Holooly Plus Logo

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.

Step-by-Step
The 'Blue Check Mark' means that this solution was answered by an expert.
Learn more on how do we answer questions.

Recommendation: The proposal is not financially viable.

Determination \>of\> CFAT
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)
Determination \>of\> NPV\> assuming \>CFAT\> are\> received \>uniformly \>throughout \>the\> year.
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.

Related Answered Questions