Berick Ltd is a relatively small engineering company that manages to compete effectively with larger companies by adapting to changing market requirements and specialising in innovative products with limited markets. The products are sold to a wide range of companies, but most of its sales are to companies in the oil industry. On this basis it has maintained a high rate of return on capital employed in relation to the engineering sector as a whole. The latest product to be developed, a high pressure valve, has completed its testing stage and the company now has to decide on whether or not to invest in a production facility and a marketing programme.
The work already undertaken on the product has cost £1.3 million and it is anticipated that some further development work will cost a further £0.2 million. It is estimated that an investment of £9.00 million will be necessary in plant and machinery. This expenditure can be written off (capital allowances) for tax purposes on a straight-line basis over the product's expected six year life. It is anticipated that the re-sale value of the equipment will be about £2.00 million at the end of the six years. The outlay would have been larger, but the company already owns some finishing equipment that will be required. This was previously used in the manufacture of another product that is no longer being produced. It is fully depreciated for tax purposes and could be sold today for £180,000. If used for the next six years it will have no resale value.
The production facility would be located in one of the company's factories with spare capacity available. It will occupy 15 per cent of the factory's space. The company has no alternative uses available for this space for the foreseeable future and has further spare capacity available in other factories. The product will be charged
£50,000 per annum for this space by the company's management accounting system, though only 20 per cent of this figure will stem from incremental costs resulting from heating and lighting. The fixed costs directly attributable to the production are expected to be £ 90,000 per annum. Each product sold by the company is also allocated a general overhead charge equivalent to 10 per cent of the revenues it generates. This allocation is made by the company's accountant to cover head office expenses.
The selling price is expected to be set at £38.00 per unit and it is anticipated that sales in the first year will be about 150,000 units, rising to 200,000 in year two, and staying at this level for the following four years. The introduction of the product would require a marketing campaign that will cost £150,000. As a result of the rapid technological development in the area a six year product life is all that can be expected.
The direct manufacturing costs are expected to be £12.00 per unit. The company will need to hold stocks of the product at the start of each year equivalent to 25 per cent of the sales expected in the year to come. The increase in debtors as a result of introducing the product will be just about offset by the increase in creditors. The company requires a rate of return of 14 per cent on investments of this nature, and the tax rate is 40 percent.
a) Determine the investment's net present value and the internal rate of return. All key assumptions should be specified and explained.
b) Undertake a sensitivity analysis for the assumed price and volume of expected sales and interpret your results carefully.
c) Provide a brief general discussion of the potential risks associated with this investment