Reference no: EM132744146

Question - Polyester division of Quintex Ltd has forecast a net profit before tax of N$3 million per annum for the next five years, based on net capital employed of N$10 million. Plant replacement over this period is expected to be equal to the annual depreciation each year. These figures compare well with the group's required rate of return of 20% before tax. Polyester's management is currently considering a substantial expansion of its manufacturing capacity to cope with the forecast demands of a new customer.

The customer is prepared to offer a five year contract providing Polyester with annual sales of N$2 million.

In order to meet this contract, a total additional capital outlay of N$2 million is envisaged, being N$1.5 million of new fixed assets plus N$0.5 million of working capital. The plant life is expected to be 5 years with zero scrap value.

Operating costs for the contract are estimated to be N$1.35 million per annum, excluding depreciation.

This is considered to be a low-risk venture as the contract would be firm for 5 years and the manufacturing processes are well understood within Polyester.

The consequences of income tax on the proposal may be ignored.

REQUIRED -

1. Calculate the impact of accepting the contract on Polyester division's:

a) Return on investment (ROI) for each of the 5 years.

b) Residual income (RI) for each of the 5 years, using 20% imputed interest rate.

2. Discuss with reasons, for each method whether or not it would be attractive to Polyester division's management.

3. Explain three reasons why a performance measurement system based solely on financial measure may not be effective in evaluating the long-term performance of companies.