Greinam Dynamic, a division of the major engineering and mining conglomerate Thistle International, is considering investing £680,000 in new machinery to be used in the manufacturing of one of the company’s products. The accounting information produced for discussion by the management group of the company does not make encouraging reading and has lead to the Managing Director demanding a review of the figures within the next two days and an assurance that the project will pay for itself in three years. You are the company’s newly appointed Management Accountant and have been asked to review the figures produced by your financial colleagues and to make a clear recommendation to the Managing Director on the viability of the project.
The financial accountants have produced the following figures for the four year expected life cycle of the project:
2009 2010 2011 2012
(£000) (£000) (£000) (£000)
Sales 640 980 1200 950
Less: Materials 280 400 540 400
Labour 100 150 150 100
Other production expenses 100 120 124 120
Depreciation 80 80 80 80
Administrative overhead 68 90 88 82
Interest on loans to finance the project 40 40 40 40
Total cost 668 880 1022 822
Profit (loss) (28) 100 178 128
The figures would appear to illustrate very clearly that the project is not viable and certainly does not meet the Managing Director’s requirement of Payback within three years. You, however, are surprised at the figures produced by your accounting colleagues and have, by careful questioning at the meeting, discovered the following:
- It is fair to assume that given market developments the product’s life cycle would not exceed four years. At the end of the four years the machinery could be sold for scrap at an estimated price of £55,000.
- The company already holds 25% of the materials required in the first year. This material was bought some years ago for £65,000 but if not used in the project could only be sold for scrap at an estimated value of £30,000. For the purposes of the presentation the financial accountants have priced the existing stock at the current market value.
- Included in the provision for “Other production expenses’’ was an apportionment of fixed overheads calculated at 20% of labor costs.
- The ‘’Administrative overhead’’ charge is an allocation of fixed overheads.
- There is no evidence of the company having to meet any new or additional overhead costs as a result of starting the project.
As a matter of urgency, you hold meetings with other senior managers within the company at which you learn the following:
- The Production Manager is of the view that if the new machine is acquired it will have sufficient capacity to enable an existing machine to be sold immediately for £25,000 and, given the added efficiency of the new machine, will produce operating savings of £20,000 each year. He has also estimated that an investment of £150,000 in working capital is required at the onset of the programme of which 70% will be recovered at the end of the full period.
- The Marketing Manager argues that to reach the sales figures quoted an immediate investment of £30,000 in advertising and promotion is essential and that a budget of £12,000 annually would be required to maintain market share. A bill for £26,000 for market research carried out over the previous three months has been paid within the last few days.
- The Marketing Manager is also concerned that introduction of the new product will reduce sales of another of the company’s products. He calculates that sales of as much as £80,000 each year of a product with a gross profit margin of 25% will be lost.
- You discover that investment in a project of this nature will attract capital allowances against taxation liabilities of 25% per annum on the written down value of the investment. The company pays corporation tax at 30%. For the purposes of this evaluation you decide tax should be accounted for in the year in which the liability arises.
Your financial accounting colleagues are rather unclear about the return required on an investment of this nature and seem to be unaware of modern project assessment techniques. They have always assessed projects on the Payback Period and are recommending, on that basis and given the figures they have produced, that the project should be rejected. The Managing Director has always accepted the views of the financial accountants on such issues and will need to be persuaded that the project may be assessed differently. Your view is that cash flows are much more relevant to investment decisions than accounting profits and, also, that cash flow discounting techniques should be used to evaluate project viability.
The company is funded from 2 million £1 ordinary shares, currently trading at 440p per share and £2 million 7% redeemable debentures at £94. The company has recently paid a dividend on the ordinary shares of 46p per share and company reports show the dividend paid four years previously as 37.8p per share. The debentures are due to be redeemed in four years time. You also discover that the equity beta of the company is 1.2 and that the risk-free rate in the market is 4% with a market premium of 8.4%.
You are required to produce a report for the Managing Director which should address the following issues:
- The manner in which information is presented and investment decisions made.
- The relevance of the cost figures produced by the financial accountants and the information you have gathered.
- The minimum return required on a project of this nature given the capital structure of the company and the level of risk attached to the project.
- The Net Present Value of the project and a recommendation on whether or not the company should proceed with the investment.
You will be assessed on the following:
- Clarity of the report (10%)
- Comprehension shown of the principles involved: (30%)
- Layout and accuracy of calculations: (45%)
- Conclusions and recommendations (15%)