CA Aman Agarwal https://t.

me/costingwithcaaman

Chapter wise Test (2005)

Investment Decision

Instructions
- All questions are compulsory.
- Test Duration will be 60 Minutes, starting from 11:00 AM to 12:00 noon
- 5 minutes reading time will be provided before 11, i.e. question paper will be
shared by 10:55 AM.
- Share your scanned answer sheets by 12:10 on below link
https://forms.gle/wLRZWiTvMELNpCeC6

1. [5 Marks] ABC Ltd. is considering to purchase a machine which is priced at Rs.

5,00,000. The estimated life of machine is 5 years and has an expected salvage value
of Rs. 45,000 at the end of 5 years. It is expected to generate revenues of Rs. 1,50,000
per annum for five years. The annual operating cost of the machine is Rs. 28,125,
Corporate Tax Rate is 20% and the cost of capital is 10%.
You are required to analyse whether it would be profitable for the company to
purchase the machine by using;
(i) Payback period Method
(ii) Net Present value method
(iii) Profitability Index Method

Solution
Computation of Annual Cash Flows
Particular (Rs. )

Revenue 1,50,000

Less: Operating Cost (28,125)

Less: Depreciation
( , , , ) (91,000)

Profit before Tax 30,875

Less: Tax (6,175)

Profit after Tax 24,700

Add: Depreciation 91,000

Annual Cash Inflows 1,15,700

(i) Computation of Payback Period

Year Cash Flows Cumulative Present Value

1 1,15,700 1,15,700
2 1,15,700 2,31,400

3 1,15,700 3,47,100

4 1,15,700 4,62,800
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5 (Including Salvage) 1,60,700 6,23,500

Amount to be recovered in 5th year cash flow = Rs. 5,00,000 – Rs. 4,62,800 =
Rs. 37,200
,
Payback period = 4 years + , ,
= 4.23 years

Since the payback period is less than the life of machinery, the company may
purchase the machine.

(ii) Computation of Net Present Value

Year Cash Flows PVF @10% Present Value
0 (5,00,000) 1.000 (5,00,000)

1-5 1,15,700 3.791 4,38,594

5 45,000 0.621 27,941

Net Present Value (33,465)

Since the net present value (NPV) is negative, the company should not
purchase the machine.

(iii) Computation of Profitability Index (PI)

Profitability Index (PI) =
𝑅𝑠. 4,38,594 + 𝑅𝑠. 27,941
= = 0.93
𝑅𝑠. 5,00,000
Since the profitability index is less than 1, the company should not purchase the
machine.

2. [8 Marks] NC Ltd. Is considering purchasing a new machine to increase its

production facility. At present, it uses an old machine which can process 5,000
units of TVs per week. NC could replace it with new machine, which is product
specific and can produce 15,000 units per week. New machine cost ` 100 crores and
requires the working capital of ` 3 crores, which will be released at the end of 5th
year. The new machine is expected to have a salvage value of ` 20 crores.
The company expects demand for TVs to be 10,000 units per week. Each TV sells
for ` 30,000 and has Profit Volume Ratio (PV) of 0.10. The company works for the
56 weeks in the year. Additional fixed costs (excluding depreciation) are estimated
to increase by ` 10 crores. The company is subject to a 40% tax rate and its after-
tax cost of capital is 20%. The relevant rate of depreciation is 25 % for both taxation
and accounts. The company uses the WDV method of depreciation. The existing
machine will have no scrap value.
You are required to:
ADVISE whether the company should replace the old machine. (Decimal may be
taken up to 2 units)

Solution
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3. [8 Marks] Four years ago, Z Ltd. had purchased a machine of Rs. 4,80,000 having
estimated useful life of 8 years with zero salvage value. Depreciation is charged using
SLM method over the useful life. The company want to replace this machine with a
new machine. Details of new machine are as below:
- Cost of new machine is Rs. 12,00,000, Vendor of this machine is agreed to
take old machine at a value of Rs. 2,40,000. Cost of dismantling and removal
of old machine will be Rs. 40,000. 80% of net purchase price will be paid on
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spot and remaining will be paid at the end of one year.

- Depreciation will be charged @ 20% p.a. under WDV method.
- Estimated useful life of new machine is four years and it has salvage value of
Rs. 1,00,000 at the end of year four.
- Incremental annual sales revenue is Rs. 12,25,000.
- Contribution margin is 50%.
- Incremental indirect cost (excluding depreciation) is Rs. 1,18,750 per year.
- Additional working capital of Rs. 2,50,000 is required at the beginning of year
and Rs. 3,00,000 at the beginning of year three. Working capital at the end of
year four will be nil.
- Tax rate is 30%.
- Ignore tax on capital gain.

Z Ltd. will not make any additional investment, if it yields less than 12% Advice,
whether existing machine should be replaced or not.
Year 1 2 3 4 5

PVIF0.12, t 0.893 0.797 0.712 0.636 0.567

Solution
Working Notes:
(i) Calculation of Net Initial Cash Outflow
Particulars Rs.

Cost of New Machine 12,00,000

Less: Sale proceeds of existing machine 2,00,000

Net Purchase Price 10,00,000

Paid in year 0 8,00,000

Paid in year 1 2,00,000

(ii) Calculation of Additional Depreciation

Year 1 2 3 4

Rs. Rs. Rs. Rs.

Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000

Depreciation on new machine @ 20% 2,00,000 1,60,000 1,28,000 1,02,400

Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600

Depreciation on old machine (4,80,000/8) 60,000 60,000 60,000 60,000

Incremental depreciation 1,40,000 1,00,000 68,000 42,400

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(iii) Calculation of Annual Profit before Depreciation and Tax (PBDT)

Particulars Incremental Values
(Rs.)
Sales 12,25,000

Contribution 6,12,500

Less: Indirect Cost 1,18,750

Profit before Depreciation and Tax (PBDT) 4,93,750

Calculation of Incremental NPV

Year PVF PBTD(Rs.) Incremental PBT(Rs.) Tax @ Cash PV of Cash
@ Depreciation 30%(Rs.) Inflows Inflows (Rs.)
12% (Rs.) (Rs.)

(1) (2) (3) (4) (5) = (4) x (6) = (4) – (7) = (6) x (1)
0.30 (5)+ (3)
1 0.893 4,93,750 1,40,000 3,53,750 106,125 3,87,625 3,46,149.125

2 0.797 4,93,750 1,00,000 3,93,750 1,18,125 3,75,625 2,99,373.125

3 0.712 4,93,750 68,000 4,25,750 1,27,725 3,66,025 2,60,609.800

4 0.636 4,93,750 42,400 4,51,350 1,35,405 3,58,345 2,27,907.420

* * 11,34,039.470

Add: PV of Salvage (Rs. 1,00,000 x 0.636) 63,600

Less: Initial Cash Outflow - Year 0 8,00,000

Year 1 (Rs. 2,00,000 × 0.893) 1,78,600

Less: Working Capital - Year 0 2,50,000

Year 2 (Rs. 3,00,000 × 0.797) 2,39,100

Add: Working Capital released - Year 4 (Rs. 5,50,000 × 0.636) 3,49,800

Incremental Net Present Value 79,739.470

Since the incremental NPV is positive, existing machine should be replaced.

Alternative Presentation Computation of Outflow for new Machine:
Rs.
Cost of new machine 12,00,000
Replaced cost of old machine 2,40,000
Cost of removal 40,000
Net Purchase price 10,00,000
Outflow at year 0 8,00,000
Outflow at year 1 2,00,000
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Computation of additional deprecation

Year 1 2 3 4

Rs. Rs. Rs. Rs.

Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000

Depreciation on new machine @ 2,00,000 1,60,000 1,28,000 1,02,400
20%
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600

Depreciation on old machine 60,000 60,000 60,000 60,000

(4,80,000/8)
Incremental depreciation 1,40,000 1,00,000 68,000 42,400

Computation of NPV
Year 0 1 2 3 4

Rs. Rs. Rs. Rs. Rs.

1. Increase in sales revenue 12,25,000 12,25,000 12,25,000 12,25,000

2. Contribution 6,12,500 6,12,500 6,12,500 6,12,500

3. Increase in fixed cost 1,18,750 1,18,750 1,18,750 1,18,750

4. Incremental Depreciation 1,40,000 1,00,000 68,000 42,400

5. Net profit before tax [1- 3,53,750 3,93,750 4,25,750 4,51,350

(2+3+4)]

6. Net Profit after tax (5 x 70%) 2,47,625 2,75,625 2,98,025 3,15,945

7. Add: Incremental

depreciation 1,40,000 1,00,000 68,000 42,400

8. Net Annual cash inflows (6 3,87,625 3,75,625 3,66,025 3,58,345

+ 7)

9. Release of salvage value 1,00,000

10. (investment)/disinvestment (2,50,000) (3,00,000) 5,50,000

in working capital

11. Initial cost (8,00,000) (2,00,000)

12. Total net cash flows (10,50,000) 1,87,625.0 75,625 3,66,025 10,08,345

13. Discounting Factor 1 0.893 0.797 0.712 0.636

14. Discounted cash flows (12 x (10,50,000) 1,67,549.125 60,273.125 2,60,609.800 641307.420
13)

NPV = (1,67,549 + 60,273 + 2,60,610 + 6,41,307) - 10,50,000 = Rs. 79,739

Since the NPV is positive, existing machine should be replaced.
 CA Aman Agarwal https://t.me/costingwithcaaman

4. [4 Marks] A company has Rs. 1,00,000 available for investment and has identified
the following four investments in which to invest.

Project Investment (Rs.) NPV (Rs.)

C 40,000 20,000

D 1,00,000 35,000
E 50,000 24,000

F 60,000 18,000

You are required to optimize the returns from a package of projects within the capital
spending limit if-
(i) The projects are independent of each other and are divisible.
(ii) The projects are not divisible.

Solution
(i) Optimizing returns when projects are independent and divisible.
Computation of NPVs per Re.1 of Investment and Ranking of the Projects
Project Investment NPV NPV per Re. 1 Ranking
(₹) (₹) Invested (₹)
C 40,000 20,000 0.50 1
D 1,00,000 35,000 0.35 3
E 50,000 24,000 0.48 2
F 60,000 18,000 0.30 4

Building up of a Package of Projects based on their Rankings

Project Investment (₹) NPV (₹)
C 40,000 20,000
E 50,000 24,000
D 10,000 3,500
(1/10th of Project)
Total 1,00,000 47,500

The company would be well advised to invest in Projects C, E and D (1/10 th) and
reject Project F to optimise return within the amount of ₹ 1,00,000 available for
investment.

(ii) Optimizing returns when projects are indivisible.

Package of Project Investment (₹) Total NPV (₹)
C and E 90,000 44,000
(40,000 + 50,000) (20,000 + 24,000)
C and F 1,00,000 38,000
(40,000 + 60,000) (20,000 + 18,000)
Only D 1,00,000 35,000
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The company would be well advised to invest in Projects C and E to optimise return
within the amount of ₹ 1,00,000 available for investment.

5. [5 Marks] XYZ Ltd. is presently all equity financed. The directors of the company
have been evaluating investment in a project which will require Rs. 270 lakhs capital
expenditure on new machinery. They expect the capital investment to provide annual
cash flows of Rs. 42 lakhs indefinitely which is net of all tax adjustments. The
discount rate which it applies to such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take
advantage of tax benefits of debt, and propose to finance the new project with
undated perpetual debt secured on the company's assets. The company intends to
issue sufficient debt to cover the cost of capital expenditure and the after tax cost of
issue.
The current annual gross rate of interest required by the market on corporate
undated debt of similar risk is 10%. The after tax costs of issue are expected to be
Rs. 10 lakhs. Company's tax rate is 30%.
You are required to calculate:
(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and
Explain the circumstances under which this adjusted discount rate may be used to
evaluate future investments.

Solution
(i) Calculation of Adjusted Present Value of Investment (APV)
Adjusted PV = Base Case PV + PV of financing decisions associated with the project
Base Case NPV for the project:
(-) Rs. 270 lakhs + (Rs. 42 lakhs / 0.14) = (-) Rs. 270 lakhs + Rs. 300 lakhs
= Rs. 30
Issue costs = Rs. 10 lakhs
Thus, the amount to be raised = Rs. 270 lakhs + Rs. 10 lakhs
= Rs. 280 lakhs
Annual tax relief on interest payment = Rs. 280 X 0.1 X 0.3
= Rs. 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = Rs. 8.4 lakhs / 0.1
= Rs. 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= Rs. 30 lakhs – Rs. 10 lakhs + 84 lakhs = Rs. 104 lakhs

(ii) Calculation of Adjusted Discount Rate (ADR)

Annual Income / Savings required to allow an NPV to zero
Let the annual income be x.
(-) Rs.280 lakhs X (Annual Income / 0.14) = (-) Rs.104 lakhs
Annual Income / 0.14 = (-) Rs. 104 + Rs. 280 lakhs
Therefore, Annual income = Rs. 176 X 0.14 = Rs. 24.64 lakhs
Adjusted discount rate = (Rs. 24.64 lakhs / Rs.280 lakhs) X 100
= 8.8%
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(iii) Useable circumstances

This ADR may be used to evaluate future investments only if the business risk of the
new venture is identical to the one being evaluated here and the project is to be
financed by the same method on the same terms. The effect on the company’s cost
of capital of introducing debt into the capital structure cannot be ignored.