Capital Budgeting

Practice Problems

Pay Back period

1. Cost of the new machine is RS 1,50,000 and expected cash inflow is RS 30,000 p.a. Life of
the machine is 7 years. Calculate pay-back period. (Ans. PBP= 5 Years)

2. Shobha Ltd. is considering to purchase a machine. Two machines A and B are available at
the cost of RS 1,20,000 each. Earnings after tax but before depreciation are as under:

Year Machine A Machine B

(RS) (RS)

1 50,000 20,000
2 40,000 30,000
3 30,000 50,000
4 20,000 40,000
5 20,000 40,000

Evaluate Pay-back period Method and suggest which machine to buy.

(Ans. PBP= 3 Years for A & 3 Years 6 months for B, so A is preferable)

3. A Company is evaluating a proposal to acquire a new plant for its production department.
The cots of the plant is RS 4,50,000. The plant has a useful life of 10 years and is expected to
yield an annual profit of RS 75,000 after depreciation but before tax. Depreciation is
charged @10% on straight line basis. Tax rate is 40%. Compute the payback period.

4. A Company wants to replace the manual operations by new machine. There are two
alternative models of P and Q of the new machine. Using pay-back period, suggest the most
profitable investment. Ignore taxation.

Particulars Machine P Machine Q

 Original Investment 9,000 18,000

Estimated saving in scrap 500 800

Estimated savings in wages 6,000 8,000

Additional cost of maintenance 800 1,000

Additional cost of supervision 1,200 1,800

Estimate life of the machine Years 4 5

5. A Company proposing to expand its production can go either for an automatic machine
costing RS 2,24,000 with an estimated life of 5 years and 6 months. Or an ordinary machine
costing RS 60,000 having an estimated life of 8 years.

Particulars Automatic Machine Ordinary Machine

Annual sales 1,50,000 1,50,000

Annual Costs:

Material 50,000 50,000

Labour 12,000 60,000

Variable overheads 24,000 20,000

Compute the comparative profitability under pay-back method

6. A concern is considering two projects X and Y. Following are the particulars.

 Particulars Project X Project Y

Cost 1,40,000 1,40,000

Economic life (years) 10 10

Estimated scrap 10,000 14,000

Annual savings 25,000 20,000

Which project is better for investment based on:

a. pay-back period
b. post pay-back profits
c. Index of post pay-back profit

Ignore taxation.

7. Calculate Payback periods if Capital outlay is RS 56,125 for both projects.

Annual CFAT
Years Project A Project B

1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000

8. Calculate the average rate of return for project A and B from the following.

Project A Project B
 Investment 20,000 30,000
Expected Life (no salvage value) 4 Years 5 Years

Projected income, after interest, depreciation and taxes:

Years Project A Project B

1 2,000 3,000
2 1,500 3,000
3 1,500 2,000
4 1,000 1,000
5 Nil 1,000

If the rate of return is 12% which project should be undertaken?

9. A company is considering an investment proposal to install new machine. The project will
cost RS 50,000. The facility has a life expectancy of 5 years and no salvage value. The
company’s tax rate is 55% and no investment tax credit is allowed. The firm uses straight
line depreciation. The estimated cash flow before tax (CFBT) from the proposed investment
are as under:

Year CFBT

1 10,000
2 11,000
3 14,000
4 15,000
5 25,000

Compute the following:

a. Pay-back period
b. Average Rate of Return
10. Compute the net present value for a project with net investment of RS 1,00,000 and the
following cash flows if the company’s cost of capital is 10%. Net cash flows for year one is RS
55,000, year two is RS 80,000 and year three is RS 15,000. [PVIF @10% for three years are
0.909, 0.826 and 0.751]

11. A Fertilizer company is considering a proposal for the investment of RS 5,00,000 on product
development which is expected to generate cash inflows for 6 years as under:
 Year Net cash inflows

1 Nil
2 1,00,000
3 1,60,000
4 2,40,000
5 3,00,000
6 6,00,000

The following are the present value factor @15% p.a.

Year 1 2 3 4 5 6
Factor 0.87 0.76 0.66 0.57 0.50 0.43

Provide decision support to the management.

12. A choice is to be made between two competing projects, which require an equal
investments of RS 50,000 each and are expected to generate net cash flows as under:

Year Project I Project II

1 25,000 10,000
2 15,000 12,000
3 10,000 18,000
4 Nil 25,000
5 12,000 8,000
6 6,000 4,000

The cost of capital is 10%. Using discounted cash flow method, recommend which project is to
be preferred. Use PVF @10%

13. A Ltd is considering to purchase a new machine costing RS 5,85,000. An additional

investment will be required for the following reasons.
a. Installation charges RS 15,000
b. Working capital RS 1,00,000
The machine has a working life of 5 years and salvage value will be RS 1,00,000. The working
capital will also be released after 5 years. Investment allowance benefit will be available @ 20%
on the cost of new machine.

The estimated cash inflows (before depreciation and tax) are as under:

Year Cash inflows

1 1,00,000
2 1,80,000
3 2,50,000
4 2,00,000
5 1,50,000

You can assume:

a. straight line method for charging depreciation
b. cost of capital of 15% and
c. corporate tax @ 50%

Should company purchase then machine?

14. A machine purchased six years ago for RS 3,00,000 has been depreciated to a book value of
RS 1,80,000. Its economic life was 15 years with no salvage value. If this machine is replaced
by a new machine costing RS 4,50,000 the operating cost would be reduced by RS 60,000
for the next 10 years. The old machine could also be sold for RS 1,00,00. The cost of capital
is 10%. The new machine will be depreciated on straight line basis over eight years life with
RS 50,000 as salvage value. The company’s tax rate is 55%. Using NPV method, state
whether the old machine should be replaced or not.

15. Original outlay RS 10,000, Life of the project 5 years; cash inflows RS 4,000 each year and
cost of capital 10%. Expected rates at which cash flows will be reinvested:

Year end 1 2 3 4 5
Rate (%) 6 6 8 8 8
Compounding factors 1.262 1.191 1.166 1.080 1.000

16. Modern Enterprises Ltd is considering the purchase of a new computer system for its R&D
division, which would cost RS 35 Lakh. The operation and maintenance costs (excluding
depreciation) are expected to be RS 7 Lakh p.a. 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
draftsmanship costs would be RS 12 Lakh p.a.

The disposal of used drawing office equipment and furniture initially is anticipated to net RS 9
Lakh. As capital expenditure in R&D, the proposal would attract a 100% write-off for tax
purposes. The gains arising from disposal of used assets may be considered tax free. The
effective tax rate is 35%. The average cost of capital of the company is 12%. After appropriate
analysis of cash flows, advise the company of the financial viability of the proposal. Ignore tax
on salvage value. (PV Factor for annuity for 6 years = 4.11)

17. Investment proposal to install a new milling control at a cost of RS 50,000, life expectancy of
5 years and no salvage value. The tax rate is 35%. SLM is adopted, and the same is allowed
for tax purposes.

The estimated cash flows before depreciation and tax (CFBT) from the investment proposal are
given in table below. Year
1 2 3 4 5

CFBT 10,000 10,692 12,769 13,462 20,385

You are required to calculate

a. Pay back period

b. Average Rate of return
c. NPV at 10% discount rate
d. Profitability Index at 10% discount rate

18. Northern Chemical owns machine with the following details:

Book value RS 1,10,000

Current Market price RS 80,000
Annual cash operating costs RS 36,000
Expected salvage at the end of the 5th year Nil

Firm’s cost of capital is 15%, tax rate 35% and straight line method of depreciation is followed,
same is acceptable for Income Tax purpose. Management is considering selling this machine. If
it does so, the total cash operating costs to perform the work now done by machine will
increase by RS 40,000 per year to RS 76,000 per year. Advise whether the machine should be
sold.

19. Calculate Internal Rate of return for Project A. The details of the project are as under:

Initial cost RS 10,500

Cash Inflow year-wise as under:

Year 1 2 3 4

Cash Inflows 2,000 3,000 4,000 5,000

PV @10% 0.909 0.826 0.751 0.683

PV @12% 0.893 0.797 0.712 0.636

20. Calculate IRR for the two machines

Particulars Machine M Machine N

Purchase price 60,000 60,000

Cash inflow Year -1 16,000 24,000
Year -2 17,000 21,000
Year -3 19,000 19,000
Year – 4 21,000 17,000
Year – 5 24,000 16,000

Estimated life 5 years 5 years