Roland plc manufactures high quality vehicle tyres. It has just won a contract to supply 80,000 mud track tyres to the car manufacturer, Toyota, for the next eight years. The company will need to purchase new equipment for this purpose, although existing factory space with a book value of 6,800,000 will be used as the manufacturing site, and is evaluating the two options posed below.

Option 1: The equipment will cost the company 5,600,000, payable immediately. It has a life of 4 years, and is not expected to generate a resale value at the end of its life.

Costs associated with the manufacture of the tyres using this equipment are as follows: Materials Labour Variable overhead Cost per unit (C) 16 8 10 Annual fixed costs (inclusive of depreciation, calculated on a straight line basis) have been estimated at 2,000,000. Option 2: The equipment will cost the company 8,000,000, payable immediately. It has a life of 8 years, and is estimated to generate a scrap value of 800,000 at the end of its life. Costs associated with the manufacture of the tyres using this equipment are as follows: Materials Labour Variable overhead Cost per unit (2) 17 7 11 12 Annual fixed costs (inclusive of depreciation, calculated on a straight line basis) have been estimated at 3,000,000. In addition, given the technical advancement of this equipment, the company will incur training costs worth 200,000 in its first year. This cost will not be repeated in subsequent years. For both options, the company will need a working capital investment worth 1,000,000. This will be recovered at a rate of 90% when the contract with Toyota comes to an end in 8 years time. Further, it is company policy to allocate 10% of head office costs to individual projects. Annual head office costs currently stand at 1,000,000. Roland plc has a cost of capital of 12%. REQUIRED: (a) For the benefit of management at Roland plc, determine which equipment option will be more cost effective for the company. (14 marks) (b) Explain the implications of each of the following on your decision in (a) above (you are not expected to conduct any further computations): i. Toyota, Roland ple's customer, delayed the start of the contract by 12 months; ii. The equipment in Option 2 did not generate a scrap value; and iii. Toyota extended the contract for another 8 years. (6 marks) Notes: assume all cash flows take place at the end of the year, unless otherwise stated. Ignore taxation and inflation