High Hills plc produce underwater turbines to generate energy and are considering introducing machinery that will reduce the labour hours required to produce a turbine from 5 hours to 2 hours for the remainder of the product life cycle of 3 years.
The production volumes are forecast based on the state of the industry as follows:
Industry Year 1 Year 2 Year 3
Weak (probability 50%) 3,000 units 4,000 units 3,000 units
Strong (probability 50%) 5,000 units 6,000 units 7,000 units
The employees hourly rate for the coming year is £7.00 rising in year 2 and year 3 to £8.00 and £9.00 respectively.
The machinery has a capital cost of £200,000 with an estimated residual value at the end of year 3 of £60,000 and capital allowances are at 25% on a reducing balance basis.
The company pays corporation tax (income tax) at a rate of 30%. The company assesses projects of this type using a discount rate of 8%. Any difference between the written down value and proceeds from the sale may be claimed as a tax credit in the year of the sale. Taxes are considered one year in arrears.
Required:
a) Calculate the annual cost savings for years 1, 2 and 3.
b) Calculate the impact on taxable profits for years 1, 2 and 3.
c) Calculate the total cash flows for each year.
d) Calculate the expected present value of the project suggesting whether the company
should invest in the new machinery.
e) Discuss how the company might consider risk in reviewing projects of this type.
a) To calculate the annual cost savings, we need to find the difference in labor hours required before and after introducing the machinery and multiply it by the hourly rate for each year.
Year 1:
Labor hours saved per turbine = 5 hours - 2 hours = 3 hours
Cost savings per turbine = 3 hours * £7.00 = £21.00
Annual cost savings = Cost savings per turbine * Production volume
Weak Industry: £21.00 * 3,000 units = £63,000
Strong Industry: £21.00 * 5,000 units = £105,000
Year 2:
Labor hours saved per turbine = 5 hours - 2 hours = 3 hours
Cost savings per turbine = 3 hours * £8.00 = £24.00
Annual cost savings = Cost savings per turbine * Production volume
Weak Industry: £24.00 * 4,000 units = £96,000
Strong Industry: £24.00 * 6,000 units = £144,000
Year 3:
Labor hours saved per turbine = 5 hours - 2 hours = 3 hours
Cost savings per turbine = 3 hours * £9.00 = £27.00
Annual cost savings = Cost savings per turbine * Production volume
Weak Industry: £27.00 * 3,000 units = £81,000
Strong Industry: £27.00 * 7,000 units = £189,000
b) To calculate the impact on taxable profits, we simply subtract the annual cost savings from the current labor costs in each year.
Year 1:
Taxable profit impact = Labor cost reduction - Annual cost savings
Weak Industry: £7.00 * 5 hours * 3,000 units - £63,000
Strong Industry: £7.00 * 5 hours * 5,000 units - £105,000
Year 2:
Taxable profit impact = Labor cost reduction - Annual cost savings
Weak Industry: £8.00 * 5 hours * 4,000 units - £96,000
Strong Industry: £8.00 * 5 hours * 6,000 units - £144,000
Year 3:
Taxable profit impact = Labor cost reduction - Annual cost savings
Weak Industry: £9.00 * 5 hours * 3,000 units - £81,000
Strong Industry: £9.00 * 5 hours * 7,000 units - £189,000
c) To calculate the total cash flows for each year, we need to consider the annual cost savings and any changes in tax liabilities.
Year 1:
Cash flow = Annual cost savings + Tax liability
Weak Industry: £63,000 + (Taxable profit impact * 30%)
Strong Industry: £105,000 + (Taxable profit impact * 30%)
Year 2:
Cash flow = Annual cost savings + Tax liability
Weak Industry: £96,000 + (Taxable profit impact * 30%)
Strong Industry: £144,000 + (Taxable profit impact * 30%)
Year 3:
Cash flow = Annual cost savings + Tax liability
Weak Industry: £81,000 + (Taxable profit impact * 30%)
Strong Industry: £189,000 + (Taxable profit impact * 30%)
d) To calculate the expected present value of the project, we need to discount the cash flows from each year using the discount rate of 8% and sum them up.
e) In reviewing projects of this type, the company can consider risk by assigning probabilities to the different industry scenarios (weak and strong). This allows them to weigh the expected cash flows based on the likelihood of each scenario occurring. Additionally, sensitivity analysis can be performed by evaluating the impact of changes in key variables such as production volumes, labor rates, and discount rate on the project's profitability. By considering these factors, the company can better assess the risks associated with the investment decision.
To calculate the annual cost savings, we need to determine the labor cost reduction for each year. Here's how you can calculate it:
a) The labor hours reduction is from 5 hours to 2 hours per turbine.
Year 1:
Labor cost reduction per unit = (5 hours - 2 hours) * Hourly rate for Year 1
Labor cost reduction = Labor cost reduction per unit * Forecasted units for Year 1
Total cost savings for Year 1 = Labor cost reduction * (1 - Tax Rate)
Year 2:
Labor cost reduction per unit = (5 hours - 2 hours) * Hourly rate for Year 2
Labor cost reduction = Labor cost reduction per unit * Forecasted units for Year 2
Total cost savings for Year 2 = Labor cost reduction * (1 - Tax Rate)
Year 3:
Labor cost reduction per unit = (5 hours - 2 hours) * Hourly rate for Year 3
Labor cost reduction = Labor cost reduction per unit * Forecasted units for Year 3
Total cost savings for Year 3 = Labor cost reduction * (1 - Tax Rate)
b) To calculate the impact on taxable profits, we need to deduct the cost savings from taxable profits.
Impact on taxable profits for Year 1 = Total cost savings for Year 1
Impact on taxable profits for Year 2 = Total cost savings for Year 2
Impact on taxable profits for Year 3 = Total cost savings for Year 3
c) The total cash flows for each year can be determined by considering the cost savings, tax credits, capital allowances, and the change in working capital.
Total cash flows for Year 1 = Cost savings for Year 1 + Tax credit from the sale of machinery (if any) + Capital allowances (if any) + Change in working capital
Total cash flows for Year 2 = Cost savings for Year 2 + Tax credit from the sale of machinery (if any) + Capital allowances (if any) + Change in working capital
Total cash flows for Year 3 = Cost savings for Year 3 + Tax credit from the sale of machinery (if any) + Capital allowances (if any) + Change in working capital
d) The expected present value of the project can be calculated by discounting the total cash flows using the discount rate. If the present value is positive, it suggests that the company should invest in the new machinery.
Expected present value of the project = (Total cash flows for Year 1 / (1 + Discount rate) ^ 1) + (Total cash flows for Year 2 / (1 + Discount rate) ^ 2) + (Total cash flows for Year 3 / (1 + Discount rate) ^ 3)
e) In reviewing projects of this type, the company might consider risk by assessing the probability of industry conditions (weak or strong) and their potential impact on the forecasted units and profitability. They might also evaluate the project's sensitivity to changes in parameters such as labor rates, tax rates, discount rate, and machinery costs. Additionally, the company might conduct a sensitivity analysis and scenario planning to understand the potential outcomes under different risk scenarios and make informed decisions based on that information.