Capital Budgeting - LA Page 1

Capital Budgeting techniques and Analysis of Cash flows

1. Calculate the projects ARR.
Year Book value of fixed investment Profit after tax
1 90,000 20,000
2 80,000 22,000
3 70,000 24,000
4 60,000 26,000
5 50,000 28,000

2. A project costs Rs 36,000 and is expected to generate cash inflows of Rs 11,200 annually for 5 years. Calculate
the IRR of the project.
3. A company has Rs 7 crores available for investment. It has evaluated its options and found that only 4
investment projects given below have positive NPV. All these investments are divisible. Advise the management
which investment(s) / projects it should select.
Project Initial investment
(Rs crore)
NPV (Rs crore) PI
X 3.00 0.60 1.20
Y 2.00 0.50 1.25
Z 2.50 1.50 1.60
W 6.00 1.80 1.30

4. Modern Enterprises Ltd. is considering the purchase of a new computer system for its research and development
division, which would cost Rs 35 lakh. The operation and maintenance costs (excluding depreciation) are
expected to be Rs 7 lakh 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 lakh.
The tangible benefits expected in the form of reduction in design and draftsmanship costs would be Rs 12 lakh
per annum. The disposal of used drawing office equipment and furniture initially is anticipated to net Rs 9 lakh.
As capital expenditure in research and development, the proposal would attract a 100% write-off for tax
purposes. The gains arising from disposal of used assets may be considered tax free. The effective tax rate is
35%. The average cost of capital of the company is 12%.
After appropriate analysis of cash flows, advise the company of the financial viability of the proposal. Ignore tax
on salvage value.
5. 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 has no salvage value. The tax rate is 35%. Assume the firm uses SLM
depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax
(CFBT) from the investment proposal are as follows:
Year CFBT (Rs)
1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
Capital Budgeting - LA Page 2

Compute the following: (i) PayBack period (ii) average rate of return (iii) Internal rate of return (iv) NPV at 10%
discount rate (v) Profitability index at 10% discount rate.
6. A firm is considering to install a large stamping machine. Two machines currently being marketed will do the job
satisfactorily. Machine A costs Rs 50,000 and will require cash running expenses of Rs 15,000 each year. It has a
useful life of 6 years and is expected to yield Rs 2000 salvage value at the end of its useful life. Machine B costs Rs
65,000 but cash running expenses are expected to be Rs 12,000. This machine is expected to have a useful life of
10 years with salvage value of Rs 5,000. Assume both the machines will be depreciated on SLM for tax purposes.
If the corporate tax rate is 35% and cost of capital is 10%, which machine should be bought by the company?
7. Mr Rao, Finance Director of Modern synthetics Ltd, called Mr Diwan, Manager Management Services Division of
the company to explore ways and means of improving the MIS in the company. On the basis of their discussion it
became obvious that the company needed a computer system for processing efficiently and accurately the
growing volume of information generated in the business. It was felt that the computer system would also
facilitate the timely preparation of control reports needed by the management. Mr Rao asked Mr Diwan to find
out which computer system would be suitable for the needs of the company and estimate the costs and benefits
expected from it. On the basis of discussions with vendors, Mr Diwan felt that the Alpha III system supplied by
Computronics Ltd was quite suitable for the needs of Modern Syntex Ltd. he estimated the costs and benefits of
the system as follows:
Cost of the computer along with accessories Rs 15 lakh
Operation and maintenance cost Rs 2.5 lakh per annum
Savings in clerical cost Rs 6 lakh per annum
Savings in space cost Rs 1 lakh per annum
The computer would have an economic life of five years and it would be depreciated at the rate of 33 1/3% per
year as per the written down value method. After five years, it would be disposed off for a value equal to its book
value. The tax rate is 50%.
On examining the above information, Mr Rao asked Mr Diwan to prepare a capital budgeting proposal for
submission to the Executive Committee of the Company. He advised him to calculate the internal rate of return.
8. Determine the average rate of return from the following dta of two machines A and B.
Particulars Machine A Machine B
Cost Rs 56,125 Rs 56,125
Annual estimated income after
depreciation and income tax:

Year 1 3,375 11,375
Year 2 5,375 9,375
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
36,875 36,875
Estimated Life (Years) 5 5
Estimated salvage value 3,000 3,000


Dep charged at SLM method