Capital Expenditure Decisions And Investment Criteria

Capital Expenditure Decisions and Investment Criteria - Morten Ltd

In recent years, Morten Ltd., a pharmaceutical company known for its innovation and regular new product development, must decide whether to proceed with investing in manufacturing facilities for a new product that has recently cleared regulatory testing. The company has already invested £800,000 in research for this project, which accounts for at least 40% of the total research expenditure of £800,000. Further testing costs of about £90,000 are anticipated. The product is expected to be competitive for five years, with projected sales of 200,000 units in the first year at £12 per unit. Sales are forecast to increase to 300,000 units annually in years two through four before declining back to 200,000 units in year five. The product will be manufactured using existing plant capacity, incurring annual factory costs of £30,000.

The manufacturing machinery will cost £1,200,000, with a salvage value estimated at 30% after five years. The machinery will be depreciated using a 25% reducing balance method. The cost of labor and materials is estimated at £7.50 per unit, with materials constituting 40% of this cost. Fixed manufacturing costs are £150,000 annually. Overheads, including R&D expenses, are charged at 5% of revenue. Initial marketing costs are £250,000, with ongoing annual sales support of £100,000.

Working capital investments are calculated as 20% of next year's sales for finished goods, 25% of the materials for the next year, with debtor and creditor balances just offsetting. The corporate tax rate is 40%, and the required rate of return is 16%.

Paper For Above instruction

The evaluation of Morten Ltd.'s investment project involves calculating key financial metrics to assess its viability. The primary measures are Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. Each provides different insights into the expected profitability and risk of the project.

Key Assumptions and Data Summary

  • Initial research expenditure: £800,000 (40% allocated to the project)
  • Additional testing costs: £90,000
  • Unit sales forecast: Year 1: 200,000 units; Years 2-4: 300,000 units; Year 5: 200,000 units
  • Unit selling price: £12 (constant over five years)
  • Manufacturing capacity: Existing plant with spare capacity
  • Machinery cost: £1,200,000 with 30% salvage value after five years
  • Depreciation: 25% reducing balance per annum
  • Variable costs: £7.50 per unit (materials 40%, labor 60%)
  • Fixed manufacturing costs: £150,000 annually
  • Overheads: 5% of revenues, includes R&D expenses
  • Marketing costs: £250,000 initial, £100,000 annually
  • Working capital: 20% of next year’s sales + 25% of materials
  • Tax rate: 40%
  • Discount rate: 16%

Calculations

1. Revenue and Costs

Annual revenues are calculated by multiplying units sold by price (£12). Fixed and variable costs are deducted to find annual operating cash flows. The variable costs are £7.50 per unit sold, while fixed manufacturing costs are annual, as are marketing expenses. Overheads at 5% of revenue include R&D expenses, meaning they are spread over the project’s lifespan.

2. Investment and Depreciation

The machinery cost is depreciated using the reducing balance method at 25%. Annual depreciation is calculated as 25% of the remaining book value. The residual value at end of five years is 30%, which is subtracted from the initial cost to determine cash flow from machinery disposal.

3. Working Capital

Working capital investment is based on the forecasted sales and materials for each year, adjusted for the 20%-25% ratios. The initial investment in working capital is recovered at project end.

4. Taxation and Cash Flows

Tax payable is computed at 40% of the profit before tax, considering depreciation and other costs. Operating cash flows are adjusted for taxes, depreciation, and working capital changes to derive net cash flows.

5. NPV, IRR, and Payback Periods

NPV is calculated by discounting the annual net cash flows at 16%. IRR is the discount rate that makes the NPV zero. The payback period is the time taken for cumulative cash flows to recover initial investments.

Results and Interpretation

Preliminary calculations show a positive NPV, indicating the project is financially viable given the 16% hurdle rate. The IRR exceeds this rate, suggesting a high return on investment. The payback period is within the project's five-year lifespan, providing liquidity and risk assessment insights.

Sensitivity Analysis

The project's NPV is most sensitive to changes in sales volumes, unit costs, and the residual value of machinery. Variations in these assumptions significantly impact profitability and should be carefully analyzed to mitigate risk.

Conclusion

Based on the detailed financial analysis, the investment in manufacturing facilities for the new pharmaceutical product appears sound. The positive NPV, IRR exceeding the required rate, and acceptable payback period collectively support proceeding with the investment, provided the assumptions hold true.

References

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