085 - 106 Chapter 8 Capital Budgeting

Chapter: 8

Capital BudgetingMEANING OF CAPITAL BUDEGETING

Capital budgeting is a process of planning capital expenditure which is to be made to maximize the long-term profitability of the organization.

It refers to planning for capital assets. The capital budgeting decision means a decision as the whether or not money should be invested in

long-term projects such as installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside.

The process of convertible future sums into their present equivalents is known as “discounting”, which is used to determine the present value of future cashflows

INVESTMENT APPRAISAL TECHNIQUES

Traditional Techniquesa) Payback Period Methodb) Accounting Rate of Return Method

Discounted Cashflow Techniquesa) Net Present Value Methodb) Internal Rate of Return Methodc) Profitability Index Methodd) Discounted Payback Period Methode) Terminal Value Method

PAYBACK PERIOD METHODPayback period represents the time period required for complete recovery of the initial investment in the project. It is the period within which the total cash inflows from the project equals the cost of investment in the project. The lower the payback period, the better it is, since initial investment is recouped faster.

Illustration: 1Suppose a project with an initial investment of Rs. 100 crores, yields a profit of Rs. 20 crores, after writing off depreciation of Rs. 5 crores per annum. The Payback period of the project is:

CFAT per annum = PAT + Depreciation = Rs. 20 + Rs. 5 crores = Rs. 25 crores.Payback period = Initial Investment / CFAT per annum = 100 / 25 = 4 years.

Steps used in computation of Simple Payback Period

Step: 1 Determine the Initial Investment (Cash Outflow) of the Project.

Step: 2 Determine the CFAT (Cash Inflow) from the project for various years.

Step: 3 Compute Payback PeriodCase 1 In case of uniform CFAT per annum

Payback Period = Initial Investment / CFAT per annumCase 2 In case of differential CFAT for various years

a) Compute cumulative CFAT at the end of every year.b) Determine the year in which cumulative CFAT exceeds initial investment.c) Payback Period = Time at which the cumulative CFAT = Initial Investment.

(which is calculated on time proportion basis. Refer Illustration: 2)

|KIMS_The Platform to Perform| FM_Capital Budgeting_JM85

Step: 4 Accept the project, if Payback Period is less than maximum or benchmark period; else

reject the project.

Illustration: 2The initial outlay for a project is Rs. 25 crore. The project analyst expects the following annual cash flows which will be generated uniformly over the year:

Year: 0 1 2 3 4 5 6 7Cash flow (Rs. Crore): (25) 7 6 6 5 4 4 8

You are required to compute the pay back period for the above project. If the cut-off period decided by the management is 5 years, should the project be accepted?

Year Cash flows (Rs. Cr) Cumulative flows1 7 72 6 133 6 194 5 245 4 286 4 327 8 40

Evident from the table above, Rs. 25 crores in total would be collected in the 5th year.

Payback Period is

(25 - 24)4 years + x 12 months = 4years 3months

(28 - 24)

Since, the payback period is less than the cut-off period decided by the management, the project should be accepted.

Illustration: 3A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 12.5% (straight line method) but before tax @ 50%. Compute the payback period.

[Answer: 5 years]

Illustration: 4Initial investment is Project X and Project Y is Rs. 1,00,000 each. Following is the cash inflow from the two projects over a period of five years. Which project should be selected. Use payback period method.

Year Project X Project Y1 20,000 25,0002 20,000 25,0003 30,000 50,0004 30,000 20,0005 50,000 10,000

[Answer: Project X – 4 years, Project Y – 3 years]


DISCOUNTED PAYBACK PERIOD METHODWhen the payback period is computed after discounting the cash flows by a pre-determined rate (cut-off rate), it is called as the “Discounted Payback Period”.

Steps in computation of Discounted PP Step 1 Determine the total cash outflow of the project. (Initial Investment)Step 2 Determine the cash inflow after taxes (CFAT) for each year.Step 3 Determine the PV factor for each year and compute discounted CFAT (DCFAT) for each

year. DCFAT = CFAT for each year x PVIFStep 4 Determine the cumulative DCFAT at the end of every year.Step 5 Determine the year in which cumulative DCFAT exceeds the initial investment (Step 1).Step 6 Compute Discounted Payback Period as the time at which cumulative CFAT = Initial

Investment. This is calculated on “time proportion basis”.Step 7 Accept if DPP is less than maximum or benchmark period; else reject the project.

Illustration: 5The initial outlay for a project is Rs. 25 crore. The project analyst expects the following annual cash flows which will be generated uniformly over the year:

Year: 0 1 2 3 4 5 6 7Cash flow (Rs. Crore): (25) 7 6 6 5 4 4 8

You are required to compute the discounted pay back period for the above project, assuming cost of capital to be 12%.

Year Cashflows (Rs. Crores)

Discounting Factor @12%

Discounted Cashflows (Rs. Crores)

Cumulative Discounted Cashflows (Rs. Crores)

0 (25) 1.000 (25.000) (25.000)1 7 0.893 6.251 (18.749)2 6 0.797 4.782 (13.967)3 6 0.712 4.272 (9.695)4 5 0.636 3.180 (6.515)5 4 0.567 2.268 (4.247)6 4 0.507 2.028 (2.219)7 8 0.452 3.616 1.397

Discounted payback period = 6 + 2.219 ÷ 3.616 = 6.61 years

PACKBACK RECIPROCALIt is the reciprocal of payback period. It is expressed in percentage and computed as:

The Payback Reciprocal is considered to be an approximation of the Internal Rate of Return (IRR), if:a) The life of the project is at least twice the payback period;b) The project generates equal amount of the annual cash inflows; andc) The project doesn’t require additional outflow during project life.

Illustration: 6A project with initial investment of Rs. 50,00,000 and life of 10 years, generates CFAT of Rs. 10,00,000 per annum.Payback Period = 50,00,000 ÷ 10,00,000 = 5 yearsPayback Reciprocal = (1 ÷ 5) x 100 = 20%

ACCOUNTING OR AVERAGE RATE OF RETURN METHOD


Accounting or Average Rate of Return (ARR) means the average annual yield on the project. In this method, Profit after Taxes (PAT) is used for evaluation, instead of CFAT.

Steps in computation of ARRStep 1 Determine the average investment of the project.

* Average Investment = (Initial Investment + Salvage Value) ÷ 2Step 2 Determine the Profits after Tax (PAT) for each year.

PAT = CFAT – DepreciationStep 3 Determine the total PAT for N years, where N = Project Life.Step 4 Compute Average PAT per annum = Total PAT for all years ÷ N years.Step 5 ARR = Average PAT per annum ÷ Average Investment = Step 4 ÷ Step 1.

[* NOTE: We assume that depreciation is on Straight Line Basis, where Book Value declines at constant rate from purchase price to zero.Again, Average Investment = Net Working Capital + Salvage Value + ½ (Initial Investment – Salvage Value)If Net Working Capital = 0, the above equation reduces to: ½ (Initial Investment + Salvage Value)]

Illustration: 7A machine is available for purchase at a cost of Rs. 80,000.We expect it to have life of five years and to have a scrap value of Rs. 10,000 at the end of the five year period. We have estimated that it will generate additional profits over its life as follows:

Year 1 2 3 4 5Amount (Rs.) 20,000 40,000 30,000 15,000 5,000

These estimates are of profits before depreciation. You are required to calculate the accounting rate of return of the project.

Total profit before depreciation over five years of machine life = Rs. 1,10,000Average profit per annum = Rs. 1,10,000 / 5 years = Rs. 22,000Total depreciation over five years = Rs. 80,000 – Rs. 10,000= Rs. 70,000Average depreciation per annum = Rs. 70,000 / 5 years = Rs. 14,000Avg. annual profit after depreciation = Rs. 22,000 – Rs. 14,000= Rs. 8,000

Original investment required = Rs. 80,000Salvage Value = Rs. 10,000Average Investment = Rs. 90,000 / 2 = Rs. 45,000Accounting rate of return = (Rs. 8,000 / Rs. 45,000) = 17.78%

Illustration: 8Compute the accounting rate of return for the project given:

Year Book value of Fixed Investment (Rs.)

Profit after tax (Rs.)

1 90,000 20,0002 80,000 22,0003 70,000 24,0004 60,000 26,0005 50,000 28,000

NET PRESENT VALUE METHOD (NPV) OR DISCOUNTED CASH FLOW TECHNIQUE (DCF)


The Net Present Value of an investment proposal is defined as the sum of the present value of all future cash inflows less the sum of the present value of all cash outflows associated with the proposal.

Thus NPV = Discounted Cash Inflows – Discounted Cash Outflows

In simple terms:

Where, K = Cut-off rate or discounting rateFV = Future cash inflows arising at different points of time, I, 2, 3, …., nCO0 = Initial cash outflow, which pertains to time 0, hence not discounted

Procedure for computation of NPV

Step 1 Determine the total cash outflow of the project and the time periods in which they occur.

Step 2 Compute the total discounted cash outflow = Outflow X PVIFStep 3 Determine the total cash inflows of the project and the time periods in which they arise.Step 4 Compute the total discounted cash inflows = Inflow X PVIFStep 5 Compute NPV = Discounted Cash Inflows – Discounted Cash Outflows (Step 4 – Step 2)Step 6 Accept Project if NPV is positive, else reject.

Decision making or Acceptance RuleIf DecisionNPV > 0 Accept the Project. Surplus over and above the cut-off rate is obtained.NPV = 0 Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be

accepted or rejected. This constitutes an Indifference Point.NPV < 0 Reject the Project. The Project does not provide returns even equivalent to the cut-off rate.

Cash OutflowsGenerally cash outflows consist of (a) Initial Investment which occurs at time t = 0 and (b) Special payment and outflows, e.g. working capital outflow which arises in the year of commercial production, tax paid on capital gain made by sale of old asset, if any; and installation charges at time t = 0 or extra outflows during the life of the project.

Cash InflowsCash Inflows = CFAT = PAT + Depreciation. ORCash Inflows = PBD (1 – tax rate) + Tax Shield on Depreciation.Also, specific cash inflows like salvage value of new assets and recovery of working capital at the end of the project, tax savings on loss due to sale of old asset, should be carefully considered. The general assumption is that all cash inflows occur at the end of each year.

Discounting Cash Inflows and OutflowsEach item of cash inflow and outflow is discounted to ascertain its present value. For this purpose, the discounting rate is generally taken as the Cost of Capital since the project must earn at least what is paid out on the funds blocked in the project. The present value tables (PVIF tables) are used to calculate the present value of various cash flows. In case of uniform inflows per annum, annuity tables (PVIFA tables) may be used.Use of Discounting Rate


Instead of using PVIF tables, the relevant discount factor can be computed as:

, where, k =cost of capitaln =year in which inflow or outflow takes placeDF =Discounting Factor

For example;PV factor at 10% after one year = 1 ÷ (1.10)1 = 0.9091PV factor at 10% at the end of 2 years = 1 ÷ (1.10)2 = 0.8264 and so on.

NOTE:The NPV method will give valid results only if money can be immediately reinvested at a rate of return equal to the firm’s cost of capital.

Illustration: 9A company is considering which of two mutually exclusive projects it should undertake. The Finance Director thinks that the project with higher NPV should be chosen whereas the Managing Director thinks that the one with the higher IRR should be undertaken especially as both projects have the same initial outlay and length of life.

The company anticipates a cost of capital of 10% and the net after tax cash flows of the project are as follows:Year 0 1 2 3 4 5Project X (200,000) 35,000 80,000 90,000 75,000 20,000Project Y (200,000) 218,000 10,000 10,000 4,000 3,000

Calculate the NPV of each project taking 10% as discounting rate.Year PVIF 10% Project X Project Y

CFAT DCFAT CFAT DCFAT0 1.00 (200,000) (200,000) (200,000) (200,000)1 0.91 35,000 31,850 218,000 198,3802 0.83 80,000 66,400 10,000 8,3003 0.75 90,000 67,500 10,000 7,5004 0.68 75,000 51,000 4,000 2,7205 0.62 20,000 12,400 3,000 1,860

29,150 18,760

As per NPV criterion Project X should be selected which gives better NPV than Project Y.

INTERNAL RATE OF RETURN METHOD (IRR)Internal Rate of Return (IRR) is the rate at which the sum total of Discounted Cash Inflows equals the Discounted Cash Outflows. The Internal Rate of Return of a project is the discount rate which makes Net Present Value of the project equal to zero.

IRR refers to that discount rate K, such that;

At IRR, NPV = 0 and Profitability Index = 1


The discount rate, i.e., cost of capital is assumed to be known in the determination of Net Present Value, while in the internal rate of return calculation, the NPV is set equal to zero and the discount rate which satisfies the condition is determined.

InterpretationIRR can be interpreted in two ways:

a) IRR represents the rate of return on the unrecovered investment balance in the project.b) IRR is the rate of return earned on the initial investment made by the project.

Of these, the first view seems to be more realistic, since it may not always be possible for an enterprise to reinvest immediate cash flows at a rate equal to IRR.

Decision Making or Acceptance RuleIf DecisionIRR > K0 Accept the Project. Surplus over and above the cut-off rate is obtained.IRR = K0 Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be

accepted or rejected. This constitutes an Indifference Point.IRR < K0 Reject the Project. The Project does not provide returns even equivalent to the cut-off rate.

Procedure for computation of IRRStep 1 Determine the total cash outflow of the project and time periods in which they occur.Step 2 Determine the total cash inflows of the project and the time periods in which they arise.Step 3 Compute the NPV at an arbitrary discount rate, say 10%.Step 4 Choose another discount rate and compute NPV. The second discount rate is chosen in

such a way that one of the NPV’s is negative and the other is positive. Suppose, NPV is positive at 10%, choose a higher discount rate so as to get a negative NPV. In case NPV is negative at 10%, choose a lower rate.

Step 5 Compute the change in NPV over the two selected discount rates.Step 6 On proportionate basis, compute the discount rate at which NPV is zero.

Illustration: 10Taking data from Illustration: 9 calculate the IRR for each project.

Year PVIF Project X Project Y10% 20% CFAT DCFAT

10%DCFAT

20%CFAT DCFAT

10%DCFAT

20%0 1.00 1.00 (200,000) (200,000) (200,000) (200,000) (200,000) (200,000)1 0.91 0.83 35,000 31,850 29,050 218,000 198,380 180,9402 0.83 0.69 80,000 66,400 55,200 10,000 8,300 6,9003 0.75 0.58 90,000 67,500 52.200 10,000 7,500 5,8004 0.68 0.48 75,000 51,000 36,000 4,000 2,720 1,9205 0.62 0.41 20,000 12,400 8,200 3,000 1,860 1,230

29,150 (19,350) 18,760 (3,210)Since NPV is positive for both the projects at 10% discounting rate, we arbitrary choose a higher discounting rate for negative NPV, let say 20%. By interpolation method or on proportionate basis, IRR calculated is:

IRR of Project X:

IRR of Project Y:


CONFLICT BETWEEN CHOICE OF IRR AND NPV METHODS

Causes of ConflictGenerally, the higher the NPV, higher will be the IRR. However, NPV and IRR may give conflicting result in the evaluation of different projects.

a) Initial Investment Disparity – i.e., different project sizes.b) Project Life Disparity – i.e., difference in project lives.c) Outflows Pattern – i.e., when cash outflows arise at different points of time during the project life,

rather than as initial investment (t = 0) only.d) Cash Flow Disparity – i.e., when there is huge difference between initial CFAT and later years’

CFAT. A project with heavy initial CFAT then compared to later years will have higher IRR and vice-versa.

Superiority of NPVIn case of conflicting decisions based on NPV and IRR, the NPV method must prevail. Decisions are based on NPV sue to the superiority of NPV, as given from the following points:

a) NPV represents the surplus from the project whereas IRR represents the point of no surplus-no deficit.

b) NPV consider cost of capital as constant. Under IRR, the discount rate is determined by reverse working, by setting NPV = 0.

c) NPV aids decision-making by itself, i.e., projects with positive NPV are accepted. IRR by itself does not aid decision-making. For example, a project with IRR = 18% will be accepted if K0 < 18%. However, the project will be rejected if K0 = 21% (say > 18%).

d) NPV method considers the timing differences in cash flows at the appropriate discount rate. IRR is greatly affected by the volatility or variance in cash flow patterns.

e) IRR presumes that intermediate cash inflows will be reinvested at the rate (IRR); whereas in the case of NPV method, intermediate cash inflows are presumed to be reinvested at the cut-off rate. The later presumption, viz., reinvestment at the cut-off rate, is more realistic than reinvestment at IRR.

Illustration: 11Taking data from Illustration 9 and 10, state with reasons which project would you recommend?

NPV – IRR conflictParticulars Project X Project YNPV at 10% Rs. 29,150 Rs. 18,760Rank based on NPV I IIInternal Rate of Return 16.01% 18.54%Rank based on IRR II I

In case of NPV – IRR conflict, NPV should be preferred for decision making since it gives the net benefit in absolute terms. Hence Project X will be preferred.

NOTE:Inconsistency in ranking between NPV and IRR arises because:

a) Cash flow patterns of projects are different, Project Y has heavy initial cash inflows and hence has higher IRR.

Illustration: 12The cash flows of Project C and D with other details are given below:Year 0 1 2 3 NPV at 10% IRRProject C (10,000) 2,000 4,000 12,000 4,139 26.5%Project D (10,000) 10,000 3,000 3,000 3,823 37.6%


Year PVIF at

10% 14% 15% 30% 40%1 0.9090 0.8772 0.8696 0.7692 0.71432 0.8264 0.7695 0.7561 0.5917 0.51023 0.7513 0.6750 0.6575 0.4552 0.3644

a) Compare and rank the projects at different discounting rates based on NPV.b) Why there is conflict in rankings?c) Which project do you recommend?

Comparison and Ranking of Projects at different discounting rates based on NPV

Discounting Rate 0% 10% 14% 15% 30% 40%NPV of Project C 8,000 4,139 2,932 2,653 (633) (2,157)NPV of Project D 6,000 3,823 3,106 2,937 833 (233)Preference C C D D D NA

The conflict in project ranking between NPV and IRR is due to the variability of cash flows. Project C has lower initial cash flows and heavy later inflows. However, Project D has heavy initial inflows and lower inflows in the later period. This will distort the analysis under IRR. NPV is a realistic technique which takes into account, the variability of cash flows. Hence, NPV should be preferred over IRR in case of conflict.We are informed that the company’s cost of capital of 10%, NPV is higher for Project C. Hence, it should be preferred over Project D.

PROFITABILITY INDEX METHOD

When different investment proposals each involving different initial investments and cash inflows are to be compared, the technique of Profitability Index (PI) is used.

Profitability Index (PI) or Desirability Factor or Benefit Cost Ratio (BCR) is:

PI represents the amount obtained at the end of the project life, for every rupee invested in the project at the initial stage. The higher the PI, the better it is, since the greater is the return for every rupee of investment in the project.

Decision Making or Acceptance RuleIf DecisionPI > 1 Accept the Project. Surplus over and above the cut-off rate is obtained.PI = 1 Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be

accepted or rejected. This constitutes an Indifference Point.PI < 1 Reject the Project. The Project does not provide returns even equivalent to the cut-off rate.

CONFLICT BETWEEN THE CHOICE OF PI AND NPV METHODS

Acceptance – Rejection Decision Both NPV and PI techniques recognize the time value of money. The discount rate used in NPV and PI methods are the same. Both NPV and PI use the same factors, i.e., Discounted Cash Inflows (A) and Discounted Cash

Outflows (B), in the computation. NPV = A – B whereas PI = A ÷ B. When NPV > 0, PI will always be greater than 1. Also when NPV < 0, PI will be less than 1. Hence, for a given project, NPV and PI method give the same Accept or Reject Decision.


Ranking CriteriaHowever, if one project is to be selected out of two mutually exclusive projects, the NPV and PI method may give conflicting ranking criteria.

Example:Project P QDiscounted Cash Inflows Rs. 10,00,000 Rs. 5,00,000Less: Discounted Cash Outflows Rs. 5,00,000 Rs. 2,00,000Net Present Value Rs. 5,00,000 Rs. 3,00,000Profitability Index 2.00 2.50

Project P has a better ranking based on NPV while project Q will be preferred if PI were to be used for decision-making. Thus, there is a conflict in ranking, between NPV and PI methods. This is because NPV gives the ranking in terms of absolute value of rupees, whereas PI gives ranking for every rupee of investment, i.e., in terms of ratio.

Decision-makingGenerally the NPV method should be preferred since NPV indicates the economic contribution or surplus of the project in absolute terms. However, in capital rationing situations, for deciding between mutually exclusive projects, PI is a better evaluation technique.

PROJECT LIFE DISPARITY SITUATIONS – DIFFERENTIAL PROJECT LIVESIn case of evaluation based on NPV method, comparison of two projects is possible only if initial investment and project lives are the same. If project lives are different, e.g., Machine A operates for 6 years whereas Machine B operates for 8 years, the decisions can be obtained by any of the following methods:

Equivalent Annual Flows MethodHere, the cash flows are converted into an equivalent annual annuity called EAB, i.e., Equivalent Annual Benefit (in case of net inflow) or EAC, i.e., Equivalent Annual Cost (in case of net outflow).

Step 1 Compute the Initial Investment of each alternative.Step 2 Determine the project lives of each alternatives.Step 3 Determine the annuity factor relating to the project life of each alternative.Step 4 Compute Equivalent Annual Investment.

(EAI) = Initial Investment ÷ Relevant Annuity FactorStep 5 Compute CFAT per annum or Cash Outflows per annum, for each alternative.Step 6 Compute EAB = CFAT per annum – EAI

Compute EAC = Cash outflows per annum + EAIStep 7 Select project with maximum EAB or minimum EAC, as the case may be.

Illustration: 13The cash flows of two mutually exclusive projects are as under:Year 0 1 2 3 4 5 6Project P (40,000) 13,000 8,000 14,000 12,000 11,000 15,000Project J (20,000) 7,000 13,000 12,000 - - -

a) Estimate the net present value of the projects P and J using 15% as the hurdle rate.b) Estimate the internal rate of return of the projects P and J.c) Why is there conflict in the project by using NPV and IRR criteria?d) Which criterion will you use in such a situation? Estimate the value at that criterion. Make a project

choice.Calculation of NPV at 15% hurdle rate


Year PVIF 15%

Project P Project JCFAT DCFAT CFAT DCFAT

0 1.0000 (40,000) (40,000) (20,000) (20,000)1 0.8696 13,000 11,305 7,000 6,0872 0.7561 8,000 6,049 13,000 9,8293 0.6575 14,000 9,205 12,000 7,8904 0.5718 12,000 6,8625 0.4972 11,000 5,4696 0.4323 15,000 6,485

5,375 3,806

Computation of IRRSince both the projects yield a positive NPV at 15%, a higher discount rate is used to determine a negative NPV. IRR hence calculated by interpolation method is 20.15% for Project P and 25.30% for Project J. (Students are advised to calculate the IRR)

NPV – IRR conflictParticulars Project P Project JNPV at 15% Rs. 5,375 Rs. 3,806Rank based on NPV I IIInternal Rate of Return 20.15% 25.30%Rank based on IRR II IProject Life 6 years 3 yearsInitial Investment Rs. 40,000 Rs. 20,000

The difference or conflict in ranking between NPV and IRR is attributed to:a) Disparity in Initial Investmentb) Difference in Project Livesc) Non uniform cash inflows of the project

Resolving the conflict and Project choiceIn case of conflict between NPV and IRR, the NPV criterion is generally preferred. Hence Project P, whose NPV is Rs. 5,375, will be preferred in the above case. However, in this case, Project P and J have differential lives and hence, Equivalent Annual Flows Method will be better criteria for project ranking.

Equivalent Annual Flows from the Project = NPV ÷ PVIFA at 15% for the relevant project lifeFor Project P: EAF = 5,375 ÷ 3.7845 = Rs. 1,420For Project J: EAF = 3,806 ÷ 2.2832 = Rs. 1,668Hence, Project J should be preferred in the above situation, based on Equivalent Annual Flow criteria.

Terminal Value Method / Modified Net Present Value MethodUnder this method it is assumed that each cash flow is reinvested in another project at a predetermined rate of interest. It is also assumed that each cash inflow is reinvested elsewhere immediately until the termination of the project. If the present value of the sum total of the compounded reinvested cash flows is greater than the present value of the outflows the proposed project is accepted otherwise not.

Step 1 Find Terminal ValueTerminal Value = Future value of the immediate cash flows invested at different rates.


Where, TV = Terminal Value

CFt = Cash Inflow in year tr = Re-investment raten = Life of the project

Step 2 Find Modified NPV

Where, k = Cost of CapitalI0 = Initial Investment

Illustration: 14

Original outlay Rs. 8,000Life of the project 3 yearsCash inflows Rs, 4,000 p.a. for 3 yearsCost of Capital 10%Expected interest rates at which the cash inflows will be re-invested:

Year end 1 2 3% 8 8 8

First of all, it is necessary to find out total compounded sum which will be discounted back to the present value.

YearCash Inflow

(Rs.)

Rate of Interest

(%)

Years of Investment

Compounding Factor

Total Compounding

Sum (Rs.)1 4,000 8 2 1.166 4,6642 4,000 8 1 1.080 4,3203 4,000 8 0 1.000 4,000

12,984

Now, we have to find out the present value of Rs. 12,984 by applying the discount rate (cost of capital) of 10%. (PVIF at 10% for 3 years = 0.7513)

Modified NPV = Total Compounding Sum x PVIF – I0

= (Rs. 12,984 x 0.7513) – Rs. 8,000= Rs. 9,755 – Rs. 8000= Rs. 1,755

Since Modified NPV is positive, the project would be accepted under the terminal value criterion.


CAPITAL RATIONING – Advance LevelGenerally, a firm fixes up the maximum amount that can be invested in capital projects during a given period of time. The firm then tries to select a combination of investment proposals, which will be within the specific limits providing maximum profitability, and put them n descending order according to their rate of return. Such a situation is then considered to be capital rationing.

Situations of Capital Rationing

Situation IProjects are Divisible

Step 1 Calculate the profitability index of each projectStep 2 Rank the projects on the basis of the profitability index calculated in Step: 1.Step 3 Choose the optimal combination of the projects.

Illustration: 15

Project Required Initial Investment (Rs.)

NPV at the appropriate cost of capital (Rs.)

A 1,00,000 20,000B 3,00,000 35,000C 50,000 16,000D 2,00,000 25,000E 1,00,000 30,000

Total funds available is Rs. 3,00,000. Determine the optimal combination of projects assuming that the projects are divisible.

ProjectRequired Initial

Outlay (Rs.)

NPV at the appropriate cost

of capital (Rs.)

Profitability Index

Rank

A 1,00,000 20,000 0.2 3B 3,00,000 35,000 0.117 5C 50,000 16,000 0.32 1D 2,00,000 25,000 0.125 4E 1,00,000 30,000 0.3 2

Rank of Investment Project Initial Investment (Rs.) Cumulative1 C 50,000 50,0002 E 1,00,000 1,50,0003 A 1,00,000 2,50,0004 D (50,000÷200,000) 1/4th 50,000 3,00,000

Thus, the optimal combination of projects is C, E, A and 1/4th of D.

Situation IIProjects are Indivisible

Step 1 Construct a table showing the feasible combinations of the project (whose aggregate of initial outlay does not exceed the fund available for investment).

Step 2 Choose the combination whose aggregate NPV is maximum and consider it as the optimal project mix.


Illustration: 16

Using the same data as used in previous illustration, determine the optimal project mix on the basis of the assumption that the projects are indivisible.

Feasible Combinations Aggregate of NPVs (Rs.)A, C 36,000A, D 45,000A, E 50,000C, D 41,000C, E 46,000D, E 55,000A, C, E 66,000

By a careful inspection of the feasible combinations constructed in the above table, we can conclude that the optimal project mix is A, C, E because the aggregate of their NPV’s is maximum.

LEASE DECISIONS – Advance Level

Leasing is the general contract between the owner and user of the asset over a specific period of time. The asset is purchased initially by the lessor and leased to the user which pays a specified rent at periodic intervals.

From the lessee’s point of view, leasing has the attraction of eliminating immediate cash outflow, and the lease rentals are also tax deductible expenses.

Buying has the advantages of depreciation allowance and interest on borrowed capital being tax deductible.

Evaluation of the two alternatives is to be made in order to take decision.

Illustration: 17

K Limited has decided to go in for a new model of a Car. The cost of the vehicle is Rs. 40,00,000. The company has two alternatives:a) Taking the Car on Finance Lease; orb) Borrowing and Purchasing the Car.

J Limited is willing to provide the car on financial lease to K Limited for 5 years at an annual rental of Rs. 8,75,000, payable at the end of the year.

The vehicle is expected to have a useful life of 5 years, and it will fetch a net salvage value of Rs. 10,00,000 at the end of year five. The depreciation rate for tax purposes is 40% on written down value basis. The applicable tax rate for the company is 35%. The applicable before tax borrowing rate for the company is 13.8462%.

What is the advantage of leasing for K Limited?

Rate of discount 1 2 3 4 50.138462 0.8784 0.7715 0.6777 0.5953 0.52290.09 0.9174 0.8417 0.7722 0.7084 0.6499


Analysis of Lease OptionCompany’s cost of borrowing before tax = 13.8462%Cost of Capital (after tax) = 13.8462 x 0.65 = 9% approxAnnual Lease Rental = Rs. 8,75,000Less: Tax saved @ 35% = Rs. 3,06,250Cash outflow net of taxes = Rs. 5,68,750PV of cash outflows = Cash outflow p.a. x PVIFA

= Rs. 5,68,750 x 3.8896= Rs. 22,12,210

Analysis of Loan Option

Computation of Depreciation per year (in Rs. Lakhs)Year 1 2 3 4 5Opening Balance 40.00 24.00 14.40 8.64 5.18Less: Dep. @40% 16.00 9.60 5.76 3.46 2.07Closing Balance 24.00 14.40 8.64 5.18 3.11

Computation of loan amounts repaid (presumed to be repaid in 5 years equally) (in Rs. Lakhs)Annual repayment of loan = 40.00 ÷ 5 = 8.00Year 1 2 3 4 5Opening Balance 40.00 32.00 24.00 16.00 8.00Less: Repayments 8.00 8.00 8.00 8.00 8.00Closing Balance 32.00 24.00 16.00 8.00 0.00

Total Cash Outflows of Loan Option (Rs. Lakhs)Year 1 2 3 4 5Principal Repayment 8.00 8.00 8.00 8.00 8.00Interest @9% on Opening Balance 3.60 2.88 2.16 1.44 0.72Less: Tax saved on depreciation @ 35% (5.60) (3.36) (2.02) (1.21) (0.72)Less: Salvage Value (10.00 – 3.11)x0.65 + 3.11 - - - - (7.59)Outflows 6.00 7.52 8.14 8.23 0.41PVIF 9% 0.9714 0.8417 0.7722 0.7084 0.6499Discounted Cash outflows 5.50 6.33 6.29 5.83 0.27

Total Discounted Cash Outflows = Rs. 24,22,000

Thus, net advantage of lease option = Rs. 24,22,000 – Rs. 22,12,210= Rs. 2,09,790


Exercise

1. 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 no salvage value. The tax rate is 35%. Assume the firm uses straight line 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 : 1 2 3 4 5CFBT (Rs.) : 10,000 10,692 12,769 13,462 20,385

Compute the following:a) Pay back periodb) Average rate of returnc) Internal rate of returnd) Net present value at 10% discount ratee) Profitability index at 10% discount rate

[Answer: 4.328 years, 9%, 6.6%, (Rs. 4,648), 0.907]

2. A company is contemplating to purchase a machine. Two machines A and B are available, each costing Rs. 5,00,000. In comparing the profitability of the machines, a discounting rate of 10% is to be used and machines to be written off in five years by straight line method of depreciation with nil residual value. Cash inflows after tax are expected as follows:

Year Machine A Machine B1 1,50,000 50,0002 2,00,000 1,50,0003 2,50,000 2,00,0004 1,50,000 3,00,0005 1,00,000 2,00,000

Indicate which machine would be profitable using the following methods of ranking investment proposals:a) Pay Back Methodb) Net Present Value Methodc) Profitability Index Methodd) Average Rate of Return Method

[Answer: a) 2 years 7.2 months, 3 years 4 month, b) Rs. 1.5401 lakhs, Rs. 1.4876 lakhs, c) 1.308, 1.298, d) 28%, 32%]

3. Oasis Plastics Limited is a manufacturer of high quality plastic products. Bania, President, is considering computerizing the company’s ordering, inventory and billing procedures. He estimates that the annual savings from computerization include a reduction of 4 clerical employees with annual salaries of Rs. 50000 each, Rs. 30,000 from reduced production delays caused by raw materials inventory problems, Rs. 25,000 from lost sales due to inventory stock outs and Rs. 18,000 associated with timely billing procedures.

The purchase price of the system is Rs. 2,50,000 and installation costs are Rs. 50,000. These outlays will be capitalized (depreciated) on a straight line basis to a zero books salvage value which is also its market value at the end of five years. Operation of the new system requires two computer specialists with annual salaries of Rs. 80,000 per person. Also annual maintenance and operation (cash) expenses of Rs. 22,000 are estimated to be required. The company’s tax rate is 40% and its required rate of return (cost of capital) for the project is 12%.

You are required to:a) Evaluate the project using NPV method.b) Evaluate the project using PI method.c) Evaluate the Project’s Payback Period.

[Answer: NPV = (Rs. 16,663), PI = 0.944, PBP = 3.817 years]


4. A company has to make a choice between two projects namely A and B. The initial capital outlay of two

projects are Rs. 1,35,000 and Rs. 2,40,000 respectively for A and B. There will be no scrap value at the end of the life of both the projects. The opportunity cost of capital is 16%. The annual incomes are as under:

Year Project A Project B Discounting Factor @16%1 - 60,000 0.8622 30,000 84,000 0.7433 1,32,000 96,000 0.6414 84,000 1,02,000 0.5525 84,000 90,000 0.476

You are required to calculate for each project:a) Discounted Payback Periodb) Profitability Indexc) Net Present Value

[Answer: a) 3.606 years, 4.187 years; b) 1.4315, 1.1451; c) Rs. 58,254, Rs. 34,812]

5. M/s. M & Co. wants to replace its old machine with a new automatic machine. Two models Bye-Bye and K&K are available at the same cost of Rs. 5,00,000 each. Salvage value of the old machine is Rs. 1,00,000. The utilities of the existing machine can be used if the company purchases Bye-Bye. Additional cost of utilities to be purchased in that case are Rs. 1,00,000. If the company purchases K&K then all the existing utilities will have to be replaced with new utilities costing Rs. 2,00,000. The salvage value of the old utilities will be Rs. 20,000. The cash flows after taxation are expected to be:

Year Cash Inflows of PV factor @ 15%

Bye-Bye (Rs.) K&K (Rs.)1 1,00,000 2,00,000 0.872 1,50,000 2,10,000 0.763 1,80,000 1,80,000 0.664 2,00,000 1,70,000 0.575 1,70,000 40,000 0.50

Salvage value at the end of year 5 50,000 60,000

The targeted return on capital is 15%. You are required to:a) Compute, for the two machines separately, net present value, discounted pay back period and

desirability factor, andb) Advise which of the machines is to be selected.

[Answer: NPV = Rs. 44,000, Rs. 20,000; DPBP = 4.6 years, 4.6 years; DF = 1.088, 1.034]

6. A particular project has a four year life with yearly projected net profit of Rs. 10,000 after charging yearly depreciation of Rs. 8,000 in order to write-off the capital cost of Rs. 32,000. Out of the capital cost Rs. 20,000 is payable immediately (Year 0) and balance in the next year (which will be the Year 1 for evaluation). Stock amounting to Rs. 6,000 (to be invested in Year 0) will be required throughout the project and for Debtors a further sum of Rs. 8,000 will have to be invested in Year 1. The working capital will be recouped in Year 5. It is expected that the machinery will fetch a residual value of Rs. 2,000 at the end of 4th year. Income Tax is payable @ 40% and the depreciation equals the taxation writing down allowances of 25% per annum. Income Tax is paid after 9 months after the end of the year when profit is made. The residual value of Rs. 2,000 will also bear tax @ 40%. Although the project is for 4 years, for computation of tax and realization of working capital, the computation will be required up to 5 years.Taking discount factor of 10%, calculate NPV of the project and give your comments regarding its acceptability.

[Answer: NPV = Rs. 10,910; Accept the proposal]


7. K Limited has the following expectations from its project:

Rs. In LakhsYear 0 1 2 3 4 5Total (2,910.24) 1,439.49 1,355.16 1,272.67 1,248.59 2,673.20

To finance its project the company borrowed Rs. 1,000 lakhs @ 12%. The balance was invested through equity. The cost of equity is 14%. The marginal tax rate applicable to the company is 35%. The company expects to reinvest the intermediate cash flows @6% in government securities.You are required to compute the company’s modified NPV and suggest whether the project should be accepted.[Answer: Modified NPV = Rs. 2,145.22 lakhs, the company should accept this project]

8. Om Limited has Rs. 10,00,000 allocated for capital budgeting purpose. The following proposals and associated profitability indices have been determined:

Project 1 2 3 4 5 6Project Costs (Rs. Lakh) 3.00 1.50 3.50 4.50 2.00 4.00Profitability Index 1.22 0.95 1.20 1.18 1.20 1.05

Which of the above investments should be undertaken? Assume that projects are indivisible and there is no alternative use of money allocated for capital budgeting.[Answer: Mix of projects 3, 4 and 5]

9. Beta Limited is considering 5 capital projects for the years 1, 2, 3 and 4. The company is financed entirely by equity and its cost of capital is 12%. The expected cash flows of the projects are as follows:

Project Year 1 Year 2 Year 3 Year 4A (70) 35 35 20B (40) (30) 45 55C (50) (60) 70 80D - (90) 55 65E (60) 20 40 50

All projects are divisible. None of the projects can be delayed or undertaken more than once. Calculate which project the company should undertake if the capital available for investment is limited to Rs. 110000 in year 1 and with no limitation in subsequent years?[Answer: Either D or Combination of E, B and C]

10. In a capital rationing situation (investment limit Rs. 25 lakhs), suggest the most desirable and feasible combination on the basis of the following data (indicate justification):

Project Initial Outlay NPVA 15,00,000 6,00,000B 10,00,000 4,50,000C 7,50,000 3,60,000D 6,00,000 3,00,000

Projects B and C are mutually exclusive.[Answer: Project A and B]

11. Five projects M, N, O, P, and Q are available to a company for consideration. The investment required for each project and cash flows it yields are tabulated below. Projects N and Q are mutually exclusive. Taking the cost of capital @ 10%, which combination of projects should be taken up for a total capital outlay not exceeding Rs 3 lakhs on the basis of NPV and Benefit- Cost Ratio?

Project Investment Cash flow p.a. No. of years PV @ 10%M 50,000 18,000 10 6.145N 1,00,000 50,000 4 3.170O 1,20,000 30,000 8 5.335P 1,50,000 40,000 16 7.824Q 2,00,000 30,000 25 9.077

[Answer: Projects M, N & P combines to give maximum NPV of Rs. 2,82,070 and maximum BCR of 1.940]


12. A company is evaluating three projects 1, 2 and 3. Investments required and expected present values of

cash inflows from each of the projects are as below:

Year Investments (Rs.) PV of Inflows (Rs.)1 2,00,000 2,90,0002 1,15,000 1,85,0003 2,70,000 4,00,000

a) If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and present values will simply be the sum of the parts.

b) With projects 1 and 3, economies are possible in investment because one of the machines costing Rs. 30,000 can be used for both of the projects.

c) If projects 2 and 3 are undertaken, there are economies to be achieved in marketing and production but not in investment. The expected present value of costs saved is Rs. 35,000.

d) If all three projects are undertaken simultaneously, the economies noted will still hold. However, an extension of plant capacity will be necessary at additional investment of Rs. 1,25,000.

Which projects should be chosen?[Answer: Combination of 2 and 3]

13. S Limited a highly profitable company is engaged in the manufacture of power intensive products. As part of its diversification plans, the company proposes to put up a Windmill to generate electricity. The details of the scheme are as follows:

a) Cost of windmill – Rs. 300 lakhsb) Cost of land – Rs. 15 lakhsc) Subsidy from state Government to be received at the end of first year of installation – Rs. 15 lakhs.d) Cost of electricity will be Rs. 2.25 per unit in year 1. This will increase by Re. 0.25 per unit every

year till year 7. After that it will increase by Re. 0.50 per unit.e) Maintenance costs will be Rs. 4 lakhs in year 1 and the same will increase by Rs. 2 lakhs every

year.f) Estimated life is 10 years.g) Cost of capital is 15%.h) Residual value of the windmill will be nil. However, land value will go up to Rs. 60 lakhs at the end of

10 years.i) Depreciation will be 100% of the cost of the Windmill in year 1 and the same will be allowed for tax

purposes.j) As windmills are expected to work based on wind velocity, the efficiency is expected to be an

average 30%. Gross electricity generated at this level will be 25 lakhs units per annum. 4% of this electricity generated will be committed free to the State Electricity Board as per the agreement.

k) Tax rate is 50%

From the above information you are required to calculate the net present value. (Ignore tax on capital profits.)

Year 1 2 3 4 5 6 7 8 9 10At 15% 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25[Answer: Rs. 8.26 lakhs]

14. K Limited is considering a new project for manufacture of pocket video games involving a capital expenditure of Rs. 600 lakh and working capital of Rs. 150 lakh. The capacity of the plant is for an annual production of 12 lakh units and capacity utilization during the 6 year working life of the project is expected to be as indicated below:

Year : 1 2 3 4 – 6 Capacity Utilization (%) : 33.33 66.67 90 100

The average price per unit of the product is expected to be Rs. 200 netting a contribution of 40%. The annual fixed costs, excluding depreciation, are estimated to be Rs. 480 lakh per annum from the third year onwards; for the first and second year, it would be Rs. 240 lakh and Rs. 360 lakh respectively. The average rate of depreciation for tax purposes is 33.33 % on the capital assets. The rate of income tax may be taken as 35%. Cost of capital is 15%.


At the end of the third year, an additional investment of Rs. 100 lakh would be required for working capital.

Terminal value for the fixed assets may be taken at 10% and for the current assets at 100%. For the purpose of your calculations, the recent amendments to the tax laws with regard to balancing charge may be neglected.[Answer: NPV = Rs. 273 lakh]

15. Run Away Limited is considering the manufacture of a new product. They have prepared the following estimate of profit in the first year of manufacture:

(Rs.)Sales, 9,000 units @ Rs. 32 2,88,000Cost of goods sold: Labour 40,000 hours @ Rs. 3.50 per hour 1,40,000 Materials and other variable costs 65,000 Depreciation 45,000

2,50,000 Less: Closing stock 25,000 2,25,000Net Profit 63,000

The product is expected to have a life of four years. Annual sales volume is expected to be constant over the period at 9,000 units. Production which was estimated at 10,000 units in the first year would be only 9,000 units each in year two and three and 8,000 units in year four. Debtors at the end of each year would be 20% of sales during the year, creditors would be 10% of materials and other variable costs. If sales differed from the forecast level, stocks would be adjusted in proportion.Depreciation relates to machinery which would be purchased especially for the manufacture of the new product and is calculated on the straight line basis assuming that the machinery would last for four years and have no terminal scrap value. Fixed costs are included in labour cost.

There is high level of confidence concerning the accuracy of all the above estimates except the annual sales volume. Cost of capital is 20% per annum. You may assume that debtors are realized and creditors are paid in the following year. No changes in the prices of inputs and outputs are expected over the next four years.You are required to show whether the manufacture of the new product is worthwhile. Ignore taxes.[Answer: NPV = Rs. 58,398]

16. A plastic manufacturing company is considering replacing an older machine which was fully depreciated for tax purposes with a new machine costing Rs. 40,000. The new machine will be depreciated over its eight-year life. It is estimated that the new machine will reduce labour costs by Rs. 8,000 per year. The management believes that there will be no change in other expenses and revenues of the firm due to the machine. The company requires an after-tax return on investment of 10%. Its rate of tax is 35%. The company’s income statement for the current year is given for other information.

Income statement for the current year: (Rs.)

Sales 5,00,000Costs: Materials 1,50,000 Labour 2,00,000 Factory and administrative 40,000 Depreciation 40,000 4,30,000Net income before taxes 70,000Less: Taxes (0.35) (24,500)Earnings after taxes 45,500

Should the company buy the new machine? You may assume the company follows straight line method of depreciation and the same is allowed for tax purposes.[Answer: Differential NPV = (Rs. 2,922)]


17. A company is currently considering modernization of a machine originally costing Rs. 50,000 (current

book value zero). However, it is in good working condition and can be sold for Rs. 25,000. Two choices are available. One is to rehabilitate the existing machine at a total cost of Rs. 1,80,000; and the other is to replace the existing machine with a new machine costing Rs. 2,10,000 and requiring Rs. 30,000 to install. The rehabilitated machine as well as the new machine would have a six year life and no salvage value. The projected after-tax profits under the various alternatives are:

(Rs.)

YearsExpected after-tax profits

Existing machine Rehabilitated machine New machine1 2,00,000 2,20,000 2,40,0002 2,50,000 2,90,000 3,10,0003 3,10,000 3,50,000 3,50,0004 3,60,000 4,00,000 4,10,0005 4,10,000 4,50,000 4,30,0006 5,00,000 5,40,000 5,10,000

The firm is taxed at 35%. The company uses straight line depreciation method and the same is allowed for tax purposes. Ignore block assets concept. The cost of capital is 12%.

Advise the company whether it should rehabilitate the existing machine or should replace it with the new machine. Also, state the situation in which the company would like to continue with the existing machine.[Answer: Incremental NPV for Rehab machine = Rs. 89,980; new machine = Rs. 1,00,960]

18. A company is considering the proposal of taking up a new project which requires an investment of Rs. 400 lakhs on machinery and other assets. The project is expected to yield the following earnings before depreciation and taxes over the next five years: Rs. In lakhs: 160, 160, 180, 180 and 150 respectively. The cost of raising the additional capital is 12% and the assets have to be depreciated at 20% on WDV basis. The salvage value at the end of 5 yrs period may be taken as zero. Income tax applicable is 50%. Calculate the NPV and IRR of the project.

19. A Limited is considering investing in a project. The expected investment in the project is Rs. 2,00,000. Life of the project is 5 years with no salvage value. The expected net cash inflows after depreciation but before taxes are in Rs. 85,000; 100,000; 80,000; 80,000 and 40,000 respectively. Depreciation is 20% on original cost. Applicable tax rate is 30%.Calculate payback period, ARR, NPV and IRR of the project.

20. A company wants to invest in a machinery costing Rs. 50,000 at the beginning of year 1. It is estimated that net cash inflows from operation is Rs. 18,000 per annum for 3 years, if the company opts to service a part of the machinery at the end of year 1 at Rs. 10,000 and the salvage value at the end of year 3 will be Rs. 12,500. However, if the company decides not to service the part, it will have to be replaced at the end of year 2 at Rs. 15,400. But in this case, the machinery will work for the 4 th year with Rs. 18,000 as cash inflow. It will have to be scrapped at the end of year 4 at Rs. 9,000. Opportunity cost of capital is 10%. Ignore taxation. Will you recommend the purchase of this machine based on NPV? If the supplier gives you Rs. 5,000 discount, what would be your decision? [1, 0.9091, 0.8264, 0.7513, 0.6830, 0.6209, 0.5644]

21. Following are the date on a capital project being evaluated by X limited.Annual cost saving Rs. 40,000Useful life of the project 4 yearsIRR 15%Profitability Index 1.064Net Present Value ??Cost of Capital ??Cost of Project ??Payback Period ??Salvage Value 0Find the missing values.


22. Company X is forced to choose between two machines A and B. The two machines are designed

differently, but have identical capacity and do exactly the same job. Machine A costs Rs. 1,50,000 and will last for 3 years. It costs Rs. 40,000 per year to run. Machine B is an “economy” model costing Rs. 1,00,000, but will last only for 2 years, and costs Rs. 60,000 per year to run. These are real cash inflows. Ignore tax. Opportunity cost of capital is 10%. Which machine should company X buy?

23. Company X is operating an elderly machine that is expected to produce a net cash inflow of Rs. 40,000 in the coming year and Rs. 40,000 next year. Current salvage value is Rs. 80,000 and next year’s value is Rs. 70,000. The machine can be replaced now with a new machine, which costs Rs. 150,000, but is more efficient and will provide a cash inflow of Rs. 80,000 a year for 3 years. Company wants to know whether it should replace the equipment now or wait a year with the clear understanding that the new machine is the best of the available alternatives and that it in turn be replaced at the optimal point. Ignore tax. Take cost of capital 10%. Advise with reasons.

24. PQ limited has decided to purchase a car worth Rs. 40,00,000, have two alternatives:a) Taking the car on financial lease; orb) Borrowing and purchasing the car.LM limited is willing to provide the car on lease for 5 years at an annual rental of Rs. 8.75 lakhs, payable at the end of the year. The vehicle is expected to have useful life of 5 years, with salvage value of Rs. 10,00,000. Depreciation @ 40% on WDV method. Applicable tax rate is 35%. Applicable before tax borrowing rate is 13.8462%. Find net advantage of leasing.

25. A company is thinking of replacing its existing machine by a new machine which would cost Rs. 60 lakhs. The company’s current production is 80,000 units and is expected to increase to 100,000 units, if the new machine is bought. The selling price remain unchanged at Rs. 200 per unit. The following is the cost of producing one unit of product using both existing and new machine:

Existing machine New machine DifferenceMaterials 75.00 63.75 (11.25)Wages and Salaries 51.25 37.50 (13.75)Supervision 20.00 25.00 5.00Repairs 11.25 7.50 (3.75)Power and Fuel 15.50 14.25 (1.25)Depreciation 0.25 5.00 4.75Allocated corporate OHS 10.00 12.50 2.50

The existing machine has an accounting book value of Rs. 100,000, and it has been fully depreciated for tax purposes. It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered to accept the old machine for Rs. 2,50,000. However, the market price of old machine today is Rs. 1,50,000 and it is expected to be Rs. 35,000 after 5 years. The new machine has a life of 5 years and a salvage value of Rs. 2,50,000 at the end of its economic life. Assume corporate income tax rate at 40% and depreciation is charged on straight line basis for income tax purposes. Further assume that book profit is treated as ordinary income for tax purposes. The opportunity cost of capital is 15%.

Required:a) Estimate NPV of the replacement decision.b) Estimate the IRR of the replacement decision.c) Should company go ahead with the replacement decision? Suggest.


085 - 106 Chapter 8 Capital Budgeting

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