ARUMBAFM003 Financial Management

Last year Numpty Ltd purchased a licence for £200,000 to manufacture toys based on a forthcoming film. They are now planning how to best manufacture the toys. They have two options open to them to purchase Machine A or Machine B.Machine A costs £1,250,000 and has a life of five years after which it will be worn out and unable to produce any more toys. It will have no scrap value. Machine B costs £1,500,00 and has a life of ten years. However, Numpty Ltd would cease production of the toys after six years as the market would then be too small to continue producing the toys. The machine the will have a scrap value of £100,000 at the end of six years.

Sales would be £1,600,000 in year one and then reduce by 50% for each subsequent year. So year two would be £800,000 and year 3 would be £400,000 and so on until each machine is disposed of.
Whichever machine is chosen there will be marketing costs as follows:
Year 1 Year 2 Year 3 Year 4
£100,000 £50,000 £25,000 £25000

The cost of production will be 40% of the value of sales for machine A, whilst for machine B it will only be 35% of the sales value. Numpty is funded by a mixture of debt and equity. The value of debt is £2,000,000 and the bank requires a 6% return on this. The shareholders require a rate of return of 15% and the shares are valued at £4,000,000.Ignore taxation
Requirements:
a) Calculate the weighted average cost of capital for Numpty Ltd. 
b) Produce a series of calculations that will help the managers of Numpty Ltd make the best decision as to which machine they should purchase. 
c) Highlight the key issues with the techniques that you have used that a manger in Numpty Ltd would have to understand to ensure that they made the best decision.
d) Given the result of your calculations how much do you think Numpty Ltd should have paid for the licence to produce these toys
e) Another option that has been suggested is that Numpty Ltd outsource the production of the toys to another company based in an Asian country. Briefly outline the risks that Numpty might face if they were to do this and how they might mitigate these.

Answer: