DIGITAL TWO plc, a software company, has developed a new game, 'Narugo', which it plans to launch in the near future. Sales of the new game are expected to be very strong, following a favourable review by a popular PC magazine. DIGITAL TWO plc has been informed that the review will give the game a 'Best Buy' recommendation. Sales volumes, production volumes and selling prices for 'Narugo' over its four-year life are expected to be as follows.

Year12 3 4

Sales and production (units) 150,000 70,000 60,000 60,000

Selling price (RM per game) RM25 RM24 RM23 RM22

Financial information on 'Narugo' for the first year of production is as follows:

Direct material costRM540 per game

Other variable production cost RM600 per game

Fixed costs RM600,000 per year

Advertising costs to stimulate demand are expected to be RM650,000 in the first year of production and RM100,000 in the second year of production. No advertising costs are expected in the third and fourth years of production. 'Narugo' will be produced on a new production machine costing RM800,000. Although this production machine is expected to have a useful life of up to ten years, government legislation allows DIGITAL TWO plc to claim the capital cost of the machine against the manufacture of a single product. Capital allowances will therefore be claimed on a straight-line basis over four years.

DIGITAL TWO plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which they arise. DIGITAL TWO plc uses an after-tax discount rate of 10% when appraising new capital investments. Ignore inflation.

Required:

(a) Calculate the net present value of the proposed investment and comment on your findings. (14marks)

(b) Operating cash flows rather than operating profit formed the basis for capital budgeting decisions.Briefly explain THREE (3) types of costs that need to be considered in determining incremental cash flows. (3 marks)

(c) Lists THREEreasons why the net present value investment appraisal method is preferred to other investment appraisal methods such as payback, return on capital employed and internal rate of return.(3 marks)