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    FMCN6

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    Financial Management – 6th Semester B.

    Com(H) – Prof Radhanath Pyne – Capital Budgeting

    FMCN6(13.4.2020)

    This class is completely a revisionary class. Still there is scope of asking question through mail about any
    lessons given before. Later on we shall be going to complete the assignments.

    Problem 1

    Using the information given below compute the payback period under (a) Traditional pay Back method
    and (b) Discounted Pay back method and comment on the results.

    Initial outlay Rs. 80,000

    Estimated Life 5 years

    Profit after Tax

    End of Year 1 Rs. 6,000

    2 14,000

    3 24,000

    4 16,000

    5 Nil

    Depreciation has been calculated under straight line method. The cost of capital may be taken at 20% p.
    a. and the P.V. of Re.1 at 20% p.a. is given below

    Year 1 2 3 4 5

    P.V. Factor .83 .69 .58 .48 .40

    Solution 1

    (a) Traditional Pay Back

    Year PAT Deprn. Cash Inflows Cumulative Cash Inflows

    1 Rs. 6,000 Rs. 16,000 Rs. 22,000 Rs. 22,000

    2 Rs.14,000 Rs.16,000 Rs.30,000 Rs.52,000

    3 Rs.24,000 Rs.16,000 Rs.40,000 Rs.92,000

    4 Rs.16,000 Rs.16,000 Rs.32,000 Rs.1,24,000

    5 Nil Rs.16,000 Rs.16,000 Rs.1,40,000


    Pay back period = 2 + 28000/40000 yrs. = 2.7 years

    (b) Discounted Pay Back Method

    Year Cash Inflow Disc Factor Disc Cash Flow Cum Disc Cash Inflow

    1 Rs.22,000 .83 Rs.18,260 Rs.18,260

    2 Rs.30,000 .69 Rs.20,700 Rs.38,960

    3 Rs.40,000 .58 Rs.23,200 Rs. 62,160

    4 Rs.32,000 .48 Rs.15,360 Rs.77,520

    5 Rs.16,000 .40 Rs.6,400 Rs.83,920

    Discounted Pay Back period = 4 + 3,920/6,400 = 4.61 years

    TN1 As we have discussed in our class notes that if the discounting factor increases the period of pay
    back period will also increase.

    Problem 2

    The directors of B Ltd are decided to purchase a new machine to replace a machine which has been in
    operation in the factory for the last 5 years.

    Ignoring interest but considering tax at 5% of net earnings suggest which of the two alternatives should
    be preferred. The following are the details

    Old machines New machines

    Cost of Machines Rs.40,000 Rs.60,000

    Life of Machine 10 years 10 years

    Machine running hrs per annum 2000 2000

    Units per hour 24 36

    Wages per running hour 3 5.25

    Power per annum 2,000 4,500

    Consumables Stores per anum 6000 7500

    All other Charges per annum 8,000 9,000

    Material Cost per unit 0.50 0.50


    Selling price per unit 1.25 1.25

    Depreciation will be charged according to straight line

    Solution 2

    Profitability Statement

    Cost of the machine Rs.40,000 Rs.60,000

    Life of the machine 10 years 10 years

    Output (uts) 48,000 72,000

    Sales Rs.60,000 Rs.90,000

    Less: Cost of Sales

    Dir Mat Rs.24,000 Rs.36,000

    Wages Rs.6,000 Rs.10,500

    Power Rs.2,000 Rs.4,500

    Cons stores Rs.6,000 Rs. 7,500

    Other charges Rs.8,000 Rs.9,000

    Depr Rs.4,000 Rs.6,000

    Rs.50,000 Rs.73,500

    Profit before Tax Rs.10,000 Rs.16,500

    Tax at 50% Rs. 5,000 Rs. 8,250

    Profit after Tax Rs. 5,000 Rs. 8,250

    Accounting Rate of Return

    Old Mach New Machine

    Net Earning/Original Investment Net Earning/Original Investment

    5000/40000 x 100 8250/60000 x 100

    = 12.5% = 13.75%

    Net Earnings/Average Investment


    5000/20000 x 100 = 25% 8250/30000 x 100 = 27.5%

    Incremental Earning/Incremental Investment

    3250/(60000-20000) x 100 = 8%

    Assuming that the old asets will be sold at book value i.e. 20,000 .Thus replacement of the old machine
    by the new machine ( ignoring interest) is preferable.

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