A capital budgeting decision is faced by Sunrise manufacturing company. The company is planning to introduce a new product line requiring additional machine. The management must choose between two imported machines with

CS Executive · Corporate Accounting and Financial Management · PYQS · June 2026
A capital budgeting decision is faced by Sunrise manufacturing company. The company is planning to introduce a new product line requiring additional machine. The management must choose between two imported machines with same capital cost but different annual operating costs, operating lives, overheads and cash flow implications. Based on projected sales, operating costs, advertisement expenditure, depreciation, taxation and additional equipment requirements, the company evaluates the financial feasibility of the imported machine and identifies one of the most suitable machines in current scenario. The company is planning to diversify its operations by launching a new product line. The decision to introduce the product is driven by changing market conditions, technological advancements and the need to remain competitive. The management team, led by the CEO and supported by the financial analyst, operations manager and marketing manager, undertakes a detailed evaluation of market demand, pricing strategy, desired quality product of additional output and production requirements. Due to fast changing technology, the expected life span of machine is not for longer period. After carefully marketing the new product line and analysis of both the imported machines, the management team desires to consider the most profitable machine out of two imported machines. The details of both the machines and expected sales revenue and cost associated with output from these machines are as follows: Particulars Machine X Machine Y Expected economic life of machine 2 years 3 years Capital cost of machine (in Lakh) 60,000 60,000 Annual sales of additional output at standard price (in Lakh) 1,00,000 80,000 Annual cost (other than depreciation of machine) related to additional output: (in lakh) Wages 10,000 6,000 Material 8,000 10,000 Factory Overhead 12,000 10,000 Administration Cost 4,000 2,000 Selling cost 2,000 2,000 Salvage value at the end of the economic life of machine NIL NIL Depreciation for tax purposes (straight line method) (straight line method) Effective tax rate on company taxable income @35% @35% Ignore interest on capital cost of machine. The discount factors at appropriate discount rate of 10% are 1st year 0.909 2nd year 0.826 3rd year 0.751 On the basis of above facts given, you are required to calculate the most profitable investment option by following method : (a) Average Accounting Rate of Return Method; (b) Pay-back period Method; (c) Equivalent Net Present Value Method; (d) Determine Annual profit after tax and Annual Cash Flow after tax.

Answer & Explanation:

Answer 5 Evaluation of Most Profitable Investment Option (d) Computation of Annual PAT & Annual CFAT of both imported machines (in Lakh) Particulars Machine X Machine Y Annual sales of additional output of machine 1,00,000 80,000 Less: Annual cash cost of additional output of M/C: Wages 10,000 6,000 Material 8,000 10,000 Factory O/H 12,000 10,000 Administrative cost 4,000 2,000 Selling cost 2,000 2,000 Annual profit before Depreciation & Tax 64,000 50,000 Less: Depreciation (Machine X: 60,000/2; Machine Y: 60,000/3) 30,000 20,000 Annual Operating profit before tax 34,000 30,000 Less: Tax 35% 11,900 10,500 Annual Profit after Depreciation & Tax (PAT) 22,100 19,500 Add: Depreciation 30,000 20,000 Annual Cash Flow after tax (CFAT) 52,100 39,500 (a) On the basis of Average Accounting Rate of Return Method: (in Lakh) Particulars Machine X Machine Y Average Accounting Profit After Tax 22,100 19,500 Average Investment in machine = (60000 - Nil) / 2 30,000 30,000 Average rate of return = (22,100/₹30,000) * 100 73.67% Average rate of return = (19,500/₹30,000) * 100 65% Decision: Investment in Machine X is more profitable than that in Machine Y. (b) On the basis of Pay-back Period Method: Particulars Machine X Machine Y Annuity cash flow ₹52,100 ₹39,500 Initial investment in machine ₹60,000 ₹60,000 Pay-back Period = Initial Investment / Annual CF ₹60,000 / ₹52,100 ₹60,000 / ₹39,500 1.15 Year 1.52 Year Decision: Machine X is recommended because its Pay-back period is less. (c) On the basis of NPV method: As lives of two machines are unequal, decision of most profitable option is to be based on Equivalent Net Present Value. Computation of NPV of both imported machine and Equivalent NPV Year Discount Factor at 10% Machine X Machine Y CFAT P.V. of CFAT CFAT P.V. of CFAT 1. 0.909 ₹52,100 47,359 ₹39,500 35,906 2. 0.826 ₹52,100 43,035 ₹39,500 32,627 3. 0.751 NIL NIL ₹39,500 29,665 Present Value of Project 90,394 98,198 Less: Initial investment 60,000 60,000 NPV of Machines 30,394 38,198 Calculation of Equivalent NPV: NPV of the machine / Cumulative Discount Factors for life of the machine (in lakh) Machine X = ₹30,394 / (0.909 + 0.826) = ₹30,394 / 1.735 = ₹17,518 Machine Y = ₹38,198 / (0.909 + 0.826 + 0.751) = ₹38,198 / 2.486 = ₹15,365 Decision: Machine X is more profitable than machine Y because its equivalent NPV is more than that of machine Y.

Topics: Financial Management

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