PROBLEMS ON CAPITAL BUDGETING
P-1. The cash flow of two different projects is given below
YEAR
0
1
2
PROJECT A – RS. 25000
8000
7000
PROJECT
– RS.
B 25000
7000
7000
3
6000
7000
4
5000
7000
5
4000
7000
Required: If cost of capital is 10%, which project should be accepted under NPV method
and why?
P-2. The cash flows of two projects are given below.
YEAR
0
1
PROJECT A
– RS. 20,000
6,000
PROJECT B
– RS. 20,000
8,000
2
6,000
7,000
3
6,000
6,000
4
6,000
5,000
Required: Internal Rate of Return (IRR)
P-3. A company is considering the purchase of a machine. Two machine are available and
each machine costing Rs. 50,000. Each machine has expected life of 5 years. The cost of
capital is 10%. Net cash flow during the expected life of the machinery is given below.
Years
1
2
3
4
5
Machine A
RS. 20,000
18,000
15,000
12,000
10,000
Machine B
RS. 15,000
15,000
15,000
15,000
15,000
Required: Which machine is preferable on the basis of the following evaluation methods?
i) Payback Period
ii)
Accounting Rate of Return
iii) Net Present Value
iv)
Profitability Index
v) Internal Rate of Return
P-4. A large sized chemical company is considering investing in a project that costs Rs
400,000. The estimated salvage value is zero, tax rate is 55%. The company uses straight
line depreciation and the proposed project has cash flow before tax (CFBT) as follows:
Year
CFBT
1
RS. 100,000
2
100,000
3
150,000
4
150,000
5
250,000
Determine:
a. Payback Period
b. Average Rate of Return
c. Internal Rate of Return
d. Net Present Value at 15%
e. Profitability Index at 15%
P-5 A company has the choice of overhauling its present plant or purchasing a new one.
The company has assembled the following information:
Present machine New machine
Purchasing cost
Rs. 8,000
Rs. 10,000
Remaining book value
3,000
–
Overhaul needed now
4,000
–
Annual cash operating cost
7,000
4,000
Salvage value now
2,000
–
Salvage value 5 yrs from now
500
2,000
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management1
The book salvage value of both machines in 5 years from now would be zero. If the
company keeps the old machine, it will have to be overhauled at the cost shown above.
With the overhaul, it can be made to last for 5 more years. If the new machine is
purchased, it will be used for five years. The company computes depreciation on straight
line basis. The minimum required rate or return is 10% and tax rate is 40%.
Required: Should the company keep the old machine or purchase new one.
P-6 A Company is considering the acquisition of one of two machines. As a basis for
selection of one of them the following data developed
Machine X Machine Y
Investment (original cost)
Rs. 25,000 Rs. 25,000
Annual estimated income after depreciation and income taxes:
Year 1
1,000
4,000
Year 2
1,000
3,000
Year 3
2,000
2,000
Year 4
3,000
2,000
Year 5
5,000
1,000
Estimated life straight line (years)
5
5
Estimated residual value
0
0
Estimated average income tax rate
40%
40%
Required:
a. Compute the cash inflow on each machine
b. Compute Payback period
c. Compute discounted cash flow return i.e. Net present value and internal rate of return
d. Evaluate the results.
P-7. Jackson manufacturing company plans to buy a new machine for one of its factory
departments. Two competing machines from different suppliers are under consideration.
The following reliable data have been developed.
Particulars
Machine A Machine B
Investment (cash cost)
$ 26,563 $ 26,563
Annual estimated income after dep. and taxes
Year – 1
$ 687
$ 4,687
Year – 2
1,687
3,687
Year – 3
2,687
2,687
Year – 4
3,687
1,687
Year – 5
4,689
689
Total
$ 13,437 $ 13,437
Estimated life – (straight line) years
5
5
Estimated residual value
0
0
Estimated average tax rate
30%
30%
Minimum desired rate of return –16 percent
–
–
Required:
1. Compute the net cash in flow on each machine for each year and the total. Assume
depreciation is the only non-cash expenses induced in the above data.
2. Compute the following measures of economic value of investment worth (a) DCF net
present value method, (b) payback method and (c) Average Return on total investment
3. Prepare on evaluation of the result.
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management2
P-8 Jackson manufacturing company plans to buy a new machine for one of its factory
departments. Two competing machines from different suppliers are under consideration.
The following reliable data have been developed.
Particulars
Investment (cash cost)
Annual estimated income after dep.and taxes
Year – 1
Year – 2
Year – 3
Year – 4
Year – 5
Total
Estimated life – (straight line) years
Estimated residual value
Estimated average tax rate
Minimum desired rate of return –16 percent
Machine A
$ 26,563
$ 687
1,687
2,687
3,687
4,689
$13,437
5
0
30%
–
Machine B
$26,563
$4,687
3,687
2,687
1,687
689
$13,437
5
0
30%
–
Required:
1. Compute the net cash in flow on each machine for each year and the total.
2. Compute net present value method, payback method and Average Return on total
investment
3. Evaluate the result.
P-9. A company furnished the following information.
Purchase price of new machine
Rs10,000
Transportation and installation cost
2,000
Increase in working capital in 0 year
2,500
Book salvage value of new machine at end
2,000
Cash salvage value of new machine at end
3,500
Annual cash saving before depreciation and tax
4,000
CSV of old machine today
5,000
CSV of old machine in 4 years
1,000
Service life of old machine
4 years
Current Book salvage value of old machine
4,000
The cost of capital is 10% and corporate tax rate is 50%. Diminishing balance method is
used for all the firm's equipments:
Required: Give your decision whether the old machine should be replaced or not?
P-10. The management of a company has to replace an old machine and is considering to
purchase a new machine. Two competing manufacturers have machines which would satisfy
the managements’ specifications. Data collected to date on each of the two competing
machines are:
Particulars
Machine A
Machine B
Purchase price
Rs. 200,000 Rs. 300,000
Estimate life
5 yrs
5 yrs
Book salvage value, final
Rs. 20,000 Rs. 40,000
Cash salvage value, final
Rs. 20,000 Rs. 30,000
Average annual earning before depreciation and taxes Rs. 60,000 Rs. 100,000
Tax rate
25%
25%
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management3
The book and cash salvage value of existing machine at present is Rs. 20,000. The
company uses straight line depreciation for tax purpose. The target rate of return is 10%.
The company has always used Net Present Value for evaluating the project but thinking
about the investment amount of machine A and machine B; the company has planned to use
profitability index.
Required:
1. Net investment cost and Annual Net Cash Flow of machine A and machine B
2. Which machine should be purchased and why?
P-11 An investment project requires cash outlay of Rs. 200,000. The project would have an
effective life of 5 years. Transport and installation charges for project would be additional
amount of Rs. 20,000. At the end of the 5th year the project would have a zero salvage
value and cash salvage of Rs. 20,000. The tax rate would be 30% and minimum required
rate of return 10%. The present value of Re. 1 to be received at the end of 5 years
discounted at 10% rate is 3.791 and at the end of 5th year is 0.621. The total present
value of the project would be Rs. 315,411.2 without including net salvage value of final
year.
Required:
1. Net Cash Outlay or Investment
2. Annual Cash Flow
3. Net Salvage Value
4. Net Present Value
P-12 A machine purchased 10 years ago for Rs. 100,000 has been depreciated to a zero
book value. Its scrap value at present is estimated at Rs. 2,000. The existing value\e could
be used indefinitely if the firm is willing for high maintenance costs. The final cash value of
the machine will be nil. The company is considering replacing this machine by a new one
costing Rs.150,000. Its installation cost will be Rs.20,000. The book and cash salvage value
of the new machine after 10 years from now will be Rs. zero the new machine require
lower maintenance cost and would release a personal who is normally engaged to monitor
the system.
The firm's marginal tax rate is 50% and minimum required rate of the return is 10%. The
present value of re.1 to be received at the end of each of ten years discounted at 10%
rate is 6.145. The total present value by replacing the old machine will be Rs. 184,350.
Required:
1.
Net cash outlay or net investment cost.
2.
Annual saving on maintenance cost or differential net cash flow
3.
Net present value
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management4
UNIVERSITY QUESTIONS ON CAPITAL BUDGETING
P- 13 The Royal Industries is considering the replacement of one of its molding machines.
The existing machine is in good operating condition but is smaller than required if the firm is
to expand its operation. The old machine is 5 year old, and has a current salvage value of
Rs. 30,000 and a remaining depreciable life of 10 years. The machine was originally
purchased for Rs. 75,000 and is being depreciated at Rs. 5,000 per year for tax
purposes. The new machine will cost Rs. 150,000 and will be depreciated on a straight line
basis over 10 years, with no salvage value. The management anticipates with the expand
operations; there will be need of additional net working capital of Rs. 30,000. The new
machine will allow the firm to expand the current operations and thereby increases annual
sales from Rs. 400,000 to 440,000; annual variable operating costs from Rs. 200,000 to
Rs. 210,000. The company's tax rate is 55% and its cost of capital is 10%.
Required: Desirability of project using PI and NPV.
P-144 Kanchanjunga Textile is considering the replacement of existing machine that can run
for 5 more years producing annual revenues of Rs. 90,000 with cash expenses of Rs.
60,000. Its current book value is Rs. 20,000 and is being depreciated at a Rs. 4,000 per
year down to a zero book value. The machine can be sold today to net Rs. 10,000 and it
could be sol in 5 years to net Rs. 5,000.
The replacement machine will cost Rs. 60,000 plus an additional Rs. 10,000 to install it. It
will generate Rs. 1,20,000 but will have cash expenses of Rs. 60,000. It will be
depreciated using the straight line method of depreciation method over 5 years period at
which time it will have a book value of Rs. 25,000 and cash salvage value of Rs. 30,000.
The replacement machine will require additional working capital of Rs. 10,000.
The firm decides to finance additional investment by taking loans from a bank at 15%
interest rate. The current tax rate is 40%.
Required: Should the firm make replacement? Base your answer on NPV and IRR.(PU
2007Spring)
P-15 Western Kansas University is considering replacing some Ricoh copiers with faster
copiers purchase from Kodak. The administration is very concerned about the rising cost of
operating during the last decade. To divert to Kodak, two operators would have to retrain.
Training and Modeling cost would be $4,000.
Western Kansas’s three Ricoh machines were purchased fro $10,000 each five years ago.
Their expected life was ten years. Their resale value now $1000 each and will be zero in
five more years.
Total cost of new Kodak machines will be $54,000; it will have zero disposal value in five
years. Three Ricoh operators are paid $8 per hour each. They usually work forty hours (40
Hours) a week. Machine break down occurs monthly on each machine, resulting a repair
cost $50 per month. And overtime e four hours at time and one half, per machine per
month to complete the normal monthly work load. Toner, supplies and so on cost $100 a
month for each Ricoh copier.
Kodak system requires will require only two regular operators, on a regular work week of
40 hours each, to do the same work, rates are $10 an hour and no over timing is expected.
Toner supplies and so on will cost of $3,300 annually. Maintenance and repair are fully
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management5
serviced by Kodak for $1050 annually. (Assume a 52 wee year). The cost of capital is
12% and Western Kansas does not pay tax as it is a non profit university.
Required: Should the Western Kansas keep the Ricoh machines or replace by Kodak? (PU
2007Spring)
P-16 Qualitech Photocopy, Putalisadak is considering to buy advanced photo copy machine
that has capacity to produce 1,500,000 copies of photocopies during its life of six years.
Information regarding the machine is as follows:
Cost of photocopy machine
Rs. 200,000
Installation costs
20,000
th
Book salvage value at the end of 6 year
Nil
Cash salvage value at the end of 6th year
20,000
Working capital required at zero year
100,000
Selling price per page of photocopy
1
Variable cost of paper and ink per page
0.60
Maintenance and other operating cost per 3,000
month
Sales of photocopy pages/paper per year
200,000
pieces
Required: Recommend whether Qualitech Photocopy should install the new photo copy
machine. To support your recommendation, use Payback Period, NPV and Internal Rate of
Return criteria. (PU 2007 Fall)
P-17 Trinton Company was operating its production schedule with an old machine
purchased five years before at a cost of $ 9,00,000 with an effective life of 10 years. The
company follows a straight line depreciation policy, and at the end of 5 years the machine
would have no book and cash salvage value.
The company is considering to replace this machine by a modern and superior machine .
The new machine would cost $ 8,00,000 and $ 2,00,000 as installation cost. The machine
being highly automatic would require additional investment of $ 2,00,000 in working
capital. At the end of the 5th year, the machine would have book and cash salvage value
of $ 1,50,000 and $ 1,00,000 respectively.
The old machine could be sold at a market value of $ 5,00,000 today. The company
would be able to save $ 2,00,000 every year for 5 years by using the new machine. The
average cost of capital is 12% and the effective rate of tax is 35%.
Required: NPV and IRR to assess the desirability of the projects. (PU 2006 Spring)
P-18 A mining company, that extracts iron ore from an open pit mine, is considering
investing in a new processing plant that will further process the current output “ore. During
the year 2005, a total of 100,000 tons of ore is extracted. If the output from the
extraction process is sold immediately, a price of Rs. 1,000 per ton of ore can be obtained.
The company has estimated that its extraction costs amount to 70 percent of the net
realizable value of the ore.
As an alternative to selling all the ore at Rs. 1,000 per ton, it is possible to process further
25 percent of the output. The additional cash costs of further processing will be Rs. 100 per
ton. The proposed ore will yield 80 percent final outputs, and can be sold at Rs. 1,600 per
ton.
For additional processing, the company will have to install equipment costing Rs. 10 million.
The equipment is subject to 30 percent depreciation per annum on double declining value
method. It is expected to have a useful life of 5 years. Additional working capital
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management6
requirement is estimated at Rs. 1 million. The expected salvage of the new equipments is
Rs. 0.5 million.
Corporate income tax rate is 25 percent. The minimum required return; i.e. the marginal
cost of capital on this investment proposal is estimated to be 15%.
Required
a. Estimate the net cash flows from startup costs to the termination of the project.
b. b) Is the installation of further processing plant desirable? Use the NPV, IRR and
Payback Period criteria for the project evaluation. (PU 2006 Fall)
P-19 The Raymond Seed Production Company (RSPC) Ltd. is in the business of developing
new varieties of seeds and their processing and marketing through a large network of
dealers all over Nepal. It has recently developed a hybrid seed of rice. On the basis of the
marketing of a small quantity of this seed, the company finds that the seed has a viable
demand. Since the necessary processing facilities are yet to be developed, it has got the
seeds processed on a plant hired from the National Trading Company (NTC) Ltd. which
charges Rs. 125 per hour for 8 hours a day. The NTC Ltd. estimates that it will require
1250 hours working of the plant for 100 days so that the seeds reach the market at right
time.
The RSPC Ltd. is considering setting up its own plant in order to economize the operations
as well as to exercise a better control. The plant is expected to have a useful life of 5
years with a salvage value of Rs. 50,000 at the end of the fifth year. The cost associated
with its acquisition and operations are detailed below.
Acquisition cost, Rs. 325,000
Installation cost, Rs. 75,000
Additional working capital, Rs. 30,000
Annual operating costs
a) Maintenance cost, Rs. 25,000
b) Energy consumption, Rs. 90,000
c) Additional manpower, Rs. 80,000
d) Additional overheads, Rs. 50,000
Besides using for own purpose, the plant can be rented out at least six hours a day for Rs.
150 per hour for 200 days in a year. Tax rate is 30 percent, the cost of capital is 10
percent and depreciation allowed is 25 percent on a double declining basis.
Required:
a. Estimate the incremental net cash flows associated with the acquisition of own plant.
b. Assess the financial viability of the proposal to install the plant. Base your answer
on NPV, PBP and IRR. (PU 2005 Fall)
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management7
RISK AND UNCERTAINTY PROBLEM ON CAPITAL BUDGETING
P -20 A company furnished the following information of three projects.
Projects
A
B
C
Net cash outlays
50,000
60,000
70,000
Projected life
5 YRS
5 YRS
5 YRS
Annual cash inflow
15,000
20,000
25,000
Co-efficient of variation
0.4
0.8
1.2
The company selects the risk adjusted rate of discount on the basis of co-efficient of
variation.
Co-efficient of variation
Risk adjusted rate of discount
0.0
10%
0.4
12%
0.8
14%
1.2
16%
1.6
18%
More Than 2
20%
Required: NPV of the projects and suggest for decision.
P – 21. A company is considering an investment in a project which requires an initial outlay
Rs. 50,000 with an expected cash flow generated over three years as under.
Year I
Cash flow
15000
20000
25000
30000
Prob.
0.1
0.2
0.4
0.3
Year II
Cash flow
15000
20000
25000
30000
Prob.
0.1
0.3
0.4
0.2
Year III
Cash flow
15000
20000
25000
30000
Prob.
0.2
0.5
0.2
0.1
Required: Net Present Value and standard deviation about the expected value. Discount
rate is 5%.
P – 22. Arona Company is considering an investment in two mutually exclusive projects for
Rs. 10,000. The following information regarding the project is given below.
Project I
Year i
Year ii
Year iii
Year iv
Cash flow Prob.
Cash flow Prob.
Cash flow Prob.
Cash flow Prob.
Rs. 1,600
0.1
1,600
0.3
1,600
0.2
1,600
0.2
2,000
0.2
2,000
0.2
2,000
0.5
2,000
0.3
2,400
0.4
2,400
0.3
2,400
0.2
2,400
0.1
3,000
0.3
3,000
0.2
3,000
0.1
3,000
0.4
Project II
Year i
Cash flow Prob.
RS. 1,500
0.1
2,000
0.3
2,500
0.4
3,000
0.2
Year ii
Cash flow Prob.
1,500
0.1
2,000
0.2
2,500
0.3
3,000
0.4
Year iii
Cash flow Prob.
1,500
0.1
2,000
0.2
2,500
0.4
3,000
0.3
Year iv
Cash flow Prob.
1,500
0.1
2,000
0.3
2,500
0.2
3,000
0.4
Required: Which project is preferable to the company if discount rate is 5%..
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management8
.
P – 23. A company is considering an investment in a project that requires an initial outlay of
Rs. 150,000 with an expected cash flow generated over three year’s life.
YEAR I
YEAR II
YEAR III
CFAT
PROB.
CFAT PROB.
CFAT PROB.
RS. 40,000
0.1
RS. 40,000
0.1 RS. 40,000
0.2
50,000
0.2
50,000
0.3
50,000
0.5
75,000
0.4
75,000
0.4
75,000
0.2
100,000
0.3
100,000
0.2
100,000
0.1
Required:
(a) What is the expected NPV of this project, if risk free rate of return is 6%?
(b) Calculate standard deviation about the expected value
(c) Find out the probability that NPV will be greater than or less than zero.
P – 24 A transport company is going to lunch the transport service from Ratnapark to
Banepa. Three vehicle alternatives like Micro bus, minibus and tempo are available
for 5 years life. The annual cash flow estimation for micro bus, minibus and tempo is
given below.
Cash flow
(tempo) (rs.)
10,000
15,000
20,000
25,000
Prob.
0.2
0.4
0.3
0.1
Cash flow (micro
bus) (rs.)
30,000
50,000
75,000
90,000
Prob.
0.4
0.2
0.3
0.1
Cash flow (mini bus)
(rs.)
100,000
120,000
125,000
130,000
Prob.
0.2
0.1
0.3
0.4
The net investment in tempo is Rs. 50,000, micro bus Rs. 150,000 and minibus Rs. 350,000.
The cost of capital is 10%.
Required: Which transport service is preferable to the transport company?
P -25 A company employs the certainty equivalent approach in evaluation of risky
investments. The following information is gathered for making decision either the
project is accepted or rejected.
Year
CFAT
Certainty Equivalent Quotient
0
RS. 200,000
1.0
1
120,000
0.8
2
100,000
0.7
3
90,000
0.6
4
90,000
0.4
5
70,000
0.3
The firm’s cost of equity capital is 15%, its cost of debt is 10% and interest rate on
government securities is 6%.
Required: Desirability of the project using NPV.
P -26 Rama Textile Ltd. is considering an investment in a project which requires an initial
outlay of Rs. 300,000 with an expected life of three years as under the following
estimated cash flow.
Cash Flow (RS.)
Probability
Year I
Year II
Year III
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management9
80,000
100,000
150,000
200,000
0.1
0.3
0.2
0.4
0.2
0.3
0.4
0.1
0.5
0.2
0.2
0.1
Required:
a.
b.
c.
d.
What is expected NPV of the project, if the discount rate is 6%.
Calculate the standard deviation about the expected value.
Find out the probability that NPV is less than zero and more than zero.
What is the probability of being NPV more than 40,000 and less than 40,000.
P -27 The Bottlers Nepal is considering to bring a new soft drink Coca. The project will cost
as investment Rs. 20,000 and will have a service life of three years. The company expects
a net profit after tax cash flow for the three years as follows:
Year I
Year II
Year III
Cash flow
Prob.
Cash flow
Prob.
Cash flow
Prob.
Rs. 2,000
0.10
Rs. 6,000
0.15
Rs. 8,000
0.10
6,000
0.15
10,000
0.20
12,000
0.20
10,000
0.50
14,000
0.40
16,000
0.50
14,000
0.25
18,000
0.25
20,000
0.20
The expected cash flows have perfect correlation overtime and company’s cost of capital is
10%.
Required:
a. The desirability of the project form NPV point of view
b. The chances of NPV being less than zero or more than Rs. 15,000
c. The standard deviation of the probability distribution of Possible Present Value
(assume normal distribution)
P -28 A company adopts certainty equivalent approach for evaluations of risky
investment. The information regarding the project is given below.
Year
Expected CFAT
Certainty equivalent quotient
0
– Rs. 150,000
1.0
1
80,000
0.8
2
70,000
0.7
3
60,000
0.6
4
50,000
0.4
5
40,000
0.3
The firm’s cost of equity capital is 15% its cost of debt is 9% and the riskness rate of
interest on government securities is 6%, should the project be accepted?
The Karnali Project has under consideration two mutually exclusive projects for increasing its
plant capital. The project has developed pessimistic, most likely and optimistic estimates of
the annual cash flows associated with two projects. The estimated cash flows are as under:
Project I
Project II
Net investment outlay
Rs.120,000
Rs.120,000
Net cash flow after taxPessimistic
5,000
16,000
Most likely
18,000
18,000
Optimistic
30,000
21,000
Required: NPV associated with each estimate given for both the projects. Both projects
have 15 years life with cost of capital 10%. Also recommend to the company the project
which it should choose. Give reasons in support of your answer.
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management
10
ASSIGNMENT QUESTIONS:
All EVEN NUMBERS PROBLEMS for even ROLL NUMBER
STUDENTS and uneven questions for UNEVEN ROLL NUMBER
STUDENTS To be submitted within One week from the date of
completion of the chapter.
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof Management
11