The Steel Tube division was a profitable business operating within an attractive market. The investment, which employed new technology, had recently been identified as part of the group's core activities. The chief engineer felt that once they had got to grips with the new technology it should deliver improved product quality, and greater flexibility, enabling shorter production runs and other benefits.
The latest accounts for the division showed a 16 percent return on assets, but the MD talked about a three-year payback requirement. His phone call to the finance director at head office, to whom this proposal would eventually be sent, was distinctly unhelpful: 'We have, in the past, found that whenever we lay down a hurdle rate for divisional capital projects, it merely encourages unduly optimistic estimates from divisional executives eager to promote their pet proposals. So now we give no guidelines on this matter.'
James decided to use 10 per cent as the required rate of return for the project (WACC). He went home that evening with a very full briefcase and a number of unresolved questions:
Q1. How much of the information which he had gathered was really relevant to the decision?
Q2. What was the best approach to assessing the economic worth of the proposal? The company used payback, but he felt that discounted cash flow techniques (IRR and NPV) had some merit.
Q3. How should the strategic factors be assessed?
Other information concerning the new project is as follows:
Medlock Cones & Tubes Plc pays Corporation Tax at 30 per cent and annual writing-down allowances (capital allowance) of 25 per cent on the reducing balance may be claimed. The existing machine has a nil value for tax purposes and tax is payable in the same year as the cash flows to which it relates. The impact of changes in working capital is to be ignored.
Required
Prepare the case, with recommendations, to be presented by James at tomorrow's meeting. Your report should not be more than 2000 words and should address questions 1-3 above. Information on the deadline for submitting this coursework and MBS rules on assignments can be found on Blackboard.