Capital budgeting is considered to be one of the crucial decisions undertaken by any organization that are generally long term and irreversible. These characteristics makes it evident for the finance manager to consider different alternatives before taking the final decision. A generic understanding of the techniques of capital budgeting is expected by the students pursuing PGDM and PGDM(IB) from JIMS Kalkaji. Modern techniques taking into account time value of money are to be covered in the curriculum covering Net Present Value, Profitability Index, Internal Rate of Return, Modified Internal Rate of Return and Discounted Pay Back Period. Significant decisions like replacement and modernisation decision, expansion decision and diversification decisions are taken. One of the decisions that underscores the worth of the machinery is ‘Installation of Machinery’. The finance manager is entrusted with the task to replace outdated technology as per the life of the asset and install machinery that adds to the economic worth of the project undertaken. To understand the dynamics involving this decision, following case is discussed to comprehend the desirability of installing a machine in the ongoing project.
Case
Adria Ltd. is a private profit-making organization that is considering the setting up of a waste recycling machine that will convert waste into a saleable product. Currently a scrap waste disposer takes a payment of ₹ 150 lakh per annum for the next 4 years. Once the contract is terminated, there is an alternative to install machinery for a payment of ₹90 lakh before waste recycling commences. The machinery will require a recycling cost of ₹600 lakh. At the end of 4th year, the machinery can be scrapped at ₹60 lakh and the cost of elimination of machinery will be ₹45 lakh.
Estimated Revenue and direct costs of the saleable product produced from the waste recycler machine for 4 years are given below-
At the first year materials worth ₹60 lakh are required.
The levels of stock of the materials are to be ensured at the conclusion of first year, second year and thirds year at ₹165 lakh and ₹0 lakh worth of stock at the conclusion of fourth year. Space shall be utilised by storing materials which would otherwise have provided rent of ₹30 lakh per annum. There shall be a set of 40 workers who would be transferred to the department where scrap processing machine shall be operated. This rotation will enable a savings to the company in the payment of idle time to these workers as per the following –
- For year 1 ₹45 lakh
- For year 2 ₹30 lakh
Production overheads include apportionment of general production overheads except to the extent
of insurance expenses of ₹90 lakh per annum payable on this set up. 30% is the tax rate.
Consider cost of capital @ 14%, the present value factors of which is given below for four years:
The finance manager needs to advise on the desirability of setting up the waste recycler machine.
Data Analysis
The finance manager is required to generate two crucial statements needed to give the recommendations regarding the installation to be undertaken by the company –
- Statement of Operating Profit from processing of waste
- Statement of Incremental Cash Flows
Statement of Operating Profit from processing of waste (₹ In lakh)
Statement of Incremental Cash Flows (₹ In lakh)
Working notes:
- Increments in material stock considered in the calculation of cash flows.
- Idle time wages to be included.
- Insurance expenses directly having an impact on the project are to be taken into account.
- Sale of machinery – Net income after deducting removal expenses taken.
- Saving in contract payment and income tax thereon is considered in the cash flows.
Recommendations by the finance manager
Following observations were recorded after doing the data analysis:
- positive NPV – Net present value of cash flows is ₹528.16 lakh
- Cost of contract with scrap waste disposer is ₹600 lakh whereas if the company decides to install the machinery then considering all costs and benefits over a time span of 4 years , a positive NPV of ₹528.16 lakh shall be generated by selling marketable products generated by waste scrap waste disposer.
Thus, the management should install the machine for processing the waste.
The case let shall be discussed in the teaching pedagogy of Financial Management with the students pursing PGDM and PGDM(IB) from JIMS Kalkaji, the Top PGDM College in Delhi.
JIMS, Kalkaji
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