Question

Scenario:

Midal cables limited, is currently considering the launch of a new product. A market survey was recently commissioned to assess the likely demand for the product and this showed that the product has an expected life of four years. The survey cost $30,000 and this is due for payment in four months’ time. On the basis of the survey information as well as internal management accounting information relating to costs, the assistant accountant prepared the following profit forecasts for the product.

Year	1	2	3	4
	$'000	$'000	$'000	$'000
Sales	180	200	160	120
Cost of sales	(115)	(140)	(110)	(85)
Gross profit	65	60	50	35
Variable overheads	(27)	(30)	(24)	(18)
Fixed overheads	(25)	(25)	(25)	(25
Market survey written off	(30)
Net profit/(loss)	(17)	5	1	(8)

These profit forecasts were viewed with disappointment by the directors and there was a general feeling that the new product should not be launched. The Chief Executive pointed out that the product achieved profits in only two years of its four-year life and that over the four-year period as a whole, a net loss was expected. However, before a meeting that had been arranged to decide formally the future of the product, the following additional information became available:

The new product will require the use of an existing machine. This has a written down value of$80,000 but could be sold for $70,000 immediately if the new product is not launched. If the product is launched, it will be sold at the end of the four-year period for $10,000.

Additional working capital of $20,000 will be required immediately and will be needed over the four-year period. It will be released at the end of the period.

The fixed overheads include a figure of $15,000 per year for depreciation of the machine and $5,000 per year for the re-allocation of existing overheads of the business.

The company has a cost of capital of 10%.

Ignore taxation.

Required

Use integrated financial software you are familiar with and perform the task below. For example, you may use excel spreadsheet for calculation and presentation of cash flow and Microsoft word to explain the phenomenon.

Calculate the incremental cash flows arising from a decision to launch the product.    

Calculate the approximate internal rate of return of the product.

Explain, with reasons, whether or not the product should be launched. (50-100 words)

Answer 1

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