UNIT 2

CAPITAL BUDGETING DECISIONS

Illustrations
1. A company is considering expanding its production. It can go in either for an
automatic machine costing Rs.2,24,000 with an estimated life of 5 years or an
ordinary machine costing Rs. 60,000 having an estimated life of 8 years. The annual
sales and cost are estimated as follows:

Automatic Machine Ordinary Machine

(Rs) (Rs)
Sales 150000 150000
Material cost 50000 50000
Labour cost 12000 60000
Variable Overheads 24000 20000
Calculate the payback period.

2. XYZ is considering two projects. Each project requires an investment of Rs.10,000.

The firm’s cost of capital is 10 percent. The net cash inflows from investments in two
projects X and Y are as follows:

Year 1 2 3 4 5
X (Rs) 5000 4000 3000 1000 -
Y (Rs) 1000 2000 3000 4000 5000
The company has fixed 3 ears PBP as cut off point. State which project should be
accepted.

3. A project costs Rs.5,00,000 and has a scrap value of Rs.1,00,000. Its stream of
income before depreciation and taxes during first year through five years is
Rs.1,00,000, Rs.120000, Rs.140000, Rs160000 and Rs.200000. Assume a 50% tax
rate and depreciation on straight line basis. Calculate the average rate for the project.
Also state whether you recommend the project for investment when the management
expects a rate of return of 10%.

4. A limited company has under consideration the following two projects. Their details
are as follows:

Project X (Rs) Project Y (Rs)

Investment in machinery 1000000 1500000
Working capital 500000 500000
Life of machinery (years) 4 6
Scrap value of machinery 10 % 10 %
Tax rate (%) 50 % 50 %
Income before Depreciation and Tax
 Year 1 2 3 4 5 6
X (Rs) 800000 800000 800000 800000 - -
Y (Rs) 1500000 900000 1500000 800000 600000 300000
You are required to calculate the Average rate of return and suggest which project is
to be preferred.

5. Calculate the NPV for a project which require an initial investment of Rs 20,000 and
which involves a cash inflow of Rs.6000 each year for 6 years. Cost of funds 8%.

6. A company must select one of the two projects:

Year 0 1 2 3 4
Project X 11,000 6,000 2,000 1,000 5,000
Project Y 10,000 1,000 1,000 2,000 10,000
Cost of capital is 6%. Compute NPV and suggest the best alternative
7. A project costs an initial investment of Rs.40,000 and is expected to generate annual
cash inflows of Rs.16,000 for 4 years. Calculate IRR

8. A company must select one of the two projects:

Year 0 1 2 3 4
Project X 11,000 6,000 2,000 1,000 5,000
Project Y 10,000 1,000 1,000 2,000 10,000
Calculate IRR. Suggest the best alternative.

9. A project requires an investment of Rs.10,000 and the expected cash flows are: Year 1
Rs.12,000 and Year 2 Rs.4,000. The cost of capital is 10% and the present value
factors at 10% are 1st year 0.909 and 2nd year- 0.826. Compute Profitability Index.

10. Zenith Industries Limited are thinking of investing in a project costing Rs.20 lakhs.
The life of the project is 5 years, and the estimated salvage value of the project is
Zero. Straight line method of depreciation is followed. The tax rate is 50%. The
expected cash flows before tax are as follows:

Year 1 2 3 4 5
CF before 4 6 8 8 10
depreciation &
tax (in lakhs)
Compute PBP, ARR, NPV, IRR& PI. Cost of capital is 10%.
Exercise Problems
11. A company is considering an investment proposal to install new milling controls at a
cost of Rs.50,000. The facility has a life expectancy of 5 years and no salvage value.
The tax rate is 35%. Assume the firm uses straight line depreciation and the same is
allowed for tax purposes. The estimated cash flows before depreciation and tax from
the investment proposal are as follows:

Year 1 2 3 4 5
EBT 10,000 10,692 12,769, 13462 20,385
Compute the following: PBP, ARR, IRR, NPV @ 10% discount rate and PI @ 10%
discount rate.

12. Karnataka Ltd plans to undertake a project for placing a new product in the market.
The company’s cut off rate is 12%. It was estimated that the project would cost
Rs.40,00,000 in plant and machinery in addition to working capital of Rs.10,00,000,
which will be recovered in full when the project’s 5 years life is over. The scrap value
of plant and machinery at the end of 5 years was estimated at Rs.5,00,000. After
providing for depreciation on straight line basis, profit after tax were estimated as
follows:

Year 1 2 3 4 5
PAT (Rs) 3,00,000 8,00,000 1300,000 5,00,000 4,00,000
Evaluate the projects under PBP, ARR, IRR, NPV &
13. You are a financial analyst of XYZ company Ltd. The director of capital budgeting
has asked to analyse two proposed capital investments, Project P and Q. each project
has a cost of 10 lakhs as the cost of capital for each project is 12%. The project’s
expected net cash flows are as follows:

Year Project P (Rs) Project Q (Rs)

0 (10,00,000) (10,00,000)
1 6,50,000 3,50,000
2 3,00,000 3,50,000
3 3,00,000 3,50,000
4 1,00,000 3,50,000
a. Calculate each project’s payback period, NPV, IRR
b. Which project or projects should be accepted if they are independent?
c. Which project should be accepted if they are mutually exclusive?
14. Modern Enterprises Ltd is considering the purchase of a new computer system for
its research and development division, which would cost Rs.35,00,000. The operation
and maintenance costs (excluding depreciation) are expected to be Rs.7,00,000 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.1,00,000.
 The tangible benefits expected from the system in the form of reduction in design and
draftmanship costs would be Rs12,00,000 per annum. The disposal of used drawing
office equipment and furniture initially is anticipated to net Rs.9,00,000.
As capital expenditure in research and development, the proposal would attract a 100
percent 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 cashflows, advice the company of the financial viability
of the proposal. Ignore tax on salvage value.

15. SCL Ltd is engaged in the manufacture of power intensive products. As a part of the
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 state government to be received at the end of the first year of
installation, Rs.15 lakh.
d. Cost of electricity will be Rs2.25 per unit in year 1. This will increase by Rs.0.25
per unit every year till year 7. After that, it will increase every year by Rs.0.50 per
year till year 10.
e. Maintenance cost will be Rs.4 lakh in year 1 and the same will increase by Rs.2
lakh every year.
f. Estimated life 10 years.
g. Cost of capital 15%.
h. Residual value is nil. However, land value will go up by Rs.60 lakh, at the end of
year 10.
i. Depreciation will be 100% of the cost of the windmill 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 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 NPV. Ignore tax on
capital profits. Use present value upto two digits.