ICAA Adapted Questions and Answers

ICAA Adapted (18% of 3 hour exam = 35 mins) Low Computers Limited (LC) is a manufacturer of high quality computer equipment for the local business market. Sales of Putmo, a computer modem, have fallen dramatically and management have decided to cease sales of this product from 1 January 1999. Putmo has been one of LC's market leaders and has led to strong sales of associated products and software distributed by the company. It is anticipated that local sales of other products with a variable cost ratio of 65% will fall by $1,000,000 each year for the next three (3) years unless a suitable replacement modem can be found. Management have put forward a proposal to produce a new modem to target the business internet and video conferencing market. It is considered this new modem will ensure that local sales of other products are not affected by the decision to cease production of Putmo. The preliminary evaluation of the new modem has indicated a product life of three (3) years and that it can be produced at the same production facility as Putmo. LC has planned to enter the export market in the South Pacific region and management believes that the new modem is the ideal product to launch the company's range of products in this region. The company anticipates generating sales of other products once the modem has established the company's credentials in the marketplace. At present no estimates have been made of likely sales. New plant and equipment of $10 million will be bought at 31 December 1998. The plant and equipment will have a $Nil value at the end of the three years and can be depreciated on a straight line basis for both tax and accounting purposes. The company's bankers have indicated the funds could be made available via a 7% per annum, three (3) year amortising loan. The company needs to purchase the production rights for the new modem. The cost of acquiring these rights for a period of ten (10) years is $5 million payable 31 December 1998. It is considered these rights will have little value at the end of three (3) years and are non tax deductible. The company has $6 million on term deposit earning 6% per annum maturing on 1 November 1998 which can be used to pay for the production rights. The initial variable costs of production of $150 per unit are estimated to increase by 10% per annum. All export product will incur freight costs of $20 per unit. This amount is not expected to increase during the period. Marketing costs in the South Pacific region are estimated as: Year 1 Year 2 Year 3 $150,000 $180,000 $120,000 Estimates of sales and variable costs of manufacture for the two markets are given below: Year 1 Sales Units Local Export Sales Price 35,000 4,000 Year 2 48,000 11,000 Year 3 40,000 20,000 Local Export $350 $300 $310 $310 $280 $310 Variable Costs per unit $150 $165 $181.5 The company will be eligible to receive an Export Market Development Grant which will entitle them to receive a tax free grant based on their marketing costs in the South Pacific region on 31 December each year, . Estimated grants are: Year 1 80% of marketing costs above $30,000 Year 2 70% of marketing costs above $30,000 Year 3 60% of marketing costs above $30,000 All cash flows including tax at the rate of 36% can be assumed to occur on the last day of the relevant year (tax year ends 31 December). The company's weighted average cost of capital in nominal terms is 11%. REQUIRED (1) Calculate the Net Present Value of the proposed production of the new modem. Clearly state any assumptions made. [Exam technique hint: you should do this anyway, even if not asked!] (14 marks) (2) Recommend whether the project should proceed or not. Give reasons. (4 marks) Solution Need to make some kind of assumption about the fixed costs. Here it is assumed that there would be no fixed cost savings when production of Putmo ceases and the $1 million sales from other products is lost. It is also assumed that the only incremental fixed costs for the new modem are as given in the question - production rights, equipment depreciation and marketing. Plus no working capital implications. (2 marks) Note that all financing flows should be excluded - inclusion of interest, principal or interest lost is incorrect as financing aspects are captured in the discount rate. (inclusion = -3 marks) $'000s Production Rights Equipment Year 1 Year 2 Year 3 Marks 0.5 0.5 Local sales Export Sales Variable Costs Depreciation Freight Marketing EBIT EBIT (1-t) 12,250 1,200 -5,850 -3,333 -80 -150 4,037 2583 14,880 3,410 -9,735 -3,333 -220 -180 4,822 3086 11,200 0.5 6,200 0.5 -10,890 1 -3,333 0.5 -400 1 -120 1 2,657 1700 1 (tax) add back depn Saved GP (1-t) Export Grant 3333 224 96 3333 224 105 3333 224 54 6,237 0.9009 6,748 0.8116 5,312 0.7312 Net Cash Flow PV Factor(11%) Net Present Value Year 0 -5,000 -10,000 -15,000 1 -21 (2) Discussion of NPV and impact on wealth (positive or negative) Sales of other products in South Pacific - would increase NPV 1 mark 1 mark Other Factors (1 mark for each point to a max of 2) Have rights to modem for another 7 years - could increase NPV Opening up new market - strategic considerations May be incremental fixed costs (see part 1) - would decrease NPV Strategic planning - must have full range of products Other 0.5 2 1 1 1