CAPITAL BUDGETING

1. SCL Limited is engaged in the manufacture of power-intensive products. As part of its diversification plans,
the company proposes to put up a windmill to generate electricity. The details of the scheme are as follows:
a. Cost of the windmill, Rs 300 lakhs
b. Cost of land, Rs 15 lakhs
c. Subsidy from the state government to be received at the end of the first year of installation, Rs 15 lakh.
d. Cost of electricity will be Rs 2.25 per unit in year 1. This will increase by Re 0.25 per unit every year
till year 7. After that, it will increase every year by Re 0.50 per year till year 10.
e. Maintenance cost will be Rs 4 lakh in year one and the same will increase by Rs 2 lakh every year.
f. Estimated life, 10 years.
g. Cost of capital, 15 per cent.
h. Residual value, nil. However, the land value will go up to Rs 60 lakh, at the end of year 10.
i. Depreciation will be 100 percent of the windmill cost in year 1 and the same will be allowed for tax
purposes.
j. As windmills are expected to work based on wind velocity, the efficiency is expected to be on an
average of 30 percent. Gross electricity generated at this level will be 25 lakh units per annum, 4 percent
of which will be committed to the state electricity board as per the agreement.
k. Tax rate, 35 percent.
From the above information, you are required to calculate the net present value. Ignore tax on capital profits.
Use present value up to two digits.

2. A plastic manufacturer has under consideration the proposal of production of high-quality plastic glasses.
The necessary equipment to manufacture the glasses would cost Rs 1 lakh and would last 5 years. The tax
relevant rate of depreciation is 20 percent on written down value. There is no other asset in this block. The
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 a 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 percent. Should the
proposed equipment be purchased? Assume 20 percent cost of capital and additional working requirement, Rs
50,000. Also assume that the firm would have sufficient short-term capital gains in year 5.

3. Techtronics Ltd is considering a new project for the manufacture of pocket video games involving a capital
expenditure of Rs 600 lakh and working capital of Rs 150 lakh. The capacity of the plant is for an annual
production of 12 lakh units and capacity utilization during the 6-year working life of the project is expected
to be as indicated below:

Year Capacity utilisation (percent)

1 33.33
2 66.67
3 90
4-6 100

The average price per unit of the product is expected to be Rs 200 netting a contribution of 40 percent. The
annual fixed costs, excluding depreciation, are estimated to be Rs 480 lakh per annum from the third year
onwards; for the first and second year, it would be Rs 240 lakh and Rs 360 lakh respectively. The average rate
of depreciation for tax purposes is 33.33 percent on the capital assets. The rate of income tax may be taken at
35 percent. The cost of capital is 15 percent.

At the end of the third year, an additional investment of Rs. 100 lakh would be required for working capital.

Terminal value for the fixed assets may be taken at 10% and for the current asset at 100%. For the purpose of
your calculations, the recent amendments to tax laws with regard to balancing charge may be ignored.
4. Modern Enterprises Ltd is considering the purchase of a new computer system for its research and
development division, which would cost Rs 35 lakh. The operation and maintenance costs (excluding
depreciation) are expected to be Rs 7 lakh per annum. It is estimated that the useful life of the system would
be 6 years, at the end of which the disposal value is expected to be Rs 1 lakh.

The tangible benefits expected from the system in the form of reduction in design and draft Manship costs
would be Rs 12 lakh per annum. The disposal of used drawing office equipment and furniture initially is
anticipated to net Rs 9 lakh. As capital expenditure in research and development, the proposal would attract
a 100 per cent write-off for tax purposes. The gains arising from disposal of used assets may be considered
tax free. The effective tax rate is 35 per cent. The average cost of capital of the company is 12 per cent.
After appropriate analysis of cash flows, advise the company of the financial viability of the proposal.
Ignore tax on salvage value.

5. United Petroleum Ltd (UPL) has a retail outlet for petrol, diesel, and petroleum products. Presently, it has
two pumps exclusively for petrol, one for non-lead petrol and one for diesel. Free air filling is carried out
for vehicles buying fuel from the outlet. The pumps have a useful life of 10 years with no salvage value as
the underground tank will be completely corroded and unfit for reuse. The UPL sells petrol and diesel @ Rs
100 and Rs 90 per liter respectively. The existing annual sale is petrol, 5 lakh liters, and diesel, 2 lakh liters.
Its earnings are 2 percent as commission on sales. Due to a manifold increase in traffic, the existing pumps
are not able to meet the demand during peak hours. The UPL is contemplating the installation of additional
pumps for diesel and petrol at a cost of Rs 15,00,000 together with additional working capital of Rs
5,00,000. The additional sales of petrol and diesel are expected to be 2 lakh liters and 1 lakh liters per
annum respectively. As a result of the installation of the new pump, the operating cost would increase by Rs
24,000 annually by way of the salary of the pump operator. Other yearly associated additional costs are
estimated to be: insurance @ 1 percent of the cost of the pump, maintenance cost, Rs 12,000, and power
costs, Rs 13,000. United Petroleum Ltd pays 35 percent on tax on its income. Depreciation will be on a
straight-line basis and the same is allowed for tax purposes

The management of UPL seeks your advice on the financial viability of the expansion proposal, assuming a
12 percent required rate of return. Kindly Suggest