LOVELY PROFESSIONAL UNIVERSITY Form/LPUO/AP-3

MODEL HOMEWORK NO 1

School:LHSB Name of the faculty member : Suruchi Course No: MGT 564 Class: MBA(Hons) Max. Marks Twenty Term: 2B

Department: Management

Course Title: Corporate Finance-II Section: Q1002 Batch: 2010

Date of Allotment:18/3/2011

Date of Submission: 26/3/2011 Date of Test: 30/3/2011

Topic: Numerical Problems on the Capital Budgeting decision. Each student is required to submit the HW containing solution of each problem. Evaluation Details: Six problems have been given to all the students. Evaluation will be made as follows: 5 Marks for submission 15 marks of test based on assignment. Part-A: Techniques of Capital Budgeting Q.1: A company is considering for expanding its production. It can either go for an automatic machine costing Rs. 2,24,000 with an estimated life of 5.5 years or an ordinary machine costing Rs. 60,000 having an estimated life of 8 years. The annual sales and costs are estimated as follows: Automatic Machine Sales Costs: Materials Labour Variable Overheads 50,000 12,000 24,000 50,000 60,000 20,000 Rs. 1,50,000 Ordinary Machine Rs. 1,50,000

Compute the comparative profitability of the proposals under the payback period and return on investment methods. Explain the difference in the results obtained under two methods.

Q.2: A company is considering which of two mutually exclusive projects it should undertake. The Finance Director thinks that the project with higher NPV should be chosen whereas Managing Director thinks that the one with higher IRR should be undertaken especially as both projects have same initial outlay and length of life. The company anticipates a cost of capital of 10% and net after tax cash flows of the projects are as follows: Year (Cash Flows Rs.) Project X Project Y Required: a) Compute the NPV and IRR of each project. b) State, with reasons, which project you would recommend? Q.3: ABC Ltd. is considering to invest in a project with a capital outlay of Rs. 2,00,000. The forecasted annual income after depreciation but before tax is as follows: Year 1 2 3 4 5 Rs. 1,00,000 1,00,000 80,000 80,000 40,000 (2,00,000) 35,000 80,000 10,000 90,000 10,000 75,000 4,000 20,000 3,000 0 1 2 3 4 5

(2,00,000) 2,18,000

Depreciation may be taken as 20% on original cost of asset and taxation at 50% on net income. You are required to evaluate the project according to each of the following methods: a) Payback method. b) Rate of return on original investment method. c) Rate of return on average investment method. d) Discounted cash flows method taking cost of capital at 10%. e) Net present value & Profitability Index method

f)

Internal rate of return method

Part-B: Risk Analysis in Capital & Capital Rationing Q.4: Go ahead Combines Ltd. is considering two mutually exclusive projects A and B. Project A costs Rs.60,000 and Project B Rs. 72,000. You have been given below the net present value & probability distribution for each project: Project A NPV Estimate Rs. 6,000 12,000 24,000 30,000 Required: a) Ascertain the expected net present value of the Projects A and B. b) Compute the risk attached to each project i.e. Standard deviation of each probability distribution. c) According to you, which project is more risky & why? d) Compute the profitability index of each project and give recommendation. Q.5: Royal Industries is considering five projects for the year 1 and 2. The company is financed by equity entirely and its cost of capital is 12%. The expected cash flows of the project are as below: 0.1 0.4 0.4 0.1 Probability Project B NPV Estimate Rs. 6,000 12,000 24,000 30,000 0.2 0.3 0.3 0.2 Probability

Project 1 A B C D (70) (40) (50) ---

Year and cash flows (Rs. 000) 2 35 (30) (60) (90) 3 35 45 70 55 4 20 55 80 65

(60)

20

40

50

Note: Figures in brackets represent cash outflows. All project are divisible, i.e. size of investment can be reduced, if necessary in relation to availability of funds. None of the project can be delayed or undertaken more than once. Calculate which project Royal Industries should undertake if the capital available for investment is limited to Rs.1,10,000 in year 1 and with no limitation in subsequent years. (Present value factors for Year 1is 1.00, Year 2 is 0.89, Year 3 is 0.80 and Year 4 is 0.71.

Q.6: A firm has an investment proposal requiring an outlay of Rs.40,000. The investment proposal is expected to have 2 years economic life with no salvage value. In year I, there is a 0.4 probability that cash flow after tax will be Rs. 25,000 and 0.6 probability that cash flow after tax will be Rs. 30,000. The probabilities assigned to inflows after tax for year II are as follows: The Cash inflow for year I The Cash inflow for year II Probability Rs. 12,000 Rs. 16,000 Rs. 22,000 0.2 0.3 0.5 Rs. 20,000 Rs. 25,000 Rs. 30,000 Probability 0.4 0.5 0.1 Rs. 25,000 Rs. 30,000

The firm uses a 10% discount rate for this type of investment. (PVF: Yr I is 0.909 & Yr II is 0.826) Required: a) Construct a decision tree for the proposed investment project. b) What net present value will the project yield if worst outcome is realized? What is the probability of occurrence of this NPV? c) What will be the beat and the probability of that occurrence? d) Will be project be accepted?