Question

Investment Appraisal for Estia plc - The smart oven project

Estia plc, is a large, established and fast-growing manufacturer of home appliances. The company is highly profitable and cash-rich and has hired your management consulting company to advise the Board on a new investment project. In the previous meeting of the Board, the CEO has presented two alternative options for the development of a new smart oven. The new oven will function as a normal oven but will also allow the homeowner or user to have virtual control remotely from the Web or via a mobile phone app.

The first option is for Estia plc to have the new oven manufactured in China and the second is to produce it at home, in its current UK manufacturing facilities.

The sales of the new smart oven are expected to be 100,000 units per year and the investment will last five years. At the end of this period, the investment will be terminated with no residual value. The selling and administrative costs will be £3,000,000 per year.

The selling price of the new smart oven is estimated to be £360 per unit.

Estia plc will have to make an initial investment of £20,000,000 in non-current assets, at the start of the project. The full cost of this investment in non-current assets will be depreciated over 5 years, using the straight-line method.

We assume that the revenues and expenses occur at the end of each year. The corporate tax rate is 40%. All other taxes can be ignored.

Estia plc will use 12% as the cost of capital for the new investment.

Option 1:

Estia plc decides to sub-contract the manufacturing of the smart oven to a Chinese manufacturer, paying the subcontractor an all-inclusive cost of £250 per unit.

Option 2:

Estia plc decides to manufacture the smart oven at its own home factory. With this option, an initial investment in working capital of £3,000,000 will be required, at the start of the project. This amount will be recovered at the end of the fifth year, when the investment will be terminated.

The production line will occupy plant space of 50,000 sq m, which otherwise could have been rented out for an annual rent of £2,800,000.

The cost of materials £140 per unit

Each unit will require 1 hour of engineer’s time and 2 hours of skilled labour time.
The cost of labour for Estia plc is £40 per hour for the engineers and £20 per hour for the skilled labour workers.

Required:

1. a) Estimate the net present value and the internal rate of return if Estia plc decides to sub-contract the production of the new smart oven to a Chinese manufacturer (Option 1). Show clearly your workings.

2. b) Estimate the net present value and the internal rate of return if Estia plc decides to

   produce the new smart oven in-house (Option 2). Show clearly your workings.
   

3. c) Provide a short report for the Board of Estia plc discussing the factors and issues that they have to consider in the deliberation of their decision of which of the two options to approve. You can include references to advantages, disadvantages and risks of each option. As sensitivity analysis, estimate the NPV of the two options if the selling price increases by 10% or decreases by 10%.

d) Produce a clear, well-structured and readable report.

Answer 1

The Estia Inc should go fro sub contracting with chinese manufacturer. Below are my workings of NPV and IRR on both the options along-with Sensitivity analysis: