Simtex Ltd has invested 120,000 to date in developing a new type of shaving foam. The shaving foam is now ready for production and it has been estimated that the new product will sell 160,000 cans a year over the next four years. At the end of four years, the product will be discontinued and replaced by a new product. The shaving foam is expected to sell at £6 a can and variable costs are estimated at £4 a can.

Fixed costs (excluding depreciation) are expected to be £300,000 a year. (This figure includes

£130,000 in fixed costs incurred by the existing business that will be apportioned to this new product.)

To manufacture and package the new product, equipment costing £480,000 must be acquired immediately. The estimated value of this equipment in four years’ time is £100,000. The business calculates depreciation using the straight-line method, and has an estimated cost of capital of 12 per cent.

Required:

(a) Deduce the net present value of the new product.

(b) Calculate by how much each of the following must change before the new product is no longer profitable:

(i) the discount rate;

(ii) the initial outlay on new equipment;

(iii) the net operating cash flows;

(iv) the residual value of the equipment.

(c) Should the business produce the new product?

AppendixLO1