SECTION A

CAPITAL BUDGETING - QUESTIONS

QUESTION 1
Everest Ltd is considering the replacement of a group of machines used exclusively for the manufacture
of one of its products, the Yeti. The existing machines have a book value of Rs 65,000 after deducting
straight-line depreciation from historical cost; however, they could he sold only for Rs 45,000. The new
machines would cost Rs 100,000. Everest expects to sell Yetis for four more years. The existing
machines could be kept in operation for that period of time if it were economically desirable to do so. After
four years, the scrap value of both the existing machines and the new machines would be zero.
The current costs per unit of manufacturing Yetis on the existing machines and the new

machines are as

follows:

Materials
Labour (32 hours at Rs 1.25)
Overheads (32 hours at Rs 0.60)

Existing machines
Rs
22.00
40.00
(16 hours at Rs 1.25)
19.20
(16 hours at Rs 1.80)
81.20

New Machines
Rs
20.00
20.00
28.00
68.80

Overheads are allocated to products on the labour-hour rate method. The hourly rates of 60p and Rs 1.80
comprise 25p and 62.5p for variable overheads and 35p and Rs 1.175 for fixed overheads, inducing
depreciation. Apart from depreciation fixed overheads for the organisation as a whole are not expected to
change if the new machines are used.
Current sales of Yetis are 1,000 units per annum at Rs 90 each; if the new machines were purchased,
output would be increased to 1,200 units and selling price would be reduced to Rs 80.
Everest requires a minimum rate of return on investment of 20% per annum in money terms. Materials
costs, overheads and selling prices are expected to increase at the rate of 15% per annum, in step with
the index of retail prices. Labour costs are expected to increase at the rate of 20% per annum. Assume
that annual receipts and payments would arise annually on the anniversary of the installation of the new
machinery.
QUESTION 2
A sugar mill is planning to introduce a new product. The project has projected life of 8 years. Initial
equipment cost will be Rs.140 million and additional equipment of Rs.10 million will be needed in the third
year. At the end of 8 years, the original equipment will have no resale value, but the supplementary
equipment can be sold for Rs.1 million. A working capital of Rs.15 million will be needed. The sales
volume of 8 years period have been forecasted as follows:
Year
1
2
35
68

UNITS
80,000
120,000
300,000
200,000

A-1

SECTION A

CAPITAL BUDGETING - QUESTIONS

Sale price of Rs.1,000 per unit is expected and variable expenses will amount to 40% of sales revenue.
Fixed cash operating costs will amount to Rs.16 million per year. In addition an extensive advertisement
campaign will be implemented requiring annual outlays as follows:

Year
1
2
35
68

(RS. MILLION)
30
15
10
4

The company is subject to 50% tax rate and considers 12% to be an appropriate after tax cost of capital
for this project. The company follows straight line method of depreciation.
Required: The management has requested you to advise whether the project is viable. Assume the
company has enough income from other existing projects.
QUESTION 3
A Company has decided to make a capital investment of Rs.10 million on heavy-duty trucks which have a
life of 10 years. The trucks will be contracted out for long distance transportation of goods. Working
capital requirement for the period is estimated at Rs.1 million. Compute the required volume in tons that
the trucks must carry so that the annual cash flows break-even with the net present value of the
investment assuming that
(a) truck hire is Rs.5,000 per ton,
(b) variable cost for running the truck is Rs.3,000 per ton,
(c) Annual fixed cots, excluding depreciation, will amount to Rs.372,722
(d) tax depreciation will be as per current Tax Laws,
(e) Working capital investment of Rs.1 million will be recovered by the tenth year and
(f) the company policy is to earn a return of 20% on capital investments.
QUESTION 4
Fluorine Ltd is choosing which investment to undertake during the coming year. The following table has
been prepared, summarizing the main features of available projects:
Project

Sodium
Magnesium
Aluminum
Silicon
Phosphorus

Cash Outlays
Time 0
Time 1
Rs 000
Rs 000
20
50
40
35
50
35
40
15
30
40

Cash Receipts
Time 1
Time 2
Rs 000
Rs 000
20
80
40
55
10
115
10
75
20
80

A-2

SECTION A

CAPITAL BUDGETING - QUESTIONS

There will be no cash flows on any of the projects after time 2. All projects are regarded as being of equal
risk. Fluorine uses only equity sources of finance at an estimated cost of 20% per annum.
Cash flows given above represent estimated results for maximum possible investment in each project;
lower levels of investment may be undertaken, in which case all cash flows will be reduced in proportion.
You are required to:
(a)

Prepare calculations to identify the optimal set of investments assuming that capital available is
limited to Rs 100,000 at time 0, and Rs 200,000 at time 1; assume for the purpose of this
requirement only that the Aluminum project and the Silicon project are mutually exclusive.

(b)

Explain what calculations you would undertake to identify the optimal set of investments assuming
that capital available is limited to Rs 100,000 at time 0 and to Rs 40,000 at time 1; give reasons for
your choice of method but do not give calculations.

(c)

Draft short notes for a reply to a director of Fluorine who has seen your proposals, has commented
that the use of sophisticated methods of calculation is unjustified in view of the uncertainty of the
estimates of cash flow and has expressed his opinion that the payback method is generally to be
preferred.
Ignore taxation.
(25 marks)

QUESTION 5
Stadler is an ambitious young executive who has recently been appointed to the position of financial
director of Paradis Ltd., a small listed company. Stadler regards this appointment as a temporary one,
enabling him to gain experience before moving to a larger organization. His intention is to leave Paradis
Ltd. in three years time, with its share price standing high. As a consequence, he is particularly concerned
that the reported profits of Paradis Ltd. should be as high as possible in his third and final year with the
company.
Paradis Ltd. has recently raised Rs.350,000 from a rights issue, and the directors are considering three
ways of using these funds. Three projects (A, B and C) are being considered, each involving the
immediate purchase of equipment costing Rs.350,000. One project only can be undertaken, and the
equipment for each project will have a useful life equal to that of the project, with no scrap value. Stadler
favours project C because it is expected to show the highest accounting profit in the third year. However,
he does not wish to reveal his real reasons for favouring project C, and so, in his report to the chairman,
he recommends project C because it shows the highest internal rate of return. The following summary is
taken from his report:

Project

A
B
C

Net cash flows (Rs. 000)

years
0
(350)
(350)
(350)

1
100
40
200

2
110
100
150

3
104
210
240

4
112
260
40

5
138
160
-

Internal
rate of
return (%)
6
160
-

7
180
-

8
-

27.5
26.4
33.0

A-3

SECTION A

CAPITAL BUDGETING - QUESTIONS

The chairman of the company is accustomed to projects being appraised in terms of payback and
accounting rate of return, and he is consequently suspicious of the use of internal rate of return as a
method of project selection. Accordingly, the chairman has asked for an independent report on the choice
of project. The company's cost of capital is 20% and a policy of straight-line depreciation is used to write
off the cost of equipment in the financial statements.
Requirements:
(a)
(b)
(c)
(d)

Calculate the payback period for each project.

(3 marks)
Calculate the accounting rate of return for each project.
(5 marks)
Prepare a report for the chairman with supporting calculations indicating which project should be
preferred by the ordinary shareholders of Paradis Ltd..
(12 marks)
Discuss the assumptions about the reactions of the stock market that are implicit in Stadler's
choice of project C.
(5 marks)
Note: ignore taxation.
(Total 25 marks)

QUESTION 6
CD is an aviation company engaged in providing transport services to tour operators and industrial
customers. CD's cost of money is 10%.
CD is considering the acquisition of three new aircraft which have a cost price of Rs.2,000,000 each.
Each aircraft has a useful life of five years, requires an overhaul (costing Rs.600,000) at the end of the
third year of its life, incurs fixed operating costs of Rs. 100,000 per year and has nil residual value at the
end of its useful life.
If an aircraft is purchased and fully utilised then it flies for 2400 hours per year and generates an expected
contribution of Rs.1,600,000 per year.
As an alternative to buying an aircraft, it is possible to rent it via a broker. The terms of the rental are a
fixed fee of Rs.250,000 per year (payable annually in advance) and a variable charge of Rs.361 per flying
hour (calculated and paid annually in arrears). If an aircraft is rented, then CD will avoid fixed operating
and overhaul costs. However, CD will incur the same variable operating costs regard-less of whether the
aircraft is purchased or rented.
Requirements:

A-4

SECTION A

CAPITAL BUDGETING - QUESTIONS

(a) Advise CD on the minimum average flying hours per year required m order to

make renting an aircraft a viable proposition,

make buying an aircraft a viable proposition,

and advise CD on the average flying hours per year required in order to make buying and renting an
aircraft equally viable propositions.
(15 marks)
(b) Advise CD as to how many aircraft it should acquire, and how it should acquire them (purchase or
rent) on the basis of a flying hour requirement forecast of 5750 hours per year for five years.
Support your advice with a full financial analysis. (10 marks)
Note: You may ignore tax and inflation. (Total 25 marks)
QUESTION 7
In the manufacture of a company's range of products, the processes give rise to two main types of waste
material.
Type A is the outcome of the company's original processes. This waste is sold at Rs.2 per tonne, but this
amount is treated as sundry income and no allowance for this is made in calculating product costs.
Type B is the outcome of newer processes in the company's manufacturing activity. It is classified as
hazardous, has needed one employee costing Rs.9,000 per year specially employed to organise its
handling in the factory, and has required special containers whose current resale value is assessed at
Rs.18,000. At present the company pays a contractor Rs.14 per tonne for its collection and disposal.
Company management has been concerned with both types of waste and after much research has
developed the following proposals.
Type A waste

A-5

SECTION A

CAPITAL BUDGETING - QUESTIONS

This could be further processed by installing plant and equipment costing Rs.20 000 and incurring extra
direct costs of Rs.2.50 per tonne and extra fixed costs of Rs.10,000 per annum.
Extra space would be needed, but this could be obtained by taking up some of the space currently used
as a free car park for employees. The apportioned rental cost of that land is Rs.2,500 per annum and a
`compensation' payment totalling Rs.500 per annum would need to be paid to those employees who
would lose their car-parking facilities.
The selling price of the processed waste would be Rs.12.50 per tonne and the quantity available would be
2000 tonnes per annum.
Type B waste
Using brand-new technology, this could be further processed into a non-hazardous product by instal-ling a
plant costing Rs.120,000 on existing factory space whose apportioned rental cost is Rs.12,500 per
annum.
This plant cost includes a pipeline that would eliminate any special handling of the hazardous waste.
Extra direct costs would be Rs.13.50 per tonne and extra fixed costs of Rs.20,000 per annum would be
incurred.
The new product would be saleable to a limited number of customers only, but the company has been
able to get the option of a contract for two years' sales renewable for a further two years. This would be at
a price of Rs.11 per tonne and the output over the next few years is expected to be 4,000 tonnes per year.
For Type A waste project, the board wants to achieve an 8% DCF return over four years. For Type B
waste project, it wants a 15% DCF return over six years.
You are required
(a) to recommend whether the company should invest in either or both of the two projects. Give
supporting figures and comments. Assume that no capital rationing exists. (20 marks)
(b)

to explain briefly in respect of Type B waste project what major reservations (apart from the cost
and investment figures) you might have about the project, irrespective of whether you recommend it
in (a) above. (5 marks)

Ignore inflation and taxation.

(Total 25 marks)

QUESTION 8
Armcliff Ltd is a division of Shevin Ltd. which requires each of its divisions to achieve a rate of return on
capital employed of at least 10% p.a. For this purpose, capital employed is defined as fixed capital and
investment in stocks. This rate or return is also applied as a hurdle rate for new investment projects.
Divisions have limited borrowing powers and all capital projects are centrally funded.
The following is an extract from Armcliff's divisional accounts:
Profit and loss account for the year
ended 31 December
Turnover
Cost of sales
Operating profit

(Rs.m)
120
(100)
20

A-6

SECTION A

CAPITAL BUDGETING - QUESTIONS

Assets employed as at 31 December 1994

Fixed (net):
Current assets (inc. stocks Rs.25m)
Current liabilities:
Net capital employed

Rs. m

Rs. m
75

45
(32)

13
88

Armcliff's production engineers wish to invest in a new computer-controlled press. The equipment cost is
Rs.14m. The residual value is expected to be Rs.2m after four years operation, when the equip-merit will
be shipped to a customer in South America.
The new machine is capable of improving the quality of the existing product and also of producing a
higher volume. The firm's marketing team is confident of selling the increased volume by extending the
credit period. The expected additional sales are:
Year
Year
Year
Year

1
2
3
4

2,000,000 units
1,800,000 units
1,600,000 units
1,600,000 units

A-7

SECTION A

CAPITAL BUDGETING - QUESTIONS

Sales volume is expected to fall over time due to emerging competitive pressures. Competition will also
necessitate a reduction in price by Rs.0.5 each year from the Rs.5 per unit proposed in the first year.
Operating costs are expected to be steady at Rs. 1 per unit, and allocation of overheads (none of which
are affected by the new project) by the central finance department is set at Rs.0.75 per unit.
Higher production levels will require additional investment in stocks of Rs.0.5m, which would be held at
this level until the final stages of operation of the project. Customers at present settle accounts after 90
days on average.
Required:
(a)

Determine whether the proposed capital investment is attractive to Armcliff, using the average rate
of return on capital method, as defined as average profit-to-average capital employed, ignoring
debtors and creditors. [Note: Ignore taxes] (7 marks)

(b)

(i) Suggest three problems which arise withthe use of the average return method for appraising
new investment. (3 marks)
(ii) In view of the problems associated with the ARR method, why do companies continue to use it
in project appraisal? (3 marks)
(Total 13 marks)

QUESTION 9
Khan Ltd is an importer of novelty products. The directors are considering whether to introduce a new
product, expected to have a very short economic life. Two alternative methods of promoting the new
product are available, details of which are as follows:
Alternative 1 would involve heavy initial advertising and the employment of a large number of agents. The
directors expect that an immediate cash outflow of Rs.100,000 would be required (the cost of advertising)
which would produce a net cash inflow after one year of Rs.255,000. Agents' commission, amounting to
Rs.157,500, would have to be paid at the end of two years.
Alternative 2 would involve a lower outlay on advertising (Rs.50,000, payable immediately), and no use of
agents. It would produce net cash inflows of zero after one year and Rs.42,000 at the end of each of the
subsequent two years.
Mr Court, a director of Khan Ltd, comments, `I generally favour the payback method for choosing between
investment alternatives such as these. However, I am worried that the advertising expenditure under the
second alternative will reduce our reported profit next year by an amount not compensated by any net
revenues from sale of the product in that year. For that reason I do not think we should even consider the
second alternative.'

A-8

SECTION A

CAPITAL BUDGETING - QUESTIONS

The cost of capital of Khan Ltd is 20% per annum. The directors do not expect capital or any other
resource to be in short supply during the next three years.
You are required to:
(a)
(b)
(c)

calculate the net present values and estimate the internal rates of return of the two methods of
promoting the new product;
(10 marks)
advise the directors of Khan Ltd which, if either, method of promotion they should adopt, explaining
the reasons for your advice and noting any additional information you think would be helpful in
making the decision;
(8 marks)
comment on the views expressed by Mr Court.
(7 marks)

Ignore taxation.
QUESTION 10
FG Ltd has two machines used on a contract for a large customer, LC Ltd. Each machine can produce the
same product and has a capacity of 40,000 units per year, but each has different characteristics resulting
in the following total annual costs at different production levels which must be in lots of 10000 units:
Annual production
level
(units)

Nil
10000
20000
30000
40000

Annual total costs

Machine X
Machine Y
(Rs.000)
(Rs.000)
52*
105
132
148
174

65*
108
122
131
204

A-9

SECTION A

CAPITAL BUDGETING - QUESTIONS

The brush is moulded on a purpose-built machine which was installed in January 1997 at a cost of
Rs.210,000 with an expected useful life of 7 years. This machine was assumed to have zero scrap value
at the end of its life and was depreciated on the same straight line basis that the company used for all
equipment.
Recently an improved machine has become available, at a price of Rs.130,000, which requires two men
to operate it rather than the five men required by the existing machine. It also uses a coarser grade of raw
material costing Rs.70 per tonne (1,000 kg), compared with Rs.75 per tonne for the present material.
Further, it would use only 60% of the power consumed by the existing machine. However, it has an
expected life of only three years and an expected scrap value of Rs.10,000.
The factory manager is considering replacing the existing machine immediately with the new one as the
suppliers have offered him Rs.40,000 for the existing machine, which is substantially more than could be
obtained on the second hand market, provided the new machine is installed by 1 January 2001.
Unfortunately this would leave stocks of the old raw material sufficient to make 40,000 brushes which
could not be used and which would fetch only Rs.25 per tonne on resale.
The brush department is treated as a profit centre. Current production amounts to 200,000 brushes a year
which are sold at a wholesale price of Re.1 each. The production of each brush uses 2 kg of the raw
material, consumes 1 kW hour of electricity costing Rs.0.05, and incurs direct labour costs amounting to
Rs.0.25 per brush. Over-head costs amount to Rs.60,000 per annum and include Rs.10,000 relating to
supervision costs which vary according to the number of employees. The men no longer required to
operate the new machine could be found employment else-where in the factory and would be paid their
current wage although they would be performing less skilled work normally paid at 80% of their current
rate.
Requirements:
(a)
(b)
(c)

Evaluate the proposal to replace the existing machine with the new model, ignoring the time value
of money in your analysis. (10 marks)
Construct brush department profit and loss accounts for each alternative for 2001, 2002 and 2003.
Indicate how the factory manager's decision might be influenced by these figures. (8 marks)
Explain how your analysis would be affected if the new machine had a longer expected life and the
time value of money was to be taken .nto account. (7 marks)
(Total 25 marks)

Note: Ignore taxation.

QUESTION 11
A theatre with some surplus accommodation proposes to extend its catering facilities to provide light
meals to its patrons.

A - 10

SECTION A

CAPITAL BUDGETING - QUESTIONS

The Management Board is prepared to make initial funds available to cover capital costs. It requires that
these be repaid over a period of five years at a rate of interest of 14%.
The capital costs are estimated at Rs.60,000 for equipment that will have a life of five years and no
residual value. Running costs of staff, etc. will be Rs.20,000 in the first year, increasing by Rs.2,000 in
each subsequent year. The Board proposes to charge Rs.5,000 per annum for lighting, heating and other
property expenses, and wants a nominal Rs.2,500 per annum to cover any unforeseen contingencies.
Apart from this, the Board is not looking for any profit, as such, from the extension of these facilities,
because it believes that this will enable more theatre seats to be sold. It is proposed that costs should be
recovered by setting prices for the food at double the direct costs.
It is not expected that the full sales level will be reached until Year 3. The proportions of that level
estimated to be reached in Years I and 2 are 35% and 65% respectively.
You are required to
(a)

calculate the sales that need to be achieved in each of the five years to meet the Board's targets;
(13 marks)
(b)
comment briefly on five aspects of the proposals that you consider merit further investigation.
(7 marks)
Ignore taxation and inflation. (Total 20 marks)
QUESTION 12
Assume that you have been appointed finance director of Breckall Ltd. The company is considering
investing in the production of an electronic security device, with an expected market life of five years.
The previous finance director has undertaken an analysis of the proposed project; the main features of his
analysis are shown below. He has recommended that the project should not be undertaken because the
estimated annual accounting rate of return is only 12.3%
Proposed electronic security device project
Year 0
Year 1
Year 2
Year 3
(Rs.000)
(Rs.000)
(Rs.000)
(Rs.000)
Investment in depreciable
fixed assets
Cumulative investment in
working capital
Sales
Materials
Labour
Overhead
Interest
Depreciation
Taxable profit
Taxation
Profit after tax

Year 4
(Rs.000)

Year 5
(Rs.000)

4,500
300

400
3,500
535
1,070
50
576
900
3,131
369
129
240

500
4,900
750
1,500
100
576
900
3,826
1,074
376
698

600
5,320
900
1,800
100
576
900
4,276
1,044
365
679

700
5,740
1,050
2,100
100
576
900
4,726
1,014
355
659

700
5,320
900
1,800
100
576
900
4,276
1,044
365
679

A - 11

SECTION A

CAPITAL BUDGETING - QUESTIONS

Total initial investment is Rs.4,800,000 Average annual after tax profit is Rs.591,000
All the above cash flow and profit estimates have been prepared in terms of present day costs and prices,
since the previous finance director assumed that the sales price could be increased to compensate for
any increase in costs.
You have available the following additional information:
(a)
(b)
(c)
(d)
(e)
(f)

Selling prices, working capital requirements and overhead expenses are expected to increase by
5% per year.
Material costs and labour costs are expected to increase by 10% per year.
Capital allowances (tax depreciation) are allowable for taxation purposes against profits at 25% per
year on a reducing balance basis.
Taxation on profits is at a rate of 35%, payable one year in arrears.
The fixed assets have no expected salvage value at the end of five years.
The company's real after-tax weighted average cost of capital is estimated to be 8% per year, and
nominal after-tax weighted average cost of capital 15% per year.

Assume that all receipts and payments arise at the end of the year to which they relate, except those in
year 0, which occur immediately.

Required:
(a)
(b)
(c)

Estimate the net present value of the proposed project. State clearly any assumptions that you
make.
(13 marks)
Calculate by how much the discount rate would have to change to result in a net present value of
approximately zero.
(4 marks)
Describe how sensitivity analysis might be used to assist in assessing this project. What are the
weaknesses of sensitivity analysis in capital investment appraisal? Briefly outline alternative
techniques of incorporating risk into capital investment appraisal. (8 marks)
(Total 25 marks)

QUESTION 13
Ceder Ltd has details of two machines that could fulfil the company's future production plans. Only one of
these will be purchased.
The `standard' model costs Rs.50,000 and the `deluxe' Rs.88,000, payable immediately. Both machines
would require the input of Rs.10 000 working capital throughout their working lives, and both have no
expected scrap value at the end of their expected working lives of 4 years for the standard machine and 6
/ears for the deluxe machine. The forecast pre-tax operating net cash flows (Rs.) associated with the two
machines are:
1
Standard
Deluxe

2
20,500
32,030

3
22,860
26,110

Years hence
4
24,210
23,410
25,380
25,940

6
38,560

35,100

A - 12

SECTION A

CAPITAL BUDGETING - QUESTIONS

The deluxe machine has only recently been introduced to the market, and has not been fully tested in
operating conditions. Because of the higher risk involved, the appropriate discount rate for the de luxe
machine is believed to be 14% per year, 2% higher than the discount rate for the standard machine.
The company is proposing to finance the purchase of either machine with a term loan at a fixed interest
rate of 11% per year.
Taxation at 35% is payable on operating cash flows one year in arrears, and capital allowances are
available at 25% per year on a reducing balance basis.
Required:
(a)

For both the standard and the deluxe machines calculate:

(i)
(ii)

payback period;
net present value.

Recommend, with reasons, which of the two machines Ceder Ltd should purchase. (Relevant
calculations must be shown.)
(13 marks)
(b)

Surveys have shown that the accounting rate of return and payback period are widely used by
companies in the capital investment decision process. Suggest reasons for the widespread use of
these investment appraisal techniques. (6 marks)
(Total 25 marks)

QUESTION 14
Sound Equipment Ltd was formed five years ago to manufacture parts for hi-fi equipment. Most of its
customers were individuals wanting to assemble their own systems. Recently, however, the company has
embarked on a policy of expansion and has been approached by JBZ Ltd., a multinational manufacturer
of consumer electronics. JBZ has offered Sound Equipment Ltd a contract to build an amplifier for its
latest consumer product. If accepted; the contract will increase Sound Equipment's turnover by 20%.
JBZ's offer is a fixed price contract over three years, although it is possible for Sound Equipment to apply
for subsequent contracts. The contract will involve Sound Equipment purchasing a specialist machine for
Rs.150,000. Although the machine has a 10-year life, it would be written off over the three years of the
initial contract as it can only be used in the manufacture of the amplifier for JBZ.
The production director of Sound Equipment has already prepared a financial appraisal of the proposal.
This is reproduced below. With a capital cost of Rs. 150,000 and total profits of Rs.60,300, the production
director has calculated the return on capital employed as 40.2%. As this is greater than Sound
Equipment's cost of capital of 18%, the production director is recommending that the board accepts the
contract

A - 13

SECTION A

CAPITAL BUDGETING - QUESTIONS

Turnover
Materials
Labour
Depreciation
Pre-tax profit
Corporation tax at 33%
After-tax profit

Year 1
(Rs.)
180,000
60,000
40,000
50,000
30,000
9,900
20,100

Year 2
(Rs.)
180,000
60,000
40,000
50,000
30,000
9,900
20,100

Year 3
(Rs.)
180,000
60,000
40,000
50,000
30,000
9,900
20,100

Total
540,000
180,000
120,000
150,000
90,000
29,700
60,300

A - 14

SECTION A

CAPITAL BUDGETING - QUESTIONS

You are employed as the assistant accountant to Sound Equipment Ltd and report to John Green, the
financial director, who asks you to carry out a full financial appraisal of the proposed contract. He feels
that the production director's presentation is inappropriate. He provides you with the following additional
information:

Sound Equipment pays corporation tax at the rate of 33%;

the machine will qualify for a 25% writing-down allowance on the reducing balance;
the machine will have no further use other than in manufacturing the amplifier for JBZ;
on ending the contract with JBZ, any out-standing capital allowances can be claimed as a
balancing allowance;
the company's cost of capital is 18%;
the cost of materials and labour is forecast to increase by 5% per annum for years 2 and 3.

John Green reminds you that Sound Equipment operates a just-in-time stock policy and that production
will be delivered immediately to JBZ, who will, under the terms of the contract, immediately pay for the
deliveries. He also reminds you that suppliers are paid immediately on receipt of goods and that
employees are also paid immediately.
Write a report to the financial director. Your report should:
(a)
(b)
(c)

use the net present value technique to identify whether or not the initial three-year contract is
worthwhile;
explain your approach to taxation in your appraisal;
identify one other factor to be considered before making a final decision

Notes:
For the purpose of this task, you may assume the following:

the machine would be purchased at the beginning of the accounting year;

there is a one-year delay in paying corporation tax;
all cashflows other than the purchase of the machine occur at the end of each year;
Sound Equipment has no other assets on which to claim capital allowances.

QUESTION 15
Banden Ltd is a highly geared company that wishes to expand its operations. Six possible capital
investments have been identified, but the company only has access to a total of Rs.620 000. The projects
are not divisible and may not be postponed until a future period. After the projects end it is unlikely that
similar investment opportunities will occur.
Expected net cash inflows (including salvage
Project Year 1
(Rs.)
A
70,000
B
75,000
C
48,000
D
62,000
E
40,000
F
35,000

2
(Rs.)
70,000
87,000
48,000
62,000
50,000
82,000

3
(Rs.)
70,000
64,000
63,000
62,000
60,000
82,000

4
(Rs.)
70,000

5
(Rs.)
70,000

73,000
62,000
70,000

40,000

Outlay
(Rs.)
246,000
180,000
175,000
180,000
180,000
150,000

A - 15

SECTION A

CAPITAL BUDGETING - QUESTIONS

Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the company's
existing capital investments.
Any surplus funds may be invested in the money market to earn a return c`9% per year. The money
market may be assumed to be an efficient market.
Banden's cost of capital is 12% per year.
Required:
a) Calculate:
i)
ii)

The expected net present value;

The expected profitability index associated with each of the six projects, and rank the projects
according to both of these investment appraisal methods.

Explain briefly why these rankings differ.

(8 marks)

(b) Give reasoned advice to Banden Ltd recommending which projects should be selected. (6 marks)
(c) A director of the company has suggested that using the company's normal cost of capital might not be
appropriate in a capital rationing situation. Explain whether you agree with the director.
(4
marks)
(c)

The director has also suggested the use of linear or integer programming to assist with the
selection of projects. Discuss the advantages and disadvantages of these mathematical programming
methods to Banden Ltd. (7 marks)
(Total 25 marks)

QUESTION 16
XYZ Ltd. uses 10 very old injection moulding machines, which are of a ype which are no longer
obtainable. It is proposed that they be replaced by 4 `new model' machines with the same total capacity.
The old machines have a further life of 3 years and will have no salvage value at that time the present
salvage value averages Rs.5000 per machine. Annual operating costs are Rs.10 000 per machine.
Each new machine, which has a life of 7 years, costs Rs.52 000 and is expected to have an end of life
scrap value of Rs.4000. Total annual operating costs are Rs.15 000 per machine.
The 6 operators who would be released following replacement of the old machines would be redeployed
within the firm thereby saving some additional external recruitment.
There is the possibility that the installation of the new machines would entail modifications, costing
Rs.60000, to the factory building.
An appropriate discount rate suitable for the appraisal of all cash flows relevant to this decision is 12%.
Required:
Ignoring the possibility of modifications to the factory building determine whether the old machines should
be replaced now or operated for a further 3 years.

A - 16

SECTION A

CAPITAL BUDGETING - QUESTIONS

Indicate how the costs of modifying the factory building should be included in the analysis. Specify any
assumptions and outline the deficiencies inherent in your analysis. Taxation may be ignored. (12 marks)

QUESTION 17 - QUESTION E 12. GATEWAY LTD

Gateway Ltd, a car hire firm, is considering its future cash flows. The directors of the company are
interested in the period from now, that is the end of January 19-1, to the end of 19-6. In particular, they
wish to decide on the optimal replacement cycle for the fleet of thirty hire cars. On 1 January 19-1, the
company purchased its existing fleet at a cost of Rs 300,000. The vehicles are to be depreciated in the
accounts over a three-year life, on a straight line basis. The resale value of a one-year-old car of the type
used in the fleet is at present Rs 7,000.
Inflation is at the rate of 10% per annum, and it is thought that it will continue at this rate for the
foreseeable future. New car prices will increase in line with inflation, but second hand values are expected
to remain at the present levels for a number of years. The resale value of a two-year-old fleet car is at
present Rs 4,000 and the scrap value of a three-year old car is Rs 500.
The revenue from operating the fleet is expected to be Rs 250,000 in 19-1. This annual revenue is
expected to increase at a rate of 10% per annum irrespective of the age of the vehicles. The operating
and maintenance costs for 19-1 are estimated to be:
Rs 70,000 for cars in the first year of their life
Rs 100,000 for cars in the second year of their life
Rs 160,000 for cars in the third year of their life
The operating and maintenance costs are expected to increase at a rate of 10% per annum in line with
inflation. The cars are not worth keeping for longer than three years.
The company's cost of capital is 15%.
Required:
(a)

You are asked to advise the company on the optimal replacement policy for its fleet of cars or the
period 1 February 19-1 to 31 December 19-6. You can ignore taxation, and can assume that the
cash flows relating to revenue and operating costs arise on the last day of the respective years.
(16 marks)

(b)

Comment in general terms on how taxation influences investment decisions (4 marks).

(Total 20 marks)

QUESTION 18 - QUESTION E13. TALEB INC

Taleb Inc is a manufacturing company trading in Ruritania, a country in which there has been virtually no
inflation for many years, and in which none is expected in the future. The company produces a wide
range of products, one of which, the Bat, requires the use of a special Dot machine. The company's
present policy is to replace each Dot machine at the end of its physical productive life of four years. The
directors are now considering whether to replace the machine at the end of its physical productive life of
four years. The directors are now considering whether to replace the machine more frequently than once
every four years in view of the fact that its productive capacity declines as it gets older and potential sales
of Bats are lost. There is insufficient demand for the company's Bats to justify the purchase of a second
Dot machine.
Taleb Inc charges a selling price of Re 0.12 per Bat, at which price it is able to sell up to 500,000 per
annum. Variable costs, excluding machine depreciation and running costs, amount to Rs 0.04 per Bat.

Details of productive capacities and running costs (including maintenance) of the Dot machine
are as follows:
A - 17

SECTION A

CAPITAL BUDGETING - QUESTIONS

During first year of machine's lift

During second year of machine's life
During third year of machine's life
During fourth year of machine's life

Productive
Running costs
Capacity
(Rs)
(Bats)
500,000
6,000
500,000
6,500
400,000
7,500
400,000
9,000

Annual running costs are independent of the number of Bats manufactured. The directors wish to
continue their present policy of always buying new Dot machines, at a price of Rs 60,000 each. Resale
values of Dot machines are Rs 40,000 for three-year-old machines and zero for four-year-old machines.
The company provides depreciation on all its fixed assets using the straight line method.
All costs and revenues are paid or received in cash at the end of the year to which they relate, with the
exception of the initial price of the Dot machine which is paid immediately on purchase. Taleb Inc has an
annual cost of capital of 10%.
Required:
(a) You are required to prepare calculations for the directors of Taleb Inc showing whether they should
replace the Dot machine every one, two, three or four years. Ignore taxation. (15 marks)
(b) Discuss how investment appraisal procedures in general are affected by the existence of inflation.
Ignore taxation. (10 marks)
(Total 25 marks)
QUESTION 19 14.12* Advanced: Evaluation of projects with unequal lives
A2Z Ltd. supports the concept of terotechnology or life cycle costing for new investment decisions
covering its engineering activities. The financial side of this philosophy is now well established and its
principles extended to all other areas of decision making.
The company is to replace a number of its machines and the Production Manager is torn between the Exe
machine, a more expensive machine with a life of 12 years, and the Wye machine with art estimated life
of 6 years. If the Wye machine is chosen it is likely that it would be replaced at the end of 6 years by
another Wye machine. The pattern of maintenance and running costs differs between the two types of
machine and relevant data are shown below.

Purchase price
Trade-in value
Annual repair costs
Overhaul costs
Estimated financing costs averaged over machine life

Exe
(Rs.)
19,000
3,000
2,000
4,000
(at year 8)
10% p.a.

Wye
(Rs.)
13,000
3,000
2,600
2,000
(at year 8)
10% p.a.

A - 18

SECTION A

CAPITAL BUDGETING - QUESTIONS

You are required to

(a) recommend, with supporting figures, which machine to purchase, stating any assumptions made;
(10 marks)
(b) describe an appropriate method of comparing replacement proposals with unequal lives; (4 marks)
(Total 14 marks)
QUESTION 20 - 14.14* Advanced: Inflation adjustments and sensitivity analysis
(Burley Ltd., a manufacturer of building products, mainly supplies the wholesale trade. It has recently
suffered falling demand due to economic recession, and thus has spare capacity. It now perceives an
opportunity to produce designer ceramic tiles for the home improvement market. It has already paid
Rs.0.5m for development expenditure, market research and a feasibility study.
The initial analysis reveals scope for selling 150 000 boxes per annum over a five-year period at a price of
Rs.20 per box. Estimated operating costs, largely based on experience, are as follows:

Cost per box of tiles at todays prices:

Material cost
Direct labour
Variable overhead
Fixed overhead (allocated)
Distribution, etc.

(Rs.)
8.00
2.00
1.50
1.50
2.00

A - 19

SECTION A

CAPITAL BUDGETING - QUESTIONS

Production can take place in existing facilities although initial re-design and set-up costs would be Rs.2m
after allowing for all relevant tax reliefs. Returns from the project would be taxed at 33%.
Burley's shareholders require a nominal return of 14% per annum after tax, which includes allowance for
generally-expected inflation of 5.5% per annum. It can be assumed that all operating cash flows occur at
year ends.
Required:
Assess the financial desirability of this venture in real terms, finding both the Net Present Value and the
Internal Rate of Return to the nearest 1%) offered by the project.
Note: Assume no tax delay.

(7 marks)

(a) Briefly explain the purpose of sensitivity analysis in relation to project appraisal, indicating the
drawbacks with this procedure. (6 marks)
(b) Determine the values of
(i) price
(ii) volume
at which the project's NPV becomes zero. Discuss your results, suggesting appropriate management
action.
(7 marks)
(Total 20 marks)
QUESTION 21 - QUESTION H1. BUTCHER LTD
Butcher Ltd is considering whether to set up a division in order to manufacture a new product, the Azam.
The following statement has been prepared, showing the projected profitability per unit of the new
product:
Rs
Selling price
Price 22.00
Less: Direct labour (2 hours at Rs 2.50 per hour)
Material (3 kg at Rs 1.50 per kg)
Overheads
Net profit per unit

Selling

Rs
22.00

5.00
4.50
11.50
21.00
1.00

A - 20

SECTION A

CAPITAL BUDGETING - QUESTIONS

A feasibility study, recently undertaken at a cost of Rs 50,000, suggests that a selling price of Rs 22 per
Azam should be set. At this price, it is expected that 10,000 Azams would be sold each year. Demand for
Azams is expected to cease after 5 years. Direct labour and materials costs would be incurred only for the
duration of the product life.

Overheads per unit have been calculated as follows:

Variable overheads
Rent (see note (1) below
Rs 8,000 10,000 units)
Manager's salary (see note (2) below
Rs 7,000 10,000 units)
Depreciation (see note (3) below
Rs 50,000 10,000 units)
Head office costs (see note (4) below
2 hours at Rs 1.25 per hour)

Rs.
2.50
0.80
0.70
5.00
2.50
11.50

A - 21

SECTION A

CAPITAL BUDGETING - QUESTIONS

(1) Azams would be manufactured in a factory rented specially for the purpose. Annual rental would be
Rs 8,000 payable only for as long as the factory was occupied.
(2) A manager would be employed to supervise production of Azams, at a salary of Rs 7,000 per annum.
The manager is at present employed by Butcher Ltd, but is due to retire in the near future on an
annual pension of Rs 2,000, payable by the company. If he continued to be employed, his pension
would not be paid during the period of his employment. His subsequent pension rights would not be
affected.
(3) Manufacture of the Azam would require a specialized machine costing Rs 250,000. The machine
would be capable of producing Azams for an indefinite period, although due to its specialized nature
it would not have any resale or scrap value when the production of Azams ceased. It is the policy of
Butcher Ltd to provide depreciation on all fixed assets using the straight line method. The annual
charge of Rs 50,000 for the new machine is based on a life of 5 years, equal to the period during
which Azams are expected to be produced.
(4) Butcher Ltd allocates its head office fixed costs to all products at the rate of Rs 1.25 per direct labour
hour. Total head office fixed costs would not be affected by the introduction of the Azam to the
company's range of products.
The cost of capital of Butcher Ltd is estimated at 5% per annum in real terms, and you may assume that
all costs and prices given above will remain constant in real terms. All cash flows would arise at the end of
each year, with the exception of the cost of the machine which would be payable immediately. The
directors of Butcher Ltd are very confident about the accuracy of all the estimates given above with the
exception of those relating to product life, annual sales volume and material cost per Azam.
You are required to:

(a) Prepare net present value calculations, based on the estimates provided, to show whether Botcher
Ltd should proceed with manufacture of the Azam. (10 marks)
(b) Prepare a statement showing how sensitive the net present value of manufacturing Azams is to errors
of estimation in each of the three factors, product life, annual sales volume and material cost per
Azam.(6 marks)

(c) Discuss briefly the limitations of your calculations in (a) and (b) above, and indicate any additional
information that would be helpful in arriving at a decision. Ignore taxation. (9 marks)
Ignore taxation.
(Total 25 marks)

QUESTION 22
Ramelton Ltd. is a large entirely equity financed engineering company, whose financial year ends on 31
December.
The company's objective is to maximise share-holder's wealth, and it generates sufficient taxable profits
to relieve all capital allowances at the earliest opportunity.
Currently one of the company's divisional managers has to fulfil a particular contract, and he can do this
in one of two ways.

A - 22

SECTION A

CAPITAL BUDGETING - QUESTIONS

Under the first (Proposal 1), he can purchase plant and machinery; while under the second (Proposal 2),
he
can use a machine already owned by the company. The end-year operating net cash inflows in
nominal (i.e. money) terms and before corporation tax are as follows:
Proposal 1
Proposal 2

40 000
70 000

55 000
70 000

70 000

Proposal 1
Under the first proposal the company will incur an outlay of Rs.62 500 on 31 December 2000 for the
purchase of plant and machinery.
The labour force required under this proposal will have to be recruited locally, and budgeted wages have
been taken into account in preparing the estimates of future nominal net cash inflows given above.
The plant and machinery is expected to be scrapped on 31 December 2003, the nominal cash proceeds
at that date being projected as Rs.5000.
Proposal 2
The second proposal covers a two year period from 31 December 2000. It will require the company to use
a machine which was purchased for Rs.150000 a number of years ago when 100% first year capital
allowances were available and which is therefore fully written down for tax purposes. The company has
no current use for the machine, and its net realisable value at 31 December 2000 is Rs.50 000.
However, if retained unused there would be no incremental costs of keeping it, and it would be sold on 1
January 2002 for an estimated Rs.60 000 in nominal money terms. If used under the second proposal,
the expected residual value of the machine would be zero at the end of the two year period.
The labour force required under the second proposal would be recruited from elsewhere within the
company, and in end-year nominal cash flow terms would be paid Rs.20 000 and Rs.21 600 respectively
for 2001 and 2002. However, the staff that would have to be taken on in other divisions to replace those
switched over to the new project would in corresponding end-year nominal cash flow terms cost Rs.22
000 for 2001 and Rs.23 760 for 2002.
The end-year nominal net cash inflows of Rs.70 000 for both 2001 and 2002 which are associated with
the second proposal are after deducting the remuneration of the work force actually employed on the
scheme.
Working capital requirements
Working capital requirements in nominal money terms at the beginning of each year are estimated at 10%
of the end-year operating net cash inflows referred to in the table above.
The working capital funds will be released when a proposal is completed. There are no tax effects
associated with changes in working capital.
Other information
Expected annual inflation rates over the next four calendar years are:
2001
10%

2002
8%

2003
6%

2004
5%

A - 23

SECTION A

CAPITAL BUDGETING - QUESTIONS

The company's real cost of capital is estimated at 10% per annum and is expected to remain at that rate
for the foreseeable future.
The corporation is expected to be 50% over the planning period, tax being payable twelve months after
the accounting year end to which it relates.
The annual writing down allowance for plant and machinery is 20% reducing balance. A full writing down
allowance is given in the year of acquisition, but none in the year of disposal. Any balancing charges or
allowances are calculated for individual assets (i.e. they are not part of the general pool for tax purposes).
Requirements:
(a)

Calculate the net present value at 31 December 2000 of each of the two mutually exclusive
projects; and (15 marks) (b) indicate briefly any reservations you might have in basing an
investment decision on these figures. (3 marks)
Repetition of a project is not possible. (Total 18 marks)

QUESTION 26
A small loss-making company is considering the use of a new type of forklift truck. It is considering leasing
as an alternative to purchase. The truck can be leased for a four-year period, the lease payments being
Rs 5,000 per annum payable in advance. Maintenance and servicing needs are covered by the leasing
agreement.
The truck could be purchased for Rs 12,000. At the end of four years the company has been guaranteed
a trade-in price of Rs 2,000. The service and maintenance costs under a suppliers maintenance contract
will be Rs 1,000 per annum, payable at the end of each year. The truck would be depreciated both for tax
and internal accounting purposes on the straight line basis over four years.
If the forklift truck is used the company estimates it will save on the services of one employee which will
save the company wage payments of approximately Rs 6,000 per annum.
The company could borrow money from a bank at a nominal interest rate of 12% per annum. The
company's weighted average before tax cost of capital is 20%, and its weighted average after tax cost,
16%. Funds cost the leasing company 8%.
The corporation tax rate is 50%, but the company has not paid any tax for the last two years. It is
anticipated that the company will not pay any tax for the next two years because of continuing trading
losses, but that large profits will be earned during year 2 of the forklift truck's life. The company will then
continue to earn profits for a number of years. Accumulated losses can be carried forward for tax
purposes. The amount of profits in year 2 are expected to be well in excess of the accumulated losses.
You can assume, when appropriate, that tax is paid one year after the date of reporting profits. (14 marks)
Required:
a) Should the company use the forklift truck? (6 marks)
b) Which is the less expensive alternative, to purchase or to lease the forklift truck? (14 marks)
c) Explain the factors that you have taken into account in deciding which discount rate or rates to use in
making the decisions. (8 marks)
(Total 28 marks)
QUESTION 27

A - 24

SECTION A

CAPITAL BUDGETING - QUESTIONS

Drifter Ltd trades in Ruritania and has, for a number of years, rented a photocopying machine from Delroy
Ltd. A representative of Delroy Ltd has recently suggested to the finance director of Drifter Ltd that the
company may prefer to lease or buy the existing photocopying machine in preference to continuing the
rental agreement, and has provided the following cost information.
(1)

Rent. The annual rental charge will be Rs 500 for next year payable in advance, and includes
servicing the machine. In addition, the charge per photocopy made will be 2.15p payable annually
in arrears.

(2)

Lease. Under the terms of the proposed lease, three lease payments of Rs 2,500 would be due,
one at the beginning of each of the next three years. At the end of the third year, Drifter Ltd would
be entitled to purchase the photocopying machine for a nominal amount of Rs 100. The annual
servicing charge would be Rs 600, both during and after the lease period, payable annually in
arrears. The servicing charge would include the cost of the first 50,000 photocopies each year.
The charge for each additional copy would be 0.55p.

(3)

Purchase. The machine could be purchased at the start of next year for Rs 6,500, payable at the
beginning of the year. Annual servicing charges and costs of additional copies would be as for the
leasing alternative.

The finance director of Drifter Ltd expects that all costs except lease payments will increase in the future
at an annual compound rate of 5%. Whichever alternative is selected, the company will continue to insure
the photocopying machine. The premium for next year is expected Co be Rs 150. The finance director
estimates that the remaining useful life of the machine is 5 years at the end of which time it will have no
scrap or resale value. The company presently makes about 80,000 photocopies per annum and this level
is expected to continue over the next five years.
Drifter Ltd obtains corporation tax relief at 52% on its costs one year after the costs arise. A one hunched
per cent first-year tax allowance is available on photocopying machinery. Drifter Ltd has a money cost of
capital, net of corporation tax, of 10% per annum.
You are required to:
(a)

Prepare calculations for the finance director of Drifter Ltd showing whether the photocopying
machine should be rented, leased or purchased (15 marks)

(b)

Prepare a report for the finance director justifying the method of appraisal you have used in
preparing your calculations and describing any reservations you have about your advice. (10 marks)

(Total 25 marks)

QUESTION 23
Daimaru Company Limited, a leading car manufacturing company is considering to build a new type of
luxurious car Costa VX. Costa VX will have a new aero-dynamic design with a new technology which will
decrease fuel consumption by 1/3rd as compared to the existing models in the market. The target launch
date for Costa VX is 1.1.2004. The initial study has shown the following important figures as at 1.1.2002:
i)

Designing research cost Rs.60 million

A - 25

SECTION A
ii)
iii)
iv)
v)
vi)

CAPITAL BUDGETING - QUESTIONS

Technological research cost Rs.120 million

Cost of moulds and shifting of production lines to suit Costa VX Rs.60 million
Manufacturing cost (material, labor and overheads including admin overheads) Rs.300,000 per car
Average selling and distribution cost Rs.20,000 per car
Advertising and publicity cost:
First 2 years starting 2003
Subsequently

local market
- Foreign market
- local market
- Foreign market

Rs.50 million per annum

US$ 1 million per annum
Rs. 20 million per annum
US$ 250,000 per annum

The timings of cash flows of above costs are as follows:

(i) and (ii) equally from 1.1.2002 till 30.6.2003
(iii) during the third quarter of 2003
(iv) and (v) equally during the years of manufacturing of cars
All the above cash flows are evenly distributed throughout the year occurring at the beginning of each
quarter. It is estimated that production time for each car will be one week, although the manufacturing of
the first batch shall start during the last month of 2003, however, it may be assumed that its cash flow will
occur on 1.1.2004. The production and sale of cars is also evenly distributed throughout the year.
To finance the project, the company will arrange six years term loan of US$5 million @ 6% per annum,
payable quarterly at the beginning of each quarter, to be acquired on 1.1.2004. The loan shall be repaid
on 31.12.2009. The current US$/ Rupee exchange rate is Rs.60.
The principal amount of term loan will have to be hedged during the first 3 years after which the export
sale revenue shall provide natural hedging to the loan. The company uses forward contracts to hedge its
foreign currency exposure. The cost of hedging during the first 3 years is estimated to be 10% per annum.
The cost of hedging should be calculated with reference to the average exposures required to be hedged,
which are as follows:
1st year
2nd year
3rd year

US$ 5 million
US$ 4.5 million
US$ 4 million

Based on the initial study it is estimated that the company will be able to sell 6,000 cars per annum. The
life cycle of Costa VX in the local market is expected to be 3 years after which the export market will
compensate for the drop in local market for the next 3 years. After 6 years it will take major changes in the
basic model which will require fresh investment.
The company expects to make profits of Rs.100 million before tax each year during 6 years life of the
product. Assume that the company uses 20% rate of return to discount its similar projects.
Required: Calculate the price of the car to be determined on 1.1.2004 using NPV method.
QUESTION 24 - Q.5 MAY1999 FM ICMA
Following are the details regarding an equipment to be given on lease by A Ltd:
(i)
Cost of equipment to the lessor Rs.100,000 financed 80% through debt and balance through
equity. Cost of debt 18% and equity 15% before tax.
(ii)
The lessor is in 55% tax bracket. The equipment is used for 3 shifts. The rate of depreciation is
normal 15% and 7.5% of each additional shift. Deprecation is charged according to diminishing
balance method.

A - 26

SECTION A
(iii)
(iv)
(v)
(vi)

CAPITAL BUDGETING - QUESTIONS

Salvage value of equipment is Rs.16,000.

Direct cost to lessor Rs.500 in 1st year.
Estimated cost for maintenance and general administration in respect of the equipment to lessor
is Rs.1,500 per annum.
The lessee agrees to pay the following:
(a) Annual Rent Rs.36,000 for 5 years. Payment is to be made at the end of each year.
(b) Security deposit of Rs.3,000 which is refundable at the end of lease term.
(c) A sum of Rs.1,350 as non-returnable management fee payable at the inception of lease.

Required: Suggest whether it is beneficial for the lessor to lease the equipment using IRR technique.

A - 27