Case 011Capital budgetingHard
A biscuit maker's premium line has a market study already paid for, cannibalises existing sales and uses an idle warehouse. Work out the NPV.
1The situation
Mridula Biscuits plans a premium cookie line. It expects Rs 80 crore of sales a year at a 25% contribution margin, but about Rs 30 crore of those sales will come from customers who now buy its regular biscuits, which earn a 30% contribution margin. A Rs 5 crore market study has already been paid for. The line will use a warehouse that stands idle today but could be rented out for Rs 1 crore a year.
Capex is Rs 40 crore, depreciated straight line over six years to nil, and working capital of Rs 10 crore is needed at the start and recovered at the end. Tax is 25%, the life is six years and the discount rate 12%.
2Your task
Which cash flows belong in the analysis, what is the NPV, and should Mridula launch?
Quick check
Which item should stay out of the NPV?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The NPV is about minus Rs 7.2 crore, so on these numbers Mridula should not launch. Annual after-tax cash flow is Rs 9.17 crore once Rs 9 crore of lost regular contribution and Rs 1 crore of forgone rent are counted; the sunk Rs 5 crore study stays out. Ignoring cannibalisation alone would show plus Rs 20.5 crore and flip the decision.
Step 1What is the one test for every line in a project appraisal?
Compare the company's cash with the launch and without it; only the difference counts. If you have already paid for a concert ticket and then feel unwell, the ticket price should not decide whether you go, because you lose it either way. A sunk costMoney already spent that no future decision can recover. It is irrelevant to the decision, however painful. is out; anything the decision causes, including profit lost elsewhere and income given up, is in. That one test sorts every item in this case.
Step 2What is the annual cash flow?
New contribution is 25% of Rs 80 crore, Rs 20 crore. Cannibalised sales take away 30% of Rs 30 crore, Rs 9 crore, and the warehouse costs Rs 1 crore of rent forgone, so the launch adds only Rs 10 crore a year before tax. Depreciation of Rs 6.67 crore is not cash, but it reduces tax: taxable profit is Rs 3.33 crore, tax Rs 0.83 crore, and after-tax cash flow Rs 9.17 crore a year. The opportunity costThe income given up by using an asset for this project instead of its best alternative use, here renting the warehouse out. of the warehouse is small here, but it is real money the company gives up.
| Rs crore | Year 0 | Years 1 to 6, each | Year 6 extra |
|---|---|---|---|
| New contribution, 25% of 80 | 20.00 | ||
| Lost contribution, 30% of 30 | (9.00) | ||
| Warehouse rent forgone | (1.00) | ||
| Tax at 25% after depreciation | (0.83) | ||
| Capex | (40.00) | ||
| Working capital | (10.00) | 10.00 | |
| Cash flow | (50.00) | 9.17 | 10.00 |
| Present value at 12% | (50.00) | 37.69 | 5.07 |
| 50 | capex of 40 plus working capital of 10, paid now |
| 9.167 | after-tax cash flow each year |
| 4.1114 | six-year annuity factor at 12% |
| 10 / 1.12^6 | working capital recovered at the end |
Step 3Why does getting the relevant costs wrong flip the decision?
Run the mistakes. Leaving out cannibalisation raises the annual pre-tax gain from Rs 10 crore to Rs 19 crore and the NPV to plus Rs 20.5 crore; leaving out the rent too gives plus Rs 23.6 crore. Charging the sunk study pushes the right answer further down, to minus Rs 12.2 crore. The sign of the decision depends on getting these lines right, not on the discount rate.
Close with what would change the answer. The line needs about Rs 2.3 crore a year more pre-tax contribution to reach zero NPV, for example by cannibalising less, through a distinct brand or channel, or by a slightly higher price. The decision rests on the Rs 30 crore cannibalisation estimate, so the next step is to test it, not to argue about the 12%.
Where candidates lose it
The classic loss is including the market study because it appears in the project file, or ignoring cannibalisation because the new line's own figures look good. Both come from appraising the product rather than the decision.
The quieter miss is treating depreciation as a cash outflow. It matters only through the tax it saves, Rs 1.67 crore a year here.
What the interviewer asks next
- Marketing argues half the cannibalised customers would have switched to a rival's premium biscuit anyway. How does that change the NPV?
- What if the warehouse could be sold today for Rs 8 crore instead of rented?
- How would you set the discount rate for a new product line rather than the company as a whole?
Company names and figures are illustrative.