2. 100 The directors of Silberman Ltd are considering a proposal for a new machine that is estimated to cost 2,500,000. This would enable the company to manufacture a superior, additional new product, product Z. The accountant has prepared the following profit forecast on the assumption that the funds will be borrowed and the loan repaid at the end of the project: Profit forecast Year 1 Year 2 Year 3 Year 4 000 000 000 000 Sales 3.125 3.750 5.000 6.250 Less: Cost of sales 1,875 1,950 3,450 4.200 Other production expenses 550 575 700 940 Administration charge 750 820 930 1,050 Interest on loan 100 100 100 Profit/(loss) (150) 305 (180) (40) The figures in the profit forecast are based on the following: Cash received from sales and paid for costs will coincide with the financial year. The administration charge is an apportionment of central administration fixed overheads It is assumed that the product has a four-year life. The machinery could be sold for 400,000 at the end of year 4. The other production expenses include the depreciation of the machine, using straight line depreciation. The following additional information not included in the profit forecast above is available: The production manager has said that if the new machine were installed there would be sufficient capacity to enable an existing machine to be sold immediately for approximately 350,000 and would create annual operating savings of 250,000. However, the accountant has told him that the existing machine currently stands in the books at 675,000 and the company could not afford to write off the asset against this year's profits. I Initial market research for the new product has been performed by marketing consultants whose fee of 110,000 has just been received The accountant has not included the following costs in the four-year profit calculation: The directors have spent a considerable amount of time on this project so far and they estimate the costs of their time equates to 50,000. 1 advertising and sales promotion costing 400,000 would be needed at the start of the project. Additionally for years 1 & 2, 80,000 per year and for years 3 & 4, 60,000 per year would be needed. Maintenance costs for the new machine are estimated to be 25,000 in the first year and increase by 40% in each subsequent year. The replacement of key components of the machine at the end of year 2 are estimated to be 65,000 The company uses a cost of capital of 10%. The discount factors for years 1 to 4 are as follows: Year Discount factor 0 1.000 0.909 0.826 3 0.751 0.683 Required: a) Calculate the relevant cash flow for each year of the project providing all workings and clear explanations of the figures you have included (8 marks) b) Using the relevant cash flows from part a) determine the net present value of the project and state whether the project is worthwhile. (2 marks) c) The marketing director is very concerned about the impact on other products within the product range. If the investment goes ahead, he believes it will lead to a reduction in sales and the contribution to sales (C/S) ratio of two of the company's competing products as follows: Year 1 Year 2 Year 3 Year 4 000 000 000 000 Product W Reduction in sales 625 500 500 400 CIS ratio of product W 40% 40% 50% 44% Product G Reduction in sales 600 -500 300 CIS ratio of product G 30% 18% 24% 26% Recalculate the net present value of the project taking the marketing director's concerns into account and determine whether the project is worthwhile. (4 marks) d) Briefly explain the problems of short run and long run issues in investment decision making picking up on the accountant's concern relating to the loss on sale of the existing machine. (3 marks) e) Discuss any other factors that the company should consider before making a decision to proceed with product Z and invest in this machine. (3 marks) 400 2. 100 The directors of Silberman Ltd are considering a proposal for a new machine that is estimated to cost 2,500,000. This would enable the company to manufacture a superior, additional new product, product Z. The accountant has prepared the following profit forecast on the assumption that the funds will be borrowed and the loan repaid at the end of the project: Profit forecast Year 1 Year 2 Year 3 Year 4 000 000 000 000 Sales 3.125 3.750 5.000 6.250 Less: Cost of sales 1,875 1,950 3,450 4.200 Other production expenses 550 575 700 940 Administration charge 750 820 930 1,050 Interest on loan 100 100 100 Profit/(loss) (150) 305 (180) (40) The figures in the profit forecast are based on the following: Cash received from sales and paid for costs will coincide with the financial year. The administration charge is an apportionment of central administration fixed overheads It is assumed that the product has a four-year life. The machinery could be sold for 400,000 at the end of year 4. The other production expenses include the depreciation of the machine, using straight line depreciation. The following additional information not included in the profit forecast above is available: The production manager has said that if the new machine were installed there would be sufficient capacity to enable an existing machine to be sold immediately for approximately 350,000 and would create annual operating savings of 250,000. However, the accountant has told him that the existing machine currently stands in the books at 675,000 and the company could not afford to write off the asset against this year's profits. I Initial market research for the new product has been performed by marketing consultants whose fee of 110,000 has just been received The accountant has not included the following costs in the four-year profit calculation: The directors have spent a considerable amount of time on this project so far and they estimate the costs of their time equates to 50,000. 1 advertising and sales promotion costing 400,000 would be needed at the start of the project. Additionally for years 1 & 2, 80,000 per year and for years 3 & 4, 60,000 per year would be needed. Maintenance costs for the new machine are estimated to be 25,000 in the first year and increase by 40% in each subsequent year. The replacement of key components of the machine at the end of year 2 are estimated to be 65,000 The company uses a cost of capital of 10%. The discount factors for years 1 to 4 are as follows: Year Discount factor 0 1.000 0.909 0.826 3 0.751 0.683 Required: a) Calculate the relevant cash flow for each year of the project providing all workings and clear explanations of the figures you have included (8 marks) b) Using the relevant cash flows from part a) determine the net present value of the project and state whether the project is worthwhile. (2 marks) c) The marketing director is very concerned about the impact on other products within the product range. If the investment goes ahead, he believes it will lead to a reduction in sales and the contribution to sales (C/S) ratio of two of the company's competing products as follows: Year 1 Year 2 Year 3 Year 4 000 000 000 000 Product W Reduction in sales 625 500 500 400 CIS ratio of product W 40% 40% 50% 44% Product G Reduction in sales 600 -500 300 CIS ratio of product G 30% 18% 24% 26% Recalculate the net present value of the project taking the marketing director's concerns into account and determine whether the project is worthwhile. (4 marks) d) Briefly explain the problems of short run and long run issues in investment decision making picking up on the accountant's concern relating to the loss on sale of the existing machine. (3 marks) e) Discuss any other factors that the company should consider before making a decision to proceed with product Z and invest in this machine. (3 marks) 400
