Question

Cantelevellers plc’s primary financial objective is to maximize the wealth of its shareholders. The business specializes in the development and assembly of high quality television sets. It normally subcontracts manufacture of the components of each set, carrying out the final assembly itself.

Recently the business has developed a new TV set that has been named Flatview and a decision now needs to be taken as to whether to take it into production. The following data are available:

1. If the decision is taken to go into production with the Flatview, production and sales will start on 1 January 20X4 and end in 20X8. It is estimated that each set will be sold for £2,000. It is also estimated that the annual production and sales of Flatview televisions will be a steady 1,500 units for each of the five years.
   
2. Development and market research in relation to the Flatview were undertaken during 20X3. The cost of these total £3 million. It is the business’s policy to write off all such costs against profits as they are incurred. Of the £3 million, £1.8 million was an apportionment of development department overheads. The remaining £1.2 million was spent on materials and services, including a market survey, which were purchased specifically in respect of the Flatview project.
   
3. Assembly of the Flatview would take place in premises leased specifically for the assembly work, separate from the business’s main premises. The directors believe that suitable premises could be leased at an annual rent of £450,000, payable annually in advance.
   
4. Labor for the Flatview project is available from the business’s existing staff. If the project is not undertaken the staff involved will be declared redundant on 31 December 20X3 and paid a total of £250,000 in compensation at that time. If the project goes ahead the total incremental cost of employing the staff concerned is estimated at £200,000 per annum throughout the duration of the project. At the end of the project the staff concerned will all be made redundant, with estimated total compensation cost of £300,000 payable at that point.
   
5. Assembly of each Flatview set requires the use of a number of different bought-in components. Tenders have been obtained from the business’s normal suppliers, and the lowest total purchase cost of all of the components necessary to make one Flatview is £380. This figure includes £120 for component F451. This component is the only one of which the business already has a stock since 500 units of F451 are held in stock as the result of a surplus from a previous project. These originally cost £80 each. If the Flatview project does not proceed, the only possible use for these stock items has been identified as selling them back to the original manufacturer at a price of £100 each, with the buyer bearing transport costs. Since the manufacturer cannot use these items until the end of 20X5, delivery and payment will not take place before that time. There are no incremental storage costs involved with retaining this stock until 20X5.
   

Each Flatview set requires the use of one component F451.

6. Incremental overheads associated with the Flatview project are expected to cost £200,000 for each year of production.
   
7. Plant and machinery will have to be bought and paid for on 1 January 20X4. The total cost will be £5 million, which includes all installation costs. It is estimated that at the end of the Flatview manufacturing project (20X8) the plant will have a disposal value of £1 million.
   
8. The directors judge that the Flatview project will cost 15 percent per annum to finance.

Prepare a schedule that derives the annual net relevant cash flows arising from the Flatview project, and use this to assess the project on the basis of its net present value as at 31 December 20X3.

Ignore any factors (such as taxation) that are not referred to in the question.

Answer 1

1) What i the Net Relevant Cash flow arising from Flatview Project.

The following table shows the calculation for Flatview project.

Particulars	2013	2014	2015	2016	2017	2018
Sales in Units - A	£                           -	1,500	1,500	1,500	1,500	1,500
Selling price per unit - B	£                           -	£                    2,000	£                    2,000	£                    2,000	£                    2,000	£                    2,000
Sales in value C = AxB	£                           -	£            3,000,000	£            3,000,000	£            3,000,000	£            3,000,000	£            3,000,000
F451 Material cost per Unit - D	£                           -	£                        120	£                        120	£                        120	£                        120	£                        120
Other Mateial cost per Unit - E	£                           -	£                        260	£                        260	£                        260	£                        260	£                        260
F451 Material quantity required - F	£                           -	1,000	1,500	1,500	1,500	1,500
F451 Material cost G = D x F	£                           -	£               120,000	£               180,000	£               180,000	£               180,000	£               180,000
Other Material cost H = Ax E	£                           -	£               390,000	£               390,000	£               390,000	£               390,000	£               390,000
Opportunity cost on F451* - 500 Units @ 100/Unit - I	£                           -	£                           -	£                  50,000	£                           -	£                           -	£                           -
Total Material cost J = G+H+I	£                           -	£               510,000	£               620,000	£               570,000	£               570,000	£               570,000
Labour cost - K	£                           -	£               200,000	£               200,000	£               200,000	£               200,000	£               200,000
Overhead - L	£                           -	£               200,000	£               200,000	£               200,000	£               200,000	£               200,000
Lease rent -M	£                           -	£               450,000	£               450,000	£               450,000	£               450,000	£               450,000
Cash from Operation N = C-J-K-L-M	£                           -	£            1,640,000	£            1,530,000	£            1,580,000	£            1,580,000	£            1,580,000
Initial Outflow - O	-£           4,750,000	£                           -	£                           -	£                           -	£                           -	£                           -
Salvage Value - P	£                           -	£                           -	£                           -	£                           -	£                           -	£               700,000
Net Relevant Cash flow N+O+P	-£           4,750,000	£            1,640,000	£            1,530,000	£            1,580,000	£            1,580,000	£            2,280,000

Note:

i) The following costs are not considered as these are not relevant.

Type of cost	Amount in £	Reason for not considering
Development and market research	3,000,000	It is a sunk cost as it is already incurred. Hence it is not considered.

ii) Initial outflow

Initial Outflow	2013
Purchase of Machine	-£       5,000,000
Savings on Labour compensation	£            250,000
Total Initial Outflow	-£       4,750,000
iii) Terminal Flow
Terminal Flow	2018
Sale of Machine	£        1,000,000
Compensation to Labourers	-£           300,000
Total Terminal flow	£            700,000

* iv) Opportunity cost on Material F451 - If the project doesnot go ahead, the stock of 500 units of F451 could have been retrurned to the supplier at £100 per unit. This is an opportunity cost and hence relevant for this project. It has been considered as outflow in 2015.

2) What is the Net Present Value (NPV) of the Project.

NPV of the project is derived at by discounting the relevant cash flows with the discounting factor (in this case, it will be 15%). The following table shows the NPV for the project.

Year	Cash flow - A	Discounting factor @ 15% - B	PV - AxB
2013	-£ 4,750,000	1	-£     4,750,000
2014	£ 1,640,000	0.870	£      1,426,087
2015	£ 1,530,000	0.756	£      1,156,900
2016	£ 1,580,000	0.658	£      1,038,876
2017	£ 1,580,000	0.572	£          903,370
2018	£ 2,280,000	0.497	£      1,133,563
		NPV (Sum)	£          908,795

Discounting factor = 1/(1+i)^n
i = Discounting rate (in this case 15%)
n = Period (in this case 1 to 5).

Conclusion - Since the NPV is positive,  Cantelevellers plc can proceed with the Flatview project.