You are the newly appointed team of financial consultants advising Shelton Limited, a company manufacturing packaging material under the brand name "Shelton". You have been summoned to a meeting of Shelton's management team, in the boardroom of the company's Chairman, Ted Bear. The others present at the meeting are Managing Director Sarah Wong, Factory Manager Stu Ormsy, Marketing Manager Prem Sneaker, Accounts Manager Penny Counter, Personnel Manager Job Worth and Manager (Research \& Development) Izzy Moss. You listen carefully as the team discusses Izzy's proposal for introducing a new modified product design called "Difluzer", to be manufactured in addition to the existing product line, i.e. Shelton. Difluzer is less durable than Shelton but would be cheaper and more convenient to use. You have been asked to prepare a financial appraisal in respect of the project. Ted: Okay, let's get this meeting started. As we all know, due to restrictions imposed by our lenders, our capital expenditure budget for this year cannot exceed f2m to 2.5m under any circumstances. What are the proposals we're looking at? Sarah: Well, Prem, as you know, wants to use the money for developing and expanding our market for Shelton in South Asia and the Far East. But R\&D are proposing manufacture of this new cheaper product which they have developed, i.e. Difluzer. Either project would need the same amount of factory space. Ted: Just how much of space would be required, Izzy? Izzy: Whichever project we decide on, we'd need to locate it in the unused section at the eastern end of the factory building. There's 30,000 sq. ft. of space available there, which is more than enough. Ted: Hold on - weren't we planning to lease out that section for 120,000 a year? Stu: Yes, but that proposal would be dropped if we go in for diversification. It'll save us the cost of building a new, small factory. Sarah: The new product would have to bear a fair share of the factory rent, though. How much would that work out to, Penny? Penny: (Doing a quick computation on her calculator) Let's see - we're paying 600,000 a year for the whole area of 120,000 sq. ft.; that means the rent chargeable to the new product would be 150,000 per year. Sarah: (Nodding at you) I'm sure you won't forget to take that into account. Stu: (Addressing you) We have also spent 200,000 on renovating the section with the intention of either leasing it out or using it for a new project - that should be included too. Ted: Exactly how much is this proposed new project going to cost, Izzy? Izzy: I've worked out that the equipment for the Difluzer project would cost 1.95m, including shipping and installation. Ted: Will the equipment be worth anything at the end? Izzy: We expect that the equipment would have no residual value at the end of the planned project period of 5 years and would have to be completely replaced if we want to continue the project thereafter. Sarah: What about working capital investment? Stu: My estimate is that there needs to be an injection of working capital at the start of the project amounting to f1m. We have proven ourselves to be efficient in the past and I expect a full recovery of working capital at the end of the project. Ted: Is that all? I'd have thought we'd need more working capital investment, given the amount of credit we allow to our customers. Prem: (interjecting) That's because we've taken account of the fact that receivables on account of Difluzer are going to be partially offset by a reduction in debtors on account of Shelton. That's one aspect of the Difluzer project that worries me a lot - it's going to take away sales from Shelton, on which we presently earn a contribution of 13 a unit. Sarah: How much do you estimate Shelton's sales would come down by? Prem: Not a lot - but enough to matter. Given the output targets for the Difluzer, I would reckon that Shelton sales would be reduced by about 40,000 units per year. Sarah: Well, that's a problem which you'd have to tackle by intensifying your marketing effort for Shelton, Prem. It doesn't really have anything to do with the financial appraisal of the Difluzer project, does it? Prem: (doubtfully) Well, I guess not. Ted: What is the selling price you expect to set for Difluzer? Prem: 30 per unit is what we've agreed with the distributors. Sarah: And what kind of output are you looking at? Prem: I estimate a demand of 120,000 units in the first year, increasing at an average growth rate of 7.5% per year for the duration of the project. Ted: Have you assessed the operating costs of the new project? Stu: Yes; our estimate is that the cash operating cost - that is, the operating cost before charging depreciation - would amount to about 40% of the selling price. Ted: Does that include all the costs other than depreciation? Penny: No, those are just the variable factory costs. You'd have to include fixed costs plus selling and general expenses as well. I've already mentioned the apportionment of rent. In addition, we'd apportion administrative costs of 200,000 per annum. There would also be extra sales promotion expenses of 300,000 a year, and interest charges of 100,000 on the loan needed to finance the project. All of the revenues and costs that we have estimated are at today's prices. Ted: What about depreciation? Penny: Yes of course, the tax authorities do not allow us to charge straight line depreciation over the life of the project. Instead, we will have to take advantage of capital allowances at 25% on a reducing balance basis. Sarah: The administrative costs you mentioned - does that include the salary of the additional supervisor who is going to be responsible for the new production department? Job: (Speaking for the first time) No new supervisor would be necessary, because we'd be shifting an existing supervisor - Ivan Berbatov - from Shelton to Difluzer. Sarah: But isn't he due to take his pension of 20,000 per year and retire? Job: Yes, but he's agreed to stay on for the duration of the project at his existing salary of 45,000 per annum. Sarah: I see. There's no extra expenditure on account of the supervisor then. Will there be any change in his pension when he does ultimately retire? Job: No, it'll be more or less the same. Ted: What about the tax angle? Penny: We expect that the current tax rate of 20% would continue unchanged and, as usual, tax is paid 1 year in arrears. Ted: (Turning towards you) I hope you've taken note of all that. Our shareholders will want a report on the net present value of the project. I don't suppose that Difluzer would be any more or less risky than our present operations, so you can use our existing cost of capital for your computations. How much is that at present, Penny? Penny: Well, our after-tax weighted average cost of capital is 15%, and is not expected to change as a result of the project. That is based on rates of return required in the market for investments of this level of risk. The rate of inflation on all costs and revenues is expected to remain at the current level of about 2.5% for the next few years. Sarah: Is it necessary to bother about inflation? I know that all the cash flow estimates you've given us are at today's prices, but inflation is going to affect both sides - revenues as well as costs. The net effect on the project will be negligible. Ted: (Thoughtfully) I suppose you're right. But I always feel a bit uncomfortable when trying to estimate a cost of capital for discounting a project's cash flows. That's why I feel much more comfortable with the internal rate of return - the IRR. It doesn't require you to discount the cash flows with a particular cost of capital. Prem: (Enthusiastically) I agree with Ted - the IRR is much easier to use and understand. That's another reason why I prefer my alternative proposal for capital investment of 2 million for additional production of Shelton for the Asian and Far Eastern market at the existing price of f50 a unit. This will generate net after-tax cash flows of 1.5m per year for the first two years (at today's prices). The net after-tax cash flows would fall off to f0.5m per year (at today's prices) for the next three years thereafter, but the project has a very high IRR and will be better than the proposed Difluzer project. Ted: (Nodding towards you) I hope you'll make a note of Prem's points and let me have your analysis soon. Your report should indicate which course of action is preferable - if, in spite of what Prem has said, you still think we should go for the Difluzer project, I will expect you to clearly explain your reasons. Please make sure that you include all the information you gathered here today - if you omit any of it, I will want to know why. And one last thing - seeing that all the persons in your consulting group have come straight out of university, we'd like your constructive comments on any errors in reasoning that you may have observed during the course of the discussion between myself and the members of the management team. I personally would also appreciate your thoughts on the theoretical underpinning of both NPV and IRR. a) Using the information provided in the case, perform a comparative numerical evaluation of the two projects using both the net present value (NPV) and internal rate of return (IRR) methods. You must provide an explanations of your reasons for including or excluding any of the information that has been provided. (30 Marks)