Ebroo Clothing Company

Urgent Need for Capital Budgeting Advice

It is September 2016 and Santosh Renjit has decided to hire you - based on a recommendation from a contact he has at Mays Business School, in the United States - as his consultant on this case. For clarity, and in order to specify your deliverables, he specifies the input he requires of you in the form of two questions, which he spells out at the bottom of this document that he sends to you. The document provides background to the dilemma that his company faces as well as the information you need to be able to make your recommendation.

As a particular requirement, he also specifies that your recommendation should be clear and concise and should be understandable to non-finance experts: his executive board members - like most other company boards - are drawn from different parts of the company and are not necessarily conversant with typical finance terminology. As such, the recommendation, while being as brief as is possible, should also indicate the process and reasoning at every stage of the report. For example, he says, you should divide your report into the appropriate number of sections so that if calculating cash flow, say, you should explain why that is necessary; same for if you are evaluating things like operating costs, etc.; meaning you should explain what each concept means and why you are using it. In other words, he requires that you guide the reader as they go over your report so that they understand what youre doing at its various steps and why. He insists that you carry the reader along, step by step, all the way through to the end.

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Abstract:

On September 20, 2016, Santosh Renjit, Senior Vice President of Ebroo Clothing Company, sat in his office pondering the new capital budgeting proposal for se ng up a product line of branded shirts. As per standard company practice, he was required to evaluate the capital budgeting project using the traditional Net Present Value (NPV) approach and the Internal Rate of Return (IRR) criterion and present his findings to the management committee meeting scheduled for the next week. Santosh wondered whether this new proposal would turn out to be a good investment for his company, which was looking to deploy funds in NPV positive projects.

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Introduction:

Atop Santosh Ebroos desk was a capital budgeting and investment proposal a new product line of branded shirts that the committee was considering for launch. As the head of the finance department, Santosh was required to work along with his team on a detailed capital budgeting analysis and present the findings to the management committee for their approval. As per standard company practice, each capital budgeting and investment project was evaluated using the traditional Net Present Value (NPV) approach and the Internal Rate of Return (IRR) criterion for determining whether the company would undertake the project or not.

Santosh had a lot to think about as he considered the analysis of the capital budgeting project using the traditional Net Present Value (NPV) approach and the Internal Rate of Return (IRR) criterion. What would be the basis for calculating the after-tax operating cash flows for the capital project? How would he arrive at the depreciation and working capital requirements for computing the NPV? What would be the basis for calculating the terminal year cash flows? With all these questions in mind, Santosh decided to focus on the proposed capital budgeting project for the next few days.

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Indian Retail Market:

The Indian retail market is at the cusp of a sweet spot driven by strong GDP (Gross Domestic Product) growth, benign inflation, and rising per capita income and purchasing power of consumers. Currently, the retail industry accounts for more than ten percent of the Indian Gross Domestic Product and approximately eight percent of employment. The industry is expected to nearly double, from US$600 billion in 2015 to US$1 trillion by 2020, driven by income growth, urbanization, and a tudinal shift (Indian Terrain Annual Report, 201516). It has been estimated that, by 2030, the Indian apparel market, in particular, is expected to grow at a CAGR (compounded annual growth rate) of approximately 1012%, backed by increasing affordability on account of an increase in disposable incomes, an increase in aspirations, and a shift from unbranded to branded products by the burgeoning middle class. This trend is likely to be further accentuated by the rise of e-commerce companies that enable shopping from anywhere, thereby leading to increased penetration in small cities and towns (Indian Terrain Annual Report, 201516).

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Company Background:

Ebroo Clothing is a small, privately owned clothing company based in New Delhi, India. It was founded in 1995 by Sumit Ebroo, a retired executive. Since then, the company has grown steadily by catering to middle to low income consumers in the Delhi-National Capital Region (NCR). The company recorded a stellar growth of 50% in its sales during the last financial year of 201516. With a healthy operating margin and low leverage levels, the company had been able to grow its profits at a CAGR of 25% during the last 10 years. With a good brand name and healthy financial metrics, the company was now looking to expand its footprint to new product lines catering to middle to high income customers.

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Project Investment Proposal Details:

The project is estimated to be of 10 years duration. It involves se ng up new machinery with an estimated cost of as much as INR 500 million, including installation. This amount could be depreciated using the straight line method (SLM) over a period of 10 years with a resale value of INR 15 million. The project would require an initial working capital of INR 20 million with cumulative investment in net working capital to be maintained at 10% of each years projected revenue. With the planned new capacity, the company would be able to produce 240,000 pieces of shirts each year for the next 10 years. In terms of pricing, each shirt can initially be sold at INR 1,300, which takes into account the target segment and competitor pricing. The project proposal incorporates an annual increase of 3% in the price of the shirt to compensate for inflationary impact. With regards to the raw material costs and other expenses, the project estimated the following details:

Raw material cost for manufacturing shirts at INR 400 per shirt, slated to rise by 5% per annum on account of inflation.

Other direct manufacturing costs at INR 125 per shirt with an annual increase of 5% per annum on account of inflation.

Selling, general, and administrative expenses (including employee expenses) at INR 35 million per annum, expected to increase by 10% each year.

Depreciation expense on the basis of SLM.

Tax rate is assumed to be 25%.

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Funding:

For funding of the expansion project, the promoters agreed to infuse 50% in the form of equity with the rest (50%) being financed from issue of new debt. Based on the current credit position and market scenario, new debt can be raised by the company at 12% per annum. Cost of equity was assumed to be 15% by Santosh. He reckons the requisite discounting rate or weighted average cost of capital (WACC) for NPV and IRR calculations may be determined with the help of these assumptions.

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Demand Scenario:

Although the project proposal estimates a maximum annual production of 240,000 shirts, Santosh would like the capital budgeting analysis to be done under two demand scenarios: Optimistic and Expected. The likely annual demand estimated under each scenario is as follows:

Scenario Annual Demand

Optimistic 240,000 shirts

Expected 200,000 shirts

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Your Mandate:

I. On the basis of the financial information given in the case, calculate the after-tax operating cash flows, NPV, and IRR under the Optimistic and Expected scenarios. Clearly specify the calculations applied.

II. Based on your analysis, what recommendation would you make on whether the company should

undertake the project or not? Clearly specify the decision based on both the NPV and the IRR criteria.