UMACTA-30-M - Engineering Products plc (EP)

Assignment Task

Case Study

Roger Davis, the financial analyst of the Steel Tube division of EP, shut his office door and walked over to his desk. He had just 24 hours to re-examine the accountant’s profit projections and come up with a recommendation on the proposed new computer numerically controlled (CNC) milling machine.Davis had been working for EP for the last 15 years and he had witnessed how technological innovations could threaten the existence of the company.

He had just left a very heated meeting where tensions amongst the top management were running high. The managing director made it quite clear: “If the project can’t pay for itself in the first three years, it’s not worth bothering with.” Davis was unhappy with the accountant’s analysis, which showed that the project was a loss maker.

But as the MD said: “Unless you can convince me by this time tomorrow that spending £240,000 on this capital project makes economic sense, you can forget the whole idea.” His first task was to re-examine the accountant’s profitability forecast in the light of the following facts that emerged from the meeting:

a. Given the rapid developments in the market, it was unrealistic to assume that the product had more than a four-year life. The machinery would have no other use and could not raise more than £20,000 in scrap metal at the end of the project.

b. The opening stock in Year 1 would be acquired at the same time as the machine. All other stock movement would occur at the end of the year-ends.

c. This type of machine was depreciated over six years on a straight-line basis.

d. Within the “other production expenses” were apportioned fixed overheads equal to 20 per cent of labour costs. As far as could be seen, none of these overheads were incurred as a result of the proposal.

e. The administration charge was an appointment of central fixed overheads.

f. The rate of inflation is expected to be 5 each year

Questions

1. How much of the information which he had gathered was really relevant to the decision?

2. What was the best approach to assessing the economic worth of the proposal, and why? The company used payback and return on investment, but he felt that discounted cash flow techniques had some merit.

3. Cash was particularly limited this year and acceptance of this project could mean that other projects would have to be deferred. How should this be taken into consideration?

4. How should the strategic factors be assessed?

5. What about tax? Engineering Products plc pays Corporation Tax at 30 per cent, and annual writing-down allowances of 25 per cent on the reducing balance may be claimed. The existing machine has a nil value for tax purposes and tax is payable in the same year as the cash flows to which it relates.

6. How would risk be assessed?

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