Question

Johnson and Company provides you the following information

Purchase price of each Machine                                  300,000

Useful life of each machine                                        5 years

Salvage value                                                              100,000

Method of Depreciation                                             Straight line

Tax rate                                                                       50%

Cost of Debts                                                              10%

Earnings before depreciation & Tax

Machine	Year 1	Year 2	Year 3	Year 4	Year 5
X	200,000	10% increase	10% increase	10% increase	10% increase
Y	0	100,000	200,000	300,000	1200,000

Required which of the machine should be purchase on the following basis

1. Payback period
2. Net Present value
3. IRR
4. Which projects should be accepted?
5. What is the concept of capital budgeting?
6. What is the purpose of capital budgeting?

Answer 1

Machine X	Year 0	Year1	Year2	Year3	Year4	Year5	Formula
Earnings before depreciation and tax	(300,000)	200,000	220,000	242,000	266,200	292,820
Depreciation (Cost - Salvage value)/No of years		(40,000)	(40,000)	(40,000)	(40,000)	(40,000)	(300,000-100000/5 years)
Net income		160,000	180,000	202,000	226,200	252,820
tax @ 50%		(80,000)	(90,000)	(101,000)	(113,100)	(126,410)
Profit after tax		80,000	90,000	101,000	113,100	126,410
Add depreciation (Non cash)		120,000	130,000	141,000	153,100	166,410
Net annual cash inflows		160,000	170,000	181,000	193,100	206,410
salvage value (No tax as salvage = cost after depreciation)						100,000
Total cash flows		160,000	170,000	181,000	193,100	306,410
PV factor @ 10% (1/1+r)^n	1	0.909090909	0.826446281	0.751314801	0.683013455	0.620921323
Discounted cash flows	(300,000)	145,455	140,496	135,988	131,890	190,257
NPV - Sum of all years Cash flows	444,085
Machine Y	Year 0	Year1	Year2	Year3	Year4	Year5
Earnings before depreciation and tax	(300,000)	-	100,000	200,000	300,000	1,200,000
Depreciation (Cost - Salvage value)/No of years		(40,000)	(40,000)	(40,000)	(40,000)	(40,000)	(300,000-100000/5 years)
Net income		(40,000)	60,000	160,000	260,000	1,160,000
tax @ 50%		20,000	(30,000)	(80,000)	(130,000)	(580,000)
Profit after tax		(20,000)	30,000	80,000	130,000	580,000
Add depreciation (Non cash)		20,000	70,000	120,000	170,000	620,000
Net annual cash inflows		60,000	110,000	160,000	210,000	660,000
salvage value (No tax as salvage = cost after depreciation)						100,000
Total cash flows		60,000	110,000	160,000	210,000	760,000
PV factor @ 10% (1/1+r)^n	1	0.909090909	0.826446281	0.751314801	0.683013455	0.620921323
Discounted cash flows	(300,000)	54,545	90,909	120,210	143,433	471,900
NPV - Sum of all years Cash flows	580,998

NPV of project Y is greater than X and should be taken up.

2. Capital budgeting is a process which is used to determine if the proposed project can be accepted or declined. This process is to create an financial understanding of each proposal and evaluate the same.

3. Same as above. Purpose to is identify if a given project can be accepted or not, if the NPV is positive, then the project can be accepted. Project which has the greater NPV is more profitable. There are various tools to identify the profitability and one such tool is NPV, which is present value of cash inflows - Ouflows which is the net profit discounted to present terms.