The directors of Digitech ltd, a reasonably large but family owned business, need to increase capacity in order to meet demand for a new component (Product X) which is to be used in the manufacture of a new generation of tablet computers. Product X cannot be manufactured on existing machinery. The directors have obtained tenders on two machines which can manufacture Product X. One tender is from a French supplier and the other from a German supplier. Both machines have the same capacity of 60,000 units per year.

The following data applies to the machines:

French Machine

The machine will cost £477,700 and will last for four years, at the end of which time it will have zero scrap value. Maintenance costs will be £20,000 in the first year of operation, increasing by £6,000 per year for each year of operation.

German Machine

The machine will cost £430,000 and will last for four years, at the end on which time it will have zero scrap value. Maintenance costs will be £20,000 in the first year of operation, increasing by £10,000 per year for each year of operation.

Digitech plc expects demand for Product X to be 30,000 units per year in the first year, and to increase by a further 10,000 units per year in each subsequent year. Selling price is expected to be £20.00 per unit and the marginal cost of production is expected to be £15.60 per unit. Incremental fixed production overheads of £20,000 per year will be incurred. Selling price and costs are all in current terms.

The company has forecast the following annual inflation rates relevant to their circumstances:

General rate of inflation in UK 2.8%

Selling Price of Product X 4.0%

Marginal cost of production 4.0%

Maintenance Costs 5.0%

Fixed production overheads 6.0%

The family investors in Digitech plc expect a real rate of return on investments of 8%.

Required:

a) Calculate the Net Present Value (NPV) arising out of the incremental cash flows for each machine and recommend whether the company should buy the French or German machine. You should also provide a brief interpretation of your answer. (15 marks)

b) Calculate the Internal Rate of Return (IRR) for each machine and briefly comment on your findings.

(5 marks)

c) Digitech’s Production Manager is heard to say, “Let’s base our decision on the Internal Rate of Return outcome as it is easy to rank projects using percentage returns. I don’t even understand the meaning of NPV.”

You should provide a response to the Production Manager which will recommend a method to use and compare and contrast the two appraisal methods in question.

(15 marks)

(Total 35 marks)

Task 2

In response to the above debate with regard to project appraisal, Digitech’s assistant finance manager attends a two-day course on the use of Real Options Analysis.

The following quote was brought to her attention at the development session:

“When estimating project value planners need to include the economic value of flexibility in project strategies.” (Ford and Bhargav, 2006, p275)

During the course the trainer went on to emphasise this point and said, “it is suggested that Real Options Analysis can be used to allow for the benefit of flexibility and to direct management attention to particular strategic issues, as opposed to the sole use of Net Present Value calculations which assume certainty.”

The assistant finance director finds this to be a rather confusing topic and turns to you for help.

You are, therefore, required to prepare a brief report in order to consider the points made above and to particularly comment on the issues of flexibility and management attention directing, which are the supposed benefits of Real Options Analysis.

(30 marks)

Task 3

The family owning the shares of Digitech ltd is looking to make an exit from the company within the next three years. The younger generation of the family is not interested in running the business although they do enjoy spending the money.

Naturally, those who have owned and managed the business for many years would like to maximize the value of the company when the sell it.

You are required to prepare a brief report to address the following:

Provide practical advice to the family with regard to what they should do

over the next three years in order to prepare for the sale of the company and to maximize the value of the business. You should provide a rationale for any advice that you offer.

(15 marks)

One of the family is heard to say, “It seems as though the valuation of a

business is sophisticated guesswork, involving many estimates, with

different approaches leading to different valuations.”

You are required to respond to the family member with a critical analysis of the views expressed. It would also be worthwhile to develop some numeric examples in order to support any points that you make.

(20 marks)

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Posted on May 4, 2016Author TutorCategories Question, Questions