Neogi Chemical co.

• What are the limitation of payback period

and accounting rate of return as
methods in measuring an investment’s
worth?
• Why is NPV method considered to be
better than IRR method? Why do NPV
and IRR methods give different results?
• You just heard Mr. Neogisaying the
following: “The Project No. 1 if accepted
would be financed by raising ten year 15
percent debt.” Do you agree that the
required rate of return should only
exceed after tax cost of debt?
 Why is it necessary to assume that the
capital structure would be maintained at a
debt-equity ratio of 3:2 in the long run?
• Objective
• To discuss the strengths and
limitations of various investment
criteria and indicate the superiority
of the NPV method.
• To discuss the concept of cost of
capital in a simple situation.
•
 ExhIV. (in lakhs)
Paid up capital (30 lakhshares @ Rs 100 each) Rs
3000
Reserves & surplus Rs
1800
Total borrowings Rs
7200
Capital employed Rs
12000


Notes:
1. The company’s share is currently selling for Rs 200.

The company’s dividend rate is 22 percent which is

expected to grow at 7.5 percent for a long period of
time.
• Overall Cost of capital
• Cost of equity = D/P + g =
(22/200) + 0.075 = .185
• Cost of debt = Kd (1-t) = .
15(1-.35) = .0975
• Overall cost of capital = .0975
(3/5) + .185(2/5) = 0.1325
•
• Initial outlay
• Gross:
Rs 450 lakh
• Add, working capital
Rs 32 lakh
• Less, Salvage value of old project Rs
45 lakh
• Net outlay
Rs 437 lakh
•
• Depreciation base of new project:
• Book value of old project Rs
30 lakh
• Cost of new project Rs
450 lakh
• Less salvage value of old project Rs
45 lakh
•
• Depreciation base
Rs 435 lakh.
 Differential cash savings
Present Proposed Cash savings
project project
Revenue 510 692 182
Raw material 262 348 -86
Labour cost 80 65 15
Supervision 8 6 2
Power 15 11 4
Repairs & 4 5 -1
maintenance
Total savings 116
 Incremental cash flow
Year Cash After Dep Dep Diff. Dep Total Present
saving tax old new dep (3) tax increm value
s (1) cash shield ental @13.2
saving (4) cash 5%
s (2) flow
(5) =
1 116 75.4 7.5 108.75 101.25 35.43 (2)+(4) 97.86
110.83
2 116 75.4 5.63 81.56 75.93 26.57 101.97 79.48
3 116 75.4 4.22 61.17 56.95 19.93 95.33 65.63
4 116 75.4 3.16 45.87 42.71 14.95 90.35 55.03
5 116 75.4 2.37 34.41 32.04 11.21 86.61 46.49
6 116 75.4 1.77 25.80 24.03 8.41 83.81 39.73
7 116 75.4 1.33 19.35 18.02 6.31 81.71 34.19
8 116 75.4 1.00 14.52 13.52 4.73 80.13 29.61
9 116 75.4 .75 10.89 10.14 3.55 78.95 25.76
10 116 75.4 .56 8.17 7.61 2.66 78.06 22.49
Incr. 25 7.20
Salvag
• NPV = 512.6 -437 = Rs 75.69 lakh.