CORPORATE FINANCE Financing Decision Mini Cases Lecturer: Dr Ali Malik

CASE 1: NEW IDEA LTD

New Idea Ltd. is considering a proposal that it should manufacture a mobile phone that includes an in-built television. The new product would be targeted at the modern professional trader operating in financial markets. A management consultant has been hired at a cost of 20,000 to conduct market research and conduct a feasibility study. The manufacture of this new product would require the use of an existing machine, which although having no alternative use has a net book value in the financial accounts of 100,000 and could be sold for 50,000 if the proposal was rejected. In addition, a new production line would have to be set up at an initial investment of 350,000. Maintenance costs for the production machinery are expected to total 60,000 per annum with all equipment being sold at the end of the product life cycle for 100,000. A special promotional campaign will be mounted for the first year of the project at a cost of 250,000 with an additional advertising budget of 50,000 per annum for the remainder of the project's life. The estimated unit selling price and costs (excluding production machinery and promotion) are as follows: Per Unit Selling Price Less: Materials Labour Variable Overheads General Fixed Overheads [Absorbed on a direct labour hour basis] Surplus 15 10 5 5 120

35 85

Specific fixed costs relating to distribution of the new product have been estimated at 30,000 per year. The management consultant has identified the following demand profile over the products anticipated life cycle: Year 1 2 3 4 sales (units) 1,000 8,000 6,000 1,000

New Idea Ltd. has a cost of capital of 12% per annum. REQUIRED: a) Using the Net Present Value method of investment appraisal, evaluate the proposal and recommend whether it should be accepted or not. Briefly justify the acceptance or rejection of the figures detailed in the question. b) Why is it necessary to build a discount factor (i.e. present value interest factors on the basis of
Page 1

Corporate Finance: Financing Decisions Cases: Lecturer Dr Ali Malik

cost of capital) into long term decision making? c) d) Comment on two non-financial factors that should be considered before the proposal is accepted or rejected. Compare NPV and IRR as methods of investment appraisal.

CASE 3: KEEPKOOL PLC Keepcool PLC manufactures and distributes small electric fans. It is considering adding a new compact air conditioner to its product range. The marketing manager feels that there will be a demand for these with average temperatures rising due to global warming. A report has been commissioned from the meteorological office at a cost of 15,000 to investigate the likelihood of increased temperatures leading to sales of air conditioners. The results for the next 5 years were as follows: No change in temperature 10 increase in temperature 20 increase in temperature 30 increase in temperature Probability 20% 40% 30% 10%

She feels that with no change in temperature she can sell 10,000 air conditioners per year and with each increase in temperature of 10 beyond this sales will increase by 10,000 per year. If the air conditioners are to be manufactured, new production facilities will be required, costing 2 million, with an expected useful life of 5 years. At the end of the fifth year they could be sold for 50,000 scrap. Extra working capital required would be 100,000. The unit manufacturing variable cost is estimated to be 40 and additional fixed costs relating to the production and distribution of the air conditioner are estimated to be 90,000 per year. The air conditioners will sell at 70 each. The company has a cost of capital of 8%. Required: a) Evaluate the proposal on NPV method of investment appraisal. Give reasons for including or rejecting figures. b) If you were the marketing director, what other information would you require before going ahead with the investment? Discuss why NPV is a superior method of appraising investment proposals.

Corporate Finance: Financing Decisions Cases: Lecturer Dr Ali Malik

Page 2

CASE 3: DENALI PLC Denali PLC is considering the introduction of a new product to add to its range of electrical components. The following information relating to the product is available. A market survey has been undertaken, but not yet paid for. This will cost 15,000. This survey suggests that demand will last for the next four years as follows: Quantity sold (No. of units) 8,000 10,000 12,000 Probability 0.2 0.5 0.3

The market survey suggests that whichever level of demand actually occurs, it will remain at that level for the life of the project. The selling price will be 17 per unit. The company already owns the machinery that could be used in the manufacture of the product. If it is not used for the new product it will be sold immediately for 100,000. If it is used for the new product it is expected to have residual value of 20,000 at the end of four years. Since the production cycle is very short, both production and sales could start immediately, should the decision be made to go ahead and produce. Each unit of the new product will require 2 hours labour that will need to be hired. There will be no problems hiring sufficient staff at 2.50 per hour. Each unit of the new product will require one component, a capacitor, and 4 of sundry raw materials, such as wire and circuit board. The company has a stock of 15,000 capacitors, which were bought for 3 each two years ago. These have no resale value elsewhere. Any capacitors needed from now on will cost 4 each to purchase. The company holds no stock of the sundry raw materials. Overheads relating to the project will be 20,000 per annum. The cost of capital is 15%. Assume that all cash flows fall on the last day of the year. REQUIRED: a) b) c) Calculate the Net Present Value of the project. Comment on whether you would accept the project, and what other factors you would take into consideration in making your decision. Why are interest payments not shown in your calculations?

Corporate Finance: Financing Decisions Cases: Lecturer Dr Ali Malik

Page 3