Question 5.S2.RQ.19: ABC Ltd manufactures toys and other short-lived fad items. T......
ABC Ltd manufactures toys and other short-lived fad items. The research and development department has come up with an item that would make a good promotional gift for office equipment dealers.
As a result of efforts by the sales personnel, the firm has commitments for this product.
To produce the quantity demanded, ABC Ltd will need to buy additional machinery and rent additional space. It appears that about 25,000 sq. ft. will be needed; 12,500 sq. ft. of presently unused space, but leased at the rate of Rs 3 per sq. ft. per year, is available. There is another 12,500 sq. ft. adjoining the facility available at the annual rent of Rs 4 per sq. ft.
The equipment will be purchased for Rs 9,00,000. It will require Rs 30,000 in modifications and Rs 1,50,000 for installation. The equipment will have a salvage value of about Rs 2,80,000 at the end of the third year. It is subject to 25 per cent depreciation on reducing balance basis. The firm has no other assets in this block. No additional general overhead costs are expected to be incurred.
The estimates of revenues and costs for this product for the 3 years have been developed as follows:
If the company sets a required rate of return of 20 per cent after taxes, should this project be accepted?
| Particulars | Year 1 | Year 2 | Year 3 |
| Sales | Rs 10,00,000 | Rs 20,00,000 | Rs 8,00,000 |
| Less costs: | |||
| Material, labour and overhead incurred | 4,00,000 | 7,50,000 | 3,50,000 |
| Overheads allocated | 40,000 | 75,000 | 35,000 |
| Rent | 50,000 | 50,000 | 50,000 |
| Depreciation | 2,70,000 | 2,02,500 | Nil |
| Total costs | 7,60,000 | 10,77,500 | 4,35,000 |
| Earnings before taxes | 2,40,000 | 9,22,500 | 3,65,000 |
| Less taxes | 84,000 | 3,22,875 | 1,27,750 |
| Earnings after taxes | 1,56,000 | 5,99,625 | 2,37,250 |
Recommendation: The projected should be accepted.
Cash outflows
| Cost of equipment | Rs 9,00,000 |
| Modification cost | 30,000 |
| Installation cost | 1,50,000 |
| 10,80,000 |
Cash inflows-operating
| Particulars | Year 1 | Year 2 | Year 3 |
| Sales revenue | Rs 10,00,000 | Rs 20,00,000 | Rs 8,00,000 |
| Less relevant/incremental cost: | |||
| Material, labour and overhead incurred | 4,00,000 | 7,50,000 | 3,50,000 |
| Rent payable | 50,000 | 50,000 | 50,000 |
| Rent sacrificed | 37,500 | 37,500 | 37,500 |
| Depreciation | 2,70,000 | 2,02,500 | Nil |
| Earnings before taxes | 2,42,500 | 9,60,000 | 3,62,500 |
| Less taxes | 84,875 | 3,36,000 | 1,26,875 |
| Earnings after taxes | 1,57,625 | 6,24,000 | 2,35,625 |
| Add depreciation | 2,70,000 | 2,02,500 | Nil |
| CFAT | 4,27,625 | 8,26,500 | 2,35,625 |
Net present value
| Particulars | Year | Amount (at 0.20) |
PV factor | Total PV |
| Cash outflows | t = 0 | Rs (10,80,000) | 1.000 | Rs (10,80,000) |
| Operating CFAT | 1 | 4,27,625 | 0.833 | 3,56,212 |
| Operating CFAT | 2 | 8,26,500 | 0.694 | 5,73,591 |
| Operating CFAT | 3 | 2,35,625 | 0.579 | 1,36,427 |
| Salvage value | 3 | 2,80,000 | 0.579 | 1,62,120 |
| Tax advantage on short-term capital | ||||
| loss (Rs 3,27,500 ¥ 0.35) | 3 | 1,14,625 | 0.579 | 66,368 |
| NPV | 2,14,718 |