Page 148 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

The cost of capital is considered as consisting of different sources of funds. The cost of each Notes
source is called as specific cost of capital and these specific costs when combined refer to overall
cost of capital or weighted cost of capital.

Assumptions – Cost of Capital

1. That the firm's business and financial risk are unaffected by the acceptance and financing
of projects.
2. The firm's financial structure is assumed to remain fixed. It implies that the additional
funds required to finance the new project are to be raised in the same proportion as the
firm's existing financing.

Practice Problems

Problem 1: A project costing 5,60,000 is expected to produce annual net cash benefits of 80,000
over a period of 15 years. Estimate the IRR. Also, find the payback period and obtain the IRR
from it. How do you compare this IRR with the one directly estimated?

Solution:

Payback period = = 7

Hence from the present value of annuity 1 – 15 years closest factors to 7 are 7.191, (at 11% rate of
discount) and 6.811 (at 12% rate of discount). Hence IRR would be somewhere between 11% and
12%.

Using interpolation IRR would be:

11% + = 11% + = 11.5%

We know that reciprocal of payback period is a good approximation of the IRR provided the life
of the project is large or at least twice the payback period and the project generates equal annual
cash inflows. Since both the conditions are satisfied. IRR would be reciprocal of the payback
period i.e., 1/7 = 14.28%.

The two IRR's are different. The second method is an approximation present value whereas the
first gives the correct IRR, since at that discount rate cash inflows equals the cost of the project or
the net present value is zero.
Problem 2: Valuable Products are considering purchase of a machine for its production line. Two
types of options are available deluxe model with 30,000 initial cost and economy model with
20,000 initial cost. Each model has 5 years life and no salvage value. The net cash flows after
taxes associated with each investment proposal are:

Deluxe Model Economy Model
Net cash flows after taxes 1-5 years 9,000 6,000

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