Financial Decision Making
Strategic and Financial Decision Making
The directors of Digitechplc need to increase capacity in order to meet demand for a new component (Product X) which is to be used in the manufacture of a new generation of tablet computers. Product X cannot be manufactured on existing machinery. The directors have obtained tenders on two machines which can manufacture Product X. One tender is from a French supplier and the other from a German supplier. Both machines have the same capacity of 60,000 units per year.
The following data applies to the machines:
The machine will cost £477,700 and will last for four years, at the end of which time it will have zero scrap value. Maintenance costs will be £20,000 in the first year of operation, increasing by £6,000 per year for each year of operation.
The machine will cost £430,000 and will last for four years, at the end on which time it will have zero scrap value. Maintenance costs will be £20,000 in the first year of operation, increasing by £10,000 per year for each year of operation.
Digitechplc expects demand for Product X to be 30,000 units per year in the first year, and to increase by a further 10,000 units per year in each subsequent year. Selling price is expected to be £20.00 per unit and the marginal cost of production is expected to be £15.60 per unit. Incremental fixed production overheads of £20,000 per year will be incurred. Selling price and costs are all in current terms.
The company has forecast the following annual inflation rates relevant to their circumstances:
General rate of inflation in UK 2.8%
Selling Price of Product X 4.0%
Marginal cost of production 4.0%
Maintenance Costs 5.0%
Fixed production overheads 6.0%
The investors in Digitechplc expect a real rate of return on investments of 8% and the company has a target Average Accounting Rate of Return of 25%.
- a) Calculate the Net Present Value (NPV) arising out of the incremental cash flows for each machine and recommend whether the company should buy the French or German machine. You should also provide a brief interpretation of your answer. (15 marks)
- b) Calculate the Average Accounting Rate of Return for each machine and briefly comment on your findings.
- c) Digitech’s Production Manager is heard to say, “Let’s base our decision on the Average Accounting Rate of Return outcome as this measurement is linked to Return on Capital Employed with which we are familiar. I don’t understand the meaning of NPV.”
You should provide a response to the Production Manager which will recommend a method to use and compare and contrast the two appraisal methods in question.
(Total 40 marks)
The assistant finance manager of Digitech is interested in your capital investment appraisal calculations and mentions that when she was a student she can remember using the Capital Asset Pricing Module in order to calculate a suitable cost of capital for use in determining an appropriate discount factor. She also remembers that the cost of capital for a corporation relies upon the size of the company’s beta factor.
With this in mind she says to you, “I am rather confused by beta as it seems to be rather random. If I look at the beta for two well-known UK registered organisations such as J. Sainsbury plc and Intercontinental Hotels Group plc, they are 0.61 and 1.15 respectively (Digitallook.com, accessed 05/07/17). How can it be possible that two such companies can have such different betas?
You are required to provide a response discussing explicitly why the betas of the two companies (Sainsbury and Intercontinental Hotels) may have such different beta factors and considering the implications of this difference.
In response to the above debate with regard to project appraisal, Digitech’s assistant finance manager attends a two-day course on the use of Real Options Analysis.
The following quote was brought to her attention at the development session:
“When estimating project value planners need to include the economic value of flexibility in project strategies.” (Ford and Bhargav, 2006, p275)
During the course the trainer went on to emphasise this point and said, “it is suggested that Real Options Analysis can be used to allow for the benefit of flexibility and to direct management attention to particular strategic issues, as opposed to the sole use of Net Present Value calculations which assume certainty.”
The assistant finance director finds this to be a rather confusing topic and turns to you for help.
You are, therefore, required to prepare a brief report in order to consider the points made above and to particularly comment on the issues of flexibility and management attention directing, which are the supposed benefits of Real Options Analysis.
(Total 100 marks)
You are required to present well-structured answers of no more than 3,000 words in total (excluding calculations).
Assignments will be graded according to the following criteria (as well as the generic postgraduate assessment criteria:
- Evidence of critical judgement in selecting, ordering and analysing content in order to present a sound argument.
- The demonstration and understanding of relevant concepts and models.
- The demonstration of insight and originality in responding to the assignment.
- The extent and level of research undertaken and the degree to which this research is appropriately referenced.