Investment Appraisal Report for Penelope ltd

Penelope ltd is a specialist bakery specializing in wedding cakes, It provides quality products at the

high end of the market and has a strategy of constant innovation to keep ahead of the competition.

One of the popular products is the 'Heaven' ice cream cake, but recent arrival of new competitors

has threatened its market share. We are currently at the end of the accounting year, which is 31

December2 021,a nd the Boardo f the companyconsidersgradualtyre placingt he Heaveni ce cream

cake with the new innovative 'Heir ice cream cake, which is an organic, low calorie ice cream cake

that does not melt even in high room temperatures.

The Hell ice cream cake has been developed by the research and development department over

the last year. The research and development has already costed 32,500, of which 10,000 has not

paid yet, by 31 December 2021, to the commissioned food technology company.

The cost of capital the company uses for investment appraisals is 10%.

You are appointed as a consultant to advise the Soard of Directors, which is due to meet this

afternoon, on the effect of the introduction of the Hell ice cream cake to gradually replace the

Heaven ice cream cake.

The sales of the new Hell ice cream cake are expected to last 5 years and the marketing department

has estimated the following sales for the five-year period from 2022 to 2026:

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Table 1. Estimated sales of Hell ice cream for period from 2022 to 2026

The selling price is 11.50 per kg; the variable cost is 4.50 per kg and the relevant fixed costs

30,000 per year.

Penelope will introduce the new Hell ice cream cake and for the initial 3 years will also retain the

current Heaven ice cream cake, which is aimed at the lower price market, selling at 9.6 per kg.

The sales quantities of the current Heaven ice cream cake for the retained period of the initial 3

years are shown in Table 2 below.

Table 2. Sale of the current Heaven ice cream cake across 3 years

However, the retention and sales of Heaven ice cream cake for three years will reduce the sales of

the new Heat ice cream over this period by one kg of Hell for every two kg of Heaven.

The Heaven ice cream cake has an estimated variable cost of 5.50 per kg and relevant fixed costs

2,000 per year.

The machinery currently used for the production of Heaven ice cream cake w;u continue to be in

place for a number of years, has zero written-down value and zero market value.

If the Heat ice cream is introduced, new machinery should be bought for 150,000. The machine

is available and can be purchased, paid in cash now and be used for immediate production at the

startof the accounting year 2022. The machine is expected to operate for the five years period,

2022-26,that Hell ice cream cake will be produced and then be scrapped with zero market value.

The gradual replacement of the Heaven ice cream cake will result to redundancy payments as in

Table 3 Redundancy payments

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All redundancy payments are ta>Meducing expenses and will attract corporate tax relief.

The operations manager has informed you of the need for working capital, which is 10% of the

following-year's sales and has to be in place at the start of each accounting year. Currently, there

is no such working capital in place. The working capital will be reduced to zero at the end of the

five year investment period and has no tax implications.

The corporate tax rate is 20% and is expected to remain unchanged over the period of the

investment. The new machinery will attract full capital allowances at 2S% per year on reducing

balance basis. At the end of the five-year period, 31 December 2026, a balancing charge or

allowance will arise on disposal of the new machinery.

Required:

(a) Estimate the Net Present Value of the project, showing clearly all your calculations.

(b) Estimate the Internal Rate of Return of the project, showing dearly all your calculations.

(c) Write a short report to explain to the members of the Board of Penelope ltd the reasons that

they may wish to adopt the NPV appraisal method against the other possible alternative

investment appraisal methods Include in this section a discussion of the critical factors that

might affect the outcome of this investment.

Table L. Estimated sales of Hell ice cream lot penod from 2027 to 2020 Year Sales of Hell ice cream cake (in kg) 2022 12,000 2023 18,000 2024 24,000 2025 18,000 2026 12,000 Table 2. Sale of the current Heaven Ice cream Gake across 3 years Year Sales of Dream loe cream (in kg) 2022 4,800 2023 3,600 2024 2,400 Table 3 Redundancy payments Year Redundancy payments () 2021 (31 Dec, i.e., L=0) 5,000 2022 (31 Dec, i.e., L=1) 4,800 2023 (31 Dec 1.e., t=2) 4,800 2024 (31 Dec, i.e.. =) 2,400 The net present value (NPV) of a project or investment is the difference between the present value of its benefits and the present value of its costs. Net Present Value: NPV = PV(Benefits) PV (Costs) = If NPV > O Accept the projects If NPV O Accept the projects If NPV