Exercise on investment appraisal



TREASURY Company is a jewelry manufacturer that is now facing troubles in its activities.
The sales of its main product, a gold and titanium necklace, are stagnant and production costs are higher than those of competitors.
The overall necklace market is equal to 50,000 units (annual value).
The company owns the 8% of this market.
The necklaces are sold at a price of 700 € each, while the production costs amount to 200 € each unit.
To solve its problems, TRESURY Company contacted the Yes or No consulting company, who proposes a recovery plan in two stages:

  1. Today (Year 0): make an investment in product redesigning to renew necklaces according to client needs.
    This operation requires a revision of the processing cycle to simplify some particularly complex production activities.
    The estimated costs for this phase are equal to 400,000 €.
    The expected benefits are expected to occur from Year 1.
    They include the increase of TREASURY Company’s market share, which is expected to pass from 8% to 12%, and the reduction of unitary production cost of 15 €;
  2. Year 2: replace the production machine currently in use with more advanced technological solutions.
    Expected costs of this investment equal 2,5 million € (entirely paid in Year 2).
    This technological upgrade would allow further reduction in unitary production costs of 30 €/u.
    The useful life of the new equipment is estimated in 5 years.

The Yes or No consulting company requires a compensation of 300,000 €, which can be paid in a one solution at the third year (Year 3), when the new machinery is expected to become fully operational.
Assuming a cost of capital of 6%, evaluate the convenience of the proposed investment.