Question 1
Jasmine is a large company which manufactures children’s toys. It is a private UK limited company with a diversified shareholder base. The company has its headquarters in London, and as part of a group structure, wholly owns subsidiary companies in the UK, China and the US.
A new chief executive (CEO), Mr Harold Jordan, was recently appointed by the Board to replace the retiring CEO, Mr James Hannah, who led the company for the past twenty-five years. During this time, Jasmine has produced an extensive range of products for the children’s toy industry. Many of the toys manufactured are protected through patents and trademarks held by the company. The manufacturing business has a small innovation team which is tasked with improving or developing products for markets. Over the last few years, however, the company’s profitability has declined through a combination of factors including increasing competition and rising costs. Mr. Jordan has been tasked with reinvigorating the company, and providing growth in the business lines, ultimately improving profitability and the overall value of the company.
After undertaking a full review of the company’s operations, Mr Jordan has announced a five-year strategic plan which he calls “Vision 2027”. Mr Jordan has suggested that the company needs to restructure, reduce staffing, and crucially, focus on entering new markets in Europe. As part of Vision 2027, Mr Jordan plans to introduce new environmentally friendly technology to manufacture drones and robots for the toy market; to develop a series of family orientated toys to encourage family bonding; and produce a new range of educational toys. Vision 2027 will require new manufacturing plants to be opened up, and because of Brexit, Mr Jordan is thinking of moving the company’s headquarters to Paris. He has yet to discuss these plans with the Board, and although he knows he has been hired to provide a new direction for the company, he recognises that Vision 2027 will raise several concerns with his senior colleagues. Supporting financial and operational information appears in the Appendices.
Based on the information given in Appendix Q1.1 below, answer the following questions.
- a.Using the information in Table 1, and your knowledge of relevant costs, calculate the increase/ decrease in operating profit for the company if the Fixed-Wing drones were discontinued.
- b.One of the directors says that Fixed Wing drones should be continued as they currently make a positive contribution of £38,000. Using your knowledge of marginal and relevant costing explain why they are mistaken.
- c.Based on your analysis of relevant and non-relevant costs:
- i.Amend the operating statement in Table 1 to provide the total profitability of the drones as well as the profitability of each drone. Assume that the Fixed Wing drone has been discontinued and that the depreciation will be allocated to each drone continuing in production in proportion to sales achieved.
- ii.Explain the value to the business in producing the new operating statement you propose in c (i) above.
- d.Using the information in Table 2, and your knowledge of relevant costs, calculate the difference in profit over the next five years between keeping and replacing the old machine.
- e.Evaluate the response of the Board of Directors to the proposed new machine.
- f.Outline two potential advantages of purchasing a new machine that can’t be measured from the information given in Table 2 .
Appendix Q1.1
Mr Jordan plans to introduce new environmentally friendly technology into the manufacture of the drones. Jasmine currently produces three types of drone which are manufactured on two specialist machines in a UK factory that produces no other toys. Table 1 shows revenue and cost information for the last month.
| Table 1: Operating statement | |||||
| Total | Fixed-wing | Fixed-wing hybrid | Multi-rotor | ||
| £ | £ | £ | £ | ||
| Sales | 772,000 | 125,000 | 410,000 | 237,000 | |
| Variable expenses | 320,000 | 87,000 | 145,000 | 88,000 | |
| Contribution | 452,000 | 38,000 | 265,000 | 149,000 | |
| Marketing | 89,000 | 23,000 | 47,000 | 19,000 | |
| Deprecation of equipment | 108,000 | 36,000 | 46,000 | 26,000 | |
| Line supervisors’ salaries | 43,000 | 17,000 | 14,000 | 12,000 | |
| Factory overheads | 193,000 | 31,250 | 102,500 | 59,250 | |
| Total overheads | 433,000 | 107,250 | 209,500 | 116,250 | |
| Net operating profit (loss) | Total19,000 | Total(-69,250) | Total55,500 | Total32,750 |
Mr Jordan is concerned about the continuing losses from Fixed Wing drones and wants to decide whether to discontinue their manufacture.
The following information is relevant to overhead figures in Table 1:
- a.The two specialist machines used to produce the drones currently have no resale value.
- b.The company has no other use for the spare capacity that would become available if Fixed Wing drone production was stopped.
- c.If Fixed Wing drone production was stopped, both line supervisors responsible for its manufacture would become redundant.
- d.The marketing expense for each model of drone is exclusively spent on that drone.
- e.Factory overheads are general and fixed common costs that are allocated based on sales.
Proposal of new machine and other new information
After consultation with the production manager, Mr Jordan is considering the purchase of a single new machine that will replace one the existing two machines. The new machine uses new environmentally friendly technology and will cut scrap and rework rates (the cost of remedying manufacturing problems) resulting in a substantial savings in materials and labour costs. A production manager has gathered the following information concerning the old machine and the proposed new one.
| Table 2: Information for replacing old machine | ||||||
| Old machine | Proposed new machine | |||||
| Original cost | £100,000 | List price new | £250,000 | |||
| Remaining book value | £80,000 | Expected life | 4 years | |||
| Remaining life | 4 years | Disposal value in five years | £0 | |||
| Disposal value now | £30,000 | Annual variable operating expenses | £215,000 | |||
| Disposal value in five years | £0 | Annual revenue from sales | £450,000 | |||
| Annual variable operating expenses | £230,000 | |||||
| Annual revenue from sales | £400,000 |
During the initial discussion about the proposal to replace the machine, the first response, from the Board of Directors was to reject purchase of the new machine. By way of explanation, the Board emphasised that the company had already made an investment of £100,000 in the old machine and as the remaining life of the machine was four years the original cost would be wasted. In fact, the company would make a loss of £50,000 if the machine was sold now for £30,000.
Question 2
Based on the information in outlined in Appendix Q2.1 and Q2.2, evaluate the proposal to move the manufacturing facility from China to Vietnam. Use Discounted Cash Flow (DCF) analysis. Calculate Net Present Value (NPV) for the project and give a clear recommendation whether the proposal should proceed. Your answer should include a review of all the assumptions you make that need to be factored into the decision-making process. Set out your analysis clearly and show all workings. Work to the nearest million dollars.
Appendix Q2.1
| Table 3: Analysis of Child Toy Manufacturing (Multi-Currency) | |||||||||
| China | China | China | UK | UK | UK | Total | Total | Total | |
| ¥m | ¥m | ¥m | £m | £m | £m | £m | £m | £m | |
| 2019 | 2020 | 2021 | 2019 | 2020 | 2021 | 2019 | 2020 | 2021 | |
| Product sold (units) | 8,500,000 | 7,950,000 | 6,250,000 | 6,700,000 | 5,500,000 | 5,100,000 | 15,200,000 | 13,450,000 | 11,350,000 |
| Sales | 2,178 | 2,404 | 2,113 | 238 | 200 | 175 | 596 | 582 | 500 |
| Cost of sales | 1,013 | 1,161 | 1,088 | 112 | 95 | 89 | 272 | 279 | 256 |
| Admin expenses | 370 | 481 | 454 | 41 | 39 | 38 | 102 | 115 | 108 |
| Selling & distribution expenses | 320 | 433 | 423 | 33 | 35 | 35 | 85 | 104 | 100 |
| Operating profit | 475 | 329 | 148 | 52 | 31 | 13 | 131 | 84 | 36 |
| Interest | 0 | 0 | 0 | 6 | 7 | 10 | 6 | 7 | 10 |
| Tax | 0 | 0 | 0 | 13 | 8 | 3 | 13 | 8 | 3 |
| Profit after tax | 475 | 329 | 148 | 33 | 16 | 0 | 112 | 69 | 23 |
Appendix Q2.2: Manufacturing Unit’s Business Proposal to Move Production from China to Vietnam
The following information has been prepared by a business development team. The initial capital investment to establish of a production facility on the outskirts of Hanoi City would cost US$380m. 90% of this investment would be payable at the end of year one, with the remainder payable now. The Vietnamese government incentivises foreign direct investment, with incentives including capital grant funding of up to 50% of the initial capital investment, payable in equal instalments over 5 years, starting in year 1. No writing down allowance is available on any element of the capital expenditure as a result of the capital grant provision. The grant funding is repayable if the company leaves Vietnam within 5 years.
In addition, a working capital investment of US$86m would be required at the outset of the investment. A subsidiary company (Jasmine Vietnam) would be the corporate vehicle through which the company would operate in Vietnam. US$30,000 has already been incurred to date exploring the legal structure of a company in Vietnam.
A loan facility of US$380m would be established with Bank Vietnam to finance the construction of the production facility, with and expected interest rate cost of 12%. In addition, an overdraft facility of US$100m would be established with an interest rate cost of 15%.
Jasmine Group’s benchmark cost of capital for appraisal of investments of this nature is 10%.
The following plant saving projections have been provided and are expressed in current terms:
| Table 4: Project savings projection | |||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| $m | $m | $m | $m | $m | |
| Reduced labour costs | 30 | 28 | 26 | 24 | 22 |
| Savings on distribution costs | 10 | 10 | 10 | 10 | 10 |
The corporate tax rate for investors in Vietnam is 5% based on sales value for the relevant year and is paid one year in arrears.
By relocating to Vietnam, it is expected that sales demand will increase 25% compound per annum over the 2021 sales units achieved from the China plant. The reduced cost base on relocating to Vietnam is expected to enable a lower average sales price of US$40 per unit to be achieved thus generating the additional sales demand. A net margin of 20% is assumed on the additional sales.
An estimate of US$30m per annum (in current terms) has been computed for the allocation of central fixed costs of the parent entity to this activity.
Plant closure and wind down costs of the China facility are expected to be equivalent of US$70m, with 30% payable now, and the balance payable at the end of year 1.
As part of the conditions for the original investment in China (and any incentives received by Jasmine), the sale of the plant and associated lands in China cannot be realised until year 3 post cessation of activities. The expected net sales value in year 3 is US$160m. The land in China had an original cost of US$45m.
You may ignore inflation.
All transactions have been reflected in US$ as part of the capital proposal generation. There is no tax impact on transactions included in the NPV analysis associated with the China facility. The capital grant received from Vietnamese government is not subject to tax in Vietnam.
Question 3
Based on the information given in Appendix Q3.1, answer the following questions.
- a.In the context of ‘Vision 2027’, the new management is considering building a new factory in South Korea. The Korean subsidiary will require an initial investment of 160,000m South Korean Won (KRW). Jasmine can borrow money to finance this investment in the UK market, in France, or in South Korea. Table 5 offers information about the borrowing costs in different currencies and an estimation of the future value of FX. Discuss the foreign exchange risk associated with this expansion plan and advise which is the best way to finance the Korean factory
- b.Mr Jordan is considering moving the Chinese factory to South Korea. What are the risks that would be caused by relocating production?
- c.The research department of a large financial institution provided inflation expectations for the next five years. According to the forecasts, UK will have 2% more inflation than France and 4% higher inflation than South Korea. On the basis of this new evidence, would you reconsider your proposal with regard to financing the Korean factory? Explain your answer.
- Appendix Q3.1: Borrowing costs, exchange rates and expected appreciation of currencies
| Table 5: Borrowing costs | |
| Initial investment (KRW) | 160,000 |
| Interest rate in UK (5-year loan) | 8% per annum |
| Interest rate in South Korea (5-year loan) | 16% per annum |
| Interest rate in France (5-year loan) | 10% per annum |
| Spot exchange rate: KRW per GBP | 1,600.00 |
| Expected appreciation of GBP in relation to KRW | 5% per annum |
| Spot exchange rate: EUR per GBP | 1.20 |
| Expected appreciation of GBP in relation to EUR | 3% per annum |
Question 4
Jasmine has well established export markets but if the Board approves Vision 2027, it will begin to enter new markets abroad.
- a.What options does Jasmine have to best support its new foreign operations when considering where to borrow long-term funds?
- b.What finance methods might Jasmine adopt to satisfy itself that it will be paid for shipping goods to new importers?
