Restore Ltd. has just developed a new product to be called Relounge and is now considering whether to put it into production.

Costs incurred in the development of Relounge were 400,000.

Production of Relounge would require the purchase of new machinery at a cost of 6,000,000 (payable immediately). The machinery would have a useful life of 4 years, at the end of which its salvage value would be zero.

Production costs per unit of Relounge (at year 1 prices) would be as follows:

Variable materials 23

Variable labour 36

Variable overheads 10

In addition, fixed production costs (at year 1 prices), including straight line depreciation

on plant and machinery would be 1,800,000.

The selling price of Relounge will be 110 per unit (at year 1 prices) and sales are expected to be 58,000 units in each of the next 4 years.

The retail price index is expected to rise at a rate of 3% per year for the next 4 years and the selling price of Relounge is expected to rise at the same rate. Annual inflation rates for production costs are expected to be as follows:

Variable materials 2%

Variable labour 4%

Variable overheads 5%

Fixed costs 3%

The companys weighted average cost of capital (in nominal terms) is expected to be 14%.

Note: You may ignore taxation and also assume that all costs and revenues rise at the end of each year.

REQUIRED (making any necessary assumptions and showing all workings):

1. Based on the above information, perform relevant calculations to determine the net present value of the Relounge project and offer your advice on whether or not Restore Ltd should go ahead with the production of Relounge. (30 marks)

2. Discuss the advantages and disadvantages of the following capital investment techniques:
   1. Payback period
   2. Net present value
   3. Internal rate of return
   4. Profitability index (30 marks)

c.Explain how you would treat inflation consistently while estimating a projects NPV.