Ltd is assessing an investment project: the company plans to manufacture a new
product, ‘product Y’. The project is based on market research undertaken at a cost of
£200,000.
An initial investment of £30m is required: all of this will be invested in new machinery. The
company’s depreciation policy is to depreciate machinery over five years using the
straight-line method. The project will also require an investment in working capital of £5m
at the start (i.e. in year 0), which is expected to be recovered when production using the
new machinery stops at the end of year 6.
Production of product Y will take place in an empty building that is already owned by Vigo
Ltd. If the investment project does not proceed, the building will be rented out for £1.5m
per annum.
Forecast revenues from the sale of product X are £15m in year 1 and are expected to rise
by 2% per annum until the end of year 6. Costs are estimated to be 40% of revenues.
However, it is estimated that the production of product Y will cause sales of another of
Vigo Ltd’s products, product X, to decrease by 20%. In year 1, product X has estimated
revenues in year 1, of £7m. Revenues from product X are forecast to grow at 1% per
annum.
For management accounting and costing purposes, head office costs are allocated to
departments on product lines on the basis of 10% of revenues generated.
Tax is chargeable at 19% on taxable profits made and is paid one year in arrears. Capital
allowances of £7.5m per annum can be claimed in each of years 3 to 6 inclusive,
respectively. Capital allowances can be subtracted from revenues as part of the
calculation of taxable profits.
Vigo Ltd’s cost of capital is 4%.
Required:
(a) Calculate the net present value of the investment project.
(26 marks)
(b) Calculate the payback period of the investment project.
(4 marks)
(c) Prepare a data table that shows the impact on net present value of varying
percentages of lost revenues from product X. You should include a range of
lost revenues from 15% to 25% and show the effect of a range of revenue
growth from 1.5% to 2.5%.
(4 marks)
(d) Compare and contrast the net present value and internal rate of return
techniques.
(16 marks)
(Total marks: 50)
In harvard style format
