Calculate the following from the data below:
- incremental cash flows
- present values
- NPV (net present value)
- IRR
- Payback period
Data:
The production equipment required for the proposed new line is expected to cost £500,000 and last for five years before being replaced by modified product designs. The residual (scrap) value of the machinery at the end of the project’s life is expected to be about £50,000. Marketing Manager Bruce Dwayne strongly supports the proposal for manufacturing Baldacci (new project), quoting his market research data, which indicates that a quantity of 80,000 units could be sold in the first year, and the unit sales could be expected to grow at a rate of 6% per annum, without any adjustment of the selling price. The current estimate of the selling price is £10 per unit. However, he concedes that there is likely to be some reduction of sales of the lower-priced Micro brand of memory stick (company's main product line at present). Although Micro sells for only £8, the shift in demand to the new memory stick could be expected to result in Micro’s sales falling below the level they would otherwise have been at; the amount of this fall in Micro’s sales is likely to be 20,000 units per year in the first two years, but only 10,000 units per year thereafter. This fall in turnover would not affect the overhead costs, and savings would be limited to the variable costs per unit of Micro, which are presently £3.50.
DMS’s trainee Accountant, Maisie Misled, has drawn up the following estimates of the costs connected with the new project:
Direct costs (per unit) Materials:
10 grammes of Material A @ £0.15 per gramme.
2 grammes of Material B @ £0.12 per gramme.
1 unit of Component X at £0.16 per unit.
1 unit of Component Y @ £0.30 per unit.
Labour: 20 minutes of skilled labour @ £3.60 an hour.
10 minutes of unskilled labour @ £1.80 an hour.
Other variable costs: £0.30 per unit.
Indirect costs Annual recurring overheads attributable to the new product
Apportionment of rent payable for factory building £40,000
Apportionment of administrative costs (including managerial & supervisory salaries) £60,000
Selling expenses for promotion & distribution of Baldacci £150,000
Interest charges on term loan raised for the project £100,000
Other recurring overheads attributable to Baldacci £45,000
6 Non-recurring overheads attributable to the new product Product development expenses incurred so far £125,000
Market research expenses incurred earlier this year £90,000
Other overheads attributable to Baldacci £45,000
In addition to the above, depreciation would have to be charged over the life of the project, using the company’s usual straight-line method. The amount of £40,000 is the factory building rental which is the proportionate charge for this portion of the building (out of the total rental of £120,000 paid by the company for the entire building). The stores vacated from the area to make room for the new project equipment would need to be housed in an alternative building to be rented at a cost of £20,000 per annum. Materials Manager Michaela Mann reports that a quantity of 700 kilograms of Material A is lying in stock. As the company had no other use for this material at present, it was about to be disposed of for its net realisable value of £56,000 for the lot. Michaela and Bruce have together made an estimate of the working capital required for the project, taking into account optimum inventory levels, trade credit available on purchases, and the likely level of outstanding debtors. They estimate that the company would need to input additional net working capital of the new project of £80,000. The required level of working capital investment would need to be in place at the start of the project and would expected to be fully recovered at the end of the fifth year. The Personnel Manager, Mr. Baz Sakham, feels that one junior manager would need to be recruited for the project at an annual salary of £25,000. However, no additional supervisor needs to be appointed because one of the existing supervisors (who is due to retire immediately on a final salary pension of £8,000 per year) can be asked to stay on for five years at his existing salary of £20,000 per year. Retention of the supervisor for five years would not alter the rate of pension ultimately payable to him. As a hurdle rate for the project evaluation, Jay proposes to use a cost of capital of 12%. Jay has expressed concern that the estimates of costs and revenues are all at today’s prices and do not take into account inflationary pressures.