Question
shraq Ltd. ('lshraq') has recently developed a portable, lightweight image scanner that can be used by business executives when travelling.The scanner cost TK850 ,000 to
shraq Ltd. ('lshraq')has recently developed a portable, lightweight image scanner that can be used by business executives when travelling.The scanner cost TK850 ,000 to develop and has recently been subject to market research and testing at a cost of TK250,000. The scanner has an estimated product life cycle of four years. Annual demand and selling prices for the scanner over its life cycle are estimated as follows:
Year to 31 May 2015 2016 2017 2018
Demand (units) 28,000 40,000 35,000 20,000
Selling price (tK) 450 400 320 275
The following points relate to production of the scanner:
- Production of the new scanner will take place in a factory building that is owned by lshraq but is currently being rented to a biomedical business for an. annual rent of TK120,000 per year.
- To produce the scanner, new equipment costing TK8,000,000 must be purchased immediately. In addition, existing equipment, which is not currently being used, must be employed in the production process. This equipment cost TK4,000,000, has a written down value of TK2,000 ,000 and has a current resale value of TK1,500,000. All of the equipment used in producing the new scanner will be sold for an estimated TK1,000,000 when production ceases. The company uses the straight-line method of depreciation for all its equipment.
- New employees will be recruited to produce the new scanner at a cost of TK2,460,000 per year. At the end of the four-year product life cycle, the employees will be released and severance payments of TK900 ,000 are expected to be incurred.
- As a result of a recently cancelled order from an overseas government , sufficient material to produce 20,000 scanners is already held by lshraq. This material cost TK240,000 and has a resale value of TK180 ,000. The material cannot be used for any other purpose by lshraq. The cost of new material purchased is expected to be TK125 per scanner.
- Working capital of TK5,000,000 will be required immediately and will be released when production of the new scanner ceases.
- Fixed overheads of TK4,425,000 per year relate specifically to the scanner. This includes a depreciation charge for equipment. In addition, there are head office overheads of TK8,000,000 per year. These overheads do not relate specifically to the scanner but TK380 ,000 will be apportioned to the scanner to represent a 'fair share' of the overhead burden.
- The company is entirely financed by equity. The company's shares have a beta of 1.4. The risk-free rate of return is 3% and returns to the market are 8%.
The current economic climate has made forecasting increasingly difficult for the company. As a result, scenario analysis is being considered as a means of achieving a better understanding of the risk and uncertainty involved in launching the new product. This form of analysis has not been used by the company in the past and its potential usefulness is not well understood. The company secretary has, therefore, been asked to provide advice to senior managers on the usefulness of scenario analysis in investment decisions.
Note: Ignore tax and inflation and assume that it is now 31 May 2014.
Required:
- Calculate the net present value of producing the new image scanner and discuss your results.
- Assume the role of CMA and provide a briefing paper to senior management which explains:
- Why risk should be taken into account when making investment decisions.
- The strengths and weaknesses of scenario analysis in dealing with risk.
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