Question 1: A Capital Expenditure Decision: ABC Plc

The finance director of ABC Ltd has been asked to evaluate an investment in the facilities required to manufacture a new product developed by the companys R&D Department. The development of the product has cost the company 250,000 and it has been established that the patent for the product could be sold for 500,000. To manufacture the product, it will be necessary to invest 8 million in machinery that will be located in one of the companys existing buildings in which there is considerable unused space. The companys internal accounting system allocates rental costs to all production activities based on the space utilised, and for this product the charge will be 40,000 per annum. The machinery will be depreciated on a straight-line basis over five years for tax purposes and is expected to have resale value of 0.5 million. The product is expected to be sold at a price per unit of 25 and sales are expected to be 300,000 units per annum for each of the next five years. Variable costs per unit have been estimated at 12 while fixed costs of 600,000 per annum are anticipated. The companys accounting system also allocates overheads to each production activity on the basis of 10 per cent of revenues. Working capital requirements are expected to be about 1.8 million.

a) If the tax rate is 30 per cent and required rate of return is 14 per cent is this a profitable investment? State and explain all the critical assumptions.

b) Use sensitivity analysis and scenario analysis to improve your capital budgeting analysis. You should use your own input estimates. Write a brief report on your findings