BBA SEM VI: Advance Financeial Management

Problem 9
Satya corporation is toying with the idea of replacing its existing machine. The following
are the relevant data
1. Existing Machine
Purchased 2 years ago
Remaining life 6 years
Salvage value Rs 500
Current book value Rs 2,600 and its realisable market value Rs 3,000
Annual depreciation Rs 350
2. New machine
Capital cost of Rs 8,000
Estimated useful life 6 years
Estimated salvage value Rs 800
The replaced machine would permit an output expansion. As a result, sales is expected to
rise by Rs 1,000 per year, operating expenses would decline by Rs 1,500 per year. It
would require an additional inventory of Rs 2,000
Assuming corporate tax rate of 40% and cost of capital of 15%, advice the company
Solution
1. Calculation of incremental cash flows from purchase of new machinery
Rs.
1. Incremental cash outflow (Year 1)
Cost of new machinery
Add : Addition to working capital
a. Inventory
Total
Less : Net sale price (3,000 tax on profit @ 40% of Rs 400)
Net cash outflow of year 1

2,000
10000
2,840
7,660

2. Subsequent cash inflows

Increase in sales
Add : savings in cost
Less : increase in depreciation (Rs 1,200 350)

1,000
1,500
850

Increase in profit before tax

1,650

8,000

Less : tax @ 40%

Net profit

660
990

Add : depreciation
Net cash flow

850
1840

2. Calculation of net present value @ 15% discounting factor.

Prepared By: Mahendra Patel, Parul Institute of Business Administration

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BBA SEM VI: Advance Financeial Management

Year

Cash inflows / (outflow)

0
1
2
3
4
5
6
6
6

(7660)
1,840
1,840
1,840
1,840
1,840
1,840
1,500
480
NPV

Discounting factor
@ 15%
1
0.870
0.756
0.658
0.572
0.497
0.432
0.432
0.432

Present value
Rs.
(7660)
1,601
1,391
1,211
1,052
915
795
648
207
220

In year 6 additional cash inflows will be

Recovery of working capital
Sale proceeds of machinery
Less: tax on sale @40%

Rs 1,500
Rs 800
Rs 320
Rs 480

Since the NPV of the project is positive the company should go for replacement of old
machinery.
Problem 10
A large profit making company is considering the installation of a machine to process the
waste produced by one of its existing manufacturing process to be converted into a
marketable product. At present, the waste is removed by a contractor for disposal on
payment by the company of Rs 50 lacs per annum for next 4 years. The contract can be
terminated on installation of the aforesaid machine on payment of a compensation of Rs
30 lakhs before the processing operation starts. This compensation is not allowed as
deduction for tax purposes.
The machine required for carrying out the processing will cost Rs 200 lakhs to be
financed by a loan repayable in 4 equal instalments commencing from the end of year 1.
The interest rate is 16% p.a At the end of 4 th year, the machine can be sold for Rs 20
lakhs and the cost for dismantling and removal will be Rs 15 lakhs.
Sales and direct cost of the product emerging from waste processing for 4 years are
estimated as under:
Sales
Material consumption
Wages
Other expenses
Factory overheads
Depreciation ( As per income tax)

1
322
30
75
40
55
50

2
322
40
75
45
60
38

Prepared By: Mahendra Patel, Parul Institute of Business Administration

3
418
85
85
54
110
28

4
418
85
100
70
145
21

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BBA SEM VI: Advance Financeial Management

Initial stock required before commencement of the processing operations is Rs 20 lacs at
the start of year 1. The stock levels of materials to be maintained at the end of year 1,2
and 3 will be Rs 55 lacs and the stock at the end of year 4 will be nil. The storage of
material will utilise the space which otherwise would have been rented out for Rs 10 lakhs
per annum. Labour cost includes wages of 40 workers, whose transfer to this process will
reduce idle time payments of Rs 15 lacs in year 1 and Rs 10 lacs in year 2. Factory
overheads include apportionment of general factory overheads except to the extent of
insurance charges of Rs 30 lakhs per annum attributable to this venture.The companys
tax rate is 50% for revenue incomes.
Advice the management on the desirability of installing the machinery for processing the
waste. All calculation should form part of the answer. Required rate of return is 15%.
(CA final, May 1999)
Solution 1. Statement of incremental cash flows from operations Sales

1
322

2
322

3
418

Rs lakhs
4
418

Less :
Material consumption
Wages
Other expenses
Factory overheads (Insurance)
Loss of rent
Interest
Depreciation
Total cost

30
60
40
30
10
32
50
252

40
65
45
30
10
24
38
252

85
85
54
30
10
16
28
308

85
100
70
30
10
8
21
324

Incremental profits before tax

Less: Tax @ 50%
Net profit

70
35
35

70
35
35

110
55
55

94
47
47

Add : depreciation
Net cash flow

50
85

38
73

28
83

21
68

Overheads other than insurance is not considered as they remain unchanged even
though the project is not executed
2. Statement of incremental cash flows (net)

Net cash flow from operations

(Increase) / realisation of
inventories
Contract payment saved

1
85
(35)

2
73
-

3
83
-

Rs lakhs
4
68
55

25

25

25

25

Prepared By: Mahendra Patel, Parul Institute of Business Administration

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BBA SEM VI: Advance Financeial Management

(Net of tax saving @ 50%)
Loan repayment
Profit on sale of machine
Total incremental cash flows

(50)
-

(50)
-

(50)
-

(50)
5

25

48

58

103

3. Net present value of all cash flows @ 15%Year

Cash inflows / (outflow)

0
1
2
3
4

(50)
25
48
58
103

Discounting factor
@ 15%
1
0.870
0.756
0.658
0.572

NPV
Cash outflow of year 1 is

Rs lakhs
Present value
Rs.
(50)
21.75
36.29
38.16
58.92
105.12

Compensation for contract + increase in inventory level

- Rs 30 lakhs + Rs 20 lakhs = Rs 50 lakhs.

Comment - It is advisable to implement the proposal as the net present value is positive.
Problem 11
A company is setting up a plant at a cost of Rs 300 lakhs of investment in fixed assets. It
has to decide whether to locate the plant in a forward area (FA) or backward are (BA).
Locating in backward area means a cash subsidy of Rs 15 lakhs from the central
government. Besides the taxable profit to the extent of 20% is exempt for 10 years. The
project envisages a borrowing of RS 200 lakhs in either case. The cost of borrowing will
be 12% in forward area and 10% in backward area. However the revenue costs are
bound to be higher in the BA. The borrowing principle has to be repaid in 4 equal annual
instalments beginning from the end of year 4. With the help of following information and
by using Discounted Cash Flow technique you are required to suggest proper location for
the project. Assume straight-line depreciation with no residual value.
Earning before interest and tax (Rs in lakhs)
Year
FA
1
-6
2
34
3
54
4
74
5
108
6
142
7
156
8
230
9
330
10
430

Prepared By: Mahendra Patel, Parul Institute of Business Administration

BA
-50
-20
10
20
45
100
155
190
230
330

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BBA SEM VI: Advance Financeial Management

Assume
1. Discounting rate to be 15%
2. Rate of Income tax to be 50%
3. Central subsidy is not to affect depreciation or tax.
4. No other relief and rebates will be available to the company other than those
mentioned above.
[CA final May 1991]
Solution 1. Calculation of cash flows from the operation for Forward area
Year
1
2
3
4
5
6
7
8
9
10

EBIT
-6
34
54
74
108
142
156
230
330
430

Interest
24
24
24
24
18
12
6
-

Depreciation
30
30
30
30
30
30
30
30
30
30

PBT
-60
-20
20
60
100
120
200
300
400

Tax
50
60
100
150
200

PAT
-60
-20
20
60
50
60
100
150
200

Inflow
-30
10
30
50
90
80
90
130
180
230

PAT
-100
-70
-40
-30
60
120
120
120
180

Inflow
-70
-40
-10
30
90
150
150
150
210

2. Calculation of cash flows from the operation for Backward area

Year
1
2
3
4
5
6
7
8
9
10

EBIT
-50
-20
10
20
45
100
155
190
230
330

Interest
20
20
20
20
15
10
5
-

Depreciation
30
30
30
30
30
30
30
30
30
30

PBT
-100
-70
-40
-30
60
120
160
200
300

Tax
40
80
120

3. Calculation of net present value of project in forward area @ 15% discounting factor
Rs lakhs
Year
Cash inflows /
Cash
Net cash
Discounting
Present
(outflow)
outflows
flows
factor
value
@ 15%
Rs.
0
(100)
(100)
1
(100)
1
-30
-30
0.870
(26.10)
2
10
10
0.756
7.56
3
30
30
0.658
19.74
4
50
50
0
0.572
0
5
90
50
40
0.497
19.88
6
80
50
30
0.432
12.96
Prepared By: Mahendra Patel, Parul Institute of Business Administration

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BBA SEM VI: Advance Financeial Management

7
8
9
10

90
130
180
230
NPV

50
-

40
-

0.376
0.327
0.284
0.247

15.04
42.51
51.12
56.81
99.52

Cash outflow of year 1 = Total cash outflow loan amount = Rs 300 lakhs Rs 200 lakhs
= Rs 100 lakhs.
4. Calculation of net present value of project in backward area @ 15% discounting factor
Rs lakhs
Year
Cash inflows /
Cash
Net cash
Discounting
Present
(outflow)
outflows
flows
factor
value
@ 15%
Rs.
0
(85)
(85)
1
(85)
1
-70
-70
0.870
-60.9
2
-40
-40
0.756
-30.24
3
-10
-10
0.658
-6.58
4
50
-50
0.572
-28.60
5
30
50
-20
0.497
-9.94
6
90
50
40
0.432
17.28
7
150
50
100
0.376
37.6
8
150
150
0.327
49.05
9
150
150
0.284
42.60
10
210
210
0.247
51.87
NPV
22.86
Cash outflow of year 1 = Total cash outflow loan amount subsidy = Rs 300 lakhs Rs
200 lakhs Rs 15 lakhs = Rs 85 lakhs.
Working notes
1. Taxability of backward area starts only from year 8 th as in year 6 and 7 the losses
of year 1 to 5 are adjusted against the profits.
2. For year 8,9 and 10 tax is levied only on 80% of the profits as 20% profit is
exempt.
3. Ideally the discounting factor shall be 12% and 10%, which is cost of capital at FA
and BA respectively, in that case interest should be ignored. But as the problem
states the cost of capital to be 15%, calculations done considering interest as cash
out flow
Comment As NPV of FA is positive and NPV of BA is negative project should be
located in FA.

Problem 12

Prepared By: Mahendra Patel, Parul Institute of Business Administration

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BBA SEM VI: Advance Financeial Management

X ltd. is considering two mutually exclusive projects X and Y. Following details are made
available to you :
Rs. In lacs
Project X
Project Y
Project cost
Cash inflows
Year
1
2
3
4
5

1,000

1,000

200
150
320
450
500

200
600
250
100
150

Assume no residual value at the end of fifth year. The firms cost of capital is 10%.
Required, in respect of each of the two projects:
i. NPV using 10% discounting rate
ii. IRR and
iii. Profitability index
iv. Payback period
Solution
1. Net present value of cash flows of project X @ 10%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(1,000)
200
150
320
450
500

Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621

NPV

Rs lakhs
Present value
Rs.
(1,000)
181.80
123.90
240.32
307.35
310.5
163.87

2. Net present value of cash flows of project Y @ 10%Year

Cash inflows / (outflow)

0
1
2
3
4

(1,000)
200
600
250
100

Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683

Prepared By: Mahendra Patel, Parul Institute of Business Administration

Rs lakhs
Present value
Rs.
(1,000)
181.80
495.60
187.75
68.30

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BBA SEM VI: Advance Financeial Management

5

150

0.621

93.15

NPV

26.60

Problem 2
A company proposes to undertake two mutually exclusive projects AXE and BXE :
Initial capital outlay
Economic life (years)
After tax annual cash inflows
Year
1
2
3
4
5
6
7

AXE
Rs 22,50,000
4
6,00,000
12,50,000
10,00,000
7,50,000
-

BXE
Rs. 30,00,000
7
5,00,000
7,50,000
7,50,000
12,00,000
12,50,000
10,00,000
8,00,000

The companys cost of capital is 16%. Please calculate the net present value and IRR for
both the projects
Solution 1. Calculation of NPV of both the projects
Calculation of present value of the project AXE @ 16% discounting rate
Year

Cash inflows / (outflow)

0
1
2
3
4

(22,50,000)
6,00,000
12,50,000
10,00,000
7,50,000
NPV

Discounting factor
@ 16%
1
0.862
0.743
0.641
0.552

Present value
Rs.
(22,50,000)
5,17,200
9,28,750
6,41,000
4,14,000
2,50,950

Calculation of present value of the project BXE @ 16% discounting rate

Year

Cash inflows / (outflow)

0
1
2
3

(30,00,000)
5,00,000
7,50,000
7,50,000

Discounting factor
@ 16%
1
0.862
0.743
0.641

Prepared By: Mahendra Patel, Parul Institute of Business Administration

Present value
Rs.
(30,00,000)
4,31,000
5,57,250
4,80,750

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BBA SEM VI: Advance Financeial Management

4
5
6
7

12,00,000
12,50,000
10,00,000
8,00,000
NPV

0.552
0.476
0.410
0.354

6,90,000
5,93,750
4,10,000
2,83,200
4,46,350

As NPV of project BXE is substantially higher than project AXE project BXE is more
profitable.
Problem 3
Precision instruments is considering two mutually exclusive projects X and Y. Following
details are made available to you :
Rs. In lacs
Project X
Project Y
Project cost
Cash inflows
Year
1
2
3
4
5

700

700

100
200
300
450
600

500
400
200
100
100

Assume no residual value at the end of fifth year. The firms cost of capital is 10%.
Required, in respect of each of the two projects :
i. NPV using 10% discounting rate
ii. IRR and
iii. Profitability index
(ICWA inter, June 1995)
Solution 1. Calculation of Net present value
Calculation of present value of the project X @ 10% discounting rate
Year

Cash inflows / (outflow)

0
1
2
3
4
5

(700)
100
200
300
450
600
Present value of inflows
NPV

Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621

Prepared By: Mahendra Patel, Parul Institute of Business Administration

Rs lakhs
Present value
Rs.
(700)
90.90
165.20
225.30
307.35
372.60
1,161.35
461.35

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BBA SEM VI: Advance Financeial Management

Calculation of present value of the project Y @ 10% discounting rate
Year

Cash inflows / (outflow)

0
1
2
3
4
5

(700)
500
400
200
100
100
Present value of inflows
NPV

Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621

Present value
Rs.
(700)
454.50
330.40
150.20
68.30
62.10
1,065.50
365.50

2. Profitability index
PI =

Total present value of all cash inflows

Total present value of cash outflows

PI of project X

=
=

PI of project Y

=
=

1,161.35
700
1.659
1,065.50
700
1.522

3. Internal rate of return (IRR)

Calculation of present value of the project X @ 27% discounting rate
Year

Cash inflows / (outflow)

0
1
2
3
4
5

(700)
100
200
300
450
600
NPV

Discounting factor
@ 27%
1
0.787
0.620
0.488
0.384
0.303

Rs lakhs
Present value
Rs.
(700)
78.70
124
146.40
172.80
181.80
3.70

Calculation of present value of the project X @ 28% discounting rate

Year

Cash inflows / (outflow)

0
1
2
3

(700)
100
200
300

Discounting factor
@ 28%
1
0.781
0.610
0.477

Prepared By: Mahendra Patel, Parul Institute of Business Administration

Rs lakhs
Present value
Rs.
(700)
78.10
122.00
143.10
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BBA SEM VI: Advance Financeial Management

4
5

450
600
NPV

By interpolation formula IRR = 27 +

0.373
0.291

167.65
174.60
-14.35

3.70
*1
3.70+14.35

= 27.21%
IRRR of project X = 27.21%
Calculation of present value of the project Y @ 37% discounting rate
Year

Cash inflows / (outflow)

0
1
2
3
4
5

(700)
500
400
200
100
100
NPV

Discounting factor
@ 37%
1
0.73
0.533
0.389
0.284
0.207

Rs lakhs
Present value
Rs.
(700)
365
213.20
77.80
28.40
20.70
5.10

Calculation of present value of the project Y @ 38% discounting rate

Year

Cash inflows / (outflow)

0
1
2
3
4
5

(700)
500
400
200
100
100
NPV

By interpolation formula IRR = 37 +

Discounting factor
@ 38%
1
0.725
0.525
0.381
0.276
0.200

5.10
5.10+3

Rs lakhs
Present value
Rs.
(700)
362.50
210
76.20
27.60
20.70
-3.00

*1

= 37.63%
IRR of project Y = 37.63%
Summary of both the projects
Profitability index
Net present value
Internal rate of return

Project X
1.659
461.35
27.21%

Project y
1.522
365.50
37.63%

Problem 12
X ltd. is considering two mutually exclusive projects X and Y. Following details are made
available to you :
Prepared By: Mahendra Patel, Parul Institute of Business Administration

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BBA SEM VI: Advance Financeial Management

Project cost
Cash inflows
Year
1
2
3
4
5

Project X

Rs. In lacs
Project Y

1,000

1,000

200
150
320
450
500

200
600
250
100
150

Assume no residual value at the end of fifth year. The firms cost of capital is 10%.
Required, in respect of each of the two projects:
i. NPV using 10% discounting rate
ii. IRR and
iii. Profitability index
iv. Payback period
Solution
1. Net present value of cash flows of project X @ 10%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(1,000)
200
150
320
450
500

Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621

NPV

Rs lakhs
Present value
Rs.
(1,000)
181.80
123.90
240.32
307.35
310.5
163.87

2. Net present value of cash flows of project Y @ 10%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(1,000)
200
600
250
100
150

Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621

NPV

Prepared By: Mahendra Patel, Parul Institute of Business Administration

Rs lakhs
Present value
Rs.
(1,000)
181.80
495.60
187.75
68.30
93.15
26.60

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BBA SEM VI: Advance Financeial Management

4. i. Profitability index of project X

ii. Profitability index of project Y

1163.8
1000

1.164

1026.60
1000

1.027

5. Calculation of internal rate of return for project X a. Net present value of cash flows of project X @ 15%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(1,000)
200
150
320
450
500

Discounting factor
@ 15%
1
0.870
0.756
0.658
0.572
0.497

NPV

Rs lakhs
Present value
Rs.
(1,000)
174.00
113.40
210.56
257.40
248.5
3.86

AS net present value Rs 3.86 lacs (almost nil), it can be said that the IRR of the project is
slightly higher than 15%
b. Net present value of cash flows of project Y @ 12%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(1,000)
200
600
250
100
150

Discounting factor
@ 12%
1
0.893
0.797
0.712
0.636
0.567

NPV

Rs lakhs
Present value
Rs.
(1,000)
178.6
478.20
178.00
63.60
85.05
-16.55

As net present value Rs 16.55 lacs, it can be said that the IRR of the project is higher
than 10% but lesser than 12%. The IRR can be calculated by interpolation method.
IRR

= 10 + (26.60 / 16.55+26.60) *2
= 10+1.24
= 11.25 %

Prepared By: Mahendra Patel, Parul Institute of Business Administration

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BBA SEM VI: Advance Financeial Management

IRR of project Y is 11.25%
Problem 13
A company is considering as to which of two mutually exclusive projects it should
undertake. The finance directors thinks that the project with the higher NPV should be
chosen whereas the managing director thinks that the one with higher IRR should be
undertaken especially as both the projects have the same initial outlay and length of life.
The company anticipates a cost of capital of 10% and the net after tax cash flows of the
project are as follows
Year
Project X
Project Y
0
(200)
(200)
1
35
218
2
80
10
3
90
10
4
75
4
5
20
3
Required
1. Calculate the NPV and IRR of each project
2. state with reasons which project you would recommened
The discounting factors are as follows
Year
1
2
3
4
5

10%
0.91
0.83
0.75
0.68
0.62

20%
0.83
0.69
0.58
0.48
0.41

[ CA final May 1995]

Solution
1. Analysis of project x
a. Net present value of cash flows of project X @ 10%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(200)
35
80
90
75
20

Discounting factor
@ 10%
1
0.91
0.83
0.75
0.68
0.62

Prepared By: Mahendra Patel, Parul Institute of Business Administration

Rs lakhs
Present value
Rs.
(200)
31.85
66.40
67.50
51.00
12.40

Page 14

BBA SEM VI: Advance Financeial Management

NPV

29.15

b. Net present value of cash flows of project X @ 20%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(200)
35
80
90
75
20

Discounting factor
@ 20%
1
0.83
0.69
0.58
0.48
0.41

NPV

Rs lakhs
Present value
Rs.
(200)
29.05
55.20
52.20
36.00
8.20
-19.35

IRR for project X can be calculated by interpolation method as follows

IRR

= 10 + (29.15 / 29.15+19.35)*10
= 16%

a. Net present value of cash flows of project X @ 10%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(200)
35
80
90
75
20
NPV

Discounting factor
@ 10%
1
0.91
0.83
0.75
0.68
0.62

Rs lakhs
Present value
Rs.
(200)
31.85
66.40
67.50
51.00
12.40
29.15

2. Analysis of project Y a. Net present value of cash flows of project Y @ 10%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(200)
218
10
10
4
3

Discounting factor
@ 10%
1
0.91
0.83
0.75
0.68
0.62

NPV
Prepared By: Mahendra Patel, Parul Institute of Business Administration

Rs lakhs
Present value
Rs.
(200)
198.38
8.30
7.50
2.72
1.86
18.76
Page 15

BBA SEM VI: Advance Financeial Management

b. Net present value of cash flows of project Y @ 20%Year

Cash inflows / (outflow)

0
1
2
3
4
5

(200)
218
10
10
4
3
NPV

Discounting factor
@ 10%
1
0.83
0.69
0.58
0.48
0.41

Rs lakhs
Present value
Rs.
(200)
180.94
6.90
5.80
1.92
1.23
-3.21

IRR for project Y can be calculated by interpolation method as follows

IRR

= 10 + (18.76 / 18.76+3.21)*10
= 18.54%

Prepared By: Mahendra Patel, Parul Institute of Business Administration

Page 16