Question Capital Expenditure Decisions and Investment Criteria

Bodmin plc

Bodmin plc is a highly profitable electronics company that manufactures a range of innovative products for industrial use. Its success is based to a large extent on the ability of the company's development group to generate new ideas that result in commercially viable products. The latest of these products is just about to undergo some final tests and a decision has to be taken whether or not 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 Bodmin £1.60 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 20,000 units will be sold at a price of £170. From year two through to year four sales are expected to be 30,000 units per annum, but are expected to fall back to 20,000 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 on the basis of 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.

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 the costs and benefits that you think should be included in a rational decision making process.

b) Assess how sensitive the calculated NPV is to three inputs employed in the analysis. Provide an interpretation of your results and comment on how valuable you think this analysis may be in taking a decision on the investment.

c) Assume that the annual rate of inflation is expected to be 4 per cent per annum for the next five years. Also assume that the required rate of return of 14 per cent you employed above is a market determined rate and incorporates an allowance for the expected rate of inflation of 4 per cent. Explain how you would take the expected rate of inflation into account in a revised analysis. (Part (a) of the question should be completed on the basis that the expected rate of inflation is zero.)