilitate and aid training.

On an average there were 5 classes a day and the Instructors used Marker Board and
O.H.P. in their sessions.

Projectors were old and there was a huge amount of cost incurred in maintaining them
and the cost of transparencies was also very high. Students made presentation of case
studies and projects, for which they used OHP & LCD extensively. Institute had a very
well maintained computer laboratory.

Students used to prepare the project on the computer but for presentation purposes they
had to get the whole thing done on the transparency.
So on 2 September, 2002, management decided to procure 4 New LCD, which were
supposed to be fixed on the roof, so that each class room has a permanent
structure/facility to support the smooth functioning, and reduce the cost for the institute in
terms of maintenance of OHP and cost and printing of transparencies. Institute had
procured LCD in 1999 & 2000 at an average cost of 260,000.

After a very careful thought management appointed a Committee of 5 persons, which was
headed by Mr Jai, a very Senior Professors of the Institute. The committee also had Mr
Ajay a chartered accountant and Mr Sameer an expert in computers and networking.

On the basis of their experience with the previously purchased LCD they invited
quotations from companies like EPSON, SANYO and Philips, supposed to be the best in
the industry. The summarized table of their quotation is given in Exhibit (1).

When the committee met for discussing the issue Mr. Sameer said that now since SVGA
(Super Video Graphic Adapter)” is going to be out of the market very soon, we should
consider only XGA (Extended Graphic Adapter). Since other people were not familiar
with the technical words they asked Mr. Sameer to explain to them the essential feature
that a buyer should look for in a LCD. So, Mr. Sameer in a Layman language said that
the difference between a Dot Matrix printout and a Lazer printout is the difference
between SVGA & XGA, in terms of Quality of print. He also said that all the companies
are ready to provide for the Annual Maintenance contract (AMC), at some nominal Rate,
which keeps on increasing as the machine get older.

In a LCD the two important components are LCD Panel and the Bulb.

Chapter –7 Page - 64 -
Bulb normally has a life of 2000 hrs. and cost around 20,000-25,000/-. These bulbs
contain Halonix and after a normal usage the light start getting dimmer and after 2000 hrs
it is definitely going to go dim.

LCD are not considered as Electronics item although they are and so Philips being a India
company charge a sales tax of 8% on their product price, whereas other companies
charge only 4%.

For effective functioning LCD should be fixed at a distance of 12 feet from the wall and
to fix it on the wall requires a clamp which normally cost around 1,200/-. The Lumen is
also important component. It is primarily the unit for denoting brightness of the LCD.
The higher it is the better.

XGA has a resolution of 1024 X 768 and SVGA has a resolution of 800 X 600.

All the products are under warranty and in that given period the vendor has to open a
bank guarantee in favor of the institute in order to be sure that if something goes wrong
with the product in that year, then the institute will invoke the bank guarantee and get the
amount bank from the vendor. At this point Mr. Ajay who was a Chartered Accountant
Intervene and said that invoking a Bank Guarantee is very difficult and we should think
of some other option.

Mr. Jai said that we should ask all of them to give a presentation so that we can see how
the new LCD works.

Mr. Shrimali said that we should ask them to give us a discount by giving them an
impression that we will soon require more LCD since we are in the process of expansion
and we will soon start some new courses. So, on 24 October all the company
representative came and gave a live demonstration of the product. The Philips person
said that the bulb which is used in there model No. B Sure –XG-1 is the best and will
have a life more than 2000 hrs. and guaranteed a excellent performance. The committee
also found that XGA performance was much superior to SVGA and since the institute
had no cash problem and having LCD in all the rooms will give a better impression to the
market, and further help in improving the institute infrastructure.

The management wanted that in all the 7 rooms LCD should be fixed on the roof and one
LCD should be mobile for which they also thought of procuring 7 Personnel Computers
P-4, with all the latest features, which will cost them around 45,000/- each.
The institute also had a course which used to run in the same class room in the evening,
in which the strength of student was lean but the classes were held religiously for four
days in a week. (The term was of 6 months).
Finally in December, the committee decided to procure one LCD which they thought to
be the best, and decided to procure more after 6 months as they wanted to be sure of the
performance of the LCD they have purchased

Chapter –7 Page - 65 -
 Exhibit 1

Model EPSON Sanyo Sanyo Philips – Philips-B Sure

EM51 PLUSU-30 PLCXV-30 Bsure-SV-1 – XG-1
SVGA SVGA XGA SVGA XGA
Price 160,000 192,000 209,000 160,000 215,000
Weight 3.1 kg 3.9 Kg. 3.9 Kg. 3.7 Kg. 3.7 Kg.
Warranty 2 years 1 year 1 year 3 years 3 years
Terms & 90% on 0% on order 0% on order 0% on order 0% on order
Conditions order 100% on 100% on 100% on 100% on
10% on delivery delivery delivery delivery
delivery
AMC 10% 9% 9% 7% 7%
Lumen 1,200 1,700 1,400 1,200 1,200

Following assumption can be taken:

Faculty uses 15 slides for a session, work out your own cost for preparing a slide

Chapter –7 Page - 66 -
 SITUATION BASED CASE STUDY
SUNCITY REAL ESTATE DEVELOPER

Ms. Sethi who worked long hours managed Suncity, the well-known real estate
developer, and she expected her staff to do the same. So, the manager of the organization
Mr. Manish was not surprised to receive a call from the boss just as
Manish was about to leave from the office in the evening.

Ms. Sethi success had been built on a remarkable instinct for a good site but she knew
little about finance. She was planning for an investment of Rs. 90 million for a mall
designed to attract tourists between Delhi and Jaipur. So, she worked out some details of
the proposal and handed it over to Mr. Manish as shown in Table 1 for his analysis.

Revenues would come from one source, which are rentals from the Mall. The company
would charge shopkeepers an annual rent for the space they occupied.

Construction of the mall was likely to take three years. The construction costs could be
depreciated using straight-line method over 15 years starting from the 3rd year. The land
was expected to retain its value, but could not be depreciated for tax purposes.

Construction costs, revenues, operating and maintenance costs, and real estate taxes were
all likely to rise in line with inflation, which was forecasted at 4 percent a year. The
company’s tax rate was 35 percent and the cost of capital was 9 percent in nominal terms.

Table 1: Projected revenues and costs in real terms for the Suncity Mall

Year
0 1 2 3 4 5-17
Investments:
Land 30
Construction 20 30 10
Operations:
Rentals 36 36 36
Operating and maintenance costs 2 4 4 10 10 10
Working Capital Requirement 4 6 8

Manish decided first to check that the project made financial sense by using NPV
approach. He then proposed to look at some of the things that might go wrong. The
Mooncity project had been a disaster because rentals were low by 30 percent below
forecast so he wanted to check the Suncity project if the rental move down by the same
percent. Manish wondered how far could a fall in rental can the company withstand.

He also wanted to check the NPV of the project if the inflation touches 10%.

Chapter –7 Page - 67 -
A third concern was possible delay in setting up the project because of labour strike or
shortage in material so he also wanted to see the NPV if the construction cost of the
project go up by 10%.

Questions:

1. Conduct sensitivity and a scenario analysis of the project. Also use the
function Goal Seek.
2. In how many scenarios does the project have negative NPV?
3. What if all his expected problems come up?

NOTE: Discount the Real Flows with the Real Interest Rate and the Nominal flow
with Nominal Interest Rate.

Chapter –7 Page - 68 -