CASE STUDY IN CAPITAL BUDGETING

Question # 1:

What capital mix do you recommend for each project?

Definition:

Capital mix is the combination of debt and equity. Which a business is use to assess the
percentage of debt and equity.

Capital Mix for New Lights Plant:

Particular Weight Rupees(In Million) Cost(In %age) Weighted cost

Equity 70% 66.5 20% 14%
Loan 30% 28.5 12% 3.6%
Total 100% 95.00 17.6%

By using the weighted average cost of capital method we assumes that how much is the
percentage of debt and how much is equity for the project of New lights plant.

The result shows that company needed 70% equity and 30% debt for the project of New lights
plant. It shows that the company depend upon 70% of this project is on equity rather than the
debt.

Capital Mix for New Electrical Switches Plants:

Particular Weight Rupees(In Cost(In %age) Weighted cost

Million)
Equity 20% 22 20% 04%
Loan 80% 88 12% 9.6%
Additional 2%
Total 100% 110.00 15.6%
 CASE STUDY IN CAPITAL BUDGETING
By using the weighted average cost of capital method we assumes that how much is the
percentage of debt and how much is equity for the project of new lights and plants.

The result shows that company needed 20% equity and 80% debt for the project of new
electrical switches plants. It shows that the company depend upon 80% of this project is on
debt rather than the equity.

Question # 2:

Based on your recommended capital mix, what discounting rate would you use for each
project?

Definition:

The percentage rate which you use to calculate present value is called discounting rate.

Discounting rate for New lights and Plants:

Base on the recommendation of capital mix the company can use 17.6% for the project of New
lights plant.

Discounting Rate for New Electrical Switches Plant:

Base on the recommendation of capital mix the company can use 15.6% for the project of new
electrical switches plant
 CASE STUDY IN CAPITAL BUDGETING
Question # 3:

Do you agree with the Chiragh Din that a higher discounting rate should be used for the
switches project? Why?

Yes, I am agreed with the Chiragh Din that they should use higher discounting rate for the
project of switches. Because in this project company is going to enter new international market,
this is considered to be risky market because they are new in this market and they have a lot of
competitor in the market. There is a lot of risk involved that’s why Chiragh Din us higher
discount rate. As the factor of risk increases that may also increase the interest rate.

Question #4:

Calculate each project’s Payback period, ARR, NPV and IRR?

Years Sales Direct Admin Marketing Profit Deprecation Cash Accumulated

Revenue Cost Overhead Overhead Profit Cash Flows

0 (95)
1 45 27 2 6.2 9.8 7.5 17.3 (77.7)
2 60 36 2.5 5 16.5 7.5 24 (53.7)
3 75 45 3 5 22 7.5 29.5 (24.2)
4 85 51 3.5 5.5 25 7.5 32.5 (8.3)
5 100 60 4 5.5 30.5 7.5 38 46.3
6 110 66 4.5 6 33.5 7.5 41 87.3
7 124 74.4 5 6 38.6 7.5 46.1 133.4
8 135 81 5.5 6.5 42 7.5 49.5 182.9
9 151 90.6 6 6.5 47.9 7.5 55.4 238.3
10 165 99 6.5 7 52.5 7.5 60 298.3
Estimated Revenue and Expenses of New Lights Plant:

Payback period:

The payback period for the project is 4 year. Because in this year company has return its initial
investment.
 CASE STUDY IN CAPITAL BUDGETING

Accounted Rate of Return (ARR):

Average profit /initial investment *100

39.33 /95 *100 =41.4%

Net Present Value (NPV):

Years Cash flows Present value of future cash flow Present value of future cash
(17.6%) flow (31%)
0 (95) (95) (95)
1 17.3 14.710 13.206
2 24 17.353 13.985
3 29.5 18.138 13.122
4 32.5 16.992 11.035
5 38 16.894 9.8497
6 41 15.500 8.1125
7 46.1 14.820 6.9630
8 49.5 13.531 5.7073
9 55.4 12.877 4.8760
10 60 11.859 4.0312
Total 57.696 (4.110)

Internal rate of return (IRR):

LDR+ (HDR-LDR) (PNPV) / (PNPV-NNPV)

0.176+ (0.31-0.176) (57.696) / (57.696+4.110) = 30.10%

 CASE STUDY IN CAPITAL BUDGETING

Estimated Revenue and Expenses of New Electrical Switches Plant:

Year Sales Direct Admin Marketing Profit Deprecation Cash Accumulated

s Revenue cost overhead overhead profit cash flows
0 (110)
1 80 57.6 3 7.5 11.9 8 19.9 (90.1)
2 88 63.4 3.5 5 16.1 8 24.1 (66)
3 96.8 69.7 4.2 5 17.9 8 25.9 (40.1)
4 106.5 76.7 5 5.5 19.3 8 27.3 (12.8)
5 117.1 84.3 5.5 5.5 21.8 8 29.8 17
6 128.8 92.8 6 6 24 8 32 49
7 141.7 102 6.6 6 27.1 8 35.1 84.1
8 155.9 112.2 7 6.5 30.2 8 38.2 122.3
9 171.5 123.5 7.5 6.5 34 8 42 164.3
10 188.6 135.8 8 7 37.8 8 45.8 210.1

Payback period:

The payback period for the project is 5 year. Because in this year company has return its initial
investment.

Accounted Rate of Return (ARR):

Average profit/initial investment*100

32.01/110*100 =29.1%
 CASE STUDY IN CAPITAL BUDGETING

Net Present Value (NPV):

Years Cash Flows Present value of future cash Present value of future
flow (15.6%) cash flow (23%)
0 (110) (110) (110)
1 19.9 17.214 16.17886
2 24.1 18.034 15.92967
3 25.9 16.765 13.91824
4 27.3 15.287 11.9273
5 29.8 14.435 10.585
6 32 13.409 9.241007
7 35.1 12.723 8.240837
8 38.2 11.978 7.291594
9 42 11.392 6.517834
10 45.8 10.747 5.77849
Total 31.988 (4.391)

Internal rate of return (IRR):

LDR+ (HDR-LDR) (PNPV) / (PNPV-NNPV)

0.156+ (0.23-0.156) (37.988) / (37.988+4.391) = 22.23%

Question # 5:

Do you think the company should undertake both the projects simultaneously? Give reasons
to support your answers?
 CASE STUDY IN CAPITAL BUDGETING
No we don’t think so that company should undertake both the projects simultaneously.
Because if you see the different techniques of evaluating the investment than these techniques
didn’t support the project. Base on these techniques we suggest Chiragh din that they cannot
accept the new electrical switches plant project. Now we can compare both the project on the
basis of techniques which we can use for evaluating the project.

If you can compare it with the payback period of both the project than the payback period for
new lights plant are a 4 year and new electrical switch plant is 5 year. So the payback for new
electrical switches plant is higher than the new lights plant. Which can support our first project?

If you can compare it with the technique of accounted rate of return than the accounted rate of
return of new lights plant are higher than the new electrical switches plant. The ARR for new
lights and plant is 41.4% and ARR for new electrical switches plant is 29.1%. So the ARR for is
higher which can be in favor of them.

If you can compare it with the technique of net present value, than the discounting rate which
we can be assumed on the weighted cost that can also support the project. Because the
present value of future cash flows of new lights plant is better than electrical switches.

If you can compare it with the technique of IRR, than the IRR also accept the project of new
lights plant. The IRR for new lights plant is 30.10% and IRR for new electrical switches is 22.23%.

If the company can go for switches project than they can use their name ZAPP. If that company
can cancel the contract or the contract duration are completed and they didn’t continue any
more then the chiragh has no reorganization in this market they are zero.
 CASE STUDY IN CAPITAL BUDGETING
So at the end we can conclude that all of the techniques which we can use for evaluating the
projects are in favor of new lights and plant project. That’s why it’s better for the company that
they should not undertake both the projects simultaneously.

Question # 6

If the company should implement only one project, which one it should be? Why?

On my recommendation the company should implement only one project that is

project. Because company is already in the same project in the north of the twin cities of
Rawalpindi and Islamabad, going up to Peshawar. So it’s better for the company that they
should enter into the market of Punjab. This can not only expand its business in other market
but also increase the good will of Chiragh din’s company.

If the company go for the switches project that’s not the better option. Because in this
project the company is using the name of British firm that is Zapp. So its self Chiragh din has no
reorganization in international market. If British firm has cancel the project then Chiragh din is
zero in that market.

The techniques which we can use to evaluate the project are totally supporting the
project of new lights plant. This project is less risky than the new electrical switches project.
Because in this project company is more depend upon equity rather than the loan.