Question 1 OR (b)
New project with rising capacity use: NPV
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 1 OR (b) · 11 marksHIJ Technology Ltd. is considering a new project to manufacture solar energy games kit, involving a capital expenditure of ₹ 720 lakh and working capital of ₹ 180 lakh. The plant's annual production capacity is 14.4 lakh units, and its capacity utilisation over the project's 6-years working life is expected to be as below:
| Year | Capacity Utilisation (%) |
|---|---|
| 1 | 33.33 |
| 2 | 66.67 |
| 3 | 80 |
| 4 | 100 |
| 5 | 100 |
| 6 | 100 |
The product's average price per unit is expected to be ₹ 200, netting a contribution of 40%. Excluding depreciation, the annual fixed costs are estimated at ₹ 576 lakh per annum from the third year onwards; for the first and the second year, they would be ₹ 288 lakh and ₹ 432 lakh respectively. Depreciation is charged @ 33.33% on the written down value (WDV) method. Income tax may be taken at a rate of 35%. The cost of capital is 15%.
An additional investment of ₹ 100 lakh in working capital would be needed at the end of the third year. The terminal value of the fixed assets (sold as scrap) may be taken as 10%, and of the current assets as 100%. Give a suggestion to HIJ Technology Ltd. on taking up the new project. 11
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
What the paper leaves open
The additional working capital is invested at the end of year 3 and, with the initial working capital, recovered in full at the end of year 6. Fixed assets are taken as one asset on the WDV basis at one-third a year (33.33%); the scrap value (10% of cost) is received at the end of year 6, with no tax on the sale (C7). Capacity utilisation of 33.33% and 66.67% is read as one-third and two-thirds. The year-1 loss is taken to save tax, being set off against the company's other income.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Units, contribution and EBDT by year 3 marks 5 min
- 2 WDV depreciation, tax (including the year-1 saving) and cash flows 4 marks 7 min
- 3 Working capital invested and recovered; scrap 2 marks 4 min
- 4 Present values, NPV and suggestion 2 marks 4 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
All figures in ₹ lakh. Readings (paper note): utilisation of 33.33% and 66.67% taken as one-third and two-thirds; depreciation at one-third of WDV; the year-1 loss saves tax, being set off against other income; the extra working capital of 100 is invested at the end of year 3 and all working capital is recovered at the end of year 6; scrap of 10% of cost (72) is received at the end of year 6, untaxed. Contribution per unit = 40% of ₹200 = ₹80. Only incremental cash flows count, and depreciation matters only through its tax saving.
| Year | Units (lakh) | Contribution | Fixed cost | EBDT | Depreciation (1/3 of WDV) | EBT | Tax @ 35% | EAT | Add: depreciation | Cash flow after tax |
|---|---|---|---|---|---|---|---|---|---|---|
| 1 | 4.80 | 384.00 | 288.00 | 96.00 | 240.00 | (144.00) | (50.40) | (93.60) | 240.00 | 146.40 |
| 2 | 9.60 | 768.00 | 432.00 | 336.00 | 160.00 | 176.00 | 61.60 | 114.40 | 160.00 | 274.40 |
| 3 | 11.52 | 921.60 | 576.00 | 345.60 | 106.67 | 238.93 | 83.63 | 155.30 | 106.67 | 261.97 |
| 4 | 14.40 | 1,152.00 | 576.00 | 576.00 | 71.11 | 504.89 | 176.71 | 328.18 | 71.11 | 399.29 |
| 5 | 14.40 | 1,152.00 | 576.00 | 576.00 | 47.41 | 528.59 | 185.01 | 343.58 | 47.41 | 390.99 |
| 6 | 14.40 | 1,152.00 | 576.00 | 576.00 | 31.60 | 544.40 | 190.54 | 353.86 | 31.60 | 385.46 |
| Year | Net cash flow | PV factor @ 15% | Present value |
|---|---|---|---|
| 1 | 146.40 | 0.870 | 127.37 |
| 2 | 274.40 | 0.756 | 207.45 |
| 3 (261.97 − extra working capital 100.00) | 161.97 | 0.658 | 106.58 |
| 4 | 399.29 | 0.572 | 228.39 |
| 5 | 390.99 | 0.497 | 194.32 |
| 6 (385.46 + scrap 72.00 + working capital 280.00) | 737.46 | 0.432 | 318.58 |
| Total present value | 1,182.69 | ||
| Less: initial outlay (capital expenditure 720 + working capital 180) | 900.00 | ||
| NPV | 282.69 |
Suggestion. The NPV is positive, ₹282.69 lakh, and a project with a positive NPV is accepted. HIJ Technology Ltd. should take up the project. (The written down value at the end of year 6 is ₹63.21 lakh against scrap of ₹72 lakh; the paper says nothing about taxing the sale, so it is taken untaxed.)
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Units, contribution and EBDT by year | 3 |
| 2 | WDV depreciation, tax (including the year-1 saving) and cash flows | 4 |
| 3 | Working capital invested and recovered; scrap | 2 |
| 4 | Present values, NPV and suggestion | 2 |
| Total | 11 |
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