Serial No……………...

Student No……………

B.Com, Semester – V
FIN 304: Capital Budgeting
(Mid Semester Examination– September 2019)

Time: 2 Hours Max. Marks: 50

Instructions
 Write your Student No. on the top right-hand corner immediately on
receiving this Q paper.
 Write Sl. No. of Q paper on your answer booklet in the space provided.
 The first 15 minutes is for reading the Q Paper. Candidates must not start
writing during this time.
 This Q Paper contains two parts, Part A and Part B.
 The intended marks for each Q are given in brackets.

Part A – (20 Marks)

Answer ALL Questions

Question 1
State with reasons whether the following statements are true or false: -- (1x5=5)
(i) Projects are independent when their cash flows are unrelated.
Ans : True – Independent due to unrelated Cash Flows.
(ii) A project with PI greater than one will have positive NPV.
Ans : True - This is the acceptance rule of PI technique of Capital Budgeting.
(iii) The opportunity cost of an input is always considered in capital budgeting.
Ans: False - Never always. Only on special situations.
(iv) There is a time element involved in capital budgeting.
Ans : True – TVM is used by modern techniques.
(v) Cash Flows are same as profit before tax.
Ans : False – Cash flows = PAT + Depreciation.

Question 2 (3 + 2=5)
(i) Examine the effects of depreciation policy on the cash flows of a firm. How depreciation
does affect the cash flows of a proposal?

Ans: Companies use investing cash flow to make initial payments for fixed assets that are
later depreciated.

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  Depreciation is a type of expense that is used to reduce the carrying value of an
asset.
 Depreciation is entered as a debit-to-expense and a credit to asset value so actual
cash flows are not exchanged

Depreciation affects the cash flows : i/ reduce expected profit being generated by the
proposed project; ii/ reduce the tax liability; iii/reduces the taxable income

(ii) Compute IRR through interpolation if Low Rate is 23% and High Rate is 24%. Assume that
the NPV at Low Rate is Nu. 200 and that of High Rate is Nu. – 322.
Ans : 23 + [200 x (24-23)] / 200 + 322 = 23.38%

Question 3 (1x5=5)
Explain in brief the following financial term with regards to incremental cash flows:
(i) Sunk Cost – Irrecoverable cost incurred already and it is an irrelevant cash flow item.
(ii) Allocated Overheads – Irrelevant cash flow item on actual overhead. Only incremental
overheads if any, related to the proposal shall be considered as relevant cash flow.
(iii) Conventional Cash Flows – It is a series of inward and outward cash flows over time in
which there is only one change in the cash flow direction. Basically a conventional cash flow
is structured as an initial outlay or outflow, followed by a number of inflows over a period
of time.
(iv) Working Capital – CA - CL
(v) Transfer Pricing – Transfer Pricing is the setting of the price of goods and services sold
between controlled (or related) legal entities within an enterprise. Eg. If a subsidiary sells
goods to its parent, the price paid by parent company to the subsidiary company for the
goods is known as transfer price.

Question 4 (3 + 2 = 5)
Migmar Company has an investment opportunity costing Nu. 1, 00,000 with the following
expected cash inflows (i.e after tax and before depreciation):

Year Cash Inflows

(Nu.)
1 17,000
2 17,000
3 17,000
4 17,000
5 17,000
6 18,000
7 10,000
8 15,000
9 10,000
10 14,000

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Using 10% as the cost of capital (rate of discount), determine (i) Net Present Value; and
(ii) Profitability Index.

Solution : Calculation of NPV

Year Cash Inflows PVF (10%,n) PV (Nu.)

(Nu.)
0 (1,00,000) 1.000 (1,00,000)
1 17,000 0.909 15,453
2 17,000 0.826 14,042
3 17,000 0.751 12,767
4 17,000 0.683 11,611
5 17,000 0.621 10,557
6 18,000 0.564 10,152
7 10,000 0.513 5,130
8 15,000 0.467 7,005
9 10,000 0.424 4,240
10 14,000 0.386 5,404
Net Present Value (3,639)

Calculation of Profitability Index:

Profitability Index = Present Value of Cash Inflows / Present Value of Cash Outflows
= 96,361 /1,00,000 = 0.963

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 Part – B (30 Marks)
Answer ALL Questions

Question 5 (8+2 =10)

Sakay Company purchased a machine three years ago at a cost of Nu. 10,000. The machine had a
life of 8 years at the time of its purchase. It is being depreciated on straight-line basis for the
purpose of taxes. The company is thinking of replacing it with a new machine costing Nu.
20,000 with an expected 5 year life. The profit before depreciation is estimated to increase by
Nu. 2,440 a year. Assume that the old and new machine will be depreciated on straight-line
basis for tax purposes. The salvage value of the new machine is anticipated as Nu. 2,500 after 5
years. The market value of the old machine today is Nu. 11,500. It is estimated to have zero
salvage value after 5 years. The corporate income tax rate may be assumed as 30%. Further, the
long-term capital gain tax rate is 20%. The amount in excess of the original cost is treated as the
long-term capital provided the asset is held, at least, for one year. The short-term capital gains
are treated as ordinary income and taxed at 30%. The company’s after-tax cost of capital is 12%.
Advise the company for replacement option.

Solution:
Incremental Cash Flows (Replacement Decisions using Incremental Approach)
Year Particulars Cash Flows (Nu.) PV PV (Nu.)
/PVAF(n5,
i12%
Initial Cash Flows:
Cost of New Machine 20,000
(-) Sale of Old Machine (11,500)
(+) Tax on STCG 300
(+) Tax on OI 1125 1,425
Cost of Initial Inv. (9,925) 1.000 (9,925)

Incremental Operating Cash

Flows:
Incremental Rev. 2,440 (1-0.30) 1,708
Tax Saving on Inc. Deprn. 675
Operating Cash Flows 2,383 3.605 8,591

Terminal Cash Flows

(2,500 – 0) 2,500 0.567 1,419

Net Present Value 85

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Recommendation : The new machine should be accepted
Working Note
The depreciation value of the old machine today is Nu. 6,250 as shown below.
The total proceeds from the sale of the old machine is Nu. 11,500. The book profit is :
11,500 – 6,250 = Nu. 5,250. Of this project, Nu. 1,500 (i.e Nu. 11,500 – 10,000) is long-term
capital gain and remaining Nu. 3,750 is short-term capital gain (treated as ordinary
income).
Year Depreciation (15%) Book-value
(balance)
0 - 10,000
1 1,250 8,500
2 1,250 7,500
3 1,250 6,250
New machine costs Nu. 20,000. If it is acquired, the old machine will be sold. Thus the net
cash outlay will be as below.
Net cash outlay
Cost of new machine Nu. 20,000
Less : Total sale proceeds of old machine 10,075
After Tax 9,925

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Question 6 (5+5 =10)
(i)
(a) Explain diagrammatically the steps involved in capital budgeting decisions in detail.
Ans:

(b) Highlight FIVE objectives of Capital Budgeting.

Ans : Establishing Priorities : Cash Planning; Construction Planning; Eliminating
Duplication; Revising Plans.

OR

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(ii) (10)
An initial investment of Nu. 23, 24,300 is expected to generate cash inflows of Nu. 5, 80,000 per
year for 7 years. Calculate the discounted payback period of the investment if the discount rate is
11%.

Solution:

Year NCF (Nu.) [ PVNCF @ 11% Cumulative NCF

(Nu.)
0 (23,24,300)
1 5,80,000 5,22,522.52 5,22,522.52
2 5,80,000 4,70,741.01 9,93,263.53
3 5,80,000 4,24,091.00 14,17,354.53
4 5,80,000 3,82,063.97 17,99,418.50
5 5,80,000 3,44,201.77 21,43,620.27
6 5,80,000 3,10,091.68 24,53,711.95
7 5,80,000 2,79,361.88 27,33,073.83

DPB = 5 + [ (23,24,300 – 21,43,620.27) / 3,10,091.68]

= 5 + 0.58
= 5.58 years

Question 7 (6 + 4 = 10)
(i)
a) You are an assistant to Rinzin, the corporate finance director at Solotshangma, a Bhutanese
civil engineering firm. Two of the company’s recent bids are accepted. The first relates to
construction of a new airport in Gedu. The second relates to construction of motorway
connecting Dewathang with Thimphu, the capital. Both the projects are expected to take 3 years.
The applicable finance rate is 10% and the project’s cash flow in Bhutanese Ngultrum are given
below:

Year Airport Motorway

0 (1,20,00,000) (1,80,00,000)
1 60,00,000 80,00,000
2 80,00,000 100,00,000
3 40,00,000 100,00,000

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The company submitted bids for both projects because both had positive net present values.
Dophu, the CEO, has asked Rinzin to recommend which project the company should accept.
Dophu is a fan of IRR approach. Rinzin, on the other hand, is worried about the shortcomings of
the IRR approach. He believes that the economy might slow down a little in next few years and a
lower reinvestment rate should be factored in. He asked you to calculate MIRR for both the
projects and interpret accordingly.

Solution:
MIRR – Airport
= (Nu. 20060000 / 1,20,00,000)^(1/3) – 1
= 18.68%

MIRR – Motorways
= (Nu. 30680000 / Nu. 1,80,00,000 )^(1/3) – 1
= 19.45%

The motorway project should be preferred based on MIRR approach.

b) Define a capital budgeting decision and state its main features.

Ans : It is firm’s decision to invest it’s current funds most efficiently in the long-term assets
in anticipation of an expected flow of benefits over a series of years.

 Features
1. Exchange of current funds for future benefits
2. The funds are invested in long-term assets
3. The future benefits will occur to the firm over a series of years

OR
(ii) (10)
A firm is currently using a machine which was purchased two years ago for Nu. 70,000 and has a
remaining useful life of 5 years.
It is considering to replace the machine with a new one which will cost Nu. 1,40,000. The cost of
installation will amount to Nu. 10,000. The increase in working capital will be Nu. 20,000. The
expected cash inflows before depreciation and taxes for both the machines are as follows :

Year Existing Machine New Machine

(Nu.) (Nu.)
1 30,000 50,000
2 30,000 60,000
3 30,000 70,000
4 30,000 90,000

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 5 30,000 1,00,000

The firm use Straight Line Method of depreciation. The average tax on income as well as on
capital gain / loss is 40%.
Calculate the incremental cash flows assuming sale value of existing machine : (i) Nu. 80,000,
(ii) Nu. 60,000, (iii) Nu. 50,000, and (iv) Nu. 30,000.

Solution:
Incremental Initial cash outflows: (figures in Nu.)
Year (i) (ii) (iii) (iv)
Cost of new machine 1,40,000 1,40,000 1,40,000 1,40,00
+ Installation cost 10,000 10,000 10,000 0
+ Additional Working Capital 20,000 20,000 20,000 10,000
- Scrap Value 80,000 60,000 50,000 20,000
90,000 1,10,000 1,20,000 30,000
Tax Liability / Savings 12,000 4,000 0 1,40,00
Cash Outflow 1,02,000 1,14,000 1,20,000 0
Calculation of tax paid / saved - 8,000
Book value of old plant 50,000 50,000 50,000 1,32,00
- Scrap value 80,000 60,000 50,000 0
Profit / Loss 30,000 10,000 ---
50,000
Tax @ 40% on capital Gain/Loss 12,000 4,000 --- 30,000
(20,000
)

(8,000)

Subsequent Cash Inflows (Annual):

Year Year 1 Year 2 Year 3 Year 4 Year 5
Cash Inflows (before Deprn. & Tax):
On New Machine 50,000 60,000 70,000 90,000 1,00,00
On Old Machine 30,000 30,000 30,000 30,000 0
Incremental cash Inflow 20,000 30,000 40,000 60,000 30,000
- Incremental Depreciation 20,000 20,000 20,000 20,000 70,000
Profit Before Tax 0 10,000 20,000 40,000 20,000
- Tax at 40% 0 4,000 8,000 16,000 50,000
PAT 0 6,000 12,000 24,000 20,000
Depreciation (Added Back) 20,000 20,000 20,000 20,000 30,000
Net Cash Inflow 20,000 26,000 32,000 44,000 20,000
50,000

The amount of incremental depreciation has been calculated as follows:

Depreciation on new machine = (Nu. 1,40,000 + Nu. 10,000) / 5
= Nu. 30,000
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Depreciation onold machine = Nu. 70,000 / 7
= Nu. 10,000
Therefore, incremental depreciation = Nu. 20,000
Terminal cash flow : There will be a terminal cash flow of Nu. 20,000 at the end of 5 th year
in the form of working capital released.

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