Jim’s Shoes Ltd manufactures elite sports shoes. The main raw material for the production of these sport shoes is the shoe soles. Jim’s Shoes currently purchases these shoe soles at £4.50 per sole and it has locked this price in for the next four years with an agreed contract. The company is considering producing these soles in-house and is planning to buy a new machine that will allow them to manufacture these soles. The new machine to manufacture the shoe soles will cost Jim’s Shoes £1,500,000. Jim’s Shoes expects that after four years, the machine will have a salvage value of £500,000. The costs associated with the planned project is as follows: Variable cost (per shoe sole produced) £0.50 Fixed costs (per annum) £500,000 The additional fixed costs for Jim’s Shoes include £150,000 for machine maintenance and a charge for depreciation on the machine which is calculated on a straight-line basis over the useful life of the asset. All quoted prices above are in current terms, the following is the expected annual increases due to inflation. Variable cost 4% Maintenance costs 6% Other fixed cost 5% The finance manager of Jim’s Shoes Ltd has provided in the table below the annual demand for the shoe soles based on the expected sales for the company. Year 1 Year 2 Year 3 Year 4 Demand (units) 120,000 130,000 140,000 170,000 The company pays annual tax of 30% in arrears; the company can claim tax allowable depreciation at a rate of 25% on the cost of the equipment calculated on a reducing balance basis. The balancing allowance will be claimed in Year 4 when the machine is sold. /Question continues on the next page.3 Required: a) Calculate the Net Present Value (NPV) for the proposed project using the after-tax discount rate of 10% and advise the management of Jim’s Shoes Ltd on the desirability of investing in this machine. b) Discuss the limitations of NPV in appraising investment projects. c) Discuss how corporate governance can help mitigate possible agency problems Jim’s Shoes Ltd.
Jim’s Shoes Ltd manufactures elite sports shoes. The main raw material for the production of these sport shoes is the shoe soles. Jim’s Shoes currently purchases these shoe soles at £4.50 per sole and it has locked this price in for the next four years with an agreed contract. The company is considering producing these soles in-house and is planning to buy a new machine that will allow them to manufacture these soles. The new machine to manufacture the shoe soles will cost Jim’s Shoes £1,500,000. Jim’s Shoes expects that after four years, the machine will have a salvage value of £500,000. The costs associated with the planned project is as follows: Variable cost (per shoe sole produced) £0.50 Fixed costs (per annum) £500,000 The additional fixed costs for Jim’s Shoes include £150,000 for machine maintenance and a charge for
All quoted prices above are in current terms, the following is the expected annual increases due to inflation.
Variable cost 4%
Maintenance costs 6%
Other fixed cost 5%
The finance manager of Jim’s Shoes Ltd has provided in the table below the annual demand for the shoe soles based on the expected sales for the company.
Year 1 Year 2 Year 3 Year 4
Demand (units) 120,000 130,000 140,000 170,000
The company pays annual tax of 30% in arrears; the company can claim tax allowable depreciation at a rate of 25% on the cost of the equipment calculated on a reducing balance basis. The balancing allowance will be claimed in Year 4 when the machine is sold. /Question continues on the next page.3
Required:
a) Calculate the
b) Discuss the limitations of NPV in appraising investment projects.
c) Discuss how corporate governance can help mitigate possible agency problems Jim’s Shoes Ltd.
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