Capital Budgeting: Case Study1

PT (P) Ltd. is setting up a project to manufacture electrolytic capacitor and few other
electronic components in Dharwar District, a most backward industrial area in Karnataka.
The product is used in many electronic devices and the installed capacity of the project is 300
lakhs unit per annum. The project is promoted by two entrepreneurs, one having good
experience in trading electronic components and the other promoter is having 20 years of
experience at senior level in manufacturing of capacitors. Though the existing marketing
environment is competitive, the demand is expected to grow at a high rate due to increased
usage of electronic products and emergence of new products. The company estimates if the
current trend in demand continues, there will be at least 10% gap between demand and supply
in next three years. The technology involved in manufacture of capacitor is well known and
hence there is no need for any technology partner for the project. However, the promoters
plan to hire a technical consultant for setting up the plant. While critical plant and
machinery are to be imported, the other machines are available indigenously. The estimated
cost of the project and means of financing the project are listed below.

Project Cost Estimate (Rs. In Lakhs) Means of Finance (Rs. In Lakhs)

Land 20.00 Share Capital  
Building 40.00 Promoters Contribution 100.00
Plant and Machinery - Imported 150.00 Public -
- Domestic 50.00 Rupee Loan @ 12% interest 200.00
Technical Consultant Fees 20.00 Interest Free Development Loan 30.00
Net Working Capital 50.00
Total 330.00 Total 330.00

The revenue and expenses related to project are given below:

1. Capacity Utilization: 50% in year 1, 65% in year 2, 85% from Year 3 to Year 10.
2. The company expects that the sales price per unit will be Rs. 1.20 per unit and will
increase at the rate of 5% per year on account of inflation.
3. Raw Material Cost is purely variable and is expected to be 70% of sales
4. Utilities (Power and Water) are expected to cost Rs. 5.00 lakhs for Year 1, Rs. 6.00
for Year 2 and Rs. 8 for year 3 and will increase at 5% per year from year 4 to 10.
5. Employee Cost: Fixed Rs. 10 lakhs for Year 1 and increase at the rate of 5% per year
6. Factory Overhead: Fixed: Rs. 4 lakhs for Year 1 and increase at 10% per year
(mainly to handle additional maintenance expenses and inflation)
7. Administrative Expenses: Fixed Rs. 8 lakhs per year but will increase at 6% per year.
8. Selling Expenses: Fixed: Rs. 2 lakhs per year; Variable: 5% of Sales

9. Other Expenses: Rs. 15 lakhs for Year 1 and increase 5% per year.
1
Professor Narasimhan M S prepared this case for classroom discussion rather than illustrating either the
effective or ineffective handling of administrative situation.
 10. Depreciation: For Plant and Machinery: 20% and Building: 10%. Depreciation is
charged under Written Down Value Method for Income Tax purpose.
11. 100% of Technical Know-how fee is expensed in year 1 for tax purpose.
12. Principal part of the loan is to be repaid from Year 4 to Year 8 at the rate of 20% of
loan amount.
13. Tax Rate: 30%
14. The life of the project is 10 years. At the end of 10th year, the land, building and book
value of machines are realized at book value (depreciated value). The estimated land
value at the end of 10 years is Rs. 80 lakhs.

Required
Part I
(a) Find the financial viability of the project by computing IRR and NPV of the project.
Assume Discount Rate is 15% (Make necessary additional assumptions).
(b) Find Pay-back period of the project.
(c) Perform sensitive analysis on an assumption of 5% forecast error on all variables.

Part II (This part has to be answered after learning cost of capital)

The average equity beta of few electronic component manufacturing companies is equal to
1.40. The current risk-free rate is 7% and the average historical market equity risk premium
(Refer the appended Table) is 6.38%.
Table 1: Risk Free Return, Market Return and Risk Premium
Year G-Sec Return (%) Sensex Return (%) Risk Premium (%)
1980-81 7.03 13.53 6.50
1981-82 7.29 49.72 42.43
1982-83 8.36 6.54 -1.82
1983-84 9.29 7.59 -1.70
1984-85 9.98 11.69 1.71
1985-86 11.08 84.92 73.84
1986-87 11.38 15.27 3.89
1987-88 11.25 -19.90 -31.15
1988-89 11.40 35.03 23.63
1989-90 11.49 18.88 7.39
1990-91 11.41 43.87 32.46
1991-92 11.78 79.08 67.30
1992-93 12.46 54.07 41.61
1993-94 12.63 0.10 -12.53
1994-95 11.90 37.13 25.23
1995-96 13.75 -17.26 -31.01
1996-97 13.69 5.49 -8.20
1997-98 12.01 9.90 -2.11
1998-99 11.86 -13.59 -25.45
1999-00 11.77 41.39 29.62
2000-01 10.95 -8.35 -19.30
2001-02 9.44 -21.96 -31.40
2002-03 7.34 -3.77 -11.11
2003-04 5.71 40.11 34.40
2004-05 6.11 27.80 21.69
2005-06 7.34 44.20 36.86
2006-07 7.89 48.30 40.41
2007-08 8.12 34.96 26.84
2008-09 7.69 -25.37 -33.06
2009-10 7.23 26.04 18.81
2010-11 7.92 19.38 11.46
2011-12 8.52 -6.35 -14.87
2012-13 8.36 8.11 -0.25
2013-14 8.45 18.85 10.40
2014-15 8.51 24.89 16.38
2015-16 7.89 -9.36 -17.25
2016-17 7.25 16.88 9.63
Average 9.64 18.86 9.22

Geometric Mean Arithmetic Mean

Period Sensex Return
Risk Premium Risk Premium
1981-2017 6.38% 18.86% 9.22%
1986-2017 6.06% 19.02% 9.19%
1991-2017 5.17% 17.58% 8.02%