Workbook 6

Capital Budgeting/Making Capital Investment Decisions/ Estimation of Project

Cash Flows
1. Ojus Enterprises is determining the cash flow for a project involving replacement of an old machine by a
new machine. The old machine, bought a few years ago, has a book value of Rs 400,000 and it can be sold
to realize a post-tax salvage value of Rs 500, 000. It has a remaining life of 5 years after which its net
salvage value is expected to be Rs 160,000. It is being depreciated annually at a rate of 25 % under the
WDV method. The working capital required for the old machine is Rs 400,000.
The new machine costs Rs 1,600,000. It is expected to fetch a net salvage of Rs 800,000 after 5
years when it will no longer be required. The depreciation rate applicable to it is 25 % under the
written down value method. The net working capital required for the new machine is Rs 500,000. the
new machine is expected to bring a saving of Rs 300,000 annually in manufacturing costs (other
than depreciation). The tax rate applicable to the firm is 40 %.

Given the above information, the incremental after-tax cash flow associated with the replacement
project has been worked out below:

Solution:

1. The Farlow Company is considering the replacement of a riveting machine with a new one that will
increase the earnings before depreciation from Rs 20,000 per year to Rs 51,000 per year. The new machine
will cost Rs 100,000 and has an estimated life of 8 years with no salvage value. The applicable corporate
tax rate is 40%, and the firm’s cost of capital is 12%. The old machine has been fully depreciated and has
no salvage value.
a) Evaluate the replacement decision using a MACRS 5 year class life
b) Evaluate the replacement decision using the pre-MACRS sum of the years digit accelerated
depreciation
c) Comapre the results
Solution:

a) Calculation of Depreciation

Year 1 2 3 4 5 6 7 8
Depreciation rate 20% 32% 19.20% 11.52% 11.52% 5.76 - -
Depreciation (Rs 100,000x rate) 20,000 32,000 19,200 11,520 11,520 5,760 - -

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Note: Calculating depreciation through MACRS , the estimated salvage value need not be deducted from the
original investment outlay.

Calculation of incremental cash flow

Year 1 2 3 4 5 6 7 8
Incremental 31,000 31,000 31,000 31,000 31,000 31,000 31,000 31,000
EBDT
Less: Dep 20,000 32,000 19,200 11,520 11,520 5,760 - -
EBT (1,000)
Less: Tax @ (400)
40%
EAT (600)
Add: Dep 32,000
Cash Flow 26,600 31,400 26,280 23,208 23,208 20,904 18,600 18,600

Calculation of NPV

Year Cash Flow PVIF@ 12% PV

0 (100,000)
1 26,600
2 31,400
3 26,280
4 23,208
5 23,208
6 20,904
7 18,600
8 18,600
Net Present Value = ∑ of all PVs = Rs 21,922

Since NPV is positive, replacement should be done

b) Sum of the years = 1+2+3+4+5+6+7+8=36

Depreciation = (Cost – SV) x (Remaining useful life/sum of the years)

Year Depreciation
1 Rs 100,000 x 8/36 = Rs 22,222
2 Rs 100,000 x 7/36 = Rs 19,444
3 Rs 100,000 x 6/36 = Rs 16,667
4 Rs 100,000 x 5/36 = Rs 13,889
5 Rs 100,000 x 4/36 = Rs 11,111
6 Rs 100,000 x 3/36 = Rs 8,333
7 Rs 100,000 x 2/36 = Rs 5,556
8 Rs 100,000 x 1/36 = Rs 2,778

Find the Cash Flow as in (a)

Find NPV @ 12% disount rate as in (a)
Ans: NPV = Rs 20,476 (accept the replacement)

c) NPV in (a) is higher than in (b). It is because, higher depreciation is charged in the earlier year than in
the sum-of-the-year-digit method. The higher the cash flow in the earlier years, the higher will be the
NPV than the lesser cash flow

2. Natural Breverage is contemplating the replacement of one of its bottling machines with a newer and more
efficient one. The old machine has a book value of Rs 500,000 and a remaining useful life of 5 years. The
firm does not expect to realize any return from scrapping the old machine in five years; but it can sell the

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 machine new to another firm in the industry for Rs 300,000. Pre-MACRS straight line depreciation was
used for the old machine.
The new machine has a purchase price of Rs 1.1 million, an estimated useful life of 5 years, and an
estimated salvage value of Rs 200,000. It is expected to economize on electric power usage, labor and
repair costs and reduce the number of defective bottles. In total, an annual savings of Rs 250,000 will be
realized if the new machine is installed. The company is in the 40% tax bracket, has a 10% cost of capital,
and will use MACRS 5 year class life depreciation on the new machine.
a) What is the initial cash outlay required for the new machine ?
b) Should Natural Breverages purchase the new machine ? Support your answer.

Solution:
a) Calcuation of initial cash outlay for the new machine:
Cost of new machine Rs 1,100,000
Sale of old machine (300,000)
Tax savings on old (500,000-300,000)x0.40 (80,000)
Initial Cash Outlay Rs 720,000

b) Calcuation of Depreciation of Old machine:

Depreciation of old machine = (Rs 500,000 – 0)/5 = Rs 100,000
Calcuation of Depreciation of New machine:

Year 1 2 3 4 5 Total
Dep rate 20% 32% 19.20% 11.52% 11.52% 94.24%
Dep (Rs 1,100,000 x rate) 220,000 352,000 211,200 126,720 126,720 1,036,640

Book Salvage Value = Cost of machine – Total depreciation = Rs 1,100,000 – Rs 1,036,640 = Rs 63,360

Calculation of Incremental Cash Flow:

Year 1 2 3 4 5
a. Savings (EBDT) 250,000 Rs 250,000 Rs 250,000 Rs 250,000 Rs 250,000
Differential depreciation:
Depreciation, New 220,000 352,000 211,200 126,720 126,720
Less: Depreciation, Old 100,000 100,000 100,000 100,000 100,000
b. Differential Dep 120,000 252,000 111,200 26,720 26,720
EBT (a-b)
Less: Tax @ 40%
EAT
Add: Diff Dep
Cash Flow

Calculation of final year cash flow:

Operating Cash flow in year 5 Rs 160,000
Cash SV of new machine 200,000
Tax on profit on sale (Rs 200,000 – 63,360) x x0.40 (54,656)
Cash Flow Rs 306,032

Calcuation of NPV

Year Cash Flow PVIF@10% PV

0 (720,000) 1
1 198,000
2 250,800
3 194,480
4 160,688
5 306,032
Net present value = Rs 113,162
New machine should be purchased.
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3. The Starbuck Compnay is considering the purchase of a new machine tool to replace an obsolete one. The
machine being used for the operation has both a tax book value and a market value to zero, it is in good
working order and will last, physically, for at least 5 years. The proposed machine will perform the
operation so much more efficiently that Starbuck engineers estimate that labor, material, and other direct
costs on the operation will be reduced Rs 6,500 a year if it is installed. The proposed machine costs Rs
30,000 delievered and installed, and its economic life is estimated to be 10 years, with zero salvage value.
The company expects to earn 12% on its investment after taxes. The tax rate is 40% and the firm has been
advised that the new equipment will qualify for a MACRS 7 year class life.
a) Should Starbuck buy the new machine ?
b) Assume that the tax book value of the old machine is Rs 6,000, that the annual depreciation charge is
Rs 400, and that the machine has no market value. How do these assumptions affect your answer?
c) Answer part (b) assuming that the old machine has a market value or Rs 4,000
d) Answer part (c) assuming that the annual savings will be Rs 8,000.

Solution:

Given,
Cost of new machine = Rs 30,000
Annual savings on cost = Rs 6,500
Economic life = 10 years
Cost of capital = 12%
Tax rate = 40%
Depreciation = MACRS 7 years class

Calculation of depreciation:
Year 1 2 3 4 5 6 7 8 9 10
Rate 14.29% 24.49 17.49 12.49 8.93 8.93 8.92 4.46 - -
Depreciation (Rs 30,000 x Rate) 5247 1338 - -

Calcualation of Cash Flows:

Year 1 2 3 4 5 6 7 8 9 10
EBDT 6500 6500 6500 6500 6500 6500 6500 6500 6500 6500
Less: Depreciation 5247 1338 - -
EBT (847)
Less: Tax@ 40% (339)
EAT (508)
Add: Depreciation 7347
Operating Cash Flow 6839 4435 3900

a) Calcuation of NPV
Year Cash Flow PVIF @ 12% PV
0 (30,000) 1 (30,000)
1 5615 0.8929
2 5452
3
4
5 4972 0.5674
6 4972
7 2248
8
9 3900
10 0.3220
NPV = 208
As the NPV is positive, the company should buy the new machine.

b) Given,
Book value of old machine = Rs 6,000

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 Annual Depreciation = Rs 400
Now,
Calculation of net cash outlay:
Cost of New machine Rs 30,000
Sale of old machine 0
Tax adjustment:
Cash Salvage value, old
Less: Book salvage value, old 0
Loss Rs 6,000
Tax savings @ 40% Rs 6000
(2400)
Net cash outlay Rs 27,600

Calculation of Differential Depreciation

Year 1 2 3 4 5 6 7 8 9 10
Depreciation, new 5247 1338 - -
Depreciation, old 400 400 400 400 400 - - - - -
Differential Depreciation 3887 3347 1338 - -

Calculation of Cash Flow

Year 1 2 3 4 5 6 7 8 9 10
Annual saving (EBDIT) 6500 6500 6500 6500 6500 6500 6500 6500 6500 6500
Less: Differential Deprn 3887 3347 1338 - -
EBT 2613 (447)
Less: Tax @ 40% (179)
EAT (268)
Add back: Depreciation 6947
Operating cash flows 5239 4435 3900

Calculation of NPV
Year Cash Flow PVIF @ 12% PV
0 (27,600) 1
1 0.8929
2
3 5839
4
5 0.5674
6 2519
7 4970
8
9 1406
10 0.3220
NPV =2031
The present value increases over the part (a), if the given condition exists.

c) Given,
Market value of old machine = Rs 4,000
Now,
Calculation of net cash outlay:
Cost of New machine Rs 30,000
Sale of old machine (4000)
Tax adjustment:
Cash Salvage value, old
Less: Book salvage value, old 4,000
Loss Rs 6,000
Tax savings @ 40% Rs 2,000
(800)
Net cash outlay Rs 25,200
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 Calculation of NPV

Present value of cash flows from part (b) = Rs 29,631

Less: Net cash outlay = Rs 25,200
NPV = Rs 4431

d) Given (related with b and c)

Annual saving = Rs 8,000
Calculation of Cash Flow
Year 1 2 3 4 5 6 7 8 9 10
Annual saving (EBDIT) 8000 8000 8000 8,000 8,000 8,000 8,000 8,000 8,000 8,000
Less: Differential Deprn 3887 3347 1338 - -
EBT 4113 1053 8000
Less: Tax @ 40%
EAT 1892 3997
Add back: Depreciation 6947
Operating cash flows 6139 5872 4800

Calculation of NPV
Year Cash Flow PVIF @ 12% PV
0 (25,200) 1
1 0.8929
2
3 6739
4 3,901
5 0.5674
6
7 5870
8 2,155
9
10 0.3220
NPV =9,517

4. The Longdon Company has two alternative investment projects, E and F. As a result of a capital rationing
policy, the management is contemplating which project they should accept. The following table provides
the management with all related financial information:
Project E Project F
Cost Rs 15,000 Rs 15,000
Cash flow per year Rs 5,500 3,200
Life 4 years 8 years
Cost of capital 12% 12%
Calculate the NPV and IRR for each project and make your recommendation.

Solution:

Steps:
 Find out NPV of Project E = Rs 1705
 Find out UAE (EAB) = NPV / PVIFA (4,12%)
o UAE for E = Rs 561.48
o UAE for F = Rs 180.46
Based on UAE, (since NPV is positive), Project E should be accepted
 Find out IRR (since cash flow is annuity)
o Find the factor = Initial Cost / Cash flow per year = 2.7273
o See PVIFA table, factor lies between the factors of 17% and 18%
o Find out the right IRR by interpolation (Ans: 17.31% for Project E)
 Repeat same procedure for Project F (NPV = Rs 896, IRR = 13.70%)
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  Project E should be accepted.

5. The Grant Corporation is considering a project which has a five-year life and costs Rs 25,000. It would
save Rs 4,100 per year in operating costs and increase reveue by Rs 5,000 per year. It would be financed
with a five-year loan with the following payment schedule (annual rate of interest is 8%). No salvage value
for the new purchased equipment is assumed at the end of the project.
Payment Interest Payment of Principal Balance
626.14 2000 426.14 2073.86
626.14 165.91 460.23 1613.63
626.14 129.09 497.05 1116.58
626.14 89.33 536.81 579.77
626.14 46.37 579.77 0
630.70 2500
If the company has a 12% after tax cost of capital and a 40% tax rate, what is the NPV of the project if the
company uses MACRS 3 years class life depreciation?

Solution:
Note: The financing cash flow has no bearing on the solution what-so-ever.
Cash flow before tax = Rs 4,100 + Rs 5,000 = Rs 9,100
Calculation of depreciation:
Year 1 2 3 4 5
Rate 33.33 44.45 14.81 7.41 -
Depreciation (Rs 25,000 x 11,113 1,852 -
rate)

Calculation of Cash flow:

Year 1 2 3 4 5
Cash flow before tax 9,100 9,100 9,100 9,100 9,100
Less: Depreciation 11,113 1,852 -
EBT (2012)
Less: Tax@ 40% (805)
EAT (1207)
Add: Depreciation 11,113
Operating Cash Flow 8793 6201

Calculation of NPV
Year Cash Flow PVIF @ 12% PV
0 (25,000) 1
1 0.8929
2
3 6941
4 3,941
5 0.5674
NPV =2,727
NPV of project is positive, so the project should be accepted.

6. Thoma Pharmaceutical Company may buy DNA testing equipment costing Rs 60,000. This equipment is
expected to reduce clinical staff labor costs by Rs 20,000 annually. The equipment has a useful life of 5
years, but falls in the 3 year property class for cost recovery (depreciation) purpose. No salvage value is
expected at the end. The corporate tax rate for Thoma is 38%, and its required rate of return is 15%. (If
profits before taxes on the project are negative in any year, the firm will receive a tax credit of 38% of the
loss in that year). On the basis of this information, what is the NPV of the project ? Is it acceptable ?

Solution:
Calculation of Depreciation:
Calculation of depreciation:
Year 1 2 3 4 5
Rate 33.33 44.45 14.81 7.41 -
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 Depreciation (Rs 60,000 x 26,670 4,446 -
rate)

Calculation of Cash flow:

Year 1 2 3 4 5
Cash flow before tax 20,000 20,000 20,000 20,000 20,000
Less: Depreciation 26,670 4,446 -
EBT (6670)
Less: Tax@ 38% (2535)
EAT (4135)
Add: Depreciation 26,670 4,446 -
Operating Cash Flow 22,535 14,089

Calculation of NPV
Year Cash Flow PVIF @ 15% PV
0 (60,000) 1
1 19,999 17,391
2 0.7561
3 10,373
4
5 12,400 0.4972
NPV =(975)
As the NPV is negative, the project is not acceptable.

7. In problem 8, suppose 6% inflation in labor cost savings is expected over the last 4 years, so that savings
in the first year are Rs 20,000, savings in the second year are Rs 21,200 and so forth.
a. If the required rate of return is still 15%, what is the NPV of the project? Is it acceptable?
b. If the working capital requirement of Rs 10,000 were required in addition to the cost of the
equipment and this additional investment were needed over the life of the project, what would be
the effect on NPV? (all other things are the same in part a)
Solution:
Given, Inflation, i = 6%
Calculation of cash flow with a consideration of inflation

Year 1 2 3 4 5
Cash flow before tax (in real terms) 20,000 21,200 22,472 23,820 25,250
Less: Depreciation 26,670
EBT (5470)
Less: Tax@ 38% (2079)
EAT (3391)
Add: Depreciation
Nominal Cash Flow 23,279
Real Cash Flow = Nominal Cash Flow / (1+i)n 20,718 13,036 11,698

Calculation of NPV on the basis of Nominal and Real cash flow

Year PVIF @ 15% Nominal Cash Flow PV Real Cash Flow PV

0 1 (60,000) (60,000)
1 0.8696 18867
2 15666
3 17,309 14,533
4 9411
5 0.4972 7784 5816
NPV (nominal) = 3,586 NPV (real)= (5,103)

In nominal basis, though the project is acceptable, its not acceptable on the real basis

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b) Additional working capital requirement = Rs 10,000
Now,
Recalculating the initial investment
Cost of the equipment = Rs 60,000
Add: additional working capital = Rs 10,000
Total initial investment = Rs 70,000

Recalculating terminal cash flow

Operating cash flow of 5th year = Rs 15,655
Add: Working capital release = Rs 10,000
Nominal Cash Flow = Rs 25,655

Year PVIF @ 15% Nominal Cash Flow PV Real Cash Flow PV

0 1 (70,000) (70,000)
1 0.8696 19,999 18867
2 15,666
3 17,309
4 9411 13,036
5 0.4972 12,756 9,532
NPV (nominal) = (1,461) NPV (real)= (11,387)

Project is not acceptable on both basis of cash flows.

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