Question

ABC Co, a large stock-exchange-listed company, is evaluating an investment proposal to manufacture Product WWW, which has performed well in test marketing trials conducted recently by the company’s research and development division. Product WWW will be manufactured using a fully-automated process which would significantly increase noise levels from ABC Co’s factory. The following information relating to this investment proposal has now been prepared: PAGE 10 OF 13 Initial investment RM 2 million Selling price (current price terms) RM 20 per unit Expected selling price inflation 3% per year Variable operating costs (current price terms) RM 8 per unit Fixed operating costs (current price terms) RM 170,000 per year Expected operating cost inflation 4% per year The research and development division has prepared the following demand forecast as a result of its test marketing trials. The forecast reflects expected technological change and its effect on the anticipated life-cycle of Product WWW. Year 1 2 3 4 Demand (units) 60,000 70,000 120,000 45,000 It is expected that all units of Product WWW produced will be sold, in line with the company’s policy of keeping no inventory of finished goods. No terminal value or machinery scrap value is expected at the end of four years, when production of Product WWW is planned to end. For investment appraisal purposes, ABC Co uses a nominal (money) discount rate of 10% per year and a target return on capital employed of 30% per year. Ignore taxation.

Required: a) Calculate the following values for the investment proposal:

i) Net present value. [8 marks]

ii) Internal rate of return. [3 marks]

iii) Return on capital employed (accounting rate of return) based on average investment. [3 marks]

b) Briefly discuss your findings in each section of (a) above and advise whether the investment proposal is financially acceptable. [5 marks]

c) Discuss how the objectives of ABC Co’s stakeholders may be in conflict if the project is undertaken.[6 mark}

Answer 1

(a)

(i)

The investment proposal has a positive net present value (NPV) of $366,722 and is therefore financially acceptable.

The results of the other investment appraisal methods do not alter this financial acceptability, as the NPV decision rule will always offer the correct investment advice.

The internal rate of return (IRR) method also recommends accepting the investment proposal, since the IRR of 18·2% is greater than the 10% return required by PV Co.

If the advice offered by the IRR method differed from that offered by the NPV method, the advice offered by the NPV method would be preferred.

The calculated return on capital employed of 25% is less than the target return of 30%, but as indicated earlier, the investment proposal is financially acceptable as it has a positive NPV.

The reason why PV Co has a target return on capital employed of 30% should be investigated. This may be an out-of-date hurdle rate which has not been updated for changed economic circumstances.

(ii)

Part b)

(iii) Calculation of return on capital employed
Total cash inflow = 560,000 + 696,028 + 1,350,773 + 392,874 = $2,999,675
Total depreciation and initial investment are same, as there is no scrap value.
Total accounting profit = 2,999,675 – 2,000,000 = $999,675
Average annual accounting profit = 999,675/4 = $249,919
Average investment = 2,000,000/2 = $1,000,000
Return on capital employed = 100 x 249,919/1,000,000 = 25%

(b)

The investment proposal has a positive net present value (NPV) of $366,722 and is therefore financially acceptable.

The results of the other investment appraisal methods do not alter this financial acceptability, as the NPV decision rule will always offer the correct investment advice.

The internal rate of return (IRR) method also recommends accepting the investment proposal, since the IRR of 18·2% is greater than the 10% return required by PV Co.

If the advice offered by the IRR method differed from that offered by the NPV method, the advice offered by the NPV method would be preferred.

The calculated return on capital employed of 25% is less than the target return of 30%, but as indicated earlier, the investment proposal is financially acceptable as it has a positive NPV.

The reason why PV Co has a target return on capital employed of 30% should be investigated. This may be an out-of-date hurdle rate which has not been updated for changed economic circumstances.

(c)

As a large listed company, PV Co’s primary financial objective is assumed to be the maximisation of shareholder wealth.

In order to pursue this objective, PV Co should undertake projects, such as this one, which have a positive NPV and generate additional value for shareholders.

However, not all of PV Co’s stakeholders have the same objectives and the acceptance of this project may create conflict between the different objectives.

Due to Product W33 being produced using an automated production process, it will not meet employees’ objectives of continuity or security in their employment. It could also mean employees will be paid less than they currently earn.

If this move is part of a longer-term move away from manual processes, it could also conflict with government objectives of having a low rate of unemployment.

The additional noise created by the production of Product W33 will affect the local community and may conflict with objectives relating to healthy living.

This may also conflict with objectives from environmental pressure groups and government standards on noise levels as well.