Crypton plc, is quoted on the Alternative Investment Market, in London, UK. It is a technology company working on a product to undertake Coronavirus (COVID-19) testing, which it assumes will replace the current disposable tests. These can be deployed within hospitals or testing centres and will have unlimited use. It is assumed that the product will be launched in 2022, after investing £20 million in production capacity in the current year (Time 0). It is assumed that this investment will have zero residual value by the end of the project.
Before investing in any production capacity, the company has already undertaken Research & Development costing £2.5 million and market research costing £1.0 million. The market research does indicate that there will be a market available for a maximum of 4 years. The limited life span will be due to extreme competition within the product area.
The market research indicates the following, with regard to costs, revenues and sales:
Year 2022 2023 2024 2025
Sales volume (units) 700 560 450 400
As at 2021 the following are forecast:
Selling Price/unit £26,500
Incremental Fixed costs/annum £1,400,000
It is thought that selling price will increase by 3% per annum and that inflation will cause fixed costs to increase at 4% per annum.
The purchasing department is of the opinion that variable costs will depend upon the level of competition between suppliers. This, in turn, will be dependent upon how many competitor manufacturers enter the market. Naturally, if there is strong competition between suppliers, the unit cost will be lower to Crypton plc. The purchasing department predicts the following as at 2021:
Competition between suppliers Strong Moderate Weak
Probability 45% 35% 20%
Variable cost/unit (£) 11000 12000 13000
The variable cost forecasts are before taking account of variable cost inflation of 4%, over the life of the product.
It is planned to finance this particular project with a corporate bond issue, at 8% interest, redeemable in ten years’ time. Crypton has a cost of equity of 12%, a nominal (money) weighted average cost of capital of 10% and a real weighted average cost of capital of 6%.
As Crypton plc is an innovative technology company it is thought that this project will carry a similar risk profile to current activity.
Within the general industry, within which Crypton plc operates, the expected target Return on Capital Employed is 20%.
At a Board meeting to discuss the proposals the following conversations were heard:
Margaret Poulton, the Finance Director, said, “I think that we should calculate the Net Present Value (NPV)of the project, in order to ascertain if it is worthwhile.”
Samuel Komakech, the HR Director, responded to this as follows, “I have never understood NPV, can’t we use an appraisal method which measures percentage return. I always think it is more straightforward basing financial decisions on percentages.”
The Managing Director (CEO), Vitor Leone then said, “Never mind the appraisal method, I have a more fundamental question. We plan on raising the £20 million investment funds through a Corporate Bond issue. Would it be safer to raise the money through an issue of shares and will this impact the returns on the project?”
Working as consultant to Crypton plc, you are required to respond to the following tasks.
Required:
Task 1
a) Calculate the Expected Net Present Value (ENPV) arising out of the incremental cash flows for the investment. You should also comment on the potential impact of any risk factors attached to variable costs. In addition, related to your calculations, provide a view on the financial acceptability of the project (15 marks)
b) In order to satisfy Samuel Komakech, calculate the Average Accounting Rate of Return for the investment and briefly comment on your findings. In addition, provide a summary comment with regard to project acceptability, taking account of your calculations in part (a) above.
(10 marks)
c) Provide a brief report to Margaret Poulton and Samuel Komakech indicating, with a fulsome rationale, which appraisal method is generally regarded as being the most acceptable. i.e. – Net Present Value or Accounting Rate of Return?
(15 marks)
(Total 40 marks)
Task 2
Provide a response to Vitor Leone, where he says, “We plan on raising the £20 million investment funds through a Corporate Bond issue. Would it be safer to raise the money through an issue of shares and will this impact the returns on the project?”
Your response should consider the theoretical and practical factors which may influence Crypton’s choice of debt or equity capital financing.
(20 marks)
Task 3
Tom Webster, the assistant to Margaret Poulton, has recently graduated from a university postgraduate programme. He says, that, “when I was at university, we considered the use of real options analysis, with investment decision making. It was considered to be superior to traditional methods of capital appraisal.”
He presents extracts from two papers in order to support his views:
Zarkos et al (2007, p315) state that, “the proactive character of the real options approach is contrasted with the inflexible nature of conventional strategic planning [i.e. NPV appraisal] that leaves firms ill-prepared to cope with uncertainty.”
Tom points out that Ley-Chyan (2014) supports this view when he indicates that managers do have the ability to change their minds and that traditional investment appraisal methods, such as NPV, “have been criticised as they neglect a project manager’s flexibility to adjust earlier decisions.” Here the author is emphasising that managers can alter strategic decisions once an investment project is underway, which is a factor which that traditional approaches do not recognise.
However, the Board actually find this to be quite confusing.
You are, therefore, required to clarify the difference in decision-making approach between the assumptions of Net Present Value and those of Real Options Analysis. Your response should also debate the general strategic factors that managers are directed towards when they are attempting to maximise the future value of real options.
(25 marks)
Task 4
As Crypton plc is expanding quite rapidly it is considering future growth strategies. The marketing director favours acquiring a French competitor that is already further down the line towards producing similar testing machines, whereas the CEO says, “it would be far more sensible to grow organically.”
You are required to prepare a brief report for the management team providing a critical analysis of the above suggested strategies for growth, in relation to Crypton plc.
(15 marks)
