a
fis increase manufacturing capacity
Bes of Sassone: pic’ neéd 10 increase capacity in order to meet expected demend for a new product,
shih i to be usad in the manviacture af new-yeneralion personal computers. Produict G canna be
Son exisling machines. The directors nave scented two machines which can manufacture
fesch with 2 capacity of 60,000 unis per year, as follows:
@ will cost £238,850 and last for five: years, at the end of which time il will have zero sevap value.
£0515 will be £10,000 in The Test year of operation, incaessing by £3,000 per yest for each year ot
eachine wil O2st £215,000 0 ll oe four years, atthe end cf which tis it will have xem scrap walue, fa?
(Maieerance tosis wil be £10,000 fn the fist yest ol operation. increasing by £5,000 per yest tar earn year
Sasson plc expects derviand for Pcdyct G tw be 30,000 units per year in the first yor, and to increase by a
rte: 10,000 units per year in ench subsequent year. Selling price is expected to be £10-00 per unit and the
‘marginal cost ol production is expected t0 be £7-80 per uni. Incremental fixed production everheods ol £10,000
‘per year will be incurred. Selling price and cosls are all in current price terms,
‘Anoual inflation rates are expected lo be as follows:
Selling price of Product G: 4% per year
Marginal cost of prodection: 9% per year
Maictenance costs: 5% per year
Foes peoduttion overesds: 8% per year
information
e pic has a real cost of capital of Bs and uges @ nominal (money) cost of capital of 1196 in investment
|. The company pays lax one. year in arrears at an annual rate of 30% and ean claim capital allowances. on
125% seducing halance basis. with a bolancing allowance at the end of the lie of the machines, The company
iales Fived asselS 00 # straight-ine asis over the lite of the asset and hes a target bafore-tax retum on capital
ployed {accounting rale of relurn) of 25%
paired
Fy Using equivalent _awual ost and considering machine purchase prices and maintenones costs only,
determing whieh machine should be purchased by Sassane. Ignore Inflation and taxation in this part of the
question enly. ee
Catcutate the net present valve of the incremental cash flows arising from purchasing Machine Two and
advise on ils acquisition. (a8 mares)
‘Calculate the before-tax return on capital employed (eecounting rate of peturn) of the incremental cash flows
‘arising from purchasing Machine Two based on the average investment and cornment on your ae -poe: eed
SAS tess Sasseia Pe Ce
Year oO 1 2 3 4 5
Initial Investment (238,850)
Maintenance @0,000) (23,000) (16,000) (19,000) —¢22,000)
11% Gscovnt factors: 1-000, 0-901 O-B12 0-731 0-659, 0-553 q
(73g.850) 3.010)» 0.556) «= 1,698) 12.521) 3.048)
Present value of costs = £298,679
‘Anmuiy factor for ve years: at 11% = 3-696
Equivalont annual cost = 255,675/3-696 = £80,000 per year
Machine Tro
Year 0 Haj! 2 3 4
= 5 £ £ £
Initial lovestnent (215,000)
Maiedenance 9,000) (95,000) (20,000) (25,000)
11% discount factors 1-000 e901 ete o731 0-658
(215,000) (9.010) (92,180) 14.620) 1675)
Present walue of cose = £267,285
‘Annuity factor for four years at 11% ~ 3-102
Equivalent annual cost = 267,2852-102 = £86,165 per year
Machine One showld be bought as it has the lowest equivalent annual cost,Sales volume reaches the maximum capacity of the new machine in Year 4.
‘Year 1 2 3 4 5
£ & £ = £
Gales revenue 312,000 432,800 562.500 702,000
Marginal cost (243,200) (337,600) (438,500) (547.200)
Maintenance {10,5007 (11,236) (21,319) (12,625)
Fixes cost (20,000). (22,050)
Taxable cash flow 48,100 90,040 113,234
Taxation (20,464) (27,012) (33,970)
WDA tax benefit 9 9,070
Net cash frow 48,100
‘Discount factors S01
Present values 43,338
£
Sum cf cresent values 218,595
Initial investment 715,000
Net present value 3,554
The positive NPV indicates that
the investment in Machine Two is finoncally acceptable, although the NPV is 20 ‘smell that
there is they ta be a significant possitliny of a nogetve MPU.
Workings
Yer 1 2 3 4
Selling price «Ciunit) 10-40 10-82 nz 70
Sales (united) 30,000 40,000 50,000 60,900
Sales revenue (En) 312,000 432,800 962,500 7o2.000
Year oi z Ea 4
Marginal cast (Elvnith B11 ead a7? O12
Sales (units) 20,000 40,000 50,000 60,000
Marginal cost (Ele) 243,300 387.600 238,500 547,200
Year 1 2 3 4
Maintenance