High Hills plc produce underwater turbines to generate energy and are considering introducing machinery that will reduce the labour hours required to produce a turbine from 5 hours to 2 hours for the remainder of the product life cycle of 3 years.

The production volumes are forecast based on the state of the industry as follows:

Industry Year 1 Year 2 Year 3

Weak (probability 50%) 3,000 units 4,000 units 3,000 units

Strong (probability 50%) 5,000 units 6,000 units 7,000 units

The employees hourly rate for the coming year is 7.00 rising in year 2 and year 3 to 8.00 and 9.00 respectively.

The machinery has a capital cost of 200,000 with an estimated residual value at the end of year 3 of 60,000 and capital allowances are at 25% on a reducing balance basis.

The company pays corporation tax (income tax) at a rate of 30%. The company assesses projects of this type using a discount rate of 8%. Any difference between the written down value and proceeds from the sale may be claimed as a tax credit in the year of the sale. Taxes are considered one year in arrears.

Required:

a) Calculate the annual cost savings for years 1, 2 and 3.

b) Calculate the impact on taxable profits for years 1, 2 and 3.

c) Calculate the total cash flows for each year.

d) Calculate the expected present value of the project suggesting whether the company

should invest in the new machinery.

e) Discuss how the company might consider risk in reviewing projects of this type.