AFM Capital Budgeting

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BBA SEM VI: Advance Financeial Management

Problem 9

Satya corporation is toying with the idea of replacing its existing machine. The followingare the relevant data –

1. Existing Machine

Purchased 2 years agoemaining life – ! yearsSalvage value – s "##$urrent %oo& value – s 2'!## and its realisa%le mar&et value – s ('### )nnual depreciation – s ("#

2. *ew machine

$apital cost of s +'###Estimated useful life – ! yearsEstimated salvage value – s +##

The replaced machine would permit an output expansion. )s a result' sales is expected torise %y s 1'### per year' operating expenses would decline %y s 1'"## per year. ,twould re-uire an additional inventory of s 2'### )ssuming corporate tax rate of #/ and cost of capital of 1"/' advice the companySolution –

1. $alculation of incremental cash flows from purchase of new machinery –

s.

1. ,ncremental cash outflow 0ear 1$ost of new machinery +'### )dd 3 )ddition to wor&ing capitala. ,nventory 2'### Total 1####4ess 3 *et sale price 0('### – tax on profit 5 #/ of s ## 2'+#

*et cash outflow of year 1 6'!!#

2. Su%se-uent cash inflows

,ncrease in sales 1'### )dd 3 savings in cost 1'"##4ess 3 increase in depreciation 0s 1'2## – ("# +"#

,ncrease in profit %efore tax 1'!"#

4ess 3 tax 5 #/ !!#

*et profit 77#

)dd 3 depreciation +"#

*et cash flow 1+#

2. $alculation of net present value 5 1"/ discounting factor.

Prepared By: Mahendra Patel, Parul Institute of Business Administration Page 1


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ear $ash inflows 8 0outflow 9iscounting factor 5 1"/

Present values.

# 06!!# 1 06!!#

1 1'+# #.+6# 1'!#1

2 1'+# #.6"! 1'(71( 1'+# #.!"+ 1'211

1'+# #."62 1'#"2

" 1'+# #.76 71"

! 1'+# #.(2 67"

! 1'"## #.(2 !+

! +# #.(2 2#6

NPV 220

,n year ! additional cash inflows will %e –

ecovery of wor&ing capital s 1'"##Sale proceeds of machinery s +##4ess3 tax on sale 5#/ s (2#

s +#

Since the *P: of the pro;ect is positive the company should go for replacement of oldmachinery.

Problem 10

) large profit ma&ing company is considering the installation of a machine to process thewaste produced %y one of its existing manufacturing process to %e converted into amar&eta%le product. )t present' the waste is removed %y a contractor for disposal onpayment %y the company of s "# lacs per annum for next years. The contract can %eterminated on installation of the aforesaid machine on payment of a compensation of s(# la&hs %efore the processing operation starts. This compensation is not allowed asdeduction for tax purposes.

The machine re-uired for carrying out the processing will cost s 2## la&hs to %efinanced %y a loan repaya%le in e-ual instalments commencing from the end of year 1.The interest rate is 1!/ p.a )t the end of th year' the machine can %e sold for s 2#

la&hs and the cost for dismantling and removal will %e s 1" la&hs.

Sales and direct cost of the product emerging from waste processing for years areestimated as under3

1 2 3 4

Sales (22 (22 1+ 1+

Material consumption (# # +" +"


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,nitial stoc& re-uired %efore commencement of the processing operations is s 2# lacs atthe start of year 1. The stoc& levels of materials to %e maintained at the end of year 1'2and ( will %e s "" lacs and the stoc& at the end of year will %e nil. The storage of material will utilise the space which otherwise would have %een rented out for s 1# la&hs

per annum. 4a%our cost includes wages of # wor&ers' whose transfer to this process willreduce idle time payments of s 1" lacs in year 1 and s 1# lacs in year 2. >actoryoverheads include apportionment of general factory overheads except to the extent of insurance charges of s (# la&hs per annum attri%uta%le to this venture.The company?stax rate is "#/ for revenue incomes.

)dvice the management on the desira%ility of installing the machinery for processing thewaste. )ll calculation should form part of the answer. e-uired rate of return is 1"/.0$) final' May 1777

Solution -

1. Statement of incremental cash flows from operations @s la&hs

1 2 3 4

Sales (22 (22 1+ 1+

4ess 3Material consumption (# # +" +"actory overheads 0,nsurance (# (# (# (#4oss of rent 1# 1# 1# 1#,nterest (2 2 1! +9epreciation "# (+ 2+ 21

Total cost 2"2 2"2 (#+ (2

,ncremental profits %efore tax 6# 6# 11# 74ess3 Tax 5 "#/ (" (" "" 6

*et profit (" (" "" 6

)dd 3 depreciation "# (+ 2+ 21

*et cash flow +" 6( +( !+

=verheads other than insurance is not considered as they remain unchanged eventhough the pro;ect is not executed

2. Statement of incremental cash flows 0net

s la&hs

1 2 3 4

*et cash flow from operations +" 6( +( !+0,ncrease 8 realisation ofinventories

0(" @ @ ""

$ontract payment saved 2" 2" 2" 2"



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0*et of tax saving 5 "#/4oan repayment 0"# 0"# 0"# 0"#Profit on sale of machine @ @ @ "

Total incremental cash flows 2" + "+ 1#(

(. *et present value of all cash flows 5 1"/@s la&hs


Present values.

# 0"# 1 0"#

1 2" #.+6# 21.6"

2 + #.6"! (!.27

( "+ #.!"+ (+.1!

1#( #."62 "+.72

NPV 105.12

$ash outflow of year 1 is – $ompensation for contract A increase in inventory level@ s (# la&hs A s 2# la&hs B s "# la&hs.

Comment - ,t is advisa%le to implement the proposal as the net present value is positive.

Problem 11 ) company is setting up a plant at a cost of s (## la&hs of investment in fixed assets. ,t

has to decide whether to locate the plant in a forward area 0>) or %ac&ward are 0C).4ocating in %ac&ward area means a cash su%sidy of s 1" la&hs from the centralgovernment. Cesides the taxa%le profit to the extent of 2#/ is exempt for 1# years. Thepro;ect envisages a %orrowing of S 2## la&hs in either case. The cost of %orrowing will%e 12/ in forward area and 1#/ in %ac&ward area. Dowever the revenue costs are%ound to %e higher in the C). The %orrowing principle has to %e repaid in e-ual annualinstalments %eginning from the end of year . low techni-ue you are re-uired to suggest proper location for the pro;ect. )ssume straight@line depreciation with no residual value.

Earning %efore interest and tax 0s in la&hs

Year FA BA1 @! @"#

2 ( @2#

( " 1#

6 2#

" 1#+ "

! 12 1##

6 1"! 1""

+ 2(# 17#

7 ((# 2(#

1# (# ((#



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)ssume –1. 9iscounting rate to %e 1"/2. ate of ,ncome tax to %e "#/(. $entral su%sidy is not to affect depreciation or tax.. *o other relief and re%ates will %e availa%le to the company other than those

mentioned a%ove.$) final May 1771F

Solution -

1. $alculation of cash flows from the operation for >orward area

Year B!" !ntere#t $e%re&iation PB" "a' PA" !n(lo)

1 @! 2 (# @!# @ @!# @(#

2 ( 2 (# @2# @ @2# 1#

( " 2 (# @ @ @ (#

6 2 (# 2# @ 2# "#" 1#+ 1+ (# !# @ !# 7#

! 12 12 (# 1## "# "# +#

6 1"! ! (# 12# !# !# 7#

+ 2(# @ (# 2## 1## 1## 1(#

7 ((# @ (# (## 1"# 1"# 1+#

1# (# @ (# ## 2## 2## 2(#

2. $alculation of cash flows from the operation for Cac&ward area

Year B!" !ntere#t $e%re&iation PB" "a' PA" !n(lo)

1 @"# 2# (# @1## @ @1## @6#2 @2# 2# (# @6# @ @6# @#

( 1# 2# (# @# @ @# @1#

2# 2# (# @(# @ @(# @

" " 1" (# @ @ @ (#

! 1## 1# (# !# @ !# 7#

6 1"" " (# 12# @ 12# 1"#

+ 17# @ (# 1!# # 12# 1"#

7 2(# @ (# 2## +# 12# 1"#

1# ((# @ (# (## 12# 1+# 21#

(. $alculation of net present value of pro;ect in forward area 5 1"/ discounting factor s la&hs

ear $ash inflows 80outflow

$ashoutflows

*et cashflows

9iscountingfactor

5 1"/

Presentvalues.

# 01## @ 01## 1 01##

1 @(# @ @(# #.+6# 02!.1#

2 1# @ 1# #.6"! 6."!

( (# @ (# #.!"+ 17.6

"# "# # #."62 #

" 7# "# # #.76 17.++! +# "# (# #.(2 12.7!



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6 7# "# # #.(6! 1".#

+ 1(# @ @ #.(26 2."1

7 1+# @ @ #.2+ "1.12

1# 2(# @ @ #.26 "!.+1

NPV 99.52

$ash outflow of year 1 B Total cash outflow – loan amount B s (## la&hs – s 2## la&hsB s 1## la&hs.

. $alculation of net present value of pro;ect in %ac&ward area 5 1"/ discounting factor s la&hs

ear $ash inflows 80outflow

$ashoutflows

*et cashflows

9iscountingfactor

5 1"/

Presentvalues.

# 0+" @ 0+" 1 0+"

1 @6# @ @6# #.+6# @!#.72 @# @ @# #.6"! @(#.2

( @1# @ @1# #.!"+ @!."+

@ "# @"# #."62 @2+.!#

" (# "# @2# #.76 @7.7

! 7# "# # #.(2 16.2+

6 1"# "# 1## #.(6! (6.!

+ 1"# @ 1"# #.(26 7.#"

7 1"# @ 1"# #.2+ 2.!#

1# 21# @ 21# #.26 "1.+6

NPV 22.*+

$ash outflow of year 1 B Total cash outflow – loan amount – su%sidy B s (## la&hs – s2## la&hs – s 1" la&hs B s +" la&hs.

,orin note# –

1. Taxa%ility of %ac&ward area starts only from year +th as in year ! and 6 the lossesof year 1 to " are ad;usted against the profits.

2. >or year +'7 and 1# tax is levied only on +#/ of the profits as 2#/ profit isexempt.

(. ,deally the discounting factor shall %e 12/ and 1#/' which is cost of capital at >)and C) respectively' in that case interest should %e ignored. Cut as the pro%lemstates the cost of capital to %e 1"/' calculations done considering interest as cashout flow

Comment – )s *P: of >) is positive and *P: of C) is negative pro;ect should %elocated in >).

Problem 12



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G ltd. is considering two mutually exclusive pro;ects G and . >ollowing details are madeavaila%le to you 3

s. ,n lacsPro;ect G Pro;ect

Pro;ect cost 1'### 1'###$ash inflowsear1 2## 2##2 1"# !##( (2# 2"# "# 1##" "## 1"#

)ssume no residual value at the end of fifth year. The firms cost of capital is 1#/.e-uired' in respect of each of the two pro;ects3

i. *P: using 1#/ discounting rateii. , andiii. Profita%ility indexiv. Pay%ac& period

Solution –

1. *et present value of cash flows of pro;ect G 5 1#/@ s la&hs

ear $ash inflows 8 0outflow 9iscounting factor 5 1#/

Present values.

# 01'### 1 01'###

1 2## #.7#7 1+1.+#

2 1"# #.+2! 12(.7#

( (2# #.6"1 2#.(2

"# #.!+( (#6.("

" "## #.!21 (1#."

NPV 1+3.*/

2. *et present value of cash flows of pro;ect 5 1#/@s la&hs


Present values.

# 01'### 1 01'###

1 2## #.7#7 1+1.+#

2 !## #.+2! 7".!#

( 2"# #.6"1 1+6.6" 1## #.!+( !+.(#



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" 1"# #.!21 7(.1"

NPV 2+.+0

Problem 2

) company proposes to underta&e two mutually exclusive pro;ects )GE and CGE 3

)GE CGE,nitial capital outlay s 22'"#'### s. (#'##'###Economic life 0years 6 )fter tax annual cash inflowsear 1 !'##'### "'##'###2 12'"#'### 6'"#'###( 1#'##'### 6'"#'### 6'"#'### 12'##'###" @ 12'"#'###! @ 1#'##'###6 @ +'##'###

The company?s cost of capital is 1!/. Please calculate the net present value and , for %oth the pro;ects

Solution -

1. $alculation of *P: of %oth the pro;ects

$alculation of present value of the pro;ect )GE 5 1!/ discounting rate

ear $ash inflows 8 0outflow 9iscounting factor 5 1!/

Present values.

# 022'"#'### 1 022'"#'###

1 !'##'### #.+!2 "'16'2##

2 12'"#'### #.6( 7'2+'6"#

( 1#'##'### #.!1 !'1'### 6'"#'### #.""2 '1'###

*P: 250950

$alculation of present value of the pro;ect CGE 5 1!/ discounting rate

ear $ash inflows 8 0outflow 9iscounting factor 5 1!/

Present values.

# 0(#'##'### 1 0(#'##'###

1 "'##'### #.+!2 '(1'###

2 6'"#'### #.6( "'"6'2"#( 6'"#'### #.!1 '+#'6"#



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12'##'### #.""2 !'7#'###

" 12'"#'### #.6! "'7('6"#

! 1#'##'### #.1# '1#'###

6 +'##'### #.(" 2'+('2##

*P: 44+350

)s *P: of pro;ect CGE is su%stantially higher than pro;ect )GE pro;ect CGE is moreprofita%le.

Problem 3

Precision instruments is considering two mutually exclusive pro;ects G and . >ollowingdetails are made availa%le to you 3

s. ,n lacs

Pro;ect G Pro;ect

Pro;ect cost 6## 6##$ash inflowsear1 1## "##2 2## ##( (## 2## "# 1##" !## 1##

)ssume no residual value at the end of fifth year. The firms cost of capital is 1#/.e-uired' in respect of each of the two pro;ects 3i. *P: using 1#/ discounting rateii. , andiii. Profita%ility index!C,A inter une 1995

Solution -

1. Cal&ulation o( Net %re#ent alue

$alculation of present value of the pro;ect G 5 1#/ discounting rates la&hs


Present values.

# 06## 1 06##

1 1## #.7#7 7#.7#

2 2## #.+2! 1!".2#

( (## #.6"1 22".(#

"# #.!+( (#6.("

" !## #.!21 (62.!#

Present value of inflows 1'1!1.("*P: 4+1.35



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$alculation of present value of the pro;ect 5 1#/ discounting rate


Present values.

# 06## 1 06##1 "## #.7#7 "."#

2 ## #.+2! ((#.#

( 2## #.6"1 1"#.2#

1## #.!+( !+.(#

" 1## #.!21 !2.1#

Present value of inflows 1'#!"."#

*P: 3+5.50

2. Pro(itabilit in6e'

P, B Total present value of all cash inflowsTotal present value of cash outflows

P, of pro;ect G B 1'1!1.(" 6##

B 1.!"7

P, of pro;ect B 1'#!"."# 6##

B 1."22

3. !nternal rate o( return !77

$alculation of present value of the pro;ect G 5 26/ discounting rates la&hs

ear $ash inflows 8 0outflow 9iscounting factor 5 26/

Present values.

# 06## 1 06##

1 1## #.6+6 6+.6#

2 2## #.!2# 12

( (## #.++ 1!.#

"# #.(+ 162.+#

" !## #.(#( 1+1.+#

*P: 3./0

$alculation of present value of the pro;ect G 5 2+/ discounting rates la&hs

ear $ash inflows 8 0outflow 9iscounting factor 5 2+/

Present values.

# 06## 1 06##

1 1## #.6+1 6+.1#

2 2## #.!1# 122.##( (## #.66 1(.1#



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"# #.(6( 1!6.!"

" !## #.271 16.!#

*P: -14.35

Cy interpolation formula , B 26 A (.6# H1

(.6#A1.("B 26.21/

, of pro;ect G B 26.21/

$alculation of present value of the pro;ect 5 (6/ discounting rates la&hs

ear $ash inflows 8 0outflow 9iscounting factor 5 (6/

Present values.

# 06## 1 06##

1 "## #.6( (!"

2 ## #."(( 21(.2#( 2## #.(+7 66.+#

1## #.2+ 2+.#

" 1## #.2#6 2#.6#

*P: 5.10

$alculation of present value of the pro;ect 5 (+/ discounting rates la&hs

ear $ash inflows 8 0outflow 9iscounting factor 5 (+/

Present values.

# 06## 1 06##

1 "## #.62" (!2."#2 ## #."2" 21#

( 2## #.(+1 6!.2#

1## #.26! 26.!#

" 1## #.2## 2#.6#

*P: -3.00

Cy interpolation formula , B (6 A ".1# H1".1#A(

B (6.!(/, of pro;ect B (6.!(/

Summar o( bot8 t8e %roe&t#

Pro;ect G Pro;ect y

Profita%ility index 1.!"7 1."22

*et present value !1.(" (!"."#

,nternal rate of return 26.21/ (6.!(/

Problem 12

G ltd. is considering two mutually exclusive pro;ects G and . >ollowing details are madeavaila%le to you 3



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. i. Profita%ility index of pro;ect G B 11!(.+1###

B 1.1!

ii. Profita%ility index of pro;ect B 1#2!.!#1###

B 1.#26

". $alculation of internal rate of return for pro;ect G @

a. *et present value of cash flows of pro;ect G 5 1"/@s la&hs


Present values.

# 01'### 1 01'###

1 2## #.+6# 16.##

2 1"# #.6"! 11(.#

( (2# #.!"+ 21#."!

"# #."62 2"6.#

" "## #.76 2+."

NPV 3.*+

)S net present value s (.+! lacs 0almost nil' it can %e said that the , of the pro;ect isslightly higher than 1"/

%. *et present value of cash flows of pro;ect 5 12/@s la&hs

ear $ash inflows 8 0outflow 9iscounting factor 5 12/

Present values.

# 01'### 1 01'###

1 2## #.+7( 16+.!

2 !## #.676 6+.2#

( 2"# #.612 16+.##

1## #.!(! !(.!#

" 1"# #."!6 +".#"

NPV -1+.55

)s net present value s 1!."" lacs' it can %e said that the , of the pro;ect is higher than 1#/ %ut lesser than 12/. The , can %e calculated %y interpolation method.

, B 1# A 02!.!# 8 1!.""A2!.!# H2

B 1#A1.2B 11.2" /



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IRR of project Y is 11.25%

Problem 13

) company is considering as to which of two mutually exclusive pro;ects it shouldunderta&e. The finance directors thin&s that the pro;ect with the higher *P: should %echosen whereas the managing director thin&s that the one with higher , should %eunderta&en especially as %oth the pro;ects have the same initial outlay and length of life.The company anticipates a cost of capital of 1#/ and the net after tax cash flows of thepro;ect are as follows –

Year Proe&t : Proe&t Y

# 02## 02##

1 (" 21+

2 +# 1#

( 7# 1# 6"

" 2# (

e-uired –

1. $alculate the *P: and , of each pro;ect2. state with reasons which pro;ect you would recommened

The discounting factors are as follows –

Year 10; 20;1 #.71 #.+(

2 #.+( #.!7

( #.6" #."+

#.!+ #.+

" #.!2 #.1

$) final May 177"F

Solution –

1. Anal#i# o( %roe&t '

a. *et present value of cash flows of pro;ect G 5 1#/@s la&hs


Present values.

# 02## 1 02##

1 (" #.71 (1.+"

2 +# #.+( !!.#

( 7# #.6" !6."#

6" #.!+ "1.##" 2# #.!2 12.#



15/16


NPV 29.15

%. *et present value of cash flows of pro;ect G 5 2#/@s la&hs


Present values.

# 02## 1 02##

1 (" #.+( 27.#"

2 +# #.!7 "".2#

( 7# #."+ "2.2#

6" #.+ (!.##

" 2# #.1 +.2#

NPV -19.35

, for pro;ect G can %e calculated %y interpolation method as follows –

, B 1# A 027.1" 8 27.1"A17.("H1#

B 1!/

a. *et present value of cash flows of pro;ect G 5 1#/@s la&hs


Present values.

# 02## 1 02##1 (" #.71 (1.+"

2 +# #.+( !!.#

( 7# #.6" !6."#

6" #.!+ "1.##

" 2# #.!2 12.#

NPV 29.15

2. Anal#i# o( %roe&t Y -

a. *et present value of cash flows of pro;ect 5 1#/@s la&hs


Present values.

# 02## 1 02##

1 21+ #.71 17+.(+

2 1# #.+( +.(#

( 1# #.6" 6."#

#.!+ 2.62

" ( #.!2 1.+!

NPV 1*./+



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%. *et present value of cash flows of pro;ect 5 2#/@s la&hs

ear $ash inflows 8 0outflow 9iscounting factor

5 1#/

Present value

s.# 02## 1 02##

1 21+ #.+( 1+#.7

2 1# #.!7 !.7#

( 1# #."+ ".+#

#.+ 1.72

" ( #.1 1.2(

NPV -3.21

, for pro;ect can %e calculated %y interpolation method as follows –

, B 1# A 01+.6! 8 1+.6!A(.21H1#

B 1+."/


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