SITUATION NO. 1 National Toys Ltd is a protable mediumsized toy manufacturer that has been listed on a stock exchange for three years. Although the company has an overdraft, it has no longterm debt and its current interest cover is high compared to similar companies. Its return on capital employed, however, is close to the average for its business sector. One of its machines is leased under an operating lease, but the company has no other leasing or hire purchase commitments The company owns two factories and the land on which they are built, as well as a small eet of delivery vehicles. The company does not own any retail outlets through which to distribute its manufactured output. National Toys Ltd is considering an investment in a new machine, with a maximum output of 200,000 units per annum, in order to manufacture a new toy. Market research undertaken for the company indicated a link between selling price and demand, and the research agency involved has suggested two sales strategies that could be implemented, as follows: Strategy 1 Strategy 2 Annual mcrease in sales volume after 1 5! year The services of the market research agency have cost 25 ,000 and this amount has yet to be paid. National Toys Ltd expects economies of scale to reduce the variable cost per unit as the level of production increases. When 100,000 units are produced in a year, the variable cost per unit is expected to be 300 (in current price terms). For each additional 10,000 units produced in excess of 100,000 units, a reduction in average variable cost per unit of 005 is expected to occur. The average variable cost per unit when production is between 110,000 units and 119,999 units, for example, is expected to be 295 (in current price terms); and the average variable cost per unit when production is between 120,000 units and 129,999 units is expected to be 290 (in current price terms), and so orr The new machine would cost 1,500,000 and would not be expected to have any resale value at the end of its life. Capital allowances would be available on the investment on a 25% reducing balance basis. Although the machine may have a longer useful economic life, National Toys Ltd uses a veyear planning period for all investment projects. The company pays tax at an annual rate of 30% and settles tax liabilities in the year in which they arise. Operation of the new machine will cause xed costs to increase by 110,000 (in current price terms). Ination is expected to increase these costs by 4% per year. Annual ination on the selling price and unit variable costs is expected to be 3% per year. For prot reporting purposes National Toys Ltd depreciatcs machinery on a straightline basis over its planning period. National Toys Ltd applies three investment appraisal methods to new projects because it believes that a single investment appraisal method is unable to capture the true value of a proposed investment. The methods it uses are net present value, intcmal rate of return and return on capital employed (accounting rate of return). The company believes that net present value measures the potential increase in company value of an investment project: that a high internal rate of return offers a margin of safety for risky projects; and that a project's beforetax return on capital employed should be greater than the company's before-tax return on capital employed, which is 20%. National Toys Ltd does not use any explicit method of assessing project risk and decided to use Average cost of capital as a discounting factor. Currently cost of debt is 7% and cost of
