08 December 2011
An oil company proposes to install a pipeline to transport crude oil from the wells to the refinery. Investment and operating costs of the pipeline vary for different sizes (diameter) of pipes. The following details have been collected: Pipeline diameter 3" 4" 5" 6" 7" Investment required (Rs lakh) 16 24 36 64 150 Gross annual savings in operating costs 5 8 15 30 50 before depreciation Estimated life of the installation is 10 years. Tax rate is 50%. Questions: 1. Calculate the net saving after paying tax and generating the cash flow. Recommend the largest pipeline to be installed if the company desires 15 per cent profit after tax return. Also indicate the proposal that has the shortest payback. Assume the company follows the straight-line method of depreciation, and there is no salvage value of pipeline after ten years. 2. Why is the Net Present Value method of evaluation superior in evaluating capital expenditure decisions?