Sona limited is a leading manufacturer of automotive components. It supplies to the original equipment manufacturers as well as the replacement market.

Its projects typically have a short life as it introduces new models periodically . You have recently joined Sona Limited as a financial analyst reporting to Suresh Gopal, the CFO of the company
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He has provided you with the following information about 3 projects A , B,and C that are being considered by executive committee of the company. Project A is an extension of an existing line. Its cash flows will decrease over time. Project B involves a new product . Building its market will take some time and hence its cash flow will increase over time.

Project C is concerned with sponsoring a pavilion at a trade fair. It will a cost initially which will be followed by huge benefit for one year. However , in the year following that a substantial cost will be incurred to raze the pavilion.

The expected Net cash flows of the three projects are as follows
YEAR PROJECT A PROJECT B PROJECT C

0 1 2 3

(5000) 3500 2500 1500

(5000) 1000 3000 4000

(5000) 15000 (10000)

Firms cost of capital is 12% You are asked to evaluate the projects What is Payback period and discounted Pay back for project A and B Calculate NPV/IRR of all the projects. Calculate MIRR assuming that the intermediate cash flows can be reinvested at 12%
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PAYBACK PERIOD
YEAR PROJECT A PROJECT B PROJECT C

0 1 2 3 Payback period

(5000) 3500 2500 1500

(5000) 1000 3000 4000

(5000) 15000 (10000)

EXAMPLE
Suppose a project costs Rs 20,00,000 and yields annually a profit of Rs 3,00,000 after depreciation @ 12 % (straight line method) but before tax @ 50%.

Calculate the cash inflow from this project and Pay back period

The cash inflow is Rs. 4,00,000 calculated as follows: PROFIT BEFORE TAX Less: Tax @ 50% Profit after tax Add: Depreciation written off CASH INFLOWS 3,00,000 1,50,000 1,50,000 2,50,000 4,00,000

While calculating cash inflow, depreciation is added back to profit after tax since it does not result in cash outflow. The cash generated from a project therefore is equal to profit after plus depreciation. The payback period in this case is 5 years, i.e. Rs. 20,00,000 4,00,000

The project with the lower payback period will be preferred. Sometimes the management has a set idea regarding what should be a maximum pay back period. Thus management may for example, decide that they will not accept any project if the pay back period is more than 3 years.

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COST OF CAPITAL
Illustration A firms after tax cost of capital of the specific sources is as follows: Cost of Debt 8% Cost of Equity Capital 17%

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The following is the capital structure: Source Amount Debt Rs. Rs 400000

Equity Capital Rs. 600000 TOTAL Rs. 1000000

Compute Cost of Capital (WACC)

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Sources of Fund

Amount

Proportion

Cost (%)

Weighted

DEBT EQUITY

400000 600000

.4 .6

.08 .17

.032 .102

.134 Weighted Average Cost of Capital = 13.4 %

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