Case 8.2. – Capital Budgeting Decisions
Calmex Company Ltd.
Calmex is situated in North India. It specializes in manufacturing overhead water tanks. The management of Calmex has identified a niche market in certain Southern cities that need a particular size of a water tank, not currently manufactured by the company. The company is therefore thinking of producing a new type of overhead water tank. The survey of the company's marketing department reveals that the company could sell 120,000 tanks each year for six years at a price of Rs.700 each. The company's current facilities cannot be used to manufacture the new-size tanks. Therefore, it will have to buy new machinery. A manufacturer has offered two options to the company. The first option is that the company could buy four small machines with the capacity of manufacturing 30,000 tanks each at Rs.15 million each. The machine operation and manufacturing cost of each tank will be Rs.535. Alternatively, Calmex can buy a larger machine with a capacity or 120,000 units per annum for Rs.90 milion. The machine operation and manufacturing costs for each tank will be Rs.475. The company has a required rate of return of 12%. Assume that the company does not pay any taxes.
Discussion Questions
1. Which option should the company accept? Use the most suitable method of evaluation to give your recommendation and explicitly state your assumptions.
2. Why do you think that the method chosen by you is the most suitable method in evaluating the proposed investment? Give the computation of the alternative methods.
3. Assume that price and operation and manufacturing cost increase at 5% annually after one year of operations. Make new computations and give your recommendation.
