Fundamentals of Finance Coursework Case Study for 2019-20 Chowkidar plc
Chowkidar plc has an established market for its product, a premium electronic security device called ‘Eagle Eye’. The company is now considering two alternative investment projects.
Introduction of a new product for the low-end market:
The first proposal is to launch a new low-cost electronic security device called ‘Watchdog’ which has been developed in the company’s research lab. The initial investment in depreciable plant and machinery required for this project is estimated at £40 million, which would result in sales of £70 million in the first year of operation. The sales are expected to grow at a rate of 6% per year in the second, third and fourth years, before dipping by 4% in the fifth year. The product is expected to become obsolete and be replaced by new technology by that time. The company’s planning horizon for the product is therefore limited to five years, at the end of which the salvage value of the plant and machinery is expected to be about 5% of the original cost.
The company follows the accounting practice of depreciating its plant and machinery on a straight-line basis over its useful life which, in this case, is estimated at 5 years. HMRC permits capital allowances to be claimed on a new investment of this nature at the rate of 18% per annum, on a reducing balance basis. The company pays corporation tax at the rate of 19%, in the year in which it arises.
In consultation with the Production Manager, Chowkidar’s junior accountant Jai Veeru has estimated that the direct material cost of ‘Watchdog’ would be 25% of the selling price, but the direct labor cost would be 42% of the selling price. Since the new product is proposed to be manufactured in a vacant portion extending to about a quarter of the existing factory space, he proposes to allocate to the new project 25% of the annual rent of £180,000 being paid for the factory building.
A new senior executive would need to be appointed for the ‘Watchdog’ project, at an annual salary of £100,000. After adding this extra expenditure to the company’s existing overheads, Jai proposes to allocate a total of £0.6 million of the company’s overheads to the new project.
One of Jai’s colleagues who has been working with him on the project has ascertained that R&D expenses of £1½ million that were incurred in developing the new low-cost electronic security device ‘Watchdog’ are yet to be written off – she has suggested that these costs should be taken into account for a correct project appraisal.
Chowkidar’s Marketing Manager Debbie Ekunwe has estimated that launching of the ‘Watchdog’ product is likely to result in some decline in sales of the existing premium ‘Eagle Eye’ product – the net loss of contribution on account of the decline in ‘Eagle Eye’ sales are expected to be £2 million. Jai has responded to her that this is a marketing issue, not connected with investment appraisal of the new project.
For production and sales of ‘Watchdog’ to reach the expected levels, the company would need to maintain an additional networking capital investment equivalent to 14% of the year’s sales. The required level of working capital investment would need to be in place at the start of each of the five years. All working capital investment would be recovered at the end of the fifth year.
Expansion of the market for the existing product:
The alternative proposal is to spend a sum of £50 million on market development and other expenses, to tap into the potential export market for the existing ‘Eagle Eye’ product in African and Middle Eastern countries. This initial spend of £50 million is expected to generate net additional after-tax cash flows of £25 million for each of the next three years, falling off to £12 million per year in the fourth and fifth years. This project is also being evaluated over a time horizon of five years.
Other information:
All the estimates for both projects have been made at current prices. Although the rate of inflation is expected to be about 2% per annum for the foreseeable future, Jai believes that this is immaterial for the purpose of evaluating the projects as inflation would affect both revenues and costs.
Chowkidar can only implement one of the proposed projects, not both. Either project would need to be implemented in its entirety, i.e. part-implementation would not be possible.
Chowkidar’s long-term aim is to maintain its existing capital structure, which consists of the following three types of finance in the ratio of 0.59 : 0.4: 1
- 4% bonds with a face value of £100 each, a current market price of £91.50 each, and seven years remaining to maturity.
- 8% mezzanine finance.
- Ordinary shares, currently trading at a market price of 100 pence per share.
Chowkidar has paid a dividend per share of 14 pence in the year just completed. The dividend has grown to this level from 11 pence per share 6 years ago, and a similar growth rate is expected to be maintained.
Whichever project is chosen for implementation, the interest charges payable on the additional finance raised for the project would be approximately £4 million per year.
Chowkidar’s Chairman, Vikram Veera, has asked a team of financial consultants to use the estimates provided by his accountants to evaluate both the project for the production of ‘Watchdog’ and the project for expanding the market for ‘Eagle Eye’ and to let him know which one would be more value-enhancing. He particularly wishes to know whether the company’s Marketing Manager Debbie Ekunwe is correct in saying that the expansion project would create greater shareholder value because it has a significantly higher internal rate of return.
Chowkidar’s Chairman is also concerned about the risks of these proposed investments. For the ‘Watchdog’ project, he has asked for an analysis of its vulnerability to fluctuations in the initial investment cost, the material cost, and the cost of capital.
Whichever project is selected, the main source of capital at this point in time is proposed to be from mezzanine financing – Vikram has therefore suggested that the relevant interest rate of 8% per annum should be used as the cost of capital for the project evaluations. However, the company’s Chief Accountant, Wendy Hu, has suggested that the weighted average cost of capital may be more appropriate.
Required for the Report:
1. Calculate the company’s weighted average cost of capital, and discuss the views of the Chairman and the Chief Accountant about what would be the appropriate cost of capital to use for evaluating these projects. You should provide full explanations of the points that you make, using your own words.
2. Using the information provided in the case, perform a comparative evaluation of the two projects. Use whatever project appraisal techniques you consider to be useful and relevant to the problem, and provide explanations of your reasons for including or excluding any of the information that has been provided.
3. Based on your numerical evaluation of the projects, explain the particular problems that can arise in the use of investment appraisal techniques like net present value, internal rate of return and payback period. Your answer should provide a full and clear explanation of any such issues arising out of your evaluation in your own words, and with reference to the case in question, including the particular concerns expressed by Chowkidar’s Chairman.
4. Based on your chosen investment appraisal method(s) recommend an appropriate course of action for Chowkidar Limited, also commenting on other aspects that the management team may wish to consider.
5. Demonstration of information technology skills particularly in the use of Microsoft Excel (competent word processing skills will also be recognized).
6. Demonstration of written communication skills – essentially the preparation and presentation of a report to the top management of a company.