Capital BudgetingSolved Problems

1. A company is considering three methods of attracting customers to expand its business: (A) advertisement campaign, (B) Display of neon signs, and (C) Direct delivery service. The initial outlays for each alternatives are

A 100,000B 150,000C 150,000

If A is carried out, but not B, it has an NPV of $ 125,000. If B is done but not A, then B has an NPV of $45,000. However if both are done, their NPVs are 200,000. The NPV of delivery system C is $ 90,000. Its NPV is not dependent on whether A or B is adopted and NPV of A or B does not depend on whether C is adopted. Which of the investments should be made by the company (i) If the firm has no budget constraint, (ii) If the budget amount is only $ 250,000?

Solution:

Mode of attracting customers Initial Outlay ($) Expected NPV($)

Advertisement Campaign (A) 100,000 125,000Display of Neon signs(B) 150,000 45,000{ (A) + (B)} 250,000 200,000Direct delivery service (C) 150,000 90,000

(i) In case of no budget constraint, the firm should adopt (A + B) and C modes of attracting customers.

(ii)In case of budget constraint of 250,000 (A) and (C) as the NPV from this combination is the maximum.

2. A company is investigating the feasibility of manufacturing one of the components needed for its finished product rather than purchasing it from an outside supplier. Its present supplier has just announced that he intends to increase the price from $ 100 to $ 125 per unit, provided the company purchases 6000 units per year.

The equipment needed to make this product can be purchased for $ 1,200,000 and is expected to have salvage value of $ 300,000 and increase by 100,000 per year. The variable cost of manufacturing each component will be $ 30 per unit. Straight line depreciation will be used. The company is subject to a 50% tax rate and 15% is the appropriate cost of capital for this project. The company projects annual needs at 7500 units per year for the 6 years period.

Advice the company whether it should continue buying from outside suppliers or start manufacturing on its own. Will your answer be different if the requirement of the company is only 6000 units per year?

Solution:

Cash out flows:Cost of equipment($) 1,200,000

Cash Inflows (CFAT):7500 units( $) 6000 units($)

Buying cost @ 125 per unit 937,500 750,000

Less manufacturing costs:Variable cost @ 30 per unit 225,000 180,000Fixed cost 100,000 100,000Depreciation (900,000/6 yrs) 150,000 150,000

Cost savings( profit) before taxes 462,500 320,000Less taxes (50%) 231,250 160,000

Earnings after tax 231,250 160,000Add depreciation 150,000 150,000CFAT 381,250 310,000

Net Present Value calculation

Particulars year Amt($) PV factor@ Total PV 15% ($)

a. At 7500 units:Cash out flows t = 0 (1,200,000) 1.000 (1,200,000)Operating CFAT t = 1 to 6 381,250 3.784 1,442,650 Salvage value t = 6 300,000 0.432 129,600

_______ 372,250

b. At 6000 units:Cash out flows t = 0 (1,200,000) 1.000 (1,200,000)Operating CFAT t = 1 to 6 310,000 3.784 1,173,040 Salvage value t = 6 300,000 0.432 129,600

_______ 102,640

Recommendation: The company is advised to start manufacturing on its own irrespective of the fact whether the required units are 7500 or 6000, as NPV is positive in both the situations.

3. A plastic manufacturing company now makes products by a labor intensive process. the firm is experiencing difficulty in expanding production to meet the increased demand and is considering purchasing a machine that will enable production to increase by 20%( from 50,000 units to 60,000 units). The machine costs 100,000 birr and has a useful life of 10 years with no salvage. Investment allowance is 25%.

There will be increased working capital requirement of 25,000 birr. The variable cost per unit is 4.00 birr; fixed costs are 100,000 birr per annum; variable costs per unit will remain the same and fixed costs will increase by the amount of depreciation on the new machine. The current selling price is 10.00 birr per unit. The firm expects to sell all its production at 9.50 birr per unit if the machine is bought.

The company will be using straight line method of depreciation. The corporate tax rate is 55 % and the minimum required rate of return is 15%. Advise the company whether the machine should be bought or not.

Solution:Cash outflows:Particulars Amount (Birr)Cost of new machine 100,000Plus Increase in working capital 25,000Less tax savings on account of

Investment allowance 55% ( 25,000 birr) 13,750Total 111,250

Cash inflows:Existing Proposed( Birr) (Birr)

Revenues: (50,000 X 10) 500,000 : ( 60,000 X 9.5) 570,000

Less variable costs: ( 50,000 X 4) 200,000 : ( 60,000 X 4) 240,000

Contribution 300,000 330,000Excess contribution 30,000Less depreciation ( 100,000/10 yrs) 10,000Increase in taxable income 20,000Less tax (55%) 11,000After tax amount 9,000Add depreciation 10,000CFAT for t = 1 to 9 19,000CFAT in t = 10 (wc recovered) 25,000 44,000

Present value of cash inflows:

Year CFAT (birr) PV factor @ 15% Total PV

1 – 9 19,000 4.772 90,66810 44,000 0.247 10,868

Total present value 101,536Less PV of cash outflows 111,250NPV ( 9714)

Recommendation: The machine should not be purchased as it yields negative NPV

4. Zenith industries ltd., is considering replacing a hand – operated machine with a new, fully automated one. Given the following information, advise the management whether the machine should be replaced or not.

Existing situation:One full-time operator’s salary 36,000Variable overtime 3000Fringe benefits 3000Cost of defects 18,000Original price of hand operated machine 60,000

Expected life 3 yearsExpected salvage value NilAge 15 yearsDepreciation method Straight lineCurrent salvage value 36,000Marginal tax rate 50%Required rate of return 15 %

Proposed situation:Fully automated operation No operator requiredCost of machine 180,000Shipping fee 3000Installation costs 15,000Expected economic life 15 yearsDepreciation method Straight line methodSalvage value after 15 years NilAnnual maintenance 3000Cost of defects 3000

Solution:i. Cash outflows if machine is purchased

Cost of machine 180,000Add shipping fee 3000Add installation costs 15,000Less cash inflow from sale of old machine 36000

Less cash payment @ 50% on gains( 36000- 30000 current book value) 3000 33,000

______165,000

ii. Cost savings if machine is purchased:Existing Proposed DifferentialSituation situation cost savings

Salary 36,000 Nil 36,000Variable overtime 3,000 Nil 3,000Fringe benefits 3,000 Nil 3,000Cost of defects 18,000 3,000 15,000Annual maintenance Nil 3,000 (3,000)Depreciation 2,000 13,000 (11,000)

______ _____ _____62,000 19,000 43,000

iii. Determination of CFAT:Cost savings, i.e., increase in profits 43,000Less taxes (50%) 21,500Earnings after tax 21,500Add depreciation 11,000CFAT 32,500

iv. Determination of NPV:

Years CFAT PV factor @15% Total PV1 to 15 years 32,500 5.847 190,027.50Less PV of cash outflows 165000

________25,027.5

Recommendation: The machine should be replaced as the NPV is positive

5.

Solution:

The following table gives initial investments and annual cash flows from projects

Initial Investment and annual cash flows

Incremental depreciation schedule

Calculation of depreciation

The computation of the incremental cash flows of replacement decision is briefly described below

Practice Problems

1. A textile company is considering two mutually exclusive investment proposals for its expansion programme. Proposal A requires an initial investment of $ 750,000 and yearly cash operating costs of $50,000. Proposal B requires an initial investment of $500,000 and yearly cash operating costs of $ 10,000. The life of the equipment used in both the investment proposals will be 12 years, with no salvage value; depreciation is on the straight line basis. The firms’ tax rate is 55 % and its cost of capital is 15%. Which investment proposal be undertaken by the company.

2. To meet the growing demand for electricity, Addis suburban electricity supply co. ltd has decided to expand its generating capacity. The required capacity can be provided by constructing two thermal plants (alternative 1), or one hydro plant (alternative 2). The following information has been compiled for analysis.

Amount (in million Birr)Alt 1 Alt 2

Initial investment 680 980Yearly operating costs ( excluding depreciation)

Operations 160 80Maintenance 40 20Transmission 60 50Cost to dismantle plant at the end of useful life of 20 years 10 30

Which alternative should the firm select? Its cost of funds is estimated at 10%. Ignore taxes and assume a straight line method of depreciation.

3. ABC ltd manufactures toys and other short lived fad items. The research and development department has come up with an item that would make a good promotional gift for office equipment dealers. As a result of efforts by the sales personnel, the firm has commitments for this product.

To produce the quantity demanded, ABS ltd will need to buy additional machinery and rent additional space. It appears that about 25,000 square feet will be needed; 12,500 sq.ft of presently unused space but leased at a rate of $ 3 per sq.ft is available. There is another 12,500 sq.ft adjoining the ABC facility available at the annual rent of $ 4 per sq.ft.

The equipment will be purchased for 900,000. it will require $ 30,000 in modifications, $ 60,000 for installation and $ 90,000 for testing. The equipment will have a salvage value of about $180,000 at the end of the third year. No additional general overhead costs are expected to be incurred.

The estimates of revenues and costs for this product for the three years have been developed as follows:

Particulars Year1 Year 2 Year3

Sales 1,000,000 2,000,000 800,000Less Costs:Material, labor and overhead incurred 400,000 750,000 350,000Over heads allocated 40,000 75,000 35,000Rent 50,000 50,000 50,000Depreciation 300,000 300,000 300,000Total costs 790,000 1,175,000 735,000Earnings before tax 210,000 825,000 65,000Less taxes 105,000 412500 32500Earnings after taxes 105,000 412500 32500

If the company sets a required rate of return of 20% after taxes, should this project be accepted?

4. Royal industries requires some machinery for a manufacturing process that will be carried out for the next eight yeas. The two machineries that meet the firm’s needs are available. The relevant data regarding these two machines are as follows:

Machine X Machine Y

Purchase cost 43,600 78,400

Annual cash operating expenses 25,000 20,000

Salvage value at the end of useful life 8000 8000

Useful life ( in years) 4 4

The company makes use of straight line method of depreciation. In determining the amount of depreciation, provision would be made for salvage value. It is estimated that the firm would need 48,000 to replace machine A at the end of 4 years, if that machine is selected. The other data applicable to machine X given above will apply to the replacement model as well.

Cost of capital is 15% and tax rate is 50%. You are required to determine the course of action that the firm should take.

5. A job which is presently done entirely by manual methods has a labor cost of 46,000 a year. it is proposed to install a machine to do the job which involves an investment of 80,000 and an annual operating cost of 10,000. Assume that the machine can be written off in 5 years on straight line depreciation basis for tax purposes. Salvage value at the end of its economic life is zero. The tax rate is 55 %. Analyze the economic implications of the proposal by internal rate of return method.