Exam Standard Question
Bracket Ltd manufactures a range of fixtures and fittings. The company has recently been offered a patent for a new type of door hinge, the design of which is far superior to the hinges the company currently manufactures.
The patent for the new hinge can be bought for £40,000 cash and current equipment can be modified to produce the new hinge at a cost of £72,000. After modification the equipment will have a remaining useful life of four years, at the end of which time its scrap value will be £10,000. Variable costs for the new hinge will increase by £1 per unit, but fixed costs will be unchanged. If the machine is modified, the current hinge could no longer be manufactured.
Financial information on existing annual hinge production is as follows.
£ £
Sales (100,000 hinges @ £4) 400,000
Variable costs 225,000
Fixed costs* 120,000
Total costs 345,000
Net Income 55,000
*Note: All fixed costs are directly related to the production of the current hinge and include annual depreciation on equipment of £20.000 calculated on a straight line basis with a useful life of 10 years.
Market research indicates three key findings regarding the new hinge production:
1. Bracket's competitor will buy the patent if they do not. If this happens, sales of the existing hinge will fall to 60,000 units per year.
2. If Bracket buys the patent and retains the existing selling price for the new hinge, the company will sell 190,000 hinges.
3. Continual developments in alternative materials will mean the patent will be worthless at the end of four years.
The uncertainty of the current situation has resulted in the raw material stock being virtually exhausted. Regardless of the decision that is made, the stocks need substantial and immediate replenishment. If the new model is produced, Production Control estimates that average monthly raw material stocks will need to be £24,000. If the old model is retained, however, stock levels will average £9,000 per month.
Bracket uses a discount rate of 14% for appraising investment projects.
Required
(a) Assess the proposal to purchase the hinge patent and recommend which alternative should be selected. Your recommendation should include a discussion of any non-financial factors which you consider to be relevant to the decision.
(b) Following his recent studies on an MBA course the Production Director has said that he wishes to use internal rate of return (IRR) to compare investments rather than net present value (NPV).
Write a memo to the Production Director commenting on his proposal. Your memo should clearly highlight any benefits or drawbacks of using IRR, particularly in relation to NPV.