Capital Budgeting

1. A company is considering an investment proposal to install new milling controls at a cost of Rs.
50,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume
the firm uses straight-line depreciation and the same is allowed for tax purposes. The estimated cash
flows before depreciation and tax from the investment proposal are as follows
Year
Cash flow before depreciation and tax
1
Rs. 10,000
2
Rs. 10,692
3
Rs. 12,769
4
Rs. 13,462
5
Rs. 20,385
Compute the following (i) Pay back period; (ii) Average rate of return; (iii) Internal rate of return;
(iv) Net present value at 10% discount rate; (v) Profitability index at 10% discount rate
2. Band Box is considering the purchase of a new wash and dry equipment in order to expand its
operations. Two types of options are available: a low-speed system (LSS) with an initial cost of Rs.
20,000 and a high-speed system (HSS) with an initial cost of Rs. 30,000. Each system has a life of
fifteen years and no salvage value. The net cash flows after taxes associated with each investment
proposal are Rs. 4,000 p.a. for LSS and Rs. 6,000 p.a. for HSS. Which speed system should be chosen
by Band Box assuming 14% cost of capital?
3. Honda Motors Ltd. installed a machine with an estimated life of 5 years and used it for 3 years. The
initial cost including installation charges amounted to Rs. 80 lakhs. According to current assessment, the
machine can be used for another 4 years. The company has just received an offer of Rs. 50 lakhs for the
machine. It is unlikely that a similar offer will be received in the near future. The machine is used for
manufacturing a product which has a falling demand. Losses are anticipated over the next two years.
Details of profitability projections for the next 4 years are as follows
Particulars
Sales
Less: Variable cost
Fixed cost (allocated)
Depreciation
Net Profit/(loss)

Year 1
50.00
27.00
8.00
16.00
(1.00)

2
45.00
24.50
7.50
16.00
(3.00)

3
40.00
23.00
6.50
-10.50

4
35.00
18.00
6.00
-11.00

(in Rs. Lakhs)

As the estimated working results are not very good and as the company has got a very good offer for the
machine, the MD feels that the machine should be sold immediately. What is your advice to the MD?
(Cost of capital for the company is 15%).
4. XYZ Ltd. manufactures components for car industry. It is considering automating its line for
producing crankshaft bearing. The automated equipment will cost Rs. 75 lakhs. It will replace equipment
with a residual value of Rs. 8 lakhs and a written down book value of Rs. 20 lakhs. It is anticipated that
the existing machine has a further five years to run, after which its scrap value would be Rs. 50,000. At
present, the line has a capacity of 12.5 lakh units per annum but it has been running at 80% of capacity
because of lack of demand for its output. The new line will have a capacity of 14 lakh units per annum.
Its life is expected to be 5 years after which scrap value will be Rs. 10,50,000. The main benefit of the
new proposal will be reduction in staffing level and an improvement in price due to its superior quality.
The accountant has prepared the cost estimates shown below based on output of 10 lakh units per
annum. Fixed overheads include depreciation on the old machine of Rs. 4 lakhs per annum and Rs. 13

lakhs for the new machine. It is considered that for the company overall other fixed overheads are
unlikely to change.
Particulars
Old Line
New Line
Selling Price
Rs. 15.00
Rs. 15.50
Material Cost (Variable)
Rs. 4.00
Rs. 3.60
Labour cost (Variable)
Rs. 2.20
Rs. 1.50
Variable overheads
Rs. 1.40
Rs. 1.40
Fixed overheads
Rs. 3.40
Rs. 4.00
Profit per unit
Rs. 4.00
Rs. 5.00
The introduction of new machine will enable the average level of stocks held, to be reduced by Rs. 16
lakhs. After 5 years, the machine will probably be replaced by a similar one. The companys cost of
capital is 10%. Ignoring taxation, assess the viability of the proposal.
5. ABC Manufacturing Co. Ltd. has found that after only two years of using a machine for a semiautomatic process, a more advanced model has arrived in the market. This advanced model will not only
produce the current volume of the companys product more efficiently, but also allow increased output.
The existing machine had cost Rs. 3,20,000 and was being depreciated as per straight-line method over a
10-year period, at the end of which it would be scrapped. Its market value is currently Rs. 1,50,000.
The advanced model will cost Rs. 12,35,000 with a life of 8 years and a scrap value of Rs. 2,05,000. A
comparison between the two is as follows
Particulars
Existing machine
Advanced model
Capacity per annum
2,00,000 units
2,30,000 units
Selling price per unit
Rs. 9.50
Rs. 9.50
Material cost per unit
Rs. 4.80
Rs. 4.60
Labour cost per unit
Rs. 1.20
Rs. 0.80
Fixed overheads (allocated)
Rs. 2.50
Rs. 1.60
The sales director feels that additional output could be sold at Rs. 9.50 per unit. If the advanced model is
run at old production level, the operators would be free for a proportionate time so that they can be
reassigned to other operations. The required return is 15%. Calculate Pay Back period, Net Present
value, Internal Rate of Return and other relevant consideration to be considered for decision.
6. XYZ Co. Ltd. is increasing the level of automation of a production line dedicated to a single product,
the Hudson. The options available are total automation or partial automation. The company works on a
planning horizon of five years and either option will produce the 10,000 Hudsons which are sold
annually. Total automation will involve a total capital cost of Rs. 10 lakhs. Material costs will be Rs. 12
per Hudson and labour and variable overheads will be Rs. 18 per Hudson, under total automation. Partial
automation will result in higher material wastage and an average cost of Rs. 14 per Hudson. Labour and
variable overheads are expected to cost Rs. 41 per Hudson. The capital cost of this alternative is Rs.
250,000.
The Hudson sells for Rs. 75 each regardless of the production method employed. The scrap value of the
automated production line, in five years time, will be Rs. 100,000, whilst the partial automated line will
have a nil residual value. The management uses straight-line depreciation and the required rate of return
on capital investment is 16% per annum. Depreciation is considered to be the only incremental fixed
cost.
In analysing investment opportunities of this type, the company calculates the average total cost per unit,
annual profit, the break-even volume per year and the NPV.

a) Discuss the figures which would be circulated to the management of XYZ Co. Ltd., in order to
assist their investment analysis.
b) Comment on the figures produced and make a recommendation, discussing any reservations you
consider to be appropriate.
7. Avon Chemical Company Limited is presently paying an outside firm Re. 1 per gallon to dispose the
waste material resulting from its manufacturing operations. At normal operating capacity, the waste is
about 40,000 gallons per year. After spending Rs. 40,000 on research, the company discovered that the
waste could be sold for Rs. 15 per gallon if it was processed further. Additional processing would,
however, require an investment of Rs. 6,00,000 in new equipment, which would have an estimated life
of 5 years and no salvage value. Depreciation would be computed by WDV method @ 25%. There are
no other assets in the 25% block.
Except for the cost incurred in advertising Rs. 20,000 per year, no change in the present administrative
and selling expenses is expected if the new product is sold. The details of additional processing costs are
as follows: Variable Rs. 5 per gallon of waste put into process; Fixed (excluding depreciation) Rs.
30,000 per year. In costing the new product, general factory overheads will be allocated @ Re. 1 per
gallon. There will be no losses in processing and it has been assumed that all the waste processed in a
given year will be sold in that very year. Unprocessed waste will be sold off as per present policy.
Estimates indicate that 30,000 gallons of the new product could be sold each year.
The management seeks your advice in deciding whether to dispose off the waste or process it further.
Which alternative would you recommend? (Assume that the firms cost of capital is 15% and the tax rate
applicable to it is 35%.)
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