Problem(s) (caselet) on Time Value of Money

A company is considering the following proposals for investment. The corporate tax rate is
30%, and the opportunity cost of capital (after tax) is 13%.

Proposal 1: The company is planning to invest in New Equipment worth Rs.40 lakh whose
estimated life is 10 years. The estimated (incremental) annual after tax cashflows are Rs.7.6
lakh for the first 4 years, and Rs.8.5 lakhs for the remaining 6 years. The salvage value (sale
price) is expected to be half of the book value at the end of its useful economic life. The
depreciation can be charged on Written Down Value (WDV) basis at 25%. Should the
company invest in the new equipment?

Proposal 2: The company is planning to buy a new machine worth Rs.46.35 lakh by paying
for it in 8 equal annual instalments (EAIs) at a compounded rate of interest of 18%. What is
the EAI? What is the cost of the machine given the tax shield on interest? What is the
minimum annual after tax saving that should accrue to the company to recover the investment
made on instalment basis given the life of the machine of 15 years?

Proposal 3: The company is planning to buy a refrigeration system priced at Rs.14 lakh. The
distributor of the system offered the option of paying in 4 EAIs as follows:

Interest rate = 13%

Principal = Rs.14 lakh.

Four years of interest @ 13% = Rs.7.28 lakh

Total amount = Rs.21.28 lakh.

Annual payments = Rs.5.32 lakh.

What is the rate of return earned by the distributor on such instalment payments if the
company accepts the same? What should be the EAI if the distributor indeed earns 13% as
promised?

Proposal 4: The company is planning to borrow Rs.65 lakh in the form of a 7 year term loan
at 15%, and return the amount due in one go at the end of the 7th year. How much should the
company save every year and invest the same outside at 18.5% so that it can honour the
repayment obligation(s)? Assume that the annual savings accrue to the company at the
beginning of the year.

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 Problem(s) (caselet) on Capital Budgeting

In January 2020, a company is discussing the option of replacing existing old machine bought
and installed in 2018 for Rs.35 lakh (including installation cost of Rs.10 lakh). The new
machine will cost Rs.65 lakh which has to be paid in two equal installments – one at the time
of ordering in January 2020, and the other at the time of installation in January 2021 as it
would take 12 months to deliver the new machine. The cost of installing the new machine is
Rs.15 lakh which can be capitalized. The rate of depreciation is 25% on WDV basis for both
the machines. The annual operating cash cost will decline from Rs.28 lakh (with old
machine) to Rs.10 lakh, and the old machine will be sold for Rs.4 lakh when the new
machine is installed. The new machine can be sold for 10% of its original cost at the end of
its useful life of 12 years (in 2032). The cost of capital for replacement is 16% and the
corporate tax rate is 30%. Eighty percent of the operating expenses are due to fuel whose
prices are expected to rise at an annual rate of 10% while the remaining will increase at the
expected annual general rate of inflation of 6%. You may assume that the revenues will also
rise at an annual rate of 6%. Should the company replace the old machine given the costs and
benefits?

The company also has the option of overhauling the old machine at a cost of Rs.25 lakh
which will extend its life by 5 years (until 2030), and also bring down the annual operating
cash cost to Rs.22 lakh. The overhauled machine can be sold for Rs.3 lakh in 2030. The rate
of depreciation, corporate tax rate, and the rise in operating expenses and revenues will
remain the same as above while the cost of capital for overhaul is 18%. Will the expenditure
of Rs.25 lakh be justified if the company decides to overhaul the old machine?

Which of the two alternatives – replacement, and overhaul – do you recommend to the
company, and Why? You may estimate the NPV and IRR with (and without) the benefit of
Investment Allowance at the rate of 25%. You may also estimate the payback period.

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 Problem(s) (caselet) on Capital Budgeting

A company is contemplating to replace an old machine with a new machine at a cost of

Rs.450 lakhs. The new machine will require additional (net) working capital of Rs.32 lakh,
and it (machine) is expected to have a useful life of 10 years. The book value of old machine
is 30 lakhs, and can be sold for Rs.20 lakhs now and for Rs.15 lakh at the end of its useful life
of 10 years (from now). The new machine has estimated salvage value of Rs.40 lakhs at the
end of its life. The corporate tax rate is 30%, and the rate of depreciation on WDV basis on a
block of assets is 25%.

Estimated Revenue and Costs with the New Machine (Rs. Lakhs)
Old Machine New
Machine
Annual Sales Revenue 510 692
Raw Material 262 348
Labour Costs 80 65
Supervision 8 6
Power 15 11
Repairs and Maintenance 4 5
Depreciation (Straight line method) 3 45
Allocated Corporate Overheads* 5 7
* (These are allocated overhead expenses)

Present Capital Structure as on March 31, 20XX (Rs. in lakhs)

Paid-up Equity Share Capital (30 lakh shares @Rs.100 3,000
Reserves and Surplus 1,800
Total Borrowings 7,200
Total Capital Employed 12,000

The company’s share is currently selling for Rs.200. The company’s dividend rate is 22% and
is expected to grow at an annual rate of 7.5% in future. The company has a target debt-
equity ratio of 3:2, and the average interest rate on borrowings in the past has been 12%.
The company knows that it can raise new debt at 15% per annum before tax.

Should the company replace the old machine? Justify your answer with the NPV (and IRR)
after estimating the (marginal) cashflows and appropriate discount rate. What is the
(approximate) conventional and discounted payback (in years)?

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 Problem on Leasing

ABC Ltd. is planning to acquire a computer at a price of Rs.75 lakh, which has an expected
life of eight years. The company expects to receive an annual pre-tax benefit of Rs.18 lakh
from the use of that computer. The company can depreciate the computer on written down
value basis at 25 per cent per annum. If the company takes the computer on lease, it will have
to pay lease rentals of Rs.14 lakh at the beginning of each year for eight years. If the
company buys or acquires it on hire purchase, it will be serviced free of cost, but in the case
of lease, the company will have to incur a maintenance cost of Rs.1.75 lakh per annum to be
paid at the end of each year for eight years. The computer may have a salvage value of Rs.6
lakh at the end of its useful life. The company’s after-tax cost of borrowing is 9.5 per cent per
annum, and the corporate tax rate is 30 per cent.

The manufacturer has quoted a hire purchase installment of Rs.18.375 lakh per annum
payable at the beginning of the year for eight years. The company is entitled to claim
depreciation and salvage value under hire purchase. All tax shields accrue to the company at
the end of the year.

Should the company buy the machine or take it on lease or hire purchase? Justify your answer
with net advantage (disadvantage) of leasing, and hire purchase.