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Question 1: Capital Expenditure Decisions and Investment Criteria
Sunrise Ltd is an electronics company that manufactures and markets a range of innovative products. Its success is based to a large extent on the ability of a small development groups to generate ideas for new products. The latest of these products will be tests next month to ensure it meets various regulatory requirements and a decision has to be taken soon on whether or not to proceed with an investment in the facilities required for manufacturing. The company's finance director has been asked to undertake an evaluation of this investment.
The company has already spent £250,000 on the development of this product and a related product that will get to the testing stage a few months from now. It is impossible to allocate the expenditure already undertaken between the two products and the development director has suggested a simple fifty/fifty split of the expenditure between the products. The testing of the first of the products to reach this stage will cost about £90,000. the development director is very confident that the tests will be successful and are to be undertaken to meet formal regulatory requirements rather than to develop further understanding of the product's rather than to develop further understanding of the product's characteristics. Another company has already offered the company £700,000 for the rights to the product even though the final testing is still to be completed, a price that is substantially in excess of the cost of the product's development.
The company anticipates that the product will remain competitive for the next five years after which it is likely to be displaced by the new products that are always being developed as the underlying technology evolves. In the first year it is anticipated that 20,000 units will be sold at a price of £120. 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 years five. It is anticipated that the price of the product will remain unchanged over the five year period.
The product will be manufactured in a factory already owned by the company. This factory has considerable spare capacity. It is very unlikely that the space taken up by the manufacture of the product will be required for any other purpose over the five year period that is planned to manufacture the product. All products are charged for the factory space that they require and this will amount to £60,000 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 having allowed for the allowances claimed in previous years). At the end of the five year period the machinery will be sold or, if it is more profitable, used 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.
The cost of the labour and components required for the manufacture of the product has been estimated at £75 per unit, with components accounting for 40 per cent of the cost and labour the residual 60 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 and this will be set at 5 per cent of the company's revenue. The overheads include the company's expenditure on new product development - an important expense of the company. The initial marketing of the product will cost £250,000 and the sales support per annum will cost £100,000. 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 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 40 per cent and the required rate of return on investments of this nature is 16 per cent.
b) Interpret the reported NPV, IRR, payback and the discount payback period, using Sunrises's investment to illustrate your answer.
c) To which inouts in the analysis is the NV most sensitive?