Case Study of Capital Budgeting

Multan Sultan $($MS$)$ is considering the launch of a product called Miswak. Following information has

been gathered in this regard:

MS will need to spend Rs$.250$ million on purchasing and installing the plant for the

manufacturing of Miswak. At the end of year $4,$ the plant's resale value is expected to be Rs$.65$

million. The plant will be subjected to accounting$/$tax depreciation at $25\%$ using the reducing

balance method.

MS estimates immediate working capital requirement to be Rs$.75$ million. A $15\%$ increase,

inclusive of inflation, in the working capital requirement $($based on the previous balance$)$ is

anticipated at the start of years $2,3,$ and $4.$ However, only $60\%$ of the working capital is

expected to be realised at the project's end. The remaining balance would be written off as

unsaleable inventory at the end of year $4.$

Sales of Miswak are expected to be $30,000$ units per annum, remaining constant over a $4-$year

period. The selling price is estimated to be Rs$.4,000$ per unit.

Raw material requirements for the year, along with current inventory details, are as follows

SB will not be available in the market until the end of the first year. Further, it is also used in

another product, requiring $600kg$ for the year. However, that product will be discontinued at the

end of the year. SB is not used in any other product and can be sold in the market at $50\%$ of its

cost$.$

MS estimates an annual labour requirement of $30,000$ semi$-$skilled labour hours at Rs$.150$ per

hour and $10,000$ skilled labour hours at Rs$.250$ per hour.

The annual fixed cost $($excluding depreciation$)$ is estimated to be Rs$.1\mathrm{.}8$ million.

The applicable tax rate would be $30\%.$ Taxes will be payable or refundable in the year in which

the tax liability or asset arises.

All revenues and costs are quoted in today's rate. Annual inflation is estimated to be $11\%$ and

will apply to all revenues and costs $($except where specified$)$ from the first year onwards.

MS$\text{'}$s cost of capital is $22\%.$

Required:

Compute internal rate of return $($IRR$)$ of Miswak and advise whether MS should introduce it$.$

$($Assume that all cash flows arise at the end of each year unless specified otherwise.$)$