A company is considering the proposal to take up a new project which requires investment of 850 lakhs in plant & machinery and 150 lakhs in…

CA Intermediate · Financial Management and Strategic Management · RTP · January 2025
A company is considering the proposal to take up a new project which requires investment of 850 lakhs in plant & machinery and 150 lakhs in working capital. The project is expected to yield the following Cash flows before tax and depreciation over the next five years: Year Amount (in Lakhs) 1 290 2 320 3 360 4 390 5 270 The desired rate of return from the project is 14% and assets must be depreciated at 20% on a written down value basis. The scrap value at the end of the five-year period may be taken as 140 lakhs. The income tax applicable to the company is 20%. This is the only asset in the entire block. Capital gains tax is at 15% (for capital loss as well) You are required to CALCULATE the net present value of the project and advise the management to take appropriate decisions. Also calculate the Internal Rate of Return and Desirability factor of the Project. Note: Present values of Re. 1 at different rates of interest are as follows: Year 14% 16% 20% 1 0.88 0.86 0.83 2 0.77 0.74 0.69 3 0.67 0.64 0.58 4 0.59 0.55 0.48 5 0.52 0.48 0.40

Suggested Answer and Working Notes:

(A) Calculation of NPV WN 1: Calculation of Present Value of Cash Outflow (PV CO) (i) Initial Investment = 850 lakhs (ii) Working capital outlay = 150 lakhs Therefore, total PV CO = 1000 lakhs WN 2: Calculation of Present Value of Cash Inflows (PV CI) Cash flows before tax are given i.e. nothing but NPBDT Year 1 2 3 4 5 NPBDT 290.00 320.00 360.00 390.00 270.00 (-) Dep 170.00 136.00 108.80 87.04 69.63 NPBT 120.00 184.00 251.20 302.96 200.37 (-) Tax 24.00 36.80 50.24 60.59 40.07 NPAT 96.00 147.20 200.96 242.37 160.29 (+) Dep 170.00 136.00 108.80 87.04 69.63 CFAT 266.00 283.20 309.76 329.41 229.93 (+) Working Capital Release 150.00 (+) Scrap 140.00 PV Factor @ 14% 0.88 0.77 0.67 0.59 0.52 PV CI 234.08 218.06 207.54 194.35 270.36 (i) Total PV CI = 1124.40 Lakhs WN 3: Calculation of Present Value of tax savings on short term Capital loss in Lakhs WDV at end of 5th year 278.53 (-) Sale value 140.00 Loss on sale 138.53 Tax savings on above @ 15% 20.78 PV of tax savings on short term capital loss (STCL) = Tax saving x PV factor (14%, 5th year) = 20.78 x 0.52 = 10.81 lakhs NPV = PV CI + PV of tax savings on STCL - PV CO = 1124.40 + 10.81 - 1000 NPV = 135.20 lakhs Advise: Since the NPV of the project is positive, project should be accepted (B) Calculation of IRR IRR is that discounting rate where NPV = 0 (point where PV of all CI = PV Co) We know that @ 14%, NPV is 135.20, so by trial-and-error method we need to calculate that rate where NPV equals 0. When Discounting rate is 16% 1 2 3 4 5 CFAT 266.00 283.20 309.76 329.41 229.93 (+) Working Capital Release 150.00 (+) Scrap 140.00 PV Factor @ 14% 0.86 0.74 0.64 0.55 0.48 PV CI 228.76 209.57 198.25 181.17 249.56 PV CI = 1067.31 (+) PV of tax savings on STCL = 9.97 {20.78 x 0.48} (-) PV CO = (1000) NPV = 77.29 Since NPV is positive at 16% as well, we need to go for Trial II at 20% When Discounting rate is 20% 1 2 3 4 5 CFAT 266.00 283.20 309.76 329.41 229.93 (+) Working Capital Release 150.00 (+) Scrap 140.00 PV Factor @ 14% 0.83 0.69 0.58 0.48 0.4 PV CI 220.78 195.41 179.66 158.12 207.97 PV CI = 961.94 (+) PV of tax savings on STCL = 8.31 {20.78 x 0.40} (-) PV CO = (1000) NPV = ₹ (29.75) Since NPV is negative at 20%, IRR lies somewhere between 16% and 20% IRR = LR + [NPV at LR / (NPV at LR - NPV at HR)] x (HR - LR) LR = Lower Rate (16% here) HR = Higher Rate (20% here) IRR = 16 + [77.29 / (77.29 - (-29.75))] × (20-16) IRR = 18.89% (C) Calculation of Desirability Factory (Profitability Index) PI = TOTAL PV CI / PV CO PI = 1135.21 / 1000 PI = 1.13521

Topics: Part-A: Financial Management

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