Question

Question 1

ERS Ltd is considering the launch of a new product after an extensive market research whose costs were K20, 000. The research cost is due for payment in a months’ time. Based on the research findings, as well as internal management accounting information relating to costs, the assistant accountant prepared the following forecasts for the product.

Year 1 2 3 4

Sales 180,000 200,000 160,000 120,000

Cost of sales. (115,000) (140,000) (110,000) (85,000)

Variable overheads. (27,000) (30,000) (24,000) (18,000)

Fixed overheads. (25,000) (25,000) (25,000) (25,000)

Market research cost expensed. (20,000)

Net profit/ (loss). (7,000) 5,000 1,000 (8,000)

The CEO pointed out that the product achieved profits in only two years of its four-year life and that over the four-year period as a whole, a net loss was expected. However, before a meeting that had been arranged to decide formally the future of the product, the following additional information became available:

• The new product will require the use of an existing machine. This machine was acquired some time back for K400,000 and has since been depreciated down value to a book value of K80,000. The machine can be sold for K70,000 immediately if the new product is not launched. If the product is launched, it will be sold at the end of the four-year period for K10,000.

• Additional working capital of K30,000 will be required immediately and will be needed over the four-year period. It will be released at the end of the period.

• The fixed overheads include a figure of K15,000 per year for depreciation of the machine and K5,000 per year for the re-allocation of existing overheads of the business. The company has a cost of capital of 10%. Ignore taxation.

Required:

a) Identify the relevant cash flows associated with the decision to launch the product and determine the net cash flows for years 1 to 4.

b) Calculate the Net present value (NPV) and the approximate internal rate of return (IRR) of the product and comment (with reasons) whether or not the product should be launched.

c) Outline the strengths the NPV over the IRR method as a basis for investment appraisal.

d) Briefly discuss how the firm’s investment decision influences its financing decisions.

Answer 1

Answer a:

The relevant cash flows associated with the decision to launch the product are:

1. Current market value of machine
2. Increase in working capital / Release of working capital
3. Sales
4. Cost of Sales
5. Variable Overheads
6. Fixed overhead of K5,000
7. Salvage value at the end of year 4

The cash flows related to 'Market research cost expensed' and  're-allocation of existing overheads of the business' are not relevant as the same are incurred irrespective of whether the company launches the new product or not. Depreciation being non-cash expenditure and since tax is ignored, depreciation is also not relevant.

Net cash flows for years 1 to 4 are as below:

Answer b):

Net Present Value (NPV) and internal rate of return (IRR) are calculated as below:

NPV is positive and IRR (at 10.44%) is higher than the cost of capital (of 10%). Hence new product should be launched.

Answer d:

Strengths the NPV over the IRR method:

NPV gives addition to shareholders value in terms of absolute amount and as such consistent with normal objective of firm's which is to increase in shareholders' value. IRR gives % return where NPV equal zero.

IRR is complex. Some situations where cash flows are uneven (cash flow pattern which are not normal) and where cash flows are mix of positive and negative values, may result in multiple IRRs. This is not the case for NPV.

Answer d:

Firm’s investment decision may influence its financing decisions:

1. Duration /useful life of investment influences the duration of financing required.

2. Cash flow pattern may influence financing decision. A higher cash flow may suit to financing decision where interest and portion of principal can be repaid yearly.

3. The risk/return profile of investment decision may influence financing decision.