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Portfolio 2 Mondi Plc makes chassis for caravans. A new chassis has been developed which requires a machine to be bought, costing 800,000. A net

Portfolio 2

Mondi Plc makes chassis for caravans. A new chassis has been developed which requires a machine to be bought, costing 800,000. A net present value appraisal has been carried out that indicates a positive net present value (NPV) of 183,200. This appraisal was followed up with an assessment of the riskiness of the project. This was achieved by taking each of the input factors in turn and estimating the value for it at which the project would have a zero NPV. In looking at each input factor it was assumed that the other factors would be as originally estimated.

Data on the original estimates are as follows:

Original estimate Cost of machine 800,000 Selling price (per chassis) 400 Material cost (per chassis) 120 Labour cost (per chassis) 160 Variable overheads (per chassis) 40 Sales life 10 years

The assessment above is based on the assumptions of a discount rate of 10% and of constant sales of 2,000 chassis per annum. It has been reliably established that the new production would not affect fixed costs or working capital to any significant extent. There are no other input factors for the decision. At a recent board meeting held to discuss whether the project should go ahead the following comments were made:

Jeff Mondi (Managing Director): 'Now we know how sensitive the project is to the input factors, we can make a decision using this information.'

Alan Mondi (Management Accountant): 'But we haven't considered whether the project reduces the company's risk. We should use the portfolio theory.'

Lain Sooraj (Financial Director): 'What about our shareholders' risk? We should use CAPM to make the decision.' You are required to:

  1. To generate a zero NPV, estimate separately and in turn the values for the discount rate, the annual sales volume and the cost of the machine. Discuss how sensitive the project is to each of these input factors. Ignore taxation and inflation. (15 marks)
  2. Compare and contrast sensitivity analysis, portfolio theory and the capital asset pricing model as techniques for dealing with risk in project appraisal. (18 marks)

(Total 33 marks)

Portfolio 3

Bradman Co. is reviewing its trade credit policy. The company, which sells all of its goods on credit, has estimated that sales for the forthcoming year will be 3 million under the existing policy. Based on previous years' figures 30% of customers are expected to pay one month after being invoiced, and 70% two months after being invoiced.

At present, no cash discounts are offered to customers. However, to encourage prompt payment, the company is considering giving a 2.0% cash discount to customers who pay in one month or less. Given this incentive, the company expects 60% to pay within one month, and 40% two months after being invoiced. The company believes that the introduction of a cash discount policy will prove attractive to some customers and will lead to a 5% increase in total sales.

Irrespective of the trade credit policy adopted, the gross profit margin of the company will be 20% for the forthcoming year, and three months' inventory will be held. Fixed monthly expenses of 15,000 and variable expenses (excluding discounts) equivalent to 10% of sales will be incurred and will be paid one month in arrears. Trade payables will be paid in arrears and will be equal to two months' cost of sales. The company will hold a fixed cash balance of 140,000 throughout the year, whichever trade credit policy is adopted.

You are required to:

  1. Explain how a credit control department might function and the importance of good credit control for a company such as Bradman Co. (12 marks)
  2. Calculate the investment in working capital at the end of the forthcoming year under the existing policy and the proposed policy. (12 marks)
  3. Calculate the expected net profit before interest and tax for the forthcoming year under the existing policy and the proposed policy. (6 marks)
  4. Advise the company as to whether it should implement the proposed policy of discounts to pay in one month or less. (4 marks)

(Total: 34 marks)

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