CAPITAL BUDGETING

Problem No.1
A Company is considering the replacement of its existing Machine which is obsolete and unable to
meet the rapidly rising demand for its Product. The Company is faced with two alternatives: to buy
Machine X which is similar to the Existing Machine or to go in for Machine Y which is more expensive
and has much greater capacity. The Cash Flows at the Present level of operation is under the two
alternatives are as under:
Particulars Machine x Machine Y
Rs. Rs.
Cost of Machine 5,00,000 8,00,000
Cash flow (years):
1 -- 2,00,000
2 1,00,000 2,80,000
3 4,00,000 3,20,000
4 2,80,000 3,40,000
5 2,80,000 3,00,000
The Company's Cost of Capital is 10%.
The finance manager tries to appraise the Machine by calculating the following:
(1) Net Present Value; (2) Profitability Index; (3) Pay back Period; (4) Discounted Pay back Period.
Note: Present Values of Re. 1 at 10% discount rate are as follows:-
Years 0 1 2 3 4 5
P.V 1.00 0.91 0.83 0.75 0.68 0.62
Answer
Machine X
Yr CIFs PVF @ 10% PVCFs Cum CFs Cum PVCFs
1 - 0.91 - - -
2 1,00,000 0.83 83,000 1,00,000 83,000
3 4,00,000 0.75 3,00,000 5,00,000 3,83,000
4 2,80,000 0.68 1,90,400 7,80,000 5,73,400
5 2,80,000 0.62 1,73,600 10,60,000 7,47,000
PVCIFs 7,47,000
- PVCOFs 5,00,000
NPV 2,47,000

PV of CIFs 7,47,000
PI = =
PV of COFs 5,00,000
= 1.494

Payback period = 3 yrs

360
Discounted payback period = 3yrs + *1,17,000
1,90,400
= 3yrs + 221 days
= 3 yrs + 7 mths + 11 days

Machine Y

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Yr CIFs Cum CFs PVF @ 10% PVCFs Cum PVCFs

1 2,00,000 2,00,000 0.91 1,82,000 1,82,000
2 2,80,000 4,80,000 0.83 2,32,400 4,14,400
3 3,20,000 8,00,000 0.75 2,40,000 6,54,400
4 3,40,000 11,40,000 0.68 2,31,200 8,85,600
5 3,00,000 14,40,000 0.62 1,86,000 10,71,600
PVCIFs 10,71,600
- PVCOFs 8,00,000
NPV 2,71,600
PV of CIFs 10,71,600
PI = =
PV of COFs 8,00,000
= 1.3395
Payback period = 3 yrs
360
Discounted payback period = 3yrs + *1,45,600
2,31,200
= 3yrs + 222 days
= 3 yrs + 7 mths + 17 days
Problem No.2
Surya Ltd. is purchase a machine. Two proposal are available, each costing Rs. 10,00,000. In comparing
the profitability of the machines, a discounting rate of 10% is to be used and machine is to be written
off in five years by straight line method of depreciation with nil residual value. Cash inflows after tax
are expected as follows:
Years Proposal I Proposal II
Rs. Rs.
1 3,20,000 1,05,000
2 4,05,000 3,00,000
3 5,10,000 4,10,000
4 3,00,000 5,90,000
5 2,00,000 4,00,000
Indicate which machine would be profitable using the following methods of ranking investment
proposal.
1. Payback method
2. Net present value method
3. Profitability Index Method
4. Average Rate of Return Method
Answer
Proposal I
Yr CIFs Cum CFs PVF @ 10% PVCFs Cum PVCFs
1 3,20,000 3,20,000 0.909 2,90,880 2,90,880
2 4,05,000 7,25,000 0.826 3,34,530 6,25,410
3 5,10,000 12,35,000 0.751 3,83,010 10,08,420
4 3,00,000 15,35,000 0.683 2,04,900 12,13,320
5 2,00,000 17,35,000 0.621 1,24,200 13,37,520

Payback method = 2+ 360 *2,75,000

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5,10,000
= 2 + 194 days
= 2 years + 6 moths + 14 days

NPV = PVCIFs - PVCOFs = 13,37,520 - 10,00,000 = 3,37,520

PV of CIFs 13,37,520
PI = =
PV of COFs 10,00,000
= 1.34

Proposal II
Yr CIFs Cum CFs PVF @ 10% PVCFs Cum PVCFs
1 1,05,000 1,05,000 0.909 95,445 95,445
2 3,00,000 4,05,000 0.826 2,47,800 3,43,245
3 4,10,000 8,15,000 0.751 3,07,910 6,51,155
4 5,90,000 14,05,000 0.683 4,02,970 10,54,125
5 4,00,000 18,05,000 0.621 2,48,400 13,02,525

360
Payback method = 3+ *1,85,000
5,90,000
= 3 + 113 days
= 3 yrs + 3 mths + 23 days

NPV = PVCIFs - PVCOFs = 13,02,525 - 10,00,000 = 3,02,525

PV of CIFs 13,02,525
PI = =
PV of COFs 10,00,000
= 1.3
Calculation of IRR
Proposal I
Yr CIFs PVF @ 29% PVCIFs PVF @ 23% PVCIFs PVF @ 24% PVCIFs
1 3,20,000 0.775 248000 0.813 2,60,160 0.806 2,57,920
2 4,05,000 0.601 243405 0.66 2,67,300 0.65 2,63,250
3 5,10,000 0.466 237660 0.537 2,73,870 0.524 2,67,240
4 3,00,000 0.361 108300 0.437 1,31,100 0.423 1,26,900
5 2,00,000 0.280 56000 0.355 71,000 0.341 68,200
8,93,365 10,03,430 9,83,510

1
IRR = 23% + *3,430
19,920

= 23.17%

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Proposal II
Yr CIFs PVF @ 18% PVCIFs PVF @ 19% PVCIFs PVF @ 20% PVCIFs
1 1,05,000 0.847 88935 0.84 88,200 0.833 87,465
2 3,00,000 0.718 215400 0.706 2,11,800 0.694 2,08,200
3 4,10,000 0.609 249690 0.593 2,43,130 0.579 2,37,390
4 5,90,000 0.516 304440 0.499 2,94,410 0.482 2,84,380
5 4,00,000 0.437 174800 0.419 1,67,600 0.402 1,60,800
10,33,265 10,05,140 9,78,235

1
IRR = 19% + *5,140
26,905

= 19.19%

Problem No.3
A company is considering an investment proposal to install new milling controls. The project will cost
Rs. 50,000. The facility has a life expectancy of 5 years and no salvage value. The company tax rate is
55%. The firm uses straight line depreciation. The estimated profit before Dep. from the proposed
investment proposal are as follows:
Year Profit Rs.
1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Compute the following:
a. Payback period. (b) Average rate of return. (c) Internal rate of return.
(d) Net present value at 10% discount rate. (e) Profitability index at 10% discount rate.
Answer
Calculation of cash flows:
Particulars 1 2 3 4 5
PBDT 10,000 11,000 14,000 15,000 25,000
- Dep 10,000 10,000 10,000 10,000 10,000
PBT - 1,000 4,000 5,000 15,000
- tax @ 55% - 550 2,200 2,750 8,250
PAT - 450 1,800 2,250 6,750
+ dep 10,000 10,000 10,000 10,000 10,000
CIFs 10,000 10,450 11,800 12,250 16,750

Yr CIFs PVF @ 10% PVCIFs

1 10,000 0.909 9090
2 10,450 0.826 8631.7
3 11,800 0.751 8861.8
4 12,250 0.683 8366.75

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5 16,750 0.621 10401.75

45,352

360
Payback period = 4+ *5,500
16,750
= 4 + 118 days
= 4 yrs + 3mths + 28 days

NPV = PVCIFs - PVCOFs = 45,352 - 50,000 = -4,648

Avg net profit

ARR =
Avg investment

Avg. net profit = 2,250

Avg investment = (50,000 + 0)/2 = 25,000
2,250
ARR= *100 = 9%
25,000

PV of CIFs 45,352
PI = =
PV of COFs 50,000
= 0 .907
Yr CIFs PVF @ 6% PVCIFs PVF @ 7% PVCIFs
1 10,000 0.943 9,430 0.935 9,350
2 10,450 0.890 9,300 0.873 9,123
3 11,800 0.840 9,912 0.816 9,629
4 12,250 0.792 9,702 0.763 9,347
5 16,750 0.747 12,512 0.713 11,943
50,857 49,391
Difference for 1% i.e., 6% to 7%
= 50,856.75 - 49,391.15 = 1,465.6
Required variance is 856.75
Therefore,
1
6% + *856.75
1,465.60
= 6.58%

Problem No.4
A company is considering the replacement of its existing machine which is obsolete and unable to
meet the rapidly rising demand for its product. The company is faced with two alternatives: (i) to buy
Machine A which is similar to the existing machine or (ii) to go in for Machine B which is more
expensive and has much greater capacity. The cash flows at the present level of operations under the
two alternatives are as follows:
Cash flows (in lacs of Rs.) at the end of year:
Particulars 0 1 2 3 4 5

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Machine A 25 -- 5 20 14 14
Machine B 40 10 14 16 17 15

The company's cost of capital is 10%. The finance manager tries to evaluate the machines by
calculating the following:
(1) NPV (2) Profitability Index; (3) Payback period; and (4) Discounted pay back period;
At the end of the calculations, however, the finance manager is unable to make up his mind as to
which machine to recommend.
You are required to make these calculation and in the light thereof to advise the finance manager
about the proposed investment.
Answer
Machine A
Yr CIFs Cum CFs PVF @ 10% PVCFs Cum PVCFs
1 - - 0.909 - -
2 5,00,000 5,00,000 0.826 4,13,000 4,13,000
3 20,00,000 25,00,000 0.751 15,02,000 19,15,000
4 14,00,000 39,00,000 0.683 9,56,200 28,71,200
5 14,00,000 53,00,000 0.621 8,69,400 37,40,600
PVCIFs 37,40,600
- PVCOFs 25,00,000
NPV 12,40,600

PV of CIFs 37,40,600
PI = =
PV of COFs 25,00,000
= 1.496
Payback period = 3 yrs
360
Discounted payback period = 3yrs + *5,85,000
9,56,200
= 3yrs + 220 days
= 3 yrs + 7mths + 10 days

Machine B
Yr CIFs Cum CFs PVF @ 10% PVCFs Cum PVCFs
1 10,00,000 10,00,000 0.909 9,09,000 9,09,000
2 14,00,000 24,00,000 0.826 11,56,400 20,65,400
3 16,00,000 40,00,000 0.751 12,01,600 32,67,000
4 17,00,000 57,00,000 0.683 11,61,100 44,28,100
5 15,00,000 72,00,000 0.621 9,31,500 53,59,600
PVCIFs 53,59,600
- PVCOFs 40,00,000
NPV 13,59,600

PV of CIFs 53,59,600
PI = =
PV of COFs 40,00,000

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= 1.340
Payback period = 3 yrs
360
Discounted payback period = 3yrs + *7,33,000
11,61,100
= 3yrs + 227 days
= 3 yrs + 7mths + 17 days

Problem No.5
A Company has to make a choice between projects namely A and B. The initial capital outlay of two
project are Rs. 135000 and 240000 respectively for A and B. There will be no scrap value at the end
of the life of both the projects. The opportunity cost of capital of the company is 16%. The annual
incomes are as under:
Years Project A Project B Project C
Rs. Rs. Rs.
1 -- 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476
You are required to calculate for each of the project:
(i) Discounted Payback Period (ii) Profitability Index (iii) NPV
Answer
Project A
Yr CIFs Cum CFs PVF @ 16% PVCFs Cum PVCFs
1 - - 0.862 - -
2 30,000 30,000 0.743 22,290 22,290
3 1,32,000 1,62,000 0.641 84,612 1,06,902
4 84,000 2,46,000 0.552 46,368 1,53,270
5 84,000 3,30,000 0.476 39,984 1,93,254
PVCIFs 1,93,254
- PVCOFs 1,35,000
NPV 58,254

PV of CIFs 1,93,254
PI = =
PV of COFs 1,35,000
= 1.432
Payback period = 2 yrs + 9 months+ 16 days
360
Discounted payback period = 3yrs + *28,098
46,368
= 3yrs + 218 days
= 3 yrs + 7mths + 8 days
Project B
Yr CIFs Cum CFs PVF @ 16% PVCFs Cum PVCFs
1 60,000 60,000 0.862 51,720 51,720
2 84,000 1,44,000 0.743 62,412 1,14,132

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3 96,000 2,40,000 0.641 61,536 1,75,668

4 1,02,000 3,42,000 0.552 56,304 2,31,972
5 90,000 4,32,000 0.476 42,840 2,74,812
PVCIFs 2,74,812
- PVCOFs 2,40,000
NPV 34,812

PV of CIFs 2,74,812
PI = =
PV of COFs 2,40,000
= 1.145
Payback period = 4 yrs
360
Discounted payback period = 4 yrs + *8,028
42,840
= 4 yrs + 67 days
= 4 yrs + 2mths + 7 days

Problem No.6
A Company is considering the proposal of taking up a new project which requires an initial investment
of Rs. 400 lakhs on machinery and other assets. The project is expected to yield the following earning
(before depreciation and taxes) over the next five years:
Years Earning (in Rs Lakh)
1 160
2 160
3 180
4 180
5 150
The cost of raising the additional capital is 12% and 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%.
You are required to calculate the net present value of the project and advise the management to take
appropriate decision. Also calculate the Internal rate of return of the project.
Answer
Calculation of depreciation:
Cost of asset 4,00,00,000
- dep @ 20% I 80,00,000
3,20,00,000
- dep @ 20% II 64,00,000
2,56,00,000
- dep @ 20% III 51,20,000
2,04,80,000
- dep @ 20% IV 40,96,000
1,63,84,000
- dep @ 20% V 32,76,800
1,31,07,200

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Particulars 1 2 3 4 5
PBDT/Earnings 1,60,00,000 1,60,00,000 1,80,00,000 1,80,00,000 1,50,00,000
- Dep 80,00,000 64,00,000 51,20,000 40,96,000 1,63,84,000*
PBT 80,00,000 96,00,000 1,28,80,000 1,39,04,000 -13, 84,000
- tax @ 50% 40,00,000 48,00,000 64,40,000 69,52,000 +6,92,000
PAT 40,00,000 48,00,000 64,40,000 69,52,000 -6,92,000
+ dep 80,00,000 64,00,000 51,20,000 40,96,000 *1,63,84,000
CIFs 1,20,00,000 1,12,00,000 1,15,60,000 1,10,48,000 1,56,92,000
PVF @ 12% 0.893 0.797 0.712 0.636 0.567
PVCIFs 1,07,14,286 89,28,571 82,28,180 70,21,204 88,97,364
*This amount includes depreciation for last year (₹32,76,800 ) + Short term capital loss (1,31,07,200);

Asset’s residual value is Nil – it means the remaining WDV at the end of the life is considered as capital
loss (as per Income tax Act) and that gets the entity tax benefit. Hence it should also be considered.

IRR lies between 15 & 16%

Therefore, NPV = 4,00,77,614 - 4,00,00,000 = 77,614
IRR = 16.07 * 2
14 +
19.93
= 15.61%
Problem No. 7
C Ltd. is considering investing in a project. The expected original investment in the project will be Rs.
2,00,000, the life of the project will be 5 years with no salvage value. The expected PBT during the life
of the project will be as follows:
Year 1 2 3 4 5
Rs. 85,000 1,00,000 80,000 80,000 40,000
The project will be depreciated at the rate of 20% on original cost. The company is subject to 30% tax
rate:
Required:
(i) Calculate payback period and average rate of return
(ii) Calculate NPY and NPY Index if cost of capital is 10%
(iii) Calculate internal rate of return
Answer

Calculation of CIFs
Particulars 1 2 3 4 5
PABDT 85,000 1,00,000 80,000 80,000 40,000
- tax @ 30% 25,500 30,000 24,000 24,000 12,000
PAT 59,500 70,000 56,000 56,000 28,000
+ dep (2,00,000 * 20%) 40,000 40,000 40,000 40,000 40,000
CIFs 99,500 1,10,000 96,000 96,000 68,000

2,69,500
Avg net profit = =53,900
5
Avg investment = 2,00,000 + 0 =1,00,000

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2
Project A
Yr CIFs Cum CFs PVF @ 10% PVCFs Cum PVCFs
1 99,500 99,500 0.909 90,455 90,455
2 1,10,000 2,09,500 0.826 90,909 1,81,364
3 96,000 3,05,500 0.751 72,126 2,53,490
4 96,000 4,01,500 0.683 65,569 3,19,059
5 68,000 4,69,500 0.621 42,223 3,61,282
PVCIFs 3,61,282
- PVCOFs 2,00,000
NPV 1,61,282

PV of CIFs 3,61,282
PI = =
PV of COFs 2,00,000
= 1.806
Payback period = 2 yrs

360
Discounted payback period = 1yrs + *1,00,500
1,10,000
= 1yrs + 329 days
= 1 yr + 10 mths + 29 days

Avg net profit

ARR = *100
Avg investment
53,900
= *100
1,00,000
= 53.9%
CIFs PVF @ 39% PVCIFs PVF @ 40% PVCIFs
99,500 0.719 71,583 0.714 71,071
1,10,000 0.518 56,933 0.510 56,122
96,000 0.372 35,746 0.364 34,985
96,000 0.268 25,717 0.260 24,990
68,000 0.193 13,105 0.186 12,644
2,03,083 1,99,812

1
IRR = 39 + *3084.5
3389.5
= 39.91%

Problem No. 8
PR Engineering Ltd. is considering the purchase of a new machine which will carry out some operations
which are at present performed by manual labour. The following information related to the two
alternative model - 'MX' and 'MY' are available:

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Particulars Machine MX Machine MY

Cost of Machine Rs. 8,00,000 Rs. 10,20,000
Expected Life 6 years 6 years
Scrap value Rs. 20,000 Rs. 30,000

Estimated net income before depreciation and tax:

Year Rs. Rs.
1 2,50,000 2,70,000
2 2,30,000 3,60,000
3 1,80,000 3,80,000
4 2,00,000 2,80,000
5 1,80,000 2,60,000
6 1,60,000 1,85,000

Corporate tax rate for this company is 30 percent and Company required rate of return on
investment proposal is 10 percent. Depreciation will be charged on straight line basis.
You are required to:
(i) Calculate the pay back of each proposal.
(ii) Calculate the net present value of each proposal.
(iii) Which proposal you would recommend and why?
Answer
Working Notes:
1. Annual Depreciation of machines
Rs.8,00,000 - Rs.20,000
Depreciation of Machine 'MX' = = Rs.1,30,000
6

Rs.10,20,000 - Rs.30,000
Depreciation of Machine 'MY' = = Rs.1,65,000
6

1. Calculation of Cash inflows:

Machine 'MX' Years
1 2 3 4 5 6
Income before dep & Tax 2,50,000 2,30,000 1,80,000 2,00,000 1,80,000 1,60,000
Less: Depreciation 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000
PBT 1,20,000 1,00,000 50,000 70,000 50,000 30,000
Less: Tax @ 30% 36,000 30,000 15,000 21,000 15,000 9,000
PAT 84,000 70,000 35,000 49,000 35,000 21,000
Add: Depreciation 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000 1,30,000
Cash inflows 2,14,000 2,00,000 1,65,000 1,79,000 1,65,000 1,51,000

Machine 'MY' Years

1 2 3 4 5 6
Income before dep & Tax 2,70,000 3,60,000 3,80,000 2,80,000 2,60,000 1,85,000
Less: Depreciation 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000
PBT 1,05,000 1,95,000 2,15,000 1,15,000 95,000 20,000

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Less: Tax @ 30% 31,500 58,500 64,500 34,500 28,500 6,000

PAT 73,500 1,36,500 1,50,500 80,500 66,500 14,000
Add: Depreciation 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000 1,65,000
Cash inflows 2,38,500 3,01,500 3,15,500 2,45,500 2,31,500 1,79,000
i. Calculation of Pay-back period:
Cumulative Cash Inflows:
Years
1 2 3 4 5 6
Machine 'MX' 2,14,000 4,14,000 5,79,000 7,58,000 9,23,000 10,74,000
Machine 'MY' 2,38,500 5,40,000 8,55,500 11,01,000 13,32,500 15,11,500

Payback period of “MX’

(8,00,000 - 7,58,000)
=4+
1,65,000

= 4.25 years or 4 years and 3 mths

Payback period of “MY’
(10,20,000 - 8,55,500)
=3+
2,45,500

= 3 + 0.67 = 3.67 years

Or, 3 years and 8 mths

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ii. Calculation of Net Present Value:

Machine ' MX' Machine 'MY'
Year PV Factor Cash Inflows Rs. Present Value Rs. Cash inflows Rs. Present Value Rs.
0 1 -8,00,000 -8,00,000 -10,20,000 -10,20,000
1 0.909 2,14,000 1,94,526 2,38,500 2,16,797
2 0.826 2,00,000 1,65,200 3,01,500 2,49,039
3 0.751 1,65,000 1,23,915 3,15,500 2,36,941
4 0.683 1,79,000 1,22,257 2,45,500 1,67,677
5 0.621 1,65,000 1,02,465 2,31,500 1,43,762
6 0.564 1,51,000 85,164 1,79,000 1,00,956
Scrap Value 0.564 20,000 11,280 30,000 16,920
Net Present Value 4,807 1,12,092

iii. Recommendation:
Machine 'MX' Machine 'MY'
Ranking according to Pay-back period II I
Ranking according to NPV II I

Problem No. 9
XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is to be set
up in Special Economic Zone (SEZ) qualifies for onetime (at starting) tax free subsidy from the state
Government of Rs. 25,00,000 on capital investment. Initial equipment cost will be Rs. 1.75 crore.
Additional equipment cost Rs. 12,50,000 will be purchased at the end of the third year from the cash
inflow of this year. At the end of the 8 years, the original equipment will have no resale value, but
additional equipment can be sold for Rs. 1,25,000. A working capital of Rs. 20,00,000 will be needed
and it will be released at the end of the eighth year. The project will be financed with sufficient amount
of equity capital.
The sales volumes over the eight years have been estimated as follows
year 1 2 3 4-5 6-8

Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sale price of Rs. 120 per unit is expected and variable expenses will amount to 60% of sales revenue.
Fixed cash operating cost will amount Rs. 18,00,000 per year. The loss of any year will be set off from
the profit of subsequent two year. The company is subject to 30% tax rate and considered 12% to be
an appropriate after tax cost of capital for this project. The company follows straight line method of
depreciation.
Required:
Calculate the net present value of the project and advise the management to take appropriate
decision.
Answer
Calculation of COFs
Equipment cost 1,75,00,000
+ Additional cost 8,90,000 (12,50,000 * 0.712)
+ Working capital 20,00,000

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2,03,90,000
- subsidy 25,00,000
COFs 1,78,90,000

Terminal value
Working capital 20,00,000
Salvage value 1,25,000
21,25,000

Calculation of depreciation
= 175,00,000/8 = 21,87,500 for 3yrs
= (12,50,000 - 1,25,000)/5 = 2,25,000 + 21,87,500
= 24,12,500 for next 5 yrs

Calculation of CIFs
Yr Sales VC @ 60% FC PBDT Dep
1 86,40,000 51,84,000 34,56,000 18,00,000 16,56,000 21,87,500
2 1,29,60,000 77,76,000 51,84,000 18,00,000 33,84,000 21,87,500
3 3,12,00,000 1,87,20,000 1,24,80,000 18,00,000 1,06,80,000 21,87,500
4 to 5 3,24,00,000 1,94,40,000 1,29,60,000 18,00,000 1,11,60,000 24,12,500
6 to 8 2,16,00,000 1,29,60,000 86,40,000 18,00,000 68,40,000 24,12,500

PBT Tax @ 30% PAT + Dep PVF @ 12% PVCIFs

-5,31,500 - 16,56,000 0.893 14,78,571
11,96,500 1,99,500 31,84,500 0.797 25,38,664
84,92,500 25,47,750 81,32,250 0.712 57,88,375
87,47,500 26,24,250 85,35,750 1.203 1,02,68,507
44,27,500 13,28,250 55,11,750 1.363 75,12,515
T.V 21,25,000 0.404 8,58,500

= 2,84,46,539 - 178,90,000
NPV = 1,05,56,539
The company should select the project

Problem No. 10
National Bottling Company is contemplating to replace one of its bottling machines with a new and
more efficient machine. The .old machine has a cost value of Rs. 10 lakhs and a useful life of ten years.
The machine was bought five year back. The company does not expect to realise any return from
scrapping the old machine at the end of ten years but presently if it is sold to another company in the
industry, National Bottling Company would receive Rs. 6 lakhs for it. The new machine has a purchase
price of Rs. 20 lakhs. It has an estimated salvage value of Rs. 2 lakhs and has useful life of five years.
The new machine will have a greater capacity and annual sales are expected to increase from Rs. 10
lakhs to Rs. 12 lakhs. Operating efficiencies with the new machine will also produce savings of Rs. 2
lakhs a year. Depreciation is on a straight-line basis over five year life.

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The cost of capital is 8% and a 50% tax-rate is applicable. The present value interest factor for an
annuity for five years, at 8% is 3.993 and present value interest factor at the end of five years is 0.681.
Capital gain is taxable. Should the company replace the old machine?
Answer
Cost of the machine = 20,00,000
- salvage value of old machine = 6,00,000

Book value of old machine = 5,00,000

- selling price 6,00,000
capital profit 1,00,000
add: capital profit * tax
1,00,000 * 50% 50,000
Cash outflows 14,50,000

Incremental savings
current sales 12,00,000
- old sales 10,00,000
2,00,000
operating sales 2,00,000
incremental PBDT 4,00,000

Incremental depreciation
Dep on old machine (5,00,000/5) 1,00,000
Dep on new machine
(20,00,000 - 2,00,000)/5 3,60,000
Incremental dep 2,60,000

Calculation of cash inflows:

Year PBDT Dep PBT Tax @ 50% PAT Dep CIFs
1 to 5 4,00,000 2,60,000 1,40,000 70,000 70,000 2,60,000 3,30,000

3,30,000 * 3.993 = 13,17,690

2,00,000 * 0.681 1,36,200
14,53,890
14,50,000
NPV 3,890

Problem No. 11
A company has a machine which has been in operations for 2 years; its remaining estimated useful is
10 years with no salvage value at the end. Its current market value is Rs. 1,00,000. The management
is considering a proposal to purchase as improved model of a machine, which gives increased output.
The relevant particulars are as follows:
Particulars Existing Machine New Machine
Purchaser Price Rs. 2,40,000 Rs. 4,00,000

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Estimated life 12 year 10 year

Salvage value -- --
Annual operating hours 2,000 2,000
Selling price per unit Rs. 10 Rs. 10
Output per hour 15 units 30 units
Material cost per unit Rs. 2 Rs. 2
Labour cost per hour Rs. 20 Rs. 40
Consumable stores per year 2,000 5,000
Repairs and maintenance per year 9,000 6,000
Working capital 25,000 40,000
The company follows the straight-line method of depreciation and is subject to 50% tax should the
existing machine be replaced? Assume that the company's required to rate of return is 15% and that
the loss on sale of assets is tax deductible.
Answer

Cost of the machine = 4,00,000

- salvage value of old machine = 1,00,000
3,00,000
Cost of old machine 2,00,000
- selling price 1,00,000
capital loss -1,00,000
tax @ 50% 50,000
1,00,000 * 50% -50,000 -50,000
2,50,000
add: additional WC (40,000 - 25,000) 15,000
Incremental cash outflows at Y0 2,65,000

Calculation of incremental profits

Particulars Old machine New machine
Units 30,000 60,000
(2,000 * 15) (2,000 * 30)
Sales 3,00,000 6,00,000
- Material cost -60,000 -1,20,000
- Labour cost -40,000 -80,000
- consumable stores -2,000 -5,000
- Repairs -9,000 -6,000
Profit 1,89,000 3,89,000
Incremental profit before dep = 2,00,000

Calculation of additional dep

Old machine dep (2,40,000/12) 20,000
New machine dep (4,00,000/10) 40,000
incremental dep 20,000

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T.V
Old asset W.C 25,000
New asset W.C 40,000
Incremental W.C 15,000

Incremental profit before dep

dep tax dep
1 to 10 2,00,000 20,000 1,80,000 90,000 90,000 20,000 1,10,000

1 to 10 1,10,000 * 5.019 = 5,52,090

10 15,000 * 0.247 = 3,705
5,55,795
- ICOF 2,65,000
NPV 2,90,795

Machine should be replaced

Problem No. 12
A company is required to choose between two machines A and B. The two machine are designed
differently, out have identical capacity and do exactly the same job. Machine A cost Rs. 6,00,000 and
will last for 3 years. It cost Rs. 1,20,000 per year to run.
Machine B is an economy model costing Rs. 4,00,000 but will last only for two years, and cost Rs.
1,80,000 per year to run. These are real cash flows. The cost are forecasted in Rupees of constant
purchasing power. Opportunity cost of capital is 10%. Which machine company should buy? Ignore
tax
Answer

Machine A Cost p.a.

Equated cost
(6,00,000/2.487) 2,41,268
+ co-running cost p.a. 1,20,000
cost p.a. 3,61,268

Machine B Cost p.a.

Equated cost
(4,00,000/1.736) 2,30,476
+ co-running cost p.a 1,80,000
cost p.a 4,10,476
Machine A should be selected as per annum cost is lower
Problem No. 13
Samreen Enterprises has been operating its manufacturing facilities till 31.3.2017 on a single shift
working with the following cost structure:
Per unit (₹)

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Cost of Materials 6.00

Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% fixed) 5.00
Profit 2.00
Selling Price 18.00
Sales during 2016-17 – ₹ 4,32,000.
As at 31.3.2017 the company held:

(₹)
Stock of raw materials (at cost) 36,000
Work-in-progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 1,08,000
In view of increased market demand, it is proposed to double production by working an extra shift.
It is expected that a 10% discount will be available from suppliers of raw materials in view of
increased volume of business. Selling price will remain the same. The credit period allowed to
customers will remain unaltered. Credit availed of from suppliers will continue to remain at the
present level i.e., 2 months. Lag in payment of wages and expenses will continue to remain half a
month.

You are required to PREPARE the additional working capital requirements, if the policy to increase
output is implemented.

Answer
This question can be solved using two approaches:
(i) To assess the impact of double shift for long term as a matter of production policy.
(ii) To assess the impact of double shift to mitigate the immediate demand for next year only.
The first approach is more appropriate and fulfilling the requirement of the question.
Workings:
(1) Statement of cost at single shift and double shift working
24,000 units 48,000 Units
Per unit Total Per unit Total
(₹) (₹) (₹) (₹)
Raw materials 6.00 1,44,000 5.40 2,59,200
Wages - Variable 3.00 72,000 3.00 1,44,000
Fixed 2.00 48,000 1.00 48,000
Overheads - Variable 1.00 24,000 1.00 48,000
Fixed 4.00 96,000 2.00 96,000
Total cost 16.00 3,84,000 12.40 5,95,200
Profit 2.00 48,000 5.60 2,68,800
18.00 4,32,000 18.00 8,64,000
(2) Sales in units 2016-17 = Sales / Selling price p.u. = 4,32,000 / 18 = 24,000 units
(3) Stock of Raw Materials in units on 31.3.2017 = Value of stock / Cost p.u. = 36,000 / 6 =
6,000 units

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(4) Stock of work-in-progress in units on 31.3.2017 = Value of WIP / Prime cost p.u. = 22,000
/ (6+5) = 2,000 units;
(5) Stock of finished goods in units 2016-17 = Value of stock / Total cost p.u. = 72,000 / 16 =
4,5000 units

Assessment of impact of double shift for long term as a matter of production policy:
Comparative Statement of Working Capital Requirement

Single Shift Double Shift

Unit Rate Amount Unit Rate Amount
(₹) (₹) (₹) (₹)
Current Assets
Inventories:
Raw Materials 6,000 6.00 36,000 12,000 5.40 64,800
Work-in-Progress 2,000 11.00 22,000 2,000 9.40 18,800
Finished Goods 4,500 16.00 72,000 9,000 12.40 1,11,600
Sundry Debtors 6,000 16.00 96,000 12,000 12.40 1,48,800
Total Current Assets: (A) 2,26,000 3,44,000
Current Liabilities
Creditors for Materials 4,000 6.00 24,000 8,000 5.40 43,200
Creditors for Wages 1,000 5.00 5,000 2,000 4.00 8,000
Creditors for Expenses 1,000 5.00 5,000 2,000 3.00 6,000
Total Current Liabilities: (B) 34,000 57,200
Working Capital: (A) – (B) 1,92,000 2,86,800
Additional Working Capital requirement = ₹ 2,86,800 – ₹ 1,92,000 = ₹ 94,800

Assessment of the impact of double shift to mitigate the immediate demand for next year
only.
Workings:

(3) Calculation of no. of units to be sold:

No. of units to be Produced 48,000
Add: Opening stock of finished goods 4,500
Less: Closing stock of finished goods (9,000)
No. of units to be Sold 43,500

(4) Calculation of Material to be consumed and materials to be purchased in units:

No. of units Produced 48,000
Add: Closing stock of WIP 2,000
Less: Opening stock of finished goods (2,000)
Raw Materials to be consumed in units 48,000
Add: Closing stock of Raw material 12,000
Less: Opening stock of Raw material (6,000)

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Raw Materials to be purchased (in units) 54,000

Credit allowed by suppliers: (54,000 * 5.40) * 2 months / 12 months = Rs. 48,600;
Comparative Statement of Working Capital Requirement
Single Shift Double Shift
Unit Rate Amount Unit Rate Amount
(₹) (₹) (₹) (₹)
Current Assets
Inventories:
Raw Materials 6,000 6.00 36,000 12,000 5.40 64,800
Work-in-Progress 2,000 11.00 22,000 2,000 9.40 18,800
Finished Goods 4,500 16.00 72,000 9,000 12.40 1,11,600
Sundry Debtors 6,000 16.00 96,000 12,000 12.40 1,48,800
Total Current Assets: (A) 2,26,000 3,44,000
Current Liabilities
Creditors for Materials 4,000 6.00 24,000 9,000 5.40 48,600
Creditors for Wages 1,000 5.00 5,000 2,000 4.00 8,000
Creditors for Expenses 1,000 5.00 5,000 2,000 3.00 6,000
Total Current Liabilities: (B) 34,000 62,600
Working Capital: (A) – (B) 1,92,000 2,81,400
Additional Working Capital requirement = ₹ 2,81,400 – ₹ 1,92,000 = ₹ 89,400
Notes:
(i) The quantity of material in process will not change due to double shift working since work
started in the first shift will be completed in the second shift.
(ii) It is given in the question that the WIP is valued at prime cost hence, it is assumed that the
WIP is 100% complete in respect of material and labour.
(iii) In absence of any information on proportion of credit sales to total sales, debtors quantity
has been doubled for double shift.
(iv) It is assumed that all purchases are on credit.
(v) The valuation of work-in-progress based on prime cost as per the policy of the company is
as under.
Single shift Double shift
(₹) (₹)
Materials 6.00 5.40
Wages – Variable 3.00 3.00
Fixed 2.00 1.00
11.00 9.40

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