Rice Mill Expansion: Ownership Versus Lease in Nagaon
A cooperative society in Nagaon is evaluating a rice mill. The equipment costs ₹45 lakh, installation ₹5 lakh, and an additional ₹10 lakh must be held as working capital from the start; this working capital is recovered at the end of year 5. The mill has a five-year life, after which the equipment is expected to sell for ₹8 lakh. Annual sales are projected at ₹70 lakh and annual operating costs, excluding depreciation, at ₹48 lakh. Depreciation is straight-line to the salvage value. The cooperative pays tax at 25% and uses a 12% discount rate. A neighbouring mill owner has offered to lease a similar mill to the cooperative for ₹14 lakh a year, with the owner bearing maintenance; under that option the cooperative would still need ₹10 lakh of working capital. The cooperative's board is split: some members want ownership, others prefer the lease because paddy prices are volatile. You are asked to test the project with NPV and payback, and to show how a 10% shortfall in sales would change the decision.
1. Compute the initial outlay, annual operating cash flow, NPV, and payback for the ownership option.
Read the worked answer
Initial outlay = equipment ₹45 lakh + installation ₹5 lakh + working capital ₹10 lakh = ₹60 lakh.
Depreciable base = ₹50 lakh; salvage ₹8 lakh; annual depreciation = (50−8)/5 = ₹8.4 lakh.
Annual operating cash flow: sales 70.0 − operating costs 48.0 − depreciation 8.4 = PBT 13.6; tax at 25% = 3.4; PAT = 10.2; add back depreciation = ₹18.6 lakh.
Terminal cash flow in year 5 = salvage ₹8 lakh + working capital recovery ₹10 lakh = ₹18 lakh.
NPV at 12%: annuity factor 3.6048. PV of OCF = 18.6×3.6048 = ₹67.05 lakh. PV of terminal = 18/1.7623 = ₹10.21 lakh. Total PV = ₹77.26 lakh; NPV = ₹17.26 lakh.
Payback: cumulative OCF after three years = ₹55.8 lakh; shortfall = ₹4.2 lakh; payback = 3 + 4.2/18.6 = 3.23 years. Discounted payback is between four and five years.
2. Sales fall 10%. Recalculate NPV and assess the project's margin of safety.
Read the worked answer
Sales fall 10% to ₹63 lakh. Costs and depreciation unchanged. PBT = 63 − 48 − 8.4 = ₹6.6 lakh; tax = ₹1.65 lakh; PAT = ₹4.95 lakh; OCF = ₹13.35 lakh.
PV of OCF = 13.35×3.6048 = ₹48.12 lakh; PV of terminal = ₹10.21 lakh; total = ₹58.33 lakh. NPV = −₹1.67 lakh.
A 10% sales shortfall therefore turns NPV negative. The project's margin of safety is thin: roughly a 9% fall in sales is enough to wipe out NPV. The cooperative should stress-test paddy prices and yields, not just accept the base case.
3. Compare the lease alternative with ownership and advise the board.
Read the worked answer
Lease alternative: after-tax lease cost = ₹14 lakh × (1−0.25) = ₹10.5 lakh a year. Working capital of ₹10 lakh is required and recovered. NPV of the lease cost = −10 + 10/1.7623 − 10.5×3.6048 = −10 + 5.67 − 37.85 = −₹42.18 lakh. That cost must be compared with ownership, not with zero.
Comparing the two operating options: under the lease, sales 70 − costs 48 − rent 14 = ₹8 lakh PBT; tax 25%; PAT ₹6 lakh; PV ₹21.63 lakh less net working-capital cost ₹4.33 lakh = +₹17.30 lakh. Ownership is +₹17.26 lakh. The two are nearly identical on NPV.
Judgement: ownership is only marginally better and carries construction, maintenance, and volume risk. The lease preserves capital and shifts utilisation risk, which matters when paddy prices are volatile. Choose the lease unless the cooperative can lock in paddy supply and utilisation above about 90%; if it chooses ownership, negotiate a fixed-price equipment contract and keep the working-capital line committed.