Arkwright Mills plc is considering expanding its production of a new yarn, code name X15.

The plant is expected to cost £1 million and have a life of five years and a nil residual value.

It will be bought, paid for and ready for operation on 31 December Year 0.

£500,000 has already been spent on development costs of the product, and this has been charged in the income statement in the year it was incurred.

The following results are projected for the new yarn:

Year 1

£m Year 2

£m Year 3

£m Year 4

£m Year 5

£m Sales revenue 1.2 1.4 1.4 1.4 1.4 Costs, including depreciation (1.0

) ( 1.1

) ( 1.1

) ( 1.1

) ( 1.1

)

Profit before tax 0.2 0.3 0.3 0.3 0.3 Tax is charged at 50 per cent on annual profits (before tax and after depreciation) and paid one year in arrears. Depreciation of the plant has been calculated on a straight-line basis. Additional working capital of £600,000 will be required at the beginning of the project and released at the end of Year 5.

You should assume that all cash flows occur at the end of the year in which they arise.

Required:

(a) Prepare a statement showing the incremental cash flows of the project relevant to a decision concerning whether or not to proceed with the construction of the new plant.

(b) Compute the net present value of the project using a 10 per cent discount rate.

(c) Compute the payback period to the nearest year. Explain the meaning of this term.