Warden Limited (Warden) is a listed company based in the USA and manufactures electronic devices. One of its devices, the Xâ€IT, is designed exclusively for the North American market. In order to start the production, Warden plans to buy a new machine. The cost of the machine, payable immediately, is $800,000 and the machine has an expected life of five years. Additional investment in working capital of $90,000 will be required at the start of the first year of operation. At the end of five years, the machine will be sold for scrap, with the scrap value expected to be 5% of the initial purchase cost of the machine. The machine will not be replaced. Production and sales from the new machine are expected to be 100,000 units per year. Each unit can be sold for $16 per unit and will incur variable costs of $11 per unit. Incremental fixed costs arising from the operation of the machine will be $160,000 per year. Warden has an afterâ€tax cost of capital of 11% which it uses as a discount rate in investment appraisal. The company pays profit tax one year in arrears at an annual rate of 30% per year. Capital allowances and inflation should be ignored. Due to the uncertainty about economy, Warden is more concerned if the Xâ€IT can be sold at $16. Any change in price may have an impact on the success of the investment. Currently, securities market condition is not such good that fund may not be easily to get although Warden may use its internal source to support the investment.
Prepare a report for the Board of Directors of Warden Co that
a) Evaluate whether or not Warden Co should purchase machine to produce the Xâ€IT. Explain which evaluation methods should be the most appropriate. In the most appropriate evaluation, include all relevant calculations in the form of a financial assessment and explain any assumptions made.
b) Explain the difference between risk and uncertainty in the context of investment appraisal, and suggest how Warden can quantify the risk in change in selling price and comment on our findings.
c) The board heard about scenario analysis in a seminar but just know about the term. Briefly explain in the report how scenario analysis can be used to incorporate risk into the investment appraisal.
d) Discuss the nature and causes of the problem of capital rationing in the context of investment appraisal, and explain how this problem can be overcome in reaching the optimal investment decision for a company.
The question belongs to Accounting and it discusses about preparing a report addressing the board of directors of Warden Co. about purchasing a machine, the risk and uncertainty of the investment and also discusses about nature and causes of capital rationing in investment appraisal.
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