Feasibility using two methods, MARR 15%

Importance of capital budgeting

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

Feasibility of the project

Net annual cash flow = 25,00,000 - 4,50,000 = Rs 20,50,000. The salvage value of Rs 40,00,000 is received at the end of year 5. MARR = 15%.

Method 1: Present worth (net present value)

$$\begin{aligned} (P/A, 15\%, 5) &= 3.3522, \quad (P/F, 15\%, 5) = 0.4972\\ PW &= -1{,}00{,}00{,}000 + 20{,}50{,}000 \times 3.3522 + 40{,}00{,}000 \times 0.4972\\ &= -11{,}39{,}375 \end{aligned}$$

(With exact factors; rounded table factors give about -11,39,190.)

PW is negative, so the project is not feasible at MARR = 15%.

Method 2: Internal rate of return

Solve $-1{,}00{,}00{,}000 + 20{,}50{,}000\,(P/A,i,5) + 40{,}00{,}000\,(P/F,i,5) = 0$.

• At $i = 10\%$: PW = 2,54,798 (positive)
• At $i = 15\%$: PW = -11,39,375 (negative)

So the IRR lies between 10% and 15%. By trial (interpolating between 10% and 11%), IRR = 10.83%, which is less than MARR = 15%, so the project is not feasible.

(Check by benefit-cost ratio: $B/C = \dfrac{PV\ \text{of benefits}}{PV\ \text{of costs}} = \dfrac{88{,}60{,}625}{1{,}00{,}00{,}000} = 0.886 < 1$; the annual worth = -3,39,893.)

Answer: PW = Rs -11,39,375 and IRR = 10.83% < 15%; the project is not feasible.