Serial No……………...

Student No……………

B. Com-V (Finance)
FIN 304÷ Capital Budgeting
(Mid-sem Examination – September 2021)

Time: 2 Hours Max. Marks: 50

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

Part A – (20 Marks)

Answer ALL Questions

Question 1
Choose the most appropriate answer from the given choices. (5x1 =5)

(i) The basic discount rate used in net present value analysis is:
(a) the internal rate of return
(b) the cost of common equity
(c) the net discount rate
(d) the cost of capital to the firm
ANSWER: D

(ii) All of the following influence capital budgeting cash flows EXCEPT:
(a) Accelerated depreciation.
(b) Salvage value.
(c) Tax rate changes.
(d) Method of project financing used.
ANSWER: D

(iii) The current worth of a sum of money to be received at a future date is called:
(a) Real value

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 (b) Future value
(c) Present value
(d) Salvage value
ANSWER: C

(iv) Two mutually exclusive investment proposals have "scale differences" (i.e., the cost of the
projects differ). Ranking these projects on the basis of IRR, NPV, and PI
methods___________give contradictory results.
(a) will never
(b) will always
(c) may
(d) will generally
ANSWER: C

(v) An increase in the discount rate will:

(a) Reduce the present value of future cash flows.
(b) Increase the present value of future cash flows.
(c) Have no effect on net present value.
(d) Compensate for reduced risk.
ANSWER: A

Question 2
(i) Drubza Limited is evaluating a project that has the following cash flow stream associated
with it:

Year 0 1 2 3 4 5 6
Cash Flow (Nu.) -120 -80 20 60 80 100 120

What will be the project’s MIRR when the cost of capital is 15 percent? (3)

Answer:
Terminal Value of Cash Inflows = 20 (1.15)^4 + 60 (1.15)^3 + 80 (1.15)^2 + 100 (1.15) +120
= 34.98 + 91.26 + 105.76 + 115 + 120 = Nu. 467.
Present Value = 120 + 80/(1.15)^1 = Nu. 189.57

MIRR = [467/189.57]^1/6 – 1 = 1.166 – 1 = 0.166 03 16.6%

(ii) Why is payback popular despite being a non-DCF method of investment evaluation? (2)
Answer : Short-term projects and if the liquidation is the primary desire.

Question 3
(i) Once we have assumed that the old asset is replaced, why should we consider its operating
cash inflows and terminal cash flow subsequently? Explain with an example. (3+1=4)

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Ans: If you consider the advantage derived from liquidating the old asset, you should also
consider the disadvantage suffered by not having the asset in future.
Example is self-explanatory.

(ii) What is modified IRR? How is it calculated? (1/2+1/2=1)

Ans: The modified internal rate of return (MIRR) assumes that positive cash flows are
reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's
financing cost.
It is calculated as follows:

Question 4
Dophu estimates that the required rate of return is 6%. The company is considering two mutually
exclusive projects whose after-tax cash flows are as follows:

Year Serichu Project Chamkharchu Project

(Nu.) (Nu.)
0 (1,255) (1,060)
1 625 (470)
2 905 905
3 930 780
4 (245) 920

Compute the Modified Internal Rate of Return (MIRR) for the two projects and interpret your
results. (5)
Answer:
For Serichu Project:
TV(inflows) = Nu. 625(1.06)^3 + Nu. 905 (1.06)^2 + Nu. 930 (1.06)^1
= Nu. 744.39 + Nu. 1,016.86 + Nu. 985.80 = Nu. 2,747.05

PV (Outflows) = Nu. 1,255 + Nu. 245(1.06)^-4 = Nu. 1,255 + Nu. 194.06 = Nu. 1,449.06
MIRR = (Nu. 2,747,05 / Nu. 1,449.06)^1/4 – 1.0 = 17.3%

For Chamkharchu Project:

TV(inflows) = Nu. 905(1.06)^2 + Nu. 780 (1.06)^1 + Nu. 920 (1.06)^0
= Nu. 1,016.86 + Nu. 826.80 + Nu. 920 = Nu. 2,763.66

PV (Outflows) = Nu. 1,060 + Nu. 470(1.06)^-1 = Nu. 1,060 + Nu. 443.40 = Nu. 1,503,40
MIRR = (Nu. 2,763.66 / Nu. 1,503.40)^1/4 – 1.0 = 16.44 %

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Since these projects are mutually exclusive, we would choose Serichu Project

Part – B (30 Marks)

Answer ALL Questions

Question 5
An iron ore company is considering investing in a new processing facility. The company extracts
ore from an open pit mine. During a year, 1,00,000 tons of ore is extracted. If the output from the
extraction process is sold immediately upon removal of dirt, rocks and other impurities, a price
of Nu. 1000 per ton of ore can be obtained. The company has estimated that its extraction cost
amount to 70% of the net realizable value of the ore.
As an alternative to selling all the ore at Nu. 1,000 per ton, it is possible to process further 25%
of the output. The additional cash cost of further processing would be Nu. 100 per ton. The
proposed ore would yield 80% final output, and can be sold at Nu. 1,600 per ton.
For additional processing, the company would have to install equipment costing Nu. 10 million.
The equipment is subject to 25% depreciation p.a on reducing balance (WDV) basis/method. It is
expected to have useful life of 5 years. Additional working capital requirement is estimated at
Nu. 1 million. The company’s cut-off rate for such investments is 15%. Corporate tax is 35%.
Assuming there is no other plant and machinery subject to 25% depreciation, should the
company install the equipment if the expected salvage is Nu. 1 million? (The capital gain or loss
may be taken as not subject to tax). (10)

Answer:
Incremental Cash Flow
A. Initial Investment / Outflows
Year Particulars Cash Flows PV
(Nu.)
0 Cost of Equiptment 10,000,000
(+) Additional WC 1,000,000
Initial Outlay 11,000,000 11,000,000

B. Cash Inflows/ Subsequent Cash Flows and Terminal CF

Year EBITD Cost Deprn. PBT PAT CF PV
1 7,000,000 2,500,000 2,500,000 2,000,000 1,300,000 3,800,000 3,306,000
2 7,000,000 2,500,000 1,875,000 2,625,000 1,706,250 3,581,250 2,707,425
3 7,000,000 2,500,000 1,406,000 3,094,000 2,010,937 3,417,187 2,248,509
4 7,000,000 2,500,000 1,054,688 3,445,312 2,239,453 3,294,141 1,884,509
5 7,000,000 2,500,000 -- 4,500,000 2,925,000 2,925,000 1,453,725
5 Salvage Value 1,000,000 4,97,000

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5 Recovery of Working Capital 1,000,000 4,97,000
Present Valu of Cash Inflows 12,593,908
Net Present Value = 12,593,908 – 11,000,000 = Nu. 1,593,908
The company is advised to install the equipment as it promises a positive NPV.

Working Note:
1. Revenue : Revenue from Processing [Nu. 1,600 x 20,000] – [Nu. 1,000 x 25,000] = Nu.
7,000,000. (Here, further 25% of 100000 = 25,000 tonnes. 80% of 25,000 sold at Nu. 1,600.)

2. Cost: Processing Cost (Cash Cost Nu. 100 x 25,000 tonnes) = Nu. 2,500,000.

3. Depreciation :
Year Deprn. Base of Equipment Deprn. @ 25% WDV
1. 10,000,000 2,500,000
2. 7,500,000 1,875,00
3. 5,625,000 1,406,250
4. 4,218,750 1,054,688
5. 3,164,062 NIL

As the block consists of a single asset, no depreciation is to be charged in the terminal year of
the project.

Question 6
(i)
(a) Central Gas Ltd. considers to enhance its production capacity. The following two mutually
exclusive proposals are being considered:

Particulars Proposal I Proposal II

(Nu.) (Nu.)
Plant 2,00,000 3,00,000
Building 50,000 1,00,000
Installation 10,000 15,000
Working Capital Required 50,000 65,000
Annual Earnings (Before Depreciation) 70,000 95,000
Sales Promotion Expenses - 15,000
Scrap value of Plant 10,000 15,000
Disposable value of Building 30,000 60,000

Life of the project is 10 years. Sales Promotion expenses of Proposal II are required to be
incurred at the end of 2nd year. These expenses have not been considered to find out the Annual
earnings as given above. Which proposal will be accepted given that the cost of capital of the
firm is 8%? Ignore Tax. (8)

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Answer:
The proposals may be evaluated as follows:

Particulars Proposal I Proposal II

(Nu.) (Nu.)
Initial Cash Outflows
Cost of Plant 2,00,000 3,00,000
Installation Expenses 10,000 15,000
Cost of Building 50,000 1,00,000
Working Capital Required 50,000 65,000
Total Outflow 3,10,000 4,80,000
Present Value of Annual Inflow:
Profit before Depreciation 70,000 95,000
PVAF(8%,10) 6.710 6.710
PV of Profit 4,69,700 6,37,450
(-) PV of Sales Promotion Exp. ---- (12,855)
(1500*PVF8%,2yr)
PV of Inflows (Annual) 4,69,700 6,24,595
Present Value of Terminal Inflows:
Release of WC 50,000 65,000
Sale value of plant 10,000 15,000
Disposable value of Building 30,000 60,000
90,000 1,40,000
PVF(8%,10) 0.463 0.463
PV of Terminal Inflows 41,670 64,820

Calculation of NPV:

Particulars Proposal I Proposal II

(Nu.) (Nu.)
PV of Annual Inflows 4,69,700 6,24,395
(+) PV of Terminal Inflows 41,670 64,820
Total 5,11,370 6,89,415
(-) PV of Outflows 3,10,000 4,80,000
Net Present Value 2,01,370 2,09,415

Proposal II has higher NPV, it may be accepted by the firm.

(b) What does NPV and PI measures in particular? (2)

Answer: NPV measures profitability of the project and PI measures the present value of
returns per ngultrum invested. (2)

OR

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(ii)
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%. (10)

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
(i)
Jigdrel 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. (10)

Answer:
Incremental Cash Flows (Replacement Decisions using Incremental Approach)
Year Particulars Cash Flows (Nu.) PV PV (Nu.)
/PVAF(n5,

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 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

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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 OR

(ii)
(a) Describe the concept of discounted cash flows in making investment decisions and its
superiority over the traditional methods of investment evaluation? (4)
Answer: In Finance, DCF analysis is a method of valuaing a project, company, asset using
the concept of the Time Value of Money. DCF uses Effective Interest Rate (EIR). DCF
valuation estimates the intrinsic value of an asset/business based upon its fundamentals.
It can be used as sanity check system. It is more reliable as it takes into account
underlying fundamental drivers of a business (cost of equity, cost of debt, WACC,
growth rate, re-investment rate, etc.)

(b) Your company is considering two projects, S and T, each of which requires an initial outlay
of Nu. 50 million. The expected cash inflows from these projects are:
Year Project S Project T
1 11 38
2 19 22
3 32 18
4 37 10

I. If the two project are independent and the cost of capital is 10%, which project should the
firm invest in?
II. If the two projects are mutually exclusive and the cost of capital is 15%, which project should
the firm invest in?
III. What is the payback period for S and T? (6)

Answer
I. Both Projects (2 Marks)
II. Invest in Project S (2 Marks)
III. Project S 2.63 years and Project T 1.55 years (2 Marks)

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