C. George (Controls) Ltd manufactures a thermostat that can be used in a range of kitchen appliances. The manufacturing process is, at present, semi-automated. The equipment used costs £540,000, and has a written-down (balance sheet) value of £300,000. Demand for the product has been fairly stable, and output has been maintained at 50,000 units a year in recent years.

The following data, based on the current level of output, have been prepared in respect of the product:

Per unit

£ £

Selling price 12.40 Less Labour 3.30 Materials 3.65 Overheads: Variable 1.58 Fixed 1.60 10.13 Operating profit 2.27 Although the existing equipment is expected to last for a further four years before it is sold for an estimated £40,000, the business has recently been considering purchasing new equipment that would completely automate much of the production process. The new equipment would cost £670,000 and would have an expected life of four years, at the end of which it would be sold for an estimated £70,000. If the new equipment is purchased, the old equipment could be sold for £150,000 immediately.

The assistant to the business’s accountant has prepared a report to help assess the viability of the proposed change, which includes the following data:

Per unit

£ £

Selling price 12.40 Less Labour 1.20 Materials 3.20 Overheads: Variable 1.40 Fixed 3.30 9.10 Operating profit 3.30 Depreciation charges will increase by £85,000 a year as a result of purchasing the new machinery; however, other fixed costs are not expected to change.

In the report the assistant wrote:

The figures shown above that relate to the proposed change are based on the current level of output and take account of a depreciation charge of £150,000 a year in respect of the new equipment. The effect of purchasing the new equipment will be to increase the operating profit to sales revenue ratio from 18.3%

to 26.6%. In addition, the purchase of the new equipment will enable us to reduce our inventories level immediately by £130,000.

In view of these facts, I recommend purchase of the new equipment.

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

14.2 561 CHAPTER 14 MAKING CAPITAL INVESTMENT DECISIONS Required:

(a) Prepare a statement of the incremental cash flows arising from the purchase of the new equipment.