Sion Plc: A Capital Expenditure Decision

Sion plc is considering the introduction of a new product that has evolved from work undertaken by the companys R&D department that has cost 700,000 to complete. The manufacture of the product will require investment of 5 million in a new plant and machinery. It will also require the use of some equipment already owned by the company. This is fully depreciated for tax purposes but could be sold today for 0.6 million. If used on the project it will have no resale value of the project. The company anticipates it could manufacture and sell of 20,000 units of the product per annum and the companys market research has found that there is a market for this level of sales at a price of 250 per unit. The variable costs of production would be 120 per unit and there would also be fixed costs of 250,000 per annum to take into account. The activity would also be allocated overheads of 60,000 per annum through the companys cost accounting system to cover the companys R&D expenditure and head office expenses. In addition the activity will be charged 100,000 per annum for the space utilised in the companys production unit, even though at present the company has considerable free space available for which it has no alternative use. The expenditure on plant and machinery would be depreciated for tax purposes on a straight-line basis over an anticipated product life of four years. At the end of the four years it is anticipated that the plant could be sold for 0.9 million. The project would require holding stocks of raw materials and components worth 120,000 and 3,750 units of the final product ready for sale.

(i) 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.

(ii) How sensitive is the NPV to the price expected for the product?