Dstreet - Finance

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Lakshya 2010

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 1

Krishna Petro Limited

Krishna Petro Limited (KPL) is one of the largest manufacturing companies in

India with a diversified product line covering petrochemicals, fertilizers, dyes,paints and explosives. The companys Research Division has recently per fecteda special brand of Purifier specially suited to Indian homes. The technical and

commercial feasibilities of the products have been successfully evaluated andits financial feasibility is now under the consideration of the managementwhich has the following alternatives:

(a) Manufacture the product in one of the companys divisions; or

(b) Sub-contract manufacturing to outside parties.In either case the product, if finally cleared, will be marketed by the companys

well-established marketing division under its family brand name KPL.

Marketing

The marketing division proposes to fix the selling price of KPL at ` 8 per tin. Themarketing manager expects to maintain the price at ` 8. Any probability of

increasing the selling price is completely ruled out, according to him. Howevera maximum reduction of ` 2 per tin may be a possibility in the event of toughcompetition. But the chances of such a price reduction are only 25 out of 100according to Mr.Rajan, the Marketing Manager. He says it is extremely difficultto predict the sale of a new product like KPL before the brand is established.According to him the trend could be any of the following over the 10 yearsperiod, irrespective of the selling price:


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1 2 3 4 5 6 7 8 9 10Trend 1 250 300 340 350 420 450 480 500 520 540Trend 2 200 200 220 250 240 230 210 200 180 150Trend 3 250 230 210 200 180 160 140 120 100 100

(No. of tins in thousands)

Once a trend is established it is fairly easy, Mr.Rajan says, to give an estimateof sales within a range of +/- 10 %. There is 60% chance of actual sales being onthe plus (+) side of any trend and 30% on the minus (-) side. Mr.Rajan feels thatany of the three trends is equally probable. Whatever be the actual trend, thecompany should have, according to Mr.Rajan, a marketing program involving

the following expenditure schedule:

First two years ` 8 Lakh each year

3 rd and 4 th years ` 5 lakh each year

Thereafter ` 2 lakh each year

The normal credit given to trade is 30 days.

Manufacturing

There is no spare plant facility in the existing divisions of the company formanufacturing KPL. The following are the estimates for constructing a smallplant for the new product:

`

Building 100000

Machinery 450000

Special equipment 50000

Total 600000

KPL will require the following accommodation for storage:

500 square feet for storing the finished goods

1500 square feet for storing raw material


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The company can rent the storage facility for finished goods at ` 12 per squarefeet and at ` 5 per square feet for the raw materials. However, if the companydecides to build the storage also an addition of ` 75000 will have to be addedto the building cost estimate of ` 1 Lakh. For purpose of income tax, buildingcan be depreciated @5% and machinery and other equipment @20% of thewritten down value.

Besides, a development rebate of 25% will be available for machinery andother equipment. The income tax rate applicable is 55%. The gestation periodrequired for the production to commence is 12 months.

The manufacturing costs of KPL are estimated as follows:

Raw Material ` 2.30 per tin

Direct labour and other variable expenses ` 1.00 per tin

Repairs and maintenance 4% of capital investment

Insurance 0.2 % of capital investment

The life of machinery is estimated at 6 years and special equipment at 4 years.It is very difficult to estimate the replacement value of the machinery and

special equipment. The best guess could be the present cost of machinery andequipment plus 5% increase per year for inflation. The scrap value of machinery could be about ` 50000 and special equipment ` 5000. The buildingwill have a life of several decades; as it will be built as an adjunct to one of thedivisions plant, it cannot be disposed of to a third party if not required;

however, a rental value of `3 0000 per year could be realised.

The KPL production will require the following inventories:

Raw Material 3 months consumption

Work-in- progress 1 days factory cost

Finished goods 3 months requirements

Raw material could be purchased from suppliers on 30 days cre dit.


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SUB-CONTRACTING

Avaron Co. has been the sub-contractor for the company for years formanufacturing some of the products of the company. On enquiry it isascertained that Avaron will be willing to manufacture KPL (the new product)

in any quantity required, provided they are helped financially in the beginningby providing them ` 5 lakhs at 8% interest per annum which could besubsequently recovered from the amount due to them@ ` 1 per tinmanufactured and supplied by them subject to the condition, however, thatthe repayment schedule should commence after the first five lakh tinsmanufactured and delivered. They are willing to enter into a firm contract tosupply any quantity of KPL at a fixed price of ` 3.5 per tin for a period of oneyear. The price is negotiable at the time of each renewal of the yearly contract.In the alternative, they are willing to enter into a long-term contract of 5 ormore years provided a price hike of 10% per year is built into the contract.

FINANCE

The financial data of the company for the last 5 years are given in Exhibit-1 .The Financial Manager, Mr.Kumar states that any additional finance requiredwould be easily raised by way of term loan @ 9.5% interest per annum up to

` 10 Lakhs. Besides depreciation reserves, the company will require annuallyabout ` 10 Lakhs out of its profits for capital expenditure for the next 8 years.The companys repayment of some of existing loans is scheduled as follows:

5 th year end ` 10 Lakhs



The company has been paying 10% cash dividend to equity shareholders in therecent past and the management desires that the rate of dividend should beprogressively increased to at least 12 %.

Based on this data, Mr.Kumar prepared a statement of cost of capital asreproduced in Exhibit-2 and indicated that the companys average cost of

capital for the next decade would be about 15% which factor must be taken


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into consideration by the management in evaluating any capital expenditureproject.

Questions:

Evaluate the alternatives available for KPL by weighing sub-contracting andmanufacturing options. Indicate the method of evaluation.

Make suitable assumptions wherever required and indicate the same.


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(`in lakhs)

Exhibit-1Some Selected Financial Data

Year

TotalAssets(Net)

AccumulatedDepreciation

TotalDebt

Paid-upEquityCapital Reserves

NetProfitAfterTax

DepreciationProvision &

DevelopmentRebate Reserves Interest

2009 866 168 496 150 90 36 31 392008 893 147 519 150 43 22 23 422007 921 127 514 150 51 15 21 422006 840 110 449 150 20 12 21 362005 740 91 352 150 46 13 23 242004 571 76 260 150 26 11 19 17


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Exhibit-2 Assessment of Returns Required

YearPaid-up

Reserves

Capital(` inlakhs)

Long-

term(` inlakhs)

TotalBorrowing(` in lakhs)

% of (` in

lakhs)

% of paid-up capital

to total

Dividendlong-term

borrowing tototal(in %)

Equity

Coveron

EquityCapital(in %)

fordividend

2010 150 50 400 600 25 66.66 101.33

times

2011 150 60 400 610 24.6 65.6 101.40

times

2012 150 70 400 620 24.6 64.5 111.46

times

2013 150 80 400 630 23.8 63.5 11 1.53times

2014 150 90 390 630 23.8 61.9 111.6

times

2015 150 100 390 640 23.4 60.9 121.66

times

2016 150 120 380 650 23.08 58.45 121.8

times

2017 150 140 360 650 23.08 55.38 121.93

times

Exhibit-2 (Contd. from column 10 onwards)

Capital

On Equity CapacityOn long-termborrowing

Total ReturnRequired

Profitrequired

afterincome

tax(in %)

Profitrequiredbeforeincome

tax

13.33 30 25%@30%=7.5% 66.66%@9%=6% 7.5%+6%=13.5%14 31 24.6%@31%=7.6% 65.6%@9%=5.9% 7.6%+5.9%=13.5%16 35 24.2%@35%=8.5% 64.5%@9%=5.8% 8.5%+5.8%=14.3%

16.83 37.4 23.8%@37.4%=8.9% 63.5%@9%=5.7% 8.9%+5.7%=14.6%17.6 39.3 23.8%@39.3%=9.35% 61.9%@9%=5.57% 9.3%+5.6%=14.9%

19.92 44.25 23.4%@44.25%=10.35% 60.9%@9%=5.48% 10.3%+5.5%=15.8%21.6 48 23.08%@48@=11.07% 58.45%@9%=5.26% 10.07%+5.26%=16.3%

23.16 51.4 23.08%@51.4%=11.86% 55.38%@9%=4.98% 11.86%+4.98%=16.8%


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Notes:

Income tax is calculated@55%

The Cover for dividend provided under the head Equity Capital provides for a r eturn@10%,

11%, 12% on reserves. The cost of finance on reserves has accordingly been duly considered.

T he average over -all return for a period of 8 years works out to 15%. This has been

considered as the discounting rate.


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