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Capital Expenditure Decision

Evaluation Criteria

Discounting Techniques: a) Net present value (NPV) b) Benefit cost ratio (BCR) OR Profitability index (PI) c) Net benefit cost ratio (NBCR) d) Internal rate of return (IRR) e) Annual capital charge (ACC) Formulaes: a) Net present value:Total PV of cash inflow Investment Decision criteria:- If NPV is +ve than accept it or vice versa. b) Benefit cost ratio:Total PV of cash inflow / Investment Decision criteria:- If BCR > 1, accept it or vice versa. c) Net benefit cash ratio:(Total PV of cash inflow Investment) / Investment. OR BCR 1 OR NPV / Investment Decision criteria:- If NBCR > 0, than accept it or vice versa. d) Internal rate of return:L1 + (L2 L1) (H B) (H S) If NPV = 0 than use this formulae. Where :L1=Lower Rate.

Non Discounting Techniques: a) Pay back period b) Accounting rate of Return

L2=Higher Rate. H=highest Value. S=Smallest Value. B=Base Value. e) Annual capital charge: Investment + total PV of cost / PVIFA (kd,n) f) Pay back period: Total Investment / Cash Inflow per annum g) Accounting rate of return: Average annual income / Average Investment Where: Average Investment = (Opening investment + Closing investment) / 2 OR Investment /2

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Cash Inflow: = (Increase in profit + Decrease in Cost Increase in depreciation) (1-t) + Increase in depreciation + Increase in scrap value. Scrap value: used in final year cash flow. Increase in depreciation: Depreciation on new machine Depreciation on old machine.

Some Numerical Questions Based on Above Formulas

Q1.Zoya Limited is considering 4 projects A, B, C and D with the following characteristics: Projects Initial Investment Annual net Cash Flow (Year 1 to 5) A (20) 8.5 B (4.5) 2.5 C (7) 3.5 D (8) 4.5 The funds available are limited to Rs.20 lakh and the cost of funds to the firm is 14%. According to Benefit Cost Ratio (BCR), the rank of the projects are (a) A, B, C and D (b) A, D, C and B (c) B, C, A and D (d) C, B, A and D (e) D, B, C and A. Q2.Anil Enterprises Limited (AEL) has placed two orders to Sunil Enterprises limited (SEL) in order to purchase machines from them. Each machine is sold at a price of Rs.5,00,000 at a profit margin of 20%. It is estimated that the probability of default is 10% for the first order and 5% for the second order. What is the expected profit to SEL from granting the second credit to AEL, assuming that the first order has been paid? (a) Rs.67,500 (b) Rs.75,000 (c) Rs.85,000 (d) Rs.90,000 (e) Rs.95,000. Q3.Calculate the Accounting Rate of Return (ARR) from the following table: Year 0 1 2 3 Investment-------------------------- (1,00,000) Sales Revenue-----------------------------------------1,30,000 1,00,000 90,000 Operating expenses (excluding depreciation)--------------------------64,000 50,000 50,000 Depreciation------------------------------------------ 30,000 40,000 20,000 Annual income--------------------------------------- 36,000 10,000 20,000 Please visit for more info: www.financialpath.in

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(a) 44% (b) 45% (c) 50% (d) 54% (e) 55%. Q4.Visual Printers Ltd. (VPL) currently uses a machine, whose book value is Rs.12 lakh with the remaining useful life of 5 years and a salvage value of Rs.2 lakh at the end of the useful life. VPL is proposing to replace the machine by a new machine costing Rs.20 lakh and has a useful life of 5 years and salvage value of Rs.4 lakh at the end of 5 years. The new machine is expected to reduce the annual operating costs by Rs.0.5 lakh and increase the annual income by Rs.1 lakh. The old machine, if sold now, can realise Rs.9 lakh. EPL follows straight-line method of depreciation and is in the tax bracket of 40%. The net incremental cash flows of the new machine during year 0 and year 5 respectively are (a) Rs.20 lakh, Rs.3.38 lakh (b) Rs.11 lakh, Rs.3.38 lakh (c) Rs.11 lakh, Rs.4.10 lakh (d) Rs.20 lakh, Rs.2.10 lakh (e) Rs.11 lakh, Rs.2.10 lakh Q5.The minimum cash flow that must be received at the end of year three, with an initial investment of Rs.40,000 with cash flows for the first and second year of Rs.13,000 each and an opportunity cost of capital of 12.5%, is (a) Rs.18,173 (b) Rs.18,275 (c) Rs.19,284 (d) Rs.25,875 (e) Rs.30,565 Q6.If the cost of an investment is Rs.25,000 and it results in a net cash inflow of Rs.1,800 per annum forever. Assuming that the discount rate is 8%, the net benefit cost ratio of that investment is (a) 0.11 (b) 0.10 (c) 0.09 (d) 0.10 (e) 0.11 Q7. Bhagerrata construction corporation uses pay back period for the appraisal projects. What is the pay back period of the projects with the following expected cash flows? Year 0 1 2 Cash flows(Rs) (2,00,000) 80,000 70,000 Please visit for more info: www.financialpath.in

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3 4 5 (a) (b) (c) (d) (e) 3.0 years 3.5 years 4.1 years 3.8 years 5.0 years 30,000 40,000 60,000

Q8. Based on the following data: Year 0 1 2 (Investment) (4,00,000) Annual income 40,000 50,000 The accounting rate of return is (Assume no salvage value after 3years) a) 10% b) 20% c) 30% d) 40% e) 50%

3 30,000

Q9. A project has an initial cash outflow of Rs 5,00,000 and another outflow of Rs. 2,00,000 at the end of 3rd year. What is the Net Present Value(NPV) of the project with the following cash inflows considering discount rate as 20%? (correct to nearest hundred) Year 1 2 3 4 5 Cash 2,00,000 3,50,000 3,00,000 2,50,000 2,00,000 flows(Rs) a) Rs 84,300 b) Rs 84,300 c) Rs 1,68,500 d) Rs 6,00,000 e) Rs 8,00,000 Q10. Navayuga Pharmaceuticals Ltd, is evaluating system which is expected to have an economic life of six years. The initial outlay and annual operating associated with this system are as follows: Year 0 1 2 3 4 5 6 Costs 15,00,000 1,00,000 1,10,000 1,25,000 1,10,000 1,30,000 2,00,000 If the cost of capital is 12% the annual capital charge associated with the system is a) Rs 3,87,000 b) Rs 4,45,400 c) Rs 4,89,200 d) Rs 5,03,500 e) Rs 5,84,600 Please visit for more info: www.financialpath.in

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Q11. Mahavir Engineering Ltd. (MEL) currently uses a machine whose book value is Rs 12lakh and has a remaining useful life of 5years and a salvage value of Rs 2 lakh at the end of useful life. MEL is proposing to replace the machine by a new machine costing Rs 20 lakh and has a useful life of 5 years and salvage value of Rs 4 lakh at the end of 5 years. The new machine is expected to reduce the annual operating costs by Rs 50,000 and increase the annual income by Rs 1,00,000. The old machine can be sold at Rs 9 lakh. MEL uses straight line depreciation and is in tax bracket of 40%. The net incremental cash flow in the 1st year is: a) Rs. 0.90 lakh b) Rs. 1.38 lakh c) Rs. 1.50 lakh d) Rs. 3.38 lakh e) Rs. 4.10 lakh Q12. If the cost of an investment is Rs 2 lakh and it pays Rs 17,500 in perpetuity at an interest rate of 8% p.a., the benefit cost ratio of the investment is a) -1.29 b) -0.09 c) 0.70 d) 1.09 e) 1.22 Q13. Labour Motors Services is considering the purchase of a new bus which requires a cash outlay of Rs. 25,00,000 and has an economic life of five years. If the company provides depreciation of 20% on written down value method, the book value of the asset at the end of 5 th year is a) Rs. 8.19 lakh b) Rs.10.24 lakh c) Rs.12.80 lakh d) Rs.16.00 lakh e) Rs.16.35 lakh Q14. M/s Priya Garments and Exports is considering to buy a new piece of equipment, which is expected to cost Rs 4,00,000 and will produce cash flows for the next 6 years (the first cash flow will be exactly one year from today). If the company is able to invest in an upgrade which would cost Rs. 1,20,000 in year 3, it would increase the annual cash flows from 4th year onwards to Rs.2,00,000. If the discount rate appropriate for the company is 15%, the NPV of the investment is approximately. a) Rs. 28,765 b) Rs. 36,674 c) Rs. 45,295 d) Rs. 49,672 e) Rs. 52,605

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Q15. The finance manager of Kargil Engineering Ltd, is analyzing a project with a life of 5 years, which requires an initial investment in equipment and machinery of Rs 80 lakh. The equipment is expected to have a 5-year lifetime and have no salvage value which is to be depreciated on straight line basis. The project is expected to generate revenues of Rs 40 lakh each year for the 5 years and have operating expenses (not including depreciation) amounting to 30% of revenues. The tax rate is 40%. What is the Internal Rate of Return (IRR) of the project? a) 13.82% b) 13.94% c) 14.16% d) 15.25% e) 18.00% Q16. Based on the following data of a project: Year Cash flow (Rs) 0 (1,42,000) 1 50,000 2 65,000 3 80,000 4 90,000 5 92,000 And the cost of capital is 10%, the discounted payback period is: a) 2.34 years b) 2.71 years c) 3.15 years d) 3.82 years e) 4.46 years Q17. Palaniappa Tools & Spares Ltd., is planning to purchase a purchasing machine with the following features: Cost of machine Rs, 3,00,000 Annual cost of operations Rs, 2,50,000 for the first four years Rs, 3,00,000 for the subsequent years Useful life 10 years The annual capital charge of the machine, if cost of capital is 10 percent, is a) Rs. 5,06,236 b) Rs. 6,54,558 c) Rs. 7,62,382 d) Rs. 8,29,780 e) Rs. 9,42,732

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ANSWERS OF THE QUESTION

1- Ans. (e) The NPV of the 4 projects are: Project Present value of future Cash flows (Rs.in lakh) A 8.5 PVIFA(14%,5)=29.18 B 2.5 PVIFA(14%,5)=8.583 C 3.5 PVIFA(14%,5)=12.016 D 4.5 PVIFA(14%,5)=15.449 BCR(PV/I) 29.18/20=1.459 8.583/4.5=1.907 12.016/7=1.717 15.449/8=1.931 RANK I II III IV

2- Ans. (a) The expected profit from granting the second credit to AEL, assuming the payment for the first order has been made by AEL ,is 0.90{0.95 100000 - 0.05 400000} = Rs.67,500 3- Ans (a) Accounting rate of Return = Average profit after tax/average book value of investment Average annual income =36,000+10,000+20, 000 3 = 22,000 Average net book value of investment = (1,00,000+0) 2 = 50,000 ) 100=44%. Accounting Rate of return = ( 4- Ans (b) Net incremental cash flow during year 0 is = - (Investment for new machine Present realizable value of old machine) = - (20 - 9) = -Rs 11 lakh Net incremental cash flow during year 5 is = Incremental PAT + Incremental Depreciation + Incremental Scrape realizable value. Depreciation of old machine = (12 2) / 5 = Rs 2,00,000 Depreciation of old machine = (20 4) / 5 = Rs 3,20,000 Incremental depreciation = Rs 3,20,000 2,00,000 = Rs 1,20,000. Net incremental cash flow during year 5 = (50,000 + 1,00,000 1,20,000) (1-0.4) + 1,20,000 + 2,00,000 = Rs 3,38,000 5- Ans (d) 40,000 = 13,000(1.125)1 + 13,000(1.125)2 + X (1.125)3 or, 40,000 = 11,555.55+ 10,271.60 + X(1.125)3 or, X(1.125)3= 18,172.84 or, X = 18,172.84 x(1.125)3 = Rs. 25,875.00

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6- Ans (b) The present value of cash flow will be = NPV of that investment = Rs. 22,500 Rs. 25,000 = - Rs 2500. Hence, the net profit cost ratio for that investment = 7- Ans (b) Initial outlay = Rs.2,00,000 Amount receivables in 3 years = 80000 + 70000 + 30000 = 1,80,000. Hence, the number of years required to recover the initial outlay will be = 3years + (2,20,000 2,00,000) 40,000 = 3.5 yrs. Hence, answer is 3.5 years. 8- Ans (b) Average annual income for 3 years = (50,000 + 40,000 + 30,000) 3 = Rs. 40,000 Average net book value of investments = (4,00,000 + 0) 2 = Rs 2,00,000 Accounting rate of return = (40,000 2,00,000) 100 = 20% 9- Ans (c) Present value of cash outflows = 5,00,000 + (2,00,000 PVIF20%, 3 yrs) = Rs.6,15,741 Present value of cash inflows = (2,00,000 PVIF20%, 1 yrs) + (3,50,000 PVIF20%, 2 yrs) + (3,00,000 PVIF20%, 3 yrs) + (2,50,000PVIF20%, 4 yrs) + (2,00,000 PVIF20%, 5 yrs) = Rs.7,84,265 NPV = Total Present Value of Cash inflow Total Investment Rs.7,84,265 Rs.6,15,741 = Rs 1,68,524 10- Ans (c) Annual capital charge = PV of costs associated with the system = (1,00,000 PVIF12%,1yrs) + (1,10,000 PVIF12%,2yrs) + (1,25,000 PVIF12%,3yrs) + (1,10,000PVIF12%,4yrs) + (1,30,000 PVIF12%,5yrs) + (2,00,000 PVIF12%,6yrs) = Annual capital charge = = 4,89,200. 11- Ans (b) Net incremental cash flow during year 0 is = -(Investment for new machine present realizable value of old machine) = -(20 9) = -11 lakhs. Net incremental cash flow during year 5 is: = Incremental PAT + Incremental Depreciation + Incremental realizable value Depreciation of old machine = (12,00,000 2,00,000) 5 = Rs.2,00,000 Depreciation of new machine = (20,00,000 4,00,000) 5 = Rs.3,20,000 Incremental depreciation = Rs 3,20,000 2,00,000 = Rs 1,20,000 Net incremental cash flow during year = (50,000 + 1,00,000 1,20,000) (1 - 0.4) + 1,20,000 = Rs.1,38,000 = 1.38 lakh. Please visit for more info: www.financialpath.in

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12- Ans (d) Present value of cost = Rs 2,00,000 Present value of Perpetuity = Rs.17,500 .08 = Rs 2,18,750 BCR = Total Present Value of Benefit Investment = Rs.2,18,750 2,00,000 = 1.09 13- Ans (a) Year Book value of asset (Rs) 1 25,00,000 2 20,00,000 3 16,00,000 4 12,80,000 5 10,24,000

Depreciation (Rs) 5,00,000 4,00,000 3,20,000 2,56,000 2,04,800

Remaining book value (Rs) 20,00,000 16,00,000 12,80,000 10,24,000 8,19,000

14- Ans (d) In the scenario given, the cash flow would look like this: YEAR 0 1 2 3 4 5 6 Out Flow -4L -1.2 In flow 1L 1L 1L 2L 2L 2L Total Out Flow = - 4L - (1.2L PVIF15%,3Yrs) = -4.789L Total Inflow = (1L PVIFA15%,3Yrs) + 2L (PVIFA15%,6Yrs - PVIFA15%,3Yrs) = 5.285L NPV = Total Inflow Total Out flow = 5.285L 4.789L = Rs 49,672 15- Ans (a) Year 0 Year (1-5) Rs (lakh)

Initial invsestment 80 Revenue 40 Operating expenses 12 Depreciation (80/5) 16 Earning before tax 12 Tax @ 40% 4.8 Profit after tax 7.2 Operating cash flow = PAT 23.2 + Depreciation 80 = 23.8 PVIFA(k,5yrs) K = 13% RHS = 23.2 3.517 = 81,59,440 K = 14% RHS = 23.2 3.433 = 79,64,560 By Interpolation Method. ( ( ) (

) )

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16- Ans (b) Calculation of discounted payback period: Year Cash PVIF @ Present value flows(Rs.) 10% cash flows 1 50,000 0.909 45,450 2 65,000 0.826 53,690 3 80,000 0.751 60,080 4 90,000 0.683 61,470 5 92,000 0.621 57,132 Sum of first two year is = 45,450 + 53,690 = Rs.99,140 1,42,000 99,140 = 42,860 =2 + (1,42,000 99,140) 60,080 = 2.71 Discounted payback period is 2.71 years. 17- Ans (c) Present value of the costs associated with the machine will be Rs.30,00,000 + Rs.2,50,000 * PVIFA(10%,4years) + Rs.3,00,000 * PVIFA(10%,6years) * PVIF(10%,4years) = Rs.30,00,000 + Rs.2,50,000 * 3.170 + Rs.3,00,000 * 4.355 * 0.683 = Rs.46,84,839.50 The required annual capital charge will be = ( Cost + Total PV of Annual Cost ) PVIFA(10%,10years) = Rs.7,62,382(approx).

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