Reference no: EM133079753

Question - Diamond Plc is a UK electronic company engaged in the design, manufacture and distribution of a range of electrical and electronic products. In addition to online marketing and sales, the company maintains a chain of stores both in the UK and European Union.

Despite the difficult conditions in the European Union in the last few years, Diamond Plc managed to achieve an average sales growth of 25%, considerably higher than its planned target of 20%.

Given its significant growth, the company's production capacity is fully utilised, and any future growth will require additional significant investment. If no investment takes place, the company expects sales and operating costs to grow at 1% per year in real terms for the foreseeable future.

Diamond Plc is considering undertaking a capital investment project to expand into markets outside the EU where there is strong demand for high priced electrical and electronic products.

Financial Information - The company has spent £10m in the last twenty-four months developing a unique smart television set called theUlex, and initial tests carried out have confirmed its technical viability and the directors are confident that introduction of the product will be successful.

Following a successful market survey which cost £5m, the company is planning to produce and sell Ulex in the UK and outside the EU for the next five years. However, before the manufacture of the new product can be undertaken, a further expenditure of £6.5m would be required to improve its design features.

Production of Ulex will require an investment of £200m in manufacturing equipment. It is expected that the manufacturing equipment could be sold for cash of £20m, at year 5 prices, at the end of the life of the project. The manufacturing equipment will be depreciated over 5 years using the straight-line method.

The following additional information is available

-Production of Ulex will commence from 1 January 2018 and it is estimated that 720,000 units of Ulex will be sold throughout the five-year life cycle of the product. The pattern of production and sales volume over the life cycles of the product is expected to be as follows:

Year 1 15%

Year 2 30%

Year 3 25%

Year 4 20%

Year 5 10%

The initial selling price for the Ulex has been set at £2,000 per unit and the company expects to maintain this selling price for the first year; thereafter, the price will reduce by 10% per annum.

-Production of Ulex requires two types of materials: alpha and beta.

1 kilo of alpha is required for the manufacture of each unit of Ulex. Its current replacement cost is £400 per kilo and this cost is expected to rise by 6% per annum.

 

Manufacture of one unit of Ulex requires 2 kilos of beta. The company has reached an agreement with a supplier for the annual purchase of all of its requirements of beta at a fixed cost of £110 per kilo for the next five years.

-The labour force required for the manufacture of Ulex has already undergone special training costing £3.0m. Production of each Ulex would require 8 hours of this skilled labour which is paid for at an hourly rate of £30. Having negotiated a redundancy pay settlement of £18m (at Year 5 prices) payable at the termination of production of Ulex, the staff union have agreed to maintain the hourly labour rate at £30 for the five-year period.

-The total fixed costs in Year 1 will be £60m, including depreciation. The fixed costs are expected to increase, thereafter, by the general rate of inflation each year.

-Production of Ulex will also require an investment of £50m in working capital at the beginning of the project. The amount of investment in working capital is expected to increase by the general rate of inflation.

Assume that all operating cash flows occur at the end of the year to which they relate, except those in Year 0, which occur immediately.

Diamond Plc has a real cost of capital of 10¼% per annum and pays tax at an annual rate of 30% on its taxable profits. Half of the tax is payable in the year in which it arises, the balance is paid in the following year. The company can claim tax-allowable depreciation (capital allowance) on a 25% reducing balance basis.

General inflation rate is expected to be 4% per annum.

REQUIRED -

(a) Using the information provided and all relevant cash flows for the investment proposal calculate the net present value of the project and advise the company if it should undertake it.

(b) What factors [other than your answer to part (a) above] would you advise the company to take into consideration if it decides to embark on the project.