Question
USIL Company has developed a new detergent that can be sold for KES 350 per unit. The company has undertaken market research at a cost
USIL Company has developed a new detergent that can be sold for KES 350 per unit. The company has undertaken market research at a cost of KES 12 million in order to forecast the future cash flows of the investment project. The detergent is expected to continue gaining popularity for many years. The Chief Finance Officer has, however, proposed that investment in the new product should be evaluated over a four-year time-horizon, (even though sales would continue after the fourth year), on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both in current price terms) are as follows:
Sales volume (units) | Less than 1 million | 1 to 1.9 million | 2 to 2.9 million | 3 to 3.9 million |
Variable cost (KES per unit) | 250 | 270 | 280 | 300 |
Total fixed cost (KES) | 5 million | 5. 8 million | 6.8 million | 7.8 million |
The forecasted sales volumes are as follows:
Year | 1 | 2 | 3 | 4 |
Demand (units) | 700,000 | 1,200,000 | 1,600,000 | 2,200,000 |
The machinery required for production of the new detergent line would cost KES 200 million. An additional initial investment of KES 125 million will be needed for working capital. Plato Manufacturing Company pays corporate tax at the rate of 30% per year, payable one year in arrears. Selling price and cost information are in current price terms, before applying selling price inflation of 6% per year, variable cost inflation of 4 % per year and fixed cost inflation of 6% per year.
USIL Company uses an after-tax cost of capital of 14% to appraise all new capital projects. Assume that production lasts for only the four years under consideration above, calculate the NPV of investing in the new machine and advice if its financially acceptable (work to two decimal places).
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