capital budgeting narain notes

7/30/2019 Capital Budgeting narain notes

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F CA Ranjee t K unwar

B r i g h t P r o f e s s i o n a l s ( P ) L T D . 1 / 5 3 , L a l i t a P a r k , L a x m i n a g a r , D e l h i - 9 2

P h o n e

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Capital Budgeting

Capital Budgeting and Time value of moneyMeaning and Concepts:

Capital budgeting is commonly referred to as a fixed- asset management, when integrated with the financial

managers goal of attaining proper combinations of assets (i.e. optimal asset mix ) fixed assets assume a great

deal of significance . Fixed assets are also frequency termed as the earning assets of the firm since they usuallygenerate large returns.

Such return is contrary to the limited earning power of and returns from short term assets.

It is the decision making process by which the firms evaluate the purchase of major fixed assets. It involves

firms decision to invest its current funds for addition, disposition, modification and replacement of long-term or

fixed assets. Capital budgeting decision involve the entire process of decision making relating to acquisition of

long-term assets whose returns are expected to arise over a period beyond one year, planning and control of

capital expenditures is a major decision area in any organisation. Its basic features can be summarised asfollows:

(i) It has the potentially of making large anticipated profits(ii) It involves a high degree of risk(iii) It involves a relatively long-term period between the initial outlay and the anticipated return.

Significance of Capital Budgeting

There are several factors and consideration which make the capital budgeting decisions as the most important

decisions of a finance manager. The relevance and signify of capital budgeting may be stated as follows:

(a) Long term effects: the most important features of a capital budgeting decision and which makes the

capital budgeting so significant is that these decisions have long term effects on the risk and return

composition of the firm. These decisions affect the future position of the firm to a considerable extent as

the capital budgeting decisions have long term implications and consequences. By taking a capital

budgeting decision, a finance manager in pact makes a commitment into the future, both by committing

to the future needs of funds of the projects and by committing to its future implications.

(b) Substantial commitments: the capital budgeting decisions generally involve large commitment of

funds and as a result substantial portion of capital funds are blocked in the capital budgeting decisions,

otherwise the firm may suffer from the heavy capital losses in time to come. It is also possible that the

return from projects may not be sufficient enough to justify the capital budgeting decision.

(c) Irreversible decisions: most of the capital budgeting decisions are irreversible decisions. Once taken,

the firm may not be in a position to revert back unless it is ready to absorb heavy losses, which may result

due to abandoning a project in midway.

(d) Affect the capacity and strength to compete: The capital budgeting decisions affect the capacity and

strength of a firm to face the competition. A firm may lose competitiveness of the decision to modernise is

delayed or not rightly taken. Similarly, a timely decision to take over a minor competitor may ultimately

result even in the monopolistic position of the firm.


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Capital Budgeting

Kinds of Capital Budgeting Decisions

Since capital budgeting includes the process of generating, evaluating, selecting and following up on capital expenditure

alternatives, allocation of financial resources should be made by the firm to its new investment projects in the most efficient

manner. A firm may adopt the following three types of capital budgeting decisions:

(i) Mutually Exclusive Projects

It means if a firm accepts one project, it may rule out the necessity for other, i.e. the alternatives are mutually exclusive and

only one is to be chosen.

(ii) Accept- Reject Decisions

The proposals which yield a higher rate of return in comparison with a certain rate of return or cost of capital are accepted

and naturally, the others are rejected. For example, if the minimum acceptable return from a project is say 10%, after tax

and an investment proposal which shows a return of 12%, may be accepted and another project which gives a return of 8%

only may be rejected.

In other words, using Net Present Value Method Criterion an investment opportunity will be accepted if NPV>0, or, the same

will be rejected if NPV< 0. That is, all independent projects are accepted under this criterion. It is to be noted that

independent projects are those which do not compete with one another, i.e. the acceptance of one precludes the acceptanceof other. At the same time, those projects which will satisfy the minimum investment criterion should be taken into

consideration.

(iii) Capital Rationing Decision

Capital rationing is normally applied to situations where the supply of funds to the firm is limited in some way. As such, the

term covers many different situations ranging from that where the borrowings and lending rates faced by the firm differ to

that where the funds available for investments are strictly limited.

In other words, it occurs when a firm has more acceptable proposals than it can finance. At this point, the firm ranks the

projects from highest to lowest priority and as such, a cut-off point is considered.

Naturally, those proposals which are above the cut-off point will be accepted and those which are below the cut-off point are

rejected, i.e. ranking is necessary to choose the best alternatives.

Capital Budgeting Techniques

Accounting Rate of Return Pay Back Period

Net Present Internal Rate Profitability TerminateValue of Return Index Value

Traditional or Non-discountingor, Unsophisticated

Time-Adjusted or Discounted Cash Flowsor, Sophisticated


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Capital Budgeting

Traditional or non-discounted cash flow techniques.

(a) Payback period

The term pay-back refers to the period in which the project will generate the necessary cash to recoup the initial

investment.

For example, if a project requires Rs. 20,000 as initial investment and it will generate on annual cash inflow of

Rs. 5,000 for 10 years, the pay-back period will be 4 years, calculated as follows:-

Pay-back period =flowincashannual

investmentinitital

=000,5

000,20

The annual cash inflow is calculated by taking into account the amount of net income on account of the asset

before depreciation but after taxation. The income so earned if expressed as a percentage of initial

investment, is termed as unadjusted rate of return.

Unadjusted rate of return = 100investmentinitial

returnannual

= %25100000,20

5000

Advantages

(i) It is simple to apply, easy to understand and of particular importance to business which lack theappropriate skills necessary for more sophisticated techniques.

(ii) In case of capital rationing, a company is compelled to invest in projects having shortest paybackperiod.

(iii) This method gives an indication to the prospective investors specifying when their funds are likely tobe repaid.

(iv) Ranking projects according to their ability to repay quickly may be useful to firm when experiencingliquidity constraints.

Disadvantages

(i) It does not indicate whether an investment should be accepted or rejected, unless the payback periodis compared with an arbitrary managerial target.

(ii) If fails to take into account the timing of returns and the cost of capital. It fails to consider the wholelife of a project.

(iii) The traditional payback approach does not consider the salvage value of an investment. The bailoutpayback method concentrates on the abandonment alternative.

(iv) This method makes no attempt to measure a percentage return on the capital investment and isoften used in conjunction with other methods.

(v) The investment in projects with long payback periods are made with long-term planning and maynot yield highest returns for a number of years and the payback method is biased against such

investments.


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Capital Budgeting

(b) Average rate of return (ARR) method

According to this method, the capital investment proposals are judged on the basis of their relative profitability.

For this purpose, capital employed and related incomes are determined according to commonly accepted

accounting principle and practices over the entire economic life of the project and then the average yield is

calculated. Such a rate is termed as accounting rate if return. It may be calculated according to any of the

following methods.

(I) 100investmentoriginal

earningsnetAverageAnnual

(II) 100investmentAverage

earningsnetAverageAnnual

Average Investment: - (Initial Cost +Installation Expenses-Salvage Value) + Salvage Value

Advantages of ARR

(i) The most significant attribute of ARR is that it is very simple to understand and easy to calculate,

(ii) It can be easily computed on the basis of accounting data which are furnished by the financial statements.

Disadvantages of ARR

(i) The principal shortcoming of ARR is that it recognises only the accounting income instead of cash flows.

(ii) It does not recognise the time value of money.

(iii) It does not take into consideration the length of lives of the projects.

(iv) It does not consider the fact that the profits may be re-invested

Modern or Discounted Cash Flow Techniques

Time Value of Money

One of the most important principles in all of finance is the relationship between value of a rupee today and

value of rupee in future. This relationship is known as the 'time value of money'. A rupee today is more valuable

than a rupee tomorrow. This is because current consumption is preferred to future consumption by the

individuals, firms can employ capital productively to earn positive returns and in an inflationary period, rupee

today represents greater purchasing power than a rupee tomorrow.

The value of money received today is different from the value of money received after some time in the future.

The preference of money now, as compared to future money is, known as time preference for money.

A rupee today is more valuable than a rupee after a year due to several reasons.

Inflation: Under inflationary conditions the value of money, expressed in terms of its purchasing powerover goods and services, declines.

Risk: Re. 1 now is certain, whereas Re.1 receivable tomorrow is less certain. This bird-in-the-handprinciple is extremely important in investment appraisal.

Personal consumption preference: Many individuals have a strong preference for immediate rather


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Capital Budgeting

than delayed consumption. The promise of a bowl of rice next week counts for little to the hungry man

Investment opportunities: Many like any other desirable commodity have a price, given the choice ofRs. 100 now or the same amount in one years time it is always preferable to take the Rs. 100 nowbecause it could be invested over the next year at say) 16 per cent interest rate to produce Rs. 116 at the

end of one year. If 16 per cent is the best return available then you would be indifferent to receiving Rs.

100 now or Rs. 116 in one years time. Expressed another way, the present value of Rs. 116 receivable

one year hence is Rs. 100.

The time value of the money may be computed in the following circumstances.

(a)Future value of a single cash flow

(b)Future value of an annuity

(c)Present value of a single cash flow

(d)Present value of an annuity

Future Value of a Single Cash Flow

For a given present value (PV) of money, future value of money (FV) after a period t' for which compounding is

done at an interest rate of r, is given by the equationFV = PV (1 + r)t

This assumes that compounding is done at discrete intervals. However, in case of continuous compounding, the

future value is determined using the formula

FV = PV * ert

Where e' is a mathematical function called 'exponential' the value of exponential (e) = 2.7183.

The compounding factor is calculated by taking natural logarithm (log to the base of 2.7183).

Example 1: Calculate the value of a deposit of Rs.2,000 made today, 3 years hence if the interest rate is 10%.

By discrete compounding:

FV = 2,000 * (1+0.10)3 = 2,000 * (1.1)3 = 2,000 * 1.331 = Rs. 2,662

By continuous compounding:

FV = 2,000 * e (0.10*3) =2,000 * 1.349862 = Rs. 2699.72

Example 2. Find the value of Rs. 70,000 deposited for a period of 5 years at the end of the period when the

interest is 12% and continuous compounding is done.

Future Value = 70,000* e(0.12*5) = Rs. 1,27,548.827.

The future value (FV) of the present sum (PV) after a period 't' for which compounding is done m' times a year at

an interest rate of r, is given by the following equation:

FV = PV (1 + (r/m)) ^mt

Example 3: How much a deposit of Rs. 10,000 will grow at the end of 2 years, if the nominal rate of interest is 12

% and compounding is done quarterly?

Future value = 10,000 *(1+0.12/4)4*2 = Rs. 12,667.70


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Capital Budgeting

Future Value of an Annuity

An annuity is a stream of equal annual cash flows. The future value (FVA) of a uniform cash flow (CF) made at

the end of each period till the time of maturity t for which compounding is done at the rate V is calculated as

follows:

r (1+ r)t-1

FVA = CF*l + r)t-1 + CF* (1+ r)t-2+ ...+ CF*(l + r)1+CF

= CF (1+r)t- 1)

r

The term (1+r)t- 1) is referred as the Future Value Interest factor for an annuity (FVIFA).

r

The same can be applied in a variety of contexts. For e.g. to know accumulated amount after a certain period,; to

know how much to save annually to reach the targeted amount, to know the interest rate etc.

Example 4: Suppose, you deposit Rs.3,000 annually in a bank for 5 years and your deposits earn a compound

interest rate of 10 per cent, what will be value of this series of deposits (an annuity) at the end of 5 years?Assume that each deposit occurs at the end of the year.

Future value of this annuity is:

= Rs.3000*(1.10)4 + Rs.3000*(1.10)3 + Rs.3000*(1.10)2 + Rs.3000*(1.10)+ Rs.3000

= Rs.3000*(1.4641) + Rs.3000*(1.3310) + Rs.3000*(1.2100) + Rs.3000*(1.10)+ Rs.3000

= Rs. 18315.30

Example 5: You want to buy a house after 5 years when it is expected to cost 40 lakh how much should you save

annually, if your savings earn a compound return of 12 %?

The annual savings should be: 4000000/6.353 = 6,29,623.80

In case of continuous compounding, the future value of annuity is calculated using the formula:

FVA = CF * (ert-1)/r.

Present Value of a Single Cash Flow

Present value of (PV) of the future sum (FV) to be received after a period 't' for which discounting is done at an

interest rate of V, is given by the equation

In case of discrete discounting: PV = FV / (1+r)t

Example 6: What is the present value of Rs.5,000 payable 3 years hence, if the interest rate is 10 % p.a.

PV =5000/(1.10)3 i.e. = Rs.3756.57

In case of continuous discounting: PV = FV * e-rt

Example 7: What is the present value of Rs. 10,000 receivable after 2 years at a discount rate of 10% under continuous

discounting?

Present Value = 10,000/(exp^(0.1*2)) = Rs. 8187.297


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Capital Budgeting

Present Value of an Annuity

The present value of annuity is the sum of the present values of all the cash inflows of this annuity.

Present value of an annuity (in case of discrete discounting)

PVA = FV[{(l + r)t - 1}/{r*(l + r)t}]

The term [(1+r)1 - 1/ r*(1+r)t1] is referred as the Present Value Interest factor for an annuity (PVIFA).

Example 8: What is the present value of Rs. 2000/- received at the end of each year for 3 continuous years

= 2000*[1/1.10] + 2000*[1/1.10]^2+2000*[1/1.10]^3

= 2000*0.9091+2000*0.8264+2000*0.7513

= 1818.181818+1652.892562+1502.629602

= Rs. 4973.704

Example 9: Assume that you have taken housing loan of Rs.10 lakh at the interest rate of Rs.ll percent per annum. What

would be you equal annual installment for repayment period of 15 years?

Loan amount = Installment (A) *PVIFA n = 15, r=ll%

10,00,000 = A* [(1+r)t

-1/r*(1+r)t

]10,00,000 = A* [(1.11)^15 - 1/ 0.11(1.11^15]

10,00,000 = A* 7.19087

10,00,000/7.19087 = A

A = Rs. 1,39,065.24

Present value of an annuity (in case of continuous discounting) is calculated as:

PVa - FVa * (l-e-rt)/r

(a) Net present value method

This is generally considered to be the best method for evaluating the capital investment proposals. In case if this

method cash inflows and cash outflows associated with each project are first worked out. The present value ofthese cash inflows and outflows in then calculated at the rate of return acceptable to the management this rate

of return is considered as the out-off rate and is generally determined on the basis of cost of capital suitably

adjusted to allow for the risk element involved in the project. The working capital is taken as cash out flow in the

year the project starts commercial production.

The net present value (NPV) is the difference between the total present value of future cash inflows and the total

present value of future cash inflows and future cash outflows.

Equation for NPV

NPV =

n

n

K

R

K

R

K

R

K

R

K

R

111101

0

3

3

2

2

1

1

R = cash inflows at different time

K = cost of capital

The decision Rule: the decision rate under the NPV method is: accept the proposal if its NPV is positive andreject the proposal if the NVP is negative. NPV represents the excess of benefits over the costs in real terms.


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Capital Budgeting

In case of ranking of mutually exclusive proposals, the proposal with the highest positive NVP is given the top

priority and the proposal with the lowest positive NPV is assigned the lowest priority. The proposals with

negative NPV should be rejected. However, if NVP is 0 then firm may be indifferent between acceptance and

rejection of the proposal.

(i) It recognizes time value of money.

(ii)It also recognizes all cash flows throughout the life of the project.

(iii)It helps to satisfy the objectives for maximizing firm's values.

(iv)This method is particularly useful for the selection of mutually exclusive projects.

Disadvantages

(i) It is difficult to calculate as well as understand it as compared to accounting rate of return method orpayback method.

(ii) It does not present a satisfactory answer when there are different amounts of investments for thepurpose of comparison.

(iii) It does not also present a correct picture in case of alternative projects or where there are unequal

lives of the project with limited funds.

(iv) The NPV method of calculation is based on discount state which again depends on the firm's cost ofcapital. The latter is to some extent difficult to understand as well as difficult to measure in actual

practice.

(b) Profitability Index (PI)

PI is defined as the benefits (in present value terms) per rupee invested in the proposal. This technique which is a

variant of the NPV technique, is also known as benefit-cost ratio, or present value index the PI is based upon the

basis concept of discounting the future cash flows and is ascertained by comparing the present value of the

future cash inflows with the present value of the future cash outflows. The PI is calculated by dividing the former

by the latter.

PI=outflowscashofvauepresentTotal

lowscashofvaluepresentTotal inf

The decision Rule: under the PI technique, the decision rule is: accept the project if its PI is more than I and

reject the proposal if the PI is less than I. if the PI is equal to 1, then the firm may be indifferent because the

present value of inflows is expected to be just equal to the present value of outflows.

(c) Internal Rule of return (IRR)

Internal rate of return is the rate at which the sum of discounted cash inflows equals the sum of discounted cash

outflows. In other words, it is the rate which discounts the cash flows to zero.

It can be stated in the form of a ratio as follows:

1inf

outflowsCash

lowsCach

Thus, in case if this method the discount rate is not known bit the cash outflows and cash inflows are known.

For example, if a sum of Rs. 800 invested in a project becomes Rs. 1000 at the end of a year, the rate of return

comes to 25% calculated as follows:

I =VI

R

I = cash outflow

K = cash inflow


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Capital Budgeting

R = rate of return yielded by the investment

In case of return is over a number of years, the calculation would take the following pattern

I =

nv

Rn

v

R

v

R

v

R

11113

3

2

2

1

1

I = cash outflowR = cash inflow at different time periods

R = Rae of return yielded by the investment

The decision Rule: - In over to make a decision on the basis of IRR technique the firm has to determine, in the

firm instance, its own required rate of return (K)

A particular proposal may be accepted if its IRR (v) is more than the minimum rate I.e. (k), otherwise rejected.

However, if the IRR is just equal to the minimum rate, k, the firm may be indifferent. In case of mutually exclusive

proposals, the proposal with the highest IRR is given the top priority

Advantages

(i) It recognises the time value of money like Net Present Value Method;

(ii) It also takes into account the cash flows throughout the life of the project;

(iii) This method also reveals the maximum rate of return and presents a fairly good idea about theprofitability of the project even if the firm's cost of capital is absent since the latter is not a precondition

for use of it;

(iv) The percentage which is calculated under the method is more meaningful and justified and that is why itis acceptable to the users since it satisfies them in relation to cost of capital.

Disadvantages

(i) The method of calculation is no doubt complicated and it is difficult to use and understand the same.

(ii) This method does not present unique answers under all circumstances and situations. It may evenpresent a negative rate or multiple rates under certain circumstances.

(iii) This method recognizes the fact that intermediate cash inflows which are generated by the project arere-invested at the internal rate whereas the NPV method recognises that cash inflows are reinvested at

the firm's cost of capital which is more appropriate and justified in comparison with IRR method.

(iv) It may present inconsistent result with the NPV method when the projects actually differ from theirexpected life or cash outlays or timing of cash flows.

Conflict in results under NPV and IRR

NPV and IRR methods may give conflicting results in case of mutually exclusive projects, i.e., projects where

acceptance of one world result in non-acceptance of the other such conflict of result may be due to any one or

more of the flowing reasons:

(i) The projects require different cash outlays(ii) The projects have unequal loves.(iii) The projects have different patterns of cash flows.


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Capital Budgeting

In such a situation, the result given by the VPN method should be relied upon. This is because the objective of a

company is to maximise its shareholders wealth. IRR method is concerned with. The rate of return on investmentrather than total yield on investment hence it is not compliable with the goal of wealth maximisation. NPV

method considers the total yield on investment. Hence, in case if mutually exclusive projects, each having a

positive NVP, the one with largest NPV will have the most beneficial effect on shareholder is wealth.

The IRR approach solves for a rate unique to each project, while the NPV approach solves for the trade-off cash

inflows and outflows using a general required rate of return. On the basis of the above discussion of NPV and IRR,a comparison between the two may be attempted as follows:

(a) Advantage of IRR over NPV: IRR may be considered superior to the NPV for the following reasons :

i) IRR gives percentage return while the NPV gives absolute return.

ii) For IRR, the availability of required rate of return is not a pre-requisite while for NPV it ismust.

(b) Advantage of NPV over IRR: The NPV is said to have superiority over IRR for

i) NPV shows expected increase in the wealth of the shareholders.

ii) NPV gives clear cut accept-reject decision rule, while the IRR may give multiple results also.

iii) The NPV of different projects are stabilizer while the IRR cannot be added.iv) NPV gives better ranking as compare to the IRR.

Terminal Value (TV) Method

Under this method, it is assumed that each cash inflow is re-invested in another asset at a certain rate of return

and calculating the terminal value of net cash flows at the end of project life.

In short, the NCF and the outlay are compounded forward rather than backward by discounting which is used by

NPV method.

Acceptance Rule

From the foregoing discussion it becomes clear that if the value of the total compounded re-invested cash flows is

greater than the present value of outflow, i.e. if NCF have a higher terminal value in comparison with the outlay,

the project is accepted and vice-versa. The accept-reject rule can, thus, be formulated as under:

(1) If there is a single project : Accept the project if the terminal value (TV) is positive,

(2) If there are mutually exclusive projects : The project will be more profitable which has

a highest positive terminal value (TV).

It can also be stated that if TV is positive, accept the project and if TV is negative, reject the project.

It should be remembered that TV method is similar to NPV method. The only difference is that in case of former,values are compounded while in case of latter, values are discounted, of course, both of them will present the same

result provided the rate is same.


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Capital Budgeting

LEASE FINANCING

CONCEPT OF LEASING:

Leasing, as a financing concept, is an arrangement between two parties, the leasing company or lessor and the user

or lessee, whereby the former arranges to buy capital equipment for the use of the latter for an agreed period to

time in return for the payment of rent. The rentals are predetermined and payable at fixed intervals of time,

according to the mutual convenience of both the parties. However, the lessor remains the owner of the equipment

over the primary period. By resorting to leasing, the lessee company is able to exploit the economic value of the

equipment by using it as if he owned it without having to pay for its capital cost. Lease rentals can be conveniently

paid over the lease period out of profits earned from the use of the equipment and the rent is cent percent tax

deductible.

FORMS OF LEASE RENTALS:

The lease rentals may be quoted in several forms, for instance

(i) Level or constant period

(ii) Stepped where the lease rental increases at a fixed percentage over the earlier period,

(iii) Deferred, where the rental is deferred for certain periods to accommodate gestation period,

(iv) Ballooned under which major part of the rentals is collected in a lump sum at the end of the primary period,

(v) Bell shaped where the rental is gradually stepped up, rises to its peak in the middle of the lease period and is

then gradually stepped down and

(vi) Zig-zag where the rental is stepped up in one period and then stepped down in the succeeding period and so on.


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Capital Budgeting

1. The cost of plant of Rs. 6,00,000. It has an estimated life of 5 years after which it would bedisposed-off (scrap value nil). Profit before depreciation, interest and taxes (PBIT) is

estimated to be Rs. 2,50,000 p.a. Find out the yearly cash flow from the plant. (Given thetax rate @ 40%).

2. RMS Ltd. is evaluating a capital budgeting proposal for which relevant figures are as follows:

Cost of the plant Rs. 15, 00,000Installation cost Rs. 5,000Economic life 7 yearsScrap value Rs. 50,000

Profit before depreciation and tax Rs. 2,50,000Tax rate 40%Calculate yearly cash flows.

3. A firm buys an asset costing Rs. 2,00,000 and expects operating profits ( beforedepreciation @ 15% WDV and tax @ 40%) of Rs. 35,000 p.a. for the next 4 years after

which the asset would be disposed-off for Rs. 1,40,000. find out the cash flows for differentyears.

4. Following is the income statement of a project, on the basis of which calculate the annualcash inflows.

Income statement of the project

Net sales revenue Rs. 5,75,000

- Cost of goods sold Rs. 2, 00,000- General expenses Rs. 1, 00,000

- Depreciation 60,000 3,60,000profit before interest and taxes 2,15,000

- interest 25,000

Profit before tax 1,90,000- tax @ 40% 76,000

Profit after tax 1,14,000

5. Jaydev Ltd. in considering an investment proposal for which the relevant information is asfollows:

Rs.

Purchase price of the new asset 10,00,000Installation costs 2,00,000Increase in working capital in year zero 2,50,000Scrap value of the new assets after 4 years 3,50,000Revenues from new asset (annual) 21,50,000Cash expenses on new asset (annual) 9,50,000Current book value (old asset) 3,00,000

Present scrap value (old asset) 5,00,000Revenue from old asset (annual) 19,25,000Cash expenses on old asset 11,25,000

Planning period, 4 years. Tax rate 30%

Practice Questions


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4 7 6 6 5 5 5 5 ( 3 0 L i n e s ) , 9 8 1 1 1 3 6 9 8 7 , 9 8 1 1 0 4 2 4 5 8 78

Capital Budgeting

Depreciation on new asset: 94% the cost is to be depreciated in the ratio of 5:6:7:4 over 4years.

Existing asset is depreciated at a rate of Rs. 1,10,000 p.a.

6. Ramjee & Co. is considering a proposal to replace one of its old plant costing Rs. 80,000

and having a written down value of Rs. 25,000. The remaining economic life of the plant is4 years after which it will have no salvage value. However, if sold today, it has a salvagevalue of Rs. 20,000. The new machine costing Rs. 1,50,000 is also expected to have a life

of 4 years with a scrap value of Rs. 15,000. The new machine, due to its technologicalsuperiority, is expected to contribute additional annual benefit (before depreciation andtax) of Rs. 65,000. Find out the cash flows associated with this decision given that the tax

rate applicable to the firm is 40%. (The capital gain or loss may be taken as not subject totax.)

7. Gopikant Ltd. is interested in assessing the cash flows associated with the replacement ofan old machine by a new machine. The old machine bought a few years ago has a bookvalue of Rs. 95,000 and it can be sold for Rs. 95,000. It has a remaining life of five years

after which its salvage value is expected to be nil. It is being depreciated annually at therate of 15% per cent (written down value method).

The new machine costs Rs. 4,20,000. It is expected to fetch Rs. 2,00,000 after five yearswhen it will no longer be required. It will be depreciated annually at the rate of 30%(written down value method.) The new machine is expected to bring a saving of Rs.1,30,000 in manufacturing costs. Investment in working capital would remain unchanged.The tax rate applicable to the firm is 40 %.

8. Ramlal & co. firm is currently using a machine which was purchased two years ago for Rs.70,000 and has a remaining useful life of 5 years.

It is considering to replace the machine with a new one which will cost Rs. 1,40,000 . Thecost of installation will amount to Rs. 10,000. The increase in working capital will be Rs.30,000. The expected cash inflows before depreciation and taxes for both the machines are

as follows;

Year existing machine new machine

1 30,000 50,0002 30,000 60,0003 30,000 70,000

4 30,000 90,0005 30,000 1,00,000

The firm use straight line method of depreciation. The average tax on income as well as oncapital gain/loss is 40%.

Calculate the incremental cash flows assuming sale value of existing machine. (i) Rs. 80,000(ii) Rs. 60,000 (iii) Rs. 50,000, (iv) Rs. 30,000

9. Kailashgiri Ltd. is trying to decide whether it should replace a manually operated machinewith a fully automatic version of the same machine. The existing machine, purchased ten

years ago, has a book value of Rs. 1,60,000 and remaining life of 10 years. Salvage valuewas Rs. 50,000. The machine has recently begun causing problems with breakdowns and iscosting the company Rs. 24,000 per year in maintenance expenses. The company has been


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Capital Budgeting

offered Rs. 1,00,000 for the old machine as a trade-in on the automatic model which has adeliver price (before allowance for trade-in) of Rs. 2,10,000. It is expected to have a ten-year life and a salvage value of Rs. 25,000. The new machine will require installationcosting Rs. 50,000 to the existing facilities, but it is estimated to have a cost savings inmaterials of Rs. 85,000 per year. Maintenance costs are included in the purchase contractand are borne by the machine manufacturer. The tax rate is 40% (applicable to bothrevenue income as well as capital gains/losses). Straight line depreciation over ten years

will be used. Find out the relevant cash flows.

10. Udarraj Ltd. purchased a special machine one year ago at a cost of Rs. 25,000. At that timethe machine was estimated to have a useful life of 6 years and no salvage value. Theannual cash operating cost is approximately Rs. 21,000. A new machine has just come on

the market which will do the same job but with an annual cash operating cost of only Rs.15,000. The new machine costs 30,000 and has an estimated life of 5 years with zerosalvage value. The old machine can be sold for Rs. 10,000 to a scrap dealer. Straight line

depreciation is used. And the companys income tax rate is 40 %. Assuming a cost ofcapital of 10%, you are required to compute the incremental cash flows after taxes:

11. Tiripati Ltd. is considering installing a machine costing. Rs. 5,00,000 with an additional

investment of Rs. 1, 50,000 for its installation. The salvage value at the end of year 10 isestimated at Rs. 2,50,000. The machine is estimated to generate sales revenue of Rs.20,00,000 in the first year and the sales are expected to grow at 5% p.a. for the remaininglife of the machine. The profit after tax is expected at 10% of the sales while the workingcapital requirement is expected to be 5% of the sales. Find out the cash flows generated bythe machine given that

1. The machine is depreciated as per straight line method, and2. The additional working capital is required in the beginning of the year and is fully

salvageable year 10.

12. The initial outlay of the project is Rs. 1,00,000 and it generates cash inflows of Rs. 50,000, Rs.

40,000, Rs. 30,000 and Rs. 20.000 in the four years of its life span. You are required tocalculate the following:

(a)Net Present Value (NPV)(b)Profitability Index (PI)

(c)Discounted payback period of the project assuming 10% rate of discount.

Present value of Re. 1 due at the end of a periods at 10% rate of discount.

Year 1 2 3 4 5PV Fatl0% 0.909 0.826 0.751 0.683 0.621

13. Siddhvinayak Ltd. is considering the purchase of a new machine. Two alternative machines

have been suggested, each costing Rs. 4,00,000 earnings after tax but before depreciation areexpected to be as follows:

Year Cash-FlowsMachine Machine B

1 40,000 1,20,000

2 1,20,000 1,60,000

3 1,60,000 2,00,000

4 2,40,000 1,20,000

5 1,60,000 80,000

7,20,000 6,80,000


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Capital Budgeting

The company has a target rate of return on capital @ 10% and on this basis, you are required:

(i) Compare profitability (NPV) of the machines and state which alternative you considerfinancially preferable.

(ii) Compute the payback period for each project and.

(iii) Compute annual rate of return for each project.

14. Gopi Ltd. is considering the purchase of new machine. Two machine A and B are available,each costing Rs. 5 lakhs. In comparing the profitability of the machine, a discounting rate of

10% is to be used and machine is to be written off in five years by straight line method ofdepreciation with nil residual value. Cash inflows after tax are expected as follows:

Year Machine A Machine B(Rs. In lakhs) (Rs. In lakhs)

1 1.5 0.52 2.0 1.5

3 2.5 2.5

4 1.5 3.05 1.0 2.0Indicate which machine would be profitable using the following methods of ranking investment

proposals;

(i) Pay back method;(ii) Net present value method;

(iii) Profitability index method ; and(iv) Average rate of return method.

The discounting factors at 10% are

Year 1 2 3 4 5

Discounting factor 0.909 0.826 0.751 0.683 0.621

15. Hariom Ltd. has decided to purchase a machine to increase the installed capacity. There are threemachines under consideration. The relevant details including estimated yearly expenditure are

sales are given below: All sales are on cash and income tax rate is 40%.

Machine A Machine B Machine C

Initial investment required Rs. 6, 00,000 Rs. 6, 00,000 Rs. 6, 00,000

Estimated annual sales 9, 00,000 8, 00,000 8, 50,000Cost of production (estimate):

Direct materials 80,000 90,000 88,000Direct labour 90,000 60,000 76,000

Factory overheads 90,000 90,000 88,000

Administration costs 30,000 20,000 35,000Selling and distribution costs 30,000 20,000 30,000

The economic life of machine A is 2 years, while it is 3 years for the other two. The scrap values

are Rs. 70,000, Rs. 45,000 and Rs. 60,000 respectively.

You are required to find most investment based onPay Back Method.


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Capital Budgeting

16. Nitse Ltd. decided to purchase a machine to increase the installed capacity.

The company has four machines under consideration. The relevant details including estimated yearlyexpenditure and sales are given below. All sales are for cash. Corporate Tax Rate @ 33.99% (inclusive ofSurcharge @ 10%, Eduction cess @ 2% and Secondary & Higher Education cess @ 1%)

Particulars M1 M2 M3 M4Initial Investment (Rs. lacs) 30.00 30.00 40.00 35.00

Estimated Annual Sales (Rs. lacs) 50.00 40.00 45.00 48.00Cost of Production (Estd) (Rs. lacs) 18.00 14.00 16.70 21.00Economic Life (yrs) 2 3 3 4Scrap Values (Rs. lacs) 4.00 2.50 3.00 5.00

Calculate Payback Period

17.A project costing Rs. 10 lacs. EBITD (Earnings before Depreciation, Interest and Taxes) during the first fiveyears is expected to be Rs. 2,50,000; Rs. 3,00,000; Rs. 3,50,000; Rs. 4,00,000 and Rs. 5,00,000. Assume33.99% tax and 30% depreciation on WDV Method.

18. Project Cost Rs. 1,10,000

Cash Inflows :Year 1 Rs. 60,000Year 2 Rs. 20,000Year 3 Rs. 10,000Year 4 Rs. 50,000

Calculate the Internal Rate of Return.

19. The Income Statement of Bertrand Russell Ltd. for the current year is as follows:

Sales 7,00,000Less: Costs

Material 2,00,000Labour 2,50,000

Other operating costs 80,000Depreciation 70,000 6,00,000

EBIT 1,00,000Less: Taxes: @ 40% 40,000EAT 60,000

The plant manager proposes to replace an existing machine by another machine costing Rs. 2,40,000. Thenew machine will have 8 years life having no salvage value. The old machine will realise Rs. 40,000.Income statement does not include the depreciation on old machine (the one that is going to be replaced)as the same had been fully depreciated, for a few years more. It is believed that there will be no change inother expenses and revenues of the firm due to this replacement. The company requires an after tax return10%. The rate of tax applicable to companys income is 40%. Should the company buy the new machine,assuming that the company follows straight line method of depreciation and the same is allowed for tax

purposes?.

20. A firm whose cost of capital is 10% is considering two mutually exclusive projects A and B, thedetails of which are:

Year Project A Project BCost 0 2,00,000 2,00,000

Cash inflows 1 20,000 1,00,0002 40,000 80,000

3 60,000 40,0004 80,000 20,000

5 1,20,000 20,000


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Capital Budgeting

Compute the net present value at 10%. Profitability index and internal rate of return for the

two projects.

21. Ramveer Ltd. considers following mutually exclusive projects.

Project A Project B

Present Value of cash inflows Rs. 20,000 Rs. 8,000Initial cash outlay 15,000 5,000Net present value 5,000 3,000

Profitability index 1.33 1.6

Which project should be preferred and why?

22. Following details are provided you to evaluate which machine should be selected on the basisof NPV approach?

Machine A costs Rs. 2,00,000 payable at Zero time.

Machine B costs Rs. 1,90,000 half payable immediately and half payable in one years time.

Receipt costs expected are as follows:

Year (at end) Machine A Machine B1 Rs. 30,000 10,000

2 50,000 70,0003 30,000 80,000

4 35,000 70,000

5 20,000 -------At 8% opportunity cost, which machine should be selected on the basis of NPV?

23. Jayram Ltd. is considering a new project for which the investment data are as follows:Capital outlay Rs. 3, 00,000Depreciation 20% p.a.

Estimated annum income before charging depreciation, but after all other charges are asfollows:

Year

1 1,50,000

2 1,50,0003 90,0004 90,000

5 80,000

You are required to evaluate above project on the basis of following technique.

(a) Payback Period method.

(b) Rate of return on original investment.

24. Ram managing director of a private company has to consider the following project.

Cost Rs. 5,00,000

Cash inflows:Year

1 50,000

2 50,0003 1,00,0004 4,80,000

Calculate the IRR and comment on the project if the cost of capital is 14%.


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Capital Budgeting

25. Arundev Ltd. is considering a new five year project. Its investment costs and annual profits areprojected as follows:

Year Rs.

Investment

Profits

0

1

23

4

5

(5,00,000)

1,80,000

1,60,00040,000

1,20,000

80,000

The residual value at the end of the project is expected to be Rs. 40,000 and depreciation of

the original investment is on straight line basis. Using average profits and average capitalemployed calculated the ARR for the project and the payback period.

26. An investment of Rs. 1,36,000 yields the following cash inflows (profits before depreciation butafter tax).

Year 1 2 3 4 5

Cash flows 30,000 40,000 60,000 30,000 20,000PVF at 10% 0.90

0.826 0.751 0.683 0.621

PVF at 12% 0.893 0.797 0.712 0.636 0.567

Calculate NPV at discount rate 10% and 12%. Also calculate IRR.

27. Ramdayal Ltd. proposes to install a machine involving a capital cost of Rs. 3,60,000. The life ofthe machine is 5 years and its salvage value at the end of the life is nil. The machine willproduce the net operating income after depreciation of Rs. 68,000 per annum. The company's

tax rate is 45%. The Net Present Value factors for 5 years are as under:

Discounting Rate 14% 15% 16 % 17% 18%

Cumulative factor 3.43 3.35 3.27 3.20 3.13

You are required to calculate the internal rate of return of the proposal.

28. Following are the data on a capital project being evaluated by the management of Gopal Ltd.:

Annual cost saving Rs. 40,000

Useful life 4 years

I.R.R. 15%

Profitability Index (P.I.) 1.064

NPV ?

Cost of capital ?

Cost of project ?

Payback ?

Salvage value 0Find the missing values considering the following table of discount factor only:

Discount factor 15% 14% 13% 12%

1year 0.869 0.877 0.885 0.893

2year 0.756 0.769 0.783 0.797

3year 0.658 0.675 0.693 0.712

4year 0.572 0.592 0.613 0.636

2.855 _____ 2.913 ____ 2.974 _____ 3.038

29. Kailash Ltd. has an investment opportunity costing Rs. 3,00,000 with the following expected cashinflow (i.e. after tax and before depreciation):


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Capital Budgeting

Year Inflows PVF(10%) year inflows PVF(10%.)1 50,000 0.909 6 50,000 0.5642 50,000 0.826 7 30,000 0.513

3 55,000 0.751 8 50,000 0.467

4 55,000 0.683 9 30,000 0.4245 50,000 0.621 10 40,000 0.386

Using 10% as the cost of capital determine the

(i) Net present value; and(ii) Profitability index.

30. Tirupati Ltd. requires an initial investment of Rs. 1,00,000. The estimated net cash flows are asfollows:

Year 1 2 3 4 5

Net cash 16,000 17,000 18,000 17,000 15,000

Year 6 7 8 9 10

20,000 30,000 40,000 25,000 10,000

Using 10% as the cost of capital (rate discount) determine the following:

(i) Pay Back (ii) Net Present Value and (iii) Internal Rate of Return.

31. Ramdeen Ltd. is considering the replacement of its existing machine which is outdated and unableto meet the rapidly rising demand for its product.

The company has two alternatives:

(i) to buy machine A which is similar to the existing machine or

(ii) to go in for machine B which is more expensive and has much greater capacity. The cashflows at the present level of operations under the two alternatives are as follows;

Cash flows ( in lacs ) at the end of year:

Time 0 1 2 3 4 5

Machine A -25 -- 2 20 14 14

Machine B -40 10 14 16 17 15

The companys cost of capital is 10%. The finance manager tries to evaluate the machines by

calculating the following:

1. Net present value,2. Profitability index,3. Pay- Back period,

At the end of his calculations, however, the finance manager is unable to make up his mind as to

which machine to recommend. You are required to make these calculation and in the light thereof toadvise the finance about the proposed investment.

Present values of re. 1 at 10% discount rates is as follows:Year 0 1 2 3 4 5

P. V. 1.00 .91 .83 .75 .68 .62


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Capital Budgeting

32. Prabhu Ltd. is forced to choose between two machines A and B. The two machines are designeddifferently, but have identical capacity and do exactly the same job. Machine A costs Rs.1,50,000 and will last for 3 years. It costs Rs. 40,000 per year to run. Machine B is an

economy' model costing only Rs. 1,00,000, but will last only for 2 years and costs Rs. 60,000per year to run. Cost of capital is 10%. Which machine should buy?

33. Ramjee Ltd. is considering installing either of the two machines which are mutually exclusive. Thedetails oftheir purchase price and operating costs are:

Year Machine X Machine Y

Purchase cost 0 Rs. 10,000 Rs. 8,000Operating cost 1 Rs. 2,000 Rs. 2,500

Operating cost 2 Rs. 2,000 Rs. 2,500





Operating cost 7 Rs. 3,000Operating cost 8 Rs. 3,000

Operating cost 9 Rs. 3,000

Operating cost 10 Rs. 3,000

Machine X will recover salvage value of Rs. 1,500 in the year 10, while Machine Y will recover Rs. 1,000 in theyear 6. Determine which machine is cheaper at 10 per cent cost of capital, assuming that both the machines

operate at the same efficiency.

34. A project with 5 years life requires initial investments as underPlant and Machinery Rs. 2,70,500Working Capital Rs. 40,000

Rs. 3,10,500

The working capital will be fully realized at the end of the 5 th year. The scrap value of the plantexpected to be realized at the end of the 5 th year is only Rs. 5,500. The earnings from project

are:

Year 1 2 3 4 5

Cash flows Rs. 90,000 Rs. 1,30,000 Rs. 1,70,000 Rs. 1,16,000 Rs. 19,500(before depreciation & tax)

Tax payable Rs. 20,000 Rs. 30,000 Rs. 40,000 Rs. 26,000 Rs 5,000

You are required to compute the present value of cash follows discounted at the various ratesof interests given below and state the return from the project.

PVF at Interest rate 15% 14% 13% 12%1Year 0.869 0.877 0.885 0.8932 Year 0.756 0.769 0.785 0.7973 Year 0.658 0.675 0.693 0.7124 Year 0.572 0.592 0.613 0.6365 Year 0.497 0.519 0.543 0.567


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Capital Budgeting

35. Bramha Ltd. is considering two different investment proposals, A and B details are as under:

Proposal A Proposal B

Investment cost Rs. 9,500 Rs. 20,000Year1 4,000 8,000

Year 2 4,000 8,000

Year 3 4,500 12,000

Suggest the most attractive proposal on the basis of the NPV method considering that the

future incomes are discounted at 12% also find out the IRR of the two proposals.

36. The cash flows from two mutually exclusive projects A and B are as under;

Years Project A Project B

0 Rs. 22,000 Rs. 27,0001-7 (annual) 6,000 7,000

Project life 7 years 7 years

i) Calculate NPV of the proposals at discount rates of 15%, 16%, 17%, 18%, 19% and 20%.ii) Advise on the project on the basis of IRR method.

37. Tirudev Ltd. had the option to buy either Machine A or Machine B. Machine A has a cost of Rs.75,000. Its expected life is 6 years with no salvage value at the end. It would generate netcash flows of Rs. 20,000 per year. Machine B on the other hand would cost Rs. 50,000. Its

expected life is 6 years with no salvage value at the end. It would generate net cash of Rs.15,000 per year. Assuming that the cost of capital of both the machines is 10%, you arerequired to calculate:

a) Net present value for each machine.

b) Internal rate of return for each machinec) Which machine should be recommended and shy?

38. Harigovind Ltd. is evaluating three investment situations. If only the project in question is undertaken, the expected present values and the amounts of investment required are

Project InvestmentRequired

Present value offuture cash flows

123

$200,000115,000270,000

$290,000185,000400,000

If projects 1 and 2 are jointly undertaken, there will be no economics, there will be noeconomics, the investments required and present value will simply be the sum of the parts.With projects 1 and 3, economics are possible in investment because one of the machinesacquired can be used in both production processes. The total investment required for projects 1and 3 combined is $ 440,000. If projects 2 and 3 are undertaken, there are economics to beachieved in marketing and producing the products but not in investment. The expected presentvalue of future cash flows for projects 2 and 3 is $ 620,000. If all three projects are undertakensimultaneously, the economics noted will still hold. However, a $125,000 extension on the plantwill be necessary, as space is not available for all three projects. Which project or projectsshould be chosen?


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Capital Budgeting

39. Surya Ltd. Has Rs. 30 lacs available for investment in capital projects. It has the option ofmaking investment in projects 1,2,3 and 4. Each project is entirely independent and has a

useful life of 5 years. The expected present value of cash flows the projects are as follows:

Projects Initial Outflow PV of Cashflows1 8,00,000 10,00,000

2 15,00,000 19,00,000

3 7,00,000 11,40,0004 13,00,000 20,00,000

Which of the above investment should be undertaken? Assume that the cost of capital is 12%

and risk free interest rate is 10% per annum.Compounded sum of Re. 1 at 10% in 5 years is Rs. 1.611 and discount factor of Re. at 12%

rate for 5 years is 0.567

40. Radheshyam Ltd. is considering its capital investment (Rs. 12 lacs) programme for next year. Ithas five projects all of which give a positive NPV at the company cut-off rate of 15%. The

investment outflows and PV being as follows:

Project Investment (Rs.) NPV @ 15% (Rs.)

A

BCD

E

500000

400000250000300000

350000

154000

187000101000112000

193000

You are required to optimize the returns from a package of projects within the capital spending

limit. The projects are independent of each other and are divisible (i.e. part-project is

possible).

41. Five Projects M, N, O, P and Q are available to a company for consideratio.

The investment required for each project and the cash flows it yields are tabulated below. Projects N and Qare mutually exclusive. Taking the cost of capital @ 10%, which combination of projects should be takenup for a total capital outlay not exceeding Rs. 3 lakhs on the basis on NPV and Benefit-Cost Ratio (BCR)?

Project Investment Cash flow p.a. No of years P.V. @ 10%M 50,000 18,000 10 6.145N 1,00,000 50,000 4 3.170O 1,20,000 30,000 8 5.335P 1,50,000 40,000 16 7.824Q 2,00,000 30,000 25 9.077

Total Capital outlay < Rs. 3.00 lakhs

42. Gopi Ltd. is considering 5 capital projects for the years 2002, 2003, 2004, 2005. The companyis financed by equity entirely and its cost of capital is 12%. The expected cash flows of the

projects are as follows:

project Years and cash flows

2002 2003 2004 2005

A

BC

DE

(70,000)

(40,000)(50,000)

--(60,000)

35,000

(30,000)(60,000)

(90,000)20,000

35,000

45,00070,000

55,00040,000

20,000

55,00080,000

65,00050,000


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Capital Budgeting

All projects are divisible i.e. size of investment can be reduced, if necessary in relation to

availability of funds. None of the projects can be delayed or undertaken more than once.Calculate which project should undertake if the capital available for investment is limited to Rs.

1,10,000 in year 2002 and with no limitation in subsequent years. For your analysis, use the

following PVF:

Year 2002 2003 2004 2005PVF 1.00 0.89 0.80 0.71

43. A share of the face value of Rs. 100 has current market price of Rs. 480. Annual expected dividend is30%. During the fifth year, the shareholder is expecting a bonus in the ratio of 1:5. Dividend rate isexpected to be maintained on the expanded capital base. The shareholder intends to retain the share tillthe end of the eighth year. At that time the value of share is expected to be Rs. 1,000. Incidentalexpenses at the time of purchase and sale are estimated at 5% on the market price. There is no tax ondividend income and capital gain. The shareholder expects a minimum return of 15% p.a.Should he buy the share? What is the maximum price he can pay for the share? Show complete working.

44. Ramjee Ltd. is in the business of manufacturing. It has a plant on a piece of land measuring twoacres which was purchased ten years ago for Rs. 10 lacs. The firm is now planning to set up

another plant on the same land. 50% of the existing plot is to be earmarked for this purpose.The accountant has supplied the following information:

Capital expenditure for setting up new plant (incurred in the beginning of the year):

Year 1 Cost of land 5,00,000Land development 2,00,000

Payment to building contractor 15,00,000Payment for purchase of machine 20,00,000

Year 2 Final payment to building contractor 15,00,000

Final payment to machine supplier 70,00,000

The plant has an estimated useful life of 5 years and the company follows SLM of depreciation.

The information regarding sales and operational expenses is as follows:

Year 1 2 3 4 5

Sales (Rs. Lacs) 25 30 35 40 45

Expenses (Rs. Lacs) 5 7 10 12 15

During first year and last year, all sales will be cash sales. In others, 10% of sales will be on

credit for a period of one year. If the companys rate of discount is 15% and the tax rate is50%, should the above proposal be accepted.

45. Thomas Alva Edison Limited, a highly profitable company, is engaged in the manufacture of powerintensive products. As part of its diversification plans, the company proposes to put up a Windmill togenerate electricity. The details of the scheme are as follows:

(1) Cost of the Windmill Rs. 300 lakhs

(2) Cost of Land Rs. 15 lakhs

(3) Subsidy from State Govenment to be received at the end of first year of installation Rs. 15 lakhs

(4) Cost of electricity will be Rs. 2.25 per unit in year 1. This will incerease by Rs. 0.25 per unit everyyear till year 7.

After that it wil increae by Rs. 0.50 per unit.

(5) Maintennce cos will be Rs. 4 lakhs in year 1 and the same will increase by Rs. 2 lakhs every year.


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Capital Budgeting

(6) Estimated life 10 years.

(7) Cost of capital 15%.

(8) Residual value of Windmill will be nil. However land value will go up to Rs. 60 lakhs, at the end ofyear 10.

(9) Depreciation will be 10% of the cost of the Windmill in year 1 and the same will be allolwed for taxpurposes.

(10) As Windmills are expected to work based on wind velocity, the efficiency is expected to be anaverage 30%. Gross electricity generates at this level will be 25 lakh units per annum. 4% of thiselectricity generated will be committed free to the State Electriciy Board as per the agreement.

(11) Tax rate 50%.

From the above information you are required to:

(a) Calculate the Net Present Value. [Ignore tax on capital profits.]

(b) List down two non-financial factors that should be considered before taking a decision.

For your exercise use the following discount factors.

Year 1 2 3 4 5 6 7 8 9 10PVF 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25

46. Determine which of the following two mutually exclusive projects should be selected it may are :(i) One-off investments or(ii) It they can be repeated indefinitely:

(Rs.)Particulars Project A Project BInvestment 40,000 60,000Life 4 years 7 years

Annual net cash inflows 15,000 16,000Scrap value 5,000 3,000

Cost of capital is 15%. Ignore taxation. The Present Value of annuity for 4 years and 7 years at 15% arerespectively 2.8550 and 4.1604 and the discounting factors at 4 years/7 years respectively 0.5718 and 0.3759.

47. Appa Ltd. is evaluating the following two mutually exclusive proposals.

Project X Project YOutlay 80,000 1,20,000

Annual net inflow 30,000 32,000

Life 4 years 7 years

Scrap value 10,000 6,000

Evaluate the proposals if the discount rate is 15%.

48. During the manufacturing process the Gopikant Ltd. is generating 1,00,000 units waste materialper annum. The waste material can be processed further and sold @ Rs. 1000 per unit and thevariable cost of processing comes to 70% of selling price.

Out of the processed waste material, 25% can be refabricated at a cost of Rs. 100 per unit. theprefabricated product can be sold at a price of 1500 per unit and there is a waste of 20% of

processed material at the time of refabrication.

The refabrication procedure requires


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Capital Budgeting

(i) A Plant costing Rs. 1,00,00,000 with life 5 years . (Depreciation is chargeable @ 25%WDV) and

(ii) Additional working capital of Rs. 10,00,000.

Evaluate the proposal to refabricate the processed waste material given that:

(i) Required rate of return if 15%

(ii) Tax rate applicable of company is 30%.(iii) Expected salvage value of the plant is Rs. 10,00,000.

(iv) There is no other asset in the same block of assets.

49. Ramdhun Ltd. wants to installed computer for office work. For this purpose two models haveshortlist, for which the relevant information is as follows:

Model I Model IICost 1,50,000 2,50,000

Salvage value nil 20,000

Working capital required 50,000 70,000Savings in expense 1,00,000 p.a. 1,50,000 p.a.Life 5 years 5 years

Depreciation 15% W. D. V. 15% W.D. V.

Find out which model is better given that

(i) Tax rate is 30% .

(ii) Required rate of return is 13% .(iii) There is no other asset in the same block of assets.

50. Asmi industries Ltd. is expanding its operations and is in the middle of replacing one of its plant(original cost Rs. 10,00,000 life 10 years, Dec. @ 15% WDV) which has a remaining life of 6years. This machine has a salvage value of Rs. 2,00,000 at present.

The new machine being considered for replacement is costing Rs. 15,00,000 ( salvage value10% at the end of 6 years). The important data regarding new machine are as follows:

Incremental revenue 5,00,000Fixed cost (excluding depreciation) unchanged

Variable cost 30%

Depreciation rate 15% WDV.(i) the required rate decision given that 10%

(ii) rate of tax 30%

(iii) There are several assets in the same block of assets.

51. An oil company proposes to install a pipeline for transport of crude from wells to refinery. Investments andoperating costs of the pipeline very for different sizes of pipelines (diameter). The following details havebeen conducted :

(a) Pipeline diamter (in inches) 3 4 5 6 7(b) Investment required (Rs. lakhs) 16 24 36 64 150(c) Gross annual savings in operating

Costs before depreciation (Rs. lakhs) 5 8 15 30 50

The estimated life of the installation is 10 years. The oil companys tax rate is 50%. There is no salvage valueand straight line rate of depreciation is followed. Calculate the net savings after tax and cash flow generationand recommend therefrom, the largest pipeline to be installed, if the company desires a 15% post-tax return.

Also indicatewhich pipeline will have the shortest payback. The annuity P.V. factor at 15% for 10 years is5.019.


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Capital Budgeting

52. Indo Plastics Ltd. is a manufacturer of high quality plastic products. Rasik, President, is consideringcomputerizing the companys ordering, inventory and billing procedures. He estimates that the annualsavings from computerization include a reduction of 4 clerical employees with annual salaries of Rs.50,000 each, Rs. 30,000 from reduced production delays caused by raw materials inventory problems, Rs.25,000 from lost sales due to inventory stock outs and Rs. 18,000 associated with timely billingprocedures.

The purchase price of the system in Rs. 2,50,000 and installation costs are Rs. 50,000. These outlays willbe capitalized (depreciated) on a straight line basis to a zero books salvage value which is also its marketvalue at the end of five years. Operation of the new system requires two computer specialists with annualsalaries of Rs. 80,000 per person. Also annual maintenance and operating (cash) expenses of Rs. 22,000are estimated to be required. The companys tax rate is 40% and its required rate of return (cost of capital)for this project is 12%

You are required to(i) Evaluate the project using NPV method;(ii) Evaluate the project using PI method;(iii) Calculate the Projects payback period.

Note :

(a) Present value of annuity of Re. 1 at 12% rate of discount for 5 years is 3.605.(b) Present value of Re. 1 at 12% rate of discount, received at the end of 5 years is 0.567.

53. Deenanath Ltd. is presently operating with a machine X (WDV of Rs. 1,00,000, Salvage valuetoday Rs. 50,000) and it can be used for next 5 years to general net annual earning of Rs.

1,50,000 (before depreciation). The salvage value after 5 years is expected to be Rs. 5000only.

The machine could be replaced by a new machine costing Rs. 4,00,000 ( life 5 years, salvage

value Rs. 20,000). The new machine is expected to generate net annual earnings of Rs.

3,00,000 (before depreciation)

The firm depreciates its asset @ 15% WDV and there is no other asset in the same block ofasset. Evaluate the replacement proposal.

Tax rate is 30% and cost of capital is 20%.

54. JJ Associates is considering to acquire an asset costing Rs. 5,00,000. The company has an offerfrom a bank to lend @15%. The principal amount is repayable in 5 years end installments. Aleasing company has also submitted a proposal to the company to acquire the asset on lease at

yearly rentals of Rs. 300 per Rs. 1,000 of the assets value for 5 years payable at year end. The

salvage value of the asset at the end of 5 years period is estimated to be Rs. 1,000. Whetherthe company should accept the proposal of bank or leasing company, if the effective tax rate of

the company is 40% and discount rate is 15%?

55. William Ford Ltd. has received 3 proposals for the acquisition of an assets on lease costing Rs. 1,50,000.

Option I : The terms of offer envisaged payment of lease rentals for 96 months. During the first 72months, the lease rentals were to be paid @ Rs. 30 p.m. per Rs. 1,000 and during the reamining 24months @ Rs. 5 p.m. per Rs. 1,000. At the expiry of lease period, the lessor has offered to sale the assetsat 5% of the original cost.

Option II : Lease agreement for a period of 72 months during whcih lease rentals to be paid per monthper Rs. 1,000 are Rs. 35, Rs. 30, Rs. 26, Rs. 24, Rs. 22 and Rs. 20 for next 6 years. At the end of leaseperiod the asset is proposed to be abandoned.


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Capital Budgeting

Option III : Under this offer a lease agreement is proposed to be signed for a period of 60 monthswherein an initial lease deposit to the extent of 15% will be made at the time of signing of agreement.Lease rentals @ Rs. 35 per Rs. 1,000 per months will have to be paid for a period of 60 months on theexpiry of leasing agreement, the assets shall be sold against the initial deposit and the asset is expectedto last for a further period of three years.

You are required to evaluate the proposals keeping in view the following parameters.

(i) Depreciation @ 25%

(ii) Discounting rate @ 15%

(iii) Tax rate applicable @ 40%

The monthly and yearly discounting factors @ 15% discount rate are as follows:

Period 1 2 3 4 5 6 7 8Monthly 0.923 0.765 0.685 0.590 0.509 0.438 0.377 0.325Yearly 0.869 0.756 0.658 0.572 0.497 0.432 0.376 0.327

56. The following details relate to an investment proposal of Freud Ltd.

Investment outlay Rs. 100 lakhsLease Rentals are payable at Rs. 180 per Rs.1000

Term of lease 8 years

Cost of capital for the firm is 12%

Find the Present Value of Lease Rentals if

a. Lease Rentals are payable at the end of the year

b. Lease Rentals are payable at the beginning of the year

57. Find out Loan payments per annum for the following :

Cost of Equipment : Rs. 50 lakhsBorrowing rate : 15%Term of Loan : 5 years

a. Principal is payable in equal investment over the period of five years

b. Amount of Loan is payable equally over the period of five years

Prepare a table showing principle & interest payments and the total payable overperiod of five years.

58. Mao Leasing Company is considering a proposal lease out a school bus. The bus can be purchased forRs. 50,0000 and in turn, be leased out at Rs. 125000 per year for 8 years with payments occuring at theend of each year.

(a) Estimate the IRR for the company assuming tax is ignored.

(b) What should be the yearly lease payment charged by the company in order to earn 20% annualcompounded rate of return before expenses and taxes?

(c) Calculate the annual lease rent to be charged so as to amount to 20% after tax annual compoundedrate of return, based on thr following assumptions :

i. Tax rate is 40%ii. Straight Line Depreciationiii. Annual expenses of Rs. 50000, andiv. Resale value Rs. 100000 after the turn.


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Capital Budgeting

59. ABC and Co. is considering two mutually exclusive machines A and B. the company usescertainty Equivalent approaches to evaluate the proposals. The estimated cash and certainty

equivalents for both machines are as follows:

Machine X Machine Y

Year Cash flow Cer. Eqult. Cash flow Cer. Equilt.

0 30,000 1.00 40,000 1.00

1 15,000 .95 25,000 .902 15,000 .85 20,000 .80

3 10,000 .70 15,000 .704 10,000 .65 10,000 .60

Which machine should be accepted, if the risk free discount rate is 5 percent?

60. You are required to determine the Risk Adjusted Net Present Value of the following projects:G K R

Net cash outlay (Rs.) 1,00,000 1,20,000 2,10,000Project life 5 years 5 years 5 years

Annual cash inflow (Rs.) 30,000 42,000 70,000Coefficient of Variation 0.4 0.8 1.2

The company selects the risk adjusted rate of discount on the basis of the coefficient of variation;

Coefficient of Risk adjusted rate Present Value factor 1 to 5Variation of discount years at Risk Adjusted

Rate of discount0.0 10% 3.791

0.4 12% 3.605

0.8 14% 3.4331.2 16% 3.274

1.6 18% 3.1272.0 22% 2.864

More than 2.0 25% 2.689

61. Nine Gems Ltd. has just installed Machine-R at a cost of Rs. 2,00,000. The machine has a five year life with no residualvalue. The annual volume of production is estimated at 1,50,000 units, which can be sold at Rs. 6 per unit. Annualoperating costs are estimated at Rs. 2,00,000 (excluding depreciation) at this output level. Fixed costs are estimated atRs. 3 per unit for the same level of production.Nine Gems Ltd. has just come across another model called Machine-S capable of giving the same output at anannual operating cost of Rs. 1,80,000 (exclusive of depreciation).There will be no change in fixed costs. Capitalcost of this machine is Rs. 2,50,000 and the estimated life is for five years with nil residual value.

The company has an offer for sale of Machine-R at Rs. 1,00,000. But the cost of dismantling and removal willamount to Rs. 30,000. As the company has not yet commenced operations, it wants to sell Machine R and

purchase Machine-S.

Nine Gems Ltd. will be a zero-tax company for seven years in view of several incentives and allowances available.

The cost of capital may be assumed at 14%. P.V. factors for five years are as follows:

Year P.V. Factors

1 0.877

2 0.769

3 0.675

4 0.592


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Capital Budgeting

5 0.519

(i) Advise whether the company should opt for the replacement.

(ii) Will there be any change in your view if Machine-R has not been installed but the company is in the process ofselecting one or the other machine?

Support your view with necessary workings. (Final-Nov. 1996) (12 marks)

62. A large profit making company is considering the installation of a machine to process the waste produced by one of itsexisting manufacturing process to be converted into a marketable product. At present, the waste is removed by acontractor for disposal on payment by the company of Rs. 50 lacs per annum for the next four years. The contract can beterminated upon installation of the aforesaid machine on payment of a compensation of Rs. 30 lacs before theprocessing operation starts. This compensation is not allowed as deduction for tax purposes.The machine required for carrying out the processing will cost Rs. 200 lacs to be financed by a loan repayable in 4equal installments commencing from the end of year 1. The interest rate is 16% per annum. At the end of the 4 thyear, the machine can be sold for Rs. 20 lacs and the cost of dismantling and removal will be Rs. 15 lacs.

Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:

(Rs. In lacs)

Year 1 2 3 4

Sales 322 322 418 418Material consumption 30 40 85 85

Wages 75 75 85 100

Other expenses 40 45 54 70

Factory overheads 55 60 110 145

Depreciation (as per income tax rules) 50 38 28 21

Initial stock of materials required before commencement of the processing operations is Rs. 20 lacs at the start ofyear 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be Rs. 55 l acs and the stocksat the end of year 4 will be nil. The storage of materials will utilise space which would otherwise have been rented outfor Rs. 10 lacs per annum. Labour costs include wages of 40 workers, whose transfer to this process will reduce idle

time payments of Rs. 15 lacs in the year 1 and Rs. 10 lacs in the year 2. Factory overheads include apportionment ofgeneral factory overheads except to the extent of insurance charges of Rs. 30 lacs per annum payable on thisventure. The companys tax ra te is 50%.

Present value factors for four years are as under:

Year 1 2 3 4

Present value factors 0.870 0.756 0.658 0.572

Advise the management on the desirabili ty of instal ling the machine for processing the waste. All calculations should formpart of the answer. (Final-May 1999) (20 marks)

63.(a) Company X is forced to choose between two machines A and B. The two machines are designed differently, but have

identical capacity and do exactly the same job. Machine A costs Rs. 1,50,000 and will last for 3 years. It costs Rs. 40,000per year to run. Machine B is an economy model costing only Rs. 1,00,000, but will last only for 2 years, and costs Rs.60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing power.Ignore tax. Opportunity cost of capital is 10 per cent. Which machine company X should buy?

(b) Company Y is operating an elderly machine that is expected to produce a net cash inflow of Rs. 40,000 in the comingyear and Rs. 40,000 next year. Current salvage value is Rs. 80,000 and next years value is Rs. 70,000. The machinecan be replaced now with a new machine, which costs Rs. 1,50,000, but is much more efficient and will provide acash inflow of Rs. 80,000 a year for 3 years. Company Y wants to know whether it should replace the equipment nowor wait a year with the clear understanding that the new machine is the best of the available alternatives and that it inturn be replaced at the optimal point. Ignore tax. Take opportunity cost of capital as 10 percent. Advise with reasons.

(Final-May 2000) (12 + 8 marks)


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Capital Budgeting

64. X Ltd. an existing profit-making company, is planning to introduce a new product with a projected life of 8 years. Initialequipment cost will be Rs. 120 lakhs and additional equipment costing Rs. 10 lakhs will be needed at the beginning ofthird year. At the end of the 8 years, the original equipment will have resale value equivalent to the cost of removal, butthe additional equipment would be sold for Rs. 1 lakh. Working capital of Rs. 15 lakhs will be needed. The 100% capacityof the plant is of 4,00,000 units per annum, but the production and sales-volume expected are as under:

Year Capacity in percentage

1 20

2 30

3-5 75

6-8 50

A sale price of Rs. 100 per unit with a profi t volume ratio of 60% is li kely to be obtained. Fixed Operating Cash Cost arelikely to be Rs. 16 lakhs per annum. In addition to this the advertisement expenditure will have to be incurred as under:

Year 1 2 3-5 6-8

Expenditure in Rs. lakhs each year 30 15 10 4

The company is subjected to 50% tax, straight-line method of depreciation, (permissible for tax purposes also) and taking12% as appropriate after tax cost of Capital, should the project be accepted? (Final-May 2002) (14 marks)

65. A company proposes to install a machine involving a Capital Cost of Rs.3,60,000. The life of the machine is 5 years andits salvage value at the end of the life is nil. The machine will produce the net operating income after depreciation ofRs.68,000 per annum. The Companys tax rate is 45%.

The Net Present Value factors for 5 years are as under:

Discounting Rate : 14 15 16 17 18

Cumulative factor : 3.43 3.35 3.27 3.20 3.13

You are required to calculate the internal rate of return of the proposal.

(PE-II-Nov. 2002) (4 marks)

66. The cash flows of projects C and D are reproduced below:

Cash Flow NPV

Project C0 C1 C2 C3 at 10% IRR

C Rs.10,000 + 2,000 + 4,000 + 12,000 + Rs.4,139 26.5%

D Rs.10,000 + 10,000 + 3,000 + 3,000 + Rs.3,823 37.6%

(i) Why there is a conflict of rankings?

(ii) Why should you recommend project C in spite of lower internal rate of return?

Time 1 2 3

Period

PVIF0.10, t 0.9090 0.8264 0.7513

PVIF0.14, t 0.8772 0.7695 0.6750

PVIF0.15, t 0.8696 0.7561 0.6575

PVIF0.30, t 0.7692 0.5917 0.4552

PVIF0.40, t 0.7143 0.5102 0.3644

(PE-II-May. 2003) (8 marks)

67. Beta Company Limited is considering replacement of its existing machine by a new machine, which is expected to costRs.2,64,000. The new machine will have a life of five years and will yield annual cash revenues of Rs.5,68,750 and incur


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Capital Budgeting

annual cash expenses of Rs.2,95,750. The estimated salvage value of the new machine is Rs.18,200. The existingmachine has a book value of Rs.91,000 and can be sold for Rs.45,500 today.

The existing machine has a remaining useful life of five years. The cash revenues will be Rs.4,55,000 and associated cashexpenses will be Rs.3,18,500. The existing machine will have a salvage value of Rs.4,550, at the end of five years.

The Beta Company is in 35% tax- bracket, and write off depreciation at 25% on written-down value method.

The Beta Company has a target debt to value ratio of 15%. The Company in the past has raised debt at 11% and it canraise fresh debt at 10.5%.

Beta Company plans to follow dividend discount model to estimate the cost of equity capital. The Company plans to pay adividend of Rs.2 per share in the next year. The current market price o

capital budgeting narain notes

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