CHAPTER 12

MINICASE 1

Metaland is a major manufacturer of light commercial vehicles. It has a very strong R&D
centre which has developed very successful models in the last fifteen years. However,
two models developed by it in the last few years have not done well and were
prematurely withdrawn from the market.
The engineers at its R&D centre have recently developed a prototype for a new
light commercial vehicle that would have a capacity of 4 tons.
After a lengthy discussion, the board of directors of Metaland decided to carefully
evaluate the financial worthwhileness of manufacturing this model which they have
labeled Meta 4.
You have been recently hired as the executive assistant to Vijay Mathur, Managing
Director of Metaland. Vijay Mathur has entrusted you with the task of evaluating the
project.
Meta 4 would be produced in the existing factory which has enough space for one
more product. Meta 4 will require plant and machinery that will cost Rs.400 million. You
can assume that the outlay on plant and machinery will be incurred over a period of one
year. For the sake of simplicity assume that 50 percent will be incurred right in the
beginning and the balance 50 percent will be incurred after 1 year. The plant will
commence operation after one year.
Meta 4 project will require Rs.200 million toward gross working capital. You can
assume that gross working capital investment will occur after 1 year.
The proposed scheme of financing is as follows : Rs.200 million of equity, Rs.200
million of term loan, Rs.100 million of working capital advance, and Rs.100 million of
trade credit. Equity will come right in the beginning by way of retained earnings. Term
loan and working capital advance will be raised at the end of year 1.
The term loan is repayable in 8 equal semi-annual instalments of Rs.25 million
each. The first instalment will be due after 18 months of raising the term loan. The
interest rate on the term loan will be 14 percent.
The levels of working capital advance and trade credit will remain at Rs.100 million
each, till they are paid back or retired at the end of 5 years, after the project commences,
which is the expected life of the project. Working capital advance will carry an interest
rate of 12 percent.

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 Meta 4 project is expected to generate a revenue of Rs.750 million per year. The
operating costs (excluding depreciation and taxes) are expected to be Rs.525 million per
year.
For tax purposes, the depreciation rate on fixed assets will be 25 percent as per the
written down value method. Assume that there is no other tax benefit.
The net salvage value of plant and machinery is expected to be Rs.100 million at
the end of the project life. Recovery of working capital will be at book value.
The income tax rate is expected to be 30 percent.
Vijay Mathur wants you to estimate the cash flows from three different points of
view:

a. Cash flows from the point of all investors (which is also called the explicit cost
funds point of view).
b. Cash flows from the point of equity investors.

Solution:
Cash Flows from the Point of all Investors
Item 0 1 2 3 4 5 6

1. Plant and equipment (200) (200)

2. Net working capital (100)
3. Revenue 750 750 750 750 750
4. Operating costs 525 525 525 525 525
5. Depreciation 100 75 56.3 42.2 31.6
6. Profit before tax 125 150 168.7 182.8 193.4
7. Profit after tax 87.5 105 118.1 128.0 135.4
(0.7 x 6)
8. Net salvage value 100
of plant and
equipment
9. Recovery of net
working capital 100
10. Initial investment (200) (300)
11. Operating cash
flow (7 + 5) 187.5 180 174.4 170.2 167
12. Terminal cash
inflow 200

13. Net cash flow (200) (300) 187.5 180 174.4 170.2 367

131
 Cash Flows from the Point of Equity Investors

Item 0 1 2 3 4 5 6

1. Equity funds (200)

2. Revenues 750 750 750 750 750
3. Operating costs 525 525 525 525 525
4. Depreciation 100 75 56.3 42.2 31.6
5. Interest on
working capital 12 12 12 12 12
6. Interest on term loan 28 26.3 19.3 12.3 5.3
7. Profit before tax 85 111.7 137.4 158.5 176.1
8. Profit after tax 59.5 78.2 96.2 111 123.3
9. Net salvage value of
plant & equipment 100
10. Recovery of working
capital 200
11. Repayment of term
loans 50 50 50 50
12. Repayment of
working capital
advance 100
13. Retirement of trade
credit 100

14. Initial investment (1) (200)

15. Operating cash
inflows (8 + 4) 159.5 153.2 152.5 153.2 154.9
16. Liquidation &
retirement cash
flows (50) (50) (50) 50
(9 + 10 – 13 – 14 – 15)

17. Net cash flow (200) - 159.5 103.2 102.5 103.2 204.9

132
 MINICASE 2

Max Drugs Limited is a leader in the bulk drug industry. It manufactures a range of bulk
drugs, technically called APIs (active pharmaceutical ingredients). Max is considering a
new bulk drug called MBD-9.
You have recently joined Max as a finance officer and you report to Prakash Singh,
Vice President (Finance), who coordinates the capital budgeting activity. You have been
asked to develop the financials for MBD-9.
After discussing with marketing, technical, and other personnel, you have gathered
the following information.
The MBD-9 project has an economic life of 5 years. It would generate a revenue of
Rs.50 million in year1 which will rise by Rs.10 million per year for the following two
years. Thereafter, revenues will decline by Rs.10 million per year for the remaining two
years. Operating costs (costs before depreciation, interest, and taxes) will be 60 percent of
revenues. MBD-9 is expected to erode the revenues of an existing bulk drug. Due to this
erosion there will be a loss of Rs.4 million per year by way of contribution margin for
5 years. While there may be some other impacts as well, they may be ignored in the
present analysis.
MBD-9 will require an outlay of Rs.40 million in plant and machinery right in the
beginning. The same will be financed by equity and term loan in equal proportions. The
term loan will carry an interest of 8 percent per annum and will be repayable in 4 equal
annual instalments, the first instalment falling due at the end of year 1.
For tax purposes, the depreciation rate will be 15 percent as per the written down
value method. The net salvage value of plant and machinery after 5 years is expected to
be Rs.20 million.
The net working capital requirement will be 20 percent of revenues. Assume that
the investment in net working capital will be made right in the beginning of each year and
the same will be fully financed by working capital advance carrying an interest rate of 10
percent per annum. At the end of 5 years the working capital is expected to be liquidated
at par. The effective tax rate is 30%

Required

1. Estimate the net cash flows relating to explicit cost funds (investor claims) over
the 5-year period.
2. Estimate the net cash flows relating to equity over the 5-year period.

133
Solution:

Net Cash Flows Relating to Explicit Cost Funds

(Rs.in million)
0 1 2 3 4 5
1. Fixed assets (40.0)
2. Net working (10.0) (2.0) (2.0) 2.0 2.0
capital
3. Revenues 50.0 60.0 70.0 60.0 50.0
4. Operating costs 30.0 36.0 42.0 36.0 30.0
5. Loss of contribution 4.0 4.0 4.0 4.0 4.0
margin
6. Depreciation 6.0 5.1 4.34 3.68 3.13
7. Profit before tax 10.0 14.9 19.66 16.32 12.87
8. Tax 3.0 4.47 5.90 4.90 3.86
9. Profit after tax 7.0 10.43 13.76 11.42 9.01
10. Net salvage value of 20.0
fixed assets
11. Recovery of 10.0
working capital
12. Initial outlay & (50.0) (2.0) (2.0) 2.0 2.0
working capital
13. Operating cash 13.0 15.53 18.10 15.1 12.14
flow (9 + 6)
14. Terminal cash inflow 30.00
(10 + 11)
15. Net cash flow (50.0) 11.0 13.53 20.10 17.1 42.14
:

134
 Net Cash Flows Relating to Equity(Rs.in million)
0 1 2 3 4 5
1. Equity funds (20.0) - - - - -
2. Revenues 50.0 60.0 70.0 60.0 50.0
3. Operating costs 30.0 36.0 42.0 36.0 30.0
4. Loss of contribution 4.0 4.0 4.0 4.0 4.0
margin
5. Depreciation 6.0 5.1 4.34 3.68 3.13
6. Interest on working 1.0 1.2 1.40 1.20 1.00
capital advance
7. Interest on term 1.6 1.2 0.8 0.4 -
loan
8. Profit before tax 7.4 12.5 17.46 14.72 11.87
9. Tax 2.22 3.75 5.24 4.42 3.56
10. Profit after tax 5.18 8.75 12.22 10.30 8.31
11. Net salvage value of 20.0
fixed assets
12. Net salvage value of 10.0
current assets
13. Repayment of term 5.0 5.0 5.0 5.0 -
loan
14. Repayment of working 10.0
capital advance
15. Initial investment (1) (20.0) - - - - -
16. Operating cash flows 11.18 13.85 16.56 13.98 11.44
(10 + 5)
17. Liquidation &
retirement cash flows (5.0) (5.0) (5.0) (5.0) 20.0
(11 + 12 – 13 – 14)
18. Net cash flow (20.0) 6.18 8.85 11.56 8.98 31.44
(15+16+17)

135
 MINICASE 3

Medipharm, a pharmaceutical company, is considering the manufacture of a new

antibiotic preparation, M-cin, for which the following information has been gathered.
 M-cin is expected to have a product life cycle of five years and thereafter it would
be withdrawn from the market. The sales from this preparation are expected to be
as follows:

Year Sales ( Rs in million)

1 50
2 100
3 150
4 100
5 50

 The capital equipment required for manufacturing M-cin will cost Rs.80 million
and it will be depreciated at the rate of 25 percent per year as per the WDV
method for tax purposes. The expected net salvage value of the capital equipment
after 5 years is Rs.20 million.
 The net working capital requirement for the project is expected to be 25 percent of
sales. The net working capital will be adjusted at the beginning of the year in
relation to the expected sales for the year. For example, the net working capital at
the beginning of year 1 (i.e at the end year 0) will be Rs.12.5 million, that is 25
percent of the expected revenue of Rs.50.0 million for year 1.
 The accountant of the firm has provided the following cost estimates for M-cin :
Raw material cost : 40 percent of sales
Variable labour cost : 10 percent of sales
Fixed annual operating: Rs.4 million
and maintenance cost
Overhead allocation : 10 percent of sales
(excluding depreciation
maintenance, and interest)
While the project is charged an overhead allocation , it is not likely to
have any effect on overhead expenses as such.
 The manufacture of M-cin would use some of the common facilities of the firm.
The use of these facilities will necessitate reducing the production of other
pharmaceutical preparations of the firm. This will mean a reduction of Rs.10
million of contribution margin from those preparations.
 The tax rate applicable for this project is 30 percent.

(a) Estimate the post-tax incremental cash flows of the project viewed from the
point
of all investors(which is also called the explicit cost funds point of view).

(b) To calculate the cash flows from the point of equity investors, what additional
information would you need ?

136
Solution:

Cash Flows from the Point of All Investors

Item 0 1 2 3 4 5

1. Fixed assets (80)

2. Net working capit-
al level 12.5 25.0 37.5 25.0 12.5 –
3. Investment in net
working capital (12.5) (12.5) (12.5) 12.5 12.5 –
4. Sales 50.00 100.00 150.00 100.00 50.00
5. Raw material cost 20.00 40.00 60.00 40.00 20.00
6. Variable labour
cost 5.00 10.00 15.00 10.00 5.00
7. Fixed annual oper-
ating cost 4.00 4.00 4.00 4.00 4.00
8. Depreciation 20.00 15.00 11.25 8.44 6.33
9. Loss of contribu-
tion margin 10.00 10.00 10.00 10.00 10.00
10. Profit before tax ( 9.00) 21.00 49.75 27.56 4.67
11. Profit after tax (6.30) 14.70 34.83 19.29 3.27
12. NSV of fixed
assets 20.00
13. Recovery of NWC
at the end 12.5

14. Initial investment

in fixed assets (80)
15.  Inv. In NWC (12.5) (12.5) (12.5) 12.5 12.5
16. Cash flow from
operation (11+8) 13.7 29.70 46.08 27.73 9.60
17. Terminal cash
flow (12+13) 32.5

Net Cash Flow (92.5) 1.20 17.20 58.58 40.23 42.10

b. The additional information needed for calculating the cash flow from the point of
view of equity investors are:
 Equity funds committed to the project
 Interest cost on all borrowings
 Repayment /retirement schedule of all borrowings and trade creditors
 Net salvage value of all current assets
 Preference dividend and redemption of preference capital

137
 MINICASE 4

Zesna Auto Ltd is considering the manufacture of a new bike, Gale, for which the
following information has been gathered.

Gale is expected to have a product life cycle of five years after which it will be
withdrawn from the market. The sales from this product is expected to be as follows:
Year 1 2 3 4 5
Sales (Rs. in million) 700 850 1100 1000 800

• The capital equipment required for manufacturing Gale costs Rs.600 million and
it will be depreciated at the rate of 25 percent per year as per the WDV method
for tax purposes. The expected net salvage value after 5 years is Rs.100 million.
• The working capital requirement for the project is expected to be 10% of sales.
Working capital level will be adjusted at the beginning of the year in relation to
the sales for the year. At the end of five years, working capital is expected to be
liquidated at par, barring an estimated loss of Rs.5 million on account of bad debt,
which of course, will be tax-deductible expense.
• The accountant of the firm has provided the following estimates for the cost of
Gale.
Raw material cost : 40 percent of sales
Variable manufacturing cost : 20 percent of sales
Fixed annual operating and : Rs.2.5 million
maintenance costs
Variable selling expenses : 15 percent of
sales
 The tax rate for the firm is 30 percent.

Required:

(a) Estimate the post-tax incremental cash flows for the project to manufacture
Gale.
(b) What is the NPV of the project if the cost of capital is 18 percent?

138
Solution:

Cash flows for the Gale Project

(Rs. in million)
Year 0 1 2 3 4 5
1. Capital equipment 600
2. Level of working capital 70 85 110 100 80 -
3. Revenues 700 850 1100 1000 800
4. Raw material cost 280 340 440 400 320
5. Variable manufacturing cost 140 170 220 200 160
6. Operating and maintenance cost 2.5 2.5 2.5 2.5 2.5
7. Variable selling expenses 105 127.5 165 150 120
8. Depreciation 150 112.5 84.4 63.3 47.5
9. Bad debt loss 5
10.Profit before tax 22.5 97.5 188.1 184.2 145.0
11.Tax 6.8 29.25 56.4 55.3 43.5
12.Profit after tax 15.7 68.25 131.7 128.9 101.5
13.Net Salvage Value of Capital 100
Equipment
14.Recovery of Working Capital 75
15.Initial Investment (600)
16.Operating cash flow (12+8+9) 165.70 180.75 216.1 192.2 154.0
17. Terminal cash flow (13 + 14) 175
18. Working Capital investment (70) (15) (25) 10 20
19. Net cash flow
(15 + 16 + 17 + 18) (670) 150.7 155.75 226.1 212.2 329

150.70 155.75 226.1 212.2 329

(b) NPV = - 670 + + + + +
(1.18) (1.18)2 (1.18)3 (1.18)4 (1.18)5

= - 670 + 127.71 + 111.86 + 137.61 + 109.45 + 143.81

= -39.56

139
 MINICASE 5

Phoenix Pharma is considering the manufacture of a new drug, Torrexin, for which the
following information has been gathered

 Torrexin is expected to have a product life cycle of five years after which it will
be withdrawn from the market. The sales from this drug are expected to be as
follows:

Year 1 2 3 4 5
Sales ( Rs in million) 100 150 200 150 100

 The capital equipment required for manufacturing Torrexin is 120 million and it
will be depreciated at the rate of 25 percent per year as per the WDV method for
tax purposes. The expected net salvage value after 5 years is Rs.30 million
 The working capital requirement for the project is expected to be 20 percent of
sales. Working capital level will be adjusted at the beginning of the year in
relation to the sales for the year. At the end of five years, working capital is
expected to be liquidated at par, barring an estimated loss of Rs.5 million on
account of bad debt which, of course, will be tax-deductible expense
 The accountant of the firm has provided the following estimates for the cost of
Torrexin
Raw material cost : 40 percent of sales
Variable manufacturing : 10 percent of sales
cost
Fixed annual operating and : Rs.8 million
maintenance costs
Variable selling expenses : 10 percent of sales

 The tax rate for the firm is 30 percent

Required :

(a) Estimate the post-tax incremental cash flows for the project to manufacture
Torrexin
(b) What is the NPV of the project if the cost of capital is 15 percent?

140
Solution:

(a)

0 1 2 3 4 5

1. Capital equipment (120)

2. Level of working capital 20 30 40 30 20
(ending)
3. Revenues 100 150 200 150 100
4. Raw material cost 40 60 80 60 40
5. Variable mfrg cost 10 15 20 15 10
6. Fixed annual operating and 8 8 8 8 8
maintenance costs
7. Variable selling expenses 10 15 20 15 10
8. Bad debt loss - - - - 5

9. Depreciation 30 22.5 16.9 12.7 9.5

10. Profit before tax 2 29.5 55.1 39.3 17.5
11. Tax 0.6 8.9 16.5 11.8 5.3
12. Profit after tax 1.4 20.6 38.6 27.5 12.2
13. Net salvage value of capital 30.0
equipment
14. Recovery of working capital 15.0
15. Initial investment (120)
16. Operating cash flow 31.4 43.1 55.5 40.2 26.7
(12 + 8 + 9)
17. ∆ Working capital 20 10 10 (10) (10)
18. Terminal cash flow (13+14) 45.0
19. Net cash flow (140) 21.4 33.1 65.5 50.2 71.7
(15 + 16 + 17 + 18)

21.4 33.1 65.5 50.2 71.7

(b) NPV = - 140 + + + + +
(1.15) (1.15)2 (1.15)3 (1.15)4 (1.15)5

= - 140 + 18.6 + 25.0 + 43.1 + 28.7 + 35.6

= Rs 11.0 million

141
 MINICASE 6

Malabar Corporation is determining the cash flow for a project involving replacement of
an old machine by a new machine. The old machine bought a few years ago has a book
value of Rs.1,200,000 and it can be sold to realise a post tax salvage value of Rs.800,000.
It has a remaining life of four years after which its net salvage value is expected to be
Rs.500,000. It is being depreciated annually at a rate of 20 percent the WDV method. The
working capital associated with this machine is Rs.700,000.
The new machine costs Rs.5,000,000. It is expected to fetch a net salvage value of
Rs.2,500,000 after four years. The depreciation rate applicable to it is 20 percent under
the WDV method. The new machine is expected to bring a saving of Rs.800,000 annually
in manufacturing costs (other than depreciation).The incremental working capital
associated with the new machine is Rs.200,000. The tax rate applicable to the firm is 34
percent.
(a) Estimate the cash flow associated with the replacement project.
(b) What is the NPV of the replacement project if the cost of capital is 15
percent?

Solution:

(a) A. Initial outlay (Time 0)

i. Cost of new machine Rs. 5,000,000

ii. Salvage value of old machine 800,000
iii Incremental working capital requirement 200,000
iv. Total net investment (=i – ii + iii) 4,900,000

B. Operating cash flow (years 1 through 4)

Year 1 2 3 4

i. Post-tax savings in
manufacturing costs 528,000 528,000 528,000 528,000

ii. Incremental
depreciation 760,000 608,000 486,400 389,120

iii. Tax shield on

incremental dep. 258,400 206,720 165,376 132,301

iv. Operating cash

flow ( i + iii) 786,400 734,720 693,376 660,301

14242
 C. Terminal cash flow (year 4)

i. Salvage value of new machine Rs. 2,500,000

ii. Salvage value of old machine 500,000
iii. Recovery of incremental working capital 200,000
iv. Terminal cash flow ( i – ii + iii) 2,200,000

D. Net cash flows associated with the replacement project (in Rs)

Year 0 1 2 3 4
NCF (4,900,000) 786,400 734,720 693,376 2,860,301

(b) NPV of the replacement project

= - 4,900,000 + 786,400 x PVIF (15,1)
+ 734,720 x PVIF (15,2)
+ 693,376 x PVIF (15,3)
+ 2,860,301 x PVIF (15,4)
= - Rs.1,568,050

143
 MINICASE 7

Sangeeta Enterprises is determining the cash flow for a project involving replacement of
an old machine by a new machine. The old machine bought a few years ago has a book
value of Rs.2,800,000 and it can be sold to realise a post tax salvage value of
Rs.2,200,000. It has a remaining life of five years after which its net salvage value is
expected to be Rs.900,000. It is being depreciated annually at a rate of 30 percent the
WDV method. The working capital associated with this machine is Rs.1.000,000.
The new machine costs Rs.8,000,000. It is expected to fetch a net salvage value of
Rs.3,500,000 after five years. The depreciation rate applicable to it is 25 percent under
the WDV method. The new machine is expected to bring a saving of Rs.1,000,000
annually in manufacturing costs (other than depreciation).The incremental working
capital associated with the new machine is Rs.600,000. The tax rate applicable to the firm
is 33 percent.
(a) Estimate the cash flow associated with the replacement project.
(b) What is the NPV of the replacement project if the cost of capital is 14 percent?

Solution:

(a) A. Initial outlay (Time 0)

i. Cost of new machine Rs. 8,000,000

ii. Salvage value of old machine 2,200,000
iii Incremental working capital requirement 600,000
iv. Total net investment (=i – ii + iii) 6,400,000

E. Operating cash flow (years 1 through 4)

Year 1 2 3 4 5

i. Post-tax savings in
manufacturing costs 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
ii. Depreciation on
new machine 2,000,000 1,500,000 1,125,000 843,750 632,813
iii. Depreciation on
old machine 840,000 588,000 411,600 288,120 201,684
iv.Incremental
dereciation 1,160,000 912,000 713,400 555,630 431,129
v.Tax shield on
incremental dep. 382,800 300,960 235,422 183,358 142,273
iv. Operating cash
flow( i +v) 1,382,800 1,300,960 1,235,422 1,183,358 1,142,273

144
 F. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 3,500,000

ii. Salvage value of old machine 900,000
iii. Recovery of incremental working capital 600,000
iv. Terminal cash flow ( i – ii + iii) 3,200,000

G. Net cash flows associated with the replacement project (in Rs)

Year 0 1 2 3 4 5

NCF (6,400,000) 1,382,800 1,300,960 1,235,422 1,183,358 4,342,273

(c) NPV of the replacement project

(6,400,000)+ 1,382,800x PVIF (14,1)+ 1,300,960x PVIF (14,2) + 1,235,422x

PVIF (14,3)+ 1,183,358x PVIF (14,4) +4,342,273x PVIF (14,5)
= - Rs.398,749

8. A machine costs Rs.250,000 and is subject to a depreciation rate of 24 percent

under the WDV method. What is the present value of the tax savings on account
of depreciation for a period of 5 years if the tax rate is 34 percent and the discount
rate is 16 percent?

Solution:

Tax shield (savings) on depreciation (in Rs)

Depreciation Tax shield PV of tax shield
Year charge (DC) =0.34 x DC @ 16% p.a.

1 60,000 20,400 17,586

2 45,600 15,504 11,522

3 34,656 11,783 7,549

4 26,339 8,955 4,946

5 20,017 6,806 3,240

----------
44,843
----------

Present value of the tax savings on account of depreciation = Rs.44,843

145
9. A machine costs Rs.680,000 and is subject to a depreciation rate of 27 percent
under the WDV method. What is the present value of the tax savings on account
of depreciation for a period of 4 years if the tax rate is 36 percent and the discount
rate is 18 percent?

Solution:

Tax shield (savings) on depreciation (in Rs)

Depreciation Tax shield PV of tax shield
Year charge (DC) =0.36 x DC @ 18% p.a.

1 183,600 66,096 56,014

2 134,028 48,250 34,652
3 97,840 35,222 21,437
4 71,423 25,712 13,262
----------
125,365
----------
Present value of the tax savings on account of depreciation = Rs.125,365

14646