27 Final Selections in RBI Grade B 2017

Final Results Awaited for RBI Grade B 2018

Summary Sheet – Helpful for Retention

For

Capital Budgeting

Important Points

1. This Summary Sheet shall only be used for Quick Revision after you have read the
Complete Notes

2. For Building Concepts along with examples/concept checks you should rely only on
Complete Notes

3. It would be useful to go through this Summary sheet just before the exam or before any
Mock Test

4. Questions in the exam are concept based and reading only summary sheets shall not
be sufficient to answer all the questions

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 1 Summary Points

➢ Capital Budgeting (Investment Appraisal): Planning process used to determine whether an

organization’s long term investments such as new machinery, replacement of machinery,
new plants, new products and R&D projects are worth the funding of cash through the firm’s
capitalization structure( debt, equity or retained earnings)
➢ Importance of Capital Budgeting:
1. Involves the investment of substantial amount of funds
2. Such decision has its effect over a long period of time affecting the rate and direction
of growth of the firm
3. Investment decisions are irreversible
4. Difficult to estimate in quantitative terms all the benefits or the costs resulting from
an investment decision, hence a complex task
➢ Types of Investment Decisions:
1. On the basis of Firm’s existence:
a) Cost Reduction Decisions:
✓ Replacement and Modernization decisions: To improve operating
efficiency and to reduce cost by replacing old machinery or installing
new technology
b) Revenue expansion decisions:
✓ Expansion decisions: Due to growth in demand of their product
line
✓ Diversification decisions: Relating to diversification into new
product lines, new markets etc. for reducing the risk of failure
2. On the basis of decision situation:
a) Mutually exclusive decisions: Acceptance of one proposal excludes the
acceptance of the other alternative proposals
b) Accept-reject decisions: Independent proposals that firm may accept or
reject on the basis of a minimum return on the required investment
c) Contingent decisions: Dependent proposals in which the investment in one
proposal requires investment in one or more other proposals
➢ Making a decision whether investment is viable or not requires,
1. Future Cash Flows
2. Required Rate of Return (Cost of Capital)
➢ Opportunity Cost of Capital: The incremental return on investment that a business
foregoes when it elects to use funds for an internal project, rather than investing cash in
a marketable security

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 ➢ Capital Budgeting Techniques:

➢ NPV (Net Present Value):

Where
C0 is the initial investment
C1, C2, C3 are the cash inflows in the year 1, 2, 3 and so on
n is the number of years
r is discounted rate or opportunity cost of capital

If NPV > 0 it means that project must be accepted

If NPV < 0 it means that project must be rejected
➢ Example: A 5-year project costs 100,000 now and it is expected to generate year-end cash
inflow of 20,000; 30,000; 40000; 50,000 and 30,000 in years 1 through 5. The opportunity
cost of capital may be assumed to be 12 %. Find whether the project is viable or not
Solution: NPV = -100,000 + 20,000 / (1.12) + 30,000 / (1.12) ^2 + 40,000 / (1.12) ^3 +
50,000 / (1.12) ^4 + 30,000 / (1.12) ^5
= -100,000 + 17,860 + 23,910 + 28,480 + 31,800 + 17,010 = 19,060
Since NPV is positive it means that the project is viable

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 ➢ IRR (internal rate of return): Discount rate that makes the present value of subsequent
net cash flows equal to the initial investment (NPV=0)

Where
C0 is the initial investment
C1, C2, C3 are the cash inflows in the year 1, 2, 3 and so on
n is the number of years
r is internal rate of return when NPV = 0

If r > k it means that project must be accepted (k is opportunity cost of Capital)

If r < k it means that project must be rejected
➢ Example: A project has 16000 costs and is expected to generate inflows of 8000. 7000 and
6000 in years 1 to 3. Find whether project is feasible or nor if opportunity cost of capital
is 16%
Solution: NPV = -16000 + 8000/ (1+r) 1 + 7000 / (1+r) 2 + 6000 / (1+ r) 3
Since, NPV = 0
So, 16000 = 8000/ (1+r) 1 + 7000 / (1+r) 2 + 6000 / (1+ r) 3
You need to do hit and trial.
Put r = 16% or .16 then you would get RHS = 15943
Since at 16% we get RHS as 15493 then it means than r should be less than 16% in RHS for it
to be equal to 16000 on LHS.
So, r is definitely less than 16% which is opportunity cost of capital which means r < k and
hence project is not feasible

➢ Profitability Index:

➢ Example: The initial cash outlay of the project is 100000. It can generate a cash inflow of

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 40000, 30000, 50000 and 20,000 in year 1 to 4. If required rate of return is 10% then find
the PI.
Solution: The present value of the cash inflows will be
40000 / (1+.1)1 + 30000 / (1+.1) 2 + 50000/ (1+.1) 3 + 20000/ (1+.1) 4
= 112350
PI = 112350 / 100000 = 1.1235
IF PI > 1 then project should be accepted

➢ Payback Period: If project generates constant cash flows,

Lesser the payback period the better it is

➢ Payback Period for Unequal Cash Flows:

Example: Suppose the project requires initial outlay of 20,000 and yield cash inflow of 8000,
7000, 4000 and 3000 in years 1 to 4. What is the projects payback period?
Solution: We can find this by adding the cash inflows till they become 20,000
So in first 3 years we get inflow of 8000 + 7000 + 4000 = 19000
Remaining inflow = 20,000 – 19,000 = 1000
In 4th year or next 12 months the inflow is 3000. So for 1000 inflow it will require (1000/3000)
* 12 i.e. 4 months
➢ Reciprocal of Payback Period (Rate of Return) = 1/Payback = Annual Cash Inflow / Initial
Investment = C/ C0, holds true only if
The life of the project is large and generates equal cash flows
➢ Discounted Payback: In this, first the cash flows are discounted and then the payback is
calculated

Initial C1 C2 C3 Payback
Investment Period
A 4000 3000 1000 1000 2 years
Discounted 2727 826 751 2.6
Cash Flow years
for A

➢ NPV and IRR will give same accept or reject decision on projects, if investments are
conventional
➢ Conventional investment means that all the cash flows are + followed by initial negative cash
flow or cash outflow

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 ➢ Unconventional cash flows: Where after first cash outflow there are inflows as well as
outflows. In this, IRR can give multiple values or none and hence confusing results of either
accept or reject of projects. So, it’s better to follow NPV method in such cases
➢ NPV and IRR decisions can differ in mutually exclusive projects depending on the different
cash flow pattern of the projects, initial investment and lifetime of projects. In such cases
too, one should prefer NPV over IRR
➢ Fisher Intersection Point: The point or the discount rate where the NPV of two or more
projects is the same
➢ Incremental IRR: When IRR is not consistent with NPV due to unconventional cash flows or
projects being mutually exclusive then this method is used. Example: Consider,

Project Initial C1 NPV at 10% IRR

Outflow
A -1000 1500 364 50%
B -100000 120000 9091 20%
In incremental IRR we subtract the cash flow of one project from another. So if subtract
the cash flow of A from B we get the below table. From this we get IRR = 19.7%. Here, IRR
of 19.7 % is greater than the required rate of return and hence B should be accepted. On
the other hand, if we subtract A from B then we will get negative IRR and hence A is not
superior to B

Project Initial C1 NPV at 10% IRR

Outflow
B–A -99000 118500 8727 19.7
➢ Modified IRR (MIRR): MIRR assumes that project cash flows are reinvested at the cost of
capital, whereas the regular IRR assumes that project cash flows are reinvested at the
project’s own IRR. MIRR is superior to IRR,
✓ MIRR solves the problem of multiple rates faced in case of IRR
✓ MIRR is suitable for conventional as well as unconventional cash flows
✓ MIRR is applicable in case of mutually exclusive projects of same size where NPV and
MIRR lead to the same decision irrespective of variations in life
➢ Example: An investment of ` 1,36,000 yields the following cash inflows (profits before
depreciation but after tax). Determine MIRR considering 8% as cost of capital

Year
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000

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 Solution: First we will calculate the value of each cash flow in the 5th year
Value of 1st Cash flow 30,000 in 5th year would be = 30000 * (1.08) 4 = 40815
Value of 40,000 in 5th year would be = 40000 * (1.08) 3 = 50388
Value of 60,000 in 5th year would be = 40000 * (1.08) 2 = 69984
Value of 30,000 in 5th year would be = 30000 * (1.08) 32000
Value of 20,000 in 5th year would be = 20000* 1 = 20000
So the sum of all the cash flows in 5th year would be = 213587
So Total return = 213587/136000 = 1.5705
5
MIRR = √1.57 - 1 = 9%

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