Question

The project is estimated to be of 10 years duration. It involves setting up new machinery with an estimated cost of as much as Thai baht (THB) 375 million, including installation. This amount could be depreciated using the straight-line method (SLM) over a period of 10 years with a resale value of THB13.5 million. The project would require an initial working capital of THB 15.5 million. With the planned new capacity, the company would be able to produce 60,000 pieces of shirts each year for the next 10 years. In terms of pricing, each shirt can initially be sold at THB 900 a piece, which takes into account the target segment and competitor pricing. The project proposal incorporates an annual increase of 3% in the price of the shirt to compensate for inflationary impact.

With regards to the raw material costs and other expenses, the project estimated the following details: Raw material cost for manufacturing shirts at THB325 per shirt, slated to rise by 2.5% per annum on account of inflation. Other direct manufacturing costs at THB55 per shirt with an annual increase of 2.5% per annum on account of inflation. Selling, general, and administrative expenses (including employee expenses) at THB 24 million per annum, expected to increase by 6% each year. Depreciation expense on the basis of SLM. Tax rate was assumed to be 30%.

For funding of the expansion project, the promoters agreed to infuse 50% in the form of equity with the rest (50%) being financed from issue of new debt. Based on the current credit position and market scenario, new debt can be raised by the company at 12% per annum. Cost of equity was assumed to be 15%. The requisite discounting rate or weighted average cost of capital (WACC) for NPV and IRR calculations can now be calculated with the help of the above assumptions.

Demand Scenario Although the project proposal estimates maximum annual production of 240,000 shirts, Saurabh decided to do capital budgeting analysis under two demand scenarios: Optimistic and Expected.

The likely annual demand estimated under each scenario is as follows:

Annual demand
Optimistic 60,000
Expected 120,000

A. On the basis of the financial information given in the case, calculate the after-tax operating cash flows, NPV, and IRR under the Optimistic and Expected scenarios. Clearly specify the calculations required for the same.

B. Based on your analysis, as Boon Mee, what recommendation would you make on whether the company should undertake the project or not? Clearly specify the decision based on both the NPV technique as well as the IRR criterion.

Answer 1

Discount rate for the project = WACC calculated as (cost of equity + after-tax cost of debt)/2 since equity and debt are equally weighted.

Discount rate = (15% + 12%*(1-30%))/2 = 11.70%

A). NPV & IRR calculation for optimistic demand of 60,000:

NPV & IRR for expected demand of 120,000:

B). Optimistic demand - NPV and IRR both are negative which means that it will be a loss making project so it should not be undertaken.

Expected demand - NPV is still negative which means the project is still loss making. IRR is positive but less than the discount rate so the project is loss making. It should not be undertaken.

Note: There appears to be some error in the question because optimistic demand cannot be less than expected demand. Please check the figures given in the question.