INVESTMENT CRITERIA

Q1. Megatronics Limited is evaluating a project whose expected cash flows are as follows:

Year Cash flow

0 -500,000
1 100,000
2 200,000
3 300,000
4 100,000
(i) What is the NPV of the project if the cost of capital is 10 percent?
(ii) What is the IRR of the project?
(iii) What is the Modified IRR (MIRR) of the project if the reinvestment rate is 13%?
(iv) What is the Modified NPV if the reinvestment rate is 13%?
(v) What is the unrecovered investment balance at the end of year 2 at IRR?
(vi) What is the PI @10%?

Q2. An equipment costs Rs.10,00,000 and lasts for 6 years. What should be the minimum annual cash inflow to
justify the purchase of the equipment? Assume that the cost of capital is 12 percent.

Q3.The cash flow stream of a project is given below

Year Cash flow
0 -9,000
1 0
2 10,000
3 2,714

What is the unrecovered cash balance at the end of year 2?

Q4. What is the internal rate of return of an investment which involves a current outlay of Rs. 250,000 and
results in an annual cash inflow of Rs. 80,000 for 8 years?

Q5. How much can be paid for a machine which brings in an annual cash inflow of Rs. 50,000 for 8 years?
Assume that the discount rate is 15 percent?

Q6. A company is considering two mutually exclusive investments, Project X and Project Y. The expected cash
flows of these projects are as follows :
Year Project X Project Y
0 (5,000) (2,500)
1 (2,500) 800
2 300 1,000
3 2,000 2,000
4 5,000 2,000
5 6,000 1,500

Which project should it choose if the cost of capital is 15 percent?

Q7. Maharaja Associates is considering a project which requires an initial outlay of Rs.100 million. The cost of
capital is 15 percent and the expected cash inflows from these projects are:

Year 1 2 3 4 5
Cash flow in Rs. Million 20 30 30 50 70

(a) What is the payback period?

(b) What is the discounted payback period?
(c) What is the Benefit Cost Ratio?

Q8. The following financial information is available about a project:

(Rs. in million)
Year 1 2 3 4 5 6 7 8
Investment 3.60 3.15 2.70 2.25 1.80 1.35 0.90 0.45
Depreciation 0.45 0.45 0.45 0.45 0.45 0.45 0.45 0.45
Income before
interest and taxes 0.90 0.95 0.80 0.85 0.90 0.70 0.85 0.80
Interest 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30
Income before tax 0.60 0.65 0.50 0.55 0.60 0.40 0.55 0.50
Tax 0.12 0.13 0.10 0.11 0.12 0.08 0.11 0.10
Income after tax 0.48 0.52 0.40 0.44 0.48 0.32 0.44 0.40

Compute the accounting rate of return.

Q9. An iron ore company is considering investing in a new processing facility. The company extracts ore from
an open pit mine. During a year, 1,00,000 tonnes of ore is extracted. If the output from the extraction process is
sold immediately upon removal of dirt, rocks and other impurities, a price of Rs 1,000 per ton of ore can be
obtained. The company has estimated that its extraction costs amount to 70 per cent of the net realisable value
of the ore.
As an alternative to selling all the ore at Rs 1,000 per tonne, it is possible to process further 25 per cent of the
output. The additional cash cost of further processing would be Rs 100 per ton. The proposed ore would yield
80 per cent final output, and can be sold at Rs 1,600 per ton
For additional processing, the company would have to instal equipment costing Rs.100 lakh. The equipment is
subject to 25 per cent depreciation per annum on reducing balance (WDV) basis/method. It is expected to have
useful life of 5 years. Additional working capital requirement is estimated at Rs.10 lakh. The company’s cut-off
rate for such investments is 15 per cent. Corporate tax rate is 35 per cent.
Assuming there is no other plant and machinery subject to 25 per cent depreciation, should the company instal
the equipment if (a) the expected salvage is Rs 10 lakh and (b) there would be no salvage value at the end of
year 5.

Q10. Royal Industries Ltd is considering the replacement of one of its moulding machines. The existing
machine is in good operating condition, but is smaller than required if the firm is to expand its operations. It is 4
years old, has a current salvage value of Rs 2,00,000 and a remaining life of 6 years. The machine was initially
purchased for Rs 10 lakh and is being depreciated at 25 per cent on the basis of written down value method.
The new machine will cost Rs 15 lakh and will be subject to the same method as well as the same rate of
depreciation. It is expected to have a useful life of 6 years, salvage value of Rs 1,50,000 at the sixth year end.
The management anticipates that with the expanded operations, there will be a need of an additional net
working capital of Rs 1 lakh. The new machine will allow the firm to expand current operations and thereby
increase annual revenues by Rs 5,00,000; variable cost to volume ratio is 30 per cent. Fixed costs (excluding
depreciation) are likely to remain unchanged. The corporate tax rate is 35 per cent. Its cost of capital is 10 per
cent. The company has several machines in the block of 25 per cent depreciation
Should the company replace its existing machine? What course of action would you suggest, if there is no
salvage value?

Q11. A company is considering two mutually exclusive proposals, X and Y. Proposal X will require the
purchase of machine X, for Rs 1,50,000 with no salvage value but an increase in the level of working capital to
the tune of Rs 50,000 over its life. The project will generate additional sales of Rs 1,30,000 and require cash
expenses of Rs 30,000 in each of the 5 years of its life. Proposal Y will require the purchase of machine Y for
Rs 2,50,000 with no salvage value and additional working capital of Rs 70,000. The project is expected to
generate additional sales of Rs 2,00,000 with cash expenses aggregating Rs 50,000.
Both the machines are subject to written down value method of depreciation at the rate of 25 per cent.
Assuming the company does not have any other asset in the block of 25 per cent; has 12 per cent cost of capital
and is subject to 35 per cent tax, advise which machine it should purchase? What course of action would you
suggest if Machine X and Machine Y have salvage values of Rs 10,000 and Rs 25,000 respectively?

Q12. Swastik Ltd, manufacturers of special purpose machine tools, have two divisions which are periodically
assisted by visiting teams of consultants. The management is worried about the steady increase of expenses in
this regard over the years. An analysis of the last year’s expenses reveals the following:
Consultant’s remuneration Rs 2,50,000
Travel & Conveyance Rs 1,50,000
Accomodation expenses Rs 6,00,000
Boarding charges Rs 2,00,000
Special allowances Rs 50,000
Rs 12,50,000
The management estimates accommodation expenses to increase by Rs 2,00,000 annually. As part of cost
reduction drive, Swastik Ltd is proposing to construct a consultancy centre to take care of the accommodation
requirements of the consultants. This centre will additionally save the company Rs 50,000 in boarding charges
and Rs 2,00,000 in the cost of executive training programme hitherto conducted outside the company’s
premises, every year.
The following details are available regarding the construction and maintenance of the new centre.
(a) Land: at a cost of Rs 8,00,000 already owned by the company, will be used.
(b) Construction: Rs 15,00,000 including special furnishing.
(c) Cost of annual maintenance: Rs 1,50,000.
(d) Construction cost will be written off (at a uniform rate) over 5 years, being the useful life.
Assuming that the write-off of construction cost as aforesaid will be accepted for tax purposes, that the rate of
tax will be 35 per cent and that the desired rate of return is 15 per cent, you are required to analyse the
feasibility of the proposal and make recommendations.

Q13. The United Petroleum Ltd (UPL) has a retail outlet of petrol, diesel and petroleum products.
Presently, it has two pumps exclusively for petrol, one for non-lead petrol and one for diesel. Free air filling is
carried out for vehicles buying fuel from the outlet. The pumps have a useful life of 10 years with no salvage
value as the underground tank will be completely corroded and unfit for reuse.
The UPL sells petrol and diesel @ Rs 23 and Rs 10 per litre respectively. The existing annual sale is petrol, 5
lakh litres, and diesel, 2 lakh litres. Its earnings are 4 per cent as commission on sales.
Due to a manifold increase in traffic, the existing pumps are not able to meet the demand during peak hours.
The UPL is contemplating installation of additional pumps for diesel and petrol at a cost of Rs 10,00,000
together with additional working capital of Rs 5,00,000. The additional sales of petrol and diesel are expected to
be 2 lakh litres and 1 lakh litres per annum respectively. As a result of the installation of the new pump, the
operating cost would increase by Rs 24,000 annually by way of salary of the pump operator.
Other yearly associated additional costs are estimated to be: insurance @ 1 per cent of the cost of the pump,
maintenance cost, Rs 12,000 and power costs, Rs 13,000.
United Petroleum Ltd pays 35 per cent on tax on its income. Depreciation will be on straight line basis and the
same is allowed for tax purposes.
The management of UPL seeks your advice on the financial viability of the expansion proposal.
Prepare a report for its consideration, assuming 12 per cent required rate of return.

Q14. Band-Box is considering the purchase of a new wash and dry equipment in order to expand its operations.
Two types of options are available: a low-speed system (LSS) with a Rs 20,000 initial cost and a
high speed system (HSS) with an initial cost of Rs 30,000. Each system has a fifteen year life and no salvage
value. The net cash flows after taxes (CFAT) associated with each investment proposal are:
Low speed system (LSS) High speed system (HSS)
CFAT for years 1 through 15 Rs 4,000 Rs 6,000
Which speed system should be chosen by Band-Box, assuming 14 per cent cost of capital

Q15. Senior executives of Laxmi Rice Mill Ltd have been considering the proposal to replace the existing coal-
fired furnace in the paddy boiling section by a new furnace is cyclone type husk-fired furnace. The capital cost
of the new furnace is expected to be Rs 1 lakh. It will have useful life of 10 years at the end of which period its
residual value will be negligible. The present furnace has a book value of Rs 15,000 and can be used for another
10 years with only minor repairs. If scrapped now, it can fetch Rs 10,000 but it cannot fetch any amount if
scrapped after ten more years of use.
The basic advantage of the new furnace is that it does not depend on the coal whose supplies are becoming
increasingly erratic in recent years. On a conservative estimate, the new furnace will result in a saving of Rs
25,000 per annum on account of eliminated coal cost. However, the cost of electricity and other operating
expenses are likely to go up by Rs 8,000 and Rs 4,000 per annum respectively.
The husk which results as a by-product during the normal milling operations at 3,000 metric ton of paddy
milled per year is considered adequate for operating the new furnace. On a average, for every metric ton of
paddy milled, the husk content is 20 per cent. At present, the husk resulting during the milling operations is sold
at a price of Rs 50 per metric ton. Once the new furnace is installed, the husk will be diverted for own use.
‘White Ash’ which constitutes about 5 percent of the husk burnt in the new furnace, will be collected in a
separate ash-pit as it has considerable demand in the refractory industry. It can be sold very easily at a price of
Rs 1,500 per metric ton.
The new furnace will require a motor of 15 HP, whose cost is not included in Rs 1 lakh, the capital cost of the
furnace. A 15 HP motor is lying idle with the polishing section of the Mill which can fetch an amount of Rs
3,000 on sale. It has a net book value of Rs 5,000. The motor can be used for the new furnace. At the end of the
ten years, it can be scrapped at zero residual value.
All the assets of the company are in the same block. Depreciation will be on straight line basis and the same is
assumed to be acceptable for tax purpose as well. Applicable tax rate is 35 per cent and cost of capital is 12 per
cent.
Required:
(i) Formulate the incremental net after-tax cash flows associated with the replacement project. (ii) Also
calculate the project’s NPV. (iii) Give your recommendation

Q16. Welcome Limited is considering the manufacture of a new product. They have prepared the following
estimate of profit in the first year of manufacture:
Sales, 9,000 units @ Rs 32 Rs 2,88,000
Cost of goods sold:
Labour 40,000 hours @ Rs 3.50 per hour Rs 1,40,000
Materials and other variable costs 65,000
Depreciation 45,000
2,50,000
Less: Closing stock 25,000 2,25,000
Net profit 63,000
The product is expected to have a life of four years. Annual sales volume is expected to be constant over the
period at 9,000 units. Production which was estimated at 10,000 units in the first year would be only 9,000 units
each in year two and three and 8,000 units in year four. Debtors at the end of each year would be 20 per cent of
sales during the year; creditors would be 10 per cent of materials and other variable costs.
If sales differed from the forecast level, stocks would be adjusted in proportion.
Depreciation relates to machinery which would be purchased especially for the manufacture of the new product
and is calculated on the straight line basis assuming that the machinery would last for four years and have no
terminal scrap value. Fixed costs are included in labour cost.
There is high level of confidence concerning the accuracy of all the above estimates except the annual sales
volume. Cost of capital is 20 per cent per annum. You may assume that debtors are realized and creditors are
paid in the following year. No changes in the prices of inputs or outputs are expected over the next four years.
You are required to show whether the manufacture of the new product is worthwhile. Ignore taxes.

Q17. Nine Gems Ltd has just installed Machine-R at a cost of Rs 2,00,000. The machine has a five year life
with no residual value. The annual volume of production is estimated at 1,50,000 units, which can be sold at Rs
6 per unit. Annual operating costs are estimated at Rs 2,00,000 (excluding depreciation) at this output level.
Fixed costs are estimated at Rs 3 per unit for the same level of production.
Nine Gems Ltd has just come across another model called Machine-S capable of giving the same output at an
annual operating cost of Rs 1,80,000 (exclusive of depreciation). There will be no change in fixed costs. Capital
cost of this machine is Rs 2,50,000 and the estimated life is for 5 years with no residual value.
The company has an offer for sale of Machine-R at Rs 1,00,000. The cost of dismantling and removal will be
Rs 30,000. As the company has not yet commenced operations, it wants to sell Machine-R and purchase
Machine-S.
Nine Gems Ltd will be a zero-tax company, for seven years in view of several incentives and allowances
available. The cost of capital may be assumed at 14 per cent.
(i) Advise whether the company should opt for replacement.
(ii) Will there be any change in your view if Machine-R has not been installed but the company is in the process
of selecting one or the other machine?