Dreadmill Plc manufactures and distributes a wide range of health fitness equipment. The company is considering a proposed project to introduce a new fitness tracker smartwatch and has hired a consultancy firm to explore the feasibility of launching this new product on the European market.

Dreadmill has received a report from the consultancy firm which details the following:

• It is expected that the new product will have initial sales of 650,000 in year 1, and that this will decline by 20% year on year due to newer competitor products coming onto the market. The product will be withdrawn from the market after year 4.

• The gross profit margin on sales is expected to be 60%.

• The company will need to upgrade its machinery in order to manufacture the new product. The new machinery is expected to have a useful life of 4 years and its capital cost will be depreciated on a straight-line basis for tax purposes over this period, ignoring residual value. The machinery will be purchased immediately for a cost of 500,000 and is expected to have a cash residual value of 80,000 in four years time.

• The company began development of a prototype of the smartwatch last year. This had a cost of 75,000, of which 40,000 has been paid. The balance will be paid in one year.

• Dreadmill Plc will be required to hold the following additional working capital levels as a result of the project:

  The launch requires an immediate working capital investment of 280,000.

• Fixed cash costs of Dreadmill are 372,000 per annum at present. This will increase to 434,000 per annum if the project goes ahead. These costs will revert back to their normal level once the product is withdrawn in four years.

• Assume all cash flows arise at the end of the year unless otherwise stated.

• Dreadmill Plc pays corporation tax at 40% on taxable profits. Assume taxes are paid in

	Year 1	Year 2	Year 3	Year 4
Working Capital	315,000	340,000	320,000	0

the same year as they are charged.

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Question 1 continued ...

Required:

1. (a) Prepare a statement of after-tax cash flows attributable to the project for each year of its four-year life. Explain clearly the reasons for omitting any items of financial information provided in the question. (Note: NPV, IRR calculations are not required).

   (15 marks)

2. (b) Explain what is meant by the agency problem in financial management, and suggest ways in which this problem can be resolved.