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Rahat A.

Khan C-257, Hans-Marg, Malviya-Nagar, Jaipur # 9829464488

CAPITAL BUDGETING
Solution of Practice Question No. 3:
Synergy Plastics Ltd. is considering a proposal of producing high quality plastic glasses. The necessary equipment to manufacture the glasses would cost Rs. 1 lac and would last 5 years. The tax relevant rate of depreciation is 25 per cent on WDV. There is no other asset in this block. The expected salvage value is Rs. 10,000. The glasses can be sold at Rs. 4 each. Regardless of the level of production, the manufacturer will incur cash cost of Rs. 25,000 each year if the project is undertaken. The overhead costs allocated to this new line would be Rs. 5,000. The variable costs are estimated at Rs. 2 per glass. The manufacturer estimates it will sell about 75,000 glasses per year; the tax rate is 35 per cent. Should the proposed equipment be purchased? Assume 20 per cent is the cost of capital and additional working capital requirement is Rs. 50,000. In the terminating year, no depreciation is to be charged, due to the asset been sold in the year.

Solution:
Initial Cash Outlay: Cost of Equipment = Add: W.C. Required = Initial Cash Outlay (O) = Rs. 1,00,000 Rs. 50,000 Rs. 1,50,000

Annual PBDT: Sales (75,000 4): Less: Variable Cost (75,000 2): Contribution (C): Less: Fixed Cost: Profit Before Dep. & Tax (PBDT):

Rs. 3,00,000 Rs. 1,50,000 Rs. 1,50,000 Rs. 25,000 Rs. 1,25,000

Annual Depreciation @ 25% W.D.V.: Year Opening Value Depreciation Closing Value Annual Cash Inflows: Particulars PBDT Less: Dep. PBT Less: Tax PAT Add: Dep. Cash Inflow Year 1 1,25,000 25,000 1,00,000 35,000 65,000 25,000 90,000 Year 2 Year 3 1,25,000 1,25,000 18,750 14,063 1,06,250 1,10,937 37,187 38,828 69,063 72,109 18,750 14,063 87,813 86,172 Year 4 Year 5 1,25,000 1,25,000 10,547 ----1,14,453 1,25,000 40,058 43,750 74,394 81,250 10,547 ----84,941 81,250 1 1,00,000 25,000 75,000 2 75,000 18,750 56,250 3 56,250 14,063 42,187 4 42,187 10,547 31,640 5 31,640 ---31,640

Rahat A. Khan C-257, Hans-Marg, Malviya-Nagar, Jaipur # 9829464488


Terminal Cash Inflow: Salvage Value: Add: Release of W.C. Rs. 10,000 Rs. 50,000 Rs. 60,000 Add: Tax Saving on Capital Loss: Rs. 7,574* Terminal Inflow: Rs. 67,574 *Calculation of Tax Saving on Capital Loss on Sale of Equipment in the Terminating Year: As per Income Tax provisions for Block of Assets containing single asset it is assumed that the asset is sold at the start of the terminating year. WDV of the equipment at the start of terminating year: Rs. 31,640 Less: Salvage Value of the Equipment: Rs. 10,000 Loss on Sale of Equipment in the Terminating Year: Rs. 21,640 Tax Saving on Loss on Sale (Rs. 21,640 35%): Rs. 7,574 PV Factor @ 20% 1.000 Present Value of Cash Inflows (1,50,000)

Cash Flows Initial Cash Outlay (O) (1,50,000) Annual Cash Inflows: 1. 2. 3. 4. 5. Terminal Cash Inflow: 5.

90,000 87,813 86,172 84,941 81,250

0.833 0.694 0.579 0.482 0.402

74,970 60,942 49,894 40,941 32,663

67,574

0.402 =

27,165 1,36,575

Net Present Value (NPV)