4.

2 Making Capital Investment Decisions/ Estimation of Project Cash Flows

Illustration 1
Cash Enterprises is considering a capital project about which the following information is
available:

 The investment outlay on the project will be Rs 100 million. This consists of Rs 80
million on the plant and machinery and Rs 20 million on net working capital. The entire
outlay will be incurred at the beginning of the project.
 The project will be financed with Rs 45 million of equity capital, Rs 5 million of
preference capital, and Rs 50 million of debt capital. Preference capital will carry a
dividend rate of 15 %; debt capital will carry an interest rate of 15 %.
 The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will
fetch a net salvage value of Rs 30 million, whereas net working capital will be liquidated
at its book value.
 The project is expected to increase the revenues of the firm by Rs 120 million per year.
The increase in costs on account of the project is expected to be Rs 80 million per year.
(This includes all items of costs other than depreciation, interest and tax). The effective
tax rate will be 30 %.
 Plant and machinery will be depreciated at the rate of 25 % per year as per the written
down value method. Hence, the depreciation charges will be:
First year : Rs 20.00 million
Second year : Rs 15.00 million
Third year : Rs 11.25 million
Fourth year : Rs 8.44 million
Fifth year : Rs 6.33 million
Given the above details, the project cash flows are shown below:

Illustration 2
Pharma Ltd is engaged in the manufacture of pharmaceuticals. The company was established in
1991 and has registered a steady growth in sales since then. Presently, the company manufactures
16 products and has an annual turnover of Rs 2200 million. The company is considering the
manufacture of a new antibiotic preparation, K-cin, for which the following information has been
gathered.
1. K-cin is expected to have a product life cycle of five years and thereafter it would be
withdrawn from the market. The sales from this preparation are expected to be as follows:
Year Sales (in million Rs)
1 100
2 150
3 200
4 150
5 100
2. The capital equipment required for manufacturing K-cin is Rs 100 million and it will be
depreciated at the rate of 25 % per year as per the WDV method for tax purposes. The
expected net salvage value after 5 years is Rs 20 million.
3. The working capital requirement for the project is expected to be 20 % of sales. At the
end of 5 years, working capital is expected to be liquidated at par, barring an estimated
loss of Rs 5 million on account of bad debt. The bad debt loss will be a tax deductible
expense.
4. The accountant of the firm has provided the following cost estimates for K-cin:
Raw material cost : 30 % of sales
Variable labor cost : 20 % of sales
Fixed annual operating and maintenance cost : Rs 5 million
Overhead allocation (excluding depreciation,
Maintenance and interest ) : 10 % of sales
While the project is charged on an overhead allocation, it is not likely to have any effect
on overhead expenses as such.
5. The manufacturer of K-cin would also require some of the common facilities of the firm.
The use of these facilities would call for reduction in the production of other
pharmaceutical preparations of the firm. This would entail a reduction of Rs 15 million of
contribution margin.
6. The tax rate applicable to the firm is 40 %.
Hints:
 The loss of contribution is an opportunity cost
 Overhead expenses allocated to the project have been ignored as they do not
represent incremental overhead expenses for the firm as a whole.
 It is assumed that the level of working capital is adjusted at the beginning of the
year in relation to the expected sales for the year. For example, working capital at
the beginning of the year 1 (i.e. at the end of year 0) will be Rs 20 million, that is
20 % of the expected revenues of Rs 100 million for year 1. Likewise, the level of
working capital at the end of year 1 (i.e. at the beginning of year 2) will be Rs 30
million that is 20 % of the expected revenues of Rs 150 million for year 2.
 Illustration 3 (Replacement Project)

Ojus Enterprises is determining the cash flow for a project involving replacement of an old
machine by a new machine. The old machine, bought a few years ago, has a book value of Rs
400,000 and it can be sold to realize a post-tax salvage value of Rs 500, 000. It has a remaining
life of 5 years after which its net salvage value is expected to be Rs 160,000. It is being
depreciated annually at a rate of 25 % under the WDV method. The working capital required for
the old machine is Rs 400,000.
The new machine costs Rs 1,600,000. It is expected to fetch a net salvage of Rs 800,000 after 5
years when it will no longer be required. The depreciation rate applicable to it is 25 % under the
written down value method. The net working capital required for the new machine is Rs 500,000.
the new machine is expected to bring a saving of Rs 300,000 annually in manufacturing costs
(other than depreciation). The tax rate applicable to the firm is 40 %.

Given the above information, the incremental after-tax cash flow associated with the replacement
project has been worked out below: