Capital Budgeting - LA Page 1

Capital Budgeting techniques and Analysis of Cash flows

1. Calculate the projects ARR.

Year Book value of fixed investment Profit after tax

1 90,000 20,000

2 80,000 22,000

3 70,000 24,000

4 60,000 26,000

5 50,000 28,000

2. A project costs Rs 36,000 and is expected to generate cash inflows of Rs 11,200 annually for 5 years. Calculate

the IRR of the project.

3. A company has Rs 7 crores available for investment. It has evaluated its options and found that only 4

investment projects given below have positive NPV. All these investments are divisible. Advise the management

which investment(s) / projects it should select.

Project Initial investment

(Rs crore)

NPV (Rs crore) PI

X 3.00 0.60 1.20

Y 2.00 0.50 1.25

Z 2.50 1.50 1.60

W 6.00 1.80 1.30

4. Modern Enterprises Ltd. is considering the purchase of a new computer system for its research and development

division, which would cost Rs 35 lakh. The operation and maintenance costs (excluding depreciation) are

expected to be Rs 7 lakh per annum. It is estimated that the useful life of the system would be 6 years, at the end

of which the disposal value is expected to be Rs 1 lakh.

The tangible benefits expected in the form of reduction in design and draftsmanship costs would be Rs 12 lakh

per annum. The disposal of used drawing office equipment and furniture initially is anticipated to net Rs 9 lakh.

As capital expenditure in research and development, the proposal would attract a 100% write-off for tax

purposes. The gains arising from disposal of used assets may be considered tax free. The effective tax rate is

35%. The average cost of capital of the company is 12%.

After appropriate analysis of cash flows, advise the company of the financial viability of the proposal. Ignore tax

on salvage value.

5. A company is considering an investment proposal to install new milling controls at a cost of Rs 50,000. The

facility has a life expectancy of 5 years and has no salvage value. The tax rate is 35%. Assume the firm uses SLM

depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax

(CFBT) from the investment proposal are as follows:

Year CFBT (Rs) 1 10,000 2 10,692 3 12,769 4 13,462 5 20,385

Capital Budgeting - LA Page 2

Compute the following: (i) PayBack period (ii) average rate of return (iii) Internal rate of return (iv) NPV at 10%

discount rate (v) Profitability index at 10% discount rate.

6. A firm is considering to install a large stamping machine. Two machines currently being marketed will do the job

satisfactorily. Machine A costs Rs 50,000 and will require cash running expenses of Rs 15,000 each year. It has a

useful life of 6 years and is expected to yield Rs 2000 salvage value at the end of its useful life. Machine B costs Rs

65,000 but cash running expenses are expected to be Rs 12,000. This machine is expected to have a useful life of

10 years with salvage value of Rs 5,000. Assume both the machines will be depreciated on SLM for tax purposes.

If the corporate tax rate is 35% and cost of capital is 10%, which machine should be bought by the company?

7. Mr Rao, Finance Director of Modern synthetics Ltd, called Mr Diwan, Manager Management Services Division of

the company to explore ways and means of improving the MIS in the company. On the basis of their discussion it

became obvious that the company needed a computer system for processing efficiently and accurately the

growing volume of information generated in the business. It was felt that the computer system would also

facilitate the timely preparation of control reports needed by the management. Mr Rao asked Mr Diwan to find

out which computer system would be suitable for the needs of the company and estimate the costs and benefits

expected from it. On the basis of discussions with vendors, Mr Diwan felt that the Alpha III system supplied by

Computronics Ltd was quite suitable for the needs of Modern Syntex Ltd. he estimated the costs and benefits of

the system as follows:

Cost of the computer along with accessories Rs 15 lakh

Operation and maintenance cost Rs 2.5 lakh per annum

Savings in clerical cost Rs 6 lakh per annum

Savings in space cost Rs 1 lakh per annum

The computer would have an economic life of five years and it would be depreciated at the rate of 33 1/3% per

year as per the written down value method. After five years, it would be disposed off for a value equal to its book

value. The tax rate is 50%.

On examining the above information, Mr Rao asked Mr Diwan to prepare a capital budgeting proposal for

submission to the Executive Committee of the Company. He advised him to calculate the internal rate of return.

8. Determine the average rate of return from the following dta of two machines A and B.

Particulars Machine A Machine B Cost Rs 56,125 Rs 56,125 Annual estimated income after depreciation and income tax:

Year 1 3,375 11,375 Year 2 5,375 9,375 Year 3 7,375 7,375 Year 4 9,375 5,375 Year 5 11,375 3,375 36,875 36,875 Estimated Life (Years) 5 5 Estimated salvage value 3,000 3,000

aaTypewritten Text

aaTypewritten Text

aaTypewritten Text

aaTypewritten Text

aaTypewritten Text

aaTypewritten Text

aaTypewritten Text

aaTypewritten TextDep charged at SLM method

aaTypewritten Text