Case Analysis

Case Study-5

DHPL is a small-sized firm manufacturing hand tools. Its manufacturing plant is situated in Faridabad. The company's sales in the year ending on 31st March 2004 were Rs. 1,000 million (Rs. 100 crore) on an asset base of Rs. 650 million. The net profit of the company was Rs. 76 million. The management of the company wants to improve profitability further. The required rate of return of the company is 14 per cent. The company is current considering two investment proposals. One is to expand its manufacturing capacity. The estimated cost of the new equipment is Rs. 250 million. It is expected to have an economic life of 10 years. The accountant forecasts that net cash in flowed would be Rs. 45 million per annum for the first three years. Rs. 68 million per annum from year four to year eight and for the remaining two years Rs. 30 million per annum. The plant can be sold for Rs. 55 million at the end of its economic life.

The second proposal before the management is to replace one of the old machines in the Faridabad plant to reduce the cost of operations. The new machine will involve a net cash outlay of Rs. 50 million. The life of the machine is expected to be 10 years without any salvage value. The company will go for the replacement only if it generates sufficient cost savings to justify the investment.

If the company accepts both projects, it would need to raise external funds of Rs. 200 million, as about Rs. 100 million internal funds are available. The company has the following options of borrowing Rs. 200 million.

v The company can borrow funds from the State Bank of India (SBI) at an interest rate of 14 per cent per annum for 10 years. It will be required to pay equal annual instalments of interest and repayment of principal. The managing director of the company was wondering if it were possible to negotiate with SBI to make one single payment of interest and principal at the end of 10 years (instead of annual...