THE NEOGI CHEMICAL COMPANY1

The Neogi Chemical Company (NCC) was started in 1988 as a private limited company with an initial investment of Rs.25 crore. Under the able guidance of its chairman, Mr. Chaman Lal Neogi, the company made tremendous progress during the last decade. As a result of its increasing sales and profits and increasing demand of funds for financing the expansion, the company was converted into a public limited company in 1994. On March 31, 1997, the total capitalization of the company was Rs.120 crore. Although the company is highly profitable and growing constantly, there is ample scope to introduce more scientific managerial techniques to improve profitability further. For example, the company has not been following a sophisticated approach in screening and evaluating its capital projects. The finance committee is authorized to screen and approve only those projects which involve capital expenditure exceeding Rs. 25 lakh. Departmental heads are members of the committee and the controller of finance is its chairman. It is the responsibility of the departmental heads to submit a detailed description of proposed projects together with estimates of cost and benefits. Six such projects are currently under consideration (Exhibit 1). The finance committee does not follow a standard procedure to screen capital projects. Rather the committee listens to the views of the various members and decides on the basis of the merits and force of the arguments made by the committee members. After attending an Executive Development Programme on Techniques of Investment Analysis recently, Mr. Neogi was convinced that his company would be able to allocate funds rationally if it adopts a more scientific approach towards investment decisions. He, therefore, asked the finance committee to standardize its screening procedure and adopt some scientific evaluation techniques to ensure equitable treatment to each project and maximum possible return to the company on its investment expenditure. Keeping in view the desire of the companys chairman, the finance committee met to consider the current projects. Mr. Neogi was also present at the meeting. A number of issues were raised by the committee members in an attempt to establish a sound screening programme. For example, it was the view of Mr. Jagat, the chief accountant, that the first and foremost concern of the company should be that the money invested in a project be recovered within a short period of time. He opined that a maximum acceptable, payback period, of four years for NCC should be the basis to accept a project. To emphasise his point, he argued that such an approach was not only simple, but also did not require the calculation of the cost of capital which is a formidable task. Mr. Laxmi Chand, the marketing manager, reacted sharply to this view. He pointed out
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Adapted from I M Pandeys Cases in Finance.

that following such a policy may result in accepting those projects that were not beneficial to the company and rejecting profitable ones. He added that the desirability of a project depended not only on the speed with which investment was recovered, but also the life of the project over which benefits would be derived. He favoured the use of the internal rate of return (IRR) method. This method, according to him, incorporates all cash flows over the life of the project and adjusts them for the time value as well. He stated further that the computation of the cost of capital was not necessary for the use of this method. Mr. Jagat reacted to these suggestions by stating that the rate of return method is difficult and at times unrealistic for evaluating projects. Because of the mathematics of the formula for computing internal rate of return, it could give multiple (and also imaginary) rates of return for an investment project. Defending the use of payback, period as an evaluation criterion, he pointed out that besides being simple, payback method can be used as a measure of risk and liquidity. He stated that one simply needed to shorten the maximum acceptable payback period to account for risk and liquidity. He also stated that the method also gives an idea of the projects rate of return, under the conditions of constant cash flows and a sufficiently long life of the project its reciprocal gives an approximation of the projects rate of return. Mr. Neogi intervened at this stage of the discussion to say that payback may be a useful investment criterion, but its use as the only criterion cannot be defended. Mr. Vinod Mittal, the controller of budgets, felt that the best method to use was the net present value (NPV) method. It clearly indicates what wealth would accrue to the owners of the company from the project. Mr. Mittal also stated that if present values of cash flows are calculated, one can also compute the ratio of the present value of cash inflows to initial cash outlay, in order to assess the relative significance of various investment proposals. He explained further that like internal rate of return (IRR) the NPV method adjusts cash flows for time value and is very simple in its computations. He also stated that since internal rate of return and the net present value methods give the same accept-reject decisions, those who have an objection to the use of the internal rate of return method on account of its involved computations and the possibility of multiple rates of return would have no objection in accepting the use of the net present value method as an investment criterion. Mr. Neogi reacted to Mr. Mittals arguments by saying that under certain conditions, particularly when one has to rank mutually exclusive projects, internal rate of return and net present value methods could give conflicting rankings. According to him, this perhaps happens due to the difference in the cash flow patterns of the mutually exclusive projects. He, however, informed the meeting that when this topic was discussed in the executive development programme, which he had attended, there was a conatoversy regarding the cause of the conflicting rankings given by IRR and NPV methods. One point of view was that this happened because of the different implicit
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reinvestment assumptions inherent in the formula of the two methods. NPV method assumes that the intermediate cash flows generated by an investment are reinvested at the rate of discount (cost of capital to the firm), while the IRR method assumes that they are reinvested at the projects internal rate of return. The contrary view was that the ranking conflict arose solely due to the different patterns of the cash flows of the projects; the reinvestment argument was indefensible. He informed further that the majority view in the executive development programme was that NPV method was more consistent with wealth maximization principle than IRR method in the evaluation of the investment projects. To clarify the issues relating to the controversy of NPV vs. IRR, as understood by Mr. Neogi, he illustrated the example given in Exhibit II. Investment project A and B in Exhibit II require the same initial outlay, although their cash inflow patterns differ. At a required rate of return of 10 per cent, project As NPV (Rs. 4,140) is higher than Project Bs NPV (Rs. 3,824). However, Project B earns a higher IRR (37.63 per cent) than Project A (26.55 per cent). Mr. Parmod, the production manager, shifted the discussion to the questions of the cutoff rate. He complained that the committee had been very conservative in the past in approving projects. He felt that there would be no difficulty in financing all those projects that earn rates higher than the cost of debt, which at present is approximately 9.75 per cent (after-tax). This view was countered by Mr. Lal, the finance manager. He contended that indiscriminate use of debt financing was risky. It would put the capital structure in imbalance and alarm the tenders. The result was likely to be an increase in effective interest rates and more restrictive loan covenants. This also could have an adverse effect on the sharp prices of the company. He, therefore, felt that a basic change in the capital structure would have serious consequences for the company. He did not know what would be the cost and repercussions if the projects were financed by raising equity capital, instead of debt capital. Some committee members also raised the question of using retained earnings for financing the project since it is a cost free source. However, the chairman of the committee informed the members that, in his opinion, no source of funds could be said to be free of cost; at least, there was an opportunity cost involved. The chairman also said that the problem would become simple if the cost of capital could be calculated. He also informed the members that as a policy, the company would like to maintain a debt-equity ratio of 3:2 at its book values in the long run. At this juncture, the chairman of the committee adjourned the meeting requesting the members to come with their recommendations regarding Project No. 1 in the light of the discussions in the meeting. The estimates of the costs and benefits of Project No. 1 (Exhibit III) were circulated to each member. The information about the companys capital structure and other relevant data (Exhibit IV) were also circulated. The chairman also informed the members that this year for financing any investment project the company might have to raise debt at 15 per cent per annum.

Exhibit I
THE NEOGI CHEMICALS COMPANY List of Proposed Capital Projects Type Basis for Decision

Project Description Adoption Chemical Process of

New Replacement Mixing Expansion

Gross Outlay (Rs. Lakh) Cost Saving and 450 Revenue Generation Increased Revenue Management Strategy 600 300

Starting a New Product Expansion Division Purchase of Land for Strategic Possible Future Expansion Expansion Purchase of an Expansion Additional Warehouse Improvement of Replacement Material Handling Facilities Opening a New Office Strategic to Handle Foreign Expansion Operations Independently

Increased Profits Cost Saving

500 200

Management Strategy

400

Exhibit II
THE NEOGI CHEMICALS COMPANY

Illustration of NPV vs. IRR

Project A B 0 -10,000 -10,000 Cash Flows (Rs.) in Year 1 2 2,000 10,000 4,000 3,000 NPV at 3 10% (Rs.) 12,000 3,000 4,140 3,824 IRR (%) 26.55 37.63

Exhibit III
THE NEOGI CHEMICALS COMPANY Estimated Revenue and Costs of Project No. 1 (Rs. In lakh) Present Project Proposed Project Annual Revenue Sales 510 692 Annual Costs Raw Material 262 348 Labour Costs 80 65 Supervision 8 6 Power 15 11 Repairs and Maintenance 4 5 Depreciation (Straight-line Method) 3 45 Allocated Corporate Overheads 5 7 Note: In addition to the gross outlay of Rs. 450 lakh, the proposed project will require a net increase in working capital of Rs. 32 lakh. The estimated life of the proposed project is 10 years. The present project has a book value of Rs. 30 lakh and a market value of Rs. 45 lakh and if retained for 10 years, its salvage value at the end of the tenth year is expected to be Rs. 15 lakh. The proposed project has estimated salvage value of Rs. 40 lakh at the end of its life. Corporate tax rate is 35 per cent, and a 25 per cent written-down depreciation rate for tax purposes (see Appendix I).

Exhibit IV
THE NEOGI CHEMICALS COMPANY Capital Structure Year Ended March 31, 1998 (Rs. In lakh) Paid-up share capital (30 lakh shares @ Rs. 100) 3,000 Reserves and surplus 1,800 Total Borrowings 7,200 The Capital Employed 12,000

Notes: 1. The Companys share is currently selling for Rs. 200. The companys dividend rate is 22 per cent which is expected to grow at 7.5 per cent for a long period of time. 2. Average interest rate on borrowings in past year has been about 16 per cent.

APPENDIX 1 For tax purposes depreciation is allowed as deduction every year in respect of buildings, machinery, plant or furniture till the cost of such asset as fully written off. 1. Conditions for allowing depreciation allowance: (a) The asset should be owned by the assessee; (b) the assets should actually be used for the purpose of the assessees business or profession. 2. Basis of calculation of deprecation allowance: Depreciation will be allowed on the written down value of the block of assets. Block of assets means a group of assets falling within a class of assets, being buildings, machinery, plant or furniture, in respect of which the same percentage of deprecation is prescribed. 3. Written down value: This is defined under section 43(6) of the Income Tax Act. In the case of block of assets, the written down value shall be arrived as under: (a) The aggregate of the written down value of all the assets falling within that block of assets at the beginning of the previous year shall first be calculated. (b) the aggregate if the written down value arrived at as in (a) shall be increased by the actual cost of any asset falling in that block which was acquired during the previous year; and (c) the sum so arrived at in (b) shall be reduced by the money receivable together with scrap value, if any, in respect of any asset falling within that block which is sold or discarded or demolished or destroyed during the previous year. So, however, that the amount of such reduction does not exceed the written down value as so increased.