CMA Final - Strategic Financial Management (SFM) | Concept Class - 5 | Capital Budgeting ‪@gkabra‬

Hello there, welcome back. How are you all? Welcome back to our channel. I'm Gaurav Kabra and as always, I have brought another awesome concept video of SFM for you all. Today we are going to discuss life disparity from capital budgeting I understand that this is an intermediate level topic. What are you doing in the final level? So see, it should have been clear in the intermediate level as well but unfortunately, I have seen till the final level that many CMA final SFM students face problems in this. That's why I am discussing life disparity well. As always, this concept video will be very detailed and very good. Watch the whole video watch it in speed if possible but this whole playlist is being made in a very amazing way for you. So watch the whole video. This playlist is very amazing for you. Let's start goes without saying If you like it, please like it. Let's start. Today's topic is life disparity and in discussing life disparity, the first situation that comes to us is that here also we are comparing two projects and will take one of them or will accept one of them. It means these are mutually exclusive projects this is for sure. I will repeat again. Mutually exclusive projects are those projects where you are doing analysis between two projects but you will select only one you will not select the other one you will reject it. In this way both are competitive both are in competition so we call them mutually exclusive The amazing thing is that NPV method already gives suggestions for mutually exclusive projects. It tells what to do and in that it is said that whichever project has more NPV, accept it. We read in case of mutually exclusive that there can be a fight between NPV and IRR still you don't want to listen to IRR you want to listen to NPV We have already discussed in this playlist all the concept videos we have made we have already given all the arguments but now comes a special case we can take decision in two mutually exclusive projects by looking at NPV we can do it if it has more NPV but there is a condition behind it that life of both the projects should be same but it is not necessary that life will always be same Life could be in disparity It means life could be different If there are two projects one of them is 5 years old and other one is 7 years old then you can't take decision by looking at NPV There is a different way to take decision and for that we read this special case which we call life disparity If someone asks you what is life disparity you have to throw light on two things No.1 Two projects are mutually exclusive This is condition No.1 and condition No.2 that life of both the projects is not same but different If this condition is there then we can apply life disparity Here we have mentioned all these things I have written here that NPV method suggests to accept the project that offers higher NPV However, life of the projects differ we cannot directly use NPV method When life of the project will differ then we cannot directly use NPV method So, what to do in life disparity In life disparity there are two methods The first method is Equivalent Annual Annuity method We can also call it EACF method Why it is known as EACF we will get to know in a minute There is another method which we call Least Common Multiple Approach This can also be used How to use this method will also be covered in this video If you ask me about both these methods then I will go on to say that our first method is more popular Let's discuss a small example Let's understand the situation and then solve it Let's take a small situation Project A and Project B If you see Investment involved is similar You are getting 5 Lakhs investment But in project A you are getting 7.5 Lakhs which you will get at the end of first year So, in second year and third year you will not get anything So, technically this project is of one year You invest 5 Lakhs today and get 7.5 Lakhs next year Your work is done If we talk about project B You are getting cash inflows in three years You are getting 2 Lakhs for first year and second year respectively and you are getting 7 Lakhs at the end of the third year If you see both the projects they are mutually exclusive You have to select one of them In both the projects direct application cannot be done because their life is different Project A's life is only one year while Project B's life is three years In such a situation if we are given cost and capital then how will we take decision So, for this we have to use both the methods which we have read above So, what happens in both the methods Let's understand Our first method is Equivalent Annual Cash Flow or Equivalent Annual Annuity What do we assume in this We assume that If there is a project whose NPV we know today then we will calculate the equivalent cash flow amount of this NPV that how much cash flow we get every year Along with this we also assume that this project can be repeated innumerable times i.e. we will get cash flows till infinity This is our assumption Let me explain again That we have NPV We want to convert this NPV into annual cash flows Along with this we also assume that this project can be repeated innumerable times 10 times, 20 times You can do it This is a small assumption What will happen with this We will keep on converting our NPV into cash flow and when we have to compare our two projects rather than comparing the NPV we will compare their cash flows It will be easier to understand But let me explain it We want to convert our NPV into cash flow Once the comparison is done then the project whose cash flow will be more on annual basis will be accepted Let's see We are doing the first method I have written the steps We will do it slowly The first step is to get the NPV of both the projects and get ready We were going to get it anyways The NPV method says the higher the NPV, the better But since the life of both the projects is not same, we will not use the decision making of NPV The second step is to get the EACF The full form of EACF is Equivalent Annual Cash Flow To get the EACF this formula will be required Which is NPV divided by PVIFA NPV divided by PVIFA Let me explain where this formula comes from This formula comes from a very basic place We have read it in time value of money Present value of annuity is equal to annuity amount into PVIFA We have read it Correct? If you look at this formula We are looking for cash flow instead of A And we have NPV instead of PV So what we have done We have put this PVIFA below the NPV And what we are looking for is our annual cash flow So in a way, this is the basic formula of time value of money which is broken down to find the EACF Now here we will assume this EACF that it will come to us every year Now you will say How will it come? If the project is of 3 years then how will it come in 5th, 6th or 7th year So this assumption is being done because we are also assuming that once the project is finished then it will be done again 12th, 14th and whatever happens after that will also be done Basically we will complete the project We will continue We will repeat In this way, the cash flow of NPV which you are generating it will not end in 1st, 2nd or 3rd year It will come to you every year And I am showing you the same thing by solving project A I will show both project A and project B First of all, compute NPV for project A which is fairly easy to compute In project A, we have only one cash flow in the name of inflow which is 7,50,000 coming at the year end of 1st year So we subtracted that from the PV, initial investment NPV is 169,750 169,750 is our NPV We have to convert this NPV into EACF For EACF, the formula is NPV divided by PVIFA So this is NPV and this is PVIFA Why did you take the same value in the name of PVIFA because it was the same year Generally, we take PVIFA 12% comma 1 So this is either PVIFA or PVIF It is the same thing Anyway, we divided it We got the value as 1,90,090 What is its interpretation? Its interpretation is that the project on which you were getting 1,69,750 NPV is equivalent to 1,90,000 Though the total amount is 1,90,090 So it is equivalent to this amount at every single year Yes, how can we assume that this NPV is once but how is the cash flow every year No, no, no, actually this NPV will come again and again So you did this project in the beginning of the first year So you will do this project in the beginning of the second year You will do it in the beginning of the third year You will do it in the beginning of the fourth year and so on You will continue it till infinity So at the beginning of every year you will get to see 1,69,750 NPV which we are converting in equivalent terms in the year-end cash flow and our year-end cash flow is 1,90,090 at the end of every single year till infinity We will do the same thing for project B We did the same thing in project B We computed the NPV and now we are converting the NPV in EACF EACF is Equivalent Annual Cash Flow So the formula is NPV divided by PVIFA So this is my NPV We divided it by PVIFA It is easy to do PVIFA We did 1.1 divided by 1.12 equal to 3 times and then we did GT So the result is 2.402 This is our PVIFA And here the value of EACF is 1,40,050 Now if we interpret this It means NPV is at 0 3,36,000 Interpretation is it will give us 1,40,000 at the end of every year Of course you will ask How will it give after 3rd year It should give after 3 years So after 3 years We will repeat this project So at the end of 3 years NPV will be again 3,36,400 So it means Now 4th year 5th year This will continue till infinity And we will receive the annual cash flow of 1,40,040 every single year So here You have to keep 2 things in mind No.1 For your project EACF will be NPV divided by PVIFA And whatever EACF will come We will assume it till infinity By thinking that The project is being repeated Project is being repeated If this happens Then you have to understand That your EACF will come continuously Goes without saying Whoever has better EACF will have better method And this is clearly in case of project A So in project A You are getting higher EACF And that is where you should decide In which project You have to invest From start to end In very limited sentences I will explain In case of mutually exclusive project If life is not same Then we call it as life disparity In case of life disparity EACF has to be calculated Which is NPV divided by PVIFA Whatever EACF will be The highest project We will accept that project There is one more catch in this Sometimes in questions They don't give you NPV In some questions They just give you cost Means it is only about cost It is not about revenue It is not about inflows In such projects EACF will be calculated as it is But because Your objective or perspective Is cost oriented Then it will not be higher the better It will be lower the better Understand Means calculate EACF After calculating EACF You have to decide when it will be higher And when it will be lower It depends on perspective If you take perspective of NPV Then it will be higher the better And if you take perspective of expenses Then in that case It will be lower the better Keep this in mind There are many questions in the book Attempt it The questions will be easy This is also a question of math So by doing this question also You will be able to understand Let's talk about the second method The second method is Least common multiple approach I will explain what is least common multiple approach First of all We take out LCM What is LCM? Your project no.1 Project no. A Is a one year project Project no. B is a three year project So we have to find a common Years In which both the projects Will be completed more than once Or whatever it is It will be completed in whole number So the result is three years How? If we do three years Anclan Then we will do A three times And we will do B once After completing three years We have attempted A three times We will do B only once Now the life of both the projects Will be same It is different It is one year and three years But if you do A three times Then the life can be considered as three years So A will be repeated three times And B will be repeated only once Now the combined life of both the projects Is three years Now they can be compared With NPV method I know you will have a question That if A and B Were different years Then how would it be? Like If A was of two years And B was of three years Then how would it be? So we consider LCM As six years And then we would repeat A three times And B two times Do you understand the logic? Ultimately we would have Brought both their life for six years And after six years Their life became same So this question of life disparity Was not there So LCM is a very simple method And I have written its steps here Step no.1 says Calculate NPV under both the projects Step no.2 says Take out LCM And see how many times You have to do it Step no.3 says Take out NPV of both the projects And see how many times How will this be solved? Let's see If we talk about project A I have written it clearly How many times we have to repeat it Because our LCM is of three years Project A is of only one year So we have to repeat project A Three times And project B is of three years So we have to do it only once And duration of three years will be covered So it is written here How will A look like? A will look like this I will explain this timeline See If we talk about project A Its timeline was like this This was 0 This was 1 If you are taking project You were getting NPV of 169750 We had computed it before You were getting NPV of 169750 When the project was of only one year But now we will extend this project And do it again And again So what does it mean? When we took project at 0 We got NPV at that time So we will get it at 1 And at 2 Will we get it at 3? No, because we get NPV At the beginning of the project So you will get NPV at 0, 1 and 2 So three times You are getting NPV at project 1 Reason is also very simple We have done this project three times So if you see its timeline You will understand Yes, we got NPV at 0 We got NPV at 1 We got NPV at 2 Now You have to do PVIFA Of all the NPV I have done PVIFA But while applying formula I have applied formula Of annuity due Why annuity due? Because we are getting NPV at 0 So it is beginning Of the year cash flow Not end of the year cash flow So it should be solved in such a way That when you do PV Think about annuity due Not ordinary annuity If I have become too technical About time value of money So forgive me So its NPV should be 169750 Plus You don't have to do PV of first one Because it is already at 0 If you want to do PV of second one Then multiply it by 0.893 If you want to do PV of third one Then multiply it by 0.751 This is the factor Clear So here All the factors Will be considered And after that Our PV will come PV value is 4,56,668 So 0 doesn't have to do PV 1 has to do PV 2 has to do PV It can be written like this 169750 Plus 169750 Divided by 1.12 to the power 1 Plus 169750 Divided by 1.12 To the power 3 Sorry to the power 2 Clear So in this way also it can be written We solved it Result is in front of us It is wrong in Institute's Math Wrong means See the mistake in Institute's Math I am showing you You can see in your module Where least common multiple use is discussed There they have solved this Illustration They have solved this And they have believed that You will get NPV at the end of first year Then at the end of second year And at the end of third year They should have thought a little Whoever is making this book They should have thought a little Then they would have thought That project's NPV is not found at the end It is found at the beginning And this structure should have been Not at 1,2,3 but at 0,1,2 Because of this They have made it wrong at the end of 1,2,3 Result is 407482 I am sure After seeing this mistake The one who is making this Institute's Math Will say that it was a big mistake It was a blunder Because it is a blunder It is a very big blunder You are teaching finance And that too at the final level How can you make such a basic mistake When is your project's Cashflow falling If you don't have an idea about this How is this book of finance being made So this is a very big mistake And because of this it was a very big mistake It was a blunder I think here A statement should come out That yes it is a mistake It is a big mistake Especially if it is a mistake while explaining a concept Then I feel a little pain for those self study candidates That how will you do self study When your concepts are becoming so weak So this is an attempt To make such videos from this playlist Which will correct your concepts I hope we are able to do it If you are getting a little clarity about this Then just stay in this playlist And keep liking videos Keep commenting I get a lot of encouragement from this Let's move ahead Let's do project B So there is no need to do project B Project B's NPV is 3,36,400 It is already at zero Remember this You didn't repeat You did project A three times But you did project B only once And its NPV is already at zero So there is no need to bring it further to zero And that's why Both of them can be directly compared The NPV on project A Is coming around 4,56,000 Whereas The NPV on B is 3,36,000 Clearly project A Is a better project Because its PV of NPV is higher So both the methods You can use EACF method Or you can use LCM method Result will be same in both the methods I agree that both methods have different ways But the result of both Will be same Means the decision will be same Numbers will be different Because both approaches are different So this was an amazing concept video In which I tried to Explain this life disparity to you Again goes without saying If this was an intermediate level topic I would have given more time to explain it But because this was a final level topic I think you already knew About it That's why I was touching only important issues And kept these things in front of you If you feel that You need more elaborate video Then put it in the comment I will definitely try To make more elaborate video That's all for now I hope you enjoyed this concept class See you in next concept class Bye Bye