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 Machine’A’ Machine’B’
Cost 56,125 56,125
Net income after depreciation and taxes:
Ist Year 3,375 11,375
2nd Year 5,375 9,375
rd
3 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 machine’A” 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 B C
Cost (Rs.) 50,000 70,000 70,000
Life 10 years 12 years 14
years
Estimated scrap (Rs.) 5,000 10,000 7,000
Annual Profit after Taxation 5,000 6,000 5,500
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 PROJECT Y
4 Years 6 Years
Life of the project (Rs. In Lakhs)
Estimated Cash Outflow 15 15
Estimated Cash Inflow
1st Year 8 7
2nd Year 10 8
rd
3 Year 7 8
4th Year 3 6
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
rd
3 .579 .512 .455 .406 .364 .328 .296
4th .482 .410 .350 .301 .260 .226 .198
th
5 .402 .328 .269 .223 .186 .156 .132
6th .335 .262 .207 .165 .133 .108 .088

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
company’s 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.)
Initial Investment 1, 00,000 1, 40, 000
Year Profits after taxes
1 10,000 25,000
2 15,000 25,000
3 20,000 25,000
4 25,000 25,000
5 35,000 25,000

(i) Calculate the ‘net present value’ and ‘benefit-cost ratio’ for each project.
(ii) Evaluate the acceptability of each project on the basis of above mentioned two
techniques.
(iii) Select the best projects, using NPV and benefit cost ratios and comment on
the resulting rankings.
(iv) Assume that the Klein Co. has an 11% cost of capital.
(v) 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
nd
2 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 year’s 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 If CFAT= Rs. 30,000

_____________________ _____________________

Amount (Rs) Probability Amount (Rs) Probability

12,000 0.2 20,000 0.4

16,000 0.3 25,000 0.5
22,000 0.5 30,000 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.
 Assignment

Dear all

Please submit these assignments only in hard copy form on or before 27th Jan and 4th Feb
2011 to your class representative, no direct submission in my office.

Note: In case of any submission after due date, you are eligible for 1 marks deduction per
day and in case of cut copy past, maximum marks allotted is zero.

CIA-1
Marks Components
1. Three thought paper : 5 Marks [ Last date-27-01-2011]
2. 12 Assignment Problems: 5 Marks [ Last date-04-02-2011]
3. 3 Quiz-Best two is part of CIA10 Marks Declared Quiz up to 4th Feb
______________
20 Marks
______________

Date- 9-01-2011

Regards
Prof. Ramkesh Gupta
Instructor- Finance Area
Institute of Management
Christ University
Bangalore
Email- ram.kesh@christunivesity.in
Office: 918040129548