Question

The project is estimated to be of 10 years duration. It involves setting up new machinery with an estimated cost of as much as Thai baht (THB) 375 million, including installation. This amount could be depreciated using the straight-line method (SLM) over a period of 10 years with a resale value of THB 13.5 million. The project would require an initial working capital of THB 15.5 million. With the planned new capacity, the company would be able to produce 200,000 pieces of shirts each year for the next 10 years. In terms of pricing, each shirt can initially be sold at THB 900 a piece, which takes into account the target segment and competitor pricing. The project proposal incorporates an annual increase of 3% in the price of the shirt to compensate for inflationary impact.

With regards to the raw material costs and other expenses, the project estimated the following details: Raw material cost for manufacturing shirts at THB 325 per shirt, slated to rise by 2.5% per annum on account of inflation. Other direct manufacturing costs at THB 55 per shirt with an annual increase of 2.5% per annum on account of inflation. Selling, general, and administrative expenses (including employee expenses) at THB 24 million per annum, expected to increase by 6% each year. Depreciation expense on the basis of SLM. Tax rate was assumed to be 30%.

For funding of the expansion project, the promoters agreed to infuse 50% in the form of equity with the rest (50%) being financed from issue of new debt. Based on the current credit position and market scenario, new debt can be raised by the company at 12% per annum. Cost of equity was assumed to be 15%. The requisite discounting rate or weighted average cost of capital (WACC) for NPV and IRR calculations can now be calculated with the help of the above assumptions.

Demand Scenario Although the project proposal estimates maximum annual production of 240,000 shirts, Saurabh decided to do capital budgeting analysis under two demand scenarios: Optimistic and Expected.

The likely annual demand estimated under each scenario is as follows:

Annual demand
Optimistic scenario 200,000
Expected scenario 150,000

A. On the basis of the financial information given in the case, calculate the after-tax operating cash flows, NPV, and IRR under the Optimistic and Expected scenarios. Clearly specify the calculations required for the same.

B. Based on your analysis, as Boon Mee, what recommendation would you make on whether the company should undertake the project or not? Clearly specify the decision based on both the NPV technique as well as the IRR criterion.

Answer 1

Cost of Production :

Fixed Cost of Plant and installation = 375000000

Resale value after 10 years = 13500000

Depreciation Rate using straight line method

= (Initial cost - Resale value)/ Number of useful years

= (375000000-13500000)/10 = 36150000 approx 9.64%

Working capital requirement = 15500000

Annual Production of Shirt 200000

Revenue Per Year (Optimistic Case)

200000*900 = 180000000

Variable Cost of Production:

Raw Material 325

other direct costs 55

Selling Distribution and Administration Cost:

24000000

Calculation of weighted average cost of capital:

K = Cost of Equity * Weightage of Equity + Cost of Debt * Weightage of Debt

= 0.15* 0.5 + 0.12 * 0.5

= 13.5%

Below is the worksheet image of calculations done using the data given in the question

Operating Profit in Best Case : 257969028

Operating Profit in Expected Case : 45861807

Company Should take the project as in best case scenario it would make a profit of 34844004