The board are reviewing investment opportunities and they have received one from the management of one of
Question:
The board are reviewing investment opportunities and they have received one from the management of one of their subsidiaries, an engineering company.
The engineering company manages to compete in their market by adapting to changing market requirements and specialising in innovative products with limited markets. The products are sold to a wide range of companies, but most of its sales are to companies in the oil industry. On this basis it has maintained a high rate of return on capital employed in relation to the engineering sector as a whole. The latest product to be developed, a highpressure valve, has completed its testing stage and the board now has to decide on whether or not to invest in a production facility and a marketing programme.
The work already undertaken on the product has cost million and it is anticipated that some further development work will cost a further million. It is estimated that an investment of million will be necessary in plant and machinery. This expenditure can be written off capital allowances for tax purposes on a straightline basis over the products expected sixyear life. It is anticipated that the resale value of the equipment will be about
million at the end of the six years. The outlay would have been larger, but the company already owns some finishing equipment that will be required. This was previously used in the manufacture of another product that is no longer being produced. It is fully depreciated for tax purposes and could be sold today for If used for the next six years, it will have no resale value.
The production facility would be located in one of the companys factories with spare capacity available. It will occupy per cent of the factorys space. The company has no alternative uses available for this space for the foreseeable future and has further spare capacity available in other factories. The product will be charged per annum for this space by the companys management accounting system, though only per cent of this figure will stem from incremental costs resulting from heating and lighting. The fixed costs directly attributable to the production are expected to be per annum. Each product sold by the company is also allocated a general overhead charge equivalent to per cent of the revenues it generates. This allocation is made by the companys accountant to cover head office expenses.
The selling price is expected to be set at per unit and it is anticipated that sales in the first year will be about units, rising to in year two, and staying at this level for the following four years. The introduction of the product would require a marketing campaign that will cost As a result of the rapid technological development in the area a sixyear product life is all that can be expected.
The direct manufacturing costs are expected to be per unit. The company will need to hold stocks of the product at the start of each year equivalent to per cent of the sales expected in the year to come. The increase in debtors as a result of introducing the product will be offset by the increase in creditors. The company requires a rate of return of per cent on investments of this nature, and the tax rate is per cent.
The board have asked you to:
a Undertake a capital budgeting exercise to determine the investments net present value and the internal rate of return. All key assumptions should be specified and explained.
b Undertake a sensitivity analysis on the estimated price and volume of expected sales.
c Provide a brief general discussion of the potential risks associated with this investment.
Foundations of Financial Management
ISBN: 978-1259024979
10th Canadian edition
Authors: Stanley Block, Geoffrey Hirt, Bartley Danielsen, Doug Short, Michael Perretta