Ring Frame Replacement Under a PKR 450 Million Capital Cap
Faisalabad Spinning Mills runs 48 ring frames commissioned in 2017. End-breakage rates on 24 of them have risen to 38 per 1,000 spindle-hours, while a European buyer's 30/1 combed yarn order requires a consistent 22. The mill must commit its FY26 capital budget of PKR 450 million by June. Three proposals are on the table. Refurbishment (A) costs PKR 180 million, has a four-year economic life and is expected to generate after-tax operating cash flows of PKR 62 million a year. New open-end rotors (B) cost PKR 420 million, last ten years and generate PKR 118 million a year after tax. A waste-heat recovery unit (C) costs PKR 90 million, lasts six years and yields PKR 31 million a year after tax. The CFO uses a 17% nominal rupee WACC, a 29% tax rate and 15% reducing-balance tax depreciation. Gas curtailment makes power 38% of conversion cost, and the buyer will not wait beyond the current season.
1. Rank the three proposals under the PKR 450 million capital constraint and recommend a feasible portfolio. Show NPV, profitability index and equivalent annual annuity, and explain which metric governs.
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At 17%, the annuity factors are 2.743 for 4 years, 3.589 for 6 years and 4.659 for 10 years.
- A: PV inflows = 62 x 2.743 = PKR 170.1m; NPV = -9.9m; PI = 0.945; EAA = -3.6m.
- B: PV inflows = 118 x 4.659 = PKR 549.7m; NPV = 129.7m; PI = 1.309; EAA = 27.8m.
- C: PV inflows = 31 x 3.589 = PKR 111.3m; NPV = 21.3m; PI = 1.236; EAA = 5.9m.
With a hard PKR 450m cap, B consumes 420m and leaves 30m, which cannot fund C. A plus C costs 270m and produces only 11.4m of NPV. B alone dominates every feasible combination. PI ranks the projects in the same order here, but PI is only a screening tool when projects are divisible. Because the projects are lumpy, the correct test is NPV of each feasible portfolio; EAA is useful for the unequal-life A-versus-B comparison but does not solve the budget constraint. Recommend B, with C queued for next year if the waste-heat unit can be installed later without losing the efficiency gain.
2. The CFO proposes to compare A and B using equivalent annual annuity and to ignore C because it is a 'support project'. Evaluate this reasoning.
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EAA is defensible for A versus B because they are mutually exclusive replacement paths with different lives, but only if the cash-flow profiles are level and the assets can be repeated at similar cost. A has a negative EAA, so it fails on its own terms even before the capital cap. Repeating a four-year refurbishment assumes spare parts and labour remain available and that the frames are not obsolete by year eight; that is an assumption to state, not a fact.
Ignoring C is harder to defend. C has a positive NPV and a positive EAA. It is not a support project in the sense of having no incremental cash flow; it saves energy and earns a return. The real issue is indivisibility and the 450m cap. If B can be phased, for example six of eight rotor lines, the marginal PKR 90m for C may earn more than the last slice of B. The CFO should compare the marginal PI of the deferred B spend against C's PI, not dismiss C categorically. Also check whether C qualifies for any energy-efficiency financing that relaxes the cap.
3. Power tariffs are expected to rise 18% in year one and 12% a year thereafter. A is more power-intensive per kilogram than B. How does this change the ranking, and what data would you need to quantify it?
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A rising tariff hurts A more because A consumes more electricity per kilogram, so its after-tax operating cash flow of PKR 62m will decline faster than B's PKR 118m. The direction of the effect is clear; the ranking almost certainly moves further toward B, which already has the higher NPV and EAA.
To quantify it, obtain for each option the kWh per kilogram, annual output, and the base tariff embedded in the cash-flow estimate. Split the PKR 62m and PKR 118m into revenue, non-power cost and power cost. Rebuild annual cash flows with the escalating tariff, tax-effect the changes at 29%, and discount year by year at 17% rather than using a level annuity. Then compute the tariff escalation at which A's NPV equals B's. If A is being refurbished specifically to reduce kWh per kilogram, the sign could reverse: higher tariffs would increase A's savings. The setup says A is more power-intensive, so the expected crossover will be below the forecast path. Use a sensitivity table of NPV against tariff escalation, not a single point estimate.