In: Finance
Abstract
On September 20, 2016, Santosh Renjit, Senior Vice President of
Ebroo Clothing Company, sat in his office
pondering the new capital budgeting proposal for setting up a
product line of branded shirts. As per
standard company practice, he was required to evaluate the capital
budgeting project using the traditional
Net Present Value (NPV) approach and the Internal Rate of Return
(IRR) criterion and present his findings to
the management committee meeting scheduled for the next week.
Santosh wondered whether this new
proposal would turn out to be a good investment for his company,
which was looking to deploy funds in NPV
positive projects.
Introduction
Atop Santosh Ebroo’s desk was a capital budge5ng and investment
proposal – a new product line of branded
shirts that the committee was considering for launch. As the head
of the finance department, Santosh was
required to work along with his team on a detailed capital
budgeting analysis and present the findings to the
management committee for their approval. As per standard company
practice, each capital budgeting and
investment project was evaluated using the traditional Net Present
Value (NPV) approach and the Internal
Rate of Return (IRR) criterion for determining whether the company
would undertake the project or not.
budgeting traditional Net Present Value (NPV) approach and the
Internal Rate of Return (IRR) criterion. What would be
the basis for calculating the after-tax opera5ng cash flows for the
capital project? How would he arrive at
the depreciation and working capital requirements for computing the
NPV? What would be the basis for
calculating the terminal year cash flows? With all these questions
in mind, Santosh decided to focus on the
proposed capital budgeting project for the next few days.
Indian Retail Market
The Indian retail market is at the cusp of a sweet spot driven by
strong GDP (Gross Domestic Product)
growth, benign inflation, and rising per capita income and
purchasing power of consumers. Currently, the
retail industry accounts for more than ten percent of the Indian
Gross Domestic Product and approximately
eight percent of employment. The industry is expected to nearly
double, from US$600 billion in 2015 to
US$1 trillion by 2020, driven by income growth, urbanization, and
attitudinal shifts (Indian Terrain Annual
Report, 2015–16). It has been es5mated that, by 2030, the Indian
apparel market, in particular, is expected
to grow at a CAGR (compounded annual growth rate) of approximately
10–12%, backed by increasing
affordability on account of an increase in disposable incomes, an
increase in aspirations, and a shift from
unbranded to branded products by the burgeoning middle class. This
trend is likely to be further
accentuated by the rise of e-commerce companies that enable
shopping from anywhere, thereby leading to
increased penetration in small cities and towns (Indian Terrain
Annual Report, 2015–16).
Company Background
Ebroo Clothing is a small, privately-owned clothing company based
in New Delhi, India. It was founded in
1995 by Sumit Ebroo, a retired executive. Since then, the company
has grown steadily by catering to middle
to low income consumers in the Delhi-national Capital Region (NCR).
The company recorded a stellar
growth of 50% in its sales during the last financial year of
2015–16. With a healthy operating margin ratio
and low leverage levels, the company had been able to grow its
profits at a CAGR of 25% during the last 10
years. With a good brand name and healthy financial metrics, the
company was now looking to expand its
footprint to new product lines catering to middle to high income
customers.
Project Investment Proposal Details
The project is estimated to be of 10 years duration. It involves
setting up new machinery with an estimated
cost of as much as INR 500 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 INR 15 million. The project would
require an initial working capital of INR 20 million with
cumulative investment in net working capital to be
maintained at 10% of each year’s projected revenue. With the
planned new capacity, the company would be
able to produce 240,000 pieces of shirts each year for the next 10
years. In terms of pricing, each shirt can
initially be sold at INR 1,300, 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 INR 400 per shirt,
slated to rise by 5% per annum on
account of inflation.
• Other direct manufacturing costs at INR 125 per shirt with an
annual increase of 5% per annum on
account of inflation .
• Selling, general, and administrative expenses (including employee
expenses) at INR 35 million per annum,
expected to increase by 10% each year.
• Deprecia5on expense on the basis of SLM.
• Tax rate is assumed to be 25%.
Funding
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% by Santosh.
He reckons the requisite discounting rate or weighted average cost
of capital (WACC) for NPV and IRR
calculations may be determined with the help of these
assumptions.
Demand Scenario
Although the project proposal estimates a maximum annual production
of 240,000 shirts, Santosh would
like the capital budgeting analysis to be done under two demand
scenarios: Optimistic and Expected. The
likely annual demand estimated under each scenario is as
follows:
Scenario Annual Demand
Optimistic: 240,000 shirts
Expected: 200,000 shirts
Your Mandate
I. 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 applied.
II. Based on your analysis, what recommendation would you make on
whether the company should
undertake the project or not? Clearly specify the decision based on
both the NPV and the IRR criteria.
Solution:
I. 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.
There are two set of excel sheets: First set contains the complete solution along with the detail of the calculation and second set contains excel formulas used for this solution.
Excel sheets showing complete solution and calculation details:
Excel sheets showing the formulas used in above solution:
(Please zoom these sheets for better view of the formulas)
II. Based on your analysis, what recommendation would you make
on whether the company should
undertake the project or not? Clearly specify the decision based on
both the NPV and the IRR criteria.
On the basis of above analysis it is recommended that the company should take the project considering both the Optimistic and Expected Scenarios. The NPV for the project is positive for both the cases that means the project will increase the net worth of the firm so according to NPV rule this project should be undertaken. The IRR for the project is greater than the firm's WACC for both the cases therefore the project will generate higher return as compared to the return required by the capital providers so according to the IRR rule the project should be undertaken.
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