Reference no: EM133305504

The project is estimated to be of 10 years duration. It involves setting up new machinery with an estimated cost of as much as INR 500 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 INR 15 million. The project would require an initial working capital of INR 20 million with cumulative investment in net working capital to be maintained at 10% of each year's projected revenue. With the planned new capacity, the company would be able to produce 240,000 pieces of shirts each year for the next 10 years. In terms of pricing, each shirt can initially be sold at INR 1,300 apiece, 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:

Funding 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% by Saurabh. 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: Scenario Annual demand Optimistic 240,000 Shirts Expected 200,000 Shirts

Questions

1. Why are capital budgeting decisions important for a business ?rm? Discuss their concept and significance.

2. List the types of information generally required for evaluating the capital budgeting decisions of a firm from a ?nancial standpoint.

3. What is meant by the Net Present Value (NPV) technique? Discuss its key assumptions and calculation methodology (including an estimation of the discount rate).

4. Explain the concept of the Internal Rate of Return (IRR). What is the criterion generally used by firms while accepting or rejecting a capital budgeting project on the basis of the IRR technique?

5. On the basis of the ?nancial 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.

6. Based on your analysis, as Saurabh Sharma, 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.