Capital Budgeting1. 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 1 000 units 2.00 Rs. 3. The company works on a planning horizon of five years and either option will produce the 10. ABC Manufacturing Co. If the advanced model is run at old production level.40 Fixed overheads Rs.000. assess the viability of the proposal. 2.000 with a life of 8 years and a scrap value of Rs. 9.50 Material Cost (Variable) Rs. in five years time.80 Fixed overheads (allocated) Rs. 9.000 Hudsons which are sold annually. Ignoring taxation. the company calculates the average total cost per unit. will be Rs. but also allow increased output. 1. the operators would be free for a proportionate time so that they can be reassigned to other operations. Ltd. 4. 5.35.30.50 Variable overheads Rs. 15.20 Rs. is increasing the level of automation of a production line dedicated to a single product. 250. The capital cost of this alternative is Rs. 15.00 Rs.80 Rs. the machine will probably be replaced by a similar one.05. 1.50 Rs. A comparison between the two is as follows – Particulars Existing machine Advanced model Capacity per annum 2. The scrap value of the automated production line.20. 1.00.000 units Selling price per unit Rs. 9.000. 12 per Hudson and labour and variable overheads will be Rs. The management uses straight-line depreciation and the required rate of return on capital investment is 16% per annum. 18 per Hudson. 4. 2. 4. 3.50 Rs. the break-even volume per year and the NPV. Calculate – Pay Back period. 4. Its market value is currently Rs. 2 . 41 per Hudson.60 The sales director feels that additional output could be sold at Rs. to be reduced by Rs.20 Rs.000. The existing machine had cost Rs. The advanced model will cost Rs. 10 lakhs. XYZ Co. 0. 2.50 Material cost per unit Rs. Depreciation is considered to be the only incremental fixed cost. The Hudson sells for Rs. 100. the Hudson. The required return is 15%. After 5 years.60 Labour cost per unit Rs.00 The introduction of new machine will enable the average level of stocks held. This advanced model will not only produce the current volume of the company’s product more efficiently. The options available are total automation or partial automation. Ltd. 1. It is considered that for the company overall other fixed overheads are unlikely to change. 16 lakhs.40 Rs. Partial automation will result in higher material wastage and an average cost of Rs. Internal Rate of Return and other relevant consideration to be considered for decision. annual profit. Particulars Old Line New Line Selling Price Rs.000 and was being depreciated as per straight-line method over a 10-year period. 5. has found that after only two years of using a machine for a semiautomatic process. at the end of which it would be scrapped. 4.40 Rs.lakhs for the new machine. under total automation. 12. 14 per Hudson.00 Rs. 1.000. whilst the partial automated line will have a nil residual value. 1. The company’s cost of capital is 10%. a more advanced model has arrived in the market. 6. 75 each regardless of the production method employed. Net Present value. Labour and variable overheads are expected to cost Rs. 3. In analysing investment opportunities of this type. Material costs will be Rs.50 per unit. Total automation will involve a total capital cost of Rs.00 Profit per unit Rs.60 Labour cost (Variable) Rs.50. The management seeks your advice in deciding whether to dispose off the waste or process it further.a) Discuss the figures which would be circulated to the management of XYZ Co. 15 per gallon if it was processed further.000 per year. which would have an estimated life of 5 years and no salvage value. require an investment of Rs.000 on research. Estimates indicate that 30. the waste is about 40.) ____ 3 . 6. 1 per gallon to dispose the waste material resulting from its manufacturing operations. 7. however. Avon Chemical Company Limited is presently paying an outside firm Re. Unprocessed waste will be sold off as per present policy. Which alternative would you recommend? (Assume that the firm’s cost of capital is 15% and the tax rate applicable to it is 35%. 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. 1 per gallon. At normal operating capacity.000 per year. Fixed (excluding depreciation) – Rs. Depreciation would be computed by WDV method @ 25%.. 5 per gallon of waste put into process. b) Comment on the figures produced and make a recommendation. no change in the present administrative and selling expenses is expected if the new product is sold. 20. There are no other assets in the 25% block. 30. The details of additional processing costs are as follows: Variable – Rs.000 gallons per year.000 in new equipment.000 gallons of the new product could be sold each year. 40. general factory overheads will be allocated @ Re. In costing the new product. After spending Rs. Additional processing would. in order to assist their investment analysis. the company discovered that the waste could be sold for Rs.00. Ltd. Except for the cost incurred in advertising Rs. discussing any reservations you consider to be appropriate.