Investment Decision-Capital Budgeting

Exercises on Determining Project Cash Flows

1. LGB Ltd is a highly profitable firm specializing in manufacturing home appliances. Currently, the
company is analyzing a proposal to set up a plant to manufacture water heaters. The project would
involve a plant costing INR 450 lakh, installation cost of INR 50 lakh and working capital of INR 200
lakh. The annual capacity of the plant is to manufacture 40,000 water heaters. The selling price per
water heaters would be INR 6,000. The variable cost to sales ratio is 70%. The fixed cost per annum
would be INR 200 lakh (excluding depreciation). The company would have to incur promotion
expenditure of INR 40 lakh in the first year. The depreciation rate is assumed to be 25% based on
written down value. Working capital requirement is estimated to be 30% of sales. The company expects
that the plant’s capacity utilization over its economic life of 5 years would be as:

Year 1 2 3 4 5
Capacity Utilization (%) 65 75 80 90 100

The residual value of the plant is net of the accumulated depreciation. Assuming a target rate of return of
12% and corporate tax rate of 40%., provide your recommendation to the company whether to accept or
reject the proposal.

2. HGL Ltd is a highly profitable firm specializing in manufacturing home appliances. Currently, the
company is analyzing a proposal to set up a plant to manufacture washing machines. The project would
involve a plant costing INR 1100 lakh, installation cost of INR 100 lakh and working capital of INR
400 lakh. The annual capacity of the plant is to manufacture 30,000 washing machines. The selling
price per washing machines would be INR 15,000. The variable cost to sales ratio is 65%. The fixed
cost per annum would be INR 300 lakh (excluding depreciation). The company would have to incur
promotion expenditure of INR 70 lakh in the first year. The depreciation rate is assumed to be 25%
based on written down value. Working capital requirement is estimated to be 25% of sales. The
company expects that the plant’s capacity utilization over its economic life of 5 years would be as:

Year 1 2 3 4 5
Capacity Utilization (%) 50 60 70 80 100

The residual value of the plant is net of the accumulated depreciation. Assuming a target rate of return of
12% and corporate tax rate of 40%., provide your recommendation to the company whether to accept or
reject the proposal.

3. Sunrise Engineering Company is considering replacement of its existing fabrication machine by a new
machine, which is expected to cost Rs 160000. The existing machine has a book value of Rs 40000 and
can be sold for Rs 20000 now. It is utilizable for the next five years and if sold after five years, the
salvage value of the existing machine can be expected to be Rs 10000. The new machine will have a
life of five years. The estimated salvage value of the new machine is Rs 40000. It is expected to save
costs and improve the quality of the product that would help to increase the sales. The savings in annual
costs will be Rs. 20000 and revenue from operations will increase by Rs. 30000 each year. The
company pays tax at 30% and writes off depreciation at 25% on the written-down value (WDV) of the
asset. The cost of capital for the company is 15%. Should the company replace the existing machine?
Answer 1

            in lakhs
Year 0 1 2 3 4 5
Initial Outlay
Investment          
NWC          
           
Operating Cash flows
Capacity  
Units  
Sales
VC
FC
Promotion
EBDIT
BV of Plant
Dep
EBIT
Tax
PAT  
Add Dep  
PAT + Dep
Working Cap
Change in NWC  
OCFs  
Terminal Cash flow
Salvage Value  
Release NWC  
TCF  
Net Cash Flows
PVIF
PV of CIF  
Total CIF  
NPV  
Answer 2

            in lakhs
Year 0 1 2 3 4 5
Initial Outlay
Investment          
NWC          
           
Operating Cash flows
Capacity  
Units  
Sales
VC
FC
Promotion
EBDIT
BV of Plant
Dep
EBIT
Tax
PAT
Add Dep
PAT+ Dep
Working Cap
Change in NWC  
OCFs  
Terminal Cash flow
Salvage Value          
Release NWC          
TCF          
Net Cash Flows
PVIF
PV of CIF
Total CIF          
NPV          

Answer 3
  Years
  Particulars 0 1 2 3 4 5
I Initial Cash Flows
1 Investment in new Machine
2 Salvage value of the old machine
3 Book Value of the old machine
4 Capital Loss
5 Tax benefit on capital loss
6 Net investment in new machine
II Operating Cash Flows
7 Savings in annual costs
8 Increase in annual revenue
9 Total incremental income
10 Book Value of the new machine
11 Depreciation of new machinery
12 Book Value of the old machine
13 Depreciation of old machinery
14 Incremental depreciation
15 Profit before tax
16 Tax
17 Profit after tax
18 Operating Cash Flows (17+14)
19 Discounted operating cash flows
III Terminal cash flows
20 Salvage value of the new machine
21 Book Value of the new machine
22 Tax on capital gain
23 Net proceed from sale of new M

24 Salvage value of the old machine

28 Net salvage value