Calculation of accounting rate of return and NPV A company is proposing to enter a new market and has collected the following data.

Capital expenditure on plant and machinery to product product X will total £1 500 000, to be paid immediately. During the first year, while the plant is being erected and machinery installed, no production or sales of product X is expected.

Sales of product X are expected to be 12500 units each year from year 2 to year 5 inclusive. At the end of year 5 the plant and machinery will be sold for scrap, with cash receipts estimated at

£100 000.

Data per unit of product X:

Cost and revenue data are expected to remain constant throughout the project’s life.
The fixed overhead of £30 per unit is made up of depreciation (£28) and general overhead (£2).
The general overheads are the company’s fixed costs which are allocated to each product on the basis of an absorption rate of 6.66% of unit variable cost. There are no fixed costs which are specific to this project.

The company’s cost of capital is 20% p.a.
Required:

(a) Calculate:
(i) the average accounting rate of return on average capital employed to one decimal place; (4 marks)
(11) the net present value. (10 marks)

(b) Discuss the relative merits of the accounting rate of return and net present value methods of investment appraisal, and explain whether you would undertake the product.

Transcribed Image Text:

() Selling price 80 Variable cost 30 Fixed overheads 30 Profit 20