The directors of Silberman Ltd are considering a proposal for a new machine that is

estimated to cost 2,500,000. This would enable the company to manufacture a superior, additional new product, product Z.The accountant has prepared the following profit forecast on the assumption that the funds will be borrowed and the loan repaid at the end of the project:

Profit forecast

Year 1

Year 2

Year 3

Year 4

000

000

000

000

Sales

3,125

3,750

5,000

6,250

Less: Cost of sales

1,875

1,950

3,450

4,200

Other production expenses

550

575

700

940

Administration charge

750

820

930

1,050

Interest on loan

100

100

100

100

Profit/(loss)

(150)

305

(180)

(40)

The figures in the profit forecast are based on the following:

Cash received from sales and paid for costs will coincide with the financial year.

The administration charge is an apportionment of central administration fixed overheads.

It is assumed that the product has a four-year life. The machinery could be sold for 400,000 at the end of year 4.

The other production expenses include the depreciation of the machine, using straight line depreciation.

The following additional information not included in the profit forecast above is available:

The production manager has said that if the new machine were installed there would be sufficient capacity to enable an existing machine to be sold immediately for approximately 350,000 and would create annual operating savings of 250,000. However, the accountant has told him that the existing machine currently stands in the books at 675,000 and the company could not afford to write off the asset against this year's profits.

Initial market research for the new product has been performed by marketing consultants whose fee of 110,000 has just been received.

The accountant has not included the following costs in the four-year profit calculation:

The directors have spent a considerable amount of time on this project so far and they estimate the costs of their time equates to 50,000. Marketing has estimated that to meet the required sales forecasts additional advertising and sales promotion costing 400,000 would be needed at the start of the project. Additionally for years 1 & 2, 80,000 per year and for years 3 & 4, 60,000 per year would be needed. Maintenance costs for the new machine are estimated to be 25,000 in the first year and increase by 40% in each subsequent year. The replacement of key components of the machine at the end of year 2 are estimated to be 65,000. The company uses a cost of capital of 10%. The discount factors for years 1 to 4 are as follows:

Year

Discount factor

0

1.000

1

0.909

2

0.826

3

0.751

4

0.683

Required:

a)Calculate the relevant cash flow for each year of the project providing all workingsand clear explanations of the figures you have included. (8 marks)

b)Using the relevant cash flows from part a) determine the net present value of theproject and state whether the project is worthwhile. (2 marks)

c)The marketing director is very concerned about the impact on other productswithin the product range. If the investment goes ahead, he believes it will lead toa reduction in sales and the contribution to sales (C/S) ratio of two of thecompany's competing products as follows:

Year 1

Year 2

Year 3

Year 4

000

000

000

000

Product W

Reduction in sales

625

500

500

400

C/S ratio of product W

40%

40%

50%

44%

Product G

Reduction in sales

600

500

400

300

C/S ratio of product G

30%

28%

24%

26%

Recalculate the net present value of the project taking the marketing director's concerns into account and determine whether the project is worthwhile. (4 marks)

d)Briefly explain the problems of short run and long run issues in investmentdecision making picking up on the accountant's concern relating to the loss onsale of the existing machine. (3 marks)

e)Discuss any other factors that the company should consider before making adecision to proceed with product Z and invest in this machine. (3 marks)