8/8/2019 FM MITSoB Capital_Budgeting Exercises)

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Exercises on Capital Budgeting

1 MIT-SOB Batch 27 : Course Financial Management

1.

The following two machines are mutually exclusive and the firm would be required to

replace the same whatever machine it buys. Machine A would be replaced every 4 years,machine B every 3 years. The cash flows associated with each machine are tabulated as

follows; all numbers are in Rupee (0,000); the relevant discount rate is 10% for both

machines.

Year M/c A M/c B

0 (80) (100)

1 50 60

2 50 60

3 50 60

4 25 -

(a)Which of the two machines is the better investment project?

(b)Reassess the better investible machine, analyzing the question under the assumptionthat, whatever machine the company buys has to be reinvested in perpetuity.

(c)Suppose machine A fits current technology, whereas machine B needs a one-time re-tooling for the company. These one-off installation costs would be Rs. 100,000 today.

What is the optimal investment decision now?

(d)Suppose the firm has an old machine in place that would serve for another two years.

They can postpone investing in either machine A or B and keep using this machine.

When should they stop using the old machine? Cash flows for the old machine are:

Year Cash Flow

1 50

2 20

3 0

(e)Suppose the investment opportunity described above lasts only for 24 years.Recalculate your decision rule for questions (b) and (c). What is the NPV of the

optimal investment policy now?

8/8/2019 FM MITSoB Capital_Budgeting Exercises)

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Exercises on Capital Budgeting

2 MIT-SOB Batch 27 : Course Financial Management

2.(a) A corporation is considering purchasing a machine that has an expected eight-yearlife and will generate for the firm Rs. 110,000 per year in net operating income before

taxes. The machine will be depreciated using the straight-line method to its anticipatedsalvage value of Rs. 120,000. The firm has a 34% marginal tax rate and the required

return for this project is 12% p.a. If the machine costs Rs. 600,000, should it be

purchased?

(b)Another machinery salesman comes by the company's office and says that he iswilling to negotiate the purchase price of the machine described in the previous

question. What is the maximum price the firm is willing to pay for the machine?

[Hint: the price of the machine determines the level of depreciation and therefore

the taxes that the firm pays].

3.A company is trying to determine an optimal replacement policy for a piece of itsequipment. The cost of the machine is Rs. 150,000 and the annual maintenance costs

are Rs. 10,000 in the first year, Rs. 20,000 in the second year and Rs. 3,000 in the third

year. Anticipated salvage values are Rs. 60,000, Rs. 30,000 and Rs. 0 at the end of years

1 through 3, respectively. Assume that the company's revenues are unaffected by the

replacement policy and that the firm has a 34% tax rate; required return on this project

is 12% and uses a straight-line depreciation. Should the equipment be replaced every

year, every second year, or every third year? Be sure to explicitly consider the

depreciation and tax effects.

4.Better Cement Ltd. is considering an investment opportunity that requires an initialoutlay equal to Rs. 5,750,000. In years 1 and 2 the net cash flows are expected to equalRs. 5,000,000. The required rate of return is 25% p.a.

(a)Given that the BCL's criterion whether to invest or not is the project's internalrate of return (IRR), should the companys managers invest in this project? Is

IRR criterion the correct decision rule in this case? If not, which criterion should

have been used?

(b)After observing the managers' decision, a shrewd businessman offers themanagers of BCL. the following modified project. The businessman offers that

the company will pay the initial outlay Rs. 5,750,000 only in year 2 and receivethe Rs. 5,000,000 in years 0 and 1. As a compensation for receiving this offer, the

businessman proposes that the company pay him Rs. 11,000,000 in year 3. BCL's

CFO argues that according to the IRR criterion the proposal is profitable since

the 25% required rate of return is lower than the new IRR for this investment. Is

the CFO correct in his argument that the required rate of return is lower than the

IRR? Does this decision rule lead to optimal investment by the company?

8/8/2019 FM MITSoB Capital_Budgeting Exercises)

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