1.

Ambi’s Tiffin Room (Ambi’s) is looking at opening a new eatery outside Lal Bagh, West Gate in
Bangalore. Some key elements of the financial forecast and investment outlay that Ambi’s
financial consultant prepared as part of capital budgeting are given below, with brief remarks
explaining each of the line items. You are required to prepare a similar table (use the blank table
on the next page) in order to arrive at the Cashflow for Capital Budgeting at the end of the fifth
year (when Ambi will exit the proposed new business) giving line items that are relevant. If there
are entries in the consultant’s statement that you do not agree with you may recast them as you
consider appropriate.

Amount
No Item Rs / Remarks
lakhs
Depreciated over 5 years, WDV rate = 25%. Salvage value at the end
1 Equipment 25
of Year 5 estimated as zero
Utensils,
2 3 Depreciated fully in Year 1
cutlery
Level of working capital required each year is set at 10% of revenue
Investment in
for that year. Investment in working capital will be made on the
3 Working 10
last day of the previous accounting year. Working capital will be
Capital
liquidated at cost at the end of Year 5.
4 Revenue 100 Expected to grow at 25% per annum
Expected to grow at 20% per annum. Includes a constant, fixed
Operating
5 50 allocation of Rs 10 lakhs towards the new restaurant’s share of an
costs
existing pool of common costs.
Amortised Represents the new unit's share of the cost of a master plan for the
6 start-up 4 whole firm, drawn three years back. The cost is a fee paid to
expenses consultants recruited at that time.
Marketing
7 10 Grows at 15% per annum
Expenses
PBIDTA (4-5-6-
8 36 Profit before Interest Depreciation Tax and Amortisation
7)
9 Interest 2 Assumes interest at 10% per annum, payable quarterly
10 Depreciation 9.25 Charged as above, including write off of utensils
Profit Before
11 24.75 PBIDTA - Interest – Depreciation
Tax
Tax credit / shield if any are required to be utilised in the same
12 Tax @ 40% 9.90
year.
Profit After
13 14.85 PBT-Tax
Tax
Cashflow for
14 24.10 PAT + Non cash charges
Cap Budgeting
Note
(i) Items (1) to (3) relate to investments at current time
(ii) Items (4) through (14) relate to operational revenue, costs, and cashflow in Year 1
2. Polybed Ltd., a leading manufacturer of moulded beds, sells 3,000 beds per year. The selling price
of a moulded bed was Rs. 5,000 and the manufacturing cost of a bed was Rs. 3,000 during the year
that just got over. Both prices and costs increase by 10% annually. The beds are currently
manufactured using machines that were purchased a long time back and are fully depreciated.
These machines are built to last for ever. Polybed’s product has good demand and current trends
suggest that revenues will continue to grow at the current rate for ever.

Polybed is now considering use of a new, improved machine. The new machine costs Rs. 10 million
but it reduces the cost of manufacturing to 2/3 of the currently used machine. Its production
capacity is the same as that of the old one, and it is also built to last forever. As part of a fiscal
stimulus package, the government has allowed firms to depreciate new investments in machinery
on a straight line basis over 2 years. The new machine can be set-up very quickly, and production
can start immediately. The old machine will have to be scrapped but it has no salvage value.
Polybed’s tax rate is 30%.

What are the cash flow implications if Polybed invests in the new machine? Use the table on the
next page to present and explain your answer.

Given your answer to (a), should Polybed invest in the new machine? Assume an opportunity cost
of capital of 15% . What will be the impact on the current value of Polybed if it undertakes this
new investment?

3. Ramji Systems has developed a new security device using cornea-imaging technology (CIT) for
identification purposes. So far Ramji Systems has invested Rs. 2 crores to develop the technology
solution. The product has gone through several rounds of testing and has got a favourable response
from potential customers.

Ramji Systems needs to take a decision about investing a further Rs. 10 crores to take the product
to the market. The company estimates that there would be demand for 10 systems in a year. Beyond
5 years there would not be any demand for this product since by then more advanced products would
be there in the market. The investment of Rs. 10 crores would be in plant and equipment, which is
depreciated at the rate of Rs. 1.50 crores per year for tax as well as book purposes. Ramji estimates
that the plant and equipment could be sold at a market value of Rs. 3 crores at the end of 5 years.
The project would be housed in a facility that cost Rs 50 lakhs to build. Prior to setting up this
project the company was planning to sell off the building at cost. Once used for this project, at the
end of the project the building will have no market value. The land on which the building has been
constructed is on lease that lapses at the end of the proposed project. The depreciation on the
building would be Rs 10 lakhs a year for tax as well as book purposes.
The price of each CIT solution would be increased at 10% each year starting with Rs. 1 crore in the
first year. The annual increase in the price of the solution year is expected to cover the higher cost
of production as a result of inflation. It is expected that 10 units would be sold every year. Net
working capital requirement is 10% of sales and has to be provided for at the beginning of the year.
Working capital consists of raw material inventory and will be entirely recovered at cost at the end
of 5 years. Cost of goods sold, excluding depreciation, is 60% of revenues. The tax rate is 30%. The
financial controller of Ramji Systems believes that Rs. 2 crores invested in developing the product
should be recovered and should be included as part of the investment in the project.
Forecast cash flows for the project.

4. Indian Pharma is engaged in the manufacture of pharmaceuticals. The company was established in
1991 and has registered a steady growth in sales since then. Presently the company manufactures
16 products and has an annual turnover of Rs 2200 mn. The company is considering the
manufacture of a new antibiotic, K-cin, for which the following information has been gathered.
 K-cin would have a product life cycle of five years after which the product would be withdrawn
from the market. The sales from K-cin are expected to be as follows:

Year 1 2 3 4 5
Sales (Rs mn.) 100 150 200 150 100

The capital equipment required for K-cin is Rs 100 mn. and it will be depreciated at the rate of 25%
per annum as per the WDV method for tax purposes. The expected net salvage value after five
years is Rs 20 mn.

The working capital requirement for the project is 20% of sales. At the end of five years working
capital is to be liquidated at par, barring an estimated loss of Rs 5mn. on account of bad debt.

The accountant of the firm has provided the following cost estimates for K-cin:

Raw Material Cost 30% of sales

Variable Labour Cost 20% of sales
Fixed Annual Operating and Maintenance Cost Rs 5 mn.
Overhead allocation (excluding depreciation,
maintenance and interest) 10% of sales

While the project is charged an overhead allocation, it is not likely to have any effect in terms of
additional overhead expenses.

The manufacture of K-cin would also require some of the common facilities of the firm. The use of
these facilities would call for reduction in the production of other pharmaceutical operations of the
firm. This would entail a reduction in contribution margin of Rs 15 mn.

The tax rate applicable to the firm is 40%.

Develop a set of cash flows for the project that can be used to calculate the NPV for the proposed
project.

* Adapted from the book by Prasanna Chandra

5. Kakofonix Musicals (Kakofonix, hereafter) has been extremely successful in publishing several new
genres of music that has taken the world of young by storm. Although extremely harsh on the
human ear, their style and grammar is seen by their fans as a Luddite expression of anger at
mindless automation, jobless growth and widening income inequality. The management in
Kakofonix now sees an opportunity in providing bands trained in their genres to various venues like
cafes, pubs and corporate events on a “rent per event” basis (“Rent a Band” project, hereafter).
The capital budgeting proposal for Rent A Band is captured in the table below. Explanation for the
line items are also given below after the table. You are required to prepare the cash flows
required for evaluating the net present value for this project, assuming a cost of capital of 20%.
The marginal corporate tax for the business is 40%. The albums business of Kakofonix is highly
profitable and is expected to remain so for the next ten years or more…… 15 marks
i. The business will be organized as a division of Kakofonix, the other division being the album
business.
ii. Sales is expected to be collected in the same month. To the extent that there is a delay beyond a
month the amount has been provided for in working capital build-up.
iii. Cost of musicians will be paid in the same month in which they render services.
iv. Sales and administrative costs relate to the Rent A Band business and will also be paid in the month
in which it is incurred.
 v. Office and Infrastructure Investments will be made at the start of the project and will be written
off for tax and accounting purposes at the same rate of Rs 20 lakhs per annum over a five year
period.
vi. Marketing costs allocated are in respect of digital marketing services that the project will avail of
from the album business. These expenses are part of digital campaign costs that Kakofonix anyway
runs for the album business.
vii. For capital budgeting purposes the business is expected to be wound down at the end of five years.
The infrastructure will disposed of as scrap for negligible value. Working capital will be salvaged at
cost in the fifth year as the business winds down.

All figures in lakhs of rupees unless stated otherwise

0 1 2 3 4 5
Office and Infrastructure -100 0
Net Working Capital - Cumulative -40 -60 -75 -75 -75
Sales 25 100 200 300 400
Cost of musicians 60 90 150 200 240
Sales and administrative costs 20 50 60 70 80
Office and Infrastructure written off 20 20 20 20 20
Taxable Income -75 -60 -30 10 60
Marketing costs allocated 25 25 25 25 25