Financial Decision Making-1

Introduction

The assessment assesses learning outcomes 2 and 3 of the 3 module learning outcomes of this module, which are that on successful completion of the module students will be able to:

· Demonstrate an understanding and use of the appropriate analytical techniques to be applied to business case development and Investment appraisal; the raising of finance and the distribution of funds to investors;

· Communicate financial information, analysis, issues and recommendations clearly and concisely.

The Question

Background information

Smart Home Plc (a fictional company) is a UK incorporated and UK tax resident technology company focussing on the manufacture and retail of internet enabling devices for homes.

The business has been conducting Research and Development on a new smart watch and now needs to make a decision whether to go ahead with launching the product and determining what is an appropriate price for it.

You are the Business Manager responsible for the product launch and the CEO has asked you to prepare a report on the investment in the new product. With the Finance Manager on leave for the next 3 weeks, you are on your own for the presentation.

You have been given the following information from various teams in the organisation.

R&D Team

“We’ve spent quite a lot on developing this project - £450,000 – and it would be a shame if we didn’t get it to market. I would estimate that we would need to spend around and other £60,000 on research costs to get it to a position where it is ready to launch”.

The production department:

“I’ve looked into the production of the smart watch and we will need to purchase a new machine to manufacture at the scale we want which will which will cost us £1,500,000. We have spare capacity in current staff to run the machine, but we will need to hire a “Specialist Supervisor” for the machine – I asked the HR team to let me know what the salary for that person would be, but they haven’t got back to me yet. The machine will last for around 5 years – you need that for your depreciation calculations right?”

The Marketing director

“I’ve done some research on the potential pricing of the watch and likely customer targets and worked with someone in the finance team to look at pricing. I think our wholesale sales price should be £150 per watch over the course of the whole 5 years. The cost of the raw materials makes up 40% of the sales price. My team have estimated that sales for the first 5 years should be as follows:

After 5 years we think that the tech will have advanced beyond this and the product will no longer be attractive so we are assuming that the life of this project will probably only be until then before we need to make a new investment, and we are constantly innovating other projects. The machine will not have any scrap value at this stage.

We’re planning an advertising and marketing campaign costing £545k in year 1 to get started and these costs will the same in in year 2 and 3, and fall to £190k in years 4 and 5. Oh, and HR have just confirmed that the Supervisor salary and benefits will start at £36k in year 1 but we expect inflationary rises to be 3% year on year. That includes our National Insurance costs”

You have investigated how to calculate an appropriate cost of capital (WACC) and gathered the following information:

· The market value of the shares is £2.75 per share and there are 5.5 million ordinary shares in issue. Dividends are expected to continue at 30p per share for the foreseeable future

· The company has £10m in irredeemable loan capital with an interest rate of 7% and it is currently quoted at £95 per £100. The tax rate is 20%.

The business has previously been using an estimated Weighted Average Cost of Capital of 20% and the management team would like to see your calculations using the WACC you have calculated and the original estimate of 20%.

Your task

In the absence of the Finance Manager the CEO wants you to make a presentation to the Board about whether the project should go ahead. The Board are not finance people but are very interested in the techniques that are used to appraise investments and so would like a comprehensive explanation of how you came to your conclusion. In particular they would like you to include the following:

1. Executive summary

2. A projected cash flow for the project over its 5 year life

3. An explanation of cost of capital including:

a. What is Weighted Average Cost of Capital (WACC)?

b. What do we use WACC for?

c. Your calculations of the WACC of capital for the business showing each of the individual components.

4. A financial evaluation of the project using the NPV and Payback Period Methods including:

a. Your calculations of NPV and Payback period for the project using WACC (the detail should be in the Appendix of the report and should be calculated in Excel)

b. Your calculations of NPV and Payback period for the project using the previous business cost of capital of 20% (the detail should be in the Appendix of the report and should be calculated in Excel)

c. A decision as to whether the project should go ahead and your justification for this decisions

5. An explanation of the benefits and limitations of the 4 main investment appraisal techniques.

6. An explanation of the different types of funding available to a company (Long term, short term, equity and debt and others), the advantages and disadvantages of each and a detailed explanation of what a bank might look at in deciding whether to make a loan to a company and the steps they might take for extra protection on the loan repayment.

7. Conclusion

Your report should have an executive summary at the start and a conclusion at the end and you should conclude on the viability of the project at the current cost of capital and the situation if cost of capital were 20%.

Structure of the report

The report should be prepared in PowerPoint and should contain the following slides:

· Executive summary ( A summary of your proposal in a page)

· Introduction

· Calculation and critical evaluation of WACC (detailed calculation may be shown in an Appendix)

· Projected cash flow

· Calculation of NPV and PP (detailed calculation may be shown in an Appendix) using the WACC

· Calculation of NPV and PP (detailed calculation may be shown in an Appendix) using a cost of capital of 20%

· Explanation of and critical evaluation of the 4 main capital investment appraisal techniques

· Critical explanation of different forms of funding for companies

· Conclusion

· Appendices – detailed calculations and references

The Powerpoint file should be uploaded to Turnitin. A template is provided but you should feel free to adapt and personalise this.

Assessment Marking Scheme  

The assessment is marked out of 100.