Plastics Ltd manufactures watertight plastic

equipment cases for tradesman. Plastics Ltd has divisions operating throughout Australia. Division managers receive a bonus each year based on their accrual accounting rate of return for that year (with calculations based on end-of-year total assets). At the moment, the Sydney Division generates cash revenues of $1,500,000, incurs cash costs of $900,000, annual depreciation of $200,000, with an investment in assets of $9,900,000. The Sydney Division Manager's current ARR is 4%.

New technology has recently been developed to build custom cases that eliminate wasted space. This new technology would allow the Sydney Division to expand into making cases for the aviation industry. The manager estimates that the new technology will require an investment in working capital of $65,000. Because the company already has a facility, there would be no additional rent or purchase costs for a building, but the project would generate an additional $190,000 in annual cash overhead. Moreover, the manager expects annual materials cash costs for the expansion to be $700,000 and labour to be about $450,000. As this is new technology, there may be a shortage of suitably trained staff.

The management accountant of Plastics Ltd estimates that the expansion would require the purchase of equipment with a $2,300,000 cost and an expected disposal value of $400,000 at the end of its seven-year useful life (although there is some concern that the expected disposal value may be as low as $100,000). Depreciation would occur on a straight-line basis.

The management accountant of Plastics Ltd determines the company's cost of capital as 6%. The management accountant's salary is $160,000 per year; the expansion will not change that. The CEO asks for a report on expected revenues for the project, and is told by the Marketing Department that it might be able to achieve cash revenues of $1,750,000 annually from the aviation industry. Plastics Ltd has a tax rate of 30% but the government is suggesting that the tax rate may have to go to 40% in the near future in order to reduce the government deficit.

Using the figures provided, the NPV of the expansion project has been calculated to be $962 (using MS Excel) and the IRR has been calculated to be 6.01%. The payback period on this investment is 6.42 years. The overall AARR for this investment is 6.86%.

The impact on the Manager's bonus over the course of the 7 year investment.

(Calculations based on end of year investment balance (not average investment).

Continued over....

Year 1Year 2Year 3Year 4Year 5Year 6Year 7Profit after tax97,000$ 97,000$ 97,000$ 97,000$ 97,000$ 97,000$ 97,000$ Beginning Balance2,365,000$ 2,093,571$ 1,822,142$ 1,550,713$ 1,279,284$ 1,007,855$ 736,426$ Less depreciation271,429$ 271,429$ 271,429$ 271,429$ 271,429$ 271,429$ 271,426$ Ending Balance2,093,571$ 1,822,142$ 1,550,713$ 1,279,284$ 1,007,855$ 736,426$ 465,000$ Investment2,229,286$ 1,957,857$ 1,686,428$ 1,414,999$ 1,143,570$ 872,141$ 600,713$ ARR4.63%5.32%6.26%7.58%9.62%13.17%20.86%

Required:

(Note there are no further calculations required for this question)

a) Describe the five stages of the capital budgeting process for this expansion project.

(3 marks - Suggested time approx. 10 minutes)

b) Discuss whether the company should invest in the new expansion. Your discussion should include comments on the analysis provided, (NPV, IRR, Payback Period, AARR) and the impact the investment may have on the Sydney Division's Manager. Your comments should also include whether the impact of future changes to the tax rate and possible reduction of the salvage value, will alter a decision to invest (and why) - calculations not required.