Dirk plc has recently created a new male fragrance ‘Sirocco’ at a total development cost of

£0.4 million. The business is now considering producing the fragrance, which will require an immediate outlay for new equipment of £10.5 million. Estimates relating to production of the fragrance are:

Year 1 Year 2 Year 3 Year 4 Sales price (£/per bottle) 9.0 8.0 6.0 6.0 Sales volume (bottles) 1.0m 1.2m 1.2m 0.5m Variable cost (£/per bottle) 1.0 1.0 1.0 1.4 Fixed cost (£) 4.5m 4.5m 4.5m 4.5m The fixed cost includes depreciation of £2.5 million a year for the new equipment that is needed. This equipment will be sold at the end of the four years of production and the sales proceeds will reflect the residual value. Fixed cost also includes an allocation of £0.3million to represent a ‘fair share’ of general business overheads.

If the project goes ahead, sales of an existing male fragrance, ‘Mistral’, will decline, resulting in a loss of contribution of £0.8 million per year for the next three years.

Producing the new fragrance will require an immediate outlay for working capital of £1.8 million, which can be released at the end of the production period.

Dirk plc has a cost of capital of 8 per cent.

Required:

(a) Calculate for the investment project:

(1) The net present value.

(2) The approximate internal rate of return.

(b) Briefly comment on the results of your calculations in (a).

AppendixLO1