Question 3.PP.43: A company has spent Rs 75,000 on research in developing a ne......
A company has spent Rs 75,000 on research in developing a new product. The product will be marketed if it promises a risk-adjusted rate of return (applicable to such projects) of at least 25 per cent after taxes. For the purposes of financial analysis, the following information has been collected.
\, 1. The estimated life of the product is 3 years
\, 3. Variable costs to manufacture and sell the product are estimated at 60 per cent of the selling
\, price.
\, 4. The present cash fixed costs will be increased by Rs 10,000 to cover insurance, and maintenance
\, of new equipment.
\, 5. Advertising of the new product will be incurred uniformly, and will total Rs 1,25,000 in the first
\, year, and Rs 75,000 and Rs 60,000 in
\, years 2 and 3, respectively.
\, 6. New machinery will have to be purchased at an estimated cost of Rs 9,60,000. The machinery
\, will be depreciated at the rate of 33.33 per cent on the basis of written down value method
\, of depreciation. The salvage value at the expiry of 3 years is estimated at Rs 1,00,000. There are
\, several other machines in this block of assets.
\, 7. The new machinery will be installed in a factory area now occupied by equipment that can be
\, no longer be used, that is, scrap equipment. The company has already arranged for removal
\, of the old equipment at a cost of Rs 10,000.
\, 8. The new product will be stored in a company owned warehouse in a portion that is vacant now.
\, The company has been trying unsuccessfully to rent this space at Rs 25,000 per year. Several
\, offers have been rejected, the highest rent offer being Rs 15,000 per year, payable uniformly over
\, the year under a 3-year lease.
\, 9. The firm pays 35 per cent tax on its income. It is assumed that these taxes will be paid uniformly
\, as income is earned.
\, 2. Projected sales are as follows:
| Sales\>revenue | Year |
| Rs 15,00,000 | 1 |
| 25,00,000 | 2 |
| 6,00,000 | 3 |
\, 10. PV of Re 1 at a 25 per cent discount rate are as follows:
| Re\>1\>received\>uniformly\>over\>the\>year | Re\>1\>received\>at\>the\>end\>of\>year | Year |
| 0.88 | 0.80 | 1 |
| 0.69 | 0.64 | 2 |
| 0.54 | 0.51 | 3 |
Evaluate the financial implications of the proposal, assuming that the operating cash flows occur uniformly throughout the period of the project’s life.
Recommendation: The proposal is not financially viable.
| Year\>3 | Year\>2 | Year\>1 | Particulars |
| Rs 6,00,000
|
Rs 25,00,000
|
Rs 15,00,000
|
Sales revenue |
| Less \>costs: | |||
| 3,60,000 | 15,00,000 | 9,00,000 | Variable costs (0.60) |
| 10,000 | 10,000 | 10,000 | Incremental fixed costs |
| 60,000 | 75,000 | 1,25,000 | Advertising costs |
| 1,42,222 | 2,13,333 | 3,20,000 | Depreciation (0.333) |
| 15,000
|
15,000
|
15,000
|
Rent (opportunity cost of the space used) |
| 5,87,222
|
18,13,333
|
13,70,000
|
Total costs |
| 12,778 | 6,86,667 | 1,30,000 | EBT |
| 4,472
|
2,40,333
|
45,500
|
Less taxes paid (0.35) |
| 8,306
|
4,46,334
|
84,500
|
EAT |
| 1,50,528 | 6,59,667 | 4,04,500 | CFAT (EAT + Depreciation) |
| Total\>PV | PV\>factor\>(0.25) | CFAT | Year |
| Rs 3,55,960 | 0.88 | Rs 4,04,500 | 1 |
| 4,55,170 | 0.69 | 6,59,667 | 2 |
| 81,285 | 0.54 | 1,50,528 | 3 |
| 51,000
|
0.51 | 1,00,000 (salvage value)* | 4 |
| 9,43,415 | Total present value | ||
| 9,60,000
|
Less cash outflows | ||
| (16,585) | NPV |
*At the beginning of year 4.