Additional Exercises and Cases for Capital Budgeting

1. Dee Industries must choose between a gas-powered and an electric-powered forklift truck
for moving materials in its factory. Since both forklifts perform the same function, the
firm will choose only one. The electric-powered truck will cost more, but it will be less
expensive to operate; it will cost `1,100,000, whereas the gas-powered truck will cost
`875,000. The cost of capital that applies to both investments is 12 percent. The life for
both types of truck is estimated to be 6 years, during which time the operating expenses
for the electric-powered truck is estimated to be `250,000 per year and those for the gas-
powered truck to be `325,000 per year. The trucks are depreciated @ 40% on WDV basis
for income tax purposes and the applicable tax rate is 30%. The residual value of the
trucks net of taxes is expected to be `50,000 and `40,000 respectively. In either case the
working capital requirement will go up by `50,000. Which one would you recommend.

2. CTC Mining Limited spent `20 million for getting the mining rights and another `10
million on exploration. After discovering a new gold mine, it must decide whether to
mine the deposit. The most cost-effective method of mining gold is sulfuric acid
extraction, a process that results in environmental damage. To go ahead with the
extraction, CTC must spend `45 million for new mining equipment and pay `7 million for
its installation. The equipment will be depreciated @25% for tax purposes and the tax
rate applicable to the firm is 30%. After five years the equipment will have a net residual
value of `10 million net of taxes. The gold mined will net the firm an estimated `20
million each year over the 5-year life of the vein. CTC’s cost of capital is 14 percent.
a. What are the NPV and IRR of this project?
b. Should this project be undertaken, ignoring environmental concerns?
c. How should environmental effects be considered when evaluating this, or any
other, project? How might these effects change your decision in part b?
d. Instead of mining the gold itself CTC is considering selling the mining rights. The
company has received a proposal for outright sale of the mining rights for `7.5
million. What should it do?

3. The Pink Panther Publishing Company is considering two mutually exclusive expansion
plans. Plan A calls for the expenditure of `2,500 million on a large-scale, integrated plant
which will provide an expected cash flow stream of `400 million per year for 20 years.
Sanjay Dhamija
 Plan B calls for the expenditure of `750 million to build a somewhat less efficient, more
labor-intensive plant which has an expected cash flow stream of `170 million per year for
20 years. The firm’s cost of capital is 10 percent.
a. Calculate each project’s NPV and IRR
b. Set up a Project  by showing the cash flows that will exist if the firm goes with
the large plant rather than the smaller plant. What are the NPV and the IRR for
this Project?

4. Kit Kit Ltd. is considering two investment projects, each of which require an up-front
expenditure of `1250 million. You estimate that the cost of capital is 10 percent and that
the investments will produce the following after-tax cash flows (in millions of rupees):

Year Project A Project B

1 250 1000
2 500 500
3 750 400
4 1000 300

a. What is the regular payback period for each of the projects?

b. What is the discounted payback period for each of the projects?
c. If the two projects are independent and the cost of capital is 10 percent, which
project on projects would the firm undertake?
d. If the two projects are mutually exclusive and the cost of capital 15 percent,
which project should the firm undertake?
e. If the reinvestment rate is 10 percent, what is the modified IRR (MIRR) of each
project?

5. The CC Limited is evaluating the proposed acquisition of a new milling machine. The
machine’s base price is `5,400,000, and it would cost another `600,000 to modify it for
special use. The machine falls into 40% tax rate at WDV and it would be sold after 3
years for `3,250,000. The machine would require an increase in net working capital of
`1,275,000. The milling machine would have no effect on revenues, but it is expected to
save the firm `2,200,000 per year in before-tax operating costs, mainly labor. The
applicable tax rate is 30 percent.
a. What is the net cost of the machine for capital budgeting purposes? (That is, what
is the Year 0 net cash flow?)
b. What are the net operating cash flow in Years 1, 2 and 3?
Sanjay Dhamija
 c. What is the terminal year cash flow?
d. If the project’s cost of capital is 12 percent, should the machine be purchased?

CASE: Opening a new retail outlet

XYZ Oil Limited is an Oil Marketing Company. It is planning to open another outlet in Delhi. To
identify a suitable location and to carry out a detailed feasibility study the company hired a
consultant and paid a fee of ` 500,000 towards the same.

Based upon the feasibility report the following details were identified:

MARKET ANALYSIS AND PRODUCT-MIX

The following demand estimates were made for the first year of operations

 Petrol: 30,000 liters per day

 Diesel: 10,000 liters per day

It is estimated that the petrol will generate a margin of `2 per liter whereas the margin on diesel
would be `1.20 per liter. The demand is expected to grow by 10% per annum. The margins are
expected to grow by 3% per annum.

COST OF THE PROJECT

The land would be taken on a 10 years lease at an initial deposit of `2 crores and a monthly
rent of `2 lakhs. The other costs are estimated as follows:

 Leveling of plot, site preparation, construction etc. `2 crores

Sanjay Dhamija
  Equipments cost and installation `3 Crores

 Working Capital Requirement `1 Crore.

It is estimated that the residual value of the plant and machinery would be just sufficient to meet
the cost of removal. As per the lease agreement any building and structure would revert back to
the Landlord. The working capital requirement would increase by 10% every year. The funds
blocked in the working capital would be recovered in full at the end of the project life.

MEANS OF FINANCE

The project would be financed 50% by internal resources and 50% by borrowed funds. The rate
of interest on the borrowed funds is 12%. As per the internal policy of the company the required
rate of return on such projects is 16%.

OPERATING COST

 Manpower cost : `100,000 per month

 Maintenance : 10% per annum of the cost of equipment

 Other Expenses : `1,00,000 per month.

 Contingent Expenses : 10% of the above expenses

It is estimated that the expenses would increase by 5% every year.

Cost of site preparation and building would be depreciated at the rate of 20% per annum on the
written down value basis. The rate of deprecation on Equipments would be @ 25% on the WDV
basis.

The applicable tax rate for the company is 30%.

Sanjay Dhamija