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Capital Budgeting - Solved Problems

# Capital Budgeting - Solved Problems

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05/14/2015

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FINANCIAL MANAGEMENT
Solved Problems
Rushi Ahuja1
SOLVED PROBLEMS – CAPITAL BUDGETING
Problem 1
The cost of a plant is Rs. 5,00,000. It has an estimated life of 5 years after which it would be disposed off (scrap value nil). Profit before depreciation, interest and taxes (PBIT) is estimated to be Rs. 1,75,000 p.a.Find out the yearly cash flow from the plant. Tax rate 30%.
Solution
Annual depreciation charge (Rs. 5,00,000/5) 1,00,000Profit before depreciation, interest and taxes 1,75,000- Depreciation 1,00,000Profit before tax 75,000Tax @ 30% 22,500Profit after Tax 52,500+ depreciation (added back) 1,00,000herefore, cash flow 1,52,500
Problem 2
A cosmetic company is considering to introduce a new lotion. The manufacturing equipment will cost Rs.5,60,000. The expected life of the equipment is 8 years. The company is thinking of selling the lotion in asingle standard pack of 50 grams at Rs. 12 each pack. It is estimated that variable cost per pack would beRs. 6 and annual fixed cost Rs. 4,50,000. Fixed cost includes (straight line) depreciation of Rs. 70,000and allocated overheads of Rs. 30,000. The company expects to sell 1,00,000 packs of the lotion eachyear. Assume that tax is 45% and straight line depreciation is allowed for tax purpose. Calculate the cashflows.
Solution
Initial cash outflow
Cost of equipments Rs. 5,60,000
Subsequent cash flows
Units sold 1,00,000Sales @ Rs. 12/- Rs. 12,00,000- Variable cost @ Rs. 6/- 6,00,000- Fixed cost (4,50,000 30,000 70,000) 3,50,000- Depreciation 70,000Profit before tax 1,80,000Tax @ 45% 81,000Profit after tax 99,000Depreciation (added back) 70,000Cash flow 1,69,000There is no terminal cash inflow. It may be noted that the allocated overheads of Rs. 30,000 gave beenignored as they are irrelevant.
Problem 3

FINANCIAL MANAGEMENT
Solved Problems
Rushi Ahuja 2
ABC and Co. is considering a proposal to replace one of its plants costing Rs. 60,000 and having awritten down value of Rs. 24,000. The remaining economic life of the plant is 4 years after which it willhave no salvage value. However, if sold today, it has a salvage value of Rs. 20,000. The new machinecosting Rs. 1,30,000 is also expected to have a life of 4 years with a scrap value of Rs. 18,000. The newmachine, due to its technological superiority, is expected to contribute additional annual benefit (beforedepreciation and tax) of Rs. 60,000. Find out the cash flows associated with this decision given that thetax rate applicable to the firm is 40%. (The capital gain or loss may be taken as not subject to tax).
Solution
(Amount in Rs.)
1. Initial cash outflow: 1,30,000Cost of new machine 20,000- Scrap value of old machine 1,10,0002. Subsequent cash inflows (annual)Incremental benefit 60,000- Incremental depreciationDep. On new machine 28,000Dep. On old machine 6,000 22,000Profit before tax 38,000- Tax @ 40% 15,200Profit after tax 22,800+ Depreciation (added back) 22,000Annual cash inflow 44,800The amount of depreciation of Rs. 28,000 on the new machine is ascertained as follows: (Rs. 1,30,000-Rs. 18,000)/4 = Rs. 28,000. It may be noted that in the given situation, the benefits are given in theincremental form i.e., the additional benefits contributed by the proposal. Therefore, only the incrementaldepreciation of Rs. 22,000 has been deduced to find out the taxable profits. The same amount of depreciation has been added back to find out the incremental annual cash inflows.
Terminal cash inflow:
There will be an additional cash inflow of Rs. 18,000 at the end of 4
th
year whenthe new machine will be scrapped away. Therefore, total inflow of the last year would be Rs. 62,800 (i.e.Rs. 44,800 + Rs. 18,000).
Problem 4
XYZ is interested in assessing the cash flows associated with the replacement of an old machine by a newmachine. The old machine bought a few years ago has a book value of Rs. 90,000 and it can be sold forRs. 90,000. It has a remaining life of five years after which its salvage value is expected to be nil. It isbeing depreciated annually at the rate of 20 per cent (written down value methd).The new machine costs Rs. 4,00,000. It is expected to fetch Rs. 2,50,000 after five years when it will nolonger be required. It will be depreciated annually at the rate of 33 1/3 per cent (written down valuemethod). The new machine is expected to bring a saving of Rs. 1,00,000 in manufacturing costs.Investment in working capital would remain unaffected. The tax rate applicable to the firm is 50 percent.Find out the relevant cash flow for this replacement decision. (Tax on capital gain / loss to be ignored).

FINANCIAL MANAGEMENT
Solved Problems
Rushi Ahuja 3Solution
Initial cash flows: Amt. (Rs.)
Cost of new machine 4,00,000- Salvage value of old machine 90,0003,10,000
Subsequent annual cash flows:(Amount Rs. ‘000)
Yr.1 Yr.2 Yr.3 Yr.4 Yr.5
Savings in costs (A) 100 100 100 100 100Depreciation on new machine 133.3 88.9 59.3 39.5 26.3- Depreciation on old machine 18.0 14.4 11.5 9.2 7.4Therefore, incremental depreciation (B) 115.3 74.5 47.8 30.3 18.9Net incremental saving (A B) -15.3 25.5 52.2 69.7 81.1Less: Incremental Tax @ 50% -7.6 12.8 26.1 34.8 40.6Incremental Profit -7.7 12.7 26.1 34.9 40.5Depreciation (added back) 115.3 74.5 47.8 30.3 18.9Net cash flow 107.6 87.2 73.9 65.2 59.4
Terminal cash flow:
There will be a cash inflow of Rs. 2,50,000 at the end of 5
th
year when the newmachine will be scrapped away. So, in the last year the total cash inflow will be Rs. 3,09,400 (i.e. Rs.2,50,000 + Rs. 59,400).
Problem 5
A firm is currently using a machine which was purchased two years ago for Rs. 70,000 and has aremaining useful life of 5 years.It is considering to replace the machine with a new one which will cost Rs. 1,40,000. The cost of installation will amount to Rs. 10,,000. The increase in working capital will be Rs. 20,000. The expectedcash inflows before depreciation and taxes for both the machines are as follows:
Year Existing Machine New Machine
1 Rs. 30,000 Rs. 50,0002 30,000 60,0003 30,000 70,0004 30,000 90,0005 30,000 1,00,000The firm use Straight Line Method of depreciation. The average tax on income as well as on capital gains / losses 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, and (iv) Rs. 30,000.