SECTION A:

QUESTION 1

The directors of Jump Plc has just developed two new products A and B and is now considering to put one of them into production. 

The following information is available:

For Product A

Research and development costs already incurred         £100,000

Initial investment in machinery                                                 £2 million

Residual value                                                                         £130,000

Selling Price                                                                                 £45 per unit

Variable production costs                                                         £35 per unit

Incremental fixed production costs.                                 £115,000 per year

For Product B

Research and development costs already incurred         £200,000

Initial investment in machinery                                                 £2 million*

Residual value                                                                         £200,000

Selling Price                                                                                 £50 per unit

Variable production costs                                                         £40 per unit

Incremental fixed production costs.                                 £115,000 per year

*Please note for the initial investment in machinery of product B, half is payable immediately and the other half is payable after one year.

Expected demand per year in units

        Product A Product B

Year 1   80,000   64,500

Year 2   88,000   67,300

Year 3   94,600   71,300

Year 4   66,700   78,500

Year 5   25,000 101,500

Machinery of product B requires an additional £130,000 as a working capital payable at the start of the project. This is not expected to change during the life of the investment.

Required

a) Calculate the table of annual cashflow.

b) Evaluate the two investments using two methods:

i) Payback period.

ii) Net present value using 13% as a discount rate.

Note: the discount rates table of present value attached above.

c) You need to comment on your answer in 1 and recommend which investment should be undertaken. The comments should include a discussion of the main advantages and disadvantages of the two methods and a conclusion stating the reasons for selecting one of the investments considering the two methods.

d) In order to obtain a reliable result using any of the investment appraisal methods, you need to consider all relevant cash inflows & outflows relevant to the projects under consideration. Sunk costs, working capital and residual values are examples of such items.

You need to evaluate and discuss each of these three items in terms of their relevancy to the investment appraisal calculation and, briefly explain the rationale behind taking or not taking each into consideration during the computation of the two methods calculated above in a).