Question 3.15: Proposal X requires an initial capital outlay of Rs 2,00,000......

Management Accounting and Financial Analysis for CA Final Examination [995093]

Proposal X requires an initial capital outlay of Rs 2,00,000, with no salvage value, and will be depreciated on a straight line basis for tax purposes. The earnings before depreciation and taxes (EBDT) during its 5 year life are:
The corporate tax rate is 35 per cent and the company evaluates its capital budgeting projects at 12 per cent cost of capital. Advise the company whether the project should be accepted.
(i) when there is no inflation and (ii) when there is inflation at the rate of 15 per cent per annum, and its stated gross earnings are also expected to grow at this rate of inflation.

5	4	3	2	1	$Year$
Rs 52,000	Rs 60,000	Rs 80,000	Rs 76,000	Rs 70,000	EBDT

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$\,$ Since the net present value is positive, the project is worth accepting in a non-inflationary scenario.
$\,$ In the inflationary situation, EBDT are expected to grow at 15 per cent. As per Table A-1 (showing compound sum of one rupee), EBDT values can be determined (reflecting 15 per cent compound rate of growth). Depreciation amount remains unchanged. As a result, taxable profits as well as taxes go up.
Detailed computations are shown in Table 3.4.
$\,$ Since CFAT are inflated sums, they are to be deflated at the rate of inflation (15 per cent) to determine real cash flows. Table 3.5 contains relevant calculations in this regard.
$\,$ It may be observed that real cash flows are substantially lower than nominal cash flows. This is caused on account of the fact that increased income (as depreciation charges do not change) is subject to higher amount of taxes; corporate tax rate is more than twice (35 per cent) the inflation rate (15 per cent). The NPV of real cash inflows is shown in Table 3.6.
$\,$ Since the NPV is negative under inflationary situations, the investment proposal is not acceptable. Similar conclusions follow based on the internal rate of return method. The IRR based on real CFAT is 11 per cent—lower than the cost of capital (12 per cent).
$\,$ It is apparent, therefore, that inflation results both in lower cash flows and lower real rates of return. Example 3.15 is important in that it highlights that corporate firms (conscious of protecting the real purchasing power of their owners) may go for unprofitable investment projects, affecting the shareholders wealth adversely. In brief, the example underlines the significance of incorporating the inflation factor in evaluating capital budgeting decisions, in particular for business firms interested in real returns.
$\,$ Consistency warrants that the real cost of capital should be used to discount real cash inflows after taxes and the nominal cost of capital should be employed for nominal CFAT. This point is illustrated in Example 3.16.

Determination of NPV (when there is no Inflation)
$\,$ $(Amount\>is \>in\> thousand\> rupees)$

$Total\>PV$ $(Col.\>6 × 7)$ $\,$	$PV$ $factor$ $\,$	$CFAT$ $(Col.\>5 + 3)$ $\,$	$EAT$ $(Col. 4\>× 0.65)$ $\,$	$Taxable$ $income$ $(Col.\>3– 2)$	$Depreciation$ $(200 \div 5)$ $\,$	$EBDT$ $\,$ $\,$	$Year$ $\,$ $\,$
8	7	6	5	4	3	2	1
53.13	0.893	59.5	19.5	30	40	70	1
50.53	0.797	63.4	23.4	36	40	76	2
46.99	0.712	66.0	26.0	40	40	80	3
33.71	0.636	53.0	13.0	20	40	60	4
27.10	0.567	47.8	7.8	12	40	52	5
211.46	Gross present value
200.00	Less cash outflows
11.46	Net present value

Table 3.4 Determination of CFAT in Inflationary Situation

$\,$ $(Amount\>is \>in\> thousand\> rupees)$

$CFAT$ $(Col.\>7 + 5)$ $\,$	$EAT$ $(Col.\>6 × 0.65)$ $\,$	$Taxable$ $income$ $(Col.\>4 – 5)$	$Depreciation$ $\,$ $\,$	$Revised$ $EBDT$ $(Col.\>2 × 3)$	$Compound$ $Factor$ $at\>0.15$	$EBDT$ $\,$ $\,$	$Year$ $\,$ $\,$
8	7	6	5	4	3	2	1
66.32	26.32	40.50	40	80.50	1.150	70	1
79.31	39.31	60.47	40	100.47	1.322	76	2
93.09	53.09	81.68	40	121.68	1.521	80	3
82.21	42.21	64.94	40	104.94	1.749	60	4
81.97	41.97	64.57	40	104.57	2.011	52	5

Table 3.5 Determination of Real Cash Flows

$\,$ $(Amount\>is \>in\> thousand\> rupees)$

$Real\>cash\>inflows$ $(CFAT)\>(Col.\>2 × 3)$	$Discount/\>Deflated\>factor\>at$ $0.15\>as\>per\>Table\>A – 3$	$CFAT$ $\,$	$Year$ $\,$
4	3	2	1
57.70	1/1.15 = 0.870	66.32	1
59.96	1/ (1.15)² = 0.756	79.31	2
61.25	1/(1.15)³ = 0.658	93.09	3
47.02	1/(1.15) $^4$ = 0.572	82.21	4
40.74	1/(1.15) $^5$ = 0.497	81.97	5

Table 3.6 NPV of Real CFAT

$Total\>PV\>(Col.\>3 x 4)$	$PV\>factor\>at\>12\%$	$Real\>CFAT$	$Year$
4	3	2	1
51.53	0.893	57.70	1
47.79	0.797	59.96	2
43.61	0.713	61.25	3
29.90	0.636	47.02	4
23.10	0.567	40.74	5
195.93			Gross present value
200.00			Less cash outflows
(4.07)			Net present value

Table A-1 The Compound Sum of One Rupee

$10\%$	$9\%$	$8\%$	$7\%$	$6\%$	$5\%$	$4\%$	$3\%$	$2\%$	$1\%$	$Year$
1.100	1.090	1.080	1.070	1.060	1.050	1.040	1.030	1.020	1.010	1
1.210	1.188	1.166	1.145	1.124	1.102	1.082	1.061	1.040	1.020	2
1.331	1.295	1.260	1.225	1.191	1.158	1.125	1.093	1.061	1.030	3
1.464	1.412	1.360	1.311	1.262	1.216	1.170	1.126	1.082	1.041	4
1.611	1.539	1.469	1.403	1.338	1.276	1.217	1.159	1.104	1.051	5
1.772	1.677	1.587	1.501	1.419	1.340	1.265	1.194	1.126	1.062	6
1.949	1.828	1.714	1.606	1.504	1.407	1.316	1.230	1.149	1.072	7
2.144	1.993	1.851	1.718	1.594	1.477	1.369	1.267	1.172	1.083	8
2.358	2.172	1.999	1.838	1.689	1.551	1.423	1.305	1.195	1.094	9
2.594	2.367	2.159	1.967	1.791	1.629	1.480	1.344	1.219	1.105	10
2.853	2.580	2.332	2.105	1.898	1.710	1.539	1.384	1.243	1.116	11
3.138	2.813	2.518	2.252	2.012	1.796	1.601	1.426	1.268	1.127	12
3.452	3.066	2.720	2.410	2.133	1.886	1.665	1.469	1.294	1.138	13
3.797	3.342	2.937	2.579	2.261	1.980	1.732	1.513	1.319	1.149	14
4.177	3.642	3.172	2.759	2.397	2.079	1.801	1.558	1.346	1.161	15
4.595	3.970	3.426	2.952	2.540	2.183	1.873	1.605	1.373	1.173	16
5.054	4.328	3.700	3.159	2.693	2.292	1.948	1.653	1.400	1.184	17
5.560	4.717	3.996	3.380	2.854	2.407	2.026	1.702	1.428	1.196	18
6.116	5.142	4.316	3.616	3.026	2.527	2.107	1.753	1.457	1.208	19
6.727	5.604	4.661	3.870	3.207	2.653	2.191	1.806	1.486	1.220	20
7.400	6.109	5.034	4.140	3.399	2.786	2.279	1.860	1.516	1.232	21
8.140	6.658	5.436	4.430	3.603	2.925	2.370	1.916	1.546	1.245	22
8.954	7.258	5.871	4.740	3.820	3.071	2.465	1.974	1.577	1.257	23
9.850	7.911	6.341	5.072	4.049	3.225	2.563	2.033	1.608	1.270	24
10.834	8.623	6.848	5.427	4.292	3.386	2.666	2.094	1.641	1.282	25
17.449	13.267	10.062	7.612	5.743	4.322	3.243	2.427	1.811	1.348	30
28.102	20.413	14.785	10.676	7.686	5.516	3.946	2.814	2.000	1.417	35
45.258	31.408	21.724	14.974	10.285	7.040	4.801	3.262	2.208	1.489	40
72.888	48.325	31.920	21.002	13.764	8.985	5.841	3.781	2.438	1.565	45
117.386	74.354	46.900	29.456	18.419	11.467	7.106	4.384	2.691	1.645	50

(Contd.)

$20\%$	$19\%$	$18\%$	$17\%$	$16\%$	$15\%$	$14\%$	$13\%$	$12\%$	$11\%$	$Year$
1.200	1.190	1.180	1.170	1.160	1.150	1.140	1.130	1.120	1.110	1
1.440	1.416	1.392	1.369	1.346	1.322	1.300	1.277	1.254	1.232	2
1.728	1.685	1.643	1.602	1.561	1.521	1.482	1.443	1.405	1.368	3
2.074	2.005	1.939	1.874	1.811	1.749	1.689	1.630	1.574	1.518	4
2.488	2.386	2.288	2.192	2.100	2.011	1.925	1.842	1.762	1.685	5
2.986	2.840	2.700	2.565	2.436	2.313	2.195	2.082	1.974	1.870	6
3.385	3.379	3.185	3.001	2.826	2.660	2.502	2.353	2.211	2.076	7
4.300	4.021	3.759	3.511	3.278	3.059	2.853	2.658	2.476	2.305	8
5.160	4.785	4.435	4.108	3.803	3.518	3.252	3.004	2.773	2.558	9
6.192	5.695	5.234	4.807	4.411	4.046	3.707	3.395	3.106	2.839	10
7.430	6.777	6.176	5.624	5.117	4.652	4.226	3.836	3.479	3.152	11
8.916	8.064	7.288	6.580	5.936	5.350	4.818	4.334	3.896	3.498	12
10.699	9.596	8.599	7.699	6.886	6.153	5.492	4.898	4.363	3.883	13
12.839	11.420	10.147	9.007	7.987	7.076	6.261	5.535	4.887	4.310	14
15.407	13.589	11.974	10.539	9.265	8.137	7.138	6.254	5.474	4.785	15
18.488	16.171	14.129	12.330	10.748	9.358	8.137	7.067	6.130	5.311	16
22.186	19.244	16.672	14.426	12.468	10.761	9.276	7.986	6.866	5.895	17
26.623	22.900	19.673	16.879	14.462	12.375	10.575	9.024	7.690	6.543	18
31.948	27.251	23.214	19.748	16.776	14.232	12.055	10.197	8.613	7.263	19
38.337	32.429	27.393	23.105	19.461	16.366	13.743	11.523	9.646	8.062	20
237.373	38.591	32.323	27.033	22.574	18.821	15.667	13.021	10.804	8.949	21
55.205	45.923	38.141	31.629	26.186	21.644	17.861	14.713	12.100	9.933	22
66.247	54.648	45.007	37.005	30.376	24.891	20.361	16.626	12.552	11.026	23
79.496	65.031	53.108	43.296	35.236	28.625	23.212	18.788	15.178	12.239	24
95.395	77.387	62.667	50.656	40.874	32.918	26.461	21.230	17.000	13.585	25
237.373	184.672	143.367	111.061	85.849	66.210	50.949	39.115	29.960	22.892	30
590.657	440.691	327.988	243.495	180.311	133.172	98.097	72.066	52.799	38.574	35
1469.740	1051.642	750.353	533.846	378.715	267.856	188.876	132.776	93.049	64.999	40
3657.176	2509.583	1716.619	1170.425	795.429	538.752	363.662	244.629	163.985	109.527	45
9100.191	5988.730	3927.189	2566.080	1670.669	1083.619	700.197	450.711	288.996	184.559	50