Chapter 4

MARKET AND DEMAND ANALYSIS

1. We have to estimate the parameters a and b in the linear relationship

Yt = a + bT
Using the least squares method.
According to the least squares method the parameters are:

∑TY–nTY
b=
∑T2–nT2

a = Y – bT
The parameters are calculated below:
Calculation in the Least Squares Method
T Y TY T2
1 2,000 2,000 1
2 2,200 4,400 4
3 2,100 6,300 9
4 2,300 9,200 16
5 2,500 12,500 25
6 3,200 19,200 36
7 3,600 25,200 49
8 4,000 32,000 64
9 3,900 35,100 81
10 4,000 40,000 100
11 4,200 46,200 121
12 4,300 51,600 144
13 4,900 63,700 169
14 5,300 74,200 196
∑ T = 105 ∑ Y = 48,500 ∑ TY = 421,600 ∑ T 2 = 1,015
T = 7.5 Y = 3,464

∑TY–nTY 421,600 – 14 x 7.5 x 3,464

b= =
∑T2–nT2 1,015 – 14 x 7.5 x 7.5

57,880
= = 254
227.5
a = Y – bT
= 3,464 – 254 (7.5)
= 1,559
 Thus linear regression is
Y = 1,559 + 254 T
2. In general, in exponential smoothing the forecast for t + 1 is
Ft + 1 = Ft + α et

Where Ft + 1 = forecast for year ) α = smoothing parameter

et = error in the forecast for year t = St - Ft
F1 is given to be 2100 and α is given to be 0.3
The forecasts for periods 2 to 14 are calculated below:
Period Data (St) Forecast Error Forecast for t + 1
t (Ft) (et= St - Ft) (Ft + 1 = Ft + α et)

1 2,000 2100.0 -100 F2 = 2100 + 0.3 (-100) = 2070

2 2,200 2070 130 F3 = 2070 + 0.3(130) = 2109
3 2,100 2109.0 -9 F4 = 2109 + 0.3 (-9) = 2106.3
4 2,300 2106.3 193.7 F5 = 2106.3 + 0.3(193.7) = 2164.4
5 2,500 2164.4 335.6 F6 = 2164.4 + 0.3(335.6) = 2265.1
6 3,200 2265.1 934.9 F7 = 2265.1 + 0.3(934.9) = 2545.6
7 3,600 2545.6 1054.4 F8 = 2545.6+ 0.3(1054.4) = 2861.9
8 4,000 2861.9 1138.1 F9 = 2861.9+ 0.3(1138.1) = 3203.3
9 3,900 3203.3 696.7 F10 = 3203.3 + 0.3(696.7) = 3412.3
10 4,000 3412.3 587.7 F11 = 3412.3 + 0.3(587.7) = 3588.6
11 4,200 3588.6 611.4 F12 = 3588.6 + 0.3(611.4) = 3772
12 4,300 3772 528 F13 = 3772 + 0.3(528) = 3930.4
13 4,900 3930.4 969.6 F14 = 3930.4 + 0.3(969.6) = 4221.3

3. According to the moving average method

St + S t – 1 +…+ S t – n +1
Ft + 1 =
n
where Ft + 1 = forecast for the next period
St = sales for the current period
n = period over which averaging is done

Given n = 3, the forecasts for the period 4 to 14 are given below:

Period Data (St) Forecast Forecast for t + 1
t (Ft) Ft + 1 = (St+ S t – 1 + S t – 2)/ 3

1 2,000
2 2,200
3 2,100 F4 = (2000 + 2200 + 2100)/3 = 2100
4 2,300 2100 F5 =(2200 + 2100 + 2300)/3= 2200
5 2,500 2200 F6 = (2100 + 2300 + 2500)/3 = 2300
6 3,200 2300 F7 = (2300 + 2500 + 3200)/3= 2667
7 3,600 2667 F8 = (2500 + 3200 + 3600)/3 = 3100
8 4,000 3100 F9 = (3200 + 3600 + 4000)/3 = 3600
9 3,900 3600 F10 = (3600 + 4000 + 3900)/3 = 3833
10 4,000 3833 F11 = (4000 + 3900 + 4000)/3 =3967
11 4,200 3967 F12 =(3900 + 4000 + 4200)/3 = 4033
12 4,300 4033 F13 = (4000 + 4200 + 4300)/3 = 4167
13 4,900 4167 F14 = (4200 + 4300 + 4900) = 4467
14 5,300 4467

4.
Q1 = 60
Q2 = 70
I1 = 1000
I2 = 1200
Q2 – Q1 I1 + I2
Income Elasticity of Demand E1 = x
I2 - I1 Q2 + Q1
E1 = Income Elasticity of Demand
Q1 = Quantity demanded in the base year
Q2 = Quantity demanded in the following year
I1 = Income level in base year
I2 = Income level in the following year

70 – 60 1000 + 1200
E1 = x
1200 – 1000 70 + 60

22000
E1 = = 0.846
26000
5.
P1 = Rs.40
P2 = Rs.50
Q1 = 1,00,000
Q2 = 95,000
Q2 – Q1 P1 + P2
Price Elasticity of Demand = Ep = x
P2 –P1 Q2 + Q1
P1 , Q1 = Price per unit and quantity demanded in the base year
P2, Q2 = Price per unit and quantity demanded in the following year
Ep = Price Elasticity of Demand

95000 - 100000 40 + 50
Ep = x
50 - 40 95000 + 100000

- 45
Ep = = - 0.231
1950
 Chapter 6

FINANCIAL ESTIMATES AND PROJECTIONS

1.
Projected Cash Flow Statement (Rs. in million)

Sources of Funds
Profit before interest and tax 4.5
Depreciation provision for the year 1.5
Secured term loan 1.0
Total (A) 7.0

Disposition of Funds
Capital expenditure 1.50
Increase in working capital 0.35
Repayment of term loan 0.50
Interest 1.20
Tax 1.80
Dividends 1.00
Total (B) 6.35

Opening cash balance 1.00

Net surplus (deficit) (A – B) 0.65
Closing cash balance 1.65

Projected Balance Sheet

(Rs. in million)
Liabilities Assets
Share capital 5.00 Fixed assets 11.00
Reserves & surplus 4.50 Investments 0 .50
Secured loans 4.50 Current assets 12.85
Unsecured loans 3.00 * Cash 1.65
Current liabilities 6.30 * Receivables 4.20
Provisions 1.05 * Inventories 7.00
24.35 24.35

2. Projected Income Statement for the 1st Operating Year


Working capital here is defined as :
(Current assets other than cash) – (Current liabilities other than bank borrowings)
In this case inventories increase by 0.5 million, receivables increase by 0.2 million and current liabilities
and provisions increase by 0.35 million. So working capital increases by 0.35 million
 Rs.
Sales 4,500
Cost of sales 3,000
Depreciation 319
Interest 1,044
Write off of Preliminary expenses 15
Net profit 122

Projected Cash Flow Statements

Construction period 1st Operating year
Sources
Share capital 1800 -
Term loan 3000 600
Short-term bank borrowing 1800
Profit before interest and tax 1166
Depreciation 319
Write off preliminary expenses 15
4800 3900
Uses
Capital expenditure 3900 -
Current assets (other than cash) - 2400
Interest - 1044
Preliminary expenses 150 -
Pre-operative expenses 600 -
4650 3444
Opening cash balance 0 150
Net surplus / deficit 150 456
Closing balance 150 606
Projected Balance Sheet
Liabilities 31/3/n+1 31/3/n+2 Assets 31/3/n+1 31/3/n+2
Share capital 1800 1800 Fixed assets (net) 4500 4181
Reserves & surplus - 122
Secured loans : Current assets
- Term loan 3000 3600 - Cash 150 606
- Short-term bank 1800 Other current assets 2400
borrowing
Unsecured loans - - Miscellaneous
expenditures & losses
Current liabilities and - Preliminary 150 135
provisions expenses
4800 7322 4800 7322
Notes :
i. Allocation of Pre-operative Expenses :

Type Costs Allocation Costs after

before allocation
allocation
Land 120 19 139
Building 630 97 727
Plant & machinery 2700 415 3115
Miscellaneous fixed assets 450 69 519
3900 600 4500

ii. Depreciation Schedule :

Lan Building Plant & machinery M.Fixed Total

d assets
Opening balance 139 727 3115 519 4500
Depreciation - 25 252 42 319
Closing balance 139 702 2863 477 4181

iii. Interest Schedule :

Interest on term loan of 3600 @20% = 720
Interest on short term bank borrowings of 1800 @ 18% = 324
1044

MINICASE
 Projected Income Statements

I Operating II Operating
Year Year
--------------
Projected Cash Flow Statement ---------------
Sales 42,000 60,000
Cost of sales 28,000 40,000
Depreciation 3,643 3,643
Interest 4,838 4,722
Write-off of preliminary expenses 86 86
Net profit 5,433 11,549

Projected Cash flow statements

--------------------------------------

Sources Construction period I Operating II Operating

Year Year
e. ----------- ---------------------- ------------- ----------------
f.  Equity capital 16,300 Nil Nil
 Term loan 29,000 5,704 500
g.  Short-term bank borrowing Nil 17,100 2,000
 Profit before interest and taxes 10,271 16,271
 Depreciation 3,643 3,643
 Write-off of preliminary expenses 86 86
 Total 45,300 36,804 22,500
Uses
 Capital expenditure 36,480 Nil Nil
 Current assets( other than cash) Nil 22,804 2,500
 Repayment of Term loan 2,169 4,400
 Preliminary expenses 860 Nil Nil
 Preoperative expenses 4,800 Nil Nil
 Interest Nil 4,838 4,722
Total 42,140
Projected balance sheets 29,811 11,622
 Opening cash balance 0 3,160 10.,153
 Net surplus/deficit 3,160 6,993 10,878
 Closing balance 3,160 10,153 21,031

Projected Balance Sheets

Liabilities 31/3/n+1 31/3/n+2 31/3/n+3 Assets 31/3/n+1 31/3/n+2 31/3/n+3

 Share capital 16,300 16,300 16,300 Fixed assets 41,280 37,637 33,994
(net)
 Reserves & Nil 5,433 16,982
surplus
 Secured loans Current assets
 Term loans 29,000 32,535 28,635 Cash 3,160 10,153 21,031
 Short-term Nil 17,100 19,100 Other current Nil 22,804 25,304
bank borrowing assets

 Unsecured loans Nil Nil Nil

 Current liabilities Nil Nil Nil
Miscellaneous
and provisions expenditure &
losses
Preliminary 860 774 688
a -------- -------- -------- Expenses -------- -------- ---------
45,300 71,368 81,017 45,300 71,368 81,017

Notes:
Allocation of Preoperative expenses
Cost before allocation Allocation Cost after
allocation
--------------------------- -------------
------------------------
Land 1,220 160 1,380
Building 6,100 803 6,903
Plant and machinery 24,440 3,216 27,656
Miscellaneous fixed assets 4,720 621 5,341
Total 36,480 4,800 41,280

Term loan repayment schedule

Operating Opening loan Interest Instalment Closing loan
half year balance balance
----------- --------------- ---------- ------------ ---------------
1 34,704 1,735 Nil 34,704
2 34,704 1,735 2,169 32,535
3 33,035 1,652 2,200 30,835
4 30,835 1,542 2,200 28,635
Interest on Short term bank loan:
Loan outstanding at the beginning of I operating year : 17,100
Interest on the above at 8 percent : 1,368
Loan outstanding at the beginning of II operating year : 19,100
Interest on the above at 8 percent : 1,528

Depreciation schedule:

I operating year II operating year

Asset Opening Depreciation Closing Depreciation Closing

Balance balance balance
-------- ----------- --------------- ----------- ---------------- -----------
Land 1,380 Nil 1,380 Nil 1,380
Building 6,903 231 6,672 231 6,441
Plant and
Machinery 27,656 2,860 24,796 2,860 21,936
Misc.Fixed
Assets 5,341 552 4,789 552 4,237
Total 41,280 3,643 37,637 3,643 33,994
 Chapter 7

THE TIME VALUE OF MONEY

1. Value five years hence of a deposit of Rs.1,000 at various interest rates is as

follows:

r = 8% FV5 = 1000 x FVIF (8%, 5 years)

= 1000 x 1.469 = Rs.1469

r = 10% FV5 = 1000 x FVIF (10%, 5 years)

= 1000 x 1.611 = Rs.1611

r = 12% FV5 = 1000 x FVIF (12%, 5 years)

= 1000 x 1.762 = Rs.1762

r = 15% FV5 = 1000 x FVIF (15%, 5 years)

= 1000 x 2.011 = Rs.2011

2. Rs.160,000 / Rs. 5,000 = 32 = 25

According to the Rule of 72 at 12 percent interest rate doubling takes place

approximately in 72 / 12 = 6 years

So Rs.5000 will grow to Rs.160,000 in approximately 5 x 6 years = 30 years

3. In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 2 3 times the initial

deposit. Hence doubling takes place in 12 / 3 = 4 years.

According to the Rule of 69, the doubling period is:

0.35 + 69 / Interest rate

Equating this to 4 and solving for interest rate, we get

Interest rate = 18.9%.

4. Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is
equivalent to saving Rs.2000 a year for 15 years and Rs.1000 a year for the
years 6 through 15.

Hence the savings will cumulate to:

2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)

 = 2000 x 31.772 + 1000 x 15.937 = Rs.79481.

5. Let A be the annual savings.

A x FVIFA (12%, 10 years) = 1,000,000

A x 17.549 = 1,000,000

So A = 1,000,000 / 17.549 = Rs.56,983.

6. 1,000 x FVIFA (r, 6 years) = 10,000

FVIFA (r, 6 years) = 10,000 / 1000 = 10

From the tables we find that

FVIFA (20%, 6 years) = 9.930

FVIFA (24%, 6 years) = 10.980

Using linear interpolation in the interval, we get:

(10.000 – 9.930)
r = 20 + -------------------- x 4% = 20.3%
(10.980 – 9.930)

7. 1,000 x FVIF (r, 10 years) = 5,000

FVIF (r,10 years) = 5,000 / 1000 = 5

From the tables we find that

FVIF (16%, 10 years) = 4.411
FVIF (18%, 10 years) = 5.234

Using linear interpolation in the interval, we get:

(5.000 – 4.411) x 2%
r = 16% + = 17.4%
(5.234 – 4.411)

8. The present value of Rs.10,000 receivable after 8 years for various discount
rates (r ) are:
r = 10% PV = 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670

r = 12% PV = 10,000 x PVIF (r = 12%, 8 years)

= 10,000 x 0.404 = Rs.4,040
 r = 15% PV = 10,000 x PVIF (r = 15%, 8 years)
= 10,000 x 0.327 = Rs.3,270
9. Assuming that it is an ordinary annuity, the present value is:

2,000 x PVIFA (10%, 5years)

= 2,000 x 3.791 = Rs.7,582

10. The present value of an annual pension of Rs.10,000 for 15 years when r = 15%
is:

10,000 x PVIFA (15%, 15 years)

= 10,000 x 5.847 = Rs.58,470

The alternative is to receive a lumpsum of Rs.50,000.

Obviously, Mr. Jingo will be better off with the annual pension amount of
Rs.10,000.

11. The amount that can be withdrawn annually is:

100,000 100,000
A = ------------------ ------------ = ----------- = Rs.10,608
PVIFA (10%, 30 years) 9.427

12. The present value of the income stream is:

1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)

+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)

= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.

13. The present value of the income stream is:

2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)

= 2,000 x 3.791 + 3000/0.10 x 0.621
= Rs.26,212

14. To earn an annual income of Rs.5,000 beginning from the end of 15 years from
now, if the deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000

is required at the end of 14 years. The amount that must be deposited to get this
sum is:
 Rs.50,000 / FVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,168

15. Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years)

PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00

From the tables we find that:

PVIFA (15%, 10 years) = 5.019

PVIFA (18%, 10 years) = 4.494

Using linear interpolation we get:

5.019 – 5.00

r = 15% + ---------------- x 3%
5.019 – 4.494
= 15.1%

16. PV (Stream A) = Rs.100 x PVIF (12%, 1 year) + Rs.200 x

PVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 x
PVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +
Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +
Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +
Rs.1,000 x PVIF (12%, 10 years)

= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712

+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507
+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361
+ Rs.1,000 x 0.322

= Rs.2590.9

Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs.2,825.5

17. FV5 = Rs.10,000 [1 + (0.16 / 4)]5x4

= Rs.10,000 (1.04)20
= Rs.10,000 x 2.191
= Rs.21,910

18. FV5 = Rs.5,000 [1+( 0.12/4)] 5x4

= Rs.5,000 (1.03)20
= Rs.5,000 x 1.806
 = Rs.9,030

19. A B C

Stated rate (%) 12 24 24

Frequency of compounding 6 times 4 times 12 times
Effective rate (%) (1 + 0.12/6)6- 1 (1+0.24/4)4 –1 (1 + 0.24/12)12-1
= 12.6 = 26.2 = 26.8
Difference between the
effective rate and stated
rate (%) 0.6 2.2 2.8

20. Investment required at the end of 8 th year to yield an income of Rs.12,000 per
year from the end of 9th year (beginning of 10th year) for ever:

Rs.12,000 x PVIFA(12%, ∞ )
= Rs.12,000 / 0.12 = Rs.100,000

To have a sum of Rs.100,000 at the end of 8 th year , the amount to be deposited

now is:

Rs.100,000 Rs.100,000
= = Rs.40,388
PVIF(12%, 8 years) 2.476

21. The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of
Rs.5,000 now is:

Rs.5,000 x FVIF (r,10 years) = Rs.20,000

Rs.20,000
FVIF (r,10 years) = = 4.000
Rs.5,000

From the tables we find that

FVIF (15%, 10 years) = 4.046
This means that the implied interest rate is nearly 15%.
I would choose Rs.20,000 for 10 years from now because I find a return of 15%
quite acceptable.

22. FV10 = Rs.10,000 [1 + (0.10 / 2)]10x2

= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653
= Rs.26,530
 If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in
terms of the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283

23. Let us assume an interest rate of 12 percent.

A constant deposit at the beginning of each year represents an annuity due.

PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)

To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should
be

Rs.50,000
A = FVIFA(12%, 10 years) x (1.12)

Rs.50,000
= = Rs.2544
17.549 x 1.12

24. The discounted value of Rs.20,000 receivable at the beginning of each year from
2005 to 2009, evaluated as at the beginning of 2004 (or end of 2003) is:

Rs.20,000 x PVIFA (12%, 5 years)

= Rs.20,000 x 3.605 = Rs.72,100.

The discounted value of Rs.72,100 evaluated at the end of 2000 is

Rs.72,100 x PVIF (12%, 3 years)

= Rs.72,100 x 0.712 = Rs.51,335

If A is the amount deposited at the end of each year from 1995 to 2000 then
A x FVIFA (12%, 6 years) = Rs.51,335
A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115 = Rs.6326

25. The discounted value of the annuity of Rs.2000 receivable for 30 years,
evaluated as at the end of 9th year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854
The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)
= Rs.18,854 x 0.424
= Rs.7,994
26. 30 percent of the pension amount is
0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate
of 12% is 1%, the discounted value of an annuity of Rs.180 receivable at the end of
each month for 180 months (15 years) is:
Rs.180 x PVIFA (1%, 180)

(1.01)180 - 1
Rs.180 x ---------------- = Rs.14,998
.01 (1.01)180
If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%

P x (1.01)60 = Rs.14,998
P x 1.817 = Rs.14,998

Rs.14,998
P = ------------ = Rs.8254
1.817
27. Rs.300 x PVIFA(r, 24 months) = Rs.6,000

PVIFA (r%,24) = Rs.6000 / Rs.300 = 20

1 – [1/(1+r)n]
Using the formula PVIFA = ------------------
r

we find that:
PVIFA(1%,24) = 21.244
PVIFA (2%, 24) = 18.914

Using a linear interpolation

21.244 – 20.000
r = 1% + ---------------------- x 1%
21.244 – 18 .914

= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)12 – 1 ] x 100 = 20%

28. The discounted value of the debentures to be redeemed between 8 to 10 years

evaluated at the end of the 5th year is:
Rs.10 million x PVIF (8%, 3 years)
 + Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)
= Rs.10 million (0.794 + 0.735 + 0.681)
= Rs.22.1 million
If A is the annual deposit to be made in the sinking fund for the years 1 to 5, then
A x FVIFA (8%, 5 years) = Rs.22.1 million
A x 5.867 = Rs.22.1 million
A = Rs.22.1 million / 5.867 = Rs.3.767 million

29. Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn
annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (10 %, n) = Rs.100,000 / Rs.20,000 = 5.000
From the tables we find that
PVIFA (10%, 7 years) = 4.868
PVIFA (10%, 8 years) = 5.335
Thus n is between 7 and 8. Using a linear interpolation we get

5.000 – 4.868
n=7+ ----------------- x 1 = 7.3 years
5.335 – 4.868

30. Equated annual installment = 500000 / PVIFA(14%,4)

= 500000 / 2.914
= Rs.171,585

Loan Amortisation Schedule

Beginning Annual Principal Remaining

Year amount installment Interest repaid balance
1 500000 171585 70000 101585 398415
2 398415 171585 55778 115807 282608
3 282608 171585 39565 132020 150588
4 150588 171585 21082 150503 85*

(*) rounding off error

31. Define n as the maturity period of the loan. The value of n can be obtained
from the equation.
200,000 x PVIFA(13%, n) = 1,500,000
PVIFA (13%, n) = 7.500
From the tables or otherwise it can be verified that PVIFA(13%,30) = 7.500
Hence the maturity period of the loan is 30 years.
32. Expected value of iron ore mined during year 1 = Rs.300 million
Expected present value of the iron ore that can be mined over the next 15 years
assuming a price escalation of 6% per annum in the price per tonne of iron

1 – (1 + g)n / (1 + r)n
= Rs.300 million x (1+g) x ------------------------
r-g

= Rs.300 million x 1.06 x 1 – (1.06)15 / (1.16)15

0.16 – 0.06

= Rs.300 million x 1.06 x (0.74135 / 0.10)

= Rs.2357.5 million

MINICASE

1. How much money would Ramesh need 15 years from now?

500,000 x PVIFA (10%, 15years)

+ 1,000,000 x PVIF (10%, 15years)
= 500,000 x 7.606 + 1,000,000 x 0.239
= 3,803,000 x 239,000
= Rs.4,042,000

2. How much money should Ramesh save each year for the next 15 years to be
able to meet his investment objective?

Ramesh’s current capital of Rs.600,000 will grow to :

600,000 (1.10)15 = 600,000 x 4.177 = Rs 2,506,200

This means that his savings in the next 15 years must grow to :

4,042,000 – 2,506,200 = Rs 1,535,800

So, the annual savings must be :

 1,535,800 1,535,800
= = Rs.48,338
FVIFA (10%, 15 years) 31.772

3. How much money would Ramesh need when he reaches the age of 60 to meet
his donation objective?

200,000 x PVIFA (10% , 3yrs) x PVIF (10%, 11yrs)

= 200,000 x 2.487 x 0.317 = 157,676

4. What is the present value of Ramesh’s life time earnings?

400,000 400,000(1.12) 400,000(1.12)14

46
1 2 15

15
1.12
1–
1.08
= 400,000
0.08 – 0.12

= Rs.7,254,962

Chapter 8

INVESTMENT CRITERIA

1.(a) NPV of the project at a discount rate of 14%.

 100,000 200,000
= - 1,000,000 + ---------- + ------------
(1.14) (1.14)2

300,000 600,000 300,000

+ ----------- + ---------- + ----------
(1.14)3 (1.14)4 (1.14)5

= - 44837

(b) NPV of the project at time varying discount rates

= - 1,000,000

100,000
+
(1.12)

200,000
+
(1.12) (1.13)

300,000
+
(1.12) (1.13) (1.14)

600,000
+
(1.12) (1.13) (1.14) (1.15)

300,000
+
(1.12) (1.13) (1.14)(1.15)(1.16)

= - 1,000,000 + 89286 + 158028 + 207931 + 361620 + 155871

= - 27264

2. Investment A

a) Payback period = 5 years

b) NPV = 40000 x PVIFA (12%,10) – 200 000
= 26000
c) IRR (r ) can be obtained by solving the equation:
40000 x PVIFA (r, 10) = 200000
i.e., PVIFA (r, 10) = 5.000

From the PVIFA tables we find that

PVIFA (15%,10) = 5.019

PVIFA (16%,10) = 4.883

Linear interporation in this range yields

r = 15 + 1 x (0.019 / 0.136)
= 15.14%

d) BCR = Benefit Cost Ratio

= PVB / I
= 226,000 / 200,000 = 1.13

Investment B

a) Payback period = 9 years

b) NP V = 40,000 x PVIFA (12%,5)

+ 30,000 x PVIFA (12%,2) x PVIF (12%,5)
+ 20,000 x PVIFA (12%,3) x PVIF (12%,7)
- 300,000

= (40,000 x 3.605) + (30,000 x 1.690 x 0.567)

+ (20,000 x 2.402 x 0.452) – 300,000
= - 105339

c) IRR (r ) can be obtained by solving the equation

40,000 x PVIFA (r, 5) + 30,000 x PVIFA (r, 2) x PVIF (r,5) +
20,000 x PVIFA (r, 3) x PVIF (r, 7) = 300,000
Trying r = 1%, LHS =( 40,000 x 4.853 )+ (30,000x1.970x0.951)
+(20,000x2.941x0.933)
= 194120+56204 + 54879 = 305,203
Trying r = 2%, LHS ==( 40,000 x 4.713)+ (30,000x1.942x0.906)
+(20,000x2.884x0.871)
= 188520+52784 + 50239 = 291,543
By linear interpolation, r = 1 +( 305203-300000) / (305203-291543)
= 1 + 0.38 = 1.38 %

d) BCR = PVB / I
 = 194,661 / 300,000 = 0.65

Investment C

a) Payback period lies between the 2nd and 3rd years as the cumulative
cash flow at the end of the second year is - 70,000 and at the end of the third
year is 10,000. Linear interpolation in this range provides an approximate
payback period = 2 + 70,000/ ( 70,000+10,000) = 2.88 years.

b) NPV = 80.000 x PVIF (12%,1) + 60,000 x PVIF (12%,2)

+ 80,000 x PVIF (12%,3) + 60,000 x PVIF (12%,4)
+ 80,000 x PVIF (12%,5) + 60,000 x PVIF (12%,6)
+ 40,000 x PVIFA (12%,4) x PVIF (12%,6)
- 210,000

= 80.000 x 0.893 + 60,000 x 0.797

+ 80,000 x 0.712 + 60,000 x 0.636
+ 80,000 x 0.567 + 60,000 x 0.507
+ 40,000 x 3.037 x 0.507- 210,000
= 141,750

c) IRR (r) is obtained by solving the equation

80,000 x PVIF (r,1) + 60,000 x PVIF (r,2) + 80,000 x PVIF (r,3)
+ 60,000 x PVIF (r,4) + 80,000 x PVIF (r,5) + 60,000 x PVIF (r,6)
+ 40000 x PVIFA (r,4) x PVIF (r,6) = 210000

Trying r = 28 %, LHS =
80,000 x 0.781 + 60,000 x 0.610 + 80,000 x 0.477
+ 60,000 x 0.373 + 80,000 x 0.291 + 60,000 x 0.227
+ 40000 x 2.241 x 0.227
= 62,480 + 36,600+38,160+22,380+23,280+13,620+20,348= 216,868

Trying r = 32 %, LHS =
80,000 x 0.758 + 60,000 x 0.574+ 80,000 x 0.435
+ 60,000 x 0.329 + 80,000 x 0.250 + 60,000 x 0.189
+ 40000 x 2.096 x 0.189
= 60,640 + 34,440 + 34,800 + 19,740 + 20,000 + 11,340 + 15,846
= 196,806
By linear interpolation in the range , we get
. r = 28 + [4 x ( 216,868-210,000) / ( 216,868 –196,806)] = 29.36 %

d) BCR = PVB / I = 351,750 / 210,000 = 1.67

Investment D

Payback period lies between the 8th and 9th years as the cumulative cash flow
at the end of the eighth year is - 100,000 and at the end of the ninth year is
100,000. So ,by linear interpolation , it becomes nil half way through, i.e. in 8.5
years, which is the payback period

b) NPV = 200,000 x PVIF (12%,1)

+ 20,000 x PVIF (12%,2) + 200,000 x PVIF (12%,9)
+ 50,000 x PVIF (12%,10) - 320,000
= (200,000 x 0.893) +(20,000 x 0.797) +( 200,000 x 0.361)
+( 50,000 x 0.322) = 178,600+15,940+72,200+16,100-320,000
= - 37,160

c) IRR (r ) can be obtained by solving the equation

200,000 x PVIF (r,1) + 20,000 x PVIF (r,2)
+ 200,000 x PVIF (r,9) + 50,000 x PVIF (r,10)
= 320000
Trying r = 8 %, LHS = (200,000 x 0.926 )+ (20,000 x 0.857)
+ (200,000 x 0.500 )+ (50,000 x 0.463)
= 185,200+17,140+100,000+23,150 = 325,490

Trying r = 9 %, LHS =( 200,000 x 0.917)+ (20,000 x 0.842)

+( 200,000 x 0.460)+ (50,000 x 0.422)
= 183,400+16,840+92,000+21,100 = 313,340
By linear interpolation, we get
. r = 8 + ( 325,490 –320,000)/ ( 325,490 –313,340) = 8.45%

d) BCR = PVB / I = 282,840 / 320,000 = 0.88

Comparative Table

Investment A B C D

a) Payback period
(in years) 5 9 2.88 8.5

b) NPV @ 12% 26000 -105339 141750 -37160

c) IRR (%) 15.14 1.38 29.36 8.45

d) BCR 1.13 0.65 1.67 0.88

Among the four alternative investments, the investment to be chosen is ‘C’

because it has the a. Lowest payback period
 b. Highest NPV
c. Highest IRR
d. Highest BCR

3. IRR (r) can be calculated by solving the following equations for the value of r.
60000 x PVIFA (r,7) = 300,000
i.e., PVIFA (r,7) = 5.000
Trying r= 9%, LHS = 60,000 x 5.033 = 301,980
Trying r=10%, LHS = 60,000 x 4.868 = 292,080
(301,980 – 300,000)
By linear interpolation , r = 9 + 1 x ------------------------- = 9.20%
(301,980 – 292,080)

4. The IRR (r) for the given cashflow stream can be obtained by solving the
following equation for the value of r.
-3000 + 9000 / (1+r) – 3000 / (1+r)2 = 0
Simplifying the above equation we get
r = 1.61, -0.61; (or) 161%, (-)61%

Note : Given two changes in the signs of cashflow, we get two values for the
IRR of the cashflow stream. In such cases, the IRR rule breaks down.

5. Define NCF as the minimum constant annual net cashflow that justifies the
purchase of the given equipment. The value of NCF can be obtained from the
equation
NCF x PVIFA (10%,8) = 500000
NCF = 500000 / 5.335
= 93271

6. Define I as the initial investment that is justified in relation to a net annual cash
inflow of 25000 for 10 years at a discount rate of 12% per annum. The value
of I can be obtained from the following equation
25000 x PVIFA (12%,10) = I
i.e., I = 141250

7. Let us assume a discount rate of 15 percent.

PV of benefits (PVB) = 25000 x PVIF (15%,1) +40000 x PVIF (15%,2)
+ 50000 x PVIF (15%,3)+ 40000 x PVIF (15%,4)
+ 30000 x PVIF (15%,5)
= (25000 x 0.870) +(40000 x 0.756)+( 50000 x 0.658)
+( 40000 x 0.572)+ ( 30000 x 0.497)
= 21750+30240+32900+22880+14910=122680 (A)
Investment = 100,000 (B)
Benefit cost ratio = (A) / (B) = 1.23
8. The NPV’s of the three projects are as follows:

Project
P Q R
Discount rate
0% 400 500 600
5% 223 251 312
10% 69 40 70
15% - 66 - 142 - 135
25% - 291 - 435 - 461
30% - 386 - 555 - 591

9.
(a) NPV profiles for Projects P and Q for selected discount rates are as follows:
Project
P Q
Discount rate (%)
0 2950 500
5 1876 208
10 1075 - 28
15 471 - 222
20 11 - 382

b) (i) The IRR (r ) of project P can be obtained by solving the following

equation for `r’.

-1000 -1200 x PVIF (r,1) – 600 x PVIF (r,2) – 250 x PVIF (r,3)
+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5) = 0
Trying r=20%,
LHS= -1000 -(1200 x 0.833) – (600 x 0.694) – (250 x 0.579)
+( 2000 x 0.482) +( 4000 x 0.402)
= -1000-999.6-416.4-144.75+964 +1608 = 11.25
Trying r=24%,
LHS = -1000 -(1200 x 0.806) –( 600 x 0.0.650) –( 250 x 0.524)
+( 2000 x0.423) +( 4000 x 0.341)
= -1000-967.2- 390 – 131 +846 + 1364 = - 278.2
By linear interpolation, we get
11.25
. r = 20 + 4 x ----------------------- = 20 + 0.16 = 20.16%
( 11.25 + 278.2)
 (ii) The IRR (r') of project Q can be obtained by solving the following
equation for r'
-1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5) = 0

Through a process of trial and error we find r' as follows

Trying r’ = 9%, we get LHS
= -1600 + (200 x 0.917)+ (400 x 0.842) +( 600 x 0.772)
+ (800 x 0.0.708) + (100 x 0.650)
= -1600 + 183.4 + 336.8 + 463.2 + 566.4 +65.0 = 14.8
Trying r’ = 10 %, we get LHS
= -1600 + (200 x 0.909)+ (400 x 0.826) +( 600 x 0.751)
+ (800 x 0.0.683) + (100 x 0.621)
= -1600 + 181.8 + 330.4 + 450.6 + 546.4 +62.1 = - 28.7
By linear interpolation, we get
. 14.8
’
r = 9 + ------------------ = 9 + 0.34 = 9.34 %
( 14.8 + 28.7)

c) From (a) we find that at a cost of capital of 10%

NPV (P) = 1075
NPV (Q) = - 28
As NPV (P) > NPV (Q) and NPV (P) > 0, I would choose project P.
From (a) we find that at a cost of capital of 20%
NPV (P) = 11
NPV (Q) = - 382
Again NPV (P) > NPV (Q); and NPV (P) > 0. I would choose project P.

d) Project P
PV of investment-related costs
= 1000 x PVIF (12%,0)
+ 1200 x PVIF (12%,1) + 600 x PVIF (12%,2)
+ 250 x PVIF (12%,3)
= 1000 + (1200x 0.893) + (600x0.797) +(250x0.712)
= 1000+ 1071.6+478.2+178 = 2728
TV of cash inflows = 2000 x (1.12) + 4000 = 6240
The MIRR of the project P is given by the equation:
6240
------------ = 2728
(1 + MIRR)5
(1 + MIRR)5 = 2.2874 . MIRR = 18%
 Project Q

PV of investment-related costs = 1600

TV of cash inflows = 200x (1.12) + 400x(1.12) +600x(1.12)2 +800x(1.12)1 +100
4 3

= 314.70 + 561.97 +752.64+896 +100= 2625.31

The MIRR of the project Q is given by the equation:

2625.31
------------ = 1600
(1 + MIRR)5
(1 + MIRR)5 = 1.6408. MIRR = 10.41%

10.
(a) Project A
NPV at a cost of capital of 12%
= - 100 + 25 x PVIFA (12%,6)
= Rs.2.78 million

IRR (r ) can be obtained by solving the following equation for r.

25 x PVIFA (r,6) = 100
i.e., PVIFA (r,6) = 4 By trial and error we can find the value of r as
follows. Trying r = 12 % we get LHS = 4.111
. Trying r = 13% we get LHS = 3.998 . By linear interpolation we get
( 4.111 – 4.000)
r = 12 + 1 x --------------------- = 12 + 0.98
( 4.111-3.998)
r = 12,98%

Project B
NPV at a cost of capital of 12%
= - 50 + 13 x PVIFA (12%,6)
= Rs.3.45 million

IRR (r') can be obtained by solving the equation

13 x PVIFA (r',6) = 50. i.e. PVIFA (r',6) = 3.846

By trial and error we can find the value of r’ as follows.

Trying r’ = 14% we get LHS = 3.889
. Trying r’ = 15% we get LHS = 3.784 . By linear interpolation we get
( 3.889 – 3.846)
,
r = 14 + 1 x --------------------- = 14 + 0.41 =14.41 %
( 3.889-3.784)
(b) Difference in capital outlays between projects A and B is Rs.50 million
Difference in net annual cash flow between projects A and B is Rs.12 million.
NPV of the differential project at 12%
= -50 + 12 x PVIFA (12%,6)
= - Rs.0.668 million

IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6) = 50 i.e. PVIFA (r'', 6) = 4.167
By trial and error we can find the value of r’’ as follows.
Trying r’’ = 11% we get LHS = 4.231
. Trying r’’ = 12% we get LHS = 4.111 . By linear interpolation we get
( 4.231– 4.167)
’’
r = 11 + 1 x --------------------- = 11 + 0.53 =11.53 %
( 4.231- 4.111)

11.
(a) Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period
20
= 2 + 1 x ----- = 2.63 years
3
Project N
The pay back period lies between 1 and 2 years. Interpolating in this range we
get an approximate pay back period
12
= 1 + 1 x -------- = 1.55 years
22

(c) Project M
( Rs. in millions)
-------------------------------------------------------------------------------------------------
Year Cash Flow Discounting Present Value Cumulative Net Cash
Factor @12% Flow after Discounting
-------------------------------------------------------------------------------------------------
0 - 50 1.000 - 50 - 50
1 11 0.893 9.823 - 40.177
2 19 0.797 15.143 - 25.034
 3 32 0.712 22.784 - 2.250
4 37 0.636 23.532 21.282

Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in
2.250
this range we get an approximate DPB = 3 + 1 x ------------------- = 3.1 years
( 2.250 + 21.282)

Project N

( Rs. in millions)
-------------------------------------------------------------------------------------------------
Year Cash Flow Discounting Present Value Cumulative Net Cash
Factor @12% Flow after Discounting
-------------------------------------------------------------------------------------------------
0 - 50 1.000 - 50 - 50
1 38 0.893 33.934 - 16.066
2 22 0.797 17.534 1.468

Discounted pay back period (DPB) lies between 1 and 2 years. Interpolating in
16.066
this range we get an approximate DPB = 1 + 1 x ------------------- = 1.92 years
( 16.066 + 1.468 )
.
(c) Project M
Cost of capital = 12% per annum
NPV = - 50 + 11 x PVIFA (12%,1)+ 19 x PVIF (12%,2)
+ 32 x PVIF (12%,3)+ 37 x PVIF (12%,4)
= -50 + (11 x0.893)+ (19 x 0.797)+ ( 32 x 0.712)+( 37 x0.636)
= - 50 + 9.823 + 15.143 + 22.784 + 23.532 = Rs.21.282 million

Project N
Cost of capital = 12% per annum
NPV = - 50 + 38 x PVIFA (12%,1)+ 22 x PVIF (12%,2)
+ 18 x PVIF (12%,3)+ 10 x PVIF (12%,4)
= - 50 + (38 x0.893)+ (22 x 0.797)+ ( 18 x 0.712)+( 10 x0.636)
= - 50 + 33.934 + 17.534 + 12.816+ 6.360 = Rs.20.644 million

Since the two projects are independent and the NPV of each project is (+) ve,
both the projects can be accepted. This assumes that there is no capital
 constraint.

(d) Project M
Cost of capital = 10% per annum

NPV = - 50 + 11 x PVIFA (10%,1)+ 19 x PVIF (10%,2)

+ 32 x PVIF (10%,3)+ 37 x PVIF (10%,4)
= -50 + (11 x0.909)+ (19 x 0.826)+ ( 32 x 0.751)+( 37 x0.683)
= - 50 + 9.999 + 15.694 + 24.032+ 25.271 = Rs.24.996 million

Project N
Cost of capital = 10% per annum
NPV = - 50 + 38 x PVIFA (10%,1)+ 22 x PVIF (10%,2)
+ 18 x PVIF (10%,3)+ 10 x PVIF (10%,4)
= -50 + (38 x0.909)+ (22 x 0.826)+ ( 18 x 0.751)+( 10 x0.683)
= - 50 + 34.542 + 18.172 + 13.518+ 6.830 = Rs.23.062 million

Since the two projects are mutually exclusive, we need to choose the project
with the higher NPV i.e., choose project M.

Note : The MIRR can also be used as a criterion of merit for choosing between
the two projects because their initial outlays are equal.

(e) Project M
Cost of capital = 15% per annum
NPV = - 50 + 11 x PVIFA (15%,1)+ 19 x PVIF (15%,2)
+ 32 x PVIF (15%,3)+ 37 x PVIF (15%,4)
= -50 + (11 x0.870)+ (19 x 0.756)+ ( 32 x 0.658)+( 37 x0.572)
= - 50 + 9.570 + 14.364+ 21.056 + 21.164 = Rs.16.154 million

Project N
Cost of capital: 15% per annum

NPV = - 50 + 38 x PVIFA (15%,1)+ 22 x PVIF (15%,2)

+ 18 x PVIF (15%,3)+ 10 x PVIF (15%,4)
= -50 + (38 x0.870)+ (22 x 0.756)+ ( 18 x 0.658)+( 10 x0.572)
= - 50 + 33.06 + 16.632 + 11.844 + 5.720 = Rs.17.256 million
Again the two projects are mutually exclusive. So we choose the project with the
higher NPV, i.e., choose project N.

(f) Project M
Terminal value of the cash inflows:
 = 11x(1.14)3 + 19 x (1.14)2 + 32x(1.14) + 37 = 16.297 + 24.692 + 36.48 +37
= 114.469
MIRR of the project is given by the equation
50 (1 + MIRR)4 = 114.469 i.e. (1 + MIRR)4 = 2.289
i.e., MIRR = 23.00 %
Project N
Terminal value of the cash inflows:
= 38 x(1.14)3 + 22 x (1.14)2 + 18x(1.14) +10 = 56.299+ 28.591+20.52 +10
= 115.41
MIRR of the project is given by the equation
50 (1 + MIRR)4 = 115.41 i.e. (1 + MIRR)4 = 2.308
i.e., MIRR = 23.26%

12. The internal rate of return is the value of r in the equation

2,000 1,000 10,000 2,000

8000 = - + +
(1+r) (1+r)2 (1+r)3 (1+r)4
At r = 18%, the right hand side is equal to
= 1694.92 – 718.18 + 6086.31 + 1031.58 = 8094.63

At r = 20%, the right hand side is equal to

= 1666.67 – 694.44 + 5787.04 + 964.51 = 7723.78

By linear interpolation we get

(8094.63 – 8000)
. r = 18% + x 2% = 18.5%
(8094.63 – 7723.78)

Unrecovered Investment Balance

Year Unrecovered Interest for the Cash flow at the Unrecovered
investment balance at year Ft-1 (1+r) end of the year investment balance at
the beginning Ft-1 CFt the end of the year Ft-1
(1+r) + CFt
1 -8000 -1480 2000 -7480
2 -7480 -1383.8 -1000 -9863.8
3 -9863.8 -1824.80 10000 -1688.60
4 -1688.60 -312.39 2000 0
13. Rs. in lakhs
Year 1 2 3 4 5 6 7 8 Sum Average
Investment 24.0 21.0 18.0 15.0 12.0 9.0 6.0 3.0 108 13.500
Depreciation 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 24.0 3.000
Income before 6.0 6.5 7.0 7.0 7.0 6.5 6.0 5.0 51.0 6.375
interest and tax
Interest 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 20.0 2.500
Income before tax 3.5 4.0 4.5 4.5 4.5 4.0 3.5 2.5 31.0 3.875
Tax - 1.0 2.5 2.5 2.5 2.2 1.9 1.4 14.0 1.750
Income after tax 3.5 3.0 2.0 2.0 2.0 1.8 1.6 1.1 17.0 2.125

Measures of Accounting Rate of Return

A. Average income after tax 2.125

= = 8.9%
Initial investment 24

B. Average income after tax 2.125

= = 15.7%
Average investment 13.5

C. Average income after tax but before interest 2.125 + 2.5

= = 19.3%
Initial investment 24

D. Average income after tax but before interest 2.125 + 2.5

= = 34.3%
Average investment 13.5

E. Average income before interest and taxes 6.375

= = 26.6%
Initial investment 24

F. Average income before interest and taxes 6.375

= = 47.2%
Average investment 13.5

G. Total income after tax but before

 Depreciation – Initial investment 17.0 + 24.0 – 24.0
=
(Initial investment / 2) x Years (24 / 2) x 8

= 17.0 / 96.0 = 17.7%

MINICASE
The theory part of the solution may be obtained from the relevant part of the
text. The solution for the calculation part is as under.

a) Project A.
Year Cash flow Unrecovered investment balance By linear interpolation
----- ---------- -------------------------------- the payback period
0 ( 5000) ( 5000) 1500
1 3500 ( 1500) = 1 + -- --------- = 1.6 years
2 2500 1000 1500 + 1000

Calculation of discounted payback period

--------------------------------------------
Year Cash flow Discounting factor Present Cumulative net cash
at 12 percent Value flow after discounting
------ ----------- ------------------- ------ ---------------------
0 ( 5000) 1.000 ( 5000) ( 5000)
1 3500 0.893 3126 ( 1874)
2 2500 0.797 1993 119
1874
By linear interpolation, the discounted payback period is = 1 + ------------ = 1. 94
years 1874 + 119

Project B
Year Cash flow Unrecovered investment
balance
----- ---------- ----------------------------- By linear interpolation the payback
0 ( 5000) ( 5000) 1000
1 1000 ( 4000) period= 2 + ------------- = 2.25years
2 3000 (1000) 1000 + 3000
3 4000 3000
 Calculation of discounted payback period
--------------------------------------------
Year Cash flow Discounting factor Present Cumulative net cash
at 12 percent Value flow after discounting
------ ----------- ------------------- ------- ---------------------
0 ( 5000) 1.000 ( 5000) ( 5000)
1 1000 0.893 893 ( 4107)
2 3000 0.797 2391 1716
3 4000 0.712 2848 1132
1716
By linear interpolation, the discounted payback period is = 2 + ----------- = 2.60 years
1716 + 1132

b)
NPV of project A = -5000 + 3500 PVIF( 12%, 1yr) + 2500 PVIF (12%, 2yrs) +
1500 PVIF( 12%, 3yrs)
= -5000+ 3500 x 0.893 + 2500 x 0. 797 + 1500 x 0.712
= - 5000 + 3126 + 1992 + 1068 = 1186
NPV of project B = -5000 + 1000 PVIF( 12%, 1yr) + 3000 PVIF( 12%, 2yrs) +
4000 PVIF( 12%, 3yrs)
= -5000 + 1000x 0. 893 + 3000 x 0. 797 + 4000 x 0.712
= -5000 + 893 + 2391 + 2848 = 1132
NPV of project C = -5000 + 15000 PVIF( 12%, 1yr) - 10000 PVIF( 12%, 2yrs)
= -5000 + 15000x 0. 893 - 10000 x 0. 797
= -5000 + 13395 - 7970 = 425

c)
Project A

Let the IRR be r . We then have

3500 PVIF( r, 1yr) + 2500 PVIF ( r, 2yrs) + 1500 PVIF ( r, 3yrs) = 5000
Trying r=24 %, LHS = 3500 x 0. 806 + 2500 x 0.650 + 1500 x 0.524
= 2821 + 1625 + 786 = 5232
As the RHS is slightly higher than 5000, we try a higher value for r
Trying r=28 %, LHS = 3500 x 0. 781+ 2500 x 0.610 + 1500 x 0.477
= 2733 + 1525 + 716 = 4974
5232 - 5000
By linear interpolation in the range of 24% and 28%, r = 24 + ( 28-24)x -------------
5232 – 4974
= = 24 + 3.60 = 27.60%

Project B
 Let the IRR be r . We then have
1000 PVIF( r, 1yr) + 3000 PVIF ( r, 2yrs) + 4000 PVIF ( r, 3yrs) = 5000
Trying r=20 %, LHS = 1000 x 0. 833 + 3000 x 0.694 + 4000 x 0.579
= 833 + 2082 + 2316 = 5231
As the RHS is slightly higher than 5000, we try a higher value for r
Trying r=24 %, LHS = 1000 x 0. 806+ 3000 x 0.650 + 4000 x 0.524
= 806 + 1950 + 2096 = 4852
5231 - 5000
By linear interpolation in the range of 20% and 24%, r = 20 + ( 24-20)x --------------
5231 – 4852
= = 20 + 2.44 = 22.44%

Project C

As the cash flow stream is non-conventional, IRR is not uniquely defined.

d)
Project A

Present value of the costs = 5000

Present value of the benefits discounted at the cost of capital 12 percent
= 3500 PVIF( 12%, 1yr) + 2500 PVIF (12%, 2yrs) + 1500 PVIF( 12%, 3yrs)
= 3500 x 0.893 + 2500 x 0.797 + 1500 x 0.712 = 3126 + 1992 + 1068 = 6186
6186
We have -------------- = 5000
( 1 + MIRR)3

( 1 + MIRR)3 = 1. 2372 or 1+ MIRR =1.0735. Therefore MIRR= 7.35 percent

Project B

Present value of the costs = 5000

Present value of the benefits discounted at the cost of capital 12 percent
= 1000 PVIF( 12%, 1yr) + 3000 PVIF (12%, 2yrs) + 4000 PVIF( 12%, 3yrs)
= 1000 x 0.893 + 3000 x 0.797 + 4000 x 0.712 = 893 + 2391 + 2848 = 6132
6132
We have -------------- = 5000
( 1 + MIRR)3

( 1 + MIRR)3 = 1. 2264 or 1+ MIRR =1.0704. Therefore MIRR= 7.04 percent

Project C

Present value of the costs = 5000 + 10,000 PVIF ( 12%, 2yrs)

 = 5000 x 10,000 x 0.797 = 5000 + 7970 = 12,790
Present value of the benefit discounted at the cost of capital 12 percent
= 15,000 PVIF( 12%, 1yr) = 15,000 x 0.893 = 13,395
13,395
We have -------------- = 12,790
( 1 + MIRR)2

( 1 + MIRR)2 = 1.0328 or 1+ MIRR =1.0163. Therefore MIRR= 1.63 percent

Chapter 9

PROJECT CASH FLOWS

1.
(a) Project Cash Flows (Rs. in million)

Year 0 1 2 3 4 5 6 7

1. Plant & machinery (150)

2. Working capital (50)

3. Revenues 250 250 250 250 250 250 250

4. Costs (excluding de-

preciation & interest) 100 100 100 100 100 100 100

5. Depreciation 37.5 28.13 21.09 15.82 11.87 8.90 6.67

6. Profit before tax 112.5 121.87 128.91 134.18 138.13 141.1 143.33

7. Tax 33.75 36.56 38.67 40.25 41.44 42.33 43.0

8. Profit after tax 78.75 85.31 90.24 93.93 96.69 98.77

100.33

9. Net salvage value of

plant & machinery 48

10. Recovery of working 50

capital

11. Initial outlay (=1+2) (200)

12. Operating CF (= 8 + 5) 116.25 113.44 111.33 109.75 108.56 107.67 107.00

13. Terminal CF ( = 9 +10) 98

14. NCF (200) 116.25 113.44 111.33 109.75 108.56 107.67 205

(d) IRR (r) of the project can be obtained by solving the following equation for r

-200 + 116.25 x PVIF (r,1) + 113.44 x PVIF (r,2)

+ 111.33 x PVIF (r,3) + 109.75 x PVIF (r,4) + 108.56 x PVIF (r,5)
+107.67 x PVIF (r,6) + 205 x PVIF (r,7) = 0
 Through a process of trial and error, we get the value of r as under.
Trying r =55%, LHS
116.25 113.44 111.33 109.75 108.56 107.67 205
= -200 + --------- + --------- + -------- + --------- + -------- + -------- + ---------
1.55 (1.55)2 (1.55)3 (1.55)4 (1.55)5 (1.55)6 (1.55)7

= - 200 + 75 + 47.22 +29.90 + 19.01 +12.13 + 7.76 + 9.54 = 0.56

Trying r =56 %, LHS

116.25 113.44 111.33 109.75 108.56 107.67 205
= -200 + --------- + --------- + -------- + --------- + -------- + -------- + ---------
1.56 (1.56)2 (1.56)3 (1.56)4 (1.56)5 (1.56)6 (1.56)7

= - 200 + 74.52 + 46.61 +29.33 + 18.53 +11.75 + 7.47 + 9.12 = - 2.67

0.56
By linear interpolation r = 55 + 1 x ------------- = 55 .17%
0.56 + 2.67

2. Post-tax Incremental Cash Flows (Rs. in million)

Year 0 1 2 3 4 5 6 7

1. Capital equipment (120)

2. Level of working capital 20 30 40 50 40 30 20
(ending)
3. Revenues 80 120 160 200 160 120 80
4. Raw material cost 24 36 48 60 48 36 24
5. Variable mfg cost. 8 12 16 20 16 12 8
6. Fixed operating & maint. 10 10 10 10 10 10 10
cost
7. Variable selling expenses 8 12 16 20 16 12 8
8. Incremental overheads 4 6 8 10 8 6 4
9. Loss of contribution 10 10 10 10 10 10 10
10.Bad debt loss 4
11. Depreciation 30 22.5 16.88 12.66 9.49 7.12 5.34
12. Profit before tax -14 11.5 35.12 57.34 42.51 26.88 6.66
13. Tax - 4.2 3.45 10.54 17.20 12.75 8.06 2.00
14. Profit after tax - 9.8 8.05 24.58 40.14 29.76 18.82 4.66
15. Net salvage value of
capital equipments 25
16. Recovery of working 16
capital
17. Initial investment (120)
18. Operating cash flow 20.2 30.55 41.46 52.80 39.25 25.94 14.00
(14 + 10+ 11)
19.  Working capital 20 10 10 10 (10) (10) (10)
20. Terminal cash flow 41

21. Net cash flow (140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00
(17+18-19+20)

(b) NPV of the net cash flow stream @ 15% per discount rate

= -140 + 10.20 x PVIF(15%,1) + 20.55 x PVIF (15%,2)

+ 31.46 x PVIF (15%,3) + 62.80 x PVIF (15%,4) + 49.25 x PVIF
(15%,5) + 35.94 x PVIF (15%,6) + 55 x PVIF (15%,7)
= -140 + (10.20 x 0.870) + (20.55 x 0.756)+( 31.46 x 0.658)
+( 62.80 x 0.572) +( 49.25 x 0.497) +( 35.94 x 0.432) +( 55 x 0.376)
= -140+ 8.874 + 15.536 +20.701 + 35.922 +24.477 +15.526 + 20.68
= Rs.1.716 million

3. Note: In the problem where it is stated that the ‘working capital associated with
ths machine is Rs.500,000’ the same should be read as ‘ incremental working capital
associated with the new machine is Rs. 500,000’. Also in the sentence ‘ The net
working capital required for the new machine is expected to bring a saving of
Rs.650,000 annually in manufacturing costs…..’ delete the words ‘ The net working
capital required for’.
(a) A. Initial outlay (Time 0)

i. Cost of new machine Rs. 3,000,000

ii. Salvage value of old machine 900,000
iii Incremental working capital requirement 500,000
iv. Total net investment (=i – ii + iii) 2,600,000

B. Operating cash flow (years 1 through 5)

Year 1 2 3 4 5

i. Post-tax savings in
manufacturing costs 455,000 455,000 455,000 455,000 455,000

ii. Incremental
depreciation 550,000 412,500 309,375 232,031 174,023

iii. Tax shield on

incremental dep. 165,000 123,750 92,813 69,609 52,207

iv. Operating cash

flow ( i + iii) 620,000 578,750 547,813 524,609 507,207

C. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 1,500,000

ii. Salvage value of old machine 200,000
iii. Recovery of incremental working capital 500,000
iv. Terminal cash flow ( i – ii + iii) 1,800,000

D. Net cash flows associated with the replacement project (in Rs)

Year 0 1 2 3 4 5

NCF (2,600,000) 620,000 578,750 547,813 524,609 2,307,207

(b) NPV of the replacement project

= - 2600000 + 620000 x PVIF (14%,1) + 578750 x PVIF (14%,2)

+ 547813 x PVIF (14%,3) + 524609 x PVIF (14%,4) + 2307207 x PVIF (14%,5)
= - 2600000 + (620000 x 0.877) +(578750 x 0.769) +( 547813 x 0.675)
 +( 524609 x 0.592) +( 2307207 x 0.519)
= - 2600000 + 543740 + 445059 + 369774 + 310568 +1197440 = 266,581
4. Tax shield (savings) on depreciation (in Rs)

Depreciation Tax shield PV of tax shield

Year charge (DC) =0.4 x DC @ 15% p.a.

1 25000 10000 8696

2 18750 7500 5671

3 14063 5625 3699

4 10547 4219 2412

5 7910 3164 1573

--------
22051
--------

Present value of the tax savings on account of depreciation = Rs.22051

5. A. Initial outlay (at time 0)

i. Cost of new machine Rs. 400,000

ii. Salvage value of the old machine 90,000
iii. Net investment 310,000

B. Operating cash flow (years 1 through 5)

 Year 1 2 3 4 5

i. Depreciation
of old machine 18000 14400 11520 9216 7373

ii. Depreciation
of new machine 100000 75000 56250 42188 31641

iii. Incremental depre-

ciation ( ii – i) 82000 60600 44730 32972 24268

iv. Tax savings on inc-

remental depreciation
( 0.35 x (iii)) 28700 21210 15656 11540 8494

v. Operating cash flow 28700 21210 15656 11540 8494

C. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 25000

ii. Salvage value of old machine 10000
iii. Incremental salvage value of new
machine = Terminal cash flow 15000

D. Net cash flows associated with the replacement proposal.

Year 0 1 2 3 4 5

NCF (310000) 28700 21210 15656 11540 23494

6. Net Cash Flows Relating to Equity

(Rs. in million)
Particulars Year
 0 1 2 3 4 5 6
1. Equity funds (100)
2. Revenues 500 500 500 500 500 500
3. Operating costs 320 320 320 320 320 320
4. Depreciation 83.33 55.56 37.04 24.69 16.46 10.97
5. Interest on working capital 18.00 18.00 18.00 18.00 18.00 18.00
advance
6. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.50
7. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.53
8. Tax 24.335 38.97 51.23 60.405 67.52 73.265
9. Profit after tax 24.335 38.97 51.23 60.405 67.52 73.265
10. Net salvage value of fixed assets 80.00
11. Net salvage value of current 20.00
assets
12. Repayment of term-loans - 40 40 40 40 40
13. Repayment of working capital 100
advance
14. Retirement of trade creditors 50
15. Initial investment (1) (100)
16. Operating cash flows (9+4) 107.665 94.53 88.27 85.095 83.98 84.235
17. Liquidation and retirement cash (40) (40) (40) (40) ( 90)
flows (10+11-12-13-14)
18. Net cash flows (15+16+17) (100) 107.665 54.53 48.27 45.095 43.98 (5.765)

Net Cash Flows Relating to Long-term Funds (Rs. in million)

Particulars Year
0 1 2 3 4 5 6
1. Fixed assets (250)
2. Working capital margin (50)
3. Revenues 500 500 500 500 500 500
4. Operating costs 320 320 320 320 320 320
5. Depreciation 83.33 55.56 37.04 24.69 16.46 10.97
6. Interest on working capital 18.00 18.00 18.00 18.00 18.00 18.00
advance
7. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.50
8. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.53
9. Tax @ 50% 24.335 38.97 51.23 60.405 67.52 73.265
10. Profit after tax 24.335 38.97 51.23 60.405 67.52 73.265
11. Net salvage value of fixed assets 80
12. Net recovery of working capital 50
margin
13. Initial investment (1+2) (300)
14. Operating cash inflow [10+5+7 122.665 108.78 99.52 93.345 89.23 86.845
(1-T) )]
15. Terminal cash flow (11+12) 130.00
16. Net cash flow (13+14+15) (300) 122.665 108.78 99.52 93.345 89.23 216.845
Cash Flows Relating to Total Funds
(Rs. in million)
Year
0 1 2 3 4 5 6
1. Total funds (450)
2. Revenues 500 500 500 500 500 500
3. Operating costs 320 320 320 320 320 320
4. Depreciation 83.33 55.56 37.04 24.69 16.46 10.97
5. Interest on term loan 30.00 28.50 22.50 16.50 10.50 4.50
6. Interest on working capital 18.00 18.00 18.00 18.00 18.00 18.00
advance
7. Profit before tax 48.67 77.94 102.46 120.81 135.04 146.53
8. Tax 24.34 38.97 51.23 60.41 67.52 73.265
9. Profit after tax 24.34 38.97 51.23 60.41 67.52 73.265
10. Net salvalue of fixed assets 80
11. Net salvage value of current assets 200
12. Initial investment (1) (450)
13. Operating cash inflow [9+4+6 131.67 117.78 108.52 102.35 98.23 95.485
(1-t) + 5(1-t)]
14. Terminal cash flow (10+11) 280
15. Net cash flow (12+13+14) (450) 131.67 117.78 108.52 102.35 98.23 375.485

MINICASE
 Cash Flows from the Point of all Investors

Item 0 1 2 3 4 5 6

1. Plant and equipment (200) (200)

2. Net working capital (100)

3. Revenue 750 750 750 750 750

4. Operating costs 525 525 525 525 525

5. Depreciation 100 75 56.3 42.2 31.6

6. Profit before tax 125 150 168.7 182.8 193.4

7. Profit after tax 87.5 105 118.1 128.0 135.4

(0.7 x 6)
8. Net salvage value 100
of plant and
equipment

9. Recovery of net
working capital 100

10. Initial investment (200) (300)

11. Operating cash

flow (7 + 5) 187.5 180 174.4 170.2 167

12. Terminal cash

inflow 200

13. Net cash flow (200) (300) 187.5 180 174.4 170.2 367

Cash Flows from the Point of Equity Investors

 Item 0 1 2 3 4 5 6

1. Equity funds (200)

2. Revenues 750 750 750 750 750
3. Operating costs 525 525 525 525 525
4. Depreciation 100 75 56.3 42.2 31.6
5. Interest on
working capital 12 12 12 12 12
6. Interest on term loan 28 26.3 19.3 12.3 5.3
7. Profit before tax 85 111.7 137.4 158.5 176.1
8. Profit after tax 59.5 78.2 96.2 111 123.3
9. Net salvage value of
plant & equipment 100
10. Recovery of working
capital 200
11. Repayment of term
loans 50 50 50 50
12. Repayment of
working capital
advance 100
13. Retirement of trade
credit 100

14. Initial investment (1) (200)

15. Operating cash
inflows (8 + 4) 159.5 153.2 152.5 153.2 154.9
16. Liquidation &
retirement cash
flows (50) (50) (50) 50
(9 + 10 – 13 – 14 – 15)

17. Net cash flow (200) - 159.5 103.2 102.5 103.2 204.9

Cash Flows as defined by Financial Institutions

Item 0 1 2 3 4 5 6
1. Plant and equipment (200) (200)

2. Net working capital (100)

3. Revenues 750 750 750 750 750

4. Operating costs 525 525 525 525 525

5. Depreciation 100 75 56.3 42.2 31.6

6. Interest on working
capital 12 12 12 12 12

7. Interest on term loan 28 26.3 19.3 12.3 5.3

8. Profit before tax 85 111.8 137.5 158.6 176.1

9. Profit after tax 59.5 78.2 96.3 111 123.3

10. Recovery of net

working capital 100

11. Residual value of

capital assets 20

12. Initial investment (200) (300)

(1 + 2)

13. Operating inflow 199.5 191.5 183.9 177.5 172.2

(8 + 4 + 5 + 6)

14. Terminal inflow 120

(9 + 10)

15. Net cash flow (200) (300) 199.5 191.5 183.9 177.5 192.2
(11 + 12 + 13)

Chapter 10
 THE COST OF CAPITAL

1(a) Define rD as the pre-tax cost of debt. Using the approximate yield formula, rD
can be calculated as follows:

14 + (100 – 108)/10
rD = ------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108

(b) After tax cost = 12.60 x (1 – 0.35) = 8.19%

2. Define rp as the cost of preference capital. Using the approximate yield formula
rp can be calculated as follows:

9 + (100 – 92)/6
rp = --------------------
0.4 x100 + 0.6x92

= 0.1085 (or) 10.85%

3. WACC = 0.4 x 13% x (1 – 0.35)

+ 0.6 x 18%
= 14.18%

4. Cost of equity = 10% + 1.2 x 7% = 18.4%

(using SML equation)
Pre-tax cost of debt = 14%
After-tax cost of debt = 14% x (1 – 0.35) = 9.1%
Debt equity ratio = 2:3
WACC = 2/5 x 9.1% + 3/5 x 18.4%
= 14.68%

5. Given
0.5 x 14% x (1 – 0.35) + 0.5 x rE = 12%

where rE is the cost of equity capital.

Therefore rE = 14.9%
Using the SML equation we get
11% + 8% x β = 14.9%
where β denotes the beta of Azeez’s equity.
Solving this equation we get β = 0.4875.
6 (a) The cost of debt of 12% represents the historical interest rate at the time the debt
was originally issued. But we need to calculate the marginal cost of debt (cost
of raising new debt); and for this purpose we need to calculate the yield to
maturity of the debt as on the balance sheet date. The yield to maturity will not
be equal to 12% unless the book value of debt is equal to the market value of
debt on the balance sheet date.

(b) The cost of equity has been taken as D1/P0 ( = 6/100) whereas the cost of equity
is (D1/P0) + g where g represents the expected constant growth rate in dividend
per share.

7. The book value and market values of the different sources of finance are
provided in the following table. The book value weights and the market value
weights are provided within parenthesis in the table.

(Rs. in million)
Source Book value Market value
Equity 800 (0.54) 2400 (0.78)
Debentures – first series 300 (0.20) 270 (0.09)
Debentures – second series 200 (0.13) 204 (0.06)
Bank loan 200 (0.13) 200 (0.07)
Total 1500 (1.00) 3074 (1.00)

8.
(a) Given
rD x (1 – 0.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pre-tax cost of debt.

(b) Given
13% x (1 – 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.

9. Cost of equity = D1/P0 + g

= 3.00 / 30.00 + 0.05
= 15%
(a) The first chunk of financing will comprise of Rs.5 million of retained
earnings costing 15 percent and Rs.2.5 million of debt costing 14 (1-.6) = 5.6
percent.
The second chunk of financing will comprise of Rs.5 million of additional
equity costing 15 percent and Rs.2.5 million of debt costing 15 (1-.6) = 6.0
percent.
 (b) The marginal cost of capital in the first chunk will be :
5/7.5 x 15% + 2.5/7.5 x 5.6 % = 11.87%
The marginal cost of capital in the second chunk will be :
5/7.5 x 15% + 2.5/7.5 x 6% = 12%

Note : We have assumed that

(i) The net realisation per share will be Rs.25, after floatation costs, and
(ii) The planned investment of Rs.15 million is inclusive of floatation costs

10. The cost of equity and retained earnings

rE = D1/PO + g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :
11 + (100-75)/10
rE = = 15.9%
0.6x75 + 0.4x100
The pre-tax cost of debentures, using the approximate formula, is :
13.5 + (100-80)/6
rD = = 19.1%
0.6x80 + 0.4x100

The post-tax cost of debentures is

19.1 (1-tax rate) = 19.1 (1 – 0.5)
= 9.6%
The post-tax cost of term loans is
12 (1-tax rate) = 12 (1 – 0.5)
= 6.0%

The average cost of capital using book value proportions is calculated below :

Source of capital Component Book value Book value Product of

cost Rs. in million proportion (1) & (3)
(1) (2) (3)
Equity capital 14.5% 100 0.28 4.06
Preference capital 15.9% 10 0.03 0.48
Retained earnings 14.5% 120 0.33 4.79
Debentures 9.6% 50 0.14 1.34
Term loans 6.0% 80 0.22 1.32
360 Average cost 11.99%
of capital

The average cost of capital using market value proportions is calculated below :

Source of capital Component Market value Market value Product of

 cost Rs. in million
(1) (2) (3) (1) & (3)

Equity capital
and retained earnings 14.5% 200 0.62 8.99
Preference capital 15.9% 7.5 0.02 0.32
Debentures 9.6% 40 0.12 1.15
Term loans 6.0% 80 0.24 1.44

327.5 Average cost 11.90%

of capital

(b)
The Rs.100 million to be raised will consist of the following:
Retained earnings Rs.15 million
Additional equity Rs. 35 million
Debt Rs. 50 million
The first batch will consist of Rs. 15 million each of retained earnings
and debt costing 14.5 percent and  14(1-0.5)= 7 percent  respectively. The
second batch will consist of Rs. 10 million each of additional equity and
debt at 14.5 percent and 7percent respectively. The third chunk will
consist of Rs.25 million each of additional equity and debt costing 14.5
percent and 15(1-0.5) = 7.5 percent respectively.
The marginal cost of capital in the chunks will be as under
First batch: (0.5x14.5 ) + (0.5 x 7)    = 10.75 %
Second batch:  (0.5x14.5 ) + (0.5 x 7)   = 10.75 %
Third batch  :   (0.5x14.5 ) + (0.5 x 7.5) = 11 %

The marginal cost of capital schedule for the firm will be as under.

Range of total financing       Weighted marginal cost of

( Rs. in million)         capital ( %)

0 - 50 10.75
50-100 11.00

Here it is assumed that the Rs.100 million to be raised is inclusive of

floatation costs.

11.
(a) WACC = 1/3 x 13% x (1 – 0.3)
+ 2/3 x 20%
= 16.37%
(b) Weighted average floatation cost
= 1/3 x 3% + 2/3 x 12%
= 9%

(c) NPV of the proposal after taking into account the floatation costs
= 130 x PVIFA (16.37%, 8) – 500 / (1 - 0.09)
= [1- 1/(1.1637)8]
130 x --------------------- - 549.45
0.1637
= 130 x 4.292 – 549.45 = 8.51 million

MINICASE

a. All sources other than non-interest bearing liabilities

b. Pre-tax cost of debt & post-tax cost of debt

10 + (100 – 112) / 8 8.5

rd = = = 7.93
0.6 x 112 + 0.4 x 100 107.2

rd (1 – 0.3) = 5.55

c. Post-tax cost of preference

9 + (100 – 106) / 5 7.8

= = 7.53%
0.6 x 106 + 0.4 x 100 103.6

d. Cost of equity using the DDM

2.80 (1.10)
+ 0.10 = 0.385 + 0.10
80
= 0.1385 = 13.85%

e. Cost of equity using the CAPM

 7 + 1.1(7) = 14.70%

f. WACC
0.50 x 14.70 + 0.10 x 7.53 + 0.40 x 5.55
= 7.35 + 0.75 + 2.22
= 10.32%

g. Cost of capital for the new business

0.5 [7 + 1.5 (7)] + 0.5 [ 11 (1 – 0.3)]

8.75 + 3.85
= 12.60%

Chapter 11

RISK ANALYSIS OF SINGLE INVESTMENTS

1.
(a) NPV of the project = -250 + 50 x PVIFA (13%,10)
= Rs.21.31 million

(b) NPVs under alternative scenarios:

(Rs. in million)
Pessimistic Expected Optimistic

Investment 300 250 200

Sales 150 200 275
Variable costs 97.5 120 154
Fixed costs 30 20 15
Depreciation 30 25 20
Pretax profit - 7.5 35 86
Tax @ 28.57% - 2.14 10 24.57
Profit after tax - 5.36 25 61.43
Net cash flow 24.64 50 81.43
Cost of capital 14% 13% 12%

NPV - 171.47 21.31 260.10

Assumptions: (1) The useful life is assumed to be 10 years under all three
scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.

(2) The investment is assumed to be depreciated at 10% per

annum; and it is also assumed that this method and rate of
depreciation are acceptable to the IT (income tax)
authorities.

(3) The tax rate has been calculated from the given table i.e.
10 / 35 x 100 = 28.57%.

(4) It is assumed that only loss on this project can be offset

against the taxable profit on other projects of the
company; and thus the company can claim a tax shield on
the loss in the same year.

(c) Accounting break even point (under ‘expected’ scenario)

Fixed costs + depreciation = Rs. 45 million
Contribution margin ratio = 80 / 200 = 0.4
Break even level of sales = 45 / 0.4 = Rs.112.5 million
 Financial break even point (under ‘expected’ scenario)

i. Annual net cash flow = 0.7143 [ 0.4 x sales – 45 ] + 25

= 0.2857x sales – 7.14

ii. PV (net cash flows) = [0.2857x sales – 7.14 ] x PVIFA (13%,10)

= 1.5502 sales – 38.74

iii. Initial investment = 200

iv. Financial break even level

of sales = 238.74 / 1.5502 = Rs.154.01 million

2.
(a) Sensitivity of NPV with respect to quantity manufactured and sold:
(in Rs)
Pessimistic Expected Optimistic

Initial investment 30000 30000 30000

Sale revenue 24000 42000 54000
Variable costs 16000 28000 36000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax 3000 9000 13000
Tax 1500 4500 6500
Profit after tax 1500 4500 6500
Net cash flow 3500 6500 8500
NPV at a cost of
capital of 10% p.a
and useful life of
5 years -16732 - 5359 2224

(b) Sensitivity of NPV with respect to variations in unit price.

Pessimistic Expected Optimistic

Initial investment 30000 30000 30000

Sale revenue 28000 42000 70000
Variable costs 28000 28000 28000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax -5000 9000 37000
Tax -2500 4500 18500
Profit after tax -2500 4500 18500
 Net cash flow - 500 6500 20500
NPV - 31895 (-) 5359 47715

(c) Sensitivity of NPV with respect to variations in unit variable cost. [ Please note
that the variable cost per unit under the pessimistic and optimistic scenarios are
Rs.40 and Rs.15 respectively( In the problem these figures have inadvertantly
been interchanged)]

Pessimistic Expected Optimistic

Initial investment 30000 30000 30000

Sale revenue 42000 42000 42000
Variable costs 56000 28000 21000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax -19000 9000 16000
Tax -9500 4500 8000
Profit after tax -9500 4500 8000
Net cash flow -7500 6500 10000
NPV -58432 - 5359 7910

(d) Accounting break-even point

i. Fixed costs + depreciation = Rs.5000

ii. Contribution margin ratio = 10 / 30 = 0.3333
iii. Break-even level of sales = 5000 / 0.3333
= Rs.15000

Financial break-even point

i. Annual cash flow = 0.5 x (0.3333 Sales – 5000) + 2000

= 0.1666 x sales -500
ii. PV of annual cash flow = (0.1666 x sales –500) x PVIFA (10%,5)
= 0.6318 sales – 1896
iii. Initial investment = 30000
iv. Break-even level of sales = 31896 / 0.6318 = Rs.50484

3 Define At as the random variable denoting net cash flow in year t.

A1 = 4 x 0.4 + 5 x 0.5 + 6 x 0.1

= 4.7

A2 = 5 x 0.4 + 6 x 0.4 + 7 x 0.2

= 5.8
 A3 = 3 x 0.3 + 4 x 0.5 + 5 x 0.2
= 3.9

NPV = 4.7 / 1.1 +5.8 / (1.1)2 + 3.9 / (1.1)3 – 10

= Rs.2.00 million
12 = [ 0.4(4 –4.7)2 + 0.5(5-4.7)2 + 0.1( 6-4.7)2 ] = 0.41

22 = [ 0.4(5-5.8)2 + 0.4(6-5.8)2 +0.2( 7-5.8)2] = 0.56

32 = [ 0.3(3-3.9)2 +0.5(4-3.9)2 +0.2(5-3.9)2] = 0.49

12 22 32

2 (NPV) = + + = 1.00
(1.1)2 (1.1)4 (1.1)6

 (NPV) = Rs.1.00 million

4 Expected NPV
4 At
=  - 25,000
t
t=1 (1.08)

= 12,000/(1.08) + 10,000 / (1.08)2 + 9,000 / (1.08)3

+ 8,000 / (1.08)4 – 25,000

= [ 12,000 x .926 + 10,000 x .857 + 9,000 x .794 + 8,000 x .735]

- 25,000
= 7,708

Standard deviation of NPV

4 t

t=1 (1.08)t

= 5,000 / (1.08) + 6,000 / (1.08)2 + 5,000 / (1,08)3 + 6,000 / (1.08)4

= 5,000 x .926 + 6,000 x .857 + 5000 x .794 + 6,000 x .735
= 18,152

5 (a) Expected NPV

4 At
=  - 25,000 …. (1)
t=1 (1.06)t
A1 = 2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3
 = 3,100

A2 = 3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3

= 3,900

A3 = 4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2

= 4,900

A4 = 2,000 x 0.2 + 3,000 x 0.4 + 4,000 x 0.4

= 3,200 (Note: In the problem the probability of the cash flow of
4000 is wrongly printed as 0.2)
Substituting these values in (1) we get

Expected NPV = NPV

= 3,100 / (1.06)+ 3,900 / (1.06)2 + 4,900 / (1.06)3 + 3,200 / (1.06)4

- 10,000 = Rs.3,044

(b) The variance of NPV is given by the expression

4 2t
2 (NPV) =  …….. (2)
t=1 (1.06)2t

12 = [(2,000 – 3,100)2 x 0.2 + (3,000 – 3,100)2 x 0.5

+ (4,000 – 3,100)2 x 0.3]
= 490,000

22 = [(3,000 – 3,900)2 x 0.4 + (4,000 – 3,900)2 x 0.3

+ (5,000 – 3900)2 x 0.3]
= 690,000

32 = [(4,000 – 4,900)2 x 0.3 + (5,000 – 4,900)2 x 0.5

+ (6,000 – 4,900)2 x 0.2]
= 490,000

42 = [(2,000 – 3,200)2 x 0.2 + (3,000 – 3,200)2 x 0.4

+ (4,000 – 3200)2 x 0.4]
= 560,000

Substituting these values in (2) we get

 2 (NPV) = 490,000 / (1.06)2 + 690,000 / (1.06)4
+ 490,000 / (1.06)6 + 560,000 / (1.06)8
= [ 490,000 x 0.890 + 690,000 x 0.792
+ 490,000 x 0.705 + 560,000 x 0.627 ]
= 1,679,150
NPV) = 1,679,150 = Rs.1,296

NPV – NPV 0 - NPV

Prob (NPV < 0) = Prob. <
NPV) NPV)

0 – 3044
= Prob Z<
1296

= Prob (Z < -2.35)

The required probability is given by the shaded area in the following normal
curve.

P (Z < - 2.35) = 0.5 – P (-2.35 < Z < 0)

= 0.5 – P (0 < Z < 2.35)
= 0.5 – 0.4906
= 0.0094

So the probability of NPV being negative is 0.0094

6 Given values of variables other than Q, P and V, the net present value model of
Bidhan Corporation can be expressed as:
5
 [Q(P – V) – 3,000 – 2,000] (0.5)+ 2,000 0
t=1
NPV = ---------------------------------------------------------- + ------- - 30,000
(1.1)t (1.1)5
5
 0.5 Q (P – V) – 500
t=1
= ------------------------------------ - 30,000
(1.1)t

= [ 0.5Q (P – V) – 500] x PVIFA (10,5) – 30,000

= [0.5Q (P – V) – 500] x 3.791 – 30,000
= 1.8955Q (P – V) – 31,895.5
 Exhibit 1 presents the correspondence between the values of exogenous
variables and the two digit random number. Exhibit 2 shows the results of the
simulation.

Exhibit 1
Correspondence between values of exogenous variables and
two digit random numbers

QUANTITY PRICE VARIABLE COST

Two digit Two digit Two digit
Cumulative random Cumulative random Cumu- random
Value Pro Prob. numbers Value Pro Prob. numbers Value Pro lative numbers
b b b Prob.
800 0.10 0.10 00 to 09 20 0.40 0.40 00 to 39 15 0.30 0.30 00 to 29
1,000 0.10 0.20 10 to 19 30 0.40 0.80 40 to 79 20 0.50 0.80 30 to 79
1,200 0.20 0.40 20 to 39 40 0.10 0.90 80 to 89 40 0.20 1.00 80 to 99
1,400 0.30 0.70 40 to 69 50 0.10 1.00 90 to 99
1,600 0.20 0.90 70 to 89
1,800 0.10 1.00 90 to 99

Exhibit 2
Simulation Results

QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV

Run Rando Corres- Random Corres- Random Corres- 1.8955 Q(P-V)-31,895.5
 m ponding Number ponding Number ponding
Number Value value value
1 03 800 38 20 17 15 -24,314
2 32 1,200 69 30 24 15 2,224
3 61 1,400 30 20 03 15 -18,627
4 48 1,400 60 30 83 40 -58,433
5 32 1,200 19 20 11 15 -20,523
6 31 1,200 88 40 30 20 13,597
7 22 1,200 78 30 41 20 -9,150
8 46 1,400 11 20 52 20 -31,896
9 57 1,400 20 20 15 15 -18,627
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Run Rando Corres- Random Corres- Random Corres- 1.8955 Q(P-V)-31,895.5
m ponding Number ponding Number ponding
Number Value value value
10 92 1,800 77 30 38 20 2,224
11 25 1,200 65 30 36 20 -9,150
12 64 1,400 04 20 83 40 -84,970
13 14 1,000 51 30 72 20 -12,941
14 05 800 39 20 81 40 -62,224
15 07 800 90 50 40 20 13,597
16 34 1,200 63 30 67 20 -9,150
17 79 1,600 91 50 99 40 -1,568
18 55 1,400 54 30 64 20 -5,359
19 57 1,400 12 20 19 15 -18,627
20 53 1,400 78 30 22 15 7,910
21 36 1,200 79 30 96 40 -54,642
22 32 1,200 22 20 75 20 -31,896
23 49 1,400 93 50 88 40 -5,359
24 21 1,200 84 40 35 20 13,597
25 08 .800 70 30 27 15 -9,150
26 85 1,600 63 30 69 20 -1,568
27 61 1,400 68 30 16 15 7,910
28 25 1,200 81 40 39 20 13,597
29 51 1,400 76 30 38 20 -5,359
30 32 1,200 47 30 46 20 -9,150
31 52 1,400 61 30 58 20 -5,359
32 76 1,600 18 20 41 20 -31,896
33 43 1,400 04 20 49 20 -31,896
34 70 1,600 11 20 59 20 -31,896
35 67 1,400 35 20 26 15 -18,627
36 26 1,200 63 30 22 15 2,224
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Run Random Corres- Random Corres- Random Corres- 1.8955 Q(P-V)-31,895.5
Number ponding Number ponding Number ponding
Value value value
37 89 1,600 86 40 59 20 28,761
38 94 1,800 00 20 25 15 -14,836
39 09 .800 15 20 29 15 -24,314
40 44 1,400 84 40 21 15 34,447
41 98 1,800 23 20 79 20 -31,896
42 10 1,000 53 30 77 20 -12,941
43 38 1,200 44 30 31 20 -9,150
44 83 1,600 30 20 10 15 -16,732
45 54 1,400 71 30 52 20 -5,359
46 16 1,000 70 30 19 15 -3,463
47 20 1,200 65 30 87 40 -54,642
48 61 1,400 61 30 70 20 -5,359
49 82 1,600 48 30 97 40 -62,224
50 90 1,800 50 30 43 20 2,224

Expected NPV = NPV

50
= 1/ 50 NPVi
i=1
= 1/50 (-7,20,961)
= 14,419

50
Variance of NPV = 1/50 NPVi – NPV)2
i=1

= 1/50 [27,474.047 x 106]

= 549.481 x 106

Standard deviation of NPV = 549.481 x 106

= 23,441

7 To carry out a sensitivity analysis, we have to define the range and the most
likely values of the variables in the NPV Model. These values are defined
below

Variable Range Most likely value

I Rs.30,000 – Rs.30,000 Rs.30,000

r 10% - 10% 10%
F Rs.3,000 – Rs.3,000 Rs.3,000
D Rs.2,000 – Rs.2,000 Rs.2,000
T 0.5 – 0.5 0.5
N 5–5 5
S 0–0 0
Q Can assume any one of the values - 1,400*
800, 1,000, 1,200, 1,400, 1,600 and 1,800
P Can assume any of the values 20, 30, 30**
40 and 50
 V Can assume any one of the values 20*
15,20 and 40
----------------------------------------------------------------------------------------
* The most likely values in the case of Q, P and V are the values that
have the highest probability associated with them

** In the case of price, 20 and 30 have the same probability of

occurrence viz., 0.4. We have chosen 30 as the most likely value
because the expected value of the distribution is closer to 30

Sensitivity Analysis with Reference to Q

The relationship between Q and NPV given the most likely values of other
variables is given by

5 [Q (30-20) – 3,000 – 2,000] x 0.5 + 2,000 0

NPV =  + - 30,000
t 5
t=1 (1.1) (1.1)

5 5Q - 500
=  - 30,000 = (5Q-500)PVIFA(10%,5yrs)-30,000
t
t=1 (1.1)
= (5Q-500) x 3.791 - 30,000
The net present values for various values of Q are given in the following table:

Q 800 1,000 1,200 1,400 1,600 1,800

NPV -16,732 -12,941 -9,150 -5,359 -1,568 2,224

Sensitivity analysis with reference to P

The relationship between P and NPV, given the most likely values of other
variables is defined as follows:

5 [1,400 (P-20) – 3,000 – 2,000] x 0.5 + 2,000 0

NPV =  + - 30,000
t 5
t=1 (1.1) (1.1)

5 700 P – 14,500
=  - 30,000 = (700P – 14,500)PVIFA(10%,5yrs)-30,000
t
t=1 (1.1)
 = (700P – 14,500) x 3.791-30,000
The net present values for various values of P are given below :
P (Rs) 20 30 40 50
NPV(Rs) -31,896 -5,359 21,179 47,716

8. NPV -5 0 5 10 15 20
(Rs.in lakhs)
PI 0.9 1.00 1.10 1.20 1.30 1.40

Prob. 0.02 0.03 0.10 0.40 0.30 0.15

6
Expected PI = PI =  (PI)j P j
j=1
= 1.24

6
Standard deviation =  (PIj - PI) 2 P j
o f P1 j=1

=[0.02(0.9-1.24)2 + 0.03(1.00-1.24)2 +0.10(1.10-1.24)2 +0.40(1.20-1.24)2

+ 0.30( 1.30-1.24)2 + 0.15(1.40-1.24)2 ]1/2
=  .01156 = .1075
The standard deviation of P1 is .1075 for the given investment with an expected
PI of 1.24. The maximum standard deviation of PI acceptable to the company
for an investment with an expected PI of 1.25 is 0.30.

Since the risk associated with the investment is much less than the maximum
risk acceptable to the company for the given level of expected PI, the company
should accept the investment.

9. Investment A
Outlay : Rs.10,000
Net cash flow : Rs.3,000 for 6 years
Required rate of return : 12%

NPV(A) = 3,000 x PVIFA (12%, 6 years) – 10,000

= 3,000 x 4.111 – 10,000 = Rs.2,333
Let the IRR be r. We then have 3000xPVIFA(r,6yrs) = 10,000
By a series of trial and error we find the value of r as under.
Trying r=20 %, LHS = 3000 x 3.326 = 9978
Trying r=19 %, LHS = 3000 x 3.410 = 10230
(10230 – 10000)
By linear interpolation, r= 19 + ------------------- = 19.91%
 ( 10230 – 9978)

Investment B
Outlay : Rs.30,000
Net cash flow : Rs.11,000 for 5 years
Required rate of return : 14%
NPV(B) = 11,000 x PVIFA (14%, 5 years) – 30,000
= 11,000 x 3.433 – 30,000 = Rs.7763

Let the IRR be r’. We then have 11000xPVIFA(r’,5yrs) = 30,000

By a series of trial and error we find the value of r’ as under.
Trying r’=24 %, LHS = 11000 x 2.745 = 30195
Trying r’=28 %, LHS = 11000 x 2.532 = 27852

(30195 – 30000)
By linear interpolation, r’= 24 + ------------------- = 24.08 %
(30195 – 27852)

PI and IRR for the two projects are as follows:

Project A B

PI 1.23 1.26
IRR 19.91% 24.08 %

B is superior to A in terms of NPV, PI, and IRR. Hence the company must
choose B.

10 The certainty equivalent for the various years using the given formula is as
follows
----------------------------------------------------------------------------------------------
Year(t) 1 2 3 4 5
---------------------------------------------------------------------------------------------
Certainty equivalent
t = 1 – 0.06t 0.94 0.88 0.82 0.76 0.70
-------------------------------------------------------------------------------------------------
NPV of the project
0.94 x 7000 0.88 x 8000 0.82 x 9000 0.76 x 10000 0.70x 8000
= ------------- + -------------- + --------------- + ---------------- + -------------
( 1.08) ( 1.08)2 ( 1.08)3 ( 1.08)4 ( 1.08)5
- 30,000
 = 6,092 .59+ 6,035.67+ 5,858.48+ 5,586.23 + 3,811.27 – 30,000
= - Rs. 2615.76

MINICASE

1. The expected NPV of the turboprop aircraft

0.65 (5500) + 0.35 (500)

NPV = - 11000 +
(1.12)

0.65 [0.8 (17500) + 0.2 (3000)] + 0.35 [0.4 (17500) + 0.6 (3000)]
+
(1.12)2
= 2369

2. If Southern Airways buys the piston engine aircraft and the demand in year 1
turns out to be high, a further decision has to be made with respect to capacity
expansion. To evaluate the piston engine aircraft, proceed as follows:

First, calculate the NPV of the two options viz., ‘expand’ and ‘do not expand’ at
decision point D2:

0.8 (15000) + 0.2 (1600)

Expand : NPV = - 4400 +
1.12

= 6600

0.8 (6500) + 0.2 (2400)

Do not expand : NPV =
1.12
= 5071

Second, truncate the ‘do not expand’ option as it is inferior to the ‘expand’
option. This means that the NPV at decision point D2 will be 6600
 Third, calculate the NPV of the piston engine aircraft option.

0.65 (2500+6600) + 0.35 (800)

NPV = – 5500 +
1.12

0.35 [0.2 (6500) + 0.8 (2400)]

+
(1.12)2

= – 5500 + 5531 + 898 = 929

3. The value of the option to expand in the case of piston engine aircraft
If Southern Airways does not have the option of expanding capacity at the end of
year 1, the NPV of the piston engine aircraft would be:

0.65 (2500) + 0.35 (800)

NPV = – 5500 +
1.12

0.65 [0.8 (6500) + 0.2 (2400)] + 0.35 [0.2 (6500) + 0.8

(2400)]
+
(1.12)2

= - 5500 + 1701 + 3842 = 43

Thus the option to expand has a value of 929 – 43 = 886

4. Value of the option to abandon if the turboprop aircraft can be sold for 8000 at the
end of year 1

If the demand in year 1 turns out to be low, the payoffs for the ‘continuation’ and
‘abandonment’ options as of year 1 are as follows.

0.4 (17500) + 0.6 (3000)

Continuation: = 7857
1.12

Abandonment : 8000
 Thus it makes sense to sell off the aircraft after year 1, if the demand in year 1
turns out to be low.

The NPV of the turboprop aircraft with abandonment possibility is

0.65 [5500 +{0.8 (17500) + 0.2 (3000)}/ (1.12)] + 0.35 (500 +8000)
NPV = - 11,000 +
(1.12)

12048 + 2975
= - 11,000 + = 2413
1.12

Since the turboprop aircraft without the abandonment option has a value
of 2369, the value of the abandonment option is : 2413 – 2369 = 44

5. The value of the option to abandon if the piston engine aircraft can be sold for
4400 at the end of year 1:

If the demand in year 1 turns out to be low, the payoffs for the ‘continuation’
and ‘abandonment’ options as of year 1 are as follows:

0.2 (6500) + 0.8 (2400)

Continuation : = 2875
1.12

Abandonment : 4400

Thus, it makes sense to sell off the aircraft after year 1, if the demand in year 1
turns out to be low.

The NPV of the piston engine aircraft with abandonment possibility is:

0.65 [2500 + 6600] + 0.35 [800 + 4400]

NPV = - 5500 +
1.12

5915 + 1820
= - 5500 + = 1406
1.12

For the piston engine aircraft the possibility of abandonment increases the NPV
from 929 to 1406. Hence the value of the abandonment option is 477.
 Chapter 12

RISK ANALYSIS OF SINGLE INVESTMENTS

1. 2p = wi wj ij i j

2 p = w2121 + w2222 + w2323 + w2424 + w2525
 + 2 w1 w2 12 12 + 2 w1 w3 13 13 + 2 w1 w4 14 14 + 2 w1 w5 15
15 + 2 w2 w3 23 23 + 2 w2 w4 24 24 + 2 w2 w5 25 25 + 2 w3 w4
34 34 + 2 w3 w5 35 35 + 2 w4 w5 45 45

= 0.12 x 82 + 0.22 x 92 + 0.32 x 102 + 0.32 x 162 + 0.12 x 122

+ 2 x 0.1 x 0.2 x 0.1 x 8 x 9 + 2 x 0.1 x 0.3 x 0.5 x 8 x 10
+ 2 x 0.1 x 0.3 x( –0.2) x 8 x 16 + 2 x 0.1 x 0.1 x 0.3 x 8 x 12
+ 2 x 0.2 x 0.3 x 0.4 x 9 x 10 + 2 x 0.2 x 0.3 x 0.8 x 9 x 16
+ 2 x 0.2 x 0.1 x 0.2 x 9 x 12 + 2 x 0.3 x 0.3 x0.1 x 10 x 16
+ 2 x 0.3 x 0.1 x 0.6 x 10 x 12 + 2 x 0.3 x 0.1 x 0.1 x 16 x 12
= 66.448
p = (66.448)1/2 = 8.152

2. (i) Since there are 3 securities, there are 3 variance terms and 3 covariance
terms. Note that if there are n securities the number of covariance terms are: 1 +
2 +…+ (n + 1) = n (n –1)/2. In this problem all the variance terms are the same
(2A) all the covariance terms are the same (AB) and all the securities are equally
weighted (wA)
So,
2p = [3 w2A 2A + 2 x 3 AB]
2p = [3 w2A 2A + 6 wA wBAB]
1 2 1 1
=3x x 2A + 6 x x x AB
3 3 3

1 2
= 2A + AB
3 3
(ii) Since there are 9 securities, there are 9 variance terms and 36 covariance
terms. Note that if the number of securities is n, the number of covariance
terms is n(n – 1)/2.
In this case all the variance terms are the same (2A), all the covariance terms are 
1
the same (AB) and all the securities are equally weighted wA
9

So,
n(n-1)
 p= 9 w A A + 2 x
2 2 2
wA wBAB
2
2
1 1 1
 = 9 x x 2A + 9(8) x x AB
9 9 9
1 8
= 2A + AB
9 9

3. (Note: In the given problem the returns on the stock and the market portfolio for
the 19th period were intended to be 22 and 37 and not 6 and 12 as printed in the
problem.)
The beta for stock B is calculated below:
Period Return of Return on Deviation of Deviation Product of Square of
 stock B, market return on of return the the
RB (%) portfolio, stock B on market deviations deviation
RM (%) from its portfolio (RB – RB) of return
mean from its (RM – RM) on market
(RB - RB) mean portfolio,
(RM – RM) from its
mean
(RM – RM)2
1 15 9 6 -1 -6 1
2 16 12 7 2 14 4
3 10 6 1 -4 -4 16
4 -15 4 -24 -6 144 36
5 -5 16 -14 6 -84 36
6 14 11 5 1 5 1
7 10 10 1 0 0 0
8 15 12 6 2 12 4
9 12 9 3 -1 -3 1
10 -4 8 -13 -2 26 4
11 -2 12 -11 2 -22 4
12 12 14 3 4 12 16
13 15 -6 6 -16 -96 256
14 12 2 3 -8 -24 64
15 10 8 1 -2 -2 4
16 9 7 0 -3 0 9
17 12 9 3 -1 -3 1
18 9 10 0 0 0 0
19 22 37 13 27 351 729
20 13 10 4 0 0 0
180 200 Σ(RB – RB) Σ(RB – RB)2
Σ RB = 180 ΣRM = 200 (RM – RM) = 1186
RB = 9% RM = 10% = 320

Beta of stock B is equal to:

Cov (RB, RM)

2M
Σ (RB - RB) (RM – RM) 320
Cov (RB, RM) = = = 16.84
n –1 19

Σ (RM – RM)2 1186

M =
2
= = 62.42
n –1 19
 So the beta for stock B is:
16.84
= 0.270
62.42

4. According to the CAPM, the required rate of return is:

E(Ri) = Rf+ (E(RM – Rf)i

Given a risk-free rate (Rf ) of 11 percent and the expected market risk premium
{E(RM – Rf )} of 6 percent we get the following:
Project Beta Required rate(%) Expected rate (%)
A 0.5 11 + 0.5 x 6 = 14 15
B 0.8 11 + 0.8 x 6 = 15.8 16
C 1.2 11 + 1.2 x 6 = 18.2 21
D 1.6 11 + 1.6 x 6 = 20.6 22
E 1.7 11 + 1.7 x 6 = 21.2 23

a. The expected return of all the 5 projects exceeds the required rate as per the CAPM.
So all of them should be accepted.
b. If the cost of capital of firm which is 16 percent is used as the hurdle rate, project A
will be rejected incorrectly.

5. The asset beta is linked to equity beta, debt-equity ratio, and tax rate as follows:
E
A =
[1 + D/E (1 –T)]

The asset beta of A, B, and C is calculated below:

Firm Asset Beta

1.25
A = 0.49
[1 + (2.25) x 0.7]

1.15
B = 0.48
[1 + (2.00) x 0.7]

1.10
C = 0.45
[1 + (2.1) x 0.7]
 0.49 + 0.48 + 0.45
Average of the asset betas of sample firms = = 0.47
3
The equity beta of the cement project is
E = A [ 1 + D/E (1 – T)]
= 0.47 [1 + 2 (1-0.3)] = 1.128

As per the CAPM model, the cost of equity of the proposed project is:
12% + (17% - 12%) x 1.128 = 17.64%

The post-tax cost of debt is:

16% (1 – 0.3) = 11.2%

The required rate of return for the project given a debt-equity ratio of 2:1 is:
1/3 x 17.64% + 2/3 x 11.2% = 13.35%

6. E
A =
[1 + D/E (1 –T)]
E = 1.25 D/E = 1.6 T = 0.3

So, Pariman Company’s asset beta is:

1.25
= 0.59
[1 + 1.6 (0.7)]

7. (a) Asset beta for a petrochemicals project is:

E 1.30
A = =
[1 + D/E ( 1 –T)] [1 + 1.5 (1 –0.4)]

= 0.68

The equity beta (systematic risk) for the petrochemicals project of Growmore,
when D/E = 1.25 and T = 0.4, is
0.68 [1 + 1.25 (1 – .4)] = 1.19

(b) The cost of equity for the petrochemicals project is

 12% + 1.19 (18% - 12%) = 19.14%
The cost of debt is
12% (1 – 0.4) = 7.2%
Given, a debt – equity ratio of 1.25 the required return for the petrochemicals
project is
1 1.25
19.14% x + 7.2 % x = 12.5 %
2.25 2.25

MINICASE

a) Metals division
--------------- E 1.1
Asset beta of Amtex Metals : A = --------------- = ---------------------- = 0.95
D 300
1 + --- ( 1-T) 1 + ------ ( 1-0.3)
E 1300
By proxy this is the asset beta of the metals division also.
D
Equity beta of the metals division : E = A[ 1 + ---- ( 1-T) ]
E
The total asset value of the metals division is 1150 out of which the debt component
is 400. So the equity component is 1150 –400 = 750
400
Therefore E = 0.95 [ 1 + ----- ( 1- 0.3) ] =1.30
750
Cost of equity = Rf + E x Risk premium =7 + 1.30 x 7 = 16.10 %

Real Estate division

-------------------
0.95
Asset beta of MLF Realtors = -------------------- = 0.66
700
1 + ----- ( 1-0.3)
1100
600
Equity beta of the real estate division = 0.66[1 + ------ ( 1-0.3) ] = 1.27
450
Cost of equity = 7 + 1.27 x 7 = 15.89 %
 Finance division
---------------
1.2
Asset beta of Nidhi Finance = -------------------- = 0.66
700
1 + ----- ( 1-0.3)
600
500
Equity beta of the finance division = 0.66[1 + ------ ( 1-0.3) ] = 1.43
300
Cost of equity = 7 + 1.43 x 7 = 17.01 %

b)
Metals division
---------------
200 200
Post-tax weighted average cost of debt = [ ------ x 8 + ------x 10 ] ( 1-0.3) =6.3%
400 400
750 400
Weighted average cost of capital = ----- x 16.10 + ------ x 6.3 = 12.69 %
1150 1150
Real Estate division
------------------
500 100
Post-tax weighted average cost of debt = [----- x 8 + ----x 10 ] ( 1-0.3) = 5.84 %
600 600
450 600
Weighted average cost of capital = ----- x 15.89 + ------ x 5.84 = 10.15 %
1050 1050

Finance division
---------------
300 200
Post-tax weighted average cost of debt = [ ------ x 8 + ---- x 10 ] ( 1-0.3) = 6.16 %
500 500
300 500
Weighted average cost of capital = ----- x 17.01 + ------ x 6.16 = 10.23 %
800 800
 Chapter 13

SPECIAL DECISION SITUATIONS

1. PV Cost
UAE =
PVIFAr,n
 Cost of plastic emulsion painting = Rs.3,00,000 Life = 7 years
Cost of distemper painting = Rs. 1,80,000 Life = 3 years
Discount rate = 10%
UAE of plastic emulsion painting = Rs.3,00,000 / 4.868 = Rs.61,627
UAE of distemper painting = Rs.1,80,000 / 2.487 = Rs.72,376

Since plastic emulsion painting has a lower UAE, it is preferable.

2. Present value of the operating costs :

3,00,000 3,60,000 4,00,000 4,50,000 5,00,000
= + + + +
1.13 (1.13)2 (1.13)3 (1.13)4 (1.13)5
= 265,487 + 281,933 + 277,220 + 275,993 + 271,380 = Rs.1,372,013
Present value of salvage value = 3,00,000 / (1.13)5 = Rs.162,828
Present value of costs of internal transportation = 1,500,000 + 1,372,013
system – 162,828 = Rs.27,09,185
UAE of the internal transportation system = 27,09,185 / 3.517 = Rs.7,70,311

3. Cost of standard overhaul = Rs.500,000

Cost of less costly overhaul = Rs.200,000
Cost of capital = 14%
UAE of standard overhaul = 500,000 / 3.889 = Rs.128,568
UAE of less costly overhaul = 200,000 / 1.647 = Rs.121,433

Since the less costly overhaul has a lower UAE, it is the preferred alternative

4. The details for the two alternatives are shown below :

Gunning plow Coulter plow

1. Initial outlay Rs.2,500,000 Rs.1,500,000

2. Economic life 12 years 9 years
3. Annual operating and maintenance costs Rs.250,000 Rs.320,000
 4. Present value of the stream of operating Rs.1,548,500 Rs.1,704,960
and maintenance costs at 12% discount rate
5. Salvage value Rs.800,000 Rs.500,000
6. Present value of salvage value Rs.205,600 Rs.180,500
7. Present value of total costs (1+4-6) Rs.3,842,900 Rs.3,024,460
8. UAE of 7 Rs.3,842,900 Rs.3,024,460
PVIFA (12%,12) PVIFA (12%,9)
= 3,842,900 = 3,024,460
6.194 5.328
= Rs.620,423 = Rs.567,654

The Coulter plow is the cheaper alternative

5. The current value of different timing options is given below :

Time Net Future Value Current Value

Rs. in million Rs. in million
0 10 10
1 15 13.395
2 19 15.143
3 23 16.376
4 26 16.536

The optimal timing of the project is year 4.

6. Calculation of UAE (OM) for Various Replacement Periods

(Rupees)
Time Operating Post-tax PVIF Present Cumulative PVIFA UAE
(t) and operating & (12%,t) value present (12%,t) (OM)
maintenance maintenance of (3) value
costs costs
(1) (2) (3) (4) (5) (6) (7) (8)
1 20,000 12,000 0.893 10,716 10,716 0.893 12,000
2 25,000 15,000 0.797 11,955 22,671 1.690 13,415
3 35,000 21,000 0.712 14,952 37,623 2.402 15,663
4 50,000 30,000 0.636 19,080 56,703 3.037 18,671
5 70,000 42,000 0.567 23,814 80,517 3.605 22,335
Calculation of UAE (IO) for Various Replacement Periods
Time (t) Investment Outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.
1 80,000 0.893 89,586
2 80,000 1.690 47,337
3 80,000 2.402 33,306
4 80,000 3.037 26,342
5 80,000 3.605 22,191
 Calculation of UAE (DTS) for Various Replacement Periods
Time Depreciation Depreciation PVIF PV of Cumulative PVIFA UAE of
(t) charge R.s. tax shield (12%, t) depreciation present (12%, t) depreciation
tax shield value Rs.. tax shield Rs..
Rs..
(1) (2) (3) (4) (5) (6) (7) (8)
1 20,000 8,000 0.893 7,144 7,144 0.893 8,000
2 15,000 6,000 0.797 4,782 11,926 1.690 7,057
3 11,250 4,500 0.712 3,204 15,130 2.402 6,299
4 8,438 3,375 0.636 2,147 17,277 3.037 5,689
5 6,328 2,531 0.567 1,435 18,712 3.605 5,191

Calculation of UAE (SV) for Various Replacement Periods

Time Salvage PVIF Present value of PVIFA UAE of salvage
value Rs. (12%, t) salvage value Rs. (12%, t) value Rs. (4) / (5)
(1) (2) (3) (4) (5) (6)
1 60,000 0.893 53,580 0.893 60,000
2 45,000 0.797 35,865 1.690 21,222
3 32,000 0.712 22,784 2.402 9,485
4 22,000 0.636 13,992 3.037 4,607
5 15,000 0.567 8,505 3.605 2,359

Summary of Information Required to Determine the Economic Life

Replacement UAE UAE (IO) UAE UAE (SV) UAE UAE
period (OM) Rs. Rs. (DTS) Rs. (CC) Rs. (TC) Rs.
Rs.
(1) (2) (3) (4) (5) (6) (7)
1 12,000 89,586 8,000 60,000 21,586 33,586
2 13,415 47,337 7,057 21,222 19,058 32,473
3 15,663 33,306 6,299 9,485 17,522 33,185
4 18,671 26,342 5,689 4,607 16,046 34,717
5 22,335 22,191 5,191 2,359 14,641 36,976

OM - Operating and Maintenance Costs

IO - Investment Outlay
DTS - Depreciation Tax Shield
SV - Salvage Value
CC - Capital Cost
TC - Total Cost
UAE (CC) = UAE (IO) – [UAE (DTS) + UAE (SV)]
UAE (TC) = UAE (OM) + UAE (CC)
The economic life of the sewing machine which minimises the UAE of buying
and operating the machine is 2 years
 7. Calculation of UAE (OM) for Various Replacement periods
Time O&M costs Post-tax PVIF PV of post- Cumulative PVIFA UAE of
Rs. O&M costs (12%,t) tax O&M present (12%, t) O&M
Rs. costs Rs. value Rs. costs Rs.
(1) (2) (3) (4) (5) (6) (7) (8)
1 800,000 560,000 0.893 500,080 500,080 0.893 560,000
2 1,000,000 700,000 0.797 557,900 1,057,980 1.690 626,024
3 1,300,000 910,000 0.712 647,920 1,705,900 2.402 710,200
4 1,900,000 1,330,000 0.636 845,880 2,551,780 3.037 840,230
5 2,800,000 1,960,000 0.567 1,111,320 3,663,100 3.605 1,016,117

Calculation of UAE (IO) for Various Replacement Periods

Time Investment outlay Rs. PVIFA (12%, t) UAE of investment outlay Rs.
1 4,000,000 0.893 4,479,283
2 4,000,000 1.690 2,366,864
3 4,000,000 2.402 1,665,279
4 4,000,000 3.037 1,317,089
5 4,000,000 3.605 1,109,570

Calculation of UAE (DTS) for Various Replacement Periods

Time Depreciation Depreciaton PVIF PV of Cumulative PVIFA UAE of
(t) charge Rs. tax shield (12%, t) depreciation present (12%, t) depreciation
Rs. tax shield Rs. value Rs. tax shield Rs.
1 1,000,000 300,000 0.893 267,900 267,900 0.893 300,000
2 750,000 225,000 0.797 179,325 447,225 1.690 264,630
3 562,500 168,750 0.712 120,150 567,375 2.402 236,209
4 421,875 126,563 0.636 80,494 647,869 3.037 213,325
5 316,406 94,922 0.567 53,821 701,690 3.605 194,643

Calculation of UAE (SV) for Various Replacement Peiods

Time Salvage PVIF Present value of PVIFA UAE of salvage
value Rs. (12%, t) salvage value Rs. (12%, t) value Rs. (4)/ (5)
(1) (2) (3) (4) (5) (6)
1 2,800,000 0.893 2,500,400 0.893 2,800,000
2 2,000,000 0.797 1,594,000 1.690 943,195
3 1,400,000 0.712 996,80 2.402 414,988
4 1,000,000 0.636 636,000 3.037 209,417
5 800,000 0.567 453,600 3.605 125,825

Summary of Information Required to Determine the Economic Life

Replacement UAE UAE (IO) UAE UAE (SV) UAE (CC) UAE (TC)
period (OM) Rs. (DTS)
Rs. Rs. Rs. Rs. Rs.
1 560,000 4,479,283 300,000 2,800,000 1,379,283 1,939,283
2 626,024 2,366,864 264,630 943,195 1,159,039 1,785,063
3 710,200 1,665,279 236,209 414,988 1,014,082 1,724,282
4 840,230 1,317,089 213,325 209,417 894,347 1,734,577
5 1,016,117 1,109,570 194,643 125,825 789,102 1,805,219
The economic life of the well-drilling machine is 3 years

8. Adjusted cost of capital as per Modigliani – Miller formula:

r* = r (1 – TL)
r* = 0.16 (1 – 0.5 x 0.6)
= 0.16 x 0.7 = 0.112
Adjusted cost of capital as per Miles – Ezzell formula:
1+r
r* = r – LrDT
1 + rD
1 + 0.16
= 0.16 – 0.6 x 0.15 x 0.5 x
1 + 0.15
= 0.115

9.
a. Base case NPV = -12,000,000 + 3,000,000 x PVIFA (20%, b)
= -12,000,000 + 3,000,000 x 3,326
= - Rs.2,022,000

b. Adjusted NPV if the adjustment is made only for the issue cost of external equity
= Base case NPV – Issue cost
Term loan = Rs.8 million Equity finance = Rs.4 million
Issue cost of equity = 12%
Rs.4,000,000
Equity to be issued = = Rs.4,545,455
0.88
Cost of equity issue = Rs.545,455

Adjusted NPV if issue cost alone is considered = -2,022,000 – 545,455

= - 2,567,455

(c)
Computation of Tax Shield Associated with Debt Finance
Year (t) Debt outstanding Interest Tax shield Present value of
at the beginning tax shield
Rs. Rs. Rs. Rs.
 1 8,000,000 1,440,000 432,000 366,102
2 8,000,000 1,440,000 432,000 310,256
3 7,000,000 1,260,000 378,000 230,062
4 6,000,000 1,080,000 324,000 167,116
5 5,000,000 900,000 270,000 118,019
6 4,000,000 720,000 216,000 80,013
1,271,568
Present Value of tax shield on debt finance = Rs.1,271,568

10.
a. Base Case NPV = - 8,000,000 + 2,000,000 x PVIFA (18%, 6)
= - 8,000,000 + 2,000,000 x 3.498
= - Rs.1,004,000

b. . Adjusted NPV if the adjustment is made only for the issue cost of external
equity = Base case NPV – Issue cost
Term loan = Rs.5 million
Equity finance = Rs.3 million
Issue cost of equity = 10%
Rs.3,000,000
Hence, Equity to be issued = = Rs.3,333,333
0.90
Cost of equity issue = Rs.333,333
Adjusted NPV if the adjustment is made only for the issue cost of external
equity = - 1,004,000 – 333,333 = - 1,337,333

c.
Computation of Tax Shield Associated with Debt Finance
Year Debt outstanding at the Interest Tax shield Present value of tax
beginning shield

1 Rs.5,000,000 Rs.750,000 Rs.300,000 Rs.260,869

2 5,000,000 750,000 300,000 226,843
3 4,000,000 600,000 240,000 157,804
4 3,000,000 450,000 180,000 102,916
5 2,000,000 300,000 120,000 59,661
6 1,000,000 150,000 60,000 25,940
834,033
Present value of tax shield of debt finance = Rs.834,033
11. Adjusted cost of capital as per Modigliani – Miller formula:
r* = r (1 – TL)
r* = 0.19 x (1 – 0.5 x 0.5) = 0.1425 = 14.25%

Adjusted cost of capital as per Miles and Ezzell formula:

1+r
r* = r – LrDT
1 + rD
1 + 0.19
= 0.19 – 0.5 x 0.16 x 0.5 x
1 + 0.16
= 0.149 = 14.9%

12. S0 = Rs.46 , rh = 11 per cent , rf = 6 per cent

Hence the forecasted spot rates are :

Year Forecasted spot exchange rate

1 Rs.46 (1.11 / 1.06)1 = Rs.48.17
2 Rs.46 (1.11 / 1.06)2 = Rs.50.44
3 Rs.46 (1.11 / 1.06)3 = Rs.52.82
4 Rs.46 (1.11 / 1.06)4 = Rs.55.31
5 Rs.46 (1.11 / 1.06)5 = Rs.57.92

The expected rupee cash flows for the project

Year Cash flow in dollars Expected exchange Cash flow in rupees

(million) rate (million)
0 -200 46 -9200
1 50 48.17 2408.5
2 70 50.44 3530.8
3 90 52.82 4753.8
4 105 55.31 5807.6
5 80 57.92 4633.6

Given a rupee discount rate of 18 per cent, the NPV in rupees is :

2408.5 3530.8 4753.8

NPV = -9200 + + +
(1.18)1 (1.18)2 (1.18)3

5807.6 4633.6
+ +
 (1.18)4 (1.18)5
= -9200 + 2041.10 + 2535.77 + 2893.31 + 2995.5 + 2025.39
= Rs. 3291.07 million

The dollar NPV is :

3291.07 / 46 = 71.54 million dollars

Chapter 14

SOCIAL COST BENEFIT ANALYSIS

*****
1. Social Costs and Benefits
 Nature Economic Explanation
value (Rs
in million)
Costs
1. Construction cost One- 400
shot
2. Maintenance cost Annual 3
Benefits
3. Savings in the operation Annual 40
cost of existing ships
4. Increase in consumer Annual 3.6 The number of passenger hours
satisfaction saved will be : (75,000 x 2 +
50,000 + 50,000 x 2) = 600000.
Multiplying this by Rs.6 gives
Rs.3.6 million

The IRR of the stream of social costs and benefits is the value of r in the
equation

50 4.0 + 3.6 – 3.0 50 40.6

400 =  = 
t=1 (1+r)t t=1 (1+r)t

The solving value r is about 10.1%

2. Social Costs and Benefits

Costs
Decrease in customer satisfaction as reflected Rs.266,667
in the opportunity cost of the extra time taken
by bus journey
800 x (2/3) x 250 x Rs.2

Benefits
1. Resale value of the diesel train (one time) Rs.240,000
2. Avoidance of annual cash loss Rs.400,000
Fare collection = 1000 x 250 x Rs.4
= Rs.1,000,000
Cash operating expenses = Rs.1,420,000
3. The social costs and benefits of the project are estimated below :
Rs. in
million
Nature Economic Explanation
value
 Costs
1. Construction cost One-shot 24
2. Land development cost One-shot 150
3. Maintenance cost Annual 1
4. Labour cost One-shot 40 This includes the cost of
transport and rehabilitation
5. Labour cost Annual 12 The shadow price of
labour equals what others
are willing to pay.
6. Decrease in the value of the Annual from 4
timber output year 2
Benefits
7. Savings in the cost of shipping Annual 0.5
the agriculture produce
8. Income from cash crops Annual for the 10
first 5 years
9. Income from the main crop Annual from 50
year 6
10. Increase in the value of timber One-shot (at 20
output the end of
year 1)

Assuming that the life of the road is 40 years, the NPV of the stream of
social costs and benefits at a discount rate of 10 percent is :

40 1 + 12 40 4
NPV = - 24 - 150 - 40 -  - 
t=1 (1.1)t t=2 (1.1)t

40 0.5 5 10 40 50 20
+     
t=1 (1.1)t t=1 (1.1)t t=6 (1.1)t (1.1)1
= - Rs.9.93 million

4.
Table 1
Social Costs Associated with the Initial Outlay
 Rs. in
million
Item Financia Basis of Tradeable value T L R
l cost conversion ab initio
Land 0.30 SCF = 1/1.5 0.20
Buildings 12.0 T=0.50, L=0.25 6.0 3.0 3.0
R=0.25
Imported equipment 15.0 CIF value 9.0
Indigeneous equipment 80.0 CIF value 60.0
Transport 2.0 T=0.65, L=0.25 1.3 0.5 0.2
R=0.10
Engineering and know-how 6.0 SCF=1.5 9.0
fees
Pre-operative expenses 6.0 SCF=1.0 6.0
Bank charges 3.7 SCF=0.02 0.074
Working capital 25.0 SCF=0.8 20.0
requirement
150.0 104.274 7.3 3.5 3.2

Table 2
Conversion of Financial Costs into Social Costs
Rs. in
million
Item Financia Basis of Tradeable value T L R
l cost conversion ab initio
Indigeneous raw material 85 SCF=0.8 68
and stores
Labour 7 SCF=0.5 3.5
Salaries 5 SCF=0.8 4.0
Repairs and maintenance 1.2 SCF=1/1.5 0.8
Water, fuel, etc 6 T=0.5, L=0.25 3 1.5 1.5
R=0.25
Electricity (Rate portion) 5 T=0.71, L=0.13 3.55 0.65 0.8
R=0.16
Other overheads 10 SCF=1/1.5 6.667
119.2 82.967 6.55 2.15 2.3

As per table 1, the social cost of initial outlay is worked out as follows :

Rs. in million
Tradeable value ab initio 104.274
 Social cost of the tradeable component 4.867
(7.3 / 1.5)
Social cost of labour component 1.75
(3.5 x 0.5)
Social cost of residual component 1.60
(3.2 x 0.5)
Total 112.491

As per Table 2, the annual social cost of operation is worked out as follows :

Tradeable value ab initio 82.967

Social cost of the tradeable component 4.367
( 6.55 x 1/1.5 )
Social cost of labour component 1.075
(2.15 x 0.5)
Social cost of residual component 1.150
(2.3 x 0.5)
Total 89.559

The annual CIF value of the output is Rs.110 million. Hence the annual social
net benefit will be : 110 – 89.559 = Rs.20.441 million
Working capital recovery will be Rs.20 million at the end of the 20th year.

Putting the above figures together the social flows associated with the project
would be as follows :

Year / ’s Social flow (Rs. in million)

0 -112.491
1-19 20.441

Chapter 15
 MULTIPLE PROJECTS AND CONSTRAINTS

1. The ranking of the projects on the dimensions of NPV, IRR, and BCR is given below
Project NPV (Rs.) Rank IRR (%) Rank BCR Rank
M 60,610 3 34.1 2 2.21 1
N 58,500 4 34.9 1 1.59 3
O 40,050 5 18.6 4 1.33 5
P 162,960 1 26.2 3 2.09 2
Q 72,310 2 14.5 5 1.36 4

2. The two hypothetical projects are:

A B
Initial outlay 10000 1000
Cash inflows
Year 1 5000 600
Year 2 5000 600
Year 3 5000 600

NPV @ 10% Rank IRR Rank

A 2435 1 about 23% 2
B 492 2 above 35% 1

3. The two hypothetical 4-year projects for which BCR and IRR criteria give different
rankings are given below
Project A B
Investment outlay 20000 20000
Cash inflow
Year 1 2000 8000
Year 2 2000 8000
Year 3 2000 8000
Year 4 31500 8000
Project BCR Rank IRR Rank
A 1.24 1 19% 2
B 1.21 2 about 22% 1

4. The NPVs of the projects are as follows:

NPV (A) = 6000 x PVIFA(10%,5) + 5000 x PVIF(10%,5) – 20,000 = Rs.5851
NPV (B) = 8000 x PVIFA(10%,10) – 50,000 = - Rs.840
NPV (C) = 15,000 x PVIFA(10%,8) – 75,000 = Rs.5025
NPV (D) =15,000xPVIFA(10%,12)+15,000xPVIF(10%,12)–100,000
= Rs.6,995
NPV (E) = 25,000 x PVIFA (10%,7) + 50,000 x PVIF(10%,7)
 – 150,000 = - Rs.2,650

Since B and E have negative NPV, they are rejected. So we consider only A, C,
and D. Further C and D are mutually exclusive. The feasible combinations, their
outlays, and their NPVs are given below.

Combination Outlay NPV

(Rs.) (Rs.)
A 20,000 5,851
C 75,000 5,025
D 100,000 6,995
A&C 95,000 10,876
A&D 120,000 12,846

The preferred combination is A & D.

5 The linear programming formulation of the capital budgeting problem under various
constraints is as follows:
Maximise 10 X1 + 15 X2 + 25 X3 + 40 X4 + 60 X5 + 100 X6
Subject to
15 X1 + 12 X2 + 8 X3 + 35 X4 + 100 X5
+ 50 X6 + SF1 = 150 Funds constraint for year 1

5 X1 + 13 X2 + 40 X3 + 25 X4 + 10 X5
+ 110 X6 ≤ 200 + 1.08 SF1 Funds constraint for year 2

5 X1 + 6 X2 + 5 X3 + 10 X4 + 12 X5
+ 40 X6 ≤ 60 Power constraint

15 X1 + 20 X2 + 30 X3 + 35 X4 + 40 X5
+ 60 X6 ≤ 120 Managerial constraint

0 ≤ Xj ≤ 1 (j = 1,….8) and SF1 ≥ 0

Rupees are expressed in ’000s. Power units are also expressed in ’000s.

6 Given the nature of the problem, in addition to the decision variables X1 through X10
for the original 10 projects, two more decision variables are required as follows:

X11 is the decision variable to represent the delay of projects 8 by one year
X12 is the decision variable for the composite project which represents the
combination of projects 4 and 5.
The integer linear programming formulation is as follows:

Maximise 55 X1 + 75 X2 + 50 X3 + 60 X4 + 105 X5 + 12 X6 + 60 X7 + 120 X8

 + 50 X9 + 40 X10 + 100 X11+ 178.2 X12
Subject to 75 X1 + 80 X2 + 75 X3 + 35 X4 + 80 X5 + 20 X6 + 70 X7 + 155 X8 +
55 X9 + 10 X10 + 109.3 X12 + SF1 = 400

40 X1 + 85 X2 + 8 X3 + 100 X4 + 160 X5 + 9 X6 + 5 X7 + 100 X8 + 20

X9 + 90 X10 + 155 X11+ 247 X12 + SF2 = 350 + SF1 (1 + r)

X3 + X7 ≥1
X5 + X8 + X9 + X10 ≥2
X2 ≤ X6
X8 ≤ X9
X4 + X5 + X12 ≤1
X8 + X11 ≤1

Xj = {0,1} j = 1, 2….12
SFi ≥ 0 i = 1, 2

It has been assumed that surplus funds can be shifted from one period to the next
and they will earn a post-tax return of r percent.
– – – – – – – +
7 Minimise [P1(3d1+ 2 d 2 + d 3) + P 2 (4 d 4 + 2 d 5 + d 6) + P 3 (d 7 – d 7 )]

Subject to:
Economic Constraints
12 X1 + 14 X2 + 15 X3 + 16 X4 + 11 X5 + 23 X6 + 20 X7 ≤ 65

Goal Constraints

1.2 X1 + 1.6 X2 + 0.6 X3 + 1.5 X4 + 0.5 X5

– +
+ 0.9 X6 + 1.8 X7 + d 1 – d 1 = 6 Net income for year 1

1.1 X1 + 1.2 X2 + 1.2 X3 + 1.6 X4 + 1.2 X5

– +
+ 2.5 X6 + 2.0 X7 + d 2 – d 2 = 8 Net income for year 2

1.6 X1 + 1.5 X2 + 2.0 X3 + 1.8 X4 + 1.5 X5

– +
+ 4.0 X6 + 2.2 X7 + d 3 – d 3 = 10 Net income for year 3

1.0 X1 + 1.2 X2 + 0.5 X3 + 1.8 X4 + 0.6 X5

– +
+ 1.0 X6 + 2.0 X7 + d 4 – d 4 = 6 Sales growth for year 1
 1.5 X1 + 1.0 X2 + 1.2 X3 + 2.0 X4 + 1.4 X5
– +
+ 3.0 X6 + 3.0 X7 + d 5 – d 5 = 8 Sales growth for year 2

1.8 X1 + 1.2 X2 + 2.5 X3 + 2.2 X4 + 1.8 X5

– +
+ 3.5 X6 + 3.5 X7 + d 6 – d 6 = 10 Sales growth for year 3

4 X1 + 5 X2 + 6 X3 + 8 X4 + 4 X5
– +
+ 9 X6 + 7 X7 + d 7 – d 7 = 50 NPV
– +
Xj  0 d i, d i  0

8. The BCRs of the projects are converted into NPVs as of now as follows

Project Outlay (Rs.) BCR NPV (Rs.)

1 800,000 1.08 64,000
2 200,000 1.35 70,000
3 400,000 1.20 80,000
4 300,000 1.03 9,000
5 200,000 0.98 - 4,000
6 500,000 1.03 15,000/1.10 = 13,636
7 400,000 1.21 84,000/1.10 = 76,364
8 600,000 1.17 102,000/1.10 = 92,727
9 300,000 1.01 3,000/1.10 = 2,727

The integer linear programming formulation of the problem is as follows :

Maximise 64,000 X1 + 70,000 X2 + 80,000 X3 + 9,000 X4 + 13,636 X6

+ 76,364 X7 + 92,727 X8 + 2,727 X9

Subject to
800,000 X1 + 200,000 X2 + 400,000 X3 + 300,000 X4 + SF1 = 20,00,000
500,000 X6 + 400,000 X7 + 600,000 X8 + 300,000 X9 ≤ 500,000 + SF1 (1.032)

Xj = {0,1} j = 1, 2, 3, 4, 6, 7, 8, 9

Chapter 16

VALUATION OF REAL OPTIONS

1. S = 100 , uS = 150, dS = 90
 u = 1.5 , d = 0.9, r = 0.15 R = 1.15
E = 100

Cu = Max (uS – E, 0) = Max (150 – 100,0) = 50

Cd = Max (dS – E, 0) = Max (90 – 100,0) = 0

Cu – Cd 50
 = = = 0.833
(u-d)S 0.6 x 100

u Cd – d Cu 0 – 0.9 x 50
B = = = - 65.22
(u-d)R 0.6 x 1.15

C =  S + B = 0.833 x 100 – 65.22 = 18.08

2. S = 60 , dS = 45, d = 0.75, C = 5
r = 0.16, R = 1.16, E = 60

Cu = Max (uS – E, 0) = Max (60u – E, 0) = 60u - 60

Cd = Max (dS – E, 0) = Max (45 – 60, 0) = 0

Cu – Cd 60u – 60 u–1
 = = =
(u-d)S (u – 0.75)60 u – 0.75

u Cd – d Cu – 0.75 (60u – 60) 45 (1 – u)

B = = =
(u-d)R (u – 0.75) 1.16 1.16 (u – 0.75)

C = S+B

(u – 1) 60 45 (1 – u)
5 = +
u – 0.75 1.16 (u – 0.75)
Multiplying both the sides by u – 0.75 we get
45
5(u – 0.75) = (u – 1) 60 + (1 – u)
1.16

Solving this equation for u we get

u = 1.077

So Beta’s equity can rise to

 60 x 1.077 = Rs.64.62

3. E
C0 = S0 N(d1) - N (d2)
ert
S0 = 70, E = 72, r = 0.12, 0.3, t = 0.50

S0 1
ln + r+ 2 t
E 2
d1 =
 t
 70
ln + (0.12 + 0.5 x .09) x 0.50
72
=
0.30 0.50

- 0.0282 + 0.0825
= = 0.2560
0.2121

d2 = d1 -  t = 0.2560 – 0.30 0.50 = 0.0439

N (d1) = 0.6010
N (d2) = 0.5175
E 72
= = 67.81
ert e0.12x 0.50
C0 = S0 x 0.6010 – 67.81 x 0.5175
= 70 x 0.6010 – 67.81 x 0.5175 = Rs.6.98

4. E
C0 = S0 N(d1) - N (d2)
ert
E = 50, t = 0.25, S0 = 40, 0.40, r = 0.14

S0 1
ln + r+ 2 t
E 2
d1 =
  t

40
ln + (0.14 + 0.5 x 0.40) 0.25
50
d1 =
( 0.40 x 0.25)1/2

- 0.2231 + 0.085
= = - 0.4367
0.3162

d2 = d1 -  t = - 0.4367 – 0.3162 = -0.7529

N (d1) = 0.3312
N (d2) = 0.2256
E 50
= = 48.28
rt 0.14 x 0.25
e e
C0 = 40 x 0.3312 – 48.28 x 0.2256
= 2.36

5.
a. The NPV of the proposal to make Comp-I is:
20 50 50 20 + 10
-100 + + + +
1.20 (1.20)2 (1.20)3 (1.20)4

= -100 + 16.66 + 34.70 + 28.95 + 14.46

= - Rs.5.23 million
b.
The present value of the cash inflows of Comp II proposal, four years from now
will be Rs.189.54 million (Two times the present value of the cash inflows of Comp-I).
So, we have
S0 = present value of the asset = 189.54 x e–0.20 x 4 = Rs.85.17 million
E = exercise price = $ 200 million
 = 0.30
t = 4 years
r = 12

Step 1 : Calculate d1 and d2

S0 2
ln + r+ t
E 2 -0.854 + (0.12 + (.09/2)) 4 -0.194
 d1 = = = = -0.323
 t 0.3 4 0.6

d2 = d1 -  t = -0.323 – 0.60 = -0.923

Step 2 : Find N(d1) and N(d2)

N(d1) = 0.3733
N(d2) = 0.1780

Step 3 : Estimate the present value of the exercise price

E . e-rt = 200 / 1.6161 = Rs.123.76 million

Step 4 : Plug the numbers obtained in the previous steps in the Black-Scholes formula:
C0 = 85.17 x 0.3733 – 123.76 x 0.1780
= Rs.9.76

6. Presently a 9 unit building yields a profit of Rs.1.8 million (9 x 1.2 – 9) and a 15 unit
building yields a profit of Rs.1.0 million (15 x 1.2 – 17). Hence a 9 unit building is
the best alternative if the builder has to construct now.
However, if the builder waits for a year, his payoffs will be as follows:
Market Condition
Alternative Buoyant (Apartment price: Sluggish (Apartment price:
Rs.1.5 million) Rs.1.1million)
9 – unit building 1.5 x 9 – 9 = 4.5 1.1 x 9 – 9 = 0.9
15 – unit building 1.5 x 15 – 17 = 5.5 1.1 x 15 – 17 = -0.5

Thus, if the market turns out to be buoyant the best alternative is the 15 – unit
building (payoff: Rs.5.5 million) and if the market turns out to be sluggish the best
alternative is the 9 – unit building (payoff: Rs.0.9 million).
Given the above information, we can apply the binomial method for valuing the
vacant land:

Step 1: Calculate the risk-neutral probabilities.

The binomial tree of apartment values is

Rs.1.60 million (1.5 + 0.1)
p
Rs.1.2 million
 1- p Rs.1.20 million (1.1 + 0.1)

Given a risk free rate of 10 percent, the risk-neutral probabilities must satisfy the
following conditions:
p x 1.6 + (1 – p) x 1.20
1.2 million =
1.10
Solving this we get p = 0.3

Step 2: Calculate the expected cash flow next year

The expected cash flow next year is:
0.3 x 5.5 + 0.7 x 0.9 = Rs.2.28 million

Step 3: Compute the current value

2.28/ 1.10 = Rs.2.07 million

Since Rs.2.07 million is greater than Rs.1.80 million, the profit from
constructing a 9 unit building now, it is advisable to keep the vacant land. The value of
the vacant land is Rs.2.07 million.

7.
S0 = current value of the asset = value of the developed reserve discounted for
3 years (the development lag) at the dividend yield of 5% = $22 x 100/
(1.05)3 = $ 1900.4 million.
E = exercise price = development cost = $600 million
 = standard deviation of ln (oil price) = 0.25
t = life of the option = 20 years
r = risk-free rate = 8%
y = dividend yield = net production revenue/ value of reserve = 5%

Given these inputs, the call option is valued as follows:

Step 1 :

Calculate d1 and d2
S 2
ln + r–y+ t
E 2
d1 =
 t
 ln (1900.4/ 600) + [.08 - .05 + (.0625/ 2)] 20
= =
0.25 20
1.1529 + 1.225
= ------------------------- = 2.1269
1.1180

d2 = d1 -  t = 2.1269 – 1.1180 = 1.0089

Step 2 : Find N(d1) and N(d2)

N(d1) = N(2.1269) = 0.9832
N(d2) = N(1.0089) = 0.8434

Step 3 : Estimate the present value of the exercise price

E / ert = 600 / e.08 x 20 = 600/ 4.9530 = $121.14 million

Step 4 : Plug the numbers obtained in the previous steps in the Black-Scholes formula:
C = $1900.4 million x 0.9832 - $121.14 million x 0.8434
= $1766.30 million

MINICASE

Working :

a. The present value of the cash inflows of Harmonica – I is:

120 240 240 170
+ + +
(1.18) (1.18)2 (1.18)3 (1.18)4

120 (0.847) + 240 ( 0.718) + 240 ( 0.609) + 170 (0.516) = 507.8

Investment outlay = 550

NPV = - 550 + 507.8 = 42.2

Working :
b. To value the option to invest in Harmonica – II we have to cast the information
given in the case in terms of the inputs required by the Black – Scholes
formula.
So = present value of the asset = 507.8 x e- 0.18 x 4 = 247.2
E = exercise price = 1100
 σ = standard deviation of the continuously compounded
annual returns = 0.3
t = years of maturity = 4
r = interest rate per annum = 12 percent
Given the above inputs, the value of the option to invest in Harmonica – II
may
be calculated as follows:

Step 1 : calculate d1 and d2

So σ2 0.09 4
ln + r + t - 1.492 + 0.12 +
d1 = E 2 = 2

σ√t σ√4

= - 1.3867

d2 = - 1.3867 - 0.3 √4 = - 1.9867

Step 2: Find N(d1) and N(d2)

1.40 - 1.3867
N( - 1.3867) = 0.808 + x ( 0.0885 - 0.0808 )
0.05

= 0.0828

2.00 - 1.9867
N(- 1.9867) = 0.0228 + ( 0.0256 - 0.0228)
0.05

= 0.0235
Step 3 Estimate the present value of the exercise price.

E . e- rt = 1100 / 2.0544 = Rs. 535.44

Step 4 Plug the numbers obtained in the previous steps in the Black –
Scholes formula

Co = 247.2 x 0.0828 - 535.44 x 0.0235

= 20.47 - 12.58 = Rs. 7.89 million
 Chapter 18

MINICASE

A. VNR Informatics Private Limited may seek finance from friends and
relatives or from a venture capital fund. The instrument of finance should be
equity or quasi-equity because of the uncertainty characterizing the
investment in the development of a software product.
 B. Apparently, Manas Textiles require additional finance mainly for supporting
receivables. The most appropriate source of financing for Manas Textiles
seems to be factoring.

C. Bharat Oil Company has a conservative capital structure, compared to its

peers. So, it can issue debentures to finance its drilling operations.
Debentures appear to be preferable to equity because the equity of the
company presently seems to be undervalued in relation to its peers.

D. Given the riskiness of movie industry, ADCL will have to rely primarily on
external equity financing. ADCL’s recent success, particularly in a highly
visible industry (movie industry), will enable it to raise equity from the
general investing public. So, ADCL can go for an IPO to raises the required
money.

E. With all of its assets already encumbered, Tasty Foods Private Limited may
go in for an equipment lease of Rs.2 crore for its shipping department. As
the business is profitable it should not have a problem in paying the lease
rentals. Since the firm is growing rapidly it may go for a longer lease
period. This will reduce the periodic lease rental so that financial resources
may be available to support growth..

Chapter 21

PROJECT MANAGEMENT

1.
i. Cost variance: BCWP – ACWP = 5,500,000 – 5,800,000
 = – Rs.300,000

ii. Schedule variance in cost terms: BCWP – BCWS = 5,500,000 – 6,000,000

= – Rs.500,000

5,500,000
iii. Cost performance index: BCWP/ ACWP = = 0.948
5,800,000

5,500,000
iv. Schedule performance index: BCWP/ BCWS = = 0.916
6,000,000

BCTW 10,000,000
v. Estimated cost performance index: =
(ACWP + ACC) 5,800,000 + 5,000,000

= 0.926

Chapter 22

NETWORK TECHNIQUES FOR PROJECT MANAGEMENT

2. The network diagram with the earliest and latest occurrence times for each event is
shown in Exhibit 1.
 Exhibit 1
Network for the Project

2 1 5
4 4 11 11

4 5
2 3

1 3 4 5 7
0 0 9 9 14 14

2 6

3
2 3

There are two critical paths: 1-2-4-5-7 and 1-2-4-7. The minimum time required
for completing the project is 14 weeks.

3. The time estimates for various activities are shown in Exhibit 1

Exhibit 1
Time Estimates

Activity Optimistic to Most likely tm Pessimistic tp Average

to + 4 tm + tp
 te =
6
1-2 4 6 10 6 1/3
1-3 3 7 12 7 1/6
1-4 5 6 9 6 1/3
1-7 2 4 6 4
2-4 6 10 20 11
2-6 3 4 7 4 1/3
2-7 5 9 15 9 1/3
3-4 3 7 12 7 1/6
4-5 2 4 5 3 5/6
5-6 1 3 6 3 1/6
3-7 2 5 8 5
6-7 1 2 6 2 1/2

(a) The network diagram with average time estimates is shown in Exhibit 2.

Exhibit 3

2
6⅓ 6⅓ EOT LOT
 11 4⅓ 9⅓

6⅓

3⅚ 3⅙
4 5 6
17 ⅓ 17⅓ 21 1/6 211/6 24 ⅓ 24 ⅓

7⅙
6⅓

3
7⅙ 10 ⅙ 2½

7⅙

1 4 7
0 0 26 ⅚ 26 ⅚

(b) The critical path for the project is 1-2-4-5-6-7

(c) Exhibit 3 shows the event slacks.

Exhibit 3
Event slacks
Event LOT EOT Slack = LOT – EOT
1 0 0 0
2 6 1/3 6 1/3 0
3 10 1/6 7 1/6 3
4 17 1/3 17 1/3 0
5 21 1/6 21 1/6 0
 6 24 1/3 24 1/3 0
7 26 5/6 26 5/6 0

Exhibit 4 shows the activity floats

Exhibit 4
Activity Floats
Activity Duration Total Float Free Float Independent Float
(i –j) dij LOT(j) – EOT(i) – dij EOT(j) – EOT(i) – dij EOT(j) – LOT (i) – dij
1-2 6 1/3 0 0 0
1-3 7 1/6 3 0 0
1-4 6 1/3 11 11 11
1-7 4 22 5/6 22 5/6 22 5/6
2-4 11 0 0 0
2-6 4 1/3 13 2/3 13 2/3 13 2/3
2-7 9 1/3 11 1/6 11 1/6 11 1/6
3-4 7 1/6 3 3 0
3-7 5 14 2/3 14 2/3 11 2/3
4-5 3 5/6 0 0 0
5-6 3 1/6 0 0 0
6-7 2 1/2 0 0 0

(d) Standard deviation of the critical path duration = [Sum of the variances of activity
durations on the critical path]1/2
The variances of the activity durations on the critical path are shown in Exhibit 5.

Exhibit 5
Variances of Activity Durations on critical path
Activity tp to tp – to 2
 =
6
1-2 10 4 1.00 1.00
2-4 20 6 2.33 5.43
4-5 5 2 0.50 0.25
5-6 6 1 0.83 0.69
6-7 6 1 0.83 0.69
The standard deviation of the duration of critical path is:
= (1.00 + 5.43 + 0.25 + 0.69 + 0.69)1/2
= (8.06)1/2
= 2.84 weeks.

(e) Let D = specified completion date

T = mean of the critical path duration
c = standard deviation of the critical path duration
 T = sum of the mean values of the activity durations on the critical path
= 6 1/3 + 11 + 3 5/6 + 3 1/6 + 2 ½
= 26 ⅚

D–T 30 – 26.83
Prob (D< 30) = Prob < = Prob [ Z < 1.116]
c 2.84

= 0.87

4. (a) The net work diagram is given in Exhibit 6.

Exhibit 6
Network Diagram

10 7

2 6 4 9 7

5 7 6

1 4 3 12 5 12 9

(b) The all-normal critical paths are 1-2-4-6-7-9 and 1-3-4-6-7-9. For all-normal
network, the project duration is 34 weeks and the total direct cost is
Rs.66,000.
(c) The time-cost slope of the activities constituting the project is given in
Exhibit 7.
Exhibit 7
Time-Cost Slope of Activities
Time Cost (Rs.) Cost to expedite per
in weeks week (Rs.)
(1) (2) (3) (4) (5) (6)
Activity Normal Crash Normal Crash [(5)-(4) (2)-(3)]
(1-2) 5 2 6,000 9,000 1,000
(2-4) 6 3 7,000 10,000 1,000
 (1-3) 4 2 1,000 2,000 500
(3-4) 7 4 4,000 8,000 1333.35
(4-7) 9 5 6,000 9,200 800
(3-5) 12 3 16,000 19,600 400
(4-6) 10 6 15,000 18,000 750
(6-7) 7 4 4,000 4,900 300
(7-9) 6 4 3,000 4,200 600
(5-9) 12 7 4,000 8,500 900

Examining the time-cost slope of activities on the critical path, we find that
activity (6-7) has the lowest slope on both the critical paths. The project network after
crashing this activity is shown below in Exhibit 8.

Exhibit 8
6

10 4

2 6 4 9 7

5 7 6

1 4 3 12 5 12 9

As per Exhibit 8, the critical paths are (1-3-4-6-7-9) and (1-2-4-6-7-9) with a
length of 31 weeks and the total cost is Rs.66,900.
Looking at the time-cost slope of the activities on the critical paths (1-3-4-6-7-9)
and (1-2-4-6-7-9), we find that activities (1-3) and (7-9) have the least time-cost slopes
on the two critical paths respectively. The project net work after crashing these
activities is shown in Exhibit 9.

Exhibit 9
6

10 4

2 6 4 9 7
 5 7 4

1 2 3 12 5 12 9

As per Exhibit 9, the critical path is (1-2-4-6-7-9) with a length of 29 weeks and
the total direct cost is Rs.(66,900 + 2,200) = Rs.69,100. Activity (4-6) has the least
time-cost slope on the critical path. Hence this is crashed the net work after crashing
(4-6) is shown in Exhibit 10.

Exhibit 10
6

6 4

2 6 4 9 7

5 7 4

1 2 3 12 5 12 9

As per Exhibit 10, the critical path is (1-3-5-9), with a length of 26 weeks, and
total direct costs of Rs.72,100. Looking at the time-cost slope of the non-crashed
activities on this path we find that activity (3-5) has the lowest slope. Hence it is
crashed. The project net work after such crashing is shown in Exhibit 11.

Exhibit 11

6 4
 2 6 4 9 7

5 7

1 2 3 3 5 12 9

As per Exhibit 11, the critical path is (1-2-4-6-7-9), with a length of 25 weeks
and a total direct cost of Rs.75,700.
Looking at the time cost slope of the activities on this critical path, we find both
activities (1-2) and (2-4) have the same slope. We crash activity (2-4). The resulting
project network net work is given in Exhibit 12.

Exhibit 12

6 4

2 3 4 9 7

5 7

1 2 3 3 5 12 9

As per Exhibit 12, the critical path is (1-3-4-6-7-9), with a length of 23 weeks
and a total direct cost of Rs.78,700. Crashing activity (3-4), the only uncrashed activity
on this critical path, we get the net work shown in Exhibit 13.
Exhibit 13
6

6 4

2 3 4 9 7
 5 4 4

1 2 3 3 5 12 9

As per Exhibit 13, the critical path is (1-2-4-6-7-9), with a length of 22 weeks
and a total direct cost of Rs.82,700. The only uncrashed activity on this critical path is
(1-2). Crashing this we get Exhibit 14.

Exhibit 14

6 4

2 3 4 9 7

2 4 4

1 2 3 3 5 12 9

As per Exhibit 14, the critical path is (1-3-4-6-7-9) with a duration of 20 weeks,
and a total direct cost of Rs.85,700. Since all activities on this path are crashed, there is
no possibility of further time reduction.
Exhibit 15 shows the time-cost relationship.

Exhibit 15
Project Duration and Total Cost
Exhibit Activities Crashed Project Total Total Total
duration direct indirect cost (Rs.)
(in weeks) cost cost
(Rs.) (Rs.)
6 none 34 66,000 34,000 1,00,000
8 (6-7) 31 66,900 31,000 97,900
9 (6-7), (1-3) and (7-9) 29 69,100 29,000 98,100
 10 (6-7), (1-3), (7-9) and (4-6) 26 72,100 26,000 98,100
11 (6-7), (1-3), (7-9), (4-6) and (3-5) 25 75,700 25,000 1,00,700
12 (6-7), (1-3), (7-9), (4-6), (3-5) and (2-4) 23 78,900 23,000 1,01,700
13 (6-7), (1-3), (7-9), (4-6), (3-5), (2-4) and (3-4) 22 80,500 22,000 1,02,500
14 (6-7), (1-3), (7-9), (4-6), (3-5), (2-4), (3-4) and 20 83,500 20,000 1,03,500
(1-2)

If the objective is to minimise the total cost of the project, the pattern to crashing
suggested by Exhibit 8 may appear as the best. However, it is possible to reduce the
cost further without increasing the project duration beyond 26 weeks by decrashing
some activities on the non-critical paths. To do so, begin with the activity which has the
highest time-cost slope and proceed in the order of decreasing time-cost slope.

Chapter 23

PROJECT REVIEW AND ADMINISTRATIVE PROJECTS

1. Calculation of Economic Rate of Return

Year 1 2 3 4 5 6
1. Cash flow 25 30 40 45 50 30
2. Present value at the 146.895 139.518 126.268 101.408 68.543 26.786
beginning of the year; 12
percent discount rate
3. Present value at the end 139.518 126.268 101.408 68.543 26.786 0
of the year, 12 percent
discount rate
4. Change in value during -7.377 -13.250 -24.860 -32.865 -41.757 -26.786
the year (3 – 2)
5. Economic income 17.623 16.750 15.140 12.135 8.243 3.214
(1 + 4)
6. Economic rate of return 0.12 0.12 0.12 0.12 0.12 0.12
(5/2)
7. Economic depreciation 7.377 13.250 24.860 32.865 41.757 26.786

Calculation of Book Return on Investment

Year 1 2 3 4 5 6
1. Cash flow 25 30 40 45 50 30
2. Book value at the 146.895 122.412 97.929 73.446 48.963 24.480
beginning of the year,
straight line depreciation
3. Book value at the end of 122.412 97.929 73.446 48.963 24.480 -
the year, straight line
depreciation
4. Change in book value -24.483 -24.483 -24.483 -24.483 -24.483 -24.483
during the year (3 – 2
5. Book income (1 + 4) 0.517 5.517 15.517 20.517 25.517 5.52
6. Book return on .004 0.045 0.158 0.274 0.521 0.225
investment (5/2)
7. Book depreciation 24.483 24.483 24.483 24.483 24.483 24.483

2.
SV = Rs.120 million DV = Rs.175 million

30 35 45 50
PVCF = + + +
(1.12) (1.12)2 (1.12)3 (1.12)4
30 25
= = Rs.148.21 million
5 6
(1.12) (1.12)
Since DV > PVCF > SV
it is advisable to sell it to the third party at Rs.175 million