The marketing manager of MC Plc has been negotiating to supply of a modified form of one of the companys products, to a new customer. She has asked the companys finance director to assess the profitability of the proposed contracts terms. The contract would require the supply of 25,000 units per annum at a price per unit of 26.00 for each of the next four years. While it will be possible to make use of some of the companys existing machinery it will be necessary to invest in some additional equipment to finish the product to the specifications of the contract. If it is used for this contract it is not anticipated to have any resale value after four years. The additional equipment required will cost 600,000 and would have to be depreciated for tax purposes on a straightline basis over five years. It is anticipated that the equipment could be sold for 80,000 at the end of year four if the company does not have a more profitable use for it. The acceptance of the contract will required an investment in working capital of 120,000.

The finance director has provided the following analysis of the annual profitability of the contract:

Annual revenues (25,000 units at 26.00 per unit) 650,000 Expenses Raw materials 200,000 Wages 150,000 Other expenses 30,000 Share of overheads 30,000 Allowance for factory space 40,000 Charge for use of existing equipment 30,000 Depreciation charge on new equipment 120,000 (600,000) 50,000

The finance director contends that as the profit margin is below that on the companys other business the contract should not be accepted. You are aware of the financial directors tendency to be very conservative in his estimation of the costs of any venture, and recognise the need to scrutinise his figures very carefully.

a) If the tax rate is 30 per cent, and the company requires a rate of return is 14 per cent after tax, is this a profitable contract for MC Plc to undertake? Specify your assumptions. (20 marks)

b) Discuss the general principles relating to the treatment of overheads in investment appraisal. (5 marks)