7/31/2019 Capital Budgeting Case

1/2

Rahat A. KhanC-257, Hans-Marg,

Malviya-Nagar, Jaipur# 9829464488

CAPITAL BUDGETING

Solution of Practice Question No. 3:

Synergy Plastics Ltd. is considering a proposal of producing high qualityplastic glasses. The necessary equipment to manufacture the glasses wouldcost Rs. 1 lac and would last 5 years. The tax relevant rate of depreciation is25 per cent on WDV. There is no other asset in this block. The expectedsalvage value is Rs. 10,000. The glasses can be sold at Rs. 4 each.Regardless of the level of production, the manufacturer will incur cash cost ofRs. 25,000 each year if the project is undertaken. The overhead costsallocated to this new line would be Rs. 5,000. The variable costs areestimated at Rs. 2 per glass. The manufacturer estimates it will sell about75,000 glasses per year; the tax rate is 35 per cent. Should the proposedequipment be purchased? Assume 20 per cent is the cost of capital andadditional working capital requirement is Rs. 50,000. In the terminating year,no depreciation is to be charged, due to the asset been sold in the year.

Solution:

Initial Cash Outlay:

Cost of Equipment = Rs. 1,00,000Add:W.C. Required = Rs. 50,000Initial Cash Outlay (O) = Rs. 1,50,000

Annual PBDT:

Sales (75,000 4): Rs. 3,00,000Less:Variable Cost (75,000 2): Rs. 1,50,000Contribution (C): Rs. 1,50,000Less:Fixed Cost: Rs. 25,000

Profit Before Dep. & Tax (PBDT): Rs. 1,25,000

Annual Deprec iation @ 25% W.D.V.:

Year 1 2 3 4 5Opening Value 1,00,000 75,000 56,250 42,187 31,640Depreciation 25,000 18,750 14,063 10,547 ----Closing Value 75,000 56,250 42,187 31,640 31,640

Annual Cash Inflows:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5PBDT 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000Less:Dep. 25,000 18,750 14,063 10,547 -----

PBT 1,00,000 1,06,250 1,10,937 1,14,453 1,25,000Less:Tax 35,000 37,187 38,828 40,058 43,750PAT 65,000 69,063 72,109 74,394 81,250Add:Dep. 25,000 18,750 14,063 10,547 -----Cash Inflow 90,000 87,813 86,172 84,941 81,250

7/31/2019 Capital Budgeting Case

2/2

Rahat A. KhanC-257, Hans-Marg,

Malviya-Nagar, Jaipur# 9829464488

Terminal Cash Inflow:Salvage Value: Rs. 10,000Add:Release of W.C. Rs. 50,000

Rs. 60,000Add:Tax Saving on Capital Loss: Rs. 7,574*Terminal Inflow: Rs. 67,574

*Calculation of Tax Saving on Capital Loss on Sale of Equipment in theTerminating Year:As per Income Tax provisions for Block of Assets containing single asset it isassumed that the asset is sold at the start of the terminating year.

WDV of the equipment at the start of terminating year: Rs. 31,640Less:Salvage Value of the Equipment: Rs. 10,000Loss on Sale of Equipment in the Terminating Year: Rs. 21,640

Tax Saving on Loss on Sale (Rs. 21,640 35%): Rs. 7,574

Cash FlowsPV Factor

@ 20%Present Value of

Cash Inflows

Initial Cash Outlay (O) (1,50,000) 1.000 (1,50,000)

Annual Cash Inflows:1. 90,000 0.833 74,9702. 87,813 0.694 60,9423. 86,172 0.579 49,8944. 84,941 0.482 40,9415. 81,250 0.402 32,663

Terminal Cash Inflow:5. 67,574 0.402 27,165

Net Present Value (NPV) = 1,36,575