Professional Documents
Culture Documents
Chapter: 8
Capital Budgeting
MEANING OF CAPITAL BUDEGETING
• Capital budgeting is a process of planning capital expenditure which is to be made to maximize the
long-term profitability of the organization.
• It refers to planning for capital assets.
• The capital budgeting decision means a decision as the whether or not money should be invested in
long-term projects such as installing a machinery or creating additional capacities to manufacture a
part which at present may be purchased from outside.
The process of convertible future sums into their present equivalents is known as “discounting”, which is
used to determine the present value of future cashflows
Traditional Techniques
a) Payback Period Method
b) Accounting Rate of Return Method
Illustration: 1
Suppose a project with an initial investment of Rs. 100 crores, yields a profit of Rs. 20 crores, after writing off
depreciation of Rs. 5 crores per annum. The Payback period of the project is:
CFAT per annum = PAT + Depreciation = Rs. 20 + Rs. 5 crores = Rs. 25 crores.
Payback period = Initial Investment / CFAT per annum = 100 / 25 = 4 years.
Step: 2 Determine the CFAT (Cash Inflow) from the project for various years.
Illustration: 2
The initial outlay for a project is Rs. 25 crore. The project analyst expects the following annual cash flows
which will be generated uniformly over the year:
Year: 0 1 2 3 4 5 6 7
Cash flow (Rs. Crore): (25) 7 6 6 5 4 4 8
You are required to compute the pay back period for the above project. If the cut-off period decided by the
management is 5 years, should the project be accepted?
Evident from the table above, Rs. 25 crores in total would be collected in the 5th year.
Payback Period is
(25 - 24)
4 years + x 12 months = 4years 3months
(28 - 24)
Since, the payback period is less than the cut-off period decided by the management, the project should be
accepted.
Illustration: 3
A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 12.5%
(straight line method) but before tax @ 50%. Compute the payback period.
[Answer: 5 years]
Illustration: 4
Initial investment is Project X and Project Y is Rs. 1,00,000 each. Following is the cash inflow from the two
projects over a period of five years. Which project should be selected. Use payback period method.
Illustration: 5
The initial outlay for a project is Rs. 25 crore. The project analyst expects the following annual cash flows
which will be generated uniformly over the year:
Year: 0 1 2 3 4 5 6 7
Cash flow (Rs. Crore): (25) 7 6 6 5 4 4 8
You are required to compute the discounted pay back period for the above project, assuming cost of capital
to be 12%.
PACKBACK RECIPROCAL
It is the reciprocal of payback period. It is expressed in percentage and computed as:
The Payback Reciprocal is considered to be an approximation of the Internal Rate of Return (IRR), if:
a) The life of the project is at least twice the payback period;
b) The project generates equal amount of the annual cash inflows; and
c) The project doesn’t require additional outflow during project life.
Illustration: 6
A project with initial investment of Rs. 50,00,000 and life of 10 years, generates CFAT of Rs. 10,00,000 per
annum.
Payback Period = 50,00,000 ÷ 10,00,000 = 5 years
Payback Reciprocal = (1 ÷ 5) x 100 = 20%
[* NOTE:
We assume that depreciation is on Straight Line Basis, where Book Value declines at constant rate from
purchase price to zero.
Again,
Average Investment = Net Working Capital + Salvage Value + ½ (Initial Investment – Salvage Value)
If Net Working Capital = 0, the above equation reduces to: ½ (Initial Investment + Salvage Value)]
Illustration: 7
A machine is available for purchase at a cost of Rs. 80,000.
We expect it to have life of five years and to have a scrap value of Rs. 10,000 at the end of the five year
period. We have estimated that it will generate additional profits over its life as follows:
Year 1 2 3 4 5
Amount (Rs.) 20,000 40,000 30,000 15,000 5,000
These estimates are of profits before depreciation. You are required to calculate the accounting rate of
return of the project.
Total profit before depreciation over five years of machine life = Rs. 1,10,000
Average profit per annum = Rs. 1,10,000 / 5 years = Rs. 22,000
Total depreciation over five years = Rs. 80,000 – Rs. 10,000= Rs. 70,000
Average depreciation per annum = Rs. 70,000 / 5 years = Rs. 14,000
Avg. annual profit after depreciation = Rs. 22,000 – Rs. 14,000= Rs. 8,000
Illustration: 8
Compute the accounting rate of return for the project given:
NET PRESENT VALUE METHOD (NPV) OR DISCOUNTED CASH FLOW TECHNIQUE (DCF)
The Net Present Value of an investment proposal is defined as the sum of the present value of all future
cash inflows less the sum of the present value of all cash outflows associated with the proposal.
In simple terms:
n
FVi
NPV = ∑ − CO0
( 1 + K)
i
i=1
Cash Outflows
Generally cash outflows consist of (a) Initial Investment which occurs at time t = 0 and (b) Special payment
and outflows, e.g. working capital outflow which arises in the year of commercial production, tax paid on
capital gain made by sale of old asset, if any; and installation charges at time t = 0 or extra outflows during
the life of the project.
Cash Inflows
Cash Inflows = CFAT = PAT + Depreciation. OR
Cash Inflows = PBD (1 – tax rate) + Tax Shield on Depreciation.
Also, specific cash inflows like salvage value of new assets and recovery of working capital at the end of the
project, tax savings on loss due to sale of old asset, should be carefully considered. The general assumption
is that all cash inflows occur at the end of each year.
NOTE:
The NPV method will give valid results only if money can be immediately reinvested at a rate of return equal
to the firm’s cost of capital.
Illustration: 9
A company is considering which of two mutually exclusive projects it should undertake. The Finance Director
thinks that the project with higher NPV should be chosen whereas the Managing Director thinks that the one
with the higher IRR should be undertaken especially as both projects have the same initial outlay and length
of life.
The company anticipates a cost of capital of 10% and the net after tax cash flows of the project are as
follows:
Year 0 1 2 3 4 5
Project X (200,000) 35,000 80,000 90,000 75,000 20,000
Project Y (200,000) 218,000 10,000 10,000 4,000 3,000
As per NPV criterion Project X should be selected which gives better NPV than Project Y.
and Profitability
n
FVi
NPV = ∑ − CO0 = 0 Index = 1
i=1 ( 1 + K )
i
The discount
rate, i.e., cost of
capital is assumed to be known in the determination of Net Present Value, while in the internal rate of return
calculation, the NPV is set equal to zero and the discount rate which satisfies the condition is determined.
Of these, the first view seems to be more realistic, since it may not always be possible for an enterprise to
reinvest immediate cash flows at a rate equal to IRR.
Illustration: 10
Taking data from Illustration: 9 calculate the IRR for each project.
IRR of Project X:
k − 10 0 − 29,150
= = 0.601 ∴ k = 10 + 6.01 = 16.01%
20 − 10 −19, 350 − 29,150
IRR of Project Y:
k − 10 0 − 18, 760
= = 0.854 ∴ k = 10 + 8.54 = 18.54%
20 − 10 −3, 210 − 18, 760
CONFLICT BETWEEN CHOICE OF
IRR AND NPV METHODS
Causes of Conflict
Generally, the higher the NPV, higher will be the IRR. However, NPV and IRR may give conflicting result in
the evaluation of different projects.
Superiority of NPV
In case of conflicting decisions based on NPV and IRR, the NPV method must prevail. Decisions are based
on NPV sue to the superiority of NPV, as given from the following points:
a) NPV represents the surplus from the project whereas IRR represents the point of no surplus-no
deficit.
b) NPV consider cost of capital as constant. Under IRR, the discount rate is determined by reverse
working, by setting NPV = 0.
c) NPV aids decision-making by itself, i.e., projects with positive NPV are accepted. IRR by itself does
not aid decision-making. For example, a project with IRR = 18% will be accepted if K 0 < 18%.
However, the project will be rejected if K0 = 21% (say > 18%).
d) NPV method considers the timing differences in cash flows at the appropriate discount rate. IRR is
greatly affected by the volatility or variance in cash flow patterns.
e) IRR presumes that intermediate cash inflows will be reinvested at the rate (IRR); whereas in the
case of NPV method, intermediate cash inflows are presumed to be reinvested at the cut-off rate.
The later presumption, viz., reinvestment at the cut-off rate, is more realistic than reinvestment at
IRR.
Illustration: 11
Taking data from Illustration 9 and 10, state with reasons which project would you recommend?
In case of NPV – IRR conflict, NPV should be preferred for decision making since it gives the net benefit in
absolute terms. Hence Project X will be preferred.
NOTE:
Inconsistency in ranking between NPV and IRR arises because:
a) Cash flow patterns of projects are different, Project Y has heavy initial cash inflows and hence has
higher IRR.
Illustration: 12
The cash flows of Project C and D with other details are given below:
Year 0 1 2 3 NPV at 10% IRR
Project C (10,000) 2,000 4,000 12,000 4,139 26.5%
Project D (10,000) 10,000 3,000 3,000 3,823 37.6%
Year PVIF at
10% 14% 15% 30% 40%
1 0.9090 0.8772 0.8696 0.7692 0.7143
2 0.8264 0.7695 0.7561 0.5917 0.5102
3 0.7513 0.6750 0.6575 0.4552 0.3644
The conflict in project ranking between NPV and IRR is due to the variability of cash flows. Project C has
lower initial cash flows and heavy later inflows. However, Project D has heavy initial inflows and lower
inflows in the later period. This will distort the analysis under IRR. NPV is a realistic technique which takes
into account, the variability of cash flows. Hence, NPV should be preferred over IRR in case of conflict.
We are informed that the company’s cost of capital of 10%, NPV is higher for Project C. Hence, it should be
preferred over Project D.
When different investment proposals each involving different initial investments and cash inflows are to be
compared, the technique of Profitability Index (PI) is used.
Profitability Index (PI) or Desirability Factor or Benefit Cost Ratio (BCR) is:
PI represents the amount obtained at the end of the project life, for every rupee invested in the project at the
initial stage. The higher the PI, the better it is, since the greater is the return for every rupee of investment in
the project.
Example:
Project P Q
Discounted Cash Inflows Rs. 10,00,000 Rs. 5,00,000
Project P has a better ranking based on NPV while project Q will be preferred if PI were to be used for
decision-making. Thus, there is a conflict in ranking, between NPV and PI methods. This is because NPV
gives the ranking in terms of absolute value of rupees, whereas PI gives ranking for every rupee of
investment, i.e., in terms of ratio.
Decision-making
Generally the NPV method should be preferred since NPV indicates the economic contribution or surplus of
the project in absolute terms. However, in capital rationing situations, for deciding between mutually
exclusive projects, PI is a better evaluation technique.
Illustration: 13
The cash flows of two mutually exclusive projects are as under:
Year 0 1 2 3 4 5 6
Project P (40,000) 13,000 8,000 14,000 12,000 11,000 15,000
Project J (20,000) 7,000 13,000 12,000 - - -
a) Estimate the net present value of the projects P and J using 15% as the hurdle rate.
b) Estimate the internal rate of return of the projects P and J.
c) Why is there conflict in the project by using NPV and IRR criteria?
d) Which criterion will you use in such a situation? Estimate the value at that criterion. Make a project
choice.
Calculation of NPV at 15% hurdle rate
Project P Project J
Year PVIF 15%
CFAT DCFAT CFAT DCFAT
0 1.0000 (40,000) (40,000) (20,000) (20,000)
1 0.8696 13,000 11,305 7,000 6,087
2 0.7561 8,000 6,049 13,000 9,829
3 0.6575 14,000 9,205 12,000 7,890
4 0.5718 12,000 6,862
5 0.4972 11,000 5,469
Computation of IRR
Since both the projects yield a positive NPV at 15%, a higher discount rate is used to determine a negative
NPV. IRR hence calculated by interpolation method is 20.15% for Project P and 25.30% for Project J.
(Students are advised to calculate the IRR)
The difference or conflict in ranking between NPV and IRR is attributed to:
a) Disparity in Initial Investment
b) Difference in Project Lives
c) Non uniform cash inflows of the project
Equivalent Annual Flows from the Project = NPV ÷ PVIFA at 15% for the relevant project life
For Project P: EAF = 5,375 ÷ 3.7845 = Rs. 1,420
For Project J: EAF = 3,806 ÷ 2.2832 = Rs. 1,668
Hence, Project J should be preferred in the above situation, based on Equivalent Annual Flow
criteria.
∑ CF ( 1 + r )
n −1
TV = t
t=1
Illustration: 14
First of all, it is necessary to find out total compounded sum which will be discounted back to the present
value.
Rate of Total
Cash Inflow Years of Compounding
Year Interest Compounding
(Rs.) Investment Factor
(%) Sum (Rs.)
1 4,000 8 2 1.166 4,664
2 4,000 8 1 1.080 4,320
3 4,000 8 0 1.000 4,000
12,984
Now, we have to find out the present value of Rs. 12,984 by applying the discount rate (cost of capital) of
10%. (PVIF at 10% for 3 years = 0.7513)
Since Modified NPV is positive, the project would be accepted under the terminal value criterion.
Situation I
Illustration: 15
Total funds available is Rs. 3,00,000. Determine the optimal combination of projects assuming that the
projects are divisible.
NPV at the
Required Initial Profitability
Project appropriate cost Rank
Outlay (Rs.) Index
of capital (Rs.)
A 1,00,000 20,000 0.2 3
B 3,00,000 35,000 0.117 5
C 50,000 16,000 0.32 1
D 2,00,000 25,000 0.125 4
E 1,00,000 30,000 0.3 2
Situation II
Projects are Indivisible
Step 1 Construct a table showing the feasible combinations of the project (whose aggregate of initial outlay
does not exceed the fund available for investment).
Step 2 Choose the combination whose aggregate NPV is maximum and consider it as the optimal project
mix.
Illustration: 16
Using the same data as used in previous illustration, determine the optimal project mix on the basis of the
assumption that the projects are indivisible.
By a careful inspection of the feasible combinations constructed in the above table, we can conclude that the
optimal project mix is A, C, E because the aggregate of their NPV’s is maximum.
Leasing is the general contract between the owner and user of the asset over a specific period of time. The
asset is purchased initially by the lessor and leased to the user which pays a specified rent at periodic
intervals.
From the lessee’s point of view, leasing has the attraction of eliminating immediate cash outflow, and the
lease rentals are also tax deductible expenses.
Buying has the advantages of depreciation allowance and interest on borrowed capital being tax deductible.
Illustration: 17
K Limited has decided to go in for a new model of a Car. The cost of the vehicle is Rs. 40,00,000. The
company has two alternatives:
a) Taking the Car on Finance Lease; or
b) Borrowing and Purchasing the Car.
J Limited is willing to provide the car on financial lease to K Limited for 5 years at an annual rental of Rs.
8,75,000, payable at the end of the year.
The vehicle is expected to have a useful life of 5 years, and it will fetch a net salvage value of Rs. 10,00,000
at the end of year five. The depreciation rate for tax purposes is 40% on written down value basis. The
applicable tax rate for the company is 35%. The applicable before tax borrowing rate for the company is
13.8462%.
Rate of discount 1 2 3 4 5
0.138462 0.8784 0.7715 0.6777 0.5953 0.5229
0.09 0.9174 0.8417 0.7722 0.7084 0.6499
Computation of loan amounts repaid (presumed to be repaid in 5 years equally) (in Rs. Lakhs)
Annual repayment of loan = 40.00 ÷ 5 = 8.00
Year 1 2 3 4 5
Opening Balance 40.00 32.00 24.00 16.00 8.00
Less: Repayments 8.00 8.00 8.00 8.00 8.00
Closing Balance 32.00 24.00 16.00 8.00 0.00
Exercise
1. A company is considering an investment proposal to install new milling controls at a cost of Rs.
50,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume
the firm uses straight line depreciation and the same is allowed for tax purposes. The estimated cash
flows before depreciation and tax (CFBT) from the investment proposal are as follows:
Year : 1 2 3 4 5
CFBT (Rs.) : 10,000 10,692 12,769 13,462 20,385
2. A company is contemplating to purchase a machine. Two machines A and B are available, each
costing Rs. 5,00,000. In comparing the profitability of the machines, a discounting rate of 10% is to be
used and machines to be written off in five years by straight line method of depreciation with nil residual
value. Cash inflows after tax are expected as follows:
Indicate which machine would be profitable using the following methods of ranking investment
proposals:
a) Pay Back Method
b) Net Present Value Method
c) Profitability Index Method
d) Average Rate of Return Method
[Answer: a) 2 years 7.2 months, 3 years 4 month, b) Rs. 1.5401 lakhs, Rs. 1.4876 lakhs, c) 1.308,
1.298, d) 28%, 32%]
3. Oasis Plastics Limited is a manufacturer of high quality plastic products. Bania, President, is
considering computerizing the company’s ordering, inventory and billing procedures. He estimates that
the annual savings from computerization include a reduction of 4 clerical employees with annual salaries
of Rs. 50000 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
billing procedures.
The purchase price of the system is Rs. 2,50,000 and installation costs are Rs. 50,000. These outlays
will be capitalized (depreciated) on a straight line basis to a zero books salvage value which is also its
market value at the end of five years. Operation of the new system requires two computer specialists
with annual salaries of Rs. 80,000 per person. Also annual maintenance and operation (cash) expenses
of Rs. 22,000 are estimated to be required. The company’s tax rate is 40% and its required rate of return
(cost of capital) for the project is 12%.
[Answer: a) 3.606 years, 4.187 years; b) 1.4315, 1.1451; c) Rs. 58,254, Rs. 34,812]
5. M/s. M & Co. wants to replace its old machine with a new automatic machine. Two models Bye-Bye
and K&K are available at the same cost of Rs. 5,00,000 each. Salvage value of the old machine is Rs.
1,00,000. The utilities of the existing machine can be used if the company purchases Bye-Bye.
Additional cost of utilities to be purchased in that case are Rs. 1,00,000. If the company purchases K&K
then all the existing utilities will have to be replaced with new utilities costing Rs. 2,00,000. The salvage
value of the old utilities will be Rs. 20,000. The cash flows after taxation are expected to be:
[Answer: NPV = Rs. 44,000, Rs. 20,000; DPBP = 4.6 years, 4.6 years; DF = 1.088, 1.034]
6. A particular project has a four year life with yearly projected net profit of Rs. 10,000 after charging
yearly depreciation of Rs. 8,000 in order to write-off the capital cost of Rs. 32,000. Out of the capital cost
Rs. 20,000 is payable immediately (Year 0) and balance in the next year (which will be the Year 1 for
evaluation). Stock amounting to Rs. 6,000 (to be invested in Year 0) will be required throughout the
project and for Debtors a further sum of Rs. 8,000 will have to be invested in Year 1. The working capital
will be recouped in Year 5. It is expected that the machinery will fetch a residual value of Rs. 2,000 at
the end of 4th year. Income Tax is payable @ 40% and the depreciation equals the taxation writing down
allowances of 25% per annum. Income Tax is paid after 9 months after the end of the year when profit is
made. The residual value of Rs. 2,000 will also bear tax @ 40%. Although the project is for 4 years, for
computation of tax and realization of working capital, the computation will be required up to 5 years.
Taking discount factor of 10%, calculate NPV of the project and give your comments regarding its
acceptability.
9. Beta Limited is considering 5 capital projects for the years 1, 2, 3 and 4. The company is financed
entirely by equity and its cost of capital is 12%. The expected cash flows of the projects are as follows:
All projects are divisible. None of the projects can be delayed or undertaken more than once. Calculate
which project the company should undertake if the capital available for investment is limited to Rs.
110000 in year 1 and with no limitation in subsequent years?
[Answer: Either D or Combination of E, B and C]
10. In a capital rationing situation (investment limit Rs. 25 lakhs), suggest the most desirable and
feasible combination on the basis of the following data (indicate justification):
11. Five projects M, N, O, P, and Q are available to a company for consideration. The investment
required for each project and cash flows it yields are tabulated below. Projects N and Q are mutually
exclusive. Taking the cost of capital @ 10%, which combination of projects should be taken up for a total
capital outlay not exceeding Rs 3 lakhs on the basis of NPV and Benefit- Cost Ratio?
a) If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and
present values will simply be the sum of the parts.
13. S Limited a highly profitable company is engaged in the manufacture of power intensive products.
As part of its diversification plans, the company proposes to put up a Windmill to generate electricity.
The details of the scheme are as follows:
From the above information you are required to calculate the net present value. (Ignore tax on capital
profits.)
Year 1 2 3 4 5 6 7 8 9 10
At 15% 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25
[Answer: Rs. 8.26 lakhs]
14. K Limited is considering a new project for manufacture of pocket video games involving a capital
expenditure of Rs. 600 lakh and working capital of Rs. 150 lakh. The capacity of the plant is for an
annual production of 12 lakh units and capacity utilization during the 6 year working life of the project is
expected to be as indicated below:
Year : 1 2 3 4–6
Capacity Utilization (%) : 33.33 66.67 90 100
The average price per unit of the product is expected to be Rs. 200 netting a contribution of 40%. The
annual fixed costs, excluding depreciation, are estimated to be Rs. 480 lakh per annum from the third
year onwards; for the first and second year, it would be Rs. 240 lakh and Rs. 360 lakh respectively. The
average rate of depreciation for tax purposes is 33.33 % on the capital assets. The rate of income tax
may be taken as 35%. Cost of capital is 15%.
At the end of the third year, an additional investment of Rs. 100 lakh would be required for working
capital.
Terminal value for the fixed assets may be taken at 10% and for the current assets at 100%. For the
purpose of your calculations, the recent amendments to the tax laws with regard to balancing charge
may be neglected.
[Answer: NPV = Rs. 273 lakh]
The product is expected to have a life of four years. Annual sales volume is expected to be constant
over the period at 9,000 units. Production which was estimated at 10,000 units in the first year would be
only 9,000 units each in year two and three and 8,000 units in year four. Debtors at the end of each year
would be 20% of sales during the year, creditors would be 10% of materials and other variable costs. If
sales differed from the forecast level, stocks would be adjusted in proportion.
Depreciation relates to machinery which would be purchased especially for the manufacture of the new
product and is calculated on the straight line basis assuming that the machinery would last for four years
and have no terminal scrap value. Fixed costs are included in labour cost.
There is high level of confidence concerning the accuracy of all the above estimates except the annual
sales volume. Cost of capital is 20% per annum. You may assume that debtors are realized and
creditors are paid in the following year. No changes in the prices of inputs and outputs are expected over
the next four years.
You are required to show whether the manufacture of the new product is worthwhile. Ignore taxes.
[Answer: NPV = Rs. 58,398]
16. A plastic manufacturing company is considering replacing an older machine which was fully
depreciated for tax purposes with a new machine costing Rs. 40,000. The new machine will be
depreciated over its eight-year life. It is estimated that the new machine will reduce labour costs by Rs.
8,000 per year. The management believes that there will be no change in other expenses and revenues
of the firm due to the machine. The company requires an after-tax return on investment of 10%. Its rate
of tax is 35%. The company’s income statement for the current year is given for other information.
Should the company buy the new machine? You may assume the company follows straight line method
of depreciation and the same is allowed for tax purposes.
[Answer: Differential NPV = (Rs. 2,922)]
17. A company is currently considering modernization of a machine originally costing Rs. 50,000
(current book value zero). However, it is in good working condition and can be sold for Rs. 25,000. Two
choices are available. One is to rehabilitate the existing machine at a total cost of Rs. 1,80,000; and the
other is to replace the existing machine with a new machine costing Rs. 2,10,000 and requiring Rs.
30,000 to install. The rehabilitated machine as well as the new machine would have a six year life and
no salvage value. The projected after-tax profits under the various alternatives are:
(Rs.)
Years Expected after-tax profits
The firm is taxed at 35%. The company uses straight line depreciation method and the same is allowed
for tax purposes. Ignore block assets concept. The cost of capital is 12%.
Advise the company whether it should rehabilitate the existing machine or should replace it with the new
machine. Also, state the situation in which the company would like to continue with the existing machine.
[Answer: Incremental NPV for Rehab machine = Rs. 89,980; new machine = Rs. 1,00,960]
18. A company is considering the proposal of taking up a new project which requires an investment of
Rs. 400 lakhs on machinery and other assets. The project is expected to yield the following earnings
before depreciation and taxes over the next five years: Rs. In lakhs: 160, 160, 180, 180 and 150
respectively.
The cost of raising the additional capital is 12% and the assets have to be depreciated at 20% on WDV
basis. The salvage value at the end of 5 yrs period may be taken as zero. Income tax applicable is 50%.
Calculate the NPV and IRR of the project.
19. A Limited is considering investing in a project. The expected investment in the project is Rs.
2,00,000. Life of the project is 5 years with no salvage value. The expected net cash inflows after
depreciation but before taxes are in Rs. 85,000; 100,000; 80,000; 80,000 and 40,000 respectively.
Depreciation is 20% on original cost. Applicable tax rate is 30%.
Calculate payback period, ARR, NPV and IRR of the project.
20. A company wants to invest in a machinery costing Rs. 50,000 at the beginning of year 1. It is
estimated that net cash inflows from operation is Rs. 18,000 per annum for 3 years, if the company opts
to service a part of the machinery at the end of year 1 at Rs. 10,000 and the salvage value at the end of
year 3 will be Rs. 12,500. However, if the company decides not to service the part, it will have to be
replaced at the end of year 2 at Rs. 15,400. But in this case, the machinery will work for the 4 th year with
Rs. 18,000 as cash inflow. It will have to be scrapped at the end of year 4 at Rs. 9,000. Opportunity cost
of capital is 10%. Ignore taxation. Will you recommend the purchase of this machine based on NPV? If
the supplier gives you Rs. 5,000 discount, what would be your decision? [1, 0.9091, 0.8264, 0.7513,
0.6830, 0.6209, 0.5644]
21. Following are the date on a capital project being evaluated by X limited.
Annual cost saving Rs. 40,000
Useful life of the project 4 years
IRR 15%
Profitability Index 1.064
Net Present Value ??
Cost of Capital ??
Cost of Project ??
Payback Period ??
Salvage Value 0
Find the missing values.
22. 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. 40,000 per year to run. Machine B is an “economy” model costing Rs.
1,00,000, but will last only for 2 years, and costs Rs. 60,000 per year to run. These are real cash inflows.
Ignore tax. Opportunity cost of capital is 10%. Which machine should company X buy?
23. Company X is operating an elderly machine that is expected to produce a net cash inflow of Rs.
40,000 in the coming year and Rs. 40,000 next year. Current salvage value is Rs. 80,000 and next
year’s value is Rs. 70,000. The machine can be replaced now with a new machine, which costs Rs.
24. PQ limited has decided to purchase a car worth Rs. 40,00,000, have two alternatives:
a) Taking the car on financial lease; or
b) Borrowing and purchasing the car.
LM limited is willing to provide the car on lease for 5 years at an annual rental of Rs. 8.75 lakhs, payable
at the end of the year. The vehicle is expected to have useful life of 5 years, with salvage value of Rs.
10,00,000. Depreciation @ 40% on WDV method. Applicable tax rate is 35%. Applicable before tax
borrowing rate is 13.8462%. Find net advantage of leasing.
25. A company is thinking of replacing its existing machine by a new machine which would cost Rs. 60
lakhs. The company’s current production is 80,000 units and is expected to increase to 100,000 units, if
the new machine is bought. The selling price remain unchanged at Rs. 200 per unit. The following is the
cost of producing one unit of product using both existing and new machine:
The existing machine has an accounting book value of Rs. 100,000, and it has been fully depreciated for
tax purposes. It is estimated that machine will be useful for 5 years. The supplier of the new machine
has offered to accept the old machine for Rs. 2,50,000. However, the market price of old machine today
is Rs. 1,50,000 and it is expected to be Rs. 35,000 after 5 years. The new machine has a life of 5 years
and a salvage value of Rs. 2,50,000 at the end of its economic life. Assume corporate income tax rate at
40% and depreciation is charged on straight line basis for income tax purposes. Further assume that
book profit is treated as ordinary income for tax purposes. The opportunity cost of capital is 15%.
Required:
a) Estimate NPV of the replacement decision.
b) Estimate the IRR of the replacement decision.
c) Should company go ahead with the replacement decision? Suggest.