Question 1 [10 Marks]

The product development department of Very Trusty plc is contemplating renting a factory building on a four-year lease from Year 1, investing in some new plant and using it to produce a new product, code named C15.

Since there appears to be no possibility of the plant continuing to be economically viable beyond a four-year life, it has been decided to assess the new product over a four-year manufacturing and sales life.

Under the lease the business will pay $100,000 annually in advance on 1 January.

The plant is expected to cost $600,000. This will be bought and paid for in Year 0 and is expected to be scrapped (zero proceeds) on 31 December Year 4. The business will depreciate this asset, in its accounts, on a straight-line basis (25 per cent each year).

Each unit of C15 is estimated to give rise to a variable labour cost of $200 and a variable material cost of $100. C15 manufacture will be charged with an annual share of the business's administrative costs, totalling $150,000 each year. Manufacture and sales of C15s is expected to increase total administrative costs by $90,000 each year.

A market study conducted by an external consultant has provided the following expectations for the manufacture and sales of C15s:

Year ending 31 December YearUnits of C15

1400

2600

3500

4200

These will be sold for an estimated $1,400 each.

The cost of market study was $5,500 and has already been paid.

The Business would have to invest $40,000 in working capital immediately for production to begin.

The business's accounting year end is 31 December each year.

It has been decided, given the level of risk involved with the project to use a discount rate of 15 per cent a year.

Required:

(a)Identify the annual net relevant cash flows and use this information to assess the project on a net present value basis.

(b)Estimate the internal rate of return of the project, using the trial and error method.