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it
ihcsi
ling
investment (^) decisions
are
icernÉwith
the selection^ of
assets in which
funds
will be
invested
by
the
firm
investment in long
term
assets or (^) capitalexpenditure
investment
of
funds
has to be
made through carefulassessment^ of
th
various projects
L
CapitalBudgeting capitalBudgeting
refers to the (^) process ofmaking
decisions
regarding
capital
investments in
fixed
assets
It
involves identifying (^) analyzing andselecting the long
term
investment projects
whosereturns cashflows are expectedto^
extend beyond one year
Features
long
Term investment^ thesedecisions^ generally
involve investments
for
a
long
time i.e several years
The return^ comes^ over an extendedperiod
which requires the
decision maker to make a calculated^
committement into
the future
Thus (^) it involves (^) the exchange of
current
funds forfuture
benefits
Large
Anticipated Cost^ capital budgeting involves^ huge
amount
ofmoney
which (^) is to be invested^ into long
term (^) or
fined
assets
HighDegree of
Risk since (^) it involves^ long
periods (^) large
amounts there
a (^) lot
of
uncertainty
Situationswhere CapitalBudgeting
decisions are needed
Expansion
company
wishestoincreaseitscapacity (^) expandoperations
Modernisation upgradeoldmachinerytonewer
efficienttechnology
Acquisition
buy
another companyto
increasemarketshare
Replacement
replacingold
assetswith newones
Importance of
Capital (^) Budgeting
large
investments big
sums
of
money long
timeperiod
More Risky
futureis
uncertain
Irreversability
once
invested money
cannot beeasily
takenback
Effect onprofitability
eitherincreaseprofits orcausehuge
losses
Difficulties
of
investment decisions
forecastingrequiresanalysis
NationalImportance growthofeconomy
employment
Types of
CapitalBudgeting
Decisions
AcceptReject
Decisions option
Mutually
Exclusive Decisions^
Multipleoptions
CapitalRationing^
Decisions multipleoptions (^) proper
allocation
of
funds
Process
of
Capital (^) Budgeting
1 Identification
of
investmentproposals involves identifyingpotential
investment
opportunities generally done
by
top
level (^) capitalexpenditure planning
committee
Screening theproposals involves^ a (^) feasibilitystudy to check^ if
theoptions fit
the
company's goalsandstrategies
(^3) Evaluation
of
proposals (^) analysingeachprojectusingthe
evaluation techniques and
estimating the
cash flows to
check profitability
Selectingthe
best proposal
chosetheproposal which gives
thebestreturnwiththe
leastrisk
implementation
find
approvalandpreparation
of
capital expenditure^ budget before
Techniques
of
CapitalBudgeting
traditional (^) modern
PBP ARR NPV IRR PI
DiscountingTechnique
Discountingtechniques are usedtoconvertfuture
values intopresentvaluecashflows
Discounting factor titi
PV
F
n
Single
amount
unit
Evenseries^ deferred annuity end^
Pr Fv Ʃ (^) cation
annuity
due (^) beginning
Pr
Fulcifying
unevenseries or
It Eat^
Eight
Yin
Ifyou
deposit
5000 today
at 6
of
interest (^) in how manyyears
willthisamount
double (^) Workout using
Rule
of
72 andRule
of
69
A 5,000^ r^6
using
Rule
of
7 12 years
Using
Rule
of
years
calculate thecompoundvalue
of
10, at the end
of
years
at 12 rate
of
interest
wheninterest^ is calculated^ on
a a yearly
basis
b a quarterly
basis
Ev (^) suite
3 i^12
a
10,000 1 0.
3
i FV 14049.
b FV 10,^
1
0412
13
i FV^ 14257.
A
company
offers (^12)
of
interest (^) on deposits Whatis theEffectiverate
of
interes
if
compounding is^
done (^) i
half
yearly
ii quarterly
iii monthly
i (^12)
EIR
I
in
M
1
i
half
yearly
m
EIR
2
1 0.1236 (^) 12.
ii
quarterly
m 4
EIR 1
iv
monthly
m 12
EIR
12
1
Calculate the future
value (^) at theend
of
yearsof
thefollowing
series
of
paymen
at 10 rate of
interest
Yr
1 2 3 4 5
Amt 1000 2000 3000 2000 1500
n (^) Syears i^101
yr PV^ CF hi FV^ PV^ CF
1.4641 1464 1
2 2000 1.^
Mr X is to receive^
5000 after 5 yearsfrom^
now Histimepreference
for
money
is 10 p.ae
Calculate itspresentvalue^
by
using discounting^
technique
FV 5000 n 5 i 101
PV
FVY n
i pv
Calculate present value
of
thefollowing cashflows assuming a
discount rate of
Yr 1 2 3 4 s
cashflows 5,000 (^) 10,000 10, 3,000 2,
n 5 i 101
Yr
Cashflows (^) FV DF YCHI^ PV FV DF
4 3,000^ 0.^
23,613.
i pv 23,613.
Mr X hasto
receive (^2000)
peryearfor
years
calculate thepresentvalue
of
the annuity
assumingthathecanearn
interest (^) on hisinvestment^ at 10
pa
Annualcashflow
2000 n sycars
i 101
pv (^) Act
itis
2000 0.9091^ 0.2264 0.7513 (^) 0.0830 0.
(^2000) 3.
i (^) PV 7581.
MrA hasto receive^1000 atthe beginningof
each year for
years
Calculatethe present
value
of
the (^) annuitydueassuming 10 rate
of
interest
Annual (^) cashflow 1000 n Syrs
i (^101)
PV ACIF
Ʃ
1
n
i
1000 3.7907 1 0.
i PV 4169.
Calculate thepresentvalue
of
1000 received (^) in perpetuity for
an (^) infinite period taking
a
discount rate
of
10
PV
ACIF
10,
Aproject costs^
(^1) 00, and yields
an annual^ cashflow of
20,
for
years
Calculate (^) its Pay
BackPeriod
Initial Outlay
1100,
AnnualCash Inflow
PaybackPeriod
aijjtiitiipi.us
1001000
20,
Syears
Determine the (^) PayBack
Period
for
a (^) project which (^) requires a cash
outlay (^) of
10,000 (^) and generates
cash inflows of
2000 4000
3000 and
2000 in the
first
second third fourth
year
respectively
Initial Outlay
10,
Yr cashInflow^
cumulative CF
4
Through Interpolation
Pay
BackPeriod^ Proceeding
Period
casiiniiwhinsiiiain.gl
year
i
Pay
BackPeriod^ 3.
years
There (^) are two projects X (^) Y Each project requires an^
investment of
20, You are required to rank the (^) projects
based on PBPmethod
fro
thefollowing information
Yr (^) Project Project 4
2,
2,000 4,
5,
810
Calculation
of
Pay
BackPeriod
for
ProjectX
Yr AnnualCashInflows Cumulative^ CIF
3000
Pay
BackPeriod for
ProjectX^ Syears
4
5000 12,^
Rank 02
calculation
of
Pay
BackPeriod
for
Project 4
Yr AnnualcashInflow^ cumulative CIF
4000 6000
Pay
BackPeriod
for
Project
4 is
y
8000 20,
years
Rank 01
A
machine willcost 80,
initially
It will also need^ working
capitalof
20,000 at the zero period
The yearly
profits before^
tax are
expectedto be 15,
pa
The machine^ has^ a^ lifeof years
the
depreciation is^ provided
on (^) a straight
line basis (^) Tanrate is 40
Accounting
Rate of
Return ARR
Method
Thismethod^ takesinto
account theearningsfrom an^
investment over its (^) who
usesNetProfitafter
tax life^
It
is alsoknown as Average
Rate of
Return
andafterdepreciation
Average
Rate
of
Return (^) average
annualprofit 100
net investment
NetProfitafterDepreciation Tan (^) Profit Dep Tax
Average
Annual Profit
netprofitafter
depreciation (^) tan
no of years
Net
Investment Initial
Investment Scrap
AverageNet
Investment (^) net investment additiqpq.la
working
Decision
rule
for
Single
Project (^) comparewithstandard^ rate
of
return
iiiiiiiiiiimini.it
iiiiiii.iiioo
Return on average
investment
averajinetintestment
Average
Return (^) on average
investment Average
AnnualProfit 100
AverageNet
Investment
Advantages of
Accounting
Rate
of
Return Method
Earnings over theentire^
lifeof
theproject are^
considered
suitable whenthe project
life
is
Disadvantages of
AccountingRate of
ReturnMethod
of long
tohave^ a (^) rough
ignores time
value
ofmoney
assessment
of
the internalrate of based^ on accountingprinciples noton cashflow analysis
return
ignores shrinkage
of
original
investment through (^) process of
charging
depreciation
X (^) Ltd is considering thepurchase^ of
a
machine Two
machines are
available Eand
F
Thecost
of
each machineis 60,000^ Each^ machine
has an^ expected lifeof
years
Net profit before^
tax (^) and
after
depreciation during
the (^) expected
lifeof
the machine (^) is
given
below
Yr Machine^ MachineF
I
S 10,000 20,
85,000 90,
Following
the method^ of
Average
Return (^) on Average
Investment (^) ascertain
which
of
the alternative^ will (^) be profitable Tax rate is assumed^ to (^) be
Cashflow requiredis^ NetProfitaftertax^ after depreciation
computation
of
Average
Rate
of
Return
for
Machinery
Yr.NPADBTTax sot.NP ADAT
2 20,000^ 10,^
10000
25,000 12,500 12500
4
Average
Rate
of
Return
Avg AnnualProfit
AugNet
Investment
Aug
Annual Profit
Net
ProfitafterDepreciation Tax 42,500 8500
No of years
s
Net
Investment Initial
Investment Scrap
60,000 (^0) 60,
yearslife
are 12,000^ 14,400 10,800^ 19,200^ and 24,
Assuming tax (^) rate 50 and depreciation on straight
line basis^ calculate
average
rate of
return
for
the project
Cashflow requiredis^ Netprofitafterdepreciation^ tax
Yr
AnnualCashInflow Depreciation NPADBTTan sot.NDADAT
2 14,^
9600 4800 2400 2400
200 9000 9600 4800 4800
5 24,000^9600
14400 7200 7200
19,
Depreciation
cost (^) ScrapValue
Estimateduseful
life
6010005121000
Average
Rate
of
Return Avg
AnnualProfit
AvgNet
Investment
Avg
Annual Profit 19,
3840
Avg
Net
Investment 60,
12, 72,
i
Average
Rate
of
Return 3840 100
36000
If Net
Present ValueMethod^ NPVMethod
NPVis a
discounted (^) cash flow
methodthatconsideresthe timevalue
ofmoney^
in
Net
tafore
depreciation evaluating^
capital
investments
It is a
method
of
calculating the^ present
value
of
cash flows
inflows (^) or
outflows
of
an
investment proposal using
cost of
capital as^ an^ appropriate
discounting rate
NPV Total
PresentValue
Total
Present (^) Value
Cash Inflows
CashOutflows
DecisionRule Accept NPV is tve
Reject NPV is ve
consider NPV (^0)
Advantages of
Net
Present Value Method
considers (^) whole
lifeof
the projectalongwith^ salvage^
value
considerstime value
Based (^) on cash flows
rather (^) than accounting (^) profit
Disadvantages of
NetPresentValue Method
deciding appropriate^
discountrate
not suitable^ if
projects with unequal initial
investments are (^) compared
From (^) the following information^
compute NPV of
two projects and
suggestwhich^
should (^) be accepted assuming a^
discount (^) rate
of
initial investment
Estimated
life
A
company is^ considering
investment in a^ project
initial
investment a
Estimated
life
Scrap
Assume (^) the company follows^
straight line^
method of
depreciation
tax rate^40 The
Profit before^ depreciation^ before
tan
for
year
1 5 are
given
below
yr
NPBDBT 70,000 80,
1 20,000 90,000 60,
Calculate NPV (^) assuming 10
(^1) cut off rate
computation
of
Present valuecashinflows^
Outflows
YrPBDBTDepreciationPADBTTax
401 PADAT^ Depreciation PBDAT
I 70,000 40,000^ 30,000 12,000^ 18,000^ 40,000^ 58,
2 80,000^ 40,000 40,000^ 16,^
24,000 40,000 (^) 64,
1120,000 40,000 80,000^ 32,000^ 48,000 40,000 88,
90,000 40,000 50,000^ 20,000 30,000 40,000^ 70,
60,000 40,000 20,000^ 8,000 12,000^ 40,000 52,
DF
Htin PUCIF
0.9091 52727.
0.8264 52892.
0.7513 66115.
0.6830 47810.
0.6209 32287.
TPUCIF 2,
Depreciation straight
line
Method Cost^ Scrap
Estimated
life
(^9001000 0) 40,
Total
Present ValueCashOutflows^ 2,
i iii.it
o
51,834.
Y Ltd (^) is planning
a machine
for
1140,000 which (^) is likely
to
emanate (^) the following
earnings in^ the^ next^5 years
Yr
Earnings 50,000^ 55,000 60,
02,000 65,
The machine^ will require
additional working capitalof
It will also require
installation charges (^) of
10,000 The machine
will (^) bedepreciated on SLM basis (^) has salvage
value of
The company
is subject to tan at^ the rate of
50 Should^ the machine
bepurchased if
the
cost ofcapital^
is 10 Evaluate the project
using
NPV
method
computation
of
Cost
of
Machine
cost
(^1) 40,
add
installation charges
workingcapital
is
P
1,
(^000) TotalPresentValueCashOutflows
Depreciation cost^ scrap
Estimated
life
5010005
251000 25,
computation
of
Total
PresentValueCash inflows
Yy
EBDBT Depreciation EADBT (^) Taxeso 1 EADAT Depreciation
25,
EBDAT
50,000 (^) 25,000 25,000 12,500 (^) 12,500 37,
