Vindhya Ceramics kiln sensitivity
Vindhya Ceramics Ltd is evaluating a ₹12 crore automated kiln. The project has a five-year life and no salvage value. Depreciation will be straight-line to zero. Expected annual sales are 90,000 units at ₹1,500 per unit. Variable costs are 55% of sales, fixed costs excluding depreciation are ₹2.1 crore, and the tax rate is 25%. The company uses a 12% discount rate. The initial appraisal shows a positive but thin NPV. The marketing head warns that competitors may force a 10% price cut within two years, while the production head expects raw-material inflation to push variable costs to 60% of sales. The CFO wants to know how much room the project has before it destroys value, and whether the combined adverse scenario should change the decision.
1. Compute the base-case NPV and the percentage fall in selling price that makes NPV zero, holding all other variables constant.
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Base case
- Sales = 90,000 × ₹1,500 = ₹13.50 crore.
- Variable cost = 55% × ₹13.50 = ₹7.425 crore.
- Contribution = ₹6.075 crore.
- Fixed cost = ₹2.100 crore.
- Depreciation = ₹12 crore ÷ 5 = ₹2.400 crore.
- EBIT = ₹6.075 − ₹2.100 − ₹2.400 = ₹1.575 crore.
- Tax at 25% = ₹0.394 crore; PAT = ₹1.181 crore.
- Annual cash flow = ₹1.181 + ₹2.400 = ₹3.581 crore.
- PVAF at 12% for 5 years = 3.6048.
- PV of cash flows = ₹3.581 × 3.6048 = ₹12.91 crore.
- NPV = ₹12.91 − ₹12.00 = ₹0.91 crore.
Price sensitivity For zero NPV, required PV = ₹12 crore, so required annual cash flow = ₹12 ÷ 3.6048 = ₹3.329 crore. Required EBIT = (₹3.329 − ₹2.400) ÷ 0.75 = ₹1.239 crore. Required contribution = ₹1.239 + ₹2.100 + ₹2.400 = ₹5.739 crore. Contribution per ₹1 of price = 90,000 × 45% = 40,500. Required price = ₹5.739 crore ÷ 40,500 = ₹1,417. Price fall = (₹1,500 − ₹1,417) ÷ ₹1,500 = 5.5%.
So the project can absorb only about a 5.5% price reduction before NPV turns zero. A 10% price cut alone would destroy value.
2. Evaluate the combined adverse scenario of a 10% price cut and variable costs at 60% of sales. Should Vindhya proceed? What option value, if any, could justify a modified investment?
Read the worked answer
Combined adverse scenario
- New price = ₹1,350; sales = 90,000 × ₹1,350 = ₹12.15 crore.
- Variable cost = 60% × ₹12.15 = ₹7.29 crore.
- Contribution = ₹4.86 crore.
- Fixed cost = ₹2.10 crore; depreciation = ₹2.40 crore.
- EBIT = ₹4.86 − ₹2.10 − ₹2.40 = ₹0.36 crore.
- Tax = ₹0.09 crore; PAT = ₹0.27 crore.
- Cash flow = ₹0.27 + ₹2.40 = ₹2.67 crore.
- PV = ₹2.67 × 3.6048 = ₹9.63 crore.
- NPV = ₹9.63 − ₹12.00 = −₹2.37 crore.
The combined scenario is value-destroying. The base case is too thin: a 5.5% price fall alone eliminates NPV, and the marketing and production warnings are plausible together. Proceeding with the full ₹12 crore committed now would be speculation, not capital budgeting.
A modified investment could still be justified if it buys valuable flexibility. Examples: install a modular line in two phases so that phase two can be deferred until price and raw-material trends are clearer; negotiate a shorter payback or a customer price-escalation clause; retain the option to switch product mix; or lease rather than buy part of the equipment. The option value must be explicitly estimated and должна exceed the ₹2.37 crore expected loss under the adverse scenario. Without such a staged design, reject the project. Do not accept the base case merely because NPV is positive; the margin of safety is only 5.5% on price.