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Capital Budgeting Illustrative Numericals

Conceptual Qs:
1.

Payback Period and NPV: If a project with conventional cash flows has a payback period
less than the projects life, can you definitely state the algebraic sign of the NPV? Why or
Why Not? If you know that the discounted payback period is less than the projects life,
what can you say about the NPV? Explain.

2. NPV: Suppose a project has conventional cash flows and a positive NPV. What do you know
about its payback? Its discounted payback? Its profitability index? Its IRR? Explain.

Q1A. [Calculating the NPV]: Suppose Duke Co. has an investment that requires a
Rs.12 million cash outlay today. It estimates that the expected incremental CIFs
associated with this investment are Rs.5 million at the end of years 1 and 2 and
Rs.8 million at the end of year 3. Using a 15% discount rate, what is the projects
NPV? Explain the decision criteria for accepting or rejecting the project.
Q1B. [Calculating the NPV with different discount rates]:

Consider an

investment that requires an initial outlay of Rs.5 million, with expected CIFs
associated of Rs.1 million, Rs.0 million and Rs.5 million, respectively, for the
following 3 years.
(a)
(b)
(c)

What is the NPV of this investment using a 5% discount rate?

What is the NPV of this investment using a 8% discount rate?
What you observe from this (i.e., learning points)?

Q2A. [Calculating the IRR]: Suppose Duke Co. has an investment that requires a
Rs.12 million cash outlay today. It estimates that the expected incremental CIFs
associated with this investment are Rs.5 million at the end of years 1 and 2 and
Rs.8 million at the end of year 3. What is the projects Internal Rate of Return or
IRR and compute it? Why IRR is called the Internal Rate of Return?, i.e., What is
the meaning of internal here? Explain the decision criteria for accepting or
rejecting the project on the basis of IRR. Assume the projects cost of capital is
15%.

Q2B. [Calculating the IRR]: Consider an investment that requires an initial outlay
of Rs.5 million, with expected CIFs associated of Rs.1 million, Rs.0 million and Rs.5
million, respectively, for the following 3 years. What is the IRR of this investment?
Whether to accept or reject this project on the basis of IRR, assuming the
projects cost of capital as 5%. If 8%?
Q3. [A Comprehensive Example]:The expected net cash flows of a project after
tax are as follows:
Year-end
1
2
3
4
5
6

Net cash flow

- 1,00,000
20,000
30,000
40,000
50,000
30,000

The cost of capital is 12%. Calculate the followings: (a) Discounted Payback Period,
(b) Net Present Value, (c) Internal Rate of Return and (d) Modified Internal Rate
of Return.
Q4. [A Comprehensive Example]:

automotive components. It supplies to the original equipment manufacturers as well

as the replacement market. Its projects typically have a short life as it introduces
new models periodically.
You have recently joined Aman Limited as a financial analyst reporting to Ravi
Sharma, the CFO of the company. He has provided you the following information
about three projects, A, B, and C, that are being considered by the Executive
Committee of the Company.

Project A is an extension of an existing line. Its cash flow will decrease over

time.
Project B involves a new product. Developing its market will take some time

and hence its cash flow will increase over time.

Project C is concerned with sponsoring a pavilion at a Trade Fair. It will

entail a cost initially which will be followed by a huge benefit for one year.
However, in the year following that a substantial cost will be incurred to
raze the pavilion.

The expected net cash flows of the three projects are as follows.
Year

Project A

Project B

Project C

(15,000)

(15,000)

(15,000)

11,000

3,500

42,.000

7,000

8,000

(4,000)

4,800

13,000

___

Ravi Sharma believes that all the three projects have risk characteristics similar
to the average risk of the firm and hence the firm's cost of capital, viz. 12
percent, will apply to them.
You are asked to evaluate the projects.
Read the above case carefully and answer the following questions. Write the
most appropriate answer in the answer sheet. No need to show the
calculations.
1.

Find the payback periods of Projects A and B in years respectively.

(a) 1.57 and 2.27 (b) 2 and 3
(c) 1.5 and 2.5
(d) 3 and 3

2. Find the discounted payback periods of Projects A and B in years

respectively.
(a) 1.57 and 2.27

(d)

Data

3. Calculate the net present values (NPVs) of projects A, B and C respectively

(approx.).
(a) 3,520, 3,432 and 18,745

(b) 4,123,

4,096

3,758 and 19,318

(d) 4,825, 4,543 and 20,312
4. Calculate the Internal Rates of Return (IRRs) for Projects A, B respectively.
(a) 26.32, 21.56
(b) 28.84, 23.43 (c) 29.12, 24.65
(d) 27.23, 22.15
5. Calculate the Modified Internal Rates of Returns (MIRRs) for Projects A, B,
and C respectively assuming that the intermediate cash flows can be
reinvested only at 12% rate of return.
(a) 20.8, 20.7 and 60.8 (b) 23.2, 22.5 and 57.6 (c) 25.4, 23.8 and 58.9
(a) Cannot say
Q5. [A Comprehensive Example]: Consider two projects with the expected after
tax net cash flows as follows:

Year-end
1
2
3
4
5

End-of Year Expected After-Tax

Net Cash Flows (Rs. in millions)
Project M
Project N
100
- 100
0
55
0
55
0
55
240
55

The cost of capital is 8% for both projects. Calculate the followings: (a) NPV (b)
IRR

(c) PI or BCR (d) NPI or NBCR (e) PBP and (f) Discounted PBP and (g)

Crossover Rate. Which project(s) is/are to be chosen if they are independent? If

mutually exclusive?
Q6. [Life Disparity Common Life Analysis (RCA and EAB Approach)]:

Company is deciding to choose between 2 mutually exclusive projects A and B.

Project A requires an initial investment of Rs.30,00,000 and is expected to
generate cash flow of Rs.15,00,000 per annum for the 3 years of its life. Project B,
on the other hand, requires Rs.34,00,000 as initial investment, has a life of 6 years
and would generate Rs.10,00,000 every year. Rank these projects based on NPV

and IRR methods. Finally, in your opinion, which project should be accepted? Why?
Assume a 10% discount rate.
Q7. [Risk Analysis Mean-Variance Approach]: M/S XYZ Ltd. has under its
consideration a project with an initial investment of Rs.10,00,000/-. Three
probable cash inflow scenarios with their probabilities of occurrence have been
estimated as below :
Annual Cash Inflow (Rs.)
Probability

200,000
0.1

300,000

400,000

0.7

0.2

The project life is 5 years and the desired rate of return is 20%. The estimated
terminal values for the project assets under the three probability alternatives,
respectively, are Rs.0, Rs.200,000/- and Rs.300,000/-. You are required to :
(i)

(ii)

Q8. [Risk Analysis Mean-Variance Approach]: XY Ltd. has under its

consideration a project with an initial investment of Rs.1,00,000/-. Three probable
cash inflow scenarios with their probabilities of occurrence have been estimated as
below :
Annual Cash Inflow (Rs.)
Probability

20,000

30,000

40,000

0.1

0.7

0.2

The projects life is 5 years and the desired rate of return is 20%. The estimated
terminal values for the project assets under the three probability alternatives,
respectively, are Rs.0, Rs.20,000/- and Rs.30,000/-. You are required to :
(a)
(b)

Find the Probable NPV (aka Expected NPV);

Find the Worst-Case NPV and the Best-Case NPV

Q9. The Dixey Valley Company is considering two mutually exclusive projects with
different lives. The costs (cash flows) of the projects are given below:

Cash Flows (Rs. 000)

Projec
t

C0

C1

C2

150

30

30

75

40

40

C3
30

C4
30

The discount rate is 10 per cent. Which project should be selected and why?
Q10. {Project Cash Flow Estimation]: Mr Palekar, Director (Finance) of Arrow
Synthetics Limited, and Mr Roy, Manager, Management Services Division of the
company were discussing about ways to improve the management information
system in the company. They concluded that they needed a better computer
system for the growing volume of information generated in the business. Mr Roy
enquired and found that Theta X system supplied by FT Ltd. was quite suitable for
the needs of their organization.
He estimated the costs and benefits associated with the system.

Cost of the Computer along with accessories:

Operating and maintenance costs:
Savings in clerical cost:
Savings in space cost:

Rs 1.5 million
Rs 0.25 million per annum
Rs 0.6 million per annum
Rs 0.1 million per annum

The computer system would have an economic life of 5 years and it would be
depreciated at the rate of 33 percent per year as per the written down value
method. After five years, it would be disposed of for a value equal to its book
value. The tax rate is 50 percent. Mr. Roy requires your help to prepare projected
cash flows of the capital budgeting proposal. (In case there is a loss before tax, it
would provide a tax shelter)
You are also required to calculate the Net Present Value of the proposal assuming
a discount rate of 14 percent.