Chapter-3: Project Selection Problems

Problems to be solved (Profitability / Capital Budgeting Techniques)

Problem: 1
You are considering a project costing Tk. 60000 with estimated useful life of 5 years (using the
straight –line depreciation method). Expected cash flows before depreciation (EBDT) over next
five years are as follows:

Year EBDT
1 Tk.15000
2 14000
3 16000
4 18000
5 20000

Assuming 50% tax rate. Calculate i) Pay back Period (PBP) ii) Net Present value (NPV) of the
project and comment on it (when interest rate is 12%)

Solution-1:
Project costing Tk. 60000
Depreciation = 60000/5 =12000 per year

Pay Back Period:

Uncovered cost at start of
year
= Year before full recovery +
Cash flow during year
= 3 + (15000/18000)
= 3.83 years

Dr. Md Hasan Uddin, Professor. PSTU Page 1

Pay Back Period:
Uncovered cost at start of
year
= Year before full recovery +
Cash flow during year
= 4 + (4500/15000)
= 4.28 years

Year EBDT Dep EAD Tax EAT NCF= EAT +Dep Cumulative NCF Full Year
1 Tk.15000 12000 3000 1500 1500 13500 13500 1
2 14000 12000 2000 1000 1000 13000 26500 2
3 16000 12000 4000 2000 2000 14000 40500 3
4 18000 12000 6000 3000 3000 15000 55500 4
5 20000 12000 8000 4000 4000 16000

Net Present Value:

Calculation of Net cash flows
Year EBDT Dep. EBT Tax CFAT= Net PVF PV of NCF
= EBDT - Dep (50% 0f EBT) EBT- Cash (12%) = NCF
Tax Flow = x PVF
CFAT +
Dep.
1 Tk.15000 12000 3000 1500 1500 13500 0.8929 11607.7
2 14000 12000 2000 1000 1000 13000 0.7972 10363.6
3 16000 12000 4000 2000 2000 14000 0.7118 9965.2
4 18000 12000 6000 3000 3000 15000 0.6355 9532.5
5 20000 12000 8000 4000 4000 16000 0.5674 9978.6
Total PV of NCF = 51447.6

NPV = Total PV of NCFs - PV of Cash out flows

= 51447.6 – 60000

= - 8552.4

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Problem: 2
Tranter, Inc. is considering a project that would have a ten-year life and would require a
$1,500,000 investment in equipment. At the end of ten years, the project would terminate and the
equipment would have no salvage value. The project would provide net operating income each
year as follows:

$2,000,00
Sales........................................................... 0
Less variable expenses............................... 1,100,000
Contribution margin................................... 900,000
Less fixed expenses:
$500,00
Fixed out-of-pocket cash expenses......... 0
Depreciation............................................ 150,000 650,000
Net operating income................................. $ 250,000

All of the above items, except for depreciation, represent cash flows. The company's required
rate of return is 12%.
Requirement:
a. Compute the project's net present value.
b. Compute the project's internal rate of return to the nearest whole percent.
c. Compute the project's payback period.

Solution-2:
ten-year life
$1,500,000 investment
no salvage value
Depreciation........................................... 150,000
Net operating income 250,000 per year
required rate of return is 12%.

a. Compute the project's net present value.

Cash Flow per year = Net operating income + Dep

= 250,000 + 150,000 = 4,00,000

0….1…..2…..3…..4…..5….6….7….8…..9…..10

PV of Total Cash flow = PMT (PVIFA,10 years,12%)

= 4,00,000 (5.6502)
= 22,60,080
Net Present Value = Total PV of CFs - PV of Cash out flows
= 22,60,080 - 1,500,000

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 = 7,60,080

b. Compute the project's internal rate of return to the nearest whole percent.

IRR = ? ; NPV= 0

At the rate of 12% - NPV (12%) = 7,60,080

At the rate of 25% NPV(25%)

PV of Total Cash flow = PMT (PVIFA,10 years,25%)

= 4,00,000 (3.57)
= 14,28000
Net Present Value = Total PV of CFs - PV of Cash out flows
= 14,28000 - 1,500,000 = -72,000

IRR =

IRR = L+ C / D (H - L)
760080
×(0 . 25−. 12)
IRR= 0.12+760080−(−72000)
= 0.2387
= 23.87%

Pay Back Period

Payback period = Cash outlays (investment) / Annual cash flows

= 1500000 / 400000
= 3.75 years

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Problem: 3
Jamuna Company is considering purchasing one of the two machines. Particular for the both
machines are given below:
Particulars Machine- A Machine-B
Purchase price $ 80000 $ 100000
Freight and carriage 20000 25000
Installation charge 25000 25000
Working capital requirement 50000 ………
Estimated life 5 years 5 years
Purchase Price 105000 150000

Annual cash flow of the two machines are given below:

Year Machine-A Machine-B

1 $ 50000 $ 60000
2 40000 60000
3 30000 60000
4 20000 60000
5 10000 60000
15

The company pays tax @ 50% and expects 7% return on its investment. The first Machine
(Machine-A) should be depreciated on sum of the year digit method and Machine B on
straight line basis.

Sum of the year digit method = Matchine - A

Year Description Depreciation
1 (5/15) 105000
2 (4/15) 105000
3 (3/15) 105000
4 (2/15) 105000
5 (1/15) 105000
15

Straight line basis = (Purchase Price – Salvage Value) / Economic Life

Apply capital budgeting techniques and advice Jamuna Company which machine should be
purchased?
PBP - Decision
ARR - Decision
NPV- Decision
IRR- Decision
BCR- Decision

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IRR (M-A)

Description 1 2 3 4 5
EBDT
-D
EBT
-T
EAT
Net Cash flow (EAT+Dep.)
X PV factor @ 7%
PV of Cash inflow x x x x x
Summation of PV of Cash inflow xxxxx
Less Cash out flow
NPV (lower rate) @ 7%

EAT
Net Cash flow
X PV factor @ 15%
PV of Cash inflow x x x x x
Summation of PV of Cash inflow xxxxx
Less Cash out flow
NPV (higher rate ) @ 15%
-

Problem: 4
SAF Builders, a real estate developer in Chittagong, contemplating to avail one of the
two projects, project Karnafuli and Project Shangu.
You are a financial analyst and you are given the following information relating to project
Karnafuli -

NPV PBP IRR BCR

$4500 3.75 years 9% 1.1%

You are also given the following information of project Shangu -

Year Capital Operating cost(other Revenue
than depreciation)
0 $ 100000 ………………. ………………..
1 $6,000 $47,000
2 7000 49000
3 8500 51500
4 9000 55000

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The useful life of project Shangu is 4 years and the fixed assets be depreciated as per straight line
method. At the end of the project Shangu the fixed assets of the project be sold for $ 20000. The
corporate tax rate is 40% in the Bangladesh. SAF calculated its overall cost of capital is 10%.

As a financial analyst you are requested to advice SAF regarding one project selection between
Project Karnafuli and Project Shangu

Problem: 5
Below are the cash flows information related to two investment projects.

Project X Project Y
A Investment cost Tk. 50, 000 Tk. 50, 000
B Net cash Inflows
Year 1 Tk. 15000 Tk. 18000
Year 2 Tk. 15000 Tk. 20000
Year 3 Tk. 15000 Tk. 21000
Year 4 Tk. 15000 Tk. 20000

Compute PBP, NPV BCR and IRR (using 10% discount rate).

Problem: 6
Assume a project of 5 years life with the following cost and benefit characteristics

Year Capital cost Operating cost ( Other Revenue(Tk)

(Tk) than depreciation (Tk)
0 Tk. 1,00,000 - -
1 - 5000 35000
2 - 7500 40000
3 - 8000 42000
4 - 8500 45000
5 - 9000 46000

The fixed asset would have a 5 year useful life and be depreciated using 20% straight line rate.
At the end of the project the fixed assets of the project could be sold Tk. 20, 000. The tax rate is
40% and cost of fund is 10%. Calculate the PBP, NPV, BCR and IRR.

Problem: 7
A company is considering the possibility of manufacturing a particular component which at
present is being bought from outside. The manufacture of the component would call for an
investment of Tk. 7,50,000 in a new machine besides an additional investment of Tk. 50,000 in
working capital. The life of the machine would be 10 years with a salvage value of Tk. 50,000.

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The estimated saving (before tax) would be Tk. 1,80,000 p.a. the income tax rate is 50%. The
company’s required rate of return is 10%. Depreciation is considered on straight line method.

Problem: 8
The management of a firm is considering an investment project costing Tk. 1,50,000 that will
have a scrap value of Tk. 10,000 at the end of its 5-year life. Transportation cost are
expected to be Tk. 5000 and installation charges are expected to be Tk. 25,000. The project is
accepted, a spare parts inventory of Tk. 10,000 must also be acquired. It is estimated that the
spare parts will have and estimated scarp value after 5 years @60% of their initial costs.

The annual revenue from the project is expected to be Tk. 1,70,000 and annual labour,
material and maintenance expenses are estimated to be Tk. 15000, Tk. 50,000 and Tk. 5,000
respectively. The depreciation and taxes for each of the five years will be:

Year Depreciation( Taka) Taxes (Taka)

1 72,000 11,200
2 43,200 22,720
3 32,400 27,040
4 21,600 31,360
5 800 39,680

Calculate net cash flows for each year, NPV and cost of the project. (Cut of rate 12%).

Solution -8:
Given Data:
project costing Tk. 1,50,000
scrap value of project Tk. 10,000 at the end of its 5-year life.
5-year life.
Transportation cost are expected to be Tk. 5000
installation charges are expected to be Tk. 25,000.
spare parts inventory of Tk. 10,000
spare parts scarp value after 5 years @60% of their initial costs (Tk. 10,000) = Tk. 6000
annual revenue Tk. 1,70,000

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annual labour, Tk. 15000
annual material Tk. 50,000
annual maintenance expenses Tk. 5,000

depreciation and taxes

Year Depreciation( Taka) Taxes (Taka)
1 72,000 11,200
2 43,200 22,720
3 32,400 27,040
4 21,600 31,360
5 800 39,680
Discount rate 12%

Calculation of net cash flows for each year,

Description 1 2 3 4 5
Revenue 1,70,000 1,70,000 1,70,000 1,70,000 1,70,000
Less: labor 15000 15000 15000 15000 15000
1,55000 1,55000 1,55000 1,55000 1,55000
Less: material 50,000 50,000 50,000 50,000 50,000
1,05000 1,05000 1,05000 1,05000 1,05000
Less: maintenance expenses 5,000 5,000 5,000 5,000 5,000
EBDT 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Less: Depreciation 72,000 43,200 32,400 21,600 800

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 EBT 28,000 56,800 77,600 78,400 99,200
Less: Tax 11,200 22,720 27,040 31,360 39,680
EAT 16,800 34,080 50,560 47,040 59,520
Add: Depreciation 72,000 43,200 32,400 21,600 800
Add: Scrap Value of Project - - - - 10,000
Costing
Add: Scrap Value of Spare - - - - 6000
Parts
Net cash flows (NCF) 88,800 77,280 82,960 68,640 76,320
PV Factor @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674
PV of NCF 79,290 61,608 59,051 43,621 43,304
Total PV of NCF 2,86,874
Cost of The Project:
Project costing 1,50,000
Add: Transportation cost 5000
Add: Installation charges 25,000
Add: spare parts inventory 10,000
Total Cost of The Project: Tk. 1,90,000
NPV
Total PV of NCF – PV of Cost of The Project
2,86,874 - 1,90,000 = Tk. 96,874

Solved Problem:
Problem-1
Problem-2
Problem-10

Assignment: problem 1 to problem 8

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