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CASE STUDY

HOPE ELECTRONICS LTD - A

Mark Whittington1 and Ken Bates2
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BACKGROUND

Hope Electronics Ltd is an established company which has continued to be

profitable in recent years despite operating at below full capacity. Continued
investment in research and development has produced a new innovative
product, the microwave drier, which is able to dry most garments at
considerably lower cost than conventional tumble driers. Market research
supports the proposed price of £400 per drier with the following predicted sales
over the next five years:

Year Unit Sales

1 20,000
2 30,000
3 35,000
4 42,000
5 40,000

1 Senior Lecturer at University of Aberdeen Business School

2 Lecturer at Victoria University of Wellington, New Zealand

Hope - A  M Whittington & K Bates

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The company accountant has collated the following costing information

relating to the drier proposal:

£’000s
Research and Development Costs incurred to date 200
Additional pre-production development costs 800
Capital cost of production machinery 6,700
Resale value of machinery after 5 years 300

Due to the additional manufacturing and selling activity Hope’s working

capital requirements will increase by £200,000 at the start of the project, with
further increases at the end of each year (in preparation for increased activity
in the subsequent year) as follows: end of year 1, £200,000; end of year 2,
£300,000; end of year 3, £400,000; end of year 4, £500,000. This additional
working capital is assumed to be recovered in full at the end of year 5.

£ per drier £000s

per annum

Manufacturing Costs
Direct Labour 75
Direct Materials 75
Variable Overheads 75
Depreciation of Machinery 1,280
Amortisation of R&D costs 200
Other fixed costs (Note 1) 1,200
Selling and Distribution Costs
Variable 25
Fixed (Note 2) 300

Note 1 To increase output above 38,000 driers shift working

will be introduced and annual fixed manufacturing costs
will rise by £600,000.

Note 2 Annual fixed selling and distribution costs will need to

increase by £100,000 for sales to exceed 33,000 driers
and a further £100,000 for sales to exceed 38,000 driers.

The accountant has specifically excluded all costs relating to the factory unit
in which the new machinery will be installed and operated. She explains that
this unit is on a short lease which has only 7 years left to run and Hope
Electronics pays £1,500,000 per annum rental. There is no prospect of Hope
using this unit unless the current project is accepted. Whilst Hope Electronics
has not been using this unit, part of it has been sub-let to a neighbouring
company for use as a warehouse at a monthly rent of £100,000. This
arrangement could continue until the lease expires.

Hope - A  M Whittington & K Bates

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If the drier project goes ahead Hope can initially share the factory unit with the
lease but the rental income will fall to £50,000 per month. Once output exceeds
30,000 units Hope will need additional packing and storage space, so rent will
be reduced to £25,000 per month. If output exceeds 38,000 driers Hope will
need the whole factory unit and will lose all rental income.

Given its critical nature you have been called in as a consultant to advise
Hope’s board of directors with respect to this project. Hope normally ignores
tax and inflation when considering such capital assessments and uses a
discount rate of 12%.

REQUIRED:

1. Prepare your presentation to the board of Hope Electronics Ltd advising

whether or not to go ahead with this project based on the payback period
appraisal method and taking into consideration that Hope has some short
term liquidity problems. (Ignore tax and inflation). Include advice on the
strengths and weaknesses of the appraisal technique you have used in
assessing the microwave tumble drier project.

2. Prepare your presentation to the board of Hope Electronics Ltd advising

whether or not to go ahead with this project based on the Net Present Value
appraisal method (Ignore tax and inflation). Include advice on the
strengths and weaknesses of the appraisal technique you have used in
assessing the microwave tumble drier project.

3. As the microwave drier uses new technology this is a relatively high risk
project. Explain how this risk might be reflected in the project appraisal,
and how your advice may be amended as a result of appropriate
consideration of the specific risks of this project.

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Hope - A  M Whittington & K Bates