Page 176 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Since there is no alternative use of money we should maximize capital spending provided
project is profitable, that is, PI is more than I and NPV is positive. Combination of project 1, 3, 5
gives NPV of 1,76,000 but 1,50,000 remains unspent, whereas combination of 3, 4, 5 gives NPV
of 1,91,000 and every amount is spent. Hence project 3, 4, 5 are to be taken.

9.4.5 Break-Even Time and Capital Budgeting for New Products
Time is being considered as a competitive weapon specifically for firms that bring a new product
to market at a very fast rate in order to gain sizeable shares of total market sales for that product.
Hence, the increased emphasis to the use of break-even time as a capital budgeting method and
as a performance measures.
Break-Even Time (BET) is the time taken from the start of the project (the initial idea date) till the
period the Cumulative Present Value of cash inflows of a project equal to present values of the
total cash outflows. Hence, product proposals with shorter BET’s are preferred to longer BETs if
all other things are equal.
BET also promotes aggressive efforts by personnel on different functional areas such as product
design and manufacturing to speed up the time taken to bring the product to the market and
reap the benefits fast.

Did u know? Hewlett-Packard is a strong advocate of BET.

Example: Two products A and B are being evaluated by a Computer Manufacturing
Company. The estimated cash outflows covering research and development, product design,
manufacturing, marketing, distribution and customer services and cash inflows from sales are
given below:
( lakhs)
Product A Product B
Year Cash Outflows Cash Inflows Cash Outflows Cash Inflows
1 8 0 10 4
2 6 14 7 32
3 22 34 17 26
4 13 37 6 8
5 10 22 0 2

The company uses a 14% required rate of return for discounting cash flows on a before tax basis.
Solution:

For Product A
( lakhs)
Year PV Factor Cash PV of cash Cum PV of Cash PV of cash Cum. PV of
Outflows Outflows Cash Outflows Inflows Inflows cash Inflows.
1 0.877 8 7.016 7.016 0 - 0
2 0.769 6 4.614 11.63 14 10.766 10.766
3 0.675 22 14.85 26.48 34 22.95 33.716
4 0.592 13 7.696 34.176 37 21.904 55.62
5 0.519 10 5.19 39.366 22 11.418 67.038

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