D.A.L. ltd makes components for electronic equipment and has recently tendered for a contract to supply an item to a satellite navigation equipment manufacturer.

In order to produce the component D.A.L would have to purchase a special machine at a cost of 280,000, at the end of 2020. It is expected, due to the obsolescence of such equipment as satellite navigators, that the contract to manufacture the component will only last for 4 years. After that time, it is thought that the machine will not have a great deal of use and will only be disposed of for 5,000.

Demand for the component is expected to be a follows:

2021202220232024

Demand (units)38,00042,00050,00023,000

The selling price of the component is expected to be 11.00 per unit and the variable cost of production will be 7.50 per unit with incremental annual fixed overheads of 35,000. All of these forecasts are quoted in current terms.

The general rate of inflation over the relevant period is expected to be 5% per year but D.A.L. have forecast that their selling price and costs will inflate as follows each year:

Selling price3% per annum

Variable cost of production4% per annum

Fixed production overheads6% per annum

D.A.L. is aware that their investors are expecting a real rate of return of 5.7% per annum.

The company operates with a target Capital Employed of 20% and depreciation is charged on a straight-line basis over the life of an asset.

Required:

a)Calculate the net present value of buying the machine and comment on your findings.

(12 marks)

b)Calculate the accounting rate of return (based on average investment) of the investment and comment on your findings

(8 marks)

c)D.A.L's Production Manager is heard to say, "Let's base our decision on the Average Accounting Rate of Return outcome as this measurement is linked to Return on Capital Employed with which we are familiar. I don't understand the meaning of NPV. Or at least we could calculate the Internal Rate of Return and then we could use the percentage return in order to judge project acceptability."

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

(20 marks)

(Total 40 marks)

Task 2

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

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

Howell and Jgle (1998, p137), when discussing real options analysis state that, "The theory shows how it can be efficient to make a 'strategic' investment, even if this loses money in itself, provided the investment creates or preserves options for the company (e.g. in new brands, technologies etc.)."

The assistant finance manager is rather confused by this statement and thinks to herself, "how can it be worthwhile to undertake a loss-making strategic investment?"

You are, therefore, required to consider the above statement made by Howell and Jgle (1998) and to contrast it with the theoretical view and assumptions of a net present value approach.

You should also provide, for the assistant finance manager, an example of a 'strategic investment' that may fit the above quote and to indicate what generic strategic factors managers should consider when 'managing' the future value of a real option.

(30 marks)

(Total 100 marks)

Task 3

During this debate on investment appraisal methodology a further senior manager is heard to say the following, "I've just been to a conference and the main message was that the essence of company management is the creation of shareholder value. Apparently, we should be utilising value-based management techniques in order to produce Market Value Added (MVA) through the generation of Economic Value Added (EVA). I always thought that we should be maximising Net Present Value (NPV). Have our objectives changed?"

You are required to provide a brief report to the senior manager:

a)Giving your opinion as to whether or not the application of EVA and/or MVA methodologies are practical management techniques leading to the creation of shareholder value.

(20 marks)

b)Providing a critical analysis as to whether or not the adoption of EVA and/or MVA would now change objectives from that of NPV maximisation.