Question 5.S2.RQ.15: ABC Ltd is considering investing in a project that costs Rs ......
ABC Ltd is considering investing in a project that costs Rs 5,00,000. The estimated salvage value is zero; tax rate is 35 per cent. The company uses straight line depreciation for tax purposes and the proposed project has cash flows before tax (CFBT) as follows:
Determine the following: (i) Pay back period, and (ii) Average rate of return.
| Year | CFBT |
| 1 | Rs 1,00,000 |
| 2 | 1,00,000 |
| 3 | 1,50,000 |
| 4 | 1,50,000 |
| 5 | 2,50,000 |
(i) Pay back period
The pay back period is four years plus a fraction of the fifth year. The fraction value will be equal to 0.18, that is, Rs 35,000 ÷ Rs 1,97,500. The payback period is 4.18 years.
(ii) Average rate of return (ARR)
(a) ARR= (Average income/Average investment) × 100 = (Rs 32,500*/2,50,000) × 100 = 13 per cent
*Rs 1,62,500, EAT/5 years = Rs 32,500.
(b) ARR = (Average cash flow/Average investment) × 100 = (Rs 1,32,500/2,50,000) × 100 = 53 per cent.
Cash inflows
| Year | CFBT | Depreciation | Taxable earnings |
Tax | EAT | CFAT [Col 2 – 5] |
Cumulative CFAT |
| 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
| 1 | Rs 1,00,000 | Rs 1,00,000 | — | — | — | Rs 1,00,000 | Rs 1,00,000 |
| 2 | 1,00,000 | 1,00,000 | — | — | — | 1,00,000 | 2,00,000 |
| 3 | 1,50,000 | 1,00,000 | Rs 50,000 | Rs 17,500 | Rs 32,500 | 1,32,500 | 3,32,500 |
| 4 | 1,50,000 | 1,00,000 | 50,000 | 17,500 | 32,500 | 1,32,500 | 4,65,000 |
| 5 | 2,50,000 | 1,00,000 | 1,50,000 | 52,500 | 97,500 | 1,97,500 | 6,62,500 |
| 2,50,000 | 1,62,500 | 6,62,500 |