Advanced: Calculation of the internal rate of return using the interpolation method and a discussion of asset betas Amble pic is evaluating the manufacture of a new consumer product. The product can be introduced quickly, and has an expected life of four years before it is replaced by a more efficient model. Costs associated with the product are expected to be:

Direct costs (per unit)

Labour:

3.5 skilled labour hours at £5 per hour 4 unskilled labour hours at £3 per hour Materials:

6 kilos of material Z at £1.46 per kilo Three units of component P at £4.80 per unit One unit of component Q at £6.40 Other variable costs: £2.10 per unit Indirect costs Apportionment of management salaries £105 000 per year Tax allowable depreciation of machinery £213 000 per year Selling expenses (not including any salaries) £166 000 per year Apportionment of head office costs £50 000 per year Rental of buildings £100000 per year Interest charges £104000 per year Other overheads £70000 per year (including apportionment of building rates £20 000. NB rates are a local tax on property).

If the new product is introduced it will be manufactured in an existing factory, and will have no effect on rates payable. The factory could be rented for £120 000 per year (not including rates), to another company if the product is not introduced.

New machinery costing £864000 will be required. The machinery is to be depreciated on a straight-line basis over four years, and has an expected salvage value of £12000 after four years. The machinery will be financed by a four year fixed rate bank loan at an interest rate of 12% per year. Additional working capital requirements may be ignored.

The product will require two additional man¬ agers to be recruited at an annual gross cost of£25 000 each, and one manager currently costing £20 000 will be moved from another factory where he will be replaced by a deputy manager at a cost of £ 17 000 per year. 70 000 kilos of material Z are already in stock and are not required for other production. The realisable value ofthe material is £99 000.

The price per unit of the product in the first year will be £110, and demand is projected at 12 000, 17 500, 18 000 and 18 500 units in years 1 to 4 respectively.

The inflation rate is expected to be approxi¬ mately 5% per year, and prices will be increased in line with inflation. Wage and salary costs are expected to increase by 7% per year, and all other costs (including rent) by 5% per year. No price or cost increases are expected in the first year of production.

Corporate tax is at the rate of 35% payable in the year the profit occurs. Assume that all sales and costs are on a cash basis and occur at the end of the year, except for the initial purchase of machinery which would take place immediately. No stocks will be held at the end of any year.

Required:

(a) Calculate the expected internal rate of return

(IRR) associated with the manufacture of the new product. (15 marks)

(b) What is meant by an asset beta?

If you were told that the company’s asset beta is 1.2, the market return is 15% and the risk free rate is 8% discuss whether you would recommend introducing the new product.

(c) Amble is worried that the government might increase corporate tax rates.
Show by how much the tax rate would have to change before the project is not financially viable. A discount rate of 17% per year may be assumed for part (c). (5 marks)
(Total 25 marks) ACCA Level 3 Financial Management