Workbook 6

Capital Budgeting/Making Capital Investment Decisions/ Estimation of Project

Cash Flows
1. Ojus Enterprises is determining the cash flow for a project involving replacement of an old machine by a
new machine. The old machine, bought a few years ago, has a book value of Rs 400,000 and it can be sold
to realize a post-tax salvage value of Rs 500, 000. It has a remaining life of 5 years after which its net
salvage value is expected to be Rs 160,000. It is being depreciated annually at a rate of 25 % under the
WDV method. The working capital required for the old machine is Rs 400,000.
The new machine costs Rs 1,600,000. It is expected to fetch a net salvage of Rs 800,000 after 5
years when it will no longer be required. The depreciation rate applicable to it is 25 % under the
written down value method. The net working capital required for the new machine is Rs
500,000. the
new
machine is expected to bring a saving of Rs 300,000 annually in
manufacturing costs (other
than
depreciation). The
tax rate applicable to the firm is 40 %.
Given the above information, the incremental after-tax cash flow associated with the
project has been worked out below:

replacement

Solution:

1. The Farlow Company is considering the replacement of a riveting machine with a new one that will
increase the earnings before depreciation from Rs 20,000 per year to Rs 51,000 per year. The new machine
will cost Rs 100,000 and has an estimated life of 8 years with no salvage value. The applicable corporate
tax rate is 40%, and the firms cost of capital is 12%. The old machine has been fully depreciated and has
no salvage value.
a) Evaluate the replacement decision using a MACRS 5 year class life
b) Evaluate the replacement decision using the pre-MACRS sum of the years digit accelerated
depreciation
c) Comapre the results
Solution:
a) Calculation of Depreciation
Year
Depreciation rate
Depreciation (Rs 100,000x rate)
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1
2
3
4
20%
32%
19.20% 11.52%
20,000 32,000 19,200 11,520

5
11.52%
11,520

6
7 8
5.76 - 5,760 - -

Note: Calculating depreciation through MACRS , the estimated salvage value need not be deducted from the
original investment outlay.
Calculation of incremental cash flow
Year
Incremental
EBDT
Less: Dep
EBT
Less: Tax @
40%
EAT
Add: Dep
Cash Flow

1
31,000

2
31,000

20,000

32,000 19,200 11,520

(1,000)
(400)

26,600

(600)
32,000
31,400

3
4
5
6
7
8
31,000 31,000 31,000 31,000 31,000 31,000
11,520

5,760

26,280 23,208 23,208 20,904 18,600 18,600

Calculation of NPV
Year
Cash Flow
0
(100,000)
1
26,600
2
31,400
3
26,280
4
23,208
5
23,208
6
20,904
7
18,600
8
18,600
Net Present Value = of all PVs

PVIF@ 12%

PV

= Rs 21,922

Since NPV is positive, replacement should be done

b) Sum of the years = 1+2+3+4+5+6+7+8=36
Depreciation = (Cost SV) x (Remaining useful life/sum of the years)
Year
1
2
3
4
5
6
7
8

Depreciation
Rs 100,000 x 8/36 = Rs 22,222
Rs 100,000 x 7/36 = Rs 19,444
Rs 100,000 x 6/36 = Rs 16,667
Rs 100,000 x 5/36 = Rs 13,889
Rs 100,000 x 4/36 = Rs 11,111
Rs 100,000 x 3/36 = Rs 8,333
Rs 100,000 x 2/36 = Rs 5,556
Rs 100,000 x 1/36 = Rs 2,778

Find the Cash Flow as in (a)

Find NPV @ 12% disount rate as in (a)
Ans: NPV = Rs 20,476 (accept the replacement)
c) NPV in (a) is higher than in (b). It is because, higher depreciation is charged in the earlier year than in
the sum-of-the-year-digit method. The higher the cash flow in the earlier years, the higher will be the
NPV than the lesser cash flow
2. Natural Breverage is contemplating the replacement of one of its bottling machines with a newer and more
efficient one. The old machine has a book value of Rs 500,000 and a remaining useful life of 5 years. The
firm does not expect to realize any return from scrapping the old machine in five years; but it can sell the
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machine new to another firm in the industry for Rs 300,000. Pre-MACRS straight line depreciation was
used for the old machine.
The new machine has a purchase price of Rs 1.1 million, an estimated useful life of 5 years, and an
estimated salvage value of Rs 200,000. It is expected to economize on electric power usage, labor and
repair costs and reduce the number of defective bottles. In total, an annual savings of Rs 250,000 will be
realized if the new machine is installed. The company is in the 40% tax bracket, has a 10% cost of capital,
and will use MACRS 5 year class life depreciation on the new machine.
a) What is the initial cash outlay required for the new machine ?
b) Should Natural Breverages purchase the new machine ? Support your answer.
Solution:
a) Calcuation of initial cash outlay for the new machine:
Cost of new machine
Sale of old machine
Tax savings on old (500,000-300,000)x0.40
Initial Cash Outlay

Rs 1,100,000
(300,000)
(80,000)
Rs 720,000

b) Calcuation of Depreciation of Old machine:

Depreciation of old machine = (Rs 500,000 0)/5 = Rs 100,000
Calcuation of Depreciation of New machine:
Year
Dep rate
Dep (Rs 1,100,000 x rate)

1
2
3
20%
32%
19.20%
220,000 352,000 211,200

4
5
Total
11.52% 11.52% 94.24%
126,720 126,720 1,036,640

Book Salvage Value = Cost of machine Total depreciation = Rs 1,100,000 Rs 1,036,640 = Rs 63,360
Calculation of Incremental Cash Flow:
Year
a. Savings (EBDT)
Differential depreciation:
Depreciation, New
Less: Depreciation, Old
b. Differential Dep
EBT (a-b)
Less: Tax @ 40%
EAT
Add: Diff Dep
Cash Flow

1
2
3
4
5
250,000 Rs 250,000 Rs 250,000 Rs 250,000 Rs 250,000
220,000 352,000
100,000 100,000
120,000 252,000

211,200
100,000
111,200

Calculation of final year cash flow:

Operating Cash flow in year 5
Cash SV of new machine
Tax on profit on sale (Rs 200,000 63,360) x x0.40
Cash Flow

126,720
100,000
26,720

126,720
100,000
26,720

Rs 160,000
200,000
(54,656)
Rs 306,032

Calcuation of NPV
Year Cash Flow PVIF@10% PV
0
(720,000)
1
1
198,000
2
250,800
3
194,480
4
160,688
5
306,032
Net present value = Rs 113,162
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New machine should be purchased.

3. The Starbuck Compnay is considering the purchase of a new machine tool to replace an obsolete one. The
machine being used for the operation has both a tax book value and a market value to zero, it is in good
working order and will last, physically, for at least 5 years. The proposed machine will perform the
operation so much more efficiently that Starbuck engineers estimate that labor, material, and other direct
costs on the operation will be reduced Rs 6,500 a year if it is installed. The proposed machine costs Rs
30,000 delievered and installed, and its economic life is estimated to be 10 years, with zero salvage value.
The company expects to earn 12% on its investment after taxes. The tax rate is 40% and the firm has been
advised that the new equipment will qualify for a MACRS 7 year class life.
a) Should Starbuck buy the new machine ?
b) Assume that the tax book value of the old machine is Rs 6,000, that the annual depreciation charge is
Rs 400, and that the machine has no market value. How do these assumptions affect your answer?
c) Answer part (b) assuming that the old machine has a market value or Rs 4,000
d) Answer part (c) assuming that the annual savings will be Rs 8,000.
Solution:
Given,
Cost of new machine = Rs 30,000
Annual savings on cost = Rs 6,500
Economic life = 10 years
Cost of capital = 12%
Tax rate = 40%
Depreciation = MACRS 7 years class
Calculation of depreciation:
Year
Rate
Depreciation (Rs 30,000 x Rate)
Calcualation of Cash Flows:
Year
1
EBDT
6500
Less: Depreciation
EBT
Less: Tax@ 40%
EAT
Add: Depreciation
Operating Cash Flow

1
2
3
4
5
6
7
8
9 10
14.29% 24.49 17.49 12.49 8.93 8.93 8.92 4.46 - 5247
1338 - -

2
6500

3
4
5
6
7
8
9
10
6500 6500 6500 6500 6500 6500 6500 6500
5247
1338 -

(847)
(339)
(508)
7347
6839

4435

3900

a) Calcuation of NPV
Year
0
1
2
3
4
5
6
7
8
9
10

Cash Flow PVIF @ 12% PV

(30,000)
1
(30,000)
5615
0.8929
5452
4972
4972

0.5674
2248

3900
0.3220

NPV = 208
As the NPV is positive, the company should buy the new machine.
b) Given,
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Book value of old machine = Rs 6,000

Annual Depreciation = Rs 400
Now,
Calculation of net cash outlay:
Cost of New machine
Sale of old machine
Tax adjustment:
Cash Salvage value, old
Less: Book salvage value, old
Loss
Tax savings @ 40%

Rs 30,000
0
0
Rs 6,000
Rs 6000
(2400)
Rs 27,600

Net cash outlay

Calculation of Differential Depreciation

Year
1
2
3
4
5
6 7
Depreciation, new
5247
Depreciation, old
400 400 400 400 400 - Differential Depreciation 3887
3347
Calculation of Cash Flow
Year
Annual saving (EBDIT)
Less: Differential Deprn
EBT
Less: Tax @ 40%
EAT
Add back: Depreciation
Operating cash flows

1
2
3
4
5
6
7
6500 6500 6500 6500 6500 6500 6500
3887
3347
2613 (447)
(179)
(268)
6947
5239

8
1338
1338

9
-

10
-

8
9
10
6500 6500 6500
1338 -

4435

3900

Calculation of NPV
Year
0
1
2
3
4
5
6
7
8
9
10

Cash Flow PVIF @ 12% PV

(27,600)
1
0.8929
5839
0.5674
2519
4970
1406
0.3220

NPV =2031
The present value increases over the part (a), if the given condition exists.
c) Given,
Market value of old machine = Rs 4,000
Now,
Calculation of net cash outlay:
Cost of New machine
Sale of old machine
Tax adjustment:
Cash Salvage value, old
Less: Book salvage value, old
Loss
Tax savings @ 40%
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Rs 30,000
(4000)
4,000
Rs 6,000
Rs 2,000

(800)
Rs 25,200

Net cash outlay

Calculation of NPV
Present value of cash flows from part (b) = Rs 29,631
Less: Net cash outlay
= Rs 25,200
NPV
= Rs 4431
d) Given (related with b and c)
Annual saving = Rs 8,000
Calculation of Cash Flow
Year
1
Annual saving (EBDIT) 8000
Less: Differential Deprn 3887
EBT
4113
Less: Tax @ 40%
EAT
Add back: Depreciation
Operating cash flows

2
3
4
5
6
7
8
8000 8000 8,000 8,000 8,000 8,000 8,000
3347
1338
1053
1892

9
10
8,000 8,000
8000

3997

6947
6139

5872

4800

Calculation of NPV
Year
0
1
2
3
4
5
6
7
8
9
10

Cash Flow PVIF @ 12% PV

(25,200)
1
0.8929
6739
3,901
0.5674
5870
2,155
0.3220
NPV =9,517

4. The Longdon Company has two alternative investment projects, E and F. As a result of a capital rationing
policy, the management is contemplating which project they should accept. The following table provides
the management with all related financial information:
Project E Project F
Cost
Rs 15,000 Rs 15,000
Cash flow per
Rs 5,500
3,200
year
Life
4 years
8 years
Cost of capital
12%
12%
Calculate the NPV and IRR for each project and make your recommendation.
Solution:
Steps:

Find out NPV of Project E = Rs 1705

Find out UAE (EAB) = NPV / PVIFA (4,12%)
o UAE for E = Rs 561.48
o UAE for F = Rs 180.46
Based on UAE, (since NPV is positive), Project E should be accepted
Find out IRR (since cash flow is annuity)
o Find the factor = Initial Cost / Cash flow per year = 2.7273

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o See PVIFA table, factor lies between the factors of 17% and 18%
o Find out the right IRR by interpolation (Ans: 17.31% for Project E)
Repeat same procedure for Project F (NPV = Rs 896, IRR = 13.70%)
Project E should be accepted.

5. The Grant Corporation is considering a project which has a five-year life and costs Rs 25,000. It would
save Rs 4,100 per year in operating costs and increase reveue by Rs 5,000 per year. It would be financed
with a five-year loan with the following payment schedule (annual rate of interest is 8%). No salvage value
for the new purchased equipment is assumed at the end of the project.
Paymen Interest
Payment of
Balance
t
Principal
626.14
2000
426.14
2073.86
626.14 165.91
460.23
1613.63
626.14 129.09
497.05
1116.58
626.14
89.33
536.81
579.77
626.14
46.37
579.77
0
630.70
2500
If the company has a 12% after tax cost of capital and a 40% tax rate, what is the NPV of the project if the
company uses MACRS 3 years class life depreciation?
Solution:
Note: The financing cash flow has no bearing on the solution what-so-ever.
Cash flow before tax = Rs 4,100 + Rs 5,000 = Rs 9,100
Calculation of depreciation:
Year
1
2
3
4
5
Rate
33.33 44.45 14.81 7.41 Depreciation (Rs 25,000 x
11,113
1,852 rate)
Calculation of Cash flow:
Year
1
Cash flow before tax 9,100
Less: Depreciation
EBT
Less: Tax@ 40%
EAT
Add: Depreciation
Operating Cash Flow 8793

2
9,100
11,113
(2012)
(805)
(1207)
11,113

3
4
5
9,100 9,100 9,100
1,852 -

6201

Calculation of NPV
Year
0
1
2
3
4
5

Cash Flow PVIF @ 12% PV

(25,000)
1
0.8929
6941
3,941
0.5674

NPV =2,727
NPV of project is positive, so the project should be accepted.
6. Thoma Pharmaceutical Company may buy DNA testing equipment costing Rs 60,000. This equipment is
expected to reduce clinical staff labor costs by Rs 20,000 annually. The equipment has a useful life of 5
years, but falls in the 3 year property class for cost recovery (depreciation) purpose. No salvage value is
expected at the end. The corporate tax rate for Thoma is 38%, and its required rate of return is 15%. (If
profits before taxes on the project are negative in any year, the firm will receive a tax credit of 38% of the
loss in that year). On the basis of this information, what is the NPV of the project ? Is it acceptable ?
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Solution:
Calculation of Depreciation:
Calculation of depreciation:
Year
Rate
Depreciation (Rs 60,000 x
rate)
Calculation of Cash flow:
Year
1
Cash flow before tax 20,000
Less: Depreciation
EBT
Less: Tax@ 38%
EAT
Add: Depreciation
Operating Cash Flow

1
2
3
4
5
33.33 44.45 14.81 7.41 26,670
4,446 -

2
20,000
26,670
(6670)
(2535)
(4135)
26,670
22,535

3
4
5
20,000 20,000 20,000
4,446 -

4,446 14,089

Calculation of NPV
Year Cash Flow PVIF @ 15% PV
0
(60,000)
1
1
19,999
17,391
2
0.7561
3
10,373
4
5
12,400
0.4972
NPV =(975)
As the NPV is negative, the project is not acceptable.
7. In problem 8, suppose 6% inflation in labor cost savings is expected over the last 4 years, so that savings
in the first year are Rs 20,000, savings in the second year are Rs 21,200 and so forth.
a. If the required rate of return is still 15%, what is the NPV of the project? Is it acceptable?
b. If the working capital requirement of Rs 10,000 were required in addition to the cost of the
equipment and this additional investment were needed over the life of the project, what would be
the effect on NPV? (all other things are the same in part a)
Solution:
Given, Inflation, i = 6%
Calculation of cash flow with a consideration of inflation
Year
Cash flow before tax (in real terms)
Less: Depreciation
EBT
Less: Tax@ 38%
EAT
Add: Depreciation
Nominal Cash Flow
Real Cash Flow = Nominal Cash Flow / (1+i)n

1
20,000

2
21,200
26,670
(5470)
(2079)
(3391)

3
4
5
22,472 23,820 25,250

23,279
20,718

13,036 11,698

Calculation of NPV on the basis of Nominal and Real cash flow

Year
0
1
2
3
4

PVIF @ 15% Nominal Cash Flow PV

1
(60,000)
0.8696
17,309

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Real Cash Flow PV

(60,000)
18867
15666
14,533

9411

0.4972
NPV (nominal) =

7784
3,586 NPV (real)=

5816
(5,103)

In nominal basis, though the project is acceptable, its not acceptable on the real basis
b) Additional working capital requirement = Rs 10,000
Now,
Recalculating the initial investment
Cost of the equipment
= Rs 60,000
Add: additional working capital = Rs 10,000
Total initial investment
= Rs 70,000
Recalculating terminal cash flow
Operating cash flow of 5th year = Rs 15,655
Add: Working capital release
= Rs 10,000
Nominal Cash Flow
= Rs 25,655
Year
0
1
2
3
4
5

PVIF @ 15% Nominal Cash Flow PV

1
(70,000)
0.8696
19,999

Real Cash Flow PV

(70,000)
18867
15,666

17,309
0.4972
NPV (nominal) =

9411
13,036
12,756
(1,461) NPV (real)=

9,532
(11,387)

Project is not acceptable on both basis of cash flows.

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