Module 3A: Capital Budgeting

1.
An investment of Rs. 40,000 in a machine is expected to produce constant cash flows of Rs. 8,000
for 10 years. Calculate the payback period

2.
An investment of Rs. 50,00,000 in a pension plan is expected to produce constant cash flows of Rs.
500,000 annually for the next 20 years. Calculate the payback period.

3.
If the initial cost of a project is Rs. 50,000. Calculate the Payback period. Annual inflows after
depreciation after tax is as follows:
Year Amount
1 10000
2 15000
3 20000
4 25000

4.
The following are the details of two machines A and B with uneven cash flows. Find out the
payback period for them.
Machine A B
Cash Outflow 56,125 56,125
Cash Inflows: Year1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000

5.
The purchase price of a computer is Rs. 24000. Salvage value is Rs. 4000. Working capital is Rs.
6000. Economic life is 5 years. Depreciation is to be provided on SLM. Average annual profit is Rs.
40000. Required rate of return is 15%. State whether the project is acceptable by computing ARR.

6.
ZEE Ltd. provides the following information:
Purchase price – Rs.160,000
Installation charges – Rs. 40,000
Salvage value – Rs.80,000
Economic life – 4 years
Working capital required – Rs. 20,000
Annual earnings before depreciation and tax – Rs. 130000
Rate of tax – 30%
Calculate ARR if deprecation is charged using Straight Line method

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7. Initial investment Rs. 200,000, Net cash inflow Rs. 60,000 per year, Life 6 years. Cost of capital
8%, No Scrap value. Calculate NPV and Profitability Index. Calculate PBP & Discounted PBP.

8. Given the following data calculate NPV and Profitability Index.

Initial investment 60000.
Life 5 years.
Cost of capital 10%.
Year Cash Inflows
Rs.
1 14,000
2 16,000
3 18,000
4 20,000
5 25,000

9. A project costs Rs. 16,000 and is expected to generate cash inflows of Rs. 8000 and Rs. 7000 and
Rs. 6000 at the end of each year for next 3 years. Calculate IRR.

10. A project of 20 years life requires an original investment of Rs. 100,000. The other relevant
information is given below:
Average annual earnings before depreciation and tax Rs.20,000
Annual tax rate 50%
Calculate:
A) Payback period
B) Average rate of return
C) Rate of return on original Investment

11. DCF limited is implementing a project with an initial capital outlay of Rs. 8000. Its cash inflows
are as under:
Year Cash Inflows Rs.
1 6,000
2 2,000
3 1,000
4 5,000
The expected rate of return is 12%. Calculate the Discounted Payback

12.
Premont Systems is evaluating a capital project with the following characteristics:
 The initial outlay is Rs.150,000.
 Annual after-tax operating cash flows are Rs. 28,000.
 After-tax salvage value at project termination is Rs. 20,000.
 Project life is 10 years.
 The project beta is 1.20.
 The risk-free rate is 4.2 percent and the expected market return is 9.4 percent
Required:
1 Compute the project NPV. Should the project be accepted?
2 Compute the project IRR. Should the project be accepted?

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13.
P ltd is evaluating a project that has the following cash flow stream associated with it. The Cost of
Capital for P Ltd is 15%. Calculate MIRR. Investment in the project – Initially Rs 122 Lakhs and at
the end of the first year Rs 80 Lakhs and Inflow starts from the end of second year as given below.
Year Cash Flow (Rs lakh)
0 (122)
1 (80)
2 20
3 60
4 80
5 100
6 120

14.
Mr. A is considering an investment of $250,000 in a start-up. The cost of capital for the investment
is 13%. Calculate MIRR for the proposed investment. Following cash flows are expected:
Year $
0 (250,000)
1 50,000
2 100,000
3 200,000

15.
C Ltd is considering investing in a project. The expected original investment in the project will be
Rs.2,00,000. The life of project will be 5 year with no salvage value. The expected net cash inflows
after depreciation but before tax during the life of the project will be as following.
Year 1 2 3 4 5
Rs. 85,000 100,000 80,000 80,000 40,000

The project will be depreciated at the rate of 20% on original cost. The company is subjected to
30% tax rate. Cost of capital is 10%
Required:
Calculate payback period
Discounted Payback Period
Calculate average of return [ARR].
Calculate net present value
Calculate internal rate of return
Calculate Profitability Index

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16.
A company is considering which of two mutually exclusive projects it should undertake. The
finance director thinks that the project with the 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 line. The company anticipates a cost of capital of 10% and
the net after –tax cash flows of the projects are as follows:
Year 0 1 2 3 4 5
Project X (200) 35 80 90 75 20
(Rs. Lakhs)
Project Y (200) 218 10 10 4 3
(Rs. Lakhs)
Required:
[A] Calculate the NPV and IRR of each project
[B] State, the reason, which project you would recommend
[C] Explain the inconsistency in the ranking of the two projects.

17. Capital Rationing

The total available budget for a company is Rs.20 crores and the total cost of the projects is Rs.25
crores. The projects listed below have been ranked in order of profitability. Advice which projects
to undertake.

Project Cost (Rs. Crores) Profitability Index

A 6 1.5
B 5 1.25
C 7 1.2
D 2 1.15
E 5 1.1

18.
Project Cost (Rs.’000) NPV @ 15% (Rs.’000)
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3
The company is limited to a capital spending of Rs. 1,20,000. You are required to optimize the
returns from a package of projects with the capital spending limit. The projects are independent of
each other and are divisible [i.e. part project is possible]

19.
National electronics Ltd. An electronic goods manufacturing company, is producing a large range of
electronic goods. It has under consideration two projects ‘X’&‘Y’, each costing Rs.120 lakh. The
projects are mutually exclusive and the company is considering the question of selecting one of the
two. Profit Before Depreciation & Taxes have been worked out for both the projects and the details
are given below. ‘X’ has a life of 8 years and ‘Y’ has a life of 6 years. Both will have zero salvage
value at the end of their operational lives. The company is already making profits and its tax rate is
50%. The cost of capital of the company is 15%

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 Year Project X (Rs. Lakhs) Project Y (Rs. Lakhs)
1 25 40
2 35 60
3 45 80
4 65 50
5 65 30
6 55 20
7 35 -
8 15 -
The company follows straight line method of deprecating assets. Advise the company regarding the
selection of the project.

20.
A Ltd is considering the question of taking up a new project which requires an investment of Rs.200
lakhs on machinery and other assets. The project is expected to yield the following gross profits
[before depreciation and tax] over the next five years.
Year 1 2 3 4 5
Gross Profit 80 80 90 90 75
(Rs. Lakhs)
The cost of raising the additional capital is 12% and the assets have to be depreciated at 20% on
written down value basis. The scrap value at the end of the five-year period may be taken as zero.
Income tax applicable to the company is 50%.
Calculate the net present value of the project and advise the management whether the project has to
be implemented. Also calculate the internal rate of return of the project

21.
ITC Ltd. have decided to purchase a machine to augment the company’s installed capacity to meet
the growing demand for its products. There are three machines under consideration of the
management. The relevant details including estimated yearly expenditure and sales are given below.
All sales are on cash. Corporate income-tax rate is 40%. Cost of capital may be assumed to be 10%.
Particulars Machine 1 (Rs.) Machine 2 (Rs.) Machine 3 (Rs.)
Initial investment required 3,00,000 3,00,000 3,00,000
Estimated annual sales 5,00,000 4,00,000 4,50,000
Cost of production [estimated]: -
Direct materials 40,000 50,000 48,000
Direct labour 50,000 30,000 36,000
Factory overheads 60,000 50,000 58,000
Administration costs 20,000 10,000 15,000
Selling and distribution costs 10,000 10,000 10,000

The economic life of machine 1 is 2 years, while it is 3 years for the other two. The scrap values are
Rs.40,000, Rs 25,000 and Rs 30,000 respectively. You are required to find out the most profitable
investment based on ‘Payback Method’

22.
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An oil company proposes to install a pipeline for transport of crude from wells to refinery.
Investments and operating costs of the pipeline vary for different sizes of pipeline [diameter]. The
following details have been conducted;
Pipeline Diameter (inches) 3 4 5 6 7
Investment required (in Rs. Lakhs) 16 24 36 64 150
Annual Savings before Depreciation (in Rs. Lakhs) 5 8 15 30 50
The estimated life of the installation is 10 year. The tax rate is 50% there is no salvage value and
straight-line rate of depreciation is followed;
Calculate the net savings after tax and cash flow generation and recommend therefrom, the largest
pipeline to be installed, if the company desires a 15% post tax return. Also, indicate which pipeline
will have the shortest payback.

23.
Project M
Annual Cash inflow: Rs. 40,000
Life: 4 years
IRR: 15%
Profitability index [PI]: 1.064
Salvage Value: 0
Find: NPV, Cost of Capital, Payback period, Initial Investment
Given below is the table of Discounting factors:
15% 14% 13% 12%
Discount factor
1 Year 0.869 0.877 0.885 0.893
2 Year 0.756 0.769 0.783 0.797
3 Year 0.658 0.675 0.693 0.712
4 Year 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038

24.
A housewife is looking at ways of producing domestic hot water and considers two possibilities –an
electric immersion heater having an installation of cost of Rs.160 and estimated annual electric
charges of Rs.200, and a gas boiler with an installation cost of Rs.760 with annual fuel bills of
Rs.80. Assuming yourself as a consultant to this cost-conscious housewife advise her suitably by
comparing two systems on the basis of [1] total expenditure and [2] present value over 5 years of
period. Take Cost of Capital at 9%.
What will be your recommendation if you consider both the equipments for 8 years period?

25.
A chemical company is considering replacing an existing machine with one costing Rs.65,000. The
existing machine was originally purchased two years ago for Rs. 28,000 and is being depreciated by
the straight-line method over its seven-year life period. It can currently be sold for Rs.30,000 with
no removal costs. The new machine would cost Rs. 10,000 to install and would be depreciate over
five years. The management believes that the new machine would have a salvage value of Rs.5,000
at the end of year 5. The management also estimates an increase in net working capital requirement
of Rs.10,000 as a result of expanded operations with the new machine. The firm is taxed at the rate
of 50%. The company’s expected after-tax profits (in Rs.Lakhs) for next 5 years with existing
machine and with new machine are given as follows:
Year Existing New Machine

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 Machine
1 2 2.16
2 1.5 1.5
3 1.8 2
4 2.1 2.4
5 2.2 2.3
If the company’s cost of capital is 15%, determine whether the new machine should be purchased.

26.
Jupiter Inc. is considering a project that requires an initial investment of $500,000. Sales will
amount to $300,000 in the first year, and are expected to increase by 3% every year. Variable cash
operating expenses are expected to equal 50% of sales each year, while fixed cash operating
expenses will be $25,000 a year. The project will be depreciated on a straight‐line basis to zero over
its 5‐year useful life. The company’s marginal tax rate and the required rate of return are 40% and
10%, respectively. Compute NPV and advise on selection of the project.

27.
Trytonic Ltd. is considering a new project for manufacture of project video games involving a
capital expenditure of Rs. 600 Lakhs and working capital of Rs.150 lakhs. The capacity of the plants
for an annual production of 12 lakh units and capacity utilization during 6-year 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 product is expected to Rs. 200 netting a contribution of 40 percent.
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 lakhs
respectively. The average rate of depreciation for tax purpose is 33.33% on the capital assets. The
rate of income tax may be taken at 35%. The cost of capital is 15%
At end of the third year an additional investment of Rs. 100 lakhs 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 tax laws with regard to balancing
charge may be ignored. As a financial consultant what recommendation on the financial viability of
the project would you make to the Trytonic Ltd.

28.
Modern Electronic wants to take up a new project of the manufacture if an electronic device which
has good market further details are given below:
 Cost (in Rs. lakhs) of the project as estimated:
- Land: 2.00 [will be incurred at the beginning of year 1]
- Building: 3.00 [will incurred at the end of year 1]
- Machinery: 10.00 [will be incurred at the end of year 2]
- Working capital: 5.00 [will incurred at the Beginning of year 3]

 The project will go into production from the beginning of years 3 and will be operational for
a period of 5 years. The annual working results (in Rs. lakhs) are estimated as follows:
Sales: 20.00

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 Variable cost: 8.00
Fixed cost [excluding depreciation]: 4.00
 Depreciation of assets: 2.00
 At the end of the operational period, it is expected that the fixed assets can be sold for Rs. 5
Lakhs [ without any profit]
 Cost of capital of the firm is 10 % Applicable tax rate is 50%
You are required to evaluate the proposal by working out the net present value and advise the firm.

29.
B Ltd. is considering whether to set up a division in order to manufacture a new product A. The
following statement has been prepared showing the projected profitability per unit of the new
product: Rs.
Selling price: 22.0
Less:
Direct labour [ 2 hrs. @ Rs. 2.50 per hrs.] 5.00
Material [ 3 KG @ Rs.1.50 per kg] 4.50
Overheads 11.50
Total 21.0
Net profit per unit 1.0

A feasibility study, recently undertaken at a cost of Rs. 50,000 suggest that a selling price of Rs. 22
per unit should be set. At this price it is expected that 10,000 units of A would be sold each year for
5 years.

Over heads per unit have been calculated as follows Rs.

Variable overheads 2.50
Rent [note 1: Rs. 8,000/10,000 units] 0.80
Managers salary [note2: Rs. 7,000/10,000 units] 0.70
Depreciation [note 3: Rs. 50,000/10,000 units] 5.00
Head office costs [note 4: 2 hrs. @ Rs 1.25 per hrs.] 2.50
11.50

Notes:
1. Product A would be manufactured in a factory rented specially for the purpose. Annual
rental would be Rs. 8,000 payable only for as long as the factory was occupied.
2. A manager would be employed to supervise production of product A at a salary of Rs. 7,000
P.a. The manager is at present employed by the B Ltd. But is due to retire in the near future
on an annual pension of Rs.2,000, payable by the company. If he continued to be employed,
his pension would not be paid during the period of his employment. His subsequent pension
rights would not be affected.
3. Manufacture of the product A would require a specialist machine costing Rs.2,50,000. The
machine would be capable of producing product A for an indefinite period, although due to
its specialized nature, it would not have any resale or scrap value when the production of
product A ceased. It is the policy of B Ltd. To provide depreciation on all fixed asset using
straight line method. The annual charge of Rs.50,000 for the new machine is based on a life
of five years, equal to the period which product A are expected to be produced.
4. B Ltd. allocates its head office fixed costs to all products at the rate of Rs.1.25 per direct
labour hour. Total head office fixed costs would not be affected by the introduction of the
product A to the company’s range of products.

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The costs of capital of B Ltd is estimated at 5 % p.a. in real terms and you may assume that all costs
and prices given above will remain constant in real terms. All cash flows would arise at the end of
each year. With the exception of the cost of the machine which would be payable immediately.
The management of B Ltd is very confident about the accuracy of all the estimates given above,
with the exception of those relating to product life, the annual sales, volume and material cost per
unit of product A.
You are required to decide whether B Ltd. should proceed with manufacture of the product A.

30.
Lawton Enterprises is evaluating a project with the following characteristics:
a. Fixed capital investment is $2,000,000.
b. The project has an expected six-year life.
c. The initial investment in net working capital is $200,000. At the end of each year, net
working capital must be increased so that the cumulative investment in net working capital is
one-sixth of the next year’s projected sales.
d. The fixed capital is depreciated 30 percent in Year 1, 35 percent in Year 2, 20 percent in
Year 3, 10 percent in Year 4, 5 percent in Year 5, and 0 percent in Year 6.
e. Sales are $1,200,000 in Year 1. They grow at a 25 percent annual rate for the next two years,
and then grow at a 10 percent annual rate for the last three years.
f. Fixed cash operating expenses are $150,000 for Years 1–3 and $130,000 for Years 4–6.
g. Variable cash operating expenses are 40 percent of sales in Year 1, 39 percent of sales in
Year 2, and 38 percent in Years 3–6.
h. Lawton’ s marginal tax rate is 30 percent.
i. Lawton will sell its fixed capital investments for $150,000 when the project terminates and
recapture its cumulative investment in net working capital. Income taxes will be paid on any
gains.
j. The project’s required rate of return is 12 percent.
k. Calculate NPV

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