company is allowed to charge depreciation on straight-line basis for Income-tax
purpose. The estimated before-tax cash inflows are given below:
Year Before-tax Cash inflows (₹’000)
1 2 3 4 5 240 275 210 180 160
The applicable Income-tax rate to the Company is 35%. If the Company‟s opportunity Cost of Capital is 12%, calculate the equipment‟s discounted payback period, payback period, net present value and internal rate of return.
The PV factors at 12%, 14% and 15% are:
Year 1 2 3 4 5 PV factor at 12% 0.8929 0.7972 0.7118 0.6355 0.5674 PV factor at 14% 0.8772 0.7695 0.6750 0.5921 0.5194 PV factor at 15% 0.8696 0.7561 0.6575 0.5718 0.4972
(Ans. (i) Discounting Payback period= 4 years and 9.28 months (ii) Payback Period = 3 Years and 6.25 months (iii) NPV= -20.26 (iv) IRR = 13.77%)
QUESTION – 04 A company is considering the proposal of taking up a new project which requires an investment of ₹ 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:
Year Earnings (₹ in lakhs)
1 160 2 160 3 180 4 180 5 150
The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on „Written Down Value‟ basis. The scrap value at the end of the five years‟ period may be taken as zero. Income-tax applicable to the company is 50%.
You are required to calculate the net present value of the project and advise the management to take appropriate decision. Also calculate the Internal Rate of Return of the Project.
Note: Present values of Re. 1 at different rates of interest are as follows:
Year 10% 12% 14% 16%
1 0.91 0.89 0.88 0.86 2 0.83 0.80 0.77 0.74
2 [CAPITAL BUDGETING]
3 0.75 0.71 0.67 0.64
4 0.68 0.64 0.59 0.55 5 0.62 0.57 0.52 0.48
(Ans. NPV = 38.62 Lakhs, IRR = 15.61%)
QUESTION – 5 A company has to make a choice between two projects namely A and B. The initial capital outlay of two Projects is₹ 1,35,000 and ₹ 2,40,000 respectively for A and B. There will be no scrap value at the end of the life of both the projects. The opportunity Cost of Capital of the company is 16%. The annual incomes are as under:
(Ans. (i) Discounting Payback Period, Project A = 3.61 Years, Project B = 4.19 Years (ii) Profitability Index, Project A = 1.43, Project B = 1.15 (iv) NPV, Project A = 58,254, Project B = 34,812 )
QUESTION – 6 PR Engineering Ltd. is considering the purchase of a new machine which will carry out some operations which are at present performed by manual labour. The following information related to the two alternative models – „MX‟ and „MY‟ are available:
Machine ‘MX’ Machine ‘MY’
Cost of Machine ₹ 8,00,000 ₹ 10,20,000 Expected Life 6 years 6 years Scrap Value ₹ 20,000 ₹ 30,000
Corporate tax rate for this company is 30 percent and company‟s required rate of return-on-investment proposals is 10 percent. Depreciation will be charged on straight line basis.
You are required to:
(i) Calculate the pay-back period of each proposal.
(ii) Calculate the net present value of each proposal, if the P.V. factor at 10% is – 0.909, 0.826, 0.751, 0.683, 0.621 and 0.564.
(iii) Which proposal you would recommend and why?
(Ans. (i) Payback Period – MX = 4.25 years, MY = 3.67 years (ii) NPV - MX = 4,870, MY = 1,12,092)
QUESTION – 7 A Ltd. is considering the purchase of a machine which will perform some operations which are at present performed by workers. Machines X and Y are alternative models. The following details are available: Machine X Machine Y (₹) (₹) Cost of machine 1,50,000 2,40,000 Estimated life of machine 5 years 6 years Estimated cost of maintenance p.a. 7,000 11,000 Estimated cost of indirect material, p.a. 6,000 8,000 Estimated savings in scrap p.a. 10,000 15,000 Estimated cost of supervision p.a. 12,000 16,000 Estimated savings in wages pa. 90,000 1,20,000
Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the alternatives according to:
(i) Average rate of return method, and
(ii) Present value index method assuming cost of capital being 10%.
(The present value of ` 1.00 @ 10% p.a. for 5 years is 3.79 and for 6 years is 4.354)
(Ans. (i) ARR – X = 42% or 21%, Y = 35% or 17.5% (ii) PI – X = 1.5539, Y =
1.4876)
4 [CAPITAL BUDGETING]
QUESTION – 8 XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is to be set up in Special Economic Zone (SEZ), qualifies for one time (at starting) tax free subsidy from the State Government of ₹ 25,00,000 on capital investment. Initial equipment cost will be ₹ 1.75 crores. Additional equipment costing ₹ 12,50,000 will be purchased at the end of the third year from the cash inflow of this year. At the end of 8 years, the original equipment will have no resale value, but additional equipment can be sold for ₹ 1,25,000. A working capital of ₹ 20,00,000 will be needed and it will be released at the end of eighth year. The project will be financed with sufficient amount of equity capital.
The sales volumes over eight years have been estimated as follows:
Year 1 2 3 45 68
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000
A sales price of ₹ 120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed cash operating costs will amount ₹ 18,00,000 per year. The loss of any year will be set off from the profits of subsequent two years. The company is subject to 30 per cent tax rate and considers 12 per cent to be an appropriate after tax cost of capital for this project. The company follows straight line method of depreciation.
Required:
Calculate the net present value of the project and advise the management to take appropriate decision.
Note:
The PV factors at 12% are
Year 1 2 3 4 5 6 7 8
.893 .797 .712 .636 .567 .507 .452 .404
(Ans. NPV = 1,05,56,539)
QUESTION – 9 C Ltd. is considering investing in a project. The expected original investment in the project will be ₹ 2,00,000, the life of project will be 5 year with no salvage value. The expected profit after depreciation but before tax during the life of the project will be as following:
Year 1 2 3 4 5
5 [CAPITAL BUDGETING]
₹ 85,000 1,00,000 80,000 80,000 40,000
The project will be depreciated at the rate of 20% on original cost. The company is subjected to 30% tax rate.
Required:
(i) Calculate payback period and average rate of return (ARR)
(ii) Calculate net present value and net present value index, if cost of capital is 10%.
(iii) Calculate internal rate of return.
Note: The P.V. factors are:
Year P.V. at 10% P.V. at 37% P.V. at 38% P.V. at 40%
(Ans. (i) Payback Period = 1.914 years, ARR = 53.90% (ii) NPV = 1,61,197.50, NPV Index = 0.81 (iii) IRR = 39.91%)
QUESTION – 10 A hospital is considering to purchase a diagnostic machine costing ₹ 80,000. The projected life of the machine is 8 years and has an expected salvage value of ₹ 6,000 at the end of 8 years. The annual operating cost of the machine is ₹ 7,500. It is expected to generate revenues of ₹ 40,000 per year for eight years. Presently, the hospital is outsourcing the diagnostic work and is earning commission income of ₹ 12,000 per annum; net of taxes.
Required:
Whether it would be profitable for the hospital to purchase the machine? Give your recommendation under:
(i) Net Present Value method
(ii) Profitability Index method.
PV factors at 10% are given below:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 7
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
6 [CAPITAL BUDGETING]
(Ans. (i)NPV = -5,055.64 (ii) PI = 0.937)
QUESTION – 11 The management of P Limited is considering selecting a machine out of two mutually exclusive machines. The company‟s cost of capital is 12 percent and corporate tax rate for the company is 30 percent. Details of the machines are as follows:
Machine – I Machine – II Cost of Machine ₹ 10,00,000 ₹ 15,00,000 Expected life 5 years 6 years Annual income before tax and depreciation ₹ 3,45,000 ₹ 4,55,000
Depreciation is to be charged on straight line basis.
You are required to:
(i) Calculate the discounted pay-back period, net present value and internal rate of return for each machine.
(ii) Advise the management of P Limited as to which machine they should take up.
The present value factors of Re. 1 are as follows:
Year 1 2 3 4 5 6 At 12% 0.893 0.797 0.712 0.636 0.567 0.507 At 13% 0.885 0.783 0.693 0.613 0.543 0.480 At 14% 0.877 0.769 0.675 0.592 0.519 0.456 At 15% 0.870 0.756 0.658 0.572 0.497 0.432 At 16% 0.862 0.743 0.641 0.552 0.476 0.410
(Ans. (i)Discounting Payback period, NPV and IRR- Machine I= 4.49 years, 86,909, 15.46%, Machine II= 5.41 years, 1,80,074, 4.74%)
QUESTION – 12 Consider the following mutually exclusive projects:
Cash flows (₹)
Projects C0 C1 C2 C3 C4 A 10,000 6,000 2,000 2,000 12,000 B 10,000 2,500 2,500 5,000 7,500 C 3,500 1,500 2,500 500 5,000 D 3,000 0 0 3,000 6,000
Required:
(i) Calculate the payback period for each project.
