ST operates in a highly competitive market and is considering introducing a new product to expand its current range. The new product will require the purchase of a specialised machine costing £825,000. The machine has a useful life of four years and is expected to have a scrap value at the end of Year 4 of £45,000. The company uses the straight line method of depreciation. The machine would be used exclusively for the new product. 

Due to a shortage of space in the factory, investment in the new machine would necessitate the disposal, for £23,000, of an existing machine which has a net book value of £34,000. This machine, if retained for a further year, would have earned a contribution of £90,000 before being scrapped for nil value. The machine had a zero tax written-down value and therefore there will be no effect on tax depreciation arising from the disposal of the machine. 

The company employed the services of a consultant, at a cost of £29,000, to determine the demand for the new product. The consultant’s estimated demand is given below: 

Year 1....................................................... 18 000 units 

Year 2 ....................................................... 24,000 units 

Year 3 ....................................................... 26,000 units 

Year 4 ....................................................... 22,000 units 

The new product is expected to earn a contribution of £30 per unit. 

Fixed costs of £38,0000 per annum, including depreciation of the new machine, will arise as a direct result of the manufacture of the new product. 

Taxation

ST’s Financial Director has provided the following taxation information: 

● Tax depreciation: 25% per annum of the reducing balance, with a balancing adjustment in the year of disposal. 

● Taxation rate: 30% of taxable profits. Half of the tax is payable in the year in which it arises; the balance is paid in the following year. 

● ST has sufficient taxable profits from other parts of its business to enable the offset of any pre-tax losses on this project. 

Other information 

A cost of capital of 12% per annum is used to evaluate projects of this type. Ignore inflation. 

Required

Evaluate whether ST should introduce the new product. You should use net present value (NPV) as the basis of your evaluation.