Investment Appraisal and Working Capital Management: A Case Study

Hix plc's Investment in a New Machine

Q1. Hix plc is a medium-sized manufacturer of sports products that has been listed on the stock exchange for three years. Although the company has an overdraft, it has no long-term 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 fleet of delivery vehicles. The company does not own any retail outlets through which to distribute its manufactured output. 

Hix plc is considering an investment in a new machine, with a maximum output of 200,000 units per annum, in order to manufacture a new product. 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
Selling price (in current price terms)	€8.00 per unit	€7.00 per unit
Sales volume in first year	100,000 units	110,000 units
Annual increase in sales volume after first year	5%	15%

The services of the market research agency have cost €75,000 and this amount has yet to be paid.

Hix plc 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 €3.00 (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 €0.05 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 €2.95 (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 €2.90 (in current price terms), and so on.

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, Hix plc uses a five-year 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 fixed costs to increase by €110,000 (in current price terms). Inflation is expected to increase these costs by 4% per year. Annual inflation on the selling price and unit variable costs is expected to be 3% per year. For profit reporting purposes Hix plc depreciates machinery on a straight-line basis over its planning period.

Evaluation Using Internal Rate of Return

Hix plc 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, internal 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 before-tax return on capital employed should be greater than the company’s before-tax return on capital employed, which is 20%. Hix plc does not use any explicit method of assessing project risk and has an average cost of capital of 10% in money (nominal) terms.
The company has not yet decided on a method of financing the purchase of the new machine, although the finance director believes that a new issue of equity finance is appropriate given the amount of finance required.

You are required to:

(a) Critically evaluate the investment in the new machine using internal rate of return. (35 marks)

(b) Critically assess the use of NPV and IRR as investment appraisal tools. (15 Marks)

Q2. Zigg Ltd. is a wholesale distributor of a variety of imported goods to a range of retail outlets. The company specialises in supplying ornaments, small works of art, high value furnishings (rugs, etc) and other items that the chief buyer for the company feels would have a domestic market. In seeking to improve working capital management, the financial controller has gathered the following information.
   

	Months
Average period for which items are held in inventory	3.5
Average receivables collection period	2.5
Average payables payment period	2

You are required to:

(a) Calculate Zigg Ltd.’s funding requirements for working capital measured in terms of months. (5 marks)

(b) In looking to reduce the working capital funding requirement, the financial controller of Zigg Ltd is considering factoring credit sales. The company’s annual revenue is €2.5m of which 90% are credit sales. Irrecoverable debts are typically 3% of credit sales. The offer from the factor is conditional on the following:

(i) The factor will take over the sales ledger of Zigg Ltd completely.
(ii) 80% of the value of credit sales will be advanced immediately (as soon as sales are made to the customer) to Zigg Ltd, the remaining 20% will be paid to the company one month later. The factor charges 15% per annum on credit sales for advancing funds in the manner suggested. The factor is normally able to reduce the receivables’ collection period to one month.
(iii) The factor offers a ‘no recourse’ facility whereby they take on the responsibility for dealing with irrecoverable debts. The factor is normally able to reduce irrecoverable debts to 2% of credit sales.
(iv) A charge for factoring services of 4% of credit sales will be made.
(v) A one-off payment of €25,000 is payable to the factor.

The salary of the part-time sales ledger administrator (€12,500) would be saved under the proposals and overhead costs of the credit control department, amounting to €2,000 per annum, would have to be reallocated. Zigg Ltd.’s cost of overdraft finance is 12% per annum. Zigg Ltd. pays its sales force on a commission only basis. The cost of this is 5% of credit sales and is payable immediately the sales are made. There is no intention to alter this arrangement under the factoring proposals.

You are required to:

Critically evaluate the proposal to factor the sales ledger of Zigg Ltd. (15 marks)

(c) Write a report to the Managing Director of Zigg Ltd. which identifies:

• how cash flow problems can arise in companies.
• the methods available for easing cash shortages.
• the techniques, other than cash budgeting, that could be used to monitor and manage cash resources. (20 marks)