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Tutorial 07-Capital Budgeting

GSPC is considering a Rs 250 million project to build a 35 km pipeline to transport gas and LNG. The pipeline would generate Rs 200 million in annual revenue over 20 years. The project's NPV is negative Rs 4.66 million and IRR is 14.65%, below the required return of 15%. The payback period is over 6 years. Therefore, the project should not be accepted since it does not meet the company's return requirements.

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Shekhar Singh
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2K views

Tutorial 07-Capital Budgeting

GSPC is considering a Rs 250 million project to build a 35 km pipeline to transport gas and LNG. The pipeline would generate Rs 200 million in annual revenue over 20 years. The project's NPV is negative Rs 4.66 million and IRR is 14.65%, below the required return of 15%. The payback period is over 6 years. Therefore, the project should not be accepted since it does not meet the company's return requirements.

Uploaded by

Shekhar Singh
Copyright
© © All Rights Reserved
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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Tutorial 07: Capital Budgeting

Case: G.S.PetroPull Company (GSPC)


GSPC is a fast growing profitable company. The company is situated in Western India. TIs sales
are expected to grow about three times from Rs 360 million in 2003-04 to Rs 1100 million in
2004-05. The company is considering of commissioning a 35 km pipeline between two areas
to carry gas to a state electricity board. The project will cost Rs 250 million. The pipeline will
have a capacity of 2.5 MMSCM. The company will enter into a contract with the state
electricity board (SEB) to supply gas. The revenue from the sale to SEB is expected to be Rs
120 million per annum. The pipeline will also be used for transportation of LNG to other users
in the area. This is expected to bring additional revenue of Rs 80 million per annum. The
company management considers the useful life of the pipeline to be 20 years. The financial
manager estimates cash profit to sales ratio of 20 percent per annum for the first 12 years of
the projects operations and 17 percent per annum for the remaining life of the project. The
project has no salvage value. The project being in a backward area is exempt from paying any
taxes. The company requires a rate of return of 15 percent from the project.
Questions
1. What is the projects payback period and return on investment (ROI)?
2. Compute the projects NPV and IRR.
3. Should the project be accepted? Why?

Tutorial 07: Capital Budgeting


Case: G.S.PetroPull Company (GSPC)
GSPC is a fast growing profitable company. The company is situated in Western India. TIs sales
are expected to grow about three times from Rs 360 million in 2003-04 to Rs 1100 million in
2004-05. The company is considering of commissioning a 35 km pipeline between two areas
to carry gas to a state electricity board. The project will cost Rs 250 million. The pipeline will
have a capacity of 2.5 MMSCM. The company will enter into a contract with the state
electricity board (SEB) to supply gas. The revenue from the sale to SEB is expected to be Rs
120 million per annum. The pipeline will also be used for transportation of LNG to other users
in the area. This is expected to bring additional revenue of Rs 80 million per annum. The
company management considers the useful life of the pipeline to be 20 years. The financial
manager estimates cash profit to sales ratio of 20 percent per annum for the first 12 years of
the projects operations and 17 percent per annum for the remaining life of the project. The
project has no salvage value. The project being in a backward area is exempt from paying any
taxes. The company requires a rate of return of 15 percent from the project.
Questions
1. What is the projects payback period and return on investment (ROI)?
2. Compute the projects NPV and IRR.
3. Should the project be accepted? Why?
Solution: G. S. Petropull Company (GSPC)

Year
Cost of project (Rs million)
Revenue from SEB (Rs million)

250
120

0
1

Cash
flows
(Rs mn.)
-250
40

Cum.
Cash
flows
(Rs mn.)
-250
-210

Revenue from other users (Rs million)


Total revenue (Rs million)
Cash profit, 20% from year 1 to 12 (Rs million)
Cash profit, 17% from year 13 to 20 (Rs million)
Average cash profit (Rs million)
Average investment (Rs million)
ROI
Discount rate
PVFA 12, 15%
PVFA 20, 15%
PVFA (20, 12), 15%
PV of Cash profit, year 1-12 (Rs million)
PV of Cash profit, years 13-20 (Rs million)
NPV (Rs millions)

80
200
40
34
37.6
125
30.1
%
15%
5.4206
6.2593
0.8387
216.82
28.52
-4.66

2
3
4
5
6
7

40
40
40
40
40
40

-170
-130
-90
-50
-10
30

8
9
10
11
12
13
14
15
16
17
18
19
20

40
40
40
40
40
34
34
34
34
34
34
34
34
-4.66
14.65%
>6 years

70
110
150
190
230
264
298
332
366
400
434
468
502

NPV
IRR
Payback

}
Payback

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