Capital Budgeting Decision Analysis
Case
Author: Varun Dawar
Online Pub Date: January 02, 2018 | Original Pub. Date: 2018
Subject: Capital Budgeting, Corporate Finance
Level: | Type: Experience case | Length: 1405
Copyright: © Varun Dawar 2018
Organization: fictional/disguised | Organization size: Small
Region: Southern Asia | State:
Industry: Manufacture of textiles
Originally Published in:
Publisher: SAGE Publications: SAGE Business Cases Originals
DOI: http://dx.doi.org/10.4135/9781526446718 | Online ISBN: 9781526446718
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© Varun Dawar 2018
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Capital Budgeting Decision Analysis
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© Varun Dawar 2018
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Case
Learning Outcomes
By the end of this case study, students should be able to:
• Understand the concept and importance of capital budgeting and investment decision-making.
• Discuss and identify the various information required for financial evaluation of investment proposals.
• Understand and calculate after-tax operating cash flows for capital budgeting analysis, taking into
account the revenues, costs, depreciation, and working capital.
• Determine terminal year cash flows after considering salvage value and working capital.
• Understand the computation of cost of capital for determination of discounting rate.
• Determine the Net Present Value (NPV) and Internal Rate of Return (IRR) for accepting or rejecting
a capital budgeting proposal.
Introduction
On September 20, 2016, Saurabh Sharma, Senior Vice President of Bhatia Textiles Company, was preparing
for a meeting with the management committee scheduled the next week. On his desk was a capital budgeting
and investment proposal – a new product line of branded shirts that the committee was considering for launch.
As the head of the finance department, Saurabh was required to work along with his team on a detailed
capital budgeting analysis and present the findings to the management committee for their approval. As per
standard company practice, each capital budgeting and investment project was evaluated using the traditional
Net Present Value (NPV) approach and the Internal Rate of Return (IRR) criterion for determining whether
the company would undertake the project or not.
Saurabh had a lot to think about as he considered the analysis of the capital budgeting project using the
traditional Net Present Value (NPV) approach and the Internal Rate of Return (IRR) criterion. What would
be the basis for calculating the after-tax operating cash flows for the capital project? How would he arrive
at the depreciation and working capital requirements for computing the NPV? What would be the basis for
calculating the terminal year cash flows? With all these questions in mind, Saurabh decided to focus on the
proposed capital budgeting project for the next few days.
Indian Retail Market
The Indian retail market is at the cusp of a sweet spot driven by strong GDP (Gross Domestic Product)
growth, benign inflation, and rising per capita income and purchasing power of consumers. Currently, the
retail industry accounts for more than ten percent of the Indian Gross Domestic Product and approximately
eight percent of employment. The industry is expected to nearly double, from US$ 600 billion in 2015 to US$
1 trillion, by 2020 driven by income growth, urbanization, and attitudinal shifts (Indian Terrain Annual Report,
Abstract
On September 20, 2016, Saurabh Sharma, Senior Vice President of Bhatia Textiles Company,
sat in his office pondering the new capital budgeting proposal for setting up a product line
of branded shirts. As per standard company practice, he was required to evaluate the capital
budgeting project using the traditional Net Present Value (NPV) approach and the Internal
Rate of Return (IRR) criterion and present his findings to the management committee meeting
scheduled for the next week. Saurabh wondered whether this new proposal would turn out to be
a good investment for his company, which was looking to deploy funds in NPV positive projects.
The case puts students in a financial analyst role wherein they conduct capital budgeting
analysis using the popular techniques of NPV and IRR.
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2015–16). It has been estimated that, by 2030, the Indian apparel market, in particular, is expected to grow
at a CAGR (compounded annual growth rate) of approximately 10–12%, backed by increasing affordability
on account of an increase in disposable incomes, increase in aspirations, and a shift from unbranded to
branded products by the burgeoning middle class. This trend is likely to be further accentuated by the rise
of e-commerce companies that enable shopping from anywhere, thereby leading to increased penetration in
small cities and towns (Indian Terrain Annual Report, 2015–16).
Company Background
Bhatia Textiles is a small, privately owned clothing company based in New Delhi, India. It was founded in
1995 by Harish Bhatia, a retired executive. Since then, the company had grown steadily by catering to middle
to low income consumers in the Delhi-National Capital Region (NCR). The company recorded a stellar growth
of 50% in its sales during the last financial year of 2015–16. With a healthy operating margin ratio and low
leverage levels, the company had been able to grow its profits at a CAGR of 25% during the last 10 years.
With a good brand name and healthy financial metrics, the company was now looking to expand its footprint
to new product lines catering to middle to high income customers.
Project Investment Proposal Details
The project is estimated to be of 10 years duration. It involves setting up new machinery with an estimated
cost of as much as INR 500 million, including installation. This amount could be depreciated using the straight
line method (SLM) over a period of 10 years with a resale value of INR 15 million. The project would require
an initial working capital of INR 20 million with cumulative investment in net working capital to be maintained
at 10% of each year’s projected revenue. With the planned new capacity, the company would be able to
produce 240,000 pieces of shirts each year for the next 10 years. In terms of pricing, each shirt can initially
be sold at INR 1,300 apiece, which takes into account the target segment and competitor pricing. The project
proposal incorporates an annual increase of 3% in the price of the shirt to compensate for inflationary impact.
With regards to the raw material costs and other expenses, the project estimated the following details:
• Raw material cost for manufacturing shirts at INR 400 per shirt, slated to rise by 5% per annum on
account of inflation.
• Other direct manufacturing costs at INR 125 per shirt with an annual increase of 5% per annum on
account of inflation.
• Selling, general, and administrative expenses (including employee expenses) at INR 35 million per
annum, expected to increase by 10% each year.
• Depreciation expense on the basis of SLM.
• Tax rate was assumed to be 25%.
Funding
For funding of the expansion project, the promoters agreed to infuse 50% in the form of equity with the rest
(50%) being financed from issue of new debt. Based on the current credit position and market scenario, new
debt can be raised by the company at 12% per annum. Cost of equity was assumed to be 15% by Saurabh.
The requisite discounting rate or weighted average cost of capital (WACC) for NPV and IRR calculations can
now be calculated with the help of the above assumptions.
Demand Scenario
Although the project proposal estimates maximum annual production of 240,000 shirts, Saurabh decided
to do capital budgeting analysis under two demand scenarios: Optimistic and Expected. The likely annual
demand estimated under each scenario is as follows:

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Discussion Questions
• 1. Why are capital budgeting decisions important for a business firm? Discuss their concept and
significance.
• 2. List the types of information generally required for evaluating the capital budgeting decisions of
a firm from a financial standpoint.
• 3. What is meant by the Net Present Value (NPV) technique? Discuss its key assumptions and
calculation methodology (including an estimation of the discount rate).
• 4. Explain the concept of the Internal Rate of Return (IRR). What is the criterion generally used by
firmswhile accepting or rejecting a capital budgeting project on the basis of the IRR technique?
• 5. On the basis of the financial information given in the case, calculate the after-tax operating
cash flows, NPV, and IRR under the Optimistic and Expected scenarios. Clearly specify the
calculations required for the same.
• 6. Based on your analysis, as Saurabh Sharma, what recommendation would you make on
whether the company should undertake the project or not? Clearly specify the decision based on
both the NPV technique as well as the IRR criterion.
Further Reading
Bierman Jr, H. , & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects.
Abingdon, UK: Routledge.
Brealey, R. , Myers, S. C. , & Marcus, A. J. (1995). Fundamentals of corporate finance (p. 69). New York:
McGraw-Hill.
Fabozzi, F. J. , & Drake, P. P. (2009). Capital Budgeting Techniques. Handbook of Finance. Hoboken, NJ:
John Wiley & Sons, Inc.
Gitman, L. J. , & Forrester Jr, J. R. (1977). A survey of capital budgeting techniques used by major US firms.
Financial Management, 6, 66–71.
Graham, J. , & Harvey, C. (2002). How do CFOs make capital budgeting and capital structure
decisions?Journal of Applied Corporate Finance, 15(1), 8–23.
Harris, M. , & Raviv, A. (1996). The capital budgeting process: Incentives and information. The Journal of
Finance, 51(4), 1139–1174.
Myers, S. C. (1974). Interactions of corporate financing and investment decisions—implications for capital
budgeting. The Journal of Finance, 29(1), 1–25.
Ross, S. A. , Westerfield, R. , Jaffe, J. F. , & Roberts, G. S. (2002). Corporate finance (Vol. 7). New York:
McGraw-Hill/Irwin.
Shapiro, A. C. (2005). Capital budgeting and investment analysis. Upper Saddle River, NJ: Prentice Hall.
References
Indian Terrain Annual Report. (2016). Retrieved from https://martjackstorage.blob.core.windows.net/inresources/7232d1d6-e56f-49de-8ffa-2c58ed3ac3f7/Images/userimages/
Annual%20Report%202015-2016.pdf
http://dx.doi.org/10.4135/9781526446718