Question

ABC plc has a new product ready for production and sale. Fixed costs of production (excluding depreciation) are expected to be £200,000 a year. This figure is made up of £160,000 additional fixed costs and £40,000 fixed costs relating to the existing business which will be apportioned to the new product. The company estimates that the product will sell 150,000 units a year over the next five years. The sale price will be £5 per unit and variable costs are estimated to be £3 per unit.

In order to produce the product, machinery priced at £520,000 is needed and immediately payable. The estimated salvage value of this machinery in five years’ time is £100,000. The business calculates depreciation on a straight-line basis. ABC plc has invested £200,000 to date in researching on the new product, and borrowed the research cost at a cost of 7 percent per annum. The machinery cost will be borrowed at a cost of 8 percent per annum.

The business has a cost of capital of 12 per cent. Ignore taxation.

a. Calculate the net present value of the product, with explanation on the working.

b. Undertake sensitivity analysis to show by how much the following factors would have to change before the product ceased to be worthwhile:

i. The discount rate.

Use the method of interpolation with r values of 12% and 20%.

ii. The initial outlay on machinery. .

iii. The residual value of the machinery.

Answer #1

**a. Net Present value :**

WN - 1 Annual Inflow = (£5 - £3)*150000 = £300000

WN - 2 Present value of Inflow :

Year | Annual Inflow | PV Factor | PV |

1 - 5 | £ 300000 | 3.6048 | £1081433 |

5 | £100000 | 0.5674 | £56740 |

Total | £1138173 |

WN - 3 Present Value of Outflow

Year | Outflow | PV Factor | PV |

0 | £520000 | 1 | £520000 |

1 - 5 | £ 160000 | 3.6048 | £576768 |

Total | £1096768 |

Net Present Vale = PV of Inflow - PV of Outflow

= £1138173 - £1096768

= £41405

Note : Research cost is sunk cost therefore the same has not been considered while calculating PV of Outflow.

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