Lakshya 2010

Krishna Petro Limited

Krishna Petro Limited (KPL) is one of the largest manufacturing companies in
India with a diversified product line covering petrochemicals, fertilizers, dyes,
paints and explosives. The company’s Research Division has recently perfected
a special brand of “Purifier” specially suited to Indian homes. The technical and
commercial feasibilities of the products have been successfully evaluated and
its financial feasibility is now under the consideration of the management
which has the following alternatives:

(a) Manufacture the product in one of the company’s divisions; or

(b) Sub-contract manufacturing to outside parties.

In either case the product, if finally cleared, will be marketed by the company’s
well-established marketing division under its family brand name “KPL”.

Marketing
The marketing division proposes to fix the selling price of KPL at `8 per tin. The
marketing manager expects to maintain the price at `8. Any probability of
increasing the selling price is completely ruled out, according to him. However
a maximum reduction of `2 per tin may be a possibility in the event of tough
competition. But the chances of such a price reduction are only 25 out of 100
according to Mr.Rajan, the Marketing Manager. He says it is extremely difficult
to predict the sale of a new product like KPL before the brand is established.
According to him the trend could be any of the following over the 10 years
period, irrespective of the selling price:

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 1

 Lakshya 2010

1 2 3 4 5 6 7 8 9 10
Trend 1 250 300 340 350 420 450 480 500 520 540
Trend 2 200 200 220 250 240 230 210 200 180 150
Trend 3 250 230 210 200 180 160 140 120 100 100
(No. of tins in thousands)

Once a trend is established it is fairly easy, Mr.Rajan says, to give an estimate

of sales within a range of +/- 10 %. There is 60% chance of actual sales being on
the plus (+) side of any trend and 30% on the minus (-) side. Mr.Rajan feels that
any of the three trends is equally probable. Whatever be the actual trend, the
company should have, according to Mr.Rajan, a marketing program involving
the following expenditure schedule:

First two years `8 Lakh each year

3rd and 4th years `5 lakh each year

Thereafter `2 lakh each year

The normal credit given to trade is 30 days.

Manufacturing
There is no spare plant facility in the existing divisions of the company for
manufacturing KPL. The following are the estimates for constructing a small
plant for the new product:

Building 100000

Machinery 450000

Special equipment 50000

Total 600000

KPL will require the following accommodation for storage:

500 square feet for storing the finished goods

1500 square feet for storing raw material

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 2
 Lakshya 2010
The company can rent the storage facility for finished goods at `12 per square
feet and at `5 per square feet for the raw materials. However, if the company
decides to build the storage also an addition of `75000 will have to be added
to the building cost estimate of `1 Lakh. For purpose of income tax, building
can be depreciated @5% and machinery and other equipment @20% of the
written down value.

Besides, a development rebate of 25% will be available for machinery and

other equipment. The income tax rate applicable is 55%. The gestation period
required for the production to commence is 12 months.

The manufacturing costs of KPL are estimated as follows:

Raw Material `2.30 per tin

Direct labour and other variable expenses `1.00 per tin

Repairs and maintenance 4% of capital investment

Insurance 0.2 % of capital investment

The life of machinery is estimated at 6 years and special equipment at 4 years.

It is very difficult to estimate the replacement value of the machinery and
special equipment. The best guess could be the present cost of machinery and
equipment plus 5% increase per year for inflation. The scrap value of
machinery could be about `50000 and special equipment `5000. The building
will have a life of several decades; as it will be built as an adjunct to one of the
division’s plant, it cannot be disposed of to a third party if not required;
however, a rental value of `30000 per year could be realised.

The KPL production will require the following inventories:

Raw Material 3 month’s consumption

Work-in-progress 1 day’s factory cost

Finished goods 3 month’s requirements

Raw material could be purchased from suppliers on 30 day’s credit.

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 3

 Lakshya 2010
SUB-CONTRACTING
Avaron Co. has been the sub-contractor for the company for years for
manufacturing some of the products of the company. On enquiry it is
ascertained that Avaron will be willing to manufacture KPL (the new product)
in any quantity required, provided they are helped financially in the beginning
by providing them `5 lakhs at 8% interest per annum which could be
subsequently recovered from the amount due to them@`1 per tin
manufactured and supplied by them subject to the condition, however, that
the repayment schedule should commence after the first five lakh tins
manufactured and delivered. They are willing to enter into a firm contract to
supply any quantity of KPL at a fixed price of `3.5 per tin for a period of one
year. The price is negotiable at the time of each renewal of the yearly contract.
In the alternative, they are willing to enter into a long-term contract of 5 or
more years provided a price hike of 10% per year is built into the contract.

FINANCE
The financial data of the company for the last 5 years are given in Exhibit-1.
The Financial Manager, Mr.Kumar states that any additional finance required
would be easily raised by way of term loan @ 9.5% interest per annum up to
` 10 Lakhs. Besides depreciation reserves, the company will require annually
about `10 Lakhs out of its profits for capital expenditure for the next 8 years.
The company’s repayment of some of existing loans is scheduled as follows:

5th year end `10 Lakhs

7th year end `10 Lakhs

8th year end `20 Lakhs

The company has been paying 10% cash dividend to equity shareholders in the
recent past and the management desires that the rate of dividend should be
progressively increased to at least 12 %.

Based on this data, Mr.Kumar prepared a statement of cost of capital as

reproduced in Exhibit-2 and indicated that the company’s average cost of
capital for the next decade would be about 15% which factor must be taken

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 4

 Lakshya 2010
into consideration by the management in evaluating any capital expenditure
project.

Questions:

Evaluate the alternatives available for KPL by weighing sub-contracting and

manufacturing options. Indicate the method of evaluation.

Make suitable assumptions wherever required and indicate the same.

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 5

 Lakshya 2010

Exhibit-1
Some Selected Financial Data
Net Depreciation
Total Paid-up Profit Provision &
Assets Accumulated Total Equity After Development
Year (Net) Depreciation Debt Capital Reserves Tax Rebate Reserves Interest
2009 866 168 496 150 90 36 31 39
2008 893 147 519 150 43 22 23 42
2007 921 127 514 150 51 15 21 42
2006 840 110 449 150 20 12 21 36
2005 740 91 352 150 46 13 23 24
2004 571 76 260 150 26 11 19 17
(`in lakhs)

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 6

 Lakshya 2010
Exhibit-2
Assessment of Returns Required

Equity
Dividend
Reserves Long- long-term
Total % of % of paid- Cover
Year Capital term borrowing to
Borrowing (`in up capital on
Paid-up (`in (`in total
(`in lakhs) lakhs) to total Equity
lakhs) lakhs) (in %) for
Capital
(in %) dividend

1.33
2010 150 50 400 600 25 66.66 10
times
1.40
2011 150 60 400 610 24.6 65.6 10
times
1.46
2012 150 70 400 620 24.6 64.5 11
times
1.53
2013 150 80 400 630 23.8 63.5 11
times
1.6
2014 150 90 390 630 23.8 61.9 11
times
1.66
2015 150 100 390 640 23.4 60.9 12
times
1.8
2016 150 120 380 650 23.08 58.45 12
times
1.93
2017 150 140 360 650 23.08 55.38 12
times

Exhibit-2 (Contd. from column 10 onwards)

Capital
Profit
Profit
required On long-term Total Return
required On Equity Capacity
after borrowing Required
before
income
income
tax
tax
(in %)
13.33 30 25%@30%=7.5% 66.66%@9%=6% 7.5%+6%=13.5%
14 31 24.6%@31%=7.6% 65.6%@9%=5.9% 7.6%+5.9%=13.5%
16 35 24.2%@35%=8.5% 64.5%@9%=5.8% 8.5%+5.8%=14.3%
16.83 37.4 23.8%@37.4%=8.9% 63.5%@9%=5.7% 8.9%+5.7%=14.6%
17.6 39.3 23.8%@39.3%=9.35% 61.9%@9%=5.57% 9.3%+5.6%=14.9%
19.92 44.25 23.4%@44.25%=10.35% 60.9%@9%=5.48% 10.3%+5.5%=15.8%
21.6 48 23.08%@48@=11.07% 58.45%@9%=5.26% 10.07%+5.26%=16.3%
23.16 51.4 23.08%@51.4%=11.86% 55.38%@9%=4.98% 11.86%+4.98%=16.8%

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 7

 Lakshya 2010
Notes:
Income tax is calculated@55%

The ‘Cover for dividend’ provided under the head ‘Equity Capital’ provides for a return@10%,
11%, 12% on reserves. The cost of finance on reserves has accordingly been duly considered.

The ‘average’ over-all return for a period of 8 years works out to 15%. This has been
considered as the discounting rate.

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 8

 Lakshya 2010

Rules and Guidelines

 It is mandatory for all the teams to perform registration process on LakshWiz website
(http://lakshwiz.nitie.in).

 The team size should be of maximum 2 people from the same institute.

 A participant cannot be a part of more than one team participating for the same case.
However one can participate in more than one Case.

 The participants are allowed to form different teams for different modules.

 The solution should not exceed 2000 words inclusive of all exhibits and appendices.

 As mentioned earlier, clearly indicate assumptions and support them with suitable
reasons under separate heading.

 Solution format:
 Font Size – 12,
 Font Type – Times New Roman,
 1.5 line spacing
 The file should be a Microsoft Word Document/PDF.

 The front page should carry only

 Name of your Institute,
 Team Name,
 Details of the team members (Name, Email IDs, Phone Numbers)

 The details of the participants SHOULD NOT appear anywhere else in the case solution.

 Send entries to „lakshwiz@gmail.com‟ with the document name as

“Dstreet_Institute Name_Team Name” and subject of mail as “Dstreet_Institute
Name_Team Name.”

 The entries must reach us positively by Friday, September 24th, 2010 23:59:59 hrs.
Shortlisted candidates of Round I will be informed via e-mail.

 The results of Round I will also be available on official website of LakshWiz on or before
Sunday, 10th October 2010. The details of Round II will be published later.

 The decision of the organizers of the contest and the panel of judges will be final and
binding on all contestants.

National Institute of Industrial Engineering (NITIE), Mumbai-87 Page 9