PROBLEMS ON CAPITAL BUDGETING

P-1. The cash flow of two different projects is given below

YEAR
0
PROJECT RS. 25000
A RS. 25000
PROJECT
B

1
8000
7000

2
7000
7000

3
6000
7000

4
5000
7000

5
4000
7000

Required: If cost of capital is 10%, which project should be accepted

under NPV method and why?
P-2. The cash flows of two projects are given below.
YEAR
0
1
2
PROJECT A
RS.
6,000
6,000
PROJECT B
20,00
8,000
7,000
0
RS.
20,00
0

3
6,000
6,000

4
6,000
5,000

Required: Internal Rate of Return (IRR)

P-3. A company is considering the purchase of a machine. Two machine
are available and each machine costing Rs. 50,000. Each machine has
expected life of 5 years. The cost of capital is 10%. Net cash flow during
the expected life of the machinery is given below.
Years
1
2
3
4
5
Machine A
RS. 20,000
18,00
15,00
12,00
10,00
Machine B
RS. 15,000
0
0
0
0
15,00
15,00
15,00
15,00
0
0
0
0
Required: Which machine is preferable on the basis of the following
evaluation methods?
i) Payback Period
ii)
Accounting Rate of Return
iii) Net Present Value
iv)
Profitability Index
v) Internal Rate of Return
P-4. A large sized chemical company is considering investing in a project
that costs Rs 400,000. The estimated salvage value is zero, tax rate is
55%. The company uses straight line depreciation and the proposed
project has cash flow before tax (CFBT) as follows:
Year
CFBT
1
RS. 100,000
2
100,000
3
150,000
4
150,000
5
250,000
Determine:
a. Payback Period
b. Average Rate of Return
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof1
Management

c. Internal Rate of Return

d. Net Present Value at 15%
e. Profitability Index at 15%
P-5 A company has the choice of overhauling its present plant or
purchasing a new one. The company has assembled the following
information:
Present
New
machine
machine
Purchasing cost
Rs. 8,000
Rs. 10,000
Remaining book value
3,000

Overhaul needed now

4,000

Annual cash operating

7,000
4,000
cost
Salvage value now
2,000

Salvage value 5 yrs

500
2,000
from now
The book salvage value of both machines in 5 years from now would be
zero. If the company keeps the old machine, it will have to be
overhauled at the cost shown above. With the overhaul, it can be made
to last for 5 more years. If the new machine is purchased, it will be used
for five years. The company computes depreciation on straight line
basis. The minimum required rate or return is 10% and tax rate is 40%.
Required: Should the company keep the old machine or purchase new
one.
P-6 A Company is considering the acquisition of one of two machines.
As a basis for selection of one of them the following data developed
Machine X Machine Y
Investment (original cost) Rs. 25,000Rs. 25,000
Annual estimated income after depreciation and income taxes:
Year 1
1,000
4,000
Year 2
1,000
3,000
Year 3
2,000
2,000
Year 4
3,000
2,000
Year 5
5,000
1,000
Estimated life straight line (years)
5
5
Estimated residual value
0
0
Estimated average income tax rate
40%
40%
Required:
a. Compute the cash inflow on each machine
b. Compute Payback period
c. Compute discounted cash flow return i.e. Net present value and
internal rate of return
d. Evaluate the results.
P-7. Jackson manufacturing company plans to buy a new machine for
one of its factory departments. Two competing machines from different
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof2
Management

suppliers are under consideration. The following reliable data have been
developed.
Particulars
Machin
Machin
eA
eB
Investment (cash cost)
$
$
26,563
26,563
Annual estimated income after dep.
and taxes
Year 1
$ 687
$ 4,687
Year 2
1,687
3,687
Year 3
2,687
2,687
Year 4
3,687
1,687
Year 5
4,689
689
Total
$
$
13,437
13,437
Estimated life (straight line) years 5
5
Estimated residual value
0
0
Estimated average tax rate
30%
30%
Minimum desired rate of return 16

percent
Required:
1. Compute the net cash in flow on each machine for each year and the
total. Assume depreciation is the only non-cash expenses induced in
the above data.
2. Compute the following measures of economic value of investment
worth (a) DCF net present value method, (b) payback method and (c)
Average Return on total investment
3. Prepare on evaluation of the result.
P-8 Jackson manufacturing company plans to buy a new machine for
one of its factory departments. Two competing machines from different
suppliers are under consideration. The following reliable data have been
developed.
Particulars
Machine A
Investment (cash cost)
$ 26,563
Annual estimated income after dep.and taxes
Year 1
$ 687
Year 2
1,687
Year 3
2,687
Year 4
3,687
Year 5
4,689
Total
$13,437
Estimated life (straight line)
5
years

Machine B
$26,563
$4,687
3,687
2,687
1,687
689
$13,437
5

By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof3
Management

Estimated residual value

Estimated average tax rate
Minimum desired rate of return
16 percent

0
30%

0
30%

Required:
1. Compute the net cash in flow on each machine for each year and
the total.
2. Compute net present value method, payback method and
Average Return on total investment
3. Evaluate the result.
P-9. A company furnished the following information.
Purchase price of new machine
Rs10,000
Transportation and installation cost
2,000
Increase in working capital in 0 year
2,500
Book salvage value of new machine at end
2,000
Cash salvage value of new machine at end
3,500
Annual cash saving before depreciation and tax 4,000
CSV of old machine today
5,000
CSV of old machine in 4 years
1,000
Service life of old machine
4 years
Current Book salvage value of old machine
4,000
The cost of capital is 10% and corporate tax rate is 50%. Diminishing
balance method is used for all the firm's equipments:
Required: Give your decision whether the old machine should be
replaced or not?
P-10. The management of a company has to replace an old machine
and is considering to purchase a new machine. Two competing
manufacturers have machines which would satisfy the managements
specifications. Data collected to date on each of the two competing
machines are:
Particulars
Machine
Machine
A
B
Purchase price
Rs.
Rs.
200,000
300,000
Estimate life
5 yrs
5 yrs
Book salvage value, final
Rs.
Rs.
20,000
40,000
Cash salvage value, final
Rs.
Rs.
20,000
30,000
Average annual earning before depreciation Rs.
Rs.
and taxes
60,000
100,000
Tax rate
25%
25%
The book and cash salvage value of existing machine at present is Rs.
20,000. The company uses straight line depreciation for tax purpose.
The target rate of return is 10%. The company has always used Net
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof4
Management

Present Value for evaluating the project but thinking about the
investment amount of machine A and machine B; the company has
planned to use profitability index.
Required:
1. Net investment cost and Annual Net Cash Flow of machine A and
machine B
2. Which machine should be purchased and why?
P-11 An investment project requires cash outlay of Rs. 200,000. The
project would have an effective life of 5 years. Transport and installation
charges for project would be additional amount of Rs. 20,000. At the
end of the 5th year the project would have a zero salvage value and
cash salvage of Rs. 20,000. The tax rate would be 30% and minimum
required rate of return 10%. The present value of Re. 1 to be received at
the end of 5 years discounted at 10% rate is 3.791 and at the end of
5th year is 0.621. The total present value of the project would be Rs.
315,411.2 without including net salvage value of final year.
Required:
1. Net Cash Outlay or Investment
2. Annual Cash Flow
3. Net Salvage Value
4. Net Present Value
P-12 A machine purchased 10 years ago for Rs. 100,000 has been
depreciated to a zero book value. Its scrap value at present is estimated
at Rs. 2,000. The existing value\e could be used indefinitely if the firm is
willing for high maintenance costs. The final cash value of the machine
will be nil. The company is considering replacing this machine by a new
one costing Rs.150,000. Its installation cost will be Rs.20,000. The book
and cash salvage value of the new machine after 10 years from now will
be Rs. zero the new machine require lower maintenance cost and would
release a personal who is normally engaged to monitor the system.
The firm's marginal tax rate is 50% and minimum required rate of the
return is 10%. The present value of re.1 to be received at the end of
each of ten years discounted at 10% rate is 6.145. The total present
value by replacing the old machine will be
Rs. 184,350.
Required:
1.
Net cash outlay or net investment cost.
2.
Annual saving on maintenance cost or differential net cash
flow
3.
Net present value

By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof5
Management

UNIVERSITY QUESTIONS ON CAPITAL BUDGETING

P- 13 The Royal Industries is considering the replacement of one of its
molding machines. The existing machine is in good operating condition
but is smaller than required if the firm is to expand its operation. The
old machine is 5 year old, and has a current salvage value of Rs. 30,000
and a remaining depreciable life of 10 years. The machine was
originally purchased for Rs. 75,000 and is being depreciated at Rs.
5,000 per year for tax purposes. The new machine will cost Rs. 150,000
and will be depreciated on a straight line basis over 10 years, with no
salvage value. The management anticipates with the expand
operations; there will be need of additional net working capital of Rs.
30,000. The new machine will allow the firm to expand the current
operations and thereby increases annual sales from Rs. 400,000 to
440,000; annual variable operating costs from Rs. 200,000 to Rs.
210,000. The company's tax rate is 55% and its cost of capital is 10%.
Required: Desirability of project using PI and NPV.

P-144 Kanchanjunga Textile is considering the replacement of existing

machine that can run for 5 more years producing annual revenues of
Rs. 90,000 with cash expenses of Rs. 60,000. Its current book value is
Rs. 20,000 and is being depreciated at a Rs. 4,000 per year down to a
zero book value. The machine can be sold today to net Rs. 10,000 and it
could be sol in 5 years to net Rs. 5,000.
The replacement machine will cost Rs. 60,000 plus an additional Rs.
10,000 to install it. It will generate Rs. 1,20,000 but will have cash
expenses of Rs. 60,000. It will be depreciated using the straight line
method of depreciation method over 5 years period at which time it will
have a book value of Rs. 25,000 and cash salvage value of Rs. 30,000.
The replacement machine will require additional working capital of Rs.
10,000.
The firm decides to finance additional investment by taking loans from
a bank at 15% interest rate. The current tax rate is 40%.
Required: Should the firm make replacement? Base your answer on
NPV and IRR.(PU 2007Spring)
P-15 Western Kansas University is considering replacing some Ricoh
copiers with faster copiers purchase from Kodak. The administration is
very concerned about the rising cost of operating during the last
decade. To divert to Kodak, two operators would have to retrain.
Training and Modeling cost would be $4,000.
Western Kansass three Ricoh machines were purchased fro $10,000
each five years ago. Their expected life was ten years. Their resale
value now $1000 each and will be zero in five more years.
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof6
Management

Total cost of new Kodak machines will be $54,000; it will have zero
disposal value in five years. Three Ricoh operators are paid $8 per hour
each. They usually work forty hours (40 Hours) a week. Machine break
down occurs monthly on each machine, resulting a repair cost $50 per
month. And overtime e four hours at time and one half, per machine per
month to complete the normal monthly work load. Toner, supplies and
so on cost $100 a month for each Ricoh copier.
Kodak system requires will require only two regular operators, on a
regular work week of 40 hours each, to do the same work, rates are $10
an hour and no over timing is expected. Toner supplies and so on will
cost of $3,300 annually. Maintenance and repair are fully serviced by
Kodak for $1050 annually. (Assume a 52 wee year). The cost of capital
is 12% and Western Kansas does not pay tax as it is a non profit
university.
Required: Should the Western Kansas keep the Ricoh machines or
replace by Kodak? (PU 2007Spring)
P-16 Qualitech Photocopy, Putalisadak is considering to buy advanced
photo copy machine that has capacity to produce 1,500,000 copies of
photocopies during its life of six years. Information regarding the
machine is as follows:
Cost of photocopy machine
Rs. 200,000
Installation costs
20,000
th
Book salvage value at the end of 6
Nil
year
Cash salvage value at the end of 6 th 20,000
year
Working capital required at zero 100,000
year
Selling price per page of photocopy 1
Variable cost of paper and ink per 0.60
page
Maintenance and other operating 3,000
cost per month
Sales of photocopy pages/paper per 200,000
year
pieces
Required: Recommend whether Qualitech Photocopy should install the
new photo copy machine. To support your recommendation, use
Payback Period, NPV and Internal Rate of Return criteria. (PU 2007 Fall)
P-17 Trinton Company was operating its production schedule with an
old machine purchased five years before at a cost of $ 9,00,000 with an
effective life of 10 years. The company follows a straight line
depreciation policy, and at the end of 5 years the machine would have
no book and cash salvage value.
The company is considering to replace this machine by a modern and
superior machine . The new machine would cost $ 8,00,000 and $
2,00,000 as installation cost. The machine being highly automatic would
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof7
Management

require additional investment of $ 2,00,000 in working capital. At the

end of the 5th year, the machine would have book and cash salvage
value of $ 1,50,000 and $ 1,00,000 respectively.
The old machine could be sold at a market value of $ 5,00,000 today.
The company would be able to save $ 2,00,000 every year for 5 years
by using the new machine. The average cost of capital is 12% and the
effective rate of tax is 35%.
Required: NPV and IRR to assess the desirability of the projects. (PU
2006 Spring)
P-18 A mining company, that extracts iron ore from an open pit mine, is
considering investing in a new processing plant that will further process
the current output ore. During the year 2005, a total of 100,000 tons of
ore is extracted. If the output from the extraction process is sold
immediately, a price of Rs. 1,000 per ton of ore can be obtained. The
company has estimated that its extraction costs amount to 70 percent
of the net realizable value of the ore.
As an alternative to selling all the ore at Rs. 1,000 per ton, it is possible
to process further 25 percent of the output. The additional cash costs of
further processing will be Rs. 100 per ton. The proposed ore will yield 80
percent final outputs, and can be sold at Rs. 1,600 per ton.
For additional processing, the company will have to install equipment
costing Rs. 10 million. The equipment is subject to 30 percent
depreciation per annum on double declining value method. It is
expected to have a useful life of 5 years. Additional working capital
requirement is estimated at Rs. 1 million. The expected salvage of the
new equipments is Rs. 0.5 million.
Corporate income tax rate is 25 percent. The minimum required return;
i.e. the marginal cost of capital on this investment proposal is estimated
to be 15%.
Required
a. Estimate the net cash flows from startup costs to the termination
of the project.
b. b) Is the installation of further processing plant desirable? Use the
NPV, IRR and Payback Period criteria for the project evaluation.
(PU 2006 Fall)
P-19 The Raymond Seed Production Company (RSPC) Ltd. is in the
business of developing new varieties of seeds and their processing and
marketing through a large network of dealers all over Nepal. It has
recently developed a hybrid seed of rice. On the basis of the marketing
of a small quantity of this seed, the company finds that the seed has a
viable demand. Since the necessary processing facilities are yet to be
developed, it has got the seeds processed on a plant hired from the
National Trading Company (NTC) Ltd. which charges Rs. 125 per hour
for 8 hours a day. The NTC Ltd. estimates that it will require 1250 hours
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof8
Management

working of the plant for 100 days so that the seeds reach the market at
right time.
The RSPC Ltd. is considering setting up its own plant in order to
economize the operations as well as to exercise a better control. The
plant is expected to have a useful life of 5 years with a salvage value of
Rs. 50,000 at the end of the fifth year. The cost associated with its
acquisition and operations are detailed below.
Acquisition cost, Rs. 325,000
Installation cost, Rs. 75,000
Additional working capital, Rs. 30,000
Annual operating costs
a) Maintenance cost, Rs. 25,000
b) Energy consumption, Rs. 90,000
c) Additional manpower, Rs. 80,000
d) Additional overheads, Rs. 50,000
Besides using for own purpose, the plant can be rented out at least six
hours a day for Rs. 150 per hour for 200 days in a year. Tax rate is 30
percent, the cost of capital is 10 percent and depreciation allowed is 25
percent on a double declining basis.
Required:
a. Estimate the incremental net cash flows associated with the
acquisition of own plant.
b. Assess the financial viability of the proposal to install the plant.
Base your answer on NPV, PBP and IRR. (PU 2005 Fall)

By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof9
Management

RISK AND UNCERTAINTY PROBLEM ON CAPITAL BUDGETING

P -20 A company furnished the following information of three projects.
Projects
A
B
C
Net cash outlays
50,000
60,000
70,000
Projected life
5 YRS
5 YRS
5 YRS
Annual cash inflow
15,000
20,000
25,000
Co-efficient of variation
0.4
0.8
1.2
The company selects the risk adjusted rate of discount on the basis of
co-efficient of variation.
Co-efficient of variation
Risk adjusted rate of discount
0.0
10%
0.4
12%
0.8
14%
1.2
16%
1.6
18%
More Than 2
20%
Required: NPV of the projects and suggest for decision.
P 21.
A company is considering an investment in a project which
requires an initial outlay Rs. 50,000 with an expected cash flow
generated over three years as under.
Year I
Cash flow
15000
20000
25000
30000

Prob.
0.1
0.2
0.4
0.3

Year II
Cash flow
15000
20000
25000
30000

Prob.
0.1
0.3
0.4
0.2

Year III
Cash flow
15000
20000
25000
30000

Prob.
0.2
0.5
0.2
0.1

Required: Net Present Value and standard deviation about the expected
value. Discount rate is 5%.
P 22.
Arona Company is considering an investment in two
mutually exclusive projects for Rs. 10,000. The following information
regarding the project is given below.
Project I
Year i
Year ii
Year iii
Year iv
Cash flow Prob. Cash flow Prob. Cash flow Prob. Cash flow Prob.
Rs. 1,600
0.1
1,600
0.3
1,600
0.2
1,600
0.2
2,000
0.2
2,000
0.2
2,000
0.5
2,000
0.3
2,400
0.4
2,400
0.3
2,400
0.2
2,400
0.1
3,000
0.3
3,000
0.2
3,000
0.1
3,000
0.4
Project II
Year i
Year ii
Year iii
Year iv
Cash flow Prob. Cash flow Prob. Cash flow Prob. Cash flow Prob.
RS. 1,500
0.1
1,500
0.1
1,500
0.1
1,500
0.1
2,000
0.3
2,000
0.2
2,000
0.2
2,000
0.3
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof
10
Management

2,500
3,000

0.4
0.2

2,500
3,000

0.3
0.4

2,500
3,000

0.4
0.3

2,500
3,000

0.2
0.4

Required: Which project is preferable to the company if discount rate

is 5%..
.
P 23.
A company is considering an investment in a project that
requires an initial outlay of Rs. 150,000 with an expected cash
flow generated over three years life.
YEAR I
YEAR II
YEAR III
CFAT PROB.
CFAT
PRO
CFAT
PRO
B.
B.
RS. 40,000
0.1
RS.
0.1
RS.
0.2
40,000
40,000
50,000
0.2
0.3
0.5
50,000
50,000
75,000
0.4
0.4
0.2
75,000
75,000
100,000
0.3
0.2
0.1
100,000
100,000
Required:
(a) What is the expected NPV of this project, if risk free rate of return
is 6%?
(b)Calculate standard deviation about the expected value
(c) Find out the probability that NPV will be greater than or less than
zero.
P 24 A transport company is going to lunch the transport service from
Ratnapark to Banepa. Three vehicle alternatives like Micro bus,
minibus and tempo are available for 5 years life. The annual cash
flow estimation for micro bus, minibus and tempo is given below.
Cash flow
(tempo) (rs.)

Prob
.

10,000
15,000
20,000
25,000

0.2
0.4
0.3
0.1

Cash flow
(micro bus)
(rs.)
30,000
50,000
75,000
90,000

Prob
.

Cash flow (mini

bus) (rs.)

Prob.

0.4
0.2
0.3
0.1

100,000
120,000
125,000
130,000

0.2
0.1
0.3
0.4

The net investment in tempo is Rs. 50,000, micro bus Rs. 150,000 and
minibus Rs. 350,000. The cost of capital is 10%.
Required: Which transport service is preferable to the transport
company?
P -25 A company employs the certainty equivalent approach in
evaluation of risky investments. The following information is
gathered for making decision either the project is accepted or
rejected.
Year
CFAT
Certainty Equivalent
Quotient
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof
11
Management

0
RS. 200,000
1.0
1
120,000
0.8
2
100,000
0.7
3
90,000
0.6
4
90,000
0.4
5
70,000
0.3
The firms cost of equity capital is 15%, its cost of debt is 10% and
interest rate on government securities is 6%.
Required: Desirability of the project using NPV.
P -26 Rama Textile Ltd. is considering an investment in a project which
requires an initial outlay of Rs. 300,000 with an expected life of
three years as under the following estimated cash flow.
Cash Flow (RS.)
Probability
Year I
Year II
Year III
80,000
0.1
0.2
0.5
100,000
0.3
0.3
0.2
150,000
0.2
0.4
0.2
200,000
0.4
0.1
0.1
Required:
a. What is expected NPV of the project, if the discount rate is 6%.
b. Calculate the standard deviation about the expected value.
c. Find out the probability that NPV is less than zero and more than
zero.
d. What is the probability of being NPV more than 40,000 and less than
40,000.
P -27 The Bottlers Nepal is considering to bring a new soft drink Coca.
The project will cost as investment Rs. 20,000 and will have a service
life of three years. The company expects a net profit after tax cash flow
for the three years as follows:
Year I
Year II
Year III
Cash flow
Prob. Cash flow
Prob. Cash flow
Prob.
Rs. 2,000
0.10 Rs. 6,000
0.15 Rs. 8,000
6,000
0.15
10,000
0.20
12,000
10,000
0.50
14,000
0.40
16,000
14,000
0.25
18,000
0.25
20,000
The expected cash flows have perfect correlation overtime and
companys cost of capital is 10%.

0.10
0.20
0.50
0.20

Required:
a. The desirability of the project form NPV point of view
b. The chances of NPV being less than zero or more than Rs. 15,000
c. The standard deviation of the probability distribution of Possible
Present Value (assume normal distribution)
P -28 A company adopts certainty equivalent approach for evaluations
of risky investment. The information regarding the project is given
below.
By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof
12
Management

Year

Expected CFAT

Certainty equivalent
quotient
0
Rs. 150,000
1.0
1
80,000
0.8
2
70,000
0.7
3
60,000
0.6
4
50,000
0.4
5
40,000
0.3
The firms cost of equity capital is 15% its cost of debt is 9% and the
riskness rate of interest on government securities is 6%, should the
project be accepted?
The Karnali Project has under consideration two mutually exclusive
projects for increasing its plant capital. The project has developed
pessimistic, most likely and optimistic estimates of the annual cash
flows associated with two projects. The estimated cash flows are as
under:
Project I
Project II
Net investment outlay
Rs.120,000
Rs.120,000
Net cash flow after taxPessimistic
5,000
16,000
Most likely
18,000
18,000
Optimistic
30,000
21,000
Required: NPV associated with each estimate given for both the
projects. Both projects have 15 years life with cost of capital 10%. Also
recommend to the company the project which it should choose. Give
reasons in support of your answer.

ASSIGNMENT QUESTIONS:
All EVEN NUMBERS PROBLEMS for even ROLL
NUMBER STUDENTS and uneven questions for
UNEVEN ROLL NUMBER STUDENTS To be
submitted within One week from the date of
completion of the chapter.

By Ghanendra Fago (Ph D Scholar, M.Phil, MBA), For MBA, Ace Instituteof
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Management