Unit 4

Capital Budgeting and Capital Structure to Decisions

Problem 1

Assume that a project requires an outlay of Rs. 50,000 and yields annual cash inflow of
Rs. 12,500 for 7 years. Calculate the payback period for the project.

Problem 2

Suppose a project requires a cash outlay of Rs. 20,000 and generates cash inflows of Rs.
8,000; Rs. 7,000; Rs. 4,000 and Rs. 3,000 during the next 4 years. What is the project's
payback?

Problem 3

Projects P and Q involve the same outlay of Rs. 4,000 each. The opportunity cost of
capital may be assumed as 10 per cent. The cash flows of the projects are shown in the
below table. Rank the project based on Pay-back period method and discounted pay-
back period.

Year Project P Project Q

1 3,000 0

2 1,000 4,000

3 1,000 1,000

4 1,000 2,000

Problem 4

There are two projects X and Y. Each project requires an investment of Rs. 2,00,000.
Rank the project according to pay- back period.
 Profit before Depreciation and after Tax

Year Project P Project Q

1 10,000 20,000

2 20,000 40,000

3 40,000 60,000

4 50,000 80,000

5 80,000 -

Problem 5

A project costs Rs. 5,00,000 and yields annually a profit of Rs. 80,000 after depreciation
@12% per annum but before tax of 50%. Calculate the pay-back period.

Problem 6

From the following details relating to a project, calculate the pay-back period using-

a.) Traditional method and

b.) Discounted pay-back method

Cost of Project Rs. 10,000

Life 5 Years
Cost of Capital 10%
Year Net cash inflow PV of Rs.1 @10%

1 4,000 0.909

2 3,000 0.826

3 4,000 0.751

4 2,000 0.683

5 4,000 0.621

Problem 7

A company is considering a project having an initial outlay of Rs. 10,00,000. Expected

life of the machine is 5 years and no salvage is expected. Applicable tax rate is 40%.
Depreciation is charged under the straight line method.
Profit before tax and depreciation is given below:

Year Profit before tax and PV factor @10%

depreciation

1 2,00,000 0.909

2 2,15,000 0.826

3 2,55,000 0.751

4 2,70,000 0.683

5 4,10,000 0.621

Calculate pay-back period and discounted pay-back period.

Answer:

Problem 8

A project will cost Rs. 40,000. Its stream of earnings before depreciation, interest and
taxes (EBDIT) during the first year through five years is expected to be Rs. 10,000; Rs.
12,000; Rs. 14,000; Rs. 16,000 and Rs. 20,000. Assume a 50% tax rate and depreciation
on a straight-line basis. Calculate the project’s accounting rate of return.

Problem 9

A project requires an investment of Rs. 5,00,000 and has scrap value of Rs. 20,000 after
5 years. It is expected to yield profits after depreciation & taxes during the 5 years
amounting to Rs. 40,000; Rs. 60,000; Rs. 70,000; Rs. 50,000 & Rs. 20,000. Calculate the
Average Rate of Return.

Problem 10

A company intends to invest Rs. 10,00,000 in a project having a life of 4 years. The cash
inflows from the project are expected to be Rs. 3,00,000; Rs. 4,20,000; Rs. 4,00,000 and
Rs. 3,30,000 before charging depreciation and tax. Calculate the ARR assuming tax rate
@30% and straight line method of depreciation.

Problem 11

A Company wants to invest in a new set of vehicles for the business. The vehicles cost
Rs. 3,50,000 and would increase the company’s annual revenue by Rs. 100,000, as well
 as the company’s annual expenses by Rs. 10,000. The vehicles are estimated to have a
useful shelf life of 20 years, with no salvage value. calculate the ARR.

Problem 12

Assume that project X costs Rs. 2,500 now and is expected to generate year-end cash
inflows of Rs. 900; Rs. 800; Rs. 700; Rs. 600 and Rs. 500 in years 1 through 5. The
opportunity cost of the capital may be assumed to be 10 per cent. Calculate the net
present value of project X.

Project 13

A company is considering a proposal for investment of Rs. 5,00,000 which is expected to

generate cash inflows for 6 years as under-

Year Net Cash flow PV factor@15% per annum

1 Nil 0.870

2 1,00,000 0.756

3 1,60,000 0.658

4 2,40,000 0.572

5 3,00,000 0.497

6 6,00,000 0.432

The company’s cost of capital is 15%. Advise the company on desirability of accepting
the proposal.

Problem 14

Calculate the NPV of the two projects & suggest which project should be accepted
assuming a discount rate of 10%

Project X Project Y

Initial Investment 20,000 30,000

Estimated life 5 years 5 years

Scrap Value Rs. 1,000 Rs. 2,000

The profit before depreciation and after tax is as follows-

Year 1 2 3 4 5

Project X 5,000 10,000 10,000 3,000 2,000

Project Y 20,000 10,000 5,000 3,000 2,000

Problem 15

Determine the average rate of return and Pay-back period.

Project A B

Original cost 56,125 56,125

Additional investment in 5,000 6,000

working capital

Estimated life 5 Years 5 Years

Salvage Value 3,000 3,000

Tax Rate 25% 25%

Annual Income after depreciation & Tax is given in the following table. Depreciation is
charged on the straight Line Method.

Year A (Rs.) B (Rs.)

1 3,375 11,375

2 5,375 9,375

3 7,375 7,375

4 9,375 5,375

5 11,375 3,375
Problem 16

A company is considering the following investment project:

Projects Cash flows (Rs.)

C0 C1 C2 C3

A -10,000 10,000

B -10,000 7,500 7,500

C -10,000 12,000 4,000 12,000

D -10,000 10,000 3,000 3,000

a.) Rank the project according to each of the following methods:

(i) Payback period
(ii) NPV (Assuming discount rate of 10% and 15%)
(iii) IRR
b) Assuming the projects are independent, which one should be accepted? If the
projects are mutually exclusive, which project is the best?

Problem 17

A company is considering two mutually exclusive projects. Both require an initial cash
outlay of Rs. 10,000 each, and have a life of five years. The company’s required rate of
return is 10 per cent and pays tax at 50%. The projects will be depreciated on a straight-
line basis. The before taxes cash flows expected to be generated by the projects are as
follows:

Project Earnings before Depreciation, Interest and Tax (Rs.)

1 2 3 4 5

A 4,000 4,000 4,000 4,000 4,000

B 6,000 3,000 2,000 5,000 5,000

Calculate for each project- (1) Pay-back Period, (2) The average rate of return, (3) The
Net Present Value and Profitability Index, and (4) The Internal rate of Return

Which project should be accepted and why?

Project 18

A company is considering a proposal of installing drying equipment. The equipment

would involve a cash outlay of Rs. 600,000 and working capital of Rs. 80,000. The
expected life of the project is 6 years without salvage value. Assume that the company is
allowed to charge depreciation on a straight-line basis for tax purposes, and that the tax
rate is 50 per cent. The estimated before-tax cash flows (EBDIT) are given below:

Year Before-tax Cash flows (Rs. ‘000)

1 2 3 4 5 6

210 180 160 150 120 100

If the company’s opportunity cost of capital is 12 per cent, calculate the equipment’s Net
Present Value and Internal Rate of Return.

Problem 19

A company is considering an investment proposal to install new milling controls at a

cost of Rs. 50,000. The facility has a life expectancy of 5 years and no salvage value. The
tax rate is 35 per cent. Assume the firm uses straight line depreciation and the same is
allowed for tax purposes. The estimated cash flows before depreciation and tax (CFBT)
from the investment proposal are as follows:

Year CFBT

1 10,000

2 10,692

3 12,769

4 13,462

5 20,385

Compute the following-

a) Payback period

b) Average rate of return

c) Net Present value at 10 per cent discount rate

d) Profitability index at 10 per cent discount rate

e) Internal Rate of return

Problem 20

A plastic manufacturer has under consideration the proposal of production of high

quality plastic glasses. The necessary equipment to manufacture the glasses would cost
Rs.1 lakh and would last 5 years. The tax relevant rate of depreciation is 20 percent on
written down value. There is no other asset in this block. The expected salvage value is
Rs. 10,000. The glasses can be sold at Rs. 4 each. Regardless of the level of production,
the manufacturer will incur cash cost of Rs. 25,000 each year if the project is
undertaken. The variable costs are estimated at Rs. 2 per glass. The manufacturer
estimates it will sell about 75,000 glasses per year; the tax rate is 35 percent. Should the
proposed equipment be purchased? Assume 20 percent cost of capital and additional
working capital requirement, Rs. 50,000. Also assume that the firm would have
sufficient short-term capital gains in year 5.

Replacement Problems

1. A Company has a machine in current use. It was purchased for 1,60,000 & had a
projected life of 8 years with Rs 10000 salvage value. It has been depreciated at 25%
on WDV basis for 3 years to date & can be sold far Rs 30,000. A new machine can be
purchased at a cost of 2,60,000. It will have a 5 year life. Salvage value of Rs 10,000
& depreciated at 25%. It is estimated that the new machine will reduce labour
expenses by Rs. 15,000 per year & net working capital requirement by Rs 20,000.
Tax rate applicable is 35%. Assuming the required rate to be as 12%, determine
whether the new machine should be purchased?
2. A machine purchased 1 year ago has been depreciated to its current book value of Rs
50.000. The machine originally had a projected life of 10 years & zero salvage value.
A new machine will cost Rs 80000. Its installation cost is estimated to be Rs 20,000.
The technician estimates that there will be a reduction in the operating cast to Rs
30.000 per year for the next 16 years. The Old machine would be sold for Rs. 20,000.
The new machine will have a 6 years life with no salvage value; the tax rate
applicable is 35%. Assuming cost of capital at 10% and depreciation at 25%,
determine whether the existing machine should be replaced?
3. Royal Industries ltd is considering the replacement of one of its moulding machines.
The old machine is 5 years old and has a current salvage value of Rs 30,000 &
remaining depreciable life of 10 years. The machine was originally purchased for Rs
75000. It has been depreciated at Rs 5000 per year for tax purposes. The new
machine will cost Rs.150,000 & will be depreciated on a straight-line basis over 10
years with no salvage value. There will be a need for additional net working capital
of Rs 30.000. The new machine will allow firms to increase annual revenues to Rs
40000 & variable operating cost Rs 2,00,000 to 2,10,000. Tax rate is 35%, cost of
capital 10%. Should the company replace its existing machine assuming that the loss
of sale of existing machine can be claimed as short-term capital loss in the current
itself.
4. Avon Ltd is investigating the feasibility of manufacturing one of the components
needed for its finished product rather than purchasing it from an outside supplier.
Its present supplier has just announced that he intends to increase the price from Rs.
100 to Rs. 125 per unit. The equipment needed to make this product can be
purchased for Rs. 10 lakh, and is expected to have salvage value of Rs. 2,00,000 after
the expiry of the fifth year. Additional fixed costs (excluding depreciation) are
estimated to increase by Rs. 1,00,000 per year. The variable costs of manufacturing
 each component will be Rs. 30 per unit. The company is subject to a 35 per cent tax
rate and 15 per cent is the appropriate cost of capital for this project. The company
projects annual needs at 7,500 units per year for the 6-year period. The tax relevant
rate of depreciation is 25 per cent and there are no other assets in the 25 per cent
block. Advise the company whether it should continue buying from outside
suppliers, or start manufacturing on its own. Will your answer be different if the
requirement of the company is only 6,000 units per year? Assume the firm would
have sufficient short-term capital gains in year 6.
5. Avon Chemical Company Ltd. Is presently paying an outside firm Rs 1 per gallon to
dispose of the waste material resulting from its manufacturing operations. At
normal operating capacity the waste is about 40000 gallons per year. After spending
Rs. 40,000 on research, the company discovered that the waste could be sold for Rs.
15 per gallon if it was processed further. Additional processing would, however,
require an investment of Rs. 6,00,000 in new equipment, which would have an
estimated life of 5 years and no salvage value. Depreciation would be computed by
the reducing balance method @ 25 per cent. There are no other assets in the 25 per
cent block. Except for the costs incurred in advertising Rs. 20,000 per year, no
change in the present selling and administrative expenses is expected if the new
product is sold. The details of additional processing costs are as follows: variable -
Rs. 5 per gallon of waste put into process; fixed (excluding depreciation) Rs. 30,000
per year. In costing the new product, general factory overheads will be allocated at
the rate of Rs. 1 per gallon. There will be no losses in processing, and it is assumed
that all of the waste processed in a given year will be sold in that very year. Waste
that is not processed further will have to be disposed of at the present rate of Rs.1
per gallon. Estimates indicate that 30,000 gallons of the new product could be sold
each year. The management, confronted with the choice of disposing off the waste,
or processing it further and selling it, seeks your advice. Which alternative would
you recommend? Assume that the firm's cost of capital is 15 percent and it pays, on
an average, 35 per cent tax on its income. Assume the firm would have sufficient
short-term capital gains in year 5.