Question

The Indica Company Indica originally established in 1962 to make toys is now a leading producer of curios and toys. In 1990 the company introduced ‘high flite’ its first line of high-performance balls. The Indica management has sought opportunities in whatever businesses seem to have some potential for cashflow. In 1999 Mahesh, VP of the Indica identified another segment of the sports ball market that looked promising but highly competitive and served by larger manufacturers. The market was for brightly colored radiant balls and he believed a large number of young people valued appearance and style above performance. He also believed that it would be difficult for competitors to take advantage of the opportunity because of Indica’s cost advantages and ability to use its highly developed marketing skills. As a result in late 1999 Indica decided to evaluate the marketing potential of the radiant colored balls. Indica engaged a leading consulting firm to assess the market for the balls. The report of the consulting firm revealed that the market for the brightly colored balls was very good, less competitive and supported the conclusion that the product could achieve a 10 to 15 percent share of the toys market. The cost incurred by Indica towards the consulting fee and other related expenses were Rs. 150,000. Further the consultants indicated that due to this launch Indica’s current sales will be hit by around 10% amounting to Rs 50,000 on a cashflow basis. The Indica is now considering investing in a machine to produce bright colored balls. The balls will be produced in a building owned by the firm. The building is currently vacant and housing the project saves it Rs 10,000 monthly rent. The original purchase price of the property less depreciation is zero. Working with his staff, Mahesh is preparing an analysis of the proposed new product. He summarizes his assumptions in the following table: Cost of Machinery and equipment Rs. 1000,000 Life of the project 5 Estimated market value of the machinery Rs. 150,000 Expected sales (no.s) during the life of the project Year 1 7000 Year 2 10000 Year 3 14000 Year 4 12000 Year 5 8000 The price of the ball in the first year will be Rs. 102 each. The market is competitive so Mahesh believes that the price will increase at only 5% per year. Conversely the raw materials used to produce the colored ball are rapidly growing at 10% per year. Production cost in the first year will be Rs. 50. The management of Indica believes that the investment in the different items of working capital will be Rs. 15,000 and the company is in the 35% tax bracket. Is this project worthwhile at 20% required rate of return?

Answer 1

Initial Outflow:

1. Cost of Machinery: Rs. 10,00,000

2. Working Capital: Rs. 15,000

Cash flows during the year:

Years	Quantity	Price of product	Sale Value	Production Price per product	Production Cost	Profit Before Tax	Hit to other business	Net Inflow
		(increase by 5% each year)	[4=(3*2)]	(increase by 10% each year)	[6=(5*2)]	[7=(4-6)]	(As per consultant report)	[9=(7-8)]
1	2	3	4	5	6	7	8	9
1	7000	102.00	7,14,000.00	50.00	3,50,000.00	3,64,000.00	50,000.00	3,14,000.00
2	10000	107.10	10,71,000.00	55.00	5,50,000.00	5,21,000.00	50,000.00	4,71,000.00
3	14000	112.46	15,74,370.00	60.50	8,47,000.00	7,27,370.00	50,000.00	6,77,370.00
4	12000	118.08	14,16,933.00	66.55	7,98,600.00	6,18,333.00	50,000.00	5,68,333.00
5	8000	123.98	9,91,853.10	73.21	5,85,640.00	4,06,213.10	50,000.00	3,56,213.10

Net Cash flow on account of the project Years Net Inflow Tax Rate Net inflow after tax Discounting Factor Present Value (As per Table 1) [4=(2*(100-35)%] [6=(4*5)] 1 2 3 4 5 1                                   3,14,000.00 35%                   2,04,100.00                                                    0.83           1,70,083.33 2                                   4,71,000.00 35%                   3,06,150.00                                                    0.69           2,12,604.17 3                                   6,77,370.00 35%                   4,40,290.50                                                    0.58           2,54,797.74 4                                   5,68,333.00 35%                   3,69,416.45                                                    0.48           1,78,152.22 5                                   3,56,213.10 35%                   2,31,538.52                                                    0.40              93,050.14 Grand Total           9,08,687.60 Tax saving on Depreciation
Years	Depreciation	Tax saving on depreciation	Discounting Factor	Present Value of saving on Depreciation
	(Refer Note 1)	[3=(2*35%)]	@20%	[5=(3*4)]
1	2	3	4	5
1	1,70,000.00	59,500.00	0.83	49,583.33
2	1,70,000.00	59,500.00	0.69	41,319.44
3	1,70,000.00	59,500.00	0.58	34,432.87
4	1,70,000.00	59,500.00	0.48	28,694.06
5	1,70,000.00	59,500.00	0.40	23,911.72
			Grand total	1,77,946.42	B

Savings at the end of 5th year:

Sale of Machine - 1,50,000*[1/(1.2^5)] = 60,281.64

Release of Working Capital - 15,000*[1/(1.2^5)]=6,028.16

Net Present Value of the Project:

Particulars	Present Value
Inflow from sale of product	9,08,687.60
Tax saving on Depreciation	1,77,946.42
Sale of Machine at the end of 5th year	60,281.64
Release of working capital at the end of 5th year	6,028.16
Initial cost of the Machinery	-10,00,000.00
Initial investment in working capital	-15,000.00
Net Present Value of the Project	1,37,943.82

As the net present value of the project is positive, hence, the project is viable/worthwhile.

Notes:

1. Calculation of depreciation:

Depreciation amount = (Cost of Machine less Salvage Value) / Estimated life of the project

= (1000000-150000) / 5

= 1,70,000 per year

2. The cost incurred by the company towards the consultancy charges is sun cost therefore, should not be considered while calculating net present value of the project.

3. There will be no saving in the tax on account of depreciation of the building as the WDV of the building is NIL. Therefore, the same is also not considered in the calculation.