Pure Drinks

Pure Drinks is in the business of packed fruit juices. It already produces and sells orange, apple
and pine apple juices. The company engaged a well known marketing consultant to conduct a
market survey to find the scope for guava juice. The market survey indicated tremendous scope
for guava juice, and that the company could sell 900,000 sachets of guava juice every year. The
Rs. 5 million cost of the survey has not been yet paid in cash.

The survey has also shown that for 1-liter sachet of guava juice, consumers are not prepared to
pay more than Rs. 85. The accounting department of the company has estimated that the
variable cost per sachet would be Rs. 15, which includes material cost of Rs. 6.50, labour cost
Rs. 3.50 and overhead cost of Rs. 5.00. At a capacity of one million sachets, the fixed overhead
cost per sachet is estimated at Rs. 6.75. The fixed overhead costs are the allocations of the
corporate general and administrative costs. Because of the project the corporate marketing
expenses and some administrative costs are likely to increase by Rs. 0.50 million per year. The
management accountant feels that the profitability of the project would be affected by
inflation. He expects 4 percent annual consumer price inflation and estimates that the price
increases in variable overhead costs and labour cost would be 5 percent per annum and in
material cost 3 percent per annum. The management is confident that they would be able to
increase the selling price by expected consumer price inflation. Company’s current working
capital to sales ratio is 30 percent. However, the company is implementing a computer based
inventory control system that is likely to decrease the company’s working capital by 5 percent.

The company is considering using its existing building for processing of guava juice. The building
is fully depreciated for tax purpose and was not in use so far. But a few months ago it received
an offer of Rs. 100 million for the purchase of the building from a computer company. If the
company does not sell the building immediately, its value is likely to appreciate by Rs. 50 million
after five years. The processing facility ​for 1 million liter guava juice would cost Rs. 200 million.
It is expected to have an economic life of five years. The estimated savage value of the
processing equipment is Rs. 100 million. The company is allowed to charge depreciation at the
rate of 20 percent of w.d.v. for this purpose. Both the business profits and the capital gains are
taxed at the rate of 35 percent.

The company has no debt. The project will be financed from the internally generated funds. The
investors expect a real rate of return of 8.65 percent from the proposed guava project.

Analyze the financial viability of this project.