problem

NEC is considering the investment in a new machine, with maximum output of 200,000 units per annum, in order to manufacture a new toy. 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)     RM8.00 per unit    RM7.00 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 RM75,000 and this amount has yet to be paid.

NEC 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 RM3.00 (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 RM0.05 is expected to occur. The average variable cost per unit when production is between 110,000 units and 119,999 units, for ex, is expected to be RM2.95 (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 RM2.90 (in current price terms), and so on.

The new machine would cost RM1,500,000 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 the following basis:

Initial allowance – 20%
Annual allowance – 14%

Although the machine may have a longer useful economic life, NEC uses a five-year planning period for all investment projects. The company pays tax at an annual rate of 25% and settles tax liabilities in the year in which they arise.

Operation of the new machine will cause fixed costs to increase by RM110,000 (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 NEC depreciates machinery on a straight-line basis over its planning period.

NEC 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%. NEC does not use any explicit method of assessing project risk and has an average cost of capital of 10% in money (nominal) terms.

Required:

(a) Find out the sales strategy that maximizes the present value of total contribution. Ignore taxation in this part of the problem.

(b) find out the investment in the new machine using internal rate of return.

(c) find out the investment in the new machine using return on capital employed (accounting rate of return) based on average investment.