Hope Electronics Ltd is an established company which has continued to be profitable in recent years despite operating at below full capacity. Continued investment in research and development has produced a new innovative product, the microwave drier, which is able to dry most garments at considerably lower cost than conventional tumble driers. Market research supports the proposed price of £400 per drier with the following predicted sales over the next five years: Year Unit Sales 1 20,000 2 30,000 3 35,000 4 42,000 5 40,000 1 Senior Lecturer at University of Aberdeen Business School 2 Lecturer at Victoria University of Wellington, New Zealand 2 Hope - A  M Whittington & K Bates The company accountant has collated the following costing information relating to the drier proposal: £’000s Research and Development Costs incurred to date 200 Additional pre-production development costs 800 Capital cost of production machinery 6,700 Resale value of machinery after 5 years 300 Due to the additional manufacturing and selling activity Hope’s working capital requirements will increase by £200,000 at the start of the project, with further increases at the end of each year (in preparation for increased activity in the subsequent year) as follows: end of year 1, £200,000; end of year 2, £300,000; end of year 3, £400,000; end of year 4, £500,000. This additional working capital is assumed to be recovered in full at the end of year 5. £ per drier £000s per annum Manufacturing Costs Direct Labour 75 Direct Materials 75 Variable Overheads 75 Depreciation of Machinery 1,280 Amortisation of R&D costs 200 Other fixed costs (Note 1) 1,200 Selling and Distribution Costs Variable 25 Fixed (Note 2) 300 Note 1 To increase output above 38,000 driers shift working will be introduced and annual fixed manufacturing costs will rise by £600,000. Note 2 Annual fixed selling and distribution costs will need to increase by £100,000 for sales to exceed 33,000 driers and a further £100,000 for sales to exceed 38,000 driers. The accountant has specifically excluded all costs relating to the factory unit in which the new machinery will be installed and operated. She explains that this unit is on a short lease which has only 7 years left to run and Hope Electronics pays £1,500,000 per annum rental. There is no prospect of Hope using this unit unless the current project is accepted. Whilst Hope Electronics has not been using this unit, part of it has been sub-let to a neighbouring company for use as a warehouse at a monthly rent of £100,000. This arrangement could continue until the lease expires. 3 Hope - A  M Whittington & K Bates If the drier project goes ahead Hope can initially share the factory unit with the lease but the rental income will fall to £50,000 per month. Once output exceeds 30,000 units Hope will need additional packing and storage space, so rent will be reduced to £25,000 per month. If output exceeds 38,000 driers Hope will need the whole factory unit and will lose all rental income. Given its critical nature you have been called in as a consultant to advise Hope’s board of directors with respect to this project. Hope normally ignores tax and inflation when considering such capital assessments and uses a discount rate of 12%. REQUIRED: 1. Prepare your presentation to the board of Hope Electronics Ltd advising whether or not to go ahead with this project based on the payback period appraisal method and taking into consideration that Hope has some short term liquidity problems. (Ignore tax and inflation). Include advice on the strengths and weaknesses of the appraisal technique you have used in assessing the microwave tumble drier project. 2. Prepare your presentation to the board of Hope Electronics Ltd advising whether or not to go ahead with this project based on the Net Present Value appraisal method (Ignore tax and inflation). Include advice on the strengths and weaknesses of the appraisal technique you have used in assessing the microwave tumble drier project. 3. As the microwave drier uses new technology this is a relatively high risk project.

Explain how this risk might be reflected in the project appraisal, and how your advice may be amended as a result of appropriate consideration of the specific risks of this project.