Reference no: EM132952642

The directors of Digitech plc need to increase capacity in order to meet demand for a new component (Product X) which is to be used in the manufacture of a new generation of tablet computers. Product X cannot be manufactured on existing machinery. The directors have obtained tenders on two machines which can manufacture Product X. One tender is from a French supplier and the other from a German supplier. Both machines have the same capacity of 60,000 units per year.

The following data applies to the machines:

French Machine

The machine will cost £477,700 and will last for four years, at the end of which time it will have zero scrap value. Maintenance costs will be £20,000 in the first year of operation, increasing by £6,000 per year for each year of operation.

German Machine

The machine will cost £430,000 and will last for four years, at the end on which time it will have zero scrap value. Maintenance costs will be £20,000 in the first year of operation, increasing by £10,000 per year for each year of operation.

Digitech plc expects demand for Product X to be 30,000 units per year in the first year, and to increase by a further 10,000 units per year in each subsequent year. Selling price is expected to be £20.00 per unit and the marginal cost of production is expected to be £15.60 per unit. Incremental fixed production overheads of £20,000 per year will be incurred. Selling price and costs are all in current terms.

The company has forecast the following annual inflation rates relevant to their circumstances:

General rate of inflation in UK 2.8%
Selling Price of Product X 4.0%
Marginal cost of production 4.0%
Maintenance Costs 5.0%
Fixed production overheads 6.0%

The investors in Digitech plc expect a real rate of return on investments of 8% and the company has a target Average Accounting Rate of Return of 25%.

Required:

Problem a) Calculate the Average Accounting Rate of Return for each machine and briefly comment on your findings.

Problem b) Digitech's Production Manager is heard to say, "Let's base our decision on the Average Accounting Rate of Return outcome as this measurement is linked to Return on Capital Employed with which we are familiar. don't understand the meaning of NPV."

You should provide a response to the Production Manager which will recommend a method to use and compare and contrast the two appraisal methods in question.