Techniques of Capital Budgeting Part 1 solved questions with
solutions
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Techniques of Capital Budgeting numerical with
solutions
1.
RBL Ltd. is considering purchasing a machinery to increase its production
capacity to meet demand of its products. It is evaluating three machines. The
relevant details including estimated yearly expenditure and sales are given
below: Corporate Income Tax rate is 30 %.
|
|
Machine I |
Machine II |
Machine III |
|
Initial Investment |
30,00,000 |
30,00,000 |
30,00,000 |
|
Projected sales p.a. |
50,00,000 |
40,00,000 |
45,00,000 |
|
Projected Cost |
|
|
|
|
Direct Material |
4,00,000 |
5,00,000 |
4,80,000 |
|
Direct Wages |
5,00,000 |
3,00,000 |
3,60,000 |
|
Factory Overhead |
6,00,000 |
5,00,000 |
5,80,000 |
|
Administration overhead |
2,00,000 |
1,00,000 |
1,50,000 |
|
Selling and Distribution Overhead |
1,00,000 |
1,00,000 |
1,00,000 |
The
economic life of Machine 1 is 4 years, while it is 5 years for the machine II
and 6 years for machine III. The scrap values are Rs. 4,00,000, Rs. 5,00,000,
and Rs. 6,00,000 respectively. Using Payback method, find out the best alternative out
of three machines you will recommend to company.
Solution
|
|
Machine I |
Machine II |
Machine III |
|
Initial Investment (1) |
30,00,000 |
30,00,000 |
30,00,000 |
|
Projected sales p.a. (2) |
50,00,000 |
40,00,000 |
45,00,000 |
|
Projected Cost |
|
|
|
|
Direct Material |
4,00,000 |
5,00,000 |
4,80,000 |
|
Direct Wages |
5,00,000 |
3,00,000 |
3,60,000 |
|
Factory Overhead |
6,00,000 |
5,00,000 |
5,80,000 |
|
Administration overhead |
2,00,000 |
1,00,000 |
1,50,000 |
|
Selling and Distribution Overhead |
1,00,000 |
1,00,000 |
1,00,000 |
|
Total Cost (3) |
18,00,000 |
15,00,000 |
16,70,000 |
|
EBDT (2-3) |
32,00,000 |
25,00,000 |
28,30,000 |
|
Less: Depreciation |
(6,50,000) |
(5,00,000) |
(4,00,000) |
|
EBT |
25,50,000 |
20,00,000 |
24,30,000 |
|
Less tax @ 30 % |
(7,65,000) |
(6,00,000) |
(7,29,000) |
|
PAT |
17,85,000 |
14,00,000 |
17,01,000 |
|
Add: Depreciation |
6,50,000 |
5,00,000 |
4,00,000 |
|
Cash inflow (4) |
24,35,000 |
19,00,000 |
21,01,000 |
|
Payback period (1÷4) |
1.23 years |
1.58 years |
1.43 years |
Since
Machine I has lowest payback, hence company should invest in machine I.
Note: When annual cash inflows are equal
Payback
Period = Initial Investment / Annual cash inflow
Depreciation
= Initial investment / cost of machine – scrap value / Estimated life
Depreciation on Machinery I = (Rs.30,00,000
– Rs. 4,00,000) / 4 = Rs.6,50,000
Depreciation on Machinery II = (Rs.30,00,000
– Rs. 5,00,000) / 5 = Rs. 5,00,000
Depreciation on Machinery III =
(Rs.30,00,000 – Rs. 6,00,000) / 6 = Rs. 4,00,000
2.
RBL Academy Ltd. Wants to replace one of its machines in its plant. First
option available to company is Installation of equipment "King" having
cost of Rs. 7,50,000 with an expectation of cash inflow of Rs. 2,00,000 p.a.
for next 6 years. Second is to Install equipment "Queen" having
cost of Rs. 5,00,000 which is expected to generate a cash inflow of Rs.
1,80,000 per annum for next 4 years. Which equipment should be preferred under
(a) Payback period (b) Internal Rateof Return?
Solution
Since
annual cash inflows are equal;
Payback period for Equipment “King” =
Initial investment or cost of equipment ÷ annual cash inflow
=
Rs. 7,50,000 / 2,00,000 = 3.75 years.
Payback period for Equipment “Queen” =
Initial investment or cost of equipment ÷ annual cash inflow
=
Rs. 5,00,000 / 1,80,000 = 2.78 years.
From
Payback Period method, equipment “Queen” is better.
Internal Rate of Return method (IRR)
Since
cash annual cash inflows are equal for both equipment;
Initial
outflow or investment = Rs. 7,50,000
Annual
cash inflow = Rs.2,00,000
Calculating PVAF using Payback period method
PVAFr,6 =
Rs. 7,50,000 / Rs.2,00,000 = 3.75
Looking
at present value annuity factor table, the value nearest to 3.75 in the year 6
in interest rate column is 15 % (3.784) and 16 % (3.685).
Using
interpolation formula
15
% +[ (3.784 – 3.75) / (3.784 – 3.685)] × (16 % - 15%) = 15.34 %
Equipment
“Queen”-
Initial
outflow or investment = Rs. 5,00,000
Annual
cash inflow = Rs.1,80,000
PVAFr,6 =
Rs. 5,00,000 / Rs.1,80,000 = 2.778
Looking
at present value annuity factor table, the value nearest to 2.778 in the year 4
in interest rate column is 16 % (2.798) and 17 % (2.743).
Using
interpolation formula
=
16 % +[ (2.798 – 2.778) / (2.798 – 2.743)] × (17 % - 16%) = 16.36 %
Since
IRR of Equipment “Queen” has higher IRR so equipment “Queen” should be
preferred.
