Question

Jupiter Manufacturing Company has developed a new detergent that can be sold for KES400 per unit. The detergent is expected to continue gaining popularity for many years. The Chief Finance Officer has, however, proposed that investment in the new product should be evaluated over a four-year time-horizon, (even though sales would continue after the fourth year), on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both in current price terms) are as follows:

Sales volume (units)	Less than 1 million	1 to 1.9 million	2 to 2.9 million	3 to 3.9 million
Variable cost (KES per unit)	250	270	280	300
Total fixed cost (KES)	5 million	5. 8 million	6.8 million	7.8 million

The forecasted sales volumes are as follows:

Year	1	2	3	4
Demand (units)	700,000	1,200,000	1,600,000	2,200,000

The machinery required for production of the new detergent line would cost KES 200 million. An additional initial investment of KES125 million will be needed for working capital. Jupiter Manufacturing Company pays corporate tax at the rate of 30% per year, payable one year in arrears.

Selling price and cost information are in current price terms, before applying selling price inflation of 6% per year, variable cost inflation of 4 % per year and fixed cost inflation of 6% per year. Plato Manufacturing Company uses an after-tax cost of capital of 14% to appraise all new capital projects.

Assume that production lasts for only the four years under consideration above, calculate the NPV of investing in the new machine and advice if it’s financially acceptable (work to two decimal places).

Answer 1

Sol in excel:

Formula in excel:

Price or cost per unit is derived by multiplying the inflation effect.

Earnings after tax are the after tax cash flows per year

NPV = -Initial Cost + [Cash Flow of year 1 / (1+r)] + [Cash Flow of year 2 / (1+r)²] + [Cash Flow of year 3 / (1+r)³] + [Cash Flow of year 4 / (1+r)⁴]