The accountant of your business has recently been taken ill through overwork. In his absence his assistant has prepared some calculations of the profitability of a project, which are to be discussed soon at the board meeting of your business. His workings, which are set out below, include some errors of principle. You can assume that there are no arithmetical errors.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

£000 £000 £000 £000 £000 £000 Sales revenue 450 470 470 470 470 Less Costs Materials 126 132 132 132 132 Labour 90 94 94 94 94 Overheads 45 47 47 47 47 Depreciation 120 120 120 120 120 Working capital 180 Interest on working capital 27 27 27 27 27 Write-off of development costs – 30 30 30 – –

Total costs 180 438 450 450 420 420 Operating profit/(loss) (180) 12 20 20 50 50 EXErCIsEs 591 Total profit (loss)

Cost of equipment

=

(£ , )

£

28,000)

600,000

= Return on investment (4.7%)

you ascertain the following additional information:

1 The cost of equipment includes £100,000, being the carrying value of an old machine. If it were not used for this project it would be scrapped with a zero net realisable value. new equipment costing £500,000 will be purchased on 31 December year 0. you should assume that all other cash flows occur at the end of the year to which they relate.

2 The development costs of £90,000 have already been spent.

3 overheads have been costed at 50 per cent of direct labour, which is the business’s normal practice. an independent assessment has suggested that incremental overheads are likely to amount to £30,000 a year.

4 The business’s cost of capital is 12 per cent.

Ignore taxation in your answer.

Required:

(a) Prepare a corrected statement of the incremental cash flows arising from the project. Where you have altered the assistant’s figures you should attach a brief note explaining your alterations.

(b) Calculate:

(1) The project’s payback period.

(2) The project’s net present value as at 31 December year 0.

(c) Write a memo to the board advising on the acceptance or rejection of the project.

AppendixLO1