64 SFM Marketing Sample Ch04

INTRODUCTIONThis chapter extends the discussion on capital budgeting, which was dis-cussed in the previous chapter and which established the basic principles of determining relevant cash flows. Both the sophisticated (net present value [ NPV] and the internal rate of return [IRR]) and unsophisticated (average rate of return [ ARR] and payback period) capital budgeting tech-niques are discussed in detail. The discussion focusses on the computation and evaluation of the NPV, IRR, and modified IRR ( MIRR) in investment decisions, and as a practicing manager which one should one choose from among the available techniques.

Basically, the capital budgeting tools can broadly be classified as follows:A. Non-discounted cash flow-based methods (a) Payback period method (b) Discounted payback period method

A er reading this chapter, you will be able to: • Understand the role of capital budge ng techniques in the capital

budge ng process• Compute, interpret, and evaluate the payback period• Calculate, interpret, and evaluate the net present value (NPV), internal

rate of return (IRR), average rate of return (ARR), and profi tability index• Discuss NPV and IRR in terms of confl ic ng rankings, and the theore cal

and prac cal strengths of each approach

4Capital Budgeting Tools and Techniques

C H A P T E R

Learning Objec ves

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142 Strategic Financial Management

(c) Accounting rate of returnB. Discounted cash flow-based methods (a) Net present value method (b) Internal rate of return method (c) Profitability index method

Let us discuss each method in detail.

NON DISCOUNTED CASH FLOW BASED METHODSA non-discounted method of capital budgeting technique does not explic-itly consider the time value of money.

Payback PeriodThis method is considered as one of the simplest method of capital budg-eting. This is also referred to as the ‘back of the envelope’ calculation method. The payback method simply measures how long (in years and/or in months) it takes to recover the initial investment. Usually, the maximum acceptable payback period is determined by the management.

The normal rule that is followed is that if the payback period is less than the maximum acceptable payback period, one should accept the project whereas if the payback period is greater than the maximum acceptable payback period, one should reject the project. When there are two com-peting projects, the project that has the lowest payback period should be chosen.

Understanding the basic working of the tool, let us look at the merits and demerits.

Merits and demerits of payback periodThe following are the merits of payback period:

• The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects;

• It is simple and intuitive, and considers cash flows rather than account-ing profits;

• It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as NPV and IRR.

The following are the weaknesses of the payback period:

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Capital Budgeting Tools and Techniques 143

• One major weakness of the payback method is that the appropriate payback period is a number subjectively determined by the manage-ment. The cut-off period is randomly decided by the management;

• It fails to consider the principle of wealth maximization because it is not based on discounted cash flows, and thus provides no indication as to whether a project adds to firm value or not;

• It also fails to fully consider the time value of money.

Let us understand the same through a simple example.

Example 4.1Bajrang Company is a medium-sized metal fabricator which is currently contemplating two projects. Project A requires an initial investment of `42,000; Project B also requires the same investment of `42,000. The rel-evant operating and cumulative cash flows for the two projects are pre-sented below in Table 4.1. Calculate which of the two projects would be preferred on the basis of payback period.

Table 4.1 Operating and cumulative cash flows for Projects A and B

Year Project ACumula ve cash fl ow Project B

Cumula ve cash fl ow

0 −42,000 −42,000 1 14,000 14,000 28,000 28,0002 14,000 28,000 12,000 40,0003 14,000 42,000 10,000 50,0004 14,000 56,000 10,000 60,000

5 14,000 70,000 10,000 70,000

SolutionIn Table 4.1, cumulative cash flows for the projects A and B are calculated. From the table it was observed that for Project A the initial investment of `42,000 is recovered in the third year. For Project B, the initial invest-ment of `42,000 was recovered between the second and the third year. Till the second year, `40,000 was recovered and we needed to cover another `2,000. But in the third year, the project generated a cash flow of `10,000 assuming that the cash flow was generated evenly throughout the year. So to generate `2,000, it took 2.4 months. So, the payback period for Project B was 2 years 2.4 months, that is, 2.2 years.

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Between the two projects, Project B is preferable as the payback period is 2.2 years as compared to that of Project A.

But, as discussed earlier, this is not a scientific method because it does not take into account (a) the cash flow generated throughout the year and (b) the time value of money.

We have rejected Project A as it has a longer payback period, which is three years, and chosen Project B, which needs only 2.2 years.

Let us discuss the slightly modified version of the earlier-mentioned case (please note that the cash flows are changed for your understanding). See Table 4.2.

Table 4.2 Operating and cumulative cash flows for Projects A and B

Year Project ACumula ve cash fl ow Project B

Cumula ve cash fl ow

0 −42,000 −42,000 1 14,000 14,000 28,000 28,0002 14,000 28,000 12,000 40,0003 14,000 42,000 10,000 50,0004 20,000 62,000 5,000 55,000

5 25,000 87,000 5,000 60,000

Cumulative cash flows for projects A and B are calculated.In Table 4.2, we observe that post payback cash flow itself amounts to

`45,000 (exceeding the initial investment) and the total cash flow generated from Project A is `87,000.

Cumulative cash flow for Project B gives us similar results. It is observed from the table that post payback cash flow itself amounts to `10,000 and the total cash flow generated from Project B is `60,000.

This is also one of the major flaws of the payback period method.

Discounted payback periodOne of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this limitation, an alternative pro-cedure called discounted payback period may be followed, which accounts for time value of money by discounting the cash inflows of the project.

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This method is used to determine the profitability of a project. This is a variation of the payback method wherein everything remains the same. Only, instead of taking the actual cash flows the discounted cash flows are considered.

Let us understand the same through a simple example.

Example 4.2 Assuming that the cost of capital is 10 per cent, calculate the payback period and the discounted payback period. Refer to Table 4.3.

Table 4.3 Operating cash flows for Projects A and B

Year Project A Project B

0 −42,000 −42,000 1 28,000 28,0002 12,000 40,0003 10,000 50,0004 5,000 55,000

5 5,000 60,000

SolutionIn Table 4.4, it can be seen that payback is between the third and fourth year. Till the third year, only `34, 816 is recovered. To cover the balance of `7,184, it takes another nine months [(12/9562)*7184]. Hence, the dis-counted payback period for Project A is three years and nine months.

Table 4.4 Discounted payback period for Project A

Year Project APresent value of cash

fl ows 10%Cumula ve present value of cash fl ows

0 −42,000 -

1 14,000 12,727 12,727

2 14,000 11,570 24,298

3 14,000 10,518 34,816

4 14,000 9,562 44,378

5 14,000 8,693 53,071

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Similarly, in Table 4.5, it is seen that payback period is between second and third year. Till the second year, `35,372 is recovered. To cover the balance of `6,628, it takes another 10.6 months [(12/7513)*6628].

Hence, the discounted payback period for Project B is 2 years and 11 months.

Table 4.5 Discounted payback period for Project B

Year Project BPresent value of cash fl ows 10%

Cumula ve present value of cash fl ows

0 −42,000

1 28,000 25,455 25,455

2 12,000 9,917 35,372

3 10,000 7,513 42,885

4 5,000 3,415 46,300

5 5,000 3,105 49,405

Hence, Project B is chosen as it has the lowest payback period.

Accounting rate of return Contrary to the earlier methods, this method uses accounting information as per the financial statements instead of using the cash flow generated from the project alone. The ARR is computed by dividing the average after-tax profit by the average investment. Accordingly, ARR can be calculated using the following formula:

ARR = average income ÷ average investment

Decision ruleNormally the management establishes a cut-off ARR. So, all the projects above the cut-off rates will be accepted. When there are competing pro-jects, the project with the highest ARR will be selected.

Let us understand this concept though a simple example.

Example 4.3Suppose that a project that requires an initial investment of `42,000 is expected to generate the following earnings (note that it is not cash flows) before depreciation, interest, and taxes. Assume that the company has no

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debts but is in the 40 per cent tax bracket, and assets are depreciated on a straight line basis during the life of the project, which is six years. Compute the ARR. See Table 4.6.

Table 4.6 Income statement

1 2 3 4 5 6

Earnings before deprecia on, interest, and tax 10,000 12,000 14,000 15,000 21,000 17,000Less: deprecia on—Straight line method (42,000/6) 7,000 7,000 7,000 7,000 7,000 7,000Earnings before tax 3,000 5,000 7,000 8,000 14,000 10,000Taxes (40%) 1,200 2,000 2,800 3,200 5,600 4,000

Earnings a er tax 1,800 3,000 4,200 4,800 8,400 6,000

SolutionARR = average income ÷ average investment = 4700/21,583 = 21.78%

Book value of investment

Opening value 42,000 35,000 28,000 21,000 14,000 7,000

Closing value 35,000 28,000 21,000 14,000 7,000 7,000

Average 38,500 31,500 24,500 17,500 10,500 7,000

Average income 4,700

Average investment 21,583

Merits and limitations of ARREven though the method is used across organizations, it has some merits and demerits, which are listed as follows.

Merits(a) The method is simple to understand and easy to calculate.(b) The ARR is computed based on the accounting data, which is from the

financial statement (in this case projected) of the project.

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Demerits(a) The ARR absolutely ignores the cash flow generated by the project.(b) As in the payback method, time value of money is not considered.

DISCOUNTED CASH FLOW METHODThis is a technique that values a project and organization using the concept of time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

Net Present Value Let us now move on to an interesting and a scientific method known as NPV. It is called a scientific method because it overcomes the drawback of the payback period method in two ways. One, it considers the cash flow generated throughout the life of the project and, two, it takes into account the time value of money.

Under this method, the estimated cash flow from the project is com-puted on realistic assumptions. These estimated cash flows are discounted at an appropriate discount rate, which is normally the cost of capital. The NPV is computed by subtracting the present value of cash outflows from the present value of cash inflows.

1 22 ...

1 (1 ) (1 )T

o T

C C CNPV C

r r r= − + + + +

+ + + Eqn 4.1

–Co = initial investmentC = cash flowr = discount rateT = time

Decision criteriaIf NPV > 0, accept the projectIf NPV < 0, reject the projectIf NPV = 0, indifferent

Example 4.4Let us take the data from Example 4.1 (refer to Table 4.7) and assume that the cost of capital is 10 per cent. Compute NPV and discuss which of the two projects should be selected.

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Table 4.7 Operating cash flows


0 −42,000 −42,000 1 14,000 28,0002 14,000 12,0003 14,000 10,0004 14,000 10,000

5 14,000 10,000

SolutionThis has also been projected through Figs 4.1 and 4.2.

-42,000 14,000 14,000 14,000 14,000 14,000

53071

Project A

0 1 2 3 4 5

Fig. 4.1 NPV for Project A

NPVB = 13.924

-42,000 28,000 12,000 10,000 10,000 10,000

55,924

Project B

25,455

9,917

7,513

6,830

6,209

0 1 2 3 4 5

Fig. 4.2 NPV for Project B

NPVA = 11.071

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From the earlier calculations, it was found that both the projects have pos-itive NPVs. But, we have to choose only one between the two; we have to choose a project with the highest NPV. So, we choose Project A.

Merits and limitations of NPVWhile using this method, a manager must be aware of what advantages or disadvantages this method has. This makes the use of the method more validated.

Merits(a) It considers the time value of money.(b) It uses all cash flows generated throughout the life of the project, so it

is considered a measure of the project’s true profitability.(c) It is based on the value additive principle in which the discounting

process measures the cash flows in terms of present values, which is in terms of equivalent current rupees. Therefore, NPV of projects can be added.

Demerits(a) As this method is purely based on the cash flow, if anything goes wrong

on the cash flow projection, the entire NPV calculation goes for a toss.(b) Sometimes, NPV might provide an ambiguous result for projects with

unequal life, projects with unequal initial investment, and projects under funds or any other constraints.

INTERNAL RATE OF RETURNThis method also belongs to the family of discounted cash flow tech-

niques, which takes into account the magnitude as well as the timing of the cash flows. The IRR is the discount rate that will equate the present value of the outflows with the present value of the inflows. This is also known as the project’s intrinsic rate of return.

This can be calculated using the following formula:

1 (1 )

n

tt

CFt CFoIRR=

−+∑ Eqn 4.2

Decision criteriaIf IRR > k, accept the projectIf IRR < k, reject the projectIf IRR = k, indifferent

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Example 4.5Let us take the data from Example 4.1 and compute the IRR. Refer to Table 4.8.



0 −42,000 −42,000 1 14,000 28,0002 14,000 12,0003 14,000 10,0004 14,000 10,000

5 14,000 10,000

How IRR works?

SolutionContrary to NPV, here the ‘rate of return’ is to be identified wherein the present values of discounted cash inflows are equal to the present value of cash outflows.

In other words, IRR is the rate of return that equates the investment outlay with the present value of cash inflow received after one period. This is also rate of return, that is, the discount rate, which makes NPV = 0. See Figures 4.3 and 4.4 to find out IRRs for projects A and B, respectively.

-42,000 14,000 14,000 14,000 14,000 14,000

42000

Project A

0 1 2 3 4 5

NPVA = 0 IRRA = 19.9%

Fig. 4.3 IRR for Project A

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-42,000 28,000 12,000 10,000 10,000 10,000

42000

Project B

0 1 2 3 4 5

NPVB = 0 IRRB = 21.7%

Fig. 4.4 IRR for Project B

Merits and Limitations of IRRThe merits and limitations of the IRR method are as follows.

Merits(a) The IRR method considers the time value of money.(b) It also considers the cash flow generated throughout the life of the

project.(c) The IRR is consistent with shareholder wealth maximization concept,

which means when the IRR is more than the cost of capital, the share-holder wealth is enhanced and vice versa.

Demerits(a) Possibility of getting multiple IRR.(b) Unlike the NPV method, the IRR method does not have the concept of

value addition.

MODIFIED INTERNAL RATE OF RETURN The MIRR is a modified version of IRR. In IRR, the cash flows are ploughed back at the project’s rate of return, whereas in MIRR cash flows are ploughed back at different rates of return during the life of the project. The MIRR formula is a geometric mean; it is exactly the same formula used to find cumulative average growth rate for figures that grow exponentially, such as compound interest earnings.

It could be computed using the MS excel built-in function MIRR (values, finance rate, reinvestment rate). Here, the values indicate the range of cash flows; finance rate is the cost of capital; and reinvestment rate means the same as the term.

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PROFITABILITY INDEXThis is the third item in the discounted cash flow techniques and is also known as cost–benefit (C/B) ratio. It is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. The PI can be computed as follows:

PI = present value of cash inflows ÷ initial cash outflowLet us understand the same with the help of the following data in

Table 4.13.


Year Project A

0 −42,0001 14,0002 14,0003 14,0004 14,000

5 14,000

Present value of the cash inflows (with 10 per cent cost of capital) is `53,071 and initial investment is `42,000. Therefore, PI is as follows.

PI = 53,071/42,000 = 1.26

Decision criteriaIf PI > 1, accept the projectIf PI < 1, reject the projectIf PI = 1, indifferent

Merits and Limitations of PI Method

Merits This method takes into account the time value of money and the cash flow generated throughout the life of the project.

LimitationsThe issue predicting the cash flow is a major area of concern.

Let us compare the three main tools (payback period method, NPV, and IRR) and draw inferences. Please see Table 4.10.

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Table 4.10 Conflicting rankings

Method Project A Project B

Payback – YESNPV YES –

IRR YES

Conflicting rankings, between two or more projects using NPV and IRR, sometimes occur because of the differences in the timing and magnitude of cash flows. The underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project. The NPV assumes that intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.

Which Approach is Better?On a purely theoretical basis, NPV is the better approach because of the following:

(a) NPV assumes that intermediate cash flows are reinvested at the cost of capital, whereas IRR assumes they are reinvested at the IRR.

(b) Certain mathematical properties may cause a project with non-conven-tional cash flows to have zero or more than one real IRR.

Despite NPV’s theoretical superiority, however, financial managers prefer to use the IRR method1 because of the preference for rates of return.

SUMMARYAfter computing the relevant cash flows, the financial manager must apply appropriate capital budgeting tools and techniques to decide whether the intended project creates any value for the shareholders of the company. Among the capital budgeting tools and techniques, we have two broad groups, namely, discounted and non-discounted cash flow. In non-discounted cash

Davina Jacobs,’A Review of Capital Budgeting Practices’—IMF Working Paper-WP/08/160 (Washington: International Monetary Fund).

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Key Terms

ARR A technique used for capital budgeting that indicates the rate of return obtained by considering the profit generated by investing in an asset.Discounted cash flows Cash flows generated from a projected asset discounted at the cost of capital.IRR A technique used for capital budgeting that indicates the rate of return to be obtained from investing in an asset.NPV Present value of future cash flows minus initial investment made on an asset.Payback period It indicates within how many years or months the originally invested capital is recovered from the asset.

Concept Review Ques ons

1. Why is payback method not considered a scientific method?2. What are the drawbacks of payback method?3. What are the advantages of NPV method?4. What are the drawbacks of using ARR method?5. Sometimes NPV, IRR, and payback method might produce a conflicting

ranking. Why is it so? What are the reasons behind the same?

flow group we have payback method and ARR methods, which are relatively simple and easy to understand. But at the same time, these methods are not taking into account the cash flow generated throughout the life of the project and the concept of time value of money.

In the family of discounted cash flow techniques, we have NPV, IRR, and MIRR. These techniques are relatively scientific in the sense that they con-sider the time value of money and the cash flow generated throughout the life of the project. In practice, NPV and IRR generally are most preferred methods among the financial managers. Both use cost of capital as a deter-mining factor to decide whether a particular project adds or destroys value of the firm.

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6. Between NPV and IRR techniques, which one would you prefer and why?7. What is the significance of the PI method?

Cri cal Thinking Ques ons

1. Company ACC needs to take a call on buying machinery for its plant at Coimbatore, Tamil Nadu. The details of the same are given as follows:Initial investment `50,00,000 and estimated cash flow from the machinery, during its useful life, which is counted in years, is `15,00,000. Advise the company based on NPV, IRR, and PI, assuming the cost of capital is 10 per cent.

2. A new project costs `81,00,000 and is expected to generate net cash inflow of `40,00,000, `35,00,000, and `30,00,000 during its life of three years. Calculate the IRR of the project.

3. A project costs `9,60,000 and is expected to generate annual cash inflow of `4,80,000, `,4,20,000, and `3,60,000 at the end of each year during its life of three years. Calculate the payback period.

4. Bharat Coal Field Ltd has a policy of choosing projects with a cut-off period of six years and currently must choose between two mutually exclusive pro-jects. Project A (room and pillar mining) requires an initial investment of `25,000 (in lakhs), whereas Project B (underground mining) requires `35,000 (in lakhs). The projected cash inflows are given in the following Table 4.11. Calculate the payback period of both the projects. Which project meets the company’s standards?

Table 4.11 Expected cash flows for projects A and B

Years

Expected cash fl ows(` lakh)

Project A Project B

1 6,000 7,0002 6,000 7,0003 8,000 8,0004 4,000 5,0005 3,500 5,000

6 2,000 4,000

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5. Naga Foods is considering buying a new wrapping machine. The initial invest-ment is estimated at `25,00,000, and the machine will have a five-year life with no salvage value. Refer to Table 4.12. Using a 10 per cent discount rate, compute the NPV of the machine based on the cash flows as follows. Based on the computed NPV, advise whether the company should buy the machine or not?

Table 4.12 Cash flows

Years

Expected cash fl ows(` lakh)

Project A Project B

1 6,000 7,0002 6,000 7,0003 8,000 8,0004 4,000 5,0005 3,500 5,000

6 2,000 4,000

6. Gomathi Textiles uses IRR to select projects. Compute the IRR for each of the following projects and recommend the best project based on IRR. Project Sports T Shirt requires an initial investment of `30,000 and generates cash flows of `16,000 per year for the next four years. Project Casual T Shirt requires an investment of `50,000 and generates cash flows of `24,000 per year for the next five years.

7. Gopal Electronics, manufacturers of car audio, uses NPV technique to choose projects. Assuming 12 per cent cost of capital, compute the NPV of the pro-jects and advise the firm. Use data from Table 4.13.

Table 4.13 Initial investment and operating cash flow

Model A Model B

Ini al investment `60,000 `50,000

Year Opera ng cash fl ow

1 14,000 12,0002 20,000 18,0003 24,000 18,000

4 20,000 16,000

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8. Just Born is a chain of retail outlets located all over the southern part of India. The firm is considering expanding to two more cities and must choose one city between the two alternatives. City A requires an initial investment of `14,000,000 and generates annual after-tax cash inflow of `3,000,000 each for each of the next years. City B requires an initial investment of ̀ 21,000,000 and provides an annual cash inflow after tax of `4,000,000 for 20 years.

(a) Compute the payback period for each city.(b) Comment on the acceptability of the machines, assuming that they are

independent of each other.(c) Which city should the firm choose? Why?

9. Shanti Gears Ltd is considering two mutually exclusive projects. Each requires an initial investment of `10,00,000. Mohan, the chief financial officer of the company, has set a maximum payback period of four years. The after-tax cash inflows associated with each project are as in Table 4.14:

Table 4.14 After-tax cash inflows

Project A Project B

1 1,00,000 4,00,0002 2,00,000 3,00,0003 3,00,000 2,00,0004 4,00,000 1,00,000

5 2,00,000 2,00,000

(a) Determine the payback period of each project.(b) As the projects are mutually exclusive, the company must choose one.

Which project the company should invest in?(c) Explain why one of the projects is a be er choice than the other.

10. Luna Motors Ltd is planning to purchase the exclusive rights to manufacture and market a battery operated (solar powered) bike. The bike’s inventor has offered the company the choice of either a one-time bullet payment of `15 crore on the day of purchase or a series of five year-end payments of `3.385 crore.(a) Assuming that the company’s cost of capital is 15 per cent, which form of

payment should the company prefer?(b) Which form of yearly payment would make the two off ers iden cal in

value at a 15 per cent cost of capital?

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(c) Will your answer to this part of the ques on be diff erent if yearly pay-ments were made at the beginning of each year? Show what diff erence, if any, that change in ming would make to the present value calcula on.

(d) Suppose the a er-tax cash infl ows associated with this purchase are `2.5 crore per year for 15 years. Will this factor change the fi rm’s decision about how to fund the ini al investment?

11. Sathish Oil Industries, which extracts cooking oil from sunflower, is consider-ing the replacement of one of its oil expeller. Three alternative replacement expellers are under consideration. The relevant cash flows associated with each are shown in Table 4.15. The company’s cost of capital is 16 per cent.

Table 4.15 Cash flows for expellers A, B, and C

Expeller A Expeller B Expeller C

Ini al investment 8,50,000 6,00,000 13,00,000

Years Expected cash fl ows

1 1,80,000 1,20,000 5,00,0002 1,80,000 1,40,000 3,00,0003 1,80,000 1,60,000 2,00,0004 1,80,000 1,80,000 2,00,0005 1,80,000 2,00,000 2,00,0006 1,80,000 2,50,000 3,00,0007 1,80,000 0 4,00,000

8 1,80,000 0 5,00,000

(a) Compute the NPV for each expeller machine.(b) Using NPV, evaluate the acceptability of each expeller.(c) Rank the expellers from best to worst.

12. Hindustan Tractors Ltd, whose cost of capital is 15 per cent, is currently con-sidering a 10-year project that provides an annual cash inflow of `1,00,000 and requires an initial investment of `6,14,500.(a) Determine the IRR for this project.(b) Assuming that the cash infl ows con nue to be `1,00,000 per year, how

many addi onal years would the cash fl ows have to con nue to make the project acceptable (to make it have an IRR of 15 per cent)?

(c) With the given life, ini al investment, and cost of capital, what is the minimum annual cash infl ow that the fi rm should accept?

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13. Jaipur Printers is considering the purchase of a new modern printing press by discarding the old one. The total installed cost of the new press is `2,200,000. The old press, whose book value is zero, can be sold for `1,000,000 before taxes. Owing to the addition of the new press, it was expected that the sales will go up by `1,600,000 higher than that of the current press, but production cost (except depreciation) will be 50 per cent of sales. However, the new press will not affect the working capital requirements of the firm. The life of the machine is five years and the company uses straight line method of depreciation and is in the 40 per cent tax bracket. (Assume that both the old and new press will have a nil scrap value at the end of six years.)(a) Determine the ini al investment required by the new press.(b) Compute the opera ng cash infl ows owing to the new press.(c) Determine the payback period.(d) Determine the NPV and the IRR related to the proposed new press.(e) Make a recommenda on to accept or reject the new press and also

jus fy your answer.14. Medicare, a Gurgaon-based medical equipments manufacturing company

comes out with a new blood glucose testing unit. It is a one-time use-and-throw type. Owing to the highly competitive nature of the market, the sales department projects a demand of 5000 units in the first year and decrease in demand of 10 per cent a year after that. After five years, the project (as well as the product) will be discontinued with no salvage value. The marketing department forecasts a selling price of `15 per unit. The production depart-ment estimates an operating cost of `5 per unit, and the finance depart-ment estimates general and administrative expenses of `15,000 per year. The initial investments in land is `100,000 and non-depreciable setup costs are `100,000. The company is in 40% tax bracket and follows a straight line method of depreciation.Estimate the operating cash flow from the project on the following different scenarios:(a) If the marke ng department had forecast a decline of 15% a year in

demand(b) If the marke ng department had forecast a decline of 10% in sales price(c) If the price declines by 10% a year, the marke ng department es mates

that demand will be constant at 5000 units a year.15. BPZ Pvt. Ltd, a Pune based BPO, must decide whether to replace a computer

system with a new model. The company forecasts net before tax cost savings

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from the new computer system over five years given as follows (in `‘000). The company uses straight line method of depreciation and falls within 40% tax bracket.

Year t1 t2 t3 t4 t5

`(000) 350 350 300 300 300

(a) The new computer system costs `1 million. In addi on, the old computer can be sold for `450,000. The old computer was purchased at `1.25 million three years before (depreciable life is 5 years). What is the net investment required in the new system?

(b) Es mate the incremental cash fl ow associated with the new system?16. Pai Cornflakes Ltd wishes to capitalize the consumers’ concern about healthy

food. It is considering a new cereal ‘Veggie Flakes’ which contains small bits of cooked vegetables with cornflakes. The various teams involved in this project forecast the following demand and costs presented as follows:(a) Sales revenue for the fi rst year will be `200,000 and will increase to

`1,000,0000 the next year. Revenue will then grow by 15% a year for the next four years, remain the same ll the seventh year, and then decline by 15% a year for the next three years, and then the product will be terminated.

(b) Cost of goods sold will be 60% of sales.(c) Adver sing and general expenses will be `100,000 per year.(d) Equipment will be purchased today for `1,250,000 and will be depreci-

ated over a 10-year period using straight line method. Installa on cost is `25,000, which is depreciable over the next fi ve years on straight line basis. The equipment has no salvage value. Other ini al costs (which are expenses, not depreciable) total to `875,000.

Compute the net income and operating cash flow assuming that the company is in 40% tax bracket.

Project Assignments

Approach a private or public limited company near your place and obtain infor-mation about the capital budgeting practices of that firm and analyze the same in the context of the discussion that we have had in this chapter.

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CASE STUDIES

Case 1 Supreme Plas cs Company

Supreme Plastics Company is planning to replace their existing machine with a new one. The new machine costs `1,200,000 and requires additional cost of `1,50,000 towards transportation, insurance, and installation. The life of the new machine is five years. The existing machine can be sold for `2,50,000 before taxes. It is two years old, and was bought for `7,00,000, and the current book value is `5,00,000. It was depreciated on a straight line method for its useful life of seven years. If it is retained for five more years, the machine’s market value at the end of five years will be zero. If the new machine is bought, during its life of five years, it will reduce the operating cost by `3,00,000 every year. From earlier research and calculations, it is found that the new machine can be sold for `2,00,000 net of removal and clean-up costs at the end of five years. It is also observed that if a new machine is bought, it will enhance the working capital requirements by `35,000. Assume that the company has 12 per cent cost of capital and is in the tax bracket of 40 per cent.

Questions:

1. As manager of the company, make a recommendation as to whether the new machine should be bought or not depending on the relevant cash flows, NPV, and IRR of the proposal.

2. Also explain to the management what the highest cost of capital would be that the firm could have and still accept the project.

Case 2 Gujarat Tool and Dye Makers

Gujarat Tool and Dye Makers is considering replacing one of its lathes with either of the two new lathes—Heavy Duty All Geared Precision Lathe (HDAGPL) model or All Geared Precision Lathe (AGPL) model. The HDAGPL is heavy duty, fully automated, and expensive, whereas AGPL is less expensive and semi-automatic one. To analyze these alternatives, Patel, the chief financial officer, prepared esti-mates of the initial investments and incremental cash flows associated with each lathe machine model, which are given in Table 4.16.

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Table 4.16 Cash flows

(Figures in `)

HDAGPL AGPL

Ini al investment 660,000 360,000

Years Cash fl ows

1 1,28,000 88,0002 1,82,000 1,20,0003 1,66,000 96,0004 1,68,000 86,000

5 4,40,000 2,00,000

Patel plans to analyze both the lathes over a period five years; so at the end of the fifth year, the lathes could be sold, thus accounting for higher cash inflows.Patel feels that the two lathes are equally risky and, therefore, the acceptance of either of the lathe will not alter the company’s risk and he also decides to apply company’s 13 per cent cost of capital when analyzing the lathes. As a matter of policy, the company requires all projects to have a maximum payback period of four years.

Questions:

1. Use the payback period to assess the acceptability and relative ranking of each lathe.

2. Assuming equal risk, use the following sophisticated capital budgeting tech-niques to assess the acceptability and relative ranking of each lathe.

(a) NPV method (b) IRR method3. Summarize the preferences indicated by the techniques used in parts (i) and

(ii). Do the projects have conflicting rankings?4. Explain the plausible reasoning for such conflicting rankings?5. Using your findings in questions 1 to 5, indicate, on both (i) theoretical basis

and (ii) practical basis, which lathe would be preferred. Explain any differ-ences in recommendations.

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Documents

64 SFM Marketing Sample Ch04