Case 32

THE NEOGI CHEMICAL COMPANY

The Neogi Chemical Company (NCC) was started in 1988 as a private limited company with an
initial investment of Rs.25crore. Under the able guidance of its chairman, Mr. Chaman Lal
Neogi, the company made tremendous progress during the last decade. As a result of its
increasing sales and profits and increasing demand of funds for financing the expansion, the
company was converted into a public limited company in 1994. On March 31, 1997, the total
capitalization of the company was Rs.120 crone.
Although the company is highly profitable and growing constantly, there is ample scope to
introduce more scientific managerial techniques to improve profitability further. For example,
the company has not been following a sophisticated approach in screening and evaluating its
capital projects. The finance committee is authorized to screen and approve only those projects
which involve capital expenditure exceeding Rs.25 lakh. Departmental heads are members of the
committee and the controller of finance is its chairman. It is the responsibility of the departmental
heads to submit a detailed description of proposed projects together with estimates of cost and
benefits. Six such projects are currently under consideration (Exhibit I).
The finance committee does not follow a standard procedure to screen capital projects. Rather
the committee listens to the views of the various members and decides on the basis of the merits
and force of the arguments made by the committee members. After attending an Executive
Development Programme on Techniques of investment Analysis recently, Mr. Chaman Lal
Neogi, the chairman of the company, was convinced that his company would be able to allocate
funds rationally if it adopts a more scientific approach towards investment decisions. He,
therefore, asked the finance committee to standardize its screening procedure and adopt some
scientific evaluation techniques to ensure equitable treatment to each project and maximum
possible return to the company on its investment expenditure.
Keeping in view the desire of the company's chairman, the finance committee met to consider
the current projects. Mr.Neogi was also present at the meeting. A number of issues were raised by
the committee members in an attempt to establish a sound screening programme. For example, it
was the view of Mr.Jagat, The chief accountant, that the first and foremost concern of the
company should be that the money invested in a project be recovered within a short period of
time. He opined that a maximum acceptable, payback period, of four years for NCC should be the
basis to accept a project. To emphasize his point, he argued that such an approach was not only
simple, but also did not require the calculation of the cost of capital which is a formidable task.
Mr.Laxmi Chand, the marketing manager, reacted sharply to this view. He pointed out that
following such a policy may result in accepting those projects that were not beneficial to the
company and rejecting profitable ones. He added that the desirability of a project depended not
only on the speed with which investment was recovered, but also the life of the project over
which benefits would be derived. He favoured the use of the internal rate of return (IRR) method.
This method, according to him, incorporates all cash flows over the life of the project and adjusts
them for the time value as well. He stated further that the computation of the cost of capital was
not necessary for the use of this method,
Mr.Jagat reacted to these suggestions by stating that the rate of return method is difficult and
at times unrealistic for evaluating projects. Because of the mathematics of the formula for
computing internal rate of return, it could give multiple (and also imaginary) rates of return for an
investment project. Defending the use of payback, period as an evaluation criterion, he pointed
out that besides being simple, payback method can be used as a measure of risk and liquidity. He
stated that one simply needs to shorten the maximum acceptable payback period to account for
risk and liquidity. He also stated that the method also gives an idea of the project's rate of return,
under the conditions of constant cash flows and a sufficiently long life of the project, its
reciprocal gives an approximation of the project's rate of return.
Mr.Neogi intervened at this stage of the discussion to say that 'payback' may be a useful
investment criterion, but its use as the only criterion cannot be defended. Mr.Vinod Mittal, the
controller of budgets, felt that the best method to use was the 'net present value' (NPV) method. It
clearly indicates what wealth would accrue to the owners of the company from the project.
Mr.Mittal also stated that if present values of cash flows are calculated, one can also compute the
ratio of the present value of cash inflows to initial cash outlay, in order to assess the relative
significance of various investment proposals. He explained further that like 'internal rate of
return' (IRR) the NPV method adjusts cash flows for time value and is very simple in its
computations. He also stated that since 'internal rate of return' and the 'net present value' methods
give the same accept-reject decisions, those who have an objection to the use of the 'internal rate
of return
1
method on account of its involved computations and the possibility of multiple rates of
return would have no objection in accepting the use of the net present value method as an
investment criterion.
Mr.Neogi reacted to Mr.Mittals arguments by saying that under certain conditions,
particularly when one has to rank mutually exclusive projects, 'internal rate of return' and 'net
present value' methods could give conflicting rankings. According to him, this perhaps happens
due to the difference in the cash flow patterns of the mutually exclusive projects. He, however,
informed the meeting that when this topic was discussed in the executive development
programme, which he had attended there was a controversy regarding the cause of the conflicting
rankings given by IRR and NPV methods. One point of view was that this happened because of the
different implicit reinvestment assumptions inherent in the formula of the two methods NPV
method assumes that the intermediate cash flows generated by an investment are reinvested at the
rate of discount (cost of capital to the firm), while the IRR method assumes that they are reinvested
at the project's internal rate of return The contrary view was that the ranking conflict arose solely
due to the different patterns of the cash flows of the projects; the reinvestment argument was
indefensible. He informed further that the majority view in the executive development programme
was that NPV method was more consistent with wealth maximization principle than IRR method
in the evaluation of the investment projects. To clarify the issues relating to the controversy of
NPV vs. IRR, as understood by Mr.Neogi he illustrated the example given in Exhibit II.
Investment projects A and B in Exhibit II require the same initial outlay, although their cash
inflow patterns differ. At a required rate of return of 10 per cent, project A's NPV (Rs.4140) is
higher than Project B's NPV (Rs.3824). However, Project B earns a higher IRR (37.63 per cent)
than Project A (26.55 per cent).
Mr.Pramod, the production manager shifted the discussion to the questions of the cut-off
rate. He complained that the committee had been very conservative m the past in approving
projects. He felt that there would be no difficult in financing all those projects that earn rates
higher than the cost of debt, which at present is approximately 9.75 per cent (after-tax). This view
was countered by finance manager. He contended that indiscriminate use of debt financing was
risky It would put the capital structure in imbalance and alarm the lenders. The result was likely to
be an increase in effective interest rates and more restrictive loan covenants. This also could have
an adverse effect on the share prices of t h e company. He, therefore, felt that a basic change in the
capital structure would have serious consequences for the company. He did not know what would
be the cost and repercussions if the projects were financed by raising equity capital, instead of debt
capital.
Some committee members also raised the question of using retained earnings for financing the
project since it is a cost free source. However, the chairman of the committee informed the
members that, in his opinion, no source of fund could be said to be free of cost; at least, there was
an opportunity cost involved. The Chairman also said that the problem would become simple if
the cost of capital could be calculated. He also informed the members that as a policy, the
company would like to maintain a debt-equity ratio of 3:2 at its book values in the long-run. AT
this juncture, the chairman of the committee adjourned the meeting requesting the members to
come with their recommendations regarding Project No.l in the light of the discussion in the
meeting. The estimates of the costs and benefits of Project No. 1 (Exhibit III) were circulated to
each member. The information about the companys capital structure and other relevant data
(Exhibit IV) were also circulated. The chairman also informed the members that this year for
financing any investment project the company may have to raise debt at 15 per cent per annum.


Exhi bi t I

THE NEOGI CHEMICALS COMPANY

List of Proposed Capital Projects

Project Description Type Basis for Decision Gross Outlay
(Rs.Lakh)
Adoption of New
Chemical Mixing
Process
Replacement
Expansion
Cost Saving and
Revenue Generation
450
Starting a New
Product Division
Expansion Increased Revenue 600
Purchase of Land
for Possible Future
Expansion
Strategic
Expansion
Management
Strategy
300
Purchase of an
Additional Warehouse
Expansion Increased Profits 500
I
Improvement of
Material Handling
Facilities
Replacement Cost Saving 200
Opening a New Office
to Handle Foreign
Operations
Independently
Strategic
Expansion
Management
Strategy
400
Exhi bi t I I


THE NEOGI CHEMICALS COMPANY
Illustration of NPV vs. IRR


Cash Flows (Rs.) in Year NPV at 10%

Project 0 1 2 3 (Rs) IRR(%)
A
B
-10,000 2,000 4,000 12,000
-10,000 10,000 3,000 3,000
4,140
3,824
26.55
37.63
Exhibit I I I
THE NEOGI CHEMICALS COMPANY
Estimated Revenue and Costs of Project No. 1
(Rs in lakh)

Note:
In addition to the gross outlay of Rs.450 lakh, the proposed project will require 31
net increase in working capital of Rs.32 lakh. The estimated life of the proposed
project is 10 years. The present project has a book value of Rs.30 lakh and a
market value of Rs.45 lakh and if retained for 10 years, its salvage value at the end
of the tenth year is expected to be Rs.15 lakh. The proposed project has estimated
salvage value of Rs.40 lakh at the end of its life. Corporate tax rate is 35 per cent,
and a 25 per cent written-down depreciation rate for tax purposes (see Appendix I).

1. The Company's share is currently selling for Rs.200. The company's dividend rate
is 22 per cent which is expected to grow at 7.5 per cent for a long period of time.
2. The average interest rate on borrowings in past year has been about 16 per cent.
Present Project Proposed Project
Annual Revenue Sales 510 692
Annual Costs Raw Material 262 348
Labour Costs 80 65
Supervision 8 6
Power 15 11
Repairs and Maintenance 4 5
Depreciation (Straight-line Method) 3 45
Allocated Corporate Overheads 5 7
Exhibit I V

THE NEOGI CHEMICALS COMPANY

Capital Structure Year Ended March 31,1998


(Rs. in lakh)
Paid-up share capital (30 lakh shares @ Rs.100) 3,000
Reserves and surplus 1,800
Total Borrowings 7,200
The Capital Employed 12,000

Notes: