Mohammed Sohail Mustafa

Applications of Capital Budgeting

Problem: 1

Dell Corporation wants to purchase a new machine costing $70,000. The installation
cost of the machine is $10,000 & freight charge is $5,000. The estimated life of
the machine is 5 years with a salvage value of $10,000. The estimated cash inflows
from the machine for the next 5 years are as follows:
Year 1 2 3 4 5
Cash Inflows $30,000 $35,000 $40,000 $35,000 $30,000

The company follows straight-line method of depreciation. The cost of capital of

the new machine is 12% & the company is in 40% tax bracket. Determine whether
the company should buy the machine.

Solution:

Initial Investment = Purchase price + Installation Cost + Freight Charges

= $70,000 + $10,000 + $5,000
= $85,000
Annual Depreciation = {Initial Cost Salvage value} / Estimated life
= {$85,000 - $10,000} / 5 years
= $15,000 per annum.

Calculating Net Cash Benefit (NCB):

Year 1 2 3 4 5
Cash Inflows $30,000 $35,000 $40,000 $35,000 $30,000
(-) depreciation $15,000 $15,000 $15,000 $15,000 $15,000
$15,000 $20,000 $25,000 $20,000 $15,000
(-) Tax @40% $6,000 $8,000 $10,000 $8,000 $6,000
$9,000 $12,000 $15,000 $12,000 $9,000
(+)depreciation $15,000 $15,000 $15,000 $15,000 $15,000
$24,000 $27,000 $30,000 $27,000 $24,000
Salvage value --- --- --- --- $10,000
NCB $24,000 $27,000 $30,000 $27,000 $34,000

Net Present Value (NPV) = [$24,000/(1.12) + $27,000/(1.12)2 + $30,000/(1.12)3 +

$27,000/(1.12)4 + $34,000/(1.12)5 ] - $85,000
= $100,757.57 - $85,000.00
NPV = $15,757.57

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Mohammed Sohail Mustafa

Decision: Since the NPV of the new machine is positive, so the company may
purchase the machine.

Problem: 2 (Replacement Decision)

A leath machine was purchased 10 years ago at a cost of $75,000. The machine has
expected life of 15 years at the time it was purchased and had no salvage value.
The machine being depreciated on a straight-line basis. Therefore, its annual
depreciation charge was $5000 and its present book value is $25,000. The
financial manager is proposing purchasing of a new leath machine costing $120,000
including freight and installation costs. The life of the new machine is only 5 years
with the salvage value of $20,000. The annual saving from the new machine for the
next five years will be as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

$30,000 $35,000 $40,000 $35,000 $30,000

If the new machine is purchased, the old machine can be sold for $10,000. The
company is in 40% tax bracket and the cost of capital is 15%. Purchasing of new
machine would require $10,000 as working capital in the beginning of the year that
could be realized at the end of 5th year. Should the old machine be replaced? Use
NPV method. The new machine will be depreciated on straight-line basis.
Solution:

Calculation of Net cash outlay:

Cost of new machine $120,000

(+) Working capital $10,000
$130,000
(-) Salvage value of old machine $10,000
Tax savings at loss [($25,000- $10,000) X 40%] $6,000
$16,000
Net Cash Outlay $114,000

Calculation of Incremental depreciation:

Depreciation of new machine = ($120,000 - $20,000) / 5 years = $20,000 p.a

Depreciation of old machine = $ 5,000 p.a
__________
Incremental depreciation = $15,000

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Mohammed Sohail Mustafa

Calculation of Net Cash Benefit (NCB):

Year 1 2 3 4 5
Cash Inflows $30,000 $35,000 $40,000 $35,000 $30,000
(-) depreciation$15,000 $15,000 $15,000 $15,000 $15,000
$15,000 $20,000 $25,000 $20,000 $15,000
(-) Tax @40% $6,000 $8,000 $10,000 $8,000 $6,000
$9,000 $12,000 $15,000 $12,000 $9,000
(+)depreciation $15,000 $15,000 $15,000 $15,000 $15,000
$24,000 $27,000 $30,000 $27,000 $24,000
Salvage value --- --- --- --- $10,000
Working Capital --- --- --- --- $10,000
NCB $24,000 $27,000 $30,000 $27,000 $44,000

NPV = [$24,000/(1.15) + $27,000/(1.15)2 + $30,000/(1.15)3 + $27,000 (1.15)4 +

$44,000/(1.15)5] - $114,000.
= $199,091.14 - $114,000
= $85,091.14

Decision: Since the NPV of the new machine is positive, so the company may
replace the new one with the old one.

Problem: 3 (NPV with Inflation)

Phoenix Group of Companies is considering an investment project costing $10 million

that has an expected life of 5 years. The expected cash inflows are as follows:

Year 1 2 3 4 5
Cash Inflows (in million) $2 $4 $4 $3 $2

The company tax rate is 50% & the cost of capital is 12%. The company uses
straight-line method of depreciation. If inflation is expected to be 8% over the
life of the project, what will be the NPV of the project?

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Solution:

Calculation of inflated cash flows:

Year Cash flow X inflation rate Inflated cash flow

1 $20,00,000 X (1.08) $21,60,000
2 $40,00,000 X (1.08)2 $46,65,600
3 $40,00,000 X (1.08)3 $50,38,848
4 $30,00,000 X (1.08)4 $40,81,467
5 $20,00,000 X (1.08)5 $29,38,656

Annual Depreciation = {Cost Salvage value} / Estimated life

= {$10 million - $0} / 5 years
= $2 million p.a

Calculation of inflation adjusted Net Cash Benefit (NCB):

Year 1 2 3 4 5
Inflated cash $21,60,000 $46,65,600 $50,38,848 $40,81,467 $29,38,656
flow
(-)depreciation $20,00,000 $20,00,000 $20,00,000 $20,00,000 $20,00,000
EBT $160,000 $26,65,000 $30,38,818 20,81,467 9,38,656
(-) Tax @50% $80,000 $13,32,500 $15,19,424 $10,40,734 $4,69,328
EAT $80,000 $13,32,500 $15,19,424 $10,40,734 $4,69,328
(+)depreciatio $20,00,000 $20,00,000 $20,00,000 $20,00,000 $20,00,000
n
Inflated NCB $20,80,000 $33,32,500 $35,19,424 $30,40,734 $24,69,328
Inflation to be (1.08) (1.08)2 (1.08)3 (1.08)4 (1.08)5
adjusted
Inflation $19,25,926 $28,57,082 $27,93,860 $22,35,012 $16,80,583
adjusted NCB

NPV = [$19,25,926/(1.12) + $27,93,869/(1.12)2 + $27,93,860/(1.12)3 +

$22,35,012/(1.12)4 + $16,80,583/(1.12)5] - $100,00,000
= $8359977 - $100,00,000
NPV = ($16,40,023)

Decision: Since the NPV is negative; the project should not be accepted.

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Problem: 4

Bangladesh Oxygen Ltd is thinking to purchase one of the following two machines.
Detail information for both the machine are given below:

Machine A Machine B
Purchase price $ 50,000 $ 75,000
Freight, Insurance, Carriage etc $ 10,000 $ 15,000
Import Duty $ 25,000 $ 30,000
Installation Charge $ 15,000 $ 20,000
Working Capital Requirement $ 25,000 ----
Salvage Value $ 20,000 ----
Annual Cash Inflows:
Year 1 $ 40,000 $ 45,000
Year 2 $ 35,000 $ 45,000
Year 3 $ 30,000 $ 45,000
Year 4 $ 25,000 $ 45,000
Year 5 $ 20,000 $ 45,000

The Company charges depreciation on straight-line basis & pay tax @40%. Cost of
capital for the Company is 9%. Determine which machine the Company should
purchase.

Solution:

Machine: A

Initial cash outlay = Purchase price + Freight, Insurance, Carriage + Import duty +
Installation charge + Working capital requirement
= $50,000 + $10,000 + $25,000 + $15,000 + $25,000
= $125,000

Annual depreciation = [(initial cash outlay working capital) Salvage value] /

Estimated life
= ($125,000 - $25,000) - $20,000 / 5 years
= $16,000

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Calculation of Net Cash Benefit:

Year 1 2 3 4 5
Cash Inflows $40,000 $35,000 $30,000 $25,000 $20,000
(-) depreciation$16,000 $16,000 $16,000 $16,000 $16,000
$24,000 $19,000 $14,000 $9,000 $4,000
(-) Tax @40% $9,600 $7,800 $5,600 $3,600 $1,600
$15,000 $11,200 $8,400 $5,400 $2,400
(+)depreciation $16,000 $16,000 $16,000 $16,000 $16,000
$31,000 $27,200 $24,400 $21,400 $18,400
Salvage value --- --- --- --- $20,000
Working Capital --- --- --- --- $25,000
NCB $31,000 $27,200 $24,400 $21,400 $63,400

NPV = [$$31,000/(1.09) + 27,200/(1.09)2 + $24,400/(1.09)3 +

$21,400/(1.09)4 + $63,400/(1.09)5] - $125,000
= $126,540 - $125,000
NPV = $1,540

Machine: B

Initial cash outlay = Purchase price + Freight, Insurance, Carriage + Import duty +
Installation charge +
= $75,000 + $15,000 + $30,000 + $20,000
= $140,000

Annual Depreciation = ($140,000 - $0) / 5 years

= $28,000

Year 1-5
Cash Inflows $45,000
(-) depreciation $28,000
$17,000
(-) Tax @40% $6,800
$10,200
(+)depreciation $28,000
NCB $38,200

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NPV = $38,200 (PVIFA .09 x 5 years) - $140,000

= ($38,200 X 3.890) - $140,000
= $148,598 _ $140,000
NPV = $8,598

Decision: Since the NPV of Machine: B is higher than the NPV of Machine: A, so the
company should buy Machine: B.

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