NAME:

Roll Number:
MBA-II semester
MB0045
Financial Management

SET - I
Q1. Why wealth maximization is superior to profit maximization in today’s context?
Justify your answer.

Answer: Superiority of Wealth Maximization over Profit maximization:-

1. It is based on cash flow, not based on accounting profit.
2. Through the process of discounting it takes care of the quality of cash
flows. Distant cash flows are uncertain. Converting distant uncertain cash flows
into comparable values at base period facilitates better comparison of projects
. There are various ways of dealing with risk associated with cash flows. These
risks are adequately considered when present values of cash flows are taken to a
rrive at the net present value of any project.
3. In today’s competitive business scenario corporate play a key role. In com
pany form of organization, shareholders own the company but the management of th
e company rests with the board of directors. Directors are elected by shareholde
rs and hence agents of the shareholders. Company management procures funds for e
xpansion and diversification from Capital Markets. In the liberalized set up, th
e society expects corporate to tap the capital markets effectively for their cap
ital requirements. Therefore to keep the investors happy through the performance
of value of shares in the market, management of the company must meet the wealt
h maximization criterion.
4. When a firm follows wealth maximization goal, it achieves maximization o
f market value of share. When a firm practices wealth maximization goal, it is p
ossible only when it produces quality goods at low cost. On this account society
gains because of the societal welfare.
5. Maximization of wealth demands on the part of corporate to develop new p
roducts or render new services in the most effective and efficient manner. This
helps the consumers as it will bring to the market the products and services tha
t consumer’s need.
6. Another notable features of the firms committed to the maximization of w
ealth is that to achieve this goal they are forced to render efficient service t
o their customers with courtesy. This enhances consumer welfare and hence the be
nefit to the society.
7. From the point of evaluation of performance of listed firms, the most re
markable measure is that of performance of the company in the share market. Ever
y corporate action finds its reflection on the market value of shares of the com
pany. Therefore, shareholders wealth maximization could be considered a superior
goal compared to profit maximization.
8. Since listing ensures liquidity to the shares held by the investors, sha
reholders can reap the benefits arising from the performance of company only whe
n they sell their shares.

Therefore, it is clear that maximization of market value of shares will lead to

maximization of the net wealth of shareholders.
Therefore, we can conclude that maximization of wealth is the appropriate of goa
l of financial management in today’s context.

Q 2. Your grandfather is 75 years old. He has total savings of Rs.80, 000. He e

xpects that he live for another 10 years and will like to spend his savings by
then. He places his savings into a bank account earning 10 per cent annually. H
e will draw equal amount each year- the first withdrawal occurring one year from
now in such a way that his account balance becomes zero at the end of 10 years.
How much will be his annual withdrawal?
Answer:
Present Value (PV) =80000/-
Amount (A) =?
Interest Rate (I) = 10%
No. of Year (N) = 10
PVAn = A {1+i) n-1} / {i (1+i) n}
80000=A {1+.10)10}/ {.10(1+.10)10}
80000=A {1.593742/0.259374}
A =80000/ 6.144567
A = 13019.63 yearly
Q 3. What factors affect financial plan?

Ans.: Factors Affecting Financial Plan

1. Nature of the industry: Here, we must consider whether it is a capital i
ntensive or labor intensive industry. This will have a major impact on the total
assets that the firm owns.
2. Size of the Company: The size of the company greatly influences the avai
lability of funds from different sources. A small company normally finds it diff
icult to raise funds from long term sources at competitive terms. On the other h
and, large companies like Reliance enjoy the privilege of obtaining funds both s
hort term and long term at attractive rates.
3. Status of the company in the industry: A well established company enjoyi
ng a good market share, for its products normally commands investors’ confidence.
Such a company can tap the capital market for raising funds in competitive terms
for implementing new projects to exploit the new opportunities emerging from ch
anging business environment.
4. Sources of finance available: Sources of finance could be grouped into d
ebt and equity.Debt is cheap but risky whereas equity is costly. A firm should a
im at optimum capital structure that would achieve the least cost capital struct
ure. A large firm with a diversified product mix may manage higher quantum of de
bt because the firm may manage higher financial risk with a lower business risk.
Selection of sources of finance is closely linked to the firm’s capacity to manag
e the risk exposure.
5. The Capital structure of a company is influenced by the desire of the ex
isting management (promoters) of the company to retain control over the affairs
of the company. The promoters who do not like to lose their grip over the affair
s of the company normally obtain extra funds for growth by issuing preference sh
ares and debentures to outsiders.
6. Matching the sources with utilization: The prudent policy of any good fi
nancial plan is to match the term of the source with the term of investment. To
finance fluctuating working capital needs the firm resorts to short terms financ
e. All fixed assets financed investments are to be financial by long term source
s. It is a cardinal principle of financial planning.
7. Flexibility: The financial plan of a company should possess flexibility
so as to effect changes in the composition of capital structure when ever need a
rises. If the capital structure of a company is flexible, it will not face any d
ifficulty in changing the sources of funds. This factor has become a significant
one today because of the globalization of capital market.
8. Government Policy: SEBI guidelines, finance ministry circulars, various
clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA a
nd Department of corporate affairs (Govt. of India) influence the financial plan
s of corporate today. Management of public issues of shares demands the complian
ces with many statues in India. They are to be complied with a time constraint.
Q4. Suppose you buy a one-year government bond that has a maturity value of Rs.
1000.The market interest rate is 8 per cent. (a) How much will you pay for the b
ond? (b) If you purchase the bond for Rs.904.98, what interest rate will you ear
n from this investment?

Answer:
a) Maturity Value of Government Bond = Rs.1000
The interest rate = 8%
The amount of Interest payable = 8/108 x 1000 = Rs.74.07
Amount to be paid for the bond = Rs.1000 – 74.07 = Rs. 925.93
b) Maturity Value of Government Bond = Rs.1000
Purchase of Bond = Rs. 904.98
The interest rate earned from this investment:
Interest = 1000 – 904.98 = Rs. 95.02
(95.02/904.98) x 100 = 10.50%
Q5. Case Study: (20 Marks)
Deepak Hand tools Private Limited
DHPL is a small sized firm manufacturing hand tools. It manufacturing plan is si
tuated in Haryana. The company’s sales in the year ending on 31st March 2007 were
Rs.1000 million (Rs.100 crore) on an asset base of Rs.650 million. The net profi
t of the company was Rs.76 million. The management of the company wants to impro
ve profitability further. The required rate of return of the company is 14 perce
nt.
The company is currently considering an investment proposal. One is to expand it
s manufacturing capacity. The estimated cost of the new equipment is Rs.250 mill
ion. It is expected to have an economic life of 10 years. The accountant forecas
ts that net cash inflows would be Rs.45 million per annum for the first three ye
ars, Rs.68 million per annum from year four to year eight and for the remaining
two years Rs.30million per annum. The plant can be sold for Rs.55 million at the
end of its economic life. The company would need to raise debt to the extent of
Rs.200 million. The company has the following options of borrowing Rs.200 milli
on:
a. The company can borrow funds from a nationalized bank at the interest rate of
14 percent for 10 years. It will be required to pay equal annual installment of
interest and repayment of principal.
b. A financial institution has offered to lend money to DHPL at 13.5 per annum b
ut it needs to pay equated quarterly installment of interest and repayment of pr
incipal.
Questions:
1. Should the company expand its capacity? Show the computation of NPV
2. What is the annual installment of bank loan?
3. Calculate the quarterly installments of the Financial Institution loan
4. Should the company borrow from the bank or from the financial institution?

Answer:
1.
No. of Years Net Cash Inflows Rs. (in Million) Present Value factor @ 1
3.5% Present Value factor @ 14% Present Value (13.5%) Present Value (1
4%)
1 45 0.88106 0.87719 39.64758 39.47368
2 45 0.77626 0.76947 34.93179 34.62604
3 45 0.68393 0.67497 30.7769 30.37372
4 68 0.60258 0.59208 40.97561 40.26146
5 68 0.53091 0.51937 36.10186 35.31707
6 68 0.46776 0.45559 31.80781 30.97989
7 68 0.41213 0.39964 28.0245 27.17534
8 68 0.36311 0.35056 24.69119 23.83802
9 30 0.31992 0.30751 9.597508 9.225238
10 30 0.28187 0.26974 8.455955 8.092314
5.31952 5.21612 285.0107 279.3628

From the above table it appears that present value of net cash i
nflow is 279.363 (discounted
@14%) and 285.01 (discounted @13.5%). the net present value unde
r both situation would be
as follows:

Particulars (Rs. In Lacs)

Discounted Rates 14% 13.50%
Cash Inflow 279.36 285.01
Gross Cash Outflow 250.00 250.00
Less: Scrap Value of Rs. 55 Lacs (Under PV Method) 14.84 15.50
Net Cash Outflow 235.16 234.50
Net Cash Inflow (NPV) 44.20 50.51
% of Net Cash Inflow to Net Cash Outflow 18.80 21.54

Required the rate of return of the company is 14% but estimated return based on
forecast made by the accountant is 18.8% and 21.54% as per computation of show a
bove. Hence, the company should expand its capacity to achieve expected rate of
return. The detailed computation of NPV under both discounted rate 14% / 13.5% i
s given below:

No. of Years Net Cash Inflows Rs. (in Million) Present Value factor @ 1
3.5% Present Value factor @ 14% Present Value (13.5%) Present Value (1
4%)
1 45 0.88106 0.87719 39.64758 39.47368
2 45 0.77626 0.76947 34.93179 34.62604
3 45 0.68393 0.67497 30.7769 30.37372
4 68 0.60258 0.59208 40.97561 40.26146
5 68 0.53091 0.51937 36.10186 35.31707
6 68 0.46776 0.45559 31.80781 30.97989
7 68 0.41213 0.39964 28.0245 27.17534
8 68 0.36311 0.35056 24.69119 23.83802
9 30 0.31992 0.30751 9.597508 9.225238
10 30 0.28187 0.26974 8.455955 8.092314
5.31952 5.21612 285.0107 279.3628

2. The Annual Installment of Bank Loan would be as follows:

Principal Amount of Loan = Rs. 200Lacs
Term of Repayment = 10Yrs.
Rate of Interest = 14%

Equated Annual Installment. :

A = V / P (n, i)
P (n, i) = {(1+i )n -1}/ i (1+I)n = {(1+0.14)10 – 1}/0.14 (1+0.14)10
= 5.216
Equated Annual Installment = Rs. 2, 00, 00,000/5.216
= Rs. 38, 34,335

3. The Quarterly Installments of the Financial Institution loan would be as

follows:
Principal Amount of Loan = Rs. 200Lacs
Term of Repayment = 10Yrs.
Rate of Interest = 13.5%
Equated Quarterly Installment. : A = V / P (n, i)

P (n, i) = { (1+i )n -1}/ i (1+I)n = {(1+0.3375)40 – 1}/0.3375 (1+0.3

375)40 = 21.772
Equated Quarterly Installment = Rs. 2, 00, 00,000/21.772
= Rs. 9, 18,611
4. In the event of loan taken either from bank or from financial institutio
n, the impact of interest would be as follows:
(Rs. In lacs)
Loan from Bank Loan from Financial Institution
Total amount of Repayment 38.343 x 10 = 383.43 9.186 x 40 = 367.44
Less: Principal amt of loan 200.00
200.00
Interest payable 183.43 167
.44

From the above it appears that impact of interest is less incase of loan taken f
rom financial institution.
Hence the company should borrow from financial institution. As the mode of repay
ment is quarterly basis it would be prudent to consider such repayment in view o
f easy liquidity of company’s liability.

SET - II

Q 1. A. What is the cost of retained earnings?

B. A company issues new debentures of Rs.2 million, at par; the net proceeds bei
ng Rs.1.8 million. It has a 13.5 per cent rate of interest and 7 years maturity.
The company’s tax rate is 52 percent. What is the cost of debenture issue? What w
ill be the cost in 4 years if the market value of debentures at that time is Rs.
2.2 million?
Answer:
A. Cost of retained earnings (ks) is the return stockholders require on the
company’s common stock. A company’s earnings can be reinvested in full to fuel the
ever-increasing demand of company’s fund requirements or they may be paid off to e
quity holders in full or they may be partly held back and invested and partly pa
id off. These decisions are taken keeping in mind the company’s growth stages.
High growth companies may reinvest the entire earnings to grow more, companies w
ith no growth opportunities return the funds earned to their owners and companie
s with constant growth invest a little and return the rest. Shareholders of comp
anies with high growth prospects utilizing funds for reinvestment activities hav
e to be compensated for parting with their earnings. Therefore the cost of retai
ned earnings is the same as the cost of shareholder’s expected return from the fir
m’s ordinary shares.
That is, Kr = Ke.
Capital Asset Pricing Model Approach
This model establishes a relationship between the required rate of return of a s
ecurity and its systematic risks expressed as β. According to this model, Ke = Rf
+ β (Rm — Rf)
Where Ke is the rate of return on share, Rf is the risk free rate of return, Β is
the eta of security, Rm is return on market portfolio.
The CAPM model is ased on some assumptions, some of which are:
• Investors are risk-averse.
• Investors make their investment decisions on a single-period horizon.
• Transaction costs are low and therefore can e ignored. This translates to asset
s eing ought and sold in any quantity desired. The only considerations matteri
ng are the price and amount of money at the investor’s disposal.
• All investors agree on the nature of return and risk associated with each invest
ment.

Earnings Price Ratio Approach

According to this approach, the cost of equity can e calculated as:
Ke = E1/P where E1 is expected EPS one year hence and P is the current market pr
ice per share. E1 is calculated y multiplying the present EPS with (1 + Growth
rate).
Cost of Retained Earnings and Cost of External Equity
If retained earnings are reinvested in usiness for growth activities the shareh
olders expect the
same amount of returns and therefore Ke=Kr.


ut it should e orne in mind y the policy makers that floating a new issue an
d people su scri ing to it will involve huge amounts of money towards floatation
costs which need not e incurred if retained earnings are utilized towards fund
ing activities. Using the dividend capitalization model, the following model can
e used for calculating cost of external equity.
Ke = {D1/P0(1—f)} + g
Where Ke is the cost of external equity, D1 is the dividend expected at the end
of year 1, P0 is the current market price per share, g is the constant growth ra
te of dividends is the floatation costs as a % of current market price. The foll
owing formula can e used as an approximation:
K’e = ke/(1—f)
Where K’e is the cost of external equity, ke is the rate of return required y equ
ity holders, f is the floatation cost.


. Kd = I (1 – T) + {(F-P) / n}/ {(F +P) / 2}
Where Kd is post tax cost of de enture capital, I is the annual interest payment
per unit of de enture is the corporate tax rate is the redemption price per de
enture is the net amount realized per de enture, N is maturity period
I. Cost of De enture issue is
Kd = I (1 – T) + {(F-P) / n}/ {(F +P) / 2}
= 13.5 ( 1 –0.52) + { (100 – 90) / 7} / {(100 + 90)
/ 2}
= {13.5 (1-0.52) + 1.428} /95 = 0.083 or 8.30%
II. Cost in 4years if market value of De enture is Rs.2.20 million
Kd = I (1 – T) + {(F-P) / n} / {(F +P) / 2}
= 13.5 (1 –0.52) + { (110 – 90) / 4} / { (110 +
90) / 2}
= (6.48 + 5)/100
= 0.1148 or 11.48%

Q2. Volga is a large manufacturing company in the private sector. In 2007 the co
mpany had a gross sale of Rs.980.2 crore. The other financial data for the compa
ny are given elow: (10 Marks)
 Items Rs. In crore

Net worth 152.31
orrowing

165.47
E IT 43.17
Interest 34.39
Fixed cost (excluding interest) 118.23
You are required to calculate:
a. De t equity ratio
. Operating leverage
c. Financial leverage
d. Com ined leverage. Interpret your results and comment on the Volga’s de t polic
y.

Answer:
a. De t equity ratio : - 166.47/

152.31
=
1.092
. Operating leverage: Contri ution/E IT = FC + E IT/E IT = (118.23 + 43.1
7)/43.17 = 3.73


c. Financial leverage = E IT/ E IT – Int. & Pref. Dividend = 43.17 / 4
3.17 – 34.39 = 43.17/8.78 = 4.917
d. Com ined leverage: Operating leverage x financial leverage
= 3.7838 x 4.917
= 18.379
Volga’s orrowing is Rs.165.47crore against net worth of Rs.152.31crore. It is o s
erved that company is depending on external loan. The company’s policy is to orro
w fund from outside as its earning capacity is favora le to pay interest invol
ved on such orrowal fund.
From the financial

data given a ove it is envisaged that Interest is Rs. 34.39cr
ore against E IT of Rs.43.17crores. Hence the company is in a position to pay in
terest.

Q 3. Explain Miller and Modigliani Approach to capital structure theory.

Ans.: Miller and Modigliani Approach

Miller and Modigliani criticize that the cost of equity remains unaffected y le
verage up to a reasona le limit and KO eing constant at all degrees of leverage
. They state that the relationship etween leverage and cost of capital is eluci
dated as in NOI approach. The assumptions for their analysis are:
• Perfect capital markets: Securities can e freely traded, that is, investors are
free to uy and sell securities ( oth shares and de t instruments), there are n
o hindrances on the orrowings, no presence of transaction costs, securities inf
initely divisi le, availa ility of all required information at all times.
• Investors ehave rationally, that is, they choose that com ination of risk and r
eturn that is most advantageous to them.
• Homogeneity of investors risk perception, that is, all investors have the same p
erception of usiness risk and returns.
• Taxes: There is no corporate or personal income tax.
• Dividend pay-out is 100%, that is, the firms do not retain earnings for future a
ctivities.

asic propositions: The following three propositions can e derived ased on the
a ove assumptions: Proposition I: The market value of the firm is equal to the
total market value of equity and total market value of de t and is independent o
f the degree of leverage.
It can e expressed as: Expected NOI Expected overall capitalization rate
V + (S+D) which is equal to O/Ko = NOI/Ko V + (S+D) = O/Ko = NOI/Ko
Where V is the market value of the firm,
S is the market value of the firm’s equity,
D is the market value of the de t,
O is the net operating income,
Ko is the capitalization rate of the risk class of the firm.

The asic argument for proposition I is that equili rium is restored in the mark
et y the ar itrage mechanism. Ar itrage is the process of uying a security at
lower price in one market and selling it in another market at a higher price ri
nging a out equili rium. This is a alancing act. Miller and
Modigliani perceives that the investors of a firm whose value is higher will sel
l their shares and in return uy shares of the firm whose value is lower. They w
ill earn the same return at lower outlay and lower perceived risk. Such ehavior
s are expected to increase the share prices whose shares are eing purchased and
lowering the share prices of those share which are eing sold. This switching o
peration will continue till the market prices of identical firms ecome identica
l.
Proposition II: The expected yield on equity is equal to discount rate (capitali
zation rate) applica le plus a premium.
Ke = KO + [(KO—KD) D/S]

Proposition III: The average cost of capital is not affected y the financing de
cisions as investment and financing decisions are independent.

Q4. How to estimate cash flows? What are the components of incremental cash flow
s?
Answer:
Cash flow estimation is a must for assessing the investment decisions of any kin
d. To evaluate these investment decisions there are some principles of cash flow
estimation. In any kind of project, planning the outputs properly is an importa
nt task. At the same time, the profits from the project should also e very clea
r to arrange finances in a proper way. These forecasting are some of the most di
fficult steps involved in the capital udgeting. These are very important in the
major projects ecause any kind of fault in the calculations would result in hu
ge pro lems. The project cash flows consider almost every kind of inflows of cas
h. The capital udgeting is done through the coordination of a wide range of pro
fessionals who are going to e involved in the project. The engineering departme
nts are responsi le for the forecasting of the capital outlays. On the other han
d, there are the people from the production team who are responsi le for calcula
ting the operational cost. The marketing team is also involved in the process an
d they are responsi le for forecasting the revenue.
Next comes the financial manager who is responsi le to collect all the data from
the related departments. On the other hand, the finance manager has the respons
i ility of using the set of norms for etter estimation. One of these norms uses
the principles of cash flow estimation for the process.
There are a num er of principles of cash flow estimation. These are the consiste
ncy principle, separation principle, post-tax principle and incremental principl
e. The separation principle holds that the project cash flows can e divided in
two types named as financing side and investment side. On the other hand, there
is the consistency principle. According to this principle, some kind consistency
is necessary to e maintained etween the flow of cash in a project and the rat
es of discount that are applica le on the cash flows. At the same time, there is
the post-tax principle that holds that the forecast of cash flows for any proje
ct should e done through the after-tax method.
Incremental Principle
The incremental principle is used to measure the profit potential of a project.
According to this theory, a project is sound if it increases total profit more t
han total cost. To have a proper estimation of profit potential y application o
f the incremental principle, several guidelines should e maintained:
Incidental Effects Any kind of
project taken y a company remains related to the
other activities of the firm. ecause of this, the particular project influence
s all the other activities carried out, either negatively or positively. It can
increase the profits for the firm or it may cause losses. These incidental effec
ts must e considered.
Sunk Costs These costs should not e considered. Sunk costs represent an expendi
ture done y the firm in the past. These expenditures are not related with any p
articular project. These costs denote all those expenditures that are done for t
he preliminary work related to the project, unrecovera le in any case.
Overhead Cost All the costs that are not related directly with a service ut hav
e indirect influences are considered as overhead charges. There are the legal an
d administrative expenses, rentals and many more. Whenever a company takes a new
project, these costs are assigned.
Working Capital Proper estimation is essential and should e considered at the t
ime when the udget for the project s profit potential is prepared.
Q5. What are the steps involved in capital rationing?
Answer:
Capital Rationing takes place in a firm due to the limited financial resources w
here it needs to make a choice from among profita le investment opportunities. C
apital rationing refers to a situation in which the firm is under a constraint o
f funds, limiting its capacity to take up and execute all the profita le project
s. Such a situation may e due to external factors or due to the need to impose
internal constraints, keeping in view of the need to exercise etter financial c
ontrol.
The Steps involved in Capital Rationing are:
1. Ranking of different investment proposals
2. Selection of the most profita le investment proposal
1. Ranking of different investment proposals
The various investment proposals should e ranked on the asis of their profita
ility. Ranking is done on the asis of NPV, Profita ility index or IRR in the de
scending order.
Net present value method recognizes the time value of money. Net present value c
orrectly admits that cash flows occurring at different time periods differ in va
lue. Therefore, there is need to find out the present values of all the cash flo
ws. NPV can e represented with the following formula.
Net present value = present value of cash flow - present value of cask outflows
Profita ility index is also known as enefit cash ratio. Profita ility index is
the ratio of the present value of cash inflows to initial cash outlay. The disco
unt factor ased on the required rate of return is used to discount the cash inf
lows .
P1 = Present value of cash inflows/initial cash outlay
Internal rate of return (IRR) is the rate (i .e. discount rate) which makes the
net present value of any project equal to zero. Internal rate of return is the r
ate of interest which equates the present value (PV) of cash inflows with the pr
esent value of cash outflows.
IRR is also called as yield on investment, managerial efficiency of capital, mar
ginal productivity of capital, rate of return and time adjusted rate of return.
IRR is the rate of return that a project earns. IRR can e determined y solving
the following equation for

2. Selection of the most profita le investment proposal

After ranking the different investment proposals ased on their net present valu
e, profita ility index and the internal rate of return, the selection of the mos
t profita le investment proposal is to e done. The selection is done mainly in
a view to select the investment proposal which earns more profits than compared
to the other proposals.

The asic features to e taken under consideration during the selection of the m
ost profita le investment proposal are
• The proposal should have the potentiality of making large anticipated profits
• The proposal should involve high degree of risk
• The proposal should involve a relatively long time-period etween the initial ou
tlay and the anticipated return
Q6. Equipment A has a cost of Rs.75,000

and net cash flow of Rs.20000 per year f
or six years. A su stitute equipment would cost Rs.50,000 and generate net ca
sh flow of Rs.14,000 per year for six years. The required rate of return of oth
equipments is 11 per cent. Calculate the IRR and NPV for the equipments. Which
equipment should e accepted and why?
Answer:
No. of Years Net Cash Inflows Rs. (in Million) Present Value factor @ 1
1% Present Value (14%)
1 20000 0.901 18018.02
2 20000 0.812 16232.45
3 20000 0.731 14623.83
4 20000 0.659 13174.62
5 20000 0.593 11869.03
6 20000 0.535 10692.82
 4.23054 84610.76

Equipment A
Present value of Cash Flow = 20000 x 4.23 = 84610
Less: Cash Outlay = 75000
NPV
= 9610
Equipment
Present value of Cash Flow = 14000 x 4.23 = 59220
Less: Cash Outlay = 50000
NPV = 9220

Under NPV method Equipment is prefera le ecause initial investment was much l
ess than Equipment A. The difference etween two NPV is Rs.380 whereas the diffe

rence etween total investments of two equipments is Rs.25000. Hence, Equipment
should e accepted in view of lesser cash inflow.

For Equipment A
The initial investments y avg. cash inflows = 75000/20000 = 3.75
Since the initial investment of Rs. 75000 lies etween 15% and 16% of PVIFA Ta l
e, the IRR y interpolation:
15 + (20000 *3.7845) – 75000/ {75690 - 20000 *3.6847}
15 + 75690 – 75000/ 75690 - 73694
15 + 690/ 1996
15 + 0.345 = 15.345
IRR = 15.345


For Equipment

The initial investments y avg. cash inflows = 50000/14000 = 3.57

Since the initial investment of Rs. 50000 lies etween 17% and 18% of PVIFA Ta l
e, the IRR y interpolation:
17 + {14000 *3.5892 – 50000} / {50248 - 14000 *3.4976}
17 + (50248 – 50000) / (50248 – 48966)
17 + 248/1034
17 + 0.239 = 17.239
IRR = 17.239


Under IRR method Equipment is prefera le ecause the IRR is much higher than r
equired rate of return.