the management of Garnett

1. Garnett plc. has seen sales in one of its product lines decline over the last two years. The production is currently subcontracted and any changes require a six month notice, so the management of Garnett has to decide now what to do for their most important advertising and sales period, which starts in September every year. The two identified options are:

· Option A – Invest £4million to make small changes to the product design and manufacturing process, which will generate increased cash flows in the short term;

· Option B – completely redesign the product and production process, which will have a longer lasting effect on cash flows, but will require an investment of £15million.

Garnett’s required rate of return on investments is 10.25% and the estimated cash flows for the two options are as follows (in ‘000s):

Year	Option A	Option B
1	2,600	1,000
2	3,500	3,400
3	4,300	6,000
4	1,600	6,000
5		6,000
6		6,000
7		4,600
8		4,000
9		3,600
10		2,400

Required:

a) Discuss and compare the different types of investment appraisal methods Garnett can use, including a discussion of the advantages and disadvantages of each.

b) If Garnett had a rule that all investment projects need to payback within 3 years, what project would be chosen? Comment.

c) Make a recommendation as to which project should be undertaken.

d) If Garnett believes there is an opportunity to start exporting its product line to another country once sales are finished in its home country (i.e. from year 5), and it thinks it will be able to generate cash flows of £660,000 in the first year, £1,540,000 in the second and £2,300,000 in the subsequent four years, would your answer to part c) change? How?

The majority of banks, when making decisions on mortgage applications, will look at two indicators: salary and borrowing as a percentage of purchase price. On the first indicator, banks are normally willing to lend 2.5 times one’s salary or 3.25 times joint salary in a joint mortgage application, while currently most banks will lend up to 75% of the property price on their best rate with penalties for higher percentages. John and Julia are getting married and decided to buy a flat to move into once they do. You have been given the following data:

· John’s current salary is £39,000 p.a. and Julia’s is £37,500 p.a. plus a bonus likely to be around £5,000 (based on previous 3 years experience);

· Both have jobs where they partly telecommute, so on average each works from home 2 days a week;

· Their total savings at the moment are £25,000;

· John owns a flat which he would sell, and has been advised that he should be able to sell it for £150,000. The mortgage outstanding on this flat is £112,000;

· John and Julia are planning to apply for a 25 year mortgage;

· The average price of flats in the area they would like to move into is as follows: studios £150,000; 1-bedroom £220,000; 2-bedroom £325,000; 3-bedroom £450,000; 4-bedroom £600,000

· Having contacted a financial adviser, he has identified the following as the best available mortgage rates:

· Repayment fixed rate for 2-years of 3.69%. After that period, the rate reverts to the bank’s standard variable rate, which currently is 5.7%;

· repayment fixed rate for 5-years of 4.29%. After that period, the rate reverts to the bank’s standard variable rate, which currently is 5.7%;

· interest only mortgage at 5% for the life of the loan. In this instance, you would be required to create an investment fund, which pays an interest rate of 3.9% to cover the repayment of the mortgage.

· All the rates above are for loans of up to 75% of the property value. There is an increase of 1.5%age points if borrowing is up to 90% of the property value.

Assess:

a) What is the maximum John and Julia can borrow while taking advantage of the bank’s best mortgage rate;

b) The amount you advise them to borrow, given their financial and professional situation;

c) Which is the best mortgage that John and Julia can take out (assume they take out the amount you recommended in b);

d) Whether that advice would change if interest rates went up or down by up to three percentage points.