Financial Management

Capital Budgeting

Submitted To:Prof. Dr. Meena Sharma

Presented By:Amarinder Singh Manan Sharma Arvind Kumar Indorjot singh Mohit singla MBA General (Sec-A)

Case Study-1

1.

GSPC is a fast growing profitable company.

DETAILS ABOUT G.S.PETROPULL COMPANY:

2.

The company is situated in Western India. Its sales are expected to grow about three times from Rs 360 million in 2003-04 to Rs 1,100 million in 2004-05.
The company is considering of commissioning a 35 km pipeline between two areas to carry gas to a state electricity board. The project will cost Rs 250 million. The pipeline will have capacity of 2.5MMSCM. The company will enter into a contract with the state electricity board (SEB) to supply gas. The revenue from the sale to SEB is expected to be Rs 120 million per annum.

3. 4. 5. 6.

7.The pipeline will also be used for transportation of LNG to other users in the area. This is expected to bring additional revenue of Rs 80 million per annum.

8.The company management considers the useful life of the pipeline to be 20 years.
9.The financial manager estimates cash profit to sales ratio of 20% per annum for the first 12 years of the projects operations and 17% per annum for the remaining life of the project. 10.The project has no salvage value. The project being in a backward area is exempt from paying any taxes. The company requires a rate of return of 15 per cent from the project.

Discussion Questions:
1. What is the projects payback and ARR? 2. Compute the projects NPV and IRR. 3. Should the project be accepted? Why?

Information Extracted From Case

Current sales : Rs 360 million (2009 ) Expected sales : Rs 1,100 million (2010) Future Projects and Revenues:
Gas pipelines : Cost Rs 250 million Revenue from sale to SEB is expected to be Rs 120 million per annum. Additional revenue from transportation of LPG is Rs 80 million per annum. cash profit to sales ratio of 20% per annum for first 12years and 17% per annum for the remaining life of the project. Expected life of the project 20 years. The company requires a rate of return of 15% from the project.

Particulars
Cost of project (Rs million) Revenue from SEB (Rs million) Revenue from other users (Rs million) Total revenue (Rs million)

Cumulative Year Cash Cash flows flows (in mm.) (Rs mm.)
250 120 80 200 40 34 37.6 125 30.1% 0 1 2 3 4 5 6 7 8 9 -250 40 40 40 40 40 40 40 40 40 -250 -210 -170 -130 -90 -50 -10 30 70 110

Cash profit,20% from year 1 to 12 (Rs million) Cash profit, 17% from year 13 to 20 (Rs million) Average cash profit (Rs million)
Average investment (Rs million) ROI ARR

Payback

Discount rate PVFA 12,15% PVFA 20,15% PVFA (20,12),15%

15%

10

40

150

PV of cash profit, year 1 to 12 (Rs million) PV of cash profit, year 13 to 20 (Rs million) NPV (Rs million)

5.4206 6.2593 0.8387 216.82 28.52 -4.66

11 12 13 14 15 16 17 18 19 20

40 40 34 34 34 34 34 34 34 34 -4.66 14.65% >6 years

190 230 264 298 332 366 400 434 468 502

NPV IRR 6 years and 3 months to be precise

Pay back

Q2:Should the project be accepted and why?

ANSWER: We can see from the previous slide that the NPV is negative and Internal rate of return is less than the expected rate of return. Thus, the project should not be accepted.

Case Study-2

Details About Calmex Company

1. Calmex Company Ltd is an overhead water tank manufacturing company situated in North India. 2. The Company is contemplating manufacturing a new type of water tanks for the Southern cities. 3. The Company has two options and both require buying new machinery.

 OPTION 1 :

BUY: 4 Machines CAPACITY:30,000 tanks per year COST: Rs.15 million each MANUFACTURING COST OF TANK: Rs. 535

OPTION 2 : BUY: 1 Machine CAPACITY: 1,20,000 tanks per year. COST: Rs.120 million MANUFACTURING COST OF TANK: Rs.400

 The Company has a required rate of return of 12 percent and it does not pay any taxes.
Problems for Discussion: P.1:- Which option shall the company accept? P.2:- Why do you think that the method chosen by you is the most suitable method in evaluating the proposed investment? Give the computation of the alternative methods.

Considering Alternative-1
Number of tanks 1,20,000

Price (Rs)
Revenue(Rs million)(1,20,000*700) Small machines Cost of four small machines(Rs million) (15 * 4) Op. and mfg. cost(Rs) Total Op. and mfg. cost(Rs million) (0.12 * 535) Net revenue (Rs million) (84 - 64.2) Discount rate

700
84 60 535 64.2 19.8 12%

Project life (years)

PVFA 6, 12% PV of cash inflows (Rs million) (19.8 * 4.114) NPV (Rs million) (81.4 - 60) IRR

6
4.1114 81.4 21.4 24%

Considering Alternative-2
Large machine Cost of large machine (Rs million) Op. and mfg. cost (Rs) Total op. and mfg. cost (Rs million) (0.12 * 400) Net revenue (Rs million) (84-48) Discount rate Project life (years) PVFA 6, 12% PV of cash inflows (Rs million) (36 * 4.114) NPV (Rs million) (148 - 120) IRR 120 400 48 36 12% 6 4.1114 148 28.0 20%

Incremental Approach
Incremental cash flows Cost (Rs million) (120 - 60) Net revenue (Rs million) (36 - 19.8) 60 16.2

Discount rate
Project life (years) PVFA 6, 12% PV of cash inflows (Rs million) (16.2 * 4.114) NPV (Rs million) (66.6 - 60) IRR

12%
6 4.1114 66.6 6.60 16%

INTERPRETATIONS
As we observe from the tables, NPV is greater in case of the alternative of buying the larger machine whereas IRR is greater in the case of alternative of buying smaller machines. This leads to a conflicting situation.

The reason is while the NPV method is based on the total yield/earnings/NPV, IRR are concerned with the rate of return/earnings on investment. .

 The NPV method is conceptually superior to that of the IRR method as the former has the virtue of having a uniform rate which can be consistently applied to all investment proposals.

While IRR method is not compatible with the objective of financial decision making of the firm, the recommendation of NPV is consistent with the goal of the firm of maximizing shareholders wealth.

 The NPV method is the more suitable method of evaluation so we will select the alternative of buying larger machine .
The conflict between NPV and IRR can be resolved by modifying the IRR (by adopting the incremental approach)to give results identical to the NPV method. The logic is that the firm would get the profits promised by the smaller outlay investment project plus the profit on the incremental investments required in the project involving larger outlay.

 As the IRR of differential cash flow exceeds the required rate of return so we would select the project having greater investment outlays. By this convention we would choose the alternative of selecting the larger machine as it involves greater investment outlays.

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