Chapter 9: Capital Expenditure Decision-I Theoretical Questions: aa omer ‘mean by Capa Rationing? ee r, What is tn ‘tioning applied in case of divisible and indivis ra coer eaee decisions? ¢ importance of capital rationing? How is it applied in [2013,2014(G),2015(6)] iy Jatloning 's the process of putting restrictions on the projects thet ok Petree ve ne. <@Pital that can be invested by the company. Ths plans fn selecting only Most Profitable investments for capital Investment decision. This can b@ achieved by putting restrictive limits on the’ budget or selecting a higher cost of capital as thé"obstacle Fate for all the Projects under consideration, Capital budgeting decision is an easy process in those companies where fund is not the constraint, but in majority of the cases, ‘companies have fixed capital budget. So, a huge number of projects are POT Atst ith these limited budget, Thus, the catapany Magres tba in ®Avayen ante monioae the long run returns. Therefore, capital rationing implies to the situation where the companies have more acceptable investment proposal requiring huge amount of finance than is available with the pe upenvs tts connected with the selection of a gimulygf investMfants out of liferent investments Proposals ranked in the descending order of rate of return signifies tothe preference pf investment proposals under financial able capitél exBenditute Budget. The goal is to choose the combination ‘aximize the total NPV, Capital ratio maximum amount that can be iivested throughout a year Capital rationing can be experienced due te external factors, markets which can be gharactefized to'bad condition of stock mi etc. Internal capital rationing’is due to'the sel Capital rationing situation ig situation puts a limit on the generally imperfections in capital 'arket at present, investor attitude (1) It may be applied through budgets, (2) It can be prepared by putting up an upper limit when it has been fi only through retained earnings. (3) It can also be prepared by ‘Responsibility Accounting’, whereby management may allow a Particular department to make investment only up to a specified limit, beyond which the investment proposals are to be taken by higher-ups. Assumptions of Capital Rationing : 9874541081/9831115654 Page 55 inancing investment proposals eea sain assumption of capital rationing is that there are restrictions on capital outlays either through ‘all internal financing’ oF investment Budget restrictions’, companies have limited funds oie to invest in all the projects, It also postulates that capital rationing can come out with an past return on investment for the company whether by normal trial and error process or by applying mathematical techniques like integer, linear or goal programming etc Advantages or importance of Capital Rationing : ‘The advantages of practicing capital rationing are as follows: 1) Budget: The first and a significant advantage is that capital rationing launches a sense of strict budgeting of corporate resources of a company. Whenever there is a restriction of capital in the form of more borrowings or stock issuance capital, the resources are suitably handled and invested in profitable projects. 2) No Wastage : Capital rationing protects wastage of resources by nat investing in Gach and every new project available for investment 3) Less number of Projects: Capital rationing guarantees that less number Of projects Is chosen by imposing capital restrictions. These helps in maintaining the number of active projects to minimum ‘and so manage them well 4) High Returns projects: Through capital rationing, companies invest only jn those projects where the expected return is high, therefore ignoring projects with lower retUrps on capital. 5) More Stability : As the company is not investing in all eS the finances are not over- expanded. This helps in having sufficient Branca imesan ‘guarantees more stability and increase in the stock price of the company. < ) ‘The methods of solving the capital budget prem? as follows. LA NN) 1) In case of Divisible projects : In ths situation thé project can be accepted in certain portions and the following steps will need to follow for the purpose of selection of the projects. 1. Determine the profitability Index (PI) of each project. 2. Rank the project in descending order of PI determined in Step 1 3. Choose the optimal combinationvef projects. 2) In case of indivisible project: In this situation the complete project has to be accepted. AS a result, part acceptance or rejection of project is not possible. Under this condition, the following steps will neéd toxfollow ar the purpose of choice of projects: 1. Create’ailist of feasible Combination of projects so that the initial expenditures needed for the ‘combination never exceéd the fund available for investment. 2. Chose that combination of projects which has highest NPV and consider it as optimal project combination. ‘the condition of capital rationing are ——— 9874541081/9831115654 Page S6ar ¢, * Comput Tek e the pa N 25" Endot Year Payback period for the project 00k Value of Peer 3 4 5 Profit after tag nt Assets oo. 8 7 "6o"" 50 (Figures res ag mained 124 zB Cee ) [2006] Q2. Ra i aNd Co. | frend Co. intends to invest € 10 lakh ina project having» fe of @ yea The cash inflows 420.04 elect atthe end of year on tothe fourth yen 8 expected as 3,00,000, % caleulat 1, & 4,00,000 and & 3,30,000 before charging depreciation and tax You are required to Tafculate the Accounting Rate of Return ofthe Project and comment on the use of the rate of [2007] Q3. Th © cost ofa plant is & 20,000. The expected life of the plants 3 years. tis expected to enerate EBDIT (earnings before depreciation, interest and taxes): € 13,000, © 15,000, 7 17,000 respectively. 4, 4,44 Plt » Compute Accounting Rate of Return assuming 50% tax, and straight line method of . depreciation. {2009} —> Q.4._ From the information given below compute the Pay Back Period = Initial outlay % 80,000 Estimated life 5 years ~> Profit after tax : z Endofyear 1 6,000 am 2 14,000 3 4,000 4 6,000 10,000 [2010} 5S a Depreciation has béen caleulated under the straight line method 5. Youare requéted tBEdvice management about the purchase of a new machine on the basis of a payback reciprocal of the two: Machine X Machine ¥ Initial Outlay %2,00,000 —_% 3,00,000 10 14 Estimated life (years) %25,000 30,000 ‘Annual cash inflow after tax {2012} 6. Compute pay back period of a project of which the following details are available Endiof year 1 Zee eas) Book value of Fixed Assets (& in lakh) 450 400 © 350-300-250 Profit after Tax (& in lakh) 30 | 88 96 104 112 [2015] project | costs € 8,00,000 and project Il costs € 112,80,000. Both have a ten year life. Uniform cash receipts expected from project |-€ 1,60,000 and project I -% 3,20,000. Salvage value expected are project | € 5,60,000 declining at an annual rate of € 80,000 and project Il 6 40,000 declining at an annual rate of € 1,60,000. Which one is to be selected? Page 57 9874541081 /9831115654 Q7. {2015) tsaIne. Two machines are available, exch costing Q.8._ Fresco Ltd. is contemplating to purchase a machi _ iscounting rate of 10% is to & 5 lakh n comparing the profitaiity of the machines # discounting ‘ats of 10% sto be used, The machine is to be written off in five years by straight line with no residual value Cash flows after tax are expected to be as follows Machine A (®) Machine 8 (%) i 150,000 50,000 2 2,00,000 1,50,000 3 2,50,000 2,00,000 a 1,50,000 3,00,000 s 1,00,000 2,00,000 J Tbe Indicate which machine would be profitable using Average rate of return metho discounting factors at 10% are é Year 1 2 3 4 4 (6) Discounting factors 0.909 0.826 0.751 0.683 0.621, [2014 (6)1 1 3 d 9. A project requires an initial cash outlay of & 20,00,000 having allifelof 6 yeats. The expecte average annual profit from the project before tax is & 5,45,454. Compute the payback period of the project assuming tax rate at 45%and the rate of depreciation at 10% p.a. on straight line basis. Peastell Q.10. From the following information of MAK Ltd. calculate Pay Backeriod: [ Particulars < Purchase price of New Machinery acguge ___ Installation Expenses ae Workers’ Training Expenses incurred to put the asset to use 50,000 ~ Subsidy from Govt- 60% of purchase price Working Capital 3,00,000 Useful life of the machine = Book Salvage value 10% of purchase price Cash Salvage value. 1,20,000 Method of Depreciation sim Tax Rate 30% | Sales units - 1,00,000 units p.a Initial selling price per unitis € 10 and variable cost is 40% of initial selling price. Annual fixed cost other than depreciation is & 2,00,000. [2013] Q.11. (2) Following information available for two machines x®) YR) p Initial Investment 1,00,000 1,00,000 ‘ Life 7 years 10 years Net cash inflow 25,000 20,000 Realisable value after 5 years 50,000 75,000 ‘ With the help of pay back period method, evaluate the efficient one. (b) The cost of a plant is & 60,000. The expected life of the plant is 3 years. It is expected to ‘ generate EBDIT (Earnings before depreciation, interest and taxes) & 26,000, % 30,000, 34,000 respectively. Compute Accounting Rate of Return assuming 30% tax and straight-line method of depreciation. [2014] 1874541081 /9831115654Ne ae Qi. Using the info, Fmation tna and Sree below compute the Pay-Back Period under Discounted ial outlay : timated lif % 20,000 k ofit after tax S years Nd of year : z . 2 14,000 : 3 24,000 4 16,000 Nil Deprecia 4 tion has been calculated under straight-line method. The cost on cap taken a Faken a 20% 2, and the PV of € 1 at 20% seven Below : PVF: 1 2 3 4 S ‘actor 0.83 0.69 0.58 0.48 0.40 Q2. F ‘rom the following cash flow streams, which cash flow streams would you recommend and why? End Stream Strear st of Year A NGS rs 350 a 200 3 7 500 300, 0° \See400 350 3 Ce 300 350 4 500 200 350 {o be received at the end of each year is 3 It is given that Present value of € Dat 1 given below : Year A 2 4 PV Factor 0.91 0.83 0.75 068 {2009} 1.3. ACompany has select one the two alternative projects whose particulars are given Below: Initial Net Cash Flow (2) Outlay (%) v1 Y2 ¥3 ya Project) 14,872 10,000 2,000 1,000 1,000 Project I 10,067 1,000 1,000 2,000 10,000 The'company can arrange the fund at 8%. Compute the NPV and IRR of each project and ‘comment on the result. The Present Value of Lat different cost of capital is given below = Z Year 8% 10% 12% += 14% a 0.926 0.909 0.893 0.877 2 0857 —0.826«(0.797 0.770 3 0.794 0.751 -—«0.712(0.675 4 0.735 —«0.683-—«0.636' 0.592 {2006} Q.4. R.Ltd. presently considering two machines for possible purchase: Other information related to the machines are as follows: Bi Machine 1 Machine 2 Purchase Price %50,000 60,000 years 4years Estimated life SS ae Page 59 9874541081/9831115654suM Method of depreciation iM mt Estimated Scrap value Nit Cash flow before depreciation and tax F . 25,000 45,000 : 25,000 19,000 Ys 25,000 25,000 19 25,000 27,000 Rate of tax is 40%, Compute net present value of each machine assuming the Company should buy? The Present value of & 1 at 8% is as follows Y, = 0.926; Y2 0.857; Ys 0.794; Ye = 0.735. Cost of Capital is 8%. Which machine {2007} 5. Acompany is considering an investment project which requires an initial cash outlay of € §5,00,000 on equipment and & 20,000 as working capital. The project's economic life is 6 years- {An additional investment of & 50,000 each would also be necessary at the end of s#eond and mnprpmnae RAR AKRRDDO DDO S fourth year to restore the efficiency of the equipment The annual ash inflows expected from the project are Year Cash inflows (®) 4 80,000 2 1,20,000 3 1,80,000, 4 2,00,000 5 2,60,000 ‘ . 3,00,000 if the realisable scrap value of the equipments 720,000 after 6 years and cost of capitals 20%. Justify whether the project should be atcepted or not by determining the net present value. ‘Assume that working capital will r@éovered in full at the end of the project life. Given that, ; Year: 1 w/ 3 arouse 48 PV Factor at 20%: 0.833 0.694 0579 0.482 0.402 0.335 [2009] Q.6. ZLtd. hasto select one of the two alternative projects whose particulars are given below Project 1 - Initial Outlay - & 2,40,000. The expected cash inflows from it at the end of first year and second year are € 50,000 and & 2,50,000 respectively. Project 2 - initial outlay % 2,35,930. The expected cash inflow from this project at the end of first year and second year are % 1,90,000 and & 90,000 respectively. Rank the two projects in order of preferences by the NPV method and IRR method. Which of the alternatives would, you select and why? Assume cost of capital is 10%. Present value of € 1 at different rates of cost of capital: Year: 10% 11% 12% += «13% «14% «15% e 0.909 0.901 0.892 0.885 0.877 0.867 2 0.826 0.812 0.797 0.783 0.770 0.756 [2010] Q.7. From the following particulars given below calculate the internal rate of Return of the project (i) Net Profits after-tax over the four years of the project life: End of Year : 1 %13,750 2 % 22,000 3 27,500 4 11,000 _— Page 60ee 1d of the project life. (ii) Initial outlay : © 55,000, There will Jue at the ent i re will be no realizable scrap value at the (ii) Present value of 82 receivable at the end of year 1, 2,3 and ‘A at different discount rates ee pv factor(®) ox 0.892 0.797 0.712 0.636 14% 0.985 0.783 0.693 0.613 0.877 0.70 0.675 0.592 a 0.867 0.756 0.658 0.572 (2011) 8. X Ltd. has been producing a chemical product by using machine Z for the last two years. Now, the management of the company is thinking to replace this machine either by X or by Y ‘machine. The following details are furnished to you: * z . - Book value(®) 1,00,000 _ Resale value now (®) 1,10,000 5 e 1,80,000 245,000 Purchase price (2) Annual fixed cost (including depreciation) 92,000 1,08,000 132,000 Variable running cost : (including labour) per unit © 3 1.50 250 Production per hour (unit) 8 8 a2 You are also provided the following additional information Selling price per unit %20 Cost of materials perunit 710 Annual operating hours 2,000 Workinglife of each ofthe three machines (3s fromnow) -5 years Salvage value of machines- 2% 10,000, x ® 15,000 and ¥ % 33,000. anticipated than an The company charges depreciation using straight-line method. Its sditional cost of 8,000 peF annum would be incurred on special advertising to sell the extra output of machine ¥. Assume tax rate of 50% andicost of capital 10%. The present value oF%41 to be received at the end of each year at 10% is as under Year MY 3 4 5 Present Value 0.909 0.826 0.751 0.683 0.621 Using NPV method, analyze the feasibility of the proposal and make recommendations (2011) 2.9. Acétfipan)sants.to replace its existing machine by Machine A, which is of similar kind or by Machine Bwhich is more expensive and of higher Capacity, due to the increasing demand. The available cash flow the two machines are as follows © F ‘Machine-lmmediate ash Inflows (@ in lakhs) at the end of Cash Flow (Zinlakh) sty. 2ndyr. 3rdyr. Athyr. Sthyr. A 25 5 20 14 14 8 40 10 14 16 7 15, The Company's cost of capital is 10%. The finance manager-tries to appraise the machines by calculating the following (i) Net Present Value (ii) Profitability index (iii) Discounted Pay Back Period. ‘Comment on these Calculation and guide the manager to select the investment. Note = Present values of 1 at 10% Discount rate are as follows : 9874541081/9831115654 Page 61‘ (2012) Year eet 2 3 oe oe ama et for the current vou" Ithas y iakh for Q.20, Reliance industries Ltd, has an investment budget of € ae listed two project X and Y. Jew we ‘urther particulars regarding tl . 0,000 Project bi Se Investment required 10,00,000 000 2,05) Average estimated cash inflows z TST OMIBN TTT. 240,00 suymated ie of30 Years are /¢ depreciation and tax Aoner the @ Best rates Salvage value is assumed to be nil for both the project reciatiOn Sa ae 7 emigesineathod fo TB 35%. Assuming cost of capital to be 12%, find out the (a) NPV of both the projects. (b) IRR of both Project X and Project Y J Given PV ofan amcity oF for ten yaars a ferent HSCOUNE FAR Rate(%) 12 13 [2013] (36) 100 4262. §.2161 "8.0" (2013) Annuity value for 6.1446 5.8992 5.6502 project. The josed to undertakea Propet” +4 99,000. The ual value Of rs witha esi arnings before Q.21. A machine costing & 12,00,000 is required in order neThe estimate & effective life of the machine is expected to be 5 yea! company follows straight-line method of charging depreciat tax of the project are as follows Y year Ast 2nd ard ‘agh__) 5th Earnings 000 before tax 4,00,000 3,20. re tax (%) 4,80,000 5,60,000 « 6,40;000%4,00,00% tvalue and suggest ifthe tax rate is 40%, cost of capltal is15%, calculate the net presen! whether the machine would be acquired’er nat Given the present value factors at a discount rate of 15% rate are: year 1 2 3 4 5 P.V. Factors 0,866. 0.7561 0.6575 0.5718 0.4972 (2014) 0.12, Two machines are not fdentical in many respects Following are the isnformation regarding the two, The estimated life of both machines i five years leaving no salvage value at the end. Cost (®) ‘Anticipated Cash flow after tax per year (2) Yea Yr2 We 3 va Yrs Machine M 6,25,000 - 1,25,000 §,00,000 3,50,000 1,50,000 Machine N » 10,00,000 2,50,000 3,50,000 4,00,000 4,25,000 2,00,000 The company's cost of capital is 16%. You are required to make an appraisal of the two machines arid advice the company using (i) NPV and (i) Internal rate of return. {2015} (Given : Present value of @ 1) End of Year 16% 18% 20% 1 0.862 0.847 0.833 2 0.743 0.718 0.694 3 0.641 0.609 0.579 4 0.552 0.516 0.482 5 0.476 0.437 0.402 Q.13. 6. Ltd. wants to replace an obsolete machine to increase its productivity. There are two machines under its consideration. The cost of machine - | is 1,40,000 and that of machine - I! 987454 1081/9831115654 Page 621s € 2,20,000, The company’s cost of capitals 16% and it expects the following 25? inflows * from each of the machines. Year Machine -1 Machine =i! Discounting Factors at 16% , ‘ 60,000 0.862 F 0,000 72,000 0.743 2 25 O00) 85,000 0.641 8 ee 80,000 0.552 ‘ 2 50,000 60,000 0.476 say should purchase? On the basis of discounted pay-back period, which machine the comPat pay bee ae {2013 (6)] 5%. The following proposals are of capital 1 ind (b) PI method. Q.14. A company has & 40 lakh to invest at the cost he basis of (a) NPV a under its consideration. Rank the project on t Project Initial outlay Annual Cash Flow Life span (years) A 2,00,000 50,000 a 8 340,000 40,000, Bs i c 60,000 16,000 A D 120,000 30,000, 2 E 100,000 24,000 8 96 are as under: Given that the present value of annuity of € 1 at 15 Present Value Years 8 4.6586 10 5.1790 12 6.1230 (2014 (6)] ial investment of © Iue of % 5,00,000 and will . jon is % 10,00,000 .ct which requires an initi ars with a salvage val fit before charging depreciati Q.15. Madhumita Ltd. desiresito invest.in a proje’ 50,00,000. The useful life of the project is 10 yet be depreciated’on Straight line method. The pro p.a. The income tax rate is 35%. Compute: {2015 (G)] (i) NPV ata0% p.avand (il) Pl. 9874541081/9831115654 Page 63