Peaches plc operates in the smart phone industry. As part of its strategic planning round Peaches…

Peaches plc operates in the smart phone industry. As part of its strategic planning round Peaches plc has generated several strategic options. One option is the launch of a product to compete with Apple’s IPhone. In order to differentiate their smart phone Peaches has approached Zoggle plc which specialises in advanced communication’s technology, with a view to acquiring a patent. Zoggle has agreed to sell Peaches a patent for £5 million and provided the contract is signed within one week. In order to arrive at a strategic option to launch a smart phone to compete with Apple’s iPhone, it was necessary to conduct some market research. A market research project was carried out and the profit estimates below are based on that research.

If this strategic option is selected then Peaches plc. will have to increase its capacity. There will be a requirement for an additional manufacturing unit at a cost of £2 million plus £6 million for high end manufacturing non-current assets. Further, Zoggle plc is based in Preston but Peaches is located in London; Peaches has decided to locate the manufacturing unit in Preston in order to take advantage of the know-how of Zoggle. However, the cost of land to build on is expected to cost £3 million. Peaches plc always assumes that non-current assets have no residual value. The straight line method is used to calculate depreciation. Land is not depreciated. Patents are amortized over ten years.

Peaches plc. estimate that the product life-cycle of the proposed new smart phone is 10 years at which point the manufacturing site will be demolished at a cost of £500 thousand and the manufacturing non-current assets are estimated to be sold for £500 thousand. It is estimated that land and property prices will have remained exactly static when Peaches comes to dispose of the land at the end of 10 years.

Finance which will be directly related to the launch and establishment of this product will cost £300K (interest) paid at the end of each year in arrears. Additional working capital requirements are estimated to be £1.2 million.

The profits shown below are after charging depreciation, finance interest and launch costs (£1.5 million, all in year one).

Strategic Option 1A

Year

Profit/(loss) £m

Year

Profit/(loss) £m

1

(2.3)

6

10

2

1.5

7

8

3

6

8

6

4

8

9

4

5

10

10

2

Although the financial director likes strategic option 1A she believes that leasing instead of buying a manufacturing unit would be a course of action with less risk. From past experience she estimates that such a lease would cost £1.4 million to purchase (payable in advance) with ten annual lease payments of £800k. The manufacturing non-current assets will still have to be purchased as before. (The financial director’s view will be known as: Strategic Option 1B)

The marketing director puts a third option on the table. He believes that a cosmetic alteration to an existing smart phone would be a sufficient level of differentiation to capture some of iPhones market share. A beneficial consequence of this route is that the requirement to purchase the patent would no longer be necessary. There would be no need to opening a manufacturing unit in Preston to take advantage of the expertise of Zoogle but existing capacity in London could be used by adding an additional shift. A significant portion of the non-current manufacturing assets would need to be upgraded at a cost of £4 million but there wouldn’t be a requirement for finance and consequently no interest payments.

The profits from this phone, after charging depreciation on the new machinery, are estimated as follows:

Strategic Option 1C

Year

Profit/(loss) £m

Year

Profit/(loss) £m

1

2.1

6

2.6

2

3.6

7

2.6

3

3.6

8

1.6

4

3.6

9

1.6

5

2.6

10

0.6

Notes:

1. Peaches plc.’s cost of capital (or discount rate) is 12.5% p.a.

2. Work to the nearest £000 when performing your calculations.

3. You are expected to use a word-processor and a spread sheet for this assignment.

4. When performing your calculations, show your workings and do not use the dedicated functions for PV, NPV or any other Excel function and some calculators.

5. Remember your training: read the question properly, keep it simple and don’t stress. If there is a term that you don’t understand then look it up.

Required – 50%

1. For each of the three alternatives, calculate the following:

a. The cash flows;

b. The accounting rate of return;

c. The payback period;

d. The net present value;

e. The internal rate of return (using the ‘interpolation’ method).

2. Between 1000 to 1500 words excluding any references, create an executive report for Peaches plc.’s board of directors, appraising the capital investment decision facing them. Justify any recommendations you make and discuss any reservations you have concerning the application and interpretation of the techniques used. (Any work in excess of 1500 words will be ignored.)