EDBAS 202 Corporate Financial Management

Capital Budgeting – Additional Problems 2

1. Alpha company is considering a new product line to supplement its range line. It is anticipated
that the new product line will involve cash investment of Rs.700,000 at time 0 and 1 million in
year 1. After-tax cash inflows of Rs.250,000 are expected in year 2, Rs.300,000 in year 3, Rs.
350,000 in year 4 and Rs.400,000 each year thereafter through year 10. Though the product line
might be viable after year 10, the company prefers to be conservative and end all calculations
at that time.
(a) If the required rate of return is 15%, what is the NPV of the project? Is it acceptable? What is
the IRR?
(b) What would be the case if the required rate of return was 10%?
(c) What is the project’s payback period?

2. ABC Ltd. is evaluating three investment situations: (1) produce a new line of aluminium blivets,
(2) expand its existing blivet line to include several new sizes, and (3) develop a new, higher
quality line of blivet. If only the project in question is undertaken, the expected present values
and the amounts of investment required are as follows:

Project Investment required (Rs) Present value of future cash flows (Rs)

1 200,000 290,000

2 115,000 185,000

3 270,000 400,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the investment required and
present values will simply be the sum of the parts. With projects 1 and 3, economies are possible in
investment because one of the machines acquired can be used in both production processes. The total
investment required for projects 1 and 3 combined is Rs. 440,000. If projects 2 and 3 are undertaken,
there are economies to be achieved in marketing and producing the products but not in investment. The
expected present value of future cash flows for projects 2 and 3 combined is Rs. 620,000. If all three
projects are undertaken simultaneously, the economies noted above will still hold. However, a Rs.
125,000 extension on the plant will be necessary, as space is not available for all three projects. Which
project or projects should be chosen?

Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA

EDBAS 202 Corporate Financial Management

3. XYZ Company is planning to buy new machinery for Rs. 200,000. The machinery has a
depreciation life of 5 years. As a result of buying the new machinery, XYZ Company will sell the
existing machinery at Rs. 50,000. The existing machinery was purchased 3 years ago for Rs.100,
000. The company must pay Rs. 4,000 for delivery and Rs. 9,000 for installation of the new
machinery. Assume tax rates of 34%. Net working capital does not change. Depreciation at cost
20% in year 1, 32% in year 2, and 19% in year 3.

(a) Determine the initial cost of the project.

(b)What would be the initial cost of the project if the existing machinery was sold at Rs. 20,000?

4. Amtarc plc produces Tarcs with a machine which is now four years old. The management team
estimates that this machine has a useful life of four more years before it will be sold for scrap,
raising £10,000. Q-leap, a manufacturer of machines suitable for Tarc production, has offered
its new computer controlled Q-2000 to Amtarc for a cost of £800,000 payable immediately. If
Amtarc sold its existing machine now, on the secondhand market, it would receive £70,000. (Its
book accounting value, after depreciation, is £150,000.) The Q-2000 will have a life of four
years before being sold for scrap for £20,000. The attractive features of the Q-2000 are its lower
raw material wastage and its reduced labour requirements. Selling price and variable overhead
will be the same as for the old machine. The accountants have prepared the figures shown
below on the assumption that output will remain constant at last year’s level of 100,000 Tarcs
per annum.

Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA

EDBAS 202 Corporate Financial Management

An additional benefit of the Q-2000 will be the reduction in required raw material buffer stocks –
releasing £120,000 at the outset. However, because of the lower labour needs, redundancy payments
of £50,000 will be necessary after one year.

Assume

 No inflation or tax.
 The required rate of return is 10 per cent.
 To simplify the analysis sales, labour costs, raw material costs and variable overhead costs
all occur on the last day of each year.

Using the NPV method decide whether to continue using the old machine or to purchase the Q-
2000.

5. Consider the case of a car rental firm which is considering a switch to a new type of car. The
cars cost £10,000 and a choice has to be made between four alternative (mutually exclusive)
projects (four alternative regular replacement cycles). Project 1 is to sell the cars on the
secondhand market after one year for £7,000. Project 2 is to sell after two years for £5,000.
Projects 3 and are three-year and four-year cycles and will produce £3,000 and £1,000
respectively on the secondhand market. The cost of maintenance rises from £500 in the first
year to £900 in the second, £1,200 in the third and £2,500 in the fourth. The cars are not worth
keeping for more than four years because of the bad publicity associated with breakdowns. The
revenue streams and other costs are unaffected by which cycle is selected.

6. The estimated net earnings for the XYZ Company in the next 3 years are Rs. 100,000 Rs. 150,000
and Rs. 200,000. The annual depreciation amounts for those years are estimated as Rs. 30,000
Rs. 40,000 and Rs. 45,000 As a result of starting a new project, the estimated net earnings will
be Rs. 120,000 Rs. 165,000 and Rs. 230,000 and the annual depreciation will increase to Rs.
45,000, Rs. 62,000 and Rs. 66,000. To make it simple, assume that the tax rate is 40%. Calculate
the incremental cash flow of the new project.

7. A cosmetic company is considering to introduce a new lotion which is useful both in winters and
summers. The manufacturing equipment will cost Rs. 5,60,000. The expected life of the
equipment is 8 years. The company is thinking of selling the lotion in a single standard pack of
50 grams at Rs. 12 each pack. It is estimated that variable cost per pack would be Rs. 6 and
annual fixed cost, Rs. 450,000. Fixed cost includes (straight line) depreciation of Rs. 70,000 and
allocated overheads of Rs. 30,000. The company expects to sell 100,000 packs of the lotion each
year. Assume that the tax rate is 45% and straight line depreciation is allowed for tax purposes.
If the opportunity cost of capital is 12%, should the company manufacture the lotion?

Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA

EDBAS 202 Corporate Financial Management

8. The existing earnings under two conditions are given.

Year Existing Machine (Rs.) New Machine (Rs.)
1 100,000 150,000
2 140, 000 250,000
3 280,000 350,000
4 400,000 450,000
5 510,000 550,000

The existing machine was purchased 3 years ago at Rs. 400,000. A new machine is under
consideration for replacement at a cost of Rs. 600,000. Depreciation life is 5 years in both cases,
and the tax rate is 34%. Use the depreciation rates of 20% for year 1, 32% for year 2, 19% for
year 3, 15% for year 4, and 14% for year 5. Determine the incremental cash flow for replacing
the existing machine.

9. A company is considering two mutually exclusive projects. Both require an initial cash outlay of
Rs. 10,000 each and have a life of five years. The company’s required rate of return is 10% and
pays tax at a 50% rate. The projects will be depreciated on a straight line basis. The before
taxes cash flows expected to be generated by the projects are as follows:

Year Project A (Rs.) Project B (Rs.)

1 4,000 6,000
2 4,000 3,000
3 4,000 2,000
4 4,000 5,000
5 4,000 5,000

Calculate for each project: (a) the payback (b) the NPV (c) IRR (d) PI (e) ARR Which project
should be accepted and Why?

Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA

EDBAS 202 Corporate Financial Management

10. The general manager of the engineering division of Modern Engineering Company is considering
the replacement of a six-year old equipment. The company has to incur excessive maintenance
cost on the equipment. The equipment has a zero written down value. It can be modernized at
a cost of Rs. 120,000, enhancing its economic life to 5 years. The equipment could be sold for
Rs. 20,000 after 5 years. The modernization of equipment would help in material handling and
in reducing labour and maintenance and repair costs. The company has yet another alternative.
It can buy a new machine at a cost of Rs. 300,000 with an economic life of 5 years with a
terminal value of Rs. 60,000. The new machine is expected to be more efficient in reducing
costs of material, labour and maintenance and repair etc. The annual costs are as follows:

Existing Equipment Modernization New Equipment

Wages and salaries 40,000 30,700 11,800
Supervision 20,000 9,500 7,000
Maintenance 28,000 8,000 2,500
Power 20,000 18,000 15,000
Total 108,000 66,200 36,300

The company has a tax rate of 50% and a required rate of return of 10%. Assume straight-line
depreciation for tax purposes, and tax on the sale of equipment. Should the company
modernize its equipment or buy new equipment?

Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA