Techniques of Capital Budgeting numerical with solutions
Capital Budgeting refers to the expenditure on the capital assets. Spending money on capital assets is a very important decision that a finance manager is required to take. Capital investment expenditure may be on Plant, Machinery Equipment, Land, Building etc. It involves substantially higher amounts than for other routine expenses. The decision is irreversible, i.e. it is not possible to withdraw your steps easily, once you have taken few steps in this regard. It has long term impact on the affairs of a company and it, hence determines the future of a company.
An expenditure made on a capital asset has a long term perspective. We spend today, to gain some advantages in future. This expenditure involves a big cash outflow of funds initially, compensated by small but recurring doses of inflow of funds in future for some time.
The essence of the capital budgeting decision making is to determine, whether the initial expenditure of funds is duly compensated by the inflow of funds occurring in future. If greater values can be assigned to the inflow of funds than the present expenditure, then that capital investment proposal must be accepted because that will add up to the wealth of the company.
Initial Cash Outflow = Cost of new plan + Installation expenses + Other Capital expenditure + Additional working capital – [ Salvage value ( Scrap Value) of old plant – Tax liability on account of capital gain on sale of old plant (if any) ]
Subsequent Annual Inflows = Profit after tax (PAT) + Depreciation
Terminal Cash Inflow = Annual cash inflow + Working capital released + [Salvage value (Scrap Value) of new asset – Tax liability on account of capital gain on sale of new asset (if any)]
Capital Gain = Salvage Value of Asset – Book Value of Asset ( or Written Down Value of asset)
If the value is negative, then it is Capital Loss.
Payback Period
The payback period is the time duration required to recover the initial cash outflows. This method is based on cash flows and not on accounting data.
If the cash inflows are uniform
Payback period = Initial cash outflow / Annual cash inflow
If the cash inflows are not uniform then
Payback period = time period in which the cumulative cash flows are equal to initial inflows.
Completed Years + (Cash Flow yet to be recovered / Cash flow for the next year)
Discounted Payback Period
To overcome the limitation of the payback that it does not use time value of money, we may use the discounted cash flows in order to calculate the payback period. Obviously the discounted payback will be longer than the simple payback period.
Accounting Rate of Return (ARR)
Accounting Rate of Return means the average annual yield on the project.
It is calculated by dividing the annual average profits after taxes by the average investment.
ARR = Average PAT / Average Investment
Annual Average profit After Tax = Total Expected Earning after Depreciation and taxes / Duration of Project
Average Investment =[1/2 (original investment – scrap value)] + working capital + scrap value
Average investment = Opening investment + closing investment/ 2
Net Present Value (NPV)
It is net present value of all the cash flows that occur during the entire life span of a project. The outflows will have negative values while the inflows will have positive values. If the present value of inflows is greater than outflows, we get a positive NPV and if the present value of outflows is greater than inflows, we get a negative NPV. The positive NPV means a net gain in value maximization and, therefore, any project which gives a positive NPV is an acceptable project and if it gives a negative NPV, then the project should not be accepted.
NPV = Present value of cash inflows – Present value of cash outflows
Profitability Index
Profitability Index = Present value of cash inflows / Present value of cash outflows
Internal Rate of Return (IRR)
IRR is that rate of discount at which NPV is zero.
Techniques of Capital Budgeting numerical with solutions
1. RBL Ltd. is considering purchasing a machinery to increase its production capacity to meet demand of its products. It is evaluating three machines. The relevant details including estimated yearly expenditure and sales are given below: Corporate Income Tax rate is 30 %.
Machine I | Machine II | Machine III | |
Initial Investment | 30,00,000 | 30,00,000 | 30,00,000 |
Projected sales p.a. | 50,00,000 | 40,00,000 | 45,00,000 |
Projected Cost | |||
Direct Material | 4,00,000 | 5,00,000 | 4,80,000 |
Direct Wages | 5,00,000 | 3,00,000 | 3,60,000 |
Factory Overhead | 6,00,000 | 5,00,000 | 5,80,000 |
Administration overhead | 2,00,000 | 1,00,000 | 1,50,000 |
Selling and Distribution Overhead | 1,00,000 | 1,00,000 | 1,00,000 |
The economic life of Machine 1 is 4 years, while it is 5 years for the machine II and 6 years for machine III. The scrap values are Rs. 4,00,000, Rs. 5,00,000, and Rs. 6,00,000 respectively. Using Payback method, find out the best alternative out of three machines you will recommend to company.
Solution
Machine I | Machine II | Machine III | |
Initial Investment (1) | 30,00,000 | 30,00,000 | 30,00,000 |
Projected sales p.a. (2) | 50,00,000 | 40,00,000 | 45,00,000 |
Projected Cost | |||
Direct Material | 4,00,000 | 5,00,000 | 4,80,000 |
Direct Wages | 5,00,000 | 3,00,000 | 3,60,000 |
Factory Overhead | 6,00,000 | 5,00,000 | 5,80,000 |
Administration overhead | 2,00,000 | 1,00,000 | 1,50,000 |
Selling and Distribution Overhead | 1,00,000 | 1,00,000 | 1,00,000 |
Total Cost (3) | 18,00,000 | 15,00,000 | 16,70,000 |
EBDT (2-3) | 32,00,000 | 25,00,000 | 28,30,000 |
Less: Depreciation | (6,50,000) | (5,00,000) | (4,00,000) |
EBT | 25,50,000 | 20,00,000 | 24,30,000 |
Less tax @ 30 % | (7,65,000) | (6,00,000) | (7,29,000) |
PAT | 17,85,000 | 14,00,000 | 17,01,000 |
Add: Depreciation | 6,50,000 | 5,00,000 | 4,00,000 |
Cash inflow (4) | 24,35,000 | 19,00,000 | 21,01,000 |
Payback period (1÷4) | 1.23 years | 1.58 years | 1.43 years |
Since Machine I has lowest payback, hence company should invest in machine I.
Note: When annual cash inflows are equal
Payback Period = Initial Investment / Annual cash inflow
Depreciation = Initial investment / cost of machine – scrap value / Estimated life
Depreciation on Machinery I = (Rs.30,00,000 – Rs. 4,00,000) / 4 = Rs.6,50,000
Depreciation on Machinery II = (Rs.30,00,000 – Rs. 5,00,000) / 5 = Rs. 5,00,000
Depreciation on Machinery III = (Rs.30,00,000 – Rs. 6,00,000) / 6 = Rs. 4,00,000
2. RBL Academy Ltd. Wants to replace one of its machines in its plant. First option available to company is Installation of equipment “King” having cost of Rs. 7,50,000 with an expectation of cash inflow of Rs. 2,00,000 p.a. for next 6 years. Second is to Install equipment “Queen” having cost of Rs. 5,00,000 which is expected to generate a cash inflow of Rs. 1,80,000 per annum for next 4 years. Which equipment should be preferred under (a) Payback period (b) Internal Rate of Return?
Solution
Payback Period Method
Since annual cash inflows are equal;
Payback period for Equipment “King” = Initial investment or cost of equipment ÷ annual cash inflow
= Rs. 7,50,000 / 2,00,000 = 3.75 years.
Payback period for Equipment “Queen” = Initial investment or cost of equipment ÷ annual cash inflow
= Rs. 5,00,000 / 1,80,000 = 2.78 years.
From Payback Period method, equipment “Queen” is better.
Internal Rate of Return method (IRR)
Since cash annual cash inflows are equal for both equipment;
Equipment “King”-
Initial outflow or investment = Rs. 7,50,000
Annual cash inflow = Rs.2,00,000
Calculating PVAF using Payback period method
PVAF_{r,6 } = Rs. 7,50,000 / Rs.2,00,000 = 3.75
Looking at present value annuity factor table, the value nearest to 3.75 in the year 6 in interest rate column is 15 % (3.784) and 16 % (3.685).
Using interpolation formula
= 15 % + [ (3.784 – 3.75) / (3.784 – 3.685)] × (16 % – 15%) = 15.34 %
Equipment “Queen”-
Initial outflow or investment = Rs. 5,00,000
Annual cash inflow = Rs.1,80,000
PVAF_{r,6 } = Rs. 5,00,000 / Rs.1,80,000 = 2.778
Looking at present value annuity factor table, the value nearest to 2.778 in the year 4 in interest rate column is 16 % (2.798) and 17 % (2.743).
Using interpolation formula
= 16 % +[ (2.798 – 2.778) / (2.798 – 2.743)] × (17 % – 16%) = 16.36 %
Since IRR of Equipment “Queen” has higher IRR so equipment “Queen” should be preferred.
3. Machine A costs 1,80,000 payable immediately. Machine B costs Rs. 2,00,000 half payable immediately and half payable in one year’s time. The cash receipts expected are as follows:
Year at end | Machine A | Machine B |
1 | 40,000 | ———- |
2 | 60,000 | 80,000 |
3 | 70,000 | 1,00,000 |
4 | 50,000 | 1,20,000 |
5 | 50,000 | ———– |
At 8 % opportunity cost, which machine should be selected on the basis of NPV?
Solution
Year | Cash Flow | Machine A PVF_{0.08} | PV = Cash Flow × PVF_{0.08} | Cash Flow | Machine B PVF_{0.08} | PV= Cash Flow × PVF_{0.08} |
0 | (1,80,000) | 1.000 | (1,80,000) | (1,00,000) | 1.000 | (1,00,000) |
1 | 40,000 | 0.926 | 37,040 | (1,00,000) | 0.926 | (92,600) |
2 | 60,000 | 0.857 | 51,420 | 80,000 | 0.857 | 68,560 |
3 | 70,000 | 0.794 | 55,580 | 1,00,000 | 0.794 | 79,400 |
4 | 50,000 | 0.735 | 36,750 | 1,20,000 | 0.735 | 88,200 |
5 | 50,000 | 0.681 | 34,050 NPV=34,840 | ———– | 0.681 | ——– NPV = 43,580 |
NPV = PV of Cash inflow – PV of Cash outflow
NPV of Machine B is higher than Machine A. Hence, Machine B should be selected.
4. A company is considering a new project for which requires a Capital outlay of Rs. 5,00,000 and depreciation is to be allowed at 20 % on SLM basis. Forecasted annual earnings before charging depreciation is as follows:
Year | Earnings (Rs.) |
1 | 2,50,000 |
2 | 2,50,000 |
3 | 1,00,000 |
4 | 1,20,000 |
5 | 80,000 |
Total | 8,00,000 |
Evaluate the project using Payback and Accounting Rate of return.
Solution
Payback Period
Year | Rs. | Cumulative |
1 | 2,50,000 | 2,50,000 |
2 | 2,50,000 | 5,00,000 |
3 | 1,00,000 | 6,00,000 |
4 | 1,20,000 | 7,20,000 |
5 | 80,000 | 8,00,000 |
Total | 8,00,000 |
Payback period = 2 years (Money invested or Capital outlay of Rs. 2,00,000 has been recovered in 2 years.)
Average Rate of return on original investment
Year | Earnings (Rs.) | Less: Depreciation | Net Earnings |
1 | 2,50,000 | (1,00,000) | 1,50,000 |
2 | 2,50,000 | (1,00,000) | 1,50,000 |
3 | 1,00,000 | (1,00,000) | 0 |
4 | 1,20,000 | (1,00,000) | 20,000 |
5 | 80,000 | (1,00,000) | (20,000) |
Total | 3,00,000 |
Average income = Total net income / no. of years = Rs.3,00,000 / 5 = Rs. 60,000
Rate of return on original investment = (Average income ÷ Average investment) × 100
= (Rs. 60,000 ÷ Rs.2,50,000) × 100 = 24 %.
Average investment = (opening investment + closing investment)/2 = (5,00,000 + 0) / 2 = 2,50,000
5. RBL Academy is considering a project with an initial outflow of Rs. 1,20,000 with following cash inflow:
Year | Cash inflow |
1 | 32,000 |
2 | 28,000 |
3 | 30,000 |
4 | 30,000 |
5 | 29,000 |
Total | 1,49,000 |
Comment on the project considering cost of capital to be 7% using internal rate of return method.
Solution
Calculation of Internal rate of return
Cash outflow = Rs.1,20,000
Average cash inflow = Total cash inflow / number of years = Rs. 1,49,000 / 5 = Rs. 29,800
Approximate payback period = Cash outflow / average cash inflow
= Rs. 1,20,000 /Rs.29,800 = 4.0268
In PVAF table, value near to 4.0268 in year 5 is 4.1002 at 7 % and 3.9927 at 8%.
Year | Cash inflow | PVF at 7% | PVF at 8% | PV at 7% = Cash inflow × PVF at 7% | PV at 8% = Cash inflow × PVF at 8% |
0 | (1,20,000) | 1 | 1 | (1,20,000) | (1,20,000) |
1 | 32,000 | 0.9346 | 0.9259 | 29907.2 | 29628.8 |
2 | 28,000 | 0.8734 | 0.8573 | 24455.2 | 24004.4 |
3 | 30,000 | 0.8163 | 0.7938 | 24489 | 23814 |
4 | 30,000 | 0.7629 | 0.735 | 22887 | 22050 |
5 | 29,000 | 0.713 | 0.6806 | 20677 | 19737.4 |
Total of PV of cash inflow | 122415.4 | 119234.6 | |||
NPV= Total of PV of cash inflow – PV of cash outflow | 2415 | (765.4) |
Using interpolation formula
IRR = Lower discount rate + [NPV at lower rate / (NPV at lower rate – NPV at higher rate) × (Difference between two rates)]
= 7% + [2415/2415-(-765.4) × (8% – 7%)]
= 7% + [(2415/3180.4) × 1 %]
7% + 0.7593% = 7.7593 %
Since cost of capital is 7% and IRR is 7.7593%. Hence project should be included.
6. RBL Academy Ltd. is considering two mutually exclusive projects. The after-tax cash flows of these projects are as follows:
Year | Project A Cash flow (Rs.) | Project B Cash flow (Rs.) |
0 | (1,00,000) | (1,00,000) |
1 | 30,000 | |
2 | 30,000 | |
3 | 30,000 | |
4 | 30,000 | |
5 | 30,000 | 1,82,500 |
Opportunity cost of capital for these projects is 10 %. Calculate
a. NPV and IRR of each project.
b. Is there any conflict in ranking of projects? Which project should be accepted?
Solution
NPV of Project A = PV of cash inflow – PV of cash outflow
= Rs. 30,000 × PVAF_{0.1, 5} – Rs.1,00,000
(Since there is equal cash inflow, hence PVAF has been taken)
= (Rs. 30,000 × 3.7908) – Rs.1,00,000
= Rs. 1,13,724 – Rs.1,00,000 = Rs.13,724
NPV of Project B = PV of cash inflow – PV of cash outflow
= Rs. 1,90,000 × PVF_{0.1, 5} – Rs.1,00,000
= (Rs. 1,82,500 × 0.6209) – Rs.1,00,000 = Rs.13,314
Calculation of Internal rate of return
Project A
Initial outflow or investment = Rs. 1,00,000
Annual cash inflow = Rs.30,000
Calculating PVAF using Payback period method
PVAF_{r,5} = Rs. 1,00,000 / Rs.30,000 = 3.333
Looking at present value annuity factor table, the value nearest to 3.333 in the year 5 in interest rate column is 15 % (3.352) and 16 % (3.274).
We can calculate IRR using both methods
Method 1: Using interpolation formula
IRR = Lower discount rate + × (Higher discount rate – Lower discount rate)
= 15 % + [ (3.352– 3.333) / (3.352– 3.274)] × (16 % – 15%) = 15.34 % = 15.24
Method 2 : Using NPV for IRR calculation
NPV @ 15 % = PV of cash inflow – PV of cash outflow
= Rs.30,000 × 3.352 – Rs. 1,00,000 = Rs. 560
NPV @ 16% = Rs.30,000 × 3.274 – Rs. 1,00,000 = (Rs.1,780)
IRR = Lower discount rate + [NPV at lower rate / (NPV at lower rate – NPV at higher rate) × (Difference between two rates)]
= 15 % + [(560/560 + 1780) × 1) = 15.24%
Project B:
In this case, there is only one cash inflow in the year 5. We can use Trial and error method. In PVF table, at year 5, we need to find an interest rate whose value when multiplied by cash inflow gives positive return and other which gives negative return and difference between two rates is 1.
Looking into PVF table at year 5, 12 % (0.567) and 13 % (0.543)will be considered.
NPV at 12 % = PV of cash inflow – PV of cash outflow
= (Rs. 1,82,500 × 0.567) – Rs.1,00,000 = Rs. 3,477.5
NPV at 13 % =( Rs. 1,82,500 × 0.543) – Rs.1,00,000 = (Rs. 902.5)
IRR = Lower discount rate + [NPV at lower rate / (NPV at lower rate – NPV at higher rate) × (Difference between two rates)]
= 12 % + [ (3,477.5/ 3,477.5 + 902.5)] × 1 = 12.79 %
According to NPV method and IRR method, Project A is better. There is no difference in ranking A. Difference in ranking of projects arises because of difference in patterns of inflows. However, in this case from both methods, Project A is better than project B, hence, Project A should be opted.
7. A firm whose cost of capital is 10% is considering two mutually exclusive projects X and Y, The after-tax cash flows of these projects are as follows:
Year | Project X (Rs.) | Project Y (Rs.) |
0 | (1,00,000) | (1,00,000) |
1 | 15,000 | 45,000 |
2 | 18,000 | 45,000 |
3 | 30,000 | 22,000 |
4 | 45,000 | 10,000 |
5 | 60,000 | 10,000 |
Compute the Net Present Value at 10%, Profitability Index, and Internal Rate of Return for the two projects.
Solution
Calculation of NPV & IRR
Year | Project X (Rs.) | Project Y (Rs.) | PVF @ 10 % | PV of X = PVF × cash flow | PV of Y = PVF × cash flow |
0 | (1,00,000) | (1,00,000) | 1 | (1,00,000) | (1,00,000) |
1 | 15,000 | 45,000 | 0.909 | 13,635 | 40,905 |
2 | 18,000 | 45,000 | 0.826 | 14,868 | 37,170 |
3 | 30,000 | 22,000 | 0.751 | 22,530 | 16,522 |
4 | 45,000 | 10,000 | 0.683 | 30,735 | 6,830 |
5 | 60,000 | 10,000 | 0.621 | 37,260 | 6,210 |
Total of cash inflows | 1,68,000 | ||||
Total of PV of cash inflows | 1,19,028 | 1,07,637 | |||
PV of cash outflow | (1,00,000) | (1,00,000) | |||
NPV = Total of PV of cash inflows – PV of cash outflow | 19,028 | 7,637 | |||
Profitability index = PV of cash inflows / PV of cash outflow | 1.19028 | 1.07637 |
Calculation of IRR
Project X
Calculating PVAF using Payback period method
Payback value = Initial cash outflow / average cash inflow
Project X average cash inflow = Rs. 1,68,000 / 5 = Rs. 33,600
Payback value (PVAF_{r,5}) = Rs. 1,00,000 / Rs.33,600 = 2.976
The PVAF table indicates that for Project X, the PV Factor closest to 2.976 against 5 years is 2.991 at 20% and In the case of Project X, since Cash inflow in the initial years are considerably smaller than the average cash flows, the IRR is likely to be much smaller than 19%. So, Project X may be tried at 15% and 16% .
Year | Project X (Rs.) | PVF @ 16 % | PVF @ 15 % | PV of cash inflow @ 15 % | PV of cash inflow @ 16 % |
0 | (1,00,000) | 1 | 1 | (1,00,000) | (1,00,000) |
1 | 15,000 | 0.87 | 0.862 | 13050 | 12930 |
2 | 18,000 | 0.756 | 0.743 | 13608 | 13374 |
3 | 30,000 | 0.658 | 0.641 | 19740 | 19230 |
4 | 45,000 | 0.572 | 0.552 | 25740 | 24840 |
5 | 60,000 | 0.497 | 0.476 | 29820 | 28560 |
Total of PV of cash inflows | 101958 | 98934 | |||
NPV | 1,958 | (1,066) |
IRR = Lower discount rate + [NPV at lower rate / (NPV at lower rate – NPV at higher rate) × (Difference between two rates)]
= 15 % + [ (1,958/ 1,958 + 1,066) × 1] = 15.65%
Project Y
Calculating PVAF using Payback period method
Payback value = Initial cash outflow / average cash inflow
Project Y average cash inflow = Rs.1,32,000/5 = Rs.26,400
Payback value (PVAF_{r,5}) = Rs. 1,00,000 / Rs.26,400 = 3.788
Looking at present value annuity factor table, the value nearest to 3.788 in the year 5 in interest rate column for Project Y, is 3.791 at 10%. In the case of Project Y, Cash inflow in the initial years are considerably larger than the average cash flows, the IRR is likely to be much higher than 10%. Project Y may be tried at 14% and 15%
Year | Project Y (Rs.) | PVF @ 14 % | PVF @ 15 % | PV of cash inflow @ 14 % | PV of cash inflow @ 15 % |
0 | (1,00,000) | 1 | 1 | (1,00,000) | (1,00,000) |
1 | 45,000 | 0.877 | 0.87 | 39465 | 39150 |
2 | 45,000 | 0.769 | 0.756 | 34605 | 34020 |
3 | 22,000 | 0.675 | 0.658 | 14850 | 14476 |
4 | 10,000 | 0.592 | 0.572 | 5920 | 5720 |
5 | 10,000 | 0.519 | 0.497 | 5190 | 4970 |
Total of PV of cash inflows | 100030 | 98336 | |||
NPV | 30 | 1,664 |
IRR = Lower discount rate + [NPV at lower rate / (NPV at lower rate – NPV at higher rate) × (Difference between two rates)]
= 14 % + [ (30 / 30 + 1,664) × 1] = 14.02 %
8. A Company requires an initíal investment of Rs. 50,000. The estimated net cash flow are as follows-
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
Cash inflow | 8000 | 8000 | 8000 | 10000 | 10000 | 15000 | 8000 | 10000 | 8000 | 5000 |
Using 10% as the cost of capital (rate of discount), determine (i) Pay-back period (ii) Net Present Value and (iii) Internal Rate of Return.
Solution
Payback period:
Payback refers to time period in which initial cash outflow is recovered. Cash inflow generated in first 5 year = Rs. 44,000
Remaining cash outlay to be recovered = Rs.50,000 – Rs.44,000 = Rs.6,000
6^{th} year cash inflow = Rs. 15,000
Payback period = 5 years + (6000/15,000) = 5.4 years
NPV calculation
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
Cash inflow | 8000 | 8000 | 8000 | 10000 | 10000 | 15000 | 8000 | 10000 | 8000 | 5000 |
PVF@ 10% | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 | 0.564 | 0.513 | 0.467 | 0.424 | 0.386 |
PV of cash inflow | 7272 | 6608 | 6008 | 6830 | 6210 | 8460 | 4104 | 4670 | 3392 | 1930 |
NPV = PV of cash inflow – PV of cash outflow = Rs.55,484 – Rs.50,000 = Rs.5,484
IRR calculation
Calculating PVAF using Payback period method
Payback value = Initial cash outflow / average cash inflow
Average cash inflow = Rs. 90,000 / 10 = Rs. 9,000
Payback value (PVAF_{r,10}) = Rs. 50,000 / Rs.9,000 = 5.556
Looking at present value annuity factor table, the value nearest to 5.556 in the year 10 in interest rate column is 12 % (5.650) and 13 % (5.426).
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
Cash inflow | 8000 | 8000 | 8000 | 10000 | 10000 | 15000 | 8000 | 10000 | 8000 | 5000 |
PVFat12% | 0.893 | 0.797 | 0.712 | 0.636 | 0.567 | 0.507 | 0.452 | 0.404 | 0.361 | 0.322 |
PV of cash inflow at 12 % | 7144 | 6376 | 5696 | 6360 | 5670 | 7605 | 3616 | 4040 | 2888 | 1610 |
PVF@13% | 0.885 | 0.783 | 0.693 | 0.613 | 0.543 | 0.48 | 0.425 | 0.376 | 0.333 | 0.295 |
PV of cash inflow at 13% | 7080 | 6264 | 5544 | 6130 | 5430 | 7200 | 3400 | 3760 | 2664 | 1475 |
NPV at 12 % = Rs. 51,005 – Rs. 50,000 = Rs. 1,005
NPV at 13 % = Rs. 48,947 – Rs.50,000 = (Rs.1,053)
IRR = IRR = Lower discount rate + [NPV at lower rate / (NPV at lower rate – NPV at higher rate) × (Difference between two rates)]
= 12% + [ 1005/(1005 + 1,053) × 1] = 12.49%
9. RBL Academy Ltd. is considering the introduction of a new product. It is estimated that profits before depreciation would increase by Rs. 2, 00,000 each year for first four years and Rs. 1,00,000 each for the remaining period. An advertisement cost of Rs. 20,000 is expected to be incurred in the first year, which is not included in the above estimate of profits. The cost will be allowed for tax purpose in the first year. A new plant costing Rs.4,00,000 will be installed for the production of the new product. The salvage value of the plant after its life of 10 years is estimated to be Rs. 50,000. Working capital investment of Rs. 50,000 will be required in the year of installing the plant and a further Rs. 30,000 in the following year. The company’s tax rate is 30% and written down value depreciation at 25%. If the company’s required rate of return is 20%, should the company introduce the new product? Ignore tax effect on Profit/Loss on sale of asset.
Solution
Calculation of Depreciation
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
WDV | 400000 | 300000 | 225000 | 168750 | 126563 | 94922 | 71191 | 53394 | 40045 | 30034 |
Depreciation | 100000 | 75000 | 56250 | 42188 | 31641 | 23730 | 17798 | 13348 | 10011 | 7508 |
Calculation of PV of Cash inflow
Year | PBDT | less:Dep | PBT | Less:Tax | PAT | Add:Dep | Cash inflow | PVF @20% | PV of cash inflow |
1 | 180000 | 100000 | 80000 | 24000 | 56000 | 100000 | 156000 | 0.833 | 129948 |
2 | 200000 | 75000 | 125000 | 37500 | 87500 | 75000 | 162500 | 0.694 | 112775 |
3 | 200000 | 56250 | 143750 | 43125 | 100625 | 56250 | 156875 | 0.579 | 90831 |
4 | 200000 | 42188 | 157813 | 47344 | 110469 | 42188 | 152656 | 0.482 | 73580 |
5 | 100000 | 31641 | 68359 | 20508 | 47852 | 31641 | 79492 | 0.402 | 31956 |
6 | 100000 | 23730 | 76270 | 22881 | 53389 | 23730 | 77119 | 0.335 | 25835 |
7 | 100000 | 17798 | 82202 | 24661 | 57542 | 17798 | 75339 | 0.279 | 21020 |
8 | 100000 | 13348 | 86652 | 25995 | 60656 | 13348 | 74005 | 0.233 | 17243 |
9 | 100000 | 10011 | 89989 | 26997 | 62992 | 10011 | 73003 | 0.194 | 14163 |
10 | 100000 | 7508 | 92492 | 27748 | 64744 | 7508 | 72252 | 0.162 | 11705 |
10 | Working capital released | 80000 | 0.162 | 12960 | |||||
10 | Scrap value of plant | 50000 | 0.162 | 8100 | |||||
Total of PV of Cash inflow | 550115 |
Note: PBDT for year 1 has been taken after subtracting advertisement expense.
PV of cash outflow = Initial outflow + working capital in year zero + working capital in year 1
= Rs. 4,00,000 + Rs.50,000 + Rs.24,990 = Rs. 4,74,990
Working capital in year 1 after discounting at 20 % = Rs.30,000 × 0.833(PVF_{0.2,1}) = Rs.24,990
NPV = PV of cash outflow – PV of cash inflow = Rs.5,50,115 – Rs. 4,74,990 = Rs.75,125
Since, NPV is positive, hence project should be accepted.
10. A company is engaged in evaluating an investment project which requires an initial cash outlay of Rs. 2,50,000 on equipment. The project’s economic life is 10 years and its salvage value 30,000. It would require current assets of Rs. 5 0,000. An additional investment of Rs. 60,000 would also be necessary at the end of five years to restore the efficiency of the equipment. This would be written off completely over the last five years. The project is expected to yield annual profit (before tax) of Rs. 1,20,000. The company follows the sum of the years’ digit method of depreciation. Income-tax rate is assumed to be 30%. Should the project be accepted if the minimum required rate of return is 22 %.
Solution
The depreciation of different years have been calculated as per sum of the years’ digit method as follows:
Initial outlay – Salvage value
Rs. 2,50,000 – Rs.30,000 = Rs. 2,20,000 is to be depreciated over 10 years.
The sum of the years digits for the vears 1-10 is 55.
1+2+3+4+5+6+7+8+9+10 = 55
So, depreciation for year 1 is Rs. 2,20,000 x (10/55) = Rs.40,000
And for the year 2 it is 2,20,000 x (9/55) = Rs.36,00 and so on.
The total depreciation for first 5 years is Rs. 1,60,000 and so the written down value of the asset at the end of year 5, is Rs. 90,000 (i.e., Rs. 2,50,000 – Rs. 1,60,000).
A capital expenditure of Rs. 60000 is required at that stage. So, the total cost required to be depreciated is Rs. 1,20,000 ( ie, Rs. 90,000- Rs. 60,000 – Rs.30,000) .
As per the sum of the years digit method for 5 years (ie, remaining life), the depreciation for the year 6 is Rs. 1,20,.000 x (5/15) = Rs.40,000
for year 2 is Rs. 1,20,000 x( 4/15) = Rs.32,000 and so on.
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
EBDT | 120000 | 120000 | 120000 | 120000 | 120000 | 120000 | 120000 | 120000 | 120000 | 120000 |
Less: Dep | 40,000 | 36,000 | 32,000 | 28,000 | 24,000 | 40,000 | 32,000 | 24,000 | 16,000 | 8,000 |
EBT | 80,000 | 84,000 | 88,000 | 92,000 | 96,000 | 80,000 | 88,000 | 96,000 | 104,000 | 112,000 |
Less: Tax | 24000 | 25200 | 26400 | 27600 | 28800 | 24000 | 26400 | 28800 | 31200 | 33600 |
PAT | 56,000 | 58,800 | 61,600 | 64,400 | 67,200 | 56,000 | 61,600 | 67,200 | 72,800 | 78,400 |
Add: Dep | 40,000 | 36,000 | 32,000 | 28,000 | 24,000 | 40,000 | 32,000 | 24,000 | 16,000 | 8,000 |
Cash Inflow | 96,000 | 94,800 | 93,600 | 92,400 | 91,200 | 96,000 | 93,600 | 91,200 | 88,800 | 86,400 |
Terminal cash inflow | Salvage value + current asset= Rs.30,000 + Rs.50,000 = Rs. 80,000 | 80000 | ||||||||
PVF at22% | 0.82 | 0.672 | 0.551 | 0.451 | 0.37 | 0.303 | 0.249 | 0.204 | 0.167 | 0.137 |
PV of cash inflow | 78720 | 63706 | 51574 | 41672 | 33744 | 29088 | 23306 | 18605 | 14830 | 11837 |
PV of Terminal cash inflow | 10,960 | |||||||||
Total of PV of cash inflow including Terminal value | 3,78,041 |
Present value of cash outflow = Initial cost + current asset + PV of investment in 5^{th} year
= Rs.2,50,000 + Rs.50,000 + Rs.60,000 × 0.37 = Rs.3,22,200
NPV = Total of PV of cash inflow including Terminal value – Present value of cash outflow
= Rs. 3,78,041 – Rs.3,22,200 = Rs.55,841
Since, NPV is positive, hence project should be accepted.
11. Delhi Machinery manufacturing Company wants to replace its manual operations by new machine. There are two alternative models A and B the new machine. Using Payback period, suggest the most profitable investment. Ignore taxation.
A | B | |
Original Investment (Rs.) | 20,000 | 30,000 |
Estimated life of the Machine (Years) | 4 | 6 |
Estimated Savings in Cost (Rs. ) | 10,000 | 10,000 |
Estimated Savings in Wages (Rs.) | 6,000 | 4,000 |
Additional Cost of Maintenance (Rs.) | 5,000 | 2,000 |
Additional Cost of Supervision (Rs.) | 3,000 | 2,000 |
Solution:
A | ||
Estimated Savings in Cost (Rs. ) | 10,000 | 10,000 |
Estimated Savings in Wages (Rs.) | 6,000 | 4,000 |
Less: Additional Cost of Maintenance (Rs.) | (5,000) | (2,000) |
Less: Additional Cost of Supervision (Rs.) | 3,000) | (2,000) |
Net cash inflow | 8,000 | 10,000 |
Payback period | 20,000/8,000 = 2.5 years | 30,000/10,000= 3 years |
Project A should be opted |
12. RST is evaluating two mutually exclusive proposals, A and B. Following information is available about these projects:
Project A | Project B | |
Project Cost (Rs.) | 6,00,000 | 8,00,000 |
Annual Cash Expenses (Rs.) | 1,00,000 | 1,30,000 |
Life (Years) | 10 years | 10 years |
Salvage Value (Rs.) | 1,00,000 | 1,00,000 |
Other Information: Tax rate 40%, Required Rate of Return 12%; Evaluate the proposals on the basis of incremental Cash flows. (Proposal B over Proposal A).
Solution
Project A | Project B | B over A | |
Initial Cost | (600000) | (800000) | -200000 |
Annual Expenses | (100000) | (130000) | (30000) |
Depreciation P.a. | (50000) | 70000 | 20000 |
Annual deductible expenses (Annual Expenses + Depreciation P.a.) | (150000) | (200000) | (50000) |
Annual tax saving @40 % | 60000 | 80000 | 20000 |
Net outflow (annual deductible Expense – Tax saving ) | (90000) | (120000) | (30000) |
Terminal inflow (salvage value) | 100000 | 100000 | 0 |
Calculation of NPV | |||
PV of Annual outflows | 90000 * 5.65 = (5,08,500) | 120000* 5.65 = (6,78,000) | (169500) |
Initial Cost /outflow | (600000) | (800000) | (200000) |
Total outflows (PV) = PV of Annual outflows +Initial Cost /outflow | (1108500) | (1478000) | (369500) |
Less PV of salvage (100000*0.322) | 32200 | 32200 | 0 |
NET Present Value | 1076300) | (1445800) | (369500) |
Since Project B has negative NPV over A , Proposal A should be preferred.
13. The Eastern Corporation Ltd., a firm in the 30% tax bracket with a 15% required rate of return, is considering a new project. This project involves the introduction of a new product. This project is expected to last five years and then to be terminated. Given the following information, determine the after-tax cash flows associated with the project and then find the project’s net present value and advise the company whether it should invest in the project or not.
Cost of new Plant and Equipment: Rs. 20,90,000
Shipping and Installation Cost Rs. 30,000
Unit sales
Year | Units Sold |
1 | 10,000 |
2 | 13,000 |
3 | 16,000 |
4 | 10,000 |
5 | 6,000 |
Sales Price per unit: Rs. 500/unit in years 1-4 and Rs. 380/unit in year 5
Variable Cost per unit: 260/unit
There will be an initial Working capital requirement of Rs. 80,000 just to get production started. For each year, the total investment in net working capital will be equal to 10% of the rupee value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. Use straight-line method for providing depreciation over five years assuming that the plant and equipment will have no salvage value after five years.
Solution
Initial Cash outflow = Cost of machine + Installation cost + Initial Working Capital requirement + Working Capital required for Year 1 in the beginning of the year
= Rs. 20,90,000 + 30,000 + 80,000 + 5,00,000(10 % of sales of first year = 10 % of Rs.50,00,000)
= Rs.27,00,000
Depreciation = (Cost of machine + Installation cost – salvage value) ÷ estimated life
= (Rs. 20,90,000 + Rs.30,000) ÷ 5 = Rs.4,24,000
Change in WC = New WC – Existing WC = Current Year WC – Previous Year WC
Particulars | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
Sales (Units) | 10,000 | 13,000 | 16,000 | 10,000 | 6,000 |
Selling Price /unit ) | 500 | 500 | 500 | 500 | 500 |
Sales | 50,00,000 | 65,00,000 | 80,00,000 | 50,00,000 | 22,80,000 |
Less: Variable Cost at Rs. 260 | (26,00,000) | (33,80,000) | (41,60,000) | (26,00,000) | (15,60,000) |
PBDT | 24,00,000 | 31,20,000 | 38,40,000 | 24,00,000 | 7,20,000 |
Less: Depreciation | (4,24,000) | (4,24,000) | (4,24,000) | (4,24,000) | (4,24,000) |
PBT | 19,76,000 | 26,96000 | 34,16,000 | 19,76,000 | 2,96,000 |
Less: Tax @ 30 % | (5,92800) | (8,08,800) | (10,24,800) | (5,92,800) | (88,800) |
PAT | 13,73,200 | 18,87200 | 23,91,200 | 13,83,200 | 2,07200 |
Add: Depreciation | 4,24,000 | 4,24,000 | 4,24,000 | 4,24,000 | 4,24,000 |
Operating Cash inflow (1) | 17,97,200 | 23,11,200 | 28,15,200 | 18,07,200 | 6,31200 |
WC requirement for N+1 year | 6,50,000 | 8,00,000 | 5,00,000 | 2,28,000 | —– |
Change in WC (2) | 1,50,000(6,50,000-5,00,000) | 1,50,000 | (3,00,000) | (2,72,000) | (2,28,000) |
Release of WC in year 5 (3) | 80,000 | ||||
Net cash flow (1-2+3) | 16,47,200 | 21,61200 | 31,15,200 | 20,79,200 | 9,39,200 |
PVF at 15% | .870 | .756 | .658 | .572 | .497 |
PV of cash inflow | 14,33,064 | 16,33,867 | 20,49,802 | 11,89,302 | 4,66,782 |
NPV = PV of cash inflow – PV of cash outflow
= Rs.67,72,817 – Rs.27,00,000 = Rs.40,72817
Since NPV is positive, project should be accepted.
14. A particular project has a four years life with yearly projected net profit of Rs. 10,000 after charging yearly depreciation of Rs.8000 but before charging tax in order to write off the capital cost of Rs. 32,000. Out of the capital cost, Rs. 20,000 is payable immediately (year 0) and balance in next year (which will be needed for evaluation). Stock amounting to Rs. 6,000 (to be invested in year 0) will be required throughout the project and for debtors a further sum of 8,000 will have to be invested in year 1. The working capital will be recouped in year 5. It is expected that the machinery will fetch a residual value of Rs. 2,000 at the end of 4th year. Income tax is payable @ 40% and the cost of capital is 10%. Income tax is payable next year. The residual value of the machine, Rs. 2,000 will also bear tax @ 40%. Although the profit is for 4 years, for computation of tax and realization of working capital, the computation will be required up to 5 years. Advise the firm.
Solution
Initial Outflows = capital cost at T_{0} + capital cost at T_{1} + Working Capital (Stocks) at T_{0} + Working Capital (Debtors) at T_{1}
Rs.20,000 + (Rs.12,000 × 0.909) + Rs.6,000 + (Rs.8,000 × 0.909) = Rs.44,180
Subsequent annual Cash inflows
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Net Profit | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 |
Add: Residual Value | 2,000 | ||||
Less: Tax @ 40% of preceding year profit | (4,000) | (4,000) | (4,000) | (4,800) | |
Add: Depreciation | 8,000 | 8,000 | 8,000 | 8,000 | |
Add: Working capital recovered | 14,000 | ||||
Cash inflow | 18,000 | 14,000 | 14,000 | 16,000 | 9,200 |
PVF @ 10% | 0.909 | .826 | .751 | .683 | .621 |
PV | 16,362 | 11,564 | 10,514 | 10,928 | 5,713 |
Total PV of cash inflow | 55,081 | ||||
Less: Initial cash outflow | (44,180) | ||||
NPV | 10,901 |
Since NPV is positive, hence project should be accepted.
15. ABC & Co.is considering a proposal to replace one of its plants costing Rs. 60,000 and having a written down value of Rs. 24,000. The remaining economic life of the plant is 4 years after which it will have no salvage value. However, if sold today, it has a salvage of Rs. 20,000. The new machine costing Rs. 1,30,000 is also expected to have a lite of 4 years with a scrap value of Rs. 18,000. The machine, due to its technological superiority, is expected to contribute additional annual benefit (before depreciation tax) of Rs. 60,000. Find out the cash flows associated with the decision given that the tax rate applicable to the firm is 40%. (The capital gain or loss may be taken as not subject to tax).
Solution
Initial cash outflow = cost of machine – Salvage value of existing machine
= Rs.1,30,000 – Rs.20,000 = Rs.1,10,000
Subsequent annual cash inflow
Rs. | |
Annual benefits (PBDT) | 60,000 |
Less: Incremental Depreciation (Rs.28,000 – Rs.6,000) [Dep on new machine – Dep on old machine] | (22,000) |
Incremental Profit before Tax | 38,000 |
Less: Tax @ 40 % | (15,200) |
Incremental Profit after Tax | 22,800 |
Add: Incremental Depreciation | 22,000 |
Incremental cash inflows | 44,800 |
Terminal inflow at the end of the year of Project | 18,000 |
16. A machine purchased six years back for Rs. 1,80,000 has been depreciated to a book value of Rs. 1,08,000. It originally had a projected life of 15 years (Salvage nil). There is a proposal to replace this machine. A new machine will cost Rs. 2,50,000 and result in reduction of operating cost by Rs. 30,000 p.a. for next nine years. The existing machine can now be scrapped away for Rs. 60,000. The new machine will also be depreciated over 9 years period as per straight line method with salvage of 25,000. Find out whether the existing machine be replaced or not given that the tax rate applicable is 30% and cost of capital 10% (profit or loss on sale of assets is to be ignored for tax purposes).
Solution
Initial outflow = Cost of new machine – Salvage value of existing machine
= Rs. 2,50,000 – Rs.60,000 = Rs.1,90,000
Depreciation on new machine = (Cost of machine – Salvage value)/ estimated life = (Rs.2,50,000- Rs.25,000) /9 = Rs.25,000
Depreciation on old machine = Rs.1,80,000/15 or Rs.1,08,000/9 = Rs.12,000
Incremental Depreciation = Depreciation on new machine – Depreciation on old machine
= Rs.25,000 – Rs.12,000 = Rs.13,000
Annual incremental Cash inflow calculation
Particulars | Rs. |
Decrease in operating cost (PBDT) | 30,000 |
Less: Incremental Depreciation | (13,000) |
Incremental PBT | 17,000 |
Less: Tax @ 30% | (5,100) |
Incremental PAT | 11,900 |
Add: Incremental Depreciation | 13,000 |
Incremental Annual cash inflow | 24,900 |
Terminal cash inflow (Salvage value ) | 25,000 |
PV of Incremental Annual cash inflow = 24,900 ×5.758 (PVAF_{.1, 9}) | 1,43,374 |
PV of terminal cash inflow = 25,000 × 0.424 (PVF_{0.1, 9}) | 10,600 |
Total Present value of inflow = 1,43,374 + 10,600 | 1,53,974 |
NPV = Total Present value of inflow – Initial outflow = 1,53,974 – 1,90,000 | (36,026) |
Since, NPV is negative, hence old machine should be kept and replacement decision should not be opted.
17. RBL Ltd. has a machine having an additional life of 5 years which costs Rs. 10,00,000 and has a book value of Rs. 4,00,000. A new machine costing Rs.20,00,000 is available. Though its capacity is the same as that of the old machine, it will mean a saving inn variable costs to the extent of Rs. 7,00,000 per annum. The life of the machine will be 5 years at the end of which it will have a scrap value of Rs. 2,00,000. The rate of income-tax is 40% and P. Ltd.’s policy is not to make an investment if the yield is less than 12% per annum. The old machine, if sold today, will realize Rs. 1,00,000; it will have no salvage value if sold at the end of 5th year. Advise P. Ltd. whether or not the old machine should be replaced. Capital gain is tax free.. Will it make any difference, if the additional depreciation (on new machine) and loss on sale of old machine is also subject to same tax at the rate of 30%, and the scrap value of the new machine is Rs. 3, 00,000.
Solution
Case I: Ignoring income-tax saving on additional depreciation as well as on loss due to sale of existing machine:
Initial Cash outflow = Cost of new machine – Scrap value of old machine
= Rs.20,00,000 – Rs.1,00,000 = Rs.19,00,000
Annual cash inflow
Net saving in variable cost | 7,00,000 |
Less: Tax at 30% | (2,10,000) |
Net benefit / Annual cash inflow | 4,90,000 |
Terminal cash inflow at the end of year 5 (Salvage value of new machine) | 2,00,000 |
PV of cash inflow: Annual cash inflow × PVAF_{0.12, 5} = 4,90,000 × 3.605 = 17,66,450 Terminal cash inflow × PVF_{0.12, 5} = 2,00,000 × 0.567 = 1,13,400 Total of PV of Cash Inflow = | 18,79,850 |
Less: PV of cash outflow | (19,00,000) |
NPV | (20,150) |
Since NPV is negative, there is no need to replace existing machine. |
Case II: if the additional depreciation (on new machine) and loss on sale of old machine is also subject to same tax at the rate of 30%, and the scrap value of the new machine is Rs. 3, 00,000.
Incremental Depreciation = Depreciation on new machine – Depreciation on old machine
= (Rs.20,00,000 – Rs.3,00,000)/5 – Rs.4,00,000/5= Rs. 2,60,000
Cash outflow = Cost of new machine – salvage value of old machine – Tax saving on capital loss on sale of old machine
= Rs.20,00,000 – Rs.1,00,000 – Rs. 90,000 (30 % of Rs.4,00,000 – Rs.1,00,000) = Rs.18,10,000
Net saving in variable cost (PBDT) | 7,00,000 |
Less: Incremental depreciation | (2,60,000) |
Incremental PBT | 4,40,000 |
Less: Tax at 30% | (1,32,000) |
Incremental PAT | 3,08,000 |
Add: Incremental Depreciation | 2,60,000 |
Incremental annual cash inflow | 5,68,000 |
Terminal cash inflow at the end of year 5 (Salvage value of new machine) | 3,00,000 |
PV of cash inflow: Annual cash inflow × PVAF_{0.12, 5} = 5,68,000 × 3.605 = 20,47,640 Terminal cash inflow × PVF_{0.12, 5} = 3,00,000 × 0.567 = 1,70,100 Total of PV of Cash Inflow = | 22,17,740 |
Less: PV of cash outflow | (18,10,000) |
NPV | 4,07,740 |
Since NPV is positive, company should replace existing machine |
18. XYZ Ltd. is considering the purchase of a new computer system for its Research and Development Division, which would cost Rs. 35,00,000. The operation and maintenance costs (excluding depreciation) are expected to be Rs. 7 lacs per annum. It is estimated that the useful life of the system would be 6 years, at the end of which the disposal value is expected to be Rs. 1,00,000. The tangible benefits expected from the system in the form of reduction in design and draftsmanship costs would be Rs.12,00,000 per annum. Besides, the disposal of used drawing office equipment and furniture, initially, is anticipated to net Rs. 10,00,000. Capital expenditure in research and development would attract 100 % write-off for tax purposes. The gains arising on disposal of used assets may be considered tax-free. If company’s effective tax rate is 40%. The average cost of capital to the company is 12%. After appropriate analysis of cash flows, please advise the company of the financial viability of the proposal.
Solution
Cash outflow = Cost of new computer – Disposal of used drawing office
= Rs.35,00,000 – Rs.10,00,000 = Rs.25,00,000
Annual cash inflow calculation
Particulars | Rs. |
Saving in Design and draftsmanship cost | 12,00,000 |
Less : Operation and maintenance cost | (7,00,000) |
PBT | 5,00,000 |
Less: Tax @ 40 % | (2,00,000) |
PAT/ Annual cash inflow | 3,00,000 |
Tax saving on purchase of computer system to be available at the end of year 1 =35,00,000 × 0.4 | 14,00,000 |
Terminal value (Disposal/salvage value) | 1,00,000 |
Calculation of Present value of annual cash flow and NPV
Year | Cash flow | PVF at 12% | PV |
0 | (25,00,000) | 1 | (25,00,000) |
1 | 3,00,000 + 14,00,000(Tax saving) = 17,00,000 | 0.893 | 15,18,100 |
2 | 3,00,000 | 0.797 | 2,39,100 |
3 | 3,00,000 | 0.712 | 2,13,600 |
4 | 3,00,000 | 0.636 | 1,90,800 |
5 | 3,00,000 | 0.567 | 1,70,100 |
6 | 3,00,000 + 1,00,000 (Terminal value) = 4,00,000 | 0.507 | 2,02,800 |
NPV | 34,500 | ||
Since NPV is positive, hence project should be opted. |
19. Central Gas Ltd. is considering enhancing its production capacity. The following two mutually exclusive proposals are being considered
Proposal I | Proposal II | |
Plant | 2,00,000 | 3,00,000 |
Building | 50,000 | 1,00,000 |
Installation cost | 10,000 | 15,000 |
Working capital required | 50,000 | 65,000 |
Annual Earnings (before depreciation) | 70,000 | 95,000 |
Sales Promotion expenses | ———— | 15,000 |
Scrap Value of Plant | 10,000 | 15,000 |
Disposable Value of Building | 30,000 | 60,000 |
Life of the Project is 10 years. Sales promotion expenses of Proposal l are required to be incurred at the end of 2nd year? These expenses have not been considered to find out the Annual earnings (given above). Which proposal be accepted given that the cost of capital of the firm is 10%. Ignore taxation.
Solution
In this case, the Annual earnings before depreciation are given for the proposals. As the tax is to be ignored, these earning may be considered as cash flows also. (It may be noted that there is no tax benefit of depreciation in this case). The two proposals may be evaluated as follows:
Proposal I | Proposal II | |
Initial cash outflow: Cost of Plant Add: Installation cost Add: Cost of Building Add: WC required | 2,00,000 10,000 50,000 50,000 | 3,00,000 15,000 1,00,000 65,000 |
Total Initial cash outflow (I) | 3,10,000 | 4,80,000 |
Annual cash inflow Profit before Depreciation PVAF_{0.1, 10} PV (Profit before Depreciation × PVAF_{0.1, 10}) Less: Present value of sales promotion expenses 15,000 ×0.826 (PVF_{0.1, 2}) | 70,000 6.145 4,30,150 | 95,000 6.145 5,83,775 (12,390) |
Total of Present value Annual cash inflow (II) | 4,30,150 | 5,71,385 |
Terminal value Working capital released Sale value of plant Disposable value of building Total Terminal value PVF_{0.1, 10} | 50,000 10,000 30,000 90,000 0.386 | 65,000 15,000 60,000 1,40,000 0.386 |
Total of Present value of Terminal value (III) | 34,740 | 54,040 |
NPV = II + III – I | 1,54,890 | 1,45,425 |
Since NPV of Project I has higher NPV than Project II. Hence Project I should be accepted. |
20. ABC Ltd. is in the business of manufacturing coir mattresses. It has a plant on a piece of land measuring two acres which was purchased ten years ago for Rs. 10 lacs. The firm is now planning to set up another plant on the same land. 50% of the existing plot is to be earmarked for this purpose. The accountant has supplied the following information:
Capital Expenditure for setting up new plant (incurred in the beginning of the year):
Year 1:
Cost of land Rs. 5,00,000
Land Development Rs. 17,00,000
Payment for purchase of Machine Rs.18,00,000
Year 2:
Final payment for Land Development Rs. 13,00,000
Final payment to Machine supplier Rs. 67,00,000
The Plant has an estimated useful life of 5 years and company follows SL method of depreciation. The information regarding sales and operational expenses is as follows:
Year | 1 | 2 | 3 | 4 | 5 |
Sales (Rs.) | 25 Lakh | 30 Lakh | 35 Lakh | 40 Lakh | 45 Lakh |
Expenses (Rs.) | 5 Lakh | 7 Lakh | 10 Lakh | 12 Lakh | 15 Lakh |
During first year and last year, all sales will be cash sales. In others, 10% of sales will be on credit for a period of one year. If the company’s rate of discount is 15% and the tax rate is 30% should the above proposal be accepted, given that payment for Land Development does not quality for tax rebate.
Solution
Calculation of PV of cash outflows
Outflow in the beginning of the year | |
Land development | 17,00,000 |
Payment for machinery | 18,00,000 |
35,00,000 | |
Outflow in the beginning of year 2 | |
Final payment for land development | 13,00,000 |
Final Payment for Machine | 67,00,000 |
80,00,000 | |
PV of outflow in the beginning of year 2 or at the end of year 1 80,00,000 × .870 (PVF_{0.15, 1}) = | 69,60,000 |
Total Cash outflow = 35,00,000 + 69,60,000 | 1,04,60,000 |
Change in Working Capital arising out of credit sales:
In First year 100 % cash sales – So No change in Working capital.
Year 2: 10 % of sales Rs. 30,00,000 is on credit, hence Rs. 3,00,000 has been subtracted
Year 3 : Previous year credit sales received Rs. 3,00,000
Current Year Credit sales = 10 % of Rs. 35,00,000 = Rs. 3,50,000
Hence change in working capital = Rs. 3,00,000 – Rs. 3,50,000 = (Rs.50,000)
Year 4: Previous year credit sales received Rs. 3,50,000
Current Year Credit sales = 10 % of Rs. 40,00,000 = Rs. 4,00,000
Hence change in working capital = Rs. 3,50,000 – Rs. 4,00,000 = (Rs.50,000)
Year 5: Previous year credit sales received Rs. 4,00,000
Current Year 100% sales is on cash, so no credit sales and debtor exist and an extra of Rs.4,00,000 received of previous year. Hence change in working capital = Rs.4,00,000 – Rs.0 = Rs.4,00,000.
Cash Inflow calculation along with NPV
Particulars | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
Sales | 2500000 | 3000000 | 3500000 | 4000000 | 4500000 |
Less: Expenses | (500000) | (700000) | (1000000) | (1200000) | (1500000) |
Less: Depreciation | (1800000) | (1800000) | (1800000) | (1800000) | (1800000) |
PBT | 200000 | 500000 | 700000 | 1000000 | 1200000 |
Less Tax @ 30 % | (60000) | (150000) | (210000) | (300000) | (360000) |
PAT | 140000 | 350000 | 490000 | 700000 | 840000 |
Add: Depreciation | 1800000 | 1800000 | 1800000 | 1800000 | 1800000 |
Change in WC | (300000) | (50000) | (50000) | 400000 | |
Cash Flow | 1940000 | 1850000 | 2240000 | 2450000 | 3040000 |
PVF at 15 % | 0.87 | 0.756 | 0.658 | 0.572 | 0.497 |
PV of cash inflow | 1687800 | 1398600 | 1473920 | 1401400 | 1510880 |
Total PV of Cash Inflow | 74,72,600 | ||||
Total PV of Cash Outflow | (1,04,60,000) | ||||
NPV | (29,87,400) | ||||
Since NPV is negative, hence the project should not be opted. |
21. The Income Statement of X Ltd. for the current year is as follows
Particulars | Rs. |
Sales | 7,00,000 |
Less: Cost of Material Labour Other operating cost Depreciation | (2,00,000) (2,50,000) (2,50,000) (80,000) |
EBIT | 1,00,000 |
Less: Tax @ 30 % | (30,000) |
Profit after Tax | 70,000 |
The Plant Manager proposes to replace an existing machine by another machine costing Rs. 2,40,000. The new machine will have 8 years life having no salvage value. It is estimated that new machine will reduce the labour costs by Rs. 50,000 per year. The old machine will realize Rs. 40,000. Income statement does not include the depreciation on old machine (the one that is going to be replaced) as the same had been fully depreciated for tax purposes last year though it will still continue to function, if not replaced, for a few years more. It is believed that there will be no change in other expenses and revenue of the firm due to his replacement. The company requires a “After-Tax Return of 10%. The rate of tax applicable to company’s income is 30%. Should the company buy the new machine, assuming that the company follows straight line method of depreciation?
Solution
Initial Cash Outflow
Cost of new Machine – Salvage value of existing machine + Tax on gain of sale of existing machine
= Rs.2,40,000 – Rs.40,000 + Rs.12,000 = Rs.2,12,000.
Profit on sale of existing Machine = Salvage value – Book value = Rs.40,000 – Re. 0 = Rs.40,000
Tax on gain on sale of existing machine = 30 % of Rs.40,000 = Rs.12,000.
Calculation of Annual incremental Cash inflow
Particulars | Rs. |
Saving in Labour expenses | 50,000 |
Less: Depreciation on new Machine | (30,000) |
Incremental PBT | 20,000 |
Less: Tax @ 30 % | (6,000) |
PAT | 14,000 |
Add: Depreciation | 30,000 |
Incremental Cash inflow | 44,000 |
PVAF_{0.1, 8} | 5.335 |
PV of incremental cash inflow | 2,34,740 |
Less: PV of cash outflow | (2,12,000) |
NPV | 22,740 |
Since NPV is positive, hence replacement of machine should be opted. |
22. Strong Enterprises Ltd. is a manufacturer of high quality running shoes. Mr. RBL, President, is considering the company’s ordering, inventory and billing procedures. He estimates that the annual savings from computerization include a reduction of ten clerical employees with annual salaries of Rs. 15,000 each, Rs. 18,000 from reduced production delays caused by raw materials inventory problems, Rs.12,000 from lost sales due to inventory stock outs and Rs.10,000 associated with timely billing procedures. The purchase price of the System is 2,00,000 and installation costs are Rs.50,000. These outlays will be capitalised (depreciated) on a straight-line basis to a zero book salvage value which is also its market value at the end of five years. Operation of the new system requires two computer specialists with annual salaries of Rs. 40,000 per person. Also annual maintenance and operating (cash) expenses of Rs.12,000 are estimated to be required. The company’s tax rate is 30% and its required rate of return (cost of capital) for this project is 12%. You are required to
(a) Find the project’s different cash flows.
(b) Evaluate the project using NPV method, PI method, and payback period method.
(c) Find the project’s cash flows and NPV assuming that the system can be sold for Rs. 30,000 at the end of five years even though the book salvage value will be zero and that capital gain is subject to tax.
(d) Find the project’s cash flows and NPV assuming that the book salvage value for depreciation purposes is Rs. 20,000 even though the machine is worthless is terms of its resale value, and that such loss of Rs.20,000 (book value) is allowed for tax purposes.
Solution
a. Initial cash outflow = Cost of system + Installation cost = Rs.2,00,000 + Rs.50,000 = Rs.2,50,000.
Depreciation = (Cost of system + Installation cost) ÷ Project life = Rs.2,50,000/5 = Rs.50,000.
Calculation of subsequent cash inflow
Particulars | Rs. |
Saving due to installation of new system | |
Savings due to Reduction in clerk salaries | 1,50,000 |
Savings due to reduction in production delays | 18,000 |
Savings due to reduction in lost sales | 12,000 |
Gains due to timely billing | 10,000 |
Total savings | 1,90,000 |
Less: additional specialists cost | (70,000) |
Less: Maintenance cost | (20,000) |
PBDT | 1,00,000 |
Less: Depreciation | (50,000) |
PBT | 50,000 |
Less: Tax @ 30 % | (15,000) |
PAT | 35,000 |
Add: Depreciation | 50,000 |
Annual Cash inflow | 85,000 |
PVAF_{.12, 5} | 3.517 |
PV of cash inflow | 2,98,945 |
PV of cash outflow | (2,50,000) |
B. NPV = PV of cash inflow – PV of cash outflow | 48,945 |
Profitability Index = PV of cash inflow / PV of cash outflow | 1.2 |
Payback period = PV of cash outflow / Annual cash inflow = 2,50,000 /85,000 | 2.94 years |
Since NPV is positive and PI is greater than 1, hence project should be accepted. |
C. Calculation of cash flows in case system can be sold for Rs.30,000 at the end of fifth year
Since, book value of system at the end of fifth year will be nil. Salvage value of Rs.30,000 will be considered as capital gain and tax on capital gain at the rate of 30 % will be deducted from salvage value. Present value of after tax salvage value will be added to current NPV
Salvage value after charging 30 % tax = Rs.30,000 – (Rs.30,000 × 0.3) = Rs.21,000
PV of Post tax salvage value = Rs.21,000 × 0.567 (PVF_{0.12, 5}) = Rs.11,907
New NPV = Rs.48,945 + Rs.11,907 = Rs.60,852.
Since NPV is positive, project should be accepted.
D. Project’s cash flows and NPV assuming that the book salvage value for depreciation purposes is Rs. 20,000 even though the machine is worthless is terms of its resale value, and that such loss of Rs.20,000 (book value) is allowed for tax purposes:
Depreciation = (Cost of system + Installation cost – salvage value) ÷ Project life
= (Rs.2,50,000-Rs.20,000)/5 = Rs.46,000.
Particulars | Rs. |
Saving due to installation of new system | 1,50,000 |
Savings due to Reduction in clerk salaries | 18,000 |
Savings due to reduction in production delays | 12,000 |
Savings due to reduction in lost sales | 10,000 |
Total savings | 1,90,000 |
Less: additional specialists cost | (70,000) |
Less: Maintenance cost | (20,000) |
PBDT | 1,00,000 |
Less: Depreciation | (46,000) |
PBT | 54,000 |
Less: Tax @ 30 % | (16,200) |
PAT | 37,800 |
Add: Depreciation | 50,000 |
Annual Cash inflow | 87,800 |
PVAF_{.12, 5} | 3.517 |
PV of cash inflow | 3,08,792 |
Terminal value arising due to tax saving on loss of asset as it will not realize any value though salvage is 20,000 = 30 % of Rs.20,000 | 6,000 |
PV of terminal value = (PVF_{0.12, 5}) 0.567 × 6,000 | 3,402 |
Total PV of cash inflow = PV of terminal value + PV of cash inflow | 3,12,194 |
PV of cash outflow | (2,50,000) |
NPV = PV of cash inflow – PV of cash outflow | 62,194 |
23. A company has to make a choice between two identical machines A and B, which have been designed differently but do exactly the same job. Machine A costs Rs. 10,00,000 and will last for 3 years. It will cost Rs. 5,00,000 per year to run. Machine B is an economy model costing only Rs. 8,00,000. But it will last only 2 years. Its running charges are Rs. 3,00,000 per year. Ignore taxes. If the opportunity cost of capital is 9%, which machine the company should buy?
Solution
Machine A | Machine B | |
Cost | 10,00,000 | 8,00,000 |
Estimated life | 3 years | 2 years |
PV of annual cost | Rs.5,00,000 × PVAF_{0.09, 3} = Rs.5,00,000 ×2.531 = Rs.12,65,500 | Rs.3,00,000 × PVAF_{0.09, 2} = Rs.3,00,000 × 1.759 = Rs.5,27,700 |
Rs.22,65,500 | Rs.13,27,700 | |
PVAF_{0.09, n} | 2.531 | 1.759 |
Equivalent Annuity value (EAV) | Rs.22,65,500/2.531 = Rs.8,95,100 | Rs.13,27,700/1.759 = 7,54,804 |
Since EAv of Machine B is less , hence Machine B should be preferred.
24. ABC Ltd. is evaluating the following two mutually exclusive proposals.
Project X | Project Y | |
Outlay | 35,000 | 55,000 |
Annual net inflow | 14,000 | 15,000 |
Life | 4 years | 7 years |
Scrap value | 5,000 | 3,000 |
Evaluate the proposals if the discount rate is 12%.
Solution
Calculation of NPV for Project X & Y
Particulars | X | Y |
Annual Cash inflow | 14,000 | 15,000 |
PVAF_{0.12, 4} PVAF_{0.12,, 7} | 3.037 | 4.564 |
PV of cash inflow X = (Annual Cash inflow × PVAF_{0.12, 4}) Y =(Annual Cash inflow × PVAF_{0.12, 7}) | 42,518 | 68,460 |
Terminal value (Salvage value) | 5,000 | 3,000 |
PVF_{0.12, 4} PVF_{0.12, 4} | 0.636 | 0.452 |
PV of Terminal value X = (Annual Cash inflow × PVF_{0.12, 4}) Y =(Annual Cash inflow × PVF_{0.12, 7}) | 3,180 | 1,356 |
Total PV of cash inflow = PV of cash inflow + PV of Terminal value | 45,698 | 69,816 |
PV of cash outflow | (35,000) | (55,000) |
NPV | 10,698 | 14,816 |
In this case, the Project X is giving NPV of Rs.10,698 after 4 years and the Project Y is giving NPV of Rs.14,816 after 7 years. They can be made comparable by finding out the value of equivalent annuity as follows:
Equivalent Annuity amount = NPV/ PVAF _{r, n}
Equivalent Annuity amount of Project X = Rs.10,698 / 3.037 = Rs.3,522
Equivalent Annuity amount of Project Y = Rs.14,816 / 4.564 = Rs.3,246
Company should opt Project X as Equivalent Annuity amount of Project X is more than Project Y.
25. ABC and Co. is considering two mutually exclusive machines X and Y. The company uses a Certainty Equivalent approach to evaluate the proposals. The estimated cash flow and certainty equivalents for both machines are as follows:
Machine X | Machine Y | |||
Year | Cash flow | Certainty equivalent | Cash flow | Certainty equivalent |
0 | (30,000) | 1.00 | (40,000) | 1.00 |
1 | 15,000 | .95 | 25,000 | .9 |
2 | 15,000 | .85 | 20,000 | .8 |
3 | 10,000 | .70 | 15,000 | .7 |
4 | 10,000 | .65 | 10,000 | .6 |
Which machine should be accepted, if the risk free discount rate is 5 %.
Solution
Yr | Machine X | Machine Y | |||||||
Cash flow (A) | Certainty equivalent (B) | Certain cash flow (A ×B) | PVF@6% | PV | Cash flow (A) | Certainty equivalent (B) | Certain cash flow (A×B) | PV = PVF@6% × Certain cash flow | |
0 | (30,000) | 1.00 | (30,000) | 1 | (30,000) | (40,000) | 1.00 | (40,000) | (40,000) |
1 | 15,000 | .95 | 14,250 | .943 | 13,438 | 25,000 | .9 | 22,500 | 21,218 |
2 | 15,000 | .85 | 12,750 | .890 | 11,348 | 20,000 | .8 | 16,000 | 14,240 |
3 | 10,000 | .70 | 7,000 | .840 | 5,880 | 15,000 | .7 | 10,500 | 8,820 |
4 | 10,000 | .65 | 6,500 | .792 | 5,148 | 10,000 | .6 | 6,000 | 4,752 |
NPV =Total of PV of cash inflow- PV of Cash outflow | 5,724 | 9,030 | |||||||
Since NPV of Machine Y is more than Machine X. Hence Machine Y should be accepted |
26. Determine the Risk Adjusted Net Present Value of the following projects:
A | B | C | |
Net cash outlay | (1,10,000) | (1,30,000) | (2,20,000) |
Project Life | 5 years | 5 years | 5 years |
Annual cash inflow | 32,000 | 43,000 | 71,000 |
Coefficient of Variation | 0.4 | 0.8 | 1.2 |
The company selects the risk adjusted rate of discount on the basis of coefficient of variation:
Coefficient of variation | Risk adjusted rate of discount | Payment value factor 1 to 5 years at Risk adjusted rate of discount |
0.0 | 10% | 3.791 |
0.4 | 12% | 3.605 |
0.8 | 14% | 3.433 |
1.2 | 16% | 3.274 |
1.6 | 18% | 3.127 |
2.0 | 22% | 2.864 |
More than 2.0 | 25% | 2.689 |
Solution
Project A | Project B | Project C | |
Net cash outflow | (1,10,000) | (1,30,000) | (2,20,000) |
Coefficient of Variation (COV) | 0.4 | 0.8 | 1.2 |
Risk adjusted discounted rate as per COV | 12% | 14% | 16% |
PVAF _{r, 5} as per Risk adjusted discounted rate | 3.605 | 3.433 | 3.274 |
Annual Cash Inflow | 32,000 | 43,000 | 71,000 |
PV of cash inflow = Annual Cash Inflow × PVAF _{r, 5} as per Risk adjusted discounted rate | 1,15,360 | 1,47,619 | 2,32,454 |
NPV = PV of cash inflow – Net cash outflow | 5,360 | 17,619 | 12,454 |
27. Delta Corporation is considering an investment in one of the two mutually exclusive proposals-
Project A: It requires initial outlay of Rs. 1,80,000.
Project B: It requires initial outlay of Rs. 2,00,000.
The Certainty-Equivalent approach is employed in evaluating risky investments. The current yield on treasury bills is 6 % and the company uses this as riskless rate. Expected values of net cash inflows with their respective certainty-equivalents are:
Year | Project A | Project B | ||
Cash inflow | Certainty equivalent | Cash inflows | Certainty equivalent | |
1 | 95,000 | .8 | 95,000 | .9 |
2 | 1,10,000 | .7 | 95,000 | .8 |
3 | 1,10,000 | .5 | 1,10,000 | .6 |
Which project should be accepted? Which project is riskier? If the company was to use the Risk Adjusted Discount rate method, which project would be analyzed with higher rate?
Solution
Yr | Project A | Project B | |||||||
Cash flow (A) | Certainty equivalent (B) | Certain cash flow (A ×B) | PVF@6% | PV | Cash flow (A) | Certainty equivalent (B) | Certain cash flow (A×B) | PV = PVF@6% × Certain cash flow | |
0 | (1,80,00) | 1.00 | (1,80,000) | 1 | (1,80,000) | (1,65,000) | 1.00 | (1,65,000) | (1,65,000) |
1 | 95,000 | .8 | 76,000 | .943 | 71,668 | 95,000 | .9 | 85,500 | 80,627 |
2 | 1,10,000 | .7 | 77,000 | .890 | 68,530 | 95,000 | .8 | 76,000 | 84,550 |
3 | 1,10,000 | .5 | 55,000 | .840 | 46,200 | 1,10,000 | .6 | 66,000 | 55,440 |
NPV =Total of PV of cash inflow- PV of Cash outflow | 6,398 | 20,617 | |||||||
Since NPV of Project B is more than Project A. Hence Project B should be accepted. Project A is riskier because its certainty equivalent is lower. Project A being more risky, it would be analyzed with higher discount rate. |
28. Alpha Engineering company is generating Rs. 1,00,000 units of waste material per annum. The waste material can be processed further and sold at Rs. 1000 per unit and the variable cost of processing comes to 70% of selling price.
Out of the processed waste material, 25% can be refabricated at a cost of Rs. 10 per unit and the refabricated product can be sold at a price of Rs. 1,500 per unit and there is a waste of 20% of processed material at the time of refabrication.
The refabrication procedure requires a capital expenditure of Rs.80,00,000 with a life of 5 years.(Depreciation is chargeable at 25% WDV) and additional working capital of Rs.10,00,000. Evaluate the proposal to refabricate the processed waste material given that:
(i) Required rate of return is 15%.
(ii) Tax rate applicable to company is 30%.
(iii) Expected salvage value of the plant is Rs. 10,00,000.
(iv) There is no other asset in the same block of assets.
Solution
Out the total waste material that is 1,00,000 units, only 25 % i.e. 25,000 units can be processed and refabricated.
Cash outflow = Capital expenditure + additional working capital
= Rs.80,00,000 + Rs.10,00,000 = Rs.90,00,000
Calculation of subsequent cash inflow
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Refabricated units (25,000 – 20 % of 25,000) | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 |
Sales after refabrication at Rs.1500/unit × 20,000 | 3,00,00,000 | 3,00,00,000 | 3,00,00,000 | 3,00,00,000 | 3,00,00,000 |
Less: Loss of Sales before refabrication (25,000 ×1,000) | (2,50,00,000) | (2,50,00,000) | (2,50,00,000) | (2,50,00,000) | (2,50,00,000) |
Incremental Sales | 50,00,000 | 50,00,000 | 50,00,000 | 50,00,000 | 50,00,000 |
Less: Refabrication cost(25,000 × 100) | (25,00,000) | (25,00,000) | (25,00,000) | (25,00,000) | (25,00,000) |
Incremental PBDT | 25,00,000 | 25,00,000 | 25,00,000 | 25,00,000 | 25,00,000 |
Less: Depreciation at 25% WDV | (20,00,000) | (15,00,000) | (11,25,000) | (8,43,750) | ________ |
Incremental Profit before Tax | 5,00,000 | 10,00,000 | 13,75,000 | 16,56,250 | 25,00,000 |
Less: Tax at 30% | (1,50,000) | (3,00,000) | (4,12,500) | (4,96,875) | (7,50,000) |
Incremental PAT | 3,50,000 | 7,00,000 | 9,62,500 | 11,59,375 | 17,50,000 |
Add: Depreciation | 20,00,000 | 15,00,000 | 11,25,000 | 8,43,750 | |
Incremental Cash inflow | 23,50,000 | 22,00,000 | 20,87,500 | 20,03,125 | 17,50,000 |
Terminal cash inflow | 24,59,375 | ||||
PVF at 12 % | 0.893 | 0.797 | 0.712 | 0.636 | 0.567 |
PV of cash inflow | 20,98,550 | 17,53,400 | 14,86,300 | 12,73,988 | 23,86,715 |
Total PV of cash inflow | 89,98,953 | ||||
PV of cash outflow | 90,00,000 | ||||
NPV | 1,047 | ||||
Since NPV is negative, hence project should not be accepted. | |||||
As there is no other asset in the same block of assets, no depreciation will be charged in the last year. |
Terminal Cash inflow calculation
Tax shield on short term capital loss | |
WDV of asset | 25,31,250 |
Less: Salvage value | (10,00,000) |
15,31,250 | |
Tax saving at 30 % = 0.3 × 15,31,250 (a) | 4,59,375 |
Salvage value (b) | 10,00,000 |
Release of working capital (c) | 10,00,000 |
Total Terminal Value (a+b+c) | 24,59,375 |
Calculation of Depreciation and WDV in the year 5
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Book Value | 80,00,000 | 60,00,000 | 45,00,000 | 33,75,000 | 25,31,250 |
Depreciation | 20,00,000 | 15,00,000 | 11,25,000 | 8,43,750 |
29. Fin man Construction Company is interested in the computerization of its office work. For this purpose two models have been shortlisted, for which the relevant information is as follows:
Model I | Model II | |
Cost | 1,50,000 | 2,50,000 |
Salvage Value | Nil | Nil |
Working Capital Required | 40,000 | 50,000 |
Savings in Expenses | 1,00,000 P.a. | 1,50,000 P.a. |
Life | 5 years | 5 years |
Depreciation | 25 % WDV | 25 % WDV |
Find out which model is better given that
(i) Tax rate is 35%.
(ii) Required rate of return is 13%.
(ii) There is no other asset in the same block of assets.
Solution
Initial cash outflow
Model I | Model II | |
Cost of machine | 1,50,000 | 2,50,000 |
Working capital required | 40,000 | 50,000 |
Total cash outflow | 1,90,000 | 3,00,000 |
Calculation of initial cash inflow
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Saving in expenses | 1,00,000 | 1,00,000 | 1,00,000 | 1,00,000 | 1,00,000 |
Less: Depreciation | (37,500) | (28,125) | (21,094) | (15,820) | _______ |
Incremental PBT | 62,500 | 71,875 | 78,906 | 84,180 | 1,00,000 |
Less: Tax @ 30 % | (18,750) | (21,562) | (23,672) | (25,254) | (30,000) |
PAT | 43,750 | 50,313 | 55,234 | 58,926 | 70,000 |
Add: Depreciation | 37,500 | 28,125 | 21,094 | 15,820 | _______ |
Cash inflow | 81,250 | 78,438 | 76,328 | 74,746 | 70,000 |
Terminal value | 66,611 | ||||
PVF at 12 % | .893 | .797 | .712 | .636 | .567 |
PV of cash inflow | 72,556 | 62,515 | 54,345 | 47,538 | 39,690 |
Total Present value | 2,76,644 |
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Saving in expenses | 1,50,000 | 1,50,000 | 1,50,000 | 1,50,000 | 1,50,000 |
Less: Depreciation | (62,500) | (46,875) | (35,156) | (26,367) | _____ |
Incremental PBT | 87,500 | 1,03,125 | 1,14,844 | 1,23,633 | 1,50,000 |
Less: Tax @ 30 % | (26,250) | (30,937) | (34,453) | (37,090) | (45,000) |
PAT | 61,250 | 72,188 | 80,391 | 86,543 | 1,05,000 |
Add: Depreciation | 62,500 | 46,875 | 35,156 | 26,367 | ____ |
Cash inflow | 1,23,750 | 1,19,063 | 1,15,547 | 1,12,910 | 1,05,000 |
PVF at 12 % | .893 | .797 | .712 | .636 | .567 |
PV of cash inflow | 1,10,509 | 94,893 | 82,270 | 71,810 | |
Total Present value |
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