Questions on CAPITAL BUDGETING

Ques 1 A business enterprise can make either of two investments at the beginning of 2015.
Assuming required rate of return in 10% p.a. evaluate the investment proposals under:
(a) Return on investment
(b) Payback Period
(c) Discounted payback period
(d) Profitability index
The forecast particular are given below:
Particulars Proposal A Proposal B

Cost of Investment $20,000 28,000

Life 4 years 5 years

Scrap Value Nil Nil

Net Income (After depreciation and tax):

End of 2015 $500 Nil

End of 2016 $2,000 $3,400

End of 2017 $3,500 $3,400

End of 2018 $2,500 $3,400

End of 2019 Nil $3,400

It is estimated that each of the alternative projects will require an additional working
capital of $2,000 which will be received back in full after the expiry of each project life.
Depreciation is provided under the straight-line method. The present value of $1 to be
received at the end of each year, at 10% p.a. is given below:
Year 1 2 3 4 5

P.V. .91 .83 .75 .68 .62

Ques 2 SK Manufacturing Company uses discounted payback period to evaluate investments

in capital assets. The company expects the following annual cash flows from an investment
of $3,500,000:
YEARS CASH FLOWS $
0 (3,500,000)
1 900,000
 2 900,000
3 900,000
4 900,000
5 900,000
6 900,000
7 900,000
8 900,000

No salvage/residual value is expected. The company’s cost of capital is 12%

Required:
a) Compute discounted payback period of the investment.
b) Compute Payback period of the investment.
c) Is the investment desirable if the required payback period is 4 years or less?

Ques 3 Sunlight company needs a machine for its manufacturing process. The cost of the
new machine is $80,700. The expected useful life of the machine is 8 years. At the end of 8-
year period, the machine would have no salvage value. After installation, the machine would
increase cash inflows by $30,000 per year. Sunlight is interested to know the net present
value of the machine to accept or reject this investment. The minimum required rate of
return of the company is 16% on all capital investments.
Required:
Compute net present value of the machine.
Is it acceptable to purchase the machine?

Ques 4 A machine can reduce annual cost by $40,000. The cost of the machine is 223,000
and the useful life is 15 years with zero residual value.
Required:
Compute IRR of the machine.
Is it an acceptable investment if cost of capital is 16%?

Ques 5 A mining company is considering to open a new coal mine. The company has
collected the following information about the cash flows associated with this project:
 Equipment needed for new mine: $900,000
 Working capital required for new mine: $210,000
 Expected annual cash inflow from the sale of coal: $750,000
 Expected annual cash expenses associated with the new mine: $500,000
 Road repairs required after 5 years: $110,000
The coal in the mine would be exhausted after 15 years. The equipment would be sold for
its salvage value of $250,000 at the end of 15-year period. The company uses straight line
method of depreciation and does not take into account the salvage value for computing
depreciation for tax purpose. The tax rate of the company is 30%.
Required:
a) Compute net present value (NPV) of the new coal mine assuming a 15% after-tax
cost of capital.
b) On the basis of your computations in requirement 1, conclude whether the coal
mine should be opened or not.
Ques 6 The Universal Trading Company has obtained a license to introduce a new product
for 6 years. The product would be purchased from manufacturing company for $10 per unit
and sold to customers for $20 per unit. The estimated annual cash expenses to sell the new
product would be $18,000. Other information associated with the new product is given
below:
 Cost of equipment needed: $30,000
 Working capital needed: $40,000
 Repairs and maintenance of equipment after 5 years: $2,500
 Residual value of equipment after 6 years: $5,000
The working capital would be released at the end of 6-year period. The expected annual
sales are 5,000 units of product. The discount rate of the company is 16%.
Required:
a) Compute net present value (NPV) of the new product. (Ignore income tax).
b) Would you recommend the addition of new product?

Ques 7 The Martin Company is considering the four different investment opportunities. The
selected information about each proposal is given below:
Project 1 Project 2 Project 3 Project 4 Project 5
Investment (9,60,000) (7,20,000) (5,40,000) (9,00,000) (8,00,000)
Required
Present 1,134,540 866,800 672,280 1,045,940 759,520
Value of Cash
Inflows
Net Present 174,540 146,800 132,280 145,940 (40,480)
Value
Project Life 6 years 12 Years 6 Years 3 Years 5 Years
Internal Rate 16% 14% 18% 19% 8%
of Return

The present value of cash inflows given above have been computed using a 10% discount
rate. The company is unable to accept all available projects because the funds available for
investment are limited
Compute the profitability index (present value index) for all the projects.
Rank the four investment projects according to preference using:
(a) Net Present Value (NPV)
(b) Profitability Index (PI)
(c) Internal Rate of Return
Which one is the best approach for Martin Company to rank five competing projects?

Ques 8 Delta company manufactures silicon boards that are used in preparing small,
medium and large size electronic circuits. The company is considering reducing its cost by
automating some of its manufacturing tasks. This automation requires the installation of
new equipment. The relevant information for net present value (NPV) analysis of
investment in new equipment is given below:
  Cost of equipment: $72,000
 Expected annual cost savings to be provided by new equipment: $40,000
 Useful life of the equipment: 6 years
 Salvage value at the end of 6 years: $0
 Cost of capital: 23.2% (Nominal)
 Expected inflation rate in cash flows associated with the new equipment: 10%

Required:

1. What would be the net present value (NPV) of new equipment if:
(a). the inflation is considered?
(b). the inflation is not considered?
2. Should the new equipment be purchased?

Ques 9 Consider the following projects

Project C0 C1 C2 C3 C4 C5
A -1000 +1000
B -2000 +1000 +1000 +4000 +1000 +1000
c -3000 +1000 +1000 0 +1000 +1000

(A) If the opportunity cost of capital is 10%, which projects have a positive NPV?
(B) Calculate the payback period for each project
(C) Which projects would a firm using the pay back rule accept if the cut off period is 3
years
(D) Calculate the discounted pay back period for each project
(E) Which projects would a firm using the discounted pay back rule accept if the cut off
period is 3 years

Ques 10 Consider the following two mutually exclusive projects

Project C0 C1 C2 C3
A -100 +60 +60 0
B -100 0 0 140

(a) Calculate NPV of the each project for discount rate of 0%, 10%, and 20%. Plot these
on graphs with NPV on the vertical axis and discount rate on horizontal axis.
(b) What is approximate IRR for each project?
(c) In what circumstances should the company accept project A?