Capital Budgeting

Problem No.1: Following data in respect of two machines namely A and B are detailed below, Depreciation has been charged on straight line basis and estimated life of both machine is five years. (In Rupees) Item MachineA MachineB Cost 56,125 56,125 Net income after depreciation and taxes: Ist Year 3,375 11,375 2nd Year 5,375 9,375 3rd Year 7,375 7,375 4th Year 9,375 5,375 5th Year 11,375 3,375 36,875 36,875 Find out(a) average rate of return on A and B machines (b) Which machine is better from the point of view of pay-back period and why? (c) Calculate average rate of return when salvage value of machineA turns out to be Rs. 3,000 and when B machine has zero salvage value.

Problem No.2: Following are the details of three projects A, B and C A 50,000 10 years B 70,000 12 years 10,000 6,000 C 70,000 14 7,000 5,500

Cost (Rs.) Life years Estimated scrap (Rs.) 5,000 Annual Profit after Taxation 5,000 Select the best one using (i) Payback period (ii) Surplus life over payback period (iii) Surplus cash flow, as the decision criterion

Problem No. 3: The particular relating to two alternative Capital Projects are furnished below: PROJECT X 4 Years PROJECT Y 6 Years (Rs. In Lakhs) 15

Life of the project Estimated Cash Outflow 15 Estimated Cash Inflow 1st Year 8 7 2nd Year 10 8 3rd Year 7 8 3 6 4th Year th 5 Year 5 6th Year 4 Compute internal rate of return of Project X and Y and State which project you could recommend. You may use the present value tables given below: PRESENT VALUE OF Re. 1 After 20% 25% 30% 35% 40% 45% 50% Ist .833 .800 .769 .741 .714 .690 .677 2nd .694 .640 .592 .549 .510 .476 .444 3rd .579 .512 .455 .406 .364 .328 .296 4th .482 .410 .350 .301 .260 .226 .198 th 5 .402 .328 .269 .223 .186 .156 .132 .335 .262 .207 .165 .133 .108 .088 6th Problem No. 4: 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 year. On the other hand, Project B will cost Rs. 1, 50,000 and require cash running expenses of Rs. 20,000 per year. Both the projects have eight-year life. Project A has a Rs. 4,000 salvage value and Project B has a Rs. 14,000 salvage value. The companys tax rate is 50% and rate of return is 10%. Assume depreciation on straight line basis. Which project should be accepted? Present value of Re. 1 at the end of each year at 10% for 8 years is equal to Rs. 5.335 and present value of Rs. 1 at the end of 8th year at 10% is equal to Re. 0.467.

Problem No. 5: The Klein & Co. is contemplating either of two mutually exclusive projects. The data with respect to each are given below. The initial investment for both is equal to their depreciable value. Both will be depreciated straight line over a five-year life. Projects Projects (Rs.) (Rs.) 1, 00,000 1, 40, 000 Profits after taxes 10,000 25,000 15,000 25,000 20,000 25,000 25,000 25,000 35,000 25,000

Initial Investment Year 1 2 3 4 5 (i) (ii) (iii) (iv) (v)

Calculate the net present value and benefit-cost ratio for each project. Evaluate the acceptability of each project on the basis of above mentioned two techniques. Select the best projects, using NPV and benefit cost ratios and comment on the resulting rankings. Assume that the Klein Co. has an 11% cost of capital. The following data relates to discounting factor.

Year Discounting factor at 11% 1 .901 2 .812 3 .731 4 .659 5 .593 And discounting factor for present value of annuity discounted at 11% for five years is 3.696.

Problem No. 6 M/s Lalwani & Co. has Rs. 2, 00,000 to invest. The following proposals are under consideration. The cost of capital for the company is estimated to be 15 per cent. ________________________________________________________________________ Project Initial Outlay Rs. Annual Cash Flow Rs. Life of Project A 1, 00,000 25,000 10 B 70,000 20,000 8 C 30,000 6,000 20 D 50,000 15,000 10 E 50,000 12,000 20 Rank the above projects on the basis of------(i) Pay-back method (ii) NPV method (iii) Profitability index method Present value of annuity of Rs. 1 received is steady steam discount at rate of 15%. 8 Years = 4.6586 10 Years = 5.1790 20 Years = 6.3345

Problem No. 7 Mohan & Co. is considering the purchase of a machine. Two machines X and Y each costing Rs. 50,000 is available. Earning after taxation is expected to be as under: Year Machine X Machine Discount factor at 10% (Rupees) (Rupees) 1st 15,000 5,000 .9091 2nd 20,000 15,000 .8264 3rd 25,000 20,000 .7513 4th 15,000 30,000 .6830 th 5 10,000 20,000 .6209 Estimate the two alternatives according to(i) Payback Method (ii) Return on Investment method (iii) Net present value method- a discount rate of 10% is used.

Problem No. 8 Calculate the payback period, accounting rate of return, net present value and internal rate of return for the following investment: Year Cash flow (Rs.) 0 (30,000) 1 4,000 2 10,000 3 20,000 4 11,000 The discount rate for discounted cash flow (DCF) calculation is 12 percent. Accounting profits are the same as cash flow except that the initial expenditure should be depreciated over 4 year; there is no resale value at year 4.

Problem No. 9 The management of a company has two alternative projects under consideration. Project A requires a capacity outlay of Rs. 1,20,000 but Project B needs Rs. 1,80,000, Both are estimated to provide a cash flow for five years; A- Rs. 40,000 per year and B- Rs. 58,000 per year. The cost of capital is 10%. Show which of the two projects is preferable from the point of (i) Net Present Value; and (ii) Internal rate of Return.

Problem No. 10 Andhra Pradesh Udyog is considering a new automatic blender. The new blender would last for 10 years and would be depreciated to zero over the 10 year period. The old blender would also last for 10 more years would be depreciated to zero over the same 10 year period. The old blender has a book value of Rs. 20,000 but could be sold for Rs. 30,000 (the original cost was Rs. 40,000). The new blender would cost Rs. 1, 00,000. It would reduce labour expenses by Rs. 12,000 a year. The company is subject to a 50% tax rate on regular income and a 30% tax rate on capital gains. Their cost of capital is 8%. There is no investment tax credit in effect. You are required to(a) Identify all the relevant cash flows for this replacement decision. (b) Compute the present value, net present value and profitability index. (c) Find out whether this is an attractive project?

Problem No. 11 A most profitable company in the country is faced with the prospect of having to replace a large stamping machine. Two machines currently being marketed will do the job satisfactorily. The Zenith Stamping machine costs Rs. 100,000 and will require cash running expenses of Rs. 40,000 per year. The Godrej Stamping machine costs Rs. 150,000 but running expenses are only expected to be Rs. 30,000 per year. Both machines have a ten-year useful life with no salvage value and would be depreciated on a straight-line basis. (a) If the company pays a 50% tax rate and has 10% after-tax required rate or return, which machine should it purchase? (b) Would your answer be different if the required rate of return were 8%? Problem No. 12 A firm has an investment proposal, requiring an outlay of Rs. 40,000. The investment proposal is expected to have 2 years economic life with no salvage value. In year-1, there is a 0.4 probability that cash flow after tax (CFAT) will be Rs. 25,000 and 0.6 probabilities that CFAT will be Rs. 30,000. The probabilities assigned to CFAT for the year-2 are as follows: If CFAT= Rs. 25,000 _____________________ Amount (Rs) Probability 12,000 16,000 22,000 0.2 0.3 0.5 If CFAT= Rs. 30,000 _____________________ Amount (Rs) Probability 20,000 25,000 30,000 0.4 0.5 0.1

The firm uses a 10% discount rate for this type of investment. You are required to(i) Present the above information in the form of a decision tree. (ii) Find out the NPV under (a) the worst outcome; and (b) under the best outcome (iii)Find out the profitability or otherwise of the above investment proposal.