Exercises on Capital Budgeting Evaluation Criteria Exercise 01 a.

In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects: Year 0 1 2 3 4 Expected net cash flows Project S Project L ($100,000) ($100,000) 60,000 33,500 60,000 33,500 -33,500 33,500

The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have a 10 percent cost of capital. (1) What is each project's initial NPV without replication? (2) Now apply the replacement chain approach to determine the projects extended NPVs. Which project should be chosen? (3) Now assume that the cost to replicate project s in 2 years will increase to $105,000 because of inflationary pressures. How should the analysis be handled now, and which project should be chosen? b. You are also considering another project which has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the projects estimated cash flows: End-of-Year Net Salva ge Valu e ($5,000) 3,100 2,000 0

Initial investment and operating Year cash flows 0 ($5,000) 1 2,100 2 2,000 3 1,750

Using the 10 percent cost of capital, what is the projects NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of year 2? At the end of year 1? What is the projects optimal (economic) life?

Exercise 02 Shrieves Casting Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be set up in unused space in Shrieves main plant. The machinerys invoice price would be approximately $200,000; another $10,000 in shipping charges would be required; and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a special tax ruling which places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $25,000 after 4 years of use. The new line would generate incremental sales of 1,250 units per year for four years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firms net operating working capital would have to increase by an amount equal to 12% of sales revenues. The firms tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent. c. d. Set up, without numbers, a time line for the projects cash flows. (1) Construct incremental operating cash flow statements for the projects 4 years of operations. (2) Does your cash flow statement include any financial flows such as interest expense or dividends? Why or why not? (1) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this cost be included in the analysis? Explain. (2) Now assume that the plant space could be leased out to another firm at $25,000 a year. Should this be included in the analysis? If so, how? (3) Finally, assume that the new product line is expected to decrease sales of the firms other lines by $50,000 per year. Should this be considered in the analysis? If so, how? Disregard the assumptions in part c. What is Shrieves net investment outlay on this project? What is its net non-operating cash flow at the time the project is terminated? Based on these cash flows, what are the projects NPV, IRR, MIRR, and payback? Do these indicators suggest that the project should be undertaken? Assume that inflation is expected to average 5 percent over the next 4 years. Does it appear that Shrieves cash flow estimates are real or nominal? That is, are all the cash flows stated in the Time 0 dollars or have the cash flows been increased to account for expected inflation? Further, would it appear that the 10 percent cost of capital is a nominal or real interest rate? Does it appear that the current NPV is biased because of inflation effects? If so, in what direction, and how could any bias be removed? What does the term risk mean in the context of capital budgeting, to what extent can risk be quantified, and when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates?

e.

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h.

Exercise 03 Naveen Enterprises is considering a capital project about which the following information is available: The investment outlay on the project will be Rs. 100 crores. This consists of Rs.80 crores on plant and machinery and Rs. 20 crores on net working capital. The entire outlay will be incurred at the beginning of the project. The project will be financed with Rs. 45 crores of equity capital, Rs. 5 crores of preference capital, and Rs. 50 crores of debt capital. Preference capital will carry a dividend rate of 15%; debt capital will carry an interest rate of 15 percent. The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will fetch a net salvage value of Rs. 30 crores, whereas net working capital will be liquidated at the book value. The project is expected to increase the revenues of the firm by Rs.120 crores per year. The increase in costs on account of the project is expected to be Rs. 80 crores per year (this includes all items of costs other than depreciation, interest and tax). The effective tax rate will be 30 percent. Plant and machinery will be depreciated at the rate of 25 percent per year as per the written down value method. Estimate the post-tax cash flows of the project.

Exercise 04 Madhyabharat Pharma Ltd is engaged in the manufacture of pharmaceuticals. The company was established in 1991 and has registered a steady growth rate in sales since then. Presently the company manufactures 16 products and has an annual turnover of Rs. 2200 million. The company is considering the manufacture of a new anti-biotic preparation, K-cin, for which the following information has been gathered. 1. K-cin is expected to have a product life cycle of 5 years and thereafter it would be withdrawn from the market. The sales from this preparation are expected to be as follows:
Sales (Rs. in million) Year 1 100 Year 2 150 Year 3 200 Year 4 150 Year 5 100

2. The capital equipment required for manufacturing K-cin costs Rs. 100 million and it will be depreciated at the rate of 25 percent per year as per the WDV method for tax purposes. The expected net salvage value after five years is Rs. 20 million. 3. The net working capital requirement for the project is expected to be 20 percent of sales. Working capital level is adjusted at the beginning of the year in relation to the expected sales for the year. At the end of 5 years, working capital is expected to be liquidated at par, barring an estimated loss of Rs. 5 million on account of bad debt. The bad debt loss will be taxdeductible. 4. The accountant of the firm has provided the following estimates for the cost of Glamoin: Raw material cost : 30% of sales Variable manufacturing cost : 15% of sales Variable labor cost : 5% of sales Fixed annual operating and maintaining cost : Rs 5 million Variable selling expenses : 10% of sales Overhead allocation (excluding depreciation, maintenance and interest) : 10 % of sales While the project is charged an overhead allocation, it is not likely to have any effect on overhead expenses as such. 5. The manufacture of K-cin would also require some of the common facilities of the firm. The use of these facilities would call for reduction in the production cost of other pharmaceutical preparations of the firm. This would entail a reduction of Rs.15 million of contribution margin. 6. The tax rate applicable for the firm is 35 percent Based on the above information, estimate the incremental cash flows associated with the investment proposal.