Question
Morgan's revenue in 2016 was 25% lower than in 2012. This decline was primarily caused by a downturn in the travel industry and a decline
Morgan's revenue in 2016 was 25% lower than in 2012. This decline was primarily caused by a downturn in the travel industry and a decline in population growth along Scotland's western coast. Due to declining business conditions during this period, a number of frequent customers who used Morgan's credit facilities went bankrupt. This meant that Morgan's bad debts increased significantly and that either payment plans with the debtor had to be arranged or the receipts had to be entirely written off. This, in turn, had such a negative impact on Morgan's economic state. To make matters worse, around the same time in 2018, a strong competitor resulted in the emergence of drake, a well-known player In continental Europe, a corporation in the same industry decided to open a facility in Glasgow, about 100 kilometres from Morgan's main facility.
Table 1: Selected figures from the financial statements of Morgan '000
Year 2015 2016 2017 2018 2019
Revenue 1400 1350 1290 1220 1055 Costofgoods sold 1120 1107 1032 1037 897
Trade receivable 350 405 439 451 454
Trade payables 336 376 361 394 395
Inventory 210 176 142 110 74
Cash balance 112 101 111 122 85
As a greater portion of Morgan's business managed to lose to competitors in 2016, Richard realised that it was critical to increase marketing efforts to resurrect Morgan. In order to reclaim its former status, Richard launched a more aggressive marketing campaign that included,. Television, print, radio, and social media are all examples of mass media. He also added medium-density fiberboard (MDF) to Morgan's product line, which necessitated the acquisition of a large machine and a 400,000 capital investment near the end of 2016. Richard continued to promote his company as differentiating itself from larger rivals by offering personalised service and publicising Morgan's successful track record.
Meantime, many smaller-sized competitors exited the industry; however, Morgan was able to continue due to Richard's experience in the market, as well as his exquisite track record and reputation. To survive, Richard actively reduced Morgan's inventory level, only replenishing inventory as needed by the market. Customers frequently were unable to find enough inventories at Morgan to meet their needs due to the lower level of inventory. Richard acknowledged this actuality and maintained his tactic of stocking the bare necessities while providing expert and personalised service.
NEW MACHINE
Morgan's new introduction of a machine to manufacture MDF had proven to be a moderately successful move. On the other hand, Morgan's older timber equipment, EXIST, requires daily maintenance due to its age and lack of replacement for a long time. According to a report provided by the machine's manufacturer, a revamp of the machine was possible, which would extend the tool's life.
Richard could also start with a new machine, which would provide increased capability while requiring less servicing. Richard had done preliminary research on what types of machines were available to meet the needs of the firm, and he had his current focus on a newer machine called NEW19, which is supplied by a US-based supplier. Richard believed that this machinery would help Morgan return to its more prosperous days in the future. However, the new machine would necessitate a significant initial investment, and Richard would have to seriously reconsider this investment strategy before deciding whether to revamp the existing machine or replace it with the new one.
If Richard chose to keep EXIST (the original machine), it might be used for another five years before being scrapped for 35,000. Morgan will indeed keep claiming capital allowance or depreciation of 7,000 annually for the next five years until then. Routine maintenance costs of 25,000 each year would be required to keep the equipment operational. EXIST also required immediate repair work, for which a quote of 40,000 was recently received; this amount must be paid in advance if the repair work is to be completed. In addition, a one-time expenditure of 9,000 was anticipated in 3 years to cover scheduled maintenance. However, if Richard indeed decided to sell off EXIST now, it was expected to fetch 50,000 against the current book value of 70,000.
This sum could be used to purchase the newer machine NEW19, which would provide Richard with a more accurate timber machine with a 10-year expected life. NEW19 costs 300,000 and can be depreciated straight line or at 10% per year (capital allowance can be claimed). Although the expected life is ten years, Richard intends to use it for only five years before selling it to acquire something more high tech at the time. Based on the current conditions, Richard anticipates selling it for 45,000 in five years. Because the market for such machinery is currently competitive, the producer of NEW19 is offering Morgan a very sensible maintenance plan. Such a servicing plan would cost 5,000 in the initial year, with an annual increase of 1,000 thereafter. All such transactions would have to be made at the end of each fiscal year. Morgan's lender has offered a five-year loan facility at 8% per year, with just the interest portion payable during the first four years and the full principle and interest payable at the end of the 5 year term.
Morgan is expected to achieve efficiency and productivity, resulting in significant savings in both electricity and labour costs, thanks to the use of more latest technological innovation in NEW19. The first year of activity of NEW19 was expected to reduce electric power consumption by 18%. This wouldn't only lead to substantial savings (electricity costs averaged 8.0 per hour, 24 hours a day, seven days a week in a 50-week year), but it would also allow Richard to encourage how his company was moving toward more objectives to help the environment. After the first year, electricity savings were anticipated to be an extra fixed amount of 1,000 per year.Like savings in electricity, labour cost was expected to be lowered by 12% in the first year; and this saving was expected to be increased by additional 2,000 every year from second year onwards. Existing labour cost at Morgan is 200 per hour in total, based on a 35-hour week in a 50-week year.
The following additional details are made available:
Morgan's applicable tax rate is 25%.
While Richard has not calculated Morgan's cost of capital, a friend who works for a similar company called Troll about 250 kilometres away and has no debt advises that Troll's beta is 1.4.
The risk-free rate and market return are 3.5% and 11.5%, respectively.
Morgan's target debt-to-equity ratio is 21%.
REQUIREMENT:
(a) Determine Morgan's appropriate cost of capital.
(b) Determine the free cash flows associated with the potential investment in the new machine in order to compute Net Present Value (NPV).
(c) Morgan's internal 'hurdle rate' for investment is 19%. Based on an application of the NPV and IRR approach, advise Richard on whether to accept or reject the investment in the new machine. Determine the investment's payback period as well.
(d) Evaluate any foreign exchange exposure and mitigating measures applicable to Morgan.
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