(Examination level) Pine Ltd have spent 20,000 researching the prospects for a new range of products.

2. (Examination level) Pine Ltd have spent £20,000 researching the prospects for a new range of products. If it were decided that production is to go ahead an investment of £240,000 in capital equipment on 1 January 20X1 would be required. The accounts department has produced budgeted profit and loss statements for each of the next five years for the project. At the end of the fifth year, the capital equipment will be sold and production will cease. The capital equipment is expected to be sold for scrap on 31.12.20X5 for £40,000.Year end Year end Year end Year end Year end31.12.20X1 31.12.20X 2 31.12.20X3 31.12.20X4 31.12.20X5Sales 400 400 400 320 200Materials 240 240 240 192 120Other variable costs 40 40 40 32 20Fixed overheads 20 20 24 24 24Depreciation 40 40 40 40 40Net profit (loss) 60 60 56 32 (4)When production is started, it will be necessary to raise material stock levels by £30,000 and other working capital by £20,000. It may be assumed that payment for materials, other variable costs and fixed overheads are made at the end of each year. Both the additional stock and other working capital increases will be released at the end of the project. Customers receive one years credit from the firm. The fixed overhead figures in the budgeted accounts have two elements – 60 percent is due to a reallocation of existing overheads, 40 percent is directly incurred because of the take-up of the project. For the purpose of this appraisal, you may regard all receipts and payments as occurring at the year-end to which they relate, unless otherwise stated. The companyâs cost of capital is 12 percent. Assume no inflation or tax.Required:a. Use the net present value method of project appraisal to advise the company on whether to go ahead with the proposed project.b. Explain to a management team unfamiliar with discounted cash flow appraisal techniques the signifance and value of the NPV method.

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