The work already undertaken on the product has cost 1.3 million and it is anticipated that some further development work will cost a further 0.2 million. It is estimated that an investment of 9.00 million will be necessary in plant and machinery. This expenditure can be written off (capital allowances) for tax purposes on a straight-line basis over the products expected six year life. It is anticipated that the re-sale value of the equipment will be about 2.00 million at the end of the six years. The outlay would have been larger, but the company already owns some finishing equipment that will be required. This was previously used in the manufacture of another product that is no longer being produced. It is fully depreciated for tax purposes and could be sold today for 180,000. If used for the next six years it will have no resale value.

The production facility would be located in one of the companys factories with spare capacity available. It will occupy 15 per cent of the factorys space. The company has no alternative uses available for this space for the foreseeable future and has further spare capacity available in other factories. The product will be charged 50,000 per annum for this space by the companys management accounting system, though only 20 per cent of this figure will stem from incremental costs resulting from heating and lighting. The fixed costs directly attributable to the production are expected to be 90,000 per annum. Each product sold by the company is also allocated a general overhead charge equivalent to 10 per cent of the revenues it generates. This allocation is made by the companys accountant to cover head office expenses.

The selling price is expected to be set at 38.00 per unit and it is anticipated that sales in the first year will be about 150,000 units, rising to 200,000 in year two, and staying at this level for the following four years. The introduction of the product would require a marketing campaign that will cost 150,000. As a result of the rapid technological development in the area a six year product life is all that can be expected.

The direct manufacturing costs are expected to be 12.00 per unit. The company will need to hold stocks of the product at the start of each year equivalent to 25 per cent of the sales expected in the year to come. The increase in debtors as a result of introducing the product will be just about offset by the increase in creditors. The company requires a rate of return of 14 per cent on investments of this nature, and the tax rate is 40 per cent.

a) Determine the investments net present value and the internal rate of return. All key assumptions should be specified and explained.

b) Undertake a sensitivity analysis for the assumed price and volume of expected sales and interpret your results carefully.

c) Provide a brief general discussion of the potential risks associated with this investment.