Capital Budgeting Practice Set

Q.1

A company is considering an investment proposal to install new milling control at a cost of

Rs.50,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%.
Assume the firm uses straight line deprecation and the same is allowed for tax purpose. The
estimated cash flows before depreciation and tax (CFBT) from the investment proposal are as
follows:
Years
Cash flows before depreciation and tax (CFBT)
1
10,000
2
10,692
3
12,769
4
13,462
5
20,385
Compute the following:
1. Payback period
2. Average rate of Return
3. Internal rate of return
4. Net Present Value
5. Profitability index at 10% rate of return

Q.2

Consider the following two projects and answer the following questions.
Cash flows
NPV at
Projects C0
C1
C2
C3
10%
C
-10,000
+2,000
+4,000 +12,000 +4,134
D
-10,000
+10,000 +3,000 +3,000
+3,821
1) Why is there a conflict of rankings of these two projects?

IRR
26.5%
37.6%

2) Why should you recommend Project C in spite of a lower rate of return?

Q.3

CASE STUDY
Palco limited is a leading manufacturer of automotive components. It supplies to the original
equipments as well as the replacement market. Its projects typically have a shorter life as it
introduces new models periodically.
You have recently joined Palco Limited as a financial analyst reporting to Mr.John, the CEO of the
company. He has provided you the following information about three projects A, B, C, that are
being considered by the Executive Committee of Palco ltd:

Project A is an extension of an existing line. Its cash flow will decrease over time.

Project B involves a new product. Building its market will take some time and
hence its cash flow will increase over time.

Project C is concerned with sponsoring a pavilion at the Trade Fair. It will entail a
cost initially which will be followed by a huge benefit for one year. However, in
the year following that a substantial cost will be incurred to raze the pavilior

The expected cash flows of the three projects are as follows:

Year

Project A

Project B

Project C

(15,000)

(15,000)

(15,000)

11,000

3,500

42,000

7,000

8,000

(4,000)

4,800

13,000

----

Mr. John believes that all the three projects have risk characteristics similar to the average risk
of the firm and hence the firms cost of capital, viz. 12%, will apply to them.
You are asked to evaluate the projects.

a) What is payback period and discounted payback period? Find the payback period
and the discounted payback periods of project A and project B.
b) What is the NPV (net present value)? What are the properties of the NPV?
Calculate the NPVs of projects A, B and C.
c) What is Profitability Index of above three projects? Also interpret its value.

(PVF at 12% discount rate for 1-5 years are 0.893, 0.797, 0.712, 0.613, 0.636, 0.567)