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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.