Capital Budgeting

Solved Problems

1. A company is considering three methods of attracting customers to expand its

business: (A) advertisement campaign, (B) Display of neon signs, and (C)
Direct delivery service. The initial outlays for each alternatives are
A
100,000
B
150,000
C
150,000
If A is carried out, but not B, it has an NPV of $ 125,000. If B is done but not A,
then B has an NPV of $45,000. However if both are done, their NPVs are
200,000. The NPV of delivery system C is $ 90,000. Its NPV is not dependent
on whether A or B is adopted and NPV of A or B does not depend on whether C
is adopted. Which of the investments should be made by the company (i) If
the firm has no budget constraint, (ii) If the budget amount is only $ 250,000?
Solution:
Mode of attracting customers
Expected NPV($)
Advertisement Campaign (A)
125,000
Display of Neon signs(B)
{ (A) + (B)}
200,000
Direct delivery service (C)
(i)
(ii)

Initial Outlay

($)

100,000
150,000
250,000

45,000

150,000

90,000

In case of no budget constraint, the firm should adopt (A + B) and C

modes of attracting customers.
In case of budget constraint of 250,000 (A) and (C) as the NPV from
this combination is the maximum.

2. A company is investigating the feasibility of manufacturing one of the

components needed for its finished product rather than purchasing it from an
outside supplier. Its present supplier has just announced that he intends to
increase the price from $ 100 to $ 125 per unit, provided the company
purchases 6000 units per year.
The equipment needed to make this product can be purchased for $ 1,200,000
and is expected to have salvage value of $ 300,000 and increase by 100,000
per year. The variable cost of manufacturing each component will be $ 30 per
unit. Straight line depreciation will be used. The company is subject to a 50%
tax rate and 15% is the appropriate cost of capital for this project. The
company projects annual needs at 7500 units per year for the 6 years period.
Advice the company whether it should continue buying from outside suppliers
or start manufacturing on its own. Will your answer be different if the
requirement of the company is only 6000 units per year?

Solution:
Cash out flows:
Cost of equipment($)
Cash Inflows (CFAT):

1,200,000
7500 units( $)
937,500

Buying cost @ 125 per unit

6000 units($)
750,000

Less manufacturing costs:

Variable cost @ 30 per unit
225,000
Fixed cost
100,000
Depreciation (900,000/6 yrs)
150,000

180,000
100,000
150,000

Cost savings( profit) before taxes

Less taxes (50%)

462,500
231,250

320,000
160,000

Earnings after tax

Add depreciation
CFAT

231,250
150,000
381,250

160,000
150,000
310,000

Net Present Value calculation

Particulars
Total PV

year

Amt($)

PV factor@
15%

a. At 7500 units:
Cash out flows
(1,200,000)
Operating CFAT
1,442,650
Salvage value
129,600

t = 0
t = 1 to 6
t = 6

($)

(1,200,000) 1.000
381,250

3.784
300,000

0.432
_______
372,250

b. At 6000 units:
Cash out flows
(1,200,000)
Operating CFAT
1,173,040
Salvage value
129,600

t = 0
t = 1 to 6
t = 6

(1,200,000) 1.000
310,000

3.784

300,000

0.432
_______
102,640

Recommendation: The company is advised to start manufacturing on its own

irrespective of the fact whether the required units are 7500 or 6000, as NPV is
positive in both the situations.

3. A plastic manufacturing company now makes products by a labor intensive

process. the firm is experiencing difficulty in expanding production to meet the
increased demand and is considering purchasing a machine that will enable
production to increase by 20%( from 50,000 units to 60,000 units). The
machine costs 100,000 birr and has a useful life of 10 years with no salvage.
Investment allowance is 25%.
There will be increased working capital requirement of 25,000 birr. The
variable cost per unit is 4.00 birr; fixed costs are 100,000 birr per annum;
variable costs per unit will remain the same and fixed costs will increase by
the amount of depreciation on the new machine. The current selling price is
10.00 birr per unit. The firm expects to sell all its production at 9.50 birr per
unit if the machine is bought.
The company will be using straight line method of depreciation. The corporate
tax rate is 55 % and the minimum required rate of return is 15%. Advise the
company whether the machine should be bought or not.
Solution:
Cash outflows:
Particulars
Amount (Birr)
Cost of new machine
100,000
Plus Increase in working capital
25,000
Less tax savings on account of
Investment allowance 55% ( 25,000 birr)
13,750
Total
111,250
Cash inflows:
Existing
( Birr)
500,000

Revenues: (50,000 X 10)

: ( 60,000 X 9.5)
Less variable costs: ( 50,000 X 4) 200,000
: ( 60,000 X 4)
Contribution
300,000
Excess contribution
Less depreciation ( 100,000/10 yrs)
Increase in taxable income
Less tax (55%)
After tax amount
Add depreciation
CFAT for t = 1 to 9
CFAT in t = 10 (wc recovered)
25,000

Proposed
(Birr)
570,000
240,000
330,000
30,000
10,000
20,000
11,000
9,000
10,000
19,000
44,000

Present value of cash inflows:

Year

CFAT (birr)

PV factor @ 15%

Total PV

19
19,000
10
44,000
Total present value
101,536
Less PV of cash outflows
111,250
NPV

4.772
0.247

90,668
10,868

( 9714)

Recommendation: The machine should not be purchased as it yields

negative NPV
4. Zenith industries ltd., is considering replacing a hand operated machine with
a new, fully automated one. Given the following information, advise the
management whether the machine should be replaced or not.
Existing situation:
One full-time operators salary
Variable overtime
Fringe benefits
Cost of defects
Original price of hand operated machine
Expected life
Expected salvage value
Age
Depreciation method
Current salvage value
Marginal tax rate
Required rate of return

36,000
3000
3000
18,000
60,000

3 years
Nil
15 years
Straight line
36,000
50%
15 %

Proposed situation:
Fully automated operation
No operator required
Cost of machine
180,000
Shipping fee
3000
Installation costs
15,000
Expected economic life
15 years
Depreciation method
Straight line method
Salvage value after 15 years
Nil
Annual maintenance
3000
Cost of defects
3000
Solution:
i. Cash outflows if machine is purchased
Cost of machine
180,000
Add shipping fee
3000
Add installation costs
15,000
Less cash inflow from sale of old machine
36000
Less cash payment @ 50% on gains
( 36000- 30000 current book value)
3000 33,000
______

165,000
ii. Cost savings if machine is purchased:
Existing
Proposed
Situation
situation
Salary
36,000
Variable overtime
3,000
Fringe benefits
3,000
Cost of defects
18,000
Annual maintenance Nil
Depreciation
2,000
______
62,000
iii. Determination of CFAT:
Cost savings, i.e., increase in profits
Less taxes (50%)
Earnings after tax
Add depreciation
CFAT

Differential
cost savings

Nil
Nil
Nil

36,000
3,000
3,000

3,000
15,000
3,000
(3,000)
13,000
(11,000)
_____
_____
19,000
43,000
43,000
21,500
21,500
11,000
32,500

iv. Determination of NPV:

Years
CFAT
1 to 15 years
32,500
190,027.50
Less PV of cash outflows

PV factor @15% Total PV

5.847
165000
________
25,027.5

Recommendation: The machine should be replaced as the NPV is

positive

5.

Solution:
The following table gives initial investments and annual cash flows from
projects
Initial Investment and annual cash flows

Incremental depreciation schedule

Calculation of depreciation

The computation of the incremental cash flows of replacement decision is

briefly described below

Practice Problems

1. A textile company is considering two mutually exclusive investment proposals

for its expansion programme. Proposal A requires an initial investment of $
750,000 and yearly cash operating costs of $50,000. Proposal B requires an
initial investment of $500,000 and yearly cash operating costs of $ 10,000.
The life of the equipment used in both the investment proposals will be 12
years, with no salvage value; depreciation is on the straight line basis. The
firms tax rate is 55 % and its cost of capital is 15%. Which investment
proposal be undertaken by the company.
2. To meet the growing demand for electricity, Addis suburban electricity supply
co. ltd has decided to expand its generating capacity. The required capacity
can be provided by constructing two thermal plants (alternative 1), or one
hydro plant (alternative 2). The following information has been compiled for
analysis.
Amount (in million Birr)
Alt 1
Alt 2
Initial investment
680
Yearly operating costs ( excluding depreciation)
Operations
160
Maintenance
40
Transmission
60
Cost to dismantle plant at the
end of useful life of 20 years
10

980
80
20
50
30

Which alternative should the firm select? Its cost of funds is estimated at 10%.
Ignore taxes and assume a straight line method of depreciation.
3. ABC ltd manufactures toys and other short lived fad items. The research and
development department has come up with an item that would make a good
promotional gift for office equipment dealers. As a result of efforts by the
sales personnel, the firm has commitments for this product.
To produce the quantity demanded, ABS ltd will need to buy additional
machinery and rent additional space. It appears that about 25,000 square feet
will be needed; 12,500 sq.ft of presently unused space but leased at a rate of
$ 3 per sq.ft is available. There is another 12,500 sq.ft adjoining the ABC
facility available at the annual rent of $ 4 per sq.ft.
The equipment will be purchased for 900,000. it will require $ 30,000 in
modifications, $ 60,000 for installation and $ 90,000 for testing. The
equipment will have a salvage value of about $180,000 at the end of the third
year. No additional general overhead costs are expected to be incurred.
The estimates of revenues and costs for this product for the three years have
been developed as follows:
Particulars
Year1
Year 2
Year3
Sales
1,000,000 2,000,000 800,000

Less Costs:
Material, labor and overhead incurred
400,000
750,000
350,000
Over heads allocated
40,000
75,000
35,000
Rent
50,000
50,000
50,000
Depreciation
300,000
300,000
300,000
Total costs
790,000
1,175,000 735,000
Earnings before tax
210,000
825,000
65,000
Less taxes
105,000
412500
32500
Earnings after taxes
105,000
412500
32500
If the company sets a required rate of return of 20% after taxes, should this
project be accepted?
4.

Royal industries requires some machinery for a manufacturing process that

will be carried out for the next eight yeas. The two machineries that meet the
firms needs are available. The relevant data regarding these two machines
are as follows:
Machine X

Machine Y

Purchase cost

43,600

78,400

Annual cash operating expenses

25,000

20,000

Salvage value at the end of useful life

8000

8000

Useful life ( in years)

The company makes use of straight line method of depreciation. In

determining the amount of depreciation, provision would be made for salvage
value. It is estimated that the firm would need 48,000 to replace machine A at
the end of 4 years, if that machine is selected. The other data applicable to
machine X given above will apply to the replacement model as well.
Cost of capital is 15% and tax rate is 50%. You are required to determine the
course of action that the firm should take.
5. A job which is presently done entirely by manual methods has a labor cost of
46,000 a year. it is proposed to install a machine to do the job which involves
an investment of 80,000 and an annual operating cost of 10,000. Assume that
the machine can be written off in 5 years on straight line depreciation basis for
tax purposes. Salvage value at the end of its economic life is zero. The tax rate
is 55 %. Analyze the economic implications of the proposal by internal rate of
return method.