Rate of Return

Sion Plc: A Capital Expenditure Decision

Sion plc is considering the introduction of a new product that has evolved from work undertaken by the company’s R&D department. The R&D work has cost £700,000 to complete and is expected to finish by the end of next month. The manufacture of the product will require investment of £5 million in a new plant and machinery. It will also require the use of some equipment already owned by the company. This is fully depreciated for tax purposes but could be sold today for £0.6 million. If used on the project it will have no resale value at the end of the project. The company anticipates it could manufacture and sell 20,000 units of the product per annum and the company’s market research has found there is a market for this level of sales at a price of £250 per unit. The variable costs of production would be £120 per unit and there would also be fixed costs of £250,000 per annum to take into account. The activity would be allocated overheads of £60,000 per annum to cover the company’s total R&D expenditure and head office expenses. In addition the activity will be charged £100,000 per annum for the space utilised in the company’s production unit, even though at present the company has considerable free space available for which it has no alternative use. The expenditure on plant and machinery would be depreciated for tax purposes on a straight-line basis over an anticipated product life of four years. At the end of the four years it is anticipated that the plant could be sold for £0.9 million. The project would require holding stocks of raw materials and components worth £120,000 and 3,750 units of the final product ready for sale.

a) If the tax rate is 30 per cent and required rate of return is 14 per cent is this a profitable investment? State and explain all the critical assumptions.. (13 MARKS)

b) Use sensitivity analysis and scenario analysis to improve your capital budgeting analysis. You should use your own input estimates. Write a brief report on your findings. (7MARKS) (TOTAL 20 MARKS)

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