Question

Red Rose Company produces one of its main products in a plant located west of Dubai. The plant currently produces 50,000 units annually and its maximum capacity is 70,000 units. The sale price per unit is AED 100. The Board had a meeting early this month t o discuss plans for the coming few years. The manager of the marketing department expressed his optimis m that the demand for the coming five ( 5 ) years (starting 2019) will increase dramatically among consumers . His department assessed the market for differ ent products and pro vided t he following estimates for the demand for the Company’s main product:

Year	2018	2019	2020	2021	2022	2023
Sales units	50,000	60,000	65,000	70,000	80,000	90,000

The finance manager (the controller ) suggested increasing the sale price of the product by 5% each year to enhance the profitability of the plant as it is currently making moderate profit. All cash inflows occur at the end of each year .

The production manager indicated that the plant cannot operate at maximum capacity given the current c onditions of the equipment. It is possible only to reach 70 ,000 units per year but the waste will increase from the current level of 1 00 units to 2,000 units. The manager offered three alternatives to handle this technical problem:

1. Produce at a level of 65 ,000 units with the existing equipment to avoid increased waste and source - out the remaining units from another international producer who would label the units in the name Red Rose. The cost of sourced - out units will be AED 8 0 per unit.

2. Modernize the existing equipment to be able to produce up to 100,000 units per year. The cost to modernize the equipment will be incurred at the beginning of 2019 in the amount of twenty five (25) million dirhams. Modernized equipment can be disposed of at the end of 2023 for two million (2) dirhams. The incremental annual operating costs of the equipment will be three (3) million dirhams.

3. Replace the existing equipment with new equipment that is able to produce up to 120,000 units per year. The cost of the new equipment will be forty (40) million dirhams at the beginning of 2019. In this case, the old equipment could be sold for five (5) million dirhams. The annual operating costs of the new equipment will be two (2) million dirhams. The salvage value of th e new equipment after five (5) years will be ten (10) million dirhams.

The financ e manager indicated that t here will be no difference among the above three options in terms of the required working capital. Current level of working capital will be enough f or any of the options. She further pointed out that excess capacity in any of the five year period could be used for meeting demands of other companies but for a lower price. The lower price would result in ten (10) dirhams per unit.

The Board agreed to increase the sale price of the product and asked the finance manager to prepare a report assessing the three options to be discussed in the next Board meeting. You are working as an assistant to the finance manager and she asked you , assuming that all annual cash flows occur at the end of the year :

1. To s ketch the cash inf lows and outflows of the different options

2. To c alculate the net present value of the different options and make a recommendation of which option to use. The Company uses 10% as discount rate. (6 marks )   

Answer 1

A)

B) Best Option is 1 with Highest NPV