CAPITAL BUDGETING TECHNIQUES / METHODS

There are different methods adopted for capital budgeting. The traditional methods or
non discount methods include: Payback period and Accounting rate of return method.
The discounted cash flow method includes the NPV method, profitability index method
and IRR.

 Payback period method:

As the name suggests, this method refers to the period in which the proposal will generate
cash to recover the initial investment made. It purely emphasizes on the cash inflows,
economic life of the project and the investment made in the project, with no consideration
to time value of money. Through this method selection of a proposal is based on the
earning capacity of the project. With simple calculations, selection or rejection of the
project can be done, with results that will help gauge the risks involved. However, as the
method is based on thumb rule, it does not consider the importance of time value of
money and so the relevant dimensions of profitability.

Payback period = Cash outlay (investment) / Annual cash inflow

Example

Project A Project B

Cost 1,00,000 1,00,000

Expected future cash flow

Year 1 50,000 1,00,000

Year 2 50,000 5,000

Year 3 1,10,000 5,000

Year 4 None None

TOTAL 2,10,000 1,10,000

Payback 2 years 1 year

Payback period of project B is shorter than A, but project A provides higher returns.
Hence, project A is superior to B.

 Discounted cash flow method:

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The discounted cash flow technique calculates the cash inflow and outflow through the
life of an asset. These are then discounted through a discounting factor. The discounted
cash inflows and outflows are then compared. This technique takes into account the
interest factor and the return after the payback period.

 Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In
this technique the cash inflow that is expected at different periods of time is discounted at
a particular rate. The present values of the cash inflow are compared to the original
investment. If the difference between them is positive (+) then it is accepted or otherwise
rejected. This method considers the time value of money and is consistent with the
objective of maximizing profits for the owners. However, understanding the concept of
cost of capital is not an easy task.

The equation for the net present value, assuming that all cash outflows are made in the
initial year (tg), will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of
the investment proposal and n is the expected life of the proposal. It should be noted that
the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be
known.

NPV = PVB – PVC

where,

PVB = Present value of benefits

PVC = Present value of Costs

 Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero. The
discounted cash inflow is equal to the discounted cash outflow. This method also
considers time value of money. It tries to arrive to a rate of interest at which funds

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invested in the project could be repaid out of the cash inflows. However, computation of
IRR is a tedious task.

It is called internal rate because it depends solely on the outlay and proceeds associated
with the project and not any rate determined outside the investment.

It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept

If IR < k = reject

 Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return to
the initial cash outflow of the investment. It may be gross or net, net being simply gross
minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is
as follows.

PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital expenditures are long term investments
which involve more financial risks. That is why proper planning through capital
budgeting is needed.

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2) Huge investments and irreversible ones: As the investments are huge but the funds
are limited, proper planning through capital expenditure is a pre-requisite. Also, the
capital investment decisions are irreversible in nature, i.e. once a permanent asset is
purchased its disposal shall incur losses.

3) Long run in the business: Capital budgeting reduces the costs as well as brings
changes in the profitability of the company. It helps avoid over or under investments.
Proper planning and analysis of the projects helps in the long run.

SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial management

 Capital budgeting provides a wide scope for financial managers to evaluate
different projects in terms of their viability to be taken up for investments
 It helps in exposing the risk and uncertainty of different projects
 It helps in keeping a check on over or under investments
 The management is provided with an effective control on cost of capital
expenditure projects
 Ultimately the fate of a business is decided on how optimally the available
resources are used

Problems:

1. Proposal X and proposal Y require an initial investment of $40,000 and are expected
to generate an equal cash inflow of $20,000 over their life of four years. The net cash
inflow for each year of life of both the proposals is given below:

Required:
Compute the present value of cash inflows generated by both the proposals
assuming a discount rate of 18%.

Solution:
Both the proposals generate uneven cash inflows. The present value of cash
inflow of both the proposals would, therefore, be computed by multiplying the net
cash inflow generated in each individual year by the present value of $1 at given
interest rate of 18%. These calculations are given below:

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 *Value from present value of $1 table.

Notice that both the investment proposals generate equal cash inflow of $20,000
in 4-year period but present value of proposal Y’s cash inflow is greater than the
present value of proposal X’s cash inflow by $2,204. The reason is that proposal
Y generates most of its cash inflow in earlier years whereas proposal X generates
most of its cash inflow in later years. It reminds us that the money has a time
value.

2. LASANI Stone Crushing company is considering to purchase a new

machine. The cost of the machine is $360,000 and the life of the machine
is 10 years. The machine will reduce annual costs by $75,000.
The management uses payback period method to evaluate capital investments because
the quick recovery of any capital investment is very important for the company.
Required:
Compute the payback period for this proposal. Would the company purchase new
machine if maximum desired payback period of the management is 4 years?
Solution:
Computation of payback period:
The cost saving of the machine is even (i.e., same amount of cost savings each year). The
payback period can therefore be easily computed using payback period formula:
Payback period = Investment required to purchase the machine/Net annual cost
savings
= $360,000/$75,000
= 4.8 years
Conclusion:
The payback period of the machine is 4.8 years which is longer than the desired payback
period of the company. The machine would therefore not be purchased.

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 3. The investment and expected cash inflows of a project over 8-year period
is given below:

Required: Compute the payback period of the project. Would the project be acceptable if
the maximum desired payback period is 7 years?
Solution:
As the expected cash flows is uneven (different cash flows in different periods), the
payback formula cannot be used to compute payback period of this project. The payback
period for this project would be computed by tracking the unrecovered investment year
by year.

Payback period = years before full recovery + (Unrecovered investment at start of

the year/Cash flow during the year)
= 5 + (3,000/6,000)
= 5 + 0.5
= 5.5 years or 5 years and *6 months

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*0.5 × 12
The entire investment is expected to recover by the middle of sixth year. The payback
period of this project is, therefore, 5.5 years or 5 years and six moths.
Conclusion:
The project is acceptable because payback period promised by the project is shorter than
the maximum desired payback period of the management.
4. The Sunshine company is considering two projects, project A and project
B. Project A requires the purchase of an equipment but no working capital
investment whereas project B requires a working capital investment but no
equipment. The relevant information for net present value analysis is
given below:

The working capital required for project B will be released at the end of project life.
Sunshine company uses an 18% discount rate.
Required: Are the two projects comparable using net present value (NPV)? If yes, Select
the best investment using net present value (NPV) method. (Ignore income tax).
Solution:
Yes, the two projects are comparable because both the projects require equal amount of
initial investment.
NPV of project A:

*Value from “present value of an annuity of $1 in arrears table“.

**Value from “present value of $1 table”.
NPV of project B:

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*Value from “present value of an annuity of $1 in arrears table“.
**Value from “present value of $1 table“.
Conclusion:
According to NPV method, project A looks more desirable because its net present value
is more than project B.
Capital budgeting practice problems.
1. Evaluation of Cash Flows. Below are the cash flows for two mutually exclusive
projects.
year CF X
CF Y

0 (5,000)(5,000)
1 2,085 0
2 2,085 0
3 2,085 0
4 2,085 9,677
a. Calculate the payback for both projects.
b. Calculate the NPV for both projects.
2. More practice with Cash Flow Evaluation. Cash flows for two mutually exclusive
projects are shown below:
year CF M
CFN

0 (100) (100)
1 10 70
2 60 50
3 80 20
Both projects have a cost of capital of 10%.

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a. Calculate the payback for both projects.
b. Calculate the NPV for both projects.
3. Mutually Exclusive Projects with Unequal Lives. Murray’s Coffee House is trying
to choose between two new coffee bean roasters. The required rate of return for either
machine is 10%. Shown below are the after-tax cash flows associated with each
machine:
year CF X
CF Y

0 (50,000) (30,000)
1 20,000 20,000
2 20,000 20,000
3 20,000 -
4 20,000 -
a. Calculate the replacement chain NPV for each project.
b. Which project should be selected? Why?
4. Risk Adjustment and Project Selection. Acme Mfg is considering two projects, A &
B, with cash flows as shown below:
period CF A
CFB

0 -50,000 -100,000
1 20,000 60,000
2 20,000 25,000
3 20,000 25,000
4 20,000 25,000
The opportunity cost of capital for A is 14 percent. The opportunity cost of capital for B
is 10 percent.
a. Calculate the NPV for each project.

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 Additional Problems and Solutions

1. Payback Period – Given the cash flows of the four projects, A, B, C, and D, and using

the Payback Period decision model, which projects do you accept and which projects do

you reject with a three year cut-off period for recapturing the initial cash outflow?

Assume that the cash flows are equally distributed over the year for Payback Period

calculations.

Projects A B C D
Cost Rs.10,000 Rs.25,000 Rs.45,000 Rs.100,000
Cash Flow Year One Rs.4,000 Rs.2,000 Rs.10,000 Rs.40,000
Cash Flow Year Two Rs.4,000 Rs.8,000 Rs.15,000 Rs.30,000
Cash Flow Year Three Rs.4,000 Rs.14,000 Rs.20,000 Rs.20,000
Cash Flow Year Four Rs.4,000 Rs.20,000 Rs.20,000 Rs.10,000
Cash Flow year Five Rs.4,000 Rs.26,000 Rs.15,000 Rs.0
Cash Flow Year Six Rs.4,000 Rs.32,000 Rs.10,000 Rs.0

Solution

Project A: Year One: -Rs.10,000 + Rs.4,000 = Rs.6,000 left to

recover

Year Two: -Rs.6,000 + Rs.4,000 = Rs.2,000 left to

recover

Year Three: -Rs.2,000 + Rs.4,000 = fully recovered

Year Three: Rs.2,000 / Rs.4,000 = ½ year needed for

recovery

Payback Period for Project A: 2 and ½ years, ACCEPT!

Project B: Year One: -Rs.25,000 + Rs.2,000 = Rs.23,000 left to

recover

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 Year Two: -Rs.23,000 + Rs.8,000 = Rs.15,000 left to

recover

Year Three: -Rs.15,000 + Rs.14,000 = Rs.1,000 left to

recover

Year Four: -Rs.1,000 + Rs.20,000 = fully recovered

Year Four: Rs.1,000 / Rs.20,000 = 1/20 year needed for

recovery

Payback Period for Project B: 3 and 1/20 years, REJECT!

Project C: Year One: -Rs.45,000 + Rs.10,000 = Rs.35,000 left to

recover

Year Two: -Rs.35,000 + Rs.15,000 = Rs.20,000 left to

recover

Year Three: -Rs.20,000 + Rs.20,000 = fully recovered

Year Three: Rs.20,000 / Rs.20,000 = full year needed

Payback Period for Project B: 3 years, ACCEPT!

Project D: Year One: -Rs.100,000 + Rs.40,000 = Rs.60,000 left to

recover

Year Two: -Rs.60,000 + Rs.30,000 = Rs.30,000 left to

recover

Year Three: -Rs.30,000 + Rs.20,000 = Rs.10,000 left to

recover

Year Four: -Rs.10,000 + Rs.10,000 = fully recovered

Year Four: Rs.10,000 / Rs.10,000 = full year needed

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 Payback Period for Project B: 4 years, REJECT!

2. Payback Period – What are the Payback Periods of Projects E, F, G and H? Assume

all cash flows are evenly spread throughout the year. If the cut-off period is three years,

which projects do you accept?

Projects E F G H
Cost Rs.40,000 Rs.250,000 Rs.75,000 Rs.100,000
Cash Flow Year One Rs.10,000 Rs.40,000 Rs.20,000 Rs.30,000
Cash Flow Year Two Rs.10,000 Rs.120,000 Rs.35,000 Rs.30,000
Cash Flow Year Three Rs.10,000 Rs.200,000 Rs.40,000 Rs.30,000
Cash Flow Year Four Rs.10,000 Rs.200,000 Rs.40,000 Rs.20,000
Cash Flow year Five Rs.10,000 Rs.200,000 Rs.35,000 Rs.10,000
Cash Flow Year Six Rs.10,000 Rs.200,000 Rs.20,000 Rs.0

Solution

Project E: Year One: -Rs.40,000 + Rs.10,000 = Rs.30,000 left to

recover

Year Two: -Rs.30,000 + Rs.10,000 = Rs.20,000 left to

recover

Year Three: -Rs.20,000 + Rs.10,000 = Rs.10,000 left to

recover

Year Four: -Rs.10,000 + Rs.10,000 = fully recovered

Year Four: Rs.10,000 / Rs.10,000 = full year needed

Payback Period for Project A: 4 years

Project F: Year One: -Rs.250,000 + Rs.40,000 = Rs.210,000 left to

recover

Year Two: -Rs.210,000 + Rs.120,000 = Rs.90,000 left to

recover

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 Year Three: -Rs.90,000 + Rs.200,000 = fully recovered

Year Three: Rs.90,000 / Rs.200,000 = 0.45 year needed

Payback Period for Project B: 2.45 years

Project G: Year One: -Rs.75,000 + Rs.20,000 = Rs.55,000 left to

recover

Year Two: -Rs.55,000 + Rs.35,000 = Rs.20,000 left to

recover

Year Three: -Rs.20,000 + Rs.40,000 = fully recovered

Year Three: Rs.20,000 / Rs.40,000 = 0.5 year needed

Payback Period for Project B: 2.5 years

Project H: Year One: -Rs.100,000 + Rs.30,000 = Rs.70,000 left to

recover

Year Two: -Rs.70,000 + Rs.30,000 = Rs.40,000 left to

recover

Year Three: -Rs.40,000 + Rs.30,000 = Rs.10,000 left to

recover

Year Four: -Rs.10,000 + Rs.20,000 = fully recovered

Year Four: Rs.10,000 / Rs.20,000 = 0.5 year needed

Payback Period for Project B: 3.5 years

With a three year cut-off period, ACCEPT F and G, REJECT E and H.

3. Discounted Payback Period – Given the following four projects and their cash flows,

calculate the discounted payback period with a 5% discount rate, 10% discount rate, and

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20% discount rate. What do you notice about the payback period as the discount rate

rises? Explain this relationship.

Projects A B C D
Cost Rs.10,000 Rs.25,000 Rs.45,000 Rs.100,000
Cash Flow Year One Rs.4,000 Rs.2,000 Rs.10,000 Rs.40,000
Cash Flow Year Two Rs.4,000 Rs.8,000 Rs.15,000 Rs.30,000
Cash Flow Year Three Rs.4,000 Rs.14,000 Rs.20,000 Rs.20,000
Cash Flow Year Four Rs.4,000 Rs.20,000 Rs.20,000 Rs.10,000
Cash Flow year Five Rs.4,000 Rs.26,000 Rs.15,000 Rs.10,000
Cash Flow Year Six Rs.4,000 Rs.32,000 Rs.10,000 Rs.0

Solution at 5% discount rate

Project A: PV Cash flow year one -- Rs.4,000 / 1.05 = Rs.3,809.52

PV Cash flow year two -- Rs.4,000 / 1.052 = Rs.3,628.12

PV Cash flow year three -- Rs.4,000 / 1.053 = Rs.3,455.35

PV Cash flow year four -- Rs.4,000 / 1.054 = Rs.3,290.81

PV Cash flow year five -- Rs.4,000 / 1.055 = Rs.3,134.10

PV Cash flow year six -- Rs.4,000 / 1.056 = Rs.2,984.86

Discounted Payback Period: -Rs.10,000 + Rs.3,809.52 + Rs.3,628.12 + Rs.3,455.35 =

Rs.892.99 and fully recovered

Discounted Payback Period is 3 years.

Project B: PV Cash flow year one -- Rs.2,000 / 1.05 = Rs.1,904.76

PV Cash flow year two -- Rs.8,000 / 1.052 = Rs.7,256.24

PV Cash flow year three -- Rs.14,000 / 1.053 = Rs.12,093.73

PV Cash flow year four -- Rs.20,000 / 1.054 = Rs.16,454.05

PV Cash flow year five -- Rs.26,000 / 1.055 = Rs.20,371.68

PV Cash flow year six -- Rs.32,000 / 1.056 = Rs.23,878.89

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Discounted Payback Period: -Rs.25,000 + Rs.1,904.76 + Rs.7,256.24 + Rs.12,093.73 +

Rs.16,454.05 = Rs.12,708.78 and fully recovered

Discounted Payback Period is 4 years.

Project C: PV Cash flow year one -- Rs.10,000 / 1.05 = Rs.9,523.81

PV Cash flow year two -- Rs.15,000 / 1.052 = Rs.13,605.44

PV Cash flow year three -- Rs.20,000 / 1.053 = Rs.17,276.75

PV Cash flow year four -- Rs.20,000 / 1.054 = Rs.16,454.05

PV Cash flow year five -- Rs.15,000 / 1.055 = Rs.11,752.89

PV Cash flow year six -- Rs.10,000 / 1.056 = Rs.7,462.15

Discounted Payback Period: -Rs.45,000 + Rs.9,523.81 + Rs.13,605.44 + Rs.17,276.75 +

Rs.16,454.05 = Rs.11,860.05 and fully recovered

Discounted Payback Period is 4 years.

Project D: PV Cash flow year one -- Rs.40,000 / 1.05 = Rs.38,095.24

PV Cash flow year two -- Rs.35,000 / 1.052 = Rs.31,746.03

PV Cash flow year three -- Rs.20,000 / 1.053 = Rs.17,276.75

PV Cash flow year four -- Rs.10,000 / 1.054 = Rs.8,227.02

PV Cash flow year five -- Rs.10,000 / 1.055 = Rs.7,835.26

PV Cash flow year six -- Rs.0 / 1.056 = Rs.0

Discounted Payback Period: -Rs.100,000 + Rs.38,095.24 + Rs.31,746.03 + Rs.17,276.75

+ Rs.8,227.02 + Rs.7,835.26 = Rs.3,180.30 and fully recovered.

Discounted Payback Period is 5 years.

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Solution at 10% discount rate

Project A: PV Cash flow year one -- Rs.4,000 / 1.10 = Rs.3,636.36

PV Cash flow year two -- Rs.4,000 / 1.102 = Rs.3,307.79

PV Cash flow year three -- Rs.4,000 / 1.103 = Rs.3,005.26

PV Cash flow year four -- Rs.4,000 / 1.104 = Rs.2,732.05

PV Cash flow year five -- Rs.4,000 / 1.105 = Rs.2,483.69

PV Cash flow year six -- Rs.4,000 / 1.106 = Rs.2,257.90

Discounted Payback Period: -Rs.10,000 + Rs.3,636.36 + Rs.3,307.79 + Rs.3,005.26 +

Rs.2,732.05 = Rs.2,681.46 and fully recovered

Discounted Payback Period is 4 years.

Project B: PV Cash flow year one -- Rs.2,000 / 1.10 = Rs.1,818.18

PV Cash flow year two -- Rs.8,000 / 1.102 = Rs.6,611.57

PV Cash flow year three -- Rs.14,000 / 1.103 = Rs.10,518.41

PV Cash flow year four -- Rs.20,000 / 1.104 = Rs.13,660.27

PV Cash flow year five -- Rs.26,000 / 1.105 = Rs.16,143.95

PV Cash flow year six -- Rs.32,000 / 1.106 = Rs.18,063.17

Discounted Payback Period: -Rs.25,000 + Rs.1,818.18 + Rs.6,611.57 + Rs.10,518.41 +

Rs.13,660.27 = Rs.7,608.43 and fully recovered

Discounted Payback Period is 4 years.

Project C: PV Cash flow year one -- Rs.10,000 / 1.10 = Rs.9,090.91

PV Cash flow year two -- Rs.15,000 / 1.102 = Rs.12,396.69

PV Cash flow year three -- Rs.20,000 / 1.103 = Rs.15,026.30

PV Cash flow year four -- Rs.20,000 / 1.104 = Rs.13,660.27

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 PV Cash flow year five -- Rs.15,000 / 1.105 = Rs.9,313.82

PV Cash flow year six -- Rs.10,000 / 1.106 = Rs.5,644.74

Discounted Payback Period: -Rs.45,000 + Rs.9,090.91 + Rs.12,396.69 + Rs.15,026.20 +

Rs.13,660.27 = Rs.5174.07 and fully recovered

Discounted Payback Period is 4 years.

Project D: PV Cash flow year one -- Rs.40,000 / 1.10 = Rs.36,363.64

PV Cash flow year two -- Rs.35,000 / 1.102 = Rs.28,925.62

PV Cash flow year three -- Rs.20,000 / 1.103 = Rs.15,026.30

PV Cash flow year four -- Rs.10,000 / 1.104 = Rs.6,830.13

PV Cash flow year five -- Rs.10,000 / 1.105 = Rs.6,209.21

PV Cash flow year six -- Rs.0 / 1.106 = Rs.0

Discounted Payback Period: -Rs.100,000 + Rs.36,363.64 + Rs.28,925.62 + Rs.15,026.30

+ Rs.6,830.13 + Rs.6,209.21 = -Rs.6,645.10 and never recovered.

Initial cash outflow is never recovered.

Solution at 20% discount rate

Project A: PV Cash flow year one -- Rs.4,000 / 1.20 = Rs.3,333.33

PV Cash flow year two -- Rs.4,000 / 1.202 = Rs.2,777.78

PV Cash flow year three -- Rs.4,000 / 1.203 = Rs.2,314.81

PV Cash flow year four -- Rs.4,000 / 1.204 = Rs.1,929.01

PV Cash flow year five -- Rs.4,000 / 1.205 = Rs.1,6075.10

PV Cash flow year six -- Rs.4,000 / 1.206 = Rs.1,339.59

Discounted Payback Period: -Rs.10,000 + Rs.3,333.33 + Rs.2,777.78 + Rs.2,314.81+

Rs.1,929.01 = Rs.354.93 and fully recovered

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Discounted Payback Period is 4 years.

Project B: PV Cash flow year one -- Rs.2,000 / 1.20 = Rs.1,666.67

PV Cash flow year two -- Rs.8,000 / 1.202 = Rs.5,555.56

PV Cash flow year three -- Rs.14,000 / 1.203 = Rs.8,101.85

PV Cash flow year four -- Rs.20,000 / 1.204 = Rs.9,645.06

PV Cash flow year five -- Rs.26,000 / 1.205 = Rs.10,448.82

PV Cash flow year six -- Rs.32,000 / 1.206 = Rs.10,716.74

Discounted Payback Period: -Rs.25,000 + Rs.1,666.67 + Rs.5,555.56 + Rs.8,101.85 +

Rs.9,645.06 + Rs.10,448.82 = Rs.10,417.96 and fully recovered

Discounted Payback Period is 5 years.

Project C: PV Cash flow year one -- Rs.10,000 / 1.20 = Rs.8,333.33

PV Cash flow year two -- Rs.15,000 / 1.202 = Rs.10,416.67

PV Cash flow year three -- Rs.20,000 / 1.203 = Rs.11,574.07

PV Cash flow year four -- Rs.20,000 / 1.204 = Rs.9,645.06

PV Cash flow year five -- Rs.15,000 / 1.205 = Rs.6,028.16

PV Cash flow year six -- Rs.10,000 / 1.206 = Rs.3,348.97

Discounted Payback Period: -Rs.45,000 + Rs.8,333.33 + Rs.10,416.67 + Rs.11,574.07 +

Rs.9,645.06 + Rs.6,028.16 = Rs.997.29 and fully recovered

Discounted Payback Period is 5 years.

Project D: PV Cash flow year one -- Rs.40,000 / 1.20 = Rs.33,333.33

PV Cash flow year two -- Rs.35,000 / 1.202 = Rs.24,305.56

PV Cash flow year three -- Rs.20,000 / 1.203 = Rs.11,574.07

PV Cash flow year four -- Rs.10,000 / 1.204 = Rs.4,822.53

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 PV Cash flow year five -- Rs.10,000 / 1.205 = Rs.4,018.78

PV Cash flow year six -- Rs.0 / 1.206 = Rs.0

Discounted Payback Period: -Rs.100,000 + Rs.33,333.33 + Rs.24,305.56 + Rs.11,574.07

+ Rs.4,822.53 + Rs.4,018.78 = -Rs.21,945.73 and initial cost is never recovered.

Discounted Payback Period is infinity.

As the discount rate increases, the Discounted Payback Period also increases. The reason

is that the future dollars are worth less in present value as the discount rate increases

requiring more future dollars to recover the present value of the outlay.

4. Discounted Payback Period – Graham Incorporated uses discounted payback period

for projects under Rs.25,000 and has a cut off period of 4 years for these small value

projects. Two projects, R and S are under consideration. The anticipated cash flows for

these two projects are listed below. If Graham Incorporated uses an 8% discount rate on

these projects are they accepted or rejected? If they use 12% discount rate? If they use a

16% discount rate? Why is it necessary to only look at the first four years of the projects’

cash flows?

Cash Flows Project R Project S

Initial Cost Rs.24,000 Rs.18,000
Cash flow year one Rs.6,000 Rs.9,000
Cash flow year two Rs.8,000 Rs.6,000
Cash flow year three Rs.10,000 Rs.6,000
Cash flow year four Rs.12,000 Rs.3,000

Solution at 8%

Project R: PV Cash flow year one -- Rs.6,000 / 1.08 = Rs.5,555.56

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 PV Cash flow year two -- Rs.8,000 / 1.082 = Rs.6,858.71

PV Cash flow year three -- Rs.10,000 / 1.083 = Rs.7,938.32

PV Cash flow year four -- Rs.12,000 / 1.084 = Rs.8,820.36

Discounted Payback Period: -Rs.24,000 + Rs.5,555.56 + Rs.6,858.71 + Rs.7,938.32 +

Rs.8,820.36 = Rs.5,172.95 and initial cost is in first four years, project accepted.

Project S: PV Cash flow year one -- Rs.9,000 / 1.08 = Rs.8,333.33

PV Cash flow year two -- Rs.6,000 / 1.082 = Rs.5,144.03

PV Cash flow year three -- Rs.6,000 / 1.083 = Rs.4,762.99

PV Cash flow year four -- Rs.3,000 / 1.084 = Rs.2,205.09

Discounted Payback Period: -Rs.18,000 + Rs.8,333.33 + Rs.5,144.03 + Rs.4,762.99 +

Rs.2,205.09 = Rs.2,445.44 and initial cost is in first four years, project accepted.

Solution at 12%

Project R: PV Cash flow year one -- Rs.6,000 / 1.12 = Rs.5,357.14

PV Cash flow year two -- Rs.8,000 / 1.122 = Rs.6,377.55

PV Cash flow year three -- Rs.10,000 / 1.123 = Rs.8,541.36

PV Cash flow year four -- Rs.12,000 / 1.124 = Rs.7,626.22

Discounted Payback Period: -Rs.24,000 + Rs.5,357.14 + Rs.6,377.55 + Rs.8,541.36 +

Rs.7,626.22 = Rs.3,902.27 and initial cost is in first four years, project accepted.

Project S: PV Cash flow year one -- Rs.9,000 / 1.12 = Rs.8,035.71

20
 PV Cash flow year two -- Rs.6,000 / 1.122 = Rs.4,783.16

PV Cash flow year three -- Rs.6,000 / 1.123 = Rs.4,270.68

PV Cash flow year four -- Rs.3,000 / 1.124 = Rs.1,906.55

Discounted Payback Period: -Rs.18,000 + Rs.8,035.71 + Rs.4,783.16 + Rs.4,270.68 +

Rs.1,906.55 = Rs.996.10 and initial cost is in first four years, project accepted.

Solution at 16%

Project R: PV Cash flow year one -- Rs.6,000 / 1.16 = Rs.5,172.41

PV Cash flow year two -- Rs.8,000 / 1.162 = Rs.5,945.30

PV Cash flow year three -- Rs.10,000 / 1.163 = Rs.6,406.58

PV Cash flow year four -- Rs.12,000 / 1.164 = Rs.6,627.49

Discounted Payback Period: -Rs.24,000 + Rs.5,172.41 + Rs.5,945.30 + Rs.6,406.58 +

Rs.6,627.49 = Rs.151.78 and initial cost is in first four years, project accepted.

Project S: PV Cash flow year one -- Rs.9,000 / 1.16 = Rs.7,758.62

PV Cash flow year two -- Rs.6,000 / 1.162 = Rs.4,458.98

PV Cash flow year three -- Rs.6,000 / 1.163 = Rs.3,843.95

PV Cash flow year four -- Rs.3,000 / 1.164 = Rs.1,656.87

Discounted Payback Period: -Rs.18,000 + Rs.7,758.62 + Rs.4,458.98 + Rs.3,843.95 +

Rs.1,656.87 = -Rs.251.58 and initial cost is not recovered in first four years, project

rejected.

21
Because Graham Incorporated is using a four year cut-off period, only the first four years

of cash flow matter. If the first four years of anticipated cash flows are insufficient to

cover the initial outlay of cash, the project is rejected regardless of the cash flows in years

five and forward.

5. Comparing Payback Period and Discounted Payback Period – Mathew Incorporated

is debating using Payback Period versus Discounted Payback Period for small dollar

projects. The Information Officer has submitted a new computer project of Rs.15,000

cost. The cash flows will be Rs.5,000 each year for the next five years. The cut-off period

used by Mathew Incorporated is three years. The Information Officer states it doesn’t

matter what model the company uses for the decision, it is clearly an acceptable project.

Demonstrate for the IO that the selection of the model does matter!

Solution

Calculate the Payback Period for the project:

Payback Period = -Rs.15,000 + Rs.5,000 + Rs.5,000 + Rs.5,000 = 0 so the

payback period is 3 years and the project is a go!

Calculate the Discounted Payback Period for the project at any positive discount

rate, say 1%...

Present Value of cash flow year one = Rs.5,000 / 1.01 = Rs.4,950.50

Present Value of cash flow year two = Rs.5,000 / 1.012 = Rs.4,901.48

Present Value of cash flow year three = Rs.5,000 / 1.013 = Rs.4,852.95

22
 Discounted Payback Period = -Rs.15,000 + Rs.4,950.50 + Rs.4,901.48 +

Rs.4,852.95 = -Rs.295.04 so the payback period is over 3 years and the project is a

no-go!

6. Comparing Payback Period and Discounted Payback Period – Neilsen Incorporated is

switching from Payback Period to Discounted Payback Period for small dollar projects.

The cut-off period will remain at 3 years. Given the following four projects cash flows

and using a 10% discount rate, which projects that would have been accepted under

Payback Period will now be rejected under Discounted Payback Period?

Project Project
Cash Project One Project Two Three Four
Flows
Initial cost Rs.10,000 Rs.15,000 Rs.8,000 Rs.18,000
Year One Rs.4,000 Rs.7,000 Rs.3,000 Rs.10,000
Year Two Rs.4,000 Rs.5,500 Rs.3,500 Rs.11,000
Year Rs.4,000 Rs.4,000 Rs.4,000 Rs.0
Three

Solution

Calculate the Discounted Payback Periods of each project at 10% discount rate:

Project One

Present Value of cash flow year one = Rs.4,000 / 1.10 = Rs.3,636.36

Present Value of cash flow year two = Rs.4,000 / 1.102 = Rs.3,305.78

Present Value of cash flow year three = Rs.4,000 / 1.103 = Rs.3,005.26

23
 Discounted Payback Period = -Rs.10,000 + Rs.3,636.36 + Rs.3,305.78 +

Rs.3,005.26 = -Rs.52.60 so the discount payback period is over 3 years and the

project is a no-go!

Project Two

Present Value of cash flow year one = Rs.7,000 / 1.10 = Rs.6,930.69

Present Value of cash flow year two = Rs.5,500 / 1.102 = Rs.5,391.63

Present Value of cash flow year three = Rs.4,000 / 1.103 = Rs.3,005.26

Discounted Payback Period = -Rs.15,000 + Rs.6,930.69 + Rs.5,391.63 +

Rs.3,005.26 = Rs.327.58 so the discount payback period is 3 years and the project is a

go!

Project Three

Present Value of cash flow year one = Rs.2,500 / 1.10 = Rs.2,272.73

Present Value of cash flow year two = Rs.3,000 / 1.102 = Rs.2,479.34

Present Value of cash flow year three = Rs.3,500 / 1.103 = Rs.2,629.60

Discounted Payback Period = -Rs.8,000 + Rs.2,272.73+ Rs.2,479.34 +

Rs.2,629.20 = -Rs.618.33 so the discount payback period is over 3 years and the

project is a no-go!

Project Four

Present Value of cash flow year one = Rs.10,000 / 1.10 = Rs.9,090.91

Present Value of cash flow year two = Rs.11,000 / 1.102 = Rs.9,090.91

Present Value of cash flow year three = Rs.0 / 1.103 = Rs.0

Discounted Payback Period = -Rs.18,000 + Rs.9,090.91 + Rs.9,090.91 + Rs.0 =

Rs.181.82 so the discount payback period is 3 years and the project is a go!

24
 Projects one and three will now be rejected using discounted payback period with

a discount rate of 10%.

7. Net Present Value – Swanson Industries has a project with the following projected

cash flows:

Initial Cost, Year 0: Rs.240,000

Cash flow year one: Rs.25,000

Cash flow year two: Rs.75,000

Cash flow year three: Rs.150,000

Cash flow year four: Rs.150,000

a. Using a 10% discount rate for this project and the NPV model should this

project be accepted or rejected?

b. Using a 15% discount rate?

c. Using a 20% discount rate?

Solution

a. NPV = -Rs.240,000 + Rs.25,000/1.10 + Rs.75,000/1.102 + Rs.150,000/1.103

+ Rs.150,000/1.104

NPV = -Rs.240,000 + Rs.22,727.27 + Rs.61,983.47 + Rs.112,697.22 +

Rs.102,452.02

NPV = Rs.59,859.98 and accept the project.

b. NPV = -Rs.240,000 + Rs.25,000/1.15 + Rs.75,000/1.152 + Rs.150,000/1.153

+ Rs.150,000/1.154

25
 NPV = -Rs.240,000 + Rs.21,739.13 + Rs.56,710.76 + Rs.98,627.43 +

Rs.85,762.99

NPV = Rs.22,840.31 and accept the project.

c. NPV = -Rs.240,000 + Rs.25,000/1.20 + Rs.75,000/1.202 + Rs.150,000/1.203

+ Rs.150,000/1.204

NPV = -Rs.240,000 + Rs.20,833.33 + Rs.52,083.33 + Rs.86,805.56 +

Rs.72,337.96

NPV = -Rs.7,939.82 and reject the project.

8. Net Present Value – Campbell Industries has a project with the following projected

cash flows:

Initial Cost, Year 0: Rs.468,000

Cash flow year one: Rs.135,000

Cash flow year two: Rs.240,000

Cash flow year three: Rs.185,000

Cash flow year four: Rs.135,000

a. Using an 8% discount rate for this project and the NPV model should this

project be accepted or rejected?

b. Using a 14% discount rate?

c. Using a 20% discount rate?

Solution

a. NPV = -Rs.468,000 + Rs.135,000/1.08 + Rs.240,000/1.082 +

Rs.185,000/1.083 + Rs.135,000/1.084

26
 NPV = -Rs.468,000 + Rs.125,000.00 + Rs.205,761.32 + Rs.146,858.96 +

Rs.99,229.03

NPV = Rs.108,849.31 and accept the project.

b. NPV = -Rs.468,000 + Rs.135,000/1.14 + Rs.240,000/1.142 +

Rs.185,000/1.143 + Rs.135,000/1.144

NPV = -Rs.468,000 + Rs.118,421.05 + Rs.184,672.21 + Rs.124,869.73 +

Rs.79,930.84

NPV = Rs.39,893.83 and accept the project.

c. NPV = -Rs.468,000 + Rs.135,000/1.20 + Rs.240,000/1.202 +

Rs.185,000/1.203 + Rs.135,000/1.204

NPV = -Rs.468,000 + Rs.112,500.00 + Rs.166,666.67 + Rs.107,060.19 +

Rs.65,104.17

NPV = -Rs.16,668.97 and reject the project.

9. Net Present Value – Swanson Industries has four potential projects all with an initial

cost of Rs.2,000,000. The capital budget for the year will only allow Swanson industries

to accept one of the four projects. Given the discount rates and the future cash flows of

each project, which project should they accept?

Cash Flows Project M Project N Project O Project P

Year one Rs.500,000 Rs.600,000 Rs.1,000,000 Rs.300,000
Year two Rs.500,000 Rs.600,000 Rs.800,000 Rs.500,000
Year three Rs.500,000 Rs.600,000 Rs.600,000 Rs.700,000
Year four Rs.500,000 Rs.600,000 Rs.400,000 Rs.900,000
Year five Rs.500,000 Rs.600,000 Rs.200,000 Rs.1,100,000
Discount Rate 6% 9% 15% 22%

Solution, find the NPV of each project and compare the NPVs.

27
 Project M’s NPV = -Rs.2,000,000 + Rs.500,000/1.05 + Rs.500,000/1.052 +

Rs.500,000/1.053 + Rs.500,000/1.054 + Rs.500,000/1.055

Project M’s NPV = -Rs.2,000,000 + Rs.476,190.48 + Rs.453,514.74 +

Rs.431,918.80 + Rs.411,351.24 + Rs.391,763.08

Project N’s NPV = Rs.164,738.34

Project N’s NPV = -Rs.2,000,000 + Rs.600,000/1.09 + Rs.600,000/1.092 +

Rs.600,000/1.093 + Rs.600,000/1.094 + Rs.600,000/1.095

Project N’s NPV = -Rs.2,000,000 + Rs.550,458.72 + Rs.505,008.00 +

Rs.463,331.09 + Rs.425,055.13 + Rs.389,958.83

Project N’s NPV = Rs.333,790.77

Project O’s NPV = -Rs.2,000,000 + Rs.1,000,000/1.15 + Rs.800,000/1.152 +

Rs.600,000/1.153 + Rs.400,000/1.154 + Rs.200,000/1.155

Project O’s NPV = -Rs.2,000,000 + Rs.869,565.22 + Rs.604,914.93 +

Rs.394,509.74 + Rs.228,701.30 + Rs.99,435.34

Project O’s NPV = Rs.197,126.53

Project P’s NPV = -Rs.2,000,000 + Rs.300,000/1.22 + Rs.500,000/1.222 +

Rs.700,000/1.223 + Rs.900,000/1.224 + Rs.1,100,000/1.225

Project P’s NPV = -Rs.2,000,000 + Rs.245,901.64 + Rs.335,931.20 +

Rs.385,494.82 + Rs.406,259.18 + Rs.406,999.18

Project P’s NPV =-Rs.219,413.98 (would reject project regardless of budget)

And the ranking order based on NPVs is,

Project N – NPV of Rs.333,790.77

Project O – NPV of Rs.197,126.53

28
 Project M – NPV of Rs.164,738.34

Project P – NPV of -Rs.219,413.98

Swanson Industries should pick Project N.

10. Net Present Value – Campbell Industries has four potential projects all with an initial

cost of Rs.1,500,000. The capital budget for the year will only allow Swanson industries

to accept one of the four projects. Given the discount rates and the future cash flows of

each project, which project should they accept?

Cash Flows Project Q Project R Project S Project T

Year one Rs.350,000 Rs.400,000 Rs.700,000 Rs.200,000
Year two Rs.350,000 Rs.400,000 Rs.600,000 Rs.400,000
Year three Rs.350,000 Rs.400,000 Rs.500,000 Rs.600,000
Year four Rs.350,000 Rs.400,000 Rs.400,000 Rs.800,000
Year five Rs.350,000 Rs.400,000 Rs.300,000 Rs.1,000,000
Discount Rate 4% 8% 13% 18%

Solution, find the NPV of each project and compare the NPVs.

Project Q’s NPV = -Rs.1,500,000 + Rs.350,000/1.04 + Rs.350,000/1.042 +

Rs.350,000/1.043 + Rs.350,000/1.044 + Rs.350,000/1.045

Project Q’s NPV = -Rs.1,500,000 + Rs.336,538.46 + Rs.323,594.67 +

Rs.311,148.73 + Rs.299,181.47 + Rs.287,674.49

Project Q’s NPV = Rs.58,137.84

Project R’s NPV = -Rs.1,500,000 + Rs.400,000/1.08 + Rs.400,000/1.082 +

Rs.400,000/1.083 + Rs.400,000/1.084 + Rs.400,000/1.085

Project R’s NPV = -Rs.2,000,000 + Rs.370,370.37 + Rs.342,935.53 +

Rs.317,532.90 + Rs.294,011.94 + Rs.272,233.28

Project R’s NPV = Rs.97,084.02

29
 Project S’s NPV = -Rs.1,500,000 + Rs.700,000/1.13 + Rs.600,000/1.132 +

Rs.500,000/1.133 + Rs.400,000/1.134 + Rs.300,000/1.135

Project S’s NPV = -Rs.1,500,000 + Rs.619,469.03 + Rs.469,888.01 +

Rs.346,525.08 + Rs.245,327.49 + Rs.162,827.98

Project S’s NPV = Rs.344,037.59

Project T’s NPV = -Rs.1,500,000 + Rs.200,000/1.18 + Rs.400,000/1.182 +

Rs.600,000/1.183 + Rs.800,000/1.184 + Rs.1,000,000/1.185

Project T’s NPV = -Rs.1,500,000 + Rs.169,491.53 + Rs.287,273.77 +

Rs.365,178.52 + Rs.412,631.10 + Rs.437,109.22

Project T’s NPV = Rs.171,684.14

And the ranking order based on NPVs is,

Project S – NPV of Rs.344,037.59

Project T – NPV of Rs.171,684.14

Project R – NPV of Rs.97,084.02

Project Q – NPV of Rs.58,137.84

Campbell Industries should pick Project S.

11. Internal Rate of Return – What are the IRRs of the four projects for Swanson

Industries in problem #9?

Solution, this is an iterative process but can be solved quickly on a calculator or

spreadsheet.

Enter the keys noted for each project in the CF of a Texas BA II Plus calculator

Cash Flows Project M Project N Project O Project P

CFO -Rs.2,000,000 -Rs.2,000,000 -Rs.2,000,000 -Rs.2,000,000
CO1, F1 Rs.500,000, 1 Rs.600,000, 1 Rs.1,000,000, 1 Rs.300,000, 1
CO2, F2 Rs.500,000, 1 Rs.600,000, 1 Rs.800,000, 1 Rs.500,000, 1

30
 Year three Rs.500,000, 1 Rs.600,000, 1 Rs.600,000, 1 Rs.700,000, 1
Year four Rs.500,000, 1 Rs.600,000, 1 Rs.400,000, 1 Rs.900,000, 1
Year five Rs.500,000, 1 Rs.600,000, 1 Rs.200,000, 1 Rs.1,100,000, 1
CPT IRR 7.93% 15.24% 20.27% 17.72%

12. Internal Rate of Return -- Internal Rate of Return – What are the IRRs of the four

projects for Campbell Industries in problem #10?

Solution, this is an iterative process but can be solved quickly on a calculator or

spreadsheet.

Enter the keys noted for each project in the CF of a Texas BA II Plus calculator

Cash Flows Project Q Project R Project S Project T

CFO -Rs.1,500,000 -Rs.1,500,000 -Rs.1,500,000 -Rs.1,500,000
CO1, F1 Rs.350,000, 1 Rs.400,000, 1 Rs.700,000, 1 Rs.200,000, 1
CO2, F2 Rs.350,000, 1 Rs.400,000, 1 Rs.600,000, 1 Rs.400,000, 1
Year three Rs.350,000, 1 Rs.400,000, 1 Rs.500,000,1 Rs.600,000, 1
Year four Rs.350,000, 1 Rs.400,000, 1 Rs.400,000, 1 Rs.800,000, 1
Year five Rs.350,000, 1 Rs.400,000, 1 Rs.300,000, 1 Rs.1,000,000, 1
CPT IRR 5.37% 10.42% 23.57% 21.86%

13. Comparing NPV and IRR – Chandler and Joey were having a discussion about which

financial model to use for their new business. Chandler supports NPV and Joey supports

IRR. The discussion starts to get heated when Ross steps in and states, “gentlemen, it

doesn’t matter which method we choose, they give the same answer on all projects.” Is

Ross right? Under what conditions will IRR and NPV be consistent when accepting or

rejecting projects?

31
 Solution: Ross is partially right as NPV and IRR both reject or both accept the

same projects under the following conditions:

 The projects have standard cash flows

 The hurdle rate for IRR is the same as the discount rate for NPV

 All projects are available for acceptance regardless of the decision

made on another project (projects are not mutually exclusive)

14. Comparing NPR and IRR – Monica and Rachel are having a discussion about IRR

and NPV as a decision model for Monica’s new restaurant. Monica wants to use IRR

because it gives a very simple and intuitive answer. Rachel states that there can be errors

made with IRR that are not made with NPV. Is Rachel right? Show one type of error can

be made with IRR and not with NPV?

Solution: The most typical example here is with two mutually exclusive

projects where the IRR of one project is higher than the IRR of the other

project but the NPV of the second project is higher than the NPV of the first

project. When comparing two projects using only IRR this method fails to

account for the level of risk of the project cash flows. When the discount rate

is below the cross-over rate one project is better under NPV while the other

project is better if the discount rate is above the cross-over rate and still below

the IRR.

15. Profitability Index -- Given the discount rates and the future cash flows of each

project, which projects should they accept using profitability index?

32
 Cash Flows Project U Project V Project W Project X
Year zero -Rs.2,000,000 -Rs.2,500,000 -Rs.2,400,000 -Rs.1,750,000
Year one Rs.500,000 Rs.600,000 Rs.1,000,000 Rs.300,000
Year two Rs.500,000 Rs.600,000 Rs.800,000 Rs.500,000
Year three Rs.500,000 Rs.600,000 Rs.600,000 Rs.700,000
Year four Rs.500,000 Rs.600,000 Rs.400,000 Rs.900,000
Year five Rs.500,000 Rs.600,000 Rs.200,000 Rs.1,100,000
Discount Rate 6% 9% 15% 22%

Solution, find the present value of benefits and divide by the present value of the

costs for each project.

Project U’s PV Benefits = Rs.500,000/1.05 + Rs.500,000/1.052 +

Rs.500,000/1.053 + Rs.500,000/1.054 + Rs.500,000/1.055

Project U’s PV Benefits = Rs.476,190.48 + Rs.453,514.74 + Rs.431,918.80 +

Rs.411,351.24 + Rs.391,763.08 = Rs.2,164,738.34

Project U’s PV Costs = Rs.2,000,000

Project U’s PI = Rs.2,164,738.34 / Rs.2,000,000 = Rs.1.0824 accept project.

Project V’s PV Benefits = Rs.600,000/1.09 + Rs.600,000/1.092 +

Rs.600,000/1.093 + Rs.600,000/1.094 + Rs.600,000/1.095

Project V’s PV Benefits = -Rs.2,000,000 + Rs.550,458.72 + Rs.505,008.00 +

Rs.463,331.09 + Rs.425,055.13 + Rs.389,958.83 = Rs.2,333,790.77

Project V’s PV Costs = Rs.2,500,000

Project V’s PI = Rs.2,333,790.77 / Rs. 2,500,000 = 0.9335 and reject project.

Project W’s PV Benefits = Rs.1,000,000/1.15 + Rs.800,000/1.152 +

Rs.600,000/1.153 + Rs.400,000/1.154 + Rs.200,000/1.155

Project W’s PV Benefits = Rs.869,565.22 + Rs.604,914.93 + Rs.394,509.74 +

Rs.228,701.30 + Rs.99,435.34 = Rs.2,197,126.53

33
 Project W’s PV Costs = Rs.2,400,000

Project W’s PI = Rs.2,197,126.53 / Rs.2,400,000 = 0.9155 and reject project.

Project X’s PV Benefits= -Rs.2,000,000 + Rs.300,000/1.22 +

Rs.500,000/1.222 + Rs.700,000/1.223 + Rs.900,000/1.224 + Rs.1,100,000/1.225

Project X’s PV Benefits= -Rs.2,000,000 + Rs.245,901.64 + Rs.335,931.20 +

Rs.385,494.82 + Rs.406,259.18 + Rs.406,999.18 = Rs.1,780,586.02

Project X’s PV Cost = Rs.1,750,000

Project X’s PI = Rs.1,780,586.02 / Rs.1,750,000 = 1.0175 and accept project.

16. Profitability Index -- Given the discount rates and the future cash flows of each

project, which projects should they accept using profitability index?

Cash Flows Project A Project B Project C Project D

Year zero -Rs.1,500,000 -Rs.1,500,000 -Rs.2,000,000 -Rs.2,000,000
Year one Rs.350,000 Rs.400,000 Rs.700,000 Rs.200,000
Year two Rs.350,000 Rs.400,000 Rs.600,000 Rs.400,000
Year three Rs.350,000 Rs.400,000 Rs.500,000 Rs.600,000
Year four Rs.350,000 Rs.400,000 Rs.400,000 Rs.800,000
Year five Rs.350,000 Rs.400,000 Rs.300,000 Rs.1,000,000
Discount Rate 4% 8% 13% 18%

Solution, find the present value of benefits and divide by the present value of the

costs for each project.

Project A’s PV Benefits = Rs.350,000/1.04 + Rs.350,000/1.042 +

Rs.350,000/1.043 + Rs.350,000/1.044 + Rs.350,000/1.045

Project A’s PV Benefits = Rs.336,538.46 + Rs.323,594.67 + Rs.311,148.73 +

Rs.299,181.47 + Rs.287,674.49 = Rs.1,558,137.84

Project A’s PV Costs = Rs.1,500,000

34
 Project A’s PI = Rs.1,558,137.84 / Rs.1,500,000 = 1.0388 and accept project.

Project B’s PV Benefits = Rs.400,000/1.08 + Rs.400,000/1.082 +

Rs.400,000/1.083 + Rs.400,000/1.084 + Rs.400,000/1.085

Project B’s NPV = -Rs.2,000,000 + Rs.370,370.37 + Rs.342,935.53 +

Rs.317,532.90 + Rs.294,011.94 + Rs.272,233.28 = Rs.1,597,084.02

Project B’s PV Costs = Rs.1,500,000

Project B’s PI = Rs.1,597,084.02 / Rs.1,500,000 = 1.0647 and accept project.

Project C’s PV Benefits = Rs.700,000/1.13 + Rs.600,000/1.132 +

Rs.500,000/1.133 + Rs.400,000/1.134 + Rs.300,000/1.135

Project C’s PV Benefits = Rs.619,469.03 + Rs.469,888.01 + Rs.346,525.08 +

Rs.245,327.49 + Rs.162,827.98 = Rs.1,844,037.59

Project C’s PV Costs = Rs.2,000,000

Project C’s PI = Rs.1,844,037.59 / Rs.2,000,000 = 0.9220 and reject project.

Project D’s PV Benefits = Rs.200,000/1.18 + Rs.400,000/1.182 +

Rs.600,000/1.183 + Rs.800,000/1.184 + Rs.1,000,000/1.185

Project D’s PV Benefits = Rs.169,491.53 + Rs.287,273.77 + Rs.365,178.52 +

Rs.412,631.10 + Rs.437,109.22 = Rs.1,671,684.14

Project D’s PV Costs = Rs.2,000,000

Project D’s PI = Rs.1,671,684.14 / Rs.2,000,000 = 0.8358 and reject project.

17. Comparing All Methods -- Given the following After Tax Cash Flows for Tyler’s

Tinkering Toys on a new toy find the Payback Period, NPV, and Profitability Index of

35
this project. The appropriate discount rate for the project is 12%. If the cut-off period is

six years for major projects, determine if the project is accepted or rejected under the four

different decision models.

Year 0 cash outflow: Rs.10,400,000

Years 1 to 4 cash inflow: Rs.2,600,000 each year

Year 5 cash outflow: Rs.1,200,000

Years 6 – 8 cash inflow: Rs.750,000 each year

Solution:

Payback Period: -Rs.10,400,000 + Rs.2,600,000 + Rs.2,600,000 + Rs.2,600,000

+ Rs.2,600,000 = Rs.0 (Four years but year five is also an outflow so we need to

continue) -Rs.1,200,000 + Rs.7,500,000 + Rs.7,500,000 = Rs.300,000 so we only

need part of year seven, Rs.4,500,000 / Rs.7,500,000 = 0.6 so total Payback is 7.6

years and project is rejected with six year cut-off.

Net Present Value: -Rs.10,400,000 + Rs.2,600,000/1.12 + Rs.2,600,000/1.122 +

Rs.2,600,000/1.123 + Rs.2,600,000/1.124 - Rs.1,200,000/1.125 +

Rs.7,500,000/1.126 + Rs.7,500,000/1.127 + Rs.750,000/1.128

NPV = -Rs.10,400,000 + Rs.2,321,428.57 + Rs.2,072,704.08 + Rs.1,850,628.64 +

Rs.1,652,347.00 - Rs.680,912.23 + Rs.379,973.34 + Rs.339,261.91 +

Rs.302,912.42

NPV = -Rs.2,161,656.25 and reject project under NPV rules.

Present Value of Benefits = Rs.2,600,000/1.12 + Rs.2,600,000/1.122 +

Rs.2,600,000/1.123 + Rs.2,600,000/1.124 - + Rs.7,500,000/1.126 +

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 Rs.7,500,000/1.127 + Rs.750,000/1.128 = Rs.2,321,428.57 + Rs.2,072,704.08 +

Rs.1,850,628.64 + Rs.1,652,347.00 + Rs.379,973.34 + Rs.339,261.91 +

Rs.302,912.42 = Rs.8,919,255.73

Present Value of Costs: Rs.10,400,000 + Rs.1,200,000/1.125 = Rs.10,400,000 +

Rs.680,912.23 = Rs.11,080,912.23

Profitability Index = Rs.8,919,255.73 / Rs.11,080,912.23 = 0.8049 and reject.

18. Comparing All Methods -- Tom’s Risky Business is looking at a project with the

estimated cash flows as follows:

Initial Investment at start of project: Rs.3,600,000

Cash Flow at end of Year 1: Rs.500,000

Cash Flow at end of Years 2 through 6: Rs.625,000 each year

Cash Flow at end of Year 7 through 9: Rs.530,000 each year

Cash Flow at end of Year 10: Rs.385,000

Risky Business wants to know the Payback Period, NPV, and Profitability Index

of this project. The appropriate discount rate for the project is 14%. If the cut-off

period is six years for major projects, determine if the project is accepted or

rejected under the four different decision models.

Solution:

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 Payback Period = -Rs.3,600,000 + Rs.500,000 + Rs.625,000 + Rs.625,000 +

Rs.625,000 + Rs.625,000 + Rs.625,000 = Rs. 25,000 and we only need part of

year 6 so,

Rs.600,000 / Rs.625,000 = 0.96 and Payback Period is 5.96 years and project is

accepted.

NPV = -Rs.3,600,000 + Rs.500,000 / 1.14 + Rs.625,000/1.142 + Rs.625,000/1.143

+ Rs.625,000/1.144 + Rs.625,000/1.145 + Rs.625,000/1.146 + Rs.530,000/1.147

+ Rs.530,000 /1.148 + Rs.530,000/1.149 + Rs.385,000/1.1410

NPV = -Rs.3,600,000 + Rs.438,596.49 + Rs.480,917.21 + Rs.421,857.20 +

Rs.370,050.17

+ Rs.324,605.42 + Rs.284,741.59 + Rs.211,807.78 + Rs.185,796.30 +

Rs.162,979.21

+ Rs.103,851.37 = -Rs.614,797.27 and project is rejected using NPV rules.

Present Value of Benefits = Rs.500,000 / 1.14 + Rs.625,000/1.142 +

Rs.625,000/1.143 + Rs.625,000/1.144 + Rs.625,000/1.145 + Rs.625,000/1.146 +

Rs.530,000/1.147

+ Rs.530,000 /1.148 + Rs.530,000/1.149 + Rs.385,000/1.1410

Present Value of Benefits = Rs.438,596.49 + Rs.480,917.21 + Rs.421,857.20 +

Rs.370,050.17 + Rs.324,605.42 + Rs.284,741.59 + Rs.211,807.78 +

Rs.185,796.30 + Rs.162,979.21+ Rs.103,851.37 = Rs.2,985,202.73

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Present Value of Costs: Rs.3,600,000

Profitability Index = Rs.2,985,202.73 / Rs.3,600,000 = 0.8292 and reject.

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