Strategic and Financial Decision Making (ACFI5022)

Assignment:

Task 1

The directors of Vidal plc have decided to increase capacity in order to meet expected demand for a new product, Product Gamma. This is a component which is to be used in a new generation of personal computer Notebooks.

Product Gamma cannot be produced on existing machines and, therefore, the company has investigated the possible purchase of a new machine (Machine A).

Machine A will be capable of producing 60,000 units per year and will cost £322,500. It is expected that the demand for Product Gamma will last 4 years before it is superseded by a new product. At the end of 4 years it is estimated that Machine A will have no residual value. It is thought that Machine A will suffer maintenance costs in the first year of operation of £15,000 and that these will increase by £7,500 per year, for each year of operation.

Vidal plc expects demand for Product Gamma to be 30,000 units in the first year, and that this demand will increase by a further 10,000 units per year in each subsequent year. The selling price is expected to be £15.00 per unit and the marginal cost of production is expected to be £11.70 per unit. Incremental fixed costs of £15,000 per year will be incurred. The selling price and costs are stated in current price terms.

The management team is aware that the cash flow forecasts will be influenced by inflation and have, therefore, consulted their Corporate Strategy unit who estimate that the following annual rates of inflation will apply over the four years:

Consumer Price Index

(i.e. general rate of inflation in the UK economy)          3.7% per year

Selling price of Product Gamma                                  4.0% per year

Marginal cost of production                                       4.0% per year

Maintenance costs                                                  5.0% per year

Fixed production overheads                                       6.0% per year

With regard to analysing the viability of the above proposal the following conversation is heard to take place:

Financial Controller: "Now we have the estimated data we can get on with calculating the Net Present Value of the project. I'm aware that the shareholders require a real rate of return of 8% so there will be no problem with the calculation."

Management Accountant: "If we want to take the results of our appraisal to the next senior management meeting I think that we should calculate the Internal Rate of Return. This will give us an answer in percentage terms which is intrinsically more understandable to the non-financial members of the meeting. Most people don't understand what the Net Present Value means."

Production Director, "You're both over-complicating the issue. We state most of our financial data in accounting terms. Why don't we just calculate the Accounting Rate of Return? I remember studying that at university and it seemed to be very straightforward."

Required:

a) In order to satisfy the diverse view expressed above you should calculate:

i) The Net Present Value (NPV) generated by Machine A and state whether or not the investment is worthwhile.

ii) The Internal Rate of Return (IRR) related to the investment in Machine A.

iii) The Average Accounting rate of Return (AARR) associated with the investment in Machine A.

b) After deliberation the management team decide to investigate if there are any alternatives to Machine A. They identify two additional machines, B and C, and undertake the same financial analysis. When ranked by the different methods the following results occur:

                                    NPV                IRR                 AARR

            Machine A                 2^nd                   1^st                          2nd

            Machine B                 1^st                    2^nd                         3rd                 

            Machine C                3^rd                    3^rd                    1^st

Which machine would you recommend that Vidal plc select? Give a full consideration to the reasons for your choice.

Task 2

A senior manager was heard to say, "I have been reading, and it appears that the cost of capital calculation will be crucial to the NPV calculation. 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.'"

You are required to consider Hamilton's statement and explain why CAPM can be used to allow for risk when considering capital investments and to comment upon the process that should be followed.

Task 3

Another senior manager is heard to say the following, "I've just been to a conference and the main message was that the essence of company management is the creation of shareholder value. Apparently we should be utilising value-based management techniques in order to produce Market Value Added (MVA) through the generation of Economic Value Added (EVA). I always thought that we should be maximising Net Present Value (NPV). Have our objectives changed?"

You are required to provide a brief report to the senior manager:

a) Giving your opinion as to whether or not the application of EVA and/or MVA methodologies are practical management techniques leading to the creation of shareholder value.

b) Providing a critical analysis as to whether or not the adoption of EVA and/or MVA would now change objectives from that of NPV maximisation.