QUESTION 1: CAPITAL EXPENDITURE DECISIONS
BezingaLtd is a highly profitable electronics company that manufactures a range of innovative products for industrial use. Its success is based to a large extent on the ability of the company's Strategic Development Department (SDD), which generatesnew ideasthat result in commercially viable products. The latest of these products is just about to undergo some finaltests and a decision has to be taken whether or not to proceed with an investment in the facilities required for manufacturing. You have been asked to undertake an evaluation of this investment.
The company has already spent $750,000 on the development of this product. The final testing of the product will cost about $40,000. The head of SDDis very confident that the tests will be successful based on the work already undertaken.
The company anticipates that the product will remain competitive for the next five years after which it is likely to be displaced by some new product that are constantly being introduced as the underlying technology evolves. In the first year it is anticipated that 20,000 units will be sold at a price of $160. From year two through to year five sales are expected to be 30,000 units per annum.
The product will be manufactured in one of the company's factoriesthathas considerable spare capacity:it is most unlikely that the space required by the manufacture of this product will be required for any other purpose over the next five years.The additional costs will be incurred by the company in the form of heating, lighting and power amounting to $30,000 per annum.
The machinery required for the manufacture of the product will cost $1,200,000. It will have to be depreciated for tax purposes on the basis of an annual 25 per cent, using diminishing value method (i.e. 25 per cent of the remaining book value of the asset, the initial purchase price lessthe sum of the allowances claimed in previous years). At the end of the five year period the machinery will be sold. The resale value of machinery of this nature after being used for five years is likely to be about 30 per cent of its purchase price.
The cost of the labour and components required for the manufacture of the product has been estimated at $120 per unit with labour accounting for 60 per cent of the cost and the componentsfor the other40 per cent. There are also fixed costs of $120,000 per annum stemming from the manufacturing process. The initial marketing of the product will cost $200,000 and thereafter from year two to four, the company plans to spend $100,000 per year on marketing.
It is anticipated that the company will have to invest in working capital - holding finished products equivalent to 20 per cent of next year's unit sales and 25 per cent of the components required for the next year. It is expected that debtors and creditors will just about offset each other. The tax rate is 30 per cent and the required post-tax rate of return on investments of this nature is 16 per cent.
1.1 Determine the investment's net present value, the internal rate of return, payback period and the discounted payback period. All key assumptions should be specified and explained and an interpretation provided of results for each of the investment criteriaspecified.
1.2 Assess how sensitive the calculated NPV is to the following three inputs employed in the analysis.
(i) Sales price per unit
(ii) Sales volume
(iii) Cos of labour and component per unit
(iv) Cost of machinery
Provide an interpretation of your results and comment on how valuable you think this analysis may be in taking a decision on the investment.