Case Study II: (Marks 20)

Polite Chimney Limited

Polite Chimney Ltd (PCL) is a leading manufacturer of items used in kitchens such as gas stoves, electric chimneys, ovens and so on. It has grown significantly under the CEO Akbar Ahmed's dynamic leadership. In line with his belief to enhance competitiveness by using research and development for launching innovative products in the market, the PCL has recently developed a Zero Maintenance Electric Chimney (known as ZMEC) which is ideally suited for Pakistan cooking. The research and development cost of ZMEC amounts to Rs 2,000,000.

To gauge the market prospects for ZMEC, a market survey was conducted by Bazar Jinni Pvt. Ltd. The results of the survey were very positive showing a significant demand for ZMEC. The survey report also indicated that ZMEC could capture 8% of the current market share and would be able to sell following number of units of gas electric chimney:

Year

Units

1

10,000

2

10,300

3

10,609

4

10,927

5

11,255

Considering the growth of satellite towns/cities and residential colonies, the sale is expected to grow at 3% annually. The VP, Marketing suggested to the CEO that a market penetration pricing strategy would be most suitable and ZMEC should be priced at Rs. 3,100 per unit. The marketing and administrative costs (fixed cost) are expected to increase by Rs. 400,000 per year.

The PCL is presently using 6 machines acquired 3 years ago at a cost of Rs. 8,000,000 each, having a useful life of 8 years, with no salvage value. These machines are currently being used for manufacturing other types of chimneys. They could be sold for Rs. 2,600,000 per machine.

The machine to manufacture ZMEC is available in that market for Rs. 70,000,000 with a useful life of 5 years and salvage value of Rs. 1,000,000. It can produce other types of chimneys also. The new machine's installation cost will be 1,500,000 and being having state of the art technology would improve the productivity of the workers as well change the unit variable cost of manufacture to Rs. 600. PCL corporate tax rate is 35% and uses straight line method to calculate depreciation on all machines.

The maintenance costs currently amount to Rs. 100,000 per year (existing machine). They would total Rs. 170,000 with the new machine. The net working capital required to start production of ZMEC would be Rs. 1,000,000.

Required:

1.Calculate initial investment outlay.

2.What will be the operating cash flows over the life of the project?

3.Estimate terminal cash flows and terminal year cash flows separately.

4.Determine whether project should be accepted or not using NPV and PI criteria. Explain your answer briefly (Use WACC calculated in Case I: Fatimah Enterprises).

5.Explain briefly why financing costs are ignored at the time of cash flow calculation for capital budgeting project? Give example.