Page 174 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes
10
Net.
40 40 40 – 15 years
At IRR – Cost of the project equal to discounted cash inflows of 40 crores for total project life
i.e., 15 years.
Now, cost of the project = 200 crores.
Hence, 200 crores = cum discount factor 1 – 15 years × 40 crores or cum discount factor 1-15
200
years = = from the rate of present value of annuity, it will be observed that at 20% cum
40
present value 1-15 years 5.09158 at 19% cum present value 1-15 years 4.87586. Hence Project IRR
5 – 4.87586 0.12414
will be between 19% and 20%, it will be approximately 19% + i.e. =
5.09158 – 4.87568 0.21572
19 + 0.58%
Since, there is no corporate taxation, depreciation will not affect cash flow, hence depreciation;
has not been considered. Now the project is financed by 50 crores debt @ 15% p.a. i.e., yearly
interest of 7.50 crore and equity capital 150 crores. Hence profit available to equity shareholders
each year
= Net cash inflow – Interest outflow

= 40 – 7.5 = 32.5 crores.
Hence, cum discount factor for equity shares

150
= = 4.61538
325
If we see the present value of annuity table 1-15 years cumulative, we find
20% = 4.67547)
21% = 4.48901) Hence it will be between 20 & 21%
It will be

4.61538 – 4.48901 0.12607
20% + i.e. = 20.68%
4.67547 – 4.48901 0.18646
Equity IRR is more than project IRR, since the project is earning 19.58% on discounted basis,
interest is being paid @ 15% so capital is contributed by debt is interest paid is less than the
interest earned, the balance goes to equity share holders to increase their return.

9.4.4 Capital Rationing
The process of selecting the more desirable projects among many profitable investments is
called capital rationing. Like any rationing it is designed to maximize the benefit available from
using scarce resources. In this case the scarce resources are funds available for capital investments
and the benefits are returns on the investments. The objective is to select the combination of
projects, which would give maximization of the total NPV. The project selection under capital
rationing involves two stages:
1. The identification of the acceptable projects,
2. To select the combination, of projects. The acceptability of projects can be based either on
profitability/present value index or IRR.

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