Chapter - 13

UNIT - I
INVESTMENT DECISION
(CAPITAL BUDGETING)
Learning Outcomes

❑ State the objectives of capital investment decisions.

❑ Discuss the importance and purpose of Capital budgeting for a business entity.
❑ Calculate cash flows in capital budgeting decisions and try to explain the basic principles for
measuring the same.
❑ Discuss the various investment evaluation techniques like Pay- back, Net Present Value
(NPV),
❑ Profitability Index (PI), Internal Rate of Return (IRR), Modified Internal Rate of Return
(MIRR) and Accounting Rate of Return (ARR).
❑ Apply the concepts of the various investment evaluation techniques for capital investment
decision making.
❑ Discuss the advantages and disadvantages of the above- mentioned techniques.

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Page 13.2 STRATEGIC FINANCIAL MANAGEMENT

PROJECT EVALUATION TECHNIQUE [NPV; PI; IRR etc.]

Question No. - 1A
XYZ Ltd is considering two mutually exclusive projects. Both require an initial cash outlay of 10,000 each
for machinery and have a life of 5 years. The company’s required rate of return is 10% and it pays tax at 50%.
The projects will be depreciated on a straight line basis. The net cash flows (before taxes) expected to be
generated by the projects and the present value (PV) factor (at 10%) are as follows:
Year 1 2 3 4 5
() () () () ()
Project 1 4,000 4,000 4,000 4,000 4,000
Project 2 6,000 3,000 3,000 5,000 5,000
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
You are required to calculate
(i) the Pay Back Period of each project;
(ii) the NPV and Profitability Index of each Project
[CMA-Dec-2008-10 Marks]
Ans: (i) P1: 3Y and 4 Month; P2: 3Y and 3.42months

Question No. - 1B [Nov-1998-Old-12 Marks]

Following are the data on a capital project being evaluated by the management of X Ltd.
Project M ()
Annual cost saving 4,00,000
Useful life 4 years
I.R.R. 15%
Profitability Index (PI) 1.064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?
Salvage value 0

Find the missing values considering the following table of discount factor only:
Discount factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 years 0.756 0.769 0.783 0.797
3 years 0.658 0.675 0.693 0.712
4 years 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
[CMA-SM] [CMA-MTP-June-2015-5M] [CMA-Compendium]
Ans: Cost of Project = 11,42,000; Cost of Capital = 12%; NPV = 73,088; Pay Back Period = 2.85 Years

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CAPITAL BUDGETING Page 13.3

Question No. - 1C
Modern Enterprises is considering the purchase of a new Computer System at a cost of  35 lakhs for its Research
and Development (R&D) Division. The cost of operation and maintenance (excluding depreciation) will be  7
lakhs per annum. The useful life of the system will be 6 years after which it will have
a disposal value of 1 lakh. With the installation of the system there will be a reduction in running cost of  1 lakh
per month in the R & D Division.
Moreover, the company is expected to receive  9 Lakh immediately by disposal of some existing equipment and
furniture.
Capital expenditure in R & D will attract 100% write off for tax purpose. The effective tax rate of the company may
be taken as 50%. The gains arising from disposal of equipment and furniture are to be considered as free of tax.
Taking the average cost of capital of the company as 12%, you are required to advise financial viability of the
proposal.
[CMA-WB-2018]
Ans: NPV = 0.40 Lakhs
Question No. - 1D
ABC Ltd. furnished you the following information:
Cost of Plant 10,00,000
Working Capital 5,00,000
Annual Sales Value 15,00,000
Annual Cash operating expenses 7,00,000
Project life 4 Years
Tax rate 40%
Depreciation SML
Cost of Capital 10% p.a.
Terminal value Plant 20% of Cost & Working Capital 100%
Compute Modified Internal Rate of Return or Terminal Rate of Return.

[CMA-MTP-June-2015-New=5M]
Ans: 21.78%
Question No. – 1E
Calculate Modified NPV of an investment of  1, 50,000 which yields the following cash inflows if intermediate
period inflows are reinvested at 12% p.a.
Year Cash Inflows (in )
1 40,000
2 50,000
3 60,000
4 40,000
5 30,000
Cost of Capital is 10% p.a.
Ans: NPV =

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Page 13.4 STRATEGIC FINANCIAL MANAGEMENT
Question No. - 1F
T Ltd. has specialised in the manufacture of a particular type of transistors. Recently, it has developed a new model
and is confident of selling all the 8,000 units (new product) that would be manufactured in a year. The required
capital equipment would cost 25 lakhs and that would have an economic life of 4 years with no significant salvage
value at the end of such period. During the first four years, the promotional expenses would be as planned below;
Year 1 2 3 4
Expenses ()
- Advertisement 1,00,000 75,000 60,000 30,000
- Others 50,000 75,000 90,000 1,20,000
Variable costs of producing and selling a unit would be  250. Additional fixed operating costs to be incurred
because of this new product are budgeted at  75,000 per year. The management expects a discounted return of
15% (after tax) on investments in the new product. You are required to work out an initial selling price per unit
of the new product that may be fixed with a view to obtaining the desired return on investment. Assume a tax rate
of 40"6 and use of straight line method of depreciation for tax purpose.
Note: The present value of annuity of  1 received or paid in a steady stream throughout the period of four years in
the future at 15% is 3.0079.
[CMA-SM] [CMA-WB-2018]

Question No. - 1G
Techtronics Ltd., an existing company, is considering a new project for manufacture of pocket video games
involving a capital expenditure of  600 lakhs and working capital of 150 lakhs. The capacity of the plant is for
an annual production of 12 lakh units and capacity utilisation during the 6-year working life of the project is
expected to be as indicated below.
Year Capacity Utilization
1 33 1/3 %
2 66 2/3 %
3 90 %
4-6 100 %
The average price per unit of the product is expected to be 200 netting a contribution of 40%. Annual fixed costs,
excluding depreciation, are estimated to be 480 lakhs per annum from the third year onwards; for the first and
second year it would be 240lakhs and 360 lakhs respectively. The average rate of depreciation for tax purposes
is 33 1/3% on the capital assets. No other tax reliefs are anticipated. The rate of income-tax may be taken at 50%.
At the end of the third year, an additional investment of 100 lakhs would be required for working capital.
The company, without taking into account the effects of financial leverage, has targeted for a rate of return of 15%.
You are required to indicate whether the proposal is viable, giving your working notes and analysis.
Terminal value for the fixed assets may be taken at 10% and for the current assets at 100%. Calculation may be
rounded off to lakhs of rupees. For the purpose of your calculations, the recent amendments to tax laws with regard
to balancing charge may be ignored.
[CMA-SM]

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CAPITAL BUDGETING Page 13.5

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. 1.1 [SM-NEW] [SM-OLD]
Calculate the internal rate of return of an investment of  1, 36,000 which yields the following cash inflows:
Year Cash Inflows (in )
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Also Calculate the Modified internal rate of return (MIRR) of an investment considering 8% Cost of Capital.
Ans: IRR = 10.7%; MIRR = 9.4%
Question No. -1.2 [CA Student can ignore]
Forward Planning Ltd. is considering whether to invest in a project which would entail immediate expenditure on capital
equipment of  40,000. Expected sales from the project are as follows:
Probability Sales Volume (Units)
0.10 2,00
0.25 6,000
0.40 8,000
0.15 10,000
0.10 14,000
Once sales are established at a certain volume in the first year, they will continue at that same volume in subsequent
year. The unit selling prices will be  10, the unit variable cost  6 and the additional fixed costs will be 20,000
(all cash items). The project would have a life of 6 years after which the equipment would be sold for scrap which
would fetch  3,000. You are required to find out:
I. The expected value of the NPV of the project
II. The expected volume of sales per annum required to justify the project.
The cost of capital of the company is 10%. Discount factor of 1 per annum for 6 years @ 10% is 4.355 and the discount
factor of  1 at the end of the sixth year at 10% is 0.5645. Ignore taxation.
[CMA-MTP-June-2015-New=5M]
Ans: Expected NPV = 10,470; Annuan Sale = 7199 Units or 7200 Units

Question No. – 1.3 [CA Student can ignore]

An oil company proposes to install a pipeline for transport of crude from wells to refinery. Investments and
operating costs of the pipeline vary for different sizes of pipelines (diameter). The following details have been
conducted:
(a) Pipeline diameter (in inches) 3 4 5 6 7
(b) Investment required ( Lakh) 16 24 36 64 150
(c) Gross annual savings in operating costs before depreciation ( lakhs) 5 8 15 30 50
The estimated life of the installation is 10 years. The oil company's tax rate is 50%. There is no salvage value and
straight line rate of depreciation is followed.
Calculate the net savings after tax and cash flow generation and recommend there from, the largest pipeline to be
installed, if the company desires a 15% post-tax return. Also indicate which pipeline will have the shortest
payback. The annuity PV factor at 15% for 10 years is 5.019.
[CMA-WB-2018]

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Page 13.6 STRATEGIC FINANCIAL MANAGEMENT
Question No. – 1.4 [CA Student can ignore]
A particular project has a four-year life with yearly projected net profit of  10,000 after charging yearly
depreciation of  8,000 in order to write-off the capital cost of  32,000. Out of the capital cost  20,000 is payable
immediately (Year 0) arid balance in the next year (which will be the year 1 for evaluation).
Stock amounting to  6,000 (to be invested in year 0} will be required throughout the project and for debtors a
further sum of  8,000 will have to be invested in year 1. The working capital will be recouped in year 5. It is
expected that the machinery will fetch a residual value of  2,000 at the end of 4th year. Income tax is payable @
40% and the Depreciation equals the taxation writing down allowances of 25% per annum.
Income tax is paid after 9 months after the end of the year when profit is made. The residual value of  2,000 will
also bear tax (a 40%. Although the project is for 4 years, for computation of tax and realisation of working capital,
the computation will be required up to 5 years.
Taking discount factor of 10%, calculate NPV of the project and give your comments regarding its acceptability.
[CMA-WB-2018]
Question No. – 1.5 [CA Student can ignore]
ABC Enterprises Ltd. is evaluating an option to computerise their distribution system. The total capital cost for the
system is 100 lakhs. The operation and maintenance costs (excluding depreciation) per annum is expected to be
 10 lakhs. The computer system is expected to have an useful life of 5 years after which it is expected to become
obsolete and would require replacement. It would have negligible salvage value at that time.
The depreciation rate is 10 per cent on written down value method. There would a cost savings of 10 lakhs due to
reduction in clerical numbers, 20 lakhs due to space released and 10 lakhs on account of inventory reduction.
Previous trends indicate that costs are inflating at 10% per annum. The tax rate for the
firm is 5096. Advice whether the company should invest in the Computer system.
[CMA-WB-2018]
Question No. -1.6 [Nov-2014-8M]
Gretel Limited is setting up a project for manufacture of boats at a cost of  300 lakhs. It has to decide whether to
locate the plant in next to the sea shore (Area A) or in a inland area with no access to any waterway (Area B). If the
project is located in Area B then Gretel Limited receives a cash subsidy of  20 lakhs from the central Government.
Besides, the taxable profit to the extent of 20% is exempt for 10 year in Area B.
The project envisages a borrowing of  200 lakhs in either case. The rate of interest Per annum is 12% in Area A
and 10% in Area B. The borrowing of principal has to be repaid in 4 equal installments beginning from the end of
the 4th year.
With the help of the following information, you are required to suggest the proper location for the CEO of Gretel
Limited. Assume straight line depreciation with no residual value, income tax 50% and required rate of return 15%.
Year Earnings before Depreciation, interest and Tax (EBDIT) ( In lakhs)
Area A Area B
1 (6) (50)
2 34 (50)
3 54 10
4 74 20
5 108 45
6 142 100
7 156 155
8 230 190
9 330 230
10 430 330
The PVIF @ 15% for 10 years are as below:
Year 1 2 3 4 5 6 7 8 9 10
PVIF 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25

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CAPITAL BUDGETING Page 13.7

CONFLICT BETWEEN NPV AND IRR

Question No. 2A [Inter-May-2003-8M]
The cash flows of projects C and D are reproduced below:
Cash Flow NPV
Project C0 C1 C2 C3 at 10% IRR
C − 10,000 + 2,000 + 4,000 + 12,000 + 4,139 26.5%
D − 10,000 + 10,000 + 3,000 + 3,000 + 3,823 37.6%
(i) Why there is a conflict of rankings?
(ii) Why should you recommend project C in spite of lower internal rate of return?

Question No. 2B [Inter-May-2008-8M]

A firm can make investment in either of the following two projects. The firm anticipates its cost of capital to be
10% and the net (after tax) cash flows of the projects for five years are as follows:
Figures in  ‘000)
Year 0 1 2 3 4 5
Project-A (500) 85 200 240 220 70
Project-B (500) 480 100 70 30 20

The discount factors are as under:

Year 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62
PVF (20%) 1 0.83 0.69 0.58 0.48 0.41
Required:
(i) Calculate the NPV and IRR of each project.
(ii) State with reasons which project you would recommend.
(iii) Explain the inconsistency in ranking of two projects.

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 2.1
VEDAVYAS Ltd. is considering two mutually exclusive projects M and project N. The Finance Director thinks
that the project with higher NPV should be chosen, whereas the Managing Director thinks that the one with the
higher IRR should be undertaken, especially as both projects have the same initial outlay and length of life. The
company anticipates a cot of capital of 10% and the net after-tax cash flow of the projects are as follows:
Year 0 1 2 3 4 5
Cash flows ()
Project M (4,00,000) 70,000 1,60,000 1,80,000 1,50,000 40,000
Project N (4,00,000) 4,36,000 20,000 20,000 8,000 6,000
You are required to:
(1) Calculate the NPV and IRR of each project.
(2) State with reasons, which project you would recommended.
(3) Explain the inconsistency in the ranking of the two projects
Present value Table is given:

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Page 13.8 STRATEGIC FINANCIAL MANAGEMENT
Year 0 1 2 3 4 5
PVIF at 10% 1.000 0.909 0.826 0.751 0.683 0.621
PVIF at 20% 1.000 0.833 0.694 0.579 0.482 0.402

[CMA-RTP/PTP-June-2015-New] [CMA-PTP-Dec-2014-New-10M]
Ans: (1) NPV: M= 58260, N = 37052; IRR: M = 16.05%, N = 18.79%;
(2) Both the projects are acceptable because they generate the positive NVP at the company’s cost
of capital at 10%. However, the company will have to select PROJECT M because it has higher
NPV. If the company follows IRR method, then PROJECT N should be selected because of higher
internal rate of return (IRR). But when NPV and IRR give contradictory results, a project with
higher NPV is generally preferred because of higher return in absolute terms. Hence, Project M
should be selected.
(3) The inconsistency in the ranking of the projects arises because of the difference in the pattern
of the cash flows. Project M’s major cash flow occur mainly in the middle three years whereas
project N generated the major cash flow in the first year itself.

PROJECT WITH UNEQUAL LIFE

Question No. - 3A [May-2000-old-12 Marks]
Company X is forced to choose between two machines A and B. The two machines are designed differently, but have
identical capacity and do exactly the same job. Machine A costs  1,50,000 and will last for 3 years. It costs  40,000
per year to run. Machine B is an ‘economy’ model costing only  1,00,000, but will last only for 2 years, and costs 
60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing power.
Ignore tax. Opportunity cost of capital is 10 per cent. Which machine company X should buy?
[CMA-TP-Dec-2013-5M] [CMA-RTP-Jun-2014/2015] [CMA-PTP/MTP-Dec-2014] [CMA-PTP-Jun-2015-8M]
Ans: A = 100313.63; B = 117604

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 3.1 [May-2014-5M]
ABC Chemicals is evaluating two alternative systems for waste disposal, System A and System B, which have lives
of 6 years and 4 years respectively. The initial investment outlay and annual operating costs for the two systems are
expected to be as follows:
System A System B
Initial Investment Outlay 5 million 4 million
Annual Operating Costs 1.5 million 1.6 million
Salvage value 1 million 0.5 million
If the hurdle rate is 15%, which system should ABC Chemicals choose?
The PVIF @ 15% for the six years are as below:
Year 1 2 3 4 5 6
PVIF 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
Ans: Ans: Equal Annual Cost (ECA): System A = 27,06,949; System B = 29,00,911; System A is beneficial

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CAPITAL BUDGETING Page 13.9
Question No. - 3.2 [May-2015-5M]
A manufacturing unit engaged in the production of automobile parts is considering a proposal of purchasing one
of the two plants, details of which are given below:
Particulars Plant A Plant B
Cost  20,00,000  38,00,000
Installation charges  4,00,000  2,00,000
Life 20 years 15 years
Scrap value after full life  4,00,000  4,00,000
Output per minute (units) 200 4000
The annual costs of the two plants are as follows:
Particulars Plant A Plant B
Running hours per annum 2,500 2,500
Costs: (in ) (in )
Wages 1,00,000 1,40,000
Indirect materials 4,80,000 6,00,000
Repairs 80,000 1,00,000
Power 2,40,000 2,80,000
Fixed Costs 60,000 80,000
Will it be advantageous to buy Plant A or Plant B? Substantiate yours answer with the help of comparative units
cost of the plants. Assume interest on capital at 10%. Make other relevant assumptions:
Note: 10 percent interest tables
20 years 15 years
Present value of  1 0.1486 0.2394
Annuity of  1 (capital recovery factor with 10% interest) 0.1175 0.1315

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Page 13.10 STRATEGIC FINANCIAL MANAGEMENT
CAPITAL RATIONING
Question No. - 4A
Five Projects M, N, O, P and Q are available to a company for consideration. The investment required for each
project and the cash flows it yields are tabulated below. Projects N and Q are mutually exclusive. Taking the cost
of capital @ 10%, which combination of projects should be taken up for a total capital outlay not exceeding 3
lakhs on the basis of NPV and Benefit-Cost Ratio (BCR)?
Project Investment Cash Flow P.a. No of Years PV @10%
M 50,000 18,000 10 6.145
N 1,00,000 50,000 4 3.170
O 1,20,000 30,000 8 5.335
P 1,50,000 40,000 16 7.824
Q 2,00,000 30,000 25 9.077
[CMA-WB-2018]

Question No. - 4B [Nov-1998-Old-8M]

S Ltd. has  10,00,000 allocated for capital budgeting purposes. The following proposals and associated
profitability indexes have been determined:
Project Amount() Profitability
Index
1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05
Which of the above investments should be undertaken? Assume that projects are indivisible and there is no
alternative use of the money allocated for capital budgeting.
[CMA-SM] [CMA-WB-2018] [CMA-MTP-June-2015-6M] [CMA-Dec-2002-8M]
Ans: Select 3,4 &5

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. – 4.1 [RTP-May-2015]
JHK Private Ltd. is considering 3 projects (not mutually exclusive) has no cash reserves, but could borrow upto 
60 crore @ of 10% p.a. Though borrowing above this amount is also possible, but it shall be at a much higher rate
of interest.
The initial capital outlay required, the NPV and the duration of each of these projects is as follows:
Initial Capital Outlay NPV Duration (Years)
( Crore) ( Crore)
Project X 30.80 5.50 6
Project Y 38.00 7.20 7
Project Z 25.60 6.50 Indefinite

Other information:
1. Cost of capital of JHK is 12%.
2. Applicable tax rate is 30%.

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CAPITAL BUDGETING Page 13.11
3. All projects are indivisible in nature and cannot be postponed.
You are required to:
(a) Comment whether given scenario is a case of hard capital rationing or soft capital rationing.
(b) Which project (or combination thereof) should be accepted if these investment opportunities are likely to be
repeated in future also?
(c) Assuming that these opportunities are not likely to be available in future then and Government is ready to
support Project Y on following terms then which projects should be accepted.
(i) A cash subsidy of  7 crore shall be available.
(ii) 50% of initial cash outlay shall be available at subsidized rate of 8% and repaid in 8 equal installments
payable at the end of each year.

Question No. – 4.2

ABC Ltd. has a capital budget of  2 crore for the year. From the following information relating to six
independent proposals, select the projects if (i) the projects are divisible and (ii) projects are indivisible in order to
maximise the NPV.
Proposal Investment () NPV ()
I 8,500,000 5,000,000
II 3,500,000 2,600,000
III 6,000,000 2,000,000
IV 4,000,000 2,500,000
V 6,000,000 5,000,000
VI 8,000,000 (2,500,000)
[CMA-June-2017-6M]

Question No. – 4.3

From the following information determine the optimal combination of projects assuming that the projects are
divisible and indivisible.
Project Required initial Investment NPV at appropriate cost of capital
A1 1,00,000 20,000
A2 3,00,000 35,000
A3 50000 16,000
A4 2,00,000 25,000
A5 1,00,000 30,000
[CMA-SM]

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Page 13.12 STRATEGIC FINANCIAL MANAGEMENT
REPLACEMENT DECISION
Question No. - 5A [Nov-1996-old-12 Marks]
Nine Gems Ltd. has just installed Machine – R at a cost of  2,00,000. The machine has a five year life with
no residual value. The annual volume of production is estimated at 1,50,000 uni ts, which can be sold at  6
per unit. Annual operating costs are estimated at  2,00,000 (excluding depreciation) at this output level.
Fixed costs are estimated at  3 per unit for the same level of production.
Nine Gems Ltd. has just come across another model called Machine – S capable of giving the same output at
an annual operating cost of  1,80,000 (exclusive of depreciation). There will be no change in fixed costs.
Capital cost of this machine is  2,50,000 and the estimated life is for five years with nil residual value.
The company has an offer for sale of Machine – R at  1,00,000. But the cost of dismantling and removal will
amount to  30,000. As the company has not yet commenced operations, it wants to sell Machine – R and
purchase Machine –S.
Nine Gems Ltd. will be a zero-tax company for seven years in view of several incentives and allowances
available.
The cost of capital may be assumed at 14%. P.V. factors for five years are as follows:
Year 1 2 3 4 5
P.V. 0.877 0.769 0.675 0.592 0.519
Factors
(i) Advise whether the company should opt for the replacement.
(ii) Will there be any change in your view, if Machine-R has not been installed but the company is in the
process of selecting one or the other machine?
Support your view with necessary workings.
[CMA-Dec-2018-8M] [CMA-Compendium] [CMA-Dec-2013-10M]
Ans: (i) NPV = -111360; (ii) R = 6,58,000; S = 6,76,640

Question No. - 5B
Electronics Pvt. Ltd. is considering a proposal to replace one of its machines. In this connection, the following
information is available:
The existing machine was purchased 3 years ago for  20 Lakh. It was depreciated 20 per cent per annum on
reducing balance basis. It has remaining useful life of 5 years, but its maintenance cost is expected to increase by 
1 Lakh per year from the end of sixth year of its installation. Its present realizable value is  12 Lakh. The company
has several machines having 20% depreciation.
The new machine costs 30 Lakh and is subject to the same rate and basis of depreciation. On sale after 5 years, it
is expected to realize 18 Lakh. With the new machine, the annual pre-tax operating costs (excluding depreciation)
are expected to decrease by 2 Lakh. In addition, the machine would increase productivity on account of which net
pre-tax revenues would increase by 3 Lakh annually
(reckoned at year end). The tax rate applicable to the company is 40% and the cost of capital is 10 per cent.
Advise the company on the choice of the machine from a financial perspective on the basis of NPV.
Year 1 2 3 4 5
P.V. Factors @10% 0.909 0.826 0.751 0.683 0.621
Present an incremental analysis of using the existing machine versus replacing the machine with a new one. Present
annual discounted cash flows in your answers with separate calculation showing annual discounted cash flows on
account of incremental depreciation without netting off capital asset outflows or inflows. Calculations are to be
presented to the nearest rupee. P.V. factors with above decimal places should be used.
[CMA-June-2018-10M]

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CAPITAL BUDGETING Page 13.13
Question No. - 5C [May-2019-Old-5M]
SS Company is considering the replacement of its existing machine with a new machine. The Purchase price of the
New machine is 26 Lakhs and its expected Life is 8 years. The company follows straight-line method of
depreciation on the original investment (scrap value is not considered for the purpose of depreciation). The other
expenses to be incurred for the New Machine are as under:
(i) Installation Charges 9,000
(ii) Fees paid to the consultant for his advice to buy New Machine 6,000.
(iii) Additional Working Capital required 17,000. (will be released after 8 years)
The written down value of the existing machine is 76,000, and its Cash Salvage Value is 12,500. The dismantling
of this machine would cost 4,500. The Annual Earnings (before tax but after depreciation) from the New Machine
would amount to 3,15,000. Income tax rate is 35%. The Company's required Rate of Return is 13%.
You are required to advise on the viability of the proposal.
PVIF (13%, 8) = 0.376; PVIFA (13%, 8) = 4.80
Ans:

Question No. - 5D [Nov-2008-New-8 Marks]

Company has to replace one of its machines which has become unserviceable. Two options are available:
(i) A more expensive machine (EM) with 12 years of life,
(ii) A less expensive machine (LM) with 6 years of life.
If machine LM is chosen, it will be replaced at the end of 6 years by another LM machine. The pattern of
maintenance, running costs and prices are as under:
Particulars EM LM
Purchase price 10,00,000 7,00,000
Scrap value at the end of life 1,50,000 1,50,000
Overhauling is due at the end of 8th year 4th year
Overhauling costs 2,00,000 1,00,000
Annual repairs 1,00,000 1,40,000
Cost of capital - 14%

You are required to recommend with supporting calculations which of the machines should be purchased.
End of 4th year 0.5921
End of 6th year 0.4556
End of 8th year 0.3506
End of 12th year 0.2076
Years 1 to 6 3.8890
Years 1 to 12 5.6600
[CMA-WB-2018]
Ans: Annualised value EM: 2,83,565; LM: 3,17,647; Replace existing machine with EM

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Page 13.14 STRATEGIC FINANCIAL MANAGEMENT

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 5.1
Apex Enterprises is interested in assessing the cash flows associated with the replacement of the old machine by a
new machine. The old machine has a book value of  90,000 which can be sold for the same amount. It has a
remaining life of 5 years, after which the salvage value is expected to be 'nil'. It is being depreciated annually @
10% using the written down value method.
The new machine costs  4 lakhs, and has a resale value of 2.5 lakhs at the end of 5 years. The new machine is
expected to save manufacturing costs of  1 lakh p,a. Investment in working capital remains same. The tax rate
applicable to the firm is 50%.
You, as a Project Analyst, are required to work out the incremental cashflows associated with the
replacement of the old machine and to prepare a statement to be presented to the management for consideration.
Ans:
[CMA-WB-2018]

Question No. – 5.2 [Nov-2008-8M]

A manufacturing company has an old machine having no book value which can be sold now for  1,00,000. It can
be used for another five years after which it will have to be condemned without any sale value. The company is
examining the following options:

Option I: To upgrade the existing machine at a cost of  20 lacs and continue operations for a further 5 years at
the end of which the  20 lacs would have also fully been depreciated equally over the next 5 years and will fetch
a sale value of  50,000 at the end of the 5th year.

Option II: To replace the old machine with a new one costing  40 lacs which will have a useful life of 5 years,
during which it will be fully depreciated equally. At the end of the 5th year, this machine will have a resale value
of  10 lacs.
The following figures are the after-tax cash profits in rupees without the depreciation shield and the salvage values
for the existing situation and the fresh options:
End of year Existing Machine Upgraded Machine New Machine
1 10,00,000 11,00,000 12,00,000
2 10,80,000 11,80,000 12,80,000
3 11,20,000 12,20,000 13,80,000
4 12,00,000 13,00,000 14,80,000
5 13,00,000 14,00,000 16,00,000

The hurdle rate used for evaluation is 15%.

Consider that the salvage values and profits will be subjected to tax at the normal tax rate of 40%.
Present an incremental analysis of options I and II and state which is better.
Evaluate the better option above over continuing with the old machine without upgrading.
[CMA-Dec-2017-8M]
Ans:

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CAPITAL BUDGETING Page 13.15

Question No. - 5.3 [May-2002-14M]

X Ltd. an existing profit-making company, is planning to introduce a new product with a projected life of 8
years. Initial equipment cost will be  120 lakhs and additional equipment costing  10 lakhs will be needed
at the beginning of third year. At the end of the 8 years, the original equipment will have resale value
equivalent to the cost of removal, but the additional equipment would be sold for  1 lakhs. Working Capital
of  15 lakhs will be needed. The 100% capacity of the plant is of 4,00,000 units per annum, but the production
and sales-volume expected are as under:
Year Capacity in
percentage
1 20
2 30
3-5 75
6-8 50
A sale price of  100 per unit with a profit-volume ratio of 60% is likely to be obtained. Fixed Operating Cash
Cost are likely to be  16 lakhs per annum. In addition to this the advertisement expenditure will have to be
incurred as under:
Year 1 2 3-5 6-8
Expenditure in  lakhs each 30 15 10 4
year
The company is subject to 50% tax, straight-line method of depreciation, (permissible for tax purposes also)
and taking 12% as appropriate after tax Cost of Capital, should the project be accept ed?
[CMA-Compendium] [CMA-RTP-Dec-2014]

Question No. – 5.4

Das Ltd. A manufacturing company produces 25000 liters of special lubricants in its plant. The existing plant is
not fully depreciated for tax purposes and has a book value of 3 lakhs (it was bought for 6 lakh six year ago).
The cost of the product is as under:
Particulars Cost/liter ()
Variable costs 60.00
Fixed overheads 15.00
75.00
It is expected that the old machine can be used for further period of 10 years by carrying out suitable repairs at a
cost of 2 lakh annually.
A manufacturer of machinery is offering a new machine with the latest technology at 10 lakhs after trading off
the old plant (machine) for 1 lakh. The projected cost of the product will then be:
Particulars Cost/Liter ()
Variable costs 45.00
Fixed overheads 20.00
65.00
The fixed overheads are allocations from other department plus the depreciation of plant and machinery. The old
machine can be sold for 2 lakh in the open market. The new machine is expected to last for 10 years at the end
of which, its salvage value will be 1 lakhs. Rate of corporate taxation is 50%. For tax purposes, the cost of the
new machine and that of the old ane may be depreciated that in future the demand for the product will remain at
25000 liters.
Advise whether the new machine can be purchased Ignore capital gain taxes.
[Given: PVIFA (10%, 10 years) = 6.145, PVIF (10%, 10 years) = 0.386]
[CMA-TP-Dec-2013-10M]

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Page 13.16 STRATEGIC FINANCIAL MANAGEMENT
Question No. – 5.5 [May-1997-20M]
Excel Ltd. manufactures a special chemical for sale at  30 per kg. The variable cost of manufacture is  15
per kg. Fixed cost excluding depreciation is  2,50,000. Excel Ltd. is currently operating at 50% capacity. It
can produce a maximum of 1,00,000 kgs at full capacity.
The Production Manager suggests that if the existing machines are fully replaced the company can achieve
maximum capacity in the next five years gradually increasing the production by 10% per year.
The Finance Manager estimates that for each 10% increase in capacity, the additional increase in fixed cost
will be  50,000. The existing machines with a current book value of  10,00,000 can be disposed of for 
5,00,000. The Vice-President (finance) is willing to replace the existing machines provided the NPV on
replacement is about  4,53,000 at 15% cost of capital after tax.
(i) You are required to compute the total value of machines necessary for replacement.
For your exercise you may assume the following:
(a) The company follows the block assets concept and all the assets are in the same block. Depreciation
will be on straight-line basis and the same basis is allowed for tax purposes.
(b) There will be no salvage value for the machines newly purchased. The entire cost of the assets will be
depreciated over five year period.
(c) Tax rate is at 40%.
(d) Cash inflows will arise at the end of the year.
(e) Replacement outflow will be at the beginning of the year (year 0).
Year 0 1 2 3 4 5
Discount Factor at 1 0.87 0.76 0.66 0.57 0.49
15%
(ii) On the basis of data given above, the managing director feels that the replacement, if carried out, would
at least yield post tax return of 15% in the three years provided the capacity build up is 60%, 80% and
100% respectively. Do you agree?
[CMA-Compendium] [CMA-RTP-Dec-2013] [CMA-MTP-June-2014-12M]

Question No.- 5.6 [May-1998-20M]

S Engineering Company is considering to replace or repair a particular machine, which has just broken down.
Last year this machine costed  20,000 to run and maintain. These costs have been increasing in real terms in
recent years with the age of the machine. A further useful life of 5 years is expected, if immediate repairs of
 19,000 are carried out. If the machine is not repaired it can be sold immediately to realize about  5,000
(Ignore loss/gain on such disposal).
Alternatively, the company can buy a new machine for  49,000 with an expected life of 10 years with no
salvage value after providing depreciation on straight line basis. In this case, running and maintenance costs
will reduce to  14,000 each year and are not expected to increase much in real term for a few years at least.
S Engineering Company regard a normal return of 10% p.a. after tax as a minimum requirement on any new
investment. Considering capital budgeting techniques, which alternative will you choose? Take corporate tax
rate of 50% and assume that depreciation on straight line basis will be accepted f or tax purposes also.
Given cumulative present value of Re. 1 p.a. at 10% for 5 years  3.791, 10 years  6.145.
[CMA-Compendium]

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CAPITAL BUDGETING Page 13.17

REPLACEMENT AT OPTIMAL POINT

Question No. - 6A [June-2009-Old-10 Marks] [May-2004-old-10 Marks] [RTP-May-2014]
A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it. A & Co.
currently pays no taxes. The replacement machine costs  90,000 now and requires maintenance of  10,000 at
the end of every year for eight years. At the end of eight years it would have a salvage value of  20,000 and would
be sold. The existing machine requires increasing amounts of maintenance each year and its salvage value falls
each year as follows:
Year Maintenance Salvage
Present 0 40000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for A & Co. is 15%
Required:
When should company replace the machine?
(Note: Present value o f an annuity of 1 per period for 8 Years at interest rate of 15%: 4.4873; Present value of
1 to be received after 8 years at interest rate of 15%: 0.3269)
[CMA-SM] [As CMA-June-2017-8M]
Ans: Equivalent annual cost if replace the machine: 28600
[Cost to continue Y1 = 31,000; Y2 = 33.750; Y3 = 37250; Y4 = 51500]; Decision: Replace immediately

Question No. - 6B [May-2012-10M]

A machine used on a production line must be replaced at least every four year. Costs incurred to run the machine
according to its age are:
Age of the Machine (year)
0 1 2 3 4
Purchase price (in ) 60,000
Maintenance (in ) 16,000 18,000 20,000 20,000
Repair (in ) 0 4,000 8,000 16,000
Scrap Value (in ) 32,000 24,000 16,000 8,000
Future replacement will be with identical machine with same cost. Revenue is unaffected by the age of the
machine. Ignoring inflation and tax, determine the optimum replacement cycle. PV factors of the cost of capital of
15% for the respective four year are 0.8696, 0.7561, 0.6575 and 0.5718
[CMA-WB-2018]

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. – 6.1 [May-2000-old-8 Marks]
Company Y is operating an elderly machine that is expected to produce a net cash inflow of  40,000 in the coming year
and  40,000 next year. Current salvage value is  80,000 and next year’s value is  70,000. The machine can be
replaced now with a new machine, which costs  1,50,000, but is much more efficient and will provide a cash inflow of
 80,000 a year for 3 years. Company Y wants to know whether it should replace the equipment now or wait a y ear with
the clear understanding that the new machine is the best of the available alternatives and that it in turn be replaced at th e
optimal point. Ignore tax. Take opportunity cost of capital as 10 per cent. Advise with reasons.
[CMA-PTP-June-2015-New-8M] [CMA-PTP-Dec-2014-New-(3+3+2)=8M]

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Page 13.18 STRATEGIC FINANCIAL MANAGEMENT
Question No. – 6.2 [RTP-NOV-2013] [MTP-Nov-2013-5M]
Trouble free solution (TFS) is an authorized service center of a reputed domestic air conditioner manufacturing
company. All complaints/service related matter of Air conditioner are attended by this service centre. The service
centre employs a large number of mechanics travels approximately 40000 kms per annum. TFS decides to continue
its present policy of always buying a new bike for its mechanics but wonders whether the present policy of replacing
the bike every three year is optimal or not. It is of believe that as new models are entering into market on yearly
basis, it wishes to consider whether a replacement of either one year or two years would be better option than present
three period. The fleet of bike is due for replacement shortly in near future.
The purchase price of latest model bike is 55000. Resale value of used bike at current price in market is as follows:
Period 
1 year old 35000
2 year old 21000
3 year old 9000
Running and maintenance expenses (excluding depreciation) are as follows:
Year Road Taxes Insurance Co. () Petrol Repair Maintenance etc. ()
1 3000 30000
2 3000 35000
3 3000 43000
Using opportunity cost of capital as 10% you are required to determine optimal replacement period of bike.

Question No. – 6.3 [RTP-NOV-2014] [MTP-May-2014-5M]

XYZ Food Pvt. Ltd., a franchisee of Domino’s (World famous food chain for delivering pizza at home) is
considering a proposal of acquiring a fleet of motorbikes for delivery of pizzas at home of customers. Since pizzas
are also delivered in late night and bikes are handled by different delivery boys (due shift working) the use of fleet
will be very heavy. Hence it is expected that the motorbike shall be virtually worthless and scrapped after a period
of 3 years. However they are taken out of services before 3 years there will be a positive ‘abandonment’ cash flow.
The initial cost of the bike will be 1,00,000. The expected post tax benefit (cash inflows) from the use of bike and
abandonment cash inflows are as follows:
Year Operating Cash Flows () Abandonment Cash Flows at end of year ()
1 42,000 62,000
2 40,000 40,000
3 35,000 0

The cost of capital of XYZ Pvt. Ltd. is 10%. You are required to evaluate the proposal of acquisition of bikes and
recommend preferable life of the same.

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CAPITAL BUDGETING Page 13.19

PROJECT IRR AND EQUITY IRR

Question No. -7A [Nov-2001-old-14 Marks]
Complex Ltd., an infrastructure company is evaluating a proposal to build, operate and transfer a section of 20 kms.
of road at a project cost of 400 crores to be financed as follows:
Equity Shares Capital  100 crores, loans at the rate of interest of 15% p.a. from financial institutions  300 crores.
The Project after completion will be opened to traffic and a toll will be collected for a period of 15 years from the
vehicles using the road. The company is also required to maintain the road during the above 15 years and after the
completion of that period, it will be handed over to the Highway authorities at zero value. It is estimated that the
toll revenue will be  100 crores per annum and the annual toll collection expenses including maintenance of the
roads will amount to 5% of the project cost. The company considers to write off the total cost of the project in 15
years on a straight line basis. For Corporate Income-tax purposes the company is allowed to take depreciation @
10% on WDV basis. The financial institutions are agreeable for the repayment of the loan in 15 equal annual
instalments – consisting of principal and interest.
Calculate Project IRR and Equity IRR. Ignore Corporate taxation. Explain the difference in Project IRR and Equity
IRR.
[CMA-SM]

BASE NPV AND ADJUSTED NPV

Question No. – 8A [RTP-May-2010-Old]
TLC is considering a perpetual project with initial investment is 10,00,00,000, and the expected cash inflow is 
85,00,000 a year in perpetuity. The opportunity cost of capital with all-equity financing is 10 percent, and cost of
debt is 8%. Since the project is based on the solar technology Government is subsiding the cost of debt by 1%.
Corporate tax rate is 35%. Use APV (Adjusted Present Value) to calculate this project’s value assuming that.
(a) First that the project will be partly financed with  4,00,00,000 of debt and that the debt amount is to be fixed
and perpetual.
(b) The initial borrowing will be increased or reduced in proportion to changes in the future market value of this
project.
Also explain the reasons difference between above two answers
Ans: (a) Base case NPV = - 150 Lakh; ANPV = - 10,00,000; (b) ANPV = - 52,00,000

Question No. – 8B
A firm is considering a project requiring 50 lakh of investment. Expected cash flow is 10 lakh per annum for 8
years. The rate of return required by the equity investors from the project is 15%. The firm is able to raise  24 lakh
of debt finance carrying 14% interest for the project. The debt is repayable in equal annual instalments over the
eight-year period (the first to be paid at the end of the first year). The tax rate is 40%. Assume, Issue cost of Equity
is 5%.
Calculate Base case NPV and Adjusted NPV
[CMA-SM]
Ans: (-)512700; (-)246367

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Page 13.20 STRATEGIC FINANCIAL MANAGEMENT

UNIT - II

RISK ANALYSIS IN
CAPITAL BUDGETING
Learning Outcomes

❑ Discuss the concept of Risk and Uncertainty in Capital Budgeting.

❑ Discuss the Sources of Risk.
❑ Understand reasons for adjusting risk in Capital Budgeting.
❑ Understand various techniques used in Risk Analysis in Capital Budgeting.
❑ Discuss Concepts, Advantages and Limitations of various techniques of Risk analysis in
Capital Budgeting.
❑ Inflation adjustment in Capital budgeting decision

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CAPITAL BUDGETING Page 13.21

CERTAINTY EQUIVALENT APPROACH & RADR

Question No. - 10A [Nov-1999-old- 6 Marks] [CMA-Compendium]
The Globe Manufacturing Company Ltd. is considering an investment in one of the two mutually exclusive
proposals – Projects X and Y, which require cash outlays of  3,40,000 and  3,30,000 respectively. The
certainty-equivalent (C.E.) approach is used in incorporating risk in capital budgeting decisions. The current
yield on government bond is 8% and this be used as the riskless rate. The expected net cash flows and their
certainty-equivalents are as follows:
Project Y Project X
Year-end Cash flow C.E. Cash flow C.E.
 
1 1,80,000 .8 1,80,000 .9
2 2,00,000 .7 1,80,000 .8
3 2,00,000 .5 2,00,000 .7
Present value factors of Re. 1 discounted at 8% at the end of year 1, 2 and 3 are .926, .857 and .794 respectively.
Required:
(i) Which project should be accepted?
(ii) If risk adjusted discount rate method is used, which project would be analyzed with a higher rate?

Ans: (i) NPV: X = 44580, Y = 27.24; Accept-X

(ii) Project Y should be analysed with higher rate because project Y is more risky

Question No. - 10B [May-1999-Old-6 Marks] [As Nov-2005-Old-6 Marks] [CS-June-05-10 M]

Determine the risk adjusted net present value of the following projects:
A B C
Net cash outlays () 1,00,000 1,20,000 2,10,000
Project life 5 years 5 years 5 years
Annual cash inflow () 30,000 42,000 70,000
Coefficient of variation 0.4 0.8 1.2

The company selects the risk-adjusted rate of discount on the basis of the co-efficient of variation:
Coefficient of variation Risk adjusted rate of Present value factor 1 to 5 years
discount at risk adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
[CMA-WB-2018]
Ans: Risk Adjusted NPV: A = 8150; B = 24,186; C = 19,180

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Page 13.22 STRATEGIC FINANCIAL MANAGEMENT
Question No. - 10C [May-2016-10M] [Nov-2009-old-10 Marks]
New projects Ltd. is evaluating 3 projects, P-I, P-II, P-III. Following information is available in respect of these projects:
P-I P-II P-III
Cost 15,00,000 11,00,000 19,00,000
Inflows - Year 1 6,00,000 6,00,000 4,00,000
Year 2 6,00,000 4,00,000 6,00,000
Year 3 6,00,000 5,00,000 8,00,000
Year 4 6,00,000 2,00,000 12,00,000
Risk index 1.80 1.00 0.60
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The risk-free interest rate is 10%.
Required:
(i) Find risk adjusted discount rate (RADR) for these projects.
(ii) Which project is best?
Ans: RADR(P-I)=19%; P-II = 15%; P-III = 13%; (ii) NPV: P-I = 83151; P-II = 167800; P-III = 213800
Hint: Use RADR = Risk free rate + Risk index X (Ke - RF

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. – 10.1 [Nov-2003-old-12 Marks]
The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive proposals,
Projects M and N, which require cash outlays of  8,50,000 and  8,25,000 respectively. The
certainty-equivalent (C.E) approach is used in incorporating risk in capital budgeting decisions. The
current yield on government bonds is 6% and this is used as the risk free rate. The expected net cash
flows and their certainty equivalents are as follows:
Project M Project N
Year-end Cash Flow  C.E. Cash Flow  C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of Re. 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 and
0.840 respectively. Required:
(i) Which project should be accepted?
(ii) If risk adjusted discount rate method is used, which project would be appraised with a higher rate and why?
Ans: (i) NPV: M = 10,980; N = 1,71,315; Accept project – N;
(ii) Projet M should be appraised with a higher rate as it is more risky.

Question No. - 10.2

VATSAN LTD. is considering a project with the following expected cash flows:
Initial investment: 1,00,000
Year 1 2 3
Expected Cash Inflows 70,000 60,000 45,000
Due to uncertainty of future cash flows, the management decides to reduce the cash inflows to certainty equivalent (CE)
by taking only 80% for 1 st year, 70% for 2 nd year and 60% for 3 rd year respectively.
The cost of capital is 10%. Required: Is it worthwhile to take up the pro ject?
[CMA-Dec-2013-5 Marks] [CMA-Dec-2009-5 Marks] [CMA-MTP-June-2014-New-5M]
Ans: 5873

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CAPITAL BUDGETING Page 13.23

Question No. - 10.3

You have been asked to evaluate an investment project for the L.G. construction company Ltd. the project requires an
initial investment of  12,00,000 with 6 year life, with no salvage value and to be depreciated on a straight line basis for
tax purposes. Cash earnings before depreciation and taxes are projected in each of the next 6 years as:
Amount () Probability of occurrence
2,00,000 .20
4,00,000 .40
6,00,000 .40
The risk - free interest rate is 8% and the firm has a policy of assigning CE factors of 0.90 to the cash inflows of
projects equal to risk class, such as revenue expansion projects involving existing product lines. For projects which
require the firm’s entry into new product areas. CE quotients of 0.8 is used to adjust cash inflows. The tax rate is
35%.
(i) Determine the annual cash inflows prior to any risk adjustment.
(ii) Calculate the risk - adjusted NPV for the project if it involves expansion of (a) existing product lines, (b) new
product areas.
Ans: (i) 3,56,000; (ii) Existing line = 281,209; New line = 116,630

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Page 13.24 STRATEGIC FINANCIAL MANAGEMENT
STATISTICAL TECHNIQUES [EXPECTED NPV, SD & CV]
Question No. - 11A [June-2009-old-14 Marks] [May-1999-14 Marks] [Study Mat.]
A company is considering two mutually exclusive projects X and Y. Project X costs  30,000 and
Project Y  36,000. You have been given below the net present value, probability distribution for
each project:
Project X Project Y
NPV Estimate Probability NPV Estimate Probability
 
3,000 0.1 3,000 0.2
6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2
(i) Compute the expected net present value of Projects X and Y.
(ii) Compute the risk attached to each project i.e., Standard Deviation of each probability distribution.
(iii) Which project do you consider riskier and why?
(iv) Compute the profitability index of each project.
[CMA-SM/WB] [CMA-Dec-2003-20M] [CMA-Compendium] [CMA-June-2014-10M] [CMA-RTP-Dec-2014]
Ans: (i) Expected NPV (X) = 9,000; Y = 9,000 (ii) σx = 3795; σy = 4,450; (iii) Project Y is more risky.
(iv) PI: X = 1.30; Y = 1.25

Question No. - 11B [Nov-2006-old-16 Marks]

Following are the estimates of the net cash flows and probability of a new project of M/s X Ltd.:
Year P=0.3 P=0.5 P=0.2
Initial investment 0 4,00,000 4,00,000 4,00,000
Estimated net after tax cash 1 to 5 1,00,000 1,10,000 1,20,000
inflows per year
Estimated salvage value (after 5 20,000 50,000 60,000
tax)
Required rate of return from the project is 10%.
Find:
(i) the expected NPV of the project.
(ii) the best case and the worst case NPVs.
(iii) the probability of occurrence of the worst case if the cash flows are perfectly dependent
overtime independent overtime.
(iv) Standard deviation and coefficient of variation assuming that there are only three streams of
cash flow, which are represented by each column of the table with the given probabilities.
(v) Coefficient of variation of X Ltd. on its average project which is in the range of 0.95 to 1.0. If
the coefficient of variation of the project is found to be less riskier than average, 100 basis
points are deducted from the Company’s cost of Capital
Should the project be accepted by X Ltd?
[CMA-TP-Dec-2013-20M]
Ans: (i) Expected NPV = 39813; (ii) Best NPV = 92,060; worst NPV = - 8,580;
(iii) 0.3; (0.3)5 (iv) 35,800; CV = 0.90 (v) Expected NPV = 51851.

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CAPITAL BUDGETING Page 13.25

Question No. - 11C [May-2003-3M]

A company is considering Projects X and Y with following information:
Project Expected NPV () Standard deviation
X 1,22,000 90,000
Y 2,25,000 1,20,000
(i) Which project will you recommend based on the above data?
(ii) Explain whether your opinion will change, if you use coefficient of variation as a measure of risk.
(iii) Which measure is more appropriate in this situation and why?
[Point (ii)-CMA-PTP-June-2015-2M] [CMA-PTP-Dec-2014-2M]

Question No. - 11D [May-2018-5M]

KLM Ltd., is considering taking up one of the two projects-Project-K and Project-So Both the projects having same
life require equal investment of 80 lakhs each. Both are estimated to have almost the same yield. As the company
is new to this type of business, the cash flow arising from the projects cannot be estimated with certainty. An attempt
was therefore, made to use probability to analyse the pattern of cash flow from other projects during the first year
of operations. This pattern is likely to continue during the life of these projects. The results of the analysis are as
follows:
Project K Project S
Cash Flow (in ) Probability Cash Flow (in ) Probability
11 0.10 09 0.10
13 0.20 13 0.25
15 0.40 17 0.30
17 0.20 21 0.25
19 0.10 25 0.10
Required:
(i) Calculate variance, standard deviation and co-efficient of variance for both the projects.
(ii) Which of the two projects is more risky?

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. – 11.1 [Nov-2002-14M] [As Nov-2010-12M] [As May-2013-8M]
Skylark Airways is planning to acquire a light commercial aircraft for flying class clients at an investment of  50,00,000.
The expected cash flow after tax for the next three years is as follows:
Year 1 Year 2 Year 3
CFAT Probability CFAT Probability CFAT Probability
14,00,000 0.1 15,00,000 0.1 18,00,000 0.2
18,00,000 0.2 20,00,000 0.3 25,00,000 0.5
25,00,000 0.4 32,00,000 0.4 35,00,000 0.2
40,00,000 0.3 45,00,000 0.2 48,00,000 0.1
The Company wishes to take into consideration all possible risk factors relating to an airline operation. The company
wants to know:
(i) The expected NPV of this venture assuming independent probability distribution with 6 per cent risk free rate of
interest.
(ii) The possible deviation in the expected value.
[CMA-PTP-June-2014/2015-10M] [CMA-RTP-Dec-2014] [CMA-PTP-Dec-2014-10M]
Ans: (i) NPV = 24.974 (ii) σProject (Cash flows) = 14.3695

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Page 13.26 STRATEGIC FINANCIAL MANAGEMENT
Question No. – 11.2 [May-2003-3M]
Cyber Company is considering two mutually exclusive projects. Investment outlay of both the projects is 
5,00,000 and each is expected to have a life of 5 years. Under three possible situations their annual cash flows
and probabilities are as under:

Cash Flow ()

Situation Probabilities Project A Project B
Good 0.3 6,00,000 5,00,000
Normal 0.4 4,00,000 4,00,000
Worse 0.3 2,00,000 3,00,000
The cost of capital is 7 per cent, which project should be accepted? Explain with workings.
[CMA-MTP-June-2014-5M]

Question No. – 11.3

The following information is given in respect of two projects X and Y:
X Y
Initial outlay at the beginning
6000 5000
of the first year
After Tax year end cash Cash inflow Probability Cash inflow Probability
inflows with probabilities:
Year 1 2000 0.4 800 0.2
3000 0.6 2000 0.8
Year 2 4000 0.3 2000 0.4
2000 0.7 1000 0.6
Year 3 3000 0.5 2025 0.2
2200 0.5 4000 0.8

The risk-free discount rate is 10% and the risk adjusted discount rate is 14.13%.
Assume that cash flows are independent from year to year.
It is given that the annual standard deviation of cash inflows for X are 490, 916.5 and 400 and for Y are 480, 490
and 790.
(i) Find the NPVs for both the projects and based on this, which would you choose?
(ii) Which project would you prefer in terms of risk? Why?
[CMA-Dec-2017-8M]
Ans: NPV of both: 463.6; SD (X): 928.1291; SD (Y): 840.2684

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CAPITAL BUDGETING Page 13.27

Question No. – 11.4 [May-2005-12M]

Project X and Project Y are under the evaluation of XY Co. The estimated cash flows and their probabilities
are as below:
Project X: Investment (year 0)  70 lakhs
Probability weights 0.30 0.40 0.30
Years  lakhs  lakhs  lakhs
1 30 50 65
2 30 40 55
3 30 40 45

Project Y: Investment (year 0)  80 lakhs.

Probability weighted Annual cash flows through life
 lakhs
0.20 40
0.50 45
0.30 50
(a) Which project is better based on NPV, criterion with a discount rate of 10%?
(b) Compute the standard deviation of the present value distribution and analyse the inherent risk of the
projects.
Ans: (a)NPV: X = 37.28; Y = 33.11; (b)

Question No.- 11.5 [MTP-May-2014-10M]

XY Ltd. has under its consideration a project with an initial investment of  1,00,000. Three probable cash inflow
scenarios with their probabilities of occurrence have been estimated as below:
Annual cash inflow () 20,000 30,000 40,000
Probability 0.1 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  0, 20,000 and 30,000.
You are required to:
(i) Find the probable NPV;
(ii) Find the worst-case NPV and the best-case NPV; and
(iii) State the probability occurrence of the worst case, if the cash flows are perfectly positively correlated over
time.

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Page 13.28 STRATEGIC FINANCIAL MANAGEMENT
CAPITAL BUDGETING BASED ON UTILITIES
Question No.-12A [May-2011-8 Marks]
Jumble consultancy Group has determined relative utilities of cash flows of two forthcoming projects of its client
company as follows:
Cash Flows in  -15,000 -10,000 -4000 0 15000 10000 5000 1000
Utilities -100 -60 -3 0 40 30 20 10
The distribution of cash flows of project A and Project B are as follows:
Project A
Cash flow () -15,000 -10,000 15,000 10,000 5,000
Probability 0.10 0.20 0.40 0.20 0.10
Project B
Cash flow () -10,000 -4,000 15,000 5,000 10,000
Probability 0.10 0.15 0.40 0.25 0.10
Which project should be selected and why?
Ans: Project B would be selected [Expected utilities A = 2; Expected utilities B = 17.55]

Question No.-12B [Read with Portfolio Concept]

ABC Ltd., is a consumer goods company which earns expected return of 14% on its existing operations subject to
standard deviation of 20%. The company is owned by a family and the family has no other investment. New project
is under consideration and the new project is expected to give a return of 18% subject to standard deviation of 32%.
The new project has a correlation of 0.25 with ABC’s existing operations.
The new project is likely to account for 25% of ABC’s operations. ABC is identified a utility function to apprise
risky project. The function is as under:-
Shareholder’s utility = 100R - 𝜎 2 ; Where, R = Expected Return (in %); σ = Standard deviation of return (in %)
The project can be accepted only if total utility goes up. Evaluate the project.
[CMA-MTP-June-2014-6M]
Ans: Share holders utility without the project = (100 × 14) - 202 = 1000 units
Shareholders utility with the project = (100 × 13) - (18.68)2 = 1151 units
Hence, Project will be accepted as it will increase the Utility.

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CAPITAL BUDGETING Page 13.29

PROBABILITY OF RANGE OF NPV

Question No.-13A
A project has a mean NPV of  40 and standard deviation of NPV is 20. The finance manager wants to determine
the probability of the NPV under the following ranges:
(a) Zero or less
(b) Greater than zero
(c) Between the range of  25 and  45
[CMA-SM]

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. -13.1
The project has a mean NPV of 800, S.D. of 400. The management wants to determine the probability of the
NPV under the following ranges.
(i) Zero or less
(ii) Greater than zero
(iii) Between the range of 500 and 900
(iv) Between the range of 300 and 600
[CMA-SM]

Question No. - 13.2

Diamond industries is considering investment in specialized moulds which cost  1.00 lakh, with a life of 2 Years, after
which there is no expected value. The possible incremental cash flows (Post tax are
Year 1 Year 2
Cash flows Probability Cash flows Probability
60,000 0.2 50,000 0.2
70,000 0.5 60,000 0.5
80,000 0.3 70,000 0.3
The risk - free rate of return required by the company is 10%.
Required:
(a) Assume that the cash flows are perfectly correlated. Calculate the net present value and the standard deviation
of the net present. What is the probability of the investment providing a negative NPV?
(b) Recalculate standard deviation if the cash flows were independent. What would be the probability of the NPV
being negative?
Ans: (a) NPV=14925; SD = 12145; Prob = 10.93%; (b) SD = 8597.63; Prob = 4.09%.

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Page 13.30 STRATEGIC FINANCIAL MANAGEMENT
DECISION TREE APPROACH
Question No. - 14A [Nov-1999-Old-14 Marks] [As May-2004-Old-16 Marks] [MTP-Nov-2013-8M]
A firm has an investment proposal, requiring an outlay of  40,000. The investment proposal is expected to
have 2 years’ economic life with no salvage value. In year 1, there is a 0.4 probability that cash inflow after
tax will be  25,000 and 0.6 probability that cash inflow after tax will be  30,000. The probabilities assigned
to cash inflows after tax for the year II are as follows:
The Cash inflow year I  25,000  30,000
The Cash inflow year II Probability Probability
 12,000 0.2  20,000 0.4
 16,000 0.3  25,000 0.5
 22,000 0.5  30,000 0.1
The firm uses a 10% discount rate for this type of investment.
Required:
(a) Construct a decision tree for the proposed investment project.
(b) What net present value will the project yield if worst outcome is realized? What is the probability of
occurrence of this NPV?
(c) What will be the best and the probability of that occurrence?
(d) Will the project be accepted?
(10% Discount factor 1 year 0.909, 2 year 0.826)
[CMA-SM] [CS-June-06-20M] [CMA-Comp.] [CMA-RTP-Dec-2013] [CMA-MTP-June-2014-10M]
[CMA-Dec-2013-10M / June-2015-10M / June-2017-8M / Dec-2017-6M / Dec-2018-8M]
Ans: (b) NPV = -7363; Prob = .08 (c) NPV = 12050; Prob. = .06 (d) NPV = 3142

Question No. - 14B [Nov-2000-old-8M]

Big Oil is wondering whether to drill for oil in Westchester Country. The prospectus are as follows:
Depth of Well Total Cost Millions of Cumulative Probability of PV of Oil (If found) Millions
Feet Dollars Finding Oil of Dollars
2,000 4 0.5 10
4,000 5 0.6 9
6,000 6 0.7 8
Draw a decision tree showing the successive drilling decisions to be made by Big Oil. How deep should it be
prepared to drill?
[CMA-RTP-June-2012] [CMA-Compendium]
Ans: (a) NPV = 1769; (b) NPV = 2273

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No.- 14.1
Mr. Samik, a business man has two independent investments A and B available to him: but he lacks the capital to
undertake both of them simultaneously. He can choose to take A first and then stop, or if A is successful then take
B, or vice versa. The probability of success on A is 0.7, while for B it is 0.4. Both investments require an initial
capital outlay of  2,000, and both return nothing if the venture is unsuccessful. Successful completion of A will
return  3,000 (over cost), and successful completion of B will return  5,000 (over cost). Draw the decision tree
and determine the best strategy.
[CMA-PTP-June-2014-10M] [CMA-MTP-Dec-2014-(4+6)=10M]

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CAPITAL BUDGETING Page 13.31

SENSITIVITY ANALYSIS / WHAT IF ANALYSIS

Question No. - 15A [May-2008-16M]
XYZ Ltd. Is considering a project for which the following estimates are available:

Initial Cost of the project 10,00,000
Sales price/unit 60
Cost/unit 40
Sales volumes
Year 1 20000 units
Year 2 30000 units
Year 3 30000 units
Discount rate 10% p.a.
You are required to measure the sensitivity of the project in relation to each of the following parameters:
(a) Sales Price/unit; (b) Unit cost
(c) Sales volume; (d) Initial outlay and
(e) Project lifetime
Taxation may be ignored.

Question No. – 15B [Nov-2009-10M]

From the following details relating to a project, analyse the sensitivity of the project to changes in initial project cost,
annual cash inflow and cost of capital:
Initial project cost  120,000
Annual cash inflow  45,000
Project Life 4 Years
Cost of capital 10%
To which of the three factors, the project is most sensitive? (Use annuity factors for 10% …3.169 and 11% …3.102)
Ans: NPV = 22605; (ii) Sensitivity, Cost = 53.08%; CIF = 63.08%, CC = 13.34%

Question No.- 15C [Nov-2013-8 M]

The Easy going Company Ltd. is considering a new project with initial investment, for a product “survival”. It is
estimated that IRR of the project is 16% having an estimated life of 5 years.
Financial manager has studied the project with sensitivity analysis and informed that annual fixed cost sensitivity
is 7.8416%, whereas cost of capital (discount rate) sensitivity id 60%.
Other information available are:
Profit volume ratio (P/V) is 70%
Variable cost  60/- per unit; Annual cash flow  57500/-
Ignore depreciation on initial investment and impact of taxation.
Calculate:
(i) Initial investment of the project; (ii) Net present value of the project
(iii) Annual fixed cost (iv) Estimated annual unit of sales
(v) Break even units
Cumulative discounting factor for 5 years
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%
3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127
[CMA-June-2019-8M]

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Page 13.32 STRATEGIC FINANCIAL MANAGEMENT
 TEST YOUR KNOWLEDGE
’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 15.1
From the following project details calculate the sensitivity of the:
(a) Project cost, (b) Annual cash flow, and (c) Cost of capital.
Which variable is the most sensitive?
Project cost 12,000 Annual cash flow  4,500
Life of the project 4 years Cost of capital 14%
The annuity factor at 14% for 4 years is 2.9137 and at 18% for 4 years is 2.6667.

Question No. - 15.2

From the following project details, calculate the sensitivity of the
(i) Project cost
(ii) Cash inflows
(iii) Which variable is more sensitive ?
Project cost  12,000
Life of the project 4 years
Salvage value Nil
Cost of capital 14%

Cash inflows after tax :

end of year 1: Rs. 5,000
end of year 2: Rs. 5,000
end of year 3: 10% increase over year 1 inflow
end of year 4: 10% increase over year 1 inflow
(iv) Would you conclude that cost of capital is more sensitive than (i) or (ii) above?
[CMA-Dec-2018-New-8M]
Ans:

Question No. - 15.3

Red Ltd. Is considering a project with the following cash flows (in )
Years Cost of plant Recurring cost Savings
0 10000
1 4000 12000
2 5000 14000
The cost of capital is 9% Measure the sensitivity of the project to changes in the levels of plant value, running
cost and savings (considering each factor at a time) such that NPV becomes Zero. The P.V. factor at 9% are as
under:
Years 0 1 2
Factor 1 0.917 0.842
Which factor is the most sensitivity to affect the acceptability of the project?
[CMA-TP-Dec-2013-10M]

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CAPITAL BUDGETING Page 13.33

Question No. - 15.4 [RTP-May-2014]

Unnat Ltd. is considering investing 50,00,000 in a new machine. The expected life of machine is five years and
has no scrap value. It is expected that 2,00,000 units will be produced and sold each year at a selling price of 
30.00 per unit. It is expected that the variable costs to be 16.50 per unit and fixed costs to be 10,00,000 per year.
The cost of capital of Unnat Ltd. is 12% and acceptable level of risk is 20%.
You are required to measure the sensitivity of the project’s net present value to a change in the following project
variables:
(i) sale price; (ii) sales volume; (iii) variable cost;
and discuss the use of sensitivity analysis as a way of evaluating project risk.
On further investigation it is found that there is a significant chance that the expected sales volume of 2,00,000 units
per year will not be achieved. The sales manager of Unnat Ltd. suggests that sales volumes could depend on
expected economic states that could be assigned the following probabilities:
State of Economy Annual Sales (in Units) Prob.
Poor 1,75,000 0·30
Normal 2,00,000 0·60
Good 2,25,000 0·10

Calculate expected net present value of the project and give your decision whether company should accept the
project or not.
Ans: Sensitivity (Change in factor where NPV will be Zero) (i) 5.23%; (ii) 11.59%; (iii) 9.51%;
Expected NPV = 885163; Worst NPV = -88188; Best NPV = 2345188;
There are 30% chance that NPV will be negative and 70% chance that NPV will be positive since accepta ble level of risk is
20% and there are 30% chance of –ve NPV. Hence project should not be accepted

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Page 13.34 STRATEGIC FINANCIAL MANAGEMENT
MONTE CARLO SIMULATION
Question No. - 16A [Study Mat]
Annual Net Cash Flow & Life of the project with their probability distribution are as follows:
Annual Cash flow Project life
Value () Probability Value (Year) Probability
10,000 0.02 3 0.05
15,000 0.03 4 0.10
20,000 0.15 5 0.30
25,000 0.15 6 0.25
30,000 0.30 7 0.15
35,000 0.20 8 0.10
40,000 0.15 9 0.03
10 0.02
Risk free rate is 10%, and Initial Investment is 1,30,000. Calculate Simulated NPV in 10 trial Run.
Ans: Run 1 = 42800; Run 2= 85070.50; Run 3= -8300; Run 4= -66600; Run 5=-21130;
Run 6 = 40390; Run 7=16050.26; Run 8 = 16050.26; Run 9 = 21630.5; Run 10 = 650.78

Various Random Number generated are as follows (Random Number Table)

53479 81115 98036 12217 59526
97344 70328 58116 91964 26240
66023 38277 74523 71118 84892
99776 75723 03172 43112 83086
30176 48979 92153 38416 42436
81874 83339 14988 99937 13213
19839 90630 71863 95053 55532
09337 33435 53869 52769 18801
31151 58295 40823 41330 21093
67619 52515 03037 81699 17106

Question No. -16B

X Co. is evaluating an investment proposal which has uncertainty associated with the three important aspects:
original cost, useful life and annual net cash flows. The three probability distributions for these variables are
shown below:
Original Cost Useful life Annual net cash inflows
Value Probability Value Probability Value Probability
 60,000 0.30 5 years 0.40 10,000 0.10
 70,000 0.60 6 years 0.40  15,000 0.30
 90,000 0.10 7 years 0.20  20,000 0.40
 25,000 0.20
The company wants to perform five simulation runs of this project’s life. The firm’s cost of capital is 15% and the
risk- free rate is 6%; for simplicity it is assumed that these two values are known with certainty and will remain
constant over the life of the project.
To simulate the probablity distribution of original cost, useful life and annual net cash inflows, are the following
are the sets of random numbers:
09, 84, 41, 92, 65; 24, 38, 73, 07, 04; and 07, 48, 57, 64, 72 respectively each of the five simulation runs.
[CMA-SM]
Ans: 1:  -17,880; 2: 14, 240; 3:  28,340; 4:  -5760; 5:  14,240

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CAPITAL BUDGETING Page 13.35

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 16.1
The management of ABC company is considering the question of marketing a new product. The fixed cost required
in the project is 4,000. Three factors are uncertain viz., the selling price, variable cost and the annual sales volume.
The product has a life of only one year. The management has the data on these three factors as under:
Selling price  Probability Variable cost  Probability Sales Volume Probability
3 0.2 1 0.3 2000 0.3
4 0.5 2 0.6 3000 0.3
5 0.3 3 0.1 5000 0.4
Consider the following sequence of thirty random numbers:
81, 32, 60, 04, 46, 31, 67, 25, 24, 10, 40, 02, 39, 68, 08, 59, 66, 90, 12, 64, 79, 31, 86, 68, 82, 89, 25, 11, 98, 16
Using the sequence (First 3 random numbers for the first trial etc.) simulate the average profit for the above project
on the basis of 10 trials.
[CMA-SM]
Ans: 2100
Question No.-16.2
The Manager (Accounts) of MULTSOFT LTD. has studied his varying monthly cash Flows and has arrived at the
probabilities of cash inflows and outgo as detailed below:
Cash Inflows () Probabilities Cash Outgo Probabilities
1,40,000 0.35 1,10,000 0.15
150,000 0.20 120,000 0.25
160,000 0.15 130,000 0.30
1,70,000 0.14 140,000 0.15
1,80,000 0.11 150,000 0.11
1,90,000 0.05 1,70,000 0.04
The manager at the beginning (April) of the year has 20,000 in Bank. The manager can avail of temporary
overdraft facilities to cover any cash shortage.
Required:
(a) Simulate the process to compute sales (cash inflow) and expenses (cash outgo) of the company over a financial
year (April to March) using the following two series of random numbers:
Series-1: 34, 84, 38, 82, 36, 92, 73, 91, 63, 29, 27, 26
Series-2: 96, 57, 99, 84, 51, 29, 41, 11, 66, 30, 41, 80
(b) How much money does the Manager has at the end (March) of the year?
[CMA-June-2010-10M]
Ans: Manager has 3,00,000 after 1 year
Question No. - 16.3 [RTP-May-2012]
A company manufactures 3000 units of ‘Product P’ per day. The sale of this product depends upon demand which
has the following distribution.
Sales(Units) 2700 2800 2900 3000 3100 3200
Prob. 0.10 0.15 0.20 0.35 0.15 0.05
The production cost and sale price of each unit are 4 and 5 respectively. Any unsold product is to be disposed
off at a loss of 1.50 per unit. There is a penalty of 0.50 per unit if demand is not met.
Using the following random numbers estimate total profits/loss for the company for next 10 days: 11, 98, 66, 97,
95, 01, 79, 12, 17, 21.
If the company decides to produce 2900 items per day, what is profit/loss position of the company
Ans: Total Profit for next 10 days (for 3000 items) = 26,950; If produce 2900 items profit shall remain unchanged

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Page 13.36 STRATEGIC FINANCIAL MANAGEMENT
Question No.-16.4
A publishing house has bought out a new monthly magazine which sells at  25 per copy. The cost of purchasing
it by newsstand is  20 per copy. A newsstand estimates the sales pattern of the magazine as under:
Demand Copies Probability
0 < 200 0.18
200 < 400 0.32
400 < 600 0.25
600 < 800 0.15
800 < 1000 0.06
1000 <1200 0.04
The newsstand has contracted for 500 copies of the magazine per month from the publisher. The unsold copies are
returnable to the publisher who will take them back at cost less  2 per copy for handling charges.
The newsstand manager wants to simulate the pattern of demand and profitability.
The following random number may be used for simulation of sales pattern of each month.
26 14 55 17 97 70
51 33 60 82 96 68
You are required to:
(i) Allocate random numbers to the demand pattern forecast by the newsstand.
(ii) Simulate twelve months sales and calculate the monthly and annual profit/loss.
(iii) Calculate the loss on lost sales.
[CMA-PTP-June-2014-10M]

Question No.-16.5
A Production Manager is planning to produce a new product and he wishes to estimate the raw material requirement
for that new product. On the basis of usage for a similar product introduced previously, he has developed a frequency
distribution of demand in tonnes per day for a two month period. Used this data to simulate the raw material usage
requirements for 7 days. Compute also expected value and comment on the result.
Demand Tonnes/Day Frequency
No of Days
10 6
11 18
12 15
13 12
14 6
15 3

Random Number: 27, 13, 80, 10, 54, 60, 49.

[CMA-PTP-June-2015-6M]

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CAPITAL BUDGETING Page 13.37

OPTION IN CAPITAL BUDGETING

Question No. – 17A [May-2013-5M]
Ramesh owns a plot of land on which he intends to construct apartment units for sale. No. of apartment units to be
constructed may be either 10 or 15. Total construction costs for these alternatives are estimated to be  600 lakhs
or  1025 lakhs respectively. Current market price for each apartment unit is  80 lakhs. The market price after a
year for apartment units will depend upon the conditions of market. If the market is buoyant, each apartment unit
will be sold for  91 lakhs, if it is sluggish, the sale price for the same will be  75 lakhs. Determine the current
value of vacant plot of land. Should Ramesh start construction now or keep the land vacant? The yearly rental per
apartment unit is  7 lakhs and the risk free interest rate is 10% p.a.
Assume that the Construction cost will remain unchanged.
Ans:

Question No. – 17B [May-2017-5M]

Ram Chemical is in production Line of Chemicals and considering a proposal of building new plant to produce
pesticides. The Present Value (PV) of new proposal is  150 crores (After considering scrap value at the end of life
of project). Since this is a new product market, survey indicates following variation in Present Value (PV):
Condition Favourable in first year PV will increase 30% from original estimate
Condition sluggish in first year PV will decrease by 40% from original Figures.
In addition Rama Chemical has a option to abandon the project at the end of Year and dispose it at  100 crores. If
risk free rate of interest is 8%, what will be present value of put option?
Ans: PV = 2.907 crore; This is the value of abandonment option (Put Option).

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 17.1 [Nov-2004-old-20 marks] [Same as Q-15B]
You own an unused Gold mine that will cost 10,00,000 to reopen. If you open the mine, you expect to be
able to extract 1,000 ounces of Gold a year for each of three years. After that the deposit will be exhausted.
The Gold price is currently  5,000 an ounce, and each year the price is equally likely to rise or fall by  500
from its level at the start of year. The extraction cost is 4,600 an ounce and the discount rate is 10 per cent.
Required:
(a) Should you open the mine now or delay one year in the hope of a rise in the Gold price?
(b) What difference would it make to your decision if you could costlessly (but irreversibly) shut down the
mine at any stage? Show the value of abandonment option.

Question No. - 17.2 [MTP-Nov-2013-5M]

Government of India through one of its agency has developed a new type of variance to cure the dengue. Among
various companies’ pharmaceutical companies, applies for license a USA based MNC has been granted license to
produce vaccine at its plant situated at Noida in India. The license has been granted on the condition that company
shall start producing vaccine after 2 year when GOI will launch a drive to vaccinate the children in metropolitan
cities.
The project shall require an initial investment of 190 crore and it is expected to produce a negative NPV of 15
crore @ cost of capital of 16%. Therefore, company’s CEO Brian is of view that it is not financial viable to produce
vaccine and therefore the company should surrender back the license to GOI.
In recent Board meeting it was decided that the traditional approach to capital budgeting is highly uncertain and on
the basis of concept of real option the views of CEO to surrender back the license needs a relook. The current yield
on treasury bonds is 5%. Further expected standard deviation of future cash flows is 20%.
Suppose you have been appointed as financial consultant and you are required to:

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Page 13.38 STRATEGIC FINANCIAL MANAGEMENT
(i) Determine the value of call option of delaying the commencement of production of the vaccine.
(ii) Give your recommendation about the acceptability of the project.
Given: Area under normal curve N(0.20) = 0.5793 and (-0.08) = 0.4681 and e-0.1 = 0.904837

INFLATION IN CAPITAL BUDGETING

Question No. - 18A
A certain project is expected to generate year and annual net cash inflows of 5,00,000 for four years. The cost of
capital (real discount rate is 10%). Inflation rate is 5% p.a.
(i) What are the nominal cash flows and real cash flows of the second year's inflows which occur at the end of
year 2?
(ii) What is the present value of the inflow of the second year that you would use in determining the NPV of the
project?
(You are not required to calculate the values. You are only required to substitute the values in appropriate formulae
for the answers).
[June-2018-New-4M]
Ans: (i) 5,00,000)/(1.05) (ii) Nominal: 5,00,000/1.155; Real: 5,00,000/1.05 ÷ 1.1

Question No. - 18B [Nov-2019-Old-8M]

M/S Swastik Enterprises Wants to invest in a new project. The following information are available with regard to
the new project.
Initial Outlay of Project 80,000
Annual revenue (Without inflation) 60,000
Annual Costs excluding depreciation (Without inflation) 20,000
Useful life 4 Years
Salvage value Nil
Tax Rate 50%
Cost of Capital 12%
The expected annual Rate of inflation 10%
Determine NPV using cash flows with inflation and decide whether the new project an be accepted or not. Your
calculations are to be rounded off to 2 decimals.
The PV factors are given below:
Year 1 3 3 4
PVIF @ 12% 0.893 0.797 0.712 0.636
Ans:

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CAPITAL BUDGETING Page 13.39
Question No. - 18C [Nov-2016-Old-8M]
KLM Ltd. requires 15,00,000 for a new project. Useful life of project is 3 years.
Salvage value - NIL. Depreciation is  5,00,000 p.a.
Given below are projected revenues and costs (excluding depreciation) ignoring inflation:
Year→ 1 2 3
Revenues in  10,00,000 13,00,000 14,00,000
Costs in  5,00,000 6,00,000 6,50,000
Applicable tax rate is 35%. Assume cost of capital to be 14% (after tax). The inflation
rates for revenues and costs are as under:
Year Revenues % Costs %
1 9 10
2 8 9
3 6 7

PVF at 14%, for 3 years =0.877, 0.769 and 0.675

Show amount to the nearest rupee in calculations. You are required to calculate net present value of the project.
Ans: 19,965

Question No. - 18D

A company is considering a cost saving project. This involves purchasing a machine costing  7,000, which will
result in annual savings on wage costs of  1,000 and on material costs of  400.
The following forecasts are made of the rates of inflation each year for the next 5 years:
Wages costs 10%, Material costs 5%, General prices 6%
The cost of capital of the company, in monetary terms, is 15%.
Evaluate the project, assuming that the machine has a life of 5 years and no scrap value.
[CMA-WB-2018]
Ans: (-) 1,067

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. -18.1 [May-2005-old-8 Marks] [RTP-May-2013]
A firm has projected the following cash flows from a project under evaluation:
Year  lakhs
0 (70)
1 30
2 40
3 30
The above cash flows have been made at expected prices after recognizing inflation. The firm’s cost of capital is
10%. The expected annual rate of inflation is 5%.
Show how the viability of the project is to be evaluated.
Requirement in [CMA-PTP-Dec-2014-8M]/ [CMA-PTP-June-2015-New-8M]
Show how the viability of the project is to be evaluated using both nominal rate of discount and real rate of discount.
Ans: NPV = 5.45 Lakh. (You may calculate either adjusting cash flows or rate, Ans will become same

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Page 13.40 STRATEGIC FINANCIAL MANAGEMENT
Question No.-18.2
A Ltd company has undertaken market research at a cost of ₹ 4 Lakhs in order to forecast the future cash Flows of
an Investment Project with an expected life of four years as follows:
Year 1 2 3 4
Sales Revenue ₹ 25,00,000 ₹ 51,40,000 ₹ 1,37,80,000 ₹ 9,06,000
Costs ₹ 10,00,000 ₹ 20,00,000 ₹ 50,00,000 ₹ 35,00,000
These forecast cash flows are before considering inflation of 4.7% p.a. The Capital cost of the project, payable at
the start of first year will be ₹ 40 Lakhs. The Investment Project will have zero scrap value at the end of the fourth
year. The level of working capital investment at the start of each year is expected to be 10% of the sales revenue in
that year.
Capital allowances would be available on the Capital Cost of the investment Project on a 25 % reducing balances
basis. A Ltd. pays tax on Profit at an annual rate of 30% per year with tax being paid one year in arrears.
A Ltd. has a nominal (money terms) after tax Cost of Capital of 12% per year.
Discount Factor at 12% is as under:
Year 1 3 3 4 5
Discount Factor 0.893 0.797 0.712 0.636 0.567
Calculate the net present value of the Investment Project in nominal terms and comment on its financial
acceptability.
[CMA-June-2015-New-10M]

Important Notes:

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CAPITAL BUDGETING Page 13.41

UNIT - III

INTERNATIONAL
CAPITAL BUDGETING
Learning Outcomes

After going through the chapter student shall be able to understand

❑ International Capital Budgeting
❑ International Sources of Finance
❑ International Working Capital Management
(a) Multinational Cash Management
(b) Multinational Receivable Management
(c) Multinational Inventory Management

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Page 13.42 STRATEGIC FINANCIAL MANAGEMENT

INTERNATIONAL CAPITAL BUDGETING

Question No. 20A [Nov-2006-Old-5 Marks] [RTP-May-2013]
ABC Ltd. is considering a project in US, which will involve an initial investment of US $ 1,10,00,000. The project wil l
have 5 years of life. Current spot exchange rate is 48 per US $. The risk free rate in US is 8% and the same in India is
12%. Cash inflows from the project are as follows:
Year Cash inflow
1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
5 US $ 50,00,000
Calculate the NPV of the project using foreign currency approach. Required rate of return on this project is 14%.
[CMA-RTP-Dec-2013-New] [CMA-June-2014-New-5M] [CMA-MTP-June-2014-New-8M]
[CMA-PTP/MTP-Dec-2014-New-8M] [CMA-PTP-June-2015-New-8M]
Ans: NPV of the project =  480.72 Lakh

Question No. 20B [May-2013-5M] [RTP-May-2015]

XY Limited is engaged in large retail business in India. It is contemplating for expansion into a country of Africa
by acquiring a group of stores having the same line of operation as India.
The exchange rate for the currency of the proposed African country is extremely volatile. Rate of inflation is
presently 40% a year. Inflation in India is currently 10% a year. Management of XY Limited expects these rates
likely to continue for the foreseeable future.
Estimated projected cash flows, in real terms, in India as well as African country for first three years of the project
are as follows:
Year-0 Yeae-1 Year-2 Year-3
Cash flows in Indian [ (000)] -50,000 -1,500 -2,000 -2,500
Cash flows in African [Rands (000)] -2,00,000 +50,000 +70,000 +90,000
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year indefinitely. It evaluates all
investments using nominal cash flows and a nominal discounting raete. The present exchange rate is African Rand
6 to 1.
You are required to calculate the net present value of the proposed investment considering the following:
(i) African Rand cash flows are converted into rupees and discounted at a risk adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it’ s high risk.
(iii) Ignore taxation.
Year-1 Year-2 Year-3
PVIF @ 20% .833 .694 .579
[CMA-PTP-June-2014-New-10M]

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CAPITAL BUDGETING Page 13.43

Question No. 20BA [Nov-2015-8M]

XYZ Ltd., a company based in India, manufactures very high quality modem furniture and sells to a small number
of retail outlets in India and Nepal. It is facing tough competition. Recent studies on marketability of products have
clearly indicated that the customer is now more interested in variety and choice rather than exclusivity and
exceptional quality. Since the cost of quality wood in India is very high, the company is reviewing the proposal for
import of woods in bulk from Nepalese supplier.
The estimate of net Indian () and Nepalese Currency (NC) cash flows for this proposal is shown below:
Net Cash Flow (in millions)
Year 0 1 2 3
NC - 25.000 2.600 3.800 4.100
Indian () 0 2.869 4.200 4.600
The following information is relevant:
(i) XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All Nepalese customers are invoiced
in NC. NC cash flows are converted to Indian () at the forward rate and discounted at the Indian rate.
(ii) Inflation rates in Nepal and India are expected to be 9% and 8% p.a. respectively. The current exchange rate
is  1= NC 1.6
Assuming that you are the finance manager of XYZ Ltd., calculate the net present value (NPV) and modified
internal rate of return (MIRR) of the proposal.
You may use following values with respect to discount factor for  1 @9%.
Present Value Future Value
Year 1 0.917 1.188
Year 2 0.842 1.090
Year 3 0.772 1

Question No. 20C [RTP-May-2018-New] [Nov-2007-4M] [As-RTP-Nov-2012]

A USA based company is planning to set up a software development unit in India. Software developed at the Indian
unit will be bought back by the US parent at a transfer price of US $10 millions. The unit will remain in existence
in India for one year; the software is expected to get developed within this time frame.
The US based company will be subject to corporate tax of 30 per cent and a withholding tax of 10 per cent in India
and will not be eligible for tax credit in the US. The software developed will be sold in the US market for US $ 12.0
millions. Other estimates are as follows:
Rent for fully furnished unit with necessary hardware in India 15,00,000
Man power cost (80 software professional will be working for 10 hours each day) 400 per man hour
Administrative and other costs 12,00,000
Advise the US company on financial viability of the project. The rupee-dollar rate is 48/$.
[CMA-RTP-Dec-2018] [CMA-Compendium] [CMA-TP-Dec-2013-New-10M]
Ans: Cost of development of software in India = $ 5.268mill [taking year as 365 days]; Hence Develop
software.

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. 20.1 [RTP-Nov-2008]
An Indian company is planning to set up a subsidiary in US. The initial project cost is estimated to be US $40
million; Working Capital required is estimated to be $4 million.
The finance manager of company estimated the data as follows:
Variable Cost of Production (Per Unit Sold) $2.50

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Page 13.44 STRATEGIC FINANCIAL MANAGEMENT
Fixed cost per annum $ 3 Million
Selling Price $ 10
Production capacity 5 million units
Expected life of Plant 5 years
Method of Depreciation Straight Line Method (SLM)
Salvage Value at the end of 5 years NIL
The subsidiary of the Indian company is subject to 40% corporate tax rate in the US and the required rate of return
of such types of project is 12%. The current exchange rate is 48/US$ and the rupee is expected to depreciate by
3% per annum for next five years.
The subsidiary company shall be allowed to repatriate 70% of the CFAT every year along with the accumulated
arrears of blocked funds at the end of 5 years, the withholding taxes are 10%. The blocked fund will be invested in
the USA money market by the subsidiary, earning 4% (free of taxes) per year.
Determine the feasibility of having a subsidiary company in the USA, assuming no tax liability in India on
earnings received by the parent from the US subsidiary.
[CMA-RTP-June-2014]
Ans: NPV = 1912.87
Question No. 20.2 [SM-NEW] [Q-24A of Security Valuation] [Nov-2014-6M]
X Ltd. is interested in expanding its operation and planning to install manufacturing plant at US. For the proposed
project it requires a fund of $ 10 million (net of issue expenses/ floatation cost). The estimated floatation cost is 2%.
To finance this project it proposes to issue GDRs.
You as financial consultant is required to compute the number of GDRs to be issued and cost of the GD R with the
help of following additional information.
(i) Expected market price of share at the time of issue of GDR is  250 (Face Value  100)
(ii) 2 Shares shall underly each GDR and shall be priced at 10% discount to market price.
(iii) Expected exchange rate  60/$.
(iv) Dividend expected to be paid is 20% with growth rate 12%.

Question No. 20.3

Das Ltd. an Indian company is evaluating an investment in Hong Kong. The project costs 300 Million Hong Kong
Dollars. It is expected to generate an income of 100 Million HKDs a year in real terms for the next 4 years (project
duration). Expected inflation rate in Hong Kong is 6% p.a. Interest rate in India is 7% p.a. while in Hong Kong it is
10% p.a.
The risk premium for the project is 6% in absolute terms, over the risk free rate. The project beta is 1.25. Spot Rate
per HKD is  5.75.
Evaluate the project in Rupees, if the investment in the project is out of retained earnings.
[CMA-RTP-June-2014/2015-New]
Question No. 20.4
Nelon Company a UK Company is considering undertaking a new project in Australia. The project would require
immediate capital expenditure of A $10 Lakhs, plus A $ 5 Lakhs of working capital which would be recovered at
the end of the project’s four year life. The net cash flows expected to be generated from the project are A $ 13 Lakhs
before tax. Straight line depreciation over the life of the project is an allowable expense against company tax in
Australia, which is charged at the rate of 50 % payable at each year without delay. The project will have zero scrap
value.
Nelon Company will not have to pay any UK tax on the project due to a double taxation avoidance agreement.
The A $/ UKP spot rate is 2.0 and A $ is expected to depreciate against the UKP by 10 % per year. A similar risk,
UK - based project would be expected to generate a minimum return of 20 % after tax.
Evaluate the Cash Flows of the Project in £ and A $ and Comment on the same.
[CMA-RTP-June-2014/2015]

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