Question

The e-move Ltd Company is an established and growing manufacturer of electric mobility scooters. The company currently produces and sells 70,000 scooters annually and enjoys a constant year on year increase in sales volume of 6% and has a cost of capital 12%. However, it has recently suffered from production quality problems that had increased the cost of product failure. The e-move Ltd has recently paid £100,000 to the external consult “Op-Focus Consulting Ltd” for an engineering review of the company operations. The report of Op-Focus Ltd has found that the cost of product failure is currently as in the following table and if nothing change, this cost is going to increase in line with the increase of the production and sales of 6% over the 5 years of the investment:

Probability	Cost of product failure (£)
40%	2,000,000
25%	2,500,000
20%	1,500,000
15%	1,200,000

You are a senior manager in e-move Ltd and your task is to prepare a report for the Board of the company considering the following two alternatives: Option 1 - Operational improvements: Undertake an extensive review and modernization of the production and operations. This option will require the commissioning of the necessary engineering study and will incur an immediate cost of £500,000. It will also require an immediate investment in new machines of £25,000,000. This new machinery is expected to have a useful economic life of 5 years and zero residual value. The modernization of operations will result in the reduction of the production cost by £75 per scooter and the cost from product failure will be reduced by 90% but still will be increasing at 6% per year, in line with the increasing production and sales. Option 2 – Production changes: E-move Ltd can change its current supplier of the electric motors. The new motors will be more efficient and some modifications in the production line will save assembly costs. This second option requires an additional immediate investment of £5,000,000, which will have useful economic life 5 years and zero residual value. It will also result to an increase of fixed production costs by £2,000,000 including depreciation. This investment will save £30 per scooter in assembly costs, which will obviously increase in line with the production and sales volume over the 5 years of the investment. 3 | P a g e It is given that there are no taxes and inflation and only one of the two options can be undertaken.

Required: Estimate the Net Present Value and the Internal Rate of Return of Option 1 and Option 2, and show your calculations.

Answer 1

Year	1	2	3	4	5	Total
Units sale	74200	78652	83371	88373	93676
Average cost of product failure	£20,19,300	£21,40,458	£22,68,885	£24,05,019	£25,49,320
Option-1
Reduction of cost £75 per scooter	£55,65,000	£58,98,900	£62,52,834	£66,28,004	£70,25,684
Reduction in product failure cost @90%	£18,17,370	£19,26,412	£20,41,997	£21,64,517	£22,94,388
Total Saving in costs	£73,82,370	£78,25,312	£82,94,831	£87,92,521	£93,20,072
PV Factor @ 12% (1/1.12^n)	0.8929	0.7972	0.7118	0.6355	0.5674
Present Value of saving in costs	£65,91,402	£62,38,291	£59,04,097	£55,87,806	£52,88,459	£2,96,10,055
Less: Initial costs
Immediate cost						-£5,00,000
Immediate investment in new machines						-£2,50,00,000
NPV						£41,10,055
IRR (using XIRR formula in MS-Excel.)						18.03%
Option-2
Increase in Fixed Production costs	-£20,00,000	-£20,00,000	-£20,00,000	-£20,00,000	-£20,00,000
+Depreciation (Non-cash expense) ( £5M/5 years)	£10,00,000	£10,00,000	£10,00,000	£10,00,000	£10,00,000
Saving in assembly cost @ £30/scooter	£22,26,000	£23,59,560	£25,01,134	£26,51,202	£28,10,274
Total Saving in costs	£12,26,000	£13,59,560	£15,01,134	£16,51,202	£18,10,274
PV Factor @ 12% (1/1.12^n)	0.8929	0.7972	0.7118	0.6355	0.5674
Present Value of saving in costs	£10,94,643	£10,83,833	£10,68,477	£10,49,368	£10,27,198	£53,23,519
Less: Initial costs
additional immediate investment						-£50,00,000
NPV						£3,23,519
IRR (using XIRR formula in MS-Excel.)						14.39%

Option-1 is advisable as it has higher NPV and IRR.