CAPITAL BUDGETING

- Compiled by: CA Sapna B. Jain

Capital Budgeting decisions are related to the allocation of investible funds to different
long-term assets. Broadly speaking Capital Budgeting decisions denotes a decision
situation where the lump sum funds are invested in the initial stages of a project and the
returns are expected over a long period. Capital budgeting decisions are extremely
important because of the following reasons-

(1) These decisions have long-term effects on the risk and return composition of the
firm. These decisions affect the future position of the firm to a considerable extent.
(2) These decisions involve large commitments of funds and as a result, substantial
capital funds are blocked in the capital budgeting decisions.
(3) These are irreversible decisions, once taken the firm may not be in a position to
revert back unless it is ready to absorb heavy losses.
(4) It affects the capacity and strength of the firm to face the competition –

Before discussing capital expenditure decision methods, we may understand the

following three points-
(a) Cost of capital
(b) Time value of money
(c) Cash inflow from operation (CFAT)

There are two criteria for capital expenditure decisions-

(a) Accounting profits
(b) Cash flows

Under the cash flow criterion, we require cash flow i.e. post-tax profit before non-cash
items; important non-cash items are depreciation and allocated fixed costs. By
allocating fixed cost we mean, such fixed costs which are not being incurred because of
the proposal but which are just being changed for determining accounting profits.

CRITERIA FOR CAPITAL EXPENDITURE DECISIONS –

As stated above, there are two criteria for capital expenditure decisions
(i) Accounting profit
(ii) Cash flow

Under the accounting profits criterion, only one method is there, it is known as the
Accounting Rate of Return or unadjusted rate of return. (It is known as an unadjusted
rate of return because, for its calculation, we don’t make any adjustment, on account of
the time value of money). In the case of cash flow criterion cash inflow and cash
outflows, because of the proposal are considered for the decision, cash inflow includes
cash going out as well as reduced inflow. Cash flow criterion is preferred as compared
to accounting profit criterion for flowing reasons-

(1) Use of cash flows avoids accounting ambiguities.

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(2) It is possible to consider the time value of money.
Under the cash flow criterion, two categories of methods are there –
(i) Payback period method
(ii) Methods based on discounting cash flows-

There are three important methods based on discounted cash flows –

(a) Net Present Value Method (NPV)
(b) Profitability Index Method (PI)
(c) Internal rate of return Method (IRR)

I. ACCOUNTING RATE OF RETURN METHOD (ARR)

(a) On the basis of own funds invested –
Profit after depreciation & after Intt, on borrowed funds
Own funds invested
(b) On the basis of total funds invested
Profit after dep. but before Interest
Total funds invested
Generally, we calculate rates of return for capital expenditure decisions on the basis of
our own funds assuming that borrowed funds are available as per requirements. If
borrowed funds are available in limited amounts only. We calculate the rate of return on
the basis of total funds invested.

II. PAYBACK PERIOD METHOD

It is 2nd traditional method. The payback period is the period within which the project will
pay back its costs. Smaller the payback period, the better the project.
Pay Back Period = Investment
Constant cash flow (CFAT)
Cash flow = Profit before depreciation, before allocated fixed cost but after tax.
Discounted cash flow = Cash flow x Annuity (OR) Present value factor.

DISCOUNTED CASH FLOW ANALYSIS –

(a) NPV = PV of Inflow – PV of outflow
If NPV is positive, the project may be taken up.
If NPV is zero, the project may be taken up only if non-financial benefits are there.
If NPV is negative, Project may not be taken up.
(b) Profitability Index = Present value of inflow
Present value of outflow
If P.I. is more than 1- The project may be taken up.
If P.I. is 1 - Project may be taken up only on the basis of non-financial
Considerations
If P.I. is less than 1 – the project may not be taken up

NPV VS PROFITABILITY INDEX –

As far as accept – reject decision is concerned; both the NPV and the PI will give the
same decision. The reasons for this are obvious. The PI will be greater than 1 only for
that projects which has a +ve NPV; the project will be acceptable under both

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techniques. On the other hand, if PI is equal to 1then the NPV would also be zero.
Similarly, a proposal having PI less than 1 will also have a negative NPV. However, a
conflict between the NPV and PI may arise in the case of the evaluation of mutually
exclusive proposals.
We should use NVP if funds are not a key factor i.e. our aim is the maximization of
profits, we should use PI if funds are the key factor, i.e. we want to maximize the rate of
return on funds employed.

INTERNAL RATE OF RETURN – (IRR)

IRR is the accounting rate at which the NPV of a project is zero. Hence NPV = 0 or PI =
1 then IRR is equal to discounting rate. If NPV > 0 or PI > 1 then IRR > discounting rate.
If NPV < 0 or PI < 1 then IRR < discounting rate.

Step for calculation of IRR –

(a) Discount all cash flows at two such rates that one gives you +ve NPV and the other
gives -ve.

Lower Rate NPV

(b) Lower Rate + ----------------------------------------------- x Difference in Rate
Lower Rate NPV – Higher Rate NPV
If the two rates referred to above are not given in the question, the following steps are
required-
1. Calculate the Fake payback period (undiscounted) on the basis of average cash
flows.
Fake Pay Back period = Cash Outflow
AV. CFAT.
2. Locate the figure of the fake payback period in the annuity table against the no. of
years equal to the life of the project, and find the rate of discount.
3. Discount the cash flows at the rate found above. If NPV is positive, the other rate
should be higher than this rate, if NPV is negative, the other rate should be lower
than this rate.

Ques. 1: A firm whose cost of capital is 10% is considering two mutually exclusive
projects x and y, the details of which are –

YEAR PROJECT X PROJECT Y

Cost 0 (70,000) (70,000)
Cash Inflows 1 10,000 50,000
2 20,000 40,000
3 30,000 20,000
4 45,000 10,000
5 60,000 10,000
Compute the NPV at 10%, Profitability index, and internal rate of return for the two
projects.

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Ques. 2: A company is considering the replacement of its existing machine which is
obsolete and unable to meet the rapidly rising demand for its product. The co. is faced
with two alternatives (i) to buy the machine, ‘A’ which is similar to the existing machine
(ii) to go in for machine B which is more expensive and has much greater capacity. The
cash flows at the present level of operations under the two alternatives are as follows –
Cash flows (in lacs of Rs) at the end of the year –
0 1 2 3 4 5
Mach A -25 -- 5 20 14 5
Mach B -40 10 14 16 17 15
The company’s cost of capital is 10%. The finance manager tries to evaluate the
machines by calculating the following.
1. NPV
2. Profitability Index
3. Payback period
4. Discounted payback

Ques. 3: A Co. is engaged in evaluating an investment project, which requires an initial

cash outlay of Rs. 2,50,000 on equipment. The project’s economic life is 10 years and
its salvage is Rs. 30,000. It would require current assets of Rs. 50,000. An additional
investment of Rs. 60,000 would also be necessary at the end of five years to restore the
efficiency of the equipment. This would be written off completely over the last five years.
The project is expected to yield an annual profit (before tax) of Rs. 1,00,000. The
company follows the sum of the year’s digit method of depreciation. The income tax rate
is assumed to be 40%. Should the project be accepted if the minimum required rate of
return is 20%?

Ques. 4: Modern enterprises Ltd. is considering the purchase of a new computer

system for its Research and Development division, which would cost Rs. 35 lahks. The
operation and maintenance costs (excluding depreciation) are expected to be Rs. 7
lacks per annum. It is expected 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 a reduction in design and draughtsman ship
cost would be Rs. 12 lacs p.a. Besides, the proposal of used drawings office equipment
and furniture initially is anticipated to net Rs. 9 lacs.

Capital expenditure in research and development would attract 100% write off for tax
purposes. The gains arising from the disposal of used assets may be considered tax-
free. The company’s effective tax rate is 50%. The average cost of capital of the
company is 12%. After an appropriate analysis of cash flows, please advise the Co.
about the financial viability of the proposal.

Ques.5: ABC Ltd. manufactures toys and other gift items. The research and
development department has come up with an item that would make a good
promotional gift for office equipment dealers. As a result of efforts by the sales
personnel, the firm has commitments to this product.

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To produce the quantity demanded, ABC Ltd. will need to buy additional machinery and
rent additional space. It appears that about 25,000 sq. feet will be needed; 12500 sq.
feet of presently unused space but leased at the rate of Rs. 3 per square foot per year,
is available. There are another 12500 sq. feet available at the annual rent of Rs. 4 per
square foot.

The equipment will be purchased for Rs. 9,00,000. It will require Rs. 30,000 in
modification, Rs. 60,000 for installation, and Rs. 90,000 for testing. The equipment will
have a salvage value of about Rs. 1,80,000 at the end of the 3rd year. No additional
general overhead costs are expected to be incurred.
The estimated revenues and costs for the product for the 3 years have been developed
as follows –
Year 1 Year 2 Year 3
Sales 10,00,000 20,00,000 8,00,000
(-) Material labour & Overhead 4,00,000 7,50,000 3,50,000
(-) Overhead allocated 40,000 75,000 35,000
(-)Rent 50,000 50,000 50,000
(-) Depreciation 3,00,000 3,00,000 3,00,000
EBT 2,10,000 8,25,000 65,000
(-) Taxes 1,05,000 4,12,500 32,500
EAT 1,05,000 4,12,500 32,500
If the company sets a required rate of return of 20% after taxes, should this project be
accepted?

Ques. 6: P. Ltd. has a machine having an additional life of 5 years which costs Rs.
10,00,000 and has a book value of Rs. 4,00,000. A new machine costing Rs. 20,00,000
is available. Though its capacity is the same at that of the old machine; it will mean a
saving in variable cost to the extent of Rs. 7,00,000 p.a. The life of the machine will be 5
years at the end of which it will have a scrap value of Rs. 2,00,000. The rate of income
tax is 40% and P’s policy is not to make an investment if the yield is less than 12% per
annum. The old machine, if sole today, will realize Rs. 1,00,000; it will have no salvage
value if sold at the end of the 5th year. Advise P Ltd., whether or not the old machine
should be replaced. Capital gain is tax-free. Ignore income tax saving on additional dep.
as well as on loss due to the sale of the existing machine.

Will it make any difference if the additional depreciation (on the new machine) and gain
on the sale of old machinery are also subject to the same tax at the rate of 40%?

Ques. 7: Sagar Industries is planning to introduce a new product with a projected life of
8 years. The project is to be set up in a backward region, qualities for an overtime (at its
starting) tax-free subsidy from the government of RS. 20,00,000. Initial equipment cost
will be Rs. 1,40,00,000 and additional equipment costing Rs. 10,00,000 will be needed
at the beginning of the 3rd year. At the end of 8 years, the original equipment will have
no salvage value, but the supplementary equipment can be sold for Rs. 1,00,000. A
working capital of Rs. 15,00,000 will be needed. The sales volume over the 8 years
period have been estimated as follows –

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 Year Units
1 80,000
2 1,20,000
3-5 3,00,000
6-8 2,00,000
A sale price of Rs. 100 per unit is expected and variable expenses will amount to 40%
of sales revenue. Fixed cash operating cost will amount to Rs. 16,00,000 per year. In
addition, an extensive advertisement campaign will be implemented, requiring outlays
as follows-
Year Amount
1 30,00,000
2 15,00,000
3-5 10,00,000
6-8 4,00,000
The co. is subject to 50% tax rate and considers 12% to be an appropriate after-tax cost
of capital for this project. The co. follows the straight-line method of depreciation.
Should the project be accepted? Assume that the Co. has enough income from its
existing product. [Ans. NPV Rs. 1,29,16,190]

Ques. 8: A Co. Lt. Is producing product x and is presently commanding a market share
of 15%. The cost and product’s project margin for one unit is as under:
Sales price 100
Material 40
Labour 20
Overheads 10 70
Contribution 30
(-) Fixed cost 20
Profit 10
The sale of product is 15000 units at 15% market share in the current year. It has now
been estimated that the market share can be increased upto 25% from next year of the
following promotional expenses are incurred in the previous year –
For year 1 1,00,000
For year 2 75,000
For year 3 50,000
These will also be an increase in fixed cost by Rs. 30,000 if production has to be
increased from present level. The company wants to achieve 15% return and would
apply discounted cash flow technique.
You are required to find out the effect when –
(i) Market share is increased to 25%
(ii) Market share is increased to 20%
(iii) Market share is increased to 19%
Also recommend action to be taken by the company.

Ques. 9: Following are the data on a capital project being evaluated by the
management of X Ltd.

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 Particulars Project M
Annual cost savings 40,000
Useful life 4 years
Internal rate of return 15%
Profitability Index 1.064
NPV ?
Cost of capital ?
Cost of project ?
Pay Back period ?
Salvage value 0
Find the missing values considering the following table of Discount factors only
15% 14% 13% 12%
1 year .869 .877 .885 .593
2 year .756 .769 .783 .797
3 year .658 .675 .693 .712
4 year .572 .592 .613 .636
-------------------------------------------
Total 2.855 2.913 2.974 3.038

Ques. 10: A company has a machine which has been in operation for 2 years, its
remaining estimated useful life is 10 years, with no salvage value at the end. Its current
market value is Rs. 1,00,000.
The management is considering a proposal to purchase an improved model of a
machine, which gives increased output. The relevant particulars are as follows-
EXISTING MACH. NEW MACH.
Purchase Price 2,40,000 4,00,000
Estimated life 12 years 10 years
Salvage value - -
Annual operating hours 2,000 2,000
Selling price per unit 10 10
Out put per hour 15 units 30 units
Material cost per unit 2 2
Labour cost per hour 20 40
Consumable stores per year 2,000 5,000
Repairs & Maint. Per Year 9,000 6,000
Working capital 25,000 40,000
The company follows the straight line method of depreciation and is subject to 50% tax.
Whether the existing machinery be replaced? Assume that the CO’s required rate of
return is 15% and that the loss of asset is tax deductible.

Ques. 11: The present output of a company’s manufacturing department is as follows –

Average output per week 48,000 units
Saleable value of out per Rs. 60,000
Contribution made by output towards fixed exp. & profit Rs. 24,000
The directors plan to introduce more mechanization in the dept. at a capital cost of Rs.
16,000. The effect of this will be to reduce the number of employees from the existing

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strength of 160 to120, but to increase the output per individual employee by 60%. To
provide the necessary incentive to achieve the increased output, the directors intend to
offer a 1% increase in the existing price work of Rs. 0.10 per article for every 2%
increase in average individual out put achieved. To sell the increased output, it will be
necessary to decrease the selling price by 4%. Determine pay back period.

Ques. 12: Electromatic Excellers Ltd. specialise in the manufacture of novel transistors.
They have recently developed technology to design new ratio transistors capable of
being used as an emergency lamp also. They are quite confident of selling all the 8,000
units that they would be making in a year. The capital equipment that would be required
will cost Rs. 25 lacks. It will have an economic life of 4 years and no significant technical
salvage value. During each of the first 4 years promotional expenses are planned as
under: -
Year 1 2 3 4
Advertisement 1,00,000 75,000 60,000 30,000
Other Exp. 50,000 75,000 90,000 120,000
Variable cost of producing and selling the unit would be Rs. 250 per unit.
Additional fixed operating costs incurred because of this new product are budgeted at
RS. 75,000 per year. The company’s profit goals calls for a discounted rate of return of
15% after taxes on investments on new products. The income tax rate on an average
works out to 40%. You can assume that the straight-line method of depreciation will be
used for tax and reporting. Work out an initial selling price per unit of the product that
may be fixed for obtaining the desired rate of return on investment.

Ques. 13: Elite builders a leading construction company has been approached by a
foreign embassy to build for them a block of 6 flats to be used as guesthouse. As per
contact the foreign embassy would provide Elite builders the plans and the land costing
Rs. 25,00,000. Elite builders would build the flats at their own cost and lease them out
to foreign embassy for 15 years, at the end of which the flats will be transferred to
foreign embassy for a nominal cost of Rs. 8,00,000. Elite builders estimates the cost of
construction as follows:
Area per flat 1000 sq. ft.
Construction cost 400 per sq. ft
Registration and other cost 2.5% of cost of construction.
Elite Builders will also incur Rs. 4 lacks each in year 14 and 15 towards repairs. Elite
builders proposes to charge the lease rentals as follows –
YEAR RENTALS
1 to 5 Normal
6 to 10 120% of Normal
11 to 15 150% of Normal
Elite builders present tax rate averages at 50%. The full cost of construction and
registration will be written off over 15 years and will be allowed for tax purposes.
Calculate the normal lease rental per annum per flat for your exercise assume –
(a) Minimum desired return of 10%
(b) Rentals & Repairs will arise on the last day of the year.
(c) Construction, registration and others cost will be incurred at time ‘0’.

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(d) The relevant discounting factors are: -

Year Discounting factor Year Dis. Factor Year Dis. Factor

1 .91 6 .56 11 .35
2 .83 7 .51 12 .32
3 .75 8 .47 13 .29
4 .68 9 .42 14 .26
5 .62 10 .39 15 .24

CAPITAL RATIONING
Ques. 14: A ltd. is considering five capital projects for the year 1998 and 1999. The
company is financed by equity entirely and its cost of capital is 12%. The expected cash
flows of the projects are as follows:
YEAR & CASH FLOWS
PROJECT 1996 1997 1998 1999
A (70) 35 35 20
B (40) (30) 45 55
C (50) (60) 70 80
D -- (90) 55 65
E (60) 20 40 50
All projects are divisible. Calculate which project alpha ltd. should under take if capital
Investment is limited to 1,10,000 in 1996 and no limitation in subsequent years.

Ques. 15: L ltd. has a cost of capital of 10% and has a limit of Rs. 1,00,000 for
investment. The following indivisible projects are being considered. All these projects
have 5 years life
Projects A B C D E
Investment 35000 40000 65000 48000 23000
NPV 17500 22500 38000 31500 9000
Surplus funds can be invested to produce 12% p.a. for 5 years, optimal investment
plans?

Ques. 16: A company intends to purchase a machine costing Rs. 8000. Life 5 years,
salvage value – Nil, Straight-line method of depreciation, cost of capital 10%. The
machine will result in annual wages savings of Rs. 3000 (at current price). General rates
of inflation 20% compound from first year. Tax 40%. For 1% increase in general price
level. Wage rises by 0.75%.

Ques. 17: A company offers 12% convertible debentures to the public. Face value Rs.
200, issued at per. 50% of the face value to be converted into 4 equity shares of Rs. 10
each at a premium of Rs. 15 each one year after the allotment of debentures. At that
time market value of the equity shares is likely to be Rs. 35. The remaining portion of
the debentures is redeemable after 7 years from allotment at a premium of 5% for each
debentures, the allottee would be entitled to subscribe one fully convertible debentures
of Rs. 100 (carrying 10% p.a. interest), two years after allotment of above mentioned

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12% debentures. The fully convertible debentures would be converted one year after
issue into 4 equity shares of Rs. 10 each at Rs. 25. At the time of this conversion,
market price of the shares is likely to be Rs. 40. Advise a prospective investor whether
he should subscribe 12% convertible debentures or not assuming interest payable half
yearly in case of both the debentures. He can alternatively invest his money at 20% p.a.
interest payable half yearly.

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LEASE OR BUY

Page 11 of 18
Q.18: B ltd. is considering the acquisition of a personal computer costing Rs. 50,000. The
effective life of the computer is expected to be 5 years. The company plans to acquire the same
either by borrowing Rs. 50,000 from its bankers at 15% interest per annum or by lease. The
company wishes to know the lease rentals to be paid annually which will match the loan option.
The following further information is provided to you : -
(a) The principal amount of the loan will be paid in 5 annual equal instalments.
(b) Interest, lease rentals, principal repayments are to be paid on the last day of each year.
(c) The full cost of computers will be written off the effective life of computer on a straight line
basis and the same will be allowed for tax purposes.
(d) The company’s effective tax rate is 40% and the after tax cost of capital is 9%
(e) The computer will be sold for Rs. 1700 at the end of the 5th year. The commission on such
sales is 99% on the sale value and the same will be paid.
Compute annual lease rentals payable by Beta Ltd., which will result in indifference to the loan
option.

Q. 19: An industrial unit desires to acquire a machine costing Rs. 5 lacs which has an economic
life of 10 years. Scrap value – NIL. The unit is considering the alternative leasing company
expects a minimum yield of 10% choice of: -
(a) Taking machine on lease of
(b) Purchasing the asset by raising loan.
(c) Lease payments are to be made in advance and the lesson requires the asset to the
completely amortised over its useful life and that the asset will yield him a return of 10% cost
of debt is 16% p.a. tax 50%. Straight lone method of depreciation may be adopted. Evaluate
the proposal by all the three methods of evaluation of lease V.S. buy.

Q. 20: A company is considering two mutually exclusive projects. K will require an initial cash
investment in machinery of Rs. 2,68,000. It is anticipated that the machinery will have a useful
life of 10 years at the end of which its salvage will realise Rs. 20,500. The project will also
required an additional investment in cash sundry debtors and stock of Rs. 40,000. At the end of
5 years from the commencement of the project, balancing equipment for Rs. 45,000 has to be
installed to make the unit workable. The cost of additional machinery will be written off to
depreciation over the balance life of the project. The project is expected to yield a net cash flow
(before depreciation) of Rs. 1,00,000 annually.
Project R which is the alternative one under consideration, requires an investment of Rs.
3,00,000 in machinery and as in project K investment in current assets of Rs. 40,000. The
residual salvage value of the machinery at the end of its useful life of 10 years is expected to be
Rs. 25,000. The annual cash inflows (before depreciation) from the project is worked at Rs.
80,000 p.a. for the first five years and Rs. 1,80,000 per annum for the first five years and Rs.
1,80,000 per annum for the next 5 years.
Depreciation is written off by the company on sum of the years digit method. Income tax rate is
50%. A minimum rate of return has been calculated at 16%.

Q. 21: X ltd. is contemplating the purchase of new machinery costing RS. 30,000 with an
expected life of 5 years with salvage value of Rs. 750, in replacement of an old machine
purchase 3 years ago for Rs. 15,000 with expected life span of 8 years. Present market value of
this old machine is Rs. 16,5000. Because of the purchase of new machinery annual profit before
depreciation are expected to increase by Rs. 6,000. The company follows diminishing balance
method for depreciation. Income Tax 50% cost of capital 10% advise.

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Q. 22: A ltd. is considering the manufacturing of new product. The accountant has prepared the
following estimate of profit in the first year of manufacture: -
Sale 9000 units @ 32 Rs. 2,88,000
Cost of goods sole: -
Labour 40,000 hours @ 3,50 p.h. 1,40,000
Materials and other variable cost 65,000
Deprecations 45,000
2,50,000
Len: - Closing stock 25,000 2,25,000
63,000
The product is expected to have a life of 4 years. Annual sales volume is expected to be
constant over that period at 9000 units. Production, which was estimated at 10,000 units on the
first, would be 9000 units each in year 2 and 3 year would be 10% of materials and other
variable costs. If sales differed from the forecast level, stock would be adjust in proportion.
Debtors at the end of each year would be 20% of sales of the years. Depreciation relates
machinery, which would be purchased especially for the manufacture of the new product and is
calculated on the Straight-line basis assuming that the machinery would last for 4 years and
have no terminal scrap value. Fixed costs are included in labour cost. There is a high level of
confidence concerning the accuracy of all the above estimates except the annual sales volume,
cost of capital is 20% per annum you may assume that debtors are realised and creditors are
paid in the following year. No cheque in the prices of inputs or outputs are expected over the
next 4 years.
You are required to show whether, the manufacture of the new product is worthwhile. Ignore
taxation.

Q. 23: The progressive Co. ltd. decides to increase its productive capacity to meet an
anticipated increase in demand for its products. The extent of this increase is capacity has still
to be determined and a management meeting has been called to decide which of the following
two mutually exclusive proposals I and II should be undertaken. On the basis of the information
given below, you are required to –
(a) Evaluate the profitability (ignoring taxation) of each of the proposal and
(b) On the assumption of cost of capital of 8%, suggest the proposal to be under taken.
I II
Buildings 50,000 1.00.000
Plant 2,00,000 3,00,000
Installation 10,000 15,000
Working capital 50,000 65,000
Net income – annual – Pre. Dep.
[Note (i)] 70,000 95,000
Other relevant income / Exp.
Sales promotion [Note (ii)] --- ---
Plant scrap value 10,000 15,000
Building disposable value
[Note (iii)] 30,000 60,000
Note (i): The investment life is 10 years.
Note (ii): As exceptional amount of expenditure on sales promotion of Rs. 15,000 will
required to be spend in 2nd year on proposal II. This has not been taken into account in
calculating pre-depreciation profits.
Note (iii): It is not the intention to dispose of the building is 10 years, however it is company
policy to take a national figure into account for a project evaluation purpose.

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Q. 24: An automatic ancillary unit is proposing to set up a manufacturing establishment whose
project cost is Rs. 320 lacs. The cost of lands building including in the project cost is Rs. 40
lacs, whose break up is as follows –
Land (4400 sq. yards) Rs. 15 lacks
Building (Area 25000 sq. ft.) Rs. 25 lacks
It is anticipated that in the first 4 years profitability will be low due to time required for cultivating
the market. To meet the situation mgt. is planning to hire factory premises of the same size at
Rs. 0.80 per sq. foot per month for the first 4 years. Instead of own buildings. Repairs and
maintenance, Taxes etc to be borne by the land lord.
If the present project, provisions, has been made for dep. at the p.a. on original cost of Building
Provisions has also been made for Repairs, Maintenance Taxes etc. on building at RS.
1,20,000 p.a. The annual sales and profit figure are projected in the project report are as
follows.
Year Sales (Rs. in lacs) N/P (Rs. in lacs) Capacity utilisation
I 200 (5) 60%
II 275 5 75%
III 350 10 90%
IV 450 20 100%
After the 4th year the profit is expected to be steady at Rs. 40 lacs P.a. Institutional finance is
available upto 200 lacs under both alternatives.
(a) You are required to work out the av. Rate of return for the first 4 years, on shareholders
initial investment under both alternatives.
(b) If the lease is available for 4 years only, would you recommend leasing the promises if it is
anticipated that the cost of land will increase by 40% and cost of construction by 20% at the
end of the 4 years period. For this purpose opportunity cost of finance may be taken at 10%
p.a.

Q. 25: A firm is considering to install either of the two machine which are mutually exclusive.
The details of their purchase price and operating costs are: -
Year Machine X Machine Y
0 10,000 8000
1 2000 2500
2 2000 2500
3 2000 2500
4 2500 3800
5 2500 3800
6 2500 3800
7 3000
8 3000
9 3000
10 3000
Machine X will recover salvage value of Rs. 1500 in the year 10, while machine Y will recover
Rs. 1000 in the year 6. Determine which machine is cheaper at 10% cost of capitals consuming
that both the machines operates at the same efficiency.

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Ques. 10: Modern enterprises Ltd. is considering the purchase of a new computer system for its
Research and Development division, which would cost Rs. 35 lacs. The operation and maintenance cost
(excluding depreciation) are expected to be Rs. 7 lacs per annum. It is expected 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 lacs. The
tangible benefits expected from the system in the form of reduction in design and draughts manship cost
would be Rs. 12 lacs p.a. Besides, the proposal of used drawings office equipment and furniture, initially
is anticipated to net Rs. 9 lacs.
Capital expenditure in research and development would attract 100% write of for tax purposes. The gains
arising from disposal of used assets may be considered tax-free. The company’s effective tax rate is 50%.
The average cost of capital of the company is 12%. After appropriate analysis of cash flows, please
advise the Co. about the financial viability of the proposal.
[Ans. .39Lacs]

Ques.11 ABC Ltd. manufactures toys and other gift items. The research and development department
has come up with an item that would make a good promotional gift for office equipment dealers. As a
result of efforts by the sales personnel, the firm has commitments for this product.
To produce the quantity demanded, ABC Ltd. will need to buy additional machinery and rent additional
space. It appears that about 25,000 sq. feet will be needed; 12500 sq. feet of presently unused space but
leased at the rate of Rs. 3 per square foot per year, is available. There is another 12500 sq. feet available
at the annual rent of Rs. 4 per square foot.
The equipment will be purchased for Rs. 9,00,000. It will require Rs. 30,000 in modification, Rs. 60,000
for installation and Rs. 90,000 for testing. The equipment will have a salvage value of about Rs. 1,80,000
at the end of the 3rd year. No additional general overhead costs are expected to be incurred.
The estimated revenues and costs for the product for the 3 years have been developed as follows –
Year 1 Year 2 Year 3
Sales 10,00,000 20,00,000 8,00,000
(-) Material labour & Overhead 4,00,000 7,50,000 3,50,000
(-) Overhead allocated 40,000 75,000 35,000
(-)Rent 50,000 50,000 50,000
(-) Depreciation 3,00,000 3,00,000 3,00,000
EBT 2,10,000 8,25,000 65,000
(-) Taxes 1,05,000 4,12,500 32,500
EAT 1,05,000 4,12,500 32,500

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If the company sets a required rate of return of 20% after taxes, should this project be accepted?
[Ans. (-) 61,907 rejected]

Ques. 12: P. Ltd. has a machine having an additional life of 5 years which costs Rs. 10,00,000 and has a
book value of Rs. 4,00,000. A new machine costing Rs. 20,00,000 is available. Though its capacity is the
same at that of the old machine; it will mean a saving in variable cost to the extent of Rs. 7,00,000 p.a.
The life of the machine will be 5 years at the end of which it will have a scrap value of Rs. 2,00,000. The
rate of income tax is 40% and P’s policy is not to make an investment if the yield is less than 12% per
annum. The old machine, if sole today, will realise Rs. 1,00,000; it will have no salvage value if sold at the
end of 5th year. Advise P Ltd., whether or not the old machine should be replaced. Capital gain is tax-
free. Ignore income tax saving on additional dep. as well as on loss due to sale of existing machine.
Will it make any difference if the additional depreciation (on new machine) and gain on sale of old
machinery is also subject to same tax at the rate of 40%?
[Ans. Case I Rs. (-) 2,72,500 rejected; Case II Rs. 2,22,420 accepted]

Ques. 13: Sagar Industries is planning to introduce a new product with a projected life of 8 years. The
project to be set up in a backward region, qualities for an overtime (at its starting) tax-free subsidy from
the government of RS. 20,00,000. Initial equipment cost will be Rs. 1,40,00,000 and additional equipment
costing Rs. 10,00,000 will be needed at the beginning of the 3 rd year. At the end of 8 years, the original
equipment will have no salvage value, but the supplementary equipment can be sold for Rs. 1,00,000. A
working capital of Rs. 15,00,000 will be needed. The sales volume over the 8 years period have been
estimated as follows –
Year Units
1 80,000
2 1,20,000
3-5 3,00,000
6-8 2,00,000
A sale price of Rs. 100 per unit is expected and variable expenses will amount to 40% of sales revenue.
Fixed cash operating cost will amount to Rs. 16,00,000 per year. In addition, an extensive advertisement
compaign will be implemented, requiring outlays as follows-
Year Amount
1 30,00,000
2 15,00,000
3-5 10,00,000
6-8 4,00,000
The co. is subject to 50% tax rate and considers 12% to be an appropriate after tax cost of capital for this
project. The co. follows the straight-line method of depreciation. Should the project be accepted? Assume
that the Co. has enough income from its existing product.
[Ans. NPV Rs. 1,29,16,190]

Ques.14: A Co. Lt. Is producing product x and is presently commanding a market share of 15%. The cost
and product’s project margin for one unit is as under:
Sales price 100
Material 40
Labour 20
Overheads 10 70
Contribution 30
(-) Fixed cost 20
Profit 10
The sale of product is 15000 units at 15% market share in the current year. It has now been estimated
that the market share can be increased upto 25% from next year of the following promotional expenses
are incurred in the previous year –
For year 1 1,00,000
For year 2 75,000
For year 3 50,000

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These will also be an increase in fixed cost by Rs. 30,000 if production has to be increased from present
level. The company wants to achieve 15% return and would apply discounted cash flow technique.
You are required to find out the effect when –
(iv) Market share is increased to 25%
(v) Market share is increased to 20%
(vi) Market share is increased to 19%
Also recommend action to be taken by the company.
[Ans. at 25% - 4.15; at 20% - 0.71; at 19% - 0.02; Should try to increase by 10%.]

Ques. 15: Following are the data on a capital project being evaluated by the management of X Ltd.
Particulars Project M
Annual cost savings 40,000
Useful life 4 years
Internal rate of return 15%
Profitability Index 1.064
NPV ?
Cost of capital ?
Cost of project ?
Pay Back period ?
Salvage value 0
Find the missing values considering the following table of Discount factors only

Ques. 16: A company has a machine which has been in operation for 2 years, its remaining estimated
useful life is 10 years, with no salvage value at the end. Its current market value is Rs. 1,00,000.
The management is considering a proposal to purchase an improved model of a machine, which gives
increased output. The relevant particulars are as follows-
EXISTING MACH. NEW MACH.
Purchase Price 2,40,000 4,00,000
Estimated life 12 years 10 years
Salvage value - -
Annual operating hours 2,000 2,000
Selling price per unit 10 10
Out put per hour 15 units 30 units
Material cost per unit 2 2
Labour cost per hour 20 40
Consumable stores per year 2,000 5,000
Repairs & Maint. Per Year 9,000 6,000
Working capital 25,000 40,000
The company follows the straight line method of depreciation and is subject to 50% tax. Whether the
existing machinery be replaced? Assume that the CO’s required rate of return is 15% and that the loss of
asset is tax deductible. [Ans. NPV 5,019]

Ques. 17: The present output of a company’s manufacturing department is as follows –

Average output per week 48,000 units
Saleable value of out per Rs. 60,000
Contribution made by output towards fixed exp. & profit Rs. 24,000
The directors plan to introduce more mechanization in the dept. at a capital cost of Rs. 16,000. The effect
of this will be to reduce the number of employees from the existing strength of 160 to120, but to increase
the output per individual employee by 60%. To provide the necessary incentive to achieve the increased
output, the directors intend to offer a 1% increase in the existing price work of Rs. 0.10 per article for
every 2% increase in average individual out put achieved. To sell the increased output, it will be
necessary to decrease the selling price by 4%. Determine pay back period.
[Ans. 83.33 week]

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Ques. 18: Electromatic Excellers Ltd. specialise in the manufacture of novel transistors. They have
recently developed technology to design new ratio transistors capable of being used as an emergency
lamp also. They are quite confident of selling all the 8,000 units that they would be making in a year. The
capital equipment that would be required will cost Rs. 25 lacks. It will have an economic life of 4 years
and no significant technical salvage value. During each of the first 4 years promotional expenses are
planned as under: -
Year 1 2 3 4
Advertisement 1,00,000 75,000 60,000 30,000
Other Exp. 50,000 75,000 90,000 120,000
Variable cost of producing and selling the unit would be Rs. 250 per unit.
Additional fixed operating costs incurred because of this new product are budgeted at RS. 75,000 per
year. The company’s profit goals calls for a discounted rate of return of 15% after taxes on investments
on new products. The income tax rate on an average works out to 40%. You can assume that the
straight-line method of depreciation will be used for tax and reporting. Work out an initial selling price per
unit of the product that may be fixed for obtaining the desired rate of return on investment. [Ans. Rs.
408.47]

Ques. 19: Elite builders a leading construction company has been approached by a foreign embassy to
build for them a block of 6 flats to be used as guesthouse. As per contact the foreign embassy would
provide Elite builders the plans and the land costing Rs. 25,00,000. Elite builders would build the flats at
their own cost and lease them out to foreign embassy for 15 years, at the end of which the flats will be
transferred to foreign embassy for a nominal cost of Rs. 8,00,000. Elite builders estimates the cost of
construction as follows:
Area per flat 1000 sq. ft.
Construction cost 400 per sq. ft
Registration and other cost 2.5% of cost of construction.
Elite Builders will also incur Rs. 4 lacks each in year 14 and 15 towards repairs. Elite builders proposes
to charge the lease rentals as follows –
YEAR RENTALS
1 to 5 Normal
6 to 19 120% of Normal
11 to 15 150% of Normal
Elite builders present tax rate averages at 50%. The full cost of construction and registration will be
written off over 15 years and will be allowed for tax purposes.
Calculate the normal lease rental per annum per flat for your exercise assume –
(e) Minimum desired return of 10%
(f) Rentals & Repairs will arise on the last day of the year.
(g) Construction, registration and others cost will be incurred at time ‘0’.
(h) The relevant discounting factors are: -
[Ans. Rs. 69727 per flat

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