Question

1. Capital Budgeting Decisions and Decision Rules

You must evaluate a proposal to buy a new milling machine. The base price is Rs. 1,08,000, and shipping and installation cost would add another Rs. 12,500. The machine is depreciated under straight line basis. The life of the machine is 4 years. It will be sold after 4 years for Rs. 65,000. The machine would require a Rs. 55,000 increase in working capital. There would be net effect on pre-tax revenues and it will increase by Rs. 44,000 per year (excluding depreciation). The tax rate is 35% and the WACC is 12%. Also, the firm has spent Rs. 5,000 last year investigating the feasibility of using the machine.

a) How would the Rs. 5,000 spent last year be handled?

(b) What is the net cost of the machine for capital budgeting purpose, that is Year 0 project cash flow. Assuming that the machine will be purchased at year 0 and the proposal will start immediately?

c) What are the project's annual cash flows during the year 1,2, 3 and 4?

d) Use the various capital budgeting techniques for the above proposal. Use atleast three techniques and the reason which technique should be used.

e) Should the machine be purchased? Explain your answer with reason as to why the machine should be purchased and why not. If not, suggest measures to make it viable.

Answer 1

a) The firm has spent Rs. 5,000 last year investigating the feasibility of using the machine. How would the Rs. 5,000 spent last year be handled?

The amount of Rs. 5000 spent last year is a sunk cost and is irrelevant for the capital budgeting decisions. It should not be considered.

b) What is net cost of machine in the Year 0 (capital outflow) for the project.

Particulars	Amount in Rs.
Purchase cost (Base price)	1,08,000
Shipping & installation cost	12,500
Net cost of machine (for Year 0)	1,20,500

c) Project's annual cash flow during Year 1, Year 2, Year3 & Year 4

Particulars	Rs.
Pre-tax revenue increase	44,000
Less: Depreciation*	13,875
Profit Before tax	30,125
Less: Tax @35%	10,543.75
Profit After Tax	19,581
Add: Depreciation	13,875
Yearly cash flow	33,456
Particulars	Year 1	Year 2	Year 3	Year 4
Cash flow from Operation	33,456	33,456	33,456	33,456
Sale of Equipment				65,000
Working capital recoup				55,000
Total Cash flow from project	33,456	33,456	33,456	153,456

* Depreciation = (Cost of Asset - Recovery value)/Life of asset

Depreciation = ((120500-65000)/4

d) Use the various capital budgeting techniques for the above proposal.

Technique 1: Pay back period

To find out the payback period, we need to find out the cumulative cash flow from the project. Below table shows the cumulative cash flow for the project.

Year	Cash flow	Cumulative cashflow
Year 0	(1,75,500)	(1,75,500)
Year 1	33,456	(1,42,044)
Year 2	33,456	(1,08,588)
Year 3	33,456	(75,131)
Year 4	1,53,456	78,325

The cash flow becomes positive after year 3. The pay back period is after 3 years.

Payback = 3 years +(75,131/1,53,456)

Payback = 3 +0.5 = 3.5 years

Payback = 3 years and 6 months

Technique 2 : Internal Rate of Return.

Internal Rate of Retun (IRR) is calculated using excel function (alternatively trail and error method can also be applied).

Below table shows the IRR calculation.

Year	Cash flow
Year 0	(175,500)
Year 1	33,456
Year 2	33,456
Year 3	33,456
Year 4	153,456
IRR	12.5%

Technique 3 : Net Present Value.

Net Present Value (NPV) is calculated by discounting the cash flows of the project using WACC as the discounting factor.

The below table shows the NPV for the project.

	A	B	C=AxB
Year	DF @ 12%	Cash flow	PV
Year 0	1.0000	(175,500)	(175,500)
Year 1	0.8929	33,456	29,872
Year 2	0.7972	33,456	26,671
Year 3	0.7118	33,456	23,813
Year 4	0.6355	153,456	97,524
		NPV	2,380

Generally, NPV is the preferred Capital Budgeting techniques. Other capital budgeting techinques like Pay back period, IRR, etc have various short comings like -

Payback doesnot consider time value of money while taking the decision and

IRR assumes that the cash flows can be reinvested elsewhere at the internal rate of return, which may not be the case always.

d) Given the positive NPV from the project and the IRR from the machine is slightly higher than the WACC, the machine should be purchased.