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Problem 9
Satya corporation is toying with the idea of replacing its existing machine. The following
are the relevant data
1. Existing Machine
Purchased 2 years ago
Remaining life 6 years
Salvage value Rs 500
Current book value Rs 2,600 and its realisable market value Rs 3,000
Annual depreciation Rs 350
2. New machine
Capital cost of Rs 8,000
Estimated useful life 6 years
Estimated salvage value Rs 800
The replaced machine would permit an output expansion. As a result, sales is expected to
rise by Rs 1,000 per year, operating expenses would decline by Rs 1,500 per year. It
would require an additional inventory of Rs 2,000
Assuming corporate tax rate of 40% and cost of capital of 15%, advice the company
Solution
1. Calculation of incremental cash flows from purchase of new machinery
Rs.
1. Incremental cash outflow (Year 1)
Cost of new machinery
Add : Addition to working capital
a. Inventory
Total
Less : Net sale price (3,000 tax on profit @ 40% of Rs 400)
Net cash outflow of year 1
2,000
10000
2,840
7,660
1,000
1,500
850
1,650
8,000
660
990
Add : depreciation
Net cash flow
850
1840
Page 1
0
1
2
3
4
5
6
6
6
(7660)
1,840
1,840
1,840
1,840
1,840
1,840
1,500
480
NPV
Discounting factor
@ 15%
1
0.870
0.756
0.658
0.572
0.497
0.432
0.432
0.432
Present value
Rs.
(7660)
1,601
1,391
1,211
1,052
915
795
648
207
220
Rs 1,500
Rs 800
Rs 320
Rs 480
Since the NPV of the project is positive the company should go for replacement of old
machinery.
Problem 10
A large profit making company is considering the installation of a machine to process the
waste produced by one of its existing manufacturing process to be converted into a
marketable product. At present, the waste is removed by a contractor for disposal on
payment by the company of Rs 50 lacs per annum for next 4 years. The contract can be
terminated on installation of the aforesaid machine on payment of a compensation of Rs
30 lakhs before the processing operation starts. This compensation is not allowed as
deduction for tax purposes.
The machine required for carrying out the processing will cost Rs 200 lakhs to be
financed by a loan repayable in 4 equal instalments commencing from the end of year 1.
The interest rate is 16% p.a At the end of 4 th year, the machine can be sold for Rs 20
lakhs and the cost for dismantling and removal will be Rs 15 lakhs.
Sales and direct cost of the product emerging from waste processing for 4 years are
estimated as under:
Sales
Material consumption
Wages
Other expenses
Factory overheads
Depreciation ( As per income tax)
1
322
30
75
40
55
50
2
322
40
75
45
60
38
3
418
85
85
54
110
28
4
418
85
100
70
145
21
Page 2
1
322
2
322
3
418
Rs lakhs
4
418
Less :
Material consumption
Wages
Other expenses
Factory overheads (Insurance)
Loss of rent
Interest
Depreciation
Total cost
30
60
40
30
10
32
50
252
40
65
45
30
10
24
38
252
85
85
54
30
10
16
28
308
85
100
70
30
10
8
21
324
70
35
35
70
35
35
110
55
55
94
47
47
Add : depreciation
Net cash flow
50
85
38
73
28
83
21
68
Overheads other than insurance is not considered as they remain unchanged even
though the project is not executed
2. Statement of incremental cash flows (net)
1
85
(35)
2
73
-
3
83
-
Rs lakhs
4
68
55
25
25
25
25
Page 3
(50)
-
(50)
-
(50)
-
(50)
5
25
48
58
103
0
1
2
3
4
(50)
25
48
58
103
Discounting factor
@ 15%
1
0.870
0.756
0.658
0.572
NPV
Cash outflow of year 1 is
Rs lakhs
Present value
Rs.
(50)
21.75
36.29
38.16
58.92
105.12
Comment - It is advisable to implement the proposal as the net present value is positive.
Problem 11
A company is setting up a plant at a cost of Rs 300 lakhs of investment in fixed assets. It
has to decide whether to locate the plant in a forward area (FA) or backward are (BA).
Locating in backward area means a cash subsidy of Rs 15 lakhs from the central
government. Besides the taxable profit to the extent of 20% is exempt for 10 years. The
project envisages a borrowing of RS 200 lakhs in either case. The cost of borrowing will
be 12% in forward area and 10% in backward area. However the revenue costs are
bound to be higher in the BA. The borrowing principle has to be repaid in 4 equal annual
instalments beginning from the end of year 4. With the help of following information and
by using Discounted Cash Flow technique you are required to suggest proper location for
the project. Assume straight-line depreciation with no residual value.
Earning before interest and tax (Rs in lakhs)
Year
FA
1
-6
2
34
3
54
4
74
5
108
6
142
7
156
8
230
9
330
10
430
BA
-50
-20
10
20
45
100
155
190
230
330
Page 4
EBIT
-6
34
54
74
108
142
156
230
330
430
Interest
24
24
24
24
18
12
6
-
Depreciation
30
30
30
30
30
30
30
30
30
30
PBT
-60
-20
20
60
100
120
200
300
400
Tax
50
60
100
150
200
PAT
-60
-20
20
60
50
60
100
150
200
Inflow
-30
10
30
50
90
80
90
130
180
230
PAT
-100
-70
-40
-30
60
120
120
120
180
Inflow
-70
-40
-10
30
90
150
150
150
210
EBIT
-50
-20
10
20
45
100
155
190
230
330
Interest
20
20
20
20
15
10
5
-
Depreciation
30
30
30
30
30
30
30
30
30
30
PBT
-100
-70
-40
-30
60
120
160
200
300
Tax
40
80
120
3. Calculation of net present value of project in forward area @ 15% discounting factor
Rs lakhs
Year
Cash inflows /
Cash
Net cash
Discounting
Present
(outflow)
outflows
flows
factor
value
@ 15%
Rs.
0
(100)
(100)
1
(100)
1
-30
-30
0.870
(26.10)
2
10
10
0.756
7.56
3
30
30
0.658
19.74
4
50
50
0
0.572
0
5
90
50
40
0.497
19.88
6
80
50
30
0.432
12.96
Prepared By: Mahendra Patel, Parul Institute of Business Administration
Page 5
90
130
180
230
NPV
50
-
40
-
0.376
0.327
0.284
0.247
15.04
42.51
51.12
56.81
99.52
Cash outflow of year 1 = Total cash outflow loan amount = Rs 300 lakhs Rs 200 lakhs
= Rs 100 lakhs.
4. Calculation of net present value of project in backward area @ 15% discounting factor
Rs lakhs
Year
Cash inflows /
Cash
Net cash
Discounting
Present
(outflow)
outflows
flows
factor
value
@ 15%
Rs.
0
(85)
(85)
1
(85)
1
-70
-70
0.870
-60.9
2
-40
-40
0.756
-30.24
3
-10
-10
0.658
-6.58
4
50
-50
0.572
-28.60
5
30
50
-20
0.497
-9.94
6
90
50
40
0.432
17.28
7
150
50
100
0.376
37.6
8
150
150
0.327
49.05
9
150
150
0.284
42.60
10
210
210
0.247
51.87
NPV
22.86
Cash outflow of year 1 = Total cash outflow loan amount subsidy = Rs 300 lakhs Rs
200 lakhs Rs 15 lakhs = Rs 85 lakhs.
Working notes
1. Taxability of backward area starts only from year 8 th as in year 6 and 7 the losses
of year 1 to 5 are adjusted against the profits.
2. For year 8,9 and 10 tax is levied only on 80% of the profits as 20% profit is
exempt.
3. Ideally the discounting factor shall be 12% and 10%, which is cost of capital at FA
and BA respectively, in that case interest should be ignored. But as the problem
states the cost of capital to be 15%, calculations done considering interest as cash
out flow
Comment As NPV of FA is positive and NPV of BA is negative project should be
located in FA.
Problem 12
Page 6
1,000
1,000
200
150
320
450
500
200
600
250
100
150
Assume no residual value at the end of fifth year. The firms cost of capital is 10%.
Required, in respect of each of the two projects:
i. NPV using 10% discounting rate
ii. IRR and
iii. Profitability index
iv. Payback period
Solution
1. Net present value of cash flows of project X @ 10%Year
0
1
2
3
4
5
(1,000)
200
150
320
450
500
Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621
NPV
Rs lakhs
Present value
Rs.
(1,000)
181.80
123.90
240.32
307.35
310.5
163.87
0
1
2
3
4
(1,000)
200
600
250
100
Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
Rs lakhs
Present value
Rs.
(1,000)
181.80
495.60
187.75
68.30
Page 7
150
0.621
93.15
NPV
26.60
Problem 2
A company proposes to undertake two mutually exclusive projects AXE and BXE :
Initial capital outlay
Economic life (years)
After tax annual cash inflows
Year
1
2
3
4
5
6
7
AXE
Rs 22,50,000
4
6,00,000
12,50,000
10,00,000
7,50,000
-
BXE
Rs. 30,00,000
7
5,00,000
7,50,000
7,50,000
12,00,000
12,50,000
10,00,000
8,00,000
The companys cost of capital is 16%. Please calculate the net present value and IRR for
both the projects
Solution 1. Calculation of NPV of both the projects
Calculation of present value of the project AXE @ 16% discounting rate
Year
0
1
2
3
4
(22,50,000)
6,00,000
12,50,000
10,00,000
7,50,000
NPV
Discounting factor
@ 16%
1
0.862
0.743
0.641
0.552
Present value
Rs.
(22,50,000)
5,17,200
9,28,750
6,41,000
4,14,000
2,50,950
0
1
2
3
(30,00,000)
5,00,000
7,50,000
7,50,000
Discounting factor
@ 16%
1
0.862
0.743
0.641
Present value
Rs.
(30,00,000)
4,31,000
5,57,250
4,80,750
Page 8
12,00,000
12,50,000
10,00,000
8,00,000
NPV
0.552
0.476
0.410
0.354
6,90,000
5,93,750
4,10,000
2,83,200
4,46,350
As NPV of project BXE is substantially higher than project AXE project BXE is more
profitable.
Problem 3
Precision instruments is considering two mutually exclusive projects X and Y. Following
details are made available to you :
Rs. In lacs
Project X
Project Y
Project cost
Cash inflows
Year
1
2
3
4
5
700
700
100
200
300
450
600
500
400
200
100
100
Assume no residual value at the end of fifth year. The firms cost of capital is 10%.
Required, in respect of each of the two projects :
i. NPV using 10% discounting rate
ii. IRR and
iii. Profitability index
(ICWA inter, June 1995)
Solution 1. Calculation of Net present value
Calculation of present value of the project X @ 10% discounting rate
Year
0
1
2
3
4
5
(700)
100
200
300
450
600
Present value of inflows
NPV
Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621
Rs lakhs
Present value
Rs.
(700)
90.90
165.20
225.30
307.35
372.60
1,161.35
461.35
Page 9
0
1
2
3
4
5
(700)
500
400
200
100
100
Present value of inflows
NPV
Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621
Present value
Rs.
(700)
454.50
330.40
150.20
68.30
62.10
1,065.50
365.50
2. Profitability index
PI =
PI of project X
=
=
PI of project Y
=
=
1,161.35
700
1.659
1,065.50
700
1.522
0
1
2
3
4
5
(700)
100
200
300
450
600
NPV
Discounting factor
@ 27%
1
0.787
0.620
0.488
0.384
0.303
Rs lakhs
Present value
Rs.
(700)
78.70
124
146.40
172.80
181.80
3.70
0
1
2
3
(700)
100
200
300
Discounting factor
@ 28%
1
0.781
0.610
0.477
Rs lakhs
Present value
Rs.
(700)
78.10
122.00
143.10
Page 10
450
600
NPV
0.373
0.291
167.65
174.60
-14.35
3.70
*1
3.70+14.35
= 27.21%
IRRR of project X = 27.21%
Calculation of present value of the project Y @ 37% discounting rate
Year
0
1
2
3
4
5
(700)
500
400
200
100
100
NPV
Discounting factor
@ 37%
1
0.73
0.533
0.389
0.284
0.207
Rs lakhs
Present value
Rs.
(700)
365
213.20
77.80
28.40
20.70
5.10
0
1
2
3
4
5
(700)
500
400
200
100
100
NPV
Discounting factor
@ 38%
1
0.725
0.525
0.381
0.276
0.200
5.10
5.10+3
Rs lakhs
Present value
Rs.
(700)
362.50
210
76.20
27.60
20.70
-3.00
*1
= 37.63%
IRR of project Y = 37.63%
Summary of both the projects
Profitability index
Net present value
Internal rate of return
Project X
1.659
461.35
27.21%
Project y
1.522
365.50
37.63%
Problem 12
X ltd. is considering two mutually exclusive projects X and Y. Following details are made
available to you :
Prepared By: Mahendra Patel, Parul Institute of Business Administration
Page 11
Project cost
Cash inflows
Year
1
2
3
4
5
Project X
Rs. In lacs
Project Y
1,000
1,000
200
150
320
450
500
200
600
250
100
150
Assume no residual value at the end of fifth year. The firms cost of capital is 10%.
Required, in respect of each of the two projects:
i. NPV using 10% discounting rate
ii. IRR and
iii. Profitability index
iv. Payback period
Solution
1. Net present value of cash flows of project X @ 10%Year
0
1
2
3
4
5
(1,000)
200
150
320
450
500
Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621
NPV
Rs lakhs
Present value
Rs.
(1,000)
181.80
123.90
240.32
307.35
310.5
163.87
0
1
2
3
4
5
(1,000)
200
600
250
100
150
Discounting factor
@ 10%
1
0.909
0.826
0.751
0.683
0.621
NPV
Rs lakhs
Present value
Rs.
(1,000)
181.80
495.60
187.75
68.30
93.15
26.60
Page 12
1163.8
1000
1.164
1026.60
1000
1.027
5. Calculation of internal rate of return for project X a. Net present value of cash flows of project X @ 15%Year
0
1
2
3
4
5
(1,000)
200
150
320
450
500
Discounting factor
@ 15%
1
0.870
0.756
0.658
0.572
0.497
NPV
Rs lakhs
Present value
Rs.
(1,000)
174.00
113.40
210.56
257.40
248.5
3.86
AS net present value Rs 3.86 lacs (almost nil), it can be said that the IRR of the project is
slightly higher than 15%
b. Net present value of cash flows of project Y @ 12%Year
0
1
2
3
4
5
(1,000)
200
600
250
100
150
Discounting factor
@ 12%
1
0.893
0.797
0.712
0.636
0.567
NPV
Rs lakhs
Present value
Rs.
(1,000)
178.6
478.20
178.00
63.60
85.05
-16.55
As net present value Rs 16.55 lacs, it can be said that the IRR of the project is higher
than 10% but lesser than 12%. The IRR can be calculated by interpolation method.
IRR
= 10 + (26.60 / 16.55+26.60) *2
= 10+1.24
= 11.25 %
Page 13
10%
0.91
0.83
0.75
0.68
0.62
20%
0.83
0.69
0.58
0.48
0.41
0
1
2
3
4
5
(200)
35
80
90
75
20
Discounting factor
@ 10%
1
0.91
0.83
0.75
0.68
0.62
Rs lakhs
Present value
Rs.
(200)
31.85
66.40
67.50
51.00
12.40
Page 14
29.15
0
1
2
3
4
5
(200)
35
80
90
75
20
Discounting factor
@ 20%
1
0.83
0.69
0.58
0.48
0.41
NPV
Rs lakhs
Present value
Rs.
(200)
29.05
55.20
52.20
36.00
8.20
-19.35
= 10 + (29.15 / 29.15+19.35)*10
= 16%
0
1
2
3
4
5
(200)
35
80
90
75
20
NPV
Discounting factor
@ 10%
1
0.91
0.83
0.75
0.68
0.62
Rs lakhs
Present value
Rs.
(200)
31.85
66.40
67.50
51.00
12.40
29.15
0
1
2
3
4
5
(200)
218
10
10
4
3
Discounting factor
@ 10%
1
0.91
0.83
0.75
0.68
0.62
NPV
Prepared By: Mahendra Patel, Parul Institute of Business Administration
Rs lakhs
Present value
Rs.
(200)
198.38
8.30
7.50
2.72
1.86
18.76
Page 15
0
1
2
3
4
5
(200)
218
10
10
4
3
NPV
Discounting factor
@ 10%
1
0.83
0.69
0.58
0.48
0.41
Rs lakhs
Present value
Rs.
(200)
180.94
6.90
5.80
1.92
1.23
-3.21
= 10 + (18.76 / 18.76+3.21)*10
= 18.54%
Page 16