Milehouse plc

Milehouse plc is an electronics business that manufactures a range of video recorders.

The business is considering production of a new sophisticated video recorder, the
Spectra, that it has recently developed. To manufacture these would require a
significant outlay on purchasing new plant and machinery. The production director
has identified two options:

(1)

A capital-intensive process with high capacity and a low variable cost.

(2)

A labour intensive process with medium capacity and a moderate variable cost.

The purchasing director has, however, identified a third option:

(3)

Having the Spectras made by a Korean business that has undertaken subcontract work for Milehouse plc before. Under this option Milehouse plc would
simply sell the Spectras, under its own brand name.

The estimated useful economic life of the new plant and machinery under the first two
options would be five years and there would be a zero residual value for plant and
machinery. The term of the contract in Option (3) would also be five years.

The finance director has estimated the following:

Option 1

Option 2

Option 3

Maximum annual capacity (units)

300,000

200,000

400,000

Initial outlay

65 million

30 million

zero

The business would borrow the funds to finance any initial outlay at 10% per annum,
but the businesss cost of capital is expected to remain at 15% per annum. Selling
prices would be constant at 250 per unit.

The newly appointed accountant has drawn up a schedule of expected profit per unit
of output assuming that each option was operating at its maximum annual capacity.
The schedule is as follows:

Option 1

Option 2

Option 3

per unit

per unit

per unit

250

250

Sales revenue
Variable labour

(50)

(80)

Variable materials

(60)

(60)

Power

(10)

(8)

Interest

(26)

(15)

Depreciation

(26)

(15)

Avoidable fixed costs

(30)

(20)

Allocated fixed costs

(25)

(25)

250

(10)

Bought-in inventories

(210)

(227)

(223)

(220)

Profit per unit

23

27

30

Costs and selling prices are expected to remain constant over the next ten years in all
three options.

The marketing director has pointed out that the accountants assumption of using
maximum output is inappropriate. She argued that the calculations should be based
upon preliminary market research, which showed that expected annual sales volume
would be 250,000 units, throughout the ten years. The accountant agreed that any
investment appraisal of the three possibilities should correct for this error in his
schedule (above) and take account of the fact that the three options do not have the
same maximum output

Production would commence on 1 January next year and this would also be the date
on which payment would be made for the initial outlay on capital machinery. It can be
assumed that all operating cash flows will occur at year ends.

Required:

(a)

Determine the net present value of the three options at 1 January next year.

(b)

Calculate the annual level of sales at which Option (1) and Option (3) would
generate the same net present value.

(c)

Briefly comment, without further calculations, on the impact on the relative net
present values of the three options, if the expected level of potential demand
were (i) higher or (ii) lower than predicted.

(d)

Consider the other factors that the directors of Milehouse plc may take into
consideration before coming to a final decision on the optimal manner of
supplying Spectras.