Join Us on Telegram http://t.

me/canotes_ipc

Downloaded From www.castudynotes.com

CHAPTER-7
INVESTMENT DECISIONS

Q-1 A company is considering the proposal of taking up a new project which requires an investment of `800
lakhs on machinery and other assets. The project is expected to yield the following earnings (before
depreciation and taxes) over the next five years:
Year Earnings (` in lakhs)
1 320
2 320
3 360
4 360
5 300
The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on written
down value basis. The scrap value at the end of the five year period may be taken as zero. Income-tax
applicable to the company is 40%.
You are required to CALCULATE the net present value of the project and advise the management to take
appropriate decision. Also CALCULATE the Internal Rate of Return of the Project.
Note: Present values of Re. 1 at different rates of interest are as follows:
Year 10% 12% 14% 16% 20%
1 0.91 0.89 0.88 0.86 0.83
2 0.83 0.80 0.77 0.74 0.69
3 0.75 0.71 0.67 0.64 0.58
4 0.68 0.64 0.59 0.55 0.48
5 0.62 0.57 0.52 0.48 0.40
Ans.(i) Calculation of Net Cash Flow
(` in lakhs)
Year Profit before Depreciation PBT PAT Net cash flow
dep. and tax (20% on WDV)
(1) (2) (3) (4) (5) (3) + (5)
1 320 800 . 20% = 160 160 96 256
2 320 (800 - 160). 20% = 128 192 115.20 243.20
3 360 (640 - 128). 20% = 102.4 257.6 154.56 256.96
4 360 (512 - 102.4). 20% = 81.92 278.08 166.85 248.77
5 300 (409.6 - 81.92) = 327.68* 27.68 16.61 311.07
*this is treated as a short term capital loss.

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -169-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(ii) Calculation of Net Present Value (NPV)
(` in lakhs)
Year Net Cash Flow 12% 16% 20%
D.F P.V D.F P.V D.F P.V
1 256 0.89 227.84 0.86 220.16 0.83 212.48
2 243.20 0.80 194.56 0.74 179.97 0.69 167.81
3 256.96 0.71 182.44 0.64 164.45 0.58 149.03
4 248.77 0.64 159.21 0.55 136.82 0.48 119.41
5 311.07 0.57 177.31 0.48 149.31 0.40 124.43
941.36 850.71 773.16
Less: Initial Investment 800.00 800.00 800.00
NPV 141.36 50.71 -26.84
(iii) Advise: Since Net Present Value of the project at 12% = 141.36 lakhs, therefore the project should be
implemented.
(iv) Calculation of Internal Rate of Return (IRR)
50.71× 4
IRR 16% + 50.71 -  -26.84 

2.03
= 16% + =16%+ 2.62% = 18.62%.
77.55
Q-2 H Ltd. is considering a new product line to supplement its range of products. It is anticipated that the
new product line will involve cash investments of Rs.70,00,000 at time 0 and Rs.1,00,00,000 in year 1.
After-tax cash inflows of Rs. 25,00,000 are expected in year 2, Rs.30,00,000 in year 3, Rs.35,00,000 in year
4 and Rs.40,00,000 each year thereafter through year 10. Although the product line might be viable
after year 10, the company prefers to be conservative and end all calculations at that time.
(i) If the required rate of return is 15 per cent, FIND OUT the net present value of the project? Is
it acceptable?
(ii) COMPUTE NPV if the required rate of return were 10 per cent?
(iii) COMPUTE the internal rate of return?

Ans. (i)
Year Cash flow Discount Factor(15%) Present value
(Rs.) (Rs.) (Rs.)
0 (70,00,000) 1.000 (70,00,000)
1 (1,00,00,000) 0.870 (87,00,000)
2 25,00,000 0.756 18,90,000
3 30,00,000 0.658 19,74,000
4 35,00,000 0.572 20,02,000
5-10 40,00,000 2.163 86,52,000
Net Present Value (11,82,000)
As the net present value is negative, the project is unacceptable.

-170- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(ii) Similarly, NPV at 10% discount rate can be computed as follows:
Year Cash flow Discount Factor(10%) Present value
(Rs.) (Rs.)
0 (70,00,000) 1.000 (70,00,000)
1 (1,00,00,000) 0.909 (90,90,000)
2 25,00,000 0.826 20,65,000
3 30,00,000 0.751 22,53,000
4 35,00,000 0.683 23,90,500
5-10 40,00,000 2.974 1,18,96,000
Net Present Value 25,14,500
Since NPV = Rs.25,14,500 is positive, hence the project would be acceptable.
NPV at LR
(iii) IRR = LR + × HR -LR 
NPV at LR - NPV at HR

Rs.25,14,500
= 10% + × 15% -10% 
Rs.25,14,500 -  -  11,82,000
= 10% + 3.4012 or 13.40%
Q-3 X Ltd. is considering to select a machine out of two mutually exclusive machines. The company’s cost of
capital is 15 per cent and corporate tax rate is 30 per cent. Other information relating to both machines
is as follows:
Machine – I Machine – II
Cost of Machine Rs. 30,00,000 Rs. 40,00,000
Expected Life Annual Income 10 years. 10 years.
(Before Tax and Depreciation) Rs. 12,50,000 Rs. 17,50,000
Depreciation is to be charged on straight line basis:
You are required to CALCULATE:
(i) Discounted Pay Back Period
(ii) Net Present Value
(iii) Profitability Index
The present value factors of Re.1 @ 15% are as follows:
Year 01 02 03 04 05
PV factor @ 15% 0.870 0.756 0.658 0.572 0.497

Ans. Working Notes:

30, 00, 000
Depreciation on Machine - 1 = = ` 3, 00, 000
10

40, 00, 000

Depreciation on Machine - 2 = = `4, 00, 000
10

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -171-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Particulars Machine-I (Rs.) Machine – II (Rs.)
Annual Income (before Tax and Depreciation) 12,50,000 17,50,000
Less: Depreciation 3,00,000 4,00,000
Annual Income (before Tax) 9,50,000 13,50,000
Less: Tax @ 30% (2,85,000) (4,05,000)
Annual Income (after Tax) 6,65,000 9,45,000
Add: Depreciation 3,00,000 4,00,000
Annual Cash Inflows 9,65,000 13,45,000
Machine – I Machine - II
Year PV of Re Cash PV Cumulative Cash flow PV Cumulative
1 @ 15% flow PV PV
1 0.870 9,65,000 8,39,550 8,39,550 13,45,000 11,70,150 11,70,150
2 0.756 9,65,000 7,29,540 15,69,090 13,45,000 10,16,820 21,86,970
3 0.658 9,65,000 6,34,970 22,04,060 13,45,000 8,85,010 30,71,980
4 0.572 9,65,000 5,51,980 27,56,040 13,45,000 7,69,340 38,41,320
5 0.497 9,65,000 4,79,605 32,35,645 13,45,000 6,68,465 45,09,785
(i) Discounted Payback Period
Machine – I

Discounted Payback Period = 4 +

 30, 00, 000 - 27, 56, 040 
4, 79, 605

2,43,960
= 4+ = 4 + 0.5087 = 4,5087 years or 4 years 6.10 months
4,79,605
Machine – II

Discounted Payback Period =4+

 40, 00, 000 - 38, 41, 320 
6, 68, 465

1,58,680
= 4+ = 4 + 0.2374 = 4,2374 years or 4 years 2.85 months
6,68,465
(ii) Net Present Value (NPV)
Machine – I
NPV = 32,35,645 – 30,00,000 = Rs. 2,35,645
Machine – II
NPV = 45,09,785 – 40,00,000 = Rs. 5,09,785
(iii) Profitability Index
Machine – I

32,35,645
Profitability Index = = 1.08
30,00, 000

-172- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Machine – II
45,09,785
Profitability Index = = 1.13
40,00,000
Conclusion:
Method Machine - I Machine - II Rank
Discounted Payback Period 4.51 years 4.24 years II
Net Present Value Rs. .2,35,645 Rs. 5,09,785 II
Profitability Index 1.08 1.13 II
Q-4 Sundaram Ltd. discounts its cash flows at 16% and is in the tax bracket of 35%. For the acquisition of a
machinery worth `10,00,000, it has two options – either to acquire the asset by taking a bank loan @ 15%
p.a. repayable in 5 yearly instalments of ` 2,00,000 each plus interest or to lease the asset at yearly
rentals of ` 3,34,000 for five (5) years. In both the cases, the instalment is payable at the end of the year.
Depreciation is to be applied at the rate of 15% using ‘written down value’ (WDV) method. You are
required to STATE with reason which of the financing options is to be exercised.
Year 1 2 3 4 5
P.V factor @16% 0.862 0.743 0.641 0.552 0.476

Ans. Alternative I: Acquiring the asset by taking bank loan:

Years 1 2 3 4 5
(a) Interest (@15% p.a. onopening balance) 1,50,000 1,20,000 90,000 60,000 30,000
Depreciation (@15%WDV) 1,50,000 1,27,500 1,08,375 92,119 78,301
3,00,000 2,47,500 1,98,375 1,52,119 1,08,301
(b) Tax shield (@35%) 1,05,000 86,625 69,431 53,242 37,905
Interest less Tax shield (a)-(b) 45,000 33,375 20,569 6,758 (7,905)
Principal Repayment 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Total cash outflow 2,45,000 2,33,375 2,20,569 2,06,758 1,92,095
Discounting Factor @ 16% 0.862 0.743 0.641 0.552 0.476
Present Value 2,11,190 1,73,398 1,41,385 1,14,130 91,437
Total P.V of cash outflow = ` 7,31,540
Alternative II: Acquire the asset on lease basis
Year Lease Rentals Tax Shield Net Cash Discount Present
(` ) @35% Outflow Factor Value
1 3,34,000 1,16,900 2,17,100 0.862 1,87,140
2 3,34,000 1,16,900 2,17,100 0.743 1,61,305
3 3,34,000 1,16,900 2,17,100 0.641 1,39,161
4 3,34,000 1,16,900 2,17,100 0.552 1,19,839
5 3,34,000 1,16,900 2,17,100 0.476 1,03,340
Present value of Total Cash out flow 7,10,785
By making analysis of both the alternatives, it is observed that the present value of the cash outflow is
lower in alternative II by ` 20,755 (i.e. ` 731,540 – ` 7,10,785) Hence, it is suggested to acquire the asset
on lease basis.
Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -173-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Q-5 You are a financial analyst of B Limited. The director of finance has asked you to analyse two capital
investments proposals, Projects X and Y. Each project has a cost of `10,000 and the cost of capital for
each project is 12 per cent. The project’s expected net cash flows are as follows:
Year Expected net cash flows
Project X (`) Project Y (`)
0 (10,000) (10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
(i) CALCULATE each project’s payback period, net present value (NPV) and internal rate of return
(IRR).
(ii) DETERMINE, which project or projects should be accepted if they are independent?

Ans. (i) Payback Period Method

The cumulative cash flows for each project are as follows:
Year Cumulative Cash Flows
Project X (`) Project Y (`)
0 (10,000) (10,000)
1 (3,500) (6,500)
2 (500) (3,000)
3 2,500 500
4 3,500 4,000
` 500
Paybackx = 2 + = 2.17 years
` 3000

` 3000
Payback y = 2 + = 2.86 years
` 3500
Net Present Value (NPV)

` 6,500 ` 3000 `3000 `1,000

NPVx = - `10,000 + 1+ + 3+
      1.12 = ` 966.01
2 4
1.12 1.12 1.12

` 3,500 ` 3, 500 ` 3, 500 ` 3,500

NPVy = - `10, 000 + 1+ 2+ 3+
1.12 1.12 1.12  1.12 = ` 630.72
4

Internal Rate of Return (IRR)

To solve for each project’s IRR, find the discount rates that equate each NPV to zero:
IRRx = 18.0%.
IRRy = 15.0%.

-174- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(ii) The following table summarizes the project rankings by each method:
Project that ranks higher
Payback X
NPV X
IRR X
Analysis: All methods rank Project X over Project Y. In addition, both projects are acceptable under the
NPV and IRR criteria. Thus, both projects should be accepted if they are independent.
Q-6 State Modified Internal Rate of Return method.
Ans. Modified Internal Rate of Return (MIRR): There are several limitations attached with the concept of
the conventional Internal Rate of Return. The MIRR addresses some of these deficiencies. For example,
it eliminates multiple IRR rates; it addresses the reinvestment rate issue and produces results, which
are consistent with the Net Present Value method.
Under this method, all cash flows, apart from the initial investment, are brought to the terminal value
using an appropriate discount rate (usually the cost of capital). This results in a single stream of cash
inflow in the terminal year. The MIRR is obtained by assuming a single outflow in the zeroth year and
the terminal cash inflow as mentioned above. The discount rate which equates the present value of
the terminal cash in flow to the zeroth year outflow is called the MIRR.
Q-7 An enterprise is investing Rs. 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium
expected by the Management is 7%. The life of the project is 5 years. Following are the cash flows that
are estimated over the life of the project.
Year Cash flows (Rs. in lakhs)
1 25
2 60
3 75
4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks
adjusted discount rate.
Ans. The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is calculated as
below:
Year Cash flow Discounting factor Value at Present Value of
(Rs.) in lakh @ 7% cash flows Rs. in Lakhs
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment 100
Net Present Value (NPV) 144.34
Now when the risk-free rate is 7 % and the risk premium expected by the Management is 7 %. So the
risk adjusted discount rate is 7 % + 7 % =14%.

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -175-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:
Year Cash flow Discounting factor Value at Present Value of
(Rs.) in lakh @ 14% cash flows Rs. in Lakhs
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flow 199.80
Initial investment 100
Net present value (NPV) 99.80
Q-8 Domestic services (P) Ltd. is in the business of providing cleaning sewerage line services at homes.
There is a proposal before the company to purchase a mechanized sewerage cleaning system for a sum
of Rs. 20 lakhs. The present system of the company is to use manual labour for the job. You are provided
with the following information:
Proposed Mechanized System:
Cost of the machine Rs. 20 lakhs
Life of the machine 10 years
Depreciation (on straight line basis) 10%
Operating cost of mechanized system Rs. 5 lakhs per annum
Present system (Manual):
Manual labour 200 persons
Cost of manual labour Rs. 10,000 per person per annum
The company has an after tax cost of fund at 10% per annum.
The applicable tax rate is 30%.
PV factor for 10 years at 10% are as follows:
Years 1 2 3 4 5 6 7 8 9 10
P.V. factor 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386
You are required to DETERMINE whether it is advisable to purchase the machine. Give your
recommendations with workings.
Ans. Rs.
Cost of Manual Operation (Rs. 10,000 x 200) 20,00,000
Cost of Mechanised Operation:
(i) Operating Cost Rs. 5,00,000
(ii) Depreciation Rs. 2,00,000 7,00,000
Saving per annum 13,00,000
Tax on savings (30%) 3,90,000
Saving after tax 9,10,000
Add: Depreciation 2,00,000
Cash flow per annum 11,10,000
Cumulative PV Factor for 10 years 6.144
Present value of cash flow for 10 years 68,19,840
Less: Cost of the Machine 20,00,000
NPV 48,19,840
The Sewerage cleaning machine should be purchased as NPV is positive by Rs. 48,19,840.

-176- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Q-9 Explain the term ‘Payback reciprocal’.
Ans. Financial ratios provide clues but not conclusions. These are tools only in the hands of experts because
there is no standard ready-made interpretation of financial ratios As the name indicates it is the
reciprocal of payback period. A major drawback of the payback period method of capital budgeting is
that it does not indicate any cut off period for the purpose of investment decision. It is, however,
argued that the reciprocal of the payback would be a close approximation of the Internal Rate of Return
(later discussed in detail) if the life of the project is at least twice the payback period and the project
generates equal amount of the annual cash inflows. In practice, the payback reciprocal is a helpful tool
for quickly estimating the rate of return of a project provided its life is at least twice the payback
period.
The payback reciprocal can be calculated as follows:
Average annual cash in flow
Payback Reciprocal =
Initial investment
Q-10 A company has to make a choice between two projects namely A and B. The initial capital outlay of two
Projects are Rs.1,35,00,000 and Rs.2,40,00,000 respectively for A and B. There will be no scrap value at
the end of the life of both the projects. The opportunity cost of capital of the company is 16%. The
annual incomes are as under:
Year Project A Project B Discounting
factor @ 16%
1 — 60,00,000 0.862
2 30,00,000 84,00,000 0.743
3 1,32,00,000 96,00,000 0.641
4 84,00,000 1,02,00,000 0.552
5 84,00,000 90,00,000 0.476
You are required to CALCULATE for each project:
(i) Discounted payback period
(ii) Profitability index
(iii) Net present value
Ans. (1) Computation of Net Present Values of Projects (Amount in Rs. ‘000)
Year Cash flows Discount Discounted Cash flow
factor @ 16 %
Project A(Rs.) Project B(Rs.) Project A(Rs.) Project B(Rs.)
(1) (2) (3) (3) x (1) (3) x (2)
0 (13,500) (24,000) 1.000 (13,500) (24,000)
1 — 6,000 0.862 — 5,172
2 3,000 8,400 0.743 2,229 6,241.2
3 13,200 9,600 0.641 8,461.2 6,153.6
4 8,400 10,200 0.552 4,636.8 5,630.4
5 8,400 9,000 0.476 3,998.4 4,284
Net present value 5,825.4 3,481.2

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -177-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(2) Computation of Cumulative Present Values of Projects Cash inflows
(Amount in Rs. ‘000)
Year Project A Project B
PV of Cumulative PV of Cumulative
cash inflows (Rs.) PV (Rs.) cash inflows (Rs.) PV (Rs.)
1 — — 5,172 51,72
2 2,229 22,29 6,241.2 11,413.2
3 8,461.2 10,690.2 6,153.6 17,566.8
4 4,636.8 15,327 5,630.4 23,197.2
5 3,998.4 19,325.4 4,284 27,481.2
(i) Discounted payback period: (Refer to Working note 2)
Cost of Project A = Rs.1,35,00,000
Cost of Project B = Rs.2,40,00,000
Cumulative PV of cash inflows of Project A after 4 years = Rs.1,53,27,000
Cumulative PV of cash inflows of Project B after 5 years = Rs.2,74,81,200
A comparison of projects cost with their cumulative PV clearly shows that the project A’s cost will be
recovered in less than 4 years and that of project B in less than 5 years. The exact duration of discounted
payback period can be computed as follows:
Project A Project B
Excess PV of cash 18,27,000 34,81,200
inflows over the project cost (Rs.1,53,27,000 - Rs.1,35,00,000) (Rs. 2,74,81,200 ÷ Rs.2,40,00,000)
(Rs.)
Computation of period 0.39 year 0.81 years
required to recoverexcess (Rs. 18,27,000 ÷ Rs.46,36,800) (Rs.34,81,200 ÷ Rs. 42,84,000)
amount ofcumulative PV over
project cost (Refer toWorking
note 2)
Discounted paybackperiod 3.61 year(4 - 0.39) years 4.19 years(5 - 0.81) years
Sum of discounted cash inflows
(ii) Profitability Index: =
Initian cash outlay

Rs.1,93,25,400
Profitability Index (for Project A) = = = 1.43
Rs.1,35, 00, 000

Rs.2,74,81,200
Profitability Index (for Project B) = = = 1.15
Rs.2,40, 00,000
(iii) Net present value (for Project A) = Rs.58,25,400 (Refer to Working note 1)
Net present value (for Project B) = Rs.34,81,200

-178- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Q-11 X Limited is considering to purchase of new plant worth Rs. 80,00,000. The expected net cash flows
after taxes and before depreciation are as follows:
Year Net Cash Flows (Rs.)
1 14,00,000
2 14,00,000
3 14,00,000
4 14,00,000
5 14,00,000
6 16,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000
The rate of cost of capital is 10%.
You are required to Calculate :
(i) Pay-back period
(ii) Net present value at 10 discount factor
(iii) Profitability index at 10 discount factor
(iv) Internal rate of return with the help of 10% and 15% discount factor
The following present value table is given for you:
Year Present value of Rs. 1 at Present value of Rs. 1 at
10% discount rate 15% discount rate
1 .909 .870
2 .826 .756
3 .751 .658
4 .683 .572
5 .621 .497
6 .564 .432
7 .513 .376
8 .467 .327
9 .424 .284
10 .386 .247

Ans.(i) Calculation of Pay-back Period

Cash Outlay of the Project = Rs. 80,00,000
Total Cash Inflow for the first five years = Rs. 70,00,000
Balance of cash outlay left to be paid back in the 6th year Rs. 10,00,000
Cash inflow for 6th year = 16,00,000
So the payback period is between 5th and 6th years, i.e.,

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -179-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Rs.10, 00, 000

5 years + = 5.625 years or 5 years 7.5 months
Rs.6,00,000

(ii) Calculation of Net Present Value (NPV) @10% discount rate:

Year Net Cash Inflow(Rs.) Present Value at Present Value(Rs.)
Discount Rate of 10%
(a) (b) (c) = (a) × (b)
1 14,00,000 0.909 12,72,600
2 14,00,000 0.826 11,56,400
3 14,00,000 0.751 10,51,400
4 14,00,000 0.683 9,56,200
5 14,00,000 0.621 8,69,400
6 16,00,000 0.564 9,02,400
7 20,00,000 0.513 10,26,000
8 30,00,000 0.467 14,01,000
9 20,00,000 0.424 8,48,000
10 8,00,000 0.386 3,08,800
97,92,200
Net Present Value (NPV) = Cash Outflow – Present Value of Cash Inflows
= Rs. 80,00,000 – Rs. 97,92,200 = 17,92,200
(iii) Calculation of Profitability Index @ 10% discount rate:
Present Value of Cash inflows
Profitability Index =
Cost of the investment
Rs.97,92,200
= = 1.224
Rs.80, 00, 000
(iv) Calculation of Internal Rate of Return:
Net present value @ 10% interest rate factor has already been calculated in (ii) above, we will calculate
Net present value @15% rate factor.
Year Net Cash Inflow Present Value at Present Value
(Rs.) DiscountRate of 15% (Rs.)
(a) (b) (c) = (a)× (b)
1 14,00,000 0.870 12,18,000
2 14,00,000 0.756 10,58,400
3 14,00,000 0.658 9,21,200
4 14,00,000 0.572 8,00,800
5 14,00,000 0.497 6,95,800
6 16,00,000 0.432 6,91,200
7 20,00,000 0.376 7,52,000
8 30,00,000 0.327 9,81,000
9 20,00,000 0.284 5,68,000
10 8,00,000 0.247 1,97,600
78,84,000
Net Present Value at 15% = Rs. 78,84,000 – Rs. 80,00,000 = Rs. -1,16,000
-180- Chapter-7 : Investment Decisions
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

As the net present value @ 15% discount rate is negative, hence internal rate of return falls in between
10% and 15%. The correct internal rate of return can be calculated as follows:

NPVL
IRR = L + H - L 
NPVL - NPVH

Rs.17,92,200
= 10% + 15% - 10% 
Rs.17,92,200 -  -Rs.1,16, 000 

Rs.17,92,200
= 10% + × 5% = 14.7%
Rs.19,08,200
Q-12 AT Limited is considering three projects A, B and C. The cash flows associated with the projects are
given below:
Cash flows associated with the Three Projects (`)
Project C0 C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000
You are required to :
(a) Calculate the payback period of each of the three projects.
(b) If the cut-off period is two years, then which projects should be accepted?
(c) Projects with positive NPVs if the opportunity cost of capital is 10 percent.
(d) “Payback gives too much weight to cash flows that occur after the cut-off date”. True or false?
(e) “If a firm used a single cut-off period for all projects, it is likely to accept too many short lived
projects.” True or false?
P.V. Factor @ 10 %
Year 0 1 2 3 4 5
P.V. 1.000 0.909 0.826 0.751 0.683 0.621

Ans. (a) Payback Period of Projects

Projects C0(`) C1(`) C2(`) C3(`) Payback
A (10,000) 2000 2000 6,000 2,000+2,000+6,000 =10,000 i.e 3 years
B (2,000) 0 2,000 NA 0+2,000 = 2,000 i.e 2 years
C (10,000) 2000 2000 6,000 2,000+2,000+6,000 = 10,000 i.e 3 years
(b) If standard payback period is 2 years, Project B is the only acceptable project.

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -181-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(c) Calculation of NPV
Year PVF Project A Project B Project C
@ 10%
Cash PV of cash Cash Flows PV of cash Cash Flows PV of
Flows (`) flows (`) (`) flows (`) (` ) cash flows (`)
0 1 (10,000) (10,000) (2,000) (2,000) (10,000) (10,000)
1 0.909 2,000 1,818 0 0 2,000 1,818
2 0.826 2,000 1,652 2,000 1,652 2,000 1,652
3 0.751 6,000 4506 4,000 3004 6,000 4,506
4 0.683 0 0 6,000 4,098 10,000 6,830
NPV (-2,024) 6,754 4,806
So, Projects with positive NPV are Project B and Project C
(d) False. Payback gives no weightage to cash flows after the cut-off date.
(e) True. The payback rule ignores all cash flows after the cutoff date, meaning that future years’ cash
inflows are not considered. Thus, payback is biased towards short-term projects.
Q-13 From the following details relating to a project, analyse the sensitivity of the project to changes in the
Initial Project Cost, Annual Cash Inflow and Cost of Capital :
Particulars
Initial Project Cost ` 2,00,00,000
Annual Cash Inflow ` 60,00,000
Project Life 5 years
Cost of Capital 10%
To which of the 3 factors, the project is most sensitive if the variable is adversely affected by 10 ?
Cumulative Present Value Factor for 5 years for 10% is 3.791 and for 11% is 3.696.

Ans. Calculation of NPV through Sensitivity Analysis

`
PV of cash inflows (` 60,00,000 × 3.791) 2,27,46,000
Initial Project Cost 2,00,00,000
NPV 27,46,000
Situation NPV Changes in NPV
Base(present) ` 27,46,000

 `27, 46, 000 -` 7, 46, 000 

If initial project cost is (` 2,27,46,000
`27, 46, 000
varied adversely by 10% –` 2,20,00,000*)
= ` 7,46,000 = (72.83%)
If annual cash inflow is

 `27, 46, 000 - ` 4, 71, 400 

varied adversely by 10% [` 54,00,000(revised
`27, 46, 000
cash flow) ** × 3.791) –

-182- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(` 2,00,00,000)]= ` 4,71,400 = 82.83%

 `27, 46, 000 - ` 21, 76, 400 

If cost of capital is varied (` 60,00,000 × 3.696)–
` 27, 46, 000
adversely by 10% i.e. ` 2,00,00,000
itbecomes 11% = ` 21,76,000 = 20.76%
*Revised initial project Cost = 2,00,00,000 × 110% = 2,20,00,000
**Revised Cash Flow = ` 60,00,000 x (100 – 10) % = ` 54,00,000
Conclusion: Project is most sensitive to ‘annual cash inflow’
Q-14 PD Ltd. an existing company, is planning to introduce a new product with projected life of 8 years.
Project cost will be ` 2,40,00,000. At the end of 8 years no residual value will be realized. Working
capital of ` 30,00,000 will be needed. The 100% capacity of the project is 2,00,000 units p.a. but the
Production and Sales Volume is expected are as under :
Year Number of Units
1 60,000 units
2. 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units
Other Information:
(i) Selling price per unit ` 200
(ii) Variable cost is 40 of sales.
(iii) Fixed cost p.a. ` 30,00,000.
(iv) In addition to these advertisement expenditure will have to be incurred as under:
Year 1 2 3-5 6-8
Expenditure (`) 50,00,000 25,00,000 10,00,000 5,00,000
(v) Income Tax is 25%.
(vi) Straight line method of depreciation is permissible for tax purpose.
(vii) Cost of capital is 10%.
(viii) Assume that loss cannot be carried forward.
Present Value Table
Year 1 2 3 4 5 6 7 8
PVF@ 10 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
Advise about the project acceptability.
Ans. Computation of initial cash outlay(COF)
(` in lakhs)
Project Cost 240
Working Capital 30
270

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -183-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Calculation of Cash Inflows(CIF):
Years 1 2 3-5 6-8
Sales in units 60,000 80,000 1,40,000 1,20,000
` ` ` `
Contribution
(` 200 x 60% x No. ofUnit) 72,00,000 96,00,000 1,68,00,000 1,44,00,000
Less: Fixed cost 30,00,000 30,00,000 30,00,000 30,00,000
Less: Advertisement 50,00,000 25,00,000 10,00,000 5,00,000
Less: Depreciation (24000000/8)
= 30,00,000 30,00,000 30,00,000 30,00,000 30,00,000
Profit /(loss) (38,00,000) 11,00,000 98,00,000 79,00,000
Less: Tax @ 25% NIL 2,75,000 24,50,000 19,75,000
Profit/(Loss) after tax (38,00,000) 8,25,000 73,50,000 59,25,000
Add: Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
Cash inflow (8,00,000) 38,25,000 1,03,50,000 89,25,000
(Note: Since variable cost is 40%, Contribution shall be 60% of sales)
Computation of PV of CIF
Year CIF PV Factor `
` @ 10%
1 (8,00,000) 0.909 (7,27,200)
2 38,25,000 0.826 31,59,450
3 1,03,50,000 0.751 77,72,850
4 1,03,50,000 0.683 70,69,050
5 1,03,50,000 0.621 64,27,350
6 89,25,000 0.564 50,33,700
7 89,25,000 0.513 45,78,525
8 89,25,000 0.467 55,68,975
Working Capital 30,00,000
3,88,82,700
PV of COF 2,70,00,000
NPV 1,18,82,700
Recommendation:Accept the project in view of positive NPV.
Q-15 A company is evaluating a project that requires initial investment of ` 60 lakhs in fixed assets and ` 12
lakhs towards additional working capital.
The project is expected to increase annual real cash inflow before taxes by ` 24,00,000 during its life.
The fixed assets would have zero residual value at the end of life of 5 years.
The company follows straight line method of depreciation which is expected for tax purposes also.
Inflation is expected to be 6% per year. For evaluating similar projects, the company uses discounting
rate of 12% in real terms. Company’s tax rate is 30%.
Advise whether the company should accept the project, by calculating NPV in real terms.

-184- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

PVIF (12%, 5 years) PVIF (12%, 5 years)
Year 1 0.893 Year 1 0.943
Year 2 0.797 Year 2 0.890
Year 3 0.712 Year 3 0.840
Year 4 0.636 Year 4 0.792
Year 5 0.567 Year 5 0.747

Ans.(i) Equipment’s initial cost = ` 60,00,000 + ` 12,00,000

= ` 72,00,000
(ii) Annual straight line depreciation = ` 60,00,000/5
= ` 12,00,000.
(iii) Net Annual cash flows can be calculated as follows:
= Before Tax CFs × (1 – Tc) + Tc × Depreciation (Tc = Corporate tax i.e. 30%)
= ` 24,00,000 × (1 – 0.3) + (0.3 x ` 12,00,000)
= ` 16,80,000 + ` 3,60,000 = ` 20,40,000
So, Total Present Value = PV of inflow + PV of working capital released
= (` 20,40,000 × PVIF 12%, 5 years) + (` 12,00,000 × 0.567)
= (` 20,40,000 × 3.605) + ` 6,80,400
= ` 73,54,200 + ` 6,80,400
= ` 80,34,600
So NPV = PV of Inflows – Initial Cost
= ` 80,34,600 – ` 72,00,000
= ` 8,34,600
Advice: Company should accept the project as the NPV is Positive
Q-16 An enterprise is investing ` 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium
expected by the Management is 7%. The life of the project is 5 years. Following are the cash flows that
are estimated over the life of the project.
Year Cash flows (` In lakhs)
1 25
2 60
3 75
4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks
adjusted discount rate.
Ans. The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is calculated as
below:

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -185-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Year Cash flows ` In lakhs Discounting Factor @ 7% Present value of Cash
Flows ` In Lakhs
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment (100.00)
Net Present Value (NPV) 144.34
Now when the risk-free rate is 7 % and the risk premium expected by the Management is 7 %. So the
risk adjusted discount rate is 7 % + 7 % =14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:
Year Cash flows ` in Lakhs DiscountingFactor @ 14% Present Value of
Cash Flows ` in lakhs
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flow 199.79
Initial investment (100.00)
Net present value (NPV) 99.79
Q-17 Shiv Limited is thinking of replacing its existing machine by a new machine which would cost ` 60 lakhs.
The company’s current production is 80,000 units, and is expected to increase to 1,00,000 units, if the
new machine is bought. The selling price of the product would remain unchanged at ` 200 per unit. The
following is the cost of producing one unit of product using both the existing and new machine:
Unit cost (`)
Existing Machine New Machine Difference
(80,000 units) (1,00,000 units)
Materials 75.0 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.0 25.0 5.0
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.0 4.75
Allocated Corporate Overheads 10.0 12.50 2.50
183.25 165.50 (17.75)
The existing machine has an accounting book value of ` 1,00,000, and it has been fully depreciated for
tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine
has offered to accept the old machine for ` 2,50,000.

-186- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

However, the market price of old machine today is ` 1,50,000 and it is expected to be ` 35,000 after 5
years. The new machine has a life of 5 years and a salvage value of ` 2,50,000 at the end of its economic
life. Assume corporate Income tax rate at 40%, and depreciation is charged on straight line basis for
Income-tax purposes. Further assume that book profit is treated as ordinary income for tax purpose.
The opportunity cost of capital of the Company is 15%.
Required:
(i) ESTIMATE net present value of the replacement decision.
(ii) CALCULATE the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? ANALYSE.
Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

Ans.(i) Net Cash Outlay of New Machine

Purchase Price ` 60,00,000
Less: Exchange value of old machine ` 1,50,000
[2,50,000 – 0.4(2,50,000 – 0)] ` 58,50,000
Market Value of Old Machine: The old machine could be sold for ` 1,50,000 in the market. Since the
exchange value is more than the market value, this option is not attractive. This opportunity will be
lost whether the old machine is retained or replaced. Thus, on incremental basis, it has no impact.
Depreciation base: Old machine has been fully depreciated for tax purpose.
Thus, the depreciation base of the new machine will be its original cost i.e. ` 60,00,000.
Net Cash Flows: Unit cost includes depreciation and allocated overheads. Allocated overheads are
allocated from corporate office therefore they are irrelevant. The depreciation tax shield may be
computed separately. Excluding depreciation and allocated overheads, unit costs can be calculated.
The company will obtain additional revenue from additional 20,000 units sold.
Thus, after-tax saving, excluding depreciation, tax shield, would be
= {100,000(200 – 148) – 80,000(200 – 173)} × (1 – 0.40)
= {52,00,000 – 21,60,000} × 0.60
= ` 18,24,000
After adjusting depreciation tax shield and salvage value, net cash flows and net present value are
estimated.
Calculation of Cash flows and Project Profitability
` (`000)
0 1 2 3 4 5
1 After-tax savings - 1824 1824 1824 1824 1824
2 Depreciation(` 60,00,000 – 2,50,000)/5 - 1150 1150 1150 1150 1150
3 Tax shield on depreciation
(Depreciation × Tax rate) - 460 460 460 460 460
Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -187-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

4 Net cash flows fromoperations (1 + 3)* - 2284 2284 2284 2284 2284
5 Initial cost (5850)
6 Net Salvage Value(2,50,000 – 35,000) - - - - - 215
7 Net Cash Flows (4+5+6) (5850) 2284 2284 2284 2284 2499
8 PVF at 15% 1.00 0.8696 0.7561 0.6575 0.5718 0.4972
9 PV (5850) 1986.166 1726.932 1501.73 1305.99 1242.50
10 NPV ` 1913.32
* Alternately Net Cash flows from operation can be calculated as follows:
Profit before depreciation and tax = ` 1,00,000 (200 -148) - 80,000 (200 -173)
= ` 52,00,000 – 21,60,000
= ` 30,40,000]
So profit after depreciation and tax is ` (30,40,000 -11,50,000) × (1 - .40)
= ` 11,34,000
So profit before depreciation and after tax is :
` 11,34,000 + ` 11,50,000 (Depreciation added back) = ` 22,84,000
(ii)
` (‘000)
0 1 2 3 4 5
NCF (5850) 2284 2284 2284 2284 2499
PVF at 20% 1.00 0.8333 0.6944 0.5787 0.4823 0.4019
PV (5850) 1903.257 1586.01 1321.751 1101.57 1004.35
PV of benefits 6916.94
PVF at 30% 1.00 0.7692 0.5917 0.4550 0.3501 0.2693
PV (5850) 1756.85 1351.44 1039.22 799.63 672.98
PV of benefits 5620.12

1066.94
IRR = 20% + 10% × = 28.23%
1296.82
(iii) Advise: The Company should go ahead with replacement project, since it is positive NPV decision.
Q-18 Gauav Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The following
information regarding a new project is as follows:
Year Expected Cash flow Certainty-equivalentquotient
0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3
Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether the project
should be accepted?

-188- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Ans. Determination of Net Present Value (NPV)
Year Expected Cash Certainty Adjusted Cash PV factor Total PV (`)
flow (`) equivalent(CE) flow (Cash flow (at 0.06)
× CE) (`)
0 (4,00,000) 1.0 (4,00,000) 1.000 (4,00,000)
1 3,20,000 0.8 2,56,000 0.943 2,41,408
2 2,80,000 0.7 1,96,000 0.890 1,74,440
3 2,60,000 0.6 1,56,000 0.840 1,31,040
4 2,40,000 0.4 96,000 0.792 76,032
5 1,60,000 0.3 48,000 0.747 35,856
NPV = (6,58,776 – 4,00,000) 2,58,776
As the Net Present Value is positive the project should be accepted.
Q-19 A company has to make a choice between two projects namely A and B. The initial capital outlay of two
Projects are ` 1,35,000 and ` 2,40,000 respectively for A and B. There will be no scrap value at the end
of the life of both the projects. The opportunity Cost of Capital of the company is 16%. The annual
incomes are as under:
Year Project A (`) Project B (`) Discounting factor @ 16%
1 — 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476
Required:
CALCULATE for each project:
(i) Discounted payback period
(ii) Profitability index
(iii) Net present value
DECIDE which of these projects should be accepted?
Ans. Working notes
1. Computation of Net Present Values of Projects
Year Cash flows Disct. Discounted Cash
factor flow
@16 %
Project A(`) Project B(`) Project A(`) Project B(`)
(1) (2) (3) (3) x (1) (3) x (2)
0 (1,35,000) (2,40,000) 1.000 (1,35,000) (2,40,000)
1 — 60,000 0.862 — 51,720
2 30,000 84,000 0.743 22,290 62,412
3 1,32,000 96,000 0.641 84,612 61,536
4 84,000 1,02,000 0.552 46,368 56,304
5 84,000 90,000 0.476 39,984 42,840
Net present value 58,254 34,812

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -189-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

2. Computation of Cumulative Present Values of Projects Cash inflows
Year Project A Project B
PV of Cumulative PV of Cumulative
cash inflows (`) PV (`) cash inflows (`) PV (`)
1 — — 51,720 51,720
2 22,290 22,290 62,412 1,14,132
3 84,612 1,06,902 61,536 1,75,668
4 46,368 1,53,270 56,304 2,31,972
5 39,984 1,93,254 42,840 2,74,812
(i) Discounted payback period: (Refer to Working note 2)
Cost of Project A = ` 1,35,000
Cost of Project B = ` 2,40,000
Cumulative PV of cash inflows of Project A after 4 years = ` 1,53,270
Cumulative PV of cash inflows of Project B after 5 years = ` 2,74,812
A comparison of projects cost with their cumulative PV clearly shows that the project A’s cost will
be recovered in less than 4 years and that of project B in less than 5 years. The exact duration of
discounted payback period can be computed as follows:
Project A Project B
Excess PV of cash inflows 18,270 34,812
over theproject cost (`) (` 1,53,270 - ` 1,35,000) (` 2,74,812 - ` 2,40,000)
Computation of 0.39 year 0.81 years
period required to (` 18,270 ÷ ` 46,368) (` 34,812 ÷ ` 42,840)
recover excess
amount of cumulative
PV over project cost
(Refer to Working
note 2)
Discounted pay back 3.61 year 4.19 years
period (4 - 0.39) years (5 - 0.81) years
Sum of discounted cash in flows
(ii) Profitability Index(PI): =
Initian cash outlay

`1,93,254
Profitability Index (for Project A) = = 1.43
`1,35, 000

` 2,74,812
Profitability Index (for Project B) = = 1.15
` 2, 40, 000
(iii) Net present value(NPV) (for Project A) = ` 58,254
Net present value(NPV) (for Project B) = ` 34,812
(Refer to Working note 1)
Conclusion: As the NPV, PI of Project A is higher and Discounted Pay back is lower, therefore Project a
should be accepted.

-190- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Q-20 From the following details relating to a project, analyse the sensitivity of the project tochanges in
initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (`) 1,20,000
Annual Cash Inflow (`) 45,000
Project Life (Years) 4
Cost of Capital 10%
Required:
EXAMINE which of the three factors, the project is most sensitive? (Use annuity factors:
for 10% 3.169 and 11% 3.103).
Ans. CALCULATION OF NET PRESENT VALUE
(` )
PV of Annual cash inflows (` 45,000 × 3.169) 1,42,605
Initial Project Cost 1,20,000
NPV (PV of Cash flow – Initial Cost) 22,605
If initial project cost is varied adversely by 10%*
Initial Project Cost (1,20,000 × 110%) ` 1,32,000
NPV (Revised) (` 1,42,605 - ` 1,32,000 ) ` 10,605
Change in NPV (` 22,605 – ` 10,605)/ ` 22,605 i.e 53.08%
If annual cash inflow is varied adversely by 10%*
Revised annual inflow (` 45,000 × 90%) ` 40,500
NPV (Revised) (` 40,500 × 3.169) – (` 1,20,000) (+) ` 8,345
Change in NPV (` 22,605 – ` 8,345) / ` 22,605 63.08%
If cost of capital is varied adversely by 10%*
NPV (Revised) (` 45,000 × 3.103) – ` 1,20,000 (+) ` 19,635
Change in NPV (` 22,605 – ` 19,635) / ` 22,605 13.14 %
Conclusion: Project is most sensitive to ‘annual cash inflows’
(*It is assumed that adverse variation is 10%)
Q-21 MTR Limited is considering buying a new machine which would have a useful economic life of five
years, at a cost of `25,00,000 and a scrap value of `3,00,000, with 80 per cent of the cost being payable
at the start of the project and 20 per cent at the end of the first year. The machine would produce 75,000
units per annum of a new product with an estimated selling price of ` 300 per unit. Direct costs would
be ` 285 per unit and annual fixed costs, including depreciation calculated on a straight- line basis,
would be `8,40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included in the above
costs, would be incurred, amounting to ` 1,00,000 and `1,50,000 respectively.
EVALUATE the project using the NPV method of investment appraisal, assuming the company’s cost of
capital to be 15 percent.

Ans. Calculation of Net Cash flows

Contribution = (300 – 285) x 75,000 = `11,25,000

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -191-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Fixed costs = 8,40,000 – [(25,00,000 – 3,00,000)/5] = ` 4,00,000
Year Capital (`) Contribution(`) Fixed costs(`) Adverts(`) Net cashflow (`)
0 (20,00,000) (20,00,000)
1 (5,00,000) 11,25,000 (4,00,000) (1,00,000) 1,25,000
2 11,25,000 (4,00,000) (1,50,000) 5,75,000
3 11,25,000 (4,00,000) 7,25,000
4 11,25,000 (4,00,000) 7,25,000
5 3,00,000 11,25,000 (4,00,000) 10,25,000
Calculation of Net Present Value
Year Net cash flow (`) 12% discount factor Present value(`)
0 (20,00,000) 1.000 (20,00,000)
1 1,25,000 0.892 1,11,500
2 5,75,000 0.797 4,58,275
3 7,25,000 0.711 5,15,475
4 7,25,000 0.635 4,60,375
5 10,25,000 0.567 5,81,175
1,26,800
The net present value of the project is `1,26,800.
Q-22 SL Ltd. has invested `1,000 lakhs in a project. The risk-free rate of return is 5%. Risk premium expected
by the Management is 10%. The life of the project is 5 years. Following are the cash flows that are
estimated over the life of the project.
Year Cash flows (` in lakhs)
1 125
2 300
3 375
4 400
5 325
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks
adjusted discount rate.
Ans. The Present Value of the Cash Flows for all the years by discounting the cash flow at 5% is calculated as
below:
Year Cash flows` in lakhs Discounting Present value of Cash
Factor@5% Flows ` In Lakhs
1 125 0.952 119.00
2 300 0.907 272.10
3 375 0.863 323.62
4 400 0.822 328.80
5 325 0.783 254.47
Total of present value of Cash flow 1,297.99
Less: Initial investment 1,000.00
Net Present Value (NPV) 297.99
-192- Chapter-7 : Investment Decisions
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Now when the risk-free rate is 5% and the risk premium expected by the Management is 10%. So the
risk adjusted discount rate is 5% + 10% =15%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:
Year Cash flows ` in Lakhs DiscountingFactor@15% Present Value of Cash
Flows ` in lakhs
1 125 0.869 108.62
2 300 0.756 226.80
3 375 0.657 246.37
4 400 0.571 228.40
5 325 0.497 161.52
Total of present value of Cash flow 971.71
Initial investment 1,000.00
Net present value (NPV) (28.29)
Q-23 BT Pathology Lab Ltd. is using an X-ray machines which reached at the end of their useful lives. Following
new X-ray machines are of two different brands with same features are
available for the purchase.
Brand Cost of Life of Maintenance Cost Rate of
Machine Machine Year 1-5 Year 6-10 Year 11-15 Depreciation
XYZ ` 6,00,000 15 years ` 20,000 ` 28,000 ` 39,000 4%
ABC ` 4,50,000 10 years ` 31,000 ` 53,000 — 6%
Residual Value of both of above machines shall be dropped by 1/3 of Purchase price in the first year and
thereafter shall be depreciated at the rate mentioned above.
Alternatively, the machine of Brand ABC can also be taken on rent to be returned back to the owner
after use on the following terms and conditions:
• Annual Rent shall be paid in the beginning of each year and for first year it shall be ` 1,02,000.
• Annual Rent for the subsequent 4 years shall be ` 1,02,500.
• Annual Rent for the final 5 years shall be ` 1,09,950.
• The Rent Agreement can be terminated by BT Labs by making a payment of ` 1,00,000 as penalty.
This penalty would be reduced by ` 10,000 each year of the period of rental agreement.
You are required to:
(a) ADVISE which brand of X-ray machine should be acquired assuming that the use of machine shall
be continued for a period of 20 years.
(b) STATE which of the option is most economical if machine is likely to be used for aperiod of 5 years?
The cost of capital of BT Labs is 12%.
Ans. Since the life span of each machine is different and time span exceeds the useful lives of each model,
we shall use Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine is used for 20 years
Present Value (PV) of cost if machine of Brand XYZ is purchased
Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -193-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Period Cash Outflow (`) PVF@12% Present Value
0 6,00,000 1.000 6,00,000
1-5 20,000 3.605 72,100
6-10 28,000 2.045 57,260
11-15 39,000 1.161 45,279
15 (64,000) 0.183 (11,712)
7,62,927
PVAF for 1-15 years 6.811

`7, 62, 927

Equivalent Annual Cost = = ` 1.12, 014
6.811
Present Value (PV) of cost if machine of Brand ABC is purchased
Period Cash Outflow (`) PVF@12% Present Value
0 4,50,000 1.000 4,50,000
1-5 31,000 3.605 1,11,755
6 -10 53,000 2.045 1,08,385
10 (57,000) 0.322 (18,354)
6,51,786
PVAF for 1-10 years 5.65

` 6, 51, 786
Equivalent Annual Cost = = ` 1,15, 360
5.65
Present Value (PV) of cost if machine of Brand ABC is taken on Rent
Period Cash Outflow (`) PVF@12% Present Value
0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293
5-9 1,09,950 2.291 2,51,895
6,65,188
PVAF for 1-10 years 5.65

` 6, 65,188
Equivalent Annual Cost = = `1,17, 732
5.65
Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand XYZ the
same should be purchased.
(ii) If machine is used for 5 years
(a) Scrap Value of Machine of Brand XYZ
= ` 6,00,000 – ` 2,00,000 – ` 6,00,000 × 0.04 × 4 = ` 3,04,000
(b) Scrap Value of Machine of Brand ABC
= ` 4,50,000 – ` 1,50,000 – ` 4,50,000 × 0.06 × 4 = ` 1,92,000

-194- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Present Value (PV) of cost if machine of Brand XYZ is purchased
Period Cash Outflow (`) PVF@12% Present Value
0 6,00,000 1.000 6,00,000
1-5 20,000 3.605 72,100
5 (3,04,000) 0.567 (1,72,368)
4,99,732
Present Value (PV) of cost if machine of Brand ABC is purchased
Period Cash Outflow (`) PVF@12% Present Value
0 4,50,000 1.000 4,50,000
1-5 31,000 3.605 1,11,755
5 (1,92,000) 0.567 (1,08,864)
4,52,891
Present Value (PV) of cost if machine of Brand ABC is taken on Rent
Period Cash Outflow (`) PVF@12% Present Value
0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293
5 50,000 0.567 28,350
4,41,643
Decision: Since Cash Outflow is least in case of lease of Machine of brand ABC the same should be taken
on rent.
Q-24 A firm can make investment in either of the following two projects. The firm anticipates its cost of
capital to be 10%. The pre-tax cash flows of the projects for five years are as follows:
Year 0 1 2 3 4 5
Project A (`) (2,00,000) 35,000 80,000 90,000 75,000 20,000
Project 8 (`) (2,00,000) 2,18,000 10,000 10,000 4,000 3,000
Ignore Taxation.
An amount of ` 35,000 will be spent on account of sales promotion in year 3 in case of Project A. This
has not been taken into account in calculation of pre-tax cash flows.
The discount factors are as under:
Year 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62
You are required to calculate for each project:
(i) The payback period
(ii) The discounted payback period
(iii) Desirability factor
(iv) Net Present Value

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -195-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Ans. Calculation of Present Value of cash flows
Year PV factor Project A Project B
@ 10% Cash flows (`) Discounted Cash flows (`) Discounted
Cash flows Cash flows
0 1.00 (2,00,000) (2,00,000) (2,00,000) (2,00,000)
1 0.91 35,000 31,850 2,18,000 1,98,380
2 0.83 80,000 66,400 10,000 8,300
3 0.75 55,000
(90,000-35,000) 41,250 10,000 7,500
4 0.68 75,000 51,000 4,000 2,720
5 0.62 20,000 12,400 3,000 1,860
Net Present Value 2,900 18,760

(i) The Payback period of the projects:Project-A: The cumulative cash inflows up-to year 3 is `1,70,000 and
remaining amount required to equate the cash outflow is ` 30,000 i.e. (` 2,00,000 – ` 1,70,000) which
will be recovered from year-4 cash inflow. Hence, Payback period will be calculated as below:

3 years + = 3.4 years Or 3 years 4.8 months Or 3 years 4 months and 24 days

Project-B: The cash inflow in year-1 is ` 2,18,000 and the amount required to equate the cash outflow
is ` 2,00,000, which can be recovered in a period less than a year. Hence, Payback period will be
calculated as below:

= 0.917 years Or 11 months

(ii) Discounted Payback period for the projects:

Project-A: The cumulative discounted cash inflows up-to year 4 is ` 1,90,500 and remaining amount
required to equate the cash outflow is ` 9,500 i.e. (` 2,00,000 – ` 1,90,500) which will be recovered from
year-5 cash inflow. Hence, Payback period will be calculated as below:

4 years + = 4.766 years Or 4 years 9.19 months Or 4 years 9 months and 6 days

Project-B: The cash inflow in year-1 is `1,98,380 and remaining amount required to equate the cash
outflow is ` 1,620 i.e. (` 2,00,000 – ` 1,98,380) which will be recovered from year-2 cash inflow. Hence,
Payback period will be calculated as below:

1 year + = 1.195 years Or 1 Year 2.34 months Or 1 Year 2 months and 10 days.

(iii) Desirability factor of the projects

Desirability Factor (Profitability Index) = Discounted value Cash Inflows
Discounted value of Cash Outflows

Project A = = 1.01

Project B = = 1.09

-196- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(iv) Net Present Value (NPV) of the projects:
Please refer the above table.
Project A- ` 2,900
Project B- ` 18,760
Q-25 A large profit making company is considering the installation of a machine to process the waste produced
by one of its existing manufacturing process to be converted into a marketable product. At present, the
waste is removed by a contractor for disposal on payment by the company of ` 150 lakh per annum for
the next four years. The contract can be terminated upon installation of the aforesaid machine on
payment of a compensation of ` 90 lakh before the processing operation starts. This compensation is
not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost ` 600 lakh to be financed by a loan
repayable in 4 equal instalments commencing from end of the year 1. The interest rate is 14% per
annum. At the end of the 4th year, the machine can be sold for ` 60 lakh and the cost of dismantling and
removal will be ` 45 lakh.
Sales and direct costs of the product emerging from waste processing for 4 years are estimated as
under:
(` In lakh)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63
Initial stock of materials required before commencement of the processing operations is ` 60 lakh at
the start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be `
165 lakh and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which
would otherwise have been rented out for ` 30 lakh per annum. Labour costs include wages of 40
workers, whose transfer to this process will reduce idle time payments of ` 45 lakh in the year - 1 and
` 30 lakh in the year - 2. Factory overheads include apportionment of general factory overheads except
to the extent of insurance charges of ` 90 lakh per annum payable on this venture. The company’s tax
rate is 30%.
Present value factors for four years are as under:
Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592
ADVISE the management on the desirability of installing the machine for processing the waste. All
calculations should form part of the answer.
Ans. Statement of Operating Profit from processing of waste ( ` in lakh)
Year 1 2 3 4
Sales :(A) 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 180 195 255 300
Other expenses 120 135 162 210
Factory overheads (insurance only) 90 90 90 90

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -197-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Loss of rent on storage space (opportunity cost) 30 30 30 30
Interest @14% 84 63 42 21
Depreciation (as per income tax rules) 150 114 84 63
Total cost: (B) 744 747 918 969
Profit (C)=(A)-(B) 222 219 336 285
Tax (30%) 66.6 65.7 100.8 85.5
Profit after Tax (PAT) 155.4 153.3 235.2 199.5
Statement of Incremental Cash Flows (` in lakh)
Year 0 1 2 3 4
Material stock (60) (105) - - 165
Compensation for contract (90) - - - -
Contract payment saved - 150 150 150 150
Tax on contract payment - (45) (45) (45) (45)
Incremental profit - 222 219 336 285
Depreciation added back - 150 114 84 63
Tax on profits - (66.6) (65.7) (100.8) (85.5)
Loan repayment - (150) (150) (150) (150)
Profit on sale of machinery (net) - - - - 15
Total incremental cash flows (150) 155.4 222.3 274.2 397.5
Present value factor 1.00 0.877 0.769 0.674 0.592
Present value of cash flows (150) 136.28 170.95 184.81 235.32
Net present value 577.36
Advice: Since the net present value of cash flows is ` 577.36 lakh which is positive the management
should install the machine for processing the waste.
Notes:
(i) Material stock increases are taken in cash flows.
(ii) Idle time wages have also been considered.
(iii) Apportioned factory overheads are not relevant only insurance charges of this project are relevant.
(iv) Interest calculated at 14% based on 4 equal instalments of loan repayment.
(v) Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains
ignored.
(vi) Saving in contract payment and income tax thereon considered in the cash flows.
Q-26 Sadbhavna Limited is a manufacturer of computers. It wants to introduce artificial intelligence while
making computers. It estimates that the annual savings from the artificial intelligence (AI) include a
reduction of five employees with annual salaries of ` 3,00,000 each, ` 3,00,000 from reduction in
production delays caused by inventory problem, reduction in lost sales ` 2,50,000 and ` 2,00,000 from
billing issues.
The purchase price of the system for installation of artificial intelligence is ` 20,00,000 with installation
cost of ` 1,00,000. The life of the system is 5 years and it will be depreciated on a straight-line basis.
The salvage value is zero which will be its market value after the end of its life of five years.
However, the operation of the new system for AI requires two computer specialists with annual salaries
of ` 5,00,000 per person. Also, the estimated maintenance and operating expenses of 1,50,000 is
required.

-198- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

The company’s tax rate is 30% and its required rate of return is 12%.
From the above information:
(i) CALCULATE the initial cash outflow and annual operating cash flow over its life of 5 years.
(ii) Further, EVALUATE the project by using Payback Period, Net Present Value and Profitability Index.
(iii) You are also REQUIRED to obtain the cash flows and NPV on the assumption that book salvage
value for depreciation purposes is ` 2,00,000 even though the machine is having no real worth
interms of its resale value. Also, the book salvage value of ` 2,00,000 is allowed for tax purposes.
Also COMMENT on the acceptability of the project in (ii) and (iii) above.
Ans.
(i) Project’s Initial Cash Outlay Cost 20,00,000
Installation Expenses 1,00,000
Total Cash Outflow 21,00,000
Depreciation per year = 21,00,000/5 = 4,20,000
Project’s Operating Cash Flows over its 5-year life
Savings (A)
Reduction in salaries (` 3,00,000 x 5) 15,00,000
Reduction in production delays 3,00,000
Reduction in lost sales 2,50,000
Gains due to timely billing 2,00,000
22,50,000
Costs (B)
- Depreciation 4,20,000
- Additional Specialist Cost (` 5,00,000 x 2) 10,00,000
- Maintenance Cost 1,50,000
15,70,000
Increase in Profit before tax (A – B) 6,80,000
Less: Tax @ 30% 2,04,000
Profit after tax 4,76,000
Cash Inflows = Profit after tax + Depreciation
= 4,76,000 + 4,20,000 = 8,96,000
(ii) Evaluation of the project by using NPV Method
Year Cash Inflows PVAF (12%,5y) Total PV
1-5 8,96,000 3.605 32,30,080
Less: Total Initial Cash Outflow 21,00,000
Net Present Value 11,30,080
Since NPV is positive, therefore, the project is acceptable.
Evaluation of the project by using Profitability Index Method
Profitability Index = Present Value of Cash Inflows/Present Value of Cash Outflows
= 32,30,080/21,00,000
= 1.538
Since, the profitability index is more than 1, the project is acceptable.

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -199-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Calculation of the Project’s Payback*
Year Net Cash Flow Cumulative Cash Flow
1 8,96,000 8,96,000
2 8,96,000 17,92,000
3 8,96,000 26,88,000
4 8,96,000 35,84,000
5 8,96,000 44,80,000
Here, the payback period is 2 years plus a fraction of the 3rd year
So, payback period = 2 years + 3,08,000/8,96,000
= 2.34 years
* Payback period may also be solved directly as follows: 21,00,000/8,96,000 = 2.34 years
(iii) Project’s cash flows and NPV assuming that the book salvage for depreciation purpose is ` 2,00,000
Depreciation = (` 21,00,000 – 2,00,000)/5 = 3,80,000
Cash Inflows for the years 1 to 5 are:
Savings (calculated as earlier) 22,50,000
Less: Costs
- Depreciation 3,80,000
- Additional Specialists cost 10,00,000
- Maintenance cost 1,50,000 15,30,000
Profit before tax 7,20,000
Less: Tax @ 30% 2,16,000
Profit after tax 5,04,000
Cash Inflow (5,04,000 + 3,80,000) 8,84,000
Calculation of NPV
It may be noted that at the end of year 5, the book value of the project would be ` 2,00,000 but its
realizable value is nil. So, the capital loss of ` 2,00,000 will result in tax savings of ` 60,000 (i.e., `
2,00,000 x 30%), as the capital loss is available for tax purposes in view of the information given.
Therefore, at the end of year 5, there would be an additional inflow of ` 60,000. The NPV may now be
calculated as follows:
Year Cash Flow (`) PVAF (12%, n) PV
1-5 5 8,84,000 3.605 31,86,820
60,000 0.567 34,020
PV of inflows 32,20,840
Outflows 21,00,000
NPV 11,20,840
As the NPV of the project is positive, the project is acceptable.
Q-26 HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine.
The old machine had been fully depreciated for tax purpose but has a book value of ` 2,40,000 on 31st
March 2021. The machine has begun causing problems with breakdowns and it cannot fetch more than

-200- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

` 30,000 if sold in the market at present. It will have no realizable value after 10 years. The company has
been offered ` 1,00,000 for the old machine as a trade in on the new machine which has a price (before
allowance for trade in) of ` 4,50,000. The expected life of new machine is 10 years with salvage value of
` 35,000.
Further, the company follows straight line depreciation method but for tax purpose, written down
value method depreciation @ 7.5% is allowed taking that this is the only machine in the block of assets.
Given below are the expected sales and costs from both old and new machine:
Old machine (`) New machine (`)
Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075
From the above information, ANALYSE whether the old machine should be replaced or not if required
rate of return is 10%? Ignore capital gain tax.
PV factors @ 10%:
Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

Ans.. Workings:
1. Calculation of Base for depreciation or Cost of New Machine
Particulars (`)
Purchase price of new machine 4,50,000
Less: Sale price of old machine 1,00,000
3,50,000
2. Calculation of Profit before tax as per books
Particulars Old machine(`) New machine(`) Difference(`)
PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per books 24,000 41,500 17,500
Profit before tax anddepreciation (PBTD) 3,48,750 4,28,750 80,000
Calculation of Incremental NPV
Year PVF PBTD(`) Dep. PBT(`) Tax @ CashInflows PV of Cash
@ 10% @7.5%(`) 30%(`) (`) Inflows(`)
(1) (2) (3) (4) (5) = (4) (6) = (4) (7) = (6) x (1)
– (5)+ (3)
1 0.909 80,000.00 26,250.00 53,750.00 16,125.00 63,875.00 58,062.38
2 0.826 80,000.00 24,281.25 55,718.75 16,715.63 63,284.38 52,272.89
3 0.751 80,000.00 22,460.16 57,539.84 17,261.95 62,738.05 47,116.27

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -201-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

4 0.683 80,000.00 20,775.64 59,224.36 17,767.31 62,232.69 42,504.93
5 0.621 80,000.00 19,217.47 60,782.53 18,234.76 61,765.24 38,356.21
6 0.564 80,000.00 17,776.16 62,223.84 18,667.15 61,332.85 34,591.73
7 0.513 80,000.00 16,442.95 63,557.05 19,067.12 60,932.88 31,258.57
8 0.467 80,000.00 15,209.73 64,790.27 19,437.08 60,562.92 28,282.88
9 0.424 80,000.00 14,069.00 65,931.00 19,779.30 60,220.70 25,533.58
10 0.386 80,000.00 13,013.82 66,986.18 20,095.85 59,904.15 23,123.00
3,81,102.44
Add: PV of Salvage value of new machine (` 35,000 x 0.386) 13,510.00
Total PV of incremental cash inflows 3,94,612.44
Less: Cost of new machine 3,50,000.00
Incremental Net Present Value 44,612.44
Analysis: Since the Incremental NPV is positive, the old machine should be replaced.
Q-27 The General Manager of Merry Ltd. is considering the replacement of five-year-old equipment. The
company has to incur excessive maintenance cost of the equipment. The equipment has zero written
down value. It can be modernized at a cost of ` 1,40,000 enhancing its economic life to 5 years. The
equipment could be sold for ` 30,000 after 5 years. The modernization would help in material handling
and in reducing labour , maintenance & repairs costs.
The company has another alternative to buy a new machine at a cost of ` 3,50,000 with an economic life
of 5 years and salvage value of ` 60,000. The new machine is expected to be more efficient in reducing
costs of material handling, labour, maintenance & repairs, etc.
The annual cost are as follows:
Existing Equipment(`) Modernization(`) New Machine(`)
Wages & Salaries 45,000 35,500 15,000
Supervision 20,000 10,000 7,000
Maintenance 25,000 5,000 2,500
Power 30,000 20,000 15,000
1,20,000 70,500 39,500
Assuming tax rate of 50% and required rate of return of 10%, should the company modernize the
equipment or buy a new machine?
PV factor at 10% are as follows:
Year 1 2 3 4 5
PV factor 0.909 0.826 0.751 0.683 0.621

Ans. Workings:
Calculation of Depreciation:

` 1,40,000 - ` 30,000
On Modernized Equipment ` 22, 000 p a =
5 years

-202- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

` 3,50, 000 - ` 60,000

On New machine ` 58, 000 p a = =
5 years
(i) Calculation of Incremental annual cash inflows/ savings:
Particulars Existing Modernization New Machine
Equipment(`) Amount(`) Savings(`) Amount(`) Savings(`)
(1) (2) (3)=(1)-(2) (4) (5)=(1)-(4)
Wages & Salaries 45,000 35,500 9,500 15,000 30,000
Superv ision 20,000 10,000 10,000 7,000 13,000
Maintenance 25,000 5,000 20,000 2,500 22,500
Power 30,000 20,000 10,000 15,000 15,000
Total 1,20,000 70,500 49,500 39,500 80,500
Less: Depreciation
(Refer Workings) 22,000 58,000
Total Savings 27,500 22,500
Less: Tax @ 50% 13,750 11,250
After Tax Savings 13,750 11,250
Add: Depreciation 22,000 58,000
Incremental Annual
Cash Inflows 35,750 69,250
(ii) Calculation of Net Present Value (NPV)
Particulars Year Modernization(`) New Machine(`)
Initial Cash outflow (A) 0 1,40,000.00 3,50,000.00
Incremental Cash Inflows 1-5 1,35,492.50 2,62,457.50
(` 35,750 x 3.790) (` 69,250 x 3.790)
Salvage value 5 18,630.00 37,260.00
(` 30,000 x 0.621) (` 60,000 x 0.621)
PV of Cash inflows (B) 1,54,122.50 2,99,717.50
Net Present Value (B - A) 14,122.50 (50,282.50)
Advise: The company should modernize its existing equipment and not buy a new machine because
NPV is positive in modernization of equipment.
Q-28 K.P. Ltd. is investing `50 lakhs in a project. The life of the project is 4 years. Risk free rate of return is 6%
and risk premium is 6%, other information is as under:
Sales of 1st year ` 50 lakhs
Sales of 2nd year ` 60 lakhs
Sales of 3rd year ` 70 lakhs
Sales of 4th year ` 80 lakhs
P/V Ratio (same in all the years) 50%
Fixed Cost (Excluding Depreciation) of 1st year ` 10 lakhs
Fixed Cost (Excluding Depreciation) of 2nd year ` 12 lakhs
Fixed Cost (Excluding Depreciation) of 3rd year ` 14 lakhs
Fixed Cost (Excluding Depreciation) of 4th year ` 16 lakhs
Ignoring interest and taxes,
You are required to calculate NPV of given project on the basis of Risk Adjusted Discount Rate.
Discount factor @ 6% and 12% are as under:
Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -203-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Year 1 2 3 4
Discount Factor @ 6% 0.943 0.890 0.840 0.792
Discount Factor@ 12% 0.893 0.797 0.712 0.636
Ans. Calculation of Cash Flow
Year Sales (` in Lakhs) P/V Contribution Fixed Cost Cash Flows
(A) ratio (B) (` in Lakhs) (` in Lakhs) (` in lakhs)
(C) = (A x B) (D) (E) = (C – D)
1 50 50% 25 10 15
2 60 50% 30 12 18
3 70 50% 35 14 21
4 80 50% 40 16 24
When risk-free rate is 6% and the risk premium expected is 6%, then risk adjusted discount rate would
be 6% + 6% =12%.
Calculation of NPV using Risk Adjusted Discount Rate (@ 12%)
Year Cash flows (` in Lakhs) Discounting Factor Present Value of Cash Flows
@ 12% (` in lakhs)
1 15 0.893 13.395
2 18 0.797 14.346
3 21 0.712 14.952
4 24 0.636 15.264
Total of present value of Cash flow 57.957
Less: Initial Investment 50.000
Net Present value (NPV) 7.957
Q-29 An existing company has a machine which has been in operation for two years, its estimated remaining
useful life is 4 years with no residual value in the end. Its current market value is ` 3 lakhs. The
management is considering a proposal to purchase an improved model of a machine gives increase
output. The details are as under:
Particulars Existing Machine New Machine
Purchase Price ` 6,00,000 ` 10,00,000
Estimated Life 6 years 4 years
Residual Value 0 0
Annual Operating days 300 300
Operating hours per day 6 6
Selling price per unit ` 10 ` 10
Material cost per unit `2 `2
Output per hour in units 20 40
Labour cost per hour ` 20 ` 30
Fixed overhead per annum excluding depreciation ` 1,00,000 ` 60,000
Working Capital ` 1,00,000 ` 2,00,000
Income-tax rate 30% 30%

-204- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Assuming that - cost of capital is 10% and the company uses written down value of depreciation @ 20%
and it has several machines in 20% block.
Advice the management on the Replacement of Machine as per the NPV method.
The discounting factors table given below:
Discounting Factors Year 1 Year 2 Year 3 Year 4
10% 0.909 0.826 0.751 0.683
Ans. (i) Calculation of Net Initial Cash Outflows:
Particulars `
Purchase Price of new machine 10,00,000
Add: Net Working Capital 1,00,000
Less: Sale proceeds of existing machine 3,00,000
Net initial cash outflows 8,00,000
(ii) Calculation of annual Profit Before Tax and depreciation
Particulars Existing machine New Machine Differential
(1) (2) (3) (4) = (3) – (2)
Annual output 36,000 units 72,000 units 36,000 units
` ` `
(A) Sales revenue @ ` 10 per unit 3,60,000 7,20,000 3,60,000
(B) Cost of Operation
Material @ ` 2 per unit 72,000 1,44,000 72,000
Labour
Old = 1,800 „e ` 20 36,000
New = 1,800 „e ` 30 54,000 18,000
Fixed overhead excluding depreciation 1,00,000 60,000 (40,000)
Total Cost (B) 2,08,000 2,58,000 50,000
Profit Before Tax and depreciation (PBTD) (A – B) 1,52,000 4,62,000 3,10,000
(iii) Calculation of Net Present value on replacement of machine
Year PBTD Depreciation PBT Tax @ 30% PAT Net cash PVF @ PV
@ 20% WDV flow 10%
(1) (2) (3) (4 = 2-3) (5) (6 = 4-5) (7 = 6 + 3) (8) (9 = 7 x 8)
1 3,10,000 1,40,000 1,70,000 51,000 1,19,000 2,59,000 0.909 2,35,431.000
2 3,10,000 1,12,000 1,98,000 59,400 1,38,600 2,50,600 0.826 2,06,995.600
3 3,10,000 89,600 2,20,400 66,120 1,54,280 2,43,880 0.751 1,83,153.880
4 3,10,000 71,680 2,38,320 71,496 1,66,824 2,38,504 0.683 1,62,898.232
7,88,478.712
Add: Release of net working capital at year end 4 (1,00,000 x 0.683) 68,300.000
Less: Initial Cash Outflow 8,00,000.000
NPV 56,778.712
Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -205-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Advice: Since the incremental NPV is positive, existing machine should be replaced.
Working Notes:
1. Calculation of Annual Output
Annual output = (Annual operating days x Operating hours per day) x output per hour
Existing machine = (300 x 6) x 20 = 1,800 x 20 = 36,000 units
New machine = (300 x 6) x 40 = 1,800 x 40 = 72,000 units
2. Base for incremental depreciation
Particulars `
WDV of Existing Machine
Purchase price of existing machine 6,00,000
Less: Depreciation for year 1 1,20,000
Depreciation for Year 2 96,000 2,16,000
WDV of Existing Machine (i) 3,84,000
Depreciation base of New Machine
Purchase price of new machine 10,00,000
Add: WDV of existing machine 3,84,000
Less: Sales value of existing machine 3,00,000
Depreciation base of New Machine (ii) 10,84,000
Base for incremental depreciation [(ii) – (i)] 7,00,000
(Note: The above solution have been done based on incremental approach)
Alternatively, solution can be done based on Total Approach as below:
(i) Calculation of depreciation:
Existing Machine
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Opening balance 6,00,000 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608.00
Less: Depreciation @ 20% 1,20,000 96,000 76,800 61,440 49,152 39,321.60
WDV 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608 1,57,286.40
New Machine
Year 1 Year 2 Year 3 Year 4
Opening balance 10,84,000* 8,67,200 6,93,760 5,55,008.00
Less: Depreciation @ 20% 2,16,800 1,73,440 1,38,752 1,11,001.60
WDV 8,67,200 6,93,760 5,55,008 4,44,006.40
* As the company has several machines in 20% block, the value of Existing Machine from the block
calculated as below shall be added to the new machine of ` 10,00,000:
WDV of existing machine at the beginning of the year ` 3,84,000
Less: Sale Value of Machine ` 3,00,000
WDV of existing machine in the block ` 84,000
Therefore, opening balance for depreciation of block = ` 10,00,000 + ` 84,000 = ` 10,84,000
-206- Chapter-7 : Investment Decisions
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(ii) Calculation of annual cash inflows from operation:
Particulars EXISTING MACHINE
Year 3 Year 4 Year 5 Year 6
Annual output (300 operating
days x 6 operating hours x 20 output
per hour) 36,000 36,000 36,000 36,000
units units units
` ` ` `
(A) Sales revenue @ ` 10 per unit 3,60,000.00 3,60,000.00 3,60,000.00 3,60,000.00
(B) Less: Cost of Operation
Material @ ` 2 per unit 72,000.00 72,000.00 72,000.00 72,000.00
Labour @ ` 20 per hour for (300 x 6) hours 36,000.00 36,000.00 36,000.00 36,000.00
Fixed overhead 1,00,000.00 1,00,000.00 1,00,000.00 1,00,000.00
Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Total Cost (B) 2,84,800.00 2,69,440.00 2,57,152.00 2,47,321.60
Profit Before Tax (A – B) 75,200.00 90,560.00 1,02,848.00 1,12,678.40
Less: Tax @ 30% 22,560.00 27,168.00 30,854.40 33,803.52
Profit After Tax 52,640.00 63,392.00 71,993.60 78,874.88
Add: Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Add: Release of Working Capital 1,00,000.00
Annual Cash Inflows 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48
Particulars NEW MACHINE
Year 1 Year 2 Year 3 Year 4
Annual output (300 operating
days x 6 operating hours x 40
output per hour) 72,000 units 72,000 units 72,000 units 72,000 units
` ` ` `
(A) Sales revenue @ ` 10 per unit 7,20,000.00 7,20,000.00 7,20,000.00 7,20,000.00
(B) Less: Cost of Operation
Material @ ` 2 per unit 1,44,000.00 1,44,000.00 1,44,000.00 1,44,000.00
Labour @ ` 30 per hour for
(300 x 6) hours 54,000.00 54,000.00 54,000.00 54,000.00
Fixed overhead 60,000.00 60,000.00 60,000.00 60,000.00
Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60
Total Cost (B) 4,74,800.00 4,31,440.00 3,96,752.00 3,69,001.60
Profit Before Tax (A – B) 2,45,200.00 2,88,560.00 3,23,248.00 3,50,998.40
Less: Tax @ 30% 73,560.00 86,568.00 96,974.40 1,05,299.52
Profit After Tax 1,71,640.00 2,01,992.00 2,26,273.60 2,45,698.88
Add: Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60
Add: Release of Working Capital 2,00,000.00
Annual Cash Inflows 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48
Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -207-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(iii) Calculation of Incremental Annual Cash Flow:
Particulars Year 1 (`) Year 2 (`) Year 3 (`) Year 4 (`)
Existing Machine (A) 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48
New Machine (B) 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48
Incremental Annual
Cash Flow (B – A) 2,59,000.00 2,50,600.00 2,43,880.00 3,38,504.00
(iv) Calculation of Net Present Value on replacement of machine:
Year Incremental Annual Discounting factor Present Value of Incremental
Cash Flow (`) (A) @ 10% (B) Annual Cash Flow (`) (A x B)
1 2,59,000.00 0.909 2,35,431.000
2 2,50,600.00 0.826 2,06,995.600
3 2,43,880.00 0.751 1,83,153.880
4 3,38,504.00 0.683 2,31,198.232
Total Incremental Inflows 8,56,778.712
Less: Net Initial Cash Outflows (Working note) 8,00,000.000
Incremental NPV 56,778.712
Advice: Since the incremental NPV is positive, existing machine should be replaced.
Working Note:
Calculation of Net Initial Cash Outflows:
Particulars `
Cost of new machine 10,00,000
Less: Sale proceeds of existing machine 3,00,000
Add: incremental working capital required (` 2,00,000 – ` 1,00,000) 1,00,000
Net initial cash outflows 8,00,000
Q-30 Explain the limitations of Average Rate of Return.
Ans. Limitations of Average Rate of Return
• The accounting rate of return technique, like the payback period technique, ignores the time
value of money and considers the value of all cash flows to be equal.
• The technique uses accounting numbers that are dependent on the organization’s choice of
accounting procedures, and different accounting procedures, e.g., depreciation methods, can
lead to substantially different amounts for an investment’s net income and book values.
• The method uses net income rather than cash flows; while net income is a useful measure of
profitability, the net cash flow is a better measure of an investment’s performance.
• Furthermore, inclusion of only the book value of the invested asset ignores the fact that a project
can require commitments of working capital and other outlays that are not included in the book
value of the project.

-208- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Q-31 Define Internal Rate of Return (IRR)
Ans. Internal rate of return: Internal rate of return for an investment proposal is the discount ratethat
equates the present value of the expected cash inflows with the initial cash outflow.
Q-32 CK Ltd. is planning to buy a new machine. Details of which are as follows:
Cost of the Machine at the commencement ` 2,50,000
Economic Life of the Machine 8 year
Residual Value Nil
Annual Production Capacity of the Machine 1,00,000 units
Estimated Selling Price per unit `6
Estimated Variable Cost per unit `3
Estimated Annual Fixed Cost ` 1,00,000
(Excluding depreciation)
Advertisement Expenses in 1st year in addition of
annual fixed cost ` 20,000
Maintenance Expenses in 5th year in addition of
annual fixed cost ` 30,000
Cost of Capital 12%
Ignore Tax.
Analyse the above mentioned proposal using the Net Present Value Method and advice.
P.V. factor @ 12% are as under:
Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404
Ans. Calculation of Net Cash flows
Contribution = (` 6 – ` 3) „e 1,00,000 units = ` 3,00,000
Fixed costs (excluding depreciation) = ` 1,00,000
Year Capital Contribution Fixed costs Advertisement/ Net cash
(` ) (` ) (` ) Maintenance flow (`)
expenses (`)

0 (2,50,000) (2,50,000)
1 3,00,000 (1,00,000) (20,000) 1,80,000
2 3,00,000 (1,00,000) 2,00,000
3 3,00,000 (1,00,000) 2,00,000
4 3,00,000 (1,00,000) 2,00,000
5 3,00,000 (1,00,000) (30,000) 1,70,000
6 3,00,000 (1,00,000) 2,00,000
7 3,00,000 (1,00,000) 2,00,000
8 3,00,000 (1,00,000) 2,00,000
Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -209-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Calculation of Net Present Value
Year Net cash flow (`) 12% discount factor Present value (`)
0 (2,50,000) 1.000 (2,50,000)
1 1,80,000 0.893 1,60,740
2 2,00,000 0.797 1,59,400
3 2,00,000 0.712 1,42,400
4 2,00,000 0.636 1,27,200
5 1,70,000 0.567 96,390
6 2,00,000 0.507 1,01,400
7 2,00,000 0.452 90,400
8 2,00,000 0.404 80,800
7,08,730
Advise: CK Ltd. should buy the new machine, as the net present value of the proposal is positive i.e `
7,08,730.
Q-33 Superb Ltd. constructs customized parts for satellites to be launched by USA and Canada. The parts are
constructed in eight locations (including the central headquarter) around the world. The Finance Director,
Ms. Kuthrapali, chooses to implement video conferencing to speed up the budget process and save
travel costs. She finds that, in earlier years, the company sent two officers from each location to the
central headquarter to discuss the budget twice a year. The average travel cost per
person, including air fare, hotels and meals, is ` 27,000 per trip. The cost of using video conferencing is
` 8,25,000 to set up a system at each location plus ` 300 per hour average cost of telephone time to
transmit signals. A total 48 hours of transmission time will be needed to complete the budget each
year. The company depreciates this type of equipment over five years by using straight line method.
An alternative approach is to travel to local rented video conferencing facilities, which can be rented
for ` 1,500 per hour plus ` 400 per hour averge cost for telephone charges. You are Senior Officer of
Finance Department. You have been asked by Ms. Kuthrapali to EVALUATE the proposal and SUGGEST if
it would be worthwhile for the company to implement video conferencing. [MTP-Nov’21][10 Marks]
Ans. Option I : Cost of travel, in case Video Conferencing facility is not provided
Total Trip = No. of Locations × No. of Persons × No. of Trips per Person = 7×2×2 = 28 Trips
Total Travel Cost (including air fare, hotel accommodation and meals) (28 trips × ` 27,000 per trip)
= ` 7,56,000
Option II : Video Conferencing Facility is provided by Installation of Own Equipment at Different
Locations
Cost of Equipment at each location (` 8,25,000 × 8 locations) = ` 66,00,000
Economic life of Machines (5 years). Annual depreciation (66,00,000/5) = ` 13,20,000
Annual transmission cost (48 hrs. transmission × 8 locations × ` 300 per hour) = ` 1,15,200
Annual cost of operation (13,20,000 + 1,15,200) = ` 14,35,200
Option III : Engaging Video Conferencing Facility on Rental Basis
Rental cost (48 hrs. × 8 location × ` 1,500 per hr) = ` 5,76,000
Telephone cost (48 hrs.× 8 locations × ` 400 per hr.) = ` 1,53,600
Total rental cost of equipment (5,76,000 + 1,53,600) = ` 7,29,600
Analysis: The annual cash outflow is minimum, if video conferencing facility is engaged on rental basis.
Therefore, Option III is suggested.

-210- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Q-34 A company wants to buy a machine, and two different models namely A and B are available.
Following further particulars are available:
Particulars Machine-A Machine-B
Original Cost (`) 8,00,000 6,00,000
Estimated Life in years 4 4
Salvage Value (`) 0 0
The company provides depreciation under Straight Line Method. Income tax rate applicable is 30%.
The present value of ` 1 at 12% discounting factor and net profit before depreciation and tax are as
under:
Year Net Profit Before Depreciation and tax PV Factor
Machine-A ` Machine-B `
1. 2,30,000 1,75,000 0.893
2. 2,40,000 2,60,000 0.797
3. 2,20,000 3,20,000 0.712
4. 5,60,000 1,50,000 0.636
Calculate:
1. NPV (Net Present Value)
2. Discounted pay-back period
3. PI (Profitability Index)
Suggest: Purchase of which machine is more beneficial under Discounted pay-back period method,
NPV method nd PI method.
Ans. Workings:
(i) Calculation of Annual Depreciation

` 8, 00, 000
Depreciation on Machine – A = = ` 2, 00, 000
4

` 6, 00, 000
Depreciation on Machine – B = = ` 1, 50, 000
4
(ii) Calculation of Annual Cash Inflows
Particulars Machine-A (`)
1 2 3 4
Net Profit before Depreciation and Tax 2,30,000 2,40,000 2,20,000 5,60,000
Less: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Profit before Tax 30,000 40,000 20,000 3,60,000
Less: Tax @ 30% 9,000 12,000 6,000 1,08,000
Profit after Tax 21,000 28,000 14,000 2,52,000
Add: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Annual Cash Inflows 2,21,000 2,28,000 2,14,000 4,52,000

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -211-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Particulars Machine-B (`)
1 2 3 4
Net Profit before Depreciation and Tax 1,75,000 2,60,000 3,20,000 1,50,000
Less: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
Profit before Tax 25,000 1,10,000 1,70,000 0
Less: Tax @ 30% 7,500 33,000 51,000 0
Profit after Tax 17,500 77,000 1,19,000 0
Add: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
Annual Cash Inflows 1,67,500 2,27,000 2,69,000 1,50,000
(iii) Calculation of PV of Cash Flows
Machine – A Machine - B
Year PV of Re Cashflow PV Cumulative Cash flow PV Cumulative
1@ 12% (`) (`) PV (`) (`) (`) PV (`)
1 0.893 2,21,000 1,97,353 1,97,353 1,67,500 1,49,578 1,49,578
2 0.797 2,28,000 1,81,716 3,79,069 2,27,000 1,80,919 3,30,497
3 0.712 2,14,000 1,52,368 5,31,437 2,69,000 1,91,528 5,22,025
4 0.636 4,52,000 2,87,472 8,18,909 1,50,000 95,400 6,17,425
1. NPV (Net Present Value)
Machine – A
NPV = ` 8,18,909 - ` 8,00,000 = ` 18,909
Machine – B
NPV = ` 6,17,425 – ` 6,00,000 = ` 17,425
2. Discounted Payback Period
Machine – A ` 8, 00, 000 -` 5, 31, 437
Discounted Payback Period = 3 +
` 2, 87, 472
= 3 + 0.934
= 3.934 years or 3 years 11.21 months
Machine – B ` 6, 00, 000 -` 5,22, 025
Discounted Payback Period = 3 +
` 95, 400
= 3 + 0.817
= 3.817 years or 3 years 9.80 months
3. PI (Profitability Index)
Machine – A ` 8,18, 909
Profitability Index = = 1.024
` 8, 00, 000
Machine – B ` 6,17, 425
Profitability Index = = 1.029
` 6, 00, 000
Suggestion:
Method Machine - A Machine - B Suggested Machine
Net Present Value ` 18,909 ` 17,425 Machine A
Discounted Payback Period 3.934 years 3.817 years Machine B
Profitability Index 1.024 1.029 Machine B

-212- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Q-35 ABC & Co. is considering whether to replace an existing machine or to spend money on revamping it.
ABC & Co. currently pays no taxes. The replacement machine costs `18,00,000 now and requires
maintenance of ` 2,00,000 at the end of every year for eight years. At the end of eight years, it would
have a salvage value of ` 4,00,000 and would be sold. The existing machine requires increasing amounts
of maintenance each year and its salvage value fall each year as follows:
Year Maintenance (`) Salvage (`)
Present 0 8,00,000
1 2,00,000 5,00,000
2 4,00,000 3,00,000
3 6,00,000 2,00,000
4 8,00,000 0
The opportunity cost of capital for ABC & Co. is 15%.
REQUIRED:
When should the company replace the machine?
The following present value table is given for you:
Year Present value of `1 at
15% discount rate
1 0.8696
2 0.7561
3 0.6575
4 0.5718
5 0.4972
6 0.4323
7 0.3759
8 0.3269
Ans. ABC & Co.
Equivalent Annual Cost (EAC) of new machine
(` )
(i) Cost of new machine now 18,00,000
Add: PV of annual repairs @ ` 2,00,000 per annum for 8 years
(` 2,00,000 ? 4.4873) 8,97,460
26,97,460
Less: PV of salvage value at the end of 8 years
(` 4,00,000?0.3269) 1,30,760
25,66,700
Equivalent annual cost (EAC) (` 25,66,700/4.4873) 5,71,992
PV of cost of replacing the old machine in each of 4 years
with new machine

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -213-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Scenario Year Cash Flow PV @ 15% PV
(` ) (` )
Replace Immediately 0 (5,71,992) 1.00 (5,71,992)
0 8,00,000 1.00 8,00,000
2,28,008
Replace in one year 1 (5,71,992) 0.8696 (4,97,404)
1 (2,00,000) 0.8696 (1,73,920)
1 5,00,000 0.8696 4,34,800
(2,36,524)
Replace in two years 1 (2,00,000) 0.8696 (1,73,920)
2 (5,71,992) 0.7561 (4,32,483)
2 (4,00,000) 0.7561 (3,02,440)
2 3,00,000 0.7561 2,26,830
(6,82,013)
Replace in three years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (5,71,992) 0.6575 (3,76,085)
3 (6,00,000) 0.6575 (3,94,500)
3 2,00,000 0.6575 1,31,500
(11,15,445)
Replace in four years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (6,00,000) 0.6575 (3,94,500)
4 (5,71,992) 0.5718 (3,27,065)
4 (8,00,000) 0.5718 (4,57,440)
(16,55,365)
Advice: The company should replace the old machine immediately because the PV of cost of replacing
the old machine with new machine is least.
Q-36 An enterprise is investing ` 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium
expected by the Management is 7%. The life of the project is 5 years. Following are the cash flows that
are estimated over the life of the project.
Year Cash flows (` in lakhs)
1 25
2 60
3 75
4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks
adjusted discount rate.

-214- Chapter-7 : Investment Decisions

 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Ans. The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is calculated as
below:
Year Cash flows Discounting Factor Present value of Cash
(` in lakhs) @7% Flows (` in Lakhs)
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment 100
Net Present Value (NPV) 144.34
Now, when the risk-free rate is 7 % and the risk premium expected by the Management is 7 %. So, the
risk adjusted discount rate is 7 % + 7 % =14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:
Year Cash flows Discounting Factor Present value of Cash
(` in lakhs) @14% Flows (` in Lakhs)
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flow 199.80
Initial investment 100
Net present value (NPV) 99.80
Q-37 Manoranjan Ltd is a News broadcasting channel having its broadcasting Centre in Mumbai. There are
total 200 employees in the organisation including top management. As a part of employee benefit
expenses, the company serves tea or coffee to its employees, which is outsourced from a third -party.
The company offers tea or coffee three times a day to each of its employees. 120 employees prefer tea
all three times, 40 employees prefer coffee all three times and remaining prefer tea only once in a day.
The third-party charges ` 10 for each cup of tea and `15 for each cup of coffee. The company works for
200 days in a year.
Looking at the substantial amount of expenditure on tea and coffee, the finance department has
proposed to the management an installation of a master tea and coffee vending machine which will
cost ` 10,00,000 with a useful life of five years. Upon purchasing the machine, the company will have to
enter into an annual maintenance contract with the vendor, which will require a payment of ` 75,000
every year. The machine would require electricity consumption of 500 units p.m. and current incremental
cost of electricity for the company is ` 12 per unit. Apart from these running costs, the company will
have to incur the following consumables expenditure also:
(1) Packets of Coffee beans at a cost of ` 90 per packet.

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -215-
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

(2) Packet of tea powder at a cost of ` 70 per packet.
(3) Sugar at a cost of ` 50 per Kg.
(4) Milk at a cost of ` 50 per litre.
(5) Paper cup at a cost of 20 paise per cup.
Each packet of coffee beans would produce 200 cups of coffee and same goes for tea powder packet.
Each cup of tea or coffee would consist of 10g of sugar on an average and 100 ml of milk.
The company anticipate that due to ready availability of tea and coffee through vending machines its
employees would end up consuming more tea and coffee. It estimates that the consumption will
increase by on an average 20% for all class of employees. Also, the paper cups consumption will be 10%
more than the actual cups served due to leakages in them.
The company is in the 25% tax bracket and has a current cost of capital at 12% per annum. Straight line
method of depreciation is allowed for the purpose of taxation. You as a financial consultant is required
to ADVISE on the feasibility of acquiring the vending machine.
PV factors @ 12%:
Year 1 2 3 4 5
PVF 0.8929 0.7972 0.7118 0.6355 0.5674
Ans.A. Computation of CFAT (Year 1 to 5)
Particulars Amount (`)
(a) Savings in existing (120 × 10 ×3) + (40 ×15 × 3) + (40 ×10 × 1) 11,60,000
Tea & Coffee charges x 200 days
(b) AMC of machine (75,000)
(c) Electricity charges 500 ×12 ×12 (72,000)
(d) Coffee Beans (W.N.) 144 × 90 (12,960)
(e) Tea Powder (W.N.) 480 × 70 (33,600)
(f) Sugar (W.N.) 1248 × 50 (62,400)
(g) Milk (W.N.) 12480 × 50 (6,24,000)
(h) Paper Cup (W.N.) 1,37,280 × 0.2 (27,456)
(i) Depreciation 10,00,000/5 (2,00,000)
Profit before Tax 52,584
(-) Tax @ 25% (13,146)
Profit after Tax 39,438
Depreciation 2,00,000
CFAT 2,39,438
B. Computation of NPV
Year Particulars CF PVF @ 12% PV
0 Cost of machine (10,00,00) 1 (10,00,000)
1-5 CFAT 2,39,438 3.6048 8,63,126
Net Present Value (1,36,874)
Since NPV of the machine is negative, it should not be purchased.
-216- Chapter-7 : Investment Decisions
 Join Us on Telegram http://t.me/canotes_ipc

Downloaded From www.castudynotes.com

Working Note:
Computation of Qty of consumable
No. of Tea Cups = [(120 × 3 × 200 days) + (40 × 1 × 200 days) × 1.2 = 96,000
No. of Coffee cups = 40 × 3 × 200 days × 1.2 = 28,800

28, 800
No. of coffee beans packet = = 144
200

96, 000
No. of Tea Powder Packets = = 480
200

(96,000 + 28,800) × 10 g
Qty of Sugar = = 1248 kgs
1, 000 g

(96,000 + 28,800) × 100 g

Qty of Milk = = 12,480 litres
1,000 ml
No. of paper cups = (96,000 + 28,800) × 1.1 = 1,37,280

Q-38 A manufacturing company is presently paying a garbage disposer company ` 0.50 per kilogram to
dispose-off the waste resulting from its manufacturing operations. At normal operating capacity, the
waste is about 2,00,000 kilograms per year.
After spending ` 1,20,000 on research, the company discovered that the waste could be sold for ` 5 per
kilogram if it was processed further. Additional processing would, however, require an investment of
` 12,00,000 in new equipment, which would have an estimated life of 10 years with no salvage value.
Depreciation would be calculated by straight line method.
No change in the present selling and administrative expenses is expected except for the costs incurred
in advertising ` 40,000 per year, if the new product is sold. Additional processing costs would include
variable cost of ` 2.50 per kilogram of waste put into process along with fixed cost of ` 60,000 per year
(excluding Depreciation).
There will be no losses in processing, and it is assumed that the total waste processed in a given year
will be sold in the same year. Estimates indicate that 2,00,000 kilograms of the product could be sold
each year.
The management when confronted with the choice of disposing off the waste or processing it further
and selling it, seeks your ADVICE. Which alternative would you RECOMMEND? Assume that the firm’s
cost of capital is 15% and it pays on an average 50% Tax on its income.
Consider Present value of Annuity of ` 1 per year @ 15% p.a. for 10 years as 5.019.
Ans. Evaluation of Alternatives:
Savings in disposing off the waste
Particulars (` )
Outflow (2,00,000 × ` 0.50) 1,00,000
Less: tax savings @ 50% 50,000
Net Outflow per year 50,000

Navkar Digital Institute | Paper 8A : Compiler | Most Imp collection of Chapterwise Que. & Ans. -217-