Scenario B - Titanium Motors

Use the following information to answer the question(s) below.

Titanium Motors currently produces 500,000 electric motors a year and expects output levels to

remain steady in the future. It buys components from an outside supplier at a price of £2.50 each. The production manager believes that it would be cheaper to make these components rather than buy them. Direct in-house production costs are estimated to be only £1.80 per component. The

necessary machinery would cost £700,000 and would be obsolete in 10 years. This investment would be depreciated to zero for tax purposes using a 10-year straight-line depreciation. The

production manager estimates that the operation would require additional working capital of

£40,000 but argues that this sum can be ignored since it is recoverable at the end of the ten years. The expected proceeds from scrapping the machinery after 10 years are estimated to be £10,000.  Titanium Motors pays tax at a rate of 35% and has an opportunity cost of capital of 14%.

Questions

1.  Calculate the NPV (net present value) of manufacturing the components in-house (rounded to nearest ,000))

2.  Calculate the IRR (internal rate of return) of manufacturing the components in-house (within 1%)

3.  Calculate the incremental cash flow that Titanium Motors will incur today (Year 0) if they choose to manufacture components in-house

4.  Calculate the incremental cash flow that Titanium Motors will incur in Year 4 if they choose to manufacture components in-house

5.  What decision would you recommend Titanium Motors take regarding manufacturing the components in-house (2 marks)?

a.   Proceed with in house manufacture since NPV is negative

b.   Proceed with in house manufacture since NPV is positive

c.   Reject in-house manufacture since NPV is negative

d.   Reject in-house manufacture since IRR is greater than 14%

Scenario C - The Harbour Restaurant

Use the information below to answer the following question(s):

The owner of The Harbour Restaurant is considering selling her restaurant and retiring.  An investor

has offered to buy The Harbour Restaurant for £350,000 whenever the owner is ready for retirement.

The owner is considering the following three alternatives:

i)  Sell the restaurant now and retire.

ii) Hire someone to manage the restaurant for the next year and retire.  This will require the owner to spend £50,000 now but will generate £100,000 in profit next year. In one year the  owner will sell the restaurant for £350,000.

iii) Scale back the restaurant's hours and ease into retirement over the next year.  This will require the owner to spend £40,000 on expenses now but will generate £75,000 in profit at the end of the year.  In one year the owner will sell the restaurant for £350,000.

Questions

1.   Calculate the NPV of option i) If the interest rate is 7%:

2.  Calculate the NPV of option ii) if the interest rate is 7%:

3.   Calculate the NPV of option iii) if the interest rate is 7%:

4.   If the interest rate is 7%, which option has the highest NPV?

5.   If the interest rate is 7%, which option has the lowest NPV?