Capital Expenditure Decisions and Investment Criteria, Corporate Finance

Question 1: Capital Expenditure Decisions and Investment Criteria (30 MARKS)

In recent years Morten Ltd, a company that manufactures and markets a range of pharmaceutical products, has been highly profitable. Its success has been based to a large extent on its ability to generate and market new and innovative products on a regular basis. The latest of these products has just completed various tests to ensure it meets regulatory requirements and a decision now has to be taken on whether or not to proceed with an investment in the facilities required for manufacturing the product. You are required to undertake an evaluation of this potential investment.

The company has already spent $ 800,000 on the research programme from which this product has emerged. A number of other products are expected to get to the testing stage within the next few months. While is impossible to allocate accurately the expenditure incurred to the different products generated by the research programme it is agreed that the development of the product under consideration accounts for at least 40 per cent of the programme’s expenditure of $ 800,000.

The company will have to cover the cost of further testing of the product to be undertaken by the regulatory body and this is expected to be about $ 90,000. The development director is very confident that the tests will be successful as they have already been rigorously undertaken by the company and no problems were identified.

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 200,000 units will be sold at a price of $ 12. From year two through to year four sales are expected to be 300,000 units per annum but are expected to fall back to 200,000 units in year five. It is anticipated that the price of the product will remain unchanged over the five year period.

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 materials required for the manufacture of the product has been estimated at $7.50 per unit, with materials 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 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 materials 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.

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. (This part of the question should be completed on the basis that the expected rate of inflation is zero.)
(15 marks)

b) Assess how sensitive the calculated NPV is to three inputs (sale price, sales quantity and cost of investment) 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.
(Hint: increase/decrease sale price, sale quantity and cost of investment by 10% and measure which factor has the greatest impact on NPV)
(7 marks)

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 16 per cent you employed above doesn’t incorporate 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 and re compute the NPV of the project.
(8 marks)

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