33 - 11. Unit 10 (Solved)

7/30/2019 33 - 11. Unit 10 (Solved)

http://slidepdf.com/reader/full/33-11-unit-10-solved 1/12

“I have enough money to last me the rest of my life, unless I buy something” Jackie Mason

Capital Budgeting

Discounting Criteria

Non-Discounting Criteria

Payback Period

Accounting Rate of

Return

NP

IRR

BCR

7/30/2019 33 - 11. Unit 10 (Solved)


Financial Decision Making (MGT434)

Work Book Foundation Level 188 Capital Budgeting

Unit 10

CAPITAL BUDGETING

The process of identifying, analyzing and selecting investment project whose returns (Cash Flows) are expected to

extend beyond one year

10. Capital Budgeting Techniques There are different methods of evaluating capital investment projects

Broadly, there are two alternative methods of project evaluation and selection used in Capital Budgeting

10.1 Non-Discounting Criteria

Non-discounting techniques take into account magnitude and not timing of the expected cash flow (ignoring TVM)

Following are different non-discount techniques.

10.1.1 Payback Period

The Payback Period is the length of time required to recover the initial cash outlay on project

The payback period of the investment tells us the number of years required to cover our initial cash outflow

The major short coming of the payback period is that it fails to consider the cash flows after the payback period

Example 10.1: Calculate the Payback Period?

Cash Outflow Rs. (600,000)

Cash inflow 1st

year 150,000

Cash inflow 2d

year 100,000

Cash inflow 3d

year 150,000

Cash inflow 4 h year 200,000

Cash inflow 5h year 120,000

Solution:

If Cash inflow is constant than we can apply this equation

Capital Budgeting

Non-Discounting Criteria Discounting Criteria

PBP ARR NPV BCR IRR

Payback Period = Cash Outflow / Constant Cash Inflow

Payback Period is 4 year (150,000 + 100,000 + 150,000 + 200,000 = 600,000)

7/30/2019 33 - 11. Unit 10 (Solved)




Unit 10

Example 10.2: If Cash Outflow is Rs. 200,000 and constant cash inflow will be Rs. 50,000 per year what will be

Payback Period?

Solution:

Example 10.3: Which one of the following Investment is best?

Year Cash Flow of A Cash Flow of B

0 Rs. (100,000) Rs. (100,000)

1 50,000 20,000

2 30,000 20,000

3 20,000 30,0004 10,000 40,000

5 10,000 50,000

6 ------ 60,000

(Acceptance Criterion: The shorter the Payback Period, the more desirable the project)

Solution:

10.1.2 Accounting Rate of Return: The accounting rate of return, also called the average rate of return is defined as

Example 10.4: Find out Accounting Rate of Return overall and individual in order to decide which year is best?

Year Book Value of Investment Profit after Tax

1 Rs. 90,000 Rs. 20,000

2 80,000 22,000

3 70,000 24,000

4 60,000 26,000

5 50,000 28,000

(Acceptance Criterion: The higher the accounting rate of return the better the project)

Payback Period = Cash Outflow / Constant Cash Inflow

Payback Period = 200,000 / 50,000 = 4 years

Payback for A = (50,000 + 30,000 + 20,000) = 3 years

Payback for B = (3 + 30,000/40,000) = 3.75 years

Project A is best according to payback period criterion

ARR = Profit after Tax / Book value of the investment

7/30/2019 33 - 11. Unit 10 (Solved)


7/30/2019 33 - 11. Unit 10 (Solved)




Unit 10

10.2 Discounting Criteria

Discounting cash flow method provide more objective basis for evaluating and selecting projects

This method take into account both magnitude and timing of the expected cash flow in each period of project’s li fe

Following are some important techniques used under Discounting Criteria

10.2.1 Net Present Value (NPV)

The Net Present Value (NPV) of a project is the sum of all present values of cash inflows that are expected to occur

over the life of project minus present values of all cash outflows

So we can say that Net Present Value is difference between Cash Inflow and Cash Outflow

If NPV > 0 the investment would add value to the firm the project may be accepted

NPV < 0 the investment would subtract value from the firm the project should be rejected

NPV = 0 the investment would neither profit nor lose value for the firm

Or

Example 10.6: Find the Net Present Value assuming cost of capital is 10 %?

Year Cash Flow

0 Rs. (1,000,000)

1 200,000

2 200,000

3 300,000

4 300,000

5 350,000

(Acceptance Criterion: The higher the NPV the better the project)

Solution:

Net Present Value = Present Value of Cash Inflow - Present Value of Cash Outflow

NPV = Cash Inflow t / (1 + i)t

- Cash Outflow t / (1 + i)t


Net Present Value = [200,000 / (1+0.10)

1

+ 200,000 / (1+0.10)

2

+ 300,000 / (1+0.10)

3

+300,000 / (1+0.10)

4+ 350,000 / (1+0.10)

5] - [1, 000,000 / (1+o.10)

0]

Net Present Value = [181,818.18 + 165,289.266 +225,394.44 + 204,904.04 + 217,322.46]

- [1, 000,000]

Net Present Value = 1,024,728.386 - 1, 000,000

Net Present Value = Rs. 24,728.386

7/30/2019 33 - 11. Unit 10 (Solved)




Unit 10

10.2.2 Benefit Cost Ratio (BCR) or Profitability Index (PI)

Benefit Cost Ratio (BCR)of a project is the sum of all present values of cash inflows that are expected to occur over

the life of project divided by present values of all cash outflows

So we can say that Benefit Cost Ratio is ratio between Cash Inflow and Cash Outflow

Accepted Criteria when BCR Rule is

> 1 Accepted

= 1 Indifference

< 1 Rejected

Example 10.7: Find the BCR if cost of capital is 12 %?

Initial Investment Rs. (100,000)

Year 1st

benefit 25,000Year 2

ndbenefit 40,000

Year 3rd

benefit 40,000

Year 4th

benefit 50,000

(Acceptance Criterion: The higher the BCR the better the project)

Solution:

10.2.3 Internal Rate of Return (IRR)

o The Internal Rate of Return of a project is the discount rate which makes it NPV to zero

o The IRR is compared with RRR or cost of capital. If the IRR exceeds the required return, the project is accepted; if

not the project is rejected

Example 11.8: Consider the following cash flows and calculate IRR.

Year 0 1 2 3 4

Cash Flow (100,000) 30,000 30,000 40,000 45,000

(Acceptance Criterion: The higher the IRR the better the project)

BCR = Present Value of Cash Inflow (Benefits) / Present Value of Cash Outflow (Cost)

BCR = Present Value of Cash Inflow (Benefits) / Present Value of Cash Outflow (Cost)

BCR = 25,000 / (1+0.12)1

+ 40,000 / (1+0.12)2

+ 40,000 / (1+0.12)3

+ 50,000 / (1+0.12)4

/ 100,000

BCR = 22,321.43 + 31,887.76 + 28,471.21 + 31,775.90 / 100,000

BCR = 114,456.3 / 100,000

BCR = 1.14

Investment = CFt / (1 + i)t

7/30/2019 33 - 11. Unit 10 (Solved)




Unit 10

Solution:

Investment = CFt / (1 + i)t

100,000 = 30,000 / (1 + i) 1 + 30,000 / (1 + i) 2 +40,000 / (1 + i) 3 +45,000 / (1 + i) 4

The calculation of IRR involves a process of trial and error. We try different values of i till we find

the right-hand side of above equation is equal to 100,000. Let us, to begin with try i= 10 percent. We

make the right-hand side equal to

100,000 = 30,000 / (1 + 0.10)1

+ 30,000 / (1 + 0.10)2

+ 40,000 / (1 + 0.10)3

+ 45,000 / (1 + 0.10)4

100,000 = 27,272.7273 + 24,793.3884 + 30,052.5920 + 30,735.6055

100,000 = 112,854.31

This value is slightly higher our target value, 100,000. So we increase the value of i from 10 percentto 20 percent. The right hand side becomes

100,000 = 30,000 / (1 + 0.20)1

+ 30,000 / (1 + 0.20)2

+40,000 / (1 + 0.20)3

+45,000 / (1 + 0.20)4

100,000 = 25,000 + 20,833.3333 +23,148.1482 +21,701.3889

100,000 = 90,682.87

Since the value is now less than 100,000, we conclude that the value of IRR lies between 10 percent

and 20 percent. If more refine estimate of IRR is needed, use the following interpolation procedure.

10 % 112,854.31

a IRR 100,000 b c

20% 90,682.87

Lower Rate = 0.10; a = 0.20 - 0.10 = 0.10; b= 112,854.31 - 100,000 = 12,854.31; c = 112,854.31 - 90,682.87 = 22,171.44

IRR =Lower Rate + [(a* b)]

c

IRR =0.10 + [0.10* 12,854.31]

22,171.44

IRR =0.10 + 0.058

IRR =15.8%

7/30/2019 33 - 11. Unit 10 (Solved)




Unit 10

END-OF-UNIT ASSIGNMENT

(PROBLEMS & MULTIPLE CHOICE QUESTIONS)

Problem 10.1: You are financial analyst for the Hills Company. The director of capital budgeting has asked you to

analyze two proposal capital investment. Project X and Y. Each project has a cost of Rs. 14,000, gross inflows have Rs.

21,000 and the cost of capital for each project is 12 percent. The projects’ expected cash flows are as follow.

Expected Cash Flows

Year Project X Project Y

0 (14,000) (14,000)

1 8,000 3,500

2 2,000 6,500

3 6,000 2,000

4 5,000 9,000

Requirement: Calculate each project’s Payback, Net present value and Benefit-Cost Ratio then decided best project.

Project X

Payback Period = 2 + 4,000/6,000 = 2.67 Years


Net Present Value = 8,000 / (1+0.12)1

+ 2,000 / (1+0.12)2

+6,000 / (1+0.12)3

+5,000 / (1+0.12)4

- 14,000 /

(1+0.12)0

Net Present Value = 7,142.86 + 1,594.39 +4,270.68 +3,177.59 - 14,000

Net Present Value = 16,185.52 - 14,000


BCR = 8,000 / (1+0.12)1

+ 2,000 / (1+0.12)2

+6,000 / (1+0.12)3

+5,000 / (1+0.12)4

/ 14,000

BCR = 16,185.52 / 14,000

BCR = 1.16

Project Y



Net Present Value = 3,500 / (1+0.12)1

+ 6,500 / (1+0.12)2

+2,000/ (1+0.12)3

+9,000 / (1+0.12)4

- 14,000 /

(1+0.12)0

Net Present Value = 3,125 + 5,181.76+1,423.56 +5,719.66 - 14,000

Net Present Value = 15,449.98 - 14,000


BCR = 3,500 / (1+0.12)1

+ 6,500 / (1+0.12)2

+2,000/ (1+0.12)3

+9,000 / (1+0.12)4

/ 14,000

BCR = 15,449.98 / 14,000

BCR = 1.10

(X IS BEST)

7/30/2019 33 - 11. Unit 10 (Solved)




Unit 10

Problem 10.2: The cash stream for two mutually exclusive alternative investments; Project of Karachi and Project of

Lahore are as follows with same cash inflow of Rs. 5,300 and outflows 2,300 at different points in project life cycle. You

are required to calculate the Payback Period (PBP), Net Present Value (NPV) and Benefit Cost Ratio (BCR) if required

rate of return is 5%. Which would you choose?

Year Project of Karachi Project of Lahore0 (1,500) (800)

1 700 1.200

2 500 2,200

3 (800) 1,900

4 1,000 (400)

5 1,700 (700)

6 1,400 (400)

(For Calculation all figure are rounded to two decimal places)

Project of Karachi

1. Payable Back Period

Payback Period = 4 + 100/1,700 = 4.0588 Years

2. Net Present Value = Present Value of Cash Inflow - Present Value of Cash Outflow

Net Present Value = [700 / (1+0.05)1 + 500 / (1+0.05)2 +1,000 / (1+0.05)4 +1,700 / (1+0.05)5 +1,400 /

(1+0.05)6] - [1,500 / (1+0.05)

0+ 800 / (1+0.05)

3]

Net Present Value = [666.67 + 453.51 + 822.70 + 1,331.99 + 1,044.70] - [1,500 + 691.07]

Net Present Value = 4,319.57 - 2,191.07 = Rs. 2,128.5

3. BCR = PVB / I

BCR = [700 / (1+0.05)1

+ 500 / (1+0.05)2

+1,000 / (1+0.05)4

+1,700 / (1+0.05)5

+1,400 / (1+0.05)6] /

[1,500 / (1+0.05)0

+800 / (1+0.05)3]

BCR = [666.67 + 453.51 + 822.70 + 1,331.99 + 1,044.70] / [1,500 + 691.07]

BCR = [4,319.57 / 2,191.07] = 1.97

Project of Lahore

1. Payable Back Period


2. Net Present Value = Present Value of Cash Inflow - Present Value of Cash Outflow

Net Present Value = [1,200 / (1+0.05)1

+ 2,200 / (1+0.05)2

+1,900 / (1+0.05)3] - [800 / (1+0.05)

0+400 /

(1+0.05)4+700 / (1+0.05)

5+ 400 / (1+0.05)

6]

Net Present Value = [1,142.86 + 1,995.46 + 1,641.29] - [800 + 329.08 + 548.47 + 298.49]

Net Present Value = [4,779.61] - [1,976.04] = Rs. 2,803.57

3. BCR = PVB / I

BCR = [1,200 / (1+0.05)1

+ 2,200 / (1+0.05)2

+1,900 / (1+0.05)3] / [800 / (1+0.05)

0+400 / (1+0.05)

4

+700 / (1+0.05)5+ 400 / (1+0.05)

6]

BCR = [1,142.86 + 1,995.46 + 1,641.29] / [800 + 329.08 + 548.47 + 298.49]

BCR = [4,779.61] / [1,976.04] = 2.42

Project of Lahore is best on the basis of above criteria

7/30/2019 33 - 11. Unit 10 (Solved)




Unit 10

MULTIPLE CHOICE QUESTIONS (MCQs)

1. A project costs Rs.16,000.The estimated annual cash inflows during its 3 year life are Rs.8,000, Rs.7,000 and

Rs.6,000 respectively. What will be the pay-back period?

(a) 2 years (b) 2.5 years (c) 3 years (d) 4 years

2. To estimate an unknown number that lies between two known numbers is knows as ___________?

(a) Capital rationing (b) Capital budgeting (c) Interpolation (d) Amortization

3. Decision criterion with respect to profitability index to accept project if?

(a) Profitability index is equal to or less than 1 (b) Profitability index is greater than 1

(c) Profitability index is less than or equal to 1 (d) Profitability index is greater than 10

4. A proposal is accepted if payback period falls within the time period of 4 years. According to the given criteria

which of the following project will be accepted?

Projects Payback period

Project A 1.66

Project B 2.66

Project C 3.66

(a) Project A (b) Project B (c) Project C (d) Project A & B

5. ____________ of a project is the sum of all present values of all cash inflows minus present value of outflows?

(a) Pay Back Period (b) Internal Rate of Return (c) Benefit Cost Ratio (d) NPV

6. If you have to judge a project from its NPV, you will select the one with the______________?

(a) Highest NPV (b) Lowest NPV

(c) NPV cannot judge the project (d) Information is not enough

7. Criteria that measures how quickly project will return its original investment is?

(a) Accounting rate of return (b) Payback period

(c) Internal rate of return (d) Benefit cost ratio

8. Capital budgeting is the process of identifying analyzing and selecting investments project whose returns are

expected to extend beyond ____________________?

(a) 3 years (b) 2 years (c) 1 year (d) Months

9. Indifference criteria when BCR (Benefit Cost Ratio)?

(a) BCR > 1 (b) BCR = 1 (c) BCR < 1 (d) None of above

10. Criterion for IRR (Internal Rate of Return)?

(a) Accept IRR > Cost of capital (b) Accept IRR < Cost of capital

(c) Accept IRR = Cost of capital (d) none of the above

11. Process that involves decision making with respect to investment in fixed asset?

(a) Valuation (b) Breakeven analysis (c) Capital budgeting (d) Material management decision

12. Criterion for benefit cost ratio?

(a) Accept BCR > 1 (b) Accept BCR<1 (c) Accept BCR=1 (d) None of the above

7/30/2019 33 - 11. Unit 10 (Solved)




Unit 10

13. A capital budgeting technique that is not considered as discounted cash flow method is?

(a) Internal rate of return (b) Payback period

(c) Net present value (d) Profitability index

14. Ratio of present value of project’s future net cash flows to projects initial cash flow is?

(a) Profitability index (b) Internal rate of return(c) Net present value (d) Average rate of return

15. In non-discounting Techniques there are two methods; one is Accounting Rate of Return and the other is ______?

(a) NPV (b) Internal Rate of Return (c) Benefit Cost Ratio (d) Pay Back Period

16. On the recommendations of the Finance Manager, the board of directors will accept the project if?

(a) Benefit Cost Ratio is less than one (b) Net Present Value is greater than zero

(c) Internal Rate of Return is less than cost of capital (d) Pay Back Period is greater than target period

17. Internal Rate of Return is the Rate at which NPV=?

(a) 0 (b) 1 (c) 2 (d) 3

18. The project is most desirable whose Payback period is?

(a) More (b) Less (c) Time doesn’t make any difference (d) None of the above

19. For a single project we take it if and only if?

(a) NPV is positive (b) NPV is zero (c) NPV is negative (d) None

20. In order to compute the NPV of project we need to analyze?

(a) Cash Flows (b) Discount rates (c) Both A & B (d) None of them

21. For mutual exclusive projects take the one with?

(a) Positive & highest NPV (b) Positive & lowest NPV (c) Negative & lowest NPV (d) None

22. Which statement is true regarding Payback Period?

(a) It ignores the cash flows after the payback period (b) It ignores discounting

(c) Both A & B (d) None of them

23. The length of a time required for an investment’s net revenues to cover its cost is called?

(a) NPV (b) PI (c) IRR (d) Pay Back Period

24. Projects whose cash flows are not affected by the acceptance or non acceptance of other projects are called?

(a) Dependent projects (b) Independent projects (c) Mutually exclusive projects (d) None

25. Methods for ranking investments proposals that employ time value of money concept is called?

(a) Discounted cash flow techniques (b) Pay Back Period (c) NPV (d) IRR

26. Mutually exclusive means that you can invest in _________ project(s) and having chosen ______ you cannot choose

another?

(a) Two; one (b) Two; two (c) One; one (d) Three; one

27. What are two major areas of capital budgeting?

(a) Net present value, profitability index (b) Net present value; internal rate of return

(c) Net present value; payback period (d) Payback period; profitability index

7/30/2019 33 - 11. Unit 10 (Solved)



W k B k F d ti L l 198 C it l B d ti

Unit 10

28. Which of the following is not a cash outflow for the firm?

(a) Depreciation (b) Dividends (c) Interest (d) Taxes

29. What is the most important criteria in capital budgeting?

(a) Return on investment (b) Profitability index (c) Net present value (d) Payback period

30. The benefit we expect from a project is expressed in terms of?

(a) Cash inflows (b) Cash outflows (c) Cash flows (d) None of the given option

31. Capital budgeting focus on?

(a) Non- discounting criteria (b) Discounting criteria (c) Both a & b (d) None

32. Accounting rate of return is also known as?

(a) Average rate of return (b) Equal rate of return (d) Market rate of return (d) None

33. What do we call a formal comparison of the actual costs and benefits of a project with original estimates?

(a) Post-completion audit (b) Feedback audit

(c) Cost-benefit analysis (d) Business scorecard report

34. Why companies invest in projects with negative NPV?

(a) Because there is hidden value in each project (b) Because they have chance of rapid growth

(c) Because they have invested a lot (d) All of the given options

35. A capital investment is one that?

(a) Has the prospect of long term benefits (b) Has the prospect of short term benefits

(c) Applies only to investment in fixed assets (d) All of the given options

36. The net present value (NPV) of an investment represents the amount by which the investment is expected to

______________________shareholder wealth?

(a) Provide zero change to (b) Decrease (c) Increase (d) Provide zero change to or decrease

37. Which if the following refers to capital budgeting?

(a) Investment in long-term liabilities (b) Investment in fixed assets

(c) Investment in current assets (d) Investment in short-term liabilities

38. The capital budget for the year is approved by a company's?

(a) Board of directors (b) Capital budgeting committee (c) Officers (d) Shareholders

39. Capital budgeting is the process?

(a) Used in sell or process further decisions (b) Of determining how much capital share to issue

(c) Of making capital expenditure decisions (d) Of eliminating unprofitable product lines

40. Which of the following methods of evaluating capital budgeting proposals rests on the assumption that income is

uniform over the life of an investment?

(a) Internal rate of return (b) Payback method (c) Net present value (d) Accounting rate of return

33 - 11. Unit 10 (Solved)

Documents