Page 187 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

Notes
Loan Increase in Tax
amount loan due to Opening Depreciation savings Closing
Year o/s foreign WDV on TOTAL 25% on on WDV on
in US $ exchange addition additions (5) additions additions.
Lakhs fluctuations. @ 35%
(1) (2) (3) (4) (5 =3 + 4) 25% on (6) (7) (8 = 5-6)
1 14 32 32 8 2.8 24
2 11.2 22.4 24 46.4 11.6 4.06 34.8
3 8.4 16.8 34.8 51.6 12.9 4.515 38.7
4 5.6 11.2 38.7 49.9 12.475 4.366 37.425
5 2.8 5.6 37.425 43.025 43.025* 15.059

* Assumed that full benefit will be claimed for tax purposes.
Tax
Amt of saving
interest of Int. Tax savings Total Net cash Discount Present
Year on Addl.
and other and payments outflow factor value
charges other Depreciation
charges
0 5.040 1.764 5.04 3.276 1 3.276
1 31.92 11.172 2.8 138.32 124.348 .921 114.525
2 26.88 9.408 4.06 138.88 125.412 .848 106.349
3 21.168 7.408 4.515 138.768 126.845 .781 99.066
4 14.784 5.174 4.366 137.984 128.444 .720 92.480
5 7.728 2.704 15.059 136.528 118.765 .663 78.741
37.630 30.800 695.52 727.090 494.437

1. The absolute and discounted value of Option II seems to be better than Option I. However,
the company has to be careful about future exchange rate, since the indicated rates are
more by rule of a thumb rather than based on any specific approach. The company should
cover possible foreign exchange fluctuations in future and then work out the value.

2. In case the company has good volume of exports, then it may help the company to help in
future payments. In that case, the company may take a lenient view of covering foreign
exchange risk.
Illustration 7:
S Engineering Company is considering replacing or repairing a particular machine, which has
just broken down. Last year, this machine costed 20,000 to run and maintain. These costs have
been increasing in real terms in recent years with the age of the machine. A further useful life of
5 years is expected, if immediate repairs of 19,000 are carried out. If the machine is not repaired
it can be sold immediately to realize actual 5,000 (ignore loss/gain on such disposal).
Alternatively, the company can buy a new machine for 49,000 with an expected life of 10 years
with no salvage value after providing depreciation on straight-line basis. In this case, running
and maintenance costs will reduce to 14,000 each year and are not expected to increase much in
real terms for a few years at least.
S Engineering Company regards an annual return of 10% p.a. after tax as a minimum requirement
on any new investment. Considering the Capital Budgeting technique, which alternative will
you choose? Take corporate tax rate of 50% and assume that depreciation on straight-line basis
will be accepted for tax purposes also.

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