Capital budgeting task 1 23

Due date to submit November 2nd 2012
CAPITAL BUDGETING

Task 1 - 23

1. A company purchased an asset worth Rs. 10,00,000. The life of the asset is 5
years and each year, it generates a cash inflow of Rs. 3,50,000. Calculate pay-
back period and post pay-back period.

2. A company is considering purchase of a machinery costing Rs. 15,00,000. It
has a life of 6 years and its expected Profits after Tax are as follows:
YEAR 1 2 3 4 5 6
P.A.T.(RS.) 2,00,000 5,00,000 3,00,000 3,00,000 2,00,000 1,00,000

3. An Engineering company is considering the purchase of a new machine for its
immediate expansion programme. There are three possible machines at same
cost which are suitable for the purpose, the details of which are given below:
PARTICULARS MACHINE MACHINE MACHINE
ONE (Rs.) TWO (Rs.) THREE(Rs.)
Capital Cost 6,00,000 6,00,000 6,00,000
Cost of Production:
Direct Material 40,000 50,000 48,000
Direct Labour 50,000 30,000 36,000
Factory overheads 60,000 50,000 58,000
Administration Cost 20,000 10,000 10,000
Selling and Distbn. Cost 10,000 10,000 10,000
Total 1,80,000 1,50,000 1,67,000
Sales per annum 5,00,000 4,00,000 4,50,000

The economic life of machine I is 4 years, while it is 6 years for the other two,
after which they are expected to have a scrap value of Rs.80,000; Rs. 48,000 and
Rs. 60,000 for machines I, II and III respectively.

Sales are expected to be at the rates shown for each year during their full
economic life. Total tax to be paid is estimated at 45% of net earnings each year.
You are required to show which investment would be most profitable on the basis
of pay-back period methd.

4. An oil company proposes to install a pipeline for transportation of crude oil
from wells to refinery. Investment and operating cost of the pipeline vary for
different sizes of pipes. The following details have been collected.
5.
Diameter of the Pipe 3” 4” 5” 6” 7”
Investment required 16 24 36 64 150
(in lakh rupees)
Gross annual savings
Dr. S. Bhatt
MBA, MFM, ACS, CFA, PGPM, PGDIR, MPhil., PhD, DBA (Swiss)
drbhatt2006@gmail.com
©with Dr. Bhatt Page 1

in operating cost
before depreciation 5 8 15 30 50
(in lakh rupees)
Estimated life of the
installation (in years) 10 10 10 10 10

Taxation rate (%) 50 50 50 50 50

Calculate cash flow and on this basis indicate the proposal that has the
shortest pay-back period. If the company desires a 15% after-tax return,
recommend the largest pipeline to be installed.

6. The manager of AB Co. Ltd., is considering three mutually exclusive
investment projects A, B and C each providing a cash flow of Rs. 20,000 p.a
for an initial investment of Rs. 1,00,000. The useful lives are as follows:
Project A – 5 years; Project B – 6 years; and Project C – 7 years. Advise the
management regarding the choice of the project.

7. Two projects A and B each requiring an investment of Rs. 10,00,000 have an
economic life of 4 years and 6 years respectively. The earnings from these 2
machines are expected to be as follows:

YEAR MACHINE A (Rs.) MACHINE B (Rs.)
1 5,00,000 1,00,000
2 4,00,000 2,00,000
3 3,00,000 3,00,000
4 1,00,000 4,00,000
5 - 4,00,000
6 - 1,00,000

Which project is advisable on the basis of non-discounted cash flow
techniques?

8. The Alpha Co. Ltd., is considering the purchase of a new machine. Two
alternative machines A and B have been suggested, each costing Rs. 4,00,000.
Earnings after tax, but before depreciation are expected to be as follows:
YEAR MACHINE A (Rs.) MACHINE B (Rs.)
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

Dr. S. Bhatt

The company has a target of 10% return on capital. Suggest the company
as to the best alternative.

9. A project involves an investment of Rs. 10,00,000 and the amount has to be
spent as follows:
Beginning of first year Rs. 2,50,000
Beginning of second year Rs. 2,50,000
Beginning of third year Rs. 2,50,000
Beginning of fourth year Rs. 2,50,000
The project will give inflows as follows:
First Year - Rs. 2,30,000
Second Year - Rs. 2,28,000
Third Year - Rs. 2,78,000
Fourth Year - Rs. 2,33,000
Fifth Year - Rs. 80,000
Calculate Net Present Value of the project assuming cost of capital as 10%.

10. X Ltd., has under consideration the following two projects. The details are as
under:
PARTICULARS PROJECT X PROJECT Y
Investment in machinery Rs. 15,00,000 Rs. 10,00,000
Working Capital Rs. 5,00,000 Rs. 5,00,000
Life of machinery 6 years 4 years
Scrap value of machinery 10% 10%
Tax Rate 35% 35%
Income Before Depreciation and
Taxes: Rs. Rs.
First Year 15,00,000 8,00,000
Second Year 9,00,000 8,00,000
Third Year 15,00,000 8,00,000
Fourth Year 8,00,000 8,00,000
Fifth Year 6,00,000 -
Sixth Year 3,00,000 -

Advise the company as to the best alternative using different techniques of capital
budgeting. (Cost of Capital is 12%).

11. Using different techniques of capital budgeting advise WINE LTD., regarding
selection of the best of the following two alternatives:
PARTICULARS PROJECT X PROJECT Y
Original Cost Rs. 56,125 Rs. 56,125
Net Working Capital Rs. 5,000 Rs. 6,000
Estimated Life 5 years 5 years
Estimated salvage value Rs. 3,000 Rs. 3,000

Dr. S. Bhatt

Income Tax Rate 35% 35%
Annual Estimated Income After
Depreciation and Taxes: Rs. Rs.
Year 1 3,375 11,375
Year 2 5,375 9,375
Year 3 7,735 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375

12. The Finance Manager of CD Ltd., is considering an investment project costing
Rs. 3,00,000 and it will have a scrap value of Rs. 20,000 at the end of 5 years
life. Transportation costs are expected to be Rs. 10,000 and installation cost
Rs. 50,000. If the project is accepted spare parts inventory of Rs. 10,000 must
also be acquired and maintained. It is estimated that the spare parts will have
an estimated scrap value after 5 years amounting to 60% of their initial cost.

Annual revenue from the project is expected to be Rs. 3,40,000 and annual
labour, material and maintenance expenses are estimated to be Rs. 30,000; Rs.
1,00,000; and Rs. 10,000 respectively. The depreciation and taxes for each of
the 5 years will be as follows:

YEAR 1 2 3 4 5
Depreciation 1,44,000 86,400 64,800 43,200 1,600
(Rs.)
Taxes (Rs.) 22,400 45,440 54,080 62,720 79,360

Calculate the cost of the project and cash inflows for each year and evaluate
the project at 12% rate of interest.

13. A company has the choice of continuing making a product on the existing
machine or obtaining one of the two alternatives in lieu of it. The following
details are available:
PARTICULARS PRESENT MACHINE E MACHINE F
MACHINE (RS.) (RS.)
Book Value 50,000 - -
Resale Value 55,000 - -
Purchase price - 90,000 1,00,000
Fixed cost per annum 45,000 54,000 66,000
(including depreciation)
Variable running cost per
unit (including labour) 1,50 0.75 1.25
Units produced per hour 8 8 12
Selling price per unit 10 10 10

Dr. S. Bhatt

Additional Information:
(a) Material cost per unit –Rs.5
(b) Annual working hours – 2000
(c) Life of each machine (as from now) – 5 years.
(d) Residual value is negligible.
(e) Depreciation is to be calculated by straight line method, using
book value or purchase price as the case may be.
(f) The sales manager believes that extra production from Machine F
will need an extra expenditure of Rs. 4,000 on advertising to be
sold in full.
(g) Taxation rate may be assumed at 50% and the cost of finance is
9%.
Evaluate the project using NPV Method.

14. Home Gadgets Co., is considering building and assembling plant. The
decision has been narrowed down to two possibilities. The company desires
to choose the best plant at a level of 10,000 gadgets per month. Both plants
are expected to have a life of 10 years and no salvage value. The cost of
capital is 10%. Assuming a zero income tax rate, suggest which would be the
desirable choice.
Cost of 10,000 gadgets per month output level

PARTICULARS LARGE PLANT SMALL PLANT
Initial Cost Rs. 30,00,000 Rs. 22,93,500
Direct Labour per annum:
First Shift Rs.15,00,000 Rs. 7,80,000
Second Shift - Rs.9,00,000
Overheads per annum Rs. 2,40,000 Rs. 2,10,000

15. A company is faced with the problem of choosing between two mutually
exclusive projects. Project A requires a cash outlay of Rs. 1,00,000 and cash
running expenses of Rs. 35,000 per annum. On the other hand, Project B will
cost Rs. 1,50,000 and requires a cash running expenses of Rs. 20,000 p.a.
Both the machines have a 8 year life. Project A has Rs. 4,000 salvage value
and Project B has Rs. 14,000 salvage value. The company’s tax rate is 50%
and it has a 10% required rate of return. Assume depreciation on straight line
basis. Which project should be accepted?

16. An investment of Rs. 1,38,500 yields the following cash inflow:
YEAR 1 2 3 4 5
CASH
INFLOW 30,000 40,000 60,000 30,000 20,000
(RS.)
Find the Internal Rate of Return.

Dr. S. Bhatt

17. A sole trader installs a machinery for the production of a luxury article, the
demand for which is expected to last for only 5 years. The total capital put in
by the trader is:
Machinery Rs. 2,70,500
Working Capital Rs. 40,000
Rs. 3,10,500
The working capital will be fully realized at the end of the 5th year. The
scrap value of the machinery to be realized at the end of 5th year is
estimated at Rs. 5,500. The traders’ earnings are estimated to be as
follows:
YEAR 1 2 3 4 5
Profits
before
Depreciation 90,000 1,30,000 1,70,000 1,16,000 19,500
and Taxes
(Rs.)
Tax Payable 20,000 30,000 40,000 26,000 5,000
(Rs.)
Calculate Internal Rate of Return.

18. X Ltd., proposes to invest Rs. 2,00,000 in a machinery the life of which is
estimated to be 5 years. Profits from the project is as follows:

YEAR 1 2 3 4 5
Profits
before
Depreciation 80,000 80,000 90,000 90,000 75,000
and Taxes
(Rs.)

The company follows reducing balance of depreciation and the rate of
depreciation is 20%, the entire balance being written off in fifth year.
Rate of taxation is 35%. What is the Internal Rate of Return?

19. A project costs an initial investment of Rs. 40,000 and is expected to generate
annual cash inflow of Rs. 16,000 for 4 years. Calculate Internal Rate of
Return.

20. A project costs Rs. 16,000 and is expected to generate cash inflows of Rs.
4,000 each year, for 5 years. Calculate Internal Rate of Return.

21. You are required to suggest which project would be more feasible if the cost
of capital is 12% and the initial investment of both projects A and B is Rs.
15,00,000.

Dr. S. Bhatt


YEAR INFLOW FROM INFLOW FROM
PROJECT A (RS.) PROJECT B (RS.)
1 8,00,000 2,00,000
2 8,00,000 4,00,000
3 4,00,000 4,00,000
4 2,00,000 4,00,000
5 - 6,00,000
6 - 8,00,000
(including scrap)

22. Capro Industries plans an investment of Rs. 75,000 in new machinery that
would produce inflow of Rs. 25,000 every year for 5 years. The
representative of another equipment manufacturer presents an alternative
proposal. By investing Rs. 1,60,000 in his company’s equipment Capro
Industries can obtain a cash inflow of Rs. 50,000 every year for five years. In
future, an investment of this type can be expected to yield a discounted rate of
return of 12%.

You are required to find:
(a) which alternative is more attractive if a discounted rate of 12% is
expected?
(b) the discounted rate of return on investment alternatives, and
(c) discounted rate of return on incremental investment.

23. Pyramid Ltd., is examining two mutually exclusive proposals for new capital
investment. The data on the proposals are as follows:

PARTICULARS PROJECT A PROJECT B
Net Cash Outlays Rs. 40,000 Rs. 50,000
Salvage Value Nil Nil
Estimated Life 4 years 5 years
Income Tax Rate 50% 50%
Cut-off rate for appraisal 10% 10%
Earnings Before Depreciation
and Taxes: Rs. Rs.
Year 1 12,000 14,000
Year 2 14,000 16,000
Year 3 16,000 18,000
Year 4 22,000 22,000
Year 5 - 20,000

Using different techniques of capital budgeting, advise which proposal would
be preferable.

Dr. S. Bhatt


Dr. S. Bhatt

Capital budgeting task 1 23

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