You are the financial manager of a public limited company called Spearhead, a company that manufactures medical products.
You have agreed to write a report for the managing director for the next board meeting, to propose a revised company policy for evaluating and making decisions on future capital projects such as the proposed €3.4 million investment in a new product.
The company has always evaluated investments using the Internal Rate of Return model as the selection criteria.
The company’s managing director thinks that NPV may be a better method and is aware that some companies use multiple methods. He is also concerned about how risk is incorporated into the analysis. He now requires your opinion on these matters.
Your report will need to explain the rationale for having a corporate policy on investment decisions, which must include a critical evaluation of how investment appraisal methods support corporate investment decision making and how risk can be incorporated into the decision making process.
Your report will also cover the funding of the investment and the criteria for selecting the most appropriate methods to finance the proposed project.
It should also discuss wider financial and non-financial aspects of the evaluation of capital investment and the implications of these for the decision making process.
The appraisal is for a new product that will have an estimated life cycle of six years and which requires a new dedicated production line.
The entry into this new market will require an initial investment of €3.4 million and at the end of six years the equipment will have an estimated scrap value of €600,000.
The company has recently spent €200,000 on research and development relating to the new product.
Assume that the capital structure consists of 80% equity and 20% debt capital.
You are provided with the following information concerning the project:
Initial capital expenditure on machinery €3,100,000
Estimated scrap value of machinery €600,000
Annual net cash inflows €1,000,000
Initial working capital €300,000
The company depreciates capital equipment on a straight-line basis over the life of the machine after adjusting for any estimated scrap value.
The machine would be bought on the first day of the company’s accounting period and would attract a 25 per cent writing down allowance.
The machine would be financed with a five-year loan from Bank of Ireland Finance at an interest rate of 7 per cent.
The interest payments attract tax relief. Corporation tax is payable at 30 per cent, one year after year-end. Assume that any excess tax allowances can be utilised in the business.
The company has calculated its cost of capital at 12% cost of capital and if that return is achieved, then they will be able to increase dividends to shareholders by €100,000 a year over each of the next six years.
Assume all cash flows occur at year-end.
Include in your report the following:
- A critical evaluation of the role, relevance and application of a range of capital investment appraisal models, using the data provided.
- An explanation and evaluation as to how risk can be incorporated into the analysis using the data provided.
- A discussion of the funding of the investment and the criteria for selecting the most appropriate methods to finance the proposed project.
- A clear recommendation, justified as to how decisions should be made within the company, incorporating the assessment of non-financial factors and risk.
- Select and apply appropriate financial decision making techniques to conduct appraisals of investment decisions. Evaluate alternative corporate investment decisions.
Specific coverage of the following points is required
- Rationale for having a corporate policy on investment decisions
- A critical evaluation of how investment appraisal methods support corporate investment decision making
- Importance of risk and how risk can be incorporated into the decision making process.
- Discuss the funding of the investment and the criteria for selecting the most appropriate methods to finance the proposed project.Affect on capital structure of the company.
- A discussion of the wider financial and non-financial aspects of the evaluation and the implications of these for the decision making process.
- Evaluation and recommendation to the Board