SC Co is evaluating the purchase of a new machine to produceproduct P, which has a short product life-cycle due to rapidly changingtechnology. The machine is expected to cost $1 million. Production andsales of product P are forecast to be as follows:

Year 1 2 3 4

Production and sales (units/year)35,000 53,000 75'000 36,000

The selling price of product P (in current price terms) will be $20per unit, while the variable cost of the product (in current priceterms) will be $12 per unit. Selling price inflation is expected to be4% per year and variable cost inflation is expected to be 5% per year.No increase in existing fixed costs is expected since SC Co has sparecapacity in both space and labour terms.

Producing and selling product P will call for increased investmentin working capital. Analysis of historical levels of working capitalwithin SC Co indicates that at the start of each year, investment inworking capital for product P will need to be 7% of sales revenue forthat year.

SC Co pays tax of 30% per year in the year in which the taxableprofit occurs. Liability to tax is reduced by capital allowances onmachinery (tax-allowable depreciation), which SC Co can claim on astraight-line basis over the four-year life of the proposed investment.The new machine is expected to have no scrap value at the end of thefour-year period.

SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.

Required:

1. Calculate the net present value of the proposed investment in product P.

(12 marks)

2.Calculate the internal rate of return of the proposed investment in product P.

(3 marks)

3.Advise on the acceptability of the proposedinvestment in product P and discuss the limitations of the evaluationsyou have carried out.

(5 marks)

4.Discuss how the net present value method ofinvestment appraisal contributes towards the objective of maximising thewealth of shareholders.

SECTION #2

Tannadens Division is considering an investment in a qualityimprovement programme for a specific product group which has anestimated life of four years. It is estimated that the qualityimprovement programme will increase saleable output capacity and providean improved level of customer demand due to the enhanced reliability ofthe product group.

Forecast information about the programme in order that it may beevaluated at each of best, most likely and worst scenario levels is asfollows:

• There will be an initial investment of $4,000,000 on 1 January, year 1, with a programme life of four years and nil residual value. Depreciation will be calculated on a straight line basis.
• Additional costs of staff training, consultancy fees and the salary of the programme manager are estimated at a most likely level of $100,000 per annum for each year of the proposal. This may vary by 2.5%. This is the only relevant fixed cost of the proposal.
• The most likely additional output capacity which will be sold is 1,000 standard hours in year 1 with further increases in years 2, 3 and 4 of 300, 400 and 300 standard hours respectively. These values may vary by 5%.
• The most likely contribution per standard hour of extra capacity is $1,200. This may vary by 10%.
• The most likely cost of capital is 10%. This may vary from 8% to 12%.

Assume that all cash flows other than the initial investment take place at the end of each year. Ignore taxation.

Required:

(a)Present a table (including details ofrelevant workings) showing the net profit, residual income and return oninvestment for each of years 1 to 4 and also the net present value(NPV) for the BEST OUTCOME situation of the programme.

(10 marks)