Question

Towy Ltd is a chemical company that has grown rapidly in recent years by successfully exploiting a number of innovative products generated by research and development its department. The latest of these products has just completed the final stages of its trials and a decision must now be taken whether or not to proceed to the manufacture of the product. The decision is more difficult in this case than for other products develop by the R&D department. The marketing of a similar product by a rival company has resulted in the downward revision of expected sales. A director has suggested that as the product is now likely to be less profitable than the company’s current range of products it should not be manufactured, primarily because it will bring down the company’s rate of return on capital employed. He has also observed that if the development of the rival product had been anticipated it is very unlikely that the development of the product would have been undertaken in the first place. The product’s development has already cost the company NZ$700,000 and it is unlikely that it will be possible to recover this outlay by proceeding to the manufacture stage. The manufacture of the product will require as outlay of NZ$1 million on a production line. This expenditure could be depreciated for tax purposes over a ten year period, but the anticipated commercial life of product given the level of product innovation in the area is only four years. The residual (re-sale) value of the production line is expected to be NZ$250000. The production line would be located in one of the company’s existing production facilities with considerable spare capacity. The product is expected to sell for NZ$18.00 per unit and sales of 50,000 units are anticipated for the first year. For years two to four sales to 60,000 units are expected. The estimated variable costs, covering inputs of materials, labour, and power requirements, are NZ$8.00 per unit. The fixed costs of production directly related to the product are expected to NZ$80,000 per annum. Working capital of NZ$70,000 will be required at the start of the first year and this will increases to NZ$84,000 at the end of the first year. Promotion and marketing expenditure prior to the introduction of the production will cost NZ$100,000 and a further expenditure of NZ$30,000 per annum will be required for the next four years. The company requires an expected return of 14 per cent on investments and pays tax at 30 per cent.

Required:

Using the information above determine the following:

a) Pay-back period

b) Discounted pay-back period

c) Net present value (NPV)

d) Internal Rate of Return (IRR)

Answer 1

YEAR	0	1	2	3	4
Initial cost	-1000000
Working capital	-80000	-4000
Initial promotion post tax	-70000
Sales		900000	1080000	1080000	1080000
Less: Variable cost		400000	480000	480000	480000
Less: Fixed cost		80000	80000	80000	80000
Depreciation		100000	100000	100000	100000
Promotion and marketing		30000	30000	30000	30000
Net Income before tax		290000	390000	390000	390000
Less: Tax		87000	117000	117000	117000
PAT		203000	273000	273000	273000
Add: Depreciation		100000	100000	100000	100000
Cash flow		303000	373000	373000	373000
Resale value					355000
Working capital recovery					84000
Net Cash flows	-1150000	299000	373000	373000	812000
Discounted cash flow	$             (1,150,000.00)	$ 262,280.70	$ 287,011.39	$ 251,764.38	$ 480,769.19
NPV	$                  131,825.65
IRR	18.65%

Payback period:

Amount recovered in 3 years = 1,045,000

Balance recovery required= 1150000-1045000 = 105000

Payback period = 3 years + 105000/812000 = 3.13 years

Discounted payback

Amount recovered in 3 years = 801056.47

Balance recovery required= 1150000-801056.47= 348943.53

Payback period = 3 years + 10348943.53/480769.19 = 3.73 years

NOTES

Sunk cost of NZ$700000 will be ignored.

Initial promotion cost of 100000 is assumed to have tax saving of 30%. Hence actual expense will be $70000

Resale value = 250000 where as book value = 100000-400000= $600000.

Hence there is tax saving of 30% on loss of sale = 30%*(600000-250000)

Formulas used for computation attached