PROBLEM - 01:

An engineering company is considering the purchase of a new machine for its

immediate expansion program. There are 3 possible machines suitable for the
purpose. Their details are as follows:

Machines 1 2 3
Capital cost 300000 300000 300000
Sales (at standard 500000 400000 450000
price)
Net Cost of
Production:
Direct Materials 40000 50000 48000
Direct Labour 50000 30000 36000
Factory Overheads 60000 50000 58000
Administration 20000 10000 15000
Costs
S & D Costs 10000 10000 10000

The economic life of machine 1 is 2 years, while it is 3 years for the other two. The
scrap values are as Rs. 40000, Rs. 25000 and Rs. 30000 respectively.

Sales are expected to be at the rates shown for each year during the full economic
life of the machines. The costs relate to annual expenditure resulting from each
machine.

Tax to be paid is expected at 50% of the net earnings of each year. It may be
assumed that all payables and receivables will be settled promptly, strictly on cash
basis with no outstanding from one accounting year to another. Interest on capital
has to be paid at 8% per annum.

You are requested to show which machine would be the most profitable investment
on the principle of ‘pay back method’
SOLUTION:

Statement showing the net cash flows of 3 machines

Machine 1 2 3
Capital cost 300000 300000 300000
Sales 500000 400000 450000
(i)
Cost of Production 150000 130000 142000
Administrative cost 20000 10000 15000
S & D cost 10000 10000 10000
Total Cost 180000 150000 167000
(ii)
Profit before depreciation and 320000 250000 283000
interest (i)-(ii) =(iii)
Depreciation (cost less scrap 130000 91667 90000
value/economic life)
Interest on borrowings 24000 24000 24000
Depreciation and interest 154000 115667 114000
(iv)
Profit before Tax (iii)-(iv) 166000 134333 169000
Tax at 50% 83000 67167 84500
Profit after Tax 83000 67167 84500
Add: Depreciation 130000 91667 90000
Net Cash Flow 213000 158833 174500
Payback Period 1.41 years 1.89 years 1.72 years

Machine 1 is the most profitable.

NOTES:

1. It has been presumed that interest on borrowings will have to be paid

throughout the economic life of an asset.
2. Factory overheads do not include depreciation.
3. No borrowings will be required for working capital.
PROBLEM – 2:

Raja Limited wants to replace its existing plant. It has received 3 mutually
exclusive proposals I, II and III. The plants under the three proposals are expected
to cost Rs. 250000 each and have an estimated life of 5 years, 4 years and 3 years
respectively. The company’s required rate of return is 10%. The anticipated net
cash inflows after taxes for the three plants are as follows:

Years Plant I Plant II Plant III

1 80000 110000 130000
2 80000 90000 110000
3 60000 85000 20000
4 60000 35000 -
5 180000 - -

Which of the above proposals would you recommend to the management for
acceptance? You may use NPV technique for evaluation.

Years PVF (10%)

1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
 SOLUTION:

Computation of NPV

Year PVF Plant I Plant II Plant III

(10%)
Inflow PV Inflow PV Inflow PV
1 0.909 80000 72720 110000 99990 130000 118170
2 0.826 60000 49560 90000 74340 110000 90860
3 0.751 60000 45060 85000 63835 20000 15020
4 0.683 60000 40980 35000 23905 NIL NIL
5 0.621 180000 111780 NIL NIL NIL NIL
Gross PV 320100 262070 224050
Cash Outflow 250000 250000 250000
Net Present Value 70100 12070 25950

Plant I gives the highest net present value of Rs. 70100. Hence, it should be
recommended to the management for acceptance.

PROBLEM – 03:

The Alpha Co. Limited is considering the purchase of a new machine. 2 alternative
machines (A and B) have been suggested, each having an initial cost Rs. 400000
and requiring Rs. 20000 as additional working capital at the end of 1 st year.
Earnings after tax are expected to be as follows:

Year Machine A Machine B

1 40000 120000
2 120000 160000
3 160000 200000
4 240000 120000
5 160000 80000
 The company has a target of return on capital of 10% and on this basis, you are
required to compare the profitability of the machines and state which alternative
you consider financially preferable.

Note: The following table gives the present value of Re. 1 due in ‘n’ number of
years:

Year Present value at 10%

1 0.91
2 0.83
3 0.75
4 0.68
5 0.63

SOLUTION:

Statement showing the profitability of the two machines

Year Discounting Machine A Machine B

Factor
Inflow PV Inflow PV
1 0.9140000 36400 120000 109200
2 0.83120000 99600 160000 132800
3 0.75160000 120000 200000 150000
4 0.68240000 163200 120000 81600
5 0.62160000 9200 80000 49600
Total present value of cash 518400 523200
inflow
Total present value of cash 418200 418200
outflow
[400000 + (20000 x 0.91)]
Net Present Value 100200 105200

Recommendations: Machine B is preferable to Machine A, though the total cash

inflow of machine A is more than machine B by Rs. 40000. The NPV of machine
B is more than machine A. Moreover, in case of machine B cash inflows in the
earlier years are comparatively higher than those of machine A.

It is to be noted that the present value method (on the basis of discounted cash
inflows) assumes that the available funds would immediately be reinvested at the
chosen rate of interest (10% in the above case). If this assumption is not valid, the
decision should be on the basis of gross cash inflows and not according to
discounted cash inflows. In that case machine A would be more preferable than
machine B.

Another assumption while deciding in favor of machine B is that, in both the cases,
one is equally sure that these cash inflows will arise. In other words, the
probability of cash inflows as given in the question for both the machines is the
same. In case one is not sure about the cash inflows one should have adjusted the
discounted cash inflows of the machines with the probability factor and then only a
proper comparison would be possible.

PROBLEM – 04:

A choice is to be made between 2 competing projects which require an equal

investment of Rs. 50000 and are expected to generate net cash flows as under:

Project I Project II
End of year 1 25000 10000
End of year 2 15000 12000
End of year 3 10000 18000
End of year 4 NIL 25000
End of year 5 12000 8000
End of year 6 6000 4000

The cost of capital of the company is 10%. The following are the present value
factors at 10% per annum:
 Year Present value factor (10%)
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
6 0.564

Which project proposal should be chosen and why? Evaluate the project proposals
under:

A. Payback period
B. Discounted cash flow method, pointing out their relative merits and demerits

SOLUTION:

A. Payback period method

Project I Project II
Cash inflows Cumulative Cash inflows Cumulative
cash inflows cash inflows
End of year 1 25000 25000 10000 10000
End of year 2 15000 40000 12000 22000
End of year 3 10000 50000 18000 40000
End of year 4 NIL 50000 25000 65000
End of year 5 12000 62000 8000 73000
End of year 6 6000 68000 4000 77000

Project I has the payback period of 3 years while Project II has a payback period of
3.4 years (i.e. Rs. 40000 in 3 years and Rs. 10000 in the 4th year).

B. Discounted cash flow method

PROJECT – 1:
 Year Discount Factor Inflow Present Value
(10%)
1 0.909 25000 22725
2 0.826 15000 12390
3 0.751 10000 7510
4 0.683 NIL NIL
5 0.621 12000 7452
6 0.564 6000 3364
Total PV of future cash inflows 53461
Initial Investment 50000
Net Present Value 3461
PROJECT – 2:

Year Discount Factor Inflow Present Value

(10%)
1 0.909 10000 9090
2 0.826 12000 9912
3 0.751 18000 13518
4 0.683 25000 17075
5 0.621 8000 4968
6 0.564 4000 2256
Total PV of future cash inflows 56819
Initial Investment 50000
Net Present Value 6819

Both projects need the same investment of Rs. 50000. However, in case of project
I, there is a surplus of Rs.3461, while in case of project II, there is a surplus of Rs.
6819. Hence, project II is to be preferred.

Relative merits and demerits of the two methods:

Payback period method is relatively simple to understand and easy to work out as
compared to the discounted cash flow method. However, it does not take into
account the return after the pay-back period. Moreover, it ignores the time value of
money.

Discounted cash flow method does not have these disadvantages. It takes into
account the returns over the effective life of the asset besides considering the future
cash inflows. The method is, therefore, more scientific and dependable.

PROBLEM – 05:

The directors of Alpha Limited are contemplating the purchase of 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 50% of net earnings, suggest which of the
two alternatives should be preferred. The following are the details:

Old Machine New Machine

Purchase price 40000 60000
Estimated life 10 years 10 years
Machine running hours 2000 2000
per annum
Units per hour 24 36
Wages per running hour 3 5.25
Power per annum 2000 4500
Consumable stores per 6000 7500
annum
All other charges per 8000 9000
annum
Material cost per unit 0.50 0.50
Selling price per unit 1.25 1.25

You may assume that the above information regarding sales and cost of sales will
hold well throughout the economic life of each of the machines.
SOLUTION:

Profitability statement

Old machine New machine

Cost of machine 40000 60000
Life of machine 10 10
Output 48000 72000
Sales value 60000 90000
Less: cost of sales
Direct materials 24000 36000
Wages 6000 10500
Power 2000 4500
Consumable stores 6000 7500
Other charges 8000 9000
Depreciation 4000 6000
Profit before tax 10000 16500
Less: Tax @ 10% 5000 8250
Profit after tax 5000 8250

Accounting Rate of Return: Old machine -

1. average net earnings/original investment x 100

= 5000/40000 x 100

= 12.5%

2. average net earnings/average investment x 100

= 5000/20000 x 100

= 25%

Accounting Rate of Return: New machine -

1. average net earnings/original investment x 100

= 8250/60000 x 100
= 13.75%

2. average net earnings/average investment x 100

= 8250/30000 x 100

= 27.50%

Incremental earnings/incremental investment x 100

= 3250/60000-20000* x 100

= 8% (approx)

Thus, replacement of the old machine (ignoring interest) is profitable.

*assuming the old asset will be sold at book value i.e. Rs. 20000.

PROBLEM – 06:

Determine the average rate of return from the data of machines A and B:

Machine A Machine B
Original cost 56125 56125
Additional investment in 5000 6000
net working capital
Estimated life 5 5
Estimated salvage value 3000 3000
Average income tax rate 55% 55%
Annual estimated income
after depreciation and tax
1st year 3375 11375
2nd year 5375 9375
3rd year 7375 7385
4th year 9375 5375
5th year 11375 3375
36875 36875
Depreciation has been charged on straight line basis.
SOLUTION:

ARR = average earnings/average investment x 100

Average income = total income/no of years

Machine A = 36875/5 = Rs. 7375

Machine B = 36875/5 = Rs. 7375

Average investment = original investment – scrap value/2 + additional net

working capital + scrap value

Machine A = 56125-3000/2 + 5000 + 3000 = Rs.34562.50

Machine B = 56125-3000/2 + 6000 + 3000 = Rs.35562.50

ARR for machine A = 7375/34562.50 x 100 = 21.34%

ARR for machine B = 7375/35562.50 x 100 = 20.74%

PROBLEM – 07:

Balrampur Engineering Works manufactures part A which is used in the air-

coolers which it sells. The quantity required is 7000 units per year. The direct cost
of manufacturing this part is Rs. 4 per unit. It has received a proposal from a
Cuttack firm offering to meet the entire needs at Rs. 5 per unit. If the Balrampur
Works discontinues making this part, it can expand its existing facilities for
manufacturing a new product for sale which would involve the following:

Investment on new machines (life of 4000- hours) = Rs. 40000

Material cost = Rs. 3 per unit

Direct labor = Rs. 2 per unit

Indirect expenses (other depreciation) for 8000 hours = Rs. 12000

Estimated volume of sales is 8000 units at Rs. 9 per unit.

State whether the proposal of the Cuttack firm should be accepted or not if:

A. the current cut off rate is 25%

B. the current cut off rate is 30%

SOLUTION:

Sales (8000 x 9) 72000

Less: cost of production
Materials (8000 x 3) 24000
Labor (8000 x 2) 16000
Indirect expenses 12000
Depreciation (8000 x 1) 8000
(60000)
12000
Extra cost for part A (7000)
payable to Cuttack firm
5000
Average investment in the 20000
new project
Expected return @ 25% 5000
cut off rate
Expected return @ 30% 6000
cut off rate

The proposal may be accepted at cut off rate of 25%. However, it is not acceptable
at cut off rate of 30%.

PROBLEM – 08:

M/s. Bharat Industrial Limited purchased a machine 5 years ago. A proposal is

under consideration to replace it by a new machine. The life of the machine is
estimated to be 10 years. The existing machine can be sold at its written down
value. As the cost accountant of the company, you are required to submit your
recommendations based on the following information:
 Existing machine New machine
Initial cost 25000 50000
Machine hours per annum 2000 2000
Wages per running hour Rs. 1.25 Rs. 1.25
Power per hour 0.50 2
Indirect material per 3000 5000
annum
Other expenses per 12000 15000
annum
Cost of materials per unit 1 1
No of units produced per 12 18
hour
Selling price per unit 2 2

Interest to be paid at 10% on fresh capital invested.

SOLUTION:

Statement of profit

Existing machine New machine

Production per annum 24000 36000
(unit)
Selling price per unit 2 2
Sales 48000 72000
Less: cost of sales
Materials 24000 26000
Wages 2500 2500
Power 1000 4000
Indirect materials 3000 5000
Other expenses 12000 15000
Depreciation 2500 5000
Interest NIL 3750
(45000) (71250)
Total profit 3000 750
Cost per unit 1.87 1.98
Profit per unit 0.13 0.02
The above analysis shows that it will be better to continue with the existing
machine that replacing it by a new machine.

On the basis of accounting rate of return also, it will be better to continue with the
existing machine. This has been shown as under:

Profit on installation of new machine before charging interest = 750 + 3750 = 4500

Incremental profit = 4500 – 3000 = 1500

Incremental investment = 37500

Rate of return = 1500/37500 x 100 = 4%

In case of rate of return is calculated on average investment (i.e. ½ of 37500), the

rate of return will be 8%. This is not sufficient to pay interest at 10% on additional
investment required. Thus, it will be advisable to continue with the existing
machine.

Note: calculation of interest –

Investment in new machinery = 50,000

Less: scrap value of the old machine = (12500)

(25000 – Depreciation of 12500 on fixed installation basis)

Additional investment required = 37500

Interest at 10% per annum on 37500 = Rs. 3750.

PROBLEM – 09:

A company is considering an investment proposal to install a new machine. The

project will cost Rs. 50000 and will have a life span of 5 years and no salvage
value. The company’s tax rate is 50% and no investment allowance is required.
The firm uses straight line method of depreciation. The estimated net income
before depreciation and tax from the proposed investment proposal is as follows:
 Year Net income before depreciation and tax
1 10000
2 11000
3 14000
4 15000
5 25000

Compute the following:

1. Pay - back period

2. Average rate of return
3. NPV at 10% discount rate
4. Profitability index at 10% discount rate

Following are the present value factors at 10% per annum:

Year PV Factor at 10%

1 0.909
2 0.826
3 0.751
4 0.683
5 0.621

SOLUTION:

1. Computation of pay - back period:

Year Net Depreciation Net Tax Income Cash Cumulative

profit Income after Flow cash flow
before Tax (F+C)
Dep.
And
Tax
A B C D E F G H
1 10000 10000 NIL NIL NIL 10000 10000
 2 11000 10000 1000 500 500 10500 20500
3 14000 10000 4000 2000 2000 12000 32500
4 15000 10000 5000 2500 2500 12500 45000
5 25000 10000 15000 7500 7500 17500 62500

Pay-back period = 5000/17000 + 4 = 4.29 years.

2. Computation of average rate of return

Average income after tax/average investment x 100
Average income after tax = 0 + 500 + 2000 + 2500 + 7500/5 = Rs. 2500
Average investment = 50000/2 = Rs. 25000
Average Rate of Return = 2500/25000 x 100 = 10%

3. Computation of NPV at 10% discount factor

Year Cash flow PV Factor at PV
10%
1 10000 0.909 9090
2 10500 0.826 8673
3 12000 0.751 9012
4 12500 0.683 8537.5
5 17500 0.621 10867.5
46180
Less: Initial (50000)
Investment
NPV (3820)

4. Profitability Index at 10% discount rate

= Present value of cash inflow/present value of cash outflow x 100
= 46180/50000 x 100
= 92.36%
PRACTICAL PROBLEMS:

PROBLEM – 01:

A project costs Rs. 2000000 and yields annually a profit of Rs. 300000 after
depreciation at 12.5% but before tax at 50%. Calculate the pay-back period.

ANSWER: 5 years.

PROBLEM – 02:

ABC Limited is considering two projects. Each requires an investment of Rs.

10000. The firm’s cost of capital is 10%. The net cash inflows from investment in
two projects X and Y are as follows:

Year X Y
1 5000 1000
2 4000 2000
3 3000 3000
4 1000 4000
5 NIL 5000
6 NIL 6000

The company has fixed 3 years pay-back period as the cut-off point. State which
project should be accepted.

ANSWER: Project X should be accepted.

PROBLEM – 03:

A company has to choose one of the following two mutually exclusive projects.
Both the projects have to be depreciated on straight line basis. The tax rate is 50%.

Year Project A Project B

0 15000 15000
1 4200 4200
2 4800 4500
3 7000 4000
4 8000 5000
5 2000 10000
You have to use pay-back period as the criterion.

ANSWER: Project A should be preferred.

PROBLEM – 04:

X Limited is considering the purchase of new machine which will carry out
operations performed by labor. A and B are alternative models. From the following
information, you are required to prepare a profitability statement and work out the
pay-back period in respect of each machine:

Machine A Machine B
Estimated life 5 6
Cost of machine 150000 250000
Cost of indirect material 6000 8000
Estimated savings in 10000 15000
scrap
Additional cost of 19000 27000
maintenance
Estimated savings in
direct wages:
Employees not required 150 200
(number)
Wages per employee 600 600

Taxation is to be regarded as 50% of profit (ignore depreciation for calculation of

tax). Which model would you recommend and why?

ANSWER: Pay-back period of machine A and B is 4 years and 5 years

respectively. Hence, machine A is preferred.