Question
On May 30, 2020, Boon Mee, Senior Vice President of Tiger Land Textiles Ltd (TLT), was preparing for a meeting with the management committee scheduled
On May 30, 2020, Boon Mee, Senior Vice President of Tiger Land Textiles Ltd (TLT), was preparing for a meeting with the management committee scheduled the next week. On his 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, Boon Mee 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. Boon 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, Boon decided to focus on the proposed capital budgeting project for the next few days.
Company Background
TLT is a small, privately owned clothing company based in Cheng Mai, Thailand. It was founded in 1995 by Chaisee Benjawan, a retired executive. Since then, the company had grown steadily by catering to local and foreign tourists and local high to middle income consumers in the Cheng Mai Region (CMR). The company recorded a stellar growth of 17% in its sales during the last financial year of 2018/19. With a healthy operating margin ratio and low leverage levels, the company had been able to grow its profits at a compounding annual growth rate of 5% 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.
Project Investment Proposal Details
The project is estimated to be of 10 years duration. It involves setting up new machinery with an estimated cost of as much as Thai baht (THB) 375 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 THB13.5 million. The project would require an initial working capital of THB15.5 million. With the planned new capacity, the company would be able to produce 150,000 pieces of shirts each year for the next 10 years. In terms of pricing, each shirt can initially be sold at THB 900 a piece, 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 THB325 per shirt, slated to rise by 2.5% per annum on account of inflation. Other direct manufacturing costs at THB55 per shirt with an annual increase of 2.5% per annum on account of inflation.
Selling, general, and administrative expenses (including employee expenses) at THB 24 million per annum, expected to increase by 6% each year. Depreciation expense on the basis of SLM.
Tax rate was assumed to be 30%.
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%. The requisite discounting rate or weighted average cost of capital (WACC) for NPV and IRR calculations can now be calculated with the help of the above assumptions.
Demand Scenario
Although the project proposal estimates maximum annual production of 240,000 shirts, Saurabh decided to do capital budgeting analysis under two demand scenarios: Optimistic and Expected. The likely annual demand estimated under each scenario is as follows:
Scenario | Annual demand |
Optimistic | 200,000 Shirts |
Expected | 150,000 Shirts |
Discussion Questions
- 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 required for the same. (40 marks)
- Based on your analysis, as Boon Mee, what recommendation would you make on whether the company should undertake the project or not? Clearly specify the decision based on both the NPV technique as well as the IRR criterion. (10 marks)
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