Reference no: EM131099768

The capital budgeting problem - HH Ltd

You are required to produce a capital budget using the information below and use this to select the better of two possible projects.

HH Ltd is a manufacturer of a wide range of fashion accessories including handbags, shoes and clothing. The founding Chairman and CEO, Harriet Hart, has recently left the company following disputes with a major shareholder and his successor Matthew Brody has decided to expand the range of handbags offered. The company can go down one of two routes; either he can expand the existing product range by offering new colours and materials with existing designs or he can expand into a new design that is branded in partnership with a UK pop star. However, given restructuring in other areas and limits to managerial time, he is only prepared to authorize one product within a five-year timescale. The options have been narrowed down to the following two:

A) "The Knightsbridge"; the main selling handbag for the company over the previous ten years is a medium sized leather bag named after the famous London district. This option is expected to be less risky for the firm given high demand for the existing product, and plans are to offer a wider range of colours and a wider variety of materials.

B) "The Pixie"; a new smaller model handbag. The bags would be expected to generate smaller sales volumes initially but as the market grows sales are expected to increase at a faster rate.

Project A: "The Knightsbridge"

Part of the production for this project will take place using existing plant and machinery. Existing tools and equipment which are fully depreciated for tax purposes can be adapted for this range at a cost of £1,500,000. An additional £6,000,000 will be required to purchase the new equipment. All equipment is expected to last through the whole life of the project. At the end of the project, the machinery can be sold on as scrap for £500,000. This class of equipment qualifies for writing down allowances of 25% for both the capital expenditure on new machinery and the adapting of existing tools and equipment. Production of the handbags will take place at the company's existing factory in unused space. Head office will charge £750,000 per year for the use of this space, but the company has no alternative use of these facilities.

The company currently sells 50,000 Knightsbridge units per year, which is not expected to change over the next five years. With the inclusion of the new materials and range of colours the marketing department estimates that in the first year of the project, the total units sold for the company will be around 60,000 units. In each subsequent year, this increased number of unit sales will fall by 10% as the novelty of the new product range wears off. The extended product line will be retired after five years, but the company expects to continue selling 50,000 units per year after this period. The initial price of each handbag will be £500.00 and is expected to be increased by 4% each year.

Given the high quality of the handbags, expenses including labour and materials are estimated at £250.00 per unit, rising at 5% per year after year 1. Tax will be levied at 35% one year in 3

arrears. The project will require £100,000 in working capital in year 0 and in each subsequent year will need 5% of the total working capital to date. The cost of capital for this project is 10%

Project B: "The Pixie"

The company has spent £750,000 to date on designing this handbag, and if launched it would require an initial marketing spend of £500,000 in year 1 and £250,000 per year thereafter. Entirely new equipment will be required for manufacture of the new handbag range and will cost £10,000,000. The scrap value of this equipment is thought to be £1,000,000 at the end of the five years. As for Project A, the writing down allowance is 25% and tax is also 35% one year in arrears.

Since this handbag is aimed as a younger and more fashionable customer base than The Knightsbridge, an initial price of £750.00 will be charged. The initial sales level will be relatively low at 4,000 for the first year, but sales should increase at 20% per year as the bag becomes more popular. Price is expected to rise at 7% per annum. The expense per unit will be £300.00 rising by 5% each year.

Initial working capital will be £750,000 and in subsequent years will increase at 3% of the total working capital to date.

The balance of cost remaining on machinery can be recovered as a balancing allowance at the end of each project. Assume that all units produced will be sold. All production for whichever project is chosen will finish is year 5. Given the higher firm-specific risks involved in project B, management requires that it be evaluated using a cost of capital of 15%. 4

Requirements of assignment:

You are required to produce a report setting out the capital budgets for both projects and offering a recommendation on which project to proceed with. Your report should meet explain the following issues:

i) Set up a capital budget for each project using the information above. With this existing information, which project should HH Ltd proceed with? Show your working in Excel and explain your decision. State any assumptions made.

(35 marks)

ii) The company's treasury manager approaches you to object to the 15% discount rate used in the Pixie project. She feels that both projects should be equally risky and has criticized the board for evaluating the wrong type of risk in determining the proposed cost of capital. Explain the types of risk that should be considered by the company when selecting the cost of capital, and examine the sensitivity of both projects to the use of 10% or 15% as the appropriate cost of capital. Does this change affect your recommendation for which project to proceed with?

(15 marks)

iii) Optimistic and pessimistic forecasts have now been produced for several variables, shown below. Continuing with the original discount rates of 10% for The Knightsbridge and 15% for The Pixie, use Excel's various sensitivity analysis tools to examine the effects of these possibilities:

?? There are three estimates for the rate of growth in expenses on both projects:

Pessimistic 7.5%

Neutral 5.0%

Optimistic 2.0%

Examine these scenarios for each project. How would these change the figures? Do they change the company's investment decision?

(15 marks)

?? To meet proposed profit targets, the chosen project would have to produce an NPV after five years of £1,500,000. By making use of existing advertising contracts and adjusting the initial price of each unit, it may be possible to increase the initial number of sales in year 1, the sales growth rate, and the expenses growth rate to produce this result. Using Excel's Solver facility, adjust the sales growth rate, the initial price and the expenses growth rate for each project according to the following constraints:

For project A, the rate of change in sales can be negative up to a -5% reduction and the expenses growth rate may be as low as 2%. The maximum allowable price per unit in any year will be £575.

For project B, the sales growth rate cannot exceed 25% and the expenses growth rate may be as low as 3%. The maximum allowable price per unit in any year will be £900. 5

Is it possible to achieve the target NPV for each project? If so, what adjustments are necessary to achieve it and what level of sales would initially be required? Which project should the company undertake to meet the target and why?

(15 marks)

iv) This set of marks is allocated for the presentation of the report and the conclusions you reach as regards to which project to proceed with, and the justification for this. As noted on the front page, the reports should be no more than 12 pages. Of this 2 pages, should be your excel output of the capital budgets in the main body of the report, 2 pages should be a appendices showing the underlying formulae from these capital budgets, and the remaining 8 pages should be a mixture of text and output from excel solver and sensitivity analysis tools.

(20 marks)

(Total 100 marks)