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Armstrong plc is a large company with a number of very successful products. It has recently developed a new product which it hopes to add to its existing range.
Prior to introducing the new product Armstrong plc hired an international market consultancy to carry out research at an agreed cost of €270,000. Their research indicates that the product is expected to have a life of four years and target sales volumes and selling prices as follows:
Year 1 2 3 4
Units 500,000 600,000 600,000 400,000
Unit Selling Price €10 €11 €12 €10
You have been hired to evaluate the viability of the new product and to recommend whether Armstrong plc should proceed with the product launch. You have also obtained the following information on the new product:
- New machinery costing €1.5m will be required immediately. The machinery is expected to have scrap value of €0.3m. at the end of the project. Armstrong plc has a policy of depreciating machinery costs in its accounts at the rate of 25% per annum on a straight-line basis.
- The new product will be produced in an existing factory which is rented by Armstrong plc under a long-term lease. The factory is currently unoccupied and due to an oversupply of property available in the market the factory is expected to remain unoccupied for the foreseeable future. Armstrong plc pays annual rent of €250,000 on the factory under the lease.
- Variable overheads of production are estimated at €1 per unit.
- Each unit of the new product requires half of a kilo of raw materials to manufacture. The current cost of materials is €10 per kilo and this cost is expected to increase by 10% per annum over the next four years.
- Each unit of the new product takes a quarter of an hour to manufacture. Machine operators are currently paid €8 per hour and no wage increases are forecast for the next four years.
- The marketing director plans to spend €200,000 in each of the first two years, promoting the product. Once the market has been established this spend will be reduced to €100,000 for each of the last two years.
- Armstrong plc estimates that an additional €200,000 will be required for working capital.
- Armstrong plc’s bank has agreed to provide a term loan at a fixed interest rate of 9% per annum to cover the cost of the investment in machinery and working capital.
- Armstrong plc has a cost of capital of 12% per annum which it uses in evaluating all new capital projects.
- Taxation may be ignored and calculations should be made to the nearest €’000.
- Armstrong plc has a policy of requiring all projects to payback within a three year period and to produce a positive Net Present Value before being accepted.
1. Calculate the relevant cash flows to be used in evaluating the project.(50 marks)
2. Calculate the Payback Period. (10 marks)
3. Calculate the Net Present Value (10 marks)
4. Draft a brief report for the management of Armstrong plc, advising if it should proceed with the project and specify the reasons for your decision. (10 marks)
5. Apart from the calculations above, outline two non-financial factors which you feel Armstrong plc should consider before making a final decision on the project. (20 marks)
Total 100 marks
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