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CAPITAL BUDGETING Project report on Petrol pum dealership

1
Rahul Bansal (Finalist) (35929 Points)
11 December 2009
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Rahul Bansal (Finalist) (35929 Points)

Replied 11 December 2009

Question 1

Nine Gems Ltd. has just installed Machine-R at a cost of Rs. 2,00,000. The machine has a five year life with
no residual value. The annual volume of production is estimated at 1,50,000 units, which can be sold at Rs.
6 per unit. Annual operating costs are estimated at Rs. 2,00,000 (excluding depreciation) at this output
level. Fixed costs are estimated at Rs. 3 per unit for the same level of production.

Nine Gems Ltd. has just come across another model called Machine-S capable of giving the same output at
an annual operating cost of Rs. 1,80,000 (exclusive of depreciation).There will be no change in fixed costs.
Capital cost of this machine is Rs. 2,50,000 and the estimated life is for five years with nil residual value.

The company has an offer for sale of Machine-R at Rs. 1,00,000. But the cost of dismantling and removal
will amount to Rs. 30,000. As the company has not yet commenced operations, it wants to sell Machine –R
and purchase Machine-S.

Nine Gems Ltd. will be a zero-tax company for seven years in view of several incentives and allowances
available.

The cost of capital may be assumed at 14%. P.V. factors for five years are as follows:

Year P.V. Factors

TRENDING ONLINE CLASSES
1 0.877

2 0.769 7 Days Master Course on Tax

3 0.675 Audit u/s 44AB of Income Tax Act
4 0.592 1961
5 0.519 Manoj Lamba Enroll Now

(i) Advise whether the company should opt for the replacement.  09 September 2023
(ii) Will there be any change in your view if Machine-R has not been installed but the company is in the
Live Course On Gst & Accounting
process of selecting one or the other machine?
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Support your view with necessary workings.
 04 October 2023
(Final-Nov. 1996) (12 marks)

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Consultation and Fundraising
Answer
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(i) Replacement of Machine –R
 25 August 2023
Incremental cash out flow

VIEW ALL CLASSESS 

(i) Cash out flow on Machine –S Rs. 2,50,000

Less: Sale Value of Machine –R

Less : Cost of dismantling and removal

(Rs. 1,00,000-Rs. 30,000) Rs. 70,000

Net outflow Rs. 1,80,000

Incremental cash flow from Machine-S

Annual cash flow from Machine –S Rs. 2,70,000

Annual cash flow from Machine –R Rs. 2,50,000 BROWSE BY CATEGORY

Net incremental Cash in flow Rs. 20,000
Income Tax Audit Students
Present value of incremental cash in flows
Accounts Custom VAT Career
= Rs. 20,000 ´ (0.877 +0.769+0.675+0.592+0.519)
Service Tax Corporate Law
= 20,000 ´ 3.432 = Rs. 68,640
Info Technology Excise Shares & Stock
NPV of Machine -S = Rs. 68,640 – Rs. 1,80,000
Exams LAW Professional Resource
= (-) Rs. 1,11,360
Others Taxpayers GST
Rs. 2,00,000 spent on Machine –R is a sunk cost and hence it is not relevant for deciding the
 p g
replacement.

Decision: Since Net present value of Machine –S is in the negative, replacement is not advised.

If the company is in the process of selecting one of the two machines, the decision is to be made on the
basis of independent evaluation of two machines by comparing their Net-present values.

(ii) Independent evaluation of Machine –R and Machine –S:

Machine –R Machine –S

Units produced 1,50,000 1,50,000

Selling price per unit (Rs.) 6 6

Sale value 9,00,000 9,00,000

Less: Operating Cost

(exclusive of depreciation) 2,00,000 1,80,000

Contribution 7,00,000 7,20,000

Less: Fixed Cost 4,50,000 4,50,000

Annual cash flow 2,50,000 2,70,000

Present value of cash flows for five years 8,58,000 9,26,640

Cash Outflow 2,00,000 2,50,000

Net Present Value 6,58,000 6,76,640

As the NPV of cash in flow of Machine –S is higher than that of Machine –R, the choice should fall on
machine –S.

Note: As the company is a zero tax company for seven years (Machine life in both cases is only for
five years), depreciation and the tax effect on the same are not relevant for consideration.


 Rahul Bansal (Finalist) (35929 Points)
Replied 11 December 2009

Question 2

(a) Following are the data on a capital project being evaluated by the management of X Ltd.:

Project M

Annual cost saving Rs. 40,000

Useful life 4 years
I.R.R 15%
Profitability index (PI) 1,064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?

Salvage value 0

Fi d th i i l id i th f ll i t bl f di tf t l
 Find the missing values considering the following table of discount factor only:

Discount factor 15% 14% 13% 12%

1 Year 0.869 0.877 0.885 0.893

2 Years 0.756 0.769 0.783 0.797

3 Years 0.658 0.675 0.693 0.712
4 Years 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038

(b) S Ltd. has Rs. 10,00,000 allocated for capital budgeting purposes. The following proposals and
associated profitability indexes have been determined.

Project Amount Profitability Index

1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05

Which of the above investments should be undertaken? Assume that projects are indivisible and there is no
alternative use of the money allocated for capital budgeting.

(Final-Nov. 1998) (12 + 8 marks)

Answer

(a) Cost of Project M

At 15% I.R.R., the sum total of cash inflows = Cost of the project i.e. Initial cash outlay 11
Given:

Annual cost saving Rs. 40,000

Useful life 4 years

 IRR 15%

Now, considering the discount factor table @ 15% cumulative present value of cash inflows for 4 years
is 2.855

Therefore,

Total of cash inflows for 4 years for Project M is (Rs. 40,000 ´ 2.855) = Rs. 1,14,200

Hence, cost of the project is = Rs. 1,14,200

Payback period of the Project M

Cost of the project

Annual cost saving

Payback period = =

Rs. 1,14,200
40,000

= 2.855 or 2 years 11 months approximately

Cost of Capital

If the profitability index (PI) is 1, cash inflows and outflows would be equal. In this case, (PI) is 1.064.
Therefore, cash inflows would be more by 0.64 than outflow.

Discounted cash inflows

Cost of the Project
 Cost of the Project

Probability index (PI) =

Discounted cash inflows

Rs. 1,14,200

or 0.064 =

or 1.064 ´ Rs. 1,14,200 = Rs. 1,21,509

Hence discounted cash inflows =Rs. 1,21,509

Since, Annual cost saving is Rs. 40,000. Hence, cumulative discount factor for 4 years

1,21,509
40,000

= 3.037725 or 3.038
Considering the discount factor table at discount rate of 12%, the cumulative discount factor for 4
years is 3.038

Hence, the cost of capital is 12%

Net present value of the project

 N.P.V. = Total present values of cash inflows – Cost of the project

= Rs. 1,21,509 – Rs. 1,14,200

= Rs. 7,309

(b) Statement showing ranking of projects on the basis of Profitability Index

Project Amount P.I. Rank

(Rs.)

1 3,00,000 1.22 1

2 1,50,000 0.95 5

3 3,50,000 1.20 2

4 4,50,000 1.18 3

5 2,00,000 1.20 2

6 4,00,000 1.05 4

Assuming that projects are indivisible and there is no alternative use of the money allocated for capital
budgeting on the basis of P.I. , the S Ltd. is advised to undertake investment in projects 1,3 and 5.

However, among the alternative projects the allocation should be made to the projects which adds the most
to the shareholders wealth. The NPV method, by its definition, will always select such projects.

Statement showing NPV of the projects

Project Amount P.I. Cash inflows of project (Rs.) N.P.V. of project

(Rs.) (iv)=[(ii) ´ (iii)] (Rs.)

(i) (ii) (iii) (v)=[(iv)-(ii)]

1 3,00,000 1.22 3,66,000 66,000

2 1,50,000 0.95 1,42,500 (-) 7,500

3 3,50,000 1.20 4,20,000 70,000

4 4,50,000 1.18 5,31,000 81,000

 5 2,00,000 1.20 2,40,000 40,000

6 4,00,000 1.05 4,20,000 20,000

The allocation of funds to the projects 1,3 and 5 (as selected above on the basis of PI) will give NPV of Rs.
1,76,000 and Rs. 1,50,000 will remain unspent.

However, the NPV of the projects 3,4 and 5 is Rs. 1,91,000 which is more than the N.P.V. of projects 1,3
and 5. Further, by undertaking projects 3,4 and 5 no money will remain unspent. Therefore, S Ltd. is
advised to undertake investments in projects 3,4 and 5.

Rahul Bansal (Finalist) (35929 Points)

Replied 11 December 2009

Question 3

A large profit making company is considering the installation of a machine to process the waste produced
by one of its existing manufacturing process to be converted into a marketable product. At present, the
waste is removed by a contractor for disposal on payment by the company of Rs. 50 lacs per annum for the
next four years. The contract can be terminated upon installation of the aforesaid machine on payment of a
compensation of Rs. 30 lacs before the processing operation starts. This compensation is not allowed as
deduction for tax purposes.

The machine required for carrying out the processing will cost Rs. 200 lacs to be financed by a loan
repayable in 4 equal installments commencing from the end of year 1. The interest rate is 16% per annum.
At the end of the 4th year, the machine can be sold for Rs. 20 lacs and the cost of dismantling and removal
will be Rs. 15 lacs.
Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:

(Rs. In lacs)

Year 1 2 3 4

Sales 322 322 418 418

Material consumption 30 40 85 85

Wages 75 75 85 100

Other expenses 40 45 54 70

Factory overheads 55 60 110 145

Depreciation (as per income tax rules) 50 38 28 21

Initial stock of materials required before commencement of the processing operations is Rs. 20 lacs at the
start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be Rs. 55
lacs and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would
otherwise have been rented out for Rs. 10 lacs per annum. Labour costs include wages of 40 workers,
whose transfer to this process will reduce idle time payments of Rs. 15 lacs in the year 1 and Rs. 10 lacs in
the year 2. Factory overheads include apportionment of general factory overheads except to the extent of
insurance charges of Rs. 30 lacs per annum payable on this venture. The company’s tax rate is 50%.

Present value factors for four years are as under:

Year 1 2 3 4

Present value factors 0.870 0.756 0.658 0.572

Advise the management on the desirability of installing the machine for processing the waste. All
calculations should form part of the answer.

(Final-May 1999) (20 marks)

Answer

Statement of Incremental Profit

(Rs. in lacs)

Years 1 2 3 4

Sales :(A) 322 322 418 418

Material consumption 30 40 85 85

Wages 60 65 85 100

Other expenses 40 45 54 70

Factory overheads (insurance) 30 30 30 30

Loss of rent 10 10 10 10

Interest 32 24 16 8

Depreciation (as per income tax rules) 50 38 28 21

Total cost: (B) 252 252 308 324

Incremental profit (C)=(A)-(B) 70 70 110 94

Tax (50% of (C)) 35 35 55 47

 Statement of Incremental Cash Flows

(Rs. in lacs)

Years 0 1 2 3 4

Material stocks (20) (35) - - -

Compensation for contract (30) - - - -

Contract payment saved - 50 50 50 50

Tax on contract payment - (25) (25) (25) (25)

Incremental profit - 70 70 110 94

Depreciation added back - 50 38 28 21

Tax on profits - (35) (35) (55) (47)

Loan repayment - (50) (50) (50) (50)

Profit on sale of machinery (net) - - - - 5

Total incremental cash flows (50) 25 48 58 48

Present value factor 1.00 0.870 0.756 0.658 0.572

Net present value of cash flows (50) 21.75 36.288 38.164 27.456

Net present value = Rs. 123.658 – Rs. 50 = 73.658 lacs.

Advice: Since the net present value of cash flows is Rs. 73.658 lacs which is positive the management
should install the machine for processing the waste.

Notes:

1. Material stock increases are taken in cash flows.

2. Idle time wages have also been considered

3. Apportioned factory overheads are not relevant only insurance charges of this project are relevant.

4. Interest calculated at 16% based on 4 equal instalments of loan repayment.

 5. Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains
ignored.

6. Saving in contract payment and income tax there on considered in the cash flows.

Rahul Bansal (Finalist) (35929 Points)

Replied 11 December 2009

Question 3

A large profit making company is considering the installation of a machine to process the waste produced
by one of its existing manufacturing process to be converted into a marketable product. At present, the
waste is removed by a contractor for disposal on payment by the company of Rs. 50 lacs per annum for the
next four years. The contract can be terminated upon installation of the aforesaid machine on payment of a
compensation of Rs. 30 lacs before the processing operation starts. This compensation is not allowed as
deduction for tax purposes.

The machine required for carrying out the processing will cost Rs. 200 lacs to be financed by a loan
repayable in 4 equal installments commencing from the end of year 1. The interest rate is 16% per annum.
At the end of the 4th year, the machine can be sold for Rs. 20 lacs and the cost of dismantling and removal
will be Rs. 15 lacs.

Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:

(Rs. In lacs)

Year 1 2 3 4

Sales 322 322 418 418

Material consumption 30 40 85 85

Wages 75 75 85 100

Other expenses 40 45 54 70

Factory overheads 55 60 110 145

Depreciation (as per income tax rules) 50 38 28 21

Initial stock of materials required before commencement of the processing operations is Rs. 20 lacs at the
start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be Rs. 55
lacs and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would
otherwise have been rented out for Rs. 10 lacs per annum. Labour costs include wages of 40 workers,
whose transfer to this process will reduce idle time payments of Rs. 15 lacs in the year 1 and Rs. 10 lacs in
the year 2. Factory overheads include apportionment of general factory overheads except to the extent of
insurance charges of Rs. 30 lacs per annum payable on this venture. The company’s tax rate is 50%.

Present value factors for four years are as under:

Year 1 2 3 4

l f
 Present value factors 0.870 0.756 0.658 0.572

Advise the management on the desirability of installing the machine for processing the waste. All
calculations should form part of the answer.
(Final-May 1999) (20 marks)

Answer

Statement of Incremental Profit

(Rs. in lacs)

Years 1 2 3 4

Sales :(A) 322 322 418 418

Material consumption 30 40 85 85

Wages 60 65 85 100

Other expenses 40 45 54 70

Factory overheads (insurance) 30 30 30 30

Loss of rent 10 10 10 10

Interest 32 24 16 8

Depreciation (as per income tax rules) 50 38 28 21

Total cost: (B) 252 252 308 324

Incremental profit (C)=(A)-(B) 70 70 110 94

Tax (50% of (C)) 35 35 55 47

Statement of Incremental Cash Flows

(Rs. in lacs)

Years 0 1 2 3 4

Material stocks (20) (35) - - -

Compensation for contract (30) - - - -

 Compensation for contract (30) - - - -

Contract payment saved - 50 50 50 50

Tax on contract payment - (25) (25) (25) (25)

Incremental profit - 70 70 110 94

Depreciation added back - 50 38 28 21

Tax on profits - (35) (35) (55) (47)

Loan repayment - (50) (50) (50) (50)

Profit on sale of machinery (net) - - - - 5

Total incremental cash flows (50) 25 48 58 48

Present value factor 1.00 0.870 0.756 0.658 0.572

Net present value of cash flows (50) 21.75 36.288 38.164 27.456

Net present value = Rs. 123.658 – Rs. 50 = 73.658 lacs.

Advice: Since the net present value of cash flows is Rs. 73.658 lacs which is positive the management
should install the machine for processing the waste.

Notes:

1. Material stock increases are taken in cash flows.

2. Idle time wages have also been considered

3. Apportioned factory overheads are not relevant only insurance charges of this project are relevant.

4. Interest calculated at 16% based on 4 equal instalments of loan repayment.

5. Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains
ignored.

6. Saving in contract payment and income tax there on considered in the cash flows.


 Prabeer (B. COM (H) CA & CS Final) (5484 Points)

Replied 11 December 2009

RAHUL you must've uploaded a .pdf file as u did for hire pur. THanks.

 1 Like 

Rahul Bansal (Finalist) (35929 Points)

Replied 20 December 2009

of course

Rahul Bansal (Finalist) (35929 Points)

Replied 20 December 2009
CAPITAL BUDGETING

Attached File : 47 capital budgeting.pdf

downloaded: 255 times

 1 Like 

Rahul Bansal (Finalist) (35929 Points)

Replied 20 December 2009

DISCLAIMER:

PLEASE NOTE that users of these files are responsible for checking the accuracy, completeness and/or suitability of all

information. I makes no representations, guarantees, or warranties as to the accuracy, completeness, or suitability of the

information provided via this forum. The entire risk as to the use of information on this forum is assumed by you. I shall

have no liability to a user, or any other person or entity for any indirect, incidental, special, or consequential damages

whatsoever, even if I has been advised of the possibility of such damages, or they are foreseeable.

Umesh S. Goyal (CA Final Articled Assistant) (294 Points)

Replied 28 April 2011

Have u copied and pasted it from SD BALA Book

Anyway good job done

thanks

Sathyan Avinash (Company Secretary) (136 Points)

Replied 01 October 2012

Thanks mate for the wonderful share.

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