Assignment-3

(Solution)

1. The inflation is defined as _____________. -----------------------1 mark

A. Increase in the price level resulting in increase in purchasing power of money

B. Increase in the price level resulting in decrease in purchasing power of money
C. Decrease in the price level resulting in increase in purchasing power of money
D. Decrease in the price level resulting in decrease in purchasing power of money
Solution: Increase in the price level resulting in decrease in purchasing power of money

2. Given selling price is INR 20 per unit, variable cost is INR 12 per unit and fixed cost is
INR 16,000. What is break-even point? ---------------------------------1 mark

A. 1200 units
B. 1600 units
C. 2000 units
D. None of the above
Solution:
Assume break even quantity to be n
20*n = 12*n + 16,000
8n = 16,000
n= 2,000

3. Two pumps can be used for pumping a corrosive liquid. A pump with a brass impeller costs
INR 40,000 and is expected to last for three years. A pump with a stainless-steel impeller will
cost INR 95,000 and lasts for five years. An overhaul costing INR 15,000 will be required after
2000 operating hours of brass one while an overhaul of INR 35, 000 for stainless steel after
9000 hours. If the operating cost of each pump is INR 25/hour, how many hours /year (rounded
off to nearest integer) must the pump be required to justify the purchase of an expensive pump?
Interest rate 10% per year. ------------------------------------------------------ 2 mark

Solution:

Description Brass impeller Stainless steel impeller

Initial cost (INR) 40000 95000
Life 3 years 5 years
Overhaul costing INR 15000 @ 2000 operating INR 35000 @ 9000 operating
hours hours
 Operating cost INR 25 per hour INR 25 per hour
Interest rate 10% per annum 10% per annum

Let ‘x’ = operating hours per year

Then, Overhaul cost for brass impeller = (15000*2000) *x
Overhaul cost for stainless steel impeller = (35000*9000) *x
Operating cost for both the impeller = 25×x
To justify the purchase of an expensive pump, equate the annual costs of both the pumps:
40000(A/P,10%,3) +15000/2000*x+25*x=95000(A/P,10%,5) +35000/9000*x+25*x
40000*0.4021+15000/2000*x=95000*0.2638+35000/9000*x
16084+7.5x=25061+3.89x
Solving for x,
x=2487
Therefore, minimum 2487 operating hours are required to justify the purchase of an expensive
pump.
Answer: 2487
(Range 2470-2500)

Consider the following information for Questions 4 and 5:

1. Initial value of an equipment = INR 950,000
2. Salvage value of the equipment = INR 50,000
3. Useful life of the equipment = 5 years
4. Rate of interest whenever applicable = 20%
4.What amount needs to be set aside every year during the service life in order that the
equipment can be immediately replaced at the end of the service life, assuming that there is no
change in the initial value of the equipment? Consider the time value of money for all
calculations. (1 mark)
Note: Enter only the value rounded to the next higher integer (e.g. for INR 248.56 enter
your answer as 249). Do not put any comma. For example, (i) if your answer is INR 100,000,
then enter 100000
Answer: INR 120942
[Range: 120930 to 120980]

Solution: Let P = initial value; S = salvage value; n = service life; i = 20% = 0.2
Annual depreciation expense = sinking fund deposit factor * (P – S)
 Amount to be set aside every year A=annual depreciation expense
= i/((1+i) n-1) *(P-S) =0.2/ ((1.2)5-1) *(950000-50000) =INR 120942

5. Consider the following statements: (2 marks)

Statement 1: If the Double declining balance method of calculating the depreciation is used,
the book value of the equipment at the end of Year-5 is INR 50,000.
Statement 2: Assuming that the book value at the end of a given year is to be calculated
using the higher value of the depreciations determined using the Sum-of-years method and
the Double declining balance method, the book value of the equipment at the end of Year-
3 is INR 196,000
Which of the following statements is CORRECT?
A. Both Statement 1 and Statement 2 are TRUE
B. Statement 1 is TRUE and Statement 2 is FALSE
C. Statement 1 is FALSE and Statement 2 is TRUE
D. Both Statement 1 and Statement 2 are FALSE
Answer: C
Book values of the equipment based on Double declining balance method (DDB):

Year Opening book Depreciation Closing book Remarks

value (BVo, (lakhs) value (BVc,
lakhs) lakhs)
1 9.50 3.80 5.70
Depreciation in nth year =
2 5.70 2.28 3.42 (2/N) * (BVn-1)
3 3.42 1.368 2.052 Where N = 5, and therefore
4 2.052 0.8208 1.2312 factor of depreciation =
5 1.2312 0.49248 0.73872 (2/N) = 0.4

Thus, the closing book value of the equipment through DDB method is INR 73,872.
Switching between the methods:
Year Opening Depreciation (lakhs) Closing Remarks
book book
value Sum- Double Depreciation value Calculating Calculating
(BV ,
o of-year declining to be (BV D c, t, SOY Dt, DDB

lakhs) method balance considered = lakhs)

D t, SOY method Higher of (D t,

Dt, DDB
and D )
SOY t, DDB

1 9.50 3.00 3.80 3.80 5.70 (9.50-0.50) .4*9.50

*(5/15)
 2 5.70 2.08 2.28 2.28 3.42 (5.70-0.50) .4*5.70
*(4/10)
3 3.42 1.46 1.368 1.46 1.96 (3.42-0.50) .4*3.42
*(3/6)
4 1.96 0.9733 0.784 0.9733 0.9867 (1.96-0.50) *(2/3) .4*1.96
5 0.9867 0.4867 0.39468 0.4867 0.50 (0.9867-0.50) .4*0.9867
*(1/1)

6. Suppose you are a purchasing manager in a company who is given a responsibility to buy
a concrete pump for the construction work. You have two alternatives to select from.

Description Alternative 1 Alternative 2

Initial cost INR 10 lakhs INR 6 lakhs

Operating cost (annual) INR 3.75 lakhs INR 4.4 lakhs

Economic life 4 years 4 years

Salvage value 0 0

Assume:

i) all operating cost are admissible for a tax rebate.

ii) interest rate= 10% per year.
iii) depreciation is computed using a straight-line method, and,
iv) corporate tax is payable at @40% of the Gross income

The difference in NPW (after tax) between both the alternatives in INR Lakhs (rounded off
to two decimal places) is ___. -----------------------------------2 marks
Solution:
Post tax computation:

Description Alternative 1 Alternative 2

Operating cost (annual) INR 3.75 lakh/annum
Depreciation on initial cost (using INR (10 – 0)/4 = INR
straight line method) 2.50 lakh/annum
Total taxable amount INR (3.75 + 2.50) = INR
6.25 lakh/annum
Saving in Tax @ 40% INR (0.40 x 6.25) = INR
2.50 lakh/annum
Net cost per annum INR (3.75 – 2.50) = INR
1.25 lakh/annum
INR 4.40 lakh/annum
INR (6 – 0)/4 = INR 1.50
lakh/annum
INR (4.40 + 1.50) = INR
5.90 lakh/annum
INR (0.40 x 5.90) = INR
2.36 lakh/annum
INR (4.40 – 2.36) = INR
2.04 lakh/annum

Cash flow of alternative 1 (post tax):

NPW (alternative 1) = -10.00-1.25(P/A,10%,4) = -10.00-1.25 ×3.1699 = -INR 13.96 lakh
Cash flow of alternative 2 (post tax):
NPW (alternative 2) = -6.00-2.04(P/A,10%,4) = -6.00-2.04 ×3.1699 = -INR 12.47 lakh
Answer: 1.49; Range (1.45 to 1.54)

7.Considering the interest rate of 14% and an inflation rate of 8.5%, what is the modified
discount rate ………...? --------------------------------------------------1 mark
A.2.70%
B. 5.07%
C.5.50%
D.11.25%

Solution:
Modified discount rate = [((1+ interest rate%)/ (1+ inflation rate %))-1] *100

Modified discount rate=5.069%