## Q. 3.PP.42

Toy Enterprises Ltd designs and manufactures toys. Past experience indicates that the product life of a toy is 3 years. Promotional advertising produces an increase in sales in the early years, but there is a substantial sales decline in the final year of a toy’s life.
$\,$  Consumer demand for new toys placed on the market tends to fall into three classes. About 30 per cent of the new toys sell well above expectations, 60 per cent sell as anticipated, and 10 per cent have poor consumer acceptance.
$\,$  A new toy has been developed. The following sales projections were made by carefully evaluating the consumer demand.
$\,$  Variable costs are estimated at 30 per cent of the selling price. Special machinery must be purchased at a cost of Rs 8,60,000 which will be installed in an unused portion of the factory. The company has been trying unsuccessfully for several years to rent out the vacant portion at Rs 50,000 per year. Fixed expenses (excluding depreciation) are estimated at Rs 50,000 per year. The new machinery will be depreciated by the written down value method @ 25 per cent with an estimated value of Rs 1,10,000 at the end of the third year.
Assume this is the only asset in the block. Advertising and promotional expenses will be incurred uniformly, and will total Rs 1,00,000 in the first year, Rs 1,50,000 in the second year, and Rs 50,000 in the third year.
The company is subject to a corporate tax rate of 35 per cent. Its cost of capital is 10 per cent.
(i) Prepare a schedule computing the probable sales of this new toy in each of the three years. Also, determine the NPV of the proposal.
(ii) Assuming that cash flows occur uniformly throughout each year, determine the NPV of the proposal. The present value of Re 1 earned uniformly throughout the year discounted at 10 per cent is as follows:
(iii) Give your recommendations in both the situations.

 $Estimated\>sales\>in\>year\>(Rs\>in\>lakh)$ $Probability\>of\>occurrence$ $Consumer\>demand\>for\>a\>new\>toy$ 3 2 1 6 25 12 0.30 Above average 4 17 7 0.60 Average 1.5 9 2 0.10 Below average
 $Discount\>factor$ $Year$ 0.95 1 0.86 2 0.78 3

## Verified Solution

(iii) Recommendation: The project should be accepted in both the situations.

(i) $Schedule\> showing\> probable \>sales\> of\> the\> new\> toy,\> years\> 1–3 \>(Rs\> in\> lakh)$

 $Probable\>sales\>per\>year$ $Years\>(estimated\>sales)$ $Probability\>of\>occurrence$ $(P_j)$ $Consumer\>demand$ $for\>new\>toy$ 3 2 1 3 2 1 1.80 7.5 3.6 6 25 12 0.30 Above average 2.40 10.2 4.2 4 17 7 0.60 Average 0.15 0.9 0.2 1.5 9 2 0.10 Below average 4.35 18.6 8.0
$Determination\> of \>CFAT$
 $Years$ $Particulars$ $\qquad\qquad\qquad\qquad\qquad\qquad\qquad\qquad\qquad\qquad$ 3 2 1 Rs 4,35,000 Rs 18,60,000 Rs 8,00,000 Probable sales revenue 1,30,500 5,58,000 2,40,000 $Less$ variable costs (0.30) Nil* 1,61,250 2,15,000 $Less$: depreciation 50,000 50,000 50,000 cash fixed costs 50,000 1,50,000 1,00,000 advertising expenses 2,04,500 9,40,750 1,95,000 EBT 71,575 3,29,263 68,250 $Less$ taxes (0.35) 1,32,925 6,11,487 1,26,750 EAT 1,32,925 7,72,737 3,41,750 CFAT (EAT + Depreciation) 1,10,000 — — $Add$ salvage value 1,30,812 — — $Add$ tax savings on short-term capital loss** 3,73,737 7,27,737 3,41,750

*No depreciation in terminal year.
**(Rs 3,73,750 × 0.35)

$Determination\> of\> NPV$
 $Total\>PV$ $PV\>factor\>(0.10)$ $CFAT$ $Year$ Rs 3,10,651 0.909 Rs 3,41,750 1 6,01,111 0.826 7,27,737 2 2,80,676 0.751 3,73,737 3 11,92,438 Total present value 8,60,000 $Less$ cash outflows 3,32,438 NPV

(ii) $Determination \>of\> NPV\> assuming\> CFAT\> occurs\> uniformly \>throughout\> the\> year.$

 $Total\>PV$ $PV\>factor\>(0.10)$ $CFAT$ $Year$ Rs 3,24,662 0.95 Rs 3,41,750 1 6,25,854 0.86 7,27,737 2 1,03,681 0.78 1,32,925 3 82,610 0.751 1,10,000 (salvage value) 3 98,240 0.751 1,32,812(tax savings on short-term capital loss) 3 12,35,047 Total present value 8,60,000 $Less$ cash outflows 3,75,047 NPV