Robinson is Chief Financial Officer (CFO) of Alpha Soaps Limited (ASL). Robinson reports to Johnson who is the Chief Executive Officer (CEO) of Alpha Soaps Limited. The corporate office of ASL is located at Nariman Point, Mumbai while two plants of ASL where production of soaps take place are located at Pandurang Industrial Area, Nanded, Pune. Currently, ASL manufactures only soap bars and does not produce detergents. On April 25, 2020, the following information for the last accounting year (2019-20) is extracted by Robinson from the financial records of ASL for presentation to Johnson.

Item Amount (in Crores)

Sales 5900

Total Variable Cost 2500

Total Operating Fixed Cost (including Depreciation) 1000

Depreciation 100

Profit Before Interest and Tax 2400

Interest 600

Profit Before Tax 1800

Corporate Tax Rate 30%

PAT 1260

Debt 5000

Shareholders' Fund (Net Worth) 8000

Return on Equity 15.75%

Return on Assets (Post-tax) 12.92%

Equity Beta 0.75

Pre-tax cost of debt 12%

Cost of Equity 12.5%

Cost of Debt (Post-tax) 8.4%

Cost of Capital 11.18%

The current risk-free rate of interest is 5% per annum. The market risk premium of India is estimated at 10% per annum.

The Board of Directors of ASL decide that ASL should go for concentric diversification project and should start producing Detergents (both powder and liquid) also. The Finance Team of ASL under the leadership of Robinson (CFO) has been given the task of assessing the viability of the project. The results of the findings of the study of the Finance Team will be presented by Robinson to Johnson who in turn will make the presentation to the Board of the company.

On the basis of the results of market research, the Finance Team decides to manufacture 5 crores Kg of detergent powder and 2 crores liters of detergent liquid. The results of market research also show that detergent powder can be sold at a price of Rs. 200 per kg and detergent liquid can be sold at a price Rs. 300 per liter. The variable cost per kg of detergent powder is estimated at Rs. 125 per kg and variable cost per unit of detergent liquid is estimated at Rs. 150 per liter. The operating fixed costs to manufacture detergent powder and detergent liquid are estimated at Rs. 200 crores. The investment in fixed assets (land, building, machinery, furniture and fixtures) that will be required to manufacture detergents is estimated to cost Rs. 3000 crores. The additional working capital requirements will be negligible. The Finance Team estimates that it will take around one year time to set up the project and the production of detergents can be commenced from April 1, 2021. The Finance Team estimates that expected life of the project will be 30 years and on the completion of the project after 30 years, the fixed assets required in the project can be sold at a price of Rs. 300 crores.ASL enjoys high liquidityand currently has around Rs. 1800 crores in the form of cash and marketable securities. The Finance Team decides that out of the total investment of Rs. 3000 crores, Rs. 1500 crores can be financed through internal equity and the remaining Rs. 1500 crores can be financed through debt (by borrowing from Gamma Finance Limited) at the rate of interest of 13% per annum. Finance Team also estimates that that business risk (degree of operating leverage) of the project is the same as the existing business risk of ASL (that is, degree of operating of ASL before considering the new project). The Finance Team projects the incremental cash flow from the project which are summarizedbelow

Item Amount (in Crores)

Sales 5*200+2*300=1600

Total Variable Cost 5*125+2*250=925

Total Operating Fixed Cost (including Depreciation)* 200

Interest 195

Depreciation 90

PBIT 475

Cash Flow (T = 0) -3000

Cash Flow (T=1-29) 446.25

Cash Flow (T=30) 746.25

Debt 1500

Shareholders' Fund (Net Worth) 1500

Equity Beta 0.89

Pre-tax cost of debt 13%

Corporate Tax Rate 30%

Cost of Equity 13.87%

Cost of Debt (Post Tax) 9.1%

Cost of Capital 11.48%

NPV of the Project 549.27

* Total Operating Fixed Costs do not include interest

On the basis of the findings of the findings of the Finance Team, Robinson recommends to Johnson that since net present value of the project is positive (Rs. 549.27 crores), the project to manufacture detergents can be accepted by ASL and the production of Detergents can be commenced from April 1, 2021.

The presentation regarding the above findings was made by Robinson to Johnson and other members of the Finance Team. Johnson does not possess very sound knowledge of finance thus he raised the following questions during and after the presentation of Johnson.

Question 1:

While recommending the decision to accept the project to manufacture detergents, what objective function has been considered by the Finance Team?

Question 2:

In response of Robinson to Question 1, Johnson asks how is it ensured that whether objective function of the company has been achieved or not?

Question 3:

In response of Robinson to Question 2, Johnson asks how the expectations of the investors about the rate of return are measured. Johnson further asks how we get to know whether value for the investors has been created or not. What is the role of beta, cost of equity, cost of capital, return on equity and return on assets in this context? He further asks kindly explain why and whether beta of Maruti Limited is higher or lower than the beta of ASL

Question 4:

In response of Robinson to Question 3, Johnson asks kindly explain whether ASL has created the value for its shareholders during the accounting year 2019-20.

Question 5:

Why beta (0.89) and cost of equity (13.87%) for the new project has been taken higher than the existing beta (0.75) and cost of equity (12.5%) of ASL?

Question 6:

Why on the basis of positive value of net present value (NPV), you are recommending that new project to manufacture detergents can be accepted? What is the concept of NPV and how is it computed? How will you explain the concept of NPV to a layman (who does not have any knowledge of finance)?

Question 7:

In response of Robinson to Question 6, Johnson asks why cash flows are considered and not PBIT (or PAT) while computing net present value. Johnson further asks why present value of cash flows are calculated while computing NPV and why not cash flows are simply added while computing NPV.

After getting the satisfactory responses from Robinson and the Finance Team, Johnson made the presentation in front of the member of the board of ASL and the board took the decision to go ahead with new project to manufacture detergents.

If you had been in place of Robinson (CFO of ASL), what answers you would have given to each of the above seven questions of Johnson.