Finquilibria - Case Study
Deluxe Auto Limited
In the beginning of 2011, the board of directors of Deluxe Auto Limited (DAT) was considering an
investment proposal for the introduction of a new model two-wheeler scooter. The break-up of the
project cost is given in Exhibit I. Mr. N Ranganathan, the Production Manager of the company,
explained the technical features of the project and impressed upon the board members that it was
technically an excellent product to be introduced in the highly competitive two-wheeler market.
According to him, the company will be able to gain a technical lead over its competitors if the project
is undertaken. Mr. G Ramesh, the finance manager, who presented the financial analysis of the
project, agreed with Mr. Ranganathan that it was an attractive investment opportunity.
DAT is a large manufacturer of two-wheeler scooters. The company has passed through financial ups
and downs in the recent past. In the late seventies, the company performed very badly and
accumulated heavy losses. This performance was attributable to one of its models which was
technically superior to the existing models of the competitors, but could not find favour with
customers and failed in the market. The company has now recovered from its setback. It has wiped
out its accumulated losses and has shown surplus in the last two years. The management has,
however, become quite cautious in undertaking any new investment projects. It is generally very
reluctant to undertake a project unless its profitability is very high. The minimum cut-off rate is 18
per cent. This rate includes compensation for various kinds of risks including general price-rise. The
company has recently introduced the discounted cash flow method of project evaluation, although it
continues calculating payback period for the projects.
In his financial analysis of the current project under consideration, Ramesh has assumed input and
output prices to remain constant. His logic was that adjusting these projections for inflation will not
change the results in a significant manner, because if the cost of production goes up, this will be
followed by increase in sales prices. He reasoned that the impact of inflation could be passed on to
customers. One of the directors disagreed with him and argued that it was not possible for the
company to increase the sales price due to the inflation as the company operates under a highly
competitive environment. Yet another director felt that even if it was possible to increase prices for
any increase in input costs, ignoring inflation in the project analysis could give misleading signals. A
director nominated by a financial institution stated
that it was incorrect to assume rates of expenses such as power and fuel, wages and salaries, etc. to
remain constant. He suggested that an increasing trend was visible in the Electricity Price Index. This
implies that power and fuel expenses would increase over the years. Other expenses may also
increase in the same manner. He argued further that raw material for DAT consists of mainly tyres
and tubes, and that the Tyres and Tubes Index has been showing an upward trend.
He therefore doubted the validity of the financial analysis. Mr. Ramesh has prepared cash flow
projections only for five years as he thought that it was difficult to make reasonable forecasts
beyond this period (see Exhibit II). He however estimated the terminal value of the project at the
end of five years (see Exhibit III). In making these estimates, he considered the likely market price of
various assets at that time. Most of the board members generally agreed with the assumptions.
Mr. AK Chatterjee, Chairman of the company, after listening to the views of the board members,
asked Mr. Ramesh to gather more information on likely changes in the prices of input and output
and to appropriately incorporate them in the financial analysis of the project. Mr. Ramesh decided
to first obtain relevant price indices for the past one decade and analyse them to determine the
expected inflation rates. Exhibit IV contains the information on various price indices collected by Mr.
Ramesh. He worked out the changes in the prices over the years as given in Exhibit V. He was
wondering how he could use this information in his analysis. He was not sure whether he should use
the general inflation rate or the specific inflation rate in his calculations. He was also not sure how
inflation would affect the cut-off rate.
DISCUSSION QUESTIONS
1. The finance manager has assumed the input and output prices to remain constant. He reasons
that adjusting cash flow projections for inflation will not change results because if the cost increases
this will be immediately followed by increase in sales price. Thus, the impact of inflation could be
passed on to customers. Do you agree with the finance manager's argument?
2. How would you incorporate inflation in the calculations of cash-flows as given in Exhibit II of the
case?
3. Would you like to adjust cost of capital of 18 per cent for inflation? In what manner?
Note: Depreciation has been computed as per the income tax rates.
