Capital Budgeting:
1. Bajaj Ltd. is considering two mutually exclusive projects X and Y. The
following details are made available to you.
Rs. lakhs
Particulars
Project X
Project Y
Project Cost
700
700
------
200
100
400
350
600
---------
-------Total
1,300
1,650
--------
--------Assume no residual values at the end of the fifth year. The firms cost of capital is
10%. Required in respect of each of the two projects: (i) NPV, using 10% discounting
(ii) IRR Method .
PV of Re 1
Year
10%
25%
26%
27%
28%
36%
37%
38%
40%
0.260
0.186
Year
Present Value
X
Y
200
400
.909
181.80
363.60
100
500
.826
82.60
413.00
400
100
.751
300.40
75.10
350
200
.683
239.05
136.60
600
100
.621
372.60
62.10
Total PV
Less: Initial
investment
NPV
700.00
---------476.45
700.00
--------350.40
350.40
-------------------- * 30
350.40 +52.40
10 + 26.10 = 36.10%.
Machine A
(Rs)
150,000
1,48,000
89,000
1,09,000
56,000
Machine B
(Rs)
1,20,000
1,36,000
1,25,000
78,000
95,000
Cost of Machine
Rs 1,86,000
1,50,000
Rs 14,000
12,000
5 Years
Rs 6,000
Tax rate
5 Years
Rs 4,000
40%
40%
Calculate the average rate of return of machines and give your comment.
Ans:
Statement showing Profit after Depreciation and Tax of Mach. A
Year
Profit before
Dep. and tax
Depreciation
Profit before
tax
Tax @ 40%
Profit after
Tax
1,50,000
36,000
1,14,000
45,600
68,400
1,48,000
36,000
1,12,000
44,800
67,200
89,000
36,000
53,000
21,200
31,800
1,09,000
36,000
73,000
29,200
43,800
56,000
36,000
20,000
8,000
12,000
------------2,23,200
------------
Rs 44,640*100
-------------------------------------------------------------------Rs 1,10,000
40.58%
Rs 44,640
Profit before
Dep. and tax
Depreciation
Profit before
tax
Tax @ 40%
Profit after
Tax
1,20,000
29,200
90,800
36,320
54,480
1,36,000
29,200
1,06,800
42,720
64,080
1,25,000
29,200
95,800
38,320
57,480
78,000
29,200
48,800
19,520
29,280
95,000
29,200
65,800
26,320
39,480
------------2,44,800
------------
Rs 48,960*100
-------------------------------------------------------------------Rs 89,000
55.01%
5 years
=
Rs 48,960
3. A Company has to make a choice between two projects namely A and B. The
initial capital outlay of two projects is Rs 1,35,000 and Rs 2,40,000 respectively for A
and B. There will be no scrap value at the end of the life of both the projects. The
opportunity cost of capital of the company is 16%. The annual incomes are as under:
Year
16%
Project A
Project B
--
60,000
0.862
30,000
84,000
0.743
1,32,000
96,000
0.641
84,000
1,02,000
0.552
84,000
90,000
0.476
Discounting factor @
Ans:
Statement showing Cumulative Present Value
Year
1
Annual Income
A
B
--60,000
Discount
Rate @ 16%
.862
30,000
84,000
.743
22,290
62,412
22,290
1,14,132
1,32,000
96,000
.641
84,612
61,536
1,06,902
1,75668
84,000
1,02,000
.552
46,368
56,304
1,53,270
2,31,972
84,000
90,000
.476
39,984
42,840
1,93,254
2,74,812
A
---
PV
B
51,720
Cumulative PV
A
B
-51,720
Rs 2,40,000
(iii) Net Present Value:
NPV = PV of net cash inflows Initial investment
Project A = Rs 1,93,254 Rs 1,35,000 = Rs 58,254
Project B = Rs 2,74,812 Rs 2,40,000 = Rs 34,812.
4. A Company is considering to purchase a machine. Two machines A and B are
available, each costing Rs 5 lakhs. In comparing the profitability of the machines, a
discounting rate of 10% is to be used and machine is to be written off in five years by
Straight line method of depreciation with nil residual value.
Cash inflows after tax are expected as follows:
Rs ( lakhs)
Year
1
Machine A
1.5
Machine B
0.5
2.0
1.5
2.5
2.0
1.5
3.0
1.0
2.0
Indicate which machine would be profitable using the following methods of ranking
investment proposals: (i) Pay-back Method (ii) NPV Method (iii) PI Method (iv)
Average Rate of Return Method. The discounting factors at 10% are
Year
0.909
.826
.751
.683
5
Discounting
Factor
.621
[ CS Final June 1998]
Ans:
(i) Pay-back period:
Statement showing Cumulative Cash Inflows
Year
1
Cash Inflows
Mach. A Mach. B
1.50
0.50
2.00
1.50
3.50
2.00
2.50
2.00
6.00
4.00
1.50
3.00
7.50
7.00
1.00
2.00
8.50
9.00
Pay-back period
Machine A = 2 year + (1.50/2.50) = 2.6 years
Machine B = 3 year + (1.00/3.00) = 3.33 years.
(ii) NPV Method:
Year
PV @ 10% p.a
Present Value
Machine A Machine B
1.50
0.50
.909
1.36
0.45
2.00
1.50
.826
1.65
1.24
2.50
2.00
.751
1.88
1.50
1.50
3.00
.683
1.02
2.05
1.00
2.00
.621
0.62
1.24
.507
---------6.53
6
Total PV
Less: Initial
investment
NPV
5.00
---------1.53
6,084
--------6.48
5.00
--------1.48
Rs. 6.53
Machine A = ----------------- = 1.306
Rs. 5.00
Rs 6.48
Machine B = ----------------- = 1.296
Rs. 5.00
(iv) ARR Method:
Statement Showing Earning After Tax and Depreciation
Machine A
Total Cash inflows
Less: Total depreciation
--------Earning after tax and depreciation
Life of Machine
years
Average annual earnings
Average annual earnings
ARR = ---------------------------------- * 100
Initial investment
0.70 *100
Machine A = ---------------- = 14%
5
o.80 * 100
Machine B = -------------- = 16%
5
Machine B
8.50
5.00
---------
9.00
5.00
3.50
----------
4.00
--------
5 years
0.70
0.80
Rankings:
Method
Machine
---------------------A
B
I
II
Remarks
Shorter Pay-back
of Machine A.
II
Machine A gives
higher NPV.
(iii) PI Method
II
II
700
------
100
200
300
Year 4
450
Year 5
600
100
100
---------------Total
1,300
1,650
--------
--------Assume no residual values at the end of the fifth year. The firms cost of capital is
10%. Required in respect of each of the two projects: (i) NPV, using 10% discounting
(ii) IRR Method (iii) PI Method.
PV of Re 1
Year
1
10%
25%
26%
27%
28%
36%
37%
38%
40%
3
4
Ans:
Year
Present Value
X
Y
100
500
.909
90.90
200
400
.826
165.20
330.40
300
200
.751
225.30
150.20
450
100
.683
307.35
68.30
600
100
.621
372.60
62.10
---------
---------
454.50
Total PV
Less: Initial
investment
NPV
IRR of Project X
Statement showing NPV at 10% and 28%
Cash Inflows
Discounting rate
10%
28%
Year
1161.35
1065.50
700
---------461.35
700
--------365.50
Present Value
10%
28%
100
.909
.781
90.90
78.10
200
.826
.610
165.20
122.00
300
.751
225.30
143.10
450
.683
.373
307.35
167.85
600
.621
.291
372.60
174.60
.477
Total PV
Less: Initial
investment
NPV
700.00
---------461.35
700.00
--------(-) 14.35
461.35
-------------------- * 18
461.35 + 14.35
10 + 17.46 = 27.46%.
Year
1
IRR of Project Y
Statement showing NPV at 27% and 38%
Cash Inflows
Discounting rate
27%
38%
Present Value
27%
38%
100
78.70
.787
.725
362.50
200
.620
300
.488
450
.384
600
.303
Total PV
Less: Initial
investment
NPV
.525
124.00
210.00
146.40
76.20
.276
172.80
27.60
.200
181.80
20.70
--------703.70
--------697.00
700
---------3.70
700
--------(-) 3.00
.381
3.70
-------------------- * 11
3.70 + 3.00
27 + 6.07 = 33.07%.
Cost Of Capital
Problem 1: A Company has issued 10% Debenture of Rs 5,00,000. Corporate tax rate is
40%. Calculate the cost of debt if issued (i) at par (ii) at a premium of 10% (iii) at a
discount of 5%, assume the debt is irredeemable.
Ans: (i) Issued at par
Kd = [R(1-T)]
= 10(1-.40)
= 6%
(ii) Issued at a premium of 10%
Kd = [I / IP (1-T)]
= [50,000 /5,50,000 (1-.40)]
= 5.45%
(ii) Issued at 10% discount
Kd = [I/IP (1-T)]
= [50,000/4,75,000 (1-.40)]
= 6.32%
Problem 2: A Company issued 8% Debenture redeemable at the end of 6 years at at Rs
95. The face value of Debenture is Rs 100. Corporate tax rate is 50%. Find out cost of
debt.
Ans:
[ I + (RP IP)/N ] (1-T)
Kd = -----------------------------------[ RP + IP] / 2
[ 8 + (100-95) / 6] (1-.50)
=
------------------------------------
(100+95)/2
= 4.53%
Problem 3: A Company has issued 12% Debenture of Rs 100 each redeemable at the end
of 10 years. Tax rate is 40%. Floatation cost is 2%. Find out the cost of debt if issued (i)
at par (ii) at a premium of 10% (iii) at a discount of 5%.
Ans:
(i) If Debenture are issued at par
[ I + (RP IP)/N ] (1-T)
Kd = ---------------------------------------[ RP + IP] / 2
= 6.732/ 103.90
= 6.48%
Note: IP = (2,20,000 -4,400) = 2,15,600
Equity capital
25
24.44
Preference capital
10
27.29
Debentures
50
7.99
Retained earnings
15
18.33
Ans:
Statement showing average cost of capital (before tax)
Types of capital
Proportion
Before tax cost of capital Average cost of
in new
capital
capital
structure
1. Equity share
25%
24.44
611.00
capital (Ke)
2. Preference share
capital( Kp)
10%
27.29
272.90
3. Debenture (Kd)
50%
7.99
399.50
4. Retained
earnings (Kr)
15%
18.33
275.00
------------1558.40
WACC
Average cost of capital after tax
WACC (before tax) * (1-tax rate)
= 1558.40 (1-.55) = 7.02%
Problem 5:. A Companys capital structure is given below:
Sources of finance
(%)
Equity share capital
Amount
Proportion(%)
10,00,000
50%
12
Retained earnings
3,00,000
10
11
2,00,000
20
10
4,00,000
20
12
Ans:
Statement showing Weighted Average Cost of Capital
Sources
Amount
Cost after tax
(%)
1. Equity share capital (Ke)
10,00,000
12
3,00,000
11
33,000
2,00,000
10
20,000
4,00,000
12
48,000
------------2,23,000
LEVERAGE
1. The data relating to two companies are given below:
Company A
Company B
Equity capital
Rs 6,00,000
Rs 3,50,000
12% Debentures
Rs 4,00,000
Rs 6,50,000
60,000
15,000
Rs 30
Rs 250
Rs 7,00,000
Rs 10
14,00,000
Rs 75
You are required to calculate the operating leverage, financial leverage and
combined leverage of two companies.
Company B
Company B
Financial Leverage
Rs 10 lakhs
Contribution / Sales
0.40
Tax rate
40%
[ICWA Inter, Dec, 2002]
Ans:
PBIT
F.L = (PBIT) / (PBIT interest)
2 = PBIT / (PBIT Rs 10,00,000)
Or PBIT = Rs 20,00,000
Contribution
OL = Contribution / PBIT
4 = Contribution / 20,00,000
Or Contribution = Rs 80,00,000
Sales
Contribution / Sales = 0.40
80,00,000 / Sales = 0.40
Sales = Rs 200,00,000
Fixed Cost
Total Contribution Fixed Cost = PBIT
Or 80,00,000 Fixed Cost = Rs 20,00,000
Or Fixed Cost = Rs 60,00,000
Income Statement of the Firm
Sales
Less: Variable Cost (60% of sales)
Rs
200,00,000
120,00,000
-------------Contribution
Less: Fixed Cost
80,00,000
60,00,000
---------------PBIT
20,00,000
Less: Interest
PBT
Less: Tax @ 40%
--------------Profit after Tax (PAT)
10,00,000
--------------10,00,000
4,00,000
6,00,000
--------------
3. The following details of A Ltd for the year ended 31.3.06 are furnished.
Operating Leverage
3:1
Financial Leverage
2:1
Interest charges per annum
Rs 20 lakh
Corporate tax rate
50%
Variable cost as percentage of sales
60%
Prepare the Income Statement of the company.
[ ICWA Inter, Dec 1995]
Ans:
PBIT
F.L = (PBIT) / (PBIT interest)
300
180
120
80
( 40 * 50%)
-----------PBT
Less: Tax @ 50%
-----------Profit after Tax (PAT)
20
20
10
10
------------4. The following financial data have been furnished by A Ltd and B Ltd. For
the year ended 31.3.05.
A Ltd
B Ltd
Operating Leverage
3:1
4:1
Financial Leverage
2:1
3:1
Interest charges p.a.
Rs 12 lakhs
Rs 10 lakhs
Corporate tax rate
40%
40%
Variable cost
60%
50%
Prepare Income Statements of the companies. Also comment on the financial
position and structure of the two companies.
Ans:
A Ltd:
Financial Leverage = PBIT / PBIT-Interest
2
Or PBIT = Rs 24 lakhs
Operating Leverage = Contribution / PBIT
3
= Contribution / 24 lakhs
Contribution = Rs 72 lakhs
Now, Total contribution Fixed Cost = EBIT
72 lakhs Fixed cost = Rs 24 lakhs
Fixed cost = Rs 48 lakhs
Variable cost as % of sales = 60%
PVR = 100% - 60% = 40%
PVR = Contribution / Sales
.40 = 72 / Sales
Sales = Rs 180 lakhs
B Ltd
Financial Leverage = PBIT / PBIT-Interest
3
Or PBIT = Rs 15 lakhs
Operating Leverage = Contribution / PBIT
4
= Contribution / 15 lakhs
Contribution = Rs 60 lakhs
Now, Total contribution Fixed Cost = EBIT
= Rs 45 lakhs
180
108
--------------72
48
---------------24
12
-----------12.00
4.80
-----------7.20
Rs in lakhs
B
120
60
-----------------60
45
--------------15
10
-----------5.00
2.00
----------3.00
Wages will be paid on the last day of the week of the work.
Cash in hand is expected to be Rs 20,000.
Assume that production is carried on evenly throughout the year and overhead
accrue similarly and a time period of 4 weeks is equivalent to a month.
[ Kalyani University (H) 1997]
Ans:
Particulars
32,000
24,000
16,000
---------------72,000
8,000
Total Cost
Profit
---------------80,000
Sales
1
2
5
---------8
1
7
1
2
Debtors
Creditors
1,60,000
1,28,000
24,000
48,000
1,20,000
24,000
16,000
32,000
80,000
- To Debtors
5
32,000
8
2
6
(D) Profit:
- To Debtors
40,000
5
96,000
1,04,000
1,44,000
4,00,000
= Rs 5,60,000
= Rs 20,000
-----------------5,80,000
-----------------
Working Note:
Raw Material Storage Period = Estimated stock of Raw Material
-----------------------------------------Weekly requirement of Raw Material
=
Rs 96,000
-------------------------------------------Rs 32,000
= 3 weeks
16,000
-------------------------------------------8,000
= 2 weeks
1,84,000
30,000
25,000
16,667
4,167
75,834
24,166
1,00,000
Profit
Sales ( 1,20,000 * 10 /12)
1
2
3
6
Debtors
Creditors
67,500
30,000
25,000
50,000
56,250
(D) Profit:
- To Debtors
( 24,166*3*3/4)
12,500
1/2
5
1/2
16,667
33,334
1
2
3
37,501
16,667
6
1
5
-------54,374
3
30,000
Working Capital
Add: Cash in hand
1,01,667
( Rs 4,31,459 * 10/90)
1,43,334
2,15,625
= Rs 4,31,459
= Rs 47,940
-----------------4,79,399
-----------------
59,167
Assume that production is carried on evenly throughout the year and wages and
overhead accrue similarly. A time period of 4 weeks is equivalent to a month.
[ CU (H) 1987]
Ans:
Particulars
32,000
24,000
12,000
4,000
72,000
8,000
80,000
Profit
Sales ( 32,000 * 10 /4)
1
2
5
8
1
2
5
Debtors
Creditors
1,20,000
1,28,000
24,000
48,000
90,000
12,000
24,000
45,000
24,000
( 12,000 * 5 * )
Less: Lag in payment
8
2
6
--------
(D) Profit:
- To Debtors
( 8,000*5*3/4)
30,000
5
96,000
Working Capital
Add: Cash in hand
1,00,000
1,36,000
= Rs 4,65,000
= Rs 25,000
-----------------4,90,000
-----------------
( Rs 4,31,459 * 10/90)
Working Note:
Raw Material Storage Period = Estimated stock of Raw Material
-----------------------------------------Weekly requirement of Raw Material
=
Rs 96,000
-------------------------------------------Rs 32,000
= 3 weeks
16,000
-------------------------------------------8,000
= 2 weeks
2,85,000
1,52,000