Question

SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle due to rapidly changing technology. The machine is expected to cost Rs.1 million. Production and sales of product P are forecast to be as follows:

Year - Production and sales (units(year)                         

1 - 90,000

2 - 53,000

3 - 75,000

4 - 36,000

The selling price of product P (in current price terms) will be Rs. 20 per unit, while the variable cost of the product (in current price terms) will be Rs. 12 per unit. Selling price inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co has spare capacity in both space and labor terms.

Producing and selling product P will call for increased investment in working capital. Analysis of historical levels of working capital within SC Co indicates that at the start of each year, investment in working capital for product P will need to be 7% of sales revenue for that year. Assume a tax rate of 40% and capital allowance rate 25%. Further, assume that tax is paid in the same year in which it aroused.

SC Co uses a cost of capital of 15% for investment appraisal purposes.

You are required to,

(i) Calculate the net present value & internal rate of return of the proposed investment in product P.

(Please provide detailed answer)

Answer 1