Chapter 3
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 
StepbyStep
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 
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 shortterm capital loss** 
3,73,737  7,27,737  3,41,750 
*No depreciation in terminal year.
**(Rs 3,73,750 × 0.35)
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 shortterm capital loss)  3 
12,35,047  Total present value  
8,60,000

Less cash outflows  
3,75,047  NPV 