Page 130 - DMGT409Basic Financial Management

Unit 7: Capital Budgeting

2. Calculation of required rate or discounting factor or cost of capital is diffi cult, which Notes
involves a lengthy and time consuming process and presents illustrations. At the same
time calculation cost of capital is based on different methods.
3. In case of projects involving different cash outlays, NPV method may not give dependable
results.
Illustration 7: A choice is to be made between the two competing proposals which require an

equal investment of ` 50000 and are expected to generate net cash flows as under:
Years Project A (`) Project B (`)
1 25000 10000
2 15000 12000
3 10000 18000
4 Nil 25000
5 12000 8000
6 6000 4000
Cost of capital of the company is 10%. The following are the present value factor at 10% p.a.
Year : 1 2 3 4 5 6
P.V. Factor At 10% : 0.909 0.826 0.751 0.683 0.621 0.564
Which proposal should be selected using NPV method? Suggest the best project.

Solution:
Comparative Statement of NPV

Year PV Factor Project A Project B
@10% Cash Inflow Present Value Cash Infl ow Present Value

1 0.909 25000 22725 10000 9090
2 0.826 15000 12390 12000 9912
3 0.751 10000 7510 18000 13518
4 0.683 Nil Nil 25000 17075
5 0.621 12000 7452 8000 4968
6 0.564 6000 3384 4000 2256
Total present Value : 53461 56819
Less : Initial Investment : 50000 5000
NPV : Rs. 3461 Rs. 6819
Since project B has the highest NPV, Project B should be selected.
Illustration 8: The Gama Co., Ltd., is considering the purchase of a new machine. Two alternative
machines (X and Y have been suggested, each having an initial cost of ` 400000 and requiring `
20000 as additional working capital at the end of the 1st year. Earnings after taxation are expected
to be as follows:
Year Cash infl ows
Machine X ` Machine Y `
1 40000 120000
2 120000 160000
3 160000 200000
4 240000 120000
5 160000 80000

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