Financial Management: Case Study Analysis

INDIAN INSTITUTE OF FOREIGN TRADE- DELHI

Submitted To: Dr Miklesh Prasad Yadav (Faculty, Financial Management)

Submitted By: Mohit Gupta (Roll No 05A) EPGD- GHRM

Case Introduction: Shyam Lal & Associates

In the presented case, different units of the partnership firm Shyam Lal & Associates (SLA) have
made three investment proposals. The head of the company, Mr. Shyam Lal, aims to assess
these proposals to enhance the company's long-term profitability. The first proposal suggests
investing in a new plant to manufacture a chemical that is expected to have high demand
among plastic bag manufacturers. The estimated investment required for this proposal is Rs.
39.60 lakhs, and the estimated annual after-tax cash flow is Rs. 7.60 lakhs for years 1-4 and Rs.
8.50 lakhs for years 5-10. The plant's expected life is 10 years, and the estimated salvage value
at the end of its life is 50% of its book value. The company is entitled to depreciation at the rate
of 25% using the diminishing balance method.

The second proposal suggests investing in a machine that can reduce costs in the hardware unit
of the company. The machine's cost is Rs. 46.35 lakhs if paid in cash, but it can also be
purchased on an instalment basis, where the amount must be paid in eight equal annual
instalments, with an interest rate of 18% compounded annually.
The third proposal suggests installing a refrigeration system in a cold storage complex that the
company recently acquired. The cost of the system is Rs. 14 lakhs, and the distributor is willing
to finance it over four years with an interest rate of 13%. The annual payable is Rs. 5.32 lakhs.
Mr. Shyam Lal needs to evaluate each proposal's profitability and payment schedules. He
believes that a 12% after-tax required rate of return is appropriate for evaluating the proposals,
and the company's tax rate is 35%. Moreover, Mr. Shyam Lal estimates that the company
would require approximately Rs. 65 lakhs of funds to finance all three projects if they are
approved.

Question: What is the nature of problems being faced by Shyam Lal? What are
the key characteristics of the options he is examining? How should he decide?

Shyam Lal is currently facing a range of financial challenges in his business, with the primary
issue being a shortage of funds due to low profits and the instalment payments of a term loan
to Vishal Bank. This has made it difficult for his company, SLA, to invest in new projects or
expand its operations. Additionally, the declining profitability of the hardware unit and labour
issues have added to the company's financial difficulties.
To address these problems, Shyam Lal is evaluating various investment proposals aimed at
increasing the company's long-term profitability. These proposals include a new investment
opportunity from the Faridabad Chemical Processing Unit, a cost-saving proposal from the
hardware unit, and an expansion proposal from the cold storage unit. Shyam Lal must carefully
assess these proposals to determine which ones will provide the best return on investment and
help the company overcome its financial struggles.
Shyam Lal is examining three investment options proposed by his unit supervisors.
The first proposal is a new investment proposal from the Faridabad Chemical Processing Unit,
involving the construction of a new chemical production plant. This project is expected to
generate cash flows of Rs. 7.6 lakhs per year for the first four years and Rs. 8.5 lakhs per year
for the next six years, requiring an estimated investment of Rs. 39.6 lakhs. The plant's expected
life is 10 years, with a salvage value estimated at 50% of its book value, and the company is
entitled to depreciation at a rate of 25% using the diminishing balance method.

The second proposal is a cost-saving plan from the hardware unit that involves investing in a
machine from Automation Industry, which will reduce costs. The cost of the machine is Rs.
46.35 lakhs, and the company can pay this amount in cash or in eight equal annual instalments
at an interest rate of 18% compounded annually. The machine has a life of 15 years.

The third proposal is an expansion plan from the cold storage unit, involving the installation of
a refrigeration system in the cold storage complex at a cost of Rs. 21.28 lakhs. This cost
includes four years of interest at a rate of 13%, and the distributor is willing to accept payment
in four equal annual instalments of Rs. 5.32 lakhs each.

Question: Why do you think he should consider time value of money

and what do you mean by time value of money?

It is crucial for Shyamlal to take into account the concept of time value of money while making financial
decisions. This concept pertains to the idea that the money available in the present is more valuable
than the same amount of money in the future due to its earning potential.
In Shyamlal's case, he is evaluating two investment options that will yield returns at different points in
the future. To determine which option would generate a higher return on investment, he must factor in
the time value of money. This is because the value of money he receives in the future will be less than
the same amount received presently. Therefore, Shyamlal should calculate the present value of the
future returns he expects to receive to make a precise comparison between the two investment
options.
By considering the time value of money, Shyamlal can make a well-informed decision about which
investment option to select and ensure that he obtains the maximum return on his investment.

Question: For this purpose, what discount rate should he use?

When considering the profitability of a project, the internal rate of return (IRR) can be a useful metric. If
a project has an IRR of 15.42%, this implies that the project's cash flows generate a return of 15.42% per
annum, indicating that the project is expected to be profitable.

However, determining the appropriate discount rate for a project requires consideration of the
investment's opportunity cost and associated risk, in addition to the IRR. A discount rate that is higher
than the IRR should be used to account for these factors.

For a project with an average level of risk, a discount rate that is marginally higher than the IRR may be
considered. Therefore, if a project has an IRR of 12%, a discount rate of 15-16% shall be appropriate.
However, it's essential to note that the appropriate discount rate can be affected by various factors
such as the project's risk level, the company's cost of capital, and the projected rate of inflation.
In essence, the discount rate represents the cost of capital for the investment, and it's essential to
ensure that the expected return on the investment is higher than this rate to ensure profitability. A
thorough analysis of the investment's risk and cost of capital is critical to making an informed decision
about the appropriate discount rate to be used for the project.

Question: Explain the concept of present value and future value. While
evaluating the profitability and repayment schedule of various projects use the
following concepts:
The future value factor (FVFn,r) can be calculated using the following formula: FVFn,r =
(1+r)^n, where r represents the rate of return, which in this case is the after-tax required rate
of return of 12%, and n represents the number of years.

The Future Value Annuity Factor (FVAFn,r) is a financial tool that helps to calculate the
future value of a series of equal cash flows at the end of a specified period. The FVAFn,r
formula is derived using the number of periods and the discount rate. It is given as:
FVAFn,r = [(1+r)^n - 1] / r
Here, n represents the number of periods, and r represents the discount rate. By utilizing the
data provided in the case, we can calculate the FVAFn,r for each The First Proposals follows:

Proposal 1

The first proposal is related to purchasing machinery, the second proposal is related to buying a
refrigerator on credit, and the third proposal is related to assessing the net present value of an
investment.
The first proposal talks about purchasing machinery worth 46.35 lakhs. The installment amount
is calculated to be 11.3673 lakhs, which will be paid annually for eight years. The repayment
schedule is also provided, which shows the interest and principal paid each year. The total
interest paid is 45.06 lakhs, and the total principal paid is 45.8772 lakhs.

Year Total Amount Interest Principal Amount

1st 11.3673 8.343 3.0243

2nd 11.3673 8.1638 3.2034

3rd 11.3673 6.9186 4.4486

4th 11.3673 5.8631 5.5041

5th 11.3673 4.9687 6.3985

6th 11.3673 4.2108 7.1564

7th 11.3673 3.5684 7.7988

8th 11.3673 3.0241 8.3431

Proposal 2

The second proposal is related to buying a refrigerator on credit. The cost of the refrigerator is
14 lakhs, and the time period for payment is four years. The annual payments needed to be
made are computed to be 5.7066 lakhs. The total amount to be paid using the compound
interest method is calculated to be 22.82 lakhs, and the total interest paid is 7.28 lakhs.

Cost of refrigerator = 14 lakhs, time = 4 years, r = 13% FVIF = 22.82 lakhs

Annual Payments= 5.7066

This can be considered as an annuity with discounting rate of 13% PV= 13.9939 or 14 lakhs approx.

Four equal annual instalments as per the deal by the distributor = 5.7066 lakhs

Using compound interest method, total repayment becomes = 14,00,000 (1+0.13) with t being 4=
22,82,663.05/-

Using compound interest rate method, Total Amount to be paid = 21.28 with actual principal payment
of 14 lakhs and the remaining 7.28 as interest.
Proposal 3

The third proposal is related to assessing the net present value of an investment. An annuity of
34,93,868.33/- will be paid for 5 to 10 years, starting from the end of the fourth year. The
present value of this annuity is calculated to be 22,20,443.80/-. The total present value of cash
flow is calculated to be 45,28,361.13/-. The salvage value of the machine after 10 years is
calculated to be 19.8 lakhs, and the net book value is calculated to be 39.60 lakhs. The net
present value is calculated to be 40,33361.13/-.

Annuity of 5 to 10 years in the end of 4th year = 34,93,868.33/-

PV of this annuity = 34,93,868.33/(1.12*1.12*1.12*1.12) = 22,20,443.80/-
PVA of 760000 for 4 years = 23,07,917.33/-
Total PV of Cash Flow= 23,07,917.33 + 22,20,443.80 = 45,28,361.13/-
Salvage value of Machine after 10 years = 50% of 39.60 lakhs = 19.8 lakhs Depreciation rate is
25%, Salvage value is 50% of book value
Net Book Value = 39.60 lakhs
Using written down value depreciation method, Depreciation Expense = (39.6-19.8) x 0.25
NPV = 45,28,361.13 - 4,95,000 = 40,33361.13/-
In summary, the proposals include purchasing machinery, buying a refrigerator on credit, and
assessing the net present value of an investment. The total amount required for these
proposals is 99.95 lakhs, and the financing required is 56.2973 lakhs. The loan amortization
schedule for the Vishal Bank for a term loan of 65 lakhs for 7 years at 15% annually is also
provided. The total amount to be paid every year is calculated to be 15.623 lakhs.

Year Total Amount Interest Principal Remaining

Principal

1st 15,62,349 975000 587349 5912651

2nd 15,62,349 886897 675451 5237199

3rd 15,62,349 785579 776769 4460430

4th 15,62,349 669064 833284 3567146

5th 15,62,349 535071 1027277 2534864

6th 15,62,349 380980 1181368 1358500

7th 15,62,349 203775 1358573 0

Total 1,09,36,443 - - -