Reference no: EM133048350 , Length: word count:2000

Assessment Information - What you need to do

Eden plc is a relatively small public manufacturing company. The company plans to launch two new models of very cheap Bluetooth speakers, the Blaster and the Hounddog. The nature of the products is such that competitors are likely to join the market very quickly. For this reason it is thought that the Blaster will have a four year economic life and the Hounddog will be five years.

At a Board meeting the Marketing Director, Samuel Poulton, suggests that forecast sales (in units) of the products will be:

The costs of each product, for 2020, will be as follows, according to the Production Director, Sudesh Jain:

The incremental fixed production costs in the budget have been apportioned according to the total sales value of each product. As can be seen the company operates a cost-pluspolicy of approximately 50% on total unit product cost (allowing for rounding).

In addition, to the fixed production overheads (costs) there will be £500,000 spent on advertising in the first year of launch, and then £200,000 in each subsequent year. There are no incremental non-production costs other than advertising, associated with the products.

At the Board meeting it is the general will of the meeting to launch the products together or not at all and it becomes apparent that the products will require an initial total investment of £6,000,000 in machinery. The machinery will have no identifiable value by the end of the product life cycles.

The following rates of inflation will apply from the second year onwards, with regard to the following data:

It is apparent that the applicable tax rate over the 5 years will be 25% per annum, payable in the year that the cash flow is earned. In the current tax regime there are no capital allowances available.

The general view at the Board meeting is that the project should be appraised using Net Present Value and Internal Rate of Return principles.

Paschal Hickson, the Assistant Finance Manager, who has recently completed an MSc International Business says to the board that: "We will need to know the weighted average cost of capital (WACC), as we will need a discount factor."

To this end he indicated that the following information may help calculate the WACC:
As far as equity is concerned the company has paid the following total dividends over the last 5 years:

The company is currently financed by 3,000,000 (£1 shares), each with a market price of £5.20 ex div, along with £5,000,000 of 6% corporate bonds which are currently trading at £110 per £100 of bonds ex int. These bonds mature 5 years from now in 2024.

Before the end of the meeting, Beverley Sparkes, the HRM manager says, "When I was on a CIPD (Chartered Institute of Personnel and Development) course we were told that it is much easier to appraise projects using the Payback and Accounting Rate of Return methodologies." There was no immediate response at the meeting as many of the members could not understand the conversation.

However, to complicate matters even further Paschal Hickson, who enjoyed the limelight, said, "When looking at our financial arrangements wouldn't it be better to use more debt (corporate bonds) in our financial structure. This might make future projects look much more attractive."

This suggestion was sufficient to hasten the meeting to an end.

Required:

Working as a consultant to the board you should respond to the following tasks:

Problem Task 1

Taking account of all of the relevant information in the above scenario you should calculate both the Net Present Value, of the proposed project and the Internal Rate of Return.

In addition, you should give an opinion as to whether or not the project is worthwhile. This may include factors beyond your calculations.

Problem Task 2

Provide an analytical response to Beverly Sparkes' comment, contrasting the methods above (Task 1) with her suggestions. This should be a written discussion and requires no additional calculations.

Problem Task 3

Provide a well-argued response to Paschal Hickson's final comments concerning capital structure. You should provide a well-researched response indicating whether or not you agree with his suggestion.

Problem Task 4

As the suggested project is in a different direction to the company's usual activities you are aware that the company could use the Capital Asset Pricing Model (CAPM) in order tocalculate a risk-adjusted weighted Average Cost of Capital (WACC).

You read that, according to Hamilton (2004, p4), "The difference between a 15% discount rate and a 14% discount rate can mean a difference in value conclusion of hundreds of thousands of dollars.......the capital asset pricing model (CAPM) is among the most widely used methods to estimate the cost of capital."

Therefore, from the above it seems evident that it is important to correctly estimate the discount factor to be used in NPV calculations.

You should consider Hamilton's statement and provide a full rationale as to the use of CAPM for the calculation of a risk-adjusted specific discount rate and also provide an opinion as to why you think it is or is not an appropriate use of CAPM.

Problem Task 5

Instead of undertaking ‘organic' growth as indicated in the scenario Eden could expand into the less familiar industry by acquisition.

You are required to provide a critical analysis of the relative benefits of the two types of growth (i.e. ‘organic' and acquisition) from Eden's point of view.

Attachment:- finance assessment.rar