The Mexton Machines Company Case Study (Written as at January 2003) The Mexton Machines Company was founded in the 1950's on an old RAF airfield in the East Midlands of England. Originally, the company produced a range of small machines and tools for industry, but it expanded rapidly during the 60's and early 70's and acquired interests in industrial paint manufacture, pre-fabricated garages and building materials. New production units were opened in Leicestershire, Yorkshire and Bristol and the Head Office was moved to Loughborough. However, the company fared badly during the recession of the early 1980's. The paint manufacturing side of the business was scaled down and prefabricated garage production ceased. In 1996 a new management team took over and it was decided that the company should diversify into the consumer goods market. A range of products was developed for the DIY enthusiast including an electric drill and a car engine tuner. These are sold through the major DIY chains and hardware stores. To date, the products have been fairly successful, though sales are still small when compared with more established firms in this market. They also form only a relatively small part of the company's total turnover, as shown below: Sales (m) Product Group 1998 1999 2000 2001 2002 (*) Industrial Machinery 32.4 24.8 36.8 33.6 34.4 Paint 14.4 13.2 12.4 11.6 10.4 Building Materials 25.2 26.0 26.8 28.8 30.0 Consumer Goods 0 1.2 2.4 3.6 4.4 (* = provisional) The company is now (January 2003) considering the development of gardening tools and equipment and, as a first step, a detailed plan has been put forward to produce an electric lawnmower (code named the L5). Market research has suggested that consumers make their decisions in this market on the basis of price, convenience, safety and the presence of features such as a grass collecting box and an edge trimmer. Taking this market research information into account, an outline design has been formulated. This includes a processor that will precisely control the height of the blades on uneven lawns and an electronic voice that announces when the grass collecting box is full. Now a decision has to be made on whether the project should be continued. The market research and development of the design has already cost 2.5 million. If a decision to continue is made, it is hoped that a successful prototype can be developed by December 2003. The company's chief engineer, David Castle, has estimated that there is a 75% chance that the December target could be achieved and that research and development costs would amount to about 8 million. If the target is not achieved, the company will review the situation in January 2004. It could decide to abandon the entire project or to allow further work on the prototype. Castle estimates that modification of an unsuccessful prototype would cost around 6.4 million and the modifications would take an additional year to implement. He is, however, sure that all problems would be overcome by December 2004 The company also has to consider possible locations for the production of the L5. The list of possible sites has now been reduced to two: Wiltham in West Yorkshire would be a new site for the company, while an existing, but unused, factory at Eastoak aerodrome in Leicestershire could be converted for L5 production. The Wiltham site is an old textile mill which has been closed for two years. The site can be purchased immediately for 6 million. It is thought, however, that there is a 20% chance that the site will still be available in one year's time for the same price, though it is unlikely that the site will still be available in two year's time. Equipping the mill, which would not commence until the prototype had been successfully developed, would cost an additional 4 million. Because of the age of the buildings, and the need to carry out renovation work, it would take a year before the equipment could be installed. This means that, if a successful prototype was developed within a year, production could commence in January 2005. However, if the prototype development took two years, production could not commence at Wiltham until January 2006. The site is relatively small and could only cope with production of an estimated 50,000 lawn mowers per year. However, there are warehousing and transportation facilities and the availability of skilled labour force locally. The site is located 20 miles from the M1 motorway and 15 miles from the M62. Converting the existing site at Eastoak would involve the construction of some new buildings. The conversion would take a year and would cost about 24 million, but a decision to go ahead with conversion would not be taken until a successful prototype had been developed. This again means that production would commence in January 2005 if the prototype was successfully developed within a year. However, if the prototype took two years to develop, production could not commence until January 2006. If the site is converted, it is anticipated that it would have a capacity to produce 166,000 lawn mowers per year. The site is 14 miles from the M1 motorway. Sales of the L5 would be supported by a major advertising campaign in newspapers and local television, especially in the first few months after its launch. In order to estimate the sales that would result, extensive use has been made of market research, economic and industry-wide data. To simplify the problem, the management team has decided to estimate sales under two different market conditions: Good, and Poor. These conditions can be assumed to prevail through the entire life of the product. The probabilities of these conditions prevailing are thought to depend to some extent on how quickly the product can be launched since an early launch will give Mexton an edge over any potential competitors. The Marketing Department has estimated the following probabilities: Month production commences Market Conditions Prevailing Good Poor January 2005 0.7 0.3 January 2006 0.4 0.6 It has been decided to use a 6 year planning horizon (i.e. up to December 2008) since technological developments would probably mean that a new model would be required for the market for later years. The tables below show the estimated net cash flows which will occur during the years of the product's life. These tables exclude cash flows relating to purchase or value of buildings or installation of equipment. In arriving at these estimates, it has been assumed that, because the Wiltham site can only cope with a relatively small volume of production, net cash flows generated by production at this site will be largely unaffected by market conditions. If production is at Wiltham Net Cash flow in product's 1st year 16m 2nd year 16m 3rd year 16m 4th year 16m * (* if applicable) If production is at Eastoak Market Conditions Good Poor Net Cash flow in product's 1st year 24m 8m 2nd year 24m 8m 3rd year 24m 8m 4th year 24m* 8m (* if applicable) At the end of 2008 it has been estimated that the Wiltham site would have a value of 16m, while the Eastoak factory would have a value of 32m. In the event of the Wiltham site being disposed of without being equipped (because of the abandonment of the project after the failure of the prototype) it can be expected to be sold for its original price of 6m. The company's cost of capital is estimated to be 10% .For simplicity, it can be assumed that all cash flows occur at the end of the year. Also, the effect of factors like taxation and development grants should be ignored. Question 1 Apply decision analysis to the decision problem facing Mexton Machines and advise the company on their decision problem. Clearly state any assumptions you have made. Question 2 Discuss in detail the strengths and limitations of your analysis in the context of the context of the problem faced by Mexton Machines. This case study considers the problem of the Mexton machines company which has to decide on the location of a new manufacturing facility for an electric lawnmower which is still in the process of development. One of the locations offers greater production capacity than the other. The decision problem is made complex by the possibility that one of the locations may not be available by the time the company know whether or not the development has been successful. Since the cash flows associated with decision will occur over several years the time value of money needs to be taken into account when evaluating the options. Mextons managers have to decide whether to delay the location decision until they have information about the success of the development or whether to make the decision immediately. They also have the immediate option of abandoning the entire project. The potential returns on the investment largely depend on the level of future demand for the product. Your approach will involve a series of NPV calculation for each company. These NPV values will be used as payoffs in the construction of a decision tree. The possible levels of demand are categorized as good or poor , Assume that a given level of demand applies for the entire lifetime of the project. Also assume that cash flows only occur at the end of the year. For the sensitivity portion of the case, consider the subjective estimate percentages offered in the case. These are summarized here Prototype OK/Jan 2005 Market Condition: 70/30 Prototype OK/Jan 2006 Market Condition: 40/60 Prototype OK: 75/25 Wiltham Available: 20/80 Take one at a time, and explain, based on your model, how changing the estimate affects your decision. For example if 70/30 went to 30/70 or 40/60 went to 60/40 and so on. Also consider extreme cases ( for example 70/30 going to 95/5 or 5/95). If you have your model set up, this should just be a matter of changing specific values and letting your model recalculate