Question
Clifton-Peters Ltd is a manufacturer of household goods located in Melbourne. They presently make and wholesale fruit juicers, blenders and baking equipment. The General Manager has asked that the company now consider investing in new equipment that will allow the company to make bench-top grills.
A former manager of a Brusche electrical appliance store established Clifton-Peters in late 1990s and the growth of the company has been steady with total sales totaling $9,000,000 for the 2005-06 financial year. The net profit for the period was $1,000,000.
The company has already spent $100,000 on researching the bench-top grill investment project and $25,000 reviewing the training needs of staff that will use the new equipment. The special equipment needed to manufacture the grills and can be purchased from the United States for US$500,000. Given the current exchange rates, the equipment would cost A$560,000 and a further A$30,000 to complete installation. The equipment would be expected to have a five-year useful life for the firm.
The perception in the Australian market on Australian made electrical products would require the company to spend $150,000 straight away for marketing and a further $50,000 at the beginning of the fourth year. The General Manager also believes that a working capital injection of $70,000 would be required, but it is anticipated that the working capital would be recouped at the end of the project. The machining equipment can be fully depreciated at 20% of the total cost over the five years for taxation purposes.
A major service of the machine would be required at the end of year 3 which would cost $200,000 while a software update would be required at the beginning of year 3 is expected to cost $40,000. The service would occur over the Christmas / New Year shut down period and is not expected to have any substantial impact on production. Both the service and software are tax deductible and will be needed to ensure the equipment remains productive until the end of year 5.
The average selling price is expected to be $50 and it is estimated that variable costs would be $35 per unit and fixed costs (not including depreciation) would amount to $70,000 per year.
The following unit sales are forecast:
Year 1 30,000
Year 2 30,000
Year 3 40,000
Year 4 40,000
Year 5 50,000
The company's tax rate is 30%, and their cost of capital is 15%. After discussions with other staff members, the accountant has come to the conclusion that the machine is likely to have a resale value of $30,000 at the end of the five years.
Required:
(a) Calculate, showing all workings:
i. The net present value of the investment.
ii. The undiscounted and discounted payback period of the investment.
iii. The internal rate of return of the project to two decimal places.
iv. The profitability index for the investment.
(b) Write a memo to the General Manager of Clifton-Peters advising him whether the company should proceed with the investment, giving reasons for your decision and discussing the possible risks.
Your memo should be no longer than two pages, written professionally, and be written specifically to the General Manager who has no accounting or finance training. The memo should not discuss your calculations and the method by which they were obtained. Instead your memo should focus on the relevance of your results and what issues it raises for the company in making a decision regarding the benefit of this investment to the company.
Part 2
(a) What is the effect on the NPV for the project if (Treat each of the following situations independently):
i) The company wishes to investigate option of not spending $50,000 marketing expense in the 4th year but instead giving a sales discount of 10%. Sale figure is expected to decreased by 5% (from the initial estimates) between year 3 and 4, but an increase of 10% in year 5.
ii) The board is not convinced with your study and would like to order another independent study. The study is estimated to cost $7500.