Chhappanbhog Chimney Ltd (CCL) is a leading manufacturer of items used in kitchens such as gas stoves, electric chimneys, ovens and so on. It has grown significantly under the CEO Vivek Razdan’s dynamic leadership. In line with his belief to enhance competitiveness by using research and development for launching innovative products in the market, the CCL has recently developed a zero Maintenance Electric Chimney (known as Zimney) which is ideally suited for Indian cooking. The research and development cost of Zimney amounts to Rs 20,00,000.To gauge the market prospects for Zimney, a market survey was conducted by Bazar Gyani, the V.P., Marketing, at an estimated cost of Rs 5,00,000.

The results of the survey were very positive showing a significant demand for Zimney. The survey report also indicated that Zimney could capture 8 per cent of the current market size of 1,00,000 units of gas electric chimney. Considering the growth of satellite towns/cities and residential colonies, the market is expected to grow at 2 per cent annually. The VP, Marketing suggested to the CEO that a market penetration pricing strategy would be most suitable and Zimney should be priced at Rs 5,000 per unit in the initial year of the launch. The price could be raised in subsequent years by 5 per cent annually. The marketing and administrative costs are expected to be Rs 4,00,000 per year.

The CCL is presently using 6 machines acquired 3 years ago at a cost of Rs 10,00,000 each, having a useful life of 7 years, with no salvage value. These machines are currently being used for manufacturing other types of chimneys. They could be sold for Rs 2,00,000 per machine with a removal cost of Rs 30,000 for each.The machine to manufacture Zimney is available in the market for Rs 1,00,00,000 with a useful life of 4 years and salvage value of Rs 10,00,000. It can produce other types of chimneys also.The new machine, being state of the art technology would improve the productivity of the workers as well as reduce the unit variable cost of manufacture to Rs 600, which would increase by 5 per cent annually.

Exhibit 1 summarizes the labor cost with the existing machine and the new equipment.

Category Existing New Machine/Equipment

Number Monthly salary

Number Monthly salary

Skilled labour 20 Rs 4,000 15 Rs 4,000

Maintenance men 2 6,000 1 6,000

Floor managers 3 8,000 2 8,000

The maintenance costs currently amount to 1,00,000 per year (existing machine). They would total Rs 70,000 with the new equipment. The net working capital required to start production of Zimney would be Rs 60,00,000.

The policy of CCL is to pay five months salary as compensation in case of lay-off of employees.

Required

Should the CCL launch the Zimney. Assume the following: (i) Tax, 35 per cent (ii) Required rate of return, 14 per cent and (iii) Straight line depreciation for the tax purposes.

Solution

Financial Evaluation of Proposal to launch Zimney

(A) Incremental Cash Outflow (t = 0):

1.2.3.4.5.

Cost of new machineLess sale proceeds of existing machinesa Less tax benefits on loss of sale of existing machinesb Cost of laying-off workersc

Additional working capital

Rs 1,00,00,000(10,20,000)

(8,42,999)1,70,000

60,00,0001,43,07,001

a Sale proceeds of existing machines [(6 × Rs 2,00,000, sale price – (6 × Rs 30,000, removal cost)] = Rs 10,20,000

b Tax benefits on loss of existing machine

1. Book value of existing machine [(6 × Rs 10,00,000) – (3 × Rs 8,57142, annual depreciation i.e. Rs 60,00,000 ÷ 7)] = Rs 60,00,000 – Rs 25,71,428 = Rs 34,28,571.2. Loss on sale of existing machine [book value, Rs 34,28,571 – Rs 10,20,000, sale proceeds] = Rs 24,08,571.3. Tax benefit (Rs 24,08,571 (A) 0.35) = Rs 8,42,999.

c Cost of lay-off:

1. Skilled labour 5 × Rs 4,000 × 5 (months) = Rs 1,00,000

2. Floor manager = 1 × Rs 8,000 × 5 = 40,000

3. Maintenance person = 1 × Rs 6,000 × 5 = 30,000

1,70,000

(B) Incremental Cash Inflows: (t = 1 – 4):

Year

Particulars 1 (Rs) 2 (Rs) 3 (Rs) 4 (Rs)

1. Sales revenuea 4,00,00,000 4,28,40,000 4,58,81,640 4,91,34,408

2. Add savings in maintenance costb

30,000 30,000 30,000 30,000

3. Add savings in labour costc

4,08,000 4,08,000 4,08,000 4,08,000

4. Less variable costd (52,00,000) (55,40,800) (59,05,796) (62,96,663)

5. Less incremental depreciatione (13,92,858) (13,92,858) (13,92,858) (13,92,858)

6. EBT 3,38,45142 3,63,44,342 3,90,20,986 4,18,82,887

7. Less tax (0.35) (1,18,45,799) (1,27,20,519) (1,36,57,346) (1,46,59,010)

8. EAT 2,19,99,342 2,36,23,822 2,53,63,640 2,72,23,876

9. Add incremental depreciation 13,92,858 13,92,858 13,92,858 13,92,858

10. CFAT 2,33,92,200 2,50,16,680 2,67,56,498 2,86,16,734

11. Release of working capital — — — 60,00,000

12. Total 2,33,92,200 2,50,16,680 2,67,56,498 3,46,16,734

a Sales revenue : Year 1 (0.08 × 1,00,000 × Rs 5,000) = Rs 4,00,00,000

2 (0.08 × 1,02,000 × Rs 5,250) = 4,28,40,0003 (0.08 × 1,04,040 × Rs 5,512) = 4,58,81,6404 (0.08 × 1,06,120 × Rs 5,787) = 4,91,34,408

b Savings in maintenance cost (Rs 1,00,000, existing – Rs 70,000 proposed) = Rs 30,000

c Savings in labour cost:

1 Existing: Skilled labour (20 × Rs 4,000 × 12 months) Rs 9,60,000Floor manager (3 × Rs 8,000 × 12)

2,88,000Maintenance (2 × Rs 6,000 × 12)

1,44,000 Rs 13,92,0002 New: Skilled labour (15 × Rs 4,000 × 12) 7,20,000

Floor manager (2 × Rs 8,000 × 12) 1,92,000

Maintenance (1 × Rs 6,000 × 12) 72,000 9,84,000

4,08,000

d Variable cost and general administrative costs:

Year 1 [(0.08 × 1,00,000 × Rs 600) + Rs 4,00,000]= Rs 52,00,000 2 [(0.08 × 1,02,000 × Rs 630) + Rs 4,00,000] = 55,40,000

3 [(0.08 × 1,04,040 × Rs 661) + Rs 4,00,000] = 59,05,796 4 [(0.08 × 1,06,120 × Rs 694) + Rs 4,00,000] = 62,96,663

e Incremental depreciation:

1. New equipment (Rs 1,00,00,000 – Rs 10,00,000) ÷ 4 Rs 22,50,000

2. Existing (Book value, Rs 34,28,571 – 0) ÷ 4 8,57,142

13,92,858

(C) Computation of NPV

Year Incremental cash inflows

PV factor (0.14)

Total PV

1 Rs 2,33,92,200 0.877 Rs 2,05,14,959

2 2,50,16,680 0.769 1,92,37,826

3 2,67,56,498 0.675 1,80,60,636

4 3,46,16,734 0.592 2,04,93,106

Total 7,83,06,527

Less Incremental cash outflow 1,43,07,001

NPV 6,39,99,526

Decision: The CCL should launch the Zimney

Note: The research and development cost of Zimney (Rs 20,00,000) and expenses incurred on market survey (Rs 5,00,000) are sunk cost and, therefore, irrelevant for analysis.