DK plc is evaluating the purchase of a freeze dryer. Packets of frozen food will be sold in boxes of eight and the following information applies to each box:
............................................................€ per box
Selling price...................................................9.70
Packaging and labour........................................2.20
Frozen food and processing.................................4.80
The selling price and cost of the frozen food are expected to increase by 6 per cent per year, while packaging and labour costs are expected to increase by 5 per cent per year.
Investment in working capital will increase by €90,000 at the start of the first year and by 4 per cent per year in subsequent years. The freeze dryer will have a useful life of five years before being scrapped, the net cost of disposal being €18,000. Sales in the first year are expected to be 80,000 boxes, but sales in the second and subsequent years will be 110,000 boxes.
The freeze dryer will cost €1m, with 60 per cent to be paid initially and the 40 per cent to be paid one year later. The company's nominal cost of capital is 14 per cent. Ignore taxation.
(a) Assess whether DK plc should invest in the freeze dryer.
(b) Explain the choice of discount rate used in part (a).