AFM 32nd Batch

Case No. 4 Capital Budgeting decisions

Axa Limited manufactures varnish. The industry got instructions from central
government to stop importing components from foreign countries and produce all the raw
material in-house. The incentives would not be given to the companies in the industry if
they do not start in-house production. Company was forced to buy new machinery
immediately. Manager was asked to choose between two machines Ace and Pace. The
two machines are structurally different from each other. They however have identical
production capacity and function exactly in the similar manner.
Cost of machine Ace is Rs.3,00,000 and life is 3 years. The cost of maintenance is 80,000
per year.
Machine Pace is however an economy model and thus the purchase price is Rs.2,00,000
and life is 2 years .Annual maintenance cost is Rs. 1,20,000. Ignore tax. Minimum
requires rate of return is 11%. Evaluate the purchase packages of both the machines and
choose the best one.

Company Max Ltd. is a competitor company operating in the same industry as that of
Axa.
Max is operating an old machine currently for some other product. But now the company
will use the same for production of one of the components that it was importing
previously. Expected cash flows for the current year as also the next year are Rs. 80,000.
Salvage value of the old machine is Rs.1,60,000 if sold this year and the salvage value
will be Rs.1,40,000 if sold next year.
The machine can be replaced now with a new machine costing Rs. 3,00,000. New
machine is very efficient and is expected to produce a cash inflows of Rs.1,60,000 a year
for next three years. Max Ltd. wants to know if it should replace the machine this year or
in the next year. New machine is surely more efficient than old and is going to give more
inflows.

Guide the company correctly so that replacement is done at the correct point. Ignore
taxation. Rate of return expected is 11%. Give reasons for your advice.
Your calculations should include the followinga) Calculation of present value of cash inflows of new machine, if it replaces the old
machine now
b) Calculation of present value of cash inflows of new machine, if it replaces the old
machine next year

Answer the following before solving the case-

Both the companies are expecting a minimum rate of return of 11% at the moment. Now,
assume that the risk has increased for both the companies. What are the ways in which the
company can accommodate the risk in the cash flows and also in the rate of return? Explain
at least two ways.

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