Exercises (Capital Budgeting)

1. Alpha company is considering a new product line to supplement its range line. It is
anticipated that the new product line will involve cash investment of Rs. 700,000 at
time 0 and 1 million in year 1. After-tax cash inflows of Rs.250,000 are expected in
year 2, Rs.300,000 in year 3, Rs. 350,000 in year 4 and Rs. 400,000 each year thereafter
through year 10. Though the product line might be viable after year 10, the company
prefers to be conservative and end all calculations at that time.
(a) If the required rate of return is 15%, what is the NPV of the project? Is it
acceptable? What is the IRR?
(b) What would be the case if the required rate of return was 10%?
(c) What is the project’s payback period?

2. ABC Ltd. is evaluating three investment situations: (1) produce a new line of
aluminium blivets, (2) expand its existing blivet line to include several new sizes,
and (3) develop a new, higher quality line of blivet. If only the project in question
is undertaken, the expected present values and the amounts of investment required
are as follows:
Project Investment required Present value of
future cash flows
(Rs) (Rs)
1 200,000 290,000
2 115,000 185,000
3 270,000 400,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the

investment required and present values will simply be the sum of the parts. With
projects 1 and 3, economies are possible in investment because one of the
machines acquired can be used in both production processes. The total investment
required for projects 1 and 3 combined is Rs. 440,000. If projects 2 and 3 are
undertaken, there are economies to be achieved in marketing and producing the
products but not in investment. The expected present value of future cash flows for
projects 2 and 3 combined is Rs. 620,000. If all three projects are undertaken
simultaneously, the economies noted above will still hold. However, a Rs. 125,000
extension on the plant will be necessary, as space is not available for all three
projects. Which project or projects should be chosen?

3. XYZ Company is planning to buy new machinery for Rs. 200, 000. The machinery has
a depreciation life of 5 years. As a result of buying the new machinery, XYZ Company
will sell the existing machinery at Rs. 50,000. The existing machinery was purchased 3
years ago for Rs.100, 000. The company must pay Rs. 4000 for delivery and Rs. 9000
for installation of the new machinery. Assume tax rates of 34%. Net working capital
does not change. Depreciation at cost 20% in year 1, 32% in year 2, and 19% in year 3.
As a financial analyst, (a) Determine the initial cost of the project. (b)What would be
the initial cost of the project if the existing machinery was sold at Rs. 20,000?

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4. The estimated net earnings for the XYZ Company in the next 3 years are Rs. 100,000
Rs. 150,000 and Rs. 200,000. The annual depreciation amounts for those years are
estimated as Rs. 30,000 Rs. 40,000 and Rs. 45,000 As a result of starting a new project,
the estimated net earnings will be Rs. 120,000 Rs. 165,000 and Rs. 230,000 and the
annual depreciation will increase to Rs. 45,000, Rs. 62,000 and Rs. 66,000. To make it
simple, assume that the tax rate is 40%. Calculate the incremental cash flow of the new
project.

5. The existing earnings before interest and taxes (EBIT) under two conditions are given.

Year Existing Machine New Machine

1 Rs. 100,000 Rs. 150,000
2 140, 000 250,000
3 280,000 350,000
4 400,000 450,000
5 510,000 550,000

The existing machine was purchased 3 years ago at Rs. 400,000. A new machine is
under consideration for replacement at a cost of Rs. 600,000. Depreciation life is 5
years in both cases, and the tax rate is 34%. Use the depreciation rates of 20% for year
1, 32% for year 2, 19% for year 3, 15% for year 4, and 14% for year 5. Determine the
incremental cash flow for replacing the existing machine.

6. A company is considering two mutually exclusive projects. Both require an initial cash
outlay of Rs. 10,000 each and have a life of five years. The company’s required rate of
return is 10% and pays tax at a 50% rate. The projects will be depreciated on a straight
line basis. The before taxes cash flows expected to be generated by the projects are as
follows:
Year Project A Project B
1 Rs. 4000 Rs. 6000
2 4000 3000
3 4000 2000
4 4000 5000
5 4000 5000
Calculate for each project: (a) the payback (b) the NPV (c) IRR (d) PI (e) ARR
Which project should be accepted and Why?
7. A cosmetic company is considering to introduce a new lotion which is useful both
in winters and summers. The manufacturing equipment will cost Rs. 5,60,000.
The expected life of the equipment is 8 years. The company is thinking of selling
the lotion in a single standard pack of 50 grams at Rs. 12 each pack. It is
estimated that variable cost per pack would be Rs. 6 and annual fixed cost , Rs.
450,000. Fixed cost includes (straight line) depreciation of Rs. 70,000 and
allocated overheads of Rs. 30,000. The company expects to sell 100,000 packs of
the lotion each year. Assume that the tax rate is 45% and straight line depreciation
is allowed for tax purposes. If the opportunity cost of capital is 12%, should the
company manufacture the lotion?

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8. Consider the following two mutually exclusive projects:
Year Cash Flow (A) Cash Flow (B)
0 Rs.350,000 Rs.35,000
1 25,000 17,000
2 70,000 11,000
3 70,000 17,000
4 430,000 11,000

Whichever project you choose, if any, you require a 15 percent return on your investment.
a. If you apply the payback criterion, which investment will you choose? Why?
b. If you apply the discounted payback criterion, which investment will you choose? Why?
c. If you apply the NPV criterion, which investment will you choose? Why?
d. If you apply the IRR criterion, which investment will you choose? Why?
e. If you apply the profitability index criterion, which investment will you choose? Why?
f. Based on your answers in (a) through (e), which project will you finally choose? Why?

9. Consider the following income statement:

Sales Rs.876,400
Costs 547,300
Depreciation 128,000
EBIT ?
Taxes (34%) ?
Net income ?

Fill in the missing numbers and then calculate the OCF. What is the depreciation tax
shield?