ABC PLC is a highly profitable manufacturing company that manufactures a range of products for industrial use. The lates
Posted: Thu May 19, 2022 11:20 am
ABC PLC is a highly profitable manufacturing company that
manufactures a range of products for
industrial use. The latest of these products is just about to
undergo some final tests and a decision
must be taken whether 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 the development
group is very confident that the
tests will be successful based on the work already undertaken.
Another company has already
offered ABC PLC $1.10 million for the product’s patent and an
exclusive right to its manufacture
and sale, even though the final tests are still to be completed.
This sum being offered is well in
excess of the cost of the product’s development, but the company’s
management have decided to
delay their response to the offer until the result of the
investment evaluation is available.
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 35,000 units will be sold at a
price of $152. From year two through to year four sales are
expected to be 45,000 units per annum
but are expected to fall back to 35,000 units in year five.
The product will be manufactured in one of the company’s factories
that has 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. For the
company’s internal accounting
purposes all products are charged for the factory space that they
utilise and this will amount to
$50,000 per annum. The additional costs incurred by the company in
the form of heating, lighting
and power only amount 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 based on an annual 25 per cent writing
down allowance (ie. 25 per
cent of the remaining book value of the asset, the initial purchase
price less the sum of the
allowances claimed in previous years). At the end of the five year
period the machinery will be
sold or retained for use in the manufacture of other products. 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.
Use will also be made of some equipment already owned by the
company. This could be sold
today for $70,000 and is expected to maintain its resale value even
if it is used for the next five
years. This equipment is fully depreciated for tax purposes – it
has a zero book value – but is still
in good working order.
The cost of the labour and components required for the manufacture
of the product has been
estimated at $120 per unit for the first year, with labour
accounting for 60 per cent of the cost and
the components for the other 40 per cent. There are also fixed
costs of $150,000 per annum
stemming from the manufacturing process. The product will also be
charged an allowance for
general overheads through the management accounting system and this
is set at 5 per cent of a
product’s annual revenues. The overheads include the head office
expenditure and the company’s
expenditure on new product development – an important expense for
the company. The initial
marketing of the product will cost $200,000.
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, 25 per cent of
the components required for the
next year, and it is expected that debtors and creditors will just
about offset each other. The tax
rate is 30 per cent and the required rate of return on investments
of this nature is 14 per cent.
REQUIRED:
a) 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 criteria specified. You should identify
and explain the costs and benefits that you
think should be included in a rational decision-making
process.
Based on your analysis above, make a suitable recommendation for
the company’s top
management explaining the rationale behind it.
manufactures a range of products for
industrial use. The latest of these products is just about to
undergo some final tests and a decision
must be taken whether 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 the development
group is very confident that the
tests will be successful based on the work already undertaken.
Another company has already
offered ABC PLC $1.10 million for the product’s patent and an
exclusive right to its manufacture
and sale, even though the final tests are still to be completed.
This sum being offered is well in
excess of the cost of the product’s development, but the company’s
management have decided to
delay their response to the offer until the result of the
investment evaluation is available.
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 35,000 units will be sold at a
price of $152. From year two through to year four sales are
expected to be 45,000 units per annum
but are expected to fall back to 35,000 units in year five.
The product will be manufactured in one of the company’s factories
that has 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. For the
company’s internal accounting
purposes all products are charged for the factory space that they
utilise and this will amount to
$50,000 per annum. The additional costs incurred by the company in
the form of heating, lighting
and power only amount 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 based on an annual 25 per cent writing
down allowance (ie. 25 per
cent of the remaining book value of the asset, the initial purchase
price less the sum of the
allowances claimed in previous years). At the end of the five year
period the machinery will be
sold or retained for use in the manufacture of other products. 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.
Use will also be made of some equipment already owned by the
company. This could be sold
today for $70,000 and is expected to maintain its resale value even
if it is used for the next five
years. This equipment is fully depreciated for tax purposes – it
has a zero book value – but is still
in good working order.
The cost of the labour and components required for the manufacture
of the product has been
estimated at $120 per unit for the first year, with labour
accounting for 60 per cent of the cost and
the components for the other 40 per cent. There are also fixed
costs of $150,000 per annum
stemming from the manufacturing process. The product will also be
charged an allowance for
general overheads through the management accounting system and this
is set at 5 per cent of a
product’s annual revenues. The overheads include the head office
expenditure and the company’s
expenditure on new product development – an important expense for
the company. The initial
marketing of the product will cost $200,000.
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, 25 per cent of
the components required for the
next year, and it is expected that debtors and creditors will just
about offset each other. The tax
rate is 30 per cent and the required rate of return on investments
of this nature is 14 per cent.
REQUIRED:
a) 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 criteria specified. You should identify
and explain the costs and benefits that you
think should be included in a rational decision-making
process.
Based on your analysis above, make a suitable recommendation for
the company’s top
management explaining the rationale behind it.