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Exercises (Capital Budgeting)

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 projects 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:

Investment required

Present value of
future cash flows


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?
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. 4000 for delivery and Rs. 9000 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. As a
financial analyst, (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. 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.

5. 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 companys 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
Project A
Project B
Rs. 4000
Rs. 6000
Calculate for each project: (a) the payback (b) the NPV (c) IRR (d) PI (e) ARR
Which project should be accepted and Why?
6. 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?
7. Howell Petroleum is considering a new project that complements its existing business.
The machine required for the project costs $2 million. The marketing department predicts
that sales related to the project will be $1.2 million per year for the next four years, after
which the market will cease to exist. The machine will be depreciated down to zero over
its four -year economics life using the straight line method. Cost of goods sold and
operating expenses related to the project are predicted to be 25 percent of sales. Howell
also needs to add net working capital of $100,000 immediately. The additional net
working capital will be recovered in full at the end of the projects life. The corporate tax
rate is 35 percent. The required rate of return for Howell is 14 percent. Should Howell
proceed with the project?