Ch.

10: Determining Cash Flows for Investment Analysis

CHAPTER 10

DTERMINING CASH FLOWS FOR INVESTMENT ANALYSIS

Problem 1
Assumption: (1) It is assumed that the given annual cash inflows are after-tax. (2) ARR is calculated as average cash
profit divided by original investment. Alternatively, average investment (original investment/2) can be used for
calculation.

Required rate 10%

Tax rate 35%
Projects A B C D E
Outlay -500,000 -120,000 -92,000 -5,750 -40,000
Annual inflows 125,000 12,000 15,000 2,000 6,000
Life 8 15 20 5 10
PVAF @10% 5.3349 7.6061 8.5136 3.7908 6.1446
PV of NCF 666,865.8 91,273.0 127,703.5 7,581.6 36,867.4
NPV 166,865.8 -28,727.0 35,703.5 1,831.6 -3,132.6
IRR 18.6% 5.6% 15.4% 21.8% 8.1%
PB (years) 4.00 10.00 6.13 2.88 6.67
ARR 25.0% 10.0% 16.3% 34.8% 15.0%

Rank
Project NPV IRR PB ARR
A 1 2 2 2
B 5 5 5 5
C 2 3 3 3
D 3 1 1 1
E 4 4 4 4

Problem 2

Cost of capital 10%

Tax rate 43%
Cost of project X 20,000
Life of project X 5
Straight line depreciation 4,000
Cost of project Y 15,000
Life of project Y 5
Straight line depreciation 3,000

PROJECT X
Year 0 1 2 3 4 5
BT cash flows -20,000 4,200 4,800 7,000 8,000 2,000
AT cash flows (T = 2,730 3,120 4,550 5,200 1,300
35%)
Add: DTS (Dep. × T = 1,400 1,400 1,400 1,400 1,400
4,000 × .35 )
NCF -20,000 4,130 4,520 5,950 6,600 2,700
PVF 1.000 0.909 0.826 0.751 0.683 0.621
PV (Rs) -20,000 3,755 3,736 4,470 4,508 1,676
NPV (Rs) -1,855
PI 0.91

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

IRR 6.29%
Accumulated cash -20000 -15870 -11350 -5400 1200 3900
flows
Payback (years) 4

PROJECT Y
Year 0 1 2 3 4 5
BT cash flows -15,000 4,200 4,500 4,000 5,000 1,000
AT cash flows (T =
35%) 2,730 2,925 2,600 3,250 650
Add: DTS (Dep. × T = 1,050 1,050 1,050 1,050 1,050
3,000 × .35 )
NCF -15,000 3,780 3,975 3,650 4,300 1,700
PVF 1.000 0.909 0.826 0.751 0.683 0.621
PV (Rs) -15,000 3,436 3,285 2,742 2,937 1,056
NPV (Rs) -1,544
PI 0.90
IRR 5.59%
Cumulative cash flows -15000 -11220 -7245 -3595 705 2405
Payback (years) 4

Both projects have negative NPV and IRR less than the cost of capital. They should be rejected.

Problem 3

Required rate of return (RRR) 10%

Tax rate 35%
Outlay M: 100,000
Life (years) 5
S L depreciation: 100,000/5 20,000
Salvage value (SV) 0
Outlay N: 140,000
Life (years) 5
SV 20,000
S L depreciation: 140,000/5 28,000

PROJECT M
Year 0 1 2 3 4 5
Book value (BV) 100,000 80,000 60,000 40,000 20,000 0
SL depreciation 20,000 20,000 20,000 20,000 20,000
Earnings before depreciation & tax 25,000 25,000 25,000 25,000 25,000
Less: dep. 20,000 20,000 20,000 20,000 20,000
Earnings before tax 5,000 5,000 5,000 5,000 5,000
Tax at 35% 1750 1750 1750 1750 1750
Earnings after tax (EAT) 3,250 3,250 3,250 3,250 3,250
Plus: dep. 20,000 20,000 20,000 20,000 20,000
Plus: SV 0
NCF -100,000 23,250 23,250 23,250 23,250 23,250
PVF 1.000 0.909 0.826 0.751 0.683 0.621
PV (Rs) -100,000 21,136 19,215 17,468 15,880 14,436
NPV (Rs) -11,864
IRR 5.24%

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Ch. 10: Determining Cash Flows for Investment Analysis

Cumulative NCF -100,000 -76,750 -53,500 -30,250 -7,000 16,250

Payback (years) 4 1/2

Project N
Year 0 1 2 3 4 5
Book value 140,000 112,000 84,000 56,000 28,000 0
S L depreciation 28,000 28,000 28,000 28,000 28,000
Earnings before depreciation & 40,000 40,000 40,000 40,000 40,000
taxes
Less: dep. 28,000 28,000 28,000 28,000 28,000
Earnings before taxes 12,000 12,000 12,000 12,000 12,000
Tax 4,200 4,200 4,200 4,200 4,200
Earnings after tax 7,800 7,800 7,800 7,800 7,800
Plus: dep. 28,000 28,000 28,000 28,000 28,000
After-tax salvage 13,000
NCF -140,000 35,800 35,800 35,800 35,800 48,800
PVF 1.000 0.909 0.826 0.751 0.683 0.621
PV (Rs) -140,000 32,545 29,587 26,897 24,452 30,301
NPV (Rs) 3,782
IRR 11.0%
Cum. NCF -140,000 -104,200 -68,400 -32,600 3,200 52,000
Payback 4

* After-tax salvage: 20,000 - .35(20,000 – 0) = Rs 13,000.

Problem 4

Year 0 1 2 3 IRR NPV, 12%

O -50,000 25,270 25,270 25,270 0.24 10,694.3
P -25,000 5,000 5,000 25,570 0.15 1,650.5
Q -28,000 12,670 12,670 12,670 0.17 2,431.2
(P - Q) 3,000 -7,670 -7,670 12,900 (780.7)
Project O has the highest NPV; hence it should be preferred over other projects. Between projects P and Q, Q is better
with higher NPV. The incremental cash flow analysis also shows that P losses NPV when compared with Q.

Problem 5

Year 0 1 2 3 NPV, 10% IRR

A -6,000 8,000 2,000 2,000 4,428.2 65.6%
B -8,000 12,000 4,000 5,649.9 78.1%
(A - B) -6,000 16,000 -10,000 -2,000 (1,221.6)
Both absolute and incremental analyses reveal that B is a better project than A.

Problem 6
Year 0 1 2 3 4 NPV, 10% IRR
Cash flow 7,000 7,000 7,000 7,000 -25,000 7,332.6 -4.5%

Problem 7
RRR 10%
Tax rate 40%
Purchase price 40,000
Installation 8,000
Total cost 48,000

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Plus: WC 10,000
Less: SV, old 20,000 no tax assumed
Initial outlay 38,000
SV, new (4 yrs) 14,000
SV, old (4 yrs) 4,000
Differential SV after 4 years 10,000 no tax assumed
BV, old 16,000
Life (years), new 4
Life (years), old 4
SL dep., new 12,000
SL dep., old 4,000
Differential dep. 8,000
Diff. DTS (depreciation tax 3,200
shield): 8,000 × 0.40

Year 0 1 2 3 4
Initial outlay -38,000
BT cash flows 16,000 16,000 16,000 16,000
AT cash flows: 16,000 × (1-.4) 9,600 9,600 9,600 9,600
DTS 3,200 3,200 3,200 3,200
Differential SV 10,000
NCF -38,000 12,800 12,800 12,800 22,800
NPV 9,404.4
IRR 20%

Problem 8

Investment 300,000
Required rate 15%
Tax rate 30%
Investment period 13
Building 140,000
Merchandise 100,000
Working capital 60,000
Total investment 300,000

Annual receipts 390,000

Less: Costs 300,000
Less: SL dep. on build. 10,769
(140,000/13)
Pre-tax savings 79,231
Tax @ 30% 23,769
Post-tax savings 55,462
Add: Dep. 10,769
Less: Loss of salary 36,000
(no tax on salary
assumed)
NCF (annuity) 30,231
Post-tax SV: 50,000 × 35,000
(1 – 0.3)
Release of WC and 160,000
merchandise

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Ch. 10: Determining Cash Flows for Investment Analysis

Year-end CF 195,000
PVAF, 15%, 13 5.5831
PVF, 15%, 13 0.1625
PV of annuity 168,781
PV of year-end CF 31,688
NPV -99,531

Problem 9

BV, old 64,000

Life, old (years) 6
Cost, new 80,000
Life, new (years) 6
SV, new 0
Savings, new 16,000
WDV dep. rate 25%
Tax rate 35%
Required rate 10%

Situation I
SV, old (now) 0
SV, (after 6 years) 0
BV, old 64,000
Dep. base, new 80,000
Diff. dep. base (80,000-64,000) 16,000

Year 0 1 2 3 4 5 6
Depreciated value 16,000 12,000 9,000 6,750 5,063 3,797 2,848
WDV dep. 4,000 3,000 2,250 1,688 1,266 949
Investment -80,000
Savings 16,000 16,000 16,000 16,000 16,000 16,000
Less: depreciation* 4,000 3,000 2,250 1,688 1,266 3,797
Taxable savings 12,000 13,000 13,750 14,313 14,734 12,203
Less: Tax @ 35% 4,200 4,550 4,813 5,009 5,157 4,271
Post-tax savings 7,800 8,450 8,938 9,303 9,577 7,932
Add: depreciation* 4,000 3,000 2,250 1,688 1,266 3,797
After-tax SV (old) lost 0
NCF -80,000 11,800 11,450 11,188 10,991 10,843 11,729
PVF 1.000 0.909 0.826 0.751 0.683 0.621 0.564
PV -80,000 10,727 9,463 8,405 7,507 6,733 6,621
NPV -30,545
* New machine has zero salvage value. Its book value of Rs 2,848 at the end of 6th year will be treated as loss and will save taxes. This
amount has been added to the sixth year's depreciation.

Situation II
SV, old (now) 16000
BV, old 64,000
After-tax SV, old: 16,000 - .35(16,000-64,000) 32,800 Assumption given in the problem
SV, old (after 6 years) 0
Cost of new 80,000
Less: After-tax SV, old 32,800
Net cost of new 47,200
Diff. dep. Base (80,000-64,000) 16,000

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Year 0 1 2 3 4 5 6
Depreciated value 16,000 12,000 9,000 6,750 5,063 3,797 2,848
WDV depreciation 4,000 3,000 2,250 1,688 1,266 949
Investment -47,200
Savings 16,000 16,000 16,000 16,000 16,000 16,000
Less: depreciation* 4,000 3,000 2,250 1,688 1,266 3,797
Taxable savings 12,000 13,000 13,750 14,313 14,734 12,203
Less: Tax 4,200 4,550 4,813 5,009 5,157 4,271
Post-tax savings 7,800 8,450 8,938 9,303 9,577 7,932
Add: depreciation* 4,000 3,000 2,250 1,688 1,266 3,797
After-tax SV (old) lost 0
NCF -47,200 11,800 11,450 11,188 10,991 10,843 11,729
PVF 1.000 0.909 0.826 0.751 0.683 0.621 0.564
PV -47,200 10,727 9,463 8,405 7,507 6,733 6,621
NPV 2,255
* New machine has zero salvage value. Its book value of Rs 2,848 at the end of 6th year will be treated as loss and will save taxes. This
amount has been added to the sixth year’s depreciation.

Situation III
SV, old (now) 16000
BV, old 64,000
After-tax SV, old: 16,000 - .35(16,000-64,000) 32,800 Assumption given in the problem
SV, (after 6 years) 2,000
BV, old (after six years): 64,000 × (1-0.25)6 11391
After-tax SV, old: 2,000 - .35(2,000-11,391) 5,287
Cost of new 80,000
Less: After-tax SV, old 32,800
Net cost of new 47,200
Diff. dep. base (80,000-64,000) 16,000

Year 0 1 2 3 4 5 6
Depreciated value 16,000 12,000 9,000 6,750 5,063 3,797 2,848
WDV depreciation 4,000 3,000 2,250 1,688 1,266 949
Investment -47,200
Savings 16,000 16,000 16,000 16,000 16,000 16,000
Less: depreciation* 4,000 3,000 2,250 1,688 1,266 3,797
Taxable savings 12,000 13,000 13,750 14,313 14,734 12,203
Less: Tax 4,200 4,550 4,813 5,009 5,157 4,271
Post-tax savings 7,800 8,450 8,938 9,303 9,577 7,932
Add: depreciation* 4,000 3,000 2,250 1,688 1,266 3,797
After-tax SV (old) lost -5,287
NCF -47,200 11,800 11,450 11,188 10,991 10,843 6,442
PVF 1.000 0.909 0.826 0.751 0.683 0.621 0.564
PV -47,200 10,727 9,463 8,405 7,507 6,733 3,636
NPV -729
* New machine has zero salvage value. Its book value of Rs 2,848 at the end of 6th year will be treated as loss and will save taxes. This
amount has been added to the sixth year's depreciation.

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Ch. 10: Determining Cash Flows for Investment Analysis

Problem 10

Old Machine:
BV 0
Current MV 20,000
After-tax SV: 20,000-.35(20,000-0) 13,000
SV after 8 years 0
Remaining life (years) 8

New Machines (Vs Old):

I II
Cost 102,500 175,000
SV after 8 years 12,500 25,000
BV after 8 years 10,262 17,520
After-tax SV: SV-.35(SV-BV) 11,717 22,382
Life (years) 8 8
Dep. rate (WDV) 0.25 0.25
Tax rate 0.35 0.35
Cost of capital 0.11 0.11
Increase in sales 12,500 12,500
Cost savings 12,500 30,000
Gross savings 25,000 42,500
After-tax savings (T = 35%) 16,250 27,625
Diff. dep. base: Cost, new – BV, old 102,500 175,000
New investment: cost – After-tax 89,500 162,000
SV, old (Rs 13,000)

New machine I (Vs Old):

Years 0 1 2 3 4 5 6 7 8
Diff. dep. Base 102,500 76,875 57,656 43,242 32,432 24,324 18,243 13,682 10,262
Depreciation 25,625 19,219 14,414 10,811 8,108 6,081 4,561 3,421
Dep. Tax shield 8,969 6,727 5,045 3,784 2,838 2,128 1,596 1,197
After-tax savings 16,250 16,250 16,250 16,250 16,250 16,250 16,250 16,250
SV 11,717
NCF -89,500 25,219 22,977 21,295 20,034 19,088 18,378 17,846 29,164
PVF 1.000 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434
PV (Rs) -89,500 22,720 18,648 15,571 13,197 11,328 9,826 8,596 12,655
NPV (Rs) 23,040
IRR 18.1%

New machine II (Vs Old) :

Years 0 1 2 3 4 5 6 7 8
Diff. dep. Base 175,000 131,25 98,438 73,828 55,371 41,528 31,146 23,360 17,520
0
Depreciation 43,750 32,813 24,609 18,457 13,843 10,382 7,787 5,840
Dep. Tax shield 15,313 11,484 8,613 6,460 4,845 3,634 2,725 2,044
After-tax savings 27,625 27,625 27,625 27,625 27,625 27,625 27,625 27,625
SV 22,382
NCF -162,000 42,938 39,109 36,238 34,085 32,470 31,259 30,350 52,051
PVF 1.000 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434
PV (Rs) -162,000 38,682 31,742 26,497 22,453 19,269 16,712 14,618 22,586

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

NPV (Rs) 30,561

IRR 16.20%
The company should go for the new machine costing Rs 175,000 since it has higher NPV. NPV is consistent with
shareholder wealth maximisation.

Problem 11

The block of assets method of depreciation in India requires adjustment of salvage value in the depreciable base. Thus,
if an asset has no salvage value, it can be depreciated for ever (infinity) if the firm keeps the positive balance in the
block of assets. If it has a salvage value, the balance of the block will be reduced for the amount of salvage value less
depreciation tax shield lost on this amount.
Old Machine:
Depreciated BV 0
Exchange value 40,000
Current MV 30,000
SV after 10 years 6,000
Remaining life (years) 10
New Machine:
Cost 360,000
SV after 10 years. 40,000
Life (years) 10
WDV dep. rate 25%
Required rate 12%
Tax rate 50%

Old New
Differenc
e
Profit before tax 373,000 449,000 76,000
Add: dep. 2,000 36,000 34,000
Add: allocated
overhead 120,000 130,000 10,000
PBDT 495,000 615,000 120,000
Tax @ 50% 247,500 307,500 60,000
PBDAT 247,500 307,500 60,000

Years 0 1 2 3 4 5 6 7 8 9 10
New block 320,000 240,000 180,000 135,000 101,250 75,938 56,953 42,715 32,036 24,027 18,020
Dep. 80,000 60,000 45,000 33,750 25,313 18,984 14,238 10,679 8,009 6,007
DTS 40,000 30,000 22,500 16,875 12,656 9,492 7,119 5,339 4,005 9,091
PBDAT 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000
CFO 100,000 90,000 82,500 76,875 72,656 69,492 67,119 65,339 64,005 69,091
Investment -320,000
SV 40,000
Lost DTS on SV -
13,514
NCF -320,000 100,000 90,000 82,500 76,875 72,656 69,492 67,119 65,339 64,005 95,578
PVF 1.000 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322
PV (Rs) -320,000 89,286 71,747 58,722 48,855 41,227 35,207 30,361 26,389 23,081 30,774
NPV (Rs) 135,649
IRR 22.45%

Last year DTS includes depreciation on the remaining book value: BV × (d × T)/(k + d) = 18.020 × (0.25 × 0.50)/(0.12
+ 0.25) = Rs .6,088.

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Ch. 10: Determining Cash Flows for Investment Analysis

Note: Exchange value is higher than the current market value. Hence, the relevant salvage value of the old machine is
Rs 40,000.

Problem 12

Old Machine:
Original cost (Rs) 129,000
Original life (yrs) 12
Remaining life (yrs) 7
Depreciation rate 25%
BV after 5 years 30,612 (1-0.25)^5*129,000
BV after 12 years 4,086 (1-0.25)^12*129,000
Current MV 40,000
New Machine:
Cost 175,000
Installation 25,000
Total cost 200,000
Working capital 25,000
Gross outlay 225,000
Life (years) 7
Depreciation rate 0.25
SV (Rs) 18,000
BV after 7 years 23,360 (1-0.25)^7*175,000

Cost of capital 12%

Tax rate 35%

Increase in sales 70,000

After-tax revenue: 70,000×(1- 45,500
.35)
Gross outlay 225,000
Less: SV, old 40,000
Net outlay 185,000
Diff. Dep. Base: 200,000 - 160,000
40,000

Year 0 1 2 3 4 5 6 7
Diff. dep. base 160,000 120,000 90,000 67,500 50,625 37,969 28,477 21,357
Differential dep. 40,000 30,000 22,500 16,875 12,656 9,492 7,119
DTS* 14,000 10,500 7,875 5,906 4,430 3,322 7,542
After-tax revenue 45,500 45,500 45,500 45,500 45,500 45,500 45,500
SV 18,000
DTS lost on SV** -4,257
WC released 25,000
Net outlay -185,000
NCF -185,000 59,500 56,000 53,375 51,406 49,930 48,822 91,786
PVF 1.000 0.893 0.797 0.712 0.636 0.567 0.507 0.452
PV (Rs) -185,000 53,125 44,643 37,991 32,670 28,331 24,735 41,519
NPV 78,014
IRR 24.0%
* Last year DTS includes DTS on remaining book value: 21,357 × (.25× .35)/(.12 + .25) = Rs 5,051.
** DTS lost on SV: 18,000 × (.25 × .35)/(.25 + .12) = -4,257.

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 13

Purchase price 175,000

Life (years) 5
SV (Rs) 21,000
Maintenance cost 3,500
SL dep. 35,000
Tax rate 0.50
Cost of capital 0.10

0 1 2 3 4 5
Outlay -175,000
Tax saved on depreciation 17,500 17,500 17,500 17,500 17,500
After-tax SV 10,500 10,500
NCF -175,000 17,500 17,500 17,500 28,000 27,500
PVF 1.0000 0.9091 0.8264 0.7513 0.6209 0.6209
PV (Rs) -175,000 15,909 14,463 13,148 17,386 23,905
NPV (Rs) -102,142
* Tax payable on book profit. After-tax SV = 21,000 – 0.50(21,000 – 0)

Hiring option: 0 1 2 3 4 5
Hire charges (Rs) 0 -42,000 -42,000 -42,000 -42,000 -42,000
After-tax hire charges (Rs) 0 -21,000 -21,000 -21,000 -21,000 -21,000
PVF 1.0000 0.9091 0.8264 0.7513 0.6209 0.6209
PV (Rs) 0 -19,091 -17,355 -15,778 -14,343 -13,039
NPV (Rs) -79,607
Maintenance cost being common in both options is ignored in calculating cash flows.
Hiring option is cheaper.

Problem 14

Cost of capital 0.18

Tax rate 0.50
Dep. Rate 0.25

Project P 0 1 2 3 4 5 6 7 8 9 10

Investment 250,000 187,500 140,625 105,469 79,102 59,326 44,495 33,371 25,028 18,771 14,078
Depreciation 62,500 46,875 35,156 26,367 19,775 14,832 11,124 8,343 6,257 4,693
Additional investment 45,000 33,750 25,313 18,984 14,238 10,679
Depreciation 11,250 8,438 6,328 4,746 3,560
Total depreciation 62,500 46,875 35,156 26,367 19,775 26,082 19,561 14,671 11,003 8,252

Before-tax cash flows 90,000 90,000 90,000 90,000 90,000 90,000 90,000 90,000 90,000 90,000
After-tax cash flows 45,000 45,000 45,000 45,000 45,000 45,000 45,000 45,000 45,000 45,000
DTS 31,250 23,438 17,578 13,184 9,888 13,041 9,781 7,335 5,502 11,323*
Investment -250,000 -45,000
Working capital -50,000
Salvage value 30,000
Lost DTS on SV -8,721#
WC released 50,000
NCF -300,000 76,250 68,438 62,578 58,184 9,888 58,041 54,781 52,335 50,502 127,602

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Ch. 10: Determining Cash Flows for Investment Analysis

PVF 1.000 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191
PV -300,000 64,619 49,151 38,087 30,010 4,322 21,500 17,197 13,923 11,386 24,380
NPV -25,425
IRR 15.5%
* Includes DTS on the remaining book value: Rs (14,078 + 10,679) × (.25 × .50)/(.25 + .18) = Rs 7,197.
# Lost DTS on VS: Rs 30,000 × (.25 × .50)/(.25 + .18) = Rs 8,721.

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 15

Cost 100,000
Life (years) 5
Straight line dep. (Rs) 20,000
Savage value 0
Savings 40,000
Tax rate 0.50
Cost of capital 0.18

Year 0 1 2 3 4 5
Investment -100,000
After-tax savings 20,000 20,000 20,000 20,000 20,000
Tax saved on dep. 10,000 10,000 10,000 10,000 10,000
Salvage value 0
NCF -100,000 30,000 30,000 30,000 30,000 30,000
PVF 1.0000 0.8475 0.7182 0.6086 0.5158 0.4371
PV (Rs) -100,000 25,424 21,546 18,259 15,474 13,113
NPV (Rs) -6,185
IRR 15.2%
Here we ignore the effect of specific financing. The cost of capital, which assumes a target capital structure, is used as
the discount rate.

Problem 16

Project cost (Rs) 50,000

Cost savings (Rs) 30,000
Period (years) 5
Tax rate 0.5
Required rate 0.12
Straight line dep. (Rs) 10,000
Salvage value 0

Year 0 1 2 3 4 5
Investment (Rs) -50,000
After-tax cost savings (Rs) 15,000 15,000 15,000 15,000 15,000
Tax saved on dep. (Rs) 5,000 5,000 5,000 5,000 5,000
Salvage value (Rs) 0
NCF (Rs) -50,000 20,000 20,000 20,000 20,000 20,000
PVF 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674
PV (Rs) -50,000 17,857 15,944 14,236 12,710 11,349
NPV (Rs) 22,096
IRR 28.65%
Here we ignore the effect of specific financing. The cost of capital, which assumes a target capital structure, is used as
the discount rate.

Problem 17

(Rs 000)
Old New New -
Old
Capacity (units) 3 4 1

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Ch. 10: Determining Cash Flows for Investment Analysis

Selling price 200 180 -20

Revenue 600 720 120
Cost of production:
Materials 40 38 2
Labour 60 40 20
Variable overheads 30 15 15
Fixed overheads 2 -2
Per unit production cost 130 95 35
Total production cost 390 380 10
Profit 210 340 110
Original cost of machine (Rs) 300 500
Current book value 200
Exchange (salvage) value 100
After-tax salvage value: 100,000-.5(100,000 – 200,000) 150
Tax saved on book loss 50
Net outlay (Rs): 500,000 - 150,000 350
Salvage value after 10 years 50
After-tax salvage value: 50,000 - .5(50,000 – 0) 25
Remaining life (years) 10 10
Straight line dep. 20 50 30
Working capital 25
Tax rate 0.5
Required rate of return 0.15

(Rs ‘000)
Year 0 1 2 3 4 5 6 7 8 9 10
Cost of machine -200 -200
Working capital -25
Tax saved on SV 50
Revenue 120 120 120 120 120 120 120 120
120 120
Cost savings 10 10 10 10 10 10 10 1010 10
Increase in profits 130 130 130 130 130 130 130 130
130 130
After-tax profits 65 65 65 65 65 65 65 6565 65
Dep. tax shield 15 15 15 15 15 15 15 1515 15
After-tax SV 25
Release of WC 25
NCF -175 -120 80 80 80 80 80 80 80 80 130
PVF 1.000 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247
PV (Rs) -175 -104 60 53 46 40 35 30 26 23 32
NPV (Rs) 65.0
IRR 20.2%

Problem 18

Initial cost (Rs) 200,000

Life (years) 5
Cash inflow (Rs) 70,000
Cost of capital (real) 10.0%
Inflation 5.0%
Nominal cost of capital: [(1.10)(1.05) - 1] 15.5%

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Assumptions: (1) It is assumed that both cash flows and the cost of capital are in real terms. (2) Nominal cash flows are
calculated as follows: Real cash flows × (1 + inflation rate)n.

Year 0 1 2 3 4 5 Dis. rate NPV

Cash flows (real) -200,000 70,000 70,000 70,000 70,000 70,000 0.1000 65,355
Nominal cash flows -200,000 73,500 77,175 81,034 85,085 89,340 0.1550 65,355
It may be noticed that NPV is the same in both situations. The real cash flows are discounted at the nominal cost of
capital, and real cash flows at the real cost of capital.
Problem 19

Discount rate 20%

Tax rate 35%
General inflation rate 10%

Year 0 1 2 3 4 5
Cost -500,000
Volume 20% 10,000 12,000 14,400 17,280 20,736
Price 10% 20 22.00 24.20 26.62 29.28
Cost per unit 15% 10 11.50 13.23 15.21 17.49
Revenue 200,000 264,000 348,480 459,994 607,192
Total cost 100,000 138,000 190,440 262,807 362,674
Profit 100,000 126,000 158,040 197,186 244,518
Less: dep. 100,000 100,000 100,000 100,000 100,000
PBT 0 26,000 58,040 97,186 144,518
Tax 0 9,100 20,314 34,015 50,581
PAT 0 16,900 37,726 63,171 93,936
Add: dep. 100,000 100,000 100,000 100,000 100,000
NCF -500,000 100,000 116,900 137,726 163,171 193,936
PVF at 20% 1.000 0.833 0.694 0.579 0.482 0.402
PV at 20% -500,000 83,333 81,181 79,703 78,690 77,939
NPV -99,155
IRR 11.6%
Price increases at general inflation rate while cost increases by a higher rate of inflation. It is assumed that the cost of
capital is market determined; hence, it is in nominal terms.

Problem 20

Cash outlay 6,000,000

Life of project (years) 7
Sales growth: 2-7 years 10%
Increase in expenses 10%
Initial working capital 500,000
WC to sales 25%
WDV dep. rate 25%
Tax rate 35%
Opportunity cost of capital 21%
Salvage value: 0.20 × 6,000,000 × (1.10)7 2,338,461

14
Ch. 10: Determining Cash Flows for Investment Analysis

Nominal Cash Flows

Year 0 1 2 3 4 5 6 7
Cash outlay -6,000,000
Sales 1,200,000 2,000,000 2,200,000 2,420,000 2,662,000 2,928,200 3,221,020
Op. expenses 600,000 660,000 726,000 798,600 878,460 966,306 1,062,937
PBDIT 600,000 1,340,000 1,474,000 1,621,400 1,783,540 1,961,894 2,158,083
Depreciation 1,500,000 1,125,000 843,750 632,813 474,609 355,957 266,968
Profit/loss -900,000 215,000 630,250 988,588 1,308,931 1,605,937 1,891,116
Loss carried forward -900,000 -685,000 -54,750 0 0 0
Unrecovered loss -900,000 -685,000 -54,750 0 0 0 0
Taxable profit 0 0 0 933,838 1,308,931 1,605,937 1,891,116
Tax 0 0 0 326,843 458,126 562,078 661,890
PAT 0 215,000 630,250 661,744 850,805 1,043,859 1,229,225
Add : depreciation 1,500,000 1,125,000 843,750 632,813 474,609 355,957 266,968
Funds from operation 1,500,000 1,340,000 1,474,000 1,294,557 1,325,414 1,399,816 1,496,193
Initial working capital -500,000
Change in WC -300,000 -200,000 -50,000 -55,000 -60,500 -66,550 -73,205
Release of WC 1,305,255
Salvage value 2,338,461
NCF -6,500,000 1,200,000 1,140,000 1,424,000 1,239,557 1,264,914 1,333,266 5,066,703
PVF, 21% 1.000 0.826 0.683 0.564 0.467 0.386 0.319 0.263
PV -6,500,000 991,736 778,635 803,811 578,262 487,679 424,820 1,334,221
NPV -1,100,836
IRR 15.7%
Theoretically, the answer should not change if the analysis is made in terms of real terms. The real cash flows would be
discounted at the real cost of capital. However, since flows like deprecation tax shields are always in nominal terms, it
is difficult to use real cash flow analysis.

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

CASES
Case 10.1: Hind Petrochemicals Company
This case brings out a number of issues in calculating the relevant cash flows, the discount rate, NPV and IRR. The
important points are: (1) relevant depreciation for tax purposes, (2) irrelevance of allocated overheads, (3) sunk cost
(part of survey cost), (4) release of working capital, (5) tax shield treatment of depreciation and salvage value as per the
Indian tax system, and (6) ignoring the financing effect in calculating the cash flows.

(Rs mn.)
Cost of refinery 1,550
Cost of machinery 5,950
Total capital investment 7,500
Working capital 300
Total cash outlay 7,800

Discount rate 15%

Cash flows (Rs mn.)

0 1 2 3 4 5
Sales 5,730 5,930 5,870 3,790 4,500
Less: Wages and salaries 1,450 1,500 1,850 1,030 1,210
Selling and distribution costs 760 770 1,080 530 650
Materials and consumables 180 270 290 200 230
Depreciation (WDV) 1,875 1,406 1,055 791 593
Corporate office costs 100 100 100 100 100
Survey costs 15 - - - -
Total expenses 4,380 4,046 4,375 2,651 2,783
Profit (loss) before tax 1,350 1,884 1,495 1,139 1,717
Less: tax @ 35% 473 659 523 399 601
Profit after tax 878 1,224 972 740 1,116
Plus: depreciation 1,875 1,406 1,055 791 593
CFO 2,753 2,631 2,027 1,531 1,709
Cash outlay -7,800
Working capital released 300
Salvage value 3,600
Book value 1,780
Lost DTS on (SV -BV) -430
Net cash flows -7,800 2,753 2,631 2,027 1,531 5,179
NPV at 15% 1,365
IRR 22%

Cumulative casf flows -7,800 -5,048 -2,417 -390 1,141 6,320

Payback (years) 3.25

Note: (1) Only Rs 15 million of survey cost is rlevant. (2) All corporate office costs are not relevant for the
project; Rs 100 million costs relate to the project. (3) Interest is a financing cost. Free cash flows are calculated,
ignoring the interest ch

16
Ch. 10: Determining Cash Flows for Investment Analysis

Case 10.2: Pure Drinks Company

Like Hind Petrochemicals case, this case high lights the relevant cash flows. It introduces the concept of opportunity
cost of using existing facilities. Further, it also introduces the adjustment of inflation.

Inflation rate assumed zero

Number of sachets 900,000
(Rs)
Price 65.0
Variable costs: 15.0
Material 6.5
Labour 3.5
Overhead 5.0
Fixed costs (Rs million) 0.5
Allocated fixed costs (Rs million) 6.8
Working capital ratio 26%
Tax rate 35%
Real discount rate 8.65%
Inflation rate 0%
Nominal discount rate 8.65%
Tax rate 35%

Cost of processing facilities (Rs million) 200

Life (years) 5
SL depreciation 40
Salvage value (Rs million) 100

Current building opportunity cost (Rs mn) 100

Building opportunity cost after 5 years(Rs mn) 200
PV of building cost after 5 years: 200/(1.0865)5 132

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

(Rs lakh)
0 1 2 3 4 5
Revenue 58.50 58.50 58.50 58.50 58.50
Variable costs
Material 5.85 5.85 5.85 5.85 5.85
Labour 3.15 3.15 3.15 3.15 3.15
Overhead 4.50 4.50 4.50 4.50 4.50
Total 13.5 13.5 13.5 13.5 13.5
Fixed costs 0.50 0.50 0.50 0.50 0.50
Total cost 14.00 14.00 14.00 14.00 14.00
EBDIT 44.50 44.50 44.50 44.50 44.50
Depreciation 40.00 40.00 40.00 40.00 40.00
EBIT 4.50 4.50 4.50 4.50 4.50
Less: Tax 1.58 1.58 1.58 1.58 1.58
Post-tax earnings 2.93 2.93 2.93 2.93 2.93
Plus: depreciation 40.00 40.00 40.00 40.00 40.00
Cash flow from operations 42.93 42.93 42.93 42.93 42.93
Change in working capital -15.21 0.00 0.00 0.00 0.00 15.21
Free cash flows -15.21 42.93 42.93 42.93 42.93 58.14
Cost of processing facilities -200
Cost of building -132
Salvage value 100
Less: Tax on (SV - BV) -35
Net cash flows -347.30 42.93 42.93 42.93 42.93 123.14
NPV -125.84
NPV if WC ratio is 30% -126.63
Note: (1) Rs 5 million survey cost is sunl cost. Hence, it is ignored. (2) The corporate office fixed costs are
irrelevant for the project.

Inflation adjustment:
Number of sachets 900,000
(Rs) Inflation
Price 65.0 4%
Variable costs:
Material 6.5 3%
Labour 3.5 5%
Overhead 5.0 5%
Fixed costs (Rs million) 0.5
Working capital ratio 26%
Tax rate 35%
Real discount rate 8.65%
General inflation rate 4%
Nominal discount rate 13%
Tax rate 35%
Cost of processing facilities 200
Life 5
SL depreciation 40
Salvage value 100
Current building opportunity cost (Rs mn) 100
Building opportunity cost after 5 years(Rs mn) 200
PV of building cost after 5 years: 200/(1.13)5 109

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Ch. 10: Determining Cash Flows for Investment Analysis

(Rs lakh)
0 1 2 3 4 5
Revenue 60.84 63.27 65.80 68.44 71.17
Variable costs
Material 6.03 6.21 6.39 6.58 6.78
Labour 3.31 3.47 3.65 3.83 4.02
Overhead 4.73 4.96 5.21 5.47 5.74
Total 14.1 14.6 15.2 15.9 16.5
Fixed costs 0.52 0.54 0.56 0.58 0.61
Total cost 14.58 15.18 15.81 16.47 17.15
EBDIT 46.26 48.09 49.99 51.97 54.02
Depreciation 40.00 40.00 40.00 40.00 40.00
EBIT 6.26 8.09 9.99 11.97 14.02
Less: Tax 2.19 2.83 3.50 4.19 4.91
Post-tax earnings 4.07 5.26 6.50 7.78 9.11
Plus: depreciation 40.00 40.00 40.00 40.00 40.00
Cash flow from operations 44.07 45.26 46.50 47.78 49.11
Change in working capital -15.82 -0.63 -0.66 -0.68 -0.71 18.51
Free cash flows -15.82 43.44 44.60 45.81 47.07 67.62
Cost of processing facilities -200
Cost of building -109
Salvage value 100
Less: Tax on (SV - BV) -35
Net cash flows -324.39 43.44 44.60 45.81 47.07 132.62
NPV -118.40
NPV if WC ratio 30% -199.59
Note: (1) Rs 5 million survey cost is sunl cost. Hence, it is ignored. (2) The corporate office fixed costs are
irrelevant for the project.

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