Reference no: EM133164244
Question: Investment Appraisal
Martin Seagull and Co. manufacture high quality acoustic guitars. Established 150 years ago, they have built a global reputation for the quality of their guitars which are widely used by professional musicians around the world. Their guitars are handmade from quality solid wood and the company employs a range of skilled workers.
However, this quality comes at a high retail price, limiting the market for their guitars. The company would like to break into the mid-price guitar market which is highly competitive, with several manufacturers and lower price ranges.
To help with this the company has commissioned some market research to be undertaken, the results of which suggest that by using different materials and automated manufacturing techniques, two options could provide a feasible attempt to enter the mid-price market. The market research cost £50,000 and is payable immediately.
Option 1 - Part-wood and part-synthetic guitar manufacture
The part-wood and part-synthetic guitar is a composite guitar that makes it look like it is made of wood. The guitar is 30 percent lighter than other acoustic guitars, and-as expected with composite guitars-it does not bend.
The company needs to invest in new machinery to make these guitars costing £1,550,000 and payable immediately. The machine would last for 5 years and have no residual value. The machine is different to the existing machine and the production staff would need training to use the new machines at a cost of £62,000 in year 1.
Maintenance costs for the new machine would be £48,000 per year.
To hear how it sounds during production, the warehouse would also need to undergo development of effective acoustic sound panels. This would cost £124,000 in year 1 and £64,000 in year 2.
As this new approach to manufacturing guitars is still in its infancy, it is anticipated that sales would increase year on year as customers became used to the non-traditional look and feel of the guitars. The projected net cash inflow, after deducting estimated production costs, is £600,000 in Year 1, £600,000 in Year 2, £700,000 in Year 3, £800,000 in Year 4 and £600,000 in Year 5.
Option 2 - Laminate guitar manufacture
The laminate production process uses thin layers of wood that are glued together for strength. The laminate is flexible and can be shaped easily. This would require the purchase of additional machinery with a capital cost of £1.2m payable immediately. The machines would have a 5-year useful life and a residual value of £120,000.
The annual maintenance costs of the machinery would be £45,000.
Some of the current staff would be used to finish and quality check the guitars by hand, but these would need some retraining in the new process which would cost £25,000 in year 1.
Due to the glue used in the manufacturing process, there will be a need to deep clean the machinery during its life. This would cost £10,000 in both year 2 and year 4.
Cost estimates have been produced by the finance team based on the sales indicated in the market research and the estimated production costs and these give anticipated net cash inflows of £550,000 per year.
The company's cost of capital is 12% per year.
Required:
a) Calculate both the Payback and the Net Present Value (NPV) of each of the two projects. Using only these calculations, comment on the financial viability of each project, and which one would be preferable giving your reasons why. You must state your assumptions for any costs you exclude.
b) Based on the information given in the question, advise the management of the company of other factors that should be considered, before deciding whether either of the two options should go ahead.
c) Discuss the advantages and disadvantages of "ARR" and "Net Present Value (NPV)" as techniques for evaluating investment projects, and why you think management may have preferred to use NPV in this case.