Question

Calmex is situated in North India. It specialises in manufacturing overhead water tanks. The management of Calmex has identified a niche market in certain southern cities that need a particular size of water tank not currently manufactured by the company. The company is thus thinking of producing a new type of tank. The survey of company’s marketing department reveals that the company could sell 1,20,000 tanks each year for 6 years at a price of Rs 700 each. The company’s current facilities cannot be used to manufacture new tanks. Thus it will have to buy new machinery. A manufacturer has offered 2 options to the company.
1st option: Buy 4 small machines with the capacity of manufacturing 30,000 tanks each at Rs 15 million each. The machine operation and manufacturing cost of each tank will be Rs 535.
2nd option: Buy 1 large machine with the capacity of 120000 units p.a. for Rs 120 million. The machine operation and manufacturing cost of each tank will be Rs 400.
The company is looking at raising the required capital through a mix of debt, equity and retained earnings in the proportion of 0.5, 0.25 and 0.25 respectively. The company has just declared a dividend of 15% on equity share of face value of Rs 100 each. The expected future growth rate in dividend is 12% p.a. The equity share is currently trading at a price of Rs 168. The bonds of face value Rs 1000 and coupon rate of 16% p.a. is currently trading at Rs 900. Five years remain to maturity and bonds are redeemable at Rs 1100. Assume the applicable tax rate to be 50%. Which option should the company accept? Use alternative techniques of evaluation (NPV, Payback period and Profitability index).

there is no flotation cost in orginal question

Answer 1

		COST OF CAPITAL:
		Cost of Equity:
		D0=Current Dividend=15%*100=	15
		D1=Next Years dividend=15*1.12=	16.8
		Cost of Equity =Required Return =(D1/P0)+g
		P0=Current Price=168
		g=growth rate of dividend=0.12
	Ce	Cost of Equity=16.8/168+0.12=0.22	22.00%
		Cost of Debt:
	Nper	Number of years to maturity of bonds	5
	Pmt	Annual coupon payment=1000*16%=	160
	Pv	Current market price	900
	Fv	Redeemable price at maturity	1100
	RATE	Yield to maturity(Using RATE function of excel)	20.72%
		Before tax cost of debt	20.72%
	Cd	After tax cost of debt =20.72*(1-tax rate)	10.36%	(20.72*(1-0.5)
	We	Weight of Debt	0.5
	Ce	Weight of Equity	0.5
		Weighted Average Cost of Capital =We*Ce+Wd*Cd	16.2%	(0.5*10.36+0.5*22)
		EVALUATION OF 1st OPTION-4 small machines
	ICF	Initial Cash Flow=15 million*4	(60,000,000)
	Rate	Discount Rate =Cost of Capital	16.2%
	Nper	Number of years of cash inflow	6
	Pmt	Annual Cash inflow=120000*(700-535)	19,800,000
	PV	Present Value of cash inflows	72,610,306
		(Using PV function of excel)
	NPV=PV+ICF	Net Present Value	12,610,306
		Profitability Index=PI=(NPV+Initial Investment)/Initial Investment
		Profitability Index=PI=(12610306+60000000)/60000000	1.21
		Payback Period =Initial investment/Annual cash inflow
		Payback Period =60000000/19800000	3.03	Years
		EVALUATION OF 2nd OPTION-One large machine
	ICF	Initial Cash Flow	(120,000,000)
	Rate	Discount Rate =Cost of Capital	16.2%
	Nper	Number of years of cash inflow	6
	Pmt	Annual Cash inflow=120000*(700-400)	36,000,000
	PV	Present Value of cash inflows	132,018,738
		(Using PV function of excel)
	NPV=PV+ICF	Net Present Value	12,018,738
		Profitability Index=PI=(12018738+120000000)/120000000	1.10
		Payback Period =120000000/36000000	3.33	Years
		Alternative-1 : 4 small machine should be selected
		It has highrer NPV,Higher PI and lower Payback period