16) Round Tree Ltd. has just developed a new product to be called Zebra and is now considering whether to put it into production. Costs incurred in the development of Zebra were 600,000. Production of Zebra would require the purchase of new machinery at a cost of 3,000,000 (payable immediately). The machinery would have a useful life of 4 years, at the end of which its salvage value would be zero. Production costs per unit of Zebra (at year 1 prices) would be as follows: Variable materials 21 Variable labour 35 Variable overheads 15 In addition, fixed production costs (at year 1 prices), including straight line depreciation on plant and machinery would be 1,600,000 The selling price of Zebra will be 120 per unit (at year 1 prices) and sales are expected to be 41,000 units in each of the next 4 years. The retail price index is expected to rise at a rate of 3% per year for the next 4 years and the selling price of Zebra is expected to rise at the same rate. Annual inflation rates for production costs are expected to be as follows: Variable materials 3% Variable labour 4% Variable overheads 5% Fixed costs 5% The company's weighted average cost of capital (in nominal terms) is expected to be 14%. REQUIRED, ANSWER ALL PARTS (making any necessary assumptions and showing all workings): Note: You may ignore taxation and also assume that all costs and revenues rise at the end of each year. b. Explain how you would treat inflation consistently while estimating a project's NPV. 2 of 2 Overview 16) Round Thee Ltd. has just developed a new product to be called Zebra and is now considering whether to put it into production Costs incurred in the development of Zebra were 600,000. Production of Zebra would require the purchase of new machinery at a cost of 3,000,000 (payable immediately). The machinery would have a useful ife of 4 years at the end of which its salvage value would be zero. Production costs per unit of Zebra (at year 1 prices) would be as follows: Variable materials 21 Variable labour Variable overheads 15 In addition, fixed production costs (at year 1 prices), including straight line depreciation on plant and machinery would be 1,000,000 The selling price of Zebra will be 120 per unit (at year 1 prices) and sales are expected to be 41,000 units in each of the next 4 years The retail price index is expected to rise at a rate of 3% per year for the next 4 years and the selling price of Zebra is expected to rise at the same cate. Annual inflation rates for production costs are expected to be as follows: Variable materials 3% Variable labour 4% Variable overheads 5% Fixed costs 5% KEO 10 BD D The company's weighted average cost of capital (in nominal terms) is expected to be 14%. S S REQUIRED, ANSWER ALL PARTS (making any necessary assumptions and showing all workings): ( Note: You may ignore taxation and also assume that all costs and revenues rise at the end of each year. a. Based on the above information, perform relevant calculations to determine the net present value of the Zebra project and offer your advice on whether or not Round Tree Ltd should go ahead with the production of Zebra. (30 marks) b. Explain how you would treat inflation consistently while estimating a project's NPV. BI U E T T c. Discuss the advantages and disadvantages of the following capital investment techniques: 1. Payback period. ii. Net present value. iii. Internal rate of return. iv. Profitability index T' T B U EE E M 0