FINANCIAL MANAGEMENT

CAPITAL BUDGETING
ANSWERS

Question 1

Computation of NPVs per ` 1 of Investment and Ranking of the Projects

Project Investment NPV @ 15% NPV per `1 Ranking

`000 `000 invested
A (50) 15.4 0.31 5
B (40) 18.7 0.47 2
C (25) 10.1 0.40 3
D (30) 11.2 0.37 4
E (35) 193 0.55 1

Building up of a Programme of Projects based on their Rankings

Investment NPV @15%

Project
`000 `000
E (35) 19.3
B (40) 18.7
C (25) 10.1
D (20) 7.5 (2/3 of project
total)
120 55.6

ThusProjectAshouldberejectedandonlytwo-thirdofProjectDbeundertaken.Ifthe
projects are not divisible then other combinations can be examinedas

Investment NPV @15%

`000 `000
E+B+C 100 48.1
E+B+D 105 49.2

In this case E + B + D would be preferable as it provides a higher NPV

despite D ranking lower than C.
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Question 2

Although from NPV point of view Project cupcakes appears to be better but from
IRR point of view Project jelly appears to be better. Since, both projects have
unequal lives selection on the basis of these two methods shall not be proper. In
such situation we shall use any of the following method:

i. Replacement Chain (Common Life) Method: Since the life of the Project cupcake
is 6 years and Project jelly is 3 years to equalize lives we can have second
opportunity of investing in project jelly after one time investing. The position of
cash flows in such situation shall be as follows:

NPV of extended life of 6 years of Project jelly shall be ` 8,82,403 and IRR of
25.20%. Accordingly, with extended life NPV of Project jelly it appears to be
more attractive.

ii. Equivalent Annualized Criterion : The method discussed above has one
drawback when we have to compare two projects one has a life of 3 years and
other has 5 years. In such case the above method shall require analysis of a
period of 15 years i.e. common multiple of these two values. The simple solution
to this problem is use of Equivalent Annualised Criterion involving following
steps:

a. Compute NPV using the WACC or discounting rate.

b. Compute Present Value Annuity Factor (PVAF) of discounting factor

used above for the period of each project.

c. Divide NPV computed under step (a) by PVAF as computed under step (b)
and compare the values.

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 Accordingly, for proposal under consideration:

Project A Project B
NPV @ 12% ` 6,49,094 `5,15,488
PVAF @12% 4.112 2.402
Equivalent Annualized Criterion `1,57,854 `2,14,608
Thus, Project jelly should be selected.

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Question 3
Statement showing the Evaluation of Two Machines
Machines A B
Purchase cost (`): (i) 1,50,000 1,00,000
Life of machines (years) 3 2
Running cost of machine per year (`): (ii) 40,000 60,000
Cumulative present value factor for 1-3 years @ 10%: (iii) 2.486 -
Cumulative present value factor for 1-2 years @ 10%: (iv) - 1.735
Present value of running cost of machines (`): (v) 99,440 1,04,100
[(ii) × (iii)] [(ii) × (iv)]
Cash outflow of machines (`): (vi)=(i) +(v) 2,49,440 2,04,100
Equivalent present value of annual cash outflow 1,00,338 1,17,637
[(vi)÷(iii)] [(vi) ÷(iv)]
Decision: Company rainbow should buy machine A since its equivalent cash
outflow is less than machine B.

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Question 4
i. Initial CashOutflow:

Amount (`)
Cost of new machine 60,00,000
Less: Sale Price of existing machine 1,50,000
Net of Tax (`2,50,0100 × 0.60) 58,50,000

ii. Terminal CashFlows:

a. NewMachine

Amount (`)
Salvage value of Machine 2,50,000
Less: Depreciated WDV 2,50,000
{`60,00,000 - (`11,50,000 × 5
years)}
STCG Nil
Tax Nil
Net Salvage Value (cash flows) 2,50,000

b. OldMachine
Cash realised on disposal of existing machine after ` 35,000 Additional cash
flows atterminal year = ` 2,15,000 (2,50,000-35,000)

iii. Calculation of Net CashFlows

Particulars Existing Machine New Machine Incremental

1. Production 80,000 Units 1,00,000 Units 20,000 Units
(`) (`) (`)
2. SellingPrice 200 200
3. VariableCost 173 148
4.Earnings before
depreciation and Tax per 27 52
Unit
5.Total earnings before
21,60,000 52,00,000 30,40,000
depreciation andTax(1*4)

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6. Less:Depreciation
 60 , 00 , 000  2 , 50 , 000  11,50,000
 
 5 
7. Earning after
18,90,000
depreciation beforeTax
8. Less: Tax@40% 7,56,000
9. Earning after
11,34,000
depreciation andTax
10 .Add:Depreciation 11,50,000
11. Net Cash inflow 22,84,000

Alternatively

i. Computation of additional cash flows(yearly)

Particulars Amount (`) Amount (`)

Sales 1,60,00,000 2,00,00,000
Material 60,00,000 63,75,000
Wages & Salaries 41,00,000 37,50,000
Supervision 16,00,000 25,00,000
Repair & Maintenance 9,00,000 7,50,000
Power & fuel 12,40,000 14,25,000
Depreciation -- 11,50,000
Total cost 1,38,40,000 1,59,50,000
Profit(Sales – Total cost) 21,60,000 40,50,000
Less: Tax@40% 8,64,000 16,20,000
12,96,000 24,30,000
Add: Depreciation ** 11,50,000*
12,96,000 35,80,000
Incremental Cash inflow 22,84,000

** As mention in the question WDV of Machine is zero for tax purpose hence no
depreciation shall be provided in existing machine.
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ii. Computation of NPV @ 15%
Period Cash flow PVF PV (`)
(`)
Incremental cash flows 1-5 22,84,000 3.352 76,55,968
Add; Terminal yearcash 5 2,15,000 0.4972 1,06,898

77,62,866
Less: Additional cash 0 58,50,000 1
58,50,000
outflow
NPV 19,12,866

iii. Calculation ofIRR

(ii) IRR- Since NPV computed in Part (i) is positive. Let us discount cash flows at
higher rate say at 30%
Period Cash flow (`) PVF PV (`)
Incremental cash flows 1-5 22,84,000 2.436 55,63,824
Add: Terminal yearcash 5 2,15,000 0.2693 57,900
55,05,924

Less: Additional cash 0 58,50,000 1 58,50,000

outflow
NPV - 3,44,076

Now we use interpolation formula

19 ,12 , 866
15%  15%
19 ,12 , 866   3, 44 , 076 
19 ,12 , 866
15%  15%
22 , 56 , 942
= 15% + 12.71% = 27.71%

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Question 5

i. Calculation of Net Initial Cash Outflows:

`
Cost of new machine 10,00,000
Less: Sale proceeds of existing 2,00,000
machine 8,00,000
Net initial cash outflows

ii. Calculation of annual depreciation:

iii. Calculation of annual cash inflows from operation:

Particulars Existing machine New Machine Differential

(1) (2) (3) (4) =(3) – (2)

Annual output 30,000units 75,000units 45,000units
` ` `
(A) Sales revenue @ ` 15 per unit 4,50,000 11,25,000 6,75,000
(B) Less: Cost of Operation
Material @ ` 4 per unit 1,20,000 3,00,000 1,80,000
Labour
Old = 3,000 × ` 40 1,20,000 90,000
New = 3,000 × ` 70 2,10,000
Indirect cash cost 50,000 65,000 15,000
Depreciation 30,000 1,20,000 90,000
Total Cost (B) 3,20,000 6,95,000 3,75,000
Profit Before Tax (A – B) 1,30,000 4,30,000 3,00,000
Less: Tax @ 30% 39,000 1,29,000 90,000
Profit After Tax 91,000 3,01,000 2,10,000
Add: Depreciation 30,000 1,20,000 90,000
Annual Cash Inflows 1,21,000 4,21,000 3,00,000

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iv. Calculation of Net PresentValue

`
Present value of annual net cash
Inflows: 1 – 8 years = ` 3,00,000 × 4.968 14,90,400
Add: Present value of salvage value of new machine at
the end of 8th year (` 40,000 × 0.404) 16,160
Total present value 15,06,560
Less: Net Initial Cash Outflows 8,00,000
NPV 7,06,560

Alternative Solution:

Calculation of Net Present Value (NPV)

Period Cash Flow Present Present

(Year) (`) Value Value (` )
Particulars
Factor(PVF)
@12%
Purchase of new machine Incremental 0 - 8,00,000 1.00 - 8,00,000
Annual Cash Inflow Salvage value of 1 – 8 3,00,000 4.968 14,90,400
new machine 8 40,000 0.404 16,160
Net Present Value (NPV) 7,06,560

Advise : Hence, existing machine should be replaced because NPV is positive.

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Question 6

Advise to the Babies Hospital Management

Determination of Cash inflows

Sales Revenue 40,000
Less: Operating Cost 7,500
32,500
Less: Depreciation (80,000 – 6,000)/8 9,250
Net Income 23,250
Tax @ 30% 6,975
Earnings after Tax (EAT) 16,275
Add: Depreciation 9,250
Cash inflow after tax per annum 25,525
Less: Loss of Commission Income 12,000
Net Cash inflow after tax per annum 13,525
In 8th Year :
New Cash inflow after tax 13,525
Add: Salvage Value of Machine 6,000
Net Cash inflow in year 8 19,525

Calculation of Net Present Value (NPV)

PV Factor Present Value of Cash

Year CFAT
@10% inflows
1 to 7 13,525 4.867 65,826.18
8 19,525 0.467 9,118.18
74,944.36
Less: Cash Outflows 80,000.00
NPV (5,055.64)

Advise: Since the net present value is negative and profitability index is also
less than 1, therefore, the hospital should not purchase the diagnostic machine.
Note: Since the tax rate is not mentioned in the question, therefore, it is
assumed to be 30 percent in the given solution.
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Question 7

i. NPV of theProject

Period PVF @ 18% Cash Flow (`) PV of Cash Flow (`)

0 1.000 (10,00,000) (10,00,000)
1 0.847 2,00,000 1,69,400
2 0.718 3,00,000 2,15,400
3 0.609 4,00,000 2,43,600
4 0.516 3,00,000 1,54,800
5 0.437 2,00,000 87,400
NPV (1,29,400)
Decision: Since NPV of the project is negative it is recommended not to accept the
project.

ii. NPV of the project if Tax Break is given

Period PVF @ 18% Cash Flow (`) PV of Cash Flow (`)

0 1.000 (9,20,000) (9,20,000)
1 0.847 2,16,000 1,82,952
2 0.718 3,24,000 2,32,632
3 0.609 4,32,000 2,63,088
4 0.516 3,24,000 1,67,184
5 0.437 2,16,000 94,392
NPV 20,248

Decision: Since NPV of the project is positive it is recommended to accept the

project.

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Question 8

Working Notes:
1. Computation of AnnualDepreciation-

Particulars `
Purchase Price 26,00,000
Add:1. Installation Charges 9,000
2. Fees Paid to Consultant for Advice 6,000
Total Cost of New Machine 26,15,000
Useful Life 8 Years
Annual Depreciation (Total Cost/No. of Years) 3,26,875
2. Computation of Annual Cash Savings-

Particulars `
Annual Earnings 3,15,000
Less-Tax @35% 1,10,250
Earning after Tax 2,04,750
Add-Depreciation on New Machine 3,26,875
Annual Cash Savings 5,31,625

3. Tax effect on sale of Old Machine-

Particulars `
Proceeds of Sale 12,500
Less: Cost of Removal 4,500
Net Proceeds 8,000
Less: WDV 76,000
Net Loss due to Sale 68,000
Tax savings due to Loss on Sale@35% 23,800
Total Cash Inflow due to Sale (` 8,000+` 23,800) 31,800

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4. Computation of Net Present Value

Particulars Period Cash Flow PVF PV

(`) @13%
(`)
(a) Annual Cash inflow after Tax 1-8 5,31,625 4.8 25,51,800
(b) Net Salvage Value of Existing 0 31,800 1.0 31,800
Machine
(c) Working Capital Realized 8 17,000 0.376 6,392
Present Value of Cash Inflows 25,89,992
Less: 1. Initial Investment 0 26,15,000 1.0 26,15,000
2. Initial Working Capital 0 17,000 1.0 17,000
NPV of the Proposal (42,008)

Decision: Since NPV of the project is negative it is not viable.

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Question 9

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Since NPV is positive love airs Ltd. should accept the project.

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Question 10

Calculation of Net Cash flows

Contribution = (300 – 285) × 75,000 = `11,25,000
Fixed costs = 8,40,000 – [(25,00,000 – 3,00,000)/5] = `4,00,000

Calculation of Net Present Value

The net present value of the project is `1,26,800.

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Question 11

Working Notes:

Calculation of Equivalent Annual Cost

Computation of Cost Per Unit

Decision:As the unit cost is less in proposed Plant B, it may be

recommended that it is advantageous to acquire Plant B.

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Question 12

PV of Total Cash Outflow under System A

PV of Total Cash Outflow under System B

Since Equivalent Annual Cost (EAC) is least in case of system A hence same
should be opted.

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