Lusaka Water and Sewerage Company (SWASCO) is a regional supplier of water for domestic use. The Company has engaged sub-distributors in some of the townships it is supposed to cover. SWASCO allows it’s sub-distributors to charge a 25% mark up of agreed costs. The agreed costs that can be in corporate into any calculation of mark up are only labor costs, material costs, variable overheads, fixed overheads and machine rentals. SWASCO has been approached by Natural Water Resource Company (NWRCO) one of it’s sub distributors, with a proposal to increase output to meet a further domestic customer base not previously supplied with water. The company (SWASCO) would have to increase it’s capacity to meet this demand and increased demand from existing customers. Water output is measured in units, with each unit being 1000 liters. SWASCO is currently operating at capacity which is 80,000 units per annum as determined by processing capacity. Increasing processing capacity would require the rental of further machines that are involved in the chemical cleaning of water. There is an overall maximum capacity of 200,000 units beyond which the company cannot produce water because of physical limitations of it’s production site. Each water cleaning machine has the following rental and unit capacity details. Water Cleaning Machine Annual rental (ZMW) 22,000Maximum annual capacity (units) 45,000SWASCO has an existing budgeted direct cost structure based on it’s current level of output of 80,000units, as follows; ZMW/Unit Labor grade 1 45.00Labour grade 2 64.00Material A costs 23.85Material B costs 62.25Variable overheads (electricity, maintenance etc.) are absorbed at the rate of ZMW2.00 per Kg of material B used. 5Kg of material B is used in the manufacture of 1000 liters of water. Fixed overheads are based on an existing output of 80,000 units an are absorbed at the rate of ZMW10.20 per unit. Above 160,000 units, fixed overheads would be expected to increase at the rate of ZMW50,000 per annum for every additional 40,000 units produced or part thereof. The existing agreement that SWASCO will charge 25% mark up of agreed costs will apply for this proposal. The acceptance of this proposal would not affect any charges relating to the existing supply of 80,000 units. Domestic demand for water in the next year, if the customer base is expanded, is estimated to total110,000 units rising by 15% per annum thereafter. This level of demand growth is expected to continue for the foreseeable future. Working capital requirements are estimated at 15% of sales value and are required to be in place at the start of the period to which the sales relate. Capital investment of ZMW 7.5 million would be required in order to provide the necessary support facilities to expand capacity to 200,000 units per annum. Thereafter, updating costs of ZMW30,000 would be required at the end of every four years. The cost of capital used in appraising projects is 20% per annum. All sales and costs should be assumed to arise at the end of the year unless otherwise identified. Ignore the impact of taxation in your answer.

Required:

(a) Evaluate the proposal to expand capacity using present value methods. Make your evaluation on the basis of a five year period only. Express all calculations in this part of the question to the nearest ZMW1,000. Students are advised to state any assumptions made.(25 marks)

(b) In your capacity as Finance Director, draft a report to the Board of Directors that considers the following;

(i) The limitation of the five year period of analysis.

(ii) The problems and difficulties associated with forecasting.

(iii) The choice of an appropriate discount rate.

(c) The Managing Director believes that quarterly forecasts of demand would provide better information for planning purposes. She has requested you to forecast demand for the 1st quarter of year 6. In forecasting quarterly demand, the following quarterly seasonal adjustments should be made to the basic trend; Quarter 1 2 3 4Percentage adjustment -8 +2 +15 -