National Toys Ltd.  Is a profitable medium-sized toy manufacturer that has been listed on a stock exchange for three years. Although the company has an overdraft, it has no long-term debt and its current interest cover is high compared to similar companies. Its return on capital employed, however, is close to average for its business sector. One of its machines is leased under an operating lease, but the company has no other leasing or hire purchase commitments. The company owns two factories and the land on which they are built, as well as a small fleet of delivery vehicles. The company does not own any retail outlets through which to distribute its manufactured output. National Toys Ltd is considering an investment in a new machine, with a maximum output of 200,000 units per annum, in order to manufacture a new toy. Market research undertaken for the company indicated link between selling price and demand in the following terms and they charged Rs. 75,000 for services that is yet to be paid.
Selling price in current price terms @ Rs. 8.00 per unit
Sales volume in year 1100,000 units
Annual increase in sales volume after year 1: 5%
When 100,000 units produced in 1st year, the average variable cost per unit is expected to be Rs. 3.00 per unit (in current price terms). The new machine would cost 1,500,000 and would not be expected to havie any resale value at the end of its life. Capital allowance would be available on the investment on a 25% reducing balance basis. Although the machine may have a longer useful life, National Toys ltd uses a five-year planning period for all investment projects. The company pays tax at an annual rate of 30% and settles tax liabilities in the year in which they arise. Operation of the new machine will cause fixed costs to increase by 110,000 (in current price terms). Inflation is expected to increase these cost by 4% per year. Annual inflation on the selling price and unit variable costs is expected to be 3% per year. For profit reporting purposes National Toys Ltd depreciates machinery on a straight-line basis over its planning period.
National Toys Ltd applies three investment appraisal methods to new projects because it believes that a single investment appraisal method is unable to capture the true value of a proposed investment. The methods it uses are net present value, internal rate of return and return on capital employed (accounting rate of return). The company believes that net present value measures the potential increase in company of an investment project: that a high internal rate of return offers a margin of safety for risk projects: and that a project’s before-tax return on capital employed should be greater than the company’s before-tax return on capital employed, which is 20% . National Toys Ltd does not use any explicit method of assessing project risk and has an average cost of capital of 10% in money (nominal) terms. The company has not yet decided on a method of financing the purchase of the new machine, although the finance director believes that a new issue of equity finance is appropriate given the amount of finance required.
Required:
a. Evaluate and interpret, whether the project is viable or not on the basis of NPV.