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knowledge bank -basic learning Case-Investment Appraisal

 

CASE STUDY

 

Investment Appraisal at Somgeets Pvt. Ltd.

 

 

The case deals with Investment Appraisal for a new business venture. The case is set in a small manufacturing and services company located at Mumbai. Students may assume for analysis purposes that profits made on sale of land shall be included along with regular income.

 

On April 16th 1853, a locomotive pulling 14 carriages and 400 people left what was then

Bombay to a 21-gun salute and trundled to Thane, 34 km (21 miles) away. This particular journey marked the beginning of the Indian Railways. The network grew fast. Some of it was built by the British Raj, some by the princely states, such as Bikaner and Jodhpur, which retained their notional independence. Many of the network’s main trunk routes were laid by private companies under schemes that would now be described as “build-operate-transfer”/”build-operate-own-transfer”(BOT/BOOT). It was during those times that Somgeets Pvt Ltd (SPL) was incorporated with specific objective to manufacture and lay ‘Tracks’. After independence, the product mix gradually diversified from only ‘Tracks’ to ‘Tracks’, ‘Wheels’, Doors and ‘Lock Handles’ (LH). Supplies to parties other than the Railways were substantial and growing. The company also expanded into services and gradually but steadily increased its presence into Railway Catering. By 2000, manufacturing accounted for only 30% of sales. However, SPL was still known for its high quality manufacturing and reliable customer service. In 2000, the company bid on an Indian Railway contract to supply 1Lakh ‘Lock Handle’s’ a year for five years. SPL bid Rs 25 per ‘Lock Handle’ fixed for five years. Somesh, president of the company, wanted to grow his manufacturing base and felt sure that the contract was a good way to restart a relationship with the government that had been dormant for the last many years. The Railway order would allow SPL to bring about 30 steady jobs to the sea coast area and reactivate a factory which had been shut down in 1981 when SPL lost a contract to supply ‘Wheels’ to the Northern Railway division. The factory was located on a 5 acre land on a sea shore site near the Taj Hotel. The Plant was fully depreciated on SPL’s books; except for the Rs 10,000 cost of the land purchased from its owner who was migrating to the then newly founded Pakistan. The company had turned down Rs 9 Lakh offer for the land in 1995 from a property dealer. Somesh had no idea about the price of land today but he did not bother as the land was not for sale, anyways. If the bid of SPL was to be accepted by the Indian Railways, SPL would need to invest substantially in infrastructure. In this regard, Somesh had projected Rs 5 Lakh expenditure to renovate and refurbish the factory building and grounds. He also estimated an expenditure of Rs 8 Lakhs to buy equipment which would be required to manufacture ‘Lock Handles’ and of Rs 4.25 Lakhs for working capital which would be released at the end of the project. He planned to borrow 50% of the total requirement from banks and to use the balance from SPLs cash reserves.. A 10 year loan at 10% interest was readily available for the said purpose. The life of the equipment was estimated as 5 years whereas the building was expected to survive the next 10 years. In normal circumstances, the investment would last much longer but Somesh wanted to be conservative in his financial projections. If the five-year contract was not to be renewed, Somesh estimated zero salvage value for all infrastructures (building and equipment). ‘Lock Handles’ were specifically meant for the Rail Wagons and had not much demand elsewhere.

 

The first year income statement for the project was estimated as follows:

Sales :                                      Rs 25,00,000(Rs 25 per LH)

Factory Cost         HS Steel      Rs 10,00,000(Rs 10 per LH)

Direct labour                             Rs 4,00,000 (Rs 4 per LH)

Other Material                           Rs 1,00,000

Indirect Cost                            Rs 2,50,000

# Depreciation                           Rs 2,10,000

Factory Profit                           Rs 5,40,000

# The Company would use straight line method of depreciation for tax purposes.

 

Shipping expenses were to be borne by the Railways. No incremental selling and administrative expenses were foreseen.

Somesh estimated Taxes to be 35% of profit. According to Somesh’s estimate, his cash costs would probably grow 4% each year because of inflation. The Railway procurement officer with whom Somesh was dealing with expressed serious interest over the offer mainly because of the fixed price per unit for 5 years as proposed by SPL. According to him, the price quoted was very competitive especially because of zero escalation as projected in the bid. He asked Somesh to submit his 5- year financial forecast. Somesh was unsure of what was needed of him and so he approached his Finance Director, Geetika, for necessary advice. She suggested that SPL needs to prepare cash forecast for the proposal and then compute the “IRR”,”NPV” and “Payback” for the project. According to Geetika, 15% cost of capital was a reasonable estimate and the company would continue as a going concern in case such returns were possible. Geetika had special concern for the land value to be used for the project. She felt that the land cost should be included somehow in the analysis but was not sure how. Market estimate for the land at the sea coast was Rs 15 Lakhs but a comparable property in an industrial suburb nearby had sold recently for only Rs 3 Lakhs.

 

Questions

 

1.       You are required to prepare a cash flow forecast for the abovementioned project.

 

2.       Compute the NPV, IRR and Payback.

 

3.       Do you think that the proposal is a good deal for the Railways?

 

4.       Is it a good deal for SPL?


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