Sample
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Question 2a

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:
(a) Evaluate the financial acceptability of the investment in the Milland and, calculate and comment on the investment’s duration. (15 marks)