The Production Manager of Paradise Juice Manufacturers Ltd, manufacturers of high quality fruit juices indicates that the company plans to launch two new products in the market, at the start of January 2006, which it believes will each have a life of four years.

The sales mix is assumed to be constant.

Expected sales volumes for the two products are as follows:

Year 1 2 3 4

Majuice 60,000 110,000 100,000 30,000

Ndijuice 75,000 137,500 125,000 37,500

The selling price and costs for each product for the first year are as follows:

Majuice Ndijuice

Kes/Unit Kes/Unit

Direct material costs . 12.00 9.00

Incremental fixed production costs .. 8.00 6.00

Total cost . 20.00 15.00

Standard Mark-up 10.00 7.00

Selling price . 30.00 22.00

Incremental fixed production costs are expected to be Kes 1, 000,000.00 in the first year of operation and are apportioned on the basis of sales value. Advertising costs will be Kes 500,000 in the first year of operation and then Kes 200,000 per year for the following two years. There are no incremental non-production fixed costs other than advertising costs.

For the company to produce the two products, an investment of Kes 1,000,000 in premises, Kes 1,000,000 in machinery and Kes 1,000,000 in working capital will be needed, payable at the start of January 2006. The investment will be financed by an issue of Kes 3 million Bond at 9%.

Selling price per unit, direct material per unit and incremental fixed production costs are expected to increase as follows after the first year of operation due to inflation:

Selling price inflation . 3% p.a

Direct material cost inflation . 3% p.a

Fixed production cost inflation 5% p.a

The company pays tax in the year in which the taxable profit occurs at an annual rate of 25%. Investment in machinery attracts a first year capital allowance of 100%. The company has sufficient profits to take the full benefit of this allowance in the first year. For the purposes of reporting accounting profit, the company depreciates machinery on a straight-line basis over four years. The companys after tax discount rate is 13%

a) As the Financial Controller evaluate the proposal using a suitable investment appraisal technique.

b) Explain and discuss the likely limitations in the evaluation of the proposed investment. Please give brief but critical comments.