Question

On 31 December year 0, Khan Ltd invested in some machinery and started to manufacture a new product the ‘gadget’. The decision was based on the machinery being capable of producing gadgets until the end of Year 6 and sales continuing until that time.

Actual sales of gadgets have not been as buoyant as projected when the investment was being appraised during year 0. As a result, the business’s management is considering abandoning the project at the end of year 3, earliest date at which it would be feasible to do so. You have been asked to prepare calculations and recommend whether to abandon the project at that time or to continue as originally projected until the end of year 6.

You have discovered the following :

1. The machinery was bought on 31 December year 0 for £420,000. Where production to be abandoned at the end of year 3. Should the project continue, the machinery would be disposed of in late December year 6, for zero proceeds.

Depreciation of this machinery has been, and if retained will continue to be, charged at the rate of £70,000 a year.

2. It has been estimated that the most likely sales levels for the remaining three years of the project will be as follows:

                                                                                                Number of gadgets         

                             Year 4                                                               2,400

                             Year 5                                                             2,400

                             Year 6                                                              1,500

3. Gadgets are sold for £200 each. This produces a contribution of £80 a gadget.

4. The variable costs include £90 a gadget for materials. The only other element of variable operating cost is labour.

5. The business also has a longstanding product, the ‘widget’, for which the market is very buoyant. This uses the same manufacturing labour, paid at the same rate, as the gadgets. As a result of a shortage of this labour, sales of widgets are lost when gadgets are produced. A higher-than-planned output of widgets has occurred since Year 1, due to the labour released by the gadget sales shortfalls

6. It is believed that there are no other relevant cash flows associated with the decision.

7. Given the risk of the project, a cost of capital of 15% per year is considered appropriate.

8. Assume that all operating cash flows arise on the last day of the accounting year concerned.

Required:

Show calculations that indicate, on the basis of net present value at 31 December Year 3, whether Khan Ltd should abandon gadget production at the end of Year 3 or continue until Year 6.

Answer 1