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Situation 8 Solve
Situation 8 Solve
Situation 8 Solve
Benland plc manufacture and fit a variety of children’s playground equipment. The company at
present purchases the rubber particles used in the playground surfacing from an outside supplier, but
is considering investing in equipment which would process and shred used vehicle tyres to produce
equivalent rubber particles. One tonne of purchased particles is saved per tonne of tyres processed.
Disposal of used tyres is becoming an environmental problem, and Benland believes that it could
charge £40 per tonne to garages/tyre distributors wishing to dispose of their old tyres. This price
would be 20 per cent lower than the cost of the landfill sites currently being used, and so Benland
believes that it would face no risk or shortage of supply of what would be a key raw material for the
business. The price charged by Benland for tyre disposal (£40 per tonne) remains fixed for the next
five years. The cost to Benland of purchased particles is £3.50 per tonne for each of the next five years,
and the price has been contractually guaranteed. If the contract is terminated within the next two years,
Benland will be charged an immediate termination penalty of £100,000 which will not be allowed as a
The machine required to process the tyres will cost £1.06 million, and it is estimated that at the end of
year five the machine will have a second-hand value of £120,000 before selling costs of £5,000.
Sales of the playground surfacing which uses rubber particles are forecast to be £1.2 million in year
one, rising by 10% per year until year five but prices will remain constant. The new equipment will
result in Benland incurring additional maintenance costs of £43,000 per year. 80,000 tonnes of tyres
need to be processed in order to meet the raw material requirement for the forecast sales in year one.
Processing costs are estimated at £37 per tonne (excluding additional depreciation and maintenance).
Benland is subject to corporation tax at a rate of 33%, payable one year in arrears. Capital
expenditure is eligible for 25% allowances on a reducing balance basis, and sales proceeds of assets
are subject to tax. Benland has sufficient profits to fully utilise all available capital allowances.
Required:
(a) Using 12% as the after-tax discount rate, advise Benland on the desirability of purchasing the tyre
processing equipment.
(12 marks)
(b) Discuss which cash flows are most important in determining the outcome of the proposed
investment and how Benland might seek to minimise the risk of large changes in predicted cash
flows.
(8 marks)
(20 marks)
Answer:
(b) The most important costs are those of the equipment itself and the tyre processing. The final sales
volumes and estimated receipts from garages per tonne of tyres recycled are also critical in
determining the viability of the investment. A significant change in any of these figures could alter the
The purchase price of the equipment is of critical importance, but this is a one off cost, and so the
time scale of its variability’s strictly limited. Once Benland has signed a purchase contract, the cost is
fixed. In order to avoid any risk of a price change in the immediate short term, Benland should ask the
supplier to provide a fixed price quotation, which remains valid for a prescribed period. As long as the
purchase is made within the defined period, the company can be certain of the price to be paid. The
second-hand value of the equipment at the end of the investment period is not of great significance,
as its estimated present value is just £65,000, or 10% of the net present value.
In order to avoid the risk of large scale changes in processing costs, it may be possible for Benland to
use engineering calculations to assess the expected processing time, maintenance requirements, and
yields per tonne of used tyres. (There is insufficient detail on the question to assess which of these
aspects is most important in determining the overall cost.) It may also be possible to obtain general
cost information from other users of similar equipment, in order to verify the accuracy of Benland’s
current estimates. Once production has commenced, statistical process controls can be used to help
the company to accurately record the processing time and yields, and the amount of machine
downtime can be recorded via job-sheets. In this way changes in costs can quickly be identified. If any
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costs change by a significant amount Benland may need to revise its NPV forecast, and if necessary
look at the feasibility of disinvesting. The cash flow forecast suggests that the investment is feasible
partly because processing costs are less than the receipts from garages for used tyre disposal. If this
situation were to be reversed, then the viability of the investment may be altered.
Management of the cash flows from receipts from garages and other possible suppliers of the used
tyres should be more straightforward. If there is a cost advantage to such parties relative to the cost of
land-fill, then Benland can be assured of raw material supplies at a predictable cost. The only
circumstances under which the revenue may become less certain is if sales of the playground
equipment, and hence the company’s demand for rubber particles, rose to a level beyond that which
could be supplied from existing sources of used tyres. In such a case, the price paid for the tyres may
increase, or the company may have to revert to the use of outside suppliers to meet the shortfall in
supply. This seems unlikely, but Benland should formally assess the likelihood of sales reaching such
high levels, and monitor the company’s demand for particles relative to supply, in order to avoid any
potentially significant effect on the investment’s viability is the tax position. The appraisal is based on
the assumption of tax allowances granted on the basis of 25% of the reducing balance, and a
corporation tax rate of 33%. If either the allowances or the tax rate were to change, the NPV of the
investment would be affected. For example, if tax allowances were altered to give a 100% first year
allowance, then the cash flow impact of additional tax savings would be considerable. Conversely, if
the tax rate is reduced to, say, 25%, then the tax savings created via the capital allowances would be
reduced, but so also would the corporation tax payable on profits, and so the NPV would change.
Assessing the likelihood of changes in the tax regime is difficult, as tax rates tend to reflect political
opinion, but it is highly unlikely that tax rates would be dramatically changed. The tax aspects of the
cash flow are important, but they must be viewed as of less significance than the equipment cost,
Overall, the NPV of the project is sufficiently high to allow for some changes in all of the key variables