QUESTION 2
Polyester division of Quintex Ltd has forecast a net profit before tax of N$3 million per annum for the next five years, based on net capital employed of N$10 million. Plant replacement over this period is expected to be equal to the annual depreciation each year. These figures compare well with the group’s required rate of return of 20% before tax. Polyester’s management is currently considering a substantial expansion of its manufacturing capacity to cope with the forecast demands of a new customer.
• The customer is prepared to offer a five-year contract providing Polyester with
annual sales of N$2 million.
• In order to meet this contract, a total additional capital outlay of N$2 million is envisaged, being N$1.5 million of new fixed assets plus N$0.5 million of working
capital. The plant life is expected to be 5 years with zero scrap value.
• Operating costs for the contract are estimated to be N$1.35 million per annum,
excluding depreciation.
• This is considered to be a low-risk venture as the contract would be firm for 5 years
and the manufacturing processes are well understood within Polyester.
• The consequences of income tax on the proposal may be ignored.
Required:
Calculate the impact of accepting the contract on Polyester division’s:
a) Return on investment (ROI) for each of the 5 years
b) Residual income (RI), using 20% imputed interest rate, using average capital employed per annum, and say, with reasons, for each method whether or not it would be attractive to Polyester division’s management
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