Section B – TWO questions ONLY to be attempted
Fernhurst Co is a manufacturer of mobile communications technology. It is about to launch a new communications device, the Milland, which its directors believe is both more technologically advanced and easier to use than devices currently offered by its rivals.
Investment in the Milland
The Milland will require a major investment in facilities. Fernhurst Co’s directors believe that this can take place very quickly and production be started almost immediately.
Fernhurst Co expects to sell 132,500 units of the Milland in its first year. Sales volume is expected to increase by 20% in Year 2 and 30% in Year 3, and then be the same in Year 4 as Year 3, as the product reaches the end of its useful life. The initial selling price in Year 1 is expected to be $100 per unit, before increasing with the rate of inflation annually.
The variable cost of each unit is expected to be $43·68 in year 1, rising by the rate of inflation in subsequent years annually. Fixed costs are expected to be $900,000 in Year 1, rising by the rate of inflation in subsequent years annually.
The initial investment in non-current assets is expected to be $16,000,000. Fernhurst Co will also need to make an immediate investment of $1,025,000 in working capital. The working capital will be increased annually at the start of each of Years 2 to 4 by the inflation rate and is fully recoverable at the end of the project’s life. Fernhurst Co will also incur one-off marketing expenditure of $1,500,000 post inflation after the launch of the Milland. The marketing expenditure can be assumed to be made at the end of Year 1 and be a tax allowable expense.
Fernhurst Co pays company tax on profits at an annual rate of 25%. Tax is payable in the year that the tax liability arises. Tax allowable depreciation is available at 20% on the investment in non-current assets on a reducing balance basis. A balancing adjustment will be available in Year 4. The realisable value of the investment at the end of Year 4 is expected to be zero.
The expected annual rate of inflation in the country in which Fernhurst Co is located is 4% in Year 1 and 5% in Years 2 to 4.
The applicable cost of capital for this investment appraisal is 11%.
Other calculations
Fernhurst Co’s finance director has indicated that besides needing a net present value calculation based on this data for the next board meeting, he also needs to know the figure for the project’s duration, to indicate to the board how returns from the project will be spread over time.
Failure of launch of the Milland
The finance director would also like some simple analysis based on the possibility that the marketing expenditure is not effective and the launch fails, as he feels that the product’s price may be too high. He has suggested that there is a 15% chance that the Milland will have negative net cash flows for Year 1 of $1,000,000 or more. He would like to know by what percentage the selling price could be reduced or increased to result in the investment having a zero net present value, assuming demand remained the same.
Assessment of new products
Fernhurst Co’s last board meeting discussed another possible new product, the Racton, and the finance director presented a range of financial data relating to this product, including the results of net present value and payback evaluations. One of the non-executive directors, who is not a qualified accountant, stated that he found it difficult to see the significance of the different items of financial data. His understanding was that Fernhurst Co merely had to ensure that the investment had a positive net present value and shareholders were bound to be satisfied with it, as it would maximise their wealth in the long term. The finance director commented that, in reality, some shareholders looked at the performance of the investments which Fernhurst Co made over the short term, whereas some were more concerned with the longer term. The financial data he presented to board meetings included both short and long-term measures.
Required:
Evaluate the financial acceptability of the investment in the Milland and, calculate and comment on the investment’s duration.
The NPV is positive, which indicates the project should be undertaken.
Calculate the % change in the selling price required for the investment to have a zero net present value, and discuss the significance of your results.
Reduction in selling price
Discounted revenue cash flows = (13,250 x 0·75 x 0·901) + (16,695 x 0·75 x 0·812) + (22,789 x 0·75 x 0·731) + (23,928 x 0·75 x 0·659) = $43,441,000
Reduction in selling price = 7,801/43,441 = 18·0%
Fernhurst Co would appear to have some scope to reduce the price in order to guarantee the success of the product launch. It would be useful to know whether the finance director’s views on the success of the product would change if the product was launched at a lower price. There may be scope to launch at a price which is more than 18·0% lower than the planned launch price, and increase the sales price subsequently by more than the rate of inflation if the launch is a success.
If the directors are unwilling to reduce the price, then their decision will depend on whether they are willing to consider other ways of mitigating a failed launch or take a chance that the product will make a loss and be abandoned. They will take into account both the probability (15%) of the loss and the magnitude (at least $1,000,000 but possibly higher).
Presumably the finance director’s assessment of the probability of a loss is based more on doubts about the demand level rather than the level of costs, as costs should be controllable. Possibly Fernhurst Co’s directors may consider a smaller scale launch to test the market, but then Fernhurst Co would still be left with expensive facilities if the product were abandoned. The decision may therefore depend on what alternative uses could be made of the new facilities.
Discuss the non-executive director’s understanding of net present value and explain the importance of other measures in providing data about an investment’s short and long-term performance.
The non-executive director has highlighted the importance of long-term maximisation of shareholders’ wealth. The net present value is the most important indicator of whether an investment is likely to do that. However, the assessment of investments using net present value has to be modified if the company is undertaking a number of different investments and capital is rationed. It is not necessarily the case that the investments with the highest net present value will be chosen, as account has to be taken of the amount of capital invested as well.
However, investors are not necessarily concerned solely with the long term. They are also concerned about short-term indicators, such as the annual dividend which the company can sustain. They may be concerned if the company’s investment portfolio is weighted towards projects which will produce good long-term returns, but limited returns in the near future.
Risk will also influence shareholders’ views. They may prefer investments where a higher proportion of returns are made in the shorter term, if they feel that longer term returns are much more uncertain. The NPV calculation itself discounts longer term cash flows more than shorter term cash flows.
The payback method shows how long an investment will take to generate enough returns to pay back its investment. It favours investments which pay back quickly, although it fails to take into account longer term cash flows after the payback period. Duration is a better measure of the distribution of cash flows, although it may be less easy for shareholders to understand.