CAPITAL BUDGETING

Rahul Bansal (Finalist) (35929 Points)
Replied 11 December 2009

Question 1

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 five years with nil residual value.

The company has an offer for sale of Machine-R at Rs. 1,00,000. But the cost of dismantling and removal will amount to 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%. P.V. factors for five years are as follows:

Year	P.V. Factors
1	0.877
2	0.769
3	0.675
4	0.592
5	0.519

(i) Advise whether the company should opt for the 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?

Support your view with necessary workings.

(Final-Nov. 1996) (12 marks)

Answer

(i) Replacement of Machine –R

Incremental cash out flow

(i)	Cash out flow on Machine –S	Rs. 2,50,000
	Less: Sale Value of Machine –R
	Less : Cost of dismantling and removal (Rs. 1,00,000-Rs. 30,000)	Rs. 70,000
	Net outflow	Rs. 1,80,000
	Incremental cash flow from Machine-S
	Annual cash flow from Machine –S	Rs. 2,70,000
	Annual cash flow from Machine –R	Rs. 2,50,000
	Net incremental Cash in flow	Rs. 20,000

Present value of incremental cash in flows

= Rs. 20,000 ´ (0.877 +0.769+0.675+0.592+0.519)

= 20,000 ´ 3.432 = Rs. 68,640

NPV of Machine -S = Rs. 68,640 – Rs. 1,80,000

= (-) Rs. 1,11,360

Rs. 2,00,000 spent on Machine –R is a sunk cost and hence it is not relevant for deciding the replacement.

Decision: Since Net present value of Machine –S is in the negative, replacement is not advised.

If the company is in the process of selecting one of the two machines, the decision is to be made on the basis of independent evaluation of two machines by comparing their Net-present values.

(ii) Independent evaluation of Machine –R and Machine –S:

	Machine –R	Machine –S
Units produced	1,50,000	1,50,000
Selling price per unit (Rs.)	6	6
Sale value	9,00,000	9,00,000
Less: Operating Cost
(exclusive of depreciation)	2,00,000	1,80,000
Contribution	7,00,000	7,20,000
Less: Fixed Cost	4,50,000	4,50,000
Annual cash flow	2,50,000	2,70,000
Present value of cash flows for five years	8,58,000	9,26,640
Cash Outflow	2,00,000	2,50,000
Net Present Value	6,58,000	6,76,640

As the NPV of cash in flow of Machine –S is higher than that of Machine –R, the choice should fall on machine –S.

Note: As the company is a zero tax company for seven years (Machine life in both cases is only for five years), depreciation and the tax effect on the same are not relevant for consideration.

Rahul Bansal (Finalist) (35929 Points)
Replied 11 December 2009

Question 2

(a) Following are the data on a capital project being evaluated by the management of X Ltd.:

	Project M
Annual cost saving	Rs. 40,000
Useful life	4 years
I.R.R	15%
Profitability index (PI)	1,064
NPV	?
Cost of capital	?
Cost of project	?
Payback	?
Salvage value	0

Find the missing values considering the following table of discount factor only:

Discount factor	15%	14%	13%	12%
1 Year	0.869	0.877	0.885	0.893
2 Years	0.756	0.769	0.783	0.797
3 Years	0.658	0.675	0.693	0.712
4 Years	0.572	0.592	0.613	0.636
	2.855	2.913	2.974	3.038

(b) S Ltd. has Rs. 10,00,000 allocated for capital budgeting purposes. The following proposals and associated profitability indexes have been determined.

Project	Amount	Profitability Index
1	3,00,000	1.22
2	1,50,000	0.95
3	3,50,000	1.20
4	4,50,000	1.18
5	2,00,000	1.20
6	4,00,000	1.05

Which of the above investments should be undertaken? Assume that projects are indivisible and there is no alternative use of the money allocated for capital budgeting.

(Final-Nov. 1998) (12 + 8 marks)

Answer

(a) Cost of Project M

At 15% I.R.R., the sum total of cash inflows = Cost of the project i.e. Initial cash outlay 11 Given:

Annual cost saving	Rs. 40,000
Useful life	4 years
IRR	15%

Now, considering the discount factor table @ 15% cumulative present value of cash inflows for 4 years is 2.855

Therefore,

Total of cash inflows for 4 years for Project M is (Rs. 40,000 ´ 2.855) = Rs. 1,14,200

Hence, cost of the project is = Rs. 1,14,200

Payback period of the Project M

Cost of the project

Annual cost saving

Payback period = =

Rs. 1,14,200

40,000

=

= 2.855 or 2 years 11 months approximately

Cost of Capital

If the profitability index (PI) is 1, cash inflows and outflows would be equal. In this case, (PI) is 1.064. Therefore, cash inflows would be more by 0.64 than outflow.

Discounted cash inflows

Cost of the Project

Probability index (PI) =

Discounted cash inflows

Rs. 1,14,200

or 0.064 =

or 1.064 ´ Rs. 1,14,200 = Rs. 1,21,509

Hence discounted cash inflows =Rs. 1,21,509

Since, Annual cost saving is Rs. 40,000. Hence, cumulative discount factor for 4 years

1,21,509

40,000

=

= 3.037725 or 3.038

Considering the discount factor table at discount rate of 12%, the cumulative discount factor for 4 years is 3.038

Hence, the cost of capital is 12%

Net present value of the project

N.P.V. = Total present values of cash inflows – Cost of the project

= Rs. 1,21,509 – Rs. 1,14,200

= Rs. 7,309

(b) Statement showing ranking of projects on the basis of Profitability Index

Project	Amount (Rs.)	P.I.	Rank
1	3,00,000	1.22	1
2	1,50,000	0.95	5
3	3,50,000	1.20	2
4	4,50,000	1.18	3
5	2,00,000	1.20	2
6	4,00,000	1.05	4

Assuming that projects are indivisible and there is no alternative use of the money allocated for capital budgeting on the basis of P.I. , the S Ltd. is advised to undertake investment in projects 1,3 and 5.

However, among the alternative projects the allocation should be made to the projects which adds the most to the shareholders wealth. The NPV method, by its definition, will always select such projects.

Statement showing NPV of the projects

Project (i)	Amount (Rs.) (ii)	P.I. (iii)	Cash inflows of project (Rs.) (iv)=[(ii) ´ (iii)]	N.P.V. of project (Rs.) (v)=[(iv)-(ii)]
1	3,00,000	1.22	3,66,000	66,000
2	1,50,000	0.95	1,42,500	(-) 7,500
3	3,50,000	1.20	4,20,000	70,000
4	4,50,000	1.18	5,31,000	81,000
5	2,00,000	1.20	2,40,000	40,000
6	4,00,000	1.05	4,20,000	20,000

The allocation of funds to the projects 1,3 and 5 (as selected above on the basis of PI) will give NPV of Rs. 1,76,000 and Rs. 1,50,000 will remain unspent.

However, the NPV of the projects 3,4 and 5 is Rs. 1,91,000 which is more than the N.P.V. of projects 1,3 and 5. Further, by undertaking projects 3,4 and 5 no money will remain unspent. Therefore, S Ltd. is advised to undertake investments in projects 3,4 and 5.

Rahul Bansal (Finalist) (35929 Points)
Replied 11 December 2009

Question 3

A large profit making company is considering the installation of a machine to process the waste produced by one of its existing manufacturing process to be converted into a marketable product. At present, the waste is removed by a contractor for disposal on payment by the company of Rs. 50 lacs per annum for the next four years. The contract can be terminated upon installation of the aforesaid machine on payment of a compensation of Rs. 30 lacs before the processing operation starts. This compensation is not allowed as deduction for tax purposes.

The machine required for carrying out the processing will cost Rs. 200 lacs to be financed by a loan repayable in 4 equal installments commencing from the end of year 1. The interest rate is 16% per annum. At the end of the 4^th year, the machine can be sold for Rs. 20 lacs and the cost of dismantling and removal will be Rs. 15 lacs.

Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:

(Rs. In lacs)

Year	1	2	3	4
Sales	322	322	418	418
Material consumption	30	40	85	85
Wages	75	75	85	100
Other expenses	40	45	54	70
Factory overheads	55	60	110	145
Depreciation (as per income tax rules)	50	38	28	21

Initial stock of materials required before commencement of the processing operations is Rs. 20 lacs at the start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be Rs. 55 lacs and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would otherwise have been rented out for Rs. 10 lacs per annum. Labour costs include wages of 40 workers, whose transfer to this process will reduce idle time payments of Rs. 15 lacs in the year 1 and Rs. 10 lacs in the year 2. Factory overheads include apportionment of general factory overheads except to the extent of insurance charges of Rs. 30 lacs per annum payable on this venture. The company’s tax rate is 50%.

Present value factors for four years are as under:

Year	1	2	3	4
Present value factors	0.870	0.756	0.658	0.572

Advise the management on the desirability of installing the machine for processing the waste. All calculations should form part of the answer.

(Final-May 1999) (20 marks)

Answer

Statement of Incremental Profit

(Rs. in lacs)

Years	1	2	3	4
Sales :(A)	322	322	418	418
Material consumption	30	40	85	85
Wages	60	65	85	100
Other expenses	40	45	54	70
Factory overheads (insurance)	30	30	30	30
Loss of rent	10	10	10	10
Interest	32	24	16	8
Depreciation (as per income tax rules)	50	38	28	21
Total cost: (B)	252	252	308	324
Incremental profit (C)=(A)-(B)	70	70	110	94
Tax (50% of (C))	35	35	55	47

Statement of Incremental Cash Flows

(Rs. in lacs)

Years	0	1	2	3	4
Material stocks	(20)	(35)	-	-	-
Compensation for contract	(30)	-	-	-	-
Contract payment saved	-	50	50	50	50
Tax on contract payment	-	(25)	(25)	(25)	(25)
Incremental profit	-	70	70	110	94
Depreciation added back	-	50	38	28	21
Tax on profits	-	(35)	(35)	(55)	(47)
Loan repayment	-	(50)	(50)	(50)	(50)
Profit on sale of machinery (net)	-	-	-	-	5
Total incremental cash flows	(50)	25	48	58	48
Present value factor	1.00	0.870	0.756	0.658	0.572
Net present value of cash flows	(50)	21.75	36.288	38.164	27.456
Net present value	= Rs. 123.658 – Rs. 50 = 73.658 lacs.

Advice: Since the net present value of cash flows is Rs. 73.658 lacs which is positive the management should install the machine for processing the waste.

Notes:

1. Material stock increases are taken in cash flows.

2. Idle time wages have also been considered

3. Apportioned factory overheads are not relevant only insurance charges of this project are relevant.

4. Interest calculated at 16% based on 4 equal instalments of loan repayment.

5. Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains ignored.

6. Saving in contract payment and income tax there on considered in the cash flows.

Rahul Bansal (Finalist) (35929 Points)
Replied 11 December 2009

Question 3

A large profit making company is considering the installation of a machine to process the waste produced by one of its existing manufacturing process to be converted into a marketable product. At present, the waste is removed by a contractor for disposal on payment by the company of Rs. 50 lacs per annum for the next four years. The contract can be terminated upon installation of the aforesaid machine on payment of a compensation of Rs. 30 lacs before the processing operation starts. This compensation is not allowed as deduction for tax purposes.

The machine required for carrying out the processing will cost Rs. 200 lacs to be financed by a loan repayable in 4 equal installments commencing from the end of year 1. The interest rate is 16% per annum. At the end of the 4^th year, the machine can be sold for Rs. 20 lacs and the cost of dismantling and removal will be Rs. 15 lacs.

Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:

(Rs. In lacs)

Year	1	2	3	4
Sales	322	322	418	418
Material consumption	30	40	85	85
Wages	75	75	85	100
Other expenses	40	45	54	70
Factory overheads	55	60	110	145
Depreciation (as per income tax rules)	50	38	28	21

Initial stock of materials required before commencement of the processing operations is Rs. 20 lacs at the start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be Rs. 55 lacs and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would otherwise have been rented out for Rs. 10 lacs per annum. Labour costs include wages of 40 workers, whose transfer to this process will reduce idle time payments of Rs. 15 lacs in the year 1 and Rs. 10 lacs in the year 2. Factory overheads include apportionment of general factory overheads except to the extent of insurance charges of Rs. 30 lacs per annum payable on this venture. The company’s tax rate is 50%.

Present value factors for four years are as under:

Year	1	2	3	4
Present value factors	0.870	0.756	0.658	0.572

Advise the management on the desirability of installing the machine for processing the waste. All calculations should form part of the answer.

(Final-May 1999) (20 marks)

Answer

Statement of Incremental Profit

(Rs. in lacs)

Years	1	2	3	4
Sales :(A)	322	322	418	418
Material consumption	30	40	85	85
Wages	60	65	85	100
Other expenses	40	45	54	70
Factory overheads (insurance)	30	30	30	30
Loss of rent	10	10	10	10
Interest	32	24	16	8
Depreciation (as per income tax rules)	50	38	28	21
Total cost: (B)	252	252	308	324
Incremental profit (C)=(A)-(B)	70	70	110	94
Tax (50% of (C))	35	35	55	47

Statement of Incremental Cash Flows

(Rs. in lacs)

Years	0	1	2	3	4
Material stocks	(20)	(35)	-	-	-
Compensation for contract	(30)	-	-	-	-
Contract payment saved	-	50	50	50	50
Tax on contract payment	-	(25)	(25)	(25)	(25)
Incremental profit	-	70	70	110	94
Depreciation added back	-	50	38	28	21
Tax on profits	-	(35)	(35)	(55)	(47)
Loan repayment	-	(50)	(50)	(50)	(50)
Profit on sale of machinery (net)	-	-	-	-	5
Total incremental cash flows	(50)	25	48	58	48
Present value factor	1.00	0.870	0.756	0.658	0.572
Net present value of cash flows	(50)	21.75	36.288	38.164	27.456
Net present value	= Rs. 123.658 – Rs. 50 = 73.658 lacs.

Advice: Since the net present value of cash flows is Rs. 73.658 lacs which is positive the management should install the machine for processing the waste.

Notes:

1. Material stock increases are taken in cash flows.

2. Idle time wages have also been considered

3. Apportioned factory overheads are not relevant only insurance charges of this project are relevant.

4. Interest calculated at 16% based on 4 equal instalments of loan repayment.

5. Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains ignored.

6. Saving in contract payment and income tax there on considered in the cash flows.

Prabeer (B. COM (H) CA & CS Final) (5484 Points)
Replied 11 December 2009

RAHUL you must've uploaded a .pdf file as u did for hire pur. THanks.

1 Like

Rahul Bansal (Finalist) (35929 Points)
Replied 20 December 2009

of course

Rahul Bansal (Finalist) (35929 Points)
Replied 20 December 2009

CAPITAL BUDGETING

Attached File : 47 capital budgeting.pdf downloaded: 382 times

1 Like

Rahul Bansal (Finalist) (35929 Points)
Replied 20 December 2009

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