Question No. 01. marks 15

The Modern Manufacturing Company is evaluating the possibility of manufacturing and selling a new product. Two possible proposals have been developed as appended below:-

PROPOSAL - X

This involves an immediate payment of Rs. 80,000 to buy a new machine. It is estimated that the machine can be used effectively for three years, at the end of which time it will be scrapped for zero proceeds.

PROPOSAL - Y

This involves using an existing machine, which cost Rs. 120,000 two years ago, since when it has been depreciated at the rate of 25% per annum on cost. The business has no use for the machine, other than in the manufacture of the new product, so if it is not used for that purpose it will be sold. It could be sold immediately for Rs. 40,000. Alternatively there is a potential buyer who will pay Rs. 50,000 and take delivery of the machine in one years time. There are no additional costs of retaining the machine for another year. If the machine is retained for manufacturing the new product, it will be scrapped with zero proceeds in two years time.

The staff required for this production and sale will be transferred from within the business. The total labour cost involved is Rs. 25,000 for each of the next two years. The employees concerned will need to be replaced for two years at a total cost of Rs. 20,000 for each of those years. The operating profit estimates, given below, are based on the labour cost of the staff that will actually be working on the new product.

The estimated operating profits, before depreciation, from the new product are as under:-

PROPOSAL Year 1 Year 2 Year 3

X Rs. 30,000 Rs. 50,000 Rs. 60,000

Y Rs. 60,000 Rs. 40,000 --

The new production will require additional working capital. This is estimated at 15% of the relevant years operating profit, before depreciation. It is required by the beginning of the relevant year. The business cost of finance to support this investment is 12% per annum.

Required:

On the basis of NPV, which of the two proposals should the business adopt?