AFM MODULE -C JAIIB

TOPIC – CAPITAL BUDGETING BY: DR. PARVEZ KHAN

Points to remember

Objective of capital investment decisions: Maximizing shareholder value through optimal

allocation of resources.

Estimation of project cash flows: Predicting future cash inflows and outflows to assess project
viability.

Forecasting and its relation to regulation of capital for short, medium, and long-term periods:
Ensuring adequate capital allocation to meet future financial obligations and strategic goals.

Relationship between sales, production, and other functional budgets: Coordinating various
budgets to align operations with financial targets.

Cash forecasts: Predicting future cash positions to manage liquidity and financial planning.

Cost analysis for projects: Evaluating all project-related costs to determine feasibility and
profitability.

Methods of investment appraisal: Assessing potential investments using techniques like NPV,
ARR IRR, and payback period.

Social cost-benefit analysis: Evaluating the broader social impacts of a project to ensure net
positive outcomes for society.

NPV: Accept the project if NPV is positive, indicating value addition.

IRR: Accept the project if IRR exceeds the required rate of return.

PI: Accept the project if the Profitability Index (PI) is greater than 1, indicating profitable
investment.

ARR: Accept the project if the Accounting Rate of Return (ARR) exceeds the target rate.

Problems

1. The LMN Corporation is considering an investment that will cost Rs 80,000 and have a
useful life of 4 years. During the first 2 years, the net incremental after-tax cash flows are
 Rs 25,000 per year and for the last two years they are Rs 20,000 per year. What is the
payback period for this investment?

Answer: 3.5 years.

2. Which of the following statements is incorrect regarding a normal project?

a) If the NPV of a project is greater than 0, then its PI will exceed 1.
b) If the IRR of a project is 8%, its NPV, using a discount rate, k, greater than 8%, will be
less than 0.
c) If the PI of a project equals 0, then the project's initial cash outflow equals the PV
of its cash flows.
d) If the IRR of a project is greater than the discount rate, k, then its PI will be greater
than 1.

3. Assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs
5,430 for 6 years • The IRR of the investment can be found out as follows:

Answer

NPV = -Rs 20,000+Rs 5,430(PVAF6, r )=0

• Rs 20,000 = Rs 5,430(PVAF6, r )

• PVAF6, r = Rs 20,000/5,430

=3.683
4. Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow
of Rs 12,500 for 7 years. The payback period for the project is:

Answer: 4 years

5. Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows
of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the
project’s payback?

Answer: 3.4

6. A profitability index of .85 for a project means that:

Answer: the project returns 85 cents in present value for each current dollar invested.
7. ABC Windmill Company is considering a project that calls for an initial cash outlay
of $50,000. The expected net cash inflows from the project are $7,791 for each of 10
years. What is the IRR of the project?

Answer: [(Hint: The cash f lows from the project are an annuity so you can solve for i in the
equation PVA = R(PVIFAi,10).] 9%

8. Assume that a firm has accurately calculated the net cash flows relating to an
investment proposal. If the net present value of this proposal is greater than zero and
the firm is not under the constraint of capital rationing, then the firm should:

Answer: Accept the proposal, since the acceptance of value-creating investments should
increase shareholder wealth.

9. A project's profitability index is equal to the ratio of the__________ of a project's future

cash flows to the project's _______

Answer: Present value; initial cash outlay

10. The discount rate at which two projects have identical ______ is referred to as Fisher's
rate of intersection.

Answer: Net present values

11. The decision to accept or reject a capital budgeting project depends on –

(A) an analysis of the cash flows generated by the project

(B) cost of capital that are invested in business/project.

(C) Both (A) and (B)

(D) Neither (A) nor (B)

12. The Internal Rate of Return (IRR) criterion for project acceptance, under
theoretically infinite funds is: Accept all projects which have –

(A) IRR equal to the cost of capital

(B) IRR greater than the cost of capital

(C) IRR less than the cost of capital

(D) None of the above

13. How ARR is calculated?

(A) (Average PAT/Initial Investment) × 100

(B) (Average NPV/Investment) × 100

(C) (Average PAT/Initial Investment) ÷ 100

(D) (Initial Investment/Average PAT) × 100 Answer: (A) (Average PAT/Initial Investment) ×
100

14. Which of the following techniques does not take into account the time value of money?

(A) Internal rate of return method

(B) Simple cash payback method

(C) Net present value method

(D) Discounted cash payback method

15. higher than Project Y but IRR of Project Y is greater than Project X then you will
select –

(A) Project Y

(B) Project X

(C) Some other project

(D) None of the above

16. The beta coefficient is associated with –

Answer: Capital asset pricing model

17. Capital budgeting is the process of identifying analyzing and selecting investments
project whose returns are expected to extend beyond –

(A) 3 years

(B) 2 years

(C) 1 year

(D) Months
18. A project requires initial investment of ₹ 2,00,000 and estimated to generate cash flow
after tax of ₹ 1,00,000, ₹ 80,000, ₹ 40,000, ₹ 20,000 & ₹ 10,000 in next 5 years. What is the
payback period of the project?

Answer: 2 years and 6 months

19. A Machine requires an initial investment of ₹ 40,000 and expected to generate a cash
flow of ₹ 8,400, ₹ 14,300 & ₹ 32,800 in the next 3 years. The applicable tax rate is 30%
and the WACC of the company is 12%. The company will select machine because –
(A) It has a positive NPV of ₹ 2,522

(B) Its profitability index is 1.653 which is more than 1.

(C) Its IRR is between 14% to 15% which is more than the WACC of the company.

(D) All of the above

Hints: calculate NPV, PI and IRR cross verify with options

20. A project has the following cash inflows ₹ 34,444, ₹ 39,877, ₹ 25,000 & ₹ 52,800 for
years 1 to 4, respectively. The initial cash outflow is ₹ 1,04,000. Which of the following
four statements is correct concerning the project internal rate of return (IRR)?

(A) The IRR is less than 10%.

(B) The IRR is greater than 10%, but less than 14%.

(C) The IRR is greater than 14%, but less than 18%.

(D) The IRR is greater than or equal to 18%.

21. ABC company is faced with the decision to purchase or acquire on lease a machine.
The cost of the machine is ₹ 2,53,930. The asset can be financed by taking a loan on which
interest is payable @15% and the loan will be paid in 5 equal instalments inclusive of
interest. The tax rate is 40%. Assume loan instalment is payable at the end of each year.
What will be the loan instalment amount for each year?

(A) ₹ 75,800

(B) ₹ 65,278

(C) ₹ 67,800
(D) ₹ 66,824

Hint:

Investment cost = Investment cost /Annuity factor of 15% for 5 years =2,53,930/3.35 = 75,800

Answer: ₹ 75,800

22. If the initial investment of the ABC ltd. in buying a machine is Rs 1, 21, 000, salvage
value is Rs 11,000, working capital is Rs 12000 & life of the machine is 5 years. SLM of
depreciation is adopted. Calculate the average investment.

Answer: By using the formula, Average Investment= (original Investment- scrap value)/2
+Additional Net Working Capital + Scrap Value.

Average investment = ½ (121000 - 11000) + 12000 + 11000

= ½ (110000) + 23000

= Rs (55000 + 23000)

= Rs 78000

23. ABC company five-year project has a projected net cash flow of $15,000, $25,000,
$30,000, $20,000, and $15,000 in the next five years. It will cost $50,000 to implement the
project. If the required rate of return is 20 percent, conduct a calculation to determine
the NPV.

Answer: 12895.4