ComfortFeet plc a footwear manufacturer has a factory in Southend that it rents on a lease due to expire at the end of October 20X4. The factory is entirely devoted to making Slipon Comfy (SCs) shoes. The market for slip-on shoes has been declining and a decision had been made two years ago not to renew the lease in 20X4, but to close down the SC manufacturer when the lease expires.

At a recent meeting of the Board of Directors, the question was raised as to whether it might be profitable to close at the end of December 20X1, three years earlier than originally decided. You have been asked to look into this question.

Sales of SCs for the next three years are projected as:

Year £000s

20X2 10,000

20X3 7,500

20X4 5,000

The marketing director believes that these figures could be increased if an advertising campaign were to be undertaken. Such a campaign would involve cash outlays of £1 million on 31 December in each of 20X1, 20X2 and 20X3. The marketing director conceded that the results of the advertising campaign are uncertain. She estimates that an increase of 10% will occur with 40% probability and a 25% increase with 60% probability. If the advertising is contracted, the expenditure would be allowed for tax in the accounting year in which it is incurred.

The variable costs of manufacture of SCs are estimated at 30% of the selling price. The annual rent of the factory is £5 million payable on January 1st of each year. The owner of the factory will not agree to early termination of the lease but eh company has the right to sublet the factory. The senior management is confident that a subtenant who will pay £4 million on January 1st each year can be found for each of the three relevant years.

The plant used in the factory was all bought in January 20W8 for £2 million. Were the factory to close in 20X1, it would be sold in December 20X1 for £1 million. If it were retained till 20X4 it would be sold in December 20X4 for £0.2 million. For the purposes of taxation, the plant receives corporation tax allowances at 18% p.a. on a declining balance starting from the year of acquisition and in every subsequent year, the plant is owned by the company except in the year of disposal. In the year of disposal, there will either be a balancing charge or allowance depending on the disposal value and the written down value on the disposal date.

Apart from rent and depreciation, annual fixed costs are estimated at £1 million, including £0.3 million allocations of head office costs. When the factory closes staff will be entitled to redundancy payments of £0.4 million if the factory is closed in 20X1 rising to £0.45 if closed in 20X4. In either case, the payments will need to be made on the day of closure and will be allowed for corporation tax purposes for the year concerned.

Production of SCs requires working capital of 5% of the sales which needs to be in place at the beginning of the year of the sales. All working capital will be recovered by the end of the production period. The closure of this shoe factory is not expected to have any effect on the company's other activities. The appropriate cost of capital is 10% p.a.

The company's year-end is 31 December and corporation tax of 17% is payable at the end of the year to which it relates.

(a) Determine on the basis of NPV whether the advertising campaign should be undertaken, assuming closure is delayed till 20X4.

Is the advertising campaign worthwhile?

a. Yes

b. No

(b) Taking into account your conclusion from (a) determine, on the basis of NPV, whether the company should close the factory in either 20X1 or 20X4.

a. Closure in 20X4

b. Closure in 20X1

NPV_Advertising:

PV of NCF from Advertising

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NCF from Closure

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TaxOnCont20X4

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Disposal20X4

TaxSaved20X4BalAllowOnDisposal

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