Techniques of Capital Budgeting Part 2 solved questions with solutions
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3. Machine A costs 1,80,000 payable
immediately. Machine B costs Rs. 2,00,000 half payable immediately and half
payable in one year's time. The cash receipts expected are as follows:
|
Year at end |
Machine A |
Machine B |
|
1 |
40,000 |
---------- |
|
2 |
60,000 |
80,000 |
|
3 |
70,000 |
1,00,000 |
|
4 |
50,000 |
1,20,000 |
|
5 |
50,000 |
----------- |
At 8 % opportunity cost, which
machine should be selected on the basis of NPV?
Solution
|
Year |
Machine
A |
Machine
B |
||||
|
|
Cash Flow |
PVF0.08 |
PV = Cash Flow × PVF0.08 |
Cash Flow |
PVF0.08 |
PV= Cash Flow × PVF0.08 |
|
0 |
(1,80,000) |
1.000 |
(1,80,000) |
(1,00,000) |
1.000 |
(1,00,000) |
|
1 |
40,000 |
0.926 |
37,040 |
(1,00,000) |
0.926 |
(92,600) |
|
2 |
60,000 |
0.857 |
51,420 |
80,000 |
0.857 |
68,560 |
|
3 |
70,000 |
0.794 |
55,580 |
1,00,000 |
0.794 |
79,400 |
|
4 |
50,000 |
0.735 |
36,750 |
1,20,000 |
0.735 |
88,200 |
|
5 |
50,000 |
0.681 |
34,050 |
----------- |
0.681 |
-------- |
|
|
NPV |
34,840 |
NPV |
43,560 |
||
NPV = PV of Cash
inflow – PV of Cash outflow
NPV of Machine B is
higher than Machine A. Hence, Machine B should be selected.
4. A company is considering a new
project for which requires a Capital outlay of Rs. 5,00,000 and depreciation is
to be allowed at 20 % on SLM basis. Forecasted annual earnings before charging
depreciation is as follows:
|
Year |
Earnings (Rs.) |
|
1 |
2,50,000 |
|
2 |
2,50,000 |
|
3 |
1,00,000 |
|
4 |
1,20,000 |
|
5 |
80,000 |
|
Total |
8,00,000 |
Evaluate the project using (a)
Payback method. (b) Rate of return on original investment.
Solution
Payback Period
|
Year |
Rs. |
Cumulative |
|
1 |
2,50,000 |
2,50,000 |
|
2 |
2,50,000 |
5,00,000 |
|
3 |
1,00,000 |
6,00,000 |
|
4 |
1,20,000 |
7,20,000 |
|
5 |
80,000 |
8,00,000 |
|
Total |
8,00,000 |
|
Payback period = 2 years (Money invested or Capital outlay
of Rs. 2,00,000 has been recovered in 2 years.)
Rate of return on
original investment
|
Year |
Earnings (Rs.) |
Less: Depreciation |
Net Earnings |
|
1 |
2,50,000 |
(1,00,000) |
1,50,000 |
|
2 |
2,50,000 |
(1,00,000) |
1,50,000 |
|
3 |
1,00,000 |
(1,00,000) |
0 |
|
4 |
1,20,000 |
(1,00,000) |
20,000 |
|
5 |
80,000 |
(1,00,000) |
(20,000) |
|
Total |
|
|
3,00,000 |
Average income = Total net income / no. of years =
Rs.3,00,000 / 5 = Rs. 60,000
Rate of return on original investment = (Average income ÷
original investment) × 100
= (Rs. 60,000 ÷ Rs.5,00,000) × 100 = 12 %.
5. RBL Academy is considering a project with an initial
outflow of Rs. 1,20,000 with following cash inflow:
|
Year |
Cash inflow |
|
1 |
32,000 |
|
2 |
28,000 |
|
3 |
30,000 |
|
4 |
30,000 |
|
5 |
29,000 |
|
Total |
1,49,000 |
Comment on the project considering
cost of capital to be 7% using internal rate of return method.
Solution
Calculation of
Internal rate of return
Cash outflow = Rs.1,20,000
Average cash inflow = Total cash inflow / number of years =
Rs. 1,49,000 / 5 = Rs. 29,800
Approximate payback period = Cash outflow / average cash
inflow
= Rs. 1,20,000 /Rs.29,800 = 4.0268
In PVAF table, value near to 4.0268 in year 5 is 4.1002 at 7
% and 3.9927 at 15%.
|
Year |
Cash inflow |
PVF at 7% |
PVF at 8% |
PV at 7% = Cash inflow × PVF at 7% |
PV at 8% = Cash inflow × PVF at 8% |
|
0 |
(1,20,000) |
1 |
1 |
(1,20,000) |
(1,20,000) |
|
1 |
32,000 |
0.9346 |
0.9259 |
29907.2 |
29628.8 |
|
2 |
28,000 |
0.8734 |
0.8573 |
24455.2 |
24004.4 |
|
3 |
30,000 |
0.8163 |
0.7938 |
24489 |
23814 |
|
4 |
30,000 |
0.7629 |
0.735 |
22887 |
22050 |
|
5 |
29,000 |
0.713 |
0.6806 |
20677 |
19737.4 |
|
Total of PV of cash inflow |
122415.4 |
119234.6 |
|||
|
NPV= Total of PV of cash
inflow – PV of cash outflow |
2415 |
(765.4) |
|||
Using interpolation
formula
IRR = Lower discount rate + [NPV at lower rate / (NPV at
lower rate – NPV at higher rate) × (Difference between two rates)]
= 7% + [2415/2415-(-765.4) × (8% - 7%)]
= 7% + [(2415/3180.4) × 1 %]
7% + 0.7593% = 7.7593 %
Since cost of capital is 7% and IRR is 7.7593%. Hence
project should be included.
