The Machine Replacement With a Capacity Trap
Rupsha Textiles is deciding whether to replace a five-year-old loom. The old loom has a book value of BDT 8 crore, a remaining tax life of five years (straight-line), and could be sold today for BDT 5 crore. The new loom costs BDT 30 crore, has a ten-year tax life, and would cut annual operating costs by BDT 4.5 crore. However, the new loom produces 20% more output, and the sales director has assumed the extra output sells at current prices, adding BDT 6 crore of contribution. The plant manager notes the market is already oversupplied and the company is running at 85% utilisation. Working capital would rise by BDT 2 crore. The tax rate is 25% and the cost of capital is 12%. The board is split between the two forecasts.
1. Which incremental revenue assumption is defensible, and how does it change the investment case?
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The revenue assumption is the crux. The sales director's BDT 6 crore contribution assumes the extra 20% output is sold at today's price with no market response. But the setup states the market is oversupplied and the company runs at 85% utilisation. In an oversupplied market, incremental volume is won by price concession, not by adding to demand. The defensible assumption is therefore either (a) zero incremental contribution, treating the extra capacity as option value only, or (b) a reduced contribution reflecting a price cut on all units, not just the marginal ones.
Illustrating (b). If the extra 20% requires a 5% price cut to clear, the loss falls on existing volume too. On a base where BDT 6 crore of contribution corresponds to 20% extra output, base contribution is BDT 30 crore; a 5% price cut costs BDT 1.5 crore on the base plus the marginal effect. The 'extra' contribution can easily turn negative.
Investment case under the conservative assumption.
- Operating cost saving: BDT 4.5 crore pre-tax, BDT 3.375 crore after tax.
- Initial outlay: BDT 30 crore less after-tax sale proceeds of the old loom. Sale at BDT 5 crore against book value BDT 8 crore gives a BDT 3 crore loss, a tax shield of BDT 0.75 crore, so net proceeds are BDT 5.75 crore. Plus working capital BDT 2 crore. Net outlay ≈ BDT 26.25 crore.
- Annuity factor at 12% for ten years is 5.650; PV of savings ≈ BDT 19.1 crore.
- NPV ≈ −BDT 7 crore before any terminal value.
Verdict. On cost savings alone the project destroys value. It only clears the hurdle if incremental revenue is real, and the market conditions say it is not. The board should approve only if the sales director can evidence contracted or clearly price-resilient volume, or if the loom can be run at existing volume with proportionally lower operating cost.
2. How should the old loom's book value and the working capital change be treated, and what errors would you look for in the board papers?
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Old loom book value. The BDT 8 crore book value is a sunk accounting number and must not enter the cash-flow analysis as a cost. What matters is the opportunity cost of not selling: the BDT 5 crore foregone, adjusted for tax. Because sale proceeds are below book value, the BDT 3 crore loss generates a BDT 0.75 crore tax shield, so the effective opportunity cost is BDT 5.75 crore. Two common errors to check for: (i) deducting the BDT 8 crore book value as if it were a cash outflow, and (ii) ignoring the tax shield on the loss, which overstates the outlay by BDT 0.75 crore. A third error is deducting the full BDT 8 crore and the BDT 5 crore proceeds, double counting.
Working capital. The BDT 2 crore increase is an outflow at the start and must be recovered at the end of the project; omitting the recovery understates NPV. It should also be checked for proportionality - if the extra output assumption is rejected, the working capital increase may be smaller or zero, so the two assumptions must be consistent. A board paper that keeps BDT 2 crore of working capital while dropping the revenue is internally inconsistent.
Other errors to look for. Depreciation must be added back and only the incremental tax shield counted; the new loom's depreciation shield (BDT 30 crore ÷ 10 × 25% = BDT 0.75 crore per year) is real cash and should appear. The old loom's remaining depreciation shield is foregone and must be subtracted. The discount rate should reflect the project's risk, not the firm's blended WACC, if textile capacity risk differs from the group. Finally, check whether the analysis uses a ten-year horizon for the new loom while the old loom would have lasted five - the comparison must cover the same period or use equivalent annual cost.