As part of the five to radice costs and increase protsess a company is wort investing in new manufacturing equipment. This equipment will require a large initial
outlay and will result in positive cash inflows for the four-year useful fe. The company
commissioned and paid for a report by management consultants last year at a cost of
£50,000, which forecast the following information on the equipment
• The equipment will cost £2,000,000. It can be sold after four years for £800,000
and should be depreciated at 25% per annum using the straight ne basis
Capital allowances are available at 15% of the cost on a straight-ire basis.
• An initial investment in working capital of £50,000 is required. This will be
maintained for the four years. At the end of the four-year period this will be
recovered
• Cash savings from improved production process is expected to be £500,000
per annum in year 1 and wil grow at 3% per annum thereafter.
• Annual cash savings on labour are expected to amount to £150,000 per annum
during the four-year period
• The managing director of the company has indicated that £200,000 of existing
head office costs will be allocated to the new machinery.
• Two more staff need to be hired to operate the machinery, with an annual salary
of $40,000 each person
• The rooms where the plant will be located is currently let out to a local business
for £25,000 per annum.
• The company pays corporation tax at the rate of 12.5% payable one year in
arrears
The company has a cost of capital of 10%.
Required:
a) Explain to the management team the irrelevant information in this report, and
why it is not relevant in appraising this investment.
(2 marks)
b) Calculate the NPV of the proposed project, and advice the company whether
or not they should invest in the new equipment.
(15 marks)
c) Calculate 3 alternative methods of appraising this investment and calculate the
sensitivity of the project to its cost of capital.