Exercises on Capital Budgeting

1. The following two machines are mutually exclusive and the firm would be required to
replace the same whatever machine it buys. Machine A would be replaced every 4 years,
machine B every 3 years. The cash flows associated with each machine are tabulated as
follows; all numbers are in „Rupee („0,000)‟; the relevant discount rate is 10% for both
machines.

Year M/c A M/c B

0 (80) (100)
1 50 60
2 50 60
3 50 60
4 25 -

(a) Which of the two machines is the better investment project?

(b) Reassess the better investible machine, analyzing the question under the assumption
that, whatever machine the company buys has to be reinvested in perpetuity.

(c) Suppose machine A fits current technology, whereas machine B needs a one-time re-
tooling for the company. These one-off installation costs would be Rs. 100,000 today.
What is the optimal investment decision now?

(d) Suppose the firm has an old machine in place that would serve for another two years.
They can postpone investing in either machine A or B and keep using this machine.
When should they stop using the old machine? Cash flows for the old machine are:

Year Cash Flow

1 50
2 20
3 0

(e) Suppose the investment opportunity described above lasts only for 24 years.
Recalculate your decision rule for questions (b) and (c). What is the NPV of the
optimal investment policy now?

1 MIT-SOB Batch 27 : Course ‘Financial Management’

Exercises on Capital Budgeting

2. (a) A corporation is considering purchasing a machine that has an expected eight-year

life and will generate for the firm Rs. 110,000 per year in net operating income before
taxes. The machine will be depreciated using the straight-line method to its anticipated
salvage value of Rs. 120,000. The firm has a 34% marginal tax rate and the required
return for this project is 12% p.a. If the machine costs Rs. 600,000, should it be
purchased?

(b) Another machinery salesman comes by the company's office and says that he is
willing to negotiate the purchase price of the machine described in the previous
question. What is the maximum price the firm is willing to pay for the machine?
[Hint: the price of the machine determines the level of depreciation and therefore
the taxes that the firm pays].

3. A company is trying to determine an optimal replacement policy for a piece of its

equipment. The cost of the machine is Rs. 150,000 and the annual maintenance costs
are Rs. 10,000 in the first year, Rs. 20,000 in the second year and Rs. 3,000 in the third
year. Anticipated salvage values are Rs. 60,000, Rs. 30,000 and Rs. 0 at the end of years
1 through 3, respectively. Assume that the company's revenues are unaffected by the
replacement policy and that the firm has a 34% tax rate; required return on this project
is 12% and uses a straight-line depreciation. Should the equipment be replaced every
year, every second year, or every third year? Be sure to explicitly consider the
depreciation and tax effects.

4. Better Cement Ltd. is considering an investment opportunity that requires an initial

outlay equal to Rs. 5,750,000. In years 1 and 2 the net cash flows are expected to equal
Rs. 5,000,000. The required rate of return is 25% p.a.

(a) Given that the BCL's criterion whether to invest or not is the project's internal
rate of return (IRR), should the company‟s managers invest in this project? Is
IRR criterion the correct decision rule in this case? If not, which criterion should
have been used?

(b) After observing the managers' decision, a shrewd businessman offers the
managers of BCL. the following modified project. The businessman offers that
the company will pay the initial outlay Rs. 5,750,000 only in year 2 and receive
the Rs. 5,000,000 in years 0 and 1. As a compensation for receiving this offer, the
businessman proposes that the company pay him Rs. 11,000,000 in year 3. BCL's
CFO argues that according to the IRR criterion the proposal is profitable since
the 25% required rate of return is lower than the new IRR for this investment. Is
the CFO correct in his argument that the required rate of return is lower than the
IRR? Does this decision rule lead to optimal investment by the company?

2 MIT-SOB Batch 27 : Course ‘Financial Management’

Exercises on Capital Budgeting

5. Natural Fashions Ltd. is looking at setting up a new manufacturing plant to produce

apparel made from man-made fiber. The company bought some land six years ago for
Rs. 5,000,000 in anticipation of using it as a warehouse and distribution site, but the
company decided not to build the warehouse at that time. This seemed the right
decision at the time since they were sentenced to six years in prison for another type of
“distribution” in which they were involved. The land was appraised last week for Rs.
5,500,000. The company wants to build its new manufacturing plant on this land; The
plant will cost Rs. 17 million to build, and the site requires Rs. 2,500,000 worth of
grading before it is suitable for construction. What is the proper cash flow amount to use
as the initial investment in fixed assets when evaluating this project? Why?

Now if you are evaluating this project with the following cash flows (in „000):

CF0 CF1 CF2 CF3 CF4 CF5

(25,000) 6,000 7,000 (4,000) 15,000 10,000

(a) Assume a required rate of return of 10%. Find the NPV? Also find the Payback?

(b) Should you calculate the project‟s IRR? Why or why not? Find the MIRR?

6. A project has the following cash flows: (assume a required rate of return of 10%)

CF0 CF1 CF2 CF3 CF4 CF5

(100,000) 40,000 40,000 60,000 (20,000) 10,000

(a) Can you use IRR to determine if this is an attractive project? Why or why not?

(b) Calculate the MIRR for this project.

7. Daily Breaking News Corporation is evaluating whether to replace a printing press with
a newer model, which, owing to more efficient operation, will reduce operating costs
from Rs. 400,000 to Rs. 320,000 per year. Sales are not expected to change. The old
press cost Rs. 600,000 when purchased five years ago, had an estimated useful life of 15
years, zero salvage value at the end of its useful life and is being depreciated straight-
line. At present, its market value is estimated to be Rs. 400,000, if sold outright. The
new press costs Rs. 800,000 and would be depreciated straight-line to zero salvage over
a ten-year life. However, management expects to be able to sell the new press for Rs.
150,000 at the end of ten years. The corporation has a 40% marginal tax rate and a cost
of capital of 15%. What should management do?

3 MIT-SOB Batch 27 : Course ‘Financial Management’