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mujahid (Querist)

08 December 2011 An oil company proposes to install a pipeline to transport crude oil from the wells to the refinery. Investment and
operating costs of the pipeline vary for different sizes (diameter) of pipes. The following details have been
collected:
Pipeline diameter 3" 4" 5" 6" 7"
Investment required (Rs lakh) 16 24 36 64 150
Gross annual savings in operating costs 5 8 15 30 50
before depreciation
Estimated life of the installation is 10 years. Tax rate is 50%.
Questions:
1. Calculate the net saving after paying tax and generating the cash flow. Recommend the largest pipeline to be installed if the company desires 15 per cent profit after tax return. Also indicate the proposal that has the shortest payback. Assume the company follows the straight-line method of depreciation, and there is no salvage value of pipeline after ten years.
2. Why is the Net Present Value method of evaluation superior in evaluating capital expenditure decisions?

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Guest (Expert)

09 December 2011 Pipeline Diameter 3 4 5 6 7
Gross Annual Saving 5 8 15 30 50
Depreciation 1.6 2.4 3.6 6.4 15
Net Annual Saving 3.4 5.6 11.4 23.6 35
Taxation @ 50% 1.7 2.8 5.7 11.8 17.5
Net Saving afterTax1.7 2.8 5.7 11.8 17.5

Depreciation is a non-cash expenditure and will not be considered for computing the Cash flow.

Investment 16 24 36 64 150
Net Saving afterTax1.7 2.8 5.7 11.8 17.5
Payback Period 9.4 8.6 6.3 5.4 8.6

Installation of a 6" pipeline has the shortest payback period.

The Net Present Value method of evaluation is the most realistic method for Capital Expenditure decisions.

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